SERVICE v FC of TJudges:
Full Federal Court
MEDIA NEUTRAL CITATION:
 FCA 188
Hill, Heerey and Hely JJ
The appellant James Glen Service (``Mr Service'') was a director of JG Service Pty Limited (``the Company''). During the tax years 1993 to 1996 both inclusive Mr Service received fees (``the fees'') for acting as a director of other companies and as a member of the boards of various governmental and community bodies. The fees were in turn paid over by Mr Service to the Company. The Commissioner of Taxation (``the Commissioner'') decided that the fees were derived by Mr Service as income and that the payments were not deductible from his assessable income for the purpose of the Income Tax Assessment Act 1936 (Cth) (``the Act'').
2. An appeal by Mr Service to the Administrative Appeals Tribunal (``the AAT'') was successful [reported at 99 ATC 2095]. The AAT found that the payments were deductible under the first limb of s 51(1) of the Act. The AAT considered ``tenable'' Mr Service's alternative argument that the fees were received on a constructive trust for the Company and thus this did not form part of his assessable income.
3. An appeal by the Commissioner to a single Judge of this Court was upheld [reported at 99 ATC 4886]. Mr Service now appeals to this Full Court.
Evidence before the AAT
4. Evidence before the AAT was tendered both by way of written statement and oral evidence by Mr Service and witnesses on his behalf. He was represented by counsel and the Commissioner by a Departmental Officer.
5. In his written statement Mr Service said that he was the Executive Chairman of the Company and from 1987 up to July 1996 its Managing Director. The Company had offices in Canberra, Melbourne, Sydney, Brisbane and Perth and employed a staff of thirty-seven, thirty-two of which were professionals. It provided property consulting services and property development services to government authorities and companies throughout Australia. For the year ended 30 June 1998 the Company earned gross fees of $4,851,380. The statement included the following:
``9. It was a condition of my employment with the Company that part of my working time as an employee be spent on its behalf in providing services in various capacities to a number of government authorities and companies.
10. It was also a condition of my employment that all fees paid by such government authorities and companies belonged to the Company and not to me.
11. During my employment with the Company I have as its employee provided services in various capacities to a number of government authorities and companies on some occasions as director and others as a committee member. On all occasions I have ensured that the fees were received by the Company and not me.''
6. The statement then sets out a list of the fees in the relevant years. Nine companies or other organisations were listed. The total fees received in each tax year were as follows:
1993 $119,254 1994 $141,653 1995 $171,056 1996 $183,551
7. When Mr Service received a cheque for fees he gave the cheque to the Company's Administration Manager with standing instructions to bank the cheque to the Company's account. If tax had been deducted at source the deduction was debited to his loan account with the Company.
8. It is convenient to note here that although these payments were disclosed to the Commissioner, Mr Service did not treat them as part of his assessable income. Rather the Company included the fees in its assessable income and paid tax thereon. The Commissioner's decision, the subject of the present proceeding, is to treat the fees as part of Mr Service's assessable income but not to allow deductions in respect of the amounts paid over to the Company.
9. In his oral evidence in chief Mr Service said that he established the business in 1981 with his daughter and himself and one client. He said that in about 1984 he was offered a position as member of the Canberra Development Board. He described this occasion as follows:
``... the Secretary of the Department of Interior telephoned me and I considered two issues. One was meeting and working with Sir Laurence Muir [the Chairman of the Board of which Mr Service was to be Deputy Chairman] would open a level of access to the leaders of the Australian business community that was not previously available to me. And the second is, it would start to develop a relationship with the senior bureaucracy in the Territory, many of whom have planning and other responsibilities that were important to my clients. So, I then discussed the matter with my wife and my other family members, this being a family business. They thought that it was a very good idea and would be in the Company's interests, but they reminded me that I was also an employee of the Company and being paid by it and my time was, in their phrase, was theirs, which meant it was the Company's and therefore anything that came in would have to belong to the Company and be in the Company's interests and there was quite an extensive discussion.
Q. And any money that came in, what did you do with that money?
A. It went straight to the Company.
Q. (By AAT) How do you mean, it went straight to the Company? In whose favour were the cheques drawn?
A. Generally speaking, in those days my recollection is, Mr Block, they were drawn in my favour but I endorsed them straight to the Company and they were banked to the Company's account.''
10. Mr Service went on to say that as the years went by and the business grew, further directorships were offered. On each occasion prior to taking up directorships he had discussions with his wife and the rest of the family in substance the same as that in relation to the first.
11. In 1986 the business which had previously been conducted by the Company as trustee of a trust was transferred to the Company beneficially.
12. There were ten issued shares in the Company. Mr Service owned six and his wife and three sons one each. His daughter was not a shareholder. The directors of the Company were Mr Service himself, his wife and the three sons. Mr Service described his duties in the years in question as follows:
``Well, it was a significant business that I was running full time as the Senior Executive there with a substantial staff, a very large number of clients, offices in one, two, three, four States in Australia. That was a seven day a week job including the directorships and it was my responsibility to run the business, to look at the contracts, to decide with whom we would do business, on what terms, to employ staff, to deal with planners, other bureaucracies, the list is limitless.''
13. In cross-examination he was asked:
``Q. Mr Service, I wish to clarify some points about this agreement. This agreement that you had with the Company, was that a contract that you had with the Company or an agreement, a mere agreement?
A. I'm not aware of the difference between the two words.
Q. All right. Was it merely a practice that you adopted after consultation with your family, or was it actually a contractual arrangement for your Company?
A. I would regard it as a contractual arrangement. I would have regarded myself as stealing if I broke it.
Q. Let me - now that you've said it's a contract, I just wish to clarify the terms of this contract. I understand that the terms can be summarised thus, that you were obliged to forward any payments for directorship fees that you've received to the Company?
