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McNALLY v FC of T; FC of T v McNALLY

Judges:
Jessup J

Court:
Federal Court

MEDIA NEUTRAL CITATION: [2007] FCA 51

Judgment date: 2 February 2007

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Jessup J:

1. Before the court are two appeals on questions of law under s 44 of the Administrative Appeals Tribunal Act 1975 (Cth) ("the AAT Act") from a decision of the Administrative Appeals Tribunal ("the Tribunal") published on 22 June 2006 upon an application by the taxpayer for a review, pursuant to s 14ZZ of the Taxation Administration Act 1953 (Cth), of the Commissioner's decision, published on 15 December 2004, to disallow the taxpayer's objection against his income tax assessment for the year to 30 June 1998.

The facts

2. The taxpayer is an accountant. In 1991, he joined the firm of Duesburys Chartered Accountants ("Duesburys"). He made a capital contribution of $174,000, $160,000 of which was financed by an advance from Westpac Banking Corporation. In 1994, Duesburys merged with Deloitte Touche Thomatsu ("Deloittes"), at which time the taxpayer made a further capital contribution of $150,000, the whole of which was financed by an advance from National Australia Bank. He remained a member of Deloittes until the events of 1997 with which this proceeding is concerned.

3. The agreement between the partners at Deloittes ("the partnership agreement") was in evidence in the Tribunal. It provided that Deloittes was an ongoing partnership, not dissolved, as regards continuing partners, by the retirement, removal or resignation of a partner. It provided for a "Policy Board" to exercise a general supervision of the affairs of the partnership. It provided for the keeping of partnership books of account, and required the preparation of a balance sheet, and profit and loss account, as at 30 June each year. It provided that no partner would have any personal financial interest in the partnership apart from the accrued or accruing profits to which he was entitled from time to time, and any other amounts recorded in the partnership accounts as due to him.

4. The capital of the partnership was divided between partners according to cl 11(A) of the partnership agreement, which provided:

"The capital of the Partnership shall be divided into shares which shall be represented by Role and Responsibility Units designated as R/R units and the total number of such units and their allocation between the Partners shall be determined from time to time by the Policy Board having regard to the respective roles and responsibilities of the Partners."

For each R/R unit held by a partner, that partner was obliged to deposit with the firm a stipulated sum of money. The criteria by which R/R units were allocated to partners were dealt with in section D3 of the "Partner Manual" (there called "Role Units"). Those units then formed part of the basis for the distribution to partners of the profits of the firm for each year. The other part was according to what were called "Performance Units". They were not part of the capital, but were allocated to partners after each year to reflect their performance in that year.

5. The partnership agreement provided that a partner could retire on giving 12 months' written notice thereof, expiring on 30 June. Additionally, the Policy Board might, in its discretion, permit a partner to retire on less than 12 months' notice, and/or on a date other than 30 June. A partner retiring in any of these circumstances might, at the discretion of the Policy Board, be entitled to participate in the Partner Retirement Plan. A partner could also be involuntarily removed by resolution of the Policy Board (on the recommendation of the Chief Executive Officer) on the ground that such removal was "in the best interests" of the partnership. Upon ceasing to be a partner otherwise than by death, a partner was entitled to be paid the amount of his capital account, his share of profits from the end of the last completed year down to the date of ceasing to be a partner, and his share of other undrawn profits (if any).

6. Clause 22 of the partnership agreement dealt with the situation which arose when a partner retired, died or was removed. It provided that the partnership would not be totally dissolved, "but shall be dissolved so far only as regards that Partner". By that clause it was agreed -

"… that the share (if any) of the Outgoing Partner in the business and all assets of the Partnership shall go and belong to the

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remaining Partners without any payment whatsoever …."

The clause provided that the partnership would continue between the remaining partners, and that those partners should account to the outgoing partner for "all moneys payable to him … in accordance with the provisions" of the partnership agreement. By cl 17(C) of the partnership agreement, for the purpose of determining a person's entitlement upon ceasing to be a partner -

"… the balance sheet of the Firm as at the end of the last completed year and the profit and loss account for the current year shall be the basis of settlement between him or his legal personal representatives (as the case may be) and the remaining Partners."

7. There was a "Partner Manual", by the terms of which each partner agreed to be bound. It was divided into sections. Section D1 dealt with the subject of accounts. It provided for the firm's financial year to end on 30 June each year, and continued (in part):

"As soon as practicable after that date each Practice Office shall prepare a statement in a form determined by the Chief Executive Officer showing the fees and other income received and the expenses and outgoings paid by such Practice Office during the year ending on that day together with such other accounts and information as may be required by the Chief Executive Officer and such Practice Office shall forward copies of such statements and accounts and information to the Chief Executive Officer.

Work-in-progress shall be brought into account for the purposes of the Partnership's own accounts and for settling the rights of the Partners as between themselves but it shall not be brought into account for income tax purposes. Work-in-progress shall be valued on the basis directed by the Policy Board.

The Chief Executive Officer shall cause income tax returns to be prepared and lodged on behalf of the Partnership and he shall cause copies thereof to be forwarded to each Practice Office. Work-in-progress at the 30th day of June in each year shall be deemed to be derived as taxable income in the following year."

8. As I have said, Performance Units were allocated to partners following the end of each year. Clause 8 of section D3 of the Partner Manual provided (in part):

"It is intended that all profits of the Partnership for each year shall be distributed to the partners and following completion of the financial accounts of the partnership for each year to 30 June all undistributed profits for that year shall be distributed.

The Partners shall be entitled to the profits of the Partnership for each year to 30 June pro rata according to their respective totals for Role Units and Performance Units allocated to them in respect of that year and, to any extent necessary to reflect such entitlement, adjustments shall be made as between them having regard to distributions made on account of the profits."

It was also provided in cl 8 that a distribution on account of profits would be made to partners each month.

9. The Partner Retirement Plan was dealt with in section D6 of the Partner Manual. Clause (12) thereof dealt with a situation in which a partner retired or was removed from the partnership. In such a case -

"… the Policy Board may in its discretion determine to offer that Partner a lump sum and/or a share of income (of such amount as the Policy Board may determine) and/or such other consideration as the Policy Board may think fit in consideration of that Partner's past services to the Partnership."

The Policy Board might make any such offer conditional upon certain requirements as to the future employment, or business activity, of the departing partner.

