Federal Commissioner of Taxation v. Ryder

Judges:
Northrop J

Court:
Federal Court

Judgment date: Judgment handed down 29 March 1989.

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Northrop J.

The question of law raised by this appeal is whether legal expenses paid by

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the taxpayer in relation to the making of an objection in writing against an assessment are allowable deductions as being losses or outgoings incurred in gaining or producing assessable income namely interest paid to the taxpayer under sec. 9 of the Taxation (Interest on Overpayments) Act 1983 (``the Interest Act''). The interest was received in the year ending 30 June 1984 but the legal expenses were paid partly in the year ending 30 June 1983 and partly in the year ending 30 June 1984. At the hearing of the appeal all counsel treated the question as being identical with respect to each year and on the basis that the answer should be identical with respect to each year. The Court accepts that concession and for ease of reference will refer to the facts applicable to the year ended 30 June 1984.

The taxpayer carries on the profession of dentistry. During the year ended 30 June 1982 he paid interest on moneys borrowed for the purchase of real property which he rented to tenants. The amount of interest paid exceeded the net rents received. In his tax return for that year, he claimed the loss so resulting as being a loss or outgoing incurred in gaining or producing assessable income under sec. 51(1) of the Income Tax Assessment Act 1936 (``the Assessment Act''). In March 1983, a Deputy Commissioner of Taxation (``the Commissioner'') issued an assessment which disallowed that deduction. The tax assessed was paid by the taxpayer on 10 April 1983. On 29 April 1983, pursuant to sec. 185 of the Assessment Act, the taxpayer lodged with the Commissioner an objection in writing against the assessment claiming that the disallowance of the deduction was wrong. His accountant, on his behalf, sought legal advice with respect to the notice of objection and related matters including the preparation of the notice of objection. The total legal fees paid with respect to the notice of objection amounted to $989 being $580 counsel's fees which were paid by the taxpayer during the year ended 30 June 1983 and $409 solicitors fees which were paid by the taxpayer during the year ended 30 June 1984.

On 30 June 1983 the Treasurer announced that the Government's policy was to allow deductions in respect of the full amount of interest paid on money borrowed to purchase rental properties. On 28 September 1983 the Commissioner issued an amended assessment which allowed in full the deduction claimed by the taxpayer.

Pursuant to the Interest Act, the taxpayer sought payment of interest on the amount of tax overpaid by him on 10 April 1983. On 1 February 1984 the Commissioner paid the taxpayer the sum of $945.11 being interest in respect of the period from 10 April 1983 to 28 September 1983. Under sec. 26(jb) of the Assessment Act, that sum was to be included as assessable income when received by the taxpayer.

In his tax return for the year ended 30 June 1984, the solicitor's fees amounting to $409 paid by him in that year were claimed as a loss or outgoing incurred in gaining or producing assessable income under sec. 51(1) of the Assessment Act. The Commissioner disallowed the deduction, the taxpayer lodged an objection, the Commissioner made a decision disallowing the objection and the decision by the Commissioner came before the Administrative Appeals Tribunal (``the Tribunal'') for review [reported as Case V44,
88 ATC 368]. By a decision dated 24 February 1988, the Tribunal set aside the decision under review and allowed the objection in full. The Commissioner has appealed on a question of law from the decision of the Tribunal. The questions of law as stated in the notice of appeal are lengthy and confusing but the question in substance is that set out at the beginning of these reasons.

The Interest Act was enacted to provide for the payment of interest in respect of certain overpayments of tax. For the purposes of this appeal, sec. 9 contained provisions relating to the payment of interest to a taxpayer. The parts of sec. 9 relevant to this appeal are set out:

``9(1)... where -

• (a) an amount of relevant tax is paid by a person to the Commissioner (in this sub-section referred to as the `amount paid'); and
• (b) as a result of a decision to which this Act applies, the whole or a part of the amount paid is overpaid by the person and is refunded to the person or applied against any liability of the person to the Commonwealth;

Interest calculated in accordance with sub-sections (2) and (3) and section 10 is payable to the person in respect of -

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• (c) in a case where the whole of the amount paid is so refunded or applied - the amount paid; or
• (d) in a case where a part of the amount paid is so refunded - the part of the amount paid so refunded or applied.''