Q. I understand that the contract that you're alleging to have existed to be between yourself and the Company?
Q. (By AAT) You told us earlier, that each time you got a directorship you had a discussion with your wife and your sons, as to whether you should take up the directorship?
A. Yes, that's quite correct, Mr Block. That was not relating to the amount of fees, it was relating to the amount of time it would take for me and whether there was any reasonable nexus, I think, between that directorship and the Company. They might well have said, we don't like that company. They might have said, we think it's like Mr Christopher Skase and you shouldn't be involved in it.''
He was later asked:
``Q. Mr Service, what were the terms of the contract of 1984?
A. That any director's fees I received from these appointments and I'm again using the phrase director's fees loosely because some of them, they were not formally directorships, would go to the Company.
Q. I meant to clarify that. So that was the only term of the contract?
A. Well the other terms of the contract were that I was to be a full-time employee and devote my time, efforts, energy and so on to the interests of the Company. Normal term of employment.
Q. So there were no further terms?
A. I've no doubt there were a whole lot of implied terms.
Q. Nothing that you recall?
A. But there were no further terms specifically discussed.
Q. When you were a director of the entities in paragraph 12 of your statement, you were
ATC 4180in fact acting in your personal capacity while sitting on those boards?
A. In the legal sense of course I was. That's the law.''
14. Further he was asked:
``Q. This contract that you made with the Company was a very valuable contract, wasn't it?
A. Valuable to whom?
Q. Valuable to the Company?
A. I hope so.
Q. Given the fees that you have generated, wouldn't you be in a position to agree that, yes it has been valuable?
A. I think the contracts [sic, probably contacts] have been infinitely more valuable than the fees.
Q. That's not the question. That this has been a valuable contract that you made with the Company?
A. I don't disagree. I already said yes to that.
Q. I put it to you that there is no contract?
A. Well, I simply disagree with you.
Q. I put it to you that the story of the contract is a story you fabricated to assist you in your fight with the Commissioner of Taxation?
A. That's simply offensive.
Q. Do you deny it?
A. Of course I deny it.
Q. I put it to you, that you paid your fees to the Company in order to receive a tax benefit?
15. Mr Service then agreed that he was generally aware that the Company tax rate was lower than his highest personal tax rate, that he was the controlling shareholder of the Company and that the fees he remitted to the Company exceeded the annual salary received from the Company ($80,000). He pointed out however that he also received very large superannuation payments, by which he meant presumably that the company made a large superannuation contribution on his behalf, and provided for him ``an expensive motor car and a number of other things''. The superannuation contribution was mostly between $100,000 and $200,000 per year.
16. In answer to the AAT, Mr Service said that he had been granted 50,000 options in the share capital of Advance Bank, one of the companies of which he was director. Those options went in to the family trust and had since been exercised at a very substantial profit.
17. He agreed that ``in a formal sense'' if members of the family had disagreed he would have carried the day, but pointed out that divorce and family break-up is very expensive. He was asked:
``Q. Was there ever at any of these director discussions any opposition to your taking up a directorship?
A. There were a couple of times when people raised the question of how much time [ was] this all really going to take and there was some discussion about that. If I can just mention, Mr Block, that my family has always been very actively involved in this business. They are not in any sense onlookers.''
18. There was also evidence of Mr Service receiving an eligible termination payment (``ETP'') of $79,406 in 1993 from Managerial and Financial Services Pty Ltd which was paid to the family trust and not the Company. The matter was not however pursued in cross- examination.
19. Evidence was also given by Mr Service's son Mr James Service Jnr and his wife Mrs Dorothy Joyce Service. This evidence was in general confirmatory of Mr Service's.
The AAT's decision
20. After referring to the history and nature of the Company's operations, the AAT observed that the evidence of Mr Service and his wife was ``impressive and altogether worthy of credit''. The AAT commented that there was no written contract of service between Mr Service and the Company [at 2097], something which was
``not surprising when one considers that we are here concerned with a business which is, and always has been, a family business.''
21. The AAT said however that it was clear that from the inception of the business Mr Service had been employed on a full-time basis to devote his full time and attention to the affairs of the Company.
22. Referring to the first invitation made in 1984 to accept office as a member of the Canberra Development Board, the AAT said [at 2097]:
``... The evidence of the Applicant is that there was then a family discussion as to whether that appointment (and if relevant similar appointments offered in the future) should be accepted. The relevant factors requiring consideration included the fact that acceptance of the appointment would require the devotion of time by the Applicant (thus detracting from his time available to the Company) and the benefits which might be derived from acceptance.''
The AAT also said [at 2097-2098]:
``11. (a) The family discussion resulted in a decision to accept the offer notwithstanding its requirements as to the time of the Applicant. It was felt that membership of the Canberra Development Board would bring the Applicant into close contact with senior government officers and bureaucrats, and that these contacts could not be other than beneficial to the Company. The evidence was that it was agreed furthermore, that any and all fees derived should accrue to the Company; it was also agreed that any offers received thereafter would be dealt with in the same way but subject, in the case of each such offer, to a consideration of it and a discussion as to whether acceptance of the appointment would be beneficial to the Company. Each subsequent board appointment was in fact accepted after a discussion within the family.''
23. The AAT considered that Mr Service, ``a man of very considerable ability (and who was awarded an AM)'', had the expertise and experience which led to his appointments to boards of important bodies and companies. Those appointments were in the AAT's view of benefit, albeit indirectly, to the Company which had expanded and prospered over the years. The AAT thought Mr Service was ``undoubtedly a leader''. But there was no evidence to suggest that his was the only voice in relation to the Company [at 2099]:
``... It may well have been the most important voice; it may also be that his desires were not likely to be overruled; however his wife in particular impressed me as a person of decided character, and by no means to be characterised as a cypher.''
