• The impact of this case on ATO policy is discussed in Decision Impact Statement: De Simone and Commissioner of Taxation (Published 11 March 2010).

DE SIMONE & ANOR v FC of T

Members:
BH Pascoe SM

Tribunal:
Administrative Appeals Tribunal, Melbourne

MEDIA NEUTRAL CITATION: [2008] AATA 708

Decision date: 13 August 2008

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BH Pascoe (Senior Member)

1. These are applications to review decisions of the respondent to disallow objections to amended assessments of income tax in relation to the year ended 30 June 1999 issued against each of the applicants on 22 March 2004. The amended assessments had been issued to disallow deductions claimed by each of the applicants for a share of the loss in a partnership described as The Jolson Partnership.

2. At the hearing the applicants, Mr G De Simone and his brother Mr S De Simone, were not legally represented. The respondent, the Commissioner of Taxation, was represented by Mr S Sharpley of counsel. Evidence was given by both applicants and two accountants, Mr M Jurblum and Mr P Lefkovic, who had been responsible for preparing financial accounts and income tax returns for the partnership and another company, Jolson Australia Pty Ltd.

3. The evidence of the De Simone brothers was that, in May 1999, they were told by Mr Jurblum of a proposed theatre production of Jolson - the Musical being promoted by a Mr M Brereton, a lawyer experienced in the entertainment industry. Mr G De Simone met with Mr Brereton and was provided with an information memorandum. This information memorandum stated that the musical production was intended to open in Melbourne and run for 20 weeks and then move to Sydney for a run of 26 weeks. A budget showed pre-production costs of $3.4 million and running cots of approximately $13.8 million. The projection showed that the production would generate profits to the investors. The proposed structure was a partnership of investors who would each contribute $500,000 of which $400,000 was to be borrowed from a finance company which would have recourse only to the income from the production. The partnership was to be managed by a company, Jolson Management Pty Ltd. A Production Services and Licence Agreement was to be entered into with another company, Jolson Australia Pty Ltd, to produce the show on behalf of the partnership. The brothers were advised by Mr Brereton that it was a normal commercial arrangement to prepay the production costs in a lump sum in order to obtain significant discounts on such costs.

4. The De Simones decided to share equally the one partnership share of $500,000 and contribute $250,000 each. They said that they believed that the production would be successful and profitable. In addition, they saw the investment as a useful tool to entertain clients of their existing business, which they said was profitable and readily supplied them with the means of making such an investment. They said that they were disappointed to be told that the production would not open in Melbourne because of a problem with the theatre. The production of Jolson opened for a seven week season in Brisbane in December 1999 and then ran for approximately ten weeks in Sydney. It closed on 19 April 2000. It was accepted that there had been no meeting of partners until after the Australian Taxation Office commenced enquiries and adopted the view that deductions claimed would not be allowed.

5. The documents produced in evidence show that the following agreements were entered into:

• (a) Partnership agreement which appeared to have been signed on 30 June 1999 showing a contribution by each brother of $250,000.
• (b) Management agreement appointing Jolson Administration to manage the business of producing and presenting Jolson as agent for the Partnership.
• (c) Loan Letter of Offer. The document signed by Mr G De Simone was an application to Westminster Finance Ltd whereas the document signed by Mr S De Simone was an application to FTV Finance Pty Ltd. No formal loan documents were produced and neither of the applicants could recall receiving or signing such a document. The offer in each case was to borrow $200,000.
• (d) Production Services and Licence Agreement between Jolson Management and Jolson Australia to licence the rights to the production and for Jolson Australia to provide production services to the Partnership.
• (e) Deed of Guarantee and Indemnity under which Jolson Australia guaranteed to Westminster the repayment of moneys owed by the partners to Westminster.
• (f) Deposit and Set-Off Deed between Jolson Australia and Westminster requiring Jolson Australia to deposit $11,974,400 into a security account with Westminster. Jolson Australia had the rights to withdraw funds from the security account to meet the running costs of Jolson.
• (g) Direction to Pay under which Jolson Australia directed Jolson Management to pay $11,974,400 (the amount allegedly lent to the partners) to Westminster and Jolson Management directed Westminster to pay such amount to the credit of Jolson Australia with Jolson Management acknowledging that such amount was considered as payment of the advances to the partners.

