BJ McCabe M

Administrative Appeals Tribunal


Decision date: 4 September 2002

BJ McCabe (Member)


1. The applicants have been engaged in a wide-ranging dispute with the Commissioner over their liability to pay tax in the years ending 30 June 1992, 1993 and 1994. This decision relates to one aspect of that dispute: whether a partnership comprised of the applicants should be able to distribute losses that were inflated by the decision to treat salaries paid to the working partners as a partnership expense.

2. The respondent acknowledged at the outset that the applicants were not being accused of tax avoidance. Rather, it was a dispute over the proper characterisation of payments made to two of the partners in the business, and the implications of that characterisation for the taxation liability of all the applicants.

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The material before the Tribunal

3. Several of the applicants gave evidence in person: the patriarch of the Scott clan, Mr Donald Sutherland Scott (``DSS''); his sons, Donald Ivor Scott (``DIS''), Andrew Scott, Mark Scott and (by telephone) Christopher Scott. The applicants also called Mr Christopher Costanzo, a registered tax agent. Mr Costanzo's firm now employs DSS. The applicants also provided the Tribunal with statements from each applicant and Mr Costanzo. The applicants were represented by their mother, Mrs Clara Scott, who was the registered tax agent connected with the Scott family partnership's business of preparing tax returns. Mr Stunden of counsel represented the respondent. The Commissioner called one of his officers, Mr Ian Kennedy. Mr Kennedy was the officer responsible for an audit of the Scott family partnership. The Tribunal was also provided with the s 37 documents.

The facts

4. The applicants were members of a partnership (the Scott family partnership) that carried on the business of processing income tax returns. Mrs Scott, wife of DIS and mother of the other applicants, was a registered tax agent who contracted with the partnership for the provision of her services. She was paid a comparatively modest retainer of $25,000 each year for her services. The business was carried on from two locations in the Brisbane suburbs. Although Mrs Scott was responsible as a registered tax agent for examining the returns prepared by the firm, the bulk of the work was apparently carried out by, or under the direction of, two of the partners: DSS and another son, Allan Martin Scott. DSS and Allan worked full- time in the partnership business, although its work tended to be ``lumpy'' in the sense that work tended peaked in the period following 30 June each year when personal income tax returns were due. They claimed they were entitled to be paid a salary, even though they were equity partners in the business.

5. The other applicants did not work in the business. They were professional men: DIS is a geologist, Andrew a dentist, Mark and Christopher are medical practitioners. They are described throughout the documents as ``equity'' partners. Apparently the equity contribution in each case was a contribution in kind: various items they owned, like computers, were given to the partnership for its use. There was also evidence that at least some of the applicants who received tax refunds would not collect the refunds from the firm. They would allow the money to be used for the purposes of the business. They also provided loans. As professional men, the Scott brothers who did not work in the business were able to secure credit cards in their own names that they would use to pay business expenses.

6. The evidence about the equity contributions in particular was vague. The Scotts are a tightly-knit family. They appeared not to make a clear distinction between their individual affairs. They looked after each other. In particular, they seemed happy to go along as individuals with the plans of DSS and DIS, and they blithely relied on the advice of Mrs Scott and DSS in particular. It followed that several of the non-executive partners tended to have only a vague idea of the operations of the business, and their contributions to it. The close relationship became frustratingly evident during the hearing when Mr Stunden's questions of a witness were sometimes greeted with a chorus of answers from around the hearing room.

7. The partnership was established on 1 July 1992, although the written partnership agreement was not executed until 10 June 1996. The applicants say the delay was mainly the fault of their solicitors who failed to prepare appropriate documentation. In any case, they contend, a written agreement was unnecessary. That is true: the question of whether or not a partnership exists is a question of law: see s 5 of the Partnership Act 1891 (Qld). If the relationship between the parties bears the characteristics of a partnership, it will be deemed to be a partnership however the parties might view themselves: see
Wiltshire v Kuenzli (1945) 63 WN 47 at 51 per Roper J. The Commissioner did not seriously challenge the claim that the partnership was formed in 1992, although Mr Stunden invited me to infer the decision to formalise the agreement in 1996 was prompted by concerns about the ATO audit, and the need to clarify the position of the executive partners and their entitlement to receive a salary.

8. The members of the Scott family who participated in the partnership do not appear to have engaged in a detailed discussion at the outset about the amount of DSS's salary. DSS had no experience in the business of preparing tax returns, although he had learned the

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rudiments of bookkeeping during his service in the Army. The Scotts apparently arrived at an hourly rate for DSS that was based in part on the payments made by competitors to junior tax return preparers. The payment to DSS apparently included a premium for the extra marketing and management work that he was to undertake.

