Case X20

Members:
P Gerber DP

Tribunal:
Administrative Appeals Tribunal

Decision date: 23 January 1990.

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Dr P. Gerber (Deputy President)

This case raises, once again, the age-old problem: whether a work en ventre sa mere is on revenue account or capital. To complicate the problem, the disputants consist of a gaggle of accountants (if that is the appropriate collective noun), all distinguished and highly qualified, who formerly practised in partnership, but are now locked in mortal combat. They have come to this Tribunal for basic advice on generally accepted accounting principles.

2. For present purposes, this saga began in August 1978, when the accountancy partnership with which I am presently concerned evolved from the merger of two practices. Each of these two firms, on merging, injected their respective clients and corresponding goodwill into the new partnership. Pausing here, I am satisfied that whatever system of accounting one applies, the clients and goodwill thus contributed constituted the capital of the partnership. This is a material fact which, I am satisfied, distinguishes this case from the two principal authorities relied upon by the Commissioner.

3. In the events that occurred, the partners fell out and, in February 1981, dissolved the partnership on terms that the firm would be carried on by two of the partners (the ``continuing partners''), whilst the remaining partners (the ``retiring partners'') would each go their own way. As so often happens in acrimonious divorces, what to do with ``work in progress'' was less than adequately provided for, the dissolution agreement merely stating that:

``the final accounts shall be prepared in accordance with generally accepted accounting principles in Australia applied on a basis consistent with that adopted in the preparation of the financial statements of the partnership for the year ended 30th June, 1980 but adjusted to take into account the matters referred to in this agreement and the relevant schedules hereto as therein specified.''

The reference to ``work in progress'' in the various schedules did little to take the matter any further, an omission which was destined to lead the parties to subsequent arbitration,

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Supreme Court proceedings and a lawyers' picnic.

4. In the result, the retiring partners were credited (subject to adjustments and write-offs) for their proportionate shares in fees rendered and closing work in progress as at 28 February 1981 which the Commissioner treated as assessable income, remaining unmoved by the objections. Hence these applications.

5. The claim was put in two ways: the credit for work in progress at dissolution was a return on partnership equity, and hence was said to constitute capital; alternatively, if work in progress were deemed to be assessable income, allowance should have been given to opening work in progress.

6. A peripheral argument arose during the hearing to the effect that, should the Tribunal find that the payments were indeed assessable income, nevertheless the amended assessments were - in the case of two of the taxpayers - unauthorised under sec. 170 since there had been a full and true disclosure of all the material facts.

7. The Commissioner's defence of the assessments relied heavily on the New Zealand decision in
Jamieson v. Commr of I.R. 74 ATC 6008, which was, in turn, followed in
Stapleton v. F.C. of T. 89 ATC 4818.

8. The decision in Stapleton needs to be considered in some detail since the Crown argued that the case is in pari materia and determinative of the outcome of this application.

9. The facts are succinctly stated in the report of the case in the Australian Tax Cases and are set out hereunder:

``The taxpayer became a partner in a firm of solicitors on 1 January 1975. The firm did not have a written partnership agreement, but on becoming a partner the taxpayer was handed a memorandum para. 6 of which provided, inter alia, that the taxpayer would acquire an entitlement to a share in `work in progress' from 1 January 1975. Paragraph 7 of the memorandum provided that the amount of each retiring partner's entitlement `in work in progress' was to be paid by monthly payments over the five years following his retirement...

The taxpayer retired from the partnership on 31 March 1982. A further memorandum dated 14 December 1982 provided, inter alia, that the taxpayer was entitled to be paid $95,918, payable over five years beginning in December 1982 at $9,592 per ½ year, as distributions of work in progress. This was referred to in the memorandum as `future income entitlement'.

