Henderson v. Federal Commissioner of Taxation.Judges:
Windeyer J.: These are two appeals, heard together, brought pursuant to sec. 187 and 197 of the Income Tax Assessment Act 1936-1966, against assessments of income tax in respect of the years ended 30 June 1965 and 30 June 1966. The taxpayer, Roy Halliday Henderson, objected to the Commissioner's assessments on the unusual and surprising ground that they were too low. At the outset of the hearing the question was raised of where the onus lay. Was it for the taxpayer to show that the assessment was mistaken or for the Commissioner to show that it was correct? Counsel referred me to sec. 167, 177 and 185-190 of the Act. The last-mentioned section provides that ``the burden of proving that the assessment is excessive shall lie upon the taxpayer''. There is no express provision for the case of a taxpayer who appeals against an assessment as being too low. Although the proceedings in this Court are called an appeal, the Court is really called upon, in the exercise of its original jurisdiction, to determine the matter on the evidence before it. It has not to determine the correctness of the Commissioner's decision on the evidence before him. The Act does not in the present situation expressly state where the burden of the case lies. However, as the proceedings arise from the disallowance of the taxpayer's objection, I thought it proper to direct that the taxpayer's case should be presented first - a course to which the parties were agreeable. I did so without prejudice to the question, if it should ultimately arise, of whether the Commissioner must establish that the method of computation he had adopted was correct. However, it seems to me after hearing the evidence that the essential facts are not in dispute. The question is, what in law are their consequences?
The Act provides, in sec. 17, that income tax ``is levied, and shall be paid... upon the taxable income derived during the year of income''. Counsel were agreed that the question in this case depended upon the manner in which income should be calculated in respect of the years in question. The distinction between an earnings or accrual basis on the one hand, and a cash receipts, or modified cash basis on the other, for the computation of income, and the consequences of changing from one basis to another in the case of a continuing business are a familiar topic for accountants and in taxation law. Some aspects of these matters have been considered in this Court: see
C. of T. (S.A.) v. Executor Trustee and Agency Co. of South Australia Ltd. (Carden's case) (1938) 63 C.L.R. 108;
Arthur Murray (N.S.W.) Pty. Ltd. v. C. of T. (1965) 114 C.L.R. 314;
Country Magazine Pty. Ltd. v. F.C. of T. (1968) 42 A.L.J.R. 42. In the United States the topic has produced much litigation and literature. But there the question emerges, for revenue purposes, from a different legal and administrative setting. I therefore do no more than note that I have found writings from the United States helpful in showing how a question similar to that in this case has arisen there and there been met.
It oversimplifies this case to regard it as turning simply on the distinction between calculating a taxpayer's income on an earnings and on a cash basis. The case concerns the income of the taxpayer Henderson;
ATC 4051but the question arises in relation to income derived by him as a partner in a firm of public accountants. It is the method of calculating the income of the partnership business which is really in question. For this reason the case has implications for the future; and for other people than the taxpayer. So far as the taxpayer himself is concerned - and after all it is his tax which is in question before me - his return of income derived by him during the relevant years stated the actual amount which had been paid to him, said to be as his share of the profits of the partnership earned in the year. His case might, at first sight, therefore seem simple. It might be said that throughout the period of his membership of the firm he returned as part of his assessable income the sum he actually received in any year as his share of the partnership profits; that in the years in question that is so just as it was in earlier years. Looked at in this way, it may seem immaterial that the amount he was paid was at one time calculated on the basis of the firm's receipts and at another on the basis of its earnings - because, as a taxpayer, he has always returned as his income whatever moneys he had actually received each year by virtue of his being a partner. However, in computing the profits of the partnership business available for distribution in respect of the years in question, earnings, not actual receipts, were taken as the basis of calculation. The business was at relevant times increasing year by year. In each of the years in question the taxpayer and other persons entitled to share the profits received amounts which in total amounted to more than the total of the sums actually received by the firm during the relevant year. The firm had borrowed money to enable a distribution of more money than had actually come in.
The Commissioner contends that he is not to look only at the sum which the taxpayer received as his share in the distributable profits of the partnership business, but at how this sum was arrived at. He says that, within the meaning of sec. 167 of the Act, he was ``not satisfied with the return'' furnished by the taxpayer; and that he was therefore entitled to make the assessment that he did of the taxpayer's taxable income. This assessment, he says, must then stand unless the taxpayer can displace it; and that to displace it the taxpayer must show that it was made on an impermissible basis. Counsel for the Commissioner put it as follows: ``It is our case that the initiative rests with the Commissioner and that the initiative can only be disturbed if the taxpayer can satisfy the Court that the method is one which is not open to the Commissioner having regard to the language of the Act.'' He added: ``If the Commissioner chooses to adopt a basis which is not inconsistent with the meaning to be attached to `gross income derived' (in sec. 25 of the Act), then the fact that some other basis may be consistent with the concept of `gross income derived' does not demonstrate the Commissioner's assessment to be wrong.'' I am unable to accept this proposition in the extreme form in which it was put.
I think that the rule is better stated as Dixon J. put it in Carden's case, supra, at p. 154.
``Unless in the statute itself some definite direction is discoverable, I think that the admissibility of the method which in fact has been pursued must depend upon its actual appropriateness. In other words, the inquiry should be whether in the circumstances of the case it is calculated to give a substantially correct reflex of the taxpayer's true income.''