10. On 17 July 1997, the Policy Board of Deloittes resolved that it was in the best interests of the partnership that the taxpayer be removed from the partnership. He was informed by correspondence of that date that he had thereby ceased to be a partner. The taxpayer did not accept that he had been validly removed from the partnership. Through his solicitors, he disputed his removal, and eventually undertook negotiations with Deloittes for a resolution of that dispute. His solicitors prepared (but did not issue) an intended Statement of Claim in which the taxpayer would have sought declarations

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that the actions of the Policy Board were unlawful and invalid, but in which he would not have sought damages.

11. The dispute between the taxpayer and Deloittes was settled at mediation on 9 December 1997. The settlement agreement, as set out in the decision of the Tribunal, was as follows:

"McNALLY v DELOITTE TOUCHE TOHMATSU

TERMS OF SETTLEMENT

  • 1. This agreement is made between Walter McNally (WM) and Deloitte Touche Tohmatsu (the firm).
  • 2. This agreement is conditional upon the Policy Board of the firm confirming clause 6 below and resolving by 22 December 1997 to revoke its resolution of 17 July 1997 that WM be removed as a partner of the firm, in consideration of the parties agreeing now that WM has retired from the firm as at 17 July 1997.
  • 3. The firm agrees to pay WM the amount of $500,000 within two business days of the Policy Board referred to above.
  • 4. The firm is to obtain a discharge of the obligation by paying to the National Australia Bank such part of the capital of $150,000 that WM contributed to the firm that he has borrowed from the National Australia Bank. WM directs the firm to pay the amount of $150,000 or such amount as is owing to the National Australia Bank as part of the return of his capital and $160,000 to Westpac Banking Corporation.
  • 5. The firm releases WM from the restrictive covenants in s. 16 of the Partnership Agreement.
  • 6. In all other respects the Partnership Agreement is affirmed as between the parties except that the firm releases WM from any future liability under clause 21B of the Partnership Agreement and acknowledges that WM has satisfied his obligations for professional indemnity claims for the two years after his retirement.
  • 7. WM releases the firm from all claims he has told the firm of through his solicitors and all claims arising from his ceasing to be a member of the firm.
  • 8. These terms are confidential to the parties."

12. Pursuant to that agreement, Deloittes paid $310,000 to the two banks mentioned in cl 4 thereof, and the balance of the settlement sum of $500,000, $190,000, to the taxpayer.

13. By letter to the taxpayer dated 24 December 1997, Deloittes informed him of the passing of the resolution referred to in cl 2 of the settlement agreement, and of the application of the settlement sum in the way I have described. The letter continued:

I believe the only matters outstanding relate to taxation and I understand John Milne has sent you a Statement of your position at 30 June 1997. Based on my review this Statement is incorrect, in that John has impacted the full extent of the Capital Reconstruction. John is currently on leave and I suggest you do not attempt to complete your taxation return until you talk to John following his return from leave on the 12 January 1998.

The tax assessments

14. In his income tax return for the 1998 year, the taxpayer stated that his distribution from partnerships was $0.00. He was originally assessed on the basis of that statement. However, information from Deloittes caused the Commissioner to revisit that assessment. By letter dated 1 December 2000, Deloittes answered the Commissioner's queries concerning the entitlements of partners who had retired. One such retired partner was the taxpayer. Deloittes provided to the Commissioner a three-page statement which set out -

  • • the taxpayer's investment in the partnership as at 30 June 1998;
  • • the taxpayer's "distributable income" for the year to 30 June 1998;
  • • a schedule of the taxpayer's "taxable income" for the year to 30 June 1998; and
  • • the distribution of the taxpayer's taxable income for the year to 30 June 1998.

15. 

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According to the statement, the taxpayer had no investment in the partnership as at 30 June 1998. The statement also showed that there was, in the 1998 year, no normal profit distribution to the taxpayer. However, there was an amount of $230,000 shown as "Profit Distribution - Partnership - Gratuitous Payment". Together with two other relatively insignificant sums, the taxpayer's entitlement to distributable income for the year was shown as $233,031.63. That sum, rounded to $233,032, was shown in the taxable income schedule as the taxpayer's share of the partnership income from all sources.

16. The taxable income schedule in the statement was as follows:


"DELOITTE TOUCHE TOHMATSU
SCHEDULE OF TAXABLE INCOME 30 JUNE 1998
PARTNER MCNALLY W.A.
YOUR SHARE OF FIRM INCOME FROM ALL SOURCES 233,032
PARTNERSHIP PENSION  
- ITEM 10 BLOCK O (For Individual returns)  
INTER GROUP DIVIDENDS EX CORPORATE ENTITIES GROSSED UP 1,312
NON-DEDUCTIBLE/NON-ASSESSABLE ITEMS 1,986
SHARE OF TAXABLE INCOME BEFORE TIMING DIFFERENCES 236,330
   
OPENING TIMING DIFFERENCES  
W.I.P 89,428
PREPAYMENTS 56,997
OTHER 176,465
  322,890
   
CLOSING TIMING DIFFERENCES  
W.I.P 0
PREPAYMENTS 0
OTHER 0
PROVISIONS 0
  0
   
TOTAL TAXABLE INCOME FROM ALL SOURCES 559,220
LESS SPECIFIC PARTNERSHIP DEDUCTIONS:-  
SUPERANNUATION 0
INTEREST IN CORPORATE ENTITIES 0
(see JMM memo attached)  
SALARY  
GROUP LIFE INSURANCE 0
TAXABLE INCOME TO BE INCLUDED IN YOUR FAMILY GROUP'S RETURNS 559,220"
   

17. On the face of it, there was a discrepancy between these figures and the taxpayer's return for the 1998 year. There were, apparently, communications between the taxpayer and the Commissioner, the result of which was that the Commissioner wrote a letter to the taxpayer's accountants dated 29 November 2002, in which it was asserted that the Deloittes partnership return for the 1998 year disclosed that the taxpayer's share of the partnership net income was $557, 521, made up as follows:


$ $
Gratuitous partnership profit distribution 230,000  
Allowance 1,333  
Inter group dividends (grossed up) 1,312  
Non deductible items 1,986  
Tax timing differences that were deducted from 1997 accounting income and assessable in 1998 322,890 557,521

18. The Commissioner's letter stated that the sum of $557, 521 was the taxpayer's individual interest in the net income of the partnership for the purposes of s 92(1) of the Income Tax Assessment Act 1936 (Cth) ("the 1936 Act"). The taxpayer was reminded of the various provisions of that Act which provided for the imposition of penalties in situations of undeclared income, and was told that, in due course, the Commissioner would include the sum of $557, 521 in his assessable income for the 1998 year. The taxpayer was invited to respond to the Commissioner's letter.