24. The AAT referred to the [at 2099]:
``... modern practice pursuant to which members of various organisations render services in circumstances where they are obliged to account for the fees derived is now commonplace. [Similarly,] academics may be obliged to account to their universities for fees derived for lectures or articles.''
25. The AAT referred to par 9 of Mr Service's statement already quoted above and also par 5 of his wife's statement which was as follows [at 2100]:
``It was a condition of his employment that part of his working time as an employee of the Company be spent on its behalf in providing services in various capacities to a number of government authorities and companies. It was also a condition of his employment that all fees paid by such government authorities and companies belonged to the Company and not to him.''
26. The AAT then concluded [at 2100]:
``15. The arrangements made in 1984 in respect of the contract between the Applicant and the Company could be categorised as alterations or amendments to the original contact, or simply as an amplification of the original contract to cater for a set of circumstances not previously contemplated. Nothing turns on this; it is logical in the view of the Tribunal that where the Company is entitled to the full- time services of an employee, it is entitled to any fees referable to any services provided by its own employee utilising the time which properly belongs to the Company.''
27. The AAT referred to the Advance Bank options and said [at 2101]:
``17. The manner in which the Advance Bank options were dealt with may have been influenced by consideration of tax but there was no evidence before me as to what was realised and what the exact tax implications were. It was suggested by Mr Gormly [the Departmental representative] that tax was a consideration as to the manner in which the directors' fees were dealt with; it is possible that tax was considered; however, Part IVA of the Tax Act was not in issue before me. Nor for that matter was there any issue before me as to whether the Advance Bank
ATC 4182options were, so far as the Company was concerned, correctly dealt with.''
28. The AAT then identified the first issue as whether, assuming Mr Service derived the director's fees beneficially, he was entitled to a corresponding deduction under the first limb of s 51(1). The AAT said that it [at 2101]:
``... accepted the existence of a contract between the Applicant and the Company pursuant to which the Applicant was contractually bound to account to the Company for the director's fees.''
29. The AAT noted the Commissioner's argument that ``the assessable income'' for these purposes meant Mr Service's salary, excluding the superannuation payments and the provision of the car, and accordingly, so it was said, the 1984 arrangement did not result in any increase in Mr Service's salary and thus the payment over the fees was not incurred in gaining or producing assessable income, which was derived in any event. The AAT thought that argument mistaken because it ignored the fees themselves which must constitute a part of Mr Service's assessable income. The AAT said [ at 2101]:
``... In effect, the correct analysis is that the Applicant sought the Company's acquiescence to enable him to take up the appointments; the Company in turn granted that acquiescence conditionally upon the payment over of the director's fees. It follows then that the director's fees could not have been derived without that acquiescence and so that relevance and nexus is clearly established...''
30. The AAT went on to consider the alternative argument of a constructive trust and found it to be ``tenable''. The AAT concluded that Mr Service was entitled on either basis to succeed.
The decision of the primary Judge
31. After summarising the facts and the AAT's decision his Honour turned to the first argument, namely whether there was evidence to support the AAT's finding of a contractual obligation on Mr Service to pay over the fees to the Company. Counsel for the Commissioner had argued that the only proper inference from the evidence was that Mr Service and his family had entered into a family arrangement not intended to have contractual force; that there was no evidence to support the finding that Mr Service was contractually bound to account to the Company for the fees; that there were no specific findings that discussions were held with family members who were able to bind the Company; and that insufficient attention was paid to the fact that Mr Service did not account to the Company for the Advance Bank options. Also some of the material on which the AAT relied, especially the statements of Mr Service and his wife, was ``couched in the form of legal conclusions rather than as evidence of primary facts''.
32. His Honour rejected those arguments. He pointed out that the question on an application for judicial review is not whether the Court would necessarily have made the same findings of fact as the AAT. It is whether there was an absence of any evidence to support a material finding of fact:
Australian Broadcasting Tribunal v Bond (1990) 170 CLR 321 at 358,
Attorney General (NSW) v Quin (1990) 170 CLR 1 at 35-36. His Honour thought that there was evidence upon which the AAT could make the findings it did. For example, both Mr Service and his wife gave evidence of discussions within the family amounting to an agreement substantially in the terms found by the AAT. They also gave evidence of their understanding that the arrangement operated as a term of Mr Service's contract of employment. Further, the AAT was entitled to take account of the written statements of Mr Service and his wife, even though they may not have been admissible in a Court applying the rules of evidence: Administrative Appeals Tribunal Act 1975 (Cth) s 33(1)(c). The written statements in the present case could not be said to lack any probative value. In substance his Honour thought that the Commissioner's criticisms constituted an attempt to canvass the merits of the AAT's findings of fact and did not establish an error of law.
33. His Honour then dealt with the argument that the AAT fell into error on the first limb of s 51(1) in that it considered it sufficient that Mr Service could not have derived the director's fees without the acquiescence of the Company. It was not sufficient merely to establish that the expenditure was a prerequisite to the earning of assessable income. After reviewing the authorities his Honour said [at 4892-4893]:
``24. The AAT clearly proceeded on the basis that the acquiescence of the Company to the Taxpayer's taking up of the
ATC 4183directorships pursuant to the contractual arrangement between them, was enough of itself to establish the necessary `relevance and nexus' with the Taxpayer's assessable income in the form of the director's fees. It is true that, on the AAT's findings, the Taxpayer could not engage in the activities producing assessable income without accounting to the Company for those fees. But it was still necessary for the AAT to determine the `essential character' of the expenditure. That question was not foreclosed by the fact that the Taxpayer had chosen to enter an agreement with a Company in which he was the dominant shareholder. As Fletcher [v FC of T 91 ATC 4950; (1991) 173 CLR 1] makes clear, in a case where there is an apparent disproportion between the detriment of the outgoing and the benefit of the income, it may be necessary to weigh all the circumstances, including the direct and indirect objects and advantages which the Taxpayer sought to achieve.