Assuming that the method which a taxpayer followed in his return was, in the particular circumstances, an appropriate method of accounting by which to measure his income derived in respect of a specified period, I do not think that sec. 167 enables the Commissioner to insist on some other method being adopted, simply by saying that he is not satisfied with the taxpayer's return. Section 167 seems to me to be directed to a different situation. Certainly I think it does not put the Commissioner's decision beyond examination by the Court. It seems as well to turn at this point to what the Act says about the income of partners in business.
A ``partnership'' is defined for the purposes of the Act as meaning ``an association of persons carrying on business as partners or in receipt of income jointly, but does not include a company'' (sec. 6). This gives the word a wider meaning than it has for the ordinary law of partnership; for persons who are in receipt of income jointly are not, merely as such, partners for the
ATC 4052purposes of the Partnership Acts of the several States. The first limb of the definition in sec. 6, however, reflects the common statutory meaning of partnership - in the Western Australian Partnership Act 1895 it is sec. 7(1) - ``Partnership is the relation which subsists between persons carrying on a business in common with a view of profit''. The Income Tax Assessment Act, having defined a partnership as an association of persons, proceeds - in sec. 90-94 and elsewhere - to treat the association as if it were a separate legal entity. But this Court has made it clear that the Act is not to be read as involving any departure from the strict theory of our law:
Rose v. F.C. of T. (1951) 64 C.L.R. 118.
In Lindley on Partnership 12th ed. p. 28 this is stated:
``The law, ignoring the firm, looks to the partners composing it; any change amongst them destroys the identity of the firm; what is called the property of the firm is their property, and what are called the debts and liabilities of the firm are their debts and their liabilities.''
It could equally well be said that what is called the income of the firm is income of the partners; and that it is distributable among them according to the terms, express or implied, of the agreement between them. It would, however, be pedantic to quarrel with the provisions of the Act (sec. 90) by which ```net income' in relation to a partnership, means the assessable income of the partnership, calculated as if the partnership were a taxpayer, less all allowable deductions except the concessional deductions and deductions allowable... in respect of losses of previous years''. Whatever objections, verbal or in legal theory, may be made to speaking of a firm as if it were a legal person, there is no difficulty in the concept for accountancy and business purposes. Accountants are accustomed to what is called the ``accounting entity convention'' in relation to a partnership business, or I suppose, to any distinct enterprise. The Act requires that the collective income of the firm, as an association of persons carrying on business as partners, is to be treated as if the partnership were a taxpayer. But the Act does not subject it to tax. Section 91 provides that ``a partnership shall furnish a return of the income of the partnership, but shall not be liable to pay tax thereon''. From a partnership return it will appear that the partnership, considered as if it were a taxpayer, has either gained what the Act calls a ``net income'' or sustained what it calls a ``partnership loss''. Whichever it be, it is carried into the assessable income of each individual partner according to his share of it. In the case of net income it is added to his income from other sources in determining his taxable income of the relevant year. This is because, using the words of Rose's case, supra, at p. 124, the part of the Act which deals with partnerships ``is based upon the view that the collective income earned by the partnership belongs according to their shares to the partners regardless of its liberation from the funds of the partnership, that is, its actual distribution''. As I understand the case for the Commissioner he says that, just as a taxpayer who is a partner can be taxed on his share of the partnership profit for a particular year although it was retained in the partnership funds and not then paid out to him, so he is not to be taxed in respect of amounts actually paid him as his share of partnership profits which, according to what the Commissioner regards as proper accountancy, were not properly so described. There is no suggestion that the amount received by the taxpayer was not properly determined as his share of the aggregate income of the firm if the way in which that was calculated was permissable for income tax purposes.
The history of the business carried on by the partnership goes back many years. In 1930 a company, then known as The National Service Company Proprietary Limited, was formed. I shall hereafter call it ``the company''. It acquired by purchase an accountancy practice which had for some years before been conducted by a Mr. and Mrs. Woolcott for their own benefit. The company, led by Mr. C. P. Bird, now Sir Cyril Bird, carried on the business of public accountants until 1955. Then a change was made. This, I was told, was to comply with a view that a body corporate with limited liability should not engage in the profession of accountancy. The more senior professional employees of the company, who were also shareholders, took over, gratuitously, the accountancy practice. They carried it on as they had theretofore done, but now as partners not on behalf of the company.
ATC 4053Sir Cyril Bird became the senior partner. He has continued to exercise a dominant influence in the affairs of the firm. It became known, and has continued to be known, as ``C. P. Bird and Associates''. The company continued in existence. Its name has been changed to ``C. P. B. & A. Properties Pty. Limited''. It still exists under that name.
It seems there has never been a formal partnership agreement; but certain ``rules'' were formulated to take effect from 1 January 1955 when the partnership business began. Those rules provided that the affairs of the partnership were to be under the control of the ``Managing Partners''; and rule 1 states: ``The term `Managing Partners' means such of the partners as are for the time being Directors of the The National Service Company Proprietary Limited''. Two of the rules were as follows:
- ``11: The Managing Partners shall set aside from the net profits earned during each accounting period such sum for bonuses to partners and employees as the Managing Partners shall in their discretion think fit and such sum shall be distributed amongst such of the partners and employees in such shares and proportions as the Managing Partners shall in their discretion determine.