19. There followed a period of correspondence and discussion as between the taxpayer and his representatives of the one part and the Commissioner of the other part. Eventually, by letter dated 27 April 2004, the Commissioner informed the taxpayer that the sum of $559,219 would be added to his assessable income for the 1998 year. The adjustment was explained as follows:


$
Gratuitous partnership profit distribution 230,000
Allowance 1,333
Inter-group dividends (grossed up) 1,312
Non-deductible items 1,986
Plus opening timing differences  
  - Work In Progress 89,428  
  - Prepayments 56,997  
  - Other 176,465  
  322,890
Less closing timing differences (0)
Sub-ordinated loan interest - DH&S Services Pty Ltd 1,698
  559,219
   

20. In his letter of 27 April 2004, the Commissioner also set out how the first item on that table - the gratuitous profit distribution of $230,000 - had been reconciled by Deloittes against so much of the settlement sum agreed at the mediation in December 1997 as did not involve the return of capital ($190,000). The reconciliation was as follows:


$
Redundancy payment   180,000
Profit share 96/97   50,000
Per DTT Distribution Statement for 1998 year   230,000
Add: Interest on capital 2,437  
  Rounding 495 2,932
Less: Payment of PI Claims 96/97 (20,356)  
  Payment of deferred PI (17,850)  
Miscellaneous current account (4,726) (42,932)
Cash Distribution   190,000
     

21. An amended assessment giving effect to the adjustment issued on 10 May 2004. The Commissioner also imposed a penalty of 75% under s 226J of the 1936 Act (involving a finding that there had been an intentional disregard of the law by the taxpayer) in relation to so much of the assessment that consisted of work-in-progress in the amount of $89,428, and a penalty of 50% under s 22H of the 1936 Act (involving a finding that there had been recklessness on the part of the taxpayer) in relation to the balance of the assessment.

The taxpayer's objection

22. The taxpayer objected to the amended assessment. The version of the objection which was before the Tribunal was the taxpayer's amended notice of objection dated 8 July 2004, lodged under cover of correspondence dated 9 July 2004. In that notice, the taxpayer prefaced his grounds of objection with some general commentary on the subject of his relations with Deloittes, and with respect to the propriety of certain things alleged to have been done by Deloittes, but which appear to be otherwise irrelevant to the circumstances. In the grounds

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as such, the taxpayer dealt specifically with the question of his interest in the partnership income for the 1998 year. He denied that he had such an interest in the sum of $559,219 for the purposes of s 92(1) of the 1936 Act. He said that he had a settlement arising from legal proceedings (by which, I take it, he meant contemplated proceedings) which did not reflect an interest in the partnership income. He said that the settlement of December 1997 was all-embracing, and finalised matters between himself and Deloittes. He said that he did not receive the beneficial interest of the tax accounting treatment, such as by way of receiving monies for any work-in-progress reductions. He accused Deloittes of manipulating their books after they had reached a settlement with him. He said:

"If the taxpayer was to concede something (which he does not) then all that would be possible is to say is that the balance of monies received of $190,000 less legal fees could be argued to be assessable as income. This is not conceded, because the sum is not reflected [sic] of a loss of income but damages for loss of reputation for being marched out of the building and the consequences or damages of that news in the professional world."

He accused Deloittes of structuring the books for its own purposes to rearrange income distribution away from ongoing partners, and said that the Deloittes distribution statement was capricious and self-serving. He made a number of other points along similar lines, together with some that appeared to have little or no bearing on the question arising under s 92(1) of the 1936 Act.

23. The Commissioner disallowed the taxpayer's objection on 15 December 2004, and provided the taxpayer with his reasons for that decision. Those reasons dealt with the taxpayer's grounds of objection, and with the many individual points which he had made in his notice of objection. The Commissioner set out the facts as he understood them, including those referred to above in these reasons. Under the heading "1998 - Partnership Distribution", the Commissioner referred to the Deloittes resolution to remove the taxpayer from the partnership, to the mediation in December 1997, and to the agreed terms of settlement. He said that, after the end of the 1998 year, Deloittes "worked out the figures for its 1998 income tax return". He said that the taxpayer, and others, were issued with individualized partnership distribution statements, and that the taxpayer's statement "detailed that your share of the net income of the partnership was $559,219". He referred to the reconciliation between the figure of $230,000 and the balance on settlement of $190,000 after return of capital. He referred to the "timing differences", and said that the management at Deloittes had demonstrated to the tax office that its method of calculating the timing differences was the correct one for tax purposes. The Commissioner set out the details of that method, as disclosed to him by Deloittes:

"Deloitte incudes the value of work performed but yet unbilled as income for accounting purposes. This work in progress ('WIP') is not assessable for income tax purposes until the relevant invoices have been issued. Together with other timing differences such as prepayments, opening and closing balances of WIP are entered on the partnership income tax return reconciliation statement in order to calculate the net income of the partnership for tax purposes.

The partnership distribution statement issued to each partner by Deloitte after year-end discloses the accounting share of profit calculated through to the taxation share of net income. To arrive at a partner's share of the net income of the partnership, the net accounting share of profit is shown plus/minus the share of permanent differences, such as non-allowable deductions. Then, a partner's share of opening timing differences is added and his/her share of closing timing differences is subtracted as the final step in the tax reconciliation.

To explain Deloitte's method in more detail, the first point to note is that Deloitte, upon the entry of a new partner, does not include opening timing differences in its calculation of that partner's share of the net income of the partnership at the end of the partner's first financial year. This is because at the beginning of the partner's first year with Deloitte, he/she has no interest in Deloitte's net assets including timing differences. The

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opening timing differences are shared among all of the partners who were Deloitte members as at the beginning of the year so that the total net income of the partnership is distributed to partners and taxed. However, at year-end, a partner is a continuing partner which entitles him/her to a share of Deloitte's net assets including closing timing differences such as WIP.

