• The impact of this case on ATO policy is discussed in Decision Impact Statement: VCK and Federal Commissioner of Taxation (Published 16 March 2007).

CASE 19/2006

Members:
BH Pascoe SM

Tribunal:
Administrative Appeals Tribunal

MEDIA NEUTRAL CITATION: [2006] AATA 1073

Decision date: 12 December 2006

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BH Pascoe (Senior Member)

1. These applications are for review of decisions of the respondent, Commissioner of Taxation, to disallow objections against notices of amended assessment for the year ended 30 June 2002, and 2003 and a notice of assessment for the year ended 30 June 2004. The objections were against the disallowance of deductions claimed in respect of boat hire activity by the applicant.

2. At the hearing the applicant was represented by Mr M. Flynn of counsel and the respondent by Mr M. Moshinsky of counsel. Evidence was given by the applicant, his partner, an accountant, Mr M. Gleeson and a boat builder, Mr J. Chipp. Pursuant to s 1472E of the Taxation Administration Act 1953 the applicant requested that the hearing be in private.

3. In each of the three relevant years the applicant disclosed in his income tax returns amounts of income from hire of his boat and claimed expenses relevant thereto. Pursuant to s 26.50 of the Income Tax Assessment Act 1997 (the Assessment Act), the respondent disallowed the expenses incurred of:

Year ended 30 June 2002	$83,625
Year ended 30 June 2003	$91,525
Year ended 30 June 2004	$68,316

4. Section 26.50 provide, so far as is relevant to this matter:

• "(1) You cannot deduct under this Act a loss or outgoing to the extent you incur it:
  • (a) to acquire ownership of a *leisure facility or boat; or
  • (b) to retain ownership of a *leisure facility or boat; or
  • (c) to acquire rights to use a *leisure facility or boat; or
  • (d) to retain rights to use a *leisure facility or boat; or
  • (e) to use, operate, maintain or repair a *leisure facility or boat; or
  • (f) in relation to any obligation associated with your ownership of a *leisure facility or boat; or
  • (g) in relation to any obligation associated with your rights to use a *leisure facility or boat.

• However, there are exceptions (see subsections (3), (4), (5), (6) and (8)). …

• …

• (5) Subsection (1) does not stop you deducting a loss or outgoing for a boat if at all times in the income year you:
  • (a) hold the boat as *trading stock for sale in the ordinary course of a *business that you carry on; or
  • (b) use the boat (or hold it) mainly for letting it on hire in the ordinary course of a *business that you carry on; or
  • (c) use the boat (or hold it) mainly for transporting for payment in the ordinary course of a *business that you carry on, the public or goods; or
  • (d) use the boat for a purpose that is essential to the efficient conduct of a *business that you carry on. …
• (6) If you use a boat (or hold it) as described in subsection (5) at all times during part of the income year, then subsection (1) does not stop you deducting so much of the loss or outgoing as is reasonable in the circumstances. …
• (7) A *leisure facility or boat is taken not to be used (or held) as described in subsection (3) or (5) if:
  • (a) apart from this subsection, the leisure facility or boat would be used (or held) in that way because of a *scheme; and
  • (b) in the Commissioner's opinion, the scheme would not have been entered into or carried out if this section had not been enacted."

5. The applicant said that he and his partner hired a boat from a Queensland charter company (QC) in 2001 for a holiday in the

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Whitsundays. In the boat were documents explaining that the boats were owned by third parties, hired out by QC on their behalf and implying that ownership of a boat under such arrangements would be a good investment. The applicant said that he had been involved in boat manufacture some 20 years prior and had retained an interest in cruising boats. After returning from holiday the applicant found a boat which he thought would be suitable in a magazine and contacted the owner Mr Chipp. His partner contacted the manager of QC to discuss the suitability of this boat for charter. The manager sent a letter dated 26 June 2001 saying that the boat contemplated sounds like a very good buy and attaching a statement setting out projections of annual income and expenses. This showed a cash surplus of $23,804 before depreciation and interest to the owner. The manager inspected the boat and suggested modifications.

6. The applicant said that his accountant reviewed the forecasts supplied and advised that, subject to the projections being accurate, the ownership of the boat would be profitable after the early years. The applicant negotiated a purchase price of $233,800 for the boat with modifications in September 2001. $190,000 was borrowed to fund the purchase. The boat was transported to the premises of QC and a charter yacht management agreement was entered into with QC on 4 October 2001.