Having regard to the definitions contained in sec. 3 of the Interest Act, the tax paid by the taxpayer in April 1983 was relevant tax and the decision by the Commissioner in September 1983 to allow the objection under sec. 185 of the Assessment Act lodged by the taxpayer in April 1983 was ``a decision to which this Act applies''. It should be noted that before sec. 9 of the Interest Act applies, a taxpayer must have lodged an objection under sec. 185 of the Assessment Act. Thus, the Interest Act has no application where, in the absence of an objection under sec. 185 of the Assessment Act, the Commissioner has issued an amended assessment under sec. 170 of the Assessment Act and as a result a refund of tax is paid to a taxpayer under sec. 172.

The answer to the question raised by this appeal depends upon the correct application of sec. 51(1) of the Assessment Act. No suggestion was made that the second limb of sec. 51(1) has any application to the facts of this case, so for present purposes, the parts of subsec. 51(1) relevant to this appeal are:

``51(1) All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income... shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.''

For present purposes, the relevant assessable income is the interest received under the Interest Act and the loss or outgoing incurred in gaining or producing that income is said to be the legal costs paid by the taxpayer in preparation of the objection lodged under sec. 185 of the Assessment Act which was a prerequisite to be satisfied before the Interest Act could have any application.

It appears to be accepted law that legal expenses incurred by a taxpayer in disputing an assessment do not constitute a loss or outgoing incurred in producing the assessable income the subject of the objection; see, for example,
Smith's Potato Estates Ltd. v. Bolland (Inspector of Taxes) (1948) 2 All E.R. 367 per Lord Simonds at p. 374 and
Cliffs International, Inc. v. F.C. of T. 85 ATC 4374 per Kennedy J. at pp. 4397-4398; (1985) 80 F.L.R. 12 at pp. 41-42. The Tribunal appears to have based its decision on the facts that the lodging of an objection under sec. 185 of the Assessment Act was a prerequisite to receiving interest under the Interest Act and that the legal expenses incurred with respect to the lodging of the objection were incurred in gaining or producing the interest which constituted assessable income. In this respect, the expenditure was incurred before the income was earned or received and thus the authorities mentioned had no application. As counsel for the Commissioner contended, the Tribunal appeared to have applied a ``but for'' test. This was illustrated by the following passage from the reasons of the Tribunal [at p. 372]:

``Although the lodging of the objection, in respect of which the costs were incurred, had two purposes, i.e. the obtaining of the refund of tax and the obtaining of the interest, no question of apportionment arises. The obtaining of the refund was, by virtue of para. 9(1)(b) of the Interest Act, as essential to the obtaining of the interest as was the lodging of the objection itself. Thus, in the present context, the two purposes cannot be separated, and the whole amount in issue bears the same essential character.''

Counsel for the Commissioner contended further, that the purpose of the lodging of the objection was irrelevant.

Counsel for the Commissioner contended that if moneys are received as the result of outlay of expenditure, and the moneys received are assessable income, that consideration is relevant to, but not necessarily determinative of, the question of whether the outlay is deductible under sec. 51 of the Assessment Act. They referred to what was said by Gibbs C.J., Stephen, Mason and Wilson JJ. in
F.C. of T. v. Smith 81 ATC 4114 at p. 4115; (1981) 147 C.L.R. 578 at p. 579. They then contended that the fact that a particular expenditure is a necessary prerequisite for the gaining or producing of assessable income in the sense that if not expended, the assessable income would not have been earned, is not in itself, sufficient to make the expenditure deductible.