The second point is that Deloitte does not include closing timing differences in its calculation of an exiting partner's share of the net income of the partnership at the end of that partner's last financial year. The rationale for this method is the same as the one explained above. When a partner retires during the year, Deloitte includes his/her share of opening timing differences in its calculation. However, at year-end (30 June) the retired partner no longer has a share in closing timing differences as his/her entitlement to a share in the net assets has terminated. The closing timing differences are included in the net income calculation of the remaining partners.

The third point to note is that Deloitte's method of not including opening timing differences in its calculation of a new partner's share of the net income of the partnership often results in a new partner having a 'notional' tax loss in his/her first year notwithstanding Deloitte having a net distributable profit overall. This is because Deloitte's method includes only billed fees but allows all tax timing deductions for tax reconciliation purposes. Deloitte avoids the outcome of a new partner having a tax loss by adjusting that partner's closing timing differences in the first year and by reversing the adjustment in the following year. This results in the new partner returning no tax loss in the first year but in the second year a contra adjustment reduces his/her share of the net income of the partnership. No tax overall is avoided year by year as the other partners effectively bear the opposite side of these adjustments so that the total partnership net income is distributed to partners and taxed in their hands each year.

Overall, Deloitte's method ensures that a partner's entire share of timing differences is included in his/her share of the net income of the partnership."

In summary, the Commissioner stated that the sum of $559,219 formed part of the taxpayer's assessable income for the 1998 year by virtue of s 92(1) of the 1936 Act.

24. On the subject of penalty, the Commissioner was satisfied that the taxpayer had intentionally disregarded the law with respect to the work-in-progress component of his partnership distribution because there was "strong proof" that before he lodged his 1998 return he knew that there was going to be a tax liability. As to the balance of the partnership distribution, the Commissioner was satisfied that the taxpayer did not take the necessary steps to ensure that his tax obligations were met, and did not present "persuasive or coherent legal arguments" in his own favour.

The review by the Tribunal

25. By letter to the Tribunal dated 11 February 2005, the taxpayer requested "a full review" of the Commissioner's disallowance of his objection. He said that he believed that the reasons provided in his objection were well-founded, but reserved his right to make further representations at the hearing.

26. In a decision given on 22 June 2006, the Tribunal set aside the Commissioner's decision, and remitted the matter to the Commissioner for reconsideration in accordance with the Tribunal's findings and conclusions. Those findings and conclusions were contained in the Tribunal's reasons for decision published on the same day. The Tribunal referred to the exchange of correspondence between the taxpayer and the Commissioner which led to the amended assessment, to Deloittes explanation of the "timing differences", to relevant provisions in the partnership agreement, to the settlement of the dispute between the taxpayer and Deloittes in December 1997, to the assessability of the "opening timing differences" and to the matter of penalties. The Tribunal expressed the following conclusions:

  • "(a) no part of the settlement sum is assessable as income in the taxation year ending 30 June 1998;
  • (b) the sum of $322,890 being the sum returned in the applicant's 1997 income tax

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    return as 'closing timing differences' should have been included as income in his 1998 return; and
  • (c) any tax shortfall caused by the applicant's failure to include the opening timing differences as income in his 1998 return was caused by the applicant's recklessness with regard to the correct operation of the Act and regulations but was not caused by an intentional disregard of the same."

27. With respect to the settlement sum, the Tribunal noted that the amount of $310,000 was due to the taxpayer, upon his retirement from Deloittes, by way of return of capital. It did not, however, seek to characterise separately the balance of the settlement sum, $190,000. Rather, it looked at the total settlement sum of $500,000 in the context of the claims which the taxpayer had made, or had foreshadowed, against Deloittes, and which ought to be taken as having been settled by the payment of that overall sum. The Tribunal said:

"The character of the settlement sum was determined by the contract the parties entered into at the time the settlement was negotiated. It cannot be affected by any subsequent action taken by Deloitte in accounting for the payment in its books of account. This was a case in which the applicant received what has been referred to in a number of judicial determinations as an 'undissected' lump sum in settlement of a raft of claims, some contractual and capable of calculation and others of an unliquidated nature."

28. The Tribunal referred to
Allsop v Commissioner of Taxation (1965) 113 CLR 341 and to
Commissioner of Taxation v CSR Ltd 2000 ATC 4710; (2000) 104 FCR 44, and in particular the comment by the Full Court in the latter case that the "how and why" of a payment received by a taxpayer pursuant to an agreement should be determined by the terms of that agreement and by the nature of the consideration for which, according to the agreement, the money was paid (104 FCR at 60). The Tribunal referred also to the Full Court's observation that, in CSR, the conclusion could not be avoided that the consideration "was a release of causes of action some of which would have generated receipts of a non-income nature". (104 FCR at 60) The Tribunal said that, in both Allsop and CSR, the agreed settlement sum was treated as a payment of a capital nature, and added: "the same applies in the present case." The Tribunal concluded:

"Consistent with established judicial authority, the Tribunal is of the view that no part of the settlement sum was taxable as income in the hands of the applicant and accordingly he was not in breach of his obligations under the income tax legislation by failing to return that sum or any part of it as income in his 1998 income tax return. It follows that the applicant should not be subjected to any penalty by reason of the non-disclosure of the settlement sum in his return."

29. With respect to the "opening timing differences", the Tribunal noted that the sum of $322,890 was the same sum as had been allowed as a deduction as "closing timing differences" in the taxpayer's 1997 return. It pointed out that there was no question but that, had the taxpayer remained a partner of Deloittes until 30 June 1998, "this sum would have been included in his income tax return as income." The Tribunal asked itself the question - "whether the [taxpayer's] departure from the partnership provided a reason for not including the opening timing difference in his 1998 return". The Tribunal said that there appeared to be no logical reason why "the established practice" in relation to timing differences, of which the taxpayer had had the benefit whilst a partner, should not be applied in relation to the final year of his "tenure as a partner". It referred to some correspondence which appeared to be based upon a supposition that the opening timing differences would form part of the taxpayer's assessable income. It noted that the taxpayer's departure from the partnership would not affect his tax liability with respect to the amount that had been claimed as a deduction for closing timing differences in his 1997 return. In the result, the Tribunal took the view that the amount claimed by the taxpayer in his 1997 income tax return as closing timing differences should have been returned as income in his 1998 return.