25. That this was such a case is shown by the disparity between the amount of director's fees derived by the Taxpayer (which he on-paid to the Company) and his annual salary from the Company. The AAT acknowledged that `it was possible that tax was considered' in relation to the manner in which director's fees were dealt with. (While it might be thought that this was a rather obvious inference to draw, it is worth noting that the Taxpayer had vehemently denied in evidence that he had paid the director's fees to the Company in order to obtain a tax benefit.) By adopting the approach it did, the AAT prevented itself from considering the significance of the indirect advantages obtained, or objects achieved, by the Taxpayer from the arrangement. In this connection, it is to be remembered that, although the AAT said the Taxpayer's wife could not be described as a `cypher', it also found that the Taxpayer's was the most important voice in the Company and that his desires were not likely to be overruled (a finding more than justified by the evidence). The arrangement between the Taxpayer and the Company, albeit contractual in character (as the AAT found), could hardly be described as an arm's length transaction.
26. I have not overlooked the fact that the Taxpayer gave evidence that his entitlements from the Company were not limited to his relatively modest salary, but included superannuation entitlements and other benefits. Nor have I overlooked the AAT's finding that the Taxpayer's appointments were of benefit, albeit indirectly, to the Company. Doubtless these matters would need to be taken into account in considering the essential character of the expenditure incurred by the Taxpayer. But they do not detract from the need for the AAT to have considered the indirect advantages or objects sought to be achieved by the Taxpayer's agreement to account to the Company for Director's fees.''
34. His Honour rejected the alternative constructive trust argument for two reasons. First, the AAT, in his Honour's view, did not explain why a constructive trust could be imposed where the agreement between the parties apparently fell short of creating an express trust. Secondly, he thought the AAT did not consider why ``good conscience'' required not merely that Mr Service should not retain the fees paid to him, but that it would be unconscionable for him to deny the existence of a trust. His Honour said [at 4894-4895]:
``36. In my opinion, the AAT erred on this aspect of the case by failing to consider whether the particular circumstances of the present case required or permitted the imposition of a constructive trust in accordance with established principle. It was necessary for the AAT, at the least, to identify why it was that principles of equity required that `the director's fees' (to use the AAT's description of the subject matter of the Taxpayer's entitlement) should be held by the Taxpayer on constructive trust for the Company and why those principles required the conclusion that the Taxpayer never derived the fees in his own right. The mere assertion that the Taxpayer could not in conscience retain the director's fees was not sufficient to justify the imposition of such a trust. Accordingly, in my opinion, the AAT erred in law insofar as its decision rested on the conclusion that the director's fees were subject to a constructive trust.''
Arguments on appeal
35. Counsel for the Commissioner argued that his Honour's conclusions on the s 51(1)
ATC 4184and constructive trust issues were correct. In addition, counsel sought to uphold the judgment by contending that there was no evidence to support the AAT's finding as to Mr Service's contractual obligation to pay over the fees to the Company.
36. In essence the Commissioner's arguments on the appeal were those which we have already noted as having been put to his Honour. It is not necessary to repeat them.
37. It was in our opinion clearly open to the AAT to hold that there was a contractual obligation of the kind found. The oral evidence and statements of Mr and Mrs Service - found by the AAT to be truthful and reliable witnesses - supported such a conclusion. Insofar as their written statements were expressed in conclusionary form, that was not the subject of any objection before the AAT.
38. True it is the 1984 discussion relied on was informal and not recorded in any contemporaneous document. This informality is understandable in a setting where shareholders, directors and the party promising to pay over the fees were members of the same family. But to say as much does not deny the existence of an intent to create legal relations.
39. The matter may be tested this way. Assume that the members of the Service family were persons unrelated to each other but that otherwise the nature of the Company and its business were the same. It would make commercial sense for the Company and Mr Service for him to accept the outside directorships offered, bearing in mind that the contacts thereby made would be of value to the Company. However, if Mr Service had previously been a full-time employee of the Company, it would be unreasonable for him to spend substantial time on these outside directorships, keep the fees earned for himself and continue to receive the same remuneration from the Company. The obvious solution, fair to both sides, would be for Mr Service to pay over the fees to the Company. Since on this hypothesis parties engaged in business together, but unrelated by familial ties, are making explicit arrangements about their rights and obligations in relation to future business matters, there is no reason why a Court would do anything other than impute to them an intent to create legal relations. If the employee taking the outside directorships did not pay the fees to the Company, the parties would be taken to have expected that legal remedies would be available. An agreement is nonetheless legally binding because it represents an obvious and fair solution to a question which has arisen in a business setting. And if that is so, why should any different result be reached in the present case merely because the parties were related?
40. We do not think it was mandatory for the AAT, particularly when constituted as it was by a legally qualified member, to go through a check list of formal essentials - offer and acceptance, consideration etc - before making a finding that this was a binding contract.
41. Senior counsel for the Commissioner complained that the AAT failed to take into account relevant considerations, namely that Mr Service did not make over to the Company the 50,000 Advance Bank options or the $79,406 ETP from Managerial and Financial Services Pty Ltd. It is not clear that the Departmental representative who appeared before the AAT relied on these matters in the way now suggested. But it seems at least arguable that if the agreement extended only to ``fees'' then these benefits fell outside that term. But at worst Mr Service may have been (honestly - the contrary was not suggested) in breach of his contract with the Company. If so, the Company would be able to sue him. It by no means follows that the contract was never made - particularly if we also take into account the unchallenged evidence that fees strictly so called were meticulously made over to the Company throughout the four years in question.