9. The cross-examination of DSS in particular focused on the nature of payments he received from the partnership that were debited to a salary account. DSS said in his evidence that he did not have a bank account in his own name - apparently he has had an aversion to using banks since his bankruptcy in 1990. That complicated matters. DSS could not be paid by cheque, as he had no bank to meet the order.

10. The salary ledger entries did not on their face disclose a regular pattern of payments that one might expect of salary payments. On closer examination, however, the ledgers disclosed a number of regular payments. It turns out that many of these entries were in respect of cheques drawn in favour of creditors of Andrew Scott. The payments were made by the partnership at DSS's direction to Advance Bank to meet Andrew's mortgage repayments, to a finance company in respect of his car repayments, and in favour of the providers of Andrew's Mastercard and Visa card. But that was not apparent from the ledgers: the destination of the payments had to be explained by DSS in his evidence.

11. DSS said he was simply engaged in the practice of salary sacrifice, or salary packaging. He said he was entitled to direct that his salary be paid to anyone he desired. He said this was a normal practice: employees routinely directed their employer to pay their mortgage or their car repayments. In this case, he said, he directed that portions of his salary be paid to Andrew in settlement of separate, private obligations that were no affair of the partnership. There was also some question over the use of the petty cash account. Some of DSS's salary payments went into the petty cash account, from where he apparently drew upon them to cover his own expenses.

12. The Commissioner did not dispute that DSS was entitled to direct that his salary be paid to other persons. The respondent's complaint was the way in which the payments were recorded - or, more accurately, the failure to transparently record the destination of the payments. Concerns were also raised by about the way in which the petty cash account was being used. The respondent added there was no provision in the partnership agreement for the payments to be treated as salary - there being no written partnership agreement prior to 1996. The Commissioner relied on the opinion of Mr Kennedy that the ledgers did not appropriately record the payments and their purpose. Mr Kennedy also criticised the use of the petty cash account and some other aspects of the accounting. Mr Costanzo conceded he would advise his clients to provide a more transparent and accurate description of payments like those made by the Scott partnership.

The applicant's case

13. The applicants argued the payments of salary to DSS and Allan Scott were properly treated as expenses of the partnership. Since the partnership's total expenses (including payments of salary) exceeded the revenue of the partnership in the relevant period, the partnership generated losses that were available for distribution amongst all the partners. The individual partners were then free to offset those losses against their own income from other sources. They rely on Taxation Ruling IT 2218.

14. The Commissioner says the payments of salary cannot be treated as partnership expenses contributing to a distributable loss in this case. He does so on three bases:

  • • A partnership cannot as a matter of law pay a salary in the true sense to a partner. Payments that are sometimes characterised as salaries are in reality advance drawings by individual partners. As such they are not properly characterised as an expense of the partnership giving rise to a loss.
  • • IT 2218 does not say the payment of salaries to a partner may be treated as an expense of the partnership. In any event it is not binding on the Commissioner in this case. (Mr Stunden noted the ruling has subsequently been withdrawn).
  • • Even if the Commissioner is bound by the ruling in IT 2218, the Scotts do not satisfy its terms. The ruling requires that salary payments be made bona fide, be reasonable in their amount and be provided for in the terms of the partnership agreement.

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(a) How should a payment of ``salary'' to a partner be treated at law?

15. Mrs Scott for the applicants conceded at the outset of the hearing that a partner could not at law be paid a salary in ordinary sense. That is just as well, since the argument to the contrary is untenable.

16. A partnership is not a legal entity with its own personality and existence independent of its members. The expression ``partnership'' is used to describe a relationship amongst persons that conforms to the definition contained in the Partnership Act. It is, in essence, a mutual agency relationship in which each partner is both a principal and an agent for the other partners. While an individual partner may be both a principal and an agent, he cannot be a party to a contract of employment with the partnership, since that would mean he was entering into a contract with himself. That is a legal nonsense. The position is different in the case of a company. It has been acknowledged in cases like
Lee v Lee's Air Farming Ltd [1961] AC 12 that the sole shareholder and director of a company may be an employee of that company, even though the officer would be required to negotiate the contract in his capacity as an officer acting for the company with himself in his capacity as an employee. The company's position is different because a company is recognised at law as a legal person with a separate existence from its members and officers. While partnerships have some of the attributes of a legal person (for example, they are entitled to sue in the name of the firm), they do not have a separate existence. The partnership is regarded at law as a collection of individuals.