- 12: The Managing Partners may at any time admit an additional partner or partners.''
There were, it seems, originally only two managing partners, former directors of the company. But early in 1966 a so-called ``management board'' was formed, consisting of seven of the partners. This number was later enlarged to nine; and the provisions of rule 1, requiring them all to be directors of the company, have not been observed. There is no other provision in the rules for determining who shall be a managing partner. It seems that the selection from time to time of those to become managing partners has been made mainly by Sir Cyril Bird. The managers meet from time to time. They were called by Mr. Cowden - a senior member of the firm and one of their number, who gave evidence - ``the board'', or ``committee of management''
There were, at relevant times, nineteen persons called partners and recorded as such for legal purposes. But there are, and at all relevant times were, between sixty and seventy or more persons who share with the nineteen ``partners'' the annual profits of the accountancy business. They, like those who are dignified as partners, are all qualified or partially qualified accountants. In the internal affairs of the firm these associates, other than the partners, are called employees. Their receipts from the firm are described as salary and bonus; and for income tax purposes they are shown on group certificates. These salaries and bonuses are in fact arrived at by reference to the expected profits or the actual profits of the business. The partners return their income from the firm for taxation purposes as earnings, but they are not described as employees. That only nineteen of the participants in the profits of the business are called partners is the result of the provisions of the Companies Act 1961 of Western Australia, sec. 14(3), which at relevant times was as follows:
``No association or partnership consisting of more than twenty persons shall be formed for the purpose of carrying on any business which has for its object the acquisition of gain by the association or partnership or the individual members thereof unless it is incorporated under this Act or is formed in pursuance of some other Act or letters patent.''
(In 1966 the number twenty was by statute increased to fifty in cases such as the present one.)
Mr. Cowden, speaking of the partners and the other associates, said: ``There is really no distinction as between the type of work or what one does or what one is paid. Were it not for the limit of twenty for the partnership, probably when we first formed it the partnership would have consisted of sixty or a hundred, or something like that. We were limited, however, to that number, and that is just the way we have stayed.'' The profits are, he said, distributed among them all according to a formula related to years of service and applied to each according to the decisions and directions of the managing partners. All participate in the ``bonuses'' fixed by reference to profits actually accrued in the preceding year.
No doubt the nineteen partners could not escape from any of the legal liabilities of partners, for they have written themselves down as partners. The others could perhaps
ATC 4054deny that they were partners if it were sought to charge them as such, although on the evidence before me this is not clear. It was said that they do not all have a voice in the management of the affairs of the business, as those who carry on business as partners have. The affairs of the firm are, it seems, all under the control of the board of management, with some overriding influence by Sir Cyril Bird. But that apparently is by the consent of all these concerned. Moreover, if not having a voice in management meant always that the voiceless person cannot in law be considered a partner, then in this organisation ten of the nineteen partners so-called seem to be disqualified, for they are not members of the board of management. A seemingly anomalous position has arisen simply because considerations of professional propriety are regarded as preventing the practice of accountancy by a company, and at the same time it was unlawful for more than twenty, and is now unlawful for more than fifty, accountants to practise in partnership in Western Australia unless they be a company. ``Those who are in fact associated as C. P. Bird and Associates'' have met this difficulty by a division of their numbers which is perhaps more verbal than real and have committed the management of their affairs in large measure to a board of management. This may not matter for the determination of the present case. What does matter is to see how the profits of the accountancy business were calculated, and the share of the taxpayer therein ascertained for the years in question.
It is necessary to notice first that the company has had an increasingly important part in the whole scheme. The accountancy business is conducted in Perth, where the head office is in a building owned by the company, and also from branches in country centres in Western Australia. The company as at 30 June 1966 owned thirty-nine houses in the country, leased by it to the firm and occupied by accountants who are all associates in the business. The firm pays rent to the company. In this way the company gains profits and has declared and paid dividends to its shareholders. Many of those who participate in the profits of the accountancy business, whether as ``partners'' or ``employees'', are shareholders in the company. Others of them have lent money to the company. They receive interest on the moneys so lent. All have been encouraged by the managers to invest in the company part of the income they derive from the firm. The company and accountancy business are thus linked together for the benefit mainly of the same people. Both undertakings have prospered.
I turn now to the way in which the profits of the accountancy business have been dealt with and accounted for - first before the years of income in question in this case - secondly during these years.
The aim of the managing partners has always been that each year should finish without any profit remaining in the partnership accounts. They have accomplished this by the simple expedient of distributing all profits as salaries and bonuses and as rent to the company. The procedure adopted until 30 June 1964 was, very broadly stated, as follows. What was regarded as the gross profit of a year was arrived at as the difference between cash received and actual outgoings including ``salaries''. This was then paid or credited as rent to the company and as bonuses. The bonus for each recipient was determined by reference to his salary and years of service. The amounts for rent and for the bonuses were determined together by the managers. Whatever be the true analysis of the position of the participants other than the partners, I think that the so-called salaries paid to the nineteen partners, together with their bonuses, amounted in reality to a distribution of partnership profits, the share of each partner being calculated according to the contribution he was deemed to have made to the earning of those profits. This was of little practical consequence before the year 1964/1965, because in earlier years the partnership return of income was on an annual cash receipts basis; and each partner in his own return showed as income the salary and bonus actually received by him in each year.