42. In our opinion, it was well open on the evidence for the AAT to make the finding it did. Indeed, once the truthfulness of the participants was accepted, an opposite conclusion would be surprising.
Were the payments made by Mr Service allowable deductions under s 51(1) of the Act?
43. For Mr Service to have succeeded before the AAT and for Mr Service to succeed in his appeal before us it was and is only necessary for him to show that if he received the fees beneficially and not as trustee he was entitled to a deduction under s 51(1) of the Act for an amount equal to the fees which he paid to the Company. It then becomes unnecessary to determine whether the fees were held by him as constructive trustee and for that reason should not have been included in his assessable
ATC 4185income. Accordingly we propose to consider the s 51(1) question first.
44. Section 51(1) of the Act provides as follows:
``All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.''
45. The section is the general deduction provision applicable to losses or outgoings which have the necessary connection with the derivation of assessable income. It is expressed, and necessarily expressed, in language of some generality for it deals with a myriad of circumstances. It is designed to permit deductibility of what, in a case such as the present, may be termed ``working expenses''.
46. As has often been noted, for a loss or outgoing to be deductible it is necessary that it fall within one of the two positive limbs of the section. In the present case that means that the loss or outgoing must be one which is incurred ``in gaining or producing the assessable income''. Further, to be deductible the loss or outgoing must not fall within the negative limbs of the section as being capital or of a capital nature, private or domestic expenditure or incurred in the gaining or producing of exempt income.
47. The Commissioner did not advance before the AAT an argument that any of the negative limbs of the section had any application. The issue which the AAT was called upon to decide, and which the AAT decided, in favour of Mr Service was solely whether the payments Mr Service made to the Company were incurred by him in gaining or producing his assessable income.
48. It is perhaps not surprising, given the work which the section has to do, and the wide variety of situations which may give rise to a claim for a deduction under it, that s 51(1) has given rise to a large number of cases, which in turn have given rise to a considerable body of jurisprudence. Various tests have been propounded and applied in the resolution of the particular case which arose for decision. This is particularly so in the context of a consideration of the words ``incurred in gaining or producing the assessable income''. But it is useful to recall the words of Williams, Kitto and Taylor JJ in
Lunney v FC of T; Hayley v FC of T (1958) 11 ATD 404 at 411; (1958) 100 CLR 478 at 496 when speaking of the section:
``... The language is simple enough and, in the main, little difficulty is encountered in recognising those items... which qualify as deductions. But in the nature of things it has been impossible to devise, as a substitute for the words of the section, a simple formula which will readily and precisely mark the limits of the operation of the section.''
49. While the tests propounded and formulae suggested in the cases are clearly helpful and may often be determinative, they clearly can not replace, nor were they intended to replace, the language of the subsection itself. Stephen J said in
Handley v FC of T 81 ATC 4165 at 4169; (1981) 148 CLR 182 at 189:
``The text of s 51(1) itself provides the only criterion of deductibility.''
Ultimately, the issue for the AAT or a court will involve the resolution of what is a factual issue, namely whether the loss or outgoing was incurred in gaining or producing the assessable income. This having been said, it is useful to note briefly a number of propositions which can be said to have been established by the cases.
50. First, it is obvious enough that the language of the section requires there to be a connection between the loss or outgoing on the one hand and the assessable income on the other. This does not mean that it is necessary to find a connection between the loss or outgoing on the one hand and particular items of assessable income on the other. Rather, it has been said, the expenditure has to be ``incidental'' and ``relevant'' to the operations or activities from which the assessable income is produced:
W Nevill & Co Ltd v FC of T (1937) 4 ATD 187 at 196; (1937) 56 CLR 290 at 305,
Ronpibon Tin NL and Tongkah Compound NL v FC of T (1949) 8 ATD 431; (1949) 78 CLR 47,
Charles Moore & Co (WA) Pty Ltd v FC of T (1956) 11 ATD 147 at 148; (1956) 95 CLR 344 at 350. That this is so must clearly follow from the fact that no assessable income may in fact ever be derived by a taxpayer yet an amount outlaid may be an allowable deduction: cf
FC of T v Smith 81 ATC 4114
ATC 4186at 4117; (1981) 147 CLR 578 at 585-586 where Gibbs CJ, Stephen, Mason and Wilson JJ said:
``The section does not require that the purpose of the expenditure shall be the gaining of the income of that year, so long as it was made in the given year and is incidental and relevant to the operations or activities regularly carried on for the production of income. What is incidental and relevant in the sense mentioned falls to be determined not by reference to the certainty or likelihood of the outgoing resulting in the generation of income but to its nature and character, and generally to its connection with the operations which more directly gain or produce the assessable income.''
51. Secondly, the reference in the subsection to ``the assessable income'' does not, therefore, relate to the income of a particular year of income any more than it relates to a particular item of income, but to assessable income generally: cf
AGC (Advances) Ltd v FC of T 75 ATC 4057 at 4071; (1975) 132 CLR 175 at 196-198 per Mason J.
52. Thirdly, where the subsection refers to the loss or outgoing being incurred in gaining or producing the assessable income, this means ``in the course of'' gaining or producing the assessable income:
Amalgamated Zinc (de Bavay's) Ltd v FC of T (1935) 3 ATD 288 at 293; (1935) 54 CLR 295 at 303 per Latham CJ, at ATD 298; CLR 309 per Dixon J.