During the 1983 income year the taxpayer received a total of $19,184 in respect of work in progress. His income return for that year, which was lodged on 30 March 1984, contained a schedule headed `Disclosure of Capital Receipt'. The schedule set out various paragraphs of the memorandum of 1 January 1975, including para. 6 and 7, and then stated that the $19,184 was received on account of the disposal by the taxpayer to the firm of his interest in the assets of the partnership, other than goodwill for which a separate amount was payable, and was capital in the taxpayer's hands. The relevant assets were stated to be `work in progress', together with disbursements incurred and paid on behalf of clients but not collected and recoverable bad debts.

In June 1983, the taxpayer's accountants sent a copy of the memorandum of 1 January 1975 to the Commissioner in response to a request for a copy of the firm's partnership agreement...

On 12 June 1984 the taxpayer received a notice of assessment in respect of the 1983 income year. No part of the $19,184 received by the taxpayer in respect of work in progress was included in his assessable income. In February 1985, however, the Commissioner issued an amended assessment including that amount in the taxpayer's assessable income. The taxpayer's objection was disallowed by the Commissioner and the taxpayer appealed. He contended that the $19,184 was capital

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The Commissioner contended that payments for work in progress were assessable income in the taxpayer's hands as they were distributions of partnership income or, alternatively, were entirely referable to acts done in the course of a business in which the taxpayer was a partner.''

10. Paragraphs 6 and 7(a) of the 1975 memorandum are set out below:

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``6. The new partner... will commence to participate in the distributions from 1st January, 1975, and will acquire an entitlement to a share in `work in progress' from that date.

7(a) The amount of each retiring partner's entitlement in `work in progress' is to be paid by monthly payments continuously over the five (5) years following his retirement.''

The memorandum of 14 December 1982, although it dealt with the applicant's entitlement to payments for goodwill and for distributions of work in progress, was nevertheless referred to as ``future income entitlement'', a feature heavily relied on by the Commissioner. So far as relevant, the memorandum is as follows:

``2. FUTURE INCOME ENTITLEMENT

$95,918.

This is payable [by half-yearly instalments] over 5 years beginning in December 1982 at $9,592 per ½ year...''

11. The substantive finding to the effect that the amount in question, representing a sum which in due course of time would become income when the work was complete and therefore assessable income in the hands of the retiring partner rather than capital, needs to be examined closely since, on one view, it is fatal to the taxpayers in this case.

12. Sheppard J. commenced his enquiry by examining the submission for the applicant that income not derived by the partnership during its subsistence cannot constitute income upon its dissolution, and the characterisation of the payments as ``work in progress'' cannot convert them into income unless they had the character of a recoverable debt. This was said to be the result of Henderson's case (
Henderson v. F.C. of T. 69 ATC 4049; 70 ATC 4016).

13. At first instance, Windeyer J. dealt with the issue of ``work in progress'' in the following manner (at pp. 4059-4060):

``The value of work in progress is, no doubt, a familiar item, as an asset, in the accounts of manufacturers. And, like stock in trade, it there enters into accounting of profit and loss for taxation purposes. The rationale of this is explained in the judgments in the Court of Appeal and the House of Lords in the
Duple Motor Bodies Ltd. case (1960) 2 All E.R. 110; (1961) 2 All E.R. 167. In that case Lord Simonds said of the proposition that `stock-in-trade and work in progress must, for tax purposes, be regarded as a receipt' (at p. 171): `On that, professional accountants appear to be universally agreed, though it might not be at once obvious to the layman'. Lord Reid said, setting out what he called the background of the matter (at p. 172):

• `It appears that, at one time, it was common to take no account of stock-in-trade or work in progress for income tax purposes; but long ago it became customary to take account of stock-in-trade, and for a simple reason. If the amount of stock-in-trade has increased materially during the year, then, in effect, sums which would have gone to swell the year's profits are represented at the end of the year by tangible assets, the extra stock-in-trade which they have been spent to buy; and similar reasoning will apply if the amount of stock-in-trade has decreased. So to omit stock-in-trade would give a false result. It then follows that some account must be taken of work in progress. Suppose that the manufacture of an article was completed near the end of an accounting period. If completed the day before that date, the article, if not already sold, has become stock-in-trade; if completed the day after that date it was still work in progress on that date. It could hardly be right to take that article into account in the former case but not in the latter. I do not know when it became customary to take into account work in progress, but it appears that that has been customary for many years, and it is not disputed that, at least in all ordinary cases, that must now be done.'