7. The applicant said that income did not meet expectations and maintenance costs were much higher than anticipated. Initially he was not overly concerned as the attack on the New York World Trade Centre and the collapse of Ansett Airways had dramatically reduced tourist income in Queensland. However, he said that he became increasingly concerned at the losses being suffered and costs of rectification being charged. In August or September 2003, the applicant visited QC together with Mr Chipp and inspected the boat. The proprietor of QC said that the boat had many problems and he was reluctant to hire it out. As Mr Chipp suggested moving the boat to Port Stephens, the applicant arranged with him to transport the boat to Newcastle on 3 October 2003.

8. The applicant entered into a new management agreement with a company controlled by Mr Chipp to charter the boat from the marina at Port Stephens on 20 October 2003. The applicant said that the boat had regular bookings and commenced to be cash flow positive. Banners were made for the boat and advertising material produced. The applicant said that he paid for advertising in the local newspaper and on radio. He said that his boat was the sole boat managed by Mr Chipp's company.

9. While the agreement with QC provided for up to four weeks personal use of the boat by the owner, the applicant's evidence was that he had no interest in such personal use. He said that he and his partner used the boat on one occasion only for a brief period in June 2002 when they took it for testing.

10. The applicant's partner gave evidence that she had the responsibility of the day-to-day financial matters relating to the boat. She said that she commenced calling QC every month to query the amounts of expenses, particularly those relating to maintenance and the lower than expected hiring fees received. She confirmed the applicant's evidence of travelling to Queensland with the boat builder and finding the boat damaged and apparently neglected. She considered that many of the repair expenses charged to the applicant by QC should have been covered by warranty.

11. Mr Chipp's evidence confirmed the applicant's evidence relating to the purchase of the boat. He said that it was one of five of the same type built by him. He said that he modified the boat to make it suitable for chartering in the Whitsundays. Some modifications were in line with suggestions made by the manager of QC. He said that he received telephone calls subsequently from the applicant or his partner regarding costs of repairs by QC which he said appeared to be excessive. On a number of occasions he telephoned QC to query the reason for repair costs. At the applicant's request, Mr Chipp visited QC in approximately April 2002 and repaired a damaged false keel and other items. He said that he continued to receive calls about the costs being charged. Eventually he travelled to Queensland with the applicant to discuss the problem with QC. Subsequently, in October 2003 at the request of the applicant he moved the boat to Newcastle.

12. 

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Mr Chipp said that, while he had built boats for charter work, he had not previously been involved in operating charter boats. He agreed with the applicant to establish a charter business to operate the boat. An agreed advertising campaign was entered into with listing at a booking company, newspaper and radio advertising, printing of advertising postcards and business cards and a prominent banner on the boat when moored at the marina. Mr Chipp regarded the charter business as being successful but was terminated by the applicant in 2005 because of the difficulties with his income tax. Mr Chipp said that the applicant had requested him to sell the boat. After some repairs and new engines, he expected the boat to realise a price of more than $300,000.

13. Mr Gleeson said that the applicant and his partner had been clients for many years. He said that the partner contacted him in late June 2001 and advised him of the proposal to purchase and hire out a boat. He was asked to review the financial projections provided by QC. His view was that, if the projections were accurate, there would be a positive cash flow before interest and depreciation and that initial loans would be incurred but profit should emerge in later years. Mr Gleeson acknowledged that he had no experience in boat chartering. Mr Gleeson provided spread sheets based on the QC projections and assumed five per cent per annum growth in income and expenses in an endeavour to demonstrate that the activity would expect to generate profits after three years with progressive increases each year thereafter. These spread sheets were prepared recently.

14. In his income tax returns for the relevant years, the applicant showed the following losses from boat chartering:

Year ended 30 June	Income	Expenses	Loss
2002	$25,345	$83,626	$58,281
2003	$42,473	$91,525	$49,052
2004	$10,290	$68,317	$58,027

In each of the relevant assessments, the respondent disallowed the total expenses shown, leaving the income to be taxed. It was acknowledged by the respondent at the hearing that the amount disallowed in the 2002 year was overstated by $13,423 representing expenditure invoiced by QC but not paid by the applicant and not claimed as a deduction.

15. It was submitted for the applicant that the expenditure disallowed was deductible pursuant to s 8.1 of the Assessment Act and not excluded by s 26.50. It was said that the respondent must have accepted the deduction under s 8.1 by the reference to s 26.50 and the inclusion of the income as assessable (
Ell & Anor v Federal Commissioner of Taxation 2006 ATC 4098 (Ell) relied upon). It was argued by Mr Flynn that the activities of the applicant in each of the relevant years constituted the carrying on of a business so as to fall within the exclusions in ss 26.50(5)(b) and (c).