53. Fourthly, the question whether a particular outgoing was incurred in gaining or producing the assessable income looks to the ``essential character'' of the expenditure itself, rather than to the purpose for which an item of expenditure has been incurred. Whether or not the ``essential character'' test had its origin in Charles Moore, as the learned authors of CCH Australian Federal Tax Reporter (¶23-100) suggest, the idea of ``essential character'' was given significance in Lunney in the context of a claim for the deduction of travelling expenses from home to work. Rejecting the claim, Dixon CJ, Williams, Webb, Fullagar and Kitto JJ took the view that such expenditure did not have the essential character of an income producing expense, notwithstanding that it was necessary to incur that expenditure to gain assessable income. A corollary of that case is that the fact that expenditure may be a prerequisite of gaining or producing assessable income does not, of itself, make that expenditure deductible:
FC of T v Cooper 91 ATC 4396 at 4401-4402; (1991) 29 FCR 177 at 184 per Lockhart J and at ATC 4412; FCR 198 per Hill J.
54. Some kinds of expenditure clearly do not have the essential character of what one might call a working expense, or more accurately, expenditure incurred in gaining or producing assessable income. So, for example, deductions have been disallowed for interest or rent paid in connection with a home used, in part, as an office:
FC of T v Forsyth 81 ATC 4157; (1981) 148 CLR 203 and Handley. In these cases, as in Cooper, the essential character test had relevance to deciding whether the expenditure in question was excluded from deductibility under the exclusory limbs of the subsection. In these cases the expenditure was of a private or domestic nature, being expenditure on the home or on food.
55. There is no reference in that part of the subsection with which the present appeal is concerned to ``purpose''. This is not to say that the purpose for which the expenditure was incurred is necessarily irrelevant:
Fletcher & Ors v FC of T 91 ATC 4950 at 4957; (1991) 173 CLR 1 at 17-18. We shall return to that case later. It suffices to say that purpose may, in a particular case be relevant to the question of the characterisation of the expenditure. Generally, however, when cases such as Lunney have referred to characterisation, the reference has been to the objective characterisation of the expenditure.
56. The relationship between objective and subjective purpose has been considered by a Full Court of this Court in
Magna Alloys & Research Pty Ltd v FC of T 80 ATC 4542; (1980) 49 FLR 183. In that case Deane and Fisher JJ expressed a twofold test in the following terms at ATC 4561; FLR 210:
``... whether the outgoing was reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of that business and, if so, whether those responsible for carrying on the business so saw it.''
Although their Honours were writing of the second (business) limb of the subsection, there seems no reason to believe that what they said would not apply to the first (income production) limb. So, in Magna Alloys, the fact that the directors of a company caused the company to
ATC 4187incur expenditure with the dominant motive of protecting their own position, rather than for the benefit of the company, did not preclude deductibility where objectively the expenditure was reasonably capable of being seen as appropriate for the business ends of the company and was so seen by the directors.
57. It would follow from Magna that the fact that expenditure was incurred in circumstances where a taxpayer had as a purpose, or even a dominant purpose, the purpose of reducing tax the expenditure would be deductible, so long as objectively the outgoing was reasonably capable of being seen as directed towards the gaining and production of assessable income and was so seen by the taxpayer. Section 51(1) is not a section as such directed at tax avoidance. There is a specific Part of the Act (Part IVA) which can operate to disallow as a deduction expenditure which otherwise qualifies as a deduction under s 51(1). If s 51(1) operated to disallow a deduction in circumstances where there was a purpose of avoiding tax or even a dominant purpose of avoiding tax then Part IVA would have no operation to the case of a deduction otherwise allowable under s 51(1). However there is no suggestion that Part IVA has no operation in such a case. So, as the High Court pointed out in
John v FC of T 89 ATC 4101; (1989) 166 CLR 417, the finding that an outgoing was for trading stock and was incurred in carrying on a business for the purpose of gaining or producing assessable income denied the possibility that the outgoing was private expenditure and not deductible, even where the arrangement in question was instigated to obtain a tax advantage.
58. However, this is not to say that purpose is irrelevant to the question of characterisation, that is to say irrelevant to the question whether the outgoing was incurred in gaining or producing assessable income. Where a taxpayer borrows at a normal rate of interest but lends at a low rate of interest to persons related to him or her and thereby seeks a deduction the objective circumstances characterise the expenditure as not in whole incurred in gaining or producing the assessable income, in that case the low rate of interest:
Ure v FC of T 81 ATC 4100; (1981) 50 FLR 219. Also see, in the analogous case of premises rented at a low rate of rent:
Madigan v FC of T 96 ATC 4640; (1996) 68 FCR 12. In these cases only a proportion of the outgoing was allowed as a deduction, the subsection permitting of apportionment.
59. It is clear from these cases, as we have already pointed out, and in particular from Fletcher, that subjective purpose will have in some cases, at least, a role in the question of characterisation, that is to say a role in determining whether the loss or outgoing is incurred in gaining or producing the assessable income. In Fletcher Mason CJ, Brennan, Deane, Dawson, Toohey, Gaudron and McHugh JJ pointed out that it will be commonly possible to characterise an outgoing as being wholly of a kind falling within the subsection without reference to subjective purpose or motives. Their Honours said at ATC 4957-4958; CLR 18:
``Nonetheless, it is commonly possible to characterise an outgoing as being wholly of the kind referred to in the first limb of s 51(1) without any need to refer to the taxpayer's subjective thought processes. That is ordinarily so in a case where the outgoing gives rise to the receipt of a larger amount of assessable income. In such a case, the characterisation of the particular outgoing as wholly of a kind referred to in s 51(1) will ordinarily not be affected by considerations of the taxpayer's subjective motivation. If, for example, a particular item of assessable income can be earned by making a lesser outgoing in one of two possible ways, one of which is a loss or outgoing of the kind described in s 51(1) and the other of which is not, it will ordinarily be irrelevant that the taxpayer's choice of the method which was tax deductible was motivated by taxation considerations or that the non- deductible outgoing would have been less than the deductible one. In such a case, the objective relationship between the outgoing actually made and the greater amount of assessable income actually earned suffices, without more, to characterise the whole outgoing as one which was incurred in gaining or producing assessable income. If the outgoing can properly be wholly so characterised, it `is not for the Court or the commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent'.''