These propositions relate to `work in progress' as a synonym for tangible things, goods in process of manufacture from raw materials, things which when completed will become stock-in-trade. Accountancy theories differ as to the method of valuing such work. But `work' in that sense does not connote abstract activity, work done and

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labour expended. It denotes concrete tangible things, work on hand. But the ambiguity of the word `work' and the attraction for accountants of the phrase `work in progress' can, I think, mislead. In my opinion it is a mistake to suppose that the notion of the value of work in progress, in the sense of things uncompleted by a manufacturer or craftsman, can be simply transferred to uncompleted services by a tradesman or the practitioner of some profession, and to assume that it can there be applied in the calculation for taxation purposes, of income derived. I realise that in accountancy there is a similarity of a sort between unfinished goods and uncompleted services, and that the latter are sometimes described as work in progress. No doubt accounts can be kept in which a value is ascribed to uncompleted tasks by persons engaged in the practice of various trades and professions and rewarded by fees. Such accounts may be useful for many purposes, especially in the case of several persons practising a profession in association. The contribution of each to the earning of the collective income can be shewn by such accounts. And they may be useful in relation to the terms on which a partner retires from or a new partner enters a firm. But it is one thing to record when, and by whom, work is done which will produce income: it is another to say when income, the rewards of such work, was derived. I am aware that the expression `work in progress' has been used in some cases in arriving at the taxable income from fees for professional services: e.g. Wetton, Page & Co. v. Attwooll (Inspector of Taxes), supra. Nevertheless I think that services rendered for fees do not result in income derived within the meaning of the Act until the fees are either paid or payable. This, of course, may be before an account for payment is rendered. For example, a physician may be entitled in law to be paid for attendances upon his patient before his treatment of him for his illness has been completed and he has sent him a bill. What he is thus entitled to be paid forms part of his income calculated on an earnings basis; but not for work in progress, but for work done. Similarly an accountant engaged to conduct a continuous audit may be entitled to be paid for the hours he has spent and for his attendances, although he only asks to be paid periodically. But when a professional man is, according to the terms of his engagement, not to be paid until his task is completed, I do not think he can be said to have earned anything by that task until then. A lawyer retained to write an opinion or draw a deed cannot ordinarily say that he has earned any income by his work until he has produced the result of it. Similarly with an auditor employed to give a certificate, an architect to prepare plans, an accountant to produce a balance sheet. A half-written legal opinion, a deed drawn in part only, plans unfinished and still on the drawing board, an incomplete balance sheet, are not like goods in course of manufacture. When completed they are not valuable because of their physical properties, but for the information they convey or the legal effect they produce.

In the present case a record was kept of the time spent on each task by each accountant in the firm, partner or employee. A value was put on this work by reference to an hourly rate fixed by the managers for each person concerned according to his skill and experience. In this way the fee to be charged for services rendered was determined. This recording of the value of work in progress might be said to shew accruals, using that term in a sense which it appears often to have for accountancy practice, especially in the United States: see e.g. pp. 471-473, 708-711 of the work Accounting Practice Management Handbook, edited by MacNeill, which was tendered in evidence. But accruals in this sense are not, I think, equivalent to earnings for the application of an earnings basis for the assessment of income according to our law. As I see it, they shew in terms of money the value of work which has been done towards the earning of money, not money which has been earned. Money is not, I think, earned income until it is in law recoverable as a debt.''

