Australian taxation law cases 2019 : a guide to the leading cases for business, commerce and law students [(2019 Edition)] 9780455241784, 0455241783

Citation preview

Australian Taxation Law Cases 2019 A guide to the leading cases for business, commerce and law students

Thomson Reuters (Professional) Australia Limited Level 6, 19 Harris Street Pyrmont NSW 2009 Tel: (02) 8587 7000 [email protected] https://legal.thomsonreuters.com.au For all customer inquiries please ring 1300 304 195 (for calls within Australia only)

INTERNATIONAL AGENTS & DISTRIBUTORS

NORTH AMERICA Thomson Reuters Eagan United States of America

ASIA PACIFIC Thomson Reuters Sydney Australia

LATIN AMERICA Thomson Reuters São Paulo Brazil

EUROPE Thomson Reuters London United Kingdom

Australian Taxation Law Cases 2019 A guide to the leading cases for business, commerce and law students

Kerrie Sadiq

Professor, Queensland University of Technology, QUT Business School

THOMSON REUTERS 2019

Published in Sydney by Thomson Reuters (Professional) Australia Limited ABN 64 058 914 668 Level 6, 19 Harris Street, Pyrmont, NSW Australian Income Tax Cases ......................................................... 2006 Australian Taxation Law Cases 2007 (Successor edition). ............ 2007 Australian Taxation Law Cases 2008............................................. 2008 Australian Taxation Law Cases 2009............................................. 2009 Australian Taxation Law Cases 2010............................................. 2010 Australian Taxation Law Cases 2011 ............................................. 2011 Australian Taxation Law Cases 2012............................................. 2012 Australian Taxation Law Cases 2013............................................. 2013 Australian Taxation Law Cases 2014............................................. 2014 Australian Taxation Law Cases 2015............................................. 2015 Australian Taxation Law Cases 2016............................................. 2016 Australian Taxation Law Cases 2017............................................. 2017 Australian Taxation Law Cases 2018............................................. 2018 Australian Taxation Law Cases 2019.............................................. 2019 National Library of Australia Cataloguing-in-Publication entry Sadiq, Kerrie. Australian taxation law cases: a guide to the leading cases for commerce and law students Includes index. ISBN 9780455241784 1. Income Tax – Law and legislation – Australia – Cases. I. Sadiq, Kerrie, II. Title. 343.94052 © Thomson Reuters (Professional) Australia Limited 2019 This publication is copyright. Other than for the purposes of and subject to the conditions prescribed under the Copyright Act, no part of it may in any form or by any means (electronic, mechanical, microcopying, photocopying, recording or otherwise) be reproduced, stored in a retrieval system or transmitted without prior written permission. Inquiries should be addressed to the publishers. All legislative material herein is reproduced by permission but does not purport to be the official or authorised version. It is subject to Commonwealth of Australia copyright. The Copyright Act 1968 permits certain reproduction and publication of Commonwealth legislation. In particular, s 182A of the Act enables a complete copy to be made by or on behalf of a particular person. For reproduction or publication beyond that permitted by the Act, permission should be sought in writing. Requests should be submitted online at www.ag.gov.au/cca, faxed to (02) 6250 5989 or mailed to Commonwealth Copyright Administration, Attorney-General’s Department, Robert Garran Offices, National Circuit, Barton ACT 2600. Product Developer: Lucas Frederick Publisher: Kevin Stokes Typeset in Times by Last Word, Port Melbourne, Victoria Printed by Ligare Pty Ltd, Riverwood, NSW This book has been printed on paper certified by the Programme for the Endorsement of Forest Certification (PEFC). PEFC is committed to sustainable forest management through third party forest certification of responsibly managed forests. For more info: www.pefc.org

Preface Taxation laws are creatures of statute but the scope of the laws and the meanings of their key concepts have largely been determined by the courts in leading tax cases. Even long after the legislation on which a case is based has been changed, the principles set out by the case may continue to be persuasive or even decisive as they are applied to new fact situations to be resolved under new provisions. This book focuses on two aspects of case law. The first is the continuing relevance of cases – how can decisions based on other laws (most often UK law) or on sections that have been repealed or amended be used today? The second focus of the book is on today’s tax law. In particular, it shows how later cases or changes to the statute affect tax decisions and judicial doctrines. It does so by explaining how cases from the past would be decided under the current law if the facts in the cases were to occur today. The prime purpose of the book is to act as a study aid for commerce and tax students. It is not a substitute for a prescribed text, casebook, or course materials, but it can and should be used to enhance those materials and provide a handy guide to understanding and using cases in commerce and law tax courses. The 2019 edition of the work incorporates materials from earlier editions, including the eleven editions prior to 2018 prepared by Richard Krever dating from 2007 to 2017 and the first edition prepared by him with Celeste Black in 2006. The work continues to reflect Richard Krever’s foundation and development of this text with Celeste Black’s contributions as a key reference work in the field. This fourteenth edition also benefits from Richard Krever’s very helpful suggestions as well as feedback by a number of colleagues, friends, and users. Peter Mellor’s assistance with this edition was particularly valuable. Kerrie Sadiq 1 January 2019

v

ABBREVIATIONS The following abbreviations are used in case summaries: ITAA 1915 = Income Tax Assessment Act 1915 ITAA 1922 = Income Tax Assessment Act 1922 ITAA 1936 = Income Tax Assessment Act 1936 ITAA 1997 = Income Tax Assessment Act 1997 FBTAA = Fringe Benefits Tax Assessment Act 1986 TAA 1953 = Taxation Administration Act 1953 GST Act = A New Tax System (Goods and Services Tax) Act 1999

vi

Table of Contents Preface......................................................................................................................... v

Chapter 1 Constitutional Issues WHAT IS A TAX? ........................................................................................... 2 Roy Morgan Research (2011) .......................................................... 2 CONSTITUTIONAL CONCEPT OF INCOME.......................................... 3 Benefit from the Use of Property .......................................................... 3 Harding (1917) ................................................................................ 3 Deemed Dividends .................................................................................4 Resch (1942) .................................................................................... 4 Capital Gains ......................................................................................... 5 South Australia v Commonwealth (1992) ........................................ 5 DISCRIMINATION BETWEEN STATES .................................................. 6 Cameron (1923) ............................................................................... 6 Fortescue Metals Group Ltd (2013) ................................................ 7 CONSTITUTIONAL VALIDITY OF ADDITIONAL TAX ....................... 7 Minimum Additional Tax .......................................................................8 Re Dymond (1959) ........................................................................... 8 COMMONWEALTH TAKEOVER OF THE INCOME TAX .................... 8 South Australia & Anor v The Commonwealth (1942) .................... 9

Chapter 2 Judicial Concept of Ordinary Income ORDINARY INCOME AND CAPITAL GAINS ...................................... 12 Eisner v Macomber (1920) ............................................................ 12

© Thomson Reuters 2019

vii

AUSTRALIAN TAXATION LAW CASES 2019

THE THREE TESTS FOR ORDINARY INCOME: PERIODICITY, SOURCE, OR COMPENSATION .............................................................. 13 Periodicity ........................................................................................... 14 Keily (1983) ................................................................................... 14 Derived from a Source ........................................................................ 14 Federal Coke Co Pty Ltd (1977) ................................................... 14 Compensation ...................................................................................... 15 Scott (1935) ................................................................................... 15 MUTUALITY ............................................................................................... 16 Bohemians Club (1918) ................................................................. 16 Sydney Water Board Employees’ Credit Union Ltd (1973) ........... 17 Royal Automobile Club of Victoria (1974) .................................... 18

Chapter 3 Income from Personal Services and Employment GIFTS OR INCOME? .................................................................................. 21 Hayes (1956) ................................................................................. 22 Laidler v Perry (1966) ................................................................... 23 Scott (1966) ................................................................................... 24 Smith (1987) .................................................................................. 25 Brown (2002) ................................................................................. 26 PERIODIC PAYMENTS .............................................................................. 27 Dixon (1952) .................................................................................. 27 Harris (1980) ................................................................................ 29 Blake (1984) .................................................................................. 29 COMPENSATION PAYMENTS ................................................................. 30 Phillips (1936) ............................................................................... 30 Bennett (1947) ............................................................................... 31 TIPS ............................................................................................................... 32 Calvert (Inspector of Taxes) v Wainwright (1947) ........................ 32 WINDFALL PRIZES OR INCOME ........................................................... 32 Kelly (1985) ................................................................................... 33 FREQUENT FLYER BENEFITS ............................................................... 33 Payne (1996) ................................................................................. 34 CAPITAL OR INCOME: SELLING PERSONAL KNOWLEDGE ........ 35 Brent (1971) ................................................................................... 35 CAPITAL OR INCOME: NEGATIVE COVENANTS BY EMPLOYEES AND CONTRACTORS ...................................................... 36 Higgs (Inspector of Taxes) v Olivier (1952) .................................. 36 Woite (1982)................................................................................... 37 viii

© Thomson Reuters 2019

TABLE OF CONTENTS

CAPITAL OR INCOME: PAYMENTS AFTER CESSATION OF EMPLOYMENT ........................................................................................... 38 Blank (2016) .................................................................................. 38 SUPERANNUATION AND RETIREMENT PAYMENTS ...................... 38 Constable (1952) ........................................................................... 39 Reseck (1975) ................................................................................ 40 FRINGE BENEFITS IN KIND AND FRINGE BENEFITS TAX ........... 40 The “Cash or Convertible into Cash” Doctrine................................... 41 Tennant v Smith (Surveyor of Taxes) (1892) .................................. 41 Employee Share Benefits .................................................................... 42 Abbott v Philbin (Inspector of Taxes) (1961) ................................ 42 Indooroopilly Children Services (Qld) Pty Ltd (2007) .................. 44

Chapter 4 Income from Business and Gains from the Sale of Assets BUSINESS INCOME – THE CASH OR CONVERTIBLE REQUIREMENT .......................................................................................... 50 Cooke and Sherden (1980) ............................................................ 50 THE INDICIA OF CARRYING ON A BUSINESS .................................. 51 The Indicia of Carrying on a Business: Gambling .............................. 52 Trautwein (1936) ........................................................................... 52 Martin (1953) ................................................................................ 53 Evans (1989) .................................................................................. 53 Brajkovich (1989) .......................................................................... 54 The Indicia of Carrying on a Business: Sportspersons ....................... 55 Stone (2005)................................................................................... 55 The Indicia of Carrying on a Business: Land Sales ............................ 56 Scottish Australian (1950) ............................................................. 56 Whitfords Beach (1982) ................................................................. 58 Crow (1988) ................................................................................... 59 Casimaty (1997) ............................................................................ 60 The Indicia of Carrying on a Business: Investment ............................ 60 Trent Investments Pty Ltd (1976) ................................................... 60 London Australia Investment Co Ltd (1977) ................................. 61 Radnor Pty Ltd (1991) ................................................................... 62 AGC (Investments) Ltd (1992)....................................................... 63 ILLEGAL ACTIVITIES .............................................................................. 64 Partridge v Mallandaine (1886) .................................................... 64 ISOLATED TRANSACTIONS BY A BUSINESS .................................... 65 Commercial Transactions .................................................................... 65 Californian Copper Syndicate v Harris (1904) ............................. 65 Ducker (CIR) Rees Roturbo Development Syndicate Ltd (1928) .. 66 © Thomson Reuters 2019

ix

AUSTRALIAN TAXATION LAW CASES 2019

Myer Emporium Ltd (1987) ........................................................... 67 Westfield Ltd (1991) ....................................................................... 69 Henry Jones (IXL) Ltd (1991) ....................................................... 70 Sales of Know-How ............................................................................ 71 Evans Medical Supplies Ltd (1957) ............................................... 71 Rolls-Royce (1962) ........................................................................ 72 Lease Incentives and Fit Outs ............................................................. 73 Cooling (1990)............................................................................... 73 Rotherwood (1996) ........................................................................ 74 Lees & Leech (1997) ..................................................................... 75 Selleck (1997) ................................................................................ 77 Wattie (1998) ................................................................................. 78 Montgomery (1999) ....................................................................... 79 Payments for Negative Covenants ...................................................... 80 Dickenson (1958)........................................................................... 80 MIM Holdings Ltd (1997) ............................................................. 81 FOREIGN EXCHANGES GAINS AND LOSSES ................................... 82 International Nickel Australia Ltd (1977) ..................................... 82 ISOLATED TRANSACTIONS BY AN INDIVIDUAL ........................... 83 Profit-Making Schemes ....................................................................... 84 McClelland (1970)......................................................................... 84 Property Acquired with the Purpose of Resale at a Profit ................... 85 Steinberg (1975) ............................................................................ 86 REVENUE ASSETS .................................................................................... 87 Colonial Mutual Life Assurance Society Limited (1946) .............. 87 Chamber of Manufactures Insurance Ltd (1984) .......................... 88 INDEMNITIES AND REIMBURSEMENTS ............................................ 89 Allsop (1965) ................................................................................. 89 HR Sinclair & Son Pty Ltd (1966) ................................................. 90 National Commercial Banking Corp of Australia Ltd (1983) ....... 91 TNT Skypak International (Aust) Pty Ltd (1988)........................... 92 Warner Music Australia Pty Ltd (1996) ........................................ 93 Rowe (1997)................................................................................... 94 Denmark Community Windfarm (2018) ........................................ 95 CSR Ltd (2000) .............................................................................. 95 GOVERNMENT SUBSIDIES .................................................................... 97 GP International Pipecoaters Ltd (1990) ...................................... 97 First Provincial Building Society Ltd (1995) ................................ 98 COMPENSATION FOR LOST PROPERTY ............................................. 99 Characterisation of Compensation ...................................................... 99 Glenboig Union Fireclay Co Ltd (1922) ....................................... 99 Undissected Receipts ........................................................................ 100 McLaurin (1961) ......................................................................... 100 x

© Thomson Reuters 2019

TABLE OF CONTENTS

Compensation for Delayed Payment ................................................. 101 Federal Wharf Co Ltd v Deputy FCT (1930) .............................. 101 Northumberland Development Co Pty Ltd (1995) ...................... 102 COMPENSATION FOR DEFAMATION ................................................ 103 Sydney Refractive Surgery Centre Pty Ltd (2008) ....................... 103 COMPENSATION FOR CONTRACT TERMINATION ....................... 104 Californian Oil Products Ltd (in liquidation) (1934) .................. 104 Van den Berghs Ltd v Clark (Inspector of Taxes) (1935) ............ 105 Fleming & Co (1952) .................................................................. 106 Heavy Minerals (1966) ................................................................ 107 Allied Mills Industries Pty Ltd (1989) ......................................... 108 SALE OF RENTAL EQUIPMENT ........................................................... 109 Memorex Pty Ltd (1987) .............................................................. 109 Cyclone Scaffolding Pty Ltd (1987) ............................................ 110 GKN Kwikform Services Pty Ltd (1991) ..................................... 111 Hyteco Hiring Pty Ltd (1992) ...................................................... 112

Chapter 5 Income from Property and Instalment Sales of Property ROYALTIES �� CAPITAL GAINS ........................................................... McCauley (1944) ......................................................................... Stanton (1955) ............................................................................. Ashgrove Pty Ltd (1994) ..............................................................

117 117 118 119

BENEFITS FROM SHARE OWNERSHIP ............................................. 120 McNeil (2007) .............................................................................. 121 PREMIUMS AND DISCOUNTS ON DEBT INSTRUMENTS ............ 122 Return by Way of a Discount and Interest ........................................ 122 Lomax (Inspector of Taxes) v Peter Dixon and Son Ltd (1943) .. 122 Return by Way of a Discount Only ................................................... 123 Hurley Holdings (NSW) Pty Ltd (1989) ...................................... 123 DEALINGS IN DEBT................................................................................ 124 Cancellation of Debt.......................................................................... 124 Jackson v British Mexican Petroleum Co Ltd (1932) .................. 124 Tasman Group Services (2009).................................................... 125 Repurchase of Debt ........................................................................... 126 Mutual Acceptance (1984)........................................................... 126 Debt Defeasance................................................................................ 127 Orica (1998) ................................................................................ 127

© Thomson Reuters 2019

xi

AUSTRALIAN TAXATION LAW CASES 2019

FINANCE LEASES, INSTALMENT SALES, IMPLICIT, AND INTEREST ANNUITIES ........................................................................... 128 Finance Leases .................................................................................. 128 Citibank Ltd & Ors (1993) .......................................................... 129 Sales of Property for a Series of Payments ....................................... 130 Foley (Lady) v Fletcher (1858) ................................................... 130 Secretary of State in Council of India v Scoble (1903) ............... 131 Egerton-Warburton (1934) .......................................................... 132 Just (1949) ................................................................................... 133 Vestey (1962) ............................................................................... 134 Moneymen (1990) ........................................................................ 135 Income from a Financial Arrangement – Annuity or Blended Payment Loan.................................................................................... 136 ANZ Savings Bank (1993) and (1998) ......................................... 137

Chapter 6 Capital Gains ORIGINAL PART IIIA CGT RULES ....................................................... 141 Hepples (1991) ............................................................................ 141 CORE PROVISIONS ................................................................................. 142 Assets ................................................................................................ 142 O’Brien v Benson’s Hosiery (Holdings) Ltd (1980) ................... 142 Cost of Assets .................................................................................... 143 Granby (1995) ............................................................................. 143 Time of Acquisition ........................................................................... 144 Elmslie (1993) ............................................................................. 144 McDonald (1998) ........................................................................ 145 Time of Disposal ............................................................................... 146 Sara Lee Household & Body Care (Australia) Pty Ltd (2000) ... 146 Granting of a Lease ........................................................................... 147 Gray (1989) ................................................................................. 147 Deposit Forfeiture ............................................................................. 148 Brooks (2000) .............................................................................. 148 CONCESSIONS ......................................................................................... 149 Murry (1998) ............................................................................... 149

Chapter 7 General Deductions THE APPORTIONMENT FORMULA..................................................... 154 Ronpibon Tin NL (1949) .............................................................. 154

xii

© Thomson Reuters 2019

TABLE OF CONTENTS

CONNECTION WITH INCOME DERIVATION ................................... 155 Expenses Incurred to Reduce Future Expenses ................................ 155 W Nevill & Co Ltd (1937) ........................................................... 155 Connection in Time – Expenses Related to Future Income .............. 156 Softwood Pulp and Paper Ltd (1976) .......................................... 156 Steele (1999) ................................................................................ 157 Connection in Time – Expenses Related to Obtaining Employment ... 157 Maddalena (1971) ....................................................................... 157 Spriggs; Riddell (2009) ................................................................158 Connection in Time – Expenses Related to Previous Business ........ 159 Amalgamated Zinc (de Bavay’s) Ltd (1935) ................................ 159 AGC (Advances) Ltd (1975) ........................................................ 159 EA Marr and Sons (Sales) Ltd (1984) ......................................... 160 Placer Pacific Management Pty Ltd (1995) ................................ 162 Brown (1999) ............................................................................... 162 Jones (2002) ................................................................................ 163 Connection to Anticipated Indirect Derivation of Income ................ 164 Total Holdings (Aust) Pty Ltd (1979) .......................................... 164 Spassked Pty Ltd (2003) .............................................................. 165 Need for Current Liability ................................................................. 166 Foxwood (Tolga) Pty Ltd (1981) ................................................. 166 Life and Disability Insurance Premiums ........................................... 168 Wells (1971) ................................................................................. 168 DP Smith (1981) .......................................................................... 168 Theft Losses and Misappropriations ................................................. 169 Charles Moore & Co (WA) Pty Ltd (1956) ...................................169 Lean (2010) ..................................................................................170 QUASI-PERSONAL EXPENSES ............................................................ 170 Damages for Negligence ................................................................... 171 Strong & Co Ltd v Woodifield (1905) .......................................... 171 Herald & Weekly Times (1932).................................................... 172 Fines for Illegal Activities ................................................................ 173 Madad Pty Ltd (1984) ................................................................. 173 Legal Expenses for Alleged and Actual Illegal Activities ................. 174 Snowden & Willson Pty Ltd (1958) ............................................. 174 Magna Alloys & Research Pty Ltd (1980) ................................... 174 Day (2008) ................................................................................... 176 Expenses Incurred by Illegal Businesses ...........................................177 La Rosa (2003) ............................................................................ 177 Repaying Clients’ Losses from a Partner’s Defalcations .................. 178 Ash (1938) ................................................................................... 178 Sweetman (1996) ......................................................................... 178 BUSINESS INDICIA vs HOBBY OR PERSONAL EXPENSES .......... 179 Thomas (1972) ............................................................................. 180 Ferguson (1979) .......................................................................... 180 Walker (1985) .............................................................................. 181 © Thomson Reuters 2019

xiii

AUSTRALIAN TAXATION LAW CASES 2019

AVOIDANCE-TAINTED DEDUCTIONS .............................................. 182 Income-Splitting Service Trust ......................................................... 183 Phillips (1978) ..............................................................................183 Transfer Pricing ................................................................................. 184 Europa Oil (NZ) Ltd (No 1) (1971) ............................................. 185 Europa Oil (NZ) Ltd (No 2) (1976) ............................................. 186 Purchase Price Paid as Revenue Outgoing........................................ 187 South Australian Battery Makers (1978) ..................................... 187 Income-Splitting Family Loan .......................................................... 188 Ure (1981) ................................................................................... 188 Prepayments ...................................................................................... 189 Ilbery (1981) ................................................................................ 189 Sale and Leaseback ........................................................................... 190 Just Jeans (1987) ........................................................................ 190 Eastern Nitrogen Ltd (2001) ........................................................ 191 Timing Mismatches ........................................................................... 192 Fletcher (1991) ........................................................................... 192 Capital Protected Loans .................................................................... 193 Firth (2002) ................................................................................ 193

Chapter 8 Private and Domestic Expenses FOOD EXPENSES ..................................................................................... 197 Cooper (1991) ............................................................................. 197 COMMUTING EXPENSES ...................................................................... 198 Lunney (1958) .............................................................................. 198 Collings (1976) ............................................................................ 198 John Holland Group (2015) ....................................................... 199 TRAVELLING BETWEEN TWO PLACES OF WORK ........................ 200 Payne (2001) ............................................................................... 200 EXPENSES TO MOVE TO A NEW PLACE OF EMPLOYMENT ...... 201 Fullerton (1991) .......................................................................... 201 CHILD CARE EXPENSES ....................................................................... 201 Lodge (1972) ............................................................................... 201 Martin (1984) .............................................................................. 202 SELF-EDUCATION EXPENSES ............................................................. 203 Hatchett (1971) ............................................................................ 203 Highfield (1982) .......................................................................... 204 Wilkinson (1983) .......................................................................... 204 Studdert (1991) ............................................................................ 205 Anstis (2010) ................................................................................ 206 TRAVEL EXPENSES ................................................................................ 206 Finn (1961) .................................................................................. 206

xiv

© Thomson Reuters 2019

TABLE OF CONTENTS

HOME OFFICE EXPENSES .................................................................... 207 Faichney (1972)........................................................................... 207 Handley (1981) ............................................................................ 209 Forsyth (1981) ............................................................................. 209 Swinford (1984) ........................................................................... 209 CLOTHING EXPENSES ........................................................................... 210 Mallalieu v Drummond (1983) .................................................... 211 Edwards (1994) ........................................................................... 211 COSMETICS AND SUN PROTECTION EXPENSES .......................... 212 Mansfield (1995) ......................................................................... 212 Morris (2002) .............................................................................. 213 CHARITABLE GIFTS ............................................................................... 214 McPhail (1968) ............................................................................ 214

Chapter 9 Capital or Revenue Expenses THE CAPITAL vs REVENUE TESTS ..................................................... 216 Vallambrosa Rubber Company Ltd v Farmer (1910) ...................216 Sun Newspapers (1938) ............................................................... 217 Associated Portland Cement Manufacturers Ltd (1946) ............. 218 Nchanga Consolidated Copper Mines Ltd (1964)....................... 219 BP Australia Ltd (1965)............................................................... 219 Strick (Inspector of Taxes) v Regent Oil Co Ltd (1966) ...............220 National Australia Bank Ltd (1997) ............................................ 221 Star City Pty Ltd (2009) .............................................................. 222 AusNet Transmission Group (2015) ............................................ 223 Sharpcan Pty Ltd (2018) ............................................................. 224 PROTECTION OF TITLE EXPENSES ................................................... 225 Southern v Borax Consolidated Ltd (1941) ................................. 225 Hallstroms Pty Ltd (1946) ........................................................... 226 John Fairfax & Sons Pty Ltd (1959) ........................................... 227 Broken Hill Theatres Pty Ltd (1952) ........................................... 228 Consolidated Fertilizers Ltd (1991) ............................................ 229 MOVING EXPENSES ............................................................................... 230 Lister Blackstone Pty Ltd (1976) ................................................. 230 PURCHASES OF PROPERTY FOR A SERIES OF PAYMENTS ........ 230 Egerton-Warburton (1934) .......................................................... 230 Ramsay (1935) ............................................................................. 232 Colonial Mutual Life Assurance Society Ltd (1953) ................... 233 Cliffs International Inc (1979)..................................................... 234

© Thomson Reuters 2019

xv

AUSTRALIAN TAXATION LAW CASES 2019

Chapter 10 Specific Deductions REPAIRS OR IMPROVEMENTS ............................................................ 238 Law Shipping Co Ltd (1923) ....................................................... 238 Rhodesia Railways Ltd (1933)..................................................... 239 Western Suburbs Cinemas Ltd (1952) ......................................... 240 Lindsay (1961) ............................................................................. 241 W Thomas & Co Pty Ltd (1966) ...................................................242 Odeon Associated Theatres (1973) .............................................. 243 CAPITAL ALLOWANCES ....................................................................... 243 Quarries Ltd (1961) ..................................................................... 244 Wangaratta Woollen Mills Ltd (1969) ......................................... 244 Imperial Chemical Industries of Australia and New Zealand Ltd (1970) ................................................................................ 245 BHP Billiton Ltd (2011) .............................................................. 246 BAD DEBTS ............................................................................................... 247 Point (1970) ................................................................................. 247 GE Crane Sales (1971) ................................................................ 248 BHP Billiton Finance Ltd (2010) ................................................ 249 TAX LOSSES .............................................................................................. 249 WE Fuller Pty Ltd (1959) ............................................................ 250

Chapter 11

Tax Accounting and Income Assignments

INCOME RECOGNITION – CASH OR ACCRUAL ACCOUNTING .......................................................................................... 253 Cash or Accrual Recognition............................................................. 253 Carden’s case (1938) ................................................................... 253 Firstenberg (1976) ....................................................................... 254 Barratt (1992) .............................................................................. 254 Changing Accounting Method .......................................................... 255 Henderson (1970) ........................................................................ 255 Dormer (2002) ............................................................................. 257 INCOME RECOGNITION BY ACCRUAL-BASIS TAXPAYERS .............................................................................................. 258 Prepayment for Services Provided over Years .................................. 258 Arthur Murray (NSW) Pty Ltd (1965) ........................................ 258 Invoiced Amount Subject to Discount or Rebate .............................. 258 Ballarat Brewing Co Ltd (1951) ...................................................258 Services Provided before Billing....................................................... 259 Australian Gas Light Co (1983) .................................................. 259 Sale of Trading Stock on an Instalment Basis ................................... 260 J Rowe and Son Pty Ltd (1971) ................................................... 260 xvi

© Thomson Reuters 2019

TABLE OF CONTENTS

Sale Price Disputed by the Customer ................................................ 260 BHP Billiton Petroleum (Bass Strait) Pty Ltd (2002) ................. 260 Sale of Trading Stock Subject to Settlement ..................................... 261 Gasparin (1994) .......................................................................... 261 EXPENSE RECOGNITION ...................................................................... 262 When are Expenses “Incurred” Generally? ....................................... 262 New Zealand Flax Investments Ltd (1938) ...................................262 Compound and Deferred Interest ...................................................... 263 Australian Guarantee Corporation Ltd (1984) ............................264 Discounts in Lieu of Interest on Debt Instruments ........................... 265 Coles Myer Finance Ltd (1993) .................................................. 265 Energy Resources of Australia Ltd (1996)................................... 265 Citylink Melbourne Ltd (2006) .................................................... 266 Leave Obligations ............................................................................. 268 James Flood Pty Ltd (1934) ........................................................ 268 INCOME ASSIGNMENTS ....................................................................... 268 Assignments of Presently Existing Property Interests ...................... 269 Norman (1963) ............................................................................269 Shepherd (1965)........................................................................... 270 Assignments of Interests in Partnerships .......................................... 271 Everett (1980) .............................................................................. 271 Galland (1986) ............................................................................ 272

Chapter 12 Trading Stock WHAT IS TRADING STOCK? ................................................................. 274 St Hubert’s Island Pty Ltd (in liq) (1978) .................................... 274 Sanctuary Lakes Pty Ltd (2013) .................................................. 275 ACQUISITION OF TRADING STOCK .................................................. 276 Purchases from Associates ................................................................ 276 Cecil Bros Pty Ltd (1964) ............................................................ 276 Purchases of Trading Stock Subject to Future Delivery ................... 277 Raymor (NSW) Pty Ltd (1990) .................................................... 277 WHEN IS TRADING STOCK ON HAND? ............................................ 278 Loss of Dispositive Power over Trading Stock ................................ 278 Farnsworth (1949)....................................................................... 278 Acquisition of Dispositive Power over Trading Stock ..................... 279 All States Frozen Foods Pty Ltd (1990) ...................................... 279 Control of Trading Stock without Ownership ................................... 280 Suttons Motors (Chullora) Wholesale Pty Ltd (1985) ................. 280 VALUING TRADING STOCK ON HAND ............................................. 281 Australasian Jam Co Pty Ltd (1953) ........................................... 281 Philip Morris Ltd (1979) ............................................................. 282 © Thomson Reuters 2019

xvii

AUSTRALIAN TAXATION LAW CASES 2019

UNUSUAL DISPOSALS OF TRADING STOCK .................................. 282 Involuntary Disposals........................................................................ 282 Wade (1951) ................................................................................. 282 Disposals Outside the Ordinary Course of Business......................... 283 Pastoral and Development Pty Ltd (1971) .................................. 283

Chapter 13 Partners and Partnerships WHEN DOES A PARTNERSHIP EXIST?............................................... 286 Statutory Partnerships ....................................................................... 286 McDonald (1987) ........................................................................ 286 Yeung (1988) ................................................................................ 287 Evidence of a Partnership.................................................................. 288 Jolley (1989) ................................................................................ 288 CREATION OF A PARTNERSHIP........................................................... 289 Contributing Trading Stock and Depreciable Property ..................... 289 Rose (1951) .................................................................................. 289 CONTROL OVER THE PARTNERSHIP ................................................ 290 Robert Coldstream Partnership (1943) ....................................... 290 PARTNERSHIP PURPOSE AND ACTIONS .......................................... 291 Attributing Partnership Purpose to the Partners ................................ 291 Tikva Investments Pty Ltd (1972) ................................................ 291 Tracing the Purpose of Partnership Borrowings ............................... 292 Roberts; Smith (1992).................................................................. 292 TRANSACTIONS BETWEEN A PARTNERSHIP AND PARTNERS ................................................................................................. 293 Charging “Interest” for Excess Advances ......................................... 293 Beville (1953) .............................................................................. 293 A Partner Providing Services to the Partnership ............................... 294 Poole; Dight (1970) ..................................................................... 294 LEAVING A PARTNERSHIP.................................................................... 295 When Does a Partnership End? ......................................................... 295 Happ (1952)................................................................................. 295 WORK IN PROGRESS AND PARTNERSHIPS .................................... 296 Payments to a Departing Partner for Work in Progress..................... 296 Stapleton (1989) .......................................................................... 297 Grant (1991) ................................................................................ 297 Payments for Purchased Work in Progress........................................ 298 Coughlan (1991) .......................................................................... 298 ASSIGNMENTS OF PARTNERSHIP INTERESTS .............................. 298

xviii

© Thomson Reuters 2019

TABLE OF CONTENTS

Chapter 14 Trusts and Beneficiaries PRESENT ENTITLEMENT ...................................................................... 303 Estate Not Fully Administered .......................................................... 303 Whiting (1943) ............................................................................. 303 Beneficiaries with Contingent Interests ............................................ 304 Hobbs (1957) ............................................................................... 304 Beneficiaries Under a Legal Disability ............................................. 305 Taylor (1970) ............................................................................... 305 Crediting Trust Accounts for Beneficiaries ....................................... 306 Ward (1970) ................................................................................. 306 CONSTRUCTIVE TRUSTS ..................................................................... 307 Zobory (1995) .............................................................................. 307 TRUSTS IN FAVOUR OF THE CONTRIBUTOR’S CHILDREN ....... 308 Truesdale (1970) .......................................................................... 309 MISMATCH BETWEEN TRUST ACCOUNTING INCOME AND INCOME FOR TAX PURPOSES ............................................................. 309 Cajkusic (2006) ........................................................................... 310 Bamford (2010) .............................................................................311 SUBTRUSTS AND UNIT TRUSTS ......................................................... 313 Meaning of “Unit Trust” ................................................................... 313 ElecNet (Aust) Pty Ltd (2016) ..................................................... 313 Settlement to “Guardian” of Beneficiary .......................................... 313 Countess of Bective (1932) .......................................................... 313 Income Flows Through a Unit Trust ................................................. 314 Charles (1954) ............................................................................. 314 Income Distributed Directly to Subtrust Beneficiaries ..................... 315 Totledge Pty Ltd (1982) ............................................................... 315 STREAMING OF DISTRIBUTIONS ...................................................... 316 Thomas (2018) ............................................................................. 316

Chapter 15 Exempt Organisations Word Investments Ltd (2008) ....................................................... 320 Aid/Watch Inc (2010) ................................................................... 322

Chapter 16 Companies and Shareholders IS AN INVESTMENT IN A COMPANY A DEBT OR EQUITY INTEREST? ................................................................................................ 326 D Marks Partnership (2016) ....................................................... 326

© Thomson Reuters 2019

xix

AUSTRALIAN TAXATION LAW CASES 2019

DIVIDENDS PAID OUT OF PROFITS ................................................... 327 “Paid” Out of Profits ......................................................................... 327 Brookton Co-operative Society Ltd (1981) .................................. 328 Gift to a Company ............................................................................ 328 Slater Holdings Ltd (1984) .......................................................... 328 Cancellation of Shares....................................................................... 329 Uther (1965) ................................................................................ 329 DIVIDENDS PAID TO “SHAREHOLDERS” ........................................ 330 Patcorp (1976)............................................................................. 330 DEEMED DIVIDENDS ............................................................................. 331 Deemed Dividends on Formal Winding Up ..................................... 331 Glenville Pastoral (1963) ............................................................ 331 Gibb (1966) ................................................................................. 332 Harrowell (1967) ......................................................................... 332 Deemed Dividends on Informal Winding Up .................................. 335 Stevenson (1937) ......................................................................... 335 Blakely (1951) ............................................................................. 335 Deemed Dividends from Shareholder Loans .................................... 336 Black (1990) ................................................................................ 336 Deemed Dividends from Share Buy-backs ....................................... 336 Consolidated Media Holdings Ltd (2012) ................................... 337 CARRIED-FORWARD LOSSES .............................................................. 338 J Hammond Investments Pty Ltd (1977) ..................................... 338 Avondale Motors (Parts) Pty Ltd (1971) ..................................... 339 PRIVATE COMPANY OR PUBLIC COMPANY ................................... 340 Brookton Co-operative Society Ltd (1981) .................................. 340

Chapter 17 International Aspects of Income Taxation CORPORATE RESIDENCE ..................................................................... 345 Unit Construction Co Ltd v Bullock (Inspector of Taxes) (1960) ...................................................................................... 345 De Beers Consolidated Mines Ltd v Howe (1906) ...................... 346 Koitaki Para Rubber Estates Ltd (1940) ..................................... 347 Malayan Shipping Co Ltd (1946) ................................................ 348 Bywater Investments; Hua Wang Bank Berhad (2016) ............... 348 INDIVIDUAL RESIDENCE ..................................................................... 349 The Common Law Test – “Reside” in Australia ............................... 349 Levene (1928) .............................................................................. 349 Lysaght (1928) ............................................................................. 350

xx

© Thomson Reuters 2019

TABLE OF CONTENTS

Permanent Place of Abode ............................................................... 351 Applegate (1979) ......................................................................... 351 Jenkins (1982) ............................................................................. 352 SOURCE OF INCOME.............................................................................. 353 Income from Property and Business ................................................. 353 Nathan (1918) .............................................................................. 353 Studebaker Corporation of Australasia (1921) ........................... 353 United Aircraft Corp (1943) ........................................................ 354 Personal Service Income ................................................................... 355 French (1957) .............................................................................. 355 Mitchum (1965) ........................................................................... 356 Efstathakis (1979) ........................................................................ 357 Dividends .......................................................................................... 357 Esquire Nominees Ltd (1973) ...................................................... 357 WITHHOLDING TAX ON AUSTRALIAN-SOURCE INCOME DERIVED BY FOREIGN RESIDENTS .................................................. 359 Withholding Tax on Dividends ......................................................... 359 ABB Australia Pty Ltd (2007) ...................................................... 359 Withholding Tax on Interest .............................................................. 360 Millar (2016) ............................................................................... 360 ECONOMIC OR JURIDICAL DOUBLE TAXATION .......................... 361 Russell v FCT (2011) .................................................................. 361 TRANSFER PRICING ............................................................................... 362 Commissioner’s Right to Issue a Reassessment .............................. 362 WR Carpenter (2008) .................................................................. 362 Transfer Pricing Methodology ......................................................... 363 SNF (Australia) (2011) ................................................................ 364 Chevron Australia Holdings Pty Ltd (2017) ................................ 364 TAX TREATIES AND INTERNATIONAL AGREEMENTS ................ 366 Employment Income ......................................................................... 366 Macoun (2015) ............................................................................ 366 Jayasinghe (2017) ....................................................................... 367 Business Profits of an Enterprise ...................................................... 367 Thiel (1990) ................................................................................. 368 Virgin Holdings SA (2008) .......................................................... 368 Permanent Establishment .................................................................. 370 McDermott Industries (Aust) Pty Ltd (2005)............................... 370 Tech Mahindra (2016) ................................................................ 371 Capital Gains on the Sale of Australian Land and Land-rich Entities........................................................................................... 372 Lamesa Holdings BV (1997)........................................................ 372

© Thomson Reuters 2019

xxi

AUSTRALIAN TAXATION LAW CASES 2019

Chapter 18 Anti-avoidance Doctrines and Provisions SHAM .......................................................................................................... 376 Raftland Pty Ltd (2008) ............................................................... 377 TRADITIONAL AND NEWER UK DOCTRINES ................................ 378 The Traditional “Duke of Westminster” Doctrine ............................. 378 Duke of Westminster (1936)......................................................... 378 Fiscal Nullity and More Modern UK Statutory Interpretation.......... 379 Westmoreland Investments Ltd (2001) ......................................... 379 SECTION 260 ............................................................................................. 381 Newton (1958) ............................................................................. 381 Gulland; Watson; Pincus (1985) ................................................. 382 PART IVA .................................................................................................... 383 Can Part IVA apply if a scheme fails anyway? ................................. 384 Vincent (2002).............................................................................. 384 Can schemes be dissected to find the dominant purpose? ................ 385 Peabody (1994) ........................................................................... 385 What is the “dominant” purpose of a scheme? ................................. 387 Spotless (1996) ............................................................................ 387 Howland Rose (2002) .................................................................. 388 HowlandHart (2004) .................................................................................. 390 News Australia Holdings (2010) ................................................. 391 What is the counter-factual? .............................................................. 392 Futuris Corporation (2012) ......................................................... 392 Hart (2018) .................................................................................. 393 Dividend stripping and Part IVA ....................................................... 393 Consolidated Press Holdings Ltd (2001) .................................... 394 Imputation credits and Part IVA ........................................................ 396 Mills (2012) ................................................................................. 396

Chapter 19 Tax Administration INFORMATION SUBJECT TO LEGAL PROFESSIONAL PRIVILEGE ................................................................................................ 399 Does Privilege Apply Outside the Courtroom? ................................. 399 O’Reilly v Commissioner of the State Bank of Victoria (1982) ... 399 Baker v Campbell (1983)............................................................. 400 Opportunity to Claim Privilege ......................................................... 401 Allen Allen & Hemsley (1989) ..................................................... 401 Citibank (1989) ............................................................................ 401 “Sole” or “Dominant” Purpose of Legal Advice ............................... 402 Esso Australia Resources Ltd (1999) .......................................... 402 Documents Prepared for the Taxpayer by Third Parties ................... 403 Pratt Holdings Pty Ltd (2004) ..................................................... 403 xxii

© Thomson Reuters 2019

TABLE OF CONTENTS

Client Identification .......................................................................... 403 Coombes (No 2) (1999) ............................................................... 403 Documents Obtained for Another Purpose........................................ 404 Rennie Produce (Aust) Pty Ltd (in liq) (2018)............................. 404 ASSESSMENTS ......................................................................................... 405 Nil Assessments ................................................................................ 405 Ryan (2000) ................................................................................. 405 Asset Betterment Assessments .......................................................... 406 L’Estrange (1978) ........................................................................ 406 Double Counting Assessments .......................................................... 407 Futuris Corporation Ltd (2008) .................................................. 407 Commissioner Decisions ................................................................... 408 Pintarich (2018) ...........................................................................408 ACCESS TO BOOKS AND INFORMATION ........................................ 409 Australia and New Zealand Banking Group Ltd (1979) ............. 409 Industrial Equity Ltd (1990) ........................................................ 410 COLLECTION OF TAX DUE .................................................................. 410 Bluebottle UK Ltd (2007) ............................................................ 410 Australian Building Systems Pty Ltd (2015) .............................. 411 APPEALS .................................................................................................... 412 Appeals outside the ITAA and Tax Administration Act...................... 412 FJ Bloemen Pty Ltd (1981).......................................................... 412 David Jones Finance and Investments Pty Ltd (1991) ................ 413 Basis for Assessment on Appeal ....................................................... 415 Reynolds (1981) ........................................................................... 415 PENALTIES ................................................................................................ 416 Walstern Pty Ltd (2003) ............................................................... 416 OBLIGATION TO ISSUE A RULING ..................................................... 417 Hacon Pty Ltd (2017) .................................................................. 417

Chapter 20 GST SUPPLIES ................................................................................................... 420 Damages ............................................................................................ 421 Shaw v Director of Housing and State of Tasmania (No 2) (2001) ......................................................................................... 421 Expropriation..................................................................................... 422 CSR Ltd v Hornsby Shire Council (2004).................................... 422 Hornsby Shire Council (2008) .................................................... 423 Government Subsidies ...................................................................... 424 Secretary to the Department of Transport (Vic) (2010) ( ............... 424 Services Not Used ............................................................................. 425 Qantas Airways Ltd (2012).......................................................... 425 © Thomson Reuters 2019

xxiii

AUSTRALIAN TAXATION LAW CASES 2019

Forfeited Deposit ............................................................................... 425 Reliance Carpet Co Pty Ltd (2008) ............................................. 425 MIXED AND COMPOSITE SUPPLIES ................................................. 426 British Airways plc (1990) ........................................................... 426 Sea Containers Services Ltd (2000) ........................................... 427 Luxottica Retail Australia Pty Ltd (2011) ................................... 428 INPUT TAX CREDITS .............................................................................. 428 Rio Tinto Services (2015) ............................................................ 429 INTERNATIONAL ASPECTS OF GST .................................................. 429 Supplies of Services Connected To Australia.................................... 430 Saga Holidays Ltd (2006) ............................................................ 430 “Exported” Services .......................................................................... 431 ATS Pacific (2014) ....................................................................... 431 Travelex Ltd (2010) ..................................................................... 432 THE GST GENERAL ANTI-AVOIDANCE RULE ................................ 433 Unit Trend Services Pty Ltd (2013) ............................................. 433 Table of Cases .......................................................................................................... 435 Table of Statutes ....................................................................................................... 449 Index......................................................................................................................... 457

xxiv

© Thomson Reuters 2019

C HAPTER 1

Constitutional Issues WHAT IS A TAX? ..................................................................................................... 2 Roy Morgan Research (2011) .................................................................... 2 CONSTITUTIONAL CONCEPT OF INCOME .................................................... 3 Benefit from the Use of Property .................................................................... 3 Harding (1917) .......................................................................................... 3 Deemed Dividends ........................................................................................... 4 Resch (1942) .............................................................................................. 4 Capital Gains ................................................................................................... 5 South Australia v Commonwealth (1992) .................................................. 5 DISCRIMINATION BETWEEN STATES ............................................................. 6 Cameron (1923) ......................................................................................... 6 Fortescue Metals Group Ltd (2013) ........................................................... 7 CONSTITUTIONAL VALIDITY OF ADDITIONAL TAX ................................. 7 Minimum Additional Tax ................................................................................ 8 Re Dymond (1959) ..................................................................................... 8 COMMONWEALTH TAKEOVER OF THE INCOME TAX .............................. 8 South Australia & Anor v The Commonwealth (1942) .............................. 9

© Thomson Reuters 2019

1

C HAPTER 1

Constitutional Issues WHAT IS A TAX? Section 51(ii) of the Constitution authorises the Commonwealth Government to make laws on taxation. It is sometimes argued that the Commonwealth Government uses this power to encroach on areas of the economy that fall under State jurisdiction by imposing a “tax” that only applies if a person does not follow a Commonwealth rule that might be outside the Commonwealth’s constitutional power. Through use of a “tax”, the Commonwealth can coerce people into following its rules in areas where it may not be able to legislate directly. Taxpayers will resist these imposts by arguing they are not taxes but rather are levies that are “ultra vires” (beyond the power) of the Commonwealth Parliament.

Roy Morgan Research Pty Ltd v FCT

[2011] HCA 35; 244 CLR 97; 80 ATR 1; 2011 ATC 20-282 (Full High Court) Facts: The Commonwealth Government established a “superannuation guarantee” system that obligated employers to contribute an amount equal to a set percentage of each employee’s salary into a superannuation fund for the benefit of the employee. The obligation was enforced by a superannuation guarantee charge imposed on employers that failed to make the required contributions. The “taxpayer” in Roy Morgan was a market research company that argued its interviewers were independent contractors and not employees and, in the alternative, that in any case the superannuation guarantee charge was unconstitutional as it was not a tax but rather a charge to benefit employees. Decision: The decision of the High Court turned on the meaning of a “tax” within the Constitution and whether the amounts paid to the Commonwealth were spent on “public purposes”. The Court adopted the definition of a tax set out in an earlier High Court decision as “a compulsory exaction of money by a public authority for public purposes, enforceable by law” that is not a payment for services rendered. The High Court noted that in early decisions it had endorsed US precedents which found a tax does not cease to be valid merely because it regulates, discourages, or even definitely deters the activities taxed, even if the revenue obtained is negligible or the revenue purpose of the tax is of secondary importance. The superannuation guarantee charge 2

© Thomson Reuters 2019

CHAPTER 1

CONSTITUTIONAL ISSUES

fell within the definition of a tax. Once the money was paid into consolidated revenue, it became part of the general revenue of government and its use was for a public purpose. Relevance of the case today: The Roy Morgan case has affirmed the power of the Commonwealth to impose taxes where the primary purpose of the tax is to encourage compliance with a rule that enables the person to avoid paying the tax. The Commonwealth can use taxes of this sort to regulate in areas of the economy that might otherwise fall within State powers. If it happened today: If the facts in Roy Morgan were to happen today in respect of the superannuation guarantee charge or a similar Commonwealth impost, a court would find the charge to be a tax authorised by the Constitution.

CONSTITUTIONAL CONCEPT OF INCOME Section 55 of the Constitution provides that a tax law may not deal with more than one subject of taxation. A key constitutional question is whether section 55 restricts an “income” tax act to “income” in the narrow sense of the judicial concept of ordinary income or whether a single income tax law can include both ordinary and statutory income. Only if the constitutional notion of “income” were a broader notion akin to its economic meaning, could the ITAA validly impose tax on capital gains and other receipts outside the judicial concept of ordinary income.

Benefit from the Use of Property Harding v FCT

(1917) 23 CLR 119 (Full High Court)

Facts: The ITAA 1915 included in assessable income 5% of the capital value of owner-occupied housing as imputed income from use of one’s own property. The taxpayer argued the inclusion of an amount for the use of property was not “income” and the inclusion provision was thus unconstitutional by s 55 of the Constitution as it had the effect of introducing another subject of taxation into the ITAA. Decision: The benefit from use of one’s own property (the imputed rental value of the property) had been long subject to taxation in the UK and Australian States and had become viewed as ordinary income by most persons. The inclusion of this value in assessable income did not, therefore, infringe s 55 of the Constitution. Relevance of the case today: The benefit of the imputed rental value of owner-occupied housing is no longer included in assessable income. However, Harding remains a useful precedent to show that the constitutional concept of income may include the value of benefits from using property even if that value is not converted to cash.

© Thomson Reuters 2019

3

AUSTRALIAN TAXATION LAW CASES 2019

If it happened today: If the facts in Harding were to occur today, a court would most likely continue to hold that imputed income from household ownership continues to be within the constitutional concept of income. However, the effect of South Australia v Commonwealth (1992) 174 CLR 235 would have to be considered. The High Court in that case found capital gains tax on gains from State-owned assets to be a tax on property for the purposes of s 114 of the Constitution. It is unlikely that this conclusion would affect the current characterisation of imputed gains from property ownership as within the constitutional concept of income for s 55 purposes, but such an argument could be made.

Deemed Dividends Resch v FCT

(1942) 66 CLR 198 (Full High Court)

Facts: The taxpayer was assessed under the predecessor provision to s 47 ITAA 1936 on a distribution by a company liquidator. Such distributions were considered capital receipts and would not be included in ordinary income. They entered assessable income only because of the statutory provision. The taxpayer argued the provision that included a capital receipt in assessable income was unconstitutional, offending s 55 of the Constitution. This section prohibits taxing laws that deal with more than one subject of taxation. The taxpayer argued the income tax provision was thus invalid because it provided for the taxation of capital receipts in the income tax law. Decision: The High Court agreed that the receipts in question were not in the ordinary income concept and were included in assessable income only because of the operation of the statutory inclusion rule. However, the Court declined to apply the narrower judicial concept of ordinary income when considering the meaning of income for constitutional purposes. For the purpose of identifying a single subject of taxation under s 55 of the Constitution, an income tax could apply to “income” in the real world sense of realised gains and not merely to income in the ordinary concept sense. Thus, a measure that brought a capital receipt into assessable income was not invalid under s 55. Relevance of the case today: Since the Resch case, there has not been any dispute that it is constitutional for s 47 ITAA 1936 to treat liquidation distributions of retained profits as deemed dividends included in shareholders’ assessable income. The case stands for the broader proposition that today for constitutional purposes, “income” gains to which the ITAA can apply are wider than ordinary income. In the words of Dixon J: “The subject of the income tax has not been regarded as income in the restricted sense which contrasts gains of the nature of income with capital gains … The subject has rather been regarded as the substantial gains of persons or enterprises considered over intervals of time”. If it happened today: The same results would follow, if the case were argued today, in the context of s 47 ITAA 1936. The logic of Resch explains why the inclusion of capital gains in the ITAA is constitutionally valid.

4

© Thomson Reuters 2019

CHAPTER 1

CONSTITUTIONAL ISSUES

Capital Gains South Australia v Commonwealth

(1992) 174 CLR 235; 23 ATR 10; 92 ATC 4066

Facts: The State of South Australia and the South Australian Superannuation Fund Investment Trust (“SASFIT”) (collectively referred to here as the “taxpayer”) objected to the application of the federal income tax to income (specifically interest) and capital gains realised by the South Australian Superannuation Fund (“the Fund”). The taxpayer submitted that as the SASFIT was an agency of the State of South Australia, the Fund it managed for the State was property of the State. On this basis, the State argued the protection provided by of s 114 of the Constitution (which prohibits the Commonwealth from imposing a tax on property of any kind belonging to the State) prevented the application of the income tax to the income and capital gains of the Fund. The taxpayer argued that income tax is a tax on the ownership of property because it taxes the fruits of that property. The taxpayer also argued that the capital gains tax was a tax on property. Decision: The Court unanimously held that income tax on interest derived from money lent is not a tax on property but that income tax on net capital gains is a tax on property. In the majority opinion, the income tax imposed by the ITAA on income produced by property belonging to the taxpayer cannot be characterised generally as a tax on the ownership or holding of that property. However, it is possible that a particular relationship between a type of income and the property which produces it might be such that the income tax on that type of property is a tax on property. Therefore, the majority considered the particular case of interest on moneys lent and found that the derivation of such income was relevantly different from the ownership of property such that the tax on interest was not a tax on the property. In contrast, there were several features of the application of the income tax to net capital gains which did characterise it as a tax on property. The tax is levied on part of the proceeds of sale. The trigger for the application of the ITAA was the exercise of the right to sell the property, a right considered central to the concept of ownership. Finally, the amount of the capital gain was calculated by reference to the length of time during which the taxpayer owned the asset. When viewed in this light, the CGT is a tax on ownership of property. Relevance of the case today: The specific issue raised by this case has been resolved by legislative amendment. Section 271A ITAA 1936 was inserted after the decision to ensure that “constitutionally protected funds” (as declared in the Income Tax Regulations) are exempt from tax. It is possible that the decision of the Court that the capital gains tax is a tax on the ownership of property could be used as the basis for an argument that the inclusion of the capital gains tax provisions within the ITAA violates s 55 of the Constitution which prohibits a taxing law from dealing with more than one subject of taxation. However, such a constitutional challenge to the capital gains tax has not yet been tested in the courts. This may be in part because of a view that capital gains taxation could be a tax on property for purposes of s 114 of the Constitution but the gains could still fall within the broader concept of income within s 55 of the Constitution. © Thomson Reuters 2019

5

AUSTRALIAN TAXATION LAW CASES 2019

If it happened today: If the facts of this case were to arise today, the South Australian Superannuation Fund would be a “constitutionally protected fund” and the Fund’s income would be exempt from income tax by virtue of s 50-25, Table Item 3 ITAA 1997 and Reg 995-1-04.

DISCRIMINATION BETWEEN STATES Two provisions of the Constitution may affect the validity of tax laws if they appear to discriminate between taxpayers living in different States. Section 51(ii) of the Constitution gives the Commonwealth Parliament the power to make laws with respect to taxation, subject to the proviso that the laws may not “discriminate between States or parts of States”. A tax law that does discriminate in this manner would be invalid as “ “ultra vires” (beyond the power) of the Commonwealth Parliament. Section 99 of the Constitution prohibits the Commonwealth from enacting a trade commerce or revenue law or regulation that gives “preference to one State or any part thereof over another State or any part thereof”. Again, a tax law that discriminated in this manner would be invalid as “ “ultra vires” of the Commonwealth Parliament.

Cameron v DFCT (Tasmania) (1923) 32 CLR 68 (Full High Court)

Facts: The income tax provision measuring gains from livestock provided for the opening and closing values of livestock that was trading stock to be prescribed by regulation. The relevant income tax regulation provided different fair average values for stock of the same class in different States. The taxpayer, a pastoralist, argued that such regulations violated s 51(ii) of the Constitution. Decision: The High Court unanimously held that the regulations did violate s 51(ii) of the Constitution and were invalid. Isaacs J noted that it did not matter if the legal standards were arbitrary or measured, or whether the purpose behind them was to benefit or injure; rather, discrimination arises where different standards are applied depending on whether a taxpayer is located in one State or another. Relevance of the case today: Cameron is relevant for its discussion of the standards to be applied in determining if a taxation law (or regulation) violates s 51(ii) of the Constitution. The Court adopted the following definition from the opinion of Isaacs J in Barger’s Case (1908) 6 CLR 41: “Discrimination between localities in the widest sense means that, because one man or his property is in one locality, then, regardless of any other circumstances, he or it is to be treated differently from the man or similar property in another locality.” If it happened today: If the facts of Cameron were to occur today, the same result would follow, with the regulations being declared invalid.

6

© Thomson Reuters 2019

CHAPTER 1

CONSTITUTIONAL ISSUES

Fortescue Metals Group Ltd v The Commonwealth

[2013] HCA 34; 250 CLR 548; 89 ATR 1; 2013 ATC 20-405 (Full High Court) Facts: The Commonwealth government imposed a minerals resource rent tax on large mining companies in respect of sales of iron ore and select other minerals. While the tax was uniform across the country, companies could credit State royalty payments against their minerals resource rent tax liability. As mineral royalties varied from State to State, the liability to minerals resource rent tax would also vary. The taxpayer, an iron ore mining company, argued this violated s 51(ii) of the Constitution. Decision: The High Court unanimously held that the mineral resources rent tax did not violate s 51(ii) of the Constitution. The Court noted that the tax applied the same formula in all States – a reduction of liability to offset State royalty obligations. The differences in mineral resources rent tax from State to State thus did not turn on anything in the Commonwealth law; rather, it was due to differences in the State laws. The Commonwealth law, as a result, did not discriminate between States or residents of States. Relevance of the case today: Fortescue Metals is authority for the proposition that Commonwealth tax laws can impose different burdens in different States if the Commonwealth laws recognise the effect of State laws and the State laws lead to differences in tax liability under the Commmonwealth law. If it happened today: The minerals resource rent tax was repealed in 2014 and facts identical to those in Fortescue Metals would not arise today. However, if the Commonwealth government were to enact another tax that imposed different burdens in different States because it took into account the liability of taxpayers to pay different taxes in the different States in respect of matters also covered by the Commonwealth tax, a result similar to that in Fortescue Metals would follow, with the Commonwealth tax law viewed as constitutional even if it imposed different liabilities in different States as a result of State laws recognised by the Commonwealth law.

CONSTITUTIONAL VALIDITY OF ADDITIONAL TAX Until 2001, the ITAA 1936 allowed the Commissioner to impose an administrative penalty known as “additional tax”. The additional tax provisions set a minimum additional tax payable and allowed the Commissioner to remit additional tax in some cases. Section 55 of the Constitution provides that “laws imposing taxation shall deal only with the imposition of taxation”, which has led to the separation of tax laws into the assessment Act, imposing the liability, and the ratings Act, setting out the rates of tax. The question arose as to whether setting out a minimum tax payable in the assessment Act amounted to an unconstitutional setting of a tax rate in an assessment Act. A related question was whether the power to impose an additional tax amounted to the exercise of a judicial power in the ITAA that would be unconstitutional under s 55 of the Constitution. In 2001, the additional tax was replaced with administrative penalty provisions in the Taxation Administration Act 1953 and the constitutional questions previously addressed became moot issues. © Thomson Reuters 2019

7

AUSTRALIAN TAXATION LAW CASES 2019

Minimum Additional Tax Re Dymond

(1959) 101 CLR 11 (Full High Court)

Facts: The case arose as an appeal from a bankruptcy case in which the Commissioner was a creditor in respect of unpaid sales tax. The taxpayer argued the Commissioner’s claim was not a valid debt of the taxpayer because it was based on an unconstitutional taxing law. The argument rested on the fact that the additional tax provisions set out rules for determining additional tax but also set out a minimum additional tax payable if the rules yielded a lesser tax. The taxpayer argued stipulation of the minimum amount payable amounted to establishing a rate of tax, not the imposition of tax, so the remainder of the sales tax law was constitutionally invalid. Decision: The High Court held that measures setting out assessment, levying, collection and recovery of tax are validly part of a law to impose tax and the rule establishing the minimum additional tax was incidental to this purpose and within the same subject matter. The Sales Tax Act was thus constitutionally valid and the Commissioner’s claim against the taxpayer was a valid debt owed by the taxpayer. Relevance of the case today: With the shift of the additional tax measures from the ITAA to administrative penalties in the Tax Administration Act, the issue arising in Dymond no longer arises. The case remains relevant as an indication that the courts are generally reluctant to strike down laws as unconstitutional on the basis of a violation of s 55 of the Constitution and assessment Acts will be read generously to avoid finding them unconstitutional. If it happened today: The Sales Tax Act was replaced with the GST Act effective from 1 July 2000 and assessments could not arise under the Sales Tax Act today. The administrative penalties for the GST Act are found in the Tax Administration Act and are consequently protected from challenge on the basis of the argument raised in Re Dymond.

COMMONWEALTH TAKEOVER OF THE INCOME TAX Income tax was first levied at the State level in Australia and the Commonwealth joined the field in 1915. Inconsistent State and Commonwealth income tax laws operated in parallel with each other until 1936, when the Commonwealth and States agreed the States would model their laws after the ITAA 1936. Subsequent amendments to the State laws reintroduced a divergence between the State and Commonwealth legislation. In 1942, citing the national emergency of war, the Commonwealth sought to appropriate the income tax field by forcing State governments to relinquish their State income taxes in return for transfer payments from the Commonwealth to the States.

8

© Thomson Reuters 2019

CHAPTER 1

CONSTITUTIONAL ISSUES

South Australia & Anor v The Commonwealth

(1942) 65 CLR 373 (Full High Court)

Facts: The Commonwealth passed a set of four laws to effectively appropriate all income tax collection powers to itself and institute a grant regime to provide the States with funds to offset the loss of their income tax revenues. The Commonwealth claimed its laws were based on the Commonwealth’s deduction. They effectively forced the States out of the income tax field by raising the level of Commonwealth taxation to the level of the existing separate State and Commonwealth income taxes and then requiring taxpayers to pay Commonwealth income tax before paying State income tax. They also provided for the transfer of all State income tax officers to the Commonwealth. South Australia joined with three other States to oppose the laws as unconstitutional on the basis of their effect to deprive the States of their concurrent constitutional rights and power to raise revenue by way of income tax and other constitutional grounds. Decision: A majority of the High Court upheld the Commonwealth’s powers to pass the legislation and take over the income tax field on the basis of the Commonwealth’s war powers. Relevance of the case today: The legislation objected to in the South Australia case was set to expire at the end of the first financial year after the end of the war. The Commonwealth retained its income tax regime after the war and there were further challenges to the Commonwealth’s powers that were similarly upheld. The South Australia case is primarily relevant on historical grounds by paving the way for a single Commonwealth income tax and grants regime. While several States are unhappy with the formula used to determine grants to the States, no States have moved to reclaim the income tax power for half a century and such a move is unlikely to happen for political reasons. If it happened today: While many constitutional observers believe the tendency of the High Court is to uphold Commonwealth laws that have the effect of centralising government revenue and spending functions, a prime constitutional basis for upholding the Commonwealth’s legislation in the South Australia case, the Commonwealth’s war powers, could not be relied upon if the facts were to arise today. However, the High Court did not find any of the Commonwealth’s laws prima facie unconstitutional so they needed to be saved by the war power. The Commonwealth did not repeal the legislation at the end of the war and a second constitutional challenge was mounted. The High Court agreed the constitutional basis for the Commonwealth’s continued usurpation of income taxation was shaky in Victoria v Commonwealth; New South Wales v Commonwealth (1957) 99 CLR 575 but perhaps partly on the basis that it would be difficult to unwind the system upheld again the Commonwealth legislation. Given the States’ political acceptance of the current regime, it is highly unlikely that there would be any challenge to the legal structure now in place.

© Thomson Reuters 2019

9

C HAPTER 2

Judicial Concept of Ordinary Income ORDINARY INCOME AND CAPITAL GAINS ................................................. 12 Eisner v Macomber (1920) ...................................................................... 12 THE THREE TESTS FOR ORDINARY INCOME: PERIODICITY, SOURCE, OR COMPENSATION ........................................................................ 13 Periodicity...................................................................................................... 14 Keily (1983) ............................................................................................. 14 Derived from a Source................................................................................... 14 Federal Coke Co Pty Ltd (1977).............................................................. 14 Compensation ................................................................................................ 15 Scott (1935) .............................................................................................. 15 MUTUALITY.......................................................................................................... Bohemians Club (1918) ........................................................................... Sydney Water Board Employees’ Credit Union Ltd (1973)...................... Royal Automobile Club of Victoria (1974) ..............................................

16 16 17 18

© Thomson Reuters 2019

11

C HAPTER 2

Judicial Concept of Ordinary Income The term “income” was not defined in the 1936 or predecessor income tax Acts. In the absence of a statutory definition for the key concept in the income tax law, the courts developed a meaning derived in part from trust law and property law doctrines. Income that satisfied the judicial notion of income became known as “income according to ordinary concepts” or “ordinary income” for short, the term now used in the ITAA 1997, based on the description of Jordan CJ in Scott v Commissioner of Taxation (NSW) (1935) 35 NSWSR 215. Generally, receipts will be characterised as ordinary income if they satisfy one of three broad income tests – they take the form of anticipated periodic payments, there is a clear nexus between the receipts and a source that generated them (services, business activity or property) or they were derived in substitution for income or as compensation for lost income. The same tests are used to identify all types of income (personal services income, income from business, and income from property) but the cases applying the tests to each type of income are often considered separately and this approach is used in the following three chapters.

ORDINARY INCOME AND CAPITAL GAINS Receipts that are not ordinary income are most commonly labelled “capital receipts” by the courts. Some scholars have claimed there are three types of receipts, being income, capital and “other receipts”, with gifts falling into the third category. Other scholars say gifts are another type of capital receipt and there are only two types of receipt, income and capital receipts. When describing the difference between income receipts and capital gains, courts very often use the analogy of fruit and trees, with trees being capital or the source of income and the fruit being similar to income. The courts commonly quote from a US Supreme Court case, Eisner v Macomber as the source of the fruit and tree analogy.

Eisner v Macomber

(1920) 252 US 189 (US Supreme Court)

Facts: The taxpayer was a shareholder in a company that paid a “stock dividend” or a dividend comprising shares in the company. In Australia this is often called a “bonus share”. To issue a bonus share, the company will shift some retained earnings into the 12

© Thomson Reuters 2019

CHAPTER 2

JUDICIAL CONCEPT OF ORDINARY INCOME

company’s capital account and issue new shares to the shareholder equal in value to the capitalised earnings. The US Commissioner assessed the shareholder on the value of the stock dividends she received. Decision: The Court found the value of the bonus shares received was not income because there was no severed gain received by the taxpayer. The total value of the shares owned by the taxpayer had not changed as a result of the capitalisation of retained earnings and issue of new shares; all that had happened was that the value of the existing shares fell to the extent there were more shares on issue but the total value of the company remained the same. Importantly, in the course of the judgment the court referred to the fruit and tree illustration: “The fundamental relation of ‘capital’ to ‘income’ has been much discussed by economists, the former being likened to the tree or the land, the latter to the fruit or the crop”. This quotation is often used by Australian courts to explain the difference between capital gains and income. Relevance of the case today: While the tax treatment of bonus shares in Australia is now similar to that in the United States at the time of Eisner v Macomber, the case is not directly relevant for its main holding, that bonus shares are not included in assessable income. This is also the case in Australia but this is the result of the definition of “dividend” in s 6(1) ITAA 1936, not a judicial doctrine. Bonus shares were previously included in the definition of dividend but are now excluded unless the shareholder is offered the option of a bonus share or cash dividend. However, the Eisner v Macomber case continues to be widely cited for the tree and fruit analogy and the argument in Australia that capital gains are not ordinary income. If it happened today: If the facts of Eisner v Macomber were to happen in Australia today, the stock dividends would be labelled bonus shares and would fall outside the definition of dividend in s 6(1) ITAA 1936. The cost base of the shareholder’s original shares are pro-rated across the original and bonus shares under s 6BA(3)(b) ITAA 1936 and any gain realised on the eventual disposal of the shares would be assessed as a capital gain.

THE THREE TESTS FOR ORDINARY INCOME: PERIODICITY, DERIVED FROM A SOURCE, OR COMPENSATION There are three broad strands to the judicial concept of ordinary income. A receipt may be ordinary income if: • it has the inherent characteristics of ordinary income such as periodicity, being anticipated and expected by the recipient, and applied for the purposes for which other types of income such as salaries would be applied; • it is severed from, but clearly is a product of, a source. Possible sources of income are services by a taxpayer, a taxpayer's business activities, or property owned by the taxpayer; or • it is received as compensation for or in substitution for what clearly would have been an income amount. © Thomson Reuters 2019

13

AUSTRALIAN TAXATION LAW CASES 2019

Periodicity Keily v FCT

(1983) 14 ATR 156; 83 ATC 4248 (Supreme Court of South Australia)

Facts: The taxpayer was an aged person who received an aged person’s pension payable under the Social Security Act. The Commissioner regarded the government pension as ordinary income and as the pension (combined with a small amount of other income derived by the taxpayer) exceeded the tax-free threshold, the Commissioner assessed the taxpayer and imposed tax on the total amount to the extent it exceeded the threshold. Decision: The Court found the pension was ordinary income as payments that were periodic in nature, expected by the taxpayer and used as the basis for support. Relevance of the case today: The Keily decision can be used as authority that a periodic payment expected by the taxpayer and used by the taxpayer as the basis for support will have an income character even if it cannot be traced directly to a source connected with the taxpayer. If it happened today: The aged pension payable today exceeds the current taxfree threshold. If the facts in Keily were to take place today, the taxpayer would be assessable on the income.

Derived from a source The source of income will be personal services of an individual, a business carried on by the taxpayer or property owned by the taxpayer. Where a person who is entitled to income diverts the receipt to another person, under s 6-5(4) ITAA 1997, the person who directed the amount to be paid to someone else will be treated as having derived the diverted income. If the Commissioner in error assesses the person who receives the diverted amount instead of using s 6-5(4) to assess the person who diverted the income, the Commissioner may discover that the amount is no longer ordinary income in the hands of the new recipient. For example, if a person who derives income from business diverts the payment to another person, in the hands of the new recipient, the amount will not be derived from a source attributable to the taxpayer. If the payment does not have an income character on another basis (e.g., is a periodic payment or compensation for lost income), it will not have an ordinary income character.

Federal Coke Co Pty Ltd v FCT

(1977) 7 ATR 519; 77 ATC 4255 (Full Federal Court)

Facts: Bellambi, an Australian coal mining company, had a contract with a French company, Le Nickel, which obligated Le Nickel to purchase stipulated amounts of coke from Bellambi at stipulated prices. Bellambi paid a subsidiary, Federal Coke, to process coal supplied by Bellambi into Coke. 14

© Thomson Reuters 2019

CHAPTER 2

JUDICIAL CONCEPT OF ORDINARY INCOME

When market conditions changed, Le Nickel sought to end the contract and agreed to pay two instalments of $500,000 each to Bellambi for cancellation of the contract. Bellambi subsequently sought to change the settlement between the companies so Le Nickel would pay the compensation for cancellation of the contract to its subsidiary, Federal Coke. It returned the cheque it had received from Bellambi and a new cheque was delivered to Federal Coke. Rather than assess Bellambi on the diverted payment using s 19 ITAA 1936, the predecessor to s 6-5(4) ITAA 1997, the Commissioner sought to assess Federal Coke on the amount it received, seeking to characterise the payment as ordinary income to Federal Coke. Decision: The interest was not income to the taxpayer. There was no contractual or other relationship between the taxpayer and the party paying an amount to it and there was, therefore, no basis for characterising the payment as income from the taxpayer’s activities or as income received as a substitute for other income payments that would have been received if the contract had not been cancelled. Relevance of the case today: This case remains authority for the proposition that for a receipt to be income, it must either have an inherent income nature because of its income characteristics, be the product of a source (services, business or property) provided by or owned by the recipient, or be a compensation for what would have been an income receipt. Receipts that do not satisfy one of these bases for ordinary income will not be considered ordinary income. If it happened today: If the same facts arose today and the Commissioner assessed the recipient of diverted income rather than the company that diverted the income, a court is likely to follow the precedent in Federal Coke and find the receipt is not ordinary income. However, the same facts are unlikely to arise again – as a result of the Federal Coke decision, the Commissioner is more likely to ensure the correct party is assessed, namely the party that directed the income be diverted instead of the party that received diverted income. The assessment of the party that directed the income be diverted would be done on the basis of s 6-5(4) ITAA 1997 and perhaps reinforced with the application of the general anti-avoidance rule in Part IVA ITAA 1936.

Compensation Scott v Commissioner of Taxation (NSW) (1935) 35 NSWSR 215 (NSW Supreme Court)

Facts: The taxpayer had been appointed as chairman of a government created Metropolitan Meat Industry Board. Legislation subsequently abolished the board but provided for compensation for members losing their office. The Commissioner assessed the taxpayer on the amount received as ordinary income based on the taxpayer’s service or compensation for the lost income following abolition of the position. The taxpayer argued the payment was a capital receipt, in compensation for the loss of office. Decision: The NSW Supreme Court found the payment was not income as it was compensation for the loss of an office rather than compensation for the lost income © Thomson Reuters 2019

15

AUSTRALIAN TAXATION LAW CASES 2019

that would have been derived from holding the office. The characterisation was based on evidence that the compensation was calculated as the amount that would have been paid if the taxpayer had sued for wrongful dismissal. Relevance of the case today: The expansion of the income tax base to include statutory income and specifically capital gains would mean there is no longer an important benefit to a taxpayer to argue compensation is for abolition of office rather than lost income. However, Scott v Commissioner of Taxation (NSW) (1935) [the year is usually added to the citation to distinguish this case from a later income case with the same name: see Chapter 3] remains an often-cited case as the source of the term “income according to ordinary concepts”. The cited phrase is the explanation by Jordan CJ that whether receipts have the character of income “must be determined in accordance with the ordinary concepts and usages of mankind”. If it happened today: If the same facts arose today, the Commissioner would assess on the basis of CGT event C2 (s 104-25 ITAA 1997 1997), though it is a little difficult to say the taxpayer has “ownership” of the original employment contract. The taxpayer’s capital proceeds would be the amount to be paid under the agreement to terminate the contract and the taxpayer’s cost base would be the cost of acquiring the original contract, which most likely was nil. Thus, the payments would not be considered employment termination payments. The payments are not in substitution for income or compensation for income and three payments over two years probably does not constitute periodicity sufficient to stamp the payments with the character of ordinary income. As the payments are not in respect of employment, they would not be a fringe benefit as defined in s 136(1) FBTAA for FBT purposes.

MUTUALITY For a receipt to constitute ordinary income, it must display a characteristic of income (periodicity, nexus with a source of labour, property or business, and so on) and further derive from a source external to the taxpayer – a person cannot pay “income” to him or herself. This principle extends to “mutual” activities where a group of individuals contribute to an interposed entity such as a club and then derive the benefits of their contributions.

Bohemians Club v Acting FCT (1918) 24 CLR 334 (Full High Court)

Facts: The taxpayer was a social club that collected membership dues from its members and applied the funds towards activities for the members. The definition of a company in the predecessor to s 6 ITAA 1936 includes an unincorporated association. At the end of the income year the taxpayer had a surplus of funds and the Commissioner assessed the taxpayer on the basis that this amount was taxable income of the taxpayer. Decision: A person cannot be the source of his or her own income; income must be derived from sources outside of the person. Contributions made by a person for expenditure for his or her own benefit cannot be regarded as income and contributions 16

© Thomson Reuters 2019

CHAPTER 2

JUDICIAL CONCEPT OF ORDINARY INCOME

by members to a body are simply savings to be applied for the common personal benefit of the members. Any surplus of contributions over expenditure remains savings to be applied in the future to the benefit of members. Relevance of the case today: The Bohemians Club case remains authority for the proposition that a member’s contributions to a club cannot be income of the club provided the funds are applied to provide benefits to the contributors. If it happened today: If the facts in Bohemians Club arose today, courts would continue to apply the principle that a person cannot be the source of his or her own income and contributions to a club will not be income of the club if it is simply a vehicle to provide benefits to the club member.

Sydney Water Board Employees’ Credit Union Ltd v FCT

(1973) 129 CLR 446; 4 ATR 157; 73 ATC 4129 (Full High Court)

Facts: The taxpayer was a credit union that took deposits from and made loans to members. Only a portion of the members had borrowed from the credit union and paid interest on their loans. Other members received interest on their deposits. The surplus could be used in part to provide rebates to members who had borrowed in the year. The Commissioner assessed the taxpayer on its interest income. The taxpayer claimed the interest payments were contributions that were exempt from tax based on the mutuality principle. Decision: The High Court denied the taxpayer’s appeal, holding the interest payments were assessable to the taxpayer. The mutuality principle does apply when only a subset of members makes payments to the organisation and does so on the basis of individual contracts between the borrowing members and the credit union. Relevance of the case today: Amendments to the ITAA 1936 subsequent to the Sydney Water Board case mean that case is of no direct continuing relevance to the taxation of credit unions. The case continues to stand for the general proposition that where members make payments to an organisation on the basis of their individual contracts with the organisation, the mutuality principle will not apply to prevent the payments from being treated as income of the organisation. If it happened today: Subsequent to the Sydney Water Board case, a special regime for taxing credit unions was inserted in the ITAA 1936. The treatment of income derived by a credit union will depend on whether the credit union is classified as a small, medium, or large credit union under s 6H ITAA 1936. If the credit union is a small credit union, the income is exempt from taxation under s 23G(2) ITAA 1936. Large and medium credit unions do not qualify for the exemption and are taxed as companies, though a rebate reduces the income tax rate applied to medium credit unions.

© Thomson Reuters 2019

17

AUSTRALIAN TAXATION LAW CASES 2019

Royal Automobile Club of Victoria v FCT

[1974] VR 651; 23 FLR 175 [also 73 ATC 4153, but this report does not include the 1974 further reasons of the Court] (Supreme Court of Victoria)

Facts: The taxpayer was an “automobile club” providing a range of services including road service for members, a driving school for members and non-members, a journal which contained commercial advertising, a touring service for members, a travel service which received commissions from overseas hotels and airlines, and a technical and testing services. The taxpayer also referred members to an insurance company and finance company and received commissions for the referrals. The Commissioner assessed the taxpayer on its receipts. The taxpayer sought to use the mutuality principle to exempt its receipts from tax. Decision: The road service, touring service, technical and testing service, journal, and travel service in respect of travel within Australia, were mutual activities. Advertising in the journal, the finance service and insurance service, the travel service in respect of overseas travel, and the driving school in respect of tuition to non-members were not mutual activities. Income from non-mutual activities is assessable income to the taxpayer. Expenses that relate to both mutual and non-mutual activities must be apportioned on an appropriate basis and deductions will be allowed for the proportion of expenses attributable to the non-mutual activities. Relevance of the case today: The principles set out in the RACV case continue to apply to mutual organisations. To the extent they receive dues from members and provide services back to those members, the mutuality principle will apply. To the extent the organisation provides services to non-members, income received for the services is assessable income. Expenses must be apportioned between mutual and non-mutual activities. If it happened today: The principles set out in the RACV case continue to apply today and the facts in the case do arise today for many mutual organisations. In each case, income from mutual activities is distinguished from services to non-members with payments related to services to members not being characterised as income and amounts received by non-members for services being characterised as assessable income. Expenses must be apportioned to the mutual and non-mutual activities and only the latter are deductible.

18

© Thomson Reuters 2019

C HAPTER 3

Income from Personal Services and Employment GIFTS OR INCOME? ............................................................................................. 21 Hayes (1956) ............................................................................................. 22 Laidler v Perry (1966) .............................................................................. 23 Scott (1966) ............................................................................................... 24 Smith (1987) .............................................................................................. 25 Brown (2002) ............................................................................................ 26 PERIODIC PAYMENTS ......................................................................................... 27 Dixon (1952) ............................................................................................. 27 Harris (1980) ........................................................................................... 29 Blake (1984) .............................................................................................. 29 COMPENSATION PAYMENTS ............................................................................ 30 Phillips (1936) .......................................................................................... 30 Bennett (1947)........................................................................................... 31 TIPS ........................................................................................................................... 32 Calvert (Inspector of Taxes) v Wainwright (1947) .................................... 32 WINDFALL PRIZES OR INCOME ...................................................................... 32 Kelly (1985) .............................................................................................. 33 FREQUENT FLYER BENEFITS ........................................................................... 33 Payne (1996) ............................................................................................. 34 CAPITAL OR INCOME: SELLING PERSONAL KNOWLEDGE ................... 35 Brent (1971) .............................................................................................. 35 CAPITAL OR INCOME: NEGATIVE COVENANTS BY EMPLOYEES AND CONTRACTORS ........................................................................................... 36 Higgs (Inspector of Taxes) v Olivier (1952) ............................................. 36 Woite (1982) .............................................................................................. 37 CAPITAL OR INCOME: PAYMENTS AFTER CESSATION OF EMPLOYMENT .......................................................................................................38 Blank (2016) ..............................................................................................38 © Thomson Reuters 2019

19

AUSTRALIAN TAXATION LAW CASES 2019

SUPERANNUATION AND RETIREMENT PAYMENTS ................................. 38 Constable (1952)....................................................................................... 39 Reseck (1975) ............................................................................................ 40 FRINGE BENEFITS IN KIND AND FRINGE BENEFITS TAX ...................... 40 The “Cash or Convertible into Cash” Doctrine .............................................. 41 Tennant v Smith (Surveyor of Taxes) (1892) ............................................. 41 Employee Share Benefits................................................................................ 42 Abbott v Philbin (Inspector of Taxes) (1961) ............................................ 42 Indooroopilly Children Services (Qld) Pty Ltd (2007) ............................. 44

20

© Thomson Reuters 2019

C HAPTER 3

Income from Personal Services and Employment A receipt will be considered ordinary income to the recipient if it is the severable product of labour, business or property or has inherent income characteristics such as periodicity or substitutes for what would have been income payments. Furthermore, the receipt must be “cash or convertible into cash” to be ordinary income. Cases involving income from personal services and employment fall into two broad camps. The first comprises cases in which the taxpayers argue there is an insufficient nexus between the payments and the provision of services for the payments to be income from services. These cases look at the nexus between the payments and services provided by taxpayers to determine if the receipts constitute income because they are a product of those services or because they satisfy another income test such as periodicity or compensation for income. The second group of cases looks at receipts that are not cash or convertible into cash. Receipts that were not cash or convertible into cash would not be considered assessable income. The legislature first tried to deal with these cases through a legislative provision, s 26(e) ITAA 1936, that included the value of non-convertible benefits from services and employment in assessable income. Application of the provision proved problematic, however. In 1986 a new approach was taken with the adoption of the Fringe Benefits Tax Assessment Act, which assesses employers on the value of benefits other than salary or wages provided to employees. The FBTAA took precedence over s 26(e) which was replaced in 2006 by s 15-2 ITAA 1997. While s 15-2 has limited, if any, residual application to employees, it will continue to apply to receipts derived by contractors and other non-employee service providers.

GIFTS OR INCOME? For an amount to be income from the provision of services, there must be a direct connection between the payment and the services – the payment must be in consequence of the provision of services. In many cases in which the link between payment and the provision of services was not certain, the Commissioner would assess in the alternative on the basis of s 26(e) ITAA 1936, predecessor to current s 15-2 ITAA 1997. That © Thomson Reuters 2019

21

AUSTRALIAN TAXATION LAW CASES 2019

section was primarily aimed at overcoming the “cash or convertible into cash” doctrine derived from Tennant v Smith [1892] AC 150 with respect to benefits in kind, but it also applied to cash payments. The Commissioner hoped the broad language of s 26(e), applying to amounts paid “in respect of, or for or in relation directly or indirectly to, any employment of or services”, would allow it to apply to payments that might fall outside the ordinary income scope of former s 25(1) ITAA 1936, current s 6-5(1) ITAA 1997 (the same words are used in current s 15-2 ITAA 1997). Early cases suggested the same nexus was required for receipts to be ordinary income and assessable under s 26(e). However, Smith v FCT (1987) 164 CLR 513, in which an employee was taxed under s 26(e) only, suggests a different nexus may be needed for s 26(e) than for s 6-5(1). On the other hand, the taxpayer in Smith was only assessed on the basis of s 26(e); it is possible the Commissioner may have been equally successful had he assessed on the basis of s 25(1). A similar question arises with the fringe benefits tax. Cash payments may be fringe benefits unless they constitute salary or wages (definition of “fringe benefit” in s 136(1) FBTAA). Like s 26(e), which used broad nexus language (benefits granted “in respect FBTAA of, or for or in relation directly or indirectly to” employment or services), the FBT uses expansive language, applying to benefits given in relation to employment, including “in relation directly or indirectly to, that employment”. The language of the nexus test is further broadened by s 148 FBTAA. It has been generally assumed that a similar nexus is needed for s 6-5(1), s 26(e)/ s 15-2, and the FBTAA. While the question remains open, it is generally assumed that if the nexus between a payment and employment was not sufficient to bring the payment under s 26(e)/15-2, a similar payment today would not have a sufficient nexus with employment to bring it within the FBTAA as a benefit other than salary or wages.

Hayes v FCT

(1956) 96 CLR 47 (High Court)

Facts: The taxpayer was an accountant who had served in various capacities for Mr Richardson and his business. Initially, Hayes was a supervising accountant and general financial adviser to the business and when the business was sold over to a newly formed company (of which Richardson was not a controlling shareholder), Hayes became a shareholder, director and secretary. After several years, Richardson resumed control of the company and Hayes was convinced to sell his shares to Richardson, though he remained as secretary for the company. The business was successful and was transferred to a public company, with Richardson acquiring a significant number of shares in that company. Shortly thereafter, Richardson transferred several parcels of shares as gifts, including a parcel of 12,000 shares to Hayes. The Commissioner argued that the value of the shares was income to Hayes as ordinary income or, alternatively, under former s 26(e) ITAA 1936 (predecessor to current s 15-2 ITAA 1997 1997). Decision: The value of the shares was not income to Hayes, but instead it was a nontaxable gift. Richardson and Hayes had developed a personal relationship in addition to a close business relationship. Although the motive of the donor is relevant, it was 22

© Thomson Reuters 2019

CHAPTER 3

INCOME FROM PERSONAL SERVICES AND EMPLOYMENT

not considered decisive. Rather, to determine the nature of the receipt in the hands of the recipient, one must identify employment or other personal exertion which can be said to have produced the receipt. Hayes had been fully remunerated for the services he provided to the initial business and the companies, and the shares could not be seen as additional remuneration for this work. In addition, although Hayes had provided informal advice to Richardson on various business matters, this could not be characterised as an income producing activity. It was considered that s 26(e) would not bring into income a receipt which was not, in its nature, income according to ordinary concepts – the provision requires a “real relation” between the receipt and the employment or services similar to that required for a payment to constitute ordinary income. Relevance of the case today: The decision in Hayes remains important for the principle that in determining whether a receipt is income from services, one must first identify the income earning activity and then determine whether it can be said to have produced the receipt, distinguishing a mere gift. The decision shows that the fact that a person was fully remunerated for services when the services were provided will be taken into account when determining whether later payments constitute income or gifts. If it happened today: If the facts in Hayes were to occur today, it is likely that the receipts would not be considered income according to ordinary concepts on the basis that any connection between the receipt and services provided is too remote. The Commissioner might seek to make an alternative argument that the shares were a property fringe benefit under s 40 FBTAA, provided by Richardson in his capacity either as a former employer or as an associate of a former employer. It is likely that the nexus requirements for fringe benefits tax purposes are similar to those for s 26(e) purposes, which in turn are probably similar to those required for an amount to be characterised as ordinary income. Thus, even though the nexus requirement for FBT is quite broad, it will still not extend to true gifts.

Laidler v Perry

[1966] AC 16 (UK House of Lords)

Facts: At Christmas time, the taxpayer’s employer provided all employees who had worked for the company for more than one year with gift vouchers. There was no contractual entitlement to the vouchers. The taxpayer was assessed for income tax on the value of the voucher under UK legislation that applied to amounts that would be labelled income from employment in Australia. The taxpayer appealed the assessment, arguing the vouchers had been received as gifts and not for performance of services. Decision: The House of Lords considered the motivation of the employer in providing the vouchers to all employees and concluded they were not personal gifts, but were provided to establish goodwill in relation to hoped for future services. This strengthened the conclusion that the recipients viewed the regular gifts as an incident of their employment. © Thomson Reuters 2019

23

AUSTRALIAN TAXATION LAW CASES 2019

Relevance of the case today: The decision in Laidler v Perry shows that while employment as a source of income is judged from the viewpoint of the recipient, the motive of the person providing the benefit can be considered when characterising the receipt in the hands of the recipient. If a so-called gift is made to enhance employee loyalty and is provided annually and anticipated by the employee, the benefit will have a source and constitute ordinary income to the employee. If it happened today: If the facts in Laidler v Perry were to occur today in Australia, an Australian court would find the benefit was a benefit in respect of employment. As the benefit is cash or convertible, it would constitute ordinary income. However, the benefit probably does not fall in the definition of salary or wages and as a result would also satisfy the definition of a fringe benefit in s 136(1) FBTAA. If the taxpayer successfully argued that the payments were fringe benefits assessable to his employer, the payments would be ordinary income but would be excluded from assessment by s 23L ITAA 1936 which defines the amounts that are also fringe benefits as nonassessable non-exempt income. The benefit would also be excluded from s 15-2 ITAA 1997 by s 15-2(3)(d).

Scott v FCT

(1966) 117 CLR 514 (High Court)

Facts: The taxpayer carried on business as a solicitor on his own account and he was also involved in several investments, including business enterprises, with his longtime client, Mr Freestone. Scott had also known Mrs Freestone for many years and had acted for her on several matters. Upon the death of Mr Freestone, Scott acted for Mrs Freestone on the probate and administration of the will and estate. This included the sale of a number of properties forming part of the estate, including the main property known as Greenacres. Scott played a large part in obtaining the approval to subdivide and develop the site. After the sale of Greenacres, Scott prepared his bill of costs. At about this time, Mrs Freestone directed Scott to make several gifts from the proceeds, including a substantial gift to Scott. Scott later presented his account, which was duly paid. The Commissioner argued that the “gift” receipt was income under ordinary concepts or, alternatively, income under former s 26(e) ITAA 1936 (predecessor to current 15-2 ITAA 1997 1997). The taxpayer argued that the receipt was a mere gift and therefore not assessable income. Decision: The receipt was not income to Scott as ordinary income or under s 26(e). The Court concluded s 26(e) did not bring into assessable income any money or money’s worth which would not be income under ordinary concepts but rather ensured that the value of all advantages having a money value would be included where those receipts were a reward for the services. A gift would not be ordinary income merely because it was traceable to goodwill which was engendered by services provided. For the gift to be income, the relation between the receipt and the taxpayer’s activities must be such that it is in a relevant sense a product of those services, which was not the case here. The donor made other gifts at the time, the motive of the donor was their personal relationship (she considered him her very best friend), and Scott had been fully remunerated for his services. 24

© Thomson Reuters 2019

CHAPTER 3

INCOME FROM PERSONAL SERVICES AND EMPLOYMENT

Relevance of the case today: This case is relevant for the comments made as to the nature of income from services, where the required nexus is that the receipt must be a product or ordinary incident of employment or a reward for services rendered. Applying this test to gifts, a voluntary payment will still be income if it is a product of the income producing activity. Although the Court also states that s 26(e) did not bring into assessable income any receipt which would not be income under ordinary concepts, comments in some later cases, especially Smith v FCT (1987) 164 CLR 513, suggest the nexus test in s 26(e) (and thus the successor s 15-2 ITAA 1997 1997) is wider than that applied to ordinary income. Since the fringe benefits tax uses a test similar to that in s 26(e)/s 15-2, this would imply a receipt could be in respect of employment for fringe benefits tax purposes and not have a sufficient nexus with employment to constitute ordinary income from employment. However, Scott can be cited along with earlier important authorities in support of the proposition that an amount which would be considered a mere gift under the tests for ordinary income would also be considered a mere gift for FBT purposes. If it happened today: It has been suggested that in light of the decision in Smith, a court today would interpret s 15-2 so it would now include a gift made in the circumstances of Scott. However, most observers do not believe Smith widened the s 26(e)/s 15-2 nexus requirement beyond the nexus that is used to determine if a cash payment constitutes ordinary income. If s 15-2 has a wider nexus than that required for ordinary income from services, the benefit might be assessable under that section. (It could not be assessed as a fringe benefit within the definition in s 136(1) FBTAA as the fringe benefits tax only applies to benefits from employment and not to amounts received by other service providers such as the taxpayer in Scott). However, the fact that the service provider billed for and separately was fully paid for the services he provided would likely be used by a court today to conclude there was an insufficient nexus between the additional receipt and the provision of services to give the additional receipt an income character for s 6-5(1) ITAA 1997 purposes and similarly lacked a nexus with the provision of services for s 15-2 purposes.

Smith v FCT

(1987) 164 CLR 513; 19 ATR 274; 87 ATC 4883 (Full High Court)

Facts: The taxpayer’s employer, Westpac Bank, provided payments to employees who completed an approved course of study. The Commissioner included the payments in the taxpayer’s assessable income. The taxpayer argued that the payments were not ordinary concept income under s 25(1) ITAA 1936 because they were not in respect of any services provided by the taxpayer to his employer. He further argued that s 26(e) ITAA 1936 (predecessor to s 15-2 ITAA 1997 1997) did not apply to cash amounts that were not income assessable under s 25(1). As part of his argument on this point, the taxpayer argued that the payments were for completion of studies, not for part of the employment relationship. The Commissioner argued that as a result of the broad “in relation directly, or indirectly to employment” nexus language in s 26(e), that section would apply to payments that might not be assessable under s 25(1). © Thomson Reuters 2019

25

AUSTRALIAN TAXATION LAW CASES 2019

Decision: The High Court agreed with the Commissioner that the payments were subject to s 26(e) on the basis of the broad nexus test set out in that section. While the payments were for completion of the course, they resulted indirectly because of the employment agreement. There was no element of gift or personal bounty. Relevance of the case today: On its face, Smith stands for the proposition that the broad nexus test in s 26(e) can bring into assessable income amounts that are not ordinary concept income. However, some commentators have suggested that the payments in Smith were sufficiently a consequence of employment to constitute ordinary concept income and would have been assessable under s 25(1) had the case been argued on the basis of that section. It thus remains unclear whether the nexus requirement for a cash payment from an employer to be assessable under s 15-2 is wider than that required for the payment to be ordinary income from employment assessable under s 6-5(1) ITAA 1997. If s 15-2 has a broader nexus than that required of ordinary income, the nexus requirement for FBT purposes would presumably also be wider since the FBT test is similar to that of s 26(e)/s 15-2. If this is the case, a payment might be seen as being made in respect of employment for FBT purposes but not sufficiently related to the employment to constitute ordinary income. However, while the case might be cited as support for a proposition that s 26(e)/s 15-2 and thus FBT is broader than s 6-5(1), this assertion might be countered by the argument that the application of the predecessor to s 6-5(1) was not fully explored in this case. Also, it would be argued that most authorities that have directly considered this issue have concluded the same nexus requirement applies to FBT and ordinary income. If it happened today: While the fringe benefits tax is not usually used to tax cash payments to employees apart from expense reimbursements, the FBT will apply to cash other than salary or wages if the cash is a benefit in respect of employment. The payments to the employee in Smith fall within the definition of a “fringe benefit” in s 136(1) FBTAA. These cash payments would most likely constitute a residual fringe benefit under s 45 FBTAA. If the taxpayer successfully argued that the payments were fringe benefits assessable to his employer, the payments would be ordinary income but would be excluded from assessment by s 23L ITAA 1936 which defines the amounts that are also fringe benefits as non-assessable non-exempt income. The benefit would be excluded from s 15-2 ITAA 1997 by s 15-2(3)(d).

Brown v FCT

(2002) 49 ATR 301; 2002 ATC 4273 (Full Federal Court)

Facts: The taxpayer engaged in various activities which proved to be instrumental in the success of a major property development. On completion of the development, one of the units was transferred to Brown without charge, the stamp duty on that transfer was paid on his behalf and he was provided with a significant furniture allowance. The total value of these benefits reached nearly $1 million. The Commissioner argued that the money or money’s worth was income according to ordinary concepts. The taxpayer argued that the benefits were not a reward for services but a non-assessable gift motivated by friendship and in recognition of casual advice and introductions provided by the taxpayer. 26

© Thomson Reuters 2019

CHAPTER 3

INCOME FROM PERSONAL SERVICES AND EMPLOYMENT

Decision: The receipts were a product of services provided and were income according to ordinary concepts. The facts did not support the contentions of the taxpayer. In the opinion of the Court, this was not a case of a taxpayer receiving a reward from a grateful friend for trifling assistance which happened to yield the friend a significant profit – such a case could support the argument that the receipt was a mere gift. Rather, here, there was an understanding that the taxpayer would be rewarded for his assistance if the transaction proceeded to completion and he performed work to ensure that outcome. He was not otherwise remunerated for his services. Relevance of the case today: The decision in Brown elaborates on the criteria established in Hayes v FCT (1956) 96 CLR 47, for determining when a voluntary payment is to be considered income from services and when it will be considered a non-assessable (“mere”) gift. As in Hayes the parties were friends but unlike the taxpayer in Hayes, the taxpayer in Brown was not otherwise remunerated for his efforts and had an expectation and worked towards this bonus. If it happened today: If these facts arose today, a court would likely conclude that the value of the benefits (their money’s worth) should be included in assessable income under s 6-5(1) ITAA 1997. The Commissioner could also make an argument that, alternatively, the value of the benefits would be income under s 15-2 ITAA 1997 as that provision applies to benefits received by an independent contractor (a provider of services who is not an employee), which was the status of the taxpayer in Brown.

PERIODIC PAYMENTS Amounts will be ordinary income in respect of personal services if they have a nexus with the personal services in the sense of being seen as a product of the personal services or are viewed as compensation for lost income. Amounts that fail these first two tests may nevertheless be ordinary income if they take the form of periodic and anticipated payments.

FCT v Dixon

(1952) 86 CLR 540 (High Court)

Facts: The taxpayer’s employer provided payments to employees who enlisted in the armed forces during the Second World War. The payments were calculated as the difference between the employees’ former salaries and their military salaries. There was no formal obligation for employees to return to the employer after their service, though the firm hoped they would and the taxpayer did in fact return to the employer. The Commissioner assessed the taxpayer on the payments as ordinary income subject to s 25(1) ITAA 1936 (the predecessor to current s 6-5(1) ITAA 1997 1997) and as income directly or indirectly related to the provision of services, assessable under s 26(e) ITAA 1936 (the predecessor to current s 15-2 ITAA 1997 1997). Decision: Traditionally, a key test for identifying a receipt as ordinary income from employment was the nexus between the payment and employment. While it has been © Thomson Reuters 2019

27

AUSTRALIAN TAXATION LAW CASES 2019

suggested that the “directly or indirectly” language of s 26(e) may establish a looser nexus requirement than that of s 25(1), none of the five judges who heard the appeal concluded the payments were in respect of services provided to the former (and after rehiring, later) employer or to the armed forces. However, in a joint judgment, Dixon CJ and Williams J concluded the payments were ordinary income not on the basis of nexus with employment but rather because of the fact that they were (1) expected, (2) periodic, and (3) used for the maintenance of the taxpayer and the taxpayer’s dependants. Fullagar J also concluded they were income because of their periodic nature and because they were compensation for wages that would otherwise be received or amounts paid in substitution for those payments. Relevance of the case today: The Dixon case remains an important authority for independent tests or indicia of ordinary income (the payment is periodic, expected, used to cover a taxpayer’s ordinary expenses, and made in substitution or in compensation of lost income) even where the receipt does not have a direct nexus with a source such as employment. Where a receipt has all these characteristics, the amount will itself be ordinary income. It is more difficult to say whether a payment is inherently ordinary income if only one or some of the factors found in Dixon are present. Note also however that the High Court stated in Blank v FCT [2016] HCA 42, 258 CLR 439 (discussed later in this chapter) that an amount paid after the termination of a contract of service, by a person other than the employer and separately to ordinary wages, salary or bonuses, does not detract from its characterisation as income if the payment is a recognised incident of the employment. Further, in FCT v Hart [2018] FCAFC 61, (2018) ATC 20-653, the Full Federal Court held that an amount that was diverted through a series of entities before being paid to the taxpayer from a trust was ultimately the income of the taxpayer on the basis that it was regularly received and relied upon to live. If it happened today: If the facts in Dixon were to occur today, the payment would probably be ordinary income assessable to the recipient under s 6-5(1) ITAA 1997 as a periodic receipt or a compensation receipt. The taxpayer might try to concede that the payments are ordinary income (or income under s 15-2 ITAA 1997 1997) but say they are nevertheless a fringe benefit. Fringe benefits include all benefits from employment apart from salary and wages – that is, they include amounts that are cash or convertible into cash and thus ordinary income as well as amounts that would not be ordinary income. If the payments received by the taxpayer in a situation similar to that of Dixon were a fringe benefit, liability for tax would fall on the employer and not the employee. The payments satisfy the key elements of the definition of a “fringe benefit” in s 136(1) FBTAA – they are arguably a “benefit” under the inclusive definition of “benefit”, they come from an “employer” under the definition of “employer” which includes a “former employer”, and they are not “salary or wages” which are excluded from the definition of a fringe benefit. However, for a benefit to be a “fringe benefit”, it must be provided “in respect of the employment of the employee”. The conclusion of the judges in Dixon that the payments in that case had an insufficient nexus with employment to be ordinary employment income also suggests that the payments will not satisfy the “in respect of the employment of the employee” requirement in the definition of “fringe benefit”. The decision of the High Court in Smith v FCT (1987) 164 CLR 513 implied that the nexus test in former s 26(e) (and thus now s 15-2), which appears to be similar 28

© Thomson Reuters 2019

CHAPTER 3

INCOME FROM PERSONAL SERVICES AND EMPLOYMENT

to the nexus test in the FBTAA, could be wider than the nexus for s 6-5(1). However, most of the authorities assume the nexus requirement for a benefit to be subject to s 26(e)/s 15-2 (and hence for the benefit to be subject to FBT today) is similar to the nexus requirement for a payment to constitute ordinary income from employment. If this is correct, the payment received by the taxpayer in Dixon would not be a taxable fringe benefit in respect of employment or income in respect of employment, though it would continue to be ordinary income because of its income characteristics.

FCT v Harris

(1980) 10 ATR 869; 80 ATC 4238 (Full Federal Court)

Facts: The taxpayer was a former employee of a bank in receipt of a pension from a superannuation fund. The fund’s trust deed allowed the trustees to offer fund members below a particular income supplementary payments in addition to their pension in recognition of the diminishing value of the pension payments as a result of inflation. The fund made lump sum supplementary payments to the taxpayer over a series of years and the Commissioner assessed the taxpayer on these amounts as ordinary income. Decision: A majority of the Full Federal Court concluded the payments were not ordinary income. They were not sufficiently directly connected with the employment to be income from employment and they were not compensation for lost income. The only basis for the payments to be characterised as income would be as periodic payments. However, the fact that the payments were entirely ex gratia with no contractual basis meant that they could not be expected as periodic amounts by the taxpayer even if they had been received for three years in a row. Relevance of the case today: The ITAA 1936 was amended in response to the Harris case to ensure supplements to an annuity or pension are included in assessable income as statutory income, whether the payment is made voluntarily and whether or not the payment is one of a series of recurrent payments. The Harris case is thus not of direct relevance to receipt of pension supplementary payments but it could be cited as authority for the fact that only three payments could be insufficient to establish the periodicity needed for amounts to have an income character under the periodicity test if the payments were made voluntarily and not under any agreement and there was no guarantee they would continue. If it happened today: If the facts in Harris were to arise today, the supplementary payments received by the taxpayer would be assessable as statutory income under s 27H(1)(b) ITAA 1936.

FCT v Blake

(1984) 15 ATR 1006; 84 ATC 4661 (Supreme Court of Queensland)

Facts: The taxpayer was a former employee of a bank in receipt of a pension from a superannuation fund. In a period of high inflation, the bank decided to supplement the pension payments of former senior officers with what was described as a subsidy. The © Thomson Reuters 2019

29

AUSTRALIAN TAXATION LAW CASES 2019

supplements were paid by the bank but added to the taxpayer’s fortnightly pension payments. The Commissioner assessed the taxpayer on the supplementary payments, arguing the Harris case (see above) did not create a binding precedent since the payments in that case were not paid for such a long period and were paid as annual lump sums. Decision: The Court agreed with the Commissioner that the Harris case did not create a precedent for the facts in Blake. Although the taxpayer’s former employer had no contractual obligation to make the supplementary payments, it had done so regularly for years and the taxpayer anticipated the amount and used it in the same way as the pension payments accompanying each supplement. These factors gave the payments an income character. Relevance of the case today: The statutory amendments made after the Harris case has reduced the relevance of the Blake case today. The payments in Blake would be assessable under s 27H(1)(b) ITAA 1936 if they were not ordinary income. The case can nevertheless be used to support an argument that regularly paid periodic amounts that are expected by a taxpayer and used by the taxpayer in the same manner as other periodic income acquire an income character. If it happened today: If the facts in Blake were to arise today, the supplementary payments received by the taxpayer would be assessable as ordinary income under s 65(1) ITAA 1997 and as statutory income under s 27H(1)(b) ITAA 1936 but would be assessable only one time as a result of s 6-25 ITAA 1997.

COMPENSATION PAYMENTS Amounts will be ordinary income in respect of personal services if they have a nexus with the personal services in the sense of being seen as a product of the personal services. A payment that fails to satisfy the direct nexus with personal services test may nevertheless be ordinary income if it is viewed as compensation for lost income or it takes the form of periodic and anticipated payments.

C of T (Victoria) v Phillips

(1936) 55 CLR 144 (Full High Court)

Facts: The taxpayer was the governing director of a company. He was appointed on a 10 year contract that stipulated a remuneration of 12.5% of the net annual profits of the company. In the fifth year of the contract, the company sold its business to another firm and the taxpayer’s employment was terminated. The taxpayer reached an agreement with the company which obligated the company to pay compensation for the termination of employment. The compensation amount was calculated as the total of the annual remuneration the taxpayer would have received over the remaining period of the contract. The compensation was to be paid on a monthly basis over the period for which the taxpayer would have been employed. The Commissioner included the payments in the taxpayer’s assessable income under the Victorian Income Tax Act 1928 under the equivalent of s 6-5(1) ITAA 1997. 30

© Thomson Reuters 2019

CHAPTER 3

INCOME FROM PERSONAL SERVICES AND EMPLOYMENT

Decision: All three members of the High Court who heard the appeal found the payments were ordinary income to the taxpayer. Where a right to future periodical payments over a term of years is exchanged not for a lump sum but instead for another right to payments of the same periodicity over the same term of years and the amount of the new payments is an estimated equivalent of the old, the new payments are of the same income character as the ones they replace. Relevance of the case today: While the Phillips case was decided under Victorian income tax legislation, the principles set out in the case apply equally to the ordinary income concept under the Commonwealth ITAA. Two overlapping ordinary principles emerge from the Phillips case and it may be cited to support two propositions. The first is that payments made in substitution of income payments acquire an income character. The second is that periodic expected payments normally have an income character. If it happened today: If the facts in Phillips arose today, the payments would likely be treated as a “life benefit termination payment” as defined in s 82-130(2) ITAA 1997, a category of “employment termination payment” (as defined in s 82-130(1) ITAA 1997 1997) received as a consequence of employment termination during a person’s lifetime. They would be included in assessable income under s 82-10(2) ITAA 1997 but may attract a rebate under s 82-10(3) ITAA 1997 to cap the tax rate applied to the payment. Alternatively, the payments might be considered fixed-term annuity payments assessable under s 27H ITAA 1936. If the payments are considered annuity payments, they would be assessable under s 27H in full as received.

Bennett v FCT

(1947) 75 CLR 480 (High Court)

Facts: The taxpayer was managing director of a company. His employment contract provided a number of benefits and management rights. The company negotiated a substitute contract which provided for the same remuneration as the original contract but which reduced or removed a number of rights that had been enjoyed by the taxpayer under the former contract. The company agreed to compensate the taxpayer for the removal of his contractual rights through a series of three payments payable over a two year period. The Commissioner assessed the taxpayer on the payments in the income years in which they were received. Decision: The payments were not ordinary income to the taxpayer. They were not in substitution for salary the taxpayer would have otherwise received as he remained employed and continued to receive the same remuneration after the old contract was replaced by the new contract. They were thus capital receipts paid as compensation for the removal of the taxpayer’s rights under the original employment contract. Relevance of the case today: The Bennett case shows that some payments from employers may be non-income amounts that are neither termination payments nor a fringe benefit as defined in s 136(1) FBTAA. This will be the case if the payments are not in substitution for salary or compensation for salary but rather for changes to the © Thomson Reuters 2019

31

AUSTRALIAN TAXATION LAW CASES 2019

taxpayer’s employment contract rights. These payments will be assessable only as a capital gain under the CGT regime. If it happened today: The taxpayer’s employment with the company did not end when a new employment contract was substituted for the original contract. Thus, the payments would not be considered employment termination payments. The payments are not in substitution for income or compensation for income and three payments over two years probably does not constitute periodicity sufficient to stamp the payments with the character of ordinary income. As the payments are not in respect of employment, they would not be a fringe benefit for FBT purposes. Ending the first employment contract is probably a CGT event C2 (s 104-25 ITAA 1997 though it is a little difficult to say the taxpayer has “ownership” of the original 1997), employment contract. The taxpayer’s capital proceeds would be the amount to be paid under the agreement to terminate the contract and the taxpayer’s cost base would be the cost of acquiring the original contract, which most likely was nil.

TIPS It is quite common for employees in the hospitality trade to receive tips directly from customers in addition to the salary they receive from their employers. The tips are voluntary from the customer and are not part of any contract between the employer and employee. It is, however, clear that the amounts paid relate to services provided by the employee and the question from a tax perspective thus is whether tips can be assessable as ordinary income from the source of personal services.

Calvert (Inspector of Taxes) v Wainwright

[1947] 1 All ER 282; 27 TC 475 (UK High Court of Justice)

Facts: The taxpayer was a taxi driver who received a salary from the taxi cab company and also received tips directly from customers. The UK Inland Revenue assessed the tips as income paid as a reward for services. The taxpayer argued his income was his salary for those services and the tips were personal gifts from customers. Decision: The court concluded that tips were not personal gifts but rather were payable in respect of services provided and thus constitute income from employment. Relevance of the case today: Calvert v Wainwright is cited as authority for the conclusion that tips for personal services are ordinary income to the recipient. If it happened today: If the facts in Calvert v Wainwright were to arise today in Australia, the taxpayer would be assessed on the tips received as ordinary income under s 6-5(1) ITAA 1997. Since the payments are not made by the employer or any person related to the employer, they would not be a fringe benefit as defined in s 136(1) FBTAA.

32

© Thomson Reuters 2019

CHAPTER 3

INCOME FROM PERSONAL SERVICES AND EMPLOYMENT

WINDFALL PRIZES OR INCOME? A prize won in a contest would normally not be ordinary income because it would not be the product of the taxpayer’s services, business activities or property and it would not have separate income characteristics such as periodicity or compensation for lost income. However, if the prize was related to the taxpayer’s income producing services, it might acquire an income character as an indirect product of the services.

Kelly v FCT

(1985) 16 ATR 478; 85 ATC 4283 (Supreme Court of Western Australia) Facts: The taxpayer played league football, being paid a fixed amount for each match played. The taxpayer was aware of the fact that each year the umpires voted a player as the “best and fairest” during the season and that player would be awarded a medal. Players knew that a television station provided a $20,000 cash prize to the player who won the medal. While the taxpayer did not expect to be awarded the medal, he did win the medal and the accompanying $20,000 prize. The Commissioner assessed the taxpayer on the prize money. Decision: While they might not expect to win the medal, each league member knew he was eligible for the medal and that the winner would also receive the $20,000. The prize was directly related to a football player’s employment, based on the player’s skill and performance. The fact that the taxpayer did not expect to win the prize is irrelevant. It was open to all players and was incidental to the employment of such players as employment was the proximate cause of the payment. The fact that it was paid by a third party was also not determinative of the character provided it can be seen as a product of the taxpayer’s activities in his regular employment. Relevance of the case today: Kelly continues to be cited as authority for the proposition that prizes which are awarded because of a taxpayer’s performance in the course of carrying out employment (or self-employment) activities are ordinary income to the taxpayer. The precedent applies to similar benefits where the benefits are provided by third parties but are provided because of the taxpayer’s performance in his or her employment or self-employment activities. If it happened today: If the same facts in Kelly arose today, the prize money would be considered ordinary income of the taxpayer. If the prize came in a form other than cash and could not be converted to cash, the prize would probably not be ordinary income as a result of the cash or convertible to cash requirement described in Tennant v Smith [1892] AC 150. If the prize were not cash or convertible to cash but was given to the sportsperson by a third party and the facts showed there was an arrangement between the third party and the sportsperson’s employer within the meaning of “arrangement” in s 136(1) FBTAA, the prize would likely be considered a taxable fringe benefit and the employer would be liable for fringe benefits tax on the value of the prize. If the prize was not cash or convertible to cash and was not given by a third party in connection with an arrangement with the employer, it would be included in the taxpayer’s statutory income under s 6-10 ITAA 1997 as a result of s 15-2 ITAA 1997. © Thomson Reuters 2019

33

AUSTRALIAN TAXATION LAW CASES 2019

FREQUENT FLYER BENEFITS Often, businesses that pay for travel by employees allow the employees to keep any frequent flyer points that accrue as a result of the flights and use the points for personal travel. As air travel tickets that provide frequent flyer points cost more than tickets on airlines with no frequent flyer points, it is assumed that the price of the ticket includes an element for the frequent flyer points. If the employer deducts the full cost of business travel tickets, including the portion attributable to the provision of frequent flyer points and the employee redeems the points for personal travel, no tax is paid on the benefit. To address this problem, the Commissioner attempted to tax an employee on the value of travel provided for the redemption of frequent flyer points accrued on business travel paid by the employer.

Payne v FCT

(1996) 32 ATR 516; 96 ATC 4407 (Federal Court)

Facts: The taxpayer was an employee who often flew on business trips paid by her employer. She redeemed the frequent flyer points accumulated from her travel for her employer for tickets for her parents to visit Australia from England and for a domestic trip within Australia for her parents. The Commissioner assessed the taxpayer on the value of flights obtained for redemption of points under the frequent flyer program as ordinary income from employment under s 25(1) ITAA 1936 (the predecessor section to s 6-5(1) ITAA 1997 1997) and as a benefit from employment under s 26(e) ITAA 1936 (the predecessor section to s 15-2 ITAA 1997 1997). Decision: The Federal Court found the benefits received by the taxpayer for the redemption of frequent flyer points were not ordinary income as they were not cash or convertible to cash. They were also not a benefit from employment under s 26(e) because they resulted from a personal contractual entitlement under the frequent flyer program, not a benefit given as a result of employment. For a benefit to be in relation to employment under s 26(e), the employer must play a direct role in providing the benefit and the employer played no role in the frequent flyer scheme. Relevance of the case today: The Payne case is the authority for the conclusion that frequent flyer benefits are not ordinary income or an assessable benefit in respect of employment assessable under s 15-2 ITAA 1997. If it happened today: If the facts in Payne were to happen today, the Commissioner would no longer try to assess the taxpayer on the benefit of the tickets received through the redemption of frequent flyer points accrued on business travel paid by the taxpayer’s employer. As the Commissioner was assessing the employee only in Payne, there is no consideration in the case of possible fringe benefits tax consequences to the employer from the provision of frequent flyer points related to business travel or the redemption of points for flights. However, the nexus required for a benefit to be related to employment as required by the fringe benefits tax is similar to the test used to determine if a benefit is assessable ordinary income under s 6-5(1) ITAA 1997 or s 15-2 ITAA 1997. It is, therefore, likely that the benefit enjoyed by the employee in 34

© Thomson Reuters 2019

CHAPTER 3

INCOME FROM PERSONAL SERVICES AND EMPLOYMENT

Payne would also not be assessable to the employer as a fringe benefit as defined in s 136(1) FBTAA. Subsequent to the case, the Commissioner has indicated in a public ruling TR 1999/6 that the ATO will assess the employer under the fringe benefits tax law where the entitlement to frequent flyer points is treated by the employer and employee as part of the employee’s remuneration. It also indicated in a practice statement PS LA 2004/4 (GA) that it will apply fringe benefits tax to customer loyalty benefits if an employee deliberately acquires goods or services for the employer on a personal credit card to receive consumer loyalty points such as frequent flyer points available for use of the credit card.

CAPITAL OR INCOME: SELLING PERSONAL KNOWLEDGE Often, an individual is of most value to a commercial enterprise because of knowledge possessed by the individual. The question arises whether that knowledge is a capital asset of the taxpayer and, if so, whether the sale of the knowledge will yield a capital gain outside the scope of ordinary income.

Brent v FCT

(1971) 125 CLR 418; 2 ATR 563; 71 ATC 4195 (High Court)

Facts: The taxpayer was the wife of a famous criminal, Ronald Biggs, who had participated in the infamous British “Great Train Robbery” and escaped to Brazil. She entered into a contract with a UK paper, The Daily Telegraph, to sell the exclusive world rights to the story of her life with Ronald Biggs. The contract required her to make herself available for interview by reporters or others authorised by the paper and to sign the manuscript of her life story that they prepared on the basis of the interviews. The taxpayer argued the receipts were capital amounts for the sale of a capital asset, the exclusive rights to her life story. The case took place prior to the adoption of CGT. Decision: In essence, the taxpayer was being paid not for the information she had but rather for the service she provided in conveying that information to the newspaper through the long interview process over a number of days. The knowledge she had was not “property” and further it was not transferred to the newspaper as she retained it after the transaction. What was sold was her service of providing the knowledge to the paper. The payment she received was ordinary income from the provision of personal services assessable under s 25(1) ITAA 1936 (currently s 6-5(1) ITAA 1997 1997) and under s 26(e) ITAA 1936 (currently s 15-2 ITAA 1997 1997). Relevance of the case today: The Brent case may be cited as authority for the proposition that information or knowledge is not property and cannot be “sold” unless it is transferred to a form of recognised intangible property (eg, a patent or copyright). The case is also authority for the proposition that the transfer of information by means of oral transmission is an activity generating ordinary income. As the court found there was no property transferred in this case, the decision is not authority for any view © Thomson Reuters 2019

35

AUSTRALIAN TAXATION LAW CASES 2019

on whether the transfer of property, had there been some, would have been ordinary income or a capital gain. If it happened today: If the facts in Brent arose today, the payment received by the taxpayer would once again be treated as ordinary income from the provision of services and would be assessable under s 6-5(1). If instead of reciting the story to reporters, the taxpayer wrote it out, she would have created property that could have been sold to the newspaper (that is, she could have sold the copyright in her story). However, proceeds from the sale of that asset would likely also be treated as ordinary income as the asset would be entirely a product of her own labour.

CAPITAL OR INCOME: NEGATIVE COVENANTS BY EMPLOYEES AND CONTRACTORS Employees or individual contractors who provide personal services to employers or customers sometimes enter into negative covenant agreements to be paid not for providing further services to the employers or customers but instead for agreeing not to provide those services to any other employers or customers. Taxpayers claim the payments they receive for making these covenants are capital payments for giving up a capital asset (the right to contract for these services) while the Commissioner argues they are income payments (ancillary to the existing contract to provide services to the employers or customers). Parallel arguments are raised by businesses that enter into negative covenant agreements. The parallel business cases are found in Chapter 4 under the heading“Isolated Transactions – Payments for Negative Covenants”.

Higgs (Inspector of Taxes) v Olivier

[1952] Ch 311 (England & Wales Court of Appeal)

Facts: The taxpayer was a well-known actor who entered into a contract to direct and act in a film production. After the film had been completed, the taxpayer entered into a second negative covenant agreement with the company that produced the film under which the taxpayer agreed not to act in, or produce or direct any film anywhere for a period of 18 months, except for films produced by that company. The taxpayer was assessed under the UK schedule income tax law on the basis that the gain was income in respect of a vocation as an actor. The taxpayer argued the second agreement must be read separately from the first and the negative covenant payments were not income in respect of a vocation. Decision: The Court of Appeal agreed with the taxpayer that the original agreement and the subsequent negative covenant agreement could not be read together and further that the payment was not income in respect of a vocation. Relevance of the case today: The UK income tax law is a “schedular” law and to be assessable, income must fall within a particular schedule. Australia’s income tax law, by way of contrast, is known as a “global” law, applying to income from any activity. It was suggested by Kitto J in Dickenson v FCT (1958) 98 CLR 460 that the holding 36

© Thomson Reuters 2019

CHAPTER 3

INCOME FROM PERSONAL SERVICES AND EMPLOYMENT

in Higgs v Olivier might not be applicable in Australia given the different structure of the Australian law but Australian courts have ignored this difference and rely on Higgs v Olivier as support for the proposition that payments for negative covenants will generally be capital receipts. If it happened today: If the facts of Higgs v Olivier arose today in Australia, there would be a D1 event under s 104-35 ITAA 1997 at the time the taxpayer entered into the negative covenant contract and the lump sum receipt would form the capital proceeds from the event, reduced only by any incidental costs (see s 104-35(3)). Gains arising from D1 events are excluded from the discount capital gains concession by s 115-25(3) ITAA 1997.

FCT v Woite

(1982) 13 ATR 579; 82 ATC 4578 (Supreme Court of South Australia)

Facts: The taxpayer was a professional footballer under contract to play for a club in the South Australian football league. He entered into an agreement with the North Melbourne Football Club under which he agreed that if he moved to the Victorian Football League (now the AFL), he would contract with the North Melbourne club and give up his rights to sign with any other club in the Victorian league. The Commissioner assessed the taxpayer on the basis that the $10,000 he received as consideration for signing the agreement was income derived in his capacity as a professional football player. Decision: The Court based its characterisation of the payment on the fact that the obligation undertaken by the taxpayer was not incidental to the taxpayer’s employment in South Australia for which he received income. The Court held that the payment was not income because it lacked a direct nexus with the taxpayer’s ordinary derivation of income. A payment for agreeing to restrict one’s rights is not an income payment. Relevance of the case today: The Woite case remains an important precedent for the proposition that payments for negative covenants with respect to the performance of personal services are capital amounts and outside the scope of s 6-5(1) ITAA 1997 ordinary income. While it is assessable under the CGT provisions, the CGT rules have limited application to foreign residents. In particular, s 136-15 ITAA 1997 imposes strict limits on when foreign residents may be liable to tax on CGT recognised under CGT event D1, which is the event that applies to gains from negative covenants of this sort. By arranging for the contract to be completed outside Australia, foreign residents should be able to shelter their gains from Australian tax using s 136-15. If it happened today: If the facts of Woite took place today, there would be a D1 event under s 104-35 ITAA 1997 at the time the taxpayer entered into the negative covenant contract and the lump sum receipt would form the capital proceeds from the event, reduced only by any incidental costs (see s 104-35(3)). Gains arising from D1 events are excluded from the discount capital gains concession by s 115-25(3) ITAA 1997.

© Thomson Reuters 2019

37

AUSTRALIAN TAXATION LAW CASES 2019

CAPITAL OR INCOME: PAYMENTS AFTER CESSATION OF EMPLOYMENT Blank v FCT

[2016] HCA 42; 258 CLR 439; 104 ATR 41 (High Court)

Facts: The taxpayer, a senior executive at the commodities firm Glencore, received a salary package that included an incentive profit participation arrangement. The agreement provided “deferred compensation” for services rendered, payable in several instalments after he left his position. The central issue was whether the amount was income according to ordinary concepts and therefore assessable income pursuant to s 6-5 ITAA 1997 or whether it was a capital gain. Decision: The High Court unanimously dismissed the appeal by the taxpayer and held that the payments were ordinary income. The Court rejected the taxpayer’s argument that the amount was paid in relation to the exploitation of interconnected rights that conferred on him the right to receive in the future a portion of the company’s profits. Instead, the Court held that the amount was received as part of the consideration for services rendered. Relevance of the case today: The case of Blank makes it clear that the characterisation of a reward for services rendered as income is not lost because a reward is paid in a lump sum, because the payment is deferred or because it is payable upon the occurrence of a particular event. The case also makes it clear that an amount paid after the termination of a contract of service, by a person other than the employer and separately to ordinary wages, salary or bonuses, does not detract from its characterisation as income if the payment is a recognised incident of the employment. If it happened today: If the facts in Blank were to arise today, the taxpayer’s receipt would once again be characterised as income according to ordinary concepts and included in assessable income by virtue of s 6-5 ITAA 1997.

SUPERANNUATION AND RETIREMENT PAYMENTS Prior to 1983, pension payments made by a superannuation fund were considered ordinary income on the basis of their income character (periodic, anticipated, and so forth). Generally, lump sum payments from a superannuation fund and lump sum termination payments from an employer were considered capital amounts. Section 26(d) ITAA 1936 included 5% only of these amounts in assessable income. An employer’s contributions to a superannuation plan were not taxable to the employer at the time of contribution because they did not vest immediately to the employee’s benefit (funds had rules that delayed vesting the employee’s entitlement until a condition such as a period of employment had passed). When the funds finally vested, they were not treated as income to the employee. Only on distribution from the fund would they be taxable in full as pensions or 5% of the amount received as lump sums. 38

© Thomson Reuters 2019

CHAPTER 3

INCOME FROM PERSONAL SERVICES AND EMPLOYMENT

Reforms in 1983 brought all termination payments and lump sum superannuation distributions into assessable income, subject to generous grandfathering rules for funds related to pre-July 1983 service. In 1988, superannuation funds were made taxable entities liable to pay tax in respect of contributions to the funds (other than contributions paid from after-tax amounts) and earnings from the investment of fund assets. Pensions and lump sums paid from superannuation funds were also made assessable, subject to a tax credit in the case of pensions (which in effect offset the tax which had been previously levied on the amounts received at the fund level) and caps on the rates imposed on lump sums depending on the amount received and the age of the recipient. From 1 July 2007, most types of superannuation benefits paid from complying superannuation funds are tax exempt if they were paid from amounts that had been previously taxed either in the superannuation fund or prior to contribution to the fund and the recipient is aged 60 or older.

Constable v FCT

(1952) 86 CLR 402 (Full High Court)

Facts: Both the taxpayer’s employer and the taxpayer as employee contributed to a foreign superannuation fund for the benefit of the taxpayer. The fund’s rules entitled members to a payment of all accrued benefits if there were significant changes to the fund rules. Such an alteration occurred and the taxpayer exercised his right to call for payment of the amount shown in his account. The taxpayer received an amount including all contributions to the fund and accrued gains to which he was entitled. The Commissioner assessed the taxpayer on the part of the payments which represented employer contributions and interest on contributions under s 26(e) ITAA 1936 (currently s 15-2 ITAA 1997 1997), arguing they were (indirectly) in respect of or in relation to his employment. Decision: The High Court focused on the language in s 26(e) which required that the benefit be “allowed, given or granted to him” during the year of income. In their view, the taxpayer became entitled to the payment by reason of a contingency under the fund rules which occurred and enabled him to call for payment – a contingent right to payment became absolute and payment was made accordingly. This could not be described as the allowing, giving or granting of an allowance, gratuity, compensation, benefit, bonus or premium. The amount was received as a capital sum. The Court also commented in obiter on the tax treatment of the contributions stage. The Court considered that it would be difficult to see that the contributions were income at the time that the employer made the contributions to the fund. The amounts were paid to the administrators of the fund, not to the employee, and put in a special fund and it was only after the administrators exercised a discretion that amounts were transferred to a member’s account, and even then the member was not presently entitled to the sum. The potentially broad language in s 26(e) ITAA 1936 “in respect of, or for or in relation to employment” was read down to require a direct nexus with employment, not an indirect consequence of having been in employment. Relevance of the case today: The Constable case was decided prior to the adoption of comprehensive rules for superannuation funds and payments as well as rules for © Thomson Reuters 2019

39

AUSTRALIAN TAXATION LAW CASES 2019

contributions to and payments from foreign superannuation funds. However, Constable establishes the proposition that employer contributions to superannuation funds are not income to the employee. This view is accepted by the Commissioner and forms the basis for non-taxation at the point of contribution. The case is no longer important for the interpretation of benefits from a superannuation fund given the adoption of a comprehensive set of rules dealing with the receipt of superannuation benefits including benefits from foreign superannuation funds. Constable remains important for the interpretation of s 15-2 requiring a direct nexus with employment and an indirect nexus (a payment pursuant to rules of a fund that the taxpayer joined because of employment, for example) is not sufficient for the provision to apply. If it happened today: The current superannuation rules distinguish between a “complying superannuation fund” and a “non-complying superannuation” fund. A foreign fund cannot be a complying superannuation fund and the employer’s contributions would not be deductible expenses as a result of s 290-10 ITAA 1997. Also, the employer’s contributions would be subject to fringe benefits tax. There is an exclusion from the definition of “fringe benefit” for contributions to foreign funds (s 136(1) definition of “fringe benefit” in para (j)(ii) ITAA 1936 1936) but the exclusion only applies to contributions for Div 768-R ITAA 1997 “temporary residents”. Today, the non-deductibility and FBT would operate as a strong disincentive to contributing to foreign superannuation funds, even if the earnings will not be taxed to the employee as they accrue. The lump sum payment from a foreign superannuation fund received by the taxpayer in Constable would today be included in assessable income under s 305-70 ITAA 1997.

Reseck v FCT

(1975) 133 CLR 45; 5 ATR 538; 75 ATC 4213 (High Court)

Facts: The taxpayer was employed by a construction firm. His arrangement with his employer provided for a separate contract for each project he worked on. He completed a project that had lasted almost three years on a Friday and commenced a new project on the following Monday, receiving a large “termination” payment at the end of the first project. The Commissioner did not dispute a finding by the Board of Review (predecessor to the Administrative Appeals Tribunal) that the payment was a termination payment. At the time, such payments were considered capital receipts outside the judicial concept of income but s 26(d) ITAA 1936 included 5% of lump sum termination payments in income (effectively leaving the remaining 95% tax free). The Commissioner argued that if he could show the remaining 95% had a nexus with the taxpayer’s employment, he could assess it as ordinary income under s 25(1) ITAA 1936, the predecessor to s 6-5(1) ITAA 1997. Decision: A majority of the Court concluded that if an amount satisfied the definition of a termination payment and 5% was included in assessable as statutory income, the construction of the statutory income provision implied that the remaining 95% could not be included in assessable income as ordinary income. 40

© Thomson Reuters 2019

CHAPTER 3

INCOME FROM PERSONAL SERVICES AND EMPLOYMENT

Relevance of the case today: Partly in response to cases such as Reseck, almost all the statutory income provisions in the ITAA 1997 now state explicitly that they only apply to receipts to the extent the amounts are not ordinary income. The implication of the construction used in most sections today is that part of a payment could be assessable under s 6-5(1) and part under a statutory income provision. Thus, under modern statutory income provisions it would not be possible to argue on the basis of Reseck that where a payment is only partly assessable as statutory income the remaining part should not be assessed as ordinary income. If it happened today: If the same facts in Reseck arose today, the Commissioner would most likely appeal the finding that a payment received by an employee who stopped work on a Friday and started again on the following Monday was an employment termination payment. The Commissioner would likely be successful with an appeal on this basis. If it were found that the payment was in respect of termination of employment, it would satisfy the definition of a “life benefit termination payment” in s 82-130 ITAA 1997 and be included in the taxpayer’s assessable income under s 82-10 ITAA 1997. The portion of the payment attributable to pre-July 1983 employment would be taxfree under s 82-140 ITAA 1997. The rate of tax imposed on the payment may be subject to a cap under s 82-10(3) ITAA 1997. Alternatively, the Commissioner may argue that the payment is deferred remuneration and therefore ordinary income. In Blank v FCT [2016] HCA 42, 258 CLR 439 (discussed earlier in this chapter), the High Court stated that Reseck stands for the proposition that the characterisation of a reward for services rendered as income is not lost because a reward is paid in a lump sum, because the payment is deferred or because it is payable upon the occurrence of a particular event. Further, an amount paid as a lump sum because a person has retired, or has had their office or employment terminated, is income of that office or employment if it is deferred remuneration.

FRINGE BENEFITS IN KIND AND FRINGE BENEFITS TAX Relying on UK jurisprudence, Australian courts excluded from ordinary income, income from personal services and employment benefits in kind – that is, benefits in goods or services rather than cash – unless the benefits were easily convertible to cash by the recipient. If the recipient had the choice of using or not using the benefit but no option of converting it to cash by selling it, for example, the benefit would not be ordinary income. The legislature responded to this doctrine by enacting s 26(e) ITAA 1936, predecessor to current s 15-2 ITAA 1997, which included in the assessable income of an individual providing personal services the value of remuneration for the services, including remuneration by way of benefits in kind. One shortcoming of the provision was that the amount to be included in assessable income was the value of the benefit to the taxpayer and taxpayers could argue on the basis of their personal preferences that benefits were worth less to them personally than the actual market value of the benefits. A more serious problem was the failure of the Commissioner to © Thomson Reuters 2019

41

AUSTRALIAN TAXATION LAW CASES 2019

apply the provision consistently to all benefits in kind, with automobiles being the most significant omission. In 1986 the Government moved all the tax rules for benefits in kind for employees to the Fringe Benefits Tax Assessment Act. The fringe benefits tax or FBT applies to both convertible and non-convertible benefits. The value of benefits in kind from employment (and other types of remuneration other than wages or salaries) is assessed to employers under the FBTAA. Benefits in kind for persons other than employees are assessed to the recipients under s 6-5(1) ITAA 1997 after they are deemed to be convertible to cash by s 21A ITAA 1936.

The “Cash or Convertible into Cash” Doctrine Tennant v Smith (Surveyor of Taxes) [1892] AC 150 (UK House of Lords)

Facts: The taxpayer was a bank employee provided with free accommodation in premises provided by the bank. He was allowed to use the premises as long as he was an employee of the bank but had to occupy it personally and he could not sublet it. To qualify for a low income tax concession, the taxpayer argued the provision of accommodation occupied in the course of work was not to be included in his income for tax purposes. Decision: The benefit of employer-provided premises was not included in the schedule for employment remuneration which applied to “salaries, fees, wages, perquisites, or profits whatsoever” accruing to a person by reason of office or employment. Relevance of the case today: The six law lords who heard this appeal provided different reasoning for their decisions. The UK income tax law is based on a schedular system of different categories of taxable receipts and the case could be considered to have a narrow holding that this benefit did not fall within the profits from employment schedule. However, the legacy of the case goes much further and it is most commonly thought to establish the “cash or convertible into cash” doctrine based on the judgment of Lord Watson that a benefit would only be taxable if it were “money or that which can be turned to pecuniary account”. In Australia, s 26(e) ITAA 1936 (currently s 15-2 ITAA 1997 1997) was enacted in part to overcome the “cash or convertible” doctrine by including in income the value of non-cash benefits from the provision of services. Section 26(e) has been superseded in respect of non-cash benefits for employees by the fringe benefits tax. Section 21A ITAA 1936 overcomes the doctrine in respect of non-cash business benefits (provided in a business relationship rather than an employment relationship) by deeming benefits that are not convertible to cash to be treated as if it were convertible to cash. While the doctrine has been overturned for employee fringe benefits and for business benefits, it continues to be cited in other situations such as where services or property is provided in lieu of income from property.

42

© Thomson Reuters 2019

CHAPTER 3

INCOME FROM PERSONAL SERVICES AND EMPLOYMENT

If it happened today: The accommodation provided to the taxpayer would be a “housing benefit” within the meaning of s 25 FBTAA and a “housing fringe benefit” within the meaning of s 136(1) FBTAA. The value of the benefit calculated under s 26 FBTAA would be included in the employee’s “individual fringe benefits amount” defined in s 5E FBTAA which is included in an employer’s “aggregate fringe benefits amount” defined in s 5C FBTAA which is included in the employer’s “fringe benefits taxable amount” defined in s 5B FBTAA which is subject to tax under the charging provision, s 66 FBTAA.

Employee Share Benefits The provision of shares and share options to employees was originally taxed under former s 26(e) ITAA 1936. The case of Donaldson v FCT (1974) 4 ATR 530 showed the difficulty of valuing these benefits where contingencies and options were involved. The government responded by enacting a special regime for employee share benefits, currently located in Div 83A ITAA 1997. Share benefits that are assessed under Division 83A are explicitly excluded from the definition of “fringe benefit” in s 136(1) FBTAA. Share benefits that fall outside Division 83A may be assessable under the FBTAA. In theory, an employee share arrangement that fell outside both Division 83A and the FBTAA might still be assessed to the employee under s 6-5(1) ITAA 1997 under the authority of Abbott v Philbin (see below). However, the Commissioner has not attempted an assessment on this basis. If the benefit would not be characterised as one that was in respect of employment for FBTAA purposes, it also would not be in respect of employment for s 6-5(1) purposes.

Abbott v Philbin (Inspector of Taxes) [1961] AC 352 (UK House of Lords)

Facts: In 1954, the taxpayer, who was the secretary of a company, was granted an option to purchase 2000 shares in the company for 68s 6d per share. The taxpayer paid £20 for this option. The option was non-transferable and expired on the earlier of 10 years or the death or retirement of the taxpayer. In 1956, when the market price of the shares had risen to 82s per share, the taxpayer exercised the option with respect to 250 shares. The taxpayer was assessed on the difference between the market value of the 250 shares acquired and the option (exercise) price (plus an additional amount for the relevant proportion of the price of the option) on the basis that it was an emolument of his employment. The taxpayer argued that the assessment should have been made for the 1954 year. Decision: A majority of the House of Lords held that the taxpayer should have been assessed in the year in which the option was granted and not when the option was exercised. When the option was issued to the taxpayer, he received something of value or potential value in relation to the employment. This was the receipt of a taxable benefit. When the option was exercised, it would be difficult to say that the increased difference between the prices over the period arose from the taxpayer’s office; it was due to numerous factors which had no relation to the taxpayer’s office. Therefore, there could not be a second perquisite of employment on exercise. © Thomson Reuters 2019

43

AUSTRALIAN TAXATION LAW CASES 2019

The “cash or convertible into cash” doctrine established in Tennant v Smith [1892] AC 158 did not operate to exclude the benefit from income. Although the options were not transferable, as the taxpayer could have entered into an arrangement with a third party to realise the value of the option, it was seen to satisfy the cash or convertible to cash requirement for ordinary income from employment. However, the conditions and restrictions attaching to the option could affect the value of the option. Relevance of the case today: Most share options issued or sold to employees are now subject to a special statutory regime in Division 83A ITAA 1997. Options falling outside the scope of Division 83A may be assessed as a fringe benefit as defined in s 136(1) of the FBTAA. In theory, share benefits falling outside both Division 83A and the FBTAA could still be assessed to the employee with reliance on Abbott v Philbin, although the Commissioner has not attempted to do so. The decision is of continued relevance today as authority for the proposition that the value of a benefit from employment is ascertained when the benefit is initially provided and the requisite connection with employment can be found, with any advantage arising later due to an increase in the value of the asset not sufficiently connected with the employment relationship for that advantage to be treated as a benefit in respect of employment. The decision is also relevant for the application of the convertibility to cash test to these circumstances and the holding that a restriction on transfer does not necessarily lead to the conclusion that the property cannot be turned to account. The fact that a benefit may be considered convertible into cash and thus have an income character is less relevant today, however, since it would be income other than a wage or salary, and thus subject to fringe benefit tax in the same manner as if it were not ordinary income because it was not viewed as convertible. If it happened today: If the facts of this case occurred today, the benefit would be assessed under Division 83A ITAA 1997, applicable to the acquisition of shares and rights (options) under an employee share scheme. Division 83A contains two alternative methods for taxing shares or options provided under an employee share scheme. The general rule is that the value of shares or rights are included in assessable income when received, subject to concessions for “start ups” and some other cases. An alternative rule allows the employee to defer recognition of any income if there is a real risk the right to acquire shares can be forfeited and other conditions are met. If the conditions are met, recognition of the gain can be deferred until the earlier of when there is no risk of forfeiture and sale restrictions have been lifted, the option is exercised, cessation of employment, and 15 years.

FCT v Indooroopilly Children Services (Qld) Pty Ltd (2007) 65 ATR 369; 2007 ATC 4236 (Full Federal Court)

Facts: The taxpayer operated a child care centre under a licence from ABC, a wholly owned subsidiary of a public company, ABC Public. The public company proposed to establish a trust for the benefit of employees of the licencees (which included the taxpayer’s employees) and to issue new shares which would be gifted to the trust. The trustee would distribute the shares to qualifying employees after they reached certain thresholds relating to the period of employment. At the time the shares would be issued 44

© Thomson Reuters 2019

CHAPTER 3

INCOME FROM PERSONAL SERVICES AND EMPLOYMENT

to the trust, neither ABC public nor the trustee would know which employees would qualify to receive shares. Prior to issuance of the shares, the taxpayer sought a private ruling on the question of whether there would be a liability to fringe benefits tax. The Commissioner issued a ruling indicating FBT would be payable when the shares were issued to the trust. The taxpayer appealed the ruling, arguing the fringe benefits tax could not apply if the identity of the employees who would receive the benefits is unknown at the time property is given to a trust in favour of the employees. Decision: The fringe benefits tax applies to benefits in respect of employment provided by an employer, an associate of an employer, or a third party with an arrangement with the employer. There was an arrangement between the taxpayer and ABC Public and the transfer of shares was a benefit. However, the Federal Court agreed with earlier precedents that the definition of “fringe benefit” in s 136(1) FBTAA requires the identification of the employee who receives the benefit. While the class of beneficiaries of the trust was known, it was not known which beneficiaries would receive the shares at the time they were given to the trust and as a result, there was no fringe benefit. Relevance of the case today: Indooroopilly Children Services is relevant today as confirmation that a contribution to an employees’ benefit trust is not a fringe benefit where it is not known which employees will receive benefits from the trust. If it happened today: If the facts in Indooroopilly Children Services were to arise again, a court would once again find the transfer of shares into an employee share trust was not a fringe benefit. The court in Indooroopilly Children Services appeared to agree with the taxpayer’s assertion that the taxing point would be when shares were distributed from the trust, at which time the value of the shares would be assessable income of the employees. It is not clear that this result would necessarily follow. The trust will be a provider of the benefit within para (ea) of the definition of “fringe benefit” in s 136(1) FBTAA and the distribution will thus likely be fringe benefit. If it is a taxable fringe benefit, it will be excluded from the assessable income of the employees receiving the shares as a result of s 23L ITAA 1936 which defines the amounts that are also fringe benefits as non-assessable non-exempt income.