60. However, their Honours continued at ATC 4958; CLR 18:
``The position may, however, well be different in a case where no relevant assessable income can be identified or where the relevant assessable income is less than the amount of the outgoing. Even in a case where some assessable income is derived as a result of the outgoing, the disproportion between the detriment of the outgoing and the benefit of the income may give rise to a need to resolve the problem of characterisation of the outgoing for the purposes of the sub-section by a weighing of the various aspects of the whole set of circumstances, including direct and indirect objects and advantages which the taxpayer sought in making the outgoing. Where that is so, it is a `commonsense' or `practical' weighing of all the factors which must provide the ultimate answer. If, upon consideration of all those factors, it appears that, notwithstanding the disproportion between outgoing and income, the whole outgoing is properly to be characterised as genuinely and not colourably incurred in gaining or producing assessable income, the entire outgoing will fall within the first limb of s 51(1) unless it is either somehow excluded by the exception of `outgoings of capital, or of a capital, private or domestic nature' or `incurred in relation to the gaining or production of exempt income'. If, however, that consideration reveals that the disproportion between outgoing and relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective and that part only of the outgoing can be characterised by reference to the actual or expected production of assessable income, apportionment of the outgoing between the pursuit of assessable income and the pursuit of that other objective will be necessary.''
61. It may be noted that their Honours express themselves in language that makes it clear that it will be only where the circumstances are such that the outgoing is only colourably and not genuinely incurred in gaining or producing assessable income that issues of disallowance of the deduction in whole or in part will arise. That, on its face, may well have been the case in Fletcher. A result of the arrangement, which involved the taxpayers borrowing, at interest (payable upfront), large amounts to purchase an annuity substantially payable in the future was that the taxpayers claimed a large deduction at the commencement of the arrangement and, assuming the arrangement proceeded, only derived income a long way in the future. However, the arrangement included a mechanism whereby it could be aborted and no income at all derived. It is for that reason that the Court stated the issue of fact, left undetermined in that case, to be whether the outgoings were incurred in the expectation that the plan would run its course, or whether it was the intention of any relevant person that the scheme be aborted. The judgment of the Court makes clear that if the expectation was that the plan would run its course then the deduction would (subject to the anti-avoidance provisions of the Act) be available. This would follow, notwithstanding that there was an obvious tax advantage to the taxpayers, and the inference would have been inescapable that the taxpayers were motivated by this tax advantage to enter into the arrangement. It is significant that the High Court did not direct an enquiry into whether the taxpayers were motivated in whole or in part by tax considerations. Rather the enquiry was directed towards whether the arrangement was one where no assessable income would be derived in the later years.
62. Likewise, a taxpayer who employs a family company to perform services which are directed at the gaining by the taxpayer of assessable income does not lose the deduction otherwise available under s 51(1) because, by employing the company, he or she might benefit members of the family who are shareholders. Enquiry into the subjective motivation of the taxpayer in such a case will be irrelevant if the objective circumstances are such that the outgoing is one incurred in the course of the taxpayer's income producing activity.
63. It appears to have been the position of the Commissioner in the AAT (and, with some hesitation, before us) that in an ordinary case a taxpayer employed by a company at arm's length and who was required by that company to pay director's fees to it under a contract similar to that found by the AAT to have been entered into here between Mr Service and the Company, would be entitled to a deduction under s 51(1). What was said to differentiate the circumstances of the present case from the ordinary case were four matters. These were
ATC 4189described by senior counsel for the Commissioner as follows:
``... the purpose of the taxpayer, the flavour of income splitting, the fact that the directors' fees significantly exceeded his remuneration from the Company, the fact that the other companies (which paid the fees) were not aware of the appellant's arrangements with the Company and the fact that the options and the eligible termination payment were not dealt with in the same way as the other amounts.''
It was also said to be necessary that the AAT take into account the fact that Mr Service was not bound to continue to work for the Company in the event that it had refused to ``consent'' to the appellant taking up the relevant appointments.
64. The fact that the company to whom the payment was made was one in which Mr Service's family or at least most of them were shareholders (Mr Service himself apparently held 60 percent of the shares) has of itself no relevance if the payment was made by Mr Service in gaining or producing his assessable income. We assume that is what is meant by ``the flavour of income splitting'' in the submissions. Nor could the fact that the companies, of which Mr Service was a director, were unaware of the arrangement between Mr Service and the Company have any relevance.
65. The matter upon which the greatest reliance was placed was what was said to be the ``disproportion'' between the quantum of the payment Mr Service made to the Company and the salary which Mr Service earned from the Company. Indeed this was regarded as significant by the learned primary Judge. That there was a discrepancy between the director's fees (in the year of income 1996, the director's fees amounted to $183,000) and the salary of $80,000 is true, although it is not true that this was the only remuneration which Mr Service received. Mr Service had the use of a large and expensive car and large contributions (between $100,000 and $200,000 a year) were made for superannuation benefits for him in the future. The car would probably not have been included in his assessable income but liable to fringe benefits tax in the hands of the Company. In the event of his retirement superannuation benefits would likely be included in his assessable income. The evidence did not explore the terms of the superannuation scheme of which Mr Service was a member. Nothing was put to Mr Service to suggest it would not have been assessable. On the argument we are discussing the fees themselves are likewise assessable income which he has derived, although paid over to the Company.
66. So far as purpose is concerned Mr Service, whom the AAT regarded as ``impressive and altogether worthy of credit'' and whose evidence the AAT accepted, denied that he paid the amounts to the Company ``in order to get a tax benefit''. Having accepted this evidence the AAT could not have done otherwise than to find that tax avoidance was not the purpose or even the dominant purpose of the payment. It was never put to him that he paid the amounts to benefit members of his family, if that is what is meant by ``the flavour of income splitting''. Indeed most members of the family were, according to the evidence, actively employed in the business of the Company.