Over the years the accountancy business grew greatly and continued to grow; and some change occurred in the character of the work done; and more of the work was done on a credit basis, instead of the customers paying for it as it proceeded. In 1964 the partners, or the managers for them, decided that in the conditions which had come to prevail it would be better if the partnership income tax return
ATC 4055were rendered on an earnings, or accrual, basis instead of as theretofore on a cash receipts basis. One of the matters which led them to this conclusion is said to have been a looking to the future, to the time when one or more of the senior partners would retire. It was apparently thought that by keeping the accounts of the partnership on an earnings basis each member of the firm would only receive and be taxed upon a remuneration proportionate to his contribution to the total earnings, and furthermore that neither a retiring partner nor continuing partners would suffer if a retirement occurred when there was a large sum outstanding for work done but not yet paid for. These matters were, I have no doubt, in the minds of those who decided to change the basis on which the accounts of the firm were kept. But I have not seen that they necessarily dictated a change in the method of calculating income for taxation purposes. It would no doubt be convenient if accounts kept for determining the internal affairs of the partnership, that is the relations of the partners one to another, were on the same basis as accounts kept for the purpose of recording partnership income for fiscal purposes. But, as I see it, the two do not have to correspond. The financial arrangements to be made when a partner retires or dies, and the firm is thereupon re-constituted, depend upon the agreement made or to be made between the partners to meet that situation. Nevertheless that situation, and the arrangements made by the partners to meet it, can obviously give rise to taxation problems, as for example in
Happ's case (1952) 9 A.T.D. 447. However, these questions do not arise in this case. Their only importance is that the partners thought it convenient or helpful for the regulation of their financial relations one with another, then and in the future, to adopt for the purposes of their business a new mode of accounting. And that seems to me to be a good reason why they should be permitted to adopt that mode for fiscal purposes also, if it be one which accords with the Act and truly reflects the assessable income of the partnership ``calculated as if the partnership were a taxpayer''.
The decision in 1964 to make the partnership return on an earnings basis instead of a cash basis was strengthened by, indeed perhaps prompted by, the judgment of Ungoed-Thomas J. in
Wetton, Page & Co. v. Attwooll (Inspector of Taxes) (1963) 1 W.L.R. 114; (1963) 1 All E.R. 166. But I do not myself think, as apparently the taxpayer and his colleagues did, that his Lordship's reasoning there was, without any qualification, applicable to or decisive in the facts of this case. To those facts I return.
The partnership return for the year ended 30 June 1965 was, for the first time, compiled on an earnings basis. It seems to me that, considered in the abstract, this method is quite appropriate for the kind of business which the partners were carrying on. I would be inclined to think that, for various reasons which I need not detail, it is in fact more suitable than the cash receipts method. But that is not all. As Dixon J. put it in the sentence which I have already quoted, ``the inquiry should be whether in the circumstances of the case it is calculated to give a substantially correct reflex of the taxpayer's true income''. I adopt this expression ``substantially correct reflex'' because I take the whole pronouncement in which it appears to be for me authoritative. I observe too that it accords with phrases used in the United States in statements that for a taxpayer's method of bookkeeping to be acceptable for revenue purposes it must ``clearly reflect his income'': see e.g.
Zimmerman Steel Co. v. Commr. of I. R. (N.Z.) (1942) 143 A.L.R. 1054.
I think that the form of the partnership income tax return for the year 1964/1965 did not give a substantially correct reflex of the income of the partnership. That is not because an earnings basis was not in itself appropriate to measure the collective earnings of the partners and those associated with them in business for the year in question. It it because that year was only one of the series of years during which the business was carried on. When income is a regular annual produce governed by the rotation of the seasons, any period of twelve months can stand in isolation. Thus it was with predial tithes in their primitive form; for tilling the field, sowing and harvesting the crop all occur within the year. It is so too when income of distinct annual operations is measured in money, not as produce in kind - as for example if wool be shorn and the clip sold in the same accounting year. But this case is of another kind. What has to be
ATC 4056measured is income ``derived during the year of income''. That income in this case is not like an annual crop. It is merely so much of a continuous incoming as is attributable to a particular year, either as being money received in that year or as being money earned in that year. Counsel's metaphor in argument of a continuous flow of water through a pipe to be measured in periods of time is apt and suggestive; but a difficulty obviously arises if a new meter be put upon the pipe different from that previously in use and measuring the constant flow in a different way.
A general principle was expressed by the Chief Justice in the case of
Ravenshoe Tin Dredging Ltd. (1966) 40 A.L.J.R. 76 at p. 78, when he said.
``Once annual accounting to ascertain assessable income is undertaken, apart from special statutory provisions, the financial experience of the year is, as it were, isolated from earlier and from subsequent years: so to speak, it is self contained. This is true, in my opinion, though the closing balances of one year became the opening figures for the next year's accounting.''
But, as I understand it, this postulates both a continuing business and a method or basis of accounting which is constant from year to year.