© Thomson Reuters 2019

45

C HAPTER 4

Income from Business and Gains from the Sale of Assets BUSINESS INCOME – THE CASH OR CONVERTIBLE REQUIREMENT ... 50 Cooke and Sherden (1980) ........................................................................ 50 THE INDICIA OF CARRYING ON A BUSINESS ............................................. 51 The Indicia of Carrying on a Business: Gambling ......................................... 52 Trautwein (1936)....................................................................................... 52 Martin (1953) ............................................................................................ 53 Evans (1989) ............................................................................................. 53 Brajkovich (1989) ..................................................................................... 54 The Indicia of Carrying on a Business: Sportspersons ................................... 55 Stone (2005) .............................................................................................. 55 The Indicia of Carrying on a Business: Land Sales........................................ 56 Scottish Australian (1950) ........................................................................ 56 Whitfords Beach (1982) ............................................................................ 58 Crow (1988) .............................................................................................. 59 Casimaty (1997) ........................................................................................ 60 The Indicia of Carrying on a Business: Investment ....................................... 60 Trent Investments Pty Ltd (1976) .............................................................. 60 London Australia Investment Co Ltd (1977) ............................................ 61 Radnor Pty Ltd (1991) .............................................................................. 62 AGC (Investments) Ltd (1992) .................................................................. 63 ILLEGAL ACTIVITIES .......................................................................................... 64 Partridge v Mallandaine (1886) ............................................................... 64 ISOLATED TRANSACTIONS BY A BUSINESS ............................................... 65 Commercial Transactions ............................................................................... 65 Californian Copper Syndicate v Harris (1904) ........................................ 65 Ducker (CIR) Rees Roturbo Development Syndicate Ltd (1928) ............. 66 Myer Emporium Ltd (1987) ...................................................................... 67 Westfield Ltd (1991) .................................................................................. 69 Henry Jones (IXL) Ltd (1991) ................................................................... 70 Sales of Know-How ....................................................................................... 71 Evans Medical Supplies Ltd (1957) .......................................................... 71 Rolls-Royce (1962).................................................................................... 72 © Thomson Reuters 2019

47

AUSTRALIAN TAXATION LAW CASES 2019

Lease Incentives and Fit Outs......................................................................... 73 Cooling (1990) .......................................................................................... 73 Rotherwood (1996) ................................................................................... 74 Lees & Leech (1997) ................................................................................. 75 Selleck (1997)............................................................................................ 77 Wattie (1998) ..............................................................................................78 Montgomery (1999) .................................................................................. 79 Payments for Negative Covenants.................................................................. 80 Dickenson (1958) ...................................................................................... 80 MIM Holdings Ltd (1997) ......................................................................... 81 FOREIGN EXCHANGES GAINS AND LOSSES ............................................... 82 International Nickel Australia Ltd (1977) ................................................ 82 ISOLATED TRANSACTIONS BY AN INDIVIDUAL....................................... 83 Profit-Making Schemes .................................................................................. 84 McClelland (1970) .................................................................................... 84 Property Acquired with the Purpose of Resale at a Profit .............................. 85 Steinberg (1975) ........................................................................................ 86 REVENUE ASSETS ................................................................................................ 87 Colonial Mutual Life Assurance Society Limited (1946) .......................... 87 Chamber of Manufactures Insurance Ltd (1984) ..................................... 88 INDEMNITIES AND REIMBURSEMENTS ....................................................... 89 Allsop (1965)............................................................................................. 89 HR Sinclair & Son Pty Ltd (1966) ............................................................ 90 National Commercial Banking Corp of Australia Ltd (1983) .................. 91 TNT Skypak International (Aust) Pty Ltd (1988) ...................................... 92 Warner Music Australia Pty Ltd (1996) .................................................... 93 Rowe (1997) .............................................................................................. 94 Denmark Community Windfarm (2018) .................................................... 95 CSR Ltd (2000) ......................................................................................... 95 GOVERNMENT SUBSIDIES ................................................................................ 97 GP International Pipecoaters Ltd (1990) ................................................. 97 First Provincial Building Society Ltd (1995) ............................................ 98 COMPENSATION FOR LOST PROPERTY ........................................................ 99 Characterisation of Compensation.................................................................. 99 Glenboig Union Fireclay Co Ltd (1922)................................................... 99 Undissected Receipts .....................................................................................100 McLaurin (1961) ..................................................................................... 100 Compensation for Delayed Payment ............................................................ 101 Federal Wharf Co Ltd v Deputy FCT (1930).......................................... 101 Northumberland Development Co Pty Ltd (1995) .................................. 102 COMPENSATION FOR DEFAMATION ............................................................ 103 Sydney Refractive Surgery Centre Pty Ltd (2008) .................................. 103 48

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

COMPENSATION FOR CONTRACT TERMINATION .................................. 104 Californian Oil Products Ltd (in liquidation) (1934) ............................. 104 Van den Berghs Ltd v Clark (Inspector of Taxes) (1935) ........................ 105 Fleming & Co (1952) .............................................................................. 106 Heavy Minerals (1966) ........................................................................... 107 Allied Mills Industries Pty Ltd (1989) .................................................... 108 SALE OF RENTAL EQUIPMENT ...................................................................... 109 Memorex Pty Ltd (1987) ......................................................................... 109 Cyclone Scaffolding Pty Ltd (1987) ........................................................ 110 GKN Kwikform Services Pty Ltd (1991) ................................................. 111 Hyteco Hiring Pty Ltd (1992) ................................................................. 112

© Thomson Reuters 2019

49

C HAPTER 4

Income from Business and Gains from the Sale of Assets The ITAA 1997 makes a sharp distinction between “ordinary income” (ie, amounts that would be considered income under judicial income doctrines) and “statutory income” (ie, amounts that enter assessable income only because of a specific statutory inclusion provision). This distinction was not made in the ITAA 1936 and numerous cases under that Act explore the relationship between inclusion provisions and ordinary income. The issue debated time and again is whether all the inclusion provisions expanded the income tax base or whether some actually applied to amounts that would constitute ordinary income in any case. The debate was never resolved before the replacement provisions in the ITAA 1997 largely eliminated the issue by taking ordinary income out of almost every provision that included statutory income in assessable income.

BUSINESS INCOME – THE CASH OR CONVERTIBLE REQUIREMENT As is the case with receipts from the provisions of personal services and gains from the use of property, amounts received in relation to a business acquire an income character either because of inherent income characteristics (periodicity, anticipated, applied to ordinary living expenses, and so forth) or because they have a clear nexus with a source – in this case business activities – and can be seen to be a product of those business activities. In addition, to be “ordinary” income (that is, income according to ordinary or judicial concepts), the receipt must satisfy the “cash or convertible” test.

FCT v Cooke and Sherden

(1980) 10 ATR 696; 80 ATC 4140 (Full Federal Court)

Facts: The taxpayers carried on business as direct soft drink retailers (purchasing stock from the manufacturer and selling directly to final customers using trucks hired from the manufacturer). The soft drink manufacturer provided retailers who reached allotted sales quotas with trips to Queensland or South Pacific islands, paying the retailers’ air fares and accommodation costs. The taxpayers had benefited from a number of paid 50

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

holidays and the Commissioner assessed them on the value of the benefit either as ordinary income under s 25(1) ITAA 1936 (the predecessor to s 6-5 ITAA 1997 1997) or as a benefit subject to s 26(e) ITAA 1936 (which overcame the “cash or convertible” rule in respect of benefits received by a taxpayer in respect of the provision of services). Decision: As the holidays could not be transferred to other persons or otherwise convertible to cash, they could not constitute ordinary income. They were not assessable under s 26(e) because the taxpayers had not provided services to the manufacturer. Their business comprised selling products of the manufacturer but the relationship was that of buyer and seller, not a service provider to the manufacturer. Relevance of the case today: While the result in Cooke and Sherden would be reversed today by reason of new provisions in the ITAA, the decision is authority for the proposition that a non-convertible benefit will not constitute ordinary income and can only be assessed under a specific statutory income provision or a provision that deems a non-convertible benefit to be convertible. If it happened today: Section 21A ITAA 1936 was inserted in the legislation in reaction to the Cooke and Sherden decision. It deems a non-cash business benefit that is not convertible to cash shall be treated as if it were convertible to cash. However, as a result of s 21A(4), the provision will not apply if the provider is not allowed to deduct the cost of the benefit under the “entertainment” expense rule. This rule, in s 32-5 ITAA 1997, denies taxpayers deductions for entertainment expenses. Entertainment is defined in s 32-10 ITAA 1997 to include “recreation” which is, in turn, defined in s 995-1 ITAA 1997 to include “amusement, sport or similar leisure-time pursuits”. If the cruise is not considered to be entertainment, the value would be included in the assessable income of the taxpayers under s 21A. If it is considered to be entertainment, the manufacturer would not be allowed a deduction for the cost of providing the cruise and would pay additional tax as a result while no amount would be included in the assessable income of the retailers.

THE INDICIA OF CARRYING ON A BUSINESS Receipts may acquire an income character (income according to ordinary concepts) if they have income-like characteristics such as periodicity or if they are derived from an income source such as property, personal services, or business. Receipts may be characterised as income from business if the taxpayer’s activities related to the receipts satisfy the indicia of carrying on a business. Cases considering whether a taxpayer’s activities have sufficient indicia of business to constitute a business arise in two situations. Where the taxpayer enjoys a gain, the Commissioner will argue the gain is ordinary income from business. Where the taxpayer suffers a loss, the taxpayer will argue his or her activities constitute a business and associated expenses should be deductible. While the cases dealing with the question of whether a taxpayer’s activities amount to a business cover a broad spectrum of entrepreneurial and not-so-commercial activities, they may be conveniently sorted into four categories – the business of © Thomson Reuters 2019

51

AUSTRALIAN TAXATION LAW CASES 2019

gambling, the business of being a sportsperson, the business of selling land, and the business of realising gains on investments.

The Indicia of Carrying on a Business: Gambling Most often, it is the Commissioner that seeks to argue the taxpayer’s activities amount to a business so the gains from the activities can be assessed as ordinary income. In the case of gambling, however, it is often the taxpayer arguing his or her activities amount to a business, in the hope of deducting gambling losses as business expenses. The leading cases all deal with the issue from the perspective of the Commissioner assessing gains; it appears taxpayers who suffer losses are reluctant to appeal to the courts when the Commissioner rejects their arguments that the losses were incurred in the context of a business.

Trautwein v FCT

(1936) 56 CLR 196 (High Court)

Facts: The taxpayer was assessed in part on an asset betterment basis (with the Commissioner estimating his income by reference to the increase in the taxpayer’s assets over the years in question). The taxpayer operated several businesses including hotel businesses and breeding and racing racehorses. The taxpayer argued that a part of his gain attributable to betting winnings was not assessable as ordinary income. Decision: The Court agreed that in isolation gains from betting will rarely be considered ordinary income. However, having regard to the degree to which the taxpayer’s betting activities were integrated with other horse-racing activities including the breeding and racing, regular attendance at races in part to collect information, and the use and organisation of all means available to make money from horse-racing, and the size and frequency of the taxpayer’s activities, including single bets of up to £1000, the court concluded the taxpayer’s betting activities were part and parcel of a comprehensive horse-racing business. Relevance of the case today: Later cases such as Martin v FCT (1953) 90 CLR 470 indicate courts are reluctant to find a taxpayer’s betting activities amount to a business of gambling (which would imbue winnings with an income character), even when the taxpayer has other horse-racing interests or activities. However, Trautwein can be distinguished from the later cases and cited as authority for the proposition that betting activities are part and parcel of a larger horse-racing business where the activities associated with betting are significant, they appear to be integrated with other racing activities and the amounts wagered are very large (the bets in Trautwein were up to ten times the size of the largest bet wagered by the taxpayer in Martin). If it happened today: It is not clear from the judgment in Trautwein the extent to which the court was influenced by the fact that the taxpayer had not maintained any records and the Commissioner had to reconstruct income by looking at the increase in value of the taxpayer’s assets. This could have been a factor that made the court less sympathetic to the taxpayer’s arguments. Despite later cases that indicate the courts’ 52

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

reluctance to view gambling winnings as ordinary income from a business, if the facts in Trautwein were to arise today, including the extent to which the betting activities were integrated into the taxpayer’s horse-racing business and the size and frequency of the bets, a court might distinguish cases such as Martin and treat the gains as ordinary income from business.

Martin v FCT

(1953) 90 CLR 470 (Full High Court)

Facts: The taxpayer carried on business, first as a hotel-keeper and later as a farmer. He also engaged in betting on race horses on a regular basis and was also involved in owning and breeding race horses. The taxpayer employed a tax agent to keep his books of account and an account was kept of overall betting transactions under a capital account heading. In his income tax returns he disclosed the proceeds of winning bets as capital receipts. The Commissioner argued that the taxpayer was carrying on a business of betting and included the receipts in assessable income. Decision: The taxpayer was not carrying on a business of betting or racing. He was merely engaged in a personal pursuit. The factors the Court considered relevant included: the taxpayer frequented one racecourse and only on ordinary racing days; although the total number of bets appeared large, it amounted to about one bet per race; the bets undertaken were of a maximum of £100; and the taxpayer used a system in determining bets but this system would be like that used by many who find pleasure in betting. Weighing up the evidence, the Court considered that the activities of the taxpayer did not amount to a business of betting. Relevance of the case today: Cases related to the indicia of a business can only be taken as examples and every case must be determined based on its facts. This case is often quoted for the comment: “the pursuit of a pastime, however vigorous the pursuit may be, does not usually amount to carrying on a business.” If it happened today: If these facts were to arise today, the activities of the taxpayer would not be considered carrying on a business. The net receipts or losses could be considered on capital account but under s 118-37(1)(c) ITAA 1997 such gains or losses are disregarded.

Evans v FCT

(1989) 20 ATR 922; 89 ATC 4540 (Federal Court)

Facts: The taxpayer engaged in numerous instances of betting on horse-racing over a number of years. The Commissioner sought to assess the taxpayer on his winnings on the basis that he was engaged in the business of gambling. The taxpayer contended he was a “mere punter”. Decision: The taxpayer was held not to be carrying on a business of gambling. The Court stated that “if a punter is to be held to be carrying on a business it will be because his activities of betting will be systematically conducted so as to get the most favourable odds obtainable”. The evidence of such a system could include: using a © Thomson Reuters 2019

53

AUSTRALIAN TAXATION LAW CASES 2019

computer to keep data and calculate odds; formulating a plan to obtain the best odds; taking steps to lessen the element of chance; having a capital fund; and keeping records of positions, volume and size of bets. In holding that this taxpayer was not carrying on a business of gambling, it was considered significant that the taxpayer used a TAB or on-course totalisator rather than bookmaker so that odds were unknown and the dividend precisely calculated only after the race was completed. In addition, he had the tendency to make exotic bets like trifectas where winning was even more dependent on chance. His actions were quite inconsistent with the money-making, systematic, business-like character which is essential to the carrying on of a business. Relevance of the case today: This case is relevant as an example of the application of the various criteria such as evidence of systematic and calculated activities often used by the courts to determine if particular activities are to be classified as carrying on a business. If it happened today: A court hearing the same facts today would likely arrive at the same conclusion. It should also be noted that gambling winnings are not subject to capital gains tax by virtue of s 118-37(1)(c) ITAA 1997.

Brajkovich v FCT

(1989) 20 ATR 1570; 89 ATC 5227 (Full Federal Court)

Facts: When he was 36 years old, the taxpayer, who had been a life insurance salesman, real estate agent and property developer, largely retired from his business interests and commenced gambling. He claimed to have lost almost $950,000 over the course of the following four years, particularly in the first three years of that period. He sought a deduction for the alleged losses on the basis that he was operating a gambling business over that period. He kept few records of his activities, apart from cheque stubs. He owned some racehorses but the evidence showed he viewed them primarily as a tool to obtain information about racing from the stables in which they were kept. He gambled primarily on horse races and two-up, with a small amount of betting on AFL games. While the taxpayer did not derive a significant income over the period, a family trust controlled by the taxpayer derived over $4 million over the period as a result of the taxpayer’s real estate sales for the trust. Decision: The Full Federal Court agreed with the trial judge’s scepticism as to the accuracy of the taxpayer’s figures given the absence of records. The Court relied on six factors to determine whether gambling activities amounted to a business: 1. whether the betting is conducted in a systematic, organised and “business-like” way; 2. the scale of the gambling (that is, the size of the wins and losses); 3. whether the betting is related to, or part of, other activities of a business-like character such as breeding horses; 4. whether the bettor appears to engage in his activity principally for profit or principally for pleasure; 5. whether the form of betting chosen is likely to reward skill and judgment or depends purely on chance; 54

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

6. whether the gambling activity in question is of a kind which is ordinarily thought of as a hobby or pastime. In general, gambling which is unconnected with what might ordinarily be regarded as commercial activity has no tax implications unless it is of itself a business. The taxpayer in Brajkovich was able to satisfy some of the tests set out by the Court as relevant to whether the activities amounted to a business. What appears to be crucial to the conclusion that the taxpayer was not in the business of gambling is the absence of evidence that his activities were carried out in a systematic, business-like manner. The failure to maintain ordinary business records or develop any methodical business system undermined the assertion that he was in business. The trial judge also probably took into account the fact that while the taxpayer carried on no other extensive business activities for himself, he did operate the business of a trust he controlled, which further suggests the gambling activities were not his business. The Full Federal Court agreed with the findings of the trial judge that the taxpayer was merely indulging in a passion for gambling and was not engaged in a business. Relevance of the case today: The case illustrates the difficulty a taxpayer will have when seeking to claim gambling losses (and the Commissioner when seeking to assess gambling winnings). The case shows that losses (or gains) from gambling activities will only be recognised for tax purposes if the taxpayer carries on a business and while there are six criteria considered to determine if gambling activities amount to a business, the most important criterion appears to be whether there is evidence of a business in the form of records and systematic methodology. If it happened today: If the facts in Brajkovich were to arise today, a court would once again find the taxpayer was not engaged in a business of gambling and would deny the taxpayer a deduction for his losses. It remains difficult for gamblers to show their gambling activities are sufficiently systematic to amount to a business.

The Indicia of Carrying on a Business: Sportspersons FCT v Stone

[2005] HCA 21; 222 CLR 289; 59 ATR 50; 2005 ATC 4234 (Full High Court)

Facts: The taxpayer was a constable in the Queensland Police Force and a champion javelin thrower. She competed in national and international events, including the Olympics and World Cup. In the 1999 tax year, she derived $136,448 from the javelin throwing activities, mostly from prize moneys but also from government grants, sponsorship moneys, and appearance moneys. The Commissioner assessed the taxpayer on the basis that all the funds related to her javelin throwing were assessable income. She claimed she was an employee of the Queensland Police Force and did not have a separate business as an athlete. She argued that the funds from her javelin throwing activities could only be assessable income if she carried on a business of javelin throwing and that since she did not have a business as an athlete, none of the funds received was assessable income. At first instance, Hill J of the Federal Court found that the taxpayer was carrying on business as an athlete in addition to having employment as a police officer and that all © Thomson Reuters 2019

55

AUSTRALIAN TAXATION LAW CASES 2019

the receipts were business income. On the taxpayer’s appeal to the Full Federal Court, the Court found that the prize moneys and grants were not assessable income but the sponsorship moneys and appearance moneys were. Decision: The sponsorship funds were paid for services provided by the taxpayer and constituted assessable income on that basis. This showed that the taxpayer was using sporting ability to derive money. When this part of her activities was looked at together with the rest of the activities that generated payments, it could be seen that the taxpayer was carrying on a business and all of the payments she received that were attributable to that business constituted assessable income to her. Relevance of the case today: Cases involving payments to athletes are inevitably decided on the facts, with isolated prizes treated as non-assessable windfalls and payments attributable to consistent performance achievements treated as assessable income from business or as income ancillary to business income or employment income if the athlete is an employee of a sports club. As a recent case and a High Court case, Stone is an important precedent to show that deriving sponsorship payments from sporting successes is sufficient to demonstrate sporting activities may amount to a business, in which case other payments associated with the activities including grants and prize moneys will be assessable income from business. A key factor that appears to have played a significant influence in the High Court’s decision is the receipt of sponsorship fees which required the taxpayer to undertake obligations or activities that promoted the sponsor’s products. It is not entirely certain that the same result would have been reached had the taxpayer received grants and prizes but no sponsorship fees and in the future taxpayers with prizes and grants but no sponsorship fees may try to distinguish Stone on this basis. If it happened today: If the facts in Stone were to arise today, the court would find that the taxpayer’s sporting activities amounted to a business. The taxpayer, aware of the likely impact of the Stone decision, might wish to accept the characterisation of his or her athletic activities as a business but in turn claim deductions for all related expenses including travel to meets, training costs, equipment related to the activity, and so forth.

The Indicia of Carrying on a Business: Land Sales Scottish Australian Mining Co Ltd v FCT (1950) 81 CLR 188 (High Court)

Facts: The taxpayer purchased land for the purpose of carrying on coal mining operations. After so using the land for over sixty years, the mining property was exhausted and the taxpayer proceeded to develop the land for sale. These activities included subdivision of the land, building roads and a railway station and setting aside land for parks, schools and churches. The Commissioner assessed the taxpayer on the basis the gain was either ordinary income from an enterprising land sale or profit assessable under s 26(a) ITAA 1936 (the second limb of which is currently s 15-15 ITAA 1997 1997). 56

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

Decision: The Court held that the taxpayer was not at any time engaged in the business of dealing in land and rather the activities were merely the realisation of a capital asset. The profits were therefore not included in assessable income as ordinary income. Williams J suggested it would be very difficult for the Commissioner to show a taxpayer had engaged in a business that gave rise to income from a profit-making scheme where the gain arose from sale of an asset and the asset was clearly purchased originally for a purpose other than resale. Taking steps to maximise the proceeds of realisation would not be enough to bring the transaction into the scope of a profitmaking scheme giving rise to assessable income. Relevance of the case today: Section 15-15, the successor section to the second limb of s 26(a), does not apply to property acquired after 19 September 1985. The case will therefore have no relevance to a case today involving property acquired after 19 September 1985. It may also have little relevance to gains realised on the sale of property prior to that date given the much more recent decision of the Full High Court in Whitfords Beach Pty Ltd (1982) 150 CLR 355 which found gain on a subdivision of land acquired for another purpose could be assessed as ordinary income. In the Whitfords Beach case, Mason J suggested that a better view would have been that the taxpayer in Scottish Australian Mining had ceased its mining business and commenced a business of land development. However, in his judgment in Whitfords Beach, Gibbs CJ indicated that he would have applied the decision in Scottish Australian Mining had the facts in Whitfords Beach been the same as those in Scottish Australian Mining. The facts in Whitfords Beach were distinguishable because there was a complete change of shareholders in the taxpayer before it subdivided its property. Thus, a taxpayer could continue to argue that Scottish Australian Mining should apply where there has been no change in the ownership of a taxpayer prior to subdivision of property acquired for a different purpose. Such an argument is unlikely to succeed, however, as most commentators believe the holding in Whitfords Beach applies more generally when a taxpayer changes its intention and subdivides property even if there has not been a change of ownership in the taxpayer. If it happened today: The taxpayer in Scottish Australian Mining owned the property many decades before subdividing it so if the case arose today, the exclusion from s 15-15 would not apply and s 15-15 in theory could apply. Most likely, however, the case would be decided on the basis of s 6-5 ITAA 1997 with a court relying on Whitfords Beach to find the taxpayer changed its intention with respect to the land and carried on the business of land development when it subdivided the land. The land would most likely be characterised as trading stock of that new business, with s 70-30 ITAA 1997 applying to determine the relevant cost of the land at the time the basis for holding the property changed. Under s 70-30, the taxpayer can elect to recognise the gain that had accrued on the property up to the time at which the taxpayer changed its intention as a capital gain or recognise all the gain when it subsequently sells the land. Given the fact that the capital gain would be tax-free if the property were acquired prior to 20 September 1985, the taxpayer would most likely choose the first option. There is a possibility, albeit somewhat remote, that the taxpayer may be able to distinguish Whitfords Beach on the basis that the change of intention in that case was due to the change of ownership of the taxpayer. The taxpayer could argue that © Thomson Reuters 2019

57

AUSTRALIAN TAXATION LAW CASES 2019

where there has been no change of ownership, as in Scottish Australian Mining, land acquired for another purpose should continue to be treated as a capital asset even if it is subdivided and improved prior to sale. However, it is more likely that a court today would say the Whitfords Beach precedent should apply where there is substantial activity undertaken in the course of subdivision, even if the ownership of the taxpayer has not changed prior to its change of intention with respect to the land.

FCT v Whitfords Beach Pty Ltd

(1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031 (Full High Court)

Facts: The taxpayer company was established by a number of individuals to acquire beachfront land so as to provide access to shacks erected on that beach. After a number of years, the decision was made to sell the land. The sale was effected by the sale of the shares in Whitfords Beach Pty Ltd to three purchasers, all of which were engaged in the business of property development. After the change in shareholders, the company then proceeded to rezone, subdivide and sell the land. The issue was whether the profits derived from the sales of land were ordinary income or assessable income under the second limb of s 26(a) ITAA 1936 (currently s 15-15 ITAA 1997 1997). Decision: The acts of the taxpayer were not the mere realisation of a capital asset but amounted to the carrying on of a business of land development. The profits derived were therefore ordinary income under s 25 (currently s 6-5(1) ITAA 1997 1997). Alternatively, the profits would have been assessable under s 26(a). The purpose of the company taxpayer was to be determined by the purposes of the shareholders. Both Gibbs CJ and Mason J considered the change in shareholders to be critical to the conclusion that the taxpayer commenced the land development business, distinguishing Scottish Australian Mining (1950) 81 CLR 188. In contrast, the comments of Mason J suggest that the same result would follow if the original shareholders had retained the company but had changed their purpose in holding the land. In a subsequent decision, Whitfords Beach Pty Ltd v FCT (1983) 14 ATR 247; 83 ATC 4277, the issue of the appropriate cost to be attributed to the land in determining the amount of assessable profits was considered. It was decided by the Full Federal Court that the appropriate cost to use was the market value of the land when the shares were transferred. Relevance of the case today: This case stands for the proposition that a taxpayer may change the intention or purpose for which it holds an asset and may be seen to have then contributed or committed that asset to a business activity. It is also an example of an instance where net profit accounting is used to determine the amount of assessable income. The value of the asset at the time the taxpayer’s purpose changes is to be used as the cost base when calculating the portion of the profit that is ordinary income. If it happened today: If the facts in Whitfords Beach were to occur today, a court would likely come to the same conclusion that a business activity has commenced and the asset had been committed to that business when the change in purpose occurred. However, rather than applying a net profit accounting treatment, the land would likely be treated as property converted to trading stock. Where a taxpayer begins to hold an asset as trading stock that was previously held in another capacity, s 70-30 ITAA 1997 58

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

is triggered and there will be a notional sale and repurchase of the asset. The taxpayer may elect to use cost or market value for the notional sale and repurchase price. This also has implications for capital gains tax purposes. If the taxpayer elects to use cost, the gain or loss will be recognised only under the trading stock or ordinary income provisions and any potential capital gain or loss is disregarded by virtue of s 118-25 ITAA 1997. Alternatively, if the taxpayer elects to use market value, a capital gain or loss based on the difference between the original cost and the value at the time of deemed sale and repurchase may be realised under CGT event K4 (see s 104-220 ITAA 1997 1997).

Crow v FCT

(1988) 19 ATR 1565; 88 ATC 4620 (Federal Court)

Facts: The taxpayer made successive purchases of rural land for the stated purpose of use in connection with farming activities. However, in each instance, the land was subsequently subdivided and lots were sold, though a parcel of the original land was retained for continuing farming. The issue was whether these activities were considered to be carrying on the business of land development. Decision: The taxpayer was found to be carrying on a business of land development and the profits were therefore assessable as ordinary income. The Court stated that “one must look to the overall affairs of the person concerned and to the system, if any employed” and that, in this case, the various purchases, subdivisions and sales of parcels of land involved transactions which were repetitive and systematic and had the characteristics of a continuing business of land development. Alternatively, the profits would have been assessable under the second limb of s 26(a) ITAA 1936 (currently s 15-15 ITAA 1997 1997) as the profit-making purpose was evident and the transactions would be characterised as an undertaking or scheme with a business element. Relevance of the case today: This case provides an example of where land development activities would be characterised as a business. To see a case where activities of land development were not considered a business, see Casimaty v FCT (1997) 37 ATR 358. If it happened today: The same conclusions would likely be reached by a court today. The second limb of s 26(a) appears in the ITAA 1997 as s 15-15 but does not apply to the sale of property acquired on or after 20 September 1985. Rather, such property would be subject to the capital gains tax provisions. Any capital gain realised on the sale of the parcels of land would be reduced to nil by operation of s 118-20 ITAA 1997 as the profits would also be ordinary income. Alternatively, a court could conclude that the land was held as trading stock to which Division 70 ITAA 1997 applies. If that were the case, s 118-25 ITAA 1997 provides that any CGT gain or loss would be disregarded as it would be assessable under another provision of the Act.

© Thomson Reuters 2019

59

AUSTRALIAN TAXATION LAW CASES 2019

Casimaty v FCT

(1997) 37 ATR 358; 97 ATC 5135 (Full Federal Court)

Facts: The taxpayer carried on a primary production business on land acquired from his father by way of gift. Upon suffering severe financial hardship and deteriorating health, the taxpayer proceeded to subdivide the land in stages and sell the subdivided blocks. In all, eight subdivisions were undertaken. The issue was whether these activities were steps in carrying out a business of land development or carrying out a profit-making undertaking or scheme assessable under s 25A ITAA 1936 (currently s 15-15 ITAA 1997 1997). Decision: The activities of the taxpayer were no more than a mere realisation of a capital asset. Factors considered by the Court to be relevant in coming to this conclusion included the fact that the taxpayer continued to reside on the remaining land and conduct his business as a primary producer such that there was no evidence of a change in the purpose in holding the land. The taxpayer did not acquire any additional land and pursued the subdividing in a piecemeal, rather than in an organised, way. Only those works necessary for municipal approval of the subdivision and minimal activities to enhance the presentation of the lots were undertaken. The Court also held that neither the first nor second limb of s 25A had any application. Relevance of the case today: This case gives further indication as to how the factors for determining if a business is carried on can apply to an instance of land development. This case should be contrasted with Crow v FCT (1988) 19 ATR 1565; 88 ATC 4620, where the taxpayer was held to be carrying on a land development business. If it happened today: The mere realisation of a capital asset would now be subject to the capital gains tax regime. The subdivision of land is not a CGT event (see s 112-25 ITAA 1997 1997) but the sales of the individual lots would then be CGT events (if the original land were a pre-CGT asset, each of the lots would also have that status). The main residence exemption would not be available for the lots other than the one on which the residence is located (provided the taxpayer continues to use it as such) and only then to a maximum of two hectares in area (see s 118-120 ITAA 1997 1997).

The Indicia of Carrying on a Business: Investment Trent Investments Pty Ltd v FCT

(1976) 6 ATR 201; 76 ATC 4105 (Supreme Court of NSW)

Facts: The taxpayer was a private company, wholly owned by Delasala Pty Ltd which was wholly owned by the Delasala family. The taxpayer had acquired a share portfolio and varied that portfolio according to standards referred to as principles of “portfolio management”. There was no minimum yield requirement imposed on the portfolio. The investment policy provided for the sale of shares in a “weak company” in order to invest in a stronger company as well as the sale of “overpriced” stock. The issue before the Court was whether the profits realised on the sale of shares in the portfolio were assessable income, either as ordinary income or under s 26(a) ITAA 1936. 60

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

Decision: None of the shares were acquired with the purpose of profit making by sale and therefore the first limb of s 26(a) (which required such a purpose) had no application. There was another family company within the group which acquired shares for profit making. The profits realised were also not income under ordinary concepts. The activities engaged in by the taxpayer were mere investment and not the carrying on of a business. The Court acknowledged that it will sometimes be difficult to make this distinction but it will be a question of fact based on the actions of the taxpayer as well as evidence of intention. It was considered that sale of overpriced stock was not to be viewed as mere profit taking and reinvestment (which would give the transactions a revenue character) but rather was in keeping with mere investment (capital character) as an investor could not be expected to retain stock which the investor considered would likely fall in price. Relevance of the case today: This case is relevant in drawing the distinction between mere investment (capital profits) and a business of investing (revenue profits). The decision is very heavily based on the facts presented and therefore does not present many standards of general application. It was also decided before the High Court decision in London Australia Investment Co Ltd v FCT (1977) 138 CLR 106 (see below), which may be more valuable as a precedent. If it happened today: If the facts of Trent Investments were to occur today, a court could still conclude that the profits were capital in nature, though evidence in addition to investment policy would likely be considered, such as evidence of the level of switching (see London Australia Investment Co, below). The disposal of the shares would trigger a CGT A1 event under s 104-10(1) ITAA 1997 and the gains would be subject to tax under the CGT provisions (subject to a reduction under s 118-20 ITAA 1997 if the gains would now be considered income gains). If the gains are characterised as capital gains, the taxpayer would not qualify for the 50% exemption provided for discount capital gains since it is a corporation (see s 115-10 ITAA 1997 1997).

London Australia Investment Co Ltd v FCT

(1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398 (Full High Court)

Facts: The taxpayer was formed to invest in Australian shares for the purpose of deriving dividends. It sought a minimum dividend yield from its investments deduction and when the shares increased in value so the dividend yield fell, the taxpayer would sell the shares and reinvest in other shares. The taxpayer claimed the profits it realised on the sale of shares were capital gains as the shares were purchased for the purpose of generating dividends and not for sale in the course of its business. Decision: While the High Court agreed that the taxpayer’s primary intention was to acquire shares to generate dividends, a majority of the High Court found that the sale of the shares was a normal operation in the course of carrying on the business of investing for profit. To maintain a desired dividend yield, the taxpayer would have to sell shares regularly and the continual turnover of shares was part of an investment business operation. © Thomson Reuters 2019

61

AUSTRALIAN TAXATION LAW CASES 2019

Relevance of the case today: London Australia Investment shows how the sale of investment assets will be treated as a business of the taxpayer where the sales occur frequently and a regular trade in shares is necessary to achieve the taxpayer’s investment goals. If it happened today: If the facts in London Australia Investment were to arise today, the gains on the sale of shares would continue to be characterised as income gains. If the sales happen frequently and it is essential that the taxpayer engage in the trade of shares to achieve its investment goals, the taxpayer will be treated as carrying on an investment business that includes trading in shares.

FCT v Radnor Pty Ltd

(1991) 22 ATR 344; 91 ATC 4689 (Full Federal Court)

Facts: Three trusts were established and used to provide income to support a disabled child. The trustee of the three trusts, Mahana Pty Ltd (a company controlled by family members), owned all the shares in the taxpayer which in turn owned a portfolio of public company shares and shares in two private companies holding rural land. Evidence showed that shares were chosen which would provide income to support the child and also which showed prospects of capital growth to at least keep pace with inflation. Shares would be sold if there was a need for funds, if the shares were the subject of a takeover or if the shares were performing poorly. A professional manager was appointed to follow these principles. The portfolio was managed so that the proportions of each stock were roughly that of the Stock Exchange All Ordinaries Index. When takeovers were excluded, the percentage of shares sold in a year ranged between 1% and 16%. The Commissioner argued that the taxpayer was trading in shares or carrying on a business of purchasing and selling shares such that the profits were ordinary income. The taxpayer submitted that the shares were held on capital account. Decision: The taxpayer was not carrying on a business of dealing in shares but rather was investing in shares to obtain dividend income and therefore the profits and losses were of a capital nature and were not ordinary income. The question of whether a taxpayer is carrying on a business of dealing in shares is one of fact and degree. Certain factors are more significant, such as the purpose of making a profit and repetition. However, the mere fact that an investment adviser is employed who applies professional portfolio management principles will not, of itself, require the conclusion that a business is carried on if other evidence does not support that conclusion. The fact that a taxpayer is a trustee with fiduciary duties to the beneficiaries will not be determinative but is also relevant to the issue. Relevance of the case today: This case provides another example of how the question of whether a taxpayer is carrying on a business will be determined by weighing up the facts presented. The case is important for the comment regarding professional investment advisers – the fact that a taxpayer may employ a professional adviser does not alone determine that the taxpayer is carrying on a business of dealing in shares.

62

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

If it happened today: If the facts of Radnor were to occur today, the profits and losses would still be considered to be capital in nature. The disposal of the shares would trigger a CGT A1 event under s 104-10(1) ITAA 1997 and the gains would be subject to tax under the CGT provisions. The taxpayer is a corporation and if it were acting in its own capacity, it would not be entitled to the discount capital gains exemption (see s 115-10 ITAA 1997 1997). However, since it is a trustee, it qualifies for a partial exemption under s 115-10(c) ITAA 1997, with the discount for capital gains realised by a trustee set at 50% by s 115-100(a)(ii) ITAA 1997 if the asset has been held for at least 12 months.

AGC (Investments) Ltd v FCT

(1992) 23 ATR 287; 92 ATC 4239 (Full Federal Court)

Facts: The taxpayer was a wholly owned subsidiary of AGC (Insurances) Ltd which conducted an insurance business under the parent company Australian Guarantee Corp Ltd. AGC (Insurances) advanced considerable sums to the taxpayer which were invested in a portfolio of listed shares. The portfolio was managed by professional investment managers. In mid September 1987, it was decided to commence selling the share portfolio for reinvestment in fixed interest securities. A majority of the shares were sold by 30 September 1987 and a significant profit was realised. The Commissioner argued that the profits were income but the taxpayer contended that the profits were on capital account. Decision: The profits were not income. The share portfolio was purchased with the intention of holding for long term capital growth and the evidence supported that the assets were often held for long periods. The assets held by the taxpayer were not used to maintain liquidity for the insurance operations of the corporate group and therefore the banking and insurance cases were distinguishable from the facts of this case. Relevance of the case today: The decision in this case further illustrates that the investment activities of a taxpayer will be characterised as either on revenue or capital account depending in large part on the evidence provided, which will include data as to actual holdings and transactions as well as instructions given to investment managers. The AGC case can be compared with London Australia Investment Co (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398 (see above), where the regular, organised and largescale switching of investments gave rise to ordinary income, and Colonial Mutual Life Assurance Society Ltd v FCT (1946) 73 CLR 604 (see below), where the regular trading by an insurance company in its investment portfolio led to the characterisation of the investments as “revenue assets” with profits realised on the disposal of those assets treated as ordinary income. If it happened today: If the facts in AGC arose today, the profits realised would most likely be characterised as capital in nature. The disposal of the shares would trigger a CGT A1 event under s 104-10(1) ITAA 1997 and the gains subject to tax under the CGT provisions. As the taxpayer is a corporation, it would not qualify for the 50% exemption provided for discount capital gains (see s 115-10 ITAA 1997 1997).

© Thomson Reuters 2019

63

AUSTRALIAN TAXATION LAW CASES 2019

ILLEGAL ACTIVITIES One of the three tests for ordinary income is connection with a source, which can include business. Whether activities can amount to a business depends on the level of activity and nature of activity, not whether the activity is legal or illegal. Ironically, the taxpayer in the case often cited as authority for this conclusion was found to be carrying on a legal business so the comments about assessing gains from an illegal business are obiter comments, meaning they are not part of the binding judgment.

Partridge v Mallandaine

(1886) 18 QBD 276 (UK High Court of Justice)

Facts: The taxpayer bet regularly in a systematic fashion at a racecourse. He had no other business or employment. The UK Inland Revenue assessed the taxpayer on the basis that betting systematically and annually carried on came within the provisions of the Income Tax Act as a vocation. At the time, the law prevented successful gamblers from collecting gambling debts through the ordinary legal system for recovery of debts. While the taxpayer had apparently had no difficulty collecting on all successful bets, he argued that since he could not have legally recovered any amounts due to him in respect of the debts, his activities did not yield legal profits and he therefore did not carry on a vocation. Decision: The court concluded the taxpayer’s activities amounted to a vocation and the fact that it was not possible to pursue gambling debts through the courts in the same manner as other debts did not affect the character of his activities as a vocation or the nature of the profits he derived as income from a vocation. The court pointed out that betting was legal and the difficulty the taxpayer might have collecting from dishonest persons who made bets with him did not change the nature of his activities as a vocation. In the course of the judgment, one of the three judges participating in the decision said in obiter (part of the judgment that was not central to the decision and not part of the binding precedent) that hypothetically even if the taxpayer’s activities had been illegal, they could still have amounted to a vocation yielding assessable income. Relevance of the case today: Although the observation about gains from an illegal business being assessable income was an obiter comment made in respect of a hypothetical situation not found in the case (the court had separately noted the taxpayer’s activities were wholly lawful), the decision is nevertheless cited as a primary authority for the proposition that gains from an illegal business are assessable. If it happened today: If the facts in Partridge v Mallandaine were to arise today in Australia, it is likely an Australian court would find that a taxpayer with no other vocation or employment who derived all income from systematic betting activities is carrying on a business that yields assessable income.

64

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

ISOLATED TRANSACTIONS BY A BUSINESS Taxpayers seeking to characterise gains as capital amounts may argue in the first instance that their activities are not sufficiently systematic to constitute a business and instead they are merely investing or engaged in non-commercial activities so their gains are capital gains, not income gains. If the taxpayer clearly is carrying on a business, an alternative argument may be that the transaction giving rise to the profit in question took place outside the taxpayer’s business so that it can be distinguished from the taxpayer’s ordinary business income. Taxpayers in this situation thus argue they derive two types of gains – income from their business activities and capital gains from the isolated transactions that are separate from their business. Whether this argument can succeed will depend on how the taxpayer’s business is characterised – for the argument to work, the taxpayer’s business must be construed very narrowly. Section 15-15 ITAA 1997 treats profits from a profit-making scheme as statutory income if the profits are not ordinary income from an isolated transaction that is related to a larger business. Prior to 1985, the Commissioner often relied upon the predecessor section to s 15-15, s 25A ITAA 1936, formerly s 26(a) ITAA 1936, to assess the gains as an alternative to arguing an isolated transaction was part of a larger business. While it is still possible to base an assessment on s 15-15, the Commissioner rarely seeks to use the section today for two reasons. First, the section does not apply to gains from the sale of property acquired after 19 September 1985 and many isolated transactions involve the sale of property. Second, following the apparent widening of the concept of ordinary income from business by the High Court in FCT v Myer Emporium Ltd (1987) 163 CLR 199, the Commissioner is often able to show that an isolated commercial transaction is related to a larger business and the income is thus income from business assessable under s 6-5 ITAA 1997. If this approach does not succeed, the Commissioner will usually seek to tax the gain under the CGT provisions rather than argue the gain is statutory income under s 15-15.

Commercial Transactions Californian Copper Syndicate v Harris

(1904) 5 TC 159 (Court of Exchequer, Scotland)

Facts: The taxpayer company was formed to carry out a range of profit-making activities, including dealing in and mining copper. It acquired some copper-bearing land which was subsequently sold to another company in return for a substantial profit, with the consideration for the sale being shares in the purchasing company. The taxpayer claimed the company had merely substituted new capital assets (shares) for its original capital asset (the land) and any profits from the transaction were capital receipts. Decision: The fact that consideration for the land was paid in the form of shares rather than cash did not change the character of the transaction. The taxpayer realised a consideration equal to the value of the shares received. It had acquired the property in question not to retain as an income-generating investment but instead to apply in a profit-making scheme that was a part of the taxpayer’s business. Thus, the transaction © Thomson Reuters 2019

65

AUSTRALIAN TAXATION LAW CASES 2019

was not a mere enhancement of value by realising a security, but rather was a profit-making scheme that yielded profits with the character of income. Relevance of the case today: Californian Copper Syndicate is an early and key precedent explaining the difference between a mere realisation of enhanced value generating a capital gain and a profit-making scheme generating ordinary income from an isolated transaction. The taxpayer’s intention to derive a profit from the scheme is a factor that points towards the profit being ordinary income, as is the degree of active input into realisation of the profit. If it happened today: If the facts in Californian Copper Syndicate were to arise today in Australia, the gain would probably be treated as ordinary income assessable under s 6-5(1) ITAA 1997 based on the taxpayer’s apparent intention to realise a profit through the resale of the property rather than hold it as an investment. Because the taxpayer had no other business activity, the Commissioner quite likely would not rely on FCT v Myer Emporium Ltd (1987) 163 CLR 199 to support an argument that the gain was income. The Myer Emporium precedent is most useful to the Commissioner where there is another business activity carried on by the taxpayer so it can be argued the taxpayer’s isolated profit-making scheme is an activity ancillary to the principal income-earning business of the taxpayer. If the Commissioner could not show that the gain was ordinary income from a profit-making scheme, he would not be able to argue that the gain was statutory income from a profit-making scheme assessable under s 15-15(1) ITAA 1997 if the property were acquired after 19 September 1985. Whether or not the Commissioner is successful with the argument that the gain is assessable as ordinary income under s 6-5(1) or statutory income assessable under s 15-15(1), he can assess the gain as a capital gain under CGT event A1, s 104-10 ITAA 1997. The capital proceeds for the sale would be the market value of the shares received under s 116-20(1)(b) ITAA 1997.

Ducker (CIR) v Rees Roturbo Development Syndicate, Ltd [1928] AC 132 (UK House of Lords)

Facts: The taxpayer company was formed to acquire patent rights. Its primary business was to grant manufacturing licences under its patent but it always contemplated the possibility of selling some of the patents. A licensee of one of its patents exercised an option to purchase the patent and the taxpayer was assessed on the payment. The taxpayer argued the transaction was outside its ordinary business activities and the payment was a non-assessable capital receipt from the sale of a capital asset. Decision: While the taxpayer’s primary intention was to derive profits by licensing the patents it owned, it had always contemplated the possibility of selling its foreign patents. The sale was not a mere accidental dealing with a particular class of property, but was part of the taxpayer’s business. While it was not part of the primary business they intended to develop, it was a business activity they had been prepared to undertake.

66

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

Relevance of the case today: Rees Roturbo Development Syndicate reinforced the approach taken in Californian Copper Syndicate v Harris (1904) 5 TC 159 to isolated transactions that are not part of a taxpayer’s principal business operations but which are contemplated as possible profit-making transactions. If it happened today: If the facts in Rees Roturbo Development Syndicate were to arise in Australia today, it is most likely a court would find the gains were ordinary income to the taxpayer as profits derived in a transaction ancillary to the taxpayer’s principal business. This approach was affirmed by FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363 (see below).

FCT v Myer Emporium Ltd

(1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363 (Full High Court)

Facts: The taxpayer, Myer Emporium, undertook a pre-arranged plan to obtain working capital from an outside financier. The taxpayer first lent $80 million of company funds to Myer Finance (a member of the same corporate group) at a commercial rate of interest for a term in excess of seven years. Three days later, it assigned its right to interest under the loan to the outside financier, Citicorp, for a lump sum, retaining the right to receive repayment of the principal sum. The Commissioner argued that the lump sum was income according to ordinary concepts or alternatively income from a profit-making undertaking or scheme under s 26(a) ITAA 1936. Decision: The receipt was income according to ordinary concepts and alternatively was income under s 26(a). Although the assignment could be described as novel, unusual or extraordinary when judged by reference to the transactions normally engaged in by the taxpayer, the transactions were still entered into by Myer Emporium in the course of carrying on its business and therefore the profit was part of the ordinary income of Myer Emporium. There are several strands to the judgment and different views as to the basis of the decision. Observers now commonly refer to “two strands” of the decision. The first, broader, strand holds that a gross profit derived in the course of a business enterprise that is subsidiary or incidental to the taxpayer’s ordinary business activities acquires an income character similar to profits from the ordinary business activities. Under this view, the sale of the interest stream is incidental to the taxpayer’s ordinary retail and commercial operations and the gross profits are also income. The second, narrower, strand holds that the proceeds of the assignment were assessable to Myer Emporium on the basis of the compensation receipts doctrine. This doctrine holds that an amount received in exchange for an income stream acquires an income character. Under this view, Myer Emporium had exchanged a future income stream (the interest entitlements) into present income in the form of the lump sum. Relevance of the case today: This case has significant continued relevance in terms of the approaches adopted in its first and second strands. In respect of the first strand, income according to ordinary concepts will include profits made from unusual or extraordinary transactions where those transactions are made in the course of carrying © Thomson Reuters 2019

67

AUSTRALIAN TAXATION LAW CASES 2019

on a profit-making business, although not necessarily in the ordinary course of that business. The breadth of application of the principles put forward in this case is further explored in Westfield Ltd v FCT (1991) 21 ATR 1398; 91 ATC 4234. In terms of the second strand, the proceeds from the sale of an income stream will have an income character. If it happened today: It is likely that the facts in Myer Emporium would yield a very different set of results if they occurred today. Since the case, Australia has adopted a consolidation regime for company groups and while consolidation is not compulsory, it is probable that all the Myer group companies involved in the transactions would now be part of a single consolidated company group. If that is the case, the internal debt would be completely ignored and the tax consequences determined on the basis of one transaction between the Myer group and the outside financier, Citicorp. Under the single entity principle that governs consolidation, all transactions with outside parties by group members are treated as transactions entered into by the head company of the group. As the Commissioner explains in Taxation Determination TD 2004/83, the tax consequences would look at the lump sum payment from Citicorp and the stream of payments from the head company back to Citicorp. The transaction would be recharacterised as a loan by Citicorp to the Myer group and the payments by the Myer group to Citicorp would be treated as blended payments comprising partly the return of principal and partly the payment of interest. There would be no income to the group and only part of the payments (the part determined to be the interest component of each blended payment) would be deductible to the group. Although the Myer Emporium judgment came after the adoption of capital gains tax, the transactions in question took place earlier. If the same facts occurred today and the Myer group of companies was not treated as a consolidated group for tax purposes, the transaction would give rise to two financial arrangements subject to Division 230 ITAA 1997. The loan from Myer Emporium to Myer Finance constitutes a debt to Myer Finance and an asset in the hands of Myer Emporium. The asset has two components, a right to repayment of principal and to interest payments. When Myer Emporium carved off the right to interest and assigned it to Citicorp, it created two separated financial arrangements, one related to the right to repayment of principal it retained and the second related to the obligation to pass on a stream of interest in return for the payment from Citicorp. Each of the separated arrangements constitute financial arrangements as defined in Division 230 and would be dealt with under that Division. The provisions of Division 230 would treat the financial arrangement with Citicorp as a blended payment loan from Citicorp to Myer Emporium. There would be no income assessed to Myer Emporium and instead it would be allowed a deduction for the calculated interest component of each blended payment to the bank. At the same time Division 230 would treat the financial arrangement between Myer Emporium and Myer Finance left in place after the assignment (the right to repayment of principal in seven years) as a compounding loan and require Myer Emporium to recognise the accruing interest, while allowing Myer Finance to deduct the accruing interest. Section 230-20(4) ITAA 1997 provides that gains and losses recognised under Division 230 will not be taken into account under other provisions of the Act. As a result, the Division 230 measures will preclude the application of s 6-5 ITAA 1997. 68

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

Westfield Ltd v FCT

(1991) 21 ATR 1398; 91 ATC 4234 (Full Federal Court)

Facts: The taxpayer’s main activity, at relevant times, was the design, construction, letting and management of shopping centres. The taxpayer acquired options over the land with the intention of eventually acquiring the land and constructing a shopping centre on the land. The taxpayer was unable to obtain zoning permission for the centre and it ceased to pursue its building plans. It decided to let the options expire until it learned that a neighbouring shopping centre was about to be sold and the new owners, AMP, might be interested in a venture involving the taxpayer. The taxpayer and AMP entered into an agreement which involved the taxpayer selling its options over the land to AMP and AMP agreeing that the taxpayer would design and construct the shopping centre to be built on the land. The Commissioner assessed the taxpayer on the basis that its gains were ordinary income and the assessment was upheld at first instance on the basis of the precedent in FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363 (see above). Decision: The decision in Myer Emporium does not mean that all profits earned by a business have an income character. If the taxpayer realises a profit on the sale of property other than in the course of its principal business activity, the profit will have an income character if the relevant transaction was entered into for a profit-making purpose. The options were not sold in the course of the taxpayer’s ordinary business or in the course of an isolated transaction carried out for the purpose of profit-making. The options were sold to ensure the taxpayer would be able to design and construct the shopping centre to be constructed on the land. The profit was a non-assessable capital gain (the facts in the case took place before the adoption of CGT). Relevance of the case today: The Westfield case is key precedent illustrating the limitations of the income concept set out in Myer Emporium. It is regularly cited as authority to support the position of taxpayers seeking to characterise profits from an isolated transaction as capital gains. It is invoked when the taxpayers believe they can show the profit was neither derived in the course of ordinary business transactions or related transactions entered into with a profit-making purpose. If it happened today: Decisions subsequent to Westfield show that courts have accepted the limitations on the Myer Emporium reasoning that were set out in Westfield. Westfield In particular, profits that arise from isolated transactions which appear to be ancillary to the taxpayer’s principal business activities will only have an income character if the transaction had a profit-making purpose. If the facts in Westfield were to arise today, a court would likely once again distinguish the case on its facts from the broad rule in Myer Emporium and find that the profits were capital gains. Regardless of whether it could be shown that there was a profit-making purpose to the sale transaction, the profit would be assessable as a capital gain under CGT event A1, s 104-10 ITAA 1997. The taxpayer would not qualify for the 50% exemption provided for discount capital gains as it is a corporation (see s 115-10 ITAA 1997 1997).

© Thomson Reuters 2019

69

AUSTRALIAN TAXATION LAW CASES 2019

Henry Jones (IXL) Ltd v FCT

(1991) 22 ATR 328; 91 ATC 4663 (Full Federal Court)

Facts: The taxpayer was a canned fruit manufacturer that decided to exit the business. It agreed to transfer the right to use its brand names and labels to two companies through a licensing agreement in return for an annual royalty, subject to a guaranteed minimum payment. The taxpayer then assigned the right to royalties to a bank for a lump sum payment. The Commissioner assessed the assignment relying on the two limbs of Myer Emporium, namely that the transaction was carried out for the purpose of profit-making by sale within the context of a larger ongoing business and that the receipt was in compensation for an income stream. The taxpayer claimed the transfer was not made with a profit-making purpose and sought to distinguish the facts from the second strand of Myer Emporium on the basis that the taxpayer in Myer Emporium had assigned the income stream from a debt but retained the right to repayment of the principal amount while it had assigned the income stream and retained no right to principal repayment. Decision: The Full Federal Court found that the taxpayer did not enter the licence agreement or assignment with the purpose of profit making by sale so there were no grounds for upholding an assessment based on the first strand of Myer Emporium. It concluded, however, that the second strand of Myer Emporium would apply to the gain and the proceeds would be fully assessable as ordinary income. Relevance of the case today: Henry Jones (IXL) is a useful illustration of the second strand of Myer Emporium being applied to the assignment of a different type of income stream. It can be cited in support of the application of the second strand to the sale of income streams other than the right to interest. If it happened today: The facts in Henry Jones (IXL) took place prior to the adoption of CGT in Australia. The initial transaction, entering into a license agreement that involved the transfer of right to use labels and brand names in exchange for royalties (but not a transfer of the intellectual property itself), did not amount to a disposal of an asset. However, it did create rights and the arrangement could be seen as a CGT event D1 (s 104-35 ITAA 1997 1997). There would be no capital gain, however, as the payments due to the taxpayer under the agreement constitute ordinary income (as royalties) and s 118-20 ITAA 1997 would remove them from the CGT net. The subsequent assignment to a bank of the right to royalties would trigger income recognition under s 6-5(1) ITAA 1997 (applying the second strand of Myer Emporium). The Myer Emporium doctrine treats the entire proceeds of assignment as income, with no recognition of the cost of the asset sold. The assignment would also on its face trigger income recognition under s 102CA ITAA 1936. The Commissioner will not assess the same receipt twice, however, under s 6-5(1) and under s 102CA. The sale of the income stream to the bank would also trigger a CGT event A1. There may not be a net gain, however, because the cost of the right transferred (the right to the income stream) might equal the proceeds of disposal received from the bank. To 70

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

obtain the right to royalties, the taxpayer had to transfer a right to use assets (brand names and labels) belonging to the taxpayer. If this is an arm’s length transaction, the value of the consideration provided (the right to use the property) should equal the value of the property obtained (a right to royalties). Under s 110-25(2)(b) ITAA 1997, the cost base for the right to royalties equals the value of the right to use assets given as consideration for the right to royalties. As the cost base of the asset assigned to the bank equals the proceeds of disposal, there is no capital gain. Even if there was a small gain on the assignment to the bank of the right to receive royalties (for example, the taxpayer may have obtained a higher price from the bank if market conditions had changed in the meantime leading to a change in rates of return in similar assets), the gain would still be less than the amount assessable under s 6-5(1) under the second strand of Myer Emporium. It would, accordingly, be reduced to zero for tax purposes under the operation of s 118-20 ITAA 1997.

Sales of Know-How A business that is unable to operate in a particular market may agree to provide details of its know-how to a person who is able to operate in that market. The sale of knowhow could be seen as an extension of the regular business, in which case the proceeds would be ordinary income, or it could be seen as a sale of part of the business, in which case the gain would be a capital gain. Prior to 1985, the former would have been fully assessable and the latter completely exempt from tax.

Moriarty (Inspector of Taxes) v Evans Medical Supplies Ltd [1957] 3 All ER 718 (UK House of Lords)

Facts: The taxpayer was a pharmacy company that manufactured and sold drugs through agencies around the globe. It entered into an agreement with the government of Burma which required it to provide designs and know-how necessary for the establishment of a factory to manufacture various medicines in return for a payment of £100,000. The taxpayer also undertook not to provide the know-how to any other persons in Burma and not to establish its own factory in Burma. The UK Inland Revenue assessed the taxpayer under the UK company income tax under a charging provision that imposed tax on profits from carrying on a trade. UK courts had interpreted this charging provision as only catching amounts that would be akin to amounts that an Australian court would describe as ordinary income and excluding amounts that an Australian court would consider to be capital gains. The taxpayer argued the payment was a capital payment for the one-off sale of information that had not previously been sold before by the company. Decision: The House of Lords agreed with the taxpayer’s characterisation of the receipt as payment for the transfer of a capital asset. At the time of the decision, the UK had no capital gains tax and, as a result, the receipt was untaxed. Relevance of the case today: The Moriarty v Evans Medical case, like many UK decisions on the distinction between assessable profits and capital receipts, continues © Thomson Reuters 2019

71

AUSTRALIAN TAXATION LAW CASES 2019

to be used as a precedent in Australia for the distinction between ordinary income and capital gains. As capital gains are fully taxed to companies today in Australia, the relevance of the distinction is no longer as great as it once was. However, the distinction will be important if the taxpayer has any carried-forward capital losses it wishes to use because capital losses may only be deducted from capital gains. The case can be cited to support an argument that a payment for a one-off sale of know-how, combined with a promise to not manufacture in a market, is a capital gain and not an income gain. However, as noted below, the argument may be more difficult to make following the decision of the Australian High Court in FCT v Myer Emporium Ltd (1987) 163 CLR 199. If it happened today: If the facts of Moriarty v Evans Medical were to arise today in Australia, the taxpayer could argue that the Moriarty decision should be used as a precedent for characterising the proceeds of the transaction as capital receipts. If the taxpayer wanted the gains to be characterised as capital gains, it would argue that the arrangements involved a complete transfer of information coupled with a full withdrawal of the right to establish a business in the foreign jurisdiction. However, an Australian court might reach a different decision based on the precedent of FCT v Myer Emporium Ltd (1987) 163 CLR 199. The Australian court might agree the oneoff sale of know-how is different from the taxpayer’s previous trading activities but conclude it is closely related to those activities so the proceeds of the transaction are ordinary business income. If the proceeds are characterised as ordinary income, they would be assessable under s 6-5 ITAA 1997. If they are characterised as capital receipts, they would be assessable as capital gains. While the taxpayer said that it had “parted with” information, there was no actual disposal of the knowledge provided to the customer. Thus, the transaction would most likely not trigger CGT Event A1 in s 104-10 ITAA 1997. Rather, the transaction would probably give rise to a CGT Event D1 in s 104-35 ITAA 1997, creating contractual rights. In addition to providing the customer with rights from a negative covenant (the promise not to set up manufacturing operations in Burma), the taxpayer provided the customer with a series of rights to use the information, plans, processes, etc that were passed to the customer as part of the transaction. The capital gain would be the proceeds received by the taxpayer less any incidental costs incurred to complete the transaction (see s 104-35(3) ITAA 1997 1997).

Rolls-Royce Ltd v Jeffrey (Inspector of Taxes) [1962] 1 All ER 801 (UK House of Lords)

Facts: The taxpayer was a UK company that manufactured airplane engines. A number of foreign governments indicated to the taxpayer that they would not purchase engines from the taxpayer but would pay for the right to manufacture the engines locally. The taxpayer was required to supply drawings and manufacturing and engineering information needed for the manufacture. It was also required to train and then supervise local staff. The foreign governments agreed to make two types of payments: ongoing royalties as engines were manufactured and lump sums as consideration for the right to manufacture the engines. The UK Inland Revenue assessed the lump sum payments as taxable business profits. UK courts had interpreted the UK charging provision as 72

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

only applying to amounts that would be akin to amounts that an Australian court would describe as ordinary income and excluding amounts that an Australian court would consider to be capital gains in Australian terms. The taxpayer argued the payments were capital payment for the sale of part of the business structure and for agreeing not to sell into certain markets. Decision: The House of Lords found the lump sums to be taxable profits under the UK legislation, the equivalent of ordinary income in Australian terms. The Law Lords concluded that the taxpayers were not disposing of capital assets through the agreements but instead were turning their know-how to profit in the only way available to them. Arrangement for the foreign governments to manufacture the engines was an extension of the company’s direct manufacturing trade. It was noted that the company’s annual report mentioned the arrangements in terms of new sources of revenue. Relevance of the case today: The Rolls-Royce case can be used as a precedent to support an argument that payment for a sale by a business of manufacturing rights in some jurisdictions is an income receipt to the business if the business continues to manufacture and sell into other jurisdictions, the company enters into a number of similar arrangements, and the company notes the transactions as sources of business profits in its reports to shareholders. If it happened today: If the facts in Rolls-Royce were to arise today in Australia, an Australian court would most likely conclude the receipts derived by the company were ordinary income. Applying the approach used in FCT v Myer Emporium Ltd (1987) 163 CLR 199, an Australian court today would likely find the receipts were business income derived from transactions related to the taxpayer’s principal business activities, even if the modern-day transaction did not contain all the elements noted by the court in Rolls-Royce.

Lease Incentives and Fit Outs FCT v Cooling

(1990) 21 ATR 13; 90 ATC 4472 (Full Federal Court)

Facts: The taxpayer was a partner in a firm of solicitors practising in Brisbane. The firm had decided to change business premises and after negotiations it was agreed that the firm would cause its service company to enter a lease for the specified premises and the firm would be paid a lump sum incentive payment. Due to an oversupply of office space at that time in Brisbane, such incentives were a common feature of the market. The Commissioner argued that the receipt was ordinary income, income under s 26(e) ITAA 1936 (now s 15-15 ITAA 1997 1997) or a capital gain by virtue of s 160M(6) ITAA 1936 (now incorporated into CGT event D1, s 104-35 ITAA 1997 1997) or s 160M(7) ITAA 1936 (now see CGT event H2, s 104-155 ITAA 1997 1997). The taxpayer contended that the receipt was not income and was not brought into income by virtue of the CGT provisions. Decision: The incentive payment was assessable income of the taxpayer as income under ordinary concepts. When a taxpayer carries on business through rented © Thomson Reuters 2019

73

AUSTRALIAN TAXATION LAW CASES 2019

premises, the move from one premises to another and leasing the premises are acts of the taxpayer in the course of carrying on its business. The arrangement will be a profit-making scheme within the terms of the first strand of FCT v Myer Emporium Ltd (1987) 163 CLR 199 (see above), where a not insignificant purpose of the arrangement was obtaining a commercial profit – the making of the profit need not be the sole or dominant purpose. It therefore follows that the profit, here the incentive payment, will be income notwithstanding that the transaction was extraordinary. Although not necessary to the decision, a majority of the Court also found that the receipt would constitute a capital gain on application of s 160M(7) ITAA 1936, the equivalent of CGT event D1, s 104-35 of the ITAA 1997. Relevance of the case today: This case established the proposition that a lease incentive would be characterised as income to the lessee on application of the principles enunciated in Myer Emporium (see above). The majority of the High Court in FCT v Montgomery (1999) 198 CLR 639; 42 ATR 475; 99 ATC 4749 (see below), a case also involving a lease incentive receipt, agreed with the holding in Cooling. Montgomery, Cooling and Myer Emporium were applied by the Full Federal Court in Doutch v FCT [2016] FCAFC 166; 104 ATR 394 finding that fuel disbursements by a taxpayer that sold mining tenements were ordinary income in “the ordinary course of carrying on a business”. If it happened today: If these facts of Cooling were to occur today, the lease incentive would be considered an ordinary income receipt of the taxpayer.

Rotherwood Pty Ltd v FCT

(1996) 32 ATR 276; 96 ATC 4203 (Full Federal Court)

Facts: The taxpayer was a beneficiary under a discretionary trust for the benefit of the family of a partner of a firm of solicitors (Messrs Freehill Hollingdale & Page). The trustee of that trust held units in the Chancery House Unit Trust, the trustee of which was Chancery Services Pty Ltd. Chancery Services, in its capacity as trustee, provided certain secretarial, administrative and other services to Freehills as well as subleasing office premises and providing office furniture and equipment to the firm. All but one of the units in Chancery House Unit Trust were held by nominees of the Freehills partners and the Board of Directors of Chancery Services was comprised of Freehills partners. In 1982 Chancery Services entered into a 10 year lease of a premises with three options for renewal, each for an additional 5 years. The premises was used primarily as office space for Freehills. After some time, it was decided that the Chancery House Unit Trust would be replaced with a discretionary trust. In 1988, a new service trust, the FHP Service Trust, was created. In the second half of 1988, as a result of the construction of several office buildings in Perth at the time, the firm was approached by various developers offering incentives to move to a new building. The firm decided to accept an offer from its existing landlord. Under this arrangement, Chancery Services surrendered the existing lease in consideration of receiving $6 million and FHP Services entered into a new 10 year lease at a rental rate significantly higher than the then market rate. After the payment of fees and the repayment of borrowings, it was resolved that the Chancery House Unit Trust would distribute the balance to the unit holders, with the taxpayer ultimately receiving its 74

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

share of $250,317. The Commissioner argued that the $6 million was income to the Chancery House Unit Trust either as ordinary income or as a gain derived from a profit-making undertaking or scheme (under the former s 25A ITAA 1936, currently s 15-15 ITAA 1997 1997). The taxpayer argued that the surrender of the lease and receipt of the payment was the mere realisation of a capital asset. Decision: The Court held unanimously that the $6 million was ordinary income to the trust assessable under s 25(1) ITAA 1936 (now s 6-5(1) ITAA 1997 1997). The transaction was part of the ordinary incidents of the business carried on by Chancery Services, which included the negotiation of occupancy rights which Freehills could sublease and this would also include the surrender of a lease if this would advance the interests of the firm. In this instance, the surrender of the lease was one of a series of integrated steps involving Chancery Services, the firm and FHP Services which were designed to take advantage of market conditions and to secure the significant payment to the Chancery Services. The sum was a gain produced from the arrangement, not a mere realisation of a capital asset (being the lease). As this transaction was undertaken in the course of Chancery Services’ business, the profit was therefore income and it was unnecessary to consider whether the transaction was unusual or extraordinary. Relevance of the case today: This case illustrates one set of circumstances under which a lease surrender payment would be treated as ordinary income. This scenario is closely analogous to the lease incentive cases such as FCT v Montgomery (1999) 198 CLR 639; 42 ATR 475; 99 ATC 4749, as the payment to Chancery Services was effectively the incentive for FHP Services to enter the new lease. If it happened today: If the facts of Rotherwood were to occur today, it is likely that a court would conclude that the receipt is ordinary income, especially given the approach taken to lease incentives by the High Court in Montgomery. A significant factor in Rotherwood comes from the finding that the transaction giving rise to the receipt was within Chancery Services’ ordinary business. If the transaction were considered outside the ordinary course of the business of the taxpayer, the receipt of the lease surrender payment could still be income under the reasoning in FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363, where there is evidence of an intention to make a profit or gain. The surrender of a lease would also constitute a CGT event C2 (s 104-25 ITAA 1997 1997), giving rise to a capital gain in the amount of the payment less any cost base. However, if the receipt is treated as ordinary income, the capital gain would be reduced by virtue of the operation of s 118-20 ITAA 1997. If only a term of a lease is varied and the lessee receives a payment, CGT event F4 (s 104-125 ITAA 1997 1997) may apply to the payment.

Lees & Leech Pty Ltd v FCT

(1997) 36 ATR 127; 97 ATC 4407 (Federal Court)

Facts: The taxpayer carried on business as a surfwear retailer and entered into a lease of a shop. Under the terms of the lease, the taxpayer would complete the fit out and the landlord would pay $40,000 to the taxpayer as a contribution to the cost of the fit out. The taxpayer completed the fit out at a total cost of $90,000; of this © Thomson Reuters 2019

75

AUSTRALIAN TAXATION LAW CASES 2019

amount, approximately $50,000 related to demountable items and the balance related to fixtures. The lease also provided that the taxpayer had a right to remove the fit out, subject to the obligation to make good any damage. The Commissioner argued that the $40,000 contribution was ordinary income to the taxpayer as a profit or gain realised in the ordinary course of business or under the reasoning in FCT v Myer Emporium Ltd (1987) 163 CLR 199. The taxpayer contended that the amount was not ordinary income. Decision: The Court observed that there appeared to be no gain to the taxpayer from the payment. However, as this fact had not been determined at the AAT hearing of the taxpayer’s appeal in the first instance, the Court directed the parties to agree on whether there was a gain and to remit the case to the AAT if they were unable to agree. The taxpayer agreed to make the improvements which operated to benefit both the landlord, as the owner of the fixtures, and the taxpayer, and the taxpayer was reimbursed for part of the costs of those improvements. The benefit to the taxpayer was indirect and arose from the apparently valueless right at the end of the lease to remove the fit out, where the evidence showed that the only items which could be removed for value were a washbasin and taps. It was considered that the payment was not a cash incentive to take out the lease, though it was clear on the facts that the taxpayer would not have taken up the lease without the fit out contribution. The Court did not clearly indicate how it would characterise the profit if it were determined that the taxpayer had realised a gain from the payment. The Court noted that in GP International Pipecoaters Ltd v FCT (1990) 170 CLR 124 124 (see below under “Government Subsidies”), a grant used by the taxpayer to construct equipment was income because constructing the equipment was part of the taxpayer’s ordinary business. Fitting out shops may not be part of the ordinary business of a surfwear shop and on this basis a gain might not be treated as ordinary income. The gain could, however, be ordinary income on application of the principles established in Myer Emporium. No definite answer to the character of the payment if it is gain is offered in the case. Relevance of the case today: This case suggests that the principles established in the Myer Emporium case could apply to characterise as ordinary income a benefit derived from a lease incentive in the form of a contribution to a fit out if the lessee realises a gain from the lease incentive payment. However, the amount of the profit or gain may be quite limited under the circumstances where the fit out contribution is applied to install fixtures, which by their nature are property of the landlord. Therefore, the only benefit or gain to the tenant may be if the lease includes the right to remove the fixtures on expiration of the lease, and this right may have little value. If it happened today: If the facts of Lees & Leech were to occur today, there would be an argument on the authority of the decision of the Full Federal Court in Selleck v FCT (1997) 36 ATR 558; 97 ATC 4856, that a contribution to the costs of a fit out is not ordinary income, even where the tenant can realise value from that fit out. However, the decision of the Full High Court in FCT v Montgomery (1999) 198 CLR 639; 42 ATR 475; 99 ATC 4749 could provide a strong basis for arguing that such payments would be ordinary income. 76

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

Whether the payments are or are not assessable to the taxpayer, the expenses incurred to undertake the fit out would not be deductible as an ordinary revenue expense. It is likely, however, that the taxpayer would be allowed to claim capital allowance deductions for the entirety of the cost under Division 40 ITAA 1997 as the tenant is considered to be the “holder” of fixtures which were installed by the tenant for its own use (s 40-40 item 3) or where the tenant has the right to remove the fixtures at the end of the lease (s 40-40 item 2). The Commissioner could also make the argument that the receipt of the contribution constitutes a CGT event, possibly a D1 event (s 104-35 ITAA 1997 1997), as the receipt of the contribution was made in the course of creating legal leasehold rights for the landlord, entitling the landlord to rental income for the life of the lease. In this case the contribution would be a capital gain for the taxpayer. A capital gain recognised under a D1 event does not qualify for the CGT discount as a result of s 115-25(3) ITAA 1997 so the final assessable amount will be similar to the amount that would be assessable if the contribution is treated as ordinary income. The characterisation may be relevant, however, if the taxpayer has capital losses that can only be offset against capital gains. A more tax-effective arrangement could be for the lessor to retain ownership of the fit out but provide its use to the lessee without charge (a free fit out). Although the use of the fit out during the term of the lease would be a non-cash business benefit under s 21A ITAA 1936, the otherwise deductible rule at s 21A(3) would reduce the value of the benefit to nil. If this arrangement were used, the lessor could claim capital allowance deductions under Division 40 ITAA 1997.

Selleck v FCT

(1997) 36 ATR 558; 97 ATC 4856 (Full Federal Court)

Facts: The taxpayer was a partner in a firm of solicitors which had recently been formed by the merger of two other firms. It had been decided that it was desirable for the new, larger firm to have its offices in one premises. The decision was made to move to an office tower and the firm’s new landlord, AMP, made payments totalling $1 million to the firm as a cash contribution towards the cost of fitting out the new premises. The Commissioner assessed the taxpayer on the taxpayer’s share of this cash amount. The total cost of the fit out was $2.5 million, paid for by the AMP contribution and a temporary bank overdraft. The fit out was then the subject of a sale and lease back arrangement, which funded a repayment of the overdraft. Decision: The contribution by AMP to the firm to partially fund the fit out was not assessable income. It was considered that the only purpose in entering into the lease was to obtain new premises and this was not influenced by the AMP incentive payments; there was no profit-making purpose in entering into the lease. The relocation of the firm was a capital occasion and the receipt was capital. The Court distinguished FCT v Cooling (1990) 21 ATR 13; 90 ATC 4472, on the basis that in Cooling the Court found that the decision to take up the lease with AMP was influenced by the incentive payment whereas in Selleck this was held not to be the case. Beaumont J also

© Thomson Reuters 2019

77

AUSTRALIAN TAXATION LAW CASES 2019

considered it relevant that, in his opinion, there was no profit or gain as the total cost of the fit out exceeded AMP’s contribution. Relevance of the case today: This decision evidences a trend on the part of the Federal Court to restrict the application of the holding of FCT v Myer Emporium Ltd (1987) 163 CLR 199 to include lease incentives in assessable income of tenants as occurred in Cooling. However, the value of this case as a precedent may be reduced after the decision of the Full High Court in FCT v Montgomery (1999) 198 CLR 639; 42 ATR 475; 99 ATC 4749. If it happened today: If the facts of Selleck were to occur today, there would be a strong argument based on the authority of Montgomery that the cash contribution to the fit out costs, offered as an incentive to take up the lease, would be assessable income to the lessee. While the expenses incurred to undertake the fit out would not be deductible to the tenant, it is likely that the tenant would be allowed to claim capital allowance deductions for the entirety of the cost under Division 40 ITAA 1997 either because the tenant is considered to be the “holder” of fixtures which were installed by the tenant for its own use (s 40-40 item 3) or because the tenant has the right to remove the fixtures at the end of the lease (s 40-40 item 2). The Commissioner could also make the argument that the receipt of the contribution constitutes a CGT event, possibly as an H2 event (s 104-155 ITAA 1997 1997) in relation to the lease, such that the contribution would be a capital gain. A more tax-effective arrangement could be for the landlord to retain ownership of the fit out but provide its use to the tenant without charge (a free fit out). Although the use of the fit out during the term of the lease would be a non-cash business benefit to the tenant under s 21A ITAA 1936, the otherwise deductible rule at s 21A(3) would reduce the value of the benefit to nil. The tenant would not be allowed any capital allowance deductions for the assets owned by the landlord but the landlord could claim capital allowance deductions under Division 40 ITAA 1997.

Commissioner of Inland Revenue (New Zealand) v Wattie & Anor

[1998] UKPC 43; (1999) 1 WLR 873 (Privy Council on appeal from the Court of Appeal of New Zealand)

Facts: The taxpayer was a partner in a major accounting firm carrying on business in Auckland. The partnership decided to move to new premises and engaged in negotiations with various property developers. At that time, it had become common for developers to charge rents which exceeded the real market value but to link the leases to collateral arrangements whereby the lessee would receive various inducements, which effectively reduced the real rental rate. In this case, one of the inducements obtained by the partnership was a $5 million cash inducement sum. The issue before the Privy Council was whether this receipt was income or capital. Decision: The cash inducement sum was a capital receipt. The Privy Council considered that it was appropriate to view the inducement payment as a “negative premium”. A lease premium was ordinarily a payment by a lessee to a lessor in relation to the 78

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

granting of the lease and such a premium was a capital outgoing to the lessee. In this case, due to the unusual state of the commercial property market, the “premium” was paid by the landlord to the tenant. However, it would still be characterised as capital in relation to the tenant, though here a capital receipt rather than a capital outgoing. The Privy Council also discussed the potential application of FCT v Myer Emporium Ltd (1987) 163 CLR 199 to the facts. However, their Lordships were unable to accept that the $5 million was an amount of profit as it could not be severed from the obligations the taxpayer’s firm undertook as part of the overall bargain of the parties. Given that the firm’s obligations in total were greater than the benefits obtained, there could be no profit. Relevance of the case today: In the Full High Court decision in FCT v Montgomery (1999) 198 CLR 639; 42 ATR 475; 99 ATC 4749, the majority declined to adopt the “negative premium” analogy and disagreed with the decision in Wattie. The decision in Wattie therefore has limited relevance for Australian income tax purposes. If it happened today: If the facts of Wattie were to occur today in Australia, the lease incentive would likely be treated as ordinary income to the taxpayer under the authority of Montgomery.

FCT v Montgomery

(1999) 198 CLR 639; 42 ATR 475; 99 ATC 4749 (Full High Court)

Facts: The taxpayer was a partner in a large firm of solicitors which carried on its practice in Melbourne. The firm decided to move premises to a building then under construction. In addition to the lease agreement, the lessor and lessee entered into an inducement agreement whereby the lessor agreed to pay by instalments a substantial sum to the lessee as a lease incentive. Evidence showed that this type of arrangement was widespread at the time in Melbourne. The Commissioner included the taxpayer’s share of this lease incentive in assessable income while the taxpayer argued that the receipts were capital, not income. The issue before the High Court was the proper characterisation of the lease incentive receipts, whether they were income or capital. Decision: By a 4:3 majority, the Full High Court held that the lease incentive was assessable income. The majority applied the decision of FCT v Myer Emporium Ltd (1987) 163 CLR 199 to the facts presented. It was considered that although the lease was acquired as part of the profit-yielding structure of the business, the incentive amounts did not augment that structure. The inducement amounts were obtained by the firm using or exploiting its capital in the course of carrying on its business, even though the transaction would be regarded as singular or extraordinary when judged by reference to the transactions in which the taxpayer usually engaged. The reference in the various cases to “profit” or “gain” did not prevent the application of the Myer Emporium principle to a case where the gross receipt was properly considered income. The characterisation of the receipt as a negative premium and therefore capital was not accepted and the Court declined to follow the decision of the Privy Council in CIR (NZ) v Wattie [1998] UKPC 43.

© Thomson Reuters 2019

79

AUSTRALIAN TAXATION LAW CASES 2019

Relevance of the case today: This case establishes the proposition that a lease incentive receipt will be assessable income to the taxpayer where the transaction was entered into in the course of carrying on a business even though the transaction may be considered singular or extraordinary. This confirms the decision of the Full Federal Court in Cooling and rejects the view taken by the Privy Council in Wattie. It also reaffirms the continued relevance of the first strand of the Myer Emporium decision. If it happened today: If these facts were to occur today, the lease incentive would be considered an ordinary income receipt of the taxpayer. The Commissioner could also make the argument that the receipt of the contribution constitutes a CGT event, possibly as an H2 event (s 104-155 ITAA 1997 1997) in relation to the lease, such that the contribution would be a capital gain. However, any capital gain arising out of the lease incentive would be reduced to the extent the payment is also recognised as ordinary income (s 118-20 ITAA 1997 1997). While the expenses incurred to undertake the fit out would not be deductible to the taxpayer, it is likely that the tenant would be allowed to claim capital allowance deductions for the entirety of the cost under Division 40 ITAA 1997 because the tenant is considered to be the “holder” of fixtures which were installed by the tenant for its own use (s 40-40 item 3).

Payments for Negative Covenants Dickenson v FCT

(1958) 98 CLR 460 (Full High Court)

Facts: The taxpayer was the owner and operator of a garage and petrol station. The taxpayer entered into a series of agreements which effected a trade tie arrangement between Dickenson and Shell Oil Company (Dickenson effectively agreed to sell only Shell Oil products at its station). The form of the arrangement included several agreements: the taxpayer granted a 10-year lease of the station premises to Shell; Shell then granted a sublease back to the taxpayer for effectively the same period and for the same rent; the taxpayer also entered into two deeds whereby Dickenson agreed to only sell Shell products for 10 years and also agreed not to open another service station within 5 miles in the next 5 years without also agreeing to sell only Shell products there. In consideration for entering into the deeds, the taxpayer received two lump sums. The issue before the Court was whether these lump sum receipts were income according to ordinary concepts or capital receipts. Decision: The two receipts were capital sums received as an inducement to change the structure of the business. The effect of the deeds was a substantial and enduring detraction from the taxpayer’s pre-existing rights (freedom of product selection) which amounted to a part disposal of the capital of the business. This was not a transaction which was an ordinary incident of carrying on a petrol station business in the early 1950s. It was also relevant that the sums were not recurrent in nature. An alternative argument that the receipts were assessable as lease premiums also failed and it was also held that the general anti-avoidance provision, s 260 ITAA 1936, had no application.

80

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

Relevance of the case today: Dickenson is of continued relevance as one of the early cases considering payments for dealing with contract rights. It sets out several standards to determine if the receipt is income of the business, such as whether the structure of the business is significantly affected by the arrangements and whether the transaction is an ordinary incident of carrying on the business. The relevance of the case has, however, been diminished with the expansion of what is meant by business income through FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363, and with the introduction of CGT, which would also pick up these receipts. If it happened today: If the facts of this case were to occur today, it is likely that the receipts would be considered ordinary income of the taxpayer. In modern times, trade tie arrangements would generally be an ordinary incident of carrying on a petrol station business or, alternatively, these arrangements could be seen as an unusual transaction but one entered into in the course of carrying on a business and with a profit-making purpose (applying Myer Emporium). The CGT provisions would also be triggered. Entering into such a deed would be a D1 event at the time the contract is entered into and the lump sum receipt would form the capital proceeds from the event, reduced only by any incidental costs (see s 104-35 ITAA 1997 1997). However, this capital gain would be reduced through the operation of s 118-20 ITAA 1997 by the amount included in ordinary income.

MIM Holdings Ltd v FCT

(1997) 36 ATR 108; 97 ATC 4420 (Full Federal Court)

Facts: The taxpayer owned a mining company that generated electricity for its mining operations. The subsidiary also sold electricity to a local network, North Queensland Electricity Board (NORQEB) that, in turn, provided electricity to private consumers. The price paid for electricity was based on two components, the first being the current cost of the electricity and the second being a contribution towards the cost of capital equipment used to generate the electricity. When the review period for the original supply agreement arose, a new pricing agreement was reached, separating the two cost components. Under the agreement, NORQEB would make periodic payments to the mining company for electricity supplied. Separately, the Queensland State Electricity Commission would make “capital contributions” to the taxpayer in return for the taxpayer guaranteeing that its mining subsidiary supply sufficient electricity to meet a specified demand over a seven-year period. The supply could be met through construction of sufficient power generation facilities but in theory it might be necessary to have the subsidiary reduce its consumption at some times to ensure sufficient power was available to supply demand by NORQEB. The payments in question took place in years preceding and after the introduction of CGT. However, the Commissioner sought to assess the taxpayer only on the basis that the payments constituted ordinary income assessable under s 25(1) ITAA 1936 (currently s 6-5(1) ITAA 1997 1997) and not on the basis of the CGT measures. The taxpayer argued the payments were for its agreement to require its subsidiary to restrict its consumption of electricity whenever that would prevent the subsidiary from fulfilling © Thomson Reuters 2019

81

AUSTRALIAN TAXATION LAW CASES 2019

demand by NORQEB. The taxpayer claimed that viewed in this light the payments were capital receipts received for an agreement to forgo consumption. Decision: The Full Federal Court found the payments were not for negative undertakings by the taxpayer to require its subsidiary to restrict consumption but instead were payments for positive undertakings by the taxpayer to ensure its subsidiary provided all the electricity it was required to supply under the agreement. The payments were consideration for services by the taxpayer and constituted ordinary income. Relevance of the case today: The MIM Holdings case illustrates how payments made pursuant to a contract can be characterised as capital gains if the contract is construed as giving rise to a negative covenant or ordinary income if it is construed as requiring the taxpayer to provide a positive service. If it happened today: The significance of the distinction between capital negative covenant payments and income payments for services has diminished since the adoption of the CGT provisions. If the contract were construed as a negative covenant agreement, the gain would be assessable as a capital gain under CGT event D1, s 104-35 ITAA 1997 at the time the taxpayer entered into the negative covenant contract. The lump sum receipt would form the capital proceeds from the event, reduced only by any incidental costs (see s 104-35). As the taxpayer was a company, it would not be eligible for a CGT discount (see s 115-10 ITAA 1997 1997). If the taxpayer were an individual, it would not be eligible for a CGT discount as gains arising from D1 events are excluded from the discount capital gains concession by s 115-25(3) ITAA 1997. Thus, if the facts in MIM Holdings arose today, there would be no advantage to the taxpayer seeking to characterise its gain as a capital gain rather than an income gain and the Commissioner would be largely indifferent as to which characterisation the taxpayer sought.

Foreign Exchanges Gains and Losses An accrual basis taxpayer will record purchases and sales when amounts are invoiced, whether or not payment has been made or received. In the case of a cross-border transaction, the parties will record the sale price in their accounts as converted to national currencies at the time of the invoice. The normal terms of trade in business usually offer the customer some time to satisfy the debt and currency fluctuations are likely to mean that the amount actually paid is more or less than the amount recorded in the parties’ books as the cost. When payment differs from the amount recorded as income or an expense, there will be a foreign currency gain or sometimes a loss that is separate from, but related to, the items sold or purchased and a question that often arose was how the gain or loss should be characterised for tax purposes. In 1986 statutory rules dealing with foreign exchange gains and losses were enacted (currently Division 775 ITAA 1997 1997). These eliminate the distinction between foreign exchange gains and losses on revenue account and on capital account and provide recognition rules for all foreign exchange gains and losses associated with a business.

82

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

International Nickel Australia Ltd v FCT

(1977) 137 CLR 347; 7 ATR 739; 77 ATC 4383

Facts: The taxpayer purchased nickel products from a UK supplier that invoiced the taxpayer for amounts in UK pounds. The taxpayer recorded the cost in Australian dollars when the invoices were received. The value of the UK currency had fallen between the time of the invoice and the time of the payment and as a result the taxpayer paid less in Australian dollars than it had recorded as its expense. The Commissioner assessed the taxpayer on the gain and the taxpayer argued it could not derive income without a receipt and if there was a gain it was on capital account. Decision: The High Court concluded the gain realised on financial transactions can be recognised as income without the need for a receipt. It also concluded that the gain in this case was on income account because foreign exchange fluctuations were an ordinary incident of trading across borders and because the gain related to the acquisition of trading stock, a revenue activity. Relevance of the case today: The International Nickel case was one of several in the 1970s that looked at the characterisation of foreign exchange gains and losses caused by fluctuations in the Australian dollar value of foreign-denominated receipts and outgoings between the time amounts were recorded as income or expenses and when they were actually paid. International Nickel is consistent with the broad thrust of all these cases – if the foreign exchange gain or loss related to revenue activities of a company such as the acquisition or sale of trading stock, it was on income account and if it was related to the acquisition or sale of a capital asset, it was on capital account. In 1986 statutory rules dealing with foreign exchange gains and losses were enacted (currently Division 775 ITAA 1997 1997). The new statutory rules eliminate the distinction between foreign exchange gains and losses on revenue account and on capital account and provide recognition rules for all foreign exchange gains and losses associated with a business. As a result, cases such as International Nickel which distinguish foreign exchange gains of an income nature from foreign exchange gains of a capital nature are of little continuing relevance. If it happened today: If the facts in International Nickel were to take place today, the foreign exchange gain realised by the taxpayer would be included in assessable income under Division 775 ITAA 1997.

ISOLATED TRANSACTIONS BY AN INDIVIDUAL Prior to 1985, where an individual realised a profit from an isolated transaction that was not related to another larger business, the Commissioner would often seek to assess the profits under three alternative bases. First, the Commissioner would argue that the gains were ordinary income from a profit-making scheme and the taxpayer’s profit-making intention with respect to the transaction was sufficient to characterise the gain as ordinary income (using the logic of Californian Copper Syndicate v Harris (1904) 5 TC 159).

© Thomson Reuters 2019

83

AUSTRALIAN TAXATION LAW CASES 2019

Alternatively, the Commissioner would argue the gain was assessable as statutory income under s 26(a) ITAA 1936 (the predecessor to s 25A ITAA 1936, which in turn was the predecessor to the current s 15-15 ITAA 1997 1997). In its original form, s 26(a) ITAA 1936 contained two limbs, the first bringing into assessable income any gains realised by a taxpayer on the sale of property acquired for the purpose of resale at a profit and the second bringing into assessable income gains realised in the course of a profit-making undertaking or scheme. The current version of the provision, s 15-15, is much narrower than the earlier version as it no longer applies to profit from the sale of property acquired for the purpose of resale at a profit and it no longer applies to gains from profit-making undertakings or schemes where the undertakings or schemes involve the sale of property if the property was acquired after 19 September 1985. Today, if the Commissioner is unable to show gains from an isolated transaction are ordinary income, the Commissioner is most likely to base an assessment on the CGT provisions.

Profit-Making Schemes The second limb of s 26(a) ITAA 1936 included in assessable income any profit realised by a taxpayer by way of a profit-making undertaking or scheme. Decisions such as McClelland v FCT (1970) 120 CLR 487 and FCT v Myer Emporium Ltd (1987) 163 CLR 199 suggested that gains which would be caught by the second limb of s 26(a) as profits from a profit-making undertaking or scheme would also be characterised as ordinary income, while amounts that were not ordinary income would not be caught by the section. Section 26(a) has been replaced by s 15-15 ITAA 1997. However, the replacement provision only applies to profits from a profit-making undertaking or scheme that are not ordinary income. It is thus unclear which gains would be caught by s 15-15. The Commissioner is therefore more likely to assess a person deriving gains from an isolated profit-making undertaking or scheme on the basis that the gains are ordinary income (if the gains are associated with another business activity of the taxpayer or the undertaking is carried out in a particularly business-like manner) and under the capital gains provisions in other cases.

McClelland v FCT

(1970) 120 CLR 487; 2 ATR 21; 70 ATC 4115 (Privy Council)

Facts: The taxpayer and her brother inherited land as tenants in common. The taxpayer wished to retain her interest, while her brother wished to sell his immediately. To avoid being a tenant in common with a stranger, the taxpayer purchased her brother’s interest in the land. She intended to sell part of the land at once to fund the payment to her brother and then sell the remainder of the land at a later time, when it had risen in value. Part of the land was sold and the Commissioner argued that the profit realised on the sale of part of the land should be subject to tax as ordinary income or, alternatively, under s 26(a) ITAA 1936 first limb (which applied to gains realised on the sale of property acquired for the purpose of resale at a profit) or under s 26(a) second limb (which applied to profits realised from a profit-making undertaking or scheme).

84

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

Decision: The profit was not income according to ordinary concepts, as what the taxpayer did was not “an adventure in the nature of trade”. The first limb of s 26(a) could not apply to property acquired as a result of a bequest as a person could not have a profit-making purpose with respect to inherited property. The Privy Council suggested that the second limb of s 26(a) as it then stood did not apply to amounts that would not be income in character (that is, the Privy Council suggested that the section merely codified or put into the statute one of the tests for ordinary income). The Privy Council distinguished between a mere realisation of capital in an enterprising way and a scheme or undertaking to produce income. A scheme to produce income will exhibit features which give it the character of a business deal, the Privy Council suggested, while in this case the taxpayer merely set about selling sufficient land, in an enterprising way, in order to retain more valuable land. Relevance of the case today: The McClelland case was relevant for its discussion of the application of s 26(a) but the importance of this analysis is limited today as the current version of s 26(a), s 15-15 ITAA 1997, has a much narrower scope than s 26(a). It does not contain a limb dealing with property acquired for the purpose of resale at a profit. Nor does it apply if the gain is related to the sale of property acquired on or after 20 September 1985. Finally, unlike the original measure, s 15-15 only applies to profits from a profit-making scheme to the extent they are not ordinary income. As the Privy Council in McClelland suggested most profits from profit-making schemes would be ordinary income in any case, it is difficult to see where s 15-15 could apply and how the analysis in McClelland could apply to the current provision. McClelland is still useful for its discussion of whether an isolated transaction that is not related to a larger business by a taxpayer could yield ordinary income. The decision, read in conjunction with decisions such as Californian Copper Syndicate v Harris (1904) 5 TC 159, suggests an isolated transaction not related to an existing business must have a significant entrepreneurial element before it will generate ordinary income. If it happened today: If the facts of McClelland were to occur today, the Commissioner would apply the CGT provisions. When the taxpayer inherited her interest as tenant in common, she would be treated for CGT purposes as having acquired a one-half interest in the land. The taxpayer would be deemed to have acquired that interest on the date of death for the deceased’s cost base (in this case, one half of that cost base for the one-half interest) (s 128-15 ITAA 1997 1997). On the purchase of her brother’s interest, the two interests would merge, as the taxpayer would then hold the entirety of the interests in the land and the cost bases of the two interests would be added together (see s 112-25(4) ITAA 1997 1997). The subdivision of the land would not be a CGT event but the cost base would be apportioned across each of the new lots (s 112-25(1)-(3) ITAA 1997 1997). Then, when one lot was sold, a capital gain would be realised on that lot. As the taxpayer was an individual, she would qualify for the 50% CGT discount (see s 115-25(1) ITAA 1997 1997).

Property Acquired with the Purpose of Resale at a Profit The first limb of s 26(a) ITAA 1936 included in assessable income any profit realised by a taxpayer on the sale of property that had been acquired with the purpose of resale © Thomson Reuters 2019

85

AUSTRALIAN TAXATION LAW CASES 2019

at a profit. There was some debate by tax scholars as to whether this provision merely restated a test used by the courts to identify ordinary income or whether it applied to amounts that would not be ordinary income. The issue remains alive in theory because the first limb of s 26(a) has not been included in the replacement provision, s 15-15 ITAA 1997. Today, the Commissioner could try to assess a gain realised on the sale of property acquired for the purpose of resale at profit as ordinary income. However, if the sale of the property were not related to a business activity of the taxpayer, the Commissioner might find it easier to simply apply the CGT rules to the transaction.

Steinberg v FCT

(1975) 134 CLR 640; 5 ATR 565; 75 ATC 4221 (High Court)

Facts: The taxpayer acquired some direct and some indirect interests in land. The indirect interests were acquired through the purchase of shares in companies that owned land. The companies later liquidated and the land was distributed to the taxpayer as a shareholder in the liquidated companies. The taxpayer sold his interests in the land for a price exceeding the cost of the shares in the liquidated companies. The Commissioner assessed the taxpayer on the difference between the cost of the shares in the liquidated companies and the proceeds of sale from the land that had been distributed to the taxpayer when the company went into liquidation. Decision: Two of the three judges issuing decisions in the case concluded that the profits were assessable but they differed in the reason the gains were assessable. Gibbs J and Stephen J concluded the land had been acquired for the purpose of resale at a profit within the meaning of the first limb of s 26(a) ITAA 1936. Since the shares in the land holding company were purchased to enable the taxpayer to acquire the land, the land acquired on liquidation of the company was acquired for the purpose of resale at a profit. Gibbs J concluded the cost of the shares in the liquidated company could be used as the basis for calculating the assessable profit from the sale of the distributed land. However, Stephen J concluded there was no basis in the law for using that cost and in the absence of a known cost for the land, he declined to apply the first limb of s 26(a). Instead, he concluded that the gains were assessable under the second limb of s 26(a), which applies to profits realised from a profit-making undertaking or scheme, and was able to calculate a profit under that section. In the course of the judgments, a majority of the court concluded that s 26(a) could apply even if every step that culminates in the making of the profit was not planned or foreseen before the arrangement was put into operation. Relevance of the case today: Much of the judgment in Steinberg focused on the possible application of the first limb of s 26(a), which applied to gains realised on the sale of property that had been acquired for the purpose of resale at a profit. This limb does not appear in the provision that replaced s 26(a), s 15-15 ITAA 1997, and the discussion of the first limb is thus not directly relevant to considerations today. The discussion of the second limb of s 26(a) may be used to help interpret the concept of an undertaking or scheme in s 15-15. In particular, it may support the assessment of a gain 86

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

derived in an arrangement where all the steps in the scheme did not directly follow a plan devised before the scheme commenced. If it happened today: If the facts of Steinberg were to occur today, the Commissioner would apply the CGT provisions. When the company liquidated and distributed the land in specie to the shareholder, the company would realise a capital gain on the disposal of the land. The gain would be the difference between its cost of the land and the market value of the land at the time of distribution. The taxpayer would have two separate liabilities in respect of the liquidation distribution of land. First, he would have a deemed dividend under s 47(1) ITAA 1936 to the extent the proceeds were income of the company. Income of the company for the purpose of liquidation distributions is defined in s 47(1A) ITAA 1936 to include net capital gains realised by the company. Any dividend resulting from the application of s 47(1) would be franked to the extent the company would have had a tax liability on the capital gain it realised on distribution of the asset. Second, the taxpayer would realise a capital gain on the relinquishment of his share (a C2 event under s 104-25 ITAA 1997 1997). The capital gain would be calculated as the difference between the market value of the property received and the cost base of the shares that are cancelled on liquidation. However, as a result of s 118-20 ITAA 1997, the capital gain would be reduced by any deemed dividends received as a consequence of the liquidation and cancellation of the shares. The taxpayer would then have a cost base of the land equal to the market value of the shares at the time of liquidation as a result of s 110-25(2)(b) ITAA 1997. There would be a further capital gain or capital loss on disposal of the land depending on whether the proceeds of disposal are greater than or less than the cost base.

REVENUE ASSETS Unlike some overseas income tax systems that equate taxable income with net profits, subject to some modifications, the Australian ITAA starts with a gross amount – assessable income – and then allows deductions to arrive at the net amount, taxable income. The CGT provisions similarly start with a gross capital proceeds and deduct a cost base to arrive at the net capital gain. There is one instance in which the Australian tax system deviates from the normal rule and takes into account net gains only. This is the rule for what are known as “revenue assets” – assets which are held by a business in part for trading purposes but which are not trading stock of the taxpayer. An example is debt instruments held by a bank or the share portfolio of an insurance company. A bank’s primary business is taking deposits and lending money and in the course of carrying out that business, it regularly buys and sells bonds, debentures, bills of exchange, and other debt instruments. Similarly, an insurance company’s primary business is to provide insurance and to operate that business it must take the proceeds of premiums and invest in debt and equity and regularly turn over that debt and equity as market conditions change. The debt held by a bank and the shares held by an insurance company are not trading stock of the taxpayers – they are not in the primary business of selling these assets – but sales of these assets are an integral part © Thomson Reuters 2019

87

AUSTRALIAN TAXATION LAW CASES 2019

of their businesses and gains on the sale of so-called revenue assets are on revenue account. The net gains are treated as ordinary income of these taxpayers.

Colonial Mutual Life Assurance Society Ltd v FCT (1946) 73 CLR 604 (Full High Court)

Facts: The taxpayer was a mutual life assurance company that regularly sold some of its investment assets, particularly debt instruments it held, to maximise its overall investment yields when interest rates changed. The Commissioner assessed the taxpayer on gains realised on the disposal of its debt investments as profit from a profit-making scheme assessed under s 26(a) ITAA 1936 (currently s 15-15 ITAA 1997 1997) or as ordinary income assessed under s 25(1) ITAA 1936 (currently s 6-5(1) ITAA 1997 1997). Decision: The High Court held that the gains realised by the taxpayer were assessable either as profit from a profit-making scheme or ordinary concept income. One aspect of carrying on an insurance business is the investment of insurance premiums to achieve the highest yields possible. Buying and selling investment assets such as debt instruments is a material element in maximising the overall investment yield. The gains and losses on such transactions are thus part of the ordinary business income or losses to an insurance company. Relevance of the case today: The Colonial Mutual Life Assurance case was an important case in establishing the doctrine that gains and losses of an insurance company on the disposal of investment assets are on revenue account. Such assets are today often called “revenue assets” based on the analysis of Professor Ross Parsons as to why gains on the sale of these assets are ordinary income to insurance companies. If it happened today: The revenue assets doctrine continues to apply today and if the facts in Colonial Mutual Life Assurance occurred today, the gains would be treated as ordinary income under s 6-5(1). The net gains or losses on revenue assets are treated as ordinary business income or losses. Revenue assets are not considered trading stock and the trading stock annual valuation rules do not apply to these assets. The gains would also give rise to capital gains but these would be reduced to nil by operation of s 118-20 ITAA 1997.

Chamber of Manufactures Insurance Ltd v FCT

(1984) 15 ATR 599; 84 ATC 4315; [1984] FCA 124 (Full Federal Court) [note: taxpayer name is reported as Chamber of Manufacturers in FCA report]

Facts: The taxpayer was an insurance company concentrating on workers compensation insurance. It held investments in shares and short-term debt securities. The taxpayer distinguished its “core” holdings consisting of short-term debt that could be easily liquidated to satisfy claims, and “reserve” investments held as an investment fund. The taxpayer sold a significant number of shares and reinvested the proceeds in debt instruments. It claimed the sales were motivated by a desire to diversify its portfolio and because the company believed share prices had peaked and shares would 88

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

no longer offer an effective cushion against inflation. It indicated it wished to have funds available to meet contingencies in its insurance business. Decision: While an insurance company that specialised in workers compensation insurance might be in a better position to claim it holds part of its portfolio as an investment portfolio, all the taxpayer’s investments apart from its short-term debt were housed in a single “reserve” fund. This fund could thus be needed to meet insurance claims and the evidence showed that the taxpayer had realised some assets to have funds available to meet contingencies. The assets were thus assets held in the insurance business and not as separate investment assets. Profits realised on the sale of those business assets were ordinary income. Relevance of the case today: Colonial Mutual Life Assurance Society Limited v FCT (1946) 73 CLR 604 had made it clear that investment assets held by a life insurer are held as business assets and profits realised on their turnover are assessable as ordinary business income. The Chamber of Manufactures Insurance Ltd case showed investment assets held by a workers compensation insurer are also revenue assets and profits realised on their sale will be ordinary income. If it happened today: If the facts in Chamber of Manufactures Insurance Ltd arose today, the investment assets would continue to be characterised as revenue assets and the net profits realised on the sale of those assets would be treated as ordinary income assessable under s 6-5(1) ITAA 1997.

INDEMNITIES AND REIMBURSEMENTS An amount received to compensate a person for lost income acquires an income character. Some tax scholars have sought to expand this proposition to include receipts to compensate or reimburse deductible outgoings. The Commissioner has used this academic literature several times in attempts to have the courts extend the compensation principle to catch reimbursements of previously deducted expenses. However, the courts have consistently declined to use the doctrine to enable the Commissioner to recapture the benefit of the deduction by assessing the reimbursement as income.

Allsop v FCT

(1965) 113 CLR 341 (Full High Court)

Facts: The taxpayer was a transport company that paid fees to the NSW government. The legislation under which the fees were levied was found by the Privy Council to be an invalid exercise of State power. The taxpayer subsequently sued for return of the fees it had paid and reached a settlement with the government prior to litigation. The Commissioner assessed the taxpayer on the amounts recovered under s 26(j) ITAA 1936 and s 72 ITAA 1936 (both currently s 20-20 ITAA 1997 1997) which applied to indemnities and recoupments of previously deducted amounts. In the alternative, the Commissioner assessed the taxpayer on the basis that the settlement payment was ordinary income assessable under s 25(1) ITAA 1936 (currently s 6-5(1) ITAA 1997 1997) © Thomson Reuters 2019

89

AUSTRALIAN TAXATION LAW CASES 2019

among other things on the basis that recovery of a previously deducted amount would constitute income. Decision: The High Court concluded that the amount received by the taxpayer was a payment in respect of the settlement and not an actual reimbursement of the fees it had paid. As the amount was a settlement of claims and not a reimbursement of taxes, the predecessor to s 20-30 ITAA 1997 had no application. The settlement amount was not ordinary concept income under a head of ordinary income such as compensation for lost income. Relevance of the case today: Because the High Court in Allsop found the payment was an amount in respect of the settlement of a legal dispute and not a repayment of the previously deducted amount, it did not have to address directly the question of whether reimbursement of a deductible expense would automatically constitute ordinary concept income. However, the case has subsequently been read by many as implying that reimbursements of deductible expenses will not constitute ordinary concept income only because the amount has previously been deducted and later cases explicitly adopt this view. If it happened today: If the payment were characterised as an amount in respect of a legal suit, it would likely remain outside the ordinary income concept. However, the payment would likely trigger capital gains event C2 (s 104-25 ITAA 1997 1997). The cost base for the legal action would be the amount originally paid as fees but for the effect of s 110-45(2) ITAA 1997 which excludes from the cost base expenditure that was deducted. The proceeds would thus be treated as a capital gain. Because CGT event C2 is not excluded from being a discount capital gain by s 115-25(3) ITAA 1997, the gain could be a discount capital gain. However, the taxpayer in this case was a company and as such does not qualify for discount capital gain treatment (see s 115-10 ITAA 1997 1997).

HR Sinclair & Son Pty Ltd v FCT (1966) 114 CLR 537 (Full High Court)

Facts: The taxpayer had timber and sawmill operations and paid royalties to a State Forests Commission for timber it obtained. It disputed the amount of royalties payable and the Forests Commission subsequently refunded some of the royalties paid. The taxpayer argued the receipts were capital amounts while the Commissioner asserted they were income receipts that should be included in the taxpayer’s assessable income. Decision: There is no general principle that refunds of previously deducted amounts automatically acquire an income character. The partial refund was not made in settlement of a claim. It was sought and received in the ordinary course of business which included payment and monitoring of royalties and seeking reimbursement where the taxpayer believed it was required to pay too much. The expense was ordinary income from carrying on a business. Relevance of the case today: The HR Sinclair case showed that refunds of previously deducted amounts do not acquire an income character simply because they reimburse expenses that were previously deducted. However, if an expense such as a royalty is 90

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

paid and a refund pursued in the ongoing course of the taxpayer’s business, it will be an income receipt of the business. If it happened today: If the facts in HR Sinclair arose today, a court would most likely conclude again that the refunds constituted ordinary business income to the taxpayer. Today this conclusion would be buttressed by the decision in FCT v Myer Emporium Ltd (1987) 163 CLR 199 with respect to activities ancillary to the taxpayer’s principal business activities. If the taxpayer could show the refund was not received in the ordinary course of the taxpayer’s business, it would not be ordinary income. Section 20-20(3) ITAA 1997, which includes in assessable income recoupments of previously deducted expenses, would not apply as the previous deduction was not one of the types listed in s 20-30 ITAA 1997. It would be difficult to find a CGT event that was triggered by the refund, although the Commissioner might try to argue the right to the refund is a CGT asset under s 108-5 ITAA 1997 and the payment of the refund is a CGT event C2 under s 104-25(2)(b) ITAA 1997. However, a court might be reluctant to view the taxpayer as having “ownership” of a CGT asset in the form of a right to a refund, as required for that section to operate.

FCT v National Commercial Banking Corp of Australia Ltd (1983) 15 ATR 21; 83 ATC 4715 (Full Federal Court)

Facts: The taxpayer was a member of a group of banks that established the former Bankcard credit card. The initial group of card issuers allowed other banks to enter into the credit card syndicate on the condition that the newcomers pay an entry fee equal to a proportionate share of the costs incurred by the original members in establishing the credit card. The Commissioner assessed the taxpayer on its share of the fees on the basis that it was ordinary income assessable under s 25(1) ITAA 1936 (currently s 6-5(1) ITAA 1997 1997) as a reimbursement of previously deducted expenses or that it was assessable under s 26(j) ITAA 1936 (currently s 20-20(3) ITAA 1997 1997) as an indemnity for a previously deducted loss. Decision: The High Court interpreted the findings of fact by the trial judge as showing that the payments received by the taxpayer were not calculated exactly as a reimbursement of previously deducted expenses and for that reason s 26(j) would not apply to the payments. While the previously deducted expenses may have been revenue outgoings, the later payments did not compensate for missed or lost revenue and were not ordinary income for the taxpayers. Relevance of the case today: The National Commercial Banking Corp case can be used to show the difficulty in characterising amounts related to previously deducted outgoings as ordinary income if it cannot be shown that the receipts were received as an incident of the ordinary business of the taxpayer. If it happened today: If the facts in National Commercial Banking Corp were to arise today, the Commissioner could most likely assess the taxpayer using CGT event D1 in s 104-35(1) ITAA 1997 as the syndicate that received the payment in this case conferred rights to use the Bankcard credit card on the banking making the payment in © Thomson Reuters 2019

91

AUSTRALIAN TAXATION LAW CASES 2019

return for the payment. If CGT event D1 applied to the facts, the taxpayer’s gain would be the amount of the payment less the incidental costs it incurred in creating the right. The taxpayer’s incidental costs in respect of the CGT as defined in s 110-35 ITAA 1997 would likely be minimal.

TNT Skypak International (Aust) Pty Ltd v FCT (1988) 19 ATR 1067; 88 ATC 4279 (Federal Court)

Facts: The taxpayer acquired the international courier business of Ipec Holdings Ltd (“Ipec”). To effect this transaction, the taxpayer agreed to acquire the assets of the business and to assume all of Ipec’s liabilities relating to the business, including amounts due or accruing for annual leave. The price of the business was its net value – that is, the excess of the value of the assets over the value of the liabilities assumed by the taxpayer. The Commissioner assessed the taxpayer on the value of the liabilities it assumed on the basis that the taxpayer had realised this value when it was offset against the value of the assets to determine the net price of the business. The assessment was based on s 26(j) ITAA 1936 (currently incorporated into Subdiv 20-A ITAA 1997 1997) as an amount received by way of insurance or indemnity. Alternatively, the Commissioner argued that the amount was derived as ordinary income, with the offset against the value of assets when determining the purchase price being a compensation receipt for the liability assumed which would give rise to a revenue outgoing upon payment. Decision: The amount of the liability for annual leave which was assumed by the taxpayer was not income either under s 26(j) or as ordinary income. Section 26(j) did not apply as there was no amount “received” by the taxpayer as required by the section. Even if there had been an effective receipt, it was not by way of insurance or indemnity but rather was in return for the assumption of liabilities. The offset also was not ordinary income as compensation for assumption of liabilities as the compensation principle only applies where there has been a loss or an outgoing incurred which is subsequently filled by the compensation receipt. Relevance of the case today: This case establishes the importance of finding identifiable cross debts before a purported offset can give rise to income. A reduction of a purchase price by the value of liabilities assumed does not amount to an offset giving rise to income. The case also limits the application of the compensation receipts doctrine by concluding that it does not apply where the taxpayer merely assumes the obligation to incur a revenue outgoing. If it happened today: If these facts were to occur today, the provisions of Subdiv 20-A ITAA 1997 would be considered. Like s 26(j) ITAA 1936, s 20-20 ITAA 1997 continues to require that there is an amount received by the taxpayer. Under the facts presented, there is no receipt (constructive or otherwise) where there is no offset of cross-debts and therefore there cannot be an assessable recoupment. If there had been a receipt, it would still be concluded that the amount was not by way of insurance or indemnity. However, the application of Subdiv 20-A is broader than the old s 26(j) as it also applies to recoupments other than by way of insurance or indemnity where an amount 92

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

is deductible for the loss or outgoing in the current or an earlier year. Under the facts in TNT Skypak, there has been no outgoing incurred and as a result this extended provision continues to have no application. Likewise, the compensation receipts doctrine would not apply to include the “gain” in ordinary income.

Warner Music Australia Pty Ltd v FCT

(1996) 34 ATR 171; 96 ATC 5046 (Federal Court)

Facts: The taxpayer received two sales tax assessments in respect of its sales of prerecorded music. It treated the sales tax assessments as liabilities and successfully claimed deductions for income tax purposes for the amount of sales tax assessed. However, it did not actually pay the tax assessed and instead disputed the assessments. Six years later, the taxpayer reached a settlement with the Commissioner that reduced the sales tax liability by half. The Commissioner then assessed the taxpayer for the amount of the previously deducted sales tax liability that had been reversed. The Commissioner’s assessment was based on two arguments, the first being that a reversal of a previously deducted amount automatically had an income character and the second that the gain realised by the taxpayer was ordinary income under the tests established by the High Court in FCT v Myer Emporium Ltd (1987) 163 CLR 199. Decision: The Federal Court held there was no general principle that a gain from the reversal of a previously recognised expense is automatically of an income character. However, in this case the gain was so intimately connected with the taxpayer’s business of selling records that it must be treated as being an incident of that business, even if not an ordinary incident of that business. As a result, the gain was “stamped’’ with the character of income based on the tests in Myer Emporium. Relevance of the case today: The proposition that there is no general principle in Australian law that a gain from the reversal of a previously recognised expense is automatically of an income character was later endorsed and adopted by the Full High Court in FCT v Rowe (1997) 187 CLR 266. As this is a decision of a higher court, it is the Rowe case that would be cited for support of this proposition, not the lower Federal Court decision in Warner Music. However, Warner Music can be used to show that in some cases, the reversal of a previously deducted expense can constitute a gain incidental to the taxpayer’s business activities and as such acquire an income character. If it happened today: It would not be possible for facts identical to those in Warner Music to arise today as sales tax is no longer imposed on wholesalers. However, businesses may face analogous liabilities for other taxes that are treated as deductible expenses for income tax purposes. If this happened and the taxpayer’s liability for the other taxes was subsequently reduced or reversed, the resulting gain could be ordinary income if the related events (incurring an assessment for another tax and succeeding in disputing the assessment) were seen as incidental to the taxpayer’s ordinary business activities. If the amount were not ordinary income, the Commissioner might seek to assess the gain as a capital gain. The taxpayer may have paid the tax and sought a refund, in which case it might be possible to apply CGT event C2 (s 104-25 ITAA © Thomson Reuters 2019

93

AUSTRALIAN TAXATION LAW CASES 2019

1997 when the taxpayer surrendered its right to a refund, provided that right is 1997) considered a CGT asset under s 108-5 ITAA 1997. Alternatively, as in Warner Music, the taxpayer may have not paid the tax and as a result only had a liability or debt to pay the tax. In this case, it may not be possible to apply the CGT provisions as there is no CGT asset. Division 245 ITAA 1997 requires taxpayers to realise indirectly gains on the cancellation of commercial debt by reducing the cost of different types of other assets held by the taxpayer when a commercial debt is cancelled. However, in the circumstances of Warner Music, the apparent “liability” for tax turned out to have not been a liability and as a result it may not be possible for the Commissioner to use the debt forgiveness provisions.

FCT v Rowe

(1997) 187 CLR 266; 35 ATR 432; 97 ATC 4317 (Full High Court)

Facts: The taxpayer had incurred legal expenses in respect of an inquiry relating to his suspension from a local government authority and been allowed to deduct the expenses. The State government later reimbursed the taxpayer by way of an ex gratia payment for the legal expenses. The Commissioner treated the reimbursement payment as assessable income of the taxpayer on the basis that a reimbursement of a previously deducted expense is an income amount. Decision: The High Court confirmed that a reimbursement does not acquire an income character merely because it is reimbursement of a previously deducted amount. The character of receipts and outgoings for tax purposes derives from the application of tests based on “ordinary concepts” and these do not necessarily yield reciprocal results for income and expenses. In this case the reimbursement was not received in the taxpayer’s income earning role as an employee and it was therefore not ordinary income. Relevance of the case today: Rowe reaffirms the judicial doctrine that a reimbursement does not acquire an income character merely because it is reimbursement of a previously deducted amount. It is cited by taxpayers whenever it will be difficult for the Commissioner to show that the reimbursement was sought and received as part of the taxpayer’s ordinary income-earning activities. If it happened today: If the facts in Rowe were to arise today, the court would most likely conclude once again that the reimbursement of legal expenses did not constitute ordinary income. Section 20-20(3) ITAA 1997, which includes in assessable income recoupments of previously deducted expenses, would not apply as the previous deduction was not one of the types listed in s 20-30 ITAA 1997. To fit the payment into a CGT event, the Commissioner would first have to show the taxpayer had a right to reimbursement and this right was a CGT asset under s 108-5 ITAA 1997. However, because the taxpayer received an ex gratia payment and there was never a finding that the taxpayer had a right to reimbursement, an argument that the payment was in respect of extinguishment of an asset (a CGT event C2 under s 104-25(2)(b) ITAA 1997) would be difficult to sustain. 1997 94

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

Denmark Community Windfarm v FCT [2018] FCAFC 11, (2018) ATC 20-646

Facts: The taxpayer incurred costs associated with the construction of two wind turbines in Western Australia. The Western Australia Coordinator of Energy provided the taxpayer with a Grant, payable in instalments on completion of project milestones in respect of 50% of the eligible project costs, being capital costs. The taxpayer sought a private ruling on the issue of whether the Grant was assessable income under ss 6-5 or 15-10 of ITAA 1997, or as an assessable recoupment under subdivision 20-A of ITAA 1997. The Commissioner ruled that the grant was not assessable under section 6-5 or 15-10. Rather, it was paid by way of an indemnity and therefore an assessable recoupment under subdivision 20-A. The Commissioner assessed the taxpayer on this basis. The taxpayer subsequently objected to its assessment and appealed the Commissioner’s decision to the Federal Court on the basis that the Grant was not received by way of indemnity or insurance, it did not claim any deductions for the loss or outgoing, and the simplified depreciation rules are not included in the list of deductions in s 20-30 ITAA 1997. Decision: The Full Federal Court found in favour of the Commissioner on all three aspects argued by the taxpayer. That is, the Grant was received by way of indemnity, a deduction for depreciation was a deduction for the cost of the relevant asset, and, as depreciation under Div 40 of ITAA 1997 is a listed deduction, that provision is also satisfied. The result is that the Grant was considered an assessable recoupment both as an amount received by way of insurance or indemnity (the first test under s 20-20) and a recoupment of a loss or outgoing where the taxpayer can deduct an amount either in the current year or an earlier year and the loss or outgoing is specified in s 20-30 (the second test under s 20-20). Relevance of the case today: The case stands for the proposition that where Grants are received by a taxpayer by way of indemnity for capital costs which are depreciated, the Grant will be an assessable recoupment under s 20-20 of ITAA 1997. If it happened today: If the facts in Denmark Community Windfarm arose today, the Commissioner would apply s 20-20 to assess the taxpayer on the amount of the Grant.

FCT v CSR Ltd

(2000) 45 ATR 559; 2000 ATC 4710 (Full Federal Court)

Facts: A subsidiary of the taxpayer mined and sold asbestos and the taxpayer acquired public liability insurance to cover any claims against the taxpayer in respect of the subsidiary’s products. The taxpayer was later subject to numerous personal injury claims arising out of the mining and sale of asbestos and it sought indemnification from its insurer. The insurer refused to pay the indemnification and the taxpayer commenced an action against the insurer which was subsequently settled for a lump sum of $100 million. The Commissioner assessed the taxpayer on the basis of s 26(j) ITAA 1936 (currently s 20-20 ITAA 1997 1997) as an indemnity to reimburse the taxpayer © Thomson Reuters 2019

95

AUSTRALIAN TAXATION LAW CASES 2019

for a previously deducted outgoing. In the alternative, he assessed the taxpayer under s 25(1) ITAA 1936 (currently s 6-5(1) ITAA 1997 1997) on the basis that the settlement was on revenue account as part of the taxpayer’s business activities if those activities were looked at in a comprehensive fashion. Decision: The holding of the High Court in Allsop v FCT (1965) 113 CLR 341 governed the characterisation of the payments in CSR. As was the case in Allsop, the taxpayer in CSR received an undissected lump sum in settlement of all claims against another party and it therefore could not be said that the payment was an indemnity for deductible outgoings of the taxpayer. It was, therefore, not assessable under s 26(j). The undissected lump sum settlement was not received in the ordinary course of the taxpayer’s business activities and did not constitute ordinary business income to the taxpayer, even if the taxpayer’s business were considered from the perspective of the entirety of its operations. The receipt was therefore not ordinary income assessable under s 25(1). Relevance of the case today: The CSR case is further authority for the proposition that a lump sum settlement amount cannot be assessed as an indemnity or recoupment subject to s 20-20. It is also authority for the fact that a lump sum settlement is unlikely to constitute ordinary income assessable under s 6-5(1). If it happened today: If the facts in CSR were to arise today, it is probable that a court using the same logic as the Court in CSR would find that the lump sum settlement was not assessable under s 20-20 ITAA 1997 or s 6-5 ITAA 1997. If the facts arose today, the Commissioner would assess the taxpayer under the CGT provisions. The payment would likely trigger capital gains event C2 (s 104-25 ITAA 1997 1997) in respect of the taxpayer’s surrender of its rights to compensation. The cost base for the legal action would be the amount originally paid as insurance premiums but for the effect of s 110-45(2) ITAA 1997 which excludes from the cost base expenditure that was deducted. The proceeds would thus be treated as a capital gain. Because CGT event C2 is not excluded from being a discount capital gain by s 115-25(3) ITAA 1997, the gain could be a discount capital gain. However, the taxpayer in this case was a company and, as such, would not qualify for discount capital gain treatment (see s 115-10 ITAA 1997 1997). The Full Federal Court in CSR did not consider the possible application of the CGT provisions to the payment received by the taxpayer. At the first court hearing before a single judge of the Federal Court (2000) 44 ATR 115; 2000 ATC 4215, the Court also found that the payment was neither ordinary income nor an assessable indemnity but the Commissioner succeeded with the argument that the amount was assessable as a capital gain. The Commissioner’s motivation for appealing further even though the Court had found the gain assessable as a capital gain suggests the ATO was anxious to achieve a precedent that the amount was assessable under the predecessor to s 6-5(1) or s 20-20. It is also possible that the Commissioner sought the ordinary income characterisation to prevent the taxpayer from utilising carried-forward losses.

96

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

GOVERNMENT SUBSIDIES Section 15-10 ITAA 1997 includes in assessable income a bounty or “subsidy” received in relation to carrying on a business, provided the payment is not ordinary income. The predecessor section (s 26(g) ITAA 1936 1936) overlapped with the ordinary income provision as it applied to both those subsidies that were ordinary income and those that were not. Prior to the adoption of CGT, taxpayers would argue a payment was a capital receipt, not ordinary income or a statutory income subsidy. Since 1985, taxpayers would also have to show that the payment also did not trigger CGT event D1, s 104-35 ITAA 1997 by bestowing rights on the person making the payment, or CGT event C2, s 104-25(1) ITAA 1997 by extinguishing a right to payment held by the person receiving the payment.

GP International Pipecoaters Ltd v FCT

(1990) 170 CLR 124; 21 ATR 1; 90 ATC 4413 (Full High Court)

Facts: The State Electrical Commission of Western Australia (SECWA) sought bids for a tender to coat pipes to be used in a natural gas pipeline. The two companies winning the tender would have preferred to have the pipes coated overseas but the SECWA wished to have the work done in Australia. The winning bidders agreed to establish a jointly owned subsidiary to carry out the work if the SECWA would pay the costs of constructing the facility where the work would take place. The company created was the taxpayer and it received three “establishment” payments totalling $4.675 million before the plant was completed and another payment of $0.55 million before any pipes were delivered. The taxpayer did not include these amounts as assessable income on its income tax returns. The Commissioner reassessed the taxpayer on the basis that the payments it received were ordinary income, assessable under s 25(1) ITAA 1936 (currently s 6-5(1) ITAA 1997 1997). Decision: The establishment costs were received by the taxpayer under the contract as part of the consideration payable for the taxpayer’s performance of the contract. To complete its obligations under the contract, the taxpayer was required to construct a plant and coat the pipes. It earned the money by doing the work it had contracted to do and the payments were ordinary business income to the taxpayer. Relevance of the case today: The decision of the High Court in GP International Pipecoaters was based on the fact that the contract with the taxpayer required it to construct a plant and carry out activities in the plant so payments related to either the construction or the coating were seen as income derived under the contract. It has been suggested the case can be used as a guide for obtaining a different result by severing the taxpayer’s obligation to deliver a product from arrangements that relate to the construction of the facility at which the work would be performed. It is possible that the nexus between payments and the taxpayer’s ordinary business activities could be broken if the arrangements were separated into different parts in this manner. If it happened today: If the facts in GP International Pipecoaters were to arise today, a court would once again find the payments received by the taxpayer to be ordinary © Thomson Reuters 2019

97

AUSTRALIAN TAXATION LAW CASES 2019

income. If the taxpayer reacted to the GP International Pipecoaters decision and arranged for the payments for the construction of the plant to be made pursuant to a separate agreement, the Commissioner may argue on the basis of the holding in FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363 that a separate payment related to the construction of plant is income from an arrangement ancillary to the taxpayer’s principal business. The Commissioner did not argue the payments in GP International Pipecoaters could be assessable as subsidies. If the facts arose today, he might argue in the alternative that the payments are assessable as statutory income under s 15-10 ITAA 1997. He might also argue that in the alternative they are assessable as capital gains under CGT event C2, s 104-25(1) ITAA 1997 if the taxpayer has a right to the payments that is satisfied upon payment or under CGT event D1, s 104-35 ITAA 1997 if the subsidy agreement requires the taxpayer to use the funds in a specific way and thus bestows certain enforcement rights on the government agency providing the funds.

First Provincial Building Society Ltd v FCT

(1995) 30 ATR 207; 95 ATC 4145 (Full Federal Court)

Facts: The taxpayer was a building society that had been required to make contributions to a State-wide statutory fund to protect depositors in the event of the collapse of a building society. In 1992, under a State-Commonwealth agreement, supervision of building societies was transferred from the States to the Commonwealth and the Queensland supervision scheme and statutory fund were wound up. The proceeds of the fund were transferred into the State’s consolidated revenue and then distributed to building funds. The taxpayer received $1.92 million. The Commissioner issued a private ruling to the Queensland Association of Permanent Building Societies setting out the Commissioner’s view that the payment was income according to ordinary concepts under s 25(1) ITAA 1936, a bounty or subsidy forming part of assessable income under s 26(g) ITAA 1936, or a capital gain under Pt IIIA ITAA 1936. The taxpayer appealed against the ruling insofar as it would apply to the taxpayer. Decision: The payment was made to the taxpayer as a result of the establishment of a national regulatory scheme and the winding up of the State fund, not as consideration for any trading activities of the taxpayer. It lacked a sufficient connection with the taxpayer’s business activities to constitute ordinary income. The amount was paid in relation to the taxpayer’s business as a building society, however, and accordingly was assessable under s 26(g) (currently s 15-10 ITAA 1997 1997). As the amount was assessable under s 26(g), the Court did not have to decide if it was also assessable as a capital gain. Relevance of the case today: The First Provincial Building Society Ltd case shows that a “subsidy” in the meaning of s 15-10 does not mean a payment designed to assist or underwrite or partially cover the cost of a particular activity or investment by a taxpayer. Any untied payment from the government can amount to a subsidy and if it is given to the taxpayer in consequence of the taxpayer being in a particular type of business, it will be assessable under s 15-10 if it is not ordinary income. 98

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

If it happened today: If the facts in First Provincial Building Society Ltd were to arise today, the payment would most likely be characterised as statutory income assessable under s 15-10. Given the source of the payment as an ex-gratia distribution by the government, it is probable that courts today would continue to find it was not ordinary income that was derived in an activity ancillary to the taxpayer’s ordinary business activities. Because it is not given in response to any claim by the taxpayer, it is difficult to find a CGT event that might apply to the payment. If the Commissioner were unsuccessful in showing the payment was a subsidy subject to s 15-10, he could try to argue that the government statute which authorised payments to building societies created a right for the taxpayer to receive a specified payment and when the payment was made, there was an extinguishment of the right triggering CGT event C2 in s 104-25(1) ITAA 1997.

COMPENSATION FOR LOST PROPERTY Characterisation of Compensation A taxpayer may lose ownership of property or have other rights over property usurped by way of compulsory acquisition of the property by a government authority or under the authority of a statute that provides for a private party to usurp some property rights. The compensation paid is most likely to have a capital character, provided the property is a structural asset of the taxpayer’s business. The taxpayer may also lose property due to another person’s negligence. The character of compensation in these cases will depend on whether the lost assets are considered revenue assets or capital assets.

Glenboig Union Fireclay Co Ltd v Commissioners of Inland Revenue [1922] SLT 182; 12 TC 427 (UK House of Lords)

Facts: The taxpayer carried on a business of mining of clay deposits and manufacturing fireclay products. It held the rights to mine deposits adjacent to a railway line. The railway company exercised a statutory right to prevent the deposits being mined near the rail line and, after arbitration, an amount was paid to the taxpayer to compensate it for the loss of the right to mine. The amount of the payment was calculated on an estimate of the profits which would have been derived from the exercise of the rights. The issue presented was whether the receipt was ordinary income or a capital receipt. Decision: The receipt was of a capital nature and not ordinary income to the taxpayer. Part of the capital of the company was effectively “sterilised” and destroyed when the taxpayer was prevented from exercising those mining rights. It was considered that the receipt should be given the same character as if the rights had been sold. Relevance of the case today: One of the tests used to identify ordinary income is whether the payment is made to compensate the taxpayer for a loss of ordinary income. However, the Glenboig Union Fireclay case showed there is a difference between © Thomson Reuters 2019

99

AUSTRALIAN TAXATION LAW CASES 2019

compensation made directly for lost profits and compensation made for the loss of profit-making property rights where the value of the property rights is calculated by reference to the profits it would have produced. Glenboig Union Fireclay is most often referred to for Lord Buckmaster’s comments regarding the characterisation of the receipt given the fact that the amount paid was based on a determination of lost profits: “But there is no relation between the measure that is used for the purpose of calculating a particular result and the quality of the figure that is arrived at by means of the application of that test.” If it happened today: If the facts of this case were to occur today in Australia, a court would likely find once again that the payment was not ordinary income. However, the payment would likely trigger a CGT event. Depending on the details of the arrangements, a C2 event could have occurred if the rights could be considered surrendered or forfeited (s 104-25 ITAA 1997 1997) or alternatively an H2 event (s 104-155 ITAA 1997 1997) might arise if the taxpayer realises proceeds as a result of a transaction or event occurring in relation to a CGT asset owned by the taxpayer. The benefit of a C2 event from the taxpayer’s perspective is that when calculating the capital gain from a C2 event, a taxpayer may reduce the capital proceeds by any cost base in the rights. No such reduction is allowed for under the H2 event.

Undissected Receipts The judicial concept of income includes amounts that are received in direct substitution for income or as compensation for income. On this basis, amounts received as compensation for trading stock, for example, would have an income character. Often, however, taxpayers receive undissected lump sum amounts that are partly compensation for lost income amounts and partly compensation for capital losses. If the receipts are not dissected by the parties, courts will characterise the entire amount as capital.

McLaurin v FCT

(1961) 104 CLR 381 (Full High Court)

Facts: The taxpayer was a grazier whose property was severely damaged in a fire that was caused by a railway. The taxpayer sued the railway for damages under several heads including the loss of fee pasture, trading stock and animals, consumables, buildings and depreciable property. The matter was eventually settled when the railway paid a lump sum in satisfaction of all claims by the taxpayer. The Commissioner included a high proportion of the settlement amount in the taxpayer’s assessable income by attributing that part of the settlement to revenue items and balancing charges on depreciable property. The taxpayer argued the settlement payment was a lump sum capital receipt. Decision: Where compensation for losses takes the form of a non-dissected lump sum amount, it is not possible to attribute parts of the lump sum whole to particular income items. Accordingly, if an undissected lump sum is compensation for income and capital losses, the entire payment will be treated as a capital receipt and no part will be ordinary income. 100

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

Relevance of the case today: The principle set out in McLaurin continues to apply to Australian tax jurisprudence and undissected damages, compensation payments or settlements made in respect of revenue and capital losses will be treated as capital receipts. However, in McLaurin the facts showed the compensation was for significant capital and revenue losses. It remains to be seen whether it is possible a court would find compensation was of a revenue nature if the compensation was almost entirely for revenue losses. If it happened today: Proceeds by way of settlement would now be subject to the CGT provisions. The capital proceeds may be taxed in full under CGT event H2 (s 104-155 ITAA 1997 1997) if the proceeds are not attributed to the disposal or part disposal of specific assets. However, the Commissioner in Taxation Ruling TR 95/35 has indicated that the ATO does not regard McLaurin as preventing the ATO from allocating a settlement amount on a pro-rata basis across different assets for which compensation is paid. Taxpayers will generally prefer this approach because they will be able to designate a cost base for a separate CGT event for each asset, reducing the taxable gain significantly. It is also possible that the Commissioner today could seek to assess the taxpayer on the basis that the settlement triggered a GGT event C2 (s 104-25 ITAA 1997 1997) based on the satisfaction of the taxpayer’s right to compensation. If s 104-25 were to apply, the taxpayer would have no cost base and the entire proceeds would thus be treated as a capital gain. As a CGT event C2 gain is not excluded from being a discount capital gain by s 115-25(3) ITAA 1997, the gain could be a discount capital gain. The taxpayer in this case was an individual and would qualify for discount capital gains treatment, but only if he could show the right arose more than 12 months prior to the CGT event (see s 115-25(1) ITAA 1997 1997).

Compensation for Delayed Payment While compensation for capital assets subject to compulsory acquisition is likely to be treated as a capital gain, the Commissioner may seek to characterise part of the compensation as having an income character on the basis that it is compensation for the delay in payment of the primary compensation.

Federal Wharf Co Ltd v Deputy FCT (1930) 44 CLR 24 (High Court)

Facts: The taxpayer’s property was subject to compulsory acquisition by the South Australian Government in 1919. The legislation authorising the acquisition provided for interest to be paid from the time of acquisition until the time compensation is paid to the former property owner. The government paid the interest amount based on an estimated value of the property until the actual value was agreed upon and compensation paid. The ATO assessed the taxpayer on the interest as ordinary income. The taxpayer argued it was a capital payment forming part of the compensation for the acquisition of its asset. © Thomson Reuters 2019

101

AUSTRALIAN TAXATION LAW CASES 2019

Decision: The Court agreed with the taxpayer that the label of a payment as “interest” under the State legislation authorising compulsory acquisition did not determine its true nature for income tax purposes. However, without determining that the payment was interest, the Court found it was compensation not for asset taken by the government but rather for the loss of the use of capital that would have earned income from the time of acquisition until the time compensation was paid. This was the equivalent to the income that would have been earned had the taxpayer retained the asset or been paid compensation immediately and on this basis the payments for the delay in payment of compensation had an income character. Relevance of the case today: The Federal Wharf case can be cited as authority that compensation for the time lag between entitlement to compensation arises and when it is paid is similar in nature to interest and has a revenue character. The character of this part of compensation payments will affect how it enters assessable income and when it is recognised. However, before Federal Wharf is applied, the facts of the case must be carefully checked to ensure part of the payment is explicitly attributed to compensate for the delay in payment of the main compensation. If compensation for the delay is merely one factor taken into consideration when determining the whole amount of compensation as in FCT v Northumberland Development Co Pty Ltd (1995) 31 ATR 161; 95 ATC 4483, the entire payment may be treated as a capital receipt. If it happened today: If the facts of Federal Wharf arose today, the part of the payment that compensates the taxpayer for the delay in receiving the principal compensation would be treated as an income amount. The disposal of the taxpayer’s property would be a CGT A1 event under s 104-10(2) ITAA 1997 payment and the time of the event would be when the government acquired the property under s 104-10(6) ITAA 1997. While the capital proceeds in respect of the acquisition will include all amounts to be received by the taxpayer under s 116-20(1)(a) ITAA 1997, the resulting capital gain will be reduced under s 118-20 ITAA 1997 by the amount that is assessable as ordinary income.

FCT v Northumberland Development Co Pty Ltd (1995) 31 ATR 161; 95 ATC 4483 (Full Federal Court)

Facts: The taxpayer held as a capital asset a two-thirds undivided interest in all coal and other minerals located at a specific mine. The taxpayer’s relevant coal interests were compulsorily acquired by the Crown under the Coal Acquisition Act 1981 (NSW) which also provided for compensation. The calculation of compensation involved an estimate of the tonnes of saleable coal to be extracted (the “royalty” amount) plus an amount per hectare (the “rent” amount) adjusted by an appropriate incremental factor. This incremental factor was based on interest rates and applied to the period from the acquisition date to the date of the determination of the compensation payable. The Commissioner argued that the amount of the compensation payment which reflected the incremental factor was in its nature interest and was therefore income to the taxpayer. The taxpayer argued that the compensation was a capital receipt which should not be dissected. 102

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

Decision: No part of the compensation sum was income to the taxpayer. There was no entitlement to compensation until the time of the determination of the amount due and therefore it must follow that the “incremental factor” was not compensation for the loss of the use of those moneys and therefore was not interest. Apportionment was not available in this case. The compensation was payable under the statute in respect of one item – the coal – and the compensation board did not purport to award interest to any claimant. Relevance of the case today: This case sets out criteria which may be used in determining if a portion of an amount payable that would otherwise be characterised as a capital receipt can be treated as interest or in the nature of interest. It was important under the facts that this was not a case where an entitlement to an amount of damages arose at an earlier time, there was a delay in payment and therefore the amount payable was increased to compensate for this delay. Rather, the incremental factor was merely one part of the method for calculating the damages entitlement. If it happened today: If the facts of Northumberland arose today, the compensation receipt would continue to be treated as an undissected capital sum. The disposal of the taxpayer’s rights to mine the coal would be considered a CGT event which could give rise to a capital gain or loss. Where an asset has been compulsorily acquired, the time of the A1 event is the earliest of when the taxpayer receives compensation, when the government entity becomes the owner of the asset, or when the entity enters it or takes possession of the asset under that power (see s 104-10(6) ITAA 1997 1997).

COMPENSATION FOR DEFAMATION Sydney Refractive Surgery Centre Pty Ltd v FCT (2008) 73 ATR 28; 2008 ATC 20-081 (Full Federal Court)

Facts: The taxpayer successfully sued a television broadcaster for defamation, claiming it had been defamed in an investigative program produced by the broadcaster. The trial court awarded damages to the taxpayer applying the Gourley doctrine. This doctrine is named after a UK case ((British Transport Commission v Gourley [1956] AC 185) that is followed in Australia in tort cases (cases where the plaintiff seeks damages as a result of the defendant’s alleged negligence or deliberate harmful actions). The doctrine states that damages in a tort case which are based on lost profits or income should be calculated by reference to the after-tax amount that would have been retained by the plaintiff if the defendant had not committed the tort. This approach assumes that damages paid in a tort case would not be assessable income even if the damages were calculated by reference to the plaintiff’s lost income. However, the Commissioner assessed the taxpayer on the basis that the damages it received were received in substitution for lost income and thus acquired an income character. The taxpayer argued that although the trial court calculated the damages by reference to lost earnings, the actual damages were for injury to its business reputation and the reference to earnings was merely a way to determine the loss to the business reputation.

© Thomson Reuters 2019

103

AUSTRALIAN TAXATION LAW CASES 2019

Decision: An award of damages for injury is not income according to ordinary concepts, even if the amount of damages is calculated by reference to lost income. The process of determining the amount of loss suffered by the plaintiff is one of quantification of damages but it does not affect the character of the damages, which remain outside the scope of ordinary income as compensation for injury. Relevance of the case today: The Sydney Refractive Surgery case strengthens the long-held view in Australia that damages for personal injury are not assessable income. The case is authority for the proposition that personal injury damages are not ordinary income even if they are calculated by reference to earnings lost as a result of the injury. The damages are for the injury suffered and are not paid in substitution for lost income if the income lost as a result of the injury is considered when setting the amount of the damages. If it happened today: If the facts in Sydney Refractive Surgery were to arise today, it is most likely that the plaintiff would stress in its pleadings at the tort trial that it was seeking compensation for injury, not amounts for lost income. A later court hearing a tax appeal over the character of the damages awarded in the earlier case would then most likely follow the approach of the court in Sydney Refractive Surgery and conclude the damages were not ordinary income as an amount received in substitution for income.

COMPENSATION FOR CONTRACT TERMINATION A receipt upon termination of a contract may have an income character if it substitutes for income that would have been derived under the contract or may be a capital payment if it is compensation for the loss of the contract itself and the contract is a structural asset of the taxpayer’s business.

Californian Oil Products Ltd (in liquidation) v FCT (1934) 52 CLR 28 (Full High Court)

Facts: The taxpayer held a contract with the Australian subsidiary of a US oil company that provided for the taxpayer to be the exclusive distributor in Australia of the products of the US company. The taxpayer had no other business operations. When the US company decided to shift distribution to its local subsidiary, the contract with the taxpayer was terminated in return for 10 semi-annual payments over the five year life of the original contract. The Commissioner sought to assess the taxpayer on the proceeds on four grounds: as ordinary concept income under the predecessor section to s 6-5(1) ITAA 1997, as income from a profit-making undertaking or scheme under the predecessor section to s 15-15 ITAA 1997, as income in periodic payments from the disposal of property under the predecessor section to s 262 ITAA 1936, and as income from the disposal of goodwill under a previous section no longer included in the legislation.

104

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

Decision: The High Court concluded the payments were capital receipts and not ordinary concept income from business or a profit subject to tax under other provisions. The key factor that led to characterisation was that the payment was for termination and liquidation of the taxpayer’s distribution business for the US company rather than merely a restriction of the business. Because this factor was paramount, it did not matter that the payments were structured as regular semi-annual payments or that the amount may have been calculated by reference to the anticipated profits that the taxpayer would have made if the contract had not been terminated. Relevance of the case today: The Californian Oil Products case continues to be cited for the proposition that a payment for cessation of a business rather than a restriction is a capital receipt. As a capital gain, it may qualify for concessional treatment or exemption. If it happened today: If the facts in Californian Oil Products were to occur today, the payment would probably be assessable as a capital gain under CGT event C2, s 104-25 ITAA 1997. Because CGT event C2 is not excluded by s 115-25(3) ITAA 1997, if the taxpayer were an individual or trustee, the gain could be a discount capital gain. The taxpayer in this case was a company and, as such, does not qualify for discount capital gain treatment (see s 115-10 ITAA 1997 1997). However, the gain could qualify for one or more of the small business capital gains concessions set out in Division 152 ITAA 1997 if the qualifying conditions are satisfied.

Van den Berghs Ltd v Clark (Inspector of Taxes) [1935] AC 431 (UK House of Lords)

Facts: The taxpayer, a margarine manufacturer, had entered into a market-sharing agreement with a Dutch competitor. Following a number of disputes between the parties over profit-sharing requirements in the contract, the contract was terminated with the Dutch party making a £3.5 million payment to the English taxpayer in respect of the cancellation. The taxpayer claimed it was a non-assessable capital receipt while the Commissioners sought to assess it as profit or gain from a trade. Decision: The Commissioners sought to assess the gain as a profit or gain from a trade but the Court concluded it was a capital receipt as the cancelled agreements related to the structure of the taxpayer’s profit-making apparatus. The asset surrendered was a capital asset and the payment in relation to the cancellation was treated as a capital receipt, while profits from business were related to manufacturing and dealing in margarine. Relevance of the case today: This is a UK decision based on UK tax law. The UK income tax is a schedular tax and income subject to tax must first fit into one of the charging schedules. The Court looked to see if the gain in this case fitted in the schedule applying to profit or gain from a trade. However, Australian courts apply UK decisions on profit or gain from a trade as if the test were whether the gain were income under the Australian income concept and amounts considered capital receipts in UK cases

© Thomson Reuters 2019

105

AUSTRALIAN TAXATION LAW CASES 2019

would likely be characterised as capital amounts outside the scope of ordinary income in s 6-5(1) ITAA 1997. If it happened today: The facts in Van den Berghs would be unlikely to take place in Australia now. The agreement made between the taxpayer and its competitor to divide market share and reduce competition would be illegal under the Competition and Consumer Act 2010 (Cth). Under the Australian common law, an illegal contract is “void” – meaning it has no existence and could never been enforced. Thus, even if the taxpayer and its competitor entered into the agreement, the agreement would have no legal effect in so far as it breached the Competition and Consumer Act and the taxpayer would hold no rights or asset that could be used as the basis for any claim of compensation or any other payment if the agreement ended prematurely. If the facts were changed slightly and the taxpayer and another business entered into an agreement that was legal but in circumstances that were otherwise similar to those of Van den Berghs or if the agreement had other valuable parts that could be severed from the void parts, an Australian court would likely use similar logic to the UK court’s and find that the payment was a capital receipt outside the scope of s 6-5(1). However, the termination of the agreement would probably be a CGT C2 event (s 104-25 ITAA 1997). The capital proceeds from the termination less the cost base of the agreement 1997 would be a capital gain of the taxpayer. Since the taxpayer was a company, this would not be a discount capital gain and the full amount of the capital gain would be taken into account when determining the taxpayer’s net capital gain included in assessable income.

Commissioners of Inland Revenue v Fleming & Co (Machinery), Ltd (1952) 33 TC 57 (Scottish Court of Session)

Facts: The taxpayer was an agent for nine other companies, including a manufacturer that had agreed to make the taxpayer the exclusive agent in Scotland for sales of the manufacturer’s products. The agreement could be terminated at will and the manufacturer terminated the agreement and paid an amount to the taxpayer as compensation for the termination. The taxpayer claimed the payment received was a capital amount as compensation for the agreement, a capital asset. The UK Inland Revenue Department pointed out the agreement was one of many and its termination did not end the taxpayer’s business. Decision: Three factors indicated the compensation payment received by the taxpayer was of a revenue character. First, the fact that the agreement was one of many held by the taxpayer indicated entering into and terminating agreements was an ordinary incident of business. Second, the fact that the taxpayer was able to continue its operations without major disruption showed the agreement was not a crucial part of the structure of the taxpayer’s business. Third, the fact that the payment could be terminated at will meant it had little goodwill value and the payment was thus compensation for lost profits.