30. With respect to penalties, in the light of the Tribunal's decision regarding the settlement sum, the only remaining question was whether

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the taxpayer should incur a penalty because of his failure to declare the opening timing differences as part of his income in the 1998 year. On this subject, the Tribunal said:

"Whilst the applicant's view that he was under no obligation to include either the settlement sum or the opening timing differences as income in his 1998 return was an opinion genuinely held by him, there is no evidence to suggest that his view was ever endorsed by any competent professional opinion. Given his professional standing as a practising chartered accountant, albeit not one who practiced in the field of income tax, the Tribunal is of the view that his failure to seek other advice as to the matters in issue was reckless and that the consequential tax shortfall was caused by his recklessness. There is however no basis upon which to conclude that the applicant acted with any dishonest intention or with an intentional disregard of the Act or regulations."

This finding implies the imposition of a penalty pursuant to s 226H of the 1936 Act but, as I have indicated above, the Tribunal sent the whole matter of the amended assessment back to the Commissioner for reconsideration.

The appeals in this Court

31. By notice dated 18 July 2006, the taxpayer appealed from so much of the Tribunal's decision as related to the inclusion of the opening timing differences in his assessable income and to the conclusion that his failure to include those amounts in his 1998 return was caused by his recklessness. The questions of law raised on the appeal were said to be:

  • (a) Does the net income of a partnership in a year of income include:
    • (i) work in progress and/or movements in work-in-progress of the partnership;
    • (ii) amounts recognised in the computation of the net income of the partnership in a prior year of income, and/or
    • (iii) amounts of capital expenditure or which are capital in nature?
  • (b) What is the proper basis under section 92 of the Income Tax Assessment Act 1936 (Cth) for the allocation to a partner of the net income of a partnership in a year of income - is it a proportionate or quantum approach?
  • (c) Is the failure of a taxpayer under the self assessment regime of the Income Tax Assessment Act 1936 and Income Tax Assessment Act 1997 ("the Assessing Acts") to obtain income tax advice conduct that is reckless?

32. The taxpayer's Notice of Appeal was based upon six grounds, each of which commenced with the words "the Tribunal erred in law by …." The things which the Tribunal was said to have done, and which constituted errors of law, were -

  • (a) including work-in-progress in the net income of Deloittes;
  • (b) including amounts deducted in the computation of income for a prior year in the net income of Deloittes;
  • (c) including amounts of a capital nature in the net income of Deloittes;
  • (d) including amounts which were not the net income of Deloittes in the assessable income of the taxpayer;
  • (e) including amounts referrable to Deloittes, in which the taxpayer was not a partner, in his assessable income;
  • (f) adjudging as reckless the taxpayer's self assessment of his taxable income.

33. By Notice of Appeal dated 20 July 2006, the Commissioner appealed from so much of the decision of the Tribunal as held that no part of the $500,000 paid to the taxpayer under the settlement of December 1997 was assessable income, and that the tax shortfall caused by the taxpayer's failure to include the opening timing differences in his assessable income was caused by his recklessness. The questions of law said to arise on this appeal were:

  • (1) Is a distribution by a partnership to a retiring partner, calculated as a retiring partner's individual interest in the net income of the partnership pursuant to s 92 of the Income Tax Assessment act 1936 for the year in which he retired (year ended 30 June, 1998), assessable income of the retiring partner?
  • (2) Whether the sum of $190,000 formed part of the respondent's individual interest in the net income of the partnership pursuant to

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    s 92 of the Income Tax Assessment Act 1936 for the year ended 30 June, 1998?
  • (3) Alternatively, whether the sum of $190,000 formed part of the respondent's assessable income:-
    • (a) pursuant to section 6-5 of the Income Tax Assessment Act, 1997:
    • (b) pursuant to Part 3-1 of the Income Tax Assessment Act, 1997?
  • (4) Whether any part of the tax shortfall caused by the respondent's failure to include opening timing differences, in the sum of $322,890, as income in his 1998 return was caused by the respondent's intentional disregard of the operation of the Income Tax Assessment Act 1936?

34. In his grounds, the Commissioner contended that the Tribunal erred in holding that the sum of $190,000, calculated as part of the taxpayer's individual interest in the net income of Deloittes under s 92 of the 1936 Act, was not assessable income. He contended that the Tribunal should have held that the whole of the sum $559,219, so calculated, was assessable income. He contended that the Tribunal erred in holding that no part of the sum of $500,000 paid pursuant to the settlement of December 1997 was assessable income, and that the whole amount was a capital receipt in the nature of an undissected lump sum. He contended that the Tribunal should have held that the sum of $190,000 formed part of the taxpayer's individual interest in the net income of Deloittes under s 92. He contended that the Tribunal erred in concluding that the tax shortfall arising from the taxpayer's failure to include the opening timing differences in his 1998 return was caused by his recklessness.

35. As is apparent from the third of the Commissioner's questions of law, the Commissioner sought to argue in the alternative that the sum of $190,000 was part of the taxpayer's assessable income, as a capital gain pursuant to Pt 3-1 of the Income Tax Assessment Act 1997 ("the 1997 Act"). The taxpayer opposed the Commissioner's attempt to introduce the question of liability to capital gains tax into the appeal. He applied to have so much of the Commissioner's grounds as related to the matter of capital gains tax struck out. The Commissioner's attempt to make the matter of capital gains part of this appeal was based upon two propositions. First, Ms Symon SC, who appeared with Mr Sest on behalf of the Commissioner, submitted that, having held that the whole of the settlement sum of $500,000 was, in effect, a capital payment, the Tribunal should have proceeded to consider whether any part of that payment constituted an assessable capital gain. She submitted that, once the taxpayer had brought the correctness of the amended assessment into dispute in the Tribunal, the Tribunal's function was not completed merely by having dealt with the question whether the basis upon which the Commissioner made his assessment was right or wrong: the Tribunal was required to go further and to consider whether the amended assessment was excessive. She submitted that it was for the taxpayer to show that the assessment was excessive in the sense that it could not be justified under any provision of the legislation. Secondly, Ms Symon referred to a written submission made in reply on behalf of the taxpayer in the Tribunal. Reiterating his submission that the whole of the $500,000 was not income according to ordinary concepts, but was capital, the taxpayer had observed that neither was it taxable as a capital gain, because of the operation of s 160ZB of the 1936 Act. Ms Symon submitted that the taxpayer had thus made the question of assessability under the capital gains provisions of the legislation relevant to the proceedings in the Tribunal, and that it was an error of law for the Tribunal not to have dealt with the matter.