What has actually happened in the present case is that a sum of $179,530, treated in the partnership books as received by the partnership after 30 June 1964 in payment for work done in the year 1963/1964, has not been taken into account at all as income for taxation purposes. It was not shown in the 1964/1965 return, because that was on an earnings basis and the work by which it was earned was done in the previous year. It had not been shown in the previous year, because that was made on a cash receipts basis and it was not received in that year. The amount in question did not find its way into the distributable partnership profit of the year 1964/1965 and thus come to charge as income of the partners. That was secured by the entry as a debit in the partnership books of an equivalent sum (as at 30 June 1965, $175,668) as a liability to the company in respect of a premium for a lease by the company to the partnership of new business premises.
The partnership, regarded as a taxpayer, thus says in effect that the whole of this sum of $179,530 is outside its assessable income and escapes tax: in the year it was earned it was not counted because it was not then paid: in the year it was paid it was not counted because it was not then earned. It is this kind of result of changing from a cash basis to an earnings basis, and then regarding the next year in isolation, that prevents the partnership return for 1964/1965 being a true reflex of income. It is not a true reflex, simply because taking the income there shown with the income shown in the previous year the two together do not reflect the true income over the period of two years combined. In the United States it has long been seen that adjustments must be made in the strictly logical application of a changed method of accounting in the year following the change, if either an escape of income from taxation or the subjection of the same income to taxation in successive years is to be avoided. Much has been written on this, and to meet the situation various conventions and procedures have become established in America. At one stage the change from one basis to another there depended largely upon the discretion of the revenue authorities. I gather from an article in the American Journal of Taxation of April 1967 that in the United States taxpayers no longer require permission to change from a cash to an accruals basis of accounting, for the adjustments to be made have apparently become stereotyped. But these administrative procedures are not applicable in law in the United Kingdom or in Australia.
A method which is well-recognised in accountancy, and its rationale is apparent, for the determination of gross income of a period on an earnings basis may be stated broadly as follows. The net receipts of the business, being the difference between actual receipts and outgoings in the period, is first ascertained. To this is added the amount which at the end of the period is outstanding as debts due to the business proprietor in respect of the business. From the total of these two sums there is then subtracted the amount which was outstanding for debts due but not collected at the beginning of the period. The result will show a profit or a loss for the period. The application of that method in the present case is complicated because to both the commencing and the ending figure for money due to the partnership there were
ATC 4057added sums for what was called ``work in progress''. I shall come later to this. For immediate purposes, let it be assumed that the figure for work in progress represents money earned at the relevant date, and therefore properly added to the debts owing to the business as at those dates. As it happened, and whether by chance or design matters not, there was on 1 July 1964 the beginning of the year for which the partners had decided to adopt the new basis, a large sum owing to the partnership for uncollected debts for work done before then; and also a very large sum for work in progress. This was in part, if not wholly, the result of the steady growth of the business.
The year ended 30 June 1965.
In figures the position was as follows (I shall state all figures in dollars, not in pounds, irrespective of the period to which they relate):
- (a) Debtors as at 1 July 1964 (that is the closing figure for the year ended 30 June 1964) $66,002: add work in progress at that date $113,528: total $179,530: from this subtract $2,432 liabilities of the business as at that date. The result is an opening figure of $177,098.
- (b) The closing figures, as at 30 June 1965, were: closing debtors $226,198: add work then in progress $77,862: total $304,060: from this subtract liabilities of the business as at that date, $47,032. The result is a closing figure of $257,028.
Following the customary way of disposing of all profit, the partnership accounts showed no cash profit (apart from an incidental sum of $284) for the period after payment of bonuses and current outgoings, including ``salaries'' and rent. The partnership return stated the partnership income as $284. The income of Henderson, the taxpayer, for the same period was shown in his return as including ``partner's salary $10,646''. This was made up of $9,106 ``salary'' and $1,540 bonus.
The Commissioner did not accept these returns as correct. In relation to the partnership income, he did not dispute that the salaries and bonuses were a proper charge in ascertaining profits; but he, in effect, wrote back the figures as returned to a cash basis by adding $177,098 to the $284 stated income, and then deducting $257,028, leaving a debit balance of $79,646. In this way he reversed the ordinary process of calculation on an earnings basis which the partnership had adopted. He added what had been subtracted and subtracted what had been added. He thereby reached the conclusion that the partnership had made a loss of $79,646. He then proceeded to distribute this among the nineteen partners. Ignoring the fact that, according to the arrangement between themselves, they did not participate equally in gains, he said that each should be regarded as liable for $4,192 as his share of what he had found to be a ``loss''. In the case of the taxpayer Henderson, this meant that his taxable income, shown in his return as $8,836, was reduced by the Commissioner by $4,192. After an addition of $30 by way of an adjustment immaterial for present purposes, a notice of assessment of tax was on 11 July 1967 issued to Henderson, based on a taxable income of $4,674 for the year ended 30 June 1965. Adjustments were made on similar lines in respect of the taxable incomes for the same period of each of the other eighteen partners; but it is only Henderson's case that is before me.
The delay until July 1967 in issuing a notice of assessment for the year ended 30 June 1965 is explained by negotiations with the Commissioner which were proceeding in the meantime. But I have not been able, from the material before me, to reconcile the date 11 July 1967 with that stated in the first paragraph in a letter written by Cowden on behalf of the firm to the Commissioner dated 7 November 1966. This discrepancy in the dates of the notice of assessment seems to be of no moment; but the first three paragraphs of the letter are significant for other reasons. I therefore set them out.