106

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

Relevance of the case today: This is a Scottish decision but the approach taken by the court would likely be followed today in Australia. The three factors considered by the Scottish court in characterising the payment as an income amount would all be relevant to the characterisation of similar payments in Australia. If it happened today: If facts similar to those in Fleming & Co were to arise today in Australia, having regard to the same factors considered by the Scottish Court in Fleming & Co, an Australian court would probably characterise the payment as ordinary income subject to s 6-5(1) ITAA 1997. There would not be a significant difference to the taxpayer’s position if it were characterised as a capital receipt, however. The termination of the agency agreement would be a C2 event under s 104-25 ITAA 1997 and as the taxpayer had no apparent cost base for the agreement that was cancelled, the full payment would be a capital gain. The taxpayer is a company and the gain can therefore not qualify as a discount capital gain under s 115-20.

Heavy Minerals Pty Ltd v FCT (1966) 115 CLR 512 (High Court)

Facts: The taxpayer was engaged in the business of mining and selling rutile. It entered into four forward-selling contracts when the price for rutile was high. Later, the world market for rutile collapsed and the price fell significantly. The taxpayer’s customers sought to be released from the contracts and, after negotiations, the contracts were cancelled and the taxpayer received lump sums in compensation. The Commissioner argued that the receipts were income of the taxpayer and the taxpayer argued that the sums were capital receipts for the disposal of capital assets, given that these were the taxpayer’s only supply contracts. Decision: The payments made to the taxpayer were ordinary income. The fact that the contracts ensured regular customers and a market for the taxpayer’s product did not make the contracts capital assets. Rather, the mining rights and mining equipment were the capital assets of the taxpayer and the taxpayer was still free to mine using these assets after the contract termination. The business of mining had been abandoned not because the contracts were cancelled but because of the collapse in the market price for rutile. Relevance of the case today: The Heavy Minerals case continues to be relevant for its analysis of the relationship between the contracts and the overall business in determining if a payment for cancellation of a contract will be characterised as ordinary income or as a capital receipt. It is usually cited as a means of distinguishing a fact situation from that of Californian Oil Products Ltd (in liq) v FCT (1934) 52 CLR 28 (see above) and Van den Berghs Ltd v Clark [1935] AC 431 (see above) where receipts on cancellation of contracts were considered to be capital in nature due to their relative importance to the capital structure of the business carried on. In particular, Heavy Minerals suggests receipts for cancellation of a contract are more likely to be income in nature if the taxpayer could continue to sell the subject of the contract to other customers. As the CGT provisions will now bring such capital receipts to tax and

© Thomson Reuters 2019

107

AUSTRALIAN TAXATION LAW CASES 2019

there is no CGT discount for corporate taxpayers, the distinction between these cases is of reduced significance. If it happened today: Receipts on cancellation of supply contracts in the circumstances presented in Heavy Minerals would likely still be considered ordinary income receipts. In addition, such amounts would be capital proceeds received under a CGT event C2 (s 104-25 ITAA 1997 1997), which could be reduced by any cost base there might be in the contract rights, but any resulting capital gain would be reduced by the operation of s 118-20 ITAA 1997.

Allied Mills Industries Pty Ltd v FCT

(1989) 20 ATR 457; 89 ATC 4365 (Full Federal Court)

Facts: The taxpayer carried on a business of production, manufacture and distribution of food products and by-products and their raw materials. As part of this business, the taxpayer was, under a distribution arrangement, the sole selling and distribution agent for Peek Frean biscuits in Australia, Papua New Guinea and Fiji and also had a licence to manufacture and sell Vita Weat biscuits. The arrangements were amended from time to time but a few years later Peek Frean, then owned by Arnotts, decided to terminate the agency agreement and the taxpayer received a lump sum payment in compensation for the termination. The taxpayer argued that the receipt was capital in nature but the Commissioner treated it as an income receipt. Decision: The receipt was income to the taxpayer. The Court considered that the character of the payment would be dictated by whether the agreement which was terminated constituted a structural asset of the taxpayer. In order for a contract to be so regarded, it must be of substantial importance to the structure of the business itself. In this case, the taxpayer was not parting with a substantial part of its business and was not disposing of part of the fixed framework of the business, distinguishing Californian Oil Products Ltd (in liq) v FCT (1934) 52 CLR 28 (see above) and Van den Berghs v Clark [1935] AC 431 (see above). The Court considered it relevant that terms of the agreements fluctuated considerably over the years so that the arrangement could not be described as permanent. It was part of the business of the taxpayer to provide distribution services and this contract was made in the ordinary course of that business. The payment was essentially designed to compensate the taxpayer for the loss of anticipated profits which would have flowed from the contract. All of these factors indicated that the receipt was income in nature. Relevance of the case today: This case is another illustration of the factors that a Court will consider in determining whether compensation for the disposal of contract rights will give rise to an income or capital receipt. The test as enunciated by the court involves a determination of the importance of the contract to the structure of the business. This is a question of fact and a matter of degree. If it happened today: If the facts of Allied Mills were to occur today, a court would most likely consider that such a compensation receipt is income to the taxpayer. In addition, the cancellation of the contract rights would be considered a CGT event C2 108

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

(s 104-25 ITAA 1997 1997) and a capital gain would likely arise but would be reduced by operation of s 118-20 ITAA 1997.

SALE OF RENTAL EQUIPMENT Prior to 2001, when a taxpayer sold an item of depreciable property for more than the original cost, the balancing charge provisions recaptured the depreciation from the depreciated value to original cost and the excess of proceeds over cost could be characterised as a revenue gain or a capital gain depending on the nature of the sale in relation to the taxpayer’s business activities. The insertion of s 40-285 ITAA 1997 into the ITAA ended the litigation as it includes the excess of proceeds of sale over depreciated value in assessable income without regard to the original cost. The earlier cases are still useful as illustrations of the tests used by courts to distinguish income from capital gains.

Memorex Pty Ltd v FCT

(1987) 19 ATR 553; 87 ATC 5034 (Full Federal Court)

Facts: The taxpayer carried on business of selling new computer equipment, leasing computer equipment and advising on the design of computer packages. Often the leased equipment was sold to customers at the end of the lease, generating a profit. The taxpayer treated the leased equipment as depreciable assets and, on sale of an item, would include in income the difference between the written down value and the proceeds up to the original cost (depreciation recapture). Any proceeds in excess of the original cost were treated as capital receipts. The Commissioner argued that the profits should be included in income as profits arising from the taxpayer’s business operations which included selling leased equipment. The taxpayer sought to split its activities into two businesses, that of selling new equipment and leasing equipment. The leased equipment would therefore be capital assets of that separate business such that any profits realised would be capital in nature. The taxpayer also argued that the profits would be income only if it were shown that the equipment was acquired for the purpose of resale. Decision: The profits in excess of cost were income of the taxpayer. The business of the taxpayer was broadly defined as the distribution of computer equipment. The sale of previously leased goods was never a major part of the business but the sales were of sufficient regularity and magnitude to be regarded as an ordinary part of the business. As a result, the profits realised on the sale of previously leased equipment were profits arising from the ordinary course of the taxpayer’s business. The Court considered it unnecessary to determine whether the equipment was acquired for the purpose of resale at a profit. The leasing business was not a separate business but an integral part of the overall business activities. It was relevant that the taxpayer did not have a business whereby it held standard items of equipment in stock to be hired out to one customer following another – the equipment was acquired and supplied to meet the particular requirements of each customer. © Thomson Reuters 2019

109

AUSTRALIAN TAXATION LAW CASES 2019

Relevance of the case today: The Memorex case highlights the importance of the definition or delineation of the business undertaken by the taxpayer when determining if particular profits fall within the ordinary course of that business, the key factor used to characterise those profits as income or capital receipts. The treatment of gains realised on the sale of depreciable assets is more certain now as the total of the proceeds over the written down value is included in income under the provisions of Division 40 ITAA 1997. If it happened today: If the facts of Memorex were to occur today, the leased computer equipment would be characterised as “depreciating assets” for the purposes of Division 40. The sale of an item would be a balancing adjustment event and the difference between the termination value (the proceeds) and the adjustable value (written down depreciated value) would be included in income under s 40-285 ITAA 1997, with no distinction made between recapture of excess depreciation to cost and the profits in excess of cost.

Cyclone Scaffolding Pty Ltd v FCT

(1987) 19 ATR 674; 87 ATC 5083 (Full Federal Court)

Facts: The taxpayer carried on a business of leasing scaffolding. The scaffolding equipment was often damaged or not returned. This would trigger a clause in the hire agreement whereby there was a deemed sale of the equipment by the taxpayer to the customer for the “list price” which generally exceeded the original cost. The taxpayer treated all equipment as trading stock until the end of the year in which it was purchased and thereafter treated it as depreciable assets. With the Commissioner’s consent, the taxpayer adopted a LIFO method of accounting for the equipment which resulted in sales being first treated as sales of trading stock and, when no further balance remained, the sale would be treated as sales of depreciable assets. In the case of the equipment treated as trading stock, the normal tax treatment was used, claiming deductions for cost and treating proceeds on sale as income. With respect to the sales allocated to depreciable assets, the taxpayer treated the difference between the proceeds and cost as capital profits. Decision: A majority of the Federal Court concluded the profits were capital in nature. The purpose of the taxpayer in acquiring the equipment was to hire it rather than for resale at a profit and therefore the profits on resale should not be treated as income. The majority also considered that the Commissioner was bound by the characterisation which he accepted in the taxpayer’s accounting system – the Commissioner could hardly accept the treatment as depreciable property in one year and then contend that it should be trading stock when sold. The majority distinguished Memorex Pty Ltd v FCT (1987) 19 ATR 553; 87 ATC 5034, on the basis that in Memorex the equipment was not part of the taxpayer’s depreciable property or fixed assets. Relevance of the case today: The relevance of Cyclone Scaffolding may be limited on the basis that the unusual accounting system applied to the equipment with the consent of the Commissioner prevented the Commissioner from succeeding on the revenue/capital argument. The particular issue of the assessment of profits on the sale 110

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

of plant also has reduced significance after the introduction of the CGT provisions and the more recent changes to the depreciation provisions, both of which operate to include the profit above cost in assessable income. If it happened today: If the facts of Cyclone Scaffolding were to arise today and the same accounting system were still accepted by the Commissioner, the scaffolding equipment would be characterised as “depreciating assets” for the purposes of Division 40 ITAA 1997. The sale of an item would be a balancing adjustment event and the difference between the termination value (the proceeds) and the adjustable value (depreciated value) would be included in income under s 40-285 ITAA 1997, with no distinction made between recapture of excess depreciation to cost and the profits in excess of cost.

FCT v GKN Kwikform Services Pty Ltd

(1991) 21 ATR 1532; 91 ATC 4336 (Full Federal Court)

Facts: The business of the taxpayer was the leasing of scaffolding equipment. If a customer failed to return equipment, under the terms of the hire arrangement, the customer was required to pay the “current list price” for the scaffolding as compensation. The current list price was often greater than the original cost of the scaffolding, resulting in a profit. The taxpayer treated the compensation payments as assessable balancing charges up to the original cost of the equipment (depreciation recapture). Any amount in excess of cost were characterised by the taxpayer as capital receipts. The Commissioner argued that the profits were income of the taxpayer. Decision: The profits were income of the taxpayer as the compensation receipts were a regular, ordinary and expected incident of the taxpayer’s business. Beaumont J took the view that the receipts should be seen as part of the consideration paid under the hiring contract (an additional hiring fee) rather than as consideration in respect of the disposal of the equipment. On that basis, it was clear that the profits were income. The Court distinguished the decision in Cyclone Scaffolding Pty Ltd v FCT (1987) 19 ATR 674; 87 ATC 5083 on the basis of the special accounting system used by the taxpayer in that case. Relevance of the case today: GKN Kwikform illustrates the principle that the income of a business will include those receipts which are derived as a regular, ordinary and expected incident of the taxpayer’s business. The decision turned on the particular terms of the hiring agreements and the evidence given of the regularity of the receipt of these compensation payments. If it happened today: If the facts of GKN Kwikform were to occur today, it is likely that the Commissioner would simply apply s 40-295 ITAA 1997 in Division 40 ITAA 1997 to include the entirety of the excess of the compensation payment and the adjustable value (written down depreciated value) of the equipment in assessable income. It is therefore unlikely that a court would be asked to characterise the excess of proceeds of disposal over cost as income or capital gains using judicial doctrines to distinguish the two. © Thomson Reuters 2019

111

AUSTRALIAN TAXATION LAW CASES 2019

FCT v Hyteco Hiring Pty Ltd

(1992) 24 ATR 218; 92 ATC 4694 (Full Federal Court)

Facts: The taxpayer carried on business hiring out forklift trucks. The taxpayer generally owned the trucks but in some cases leased the truck from financiers. Where the trucks were leased, the taxpayer would generally acquire the trucks at the end of the lease for their residual values (20% of cost) as the trucks would only then be five years old and could therefore continue to be hired out. The trucks were not purchased for the purpose of resale at a profit. If a truck was no longer suitable for hire, it was sold and in some instances the sales proceeds exceeded the original cost (which may have been the residual value under the lease). The Commissioner argued that profits were income on the basis that either the sale of trucks was an ordinary incident of the business of leasing trucks or the business of the taxpayer included the sale of forklift trucks. Decision: The profits were capital in nature. Hill J (with whom the other members of the Court agreed) defined the business of the taxpayer as that of hiring forklift trucks. The trucks were not purchased for the purpose of resale but for the purpose of hiring them out. Therefore, the profits would be income only if made in the ordinary course of the taxpayer’s business. The regularity or magnitude of the receipts will not alone determine their character. The trucks were the very apparatus with which the taxpayer conducted business and the profits derived from the sale of these assets were not part of the process by which the taxpayer operated to obtain regular returns by means of regular outlays. Hill J also commented on the application of the Full High Court’s decision in FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363 to circumstances such as these and emphasised that, in his view, the decision in Myer does not mean that every gain made by a taxpayer carrying on a business which has some relation to that business is therefore taxable as income as this would destroy the distinction between capital and income. Relevance of the case today: Like Memorex Pty Ltd v FCT (1987) 19 ATR 553; 87 ATC 5034, this case highlights the importance of the definition of the business carried on by the taxpayer in determining if particular profits are derived in the course of that business, the result determining whether those profits are income or capital receipts. The treatment of gains realised on the sale of depreciable assets is now more certain as the total of the proceeds over the written down value is included in income under s 40-295 ITAA 1997. However, if the taxpayer does not use assets after they are acquired for residual value from a lessor, they may not become depreciating assets and only the CGT provisions will apply if the facts are similar to those in Hyteco (that is, the taxpayer can show the transactions are on capital account). If it happened today: If the facts of this case were to occur today, the forklift trucks would be characterised as “depreciating assets” for the purposes of Division 40 ITAA 1997. The sale of a truck would be a balancing adjustment event and the difference between the termination value (the proceeds) and the adjustable value (the written down depreciated value) would be included in income under s 40-285 ITAA 1997, with no distinction made between recapture of excess depreciation to cost and the profits in excess of cost. 112

© Thomson Reuters 2019

CHAPTER 4

INCOME FROM BUSINESS AND GAINS FROM THE SALE OF ASSETS

However, if the taxpayer sold the trucks immediately after acquisition, they might not be treated as depreciating assets. If the taxpayer did not use the trucks but sold them soon after purchase, the question arises whether the transaction is on revenue account, generating ordinary income, or is outside the ordinary scope of the taxpayer’s business, in which case only the CGT provisions will apply. The evidence in the case suggests the sale of the trucks was not considered by the Court to be of the taxpayer’s ordinary business activities or ancillary to its ordinary activities. If this is the case, the transaction would be on capital account and the taxpayer’s cost would be the residual value for which the trucks were purchased on the basis of the authority in Granby Pty Ltd v FCT (1995) 30 ATR 400; 95 ATC 4240.

© Thomson Reuters 2019

113

C HAPTER 5

Income from Property and Instalment Sales of Property ROYALTIES �� CAPITAL GAINS ..................................................................... McCauley (1944) ................................................................................... Stanton (1955)........................................................................................ Ashgrove Pty Ltd (1994) ........................................................................

117 117 118 119

BENEFITS FROM SHARE OWNERSHIP........................................................ 120 McNeil (2007) ......................................................................................... 121 PREMIUMS AND DISCOUNTS ON DEBT INSTRUMENTS ....................... 122 Return by Way of a Discount and Interest ................................................... 122 Lomax (Inspector of Taxes) v Peter Dixon and Son Ltd (1943)............. 122 Return by Way of a Discount Only.............................................................. 123 Hurley Holdings (NSW) Pty Ltd (1989) ................................................. 123 DEALINGS IN DEBT ........................................................................................... 124 Cancellation of Debt .................................................................................... 124 Jackson v British Mexican Petroleum Co Ltd (1932) ............................ 124 Tasman Group Services (2009) .............................................................. 125 Repurchase of Debt ..................................................................................... 126 Mutual Acceptance (1984) ..................................................................... 126 Debt Defeasance .......................................................................................... 127 Orica (1998) .......................................................................................... 127 FINANCE LEASES, INSTALMENT SALES, IMPLICIT INTEREST, AND ANNUITIES ................................................................................................ Finance Leases............................................................................................. Citibank Ltd & Ors (1993)..................................................................... Sales of Property for a Series of Payments.................................................. Foley (Lady) v Fletcher (1858) .............................................................. Secretary of State in Council of India v Scoble (1903) .......................... Egerton-Warburton (1934) .................................................................... Just (1949) ............................................................................................. Vestey (1962) .......................................................................................... Moneymen (1990) ..................................................................................

128 128 129 130 130 131 132 133 134 135

© Thomson Reuters 2019

115

AUSTRALIAN TAXATION LAW CASES 2019

Income from a Financial Arrangement – Annuity or Blended Payment Loan .............................................................................................. 136 ANZ Savings Bank (1993) and (1998) ................................................... 137

116

© Thomson Reuters 2019

C HAPTER 5

Income from Property and Instalment Sales of Property ROYALTIES �� CAPITAL GAINS Payments for the actual exploitation or harvesting of property may have an income character as proceeds for sale of revenue assets. Payments for the underlying rights to exploit the property may have a capital character.

McCauley v FCT

(1944) 69 CLR 235 (Full High Court)

Facts: The taxpayer was a grazier who sold the right to cut and remove timber growing on his land with the price based on the amount of timber removed. Payments were to be made on a monthly basis. The taxpayer had not acquired the timber as trading stock or with the intent of selling it for a profit and the Commissioner did not assess him on the proceeds as ordinary income. However, the Commissioner did assess the taxpayer on the proceeds as “royalties” under s 26(f) ITAA 1936 (currently s 15-20 ITAA 1997 1997). Decision: Two of the three High Court judges hearing the appeal, Latham CJ and McTiernan J, concluded the payments were royalties as they were payable by reference to the amount of timber removed. The taxpayer’s appeal against the assessment was therefore dismissed. Both judgments implied that the proceeds for the sale of a capital asset would not be ordinary income. Relevance of the case today: In international tax usage, the term “royalties” commonly refers to payments for the use of intellectual property. McCauley confirmed the common English-language usage of the term to also include payments for natural resources where the payment is calculated by reference to the amount of resource sold or extracted. The case also stands for the proposition that a payment that is not ordinary income can nevertheless constitute a royalty. As a result of the decision in McCauley the original royalty assessment provision, s 26(f) ITAA 1936 applied to royalties that were ordinary income and royalties that were not ordinary income. The relationship between s 26(f) and the ordinary income provision, s 25(1) ITAA 1936 was not clear © Thomson Reuters 2019

117

AUSTRALIAN TAXATION LAW CASES 2019

in the case of royalties that were ordinary income. This has been clarified in s 15-20 which only applies to royalty payments that are not ordinary income. If it happened today: The payments in McCauley would continue to satisfy the ordinary meaning of royalty (as payments for the sale of a natural resource that were calculated directly by reference to the amount sold). If the facts in McCauley arose today and a court concluded the payments were not ordinary income, they would be assessable under s 15-20. However, it is also possible that if the case arose today, a modern court taking a more pragmatic view of income-earning activities could conclude the proceeds from the sale of timber by a grazier constituted ordinary income. A modern court might decide the payments were income either from an activity ancillary to the taxpayer’s principal income-earning activity as a primary producer or from a secondary income-earning activity of a taxpayer whose primary income-earning activity was that of grazier. In either of these cases, the payments would be assessable under s 6-5(1) ITAA 1997 and not under s 15-20.

Stanton v FCT

(1955) 92 CLR 630 (Full High Court)

Facts: The taxpayer, a grazier, sold a quantity of timber to a sawmill and provided the sawmill with the right to enter the property and cut and remove the timber. The pre-determined total payment was payable in quarterly instalments. The agreement provided for a maximum amount of timber to be removed and provided further for a pro-rata reduction in the total amount if less timber were removed. The Commissioner assessed the taxpayer on the payments on the basis that they were royalties, assessable under s 26(f) ITAA 1936, the predecessor to s 15-20 ITAA 1997. Decision: The Full High Court concluded the payments were not royalties because they were not calculated directly by reference to the amount of timber taken. Accordingly, they were characterised as non-assessable instalments of a capital amount. Relevance of the case today: Stanton may be used as authority for the fact that consideration for the sale of a right to exploit a resource on a person’s property can have a capital character even if it paid in instalments. The case is also sometimes used by tax planners who seek to break the royalty nexus between payments and the amount of a resource exploited by using a reducing payment formula instead of a continuing payment formula. If the payment for exploiting a natural resource is tied directly to the amount taken, the payment will be characterised as a royalty. Stanton suggests that if the same result is achieved through a reducing formula – setting a total payment for a maximum amount of resources to be taken and then reducing the payment on a pro-rata basis depending on the actual amount of resources removed, the nexus between payment and exploitation of the resource can be broken so the payment will not be characterised as a royalty. If it happened today: The broader understanding of income from business including transactions ancillary to a business which derives from FCT v Myer Emporium Ltd (1987) 163 CLR 199 may lead to a characterisation of the payments in Stanton as 118

© Thomson Reuters 2019

CHAPTER 5

INCOME FROM PROPERTY AND INSTALMENT SALES OF PROPERTY

income from a business ancillary to the grazing business conducted on the land. If the Commissioner would not succeed with a characterisation of the payments as income based on Myer Emporium, the CGT provisions will apply to the gain. Measurement of the gain will depend on the details of the contract. If the contract refers to the sale of the timber itself and the timber was on the property when it was acquired, the sale would trigger a s 104-10 ITAA 1997 CGT event A1 and the taxpayer might be able to attribute some of the cost of the property to the trees that were on the property at the time of acquisition using s 112-25 ITAA 1997. However, if the contract actually grants a right to cut and remove the timber, as opposed to a sale of the timber itself, the transaction might trigger a s 104-35 ITAA 1997 CGT event D1 (creating a right in the purchaser). In this case, the only costs the taxpayer could use to reduce the capital gain would be any incidental expenses related to the transaction itself.

Ashgrove Pty Ltd & Ors v DFCT

(1994) 28 ATR 512; 94 ATC 4549 (Federal Court)

Facts: This case involved five different taxpayers each of which entered into one or more agreements to effect the sale of standing timber on land which they owned and acquired prior to 20 September 1985. In each case, the agreements were based on the agreement considered in the case Stanton v FCT (1955) 92 CLR 630, where the Full High Court concluded that the instalments payable under the agreement were not royalties but instalments of capital. The Commissioner argued that the amounts received by the taxpayers were income under ordinary concepts or alternatively assessable as capital gains. The Commissioner took the view that the agreements involved the grant of an interest in land (such as a profit à prendre) and not the sale of goods and therefore either s 160M(6) or s 160M(7) ITAA 1936 would apply (now incorporated, with some amendment, into CGT events D1 and H2, ss 104-35 and 104-155 ITAA 1997 1997). Alternatively, the Commissioner argued, if the agreements were for the sale of goods, the goods constituted the timber, not the trees, such that the new asset being the timber would not pick up the pre-1985 acquisition date of the trees. Under either of these views, in determining the amount of capital gain, the capital proceeds would not be reduced by any relevant cost base, resulting in the amounts being fully assessable. The taxpayers submitted that in each case there was a contract for the sale of goods where the goods, being the timber, had been owned or formed part of land which was owned as at 19 September 1985 and therefore the CGT provisions should not apply. If the agreement did create an interest in land, that interest was merely incidental to the sale of goods. Decision: A profit à prendre agreement confers an immediate interest in the land to the grantee under which the grantee derives the benefit from further growth of the thing sold. In contrast, where the thing that is sold is fully mature and it is the intention of the parties that the thing be immediately removed from the land, the arrangement is for the sale of goods. Considering the agreements at issue, Hill J concluded that in each case the agreements should be treated as a sale of goods. For CGT purposes, in each case there was a disposal of part of the realty which had been acquired prior to 20 September 1985 and therefore the CGT provisions did not apply. Had the land © Thomson Reuters 2019

119

AUSTRALIAN TAXATION LAW CASES 2019

been acquired post-CGT, the arrangements would be treated as a part disposal of the land and an allocation of part of the cost base of the land to the trees would have been required under s 160ZI ITAA 1936 (currently s 112-30 ITAA 1997 1997). On the issue of whether the receipts were income according to ordinary concepts, the decision varied according to the circumstances of each taxpayer. Where the land was not acquired for a profit-making purpose and there was no evidence that a business had been commenced, the proceeds were not income. In the case of two of the taxpayers, the Stanton-style agreements provided for additional payments to be made above the original agreed lump sum based on the amount of timber taken. In each case the lump sum (which was payable in instalments) was a capital receipt but the additional payments were income as royalties. In the case of the final taxpayer, there was evidence that the taxpayer was carrying on a business of selling timber and therefore the total of the receipts was ordinary income. Relevance of the case today: This case remains relevant for a number of reasons. It provides a useful discussion of the distinctions between a profit à prendre and a sale of goods. On the meaning of “goods”, Hill J comments that the definition found in the relevant State Sale of Goods Act was created for the purposes of that Act and was not intended to change the general law. The opinion is also relevant for the analysis of the application of the CGT provisions, drawing the distinction between the disposal of part of an asset (here the trees as part of the land) and the creation of a new asset which relates to a pre-existing asset (the creation of an interest in land, for example). Where a new asset is created, there will not be an allocation of cost base from the underlying asset to the new asset. If it happened today: For the purposes of applying the CGT provisions, if the facts presented in Ashgrove were to occur today, the transactions would still be characterised as a part disposal of an asset (the land) where the part of the asset is itself an asset under s 108-5 ITAA 1997. The disposal will constitute a CGT event A1 (s 104-10 ITAA 1997 1997) and s 112-30 ITAA 1997 will apply to allocate the relevant proportion of the cost base of the land to the timber in order to determine the capital gain or loss realised. The capital proceeds would include the entirety of the proceeds to be received but the capital gain would be reduced under s 118-20 ITAA 1997 by any amount which is included in assessable income as royalty or business income. In the case where the taxpayer is carrying on a business of selling timber or the taxpayer receives consideration by way of royalty under a right granted to fell trees, the amount of income derived by the taxpayer may be similarly reduced by a portion of the cost of the land by applying s 70-120 ITAA 1997.

BENEFITS FROM SHARE OWNERSHIP Shareholders in a company may realise gains in two ways. If the company retains profits or is judged by the marketplace to be capable of greater profits, its share value will rise and the shareholder can realise a gain by selling her or his shares. Depending on the circumstances of the acquisition and sale, the profit realised on the sale of shares may be ordinary income or a capital gain. Alternatively, if the company distributes 120

© Thomson Reuters 2019

CHAPTER 5

INCOME FROM PROPERTY AND INSTALMENT SALES OF PROPERTY

its profits to shareholders as dividends, the dividends will be assessable as ordinary income under s 6-5(1) ITAA 1997 or as a dividend under s 44(1) ITAA 1936. As there is an overlap between the two provisions in respect of dividends, the specific provision is generally considered to take precedence over the general and the recognition timing rule in the specific provision (when the dividend is paid) will apply to all taxpayers. The definition of dividend in s 6(1) ITAA 1936 is broad and catches most distributions to shareholders. It will not, however, catch rights that have no value to the company but which may be valuable in the marketplace.

FCT v McNeil

(2007) 229 CLR 656; 64 ATR 431; 2007 ATC 4223 (High Court)

Facts: St George Bank announced a share buy back arrangement under which it would offer each shareholder the opportunity to sell 1/20 of their shareholding to the bank at a pre-determined price. St George issued shareholders with put options which required the bank to purchase the shares at the specified price. Because some shareholders did not wish to use rights and others wished to sell more than 1/20 of their shareholding, there was a market created for the rights as soon as they were issued and each right had a known market value as soon as it was received. The taxpayer was a shareholder who did not wish to exercise the put option rights she received and therefore made them available for sale. The rights she received had a market value of $514 at the time she received them. They were later sold for $576. The Commissioner assessed the taxpayer on the full proceeds. The taxpayer objected to the inclusion of $514 in her assessable income as ordinary income but did not object to the inclusion of the $62 difference between the issue value and the proceeds of disposal as a capital gain. Decision: The sell-back rights received by the taxpayer were not dividends and the receipt was not the consequence of partial disposal of any profit-yielding structure owned by the taxpayer. From the taxpayer’s perspective, they were a discrete and severable benefit arising out of her share ownership and the value of the rights at the time they were received constituted ordinary income. Relevance of the case today: The ITAA was amended following the McNeil case to ensure that gains on the issue of rights would be taxed as capital gains, not ordinary income gains, and the gains would be assessed when there was a disposal of the rights, not when they were received. As a result, McNeil will have little direct relevance today. However, it can continue to be cited for the fact that the specific dividend inclusion provision, s 44(1) ITAA 1936, does not act as a code for distributions from companies and benefits that are not dividends and are not subject to the capital gains rules for issues of rights may be assessable as ordinary income. If it happened today: If the facts in McNeil were to arise today, s 59-40 ITAA 1997 would exclude the rights from assessable income. When there is a disposal of the rights, the CGT rules would be triggered. The disposal would amount to an A1 CGT

© Thomson Reuters 2019

121

AUSTRALIAN TAXATION LAW CASES 2019

event and the taxpayer would have no cost base for the rights, so the entire proceeds of disposal would be a capital gain.

PREMIUMS AND DISCOUNTS ON DEBT INSTRUMENTS The return on debt instruments may be realised by way of periodic interest or by means of a discount (debt issued at less than face value and then redeemed at face value) or a premium (debt issued at face value and then redeemed for more than face value). Judicial tests are used to determine whether discounts or premiums have an income character or are capital gains. Until 1985, only discounts of an income nature were assessable. With the adoption of CGT in 1985, discounts of a capital nature were recognised as capital gains. In 1987, an accrual regime was adopted, requiring taxpayers to recognise deep discounts (greater than 1.5% per year) of an income nature on an accrual basis over the life of the loan (Division 16E ITAA 1936 1936). Deep discounts that were capital gains were recognised on the redemption of debt under the CGT rules. A separate provision adopted in 1989 brings into assessable income all shallow discounts (less than 1.5% per year) whether they are of an income nature or a capital nature (s 26BB ITAA 1936). In the case of shallow discounts of an income nature, this rule overlaps with 1936 s 6-5 ITAA 1997 but in the case of shallow discounts that are capital gains, it has the effect of removing the CGT discount. The original accruals regime ceased to apply to companies from 2009 and a new accruals system (Division 230 ITAA 1997 1997) now applies to corporate taxpayers. It applies to all discounts, effectively eliminating the distinction between discounts that are ordinary income and discounts that are capital gains. The new accrual rules do not apply to individuals who continue to recognise deep discounts of an income nature on an accrual basis (Division 16E), shallow discounts that are capital gains when the debt is redeemed (s 26BB), and deep discounts that are discount capital gains when the debt is redeemed.

Return by Way of a Discount and Interest Lomax (Inspector of Taxes) v Peter Dixon and Son Ltd

[1943] KB 671; [1943] 2 All ER 255; 25 TC 353 (UK Court of Appeal)

Facts: The taxpayer made advances to a related Finnish company which supplied wood pulp for the taxpayer’s newsprint manufacturing business. The loan was subject to some risk because of the military threat to Finland. The advances took the form of notes issued at a 6% discount. Interest was payable under the notes at a rate of 1% above the lowest discount rate of the Bank of Finland, subject to a cap of 10%. Each note was redeemed at a premium of 20%. When these features were combined, the overall return on the notes was 7.75% of the amount outstanding. The taxpayer was assessed on the interest, discounts and premiums as annual profits or gains liable 122

© Thomson Reuters 2019

CHAPTER 5

INCOME FROM PROPERTY AND INSTALMENT SALES OF PROPERTY

to assessment. The taxpayer objected, arguing that the discount and premium were capital sums and therefore not assessable. Decision: The Court of Appeal held that the discount and premium were capital sums and therefore only the interest was assessable as income. A taxpayer may choose to express the risk attached to a security through a higher interest rate (which will give rise to higher income) or through a discount or premium, where the risk is expressed through the capital advanced. The Court considered that the Crown was bound by the company’s choice and could not go behind it. Importantly, the Court accepted the argument that the interest rate based on the central bank rate was a reasonable commercial rate of interest charged and on this basis, there was no presumption that the discount or premium was in the nature of interest. Relevance of the case today: This case is often referred to for the tests enunciated by Lord Greene to determine if a discount or premium is “genuine” and therefore capital or if it is merely disguised interest, and therefore income. All the circumstances of the case will be considered but, in particular, a court will look to the term of the loan, the rate of interest stipulated, the nature of the capital risk and the extent to which the parties took into account the capital risk in fixing the terms of the contract. However, as the use of discounts and premiums has become a more common way to obtain returns on money lent, it is more likely today that a discount or premium will be treated as in the nature of interest and almost certainly a discount or premium will be treated this way if there is no interest charged on the loan and the discount or premium is the only return: see, eg, FCT v Hurley Holdings (NSW) Pty Ltd (1989) 20 ATR 1293; 89 ATC 5033. If it happened today: If the financial arrangement at issue in this case were entered into today in Australia, the taxpayer would be subject to Division 230 ITAA 1997. The entire gain would be assessable and recognised on an accrual basis, as if it were compounding interest.

Return by Way of a Discount Only Some debt instruments carry no rights to interest with the return to the investor being realised entirely by discounts as the notes are issued to lenders for an amount substantially below the redemption value of the notes. Examples include Treasury bills issued by the government and bills of exchange very commonly used in commercial lending.

FCT v Hurley Holdings (NSW) Pty Ltd

(1989) 20 ATR 1293; 89 ATC 5033 (Federal Court)

Facts: The taxpayer acquired a bill of exchange with a term exceeding one year yielding a 13% return. The note was acquired on 3 January 1983 and had a redemption date of 9 January 1984. The taxpayer argued the gain was a capital gain realised on the disposal of an appreciated asset. The Commissioner argued the discount on a bill of exchange is ordinary income. © Thomson Reuters 2019

123

AUSTRALIAN TAXATION LAW CASES 2019

Decision: The Federal Court agreed with the Commissioner that a gain realised by way of a discount on a debt instrument that provides no return to the holder apart from the discount is ordinary income. Relevance of the case today: Hurley Holdings limits the effect of Lomax v Peter Dixon and Son Ltd [1943] KB 671 to cases where the return on a debt is by way of interest and discount and the taxpayer can show the discount was provided for reasons other than an intended return to the lender. If the return is by way of discount only, Hurley Holdings will be cited as authority for the proposition that the entire discount has the character of ordinary income. The adoption of Division 230 ITAA 1997 in 2009 effectively eliminated the distinction between discounts of an income nature and discounts that are capital gains for corporate lenders. However, the decision in Hurley Holdings continues to be relevant for individuals who are not subject to Division 230. If it happened today: As the taxpayer was a corporation in Hurley Holdings, if the facts in the case were to arise today, the discount would be assessed under Division 230 as if it were compounding interest.

DEALINGS IN DEBT Cancellation of Debt A taxpayer gains in an economic sense whenever a debt owed by the taxpayer is cancelled or forgiven. In this case, the taxpayer has enjoyed the benefit of the borrowed funds but doesn’t have to repay the debt. The question arises as to whether the gain on cancellation can be assessable. Until 1996, judicial tests on the income concept were used to determine whether a gain on the cancellation of debt would be assessable. In 1996, statutory rules were adopted as a schedule to the ITAA 1936. The rules were intended to overcome the limitations of the judicial tests and generally recognise the gains from cancellation of debt, but in an indirect manner. The new measures were drafted in the style of the ITAA 1997 and numbered in the ITAA 1997 fashion as Division 245. In 2010, the entire Division was shifted into the ITAA 1997.

Jackson (Inspector of Taxes) v British Mexican Petroleum Co, Ltd (1932) 16 TC 570 (UK House of Lords)

Facts: The taxpayer purchased fuel for trading stock and incurred a debt to the fuel supplier for the cost of the fuel and transport expenses. The taxpayer deducted these expenses when invoiced by the supplier. Before paying the amount due on the invoices, the taxpayer ran into financial difficulties. It reached an agreement with its creditor under which the supplier agreed to cancel a portion of the debt. Unlike the Australian income tax law which is based on assessable income and deductions, the UK company tax law was based on company profits. Inland Revenue argued first that upon cancellation of the debt owed by the taxpayer, it should be possible to reopen the assessment for the year in which the taxpayer acquired the services which gave rise to the debt and reverse the deduction taken in that earlier year. Alternatively, Inland 124

© Thomson Reuters 2019

CHAPTER 5

INCOME FROM PROPERTY AND INSTALMENT SALES OF PROPERTY

Revenue argued there should be a recognition of a trading gain in the year the debt was cancelled. Decision: The House of Lords confirmed the rule in UK tax law that Inland Revenue cannot reopen tax assessments from previous years when the assessments were correct at the time they were originally made. It also held that under UK tax law it was not possible to record a trading receipt in the accounts of a taxpayer if a debt owed by the taxpayer is cancelled, even if the taxpayer previously deducted the cost of an acquisition that gave rise to the trade debt. Relevance of the case today: Although the Australian and UK company income tax systems are based on fundamentally different frameworks, British Mexican Petroleum has been interpreted in Australia as giving rise to a principle that cancellation of a debt does not give rise to ordinary concept income. The case and the doctrine based on it prompted the legislature to adopt Division 245 in Schedule 2C ITAA 1936 to provide a statutory regime for the indirect recognition of the value to a taxpayer from the cancellation of debt. If it happened today: If the facts in British Mexican Petroleum arose today in Australia, there would be no income or capital gain recognised as a result of the cancellation of the taxpayer’s trade debt. However, the cancellation would trigger the operation of Division 245 ITAA 1997. Division 245 requires taxpayers to recognise indirectly the value of cancelled debt obligations by reducing tax attributes such as carried forward losses and the cost base of assets by the amount of the cancelled debt.

FCT v Tasman Group Services Pty Ltd

(2009) 74 ATR 739; 2009 ATC 20-138 (Full Federal Court)

Facts: The taxpayer was an Australian company that had borrowed from its overseas parent. The parent later sold its shares in the taxpayer and as part of the sale agreement it was required to ensure the taxpayer had no outstanding debts when the sale was completed. Accordingly, the parent cancelled all loans from the subsidiary and recorded the cancellation in minutes of a parent company meeting. The Commissioner applied Division 245 to recognise the benefit of the cancellation to the taxpayer. The taxpayer argued the parent’s “cancellation” did not satisfy the definition of forgiveness of debt in s 245-35 ITAA 1936 (now ITAA 1997 1997) and that if it did, the market value of the debt was very low because the taxpayer did not have the resources to repay it. Section 245-55 ITAA 1936 (now ITAA 1997 1997) states that the value of cancelled debt should be calculated without regard to whether the taxpayer could repay it or not, but there is an exception to the rule if the debt was a CGT asset to the lender and the lender had used the asset in carrying on business in Australia. The taxpayer claimed the lender had carried on business in Australia through its subsidiary so the exception applied and the value of the forgiven loan was a small amount at best. Decision: The Full Federal Court found the provisions of Division 245 applied to cancellation of the debt. It said it was not necessary for the purposes of Division 245 © Thomson Reuters 2019

125

AUSTRALIAN TAXATION LAW CASES 2019

for a debt to be expressly forgiven and it was sufficient if a debt had been forgiven by way of conduct or implication as in this case. It found the lender had not carried on business in Australia since the business of the subsidiary was that of the separate entity and not the business of the foreign parent shareholder. Accordingly, the exception in s 245-55 did not apply and the value of the forgiven loan was its value calculated as if the taxpayer could repay the loan. Relevance of the case today: Tasman Group Services can be cited as authority for the fact that forgiveness of a loan for Division 245 purposes does not require an express “forgiving” but can be achieved implicitly or by way of conduct. If it happened today: If the facts in Tasman Group Services arose today, the value of the cancelled loan would be recognised under Division 245.

Repurchase of Debt The market value of a debt may rise or fall depending on changes in interest rates relative to the rate payable on the debt. It may fall if the market perceives the borrower’s credit rating has fallen. If the borrower is able to repurchase or redeem a debt for less than was originally borrowed, the borrower will realise a gain of the difference between the cash originally received and the amount needed to end the debt through repurchase or redemption. As the CGT provisions only apply to assets, they will not capture gains realised on debt which is a liability, the opposite of an asset. The gain may be assessable as ordinary income or, if it can be shown to arise from a profit-making undertaking or plan, under s 15-15 ITAA 1997.

Mutual Acceptance Ltd v FCT

(1984) 15 ATR 1238; 84 ATC 4831 (Supreme Court of NSW)

Facts: The taxpayer was a finance company that issued debentures to gain funds for use in its finance business. When prevailing interest rates rose, the value of its issued debentures fell and debenture holders asked the taxpayer to redeem the debentures prior to maturity so they could reinvest in new debt instruments paying higher rates of interest. The taxpayer redeemed the debentures for their market value which was less than the face value for which they had been issued. The Commissioner assessed the taxpayer on the difference between the issue price and the amount paid to redeem the debt. Decision: The gain realised on the redemption of debt for less than the issue price was ordinary income to the taxpayer incidental to its ordinary business activities. The taxpayer regularly entered into loan transactions in the ordinary course of its finance company business and gains incidental to that business were on revenue account, amounting to ordinary income for the taxpayer.

126

© Thomson Reuters 2019

CHAPTER 5

INCOME FROM PROPERTY AND INSTALMENT SALES OF PROPERTY

Relevance of the case today: Mutual Acceptance is cited as authority for the proposition that gains realised on the redemption or repurchase of debt by a finance company are ordinary income to the company. If it happened today: If the facts in Mutual Acceptance were to arise today, a court would continue to characterise the gain realised on redemption of debt by a finance company for less than its issue price as ordinary income.

Debt Defeasance For a variety of corporate finance reasons, borrowers may wish to redeem outstanding debt prior to the maturity of the debt. If the lender is unwilling to have the loan redeemed prior to maturity, the borrower can divest itself of the obligation through a “debt defeasance” which involves paying another person the present value of the debt obligation in return for the other person agreeing to assume the obligation to repay the debt. A borrower can defease its obligation to pay either the ongoing interest obligation on the loan or the principal at maturity of the loan or both the interest and principal. Two types of defeasance are possible. In a legal defeasance, the lender agrees to the transfer of loan repayment to another person. In an in substance defeasance, the original borrower pays another person to assume the obligation of repaying the loan but the original borrower remains the party with the legal obligation to repay the debt.

FCT v Orica Ltd

(1998) 194 CLR 500; 39 ATR 1147; 98 ATC 4494 (Full High Court)

Facts: The taxpayer had entered into a number of borrowings which obligated it to repay loan principals of $98 million in the future. The taxpayer entered a debt defeasance arrangement with the Melbourne Metropolitan Board of Works (MMBW) under which the taxpayer paid the MMBW $62 million, being the present value of its obligation to repay the principals on borrowings it had made, and MMBW agreed it would repay the principals on maturity of the debt on behalf of the taxpayer. The debt defeasance was an “in substance” defeasance meaning the contract between the taxpayer and the lender remained legally enforceable and the lender could recover the amount from the taxpayer if the MMBW failed to honour its obligations under the defeasance agreement. The Commissioner’s basis for assessment changed somewhat as a dispute with the taxpayer progressed through the courts but at the High Court the Commissioner’s argument was that the taxpayer realised a gain of $36 million when the MMBW paid the loan principal. The assessment presumed that the taxpayer had an obligation to repay the face value of the borrowings and realised a gain equal to the amount paid to relieve itself of the obligation and the amount paid by the MMBW. The taxpayer argued it enjoyed no economic gain from the transaction, having paid the full market value of the obligation, the present value of the future payment, to be relieved of a debt obligation worth exactly what was paid for the relief at the time of the debt defeasance. © Thomson Reuters 2019

127

AUSTRALIAN TAXATION LAW CASES 2019

Decision: As the defeasance was an in substance defeasance, the taxpayer remained legally obligated to repay the loan principal and when it was paid by the MMBW, the taxpayer realised a gain. The transaction was not in the ordinary course of the taxpayer’s business or ancillary to the ordinary course and was therefore not assessable as ordinary income under s 25(1) ITAA 1936 (currently s 6-5(1) ITAA 1997 1997). The debt defeasance contract by itself did not constitute a profit-making scheme so s 25A ITAA 1936 (currently s 15-15 ITAA 1997 1997) did not apply. The gain was subject to the CGT provision. The taxpayer’s rights against the MMBW amounted to a CGT asset under s 160A ITAA 1936 (currently s 108-5 ITAA 1997 1997) and the payment by the MMBW to the lender amounted to the release or discharge of the taxpayer’s rights against the MMBW under s 160M(3)(b) ITAA 1936 (currently s 104-25(1) ITAA 1997 1997). The difference between the amount paid by the taxpayer to be relieved of its debt obligation and the face value that was paid on redemption by MMBW was a capital gain of the taxpayer. Relevance of the case today: The decision in Orica continues to guide the tax treatment of debt defeasance transactions. It has been recognised by many tax policy analysts that the decision leads to an inappropriate result from a policy perspective as the taxpayer is taxed on a phantom gain – that is, the taxpayer is subject to tax while it has no actual gain in any economic sense. If it happened today: If the facts in Orica arose today, the taxpayer would be treated as if it had realised a capital gain on redemption of the debt equal to the difference between the amount paid for the debt defeasance agreement and the redemption value of the debt. To avoid this result, the taxpayer is most likely to seek a legal defeasance with the lender agreeing to the transfer of the principal repayment obligation. To protect its interests, the lender might require a guarantee from the taxpayer.

FINANCE LEASES, INSTALMENT SALES, IMPLICIT INTEREST, AND ANNUITIES Finance Leases A finance lease is a lease which is expected to end with the transfer of the leased property to the lessee at the end of the lease for a relatively small sum. In accounting and economic terms, a finance lease amounts to a sale of property by the lessor attached to a loan by the lessor to the lessee of the purchase price. Under accounting principles, the lessor is treated as having sold the property and each “lease” payment received by the lessor is treated as a blended loan payment that is partly interest and partly the return of the deemed loan principal. Outside Australia, it is common for tax laws to adopt the accounting principles to recharacterise lease payments on a finance lease as loan interest and principal payments. Australian courts (and to date the legislature) tend to follow the form of the transaction (eg, a lease) rather than its economic or accounting substance. The exception to this rule is found in Division 242 ITAA 1997, which treats a finance lease of a luxury car as if it were a sale by the 128

© Thomson Reuters 2019

CHAPTER 5

INCOME FROM PROPERTY AND INSTALMENT SALES OF PROPERTY

lessor to the lessee and the payments made under the lease as if they were interest and principal repayments on a loan.

FCT v Citibank Ltd & Ors

(1993) 26 ATR 423; 93 ATC 4691 (Full Federal Court)

Facts: The taxpayer carried on business primarily as a trading bank and as part of this activity it entered into leasing finance arrangements. The leases at issue in the case involved luxury cars. The arrangements were classified as “finance leases” for accounting purposes as substantially all the risks of ownership passed to the lessee; the alternative characterisation as “operating leases” for accounting purposes was therefore not appropriate. In its accounts and also for tax purposes, the taxpayer returned as income only the “interest” component of the rental receipts, treating the balance of the receipt as repayment of the principal advanced. This method was consistent with the relevant Australian accounting standards for finance leases. The Commissioner argued that the appropriate tax accounting for these arrangements did not follow the accounting treatment but rather required the entirety of the receipt to be treated as lease income and the taxpayer was then entitled to claim available depreciation deductions. As the cars were luxury cars, the cap on the depreciable cost found in s 57AF ITAA 1936 (currently s 40-230 ITAA 1997 1997) would apply to limit the depreciation deductions. Decision: Although described as leases, the arrangements were technically bailment agreements. Evidence of commercial accounting practices may be relevant and sometimes significant in resolving taxation issues but in the facts in this case, the Court concluded that the correct tax accounting method diverged from the commercial accounting method. In this case, the Court said, it was not appropriate to use the net profit figure as calculated under a financial accounting method as gross income for the purposes of the ITAA. In cases where it was appropriate to use net profit as gross income for tax purposes (eg, the gain on the sale of a revenue asset), the gross receipt used in the calculation was itself not income according to ordinary concepts. This is not the case in a finance lease situation as, in the opinion of the Court, the rent received under a chattel lease by a company carrying on a business such as the taxpayer is income under ordinary concepts as rental from premises. The gross rental receipts are income because they represent the return on property put to income producing use by the taxpayer and they are periodic. Relevance of the case today: This case establishes the proposition that for tax purposes, the gross receipts under a finance lease are income to the lessor and the lessor is then entitled as owner of the leased property to depreciation deductions for the property. A subsequent legislative regime (discussed below) which applies to luxury car leases entered into effect from 20 August 1996 now applies to transactions of the sort carried out in Citibank but the case remains relevant for finance leases of other assets. If it happened today: If the arrangements considered in the Citibank case were to be entered into today, the special provisions found at Division 242 ITAA 1997 would apply. This regime treats a luxury car lease, other than a genuine short term hire, as a notional © Thomson Reuters 2019

129

AUSTRALIAN TAXATION LAW CASES 2019

sale and loan transaction for tax purposes. The lessor must treat as income an accrual amount determined by applying the implicit interest rate to the outstanding notional loan principal on a compounding accruals basis. The lessee may be able to deduct the finance charge portion of the lease payments and may also be entitled to claim capital allowance deductions based on the cost of the car, though subject to the limit found in s 40-230 ITAA 1997. For the purposes of the capital allowance provisions, the lessee is treated as the “holder” of the car (s 40-40 item 1 ITAA 1997 1997).

Sales of Property for a Series of Payments Where a taxpayer sells property for a series of payments, the question arises whether the vendor should be treated as selling for a single capital sum payable by instalments or whether the vendor has disposed of property in return for a stream of income payments or annuity payments.

Foley (Lady) v Fletcher

(1858) 157 ER 678 (UK Court of Exchequer)

Facts: Lady Foley sold her interest in certain buildings, land and mines where the total stated price was £99,000 (Lady Foley’s share being £45,000). A total amount of £6770 was paid down and the balance was stated to be payable by instalments half-yearly over thirty years. Should an instalment not be paid, interest would then accrue on the payment. Under the relevant income tax provisions, the defendants had deducted an amount from several of the initial instalments on the basis that they were income in the form of an annuity. The issue for the court was therefore whether the payments made to Lady Foley were instalments of capital or an annuity. Decision: The Court respected the form of the agreement and concluded that the contract was to pay a principal sum of money by way of instalments. The contract did not evidence the intention of Lady Foley to sell her estate for an annuity. Although it was acknowledged by some members of the Court that each instalment payment might have included an interest component, the Court did not have the authority to apportion the payments between income and capital. Relevance of the case today: This case is the first in a series in which the English courts struggle with the distinction between instalments of purchase price which may be characterised as instalments of principal plus interest (which is therefore only partly income) or an annuity (income in its entirety, subject to a statutory formula to recover the initial capital free of tax). At the time of the case, there was no statutory formula to dissect annuity payments or blended payment financial arrangements into income and capital components. The court could characterise the payments either as wholly income (annuity) or wholly capital. In later UK cases such as Secretary of State in Council of India v Scoble [1903] AC 299 and Vestey v Inland Revenue Commissioners [1962] Ch 861, UK courts showed an inclination to recharacterise arrangements as equivalents of blended payment financial arrangements. This is particularly true where there is evidence that could be used to calculate the notional interest portion of the payments 130

© Thomson Reuters 2019

CHAPTER 5

INCOME FROM PROPERTY AND INSTALMENT SALES OF PROPERTY

(such evidence was absent in Foley v Fletcher). The recharacterisation cases have not been followed in Australia; the approach set out in Foley v Fletcher, following the taxpayer’s characterisation of proceeds as instalments of a capital amount, is more likely to be adopted in Australia. If it happened today: If the facts of Foley v Fletcher arose in Australia today, Australian courts would most likely accept the taxpayer’s characterisation of the payments as instalments of a capital amount. The disposal of the interests in the asset would constitute a CGT event A1 which would trigger a capital gain or loss under s 104-10 ITAA 1997. The capital proceeds would include all expected payments (s 116-20(1)(a) ITAA 1997 1997). The practical effect of this would be that the vendor would be subject to tax at the time of the CGT event on the entirety of the proceeds to be received in the future.

Secretary of State in Council of India v Scoble [1903] AC 299 (UK House of Lords)

Facts: In 1899 the Secretary of State for India took up an option to purchase the Great Indian Peninsula Railway and its works. Under the contract which granted the option, the purchase price could be paid either as a gross sum or by way of an annuity payable over a 99 year term. The Secretary of State elected to pay the annuity. The Secretary of State then deducted income tax from the first two payments and the annuity trustees objected on the basis that tax should not be deducted from so much of each payment which represented capital. The issue before the House of Lords was therefore whether the payments were that of an annuity, which was fully taxable, or whether only part of each payment was income as interest, the balance being capital. Decision: Although the relevant documents did describe the transaction as an annuity, it was agreed that the court should look to the nature and substance of the transaction and not be restricted by the words of the contract. It was concluded that this was not the case of a purchased annuity and the payments were rather capital and interest. As the contract stipulated a sum certain being due (the purchase price) and an interest rate, the annual payments could be treated as payments on a blended payments loan and dissected into interest and capital, the interest component only then being subject to income tax. This can be contrasted with the position in Foley v Fletcher where no suitable basis for apportionment was found. Relevance of the case today: This case is relevant as an early example of a circumstance where a UK court was willing to look to the substance of an arrangement to determine its character for tax purposes. Although the instalments of purchase price had been characterised in the relevant documents as an annuity it was considered that the payments were only partly income and the contracts provided an interest rate which could be used to determine the income component. Generally, this look through approach has not been adopted in Australia where property is sold for a series of payments and the form of the transaction as an annuity is respected if the contract states that the consideration for the sale is the provision of an annuity. The case is thus

© Thomson Reuters 2019

131

AUSTRALIAN TAXATION LAW CASES 2019

unlikely to be an influential precedent in Australia where property is sold for a series of annuity payments. If it happened today: If the facts in Secretary of State in Council of India v Scoble were to arise today in Australia, it is likely that a court (and the Commissioner) would accept the taxpayer’s characterisation of the arrangement as an annuity. Under the UK law that applied in Secretary of State in Council of India v Scoble, it was the person making the payments who was responsible for withholding tax. Under Australian law it is the recipient of annuity payments who is responsible for any tax payable on the annuity payments. As the annuity payments were made to a corporation, the recipient taxpayer would be subject to Division 230 ITAA 1936. The accrual rules in Division 230 would treat the value of the property provided for the right to receive an annuity as the cost or “issue price” of the annuity and provide for recognition of the gain as if it were compounding interest on a blended payments loan. Separately, the taxpayer would recognise a CGT gain or loss at the time of disposal of the railway. The capital proceeds would be the sum of the annuity payments to be received (s 116-20(1)(a) ITAA 1997 1997) reduced by the sum of the part of the annuity payments that would be assessable when received under Division 230 (s 118-20(1A) ITAA 1997 1997).

Egerton-Warburton & Ors v DFCT (1934) 51 CLR 568 (Full High Court)

Facts: The taxpayers in this case were a father and his two sons. The father sold certain land on which he had carried on a farming business to his sons. The sons agreed to pay the father an annuity for his life, an annuity at a reduced level to his wife (their mother) should the father predecease her and a lump sum to their sisters on death of the surviving parent. The issue before the Court from the perspective of the father was whether the payments were capital proceeds from the disposal of his farm or income amounts as an annuity. If the receipts were characterised as an annuity, the question then addressed was whether any part of the receipt would be excluded from assessable income as part of the purchase price (such an exclusion would be by operation of former s 4(d) ITAA 1922, predecessor to the current s 27H ITAA 1936 1936). The sons also argued that they were entitled to a deduction for the annuity payments under the predecessor to s 8-1 ITAA 1997 (for a discussion of this aspect of the case refer to Ch 9). Decision: On the first question, the receipts were held to be income. The taxpayer had effectively converted a capital asset into an income stream. The distinction was made between a case where the purchase price of an asset is paid by instalments over time, in which case the instalments are capital (not income), and a case where the consideration was a promise to pay a series of amounts where the receipts were income. The distinction turned on whether the agreement involved an obligation to pay a fixed gross sum. Where the purchase price is fixed, the payments could then be considered instalments of that price. Under the facts, there was no agreed purchase price but instead a promise to pay a life annutity. 132

© Thomson Reuters 2019

CHAPTER 5

INCOME FROM PROPERTY AND INSTALMENT SALES OF PROPERTY

The High Court declined to allow the taxpayer to exclude part of each annuity payment from income under s 4(d) as the Court could not determine a definite price for the annuity. The Court held that with no fixed price expressed by the parties, no expectation of life fixed when the annuity was stipulated for, and no rate of interest adopted by the parties for its calculation, it would be impossible to determine the purchase price, as required by that provision. Relevance of the case today: This case is mainly referred to for the Court’s decision regarding the characterisation of the payments received by the father as annuity payments and the fact that no undeducted purchase price can be excluded from each annuity payment if the annuitant cannot show the value of property transferred in exchange for the right to annuity payments. If it happened today: If the facts in Egerton-Warburton were to arise today, the income stream payable to the father would continue to be considered income from an annuity. As the recipient of the annuity was an individual, the annuity would be subject to Division 16E ITAA 1936. The annuity would not be an ineligible annuity as defined in s 159GP(1) and the annuity and residual lump sum would therefore be subject to Division 16E which will apportion each payment into capital and interest on a compounding accruals basis. The High Court declined to allow the taxpayer in Egerton-Warburton to recover any part of the “purchase price” of the annuity because that amount was not specified by the parties in any evidence before the Court. A different result would likely follow with Division 16E. The issue price for the security is defined in s 159GP(1) as the consideration for the security, which would be the value of the land transferred. The capital gain realised by the father upon transfer of the land would be based on the present value of the expected annuity payments. However, under s 118-20 ITAA 1997, the gain will be reduced by the income component of the annuity payments and residual lump sum.

Just v FCT

(1949) 4 AITR 185; 8 ATD 419 (High Court)

Facts: The Just brothers agreed to sell certain land to Colonial Mutual Life in return for a “rent charge” payable monthly over 50 years. The “rent charge” was equal to 90% per annum of rents in respect of three shops and a basement. The issue before the Court was the proper characterisation of these receipts – were they wholly capital, wholly income or partly capital and partly income. Decision: The Court held that the receipts were wholly income. No purchase price was indicated in the sales documents. As a result, it was held that in substance the Just brothers bargained for income, not for a capital sum. Relevance of the case today: The Just case predated the adoption of capital gains tax in Australia. It illustrated that in some circumstances a capital asset could be transferred in return for an income stream. The relevance of the case may be diminished since the © Thomson Reuters 2019

133

AUSTRALIAN TAXATION LAW CASES 2019

inclusion of capital gains in the income tax base as the Commissioner today is most likely to assess the taxpayer using the capital gains provisions to tax the gain rather than seek to tax all the receipts with no recovery of the cost base for the taxpayer. If it happened today: At the time of the Just decision, Australia had no capital gains provisions. The only options open to the Commissioner (and the courts hearing appeals from assessments) were to characterise all the payments as non-taxable “capital” receipts or as fully taxable income amounts. The characterisation of the payments as income, as in the Just case, would lead to overtaxation since there was no provision for recovery of the cost of the asset that was sold for the payment stream. To achieve a fairer result, today the Commissioner would be most likely to assess using the capital gains provisions. For CGT purposes, the vendor will be treated as receiving at the time of disposal an amount equal to the total of the known future payments (s 116-20(1)(a) ITAA 1997 1997) and the market value of the right to other payments including uncertain and contingent such as those in this case (s 116-20(1)(b) ITAA 1997 1997). The cost base would be the cost of the property sold for the payments (s 110-25 ITAA 1997 1997). In 2010 the government indicated it would introduce legislative rules to deal with earn-out arrangements (disposals of property in return for future income streams). Since 2015, under the “look-through earnout payment” rules in s 116-120 ITAA 1997, consideration for the sale of a capital asset includes future payments when they are received if the payments are based on the use of the property by the new owner. However, the rules only apply where the sale agreement provides for earnout payments for five years or less. They would not, therefore, apply to payments in a contract for sale similar to that in Just.

Vestey v Inland Revenue Commissioners

[1962] Ch 861 (UK High Court of Justice Chancery Division)

Facts: The taxpayer sold a parcel of shares under an agreement which stipulated a purchase price of £5.5 million payable by instalments of £44,000 per annum for 125 years. In working out these figures, the purchaser’s accountant had determined that, based on an agreed value of £2 million and assuming an interest rate of 2%, the equivalent annual payment over 125 years should be £44,278 which was rounded down to £44,000. This information was not made available to the taxpayer but he accepted the terms as stipulated. The issue before the Court was the proper treatment of the annual receipts by the taxpayer. The taxpayer claimed the payments were merely instalments of a capital amount. Decision: The Court concluded that common sense demanded that in a case like this, where the purchase price was payable over time and each payment clearly contained an interest component, the arrangement should be treated as the equivalent of a sale combined with a blended payments loan so each payment should be apportioned into capital and interest components. That is, where the taxpayer would be treated as having sold the property for proceeds equal to the present value of the income stream and then to have lent the proceeds to the purchaser who pays back the loan principal and interest in equal instalments over the life of the arrangement. 134

© Thomson Reuters 2019

CHAPTER 5

INCOME FROM PROPERTY AND INSTALMENT SALES OF PROPERTY

Relevance of the case today: The Vestey decision illustrates the willingness of UK courts to look through the form of transactions involving financial arrangements to ascertain their underlying substance. Where the arrangement involves the sale of property in return for a stream of payments, a UK court can rely on general principles to recharacterise the payments as the equivalent of a blended payments loan and treat the notional interest component of each payment as income. The approach has not been adopted by Australian courts which are most likely to respect the form of the transaction if it is presented as instalment payments of a capital amount. In Australia, therefore, apportionment of payments into income and capital portions must be based on statutory apportionment rules. If it happened today: If these facts were to arise today in Australia, the taxpayer would likely realise a capital gain on the disposal of the shares. Since the payment stream is certain and not contingent, the entire amount of the payments will be taken into account when determining the proceeds of disposal under s 116-20(1)(a) ITAA 1997. If the court accepted the taxpayer’s assertion that all the payments were instalments of a capital amount, there would be no reduction of the capital gain under s 118-20 ITAA 1997 as no part of the future payments would be assessable as income. The taxpayer in this case was an individual and would therefore not be subject to Division 230 ITAA 1997. Division 16E ITAA 1936 will not apply to the payments. Division 16E is only a timing rule – it will not make an amount assessable as income if it would not have been assessable when otherwise recognised for tax purposes – see s 159GX ITAA 1936. If an Australian court were willing to accept the taxpayer’s assertion that all the payments were merely instalments of a capital amount, Division 16E would have no application. However, if the court were willing to look at the basis for calculating the payments and on that basis conclude the transaction was the equivalent of a blended payments loan by the vendor, Division 16E would apply.

Moneymen Pty Ltd v FCT

[1990] FCA 486; 21 ATR 1142; 91 ATC 4019 (Full Federal Court)

Facts: The taxpayer had a 20 year agreement to supply milk at a favourable price. The taxpayer subsequently ceased business and assigned the benefit of the contract for a stream of payments with the exact amount determined by reference to future milk prices. The taxpayer argued the payments were non-assessable capital receipts for the sale of an asset (the case pre-dated the adoption of capital gains taxation in Australia) while the Commissioner argued the taxpayer had sold its asset for a series of income payments. Decision: The Court held that the asset disposed of (the rights under the contract) was a structural asset of the taxpayer but it had been sold for an income stream. There was no fixed gross sum (no agreed purchase price) of which the payments could form instalments. In this way the case was similar to Egerton-Warburton v DFCT (1934) 51 CLR 568. It was also considered that the receipts could be characterised as income on the basis that they were a substitute for the income which Moneymen would have derived under the contract and the receipts therefore took on the character of income. © Thomson Reuters 2019

135

AUSTRALIAN TAXATION LAW CASES 2019

Relevance of the case today: While the Moneymen case did not reach the Full Federal Court until 1990, the facts and the assessment being applied predated the adoption of capital gains taxation in Australia in 1985. Although the case provides another, more recent, example of circumstances where a capital asset may be converted into or transferred for an income stream, it is more likely that today the Commissioner would assess the taxpayer under the CGT rules to allow the taxpayer to recognise a cost base for the asset sold. The taxpayer, too, would prefer a CGT assessment which might qualify for a CGT discount or a small business concession. If it happened today: If the facts in Moneymen were to take place today, it is likely the Commissioner would assess the gain under the CGT provisions. For CGT purposes, the vendor will be treated as receiving at the time of disposal an amount equal to the total of the future payments expected (s 116-20(1)(a) ITAA 1997 1997) plus the market value of property received (s 116-20(1)(b) ITAA 1997 1997). Since the amount of future payments is unknown and cannot be determined, s 116-20(1)(b) will be used and the market value of the right to payments will be used to determine the capital gain. Since 2015, under the “look-through earnout payment” rules in s 116-120 ITAA 1997, consideration for the sale of a capital asset includes future payments when they are received if the payments are based on the use of the property by the new owner. However, the rules only apply where the sale agreement provides for earnout payments for five years or less. They would not, therefore, apply to payments in a contract for sale similar to that in Moneymen.

Income from a Financial Arrangement – Annuity or Blended Payment Loan The two most common types of loans are interest-only loans and blended payment loans. Under an interest-only loan, the borrower pays interest on the loan principal and repays the principal at the end of the loan. Under a blended payment loan, the borrower makes a series of regular payments over the life of the loan with each payment containing interest on the outstanding principal and some of the principal so the principal has been completely repaid at the end of the loan. While the regular payments may be equal in amount, they vary in terms of substance. The initial payments are mostly interest while the last payments are mostly principal as most of the principal has been repaid by that point so the interest component on outstanding principal must be small. A fixed term annuity is similar to a blended payment loan – a financial institution provides a customer with a lump sum and the “borrower” or annuity provider makes a series of regular annuity payments that are partly the return of the lender’s principal and partly interest. Since 1987, fixed term commercial annuities have been treated in the same manner as blended payment loans (from 1987 until 2009 under Division 16E ITAA 1936 and for large taxpayers since 2009 under Division 230 ITAA 1997 1997). However, prior to 1987, a lender that characterised a loan as an annuity could recognise an equal return of principal component in each payment. This had the effect of deferring recognition of interest compared to an equivalent blended payments loan. The different treatment encouraged lenders to purchase annuities from borrowers rather than make blended 136

© Thomson Reuters 2019

CHAPTER 5

INCOME FROM PROPERTY AND INSTALMENT SALES OF PROPERTY

payment loans to the borrowers. When this happened, the Commissioner would seek to recharacterise the annuities as blended payment loans.

ANZ Savings Bank Ltd v FCT

(1993) 25 ATR 369; 93 ATC 4370 (Full Federal Court)

FCT v ANZ Savings Bank Ltd

(1998) 194 CLR 328; 39 ATR 19; 98 ATC 4850 (Full High Court)

Facts: The taxpayer entered into an arrangement whereby, through a partnership, it borrowed significant funds from a finance company which were repayable as a blended loan, that is, the proportion of the loan repayments in the early stage of the arrangement were primarily interest while the proportion of interest to principal repayments shifted over the course of the loan. The partnership applied these borrowed funds and some of its own funds to subscribe for units in a unit trust which provided finance to a government authority through an arrangement labelled as “annuities” issued by the authority. The effectiveness of the arrangement relied on the deductibility of the interest component of the loan repayments which would more than offset the assessable component of the annuity, once it had been reduced by the operation of s 27H ITAA 1936. The arrangement would therefore generate overall losses in the early years. The first issue considered by the Full Federal Court was whether the funds were provided to the authority by way of an “annuity”, as the arrangement was described in the contract documents, or whether the arrangement was in substance a blended payment loan. In the former case, s 27H would apply and the unit trust would recognise its gain over the life of the contract. In the latter case, the unit trust would recognise its gain as interest under Division 16E ITAA 1936, with most of the recognition in the earlier payments. The trial court concluded it could look behind the legal form of the arrangement as an annuity and treat it as in substance a blended payment loan for tax purposes. The issue considered by the High Court was whether the amount of the annuity subject to the s 27H exclusion was exempt income which retained its character as it flowed through the unit trust. This issue was relevant to determine if the taxpayer could deduct the interest expenses it incurred on borrowings to purchase the annuity. Decision: The Full Federal Court concluded that the contracts did create annuities rather than loans and that s 27H was a code for annuities. Division 16E therefore had no application. The High Court held that the amount excluded from income by virtue of s 27H was exempt income which did retain its character in the hands of the taxpayer and therefore a portion of the interest expenses incurred under the loan agreement was not deductible. Relevance of the case today: The decision in this case by the Full Federal Court led to legislative amendment which had the effect of limiting the application of s 27H to annuities issued by life assurance companies to natural persons. This was achieved by excluding “qualifying annuities” from the operation of s 27H (see s 27H(4)). Qualifying annuities are defined in s 159GP(10) of Division 16E as all annuities other © Thomson Reuters 2019

137

AUSTRALIAN TAXATION LAW CASES 2019

than “ineligible annuities”. These are, as noted, annuities issued by life assurance companies to natural persons. Currently, there is legislation before Senate to extend this definition to include annuities issued by life assurance companies to complying superannuation funds to underwrite the liabilities it has to its members. Since 2009, annuities of this sort fall under the definition of a “financial arrangement” in Division 230 ITAA 1997. The decision of the Full Federal Court in ANZ Savings Bank is thus of limited relevance in terms of the characterisation of similar arrangements as either annuities or blended payments loans. Both are now subject to the same tax rules in Division 230. If it happened today: If this transaction occurred today, the form of the arrangement with the government authority as an “annuity” would be accepted by a court but the unit trust’s gain would be determined under Division 230. As a result, the assessable amount of each receipt would be calculated as if the interest component accrued on a compounding accruals basis, rather than the straight line basis which applied under s 27H. This change in the timing of the assessable amounts would undermine the tax effectiveness of the arrangements.

138

© Thomson Reuters 2019

C HAPTER 6

Capital Gains ORIGINAL PART IIIA CGT RULES ................................................................. 141 Hepples (1991) ....................................................................................... 141 CORE PROVISIONS ........................................................................................... 142 Assets ........................................................................................................... 142 O’Brien v Benson’s Hosiery (Holdings) Ltd (1980) ............................. 142 Cost of Assets .............................................................................................. 143 Granby (1995)........................................................................................ 143 Time of Acquisition ..................................................................................... 144 Elmslie (1993) ........................................................................................ 144 McDonald (1998) ................................................................................... 145 Time of Disposal.......................................................................................... 146 Sara Lee Household & Body Care (Australia) Pty Ltd (2000) ............... 146 Granting of a Lease...................................................................................... 147 Gray (1989)............................................................................................ 147 Deposit Forfeiture ........................................................................................ 148 Brooks (2000) ......................................................................................... 148 CONCESSIONS .................................................................................................... 149 Murry (1998).......................................................................................... 149

© Thomson Reuters 2019

139

C HAPTER 6

Capital Gains From 1915 until 1985, the legislature chipped away at the income-capital borderline with a wide range of piecemeal and ad hoc inclusion measures. In 1974 it had produced draft capital gains tax legislation to adopt a comprehensive capital gains tax but the plan became sidelined following a change of government. It was revived a decade later and in 1985 the CGT provisions were enacted as Part IIIA ITAA 1936. (The amending provisions were actually enacted in 1986 but applied from the date from which the government announced the tax would apply, 19 September 1985.) The CGT was structured on recognition of capital gains and losses from the disposal of an asset. However, over the previous seven decades Australian courts had identified a wide range of “capital” receipts that did not involve the disposal of assets – payments for negative covenants, payments for alteration of rights, and so forth. The drafters of Part IIIA attempted to deal with these receipts through a series of complex and (in the eyes of many) difficult to understand deeming provisions that deemed taxpayers to have acquired and then disposed of assets when they received other types of capital amounts. The most artificial of those deeming rules were amended in 1992 following the decision of the High Court in Hepples v FCT. In 1998, Part IIIA was replaced with CGT provisions in Parts 3-1 to 3-3 ITAA 1997. The drafters of the 1997 version tried to remove the artificial deeming rules in Part IIIA by setting out a series of “CGT events” that would trigger recognition of a capital gain or capital loss. Although all the Part IIIA provisions were reworded, most of the key rules dealing with the time of acquisition and disposal and the elements of cost base and capital proceeds function in essentially the same manner as the predecessor sections. The CGT rules are comprehensive – the combined effect of all 54 CGT events includes a wide range of gains that would also constitute ordinary income or be assessable under another statutory income provision. The overlap is reduced by some exclusion rules set out in Division 104 ITAA 1997 and by a number of exemptions in Division 118 ITAA 1997. The main reconciliation provision, however, is s 118-20 ITAA 1997, which reduces a capital gain by the extent to which as the result of a CGT event an amount is included in assessable income as ordinary income or as statutory income under an inclusion provision outside the CGT rules.

140

© Thomson Reuters 2019

CHAPTER 6

CAPITAL GAINS

ORIGINAL PART IIIA CGT RULES Unlike the current capital gains provisions in the ITAA 1997, which apply to CGT “events”, the original capital gains provisions in Part IIIA ITAA 1936 Act only applied to gains and losses on the disposal of assets. Two complex deeming provisions, s 160M(6) and s 160M(7) were used to treat taxpayers as if they had disposed of assets for a gain when they received payments in situations where there was no disposal of an asset such as entering into a restraint of trade agreement which creates an asset in the hands of the person making the payment (the right to sue the taxpayer if he or she breaches the agreement). Section 160M(6) applied to the situation where an asset was created and s 160M(7) applied where an act took place in relation to an asset.

Hepples v FCT

(1991) 173 CLR 492; 22 ATR 465; 91 ATC 4808 (Full High Court) Final orders (1992) 173 CLR 492; 22 ATR 852; 92 ATC 4013

Facts: The taxpayer received a payment from his employer as consideration for the taxpayer entering into a restraint of trade agreement (an agreement by the taxpayer not to work for any competitor for a period after his retirement). The Commissioner assessed the taxpayer on the payment on the basis of s 160M(6) and s 160M(7) ITAA 1936 and the taxpayer appealed. Decision: In a complicated set of judgments, 4 of the 7 judges decided s 160M(6) did not apply and 4 of the 7 judges found s 160M(7) did not apply to the payment received by the taxpayer. While a majority of judges found that at least one of the two sections did apply so that the payment might be seen to have been subject to tax, in final orders the Court confirmed that the assessment based on each provision should be considered separately and as there was no majority supporting an assessment for any one provision (even if a majority agreed it should be assessable) as a result the taxpayer’s appeal was allowed and the payment held not taxable. Relevance of the case today: Given the many judgments in the Court on the different issues in Hepples, the relevance of the decision was always ambiguous. Following the decision, in 1992 both s 160M(6) and s 160M(7) were amended to clarify their intended effect. The 1992 amendments also made it clear that CGT assets included legal or equitable rights that are not a form of property, addressing some observations in Hepples that suggested the pre-1992 definition might not include these rights. Then, in 1998 the entire CGT rules were replaced with a dramatically different regime in the ITAA 1997. While individual judgments from the Hepples decision are sometimes cited in respect of a particular point, particularly the conclusion that confidential information is a CGT asset (a position rejected by the Commissioner), the continuing relevance of the case as a precedent is limited. Its most significant legacy is a lesson for the legislative drafters to avoid complex and highly artificial deeming rules. If it happened today: If the facts in Hepples arose today, the taxpayer would be assessed under CGT Event D1, s 104-35 ITAA 1997. The ITAA 1997 construction was designed specifically with the lesson of Hepples in mind and it is probable that an © Thomson Reuters 2019

141

AUSTRALIAN TAXATION LAW CASES 2019

assessment based on s 104-35 would be successfully upheld by the High Court in a fact situation similar to that in Hepples.

CORE PROVISIONS Assets O’Brien (Inspector of Taxes) v Benson’s Hosiery (Holdings) Ltd [1980] AC 562; [1979] 3 All ER 652; 53 TC 241 (UK House of Lords)

Facts: The taxpayer was the holding company for a group of companies which carried on business selling hosiery. The taxpayer and an employee, Mr Behar, had entered an agreement whereby Behar would serve as the sales and merchandise director for the group for a period of seven years for an annual salary. Prior to the expiry of the agreement, Behar paid a lump sum to the taxpayer as consideration for being released from the employment contract. The Revenue argued that the lump sum was a capital gain accruing to the taxpayer on disposal of an asset. The primary issue before the House of Lords was whether the rights of the taxpayer under the personal services contract were an “asset” for the purposes of the relevant legislation. Decision: The House of Lords unanimously held that the rights of the employer under the contract were an asset and the agreement to release Behar from the contract was a disposal of that asset. Under the UK Finance Act 1965, the term “asset” was defined as “all forms of property” including “incorporeal property” and there was a disposal of an asset where a “capital sum [is] received in return for the forfeiture or surrender of rights, or for refraining from exercising rights…”. The taxpayer had argued that the rights of the employer could not be “property” or an “asset” because they could not be turned to account by transfer or assignment to another. However, the House of Lords considered that such a restricted meaning was not permitted by the statutory language. Where, as in this case, an employer can obtain a substantial sum for releasing an employee from his service obligations, those rights bear the mark of an asset, something that can be turned to account, notwithstanding that the type of disposal was limited to release, rather than transfer. Relevance of the case today: The discussion of the nature of an asset as property was of greater significance in Australia prior to 1992, when the definition of “asset” for CGT purposes broadly mirrored the UK definition discussed in the case. The 1992 amendments to the Australian definition, following the Final Orders in Hepples v FCT (1992) 173 CLR 492; 22 ATR 852; 92 ATC 4013, broadened the meaning of “asset” to include rights whether or not a form of property. This expanded version of the definition of asset now appears as s 108-5 ITAA 1997. If it happened today: If the facts of this case were to occur today in Australia, the rights of the employer under the employment contract would be an asset for CGT purposes and the release of those rights as against the employee would be considered a CGT event C2 (s 104-25 ITAA 1997 1997). 142

© Thomson Reuters 2019

CHAPTER 6

CAPITAL GAINS

Cost of Assets Granby Pty Ltd v FCT

(1995) 30 ATR 400; 95 ATC 4240 (Federal Court)

Facts: The taxpayer was in the contract drilling business and used equipment acquired on finance leases in its operations. At the expiry of a finance lease, the taxpayer would often purchase the leased equipment in use for the residual value set out in the finance lease agreement. Finance leases commonly provide for a token residual purchase price far below the actual market value of the lease property at that time in recognition of the fact that in a commercial sense (though not strict legal terms), a finance lease is really a means of the “lessor” providing the “lessee” with a loan to purchase the property over time. The taxpayer subsequently sold the leased property for more than its purchase price. The taxpayer argued that it was not dealing at arm’s length with the lessors and therefore s 160ZH(9)(c) ITAA 1936 (currently s 112-20 ITAA 1997 1997) applied to deem the taxpayer to have paid consideration equal to the market value of the asset at the time of acquisition rather than the much lower residual values set out in the leases. Decision: The taxpayers were operating at arm’s length from the equipment lessors from which they acquired the equipment. The fact that one element of the finance lease contract provided for the sale of property for a nominated figure that was less than the market value of the property at the time of sale did not indicate the parties were not operating at arm’s length. The parties have clearly entered into an arm’s length arrangement if the contract is regarded in its entirety. Relevance of the case today: The Granby case shows that lessors and lessees who are parties to finance leases are considered to operate at arm’s length from one another and s 112-20 will not apply to the sale of leased property for residual value at the end of the lease. Importantly, the case may also be cited for a wider principle – when businesses operating at arm’s length enter into a transaction that involves the sale of an asset for less than market value, the sale price will be treated as an arm’s length price for tax purposes. It is assumed that in the arm’s length negotiations between the parties, the agreement in its entirety is at arm’s length and the designation of a sale price different from market value for one element of the contract was agreed to because the overall contract had other offsetting elements. If it happened today: If the taxpayer continued to use the property for a period after acquisition and prior to its sale, it would likely depreciate the property and the property would be treated as “depreciating assets” for the purposes of Division 40 ITAA 1997. There is no equivalent of s 112-20 for depreciation purposes and there would be no debate over the cost of the property which would be the residual value paid by the taxpayer. The sale of an item would be a balancing adjustment event and the difference between the termination value (the proceeds) and the adjustable value (written down depreciated value) would be included in income under s 40-285 ITAA 1997, with no distinction made between recapture of excess depreciation to cost and the profits in excess of cost. © Thomson Reuters 2019

143

AUSTRALIAN TAXATION LAW CASES 2019

If the taxpayer did not use the property but purchased it to resell, the question arises whether the transaction is on revenue account, generating ordinary income, or is outside the ordinary scope of the taxpayer’s business, in which case only the CGT provisions will apply. If the taxpayer regularly conducts these transactions, it might be argued that the transaction is ancillary to its ordinary activities. As there is no general arm’s length rule equivalent to s 112-20 for revenue assets, there would be no debate over the cost of the property which would be the residual value paid by the taxpayer. However, the taxpayer might argue that the sale of formerly leased equipment is neither part of its core business nor ancillary to the business of contract drilling and the transaction should be treated as one on capital account on the basis of FCT v Hyteco Hiring Pty Ltd (1992) 24 ATR 218; 92 ATC 4694. In this case, the taxpayer’s cost would be the residual value on the basis of the authority in Granby.

Time of Acquisition Elmslie & Ors v FCT

(1993) 26 ATR 611; 93 ATC 4964 (Federal Court)

Facts: The taxpayers were four partners who owned a stockbroking firm. They wished to sell their business to a foreign merchant bank. The foreign merchant bank required permission by the Australian government’s Foreign Investment Review Board (FIRB) to obtain a majority interest in the company. The parties signed a document entitled “Heads of Agreement” in June 1985 which set out the terms of the proposed sale. In November 1985 the taxpayer and his partners transferred their business to a new company and each took back shares with a face value of $75,000 (ie, $300,000 in total). The foreign bank subscribed for a further $300,000 of shares, leaving it with a 50% ownership in the company. Following changes in the foreign ownership rules, in July and August 1987 the taxpayer and his former partners sold their shares to the foreign bank. The Commissioner assessed the taxpayer and the others on the capital gain resulting from the sale. Section 160L ITAA 1936 excluded from the application of the CGT provisions gains on the disposal of assets that were acquired prior to 20 September 1985 (currently s 104-10(5) ITAA 1997 1997). Section 160U(3) ITAA 1936 deemed the time of acquisition of an asset to be the time at which the taxpayer entered into the contract of acquisition (currently s 109-5(2) ITAA 1997 1997). The taxpayers argued they had acquired their shares in June 1985 when they signed the Heads of Agreement which provided for the allocation of shares to the taxpayers and the merchant bank. The Commissioner argued the acquisition occurred in November 1985, when the company allocated shares to the taxpayers. To calculate the capital gain, the Commissioner used the face value of the shares allocated to each taxpayer. The taxpayers argued that if the shares were subject to CGT, the Commissioner used the wrong cost base to calculate the capital gain. They argued they were not dealing at arm’s length with the company and accordingly s 160ZH(9) ITAA 1936 (currently s 112-20 ITAA 1997 1997) should apply to the allotment and the value of the shares should have been their market value based on the value of the underlying assets, not the notional face value. 144

© Thomson Reuters 2019

CHAPTER 6

CAPITAL GAINS

Decision: The Heads of Agreement was an agreement that the company would enter into an allotment contract but it was not the actual allotment contract. Section 160U(3) applies to the contract under which shares are actually allotted, not a contract to enter into that later contract. The shares were therefore not acquired prior to 20 September 1985. Shareholders who are directors of a company do not operate at arm’s length with the company and s 160ZH(9) does apply. The cost of shares acquired by allotment by the company is the market value of the shares, not the notional face value if the shares have a notional par value. Relevance of the case today: Elmslie stands for a number of propositions. First, it may be cited as authority for the application of the market value rule in s 112-20 when a company allots shares to shareholder directors. Second, it is authority for the proposition that s 109-5(2) applies to the actual acquisition contract and not to a preliminary contract that obligates a person to enter into an acquisition contract. If it happened today: If the facts in Elmslie arose today, the taxpayers would be treated as acquiring the shares when the allocation contract was completed, not when an earlier agreement to cause a company to issue shares was signed. However, since the shares would clearly be CGT assets (acquired after 19 September 1985) if they were acquired today and since the cost base of CGT assets is no longer subject to indexation, the time of acquisition is not as important an issue today as it was in this case. The cost of those shares would be their market value at the time of acquisition.

McDonald v FCT

(1998) 38 ATR 563; 98 ATC 4306 (Federal Court)

Facts: Prior to 20 September 1985, the taxpayers entered into an oral agreement to acquire land. A formal exchange of contracts took place on 31 October 1985. The oral contract for the sale of land was not enforceable as a result of s 54A of the Conveyancing Act 1919 (NSW). Section 160L ITAA 1936 excluded from the application of the CGT provisions gains on the disposal of assets that were acquired prior to 20 September 1985 (currently s 104-10(5) ITAA 1997 1997). Section 160U(3) ITAA 1936 deemed the time of acquisition of an asset to be the time at which the taxpayer entered into the contract of acquisition (currently s 109-5(2) ITAA 1997 1997). The Commissioner argued s 160U(3) applied to actual enforceable contracts only and would not apply to an unenforceable oral contract. Decision: The Court found there was no reason to limit s 160U(3) to an enforceable contract. While the oral contract may not be enforceable as a matter of law, parties could treat it as valid and carry out the contract. Section 160U(3) can apply equally to an unenforceable and an enforceable contract. Relevance of the case today: McDonald can be cited as authority for the proposition that s 109-5(2) can treat the time of acquisition of an asset as the time that a contract for the acquisition was entered into even if it is not an enforceable contract. The case may also be cited when necessary as a way of distinguishing the restriction on preliminary © Thomson Reuters 2019

145

AUSTRALIAN TAXATION LAW CASES 2019

contracts set out in Elmslie & Ors v FCT (1993) 26 ATR 611; 93 ATC 4964. The Elmslie

case held that s 160U(3) did not apply to a preliminary contract that was not the actual contract for acquisition of an asset. McDonald shows that this rule does not apply to

an initial contract for acquisition of an asset where the initial contract is perfected through another written contract. Both the initial contract and the later one were for the acquisition of the asset. This is different from the situation in Elmslie where the initial contract required the taxpayer to make another person (a company) enter into a sale contract in the future. If it happened today: If the facts in McDonald were to arise today, the time of acquisition would be the time of the initial unenforceable oral contract. Because property acquired today would not qualify for the pre-20 September 1985 CGT exemption or for the pre-21 September 1999 cost base indexation concession, determining the exact time of acquisition is no longer as important as was previously the case.

Time of Disposal FCT v Sara Lee Household & Body Care (Australia) Pty Ltd (2000) 201 CLR 520; 44 ATR 370; 2000 ATC 4378 (Full High Court)

Facts: The taxpayer was a subsidiary of Sara Lee Corporation, a US company, which directly and through subsidiaries carried on the business of manufacturing, marketing and distributing pharmaceutical and health care products in a number of countries including Australia. On 31 May 1991, the taxpayer entered into an agreement to sell its business to Roche Holding Limited. A director of the taxpayer signed the agreement. His action was only binding on the taxpayer when it was ratified by the board on 20 August 1991. On 30 August 1991 the purchaser transferred its rights and obligations under the agreement to a subsidiary, Nicholas Products Pty Ltd, a company that had not been in existence when the original contract was signed. A number of amendments to the original agreement, including a US $1 million increase in the price allocated to the Australian assets, were also made on 30 August 1991. Completion of the sale took place on 30 August 1991. The CGT provisions were applied to the transaction and, as the disposal was under a contract, s 160U ITAA 1936 dictated that the disposal occurred on the date of the contract (this timing rule is incorporated throughout the CGT provisions of the ITAA 1997; see for example s 104-10(3)). The issue before the High Court was whether the relevant date of the contract (and hence disposal) was the date of the original contract, 31 May 1991, as argued by the Commissioner, or the date of the substantially amended contract, 30 August 1991, as argued by the taxpayer. The question turned on when amendments to a contract give rise to a new contract for CGT purposes. Decision: The relevant contract was the purchase and sale agreement entered into on 31 May 1991. Section 160U provided that, where an asset was acquired or disposed of under a contract, the time of acquisition or disposal shall be taken to have been the time of the making of the contract. Where there are two or more contracts which affect the rights and obligations of the parties to the disposal, the phrase “under the contract” means the relevant contract or version of the contract is the one identified as the source 146

© Thomson Reuters 2019

CHAPTER 6

CAPITAL GAINS

of the obligation to dispose of the asset. Although the revised agreement varied some of the terms and conditions of the sale, the obligation to dispose of the asset established by the 31 May agreement did not change. Relevance of the case today: This case establishes the proposition that for CGT purposes, in determining the date of disposal of an asset under a contract, the relevant contract is the one which gives rise to the obligation to sell or transfer the asset. This rule applies equally to the CGT provisions in their re-written form in ITAA 1997. This time of disposal rule is incorporated into each CGT event and the relevant time of acquisition rule can now be found in s 109-5 ITAA 1997. If it happened today: If the exact facts of Sara Lee arose today, the sale of the business and assets would constitute a CGT event A1 and the time of the event would be the date of the making of the original contract, as this is the source of the obligation to dispose of the assets. If the taxpayer wished to shift the time of disposal to the later year (and thus defer its obligation to pay tax on the capital gain for a year), rather than agree to amendments of the original contract, it would request the purchaser to agree to discharge the initial contract completely and immediately enter into a second contract. The discharge of the original contract could trigger a CGT event C2 under s 104-25 ITAA 1997 (which applies to the end of an asset by way of release or discharge). However, provided there was a nominal payment for the discharge, s 116-30 ITAA 1997 would not apply to deem a higher consideration and there would be little or no tax consequence from the discharge. It is possible that the Commissioner could use Part IVA ITAA 1936 to attack the discharge and new contract as a tax avoidance scheme if he could show the discharge and replacement contract had no purpose other than to gain a tax benefit. Presumably the parties would find a good commercial reason for following this course of action rather than simply ratifying the original contract.

Granting of a Lease Gray & Anor v FCT

(1989) 20 ATR 649; 89 ATC 4640 (Full Federal Court)

Facts: The taxpayers, Mr and Mrs Gray, had for many years owned a property on which a service station was located. In March 1986, after the announcement of the introduction of a CGT regime but before the legislation came into force, the taxpayers leased the property to a petrol company and in consideration received a premium of $200,000. The Commissioner considered that the taxpayers had realised a capital gain on the granting of the lease by virtue of the combined application of former ss 160ZS and 160M ITAA 1936 since the granting of the lease was the creation of a new asset as well as its disposal (the relevant current provision, s 104-110 ITAA 1997, provides for a CGT event F1 on the grant of a lease – the effect of this provision is the same as the former ITAA 1936 provisions). The taxpayers argued that, based on the Treasurer’s statement in announcing the CGT that it would in every sense by prospective, the granting of a lease should be viewed as the part disposal of the land which was acquired prior to 20 September 1985 and therefore the CGT provisions should not apply to the transaction. © Thomson Reuters 2019

147

AUSTRALIAN TAXATION LAW CASES 2019

Decision: The legislation specifically provides that the grant of a lease shall not be considered as the part disposal of the property and therefore rejects the approach argued for by the taxpayers. The CGT provisions deal with the receipt of a lease premium as a capital sum received on the exploitation of the property but not its disposal. The language of the statute is clear and unambiguous and the consequence of giving the words their ordinary meaning does not lead to a manifestly absurd or unreasonable result. Therefore, the extraneous materials need not be referred to in interpreting the provisions, applying s 15AB Acts Interpretation Act 1901 (Cth). Relevance of the case today: The decision in this case confirms the approach taken in the CGT provisions that the creation of an interest in land will most often be treated as the creation of a new asset rather than a part disposal of the underlying land. As a result, the acquisition date of the lease is when it is created and does not pick up the acquisition date of the land. In addition, no part of the cost base of the land is attributed to the lease, except in the case of a long term lease and even then, only by election (see s 104-115 ITAA 1997 1997). If it happened today: If this transaction were to occur today, a CGT event F1 (s 104-110 ITAA 1997 1997) would happen where the taxpayers grant a lease. The time of the event is when the lease contract is entered into by the parties. The taxpayers would make a capital gain equal to the capital proceeds, which in this case is the $200,000 premium (see the table at s 116-20(2) ITAA 1997 1997), reduced by any non-deductible expenditure incurred on the grant. Although the taxpayers in this case are individuals, the CGT discount is not available for gains realised from a CGT event F1 (see s 115-25(3)(e) ITAA 1997 1997).

Deposit Forfeiture Brooks & Anor v FCT

(2000) 44 ATR 352; 2000 ATC 4362 (Full Federal Court)

Facts: The taxpayer was the co-owner of real property. The owners entered into a contract for the sale of the property and when the purchaser failed to complete the transaction, the owners terminated the contract for breach and forfeited the deposit that had been paid by the purchaser. The Commissioner assessed the taxpayer on its share of the forfeited deposit on the basis of one of three provisions: • s 160M(6) ITAA 1936, which treated the creation of an asset owned by another person including a right that can be exercised by the other person as a disposal, the trigger in the ITAA 1936 for a CGT event (currently s 104-35 ITAA 1997 1997), • s 160M(7) ITAA 1936, which treated the receipt paid to the owner of an asset in consequence of an act that affected the asset or which took place in relation to the asset as a disposal (currently s 104-155 ITAA 1997 1997), and • s 160ZZC(12) ITAA 1936, which treated the forfeiture of a deposit as a disposal by the person retaining the deposit (currently CGT event H1, s 104-150 ITAA 1997 1997). The taxpayer argued s 160M(6) and s 160M(7) had no application as a result of s 160MA, which prevents these sections from applying where the creation of a right requires a person to do something and doing the thing will be a separate disposal 148

© Thomson Reuters 2019

CHAPTER 6

CAPITAL GAINS

(currently s 104-35(5) and s 104-155(5) ITAA 1997 1997). It argued that s 160ZZC(12), which referred to a deposit made in respect of a “prospective” purchase, only applied where the parties to a sale had not entered into a contract of purchase on the basis of an earlier decision, FCT v Guy (1996) 32 ATR 590; 96 ATC 4520. Decision: Section 160MA does not preclude the application of s 160M(6) or s 160M(7) to a forfeited deposited. Section 160M(7) operates subject to s 160M(6) so s 160M(6) would take precedence. However, that section operates subject to other provisions including s 160ZZC(12). Section 160ZZC(12) does apply to the transaction. The Court declined to follow the precedent of Guy, which had been decided by a differently constituted Full Federal Court. This Full Federal Court indicated that while a Court should be reluctant to depart from prior authority, the decision in Guy should not be followed – s 160ZZC(12) should not be read as applying only where there was no contract for purchase. Relevance of the case today: Section 104-150 refers to a deposit that is forfeited because a “prospective” sale does not proceed. If the reasoning of Guy were followed, this section would not apply whenever a contract for purchase has been completed. However, it is generally agreed that the reasoning in Brooks more correctly reflects the intention of the legislature than does the reasoning in Guy. The approach taken by Brooks when interpreting the forfeited deposit provision in the ITAA 1936 would be applied to interpret the new provision in the ITAA 1997. If it happened today: If the facts of Brooks were to take place today, s 104-150 would apply to the taxpayer and the forfeited deposit would be treated as a capital gain of the taxpayer recognised under CGT event H1.

CONCESSIONS FCT v Murry

(1998) 193 CLR 605; 39 ATR 129; 98 ATC 4585 (Full High Court)

Facts: The taxpayer carried on a taxi business in partnership with her husband. In 1987, the partners acquired a second taxi licence and shares in a co-operative. The partnership leased the second licence to a third party, Mr Gower, who owned the vehicle which had the benefit of the second licence. In 1992, the partners sold the second licence and shares to Mr and Mrs Wilkins and, at the same time, Mr Gower sold Mr and Mrs Wilkins the vehicle. The taxpayer realised a gain with respect to the licence. The taxpayer claimed that this gain was with respect to the goodwill attaching to the licence and claimed the 50% exemption under the former s 160ZZR ITAA 1936 (currently incorporated into the small business relief provisions of Division 152 ITAA 1997). The Commissioner argued that the payment related to the disposal of the licence 1997 and not the disposal of goodwill and therefore the reduction was not available. Decision: There was a disposal of the licence and the shares but there was no disposal of goodwill. Therefore, the exemption found at s 160ZZR was not available. A taxi licence is a valuable item of property but it is merely a prerequisite to carrying on a © Thomson Reuters 2019

149

AUSTRALIAN TAXATION LAW CASES 2019

taxi business. The licence neither inherently nor when used constitutes or contains goodwill. The value of the goodwill of a taxi business is likely to be small as the services provided are virtually indistinguishable from services of others in the market and most of the custom of a taxi business is new custom. Relevance of the case today: The decision in Murry is significant for its detailed discussion of the nature of goodwill generally, rather than for its specific holding. Goodwill is described as the attractive force which brings in custom. Goodwill may have three different aspects – property, sources and value – but it is the conduct of the business that unites these aspects. Goodwill is property as it is the legal right to conduct the business in substantially the same manner and by substantially the same means that have attracted custom to it. Goodwill is a quality derived from using or applying other assets of the business in a particular way and these assets may be described as sources of goodwill, although many of the sources of goodwill are not property. In addition, as goodwill is not severable from the business to which it relates, the sale of an asset of a business does not involve a sale of goodwill unless the sale of the asset carries with it the right to conduct the business. In other words, when an asset of a business is sold and the business is not, the sale may reduce the value of the goodwill of the business but it does not involve a disposition of the goodwill. If it happened today: Taxpayers carrying on a small business may now access various CGT exemptions and concessions by virtue of Division 152 ITAA 1997. These concessions may apply to the gain realised on the disposal of goodwill since goodwill is considered an active asset as defined in s 152-40 ITAA 1997. However, under the facts of Murry the transaction did not involve the disposal of goodwill but rather the disposal of the licence. A taxi licence may also qualify as an active asset under s 152-40 such that, subject to the other requirements for the concessions being met, a 50% reduction in the capital gain may be available under s 152-205 ITAA 1997. The exemption found at s 152-105 ITAA 1997 would not be available as the asset (the licence) was not held for 15 years.

150

© Thomson Reuters 2019

C HAPTER 7

General Deductions THE APPORTIONMENT FORMULA ............................................................... 154 Ronpibon Tin NL (1949) ........................................................................ 154 CONNECTION WITH INCOME DERIVATION ............................................. 155 Expenses Incurred to Reduce Future Expenses ........................................... 155 W Nevill & Co Ltd (1937) ...................................................................... 155 Connection in Time – Expenses Related to Future Income......................... 156 Softwood Pulp and Paper Ltd (1976) .................................................... 156 Steele (1999) .......................................................................................... 157 Connection in Time – Expenses Related to Obtaining Employment .......... 157 Maddalena (1971).................................................................................. 157 Spriggs; Riddell (2009) ........................................................................... 158 Connection in Time – Expenses Related to Previous Business ................... 159 Amalgamated Zinc (de Bavay’s) Ltd (1935) .......................................... 159 AGC (Advances) Ltd (1975)................................................................... 159 EA Marr and Sons (Sales) Ltd (1984).................................................... 160 Placer Pacific Management Pty Ltd (1995) .......................................... 162 Brown (1999) ......................................................................................... 162 Jones (2002) ........................................................................................... 163 Connection to Anticipated Indirect Derivation of Income .......................... 164 Total Holdings (Aust) Pty Ltd (1979) ..................................................... 164 Spassked Pty Ltd (2003) ........................................................................ 165 Need for Current Liability ........................................................................... 166 Foxwood (Tolga) Pty Ltd (1981) ............................................................ 166 Life and Disability Insurance Premiums ..................................................... 168 Wells (1971) ........................................................................................... 168 DP Smith (1981) .................................................................................... 168 Theft Losses and Misappropriations............................................................ 169 Charles Moore & Co (WA) Pty Ltd (1956) ............................................. 169 Lean (2010) ............................................................................................. 170 QUASI-PERSONAL EXPENSES ....................................................................... Damages for Negligence ............................................................................. Strong & Co Ltd v Woodifield (1905) .................................................... Herald & Weekly Times (1932) ..............................................................

170 171 171 172

© Thomson Reuters 2019

151

AUSTRALIAN TAXATION LAW CASES 2019

Fines for Illegal Activities .......................................................................... 173 Madad Pty Ltd (1984) ............................................................................ 173 Legal Expenses for Alleged and Actual Illegal Activities ........................... 174 Snowden & Willson Pty Ltd (1958)........................................................ 174 Magna Alloys & Research Pty Ltd (1980) ............................................. 174 Day (2008) ............................................................................................. 176 Expenses Incurred by Illegal Businesses ...................................................... 177 La Rosa (2003)....................................................................................... 177 Repaying Clients’ Losses from a Partner’s Defalcations ............................ 178 Ash (1938) .............................................................................................. 178 Sweetman (1996).................................................................................... 178 BUSINESS INDICIA vs HOBBY OR PERSONAL EXPENSES .................... Thomas (1972) ....................................................................................... Ferguson (1979) ..................................................................................... Walker (1985) .........................................................................................

179 180 180 181

AVOIDANCE-TAINTED DEDUCTIONS ......................................................... 182 Income-Splitting Service Trust .................................................................... 183 Phillips (1978) ........................................................................................ 183 Transfer Pricing ........................................................................................... 184 Europa Oil (NZ) Ltd (No 1) (1971) ........................................................ 185 Europa Oil (NZ) Ltd (No 2) (1976) ........................................................ 186 Purchase Price Paid as Revenue Outgoing .................................................. 187 South Australian Battery Makers (1978) ............................................... 187 Income-Splitting Family Loan..................................................................... 188 Ure (1981) .............................................................................................. 188 Prepayments ................................................................................................ 189 Ilbery (1981) .......................................................................................... 189 Sale and Leaseback...................................................................................... 190 Just Jeans (1987) .................................................................................. 190 Eastern Nitrogen Ltd (2001) .................................................................. 191 Timing Mismatches ..................................................................................... 192 Fletcher (1991) ...................................................................................... 192 Capital Protected Loans ............................................................................... 193 Firth (2002) ........................................................................................... 193

152

© Thomson Reuters 2019

C HAPTER 7

General Deductions Income tax is imposed on taxable income which is defined in s 4-15 ITAA 1997 as assessable income less deductions. It is important that taxpayers be able to recognise all expenses incurred in deriving assessable income so tax is imposed on net gains, not gross receipts. Not all expenses incurred by taxpayers are deductible. There must be a connection between the expenditures and gaining assessable income for the expenses to be deductible. The general deduction provision, s 8-1(1) ITAA 1997, contains two “positive limbs” that set out the nexus between expenses and gaining of income that is required for the expenses to be deductible. These positive limbs are followed by four “negative limbs” in s 8-1(2) ITAA 1997 which set out four types of expenses that are not deductible under s 8-1(1). Some of the negative limbs may be redundant – for example, s 8-1(2)(c) denies a deduction for expenses incurred in deriving exempt or non-assessable income but it is impossible for these expenses to satisfy either positive limb in s 8-1(1). Similarly, some persons argue that s 8-1(2)(b), which denies a deduction for personal or domestic expenses, is redundant as these expenses, too, can never satisfy the positive limbs of s 8-1(1). It is the case, however, that courts often find this negative limb a helpful additional hook on which they can hang decisions to deny deductions for some types of outgoings. One of the negative limbs – the denial for deductions of capital expenses in s 8-1(2)(a) – is clearly not redundant. If not for this section, taxpayers would be able to deduct a wide range of capital expenses – land used to generate rental income, machines used in factories, the cost of acquiring patents or copyrights, and so forth. This negative limb is needed because the legislature does not want taxpayers to deduct immediately the cost of assets that will waste or decline in value over time or, in some cases such as land, to deduct them ever. The deduction denial in s 8-1(2)(a) is complemented by separate recognition provisions elsewhere in the ITAA that allow taxpayers to recognise these expenses over time (for example, the capital allowance provisions) or when the asset is sold. This chapter summarises the key cases that set out when an expense has a sufficient nexus with gaining assessable income to be deductible and when expenses lack that sufficient nexus. The identification of private and domestic expenses is covered in Chapter 8 and the identification of capital expenses is covered in Chapter 9. Chapter 10 contains cases based on specific deduction provisions such as the capital allowance rules.

© Thomson Reuters 2019

153

AUSTRALIAN TAXATION LAW CASES 2019

THE APPORTIONMENT FORMULA Ronpibon Tin No Liability v FCT (1949) 78 CLR 47 (Full High Court)

Facts: The taxpayer operated mines in Siam (Thailand) but it ceased to have access to mine output following the Japanese invasion of Siam in World War II. The taxpayer continued to derive investment income and continued to incur expenses for directors and maintenance of its administrative offices in Australia. As well, it made some support payments to the families of employees who had been in Siam at the time of the invasion. The income the taxpayer had derived from the mines had been exempt from Australian taxation as a result of s 23(q) ITAA 1936. Prior to the Japanese invasion, the taxpayer’s investment income was only a small fraction of its total income and the Commissioner allowed a deduction for only a small fraction of the taxpayer’s outgoings. The Commissioner continued to allow a deduction for the same amount after the taxpayer ceased to derive income from mining. The taxpayer objected, seeking to deduct all the office and administrative expenses as it was no longer deriving any exempt income. Decision: The High Court agreed the apportionment rule in s 51(1) ITAA 1936 (currently s 8-1(1) ITAA 1997 1997) permitted the Commissioner to deny a deduction for the payments to dependents of the persons who had worked in Siam as these expenses did not relate to the derivation of assessable income. It remitted the apportionment of all other expenses back to the trial judge, advising that apportionment must be made on the basis of actual findings of fact on the activities of directors and office staff, not an arbitrary formula looking at the amount of exempt income formerly derived compared to assessable or any other arbitrary measurement. Relevance of the case today: Prior to the adoption of the ITAA 1936, the ITAA did not contain explicit apportionment language “to the extent”. As the first Full High Court decision to consider directly the effect of the apportionment language, Ronpibon became and remains the leading precedent on the meaning of the apportionment words “to the extent” in s 51(1) ITAA 1936 (and later s 8-1(1) ITAA 1997 1997). The proposition it stands for – apportionment must be made on the basis of actual application of expenses, not an arbitrary formula – remains a cornerstone principle of interpretation of s 8-1. If it happened today: The taxpayer in Ronpibon operated its mines as branches of the Australian company, not through locally incorporated subsidiaries. Income derived from branches is no longer exempt under s 23(q) but may be non-assessable, non-exempt income under s 23AH ITAA 1936 if it passes an active income test which would include mining income. Thus, if the taxpayer continued to derive mining income through a branch, head office expenses would not be deductible on the basis that the foreign income was non-assessable. Whether the mines were taken over in a war or not, the head office expenses would be apportionable and following the precedent of Ronpibon, the apportionment would be done on the basis of a factual analysis of the activities carried on at the head office. Quite likely, a court would hold that many of 154

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

the expenses other than those related to relatives of employees overseas are deductible even when the taxpayer ceases to derive foreign income. This would be on the basis that expenses such as directors’ fees are related to the basic operation of a company and expenses of this nature would be incurred whether the taxpayer earned only assessable income or earned both assessable income and some non-assessable income.

CONNECTION WITH INCOME DERIVATION Expenses Incurred to Reduce Future Expenses W Nevill & Co Ltd v FCT

(1937) 56 CLR 290 (Full High Court)

Facts: The taxpayer company wished to terminate the services of a managing director. Under the termination agreement, it paid the director £2,500 payable as a £1,500 lump sum and 10 payments over 10 months. The taxpayer sought to deduct the entire £2,500 in the income year of the agreement. A number of arguments were made by the Commissioner against a deduction: • the expense lacked a sufficient nexus with the derivation of assessable income as it was incurred to reduce future expenses, not to derive income; • the expense was a capital outlay not in the ordinary course of business; • if the expense related to assessable income, it was assessable income of different income years; and • if the expense was deductible, no deduction would be available in the income year to the extent the company had issued notes promising payments in months after the end of the income year. Decision: The High Court concluded that the expense would save future expenses but was also directly related to the derivation of assessable income by the company as it would increase the efficiency and improve the operations of the business. The Court agreed the expense was not a usual one for the company but said it related to ongoing business processes, namely the hiring and termination of employees, and was therefore not a capital outlay. Importantly, the High Court concluded a predecessor provision to s 8-1 ITAA 1997 required a nexus between an expense and object of deriving assessable income but there was no requirement that it be incurred to derive assessable income in the same income year. Finally, the High Court agreed with the Commissioner that the taxpayer had not incurred expenses in respect of the promissory notes that did not have to be redeemed until the following income year. Relevance of the case today: The Nevill case remains a helpful precedent for the proposition that an outlay to reduce future expenses will satisfy the positive limbs of s 8-1. If it happened today: If the facts in Nevill occurred today, the expenditure would be deductible under s 8-1. Section 25-50 ITAA 1997, which also applies to some retirement payments, would not be relevant because the payments were not in respect of past employment.

© Thomson Reuters 2019

155

AUSTRALIAN TAXATION LAW CASES 2019

It is likely that the same result would follow with respect to the timing of the deductions. A court today could similarly characterise the promissory notes as deferred payment obligations that are deductible in the year they are paid. An alternative argument is possible, however. The taxpayer could argue that it paid some cash in the income year and gave the director intangible property in the form of interest-free or zero-coupon promissory notes, and on this basis seek a deduction for the cash paid and the present value of the promissory notes not redeemed in the income year. If the promissory notes were further characterised as “traditional securities” within the meaning of s 26BB ITAA 1936, the taxpayer could take a further deduction under s 70B ITAA 1936 between their value when given to the director and the face value when they were redeemed.

Connection in Time – Expenses Related to Future Income Softwood Pulp and Paper Ltd v FCT

(1976) 7 ATR 101; 76 ATC 4439 (Supreme Court of Victoria)

Facts: The taxpayer was formed as a vehicle for establishing a paper mill. The principal shareholder, a Canadian company, invoiced the taxpayer for expenses incurred in a feasibility study for the project. On the basis of the feasibility projects, the parties decided not to proceed with the project. The Commissioner denied a deduction for the expenses on the basis that preliminary expenses such as the cost of a feasibility study are not incurred in earning assessable income or in the course of a business. Decision: The Court agreed that preliminary expenses such as the cost of a feasibility study are incurred before the taxpayer commences to earn assessable income or operate a business and as a result would not qualify for deduction under either positive limb of s 51(1) ITAA 1936 (currently s 8-1(1) ITAA 1997 1997). The expenses were described as “entirely preliminary” to the income-earning process. The Court found further that the expenses would have been capital outgoings if they had satisfied the positive limbs and moreover that the taxpayer had not actually incurred the expenses for deduction purposes as it was disputing the liability to the foreign shareholder. Relevance of the case today: The Softwood case continues to be authority for the proposition that preliminary expenses such as feasibility studies fail to satisfy the positive limbs of s 8-1 because they are incurred prior to the income-earning process or commencement of business activities. If it happened today: If the facts in Softwood were to arise today, a court would once again find the expenses were not deductible under s 8-1 as they were incurred preliminary to gaining income or operating a business to gain income. However, since 2006 they can be deducted over a 5 year period under s 40-880 ITAA 1997 which provides a deduction regime for previously unrecognised black hole expenses.

156

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

Steele v DFCT

(1999) 197 CLR 459; 41 ATR 139; 99 ATC 4242 (Full High Court)

Facts: The taxpayer applied borrowed funds to purchase property to be used in a commercial development. Negotiations with the proposed partner fell through and the project was abandoned, with the taxpayer later selling the property. The taxpayer sought a deduction for the interest costs incurred while holding the land prior to sale. The Commissioner denied the taxpayer a deduction for the interest expenses on the basis that they were incurred prior to the gaining or producing of assessable interest. Decision: The evidence showed the taxpayer had no plans to use the property for anything other than gaining assessable income. A deductible expense does not have to be incurred contemporaneously with the gaining or production of the income to which it relates. The interest expense had a sufficient nexus with the intended gaining of income and thus satisfied the positive limbs of s 51(1) ITAA 1936 (currently s 8-1(1) ITAA 1997 1997). Relevance of the case today: As a Full High Court decision, the Steele case is an important precedent to support the argument that an expenditure incurred in respect of a business investment that is expected to produce income in the future satisfies the positive limbs of s 8-1(1) and is deductible when incurred. If it happened today: If the facts in Steele arose today, the interest expenses would be deductible under s 8-1(1). However, as the taxpayer is an individual and as the investment was intended to derive business income and not passive investment income, the non-commercial loss rules in Division 35 ITAA 1997 can apply. If the real property purchased by the taxpayer has a value under $500,000, as set out in s 35-40 ITAA 1997, the interest expenses will be quarantined against profits from the business under s 35-10 and carried forward indefinitely. As the taxpayer eventually sold the property in question and ended the business activity at that time, the only way she could use the carried-forward interest expenses would be if the profits on the sale of the property were characterised as ordinary income from the sale of a revenue business asset rather than a capital gain from the sale of a capital asset. It appears the taxpayer in Steele was able to realise her gain as a capital gain. If the facts arose today, whether she argued it was a capital gain or revenue gain would depend on whether the half inclusion of the gain under the discount capital gains rules would be greater or less than the net gain once the carried-forward interest expenses were offset against the gain.

Connection in Time – Expenses Related to Obtaining Employment FCT v Maddalena

(1971) 2 ATR 541; 71 ATC 4161 (Full High Court)

Facts: The taxpayer was an employee electrician and a professional football player. He incurred travelling expenses and legal expenses to seek and obtain a contract with a different Rugby League club. He sought to deduct the expenses under s 51(1) ITAA © Thomson Reuters 2019

157

AUSTRALIAN TAXATION LAW CASES 2019

1936 (currently s 8-1 ITAA 1997 1997) and s 64A ITAA 1936 (no equivalent provision in the ITAA 1997 1997). Decision: The High Court upheld the Commissioner’s assessment on the basis that expenses incurred to obtain employment do not form an outgoing incurred in the course of earning the wages payable in the employment. Relevance of the case today: Maddalena is the authority for the rule that expenses incurred to obtain employment do not fall within the positive limbs of s 8-1. If it happened today: If the facts in Maddalena were to arise today, a court would again find that expenses incurred to find employment are not incurred in gaining assessable income and as a result are not deductible under s 8-1. However, the taxpayer may now be able to distinguish his or her facts from those of the footballer in Maddalena and argue the later precedent of Spriggs v FCT; Riddell v FCT [2009] HCA 22 should apply. That case involved fees to a management company that negotiated an employment contract for the taxpayer. To fit into this later precedent, the taxpayer would have to show that being a professional sports player involves many business elements such as product endorsement and featuring in advertisements in addition to the underlying employment contract and that the taxpayer’s career would involve these further elements. The taxpayer would also have to argue that legal fees to obtain the employment and travel expenses are similar to management fees. This may be a difficult argument to sustain with respect to the travel expenses but the taxpayer may be able to show a link between the legal expenses and an employment contract that provided room for endorsement deals and other related sports business activities.

Spriggs v FCT; Riddell v FCT

[2009] HCA 22; 239 CLR 1; 72 ATR 148; 2009 ATC 20-109 (Full High Court)

Facts: The taxpayers were professional football players, the first playing AFL football and the second rugby league. Each incurred expenses for the services of a sports management company that negotiated their employment contracts with their sports clubs and related business contracts. They sought deductions for the cost of the management company fees under s 8-1 ITAA 1997 but the Commissioner denied the deductions on the basis of the precedent established by the Full High Court in Maddalena (1971) 2 ATR 541. The Commissioner argued that this precedent could be used to deny deductions for any expenses incurred to obtain an employment contract.

Decision: The High Court held for the taxpayers and allowed them a deduction for their management company expenses. The role of a sportsperson had greatly changed in the decades since Maddalena and a sportsperson’s income today comes from many associated business deals as well as the primary employment with a professional sports team. The employment contracts negotiated for the taxpayers anticipated and allowed for the outside income from these business deals. As a result, the High Court said, the management fees were business expenses deductible under both limbs of s 8-1. Relevance of the case today: Spriggs; Riddell is an important precedent that can be used to limit the impact of Maddalena in denying a deduction for expenses incurred to 158

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

acquire an employment contract. A deduction will be allowed if the taxpayer can show the expenses were central to the negotiation of a contract that allowed the opportunity to earn other business income associated with the taxpayer’s sports career. If it happened today: If the facts in Spriggs; Riddell were to arise today and the taxpayer sought a deduction for management company fee for a sports employment contract, a court would apply the High Court precedent and allow a deduction for the management company fee, provided the taxpayer could show the employment contract anticipated and allowed for the derivation of related business income.

Connection in Time – Expenses Related to Previous Business Amalgamated Zinc (de Bavay’s) Ltd v FCT

(1935) 54 CLR 295 (Full High Court)

Facts: The taxpayer had previously carried on business as a miner, producer and seller of zinc concentrates. In 1924, it ceased to carry on that business, selling all related plant and stock. Thereafter it earned income only from investment activities. In the 1932 and 1933 income years, the taxpayer claimed deductions under the predecessor provision to s 8-1 ITAA 1997 for compulsory contributions to a workers compensation fund to benefit former employees who had worked in its zinc business. The Commissioner denied the deductions. Decision: The deductions were not allowable. There was no connection between the expenditure and the assessable income derived in the relevant year – the expenditure was independent of the production of income in that year. These circumstances were to be distinguished from a case of a continuing business where expenditure may relate to income derived in a past year. Relevance of the case today: The relevance of this decision has been seriously limited by comments in later cases. See, in particular, AGC (Advances) Ltd v FCT (1975) 132 CLR 175; 5 ATR 243; 75 ATC 4057. If it happened today: While later cases do not explicitly overrule the decision in Amalgamated Zinc, if the facts of Amalgamated Zinc were to occur today, a court would most likely allow the deductions under s 8-1 ITAA 1997 on the authority of AGC (Advances) Ltd and Placer Pacific Management Pty Ltd v FCT FCT. However, AGC (Advances) Ltd could be distinguished as the taxpayer in that case restarted the business. Placer Pacific Management Pty Ltd would be more difficult to distinguish.

AGC (Advances) Ltd v FCT

(1975) 132 CLR 175; 5 ATR 243; 75 ATC 4057 (Full High Court)

Facts: The taxpayer was a company which had carried on a business in lending money and providing hire purchase financing. The taxpayer’s business had been suspended and the company was subject to a scheme of arrangement with creditors. Later, the taxpayer company was purchased by Australian Guarantee Corporation Ltd. At the time © Thomson Reuters 2019

159

AUSTRALIAN TAXATION LAW CASES 2019

of purchase, not all the debts from the prior money lending and hire purchase activities had been collected. In the relevant years, which followed on from the purchase of the company, the taxpayer wrote off some of these debts and claimed bad debt deductions for money lent and interest on the hire purchase arrangements under s 63 ITAA 1936 (now s 25-35 ITAA 1997 1997) and deductions in relation to principal repayments under the hire purchase agreement under s 51(1) ITAA 1936 (now s 8-1 ITAA 1997 1997). Decision: The taxpayer was entitled to the deductions claimed under s 63. The creditors scheme did not extinguish the taxpayer’s beneficial interest in the debts and therefore the s 63 deductions were appropriate. The deductions under s 51(1) were also allowable. That section does not require that the loss or outgoing relate to assessable income produced in the same period. A loss which relates to a business being carried on need not occur in a year when the company is still actively carrying on that business. The loss will be deductible where the occasion for the loss is to be found in a transaction entered into in the course of carrying on a business for the purpose of producing assessable income. In this case, the relevant transaction is the hire purchase agreements and the loss therefore has its origins in the carrying on of the business. The decision declined to follow Amalgamated Zinc (De Bavay’s) Ltd v FCT (1935) 54 CLR 295 and some comments of the Court suggest that case might be decided differently were it reheard. Relevance of the case today: This case is most relevant for the comments made regarding the nexus required under s 51(1) between a loss or outgoing and the carrying on of an income producing business. The case established the following principle: provided the occasion of a business loss or outgoing is to be found in the business operations directed towards gaining or producing assessable income generally, the fact that the loss or outgoing was incurred in a year later than the year in which the income was derived and the fact that, in the meantime, business may have ceased will not determine the issue of deductibility. That loss or outgoing will be deductible unless it is capital or of a capital nature. This principle has been applied in many succeeding cases, such as Placer Pacific Management Ltd v FCT (1995) 31 ATR 253; 95 ATC 4459, and FCT v Brown (1999) 43 ATR 1; 99 ATC 4600. If it happened today: If the facts of this case were to occur today, the deductions would be allowed under s 8-1. This case was perhaps a less difficult one as the business carried on at the time the deductions were claimed was substantially of the same nature as that carried on when the transactions were entered into and the period of time between the two businesses was short. The case of a taxpayer carrying on a significantly different business was considered in Placer Pacific Management Pty Ltd v FCT and cases where business has altogether ceased were considered in FCT v Brown (1999) 43 ATR 1; 99 ATC 4600 and FCT v Jones (2002) 49 ATR 188; 2002 ATC 4135.

FCT v EA Marr and Sons (Sales) Ltd

(1984) 15 ATR 879; 84 ATC 4580 (Full Federal Court)

Facts: The taxpayer was a member of a group of companies carrying on various business activities. The taxpayer and its six subsidiaries made up the machinery and plant division of the group. The principal activities of the taxpayer were the holding 160

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

of shares in the subsidiaries, owning and leasing land and buildings to subsidiaries, providing management and administrative services to the subsidiaries, leasing machinery and plant owned by the taxpayer to subsidiaries, and acquiring machinery and plant under finance leases from external financiers and making the equipment available to subsidiaries. With respect to the machinery and plant under lease, no formal lease agreements were entered into between the taxpayer and its subsidiaries and, after the first and sometime second payment, the lease payments were made directly by the subsidiaries to the finance companies. The taxpayer did not claim deductions for the obligations under the leases and did not show as income the rental payments from the subsidiaries. The taxpayer suffered significant losses and receivers were appointed. As the taxpayer had defaulted under most of the leases, the receivers sold any unnecessary items of plant and applied the proceeds to meet the outstanding liabilities to the finance companies. The taxpayer was also required to make additional deficiency payments for which it sought deductions under s 51(1) ITAA 1936 (currently s 8-1 ITAA 1997 1997). The Commissioner denied the deductions for these deficiency payments, arguing that the taxpayer never derived and never intended to derive assessable income from the leasing activities and the only basis under which the taxpayer could claim a deduction was that it anticipated the derivation of assessable income by way of dividends from the subsidiaries, which was not supported by the evidence. The Commissioner also submitted that the payments were made in the course of winding up and not in the course of carrying on business to produce income. Decision: The taxpayer was entitled to the deductions claimed for the deficiency payments. Although the arrangements between the taxpayer and its subsidiaries for the use of the leased equipment were very informal and no income was derived from the leasing activities, the taxpayer could have directed the profits generated by the use of the equipment by the subsidiaries to it by way of dividends and there was some evidence that the taxpayer hoped to derive a profit from these activities in the long run. It was not appropriate to separate the leasing activities from the taxpayer’s business activities as a whole when determining if the s 51(1) deduction was allowable. The payments had the relevant nexus with the carrying on of the taxpayer’s business and the receivers made the payments in anticipation of retaining the taxpayer as a going concern, distinguishing Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) 54 CLR 295. Even if the taxpayer had ceased carrying on business at the time the payments were made, it would not necessarily follow that the payments were not on revenue account. The occasion for the making of the payments was to be found in the carrying on of the business which included the leasing activities and therefore the requisite nexus between expenditure and earning assessable income existed. Relevance of the case today: EA Marr applies and arguably even extends somewhat the principle established by the High Court in AGC (Advances) Ltd v FCT (1975) 132 CLR 175; 5 ATR 243; 75 ATC 4057. The case may be cited to support the proposition that a deduction will be allowed for a loss or outgoing incurred after a particular business activity has ceased provided the occasion of the loss is to be found in the business activities directed towards generating assessable income.

© Thomson Reuters 2019

161

AUSTRALIAN TAXATION LAW CASES 2019

If it happened today: If the facts of this case were to occur today, the taxpayer most likely would be allowed to deduct the outgoings for the lease deficiencies on the basis that the outgoings related to transactions entered into in the course of carrying on a business (as broadly defined by the Court) directed toward the production of assessable income.

Placer Pacific Management Pty Ltd v FCT

(1995) 31 ATR 253; 95 ATC 4459 (Full Federal Court)

Facts: The taxpayer carried on various businesses including the manufacture of conveyor belt systems. The taxpayer had ceased carrying on that business and some eight years later was required to meet a liability claim for manufacturing a faulty system. At that time, the activities carried on by the taxpayer were limited to investment and management of related companies. The issue before the Court was whether the amount payable on settlement of the claim and related legal fees were deductible under s 51(1) ITAA 1936 (currently s 8-1 ITAA 1997 1997). Decision: The outgoing was deductible under the second limb of s 51(1). Applying the test established in AGC (Advances) Ltd v FCT (1975) 132 CLR 175, the occasion of the loss was the contract entered into with the customer which was part of the carrying on of a business to produce assessable income. The fact that the business was no longer carried on did not prevent the deductibility of the outgoing. Relevance of the case today: This case established the principle that so-called “long tail liabilities” may be deductible even though the business to which the liabilities relate may have ceased. The decision helped limit the impact of the 1935 Amalgamated Zinc (de Bavay’s) decision in the case of long tail liabilities, at least where the risk was knowingly incurred when the business was conducted. If it happened today: If the facts of Placer Pacific arose today, the expenses would continue to be deductible by the taxpayer even though the original business which gave rise to the liability had ceased.

FCT v Brown

(1999) 43 ATR 1; 99 ATC 4600 (Full Federal Court)

Facts: In 1988, the taxpayer and his wife, in partnership, borrowed funds in order to acquire a deli business, the debt being repayable over ten years. In 1990, the partnership sold the deli business and applied the net proceeds to pay down the loan but an amount remained outstanding. As a result, the partnership continued to incur interest outgoings. The issue before the Court was whether a deduction should be allowed for the interest expenses in 1993 and 1994 under s 51(1) ITAA 1936 (currently s 8-1 ITAA 1997 1997) where the business to which the loan related had ceased. Decision: The interest outgoings continued to be deductible. The loan agreement created a legal liability to pay interest over the ten year term as it provided for monthly repayments but did not provide for early repayment, though as a practical matter in practice the Bank would allow for an early repayment without penalty. The Court applied 162

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

the standard from Steele v DFCT (1999) 197 CLR 459, that a deduction for a recurrent interest outgoing may still be allowable after the business has ceased provided that the occasion of the interest outgoing is to be found in the business operations directed towards the gaining or producing of assessable income. The occasion of the outgoing in this case was to be determined by reference to the purpose of the borrowing and the use to which the funds were put. It was acknowledged that there may come a time where the outgoings are no longer sufficiently proximate to the business activity to provide a basis for deduction but this is a question of fact and under these circumstances that time had not yet come. The Court considered that the case might be different if the loan was a debt facility which was “rolled over” each month because the occasion for the interest outgoing could arguably be the roll over election, thereby breaking the nexus with the business activity. This particular point was addressed in the later case of FCT v Jones (2002) 49 ATR 188; 2002 ATC 4135. Relevance of the case today: This case is relevant for its holding that interest deductions will be allowable to taxpayers where the original borrowing was used in a business directed at producing assessable income, extending the principle of the “occasion of the loss” established in AGC (Advances) Ltd v FCT (1975) 132 CLR 175; 5 ATR 243; 75 ATC 4057 and applied in Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253; 95 ATC 4459. If it happened today: If the facts of Brown were to occur today, the interest outgoings would continue to be deductible. This would continue to be the case even if the loan were rolled over or refinanced provided that the taxpayer otherwise lacks sufficient funds to repay the loan; see the decision in FCT v Jones (2002) 49 ATR 188.

FCT v Jones

(2002) 49 ATR 188; 2002 ATC 4135 (Full Federal Court)

Facts: The taxpayer and her husband carried on a business in partnership until his death. The business was funded in part by bank borrowings. When the husband was ill, the partnership commenced to sell the business assets and reduce the debt. After the husband’s death, the proceeds of his superannuation policy were used to further reduce the debt but this still left an amount outstanding. The taxpayer later refinanced the loan to obtain a lower interest rate. The taxpayer claimed deductions under s 51(1) ITAA 1936 (currently s 8-1 ITAA 1997 1997) for the interest component of payments made on this loan. The Commissioner argued that as the taxpayer had the legal option to repay the loan but did not do so, the nexus with the business activity was broken and the interest expenses were not deductible. Decision: The interest expenses were allowable deductions. It had been shown that the taxpayer was attempting to repay the debt but did not have the financial capacity to do so. The Court commented on the obiter dicta in FCT v Brown (1999) 43 ATR 1 which suggested that having the option to repay a debt could result in the interest deductions being lost. It was considered that these comments referred to a true election, where the taxpayer has the funds to repay the debt but chooses not to do so. This was clearly not the case with Jones. It was also considered that the refinancing of the loan did not break the nexus between the interest expenses and the business. The new financing took its character from the original loan. © Thomson Reuters 2019

163

AUSTRALIAN TAXATION LAW CASES 2019

Relevance of the case today: This case extends the availability of deductions for interest outgoings incurred after the cessation of business where the relevant link to that business is retained, even where there is a contractual option to repay the debt. Even with refinancing the borrowing will retain its character as a business loan, provided the taxpayer can show that there is no capacity to repay. Like Brown, this case is concerned with the individual business person who also carries on private, consumption activities and where the tracing of the use of borrowed funds therefore becomes more relevant. If it happened today: If the facts in Jones arose today, the interest expenses could continue to be deductible under s 8-1 on the basis of that precedent.

Connection to Anticipated Indirect Derivation of Income In most cases, a taxpayer claiming a deduction for an expense will seek to show that the expense will generate income to be derived directly by the taxpayer. In some cases, however, the taxpayer may argue she or he will realise income indirectly as a result of the expenditure. An example that arises often in practice is an expense to help a company in which the taxpayer holds shares gain income. The taxpayer will argue that because the company has earned income as a result of the taxpayer’s outgoing, it will have profits from which dividends can be paid and the taxpayer will thus derive income in the form of dividends as a result of the expenditure to help another taxpayer.

FCT v Total Holdings (Aust) Pty Ltd

(1979) 9 ATR 885; 79 ATC 4279 (Full Federal Court)

Facts: The taxpayer was a holding company that on-lent borrowed funds to a subsidiary operating company on an interest-free basis. The taxpayer claimed deductions for the interest expenses it incurred on the funds it had borrowed even though it realised no income directly from the use of those funds, having used them to make an interest-free loan. The Commissioner argued the taxpayer’s intention was to increase the earnings of the subsidiary so the taxpayer could sell its shares and realise a tax-free capital gain (the case took place prior to the introduction of CGT). The taxpayer argued its intention was to increase the earnings of the subsidiary so it could pay dividends to the taxpayer. Decision: The evidence did not demonstrate an intention by the taxpayer to realise the value of earnings in the subsidiary through a sale of shares in the subsidiary. The activities of the taxpayer were designed to render the subsidiary profitable as soon as commercially feasible and to promote the generation of income by the subsidiary and its subsequent derivation by the taxpayer. There was a sufficient connection between the outgoing and anticipated income for a deduction under s 51(1) ITAA 1936 (currently s 8-1(1) ITAA 1997 1997). Relevance of the case today: The Total Holdings decision is a key precedent to support deductions for expenses incurred by a taxpayer to build the profitability of a subsidiary on the basis that the profits derived by the subsidiary will eventually be realised by the taxpayer in the form of dividends from the subsidiary. 164

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

If it happened today: If the facts in Total Holdings arose today, the taxpayer would be allowed a deduction for interest expenses incurred in respect of a loan where the taxpayer used the borrowed funds to make an interest-free loan to its subsidiary.

Spassked Pty Ltd v FCT

[2003] FCAFC 282; 54 ATR 546; 2003 ATC 5099 (Full Federal Court)

Facts: The taxpayer was a member of a group of companies some of which were considered “dividend traps” for tax purposes. The phenomenon of dividend traps arose under the former imputation system as a result of inter-corporate dividend rules that effectively locked inter-corporate dividends in companies that had incurred large interest expenses. To overcome this problem, the taxpayer was established as the borrowing company for the group. It borrowed funds from the group’s finance company and used the funds to acquire shares in a lower tier company. The top tier parent company also invested in the same lower tier company but different classes of shares were allocated to the taxpayer and the higher tier company. Most of the dividends declared by the lower tier company were paid on the shares held by the parent company and only a small number of dividends were paid to the taxpayer. As a result, it suffered substantial losses after deductions for its interest expenses. The taxpayer subsequently transferred part of those losses to other group companies. The Commissioner denied the taxpayer a deduction for the interest expenses. The taxpayer argued the deduction should be allowed, among other things on the basis of the precedent in FCT v Total Holdings (Aust) Pty Ltd (1979) 9 ATR 885; 79 ATC 4279. The Commissioner sought to distinguish that case on the basis that it involved a factually different arrangement, arguing that the taxpayer in Spassked had not incurred its interest expense in earning or producing assessable income. Decision: The Full Federal Court agreed with the Commissioner and distinguished the taxpayer’s case from that of the taxpayer in Total Holdings. In the Total Holdings case there was always an expectation and intention as well as the potential for dividends to be paid to the borrower company. By way of contrast, an objective assessment of the arrangement in the present case showed that the parties never intended the taxpayer to receive more than a small amount of dividends from the subsidiary company, with most dividends flowing directly to the parent company. The Court indicated that when determining the purpose of the borrowings, it was appropriate to consider the subjective intention of the directors who established the arrangement as a means of addressing the dividend trap by distributing profits to the parent company and not with the intention of generating assessable income for the companies that had incurred the interest expenses. Accordingly, it could not be said that the interest expenses were incurred in gaining or producing assessable income. Relevance of the case today: As explained below, the facts found in Spassked are unlikely to arise today. The case remains relevant as a precedent that shows a court will look to the totality of the taxpayer’s situation to see whether there was a genuine likelihood that future income would flow to the taxpayer as a result of its outgoings, at least in the case of borrowing to purchase shares in a group company arrangement. It also shows that the intention of a company’s directors in arranging the company’s © Thomson Reuters 2019

165

AUSTRALIAN TAXATION LAW CASES 2019

affairs can be considered when determining whether expenses incurred by a company were incurred in the derivation of assessable income. If it happened today: The arrangement in Spassked was created by the group of companies involved in the arrangement in response to the former imputation system. The goal was to lock interest expenses into one group company and allow inter-company dividends to flow directly to the parent company free of tax as a result of an inter-corporate dividend rebate in s 46 ITAA 1936. The inter-corporate rebate rules that motivated the arrangement have not applied to franked dividends since 2003 and the motivation for the arrangement no longer exists. Since 2002, groups of wholly owned companies have been able to use the consolidation rules in Divisions 700 to 721 ITAA 1997, which allow group companies to be treated as a single entity for income tax purposes. A group of companies such as those involved in the Spassked case is quite likely to elect to be treated as a single consolidated entity today. If this were the case, intra-group payments of interest would be ignored for tax purposes and the question of deductibility for intra-group interest payments would not arise.

Need for Current Liability FCT v Foxwood (Tolga) Pty Ltd

(1981) 147 CLR 278; 11 ATR 859; 81 ATC 4261 (Full High Court)

Facts: The taxpayer carried on business as a service company for a corporate group. It was decided that the businesses should be reorganised and the taxpayer sold its business to an associated company. The taxpayer’s employees were moved with the business to the associated company. Under the Queensland legislation applicable to the taxpayer, the employees’ entitlement to accrued annual leave crystallised when they ceased employment with the taxpayer. In contrast, the employees’ accrued credit towards long service leave was to be recognised by the new employer and the taxpayer’s inchoate (not yet crystallised) liability would be assumed by the purchaser. Although not obligated to under law, the taxpayer paid an amount to the associated company equal to the value of the employees’ accruing rights to long service leave. Rather than paying the employees their accrued annual leave, the taxpayer also paid an amount to the new employer equal to the value of the employees’ accrued entitlement to annual leave and sick leave. The taxpayer sought deductions for the payments in respect of employees’ accrued long service leave and annual leave. The Commissioner denied the deductions for both amounts. Decision: The payment in respect of accrued annual leave was deductible but the payment in respect of the accrued long service leave was not deductible. The transfer of employment triggered a liability to pay the accrued annual leave and the agreement between the parties for the employees to accept the annual leave payments from the new employment when their leave came due did not affect the taxpayer’s liability to make the payments. Although the payment to the purchasing company did not legally discharge the taxpayer’s obligations, it was plainly contemplated that the payment was to enable the purchaser to satisfy this obligation on behalf of the taxpayer. This liability 166

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

clearly arose in the carrying on of the business and was therefore an outgoing incurred and deductible under s 51(1) ITAA 1936 (currently s 8-1(1) ITAA 1997 1997). The case of the long service leave was different. The termination and transfer of the employees did not trigger a liability on the part of the taxpayer to make any payments to employees with regard to long service leave. In fact, it extinguished any such liability the taxpayer might have had. As the payment did not satisfy a liability of the taxpayer, it did not satisfy either of the positive limbs of s 51(1). Relevance of the case today: The decision in this case is perhaps most relevant today for its discussion of the process undertaken in determining whether an outgoing is deductible to a taxpayer. In both the opinions of Gibbs CJ and Mason J, the relevant test consideration was the object of the expenditure, from a practical and business point of view, applying the opinion of Dixon J in Hallstroms Pty Ltd v FCT (1946) 72 CLR 634. This viewpoint was particularly relevant under the facts in Foxwood (Tolga) since the annual leave payment was made to the purchaser rather than to the employees and there was therefore no legal discharge of the obligations to the employees by virtue of the payment. If it happened today: The facts of Foxwood (Tolga) arose prior to the enactment of s 51(3) ITAA 1936, the predecessor to s 26-10 ITAA 1997. While the primary purpose of s 26-10 is to prevent deductions for accrued but unpaid leave obligations, it appears to be an authorising provision as well, allowing deductions for a leave payment made to an employee and for an “accrued leave transfer payment” made in the income year. It is also not clear if s 26-10 would apply to the payment in respect of the employees’ accruing long service leave entitlement as it could be argued that the payment was a contractual obligation upon the sale of the business, not a leave payment per se. However, unlike the case with the payment related to annual leave, if s 26-10(1) did not apply to the payment, it would not be deductible under s 8-1 because it would fail to satisfy the nexus requirements of the positive limbs of s 8-1, just as such a payment failed to satisfy the positive limbs of s 51(1) in the Foxwood (Tolga) case where the Court concluded that the payment was not for a liability connected to the derivation of income. It appears the payment would not be saved by the enabling limb of s 26-10(2) as the payment was not required by legislation. However, the taxpayer could argue that the payment “facilitated” a law or award as it made it easier for the new employer to assume the liability it was required to assume. If this argument is not successful, the taxpayer could try to recognise the cost under the CGT provisions as part of the cost base of the business sold, arguing it is an incidental cost under s 110-35(3) ITAA 1997 as a cost of transferring the business. However, this argument is unlikely to succeed as the expense facilitates the transfer but is not incurred directly as a cost of changing ownership of the business. Finally, relief may be available under s 40-880 ITAA 1997 which applies to former “black hole” expenses not otherwise recognised for tax purposes. The expense appears to satisfy the requirements of the provision which allow taxpayers to deduct over 5 years otherwise unrecognised capital expenses related to a business that used to be carried on. This element of the section was probably drafted with a business that

© Thomson Reuters 2019

167

AUSTRALIAN TAXATION LAW CASES 2019

has ceased in mind, not one that has been transferred to another part of a group, but expenses related to a transferred business fall within the words of the provision.

Life and Disability Insurance Premiums FCT v Wells

(1971) 2 ATR 552; 71 ATC 4188 (High Court)

Facts: The taxpayer was a member of a partnership. To ensure the remaining partners would have sufficient funds to pay out to the estate of a deceased partner in the event of the death of a partner, the partners took out a series of joint life insurance policies in each case by the partners other than the insured partner. The partners then sought deductions for the insurance premiums. Decision: Menzies J held the expenses were not deductible under either of the positive limbs of s 51(1) ITAA 1936 (currently s 8-1 ITAA 1997 1997). The purpose of the expenses was to allow the surviving partners to meet their obligations on the death of a partner. The expenses were neither incurred in the course of gaining or producing assessable income nor incurred in the course of the taxpayer’s business. Relevance of the case today: Wells is authority for the proposition that insurance premiums on partners or key employees will not be deductible for tax purposes. The basis for the holding was that the expenses did not satisfy either of the positive limbs of s 51(1). Subsequent cases such as FCT v DP Smith (1981) 147 CLR 578 showed that insurance proceeds would be deductible if the proceeds of insurance would be assessable. Accordingly, Wells is now sometimes interpreted as authority for the proposition that insurance premiums are not deductible if the proceeds of insurance are not assessable. If it happened today: If the facts in Wells arose today, the same result would follow. The decision might be based on similar grounds to those used in Wells. Further support for the decision today might be based on an argument that the expense lacked a nexus with the production of assessable income because the insurance proceeds would not be considered ordinary or statutory income and would be excluded from tax under the CGT regime under s 118-300 ITAA 1997.

FCT v DP Smith

(1981) 147 CLR 578; 11 ATR 538; 81 ATC 4114 (Full High Court)

Facts: The taxpayer was a medical practitioner who had purchased a personal disability insurance policy. The taxpayer was injured in a traffic accident and the insurer paid regular benefits for the four months that the taxpayer was disabled. The taxpayer included the insurance proceeds in his assessable income and sought a deduction for the insurance premiums. The Commissioner denied a deduction for the premiums on the basis that they did not fall within either of the positive limbs of s 51(1) ITAA 1936 (currently s 8-1 ITAA 1997 1997). The taxpayer appealed against the deduction denial and further argued that the insurance payments were not assessable.

168

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

Decision: The insurance policy was taken out to provide a monthly indemnity against the income loss arising from the inability to earn. The benefits received by the taxpayer replaced income that would have otherwise been derived and clearly had a revenue character. They were thus assessable as ordinary income under s 25(1) ITAA 1936 (currently s 6-5(1) ITAA 1997 1997) or as indemnification payments under s 26(j) ITAA 1936 (currently s 15-30 ITAA 1997 1997). The insurance premiums paid by the taxpayer were deductible. It is not necessary to show that an expenditure will certainly yield assessable income for the expense to be deductible. It is sufficient if the taxpayer can show that an expense such as insurance premiums was incidental and relevant to the production of income. Relevance of the case today: The DP Smith decision reaffirms the long-standing principle that a deductible expense need not necessarily generate assessable income so long as the gains it might generate will be assessable. DP Smith is authority for the proposition that expenses incurred for insurance proceeds are deductible if the proceeds of the insurance policy will be assessable. If it happened today: If the facts in DP Smith were to arise today, the cost of the insurance premiums would be deductible under s 8-1.