14. On appeal, Barwick C.J., in whose judgment the other judges agreed, said (at p. 4020):

``In ascertaining such earnings [the earnings of the partnership in question in that case],

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only fees which have matured into recoverable debts should be included as earnings. In presenting figures before [Windeyer J.], allowance was made for what was termed `work in progress'. But this, in my opinion, is an entirely inappropriate concept in relation to the performance of such professional services as are accorded in an accountancy practice when ascertaining the income derived by the person or persons performing the work. When the service is so far performed that according to the agreement of the parties or in default thereof, according to the general law, a fee or fees have been earned, then it or they will be income derived in the period of time in which it or they have become recoverable. But until that time has arrived, there is, in my opinion, no basis, when determining the income derived in a period, for estimating the value of the services so far performed but for which payment cannot properly be demanded, and treating that value as part of the earnings of the professional practice up to that time and as part of the income derived in that period [my italics]. It may be that a different course can be taken if an estimation of profits is being made for some other purpose than the present. Consequently, in determining the income of the partnership in either of the years in question for the purposes of assessment of tax, only accrued fees may be included in that income.''

15. In Stapleton, Sheppard J. noted that whether a payment in respect of an accruing entitlement is on capital or revenue account is frequently a ``difficult question''. In attempting to answer that question, his Honour stated (at pp. 4824-4825):

``I find it useful to refer to what was said generally about the matter by Brennan J. (when a Judge of this Court) in
Federal Coke Co. Pty. Limited v. F.C. of T. 77 ATC 4255... His Honour said (ATC p. 4273...):

• When a recipient of moneys provides consideration for the payment, the consideration will ordinarily supply the touchstone for ascertaining whether the receipt is on revenue account or not. The character of an asset which is sold for a price, or the character of a cause of action discharged by a payment will ordinarily determine, unless it be a sham transaction, the character of the receipt of the price or payment. The consideration establishes the matter in respect of which the moneys are received. The character of the receipt may then be determined by the character, in the recipient's hands, of the matter in respect of which the moneys are received. Thus, when moneys are received in consideration of surrendering a benefit to which the recipient is entitled under a contract, it is relevant to enquire whether or not that benefit was a capital asset in his hands. To adapt the words of Lord MacMillan in
  Van den Berghs Limited v. Clark (1935) A.C. at p. 443 and of Williams J. in
  Bennett v. F.C. of T. (1947) 74 C.L.R. 480 at p. 485, the enquiry is whether the congeries of the rights which the recipient enjoyed under the contract and which for a price he surrendered was a capital asset.'

What his Honour said was recently applied by this Court in
Allied Mills Industries Pty. Limited v. F.C. of T. 89 ATC 4365. The dicta of the Court in the Allied Mills case are important and shed further light on the matter, but each case has to be considered in relation to its own facts. The facts in the Allied Mills case were very different from those of the present.

On the basis that the entitlement to the moneys was an entitlement which derived from the provisions of para. 7 of the memorandum of 1 January 1975, and that work in progress there referred to has the characteristics described by Windeyer J. in Henderson's case, it must follow that the total entitlement of the applicant, that is, the sum of $95,918, was a payment for an item to which the applicant as a retiring partner would have had no right except for the provisions of para. 7. That circumstance is the base upon which the applicant's case rests. Counsel for the applicant conceded that the work in progress had a connection with income in the sense that it would eventually yield income once the work was complete. But that had not occurred; the intention of all the partners including the applicant was that there should be an accrual of an entitlement to it from time to time which would result in the payment to a

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retiring partner of an appropriate amount for it, but only in the event of retirement. The ascertainment of an amount for work in progress was otherwise irrelevant to the relationship which the partners had with each other. Once work was completed, it would not fall into the category of work in progress; it would become part of the accrued earnings of the partnership available to be taken into account for the purposes of ascertaining profits and making distributions to partners.''