36. Towards the end of the hearing of the appeal, I heard the parties on the question whether the Commissioner should be permitted to raise the matter of capital gains tax in the appeal. I ruled that, whatever be the outcome of the appeal, the Commissioner's appeal would not be upheld upon this ground. Before the Tribunal, the Commissioner did not contend that any part of the settlement sum of $500,000 was assessable as a capital gain. Save for the matter of the taxpayer's written submission in reply, the question of capital gains was never an issue. As to that submission, I do not consider that it had the effect of making capital gains assessability an issue which the Tribunal was obliged to determine. I do not believe there is any reasonable basis upon which it could be suggested that the Tribunal's failure to consider the matter of capital gains assessability, in the

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circumstances to which I have referred above, constituted an error of law.

37. As it happens, by reason of the way in which I propose to deal with so much of the Tribunal's decision as related to the settlement sum paid in December 1997, I would, in any event, have found it unnecessary to decide the capital gains point sought to be raised by the Commissioner.

38. The primary submission advanced on behalf of the taxpayer in his appeal was that the net income of Deloittes for the 1998 year of taxation could only be determined, and was in fact determined, at the end of that year:
Federal Commission of Taxation v Galland 86 ATC 4885; (1986) 162 CLR 408. Mr Lockie, who appeared on behalf of the taxpayer, submitted that his client left Deloittes on 17 July 1997, and had no interest in the income of the partnership thereafter. Alternatively, Mr Lockie submitted that the income of the partnership, in the relevant year, did not include the so-called opening timing differences. He said that those differences were no more than accounting entries, and that the assessable income of Deloittes did not, and could not, include items which had not been invoiced.

39. In defending the Tribunal's decision on the matter of the opening timing differences, Ms Symon submitted that it was fundamental to appreciate that the taxpayer had been assessed as a member of the Deloittes partnership, rather than as an individual standing outside that partnership. Notwithstanding that, at the end of the 1998 year, the taxpayer was no longer a member of the partnership, he had been a member for some part of that year, and upon the questions whether he had an interest in the net income of Deloittes for that year, and if so in what amount, the taxpayer was contractually bound by the partnership agreement, and therefore by the decision of the partners collectively on such matters. She said that Deloittes had issued a distribution statement which set out the taxpayer's relevant interest, and it was not open to the taxpayer to contend that his interest was something other than there set out. Ms Symon submitted that, properly understood, the opening timing differences were in the nature of an adjustment, and should be regarded as corresponding with the equivalent closing timing differences which had been deducted to obtain the fiscal income of the partnership at the end of 30 June 1997. With respect to so much of the opening timing differences as related to work-in-progress, Ms Symon submitted that those sums reflected an expectation that the work would be invoiced in the 1998 year, and that, consistent with that expectation, the practice of Deloittes was to bring the sums into their fiscal income immediately upon the opening of the year. However, according to Ms Symon, the court need not be concerned as to the precise nature of the amounts referred to as opening timing differences (and indeed, significant parts of those amounts were not so readily explicable, at least conceptually, as the work-in-progress) because the critical point was that Deloittes brought them into its treatment of fiscal income on 1 July 1997, and that the taxpayer was bound by the approach which Deloittes had taken.

40. In relation to the Commissioner's appeal against so much of the Tribunal's decision as dealt with the settlement sum of $500,000, Ms Symon said that the Tribunal's written reasons for its decision were devoid of any reference to s 92 of the 1936 Act. She submitted that the Tribunal had approached this part of its task as though the only question were whether the amount paid to the taxpayer in December 1997 was income according to ordinary concepts in the hands of the taxpayer. Although documents before the Tribunal demonstrated how Deloittes reconciled its distribution statement with the actual payment made to the taxpayer in December 1997, Ms Symon submitted that, as a matter of law, such things were beside the point: whatever the taxpayer was in fact paid, such payments did not provide an answer to the questions which arose under s 92 of the 1936 Act. Ms Symon did submit, however, that Deloittes' reconciliation demonstrated that so much of the $500,000 as was not manifestly a return of capital ($190,000) was part at least of the taxpayer's interest in the income of the partnership. She submitted that, given the terms of the settlement of December 1997, it could not have been otherwise. The settlement was between the taxpayer and his former partners at Deloittes, considered as partners. Not being part of the capital of Deloittes, the payment could only be regarded as a distribution to one partner (the taxpayer) of his interest in income. It is true, Ms Symon accepted, that no combination

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of provisions of the partnership agreement appears to have entitled the taxpayer to a distribution of income in the amount of $190,000, but she submitted that the relationship between the partners was contractual, and they were always at liberty to vary the contract for the purposes of providing a benefit to a particular partner, and that was what must be taken to have been done in relation to the taxpayer in December 1997.

41. On the matter of the settlement sum, Mr Lockie reiterated his general submission that his client was not, after 17 July 1997, a member of the partnership. He submitted that the mere fact that the taxpayer had received, by way of the settlement of proposed litigation, a sum of money from his former partners did not establish, either in fact or in law, that that amount represented, or corresponded with, any income of the partnership; and he repeated that, in any event, at no relevant time did the taxpayer have an interest in that income. Mr Lockie also supported the Tribunal's conclusion that the $500,000 was a single undissected sum, and that it would be pure speculation to infer that some part of it was capital, and the remainder income. While recognising that, as a matter of mechanics, $310,000, out of the $500,000, was used by Deloittes, at the direction of the taxpayer, to repay loans which the taxpayer had previously taken from the banks, Mr Lockie submitted that that pragmatic arrangement did not imply what was the appropriate characterisation of a corresponding part of the settlement sum.

Disposition of the appeals

42. Central to the disposition of both these appeals is an appreciation that the Commissioner's amended assessment was referrable to s 92 of the 1936 Act. That is to say, the sum which the Commissioner included in the taxpayer's assessable income for 1998 was so included not because it was income according to ordinary concepts, but because it was the taxpayer's interest in the net income of Deloittes. By s 91 of the 1936 Act, a partnership must furnish a return of its income, but is not liable to pay tax thereon. Section 92 provides that the assessable income of a partner in a partnership shall include -

"…so much of the individual interest of the partner in the net income of the partnership of the year of income as is attributable to a period when the partner was a resident …."

By s 90 of the 1936 Act, the "net income" of a partnership is -

"…the assessable income of the partnership, calculated as if the partnership were a taxpayer who was a resident, less all allowable deductions …"

except certain deductions not presently material. Strictly speaking, the process of identifying the assessable income of the taxpayer should have involved two steps: determining what was the net income of Deloittes, and calculating the individual interest of the taxpayer in that income.