Theft Losses and Misappropriations A taxpayer may derive income that is lost to theft by a stranger or an employee or agent. The fact that income is stolen before it can actually be physically available to the taxpayer will not stop it from being assessable if it has been derived prior to the theft. The question arises whether theft losses before funds are available for use by a taxpayer can be deductible and whether they are deductible after receipt and application by a taxpayer. The treatment of thefts by strangers are covered by common law, particularly the Charles Moore precedent. Thefts by employees or agents may be deductible under s 25-45 ITAA 1997, which allows a deduction for theft or misappropriation by an employee or agent.

Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344 (Full High Court)

Facts: The taxpayer carried on the business of operating a department store. It was the taxpayer’s regular practice that each morning a cashier and an escort would walk the previous day’s takings to the local bank for deposit. On one particular morning, the takings were stolen at gunpoint and the taxpayer sought to deduct the loss being the cash stolen. The Commissioner argued the loss was not deductible as it was not incurred in the course of the taxpayer’s ordinary business operations. Decision: The Full High Court held that the loss was deductible as it was incurred in producing assessable income and it was not a loss of a capital nature. The Court considered that the process of transporting the day’s takings to the bank was as much a part of the ordinary course of carrying on the business to produce assessable income as any other usual step in the carrying on of a department store business such as stocking the shelves. In fact, such financial transactions could be characterised as a necessary © Thomson Reuters 2019

169

AUSTRALIAN TAXATION LAW CASES 2019

part of carrying on the business. The Commissioner’s argument that the loss was capital in nature was also dismissed. Relevance of the case today: This case is still authority for the availability of an ordinary s 8-1 ITAA 1997 deduction for theft losses of money and was applied in FCT v La Rosa (2003) 53 ATR 1; 2003 ATC 4510. A statutory deduction is also available for loss of money by way of theft (including embezzlement and misappropriation) by an employee or agent under s 25-45 ITAA 1997 where the money was included in the taxpayer’s assessable income for an income year. If it happened today: If the facts of Charles Moore were to occur today, the loss would continue to be deductible under s 8-1 ITAA 1997.

Lean v FCT

[2010] FCAFC 1; 75 ATR 213; 2010 ATC 20-159 (Full Federal Court)

Facts: The taxpayer derived capital gains from the sale of shares and transferred the proceeds of sale to a fraudulent investment agent who misappropriated the funds. The taxpayer returned the net gains as statutory income and sought a deduction under s 25-45 ITAA 1997. The Commissioner argued a deduction was only available under the section if the amount stolen retained the character of assessable income at the time of the theft. Decision: The Court held that no deduction was available to the taxpayer under section 25-45 as the money stolen had lost its character as assessable income. The court distinguished between the amount received by the taxpayer’s stockbroker, which would have been assessable income, and the funds received by the taxpayer and later used to make an investment with the fraudulent investment agent. Relevance of the case today: The Lean decision shows that s 25-45 can only apply to funds stolen by an employee or agent, as the amounts are derived as assessable income. In effect, this means the provision cannot apply once the funds are actually received by the taxpayer and deposited in an account or used for another purpose. If it happened today: If the facts of Lean were to occur today, the loss would continue to be non-deductible for tax purposes. Note that if the taxpayer purchased some type of investment asset from a fraudulent advisor and the asset turned out to be worthless following the fraud and theft, a capital loss might be available in respect of the lost funds following disposal of the worthless investment asset.

QUASI-PERSONAL EXPENSES Section 8-1(1) ITAA 1997 allows a deduction for expenses incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. Section 8-1(2)(b) ITAA 1997 denies a deduction for private expenses but arguably this section is unnecessary as a private expense would not be incurred in gaining assessable income. 170

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

There has historically been resistance by the Commissioner to allow deductions for a category of expenses that are sometimes called “quasi-personal” expenses. These are expenses that appear to be incurred in the course of producing assessable income or in a business that generates assessable income, so they are not private expenses, but they are said to have some features of private expenditure. These expenses relate to wrongdoing by the taxpayer in the course of deriving income. For example, a legitimate business may have to pay damages as a result of negligence by its employees or may pay bribes to do business in certain jurisdictions. Or, a person carrying on an illegal business may incur expenses to carry out the forbidden activities or may incur legal expenses for lawyers or fines if she or he is caught. While all these expenses appear to meet the positive limb of s 8-1, there is a view held by some that a business should not commit negligent acts or carry out illegal activities. Following from this view, the Commissioner has sometimes argued that the expenses related to wrong-doing are incurred outside the strict business or incomeearning process – hence their characterisation by some persons as “quasi-personal” expenses. At one time the courts supported this view and denied deductions for these expenses, citing an insufficient connection with the income-earning process. Over the course of several decades, the courts moved to a different view, namely that the income tax should be imposed on net gains only and deductions should be allowed for expenses incurred to derive gross assessable income, without regard to whether the expenses were legal or illegal or whether the activities were legal or illegal. The traditional doctrines continue to apply to fines, however. The legislature has accepted the shift in terms of expenses incurred as a result of negligence and legal fees. At the same time, it has enacted measures to overrule the judicial approach to deductions for some expenses incurred by illegal businesses, as well as for bribes, by inserting sections in the law that prevent deductions for these two categories of expense. In addition, the judicial prohibition on deductions for fines has been reinforced by a statutory provision that denies deductions for this type of expense.

Damages for Negligence Strong & Co Ltd v Woodifield (Surveyor of Taxes)

[1905] 2 KB 350 (UK Court of Appeal)

Facts: A brewery company paid damages to a guest in a hotel owned by the company who was injured by a falling chimney. The (UK) Commissioners denied the taxpayer a deduction for the expenses, arguing the expense was not incurred in the course of deriving assessable income. Decision: The Court of Appeal concluded the expenses due to the negligence of the company were not incurred by the company in a business capacity or in earning profits. Expenses of this sort, the Court said, were not connected with or incidental to the taxpayer’s business as an innkeeper and could therefore not be taken into account when calculating taxable income.

© Thomson Reuters 2019

171

AUSTRALIAN TAXATION LAW CASES 2019

Relevance of the case today: Strong & Co, Ltd v Woodifield was an important early case establishing the category of “quasi-personal” expenses that courts said were not incurred in the course of earning business profits. Other expenses treated similarly were fines for illegal activities and legal expenses arising from illegal activities. The case is of historical interest to show how the doctrine of quasi-personal expenses developed. However, it has little ongoing relevance today given the modern approach illustrated in Herald & Weekly Times v FCT (1932) 48 CLR 113 that recognises negligence damages as an inevitable cost of conducting business. If it happened today: In light of the pragmatic approach taken by Australian courts in decisions such as Herald & Weekly Times, it is most likely that if the facts in Strong & Co, Ltd arose in Australia today, the taxpayer would be allowed to deduct the damages as an ordinary business expenses under s 8-1(1)(b) ITAA 1997.

Herald & Weekly Times v FCT (1932) 48 CLR 113 (Full High Court)

Facts: The taxpayer, a newspaper publisher, paid amounts as damages or settlements in respect of libel actions brought against it. The Commissioner denied a deduction for the expenses, arguing there was an insufficient nexus between the outgoings and earning of assessable income to satisfy the positive limbs of the predecessor to s 8-1 ITAA 1997. The Commissioner argued, on the basis of Strong & Co, Ltd v Woodifield Woodifield, that the expense was incurred in respect of actionable wrongs committed by the taxpayer not directly in its income-earning process. Decision: The Full High Court allowed the deduction, concluding the test should not look at the direct cause of the payment, but rather should see the expense as an inevitable outcome of the taxpayer’s broader purpose of producing assessable income through newspaper publishing. Relevance of the case today: Importantly, the High Court did not overrule the decision in Strong & Co, Ltd v Woodifield Woodifield, instead distinguishing it on the basis that in that case there was not as strong a connection between the taxpayer’s trade and the cause of the liability for damages. The implication of the judgments appears to be that libel is an inevitable and unavoidable consequence of newspaper publishing while injury to customers may not be as inevitable an outcome of running an inn. While the case does not overturn the effect of Strong & Co, Ltd v Woodifield Woodifield, the pragmatic and commercially realistic approach adopted in Herald & Weekly Times has since been followed in ordinary commercial cases and it can be expected that the courts will adopt generous nexus tests for damages incurred by a business related to the business rather than personal non-business actions of an unincorporated trader. If it happened today: The broad nexus test set out in Herald & Weekly Times for damages and other quasi-personal expenses (ie, expenses that were argued to be incurred in a personal capacity rather than a business capacity) has since been liberalised and if the same facts arose today, there is little doubt the expense would be deductible. In fact, if the expenses were incurred in slightly different circumstances such as physical

172

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

injury to a person in connection with the taxpayer’s business activities, the settlement or damage payment would also likely be a deductible expense.

Fines for Illegal Activities Madad Pty Ltd v FCT

(1984) 15 ATR 1118; 84 ATC 4739 (Full Federal Court)

Facts: The taxpayer had paid “pecuniary penalties” imposed under the former Trade Practices Act. Longstanding UK doctrine accepted as applying in Australia treated fines as “quasi-personal” expenses that were said to be incurred by a business in a personal capacity. As a result, they were treated as not satisfying either of the positive limbs in s 51(1) ITAA 1936 (currently s 8-1(1) ITAA 1997 1997). However, in Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276; 80 ATC 4542, the Full Federal Court had questioned in obiter whether the old UK doctrine should continue to be followed in Australia, prompting the taxpayer in Madad to appeal to the Full Federal Court. Decision: The Court decided that it should follow obiter statements of the High Court to the effect that the UK non-deductibility of fines doctrines will apply in Australia. Relevance of the case today: Prior to the decision of the Full Federal Court in Madad being handed down, the government feared the Court might reverse the lower court decision and allow the deduction on the basis of the obiter comments in Magna Alloys. The government concluded a deduction for fines would be undesirable for social policy reasons and to prevent a possible reversal of the approach taken in first instance in Madad Madad, it enacted the predecessor section to s 26-5 ITAA 1997, which denies a deduction for a penalty imposed under an Australian or foreign law. Thus, the position taken by the Full Federal Court in Madad coincided with the position adopted by Parliament when it enacted the predecessor to s 26-5, although the decision was based on different reasons. If it happened today: If the facts in the case were to occur today, the deduction would be denied under s 26-5. It remains uncertain, however, what exactly constitutes a penalty imposed under Australian law. In particular, it is not clear whether penalties imposed by bodies other than governments but established under a law might be included in the prohibition. It is also not clear whether a court would adopt the approach used in Madad to deny a deduction for penalties imposed by non-government bodies or whether the obiter reasoning in Magna Alloys would be used to allow deductions for penalties that are not formal fines imposed by a court.

© Thomson Reuters 2019

173

AUSTRALIAN TAXATION LAW CASES 2019

Legal Expenses for Alleged and Actual Illegal Activities FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431 (Full High Court)

Facts: The taxpayer built and marketed houses in Perth. Following allegations in the WA Parliament of improper business tactics by the taxpayer, a Royal Commission was established to investigate the taxpayer’s activities. The taxpayer incurred expenses for public advertising to counter the allegations made and for legal representation before the Royal Commission. Its claim to deduct the expenses was denied by the Commissioner on the basis that they were not necessarily incurred in carrying on its business. Decision: The High Court allowed the taxpayer’s appeal, holding the expenses were necessarily incurred in carrying on its business. Allegations of wrongdoing are an incident of business and whether the taxpayer was guilty or innocent of the allegations, it was appropriate for it to defend itself against claims that impinged on its ability to carry on its business. Relevance of the case today: In the early days of Australian income tax law, the Commissioner relying on earlier UK precedents often argued that expenses related to actual or possible wrongdoings including damages for civil wrongs, fines for criminal wrongs, and legal expenses and related outgoings incurred in proceedings for civil or criminal actions should be treated as expenses falling outside the course of business. The Snowden & Willson case became an important precedent to support the deductibility of legal expenses and ancillary expenses incurred in respect of alleged wrongdoings and was later read as supporting deductions for legal expenses in respect of criminal proceedings. Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276; 80 ATC 4542 is more directly on point for the latter issue but as a Full High Court decision, Snowden & Willson remains a key precedent whenever the question of deductibility of expenses connected to business wrongdoings is examined. If it happened today: If the facts in Snowden & Willson were to arise today, there is no doubt that the taxpayer would be allowed to deduct the expenses under s 8-1(1)(b) ITAA 1997.

Magna Alloys & Research Pty Ltd v FCT

(1980) 11 ATR 276; 80 ATC 4542 (Full Federal Court)

Facts: The taxpayer was a company that had apparently used illegal sales promotions tactics to increase its sales. The company and its directors were charged with criminal offences, though the charges against the company were later dropped. The directors of the company arranged for the company to pay for their legal expenses. The company sought to deduct the amount paid as business expenses and the Commissioner denied the deduction on the basis that the primary purpose of the directors was to benefit themselves by having the company pay the lawyers’ fees and that legal expenses related to criminal activities should be non-deductible on an application of the UK fines non-deductibility doctrines (see Madad Pty Ltd v FCT (1984) 15 ATR 1118). 174

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

Decision: The Court said that in some cases the subjective intention of the taxpayer may be a factor in evaluating whether an expense has sufficient nexus with the derivation of assessable income to satisfy the positive limbs of s 51(1) ITAA 1936, the predecessor section to s 8-1 ITAA 1997, but in this case the primary motive of the company’s directors (to benefit themselves) did not determine whether the company’s expense had sufficient nexus with the derivation of assessable income. From the company’s perspective, protecting the company’s directors protected the company’s standing and its ability to continue trading so it was in the company’s interest to protect the directors, whatever their motives might have been. A sufficient nexus was thus established. The Court also rejected the argument that the UK non-deductibility of fines doctrine would prevent deductibility of legal expenses for criminal acts. (In fact, two judges, Deane and Fisher JJ, questioned in obiter whether the doctrine should continue to be applied to fines in Australia.) Relevance of the case today: While the decision in Magna Alloys is concerned with a relatively narrow issue, the deductibility of legal expenses, the case continues to be cited for the broader principles it established, namely the articulation of a business judgment rule – an expense has a sufficient nexus with the derivation of assessable income to satisfy the requirement of s 8-1(1)(b) if the persons responsible for carrying on the business view it as desirable or appropriate for the pursuit of the business ends of the business. This approach guides most deduction cases today apart from those involving tax minimisation schemes. If it happened today: The pragmatic approach adopted by the court in Magna Alloys continues to be used and if the same facts arose today, the employer would be allowed to deduct the costs of legal expenses incurred on behalf of directors. However, if the facts arose today, the payment of legal fees might be treated as a fringe benefit within the definition in s 136(1) FBTAA and subject to tax payable by the employer under the Fringe Benefits Tax Assessment Act. Through a complicated route, a director of a company is an employee of the company for fringe benefits tax purposes (in s 136(1) FBTAA, an “employee” includes a “current employee”, defined as a person receiving “salary or wages”, which in turn includes a payment to a director). The payment of legal fees would be a “benefit” and a “fringe benefit”. Depending on the arrangements, the payment could be characterised as an expense payment fringe benefit if the obligation to pay the legal fees rested with the directors (s 20 FBTAA). The taxable value of the benefit would then be the amount of the payment under s 23 FBTAA. If the company had engaged the lawyers, the benefit would not be one of the specific benefits described in Divisions 2 to 11, and it would fall to be a residual fringe benefit under s 45 FBTAA. The benefit would be defined as an “external non-period residual fringe benefit” and its value under s 50 FBTAA would be the amount paid by Magna Alloys for the legal services provided to the directors. However, the taxable value of the fringe benefit can be reduced under the “otherwise deductible” rule (s 24 FBTAA for expense payment fringe benefits and s 52 FBTAA for residual fringe benefits) if the directors could have deducted the legal fees had they paid them personally. Following Magna Alloys, it is clear that a company could deduct the legal expenses incurred on behalf of its employee/directors. It is not clear, © Thomson Reuters 2019

175

AUSTRALIAN TAXATION LAW CASES 2019

however, whether employees would be able to deduct their own legal expenses if they had incurred them directly. There is considerable inconsistent case law on analogous expenses incurred by self-employed persons and it is difficult to predict how a court might treat a claim for deductibility of legal expenses incurred by employees related to criminal charges arising out of their employment. If the facts in Magna Alloys arose today and the company were assessed for fringe benefits tax, the taxpayer would argue the expenses were “otherwise deductible” by extending the approach used in Magna Alloys to individual employees. Countering that argument, the Commissioner would most likely argue, by analogy with fines cases, that had the expenses been incurred directly by the taxpayers, they would have been “quasi-personal” expenses, incurred in a personal capacity and not in the derivation of assessable income. Section 26-54 ITAA 1997, which denies taxpayers deductions for expenses incurred in the furtherance of, or directly in relation to, the physical element of a criminal offence would not apply to legal fees incurred in respect of criminal charges.

FCT v Day

(2008) 236 CLR 163; 70 ATR 14; 2008 ATC 20-064 (Full High Court)

Facts: The taxpayer was a customs officer who had been charged with failure of duty under the Commonwealth Public Service Act 1922. He incurred expenses for legal advice and representation as a result of the charges. The taxpayer was transferred and demoted after the charges were proven. The taxpayer’s demotion was confirmed upon his appeals which resulted in the taxpayer being moved to a position with higher pay than the position to which he had been demoted originally. Legal expenses were also incurred in connection with other charges which led to a suspension from duties for the taxpayer. The Commissioner conceded that an employee’s legal expenses incurred in connection with charges of misconduct have been held to be deductible where the charges reflected the day-to-day aspects of the employment but he argued that the expenses in this case related to improper conduct that was outside the taxpayer’s duties. Decision: The High Court distinguished between expenses that might be incurred by an employee in relation to criminal or civil proceedings generally and expenses related to charges that are based on a law such as the Public Service Act which directly governs the employee’s conditions of employment. A taxpayer facing charges under the Public Service Act is exposed to charges based on his or her office. As there is a direct connection between the charges and the taxpayer’s employment, legal expenses related to the charges are incurred in deriving assessable income and are deductible. Relevance of the case today: The Day case is important for two reasons. First, it can be used to support a claim by an employee for a deduction for legal expenses incurred in respect of charges of misconduct based on a law that governs the employee’s conditions of employment. Second, it might be cited to support an argument that expenses incurred in respect of other criminal law or civil law are not deductible merely because being found guilty or liable would affect the person’s employment. This argument would have to be made with caution. While the High Court did distinguish between these two types of legal expenses, it did not have to address directly the question of whether this second type of expense could be deductible in some circumstances. 176

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

If it happened today: Based on the Day precedent, a court would allow a taxpayer to deduct legal expenses arising out of charges of misconduct where the charges are based on a law that directly governs the taxpayer’s conditions of employment.

Expenses Incurred by Illegal Businesses FCT v La Rosa

(2003) 53 ATR 1; 2003 ATC 4510 (Full Federal Court)

Facts: The taxpayer was a convicted drug dealer who was engaged in the illegal business of dealing in heroin. The taxpayer had failed to lodge income tax returns for seven years and was issued with default assessments for those years. The taxpayer objected to the assessments, seeking a deduction for a cash amount which had been stolen in the course of an attempted purchase of drugs, under the authority of Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344. The Commissioner argued that this deduction should be denied on public policy grounds by extending the arguments which had applied to deny deductions for fines and penalties. Decision: The Court held that the deduction should be allowed. The Court first considered the treatment of income derived from illegal activities and confirmed the widely accepted notion that the legality or illegality of a receipt does not determine its assessability. Once concerns of legality were set aside, a loss by or arising from theft would be deductible under s 8-1 ITAA 1997 under the authority of Charles Moore where the loss is relevant to the income earning activity. The AAT had concluded that this theft loss was relevant to the drug dealing business. The Court then considered whether the loss was capital in nature and concluded that the cash was a revenue asset of the business and the loss was therefore revenue in nature. The Court distinguished the treatment of fines and penalties from trading expenses incurred in carrying on an illegal business and concluded that the Commissioner’s argument for extending the public policy argument must fail. Relevance of the case today: This decision was the first in Australia to consider the treatment of ordinary trading expenses incurred in carrying on a wholly illegal business and built on the authority of Magna Alloys. The comments of the Court are also relevant in that they express a reluctance of the Federal Court to apply public policy arguments to deny deductions where there is not an express provision in the legislation (such as s 26-5 ITAA 1997 which denies deductions for fines and penalties). Subsequent to the case, the legislature enacted s 26-54 ITAA 1997 to overturn the effect of the decision in La Rosa. Section 26-54 denies taxpayers a deduction for expenses incurred in the furtherance of, or directly in relation to, a physical element of an offence if the taxpayer is convicted of the offence and was or could have been prosecuted on indictment. However, the La Rosa decision continues to be a precedent for expenses incurred in the course of committing a crime that will yield assessable income where the taxpayer has not been convicted for any reason or where the crime is not sufficiently serious to be prosecuted on indictment. If it happened today: If the facts of La Rosa occurred today, s 26-54 would deny the taxpayer a deduction for the expense. © Thomson Reuters 2019

177

AUSTRALIAN TAXATION LAW CASES 2019

Repaying Clients’ Losses from a Partner’s Defalcations C of T (NSW) v Ash

(1938) 61 CLR 263 (Full High Court)

Facts: The taxpayer was a solicitor whose partner had committed a fraud on clients of the firm. The taxpayer was jointly and severally liable for professional liabilities of the partner and when the partner was declared bankrupt, it fell to the taxpayer to make good the clients’ losses. The taxpayer reached a settlement with the clients under which he was obligated to pay an agreed amount by way of instalments. He sought a deduction for the payments. Decision: The High Court concluded the payments were outgoings not incurred in gaining or producing assessable income. They were made to satisfy an obligation arising from a past wrong by a partner and were an incident of partnership liability. The personal liability resulting from the fraud of the partner was distinguished from the payments to replace losses caused by dishonesty or wrongdoing of employees, which would be deductible. Relevance of the case today: The ATO continues to rely on the case as authority for denying deductions to taxpayers with similar expenses but it is not clear that the same result would follow today if the issue were reconsidered by the High Court. If it happened today: Although it is not to be found explicitly in the judgment of the High Court in Ash, some commentators have subsequently explained the decision on the basis of a moral reasoning by the Court, implying a partner should have to bear the cost of choosing a dishonest partner while expenses related to dishonest employees would be deductible. Since this case, there has been a shift by Australian courts in respect to analogous expenses that had once been considered quasi-personal outgoings because they involved payments for wrongdoings such as damages. An Australian court hearing a case today involving the same facts as Ash would most likely feel obligated to follow the High Court’s precedent in Ash. However, if the issue were appealed to the High Court, it is not clear that the same result would follow given the shift by Australian courts with regard to expenses resulting from wrongdoing and, importantly, the possible influence of the Supreme Court of Fiji in Sweetman v Commissioner of IR (1996) 34 ATR 209; 96 ATC 5107. Faced with the issue afresh, the High Court might distinguish newer cases from the facts in Ash and in this way indirectly effectively overturn the doctrine derived from Ash.

Sweetman v Commissioner of IR (Fiji)

(1996) 34 ATR 209; 96 ATC 5107 (Supreme Court of Fiji)

Facts: The taxpayer was a lawyer whose partner had misappropriated funds from partnership trust accounts. The taxpayer was required to reimburse clients for the misappropriated funds and sought a deduction for the repaid amounts. The taxpayer argued that he would not be able to continue to practise if he did not make the payments and they were therefore incurred wholly for the purpose of his profession. The Commissioner argued the expenses related to an act by the taxpayer’s partner 178

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

acting outside his business capacity and the precedent of C of T (NSW) v Ash (1938) 61 CLR 263 should govern the result of the case. Decision: The Supreme Court of Fiji allowed the taxpayer’s appeal, holding that today the risk of misappropriation by a partner in a business is a natural incident of the carrying on of a business or profession and a repayment of stolen funds should not be treated differently if the theft was by an employee or a partner. In both cases, making good on the loss is an expense incurred in carrying on a professional business. Relevance of the case today: A Fijian Supreme Court decision is not binding in Australia, although a decision of the Court when three respected jurists are sitting as the Court will be persuasive. This decision may be particularly influential because one member of the three judge panel was a former Chief Justice of the High Court of Australia. Thus, if this issue is litigated again today in Australia, the Sweetman case would certainly be cited by the taxpayer seeking to overturn the non-deductibility rule based on Ash. If it happened today: If the facts in Sweetman were to arise in Australia today, the outcome would depend on whether the court felt bound by the Ash precedent or whether it thought it could distinguish Ash and apply the approach taken in Sweetman. At a lower level first instance hearing, the court would be more likely to feel bound by Ash. If the issue were appealed to the High Court, that Court might shift from the approach used in Ash to that used in Sweetman.

BUSINESS INDICIA �� HOBBY OR PERSONAL EXPENSES The many generous tax rules applying to various types of primary production prompt many individuals to enter into arrangements that will allow them to access some of the primary production concessions. Often, they do not undertake the primary production activities themselves, but instead invest an amount in a managed scheme which hires a manager to carry out activities on behalf of a large group of individuals. The benefits of primary production tax concessions could be substantially leveraged if the taxpayer were able to take an upfront deduction for prepaid management fees. The prepayment rules now prevent upfront deductions for most types of prepaid agricultural management fees, though these upfront deductions are possible for investments in some types of forestry projects. Whether a taxpayer undertakes activities directly or through a manager, the question arises as to whether the taxpayer is actually carrying on a “business” or whether the activities are in the nature of a hobby or non-business activity. Expenses related to the activity are deductible if the taxpayer is carrying out a business and not in the latter case. However, since 2000, deductions have been subject to “non-commercial loss” rules in Division 35 ITAA 1997, which may require the taxpayer to carry forward losses from a primary production business to be deducted only from income from the same type of business.

© Thomson Reuters 2019

179

AUSTRALIAN TAXATION LAW CASES 2019

Thomas v FCT

(1972) 3 ATR 165; 72 ATC 4094 (High Court)

Facts: The taxpayer, whose chief occupation was that of a barrister, acquired three adjoining blocks of rural land and constructed a home on the property. The land was not purchased for the purpose of farming but the taxpayer later discovered it was fertile. He therefore decided also to cultivate the land by planting pear, nut and pine trees. No income had yet been generated as the trees were not fully mature but the taxpayer argued he was carrying on a business of primary production and therefore should be entitled to various business deductions. The issue was whether the activities carried on by the taxpayer were a business or, alternatively, a hobby or activities in preparation for the commencement of a business. Decision: The taxpayer was carrying out a business of primary production. Even though the activities were conducted in a small way, the trees were planted on a scale much greater than that necessary to satisfy the taxpayer’s own domestic needs. It was also relevant that the taxpayer had satisfied himself, after gathering the relevant information, that there were reasonable grounds to believe that there was a ready market for the produce and it would yield a significant return. The fact that the taxpayer was not efficient in his efforts did not prevent the conclusion that he intended to, and did, carry on a business. The facts were distinguished from Southern Estates Pty Ltd v FCT (1967) 117 CLR 481 because the taxpayer was not merely getting land ready for use in business, but the trees had been planted and were growing. Relevance of the case today: The case is often quoted for the following statement: “But a man may carry on a business although he does so in a small way.” It is relevant for the conclusion that a small scale activity, when carried on as a business, may be considered a business even if it does not generate any income in the period. If it happened today: A court would likely still conclude that the activities were that of a business. However, if the activity generated an overall loss for an income year, the non-commercial loss rules of Division 35 ITAA 1997 would be triggered. It should be noted that the deferral of deductions under Division 35 does not apply to a primary production business where the taxpayer’s assessable income from other sources is less than $40,000 (see s 35-10(4) ITAA 1997 1997). It would also be relevant under the facts presented by Thomas to consider the application of the real property test (s 35-40 ITAA 1997) as the value of the property considered used in carrying on the business must 1997 be reduced for any dwelling and adjacent land used for private purposes in association with the dwelling.

Ferguson v FCT

(1979) 9 ATR 873; 79 ATC 4261 (Full Federal Court)

Facts: The taxpayer was a member of the Royal Australian Navy. The taxpayer intended to purchase a rural property and engage in full-scale cattle production on his retirement in two or three years. In anticipation of his retirement, he sought to establish a nucleus of a herd which could eventually transfer to a property he would own. The taxpayer entered into an agreement whereby he sub-leased five identified 180

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

heifers for a term of four years. He entered into another agreement whereby a manager would manage the heifers, their progeny and descendants for a term of 10 years. The taxpayer acquired beneficial ownership in any cattle born to the leased heifers and the manager arranged for agistment of the cattle. The taxpayer submitted that he was carrying on a business and sought deductions for various expenses incurred including leasing fees, insurance, artificial insemination fees, agistment fees, cattle society fees and the costs of periodicals. The Commissioner denied the deductions on the basis that the taxpayer intended to carrying on a business in the future but that the business had not yet commenced. Decision: The taxpayer was carrying on a business and the deductions were allowable. Fisher J noted that a person may conduct a business of a limited nature where the activities are in preparation for the conduct of another business on a larger scale. Here the activities had a commercial flavour and they were conducted systematically and in a business-like manner. The majority of the day-to-day activities were carried on by the manager but the manager was carrying out these activities as agent for the taxpayer and provided monthly reports to the taxpayer, which he read. The taxpayer also maintained records and a ledger of income and expenses. Relevance of the case today: This case is relevant for its discussion of the relevant factors to be considered in determining whether expenses of a taxpayer are incurred in a business. Unlike other cases such as Thomas v FCT (1972) 3 ATR 165; 72 ATC 4094, in this case the Commissioner did not argue that the actions of the taxpayer were merely a hobby; the case was argued on the basis that the actions were preliminary to the commencement of the business. However, the judgment largely turns on whether the taxpayer was carrying on a business and the factors looked at to support the taxpayer’s argument provide a useful checklist of factors a court will consider when faced with a personal/business borderline case: profit-making purpose; business-like manner; keeping of books and records; overall system to activities; repetition and regularity in activities; volume of operations; and the amount of capital employed. If it happened today: If the facts of Ferguson were to occur today, the Commissioner would pursue the argument that the taxpayer was merely involved in a hobby and not a continuing business. A court could still conclude that a business is being carried on but where, as under these facts, an overall loss is generated, Division 35 ITAA 1997 (the non-commercial loss rules) would be triggered, effectively deferring the recognition of the loss until the same or a similar business generates overall profits.

FCT v Walker

(1985) 16 ATR 331; 85 ATC 4179 (Supreme Court of Queensland)

Facts: The taxpayer was a salaried employee who acquired a single pure-bred female Angora goat with the intention of using it for breeding purposes via an embryo transplant process. The procedure required expert management of the animal and veterinarian assistance with the embryo processing. The taxpayer purchased the animal from a stud farm and left the goat on the farm for management by the farm. He sought deductions for his losses over the following three years. The Commissioner denied the deductions © Thomson Reuters 2019

181

AUSTRALIAN TAXATION LAW CASES 2019

on the basis that the taxpayer was not in the primary production business with a single goat. Decision: Relying on the precedent in Ferguson v FCT (1979) 9 ATR 873; 79 ATC 4261, the Court concluded the taxpayer was in the primary production business. He had sought expert advice on his investment and had business projections that showed he expected to turn an overall profit after three years. Relevance of the case today: The Walker decision reinforced the approach taken by the Court in Ferguson and showed that an investment of even a single animal could constitute a primary production business if the taxpayer had evidence of business attributes including evidence of preliminary investigations, development of business plans, and continued reliance on appropriate experts for guidance and day-to-day management. However, more recent decisions such as Vincent v FCT (2002) 51 ATR 228; 2002 ATC 4742 (see Chapter 18) have shown a tendency by the Federal Court to impose somewhat more strenuous requirements on taxpayers seeking to show they are in the primary production business through limited investments in animals managed by other persons. Also, since 2000 deductions for primary production losses have been subject to the non-commercial loss rules in Division 35 ITAA 1997 and the losses may only be deducted from non-primary production income if one of the exception tests in Division 35 is met. If it happened today: While the Walker case and earlier Ferguson case remain good law, there has been a more recent tendency by courts to require more evidence of business intent and structure before an individual with a single goat managed by another person would be considered to be in the primary production business. However, if the same facts as in Walker arose today, the taxpayer might be able to satisfy a court that he or she is in the primary production business on the basis of his collection of information from expert advisers and the development of a plausible business plan. The losses would be subject to the non-commercial loss rules in Division 35, preventing a taxpayer from deducting primary production losses from other income.

AVOIDANCE-TAINTED DEDUCTIONS A large number of deduction cases involve situations where an expenditure is incurred for dual purposes. There appears to be a clear connection between the outgoing and an anticipated derivation of assessable income or between the expense and carrying on of a business. At the same time, however, the expense is incurred in a way that, it appears, is intended to minimise the taxpayer’s income tax liability. For example, a taxpayer may buy trading stock for use in its business (the legitimate business purpose) but pay twice what it would otherwise pay with the object of shifting its profits to a related person supplying the trading stock (the tax minimisation purpose). In these cases, the Commissioner will attack the deduction on the basis that none of the expense should be deductible as the main purpose is tax minimisation, or in the alternative the expense should be apportioned using the “to the extent” language in s 8-1(1) ITAA 1997, or that the deduction should be denied on the basis of the general anti-avoidance rule in Part IVA ITAA 1936. 182

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

A large number of “deduction” cases involve what are sometimes referred to as “dual purpose” outgoings – incurred apparently in deriving assessable income but at the same time incurred as part of an overall arrangement whose main purpose appears to be tax minimisation. A variety of arrangements fall into this camp including timing mismatch, character mismatch, and income-shifting arrangements. In the first case, taxpayers will seek a deduction for an outgoing that is related to future income. By bringing forward recognition of expenses and deferring recognition of resulting income, the taxpayer can enjoy significant tax savings that can be used to fund new investments or personal consumption. In the second case, taxpayers will seek a deduction for a revenue expense incurred to derive a capital gain. The object is to take the deduction in full while the resulting gain will be subject to a concessional part exclusion. In the third case, taxpayers seek to shift income from a higher bracket taxpayer to a lower bracket taxpayer, from an entity with profits to an entity with losses, or from a domestic entity subject to higher tax rates to a related offshore entity subject to lower tax rates. Apparent dual purpose expenses of the type described above have an avoidance flavour to them—their form alerts the Commissioner to the possibility that the expenditure has a tax minimisation objective as well as its notional income derivation purpose. Quite often, the Commissioner takes a multi-pronged approach to denying deductions in these cases. In the first instance, the Commissioner may argue the expense fails to satisfy either of the positive limbs to s 8-1 ITAA 1997 (or predecessor s 51(1) ITAA 1936) because it is incurred in the course of tax minimisation rather than in the course of deriving assessable income or in a business that derives assessable income. At the same time, the Commissioner may argue that even if the expense prima facie satisfies a positive limb of s 8-1, the main object is the avoidance of tax and the deduction should be denied on the basis of the general anti-avoidance provisions in Part IVA ITAA 1936. Third, depending on the nature of the expense, the Commissioner may argue a deduction should be denied on the basis of the “personal or domestic” negative limb of s 8-1 on the basis that the object of tax reduction is a personal matter. Finally, if the expense relates to a long-term investment or a capital structure, the Commissioner may argue in the alternative that it is outside the positive limbs of s 8-1 and even if it is not it is a capital expense.

Income-Splitting Service Trust FCT v Phillips

(1978) 8 ATR 783; 78 ATC 4361 (Full Federal Court)

Facts: The taxpayer was a partner in an accounting firm who had, along with his fellow partner, established a service trust with each partner entitled to a portion of units in the trust equal to their proportional interest in the partnership. The units were acquired in the names of wives, family trusts and companies of the partners. The partnership then transferred its non-professional administrative and secretarial staff to the service trust and acquired from the trust all the services it used to acquire from the transferred persons as employees of the partnership. It also transferred its fittings and office equipment and leased these back from the service trust. The amount charged for the services by the trust significantly exceeded the amount previously paid by the firm when it acquired the services directly from its employees. The cost was, however, comparable to the cost of services charged by other outside agencies such as secretarial © Thomson Reuters 2019

183

AUSTRALIAN TAXATION LAW CASES 2019

agencies. The Commissioner denied the partners a deduction for the amount paid to the service trust on the basis that the expense was incurred for tax minimisation purposes and not in the course of gaining assessable income. Decision: Based on the fact that the amount paid to the service trust was not excessive in terms of the price charged for the services from unrelated third parties, it could not be said that the expenses were incurred for a collateral or second purpose apart from gaining assessable income. Relevance of the case today: When the Phillips case was decided, it was seen by many commentators as supporting the “legal rights” doctrine used in cases such as FCT v South Australian Battery Makers Pty Ltd (1978) 14 CLR 645; 8 ATR 879; 78 ATC 4412 and Europa Oil (NZ) Ltd v CIR (NZ) (No 2) (1976) 1 WLR 464; 5 ATR 744; 76 ATC 6001. Under this doctrine, a court could not look beyond the legal rights obtained by a taxpayer in return for an outgoing to find a subsidiary benefit or purpose to the payment. Later cases substantially read down this doctrine and provided a means for courts to find dual purposes to outgoings and apportion the deduction where it appeared an arrangement had been established in part to minimise taxes. The Phillips case developed into a precedent for the proposition that the Commissioner could not look beyond the apparent purpose for an outgoing to a related service entity where the amount paid was consistent with the amount that an unrelated commercial provider would charge for the same services. If it happened today: Courts continue to use Phillips as the benchmark for allowable deductions to related service entities and when facts similar to those in Phillips arise today, courts allow deductions for the cost of acquiring services provided the amount paid is not excessive in terms of what an unrelated service provider would charge for the same services.

Transfer Pricing A common form of international tax minimisation is through transfer pricing arrangements. Under a tax minimisation transfer pricing arrangement, goods or services from abroad are routed through a connected entity located in a tax haven. The entity in the tax haven overcharges the Australian entity for the goods or services provided to the taxpayer in Australia which deducts the cost of the acquisition so taxable income is reduced in Australia and profits are increased in the related tax haven company. In Australia, the Commissioner can now use Division 815 ITAA 1997 to combat tax avoidance by means of transfer pricing but in some jurisdictions the revenue authority has tried to limit deductions for acquisitions from related companies in tax havens using the ordinary deduction provision. While not directly applicable to transfer pricing cases in Australia, these cases played an important role in Australia as precedents for the interpretation of s 51(1) ITAA 1936, the predecessor to current s 8-1(1) ITAA 1997.

184

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

Inland Revenue Commissioners v Europa Oil (NZ) Ltd (No 1) [1971] AC 760; 70 ATC 6012 (Privy Council)

Facts: The taxpayer was a New Zealand petroleum distributor that wished to purchase imported refined petrol. At the time there was a notional fixed price for petrol known as the “posted” price but suppliers found ways to sell for a lower price so that the true market value price to the taxpayer would have been below the notional posted price. The taxpayer entered into negotiations with a subsidiary of the Gulf Oil Company and as a result of those negotiations the taxpayer and Gulf established a jointly owned company in the Bahamas called Pan Eastern. Gulf sold the petrol to Pan Eastern and then repurchased it at a premium to the original price, leaving Pan Eastern with a profit. Gulf then sold the petrol to the taxpayer at the notional posted price and the taxpayer claimed a deduction for the full cost of the petrol as the cost of trading stock. The Commissioner denied the taxpayer a deduction for the full cost of the trading stock. He argued that the taxpayer’s contract with Gulf must be considered in conjunction with the arrangements between Gulf and Pan Eastern and the taxpayer’s interest in Pan Eastern. If the arrangements were viewed in their entirety, the Commissioner argued, part of the price for the trading stock was incurred to transfer profits from the taxpayer to a related company in the Bahamas. As that part was incurred for a purchase other than the acquisition of trading stock, it should not be deductible under the New Zealand equivalent to s 51(1) ITAA 1936 or s 8-1(1) ITAA 1997. The Commissioner appealed to the Privy Council from an adverse decision of the NZ Court of Appeal. Decision: A majority of the Privy Council found that the agreement between Gulf and the taxpayer involved an interdependence of obligations and benefits under a complex of separate contracts which operated as one contractual whole. Viewed in this light, the payments by the taxpayer were incurred partly for the acquisition of trading stock and partly for the purpose of shifting profits to the related company in the Bahamas. Accordingly, the Commissioner was entitled to deny a deduction for part of the purchase price. Relevance of the case today: Subsequent to the Europa (No 1) case, the taxpayer and Gulf established a different arrangement that was accepted by a differently constituted Privy Council in Europa Oil (NZ) Ltd v CIR (NZ) (No 2) [1976] 1 WLR 464; 5 ATR 744; 76 ATC 6001 (see below). The second Europa decision heralded a shift in Australian jurisprudence to the use of literalist interpretations and a “legal right” doctrine applied to deduction cases. Under this doctrine, courts would look only at the legal rights obtained under a contract and not explore the subsidiary benefits acquired through a payment. The interpretation doctrine pendulum eventually swung away from this extreme view back to a view that courts could look at the larger picture to see if there was a tax minimisation motivation behind an expense but it has been these later cases cited as authority for this approach, not the earlier decision in Europa (No 1) that first set out this approach. The original decision is thus not an important precedent today. If it happened today: If the facts in Europa (No 1) arose in Australia today, the pricing arrangements could be negated under Division 815 of the ITAA 1997. The arrangements would be seen to yield a transfer pricing benefit as defined in s 815-120 ITAA 1997 and an arm’s length price would be substituted under s 815-115 ITAA 1997. © Thomson Reuters 2019

185

AUSTRALIAN TAXATION LAW CASES 2019

The Commissioner might also seek to attribute part of the income derived by Pan Eastern to the taxpayer using the attribution rules in the Part X ITAA 1936 controlled foreign corporation (CFC) regime. However, it may not be possible to attribute the income if it is determined that Pan Eastern is able to pass the active income test in s 432 ITAA 1936. The Commissioner could also apply the general anti-avoidance rule in Part IVA ITAA 1936 to the larger scheme. The interposition of Pan Eastern into the arrangements appears to have the main purpose of facilitating a tax minimisation arrangement and as such should be sufficient to trigger the application of Part IVA and allow the Commissioner to deny the taxpayer a deduction for the full cost of the purchased petrol.

Europa Oil (NZ) Ltd v CIR (NZ) (No 2)

[1976] 1 WLR 464; 5 ATR 744; 76 ATC 6001 (Privy Council)

Facts: The facts in Europa (No 2) are similar to those described in Europa (No 1), above. The key difference is the interposition of another company in the same group of companies as the taxpayer. Rather than purchasing trading stock directly from Gulf, the taxpayer purchased its trading stock from another company in the company group and that other company purchased the trading stock from Gulf. The taxpayer sought to deduct the entire amount paid to the group company for petrol on the basis that the changed arrangements distinguished the case from the earlier Europa (No 1) case. Decision: The appeal in Europa (No 2) was heard by a differently constituted Privy Council which included the Australian High Court judge Sir Garfield Barwick. Sir Garfield had championed the strict literalism approach of the Australian High Court and in particular its adoption of the “legal rights” doctrine that required courts to look only at the actual legal rights acquired as the result of an outgoing without regard to any subsidiary benefits or arrangements not set out in the contract itself. The Privy Council found in favour of the taxpayer using the legal rights doctrine after finding that the only legal right set out in the contract was the right to have petrol delivered to the taxpayer. Relevance of the case today: Europa (No 2) was an important precedent in Australia in the later half of the 1970s as Australian courts endorsed the legal rights doctrine set out in that case when applying s 51(1) ITAA 1936 (currently s 8-1(1) ITAA 1997 1997). Later Australian Federal Court cases substantially wound back the legal rights doctrine and the significance of Europa (No 2) as a precedent for interpreting s 8-1(1) has diminished as a result. If it happened today: If the facts in Europa (No 2) arose in Australia today, the Commissioner’s options would be similar to those described above in the context of Europa (No 1).

186

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

Purchase Price Paid as Revenue Outgoing In the 1970s the Australian High Court adopted a doctrine of interpretation in tax cases sometimes known as “literalism” or the “legal rights” doctrine. Applying these doctrines, the Court would decline to look beyond the legal form of a transaction and the legal rights acquired by a taxpayer as a result of payments for what appeared on the surface to be ordinary revenue expenses. Taxpayers devised a large number of avoidance schemes designed to obtain subsidiary benefits. One set of schemes involved payments such as deductible rent to acquire real property. The endorsement of such schemes by the High Court in particular prompted the legislature to adopt both specific anti-avoidance measures aimed at the schemes and a new general anti-avoidance provision. As later courts retreated from this narrow literalistic approach to interpreting s 51(1) ITAA 1936 (currently s 8-1(1) ITAA 1997 1997), the need for the anti-avoidance provisions diminished.

FCT v South Australian Battery Makers Pty Ltd

(1978) 14 CLR 645; 8 ATR 879; 78 ATC 4412 (Full High Court)

Facts: The taxpayer wished to acquire a new factory in South Australia. It entered into a lease arrangement that involved two elements. The first was a rental agreement for the property and the second was the grant of an option to purchase the property to another company belonging to the same group of companies as the taxpayer. The option agreement provided for an annual reduction of the purchase price by the amount by which the “rental” payments exceeded a threshold amount approximately equal to what would be the interest charge if the lessor had lent funds to the taxpayer to purchase the property and the taxpayer made payments on the mortgage loan. The Commissioner denied the taxpayer a deduction for the rental payments to the extent they reduced the purchase price of the property to the associated company holding the purchase option. He argued the additional amount paid by the taxpayer was a capital expense related to the acquisition of property. Decision: A majority of the High Court allowed the taxpayer a deduction for the full amount of the rental payments. The majority declined to attribute to the taxpayer any benefit from the payment to the extent the benefit accrued to the related company holding the purchase option. Relying on the “legal rights” doctrine set out in Europa Oil (NZ) Ltd v CIR (NZ) (No 2) (1976) 1 WLR 464, the majority concluded the only benefit acquired from the outgoing was rental of the property and the entire payment should therefore be deductible as an ordinary revenue expense. Relevance of the case today: South Australian Battery Makers was a leading precedent for the strict legal rights approach to interpreting the application of s 51(1) ITAA 1936 (currently s 8-1(1) ITAA 1997 1997). Australian courts have since retreated from the strict literalist approach taken in that Court and the importance of the case as a precedent has declined significantly. If it happened today: Subsequent to the South Australian Battery Makers case, specific anti-avoidance provisions were enacted to attack the type of avoidance scheme used in that case. If the facts arose today, s 82KJ ITAA 1936 would operate to deny the © Thomson Reuters 2019

187

AUSTRALIAN TAXATION LAW CASES 2019

taxpayer a deduction. However, it is likely that today the Commissioner could rely on the general anti-avoidance provisions in Part IVA ITAA 1936 to dissect the payments and deny a deduction for the portion of the payment that reduced the purchase price of the property. Also, some argue that if the facts arose today a court would distinguish the South Australian Battery Makers precedent and in a similar case apply a more modern approach of looking at direct and subsidiary benefits derived by a taxpayer when deciding whether the outgoing should be apportioned for s 8-1 purposes.

Income-Splitting Family Loan Ure v FCT

(1981) 11 ATR 484; 81 ATC 4100 (Full Federal Court)

Facts: The taxpayer borrowed funds on four loans. He was required to pay interest on the loans of 7.5%, 8.5%, 10% and 12.5%. He on-lent the borrowed funds to his wife and a family trust at an interest rate of 1%. He sought a deduction for the full interest deduction expense he incurred on the basis that the interest expenses were incurred in gaining the assessable income by way of the 1% return on the funds that he on-lent. Some of the borrowed funds were used by his wife and the family trust to discharge debts and the remainder was invested directly or indirectly in debt instruments paying competitive market interest rates. Applying the apportionment rule in s 51(1) ITAA 1936, the Commissioner limited the taxpayer’s interest deduction to interest of 1%, asserting that the remaining interest payment was incurred for a purpose other than in gaining assessable income. Decision: The Court concluded the taxpayer borrowed funds interest rates up to 12.5% per annum to lend at a rate of 1% per annum to benefit his wife and a family trust and to obtain a tax deduction for himself in respect of the interest incurred to achieve these goals. As the lending at the lower rate could only be explained by private and domestic considerations, it was appropriate to apportion the outgoing and only allow a deduction to the extent of the interest income and to treat the remaining interest expense as a private or domestic outgoing. Relevance of the case today: Section 51(1) does not refer to a taxpayer’s “purpose” in terms of the apportionment formula and the Court in Ure took care not to base the decision explicitly on a consideration of the taxpayer’s purposes. Nevertheless, it was clear that the Court looked at the purpose of the arrangements when concluding that most of the interest expense was a private or domestic outgoing. The Ure decision remains a useful precedent for courts seeking to look behind the legal rights doctrine and apportion expenditure on the basis of multiple objectives of a taxpayer when incurring an expense in an arrangement that is partly motivated by tax minimisation objectives. If it happened today: If the facts in Ure arose today, a court might apportion the interest expense on the same basis as the Court did in Ure. A similar approach was followed by the Full Federal Court in Fletcher & Ors v FCT (1992) 24 ATR 194; 92 ATC 4611 (involving interest paid on a loan used to purchase an annuity in a tax avoidance arrangement). In some later cases such as FCT v Firth (2002) 50 ATR 1; 2002 ATC 4346 (involving interest paid on a capital protected loan), the court did not apportion 188

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

on the basis of the benefits obtained from the loan, but this case is distinguishable because the borrowed funds in Firth were used to acquire an investment that was intended to generate a gain, unlike the case in Ure where the taxpayer used the funds in a way that could only generate a net loss despite the small amount of assessable income to be derived from the on-lending.

Prepayments One of the most common types of avoidance-tainted expense is a “prepayment” expense where the taxpayer prepays expenses to cover the provision of services or the use of money for a period of many years. If successful, a prepayment scheme can turn a pre-tax loss into an after-tax gain. This will occur, for example, if the future income is not as great as the current prepayment expense. If the taxpayer is allowed an upfront deduction for the prepayment, he or she can apply the tax savings to other purposes until the funds are used in the future to pay tax on the resulting income as it arises.

FCT v Ilbery

(1981) 12 ATR 563; 81 ATC 4661 (Full Federal Court)

Facts: The taxpayer borrowed $20,000 from Jas Curzon Pty Ltd, a company engaged in money lending operations. Under the terms of the loan, the money was lent unsecured at a rate of 14% pa interest with the principal repayable in 30 years. The loan also provided the option for the borrower to prepay 5 years of interest at the 14% rate within 24 hours of signing the agreement, at which point the interest for the balance of the term would be only 4%. On 22 June 1977 the taxpayer executed the loan agreement with Curzon and immediately thereafter exercised the option and handed Curzon a cheque to prepay the interest, for a total of $14,000. The taxpayer funded the $14,000 through an overdraft from his usual bank, the ANZ, at normal commercial rates. Curzon then assigned the loan to Futuro Pty Ltd, a family company of the taxpayer. On 23 June, the taxpayer deposited the $20,000 in his building society. On 25 June, the taxpayer entered into an agreement to purchase an income producing property, the purchase price being substantially funded by the money on deposit. The taxpayer sought to deduct the $14,000 of prepaid interest under s 51(1) ITAA 1936 (currently s 8-1(1) ITAA 1997 1997) in his return for the year ended 30 June 1977. The Commissioner denied the deduction. Decision: The Court held that the deduction was not available on the basis that the interest prepayment was not incurred in the course of gaining or producing assessable income. The Court considered it to be critical that at the time of the prepayment the taxpayer had not acquired any property from which he hoped to derive income. Thus, the taxpayer had incurred the expense before any income producing activity had begun. Although the taxpayer no doubt intended to use the money to purchase the property, the loan was unsecured and the taxpayer was free to use the funds as he chose. The prepayment played no part in the acquisition of the property. It was also noted as relevant that the only purpose the taxpayer had in making the prepayment was to access the tax advantages that the deduction would bring.

© Thomson Reuters 2019

189

AUSTRALIAN TAXATION LAW CASES 2019

Relevance of the case today: The decision in Ilbery may have limited application given the unusual circumstances presented by the facts. Had the loan been immediately applied to purchase the income producing property, which may be most often the case, the main basis for the decision could be avoided. However, while the actual decision is based on the time gap between the prepayment and the acquisition of property, the case is more often referred to as one holding that the prepaid interest was not deductible since the purpose was to obtain a tax advantage. A more difficult case would arise where the prima facie purpose of the expense is to produce assessable income but the purpose in accelerating the deduction by way of a prepayment is to obtain a tax advantage. The decisions in FCT v Gwynvill Properties Ltd (1986) 17 ATR 433; 86 ATC 4512, and FCT v Lau (1984) 16 ATR 55; 84 ATC 4929, can be contrasted in this regard. If it happened today: If the facts of Ilbery happened today, a court could still conclude that the interest prepayment was not deductible because the expense was incurred before any income-producing property was acquired. If the expense were considered to be deductible, the spreading rules applicable to prepayments would apply. Since the taxpayer in this case is an individual, s 82KZM ITAA 1936 would apply to spread the deduction over a ten year period, thereby significantly reducing the tax advantages of the prepayment.

Sale and Leaseback A sale and leaseback arrangement is often used by businesses seeking additional cash for business purposes. The entity will sell an asset it is using and enter into a lease or licence agreement to continue using it. There is thus no interruption in the use of the property, just a change in legal ownership and an obligation to make continuing payments. The Commissioner may seek to deny a deduction for the continuing lease or royalty payments where the arrangement appears to be tax motivated.

FCT v Just Jeans Pty Ltd

(1987) 18 ATR 775; 87 ATC 4373 (Full Federal Court)

Facts: The taxpayer carried on business as a clothing retailer. In an arrangement that was claimed to be undertaken to increase the borrowing power of the taxpayer, the management entered into a sale and licence back of its business name, “Just Jeans”, and its logo. Pursuant to an agreement, the taxpayer purported to grant the right to use the name and logo of Just Jeans to Wilverley Mansions IBV (a Dutch company) for $6m payable in instalments. Wilverley Mansions then granted back to the taxpayer an exclusive licence for an initial period of 3 years to use the name and logo in Australia for a fee of 4% of turnover, payable annually. If certain specified events occurred, the arrangement would effectively be unwound, with all outstanding liabilities released. The two parties agreed the licence fees would be offset against the instalment payments so no cash payments were needed. The taxpayer claimed the credits for instalment payments were non-assessable capital gains (prior to the adoption of CGT) while claiming deductions for royalty debits under s 51(1) ITAA 1936 (currently s 8-1 ITAA 1997 1997). The Commissioner submitted that the expenditure did not fall within the terms of the deductions section on the basis that the trade name was not property and 190

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

was incapable of transfer at law, therefore the purported instalment sale payments and licence payments were mere naked payments to be offset against each other with the purpose of obtaining a tax advantage being the deduction. Decision: The Court concluded unanimously that the outgoings were not deductible under s 51(1). The name of a business is one aspect of goodwill and there was no authority that a bare name could be transferred independently of goodwill, which can only be transferred with the business. Therefore no enforceable rights of any sort in the name or logo were transferred to Wilverley Mansions. In return, the taxpayer acquired no enforceable rights in return for making the payments—it had the right to use its own name initially and had not validly transferred that right, so it had nothing to show for its payments. In the view of the Court, where a taxpayer incurs expenditure in a way entirely divorced from the day-to-day conduct of the business, the relevant transaction has a strange and artificial air about it, the primary purpose of the transaction cannot be achieved as a matter of law, and a significant purpose in entering into the transaction is to reduce tax, the requirements of s 51(1) have not been met. Relevance of the case today: The decision in Just Jeans is an example of where s 8-1 can effectively operate as an anti-avoidance provision. The decision provides indicia of circumstances where the deduction will be denied, specifically the emphasis on the unusual and artificial nature of the arrangements and a purpose of obtaining a tax reduction. If it happened today: If the facts of Just Jeans were to occur today, a court would likely conclude that the royalties payments would not be deductible under s 8-1 ITAA 1997. It is also likely that the Commissioner would argue, alternatively, that the arrangements amounted to a scheme to avoid tax within the terms of Part IVA ITAA 1936. The term “scheme” for these purposes is broadly defined in s 177A ITAA 1936 to include arrangements, whether or not enforceable or intended to be enforceable, and would therefore seem to apply to this arrangement. The “tax benefit” (s 177C ITAA 1936) would arise from the royalty deductions claimed. 1936 The Commissioner would probably not be able to use the transfer pricing provisions in Division 815 ITAA 1997 to counter the scheme. It appears the parties were not related and were dealing at arm’s length. The tax benefit did not arise because the price paid was too high but rather because of the different characteristics claimed by the taxpayer in respect of the payments. The taxpayer claimed the outgoings were deductible while the offsetting receipts were non-assessable.

Eastern Nitrogen Ltd v FCT

(2001) 46 ATR 474; 2001 ATC 4164

Facts: The taxpayer entered into a sale and leaseback contract under which it sold plant to a financier and immediately leased it back again. The lease was structured as a finance lease that allowed the taxpayer to repurchase the property for a residual value at the end of the lease. For financial accounting purposes, a finance lease is treated as a sale by the lessor accompanied by a loan of the purchase price so each “lease” payment is dissected into interest payments and repayments of principal on the notional loan made by the lessor to the lessee. The taxpayer sought deductions for the entire lease payments, including the part that would be treated as the capital repayments of principal © Thomson Reuters 2019

191

AUSTRALIAN TAXATION LAW CASES 2019

under the accounting characterisation of the transaction. The Commissioner denied the deduction on a number of grounds, including the general anti-avoidance provisions in Part IVA ITAA 1936 on the basis that the dominant purpose for the transaction was to obtain finance while deducting the entire lease payments and under s 51(1) ITAA 1936 on the basis that the lease payments were partly capital outgoings related to the eventual reacquisition of the plant. Decision: The Full Federal Court agreed that the arrangements were made both to obtain financing through the initial sale and also to obtain access to the plant after it had been sold. The financing was used for revenue purposes and the plant was used for revenue purposes so the entire interest expenditure was deductible. The reduction in the future repurchase price worked by each payment of rent was too remote from the immediate advantages (the use of the plant and the use of a substantial amount of money) gained from the rental outgoings to affect their character as deductible expenses. Relevance of the case today: Eastern Nitrogen provides authority for the full deductibility of rental payments in ordinary finance lease transactions and in finance leases that are incorporated into sale and leaseback arrangements. If it happened today: If the facts in Eastern Nitrogen were to arise today, the taxpayer would continue to be allowed a deduction for the entire lease payments without regard to the fact that the lease in question is a finance lease or that the lease arose in a sale-leaseback arrangement.

Timing Mismatches Fletcher v FCT

(1991) 173 CLR 1; 22 ATR 613; 91 ATC 4950 (Full High Court)

Facts: The taxpayer entered into a tax effective scheme in which the taxpayer borrowed funds to purchase an annuity. The scheme was achieved through a round robin of cheques that involved little actual output by the taxpayer. The alleged tax effectiveness of the arrangement derived from the timing mismatch for tax purposes between the loan payments made by the taxpayer and the annuity payments received by the taxpayer (which went directly to pay the loan amounts due). Under the tax accounting rules applying to blended payment loans, a large part of the initial payments was treated as interest payments while a much smaller part of the offsetting annuity payment was treated as assessable income. The loan and annuity agreement provided the taxpayer with the option of collapsing the contracts and applying the proceeds from closure of the annuity to repay the loan before the annuity payments would generate assessable income in excess of the interest component of each loan payment. The Commissioner denied the taxpayer a deduction for the interest expense, originally arguing that there was no actual interest payment as there was simply an offsetting of the annuity payments against the loan obligation. Alternatively, the Commissioner argued the parties intended the arrangements to be collapsed before the assessable income component of the annuity payments exceeded the deductible interest on the loans so the taxpayer never had the intention of using the interest expense to gain assessable income. 192

© Thomson Reuters 2019

CHAPTER 7

GENERAL DEDUCTIONS

Decision: If the assessable income derived from an investment exceeds the deductible expenses incurred to derive that income, the outgoings can be treated as fully deductible under the first limb of s 51(1) ITAA 1936 (currently s 8-1(1) ITAA 1997 1997). However, if no assessable income can be identified or if the expenses will exceed the assessable income, it is appropriate to weigh the taxpayer’s objectives in incurring the expenses. If the facts show the expenditure was incurred to earn assessable income, it is deductible but if the facts show there were other objectives behind the expense, apportionment would be appropriate. In this case, if it could be concluded the taxpayer intended to collapse the agreements before the assessable annuity income exceeded interest expenses, a deduction should only be allowed to the extent of the assessable income gained by the taxpayer. If it could be concluded that the taxpayer intended to retain the annuity for its entire life and derive all the assessable income it would generate, the entire interest expense should be deductible. Ascertaining the taxpayer’s objectives was a question of fact and the High Court remitted the matter back to the Administrative Appeals Tribunal (AAT) for a finding of the facts. The AAT subsequently found at AAT Case 5489A (1992) 23 ATR 1068; 92 ATC 2045 that the taxpayer’s dominant purpose in incurring the expense was to minimise tax, not to gain assessable income. Relevance of the case today: Fletcher is an endorsement by the High Court of an application of s 51(1) and by extension s 8-1(1) that looks to the taxpayer’s purpose in incurring an expense when it appears the expense was incurred in the course of an arrangement unlikely to generate assessable income in excess of the outgoings. If it happened today: The scheme in Fletcher was possible only because of the timing mismatch between recognition of the interest component in blended loans payments and the assessable income component in economically identical annuity payments. If the facts in Fletcher were to arise today, the annuity would be a “qualifying annuity” as defined in s 159GP(10) of Division 16E ITAA 1936. As result, the annuity would be excluded from the operation of s 27H ITAA 1936 and subject to the operation of Division 16E. Had s 27H applied to the annuity, the taxpayer could have deferred recognition of assessable annuity income as happened in Fletcher. However, if Division 16E now applies to the annuity, the assessable income generated by the annuity would be recognised at the same rate as the interest component of the loan repayments. The income would thus offset the deduction, yielding no net deduction for the taxpayer.

Capital Protected Loans FCT v Firth

(2002) 50 ATR 1; 2002 ATC 4346 (Full Federal Court)

Facts: The taxpayer borrowed funds by way of “protected” investment loans and claimed a deduction for the interest expense incurred under the loans. Under the terms of the loans, the taxpayer could use the proceeds of the loans only to acquire “approved stocks” and the liability of the taxpayer was limited to the shares so obtained. Loans of this sort are called “protected loans” because the taxpayer’s obligation to repay the loan principals was protected in the sense that if the investments purchased with the loan funds fell in value, the taxpayer could sell the shares purchased with the loan and use the proceeds to satisfy his or her obligation with the lender suffering the loss on its loan principal. To protect itself, the lender charges a higher interest rate for limited © Thomson Reuters 2019

193

AUSTRALIAN TAXATION LAW CASES 2019

recourse protected loans than for ordinary loans where it has recourse to all assets of the borrower to obtain repayment of the entire loan principal. The higher interest charge may be applied to hedging arrangements or other means of protecting the lender from the limited recourse feature of the loans. The Commissioner argued that the interest should be apportioned and that the amount considered paid for the limited recourse feature should be characterised as on capital account and therefore not deductible. The issue before the Court was whether some of the interest payable on the loan was not deductible given the limited recourse against the taxpayer for repayment. Decision: The full amount of the interest was deductible. The loan documents did not support an argument that any portion of the interest was paid for the limited recourse feature and therefore it was not appropriate to apportion the interest outgoings. The taxpayer’s purpose in incurring the interest liability was to raise and maintain the borrowing, which was applied to acquire income producing assets. The non-recourse provisions were not distinct from the loan and were not severable from it. Relevance of the case today: The decision in Firth establishes the proposition that, unless otherwise specified in the agreement, interest is the unapportioned and composite consideration for the borrowing of funds under the terms specified and it is not consideration for separate obligations on the part of the lender or separate advantages conferred on the borrowed. While the specific arrangement in Firth has been addressed by a legislative amendment, the case can be used to support an argument against apportioning interest where a benefit apart from the limited-recourse benefit is incorporated in the loan. If it happened today: If the facts of Firth were to occur today, the taxpayer would not be allowed a deduction for the component of the interest expense referable to the capital protection feature as a result of Division 247 ITAA 1997.

194

© Thomson Reuters 2019

C HAPTER 8

Private and Domestic Expenses FOOD EXPENSES ................................................................................................ 197 Cooper (1991) ......................................................................................... 197 COMMUTING EXPENSES ................................................................................. 198 Lunney (1958) ......................................................................................... 198 Collings (1976) ........................................................................................198 John Holland Group (2015) ....................................................................199 TRAVELLING BETWEEN TWO PLACES OF WORK ................................... 200 Payne (2001) ........................................................................................... 200 EXPENSES TO MOVE TO A NEW PLACE OF EMPLOYMENT ................. 201 Fullerton (1991) ...................................................................................... 201 CHILD CARE EXPENSES .................................................................................. 201 Lodge (1972) ........................................................................................... 201 Martin (1984) .......................................................................................... 202 SELF-EDUCATION EXPENSES ........................................................................ 203 Hatchett (1971) ....................................................................................... 203 Highfield (1982) ...................................................................................... 204 Wilkinson (1983) ..................................................................................... 204 Studdert (1991) ....................................................................................... 205 Anstis (2010) ........................................................................................... 206 TRAVEL EXPENSES ............................................................................................ 206 Finn (1961) ............................................................................................. 206 HOME OFFICE EXPENSES ................................................................................ 207 Faichney (1972) ...................................................................................... 207 Handley (1981) ....................................................................................... 209 Forsyth (1981) ........................................................................................ 209 Swinford (1984)....................................................................................... 209 CLOTHING EXPENSES ...................................................................................... 210 Mallalieu v Drummond (1983) ............................................................... 211 Edwards (1994) ....................................................................................... 211 COSMETICS AND SUN PROTECTION EXPENSES ..................................... 212 Mansfield (1995) ..................................................................................... 212 Morris (2002) .......................................................................................... 213 © Thomson Reuters 2019

195

AUSTRALIAN TAXATION LAW CASES 2019

CHARITABLE GIFTS .......................................................................................... 214 McPhail (1968) ....................................................................................... 214

196

© Thomson Reuters 2019

C HAPTER 8

Private and Domestic Expenses Section 8-1(2)(b) ITAA 1997, prevents taxpayers from deducting private or domestic expenses. Most commentators believe such expenses fall outside the positive limbs in s 8-1(1) in any case and the prohibition thus only reinforces the non-deductibility of private expenses. No sharp lines mark the borderline between expenses incurred in gaining assessable income and private expenses. Without food, clothing, and housing, a person would not be able to participate in the workforce but the consumption of food, clothing and housing is clearly private consumption. Expenses can thus be necessary prerequisites to deriving income but still be private outgoings. The general rule often followed is that expenses which put a taxpayer in the position to earn assessable income are private while those incurred in the process of actually earning that income are deductible outgoings. In some cases, however, courts have allowed deductions for expenses not incurred directly in an income-earning process. Although, recently we have seen legislative intervention where there is some doubt as to the deductibility of expenses under s 8-1. For example, s 26-31 ITAA 1997 now prevents a loss or outgoing for travel incurred in gaining or producing assessable income from the use of a residential rental property. Such expenses were previously considered deductible.

FOOD EXPENSES FCT v Cooper

(1991) 21 ATR 1616; 91 ATC 4396 (Full Federal Court)

Facts: The taxpayer was a professional rugby player who was directed by his coach to eat more meat and drink beer to maintain his weight. He sought deductions for the additional meat and beer consumed. Decision: The Full Federal Court denied the taxpayer a deduction for the expense, finding it was a personal expense and further that it was incurred to enable the taxpayer to be in a position to be able to carry out his profession but was not incurred in the course of that activity. Relevance of the case today: Cooper may be cited as a precedent that reinforces a primary test often used by courts to distinguish private expenses from expenses incurred

© Thomson Reuters 2019

197

AUSTRALIAN TAXATION LAW CASES 2019

in gaining assessable income. An expense for goods or services that appears to be private is not incurred in gaining assessable income merely because it is a prerequisite to enabling the taxpayer to derive assessable income. Rather, a deductible expense should be incurred in the course of deriving assessable income. If it happened today: If the facts in Cooper arose today, a court would continue to hold that an expense for food incurred to enable a sportsperson to be able to train and play is a non-deductible personal expense.

COMMUTING EXPENSES Lunney v FCT

(1958) 100 CLR 478 (Full High Court)

Facts: The taxpayer sought to deduct the cost of commuting by public transport from his home in the suburbs to his place of employment in the city. The Commissioner denied the deduction on the basis that the expense was a personal outgoing of the taxpayer and further was not incurred in gaining assessable income. Decision: Relying on long-standing UK precedents, the Court found the expenses to be personal outgoings of the taxpayer, not incurred in gaining assessable income. Relevance of the case today: Lunney is the authority in Australia for the conclusion that commuting expenses are personal, non-deductible outgoings. It may be cited as authority for the broader proposition that expenses incurred to enable someone to be in a position to carry out work are not incurred in the gaining of income from that work. Lunney is also often cited as authority for an “essential character” test used in particular to characterise expenses that may be private or business outgoings. If the essential character of the expense is not an outgoing incurred in the course of gaining assessable income, it will be considered a private outgoing. If it happened today: If the facts of Lunney arose today, a court would continue to find the commuting expenses were non-deductible private or domestic outgoings.

FCT v Collings

(1976) 6 ATR 476; 76 ATC 4254 (Supreme Court of NSW)

Facts: The taxpayer was a computer consultant who worked primarily in the office of her employer. Outside of working hours, she was “on call” for the employer and was often required to attempt to solve problems from her location at home and if they could not be resolved from home to return to the office out of working hours to deal with problems that could not be solved remotely. She sought a deduction for the additional costs of travelling from home to work outside the ordinary working hour commuting. Decision: The Court agreed with the taxpayer that the additional costs incurred to travel to the office outside of ordinary office hours were deductible expenses. The 198

© Thomson Reuters 2019

CHAPTER 8

PRIVATE AND DOMESTIC EXPENSES

Court distinguished precedents on the basis that the taxpayer’s addition expenses related to work responsibilities that started at the home, not at the office, when the taxpayer tried to address the problem remotely. Thus, the trip to the office was not a trip to go to work but a trip in the course of work. Relevance of the case today: Collings is a Supreme Court case and as a result is not a binding precedent on the Federal Court. Nevertheless, the case remains a persuasive precedent for the general proposition that expenditure for travel incurred in the course of carrying out employment responsibilities is not a private expenditure and does satisfy the positive limb of s 8-1(1). However, its application will depend on the facts of the case and a taxpayer hoping to use the Collings precedent will have to show that he or she carries out additional responsibilities from home in addition to his or her regular work responsibilities and that secondary travel to the office is in the course of carrying out the secondary responsibilities, not to travel to work to carry out the regular office responsibilities. If it happened today: The precedent of Collings would most likely be applied to any similar case that arose today, provided the taxpayer could show the additional trips to the office were incurred in the course of completing tasks that had been started at home and that were separate from the ordinary work carried on in the office by the taxpayer.

John Holland Group Pty Ltd v FCT

[2015] FCAFC 82; 99 ATR 73; 2015 ATC 20-510 (Full Federal Court)

Facts: The taxpayer was a construction company that paid for flights of employees who travelled to the work site on a “fly in fly out” basis. The Commissioner assessed the cost of the flights as a fringe benefit. The taxpayer argued the flights provided to the employees were not assessable fringe benefits under the “otherwise deductible rule” which excludes benefits from taxation if the acquisition of services or goods would have been a deductible expense to the employee had the employee made the acquisition directly. The issue before the court therefore became whether the cost of flying to and from the work site would be a deductible expense to an employee incurred in the course of employment or would be a non-deductible cost of travelling from home to work. Decision: Under the contract of employment between the employees and the construction company, the employees were required to assemble at the airport for transport to the work site. On this basis, the Court concluded the employees’ work responsibilities commenced when they arrived at the airport to travel to the work site and not when they arrived at the site. The expenses therefore would have been outgoings incurred in the course of employment had the employee borne them personally and not the cost of travelling to work. The payment instead by the employer was as a result not a taxable fringe benefit. Relevance of the case today: John Holland Group can be cited to explain the difference between a personal expense incurred to travel to work and the expense © Thomson Reuters 2019

199

AUSTRALIAN TAXATION LAW CASES 2019

incurred to travel to a remote work site where the employer requires employees to assemble at a place prior to transport to the actual site. The former is not a deductible expense while the latter would be. If it happened today: If the facts of John Holland Group were to occur today, a court would find the benefit provided by the employer was not a taxable benefit following the application of the otherwise deductible rule. It would conclude that if the employee had borne the cost of travel to a remote work site directly, the expense would have been deductible if the contract of employment required workers to assemble at one place for travel to the work site.

TRAVELLING BETWEEN TWO PLACES OF WORK FCT v Payne

(2001) 202 CLR 93; 46 ATR 228; 2001 ATC 4027 (Full High Court)

Facts: The taxpayer was a Qantas pilot flying out of Sydney airport who owned a deer farming property near Tamworth in Northern NSW. The taxpayer sought to deduct the cost of travelling between two places of unrelated income derivation. He sought to rely on a public ruling that was binding on the Commissioner in support of the claim for a deduction. Decision: A majority of the High Court concluded that travel between two income-producing activities did not occur when the taxpayer was engaged in either activity and could therefore not be said to be incurred “in the course of”’ deriving income from either activity. However, the case was remitted back to the AAT to decide on the issue of whether the taxpayer was entitled to rely on the public ruling that the taxpayer claimed supported his claim for a deduction. Relevance of the case today: Subsequent to the Payne decision, s 25-100 ITAA 1997 was enacted to allow a deduction for travel expenses between unrelated places of income earning activity. Thus, Payne has little continuing relevance for deduction claims generally for travel expenses between unrelated places of income producing activity. However, s 25-100 does not apply if the taxpayer lives at one of the places where income is produced and thus would not apply to a taxpayer in the situation of the taxpayer in Payne. The decision is of continuing importance in cases where the taxpayer travels from one workplace to another and lives at the second workplace. If it happened today: If the facts in Payne were to arise today, a court would continue to hold that the expenses were not deductible as they were not incurred in the course of an income earning activity.

200

© Thomson Reuters 2019

CHAPTER 8

PRIVATE AND DOMESTIC EXPENSES

EXPENSES TO MOVE TO A NEW PLACE OF EMPLOYMENT Fullerton v FCT

(1991) 22 ATR 757; 91 ATC 4983 (Federal Court)

Facts: The taxpayer’s employer closed its office in the town in which the taxpayer lived. To retain a position with the employer, the taxpayer had to move to another town. He sought a deduction for the moving expenses. The Commissioner denied a deduction on the basis that the expenses were private outgoings. Decision: The Federal Court felt compelled to follow the leading authorities, particularly Lunney v FCT (1958) 100 CLR 478 dealing with commuting expenses, and

hold that expenses to move from one place of employment to another place of employment were private expenses. Similar to commuting expenses, the outgoing was a prerequisite to continued derivation of income but was not incurred in the course of deriving that income.

Relevance of the case today: Fullerton continues to be a precedent for the proposition that moving expenses are private outgoings even if necessary to retain employment with the same employer. Section 58B FBTAA provides an exemption from fringe benefits tax if the employer pays removal costs directly or reimburses the employee for such costs. One effect of the Fullerton decision has been to prompt employees to enter into salary sacrifice arrangements with employers under which the employer pays moving expenses and the employee’s salary is reduced by the cost incurred by the employer. This leaves the employee in the same position he or she would be in if the employee had received the full salary, incurred a moving expense, and been allowed to deduct the expense. If it happened today: If the facts in Fullerton arose today, a court would conclude the expenditure incurred by the taxpayer was a non-deductible personal expense. However, as noted above, if a taxpayer was in a similar situation today, the taxpayer would likely seek a salary sacrifice arrangement with the employer which provided for the employer to reimburse the moving costs and reduce the taxpayer’s salary by the reimbursement amount.

CHILD CARE EXPENSES Lodge v FCT

(1972) 128 CLR 171; 3 ATR 254; 72 ATC 4174 (High Court)

Facts: The taxpayer was a single parent who worked under contract as a law costs clerk. The work was mostly carried on from her home. To enable her to carry out the work, she placed her daughter in child care nursery facilities and sought a deduction for the expense on the basis that she could not have carried on the work but for the expenditure. The Commissioner denied her the deduction sought. © Thomson Reuters 2019

201

AUSTRALIAN TAXATION LAW CASES 2019

Decision: Mason J of the High Court concluded the expense was not deductible because the cost of child care for a person’s child is a private expense and because an expense incurred to put a person in a position where the person is able to carry out activities to derive assessable income is not an expense incurred in the course of deriving assessable income. Relevance of the case today: The Lodge decision remains a leading precedent for the proposition that child care expenses are private expenses and for the proposition that expenses incurred to put a person in a position to carry out activities to derive assessable income will not be considered expenses incurred in earning the income as required by s 8-1 ITAA 1997. If it happened today: If the facts in Lodge occurred today, a court would continue to hold that the expenses are not deductible under s 8-1 because they are private expenses and because they are not incurred in earning assessable income.

Martin v FCT

(1984) 15 ATR 808; 84 ATC 4513 (Full Federal Court)

Facts: The taxpayer was a separated parent who incurred child-minding expenses to enable her to attend to her employment responsibilities. She sought a deduction for the expenses and attempted to distinguish the precedent of Lodge v FCT (1972) 128 CLR 17; 3 ATR 254; 72 ATC 4174 on the basis that unlike the taxpayer in Lodge, she was an employee and she had concluded her employer required her to find child care facilities for her child before she would be employed. The Commissioner contended that the taxpayer’s situation was not distinguishable from that of the taxpayer in Lodge and denied a deduction for the outgoings. Decision: The Full Federal Court upheld the Commissioner’s assessment. The different facts in Martin did not change the fact that the expense was incurred in order to free the taxpayer to take on the work in question. It was neither relevant nor incidental to the work which she was engaged to perform and it was therefore not incurred in the course of that work. Relevance of the case today: Martin is cited today along with Lodge as authority for the proposition that child care expenses will not satisfy the positive limb of s 8-1(1) ITAA 1997. If it happened today: If the facts in Martin arose today, a court would continue to find the expenses non-deductible outgoings. Importantly, child care provided by the employer on the employer’s premises is explicitly exempted from fringe benefits tax under s 47(2) FBTAA and if the situation were to arise today and the employer provided child care places, the taxpayer might seek a salary sacrifice arrangement with the employer which provided for the employer to provide child care and reduce the taxpayer’s salary by the cost incurred to provide the child care. This would leave the employee in the same position she would be in if she had received the full salary, incurred a child care expense, and been allowed to deduct the expense. 202

© Thomson Reuters 2019

CHAPTER 8

PRIVATE AND DOMESTIC EXPENSES

SELF-EDUCATION EXPENSES Prior to 1985, a tax offset was provided for self-education expenses exceeding a threshold. To prevent double dipping, s 82A ITAA 1936 denied a deduction for the first $250 of otherwise deductible self-education expenses. The rule was retained, possibly inadvertently, following the removal of the tax offset. Whether expenses exceeding this amount will be deductible under s 8-1 ITAA 1997 depends on whether they are viewed as private expenses or expenses incurred in earning assessable income.

FCT v Hatchett

(1971) 125 CLR 494; 2 ATR 557; 71 ATC 4184 (High Court)

Facts: The taxpayer was a primary school teacher who incurred expenses to obtain a Teacher’s Higher Certificate and to complete some Arts subjects at a university. The Higher Certificate entitled the taxpayer to a higher level of salary and was a prerequisite to certain teaching positions. The Education Department encouraged teachers to complete Arts and other university courses and partially subsidised the cost of those courses. However, they were not required of teachers and they did not qualify teachers for higher salary or promotion. The taxpayer sought deductions for non-reimbursed expenses incurred to complete the Higher Certificate and the Arts courses. Decision: Menzies J allowed the taxpayer a deduction for expenses related to the Higher Certificate and denied a deduction for expenses related to the university courses. Obtaining a Higher Certificate entitled the taxpayer to a higher salary in his current employment. There was, therefore, “a plain connection” between the expense and the taxpayer’s earning of income. Although the employer encouraged the taxpayer to study the university courses, they remained private expenditure that was not directly related to his employment as a teacher. Relevance of the case today: The Hatchett decision provides an important precedent for the proposition that outgoings for education which is directly related to employment by entitling the taxpayer to a higher salary are deductible as expenses incurred in earning assessable income. At the same time, it is authority for the proposition that expenses for courses not directly used in a taxpayer’s work or leading to higher remuneration will generally not be deductible. If it happened today: If the facts in Hatchett arose today, the expenditure for the Higher Certificate would be deductible as outgoings for studies that will directly lead to a higher salary. Subsequent cases have broadened the nexus test slightly for education expenses related to courses that could but will not necessarily lead to promotion. However, these cases are unlikely to apply to the university expenses incurred by the taxpayer in Hatchett and the same result would likely follow now for these expenses if the facts arose today.

© Thomson Reuters 2019

203

AUSTRALIAN TAXATION LAW CASES 2019

FCT v Highfield

(1982) 13 ATR 426; 82 ATC 4463 (Supreme Court of NSW)

Facts: The taxpayer was a dentist who incorporated some periodontic work in his general practice. He later completed a specialist degree in periodontics in the UK and following a period of additional clinical experience he obtained a specialist registration in periodontics and commenced practice in that speciality. The taxpayer sought deductions for his air fares, university fees, and meals and accommodation while studying. The Commissioner assessed the taxpayer on the basis that the expenses were not deductible. Decision: The Court allowed the deduction on the basis that the taxpayer had undertaken the studies with the intention of expanding his periodontics work in his existing practice. The expense was therefore incurred to increase skills for the existing income earning activity. The Court left open the question of whether a deduction would have been allowed had the taxpayer acknowledged the purpose of the expense was to enable the taxpayer to give up his general practice and commence a new position as a specialist. Relevance of the case today: Highfield is authority for the proposition that expenses for courses for skills that will be used by a professional in his or her existing practice are non-personal, deductible outgoings. The case provides no direct authority on the question of whether expenses to learn a speciality will be deductible but it has sometimes been interpreted as suggesting indirectly that no deduction would be available if the taxpayer’s intention was to change from a general practice to work as a specialist. If it happened today: If the facts in Highfield arose today, the taxpayer would be allowed to deduct the costs of further education provided he was able to show that his intention had been to use the skills learned in the courses in the taxpayer’s existing practice, whether or not he subsequently did so or instead set up a new specialised practice. Quite probably, if it could be shown that the taxpayer’s actual intention is to change his profession and become a specialist, no deduction would be allowed.

FCT v Wilkinson

(1983) 14 ATR 218; 83 ATC 4295 (Supreme Court of Queensland)

Facts: The taxpayer was an air traffic controller who incurred expenses to take flying lessons. He introduced evidence to show that his flying experience and qualifications enabled him to better carry out his responsibilities as an air traffic controller and greatly increased his prospects for promotion and a higher salary. He argued the expenses were incurred in gaining income derived in his capacity as an air traffic controller. The Commissioner denied a deduction for the expenses. Decision: The evidence showed that obtaining flying qualifications and experience provided the taxpayer with a greater appreciation of the responsibility of an air traffic controller and the consequential increase in his efficiency made promotion and a higher salary much more likely. It was shown that one of the taxpayer’s main motives, if not 204

© Thomson Reuters 2019

CHAPTER 8

PRIVATE AND DOMESTIC EXPENSES

his sole motive, was to improve his prospects of promotion and advancement in grade and salary. As there was a “perceived connection” between the outgoing and obtaining assessable income, the expenditure was incurred in gaining assessable income as an air traffic controller. Relevance of the case today: Courts are generally reluctant to allow taxpayers’ claims for self-education expenses for courses that are not directly on the subject matter of the taxpayers’ occupations, particularly where the courses could lead to the taxpayers moving to different occupations. However, the Wilkinson case shows that deductions will be allowed for such courses where the taxpayer can show how the new knowledge will be applied to make the taxpayer more efficient in his or her existing profession and will be likely to lead to promotion in the existing profession. If it happened today: If the facts in Wilkinson were to arise today, the taxpayer would most likely be allowed to deduct the cost of flying lessons provided he or she was able to prove on the evidence that the lessons would make the taxpayer a more efficient air traffic controller and was very likely to lead to promotion and a higher salary. The taxpayer in Wilkinson was in fact promoted after taking the flying lessons and this helped bolster the taxpayer’s case significantly. Similar evidence would strengthen a claim that the expense will increase the prospects of promotion.

FCT v Studdert

(1991) 22 ATR 762; 91 ATC 5006 (Federal Court)

Facts: The taxpayer was a Qantas flight engineer who incurred expenses to take flying lessons. He argued that he believed the flying lessons improved his proficiency as a flight engineer and increased his prospects of promotion to higher grades of engineer. The Commissioner argued the skills learned were not used in the taxpayer’s profession as an engineer and the expenditure was therefore not deductible. Decision: Hill J allowed a deduction for the cost of flight lessons on the basis of a finding of fact by the AAT that the skill learned could improve the taxpayer’s performance as a flight engineer and could improve his prospects of promotion. Relevance of the case today: Studdert may be cited as an authority for the proposition that expenses incurred to learn a new skill can be deductible if the taxpayer can show the skill will be used in his current income-earning activities and can assist in obtaining promotion in those activities. If it happened today: If the facts in Studdert arose today, the taxpayer would be able to deduct the costs of flying lessons provided he could show the flying skills would be of use in his position as an engineer and could lead to promotion in that capacity.

© Thomson Reuters 2019

205

AUSTRALIAN TAXATION LAW CASES 2019

FCT v Anstis

[2010] HCA 40; 241 CLR 443; 76 ATR 735; 2010 ATC 20-221 (Full High Court)

Facts: The taxpayer was a university student who received a Youth Allowance. To qualify for the allowance, the taxpayer had to show that she met the eligibility criteria set out in the Social Security Act, including the “activity test”. Her qualifying activity was enrolment in full-time studies at a university. In the course of her studies she incurred travel expenses other than to university, expenses for supplies for children during teacher rounds, student administration fees, depreciation of a computer, and expenses for textbooks and stationery. She sought deductions for these expenses under s 8-1(1)(a) ITAA 1997 on the basis that they were incurred in earning assessable income in the form of a Youth Allowance. The Commissioner argued the expenses were self-education expenses that were only deductible when the studies were related to existing employment, not gaining of qualifications in a new field of employment. Also, the Commissioner argued, they were incurred to carry out the taxpayer’s studies, not to earn the allowance, and would have been incurred whether or not she received the allowance. Decision: The High Court allowed the taxpayer’s deduction on the basis that she had derived the allowance on the condition that she carry on studies at a certain level and the expenses were incurred to satisfy this condition. The nexus between the expense and derivation of assessable income was not affected by the fact that the taxpayer would gain a qualification from the education, normally a sign of a private expense. Relevance of the case today: The government responded to the Anstis case with the enactment of s 26-19 ITAA 1997. The section applies from the 2011–12 income year, and overrides the Anstis case to reinstate the Commissioner’s practice of denying expenses incurred in the course of non-work activities that entitle eligible persons to Youth Allowance and other relevant government assistance payments. If it happened today: If the facts in Anstis were to take place today, the expenses would not be deductible as a result of s 26-19.

TRAVEL EXPENSES FCT v Finn

(1961) 106 CLR 60 (Full High Court)

Facts: The taxpayer was a senior design architect in the Department of Public Works in Western Australia. He used accumulated recreation leave and long service leave to take a trip to UK and the European continent to keep up to date with current trends in architecture. His employer asked him to extend the trip to include South America and covered the additional expenses of adding South America to his itinerary. The taxpayer kept a written diary of his findings including written notes and photographs. All his available time was devoted to studying architecture. He hoped the added knowledge would improve his prospects for promotion. 206

© Thomson Reuters 2019

CHAPTER 8

PRIVATE AND DOMESTIC EXPENSES

The taxpayer sought to deduct the costs incurred for the travel while the Commissioner argued any improvement in his capacity to carry out his work did not bring higher remuneration than the salary he would have obtained without the expenditure and the expense was therefore not incurred in gaining or producing assessable income. Decision: The High Court allowed the taxpayer a deduction for the outgoings. The test for deductibility is not whether the expense is incurred to generate income that would not otherwise be generated but rather when it is incurred in relation to the derivation of income, including the income that would otherwise be derived. The fact that the travel was taken with the endorsement of the employer and part of it was made at the request of the employer showed that the employee and employer viewed it as related to the taxpayer’s employment responsibilities. The taxpayer’s diary and documentation showed the travel was almost exclusively devoted to obtaining knowledge to be used in the taxpayer’s employment activities. The indication by the employer that the additional knowledge gained by the taxpayer would likely be taken into account when considering future applications for promotion showed the expenses had a connection with hoped for future income as well. Relevance of the case today: The Commissioner rarely accepts claims for deductions for travel taken on recreation leave or long service leave where the taxpayer claims the travel was related to the derivation of income in the course of his or her employment and in almost all cases the courts agree that such expenses are private or domestic outgoings. The Finn case can be used to support claims for travel expenses or analogous expenses if the taxpayer can show the four factors present in Finn also apply in the taxpayer’s case, namely employer endorsement of the travel, evidence that the travel was devoted to the collection of information that can be used in the employee’s work, evidence that the information collected can be applied in the course of employment activities, and evidence to show that the experience will enhance the taxpayer’s prospects for promotion and a higher salary. If it happened today: The Finn case is seen by many as a high water mark of individual travel expense claims and it is rare for taxpayers today to be allowed deductions for personal travel expenses where the travel is undertaken in recreational and long service leave time. If the facts in Finn were to arise today and the taxpayer could show all the factors that were present in the original case were present in the case today, a deduction would probably be allowed once again for the travel expenses. FCT v Studdert (1991) 22 ATR 762; 91 ATC 5006 reaffirmed the importance of showing that the knowledge gained by the expense will improve the taxpayer’s ordinary work performance and enhance the taxpayer’s prospects for promotion. In the case of travel during personal time, it would also be necessary to show the travel was devoted to collection of information to be used in the course of employment.

© Thomson Reuters 2019

207

AUSTRALIAN TAXATION LAW CASES 2019

HOME OFFICE EXPENSES FCT v Faichney

(1972) 129 CLR 38; 3 ATR 435; 72 ATC 4245 (High Court)

Facts: The taxpayer was a scientist employed by the CSIRO who used a study in his home almost exclusively for work-related activities such as reading and writing papers and reports. He sought a deduction for a portion of the interest expense in his mortgage payments, a portion of the household electricity bill, and depreciation for his desk and the carpet and curtains in his study. Decision: In what has become a leading home office precedent, Mason J held that no deductions should be allowed for a portion of home mortgage interest but deductions should be allowed for a portion of electricity expenses and depreciation. Although a study may be used exclusively for income-earning purposes, it remains an integral part of the family home and interest expenses on a mortgage for the home are inherently private outgoings. Electricity expenses should be deductible to the extent the taxpayer could show the additional electricity charges were due to the use of the study in earning assessable income and a similar logic applies to the depreciation of items that are used exclusively for that purpose. Relevance of the case today: The Faichney decision remains the authority for proposition that interest on home mortgages is a private expense while deductions will be allowed for additional expenses related to the exclusive use of a room for work purposes. The logic of the decision has been extended to other expenses such as rates and insurance that, like the mortgage expenses, would be incurred whether or not a room was used for work purposes. If it happened today: A taxpayer in the same position today as the taxpayer in Faichney would most likely not seek a deduction for any part of the interest on his or her mortgage payments but would restrict deduction claims to depreciation of property in a room used exclusively for work purposes and additional utility charges that are attributable to the use of the room for work purposes.

Handley v FCT

(1981) 148 CLR 182; 11 ATR 644; 81 ATC 4165 (Full High Court)

Facts: The taxpayer used a room in his house as a study where he carried out activities relating to his profession as a barrister. The room was used predominantly for this purpose though on other occasions it was used for other reasons. The taxpayer sought a deduction for a proportion of the interest component of his mortgage payments as well as a proportion of utility costs and local rates expenses. The Commissioner argued expenses related to an ordinary room in a family home are inherently private outgoings. Decision: A majority of the High Court agreed with the Commissioner that no deduction should be allowed for the outgoings. The study remained an integral part of 208

© Thomson Reuters 2019

CHAPTER 8

PRIVATE AND DOMESTIC EXPENSES

the family home even though it was used by the taxpayer for another purpose for some of the time. The expenditures were private outgoings related to the entire home and should not be apportioned as they would be incurred for the entire home whether or not the taxpayer used part of it sometimes as a work study. Relevance of the case today: The Handley case remains an authority for the proposition that expenses related to a home office will generally be considered non-deductible private outgoings if they would have been incurred had the taxpayer not had an office. As noted below, the relevance of the decision in respect of mortgage interest has diminished since the adoption of the capital gains tax as most taxpayers do not want to lose part of their CGT main residence exemption by seeking to deduct some mortgage interest. If it happened today: A taxpayer in the same position today as the taxpayer in Handley would most likely not seek a deduction for any part of the interest on his mortgage payments. This is because the exemption from capital gains tax for a taxpayer’s main residence will be reduced to the extent the taxpayer claims interest deductions on the basis that the residence is used partially for income earning reasons – see s 118-190 ITAA 1997. A court today would continue to deny any deduction for expenses such as rates that would be the same whether or not the taxpayer used the premises partially as a home office. A claim for a deduction for a part of the utility expenses might be accepted on the basis of FCT v Faichney (1972) 129 CLR 38; 3 ATR 435; 72 ATC 4245 if the taxpayer could identify the proportion of the expenses directly attributable to the use of the home office.

FCT v Forsyth

(1981) 148 CLR 203; 11 ATR 657; 81 ATC 4157 (Full High Court)

Facts: The taxpayer was a barrister and a trustee of a family trust that owned the home occupied by his family. He paid $20 per week to the trust to occupy a room in the house off the taxpayer’s bedroom as a home study and to place a work desk in a space at the foot of the stairs. The taxpayer stored some clothes in the study and because of its location to the bedroom used it as a dressing room. The taxpayer sought a deduction for the payments as a business expense. Decision: A majority of the High Court allowed the Commissioner’s appeal on the basis that the taxpayer’s expenses were private outgoings notwithstanding their presentation as rent for space to carry out professional work. The study was not used exclusively for business purposes and both the study and desk space were so completely integrated with the rest of the house that it was artificial to treat them as separable parts applied only to business purposes. Applying the “essential character” test set out in Lunney v FCT (1958) 100 CLR 478, the expense was a private outgoing and it could not be shown that it was an expense incurred in deriving assessable income. Relevance of the case today: Forsyth is cited primarily to support the argument that no deduction will be allowed in respect of a home office unless the office is physically discrete and is used exclusively for income-earning activities. © Thomson Reuters 2019

209

AUSTRALIAN TAXATION LAW CASES 2019

If it happened today: If the facts in Forsyth were to arise today, a court would again deny the taxpayer a deduction for the payment made to a family trust for the right to occupy space that was not used exclusively for income earning activities. However, the facts are unlikely to arise today as taxpayers are less likely to hold a main residence in a family trust. Rather, they are likely to own it directly so they can take advantage of the CGT main residence exemption in s 118-190 ITAA 1997.

Swinford v FCT

(1984) 15 ATR 1154 (Federal Court)

Facts: The taxpayer was a professional writer of radio and television scripts who worked from her residence. She set aside one room in her rental accommodation to be used exclusively for her writing work. She sought a deduction for income tax purposes of a portion of her rent attributable to the room (based on the proportion of floor space relative to the entire flat). The Commissioner denied her a deduction on the basis that the expense was personal since she would have to pay the entire rent for residential purposes whether or not she worked from home. The taxpayer argued that there were two purposes for the rent once a room was set aside to be used exclusively for work and the rent should be attributed partly to each purpose. Decision: The Federal Court agreed with the taxpayer that establishment of a distinct work room amounted to a separate application of the rented premises and a proportional amount of the rent could be deducted as a business expense. Relevance of the case today: Swinford shows that the cost of work premises in rental accommodation is deductible as a business expense and the portion of rent attributable to the exclusive work space can be determined by calculating the proportion of the floor area of the unit that was occupied as a home office. If it happened today: The approach adopted by the Federal Court in Swinford would be followed today and a taxpayer would be allowed to pro-rate the rental cost of accommodation and deduct the portion attributable to a home office.

CLOTHING EXPENSES Taxpayers may incur expenses for different types of apparel needed to carry out their work. Where the clothing could have no ordinary usage application – for example, heavy duty welder’s gloves or a construction safety hat – the Commissioner accepts taxpayers’ claims that expenditure for the clothing is incurred in the gaining of assessable income and allows a deduction for the cost of the clothing. Where, however, the clothing could also be used for non-work purposes, the Commissioner will seek to deny a deduction for the costs of acquiring the clothes. The general principles on what clothing expenses can be deducted are supplemented by statutory rules in Division 34 ITAA 1997, which restricts deductions for otherwise deductible outgoings for non-compulsory uniforms that fail to meet certain design standards.

210

© Thomson Reuters 2019

CHAPTER 8

PRIVATE AND DOMESTIC EXPENSES

Mallalieu v Drummond (Inspector of Taxes)

[1983] 2 AC 861 (UK House of Lords)

Facts: The taxpayer was a barrister who purchased subdued clothing for use in court. The clothes could be worn on other occasions but the taxpayer stated that she had plenty of other clothes for those other occasions and the clothing in question was purchased only for wearing in her professional capacity. The Commissioners relied upon the UK statutory deduction provision to deny the taxpayer deduction sought. The relevant UK deduction provision denied deductions for expenses unless they were “wholly and exclusively laid out or expended for the purposes of the trade, profession or vocation”. Decision: The House of Lords agreed with the Commissioners that no deduction should be allowed for the expenses. While the taxpayer asserted that the only reason she had purchased the clothes in question was to wear them in court, she had to wear something generally and it was open to the Commissioners to conclude that one object for the expense was to acquire clothes the taxpayer needed as a human being. The expenditure was therefore not wholly and exclusively incurred for income earning purposes and no deduction was allowed. Relevance of the case today: Section 8-1 ITAA 1997 does not contain the “wholly and exclusively” incurred test found in UK legislation and in Australia a case based on similar facts would not be decided by reference to this test. However, the Mallalieu case is used in Australia as support for a broader proposition that expenditure for conventional clothing that could be worn outside the work environment is not deductible even if the taxpayer asserts this particular clothing was purchased only to be worn in the course of work. If it happened today: If the facts in Mallalieu arose today in Australia, an Australian court would likely come to the same conclusion as the House of Lords, but based on s 8-1. Since the clothes were not a uniform or something to be worn exclusively when working, an Australian court would likely find that the cost of the clothing was not incurred in earning assessable income and further was a private expenditure. It is unlikely that a taxpayer with facts similar to those in Mallalieu could apply the distinction drawn in FCT v Edwards (1994) 28 ATR 87; 94 ATC 4255 to the facts in Mallalieu. In particular, the need to change clothes several times a day that was present in Edwards is missing from the facts in Mallalieu.

FCT v Edwards

(1994) 28 ATR 87; 94 ATC 4255 (Full Federal Court)

Facts: The taxpayer was the personal secretary to the wife of the Governor of Queensland. To carry out her duties, she often had to change clothes several times a day, sometimes moving from less formal daytime clothing to black tie formal evening wear. She sought a deduction for the cost of some of the clothing, particularly hats, gloves and black tie formal evening wear that she would not normally wear. The © Thomson Reuters 2019

211

AUSTRALIAN TAXATION LAW CASES 2019

Commissioner denied her a deduction on the basis that the expenses were not incurred in earning assessable income and they were private expenses. Decision: The Court rejected the argument that the expense of acquiring clothes to wear at work is automatically a private expense if the clothes are suitable for wearing outside work hours. The taxpayer was able to show that the many changes of clothes required in the course of the day were necessitated by her employment and while no deduction would be available for an initial set of clothes required by anyone working, it was appropriate to allow a deduction for the costs of clothes the taxpayer would have to change into while working during the day or evening. Relevance of the case today: The Edwards case showed that not all expenses for clothes that could be worn when not working are automatically non-deductible. It is cited by taxpayers trying to show that their ordinary usage clothes should be deductible as clothes acquired only for work purposes. This is most easily done if they can show that, like the taxpayer in Edwards, they are required to change their clothes in the course of the day and the clothes they change into such as formal evening wear are clothes they would never change into if not for the work responsibilities. If it happened today: The decision in Edwards is a decision of the Full Federal Court and as such is binding on most courts hearing original jurisdiction tax cases and very persuasive for appeal courts. As a result, if the facts in Edwards were to arise today, it is likely a court would apply Edwards and arrive at the same decision. However, Edwards does appear to be a widening of the traditional test for deductible clothes expenses and a court today would probably not allow a deduction for ordinary clothes unless the facts were very close to those in Edwards.

COSMETICS AND SUN PROTECTION EXPENSES Mansfield v FCT

(1995) 31 ATR 367; 96 ATC 4001 (Federal Court)

Facts: The taxpayer was an airline flight attendant who received an allowance of $1,019 from her employer which could be used for cosmetics, hairdressing, hosiery and shoes used in her employment. The taxpayer spent $1,215 on these items and sought to deduct the expenses. The Commissioner included the full allowance in the taxpayer’s assessable income but denied a deduction for the outgoings on the basis that they were private expenses and not incurred in earning assessable income. The taxpayer argued that the shoes were half a size too large to accommodate in flight swelling and could not be used outside work. The taxpayer further argued that the hosiery was part of the uniform she was required to wear, the cosmetics used were moisturisers and conditioner needed only because of the dry air in the cabin, and the hairdressing was needed because she was required by her employer to be well groomed and presentable. Decision: While expenditures for ordinary apparel are not usually deductible, they may be deductible in some circumstances. Shoes too large to be worn outside of work 212

© Thomson Reuters 2019

CHAPTER 8

PRIVATE AND DOMESTIC EXPENSES

may be treated as business apparel, and this is also true for hosiery that is considered part of a uniform. Expenses for moisturisers and conditioner that would not be used except for the working conditions faced by the taxpayer should similarly be deductible. However, expenditure for a perm is the result of a personal choice and is not occasioned by her employment. Relevance of the case today: The decision in Mansfield is often cited in support of arguments for deductions for expenses for apparel or personal items that appear to be ordinary articles of clothing or accessories but are needed only because of a particular aspect of a taxpayer’s employment or business. If it happened today: Courts remain wary of allowing deductions for clothing or accessories that appear to be ordinary items which can be worn outside of work. However, cases such as Mansfield have opened the door to deductions for these items if the taxpayer can show the items in question would not be necessary if not for the work and would not be used outside of work. Under the approach currently taken by courts, if the facts in Mansfield were to arise today, a court would likely reach the same decision as the Federal Court in Mansfield. Mansfield

Morris v FCT

(2002) 50 ATR 104; 2002 ATC 4404 (Federal Court)

Facts: The case involved a common issue faced by ten different taxpayers whose jobs in a range of fields required them to work outdoors where they were at risk from the sun. The taxpayers incurred expenses for sun hats, sunscreen lotion, and sunglasses. The Commissioner denied all taxpayers deductions for the expenses on the basis that the expenditure was not incidental or relevant to the taxpayers’ income-producing activities and was of an essentially private nature. The Commissioner argued the protection was needed because of natural elements, not because of any activity inherent in the work carried on by the taxpayers. Decision: All the taxpayers were allowed deductions for their expenditures. Some were able to show using protection was a condition of employment (eg, a tennis umpire), and all showed use of the protection increased their productivity and ability to carry out their work for longer periods or more effectively. The nature of the taxpayers’ work required them to work in the sun and protection from the sun while working was directly connected with their income earning activities. Relevance of the case today: The Morris case led to a shift in the ATO’s attitude to the deductibility of expenses for protective accessories used to protect against the elements, particularly the sun, where exposure to potentially dangerous elements was an inherent part of the taxpayers’ income earning activities. Morris remains an authority for the proposition that such expenses are deductible provided the exposure is a necessary consequence of a taxpayer’s income earning activity and protection from the elements enhances the taxpayer’s ability to carry out the activity. If it happened today: If the facts in Morris arose today, the ATO would accept the deductibility of the expenses and it is unlikely there would be a dispute raised before © Thomson Reuters 2019

213

AUSTRALIAN TAXATION LAW CASES 2019

a court. If, however, a dispute reached a court, the court would allow a deduction for the sun protection expenses.

CHARITABLE GIFTS Division 30 ITAA 1997 provides a deduction for gifts or contributions to listed organisations or purposes. Cases considering the gift deduction provision often turn on the character of a payment—was it a genuine “gift or contribution” or did the person making the payment expect to receive a benefit as a result of the payment?

FCT v McPhail

(1968) 117 CLR 111 (High Court)

Facts: The taxpayer claimed a deduction for a “gift” to a building fund for the private school attended by his son. The school had separate fee schedules for persons who made a standard contribution to the building fund and for those who did not. The fee for persons who made the standard contribution was lower than the regular schedule by the amount of the contribution. The Commissioner denied the taxpayer a deduction sought by the taxpayer under s 78(1) ITAA 1936 (currently s 30-15 and s 30-25(1), item 2.1.10 ITAA 1997 1997) on the basis that the payment was not a “gift” since the taxpayer received a commensurate benefit for the contribution by way of a reduction of the school fees that would otherwise have been payable. Decision: Owen J concluded the payment was not a gift as it was made pursuant to a contractual obligation entered into by the taxpayer and because it was made in the expectation that there would be a material advantage to the taxpayer in the form of reduced fees. Relevance of the case today: McPhail remains a leading precedent on the meaning of “gift” for purposes of the deduction for gifts allowed in Division 30 ITAA 1997. A payment will not be considered a gift if there is a reciprocal benefit to the donor. If it happened today: If the facts in McPhail were to arise today in the context of the new gift deduction provisions in Division 30 ITAA 1997, the same result would follow as the court applied the rule that a payment is not a gift where there is a reciprocal benefit to the donor.

214

© Thomson Reuters 2019

C HAPTER 9

Capital or Revenue Expenses THE CAPITAL vs REVENUE TESTS ............................................................... 216 Vallambrosa Rubber Company Ltd v Farmer (1910) ............................ 216 Sun Newspapers (1938) ......................................................................... 217 Associated Portland Cement Manufacturers Ltd (1946) ....................... 218 Nchanga Consolidated Copper Mines Ltd (1964) ................................. 219 BP Australia Ltd (1965) ......................................................................... 219 Strick (Inspector of Taxes) v Regent Oil Co Ltd (1966) .......................... 220 National Australia Bank Ltd (1997) ...................................................... 221 Star City Pty Ltd (2009) ......................................................................... 222 AusNet Transmission Group (2015) ....................................................... 223 Sharpcan Pty Ltd (2018) ........................................................................ 224 PROTECTION OF TITLE EXPENSES ............................................................. 225 Southern v Borax Consolidated Ltd (1941) ........................................... 225 Hallstroms Pty Ltd (1946)...................................................................... 226 John Fairfax & Sons Pty Ltd (1959) ....................................................... 227 Broken Hill Theatres Pty Ltd (1952) ...................................................... 228 Consolidated Fertilizers Ltd (1991) ...................................................... 229 MOVING EXPENSES ......................................................................................... 230 Lister Blackstone Pty Ltd (1976) ........................................................... 230 PURCHASES OF PROPERTY FOR A SERIES OF PAYMENTS .................. Egerton-Warburton (1934) .................................................................... Ramsay (1935) ....................................................................................... Colonial Mutual Life Assurance Society Ltd (1953).............................. Cliffs International Inc (1979) ...............................................................

230 230 232 233 234

© Thomson Reuters 2019

215

C HAPTER 9

Capital or Revenue Expenses THE CAPITAL VS REVENUE TESTS UK and Australian courts have developed a variety of tests to distinguish capital and revenue expenses, including expenditure effect tests (basically, the longevity of the benefit acquired), the expenditure form test, and the process vs structure test that incorporates elements of the other tests. The process vs structure test has emerged as the prevailing Australian test.

Vallambrosa Rubber Company Limited v Farmer (Surveyor of Taxes) [1910] SC 519; 5 TC 529 (Court of Sessions, Scotland)

Facts: The taxpayer incurred expenses maintaining and developing a rubber plantation. The rubber trees took several years to mature and produce and in the year of income only one-seventh of the trees were producing. The Commissioners allowed the taxpayer a deduction for only one-seventh of the expenditure in the year, treating the remaining portion as a capital outlay related to the development of assets to produce future income. Decision: The Court allowed a deduction for all the expenses incurred by the taxpayer in maintaining and developing the plantation. In the course of his judgment, the Lord President stated a test to distinguish capital and current expenses: “capital expenditure is a thing that is going to be spent once and for all, and income expenditure is a thing that is going to recur every year.” As the evidence showed the taxpayer incurred similar expenses each year, the expenditures were characterised as deductible revenue or current outgoings even though they related to future years’ income. Relevance of the case today: The Vallambrosa Rubber case is often cited as the source for the “once and for all vs recurring expense” test used to distinguish capital and revenue expenses. That test has been incorporated into the tests set out in Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337 and in Australia is now used as a consideration in application of the Sun tests but no longer would be decisive on its own.

216

© Thomson Reuters 2019

CHAPTER 9

CAPITAL OR REVENUE EXPENSES

If it happened today: If the facts in Vallambrosa Rubber arose today in Australia, the expenditures would most likely be classified as revenue outgoings applying the Sun Newspapers test. The Commissioner has indirectly approved of the Vallambrosa Rubber holding by using it as authority in Tax Rulings IT 2208 and 2646, which deal with other capital-revenue issues.

Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337 (Full High Court)

Facts: Sun Newspapers wished to prevent a competitor from introducing a new and more competitive newspaper into the Sydney market. It effectively bought out its competitor by paying the company owning the competing paper a sum to prevent launching of the new paper and the re-establishment of the original competitor. The payment was structured as a “lease” of the competitor’s printing and other equipment for a period of three years combined with a promise by the competitor not to publish a newspaper in this period. Sun then tried to depreciate the payment over three years for tax purposes but there was no provision in the ITAA allowing depreciation of such an expense (the depreciation rule only applied to plant and equipment). Sun then argued the expense was a revenue outgoing because it did not result in the acquisition of an enduring asset. Decision: A majority of the High Court concluded the expense was a non-deductible capital expense because Sun had achieved a lasting benefit by effectively buying out its competitor with the payment. Dixon J came to the same conclusion using a different test based on an income-earning process vs income-earning structure test, finding the outgoing related to the business structure of Sun. He looked at three factors to reach this conclusion, saying none was definitive but each could be used as a guidepost towards a probable character: whether the expense yielded a lasting benefit, whether the expenses were recurrent, and whether the benefit acquired was acquired by periodic or lump sum outlays. Subsequent cases which consider the revenue vs capital distinction often quote the three factors which Dixon J considered relevant in making such a determination. The test formulated by Dixon J takes into account the following three matters: “(a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.” Relevance of the case today: The process/structure test used by Dixon J and the use of three factors to analyse outgoings became the principal mode of analysis following the elevation of Dixon J to Chief Justice and it remains the basis for capital/revenue analysis. The test is not definitive as it and the three factors are often cited by both the taxpayer and Commissioner adopting opposite positions.

© Thomson Reuters 2019

217

AUSTRALIAN TAXATION LAW CASES 2019

If it happened today: If the facts in Sun Newspapers occurred today, the expense would most likely be characterised as a capital expense. However, the taxpayer could argue that the payment should be recognised as the cost base of a CGT asset, being the rights under the agreement. When the contractual rights expired, there would be a CGT event C2 under s 104-25 ITAA 1997 and the difference between the cost base and the proceeds of disposal (zero if the disposal resulted from the expiry of the asset) would be treated as a capital loss to be netted against capital gains or carried forward under s 102-15 ITAA 1997.

Associated Portland Cement Manufacturers Ltd v Kerr (Inspector of Taxes) [1946] 1 All ER 68 (UK Court of Appeal)

Facts: Two lifetime directors of the company were retiring. To ensure they did not engage in future competitive activities, the company entered into lifetime worldwide restrictive covenants with the retiring directors. The taxpayer made lump sum payments to the retiring directors by way of consideration. The issue was whether the payments were deductible or capital expenditure. Decision: The UK Court of Appeal concluded that the expenditures were capital and not deductible, applying the test from British Insulated and Helsby Cables Ltd v Atherton (1926) 10 TC 155. The Court looked to the nature of the asset or right acquired by the outgoing. By virtue of the payments, the taxpayer acquired an advantage for the enduring benefit of the trade, two choses in action which effectively “bought off” two potential competitors and thereby enhanced the value of the goodwill. There was nothing temporary about the advantage as the covenants were to last for the lives of the two directors. Relevance of the case today: This case is an example of the application of the enduring asset or advantage test which was applied with approval in Australia in Hallstroms Pty Ltd v FCT (1946) 72 CLR 634. However, in Australia, the tests put forward by Dixon J in Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337 and in particular the income-earning process vs income-earning structure distinction has emerged as the predominant test. As a result, Associated Portland Cement has limited continued relevance in Australia. In Riba Foods Pty Ltd v FCT (1990) 21 ATR 960; 90 ATC 4986, the Federal Court found that a payment by a company to a retiring lifetime director for entering into a restrictive covenant was a capital outgoing but reached this conclusion by applying the tests from Sun Newspapers. If it happened today: It is likely that a lump sum payment made to secure a restrictive covenant of a key employee would still be considered a capital outgoing as it relates to the structure of the business by preserving the goodwill of the employer. The rights under the restrictive covenant would be considered a CGT asset such that the payment, if not deductible, would form part of the cost base of that asset. On expiry of the covenant, a C2 event would occur, giving rise to a capital loss (s 104-25 ITAA 1997 1997).

218

© Thomson Reuters 2019

CHAPTER 9

CAPITAL OR REVENUE EXPENSES

C of T v Nchanga Consolidated Copper Mines Ltd

[1964] AC 948 (Privy Council)

Facts: The taxpayer was carrying on business mining copper. The taxpayer was a member of a group of three copper mines (the Anglo-American group) and though they were operated independently, there was a common sales department. The market for copper had fallen steeply and various large producers decided to cut production. The Anglo-American group decided to cut its production by 10%. The members of the group decided that the best way to achieve this was for its smallest producer (Bancroft) to cease production entirely for one year. It was agreed that the other members of the group would pay compensation to Bancroft for abandoning its production. Nchanga sought to deduct its portion of this payment to Bancroft but the Commissioner of Taxes (Federation of Rhodesia and Nyasaland) argued that the outgoing was capital in nature. Decision: The payment was allowed as a deduction. As part of the settlement of production policies for the group for the year, Nchanga acquired the right to have Bancroft out of production for 12 months, a benefit which was created and exhausted within 12 months. It was considered that the payment therefore related wholly to and was incidental of its output for the year. This payment was to be distinguished from one which has the effect of removing a competitor from the market – here Bancroft remained a potential producer and it was intended that Bancroft should resume production at the end of the 12 months. Relevance of the case today: As this case is based on the 1954 income tax law of Rhodesia it may be of limited relevance in Australia. In the decision, the Privy Council does discuss a structure/process test similar to that adopted in Australia based on the judgment of Dixon J in Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337 but the effect test is also given considerable weight in the Court’s emphasis on the fact that the benefit of the payment was exhausted within 12 months. If it happened today: If the facts of Nchanga were to occur in Australia today, a court could still come to the conclusion that the payment was deductible on the basis that it related to the production policies of the group for that year and therefore was incurred as part of the income earning process. Alternatively, if a court concluded that the payment related to the structure of the business, it could be considered a capital outgoing and not deductible. It could be argued that the payment related to the creation of a CGT asset, being the bundle of rights under the contract with Bancroft, such that the payment would be the cost base in the rights. On expiry of the agreement, a C2 event would occur and the taxpayer would realise a capital loss (s 104-25 ITAA 1997 1997).

BP Australia Ltd v FCT

(1965) 112 CLR 386; [1966] AC 224 (Privy Council)

Facts: BP was a petrol refiner that entered into “tied house” agreements (sometimes called “tied trade” agreements overseas) with independent retailers. In return for lump © Thomson Reuters 2019

219

AUSTRALIAN TAXATION LAW CASES 2019

sum payments from BP, the retailers contracted to sell BP fuel (and other fuel authorised by BP) exclusively for periods generally for 3 or 5 years. BP sought to deduct the payments as ordinary business expenses while the Commissioner argued the expenses were non-deductible capital outlays. The High Court concluded the expenses were capital outlays and the taxpayers appealed to the Privy Council. Decision: The Privy Council considered the 3 factors set out by Dixon J in Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337 (whether the expense yielded a lasting benefit, whether the expenses were recurrent, and whether the benefit acquired was acquired by periodic or lump sum outlays). It also considered whether the expense was related to income-earning structure or process (a factor that the Privy Council treated as a subset of the recurrent factor) and characterised the payments as currently deductible (revenue) expenses, finding the expense related to the process of finding customers, not the structure of the business. Relevance of the case today: The BP Australia case was one of two tied house agreement decisions involving petrol stations heard at the same time by senior UK judges sitting first in their capacity as the Privy Council (the body that heard cases appealed from Australia) and then, with an identical composition, sitting as the House of Lords hearing a UK tax appeal. In the BP Australia case, the judges sitting as the Privy Council found payments made under a tied house agreement with petrol stations to be revenue outgoings. In Strick v Regent Oil Co Ltd the judges sitting as the House of Lords found payments made under a tied house agreement with petrol stations to be capital outgoings in a slightly different fact situation. The Sun Newspapers factors used by the Privy Council continue to be applied and in many instances the income-earning process or income-earning structure test has been elevated to a paramount test. The BP Australia precedent may be used as authority for the proposition that transactions regularly entered into for the purpose of increasing sales of the taxpayer’s primary products are likely to be characterised as outgoings incurred in the income-earning process and assume a revenue character. If it happened today: Expenditures similar to those incurred in BP Australia continue to be characterised as revenue outlays and are deductible under s 8-1 ITAA 1997.

Strick (Inspector of Taxes) v Regent Oil Co Ltd [1966] AC 295 (House of Lords)

Facts: Regent was a petrol refiner that secured “tied house” agreements with retailers by way of lease contracts. Regent made lump sum payments to secure long term leases of petrol stations (for between 10 and 21 years) and then leased the stations back to the owners in a sub-lease contract for a token rent and the condition that the owners only sell Regent petrol. The owners ended up with significant payments and an obligation to sell only Regent petrol for the life of the leases and sub-leases. Regent sought deductions for the lump sum payments it made (called lease premiums) to obtain the long-term leases, arguing the expenditures were incurred for the purpose of securing customers. Regent argued the payments were on revenue account even though they were lump sums because it was regularly entering into these arrangements and making 220

© Thomson Reuters 2019

CHAPTER 9

CAPITAL OR REVENUE EXPENSES

payments in the course of its business. The Inland Revenue argued the expenses were capital outgoings to secure enduring advantages. Decision: The House of Lords concluded the payments made by the taxpayer in Regent were non-deductible capital outgoings relating to interests in real property and securing long-term benefits. The key consideration appeared to be the length of the benefits obtained for the payments, which were considerably longer than those obtained by the taxpayer in BP Australia Ltd v FCT (1965) 112 CLR 386; [1966] AC 224. As there were no amortisation or depreciation measures available for lump sum payments to obtain long term lease or contractual rights, the taxpayer was unable to deduct the cost of the benefits over their life. Relevance of the case today: The Regent Oil Co Ltd case is often cited in contrast to the BP Australia Ltd case to illustrate the distinction between revenue and capital expenses. It shows that longer term benefits, particularly if they are connected with real property, are more likely to be characterised as capital expenses. If it happened today: If expenditures similar to those incurred by the taxpayer in Regent Oil Co Ltd were incurred by a taxpayer in Australia today, they would likely be characterised as non-deductible capital expenses. However, they would be treated as the cost of acquiring a CGT asset, being the leasehold rights, and this cost would give rise to a capital loss on expiration of the lease agreement (a C2 event, s 104-25 ITAA 1997 1997).

National Australia Bank Ltd v FCT

(1997) 37 ATR 378; 97 ATC 5153 (Full Federal Court)

Facts: The taxpayer carried on a retail banking business. It made a large lump sum payment to the Commonwealth under an agreement that it was to be the exclusive lender for 15 years under a Commonwealth subsidised home loan scheme which was offered to members of the defence forces. The agreement also called for additional annual payments where loan quotas were exceeded. The taxpayer claimed a deduction for the lump sum payment on the basis that it was akin to a minimum royalty payment or a marketing expense. The Commissioner argued that this outgoing was not deductible as it was of a capital nature since the payment secured for the taxpayer a monopoly over a certain class of business and that this was therefore an asset or advantage for the enduring benefit of the taxpayer’s business. Decision: The outgoing was on revenue account and was therefore a deductible expense. Applying the relevant tests, the nature of the advantage sought was an expansion of the customer base and the resultant increase in income earned from these loans. The case was considered to be not unlike BP Australia Ltd v FCT (1965) 110 CLR 386. Although the initial payment was once and for all, the Bank had wanted to make periodic payments but the Commonwealth had insisted on a lump sum. It was considered that the recurrent annual payments would clearly have been deductible outgoings and it would be a strange case if the initial lump sum payment were characterised differently as the same advantages were sought by both. The payment © Thomson Reuters 2019

221

AUSTRALIAN TAXATION LAW CASES 2019

did not create a monopoly or even something in the nature of a monopoly – the defence force personnel could still obtain loans from other banks. It was also considered that the payment did not enlarge the framework of the business but rather was incurred as part of the process by which the taxpayer obtained regular returns by means of regular outlay. Relevance of the case today: This case is an example of the application of the tests put forward in Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337 and later cases involving the capital/revenue distinction. It shows that a court will look beyond the form of the outgoing and focus on the nature of the advantage sought by the expense when determining if the expense enlarged the taxpayer’s structure or related to its business activities. If it happened today: If the facts of this case were to occur today, the lump sum payment would most likely be considered on revenue account. If it were concluded that the outgoing was capital in nature, the amount could be characterised as the cost of acquiring a CGT asset, being the rights of the taxpayer under the agreement, and this cost would give rise to a capital loss on expiration of the agreement (a C2 event, s 104-25 ITAA 1997 1997).

FCT v Star City Pty Ltd

(2009) 72 ATR 431; 2009 ATC 20-093 (Full Federal Court)

Facts: The taxpayer was successful in its application to acquire an exclusive licence to operate a casino in NSW. Under the terms of its agreement with the NSW government, it was granted a 99-year lease over the land where the casino was located and a 12 year exclusive licence. It was required to make an upfront payment of $253m for the licence plus $120m in prepaid rent covering the first 12 years’ rental (being a discounted payment for an initial rental amount of $15m rent per year) and $250,000 per year for the remaining 87 years of the lease. The taxpayer argued the prepaid rent was deductible as a revenue expense. At first instance, the Federal Court agreed with the taxpayer but required it to apportion the deductions over the 12-year period under s 82KZM ITAA 1936. The Commissioner appealed, arguing the prepayment was in fact part of the cost of the casino licence and, as such, was a capital expense. Decision: The Full Federal Court reversed the decision of the lower court, agreeing with the Commissioner that the prepaid rent was mostly a payment to acquire the exclusive licence for 12 years. Factors supporting this conclusion included the fact that the amount was payable in a lump sum when the licence was granted and the fact that the rent dropped so much after the licence expired. Despite the parties’ characterisation of the payment as prepaid rent, it was clear that it was negotiated as part of the taxpayer’s bid to win the exclusive licence. Relevance of the case today: The Star City case shows that the court will look beyond the mere form of a contract and consider the true nature of a payment in the context of the overall commercial arrangement. A payment described as a revenue item will be treated as a capital outgoing if it can be shown that the parties intended it to be 222

© Thomson Reuters 2019

CHAPTER 9

CAPITAL OR REVENUE EXPENSES

part of the cost of acquiring a capital asset. One factor that will be considered by the courts when characterising so-called revenue payments is whether they are manifestly excessive compared to revenue payments not connected to the ancillary acquisition of an asset. If it happened today: If the facts of Star City were to occur today, the lump sum payment would once again be considered a capital expenditure with a court looking at the totality of the contractual arrangements to see that the excess rent was an integral part of the bid for an exclusive licence. The taxpayer may encounter a problem in recognising the payment if is found to be a capital outgoing. If it were explicitly acknowledged in the contract to be part of the cost of acquiring a CGT asset, the exclusive licence rights, the cost would give rise to a capital loss on expiration of the licence (a C2 event, s 104-25 ITAA 1997 1997). However, the taxpayer has claimed that the payment is prepaid rent for a period rather than the cost of acquiring a CGT asset. To recognise the outgoing, the taxpayer will have to convince the ATO that its characterisation of the payment as cost of the license should be recognised for CGT purposes despite the paperwork that purports to show the payment is for something else.

AusNet Transmission Group Pty Ltd v FCT

[2015] HCA 25; 255 CLR 439; 99 ATR 816; 2015 ATC 20-521 (Full High Court)

Facts: Following privitisation of a State-owned utility, the taxpayer acquired an electricity transmission business. The acquisition included tangible equipment, intangible assets such as contracts with customers and a licence issued by the State government that was required to operate the business. A condition of the licence was that the State could require from time to time licence “payments” which in effect were a mechanism to ensure the State was able to receive a portion of any excess profits derived by the company as a result of its monopoly position in the market. The taxpayer argued the regular payments were incurred as a condition of its ongoing business using the licence. The Commissioner argued the original acquisition agreement required the taxpayer to make an initial lump sum payment and ongoing licence fee payments with both parts related to the acquisition of the licence and therefore capital expenses. Decision: A majority of the High Court agreed with the Commissioner that the expenses were capital in nature as part of the cost of acquiring the licence given the structure of the original contract. The Court noted that if the payments were not made the licence could be revoked. Relevance of the case today: The privatisation arrangement faced by the taxpayer in AusNet Transmission had been designed by the State government to ensure the ongoing payments related to ownership of a monopoly right could not be construed as excise taxes, a type of tax reserved exclusively to the Commonwealth government under the Constitution. As the “licence” was permanent in nature, so long as the charges were paid, the taxpayer could not argue they were annual licence fees. The taxpayer had no option in this case but to accept the terms as set out in the privatisation legislation. The prime relevance of the case today is as a warning to investors in other situations that © Thomson Reuters 2019

223

AUSTRALIAN TAXATION LAW CASES 2019

they structure sales agreements so any future payments relate to use of a right retained by the vendor, in which case they would be characterised as deductible business expenses rather than outgoings related to the acquisition of property. If it happened today: If the facts of AusNet Transmission were to occur today, the payments would continue to be characterised as capital outlays related to the acquisition of the transmission business, including a licence to conduct the business. The payments could be considered part of the cost base of acquiring the business and be recognised if there were an eventual sale of the business. As the licence was indefinite, it would not be possible to treat the payments as a capital loss on expiration of the licence (a C2 event, s 104-25 ITAA 1997 1997).

FCT v Sharpcan Pty Ltd

[2018] FCAFC 163, (2018) ATC 20-670

Facts: The taxpayer was a sole beneficiary of a trust which conducted a hotel and gaming business. Due to legislative changes in Victoria to continue to run the gaming activities the trustee was required to bid for gaming machine entitlements to operate its 18 machines on the premises. The total cost of these entitlements was $600,000 which in turn gave the holder the right to conduct gaming on an approved machine for 10 years. The Commissioner assessed the taxpayer on the basis that the expenditure was on capital account and not deductible in the year it was incurred. The taxpayer objected to the assessment on the basis that the expense was deductible under either s 8-1 ITAA 1997 or, in the alternative if the expenditure was capital in nature, under the “black hole” provisions in s 40-880 of ITAA 1997. The AAT set the Commissioner’s assessment aside and held that the expenditure was deductible under s 8-1 ITAA 1997. The Commissioner appealed to the Federal Court contending that the expenditure was to maintain the advantage sought, that is, preserving and protecting the business and, by its very nature, related to the profit making structure of the business. Decision: Dismissing the appeal, the majority of the Full Federal Court (judgement by Greenwood ACJ, McKerracher J agreeing, Thawley J dissenting) concluded that the whole of the amount was deductible under s 8-1 as being incurred in deriving assessable income (positive limb) and not capital in nature (negative limb). In arriving at the decision, the Court relied on BP Australia Ltd v FCT (1965) 112 CLR 386 taking note of the income that would be generated from the expenditure over a 10year period. The majority also found that if the expenditure was capital in nature, it would be deductible over 5 years under s 40-880 ITAA 1997 on the basis that it merely preserved but did not enhance the value of goodwill. Relevance of the case today: Sharpcan is an important case in recognising the difficulty in determining whether expenditure is on revenue account or capital account. The Full Federal Court recognised the plurality of such expenditure. It stated: “The plurality …, the ‘evaluative judgment’ required to be made in determining the character of the outgoing by weighing up: the form of the expenditure, its purpose and its effect; the benefit derived by the taxpayer from the expenditure; and the relationship the expenditure bears to the structure of the business as distinct from the conduct 224

© Thomson Reuters 2019

CHAPTER 9

CAPITAL OR REVENUE EXPENSES

of the business. Not surprisingly, some of these factors might point in one direction while others point in a different direction”. If it happened today: If similar facts to those in Sharpcan arose today, the taxpayer would claim the expenditure on revenue account. Given the dissenting judgment in Sharpcan, along with the majority judgment emphasis on the plurality of the concept, the Commissioner may argue that the circumstances are different and the expenditure should be on capital account.

PROTECTION OF TITLE EXPENSES Early UK and Australian cases treated expenditures incurred by a taxpayer to defend its title to property as revenue expenses. The outgoings were viewed as akin to maintenance expenses for property which yielded no enduring benefit as the defeat of one person’s claim to a taxpayer’s property would not necessarily stop the rest of the world from making similar claims. The prospect of the Australian position moving away from that in other Commonwealth jurisdictions became evident in the 1946 case of Hallstroms when Dixon J applied the structure-process test he had proposed in 1938 in Sun Newspapers to find protection of title expenses to be capital outgoings. While a majority of the High Court rejected this approach at the time, not long afterwards Dixon J was elevated to Chief Justice and his dissent in Hallstroms became the basis for the majority decision in the 1952 case of Broken Hill Theatres. From that point, protection of title expenses was treated as a non-recognised capital outlay until the adoption of capital gains tax in 1986, at which point they could be added to the cost base of the assets to which they related. If the expenses were incurred to defend a taxpayer’s general position, but no specific asset, they generally remained unrecognised expenses for tax purposes – sometimes referred to as “black hole” expenses. However, in some cases, taxpayers were able to present the expenses as business maintenance expenses and distinguish precedents that would have led to the outgoings being treated as capital outgoings. In 2006, s 40-880 ITAA 1997 was amended so it would apply to expenses that would otherwise be non-recognised black hole expenses and it now allows taxpayers to deduct these expenses over 5 years. Otherwise unrecognised protection of title expenses can now be deducted under this provision. If legal expenses incurred in a dispute over the ownership of an asset were found to relate to clarifying title at the time of acquisition, the cost would most likely now be treated as part of the cost base of the asset under s 110-25(6) ITAA 1997.

Southern v Borax Consolidated Ltd [1941] 1 KB 111 (UK High Court)

Facts: The taxpayer owned land on which business buildings and wharves had been constructed. The city of Los Angeles attacked the taxpayer’s title to the land, claiming it owned the land and as a result the taxpayer owed the city various fees for the use of its land. The taxpayer incurred substantial legal expenses defending its title to the land. © Thomson Reuters 2019

225

AUSTRALIAN TAXATION LAW CASES 2019

Inland Revenue denied the taxpayer a deduction for the expenses on the basis that they were capital outgoings. Decision: The judgment of Lawrence J was based on the principle that expenses incurred to improve a capital asset are capital outlays while expenses that do not alter the asset are revenue expenses. An expense to defend a taxpayer’s title to property maintained the taxpayer’s title but did not add to it and was therefore a revenue expense that could be deducted as incurred. Relevance of the case today: The line of reasoning followed in the Borax Consolidated Limited case was originally followed in Australia where courts also treated defence of title expenses as revenue outgoings in cases such as Hallstroms Pty Ltd v FCT (1946) 72 CLR 634. However, in a dissenting opinion in Hallstroms, Dixon J argued defence of title expenses related to the structure of a business and under the process-structure distinction he proposed should be treated as capital outlays. Following his appointment as Chief Justice, Dixon CJ elevated his dissent in Hallstroms to the majority position in Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423. That doctrine remains in place in Australia today and Southern v Borax Consolidated Ltd is no longer used as precedent in Australia for characterisation of expenses incurred to defend title. If it happened today: If the facts in Southern v Borax Consolidated Ltd arose today in Australia, the taxpayer’s expenditure would be characterised as a non-deductible capital outlay. The taxpayer would be allowed to add the cost of defending title to the cost base of the land using s 105-25(6) ITAA 1997.

Hallstroms Pty Ltd v FCT

(1946) 72 CLR 634 (Full High Court)

Facts: Shortly before a competitor’s patent for a refrigerator design was due to expire, the taxpayer commenced manufacture of refrigerators based on the design protected by the patent. It collected orders from the retailers for sale after the expiry of the patent. Following the expiry of the patent, the patent holder applied for an extension of its patent. The taxpayer incurred legal fees opposing the competitor’s application. The taxpayer argued the expense was a deductible revenue outlay but the Commissioner assessed the taxpayer on the basis that the outgoing was a non-deductible capital expense. Decision: A majority of the High Court concluded the expense was a deductible revenue outgoing. It was treated as an expenditure incurred to protect existing rights, a situation described as analogous to that found in Southern v Borax Consolidated Ltd (1941) 1 KB 111. In a dissenting opinion, Dixon J found the expense to be capital on the basis of its connection with the structure of the taxpayer’s business. Utilising the distinction between expenses related to the income-earning process and the income-earning structure he set out in Sun Newspapers Ltd v FCT (1938) 61 CLR 337, Dixon J concluded the expenses were capital in character because they related to the protection of the taxpayer’s income-earning structure. Dixon J suggested the result in Southern v 226

© Thomson Reuters 2019

CHAPTER 9

CAPITAL OR REVENUE EXPENSES

Borax Consolidated Ltd Ltd, relied upon by the majority as authority for their views, could not be supported. Relevance of the case today: Ultimately, the dissenting opinion of Dixon J proved to be of far more significance than the majority opinion. Following his appointment as Chief Justice, in Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423, Dixon CJ relied on his dissent in Hallstroms to elevate the income-earning process vs income-earning distinction as the pre-eminent test for distinguishing revenue and capital expenses. As a result, Australian law ceased to follow the approach in Southern v Borax Consolidated Ltd and instead the dissent of Dixon J in Hallstroms became the basis for Australian law. The Hallstroms decision is thus most relevant today for the dissenting opinion of Dixon J than for the majority view in the case. If it happened today: If the facts in Hallstroms were to arise today, it is likely the case would be decided in favour of the Commissioner rather than for the taxpayer, as was the outcome in the original case. This is because the dissenting position of Dixon J was elevated to become the binding law in Broken Hill Theatres so expenses incurred to protect title are characterised as capital outgoings. The predecessor to s 105-25(6) ITAA 1997 was added to the ITAA to enable taxpayers to recognise the cost of protecting title or position by adding the cost to the cost base of the relevant asset. However, the provision would not assist the taxpayer in a situation similar to that in Hallstroms as there is no asset with a cost base to which the expenditure relates. Most likely, if the facts in Hallstroms were to arise today, for tax purposes the expense could be deducted over 5 years under s 40-880(2) ITAA 1997 which provides recognition for what were previously non-recognised black hole expenses.

John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30 (Full High Court)

Facts: Fairfax was a newspaper publisher that acquired control of another newspaper company, Associated, through an agreement under which Associated issued shares from previously unissued capital to Fairfax. In a directors’ meeting held shortly after midnight, sufficient shares were issued to Fairfax to give it effective control over Associated. A minority shareholder in Associated acting on behalf of a rival suitor subsequently brought an action in the Supreme Court of NSW arguing that the share issue was improper and on this basis seeking a declaration that the issuance was void. Following a number of court hearings, the action was dismissed and Fairfax was allowed to retain its controlling interest. Fairfax was a party to the case and incurred legal expenses to contest the action. The Commissioner denied Fairfax a deduction for the legal expenses on the basis that they were capital outgoings and Fairfax appealed the assessment. Decision: A majority of the High Court concluded the legal costs incurred by Fairfax were capital expenditures incurred as part of the acquisition of the shares in Associated. While the shareholder’s action had the object of voiding a transaction that was apparently completed, the action took this form only because it was not possible © Thomson Reuters 2019

227

AUSTRALIAN TAXATION LAW CASES 2019

to seek an earlier intervention given the time at which the allocation took place. As a consequence of their characterisation as capital expenses, the legal costs were not deductible under s 51(1) ITAA 1936, the predecessor provision to s 8-1 ITAA 1997. Dixon CJ also concluded the expense was a capital outgoing but arrived at the conclusion using a slightly different route, applying the tests he had suggested in Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337 and finding the expense was related to the “organization and structure of the profit-earning enterprise” as opposed to a revenue process. Relevance of the case today: The Fairfax decision was on the cusp of a shift from older tests used to distinguish capital and revenue expenses to the principal test used today, based on a distinction between expenses related to an income earning structure and those related to an income earning process. While the majority characterised the expense as capital by treating it as another expenditure incurred in the acquisition of shares, the minority opinion of Dixon CJ applied the income earning structure vs income earning process test he had first developed in Sun Newspapers and the minority opinion of Dixon CJ is often cited as authority for this test. If it happened today: If the facts in Fairfax arose today, the legal expenses incurred by the taxpayer would continue to be characterised as capital outgoings. Most likely the expenditure could be added to the cost base of the shares acquired under s 110-25(6), the fifth element of cost base.

Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423 (Full High Court)

Facts: The taxpayer incurred legal expenses opposing a licence application by a potential competitor. Licence applications were heard annually so as a result of the expenditure the taxpayer was protected from competition for 12 months. The taxpayer argued the expense should be deductible as a revenue expense as it did not alter or add to any asset of the taxpayer. Decision: The High Court stated that the approach taken in Southern v Borax Consolidated Ltd [1941] 1 KB 111 (that expenses incurred to defend title or position are revenue outgoings) could not be supported. Instead, the Court under the leadership of Dixon CJ upheld the decision at first instance based on the income earning process or income earning structure test that Dixon J (as he then was) advocated in his minority opinion in Sun Newspapers and Associated Newspapers Ltd v FCT (1938) 61 CLR 337 and applied by him to defence of title or defence of position expenses in his dissent in Hallstroms Pty Ltd v FCT (1946) 72 CLR 634. The expense was accordingly characterised as a capital outlay and the taxpayer was denied a deduction for the expense. Relevance of the case today: Broken Hill Theatres has become a leading example of the application of the income-earning process and income-earning structure distinction and it remains a key precedent in Australia for the proposition that expenses incurred to defend title or position will be capital outlays. 228

© Thomson Reuters 2019

CHAPTER 9

CAPITAL OR REVENUE EXPENSES

If it happened today: The predecessor to s 105-25(6) ITAA 1997 was added to the ITAA to enable taxpayers to recognise the cost of protecting title or position by adding the cost to the cost base of the relevant asset. However, the provision would not assist the taxpayer in a situation similar to that in Broken Hill Theatres as the taxpayer in that case has no asset with a cost base to which the expenditure relates. Most likely, if the facts in Broken Hill Theatres were to arise today, for tax purposes the expense could be deducted over 5 years under s 40-880(2) ITAA 1997 which provides recognition for what were previously non-recognised black hole expenses.

FCT v Consolidated Fertilizers Ltd

(1991) 22 ATR 281; 91 ATC 4677 (Full Federal Court)

Facts: The taxpayer was a fertiliser manufacturer whose product used a technology licensed from a US company. The US company’s right to license the technology was subject to a legal challenge and the taxpayer joined the US company’s legal defence of that right. In the final settlement of the action, the taxpayer’s right to continue using the technology was protected and it agreed to contribute to the legal fees of the other party that had launched the action against the US company. The Commissioner denied the taxpayer a deduction for its legal fees and its contribution to the other side’s legal fees on the grounds that the expenses were capital in nature. Decision: The taxpayer already held a profit-yielding asset so legal expenses were not incurred to enhance or enlarge a business or existing asset. An expenditure incurred for the purpose of preserving and protecting a business on an isolated occasion can be distinguished from an expense incurred in the course of prudent management of a business. Protecting its right to use the licensed technology was a matter requiring continual attention as it could be threatened by a number of other parties in addition to the person responsible for these particular expenses. The expenses were, accordingly, revenue outgoings incurred in the normal course of business. Relevance of the case today: The Consolidated Fertilizers case provided a means for taxpayers to avoid the implications of a strict application of the holding in Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423. If the taxpayer is able to show that the primary characterisation of an outgoing is not an expense to protect title or an existing structure, but rather an expense incurred as part of an ongoing response to business threats, it may be possible to treat the expense as a revenue outgoing rather than a capital expense. If it happened today: If the facts in Consolidated Fertilizers were to arise today, a court would likely once again find the expenses were revenue outgoings incurred as part of a continual process of managing business threats. However, another court might find on the fact that this was an isolated threat to its business structure and characterise the expense as a capital outgoing on the basis of Broken Hill Theatres. It is possible that the court in Consolidated Fertilizers was influenced by the fact that had it been decided the expense was a capital outgoing in that case, it would have been a black hole expense, never recognised for tax purposes as there was no asset directly associated with the expense and therefore no cost base to add the expense to under © Thomson Reuters 2019

229

AUSTRALIAN TAXATION LAW CASES 2019

s 105-25(6) ITAA 1997. A court looking at the facts today would not be influenced by this factor since the expense could now be deducted over 5 years under s 40-880(2) ITAA 1997, which provides recognition for what were previously non-recognised black hole expenses.

MOVING EXPENSES Lister Blackstone Pty Ltd v FCT

(1976) 134 CLR 457; 6 ATR 499; 76 ATC 4285 (Full High Court)

Facts: The taxpayer incurred moving expenses to shift its business from one location to another. Most of the expenses related to moving trading stock from the original location to the new premises. The Commissioner denied the taxpayer a deduction for the expenses on the basis that they were not incurred in gaining of assessable income or, alternatively, if they were, the expenses were capital in nature as they related to the shift of the taxpayer’s income-earning structure. Decision: Expenses related to the movement of trading stock are not incurred in respect of the structure of a business and are therefore not capital expenses. Relevance of the case today: The Lister Blackstone case shows that expenses associated with trading stock generally acquire a revenue character, even if they are extraordinary such as the one-off cost of shifting a business’ premises. If it happened today: If a business were to incur expenses today similar to those incurred by the taxpayer in Lister Blackstone, the expenses would be deductible under s 8-1 ITAA 1997.

PURCHASES OF PROPERTY FOR A SERIES OF PAYMENTS Egerton-Warburton & Ors v DFCT (1934) 51 CLR 568 (Full High Court)

Note: The High Court’s decision in Egerton-Warburton v DFCT involved two sets of taxpayers – a father who disposed of property and two sons who acquired it. The case is exceptional in the sense of deciding the tax consequences of two different taxpayers. This synopsis deals with the outgoings by the sons; the receipts to the father are considered in Chapter 5. In other cases involving the sale of property for an income stream, the tax positions of vendors and purchasers have been decided separately, sometimes with the result that one party cannot deduct the payments while the other party is fully assessable on them. While the High Court’s decision in Egerton-Warburton provided for symmetrical treatment of the vendor and purchasers, the Court made it clear that the characterisation of the payments by the purchasers was determined separately from the characterisation of the receipts to the vendor. 230

© Thomson Reuters 2019

CHAPTER 9

CAPITAL OR REVENUE EXPENSES

Facts: The taxpayers in this case were a father and his two sons. The father sold certain land on which he had carried on a farming business to his sons. The sons agreed to pay the father an annuity for his life, an annuity at a reduced level to his wife (their mother) should the father predecease her and a lump sum to their sisters on the death of the surviving parent. The agreement between the sons and father allowed the father a right of repossession of the property should the sons default on the annuity. The issue before the Court from the perspective of the sons was whether the annuity payments were deductible expenses. Decision: The sons were allowed deductions for the full amount of the annuity payments as expenses incurred to obtain and retain use of the land for the purposes of producing assessable income. Although the taxpayers obtained the farmland as a consequence of the payments, the outgoings were characterised as revenue expenses. It was noted that as a result of the charge on the property (the father’s right to repossess the land if the sons defaulted), the expenses were necessary to the retention of income-producing property. Relevance of the case today: This case is mainly referred to for the Court’s decision regarding the characterisation of the payments received by the father, not the outgoings by the sons. While it remains authority for the proposition that a taxpayer may acquire an asset by making a series of revenue payments, the decision has been distinguished in some key later cases such as Colonial Mutual Life Assurance Society Ltd v FCT (1953) 89 CLR 428 which have found a series of payments to be capital purchase price (but also see Cliffs International Inc v FCT (1979) 142 CLR 140; 9 ATR 507; 79 ATC 4059, where a series of post-acquisition payments were held to be deductible). However, Egerton-Warburton may continue to apply where payment is by way of a fixed amount annuity. If it happened today: While it is possible that a court today would again hold the payments are revenue outgoings incurred to retain property, a court might come to a different conclusion in light of the effect of the capital gains provisions. It is clear that the taxpayers acquired property (the land) as a result of the payments, with additional payments to be made in the form of an annuity. This type of agreement is generally known as an “earnout arrangement”. Prior to 24 April 2015, the Commissioner considered the earnout right or rights created under the arrangement to be separate CGT assets dealt with under the CGT provisions (see Draft Tax Ruling TR 2007/D10). Where the arrangement is entered into on or after 24 April 2015 and extends for a period of no more than five years, legislative amendments to the CGT provisions of the ITAA 1997 provide for a “look-through” approach whereby taxpayers recognise the value of any financial benefits as part of the initial transaction. For the seller, this will result in an adjustment to the capital proceeds. For a purchaser, this will result in an adjustment to the cost base of the acquisition of the asset. For arrangements of more than five years, the look-through provisions do not apply and it is likely that the Commissioner would continue to take the approach set out in Draft Tax Ruling TR 2007/D10 (though now formally withdrawn). If a court did not accept the Commissioner’s view that giving a promise to make future payments is not the giving of property, it could separate the transaction into two © Thomson Reuters 2019

231

AUSTRALIAN TAXATION LAW CASES 2019

elements – the purchase of property with the consideration being the agreement to pay an annuity and, separately, the annuity. If this approach were used, the taxpayers’ cost base for the acquisition of the land would be the present value of the annuity agreement under s 110-25(2)(a). This amount would then constitute the issue price for the security under s 159GP(1) ITAA 1936. Division 16E ITAA 1936 would then apply to apportion each annuity payment so the part that represents the return of the issue price would not be deductible to the taxpayers but the balance would be deductible.