17. How, then, does one characterise the payments bearing the label ``salary'' that are made to a partner? Mathew LJ explained in
Ellis v Joseph Ellis and Co [1905] 1 KB 324 that:

``the arrangement between him and his co- partners as to the payment of wages to him was really an agreement with regard to the mode in which accounts were to be taken between the partners, and to the share of profits to be received by him in excess of that received by the other partners in consideration of the work done by him.''

18. In other words, the payments were drawings. They should not have been treated as expenses like the cost of employing any other person. If they were not to be treated as expenses, they should not have contributed to a loss that was available for distribution at the end of the financial year.

19. The applicant's claim must therefore fail as a matter of law. But the applicants contend that even if the partnership could not employ a partner, the effect of the tax ruling in IT 2218 was to create an exception to the general principles applicable in tax cases. It therefore becomes necessary to consider the effect of the ruling.

(b) What is the effect of IT 2218?

20. IT 2218 does not say that a salary paid to a partner may be treated as an expense. Paragraph 4 of the ruling provides:

``... a salary paid to a partner does not represent salary or wages for the purposes of the tax instalment deduction provisions in Div 2 of Pt VI of the Act and is not in itself a loss or outgoing within the meaning of sub-sec 51(1)...''

21. The ruling goes on to say payments of salary might be taken into account when determining the recipient's interest in the partnership's net income (or loss) relative to the other partners. That is not the same as saying the payments may be taken into account for determining the amount of the net income itself. The Commissioner made that point in IT 2218W, his notice withdrawing the ruling. Although the withdrawal occurred after the events in question here and is therefore not relevant to the Tribunal's decision, the Commissioner's observation in the notice correctly interprets the ruling.

22. It follows that IT 2218 does not assist the applicants. But even if it did offer some prospects for relief, Mr Stunden says the Commissioner is not bound by the ruling. He is right. The Commissioner has a statutory obligation to apply the tax laws. His own conduct - no matter how unfortunate - cannot operate as an estoppel against him in the assessment and collection of the correct amount of tax: see, for example,
FC of T v Wade (1951) 9 ATD 337 at 344; (1951) 84 CLR 105 at 117 per Kitto J; see also
Bellinz Pty Limited & Ors v FC of T 98 ATC 4634; (1998) 84 FCR 154.

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23. The tax laws do create a species of statutory estoppel in the form of a binding ruling, but this is not a binding ruling. In any case, the evidence suggested the Scotts were not aware of IT 2218 when they entered into the partnership agreement in 1992. It seems they may not have become aware of it until after the ATO audit.

24. The Commissioner is entitled to disregard IT 2218. As I have already indicated, I do not think that IT 2218 would present a difficulty for him in this case, even if it were binding.

(c) Were the salary payments made bona fide, in a reasonable amount and in accordance with the terms of the partnership agreement?

25. I turn to the argument that formed the heart of the applicants' case, even though I have already concluded their application must fail as a matter of law. The applicants said the payments of salary were made bona fide, were reasonable in amount and paid in accordance with the partnership agreement. Even if I accepted that IT 2218 would permit them to treat the payments as expenses, I am not satisfied that the applicants were able to meet all the criteria laid down in paragraphs 5 and 6 of the ruling.

26. Mr Costanzo said the salary paid to DSS was reasonable. The respondent sought to cast doubt on that by arguing DSS was essentially unskilled and paid much more than Mrs Scott who was the registered tax agent responsible for supervising him. I am not satisfied that he was overpaid in light of his extra responsibilities for managing and promoting the venture.

27. There was no evidence that payments of salary (in the technical sense of that term) were provided for in the partnership agreement entered into in 1992. DIS had a vague recollection of discussing the payment of a salary to DSS at the time the partnership was being negotiated in 1992, but I am not satisfied the other partners had reached a consensus about the treatment of payments to DSS and Allan. It follows that I conclude the payments were not authorised by the partnership agreement, which puts them outside the terms of what the applicants say IT 2218 provides.

28. I am also satisfied there was a lack of bona fides in the recording of the payments. I do not mean to say there was dishonesty. Rather, I find there was a want of rigour in the recording and characterisation of the payments to DSS in particular. I accept that he may have thought he was engaged in the legitimate practice of salary sacrifice. But the evidence from Mr Kennedy (and from Mr Costanzo) made it clear the ledgers did not accurately reflect what was occurring. Payments cannot be made bona fide in my view if the ledgers do not accurately record the purpose and destination of those payments. The fact that the destination and purpose were legitimate is beside the point.


29. For the reasons given, I affirm the objection decisions under review.

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