16. For the respondent it was submitted that the applicant's activities did not amount to the carrying on of a business in relation to the boat. It was said that the applicant did little more than provide the boat to a charter company which carried on the business. Mr Moshinsky argued that the manner in which the applicant entered into the transaction of purchasing the boat and letting it to QC did not demonstrate any business-like analysis or purpose of profit making. It was said that the projections relied upon did not go beyond one year, were not subject to independent analysis and did not include interest or depreciation which would have indicated a net loss. The large disproportion between actual outgoing and income in each year was said to indicate the lack of profit making purpose and the failure to take any steps to address this for some two years was said to support such indication.

17. It is clear that the question of whether a person is carrying on a business is one of fact involving consideration of the many elements of the activities conducted. As Bowen C.J. And Franki J. said in
Ferguson v Federal Commissioner of Taxation 79 ATC 4261; (1979) 37 FLR 310 at p.314:

"There are many elements to be considered. The nature of the activities, particularly whether they have the purpose of profit-making, may be important. However, an immediate purpose of profit-making in a particular income year does not appear to be essential. Certainly it may be held a person

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is carrying on business notwithstanding his profit is small or even where he is making a loss. Repetition and regularity of the activities is also important. However, every business has to be begin, and even isolated activities may in the circumstances he held to be the commencement of carrying on business. Again, organization of activities in a business-like manner, the keeping of books, records and the use of system may all serve to indicate that a business is being carried on. The fact that, concurrently with the activities in question, the taxpayer carries on the practice of a profession or another business, does not preclude a finding that his additional activities constitute the carrying on of a business. The volume of his operations and the amount of capital employed by him may be significant. However, if what he is doing is more properly described as the pursuit of a hobby or recreation or an addiction to a sport, he will not be held to be carrying on a business, even though his operations are fairly substantial."

In his decision in Ell, in a case involving s 26.50, Emmett J expanded on these elements and referred to many of the past decisions where he said:

• 111. Although not determinative, intention is relevant where, for example, a particular activity produces no income (see John v FCT (1989) 166 CLR 417) or where the first step in a business is undertaken (see Fairwell States Pty Ltd v FCT (1970) 123 CLR 153). It is necessary to examine the activities engaged in, including their nature and extent (see Martin v FCT (1953) 90 CLR 470 at 474). Activities may constitute the carrying on of a business even though the activities are carried on in a small way and it is not for the Commissioner to dictate to a taxpayer in which business the taxpayer engages or how to run a business profitably or economically (see Tweedle v FCT (1952) 180 CLR 1). Provided that an activity said to constitute carrying on business is engaged in for the purpose of profit on a continuous and repetitive basis, that activity may constitute the carrying on of business (see Hope v Bathurst City Council (1980) 144 CLR 1).
• 112. If there were no real expectation of a profit from engaging in a particular activity, there will be real doubt as to whether engaging in that activity can be said to be the carrying on of a business. Where the expenses and outgoings of an activity are disproportionate to any income that might reasonably have been expected from engaging in the activity that involved incurring those expenses and outgoings, it may be legitimate to draw an inference that the expenses and outgoings were not incurred in gaining or producing the relevant assessable income but were incurred for some other purpose.
• 113. Where expenses and outgoings claimed as deductions are disproportionate to the assessable income produced, subjective factors, including the direct and indirect objects of a taxpayer, may become determinative (see Fletcher v FCT (1991) 173 CLR 1 at 17-19). Where an expense or outgoing claimed as an expense or outgoing of a business is disproportionate to any assessable income that may be gained, it will not be as easy to conclude that the expense or outgoing was incurred in gaining or producing that income (see Spassked Pty Ltd v Commissioner of Taxation (2003) 136 FCR 441 at [64]).
• 114. The state of mind or intention of a taxpayer may be relevant to the question of whether or not that taxpayer is carrying on a business. Even where a transaction produces no income, if the intention of the relevant taxpayer is that the transaction is the first step in a business, that subjective state of mind may be relevant. The acquisition of Athena was, the Taxpayers say, the first step in the carrying on of a business (see Fairway Estate Pty Ltd v FCT (1970) 123 CLR 153 at 166.8). Further, it is not for the Commissioner to dictate to a taxpayer in what way a business should be run. A business may be carried on even though it is not profitable or economical (see Tweedle v FCT (1952) 180 CLR 1), provided it is carried on with the purpose of making a profit (see FCT v Stone (2005) ATC 4234 at 4243). The Taxpayers say that they had a profit making purpose or intention in relation to the use of Athena.