Commissioners of Inland Revenue v Ramsay [1935] All ER 847 (UK Court of Appeal)

Facts: The taxpayer purchased a dental practice under an agreement which specified a “primary price” of £15,000. This price was to be satisfied by an initial lump sum payment of £5000 plus annual payments for ten years equal to 25% of the net profits of the practice for each year. If the total amount actually paid was greater or less than the specified “primary price” the price was considered to be so increased or decreased. In the documents the annual payments were characterised as capital but the taxpayer sought to deduct those annual amounts. The Court was required to characterise the payments as either capital or revenue. Decision: The Court held that the payments were instalments of capital and therefore were not deductible. In determining the proper construction of the arrangements, significant weight was given to the form of the arrangements. In the opinion of Romer LJ, the viewpoint of the vendor was adopted in determining the characterisation of the payments as capital or income, a characterisation which would then also apply to the purchaser. It was considered that the vendor has the power to choose the form of the payments, either as an annuity or as a lump sum payable by instalments of capital, and that choice will dictate the form of the agreement and therefore the characterisation for tax purposes. Relevance of the case today: This case is an early example of an earn-out clause which is commonly used on the sale of a small business where the vendor and purchaser cannot agree on a fixed price but rather allow for variation of the price depending on the continued profitability of the business after the departure of the founder. Other UK cases such as Secretary of State in Council of India v Scoble [1903] AC 299 and Vestey v Inland Revenue Commissioners [1962] Ch 861 showed that UK courts would look beyond the form of a sale for continuing payments where there was evidence of a capital amount and an imputed interest component to the payments. This approach has not been followed in Australia. However, if the continuing payments are akin to an income payment such as royalties for the exploitation of property, an Australian court would distinguish precedents such as Ramsay and instead follow the approach used in Cliffs International Inc v FCT (1979) 142 CLR 140; 9 ATR 507; 79 ATC 4059. Australian courts have also not adopted the approach taken by Romer LJ in assuming that the character determined from the perspective of the vendor will also apply to the purchaser. The character of the outgoings as either revenue or capital must be determined from the perspective of the taxpayer who incurs those outgoings. For an example of where the courts have considered an arrangement from the perspective of 232

© Thomson Reuters 2019

CHAPTER 9

CAPITAL OR REVENUE EXPENSES

the two parties and have determined different characterisations see Colonial Mutual Life Assurance Society Ltd v FCT (1953) 89 CLR 428 (where the outgoings were considered capital to the purchaser) and Just v FCT (1949) 4 AITR 185; 8 ATD 419 (where the receipts from the same transaction were considered income to the vendors). If it happened today: Specific CGT rules now apply to earnout payments of the type found in Ramsay. Those rules specify that earnout payments will not be deductible but instead under s 112-36 ITAA 1997 will be treated as part of the cost base of the asset that was acquired. However, the earnout payment rules do not apply to earnout payments that last longer than five years after the acquisition. This was the case in Ramsay. If a business were sold under arrangements like those in Ramsay and the earnout payments rules did not apply, the taxpayer would argue the payments are similar to those in Cliffs International Inc v FCT as they are continuing and directly related to the business operations and profits. The Commissioner would seek to apply the view expressed in the now withdrawn Draft Tax Ruling TR 2007/D10 and require the taxpayer to recognise the value of the earnout payments by adding the estimated present value of the earnout payments at the time of acquisition to the cost base in the asset acquired. The Commissioner’s view in the draft ruling has not changed despite its withdrawal and has not been tested in a case in which the taxpayer has argued earnout payments should instead be recognised as revenue expenses as they are incurred.

Colonial Mutual Life Assurance Society Ltd v FCT (1953) 89 CLR 428 (Full High Court)

Facts: Colonial Mutual Life agreed to purchase certain land from the Just brothers which adjoined other land owned by the taxpayer. In consideration for the transfer, the taxpayer agreed to pay a “rent charge” on a monthly basis over 50 years. The “rent charge” was equal to 90% per annum of rents as and when received in respect of three shops and a basement. The issue before the Court was whether these outgoings were deductible under s 51(1) ITAA 1936 (now s 8-1 ITAA 1997 1997). Decision: The Court held that the outgoings were not deductible as they were expenditure incurred in acquiring a capital asset, not working expenses, distinguishing Egerton-Warburton v DFCT (1934) 51 CLR 568. In an earlier decision, the High Court had held that these amounts were assessable in the hands of the Just brothers (see Just v FCT (1949) 4 AITR 185; 8 ATD 419) but the Court pointed out that it does not necessarily follow that because the payments are assessable income of the seller they are allowable deductions to the purchaser. Relevance of the case today: In determining the deductibility of an outgoing, this case shows that the recurrence of a payment does not necessarily mean that it is revenue in nature and not capital. The decision focuses on the effect of the outgoings – they were incurred to acquire a capital asset and therefore are capital in nature. If it happened today: If an arrangement such as this were entered into today, a court would likely find that the payments are capital outgoings, forming the purchase price of the land. Where, as in this case, the amount of money to be paid to acquire an asset is © Thomson Reuters 2019

233

AUSTRALIAN TAXATION LAW CASES 2019

uncertain, reference should be made to the now withdrawn Draft Tax Ruling TR 2007/ D10 for the ATO’s view of this type of transaction. In determining the cost base of the land under s 110-25(2) ITAA 1997 where the amount to be paid is a contingent and unascertainable amount, a contingent payment will only form part of the cost base of the land when it is incurred (at this point the amount is fixed). If the court characterised the payments as capital outgoings and also accepted the Commissioner’s view that the purchaser’s promise to make future payments is not the giving of property, the payments appear to fall outside the scope of Division 16E ITAA 1936, and there would be no basis for apportioning between income and capital components under that Division. If, however, a court did not accept the Commissioner’s view that giving a promise to make future payments is not the giving of property, it could separate the transaction into two elements – the purchase of property with the consideration being the agreement to make continuing payments. If this approach were used, the taxpayers’ cost base for the acquisition of the land under s 110-25(2)(a) would be present value of the obligation to make the future payments. The obligation would be a security for Division 230 ITAA 1997 purposes and the taxation of financial arrangements rules would then apply to apportion each payment so the part that represents the return of the issue price would not be deductible to the taxpayers but the balance would be deductible.

Cliffs International Inc v FCT

(1979) 142 CLR 140; 9 ATR 507; 79 ATC 4059 (Full High Court)

Facts: The taxpayer acquired the shares in a mining company by way of an earn-out purchase agreement for a fixed initial payment of US $200,000 plus deferred payments of US 15¢ per ton of iron ore mined, payable every six months. The payments were described as deferred purchase payments. The taxpayer then contracted with a consortium to mine the site it had acquired in return for royalty payments for iron ore extracted by the consortium. The taxpayer argued the deferred payments were deductible current expenses analogous to rent or royalties for the ongoing ownership of the shares which gave it access to mining rights. The Commissioner argued the deferred payments were capital outgoings for the purchase of shares. Decision: A majority of the Court concluded that the “deferred payments” were deductible outgoings incurred in the gaining of the taxpayer’s assessable income consisting of the royalties received from the consortium. The basis for the conclusion appeared to be the direct nexus between royalties received by the taxpayer based on the amount of iron ore extracted from its tenements and the payments it made to the company that sold it the shares in the company owning the mining tenement rights. Relevance of the case today: The decision of the majority of the Court in Cliffs International is relevant for the view taken that the description afforded the payments by the parties in their agreements can be disregarded in determining the true character of outgoings. It can be used as a precedent for construing earnout payments as current deductible expenses where the payments are linked to ongoing future income receipts. However, the case was decided prior to the adoption of the capital gains tax regime and 234

© Thomson Reuters 2019

CHAPTER 9

CAPITAL OR REVENUE EXPENSES

its relevance has been reduced to cases where the earnout payments are for a period of five years or less. In these cases, the earnout payments will not be deductible but instead under s 112-36 ITAA 1997 will be treated as part of the cost base of the asset that was acquired. If it happened today: Australia’s capital gains tax was adopted subsequent to the decision in Cliffs International. Specific CGT rules apply to earnout payments of the type found in Cliffs International. Those rules specify that earnout payments will not be deductible but instead under s 112-36 ITAA 1997 will be treated as part of the cost base of the asset that was acquired. However, the earnout payment rules do not apply to earnout payments that last longer than five years after the acquisition. This was the case in Cliffs International. If the facts of Cliffs International were to occur today, the taxpayer would argue the Cliffs International precedent should be followed and the earnout payments should be deductible as revenue outgoings incurred to derive royalty income. The Commissioner would argue that the adoption of the CGT rules after the decision in Cliffs International now offers another means for the taxpayer to recognise its expenses. Under the now withdrawn draft ruling Draft TR 2007/D10, the Commissioner argues the value of the earnout payments should be recognised by adding the estimated present value of the earnout payments at the time of acquisition to the cost base in the asset acquired. The Commissioner’s view in the draft ruling has not changed despite its withdrawal and has not been tested in a case in which the taxpayer has argued earnout payments should instead be recognised as revenue expenses as they are incurred.

© Thomson Reuters 2019

235

C HAPTER 10

Specific Deductions REPAIRS OR IMPROVEMENTS ....................................................................... 238 Law Shipping Co Ltd (1923) ................................................................... 238 Rhodesia Railways Ltd (1933) ................................................................ 239 Western Suburbs Cinemas Ltd (1952) ..................................................... 240 Lindsay (1961) ........................................................................................ 241 W Thomas & Co Pty Ltd (1966) ............................................................. 242 Odeon Associated Theatres (1973) ......................................................... 243 CAPITAL ALLOWANCES ................................................................................... 243 Quarries Ltd (1961) ................................................................................ 244 Wangaratta Woollen Mills Ltd (1969)..................................................... 244 Imperial Chemical Industries of Australia and New Zealand Ltd (1970) ........................................................................................... 245 BHP Billiton Ltd (2011) ......................................................................... 246 BAD DEBTS .......................................................................................................... 247 Point (1970) ............................................................................................ 247 GE Crane Sales (1971) ........................................................................... 248 BHP Billiton Finance Ltd (2010) ............................................................ 249 TAX LOSSES ......................................................................................................... 249 WE Fuller Pty Ltd (1959) ....................................................................... 250

© Thomson Reuters 2019

237

C HAPTER 10

Specific Deductions REPAIRS OR IMPROVEMENTS Section 25-10 ITAA 1997 allows a deduction for repair expenses. The provision is considered by many to be redundant on the basis that repair expenses would be revenue expenses allowed under s 8-1 in any case. Two key issues are raised by deduction cases. One is whether expenses for “initial” repairs on the acquisition of an asset in need of repair should be considered deductible repair expenses or capital costs of acquisition, added to the cost base of the assets that were repaired. A second issue is whether the work completed on an asset constitutes a deductible repair of the property or an improvement that should be added to the cost base of the asset.

Law Shipping Co Ltd v Inland Revenue Commissioners (1923) 12 TC 621 (Court of Session, Scotland)

Facts: The taxpayer acquired a particular steamship, the Duns Law, with the purpose of using the ship in its business. At the time of purchase, the Duns Law was out of repair and did not meet the standard required for a Lloyd’s Register survey. The taxpayer owned the ship for a short time, completing one voyage, prior to undertaking the requisite repairs to bring the ship up to standard. The taxpayer claimed that the whole of the repair costs should be allowed as a deduction as non-capital repairs. The Commissioners initially denied the deduction in its entirety. The Special Commissioners allowed the taxpayer to deduct the cost of repairs which related to the taxpayer’s period of ownership but denied the deduction for the balance of the repair costs. The issue of the treatment of the balance of the repair costs not referable to the ownership period was appealed to the Court of Session. Decision: The cost to repair the defects which existed when the ship was purchased was a capital expenditure and was therefore not deductible. This cost was capital in the same way as if the original owner had undertaken the repairs before the sale and increased the sale price to reflect the expenses. The repairs may have been deductible if undertaken by the previous owner but this does not mean that the same costs are necessarily deductible to the taxpayer since a large part of the accumulated repairs related to a time the ship was used in the vendor’s trade. 238

© Thomson Reuters 2019

CHAPTER 10

SPECIFIC DEDUCTIONS

Relevance of the case today: This case establishes the proposition that initial repair costs are non-deductible capital outgoings as they are effectively additional acquisition costs rather than maintenance costs. For the cost of repairs to be deductible, the conditions must have resulted from the taxpayer’s use of the asset in its business. This principle has been adopted in Australia through its application in the High Court’s decision in W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58. If it happened today: If the facts in Law Shipping were to arise today in Australia, the cost of initial repairs attributable to the state of the vessel at the time of acquisition by the taxpayer would continue to be characterised as capital outgoings. The taxpayer could treat these initial repair expenses as part of the cost of acquisition of the ship under s 40-190 ITAA 1997. This expense can be deducted over the effective life of the ship under s 40-25 ITAA 1997.

Rhodesia Railways Ltd v Collector of Income Tax, Bechuanaland Protectorate [1933] AC 368 (Privy Council on appeal from Bechuanaland Protectorate)

Facts: The taxpayer operated a railway and carried out substantial work on the tracks which were in need of repair. It replaced the sleepers and rails on many sections of the railway and only the sleepers on some other parts. At some points it replaced the original wooden sleepers with new wooden sleepers and at some points it replaced the original wooden sleepers with steel sleepers. The taxpayer characterised the work as “repairs” and sought deductions for the outlays while the Collector denied deductions on the basis that the expenses were capital outlays. Decision: The Privy Council found the expenses were revenue expenses for repairs, not capital expenses. This conclusion was based on the fact that the expenses were for renewal of the assets rather than improvements as they merely restored the railway to its original state. Relevance of the case today: The Rhodesia Railways case is often cited today by taxpayers in support of arguments that outlays should be classified as repair expenses if the work merely restores an asset to its original state. However, later cases such as Lindsay v FCT (1961) 106 CLR 377 (where wooden pilings were replaced with concrete pilings) and FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102 (where a ceiling was replaced with a ceiling using new materials) show that Australian courts will look to see whether the “repair” involves the replacement of some parts with superior parts rather than parts similar to the worn-out parts to determine whether the work constitutes a repair or improvement. Thus, the “restoration” test in Australia is likely to only apply to the extent the materials used in the restoration are of the same type as those being replaced. The replacement of wood sleepers with steel sleepers would probably not satisfy the current Australian test for repairs. If it happened today: If the facts in Rhodesia Railways were to arise today in Australia, on the authority of Lindsay v FCT (1961) 106 CLR 377 and FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102 an Australian court might find the expenditure was a © Thomson Reuters 2019

239

AUSTRALIAN TAXATION LAW CASES 2019

capital outlay to the extent the taxpayer replaced wooden sleepers with steel sleepers. If this result were to happen, the taxpayer could treat these initial repair expenses as part of the cost of the rail line under s 40-190 ITAA 1997. This expense can be deducted over the effective life of the rail line under s 40-25 ITAA 1997 as capital allowance deductions.

FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102 (High Court)

Facts: The taxpayer wished to repair a damaged ceiling but the materials needed to repair it using the existing type of ceiling were not available so the taxpayer replaced the ceiling with a newer type of material. The architect responsible for the work estimated the cost of repairing the old ceiling would have been £603 had the existing materials been available. The taxpayer sought to deduct £603 of the total amount paid for the new ceiling as a repair under s 53 ITAA 1936 (currently s 25-10 ITAA 1997 on the basis that the new ceiling was installed only because the repair could 1997) not be completed using the original material and the cost of repair would have been a deductible expense. The Commissioner denied a deduction, treating the expenditure as a capital outgoing incurred for an improvement to the taxpayer’s building. At the time, no capital allowance was allowed for buildings of this sort so if the expense was not deductible as a repair, it would be a black hole expense, never recognised for tax purposes. Decision: Kitto J denied the taxpayer a deduction for part of its expenditure as a repair, holding that s 53 is concerned with expenditure which was in fact incurred, not with expenditure which could have been incurred but was not. When a taxpayer has two courses open to him, one involving an expenditure which will be an allowable deduction for income tax and the other involving an expenditure which will not be an allowable deduction, and for his own reasons he chooses the second course, he cannot have his income tax assessed as if he had exercised his choice in the opposite way. Relevance of the case today: Western Suburbs Cinemas is authority for two propositions: first, that replacement of part of a building is an improvement not a repair; and second, that a taxpayer cannot deduct as a repair part of the cost of an improvement on the grounds that the improvement substituted for a repair that otherwise would have been taken. If it happened today: If a taxpayer incurred expenses today similar to those incurred by the taxpayer in Western Suburbs Cinemas, a court would hold that the expenses were costs of improvement falling outside s 25-10. However, if the expense were incurred today, the outgoing would not be a black hole expense never recognised for tax purposes. If the facts of Western Suburbs Cinemas were to arise today, the taxpayer would argue the outgoing was a cost of “capital works” (as defined in s 43-20 ITAA 1997) and the amount paid was a “construction expenditure” (as defined in s 43-70 1997 ITAA 1997 1997). If this argument is successful, this amount can be deducted over a 40 year period on a straight line basis under s 43-15 ITAA 1997, with the 40 year life set out in s 43-210 ITAA 1997. While s 43-20 ITAA 1997 limits capital allowance deductions 240

© Thomson Reuters 2019

CHAPTER 10

SPECIFIC DEDUCTIONS

for buildings to buildings constructed after 21 August 1979, it can be argued that the provision applies separately to improvements commenced after that date. If no capital allowance deduction can be claimed under Division 43 ITAA 1997, it would be possible to include the cost of capital repairs in the CGT cost base of the asset as part of the fourth element (s 110-25(5) ITAA 1997 1997). However, this will only be allowed if the expenditure is still reflected in the state or nature of the asset when it is ultimately disposed of by the taxpayer.

Lindsay v FCT

(1961) 106 CLR 377 (Full High Court)

Facts: The taxpayer was a boat slip proprietor (used to put boats in and remove them from the Brisbane River) and ship repairer. Major work was carried out to one of the taxpayer’s boat slips which had deteriorated badly. The work involved replacement of wooden parts of the slip and a lengthening of the slip. Almost the entire slip was disassembled and completely rebuilt. As timber of the size required was no longer available, the taxpayer substituted reinforced concrete for the timber that needed to be replaced. At first instance, Kitto J found that the reinforced concrete offered no advantage over timber in terms of durability or price and in fact in some respects it was not as suitable as the timber it replaced. The taxpayer conceded the cost of extending the slip was a capital outgoing but sought a deduction for the cost of restoring the remainder of the slip. It argued that the slip was part of the larger structure of the taxpayer’s entire facility and the replacement of the original slips was merely a repair of part of the larger facility. Decision: The Full High Court agreed with Kitto J that the expenditure was a capital outgoing for renewal of the asset, not a currently deductible repair expense. It concluded the slip was an asset in itself, not just a mere part of the larger facility. Renewal of the specific asset, as distinguished from repair of the larger facility, is reconstruction of substantially the whole asset and the expense a capital outlay. Relevance of the case today: The Lindsay case affirms the approach taken by the High Court in FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102 where the taxpayer’s outgoings were found to be improvements rather than repairs because the work involved replacement of materials with different materials rather than newer parts of the same type as those being replaced. An alternative interpretation of the Lindsay result is the fact that the work involved the total dismantling of the taxpayer’s asset and its reconstruction. The case can be cited as authority for the fact that “repair” expenses are actual capital renewal or improvement expenses if parts are replaced with new materials substantially different from the original materials or if the work involves the complete dismantling of property and its complete rebuilding. If it happened today: If the facts in Lindsay were to occur today, a court would find the expenses are capital expenses. The taxpayer could treat these expenses as part of the cost of the slip under s 40-190 ITAA 1997. This expense can be deducted over the effective life of the slip under s 40-25 ITAA 1997 as capital allowance deductions.

© Thomson Reuters 2019

241

AUSTRALIAN TAXATION LAW CASES 2019

W Thomas & Co Pty Ltd v FCT (1966) 115 CLR 58 (High Court)

Facts: The taxpayer purchased a building that was in poor repair. A number of repairs had to be made to the building before it could be used. The taxpayer described the outgoings as “repairs” and claimed a deduction for the full amount. The expenses included the cost of painting, replacing materials in the roof, replacing skylights, asphalting one floor, and replacing timbers in another floor. Upon later examination, the Commissioner concluded the expenses were capital in nature and sought to reassess the taxpayer. However, as the time for ordinary reassessment had expired, the Commissioner could only reassess if the taxpayer had made “full and true disclosure” of all relevant facts to the Commissioner. The taxpayer argued it had made such disclosure and as a result the Commissioner should be precluded from reassessing the taxpayer. Decision: Windeyer J found the taxpayer had made sufficient disclosure in respect of some aspects of the expenditure and not in respect of others. Accordingly, he directed the Commissioner to reassess on the basis that the taxpayer should be allowed deduction for some of the expenses and not for others. Importantly, in the course of his judgment, he found that although the Commissioner was precluded from reassessing in respect of much of the expenses, he agreed with the Commissioner that they were in fact capital outgoings. Windeyer J indicated that expenditure upon repairs is properly attributed to revenue account when the repairs are for the maintenance in the sense of periodic repair of defects that are the result of normal wear and tear arising from the operations of the person who incurs it. But if when a thing is bought for use as a capital asset in the buyer’s business and it is not in good order and suitable for use in the way intended, the cost of putting it in order suitable for use is part of the cost of its acquisition, not a cost of its maintenance. Relevance of the case today: The W Thomas & Co decision reaffirmed the principle set out in the Law Shipping Co Ltd v IRC (1923) 12 TC 621 decision that initial repairs required to make a newly acquired premises (or, in that case, equipment) suitable for use will generally be considered capital expenses ancillary to the original acquisition cost. If it happened today: If the facts of W Thomas & Co were to arise today, the taxpayer would argue the outgoing was a cost of “capital works” (as defined in s 43-20 ITAA 1997) and the amount paid was a “construction expenditure” (as defined in s 43-70 1997 ITAA 1997 1997). If this argument is successful, this amount can be deducted over a 40 year period on a straight line basis under s 43-15 ITAA 1997, with the 40 year life set out in s 43-210 ITAA 1997. While s 43-20 ITAA 1997 limits capital allowance deductions for buildings to buildings constructed after 21 August 1979, it can be argued that the provision applies separately to improvements commenced after that date. If no capital allowance deduction can be claimed under Division 43, it would be possible to include the cost of capital repairs in the CGT cost base of the asset as part of the fourth element (s 110-25(5) ITAA 1997 1997). However, this will only be allowed if the expenditure is still reflected in the state or nature of the asset when it is ultimately disposed of by the taxpayer. 242

© Thomson Reuters 2019

CHAPTER 10

SPECIFIC DEDUCTIONS

Odeon Associated Theatres Ltd v Jones (Inspector of Taxes) [1973] Ch 288 (UK Court of Appeal)

Facts: The taxpayer purchased a cinema following World War II. The cinema had not been repaired or properly maintained for many years and was somewhat run down when acquired by the taxpayer. The taxpayer incurred expenses over a seven year period commencing two years after acquisition to repair and refurbish the theatre and sought a deduction for these expenses. The taxpayer introduced evidence that the expenses were deductible under commercial accounting rules. The Court found that the value of the cinema was not lower because it was in need of repair. Decision: The Court of Appeal allowed the taxpayer to deduct the full cost of the repairs, noting that this approach accorded with commercial accounting rules and the construction of the UK income tax legislation imposed on company profits. Relevance of the case today: Although the Odeon Associated Theatres case is often considered in Australia, it has had limited impact on Australian jurisprudence with respect to initial repairs which continue to be treated as capital expenses in Australia on the basis of the Law Shipping precedent. The Odeon case can be distinguished from the general doctrine on the finding of fact that the building did not cost less because of its poor state of repairs and the fact that the expenses were not incurred for some time after the building was acquired. Also, accounting practice may have a greater influence under UK income tax law to the extent it is imposed on company profits. If it happened today: If the facts in Odeon Associated Theatres were to arise in Australia today, an Australian court might agree that the repair expenses were revenue outgoings given the facts of the case. However, it is unlikely that a court would replicate the finding that a building in a poor state of repair costs no less than a building which has been repaired. Also, accounting practice to determine profits would prove less influential in the Australian income tax system. It is quite possible that an Australian court today would characterise the expenses as capital outgoings.

CAPITAL ALLOWANCES While accounting principles allow businesses to depreciate or amortise expenses for the cost of acquiring any wasting tangible or intangible asset over the life of the asset, Australia’s tax capital allowance rules are much narrower. Originally, depreciation was only allowed for plant and equipment. Over the decades the original capital allowance rules have been supplemented by new rules providing capital allowances for buildings, intellectual property, and other wasting assets. Many of the earlier capital allowance cases involved taxpayers seeking to recharacterise an asset from a type for which no depreciation was allowed (eg, a building) to one for which depreciation was allowed (eg, plant or equipment). The cases remain important even though the capital allowance rules are much broader today as taxpayers seek to recharacterise assets from a type such as buildings with very long capital allowance lives to a type with a much shorter write-off period. © Thomson Reuters 2019

243

AUSTRALIAN TAXATION LAW CASES 2019

Quarries Ltd v FCT

(1961) 106 CLR 310 (High Court)

Facts: The taxpayer carried on a quarrying business, often at remote sites. The taxpayer transported its quarrying equipment from site to site by truck. Due to the lack of alternative accommodation, the taxpayer also transported sleeping units to each site for use by the employees. On arrival at the site, the crushing equipment would be assembled and a camp set up for the employees. The camp also included a mobile kitchen and diner. The taxpayer sought to claim depreciation deductions for the cost of the sleeping units under s 54 ITAA 1936 (the predecessor to Division 40 ITAA 1997 1997). At the time, there were no general depreciation provisions for buildings. The Commissioner argued that the taxpayer was not entitled to these deductions as the sleeping units were not “plant or articles” as required but were rather in the nature of buildings. Decision: The sleeping units were within the meaning of “plant or articles” given the special characteristics of the business of the taxpayer which required such temporary and portable accommodation units. The units were considered not to be structures in the nature of buildings in the ordinary sense of that word. Without the units it would have been impossible for the taxpayer to meet the contractual requirements of the business. They were therefore used to produce the assessable income of the taxpayer and the deductions under s 54 were allowable. Relevance of the case today: The decision in Quarries is of reduced significance today due to the consolidation of the depreciation provisions into the uniform capital allowances provision in Division 40. The phrase “plant and articles” has been replaced with “depreciating asset”, which is defined in s 40-30 ITAA 1997 as an asset with limited effective life which can reasonably be expected to decline in value over time as it is used. Capital allowances for capital works, such as buildings, are provided for in Division 43 ITAA 1997, which is given priority over Division 40 by virtue of s 40-45 ITAA 1997. (Simply put, if a deduction is available under Division 43, a deduction is not available under Division 40.) Division 43 applies to construction expenditure on capital works (which includes buildings) but specifically excludes expenditure on plant (s 43-70(2)(e) ITAA 1997 1997). Therefore, if the expenditure, like that in Quarries, is characterised as expenditure on plant, it is excluded from Division 43 and can be claimed through Division 40, usually at a faster rate. If it happened today: Expenditure on special purpose portable accommodation units would likely be considered expenditure on depreciable assets within Division 40 and not capital works under Division 43. The expenditure could therefore be recovered over the effective life of the units, having reference to the provisions of Division 40.

Wangaratta Woollen Mills Ltd v FCT

(1969) 119 CLR 1; 1 ATR 329; 69 ATC 4095 (High Court)

Facts: The taxpayer carried on a business of dyeing and spinning worsted wool. This process required specialised plant due to the caustic nature of the materials used. The building which housed the dyeing process incorporated several features unique to the 244

© Thomson Reuters 2019

CHAPTER 10

SPECIFIC DEDUCTIONS

process, such as the following: the ceiling was lined with a special material to prevent a reaction with the chemical vapours which rose from the dyeing vats; a ventilation system removed dangerous gases given off by the chemicals in the dyeing vats; and the floor was covered with special corrosion-proof tiles. At the time, there was no general capital allowance rules for whole buildings. The taxpayer sought to claim depreciation deductions under s 54 ITAA 1936 (the predecessor to Division 40 ITAA 1997 1997) for the entire cost of the building as an item of plant with each part of the building treated as part of the plant. Decision: A deduction was allowable under s 54 for costs in relation to the building as a single unit of plant, excluding only the external cladding and the roof. Due to the special nature of the taxpayer’s business and the process which produced the income, the building provided more than a mere setting for these activities. The dyehouse was in the nature of a tool of the trade of dyeing and played a part in the manufacturing process. Relevance of the case today: This case is relevant for the distinction drawn between a building as a mere setting and a building as plant. This is of continued relevance under the uniform capital allowances as expenditure on plant under Division 40 is recognised over a much shorter period than are buildings under Division 43 ITAA 1997. A fuller discussion of this point can be found under the case Quarries Ltd v FCT (1961) 106 CLR 310. If it happened today: Given the special nature of a dyehouse, a court could still conclude that the internal features of the building were in their nature plant, due to the active role these features play in the manufacturing process. These items could then be identified as a depreciating asset, the cost of which could then be recovered under Division 40. Where a particular feature could constitute a fixture, for Division 40 purposes that fixture is to be treated as separate from the land (s 40-30(3) ITAA 1997 1997). On the other hand, now that there is a general capital allowance regime for building in Division 40, courts may feel less inclined to characterise a building as an item of plant.

Imperial Chemical Industries of Australia and New Zealand Ltd v FCT (1970) 120 CLR 396; 1 ATR 450; 70 ATC 4024 (High Court)

Facts: The taxpayer owned two buildings that were fitted with a suspended ceiling comprising perforated metal panels and sound absorbing bags above the panels. The taxpayer sought to depreciate the ceilings and the electrical wiring and conduits for the wiring as plant. At the time, no capital allowances were available for buildings of the sort owned by the taxpayer. Decision: Kitto J found the ceiling parts, wiring and conduits were parts of the building and could not be depreciated separately as plant. While the ceiling parts made the building more comfortable and efficient, like all parts of a building they are part of a general setting for work, not part of the apparatus of any income-producing process. Wires carrying electricity are no different from pipes carrying water in a building and clearly are fixtures that become part of the building. © Thomson Reuters 2019

245

AUSTRALIAN TAXATION LAW CASES 2019

Relevance of the case today: Imperial Chemical Industries is used as authority for treating items incorporated directly into buildings or treated as an element of the building in the sense of forming the setting for work as parts of buildings subject to the capital allowance deductions for the cost of buildings rather than those available for the cost of plant. The holding does not extend to mechanical and moving equipment that is installed in buildings. If it happened today: If the facts in Imperial Chemical Industries were to arise today, the same result would follow and the taxpayer would be required to treat the cost of ceilings and electrical wiring and conduits as part of the building for capital allowance purposes. Today, however, those costs would be deductible through the capital allowance rules in Division 43 ITAA 1997; at the time of the original case there were no capital allowance deductions for buildings of the sort owned by the taxpayer.

FCT v BHP Billiton Ltd

[2011] HCA 17; 244 CLR 325; 79 ATR 1; 2011 ATC 20-264 (Full High Court)

Facts: The taxpayer used amounts that had been borrowed from a related group company to purchase capital assets on which it claimed capital allowance deductions. The taxpayer encountered unexpected difficulties and was unable to repay the full loan. The Commissioner applied Division 243 ITAA 1997 to reduce the capital allowances allowed to the taxpayer to the extent they were attributable to assets purchased with the debt that had not been repaid. Division 243 recaptures capital allowance deductions where the debt used to purchase capital assets is supplied on a non-recourse basis (that is, where the lender’s security is limited to the assets that have been purchased with the borrowed funds). The taxpayer argued the loan was not made on a non-recourse basis while the Commissioner argued the lender’s practical rights of recovery or recourse were effectively limited to the assets acquired with the funds. The trial court and lower appeal court rejected the Commissioner’s argument on the basis that the section looked only at legal limitations set out in the loan agreement, not arguments based on economic equivalence. Decision: The High Court upheld the lower decisions and rejected the Commissioner’s argument that Division 243 applied on the basis that the loans were limited recourse looking at the practical arrangements between the related parties. Relevance of the case today: In response to the High Court’s decision in BHP Billiton Ltd the government amended s 243-20 in Division 243 to make it clear that a loan was Ltd, a limited recourse loan where the creditor’s rights in the event of default in payment of the debt are limited by the loan agreement or any other factors to the financed property or other property. As a consequence of the amendments, the BHP Billiton Ltd case has no ongoing precedential value in respect of loans used to finance the acquisition of capital assets that give rise to capital allowance deductions. If it happened today: If the facts in BHP Billiton Ltd were to arise today, the loan used to purchase capital assets would be considered a non-recourse loan under the amended Division 243 and the taxpayer would be required to reduce prior capital allowance provisions when the loan was not repaid. 246

© Thomson Reuters 2019

CHAPTER 10

SPECIFIC DEDUCTIONS

BAD DEBTS With the exception of employees and qualifying small businesses, most taxpayers recognise income on an accrual basis, when an invoice is issued or entitlement otherwise arises. A taxpayer may find that an amount already recorded as income is not paid and cannot be recovered from the debtor. To address this problem, s 25-35(1)(a) ITAA 1997 allows taxpayers to deduct bad debts where the amount has been included in assessable income and has been written off as a bad debt. A further measure in s 25-35(1)(b) ITAA 1997 allows a taxpayer to deduct bad debts in respect of money it has lent if the taxpayer has lent the money in the ordinary course of business and subsequently written it off. In this case, the loss is allowed even though the amount has not previously been included in assessable income. For all other taxpayers, a loss in respect of a loan that becomes uncollectable would be a capital loss. The Point and G E Crane Sales cases show that a bad debt can only be deducted under s 25-35(1)(a) if the taxpayer held a right to repayment when it is written off and the debt had not been forgiven. The BHP Billiton Finance case shows that a taxpayer in the business of lending can rely either on s 25-35(1)(b) or s 8-1 to deduct a written-off loan.

Point v FCT

(1970) 119 CLR 453; 1 ATR 577; 70 ATC 4021 (High Court)

Facts: The taxpayer owned all but one share in a company which experienced financial difficulties. A provisional liquidator was appointed in December 1963 and at that time the books of account showed a debt from the company to the taxpayer and a debt from the taxpayer to the company. It was agreed that these two amounts should be offset against each other, resulting in a net debt of approximately £70,000 owing from the company to the taxpayer. No entries to this effect were made in the books but in May 1964 a deed of release was entered into whereby the company was released from the debt of £70,000 to the taxpayer. The deed of release became effective in July 1964. Sometime between September 1964 and April 1965, an entry was made in the taxpayer’s books showing the debt owing from the company as a bad debt and writing it off as irrecoverable. The taxpayer claimed a deduction under s 63 ITAA 1936 (now s 25-35 ITAA 1997 1997) for the debt written off. The issue before the Court was whether the s 63 deduction was available to the taxpayer. Decision: There was no amount allowable as a deduction under s 63. There was no writing off of the debt in year ended 30 June 1964. The purported writing off in the year ended 30 June 1965 was undertaken after the deed of release had operated to extinguish the debt. There was therefore no debt to write off and the entry into the taxpayer’s books served no purpose. Relevance of the case today: This case establishes the proposition that in order to claim the bad debt deduction, the debt must be presently existing at the time of writing off. This principle was applied in GE Crane Sales Pty Ltd v FCT (1971) 126 CLR 177; 2 ATR 692; 71 ATC 4268. Based on the lessons of this case, taxpayers now take care to write off debts in their books (and for tax purposes) before releasing the debtor from the obligation. © Thomson Reuters 2019

247

AUSTRALIAN TAXATION LAW CASES 2019

If it happened today: If the facts of the Point case were to occur today, no deduction would be available under s 25-35 as the debt no longer existed at the time of the purported writing off.

GE Crane Sales Pty Ltd v FCT

(1971) 126 CLR 177; 2 ATR 692; 71 ATC 4268 (Full High Court)

Facts: The taxpayer carried on a business of debt factoring. It advanced funds to businesses which directed their customers to remit the amounts due on sales to the taxpayer rather than the businesses making the supplies. The taxpayer experienced financial difficulties which resulted in the appointment of a receiver. On 21 June 1966, a scheme of arrangement went into effect whereby the taxpayer’s debts were released and the receiver became entitled to any payments received under the factored debts owed to the taxpayer. For the 1966/67 income year, the taxpayer sought to claim bad debt deductions under s 63 ITAA 1936 (now s 25-35 ITAA 1997 1997) for amounts not recovered from the clients’ customers. The taxpayer also sought to claim bad debt deductions in respect of a second class of debts that had been owed to the taxpayer but which had been settled for a lesser amount prior to the scheme of arrangement. The taxpayer sought to write off the balance not recovered and claimed the s 63 deduction. The issue before the Court was whether the s 63 deduction was available in respect of these two classes of debts. Decision: The Court was unanimous in holding that the deductions were not available under s 63 for each category of debt. With respect to the factored debts owed to the taxpayer, although there was no legal assignment of the clients’ debts to the taxpayer, a majority of the Court concluded that the taxpayer became the owner in equity of the debts and s 63 could apply to a debt due in equity. However, under the scheme of arrangement, the taxpayer’s beneficial interest in the factored debts transferred to the receiver and the taxpayer no longer held presently existing debts to write off for the purpose of claiming a deduction under s 63. With respect to the second class of debts, the majority of the Court considered that upon acceptance of the settlement, the right to recover the balance was extinguished and therefore there was no longer a debt to be written off in respect of the difference between the settlement amount and the original face value of the debt. Relevance of the case today: This case is relevant for the proposition that in order to claim the bad debt deduction under s 25-35, the debt in question must be presently existing and this will not be the case if the debts have been settled for a lesser sum or the debts are payable to a receiver under a scheme of arrangement. If it happened today: If the facts of GE Crane Sales were to occur today, the taxpayer would be unable to obtain a deduction under s 25-35 for the same reason the taxpayer was unable to claim a deduction under s 63. However, with the benefit of hindsight from the G E Crane Sales case and from Point v FCT (1970) 119 CLR 453; 1 ATR 577; 70 ATC 4021, with respect to the second category of debts, the taxpayer might be able to avoid the result in G E Crane Sales by first writing off the debts down to the amount of the settlement and then entering into the settlement. A court could 248

© Thomson Reuters 2019

CHAPTER 10

SPECIFIC DEDUCTIONS

also more closely consider the prerequisite that the debt be included in assessable income before the deduction is available (as required by s 25-35(1)(a)). The Court in G E Crane Sales expressed some doubt that the taxpayer would have satisfied this requirement but considered that it was not necessary to resolve this issue in deciding that the deduction was not available.

FCT v BHP Billiton Finance Ltd

(2010) 76 ATR 472; 2010 ATC 20-169 (Full Federal Court)

Facts: The taxpayer was a member of a mining company group that acted as financier for the group. It lent money to two subsidiaries in the group engaged in projects that ultimately proved unsuccessful. The taxpayer wrote off the loans as bad debts and claimed deductions for the amounts under s 25-35(1)(b) ITAA 1997 or, in the alternative, s 8-1(1) ITAA 1997. The Commissioner disputed whether a member of a company group that acted as financier to the group could be considered to be in the business of lending money in the same manner as a financial institution such as a bank. Decision: The Full Federal Court concluded the taxpayer was in the business of lending money even though it only lent money to members of the group to which it belonged and was not a separate financial institution. The evidence showed it borrowed on behalf of the entire group and then lent to group members at a higher interest rate, deriving a profit on the intra-group lending arrangements. It was entitled to deduct the losses on the written off loans under s 25-35(1)(b) or s 8-1(1). Relevance of the case today: This case is authority for the argument that a group company which acts as financier to the group can be considered to be in the business of lending money in appropriate circumstances and as such be entitled to deduct losses on written off loans under s 25-35(1)(b) or s 8-1(1). If it happened today: If the facts of the BHP Billiton Finance case were to occur today, the taxpayer would be allowed a deduction in the same manner. In a similar but not identical case, the Commissioner would try to show the financier was not truly in the business of making loans. For example, if the on-lending did not take place at a higher interest rate than that paid by the taxpayer on its borrowed funds, the Commissioner would seek to distinguish the case from the facts of BHP Billiton Finance.

TAX LOSSES Under s 36-10 ITAA 1997, the excess of deductions over assessable income is a “tax loss” for the year. Tax losses may be carried forward and deducted in future years under s 36-15 ITAA 1997 for individuals and s 36-17 ITAA 1997 for companies. Under s 36-15(3) and s 36-17(3), tax losses must first be applied against net exempt income for the year, as defined in s 36-20, drawing upon the definition of exempt income in s 6-20 ITAA 1997. Further restrictions on the deductibility of tax losses apply to companies; cases dealing with these restrictions are included in Chapter 16. © Thomson Reuters 2019

249

AUSTRALIAN TAXATION LAW CASES 2019

FCT v WE Fuller Pty Ltd

(1959) 101 CLR 403 (Full High Court)

Facts: The taxpayer was a shareholder in a company that had issued bonus shares that had been paid up out of profits recorded through the revaluation of assets owned by the company. At the time, the definition of dividend in s 6 ITAA 1936 included bonus shares (which would not be included in the ordinary meaning of dividend) but former s 44(2) ITAA 1936 excluded from assessable income bonus shares paid out of asset revaluation profits. The taxpayer wished to utilise a carried-forward tax loss but s 80 ITAA 1936 (currently s 36-15 ITAA 1997 1997) required the taxpayer to first apply the tax loss against exempt income from the year. The taxpayer argued exempt income did not include amounts that were not ordinary income but which had been included in the definition of dividend and then excluded from dividends included in assessable income. The Commissioner argued the bonus shares acquired the character of income by virtue of their inclusion in the definition of dividends so their subsequent exclusion from assessable income made them exempt income. Decision: A majority of the Court agreed the bonus shares were exempt income and had to be taken into account when applying a carried forward tax loss. They accepted the argument that inclusion of the value of bonus shares in the definition of dividend conferred an income character on bonus shares and the subsequent exclusion from assessable income of dividends comprising this particular type of bonus share amounted to an exemption for this type of income. Relevance of the case today: The former s 44(2) exclusion from assessable income for bonus shares paid out of asset revaluation profits was removed in 1987 with the adoption of the company and shareholder imputation system so the character of these gains as exempt income is no longer an issue. Former s 44(2) did not make the income exempt; it merely said assessable income did not include those types of dividends. The former definition of “exempt income” used for the carried-forward tax loss provision included income that was exempt from income tax and income that was not assessable so the issue in the case was whether income included bonus shares brought into dividends. The current carried-forward tax loss deduction provision uses slightly different language, from its predecessor, stating that ordinary income can be made exempt by express rule or by implication while statutory income (which the income in this case would be) can only be exempt income if it is expressly made exempt by a statutory provision. Thus, the specific issue in the case – whether income included what would now be known as statutory income is no longer relevant. The case would also be of limited value in interpreting the meaning of exempt income given the changed definition of that term. If it happened today: The bonus share received by the taxpayer would be assessable under s 44. A dividend in the form of a bonus share can be franked if the company paying the dividend has sufficient credit in its franking account. If the dividend were franked, the shareholder would gross up the dividend and include an amount equal to the franking offset in assessable income under s 207-20(1) ITAA 1997. There would, therefore, be no question of the bonus share being exempt income for the purpose of allocating the carried-forward tax loss against exempt income before applying it against taxable income. 250

© Thomson Reuters 2019

C HAPTER 11

Tax Accounting and Income Assignments INCOME RECOGNITION – CASH OR ACCRUAL ACCOUNTING ............ 253 Cash or Accrual Recognition ........................................................................ 253 Carden’s case (1938) .............................................................................. 253 Firstenberg (1976) .................................................................................. 254 Barratt (1992) ......................................................................................... 254 Changing Accounting Method ...................................................................... 255 Henderson (1970) ................................................................................... 255 Dormer (2002) ........................................................................................ 257 INCOME RECOGNITION BY ACCRUAL-BASIS TAXPAYERS ................. 258 Prepayment for Services Provided over Years.............................................. 258 Arthur Murray (NSW) Pty Ltd (1965) .................................................... 258 Invoiced Amount Subject to Discount or Rebate ......................................... 258 Ballarat Brewing Co Ltd (1951) ............................................................. 258 Services Provided before Billing .................................................................. 259 Australian Gas Light Co (1983) ............................................................. 259 Sale of Trading Stock on an Instalment Basis .............................................. 260 J Rowe and Son Pty Ltd (1971) .............................................................. 260 Sale Price Disputed by the Customer ........................................................... 260 BHP Billiton Petroleum (Bass Strait) Pty Ltd (2002) ............................. 260 Sale of Trading Stock Subject to Settlement ................................................ 261 Gasparin (1994) ...................................................................................... 261 EXPENSE RECOGNITION ................................................................................. 262 When are Expenses “Incurred” Generally? .................................................. 262 New Zealand Flax Investments Ltd (1938) ..............................................262 Compound and Deferred Interest ................................................................. 263 Australian Guarantee Corporation Ltd (1984) .......................................264 Discounts in Lieu of Interest on Debt Instruments ....................................... 265 Coles Myer Finance Ltd (1993) .............................................................. 265 Energy Resources of Australia Ltd (1996) .............................................. 265 Citylink Melbourne Ltd (2006) ............................................................... 266 Leave Obligations ......................................................................................... 268 James Flood Pty Ltd (1934).................................................................... 268 © Thomson Reuters 2019

251

AUSTRALIAN TAXATION LAW CASES 2019

INCOME ASSIGNMENTS ................................................................................... 268 Assignments of Presently Existing Property Interests.................................. 269 Norman (1963) ....................................................................................... 269 Shepherd (1965) ...................................................................................... 270 Assignments of Interests in Partnerships ...................................................... 271 Everett (1980) ......................................................................................... 271 Galland (1986) ........................................................................................ 272

252

© Thomson Reuters 2019

C HAPTER 11

Tax Accounting and Income Assignments INCOME RECOGNITION – CASH OR ACCRUAL ACCOUNTING Cash or Accrual Recognition (Carden’s case) C of T (SA) v Executor Trustee and Agency Co of South Australia Ltd (1938) 63 CLR 108 (Full High Court)

Facts: The taxpayer was executor for the estate of a deceased doctor who had issued invoices to clients that were paid to the estate after the doctor’s death. The Commissioner of South Australia assessed the executor for South Australian income tax purposes (the South Australia legislation was similar to the Commonwealth legislation). Prior to his death, the doctor had filed income tax returns recognising his professional income using cash basis accounting (referred to as “receipts basis accounting” in the case). Before the adoption of s 101A ITAA 1936, professional fees payable to a deceased taxpayer that were paid to the estate after the taxpayer’s death were considered capital receipts of the estate and excluded from its assessable income. Thus, the only way the Commissioner could subject to tax amounts that had been invoiced but not received prior to the taxpayer’s death was to change the basis of assessment of the deceased from a cash basis to an accrual basis (called an “earnings basis” in the case). The executor, responsible for the deceased’s tax liability contested the assessment. Decision: The judgment of Dixon J, with whom a majority of the Court agreed, stated it was necessary to use the tax accounting method that would reveal a “substantially correct reflex of the taxpayer’s true income”. The Court concluded it was appropriate to recognise professional income on a cash basis, though it agreed the Commissioner had the power to make a special assessment for the part income year in which the doctor died on an accrual basis. Relevance of the case today: The advice offered by Dixon J that the appropriate accounting method is the one which portrays a “correct reflex of the taxpayer’s true income” is cited as authority in almost all tax accounting decisions, though by itself the phrase provides no guidance as to when a particular accounting method should be © Thomson Reuters 2019

253

AUSTRALIAN TAXATION LAW CASES 2019

used. On the basis of the conclusion that the cash method of accounting was appropriate for years apart from the part income year in which the doctor died, Carden’s case has become authority for the proposition that professional income derived by a sole proprietor should be returned for tax purposes on a cash accounting basis. If it happened today: If the facts in Carden’s case arose today, a court would continue to hold that cash basis accounting is the appropriate tax accounting method for professional income derived by a sole proprietor.

FCT v Firstenberg

(1976) 6 ATR 297; 76 ATC 4141 (Supreme Court of Victoria)

Facts: The taxpayer was a sole practitioner solicitor who had calculated his taxable income on a cash basis. The Commissioner re-assessed him calculating his income in an accrual basis and treating him as having derived amounts billed but not yet received. Decision: The Supreme Court concluded a cash basis method of accounting was most appropriate for a solicitor operating a sole practice, applying the same approach used for a medical practitioner in Carden’s case (1938) 63 CLR 108 and distinguishing other precedents applying to firms of lawyers. Relevance of the case today: Firstenberg is authority for the proposition that sole practitioner lawyers and more broadly sole practitioners in a profession may use cash basis accounting when calculating taxable income. If it happened today: If the facts in Firstenberg were to arise today, a court would find the taxpayer is entitled to use cash basis accounting. Note that the cash basis accounting is understood to mean that income is “derived” when received while expenses are deductible when “incurred” which could be prior to actual payment. There is, therefore, the potential for a mismatch of income and outgoing recognition under the ordinary cash basis accounting concepts. The ordinary concepts are contrasted with the cash basis accounting rules that formerly applied to Simplified Tax System (STS) taxpayers which only allowed deductions for expenses when paid.

Barratt & Ors v FCT

(1992) 23 ATR 339; 92 ATC 4275 (Full Federal Court)

Facts: The taxpayers were medical practitioners who carried on a pathology practice in partnership. The practice used various medical equipment, some of which was very expensive, and required various services. A related service company acquired the equipment, employed people to carry out the testing and prepare reports, and provided clerical, secretarial and telephone receptionist staff. The partnership employed the nursing staff. During the relevant period of years, there was at all times a significant business operation though the size of the operation was growing throughout the period. In the final year in question, the practice included 21 collection rooms, employed 66 nursing staff and saw 92,000 patients. The primary issue before the Court was whether the income of the partnership should be determined on a cash or accrual basis. If an accrual basis was the appropriate accounting method, a further issue was whether 254

© Thomson Reuters 2019

CHAPTER 11

TAX ACCOUNTING AND INCOME ASSIGNMENTS

the operation of the Medical Practitioners Act 1938 (NSW), which required that practitioners wait 6 months before commencing a suit to recover unpaid fees, created such uncertainty as to receipt of fees that fees should not be considered derived until at least the expiration of the 6 months. Decision: The income of the taxpayers should be accounted for on an accrual basis. Although a cash basis may be more appropriate when the income arises from the exercise of personal skill (see Commissioner of Tax (SA) v Executor Trustee and Agency Co of South Australia Ltd (Carden’s case) (1938) 63 CLR 108), in this case the bulk of the work was done by nurses and other staff. The expenses incurred by the partnership represented a significant contribution to the income derivation and were closely related to the amount of the receipts. The plant used was large and expensive and a large number of staff were employed. The fees for services were to be considered derived when the bills were rendered to the patients, not when the 6 months under the statute expired. Payments were regularly made without regard to the 6 month period. The fact that the debt was not presently recoverable by action did not prevent the derivation of the income. Relevance of the case today: The decision in Barratt is most relevant for establishing the proposition that income is derived on an accrual basis when there is a claim to an ascertained amount, not subject to any contingency, even if there is a statutory impediment to immediately seeking recovery of that debt by action. In other words, a debt need not be presently recoverable by action to be income derived. The case also shows that the presence of employees who carry out much of the work and substantial equipment are factors that make it appropriate for a small partnership to recognise income on an accrual basis. If it happened today: If the facts of this case arose today, a court would conclude that accrual accounting was the appropriate basis to determine the income of the partnership and that fee income would be derived when the bills were rendered.

Changing Accounting Method Taxpayers who account on a cash basis recognise income when it is actually received. Taxpayers who account on an accrual basis recognise income when the right to payment arises, usually treated as the time an invoice is issued. A mismatch arises if a taxpayer moves from cash basis accounting to accrual basis accounting if the invoice is issued when the taxpayer accounts on a cash basis and the account is paid after the taxpayer has switched to accrual basis accounting. The invoice is normally ignored for tax purposes when issued by a cash basis taxpayer and actual payment triggers no income recognition for an accrual basis taxpayer. Whether the switch can lead to income disappearing for tax purposes in the sense of being recognised neither when invoiced nor when paid is explored in the Henderson and Dormer cases.

Henderson v FCT

(1970) 119 CLR 612; 1 ATR 596; 70 ATC 4016 (Full High Court)

Facts: The taxpayer was a partner in a large accountancy partnership which had a total of 19 partners and 295 employees. For the year ended 30 June 1964, the income © Thomson Reuters 2019

255

AUSTRALIAN TAXATION LAW CASES 2019

of the partnership was assessed on a cash basis. For the years ended 30 June 1965 and 30 June 1966, the partnership returned its income on an accrual basis. The effect of this change from cash basis accounting to accrual basis accounting was to leave out of assessable income all amounts that were invoiced but not received in the final year that the cash basis was used as these amounts, though received in the following year, did not accrue in the following year and therefore were not treated as income derived in that year. As a result, the fee income accrued but not yet received by 30 June 1964 would not be subject to tax. The Commissioner submitted that the cash basis was the proper basis to measure assessable income or, if the taxpayer were permitted to account on an accrual basis for income years after 30 June 1964, the income that had been invoiced but not received prior to the change to accrual accounting should be recognised on general principles to ensure it did not escape taxation completely. Decision: At first instance (also reported at (1970) 119 CLR 612), Windeyer J concluded that the partnership should account on an accrual basis for income years after 30 June 1964. As it was too late to reassess for previous years, Windeyer J concluded the assessable income for the 1965 and 1966 income years should include amounts invoiced but not received prior to the change to accrual basis accounting. On appeal, the Full High Court agreed that the proper basis for accounting for the income of the partnership for the 1965 and 1966 years was on an accrual basis. The nature and extent of the dealings of the partnership distinguished it from the professional practice carried on personally by the taxpayer as seen in Commissioner of Taxes (SA) v Executor Trustee and Agency Co of SA, Ltd (Carden’s case) (1938) 63 CLR 108. In applying the accrual basis, only fees which have matured into recoverable debts should be included in earnings. When the fees have matured can be determined under the agreement of the parties or under general law. There is no basis for estimating the value of the services so far performed where the fees are not yet recoverable. It was considered that an accrual basis was appropriate also for the 1964 year but the fact that this return could no longer be re-opened did not justify a departure from the annual basis of calculating income. Therefore no adjustment would be made to take into account the fee income accrued but not yet received by 30 June 1964. Relevance of the case today: The decision is often referred to for the following comment made by Barwick CJ in rejecting the suggestion that an adjustment should be made for the income that escaped recognition when the taxpayer changed accounting methods: “there cannot be any warrant in a scheme of annual taxation upon the income derived in each year of taxation for combining the result of more than one year in order to obtain the assessable income for a particular year of tax.” The case is also authority for the application of accrual basis accounting to large professional partnerships. If it happened today: If the facts of Henderson were to occur today, it is likely that a court would come to the same decision both as to correct method and the issue of adjustments. While the facts of Henderson are less likely to be repeated in a continuing partnership as following that case the Commissioner has taken care to ensure growing partnerships are assessed consistently on an accrual basis, it continues to arise. The invoiced amounts no longer escape taxation, however. When an invoice is issued, the client has a debt owing to the taxpayer. The client’s debt is an asset held by the partnership that can be sold (“factored”, as the sale of an amount owing to a business 256

© Thomson Reuters 2019

CHAPTER 11

TAX ACCOUNTING AND INCOME ASSIGNMENTS

is often called) or held until it is paid. If the partnership holds the debt owed by the customer until it is paid, under s 104-25(1) ITAA 1997 there will be a CGT event C2 when the debt is repaid and ownership of the intangible asset ends because the debt is satisfied or discharged. The capital proceeds from the debt being discharged is the amount paid to the partnership by the debtors under s 116-20(1) ITAA 1997. Because the amount owing or the debt arises because services are provided to a customer, there is no cost base for the asset under s 110-25(2) ITAA 1997. Thus, when the invoice is paid the partnership will have a capital gain equal to the amount paid. In the case of an ongoing partnership that was always using accrual accounting, the capital gain realised when the invoice is paid will be reduced under s 118-20 ITAA 1997 by the amount that was recognised as business income when the invoice was first issued. But if the partnership changed from cash accounting to accrual accounting and there was previously no income recognition when the invoice was issued, there will be no reduction of the capital gain.

Dormer v FCT

(2002) 51 ATR 353; 2002 ATC 5078 (Full Federal Court)

Facts: The taxpayer was a sole practitioner who shifted his practice into a three person partnership. Immediately prior to the formation of the partnership, the taxpayer invoiced his clients for work in progress. All invoices were paid after the taxpayer had joined with the newly formed partnership. The partnership accounted for its income on an accrual basis. Relying on the Henderson v FCT (1970) 119 CLR 612; 1 ATR 495; 70 ATC 4016 precedent, the taxpayer argued no income was derived when the invoices were issued and the taxpayer accounted on a cash basis or when the accounts were paid and the taxpayer accounted on an accrual basis. Decision: The Court distinguished the taxpayer’s former business as a sole practitioner from his later business as a member of a partnership and held that income derived by the taxpayer in respect of his former business should have continued to be accounted for on a cash basis, even if the taxpayer’s new business accounted for income on an accrual basis. Relevance of the case today: Dormer is important as a signal of the limits of Henderson arrangements whereby taxpayers shift from cash-basis to accrual-basis income recognition and in the process income that has been billed but not received prior to the change drops out of the tax system. If the post-accrual business is not the same as the pre-accrual business, the taxpayer must continue to recognise income related to the previous cash-basis business as it is received. If it happened today: If the facts in Dormer arose today, a court would decide similarly to the holding in that case that a taxpayer who shifts from a cash-basis business to a different accrual-basis business will derive income from the previous business when it is derived.

© Thomson Reuters 2019

257

AUSTRALIAN TAXATION LAW CASES 2019

INCOME RECOGNITION BY ACCRUAL-BASIS TAXPAYERS Prepayment for Services Provided over Years Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314 (Full High Court)

Facts: The taxpayer sold prepaid dancing lessons with prepaid fees attributable in part to lessons to be provided in future income years. Contracts with customers provided for no refunds where the customer left the course prior to completion but the taxpayer nevertheless sometimes provided refunds for goodwill purposes. For financial accounting purposes, the taxpayer recorded fees for lessons to be provided in future years to an “unearned deposits” account. The Commissioner assessed the taxpayer on the basis that pre-paid fees constituted income derived by the taxpayer when received. Decision: The High Court concluded that amounts received in respect of services to be provided in future years are not earned until the future obligations for which they are paid are discharged. Only as receipts are earned will they acquire the character of income derived by the taxpayer. Relevance of the case today: The Arthur Murray case is now applied generally to prepayments received by accrual-basis taxpayers in respect of future services to be provided. The deferred recognition of receipts until the years to which they apply is commonly referred to as “Arthur Murray” accounting. The approach adopted in Arthur Murray has not been extended to cash basis suppliers or to all prepayments such as prepaid interest. Nor has it been extended to the other side of the transaction, namely consumers of prepaid services. The Commissioner has also made it clear that he does not accept the deferral of recognition of income under long-term (more than one income year) construction contracts: Taxation Ruling TR 2018/3. If it happened today: If the facts in Arthur Murray arose today, the same result would follow as the doctrine has not been affected by any subsequently enacted statutory rules.

Invoiced Amount Subject to Discount or Rebate Ballarat Brewing Co Ltd v FCT (1951) 82 CLR 364 (High Court)

Facts: The taxpayer operated a brewery and sold to customers on terms that provided a discount and rebate on the invoiced price if the account was paid by the 28th day of the month following delivery. The taxpayer sought to include in its assessable income the net amount after the discount and rebate it would allow, arguing that this was the actual amount it would receive, not the notional face value of the invoices. It provided statistical evidence that in virtually all cases the discount and rebate were allowed.

258

© Thomson Reuters 2019

CHAPTER 11

TAX ACCOUNTING AND INCOME ASSIGNMENTS

Decision: The company’s approach provided a correct reflection of the true income derived from the sales as experience showed this was the amount that would be brought to account. If in the exceptional case the full face value of the invoice were received, the additional amount should be recognised as income on receipt as the taxpayer does not, on the basis of experience, expect this amount to be received at the time it issues the invoice. Relevance of the case today: Ballarat Brewing is authority for the proposition that accrual basis taxpayers are only required to recognise as income the amounts they actually expect to receive after discounts or rebates are allowed, provided they have statistical evidence to show that the lesser amount is the amount that will actually be recovered. If it happened today: If the facts in Ballarat Brewing were to occur today, a court would continue to hold that the taxpayer is only required to recognise as income the amounts it actually expects to receive after the discounts and rebates are deducted from the face value of the invoice.

Services Provided before Billing FCT v Australian Gas Light Co & Anor

(1983) 15 ATR 105; 83 ATC 4800 (Full Federal Court)

Facts: The taxpayer was a gas utility that invoiced customers on a quarterly basis. The quarter for many customers overlapped the end of the taxpayer’s income year. The Commissioner assessed the taxpayer on the basis that it had derived income from the sale of gas delivered prior to the end of the income year even though the customers had not been invoiced for the gas. The taxpayer argued that it did not derive income until it had invoiced customers, even if it had actually provided the gas. Decision: The Court agreed with the taxpayer that there was no derivation of income until customers had been invoiced. Until invoices had been issued, claims against customers for current liabilities for gas supplied had not matured into recoverable debts. Relevance of the case today: Australian Gas Light remains authority for the proposition that a regulated utility does not derive income for supplies already made if the customers have not been invoiced for those supplies. It remains an open question whether the precedent will apply to all other taxpayers. The Commissioner may be able to argue successfully that Australian Gas Light should not apply to other suppliers and that non-regulated suppliers of goods or services derive income before the time of billing if they have already made their supply. If it happened today: If the facts in Australian Gas Light were to occur today, a court would continue to hold that the taxpayer has not derived income in respect of delivered but unbilled supplies.

© Thomson Reuters 2019

259

AUSTRALIAN TAXATION LAW CASES 2019

Sale of Trading Stock on an Instalment Basis J Rowe and Son Pty Ltd v FCT

(1971) 124 CLR 421; 2 ATR 497; 71 ATC 4157 (Full High Court)

Facts: The taxpayer operated a retail store which sold household goods for cash and on terms allowing for the payment of the purchase price by instalments over up to five years. The full amount payable included interest due on instalments payable in future years. The payments were secured by a bill of sale which acknowledged that the full sum was a valid enforceable debt payable by instalments and would be payable as a present debt upon default. The Commissioner sought to assess the full price to be received for the goods sold in the income year, but excluded that part of the price which represented interest. The issue was whether the income from the sale was derived when the debt arose or when the payments were received. Decision: The income from the sale of stock was derived when the stock was sold and the debt was created. The income of a trading business is derived when it is earned and receipt is not necessary to bring the proceeds into income. This approach more correctly represents the financial position of the taxpayer as it brings into account the proceeds from sales in the same year in which the reduction of trading stock is recognised as the stock is no longer on hand. Relevance of the case today: This case establishes the principle that income from the sale of trading stock on an instalment payment basis is derived by an accrual basis taxpayer when an enforceable debt arises, not upon receipt. If it happened today: If the facts of J Rowe occurred today, the full amount of the purchase price would be income derived at the time of sale of the goods which would be included in assessable income under s 6-5 ITAA 1997.

Sale Price Disputed by the Customer BHP Billiton Petroleum (Bass Strait) Pty Ltd v FCT (2002) 51 ATR 520; 2002 ATC 5169 (Full Federal Court)

Facts: The taxpayer supplied gas from the Bass Strait to customers under contracts that contained “pass-through provisions” which enabled the taxpayer to add to the price of gas any new taxes levied on the production or supply of gas. When the gas royalty regime was replaced by a petroleum resource rent tax (PRRT), levied on the excess profit derived from exploitation of offshore gas, the taxpayer passed on the tax to its customers. The customers disputed the taxpayer’s right to do so, arguing the PRRT was not a tax on the production or supply of gas and submitted the dispute to arbitration as provided under the contract. The Commissioner assessed the taxpayer on the entire amount invoiced to the customers, including the disputed portion related to the PRRT pass-through. Expert accounting evidence presented by the taxpayer indicated that the disputed pass-through portion would not be regarded as revenue for accounting purposes as it would not satisfy the definition of “economic benefits controlled by the entity as a result of past transactions”.

260

© Thomson Reuters 2019

CHAPTER 11

TAX ACCOUNTING AND INCOME ASSIGNMENTS

Decision: The Full Federal Court could find no Australian authority which requires an accrual basis taxpayer to recognise trading income where the amount is subject to a bona fide dispute with the customer. Accounting practice regards income to be derived when the dispute is concluded. This is a common sense approach that is followed in other jurisdictions and fairer to the taxpayer and should be applied to this case. The disputed amount is therefore not derived until the dispute is settled. Relevance of the case today: The BHP Billiton Petroleum case establishes a proposition that an accrual basis taxpayer does not derive trading income in respect of invoiced amounts that are subject to a bona fida dispute with the customer until the dispute is settled. If it happened today: If the facts in BHP Billiton Petroleum were to occur today, the disputed amount would not be derived by the taxpayer until the dispute is settled. To the extent the taxpayer retained the right to payment following settlement of the dispute, that amount would be treated as derived under s 6-5 ITAA 1997 in the year of settlement.

Sale of Trading Stock Subject to Settlement Gasparin v FCT

(1994) 28 ATR 130; 94 ATC 4280 (Full Federal Court)

Facts: The taxpayer carried on business as a land developer and builder and was involved in a joint venture to purchase and subdivide land. It was accepted that the lots of land were trading stock of the taxpayer. Contracts of sale with respect to the lots had been entered into in one income year and had become unconditional but the majority of these contracts were not settled until the following income year. The issue before the Court was whether the profits from the sale of the land lots were derived in the year that the contracts became unconditional or in the year in which settlement took place. Decision: The income was derived on completion (settlement). Income from the sale of trading stock is derived when the stock is sold and a debt is created – the proceeds need not be received in the year, applying J Rowe and Son Pty Ltd v FCT (1971) 124 CLR 421; 2 ATR 497. The contracts at issue in this case were executory contracts for the sale of land and general principles dictated that the purchase price did not become a recoverable debt until conveyance. Prior to conveyance, the vendor was only entitled to sue for damages. Relevance of the case today: The Gasparin case stands for the proposition that income derived from the sale of land held as trading stock is not derived until settlement, unless the terms of the contract create a recoverable debt before then. The decision may not extend beyond the sale of trading stock that is real property as the contract principle that a real property sale contract can be unconditional but still not create a recoverable debt arises from the conveyancing rules in real property law. If it happened today: If the facts in Gasparin were to occur today, the proceeds from the sale of the lots would continue to be income under s 6-5 ITAA 1997 in the year of settlement, not in the year the sale contracts become unconditional. © Thomson Reuters 2019

261

AUSTRALIAN TAXATION LAW CASES 2019

EXPENSE RECOGNITION When income is “derived” will differ for cash-basis and accrual basis taxpayers. However, Australian courts have concluded that the term “incurred” with respect to expenses has the same meaning for both cash basis and accrual basis taxpayers and that meaning generally accords with accrual basis recognition of outgoings. A small business that has elected to be covered by the small business entity rules in Div 328 ITAA 1997 is required to recognise both income and expenses on a strict cash basis. Other cash basis taxpayers can recognise expenses as incurred which is often before actual payment.

When are Expenses “Incurred” Generally? New Zealand Flax Investments Ltd v FCT

(1938) 61 CLR 179 (Full High Court)

Facts: The business of the taxpayer involved the sale of bonds under a trust deed which subjected it to certain future obligations to the bondholders. With respect to the arrangements under consideration, bondholders either paid for the issue of bonds in cash or by instalments over up to two and a half years. The amounts paid by the bondholders were not repayable. Once the bonds were fully paid, the taxpayer was obliged to pay 7% per annum to the bondholders as interest for a period of up to 4 years. The taxpayer was also obliged to make payments of deferred commission to salesmen with respect to the bonds which were not wholly paid up in the period. The taxpayer’s main undertakings were to apply the “bond” proceeds to acquire land suitable for growing New Zealand flax, to clear and cultivate the land, and to harvest, mill and market the flax produced. This included the construction of a mill and the acquisition of relevant plant. The taxpayer was entitled to retain 5% of the gross return from sales as an administration charge. The net profits from the undertaking were then to be divided among the bondholders. In preparing its income tax returns, the taxpayer included in assessable income the full amount of the bonds issued in the period, including those amounts not yet received. The taxpayer then claimed deductions under s 23(a)(1) ITAA 1922 (currently s 8-1 ITAA 1997 1997) for the total anticipated future outlays including the bond interest, the deferred commissions, the expenses for cultivation of the flax, and the expenses for the construction of the mill, even though these expenses would be incurred over a number of years and in many cases were merely estimates. The Commissioner accepted the treatment of the income from the bond issue but declined to allow the deductions for future outlays. Decision: The Full High Court concluded that the Commissioner’s assessment was incorrect and should be set aside and remitted for reassessment. There was some doubt expressed as to whether it was appropriate to treat the bond moneys as income rather than a capital receipt but both the taxpayer and the Commissioner had proceeded on the basis that the amounts were income and therefore the Court accepted this view. However, the Court concluded that only the payments or instalments paid or payable in the period should be included in income, not the entirety of the anticipated receipts. The Court then considered the correct treatment of each anticipated outlay to determine 262

© Thomson Reuters 2019

CHAPTER 11

TAX ACCOUNTING AND INCOME ASSIGNMENTS

if the expense was incurred as was required by s 23. The obligations to pay interest to the bondholders and deferred commissions to the salesmen would not be deductible in the period unless it were determined that the liabilities were properly attributable or referable to the years in question. This issue would need to be determined on the Commissioner’s reassessment. On the other hand, the provisions for land clearing and cultivating, harvesting and milling the flax (and other associated expenses) were clearly not expenses incurred in the period. Relevance of the case today: This case is often cited for the following analysis given by Dixon J of when an expense would be considered a loss or outgoing incurred and therefore deductible under the general deduction provision: “To come within that provision there must be a loss or outgoing actually incurred. ‘Incurred’ does not mean only defrayed, discharged, or borne, but rather it includes encountered, run into, or fallen upon. It is unsafe to attempt exhaustive definitions of a conception intended to have such a various or multifarious application. But it does not include a loss or expenditure which is no more than impending, threatened, or expected.” If it happened today: If arrangements like those in New Zealand Flax were entered into today, it is likely that the taxpayer would argue that the amounts received from the bondholders should not be characterised as income but as capital, as was suggested by the High Court. Alternatively, if the receipts were considered income as payments for services to be rendered, an argument could be raised that the amounts should not be considered derived until the services were performed, applying Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314. On the issue of available deductions, the mere provisions in accounts for future outlays would not be deductible under s 8-1. The interest and deferred commission obligations were contingent on actual payment by the bondholders. Arguably the deferred commission expenses would not be incurred until the bondholder payment was received and would be deductible at that point. Once the bonds were fully paid, the interest liability became absolute but it would be considered that the liability to pay interest would accrue over the period on a daily basis: see Alliance Holdings Ltd v FCT (1981) 12 ATR 509; 81 ATC 4637; and FCT v Australian Guarantee Corporation Ltd (1984) 15 ATR 982; 84 ATC 4642.

Compound and Deferred Interest Australian interest-bearing debt instruments commonly carry an obligation to pay one of three types of interest obligations: ordinary or periodic interest, compound interest (not payable until the debt instrument is redeemed but added to the principal periodically to enlarge the base for further accruing interest), or deferred interest (not payable until the debt instrument is redeemed and not added to the principal for the purpose of determining further accruing interest). Influenced by accounting practice and principles, Australian courts have recognised compound interest and deferred interest as incurred as the right to interest accrues, even if the borrower is not obligated to pay the interest liability until a future year. The courts agreed that cash basis lenders should recognise compound interest as it accrues as the effective reinvesting for compounding purposes is equivalent to an application of income by the © Thomson Reuters 2019

263

AUSTRALIAN TAXATION LAW CASES 2019

lender. However, the courts allowed cash basis lenders to recognise deferred interest when it is received. The resulting mismatch between borrowers deducting deferred interest on an annual basis while cash basis lenders deferred recognition of the interest led to the enactment of Division 16E ITAA 1936 in 1986, which was replaced by Division 230 ITAA 1997 for entities other than some individuals in 2009. Division 230 now provides accrual recognition for deferred interest and discounts for entities other than individuals. The government announced in 2016 that it would provide an alternative set of simplified accrual recognition rules for taxpayers other than very large taxpayers from 2018. However, it was announced in December 2017 that these measures are to be deferred until legislation introducing the changes receives Royal Assent. To date, these reform measures have not been introduced into parliament.

FCT v Australian Guarantee Corporation Ltd (1984) 15 ATR 982; 84 ATC 4642 (Full Federal Court)

Facts: The taxpayer was a finance company which raised money by issuing deferred interest debenture stock with a term of 20 years. The debenture notes provided for deferred interest to accrue at a fixed rate per annum for the first five years and then at a rate to be fixed from year to year until maturity. The debentures could be redeemed by the holder from the sixth year. No interest was payable to the debenture holder until redemption. In its accounts, the taxpayer showed the interest accruing for each quarter and for tax purposes the taxpayer treated the yearly total as incurred, claiming the deduction for the interest accrued during the year. The Commissioner argued that the deferred interest expense was not incurred until the taxpayer was obligated to pay the interest. Decision: The taxpayer was allowed to deduct the amount of deferred interest that had accrued in the year. The question was whether the taxpayer subjected itself to the liability to pay interest in the given year. The liability to pay the interest had arisen in the year and was more than merely impending or threatened, even though the actual payment would not occur until a later time. There was a present liability to pay an amount in the future. Relevance of the case today: Australian Guarantee Corporation Ltd establishes the principle that interest will be deductible for tax purposes when there exists a present liability to pay the interest, even though the actual payment is deferred. A present liability arises when interest accrues under the terms of the loan, regardless of when it is payable. The case is of reduced significance since Division 230 ITAA 1997 would now apply to this kind of financing arrangement and provide compounding accrualbasis recognition for the interest obligation. If it happened today: If the facts of this case arose today, Division 230 ITAA 1997 would apply to determine the timing of the deductions for interest expenses (as well as for inclusion of the interest income derived by the debenture holders other than individuals while Div 16E ITAA 1936 would apply to interest derived by most individuals). The interest would be treated as incurred and derived on a six-monthly compounding accrual basis over the term that the debenture was held. This would work to the taxpayer’s disadvantage in an arrangement such as the debenture in Australian 264

© Thomson Reuters 2019

CHAPTER 11

TAX ACCOUNTING AND INCOME ASSIGNMENTS

Guarantee Corporation Ltd as it would allow smaller initial deductions that grow over time.

Discounts in Lieu of Interest on Debt Instruments Coles Myer Finance Ltd v FCT

(1993) 176 CLR 640; 25 ATR 95; 93 ATC 4214; 4341 (Full High Court)

Facts: The taxpayer carried on business as a finance company for a corporate group. Its activities included drawing and selling at less than face value both bills of exchange and promissory notes. The discount was an expense incurred on revenue account. Some of the bills and notes were still outstanding as at the year end. The taxpayer sought to deduct the amount of the discount in full in the year the bills were issued even if the value of the discount was not payable in the year. The Commissioner denied the deductions, arguing that the liability was not incurred until the bills were discharged in the following year. Decision: Although the amount of the discount (the difference between the face value and the issue price) was a presently existing liability when the notes were issued and the bills of exchange were drawn, this cost of acquiring funds should be spread over the term that the funds were put to profitable advantage. The deduction for this cost should therefore be spread over the term of the note or bill (on a straight-line basis given the short term). Relevance of the case today: The implications of the case may be limited following the adoption of TOFA (taxation of financial arrangements) rules in 2009. Division 230 ITAA 1997 now mandates recognition of accruing gain on a compound basis for discounts exceeding a year and allows recognition using accounting standards for arrangements lasting less than a year. If it happened today: If the facts presented in Coles Myer Finance were to occur today, the deduction for the discount would be spread over the term of the notes or bills under Div 230 ITAA 1997, either using accounting standards for short-term notes or a compounding recognition system for longer-term notes.

FCT v Energy Resources of Australia Ltd

(1996) 185 CLR 66; 33 ATR 52; 96 ATC 4536 (Full High Court)

Facts: The taxpayer carried on a mining business and obtained financing for its business operations by way of a rolling series of 90 day promissory notes issued in US dollars. Each note was issued at a discount and the proceeds of each new issue were used to redeem the notes that had just reached maturity. The Commissioner accepted that the loss was on revenue account but disagreed with the taxpayer as to the proper calculation of the loss. The Australian dollar appreciated in value between the time the notes were issued and when they were redeemed so the spread between the issue proceeds in Australian dollars and the cost of redemption was very small if the proceeds were valued in Australian dollars at the same time, when the notes were issued and the redemption © Thomson Reuters 2019

265

AUSTRALIAN TAXATION LAW CASES 2019

cost valued in Australian dollars at the time of maturity. The taxpayer argued the cost of the loan was incurred when the notes were redeemed so both proceeds and redemption cost should be valued in Australian dollars at the same time, which was when the notes were redeemed. The Commissioner argued the expense was incurred over the life of the loan and the issue price should be valued in Australian dollars at the time the notes were issued while the redemption cost should be valued in Australian dollars at the time of redemption. He argued in the alternative that the face value of the discount in US dollars could be valued at the time of maturity but this amount should be reduced by the redemption savings enjoyed by the taxpayer because of the appreciated Australian dollar. Decision: The amount of the discount was a loss that was incurred at the time that the liability to pay the face value arose, that being at the time of issue, even where the term of the note extended beyond the income tax year. There was therefore no need to apportion the deduction for the discount over the term of the notes, in contrast to the situation in Coles Myer Finance. There were no currency exchange gains or losses since the taxpayer only dealt in US dollars with respect to these transactions. Relevance of the case today: The significance of this case is limited in light of legislative changes enacted subsequent to the case, particularly Division 230 for the accrual recognition of financial obligations such as the notes issued by the taxpayer in Energy Resources of Australia (adopted in 2009) and Division 775 containing foreign exchange recognition rules (adopted in 2003). If it happened today: If the facts of this case were to occur today, the transactions would be governed by Division 230 ITAA 1997. The taxpayer would recognise the cost of finance (the discounts on notes) on an accrual basis using accounting standards and recognise the offsetting foreign exchange gains using foreign exchange translation rules based on accounting standards.

FCT v Citylink Melbourne Ltd

(2006) 228 CLR 1; 62 ATR 648; 2006 ATC 4404 (Full High Court)

Facts: The taxpayer entered into an agreement with the State of Victoria that provided the taxpayer with a lease of land on which it constructed a freeway and the right to impose tolls on the freeway. The life of the agreement was contingent on various financial factors but in any case could not last more than 53½ years, at which time the infrastructure would be transferred to State ownership. In return for these rights, the taxpayer agreed to pay a token annual rental charge ($100 per year) and a much higher “base concession fee” of $95.6 million per year for the first 25 years and sliding down to a much smaller amount after year 35. An additional concession fee was payable if profits exceeded a modelled expected return. The agreement allowed the taxpayer to satisfy its concession fee and additional concession fee obligations by issuing non-interest bearing debt for the face value of the fee. The agreement further provided for variable redemption dates based on a number of contingencies. As a result of these contingencies, the payment dates were deferred for more than three decades. The present value of the notes was a small fraction of their face value and there was some evidence it could be only a little more than nil. 266

© Thomson Reuters 2019

CHAPTER 11

TAX ACCOUNTING AND INCOME ASSIGNMENTS

The taxpayer claimed deductions for the face value of the notes in the years in which they were issued. The Commissioner denied the taxpayer the deduction it sought on the grounds that the expenses were capital, related to the taxpayer obtaining a monopoly or, alternatively, were capital outgoings akin to a form a profit distribution. The Commissioner argued in the alternative that if the payments were revenue in nature, the obligation was not incurred in the year the notes were issued or, if it was, the expense was not referable to those years and should only be deductible when the obligation to make the payment crystallised. The Federal Court held the obligations were incurred when the concession fees were due and debt notes issued to satisfy the obligation. It further held that the expenses were referable to years in which the notes were issued. However, it concluded the expenses were capital outgoings and no deduction was available for that reason. On appeal, the Full Federal Court agreed with the conclusion that the expenses were incurred when the notes were issued and were referable to those years. It held the expenses were revenue outgoings, however, and were therefore deductible. Decision: The Full High Court held that the expenditures were revenue in nature as they referred to the taxpayer’s rights under the contract in the year in which the notes were issued. It further held that the taxpayer had incurred the face value of the notes in the year in which the notes were issued as the taxpayer had subjected itself to the obligation in that year. The obligations were also referable to those years as the liability to pay the fees arose in those years and this conclusion was not affected by the fact that actual payment would occur many years in the future. Relevance of the case today: The Citylink decision was based on the very specific contract details in the case and in its narrowest application, the decision would only apply to arrangements identical to those in that case. Many commentaries suggest that the decision can apply to other cases in which a taxpayer satisfied a revenue payment obligation by issuing a debt note that might not be payable until long into the future depending on the payment conditions attached to the note. The notes themselves appear to be financial arrangements within the meaning of Division 230 ITAA 1997. However, this may not impact on the initial deductibility of the obligation. The key implication of the case, that liabilities to be paid in the future are measured in terms of their nominal values, not their present values, may continue to be relevant. If it happened today: The notes issued by the taxpayer in Citylink appear to be financial arrangements within the meaning of Division 230 ITAA 1997. Where Division 230 applies to an arrangement, the difference between the issue value and the redemption amount is recognised over the life of the instrument. In the Citylink arrangement, however, the creditor accepted the full face value of the notes price as satisfaction of the amount due so the debtor appeared to have paid the amount owed. It is not clear if Division 230 would affect the initial deduction by the taxpayer even though the obligation would have a negligible value in the taxpayer’s financial accounts. It is possible that if the facts arose today, a court might again find the expenses to be revenue expenses that are deductible when the notes are issued, even though payment will not be made until long in the future. The Commissioner might argue that the implication of Division 230 is that the taxpayer should only recognise the present value of the notes as an expense and then treat the notes as a separate compounding interest debt. Under © Thomson Reuters 2019

267

AUSTRALIAN TAXATION LAW CASES 2019

this rule, the taxpayer would be treated as incurring an annual notional interest expense each year as the note grew in value closer to the payment date.

Leave Obligations FCT v James Flood Pty Ltd

(1934) 52 CLR 28 (Full High Court)

Facts: The taxpayer carried on business as a motor body builder and general engineer. The taxpayer claimed a deduction for a provision created in its accounts for accrued holiday pay which had not yet been paid. Under the relevant award, after 12 months continuous service, 14 days leave was to be allowed annually to each employee. The taxpayer argued that entitlement to leave arose from employment and the cost of leave should be considered incurred in the period in which the relevant employment took place. The Commissioner denied the deduction on the basis that the expense was not incurred until payment for leave was actually made. Decision: The Court’s unanimous opinion denied the deduction on the basis that the expense was not incurred. The Court considered a number of factors which indicated that the taxpayer was not fully committed to the expense. Under the award there were various circumstances under which an employee could fail to become entitled to annual leave and it was noted that the employer might never be required to make the payments if the business were to be sold. In addition, a number of the employees had not yet completed the 12 months continuous service requirement and, for these employees, there was no accrued obligation – there was at best an inchoate obligation. Considering these various facts, the Court concluded that it could not be said that there was a definite obligation to make an annual leave payment in respect of each completed month of service. There was no definitive commitment to make an annual leave payment until the annual leave was actually taken. Relevance of the case today: This case establishes the proposition that accounting expenses which give rise to a provision in the financial accounts are not deductible for tax purposes unless they represent a specific liability to which the taxpayer is definitively committed. An example of a liability to which a taxpayer is definitively committed would be liabilities of an insurer that can be ascertained by reliance on actuarial evidence. If it happened today: If the facts of this case were to occur today, the annual leave provision would not be deductible as the expense has not been incurred. The result in the case is now enshrined in a statutory amendment, currently s 26-10 ITAA 1997, which specifically denies a deduction for annual leave until the payment is actually made to the employee or an accrued leave transfer payment is made on transfer of the business.

INCOME ASSIGNMENTS Australian courts used property law doctrines to determine whether taxpayers could successfully assign a right to income to another person for tax purposes so the income 268

© Thomson Reuters 2019

CHAPTER 11

TAX ACCOUNTING AND INCOME ASSIGNMENTS

was assessable to the assignee (transferee) rather than the assignor (transferor). Those doctrines recognise transfers as effective if the right to income being transferred would be recognised as a presently existing chose in action, that is a current property right as opposed to a right that would only crystallise in the future. The ability to assign income for tax purposes was first restricted by s 102B ITAA 1936 and subsequently by the CGT provisions in ITAA 1997, which could lead to recognition of gain by the assignor at the time of assignment.

Assignments of Presently Existing Property Interests Norman v FCT

(1963) 109 CLR 9 (Full High Court)

Facts: The taxpayer purported to assign the right to future interest on a loan that could be repaid at will and the right to anticipated future dividends from shares the taxpayer expected to acquire. No consideration was paid for these purported assignments. The Commissioner argued that neither income right was a presently existing property right (a current chose in action) and thus could not be transferred. He argued that the payment of interest was uncertain because the loan could be repaid at will and the right to dividends was uncertain because the taxpayer had no right to dividends unless the directors made a decision for the company to pay dividends. Thus, he argued, both rights were “mere expectancies” or potential property rights that would crystallise into choses of action only when the interest or dividends were paid. The argument relied on property law doctrines which stipulate that an assignment can only be effective if the object of the assignment is a presently existing chose in action. Decision: The High Court concluded that neither the taxpayer’s right to interest nor the right to dividends was a presently existing chose in action that could be assigned (McTiernan and Windeyer JJ dissented on the question of interest). The judgments contain some discussion on the question of whether consideration or payment for an equitable assignment could perfect an assignment that would otherwise fail because the object was a mere expectancy at the time of assignment. Relevance of the case today: While the Norman case remains authority for the proposition that it is not possible to assign a right to income that is not a presently existing chose in action, its impact has been limited over the years. The case would still be followed in the case of a purported assignment of a right to dividends. However, it is now common to accept an assignment of the right to interest as effective (financial institutions often assign rights to interest). The Norman precedent is distinguished on the basis that the loan in that case could have been terminated at will by the borrower and thus the interest was uncertain compared to the interest on other loans. Later cases have also clarified the effect of consideration paid for a purported assignment of a mere expectancy. Consideration will not cure an invalid assignment in equity. Instead, it will create a right by the assignee to have income transferred to the assignee after it is derived by the assignor. As a result, an assignment of a mere expectancy for consideration will not effectively transfer the income from the assignor to the assignee for tax purposes. © Thomson Reuters 2019

269

AUSTRALIAN TAXATION LAW CASES 2019

If it happened today: If the facts in Norman occurred today, the court would continue to find that it was not possible to assign a right to future dividends. It would likely reach a similar conclusion with respect to the interest on a loan that could be terminated at will by the borrower. If the facts were distinguished because the terms of the loan were slightly different and the assignment were effective, s 102B ITAA 1936 and the CGT provisions in ITAA 1997 might apply. These are discussed in Shepherd v FCT (1965) 113 CLR 385.

Shepherd v FCT

(1965) 113 CLR 385 (Full High Court)

Facts: The taxpayer assigned for three years by way of gift (for no consideration) an interest in 90% of the right to income from royalties payable on a licence agreement for an invention created by the taxpayer. He argued that income was derived by the person who owned the property from which the income flowed, in this case the property being the right to income from royalties. The Commissioner argued that the right to income from royalties did not constitute a presently existing property right (a current chose in action) and could not be transferred. He argued that the payment of royalties was uncertain and the right to income from the royalties was thus a “mere expectancy” or a potential property right that would crystallise into a chose of action only when the royalties were paid. The argument relied on property law doctrines which stipulate that an assignment can only be effective if the object of the assignment is a presently existing chose in action. Decision: The High Court concluded the taxpayer’s right to income from royalties was a presently existing chose in action that could be assigned to another person in whole or in part. While it was uncertain whether royalties would be paid or how much might be paid, it was clear that the taxpayer had a contractual right to royalties payable on any products made under the licence agreement. Since the right to income from royalties was a presently existing property right, it could be assigned. Income attributable to the right was derived by the person who owned the right and thus was derived by the assignee, not the taxpayer. Relevance of the case today: The Shepherd case remains a relevant precedent used to determine whether a right to income from a particular source is a presently existing chose in action that can be assigned or a mere expectancy that cannot be assigned. Where a taxpayer has a contractual right to receive income following the granting of rights under a licence, the right will be an assignable chose in action. If it happened today: The assignment in Shepherd was for a three year period. Following the case, the legislature enacted s 102B ITAA 1936 to render ineffective for tax purposes assignments of rights to income for less than seven years. If the facts in the case arose today, the income would be transferred as a matter of property law but for tax law would be included in the assessable income of the assignor. The assignment of the right to income would also trigger a capital gain under CGT event A1. Since the right to income was gifted, s 116-30 ITAA 1997 would apply and deem the taxpayer to have received proceeds equal to the market value of the assigned interest. This would be the present value of the anticipated royalty stream that was 270

© Thomson Reuters 2019

CHAPTER 11

TAX ACCOUNTING AND INCOME ASSIGNMENTS

assigned. The general reconciliation rule to prevent double taxation when an amount is assessable other than as a capital gain and as a capital gain, s 118-20 ITAA 1997, will not apply to overlap caused by s 102B ITAA 1936 and the CGT rules because the derivation of the royalty income over the term would not be considered to relate to the CGT event of assignment. As a result, the taxpayer could be taxed twice following the assignment.

Assignments of Interests in Partnerships FCT v Everett

(1980) 143 CLR 440; 10 ATR 608; 80 ATC 4076 (Full High Court)

Facts: The taxpayer was a member of a firm of solicitors. For a small consideration, he assigned to his spouse a share of his interest in the partnership including the same share of his right to distributions of partnership profits. The Commissioner assessed the taxpayer on his share of partnership income as if the assignment had not taken place on the basis that the assignment was ineffective. The taxpayer appealed. Decision: A majority of the High Court found the assignment was effective as a matter of property law and further that the income was derived by the spouse who had entitlement to the income as a matter of property law following the successful assignment. Murphy J in a strong dissent argued that it was contrary to the policy of the ITAA to allow taxpayers to transfer personal services income for tax purposes and the income in question was personal services income. He argued the ITAA should be read so assignments of partnership income are not effective for tax purposes. The majority, in contrast, said partnership income derives to the person who has title to the partnership interest or a share of a partnership interest. As the partnership interest was a presently existing property right, it was capable of assignment and once a part interest in the partnership had been successfully assigned, the income was derived by the person with ownership of the property interest, namely the taxpayer’s spouse. Relevance of the case today: The Everett case led to widespread tax minimisation by professionals who assigned parts of partnership interests to spouses. The practice largely ended with the adoption of CGT in 1985 and the case has limited continuing relevance although it remains authority for the ability of taxpayers to assign some of the income from a partnership by assigning part of their partnership interest and right to income from that share of the partnership interest. If it happened today: If the facts in Everett were to take place today, the assignment would trigger CGT event A1 and a capital gain would be recognised under s 104-10 ITAA 1997. Because the assignor and assignee are not operating at arm’s length, s 116-30(2) ITAA 1997 would apply and the assignor would be deemed to have received capital proceeds equal to the market value of the part of the partnership interest assigned. This could be calculated on the basis of a share of the net assets of the partnership but as the assignment also included all rights to future income, a more accurate method of valuing the assigned interest would probably be to determine the present value of the expected future income stream, which could be a very high value. The taxpayer’s cost base would consist of a portion of capital contributed to the partnership and incidental © Thomson Reuters 2019

271

AUSTRALIAN TAXATION LAW CASES 2019

costs of the assignment. The result is likely to be a significant capital gain at the time of assignment and this outcome has dissuaded some professionals from making Everett-type assignments today. Some partners have made Everett type assignments for market value to avoid the CGT consequences but the assignments have been ineffective for other reasons. For example, the assignment in Kelly v FCT [2013] FCAFC 88; 94 ATR 411 was not effective when it purported to assign an interest in a partnership of a partner who retired from the firm. The ATO has indicated that there is still a great deal of taxpayer confusion around Everett assignments and is currently working on guidelines to clarify its views.

FCT v Galland

(1986) 162 CLR 408; 18 ATR 33; 86 ATC 4885 (Full High Court)

Facts: The taxpayer was a partner in a two person solicitor partnership. On the third last day of the income year, he assigned part of his partnership interest to a discretionary trust for the benefit of himself and his family. The Commissioner accepted the validity of the assignment based on the precedent in FCT v Everett (1980) 143 CLR 440. However, he assessed the taxpayer on the basis that the taxpayer’s income from the partnership was derived progressively throughout the year and the assignment was only effective for the income derived on the last three days of the income year. The taxpayer argued he had no entitlement to income from the partnership until the partnership accounts were taken and this happened after the end of the year so the assignment was effective for the entire year’s income. Decision: The High Court agreed with the taxpayer that entitlement to a share of partnership income could only crystallise when the partnership accounts were taken and a partner could not derive his share of partnership income progressively throughout the year. On this basis, the assignment was effective for a share of the entire year’s income. Relevance of the case today: The Galland decision came after the introduction of CGT, although the CGT provisions did not apply to the facts in Galland which took place prior to the introduction of CGT. The introduction of CGT meant that taxpayers could not take advantage of the Galland decision to assign a share of an entire year’s income by an assignment shortly before the end of the income year. The case thus has limited impact on the question of income assignment. However, it remains very useful in terms of partnership income, and may continue to be cited as authority for the proposition that partners do not have an entitlement to a share of partnership income until the partnership accounts are taken. If it happened today: For the reasons set out above in the description of FCT v Everett (1980) 143 CLR 440, if the facts in Galland arose today, the assignment would likely trigger CGT event A1 and the assignor would be liable for tax on a significant capital gain. In the circumstances, the taxpayer is unlikely to attempt an assignment of the sort undertaken in Galland. Galland

272

© Thomson Reuters 2019

C HAPTER 12

Trading Stock WHAT IS TRADING STOCK? ........................................................................... 274 St Hubert’s Island Pty Ltd (in liq) (1978) .............................................. 274 Sanctuary Lakes Pty Ltd (2013).............................................................. 275 ACQUISITION OF TRADING STOCK ............................................................ Purchases from Associates........................................................................... Cecil Bros Pty Ltd (1964) ...................................................................... Purchases of Trading Stock Subject to Future Delivery .............................. Raymor (NSW) Pty Ltd (1990) ...............................................................

276 276 276 277 277

WHEN IS TRADING STOCK ON HAND? ...................................................... Loss of Dispositive Power over Trading Stock .......................................... Farnsworth (1949) ................................................................................. Acquisition of Dispositive Power over Trading Stock ............................... All States Frozen Foods Pty Ltd (1990) ................................................. Control of Trading Stock without Ownership ............................................. Suttons Motors (Chullora) Wholesale Pty Ltd (1985) ...........................

278 278 278 279 279 280 280

VALUING TRADING STOCK ON HAND ....................................................... 281 Australasian Jam Co Pty Ltd (1953) ..................................................... 281 Philip Morris Ltd (1979)........................................................................ 282 UNUSUAL DISPOSALS OF TRADING STOCK ............................................ Involuntary Disposals .................................................................................. Wade (1951) ........................................................................................... Disposals Outside the Ordinary Course of Business ................................... Pastoral and Development Pty Ltd (1971) ............................................

282 282 282 283 283

© Thomson Reuters 2019

273

C HAPTER 12

Trading Stock A principle of income tax law is that taxpayers should not recognise expenditure until they have actually used the expenditure—simply converting cash to an asset of equal value by buying an asset does not lead to a measurable economic decline. If the expenditure is for a capital asset, there is no deduction for the outgoing and instead it is recognised over time under the capital allowance rules as the asset is used up or when the asset is sold under the CGT rules if it does not depreciate. Expenditures for trading stock are considered revenue outgoings under judicial doctrines for characterising expenses and, accordingly, are deductible under s 8-1 ITAA 1997. Section 70-35 ITAA 1997 then applies the income tax principle of non-recognition until assets are actually used up or disposed of by providing for a re-inclusion in assessable income of amounts which had been for trading stock if the trading stock remains on hand at the end of the income year. The formula in s 70-35 also allows another deduction when there is a subsequent disposal of the stock.

WHAT IS TRADING STOCK? FCT v St Hubert’s Island Pty Ltd (in liq)

(1978) 138 CLR 210; 8 ATR 452; 78 ATC 4104 (Full High Court)

Facts: The taxpayer was a land developer, formed to acquire land, carry out development work, and subdivide and sell the developed lots. The taxpayer had acquired land on two islands and received permission to subdivide and develop that land. When the land was only partly developed, the taxpayer experienced financial difficulties and went into voluntary liquidation. In satisfaction of the rights of its sole shareholder (another company) as creditor, the taxpayer transferred the land to the shareholder. The Commissioner argued that the land was trading stock of the taxpayer and the transfer was a disposal outside the ordinary course of business to which s 36 ITAA 1936 (currently s 70-90 ITAA 1997 1997) applied such that the value of the partly developed land should be included in assessable income. Decision: Land may form part of the trading stock of a taxpayer. The meaning of trading stock is not to be restricted by the definition found at s 6 ITAA 1936 (now s 70-10 ITAA 1997 1997). Just as raw materials and partly finished goods are trading stock of a manufacturer, the trading stock of a land developer can include undeveloped land and land which is only partly developed. 274

© Thomson Reuters 2019

CHAPTER 12

TRADING STOCK

The transfer of stock by a taxpayer to its sole shareholder in the course of voluntary winding up and in satisfaction of its rights as shareholder and creditor is a disposal of stock outside the ordinary course of business to which s 36 (now s 70-90) applies. Relevance of the case today: This case is relevant for establishing the principle that land can be trading stock of a land developer and that this may include both undeveloped and partly developed land. The definition of trading stock provided in s 70-10 is not an exclusive one and must take into account its ordinary meaning. If it happened today: If the facts of this case were to arise today, the land would be considered trading stock for the purposes of Division 70 ITAA 1997 and the transfer of the land to the taxpayer’s sole shareholder would trigger the application of s 70-90 (a disposal outside the ordinary course of business), such that the assessable income of the taxpayer would include the market value of the land on the day of disposal.

Sanctuary Lakes Pty Ltd v FCT

[2013] FCAFC 50; 90 ATR 762; 2013 ATC 20-395 (Full Federal Court) Facts: The taxpayer was a member of a land development group that had lent funds to an incorporated golf club that had a fixed number of memberships for sale. When the club was unable to repay the loan, it transferred the unsold memberships to the taxpayer in satisfaction of the debt. The taxpayer subsequently disposed of the memberships in a single transaction for a value much less than the value of the loan. The golf club had treated the memberships as trading stock of the club and the taxpayer in turn recorded the memberships as trading stock with a cost equal to the value of the loan redeemed when the memberships were transferred to it. It sought to deduct the loss on the subsequent resale of the memberships as a revenue loss on the sale of trading stock. Decision: As the taxpayer was not in the business of selling golf club memberships when it acquired the memberships, they were not acquired as trading stock. It sold the memberships in a single transaction as part of a group restructure and there was no evidence to show it had been in the business of selling memberships in the interim. The loss it suffered therefore was a capital loss on the sale of a capital asset, not a revenue loss from the sale of trading stock. Relevance of the case today: The Sanctuary Lakes case is authority for the proposition that a company must show it is actually in the business of selling assets it has acquired for the assets to be treated as trading stock. If it cannot demonstrate it is in the business of selling those assets, they will be treated as capital property and any loss on their disposal will be treated as a capital loss. If it happened today: If the facts in Sanctuary Lakes were to occur today, a court would likely conclude that the club memberships were not trading stock of the company. However, the fact situation in Sanctuary Lakes took place in the context of a group of related entities all associated with a large development centred around a golf course. These facts may have influenced the court. It is quite likely that a court would © Thomson Reuters 2019

275

AUSTRALIAN TAXATION LAW CASES 2019

accept that golf club memberships were trading stock if the taxpayer were a wholly unrelated independent company operating entirely at arm’s length and could establish it intended to market the membership rights it had acquired.

ACQUISITION OF TRADING STOCK Purchases from Associates Cecil Bros Pty Ltd v FCT

(1964) 111 CLR 430 (Full High Court)

Facts: The taxpayer purchased trading stock from a related company at a price much higher than the price it would have paid had it purchased directly from the suppliers. The apparent object of the transaction was to reduce the taxpayer’s taxable income and to increase the taxable income of the supplier. The Commissioner attacked the transaction relying on two arguments. First, he argued to the extent the price of the stock was higher than it would have been had the taxpayer purchased directly, the expenses were not incurred “in gaining or producing assessable income” and therefore should not be deductible under s 51(1) ITAA 1936 (predecessor to s 8-1(1) ITAA 1997 1997). Second, he argued that the excess payment should be voided under the former general anti-avoidance provision, s 260 ITAA 1936. The Commissioner lost on the s 51(1) argument and won on the s 260 argument at first instance, before Owen J of the High Court. The taxpayer appealed to the Full High Court in respect of the decision based on s 260. Decision: The High Court concluded that the general anti-avoidance provision could not be used to annihilate a deduction where the only legal effect of the expense was to acquire trading stock. The decision reinforced the interpretation of the general deduction provision by Owen J, that the Commissioner could only look at the legal effect of the payment and if the legal effect under the contract was only to acquire stock, the other consequences of overpayment outside the contract were not a basis for denying a deduction. It also extended the legal effect doctrine to the operation of s 260, with the result that if the legal effect of a contract was solely to acquire stock, the overpayment and consequent income shifting could not be attacked using the general anti-avoidance provision. Relevance of the case today: The Cecil Bros case was one of a group of cases that established and cemented the legal effect approach to interpreting the general deduction provision, without regard to the secondary purposes for an expenditure. That approach was scaled back considerably in later decades when the courts shifted to a more purposive approach, taking in account the taxpayer’s purpose in making the outgoing. Under the later approach, courts would often deny a deduction to the extent the transaction revealed a tax minimisation purpose to an excessive payment in addition to the legal benefit acquired under the contract. As a result of these later developments, in the eyes of many tax advisers Cecil Bros is no longer an important authority. 276

© Thomson Reuters 2019

CHAPTER 12

TRADING STOCK

If it happened today: Changes to the ITAA have reduced the likelihood of a taxpayer engaging in a Cecil Bros-type arrangement to shift profits from one resident company to another resident company. At the time of the case, carried-forward losses expired and could not be used more than 7 years after they were incurred. One reason companies sought to shift profits in this way was to use up carried-forward losses before they expired. The time limit for using losses has been abolished – see s 36-15 ITAA 1997. Also, at the time of the case it was not possible to shift losses directly between related entities. Now, group companies can shift losses from a loss company to a profit company in the same group – see s 170-10 ITAA 1997. Following the Cecil Bros case, a specific anti-avoidance provision was adopted to deny a full deduction for overpriced trading stock – now s 70-20 ITAA 1997. This would prevent the deduction sought by the taxpayer in Cecil Bros. Even in the absence of such a provision a different result might follow if the case happened today as a result of the more purposive interpretation of s 8-1 used by courts where an expense is incurred partly for tax minimisation reasons, whatever the contractual legal effect of the expense. Also, the more generous consideration of taxpayers’ motives under the new general anti-avoidance rule in Part IVA ITAA 1936 might lead to annulment of the excess payment under the anti-avoidance rule.

Purchases of Trading Stock Subject to Future Delivery FCT v Raymor (NSW) Pty Ltd

(1990) 21 ATR 458; 90 ATC 4461 (Full Federal Court)

Facts: The taxpayer carried on the business of selling and distributing plumbing goods and accessories, including copper tubing. The taxpayer entered into contracts for the purchase of copper tubing whereby the base price would be paid prior to delivery. Included in the contracts was a rise and fall clause which allowed for an additional payment or refund depending on fluctuations in the price of copper. The payment of the base price was made in June of the relevant income year and delivery commenced in the following income year. It was agreed that the copper piping was trading stock to the taxpayer upon delivery. The issue before the Court was whether a deduction under s 51(1) ITAA 1936 (now s 8-1 ITAA 1997 1997) for the cost of acquisition of the trading stock was available and, if so, when was it allowable, on payment or in the following year on delivery. The taxpayer argued it was entitled to a deduction when it entered into the purchase contract. The Commissioner argued that the outgoings were capital expenses incurred to acquire an asset, that being the right to acquire trading stock in the future. Decision: The payments were on revenue account, not on capital account, and were deductible in the year the outgoings were incurred, notwithstanding that the trading stock was not yet on hand by the year end. The payments were incurred when the taxpayer bound itself under the agreements and the time of the actual payment was not relevant. If additional amounts were payable under the rise and fall clause, those amounts would be incurred and deductible on delivery. If an amount was credited or refunded, such an amount would be assessable income to the taxpayer. © Thomson Reuters 2019

277

AUSTRALIAN TAXATION LAW CASES 2019

Relevance of the case today: The decision in Raymor opened the door to significant tax minimisation opportunities by taxpayers purchasing trading stock at the end of an income year knowing it would not be shipped (or on hand) until the following income year. The government responded to the decision in Raymor by enacting s 70-15 ITAA 1997 which now operates to defer the deduction until the year in which the item becomes part of trading stock on hand. If it happened today: If the facts in Raymor were to occur today, the payment would be deductible under s 8-1 as a revenue expense to acquire trading stock but the deduction would only be available in the following year when delivery occurs under the operation of s 70-15 as it would be at this later time that the stock is on hand.

WHEN IS TRADING STOCK ON HAND? Section 70-30 ITAA 1997 provides for recognition of income if trading stock on hand at the end of the year exceeds stock on hand at the beginning or allows a deduction if opening stock exceeds closing stock. Taxpayers have an incentive to show that stock is not on hand at the end of the income year, particularly if they have deducted the cost of acquiring the stock during the year.

Loss of Dispositive Power over Trading Stock Farnsworth v FCT

(1949) 78 CLR 504 (Full High Court)

Facts: The taxpayer carried on business as a fruit grower and was a member of an association of fruit growers. During the year of income, the taxpayer and other members of the association delivered their dried fruit produce to the association packing house where it was intermingled in preparation for sale through an agent. Some of the fruit was sold in that year and the balance in the following year. The taxpayer had received monthly progress payments based on estimates of sales and at the year end the taxpayer also received a statement showing an estimate of additional payments she would receive for her fruit in the following year. The taxpayer argued that the fruit ceased to be on hand on delivery to the packing house as the produce was no longer identifiable as the taxpayer’s once it was mixed at the packing house and under the control of the association. Decision: The fruit ceased to be trading stock on hand upon delivery to the packing house. The Court was divided in its reasoning to support this conclusion but the rationale put forward by Dixon J, with McTiernan J concurring, emphasised the fact that the taxpayer was left with no dispositive power over the fruit once it was delivered to the packing house and had no power to control the disposal by the packing house. Whatever contractual or equitable rights the growers had as against the packing house, the fruit could no longer be considered stock in trade on hand of the individual growers.

278

© Thomson Reuters 2019

CHAPTER 12

TRADING STOCK

Relevance of the case today: Although the circumstances in this case might be described as unusual, the decision, and in particular the opinion of Dixon J, is of continued relevance for its discussion of the meaning of “on hand” and the importance of dispositive power in determining if stock is still on hand. The power to dispose was emphasised as a critical factor in later cases, such as FCT v Suttons Motors (Chullora) Wholesale Pty Ltd (1985) 157 CLR 277; 16 ATR 567; 85 ATC 4398 and All States Frozen Foods Pty Ltd v FCT (1990) 20 ATR 1874; 90 ATC 4175. If it happened today: If the facts of Farnsworth were to occur today, a court would likely conclude that the stock was no longer on hand upon delivery to the packing house on the basis that at this point the taxpayer has lost dispositive power over the goods. If the taxpayer had deducted the expenses to create the trading stock, there would be no amount added back to income under the formula in s 70-35 ITAA 1997.

Acquisition of Dispositive Power over Trading Stock All States Frozen Foods Pty Ltd v FCT

(1990) 20 ATR 1874; 90 ATC 4175 (Full Federal Court)

Facts: The taxpayer carried on business as a wholesaler of frozen food goods. The goods were imported from overseas and delivered by sea in shipping containers. In each case, the price had been paid and the bills of lading delivered to the taxpayer before 30 June, thereby transferring the risk of ownership to the taxpayer. However, physical delivery did not occur until after 30 June. The taxpayer deducted the cost of acquiring the stock but argued it was not on hand at the end of the income year so the value of the stock did not have to be taken into account for the purposes of s 28 of ITAA 1936 (currently s 70-35 of ITAA 1997 1997). The taxpayer argued that the goods should not be considered on hand until they were available for sale in Australia. Decision: The goods were trading stock on hand notwithstanding that physical delivery had not yet occurred. Title to the goods in transit had passed to the taxpayer and therefore the goods belonged to the inventory of the buyer, not the seller, regardless of their location. Relevance of the case today: This case is relevant for the principle that stock is considered on hand when the taxpayer has the power to dispose of the stock. After receipt of the bills of lading, the taxpayer had the power to sell the stock and it is not relevant that in the ordinary course of its business the taxpayer would wait until physical delivery in Australia before on-selling. If it happened today: If these facts in All States Frozen Foods were to occur today, the deduction for the cost of the stock would be allowed under s 8-1 ITAA 1997 and the stock would be considered on hand for the purposes of s 70-35.

© Thomson Reuters 2019

279

AUSTRALIAN TAXATION LAW CASES 2019

Control of Trading Stock without Ownership FCT v Suttons Motors (Chullora) Wholesale Pty Ltd

(1985) 157 CLR 277; 16 ATR 567; 85 ATC 4398 (Full High Court)

Facts: The taxpayer was a member of the Suttons Motors Group which carried on the business of retail sale of motor vehicles. The taxpayer’s role was to be the wholesale purchaser of vehicles from the finance company (“GMAC” which was related to the manufacturer General Motors-Holden) for sale on to the parent company (Suttons Motors, “SM”) which arranged the sales to retail customers. Under a “floor plan” arrangement, GMAC retained title to vehicles delivered to the taxpayer which in turn stored the vehicles at the showrooms of SM. When SM entered into a contract to sell a particular vehicle to a customer, the taxpayer entered into a purchase contract with GMAC and paid for the vehicle. One effect of this arrangement was that the liability to pay sales tax was deferred until the vehicles were sold to final customers. The issue before the Court was whether the taxpayer was entitled to a deduction under the former s 82D ITAA 1936 (a concessional deduction), which turned on whether the vehicles were trading stock on hand in relation to a business. Decision: The vehicles were trading stock on hand when they were delivered to the taxpayer although title had not passed. The vehicles were in possession of and at the risk of the Suttons Group (although SM, not the taxpayer, had physical possession of the stock). They were held for sale in the ordinary course of the composite business which the Group carried on. Although the Group was not legally obliged to purchase the vehicles, it was entitled to and was under a commercial obligation to purchase the cars. These various factors were enough for the Court to consider that the vehicles were trading stock on hand for the purposes of s 82D. Relevance of the case today: Although this case is often considered in the context of s 70-35 ITAA 1997, it is not clear how far the holding dealing with a concessional deduction applies in the context of the trading stock accounting provisions. It is said to be relevant for the proposition that it is not necessary that a taxpayer have legal title to trading stock or actual possession for the stock to be considered on hand. The case suggests that notwithstanding lack of payment or ownership, if the stock is held legitimately as part of the stock to be sold or exchanged in the ordinary course of the business, it will be trading stock on hand. However, the practical relevance of this apparent holding is limited as the Commissioner will not seek to apply s 70-35 to a taxpayer that has not claimed a deduction for items that it neither owns nor possesses. If it happened today: If the facts of this case were to occur today and this precedent applied, the cars would be considered trading stock on hand for the purposes of s 70-35. However, until a legally enforceable obligation to make payment for the vehicle were to arise, there would be no expense incurred to acquire the stock and therefore no deduction under s 8-1 ITAA to offset the increase in the value of trading stock on hand recognised as income under s 70-35. Fortunately, the Commissioner does not apply s 70-35 in these circumstances. It is possible that a court today would conclude the precedent in Suttons Motors should not apply for s 70-35 purposes if the Commissioner 280

© Thomson Reuters 2019

CHAPTER 12

TRADING STOCK

were to try and extend the application of the holding to that section and create an unfair burden on the taxpayer.

VALUING TRADING STOCK ON HAND The costs of acquiring or manufacturing trading stock are deductible revenue expenses under s 8-1 ITAA 1997. However, under the re-inclusion formula of s 70-35 ITAA 1997, the deducted amounts will be added back into income to the extent they are reflected in the value of trading stock at hand where the taxpayer values trading stock on the basis of cost. Taxpayers will try to minimise the recognition of deductible costs in the value of trading stock on hand while the Commissioner will try to increase the recognition of costs in the value of stock on hand to recapture some of the previous deductions.

Australasian Jam Co Pty Ltd v FCT (1953) 88 CLR 23 (High Court)

Facts: The taxpayer produced jams and canned fruit. For a period of more than 30 years the taxpayer used as the basis for cost of its trading stock a value determined at the beginning of the period. It used that cost as a “standard” cost for all similar items of stock – for example, the same cost was attributed to all types of jam even though the raw materials for different types of jam varied. The Commissioner reassessed the taxpayer for the last 11 years of the period using a different standard cost determined by taking the cost for each type of jam each year and then determining an average of all the costs. This was multiplied by the number of jars on hand at the end of the year. The taxpayer challenged the correctness of the Commissioner’s calculations. Decision: Fullagar J noted that the “standard” cost figures used by the company had long before ceased to bear any relation to actual cost and were therefore not correct for s 31 ITAA 1936 (currently s 70-45 ITAA 1997 1997) purposes. The average used by the Commissioner would be an accurate measurement of cost only if there were an equal number of each type of jam on hand, which was never the case. However, the taxpayer had not provided evidence to show an assessment based on this value was incorrect and accordingly the taxpayer was liable for tax on the assessed income. Relevance of the case today: The Australasian Jam case is authority for the proposition that taxpayers may use a “standard” value to determine the cost of trading stock on hand at the end of an income year rather than the separate actual cost for each item but the standard value must be calculated using actual costs, not a hypothetical cost based on historical data. If it happened today: If the facts in Australasian Jam were to occur today, a court would similarly reject the taxpayer’s basis for determining cost using inaccurate historical data. It would allow the taxpayer to use a standard value method of costing stock but only if the basis of calculating standard value relied on accurate estimates of actual cost. © Thomson Reuters 2019

281

AUSTRALIAN TAXATION LAW CASES 2019

Philip Morris Ltd v FCT

(1979) 10 ATR 44; 79 ATC 4352 (Supreme Court of Victoria) Facts: The taxpayer manufactured cigarettes. It valued its trading stock on hand at the end of the income year using a “direct costing” method based on the cost of raw materials used in the products on hand and labour costs of employees involved directly in the manufacturing process. The Commissioner assessed the taxpayer using an “absorption costing” method that included other operating expenses in the cost of stock on hand. Additional expenses included in the cost of stock on hand included the regular testing of manufactured product, expenditure for the removal and disposal of waste substances resulting from the manufacture, a proportion of the wages of all personnel who adjust and maintain manufacturing equipment, and a portion of depreciation of equipment used to treat tobacco leaves and manufacture the cigarettes. Decision: The Court agreed with the Commissioner that absorption costing should be used to determine the cost of manufactured trading stock on hand. Relevance of the case today: The Philip Morris decision is the key Australian authority for the proposition that manufactured trading stock should be costed using an absorption costing method. If it happened today: Since the Philip Morris decision, absorption costing has been accepted as the only appropriate basis for costing manufactured trading stock and if the facts of the case arose today, a court would continue to require the taxpayer to use an absorption costing method. There remain some disputes as to which expenses incurred by a business are reflected in the value of the stock on hand and which expenses are general business expenses not actually incorporated into the value of stock. The generally accepted rule is that expenses should be included in absorption costing only if they are directly connected with manufacturing. Thus, advertising expenses for the taxpayer’s products, for example, may affect the value of stock on hand but are not directly connected with the manufacturing and would not be partly included in the cost of trading stock on hand.

UNUSUAL DISPOSALS OF TRADING STOCK Involuntary Disposals FCT v Wade

(1951) 84 CLR 105 (Full High Court)

Facts: The taxpayer carried on business as a dairy farmer. In the relevant year, 110 of his dairy cows were condemned and destroyed. The taxpayer received a lump compensation for the loss of these cows. The Commissioner argued that the receipt was assessable on one of three alternative bases: ordinary income as a compensation receipt; income as an indemnity for loss of trading stock under s 26(j) ITAA 1936 (currently incorporated into Subdiv 20-A ITAA 1997 generally and s 70-115 ITAA 1997 specifically for indemnification of trading stock loss); or under the application 282

© Thomson Reuters 2019

CHAPTER 12

TRADING STOCK

of s 36 ITAA 1936 (currently s 70-90 ITAA 1997 1997) (disposal of trading stock outside the ordinary course of business). The taxpayer submitted that the cows were capital assets of the business and therefore the receipt was also capital in nature. Decision: The High Court concluded that the receipt was income to the taxpayer. Dixon and Fullagar JJ considered that as the dairy cows were taken into account as trading stock under the statutory definition (currently s 70-10 ITAA 1997 1997), compensation for their loss must be treated as ordinary income on revenue account. Section 36 was not applicable as it was concluded that the requirement that the stock be disposed of by the taxpayer did not cover the intervention of a government authority as occurred in this case. Kitto J concluded that the receipt would not be ordinary income as a compensation receipt because the operation of the trading stock definition to include the dairy cows was insufficient to alone warrant this result. However, he concluded the receipt would be assessable under s 26(j) as the phrase “by way of … indemnity” contemplated this type of a receipt under a statutory right to compensation. Relevance of the case today: This case establishes the proposition that compensation for loss of trading stock is ordinary income. The case is also referred to for Kitto J’s comments on the meaning of the term “indemnity” for the purposes of applying s 26(j), which is relevant to the assessable recoupment provisions found in Subdiv 20-A ITAA 1997. In Denmark Community Windfarm v FCT [2018] FCAFC 11, the Court pointed out that Wade provides helpful observations about the nature of an indemnity. However, the Full Federal Court Decision in Batchelor v FCT (2014) 219 FCR 453 provides more specific guidance by expressly referring to the statutory provisions in question. If it happened today: If the facts in Wade were to occur today, the compensation receipt would most likely be treated as ordinary income assessable under s 6-5(1) ITAA 1997. Alternatively, s 70-115 ITAA 1997 would apply to include the amount in income as a receipt by way of insurance or indemnity for a loss of trading stock.

Disposals Outside the Ordinary Course of Business Pastoral and Development Pty Ltd v FCT

(1971) 124 CLR 453; 2 ATR 401; 71 ATC 4177 (High Court)

Facts: The taxpayer carried on a pastoral business as part of a corporate group. It was decided that there would be a change in the operations at the taxpayer’s property and the livestock herd would be reduced by 50%. Rather than sell the cattle directly to the meat works, as was ordinarily the case, the taxpayer sold the cattle to a related company for a low price and that related company then on-sold the cattle to the meat works for a very much higher price. The Commissioner argued that there was insufficient documentation to support that the cattle had been sold by the taxpayer to the related company and that the transaction should be viewed as a direct sale from the taxpayer to the meat works for the greater price. Alternatively, the Commissioner argued that the sale was outside the ordinary course of the taxpayer’s business, thereby triggering s 36 ITAA 1936 (currently s 70-90 ITAA 1997 1997). © Thomson Reuters 2019

283

AUSTRALIAN TAXATION LAW CASES 2019

Decision: Although there was no written agreement to evidence the sale, it was recorded in the books of both companies and should be accepted as having occurred. However, the sale was outside the ordinary course of the taxpayer’s business and therefore s 36 applied to include the market value of the cattle in the income of the taxpayer. Section 36 did not require that a taxpayer disposes of its stock as part of ceasing business. The price paid was not a reasonable price under the circumstances and was far below the then current market price. In addition, the sales were part of the implementation of a new policy which would see a drastic reduction of the taxpayer’s stock. Considering these various factors, the sale was outside the ordinary course of the taxpayer’s business. Relevance of the case today: This case establishes the proposition that a sale of stock between related parties may be considered outside the ordinary course of business so as to trigger the application of s 70-90 where the price fixed for the sale is significantly below the market price. If it happened today: If the facts of Pastoral and Development were to occur today, s 70-90 would apply to include in the taxpayer’s income the market value of the stock sold. The acquiring entity will be taken to have paid that same amount as purchase price for the stock under s 70-95 ITAA 1997. If the taxpayer were to seek to shift profits in the other direction by charging more than market value, s 70-20 ITAA 1997 will apply to reduce the purchaser’s deductions.

284

© Thomson Reuters 2019

C HAPTER 13

Partners and Partnerships WHEN DOES A PARTNERSHIP EXIST? ......................................................... Statutory Partnerships .................................................................................. McDonald (1987) ................................................................................... Yeung (1988) .......................................................................................... Evidence of a Partnership ............................................................................ Jolley (1989) ..........................................................................................

286 286 286 287 288 288

CREATION OF A PARTNERSHIP ..................................................................... 289 Contributing Trading Stock and Depreciable Property ............................... 289 Rose (1951) ............................................................................................ 289 CONTROL OVER THE PARTNERSHIP........................................................... 290 Robert Coldstream Partnership (1943) ................................................. 290 PARTNERSHIP PURPOSE AND ACTIONS .................................................... Attributing Partnership Purpose to the Partners .......................................... Tikva Investments Pty Ltd (1972)........................................................... Tracing the Purpose of Partnership Borrowings .......................................... Roberts; Smith (1992) ............................................................................

291 291 291 292 292

TRANSACTIONS BETWEEN A PARTNERSHIP AND PARTNERS ........... Charging “Interest” for Excess Advances ................................................... Beville (1953) ......................................................................................... A Partner Providing Services to the Partnership ......................................... Poole; Dight (1970) ...............................................................................

293 293 293 294 294

LEAVING A PARTNERSHIP .............................................................................. 295 When Does a Partnership End? ................................................................... 295 Happ (1952) ........................................................................................... 295 WORK IN PROGRESS AND PARTNERSHIPS ............................................... Payments to a Departing Partner for Work in Progress ............................... Stapleton (1989) ..................................................................................... Grant (1991) .......................................................................................... Payments for Purchased Work in Progress .................................................. Coughlan (1991) ....................................................................................

296 296 297 297 298 298

ASSIGNMENTS OF PARTNERSHIP INTERESTS ........................................ 298 © Thomson Reuters 2019

285

C HAPTER 13

Partners and Partnerships WHEN DOES A PARTNERSHIP EXIST? The definition of a partnership in s 995-1 ITAA 1997, including persons in receipt of income jointly, is broader than the ordinary meaning of the word which is based on the notion of carrying on business in common with a view of profit. Tax practitioners and the Commissioner thus often refer to the definition catching two types of partnership – a common law partnership (the ordinary meaning of persons carrying on business in common with a view to profit) and a statutory partnership (persons in receipt of income jointly who would not constitute a common law partnership but who fall within the additional category of partnership in the s 995-1 definition). Neither a statutory partnership nor a common law partnership is an entity at law. A statutory partnership arises when there is joint ownership of income-producing assets and joint receipt of the income produced. A common law partnership arises when there is an agreement between persons to share profits and liabilities as set out in the agreement. The agreement may be in writing or verbal. Because partnership income is attributed to the partners for tax purposes, partnerships are useful income splitting vehicles. The Commissioner often disputes the existence of a partnership where spouses claim to be deriving income jointly through a partnership, arguing the actual business was carried on as a sole proprietorship by one of the alleged partners, notwithstanding the claims of a partnership.

Statutory Partnerships FCT v McDonald

(1987) 18 ATR 957; 87 ATC 4541 (Federal Court)

Facts: The taxpayer and his spouse purchased rental properties as joint tenants. They entered into a written agreement that provided for the spouse to receive 75% and the taxpayer to receive 25% of the net income from the properties while the taxpayer agreed to cover all losses on the properties. The properties generated a net loss in the first year and gains in later years. The taxpayer claimed a deduction for the entire loss in the first year. The Commissioner argued the taxpayer and his spouse were not partners at common law, carrying on business in common with a view of profit, but were only 286

© Thomson Reuters 2019

CHAPTER 13

PARTNERS AND PARTNERSHIPS

partners under the statutory definition of partnership in s 6(1) ITAA 1936 (currently in s 995-1 ITAA 1997 1997) as persons deriving income jointly. Thus, he argued, since there was no partnership at general law, the agreement was only a personal commitment of the taxpayer, not the basis for a division of income and losses in a partnership. He denied the taxpayer a deduction for half the loss. Decision: Beaumont J agreed with the Commissioner that the joint ownership of property amounted to a statutory partnership under the ITAA but was not a partnership at common law and the agreement between the taxpayer and his spouse was therefore not a partnership agreement that could govern the allocation of income and losses under s 92 ITAA 1936. As the relationship between the taxpayer and his spouse was a statutory partnership only, the allocation of income and losses was based on their joint ownership arrangement and the taxpayer was only entitled to a deduction for half of the loss. The agreement by the taxpayer to cover the entire loss was a private agreement between the taxpayer and his spouse and the outgoing related to the spouse’s loss was a private expenditure, not deductible under s 51(1) ITAA 1936. Relevance of the case today: McDonald is authority for the fact that joint ownership of property where the owners are not carrying on business in common with a view of profit gives rise to a statutory partnership but not a common law partnership. The allocation of income and losses of a statutory partnership is based on the ownership interests of each joint owner, not any “partnership” agreement between the joint owners. If it happened today: Since the McDonald case, the definition of “partnership” has moved from the ITAA 1936 to the ITAA 1997 and has been modified to take account of the distinction between ordinary income and statutory income in the 1997 Act. However, the changes have no material effect on the distinction between a common law partnership and a statutory partnership for income tax purposes. If the facts in the case arose today, the taxpayer and his spouse would be considered to have a statutory partnership but not a common law partnership. As a result, the agreement between them would have no effect for tax purposes and income and losses would be allocated on the basis of their ownership interests in the jointly owned property.

Yeung and Anor v FCT

(1988) 19 ATR 1006; 88 ATC 4193 (Federal Court)

Facts: The taxpayer purchased a number of properties in the name of himself and his spouse and four children. The properties were purchased with the six owners shown as tenants in common, which would be treated as a statutory partnership under the definition of “partnership” in s 6(1) ITAA 1936. Initially the mother signed documents related to the properties on behalf of the children but as they grew older they started to sign documents themselves. All of the income from the properties was deposited in an account in the name of the taxpayer and his spouse. One of the properties was sold and the proceeds also were paid into this account. It appears the taxpayers were concerned that once the children became adults they would seek to withdraw from the partnership and call for a return of their share of partnership capital. To overcome this © Thomson Reuters 2019

287

AUSTRALIAN TAXATION LAW CASES 2019

possibility, the taxpayer established a family discretionary trust and paid $250,000 from his account to the trust. In turn, the trust lent $250,000 to the partnership which used the funds to return $250,000 in capital to the partners. The entire amount was paid to the taxpayer (in fact, the trustee paid the funds directly to the taxpayer but all parties agreed it was lending the money to the partnership and forwarding the cheque to the taxpayer at the instruction of the partnership). The taxpayer argued the income derived by the partnership should be attributed to the six members for income tax purposes. The Commissioner assessed the taxpayer and his spouse on the income from the partnership properties. Decision: The Federal Court accepted the taxpayer’s argument that the purchase in the names of the six persons as tenants in common amounted to a statutory partnership for income tax purposes. The fact that the parents withdrew the capital as the children came of age indicated their belief that the children had interests in the partnership capital. However, the fact that all partnership income went into the taxpayer’s bank account and was used by the taxpayer and his spouse indicated that the six owners were not equal partners. The interests of the four children were clearly much smaller than the interests of the parents and the Commissioner’s assessment of the parents on the rental income was appropriate. Relevance of the case today: Yeung shows that ownership of property as tenants in common will give rise to a statutory partnership for income tax purposes. It also shows that there is not an automatic presumption that the partners have equal interests in partnership assets or partnership income and the Commissioner is able to look at the actual application of income to conclude which partners were entitled to and derived the income. If it happened today: If the facts in Yeung arose today, a court would again find that the parents and children were all partners in a statutory partnership but the interests of the parents were much larger than the interests of the children so income derived by the partnership should be attributed to the parents for income tax purposes. To avoid this result, the taxpayer would have to ensure that each partner had separate bank accounts and the income is divided equally between the partners and paid into and retained in each partner’s separate bank account.

Evidence of a Partnership Jolley v FCT

(1989) 20 ATR 335; 89 ATC 4197 (Full Federal Court)

Facts: The taxpayer established a business to purchase, recondition, and then resell used oil drums. Shortly after establishing the business, he proposed to his spouse that they operate the business as a partnership. A joint bank was established but all withdrawals and applications of funds were made by the taxpayer alone. A business licence was obtained in his name only. Evidence suggested the taxpayer spent the day visiting clients while his spouse stayed at home for half a day to take calls from clients with drums ready for reconditioning and arranging for their pickup. Invoices to clients 288

© Thomson Reuters 2019

CHAPTER 13

PARTNERS AND PARTNERSHIPS

were mostly in the name of the taxpayer alone, but some were in the names of both the taxpayer and his spouse. The taxpayer was assessed by the Commissioner on the business income as if no partnership existed and the assessment was upheld by the AAT. The taxpayer appealed to the Full Federal Court. Decision: A majority of Federal Court appeal judges (Burchett and Lee JJ) agreed it was open on the facts for the AAT to find that a partnership existed in the absence of a formal or written partnership agreement and accordingly ruled the matter should be remitted back to the AAT for reconsideration. Evidence of the taxpayer’s application of funds from the joint account for investments in his name was consistent with the spouse’s evidence that she had approved his actions. Evidence of invoices in his name could suggest a sole proprietorship or partnership while the invoices with two names were only consistent with the existence of a partnership. The case was subsequently reconsidered by the AAT ((AAT Case 5705, Jolley v FCT (1990) 21 ATR 3253; Case X23 90 ATC 244), which found there was a partnership in existence. Relevance of the case today: Jolley is a useful precedent for the fact that the existence of a partnership turns on the actual arrangement between the persons said to be partners, not on the existence of a formal written partnership agreement. If it happened today: If the facts of Jolley occurred today, the spouses would be treated as partners on the basis of the verbal agreement between them and their actions that demonstrated they considered themselves to be operating in partnership.

CREATION OF A PARTNERSHIP Contributing Trading Stock and Depreciable Property Rose v FCT

(1951) 84 CLR 118 (Full High Court)

Facts: The taxpayer was a pastoralist who entered into a partnership deed with his two sons, giving them each a one-third interest in all his business assets including trading stock (livestock) and depreciable assets. The Commissioner assessed the taxpayer in respect of the value of his trading stock at the time of the disposal and the balancing charge on the depreciable property (the difference between its depreciated value and actual (higher) value at the time of the disposal). On appeal, the Commissioner apparently argued in the alternative for assessment on two-thirds of these amounts, if not the full amounts. Decision: In a joint judgment, Dixon, Fullagar and Kitto JJ held that neither s 36 ITAA 1936, dealing with disposals of trading stock outside the ordinary course of business, nor s 59 ITAA 1936, determining the balancing charge on disposals of depreciated property, applied to the transfer of property to the partnership. The Court held that a person does not “dispose of” assets if the taxpayer transfers an undivided fraction interest in the property rather than the entirety of ownership of the assets. © Thomson Reuters 2019

289

AUSTRALIAN TAXATION LAW CASES 2019

Relevance of the case today: The decision in Rose appeared to be contrary to the policy intention of the legislation and the government moved quickly after the decision to insert s 36A ITAA 1936 and s 59AA ITAA 1936 to reverse the effect of Rose and treat a change in interest in trading stock or depreciable property as a part disposal of the property. At the same, time, however, the government faced pressure to facilitate transfers of the sort carried out in Rose. The result was the insertion of an optional election in s 36A and s 59AA for tax-free transfer to a partnership by way of a rollover where the tax attributes transfer from the original owner to the partnership. The case can continue to be cited as authority for the proposition that there is no disposal of property for tax purposes when property is transferred to a partnership of which the transferor is a partner unless a specific deeming provision applies. If it happened today: If the facts of Rose occurred today, the parties would most likely elect under s 70-100(4) ITAA 1997 for a tax-free rollover of trading stock to the partnership and elect under s 40-340(3) for a tax-free rollover of depreciable property to the partnership. If they did not, there would be a disposal of the interests in trading stock under s 70-100(1) ITAA 1997 and a balancing charge in respect of the disposed interests in depreciable property as a result of s 40-295(2) ITAA 1997.

CONTROL OVER THE PARTNERSHIP Robert Coldstream Partnership v FCT (1943) 68 CLR 391 (High Court)

Facts: A partnership agreement between a managing partner, his spouse and his two children prevented the spouse and children from withdrawing amounts credited to their drawing accounts without the permission of the managing partner and further required 70% of their shares of income to be deposited in the capital account of the partnership. The Commissioner sought to apply the predecessor version of s 94 ITAA 1936 to the partnership. At the time, the section imposed an additional tax at the partnership level to income of partners that was under real and effective control of another partner. For s 94 to apply as it was worded at the time, the Commissioner had to show spouse and children did not have real and effective control over their shares of partnership income and that the managing partner did have real and effective control over the income. Decision: Latham CJ agreed that the spouse and children did not have real and effective control over the 70% of their income that had to be deposited to the capital account of the partnership. But, he concluded, neither did the managing partner have control over this income. Latham CJ further concluded that both the managing partner and the other partners had some control over the other 30% of income. This was not sufficient for the provision to apply since, in the view of Latham CJ, real and effective control means “exclusive and complete” control. Relevance of the case today: In one important respect, the Robert Coldstream case is of somewhat limited relevance today. Section 94 was amended after the case to overcome the requirement that the Commissioner show someone else must have real and effective control of income over which some partners have no control. The case 290

© Thomson Reuters 2019

CHAPTER 13

PARTNERS AND PARTNERSHIPS

is still relevant for the idea that real and effective control in s 94 means exclusive and complete control. If it happened today: Following the amendments to s 94, the provision might apply to the partnership income attributed to the spouse and children. If this were the case, s 94(9) would apply and further tax described in s 12(7) Income Tax Rates Act 1986 would be payable by the spouse and children (bringing their tax rate on the partnership income up to 45%).

PARTNERSHIP PURPOSE AND ACTIONS Attributing Partnership Purpose to the Partners While a partnership is not a separate entity at law, it is recognised as a quasi-entity for the purpose of determining its taxable income under s 91 ITAA 1936, which is then allocated to partners under s 92 ITAA 1936. The only exception to this rule for capital gains and losses, which are attributed to the individual partners directly on the basis of their fractional interests in capital assets of the partnership following s 108-5(2)(c) ITAA 1997. The taxpayer’s purpose of acquisition and actions amounting to a profit-making scheme may affect whether a gain realised on the disposal of property is a capital gain or has an income character. A key question, therefore, is whether the member’s purposes flow through to the partnership and vice-versa.

Tikva Investments Pty Ltd v FCT (1972) 128 CLR 158 (High Court)

Facts: The taxpayer was a company whose controller belonged to a unincorporated syndicate whose members had jointly purchased a block of land. The controller of the company taxpayer gifted his interest in the partnership and partnership assets to the taxpayer which agreed to accept all obligation and entitlements of the controller with respect to the syndicate membership. When the land was sold by the syndicate for a substantial profit, the Commissioner assessed the taxpayer on a portion of the gain realised on the sale. The assessment was made on the basis of the two limbs of former s 26(a) ITAA 1936, applying to profits realised on property acquired with the purpose of resale at a profit or realised in the course of a profit-making scheme. The taxpayer argued that as it had simply accepted the property as donee of a gift, neither the purpose of acquisition nor any profit-making scheme of the syndicate should be attributed to it. Consequently, it claimed the gain it realised was a capital gain outside the scope of s 26(a) and since the case preceded the adoption of CGT, not taxable. Decision: While a “syndicate” is unknown in tax law, Stephen J concluded the syndicate amounted to a partnership for tax purposes as it was based on joint ownership of an asset with a common view to profit. From the perspective of the partnership, the gain realised on the sale of the land was assessable under both the first and second limb © Thomson Reuters 2019

291

AUSTRALIAN TAXATION LAW CASES 2019

of s 26(a). Stephen J found that when the taxpayer agreed to assume all obligations and entitlements of the controller flowing from his interest in the syndicate, it also accepted the intention of the syndicate members with respect to realising a profit from the sale of the land. Accordingly, the taxpayer’s share of the profit was assessable under s 26(a) as it was to the other members of the syndicate. Relevance of the case today: Section 26(a) was subsequently replaced by s 25A ITAA 1936. The provision does not apply to property acquired after 19 September 1985. Section 15-15 ITAA 1997 continued the profit-making scheme limb but it also does not apply to property acquired after 19 September 1985. Thus, the Tikva case is of limited relevance to issues about the attribution of a partnership’s purpose or scheme to individual partners for the purpose of applying these provisions. It remains authority for the proposition that a person entering a partnership and agreeing to take on the entitlements and obligations flowing from membership also assumes the partnership’s purposes and schemes with respect to partnership property, where this is relevant to the determination of the characterisation of gains as ordinary income or capital gains. If it happened today: If the facts in Tikva occurred today, the Commissioner could try to include the gain in the net income of the partnership as ordinary income under s 6-5 ITAA 1997 and then attribute it to each partner under s 92 ITAA 1936. However, since the taxpayer was a company and would not qualify for the 50% discount capital gain exemption, the Commissioner would most likely be content to simply apply the capital gains provisions. The initial gift to the taxpayer would be a CGT A1 event, triggering recognition of a capital gain under s 104-10 ITAA 1997. Under s 116-30 ITAA 1997, the deemed capital proceeds received by the controller would be the market value of the taxpayer’s interest in the land. When the partnership later sold the land, the sale would also trigger an A1 event for the taxpayer, with the provisions applying on a look-through basis through the partnership to the taxpayer’s interest in the underlying partnership asset under s 106-5 ITAA 1997.

Tracing the Purpose of Partnership Borrowings FCT v Roberts; FCT v Smith

(1992) 23 ATR 494; 92 ATC 4380 (Full Federal Court)

Facts: A prospective partner wished to join the partnership to which one of the taxpayers (Smith) belonged. The cost of joining without diluting the interests of the current partners was prohibitively expensive for the taxpayer. To reduce the cost of joining, there was a distribution of partnership capital to the existing partners. The new member then joined by making a much smaller contribution of capital and the partnership borrowed funds to bring the available funds in the partnership back to the level they were at prior to the distribution of capital. The distributed capital was used by the partners for personal purposes. The partners sought to deduct their share of the interest costs incurred on the funds borrowed by the partnership. Later, the second taxpayer (Roberts) joined the firm and agreed to assume responsibility for a share of the partnership’s debt.

292

© Thomson Reuters 2019

CHAPTER 13

PARTNERS AND PARTNERSHIPS

Had the partners left the capital in the partnership and borrowed to fund their consumption, no deduction would have been available for the interest expenses. The Commissioner argued that the borrowing was made to enable the distribution for personal consumption so the interest was therefore attributable to the personal expenses of the taxpayer. The taxpayers argued that the loan replaced a portion of the capital utilised in the business of the partnership and the interest was deductible as an expense incurred in the course of the partnership’s income producing business. Decision: The Federal Court agreed that the interest incurred by the second taxpayer, Roberts, was deductible in full as it was incurred to derive assessable income. The Court further agreed that if the capital distribution to the taxpayer was actually a return of contributed capital, interest on borrowings to replace the capital should also be deductible. However, it appeared from the evidence before the Court that some of the funds distributed from the “capital account” of the partnership might be from a notional capital account that included an amount attributed to the goodwill of the partnership. The Court suggested that interest would not be deductible to Smith to the extent the distributed capital was not actually a return of the taxpayer’s contributions, presumably on the basis that the distribution in excess of the contributions must have been paid from the borrowed funds. A majority of the Court concluded the matter should be reconsidered by the AAT if the parties could not agree on the source of the distributed amount. Relevance of the case today: The Commissioner has accepted the holding in FCT v Roberts; FCT v Smith and no longer disputes claims for interest deductions in respect of partnership borrowings where the borrowings are used to replace returns to partners of contributed partnership capital. If it happened today: If the facts in FCT v Roberts; FCT v Smith were to arise today, both the original partner and the joining partner would be allowed to deduct their shares of interest incurred in respect of the partnership borrowings, provided the return of capital to the original partner can be traced to contributed capital.

TRANSACTIONS BETWEEN A PARTNERSHIP AND PARTNERS Charging “Interest” for Excess Advances FCT v Beville

(1953) 5 AITR 458; 10 ATD 170 (High Court)

Facts: The taxpayer was a member of a partnership who withdrew advances from the partnership exceeding his allotment of profits. Under the partnership agreement, the partnership charged him “interest” which was debited from his account when the following year profits were allocated. The Commissioner assessed the taxpayer on his share of partnership profits without taking into account the debit for the “interest” charged against the account. The taxpayer argued the “interest” was simply for internal © Thomson Reuters 2019

293

AUSTRALIAN TAXATION LAW CASES 2019

partnership accounts and for tax purposes there had simply been an adjustment of the current year’s allocation of profits to take into account the benefit he had enjoyed over other partners during the previous year. Decision: Taylor J agreed with the taxpayer that the taxpayer’s income from the partnership was the lesser amount received after the notional “interest” deduction. Taylor J treated the interest charge merely as a means of calculating the taxpayer’s entitlement to a share of current year net income of the partnership. Under s 91 ITAA 1936, the partnership calculates its net income and under s 92 ITAA 1936, that income is allocated to the partners. The partners in effect reduced the taxpayer’s current year entitlement to compensate the other partners for the taxpayer’s advances in the previous year in excess of his share of profits and the interest charge was merely the mechanism for calculating the reduced entitlement. Relevance of the case today: The Beville case is authority for the proposition that internal partnership charges can be used by the partners to determine the final shares of net income of the partnership allocated to each partner for s 92 purposes. If it happened today: If the facts in Beville arose today, a court would similarly hold that the taxpayer was assessable on his share of the net income of the partnership determined after the reduction for the excess advance in the previous year. The Commissioner is required to look at the final allocation of net profits, not an initial entitlement that is adjusted by applying partnership entitlement rules.

