Heerey J

Federal Court

Judgment date: Judgment handed down 6 June 1991

Heerey J

Up until 30 June 1979 Messrs WM Harrison, F Johnston, PC Simmons and RW Vance carried on an accountancy practice in partnership under the name Sherlock & Co. On 30 June 1979 the old firm was dissolved and the business of the partnership was sold to a new firm consisting of Messrs Harrison, Simmons and Vance and three new partners, Messrs AR Coughlan, J Gianchino and ID Riley.

On 2 July 1979 members of the old firm and the new firm signed Heads of Agreement which included the following:


2. The vendors offer for sale to the purchasers the accountancy practice previously carried on by the vendors in partnership which was dissolved on 30th June, 1979.

3. It is understood by the parties that the words `accountancy practice' means the business assets and including goodwill, the firm name, and lease of premises, and the business liabilities, of the firm formerly carried on by the vendors until dissolved on 30th June, 1979.

4. It is agreed that the vendors will prepare a Balance Sheet as at 30th June, 1979, and that Balance Sheet shall be the basis of the sale to the purchasers of the accountancy practice as described in item 3 herein, subject to the adjustment of the asset Goodwill as mutually agreed upon by the parties not later than six months after 30th June, 1979.

5. The vendors agree to indemnify the purchasers against any liabilities not disclosed on the vendors' Balance Sheet as at 30th June, 1979 prepared in accordance with item 4 herein.

6. The consideration shall be paid as to 10% of the consideration on execution of the contract of sale and the balance of

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consideration shall be payable not later than twelve months dating from 1st July, 1979.



9. It is agreed and acknowledged by the vendors that the purchasers commenced business on 1st July, 1979 as partners in the accountancy practice purchased and that the vendors consent to the use of the business name Sherlock & Co, on and from that date.''

On 20 December 1979 a formal sale agreement was entered into between the old firm and the new firm which was to have effect on and from 1 July of that year. That agreement included the following provisions:

``1. The vendors shall sell and the purchasers shall purchase the assets including the goodwill of the old partnership as set out in the balance sheet annexed hereto.

2. As consideration for the assets hereby sold the purchasers assume responsibility for discharging the debts, liabilities and obligations of the old partnership set out in the balance sheet as expeditiously as possible and agree to pay to the vendors the sum of $466,523.39.''

The balance sheet which was annexed to the agreement included amongst the assets:

      Work in progress                 $195,254.58

A note to the balance sheet shows that the amount in question was made up as follows:

      Total as per EDP list                   $278,977.10
      Deduct write downs                      $ 35,222.52
      Total                                   $243,754.58
      Deduct interim billings                 $ 48,500.00
      Value as at 1 July 1979                 $195,254.58

It appears to have been accepted in these proceedings that work in progress meant work performed by the old firm, but not performed to such a stage that it was entitled to render a bill to clients. The total is made up from an electronic data processing list. The figure for write downs involves the recognition that some of this work would not be charged for, as for example where a disproportionate amount of time had been spent on a small matter.

By 30 June 1980 the new firm had completed most of the work in progress taken over from the old firm and had received approximately 90% of the fees for it.

Two questions arise in this case:

  • 1. Is the sum paid for work in progress by the new firm an outgoing of a revenue nature and deductible by the members of the new firm under s. 51(1) of the Income Tax Assessment Act 1936?
  • 2. If not, when the work in progress was completed by the new firm and fees charged, are the members of the new firm only assessable for that part of the fees which exceeded the amount paid to the old firm for the work in progress?

The Administrative Appeals Tribunal constituted by Deputy President IR Thompson answered both questions in the negative. In my opinion his decision was correct.

Viewed from the perspective of the purchaser of a business or professional practice, work in progress is a capital asset. It forms part of the structure which the purchaser acquires and from which he intends to produce income.

I accept that contracts for the performance of professional work such as accountancy services are not assignable without the consent of the client and I assume for the purposes of the present discussion that the contractual arrangements for the performance of the work in question had the effect that no fee was payable until the work was completed. The net result therefore is that, as between the new firm and the client, the former did not have a legal right to complete the work and charge the client for the total amount.