43. It is also central to an understanding of the position taken by the Commissioner that partnerships do not pay income tax as such at all. The integrity of the taxation system in relevant respects rests on the operation of s 92: all of what would, save for s 91, be the assessable income of the partnership must be "caught" by the assessment of the individual interests of the partners.

44. Deloittes filed a return of the income of the partnership, as required by s 91, for the 1998 year. Not unreasonably, the Commissioner seems to have treated the allocation of that partnership income as between the partners of Deloittes as primarily a matter for the partners themselves. Consistently with that approach, the Commissioner makes the point that a successful attempt by a partner (or former partner) to establish that his or her own interest in the partnership income is less than stated by the partnership, and accepted by the Commissioner, will inevitably mean that a portion of the partnership income is not effectively taxed, or that corresponding adjustments need to be made in the calculation of the assessable income of all other partners. Mr Lockie submits, however, and I agree, that the taxpayer "is entitled to have considered the nature of the transaction which gives rise to the suggested liability for tax unaffected by what the partnership may do or say in relation to his income":
Stapleton v Federal Commissioner of Taxation (1989) 89 ATC 4818, 4827.

45. On the other hand, this is not a full appeal from the decision of the Tribunal. The question is not whether certain sums should

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have been included in the assessable income of the taxpayer: it is whether an error of law is disclosed by the way the Tribunal answered that question. What was the taxpayer's interest in the net income of Deloittes was a question of fact. The Tribunal held that the opening timing differences should have been included in the taxpayer's assessable income as returned, thereby implicitly holding that such differences were part of the net income of Deloittes for 1998. It is only if those holdings were infected by an error of law that the taxpayer is entitled to succeed on his appeal.

46. The Commissioner accepted that the valuation of work-in-progress in a business such as that conducted by Deloittes is not as such income according to ordinary concepts. When, as appears to have been the case here, accrual accounting is employed for the purpose of calculating the income of a partnership, only when a sum has become recoverable is it to be regarded as part of that income. These propositions were, it seems to me, propounded as matters of law by the High Court in
Henderson v Federal Commissioner of Taxation 70 ATC 4016; (1970) 119 CLR 612, 650-651. It would follow that any decision which included work-in-progress as part of the net income of a partnership should be regarded as being erroneous in point of law.

47. As set out in para 7 above, the Partner Manual of Deloittes provided that work-in-progress should not be brought into account for income tax purposes. However, it also provided that work-in-progress at 30 June each year would be "deemed to be derived as taxable income in the following year". As between the partnership and the Commissioner, such a deeming provision could not be conclusive as to the calculation of the net income of the partnership pursuant to s 92 of the 1936 Act. As between the partners of Deloittes, a provision which specified how the net income of the partnership was to be distributed between them - i.e. what was each partner's interest in that income - would be binding. However, such an agreement could be effective and binding for taxation purposes only if it operated by reference to income which was in fact and in law net income within the meaning of s 90 of the 1936 Act.

48. How are the two provisions of the Partner Manual referred to in the previous paragraph to be reconciled? The first is apparently consistent with the law as stated in Henderson; the second appears not to be, in that it brings work-in-progress into taxable (i.e. fiscal) income in the following year. The answer, I consider, is to be found in the explanation provided by Deloittes as to their calculation of the timing differences as set out in para 23 above. Internally, Deloittes includes work-in-progress in the calculation of its income - "accounting income" as it has been called. However, since work-in-progress is not income for the purposes of taxation law, when calculating the figure that will be returned as the income of the partnership under s 91 of the 1936 Act, Deloittes takes the value of work-in-progress out of the accounting income figure. This procedure is intended to produce the correct figure to be returned under s 91 - one which is confined to the assessable income of the partnership as though it were an individual taxpayer, as required by ss 90 and 92 of the 1936 Act.

49. Having thus calculated their assessable income for a particular year in the correct way, Deloittes must then add the value of work-in-progress back into their reckoning of their income for taxation purposes for the following year. That is the effect of the deeming provision in the manual to which I have referred. Properly understood, that provision does not "deem" anything to be something that it is not (as lawyers are accustomed to find in legislation from time to time): rather, it is in the nature of an instruction to those responsible for maintaining the accounts that, in their calculation of the income which Deloittes will return each fiscal year under s 91 of the 1936 Act, the value of work-in-progress as at 1 July that year should be included. However, in the course of that very calculation, the value of work-in-progress at year-end will be excluded. The net effect, manifestly, will be that only to the extent that it has been invoiced - thereby losing its status as work-in-progress - will the value of what was the work-in-progress on 1 July appear in the partnership's income as returned under s 91 as at the following 30 June.

50. By the method of maintaining their accounts in the way I have described, Deloittes

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ensures that only income within the meaning of the legislation - i.e. never including work-in-progress - is treated as income of the partnership for taxation purposes. As I have said, the result is in harmony with the law as stated in Henderson.

51. In her argument on behalf of the Commissioner, Ms Symon submitted that the adding-back of work-in-progress on 1 July each year in effect corresponded with the taking-out of the same figure the day before, pursuant to the deeming provision in the Partner Manual. She submitted that those who were partners on 30 June had had the "benefit" of the taking-out, and that they should likewise bear the consequences of the adding-back. For taxation purposes, however, the removal of work-in-progress should not be regarded as a benefit - the value of such an item was not, when taken out, income in the legislative sense at all. The taking-out should be regarded as an appropriate rendering into legislative income of a figure which would otherwise include something which will never be part of that income.

52. Ms Symon also submitted that the way the system operated, in effect, was that work-in-progress became part of Deloittes' income for taxation purposes on 1 July each year, and that it remained there until some event occurred which removed it. That event might be the rendering of an invoice for the work, the conclusion of the fiscal year, or the winding-up of the partnership. In each such situation, as I understood her, Ms Symon submitted that work-in-progress would remain firmly in the taxation income figure unless and until such an event occurred. So much may be accepted, but only as a matter of internal accounting at Deloittes. Each of the events to which Ms Symon referred by way of example would involve either the disappearance of the work-in-progress (i.e. by having been invoiced) or the adjustment of taxation income to remove the work-in-progress before a s 91 return was submitted. None of these events would involve the submission of such a return of income containing work-in-progress.