A Partner Providing Services to the Partnership Poole v FCT; Dight v FCT

(1970) 122 CLR 427; 1 ATR 715; 70 ATC 4047 (High Court)

Facts: The taxpayers were lessees of rural property in Queensland. Under the lease agreement, the leasehold interest could be converted to a fee simple at the end of the lease and all previously paid rental payments would be taken into account when calculating the outstanding purchase price of the property. The taxpayers allowed a partnership (Cooinda Pastoral Company) in which they and others were partners to use the land in return for the partnership making the lease payments. The partnership sought to deduct the lease payments as revenue outgoings. The Commissioner denied the partnership a deduction on the basis that the payments were capital outgoings because they would form part of the purchase price of the property. The taxpayer argued that the partnership could not acquire the property as a result of the payments and therefore from its perspective the outgoings were revenue expenses in the nature of rent. Decision: Walsh J agreed with the taxpayers that the partnership could deal with the individual partners on a commercial basis and from the partnership’s perspective the outgoings were ordinary rental payments. However, he concluded the payments were for the benefit of the partners who as signatories to the lease had the obligation to make the lease payments. Accordingly, he allowed the partnership a deduction for the 294

© Thomson Reuters 2019

CHAPTER 13

PARTNERS AND PARTNERSHIPS

payments but treated them as rental income derived by the taxpayers and paid to the government of Queensland on behalf of the taxpayers, applying s 19 ITAA 1936. Relevance of the case today: While a partner may not derive a salary from a partnership, Poole; Dight is authority for the proposition that a taxpayer may enter into a commercial relationship with a partnership in which the taxpayer is a member. In this case expenses may be deducted by the partnership and included in the assessable income of the partner. If the payments are to a third party, they will be included in the assessable income of the partner if they satisfy an obligation of the partner. If it happened today: If the facts in Poole; Dight arose today, a court would similarly hold that the partnership was entitled to deduct the lease payments it made to the Queensland government and the taxpayer would be assessed on the value of the payments. The attribution to the taxpayer today would be based on s 6-5(4) ITAA 1997.

LEAVING A PARTNERSHIP When Does a Partnership End? FCT v Happ

(1952) 5 AITR 290; 9 ATD 447 (High Court)

Facts: The taxpayer was a member of a partnership of four persons. The partnership’s fiscal year ran from 1 July to 30 June. Following disagreements between the partners, two of the partners, including the taxpayer, decided to leave the partnership in December 1944. In the period from July to December 1944 the taxpayer had drawn advances against his share of the partnership profits. An agreement was drawn up which purported to dissolve the partnership from 1 July, almost six months earlier. The dissolution agreement provided for the taxpayer to receive a return of his contributed capital and a payment for his share of goodwill. The remaining partners completed a partnership return the following year showing a distribution to the taxpayer equal to one-quarter of the profits for the period from 1 July 1944 until December 1944. The taxpayer argued the amounts he received were the return of capital and the payment for his share of goodwill, with no component for a distribution of profits as the partnership had been dissolved as of 1 July. Decision: Williams J adopted the view that whether a partnership is in existence is a matter of fact. As the partnership operated from 1 July until December and derived profits during that period, it was not possible retrospectively to dissolve the partnership from an earlier date. As the partnership including the partner operated for the first half of the financial year, the taxpayer was required to report his share of the partnership interest under s 92 ITAA 1936. Relevance of the case today: The Happ case remains relevant today for the proposition that the time a partnership begins and ends is a matter of fact and the partners cannot retrospectively dissolve the partnership by agreement. © Thomson Reuters 2019

295

AUSTRALIAN TAXATION LAW CASES 2019

If it happened today: If the facts in Happ arose today, a court would similarly hold that the taxpayer was assessable on his share of the income from the time of the purported dissolution of the partnership until the time of actual dissolution. Unlike the case in Happ, however, the taxpayer would be assessable under the CGT provisions on the capital gain he enjoyed, the gain being the excess of proceeds he received less his contributed capital. The capital assets disposed of would be interests in partnership assets (s 108-5(2)(c) ITAA 1997 1997) and the interest in the partnership itself (s 108-5(2)(d)). The disposal would be a CGT A1 event under s 104-10 ITAA 1997, assisted by s 106-5 ITAA 1997 for partnerships. Under s 118-20 ITAA 1997, the capital gain would be reduced by the part of the proceeds treated as an assessable distribution of the net income of the partnership. The taxpayer might be entitled to a small business concession under Division 152 ITAA 1997.

WORK IN PROGRESS AND PARTNERSHIPS Payments to a Departing Partner for Work in Progress Stapleton v FCT

(1989) 20 ATR 996; 89 ATC 4181 (Federal Court)

Facts: The taxpayer retired from a partnership and pursuant to the partnership agreement over the following five years received payments equal to his entitlement to work in progress that had been completed at the time of his retirement but not yet billed to the clients. The Commissioner assessed the taxpayer in respect of the payments. The taxpayer argued the payments were capital receipts in respect of his interest in the partnership. Decision: Although the partnership had not invoiced the clients in respect of the work in progress at the time of the taxpayer’s departure, the value of the work in progress to which the payments related would be realised as ordinary income to the partnership in the due course of time. Sheppard J concluded that the payments to the taxpayer had an income character as they were based on amounts that would be income. Relevance of the case today: Stapleton opened the door to double taxation of payments to departing taxpayers for work in progress. Following Stapleton, departing partners would be assessed on amounts received in respect of unbilled work in progress completed at the time of their departure. However, the remaining partners would be assessed when the partnership eventually completed the work and the client was billed or paid. The only way to prevent double taxation would be to allow the remaining partners a deduction for payments to the departing partner. However, in later cases the Commissioner successfully argued that the payments to the departing partner were capital outgoings from the partnership’s perspective. The government responded by enacting s 25-95 ITAA 1997 which allows the remaining partners to deduct amounts to acquire the departing partner’s work in progress. At the same time, it codified the Stapleton decision by enacting s 15-50 ITAA 1997, which includes amounts paid for work in progress in assessable income. Strangely, the inclusion provision does not contain the standard exception for amounts that would be assessable anyway as 296

© Thomson Reuters 2019

CHAPTER 13

PARTNERS AND PARTNERSHIPS

ordinary income despite the fact that Stapleton showed these amounts are ordinary income. The key importance of Stapleton today is to highlight the advantage of a departing partner not selling work in progress but instead seeking a higher amount in respect of his partnership interest, realising the value as a capital gain which may be subject to the 50% discount capital gains exclusion. If it happened today: If the facts of Stapleton occurred today, the taxpayer would be assessed on the payments received in respect of work in progress under s 6-5 ITAA 1997 or s 15-50 ITAA 1997. Because the ordinary exclusion for amounts that are assessable income commonly found in statutory income provisions is missing from s 15-50, it is not clear how that provision operates in conjunction with s 6-5.

FCT v Grant & Ors

(1991) 22 ATR 237; 91 ATC 4608 (Federal Court)

Facts: The taxpayers were members of a partnership which had dissolved and reformed with some members of the dissolved partnership excluding the taxpayers. The partners who formed the successor partnership purchased the shares of the taxpayers on the basis of the taxpayers’ capital interests in the partnership and their interest in what was labelled the “current account” of the partnership comprising its work in progress. The Commissioner assessed the taxpayers on the payments attributable to the work in progress. The taxpayers argued these were capital receipts received as repayment of their equity in the dissolved partnership. Decision: While the amounts received by the departing partners as payment for their interests in the work in progress did not form part of the net income of the partnership, the receipts were on revenue account as a value for an income-earning activity and were properly included in the departing partners’ assessable income. Relevance of the case today: The Grant case extended the effect of the Stapleton decision (1989) 20 ATR 996; 89 ATC 4181 from periodic payments to a departing partner for work in progress to a lump sum payment. The decision was later codified by s 15-50 ITAA 1997, which includes amounts paid for work in progress in assessable income. The case is relevant as a signpost to departing partners that when selling their partnership interests, they should not seek a payment specifically attributable to the value of work in progress transferred to the new partnership. If the departing partners are instead simply paid a higher amount in respect of their partnership interests, they may be able to realise the value as a capital gain that may be subject to the 50% discount capital gains exclusion. If it happened today: If the facts of Grant occurred today, the taxpayers would be assessed under s 6-5 ITAA 1997 or s 15-50 ITAA 1997. Because the ordinary exclusion for amounts that are assessable income that is commonly found in statutory income provisions is missing from s 15-50, it is not clear how that provision operates in conjunction with s 6-5.

© Thomson Reuters 2019

297

AUSTRALIAN TAXATION LAW CASES 2019

Payments for Purchased Work in Progress Coughlan & Ors v FCT

(1991) 22 ATR 109; 91 ATC 4505 (Federal Court)

Facts: The taxpayers were part of a newly formed partnership which purchased an accountancy practice from a dissolved firm, some of whom joined the new firm. The new partnership paid the members of the dissolved firm for all net assets of the firm, including the value of work in progress that had not been billed to clients. The new firm subsequently completed the work that had been in progress at the time of sale and billed the clients. The Commissioner assessed the taxpayers on their share of the amounts received. The taxpayers argued that they should be allowed a deduction for the part of the purchase price attributable to the work in progress. Alternatively, they argued the payments received for the completed services should be assessable only to the extent they exceeded the amounts paid for the work in progress. Decision: Heerey J held that the work in progress acquired from the dissolved firm was part of the capital structure of the business acquired by the new firm and the entire amount paid for the assets of the dissolved firm, including its work in progress, was a non-deductible capital amount. He found the payments received by the new partnership from clients upon completion of their work were revenue in nature and assessable to the taxpayers in full, without regard to any amounts paid in respect of the acquisition of the work in progress related to the payments. Relevance of the case today: Like the Stapleton case (1989) 20 ATR 996; 89 ATC 4181 decided two years earlier, the Coughlan decision opened the door to double taxation of payments in partnership reorganisations, this time by assessing new partners on income received for completed work while denying them a deduction for the cost of acquiring the unbilled work in progress to which it related. The government responded to Coughlan by enacting s 25-95 ITAA 1997 which allows the remaining partners to deduct over one or two years amounts paid to acquire the departing partner’s work in progress. The case thus has limited direct relevance today. However, it does show more generally that when a taxpayer acquires a business, the entire purchase price may be a capital outgoing, even the part attributable to assets that will in time give rise to revenue amounts. If it happened today: If the facts of Coughlan occurred today, the taxpayers would be allowed to deduct the payments attributable to the acquisition of work in progress under s 25-95 ITAA 1997. The deduction would be allowed over one or two years depending on when the work in progress might mature into a recoverable debt.

ASSIGNMENTS OF PARTNERSHIP INTERESTS Australian property law allows persons to assign rights to income streams to other persons provided the right to income is an existing property right and not a mere expectancy of future income. When an assignment of income is effective as a matter of property law, Australian courts have treated the assignment as effective for tax law 298

© Thomson Reuters 2019

CHAPTER 13

PARTNERS AND PARTNERSHIPS

purposes also, so the assignee and not the assignor is treated as the taxpayer deriving income as it flows from the property right. Thus, an assignment of income can be used to transfer income tax liability on the income from the assignor to the assignee. Since 1985, the CGT provisions have applied to assignments of income, creating a CGT liability for the assignor at the time of assignment and as a result assignments are no longer commonly used as tax planning devices. In 1980, FCT v Everett (1980) 143 CLR 440; 10 ATR 608; 80 ATC 4076 showed that it was possible for a partner in a professional firm to assign part of his or her partnership income by assigning a fraction of his or her interest in the partnership including the right to partnership income associated with that fraction. The practice largely ceased after 19 September 1985 when CGT was introduced. A number of cases arose as a result of assignments of partnership interests between 1980 and 1985. In addition to the Everett case, an important case was FCT v Galland (1986) 162 CLR 408; 18 ATR 33; 86 ATC 4885 which looked at the tax consequences of an assignment of part of a partnership interest shortly before the end of the income year and considered whether the assignment was effective for a fraction of the partnership income for the entire year or only for the three days remaining in the income year. The Everett case and the Galland case are included in Chapter 11 – “Tax Accounting and Income Assignments” under the heading “Assignments of Interests in Partnerships”.

© Thomson Reuters 2019

299

C HAPTER 14

Trusts and Beneficiaries PRESENT ENTITLEMENT ................................................................................. 303 Estate Not Fully Administered ..................................................................... 303 Whiting (1943) ........................................................................................ 303 Beneficiaries with Contingent Interests........................................................ 304 Hobbs (1957) .......................................................................................... 304 Beneficiaries Under a Legal Disability ........................................................ 305 Taylor (1970)........................................................................................... 305 Crediting Trust Accounts for Beneficiaries .................................................. 306 Ward (1970) ............................................................................................ 306 CONSTRUCTIVE TRUSTS ................................................................................. 307 Zobory (1995) ......................................................................................... 307 TRUSTS IN FAVOUR OF THE CONTRIBUTOR’S CHILDREN .................. 308 Truesdale (1970) ..................................................................................... 309 MISMATCH BETWEEN TRUST ACCOUNTING INCOME AND INCOME FOR TAX PURPOSES......................................................................... 309 Cajkusic (2006) ....................................................................................... 310 Bamford (2010) ....................................................................................... 311 SUBTRUSTS AND UNIT TRUSTS .................................................................... 313 Meaning of “Unit Trust” ............................................................................... 313 ElecNet (Aust) Pty Ltd (2016) ................................................................. 313 Settlement to “Guardian” of Beneficiary...................................................... 313 Countess of Bective (1932) ..................................................................... 313 Income Flows Through a Unit Trust............................................................. 314 Charles (1954) ........................................................................................ 314 Income Distributed Directly to Subtrust Beneficiaries................................. 315 Totledge Pty Ltd (1982)........................................................................... 315 STREAMING OF DISTRIBUTIONS ................................................................. 316 Thomas (2018) ........................................................................................ 316

© Thomson Reuters 2019

301

C HAPTER 14

Trusts and Beneficiaries While it is common to speak of a “trust” as if it were an actual legal entity similar to a company, in fact there is no trust entity. A trust is a relationship created by the action of a person (known as the settlor) who gives property to another person (the trustee) with the stipulation that the income generated by the property and the underlying property itself be held for the benefit of a third person or persons (the beneficiaries). Thus, a trust is more accurately described as a set of obligations (the fiduciary obligations imposed on the trustee to deal with property for the benefit of the trust beneficiaries) and a complementary set of rights (the rights of beneficiaries to require the trustee to look after the property for their benefit). Because there is no actual trust entity, the ITAA 1936 imposes liability for tax on trust income on the parties to a trust rather than “the trust” per se. The tax base of the “net income” of the trust is calculated as if the trust were an entity, but liability for tax on that income is allocated to the trustee and the beneficiaries. The beneficiaries are liable for tax on any trust income to which the beneficiaries are presently entitled (s 97 ITAA 1936 1936) and the trustee is liable for tax on all trust income that has not been attributed to the beneficiaries. Originally, trustees were taxed on unallocated trust income at ordinary progressive rates under s 99 ITAA 1936. The separate taxation of different trusts settled by the same person encouraged taxpayers to settle multiple trusts, each of which was able to exploit the tax-free zone at the bottom end of the progressive rate scale and the lowest tier rates on their first dollars of taxable income. To overcome this problem, a new default assessment provision was enacted for trust income, s 99A ITAA 1936, with s 99 reserved for a limited category of trusts such as testamentary trusts where it is clear the trust was not created for tax minimisation purposes. Income assessed under s 99A is subject to a flat rate of tax equal to the highest personal rate under the Income Tax Rates Act 1986. Prior to 1985, capital gains realised by a trust were not subject to tax. With the adoption of the capital gains tax measures in 1985, capital gains were included in the assessable income of a trust and the question arose who should pay tax on the gains. The courts have had some difficulty applying the current provisions to capital gains and in 2011 the government announced its intention to reform the taxation of trusts to clarify this issue. Subdivision 115-C ITAA 1997 ensures that any capital gain allocated to a beneficiary will be treated as a capital gain in the hands of the beneficiary (and as a consequence be available to offset against any capital losses of the beneficiary) but the question remains whether the trust or a beneficiary should be taxed on the capital 302

© Thomson Reuters 2019

CHAPTER 14

TRUSTS AND BENEFICIARIES

gain. No legislation answering the question has appeared and the issue continues to be resolved using case law precedents.

PRESENT ENTITLEMENT Trust beneficiaries are assessed on the share of the net income of a trust to which they are “presently entitled”. Present entitlement is a tax law concept, not a trust law concept. It does not mean the income has actually been distributed to a beneficiary, but rather that the trustee has acknowledged the beneficiary’s entitlement to the income and the beneficiary enjoys the legal power to call for a distribution of the income or application of the income on the beneficiary’s behalf. A beneficiary cannot be presently entitled to trust income if the trustee is under an obligation to apply the income to satisfy a debt of the trust. Present entitlement must be distinguished from a “vested” interest in trust income. A vested interest is complete legal ownership of the income but vested interest may still fall short of present entitlement. For example, a trust may stipulate that a child, beneficiary A, has a vested interest in trust income but the income must be retained in the trust until a spouse, beneficiary B, passes away. While beneficiary A has a vested interest in the income, until B passes away, beneficiary A has no right to demand the trustee distribute the income. In these circumstances, beneficiary A may be deemed to be presently entitled to the trust income by s 95A(2) ITAA 1936. Because a beneficiary who is only deemed to be presently entitled cannot actually call for a distribution of income to pay the tax due, the trustee will be assessed as a surrogate taxpayer for the beneficiary under s 98(2) ITAA 1936.

Estate Not Fully Administered FCT v Whiting

(1943) 68 CLR 199 (Full High Court)

Facts: The trustee of a testamentary trust required trust income to satisfy various liabilities of the trust estate, including satisfying debts of the deceased. As the outgoings were not allowable deductions to the trust, the payments would have to be made from after-tax income of the trust. If the beneficiaries were not presently entitled to the trust income, it would have been assessed in the hands of the trustee and the income would have been sufficiently large to attract high marginal rates. The trust beneficiaries agreed with the trustee’s plan to declare the beneficiaries to be “presently entitled” to the trust income so it could be assessed to them under s 97 ITAA 1936 and thus split several ways for tax purposes (attracting lower rates). The Commissioner argued that the beneficiaries could not be presently entitled to trust income until the testamentary estate had been fully administered and all its debts satisfied. Decision: The High Court agreed with the Commissioner and concluded that being “presently entitled” to trust income meant more than having a vested and indefeasible interest in trust income. Rather, it meant being able to demand payment of the income or application of the income on behalf of the beneficiary. The Court agreed that as © Thomson Reuters 2019

303

AUSTRALIAN TAXATION LAW CASES 2019

a matter of trust law, beneficiaries could not have this right to trust income until a testamentary trust had been fully administered. Relevance of the case today: The Whiting case remains the leading statement on the meaning of “present entitlement” as conferring a right to demand payment or application of the funds on behalf of the beneficiary, subject to the modified interpretation in Taylor v FCT (1970) 119 CLR 444; 1 ATR 582; 70 ATC 4026 (see below). If it happened today: If the facts in Whiting occurred today, a court would apply the Whiting holding to find the beneficiaries were not presently entitled to trust income and the income should be assessed to the testamentary trustee under s 99 ITAA 1936. The result would be harsher today as Schedule 10 Income Tax Rates Act 1986 now removes the tax-free zone for testamentary trusts three years after the death of the testator. The assertion in Whiting that present entitlement always entails a right to demand payment or application of income has been modified in respect of beneficiaries under a legal disability (for example, infants) by the High Court’s decision in Taylor v FCT (1970) 119 CLR 444 so the rule is now understood as meaning a right to demand payment unless that is prevented by reason of the beneficiary being under a legal disability (as is the case, say, with an infant).

Beneficiaries with Contingent Interests It is possible to settle trust interests subject to contingencies – for example, a parent may settle a trust for a child but impose a condition so the child is only entitled to trust income if the child marries or if the child completes a university degree, and so forth. Where a contingent interest has been established, the trust will have a default beneficiary as well – the person who will be entitled to trust income or capital if the first beneficiary fails to satisfy the contingency set out in the trust deed.

Hobbs v FCT

(1957) 98 CLR 151 (Full High Court)

Facts: Income was derived from property settled upon a trust by the parent of children who were contingent beneficiaries under the trust deed. Their right to trust income was contingent on their attaining the age of 25 or marrying prior to that time. If they failed to do either, the income would be distributed to other beneficiaries. The Commissioner assessed the trustee on the basis of s 102(1)(b) ITAA 1936, which allows the Commissioner to assess the trustee and impose a tax equal to the tax the parent who created the trust in favour of a child would pay had the parent derived the income personally. The income in question was retained in and reinvested by the trust. The Commissioner argued the income had been “accumulated for” a child beneficiary, an action that triggered the operation of the provision. Decision: The High Court concluded s 102(1)(b) had no application to trust income in which an infant beneficiary only enjoyed a contingent interest in the income. It could 304

© Thomson Reuters 2019

CHAPTER 14

TRUSTS AND BENEFICIARIES

not be said that the income was accumulated for the children as their right to income was merely a contingent right. Relevance of the case today: The Hobbs decision is authority for the proposition that income to which a person is merely contingently entitled is not applied or accumulated for the benefit of the person and therefore cannot be subject to s 102(1)(b). It further follows that the person does not have a vested interest in the income and s 95A(2) ITAA 1936 cannot be used to deem a present entitlement to the income. If it happened today: The Commissioner’s failure to invoke s 102(1)(b) in Hobbs left the income to be taxed at under s 99 ITAA 1936 using the ordinary progressive rate scale as s 99A ITAA 1936 had not been enacted at that time. If the case were to occur today, the trustee would be assessed under s 99A and the income would be subject to tax at the highest personal marginal rate.

Beneficiaries Under a Legal Disability A beneficiary who is under a legal disability has no legal power to demand a distribution of trust income. Accordingly, the legislation provides for the trustee to pay tax under s 98(1) ITAA 1936 as a surrogate taxpayer for a beneficiary under a legal disability. The provision initially gave rise to some confusion – it speaks of a beneficiary of a trust estate who is under a legal disability but who is presently entitled to a share of the income of the trust estate. If being presently entitled means having a vested interest in trust income and having the power to demand a distribution of the income, on one interpretation, a beneficiary under a legal disability could never be presently entitled. By definition, a person who is under a legal disability cannot demand a distribution. Section 98 could only operate if “present entitlement” had a slightly different meaning for beneficiaries under a legal disability.

Taylor v FCT

(1970) 119 CLR 444; 70 ATC 4026; 1 ATR 582 (High Court)

Facts: The trustees of a trust with infant beneficiaries accumulated income for the infant beneficiaries. The trust deed provided the beneficiaries with an indefeasible and vested interest in the trust income so if they died before attaining the age of majority, the income would be distributed to their estates. The trustees argued that the children were presently entitled but under a disability and the income should be subject to s 98 ITAA 1936, which meant the trustees would be taxed separately on the income attributable to each child, thus splitting the income and attracting lower rates. The Commissioner argued the children were not presently entitled to the trust income because under the test in Whiting they could not demand a distribution as they were under a legal disability. Decision: Kitto J agreed with the trustees that the holding in Whiting should be read as if it said presently entitled beneficiaries would be able to demand distribution unless they were precluded from doing so by reason of a legal disability. Adopting this © Thomson Reuters 2019

305

AUSTRALIAN TAXATION LAW CASES 2019

interpretation, he concluded that presently entitled in s 97 ITAA 1936 and s 98 meant the beneficiaries had to have a vested and indefeasible right to income and face no barriers to distribution apart from being under a legal disability. As the income was accumulated for the benefit of the infant beneficiaries in this case, he held they were presently entitled to the income and the income was subject to s 98 and taxed in the hands of trustees separately in respect of each beneficiary. Relevance of the case today: The Taylor case continues to stand for two propositions: first, that present entitlement means a full vested and indefeasible interest and right to call for a distribution of income but for a legal disability; and second, that a beneficiary can be presently entitled to trust income if the trustee retains and reinvests the income for the benefit of the beneficiary. If it happened today: If the facts in Taylor occurred today, the trustees would be subject to tax separately under s 98 but the income would likely be income to which Division 6AA ITAA 1936 applies. The income would not be subject to Division 6AA if the trust were a testamentary trust but it appears the trust in Taylor was an inter vivos trust. If that is the case, s 13(3) of the Income Tax Rates Act 1986 will apply to the income and it will be subject to the rate prescribed in Part 1 of Schedule 12 to that Act. The effect of this would be to impose a 45% rate on all income in excess of $416. If the beneficiary were entitled under more than one trust estate, s 100 ITAA 1936 would consolidate all the income to prevent exploitation of the $416 threshold more than one time.

Crediting Trust Accounts for Beneficiaries In some cases, a trustee may derive income that is not available for distribution to beneficiaries. This would happen, for example, if the trustee had purchased a bond on which interest was compounded until maturity. The interest will be derived by the trustee as it compounds annually but no cash is received as the compounding means it is effectively reinvested in the bond. Can a beneficiary be presently entitled to trust income if it is allocated to the beneficiary so no other person can claim a right to the income but instead of being distributed the income is reinvested by the trustee for the benefit of the beneficiary?

Commissioner of Inland Revenue v Ward [1970] NZLR 1 (New Zealand Court of Appeal)

Facts: The trustee of an inter vivos trust for the benefit of her children exercised her discretion to deal with trust income for the year by allocating it to her four children and crediting trust accounts in their favour with the allocated amounts. The New Zealand Income Tax Act contained a provision similar to s 100 ITAA 1936 that had the effect of treating a beneficiary as being presently entitled to income where the trustee exercises a discretion to apply income for the benefit of a beneficiary. The Commissioner assessed the trustee on trust income under the equivalent to s 99A ITAA 1936 on the basis that 306

© Thomson Reuters 2019

CHAPTER 14

TRUSTS AND BENEFICIARIES

allocating the funds and crediting them to trust accounts for named beneficiaries did not amount to applying the income for the benefit of the beneficiaries. Decision: The Court of Appeal concluded that when a trustee exercises a discretion and allocates income to accounts for beneficiaries, the beneficiaries have a vested and absolute interest in the income. The income was, therefore, applied for the benefit of the beneficiaries and the trustee could not, therefore, be taxed on the income under the equivalent of s 99A ITAA 1936. Relevance of the case today: Although it is a New Zealand decision, Ward may be cited as authority for the proposition that crediting amounts to accounts for trust beneficiaries is an application of the income for the benefit of the beneficiaries. The decision in Ward is based on an allocation of income to accounts following the exercise of discretion by the trustee of a discretionary trust, which would trigger the application of s 101 ITAA 1936 in Australia. However, the case stands for a broader proposition as income allocated in this way in any non-discretionary trust would also be treated as income which is applied for the benefit of a beneficiary. If it happened today: If the facts in Ward were to take place today in Australia, an Australian court would treat amounts allocated to the account of a beneficiary of a discretionary trust as amounts to which the beneficiary is presently entitled following the application of s 101. If the trust were not a discretionary trust, the income would be deemed to be income to which the beneficiary is presently entitled under s 95A(2) ITAA 1936. As there would be no actual distribution of the cash in this case, the beneficiary would find it difficult to satisfy the tax liability and accordingly s 97(2) ITAA 1936 excludes the income from the operation of s 97(1) ITAA 1936 and instead it is assessed to the trustee under s 98(2) ITAA 1936.

CONSTRUCTIVE TRUSTS Most trusts are created by a formal document called a trust deed or, in the case of a testamentary trust, by a will. However, some trusts arise as a consequence of the law of equity which treats a person controlling property as a trustee where it would be equitable to do so. The most common type of trust created this way is a constructive trust. Even though the trust was created because of the application of equity law rather than a formal trust deed or will, if a constructive trust exists, the ordinary trust tax provisions apply. The person found to be a trustee of the constructive trust can only be assessed on income derived through the fund if no beneficiary was presently entitled to a share of the trust income.

Zobory v FCT

(1995) 30 ATR 412; 95 ATC 4251 (Federal Court)

Facts: The taxpayer embezzled $1 million from his employer and invested the money, earning interest on the investment. In his return for the first income year, the taxpayer included the interest earned on the misappropriated money in his assessable income. © Thomson Reuters 2019

307

AUSTRALIAN TAXATION LAW CASES 2019

By the time of the return for the second year, the embezzlement had been discovered and the interest earned for that period was shown as property of the employer. The issue before the Court was whether the income earned in the first year was income to the taxpayer. Decision: The interest was not income to the taxpayer. A constructive trust had arisen over the money at the time of the embezzlement and a constructive trust is fully effective to divert the liability for tax to the beneficiary of the trust (the employer in this case), applying MacFarlane v FCT (1986) 17 ATR 808; 86 ATC 4477. As a result, though the taxpayer had received the interest, the taxpayer merely held the interest as a trustee, not for his own benefit. Relevance of the case today: This case is still authority for the proposition that income earned on embezzled funds will be considered held on trust for the true owner and therefore is not income to the thief or embezzler. Critical to this conclusion was the existence of a constructive trust. If it happened today: It is likely that a court would come to the same conclusion as it did in Zobory if presented with the same facts. If a trust has been established, whether express or constructive, any income received by the trustee in capacity as trustee will not be considered beneficially derived by the trustee and the provisions of Division 6 of Part III ITAA 1936 will apply.

TRUSTS IN FAVOUR OF THE CONTRIBUTOR’S CHILDREN Prior to the enactment of Division 6AA ITAA 1936, parents would seek to split their investment income with their children for tax purposes by establishing trusts for the benefit of their children and shifting some income-producing assets to the trusts created for their children. Division 6AA income, which includes most investment income derived by a trust for the benefit of children, is subject to a special tax rate regime under the Income Tax Rates Act 1986 which imposes the highest individual rate on all Division 6AA income. The initial legislative response to the problem of income splitting through trusts for children was the enactment of s 102(1)(b) ITAA 1936. This provision applies where parents settle trusts for the benefit of their children. It imposes a tax surcharge on the trustee to ensure the tax levied on the trust income is the same as the tax the settlor would have paid had she or he derived the trust income personally. However, the section proved wholly inadequate when taxpayers found ways to circumvent the rule. The ease with which taxpayers avoided the application of s 102(1)(b) was a factor prompting the adoption of Division 6AA.

308

© Thomson Reuters 2019

CHAPTER 14

TRUSTS AND BENEFICIARIES

Truesdale v FCT

(1970) 120 CLR 353; 1 ATR 667; 70 ATC 4056 (High Court)

Facts: A grandfather settled a nominal amount on trust for his grandchild at the urging of the infant’s father who in turn acted on advice from his accountant. Subsequently, the father gifted funds to the trust which were used to acquire shares. The Commissioner sought to assess the trustee on the income allocated to the infant beneficiary on the basis of s 102(1)(b) ITAA 1936, arguing the father “created” a trust in favour of his child when he gifted money to the trust. The Commission relied on the New Zealand case, Tucker v CIR [1965] NZLR 1027 which involved similar facts and a similar statutory provision. Decision: Menzies J rejected the New Zealand view that a contribution to an existing trust “created” a trust upon the same terms and conditions as the original trust. He construed the notion of “creating” a trust narrowly, giving it a similar meaning to the formal settlement of a trust. Relevance of the case today: The Truesdale decision opened the door to simple avoidance of s 102(1)(b) and led to a significant increase in the use of trusts to split income from investments between family members, particularly children, for tax purposes. Rather than amend the legislation to overturn the decision in Truesdale, the legislature eventually responded with a comprehensive reform, Division 6AA ITAA 1936. This Division works in conjunction with the Income Tax Rates Act 1986 to impose the highest personal marginal tax rate on investment income derived directly by children or through a trust. The Division provides a range of exemptions where it is clear the trust was created for reasons other than tax minimisation. If it happened today: If the facts in Truesdale occurred today, the court might interpret the notion of “creating” a trust more broadly, in line with the New Zealand precedent in Tucker, on the basis of s 15AA of the Acts Interpretation Act which requires courts to interpret legislative measures in a manner that gives effect to the purpose of the provisions. However, the Commissioner is unlikely to rely on s 102(1)(b) today as its relevance is superseded by the rules in Division 6AA.

MISMATCH BETWEEN TRUST ACCOUNTING INCOME AND INCOME FOR TAX PURPOSES Section 97 ITAA 1936 attributes a share of the “net income” of a trust to each beneficiary equal to the share of the “income” of the trust to which the beneficiary is presently entitled. The “income” of the trust is understood to be income according to trust law accounting which will normally be ordinary income only. The potential for a discrepancy between the net income of a trust and its accounting income became particularly acute after 1985 when capital gains were included in the calculation of the net income of the trust. If the capital beneficiary of a trust has no interest in the “income” of the trust, how could capital gains realised by the trust be attributed to the capital beneficiary? Or, would a beneficiary presently entitled to trust income become liable to pay tax on the same proportion of the capital gain? © Thomson Reuters 2019

309

AUSTRALIAN TAXATION LAW CASES 2019

Two views emerged. The first was the “proportional” interpretation which suggested s 97 should be read as attributing to each beneficiary a portion of the trust’s taxable income equal to the share of trust income to which they are entitled, even if they might not be entitled to the entire gain under the trust deed. The alternative view was known as the “quantum” view. This view suggested that s 97 should only be used to attribute income under trust law notions and any surplus of net (taxable) income over income for trust law purposes should be treated as income to which no beneficiary is entitled. In this case, the trustee would be liable for tax on the excess amount under s 99 or s 99A ITAA 1936 rather than a beneficiary. The proportional view was first accepted by the Federal Court in Zeta Force Pty Ltd v FCT (1998) 39 ATR 277; 98 ATC 4681 and this approach was endorsed by the Full High Court in FCT v Bamford (2010) 240 CLR 481; 75 ATR 1; 2010 ATC 20-170.

Cajkusic and Ors v FCT

(2006) 64 ATR 676; 2006 ATC 4752 (Full Federal Court)

Facts: The taxpayers were beneficiaries of a trust that had incurred expenses in the 1996-1997 income year which were deductible for trust financial accounts purposes but not for tax law purposes. As a result, the trust had net income for tax purposes and a loss for trust financial accounts purposes. The following year, it had a large net income for s 95(1) ITAA 1936 tax law purposes. Trust law required the trust to carry forward the loss from the previous year and apply it against the trust income for the 1997-1998 income year. As a result, in the 1997-1998 income year the trust had a loss for trust law purposes at the same time it had a positive net income for tax purposes under s 95(1). The Commissioner assessed each of the income beneficiaries on a proportion of net income equal to the proportion of trust income to which they would be entitled under the trust deed if the trust had realised net income for trust financial accounts purposes. The beneficiaries argued that if the trust had no trust law income, they were not entitled to a share of income and there was no proportion to apply to them in respect of the net income of the trust determined under s 95(1). Decision: The Full Federal Court endorsed the proportionate approach used in the earlier Federal Court decision in Zeta Force Pty Ltd v FCT (1998) 39 ATR 277; 98 ATC 4681. However, that approach could only be used where beneficiaries were entitled to a share of the trust law income of the trust. Where the trust had no income for trust financial accounts purposes, the beneficiaries could not be entitled to a share of that income and accordingly it was not possible to attribute a share of the s 95(1) net income for tax purposes to the beneficiaries under s 97(1) ITAA 1936. In these circumstances, the entire net income of the trust would be assessed to the trustees under s 99A ITAA 1936. Relevance of the case today: Subsequent to the decision in Cajkusic, the Full High Court in FCT v Bamford (2010) confirmed that the proportionate view should be applied to s 97(1) and each beneficiary should be assessed on the share of the net income of the trust equal to the beneficiary’s share of the income of the trust measured using trust law principles. However, the trust in Bamford had a positive income measured using trust law principles and a larger net income measured using tax law rules. There 310

© Thomson Reuters 2019

CHAPTER 14

TRUSTS AND BENEFICIARIES

is nothing in the judgment in Bamford that contradicts the result in Cajkusic and it is likely that Cajkusic would continue to govern cases where there is no income of the trust measured using trust law principles. Thus, the case can continue to be cited for the proposition that beneficiaries of a trust cannot be assessed on a share of the net income of the trust under s 97 if there is no income for trust law purposes to which they would be presently entitled. If it happened today: If the facts in Cajkusic were to arise today, a court would most likely again find that no share of the s 95(1) net income of the trust can be allocated to beneficiaries under s 97(1) where there is no trust law income to which they might be presently entitled for trust law purposes.

FCT v Bamford

(2010) 240 CLR 481; 75 ATR 1; 2010 ATC 20-170 (Full High Court)

Facts: The taxpayers were beneficiaries of a discretionary trust. After calculating the trust’s net income for the year, the trustees allocated it to the taxpayers and other beneficiaries as specified amounts rather than as proportions of the total, with what was described as the “balance” allocated to a tax-exempt religious organisation. The trust had no statutory income and when the trustees allocated the trust’s income for the year, its net income for tax purposes under s 95(1) ITAA 1936 equalled its income for trust law purposes. Subsequently the Commissioner disallowed some deductions that had been claimed by the trustee and the trustee accepted the disallowance. As a result, the net income of the trust was recomputed as a higher amount than the trust income. The Commissioner calculated the proportion of trust income represented by the trustee’s allocation of a fixed amount to each beneficiary and then applied that pro-ration to the larger net income of the trust. The result was that each beneficiary was assessed on an amount greater than that available for distribution to them. The Commissioner argued that the proportionate view of s 97 ITAA 1936 applied whether the trustees had allocated fractions of the trust’s income or fixed amounts to the beneficiaries. The taxpayers argued the proportionate approach could not be applied to amounts exceeding the actual allocation to a beneficiary where the trustee had allocated to the beneficiary a specified amount rather than a proportion of the total trust income. A second dispute arose in respect of a capital gain derived by the trust two years later. The trust derived no trust income in the year but did realise a capital gain. The trust deed empowered the trustee to exercise its discretion to distribute capital gains to income beneficiaries and the trustee did so. The Commissioner argued that the capital gains could not be taxed to beneficiaries under s 97 as that section calculated the share of net income of the trust attributable to a beneficiary based on the beneficiary’s share of trust income and the beneficiaries had no entitlement to trust income in the year as there was none. Accordingly, he assessed the trustee on the capital gain under s 99A ITAA 1936 and imposed the higher tax rate applicable to income of a trust to which no beneficiary is presently entitled. The beneficiaries argued that the capital gain could © Thomson Reuters 2019

311

AUSTRALIAN TAXATION LAW CASES 2019

be treated as income to which they were presently entitled if the trust deed allowed the trustee to treat the gain as income and allocate it to income beneficiaries and the trustee did so. Decision: The Court rejected the taxpayer’s argument that the proportionate view of the operation of s 97 would not apply where the trustees had allocated fixed amounts to beneficiaries rather than fractions of the trust’s income. It endorsed the Commissioner’s approach of calculating the proportion of income to which beneficiaries were entitled using the fixed amount as a proportion of the whole income. In respect of the question of the capital gain derived by the trust, the Court said the phrase “income of the trust estate” must be interpreted using trust law principles and that if the trust instrument specifies that the trustee has a discretion to treat a capital gain as income of the trust estate and allocate it to income beneficiaries of the trust, the gain should be considered income to which the beneficiaries are presently entitled for s 97(1) purposes. Relevance of the case today: The Bamford case provides authority for the Commissioner’s application of the proportional view of s 97 where the net income of a trust exceeds income for trust law purposes. The additional net income will be apportioned to presently entitled income beneficiaries, even if their entitlement is to a fixed amount rather than a percentage of trust income. It will include capital gains if the trust deed allows the trustee to treat capital gains as income to which the income beneficiaries will be entitled. One important impact of the case is to encourage persons drafting trust deeds to include a power for the trustee to designate all types of gains that are included in the net income of the trust as income that can be distributed to income beneficiaries. This will make it possible for the income to be taxed at the beneficiaries’ marginal tax rates rather than be left in the hands of the trustee to be taxed at the highest marginal rate that applies to income assessed to a trustee under s 99A. If it happened today: If the facts in Bamford took place today, a court would apply the proportional approach to s 97 and attribute on a proportional basis the net income exceeding trust income to beneficiaries presently entitled to a share of trust income. This will include capital gains of the trust if the trust deed provides for the trustee to treat capital gains as income to which income beneficiaries are entitled. Subdivision 115-C of ITAA 1997, enacted subsequent to the case, ensures the capital gain retains its character in the hands of a beneficiary entitled to it. The subdivision grosses up the gain if any discount has been used so the beneficiary can apply any available capital losses before recomputing any discount at the level of the beneficiary.

312

© Thomson Reuters 2019

CHAPTER 14

TRUSTS AND BENEFICIARIES

SUBTRUSTS AND UNIT TRUSTS Meaning of “Unit Trust” ElecNet (Aust) Pty Ltd v FCT

[2016] HCA 51; 259 CLR 73; 104 ATR 554

Facts: ElecNet was the trustee of the Electrical Industry Severance Scheme (EISS) under a trust settled by deed. Under the EISS, employers in the electrical contracting industry could become members of the scheme and, upon doing so, became obliged to make payments to ElecNet. The payments were credited by ElecNet to accounts in the name of each of the employees in respect of whom a payment was made. When an employee’s employment was terminated, the trust deed contemplated that ElecNet was to make a payment to that employee. ElecNet requested a private ruling from the Commissioner as to whether the trust was a public trading trust for the purposes of Div 6C ITAA 1936. The Commissioner ruled that it was not a public trading trust because it did not fall within the definition of a “unit trust” in Div 6C ITAA 1936. ElecNet’s objection to the ruling was disallowed by the Commissioner so it appealed to the Federal Court. Decision: At first instance, the Federal Court held that the EISS was a unit trust, however this decision was overturned by the Full Federal Court. ElecNet appealed the decision. The High Court held that the EISS was not a unit trust for the purposes of Div 6C ITAA 1936 because any interest created by the deed in favour of employees could not be characterised as a “unit”. Relevance of the case today: The ElecNet decision clarifies the meaning of “unit trust” Div 6C ITAA 1936. This meaning accords with the common usage of the expression “unit trust” which is a trust where the beneficial interest in the trust estate is divided into units as discrete parcels of rights themselves capable of being dealt with, like shares in a company, as items of commerce. It also stands for the proposition that the inclusive definition of “unit” does not encompass an interest that would not otherwise be identifiable as a unit in relation to a prescribed trust estate merely because it is a beneficial interest in any of the income or property of the trust estate. If it happened today: If the facts in ElecNet arose today, the court would continue to find that the trust in question was not a unit trust.

Settlement to “Guardian” of Beneficiary Countess of Bective v FCT

(1932) 47 CLR 417 (High Court)

Facts: The taxpayer was named in a trust deed established by her husband. The deed required the trustees to distribute income to the taxpayer to be used for their daughter’s maintenance, education and support. The deed referred to the daughter at one point © Thomson Reuters 2019

313

AUSTRALIAN TAXATION LAW CASES 2019

as a “beneficiary”. The Commissioner assessed the taxpayer on the distributions she received, saying she had derived the income beneficially. Decision: Dixon J of the High Court concluded the taxpayer had not derived the income distributed by the trust in a beneficial capacity but rather in the capacity as a guardian for the daughter. Accordingly, the taxpayer could not be assessed on the income. Alternatively, Dixon J suggested, if the income was assessable to the taxpayer, an offsetting deduction would be available. Relevance of the case today: The Countess of Bective decision raises a number of questions that remain unresolved today. As explained below, the holding of the decision is not directly relevant today. However, it remains unclear whether a person can accept income on the condition that it be applied to a certain purpose and then deduct the expenditures on that purpose on the basis that the expenditures were necessarily incurred to derive the income. If it happened today: If the facts in Countess of Bective were to arise today, a court would most likely say the original trust deed created a head trust and a subtrust and that although the Countess received distributions from the head trust in her capacity as a beneficiary of that trust, she was at the same time the trustee of a subtrust in favour of the daughter. Thus, the head trust would not be taxable on the income it distributed as the Countess was presently entitled to that income. As the daughter was presently entitled to the income received by the Countess, but for the daughter’s legal disability as a child, the income would be taxed in the hands of the Countess under s 98 ITAA 1936. As the trust was created as an inter vivos trust, the income would likely be income to which Division 6AA ITAA 1936 applies. If that is the case, s 13(3) of the Income Tax Rates Act 1986 will apply to the income and it will be subject to the rate prescribed in Part 1 of Schedule 12 to that Act. The effect of this would be to impose a 45% rate on all income in excess of $416.

Income Flows Through a Unit Trust Charles v FCT

(1954) 90 CLR 598 (High Court)

Facts: The taxpayer invested in a unit trust (a type of fixed trust) that derived dividends and capital gains from the sale of securities and the sale of rights to securities. The capital gains and the dividends were distributed to unit holders and the Commissioner assessed the taxpayer as a beneficiary of the trust, treating the entire amount distributed as income of the taxpayer. Capital gains were not included in assessable income at the time of the case. The Commissioner argued that an investment in an investment unit trust for the purpose of obtaining regular returns from the trust was akin to an investment in a company and all ordinary distributions of profit, be it income or capital profits, should be treated as assessable income to the unit holder, as are distributions of profits from a company.

314

© Thomson Reuters 2019

CHAPTER 14

TRUSTS AND BENEFICIARIES

Decision: The High Court rejected the Commissioner’s view that profits distributed by an investment unit trust automatically acquired the character of income in the hands of the unit holder investor. It reduced the taxpayer’s assessment to the extent the distribution included capital gains. Those amounts thus remained untaxed as they passed through the trust to the beneficiary. Relevance of the case today: One key issue in Charles was whether a unit trust used as an investment vehicle would be taxed in the same manner as an ordinary family trust in which receipts derived by the trustee retained their character as they passed through to a beneficiary. The decision in Charles established the proposition that amounts passing through a trust do retain their character in the hands of beneficiaries. If it happened today: As capital gains are now included in assessable income, if the facts in Charles were to happen today, the capital gain would be included in the net income of the unit trust under s 95(1) ITAA 1936, but the trustee would be entitled to the 50% discount under s 102-5 ITAA 1997, providing the assets had been held for at least one year prior to sale. The trustee would then distribute the capital gain to the beneficiary who would be assessed under s 97(1) ITAA 1936. However, to the extent the distribution includes a capital gain, the beneficiary is allowed an offsetting deduction under s 115-215(6) ITAA 1997 so there is no net recognition of a capital gain under s 97(1). Instead, the beneficiary is treated as having a capital gain under section 115-215(3)(b) ITAA 1997. This section treats the beneficiary as realising a capital gain twice the discounted amount (that is, it treats the beneficiary as realising the pre-discount capital gain originally realised by the trustee). As the beneficiary in the Charles case was an individual, he would then be entitled to use the 50% discount under s 102-5. If the beneficiary was a non-resident or a temporary resident, the beneficiary would not be able to use the 50% discount in s 102-5, which is available to resident individuals only.

Income Distributed Directly to Subtrust Beneficiaries FCT v Totledge Pty Ltd

(1982) 12 ATR 830; 82 ATC 4168 (Full Federal Court)

Facts: The creditors of Preventicare agreed to a scheme of arrangement when the company became insolvent. Under the scheme of arrangement, the company’s business was transferred to a scheme trustee who was to operate the business and distribute the profits to the creditors until the debts had been satisfied. At that time the business would be transferred back to Preventicare. The scheme trustee had no expertise in operating this type of business so it transferred the business to an operating trust of which Totledge was the trustee. Totledge operated the business and distributed the profits directly to the creditors. The Commissioner assessed Totledge on the income under s 25(1) ITAA 1936 on the basis that there was no trust and alternatively under s 99 ITAA 1936 if there was a trust on the basis that the creditors were not presently entitled to distributions from the operating trust. (At the time, s 99A ITAA 1936 did not apply to this type of scheme of arrangement trust.)

© Thomson Reuters 2019

315

AUSTRALIAN TAXATION LAW CASES 2019

Decision: The Full Federal Court concluded that the business had been transferred to Totledge in trust and the scheme trustee was a beneficiary under the operating trust, even though it was a trustee in respect of the scheme trust. As it was entitled to all distributions from the operating trust, the distributions by Totledge to the creditors were to be treated as distributions at the direction of the scheme trustee and the scheme trustee was to be treated as presently entitled to the income distributed even though it did not receive the funds. Relevance of the case today: The Totledge decision makes it clear that a trustee of one trust can be a presently entitled beneficiary of another trust. The top level trust is commonly referred to as the “head trust” and the next level (where the trustee is a beneficiary of the top level trust and a trustee in respect of its own beneficiaries) as the “subtrust”. Where this happens, the trustee of the subtrust may be presently entitled to distributions from the head trust, even if they are distributed directly to beneficiaries of the subtrust. If it happened today: If the facts in Totledge arose today, the income derived by the head trustee would be attributed to the subtrust in its capacity as a beneficiary of the head trust.

STREAMING OF DISTRIBUTIONS FCT v Thomas [2018] HCA 31

Facts: The Trustee of the Thomas Investment Trust received franked distributions within the meaning of Div 207 of ITAA 1997. The Trustee then passed resolutions to distribute the franking credits between the beneficiaries of the Trust separately from and in different proportions to the franked distributions. This was referred to as the “Bifurcation Assumption”. The tax returns of the relevant taxpayers were lodged on the basis that the Bifurcation Assumption was legally effective. The Trustee then made a successful application to the Supreme Court of Queensland to obtain a direction to give effect to the Bifurcation Assumption. The Full Federal Court held that the directions determined the rights of the beneficiaries against the Trustee in such a way that Div 207 would operate consistently with the Bifurcation Assumption meaning that the Commissioner was bound by the directions of the Supreme Court of Queensland. Decision: The High Court, finding for the Commissioner, held that once a court has made a finding of fact, the Commissioner is bound by that fact, but not as to the taxation consequences that flow from that fact. Further, it stated that the Full Federal Court was wrong to conclude that it was bound to hold that the directions in the State Proceedings determined conclusively, against the Commissioner, the application of Div 207 to the franked distributions. The Commissioner was not a party to the making of the directions and the parties were not able to create a private arrangement which produced an outcome contrary to law or produced an outcome which required a statutory officer to administer the taxing statutes other than according to law.

316

© Thomson Reuters 2019

CHAPTER 14

TRUSTS AND BENEFICIARIES

Relevance of the case today: While Subdivision 207-B of ITAA 1997 allows a trustee to stream dividends where the trust deed permits, the Thomas decision clarifies the position that bifurcation of the franking credits and the distributions is not allowed. The franking credits are attached to the dividend income and are distributed with it. If it happened today: If the facts in Thomas arose today, the court would continue to find that the Commissioner was not bound by a direction of another court on a matter of law which is contrary to the administration of the tax legislation.

© Thomson Reuters 2019

317

C HAPTER 15

Exempt Organisations Word Investments Ltd (2008) ................................................................. 320 Aid/Watch Inc (2010) ............................................................................. 322

© Thomson Reuters 2019

319

C HAPTER 15

Exempt Organisations Section 50-1 ITAA 1997 provides an exemption from income tax for various organisations including, in s 50-5 ITAA 1997, a “registered charity”, as defined in the Australian Charities and Not-for-profits Commission Act 2012. To be registered, an organisation must first show it meets the definition of a “charity” in s 5 of the Charities Act 2013. This, in turn, requires the organisation to demonstrate it is performing a “charitable purpose” set out in s 12 of the Charities Act 2013. The adoption of the Charities Act marked an important development in Australian law. Until that time, there had been no statutory definition of a charity. Rather, the definition was based on common law principles. To qualify for exemption, a charitable institution must meet conditions set out in s 50-50 ITAA 1997, including, for Australian charities, having a physical presence in Australia and incurring its expenditure and pursuing its objectives principally in Australia.

FCT v Word Investments Ltd

[2008] HCA 55; 236 CLR 198; 70 ATR 225; 2008 ATC 20-072 (Full High Court)

Facts: Word Investments was an Australian company that acted as a financial provider to Wycliffe, the local branch of an overseas Christian missionary organisation. Wycliffe was endorsed as a charitable organisation with the purpose of advancing religion (formerly one of the common law tests for a charity and now one of the tests in the statutory definition of charity). Word Investments applied for similar endorsement. Wycliffe’s primary activity was supporting missionary work overseas by its parent body. Word Investments had carried on businesses and held investments to generate profits to contribute to Wycliffe and other similar Christian groups. The Commissioner denied Word Investments the endorsement it sought on the basis that it was a commercial organisation and not a charity. The Commissioner asserted that merely paying its profits to an evangelical body did not make Word Investment’s operations incidental to a religious purpose and was therefore not an organisation instituted to advance religion. The Commissioner also argued that as most of the money was used to support missionary activities overseas, Word Investments did not meet the qualifying condition set out in s 50-50 ITAA 1997 of incurring its expenditure and pursuing its objectives principally in Australia. 320

© Thomson Reuters 2019

CHAPTER 15

EXEMPT ORGANISATIONS

Decision: The Full High Court concluded that an institution can be charitable where it does not engage in charitable activities beyond making profits which are directed to charitable institutions which do engage in charitable activities. The institution’s charitable purpose is the object of the bodies to which it distributes funds if the application of the funds to that purpose is a natural and probable consequence of deriving profits and distributing them in this way. Word Investments also satisfied the presence in Australia requirement as the decisions to pay were made in Australia, the payments were made in Australia, and the payments were made to Australian organisations. Relevance of the case today: Subsequent to the Word Investments case, conditions in the ITAA 1997 for exemption were changed and today a taxpayer would have to be a registered charity to qualify for the exemption, as well as satisfying conditions in Division 50 ITAA 1997. The decision remains a precedent under the new rules for a charitable purpose that is “advancing religion” (relevant to the definition of “charity” in the Charities Act 2013, the type of entity that can be registered under the Australian Charities and Not-for-profits Commission Act 2012). It is also a precedent for when a charity will be considered to be incurring its expenditure in Australia and pursuing its objectives principally in Australia. If it happened today: To qualify for an exemption today under s 50-1 ITAA 1997, the taxpayer in Word Investments would have to show that it was a “registered charity” as required by s 50-5(1). The term “registered charity” is defined in s 995-1 ITAA 1997 as a charity that is registered under the Australian Charities and Not-for-profits Commission Act 2012. Section 5 Charities Act 2013 defines the term “charity” for all Commonwealth Acts. The definition of charity sets out two conditions: the entity has a charitable purpose and it is a not-for-profit entity. If a court were to consider the taxpayer’s activities to be “advancing religion” as it did in Word Investments, the taxpayer would have a “charitable purpose” under s 12(1)(d) Charities Act 2013. The government had introduced legislation to define a “not-for-profit” entity but this was not passed into law and the term is therefore defined using common law notions. Under common law, an entity will be a not-for-profit entity if it cannot distribute profits to its members or use the profits for the benefit of its members. The entity in Word Investments appears to satisfy this condition. It thus appears to satisfy both limbs of the definition of charity in the Charities Act and meet the basic condition for registration. The ITAA 1997 sets out two further conditions for exemption. Section 50-47 sets out a condition that if the taxpayer is an “ACNC type of entity”, it must be a registered charity under the Australian Charities and Not-for-profits Commission Act 2012. The definition of an “ACNC type of entity” in s 995-1 ITAA 1997 refers to the list of entities in s 25-5(5) Australian Charities and Not-for-profits Commission Act 2012, which includes an “entity with a purpose that is the advancement of religion”. The entity would therefore be an ACNC type of entity and thus meets a requirement for registration. Section s 25-5(3) Australian Charities and Not-for-profits Commission Act 2012 also requires the entity to be a “not-for-profit” entity. As noted, there is no © Thomson Reuters 2019

321

AUSTRALIAN TAXATION LAW CASES 2019

definition in the law of a not-for-profit entity but under the common law meaning, the entity in Word Investments would likely qualify as a not-for-profit entity. The second further condition in the ITAA 1997 for exemption is that the entity satisfy the conditions in s 50-50 ITAA that it have a physical presence in Australia, incur its expenditure in Australia and pursue its objectives principally in Australia. The entity in Word Investments was found to meet these conditions. The government introduced legislation in 2012 to modify the conditions in s 50-50 ITAA 1997 with the object of disqualifying an entity such as the entity in Word Investments from meeting the “in Australia” condition if it passed funds to another entity to be used outside Australia. The amendments were not legislated prior to a change of government but the proposed change remains on the new government’s work plan.

FCT v Aid/Watch Incorporated

[2010] HCA 42; 77 ATR 195; 2010 ATC 20-227 (Full High Court)

Facts: Aid/Watch was a charitable institution endorsed by the Commissioner. After a number of years, the Commissioner revoked the endorsement on the basis that the institute’s activities of monitoring aid programs and publicising information about their effectiveness constituted political activities, rather than charitable objects of relief of poverty and advancement of education as claimed by the institution. Aid/Watch appealed successfully to the AAT, but the Federal Court and then the Full Federal Court found in favour of the ATO on the basis that Aid/Watch’s main activity was influencing government and this was not changed by the indirect method used. Aid/ Watch appealed to the Full High Court. Decision: The Full High Court concluded the generation of public debate over the effectiveness of foreign aid activities satisfied the meaning of charitable activities as a purpose beneficial to the community, one of the four heads of “charity” under the common law definition, because its activities contributed to the public welfare. The Court further concluded that there is no general doctrine in Australia which excludes “political objects” from charitable purposes. Relevance of the case today: Subsequent to the Aid/Watch case, the government replaced the common law definition of “charity” with a statutory definition in s 5, Charities Act 2013. There are two limbs to the definition, first that the entity is a not-for-profit entity and second that all of its purposes are charitable purposes. While the common law definition of “charity” had four limbs, with the fourth limb being a broad, general sweep up measure, “other purposes beneficial to the community”, s 12 Charities Act 2013 sets out 10 arguably narrower purposes with an eleventh sweep up purpose tied back to the specific list: “any other purpose beneficial to the general public that may reasonably be regarded as analogous to, or within the spirit of” the 10 listed purposes. The statutory definition thus appears to be narrower than the common law definition. However, one of the listed purposes is “the purpose of advancing social or public welfare” which is similar to the “contribute to public welfare” characterisation of the entity in Aid/Watch. It is likely, therefore, that Aid/Watch could be used as a precedent 322

© Thomson Reuters 2019

CHAPTER 15

EXEMPT ORGANISATIONS

to show that generation of public debate over foreign aid activities is a charitable purpose. The case is also a precedent for the proposition that engaging in information campaigns related to charitable goals falls within the concept of charitable purpose even where the campaigns are intended to have political effects. If it happened today: If the facts in Aid/Watch were to arise today, a court would likely find the entity’s activities fell within the definition of a charitable purpose as defined in s 12 Charities Act 2013 and the entity was a charity. It could, therefore be registered as a registered charity and qualify for an income tax exemption. The definition of a “charitable purpose” excludes a purpose that is a “disqualifying purpose”, defined in s 11 Charities Act 2013. A note embedded in s 11 indicates that promoting a change to any matter established by law in the Commonwealth would not be a disqualifying purpose. The political consequences of the activities of Aid/Watch would therefore not disqualify it from having a charitable purpose.

© Thomson Reuters 2019

323

C HAPTER 16

Companies and Shareholders IS AN INVESTMENT IN A COMPANY A DEBT OR EQUITY INTEREST? ........................................................................................................... 326 D Marks Partnership (2016).................................................................. 326 DIVIDENDS PAID OUT OF PROFITS ............................................................. “Paid” Out of Profits ................................................................................... Brookton Co-operative Society Ltd (1981) ............................................ Gift to a Company ...................................................................................... Slater Holdings Ltd (1984) .................................................................... Cancellation of Shares ................................................................................. Uther (1965) ..........................................................................................

327 327 328 328 328 329 329

DIVIDENDS PAID TO “SHAREHOLDERS” ................................................... 330 Patcorp (1976) ....................................................................................... 330 DEEMED DIVIDENDS ....................................................................................... Deemed Dividends on Formal Winding Up ............................................... Glenville Pastoral (1963) ...................................................................... Gibb (1966) ............................................................................................ Harrowell (1967) ................................................................................... Deemed Dividends on Informal Winding Up ............................................. Stevenson (1937) .................................................................................... Blakely (1951) ........................................................................................ Deemed Dividends from Shareholder Loans............................................... Black (1990) ........................................................................................... Deemed Dividends from Share Buy-backs ................................................. Consolidated Media Holdings Ltd (2012) .............................................

331 331 331 332 332 335 335 335 336 336 336 337

CARRIED-FORWARD LOSSES ........................................................................ 338 J Hammond Investments Pty Ltd (1977) ................................................ 338 Avondale Motors (Parts) Pty Ltd (1971) ............................................... 339 PRIVATE COMPANY OR PUBLIC COMPANY .............................................. 340 Brookton Co-operative Society Ltd (1981) ............................................ 340

© Thomson Reuters 2019

325

C HAPTER 16

Companies and Shareholders IS AN INVESTMENT IN A COMPANY A DEBT OR EQUITY INTEREST? Company profits are distributed to shareholders by way of dividends. A dividend is defined in s 6 ITAA 1936 as a distribution made by a company to its shareholders. It is distinguished from interest paid to lenders to the company – dividends are distributions of profit and there is no deduction allowed to a company in respect of the dividends it pays. Interest may be an expense incurred to derive assessable income and consequently be a deductible expense for the company. Payments made in respect of debt interests in a company will be treated as interest and payments made in respect of equity interests in a company will be treated as dividends. However, between simple debts and shares lie a wide range of instruments such as convertible debt, hybrid securities, and so on, that are not obviously classified as loans or shares. The starting point for any investment interest that is not unambiguously a share in a company or a loan to the company is Division 974 ITAA 1997 which provides detailed rules for distinguishing what are called debt interests and equity interests in a company. A key distinction between debt and equity is whether the investment gives rise to a contingent or noncontingent obligation by the company to repay the amount invested to the investor. A contingent right to repayment identifies an equity interest in a company while a noncontingent right to repayment of the investment identifies a debt interest.

D Marks Partnership v FCT

[2016] FCAFC 86; 103 ATR 439 (Full Federal Court)

Facts: The taxpayer was a limited partnership that is treated as a company for Australian income tax purposes under s 94J ITAA 1936. The taxpayer subscribed for shares in a special class of shares issued by a company called HL Securities Pty Ltd. The constitution of HL Securities allowed for the redemption of shares of this class at the earlier of any time chosen by the directors or 47 months from the date of issue. HL Securities made payments to the taxpayer which were characterised as dividends by HL Securities and the taxpayer. The dividends carried franking imputation credits which could be used by the shareholder to offset tax owed by the shareholder. The Commissioner argued that because the interests acquired by the taxpayer would be 326

© Thomson Reuters 2019

CHAPTER 16

COMPANIES AND SHAREHOLDERS

redeemed within a specified period, they satisfied the test in s 974-20 ITAA 1997 used to identify a debt interest. This would mean the payments received by the taxpayer would not be treated as frankable dividends. Decision: The Court agreed with the Commissioner that the redeemable shares held by the taxpayer were debt interests and not equity interests in HL Securities. The Court found the conditions attached to the redeemable shares created a non-contingent obligation on the company to provide a financial benefit to the taxpayer by way of repayment of its investment. This satisfied definition of a debt interest and it followed that the payments received by the taxpayer were not frankable dividends. Relevance of the case today: The D Marks Partnership case illustrates one of the principal tests used to distinguish debt interests and equity interests (loans or shares) in a company, namely whether the company has a contingent or non-contingent obligation to provide a financial benefit to the investor. If a share is a redeemable share with a guaranteed redemption date, it will be treated as a non-contingent obligation of the company and the investment interest will be considered a debt interest. If it happened today: If the facts in D Marks Partnership were to arise today today, the taxpayer’s interest would once again be characterised as a debt interest because of the redeemable feature of the shares. As a result, the payments in respect of the shares would not be treated as frankable dividends

DIVIDENDS PAID OUT OF PROFITS It is likely that dividends paid to shareholders would constitute ordinary income and be assessable under s 6-5(1) ITAA 1997. Nevertheless, the ITAAs have always had a separate inclusion provision for dividends and this provision, currently s 44(1) ITAA 1936, has been treated by the courts and Commissioner as the only gateway into assessable income for dividends. Section 44(1) draws upon the definition of “dividend” in s 6 ITAA 1936 and contains a condition that to be assessable, a dividend must be “paid” out of “profits” of the company. The construction raises two issues: when are profits “paid” and what constitutes a payment out of “profits”. The term “profits” is not defined in the legislation and the question arises as to whether the meaning coincides with the accounting concept of profits.

“Paid” Out of Profits A company may only pay dividends out of profits. Companies sometimes declare “interim” dividends in anticipation of continuing profit levels but if the profits fail to materialise they are permitted to cancel the interim dividends.

© Thomson Reuters 2019

327

AUSTRALIAN TAXATION LAW CASES 2019

Brookton Co-operative Society Ltd v FCT

(1981) 147 CLR 441; 11 ATR 880; 81 ATC 4346 (Full High Court)

Note: A second issue raised in Brookton Co-operative Society Ltd was whether the company was a private or public company. A further summary of the case dealing with this issue is found under the “Private Company or Public Company” heading. Facts: The taxpayer was a shareholder in a second company that had derived income subject to a contingent liability. The directors of the second company concluded the changes of the contingency arising were remote and declared an interim dividend to the taxpayer which was recorded as a debt owing to the taxpayer in the second company’s books and in the books of the taxpayer. Subsequently, the contingency to which the second company was liable materialised and the company was required to use the funds that had been earmarked for payment of the dividend to satisfy the contingency. It rescinded the dividend in its books and informed the taxpayer. The Commissioner considered the interim dividend to have been paid when the second company declared the interim dividend and recorded a debt. Decision: Mason J, which whom the rest of the Court agreed, concluded there had been no debt due to the taxpayer created and the interim dividend could be validly rescinded. As a result, no dividend had been paid to the taxpayer in terms of s 44(1) ITAA 1936. Relevance of the case today: Brookton Co-operative Society Ltd remains the key authority for the proposition that declaration of an interim dividend does not constitute payment of a dividend as required by s 44(1), even if the company declaring the dividend creates a book entry for a debt for the interim dividend. If it happened today: Brookton Co-operative Society Ltd continues to be followed and if the facts of the situation arose today, a court would similarly hold that no dividend had been paid where a company declares an interim dividend.

Gift to a Company FCT v Slater Holdings Ltd

(1984) 156 CLR 447; 15 ATR 1299; 84 ATC 4883 (Full High Court)

Facts: The taxpayer company was a shareholder in Ogg Holdings Ltd, which paid a dividend sourced from revenue profits, capital profits and a gift contributed to Ogg Holdings by another shareholder. The taxpayer argued that Ogg Holdings’ profits for s 44(1) ITAA 1936 purposes did not include any amount received by Ogg Holdings as a gift. Decision: Gibbs CJ, with whom the remaining members of the bench agreed, adopted the definition of profits by Moulton LJ in Re Spanish Prospecting Co Ltd [1911] 1 Ch 92 as the amount of gain made by the business during the year. The gift contributed to an increase in Ogg Holdings’ assets and represented a profit using this definition. 328

© Thomson Reuters 2019

CHAPTER 16

COMPANIES AND SHAREHOLDERS

This view was supported by expert accounting evidence. Accordingly, the dividend had been paid from profits of Ogg Holdings and was assessable under s 44(1). Relevance of the case today: Slater Holdings remains the prime authority for the proposition that the term “profits” in s 44(1) has a broad meaning similar to the accounting concept of profits, including all gains realised by a company. If it happened today: If the facts in Slater Holdings arose today, a court would similarly hold that a gift received by a company is included in its profits and any dividend paid from the part of the profits constituted by the gift, would be assessable to the recipient shareholder under s 44(1).

Cancellation of Shares FCT v Uther

(1965) 112 CLR 630 (Full High Court)

Facts: The taxpayer was a shareholder in a company that cancelled half its issued shares and upon cancellation paid each shareholder an amount in excess of the “paid up capital” of the shares (this being the former company law term for a company’s share capital account). The Commissioner included the payment in the taxpayer’s assessable income under s 44(1) ITAA 1936, arguing that the payment was deemed to be a dividend under the definition of “dividend” in s 6(1) ITAA 1936. At the time of the case, the definition of dividend referred to any distribution by a company to a shareholder but added that a dividend did not “include a return of paid-up capital”. The taxpayer argued upon cancellation of a share the entire amount paid to the shareholder was subsumed into the paid-up capital. The Commissioner argued that a “return” of capital could not include any amount in excess of the original capital. Decision: Menzies J concluded that upon cancellation of a share, all amounts paid to the shareholder are subsumed into the paid-up capital and thus the entire payment fell outside the definition of a dividend then in effect. He and Taylor J (a majority of the three member panel) further concluded that once the payment was subsumed into paid-up capital, no part of it could be said to be paid from the retained “profits” of the company as required by s 44(1). Relevance of the case today: As noted below, the definition of dividend was amended in response to the Uther case and the direct holding of the case, that an amount paid to a shareholder upon cancellation of a share would not be a dividend under s 6(1) and would not be assessable under s 44(1), is no longer true. However, the decision may still be cited as authority for the proposition that all amounts paid upon cancellation of a share are outside the ordinary concept of a dividend and may only be assessed if the legislation specifically deems the amount to be a dividend. If it happened today: The definition of “dividend” was amended in response to the Uther case and currently applies to “any distribution” by a company to a shareholder subject to some exceptions, including a payment debited against the “share capital © Thomson Reuters 2019

329

AUSTRALIAN TAXATION LAW CASES 2019

account” of a company. The effect of the original change and the current provision would be to deem all amounts paid on cancellation in excess of the share capital account to be a dividend. Since the reference is to a specific account, it would not be possible for other amounts to be subsumed into the portion that escapes the definition of dividend. As a result, it could be said that the excess is paid from retained “profits” as required by s 44(1).

DIVIDENDS PAID TO “SHAREHOLDERS” Section 44(1) ITAA 1936 includes dividends received by a shareholder in the shareholder’s assessable income. Often, corporate investors purchase shares through “nominee” companies who hold the shares on behalf of the underlying shareholder. The question which arises in this circumstance is whether the nominee shareholder or the company on whose behalf the share is held should be treated as the shareholder for s 44(1) purposes (inclusion of the dividend in assessable income) or the “member” of the company for the purpose of entitlement to use a tax offset for franked dividends as determined under Division 207 of Part 3-6 ITAA 1997, the effect of which is explained in s 200-35 ITAA 1997. While the answer to the question seems clear in terms of the case law, based on the Patcorp case below, the Commissioner does not follow the answer consistently. He tends to apply the law strictly in a dividend stripping case but simply looks through the nominee shareholder in ordinary cases. The case of David Jones Finance and Investments Pty Ltd & Anor v FCT (1991) 21 ATR 1506; 91 ATC 4315 shows there is no estoppel restriction on the Commissioner – the fact that he may have looked through the nominee shareholder in the past does not prevent him from applying the law strictly in the case of a dividend stripping scheme.

Patcorp Investments Ltd & Ors v FCT

(1976) 140 CLR 247; 6 ATR 420; 76 ATC 4225 (Full High Court)

Facts: The taxpayer was engaged in dividend stripping operations. A dividend stripping arrangement is an arrangement to allow a company owner to extract retained profits from the company as a capital gain rather than a taxable dividend. This is done by selling the company to a dividend stripping company which declares a dividend to itself and then uses the dividend it receives to pay the purchase price for the company. Sometimes, to facilitate the scheme, the original owner “lends” the purchase price to the dividend stripper and the dividend stripper then repays the loan using the dividends it receives after it becomes the new owner and declares a dividend. The original owner thus receives the value of the retained earnings (less the fee charged by the dividend stripping company) as a preferentially taxed capital gain rather than a fully taxed dividend. The dividend stripper would then sell the shares in the stripped company for a token amount and claim a loss on the shares on the basis that the taxpayer was a share trader and this was an ordinary trading loss. The dividend stripping schemes were possible because prior to 30 June 2002, inter-corporate dividends of this sort were tax-free thanks to an inter-corporate dividend rebate in s 46 ITAA 1936. The taxpayer had engaged in eight dividend stripping schemes. In the first seven schemes, the dividend stripper became the registered shareholder of the firms it had 330

© Thomson Reuters 2019

CHAPTER 16

COMPANIES AND SHAREHOLDERS

purchased. In the eighth case, the taxpayer was the purchaser but the shares were registered to nominee shareholders and their names rather than the taxpayer’s appeared on the shareholder register of the company being stripped. The Commissioner attacked the schemes on various grounds including the former general anti-avoidance provision in s 260 ITAA 1936 and the entitlement of the shareholder to a s 46 inter-corporate dividend rebate. Decision: The High Court upheld the effectiveness of the dividend stripping scheme in the first seven cases, concluding the taxpayer was entitled to use the s 46 inter-corporate dividend rebate to receive the dividends tax-free. A majority of the High Court concluded that the taxpayer was not entitled to an inter-corporate dividend rebate in the eighth case, however, as the inter-corporate dividend rebate in s 46 was only available to the actual registered shareholder, not the underlying shareholder who owned shares via nominee holders. Relevance of the case today: The Commissioner raised the s 46 rebate question in an attempt to stop a dividend stripping tax avoidance scheme. He had not previously denied taxpayers access to the inter-corporate dividend rebate where they held shares through nominee holders in cases that were not part of tax avoidance arrangements and subsequent to the Patcorp case, he continued to allow investors to access the inter-corporate dividend rebate when they were not involved in dividend stripping schemes. The inter-corporate dividend rebate was abolished from 30 June 2002. Since that time, inter-corporate dividends are assessable to the recipient company but the recipient is entitled to a tax offset under s 207-20(2) ITAA 1997 if the dividend is franked. Patcorp shows that, strictly speaking, the franking offset should not be available to shareholders whose shares are held through nominee holders. However, the strict reading is unlikely to be applied unless the shareholder is holding the shares as part of a dividend stripping scheme. If it happened today: If the facts in Patcorp arose today, the taxpayer would be assessable under s 44(1) on all dividends received from the first seven companies and would be entitled to tax offsets under s 200-35 to the extent the dividends were franked. The nominee holder would be assessable on the dividends from the eighth company and entitled to any tax offsets tied to franked dividends.

DEEMED DIVIDENDS Deemed Dividends on Formal Winding Up Glenville Pastoral Co Pty Ltd (In Liquidation) v FCT (1963) 109 CLR 199 (Full High Court)

Facts: The taxpayer was a private company that held shares in another private company, Killen. The taxpayer received a distribution of retained profits from Killen when Killen was liquidated and it treated the distribution as a deemed dividend under s 47(1) ITAA 1936. At the time of the case, private companies were subject to an “undistributed © Thomson Reuters 2019

331

AUSTRALIAN TAXATION LAW CASES 2019

profits tax” if they failed to make a sufficient distribution by way of dividend to shareholders during the income year. The taxpayer itself liquidated and treated its distributions to shareholders as a deemed dividend under s 47(1), thus satisfying its sufficient distribution requirement. The Commissioner refused to recognise the entire distribution as a deemed dividend. He argued that the deemed dividends received by the taxpayer were included in the taxpayer’s assessable receipts under s 47(1) but were not “income” of the taxpayer in the ordinary meaning of that term. He argued that the taxpayer’s distributions could only be deemed dividends by the taxpayer under s 47(1) if they were paid from amounts that had been “income” to the taxpayer as required by that section. A second issue raised in the case is the exception to the deemed dividend provision for income that is “properly applied to replace a loss of paid-up share capital”. The Commissioner noted that the taxpayer company had shown a loss of share capital on its books from previous years when its outgoings exceeded its revenue. The Commissioner argued that income of a company must first be considered to have been retained and applied to replace the loss of paid-up share capital and only once the loss had been made good could additional revenue be distributed. By treating part of the taxpayer’s income as if it had been applied to replace the loss of paid-up share capital, the Commissioner showed the remaining funds available for distribution were insufficient to enable the taxpayer to make a sufficient distribution. The taxpayer’s counter argument was that income derived by a company could only be applied to replace a loss of paid-up share capital if the taxpayer made a formal resolution to apply its profits in this manner and made a formal entry in its financial accounts showing how the income had been applied to make up the loss. If the taxpayer chose not to follow this procedure, it was free to distribute income to shareholders as dividends and continue to show a loss of share capital in its financial accounts. Decision: The High Court held that the deemed dividend received by the taxpayer took on a “revenue” character when it was included in the taxpayer’s assessable income. The receipt could thus be considered income derived by the taxpayer for the purpose of applying s 47(1) when the amount was subsequently distributed to the taxpayer’s shareholders. With respect to the second issue, the High Court said that the application of income to replace a loss of paid-up share capital requires a formal application, not simply an after-the-fact assertion that income must have been used that way because the company had suffered a loss of paid-up share capital. Relevance of the case today: The Glenville Pastoral case was one of several important cases on the meaning of “income” in s 47(1) (see also Gibb v FCT (1966) 118 CLR 628 and Harrowell v FCT (1967) 116 CLR 607) prior to amendment of that section. The insertion of s 47(1A) ITAA 1936 in 1987 ended the need to reconcile the cases to ascertain the meaning of “income” in s 47(1). The case is thus of historical interest only in terms of the meaning of “income” in s 47(1). If it happened today: If the facts in Glenville Pastoral occurred today, the issue would be decided by reference to s 47(1A) and not the analysis followed in the case. Because the deemed dividend received by the taxpayer was included in its assessable income, 332

© Thomson Reuters 2019

CHAPTER 16

COMPANIES AND SHAREHOLDERS

s 47(1A) would treat it as income for s 47(1) purposes and upon liquidation of the taxpayer it would thus constitute deemed dividends to the taxpayer’s shareholders.

Gibb v FCT

(1966) 118 CLR 628 (Full High Court)

Facts: The taxpayer was a shareholder of a company called Gibbsons that went into liquidation. The liquidating company had received bonus shares from a subsidiary it had owned. The bonus shares did not constitute ordinary income but they were deemed to be dividends received by Gibbsons under the expanded definition of dividend in s 6(1) ITAA 1936. Under s 47(1) ITAA 1936, as the section then stood, distributions to the taxpayer by the liquidator for Gibbsons would only be deemed dividends under s 47(1) if it could be shown that they were paid out of “income” derived by Gibbsons. The question thus arose whether the effect of deeming bonus shares to be dividends would be to characterise the bonus shares as income for the purposes of s 47(1). Decision: The reference to “income” in s 47(1) is a reference to ordinary income or statutory income. The inclusion of bonus shares in the definition of a “dividend” does not affect the character of the bonus shares as income or an amount that is not income. The fact that s 44(1) ITAA 1936 brings dividends (including deemed dividends) into assessable income does not mean the bonus shares acquire an income character. In particular, bonus shares that are assessed under s 44 do not constitute “income” for the purpose of applying s 47(1). Relevance of the case today: The High Court decision in Gibb was difficult to reconcile on its face with the decision by the High Court in Harrowell v FCT (1967) 116 CLR 607 the following year where a different type of deemed dividend was treated as income for the purpose of applying s 47(1). The insertion of s 47(1A) ITAA 1997 in 1987 ended the need to reconcile the cases to ascertain the meaning of “income” in s 47(1). Section 47(1A) treats amounts included in assessable income as income for the purpose of applying s 47(1) whether or not the amounts acquire a revenue character as ordinary income. The case is thus of historical interest only in terms of the meaning of “income” in s 47(1). If it happened today: If the facts in Gibb occurred today, the issue would be decided by reference to s 47(1A) and not the analysis followed in the case. Because the deemed dividend received by the taxpayer was included in its assessable income, s 47(1A) would treat it as income for s 47(1) purposes whether or not the receipt acquired a revenue character as ordinary income and upon liquidation of the company it would thus constitute deemed dividends to the company’s shareholders.

Harrowell v FCT

(1967) 116 CLR 607 (Full High Court)

Facts: The taxpayer was an individual (a trustee) who held shares in a private company, Glenville Pastoral, that went into liquidation. The proceeds distributed to © Thomson Reuters 2019

333

AUSTRALIAN TAXATION LAW CASES 2019

the taxpayer came from an amount that was originally received by Glenville Pastoral as deemed dividends from another company that went into liquidation. The High Court had previously decided in Glenville Pastoral Co Pty Ltd (In Liquidation) v FCT (1963) 109 CLR 199 (Full High Court) that distribution of amounts received as a deemed dividend could itself be a deemed dividend for the purpose of determining whether the liquidating company had made a “sufficient distribution” to avoid the undistributed profits tax. This case involved the assessability of the same distributions in the hands of the shareholder. Under s 47(1) ITAA 1936, an amount received on distribution by a liquidator would be deemed to be a dividend provided it represented “income” derived by the company being liquidated. The question for the Court, therefore, was whether a s 47(1) deemed dividend received by a company would constitute income of the company for the purpose of characterising subsequent distributions by the company’s liquidator. Decision: Consistent with its views in Glenville Pastoral where the High Court had said the distributions were deemed dividends from the liquidating company’s perspective, the Court treated the distributions as s 47(1) deemed dividends to the shareholder. A deemed dividend received by a company acquires a revenue character as ordinary income and as a result constitutes “income” to the company for the purpose of applying s 47(1) to distributions by a liquidator of the company that received deemed dividends. Relevance of the case today: The Harrowell case was consistent with Glenville Pastoral with respect to the meaning of “income” in s 47(1) prior to amendment of that section. In the eyes of many observers, however, it was difficult to reconcile with the decision in Gibb v FCT (1966) 118 CLR 628. In that case, the High Court held that a deemed dividend in the form of a bonus share would not constitute income for the purpose of a subsequent application of s 47(1). The only apparent way to reconcile Harrowell and Gibb is to treat deemed dividends in the form of liquidation distributions as income of the receiving company ((Harrowell Harrowell)) while deemed dividends in the form Harrowell of bonus shares are not income of the receiving company (Gibb) for the purpose of subsequent application of s 47(1) on liquidation of the receiving company. The insertion of s 47(1A) ITAA 1997 in 1987 ended the need to reconcile the cases to ascertain the meaning of “income” in s 47(1). The case is thus of historical interest only in terms of the meaning of “income” in s 47(1). If it happened today: If the facts in Harrowell occurred today, the issue would be decided by reference to s 47(1A) and not the analysis followed in the case. Because the deemed dividend received by the taxpayer was included in its assessable income, s 47(1A) would treat it as income for s 47(1) purposes whether or not the receipt acquired a revenue character and upon liquidation of the company it would thus constitute deemed dividends to the company’s shareholders.

334

© Thomson Reuters 2019

CHAPTER 16

COMPANIES AND SHAREHOLDERS

Deemed Dividends on Informal Winding Up Commissioner of Taxation (NSW) v Stevenson (1937) 59 CLR 80 (Full High Court)

Facts: The director of a company whose assets had been sold distributed the proceeds to the shareholders. Subsequently, the shareholders voted for a voluntary liquidation of the company. The taxpayer was assessed on the distribution received as a dividend under s 11(b) (former) Income Tax (Management) Act 1928 (NSW), the equivalent to s 44(1) ITAA 1936. The legislation had no equivalent to s 47(1) ITAA 1936 deeming distributions on liquidation to be dividends. Decision: While the distributions were made prior to the appointment of a liquidator and winding up of the company, the Court viewed the distributions as distributions upon winding up and concluded the ordinary dividend inclusion provision would not apply to the proceeds. In the absence of a specific statutory provision to override the general rule, distributions on winding up are treated as capital receipts in replacement for the shares given up by the shareholder. Relevance of the case today: While the principle set out in Stevenson continues to apply (distributions on winding up are capital payments unless a deeming provision applies), the case is of little continuing relevance as a result of s 47(1) which overrides the result in the case. If it happened today: If the facts in Stevenson were to occur today and an assessment made under the ITAA, a court would likely conclude the distributions were distributions by a liquidator on a winding up (with the director’s actions treated as actions of an agent of the liquidator) and were subject to s 47(1) ITAA 1936. To the extent the distributions were paid from “income” of the company (as expanded by s 47(1A) ITAA 1997 1997), they would be deemed to be dividends and included in assessable income by s 44(1).

FCT v Blakely

(1951) 82 CLR 388 (Full High Court)

Facts: The taxpayer and his spouse were shareholders in a company which ceased to carry on business. The two shareholders satisfied the company’s debts and transferred the company’s business and assets to a partnership of which they were the sole partners. The Commissioner attempted to assess the shareholders on the basis that they had received dividends assessable under s 44(1) ITAA 1936 or deemed dividends on liquidation of company under s 47(1) ITAA 1997. Decision: There was no dividend from the company for the purpose of s 44(1) as the company had not made a distribution; rather, the owners had appropriated company assets. There was also no deemed dividend from the company under s 47(1) because there had been no distribution by a liquidator in the course of winding up the company.

© Thomson Reuters 2019

335

AUSTRALIAN TAXATION LAW CASES 2019

Relevance of the case today: Section 47 was amended following the Blakely case and the case is no longer a precedent for a way to avoid assessment on a tax-free appropriation of assets upon an informal winding up of a company. Some commentators have suggested the case may have continued relevance to other informal appropriations of assets from companies by owner/controllers. However, there have been no examples of taxpayers following this path successfully. If it happened today: Following Blakely, s 47(2A) was added to the ITAA 1936 to bring informal liquidations into the scope of s 47. If the facts in Blakely were to occur today, the distribution would be subject to s 47(2A) and assessed as dividends as s 47(1) (deeming the amounts to be dividends) brought the amount into the operation of s 44(1) (including dividends in assessable income).

Deemed Dividends from Shareholder Loans DFCT v Black

(1990) 21 ATR 701; 90 ATC 4699 (Federal Court)

Facts: The taxpayer had a loan account with a private company in which he was a shareholder. When the company wound up, the company forgave the outstanding debt owed by the taxpayer. The Commissioner sought to assess the taxpayer on the basis of s 108 ITAA 1936, which deems some loans to shareholders and associates to be dividends. The taxpayer argued s 108 applies when a loan is made and has no application to forgiveness of loans. Decision: The Federal Court agreed with the taxpayer that s 108 had no application to the forgiveness of loans. Relevance of the case today: Subsequent to the Black case (and partly in response to it), the legislature added Division 7A to the ITAA 1936 to deal with forgiveness of loans to shareholders and some other benefits provided to shareholders or associates. While the Black case remains a precedent for the interpretation of s 108, it has little practical value following the adoption of Division 7A. If it happened today: If the facts in Black arose today, the forgiven loan would be deemed to be a dividend to the taxpayer under s 109F ITAA 1936.

Deemed Dividends from Share Buy-backs The value of a company that retains profits will rise to reflect the retained earnings. A shareholder can realise this value by selling the shares for the higher value. If the shareholder is an individual and the shares are not sold in the ordinary course of business the gain will likely be a capital gain and eligible for the 50% capital gains discount. However, if the shares are purchased by the company that issued them in a transaction known as a share-buyback directly from the shareholder rather than on the stock exchange (in which case the shareholder would not know that the company is the buyer), part of the proceeds may be deemed to be a dividend under s 159GZZZP ITAA 336

© Thomson Reuters 2019

CHAPTER 16

COMPANIES AND SHAREHOLDERS

1936. The assumption behind the deeming provision is that the company is using profits that would otherwise be distributed as dividends to partly pay for the buy-back.

FCT v Consolidated Media Holdings Ltd

[2012] HCA 55; 250 CLR 503; 84 ATR 1; 2012 ATC 20-361 (High Court)

Facts: The taxpayer purchased shares from shareholders through an off-market share buy-back. The purchase price was debited from an account the taxpayer had labelled the “share buy-back reserve account”. The taxpayer had another account it called “shareholders’ equity account”. The taxpayer claimed the amounts paid were deemed dividends to the shareholder under s 159GZZZP ITAA 1936. If the amounts were dividends, they would be received free of tax by the shareholder, which was a company and entitled to an inter-company dividend rebate in effect at the time. If the amounts were not dividends, they would give rise to a capital gain on the disposal of the share by the shareholder. Section 159GZZZP ITAA 1936 deemed amounts paid in the course of an off-market share buy-back to be dividends to the extent they were not paid from a company’s share capital account. The Commissioner argued that the amounts were not dividends as they should be considered to have been debited from the company’s share capital account, which was defined at the time in s 6D ITAA 1936 (currently s 975-300 ITAA 1997 1997). Decision: The High Court found the company’s share buy-back reserve account was a share capital account and the payment was recorded as a debit against share capital. The Court concluded that the concept of a share capital account must be understood in the context of the obligation imposed on a company under the Corporations Law to keep written financial records that correctly reflected its share capital and accounts to which share capital had been allocated satisfied the definition in s 6D. As a result, the payments did not satisfy the definition of deemed dividends. Relevance of the case today: While the section containing the definition of share capital account has moved from the ITAA 1936 to ITAA 1997, the shift has not changed the definition in any way that could affect the outcome of the case. The decision is a precedent for the conclusion that the term share capital account does not refer to a single account with that specific title but rather to the totality of a company’s accounts that record equity capital amounts. If it happened today: If the facts in Consolidated Media Holdings arose today, the taxpayer would not be able to treat the proceeds for the disposal of the shares in an off-market buy-back as deemed dividends as the payment would be considered to have been debited from a share capital account.

CARRIED-FORWARD LOSSES Under s 36-15 ITAA 1997 (for individuals) and s 36-17 ITAA 1997 (for companies), taxpayers may deduct tax losses carried forward from previous years to reduce taxable income in the later years. For a brief period, a company was also able to make a “loss © Thomson Reuters 2019

337

AUSTRALIAN TAXATION LAW CASES 2019

carry back choice” to bring itself under s 160-10 ITAA 1997 and carry the loss back to the two previous years of income, recovering any consequent tax savings by way of a refundable tax offset. This was abolished in 2014 with effect from 2013 so only loss carry forward remains. To prevent the trade of “loss” companies to taxpayers who might divert otherwise taxable profits to newly purchased loss companies, s 165-10 ITAA 1997 prevents companies from deducting carried carried---forward forward or carried-back tax losses unless either one of two conditions is met. The first is a “continuity of ownership” test (set out in s 165-12 ITAA 1997 1997) which requires the company to be under the control of the same shareholders in the years in which tax losses were suffered and the years in which the company seeks to deduct the carried carried---forward forward losses. (The provisions are supplemented by Div 167 which applies to companies with unequal share rights.) The second is a “same business” test (set out in s 165-13 ITAA 1997 1997) which allows access to carried--forward carriedforward losses if the company carries on the same business following a change of ownership. There is considerable litigation on the question of what constitutes the same business. Currently, there is legislation before parliament to change the ‘same business test’ to a more flexible ‘similar business test’. This will potentially reduce the strict nature of the current test and allow more scope for businesses to innovate and expand without losing their ability to carry forward tax losses. Special loss carry-forward rules apply to companies that are recognised as designated infrastructure project entities under Division 415 ITAA 1997. The continuity of ownership and same business tests do not apply to their carried forward losses and they are allowed to “uplift” the amount of carried-forward losses by the long-term bond rate.

J Hammond Investments Pty Ltd v FCT

(1977) 7 ATR 633; 77 ATC 3211 (Supreme Court of NSW)

Facts: The Commissioner assessed the taxpayer relying on provisions in Division 7 ITAA 1936. The provisions in Division 7 imposed an “undistributed profits tax” on private companies that did not make a “sufficient” distribution of each year’s profits, as set out in a formula in the Act. Where a company’s distribution was in excess of the minimum sufficient distribution, it could carry the excess distribution forward and apply it against its sufficient distribution requirement for following years, provided it continued to carry on the same business. The taxpayer operated a venture capital business, providing capital to entrepreneurs by way of share subscriptions in new companies. Investments were made in a wide range of different types of enterprises, with the taxpayer company always taking a passive investment role through share subscriptions. Following a change in majority ownership of the taxpayer, it invested in a new venture by entering into a partnership with the entrepreneur rather than subscribing for shares in a new company. The Commissioner assessed the taxpayer for failing to make a sufficient distribution after concluding that it was not allowed to use carried-forward excess distributions because it had failed the same business test.

338

© Thomson Reuters 2019

CHAPTER 16

COMPANIES AND SHAREHOLDERS

Decision: The Court concluded that the taxpayer was carrying on the same business as it had carried on immediately before the change of ownership took place and furthermore that it did not derive income from a business of a kind that it had not carried on before the change. The investment via a partnership was of the same type as the taxpayer’s other business activities, namely investing in businesses, ventures and enterprises of various kinds. The form of the investment, while different from that used for previous investments, was an inconsequential matter. Relevance of the case today: While the J Hammond case was based on the provisions of Division 7 dealing with excess distribution carry-forward, the “same business test” set out in those provisions is very similar to the same business test in the loss carry-forward provisions of the ITAA 1997. Accordingly, J Hammond remains a useful precedent to show that changing the form through which a business is conducted does not change the character of the business itself. If it happened today: The Division 7 undistributed profits tax provisions have ceased to apply since 1986 and if the facts of the case arose today, there would be no assessment based on the undistributed profits tax. If the facts of case arose in the context of a loss carry-forward, a court would likely treat the taxpayer as satisfying the same business test set out in Subdivision 165-A ITAA 1997.

Avondale Motors (Parts) Pty Ltd v FCT

(1971) 124 CLR 97; 2 ATR 312; 71 ATC 4101 (High Court)

Facts: The taxpayer company sold and serviced motor vehicles and sold car parts to a related company, other motor dealers and traders, and the general public. Following a change of ownership, the company took over a business of selling motor vehicle parts and accessories to companies in the group it had joined, as well as to garages and the general public. The Commissioner denied the taxpayer a deduction for a carried-forward loss on the basis that the taxpayer was not carrying on the same business following the change in ownership. The new owners conceded that the primary reason for purchasing the taxpayer was to utilise its carried-forward losses. Decision: Gibbs J concluded that the legislative reference to the “same” business meant an identical business, not merely a similar business. While the taxpayer’s business after the change of ownership was the same kind of business it had previously conducted, it was not the same business as it was operated under a different name, at different places, with different directors and employees, with different stock and plant and in conjunction with a motor dealer having different franchises. Relevance of the case today: The test applied by Gibbs J is considered by some commentators to be a narrow view of the same business test but it remains an important precedent for the proposition that to satisfy the test, a business must be the same business as conducted before a change of ownership, not merely the same kind of business. Taxpayers seeking to avoid the result in Avondale will seek to maintain a continuity of as many of the business elements noted by Gibbs J as possible. © Thomson Reuters 2019

339

AUSTRALIAN TAXATION LAW CASES 2019

If it happened today: As noted, the test used by Gibbs J is considered by some to be a narrow one. A court today faced with the facts in Avondale would likely reach the same conclusion that the taxpayer was not carrying on the same business, particularly if the owners of the taxpayer once again admitted that the taxpayer was acquired primarily so its carried-forward losses could be used. Taxpayers able to show a continuity of some of the business elements cited by Gibbs J as different in that case will have a better chance of showing they satisfy the same business test.

PRIVATE COMPANY OR PUBLIC COMPANY Prior to 1986, Australia had a “classical” company and shareholder tax system under which companies were taxed on income and shareholders on dividends paid out of the income without regard to the fact that it had already been taxed when derived by the company. To prevent shareholders from deferring the second level of tax indefinitely by leaving profits in the company and reinvesting through the company, private companies were required to pay an “undistributed profits tax”. This tax was imposed if private companies failed to make a “sufficient distribution” in respect of each year’s taxable income. It was imposed only on private companies on the assumption that shareholder pressure would lead to sufficient distributions by publicly listed companies. With the abolition of the undistributed profits tax in 1986, one of the key reasons for distinguishing private and public companies disappeared. However, the distinction remains relevant for the “deemed dividend” provisions applicable to private companies in Division 7A ITAA 1936. Under these provisions, three types of arrangements may give rise to deemed dividends by a private company: excessive remuneration to a shareholder or associate, loans to a shareholder or associate, and the forgiveness of debts owed by a shareholder or associate. The definition of private company in s 103A ITAA 1936 is built in negative terms – a company is a private company unless it is a public company. The legislation then provides a broad definition of a public company designed to carve out of the Division 7A rules all companies for which it was thought the former undistributed profits tax and the current deemed dividends rules will not have to apply.

Brookton Co-operative Society Ltd v FCT

(1981) 147 CLR 441; 11 ATR 880; 81 ATC 4346 (Full High Court)

Note: A second issue raised in Brookton Co-operative Society Ltd was whether an interim dividend had been paid. A further summary of the case dealing with this issue is found under the “Dividends Paid out of Profits” heading. Facts: The taxpayer had been established as a “co-operative company” with the alleged principal object of buying wine and spirits for resale to members. However, it was used primarily as an investment vehicle after shares in other companies were gifted to the taxpayer. The taxpayer claimed it was a co-operative as defined in s 117 ITAA 1936, relying on s 117(1)(d), and therefore fell into the definition of a “public company” in s 103A(2)(b) ITAA 1936. The Commissioner argued that notwithstanding its constituent documents, the dominant object for which the taxpayer was established 340

© Thomson Reuters 2019

CHAPTER 16

COMPANIES AND SHAREHOLDERS

was to hold shares in subsidiary companies which would engage in share trading and dividend stripping operations. As a result, the Commissioner argued, the taxpayer did not satisfy the definition of a co-operative company in s 117. Decision: The primary object of a company for s 117 purposes is determined in respect of each income year and can have regard to the subjective intent of the company’s promoters, whatever the constituent documents may say. Further, the primary object of a company can be ascertained by reference to its actual activities as the dominant object in any year is to carry out the activities actually pursued. The facts of the case showed clearly that the object of the company fell outside the objects described in s 117(1)(d). Relevance of the case today: Brookton Co-operative Society Ltd illustrates the difficulty taxpayers will face if they attempt to disguise a commercial business or investment company as a co-operative in an attempt to avoid being treated as a private company. A court will look through the constituent documents to the actual activities of an alleged co-operative company to determine its primary object. If it happened today: If the facts in Brookton Co-operative Society Ltd arose today, a court would continue to look through the company’s constituent documents to determine that it failed to satisfy the definition of a co-operative company because its primary object was not an object set out in s 117(1). It would, therefore, continue to be characterised as a private company for income tax purposes.

© Thomson Reuters 2019

341

C HAPTER 17

International Aspects of Income Taxation CORPORATE RESIDENCE ................................................................................ Unit Construction Co Ltd v Bullock (Inspector of Taxes) (1960) .......... De Beers Consolidated Mines Ltd v Howe (1906)................................. Koitaki Para Rubber Estates Ltd (1940) ............................................... Malayan Shipping Co Ltd (1946) .......................................................... Bywater Investments; Hua Wang Bank Berhad (2016)..........................

345 345 346 347 348 348

INDIVIDUAL RESIDENCE ............................................................................... 349 The Common Law Test – “Reside” in Australia ......................................... 349 Levene (1928)......................................................................................... 349 Lysaght (1928) ........................................................................................ 350 Permanent Place of Abode .......................................................................... 351 Applegate (1979).................................................................................... 351 Jenkins (1982) ........................................................................................ 352 SOURCE OF INCOME ........................................................................................ Income from Property and Business............................................................ Nathan (1918) ........................................................................................ Studebaker Corporation of Australasia (1921) ..................................... United Aircraft Corp (1943) .................................................................. Personal Service Income ............................................................................. French (1957) ........................................................................................ Mitchum (1965)...................................................................................... Efstathakis (1979) .................................................................................. Dividends ..................................................................................................... Esquire Nominees Ltd (1973) ................................................................

353 353 353 353 354 355 355 356 357 357 357

WITHHOLDING TAX ON AUSTRALIAN-SOURCE INCOME DERIVED BY FOREIGN RESIDENTS ............................................................ Withholding Tax on Dividends .................................................................... ABB Australia Pty Ltd (2007) ................................................................ Withholding Tax on Interest ........................................................................ Millar (2016)..........................................................................................

359 359 359 360 360

© Thomson Reuters 2019

343

AUSTRALIAN TAXATION LAW CASES 2019

ECONOMIC OR JURIDICAL DOUBLE TAXATION .................................... 361 Russell v FCT (2011) ............................................................................. 361 TRANSFER PRICING ......................................................................................... 362 Commissioner’s Right to Issue a Reassessment ......................................... 362 WR Carpenter (2008)............................................................................. 362 Transfer Pricing Methodology .................................................................... 363 SNF (Australia) (2011) .......................................................................... 364 Chevron Australia Holdings Pty Ltd (2017) ........................................... 364 TAX TREATIES AND INTERNATIONAL AGREEMENTS .......................... Employment Income.................................................................................... Macoun (2015) ....................................................................................... Jayasinghe (2017) .................................................................................. Business Profits of an Enterprise ................................................................. Thiel (1990)............................................................................................ Virgin Holdings SA (2008) .................................................................... Permanent Establishment ............................................................................ McDermott Industries (Aust) Pty Ltd (2005) ......................................... Tech Mahindra (2016) .......................................................................... Capital Gains on the Sale of Australian Land and Land-rich Entities ......... Lamesa Holdings BV (1997) ..................................................................

344

366 366 366 367 367 368 368 370 370 371 372 372

© Thomson Reuters 2019

C HAPTER 17

International Aspects of Income Taxation CORPORATE RESIDENCE The definition of a “resident” in s 6 ITAA 1936 in respect of companies contains a three-pronged --pronged test: incorporation in Australia; carrying on business in Australia with central management and control also in Australia; and carrying on business in Australia where resident shareholders control the voting power in the company, whether or not it is centrally managed and controlled in Australia. The incorporation test is simple to apply and there have been very few disputes over the third test, carrying on business in Australia by a company controlled by Australian resident shareholders. It is the second test – a company carrying on business in Australia with central management and control also in Australia – that has given rise to considerable litigation over the years. The central management and control test derives from the UK and early UK jurisprudence continues to play an important role in the Australian interpretation of what amounts to “central management and control” of a company.

Unit Construction Co Ltd v Bullock (Inspector of Taxes) [1960] AC 351 (UK House of Lords)

Facts: The taxpayer was a UK company with subsidiaries in Kenya. Under the articles of association of the Kenyan companies, management was the responsibility of local directors and central management and control would take place in Kenya. However, following a rearrangement of the management structure of the group, the parent company in the UK started to manage the Kenyan subsidiaries directly from the UK, though this was contrary to the articles of association of the subsidiaries. The parent company sought a deduction for payments to the subsidiaries as allowed under the UK income tax law in effect at the time. The deduction was only available if the UK parent could show the Kenyan subsidiaries were UK residents. It argued the actual central management and control took place in the UK and under the central management and control test the subsidiaries were thus UK residents for tax purposes. The Inland Revenue Department argued the court should not recognise management and control being exercised contrary to the constitution of the companies.

© Thomson Reuters 2019

345

AUSTRALIAN TAXATION LAW CASES 2019

Decision: The House of Lords found the Kenyan companies were resident in the UK because actual management and central control took place in the UK. Relevance of the case today: Although Unit Construction is a UK case, it may be cited as authority for the fact that central management and control takes place where it actually happens, not at the place at which it is supposed to happen under a company’s constitution. If it happened today: Australian income tax law has no deduction for the type of payment made by the taxpayer to its subsidiary companies and the fact situation that arose in Unit Construction would not arise in the same manner today in Australia. However, it is possible that a similar situation might arise with actual management and control taking place somewhere other than where it should under the company’s constitution. If the taxpayer were an Australian subsidiary of a foreign company, the taxpayer would be incorporated in Australia and the place of effective control and management would not be relevant to whether the company was resident in Australia. It is possible that a foreign firm could operate a branch in Australia and the Australian branch managers actually control and manage the overseas company of which they are part. In this case, the ATO could apply Unit Construction to argue that the foreign company is an Australian resident because it carries on business in Australia and has central management and control in Australia. In this case, the overseas company would be subject to tax in Australia on its world-wide income, not only the income of its branch in Australia.

De Beers Consolidated Mines Ltd v Howe (Surveyor of Taxes)

[1906] AC 455 (UK House of Lords)

Facts: The taxpayer was a diamond miner incorporated in South Africa. UK tax authorities sought to assess it on worldwide income on the basis that it was a UK resident. The UK tax legislation contained no definition of a resident company. The taxpayer argued the test should be based on place of incorporation alone while the Commissioners argued the test of residency should be based on where central management and control takes place. While shareholders’ meetings took place in South Africa, the majority of the directors lived in the UK and the directors’ meetings in London were the meetings in which real control was “always exercised in practically all the important business of the company except the mining operations”. Decision: The company was resident in the UK because central management and control took place in the UK. Relevance of the case today: The relevant limb to the Australian definition of a “resident company” applies where a company is incorporated elsewhere but carries on business in Australia and has its central management and control in Australia. There is no definition in the ITAA 1936 of when a company carries on business, but if the company’s mining and sales operations were in South Africa, it would probably be concluded that the company did not carry on business in Australia. Thus, even if

346

© Thomson Reuters 2019

CHAPTER 17

INTERNATIONAL ASPECTS OF INCOME TAXATION

central management and control were in Australia, the company would not be resident in Australia. If it happened today: De Beers is cited for the proposition that central management and control of a company takes place where the board of directors meets and makes decisions about important business of a company rather than where decisions about day-to-day operations are made. The later Australian case of Koitaki Para Rubber Estates Ltd v FCT (1940) 64 CLR 15 suggested that in Australian law, central management and control might also take place where the management decisions about day-to-day operations of a company are made in addition to where the board of directors meet (ie, central management and control might occur in more than one place), although the facts did not support that conclusion in that case.

Koitaki Para Rubber Estates Ltd v FCT (1940) 64 CLR 15 (High Court)

Facts: The taxpayer was a company incorporated in Australia that operated a rubber plantation in Papua New Guinea. It sought an exemption from taxation of income derived from the sale of produce from Papua New Guinea that was available through the former s 23(n) ITAA 1936. To qualify for the exemption, the company had to show that it was a resident of Papua New Guinea. The evidence showed that central management and control was exercised through the company’s Sydney office but the resident manager in the company’s plantation enjoyed a great deal of autonomous decision-making power in respect of the day-to-day operations of the plantation. The taxpayer argued the company could be resident in two jurisdictions if control was exercised in both jurisdictions. Decision: Dixon J agreed with the taxpayer that it was possible for a company to be resident in more than one jurisdiction using the Commonwealth income tax definition of a “resident company”, but concluded in this case the taxpayer was resident only in Australia. While the plantation manager had considerable local decision-making power over the production and shipment of rubber, his powers did not extend to the control of the general or corporate affairs of the company such as matters of policy or of finance. A distinction was made between control of the company itself and control of the industrial or productive side of the company’s business. Relevance of the case today: Although the taxpayer in Koitaki Para Rubber Estates Ltd did not enjoy dual residency on the basis of shared central management and control, the case is often cited for the proposition accepted by Dixon J that it is possible for a company to have dual residency on this basis if the facts support this conclusion. It also shows that mere day-to-day control over the business operations of a company does not amount to central management and control of the company where that day-to-day control is subject to continual monitoring and supervision by the head office. If it happened today: The provision on which the taxpayer in Koitaki Para Rubber Estates Ltd was relying to claim income derived from the sale of rubber from Papua © Thomson Reuters 2019

347

AUSTRALIAN TAXATION LAW CASES 2019

New Guinea, s 23(n), was repealed in 1975. If the facts of the case arose today, the Australian resident company would be assessable on income derived from operations of its branch in Papua New Guinea. Because Papua New Guinea is not a listed country for the purposes of s 23AH ITAA 1936, the exemption in that section for branch income derived in a comparable tax jurisdiction will not apply.

Malayan Shipping Co Ltd v FCT (1946) 71 CLR 156 (High Court)

Facts: The taxpayer was incorporated in Singapore. Its controlling shareholder and one of three directors was resident in Australia and owned all shares except two owned in Singapore by nominees of the controlling shareholder. The company had chartered a ship and its business was to sub-charter the ship for commercial voyages. The controlling shareholder drew up all contracts for the business and arranged all of the company’s operations from his office in Melbourne, but sent contracts to Singapore for formal execution. The Commissioner assessed the company as an Australian resident on the basis of having central management and control in Australia and carrying on business in Australia. Decision: The Commissioner succeeded on both issues. Central management and control was interpreted as the actual decision-making which took place entirely in Australia, not the formal execution of contracts in Singapore or the functions of the board carried out in Singapore in response to directions from the controlling shareholder in Australia. The company’s business was interpreted as the organisation and settling of the charter and sub-charters, all of which was conducted in Australia. Relevance of the case today: Malayan Shipping Co is cited as authority for the proposition that central management and control is the actual decision-making for a company, not the formal execution of the director’s resolutions. It is also authority for the proposition that carrying on a business involves the steps that lead to the execution of contracts, not just the execution of the contracts. If it happened today: The propositions adopted by the court in Malayan Shipping Co continue to be applied in Australia and if the facts in that case were to arise today, a court would conclude that the Singapore-incorporated company was resident in Australia for income tax purposes.

Bywater Investments v FCT; Hua Wang Bank Berhad v FCT [2016] HCA 45; 260 CLR 169; 104 ATR 82

Facts: All but one of the directors of three of the taxpayer companies were resident in Switzerland. When meetings of directors were held, they took place in Switzerland. Hua Wang Bank Berhad, the other taxpayer, was incorporated in Samoa and most of its directors were employees of a Samoan international trustee and corporate service provider. The Commissioner issued assessments in respect of profits derived from the purchase and sale of shares listed on the Australian Stock Exchange. The primary 348

© Thomson Reuters 2019

CHAPTER 17

INTERNATIONAL ASPECTS OF INCOME TAXATION

judge found that the real business was conducted by an Australian Mr Gould an Australian resident, without the involvement of any of the directors. The primary judge held that the “central management and control” of the taxpayers was in Australia so each taxpayer was liable to tax as an Australian resident. On appeal, the Full Court of the Federal Court rejected the taxpayers’ argument that their central management and control was situated abroad because the meetings of their boards of directors were held abroad. The taxpayers appealed to the High Court. Decision: The High Court dismissed the appeal and held that the taxpayers were Australian residents for income tax purposes. The Court held that the fact that the boards of directors were located abroad was insufficient to locate the residence of the taxpayers abroad in circumstances where the boards of directors had abrogated their decision-making in favour of Mr Gould and only met to mechanically implement or rubber-stamp decisions made by him in Australia. Relevance of the case today: The case of Bywater makes it clear that the residence of a company is a question of fact and degree to be answered according to where the central management and control of the company is actually located. This is to be determined by reference to the company’s business and trading, rather than by reference to the documents establishing its formal structure. If it happened today: If the facts in Bywater happened today, the court would find that the taxpayers had their central management and control in Australia and carried on business in Australia. Therefore, they would be taxed as residents of Australia. The taxpayers would not be able to argue that their central management and control was in a foreign jurisdiction simply because board meetings were held there to “rubberstamp” the actual decisions made in Australia. More broadly, the Commissioner’s views on how to apply the central management and control test of company residency following Bywater are set out in Taxation Ruling TR 2018/5.

INDIVIDUAL RESIDENCE The definition of a “resident” in s 6 ITAA 1936 in respect of individuals is based on a common law concept of residency – “a person who resides in Australia” to which are added three statutory tests based on domicile in Australia, a 183-day presence in Australia test, and membership in a government superannuation fund. The domicile test and 183-day test are subject to an exception if the taxpayer’s “permanent place of abode” is outside Australia.

The Common Law Test – “Reside” in Australia Levene v Inland Revenue Commissioners [1928] AC 217 (UK House of Lords)

Facts: The taxpayer sold his house in 1918 and lived in hotels in the UK for the following two years. For the next five years he lived in hotels in the UK and abroad, © Thomson Reuters 2019

349

AUSTRALIAN TAXATION LAW CASES 2019

spending less than half a year in the UK. He retained his UK citizenship. He acquired a house in France in 1925. Decision: While the taxpayer no longer had a settled or usual abode to which he returned, none of the purposes for which he went abroad were more than temporary purposes. The House of Lords agreed that the taxpayer continued to reside in the UK during this period. The Court agreed with the Commissioners that the taxpayer ceased to be a resident of the UK when he acquired a permanent house in France. Relevance of the case today: The Levene case is cited as authority for the proposition that a person will not lose residence in a jurisdiction until they acquire a new residence in another jurisdiction. Taxpayers seeking to avoid this result will try to establish a base in another jurisdiction so their travels are seen to be travels from a base to which they regularly return. If it happened today: If the facts in Levene arose today in Australia, an Australian court would likely apply the Levene precedent to find the taxpayer was a resident under the common law test of residency. In Australia the Commissioner might rely additionally on the statutory domicile test as there was no evidence that the taxpayer had changed his domicile and had clearly not acquired any permanent place of abode elsewhere.

Inland Revenue Commissioners v Lysaght

[1928] AC 234 (UK House of Lords)

Facts: The taxpayer retired and moved his family from England to Ireland in 1919. He retained no place of abode in the UK and his main bank account was in Ireland but retained ownership of a rural field in the UK and had a small bank account for use in England. He visited England once a month on business for more than one week, usually staying in a hotel but sometimes staying with his brother. He retained membership in a Club, though he rarely used the Club’s facilities. Inland Revenue assessed the taxpayer as a resident of the UK and he appealed. At first instance, the General Commissioners decided on the facts available that the taxpayer was a resident of the UK. The Court of Appeal reversed the decision and the Commissioners appealed to the House of Lords. Decision: The House of Lords concluded the question whether the taxpayer was a resident of the UK was a question of fact and the first instance decision had been a decision based on the facts considered by the appeal body. Since it was a question of fact and not one of interpretation of the law, the House of Lords decided the question could not be appealed to a higher court. However, in the course of the judgment, the judges did explain why the conclusion on the facts that the taxpayer was a resident of the UK could have been reached by the first instance tribunal. Relevance of the case today: While the Lysaght case is based on technical reasoning – the appeal court should not overturn a finding of fact by the first instance tribunal – the judges explained why the facts could lead to the conclusion that Mr Lysaght was a resident of the UK and the case is cited as authority a person could be resident at a 350

© Thomson Reuters 2019

CHAPTER 17

INTERNATIONAL ASPECTS OF INCOME TAXATION

place away from his or her home if the stays are not casual and uncertain but are part of the ordinary course of the person’s life. If it happened today: The income derived by the taxpayer in Lysaght would have been income sourced in the jurisdiction. If the facts in Lysaght arose today, the Commissioner is unlikely to pursue the taxpayer as a resident. More likely, the Commissioner would treat the taxpayer as a non-resident assessable on Australian-source income. Tax would have been collected on the income by way of the withholding tax imposed on interest paid to a non-resident based on the taxpayer’s home address. While the basic principle in Lysaght that frequency, regularity and duration of visits are factors that can point to residency in Australia, it is not clear that an Australian court would reach the same decision as the first instance tribunal in the UK based on the limited time spent in the country and the fact that the taxpayer had a permanent place of abode in Ireland.

Permanent Place of Abode FCT v Applegate

(1979) 9 ATR 899; 79 ATC 4307 (Full Federal Court)

Facts: The taxpayer was a solicitor from Sydney sent to Vanuatu to open a branch office for his firm. He gave up his rented flat in Sydney and rented a house in Vanuatu, spending the last eight months of the 1971-72 income year in Vanuatu. He lived in Vanuatu for the 1972-73 income year, returning to Sydney at the beginning of the 1973-74 income year for medical treatment and later permanently. His intention during all income years was to return to Australia eventually so he retained an Australian domicile but he argued his permanent place of abode for the 1971-72 income year following his departure from Sydney was in Vanuatu. On this basis, he claimed to be a foreign resident for the period he was abroad and exempt from Australian taxation on his salary derived in Vanuatu. Decision: The Full Federal Court concluded that a “permanent” place of abode did not mean one that was everlasting or lasting forever but rather one that was permanent in relation to a particular year of income. While the taxpayer might plan to return to Australia at some point in the future, his abode in Vanuatu was a permanent one until he made a decision to cease to reside in Vanuatu and to return to Australia. Relevance of the case today: Applegate remains an important precedent for the meaning of a “permanent abode”. The Commissioner may seek to distinguish the case where the taxpayer maintains a residence or other direct ties in Australia but the case is relied upon where ties are severed as completely as they were in Applegate. If it happened today: The approach taken by the Federal Court in Applegate continues to be followed and if the same facts arose today, the taxpayer would continue to be found to be a foreign resident of Australia. If the facts could be distinguished and the taxpayer found to be a resident of Australia, the salary derived in Vanuatu would be taxable in Australia, subject to a foreign tax offset under s 770-10 ITAA 1997 equal to

© Thomson Reuters 2019

351

AUSTRALIAN TAXATION LAW CASES 2019

the lesser of the Australian tax payable on the income and any Vanuatu tax that might be payable on the income.

FCT v Jenkins

(1982) 12 ATR 745; 82 ATC 4098 (Supreme Court of Queensland)

Facts: The taxpayer was a bank employee transferred to Vanuatu for a three year period half way through the 1976-77 income year. The taxpayer attempted to sell his family home in Australia and when he was unable to do so, he leased it to his employer and stored his furniture. He retained his Australian bank account but cancelled his Australian health insurance. As a result of work difficulties, the taxpayer’s employer transferred him back to Australia at the end of the 1977-78 income year (that is, after 18 months abroad). The taxpayer claimed his permanent place of abode was Vanuatu for the period he spent in Vanuatu and as a result he was a foreign resident for the period he was abroad and exempt from Australian taxation on his salary derived in Vanuatu. Decision: The Court applied the test in Applegate and found the taxpayer’s permanent place of abode for the second half of the 1976–77 year and the entire 1977–78 income year was in Vanuatu. Although the taxpayer had retained a residence in Australia, the evidence showed in the years in question the taxpayer had not turned his mind to returning to Australia and had no definite plans to return at a particular time. Relevance of the case today: The Commissioner has issued a public ruling listing the factors that the ATO considers when reviewing a claim that an individual is not a resident. It is the Commissioner’s view that some of the factors present in Jenkins, including retention of a home and bank account in Australia and a stay abroad of less than two years, tend to indicate an intention to return to Australia so the person remains a resident of Australia for tax purposes even though they reside abroad for a period. However, Jenkins shows that these factors can be rebutted if the taxpayer can show that he or she had not formed a definite intention to return to Australia in the year of income. If it happened today: If the facts in Jenkins arose today, the Commissioner may try to treat the taxpayer as a resident on the basis of the factors set out in the Commissioner’s public ruling. However, the taxpayer might be able to rebut the presumptions on which the ruling is made by showing that during the year of income he or she had not formed a definite plan or intention to return to Australia. If the facts could be distinguished and the taxpayer found to be a resident of Australia, the salary derived in Vanuatu would be taxable in Australia, subject to a foreign tax offset under s 770-10 ITAA 1997 equal to the lesser of the Australian tax payable on the income and any Vanuatu tax that might be payable on the income.

352

© Thomson Reuters 2019

CHAPTER 17

INTERNATIONAL ASPECTS OF INCOME TAXATION

SOURCE OF INCOME Income from Property and Business Nathan v FCT

(1918) 25 CLR 183 (Full High Court)

Facts: The taxpayer was a UK resident who derived dividends from three UK resident companies that had operations in Australia and in other countries. The Commissioner sought to assess the taxpayer on dividends to the extent they were attributable to the company’s Australian operations. The taxpayer argued that while the companies’ incomes may be derived in part from sources in Australia, his income (the dividends received) was derived from a source in the UK. Decision: The High Court concluded the taxpayer’s dividends were income from an Australian source to the extent the profits from which they were paid were derived from the companies’ Australian business operations. The Court suggested that the source of income may be traced through a company just as if it had been derived directly by a taxpayer operating through an unincorporated partnership. Relevance of the case today: Nathan is most often quoted today for the proposition that “the ascertainment of the actual source of a given income is a practical, hard matter of fact”. The quote suggests that the source of income is a question of fact and circumstances, not based on legal doctrine and each case must be decided on its own facts. The quote provides no guidance as to what facts will determine the source of income and is commonly cited by both the Commissioner and taxpayer in the same case to support their opposite positions. If it happened today: Under s 44(1)(b)(i) ITAA 1936, dividends paid by foreign companies to foreign shareholders are in theory assessable income to the shareholders to the extent the profits from which they are paid are derived from sources in Australia. There would be serious administrative difficulties in trying to enforce this rule where the company paying dividends and the shareholders receiving them are both foreign residents. Since the adoption of the imputation system in 1986, a driving principle of company and shareholder taxation has been to ensure that income derived through a company is not subject to two levels of tax without credit to shareholders for company tax. Perhaps based on the administrative concerns and the new principles underlying imputation, it appears the Commissioner no longer seeks to assess foreign shareholders on dividends received from foreign companies.

Studebaker Corporation of Australasia v C of T (NSW) (1921) 29 CLR 225 (Full High Court)

Facts: The taxpayer was a US corporation that sold cars to an Australian subsidiary (the Australian subsidiary was a party to the case acting as agent for the separate US parent company). The sales agreements, completed in the US, provided for interest to be charged on late payments for trading stock sold by the US company to the Australian © Thomson Reuters 2019

353

AUSTRALIAN TAXATION LAW CASES 2019

company. The Commissioner argued that the interest had a source in NSW as the debtor paying the interest was located in NSW. The taxpayer argued that the interest income had a source in the US as it was payable in the US and connected with the other business income derived by the US company in the US. Decision: The High Court agreed with the taxpayer that the interest was from a source in the US because it arose from business transacted in the US. Relevance of the case today: While the result in Studebaker has been changed by amendment to the ITAA, the case itself continues to be cited for various propositions with respect to the source of income. It is now often said to stand for the proposition that income payable under a contract is sourced where the contract was entered into. Today this argument is usually made in respect of income from business, as statutory rules now govern most types of passive investment income such as interest, dividends and royalties. If it happened today: The Studebaker case arose under NSW income tax legislation. Since 1942, all income tax has been levied under the Commonwealth ITAA. The ITAA contains only a limited number of source rules and judicial doctrines on the source of income continue to apply to most types of business income. However, the imposition of a withholding tax under s 128B ITAA 1936 now makes the question of source moot for most interest payments. The withholding tax is imposed on interest payable by a resident of Australia to a foreign resident. Interest on certain types of widely held instruments may be exempt from withholding tax but none of the exemptions would apply to the interest payable in Studebaker. As a result, if the facts in the case arose today, the Australian subsidiary would be required to remit tax to the Commissioner equal to 10% of the gross interest payable to the US company.

FCT v United Aircraft Corp

(1943) 68 CLR 525 (Full High Court)

Facts: The taxpayer was a US resident company that had provided information in the United States to representatives of an Australian company who used the information, including intellectual property, to manufacture aircraft engines in Australia. The intellectual property was registered in the United States but not in Australia. The Australian company paid to the US company what was described as a “royalty” for each engine manufactured. Decision: The High Court concluded the income derived by the US company had no source in Australia as the payments were not attributable to operations of the US company in Australia or to property owned by the company in Australia. As a result, the foreign resident company was not assessable on the income. Relevance of the case today: Legislative amendments since the United Aircraft case would deem the payments in that case to be royalties and to have a source in Australia (see below). The case remains relevant to the judicial tests for income source, however, as it shows payments not related to activities in Australia or property in Australia are 354

© Thomson Reuters 2019

CHAPTER 17

INTERNATIONAL ASPECTS OF INCOME TAXATION

unlikely to have a source in Australia unless they are deemed to be royalties and said to have a source in Australia by statute. If it happened today: The payments by United would now fall into the extended definition of “royalty” in s 6(1) ITAA 1936. That definition applies to s 6C ITAA 1936 which would deem the payments to have a source in Australia. The royalties would be subject to withholding tax under s 128B(2B) ITAA 1936 and that tax would be a final tax in the sense of the income being excluded from assessable income by s 128D ITAA 1936 once it has been subject to withholding tax.

Personal Service Income FCT v French

(1957) 98 CLR 398 (Full High Court)

Facts: The taxpayer was a resident of Australia, employed by an Australian company, who carried out work for the company in New Zealand. He claimed his salary was exempt from Australian taxation under s 23(q) ITAA 1936 as income derived from sources out of Australia and not exempt from income tax where derived. It was agreed that the income was subject to New Zealand tax and the issue to be determined was whether the source of his salary was New Zealand insofar as it related to the performance of services in New Zealand. Decision: Using the “hard fact” approach set out in Nathan v FCT (1918) 25 CLR 183, a majority of the High Court concluded that the service for which the taxpayer was paid was performed in New Zealand and it followed that the source of the income was New Zealand, where the services were carried out. Relevance of the case today: French is cited as authority for the proposition that the source of income from the provision of personal services is where the services are performed. While the later case of FCT v Mitchum (1965) 113 CLR 401 indicated there may be limits to this proposition, the conclusion set out in French is usually followed in personal service income cases. If it happened today: Under Article 15 of the NZ-Australia double tax agreement, a resident of Australia deriving employment income in New Zealand can be subject to tax on the employment income in both New Zealand and Australia. If the facts of French were to take place today, the taxpayer would be assessable on the income under s 6-5(1) ITAA 1997 but be entitled to a foreign tax offset under s 770-10 ITAA 1997 equal to the lesser of the Australian tax payable on the income and the New Zealand tax payable on the income.

© Thomson Reuters 2019

355

AUSTRALIAN TAXATION LAW CASES 2019

FCT v Mitchum

(1965) 113 CLR 401 (Full High Court)

Facts: The taxpayer was a well-known US actor who contracted with a Swiss company to provide services as required. The Swiss company in turn contracted with the UK-based subsidiary of an American film studio to provide the taxpayer’s services in respect of a movie filmed in Australia. The services included acting in the movie, assisting in the production, and consulting with the producer with respect to selecting and training other cast members and making revisions of the screenplay as necessary. The UK company paid the Swiss company which in turn arranged for a US company, to which it had assigned the benefit of the contract with the taxpayer, to pay the taxpayer the salary to which he was entitled from the Swiss company. The Commissioner assessed the taxpayer on this salary on the basis that it was paid for his acting in Australia and thus had a source in Australia. Decision: The High Court concluded the decision in FCT v French (1957) 98 CLR 398 did not lead to the conclusion that remuneration for personal services always had a source where the services were performed. Thus, the Court said, it was not bound to hold that the income in Mitchum was derived from Australia, although it would be open to a court to reach this conclusion. Although the decision is often misquoted as concluding that the income in the case was not sourced in Australia, the High Court did not actually reach a decision on the source of the income. Relevance of the case today: Mitchum is most often cited today to support the proposition that income from personal services will not necessarily be derived where the services are performed if the services include advisory and consulting services that do not necessarily have to be provided in the jurisdiction, even if they are provided in the jurisdiction. While the case is often cited by taxpayers seeking to show personal services income was not derived in Australia, it has limited impact because of the finding that it would be open to a court to find that the income in the case may have had an Australian source, although the Court declined to rule on this issue. If it happened today: If the facts in Mitchum arose today, the first level court would have to decide whether the income was sourced in Australia, balancing the holding in French against the advice in Mitchum that the income might not necessarily be sourced in Australia. The decision would most likely take into account whether the services could only have been performed in Australia or included consulting and other services that might have been performed elsewhere. The Court in Mitchum did not consider whether the US-Australia double tax treaty would apply. The taxpayer in that case appeared to be an employee and the payments received appear to be employment remuneration. If this is the case, under Article 15 of the US-Australia treaty, Australia has the right to tax the income, providing the court first finds it is Australian-source income. However, if the taxpayer were an independent contractor providing services in Australia to a foreign firm, under Article 14 of the treaty, the taxpayer can only be subject to tax in Australia if the income is attributable to a “fixed base” in Australia. A movie set would be unlikely to be characterised as a fixed base, although the issue has yet to be determined in Australia. 356

© Thomson Reuters 2019

CHAPTER 17

INTERNATIONAL ASPECTS OF INCOME TAXATION

FCT v Efstathakis

(1979) 9 ATR 867; 79 ATC 4256 (Full Federal Court)

Facts: The taxpayer was a Greek national who moved to Australia anticipating promised employment with the Greek government’s Press and Information Service office in Australia. She became a Greek government public employee and was required to join the Greek government superannuation plan. Her salary was paid in Australia by cheques drawn on a Greek bank. The taxpayer argued that the income was exempt from Australian tax on the basis of various exemption sections and the Vienna Convention on Diplomatic Relations. However, the appeal before the Full Federal Court was based on an argument that the income was sourced in Greece and exempt from Australian tax under former s 23(q) ITAA 1936 which exempted residents from tax on foreign-source income that had been subject to tax in the source jurisdiction. Decision: While some factors supported the view that the income had a source abroad, the most important factor was that the income was for services performed in Australia and payment for the services was received in Australia. These factors supported the view that the source of the income was Australia. Relevance of the case today: Efstathakis shows the limitations of the discussion in Mitchum and the tendency of Australian courts to look to where services were performed to find the source of personal service income. If it happened today: If the facts in Efstathakis arose today, the income from employment with the Greek government would be treated as Australian-source income under Australian income tax law and subject to ordinary Australian income tax. While Australia has a tax treaty with Greece to deal with airline profits, it has no comprehensive tax treaty with Greece and there is thus nothing to protect against the double taxation of employment income if a person is considered resident in both countries. Under the previous foreign tax credit system, no credit would have been available in Australia for Greek taxes because the credit only applied to foreign taxes on foreign source income. The current foreign income tax offset rules contain no similar restriction and in theory an Australian foreign income tax offset could be provided for Greek tax on the Australian source income. Whether it would apply will depend on whether Greek law imposes Greek tax on the taxpayer because she is a public servant or whether Greek income tax law, like Australian law, deems public servants to be residents. If she is liable to Greek tax as a public servant of Greece but not a resident, a foreign tax offset would be available. If she is deemed to be a Greek resident under Greek income tax law, no foreign tax offset would be available as a result of s 770-10(3) ITAA 1997.

Dividends Esquire Nominees Ltd v FCT

(1973) 129 CLR 177; 4 ATR 75; 73 ATC 4114 (Full High Court)

Facts: The owners of an Australian holding company sought to distribute profits of the company in a tax effective manner. They established three tiered companies on © Thomson Reuters 2019

357

AUSTRALIAN TAXATION LAW CASES 2019

Norfolk Island, a territory of Australia that is exempt from Australian income taxation. The shares in the Australian holding company were transferred to the lowest tier company on Norfolk Island and an Australian subsidiary operating company paid a dividend to its new owner, the lowest tier company on Norfolk Island, which in turn paid a dividend to the second tier company which in turn paid a dividend to the top tier company, the taxpayer in this case. The taxpayer acted as trustee of a discretionary trust, the objects of which comprised family members of the original owners of the Australian company. The Commissioner assessed the taxpayer under s 99 ITAA 1936 as a non-resident trustee deriving Australian-source income that had not been distributed to beneficiaries in the year. The taxpayer conceded the chain of payments commenced with the original dividend payment from the Australian holding company to the lowest tier company in Norfolk Island, but argued the dividends it received in its capacity as trustee derived from sources in Norfolk Island as they were paid by a Norfolk Island resident company. Decision: The Full High Court agreed with the taxpayer that the dividends in question were from a source in Norfolk Island and the taxpayer, as a non-resident trustee, was not liable to Australian tax on income from a source outside Australia. The source of income derived by a company is determined by the location at which the company paying the dividend derived its profits. The second tier company that paid its profits to the taxpayer derived its profit in Norfolk Island from another company in Norfolk Island. The ultimate original source of the funds is not relevant to the source of dividends received by the highest tier company. Relevance of the case today: The Esquire Nominees case is the principal precedent on the source of dividend income. Dividends have their source where the company paying dividends derives the profit from which the dividends are paid. If the company paying dividends has its central management and control in a jurisdiction and derives its dividend income from another company in that jurisdiction, the dividend income it receives will have a source in that jurisdiction. If it happened today: If the facts in Esquire Nominees were to arise today, the arrangements that led to the transfer of shares in the Australian holding company to the lowest tier company in Norfolk Island would likely trigger a capital gain when the shares were transferred. Details of the arrangements used by the parties in Esquire Nominees to transfer the shares are not set out in the decision. In addition, most likely the transfer of value to the taxpayer to enable it to buy shares in the intermediate company that owned the lowest tier company which in turn ended up with the shares in the Australian resident holding company would trigger the provisions of Division 6AAA ITAA 1936. The income derived by the taxpayer in its capacity as trustee would be attributable income under s 102AAU ITAA 1936 and the original Australian resident transferors of value to the trust would be attributable taxpayers under s 102AAT ITAA 1936. The trust income would be attributed to the transferors who would be required to include it in their assessable income under s 102AAZD ITAA 1936.

358

© Thomson Reuters 2019

CHAPTER 17

INTERNATIONAL ASPECTS OF INCOME TAXATION

WITHHOLDING TAX ON AUSTRALIAN-SOURCE INCOME DERIVED BY FOREIGN RESIDENTS While residents are assessable on ordinary and statutory income sourced from within Australia and abroad, under s 6-5(2) ITAA 1997 and s 6-10(4) ITAA 1997, foreign residents are only assessable on ordinary and statutory income sourced in Australia under s 6-5(3) and s 6-10(5). Apart from this difference, as a general rule most of the provisions of the ITAA apply equally to residents and foreign residents. However, there could be significant practical problems trying to collect the tax from the foreign residents on some types of investment income such as interest, dividends or royalties, particularly if the foreign resident taxpayer has no tangible assets in Australia that could be seized if the taxpayer failed to file a return and pay the tax due. A final “withholding tax” is used to simplify collection of tax on this sort of income. There are three elements to the withholding tax system. First, s 128B ITAA 1936 imposes a special liability on the foreign resident recipient of interest, dividends or royalties to pay a withholding tax on the amount derived. Income that is subject to the withholding tax is then treated as non-assessable income so s 6-5(3) and s 6-10(5) ITAA 1997 will not apply to the payments. Separately, ss 12-210, 12-245, and 12-280 Taxation Administration Act 1953 impose a liability on the person paying interest, dividends or royalties to foreign residents to withhold an amount equal to the liability of the recipient under s 128B ITAA 1936. The payer is then obligated to remit the withheld tax to the Commissioner under s 16-75 Taxation Administration Act 1953. Since 1 July 2016 a quasi-withholding tax initially equal to 10% of the total sale price (12.5% from 1 July 2017) has applied to capital gains realised by non-residents on the disposal of taxable Australian property. Exemptions are available in some cases if, depending on the nature of the property sold, the value of the property is under $2 million ($750,000 from 1 July 2017), or the buyer receives a clearance certificate from the Commissioner, or a declaration that the seller is a resident and the purchaser does not have a reason to believe the declaration is false.

Withholding Tax on Dividends ABB Australia Pty Ltd v FCT

(2007) 66 ATR 460; 2007 ATC 4765 (Federal Court)

Facts: The taxpayer, an Australian resident company, had declared a dividend to be paid to a foreign resident shareholder. Between the time of declaration and the time of payment, the foreign resident shareholder assigned its right to receive the dividend to another person which in turn assigned its right to a resident of Australia. Following instructions from these persons, the taxpayer paid the dividend to the resident in Australia and withheld no tax. The Commissioner argued the foreign resident derived the dividend when it was declared by the taxpayer so the subsequent assignments had no effect on the withholding liability. The taxpayer argued that the specific inclusion provision for dividends, s 44(1) ITAA 1936, overrides the general derivation rule that © Thomson Reuters 2019

359

AUSTRALIAN TAXATION LAW CASES 2019

applies to s 6-5(1) ITAA 1997 so dividends are only recognised when they are paid, not when they are derived under general principles. Accordingly, the taxpayer argued, it had a valid right to the dividend, had made a valid assignment, and the dividend was derived for tax purposes by the assignee. Decision: While generally dividend income received by a passive shareholder is derived when paid, where the shareholder is the sole owner of the company paying the dividend and directs the affairs of the company and where the company and the shareholder recognise dividends for financial accounting purposes as derived when declared, the dividends are derived when declared. As a result, a subsequent assignment does not relieve the payer from the withholding tax obligation where the dividend is declared in favour of a foreign resident shareholder. Relevance of the case today: The ABB Australia case made it clear that where a foreign shareholder owns and directs an Australian resident company and recognises dividends as derived for financial accounting purposes when the dividends are declared, the dividends will be derived for tax purposes at that time, attracting a withholding tax liability even if the dividends are subsequently assigned prior to payment. It is possible that the case might also be cited to support this time of derivation rule for a resident shareholder in similar circumstances. However, the argument would probably fail to affect the time dividends are recognised for the resident shareholder as a court would be likely to say the specific recognition rule in s 44(1) ITAA 1936 overrides the rule for derivation of under the general inclusion rule in s 6-5 ITAA 1997. If it happened today: If the facts in ABB Australia were to arise today, a court would find a dividend declared to a foreign shareholder would be subject to withholding tax under s 128B ITAA 1936, with liability for the withholding falling on the company declaring the dividend under s 12-210 Taxation Administration Act 1953, without regard to the fact that the shareholder had assigned its right to receive the dividend to a resident taxpayer after the dividend was declared but prior to payment.

Withholding Tax on Interest Millar v FCT

[2016] FCAFC 94; 103 ATR 592 (Full Federal Court)

Facts: The taxpayer was an Australian business that had borrowed an amount from an entity in Samoa. The taxpayer did not pay interest due on the loan and pursuant to the loan agreement the lender capitalised the unpaid interest, adding it to the loan principal each time the interest was not paid. Subsequent interest liabilities were based on the larger principal. The Commissioner assessed the taxpayer on the basis that it was obliged to pay withholding tax under s 12-245 Taxation Administration Act 1953 on interest paid to a non-resident lender and that it had made a constructive payment to the lender when the interest was capitalised and added to the principal. This was based on s 11-5 Taxation Administration Act 1953 which treats an amount as paid by a person where another entity applies or deals with an amount on behalf of the person or at the person’s direction. 360

© Thomson Reuters 2019

CHAPTER 17

INTERNATIONAL ASPECTS OF INCOME TAXATION

Decision: The Court found that when the lender capitalised the unpaid interest, it was dealing with the amount on behalf of the taxpayer or at the taxpayer’s direction and the taxpayer had thus made a constructive payment of interest that was subject to withholding tax. In effect, it was treating the capitalisation as if the taxpayer had paid the interest and had immediately received it back as a loan. Relevance of the case today: The Millar case shows that interest payments subject to withholding tax include “constructive” payments that are deemed to be actual payments if another person deals with the interest amount on behalf of the borrower. If it happened today: If the facts in Millar were to arise today, a court would find the capitalisation of unpaid interest amounted to a constructive payment and a withholding tax liability arose.

ECONOMIC OR JURIDICAL DOUBLE TAXATION Australian domestic income tax law prevents double taxation of income from a foreign source by exempting the income from taxation in some cases or leaving it assessable but providing an offset (credit) for foreign tax paid on the income in the country of source. Australia’s tax treaties contain an Article that requires Australia to do what it already does on its own in the ITAA. The domestic measures and tax treaties only prevent what is known as “juridical” double taxation, which occurs when the same person is subject to tax on the same income in two countries. They do not work to prevent “economic” double taxation where the tax laws of the two countries attribute the same income to different persons and each country assesses a different person on the single amount of income.

Russell v FCT

(2011) 79 ATR 315; 2011 ATC 20-240 (Full Federal Court)

Facts: The taxpayer was an Australian resident that offered personal services through an interposed company that was resident in New Zealand. The company was subject to ordinary company income tax in New Zealand. Separately, the taxpayer was assessed on the personal service income derived by the company that was attributable to his labour. Under Division 86 ITAA 1997, income attributable to a person’s personal service that is derived through a personal services entity is attributable to the individual who provides the services for which the entity is paid. In other words, the rules look through the interposed entity and treat the individual working for the entity as if that person had contracted to provide the services and received the income that was paid to the interposed entity. As a result, the same income had been taxed twice, first to the New Zealand company and then to the taxpayer. The taxpayer argued this result was contrary to the Australia-New Zealand tax treaty that should have prevented double taxation. Decision: The Full Federal Court concluded that the Australian law treated the income derived by the company in New Zealand as if it were personal service income © Thomson Reuters 2019

361

AUSTRALIAN TAXATION LAW CASES 2019

derived directly by the taxpayer in Australia so there was no need under Australian law to consider the role of the Australia-New Zealand tax treaty in preventing double taxation. [The High Court subsequently refused to grant the taxpayer special leave to appeal from this decision.] Relevance of the case today: Russell may be cited as authority for the generally accepted principle that tax treaties can only prevent juridical double taxation, where one person faces tax in two jurisdictions on the same income, and not economic double taxation, where two countries attribute the same income to two different taxpayers who are each assessed on the same income. If it happened today: If the facts in Russell were to take place today, the court would once again find that a tax treaty provides no shield against economic double taxation and an Australian liable for tax under Australian domestic law cannot claim relief because another person has paid tax on the income under the law of another country.

TRANSFER PRICING Both residents and foreign residents may attempt to reduce their Australian tax liability by shifting profits to related persons offshore. This can be done by paying a higher price for acquisitions from related persons abroad or by charging too little for sales to related persons outside the country. Either of these techniques, commonly called “transfer pricing” arrangements, will shift profits from Australia to the related persons abroad. Where a taxpayer enters into a transaction with a related person abroad, the taxpayer is required under Division 815 ITAA 1997 to substitute the arm’s length values for those used by the persons in the transactions if the price paid for goods or services supplied to or acquired from the related person was higher or lower than the price that would have been paid in an arm’s length transaction between unrelated persons. Article 9 of Australia’s tax treaties similarly allows the Commissioner to modify “profits” where the transfer price differs from that which would have been used by independent parties and Division 815 contains parallel rules that explain how the transfer pricing rules apply in treaty cases.

Commissioner’s Right to Issue a Reassessment WR Carpenter Holdings Pty Ltd v FCT

(2008) 69 ATR 29; 2008 ATC 20-040; 237 CLR 198 (Full High Court)

Facts: The taxpayer was a member of a group of companies that had received assessments based on (former) s 136AD ITAA 1936 (currently s 815-115 ITAA 1997 1997). It objected to the assessments and sought an order in the Federal Court to compel the Commissioner to provide “particulars” or further details on the matters taken into account when making a transfer pricing determination. The taxpayer asked for information on three matters to be used in its appeal: the fairness and reasonableness to it in the application of the transfer pricing adjustment, its claim that there was no 362

© Thomson Reuters 2019

CHAPTER 17

INTERNATIONAL ASPECTS OF INCOME TAXATION

“tax avoidance purpose” to the transactions and its claim that it had no “profit shifting motive”. The Commissioner argued that the taxpayer was engaged in a “fishing” expedition, seeking information it might be able to use on an appeal without an otherwise specific need for that information, and that the factors cited by the taxpayer were not relevant to a transfer pricing amount determined under s 136AD, currently s 815-115 ITAA 1997. Decision: The Full High Court dismissed the taxpayer’s appeal, concluding that the factors for which the taxpayer sought information were irrelevant to a determination under s 136AD(1), currently s 815-115 ITAA 1997. Relevance of the case today: The WR Carpenter decision shows that the Commissioner can rely on objective comparisons of the prices used by a taxpayer in transactions with related parties and arm’s length prices for similar transactions when making a transfer pricing determination. There is no requirement for the Commissioner to show any motive or purpose on the part of the taxpayer for the use of a particular price in a transaction between related parties before the Commissioner can substitute a different price. If it happened today: If the facts in WR Carpenter arose today, the taxpayer would fail in any attempt to gain an order for the Commissioner to provide information that is not directly relevant to the determination of the price of international transactions between related persons.

Transfer Pricing Methodology The transfer pricing provisions in Division 815 ITAA 1997 require taxpayers to use “the most appropriate and reliable method” to determine arm’s length conditions. Section 815-135 specifically directs taxpayers to use methods consistent with those set out by the OECD in its transfer pricing “Guidelines”. The Guidelines set out two approaches to the determination of a transfer price. The first approach relies on three “traditional transaction methods”, the most common being the “comparable uncontrolled price” method that looks for a price on a comparable sale between unrelated parties. The second approach uses two “transactional profit methods” that seek to calculate an appropriate profit in light of various indicators. From 1995 until 2010, the OECD gave priority to the traditional methodologies but many countries favoured profit methods and since 2010 both approaches are given equal standing. In the SNF case (below), the taxpayer successfully argued that the OECD guidelines, and in particular the transactional profits methods in the guidelines, could not be used when making an assessment under the transfer pricing rules in the ITAA 1936 then in effect. Largely as a consequence of that case, the transfer pricing rules in the ITAA 1936 were repealed and replaced by the rules in Division 815 that explicitly rely on the OECD Guidelines which can be applied by the Commissioner in making assessments under Australian law. In 2017, the government passed legislation to further amend the domestic transfer pricing rules to give effect to “value creation” transfer pricing methods which are now included in the OECD transfer pricing Guidelines of 10 July 2017. © Thomson Reuters 2019

363

AUSTRALIAN TAXATION LAW CASES 2019

Legislation that would require very large multinational companies to report to the ATO details of their revenue and tax liabilities in the countries in which they operate (a system labelled “country-by-country” reporting) became effective in 2016. The information collected can be used to strengthen the ATO’s transfer pricing investigations and assessments.