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• 115. The fact that taxation laws affected the shape of the transaction and even influenced the Taxpayers into entering into the transaction is not fatal to the conclusion that the Taxpayers were embarking upon a business venture. Tax deductions resulted in an early positive cash flow and the fact that there were tax advantages from the transaction does not adversely impact upon a conclusion that the Taxpayers were carrying on a business (see FCT v Spotless Services Ltd (1996) 186 CLR 404 at 415-416). If the Taxpayers entered into the arrangements with a view to profit, or that was their principal motivation, it would be open to conclude that they were engaged in carrying on a business.

18. It is appropriate to consider the matters which led Emmett J in Ell to conclude that the taxpayers in that case were not carrying on a business. These were:

• • there was no foundation for the projections of likely revenue;
• • projections of revenue and expenses were the taxpayers' own optimistic figures without any independent advice;
• • there was no expectation of profit and the actual results confirmed the prediction of losses;
• • scepticism of the proposed operations by the operator was ignored;
• • no formal agreement with the operator was entered into;
• • notwithstanding the total failure to embark on any attempt to employ the boat in scheduled sightseeing tours, it was not thought appropriate to revisit the business plan; and
• • the boat was used for private purposes by the taxpayers but no record was ever kept.

Emmett J concluded at paragraph 133:

"The venture of acquiring, operating and selling Athena is really only explicable by reference to the pursuit of tax deductions in the context of owning a luxury boat."

19. In this case the applicant based his decision to purchase and charter the boat on projections provided by QC as the operator. He sought advice on these projections from his accountant. While he may be seen as naïve in accepting the projections from an operator who might be seen as having an interest in persuading a boat owner to be involved in chartering, I accept the applicant's evidence of relying on these projections. I also accept his evidence of an expectation of profit. Again, he may be seen as naive in not factoring in the interest costs [of] borrowings and depreciation of the boat. He did say, however, that he believed that such a boat would hold its value. Here there was no scepticism of the operator who, in hindsight, may well have been overly optimistic. There were formal agreements with both operators to charter the boat on the applicant's behalf.

20. I accept the evidence of the applicant and his partner that they queried the higher than expected costs and lower than expected revenue with QC and were prepared to accept that the New York World Trade Centre attack and the Ansett Airline collapse had severely impacted tourist revenue. Again the applicant may have delayed unduly in seeking to rectify the large losses by taking some appropriate action. However, after two years, he did take action to remove the boat and commence a new charter operation.

21. There was no attack on the evidence of the applicant that personal use of the boat was not contemplated or undertaken. While the applicant admitted having a personal interest in cruising boats there was no suggestion nor did I obtain any inference that he was seeking a tax effective means of owning a luxury board. No inference could be gained from any of the evidence that the boat purchase and charter were related to the pursuit of a hobby, recreation or sport. As put by Mr Flynn, if the activity was not a hobby or otherwise for private use what was it if not a business?

22. One argument of the respondent was that the applicant was a passive lessor of the boat and not carrying on a business. However, both the agreement entered into with QC and that with Mr Chipp's company were described as Management Agreement under which the operator was appointed to manage the chartering of the boat for a fee being a percentage of the charter revenue. The owner was responsible for meeting all costs. As such, the charter operator could be appropriately described as agent for the applicant and was so

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positively stated in the agreement with Mr Chipp

23. On balance and on the particular facts of this case, I find that the applicant was carrying on a business of chartering his boat. I find that his purpose was profit-making and there was no element of private purpose. As such, the expenses incurred were deductible under s 8.1 of the Assessment Act. The applicant satisfied the provisions of ss 26.50(5)(b) and (c) so that the deduction was not excluded by s 26.50(1). It follows also that the claim; for depreciation is not excluded under ss 40.25(3) and (4). While the facts are quite different, the proper result of this case is the same as that arrived at in
Re Peerless Marine Pty Ltd and Federal Commissioner of Taxation 2006 ATC 2419; (2006) AATA 765.

24. It is appropriate to note an apparent anomaly in the application of s 20.5 of the Assessment Act which the respondent had applied to disallow all deductions claimed in relation to the boat while including the whole of the income derived. It is difficult to believe that Parliament intended this result by the enactment of that section. It is unnecessary to decide in this case. But it may well be that the intention was to disallow losses in relation to non business related ownership of a leisure facility or boat rather than all expenses leaving gross income to be taxed.

25. The result of the foregoing is that the decisions of the respondent should be set aside and in their stead the applicant's objections allowed in full. As noted earlier, the respondent had disallowed expenditure in the year ended 30 June 2002 of $13,423 more than the actual amount claimed. However, given my findings, this error will be automatically rectified by allowing the objections in full.