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They referred to
Lunney v. F.C. of T. (1958) 100 C.L.R. 478. That case raised the issue of whether fares paid by taxpayers travelling day by day from their homes to their places of employment or business and back again were deductible under subsec. 51(1) of the Assessment Act. At pp. 498-499 Williams, Kitto and Taylor JJ. said:

``The question whether the fares which were paid by the appellants are deductible under s. 51 should not and, indeed, cannot be solved simply by a process of reasoning which asserts that because expenditure on fares from a taxpayer's residence to his place of employment or place of business is necessary if assessable income is to be derived, such expenditure must be regarded as `incidental and relevant' to the derivation of such income. No doubt both of the propositions involved in this contention may, in a limited sense, be conceded but it by no means follows that, in the words of the section, such expenditure is `incurred in gaining or producing the assessable income' or `necessarily incurred in carrying on a business for the purpose of gaining or producing such income'. It is, of course, beyond question that unless an employee attends at his place of employment he will not derive assessable income and, in one sense, he makes the journey to his place of employment in order that he may earn his income. But to say that expenditure on fares is a prerequisite to the earning of a taxpayer's income is not to say that such expenditure is incurred in or in the course of gaining or producing his income. Whether or not it should be so characterised depends upon considerations which are concerned more with the essential character of the expenditure itself than with the fact that unless it is incurred an employee or a person pursuing a professional practice will not even begin to engage in those activities from which their respective incomes are derived.''

At p. 501, they said:

``And even if it were possible - and we think it is not - to say that its essential purpose is to enable a taxpayer to derive his assessable income there would still be no warrant for saying, in the language of s. 51, that it was `incurred in gaining or producing the assessable income' or `necessarily incurred in carrying on a business for the purpose of gaining or producing such income'.''

Counsel referred also to
Lodge v. F.C. of T. 72 ATC 4174; (1972) 128 C.L.R. 171 in which Mason J. held that nursery fees paid by the taxpayer for the care of her child while she worked were not deductible under subsec. 51(1). At ATC p. 4176; C.L.R. pp. 175-176 his Honour said:

``In the light of the authoritative observations concerning sec. 51(1) made by this Court in its earlier decisions I have no alternative but to arrive at the conclusion that the appellant's claim in this appeal cannot succeed. The expenditure was incurred for the purpose of earning assessable income and it was an essential prerequisite of the derivation of that income. Nevertheless its character as nursery fees for the appellant's child was neither relevant nor incidental to the preparation of bills of cost, the activities or operations by which the appellant gained or produced assessable income. The expenditure was not incurred in, or in the course of, preparing bills of cost.''

Counsel for the Commissioner then contended that the true test to be applied was for the Tribunal to determine the essential character of the expenditure by asking what was the expenditure really about. In this case it was urged that the character of the expenditure was to object to the assessment made and this was the essential character of the expenditure. This was not a question of purpose which to some extent looked to the future and was inadmissible, but was directed to the character of the expenditure which related to the facts as they existed at the time of the expenditure and on this basis the character of the expenditure was to determine the correctness of the assessment.

In applying this test, counsel referred to a number of authorities as illustrating the factors to be considered. They referred to
Handley v. F.C. of T. 81 ATC 4165; (1981) 148 C.L.R. 182 and to
F.C. of T. v. Forsyth 81 ATC 4157; (1981) 148 C.L.R. 203. Those cases related to deductions claimed by barristers with respect to expenditure made relating to the use of parts of their homes for professional purposes. In Handley, Mason J. said at ATC p. 4171; C.L.R. p. 194:

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``Expenditure related to the study is therefore referable to the home. The `essential character of the expenditure' to take up the expression used in Lunney..., is therefore that of a `capital, private or domestic nature'.''

Later on the same page, his Honour said:

``I do not agree that in determining the `essential character of the expenditure' we should look only to the use to which the study is put, though use is obviously a matter of great importance. It is necessary to look to the character of what is said to have been acquired by means of the expenditure, namely the study, and to its relationship to the home of which it forms part, in order to decide whether the expenditure falls within the exception.''

Counsel for the taxpayer contended that the state of mind of the taxpayer in lodging the objection was a relevant factor to be taken into account in deciding the character of the expenditure incurred. Although no evidence was given, it appears that the Tribunal accepted as a fact that one of the purposes in lodging the objection was to lay the foundation for a claim for interest under the Interest Act. That Act was assented to on 8 June 1983 but its contents were known in April 1983 when the objection was lodged. Further, the disallowance of ``negative gearing'' at that time was limited to Victoria. In the other States deductions of the type disallowed with respect to the taxpayer, were being allowed. Counsel contended that the true tests were to consider the nature and degree of connection or nexus between the expenditure and the assessable income and to then determine the character of the expenditure. In reality, the contentions of counsel for each party were similar in this connection, the essential difference being whether purpose was a relevant factor to take into account.