FCT v SNF (Australia) Pty Ltd

[2011] FCAFC 74; 82 ATR 680; 2011 ATC 20-265 (Full Federal Court)

Facts: The taxpayer, a member of a group of companies controlled by a French parent company, purchased plastic feedstock from related companies in the United States, France and China. The Commissioner did not accept the taxpayer’s transfer prices for its purchases from related parties and reassessed relying on the transfer pricing provisions in the ITAA 1936 and in Australia’s tax treaties with the countries in which the sellers were located. The taxpayer appealed from the reassessment, arguing that the transfer price should be calculated using the comparable uncontrolled price method. It provided evidence that unrelated businesses had purchased similar products for similar prices. The Commissioner argued a transactional profits method of determining recommended by the OECD in its Guidelines for transfer pricing adjustments was more appropriate given the taxpayer’s circumstances. Decision: The Full Federal Court accepted the taxpayer’s methodology for determining a transfer price, indicating the OECD Guidelines were not persuasive or relevant to the calculation of profit using the transfer pricing rules in the ITAA 1936. Relevance of the case today: Following the SNF case, the government repealed the transfer pricing rules in ITAA 1936 and enacted in their place Division 815 ITAA 1997. Section 815-20 ITAA 1997 requires the use of the OECD Guidelines, including the transactional profits method the Commissioner had attempted to use in the SNF case, when determining arm’s length prices. The SNF case is of no persuasive value in relation to the methodology that can be used today to determine the arm’s length price. If it happened today: If the facts in SNF were to arise today, the Commissioner would be able to use a transactional profits method as set out in the OECD transfer pricing Guidelines and set a lower purchase price for the feedstock, yielding taxable profits for the taxpayer.

Chevron Australia Holdings Pty Ltd v Commissioner of Taxation

[2017] FCAFC 62; 105 ATR 599; 2017 ATC 20-615

Facts: The taxpayer known as Chevron Australia Holdings Pty Ltd (CAHPL) challenged assessments made by the Commissioner pursuant to the relevant transfer pricing provisions which were found in Division 13 ITAA 1936 for the years 2004–2008 and Div 815 ITAA 1997 for the years 2006-2008. The assessments related to interest paid by CAHPL to Chevron Texaco Funding Corporation (CFC) under an agreement 364

© Thomson Reuters 2019

CHAPTER 17

INTERNATIONAL ASPECTS OF INCOME TAXATION

between them called a “Credit Facility Agreement”. Each of the assessments was made upon the basis that the interest paid by CAHPL, an Australian company, to its United States subsidiary, CFC, was greater than it would have been under an arm’s length dealing between independent parties. CFC was established in the group as a United States subsidiary of CAHPL for CFC to lend funds to its Australian parent at about 9% interest from money raised by CFC from the issue of commercial paper in the United States at a rate of about 1.2%. CAHPL then claimed tax deductions in Australia for the interest it paid to CFC, and returned as income the dividends it received from CFC as non-assessable non-exempt income pursuant to s 23AJ ITAA 1936. The Commissioner’s assessments were made in reliance upon the transfer pricing provisions on the basis that the consideration paid by CAHPL to CFC (the interest), exceeded the arm’s length consideration that might reasonably have been expected in an agreement between independent parties acting at arm’s length. The taxpayer challenged the assessments on the basis that they were excessive. Decision: The Full Federal Court upheld the decision of the Federal Court dismissing the taxpayer’s challenge to the assessments ([2015] FCA 1092) on the basis that the taxpayer failed to discharge its burden of proving that the assessment based on the arm’s length consideration determined by the Commissioner was excessive. The Full Court found that the focus of the transfer pricing provisions was to bring a commercial reality based on an hypothesis of actors independent of each other to the viewing of a transaction in circumstances where that commercial reality had not been distorted due to a lack of arm’s length dealings between the parties. The Court rejected the taxpayer’s argument that they should be assessed as a stand-alone entity without taking into account its affiliation to its parent (orphan theory). Relevance of the case today: The Full Court’s rejection of the orphan theory is important because it means that factors beyond the mere price of an arm’s length transaction can be taken into account and group circumstances. This includes the credit strength of the parent which can be factored into the price. The concept of “consideration” is not limited to the price paid and extends to promises made by the group. The case of Chevron also demonstrates the difficulties in determining the arm’s length consideration in transfer pricing cases. If it happened today: If the facts in Chevron arose today, the Court would continue to take into account factors beyond the mere price of the loan to determine whether the taxpayer has proven that the Commissioner’s assessment is excessive.

TAX TREATIES AND INTERNATIONAL AGREEMENTS The provisions of the ITAA may be overridden by Articles in a double tax treaty with a foreign government. In its treaties, Australia has agreed to limit its domestic taxing rights over Australian-source income derived by residents of the treaty partner country. The most important restraint on Australia’s taxing power is found in Article 7 of the treaties which removes Australia’s right to tax Australian-source business profits of an enterprise resident in a treaty partner country unless the profits are © Thomson Reuters 2019

365

AUSTRALIAN TAXATION LAW CASES 2019

derived through a permanent establishment of the enterprise in Australia. The general restriction is subject to a number of exceptions. Notwithstanding the general rule about Australian-source business profits derived by a non-resident, Articles 10, 11 and 12 of the treaties allow Australia to continue to impose withholding tax on business profits that are dividends, interest and royalties, subject to a maximum rate set out in the treaties. The current treaties to which Australia is a signatory may be affected by the OECD’s Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI). The MLI, ratified by Australia on 26 September 2018, is designed to update treaties for many of the measures designed to prevent base erosion and profit shifting. In addition to its tax treaties with many countries, Australia has entered into agreements with international organisations such as the UN and its subsidiary agencies. These provide tax exemptions for the organisations and their employees.

Employment Income Macoun v FCT

[2015] HCA 44; 257 CLR 519; 102 ATR 263 (Full High Court)

Facts: The taxpayer was a former employee of the World Bank who received a pension following retirement. The pension was paid from a pension fund that contained employee and employer contributions. The taxpayer sought to shield his pension from Australian taxation under the Act which incorporated the Convention on the Privileges and Immunities of the [United Nations] Specialized Agencies into Australian law. The Convention provided an exemption from Australian tax for “salaries and emoluments” paid by agencies such as the World Bank. The taxpayer argued the pension was paid pursuant to rights he received when he was an employee and the pension payments thus fell into the exemption. Decision: Applying the interpretation principles set out in the Vienna Convention on the Law of Treaties, the court found that the pension received by the taxpayer was not covered by the exemption for salary and emoluments from his employment. His right to receive a pension, the Court said, crystallised when he retired and became entitled to pension payments. It was, therefore, income derived after employment and not salary or emolument from his employment. As a result, it was not exempt under the Act which incorporated the Convention on the Privileges and Immunities of the [United Nations] Specialized Agencies into Australian law. Relevance of the case today: While every application of a treaty turns on the taxpayer’s specific fact situation, it is likely that in most cases pensions will not be exempt from tax under a treaty that exempts from taxation salaries and emoluments of employees of international organisations. If it happened today: If the facts in Macoun were to arise today, the pension received by the retired employee of an international organisation with a tax exemption treaty with Australia would not be considered remuneration for employment and would be subject to tax. 366

© Thomson Reuters 2019

CHAPTER 17

INTERNATIONAL ASPECTS OF INCOME TAXATION

FCT v Jayasinghe

[2017] HCA 26; 260 CLR 400; 106 ATR 274

Facts: The taxpayer was a qualified engineer who was engaged by the UN as a project manager to build a road in Sudan. His appointment was under an “Individual Contractor Agreement” which gave him independent contractor status and not the status of an official of the UN for the purposes of the Convention on the Privileges and Immunities of the United Nations. The taxpayer argued that he was entitled to exemption from Australian tax as he held an office in an international organisation within the meaning of s 6(1)(d)(i) of the International Organisations (Privileges and Immunities) Act 1963 (Cth) (IOPI Act), and therefore the Commissioner was bound to exempt him by reason of s 357-60(1) of Sch 1 to the Taxation Administration Act 1953 (Cth) and Taxation Determination TD 92/153. Decision: The High Court held that the phrase “a person who holds an office in an international organisation” in s 6(1)(d)(i) requires a consideration of the structure of the organisation and the person’s place within it and was concerned with the incidents of the relationship between a person and an international organisation. These incidents depended on the substance of the terms upon which a person was engaged and the taxpayer, as an independent contractor, did not “hold an office” as defined. Relevance of the case today: The case of Jayasinghe clarifies the interpretation and construction of the meaning of the expression “holds an office” within the international law framework underpinning the IOPI Act. The case resolves any uncertainty around the concept of an office holder and whether an office holder can include all persons participating in the work of the UN. If it happened today: If the facts in Jayasinghe happened today, the court would find that the taxpayers did not hold an office in an international organisation within the meaning of s 6(1)(d)(i) of the IOPI Act. Therefore, the Commissioner would not be required to exempt Mr Jayasinghe from tax on the income he received from his independent contract.

Business Profits of an Enterprise Article 7 of Australia’s treaties removes Australia’s right to tax business profits of an enterprise resident in the treaty partner unless the profits are derived through a permanent establishment in Australia. The ATO has attempted to argue the Article does not apply to passive capital gains derived by a non-resident outside of an enterprise while the taxpayer would argue the gain is a business profit of an enterprise and shielded from taxation under Article 7.

© Thomson Reuters 2019

367

AUSTRALIAN TAXATION LAW CASES 2019

Thiel v FCT

(1990) 171 CLR 338; 21 ATR 530; 90 ATC 4717 (Full High Court)

Facts: The taxpayer was a Swiss resident individual who had invested in an Australian unit trust that later converted to a company and listed on the stock exchange. The taxpayer made significant profits selling his shares in the company and the Commissioner assessed the taxpayer on the basis of s 26AAA ITAA 1936 which formally applied to short-term capital gains realised on assets sold within 12 months of acquisition. The taxpayer claimed the profits were not assessable in Australia as a result of Article 7 of the Swiss-Australian double tax agreement as the profits were profits of an enterprise and the taxpayer had no permanent establishment in Australia. Decision: As the term “enterprise” is unknown in Australian income tax law, its meaning in the agreement must be discerned from the context in which it is used. The High Court concluded that an isolated transaction of a speculative nature would amount to an enterprise for the purposes of Article 7. The taxpayer was therefore exempt from Australian taxation as the profits were profits of an enterprise and the taxpayer had no permanent establishment in Australia. Relevance of the case today: The business profits Article of all Australia’s double tax agreements is similar to that found in the Swiss-Australia agreement. As a Full High Court decision, Thiel remains the most important authority to support the argument that short-term speculative gains derived by a foreign resident are profits of an enterprise within the meaning of Article 7 of Australia’s double tax agreements. A foreign resident deriving such gains may therefore claim protection from taxation if the person is resident in a treaty partner country and has no permanent establishment in Australia. This general rule may be overridden if the gain is attributable to real property or a right covered in Article 13 of a double tax agreement. If it happened today: The interpretation of Article 7 of Australia’s double tax agreements adopted in Thiel continues to be followed in Australia and if the facts in Thiel arose today, the same result would follow. The profits would be considered profits of an enterprise and the taxpayer would be protected from taxation under Article 7 of the double tax agreement as the taxpayer has no permanent establishment in Australia. Note that if the profits were subject to tax as capital gains under the CGT, the same result would follow as a result of Virgin Holdings SA v FCT (2008) 70 ATR 478; 2008 ATC 20-051 (described below).

Virgin Holdings SA v FCT

(2008) 70 ATR 478; 2008 ATC 20-051 (Federal Court)

Facts: The taxpayer was a resident of Switzerland and had realised a gain on the sale of shares in an Australian subsidiary. The Commissioner assessed the taxpayer on the gain under the CGT provisions (at the time, the CGT rules applied to shares in private Australian companies and substantial shareholdings in public companies). The taxpayer claimed the Swiss-Australia tax treaty shielded it from tax as the capital gain fell into the category of business profits. The tax treaty “business profits” Article 368

© Thomson Reuters 2019

CHAPTER 17

INTERNATIONAL ASPECTS OF INCOME TAXATION

excluded Swiss residents from tax on Australian business profits unless they derived the profits through a permanent establishment in Australia. The taxpayer had no permanent establishment in Australia. The Swiss-Australia treaty had been entered into prior to the enactment of the capital gains tax regime in Australia. The Commissioner argued the “business profits” Article only applied to gains that were subject to the types of profits caught under the Australian income tax when the treaty was signed and this would not have included capital gains as the capital gains tax was not part of the income tax at the time. As a result, the Commissioner argued, capital gains should not be shielded from Australian tax by the business profits Article. Decision: The interpretation of the treaty proposed by the Commissioner would have been a “static” interpretation, meaning the words of the treaty would be interpreted in the way they would have meant to the parties at the time the treaty was ratified. The Federal Court concluded an “ambulatory” interpretation was more appropriate for a treaty. Under the ambulatory interpretation approach, the words of a treaty are understood to apply to the laws as they apply at the time a party seeks to rely on the treaty, not the time it was signed. In any case, the Court pointed out that while there was no comprehensive CGT in effect at the time the treaty was signed, the Australian income tax at that point did apply to one type of capital gain, namely gains on the disposal of capital assets within a year of their acquisition. Thus, even at the time the treaty was entered into, the Australian income tax law was understood to include provisions applying to capital gains. Relevance of the case today: The Virgin Holdings case rejected the position the Commissioner had previously strongly asserted in a public ruling issued in 2001 and made it clear that tax treaties entered into before 1985, when the first comprehensive capital gains tax regime was added to the Australian income tax law, will apply to capital gains as part of the business profits of a taxpayer. As a result, taxpayers in these countries who have no permanent establishment in Australia will be able to shield their capital gains from Australian tax under the business profits Article of the treaties. Note, however, that the business profits Article (Article 7 of most treaties) is subject to another Article (Article 13) that allows treaty partners to tax non-residents on capital gains on the sale of land or shares of companies whose value is based mostly on land they own in the country, regardless of whether they have a permanent establishment in the country or not. While this Article would not have applied to the taxpayer in Virgin Holdings, it could prevent some other non-residents from using the business profits Article of a treaty to shield capital gains realised on the disposal of Australian real property from Australian tax. If it happened today: While the decision in Virgin Holdings is a judgment of a first instance court, the approach taken in the case would likely be followed by other courts and non-residents from countries that entered into tax treaties with Australia prior to 1985 could use the treaties to shield capital gains (other than on the sale of land or interests in land-holding entities) from Australian tax under the business profits Article of the treaties, provided they have no permanent establishment in Australia.

© Thomson Reuters 2019

369

AUSTRALIAN TAXATION LAW CASES 2019

Permanent Establishment McDermott Industries (Aust) Pty Ltd v FCT

(2005) 59 ATR 358; 2005 ATC 4398 (Full Federal Court)

Facts: The taxpayer was an Australian company that leased barges from a Singapore company. It sought to deduct the lease payments, or charter fees as they were labelled in the contract, as business expenses. The Commissioner denied the deduction, claiming the lease payments fell within the expanded definition of “royalty” in s 6 ITAA 1936, which included payments for the use of, or the right to use, industrial, commercial or scientific equipment. As such, the Commissioner claimed, the payments were subject to withholding tax imposed on royalties under s 221YL ITAA 1936 (which imposed withholding tax prior to 1 July 2000; the withholding provisions are now in Division 12-F of Schedule 1 to the Taxation Administration Act). Because the taxpayer had failed to withhold tax as required, the Commissioner argued, it was denied a deduction for the expenses under s 221YRA(1A) ITAA 1936, which prevents deductions for any payments for which taxpayers have failed to withhold as required. The taxpayer argued that under the definition of “permanent establishment” in the Australia-Singapore double tax agreement, the Singapore company had a permanent establishment in Australia. Article 4(3)(b) of the agreement deemed a resident of Singapore to have a permanent establishment in Australia if substantial equipment is being used in Australia by, for or under contract with the Singapore resident. The taxpayer argued further that the royalty payments were connected with the Singapore company’s permanent establishment and under Article 10(4) of the agreement were assessable as profits of a permanent establishment using the ordinary assessment provisions without regard to the withholding provisions. If this were the case, no withholding would be required and the taxpayer should be allowed a full deduction for the payments it made. Decision: Article 4(3)(b) should not be read down by the principal definition paragraphs in the definition of a “permanent establishment”, Article 4(1) and 4(2) which look to fixed places where business was carried on. When Article 4(3)(b) speaks of substantial equipment being used by, for or under contract with a non-resident, it does not mean the equipment must be physically used directly by or for the non-resident; a Singapore resident will be using equipment in Australia if it leases the equipment for use in Australia. Accordingly, the Singapore resident had a permanent establishment in Australia and the lease payments were profits of the permanent establishment. As the payments were not subject to withholding tax, the Australian taxpayer was not required to withhold tax from the payments and the Commissioner could not deny the taxpayer a deduction for the expenses on the basis that the taxpayer had failed to withhold. Relevance of the case today: While the McDermott case concerned the deductibility of expenses by an Australian taxpayer, the decision turned on the definition of a permanent establishment where substantial equipment is used in a country. It appears to have expanded the meaning of permanent establishment such that any taxpayer who leases substantial equipment for use in Australia may have a permanent establishment in Australia and be subject to full Australian taxation on the lease profits. It is not clear 370

© Thomson Reuters 2019

CHAPTER 17

INTERNATIONAL ASPECTS OF INCOME TAXATION

whether the ATO will pursue non-resident taxpayers for taxes on lease profits where the Australian users have not withheld tax on the payments. If it happened today: If the facts in McDermott were to arise today, a court would similarly hold that the non-resident equipment lessor had a permanent establishment. As a result, liability for tax on the lease payments would fall directly on the non-resident with the permanent establishment in Australia and would not be subject to any withholding tax collected by the Australian resident making the lease payments.

Tech Mahindra v FCT

[2016] FCAFC 130; 103 ATR 813 (Full Federal Court)

Facts: The taxpayer was an Indian company that provided technical services to Australian customers via its permanent establishment in Australia and directly from the Indian owner. Article 7 of the Australia-India tax treaty removes Australia’s right to tax the business profits of an enterprise resident in India unless the profits are attributable to a permanent establishment in Australia. The payments made directly to the Indian company fell within the definition of royalties in the treaty. Article 7 operates subject to Article 12 which allows Australia to impose withholding tax on royalties unless the royalties paid to the Indian company are effectively connected with its permanent establishment in Australia. The taxpayer argued the payments were effectively connected with the permanent establishment but were not earned through the permanent establishment and thus could not be taxed as profits of the permanent establishment or subject to withholding tax. Decision: Adopting a holistic approach to the interpretation of the treaty, in line with the rule of interpretation in Article 31 of the Vienna Convention on the Law of Treaties, the Full Federal Court concluded that it would defeat the intended interaction between the business profits Article and the royalties Article of a treaty if a payment were described as ‘‘effectively connected with’’ a permanent establishment but not derived by the permanent establishment. Applying the holistic approach, the Court concluded the payments in question were not “connected with” the permanent establishment for the purpose of Article 12 and consequently were subject to withholding tax. Relevance of the case today: The Tech Mahindra case is important for interpreting the interaction of the royalty withholding Article and the permanent establishment Article in Australia’s tax treaties and more generally the interaction between all withholding tax Articles and the permanent establishment Article. If a payment is not derived or attributable to a permanent establishment, it will not be effectively connected to the permanent establishment to shelter the payment from withholding tax. Equally significantly, the case shows that the courts will interpret treaties in a holistic fashion and not allow taxpayers to read Articles of a treaty in a way that allows income to escape tax by slipping outside each relevant Article if it were read separately. If it happened today: If the facts in Tech Mahindra were to arise today, a court would conclude royalty payments made to a foreign company for services at the same time payments are made to a permanent establishment for similar services are not payments © Thomson Reuters 2019

371

AUSTRALIAN TAXATION LAW CASES 2019

effectively connected with the permanent establishment and are accordingly subject to withholding tax.

Capital Gains on the Sale of Australian Land and Land-rich Entities Non-residents are subject to Australian income tax on gains on the disposal of “taxable Australian real property” and on the disposal of indirect Australian real property interests, meaning interests in entities where a majority of the assets owned by the entity are Australian real property assets. Tracing rules apply where the property is owned through a tier of entities. Taxation of capital gains on the sale of land may be restricted under Article 7 of Australia’s tax treaties which denies Australia the right to tax business profits of a non-resident enterprise if the non-resident does not have a permanent establishment in Australia. However, Article 7 of the treaties operates subject to Article 13 of Australia’s tax treaties which retains Australia’s full taxing rights over capital gains realised on the sale of real property or indirect Australian real property interests (sometimes known as interests in “land rich” entities). Article 13 overrides Article 7 so even if a non-resident does not have a permanent establishment in Australia and the capital gains on the sale of real property are part of the non-resident’s business profits, Australia’s right to tax these gains is preserved.

FCT v Lamesa Holdings BV

(1997) 36 ATR 589; 97 ATC 4752 (Full Federal Court)

Facts: The taxpayer was a Dutch company which owned an Australian company whose subsidiary owned gold mining leases. Article 13 of the Netherlands-Australia double tax agreement gave Australia the right to tax gains on the sale of land in Australia and land-rich companies whose principal assets consisted of land in Australia. The Article further defined “land” to include mining rights over land. When the taxpayer sold its shares in the Australian company, the Commissioner assessed the taxpayer, claiming the land-rich company rule in Article 13 applied to shares in a company that owned mining rights directly and shares in a higher tier company whose subsidiary owned mining rights. Decision: The Full Federal Court rejected the Commissioner’s interpretation of Article 13, pointing out the land rich company rule in Article 13 applied only to shares in companies whose assets consisted wholly or principally of land or rights in land and did not extend to shares in higher tier companies whose subsidiaries happened to be land rich companies. Relevance of the case today: Subsequent to Lamesa, the government added s 3A to the International Tax Agreements Act. This provision has the effect of extending the land rich company rule in Article 13 to higher tier companies where the value of the companies’ assets is attributable wholly or principally to land (or rights in land) held by a lower tier company. 372

© Thomson Reuters 2019

CHAPTER 17

INTERNATIONAL ASPECTS OF INCOME TAXATION

If it happened today: If the facts in Lamesa arose today, the Dutch taxpayer would be liable to Australian tax on its profits from the sale of shares in its Australian company. Section 3A of the International Tax Agreements Act would extend the powers granted to Australia under Article 13 of the Netherlands-Australia double tax agreement to assess gains on the sale of shares in a higher tier company where the principal underlying assets of the higher tier company (looking through its subsidiary) is real property, as defined in Article 13 to include mining rights.

© Thomson Reuters 2019

373

C HAPTER 18

Anti-avoidance Doctrines and Provisions SHAM .................................................................................................................... 376 Raftland Pty Ltd (2008) ......................................................................... 377 TRADITIONAL AND NEWER UK DOCTRINES .......................................... The Traditional “Duke of Westminster” Doctrine ....................................... Duke of Westminster (1936) ................................................................... Fiscal Nullity and More Modern UK Statutory Interpretation .................... Westmoreland Investments Ltd (2001) ...................................................

378 378 378 379 379

SECTION 260 ........................................................................................................ 381 Newton (1958)........................................................................................ 381 Gulland; Watson; Pincus (1985)............................................................ 382 PART IVA............................................................................................................... Can Part IVA apply if a scheme fails anyway? ............................................ Vincent (2002) ........................................................................................ Can schemes be dissected to find the dominant purpose? ........................... Peabody (1994) ...................................................................................... What is the “dominant” purpose of a scheme? ............................................ Spotless (1996) ....................................................................................... Howland Rose (2002) ............................................................................ HowlandHart (2004) ............................................................................................ News Australia Holdings (2010) ............................................................ What is the counter-factual? ........................................................................ Futuris Corporation (2012) ................................................................... Hart (2018) ............................................................................................ Dividend stripping and Part IVA ................................................................. Consolidated Press Holdings Ltd (2001) ............................................... Imputation credits and Part IVA .................................................................. Mills (2012)............................................................................................

383 384 384 385 385 387 387 388 390 391 392 392 393 393 394 396 396

© Thomson Reuters 2019

375

C HAPTER 18

Anti-avoidance Doctrines and Provisions The most basic response by tax authorities to negate a tax avoidance arrangement is to show the arrangement never had any legal effect and thus could not achieve its intended aims. This would be done by showing the entire arrangement is a “sham” with no legal basis. Australian courts have traditionally taken a very narrow view of what constitutes a sham and the Commissioner has had relatively little success in attacking avoidance arrangements on the basis that they are sham transactions. The difficulties faced by the Commissioner were originally compounded by the “literal” or “black “black-letter law” approach to interpretation of taxation that prevailed in the first half of last century. In the closing decades of the 20th century, UK courts adopted new doctrines that were used to strike down avoidance transactions as ineffective for tax purposes. In contrast to the UK reliance on judicial doctrines, the Australian legislature relied primarily on statutory anti-avoidance rules. The first general anti-avoidance rule, which became s 260 in the ITAA 1936, was rendered largely ineffective by High Court interpretations in the 1970s. The legislature responded by replacing s 260 with a new general anti-avoidance regime commonly referred to as Part IVA ITAA 1936 (pronounced “four A” for its location in the Act). Part IVA has proven fairly effective in combating avoidance schemes.

SHAM One method that the Commissioner could use to defeat a tax minimisation transaction is to show that the transaction is a “sham” or a transaction that the parties never intended to have any legal effect. The traditional understanding of a “sham transaction” is often drawn from a UK case, Snook v London and West Riding Investments Ltd [1967] 2 QB 786 at 802, which defined a sham transaction as one in which the parties used documents and acts to give third parties or a court the false impression of legal arrangements that were different from the ones the parties actually intended to have effect. An example would be the purported transfer of property or income that the transferor had no legal power to transfer.

376

© Thomson Reuters 2019

CHAPTER 18

ANTI-AVOIDANCE DOCTRINES AND PROVISIONS

The Australian understanding of “sham” is narrower than that used in the United States where courts have used the term to describe a transaction that had no economic or commercial effect other than to achieve a tax benefit. An example would be an arrangement with equal amounts of money flowing from one party to the other and in the opposite direction so there is no net effect but because of different legal titles to the flows there appears to be a loan. US courts have declined to recognise transactions they label sham arrangements as effective for tax purposes. The US approach has not been adopted in other jurisdictions, though in the past decade, this approach has been noted in some judicial cases outside the US.

Raftland Pty Ltd v FCT

[2008] HCA 21; 238 CLR 516; 68 ATR 170; 2008 ATC 20-029 (Full High Court)

Facts: The assessments in Raftland arose out of a trust arrangement. The trust provisions in the ITAA 1936 allocate income derived by a trust to beneficiaries of the trust who are presently entitled to a share of trust income. The beneficiaries to whom trust income is allocated will pay tax on the income at their marginal tax rates. The trustee will separately pay tax on the income that is allocated to beneficiaries under a legal disability. Trust income that is not allocated in one of these two ways is assessed to the trustee under s 99A ITAA 1936 and is subject to the highest personal marginal tax rate. The trust provisions contain a rule in s 100A ITAA 1936 that deems beneficiaries not to be presently entitled to a share of trust income if the income is subject to a “reimbursement arrangement” that would require the beneficiaries to pass any income to which they are entitled to other persons. The Raftland trust arrangements were structured to enable trust income to be allocated to a beneficiary with carried forward losses. If this were done, no tax would be payable on the income because it would be offset by the trust losses. While the arrangements appeared to provide for an allocation of trust income to this beneficiary, all the parties involved understood that almost all the income would actually be applied for the benefit of other persons responsible for the derivation of the income. Some income was provided to the persons with interests in the loss-making beneficiaries – in effect, their fee for making it possible to shelter the income. The Commissioner applied s 100A in Raftland to prevent trust income from being allocated to a primary beneficiary for tax purposes. If s 100A were to apply, the income would not be otherwise dealt with and would fall to be assessed to the trustee under s 99A and taxed at the highest personal marginal rate. At first instance, the Federal Court concluded that the resolutions which purported to entitle the beneficiary to trust income was a facade, contrary to the actual intentions of all the parties. This conclusion was the basis for finding that there was a reimbursement agreement and that s 100A applied. On appeal, the Full Federal Court accepted the allocation of income to the primary beneficiary but found a reimbursement agreement on the basis of wider considerations of the arrangements in their entirety. Decision: The Full High Court restored the findings of the first instance judge that there was a reimbursement arrangement because the parties never intended for income © Thomson Reuters 2019

377

AUSTRALIAN TAXATION LAW CASES 2019

to be distributed to the primary beneficiary, notwithstanding the trustee’s declaration of an allocation of trust income to that beneficiary. Justice Kirby’s judgment has received considerable attention because it explicitly labelled the arrangements a sham and stated that a court should look beyond the notional legal arrangements to find the actual legal consequences where there is a sham transaction. Relevance of the case today: The Raftland decision has clarified the traditional view of a sham transaction and reinforced it as a tool for attacking tax avoidance by allowing courts to look at the true effect of a transaction where the parties do not intend the apparent legal effect to apply in practice. The Commissioner may try to apply the Raftland approach to more cases where the evidence suggests that the parties have established the notional legal arrangements as a sham that will not be followed in practice. If it happened today: If the facts in Raftland were to arise today, a court would adopt the approach of the High Court and look to the agreements and understandings of the parties to see whether the notional allocation of trust income was in fact a sham and the parties intended another party to enjoy the benefit of the income. If that is the case, the court would find there was a reimbursement arrangement and apply the reimbursement arrangement provision. This would leave the trustee liable for tax on trust income, rather than the beneficiary to which it was notionally allocated.

TRADITIONAL AND NEWER UK DOCTRINES Prior to 2013, the UK tax law had no general anti-avoidance provision and tax authorities in the UK relied on specific rules or broader judicial doctrines to combat avoidance schemes. Originally, the UK courts tended to follow a strict interpretation approach and rarely struck down avoidance arrangements. UK judicial doctrines shifted away from this strict literalism approach in the closing decades of the 20th century.

The Traditional “Duke of Westminster” Doctrine The so-called called “literal” or “black “black-letter law” approach to interpretation of taxation statutes peaked in the UK in the period between the First and Second World Wars, with the Duke of Westminster case often cited as the leading example of this approach.

Inland Revenue Commissioners v Duke of Westminster [1936] AC 1 (UK House of Lords)

Facts: The income tax law of the UK at the time allowed taxpayers to deduct annual payments made under a covenant (written promise) that required the taxpayer to maintain payments for a minimum of seven years. The taxpayer entered into covenants with his domestic staff, agreeing to make payments equal to their weekly pay. The agreements stated that the recipients were not precluded from seeking their ordinary 378

© Thomson Reuters 2019

CHAPTER 18

ANTI-AVOIDANCE DOCTRINES AND PROVISIONS

pay in addition to the covenant payments but it was the common understanding of the parties that they would not do so. The effect of the arrangement was to allow the taxpayer to deduct the payments while the salary payments to domestic staff for which they were substituted would have been non-deductible personal expenses of the taxpayer. The taxpayer was assessed on the basis that the payments were in substance non-deductible remuneration to the domestic staff. Decision: The House of Lords accepted the validity of the gift covenant. The Court rejected the Commissioners’ argument that the “substance” of the transaction should be ascertained looking at the economic effect of the transaction in which the payments under the covenant substituted for the salary formerly paid to the staff. The “substance” of an agreement, Lord Tomlin asserted, is to be found in the strict words of the document and in this case the covenant did not technically require the employees to forgo their right to salaries, whatever the understanding of the parties as to what might happen in practice. An often-quoted passage from the decision is an aside by Lord Tomlin: “Every man is entitled, if he can, to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax.” Relevance of the case today: The Duke of Westminster case is often cited as authority for the proposition that tax consequences of a transaction are determined by the form of the transaction, not its economic substance. While Australian courts continue to assert that courts are not able to look beyond the legal nature of a transaction to base tax on its economic substance, the strict form over substance orthodoxy of Duke of Westminster has far less impact in Australia today. As a result of more liberal legislative interpretation doctrines and the need to interpret tax legislation to give effect to the purpose of the legislation on the basis of s 15AA Acts Interpretation Act, modern Australian courts will interpret words in the legislation in light of the object behind the words. Also, in Australia a contrived arrangement such as that in Duke of Westminster with the object of obtaining a tax benefit would likely be struck down by the general anti-avoidance rule in Part IVA ITAA 1936. If it happened today: Australia never had a statutory provision similar to that used by the UK taxpayer in Duke of Westminster to deduct payments made under a covenant. Whether the facts had taken place in 1936 or today, in Australia there would be no basis for the taxpayer to deduct the payments when calculating his taxable income.

Fiscal Nullity and More Modern UK Statutory Interpretation MacNiven (Inspector of Taxes) v Westmoreland Investments Ltd [2001] 1 All ER 865 (UK House of Lords)

Facts: The taxpayer was a heavily indebted company that owed considerable accrued compounded interest to pension trustees who owned the company which in turn owned © Thomson Reuters 2019

379

AUSTRALIAN TAXATION LAW CASES 2019

the taxpayer. In addition to the outstanding principal it owed, the company had accrued large unpaid compounding debt obligations and had no means of paying either the loan principal or the accrued interest obligation. Under UK law, no deduction was available for the accrued interest obligation until it was paid. The only way the pension trustees could recoup any value from the taxpayer would be to engineer a deduction for the accrued interest liability, leaving the taxpayer with a large tax loss that could be carried forward. This would make it possible to sell the taxpayer as a “tax loss” company that could be used by new owners to shelter taxable income. To enable the taxpayer to pay the accrued interest and create the tax loss, the pension trustees lent funds to the taxpayer which were then returned to the pension trustees as a payment of the outstanding interest obligation to the owner. As a result of the transactions, the taxpayer owed the same amount to the pension trustees as it did prior to the transactions but the obligation to pay accrued interest had been replaced by an obligation to repay the principal of the latest loan. The Commissioners argued that no deduction should be allowed for the interest payment based on the “Ramsay” principle set out in WT Ramsay Ltd v Inland Revenue Commissioners [1982] AC 300. That case introduced a rule that had commonly been accepted as a “principle” of UK taxation law sometimes referred to as the “fiscal nullity” doctrine. Under this rule, a court would disregard for fiscal purposes a series of transactions based on a number of pre-ordained steps where some of the intermediary steps had had no independent commercial purpose apart from facilitating tax avoidance. Decision: The House of Lords provided a different interpretation of the Ramsay principle or fiscal nullity doctrine, describing it not as a doctrine to be followed by courts in fiscal cases but rather as a useful aid in ascertaining the legal nature of transactions and in interpreting taxing statutes. In Ramsay, the taxpayer sought to recognise a capital loss that was manufactured in one step of a circular series of transactions that generated an offsetting capital gain which was not recognised for tax purposes. That decision was distinguished by the Court in Westmoreland on the basis that the capital loss provision only applied where there was an actual loss. The deduction for interest, the Court concluded, only looked to see whether an amount of interest had been paid and the source of funds used to pay the interest was not relevant. As a result, the Court allowed the deduction sought by the taxpayer. Relevance of the case today: There is considerable debate amongst UK tax authorities on the question of whether Westmoreland has narrowed the scope of the fiscal nullity doctrine. The debate is not directly relevant to Australian tax practice as the High Court in John v FCT [1989] HCA 5; 166 CLR 417; 20 ATR 1 agreed with earlier precedent that the fiscal nullity doctrine was precluded from applying in Australia by the existence of a general anti-avoidance rule in the Australian tax law. Westmoreland may be cited in Australia as an authority on statutory interpretation, however, used to support an argument that courts should not look to a chain of related transactions if a provision in the legislation applies directly to one of the transactions. If it happened today: It is highly unlikely that the facts in Westmoreland could arise in Australia today. Unlike the UK law, which prevented a deduction for accruing 380

© Thomson Reuters 2019

CHAPTER 18

ANTI-AVOIDANCE DOCTRINES AND PROVISIONS

interest obligations until they are paid, under tax accounting principles in Australia the taxpayer would likely have been able to deduct the interest liability as it accrued. Also unlike the UK, the trustees of the pension fund to whom the interest was owed would not be tax exempt but instead would be subject to the 15% income tax imposed on superannuation funds. If the facts in Westmoreland arose in Australia today, the taxpayer would have deducted interest expenses under s 8-1 ITAA 1997 as the interest obligation compounded and would have an accrued tax loss without having to make the payments. At the same time, the superannuation fund to which the money was owed would have paid tax on the compounding interest under s 6-5(1) ITAA 1997. A further loan from the superannuation fund trustees to the taxpayer to enable the taxpayer to pay the accrued interest would not trigger any tax consequences. If the superannuation fund sold the taxpayer for the value of its tax losses, under s 165-10 ITAA 1997, the taxpayer is only allowed to use the carried-forward losses if it meets the continuity of ownership test (which it couldn’t in this scenario) or the same business test set out in s 165-13 ITAA 1997.

SECTION 260 Unlike its UK counterpart, the Australian ITAA had a general anti-avoidance provision aimed at tax minimisation arrangements which appeared in the 1936 legislation as s 260 ITAA 1936. Read literally, s 260 had almost unlimited scope, applying to any contract or arrangement with the purpose or effect of reducing an income tax liability. The broad potential application for the section was severely limited, however, by judicial interpretation of the measure, eventually reducing its scope so severely the legislature enacted a replacement general anti-avoidance rule in Part IVA ITAA 1936.

Newton v FCT

(1958) 98 CLR 1 (Privy Council)

Facts: The taxpayer was one of a group of shareholders in three private companies that were facing assessments under the former “undistributed profits tax” that applied to retained profits in private companies. To extract the profits from the companies and avoid tax on the distribution, the taxpayer engaged in a “dividend stripping” scheme. The taxpayer first sold his shares in the private companies to a share trading company for the value of the retained earnings in the private companies. The share trading company had the retained profits distributed to it as dividends and then sold the now almost worthless shares for a small amount. The share trading company’s income in the form of assessable dividends was offset by a deduction for the loss on the shares. The share trading company used the dividends to pay for the original purchase of the shares. The original shareholders thus in effect received the retained profits but realised them as capital receipts for the sale of shares rather than as dividends – hence the phrase “dividend stripping” commonly used to describe transactions of these sorts. The shareholders used the proceeds to recapitalise the company through an indirect © Thomson Reuters 2019

381

AUSTRALIAN TAXATION LAW CASES 2019

transaction so the money ended up back in the private companies and the taxpayer ended up in the same position he started, as a shareholder in the private companies. The Commissioner relied on s 260 ITAA 1936 to assess the taxpayer on the proceeds he received for the sale of his shares on the basis that the proceeds were a substitution for the assessable dividends he would have received if he had not entered into the tax minimisation arrangement. Decision: The Privy Council upheld the Commissioner’s assessment on the basis of s 260, concluding that the whole of the transactions considered together demonstrated a concerted action with a goal of avoiding a tax liability. Relevance of the case today: The judgment of the Privy Council in Newton was delivered by Lord Denning. In the course of the judgment, he developed what has become known as the “predication” test – that s 260 will apply only if an observer could “predicate” (that is, assert) on the basis of a taxpayer’s actions that the acts were taken with the purpose of avoiding tax. While the Privy Council found for the Commissioner in Newton looking at the series of transactions as a whole, the predication test was subsequently used by Australian courts, particularly in the 1970s, to narrow the scope of s 260 and the legacy of the case, somewhat ironically, was to provide a tool for narrowing the application of the general anti-avoidance provision, a factor that prompted its replacement in 1981 by Part IVA. Some observers have suggested the list of factors in s 177D ITAA 1936 of Part IVA used to determine a taxpayer’s purpose is an attempted codification and expansion of the predication test. If it happened today: If the facts in Newton arose today, the Commissioner would attempt to apply Part IVA, most likely applying s 177E ITAA 1936, a provision aimed specifically at dividend stripping schemes. It is likely that the Commissioner would succeed with an assessment based on Part IVA.

FCT v Gulland; Watson v FCT; Pincus v FCT

(1985) 160 CLR 55; 17 ATR 1; 85 ATC 4765 (Full High Court)

Facts: The taxpayers were medical practitioners who shifted their practices into unit trusts of which they were the trustees and salaried employees. The doctors’ families were the beneficiaries of the trusts. The arrangements would have allowed the doctors to split the income from their medical practices between family members. Relying on s 260 ITAA 1936, the Commissioner assessed the taxpayers as if they, rather than the trusts, had received the fees for medical services provided by the taxpayers. Decision: While the facts were different for the three taxpayers (Pincus organised a similar scheme but unlike the other two taxpayers was working in a partnership), in all three cases the High Court affirmed the assessments based on s 260. The Court concluded that having regard to the arrangements in their totality, it could be said that one of the main purposes of the arrangements was tax avoidance. It was not necessary for the Commissioner to show that avoidance of tax was the sole purpose of a scheme for s 260 to apply. The Court also dealt with the “annihilation” feature of s 260. Unlike the successor general anti-avoidance rule in Part IVA ITAA 1936, s 260 did not contain a reconstruction provision. It would annihilate a transaction and allow the 382

© Thomson Reuters 2019

CHAPTER 18

ANTI-AVOIDANCE DOCTRINES AND PROVISIONS

Commissioner to ignore a transaction, but it did not expressly allow the Commissioner to then reconstruct the arrangement into one that would have taken place if not for the scheme. However, the High Court in Gulland, Watson & Pincus followed much earlier s 260 doctrines and allowed the Commissioner to assess on the basis of an implied reconstruction power once the actual arrangement was disregarded. Relevance of the case today: The Gulland, Watson & Pincus case (sometimes known as the “three doctors” case) is credited with reviving the efficacy of s 260, although, somewhat ironically, the reincarnation took place in the context of an appeal of a long-standing tax dispute and the provision itself had ceased to apply to schemes by the time the appeal was heard. The case revived s 260 in two respects. First, it shifted the analysis back to a broader view that looked at the totality of interrelated transactions to determine a main, but not sole tax avoidance purpose. Second, it overcame the problem of s 260 having no explicit reconstruction rule.

PART IVA The apparent impotence of s 260 ITAA 1936 led to the enactment of a replacement general anti-avoidance rule in Part IVA in 1981. Ironically, new life was subsequently breathed into s 260 following the adoption of Part IVA and the cut-off of application for the original anti-avoidance measure. Section 177F ITAA 1997 allows the Commissioner to make a determination increasing assessable income, reducing deductions, treating capital losses as not having been incurred or removing entitlement to some types of tax offsets where a taxpayer has entered into a scheme (identified using the factors in s 177D ITAA 1936 1936) (defined in s 177C ITAA 1936 1936) and the dominant purpose of the scheme (as set out in s 177A(5) ITAA 1936 1936) was to obtain a tax benefit as defined in s 177C ITAA 1936. The tax benefit obtained under a scheme to which Part IVA applies is determined by comparing the assessable income, allowable deductions, capital losses or relevant tax offsets calculated under the arrangements that constitute the scheme with the amounts that would have been calculated had the taxpayer entered into arrangements that could have been expected if not for the scheme. Section 177CB ITAA 1997 explains the factors to be considered to develop the hypothetical alternative arrangements that would have been carried out but for the scheme. Due to an increase in focus on multinational entity tax avoidance and uncertainty around the effectiveness of the existing regime, Part IVA was amended, effective 1 January 2016, to ensure that certain cross border arrangements are also caught. From 1 July 2017, a Diverted Profits Tax of 40% which applies to certain multinational entities was introduced to complement the existing anti-avoidance rules in Part IVA. Where the Commissioner reassesses a taxpayer using the authority of Part IVA, a four-year time limit for reassessment applies, in contrast to the two year reassessment period for ordinary reassessments of individuals or unlimited time period in cases of fraud or evasion. Where a tax benefit is reversed following the application of Part IVA, the taxpayer may be subject to additional scheme penalties under s 284-145 Taxation Administration Act 1953. © Thomson Reuters 2019

383

AUSTRALIAN TAXATION LAW CASES 2019

Can Part IVA apply if a scheme fails anyway? An avoidance motivated scheme may fail on substantive grounds such as a deduction not being allowed under s 8-1 on general principles. If a scheme fails on operation of ordinary provisions in the law, can the Commissioner also argue that it triggers Part IVA and use the additional assessment time available for Part IVA assessments or the additional penalty system for Part IVA assessments even though the scheme has otherwise failed?

Vincent v FCT

(2002) 51 ATR 228; 2002 ATC 4742 (Full Federal Court)

Facts: The taxpayer invested in a cattle breeding scheme that involved the activities of three companies controlled by the promoter. A leasing company leased cattle to the investors, a management company managed the cattle (including embryo implantation) and a finance company provided the taxpayer with a non-recourse loan to pay for the lease and management fees. The loan became a non-recourse loan if the taxpayer prepaid interest for a period on the loan. The contract provided for the finance company to pay the loaned funds directly to the management company on behalf of the taxpayer. The finance company failed to pay any funds to the management company and the Commissioner argued no expenditure had been incurred in respect of those amounts. He argued further that since no loan had been made, no interest was payable and no deduction should be allowed in respect of the interest. Separately, the Commissioner argued the other fees paid directly by the taxpayer were not revenue expenses incurred in carrying on a business. The Commissioner sought to reassess the taxpayer after the four-year amendment time limit set out in s 170 ITAA 1936 had expired. He argued Part IVA ITAA 1936 applied to the arrangements and he could rely on the then longer six year Part IVA amendment period in s 177G ITAA 1936. Decision: As no loan had been made, the Commissioner was correct in concluding that no deduction was allowable in respect of the amounts that were to have been paid with the loan or for the payments described as interest on the loan. Ordinarily, moneys outlaid for management services on a recurrent basis will ordinarily be on revenue account. However, the Court concluded the taxpayer was not in the business of raising cattle so the management fees which related mostly to the implementation of embryos were capital expenses for the acquisition of assets that were not trading stock. Thus, no deduction was allowable for those expenses either. A tax benefit to which Part IVA applies includes a deduction that is allowable to the taxpayer but which would not be allowable if the taxpayer had not entered into a scheme. As the deductions sought by the taxpayer would not have been allowable even in the absence of a scheme, the taxpayer had no tax benefit under s 177C ITAA 1936 and as a result Part IVA did not apply. This meant the Commissioner was unable to use the extended amendment period in s 177G or to apply penalties on the basis of a determination made under Part IVA. 384

© Thomson Reuters 2019

CHAPTER 18

ANTI-AVOIDANCE DOCTRINES AND PROVISIONS

Relevance of the case today: The Vincent case shows that Part IVA cannot apply where the benefit sought by the taxpayer is denied under the general provisions of the ITAA. It will only apply if the taxpayer would have obtained a tax benefit were it not for a scheme that triggered the application of Part IVA. One important consequence of this decision is that the Commissioner cannot rely on Part IVA to extend the period for amendment of assessments where the taxpayer would not be entitled to the benefit under the primary provisions of the ITAA. This means that if a taxpayer has been incorrectly allowed a tax benefit under the primary provisions of the ITAA, the Commissioner must reassess within four years. Otherwise, if it is determined that the original assessment was incorrect and a deduction should not have been allowed, there will be no tax benefit to which Part IVA can apply, even though the taxpayer did get (improperly, as it turns out) the benefit. If it happened today: If the facts in Vincent were to arise today, the Commissioner would argue the expense is not deductible under s 8-1 because the expense was a capital outlay. This would only be possible if the Commissioner were able to show that the taxpayer was not in business with respect to the cattle venture. If it was found that the taxpayer was in the business of raising cattle, operating through a manager, and the taxpayer had actually borrowed funds and prepaid some interest the Commissioner would seek to limit the taxpayer’s deductions for prepaid interest expenses using s 82KZM ITAA 1936, which would spread the deductions over the period to which the prepayment related. Even if the Commissioner reassessed within the time limit allowed by s 170, applying Part IVA would be problematic. The Full Federal Court suggested in obiter that the scheme had been devised by the promoter-manager and his dominant purpose was to ensure funds flowed to his companies, not to provide a tax benefit to the investors. If a court found similarly on a version of the scheme today, it would not be possible to apply Part IVA to the arrangements.

Can schemes be dissected to find the dominant purpose? As a result of s 177A(5) ITAA 1936, the Commissioner may cancel a tax benefit under Part IVA where the “dominant” purpose for a scheme was to obtain the tax benefit. An initial question raised on adoption of the measures was whether the dominant purpose was determined looking at a multi-element scheme in its entirety or whether the Commissioner could apply Part IVA to one or more tax-motivated steps of a larger scheme.

FCT v Peabody

(1994) 181 CLR 359; 28 ATR 344; 94 ATC 4663 (Full High Court)

Facts: The taxpayer was a beneficiary of a discretionary trust that held shares in a private company. Prior to a public float of the company, the trustee wished to acquire the shareholding of the other major shareholder. However, if it acquired the shares shortly before selling them into the float, the trustee would have been liable to full taxation on the profits from the resale under s 26AAA ITAA 1936. This outcome was avoided by arranging for a shelf company to acquire the shares followed by a company resolution to convert those shares to preference shares with limited rights so all the © Thomson Reuters 2019

385

AUSTRALIAN TAXATION LAW CASES 2019

underlying value of the company attributable to those shares would be transferred to the original shares held by the trustee. The trustee then sold the original shares into the float and claimed the profit was tax-free as the original shares were acquired prior to the introduction of CGT. The Commissioner applied the anti-avoidance provisions in Part IVA ITAA 1936 and assessed the taxpayer on the basis that if not for the trustee’s scheme, it would have derived taxable profits from the purchase and resale of the other shareholder’s shares and these would have been distributed to the taxpayer. Decision: The Full High Court denied the Commissioner’s appeal on the basis that there was no reasonable expectation that if not for the scheme the trustee would have acquired and sold the shares or that the shelf company would have acquired and sold the shares and distributed the profits as dividends to the trustee that would in turn have distributed the income in the particular year of assessment to the taxpayer as beneficiary of the trust. While the High Court found that Part IVA could not be used to support the assessment of the trust beneficiary, in the course of the judgment the Court provided some important insights into the interpretation of Part IVA. Most importantly, it indicated that to find the “dominant purpose” behind a scheme (as required by s 177A ITAA 1936 1936), the Commissioner could treat an element or selected elements of a chain of related transactions as the scheme to which Part IVA applied. Thus, for example, while the overall purpose of the larger scheme in Peabody was to float a company and sell shares to the public, the dominant purpose of the value shift was to avoid the application of s 26AAA to the sale of a parcel of shares acquired not long before the float. In effect, the Commissioner was successful on the question of whether Part IVA applied to the value shifting scheme but was ultimately unsuccessful because he sought to assess the wrong person. It was the trustee that avoided deriving assessable income as a result of the scheme and under ordinary circumstances the Commissioner would have used Part IVA to assess the trustee. However, this option was not open to the Commissioner in Peabody because by the time of the litigation the trust and all its assets had shifted offshore to a tax haven and the assets could not be reached. The only possibility was to assess a beneficiary but it was impossible to show that a particular beneficiary of a discretionary trust would have received income from the trust in a particular year but for the scheme. Relevance of the case today: Although the Commissioner did not succeed in Peabody, the case established important principles for the interpretation of Part IVA, particularly the ability of the Commissioner to extract elements from a multi-stepped arrangement and treat the separated element as a scheme to show the taxpayer’s dominant purpose. If it happened today: If the facts in Peabody arose today and a scheme had been engineered to avoid tax assessable under the CGT provisions that replaced s 26AAA, the Commissioner would be unlikely to use Part IVA to assess a beneficiary of a discretionary trust. It would be equally difficult today to show that if not for the scheme, the trust would have realised taxable income and would have distributed it to a particular beneficiary in a particular year. 386

© Thomson Reuters 2019

CHAPTER 18

ANTI-AVOIDANCE DOCTRINES AND PROVISIONS

Leaving aside the problem of finding an appropriate person to assess following the departure of the trust overseas, if the facts in Peabody arose today, the transaction would be caught by value shifting rules. With the repeal of s 26AAA, the difference between short-term capital gains (realised on assets held for less than a year) and longterm capital gains is now relevant because short-term capital gains do not qualify for the CGT discount under s 115-25(3) ITAA 1997. The value shift would give rise to a gain under the value-shifting rules in s 725-245 ITAA 1997 and the gain would be treated as a capital gain under CGT event K8 under s 104-250 ITAA 1997.

What is the “dominant” purpose of a scheme? Unless a scheme is a genuine money-losing proposition but for the tax benefit obtained through a scheme, there will be a commercial purpose to the scheme in addition to the goal of a tax benefit. The challenge for the taxpayer is to show that the commercial purpose of the scheme is the dominant purpose and the tax benefit obtained by the particular structure and transactions used was subsidiary to this dominant purpose. If the commercial purpose looks weak without the additional tax benefit, the courts will be inclined to conclude the tax benefit was a dominant purpose to the scheme. If the commercial purpose looks weak without the additional tax benefit, the courts will be inclined to conclude the tax benefit was a dominant purpose to the scheme. Since December 2015, a wider purpose test has applied to cross-border tax avoidance schemes involving large multinational enterprises. The test in this case is based on the principal purpose or one principal purpose of more than one purposes.

FCT v Spotless Services & Anor

(1996) 186 CLR 404; 34 ATR 183; 96 ATC 5201 (Full High Court)

Facts: The taxpayer wished to invest surplus funds raised through a share float. It deposited the funds in a bank located in the Cook Islands by way of a complex series of transactions involving Australian, Singapore, and Hong Kong banks. The effect of the transactions was to notionally place the funds with the bank in the Cook Islands providing the taxpayer with the security of a deposit with a larger bank in Australia or Singapore through the use of cross-transfers back to Singapore. Although the interest rate payable on the deposit in the Cook Islands was 4% lower than the rate payable on deposits in Australia, the after-tax return from the Cook Islands deposit would have been much higher. This is because interest from a deposit in Australia would have been taxed at the full corporate tax rate while interest derived in the Cook Islands would have only be subject to a low withholding tax when paid. At the time, foreign source income that had been subject to foreign withholding tax was exempt from Australian tax under s 23(q) ITAA 1936. The Commissioner assessed the taxpayer using Part IVA ITAA 1936, arguing that but for a tax avoidance scheme, the taxpayer would have deposited the funds in an Australian bank and the interest would have been subject to tax at the full company tax rate. Decision: The Full High Court upheld the Commissioner’s assessment on the basis of Part IVA. A rational commercial purpose for the arrangement would be to increase the after-tax returns for the company by investing in the Cook Islands rather than Australia. © Thomson Reuters 2019

387

AUSTRALIAN TAXATION LAW CASES 2019

However, this commercial purpose is consistent with a dominant purpose of obtaining a tax benefit and will not defeat the dominant purpose if it is clear looking at the transactions that the dominant purpose was to obtain the tax benefit. The investment at a much lower interest rate was only sensible if Australian tax could be avoided and this suggested that the dominant purpose of the arrangement was to obtain a tax benefit. Relevance of the case today: While the scheme in Spotless would not be attempted today with the repeal of former s 23(q), the case remains a leading Part IVA precedent. It shows how a court will look at whether a transaction makes economic sense but for the tax minimisation aspect of the scheme and whether the multiple inter-related steps in the scheme are directed at achieving the tax minimisation goal without exposing the taxpayer to economic risk. If it happened today: The tax minimisation scheme in Spotless relied on the operation of former s 23(q) and the complete exemption from Australian tax of interest that had been subject to a token withholding tax. If the exemption of s 23(q) had not applied, the scheme would not have been commercially viable given the dramatically lower interest rate paid on the deposit than would have been paid in Australia. Following the repeal of s 23(q) and its replacement with a foreign tax credit system (now called the foreign tax offset system), the taxpayer would not enter into the scheme today. If it did invest in a tax haven where interest is only subject to a small withholding tax, the interest (without taking into account any withholding tax) would be assessable in Australia under s 6-5(1) ITAA 1997. A foreign tax offset would be allowed for the withholding tax under s 770-10 ITAA 1997.

Howland-Rose & Ors v FCT

(2002) 49 ATR 206; 2002 ATC 4200 (Federal Court)

Facts: The taxpayer was one of several thousand participants in what is known as the “budplan” scheme. Under the scheme arrangements, investors were invited to “invest” in a scheme to research and develop products made from tea tree oil. The investments were effected through a “round robin” of money – the scheme promoters “lent” $24,000 to each investor by way of a bill of exchange and the investors promptly returned the funds to the promoters to be used for research and development. The scheme prospectus to investors indicated that in return for entering into the scheme, participants would be able to claim upfront deductions for their investment, for most investors yielding a cashflow from tax savings of almost half the investment. The scheme required the taxpayers to make further payments of interest and principal of $9,600 over the following two years, of which $3,600 would be treated as deductible interest, yielding a further tax saving cashflow. After two years, the loans would become non-recourse loans meaning there was no continuing obligation by the investors to make any payments on the loans which would be repayable only if the scheme generated a commercial profit. The scheme thus generated after-tax cash flows to investors for arrangements that might never actually turn a true profit. In the event, the scheme funds were used to pay for the promoters’ management fees and activities by related companies but there were no commercial sales of output from the scheme.

388

© Thomson Reuters 2019

CHAPTER 18

ANTI-AVOIDANCE DOCTRINES AND PROVISIONS

The Commissioner denied scheme participants a deduction for their investments on three grounds. First, he argued the round robin of cheques did not amount to real payment by the investors. Second, he argued the payments were not deductible under s 51(1) ITAA 1936 (currently s 8-1 ITAA 1997 1997) as they were incurred prior to any business or income earning activities. Third, he argued that if the arrangements were treated as payments and did satisfy the requirements of s 51(1), the arrangements could be voided under Part IVA ITAA 1936 as they were entered into for the dominant purpose of obtaining tax deductions. The Commissioner presumably sought a finding under Part IVA as well because this could be used as the basis for imposing penalties for the deductions claimed by scheme participants. Decision: Conti J of the Federal Court concluded there was no sham in the round robin of cheques and accordingly the taxpayer did make the payment for which a deduction was sought. However, Conti J accepted the Commissioner’s argument that the expense was not deductible under s 51(1) as it was incurred for research and development prior to carrying on a business. It was, therefore, not incurred in deriving assessable income. Finally, Conti J agreed that Part IVA applied to the scheme as it had been entered into for the predominant purpose of obtaining a tax benefit, namely the up-front deduction for management fees and research and development. This was confirmed by the emphasis on the deduction and resulting cash flow benefits to investors in the scheme prospectus. The scheme comprised the totality of the prospectus that promised investors a positive after-tax cash flow even if the arrangement made no profit and the steps in the scheme. Factors set out in s 177D ITAA 1936 to identify a scheme to which Part IVA applies include the manner in which the scheme was carried out. Arrangements designed to trigger a tax saving while protecting the investors from the need to repay the loan satisfied that criterion. The facts also supported the form and substance criterion manner, particularly the fact that a deduction was claimed for the entire payment but the arrangements were structured so the investors would never have to repay the entire loan used to fund what was intended to be the deductible expense. Relevance of the case today: One of the grounds on which the decision was made was the fact that research and development expenses were incurred prior to the commencement of business. The arrangements in HowlandHowland Rose were marketed as a tax minimisation scheme and it is likely that the Commissioner would not seek to apply so rigidly the argument that research and development expenses are non-deductible because they were incurred prior to carrying on a business in a more conventional business where it was clear the investors were expecting the research and development to yield results that could be used in the continuing business with which the research and development was associated. The HowlandHowland Rose case shows clearly how the marketing of mass marketed tax avoidance schemes can be used to prove they fall foul of Part IVA. Evidence that the arrangements will generate a tax benefit even if there is no commercial gain from the investment will point to a scheme to which Part IVA applies. If it happened today: Section 73A ITAA 1936 previously allowed individuals a deduction for research and development expenses. That provision no longer operates to provide individuals with deductions for these expenses, although the individuals could try to deduct research and development expenses as outgoings under s 8-1. © Thomson Reuters 2019

389

AUSTRALIAN TAXATION LAW CASES 2019

If the facts in HowlandHowland Rose were to arise today, a court would likely find that the expenses were not deductible under s 8-1 as the scheme was based on deductions prior to the commencement of any income-earning activities and in fact the taxpayer did not actually anticipate the generation of assessable income from the arrangements. Also, the Commissioner could apply Part IVA to deny the taxpayer a deduction for expenditures. To show the taxpayer’s predominant objective in entering into the scheme was to obtain a tax benefit, the Commissioner could rely on the prospectus. If the scheme is marketed primarily on the basis of an upfront deduction for an expense that investors will never actually have to pay as a result of a non-recourse loan arrangement, it is likely that a court would agree the predominant objective of the investors is to obtain a tax benefit. If the facts in HowlandHowland Rose were to arise today, they would likely also fall foul of the prepayment rules. The arrangement appears to fall within the “tax shelter” description of s 82KZME ITAA 1936 so the prepayment must be deducted on a proportional basis over the period to which the prepayment relates.

FCT v Hart

[2004] HCA 26; 217 CLR 216; 55 ATR 712; 2004 ATC 4599 (Full High Court)

Facts: The taxpayer entered into a “split loan” arrangement which was based on a single loan split into two accounts, the first for private residential property and personal expenses and the second for an investment residential property. The split loan facility allowed the taxpayer to “capitalise” the interest obligations on the investment property loan account and apply all payments on the loan to the interest obligation and principal component of the private loan account. Capitalising the interest on the investment account meant each unpaid interest amount was added to the principal. Because all payments were credited to the private loan account, the taxpayer reduced the private loan account while the investment loan account was not reduced. The taxpayer sought to deduct the compounding interest growing in the investment loan account while the payments reduced the private loan account. The Commissioner denied the taxpayer a deduction for some of the unpaid compounding interest on the investment property account on the basis of Part IVA. Decision: The High Court concluded that the factors set out in s 177D(b) ITAA 1936 pointed to a dominant purpose for entering into the split loan arrangement to obtain a tax benefit and thus avoid tax. The Court noted that the payments made by the taxpayer were the same as would have been made if the taxpayer had entered into two separate loans but because of the linked loan arrangement the taxpayer sought a deduction much higher than would have been allowed if two separate loans had been used. The Court suggested that the taxpayer would not have been able to capitalise interest and make no repayments on a separate investment property loan and this was allowed only because of the split loan facility and this indicated the arrangement was intended to provide the tax benefit. Relevance of the case today: The Hart decision is an important Part IVA precedent in terms of the meaning of a “scheme” and a “tax benefit”. The term “scheme” is read 390

© Thomson Reuters 2019

CHAPTER 18

ANTI-AVOIDANCE DOCTRINES AND PROVISIONS

broadly and can include a commercial arrangement such as a split loan agreement with a third party. The term “tax benefit” extends to a benefit from an arrangement that combined different elements if the benefit could not have been obtained had the elements been carried out separately. If it happened today: If the facts in Hart arose today, the Commissioner would most likely succeed once again if he relied on Part IVA to deny a deduction for the full interest being capitalised.

FCT v News Australia Holdings Pty Ltd

(2010) 79 ATR 461; 2010 ATC 20-191 (Full Federal Court)

Facts: The taxpayer was an Australian holding company that owned several subsidiaries, including a subsidiary in the UK. The group wished to transfer the shares in the subsidiaries to a holding company in the US and entered into a series of complex transactions to shift ownership of the shares in the subsidiaries from the taxpayer to the US company. One of the steps involved a share buy-back, with a US subsidiary of the taxpayer purchasing its shares held by the taxpayer. The taxpayer realised a significant capital loss as a result of this transaction. The Commissioner relied on Part IVA to deny the taxpayer recognition for the loss, arguing that the taxpayer engaged in the share buy-back step of the arrangements with the dominant purpose of obtaining a tax benefit as there were other ways to achieve the desired shift of assets to the US without relying on the share buy-back step. The taxpayer argued the dominant purpose of the buy-back was not to obtain a tax benefit as evidenced by its internal documents that showed it did not want to run any tax risk in the arrangements and that the use of buy-backs was motivated by UK tax considerations. Decision: The Full Federal Court found Part IVA did not apply to the scheme as the dominant purpose of the buy-back step was not to obtain a tax benefit. While internal documents that purport to show a taxpayer’s subjective intention cannot be conclusive for Part IVA purposes, the objective evidence that reflects those views can be relied on. Evidence of a motive to achieve beneficial tax outcomes in the UK can be considered as an indication of motives for a transaction other than obtaining a tax benefit in Australia. Relevance of the case today: The key issue in many Part IVA cases is whether the taxpayer’s dominant purpose in an arrangement is to obtain an Australian tax benefit. Relying on News Australia Holdings, taxpayers who have designed an arrangement to affect tax liabilities in another jurisdiction may be able to use that fact in support of an argument that the primary purpose of an arrangement was not to obtain a tax benefit in Australia.

© Thomson Reuters 2019

391

AUSTRALIAN TAXATION LAW CASES 2019

If it happened today: If the facts in News Australia Holdings were to take place today, a court would likely conclude that it had not been shown the dominant purpose of the taxpayer was to obtain a tax benefit in Australia. As a result, Part IVA would not apply to the transaction.

What is the counter-factual? To cancel a tax benefit obtained under a scheme that is subject to Part IVA, the Commissioner is required to show the income, deductions, and other factors affecting the tax that would have been payable had the taxpayer not entered into the scheme. To do this, the Commissioner constructs a counterfactual of the transaction that would have taken place if the dominant purpose had not been to obtain a tax benefit. The taxpayer may try to counter that argument by suggesting that, had the transaction not been carried out as it had, a different transaction with similar tax outcomes would have been used or even that if the tax benefit had not been available, the taxpayer would not have entered into any transaction.

FCT v Futuris Corporation Ltd

[2012] FCAFC 32; 87 ATR 828; 2012 ATC 20-306 (Full Federal Court)

Facts: The taxpayer resolved to sell a majority interest in a subsidiary by way of a public float and listing of the resulting public company on the stock exchange. In preparation for the sale, the taxpayer and subsidiaries it controlled entered into a series of transactions to transfer various assets of the group to the subsidiary that would be floated. The taxpayer elected to use rollover provisions for some of these transactions to defer tax on the transactions. Other transactions included distributions of profits by way of inter-corporate dividends that were tax-free as a result of the inter-corporate dividend rebate then in effect. The net effect of the arrangements was to raise the taxpayer’s cost base in the subsidiary it sold and thus reduce the assessable capital gain realised on the sale. The Commissioner argued that Part IVA applied and argued a counterfactual alternative arrangement that the Commissioner said the taxpayer would have followed if it had not chosen the arrangements it did with the object of reducing tax. The taxpayer argued that for Part IVA to apply, the Commissioner had to show the taxpayer would have followed the alternative path suggested by the Commissioner if not for the tax benefits of the path it chose. If there were other alternatives it could follow and evidence it had considered the other alternatives, the taxpayer argued, Part IVA could not apply. Decision: The Full Federal Court dismissed the Commissioner’s appeal, accepting the view that the taxpayer might have pursued transactions different from the counterfactual offered by the Commissioner had it not used the tax beneficial transactions that it did. Relevance of the case today: The Futuris case was one of several heard in this period in which the Commissioner lost because he was unable to convince the court that the taxpayer would follow a particular higher tax counterfactual rather than another lower tax alternative. The series of losses prompted the government to amend Part IVA to deal with this issue. 392

© Thomson Reuters 2019

CHAPTER 18

ANTI-AVOIDANCE DOCTRINES AND PROVISIONS

If it happened today: If the facts in the Futuris case arose today, the taxpayer could not argue Part IVA would not apply because there were alternative transactions in contemplation apart from that offered by the Commissioner as his counterfactual to the transactions that did take place.

Hart v FCT

[2018] FCAFC 61, (2018) ATC 20-653 (Full Federal Court)

Facts: The appellant was a solicitor in a Brisbane law firm who entered into arrangements to divert income away from himself and entities he owned, and towards a company with carry forward losses. The amounts passed through a series of trusts. Then, through a series of gifts and subscriptions of capital, the earnings were paid to the benefit of the appellant. The appellant received what was labelled a practice amount (earnings of the firm) and an “‘income earning trusts”’ (IET) amount. The appellant claimed the amounts were received by way of loan. The Commissioner assessed both amounts as taxable income in the hands of the appellant. The basis of the assessment was that the practice amount was a deemed present entitlement under Div 6 of Part III of ITAA 1936 or alternatively assessable under Part IVA of ITAA 1936. The IET amount was assessed solely on the basis of Part IVA of ITAA 1936. Decision: The Full Federal Court concluded that the judge at first instance was correct to conclude that the practice amount was income according to ordinary concepts. Partly relying on FCT v Dixon (1952) 86 CLR 540, the reason for the assessability of the income was that it was received regularly and relied upon by the appellant to fund his daily expenditure. In respect of the Part IVA assessments, the Full Federal Court held that the taxpayer failed to establish that the Commissioner’s counterfactual was unreasonable. Further, the taxpayer also failed to provide evidence of his own counterfactual. Relevance of the case today: Hart is an important case for considering the evidence that a taxpayer would need to provide to demonstrate that the alternative transactions postulated would also not have been subject to Part IVA. If it happened today: If the facts in Hart arose today, the Commissioner would attempt to apply both the income provisions and/or Part IVA of ITAA 1936 to assess the taxpayer. It is likely that the Commissioner would succeed with an assessment.

Dividend stripping and Part IVA Prior to the inclusion of capital gains in the income tax base in 1985, taxpayers would prefer to realise the value of retained earnings in a company they owned as an untaxed capital gain realised on the sale of their shares rather than as fully taxed dividend distributions. The preference continues for individuals who are able to exclude 50% of realised capital gains from assessable income. While companies are not entitled to the discount for capital gains, they may be able to defer any tax on capital gains by way of rollovers or other company reorganisation relief. © Thomson Reuters 2019

393

AUSTRALIAN TAXATION LAW CASES 2019

The different treatment of capital gains and dividends led to a surge of “dividend stripping” schemes in the 1970s and 1980s. Under these schemes, an owner of a company with retained earnings would sell the company to a dividend stripper that would extract the retained earnings and use them to pay the purchase price of the company. As a result, the former owners received the retained earnings but could characterise them as capital gains rather than dividends. Section 177E was added to Part IVA ITAA 1936 specifically to attack dividend stripping schemes. Subdivision 207F ITAA 1997 prevents the new shareholder from receiving any imputation credits where the dividend distribution is part of a dividend stripping scheme.

FCT v Consolidated Press Holdings Ltd

(2001) 207 CLR 235; 47 ATR 229; 2001 ATC 4343 (Full High Court)

Facts: The case involved two separate issues – the possible application of Part IVA to deny the taxpayer a deduction for certain income expenses and the possible application of Part IVA to assess the taxpayer in respect of what was labelled a “dividend stripping” arrangement. The taxpayer was a member of a company group that wished to make a takeover bid for a UK company through a UK subsidiary of the group. To fund the takeover bid the taxpayer borrowed funds and following advice from an international accounting firm, used those funds to subscribe for shares in an Australian subsidiary which in turn subscribed for shares in and lent funds to the UK company. The taxpayer sought a deduction for the interest incurred on the funds it had borrowed to invest in the intermediary Australian subsidiary. Section 79D ITAA 1936, which limited deductions related to foreign income, would have operated to deny the taxpayer a deduction for the interest expense had the taxpayer used borrowed funds to invest directly in the UK subsidiary. The Commissioner relied on Part IVA to deny the taxpayer deductions for its interest expenses, arguing the taxpayer had structured the arrangement through an interposed Australian subsidiary for the principal purpose of obtaining a tax benefit of an interest deduction that would have been prevented by s 79D had the taxpayer invested directly in the UK subsidiary. The dividend stripping issue arose out of the subsequent shift of the UK holdings of the group from a UK subsidiary of the taxpayer to a Bahamas company. To achieve the shift, the taxpayer sold its shares to a new company in the Bahamas and the UK subsidiary then liquidated so all its assets would be distributed to its new owner, the company in the Bahamas. The Commissioner took the view that the arrangement amounted to a dividend stripping scheme. Dividend stripping arises when a taxpayer sells shares in a company with significant retained profits and the new owner extracts the profits from the company it has acquired and uses those funds to pay for the share purchase. In effect, the vendor is able to convert what would have been dividends to a capital gain. If the shares were acquired prior to 20 September 1985, the capital gain is tax-free. The Commissioner assessed the taxpayer using s 177E ITAA 1936, the antiavoidance provision applicable to dividend stripping. The Commissioner argued that this section, which applies to dividend stripping schemes, did not require the dominant purpose of obtaining a tax benefit, unlike the remainder of Part IVA. 394

© Thomson Reuters 2019

CHAPTER 18

ANTI-AVOIDANCE DOCTRINES AND PROVISIONS

Decision: The High Court decided in favour of the Commissioner on the first issue, upholding the denial of interest deductions on the basis of Part IVA. The High Court indicated that it was both possible and sometimes appropriate to attribute the purpose of a professional adviser to a taxpayer when determining the taxpayer’s dominant purpose for the application of Part IVA. While the objective of the investment was to derive a commercial profit, the dominant purpose of the scheme used, the interposition of a domestic entity between the taxpayer and the foreign entity for which the funds were ultimately intended, was to achieve a tax benefit. The High Court decided in favour of the taxpayer on the application of s 177E. While s 177E does not include the dominant purpose test required for the application of the general anti-avoidance rule in Part IVA, the anti-dividend stripping provision should be read in the context of Part IVA and should not apply unless there was evidence of a dividend-stripping purpose to the transaction – that is, a purpose of the transaction was to receive as capital gains amounts that would otherwise be received as dividends. The evidence showed the only purpose of the taxpayer in entering into the arrangement was to move the UK assets to a non-UK company for reasons not connected with the avoidance of Australian tax. There was no evidence that a purpose, let alone the dominant purpose, of the arrangements was to enable the taxpayer to realise the value of retained earnings in the form of a capital gain. The available evidence showed that there were in fact relatively little retained earnings in the UK subsidiary at the time of the transaction. Relevance of the case today: The Consolidated Press Holdings case is an important Part IVA precedent in several respects. First, while s 79D has since been repealed, the case remains authority for the proposition that Part IVA can be used to defeat a scheme aimed at avoiding the application of another provision that has the effect of reducing a taxpayer’s deductions. Second, it shows that determining a taxpayer’s dominant purpose under s 177D ITAA 1936 is an objective test and the purpose of professional advisers in setting up a scheme can be attributed to the taxpayer even if the taxpayer is not aware of how the scheme will yield a tax benefit. The case is also an important precedent for the operation of the anti-avoidance rule aimed at dividend stripping in s 177E. Consolidated Press Holdings shows that to apply s 177E to a sale of shares, the Commissioner must show that a purpose of the transaction was to enable the taxpayer to realise the value of accumulated dividends as a capital gain for the vendor rather than as dividends. If it happened today: If the facts in Consolidated Press Holdings were to arise today, the Commissioner would, for the same reasons as applied in that case, be successful in applying Part IVA to deny the taxpayer a deduction for interest payments that would have been stopped by s 79D if the taxpayer had used borrowed funds to invest directly in a foreign subsidiary. The taxpayer would be successful in showing that s 177E did not apply to a sale of shares where there was no dividend-stripping purpose to the transaction.

© Thomson Reuters 2019

395

AUSTRALIAN TAXATION LAW CASES 2019

Imputation credits and Part IVA While franking credits are of value to some taxpayers such as non-residents who are not able to use the credits, they are valuable to resident taxpayers able to use them. Tax minimisation schemes have been developed to ensure dividend credits are attached to dividends received by taxpayers able to use them fully. Section 177EA ITAA 1936 was inserted in Part IVA specifically to counter schemes involving the distribution of franking credits. It is similar to the rest of Part IVA but differs in one significant respect. In all other circumstances, the Commissioner can invoke Part IVA only when obtaining a tax benefit was the taxpayer’s dominant purpose for entering into a scheme. However, s 177EA ITAA 1936 allows the Commissioner to apply Part IVA to a franking credit scheme where obtaining a tax benefit related to franking credits is a purpose of the scheme, without the need to show it was the dominant purpose. There is an exception, however, if the taxpayer can show the tax benefit was only an “incidental” purpose of the scheme.

Mills v FCT

[2012] HCA 51; 250 CLR 171; 83 ATR 514; 2012 ATC 20-360 (Full High Court)

Facts: The Commonwealth Bank of Australia, like all Australian banks, was subject to Australian prudential regulation that required it to hold a certain amount of capital relative to its total loans. As its business expanded, it required more capital to meet the prudential regulation requirements and it decided to do this by issuing “stapled securities” involving a debt instrument that carried no voting rights attached to a share, with the stipulation that they could not be traded separately (hence the “stapled security” title). The structure of the instruments provided a means of distributing franked dividends to investors. The Commissioner argued the goal of being able to distribute franked dividends was a purpose of the particular design of the share and debt instruments caught by s 177EA ITAA 1936. The taxpayer argued that goal was only an incidental purpose. Decision: The High Court decided in favour of the taxpayer, finding the dominant purpose of the arrangement was to raise capital required to comply with financial prudential regulations. The bank was able to show that it would have provided investors with similar amounts of franking credits however it might have structured the capital raising and it could therefore be concluded that the franking aspect was incidental to the primary purpose of raising capital. Relevance of the case today: The Mills case shows that in the case of capital raisings by banks where the purpose of the capital raising is to ensure the bank complies with prudential regulation requirements, the fact that the new instruments will entitle holders to franking credits is merely incidental to the purpose of the arrangement. If it happened today: If the facts in Mills were to arise today, the Commissioner would be unlikely to seek to apply Part IVA. If the Commissioner did attempt to use Part IVA to assess a bank engaged in a similar capital raising, the taxpayer would most likely succeed in any challenge of the assessment. 396

© Thomson Reuters 2019

C HAPTER 19

Tax Administration INFORMATION SUBJECT TO LEGAL PROFESSIONAL PRIVILEGE ..... 399 Does Privilege Apply Outside the Courtroom? ........................................... 399 O’Reilly v Commissioner of the State Bank of Victoria (1982) ............. 399 Baker v Campbell (1983) ....................................................................... 400 Opportunity to Claim Privilege ................................................................... 401 Allen Allen & Hemsley (1989) ............................................................... 401 Citibank (1989) ...................................................................................... 401 “Sole” or “Dominant” Purpose of Legal Advice ......................................... 402 Esso Australia Resources Ltd (1999) ..................................................... 402 Documents Prepared for the Taxpayer by Third Parties .............................. 403 Pratt Holdings Pty Ltd (2004) ............................................................... 403 Client Identification ...................................................................................... 403 Coombes (No 2) (1999).......................................................................... 403 Documents Obtained for Another Purpose .................................................. 404 Rennie Produce (Aust) Pty Ltd (in liq) (2018) ....................................... 404 ASSESSMENTS ................................................................................................... 405 Nil Assessments ........................................................................................... 405 Ryan (2000) ............................................................................................ 405 Asset Betterment Assessments .................................................................... 406 L’Estrange (1978) .................................................................................. 406 Double Counting Assessments .................................................................... 407 Futuris Corporation Ltd (2008) ............................................................. 407 Commissioner Decisions ............................................................................. 408 Pintarich (2018) ...................................................................................... 408 ACCESS TO BOOKS AND INFORMATION ................................................... 409 Australia and New Zealand Banking Group Ltd (1979) ........................ 409 Industrial Equity Ltd (1990) .................................................................. 410 COLLECTION OF TAX DUE ............................................................................. 410 Bluebottle UK Ltd (2007) ...................................................................... 410 Australian Building Systems Pty Ltd (2015) ......................................... 411

© Thomson Reuters 2019

397

AUSTRALIAN TAXATION LAW CASES 2019

APPEALS .............................................................................................................. Appeals outside the ITAA and Tax Administration Act ................................ FJ Bloemen Pty Ltd (1981) .................................................................... David Jones Finance and Investments Pty Ltd (1991) .......................... Basis for Assessment on Appeal .................................................................. Reynolds (1981) .....................................................................................

412 412 412 413 415 415

PENALTIES ........................................................................................................... 416 Walstern Pty Ltd (2003) .......................................................................... 416 OBLIGATION TO ISSUE A RULING ................................................................ 417 Hacon Pty Ltd (2017) ............................................................................. 417

398

© Thomson Reuters 2019

C HAPTER 19

Tax Administration INFORMATION SUBJECT TO LEGAL PROFESSIONAL PRIVILEGE The Commissioner is granted broad access powers to taxpayers’ documents and premises under s 353-15 Taxation Administration Act (TAA) 1953 (formerly s 263 ITAA 1936 1936) and under s 353-10 TAA 1953 (formerly s 264 ITAA 1936 1936) may require any person to provide information about a taxpayer. The Commissioner’s power to access taxpayers’ documents and premises under s 353-15 and to require any person to provide information about a taxpayer under s 353-10 is read as being subject to a taxpayer’s common law rights under the doctrine of legal privilege. The doctrine protects a taxpayer’s right to protect from disclosure information prepared for the purpose of providing legal advice to the taxpayer.

Does Privilege Apply Outside the Courtroom? O’Reilly v Commissioner of the State Bank of Victoria (1982) 153 CLR 1; 13 ATR 706; 82 ATC 4671 (Full High Court)

Facts: The Commissioner issued a notice to the taxpayer pursuant to s 264 ITAA 1936 (currently s 353-10 TAA 1953) requiring representatives for the taxpayer and its solicitors to attend a meeting with ATO officers and provide responses to queries posed by the ATO officers. The taxpayer claimed some information sought was privileged and protected from disclosure. The Commissioner argued the doctrine of privilege only applied to evidence sought to be used in proceedings before a court or tribunal exercising judicial functions and it did not extend to collection of information. Decision: Legal professional privilege is a rule of evidence only and may be used to protect disclosure of information as evidence in judicial or quasi-judicial proceedings. Privilege cannot be claimed in relation to the collection of information in administrative procedures including tax investigations. The obligation to protect privileged documents from disclosure may be overridden by a statutory obligation such as that set out in s 264 to provide information. Relevance of the case today: Murphy J dissented from the majority decision in O’Reilly v Commissioner of the State Bank of Victoria, holding that privilege extended © Thomson Reuters 2019

399

AUSTRALIAN TAXATION LAW CASES 2019

to the disclosure of information outside actual judicial or quasi-judicial proceedings. The Full High Court later accepted this position in Baker v Campbell (1983) 153 CLR 52; 14 ATR 713; 83 ATC 4606, overruling its decision in O’Reilly v Commissioner of the State Bank of Victoria. The decision in O’Reilly v Commissioner of the State Bank of Victoria is therefore no longer good law and the precedent would not be followed to require disclosure of privileged information. If it happened today: If the facts in O’Reilly v Commissioner of the State Bank of Victoria were to arise today, a court would not adopt the rule set out in the High Court decision in the original case and instead would find that the taxpayer was entitled to claim privilege in respect of some information sought by the Commissioner. Whether the documents were actually privileged because they were made for the dominant purpose of legal advice would remain a question of fact to be determined.

Baker v Campbell

(1983) 153 CLR 52; 14 ATR 713; 83 ATC 4606 (Full High Court)

Facts: The plaintiff was a firm of solicitors that had been served with a criminal search warrant for documents related to the alleged commission of a criminal sales tax avoidance scheme. The firm claimed the documents sought were protected by legal privilege while the police seeking the documents argued on the basis of O’Reilly v Commissioner of the State Bank of Victoria (1983) 153 CLR 1 that privilege could only be claimed to protect disclosure of information as evidence in proceedings before a court or tribunal exercising judicial functions. Decision: A majority of the High Court overruled the decision in O’Reilly v Commissioner of the State Bank of Victoria and held the doctrine of privilege applied generally to protect privileged information from disclosure when the person with the privilege wished to protect the information from disclosure. This right is not restricted to disclosure as evidence in judicial proceedings. Relevance of the case today: Baker v Campbell is important as the precedent that established the right of taxpayers to prevent disclosure of information sought by the Commissioner under s 353-15 TAA 1953 or s 353-10 TAA 1953 on the basis that the information is protected by legal privilege. If it happened today: If the facts in Baker v Campbell were to arise today, the solicitors could seek to prevent disclosure of the information sought by the Commissioner on the basis that the information is protected by legal privilege. Whether the information was actually privileged because it was created for the dominant purpose of legal advice would remain a question of fact to be determined.

400

© Thomson Reuters 2019

CHAPTER 19

TAX ADMINISTRATION

Opportunity to Claim Privilege Allen Allen & Hemsley v DFCT & Ors

(1989) 20 ATR 321; 89 ATC 4294 (Full Federal Court)

Facts: The appeal was made by a firm of solicitors. The Commissioner sought access to the firm’s trust accounts on the basis of s 263 ITAA 1936 (currently s 353-15 TAA 1953) and offered the firm the opportunity to claim privilege on behalf of its clients with respect to any parts of the accounts that might be privileged. The legal firm argued that the Commissioner’s request for access was unreasonable in light of the fact that the firm would be faced with an overly onerous task of checking 11,000 entries in their trust account records to determine whether any information was privileged. Decision: The Commissioner’s request to see the firm’s trust accounts was not an unreasonable exercise of his power under s 263 (currently s 353-15 TAA 1953). It was reasonable only in the most exceptional circumstances that an entry in a trust account ledger could be privileged as disclosing the contents of communication between solicitor and client and it should not be difficult for the firm to check the accounts for those instances. Relevance of the case today: The Allen Allen & Hemsley case is seen as authority for the Commissioner to undertake broad searches through the records of tax advisers (commonly called “fishing expeditions”) to find references that might alert the Commissioner to a taxpayer’s participation in a tax minimisation scheme. Provided the Commissioner seeks access to a database that is unlikely to contain privileged information, he will be authorised under s 353-15 TAA 1953 to request access to these records. If it happened today: If the Commissioner today sought access to information of the sort sought in Allen Allen & Hemsley or similar information that might link a list of clients to a tax minimisation scheme, he would likely succeed provided he nominated databases unlikely to contain privileged information.

FCT & Ors v Citibank Ltd

(1989) 20 ATR 292; 89 ATC 4268 (Full Federal Court)

Facts: The Commissioner searched the premises of a merchant bank on the authority of s 263 ITAA 1936 (currently s 353-15 TAA 1953). The search involved several teams of ATO officers and was conducted without warning. The bank claimed it had a responsibility to claim privilege on behalf of its clients where the papers it held for them might attract privilege. It argued that the speed with which the ATO conducted its search and the lack of warning prevented it from claiming privilege on behalf of its clients with respect to many of the documents copied. Decision: The Court agreed with the taxpayer that the Commissioner’s power to copy information under s 263 (currently s 353-15 TAA 1953) must be read as being subject to a claim of privilege in respect of the documents to be copied and that the © Thomson Reuters 2019

401

AUSTRALIAN TAXATION LAW CASES 2019

Commissioner must afford a person holding documents that might be privileged the opportunity to assert a claim of privilege over the documents. Relevance of the case today: Subsequent to the decision in Citibank, the Commissioner issued guidelines to ATO officers on conducting s 263 (currently s 353-15 TAA 1953) searches. These include instruction on cases where the person holding documents may wish to claim documents cannot be copied because they are protected by legal privilege. If it happened today: If a search were to take place today of a business such as Citibank which held documentation for a large number of clients, it is likely that the Commissioner would provide the business holding the documents an opportunity to review the documents being copied and make a claim that the documents were protected by legal privilege. If the Commissioner failed to do so, a court would find that the search for documents was conducted in a way that exceeded the powers granted under s 353-15 TAA 1953 and was thus not a legal search.

“Sole” or “Dominant” Purpose of Legal Advice Esso Australia Resources Ltd v FCT

(1999) 201 CLR 49; 43 ATR 506; 2000 ATC 4042 (Full High Court)

Facts: The taxpayer appealed to the Federal Court against an income tax assessment. The Commissioner sought access to a number of documents held by the taxpayer and the taxpayer claimed the documents were privileged. The Commissioner argued documents were privileged if they were prepared for the “sole purpose” of legal advice, based on the precedent established by the High Court majority decision in Grant v Downs (1976) 135 CLR 674. The taxpayer argued the appropriate test for legal privilege should be whether documents were prepared for the “dominant purpose” of obtaining legal advice. Decision: A majority of the High Court agreed the “sole purpose” test set out in Grant v Downs should not be followed and instead the preferred test was the “dominant purpose” test. Applying this test, the taxpayer’s documents were privileged. Relevance of the case today: The Esso Australia Resources case is important as a precedent for application of the “dominant purpose” test to determine whether information is privileged. This is a much less onerous test for taxpayers to meet than the former “sole purpose” test. If it happened today: The dominant purpose test for legal privilege set out in Esso Australia Resources remains in effect in Australia and if the facts in this case arose today, a court would apply the dominant purpose test to find the taxpayer’s documents are privileged and need not be disclosed to the Commissioner.

402

© Thomson Reuters 2019

CHAPTER 19

TAX ADMINISTRATION

Documents Prepared for the Taxpayer by Third Parties Pratt Holdings Pty Ltd & Anor v FCT

(2004) 58 ATR 128; 2004 ATC 4526 (Full Federal Court)

Facts: The taxpayer was the holding company for a group of companies that was in the course of reorganisation. The taxpayer sought advice from a legal firm on utilising accumulated losses in one of the group companies. The legal firm recommended the taxpayer obtain a valuation from an accounting firm. The taxpayer contracted with an accounting firm and requested the valuation and a briefing paper for the law firm. The Commissioner sought access to various documents prepared by the accounting firm. The accounting firm declined to provide all the documents on the basis that they were protected by the taxpayer’s right to legal privilege. The Commissioner argued that privilege would only be available if the information was prepared at the request of the legal firm or if the accounting firm were preparing the information for the legal firm as agent for the taxpayer. Decision: The documents prepared by the accounting firm for use by the legal firm could be subject to legal privilege. The test is whether the information was prepared for the dominant purpose of legal advice, it did not matter whether the information was prepared for the legal firm or solicited by the taxpayer for the purpose of passing on to the legal firm. The matter was remitted back to a lower court to see whether the documents were subject to privilege on the basis of this test. The lower court found many documents were privileged applying this test: (2005) 60 ATR 466; 2005 ATC 4903. Relevance of the case today: Pratt Holdings can be used by a taxpayer to protect information obtained by the taxpayer for third parties provided the taxpayer can demonstrate that the information was solicited for the dominant purpose of obtaining legal advice. If it happened today: If the facts in Pratt Holdings arose today, the documents prepared by an accounting firm would continue to be considered protected by legal privilege as they were solicited by the taxpayer for the dominant purpose of passing on to a law firm to obtain legal advice.

Client Identification FCT v Coombes (No 2)

(1999) 42 ATR 356; 99 ATC 4634 (Full Federal Court)

Facts: A firm of solicitors had provided clients with advice and guidance on the establishment of employee share acquisition arrangements that the Commissioner was investigating. The Commissioner requested information on employee benefit plans which had been prepared or marketed by the firm and the names and addresses of clients who had purchased, implemented or entered into the arrangements devised by the firm. The solicitors provided information on the plans but declined to provide the © Thomson Reuters 2019

403

AUSTRALIAN TAXATION LAW CASES 2019

names of clients on the basis that this information was subject to legal professional privilege. Decision: The solicitors were acting on behalf of their clients when they provided the information on the plans and this disclosure amounted to waiver of privilege over that information. The provision of names of persons who entered into transactions does not disclose a confidential communication passing between the solicitors and the clients. The identification of these persons is merely the provision of factual matters that is not subject to privilege. Relevance of the case today: The Coombes case is the basis for what are sometimes called “fishing expeditions” by the ATO with respect to mass-marketed tax avoidance schemes. Once the ATO uncovers a mass-marketed scheme, it will gather information about who has participated in the scheme through requests for client lists through the promoters or marketers of the schemes. It increases substantially the risk of participants in mass-marketed schemes being caught. If it happened today: The exclusion of lists of clients’ names from the ambit of the doctrine of legal professional privilege is no longer disputed and if the facts in Coombes were to arise today, the solicitors would most likely not seek to block disclosure on the basis that the information is privileged. The only way privilege could be claimed would be if the solicitors could show it was not possible to separate the names of clients from the information provided to the clients and this would be extremely difficult to do.

Documents Obtained for Another Purpose DCT v Rennie Produce (Aust) Pty Ltd (in liq)

[2018] FCAFC 38

Facts: The liquidators of Rennie Produce obtained documents under powers contained in the Corporations Act 2001. Two years later, the Commissioner of Taxation issued a notice pursuant to s 353-10 of Schedule 1 to the TAA 1953 requiring the production of the documents. The Commissioner considered the documents relevant to the income tax return lodged on a self-assessment basis by the sole director of Rennie Produce. The liquidators contended that they were constrained from handing over the documents on the basis of the Harman obligation which is a general law obligation that a party obtaining the disclosure cannot, without the leave of the court, use it for any purpose other than that for which it was given unless it is received into evidence. Decision: The court held that the Harman obligation does not prevent a person from complying with s 353-10 of the TAA, nor does it prevent the ATO officers from using those documents in the lawful exercise of the powers of the Commissioner. Relevance of the case today: Rennie Produce demonstrates the broad powers of the Commissioner to formally gather information about taxpayers.

404

© Thomson Reuters 2019

CHAPTER 19

TAX ADMINISTRATION

If it happened today: If the facts of Rennie Produce happened today, the liquidators would be obliged to hand over the requested documents.

ASSESSMENTS Following lodgment of an income tax return (or in the absence of one if the Commissioner makes a default assessment or special assessment), the Commissioner will issue an assessment of the taxpayer’s taxable income and tax payable on that taxable income (s 166 ITAA 1936 1936). The making of an assessment is important as it starts the clock running for amendment of assessments by the Commissioner under s 170 ITAA 1936 when more information comes to light.

Nil Assessments FCT v Ryan

(2000) 201 CLR 109; 43 ATR 694; 2000 ATC 4079 (Full High Court)

Facts: The taxpayer lodged a return for the 1986/87 year claiming her taxable income was less than the positive tax rate threshold. The Commissioner issued a “refund” notice stating that the tax payable was $0.00 and stating an amount of tax already paid to be refunded. The Commissioner issued an assessment in 1994 disallowing a deduction claimed in the taxpayer’s return, resulting in an increase in taxable income by $10,000 and an amount of tax payable. The taxpayer objected on the basis that the Commissioner was out of time allowed for amendment by s 170 ITAA 1936. The Commissioner argued that an assessment of tax due and payable required the statement of a positive amount of tax and an assessment for nil tax was not an assessment of tax due and payable. Decision: Relying on the precedent set in Batagol v FCT (1963) 109 CLR 243, a majority of the High Court agreed with the Commissioner that a refund notice which did not state a positive amount of tax payable was not an assessment of tax due and payable and as a result did not start the clock running for the limitation period on reassessment. A majority rejected the dissenting view of Kirby J which argued in favour of the taxpayer’s position based on what he claimed was a purposive interpretation of the legislation. Relevance of the case today: The definition of “assessment” in s 6(1) ITAA 1936 now provides that a notice served by the Commissioner indicating that the taxpayer has no taxable income or that no tax is payable will be treated as an assessment. The Ryan decision is thus not useful as a precedent for an argument that a notice of no tax payable does not start the clock running for the reassessment time limitation period. If it happened today: If the facts in Ryan arose today, the taxpayer could rely on the definition of “assessment” in s 6(1) ITAA 1936 to treat the initial notice of no tax payable as an assessment by the Commissioner and argue successfully that the

© Thomson Reuters 2019

405

AUSTRALIAN TAXATION LAW CASES 2019

subsequent amended assessment was out of time under s 170(2) applying the time limits for original assessments in s 170(1) to amended assessments.

Asset Betterment Assessments In cases where the Commissioner believes the taxpayer has derived assessable income not reported by the taxpayer when calculating his or her taxable income, the Commissioner can issue a “default” assessment under s 167 ITAA 1936, based on the Commissioner’s judgment of tax that should be levied. If the taxpayer appeals against the assessment, the onus of proving the assessment is excessive lies on the taxpayer under s 14ZZK and s 14ZZO Taxation Administration Act 1953. One tool often used by the Commissioner to support a default assessment is an asset betterment statement that bases presumed income on increases in the taxpayer’s net wealth.

L’Estrange v FCT

(1978) 9 ATR 410; 78 ATC 4744 (Supreme Court of Victoria)

Facts: The taxpayer was a lawyer who was assessed on gains realised on the purchase and sale of properties, instalments of consideration kept when the sales of other properties were cancelled, and on the basis of an assets betterment statement prepared by the Commissioner. The assets betterment statement calculated the taxpayer’s taxable income for a year by adding to the value of new assets acquired by the taxpayer in the year, amounts expended otherwise than to acquire new assets including gifts, private expenditure and payments of income tax. The figure was then reduced by capital receipts known to have been derived by the taxpayer. The taxpayer objected to the default assessment based on the assets betterment statement, objecting to the methodology used and the use of the statement itself when other records were available. Decision: The Court allowed the taxpayer’s appeal in respect of a small reduction of the assessment based on the assets betterment statement but accepted the validity of the general methodology used in the preparation of the statement. It ruled that the statement was evidence that could be considered in addition to any other records available. In this case, the Court found, the taxpayer was not able to show the other records he produced were more likely to show the taxpayer’s correct income than did the asset betterment statement, as adjusted for a small reduction. Relevance of the case today: L’Estrange illustrates that the methodology used by the Commissioner to construct an assets betterment statement and the statement itself will be accepted by a court as the basis for a s 167 ITAA 1936 default assessment and that it is the responsibility of the taxpayer to prove this assessment is not accurate. If it happened today: If the facts in L’Estrange were to arise today, the Court would again accept the methodology used to prepare the assets betterment statement and would accept the statement as the basis for a default assessment subject to the taxpayer proving the assessment was not correct. 406

© Thomson Reuters 2019

CHAPTER 19

TAX ADMINISTRATION

Double Counting Assessments It is not unusual for the Commissioner to issue assessments to a taxpayer seeking to assess amounts under two different provisions. Alternatively, the Commissioner may issue assessments to two different taxpayers in respect of the same amount if there is some doubt as to how the amount should be taxed. For example, an assessment may be issued against an employee in respect of a benefit that the Commissioner believes is salary or wages and against the employer under the Fringe Benefits Tax Assessment Act if there is a possibility that it will be considered a fringe benefit as defined in s 136(1) FBTAA instead. The Commissioner always pledges to only collect tax once in these cases but the fact that two assessments have been issued in respect of the single amount raises a question about the validity of the assessment.

FCT v Futuris Corporation Ltd

(2008) 237 CLR 146; 69 ATR 41; 2008 ATC 20-039; (Full High Court)

Facts: The taxpayer wished to sell off a division of its operations and arranged for a transfer of the shares of one subsidiary to another subsidiary so all the relevant parts could be in a single company which was then sold in a “float” to the public. The Commissioner applied provisions in the Act that adjusted the cost base of the taxpayer’s shares in the company that was floated following the transfer of assets into that company from another group subsidiary. The Commissioner then recomputed the capital gain from the sale of shares using the new (and lower) cost base, which led to a higher capital gain. The taxpayer objected to the reassessment. Subsequently, the Commissioner issued a separate assessment against the company based on the general anti-avoidance provisions in Part IVA ITAA 1936. This assessment included the gain that was in the original assessment. The taxpayer sought an order from the Federal Court quashing a second assessment under the powers given to the Court by the Judiciary Act 1903 to revoke an order by a government official where there is no authority in a law for the order. The taxpayer argued the law only allowed the Commissioner to assess income once. The Commissioner argued that multiple assessments were possible so long as he pledged to only collect the tax once on the successful assessment. He also argued that the objection and appeal procedures in Part IVC of the Taxation Administration Act 1953 provided the only means of appealing assessments and they could not be disputed using a process outside the procedure set out in that Act. Decision: The High Court upheld the second assessment, finding there was no abuse by the Commissioner in issuing the second assessment given his clear intention to adjust the amount assessed and collected under Part IVA by any amount assessed under the original assessment if the assessment were upheld on the taxpayer’s appeal. The Court also noted that the assessment under Part IVA did not create an irrefutable decision as it was appealable under the ordinary objection and appeal procedures of the Taxation Administration Act 1953.

© Thomson Reuters 2019

407

AUSTRALIAN TAXATION LAW CASES 2019

Relevance of the case today: Futuris will be used by the Commissioner as authority for alternative assessments, and in particular the issuance of second assessments under Part IVA after time has expired for assessments under the ordinary income tax rules. As a result of Futuris, taxpayers will have to dispute those assessments on their merits rather than attacking the validity of the assessments themselves. As it turned out in this case, the taxpayer was ultimately successful when it defined the Part IVA assessment on its merits, convincing the Full Federal Court that Part IVA would not apply to the transaction. [The subsequent appeal on Part IVA is found at [2012] FCAFC 32; 87 ATR 828; 2012 ATC 20-306; for a synopsis of the case, see p 392 in this book.] If it happened today: If the facts in Futuris were to arise today, the Court would again uphold the second assessment that covered, in part, tax also due under another assessment.

Commissioner Decisions Pintarich v DCT

[2018] FCAFC 79; (2018) ATC 20-657

Facts: The ATO sent a letter to the taxpayer headed “Payment arrangement for your income tax account debt” stating that the ATO agreed to accept a lump sum payment as payment of an outstanding account. The payout figure was stated to be inclusive of an estimated general interest charge (GIC) amount. The taxpayer subsequently made the full payment and in reliance on the letter acquired finance from the bank to cover the money owed. The letter was produced by a delegate of the Deputy Commissioner keying in certain information resulting in a computer-based template bulk issue letter. The amount specified covered the primary tax liability but only a small proportion of the GIC owed. The issue before the court was whether the letter constituted a “decision” made by the Deputy Commissioner to remit GIC. Decision: The court held that because the delegate of the Deputy Commissioner did not undertake the necessary mental process in reaching a decision to remit the GIC, nor was there an objective manifestation of that conclusion, the letter did not amount to a valid decision by the Deputy Commissioner. Relevance of the case today: Pintarich is interesting from the perspective of the influence of technology on the processes of the ATO. The case stands for the proposition that unless there is human intervention through a mental process and objective manifestation of a decision, documents produced by the ATO are unlikely to be considered a “decision” by the Commissioner. If it happened today: If the facts of Pintarich happened today, the letter would not be regarded as a “decision” of the Commissioner and further GIC may be applied.

408

© Thomson Reuters 2019

CHAPTER 19

TAX ADMINISTRATION

ACCESS TO BOOKS AND INFORMATION The ITAA 1936 provides the Commissioner of Taxation with broad powers to collect information needed for assessments. Section 353-15 TAA 1953 (formerly s 263 ITAA 1936 authorises the Commissioner to demand access to books or premises and 1936) s 353-10 TAA 1953 (formerly s 264 ITAA 1936 1936) allows the Commissioner to require information from any person.

FCT v Australia and New Zealand Banking Group Ltd (1979) 143 CLR 499; 9 ATR 483; 79 ATC 4939 (High Court)

Facts: Exercising the powers provided by s 264 ITAA 1936 (now s 353-10 TAA 1953), the Commissioner required the ANZ Bank to provide access to all documents and materials in the safety deposit boxes of particular taxpayers. The ANZ Bank argued it should not have to comply with the notices provided by the Commissioner because the safety boxes, while located on its premises, were not in its custody or control. Each box had two keys, one of which was provided to the client and one retained by the bank. The bank’s contract with clients promised that the bank would not open the box without the client’s key and the bank’s key. However, the bank retained a copy of the customer’s key in case the original was lost. The contract also promised that it would only use this key as a replacement for the original if lost. The Commissioner argued that since the bank held both keys needed to open the safe, it had custody and control over the box despite its contractual undertakings. The bank also argued that s 264 notices could not be used for a “roving inquiry” seeking access to contents generally but rather had to relate to a specific issue the Commissioner was investigating. The Commissioner argued the section authorised the Commissioner to require production of materials if they relate to the income of a person, without more specificity. Decision: The High Court found in favour of the Commissioner on both issues under appeal. It concluded the bank had control over the safety deposit box and the contractual undertakings to the client did not negate that control for the purpose of s 264. It also concluded the Commissioner was entitled to make a “roving inquiry” without specifying a specific issue being investigated, so long as the materials requested related to a taxpayer’s income or assessment. Relevance of the case today: The Australia and New Zealand Banking Group Ltd case can be used as authority for the rule that the Commissioner can use s 264 (now s 353-10 TAA 1953) powers to seek materials related to a person’s income without having to specify a particular issue being investigated. It is also authority for the proposition that a person who has the ability to provide materials is in control of the materials even if it has contracted that it will not use its ability. If it happened today: If the facts in Australia and New Zealand Banking Group Ltd occurred today, a court would allow the Commissioner to require production of materials in a safety deposit box in a bank. © Thomson Reuters 2019

409

AUSTRALIAN TAXATION LAW CASES 2019

Industrial Equity Ltd v Deputy Commissioner of Taxation (1990) 170 CLR 649; 21 ATR 934; 90 ATC 5008 (High Court)

Facts: The Commissioner established an audit program to audit the top 100 companies in Australia, including the taxpayer. The program was in a sense a random audit program as the Commissioner had not targeted the group in respect of any particular tax compliance issues. To carry out the audits, the Commissioner exercised his powers under s 263 ITAA 1936 (currently s 353-15 TAA 1953) to require access to the premises of a financial institution that provided services to the taxpayer and the taxpayer’s premises and his power under s 264 ITAA 1936 to require information from the taxpayer and from third parties. The taxpayer argued the Commissioner’s powers to issue an assessment or amend an assessment did not include the power to conduct random audits and exercise s 263 and s 264 powers on the basis of no criterion other than the fact that the taxpayer happened to be one of the largest companies. Decision: The High Court found that a random audit was an exercise of power for the purpose of the ITAA and was consequently authorised by s 263 and s 264. There was no need for the Commissioner to have a prior reason to question the original assessment of a particular taxpayer. Relevance of the case today: The Industrial Equity case is authority for the Commissioner to use s 263 and s 264 (now s 353-15 and s 353-10 TAA 1953) to collect information in the course of a random audit. If it happened today: If the facts in Industrial Equity were to arise today, the court would conclude the Commissioner can exercise powers granted under s 263 and s 264 (now s 353-15 and s 353-10 TAA 1953) to conduct a random audit of a taxpayer without prior reason to question the taxpayer’s original assessment.

COLLECTION OF TAX DUE As a general rule, responsibility for payment of tax falls on the person deriving income. In some cases, however, the person paying income is responsible for withholding tax to satisfy the recipient’s obligation. Withholding taxes are used for several types of payments to non-residents (interest, dividends, royalties and capital gains on the sale of property) and for certain payments to residents. In addition, if the recipient of income has failed to remit assessed taxes, in some circumstances the Commissioner has the power to collect the unpaid taxes from persons controlling or holding money on behalf of the person who has failed to pay taxes due.

Bluebottle UK Ltd v Deputy FCT

(2007) 232 CLR 598; 67 ATR 1; 2007 ATC 5302 (High Court)

Facts: An Australian resident company, Virgin Blue, declared a fully-franked dividend to two foreign shareholders. As the dividends were franked, no withholding tax was imposed on the dividends. The Commissioner alleged that the foreign shareholders 410

© Thomson Reuters 2019

CHAPTER 19

TAX ADMINISTRATION

owed taxes payable in respect of capital gains they had realised on the sale of shares. The Commissioner issued a notice to Virgin Blue under s 255(1) ITAA 1936 requiring Virgin Blue to pay an amount equal to the taxes payable by its shareholders in respect of the capital gains due from money held by Virgin Blue but belonging to the shareholders. The Commissioner argued that Virgin Blue was liable to pay an amount to the shareholders after it declared the dividend and was, as a result, deemed under s 255(2) ITAA 1936 to have control of money belonging to a non-resident, which brought Virgin Blue within the scope of s 255(1). Subsequent to the Commissioner issuing the s 255(1) notice to Virgin Blue, the foreign shareholders assigned their rights to the dividends to other companies. Virgin Blue and the foreign shareholders argued that the mere declaration did not give rise to a debt to the shareholders until the time fixed for payment of the dividend arrived, by which time the shareholders had assigned their rights to dividends so Virgin Blue had no debt to them. Decision: The declaration of a dividend gave rise to a debt to the shareholder on record so a subsequent assignment of the right to the dividend by the shareholder would not affect Virgin Blue’s liability to pay an amount to the foreign shareholders. From the time at which the dividend was declared, Virgin Blue was “liable” to pay money to the shareholders and this was sufficient to bring it within the scope of s 255(2). As the s 255(1) notice was issued before the assignment of dividends, it remained valid and the assignment was subject to the pre-existing charge on the dividends created by the notice. Relevance of the case today: Bluebottle UK may be cited by the Commissioner as support for the application of s 255 to a person liable to pay money to another person even if the liability does not give rise to an enforceable debt at that time. It can also be used to support a broad concept of liability more generally in any provisions of the legislation that are triggered when a person is liable to pay another person with the actual payment time to be settled at some point in the future. If it happened today: If the facts in Bluebottle UK were to arise today, the same result would follow as the legislation remains the same and the doctrines set out in the decision are consistent with the understanding of liability in later cases.

FCT v Australian Building Systems Pty Ltd (in liq)

[2015] HCA 48; 257 CLR 544; 102 ATR 359; 2015 ATC 20-548 (High Court)

Facts: Creditors of the taxpayer resolved to wind up the taxpayer to recover some of the moneys owed to them and appointed liquidators to complete the winding up process. The liquidators arranged for the taxpayer to sell real property it owned, resulting in a capital gain that would be subject to tax. The liquidators sought a ruling that s 254(1)(d) ITAA 1936 did not require them to retain any of the proceeds of sale for the payment of tax on the gain. That section requires trustees to retain amounts sufficient to pay tax that is or will become due in respect of income or gains. The taxpayer argued no amount was or would become due in respect of the capital gain on the sale of land until the Commissioner had made an assessment of the gain. The © Thomson Reuters 2019

411

AUSTRALIAN TAXATION LAW CASES 2019

Commissioner issued a ruling that the liquidators were required to retain an amount to pay the tax, presumably concerned that if the money was distributed to the taxpayer’s creditors, the company would be unable to pay tax on the gain. The taxpayer objected unsuccessfully to the ruling and then appealed to the courts, with the issue finally reaching the High Court. Decision: A majority of the High Court ruled that the retention obligation only arises after an assessment has been made in respect of the relevant income or gains. This means no tax is due or will become due until an assessment has been made. Relevance of the case today: Australian Building Systems Pty Ltd is authority for the argument that a person is not liable to retain an amount under s 254(1)(d) in respect of tax that will become payable on a gain until an assessment has been made. It also can be used as authority for the argument that no tax is due or will become due in respect of a gain until an assessment has been made. If it happened today: If the facts in Australian Building Systems Pty Ltd were to arise today, the same result would follow as the legislation remains the same.

APPEALS Appeals outside the ITAA and Tax Administration Act Section 350-10 TAA 1953 (formerly s 177 ITAA 1936 1936) states that the particulars of a tax assessment notice are presumed to be true for all purposes apart from proceedings on appeal of an assessment. The intention of the provision was to create an exclusive basis for appeal limited to the correctness of the assessment based strictly on the provisions of the ITAA. Taxpayers may seek to challenge an assessment on other grounds, conceding the assessment may be accurate as a matter of tax law but even if it is, the assessment should be declared void because it violated a principle of justice outside the tax law. The question to be considered in these situations is whether s 350-10 TAA 1953 has the effect of creating an exclusive code for appeals of assessments or whether taxpayers can still object to assessments for reasons other than the accuracy of the assessment in tax law.

FJ Bloemen Pty Ltd v FCT

(1981) 147 CLR 360; 11 ATR 914; 81 ATC 4280 (Full High Court)

Facts: The Commissioner delivered a notice of assessment to the taxpayer and subsequently tried to collect the tax owing on the basis of the assessment using s 218 ITAA 1936, which authorised the Commissioner to collect tax due from third parties who owed money to the taxpayer. The taxpayer sought to prevent the Commissioner from proceeding with the collection by obtaining a declaration from the Supreme Court of New South Wales that the assessment was invalid as it was not made for the purpose of determining the taxpayer’s taxable income and income liability but rather to enable

412

© Thomson Reuters 2019

CHAPTER 19

TAX ADMINISTRATION

the Commissioner to commence collection proceedings using s 218. It also claimed the assessment was not a final assessment but was only a tentative assessment. The Commissioner argued that s 177 ITAA 1936 (currently s 350-10 TAA 1953) and the income tax appeal measures provided an exclusive code for appealing assessments. The taxpayer conceded that as a result of s 177 (currently s 350-10 TAA 1953) a valid assessment can only be contested using the income tax objection and appeals processes. However, the taxpayer argued it was restricted only if the assessment itself was valid and the taxpayer was still free to contest the assessment itself outside that appeal process. Decision: The effect of s 177 (currently s 350-10 TAA 1953) is to make an assessment conclusive for all purposes subject to amendment on an appeal using the income tax appeal provisions. It is not possible to contest the validity of an assessment notice separately from contesting the validity of the actual amounts set out in the notice using the income tax appeal measures. In effect, s 177 (currently s 350-10 TAA 1953) and the income tax appeal rules provide an exclusive code for appealing assessments. Relevance of the case today: The FJ Bloemen decision appeared to restrict a taxpayer’s avenue of appeal of an assessment to the income tax appeal procedures which only allow the taxpayer to base an appeal on interpretation of the provisions of the income tax legislation. However, the later case of David Jones Finance and Investments Pty Ltd & Anor v FCT (1991) 21 ATR 1506; 91 ATC 4315 showed the restriction set out in FJ Bloemen was not absolute and it may still be possible to contest an assessment using the Federal Court’s power to review the actions of government officials under the Judiciary Act 1903. However, this power will only be exercised if it could be shown that the Commissioner was not acting in a bona fide manner in making an assessment. It might be very difficult to satisfy this threshold test. If it happened today: While the later case of David Jones Finance and Investments showed the rule set out in FJ Bloemen was not absolute, if the facts in FJ Bloemen were to arise today, it is most likely that the taxpayer would not be able to qualify for the exception described in David Jones Finance and Investments. There was no evidence in FJ Bloemen that the Commissioner was not acting in a bona fide manner or had treated the taxpayer differently from the way in which all other taxpayers were treated. Thus, if the facts in FJ Bloemen were to arise today, most likely a court would deny the taxpayer a declaration regarding the validity of the assessment and instead advise the taxpayer to contest the accuracy of the assessment using the income tax appeal procedures.

David Jones Finance and Investments Pty Ltd & Anor v FCT (1991) 21 ATR 1506; 91 ATC 4315 (Full Federal Court)

Facts: The taxpayer received dividends from shares it held indirectly through nominee companies. It claimed it did not have to pay tax on the dividends as a result of s 46 ITAA 1936. Section 46 provided corporate taxpayers with a “rebate” that offset any tax otherwise payable on eligible inter-corporate dividends. © Thomson Reuters 2019

413

AUSTRALIAN TAXATION LAW CASES 2019

A decade and a half earlier, the High Court had decided in Patcorp Investments Ltd & Ors v FCT (1973-1976) 140 CLR 247 that in the context of a dividend stripping scheme (a series of transactions designed to remove retained profits from a company as capital gains rather than dividends) s 46 only applied to dividends to actual shareholders, not persons holding interests through nominee companies. Given the context of the case as a dividend stripping scheme, the Commissioner did not subsequently follow the decision of the High Court regarding the operation of s 46 when taxpayers held interests through nominee companies in ordinary arrangements. The Commissioner assessed the taxpayer on the basis that s 46 did not apply to the dividends it had received as they were received through nominee companies. The Commissioner’s approach appeared to be correct as a matter of law on the basis of the Patcorp precedent but it was clearly contrary to the policy followed by the Commissioner for other taxpayers in the decade and a half prior to Patcorp and the decade and a half after that case. The taxpayer realised it could not appeal the assessment through the ordinary appeal route because it was probably correct as a matter of law. Instead, it sought a declaration from the Federal Court that the assessment was invalid. When the Commissioner’s interpretation of the law to assess the taxpayer was compared with the way the Commissioner interpreted the law to assess other taxpayers, it was argued, the assessment of the taxpayer was not made in good faith or for bona fide reasons. The taxpayer argued the Federal Court had the power under s 39B Judiciary Act 1903 to review the action of government officials and invalidate actions not made fairly or in good faith. The Commissioner argued that the operation of s 177 ITAA 1936 and the income tax appeal measures provided an exclusive code for appealing assessments and there was no room for the Federal Court to consider an assessment on any principles other than those set out in the tax laws. Decision: Section 177 ITAA 1936 did not preclude the Federal Court from reviewing the making of an assessment on the basis of s 39B Judiciary Act 1903 and declaring an assessment invalid if the Commissioner had not made the assessment in a wholly bona fide manner. The order of the trial judge striking out the taxpayer’s pleadings presumed the Federal Court could not exercise this power and its decision should be set aside. This provided the taxpayer with an opportunity to proceed with its action to be considered by the Court on its merits as to whether the assessment was valid. Relevance of the case today: The David Jones Finance and Investments case showed that s 177 (now s 350-10 TAA 1953) did not prevent taxpayers from appealing against the validity of an assessment on the basis of principles outside the ITAA 1936 or ITAA 1997 and the ordinary tax appeal procedures. A taxpayer can seek a declaration that an assessment is invalid because the Commissioner had not made the assessment in a bona fide manner. The Federal Court has the power to hear an application for a declaration on these grounds on this basis of its power under the Judiciary Act to review the action of government officials. From a practical perspective, it may be very difficult for a taxpayer to show the Commissioner has not acted in a bona fide manner. The dispute in David Jones Finance and Investments was settled by the taxpayer and ATO before the trial judge had an opportunity to reconsider the issue in light of the Full Federal Court judgment

414

© Thomson Reuters 2019

CHAPTER 19

TAX ADMINISTRATION

so the case provides no guidance as to when an assessment might be invalid because of improper behaviour by the Commissioner. If it happened today: If the facts in David Jones Finance and Investments were to arise today, the Federal Court could entertain the taxpayer’s request for a review of an assessment based on the power of the Court set out in the Judiciary Act 1903. Such a review would be based on the actions of the Commissioner in making the assessment and not the validity of the assessment under the income tax law.

Basis for Assessment on Appeal A taxpayer dissatisfied with an assessment may object to the assessment and appeal the assessment to the Administrative Appeals Tribunal or the Federal Court. One question that may arise on appeal is whether the Commissioner must defend the assessment on appeal on the basis of the same statutory provisions used as the basis for the initial assessment.

FCT v Reynolds

(1981) 11 ATR 629; 81 ATC 4131 (Supreme Court of Tasmania)

Facts: The taxpayer sold a truck it was leasing and provided the lessor with an amount equal to the “payout” cost of terminating the lease, retaining the surplus. The Commissioner assessed the taxpayer on the profit on the basis of s 26AAA ITAA 1936, which included in assessable income profits realised on the disposal of an asset within 12 months of acquisition. The taxpayer appealed the assessment to the Board of Review arguing the gain was not assessable under s 26AAA or s 25(1) ITAA 1936 (currently s 6-5(1) ITAA 1997 1997). The Commissioner defended the assessment relying on s 25(1). The Board allowed the taxpayer’s objection on the basis that the Commissioner was not entitled to rely on an appeal of an assessment on a different basis for the assessment. The Commissioner appealed. Decision: The taxpayer had argued the gain was not assessable under s 26AAA, the original basis for the assessment, and s 25(1), the section relied upon by the Commissioner on appeal. The Supreme Court of Tasmania allowed the Commissioner’s appeal, holding that an assessment is based on the application of the ITAA, not on a particular section. So long as the assessment was for the correct amount and correctly based on a section of the ITAA, there was no reason the Commissioner could not rely on a different provision to support the assessment. The Court found that an assessment based on s 25(1) was valid and upheld the assessment based on that section. Relevance of the case today: Courts have not permitted the Commissioner to base his argument on appeal on a completely new ground on which the taxpayer raised no evidence or argument. However, Reynolds shows the Commissioner can rely on a new basis on appeal of an assessment provided the taxpayer had addressed the new basis in its earlier arguments.

© Thomson Reuters 2019

415

AUSTRALIAN TAXATION LAW CASES 2019

If it happened today: If the facts in Reynolds arose today, the Commissioner would assess the taxpayer on the basis of s 6-5(1). Section 26AAA is no longer operative and as the taxpayer acted as an agent for the lessor, the disposal could not be used as the basis for an assessment under the CGT provisions. It is therefore unlikely that the Commissioner would have the opportunity to change the basis for assessment if the taxpayer appealed its assessment.

PENALTIES Taxpayers committing tax evasion are liable for criminal penalties imposed under the Crimes Act 1914, the Criminal Code Act 1995 or (more rarely), the Crimes (Taxation Offences) Act 1980. However, most prosecutions for tax offences are based on the offence provisions in the Taxation Administration Act 1953. Administrative penalties set out in Divisions 284, 286 and 288 Taxation Administration Act 1953 apply to less serious tax avoidance offences. The Division 284 penalties are imposed for making false or misleading statements, taking a position that is not reasonably arguable, and entering into schemes. These penalties are calculated as a percentage of a taxpayer’s “tax shortfall amount” which is the difference between the tax liability based on the taxpayer’s calculation and the tax liability that would have applied had the taxpayer not committed a Division 284 offence. The level of penalty will depend on the extent of the taxpayer’s culpability as well as the amount of the shortfall and whether the taxpayer was engaged in an avoidance scheme.

Walstern Pty Ltd v FCT

(2003) 54 ATR 423; 2003 ATC 5076 (Federal Court)

Facts: The taxpayer entered into a tax minimisation scheme marketed by a firm of accountants. Under the arrangement, the taxpayer contributed funds to what was described as an offshore superannuation fund. Later, the taxpayer’s two employees were invited to join the fund with the fund manager “lending” each member an amount equal to the cash invested in the fund for the benefit of that person. The taxpayer claimed a deduction for its cash contribution to the fund in the alternative as an ordinary business expense under s 51(1) ITAA 1936 (currently s 8-1(1) ITAA 1997 1997), as a contribution to a superannuation fund for the benefit of employees under s 82AAE ITAA 1936 [now repealed], or as a pension, gratuity or retiring allowance paid to an employee in good faith for past services under s 78(11) ITAA 1936 [now ITAA 1997, s 25-50]. The taxpayer also claimed the payment was not a fringe benefit as defined in s 136(1) FBTAA that attracted fringe benefits tax. The Commissioner denied the taxpayer a deduction for the contribution, assessed a liability for fringe benefits tax, and imposed a penalty under s 226K ITAA 1936 (currently s 284-75 Taxation Administration Act 1953) on the basis that the taxpayer had taken a position on the deduction and fringe benefits tax that was not “reasonably arguable” as defined in s 222C ITAA 1936 (currently s 284-15 Taxation Administration Act 1953).

416

© Thomson Reuters 2019

CHAPTER 19

TAX ADMINISTRATION

Decision: Hill J noted that the test to be used when determining whether a taxpayer’s position is reasonably arguable is an objective test which requires a conclusion that the taxpayer had a basis for believing its position was as likely as not to succeed. Hill J agreed with the Commissioner that no deduction was available for the contributions were of a capital nature and thus not deductible under s 51(1). As the only basis for the taxpayer’s position was a subjective question of purpose known only to the taxpayer, there was no objective basis for the taxpayer to adopt the position it did and accordingly the taxpayer’s position on the s 51(1) issue was not reasonably arguable. Hill J remitted to the Commissioner for reconsideration the question of penalties related to the fringe benefits tax assessment as the documentation showed the Commissioner’s initial decision was based on the assumption that the relevant penalty provision was one reserved for schemes rather than the general penalty provision that should have been used. Relevance of the case today: The Walstern decision is authority for the proposition that an objective test is used to determine whether the position taken by a taxpayer is reasonably arguable. Considerations known only to the taxpayer that are not reflected in an objective assessment of the taxpayer’s position are not taken into account when applying the reasonably arguable test. If it happened today: If the facts in Walstern arose today, the same result would follow and the taxpayer would be liable for penalties on the basis that the position it had taken with respect to the company’s deduction of the contribution to a foreign non-complying superannuation fund was not reasonably arguable.

OBLIGATION TO ISSUE A RULING FCT v Hacon Pty Ltd

[2017] FCAFC 181; 106 ATR 863

Facts: The taxpayer applied for a private ruling on the application of Part IVA to a proposed business restructure. The Commissioner exercised his discretion under s 357-110(1)(a) of Schedule 1 of TAA 1953 to decline to make a private ruling where the correctness of the ruling would be dependent on assumptions about a future event or other matter. The taxpayer applied to the Federal Court for judicial review of the decision and was successful at first instance. The Commissioner appealed. The primary issue before the Full Federal Court was whether the Commissioner was within his powers to decline to make a ruling or he was required to request further information. Decision: The Full Federal Court, finding for the Commissioner, determined that the obligation in s 357-105(1) required the Commissioner to request information from a taxpayer only where the absence of that particular information would otherwise prevent the making of the private ruling. Relevance of the case today: Hacon Pty Ltd stands for the proposition that the Commissioner may decline to make a private ruling where it would depend on assumptions about future events or other matters. Further, the Commissioner is not © Thomson Reuters 2019

417

AUSTRALIAN TAXATION LAW CASES 2019

obligated to first request that information from the taxpayer before declining to make a private ruling. However, this does not preclude the operation of s 357-105 of Schedule 1 of TAA 1953. Where further information is required and is not dependent on assumptions about future events or other matters, the Commissioner is required to ask for it under s 357-105 of Schedule 1 of TAA 1953. If it happened today: If the facts of Hacon Pty Ltd happened today, the Commissioner would be within his rights to decline to make a private ruling.

418

© Thomson Reuters 2019

C HAPTER 20

GST SUPPLIES ............................................................................................................. Damages ...................................................................................................... Shaw v Director of Housing and State of Tasmania (No 2) (2001) .................................................................................................... Expropriation ............................................................................................... CSR Ltd v Hornsby Shire Council (2004) .............................................. Hornsby Shire Council (2008) .............................................................. Government Subsidies ................................................................................. Secretary to the Department of Transport (Vic) (2010) ( ......................... Services Not Used ....................................................................................... Qantas Airways Ltd (2012) .................................................................... Forfeited Deposit ......................................................................................... Reliance Carpet Co Pty Ltd (2008) .......................................................

420 421

MIXED AND COMPOSITE SUPPLIES ............................................................ British Airways plc (1990) ..................................................................... Sea Containers Services Ltd (2000) ...................................................... Luxottica Retail Australia Pty Ltd (2011) .............................................

426 426 427 428

421 422 422 423 424 424 425 425 425 425

INPUT TAX CREDITS ........................................................................................ 428 Rio Tinto Services (2015) ....................................................................... 429 INTERNATIONAL ASPECTS OF GST .............................................................. 429 Supplies of Services Connected To Australia ............................................... 430 Saga Holidays Ltd (2006) ....................................................................... 430 “Exported” Services ..................................................................................... 431 ATS Pacific (2014) .................................................................................. 431 Travelex Ltd (2010) ................................................................................. 432 THE GST GENERAL ANTI-AVOIDANCE RULE ........................................... 433 Unit Trend Services Pty Ltd (2013)......................................................... 433

© Thomson Reuters 2019

419

C HAPTER 20

GST The GST is a consumption tax intended to fall on final consumers only. There are two models of consumption taxes directed at final consumption. The retail sales tax, used in North America, eliminates tax on businesses by “suspending” the collection of tax on supplies made to intermediate enterprises. The final consumer, who holds no certificate identifying him or her as an intermediate business, will not qualify for the exemption and thus will be taxed. The GST, by way of contrast, assumes initially that all customers are final consumers and imposes GST on taxable supplies to both final consumers and intermediate enterprises but then allows registered intermediate enterprises to recover the GST by means of input tax credits (“input tax” meaning the GST included in the acquisition price). Special rules apply to two types of supplies – input taxed supplies and GST-free supplies. Enterprises making input taxed supplies do not have to remit any GST on these supplies but are not entitled to input tax credits for input tax included in the cost of their acquisitions related to these supplies. They are presumed to pass their input tax costs on to their customers and this is the reason these supplies are labelled “input taxed” supplies. Enterprises making GST-free supplies do not have to remit any GST on these supplies but can fully recover the GST on acquisitions related to the supplies. They will not pass any GST burden on to customers in respect of these supplies – hence the label “GST-free” Division 38 GST Act lists all GST-free supplies and Division 40 GST Act all input taxed supplies. The correct technical name of the GST Act is A New Tax System (Goods and Services Tax) Act 1999. However, it is commonly called the GST Act and this term is used in this chapter.

SUPPLIES GST is imposed on “taxable supplies”, a term defined in s 9-5 GST Act Act, and “taxable importations”, a term defined in s 13-5 GST Act. The definition of a taxable supply has four positive limbs (the supply must be for consideration, made in the course of an enterprise, connected with Australia, and made by a registered person) and one negative limb (the supply is not an input taxed supply or GST-free supply). Whether a payment amounts to consideration for a supply will depend on whether there is any supply made to the person making payment. Australian tax laws are now 420

© Thomson Reuters 2019

CHAPTER 20

GST

drafted in the second person (“you” do this or that) and the introductory words to s 9-5 set out the definition of a taxable supply in terms of “you make a taxable supply if ”. The first condition also uses the second person construction: “you make the supply for consideration”. One question raised by this language is whether the phrasing adds a fifth condition to the definition of a “taxable supply” – there must be a positive act by the supplier (“you make …”) so that transfers of goods or services not involving positive acts by the supplier fall outside the definition of a taxable supply. Australian courts have considered whether there is a supply when a person receives a payment as a result of a court order for a defendant to pay damages to the person, as a result of expropriation of the person’s property, and as a result of the forfeiture of a deposit when a planned supply by the person does not proceed.

Damages The key component of a taxable supply is the “supply” itself. The term “supply” is broadly defined in s 9-10 GST Act and includes the release of an obligation owed to another party. It has been argued that this aspect of the definition should be read down so there is only a supply made on the release or termination of an obligation if the release is the direct consequence of an action by the person receiving payment. Under this approach, there would be no supply if the release of the payer’s obligation arises because of the operation of law or another factor.

Shaw v Director of Housing and State of Tasmania (No 2)

(2001) 46 ATR 242; 2001 ATC 4054 (Supreme Court of Tasmania)

Facts: The plaintiff had sued the defendant for damages caused by their negligent misrepresentation. The Court found in favour of the plaintiff and determined the damages payable. The plaintiff sought a declaration by the Court that if GST was payable by the plaintiff on receipt of the damages, the amount of damages would be increased by the GST payable. Decision: The Tasmanian Supreme Court declined to make the declaration sought by the plaintiff on the basis that it was not persuaded that the plaintiff made any supply to the defendant for the damages it received and could therefore not be found to have made a taxable supply. The Court noted the definition of a “supply” included the release of an obligation by another person but said that for the release to amount to a supply by a person receiving a payment, the release must be attributable directly to the person receiving funds. Thus, if the release is due to a factor apart from the recipient’s actions (such as a court decision), there will not be a supply by the recipient of the payment. Relevance of the case today: The Shaw case was a civil case between two private parties and the Commissioner did not participate in the hearing. It is nevertheless cited as authority for the proposition that no GST is payable by the recipient of personal injury damages and further for the proposition that there is no supply by a taxpayer if the release of another person’s obligation to the taxpayer is the result of the operation of law rather than direct intervention by the taxpayer. While the decision is not in any © Thomson Reuters 2019

421

AUSTRALIAN TAXATION LAW CASES 2019

way binding on the Commissioner, the ATO appears to have accepted the conclusion of the Court as a correct interpretation of the GST law. If it happened today: If the facts in Shaw arose today, a court would once again decline to provide the plaintiff with a declaration that a defendant could be ordered to pay additional damages if the payment were subject to GST. Most likely, if the Commissioner sought to assess a taxpayer on the receipt of personal injury damages, a court would find there was no supply by the taxpayer in relation to the receipt.

Expropriation CSR Ltd v Hornsby Shire Council

(2004) 57 ATR 201; 2004 ATC 4966 (Supreme Court of NSW)

Facts: The plaintiff was an enterprise whose land was expropriated by a local council for public purposes. As required by the expropriation law, the council compensated the plaintiff for the expropriation of its property with the promise of a payment equal to the market value of the land. The market value was based on the GST-inclusive selling price of the land. The council made a partial payment to the plaintiff but withheld an amount equal to the GST component of the value, requesting the plaintiff first provide a tax invoice so the council could claim input tax credits for the GST component of the compensation value. The plaintiff refused, indicating it had obtained a private ruling from the ATO indicating the supply was not a taxable supply. However, it sued the council for payment of the withheld part of the compensation payment. The council argued the plaintiff would be unjustly enriched if it received the full GST-inclusive value of the property but was not required to remit tax or issue a tax invoice. Decision: The NSW Supreme Court held in favour of the plaintiff, indicating the defendant council was obligated to pay the value determined by the Valuer-General which was based on the GST-inclusive value of the land. The Court declined to rule on the question of whether the plaintiff would be required to issue a tax invoice to the council as the Commissioner was not party to the proceedings and would be affected by that decision. Relevance of the case today: Although the CSR Ltd v Hornsby Shire Council case did not address directly the question of whether an involuntary appropriation would fall outside the definition of a taxable supply, it was thought by some that the case supported the argument that an enterprise had to be proactive before a transaction would give rise to an active supply. The fact that the Court declined to require the plaintiff to issue a tax invoice was seen by some as indicating the Court’s implicit view that there is no supply where property is taken from a person without action on their part. The subsequent case of Hornsby Shire Council and FCT [2008] AATA 1060 ruled directly on that point and found that there was a supply in this case, as CSR had triggered the expropriation through an application under State environmental law. However, in that case the AAT indicated it would not treat an expropriation as a supply where the landowner was a passive part of the process.

422

© Thomson Reuters 2019

CHAPTER 20

GST

If it happened today: If the facts in CSR Ltd v Hornsby Shire Council arose today, another court would most likely reach the same decision on the basis of the expropriation law requiring a council to pay the full valuation amount determined by the Valuer-General.

Hornsby Shire Council v FCT

[2008] AATA 1060; 71 ATR 442; 2008 ATC 10-061 (AAT)

Facts: The case concerned the expropriation of property that led to litigation between the council expropriating the land and the landowner in CSR Ltd v Hornsby Shire Council (2004) 57 ATR 201. The landowner in that case had triggered an expropriation of its property by initiating a process available under the NSW Environmental Planning and Assessment Act 1979. CSR Ltd v Hornsby Shire Council concerned the amount of compensation the council had to pay for the expropriated property. As a result of that case, the council was required to pay compensation based on the GST-inclusive value of the property. The council then claimed an input tax credit of 1/11 of the amount paid, on the basis that the expropriation amounted to a taxable supply by the landowner. The council offered two alternative arguments in favour of its position: first, that the definition of a “taxable supply” could include a passive supply where property was taken from a person and compensation paid; and second, that even if a passive supply was not a taxable supply, in this particular case the taxpayer’s actions in instigating the process that led to the expropriation gave rise to a deemed supply under s 9-10(2)(g) of the GST Act, while its surrender of the property in the course of the expropriation amounted to a supply under s 9-10(2)(d) GST Act. Decision: The AAT found that there was a supply by the landowner under both s 9-10(2)(d) and s 9-10(2)(g) of the GST Act and the supply satisfied all the conditions necessary to make it a taxable supply. In obiter (a non-binding part of the judgment that does not form part of the final decision), the AAT said that a passive supply without the features of the transaction in this case would likely not amount to a taxable supply. As a result, the council was entitled to an input tax credit of 1/11 of the compensation paid to the landowner. The judgment did not address the fact that under s 29-10(3) GST Act, the council could only claim the input tax credit in the tax period in which it held a tax invoice from the landowner. The earlier case of CSR Ltd v Hornsby Shire Council revealed that the landowner held a private ruling from the Commissioner stating that the ATO (wrongly, as it turned out) believed the expropriation was not a taxable supply. There are two possible ways in which the council might be able to claim input tax credits. First, as a result of this case, the landowner might agree to issue a tax invoice for taxable supply, relying on the private ruling to protect itself from any tax liability. It is more likely, also as a result of this case, that the ATO will treat another document held by the taxpayer as a tax invoice under s 29-70(1) GST Act and the council will be able to claim its input tax credits in the period in which it paid the compensation. Relevance of the case today: Hornsby Shire Council is an AAT case and is thus of limited precedential value. The AAT’s views on passive supplies expressed in this © Thomson Reuters 2019

423

AUSTRALIAN TAXATION LAW CASES 2019

case are also of limited value because its decision turned on the taxpayer’s actions in instigating the expropriation process, while its observations on passive supplies in general were made in obiter. However, since the decision is one of the only GST cases to directly address the point of whether a passive supply can be a taxable supply, it is likely to be cited to support the argument that a passive supply cannot be a taxable supply. If it happened today: If the facts in Hornsby Shire Council were to arise today, a tribunal or court would likely find once again that the landowner made a taxable supply as a result of its actions to trigger the expropriation.

Government Subsidies FCT v Secretary to the Department of Transport (Vic)

(2010) 76 ATR 306; 2010 ATC 20-196 (Full Federal Court)

Facts: The Victorian Department of Transport (DOT) provided a 50% subsidy for taxi fares paid by residents unable to use public transport because of a disability. The subsidy was paid directly to the taxi service provider, which charged the customers only half the fare on the meter, which included GST. The DOT claimed input tax credits of 1/11 of the subsidy paid, saying it was consideration for a taxable service. The Commissioner argued that there was no service acquired by the DOT as the service was provided to the passenger. The Commissioner also argued that the payment by the DOT was pursuant to a statutory obligation, not as consideration for a taxable supply. Decision: The Full Federal Court concluded the taxi operator provided two taxable supplies when it transported a disabled passenger under the subsidy scheme, one being a supply of transport to the passenger and the other being a supply of transport to the DOT of the transport of a subsidised fare passenger. As the DOT received a taxable supply, it was entitled to treat the subsidy as consideration for a taxable supply and claim an input tax credits for the GST component of the supply. Relevance of the case today: The Secretary to the Department of Transport case can be used as authority for the argument that “subsidy” payments from government agencies may be consideration for a taxable supply if the recipient of the subsidy provides goods or services to third parties in accordance with the requirements stipulated as a condition of the subsidy payment. Subsequent to the case, the GST Act was amended to take subsidies outside the definition of consideration where the subsidies are appropriated by the government and paid to government-related entities but these changes (in s 9-17 GST Act) would not change the result in Secretary to the Department of Transport. If it happened today: If the facts in Secretary to the Department of Transport were to take place today, a court would similarly conclude the subsidy payments were consideration for a taxable supply within the definition of consideration in s 9-15 GST Act, related to the provision of a subsidised service and the Department making the subsidy payments would be entitled to input tax credits in respect of the payments. 424

© Thomson Reuters 2019

CHAPTER 20

GST

Services Not Used FCT v Qantas Airways Ltd

[2012] HCA 41; 247 CLR 286; 83 ATR 1; 2012 ATC 20-352 (Full High Court)

Facts: The taxpayer and a subsidiary were airlines providing air flights to passengers. In some cases taxpayers on discount fares were not entitled to refunds if they did not show up for a booked flight and in other cases they were entitled to refunds but did not seek refunds after failing to show up for a flight. The taxpayer argued the payments it had received were for flights and as it had not provided the flights, there was no consideration received for a service provided and hence there were no taxable supplies in respect of the amounts it had received. Decision: The High Court concluded the payments received by the airline were not payments for unconditional promises to carry the passenger and baggage on a particular flight, with the service not supplied if the passenger did not show to take a flight. Rather, the majority said, the payments were for a promise to use best endeavours to carry passengers and baggage, having regard to the circumstances of the business operations of the airline. This promise, and not the actual flight, was the supply provided by the airline and there was a taxable supply whether or not the taxpayer used the service. Relevance of the case today: The Qantas Airways case distinguishes the Australian treatment of non-refundable payments for supplies that are not used from the European precedent. Non-refundable payments will be treated as consideration for taxable supplies with an obligation on the supplier to remit GST and the entitlement of the customer to claim input tax credits. If it happened today: If the facts in Qantas Airways happened today, a court looking at the deliverables set out in the booking contract between the customer and the airline would find there was a taxable supply for the promise to provide a service, whether or not the service was utilised by the customer.

Forfeited Deposit Reliance Carpet Co Pty Ltd v FCT

[2008] HCA 22; 236 CLR 342; 68 ATR 158; 2008 ATC 20-028 (Full High Court)

Facts: The taxpayer had entered into a contract to sell real property and received a deposit for the sale. When the purchaser failed to complete the purchase, the contract was rescinded and the deposit was forfeited to the taxpayer. The Commissioner assessed the taxpayer on the basis of s 99-5 GST Act, which treats a deposit as being consideration for a supply at the time it is forfeited. The taxpayer argued the section operated only if there was a supply in relation to the deposit and claimed there was no supply in this case. The deposit was for the sale of land, the taxpayer argued, and when that fell through there was no other identifiable supply related to the deposit. The Commissioner argued the prospective customer received a supply from the taxpayer when it acquired initial rights under the contract or when it was able to avoid full © Thomson Reuters 2019

425

AUSTRALIAN TAXATION LAW CASES 2019

performance upon forfeiture and one of these supplies was sufficient for s 99-5 to apply. Decision: The High Court agreed that s 99-5 would apply only if the Commissioner could show that the transaction involved a supply. It concluded that the payment of a deposit amounted to consideration for the parties entering into mutual legal obligations. In the case of a deposit for the sale of land, the deposit amounted to consideration for security for the performance of the obligation of the purchaser to complete the contract. Relevance of the case today: The High Court’s decision in Reliance Carpet is authority for the application of s 99-5 to forfeited deposits on the sale of land. Most likely, it can be cited to support the application of s 99-5 to any forfeited deposit where the recipient of the deposit had assumed an obligation as a consequence of the receipt of the deposit. The Commissioner may seek to use it to support a broader interpretation of the definition of taxable supply more generally. While the case cannot be used as authority to support the argument that passive supplies can be taxable supplies, the Commissioner may try to use it to support GST assessments in other cases where taxpayers make payments that might be considered consideration for the recipient’s undertaking to do something in the future. If it happened today: The approach adopted by the High Court in Reliance in respect of a forfeited deposit would be followed by any lower court in the case of a forfeited deposit for the sale of land.

MIXED AND COMPOSITE SUPPLIES A single transaction may result in a person acquiring goods or services or a combination of goods and services that, if separated, would constitute taxable supplies and nontaxable supplies (either exempt supplies or GST-free supplies). In Australia, supplies that are separable into taxable and non-taxable elements are known as “mixed” supplies, while supplies in which the different elements combine to form a single nonseverable supply are known as “composite” supplies. Whether a supply with different elements constitutes a severable mixed supply or a non-severable composite supply will depend on the nature of the elements and how significant individual elements are relative to the entire supply.