All of the above documents were dated 30 June 1999.

6. The result of the foregoing arrangements was that the partnership recorded that $14,962,000 was contributed by the partners; of which $2,993,600 was contributed in cash and $11,974,400 was allegedly contributed by Westminster as loans to the partners. Under the Production Services and Licence Agreement the partnership purported to pay $14,968,000 as the fee for the grant of the licence and the provision of all production services for the period of the agreement, which was to terminate on 28 July 2000. It is, perhaps, relevant to note that the agreement was to present and promote the production in Sydney and Melbourne and the budget on which the fee was allegedly based dealt with the anticipated cost of the proposed Melbourne season which did not eventuate. No apparent modification of the agreement to cover the subsequent changes of venues and length of the runs were done.

7. Without dealing with all of the large volume of documents produced for the purpose of the hearing, it is sufficient to say that they show that the only funds received by Jolson Australia to cover the pre-production and actual production and marketing costs incurred were the actual cash contributed by the partners and the net box-office receipts. Clearly no actual funds were contributed by Westminster. An example of this was an email to Mr Brereton dated 23 May 2000, after the production closed, which set out the movement of funds over the Jolson period as:

Ticket Sales	5,285,851
Interest Income	17,920
Merchandise Sales	126, 892	5,430, 663
Investors Funds	3,056,780
Total Funds	8,487,443
Expenditure
Pre-production	2,669,693
Brisbane Weekly's	1,663,853
Brisbane/Sydney move	1,038,163
Sydney's Weekly's	3,293, 955	8,665, 684
Difference Approx	178,000

8. Each of the De Simone brothers claimed a deduction of $250,000 in their income tax returns for the year ended 30 June 1999 as their share of the partnership loss. It was accepted by them that the actual expenditure in that year was $67,700 being the $50,000 contributed in cash as capital, $16,000 prepaid interest at eight per cent on the alleged $200,000 borrowed and an establishment fee of $1,700 being 85 per cent of the alleged borrowing. In the amended assessments issued on 22 March 2004, the respondent disallowed $267,700 on the assumption that, in common with other participants, this amount had been claimed. At the hearing it was accepted by the respondent that only $250,000 had been included as a deduction.

9. Under the Production Services and Licence Agreement, the partnership was to be entitled to all net profit derived by the production until the partnership had fully recouped the running expenses. Thereafter, the net profits were to be shared on the basis of 60 per cent to the partnership and 40 per cent to Jolson Australia. As no net profit was made it is somewhat academic to ascertain what was meant by running expenses of the partnership. The agreement defined this as the costs of running the Production in Melbourne and Sydney as disclosed in the Budget. This does not appear to be the same as the Production Services Fee of $14,968,000 allegedly paid by the partnership to Jolson Australia.

10. It is relevant to note that the Loan Letter of Offer signed by Mr S De Simone was to FTV Finance Pty Ltd. This alleged financer does not appear to get a mention in any other documentation, which referred to Westminster only. It is relevant, also, to note that there was no evidence of any actual loan documents being signed notwithstanding that such a document was required pursuant to the Loan Letter of Offer. Under the terms of the Letter of Offer, the borrower was required only to prepay interest at eight per cent per annum and an establishment fee. No further payments were required with the lender relying solely on the partners interest in the partnership and income receivable under the various agreements.

11. The evidence of Mr Jurblum and Mr Lefkovic was of little value. Mr Jurblum had prepared financial statements and income tax returns for the partnership and Jolson Management. These were prepared on information supplied by Mr Brereton. There were no bank records provided and the book entries were solely two journal entries recording capital contributed by partners and the one item of expense, being the fee paid to Jolson Australia. Mr Lefkovic prepared the financial statements and income tax returns for Jolson Australia. Again, all information was provided by Mr Brereton, no bank account was sighted and he did not undertake any independent verification of any items in these statements. An income tax return for the partnership in respect of the year ended 30 June 2000 was lodged by Mr Jurblum. This showed an income of $5,285,852 with no expenses. Again this was the figure provided by Mr Brereton. Both the De Simones included their respective share of $88,286 in their own income tax returns for that year. Mr Brereton had advised that the profit entitlement had been drawn by them to reduce the indebtedness to the financer. It is difficult to see how anybody could regard the $5,285,852 as profit when it was equal to the gross ticket sales which had contributed to the production expenses of nearly $6 million. The documentation shows clearly that the production receipts were not used to reduce any debt but used to cover costs. It was accepted that the respondent had amended the assessments for the year ended 30 June 2000 to exclude the included partnership profit.