67. The fact that the options and ETP were dealt with differently (and no question was put to Mr Service relating to the eligible termination payment anyway) hardly seems relevant to the issue in question. Indeed the AAT noted that there was no issue raised before the AAT as to whether options granted to Mr Service by Advance Bank were improperly dealt with. No suggestion to this effect was put to Mr Service in cross-examination.
68. It was open to the AAT on the evidence to find, and the AAT did find on that evidence, that the amounts paid by Mr Service to the Company were outgoings incurred by him in gaining or producing his assessable income and in our view no error of law has been shown to have been made by the AAT in reaching its conclusion.
69. As we have noted earlier the learned primary Judge was of the view that the AAT erred in failing to make findings concerning the direct and indirect objects which Mr Service sought to achieve. It was never put to Mr Service in the AAT that there were any direct or indirect objects he had sought to achieve other than the obtaining of a tax benefit. Mr Service denied that this was his purpose in making the payment, although the AAT noted that it was possible that tax was considered. It is difficult to see how the AAT, once it accepted Mr Service's evidence, could have made any finding other than the findings it did make,
ATC 4190namely that Mr Service was bound to pay the amounts pursuant to the contract of employment he had with the Company, that he derived assessable income of salary and potential assessable income in the form ultimately of superannuation benefits, that the director's fees were of benefit to the Company in the contacts they produced and that the payments were not made to obtain a tax benefit, whether or not tax was considered, but to obtain the Company's consent to Mr Service accepting the directorships and thus devoting less time to the affairs of the Company.
70. We should add that, to the extent that there was a disproportion between the fees and assessable income, there was nothing in the evidence to suggest that the case was one where the incurring of the outgoing could be characterised as not genuinely but rather colourably incurred in gaining or producing assessable income so as to fall within the principle discussed in the High Court in Fletcher and thus not be an allowable deduction under s 51(1) of the Act.
71. Before us senior counsel for the Commissioner sought to argue that the amounts in question represented outgoings of a private or domestic nature. It is clear from a perusal of the transcript that this was not a matter raised in the AAT. Senior counsel for Mr Service objected to the matter being raised in this Court for, had the matter been raised in the AAT (the sole arbiter of fact), evidence might have been adduced on the issue. It is also hard to see that the matter was the subject of the appeal to this Court at first instance. Nor does it seem to be the subject of the Notice of Contention filed by the Commissioner on the appeal. At best it is said to be implied by the reference to s 51(1) not permitting the deduction. We would refuse leave to raise the matter at this late stage. However, we should say that on the facts as found by the AAT, it is difficult to see how the argument could be successful.
72. It follows in our opinion that we are of the view that the learned primary Judge erred in holding that the matter should be remitted to the AAT to make findings with respect to indirect objects and advantages and then to weigh these in determining the essential character of the outgoings claimed. The appeal should accordingly be allowed, the orders of the primary Judge set aside and in lieu thereof it should be ordered that the application to this Court by the Commissioner should be dismissed. The Commissioner should pay the costs of the appeal and at first instance.
73. As we have noted, because the payments made by Mr Service to the Company were allowable deductions it is strictly unnecessary to consider the alternative argument that at the time the fees were derived they were the subject of a constructive trust and not assessable income of Mr Service. In our view s 25(1) of the Act only brings to tax income which is beneficially derived: see
Zobory v FC of T 95 ATC 4251; (1995) 64 FCR 86.
74. The AAT found that there was a contract between Mr Service and the Company pursuant to which Mr Service was obliged to account to the Company for the fees. Where there is such a contract, the relationship between the parties may be that of trustee and beneficiary, or debtor and creditor. Which it is depends upon the precise terms of the arrangement and the intention of the parties as manifested by the terms of their arrangement.
75. There was evidence before the AAT that it was a term of Mr Service's employment that the fees ``belonged to the Company'' and not to Mr Service. There was also evidence that Mr Service was ``obliged to forward any payment for director's fees'' to the Company. In fact, cheques for the fees were made payable to Mr Service and endorsed by him in favour of the Company.
76. That evidence suggests at least the possibility of an express trust of the fees in favour of the Company. However, the AAT did not make a finding as to whether or not there was an express trust. The AAT embarked upon a consideration of that question, but did not pursue it to finality. Rather, the AAT, at least tentatively, accepted that Mr Service derived the fees upon a constructive trust for the Company, upon the ground that Mr Service could not in good conscience have retained the fees which he received, having regard to the contract which obliged him to pay over those fees to the Company.
77. His Honour found that the AAT erred in law, insofar as its decision rested on the conclusion that the fees were subject to a constructive trust.
78. Before the issue of constructive trust would arise it would be logically necessary to
ATC 4191define first whether an express trust would be found from the intention of the parties as reflected in the terms of the conversations found to constitute a contract.
79. If, as we have held, the finding of contract must be upheld there would be a difficulty in finding that the monies received by Mr Service were the subject of a constructive trust, for if the relationship between Mr Service and the Company did not rise above that of debtor and creditor, there would be nothing unconscientious about his applying the director's fees for his own purposes.
80. In view of the conclusion which we have reached in relation to s 51(1) of the Act and the lack of specificity in the AAT's findings, it is not necessary for us to pursue this aspect of the matter further.
THE COURT ORDERS THAT:
1. The appeal be allowed.
2. The orders of the primary Judge be set aside and in lieu thereof it be ordered that:
- 1. The application by the Commissioner is dismissed.
- 2. The Commissioner pay the costs of the application.
3. The Commissioner pay the appellant's costs of the appeal.