``The partners in this firm have now received their Income Tax Assessment Notices in respect of the two income years ended 30th June, 1966 and by the letter attached have authorised this firm to act as their agent in respect to those Assessments.
On their behalf it is again emphasised that the `earnings' basis of calculation of the income of the partnership is now the most appropriate method. This is self evident from the accounts prepared for the two years concerned and the fact that the difference in taxable income between the `earnings' basis and the `cash' basis was $79,930 in the first year and $60,123 in
ATC 4058the second, the `cash' income being the lower in each case.
For that reason alone we feel it must be conceded that the `earnings' basis is far more appropriate than the `cash'. Another reason however is that there are many others - perhaps 50 - who would and should be partners were it not for the legal limitation to 20. Thus it can be said the present 19 partners really hold the affairs of the partnership under some moral obligation for the benefit of partners and employees alike. The rights of each person are preserved through the company and not the partnership. That is why it was necessary for the `premium' or `additional rent' (referred to in previous correspondence) to be paid to the company of an amount equivalent to the debtors and work in progress at the date of conversion. It is therefore very important that at any point of time a retiring or deceased partner has no deferred tax liability in respect of a share of debtors and work in progress to which share in fact he is not entitled and would never receive.''
The last part of this extract from Cowden's letter refers to the balance of the sum of $179,530 abovementioned which was not brought to account as assessable income. It was, as I have said, shown in the books as a liability of the partnership to the company in respect of a lease of the business premises. I shall deal with this later.
The year ended 30 June 1966.
The same question arises in respect of the year ended 30 June 1966 as for the previous year. This time, however, the matter is not complicated by the receipt of any amount said to escape taxation, such as occurred during 1964/1965. Turning then to the details of the year 1965/1966 the relevant figures are:
- (a) As at 1 July 1965, debtors and work in progress $304,060 (this the opening figure for this year is the closing figure of the previous year) less liabilities $47,032: giving an opening figure of $257,028.
- (b) The closing figures as at 30 June 1966: debtors $291,260; add work in progress $68,333: total $359,593: from this subtract liabilities $42,442. The result is a closing figure of $317,151.
Once again, what would ordinarily be regarded as partnership profits was absorbed as salaries and bonuses. The partnership return for the year therefore showed the partnership as devoid of income. The Commissioner, following the same course as in respect of the previous year, adjusted the partnership income shown as nil in the return, by adding $257,028 and deducting $317,151. That is to say he again added what had been subtracted and subtracted what had been added, thus in an artificial sense restoring a cash basis. In the result he said the partnership income showed a loss of $60,123. This he distributed among the partners, attributing to each $3,164 as his share of the partnership loss. When carried into the income tax return of the taxpayer Henderson, this share in a loss has the result that instead of his having a taxable income as he showed in his return of $13,203, the Commissioner says that his taxable income was $10,039, and tax was assessed accordingly.
It is unreal and misleading to say that there was in either of the years in question what the Act in sec. 90 calls a ``partnership loss''. In the first of the years the nineteen partners in fact received as salaries and bonuses a total of $148,476: in the second year $211,779. These amounts they got from the actual receipts of the undertaking and from moneys borrowed in anticipation of moneys earned. It is only because they chose to describe what they got as salaries, not as a share of profits, that the Commissioner can say that the partnership made a loss. The unreality of this proposition does not really matter for taxation purposes, because by sec. 91, as it now stands and was at relevant times, the partnership as such is not liable to tax. If partnership profits are distributed to partners under the name of salaries, they come to charge as income of the recipients in the year in which the salaries were received. Nevertheless the approach which the Commissioner has taken highlights the problem of this case.
Assessments and objections.
Seven of the partners, including Henderson, received notices of assessment of tax on the same date, 11 July 1967. In each case assessments for the two years in question were issued at the same time. These notices, must I assume, have taken the place of earlier notices for the same years referred to in correspondence in November 1966. A notice of objection covering these seven assessments was given in a letter, signed by Cowden on behalf of the firm acting as agents for the taxpayers concerned. This said:
``The objection is against the method of Assessment of income of the partnership, full details of which were given in our letter of the 7th November 1966. The grounds of objection are also stated fully in that letter.''
I have already set out part of the letter of 7 November. It is lengthy and argumentative and I do not think it necessary to quote it in full. Its last paragraph reads:
``We therefore object on behalf of all of the partners of C.P. Bird & Associates against the adjustments to the income of the partnership for the 2 years ended 30th June, 1966 which have the effect of changing the method of computation of income from an `earnings' to a `cash' basis and in consequence against the Assessment of income tax shown on the notices of Assessment issued to the several partners for the same years, on the grounds that:-
- 1. The `earnings' basis of computation of income was the most appropriate method in the years concerned.
- 2. There were good reasons for the change and sufficient to outweigh any difficulties in the transitional year.
- 3. If there is an obligation to include in the assessable income on a conversion from a `cash' to an `earnings' basis the value of the debtors and work in progress less creditors in addition to the `earnings' income, the methods suggested in our letters of 15th October, 1965 and 18th October, 1966 were reasonable and achieve that end.
Would you please acknowledge this letter and advise us your decision at the earliest opportunity.''
The Commissioner notified Henderson, on 19 October 1967, that the objection was disallowed. Thereupon at his, the taxpayer's request, the objection was, pursuant to the Act, treated as an appeal and forwarded to this Court.