53. Submissions were also made about the situation arising when a new partner joined Deloittes. It was said that a partner who joined during the course of a fiscal year would have the benefit of a deduction - or subtraction - from what would otherwise be his or her share of the partnership income for taxation purposes. The suggestion seemed to be that such a joining partner would somehow derive the benefit of a lower taxation income figure by reason of the fact that opening timing differences were not included, while closing timing differences were taken out. To the extent that I can follow this submission, I must say that it seems to deflect attention from the real question at stake, which is whether the effect of the Commissioner's assessment was to include work-in-progress in the calculation of the assessable income of Deloittes for the purpose of ascertaining the taxpayer's share in that income. It is to that question that I now turn.

54. It is manifest, from the Deloittes' distribution statement, that the opening timing differences for the year ended 30 June 1998 have been included in the taxpayer's interest in what is said to be the (fiscal) income of the partnership, and that those "differences" include work-in-progress. Because the closing timing differences have not been excluded, the resulting figure necessarily includes work-in-progress. The justification, presumably, for the non-exclusion of closing timing differences is that the taxpayer was not a partner on 30 June 1998, when those differences were excluded for the remaining partners. That is not, I consider, a justification which should be regarded as acceptable under taxation law. If, as I have held, the assessable income of Deloittes could not include work-in-progress, necessarily the taxpayer's share of (or interest in) that income could not include such an element. The fact that the taxpayer was a partner for part only of the year in question cannot affect the legally correct approach to the matter of the determination of Deloittes' assessable income, to the extent that the taxpayer had an interest in it. If a set of accounts for taxation purposes was struck when the taxpayer left on 17 July 1997, necessarily work-in-progress would have been taken out. That was not done, the result of which may create practical difficulties in the way of calculating the taxpayer's interest. However that may be, it provides no reason to calculate that interest in a way that unarguably includes work-in-progress.

55. The effect of the Tribunal's decision was to uphold so much of the Commissioner's

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assessment as included work-in-progress in the assessable income of the partnership for the purpose only of calculating the taxpayer's interest under s 92 of the 1936 Act. For the reasons given above, that was erroneous in point of law.

56. Within the broad category of opening timing differences, I have so far concentrated on work-in-progress (an amount of $89,428 out of a total of $322,890). The category includes also "prepayments" and "other". There was no evidence as to what these items involved. Mr Lockie explained that "prepayments" were payments for which a deduction would be allowed under taxation law, but which related to a period subsequent to the fiscal year in question and which, therefore, were not part of Deloittes' internal accounts for the year in question. If that explanation were correct, it would propound a proper basis for the adjustment of accounting income to reflect net income in the year of the deduction. Why it would be appropriate to add the prepayments back on 1 July is not clear and, as Mr Lockie submitted, would seem to be at odds with
Federal Commissioner of Taxation v Rowe 97 ATC 4317; (1997) 187 CLR 266. Ms Symon invited me not to speculate upon what these "prepayments" were - much less with respect to the item referred to only as "other". She submitted that they both represented sums which it was appropriate to keep out of income for tax purposes each 30 June, but which should be included each 1 July "in the expectation that it will be appropriate to include it for tax purposes in the next year".

57. I cannot accept that an item should be treated as part of the assessable income of Deloittes merely because there is an expectation that it will become fiscal income at some time in the year in question. In the present case, the taxpayer has had attributed to him what is said to be a share in the income of Deloittes, where that income is as appears in the accounts on 1 July 1997. On Ms Symon's explanation, there was then only an expectation that relevant items in that income would fall into the category of fiscal income. The Tribunal accepted that approach without any investigation of whether, before the taxpayer's interest in that income was calculated and for the purpose of that calculation, such an expectation had become reality. Although I know little of the exact nature of the items to which I here refer, if their inclusion is based upon the approach explained by Ms Symon, it does appear to result in amounts which were not as such part of the assessable income of Deloittes at any time being notionally apportioned in some way, and in a share of, or an interest in, such amounts being treated as the income of the taxpayer for the purposes of s 92. That approach is, I consider, wrong in law.

58. What I have said above might reasonably be read as implying that the taxpayer's interest in the net income of Deloittes in the 1998 year was some figure other than that assessed by the Commissioner. It is, however, no part of the court's role to make any such finding, and I do not do so. I was invited by Mr Lockie to find that no part of the opening timing differences should have been taken into the taxpayer's assessable income. I do not make such a finding. Indeed, the only question before the court is whether the Tribunal's decision was erroneous in point of law. In relation to work-in-progress, I consider that it was. In relation to other elements of the opening timing differences, I consider that the Tribunal erred in law to the extent that it found that the mere fact that they had been brought into Deloittes' internal account for fiscal purposes thereby made them part of the net income of the partnership within the meaning of s 90 of the 1936 Act. Whether they were part of the net income was - and will again be - a question for the Tribunal. It will doubtless involve issues of fact which are not before the court.

59. The Commissioner's appeal may be disposed of more simply. I accept Ms Symon's submission that, when the Tribunal came to consider the settlement sum of $500,000, it looked only at whether all or any part of that sum was the income of the taxpayer according to ordinary concepts. But the Commissioner had never assessed the taxpayer on that basis. He may well have defended his assessment by saying that some part of the settlement sum - $190,000 - was in the nature of an income distribution to the taxpayer. To the extent that he did so, the exercise may have been evidentiary or demonstrative, but it was otherwise something of a distraction from the issues presented by ss 90 and 92 of the 1936

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Act. These issues related to the taxpayer's interest in the net income of the partnership, not to distributions to, or drawings by, the taxpayer qua partner.

60. If it be the fact, as the Tribunal found, that the $500,000 was an undissected lump sum, such fact may have provided a useful evidentiary link in the determination of what was the taxpayer's interest in the income of Deloittes in the 1998 year. That is not for the court to say. But that fact should not be regarded as dispositive for the purposes of s 92 of the 1936 Act. As I read the Tribunal's reasons, it did so regard that fact. In this respect also I consider that the Tribunal erred in law.

61. For the above reasons, each of the appeals will be allowed. I propose to set aside the Tribunal's decision and to remit the taxpayer's application for a review of the Commissioner's assessment to the Tribunal for reconsideration in accordance with these reasons. In the circumstances, it is unnecessary to deal separately with so much of the appeals as related to the matter of penalty.


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