British Airways plc v Customs & Excise Commissioners [1990] STC 643 (UK Court of Appeal)

Facts: The taxpayer was a UK airline that supplied passenger flights on which meals were served. It charged a single fare and provided no partial rebate if passengers did not consume the meals provided. Under UK value added tax law (“VAT” – the UK term for GST), passenger flights were GST-free supplies (or “zero-rated supplies”, to use the UK terminology) while meals were normally taxable supplies. The UK Commissioners dissected the cost of airplane tickets into components for the flight 426

© Thomson Reuters 2019

CHAPTER 20

GST

and a component for the meal and assessed the airline for GST on the portion attributed to the meal. Decision: The UK Court of Appeal found the taxpayer had made a single composite supply of an airflight and the provision of a meal was merely an incidental element of the GST-free supply. Relevance of the case today: The British Airways case is cited in Australia as an example of a non-dissectible composite supply. Factors relevant to the decision that will also be taken into account in Australia include the fact that the portion of the price attributable to the meal would have been very small compared to the cost of the air carriage, the fact that the price was the same whether or not the customer consumed the meal, and the fact that the provision of the meal was considered by the supplier and customers as integral to the air carriage. If it happened today: The flights in British Airways were mostly domestic flights which would be taxable in Australia, as would the sale of meals. Thus, if the facts in British Airways were to arise in Australia, there would be no issue of dissecting the supply into taxable and non-taxable portions. However, if a different case arose involving elements that might be taxable and non-taxable if viewed separately and the factors considered by the Court in British Airways were present, an Australian court would also regard the supply as a non-dissectible composite supply. Sea Containers Services Ltd v Customs and Excise Commissioners [2000] STC 82 (UK High Court)

Facts: The taxpayer provided train excursions from London. The train excursions followed a circular route so passengers ended up at the original station at the completion of the trip. Excursions included food and beverages and advertising for the trips highlighted the meals as a feature of the trip. UK value added tax law (“VAT” – the UK term for GST) treated train transport as a GST-free (zero rated supply, using UK terminology) while the provision of meals was an ordinary taxable supply. The taxpayer argued it had made a single composite supply of train travel, citing the British Airways case as a precedent for treating the supply of transport and food as a single supply. The Commissioners argued the taxpayer had made a mixed supply and GST was payable on the portion of consideration attributable to meals. Decision: The Court distinguished the British Airways precedent and said the supply in Sea Containers was a mixed supply that could be separated into taxable and non-taxable elements. Relevance of the case today: The Sea Containers case is cited in Australia as an example of a mixed supply that can be dissected into taxable and non-taxable parts. Factors relevant to the decision that will also be taken into account in Australia include the fact that the portion of the price attributable to the meal was very large relative to the cost of the entire excursion and the fact that the taxpayer emphasised the meal as a central feature of the excursion. © Thomson Reuters 2019

427

AUSTRALIAN TAXATION LAW CASES 2019

If it happened today: Both train travel and prepared meals are taxable supplies in Australia so if the facts in Sea Containers were to arise today in Australia, there would be no argument as to whether the supply was a dissectible mixed supply or a non-severable composite supply. However, if a different case arose involving elements that might be taxable and non-taxable if viewed separately and the factors considered by the Court in Sea Containers were present, an Australian court would also regard the supply as a severable mixed supply. FCT v Luxottica Retail Australia Pty Ltd [2011] FCAFC 20; 79 ATR 768; 2011 ATC 20-243 (Full Federal Court)

Facts: The taxpayer was an optical retailer that sold glasses comprising frames and lens. If sold separately, the frames were taxable supplies while the lens are GST-free supplies. The taxpayer ran a promotion that offered a customer a discount on the price of frames if they were ordered with fitted prescription lenses. No discount was provided for the lens. The Commissioner argued the discount should apply to the entire transaction since it was only available if the customer purchased frames and lens while the taxpayer argued the value of the taxable component of the supply was reduced while the value of the GST-free part stayed the same. Decision: The Full Federal Court found the taxpayer had made a single mixed supply of discounted frames and regularly priced lens so the taxable proportion of the mixed supply should be based on the proportion of the total price represented by the discounted price of the frames. Relevance of the case today: The Luxottica decision has established a precedent that allows retailers to discount the taxable component of a mixed supply involving taxable and GST-free elements and calculate the taxable value of the supply using the discounted value of the taxable portion. If it happened today: If the facts in Luxottica were to take place today, the taxpayer would be liable to remit GST only on the discounted cost of the taxable component of the mixed supply.

INPUT TAX CREDITS A registered supplier is entitled to input tax credits in respect of input tax on acquisitions for use in carrying on the enterprise unless the acquisition is to be used to make input taxed supplies or the acquisition is of a personal or domestic nature. The latter restriction may be redundant – if an acquisition is made for personal or domestic purposes, it is not acquired for use in carrying on an enterprise.

428

© Thomson Reuters 2019

CHAPTER 20

GST

Rio Tinto Services Ltd v FCT

[2015] FCAFC 117; 101 ATR 546; 2015 ATC 20-525 (Full Federal Court)

Facts: The taxpayer operated a mine in a remote area. It provided subsidised housing to the workers, renting accommodation for less than its cost. It sought input tax credits for acquisitions related to the provision of accommodation. The Commissioner denied the input tax credits on the basis that the supply of residential premises was an input taxed supply under s 40-35 GST Act. The taxpayer argued that since the supply was obviously made at a loss, the actual purpose of the acquisition and subsequent supply should not be seen in isolation as a supply of residential premises but rather in the context of its overall taxable business of mining. Looked at from this broader perspective, the company argued, the acquisition was to ensure workers were available for its mining operations. Decision: The Full Federal Court rejected the taxpayer’s argument. The Court distinguished between general overhead expenses that supported a taxpayer’s overall business and acquisitions that could be traced to the provision of a specify supply. As the inputs in question in this case were directly tied to a specific supply, the character of the supply determined whether the acquisitions gave rise to input tax credits. The inputs that were directly related to the provision of input taxed residential accommodation could not be considered to be inputs related to the general business of the taxpayer. As a result, no input tax credits were available in respect of the acquisitions related to the provision of accommodation. Relevance of the case today: The Rio Tinto case is an important precedent for determining whether an input is acquired for a creditable purpose under s 11-15 GST Act, making it clear that the purpose of an input is based on the supply to which it is directly related, not the larger enterprise that utilises the supplies in the course of its overall operations. If it happened today: If the Rio Tinto case were to arise today, a court would deny the taxpayer input tax credits for the acquisitions used to make rental accommodation available to the workers even though the accommodation was rented at a loss for the purpose of ensuring workers were available for the mining operations.

INTERNATIONAL ASPECTS OF GST Unlike the income tax, which assesses residents on their worldwide income, the GST is said to be a “destination” basis tax, only applying in the jurisdiction where goods or services are actually consumed. Goods and services that are exported for consumption abroad are GST-free supplies, meaning the supplier recovers all input tax on acquisitions used to make the supplies and collects no tax on the export sale. Tax is collected at the country of import. Imported goods are subject to GST at the time of import. However, until 1 July 2018, a generous $1,000 exemption per import applied to goods imported by final consumers. The exemption encouraged consumers to order goods from abroad via © Thomson Reuters 2019

429

AUSTRALIAN TAXATION LAW CASES 2019

online shopping, giving foreign suppliers a cost advantage over local suppliers of similar goods. In 2017 the government passed legislation to subject these “low cost” imports to GST. However, because it would be impossible to collect the tax from every individual importer, the new law, effective from 1 July 2018, makes the supplier liable for the tax or, if the supplier uses a retail platform offering goods from multiple suppliers, makes the platform operator liable for the tax. Imported services are taxed to registered importers through what is known as a “reverse charge” rule (because the customer, and not the supplier, pays the tax) but only if the importer is not entitled to input tax credits as would be the case, for example, with a bank making input taxed financial services. There would be no reason to impose tax on registered importers who are entitled to input tax credits as they would simply show the GST liability on imports and the offsetting entitlement to input tax credits on the same return. Services imported by non-registered final consumers such as services provided over the internet were not subject to GST, creating a bias for consumers to source the services from overseas suppliers. This problem was addressed through a change in the law in 2016 commonly known as the “Netflix tax” which imposes a liability on the foreign supplier for GST where services are provided to Australian consumers from 1 July 2017.

Supplies of Services Connected to Australia One of the conditions for a supply to be treated as a “taxable supply” is that the supply is connected with the “indirect tax zone” meaning Australia other than some offshore installations. If a registered enterprise makes supplies to persons outside Australia and the supplies are not connected with the indirect tax zone, there will be no taxable supply which means the taxpayer can claim input tax related to its enterprise and not be required to include GST in the price of the supplies it makes. If the supplies are connected with the indirect tax zone and the supplier is registered or required to be registered, the supplies will be taxable supplies.

Saga Holidays Ltd v FCT

(2006) 64 ATR 602; 2006 ATC 4841 (Full Federal Court)

Facts: The taxpayer was a UK-based company that sold travel packages for persons visiting Australia. The packages included transport, tours and accommodation in Australia. It registered in Australia and claimed input tax credits for the GST included in the cost of all the services it acquired in Australia. The taxpayer argued that when it supplied rights to Australian accommodation to its customers in the UK, it was not supplying real property and the supplies were as a result not connected to Australia. Alternatively, it argued that if the supply of rights to accommodation was real property, it was an incidental supply to a supply not connected with Australia and could therefore be disregarded under s 96-5(4) GST Act. Decision: The rights provided to the taxpayer’s customers amounted to contractual rights exercisable over or in relation to land which fell in the definition of real property 430

© Thomson Reuters 2019

CHAPTER 20

GST

in s 195-1 GST Act and which therefore amounted to a supply connected with Australia. This was a separate supply and thus not incidental to the larger supply. Relevance of the case today: Concerned at an apparent proliferation of offshore suppliers of hotel accommodation in Australia which were registering, claiming input tax credits for acquisitions, and not charging customers for the supplies of rights to accommodation, before the Full Federal Court Decision in Saga the government amended the definition of “connected with Australia” by adding s 9-25(5)(c) GST Act, specifically aimed at rights to accommodation. The amendment turned out to be unnecessary in light of the decision in Saga, but in relation to future assessments the Commissioner can rely on both Saga and the section. If it happened today: The result in Saga has been guaranteed by the insertion of s 9-25(5)(c) and today these supplies are assessed as supplies connected with Australia.

“Exported” Services The Australian GST system imposes GST on consumption in Australia (or technically the “indirect tax zone”). Like all GST systems (or VAT systems, as they are called in Europe and Asia), the Australian system removes all tax on exported goods and supplies of services to foreign consumers, treating them as GST-free supplies (known as “zero rated” supplies in other GST/VAT countries). While it is relatively easy to show that goods have been exported to a customer in another country, it is more difficult to say when intangible assets or services are supplied for consumption abroad. In many countries, the GST law attempts to list all the cases in which services are treated as supplied for consumption abroad. In contrast, the Australian law, in s 38-190 GST Act Act, uses broad principles to identify when services are supplied for consumption abroad and thus are characterised as GST-free supplies. Where the supplies are treated as GSTfree “exported” services, no tax is imposed on the supply but the supplier is entitled to full input tax credits. The emphasis of the tests in s 38-190 is on where the supplier and recipient of the supply are located when the thing that gives rise to the supply is done. The general rule is subject to an override in s 38-190(2A) which prevents the supply from being a GST-free supply if it relates to real property in Australia.

ATS Pacific v FCT

[2014] FCAFC 33; 98 ATR 116; 2014 ATC 20-149 (Full Federal Court)

Facts: The taxpayer was a tourist services provider that offered non-resident travel agents options to package for their customers coming to Australia. The non-resident travel agents could choose accommodation and other services from the taxpayer’s website to put together travel packages for their clients. Once the selection was made by the non-resident travel agent, the taxpayer would book the requested product with the Australian accommodation and tour providers and charge the non-resident travel agents a fee that included the cost of the product and a margin. The taxpayer then paid the Australian providers for the services to be supplied to the non-resident tourists. The taxpayer argued it was merely providing intermediary services and not supplying © Thomson Reuters 2019

431

AUSTRALIAN TAXATION LAW CASES 2019

the underlying goods or services so its supplies were GST-free. The Commissioner argued the taxpayer was independently promising to provide the underlying supplies and thus being paid for taxable supplies even if the actual supply were provided by a third party. Decision: The underlying supplies by the Australian providers to the non-resident tourists were all connected with Australia – hotel accommodation by virtue of s 9-25(4) GST Act, goods by virtue of s 9-25(1) GST Act, and services by virtue of s 9-25(5) GST Act. The supply by the taxpayer to the non-resident travel agents could be characterised as the supply of a promise that the taxpayer would ensure that the Australian providers would provide the goods and services to the non-resident tourists when they came to Australia and this promise carries with it a right to acquire those goods or services. As the right supplied is for supplies connected with Australia, s 38-190(2) GST Act applies and the supplies cannot be GST-free supplies. Relevance of the case today: The ATS Pacific case is an important precedent for the proposition that registered enterprises providing intermediary services to non-resident customers that include a promise that other persons will provide supplies connected with Australia are themselves making supplies that cannot be GST-free. If it happened today: If the facts in ATS Pacific v FCT were to arise again in Australia, the same result would follow and the supplies would be taxable supplies.

Travelex Ltd v FCT

[2010] HCA 33; 241 CLR 510; 76 ATR 329; 2010 ATC 20-214 (Full High Court)

Facts: The taxpayer was a foreign currency supplier that operated a currency exchange booth in an Australian airport. The booth was located on the departure side of the immigration and customs clearance at the airport and thus could only make supplies to persons who were about to leave the country. The taxpayer supplied Fijian dollars to a traveller on her way to Fiji. The customer used the Fijian money to buy goods and services in Fiji. The Commissioner treated the supply as an input taxed financial supply. The taxpayer conceded it was an input taxed financial supply but argued that it was also a GST-free export under s 38-190(1) Item 4 GST Act. This section treats a supply of rights as a GST-free supply if the rights are for use outside Australia. If a supply is both an input taxed supply and a GST-free supply, the GST-free character prevails under s 9-30(3)(a) GST Act. The Commissioner argued the taxpayer had made a supply of physical notes and any rights associated with them were only incidental to the supply. Decision: The High Court concluded that the foreign currency had value only because of the rights that attached to it. The supply of currency that could only be used in another country was thus a supply of rights for use outside Australia. Consequently, the supply of foreign currency at the airport was a GST-free supply. Relevance of the case today: The Travelex case is an important precedent for the question of whether a supply of goods is mostly a supply of the rights associated with 432

© Thomson Reuters 2019

CHAPTER 20

GST

the goods. The test from Travelex appears to be whether the value of the supply is attributable mostly to the goods supplied or to the ancillary rights that come with the goods. If it happened today: If the facts in Travelex happened today, the court would continue to conclude that the taxpayer had supplied goods and rights but the supply was mostly of rights that were to be used outside Australia, thus making the supply a GST-free supply under s 38-190.

THE GST GENERAL ANTI-AVOIDANCE RULE The GST Act contains a general anti-avoidance rule modelled after Part IVA, the general anti-avoidance rule in the ITAA 1936. The threshold test for when the general anti-avoidance rule can apply differs in one important respect, however. The income tax rule applies when the “dominant purpose” of a scheme is to obtain a tax benefit: s 177A ITAA 1936. The GST rule applies where the “sole or dominant purpose” of a scheme is to obtain a GST benefit or the “principal effect” of the scheme is that a person gets a GST benefit: s 165-5 GST Act. On its face, the GST test sounds much broader than the income tax text because it does not rely on a subjective intention of the taxpayer. In practice, however, the Commissioner may encounter similar difficulties showing the primary motivation for a scheme if there are commercial reasons for a scheme as well as tax benefit reasons and showing the main effect is a GST benefit if there are commercial effects as well as GST benefits from the scheme. One type of scheme which the Commissioner has not been able to prevent is a form of phoenixing which involves non-compliance by property suppliers who sell property at a GST inclusive price but avoid remitting GST by dissolving the business prior to BAS lodgement. This has now been addressed through legislative amendment which requires certain purchasers of new residential premises or potential residential land to withhold an amount from the price of the supply for payment to the ATO.

FCT v Unit Trend Services Pty Ltd

[2013] HCA 16; 250 CLR 523; 87 ATR 13; 2013 ATC 20-389 (Full High Court)

Facts: The taxpayer was part of a house developer group. The group had purchased land prior to 2000 and after that date constructed residential buildings on the property. It was entitled to use the “margin scheme” for residential premises when selling the completed residential buildings to customers. Under the margin scheme in Division 75 of the GST Act, a seller can elect to calculate GST liability on the “margin” value of property rather than its full sale price. The margin is the difference between the value of the property on 1 July 2000 if the supplier held the property at that time and the sale price or the difference between the purchase price and the sale price if the supplier acquired the property after that time. The taxpayer group arranged for an intra-group sale of the properties prior to sale to final customers. The margin on the intra-group sale was significant (the difference between the value on 1 July 2000 and the value of almost completed housing prior to final sale) but no GST was payable on the transaction because the taxpayer elected for a tax-free intra-group transfer © Thomson Reuters 2019

433

AUSTRALIAN TAXATION LAW CASES 2019

on the basis of the GST-free election available in s 38-325 GST Act for supplies of going concerns and the rule in s 48-40 GST Act that excludes intra-group sales from the ordinary GST liability rule. The members of the group that acquired the almost completed properties then added only a small value to the properties and sold them to end buyers, again using the margin scheme so GST was payable only on the difference between their purchase prices and the sale prices. As a result of the arrangements, no GST was payable on the difference between the value of the properties on 1 July 2000 and the value of the almost completed premises at the time of the intra-group sales. The Commissioner assessed the group (Unit Trend was the GST representative company for the group) on the basis of the general anti-avoidance rule in Division 165, GST Act. The taxpayer argued the tax savings were available because it took advantage of the GST-free going concern election and the general anti-avoidance rule should not apply where it would negate the benefit of an election provided in the GST Act. Decision: The High Court rejected the taxpayer’s argument that the benefit of the scheme was the result of the election to make a GST-free intra-group supply. Rather, it said, the GST benefit resulted from the totality of the scheme which was the decision to transfer the properties within the group prior to final sale at market value but with no tax payable prior to a sale to end buyers outside the group using the margin scheme. It is not contrary to the intent of Division 165 if the GST benefit is considered as the outcome resulting from the full set of decisions and not the result of an election related to one element of the scheme. As a result, the Commissioner is entitled to apply the general anti-avoidance rule to the arrangements, assessing as if there had been no intragroup transfer and the margin was the difference between the group’s original purchase price and sale prices to end buyers. Relevance of the case today: The Unit Trend case explains the application of the general anti-avoidance rule where the taxpayer has made an election that results in a tax saving. Section 165-5(1)(b) states that the general anti-avoidance rule will not apply if the GST benefit is attributable to the making, by any entity of a choice, election, application or agreement that is expressly provided for by the GST Act. If the election takes place in the context of a wider scheme, the GST benefit is not the result of the election but rather the election used in conjunction with other steps to achieve a result not intended for by the election. If it happened today: If the facts in Unit Trend happened today, the court would allow the Commissioner to assess the group on the basis of Division 165, GST Act. It would regard the GST benefit to be the result of the overall scheme, not the election that was only part of the scheme.

434

© Thomson Reuters 2019

Table of Cases AAT Case 5489A (1992) 23 ATR 1068; 92 ATC 2045 ................................................... 193 AAT Case 5705, Jolley v FCT (1990) 21 ATR 3253; Case X23 90 ATC 244 ................ 289 ABB Australia Pty Ltd v FCT (2007) 66 ATR 460; 2007 ATC 4765 ..................... 359, 360 Abbott v Philbin (Inspector of Taxes) [1961] AC 352 ................................................ 43, 44 AGC (Advances) Ltd v FCT (1975) 132 CLR 175; 5 ATR 243; 75 ATC 4057 ...................................................................................... 159, 161, 162, 163 AGC (Investments) Ltd v FCT (1992) 23 ATR 287; 92 ATC 4239 .................................. 63 Aid/Watch Incorporated v FCT [2010] HCA 42; 241 CLR 539; 77 ATR 195; 2010 ATC 20-227 ............................................................................................... 322, 323 All States Frozen Foods Pty Ltd v FCT (1990) 20 ATR 1874; 90 ATC 4175 ................ 279 Allen Allen & Hemsley v DFCT & Ors (1989) 20 ATR 321; 89 ATC 4294 .................. 401 Alliance Holdings Ltd v FCT (1981) 12 ATR 509; 81 ATC 4637 .................................. 263 Allied Mills Industries Pty Ltd v FCT (1989) 20 ATR 457; 89 ATC 4365 ............. 108, 109 Allsop v FCT (1965) 113 CLR 341 ...................................................................... 89, 90, 96 Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) 54 CLR 295 .......... 159, 160, 161, 162 Anstis v FCT [2010] HCA 40; 241 CLR 443; 76 ATR 735; 2010 ATC 20-221 ............. 206 ANZ Banking Group Ltd; FCT v – see Australia and New Zealand Banking Group Ltd; FCT v ANZ Savings Bank Ltd v FCT (1993) 25 ATR 369; 93 ATC 4370 ........................ 137, 138 ANZ Savings Bank Ltd; FCT v (1998) 194 CLR 328; 39 ATR 19; 98 ATC 4850 ...................................................................................................... 137, 138 Applegate; FCT v (1979) 9 ATR 899; 79 ATC 4307 .............................................. 351, 352 Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314 .................................. 258, 263 Ash; C of T (NSW) v (1938) 61 CLR 263 .............................................................. 178, 179 Ashgrove Pty Ltd & Ors v DFCT (1994) 28 ATR 512; 94 ATC 4549.................... 119, 120 Associated Portland Cement Manufacturers Ltd v Kerr (Inspector of Taxes) [1946] 1 All ER 68 .................................................................................................... 218 ATS Pacific v FCT [2014] FCAFC 33; 98 ATR 116; 2014 ATC 20-149................ 431, 432 AusNet Transmission Group Pty Ltd v FCT [2015] HCA 25; 255 CLR 439; 99 ATR 816; 2015 ATC 20-521 ......................................................................... 223, 224 Australasian Jam Co Pty Ltd v FCT (1953) 88 CLR 23 ................................................. 281 Australia and New Zealand Banking Group Ltd; FCT v (1979) 143 CLR 499; 9 ATR 483; 79 ATC 4939 ........................................................................................... 409 Australian Building Systems Pty Ltd (in liq); FCT v [2015] HCA 48; 257 CLR 544; 102 ATR 359; 2015 ATC 20-548 (High Court) .......................... 411, 412 © Thomson Reuters 2019

435

AUSTRALIAN TAXATION LAW CASES 2019

Australian Gas Light Co & Anor; FCT v (1983) 15 ATR 105; 83 ATC 4800 ................ 259 Australian Guarantee Corporation Ltd; FCT v (1984) 15 ATR 982; 84 ATC 4642 ...................................................................................................... 263, 264 Avondale Motors (Parts) Pty Ltd v FCT (1971) 124 CLR 97; 2 ATR 312; 71 ATC 4101 ...................................................................................................... 339, 340 Baker v Campbell (1983) 153 CLR 52; 14 ATR 713; 83 ATC 4606 .............................. 400 Ballarat Brewing Co Ltd v FCT (1951) 82 CLR 364 ............................................. 258, 259 Bamford; FCT v (2010) 240 CLR 481; 75 ATR 1; 2010 ATC 20-170 ........... 310, 311, 312 Barger’s Case; The King and the Minister of State for the Commonwealth v Barger (1908) 6 CLR 41 ............................................................................................. 6 Barratt & Ors v FCT (1992) 23 ATR 339; 92 ATC 4275 ........................................ 254, 255 Batagol v FCT (1963) 109 CLR 243 .............................................................................. 405 Bennett v FCT (1947) 75 CLR 480 .................................................................................. 31 Benson’s Hosiery (Holdings) Ltd; O’Brien (Inspector of Taxes) v [1980] AC 562; [1979] 3 All ER 652; 53 TC 241 ............................................................................... 142 Beville; FCT v (1953) 5 AITR 458; 10 ATD 170 ................................................... 293, 294 BHP Billiton; FCT v [2011] HCA 17; 244 CLR 325; 79 ATR 1; 2011 ATC 20-264 .........................................................................................................246 BHP Billiton Finance Ltd; FCT v (2010) 76 ATR 472; 2010 ATC 20-169 ............ 247, 249 BHP Billiton Petroleum (Bass Strait) Pty Ltd v FCT (2002) 51 ATR 520; 2002 ATC 5169 .................................................................................................. 260, 261 Black; DFCT v (1990) 21 ATR 701; 90 ATC 4699 ........................................................ 336 Blake; FCT v (1984) 15 ATR 1006; 84 ATC 4661 ..................................................... 29, 30 Blakely; FCT v (1951) 82 CLR 388 ....................................................................... 335, 336 Blank v FCT [2016] HCA 42; 258 CLR 439; 104 ATR 41 .................................. 28, 38, 41 Bluebottle UK Ltd v Deputy FCT (2007) 232 CLR 598; 67 ATR 1; 2007 ATC 5302 .................................................................................................. 410, 411 Bohemians Club v Acting FCT (1918) 24 CLR 334 .................................................. 16, 17 Borax Consolidated Ltd; Southern v [1941] 1 KB 111........................... 225, 226, 227, 228 BP Australia Ltd v FCT (1965) 112 CLR 386; [1966] AC 224 .............. 219, 220, 221, 224 Brajkovich v FCT (1989) 20 ATR 1570; 89 ATC 5227 ............................................. 54, 55 Brent v FCT (1971) 125 CLR 418; 2 ATR 563; 71 ATC 4195 ................................... 35, 36 British Airways plc v Customs & Excise Commissioners [1990] STC 643 ........... 426, 427 British Insulated and Helsby Cables Ltd v Atherton (1926) 10 TC 155 ......................... 218 British Mexican Petroleum Co Ltd; Jackson (Inspector of Taxes) v (1932) 16 TC 570 ............................................................................................... 124, 125 British Transport Commission v Gourley [1956] AC 185 .............................................. 103 Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423 .............. 225, 226, 227, 228, 229 Brooks & Anor v FCT (2000) 44 ATR 352; 2000 ATC 4362 ................................. 148, 149 Brookton Co-operative Society Ltd v FCT (1981) 147 CLR 441; 11 ATR 880; 81 ATC 4346 ......................................................................... 328, 340, 341 Brown v FCT (2002) 49 ATR 301; 2002 ATC 4273 ................................................... 26, 27 Brown; FCT v (1999) 43 ATR 1; 99 ATC 4600 ...................................... 160, 162, 163, 164 Bywater Investments Ltd v FCT; Hua Wang Bank Berhad v FCT [2016] HCA 45; 260 CLR 169; 104 ATR 82 ..................................................... 348 348,, 349 436

© Thomson Reuters 2019

TABLE OF CASES

C of T (NSW) v Ash (1938) 61 CLR 263 ............................................................... 178, 179 C of T (Victoria) v Phillips (1936) 55 CLR 144 ......................................................... 30, 31 Cajkusic and Ors v FCT (2006) 64 ATR 676; 2006 ATC 4752 .............................. 310, 311 Californian Copper Syndicate v Harris (1904) 5 TC 159 ......................... 65, 66, 67, 83, 85 Californian Oil Products Ltd (in liquidation) v FCT (1934) 52 CLR 28 .............................................................................. 104, 105, 107, 108 Calvert (Inspector of Taxes) v Wainwright [1947] 1 All ER 282; 27 TC 475 ..................................................................................................................... 32 Cameron v DFCT (Tasmania) (1923) 32 CLR 68 .............................................................. 6 (Carden’s case) C of T (SA) v Executor Trustee and Agency Co of South Australia Ltd (1938) 63 CLR 108 ............................................ 253, 254, 255, 256 Case X23 90 ATC 244; AAT Case 5705, Jolley v FCT (1990) 21 ATR 3253 ................ 289 Casimaty v FCT (1997) 37 ATR 358; 97 ATC 5135 ................................................... 59, 60 Cecil Bros Pty Ltd v FCT (1964) 111 CLR 430 ..................................................... 276, 277 Chamber of Manufactures Insurance Ltd v FCT (1984) 15 ATR 599; 84 ATC 4315; [1984] FCA 124 [note: taxpayer name is reported as Chamber of Manufacturers in FCA report] ............................................................ 88, 89 Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344 .................... 169, 170, 177 Charles v FCT (1954) 90 CLR 598................................................................................. 314 Chevron Australia Holdings Pty Ltd v FCT [2017] FCAFC 62; 105 ATR 599; 2017 ATC 20-615 .................................................................................................... 364, 365 Citibank Ltd & Ors; FCT v (1993) 26 ATR 423; 93 ATC 4691 ..................................... 129 Citibank Ltd; FCT & Ors v (1989) 20 ATR 292; 89 ATC 4268 ............................. 401, 402 Citylink; FCT v Citylink Melbourne Ltd (2006) 228 CLR 1; 62 ATR 648; 2006 ATC 4404 .................................................................................................. 266, 267 Cliffs International Inc v FCT (1979) 142 CLR 140; 9 ATR 507; 79 ATC 4059 .............................................................................. 231, 232, 233, 234, 235 Coles Myer Finance Ltd v FCT (1993) 176 CLR 640; 25 ATR 95; 93 ATC 4214; 4341 ............................................................................................ 265, 266 Collings; FCT v (1976) 6 ATR 476; 76 ATC 4254 ................................................ 198, 199 Colonial Mutual Life Assurance Society Ltd v FCT (1946) 73 CLR 604 ............ 63, 88, 89 Colonial Mutual Life Assurance Society Ltd v FCT (1953) 89 CLR 428 .............. 231, 233 Consolidated Fertilizers Ltd; FCT v (1991) 22 ATR 281; 91 ATC 4677 ........................ 229 Consolidated Media Holdings Ltd; FCT v [2012] HCA 55; 250 CLR 503; 84 ATR 1; 2012 ATC 20-361...................................................................................... 337 Consolidated Press Holdings Ltd; FCT v (2001) 207 CLR 235; 47 ATR 229; 2001 ATC 4343 ............................................................................. 394, 395 Constable v FCT (1952) 86 CLR 402 ......................................................................... 39, 40 Cooke and Sherden; FCT v (1980) 10 ATR 696; 80 ATC 4140 ................................ 50, 51 Cooling; FCT v (1990) 21 ATR 13; 90 ATC 4472 .................................... 73, 74, 77, 78, 80 Coombes (No 2); FCT v (1999) 42 ATR 356; 99 ATC 4634 .................................. 403, 404 Cooper; FCT v (1991) 21 ATR 1616; 91 ATC 4396 ............................................... 197, 198 Coughlan & Ors v FCT (1991) 22 ATR 109; 91 ATC 4505 ........................................... 298 Countess of Bective v FCT (1932) 47 CLR 417..................................................... 313, 314 Crow v FCT (1988) 19 ATR 1565; 88 ATC 4620 ....................................................... 59, 60 CSR Ltd; FCT v (2000) 45 ATR 559; 2000 ATC 4710............................................... 95, 96 © Thomson Reuters 2019

437

AUSTRALIAN TAXATION LAW CASES 2019

CSR Ltd v Hornsby Shire Council (2004) 57 ATR 201; 2004 ATC 4966 .............. 422, 423 Cyclone Scaffolding Pty Ltd v FCT (1987) 19 ATR 674; 87 ATC 5083 .................110, 111 D Marks Partnership v FCT [2016] FCAFC 86; 103 ATR 439 .............................. 326, 327 David Jones Finance and Investments Pty Ltd & Anor v FCT (1991) 21 ATR 1506; 91 ATC 4315 ............................................................... 330, 413, 414, 415 Day; FCT v (2008) 236 CLR 163; 70 ATR 14; 2008 ATC 20-064 ......................... 176, 177 De Beers Consolidated Mines Ltd v Howe (Surveyor of Taxes) [1906] AC 455 .................................................................................................... 346, 347 Denmark Community Windfarm v FCT [2018] FCAFC 11; 2018 ATC 20-646 ...... 95, 283 Dickenson v FCT (1958) 98 CLR 460 .................................................................. 36, 80, 81 Dixon; FCT v (1952) 86 CLR 540 ................................................................ 27, 28, 29, 393 Donaldson v FCT (1974) 4 ATR 530; 74 ATC 4192 ........................................................ 43 Dormer v FCT (2002) 51 ATR 353; 2002 ATC 507 ............................................... 255, 257 Doutch v FCT [2016] FCAFC 166; 104 ATR 394 ............................................................ 74 DP Smith; FCT v (1981) 147 CLR 578; 11 ATR 538; 81 ATC 4114...................... 168, 169 Ducker (CIR) v Rees Roturbo Development Syndicate, Ltd [1928] AC 132 ............. 66, 67 Duke of Westminster; Inland Revenue Commissioners v [1936] AC 1 ................. 378, 379 Dymond; Re (1959) 101 CLR 11 ........................................................................................ 8 EA Marr and Sons (Sales) Ltd; FCT v (1984) 15 ATR 879; 84 ATC 4580 ............ 160, 161 Eastern Nitrogen Ltd v FCT (2001) 46 ATR 474; 2001 ATC 4164 ........................ 191, 192 Edwards; FCT v (1994) 28 ATR 87; 94 ATC 4255 ................................................. 211, 212 Efstathakis; FCT v (1979) 9 ATR 867; 79 ATC 4256 ..................................................... 357 Egerton-Warburton & Ors v DFCT (1934) 51 CLR 568 ........ 132, 133, 135, 230, 231, 231 Eisner v Macomber (1920) 252 US 189 ..................................................................... 12, 13 Elmslie & Ors v FCT (1993) 26 ATR 611; 93 ATC 4964 ............................... 144, 145, 146 ElecNet (Aust) Pty Ltd v FCT [2016] HCA 51; 259 CLR 73; 104 ATR 554 ................. 313 Energy Resources of Australia Ltd; FCT v (1996) 185 CLR 66; 33 ATR 52; 96 ATC 4536 ...................................................................................................... 265, 266 Esquire Nominees Ltd v FCT (1973) 129 CLR 177; 4 ATR 75; 73 ATC 4114 ...... 357, 358 Esso Australia Resources Ltd v FCT (1999) 201 CLR 49; 43 ATR 506; 2000 ATC 4042 .......................................................................................................... 402 Europa Oil (NZ) Ltd (No 1); IRC v [1971] AC 760; 70 ATC 6012................................ 185 Europa Oil (NZ) Ltd v CIR (NZ) (No 2) [1976] 1 WLR 464; 5 ATR 744; 76 ATC 6001 ................................................................... 184, 185, 186, 187 Evans v FCT (1989) 20 ATR 922; 89 ATC 4540 ............................................................. 53 Evans Medical Supplies Ltd; Moriarty (Inspector of Taxes) v [1957] 3 All ER 718 ............................................................................................... 71, 72 Everett; FCT v (1980) 143 CLR 440; 10 ATR 608; 80 ATC 4076 ................. 271, 272, 299 Executor Trustee and Agency Co of South Australia Ltd; C of T (SA) v (Carden’s case) (1938) 63 CLR 108 .......................... 253, 254, 255, 256 Faichney; FCT v (1972) 129 CLR 38; 3 ATR 435; 72 ATC 4245 .......................... 208, 209 Farnsworth v FCT (1949) 78 CLR 504................................................................... 278, 279 438

© Thomson Reuters 2019

TABLE OF CASES

Federal Coke Co Pty Ltd v FCT (1977) 7 ATR 519; 77 ATC 4255............................ 14, 15 Federal Wharf Co Ltd v Deputy FCT (1930) 44 CLR 24 ...................................... 101, 102 Ferguson v FCT (1979) 9 ATR 873; 79 ATC 4261 ......................................... 180, 181, 182 Finn; FCT v (1961) 106 CLR 60 ............................................................................ 206, 207 First Provincial Building Society Ltd v FCT (1995) 30 ATR 207; 95 ATC 4145 .......................................................................................................... 98, 99 Firstenberg; FCT v (1976) 6 ATR 297; 76 ATC 4141 .................................................... 254 Firth; FCT v (2002) 50 ATR 1; 2002 ATC 4346..................................... 188, 189, 193, 194 FJ Bloemen Pty Ltd v FCT (1981) 147 CLR 360; 11 ATR 914; 81 ATC 4280 ...................................................................................................... 412, 413 Fleming & Co (Machinery), Ltd; Commissioners of Inland Revenue v (1952) 33 TC 57 ................................................................................................. 106, 107 Fletcher & Ors v FCT (1992) 24 ATR 194; 92 ATC 4611 .............................................. 188 Fletcher v FCT (1991) 173 CLR 1; 22 ATR 613; 91 ATC 4950............................. 192, 193 Foley (Lady) v Fletcher (1858) 157 ER 678 .......................................................... 130, 131 Forsyth; FCT v (1981) 148 CLR 203; 11 ATR 657; 81 ATC 4157 ................................ 209 Fortescue Metals Group Ltd v The Commonwealth [2013] HCA 34; 250 CLR 548; 89 ATR 1; 2013 ATC 20-405 ................................................................. 7 Foxwood (Tolga) Pty Ltd; FCT v (1981) 147 CLR 278; 11 ATR 859; 81 ATC 4261 ...................................................................................................... 166, 167 French; FCT v (1957) 98 CLR 398 ........................................................................ 355, 356 Fullerton v FCT (1991) 22 ATR 757; 91 ATC 4983 ....................................................... 201 Futuris Corporation Ltd; FCT v (2008) 237 CLR 146; 69 ATR 41; 2008 ATC 20-039 ............................................................................................... 407, 408 Futuris Corporation Ltd; FCT v [2012] FCAFC 32; 87 ATR 828; 2012 ATC 20-306 ....................................................................................... 392, 393, 408 Galland; FCT v (1986) 162 CLR 408; 18 ATR 33; 86 ATC 4885 .......................... 272, 299 Gasparin v FCT (1994) 28 ATR 130; 94 ATC 4280 ....................................................... 261 GE Crane Sales Pty Ltd v FCT (1971) 126 CLR 177; 2 ATR 692; 71 ATC 4268 ...................................................................................................... 248, 249 Gibb v FCT (1966) 118 CLR 628 ........................................................................... 333, 334 GKN Kwikform Services Pty Ltd; FCT v (1991) 21 ATR 1532; 91 ATC 4336 ...............................................................................................................111 Glenboig Union Fireclay Co Ltd v Commissioners of Inland Revenue [1922] SLT 182; 12 TC 427 ................................................................................. 99, 100 Glenville Pastoral Co Pty Ltd (In Liquidation) v FCT (1963) 109 CLR 199 .................................................................................. 331, 332, 334 Gourley; British Transport Commission v [1956] AC 185............................................. 103 GP International Pipecoaters Ltd v FCT (1990) 170 CLR 124; 21 ATR 1; 90 ATC 4413 .................................................................................................... 76, 97, 98 Granby Pty Ltd v FCT (1995) 30 ATR 400; 95 ATC 4240 ............................. 113, 143, 144 Grant & Ors; FCT v (1991) 22 ATR 237; 91 ATC 4608 ................................................ 297 Grant v Downs (1976) 135 CLR 674 ............................................................................. 402 Gray & Anor v FCT (1989) 20 ATR 649; 89 ATC 4640 ................................................ 147 © Thomson Reuters 2019

439

AUSTRALIAN TAXATION LAW CASES 2019

Gulland; FCT v; Watson v FCT; Pincus v FCT (1985) 160 CLR 55; 17 ATR 1; 85 ATC 4765 ..................................................................................... 382, 383 Guy; FCT v (1996) 32 ATR 590; 96 ATC 4520 .............................................................. 149 Gwynvill Properties Ltd; FCT v (1986) 17 ATR 433; 86 ATC 4512 .............................. 190 Hacon Pty Ltd; FCT v [2017] FCAFC 181; 106 ATR 863 ..................................... 417, 418 Hallstroms Pty Ltd v FCT (1946) 72 CLR 634 ...................... 167, 218, 225, 226, 227, 228 Handley v FCT (1981) 148 CLR 182; 11 ATR 644; 81 ATC 4165 ........................ 208, 209 Happ; FCT v (1952) 5 AITR 290; 9 ATD 447 ........................................................ 295, 296 Harding v FCT (1917) 23 CLR 119 ................................................................................ 3, 4 Harris; FCT v (1980) 10 ATR 869; 80 ATC 4238 ....................................................... 29, 30 Harrowell v FCT (1967) 116 CLR 607 ........................................................... 332, 333, 334 Hart; FCT v [2004] HCA 26; 217 CLR 216; 55 ATR 712; [2004] ATC 4599 ................................................................................................ 390, 391 Hart v FCT [2018] FCAFC 61; 2018 ATC 20-653 ................................................... 28, 393 Hatchett; FCT v (1971) 125 CLR 494; 2 ATR 557; 71 ATC 4184 ................................. 203 Hayes; FCT v (1956) 96 CLR 47 .......................................................................... 22, 23, 27 Heavy Minerals Pty Ltd v FCT (1966) 115 CLR 512 ............................................ 107, 108 Henderson v FCT (1970) 119 CLR 612; 1 ATR 596; 70 ATC 4016 ............... 255, 256, 257 Henry Jones (IXL) Ltd v FCT (1991) 22 ATR 328; 91 ATC 4663 ................................... 70 Hepples v FCT (1991) 173 CLR 492; 22 ATR 465; 91 ATC 4808 Final orders (1992) 173 CLR 492; 22 ATR 852; 92 ATC 4013 ................. 140, 141, 142 Herald & Weekly Times v FCT (1932) 48 CLR 113 ...................................................... 172 Higgs (Inspector of Taxes) v Olivier [1952] Ch 311 .................................................. 36, 37 Highfield; FCT v (1982) 13 ATR 426; 82 ATC 4463 ..................................................... 204 Hobbs v FCT (1957) 98 CLR 151 .......................................................................... 304, 305 Howland-Rose & Ors v FCT (2002) 49 ATR 206; 2002 ATC 4200 ............... 388, 389, 390 Hornsby Shire Council v FCT [2008] AATA 1060; 71 ATR 442; 2008 ATC 10-061 ....................................................................................... 422, 423, 424 HR Sinclair & Son Pty Ltd v FCT (1966) 114 CLR 537 ............................................ 90, 91 Hurley Holdings (NSW) Pty Ltd; FCT v (1989) 20 ATR 1293; 89 ATC 5033 ...................................................................................................... 123, 124 Hyteco Hiring Pty Ltd; FCT v (1992) 24 ATR 218; 92 ATC 4694 ......................... 112, 144 Ilbery; FCT v (1981) 12 ATR 563; 81 ATC 4661 ................................................... 189, 190 Imperial Chemical Industries of Australia and New Zealand Ltd v FCT (1970) 120 CLR 396; 1 ATR 450; 70 ATC 4024 ............................................... 245, 246 Indooroopilly Children Services (Qld) Pty Ltd; FCT v (2007) 65 ATR 369; 2007 ATC 4236 ...................................................................................................... 44, 45 Industrial Equity Ltd v DCT (1990) 170 CLR 649; 21 ATR 934; 90 ATC 5008 ............ 410 International Nickel Australia Ltd v FCT (1977) 137 CLR 347; 7 ATR 739; 77 ATC 4383 ................................................................................................................ 83 J Hammond Investments Pty Ltd v FCT (1977) 7 ATR 633; 77 ATC 3211 ........... 338, 339 J Rowe and Son Pty Ltd v FCT (1971) 124 CLR 421; 2 ATR 497; 71 ATC 4157 ...................................................................................................... 260, 261 440

© Thomson Reuters 2019

TABLE OF CASES

Jackson (Inspector of Taxes) v British Mexican Petroleum Co Ltd (1932) 16 TC 570 ........................................................................................................... 124, 125 James Flood Pty Ltd; FCT v (1934) 52 CLR 28 ............................................................. 268 Jayasinghe; FCT v [2017] HCA 26; 260 CLR 400; 106 ATR 274 ................................. 367 Jenkins; FCT v (1982) 12 ATR 745; 82 ATC 4098 ......................................................... 352 John v FCT [1989] HCA 5; 166 CLR 417; 20 ATR 1 .................................................... 380 John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30 ....................................... 227, 228 John Holland Group Pty Ltd v FCT [2015] FCAFC 82; 99 ATR 73; 2015 ATC 20-510 ............................................................................................... 199, 200 Jolley v FCT (1989) 20 ATR 335; 89 ATC 4197 .................................................... 288, 289 Jones; FCT v (2002) 49 ATR 188; 2002 ATC 4135 ........................................ 160, 163, 164 Just v FCT (1949) 4 AITR 185; 8 ATD 419.................................................... 133, 134, 233 Just Jeans Pty Ltd; FCT v (1987) 18 ATR 775; 87 ATC 4373 ................................ 190, 191 Keily v FCT (1983) 14 ATR 156; 83 ATC 4248 ............................................................... 14 Kelly v FCT (1985) 16 ATR 478; 85 ATC 4283 ............................................................... 33 Kelly v FCT [2013] FCAFC 88; 94 ATR 411; 2013 ATC 20-408 .................................. 272 Koitaki Para Rubber Estates Ltd v FCT (1940) 64 CLR 15 ........................................... 347 L’Estrange v FCT (1978) 9 ATR 410; 78 ATC 4744 ...................................................... 406 La Rosa; FCT v (2003) 53 ATR 1; 2003 ATC 4510 ............................................... 170, 177 Laidler v Perry [1966] AC 16 ..................................................................................... 23, 24 Lamesa Holdings BV; FCT v (1997) 36 ATR 589; 97 ATC 4752 .......................... 372, 373 Lau; FCT v (1984) 16 ATR 55; 84 ATC 4929 ................................................................ 190 Law Shipping Co Ltd v Inland Revenue Commissioners (1923) 12 TC 621 ............................................................................... 238, 239, 242, 243 Lean v FCT [2010] FCAFC 1; 75 ATR 213; 2010 ATC 20-159 ..................................... 170 Lees & Leech Pty Ltd v FCT (1997) 36 ATR 127; 97 ATC 4407 .............................. 75, 76 Levene v IRC [1928] AC 217 ................................................................................. 349, 350 Lindsay v FCT (1961) 106 CLR 377 ...................................................................... 239, 241 Lister Blackstone Pty Ltd v FCT (1976) 134 CLR 457; 6 ATR 499; 76 ATC 4285 ....... 230 Lodge v FCT (1972) 128 CLR 171; 3 ATR 254; 72 ATC 4174 ............................. 201, 202 Lomax (Inspector of Taxes) v Peter Dixon and Son Ltd [1943] KB 671; [1943] 2 All ER 255; 25 TC 353 ........................................................................ 122, 124 London Australia Investment Co Ltd v FCT (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398 ................................................................................. 61, 62, 63 Lunney v FCT (1958) 100 CLR 478............................................................... 198, 201, 209 Luxottica Retail Australia Pty Ltd; FCT v [2011] FCAFC 20; 79 ATR 768; 2011 ATC 20-243 ....................................................................................................... 428 Lysaght; IRC v [1928] AC 234 ............................................................................... 350, 351 MacFarlane v FCT (1986) 17 ATR 808; 86 ATC 4477 ................................................... 308 MacNiven (Inspector of Taxes) v Westmoreland Investments Ltd [2001] 1 All ER 865 ................................................................................... 379, 380, 381 Macomber; Eisner v (1920) 252 US 189 .................................................................... 12, 13 Macoun v FCT [2015] HCA 44; 257 CLR 519; 102 ATR 263 ....................................... 366 © Thomson Reuters 2019

441

AUSTRALIAN TAXATION LAW CASES 2019

Madad Pty Ltd v FCT (1984) 15 ATR 1118; 84 ATC 4739 .................................... 173, 174 Maddalena; FCT v (1971) 2 ATR 541; 71 ATC 4161 ............................................. 157, 158 Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276; 80 ATC 4542 .............................................................................. 173, 174, 175, 176, 177 Malayan Shipping Co Ltd v FCT (1946) 71 CLR 156 ................................................... 348 Mallalieu v Drummond (Inspector of Taxes) [1983] 2 AC 861 ...................................... 210 Mallandaine; Partridge v (1886) 18 QBD 276.................................................................. 64 Mansfield v FCT (1995) 31 ATR 367; 96 ATC 4001.............................................. 212, 213 Martin v FCT (1953) 90 CLR 470 .............................................................................. 52, 53 Martin v FCT (1984) 15 ATR 808; 84 ATC 4513 ........................................................... 202 McCauley v FCT (1944) 69 CLR 235 .................................................................... 117, 118 McClelland v FCT (1970) 120 CLR 487; 2 ATR 21; 70 ATC 4115 ........................... 84, 85 McDermott Industries (Aust) Pty Ltd v FCT (2005) 59 ATR 358; 2005 ATC 4398 .................................................................................................. 370, 371 McDonald; FCT v (1987) 18 ATR 957; 87 ATC 4541............................................ 286, 287 McDonald; FCT v (1998) 38 ATR 563; 98 ATC 4306............................................ 145, 146 McLaurin v FCT (1961) 104 CLR 381 ................................................................... 100, 101 McNeil; FCT v (2007) 229 CLR 656; 64 ATR 431; 2007 ATC 4223............................. 121 McPhail; FCT v (1968) 117 CLR 111............................................................................. 214 Memorex Pty Ltd v FCT (1987) 19 ATR 553; 87 ATC 5034 ......................... 109, 110, 112 Millar v FCT [2016] FCAFC 94; 103 ATR 592 ..................................................... 360, 361 Mills v FCT [2012] HCA 51; 250 CLR 171; 83 ATR 514; 2012 ATC 20-360 ............... 396 MIM Holdings Ltd v FCT (1997) 36 ATR 108; 97 ATC 4420 ................................... 81, 82 Mitchum, FCT v (1965) 113 CLR 401 ........................................................... 355, 356, 357 Moneymen Pty Ltd v FCT [1990] FCA 486; 21 ATR 1142; 91 ATC 4019 ............ 135, 136 Montgomery; FCT v (1999) 198 CLR 639; 42 ATR 475; 99 ATC 4749 ........................................................................................ 74, 75, 76, 78, 79 Moriarty (Inspector of Taxes) v Evans Medical Supplies, Ltd [1957] 3 All ER 718 ............................................................................................... 71, 72 Morris v FCT (2002) 50 ATR 104; 2002 ATC 4404 ....................................................... 213 Murry; FCT v (1998) 193 CLR 605; 39 ATR 129; 98 ATC 4585.......................... 149, 150 Mutual Acceptance Ltd v FCT (1984) 15 ATR 1238; 84 ATC 4831 ...................... 126, 127 Myer Emporium Ltd; FCT v (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363 ......................................................... 65, 66, 67, 68, 69, 70, 71, 72, 73, 74, .........................................................75, 76, 78, 79, 80, 81, 84, 91, 93, 98, 112, 118, 119 Nathan v FCT (1918) 25 CLR 183 ......................................................................... 353, 355 National Australia Bank Ltd v FCT (1997) 37 ATR 378; 97 ATC 5153......................... 221 National Commercial Banking Corp of Australia Ltd; FCT v (1983) 15 ATR 21; 83 ATC 4715 ................................................................................................................ 91 Nchanga Consolidated Copper Mines Ltd; C of T v [1964] AC 948 ............................. 219 New Zealand Flax Investments Ltd v FCT (1938) 61 CLR 179 ............................ 262, 263 News Australia Holdings Pty Ltd; FCT v (2010) 79 ATR 461; 2010 ATC 20-191 ............................................................................................... 391, 392 Newton v FCT (1958) 98 CLR 1 ............................................................................ 381, 382 Norman v FCT (1963) 109 CLR 9 .......................................................................... 269, 270 442

© Thomson Reuters 2019

TABLE OF CASES

Northumberland Development Co Pty Ltd; FCT v (1995) 31 ATR 161; 95 ATC 4483 ...................................................................................................... 102, 103 O’Brien (Inspector of Taxes) v Benson’s Hosiery (Holdings) Ltd [1980] AC 562; [1979] 3 All ER 652; 53 TC 241 ................................................................................ 142 O’Reilly v Commissioner of the State Bank of Victoria (1982) 153 CLR 1; 13 ATR 706; 82 ATC 4671 ................................................................................. 399, 400 Odeon Associated Theatres Ltd v Jones (Inspector of Taxes) [1973] Ch 288 ................ 243 Olivier; Higgs (Inspector of Taxes) v [1952] Ch 311 ................................................. 36, 37 Orica Ltd; FCT v (1998) 194 CLR 500; 39 ATR 1147; 98 ATC 4494 ................... 127, 128 Partridge v Mallandaine (1886) 18 QBD 276 ................................................................... 64 Pastoral and Development Pty Ltd v FCT (1971) 124 CLR 453; 2 ATR 401; 71 ATC 4177 ...................................................................................................... 283, 284 Patcorp Investments Ltd & Ors v FCT (1976) 140 CLR 247; 6 ATR 420; 76 ATC 4225 .............................................................................................. 330, 331, 414 Payne v FCT (1996) 32 ATR 516; 96 ATC 4407 ........................................................ 34, 35 Payne; FCT v (2001) 202 CLR 93; 46 ATR 228; 2001 ATC 4027 ................................. 200 Peabody; FCT v (1994) 181 CLR 359; 28 ATR 344; 94 ATC 4663 ............... 385, 386, 387 Peter Dixon and Son Ltd; Lomax (Inspector of Taxes) v [1943] KB 671; [1943] 2 All ER 255; 25 TC 353 ........................................................................ 122, 124 Philip Morris Ltd v FCT (1979) 10 ATR 44; 79 ATC 4352 ............................................ 282 Phillips; C of T (Victoria) v (1936) 55 CLR 144 ........................................................ 30, 31 Phillips; FCT v (1978) 8 ATR 783; 78 ATC 4361 .................................................. 183, 184 Pintarich v DCT [2018] FCAFC 79; 2018 ATC 20-657 ................................................. 408 Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253; 95 ATC 4459 ...................................................................................... 159, 160, 162, 163 Point v FCT (1970) 119 CLR 453; 1 ATR 577; 70 ATC 4021................................ 247, 248 Poole v FCT; Dight v FCT (1970) 122 CLR 427; 1 ATR 715; 70 ATC 4047 ........ 294, 295 Pratt Holdings Pty Ltd & Anor v FCT (2004) 58 ATR 128; 2004 ATC 4526................. 403 Qantas Airways Ltd; FCT v [2012] HCA 41; 247 CLR 286; 83 ATR 1; 2012 ATC 20-352 ....................................................................................................... 425 Quarries Ltd v FCT (1961) 106 CLR 310 .............................................................. 244, 245 Radnor Pty Ltd; FCT v (1991) 22 ATR 344; 91 ATC 4689 ........................................ 62, 63 Raftland Pty Ltd v FCT [2008] HCA 21; 238 CLR 516; 68 ATR 170; 2008 ATC 20-029 ............................................................................................... 377, 378 Ramsay; Commissioners of Inland Revenue v [1935] All ER 847 ........................ 232, 233 Raymor (NSW) Pty Ltd; FCT v (1990) 21 ATR 458; 90 ATC 4461 ...................... 277, 278 Re Dymond (1959) 101 CLR 11 ......................................................................................... 8 Re Spanish Prospecting Co Ltd [1911] 1 Ch 92 ............................................................. 328 Rees Roturbo Development Syndicate, Ltd; Ducker (CIR) v [1928] AC 132............ 66, 67 Regent Oil Co Ltd; Strick (Inspector of Taxes) v [1966] AC 295 .......................... 220, 221 Reliance Carpet Co Pty Ltd; FCT v [2008] HCA 22; 236 CLR 342; 68 ATR 158; 2008 ATC 20-028.......................................................................... 425, 426 © Thomson Reuters 2019

443

AUSTRALIAN TAXATION LAW CASES 2019

Rennie Produce (Aust) Pty Ltd (in liq); DCT v [2018] FCAFC 38........................ 404, 405 Resch v FCT (1942) 66 CLR 198 ....................................................................................... 4 Reseck v FCT (1975) 133 CLR 45; 5 ATR 538; 75 ATC 4213 .................................. 40, 41 Reynolds; FCT v (1981) 11 ATR 629; 81 ATC 4131 ............................................. 415, 416 Rhodesia Railways, Ltd v Collector of Income Tax, Bechuanaland Protectorate [1933] AC 368 ............................................................................................................ 239 Riba Foods Pty Ltd v FCT (1990) 21 ATR 960; 90 ATC 4986....................................... 218 Rio Tinto Services v FCT [2015] FCAFC 117; 101 ATR 546; 2015 ATC 20-525 ......... 429 Robert Coldstream Partnership v FCT (1943) 68 CLR 391 ........................................... 290 Roberts; FCT v; Smith; FCT v (1992) 23 ATR 494; 92 ATC 4380 ........................ 292, 293 Rolls-Royce, Ltd v Jeffrey (Inspector of Taxes) [1962] 1 All ER 801 ....................... 72, 73 Ronpibon Tin No Liability v FCT (1949) 78 CLR 47 .................................................... 154 Rose v FCT (1951) 84 CLR 118 ............................................................................. 289, 290 Rotherwood Pty Ltd v FCT (1996) 32 ATR 276; 96 ATC 4203 ................................. 74, 75 Rowe; FCT v (1997) 187 CLR 266; 35 ATR 432; 97 ATC 4317 ............................... 93, 94 Roy Morgan Research Pty Ltd v FCT [2011] HCA 35; 244 CLR 97; 2011 ATC 20-282 ....................................................................................................... 2, 3 Royal Automobile Club of Victoria v FCT [1974] VR 651; 23 FLR 175; [also 73 ATC 4153, partial report]................................................................................ 18 Russell v FCT (2011) 79 ATR 315; 2011 ATC 20-240 ........................................... 361, 362 Ryan; FCT v (2000) 201 CLR 109; 43 ATR 694; 2000 ATC 4079................................. 405 Saga Holidays Ltd v FCT (2006) 64 ATR 602; 2006 ATC 4841 ............................ 430, 431 Sanctuary Lakes Pty Ltd v FCT [2013] FCAFC 50; 90 ATR 762; 2013 ATC 20-395 ... 275 Sara Lee Household & Body Care (Australia) Pty Ltd; FCT v (2000) 201 CLR 520; 44 ATR 370; 2000 ATC 4378 ......................................... 146, 147 Scoble; Secretary of State in Council of India v [1903] AC 299 ............ 130, 131, 132, 232 Scott v Commissioner of Taxation (NSW) (1935) 35 NSWSR 215 ..................... 12, 15, 16 Scott v FCT (1966) 117 CLR 514 .............................................................................. 24, 25 Scottish Australian Mining Co Ltd v FCT (1950) 81 CLR 188 ........................... 56, 57, 58 Sea Containers Services Ltd v Customs and Excise Commissioners [2000] STC 82 .................................................................................................... 427, 428 Secretary of State in Council of India v Scoble [1903] AC 299 ............. 130, 131, 132, 232 Secretary to the Department of Transport (Vic); FCT v (2010) 76 ATR 306; 2010 ATC 20-196 ....................................................................................................... 424 Selleck v FCT (1997) 36 ATR 558; 97 ATC 4856 ................................................ 76, 77, 78 Sharpcan Pty Ltd; FCT v [2018] FCAFC 163; 2018 ATC 20-670 ......................... 224, 225 Shaw v Director of Housing and State of Tasmania (No 2) (2001) 46 ATR 242; 2001 ATC 4054 .................................................................................................. 421, 422 Shepherd v FCT (1965) 113 CLR 385 ............................................................................ 270 Slater Holdings Ltd; FCT v (1984) 156 CLR 447; 15 ATR 1299; 84 ATC 4883 ...................................................................................................... 328, 329 Smith v FCT (1987) 164 CLR 513; 19 ATR 274; 87 ATC 4883 .................... 22, 25, 26, 28 Smith (Surveyor of Taxes); Tennant v [1892] AC 150 ................................... 22, 33, 42, 44 SNF (Australia) Pty Ltd; FCT v [2011] FCAFC 74; 82 ATR 680; 2011 ATC 20-265 ............................................................................................... 363, 364 444

© Thomson Reuters 2019

TABLE OF CASES

Snook v London and West Riding Investments Ltd [1967] 2 QB 786 ........................... 376 Snowden & Willson Pty Ltd; FCT v (1958) 99 CLR 431 .............................................. 174 Softwood Pulp and Paper Ltd v FCT (1976) 7 ATR 101; 76 ATC 4439 ........................ 156 South Australia & Anor v The Commonwealth (1942) 65 CLR 373 ................................. 9 South Australia v Commonwealth (1992) 174 CLR 235; 23 ATR 10; 92 ATC 4066 .............................................................................................................. 4, 5 South Australian Battery Makers Pty Ltd; FCT v (1978) 14 CLR 645; 8 ATR 879; 78 ATC 4412 ........................................................................... 184, 187, 188 Southern Estates Pty Ltd v FCT (1967) 117 CLR 481 ................................................... 180 Southern v Borax Consolidated Ltd [1941] 1 KB 111 ............................ 225, 226, 227, 228 Spanish Prospecting Co Ltd; Re [1911] 1 Ch 92 ............................................................ 328 Spassked Pty Ltd v FCT [2003] FCAFC 282; 54 ATR 546; 2003 ATC 5099 ........ 165, 166 Spotless Services & Anor; FCT v (1996) 186 CLR 404; 34 ATR 183; 96 ATC 5201 ...................................................................................................... 387, 388 Spriggs v FCT; Riddell v FCT [2009] HCA 22; 239 CLR 1; 72 ATR 148; 2009 ATC 20-109 ............................................................................................... 158, 159 St Hubert’s Island Pty Ltd (in liq); FCT v (1978) 138 CLR 210; 8 ATR 452; 78 ATC 4104 .............................................................................................................. 274 Stanton v FCT (1955) 92 CLR 630................................................................. 118, 119, 120 Stapleton v FCT (1989) 20 ATR 996; 89 ATC 4181 ....................................... 296, 297, 298 Star City Pty Ltd; FCT v (2009) 72 ATR 431; 2009 ATC 20-093 .......................... 222, 223 Steele v DFCT (1999) 197 CLR 459; 41 ATR 139, 99 ATC 4242 ......................... 157, 163 Steinberg v FCT (1975) 134 CLR 640; 5 ATR 565; 75 ATC 4221 ............................. 86, 87 Stevenson; Commissioner of Taxation (NSW) v (1937) 59 CLR 80 ............................. 335 Stone; FCT v [2005] HCA 21; 222 CLR 289; 59 ATR 50; 2005 ATC 4234 .............. 55, 56 Strick (Inspector of Taxes) v Regent Oil Co Ltd [1966] AC 295 ........................... 220, 221 Strong & Co, Ltd v Woodifield (Surveyor of Taxes) [1905] 2 KB 350.................. 171, 172 Studdert; FCT v (1991) 22 ATR 762; 91 ATC 5006 ............................................... 205, 207 Studebaker Corporation of Australasia v C of T (NSW) (1921) 29 CLR 225 ........ 353, 354 Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337 .................................... 216, 217, 218, 219, 220, 222, 225, 226, 228 Suttons Motors (Chullora) Wholesale Pty Ltd; FCT v (1985) 157 CLR 277; 16 ATR 567; 85 ATC 4398 ................................................................................. 279, 280 Sweetman v Commissioner of IR (Fiji) (1996) 34 ATR 209; 96 ATC 5107........... 178, 179 Swinford v FCT (1984) 15 ATR 1154 (Federal Court) ................................................... 210 Sydney Refractive Surgery Centre Pty Ltd v FCT (2008) 73 ATR 28; 2008 ATC 20-081 ............................................................................................... 103, 104 Sydney Water Board Employees’ Credit Union Ltd v FCT (1973) 129 CLR 446; 4 ATR 157; 73 ATC 4129 ............................................................................................. 17 Tasman Group Services Pty Ltd; FCT v (2009) 74 ATR 739; 2009 ATC 20-138 ............................................................................................... 125, 126 Taylor v FCT (1970) 119 CLR 444; 1 ATR 582; 70 ATC 4026 ...................... 304, 305, 306 Tech Mahindra v FCT [2016] FCAFC 130; 103 ATR 813 ............................................. 371 Tennant v Smith (Surveyor of Taxes) [1892] AC 150 .................................... 22, 33, 42, 44 Thiel v FCT (1990) 171 CLR 338; 21 ATR 530; 90 ATC 4717 ..................................... 368 © Thomson Reuters 2019

445

AUSTRALIAN TAXATION LAW CASES 2019

Thomas v FCT (1972) 3 ATR 165; 72 ATC 4094 ................................................... 180, 181 Thomas; FCT v [2018] HCA 31 ............................................................................. 316, 317 Tikva Investments Pty Ltd v FCT (1972) 128 CLR 158 ........................................ 291, 292 TNT Skypak International (Aust) Pty Ltd v FCT (1988) 19 ATR 1067; 88 ATC 4279 .......................................................................................................... 92, 93 Total Holdings (Aust) Pty Ltd; FCT v (1979) 9 ATR 885; 79 ATC 4279 ............... 164, 165 Totledge Pty Ltd; FCT v (1982) 12 ATR 830; 82 ATC 4168 .................................. 315, 316 Trautwein v FCT (1936) 56 CLR 196 ........................................................................ 52, 53 Travelex Ltd v FCT [2010] HCA 33; 241 CLR 510; 76 ATR 329; 2010 ATC 20-214 ............................................................................................... 432, 433 Trent Investments Pty Ltd v FCT (1976) 6 ATR 201; 76 ATC 4105 .......................... 60, 61 Truesdale v FCT (1970) 120 CLR 353; 1 ATR 667; 70 ATC 4056 ................................ 309 Tucker v CIR [1965] NZLR 1027................................................................................... 309 United Aircraft Corp; FCT v (1943) 68 CLR 525 .......................................................... 354 Unit Construction Co Ltd v Bullock (Inspector of Taxes) [1960] AC 351 ............. 345, 346 Unit Trend Services Pty Ltd; FCT v [2013] HCA 16; 250 CLR 523; 87 ATR 13; 2013 ATC 20-389 ............................................................................................... 433, 434 Ure v FCT (1981) 11 ATR 484; 81 ATC 4100 ........................................................ 188, 189 Uther; FCT v (1965) 112 CLR 630 ................................................................................. 329 Vallambrosa Rubber Company Limited v Farmer (Surveyor of Taxes) [1910] SC 519; 5 TC 529 ................................................................................... 216, 217 Van den Berghs, Ltd v Clark (Inspector of Taxes) [1935] AC 431 ......... 105, 106, 107, 108 Vestey v Inland Revenue Commissioners [1962] Ch 861 ...................... 130, 134, 135, 232 Victoria v Commonwealth; New South Wales v Commonwealth (1957) 99 CLR 575 ........................................................................................................ 9 Vincent v FCT (2002) 51 ATR 228; 2002 ATC 4742 ..................................... 182, 384, 385 Virgin Holdings SA v FCT (2008) 70 ATR 478; 2008 ATC 20-051 ....................... 368, 369 W Nevill & Co Ltd v FCT (1937) 56 CLR 290 .............................................................. 155 W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58 ............................................. 239, 242 Wade; FCT v (1951) 84 CLR 105 ........................................................................... 282, 283 Wainwright; Calvert (Inspector of Taxes) v [1947] 1 All ER 282; 27 TC 475 ................. 32 Walker; FCT v (1985) 16 ATR 331; 85 ATC 4179 ................................................. 181, 182 Walstern Pty Ltd v FCT (2003) 54 ATR 423; 2003 ATC 5076 ............................... 416, 417 Wangaratta Woollen Mills Ltd v FCT (1969) 119 CLR 1; 1 ATR 329; 69 ATC 4095 .............................................................................................................. 244 Ward; Commissioner of Inland Revenue v [1970] NZLR 1 ................................... 306, 307 Warner Music Australia Pty Ltd v FCT (1996) 34 ATR 171; 96 ATC 5046 ............... 93, 94 Wattie & Anor; Commissioner of Inland Revenue (New Zealand) v [1998] UKPC 43; (1999) 1 WLR 873 .............................................................. 78, 79, 80 WE Fuller Pty Ltd; FCT v (1959) 101 CLR 403 ............................................................ 250 Wells; FCT v (1971) 2 ATR 552; 71 ATC 4188 .............................................................. 168 Western Suburbs Cinemas Ltd; FCT v (1952) 86 CLR 102 ........................... 239, 240, 241 446

© Thomson Reuters 2019

TABLE OF CASES

Westfield Ltd v FCT (1991) 21 ATR 1398; 91 ATC 4234 .......................................... 68, 69 Westmoreland Investments Ltd; MacNiven (Inspector of Taxes) v [2001] 1 All ER 865 ................................................................................... 379, 380, 381 Whitfords Beach Pty Ltd; FCT v (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031 .......................................................................................................... 57, 58 Whitfords Beach Pty Ltd v FCT (1983) 14 ATR 247; 83 ATC 4277 ................................ 58 Whiting; FCT v (1943) 68 CLR 199............................................................... 303, 304, 305 Wilkinson; FCT v (1983) 14 ATR 218; 83 ATC 4295 ............................................ 204, 205 Woite; FCT v (1982) 13 ATR 579; 82 ATC 4578 ............................................................. 37 Word Investments Ltd; FCT v [2008] HCA 55; 236 CLR 204; 70 ATR 225; 2008 ATC 20-072 ....................................................................................... 320, 321, 322 WR Carpenter Holdings Pty Ltd v FCT (2008) 237 CLR 198; 69 ATR 29; 2008 ATC 20-040 ............................................................................................... 362, 363 WT Ramsay Ltd v Inland Revenue Commissioners [1982] AC 300 .............................. 380 Yeung and Anor v FCT (1988) 19 ATR 1006; 88 ATC 4193 .................................. 287, 288 Zeta Force Pty Ltd v FCT (1998) 39 ATR 277; 98 ATC 4681 ........................................ 310 Zobory v FCT (1995) 30 ATR 412; 95 ATC 4251 .................................................. 307, 308

© Thomson Reuters 2019

447

Table of Statutes The Constitution 51(ii)................................................. 2, 6, 7 55.............................................. 3, 4, 5, 7, 8 99.............................................................. 6 114 ........................................................ 4, 5 A New Tax System (Goods and Services Tax) Act 1999 (Cth) (in this book, “GST Act”) Divisions 38.......................................................... 420 40.......................................................... 420 75.......................................................... 433 165........................................................ 434 Sections

38-190(1).............................................. 432 38-190(2).............................................. 432 38-190(2A)……………………………431 38-325 .................................................. 433 40-35………………………………….429 48-40 .................................................... 433 96-5(4).................................................. 430 99-5 .............................................. 425, 426 165-5 .................................................... 433 165-5(1)(b) ........................................... 434 195-1 (“real property”) ........................ 431 Acts Interpretation Act 1901 (Cth) 15AA ............................................ 309, 379 15AB .................................................... 148

9-5 ........................................ 420, 421, 423 9-10 ...................................................... 421 9-10(2)(d) ............................................ 423 9-10(2)(g) ............................................ 423 9-15 ..................................................... 424 9-17 ..................................................... 424

Australian Charities and Not-for-profits Commission Act 2012 (Cth)

9-25(1).................................................. 432 9-25(4).................................................. 432 9-25(5).................................................. 432 9-25(5)(c) ............................................. 431 9-30(3)(a) ............................................. 432 11-15 .................................................... 429 13-5 ...................................................... 420 29-10(3)................................................ 423 29-70(1) ............................................... 423 38-190 .......................................... 431, 433

5............................................ 320, 321, 322 11 .......................................................... 323 12.......................................... 320, 322, 323 12(1)(d) ................................................ 321

© Thomson Reuters 2019

...................................................... 320, 321 25-5(3).................................................. 321 25-5(5).................................................. 321 Charities Act 2013 (Cth)

Coal Acquisition Act 1981 (NSW) ...............................................................102

449

AUSTRALIAN TAXATION LAW CASES 2019

Competition and Consumer Act 2010 (Cth) .............................................................. 106 Conveyancing Act 1919 (NSW) 54A....................................................... 145 Corporations Act 2001 (Cth) .............................................................. 404 Crimes Act 1914 (Cth) .............................................................. 416 Crimes (Taxation Offences) Act 1980 (Cth) .............................................................. 416 Criminal Code Act 1995 (Cth) .............................................................. 416

58B ....................................................... 201 66............................................................ 43 136(1) (“arrangement”) .......................... 33 136(1) (“employee”) ............................ 175 136(1) (“employer”)............................... 28 136(1) (“fringe benefit”) ........... 16, 22, 24, ...................... 25, 26, 28, 31, 32, 35, 40, 43 .................................. 44, 45, 175, 407, 416 136(1) (“housing fringe benefit”) .......... 43 148.......................................................... 22 Income Tax Act 1928 (Vic.) ................................................................ 30 Income Tax Assessment Act 1915 (Cth) (in this book, “ITAA 1915”) .................................................................. 3 Income Tax Assessment Act 1922 (Cth) (in this book, “ITAA 1922”)

.............................................................. 423

4(d) ....................................................... 132 23.......................................................... 263 23(a)(1) ................................................ 262

Fringe Benefits Tax Assessment Act 1986 (Cth) (in this book, “FBTAA”)

Income Tax Assessment Act 1936 (Cth) (in this book, “ITAA 1936”)

.... 21, 22, 28, 41, 42, 43, 44, 199, 200, 407

Divisions and Parts

Divisions

Div 6............................................. 308, 393 Div 6AA ....................... 306, 308, 309, 314 Div 6AAA ............................................ 358 Div 6C .................................................. 313 Div 7............................................. 338, 339 Div 7A.......................................... 336, 340 Div 13................................................... 364 Div 16E ....................... 122, 133, 135, 136, .............................. 137, 193, 232, 234, 264 Div 245 in Sch 2C ................ 124, 125, 126 Part IIIA ................................. 98, 140, 141 Part IVA......... 15, 147, 182, 183, 186, 188, .......... 191, 192, 277, 376, 379, 381, 382, ..................... 383, 384, 385, 386, 387, 388, ..................... 389, 390, 391, 392, 393, 394, ..................... 395, 396, 407, 408, 417, 433 Part X ................................................... 186

Environmental Planning and Assessment Act 1979 (NSW)

2 to 11................................................... 175 Sections 5B ........................................................... 43 5C ........................................................... 43 5E ........................................................... 43 20.......................................................... 175 23.......................................................... 175 24.......................................................... 175 25............................................................ 43 26............................................................ 43 40............................................................ 23 45.................................................... 26, 175 47(2) ..................................................... 202 50.......................................................... 175 52.......................................................... 175 450

© Thomson Reuters 2019

TABLE OF STATUTES

Sections ...................................................... 6 ........... 250, 274, 326, 327, 345, 349, 370 6(1) ......... 13, 121, 287, 329, 333, 355, 405 6BA(3)(b)............................................... 13 6C ......................................................... 355 6D......................................................... 337 6H........................................................... 17 19.................................................... 15, 295 21A....................................... 42, 51, 77, 78 21A(3) .............................................. 77, 78 21A(4) .................................................... 51 23(n) ............................................. 347, 348 23(q) ..................... 154, 355, 357, 387, 388 23AH ............................................ 154, 348 23AJ ..................................................... 365 23G(2) .................................................... 17 23L ............................................. 24, 26, 45 25............................................................ 58 25(1) ............ 22, 25, 26, 27, 28, 34, 35, 40, ................ 51, 75, 81, 88, 89, 91, 96, 97, 98 ............................. 117, 128, 169, 315, 415 25A....................... 60, 65, 75, 84, 128, 292 26(a) ............ 56, 57, 58, 59, 60, 61, 65, 67, .............................. 84, 85, 86, 88, 291, 292 26(d) ................................................. 38, 40 26(e) ...... 21, 22, 23, 24, 25, 26, 27, 28, 29 ...................... 34, 35, 39, 41, 42, 43, 51, 73 26(f).............................................. 117, 118 26(g) ................................................. 97, 98 26(j) ........ 89, 91, 92, 95, 96, 169, 282, 283 26AAA ......... 368, 385, 386, 387, 415, 416 26BB ............................................ 122, 156 27H......................... 31, 132, 137, 138, 193 27H(1)(b) ......................................... 29, 30 27H(4) .................................................. 137 28.......................................................... 279 31.......................................................... 281 36.......................... 274, 275, 283, 284, 289 36A....................................................... 290 44.................................................. 250, 333 44(1) ............ 121, 327, 328, 329, 330, 331, .............................. 333, 335, 336, 359, 360 44(1)(b)(i) ............................................ 353 44(2) ..................................................... 250 © Thomson Reuters 2019

46.......................... 166, 330, 331, 413, 414 47...................................................... 4, 336 47(1) ....... 87, 331, 332, 333, 334, 335, 336 47(1A) .................... 87, 332, 333, 334, 335 47(2A) .................................................. 336 51(1) .... 154, 156, 157, 160, 161, 162, 163, ............ 164, 167, 168, 173, 175, 183, 184, ............ 185, 186, 187, 188, 189, 190, 191, ............. 192, 193, 228, 233, 276, 277, 287, .............................................. 389, 416, 417 51(3) ..................................................... 167 53.......................................................... 240 54.................................................. 244, 245 57AF. .................................................... 129 59.......................................................... 289 59AA .................................................... 290 63.......................................... 160, 247, 248 64A....................................................... 158 70B ....................................................... 156 72............................................................ 89 73A....................................................... 389 78(1) ..................................................... 214 78(11) ................................................... 416 79D............................................... 394, 395 80.......................................................... 250 82A....................................................... 203 82AAE ................................................. 416 82D....................................................... 280 82KJ ..................................................... 187 82KZM................................. 190, 222, 385 82KZME .............................................. 390 91.................................................. 291, 294 92.......................... 287, 291, 292, 294, 295 94.................................................. 290, 291 94(9) ..................................................... 291 94J ........................................................ 326 95(1) ..................................... 310, 311, 315 95A(2) .................................. 303, 305, 307 97.......... 302, 303, 306, 309, 310, 311, 312 97(1) ..................... 307, 310, 311, 312, 315 97(2) ..................................................... 307 98.......................................... 305, 306, 314 98(1) ..................................................... 305 98(2) ............................................. 303, 307 99.................. 302, 304, 305, 310, 315, 358 451

AUSTRALIAN TAXATION LAW CASES 2019

99A.............. 302, 305, 306, 307, 310, 311, .............................................. 312, 315, 377 100.........................................................306 100A..................................................... 377 101........................................................ 307 101A..................................................... 253 102(1)(b) ...................... 304, 305, 308, 309 102AAT ................................................ 358 102AAU ............................................... 358 102AAZD ............................................ 358 102B ..................................... 269, 270, 271 102CA .................................................... 70 103A..................................................... 340 103A(2)(b) ........................................... 340 108........................................................ 336 109F ..................................................... 336 117 ................................................ 340, 341 117(1) ................................................... 341 117(1)(d) ...................................... 340, 341 128B ..................................... 354, 359, 360 128B(2B).............................................. 355 128D..................................................... 355 136AD ......................................... 362, 363 136AD(1) ............................................ 363 159GP(1) ...................................... 133, 232 159GP(10) .................................... 137, 193 159GX .................................................. 135 159GZZZP ................................... 336, 337 160A..................................................... 128 160L ............................................. 144, 145 160M .................................................... 147 160M(3)(b)........................................... 128 160M(6) ................. 73, 119, 141, 148, 149 160M(7) ........... 73, 74, 119, 141, 148, 149 160MA ......................................... 148, 149 160U..................................................... 146 160U(3) ................................ 144, 145, 146 160ZH(9)...................................... 144, 145 160ZH(9)(c) ......................................... 143 160ZI .................................................... 120 160ZS ................................................... 147 160ZZC(12) ................................. 148, 149 160ZZR ................................................ 149 166........................................................ 405 167........................................................ 406 452

170........................................ 384, 385, 405 170(1) ................................................... 406 170(2) ................................................... 406 177 (see also s 350-10 in Sch 1, TAA 1953)....................... 412, 413, 414 177A..................................... 191, 386, 433 177A(5) ........................................ 383, 385 177C ..................................... 191, 383, 384 177CB .................................................. 383 177D............................. 382, 383, 389, 395 177D(b) ................................................ 390 177E ..................................... 382, 394, 395 177EA .................................................. 396 177F ..................................................... 383 177G..................................................... 384 218................................................ 412, 413 221YL .................................................. 370 221YRA(1A)........................................ 370 222C ..................................................... 416 226K..................................................... 416 255........................................................ 411 255(1) ................................................... 411 255(2) ................................................... 411 260.......... 80, 276, 331, 376, 381, 382, 383 262........................................................ 104 263 (see also s 353-15 in Sch 1, TAA 1953) ....... 399, 400, 401, 402, 409, 410 264 (see also s 353-10 in Sch 1, TAA 1953)....... 399, 400, 404, 409, 410 271A......................................................... 5 432........................................................ 186 Income Tax Assessment Act 1997 (Cth) (in this book, “ITAA 1997”) Divisions and Subdivisions Subdiv 20-A ..................... 92, 95, 282, 283 Div 30................................................... 214 Div 34................................................... 210 Div 35................... 157, 179, 180, 181, 182 Div 40...........77, 78, 80, 95, 110, 111, 112, .............................................. 143, 244, 245 Div 43................... 241, 242, 244, 245, 246 Div 50................................................... 321 Div 70............................................. 59, 275 Div 83A............................................ 43, 44 © Thomson Reuters 2019

TABLE OF STATUTES

Div 104................................................. 140 Subdiv 115-C ............................... 302, 312 Div 118 ................................................. 140 Div 152......................... 105, 149, 150, 296 Subdiv 165-A ....................................... 339 Div 167.................................................338 Div 207................................................. 316 Subdiv 207-B ....................................... 317 Subdiv 207-F........................................ 394 Div 230... 68, 122, 123, 124, 132, 135, 136 ..................... 138, 234, 264, 265, 266, 267 Div 242......................................... 128, 129 Div 243................................................. 246 Div 245........................... 94, 124, 125, 126 Div 247................................................. 194 Div 328................................................. 262 Div 415................................................. 338 Divs 700-721........................................ 166 Div 768-R................................................40 Div 775..................................... 82, 83, 266 Div 815......... 184, 185, 191, 362, 363, 364 Div 974................................................. 326 Sections 4-15 ...................................................... 153 6-5 ....... 38, 51, 57, 65, 68, 72, 95, 96, 122, ............................. 260, 261, 292, 297, 360 6-5(1)..... 22, 25, 26, 27, 28, 29, 30, 32, 34, ......... 35, 36, 37, 40, 41, 42, 43, 58, 66, 70, ............. 71, 75, 81, 88, 89, 91, 96, 97, 104, ............ 106, 107, 118, 121, 128, 169, 283 .............. 327, 355, 360, 381, 388, 415, 416 6-5(2).................................................... 359 6-5(3).................................................... 359 6-5(4)........................................ 14, 15, 295 6-10 ........................................................ 33 6-10(4).................................................. 359 6-10(5).................................................. 359 6-20 ...................................................... 249 6-25 ........................................................ 30 8-1 ...... 132, 154, 155, 156, 158, 159, 160, ............ 161, 162, 163, 164, 167, 168, 169, ............. 170, 171, 172, 175, 177, 183, 188, ............. 190, 191, 197, 202, 203, 211, 220, ..................... 224, 228, 230, 233, 238, 247, ............. 262, 263, 274, 277, 278, 279, 280, ..................... 281, 381, 384, 385, 389, 390 © Thomson Reuters 2019

8-1(1)........... 153, 154, 156, 157, 164, 167, ..................... 170, 173, 182, 184, 185, 186, .................... 187, 189, 193, 197, 199, 202, .............................................. 249, 276, 416 8-1(1)(a) ............................................... 206 8-1(1)(b) ............................... 172, 174, 175 8-1(2).................................................... 153 8-1(2)(a) ............................................... 153 8-1(2)(b) ............................... 153, 170, 197 8-1(2)(c) ............................................... 153 15-2 ............. 21, 22, 24, 25, 26, 27, 28, 29 ............................ 33, 34, 35, 39, 40, 41, 42 15-2(3)(d) ......................................... 24, 26 15-10 .................................... 95, 97, 98, 99 15-15 ..... 56, 57, 58, 59, 60, 65, 73, 75, 84, .................... 85, 86, 88, 104, 126, 128, 292 15-15(1).................................................. 66 15-20 ............................................ 117, 118 15-30 .................................................... 169 15-50 ............................................ 296, 297 20-20 .................................... 89, 92, 95, 96 20-20(3)............................................ 91, 94 20-30 .................................... 90, 91, 94, 95 25-10 ............................................ 238, 240 25-35 .................................... 160, 247, 248 25-35(1)(a) ................................... 247, 249 25-35(1)(b) ................................... 247, 249 25-45 ............................................ 169, 170 25-50 ............................................ 155, 416 25-95 ............................................ 296, 298 25-100 .................................................. 200 26-5 .............................................. 173, 177 26-10 ............................................ 167, 268 26-10(1)................................................ 167 26-10(2)................................................ 167 26-19 .................................................... 206 26-31 .................................................... 197 26-54 ............................................ 176, 177 30-15 .................................................... 214 30-25(1)................................................ 214 32-5 ........................................................ 51 32-10 ...................................................... 51 35-10 .................................................... 157 35-10(4)................................................ 180 35-40 ............................................ 157, 180 36-10 .................................................... 249 453

AUSTRALIAN TAXATION LAW CASES 2019

36-15 .................................... 249, 277, 337 36-15(3)................................................ 249 36-17 ............................................ 249, 337 36-17(3)................................................ 249 36-20 .................................................... 249 40-25 .................................... 239, 240, 241 40-30 .................................................... 244 40-30(3)................................................ 245 40-40 item 1 ......................................... 130 40-40 item 2 ..................................... 77, 78 40-40 item 3 ............................... 77, 78, 80 40-45 .................................................... 244 40-190 .................................. 239, 240, 241 40-230 .......................................... 129, 130 40-285 ...................109, 110, 111, 112, 143 40-295 ...........................................111, 112 40-295(2).............................................. 290 40-340(3).............................................. 290 40-880 .......................... 156, 167, 224, 225 40-880(2).............................. 227, 229, 230 43-15 ............................................ 240, 242 43-20 ............................................ 240, 242 43-70 ............................................ 240, 242 43-70(2)(e) ........................................... 244 43-210 .......................................... 240, 242 50-1 .............................................. 320, 321 50-5 ...................................................... 320 50-5(1).................................................. 321 50-25 ........................................................ 6 50-47 .................................................... 321 50-50 ............................................ 320, 322 59-40 .................................................... 121 70-10 .................................... 274, 275, 283 70-15 .................................................... 278 70-20 ............................................ 277, 284 70-30 ........................................ 57, 58, 278 70-35 ............................ 274, 279, 280, 281 70-45 .................................................... 281 70-90 ............................ 274, 275, 283, 284 70-95 .................................................... 284 70-100(1).............................................. 290 70-100(4).............................................. 290 70-115 .......................................... 282, 283 70-120 .................................................. 120 82-10 ...................................................... 41 454

82-10(2).................................................. 31 82-10(3)............................................ 31, 41 82-130 .................................................... 41 82-130(1)................................................ 31 82-130(2)................................................ 31 82-140 .................................................... 41 102-5 .................................................... 315 102-15 .................................................. 218 104-10 ............... 66, 69, 72, 119, 120, 131, .............................................. 271, 292, 296 104-10(1).......................................... 61, 63 104-10(2).............................................. 102 104-10(3).............................................. 146 104-10(5)...................................... 144, 145 104-10(6)...................................... 102, 103 104-25 ....... 16, 32, 75, 87, 90, 93, 96, 100, ............. 101, 105, 106, 107, 108, 109, 142, .............. 147, 218, 219, 221, 222, 223, 224 104-25(1).................... 97, 98, 99, 128, 257 104-25(2)(b) ..................................... 91, 94 104-35 ......... 37, 70, 72, 73, 74, 77, 81, 82, .......................... 97, 98, 119, 141, 142, 148 104-35(1)................................................ 91 104-35(3).......................................... 37, 72 104-35(5).............................................. 149 104-110 ........................................ 147, 148 104-115 ................................................ 148 104-125 .................................................. 75 104-150 ........................................ 148, 149 104-155 ...... 73, 78, 80, 100, 101, 119, 148 104-155(5)............................................ 149 104-220 .................................................. 59 104-250 ................................................ 387 105-25(6)...................... 226, 227, 229, 230 106-5 ............................................ 292, 296 108-5 ........................ 91, 94, 120, 128, 142 108-5(2)(c) ................................... 291, 296 108-5(2)(d) ........................................... 296 109-5 .................................................... 147 109-5(2)........................................ 144, 145 110-25 .................................................. 134 110-25(2) ...................................... 234, 257 110-25(2)(a) ................................. 232, 234 110-25(2)(b) ..................................... 71, 87 110-25(5) ...................................... 241, 242 © Thomson Reuters 2019

TABLE OF STATUTES

110-25(6) ...................................... 225, 228 110-35 .................................................... 92 110-35(3) .............................................. 167 110-45(2) .......................................... 90, 95 112-20 .................................. 143, 144, 145 112-25 ............................................ 60, 119 112-25(1)-(3) .......................................... 85 112-25(4) ................................................ 85 112-30 .................................................. 120 112-36 .......................................... 233, 235 115-10 .............. 61, 63, 69, 82, 90, 96, 105 115-10(c) ................................................ 63 115-20 .................................................. 107 115-25(1) ........................................ 85, 101 115-25(3) ............... 37, 77, 82, 90, 96, 101, ...................................................... 105, 387 115-25(3)(e) ......................................... 148 115-100(a)(ii) ......................................... 63 115-215(3)(b) ....................................... 315 115-215(6) ............................................ 315 116-20(1) .............................................. 257 116-20(1)(a) .. 102, 131, 132, 134, 135, 136 116-20(1)(b) ........................... 66, 134, 136 116-20(2) .............................................. 148 116-30 .................................. 147, 270, 292 116-30(2) .............................................. 271 116-120 ...................................... 134, 136 118-20 ............... 59, 61, 70, 71, 75, 80, 81, ................. 87, 88, 102, 108, 109, 120, 133, .............................. 135, 140, 257, 271, 296 118-20(1A) ........................................... 132 118-25 .................................................... 59 118-37(1)(c) ..................................... 53, 54 118-120 .................................................. 60 118-190 ................................................ 210 118-300 ................................................ 168 128-15 .................................................... 85 136-15 .................................................... 37 152-40 .................................................. 150 152-105 ................................................ 150 152-205 ................................................ 150 160-10 .................................................. 338 165-10 .......................................... 338, 381 165-12 .................................................. 338 165-13 .......................................... 338, 381 © Thomson Reuters 2019

170-10…………………………………277 200-35 .......................................... 330, 331 207-20(1).............................................. 250 207-20(2).............................................. 331 230-20(4)................................................ 68 243-20 .................................................. 246 245-35 .................................................. 125 245-55 .......................................... 125, 126 254(1)(d) ...................................... 411, 412 290-10 .................................................... 40 305-70 .................................................... 40 725-245 ................................................ 387 770-10 .......................... 351, 352, 355, 388 770-10(3).............................................. 357 815-20 .................................................. 364 815-115 ................................ 185, 362, 363 815-120 ................................................ 185 815-135 ................................................ 363 974-20 .................................................. 327 975-300 ................................................ 337 995-1 (“ACNC type of entity”)............ 321 995-1 (“Partnership”) ................... 286, 287 995-1 (“Recreation”) .............................. 51 995-1 (“Registered charity”) ................ 321 Income Tax (Management) Act 1928 (NSW) 11(b) ..................................................... 335 Income Tax Rates Act 1986 (Cth) .............................................. 302, 308, 309 12(7) ..................................................... 291 13(3) ............................................. 306, 314 Schedule 10 .......................................... 304 Part 1 of Schedule 12 ................... 306, 314 International Organisations (Privileges and Immunities) Act 1963 (Cth) 6(1)(d)(i) .............................................. 367 International Tax Agreements Act 1953 (Cth) ...................................................... 372, 373 3A................................................. 372, 373 455

AUSTRALIAN TAXATION LAW CASES 2019

Judiciary Act 1903 (Cth) ...................................... 407, 413, 414, 415 39B ....................................................... 414 Tax Treaties Australia ....................... 361, 362, 365, 372 Australia, Article 7 ...... 365, 367, 368, 369, ...................................................... 371, 372 Australia, Article 9 ............................... 362 Australia, Arts 10, 11, 12 ..................... 366 Australia, Article 12 ............................. 371 Australia, Article 13 ............. 368, 369, 372 Australia, “business profits” ................ 368 Australia-India, Arts 7, 12 .................... 371 Australia-New Zealand ................ 355, 362 Australia-New Zealand, Article 15 ...... 355 Australia-Singapore ............................. 370 Australia-Singapore, “permanent establishment” .................................. 370 Convention on the Privileges and Immunities of the [United Nations] Specialized Agencies ....................... 366 Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (OECD) ............. 366 Netherlands-Australia .................. 372, 373 OECD Transfer Pricing Guidelines ...................................................... 363, 364 Switzerland-Australia, “business profits” ..................................... 368, 369 US-Australia, Arts 14, 15 ..................... 356

456

Vienna Convention on Diplomatic Relations .......................................... 357 Vienna Convention on the Law of Treaties, Article 31............... 366, 371 Taxation Administration Act 1953 (Cth) (in this book, “TAA 1953”) ...................................... 7, 8, 399, 407, 412 Part IVC ............................................... 407 Div 12-F in Sch 1 ................................. 370 Divs 284, 286 and 288 in Sch 1 ........... 416 11-5 in Sch 1………………………….360 12-210 in Sch 1 ............................ 359, 360 12-245 in Sch 1 ............................ 359, 360 12-280 in Sch 1 .................................... 359 14ZZK .................................................. 406 14ZZO .................................................. 406 16-75 in Sch 1 ...................................... 359 284-15 in Sch 1 .................................... 416 284-75 in Sch 1 .................................... 416 284-145 in Sch 1 .................................. 383 350-10 in Sch 1 .................... 412, 413, 414 353-10 in Sch 1 .... 399, 400, 404, 409, 410 353-15 in Sch 1 ........... 399, 400, 401, 402, ...................................................... 409, 410 357-60(1) in Sch 1 ............................... 367 357-105 in Sch 1 .................................. 418 357-105(1) in Sch 1 ............................. 417 357-110(1)(a) in Sch 1 ........................ 417

© Thomson Reuters 2019

Index Access to information books, 408–410 information, 408–410 legal professional privilege, 398 client identification, 403–404 documents obtained for another purpose, 404–405 dominant purpose test, 402 opportunity to claim, 400–402 outside courtroom, 399–400 sole purpose test, 402 third parties, 403 Accounting see also Accrual accounting; Cash accounting concession fees, 266–267 depreciation, 243 leased luxury cars, 129 rental equipment, 110, 111 finance leases, 128 luxury cars, 129–130 interest expenses, 263–268 compound interest, 263–264 deferred interest, 263–264 discounts in lieu, 265–267 future outlays, 262, 263 leave entitlements, 268 rental equipment, 110, 111 trust income, 307 proportionate approach, 310–313 Accrual accounting see also Cash accounting appropriate method, 253–255 medical partnerships, 254–255 sole legal practitioners, 254 changing method, 255 adjustments, 256 change in business structure, 257 expense recognition, 262 © Thomson Reuters 2019

future outlays, 262, 263 incurred, meaning, 262–263 income recognition, 258–259 overview, 253 pre-billing services, 259 prepayments, 258 sale price disputes, 260–261 trading stock sales, 260 instalments, by, 206 settlement, subject to, 261 Additional tax constitutional validity, 7–8 minimum, 8 Amendment of assessments period of amendment, 385, 405 nil assessments, 405–406 Annual leave accrued entitlements, 92, 166–168, 268 Annuities assessable income, 29 blended loans, as, 136–138, 192, 193 capital or revenue, 230–231 financial arrangements, 136–138 fixed term annuities, 136 qualifying annuities, 137 sale by instalment, 130, 131–133 timing mismatches, 192–193 Appeals basis for assessment on, 415–416 exclusive code, 412, 413, 414 ITAA and Tax Administration Act, outside, 412–415 Assessable income annuities, 29 assignment of income, 67, 70–71 457

AUSTRALIAN TAXATION LAW CASES 2019

bonus shares, 12–13, 246 building societies, 99–100 compensation payments, 30–32 loss of income, 89, 90 debt cancellation, 124 debt instruments, 122 discount and interest, 122–123 debt repurchase, 126 derivation, 173 dividends see Dividends employee share benefits, 43–45 employment termination payments, 28, 39–41 foreign exchange gains, 82–83 foreign residents, 353–357 government subsidies, 97–99 illegal businesses, 177 income from personal services, 21 information or knowledge, 35–36 study completion payments, 25–26 insurance or indemnity, 91, 92, 94–95 loss of income, 169, 170 loss of trading stock, 282–283 liquidators’ distributions, 4 money’s worth of benefit, 26–27 natural resources, 117, 118 non-cash benefits, 41 non-residents, 351 profit-making by sale, 83–84 profit-making schemes, 65–66 individuals, 83–87 land development, 57–60 subdivision of land, 56–60 reimbursed deductible outgoings, 89 credit card fees, 91 insurance or indemnity, 91, 92, 94–96 legal expenses, 94 refunded royalties, 90–91 reversal of recognised expense, 93 settlement payments, 89–90, 94–96 revenue assets, 87–89 royalties, 117–118 settlement payments, 89–90, 93–95 shareholders bonus shares, 12–13 deemed dividends, 331–337 dividends, 330–331 sportspersons, 55–56 statutory income, 50 458

study completion payments, 25–26 superannuation benefits, 38–41 superannuation contributions, 38–39 termination payments, 28, 38, 41 use of property, 3–4 youth allowance, 205–206 Assessable recoupments see also Reimbursed deductible outgoings credit card fees, 91 insurance or indemnity, 91, 92, 93–95 loss of trading stock, 282–283 legal expenses, 94 overview, 90 refunded royalties, 90–91 settlement payments, 89–90 Assessments amendment, 385, 405 nil assessments, 405–406 appeals against see Appeals asset betterment assessments, 406 Commissioner decisions, 408 default assessments see Default assessments diverted income, 14 double counting assessments, 407–408 nil assessments, 405–406 second assessments, 407 Assets see Capital gains tax; Profitmaking by sale; Revenue assets; Trading stock Assignment of income capital gains tax, 70–71, 269–272 compensation receipts doctrine, 67 dividends, 269 non-residents, 410 mere expectancy, 269, 270 overview, 268–269 partnership interests, 271–272, 298–299 property interest, presently existing, 269–271 royalties, 70, 71, 270–271 Associations see Clubs and associations Athletes see Sportspersons

© 2019 Thomson Reuters

INDEX

Bad debts deductions, 247, 248 factored debts, 248 group companies, 249 presently existing debt, 247 overview, 247 Banks revenue assets, 87 Beneficiaries see Trust beneficiaries Bills of exchange discount in lieu of interest, 265–267 discount only, 123–124 Bonus shares assessable income, whether, 12–13

deemed dividends, 333, 334 dividends, 250

Books access to, 409–410 Bounties or subsidies see Government subsidies Building societies government subsidies, 97–98 Business indicia, distinguished from hobbies, 179 small scale activities, 180 Business expenses see also Capital or revenue expenses accrued leave payments, 166–168, 268 “black hole” expenses, 167 defence of title, 225, 227, 229, 230 capital expenses, 153 cessation of business, 159, 161 compensation payments, 219 hire purchase arrangements, 159–160 interest expenses, 162, 163, 164 leased equipment, 161 “long tail liabilities”, 162 currency of liability, 166–168 damages libel actions, 172 negligence, 171–173 disability insurance premiums, 168–169 fines or penalties, 173 © Thomson Reuters 2019

future expense reduction, 155–156 future income, 156–157 feasibility studies, 156 interest expenses, 157 illegal activities, 171, 173–177 fines or penalties, 173 legal expenses, 174–177 illegal businesses, 177 public policy, 177 indirect derivation of income, 164–166 interest expenses, 164–165 key employee insurance, 168 legal expenses defence of title, 225–230 fringe benefits tax, 175 illegal activities, 171, 174–177 sufficient nexus, 175 life insurance premiums, 168–169 misappropriation, 168–170 moving expenses, 227 partner’s defalcation losses, 178–179 preliminary expenses, 156 research and development, 388–389 previous business, 159–164 primary production, 177 carrying on a business, 179–181 non-commercial losses, 179 theft losses, 169–170, 177 tied house agreements, 219, 220 capital outgoings, 220 lease contracts, 220 non-deductible capital expenses, 221, 225 revenue outgoings, 220 tied trade agreements, 219, 220 trading stock, 275, 281 acquisition from associates, 276–277 future delivery, 277–278 moving expenses, 230 stock on hand, 278–281 valuation, 281–282 Business income carrying on a business, 50–51 gambling, 52–55 investments, 60–63 land sales, 56–60 sportspersons, 55–56 cash or convertible test, 50–51 459

AUSTRALIAN TAXATION LAW CASES 2019

compensation, 99 apportionment, 101–103 characterisation, 99–100 compulsory acquisitions, 99–103 contract termination, 104–109 defamation, 103–104 income loss, 89, 100 mining rights, 99,102–103 reimbursed deductible outgoings, 89–96 trading stock, 100, 282–283 undissected receipts, 100–101 establishment payments, 97–98 foreign exchange gains and losses, 82–83 government subsidies, 97–99 establishment payments, 97–98 ex-gratia distributions, 94, 98 illegal businesses, 177 insurance or indemnity, 91, 92 loss of income, 169, 170 isolated transactions see Isolated transactions lease incentives, 73–75, 78–79 lease surrender payments, 74–75 leased equipment, sale, 109–113 accounting methods, 110, 111 leases contributions to fit-out, 75–78, 80 sale and leaseback, 77–78 liabilities, assumption, 92 loss of income, 89, 100, 169, 170 natural resource payments, 118 negative covenants, 80–82 non-cash business benefits, 50–51 profit-making schemes see Profitmaking schemes refunded royalties, 90–91 reimbursed deductible outgoings, 89 credit card fees, 91 legal expenses, 94 revenue assets, 87–89 reversal of recognised expense, 93 settlement payments, 89–90, 93–95 Capital allowances see also Capital works deductions; Depreciating assets limited recourse loan, 246 460

overview, 243 plant or articles, 244 related group company, 246 Capital expenses see also Capital or revenue expenses debt instruments, discount losses, 265 improvements, 238–243 overview, 151 repairs, 238 initial repairs, 238, 240, 242, 243 renewal expenses, 239, 241 Capital gains tax see also CGT events acquisition of assets, 144–146 leases, 147–148 market value rule, 145 preliminary contracts, 145–146 time of acquisition, 144–146, 148 assets, 142 cost of assets, 142–143 definition, 142 assignment of income, 70, 71, 268–271 partnership interests, 271–272, 299 bills of exchange, 123 concessions, 149 constitutional aspects, 5–6 constitutionally protected funds, 5–6 contracts, 146–147 core provisions, cost base repairs, 238, 241 sale by instalment, 134 cost of asset, 142–143 debt defeasance, 127 deceased estates, 85 deeming provisions, 140, 141 forfeited deposits, 148–149 restraint of trade agreements, 141 disposal of assets, 140, 141, 142 part disposals, 147, 148 time of disposal, 146–147 double tax agreements, 361, 365–374 business profits, 367–369 land-rich companies, 372–373 “earnout” payments, 136, 231–235 forfeited deposits, 148–149 gambling, 54 goodwill, 149–150 small business concessions, 149, 150 © 2019 Thomson Reuters

INDEX

historical background, 140 information or knowledge, 35–36 input tax credits, 420–421 isolated transactions, 65–71 individuals, 83–84, 85 know-how, 71–73 lease incentives, 73–75, 79–80 lease surrender payments, 75 negative covenants, 80–82 land sales, 57, 59, 60 lease incentives, 73–75, 81 lease surrender payments, 75 leased equipment, 143, 144 leases, grant, 147–148 part disposals, as, 147, 148 main residence exemption, 208, 209 natural resource payments, 119–120 nature of tax, 5–6 negative covenants, 80–82 ordinary income, distinction, 71–72 original Pt IIIA CGT rules, 141–142 overview, 87, 140 partnerships, 291–292 assignment of interests, 271–272, 298–299 dissolution of partnership, 296 prepaid rent, 222, 223 purchase by a series of payments, 230–234 restrictive covenants, 218 retention of, when obligation arises, 411–412 royalties, 270–271 sale by instalment, 130–136 cost base, 132 shareholders, 120–122 sell-back rights, 121–122 shares, 61, 63, 87 small business concessions, 19, 150 State owned property, 4 time of acquisition, 144–146 leases, 148 market value rule, 145 preliminary contracts, 145–146 time of disposal, 146–147 relevant contract, 146, 147 trusts, 303–304, 310–311 unit trusts, 315, 316 withholding, when obligation arises, 411–412 © Thomson Reuters 2019

Capital or revenue expenses annuities, 230–231 defence of title, 224–229 acquisition of shares, 226–227 process or structure test, 224, 227 lease payments, 217, 220–221 moving expenses, 230 prepaid rent, 222, 223 purchase by a series of payments, 230 annuities, 230–231 deferred payments, 233–234 earnout arrangements, 231–236 future payments, 134–136, 224, 231, 234 rent charge, 133, 233 restrictive covenants, 218 tests to determine, 214–224 enduring asset or advantage, 218 nature of advantage, 218–219 once and for all or recurring expense, 216 process or structure test, 216, 217, 219, 224, 227 tied house agreements, 219, 220 Capital receipts liquidators’ distributions, 4 negative covenants, 36–37, 80, 81 Capital works deductions buildings, 240–245, 246 construction expenditure, 240–241, 242 Carrying on a business categories of activities, 51–52 gambling, 52–55 extent of activities, 52–53 factors to determine, 54–55 pursuit of pastime, 53 systematic activities, 53–54 indicia, 52–63 land development, 56–60 land sales, 56–60 intention or purpose, 56, 57, 58, 59, 60 subdivided land, 56–60 primary production, 179–180 relevant factors, 180–181 scale of activities, 108–181 share sales, 60–63 capital or revenue, 61, 63 461

AUSTRALIAN TAXATION LAW CASES 2019

frequency of sales, 61–63 professional advisers, 62 share trading, 62–63 sportspersons, 55–56 Cash accounting see also Accrual accounting appropriate method, 253–255 medical partnerships, 254–255 sole legal practitioners, 254 changing method, 255 adjustments, 256 change in business structure, 257 expense recognition, 262–268 future outlays, 262, 263 incurred, meaning, 262–263 overview, 253 CGT events assignment of income, 70–71 compensation, 102 compulsory acquisitions, 102 contract termination, 104–109 mining rights, 99, 103 contracts, 146–147 date of contract, 146, 147 employment contracts, 29 termination, 104–109 employment contracts, 29 forfeited deposits, 148–149 government subsidies, 97, 98, 99 lease surrender payments, 75 leases, 145–146 contributions to fit out, 75–78, 80 natural resource payments, 119, 120 negative covenants, 36–37, 80, 81 overview, 140 refunded royalties, 90–91 reimbursed deductible outgoings, 89, 91 reversal of tax liability, 93 settlement payments, 90, 95–6 share disposals, 61, 63 Charitable gifts character of payment, 214 Charitable organisations charitable purposes, 320, 321, 322, 323 political activities, and, 322–323 religion, advancement, 320–321 exemption conditions, 321–322 462

registered charities, 320 statutory definition, 321 Child care expenses deductibility, 201–202 fringe benefits tax, 202 Clothing expenses ordinary usage, 210, 211 overview, 210 wholly and exclusive test, 210, 211 Clubs and associations mutuality, 16–18 Collection of tax capital gains tax, 410–411 dividend withholding tax, 410–411 retention, when obligation arises, 411–412 tax due, 410–412 withholding tax, 410–411 Commissioner see Access to information; Assessments Commuting expenses personal expenses, 198–199 Companies see also Dividends; Private companies; Public companies continuity of ownership, 338–339 co-operatives, 328 gift to company, 328–329 investment in, whether debt or equity interest, 326–327 public or private, distinction, 340–341 constituent documents, 340–341 residency, 345–349 central management and control, 345, 346, 347, 348 dual residency, 347 royalties, non-resident, 354–355 identical business, 339 same business test, 381 tax losses, 249–250, 336–340 effect of bonus shares, 250 same business test, 338, 339, 340 Compensation payments cessation of production, 219 characterisation of compensation, 99 © 2019 Thomson Reuters

INDEX

defamation, 103–104 delayed payments, for, 101–102 employment contracts, 30–32 income losses, 89, 99 income source, as, 15–16 personal services, income from, 30–32 employment rights, 31–32 termination of employment, 28, 30–31 property losses, 99–103 compulsory acquisitions, 99–103 mining rights, 99–100, 102–103 trading stock, 100, 228–284 undissected receipts, 100–101 termination of contract, 104–109 termination of employment, 28, 30–31 Consolidated groups interest expenses, 166 overview, 68 single entity rule, 68, 166 Constitution additional tax, validity, 7–8 discrimination between States, 6–7 mineral resources rent tax, 7 trading stock valuations, 6 income, concepts of, 3–6 benefit from use of property, 3–4 capital gains, 5–6 deemed dividends, 4 income tax regime, 8, 9 Commonwealth takeover, 8–9 tax, what constitutes, 2 Constitutionally protected funds capital gains, 5–6 Constructive trusts creation of, 307–308 Contractors negative covenants, 36–37 Contracts compensation for termination, 104–109 date of contract, 146, 147 employment contracts, 30–31 Corporations see Companies Covenants see Negative covenants; Restrictive covenants © Thomson Reuters 2019

Credit unions mutuality, 17 Damages GST, and, 421–422 libel actions, 172 negligence, 171–173 supply, whether person receiving, 421–422 Debt cancellation see Debt cancellation market value of, 126 repurchase of, 126 Debt cancellation assessable income, 124 express forgiveness, 126 forgiveness of debt, definition, 125 indirect recognition, 124, 125 overview, 124 value to taxpayer, 125, 126 Debt defeasance capital gains, 128 in substance defeasance, 127, 128 overview, 127 tax policy, and, 128 types of defeasance, 127 Debt forgiveness assessable income, 124 conduct or implication, 126 deemed dividends, 330 express forgiveness, 126 forgiveness of debt, definition, 125 indirect recognition, 122, 125 overview, 124 value to taxpayer, 125, 126 Debt instruments accruals basis, 122, 123, 124 accruals regime, 122 compound interest, 259–260 deferred interest, 259–260 discount, 122–124 genuine discount, 123 discount and interest, 122–123 discount in lieu of interest, 265–267 accruing gain on compound basis, 265 463

AUSTRALIAN TAXATION LAW CASES 2019

discount losses, 265 overview, 122 premiums on, 122 shallow discounts, 122 Debt repurchase overview, 126–127 Deceased estates inherited land, 84–85 Deductions see also Capital allowances; Capital or revenue expenses accrued leave payments, 166–168, 268 annuities, 192, 193 anticipated indirect derivation of income, 164 apportionment rule, 154–155 “to the extent”, meaning, 154 bad debts, 247–249 factored debts, 248 group companies, 249 presently existing debt, 248 “black hole” expenses, 167 bribes, 171 capital expenses, 153 capital works deductions, 240–241, 242 cessation of business, 159, 161 hire purchase arrangements, 159–160 interest expenses, 162, 163, 164 leased equipment, 161 “long tail liabilities”, 162 clothing expenses, 210 ordinary usage, 210, 211 compensation payments, 219 concession fees, 266–267 cosmetics and sun protection, 212–213 current liability, need for, 166 damages libel actions, 172 negligence, 171–173 derivation of income, 155 future expense reduction, 155–156 indirect derivation, 164–166 disability insurance premiums, 168–169 employment, expenses of obtaining, 157–159 connection in time, 157 management fees, 158–159 entertainment expenses, 51 464

family loans, 188–189 fines or penalties, 173, 177 future expenses, 262, 263 reduction, 155–156 future income, 156–157 interest expenses, 157 preliminary expenses, 156 time, connection in, 156 gambling losses, 54, 55 gifts, 212–213 school building funds, 213–214 group companies, 164–165 home office expenses, 207–210 exclusive use requirement, 207, 208, 209, 210 illegal activities, 173 fines or penalties, 173, 177 legal expenses, 171, 174–177 illegal businesses, 177 public policy, and, 177 improvements, 240 income derivation, connection with, 155 income-splitting family loans, 188–189 income-splitting service trusts, 183–184 incurred, meaning, 262–263 insurance premiums, 168–169 interest expenses, 263–268 capital protected loans, 193–194 cessation of business, 162, 163, 164 compound interest, 263–264 concession fees, 266–267 deferred interest, 263–264 discounts in lieu, 265–267 future income, 157 future outlays, 262, 263 group companies, 165–166 home office, 207, 208 partnerships, 295, 297, 299 prepayments, 189–190, 385 tax avoidance, 188 timing mismatches, 192, 193 legal expenses defence of title, 225–230 employees, 175–176 illegal activities, 171, 174–177 sufficient nexus, 175 legal rights doctrine, 185, 186 rental payments, 187 transfer pricing, 184–186 © 2019 Thomson Reuters

INDEX

life insurance premiums, 168–169 loans capital protected loans, 193–194 split loan arrangements, 390, 391 timing mismatches, 192, 193 “long tail liabilities”, 162 management fees, 158–159 misappropriations, 169–170 negative and positive limbs, 153 overview, 153 partner’s defalcations, 178–179 preliminary expenses, 156 research and development, 388–389 prepayments, 189–190, 385 interest expenses, 190 previous business expenses, connection in time, 159–164 primary production, 180 carrying on a business, 179–180 non-commercial losses, 180 private or domestic expenses, 183, 197–214 child care, 201–202 clothing, 210–211 commuting expenses, 198–200 cosmetics and sun protection, 212–213 food, 197–198 home office, 207–209 moving expenses, 201 private expenses, 170 self-education, 203–206 sun protection, 212 travel between workplaces, 200 travel expenses, 206–207 travel to workplace, 198–200 purchase by a series of payments, 230 annuities, 230–231 quasi-personal expenses, 170–171 fines or penalties, 173, 177 illegal activities, 173 illegal businesses, 177 legal expenses, 174–177 libel damages, 172 negligence damages, 171–173 partner’s defalcations, 178–179 rental payments, 187 legal rights doctrine, 187 repairs, 238–243 poor state of building, 243 © Thomson Reuters 2019

replacement of part, 239, 240, 241 restoration test, 239 research and development, 388–309 sale and leaseback, 190 arrangements, 190, 191 finance leases, 191–192 securities, 156 self-education expenses, 203–206 connection to employment, 203 non-work activities, 206 professional skills, 204 prospects for promotion, 203, 204, 205 youth allowance, 205–206 service trusts, 183–184 sportspersons, 157–159 management fees, 158–159 sun protection, 212 tax avoidance, 182–183 capital protected loans, 193–194 legal rights doctrine, 184–188 prepayments, 189–190 rental payments, 187 research and development, 388–390 sale and leaseback, 190–192 split loan arrangements, 384, 385 timing mismatches, 192–193 trading stock, 276–277 transfer pricing, 184–186 tax losses, 249–250 tax minimisation, 182, 183 dual purpose outgoings, 182, 183 family loans, 188–189 legal rights doctrine, 184–188 service trusts, 183–184 trading stock, 272, 273 transfer pricing, 184–186 theft losses, 169–170, 177 tied house agreements, 219, 220 timing of deductions, 156 trading stock, 274–278 acquisition from associates, 276–277 future delivery, 277–278 moving expenses, 230 stock on hand, 278–281 transfer pricing, 184 legal rights doctrine, 184–186 purpose of outgoing, 186 travel expenses, 198 between workplaces, 200 465

AUSTRALIAN TAXATION LAW CASES 2019

“fly in fly out” basis, 199 new place of employment, to, 200–201 on call expenses, 198 overseas travel, 206 to workplace, 198–200 Deemed dividends cancellation of shares, 329–330 formal winding up, 331–334 informal winding up, 335–336 liquidator’s distributions, 4, 86, 87, 333, 334 informal winding up, 335–336 share buy-backs, 336–337 shareholder loans, from, 336 private companies, 331, 333–334 forgiven loans, 336 share buy backs, 336–337 shareholder loans, 336 Defamation compensation payments, 103–104 Default assessments asset betterment statements, 406–407 methodology for construction, 407 illegal activities, income from, 177 trust income, 302 Definitions asset, 142 connected to Australia, 430–431 depreciating asset, 244 dividend, 121, 250, 326 entertainment, 51 fringe benefit, 22, 40, 43, 44 life benefit termination payment, 31, 41 partnership, 282 permanent establishment, 370 private company, 340–341 qualifying annuity, 137 recreation, 51 resident, 345, 349 resident company, 346 royalty, 117, 355 taxable supply, 402–421 trading stock, 274–276 Deposit forfeitures see Forfeited deposits

466

Depreciating assets accounting methods, 110, 111, 243 leased luxury cars, 129 buildings, 244–245 parts of building, 245–246 plant, as, 245 temporary accommodation, 244 debt supplied on non-recourse basis, 246 definition, 244 fixtures or fittings, 76–77, 78, 80, 245 leased luxury cars, 129, 130 overview, 243 partnerships, 290–291 plant and articles, 244 rental equipment, 109–113, 143, 144 accounting methods, 110, 111 sale, 109–113 Derivation of income see also Accruals accounting future expense reduction, 155–156 indirect derivation, 164–166 Disability insurance Premiums, 168 Discount genuine, whether, 123 return by way of, 122–124 Diverted income assessment, 14 Dividend stripping schemes anti-avoidance provisions, 381–382, 393–395 dominant purpose test, 385–391 dividend rebate, 330, 331 Dividend withholding tax collection of tax, 410–411 Dividends assignment, 269 non-residents, 359–360, 410 bonus shares, 250 deemed dividends, 331–337 forgiven loans, 336 formal winding up, 331–334 informal winding up, 335–336 liquidators’ distributions, 331–335 © 2019 Thomson Reuters

INDEX

definition, 119, 250, 326 dividend rebate, 166, 337 “dividend traps”, 165 group companies, 165, 166 indirect derivation of income, 164, 165 interim dividends, 327, 340 cancellation, 326 non-residents, 353, 359–360 assignment of dividend, 359, 411 trustee, 358 withholding tax, 359–361, 410 overview, 326 payment out of profits, 327–328 cancellation of shares, 329–330 gifts to company, 328–329 interim dividends, 327–328, 340 profits, meaning, 327 sell-back rights, and, 121 shareholders, 121, 330–331 nominee shareholders, 330–331 non-resident shareholders, 359–360, 410 source of income, 353–355 withholding tax on, 359–360 Domestic expenses see Private or domestic expenses Double tax agreements business profits, 367–369 capital gains, 367, 368, 369 enterprise, meaning, 368 permanent establishment, 370–372 short-term speculative gains, 368 capital gains, 367, 368, 369 business profits, 367–369 land-rich companies, 372–373 employment income, 366–367 juridical double taxation, 361–362 land-rich companies, 372–373 mining rights, 372–373 permanent establishment, 370–372 definition, 370 substantial equipment, 370

convertibility to cash, 42 share options, 43–45 Employee share trusts fringe benefits tax, 44, 45 identity of beneficiaries, 45 Employees legal expenses, 175–176 negative covenants, 36–37 Employment see also Income from personal services and employment expenses of obtaining, 157–159 management fees, 158–159 payments after cessation of, 38 Employment contracts compensation payments, 30–31 Employment termination payments assessable income, 28, 39–41 compensation payments, 30–32 life benefit termination payments, 31, 41 Entertainment expenses denial of deduction, 51 entertainment, definition, 51 Exempt income foreign source income, 387 tax losses, 249–250 Exempt organisations see Charitable organisations Expenses entertainment see Entertainment expenses private and domestic see Private and domestic expenses quasi-personal, 170–171 Exports GST-free supplies, 429, 431–432

Eligible termination payments see Employment termination payments

False or misleading statements penalties, 416

Employee share benefits assessable income, 43–45

Finance leases accounting, 128, 129

© Thomson Reuters 2019

467

AUSTRALIAN TAXATION LAW CASES 2019

capital gains tax, 143 luxury cars, 129–130 overview, 128–129 sale and leaseback, 191–192 Financial arrangements annuities, 136–138 blended payments, 68 sale by instalments, 136 Fines illegal activities, for, 173 non-deductibility of fines doctrine, 173 Food expenses sportspersons, 197–198 Footballers see Sportspersons Foreign companies see Non-resident companies Foreign exchange gains and losses business income, 82–83 Foreign source income double taxation, and, 355, 356, 357, 361–362, 365–374 exempt income, as, 387 foreign tax offsets, 351, 352, 355, 357, 388 treaty, income subject to, 356 withholding tax, 359–361 Foreign superannuation funds benefits paid from, 39–40 fringe benefits tax, 40 Forfeited deposits capital gains tax, 148–149 CGT events, 148 GST, 425–426 Frequent flyer programs income, as, 34–35 Fringe benefits tax see also Non-cash benefits benefits and service nexus, 22 study completion payments, 25–26 child care, 202 employee share trusts, 44–45 identity of beneficiaries, 45 468

foreign superannuation funds, 39 fringe benefit, definition, 22 gifts, 21–27 housing benefits, 42 legal expenses, 175 moving costs, 200–201 overview, 21–22, 41–42 prizes, 33 study completion payments, 25–26 Gambling carrying on a business, 52–55 extent of activities, 52–53 factors to determine, 54–55 pursuit of pastime, 53 systematic activities, 53–54 deduction for losses, 55 illegal activities, 64 Gifts charitable organisations, 214 company, to, 328–329 donor recipient relationship, 22–23 fringe benefits tax, 21–27 gift vouchers, 23–24 income from personal services, 21–27 school building funds, 214 shares, 22–23 Goodwill capital gains tax, 150 small business concessions, 150 overview, 149–150 Government subsidies CGT events, 97–99 establishment payments, 97–98 ex-gratia distributions, 94, 99 GST, 424 overview, 97 Grant assessable recoupment, 95 Group companies see also Consolidated groups bad debts, 249 dividends, 165, 166 indirect derivation of income, 164, 165 interest expenses, 164–166 © 2019 Thomson Reuters

INDEX

GST administrative penalties, 8 anti-avoidance rule, 433–434 “principal effect” of scheme, 433 sole or dominant purpose, 433 tax saving, election, 433–434 composite supplies, 426–428 non-dissectible supplies, 427 connected to Australia, 430–431 damages, and, 421–422 “destination” basis tax, 429 exported goods, 429 exported services, 431–433 expropriation, 422–424 forfeited deposits, 425–426 government subsidies, 424 GST-free supplies, 429 imported goods, 429, 430 imported services, 430 input tax credits, 428–429 international aspects, 429–430 mixed supplies, 426–428 Netflix tax, 430 overview, 420 services not used, 417 taxable supplies, 402–421 composite supplies, 426–428 connected to Australia, 430–431 damages, 421–422 expropriation, 422–424 forfeited deposits, 425–426 government subsidies, 424 mixed supplies, 426–428 services not used, 425 Hire purchase arrangements cessation of business, 159–160 Hobby or business primary production, 179–182 relevant factors, 180–181 scale of activities, 180–181 Home office expenses deductions, 207, 208 exclusive use requirement, 207, 208, 209 mortgage interest, 207, 208 © Thomson Reuters 2019

Illegal activities alleged and actual, legal expenses, 174–177 expenses incurred by illegal businesses, 177 fines for, 173 income from, default assessments, 177 Imported goods GST, 429, 430 Imported services GST, 430 reverse charge, 430 Improvements see also Repairs replacement of part, 239, 240, 241 Income see also Assessable income; Business income anticipated indirect derivation of, 164 assignment see Assignment of income

compensation, 15–16

constitutional concepts, 3 benefit from use of property, 3–4 capital gains, 5–6 deemed dividends, 4 deemed present entitlement, 393 judicial concept, 12 Income from personal services and employment assessable income, 21 compensation see Compensation payments employment termination payments, 28, 30–31 foreign income, 349–352 frequent flyer benefits, 34–35 gifts, 21–27 donor recipient relationship, 22–23 gift vouchers, 23–24 shares, 22–23 information or knowledge, 35–36 negative covenants, 36–37 nexus requirement, 21, 27, 30 non-cash benefits see Non-cash benefits overview, 21 payments after cessation of employment, 38 469

AUSTRALIAN TAXATION LAW CASES 2019

periodic payments, 27–30

armed forces, service in, 27–29 prizes, 33 source of income, 355–357 study completion payments, 25–26 superannuation benefits, 29–30 foreign funds, from, 39–40 termination payments, 28, 30–31 tips, 32 Income splitting family loans, 188–189 partnerships, 286 service trusts, 183–184 tax avoidance, 382 trusts for children, 308–309 Income tax regime Commonwealth takeover, 8–9 State laws, 8, 9 Indemnity see Insurance or indemnity Information access to, 409–410 Input tax credits entitlement to, 428–429 Instalments see Sale by instalment Insurance companies revenue assets, 87–89 Insurance or indemnity assessable recoupments, 92, 95 loss of trading stock, 283 disability insurance premiums, 168–169 key employee, 168 life insurance premiums, 168–169 loss of trading stock, 283 Interest compound interest, 263–265 contingent interests, 304–305 deferred interest, 263–265 interest-only loans, 136 withholding tax on, 360–361 Interest expenses capital protected loans, 193–194 cessation of business, 162, 163, 164 compound interest, 263–265 470

concession fees, 266–269 consolidated groups, 166 deferred interest, 263–264 discounts in lieu, 265–267 future income, 157 future outlays, 262, 263 group companies, 164–166 home office, 207–209 non-commercial losses, 157 partnerships, 289–290 prepayments, 189–190, 385, 390 tax avoidance, 373–375 prepayments, 189–190 timing mismatches, 192, 193 Interpretation “legal rights” doctrine, 187 “literalism”, 187 tax avoidance “Duke of Westminster” doctrine, 378–379 fiscal nullity doctrine, 378–379 literal approach, 378–379 Investments carrying on a business, 60–63 capital or revenue, 61, 63 frequency of sales, 61–63 professional advisers, 62 share sales, 60–63 share trading, 62–63 Isolated transactions commercial transactions, 65–71 ancillary transactions, 67, 69 assignment of income, 67, 70–71 future income, 67 novel or extraordinary transactions, 67–68 outside ordinary activities, 66–67 profit intention, 66, 69 individuals, 83–84 inherited land, 84–85 profit-making by sale, 85–87 profit-making schemes, 84–85 know-how, 71–72 lump sum payments, 72–73 lease incentives, 73–75 negative premiums, as, 78–79 ordinary course of business, 76 lease surrender payments, 74–75 © 2019 Thomson Reuters

INDEX

leases, contributions to fit-out, 75–78, 80 negative covenants, 80–82 overview, 65 Joint tenants statutory partnerships, 286–287 Know-how capital or income, 71–72 lump sum payments, 72–73 Lease incentives capital gains tax, 73, 74, 75, 77, 78, 80 negative premiums, as, 78–79 ordinary income, 73–75, 77–78, 80 Lease surrender payments CGT events, 75 ordinary course of business, 75 ordinary income, 74–75 Leaseback sale and leaseback see Sale and leaseback Leased equipment cessation of business, 161 deficiency payments, 161 depreciation, 109–113, 143, 144 sale, 109–113 accounting methods, 110, 111 Leases capital gains tax, 143, 147–148 grant of lease, 147–148 part disposals, 147, 148 time of acquisition, 148 contributions to fit-out, 75–78, 80 capital allowances, 78 sale and leaseback, 77–78 finance leases, 128–129 capital gains tax, 143 sale and leaseback, 191–192 fixtures and fittings, 76–77, 78, 80 luxury car leases, 129–130 sale and leaseback, 190 artificial transactions, 191, 192 © Thomson Reuters 2019

finance leases, 119–192 Leave obligations, 268 Legal expenses employees, 175–176 illegal activities, 171, 174–177 employees, 175–176 fringe benefits tax, 175 protection of title, 225–230 reimbursements, 94 Legal professional privilege client identification, 403–404 courtroom, application outside, 399–400 documents obtained for another purpose, 404–405 dominant purpose test, 402 opportunity to claim privilege, 401–402 overview, 399 sole purpose test, 402 third parties, 403 “Legal rights” doctrine, 187 Life insurance companies annuities, 137 Life insurance premiums deductions, 168–169 Liquidators’ distributions deemed dividends, 4, 86, 87, 333–334 informal winding up, 335–336 share buy-backs, 336–337 shareholder loans, from, 336 land, 86–87 Loans blended loans, 136 annuities, as, 136, 137–138, 192, 193 timing mismatches, 192–193 capital protected loans, 193–194 forgiven loans, 336 interest-only loans, 17, 136 “protected” loans, 193 split loan arrangements, 390, 391 scheme, meaning, 390–391 tax benefit, meaning, 390, 391 471

AUSTRALIAN TAXATION LAW CASES 2019

Long service leave accrued entitlements, 166, 167 Losses and outgoings see Deductions Lump sum payments see Employment termination payments; Superannuation benefits; Termination payments

capital receipts, 36–37, 80, 81 CGT events, 79, 81, 82 Negligence damages, 171–173

Luxury car leases depreciation, 129, 130 finance leases, 129–130

Non-cash benefits see also Fringe benefits tax convertibility to cash, 21, 41–42, 51 employee share options, 43–45 employer-provided premises, 42 leases, contributions to fit-out, 77–78 overview, 21

Management fees prepaid management fees, 179 sportspersons, 158–159

Non-cash business benefits assessability, 51 convertible to cash, 50–51 entertainment expense rule, 51

Mineral resources rent tax constitutional validity, 7 discrimination between states, 7

Non-commercial losses interest expenses, 157 primary production, 108, 181, 182

Mining rights compensation for loss, 99–100 double tax agreements, 366–367

Non-resident companies see also Double tax agreements source of income, royalties, 354–355

Misappropriations deduction for losses, 169–170

Non-residents see also Double tax agreements assessable income, 353–355 dividends, 357–358 source of income, 357 taxable supply see GST withholding tax, 359–361 dividends, 359–360 interest, 360–361 royalties, 354–355, 359

Moving expenses deductions, 200–201 trading stock, 230 Mutuality clubs and associations, 16–18 credit unions, 17 overview, 16 source of income, 16 Natural resource payments business income, 118 capital gains tax, 119–120 capital payments, 118 ordinary income, 117–118 profit à prendre agreements, 119 sale of goods, distinction, 119–120 royalties, 117–118 Negative covenants see also Restrictive covenants capital gains tax, 81–82 472

Objections overview, 412–413, 415 Offences false or misleading statements, 416 GST, 8 overview, 416 penalties see Penalties reasonably arguable position, 417 test to determine, 419 tax offences, 416 “tax shortfall amount”, 416

© 2019 Thomson Reuters

INDEX

Ordinary income see also Statutory income capital gains, distinction, 12–13, 71–72 diverted income, 14 fruit and tree analogy, 12 illegal activities, 64 isolated transactions, 65–71 judicial concept, 12 lease incentives, 73–75, 77, 79 lease surrender payments, 74–75 mutuality, 16–18 clubs and associations, 16–18 credit unions, 17 payment and service nexus, 21, 27, 30 study completion payments, 25–26 periodicity, 13, 14 prizes, 33 profit-making schemes, 65–71 receipts as, criteria, 12 revenue assets, 87–89 sale by instalments, 132 source of income, 12–13, 14–15 statutory income, and, 50 tests to determine, 13–16 Partnerships assignment of interests, 271–272, 298–299 borrowings, tracing purpose of, 292–293 capital gains tax, 291–292 assignment, 271–272, 299 dissolution of partnership, 296 common law partnerships, 286 control over, 290–291 creation of partnership, 289–290 defalcation losses, 178–179 clients’ losses, repaying, 178–179 definition, 282 depreciable property, 289–290 dissolution of partnership, 295–296 capital gains tax, 291–292 reformed partnerships, 297 ending of, 295–296 evidence of partnership, 288–289 arrangement between persons, 289 excessive advances, charging “interest” for, 293 existence of partnership, 286–289 © Thomson Reuters 2019

income-splitting vehicle, 286 joint tenants, 285–287 leaving, 295 overview, 286 partners departing, work in progress payments to, 296–297 services, providing, 294 transactions with, 293 profit-making schemes, 291–292 purpose and actions, 291 attributing purpose, 291–292 borrowings, 292–293 statutory partnerships, 286–290 joint tenants, 286–287 tenants in common, 286–287 trading stock, 289–290 transactions between partners, 239–295 excess advances, 293–294 provision of services, 294–295 work-in-progress acquisition payments, 298 leaving partners, 296–297 reformed partnerships, 297 Penalties criminal, 416 false or misleading statements, 416 Permanent establishment business profits, 367–369 definition, 370 royalty payments, 370 substantial equipment, 370 tax treaties and international agreements, 366 withholding tax, 364–366 Personal services see Income from personal services and employment Pre-business expenses feasibility studies, 156 research and development, 388–390 Premium genuine, whether, 123 Prepayments accruals accounting, 258 capital or revenue, 222 deductions, 189–190 473

AUSTRALIAN TAXATION LAW CASES 2019

interest expenses, 189–190, 385, 386 rent, 222, 223 services provided over years, for, 258 tax avoidance, 189, 378 interest expenses, 189–190, 385, 386 Primary production carrying on a business, 179–182 relevant factors, 180–181 scale of activities, 180–181 non-commercial losses, 108, 181, 182 prepaid management fees, 179 Private companies deemed dividends, 331, 333–334 forgiven loans, 336 overview, 340 public or private, distinction, 340–341 constituent documents, 340–341 same business test, 338, 339, 340, 381 undistributed profits tax, 381 Private or domestic expenses, 183, 197–214 child care, 201–202 clothing, 210–211 commuting expenses, 198–200 cosmetics and sun protection, 212–213 food, 197–198 home office, 207–209 moving expenses, 201 private expenses, 170 self-education, 203–206 sun protection, 212 travel between workplaces, 200 travel expenses, 206–207 travel to workplace, 198–200 Private ruling obligation to issue, 417–418 Prizes income from personal services, 33 connection to services, 33 overview, 33 Profit à prendre agreement, 119 sale of goods, distinguished, 120 Profit-making by sale overview, 83–84, 85 474

purpose of acquisition, 85–86 share sales, 60–63 revenue or capital profits, 61 Profit-making schemes individuals, 83–85 inherited land, 84–85 isolated transactions, 65–71 individuals, 83–85 lease incentives, 74 lease surrender payments, 74, 75 novel or extraordinary transactions, 67–68 profit intention, 66, 69 land development, 60 land sales, 56–60 intention or purpose, 56, 57, 58, 59, 60 subdivided land, 56–60 overview, 65, 84 partnerships, 287–288 revenue assets, 87 statutory income, 65–71 Property interest presently existing, assignment of, 268–271 Protection of title expenses, 225–230 Public companies public or private, distinction, 340–341 constituent documents, 340–341 Purchase by a series of payments annuities, 230–231 capital gains tax, 231, 232, 234 deferred payments, 233–234 earnout arrangements, 231, 233 earnout clauses, 232 earnout payments, 232, 234 future payments, 231, 233 rent charge, 232–233 Receipts capital, 12 cash or convertible into cash, 21 ordinary income, as, 12, 21 © 2019 Thomson Reuters

INDEX

Reimbursed deductible outgoings see also Assessable recoupments credit card fees, 91 overview, 89 refund of royalties, 90–91 settlement payments, 89–90 Rental payments deductions, 187 legal rights doctrine, 187 prepaid rent, 222, 223 Repairs see also Improvements capital works deduction, 240–241, 244 cost base, 238, 241 deduction, 238–243 initial repairs, 238, 239, 242, 243 overview, 238 poor state of building, 243 renewal of part, 239, 241 replacement of part, 239, 240, 241 restoration test, 239 Research and development deductions, 388–390 tax avoidance, 388–390

Retention obligation capital gains tax, 411–412 Revenue assets capital gains, 88 insurance companies, 87–89 overview, 87 profit-making schemes, 87 Royalties assignment of income, 70, 270–271 capital gains tax, 70, 71 definition, 117, 349 natural resource payments, 117–118 ordinary income, 117–118 permanent establishment, 370 source of income, 354–355 withholding tax, 370–372 Ruling obligation to issue, 417–418 Salary see Income from personal services and employment

Residency common law test, 349 companies, 345–349 central management and control, 345, 346, 347, 348 dual residency, 347 corporate residence, 345–349 individuals, 349–352 common law test, 349–351 permanent place of abode, 351 statutory tests, 349 permanent place of abode, 351 “reside” in Australia, 349–351 resident, definition, 345, 349 source of income business, 353–355 personal service, 355–357 property, 353–355

Sale and leaseback deductions, 190, 191 finance leases, 191–192 overview, 190 tax avoidance, 190–192 transactions, 191, 192

Restraint of trade agreements capital gains tax, 141

Sales tax see also GST additional tax, 8 reversal of liability, 93

Restrictive covenants see also Negative covenants capital gains tax, 218 capital or revenue, 218 © Thomson Reuters 2019

Sale by instalment annuities, 130, 131, 132–133 apportionment of payments, 134, 135 capital gains tax, 130–136 cost base, 134 capital payments, 130, 131, 135, 136 financial arrangements, 136 income stream, 131, 132, 133, 134 ordinary income, 132, 133 overview, 130 securities, 133

Securities deductions, 156 deferred interest, 264 475

AUSTRALIAN TAXATION LAW CASES 2019

qualifying securities, 136 sale by instalment, 133 stapled, 395

traditional securities, 156

Self-education expenses connection to employment, 203 non-work activities, 206 overview, 202–203 professional skills, 204 prospects for promotion, 203, 204, 205 youth allowance, 205–206 Service trusts deductions, 183–184 legal rights doctrine, 184 Settlement payments CGT events, 95–6 character of payments, 89, 90–91, 95–96 Share buy backs capital gains, 121–122 deemed dividends, 336–337 tax avoidance, 385 Shareholders assessable income, 327 capital gains, 120, 121 sell-back rights, 121–122 dividends, 121, 330–331 deemed dividends, 331–337 nominee shareholders, 330–331 non-resident shareholders, 353, 410 sale of shares, 120–121 share buy backs, 121–122 Shares see also Employee share schemes benefits from share ownership, 120–121 bonus shares, 12–13, 250, 333, 334 cancellation of shares, 329–330 capital gains tax, 61, 63, 87 carrying on a business, 60–63 capital or revenue, 61, 63 frequency of sales, 61–63 professional advisers, 62 share trading, 62–63 Small business concessions, 105, 136, 149

476

Source of income see also Foreign source income dividends, 353, 357–358 interest, 353–354 mutuality, 16–18 ordinary income, 12, 13, 14–15 passive investment income, 354 personal service income, 355–357 property and business, 353 royalties, 354–355 Sportspersons carrying on a business, 55–56 expenses of obtaining employment, 157–159 management fees, 158–159 food expenses, 197–198 management fees, 158–159 negative covenants, 36–37 prizes, 33 fringe benefits tax, 33 sponsorship payments, 55–56 States capital gains, 5–6 constitutionally protected funds, 5–6 discrimination between, 6–7 trading stock valuations, 6 income tax laws, 8, 9 appropriation by Commonwealth, 8–9 Statutory income see also Ordinary income ordinary income, and, 50 profit-making schemes, 65, 66 Subsidiaries indirect derivation of income, 164–165 Subsidies see Government subsidies Superannuation benefits assessable income, 29–30

lump sum payments, 38–41

foreign funds, from, 39–40 retirement payments, 38–41 tax exempt, criteria, 39

Superannuation funds complying funds, 40 constitutionally protected funds, 5–6 © 2019 Thomson Reuters

INDEX

foreign superannuation funds, 39–40 non-complying funds, 40 taxation, 38–41 Superannuation guarantee charge tax for public purposes, whether, 2–3 Supply taxable supply see GST Tax collection of tax due, 410 what constitutes, 2 Tax accounting see Accruals accounting; Cash accounting Tax avoidance see also Tax minimisation anti-avoidance provisions, 376, 381, 383 annihilation of transaction, 382–383 commercial purpose, 387–388 counter-factual, 392–393 dividend stripping, 381–382, 393–395 dominant purpose, 385–392 imputation credits, and, 393, 396 interpretation, 378 predication test, 382 reconstruction rule, 383 scheme, meaning, 390–391 scope of provisions, 381 share buy-backs, 391 split loan arrangements, 390, 391 tax benefit, meaning, 390, 391 deductions, 182–183 capital protected loans, 193–194 legal rights doctrine, 185, 187 prepayments, 189–190, 390 rental payments, 187 research and development, 388–389 sale and leaseback, 190–192 timing mismatches, 192–193 trading stock, 275, 276 transfer pricing, 184–186 dividend stripping schemes, 381–382, 393–395 dividend rebate, 330, 331, 392 dominant purpose, 385–392 income splitting, 382 © Thomson Reuters 2019

trusts for children, 309–310 interpretation of legislation, and, 378–381 Duke of Westminster doctrine, 378–379 fiscal nullity doctrine, 379–381 literal approach, 378–379 mass marketed schemes, 389, 404 nature of transactions, 379 form or substance, 379 series of transactions, 380, 392 overview, 376 prepayments, 189 interest expenses, 189–190, 379–381 rental payments, 187 legal rights doctrine, 187 round robin cheques, 192, 388, 389 sale and leaseback, 190 arrangements, 190, 119 finance leases, 191–192 sham transactions, 376–378 allocation of trust income, 377–378 United States, 377 share buy-backs, 391 dominant purpose, 391 split loan arrangements, 390, 391 scheme, meaning, 390 tax benefit, meaning, 390, 391 transfer pricing, 184–186 legal rights doctrine, 184–188 value shifting, 386, 387 Tax evasion penalties, 416–417 Tax losses carry forward, 249–250, 337–340 designated infrastructure projects, 338 effect of bonus shares, 250 continuity of ownership, 338–339 overview, 249, 337–338 same business test, 338, 339, 304, 381 identical business, 339 Tax minimisation see also Tax avoidance anti-avoidance provisions, 376, 381, 383 deductions, 182, 183 dual purpose outgoings, 182, 183 family loans, 188 477

AUSTRALIAN TAXATION LAW CASES 2019

legal rights doctrine, 184, 185 service trusts, 183–184 transfer pricing, 184–186 family loans, 188–189 foreign source income, 389 service trusts, 183–184 trading stock, 272, 273 transfer pricing, 184–186 legal rights doctrine, 184–188 purpose of outgoing, 186 Tax system overview, 87 revenue assets, 87 Tenants in common statutory partnerships, 288–289 Termination payments see also Employment termination payments assessable income, 38–41 Testamentary trusts present entitlement, 304–308 rates of tax, 305, 307 Theft losses deductions, 169–170, 179 Timber capital gains tax, 119–120 capital payments, 118 ordinary income, 117, 118 profit à prendre agreements, 119 sale of goods, distinction, 119–120 Tips income from personal services, 32 Title protection of title expenses, 225–230 Trading stock accruals accounting, 261 sale subject to settlement, 261 acquisition of stock, 276–278 associates, from, 276–277 future delivery, 277–278 overpriced stock, 277 compensation for loss, 99, 282–283 deductions, 274, 281 acquisition from associates, 276–278 478

future delivery, 277–278 moving expenses, 229 stock on hand, 278–281 definition, 274–276 disposal of stock involuntary disposals, 282–283 outside ordinary business, 283–284 unusual disposals, 282 land, as, 57, 58–59, 274, 275 overview, 274 partnerships, 290–291 sale on instalment basis, 260 sale price disputed by customer, 260 stock on hand, 278–282 acquisition of dispositive power, 279 control without ownership, 280–281 loss of dispositive power, 278–279 on hand, meaning, 279 valuation, 281–282 Trading stock valuation absorption method, 282 discrimination between States, 6 overview, 281–282 standard value, 281 Transfer pricing anti-avoidance provisions, 186 comparable uncontrolled price method, 363 deductions, 184 legal rights doctrine, 185–186 purpose of outgoing, 186 international tax minimisation, 184 methodology, 363–365 overview, 184, 362 reassessment, 362–363 transactional profits method, 363 Travel expenses between workplaces, 200 “fly in fly out” basis, 199 new place of employment, to, 200–201 on call expenses, 198 overseas travel, 206 prospects for promotion, 206 workplaces, to, 198–200 Trust beneficiaries allocation of income, 308, 309 capital gains, 302, 309–312 © 2019 Thomson Reuters

INDEX

proportionate approach, 309–312 quantum approach, 310 reimbursement agreements, 377–378 specified amounts, 311–312 contingent interests, 304–305 crediting trust accounts, 306–307 allocation for beneficiary, 309 legal disability, 305–306 guardian of beneficiary, 313–314 present entitlement, 303–307 administration of estate, 299–304 contingent interests, 304–305 crediting trust accounts, 306–307 legal disability, 305–306, 314 right to demand payment, 303–304 vested interest, distinction, 303 streaming of distributions, 316–317 sub-trusts, 313–316 direct distributions, 315–316 guardian of beneficiary, 313–314 Trustees infant beneficiaries, 305–306, 309 tax liability, 308 testamentary trusts, 233–304 Trusts accounting principles, 309–312 allocation of income, 308, 309 capital gains, 302, 309 proportionate approach, 309–312 quantum approach, 310 reimbursement agreements, 377–378 specified amounts, 311–312 capital gains, 302, 309 children of contributor, 308–309 income splitting, 308 constructive, 307–308 net income, 302, 309 overview, 302–303 reimbursement agreements, 377–378 streaming of distributions, 316–317 sub-trusts, 313–316

© Thomson Reuters 2019

direct distributions, 315–316 guardian of beneficiary, 313–314 tax avoidance, 371–372 tax on gains, and, 302–303 unit trusts, 313–315 Uniforms non-compulsory uniforms, 210–212 Unit trusts income flows through, 314–315 meaning of, 313 Value shifting

dominant purpose, 386, 387

Vienna Convention on the Law of Treaties, 366 Winding up deemed dividends on formal winding up, 331–334 informal winding up, 335–336 Withholding tax Australian-source income derived by foreign residents, 359–361 permanent establishments, 370–372 capital gains tax liability, 411–412 collection of tax, 410–412 dividends, 355, 359–360, 410–411 interest, 351, 354, 360–361 overview, 359 royalties, 354–355, 359 Youth allowance assessable income, 205–206 self-education expenses, 205–206

479