I need not set out the matters which in Mr. Cowden's letter were referred to as ``the methods suggested in our letters of 15th October, 1965 and 18th October, 1966''. The negotiations with the Commissioner had proved abortive before the present notice of assessment was issued 11 July 1967. Proposals for a settlement had been made by both sides. They were not accepted. They have become irrelevent. The question is whether the assessments made should stand.
Work in progress.
Before giving an answer to this question it is, I think, necessary to look at the figures given for what was described as ``work in progress''. The opinion which I express on this aspect is based upon what seem to me general principles. It is not directly based on the evidence in this case or derived from the arguments addressed to me. The question was mentioned cursorily by counsel; but it was not fully argued and much was taken for granted. However, I do not think I can over-look it.
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
ATC 4060not know when it became customary to take into account work in progress, but it appears 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 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. Of course, if an amount were recoverable as a quantum meruit although a task was not completed, it could be said to
ATC 4061be earned. And, as I have said, services may create debts before a bill is sent to the debtor. But services rendered do not produce taxable income until they create a debt. And it must be a debt which is in fact recoverable, not a bad debt.
Metaphorically stated, the difference between a cash basis and an earnings basis for calculating income for tax purposes is that in the first the crop is not counted until it is harvested and garnered, in the second it is counted when it is ripe for harvest; but while it is ripening and has not become harvestable, it is not to be taken into account as income: see
Shaw v. F.C. of T. (1920) 27 C.L.R. 340. Deserting metaphor for the language of law and business, I quote again from the judgment of Dixon J. in Carden's case, (supra), where (at p. 155) his Honour said: ``Speaking generally, in the assessment of income the object is to discover what gains have during the period of account come home to the taxpayer in a realised or immediately realisable form''. An estimate of the value of work in progress at a given date, made for the purposes of a taxpayer's business, does not necessarily shew that the sum so estimated is at that date immediately realisable. That is important in this case, because I cannot say from the evidence whether any part and, if any, how much of the sums set down as for work in progress at various dates really represents moneys then earned. If, as is possible, the only true earnings are the amounts described in the partnership accounts as debts to the partnership, not including the amounts said to represent work in progress, then the commencing figure for the year 1964/1965 should be $66,002. From this it would be necessary to subtract liabilities $2,432-leaving a balance of $63,570. The figures as at other dates would, as I see the matter, have to be adjusted in the same way in any computation of income on an earnings basis. However, I cannot do more than indicate what I consider to be the proper principle to be applied. The evidence does not enable me to say what would be the result of its application.
I now state and explain my conclusions on the whole case.
- (a) The Commissioner was, in my opinion, not justified in insisting on the partnership income being calculated in the year 1964/1965 or subsequent years on a cash instead of an earnings basis.
- Furthermore the Commissioner's assessments of the tax payable by the individual partners on the supposition that, calculated on a cash basis the partnership had in those years made losses to be distributed equally among the nineteen partners cannot be sustained.
- (b) The assessable income of the taxpayer Henderson will, I consider, in the result include the amounts he actually received in cash as salary and bonuses in each of the years in question as his share of the partnership profits calculated on an earnings basis, and also any further amount attributable to the calculation on a proper basis of the assessable income of the partnership.
- (c) The assessable income of the partnership for the year 1964/1965 includes, in my view, the sum of $179,530 reducible apparently to $177,098 by setting off liabilities outstanding at 30 June 1964. The amount of $179,530 is said to have included an amount of $113,528 described as for work in progress at 1 July 1964. There is nothing to shew that that amount or any part of it was then presently payable. The only evidence of the debts outstanding and payable at that date is that they amounted to $66,002. If the then outstanding liabilities of the period ended 30 June 1964 (namely $2,432) be deducted, the earnings due to the partnership and unpaid at 1 July 1964 appear to have had a value of $63,570. This amount, or whatever amount was in truth the sum of the recoverable debts earned in the earlier year, would, if the income of both periods were being calculated on a strict earnings basis, be deductible in the calculation of the income of the year 1964/1965. But that was the transitional year; and, for the reasons I have given, when for taxation purposes a cash basis of accounting is abandoned and an earnings basis is adopted, the calculation cannot proceed as if an earnings basis had been in use throughout. An adjustment must be made, and this, it seems to me, involves a bringing to account, as earnings at the time when the new basis of accounting begins, all debts then collectable-that is all debts due and payable, excluding bad debts. What on an earnings basis would ordinarily be counted as the aftermath of the previous year is counted as part of the prima tonsura of the transitional year. Although the evidence specifically shews only a sum of $63,570 to be brought to account in this way, there would have to be added to it such part, if
ATC 4062any, of the sum of $113,528 as represented debts recoverable at 30 June 1964. These two sums, $63,570 and such amount as was at the beginning of the year a recoverable debt arising from what was called work in progress must, in the view I take, be brought to account as part of the assessable income of the year 1964/1965 as an adjustment made necessary by the change from a cash to an earnings basis. If the earnings basis had been constantly in use throughout, these amounts would have entered into the calculation of partnership income for the previous year and been deducted in the calculation for the year 1964/1965.