12. During the hearing, Mr G De Simone maintained that Mr Brereton would give evidence before the Tribunal explaining the full basis of the arrangement including the loan facility. As Mr Brereton was overseas, Mr De Simone sought and was granted an adjournment of the hearing until after his return. On resumption, and not surprisingly, there was no appearance by Mr Brereton and Mr De Simone advised that he had been informed that Mr Brereton would not give evidence voluntarily and would oppose any summons served on him. Mr Brereton was also about to depart overseas again. On this basis, the Tribunal was not prepared to grant any further adjournment.

13. The first question for consideration is whether the share of loss of the partnership of $250,000 claimed for the year ended 30 June 1999 is an allowable deduction. This, in turn depends on whether the expenditure of $14,968,000 shown in the partnership returns was an allowable deduction under s 8-1 of the Income Tax Assessment Act 1997 (the 1997 Act). That is, was the expenditure incurred for the purpose of gaining or producing assessable income or necessarily incurred in carrying on a business for such purpose and not a loss or outgoing of capital or of a capital nature or private or domestic expenditure. It was submitted for the respondent that there was no loss or outgoing incurred or if there was, it was not incurred for the required purposes but in order to generate a tax deduction. It was further submitted that there was no business carried on by the applicant.

14. In relation to the first argument of the respondent, I have no difficulty in finding that there was no loss or outgoing incurred by the partnership of $14,968,000. There is simply no evidence of a loan or outgoing of $11,974,400. There were no loan agreements executed for the alleged loan of such an amount by any financier and no evidence of any payment of such amount toward the costs of the production. All the evidence is to the contrary. However, I am satisfied that the $2,993,600 contributed in cash by the partners was expended in the staging of the production, Jolson. While it is accepted that the individual partners took no active role in the production, the arrangement of appointing an agent for the partnership, Jolson Management, and sub-contracting the production to Jolson Australia is not unusual in such arrangements. It is clear that the production took place in the year ended 30 June 2000, derived assessable income from ticket and merchandise sales and interest and incurred expenditure in staging costs. I am prepared to accept the evidence of the De Simone brothers that, at the time they entered into the arrangement, and, relying on the budgets then prepared, they had the belief and expectation that the venture would be profitable. It is likely that the resultant change of venue, shortened season and ultimate loss was a result of inadequate funding but this is not a matter on which the Tribunal had any clear evidence or a need to make a finding. It is not necessary for the purpose of the first limits of s 8-1 for the income to be derived in the same year as the expense, provided such expenditure can be seen to have been incurred for the purposes of producing assessable income in a future year. In relation to the second limb, I am prepared to find that the partnership was carrying on a business through its agent for the purpose of producing assessable income. The staging of a musical production is a business albeit within a limited time frame and, as in this case, a one-off venture.

15. Having regard to the foregoing I am of the opinion that, of the amount of $250,000 claimed by each applicant, the amount of $50,000 was an allowable deduction in the year ended 30 June 1999 with the balance of $200,000 being not allowable.

16. The alternative submission of the respondent was that the deductions claimed, to the extent, if any, that they are allowable are disallowed pursuant to Part IVA of the Income Tax Assessment Act 1936 (the 1936 Act). It is clear that even if I am incorrect in the view that the full amount of $250,000 is not deductible under s 8-1 of the 1997 Act, Part IVA of the 1936 Act would apply to disallow the deduction. Pursuant to s 177D of that Act it could be readily concluded, looking objectively at the arrangement, that the promoter and the partners entered into the scheme purporting to borrow funds to increase the claim for expenditure beyond that actually incurred for the purpose of obtaining a tax benefit by inflating the amount sought to be deducted. As stated earlier, 80 per cent of the amount claimed as a deduction was attributable to funds allegedly provided by a financer by way of a loan to the partners but no actual funds were provided and, not unusual in situations such as these, a round robin of book entries was entered into. The effect of such a finding is that s 177F(1) would disallow the deduction claimed. However, in common with many other schemes which have been considered by the Tribunal and the courts, it is appropriate that a compensating adjustment be made under s 177F(3) to allow as a deduction the expenditure actually incurred by the participants. It is of some interest that, in common with many other schemes involving a genuine commercial operation, the promoters embark on a course of seeking to attract investors by a somewhat artificial increase in the promised income tax deduction using non-existent allegedly non-recourse loans.