16. After carefully analysing the decision in Jamieson (supra) (the taxpayer in that case was a partner in a firm of solicitors who withdrew from the partnership on terms that the continuing partners would pay him an amount of $3,156 for his share of the fees on uncompleted and current files for work done to the date of dissolution. The Court held the amount so paid was income because it constituted the taxpayer's share of partnership profits for work done to the date of dissolution), Sheppard J. concluded (at pp. 4826-4827):

``Notwithstanding submissions by counsel for the applicant that I should do so, I find myself unable to distinguish Jamieson's case from the present. The members of the Court of Appeal rejected the taxpayer's submission in that case because they concluded that the evidence established that the payment of the amount in question was a payment to which the taxpayer was legally entitled by reason of a legally enforceable arrangement made by the members of the firm. That applies also in the case of the amount here in question. The evidence in this case is clearer than it was in Jamieson. Paragraph 7 of the memorandum of 1 January 1975 expressly provided for the entitlement. The purpose of such a provision was said by Wild C.J. and Woodhouse J. to be to enable the respective shares of profit of the partners to be determined up to the date of the taxpayer's withdrawal or retirement from the partnership. The amount was therefore income and not capital. It, perhaps, goes without saying that the underlying assumption made by the judges in Jamieson was that the work in progress to which they referred was work in progress in the conventional sense, that is, as explained in Henderson's case, work which was incomplete and for which clients were not then obliged to pay.

Is there some reason why I should not follow Jamieson's case? It is not binding upon me, but it is highly persuasive of what I should do. It is a unanimous decision of the New Zealand Court of Appeal. Having considered the judgments of the members of the Court, I do not perceive any basis upon which it can be said that they are incorrect. On the contrary I find myself in agreement with them. In particular I agree with the passage which I have quoted from the judgment of Woodhouse J. at first instance in which judgment Wild C.J. agreed. Work in progress in this context has the particular features and characteristics described by Barwick C.J. and Windeyer J. in Henderson's case, but it is nevertheless an affair of revenue rather than capital. It represents that which will in due course of time become income when the work in question is complete. The purpose of para. 7 of the memorandum of 1 January 1975 was to enable a retiring partner to have taken into account the value of potential income, that is, something which would not otherwise be brought to account. But para. 7 did not change the nature of what was involved. It was dealing with something which directly related to income and not to capital.''

17. It is generally accepted that there are two species of ``work in progress''. In the conventional sense, work in progress is work which is incomplete and for which the person doing the work is not legally entitled to charge the client. The term is, however, also used to connote work for which the person, because of contractual arrangements with the client, is legally entitled to charge even though the work is incomplete. In the present case, only ``work in progress'' as used in the conventional sense is in issue since all chargeable clients were billed pre-dissolution.

18. The factual situation in this case is somewhat unusual, if only because two sets of accounts and tax returns were prepared and lodged with the Commissioner. The first set was prepared by the retiring partner nominated for that purpose in the dissolution agreement. A ``rival'' set was subsequently lodged on behalf of the continuing partners, using a different

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accounting method. It was this latter methodology which the Commissioner applied - at least in the case of three of the retiring partners - as the basis for the amended assessments, and which he adopted as correct in these proceedings. Pausing here, the original assessments for two of the three retiring partners were issued subsequent to the receipt of the rival partnership tax return; in the case of the third retiring partner, the original assessment was issued prior to the lodgment of the rival return, the fourth retiring partner (who had taken all his clients' files and gone home) was assessed in accordance with the rival return. It is therefore only in respect of the two retiring partners whose original assessments were amended after the lodgment of the rival return, that the Commissioner's power to amend becomes an issue.

19. In the rival return, the closing work in progress - $207,000 - was included as partnership income. The result of this inclusion was a partnership profit of $130,000. The first return disclosed a loss of some $63,000.

20. The issue between the parties thus comes down to this: the retiring partners contend the credit allowed them for closing work in progress constitutes a repayment of capital, whilst the Commissioner (and the continuing partners) maintain that the credit for work in progress was income, being future partnership profit.