- So much of the amount of $113,528 as first became recoverable as a debt during the year 1964/1965 was a part of the partnership income earned in that year. That was not as the result of the adjustment consequent upon the change from a cash to an earnings basis, but simply by virtue of the adoption of the earnings basis for the year.
- (d) I put the above figures forward tentatively as indicative of the result which would follow from the adoption of what I consider to be proper principles in ascertaining the income of the partnership for the purposes of the Act for the year 1964/1965. I do not find these figures to be the correct figures. The evidence does not enable me to do that. I state only the course which I think should be followed to ascertain for taxation purposes the income of the partnership on an earnings basis of the transitional year. I use the figures given in evidence illustratively only of the end result of following that course. I express no opinion at all as to the precise sum which, according to the view I take, should be carried into the assessable income of the taxpayer, Henderson, pursuant to sec. 92 of the Act. Moreover I am conscious that little argument was addressed to me as to the validity of taking work in progress into account.
- (e) I should add at this point that the fact that a sum of $177,098, or thereabouts, was paid to or treated as a partnership liability to the company as a premium in respect of the lease of new premises does not, I think, alter the manner of calculating the partnership income of the year 1964/1965. This amount, the balance of the sum of $179,530 in question, was treated in this way in the partnership accounts pursuant, it is said, to some arrangement of which no precise evidence was given. On such material as I have, it seems to have been a disposal by the partners of some of the partnership income to obtain what appears to be a capital asset. It was not, so far as appears, an outgoing necessarily incurred in gaining the assessable income or in carrying on the business so as to be an allowable deduction according to sec. 51 of the Act. But, as the question was not argued and the relevant facts were not investigated, I make no finding on this aspect.
- (f) One argument pressed for the taxpayer, for excluding the sum of $179,530, or any part of it, from the income, was that assessable income of the partnership for the year 1964/1965 was founded on the decision of the Court of Session in
Commissioners of Inland Revenue v. Morrison (1932) S.C. 638; 17 T.C. 325. That case was referred to by Dixon J. in Carden's case, supra, at p. 158, but nothing which his Honour said there supports the use it was sought to make of it in the present case. It was a case the reverse of this. A taxpayer changed the basis on which he calculated his ``profits and gains'' from an earnings basis to a cash basis. It was held that he was chargeable in respect of a particular sum which he received after the change, although before the change it had been taken into account in the calculation of his earnings in an earlier period. By changing the method on which he calculated his profits and gains he had subjected himself to tax in two successive years in respect of the same sum gained. However, it seems to me a mistaken use of analogy to say that means that in this case the partnership, considered as if it were a taxpayer, has, by changing the method on which it calculated its income, escaped tax altogether in respect of $179,530 which in a commercial sense formed part of its income.
- (g) The assessment of the taxpayer, Henderson, for the year 1964/1965 should, I consider, be set aside.
- (h) The assessment for the year 1965/1966 should also, I consider, be set aside. An earnings basis for ascertaining the partnership income was in my opinion appropriate for this year, as it was for the previous year. No difficulty arises in its application to the partnership for this year, and no adjustment of it is required such as was necessary in the transitional year. The recognised method of computation should be followed, namely by adding to cash gains during the year the debts payable at the end of the year and then
ATC 4063subtracting debts outstanding at the beginning of the year: but again, in my view, this should be without allowing, at either end, for work in progress unless it had resulted in debts then presently payable. The net income of the partnership ascertained in that way should then be reflected in the assessable income of the partnership according to sec. 92.
- (i) For the reasons I have given, I shall allow the appeals. I think that it has been shewn that the Commissioner in assessing the taxpayer's income adopted an erroneous method of calculating the net income of the partnership and the taxpayer's interest in it. But I am unable, on the material before me, to accept as correct the calculation proferred on behalf of the taxpayer. It seems to me that a correct assessment of the partnership income would shew a larger sum than the taxpayer reckoned on, especially for the year 1964/1965. However, he has succeeded in his contention that his taxable income was more than the Commissioner said it was. In my opinion he has succeeded too in his claim that the partners should be allowed to return the partnership income on an earnings instead of on a cash receipts basis. To make good that claim was, I assume, the main purpose of his desire to pay a larger sum as tax than the Commissioner claimed. He may have succeeded beyond and against his desires; and he may be moved to repeat the exclamation Pyrrhus is said to have uttered after his army had defeated the Romans. But he has won his case. I think he should have his costs.
- (j) The question then is what consequential orders I should make. The case is unusual. To correct the present assessment further inquiries seem to be necessary, especially about the figures for what was called work in progress and the agreement with the company for a premium for a lease. I shall therefore remit the matter to the Commissioner so that, unless the parties come to an agreement, he can issue amended assessments for the years in question.
Either party, or both parties, may wish to appeal to the Full Court from my order in this case, or they may wish to enter into negotiations. They should have sufficient time to consider the position. There are many persons directly or indirectly interested who are in Western Australia. I shall be pronouncing judgment and publishing these reasons for judgment in Sydney. I shall therefore, pursuant to Order 70 Rule 6 of the Rules of this Court, fix a day two weeks after my doing so as the date after which, within twenty-one days, either party is to be at liberty to file and serve a notice of appeal from this decision.
Appeals against the assessments allowed with costs. Matters remitted to the Commissioner. Time within which a notice of appeal against this order may be given by either party to be twenty-one days from 2 May 1969. Usual order as to exhibits.
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