But, practically speaking, there must have been a substantial degree of probability that the client would allow his work to be completed by the new firm and would in fact pay the bill for the total amount of the work, including work done prior to the purchase of the business. This seems to me in essence no different from the acquisition of goodwill. The purchaser of goodwill has no legal right to compel clients of the vendor to continue to send their work to him. Nevertheless there is a probability that this will happen. The degree of likelihood of that probability of course depends on an infinite variety of circumstances, including the nature of the work and the personal attraction of the

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vendor. But it could not be suggested that goodwill is something which conceptually can have no value. It is something intangible, but nevertheless of value, and every day purchasers of businesses pay for the goodwill attached to them.

I should add that, although the purchaser might not be able to compel the client to allow him to complete the work, he would in my opinion have a remedy against the vendor if the latter were to complete the work and charge the client for it. The effect of a contract for a sale of a business including work in progress would ordinarily be that, by agreeing to receive payment for work in progress, the vendor has bound himself not to get the benefit of the work by completing it and charging the client. To do so would be a derogation from grant and an injunction would probably go to restrain the vendor from so acting: cf.
Trego v Hunt [1896] AC 7 at p. 25.

The taxpayers' argument was that the payment for work in progress was in respect of work performed and therefore was of a revenue nature. It was, so the argument ran, of no consequence that the new firm paid for the work which had been done by the old firm. It was in principle no different from the new firm paying another accountant for work subcontracted out.

In my opinion, this argument ignores the critical circumstance that work in progress was acquired by the new firm as part of the assets of a business with the intention of using those assets to produce revenue. The new firm hoped and intended that from 1 July 1979 onwards clients would come through their door attracted by the goodwill of the name Sherlock & Co and that income would be earned by doing work for those clients. The new firm paid the old firm money to obtain that opportunity. In the same way, the new firm paid money for the right to get access to the work that was in progress in the old firm's office and the right, from 1 July 1979, to complete that work and charge clients for it. Money was paid for goodwill and work in progress, along with other assets, to acquire a structure which could be used to produce income.

The authorities to which I was referred either directly support or are consistent with the conclusion I have reached.

City of London Contract Corporation Limited v Styles (1887) 2 TC 239 the taxpayer purchased as a going concern a contracting and engineering business. The business ``... consisted entirely of partially executed or wholly unexecuted contracts, and of the rights thereunder and the benefits to accrue therefrom''. It was argued that part of the sum which was attributed to the purchase of the contracts was deductible from the income of the purchaser for tax purposes. It was said that this was not money invested as capital:

``You can use your capital in purchasing contracts from which you derive your annual profits. It is capital to start with, but then you use your capital wholly and exclusively for the purposes of your concern.''

Bowen L.J. interjected (at p. 243) with a comment which is equally apt for the present case. His Lordship said:

``You do not use it `for the purpose of' your concern, which means, for the purpose of carrying on your concern, but you use it to acquire the concern.''

In delivering judgment Lord Esher M.R. said (at p. 243):

``Now nothing can be more plain, if that be so, than that £180,000 was the capital which they embarked in that business, the money they paid for it. But then we are carried beyond that, because there is a description given of what the business is. There is an endeavour to carry out so far as to go into the description of business and to say that the £180,000 is not capital because of the description of the business, but if they bought the business, whatever it may be, and whatever it consisted of, the fact that it is the capital which they embarked in that business cannot be doubted...

... it is as plain as plain can be that you cannot deduct from those net profits so arrived at any part of the capital which you so invested, whether you paid it or not for the purchase of the business which you are obliged to purchase before you could begin the difference between expenditure and income year by year.''

An attempt was made to distinguish Styles on the grounds that the contracts in that case, being for building or engineering work, were

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assignable by vendor to purchaser without the consent of the client. However the reasoning of the Court of Appeal makes no mention of that feature. In any event, for the reasons I have mentioned, the lack of a legal right of enforcement against the client is not of itself inconsistent with work in progress acquired as part of the assets of a business being properly characterised as capital.