21. I find on the evidence:

• (i) upon the formation of the partnership, the work in progress contributed by the incoming partners constituted the partnership's major asset and was recorded as such by crediting the partners' capital accounts;
• (ii) since its commencement, in compliance with generally accepted accounting principles, the partnership's financial statements were prepared on a ``work performed'' basis, whilst the tax returns were furnished on a ``fees rendered'' basis. Furthermore, each year's balance sheet disclosed a valuation for closing work in progress as a partnership asset and the movement in work in progress was brought to account as income for purposes of determining each partner's respective share of the profit;
• (iii) adoption of the ``work performed basis'' for internal accounting purposes has the consequence that work in progress was recognised annually as a legitimate partnership asset.

22. The facts, as stated above, are thus vastly different from those found to be material in Jamieson and Stapleton. The critical distinction lies in the fact that in both the earlier cases, work in progress had not previously been brought into the accounts as an asset, whereas in the instant case, the entitlement, claimed and credited to the retiring partners for work in progress, was granted as their proportionate share in a partnership asset and movements in work in progress were (properly) treated as income in the partnership accounts and credited to the partners' current accounts.

23. It follows that upon dissolution, the retiring partners received, as credit for work in progress, a sum which constituted a repayment of their equity in the partnership. This had the effect of discharging their current and capital accounts in the partnership. On that finding the receipt is on capital account.

24. In the alternative, the retiring partners submitted that if ``work in progress'' is nevertheless assessable income, then the rival tax return did not truly reflect the proper basis for assessment in that it made no provision for opening work in progress.

25. This is accounting heresy. It does not follow that because internal management accounts are prepared on a ``work performed'' basis, the tax returns upon dissolution must also be prepared in such a manner. If it did, the applicants would have the best of both worlds; that is, they would be credited with their full share of work in progress, but only assessed upon its movement, with the consequence that the taxpayers would receive an entitlement to closing work in progress whilst at the same time obtaining a tax free distribution in respect of the downturn in work in progress for the eight months ending 28 February 1981 ($79,000). It cannot be right that the retiring partners should receive a substantial future income entitlement, and yet avoid the tax consequence from its receipt.

26. On the other hand, the rival return was clearly intended to divert the taxation burden from the continuing partners to the retiring partners. This was achieved by excluding from

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assessable income the closing work in progress from the two firms upon their merger, whilst including the work in progress as assessable income upon dissolution. In other words, the continuing partners set about to minimise their own tax liability at the expense of the retiring partners. The ``justification'' offered for this radical departure from their earlier treatment of work in progress (i.e. on the dissolution of the two previous firms and their subsequent merger) was that the inclusion of work in progress as income was forced upon them by the terms of the dissolution agreement. However, if there is such a term, it must be travelling steerage on the The Moorcock (1889) 14 P.D. 64 (``oh, of course'').

27. In the result, I am satisfied that the action by the continuing partners has no fiscal justification.

28. Since I have concluded that the credit for work in progress is ``capital'', it is unnecessary for me finally to determine whether allowance should be granted for opening work in progress. However, if I am wrong in my conclusion that the credit for closing work in progress is ``capital'', representing a distribution of partnership assets, then, consistent with Stapleton, the tax levied should be that amount assessed in reliance on the rival return.

29. For the sake of completeness, I will deal briefly with the argument, advanced by two of the retiring partners, that the two sets of accounts and tax returns, between them, provided sufficient information to constitute ``a full and true disclosure of all the material facts necessary'' for the assessments, so that the Commissioner was not empowered to amend the assessments under sec. 170. If it were necessary to make a finding on this issue, I would conclude that the Commissioner had, when issuing the amended assessments, all the material facts before him to issue the original assessments and was thus not empowered to issue the amended assessments (cf.
Lindsay v. F.C. of T. (1961) 106 C.L.R. 377). However, this point is only relevant should the credit for closing work in progress constitute assessable income.

30. For the above reasons the decision on each of the objections is set aside and allowed in full.