Counsel for the respondent relied upon opinions expressed by Hunt J. in
Martin v. F.C. of T. 83 ATC 4722 at p. 4723; (1983) 80 F.L.R. 420 at p. 421. In reality that authority is an application of the opinions expressed by Mason J. in Lodge. Counsel referred also to
Magna Alloys and Research Pty. Ltd. v. F.C. of T. 80 ATC 4542; (1980) 33 A.L.R. 213 and especially to what was said by Brennan J. at ATC p. 4547; C.L.R. p. 221 to support the view that purpose was a relevant factor in applying sec. 51(1) of the Assessment Act, but that case was related more to the second limb of that subsection and that limb has no application to this appeal. Counsel referred also to the well-known exposition of the question in
Ronpibon Tin N.L. v. F.C. of T. (1949) 78 C.L.R. 47.

Counsel contended that even applying the tests enunciated by counsel for the Commissioner and having regard to the findings of the Tribunal set out earlier in these reasons, the expenditure came within the first limb of sec. 51(1) of the Assessment Act.

On 8 February 1989 the High Court gave judgment in
John v. F.C. of T. 89 ATC 4101. A question posed in that case was whether ``motive or purpose is relevant to a consideration of whether loss or outgoing was so incurred'' under the first limb of subsec. 51(1); see Mason C.J., Wilson, Dawson, Toohey and Gaudron JJ. at pp. 4104-4105. A number of authorities were considered and the following opinion was expressed at p. 4105:

``It is readily understandable that, if no income has been gained or produced and a question arises as to whether the occasion would be expected to produce assessable income, consideration of the purpose for which the expenditure was outlaid might not be wholly irrelevant. It may be too that even where income is produced `the purpose for which the advantage occasioning the loss or outgoing is sought may evidence a sufficient relationship with the income-earning process': Handley v. F.C. of T. 81 ATC 4165 at pp. 4168-4169; (1981) 148 C.L.R. 182 at pp. 189-190, per Stephen J. But the cost of a step taken in the process of gaining or producing income must be regarded as an outgoing or taken into account in calculating the loss (if any) incurred, whatever purpose or motive may have attended all or any of the steps involved.''

In my opinion, in the present appeal, it is necessary to look at what occurred and determine the essential character of the expenditure itself and whether the expenditure should be characterised as having been incurred in gaining or producing the payment of the interest. The fact that the lodging of the objection was an essential prerequisite for the gaining of that interest is not in itself definitive of that question. What is more relevant is

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whether the expenditure was incurred in or in the course of gaining that interest.

In my opinion the expenditure incurred should be characterised as an expenditure relating to the objection to the assessment for the year ended 1982. Its essential character was to obtain a reduction in the amount of tax assessed. In this sense, it was not incurred in gaining or producing the payment of the interest.

Upon the assessment being served on him, the taxpayer was under a legal obligation to pay the amount of tax assessed. There is no suggestion that he sought an extension of time within which to pay the amount in dispute even though there appeared to be a difference of opinion between the Deputy Commissioners of Taxation in the different States as to the entitlement to deduct expenditure arising from ``negative gearing''. The taxpayer complied with the law, paid the tax assessed and exercised his right to lodge an objection. The legal costs involved are not deductible under sec. 51(1) with respect to the year for which the expenditure was not allowed. The fact that the objection is a prerequisite to the payment of interest under the Interest Act is merely incidental to the need to object in order to obtain a reduction in the assessment and does not, in my opinion, alter the proper characterisation of the expenditure. The appeal should be allowed.

Counsel for the Commissioner relied upon a further argument that in the event that the appeal would otherwise be dismissed, the Tribunal should have apportioned the expenditure. This matter does not need to be decided. Further, the Commissioner has agreed to pay the reasonable costs incurred by the taxpayer and so no order for costs will be made.

Counsel requested that if the appeal was allowed, the Court should order that the decision of the Tribunal with respect to each year be set aside and the decisions of the Commissioner affirmed. That will be done.