Styles was followed by a Board of Review in Case No. F24
(1955) 6 TBRD 149. A solicitor had purchased practices including work in progress. The purchase prices did not include any amount apportioned for that item. The books debts of the vendor were expressly excluded. The taxpayer sought to deduct from his gross income amounts representing the value of the work in progress he had acquired from the vendors. This claim was rejected. The Board said (at p. 153) that:

``... the taxpayer made lump sum payments of capital, in each instance, for the purchase of a business, a profit yielding subject including all the advantages which the completion of partly executed professional work would yield, but excluding book debts. In due course, the businesses gave forth their yields and the gross revenue or business proceeds thereof actually received by the taxpayer in the relevant period were the full amounts of £980/12/10 and £9,393/8/8 respectively.''

The New Zealand case of
Jamieson v Commr of IR (NZ) (1972) 3 ATR 361 (Woodhouse J.) 74 ATC 6008 (Court of Appeal) concerned a solicitor who withdrew from a partnership under an agreement whereby he was entitled to a proportionate share of fees for work in progress as at the date of retirement. This share was calculated and paid to him. It was held that the payment for the share of work in progress was assessable income.

It will be seen that Jamieson was not concerned with payment by a purchaser for a business, but rather with the calculation of the benefit that the taxpayer should receive from the partnership up to the time of his retirement. This appears clearly from the judgment of Woodhouse J. at p. 362. His Honour said that there was:

``... a payment which followed from the agreement of all the partners to vary the method they had used previously for the calculation and division of profits. They agreed that a calculated sum should be included in the accounts to represent the value of work in progress and that payment should then be made to the retiring partner of his appropriate share of profits including that sum. It amounted to a variation of the partnership agreement which affected the method of dividing the profits for the period. It was done for the purpose of dissolution and the inclusion of work in progress was intended to reflect and did reflect the final share of the retiring partner in the business activities of the partnership. It enabled him to be paid out for the period from the last annual accounts up to the date of dissolution. In my opinion the calculation thus made in his favour and the payment that followed it clearly has the quality and character of income in his hands.''

At p. 364 his Honour said:

``The real point of the case before me is not whether the uncompleted work had any present asset value but whether the share in it that was actually credited to the retiring partner was income in his hands. In my opinion it was a revenue or income sum computed to enable a fair and just distribution of the achievements of the partnership up to the date of dissolution.''

Stapleton v FC of T 89 ATC 4818 also concerned a payment representing a share of work in progress to a retiring partner. Sheppard J. considered the case before him was indistinguishable from Jamieson. His Honour, after expressly adopting the second of the two passages from the judgment of Woodhouse J. referred to above, said (at p. 4827):

``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.''

(Henderson v FC of T 69 ATC 4049; 70 ATC 4016 (FC); (1968-1970) 119 CLR 612 was concerned with the point in time at which professional fees of an accountancy firm should be included in assessable income - when the fee was earned or actually received. The context had nothing to do with the sale of a

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business.) After referring to the judgment of Brennan J. in
Federal Coke Co Pty Ltd v FC of T 77 ATC 4255 at p. 4273; (1977) 34 FLR 375 at pp. 401-402, Sheppard J. said (at p. 4827):

``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. Here the receipt is characterised by the nature of the matter in respect of which it was received, that is, work in progress which bore no relation to capital and was directly connected with or related to income.''

In the present case, counsel for the taxpayers relied particularly on this passage, but in my view the context was quite different. It is trite law that the same item may be a capital item or a revenue item and payments made or received in connection with the acquisition of the same item may be on capital or revenue account, depending on the nature of the business concerned and who makes or receives the payment. A ship is part of the capital of a shipping company and a price paid for the ship is a capital payment. For a shipbuilder, whose business is to manufacture and sell ships, the price received for the ship is on revenue account. The taxpayers in Jamieson and Stapleton were held to have received payments in the nature of income for work in progress because the payments were directly related to the recurrent work they did in the course of their practice. But in the present case the new firm outlaid money to acquire a business and the work in progress was simply part of the assets of that business. It was like purchasing an orchard on which there are trees growing with fruit not yet harvested.

It follows from this reasoning in my view that the alternative claim of the taxpayers must also fail. The point is covered by Styles.

I order that the appeal be dismissed with costs, including reserved costs, and that the decision of the AAT be affirmed.

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