17. The effect of these findings is that $50,000 of the $250,000 share of partnership loss claimed by the applicants in the year ended 30 June 1999 is an allowable deduction with the balance being disallowed. The applicants say that their total cash outlay under the arrangement was $67,700, including $17,700 as prepaid interest and establishment fee on the alleged loan. There is no evidence of where the additional $17,700 was paid to and whether such amount was included in the actual available funds expended by Jolson Australia on the production of the musical. It is noted that the documents indicate that $3,056,780 was expended by Jolson Australia compared with the $2,993,600 contributed by the partners in each as capital. This difference of $63,180 may have come from the further amounts claimed as interest and establishment fees. However, each of the De Simone brothers held a 1.67 per cent in the capital of the partnership. This percentage of the additional funds received by Jolson Australia produces an amount of $1,055. Given the substantial difference and the complete lack of evidence of the actual destination and expenditure of the $17,700, with the further knowledge that, as no loan was made, no interest can be claimed, it is not appropriate to extend the amount to be allowed as a deduction beyond the $50,000.

18. The final issue for consideration is the penalty for the tax shortfall. The penalty imposed by the respondent was at the rate of 50 per cent of the shortfall. The objection decisions under review stated that the penalty had been correctly imposed under s 2226L of the 1936 Act or, alternatively, s 226, on the basis that the tax shortfall related to participation in a scheme where it was not reasonably arguable that the deduction claimed was allowable. Section 226L has recently received the attention of the Full Court of the Federal Court in
Commissioner of Taxation v Starr 2007 ATC 5447; (2007) 164 FCR 436. In that case the Court decided that, while the determination as to whether Part IVA of the 1936 Act requires an objective test, s 226L imported a subjective test requiring a consideration of the taxpayers' intentions.

19. Both the De Simone brothers were firm in their evidence that their primary motivation in participating in the Jolson production was the belief in the advisors, a review of the budgets produced and the expected marketing value of the ability to take important clients to an opening night of a stage production in which they were personally involved. It was argued that, while the tax advantages of the structure proposed were promoted, this was not their primary objective. They said that they saw their tax position of simply being a cash flow benefit by obtaining a deduction in the first year but having income from the production assessed in the second year, the bulk of which would not be recovered but paid to the financer. Both strongly denied any prior knowledge that no actual funds were provided by the lender. Both accepted that the expectation of a large tax deduction led to them voluntarily increasing their assessable income from their successful business where they may not have otherwise paid themselves such dividends etc. On balance, I accept their evidence and, consequently, do not accept that the provisions of s 226L apply. However, this does not mean that there should be no penalty. Both applicants had a tax shortfall for the year ended 30 June 1999 in that their taxable incomes were $200,000 higher than disclosed in the tax returns lodged. The result is that s 226G, s 226H, s 226J and s 226K require to be considered. In this instance, I am of the view that s 226G is the appropriate provision. This section provides for additional tax by way of penalty of 25 per cent where the shortfall was caused by the failure of the tax payer or of a registered tax agent to take reasonable care. Here, it might be said that both of the De Simone brothers believed without adequate question and monitoring what was put to them, signed the papers put before them just before the last day of the year of income expired, took no active role thereafter, failed to notice that no loan agreement was actually entered into and, it may be said, enthusiastically committed $50,000 each with stars in their eyes. Section 227 provides a discretion to remit all or part of the penalty. I am of the opinion that no remission is appropriate in these circumstances.

20. It follows from the foregoing that the objection decisions under review should be varied to the extent of allowing the objection in part by allowing a deduction of $50,000 in the year ended 30 June 1999 further reducing the amount disallowed by $17,700 which had not been claimed and reducing additional tax by way of penalty to 25 per cent of the revised tax shortfall.