Case Q70

Judges: HP Stevens Ch
BR Pape M

TJ McCarthy M

Court:
No. 1 Board of Review

Judgment date: 5 August 1983.

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T.J. McCarthy (Member)

The issue in this reference is whether sec. 226(2) can have any application in relation to a deduction claimed in a taxpayer's return for his individual interest in a partnership loss, where there was no evidence that certain prepaid interest claimed in the partnership return was actually incurred and the disallowance of the interest claimed still left the partnership in a loss situation.

2. According to the file of documents forwarded to the Board by the Commissioner pursuant to reg. 35(1) of the Income Tax Regulations , a partnership return for the D Investment Partnership No. 4 was lodged for the year ended 30 June 1978 disclosing a net loss for tax purposes of $748,671, after taking into account an amount of $747,500 as ``interest paid'' to a finance company. This claim admittedly arose from a prepaid interest tax scheme and related documents were attached to the partnership return lodged. These documents comprised a deed of partnership dated 26 January 1978; an agreement dated 27 January 1978 between the finance company and a number of borrowers, including the taxpayer; a letter of

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demand dated 28 January 1978, pursuant to cl. 4 of the loan agreement, requiring the payment of 65 months' interest in advance, calculated at a rate of 13 8/10% p.a. (interest upon the loan then reducing to 8 ¾ % p.a.); an offer dated 30 January 1978 by the finance company to another company offering to assign the principal sum of $1,000,000 and any future interest accruing thereon for the sum of $320,000; a written acknowledgment of debt dated 1 February 1978 recording a loan of $747,000 to the partnership; and a deed of trust apparently dated 20 April 1978 whereby the partnership manager declared that it held certain units in a unit trust upon trust for the partners.

3. The taxpayer's return of income for the year ended 30 June 1978 was lodged by his tax agent in February 1979 and a deduction of $31,669 was claimed in respect of the taxpayer's interest in the partnership loss. His return disclosed a taxable income of $4,174. By letter dated 12 March 1979 the taxpayer's agent requested the Taxation Office to substitute what I would describe as a ``Clayton's Deduction'' for the ``Share of Loss - D Investment Partnership No. 4 - $31,669'' claimed in his return. I need not set out the ``Clayton's Deduction'' - the deduction you claim when you are not claiming a deduction - because taxpayer's counsel placed no reliance upon it.

4. On 29 June 1979 a notice of assessment for the year ended 30 June 1978 issued to the taxpayer. The taxable income was assessed as $35,843 and an accompanying adjustment sheet indicated that the taxpayer's share of loss in the D Investment Partnership No. 4 had been reduced from $31,669 to nil. Additional tax of $7,385.88 was imposed for ``incorrect return''. An objection against the disallowance of the share of partnership loss and against the imposition of additional tax was lodged on behalf of the taxpayer on 22 August 1979. By letter dated 19 July 1979 the agent requested further particulars and on 17 September 1979 the Taxation Office replied to the effect that the prepaid interest was not deductible under sec. 51(1) and in relation to additional tax said:

``Liability for additional tax in terms of sec. 226(2) of the Income Tax Assessment Act arose as the return included a claim for a deduction for interest incurred whereas expenditure in the nature of interest had not been actually incurred.''

5. On 8 May 1981 a notice of amended assessment in respect of the year ended 30 June 1978 issued to the taxpayer, but this assessment increased the tax assessed in the original assessment and is not properly before the Board. By letter dated 20 April 1982 the Commissioner disallowed the objection against the original assessment and his decision thereon was subsequently referred to this Board for review.

6. At the hearing the taxpayer was represented by Mr. J. Durack of counsel and the Commissioner by Mr. C. Porter Q.C. and Mr. R. Gelski of counsel. The reg. 35(1) file was tendered as an exhibit and counsel for the taxpayer informed the Board that for economic reasons the planned four-day hearing on the merits of the prepaid interest scheme was abandoned and no evidence was to be adduced by the taxpayer. He then made the following submissions:

• (a) Where the material on the Commissioner's file is not attacked by the Commissioner, the Board can take this material into account, even though the taxpayer is not called and no evidence is led on his behalf.
• (b) A formal submission was made that the prepaid interest was an allowable deduction to the partnership in accordance with sec. 51(1) and 90.
• (c) Section 226(2) was inapplicable because the prepaid interest was deductible. The remaining submissions were put on the basis that the interest was not deductible.
• (d) The claim made by the taxpayer in his return was a claim for his individual interest in a partnership loss. He did not include in his return as a deduction for expenditure incurred by him an amount in excess of the expenditure actually incurred by him. Accordingly, sec. 226(2) was inapplicable, reliance being placed on the decisions of this Board in Case P120, 82 ATC 604, Case P121,
  82 ATC 611 and Case P122,
  82 ATC 623 (which are all on appeal to the Supreme Court of Victoria) and the recent decision of the No. 3 Board in Case Q23,
  83 ATC 84 (also on appeal).
• (e) Even if the claim for his share of the

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  partnership loss represented a deduction claimed for expenditure incurred by him, the interest paid by the partnership was actually incurred.
• (f) If sec. 226(2) was applicable, the additional tax imposed should be further remitted. Several factors were suggested in mitigation. The documents lodged with the Commissioner approached full disclosure; the taxpayer acted on professional advice; a retrospective code of morality should not be imposed; the speeches of Lord Diplock and Lord Fraser in
  IRC v. Burmah Oil Co. Ltd. (1982) STC 30 especially at pp. 32 and 37 suggested that taxpayers should not be penalised for not foreseeing a difference in judicial approach to tax avoidance schemes, at least where real money was involved.

7. Counsel for the Commissioner made the following submissions:

• (a) As no evidence was led on behalf of the taxpayer, he had failed to discharge the burden of showing the assessment was excessive, as required by sec. 190(b).
• (b) In relation to a deduction claimed by a taxpayer in his return, sec. 226(2) requires a comparison of claimed expenditure for a particular purpose with actual expenditure for that purpose.
  Rabinov & Anor. v. F.C. of T. 82 ATC 4517 and
  Cyprus Mines Corporation v. F.C. of T. 78 ATC 4468 were correctly decided because the expenditure there claimed was actually incurred for the purposes described in the claims, even though all of the necessary elements for deductibility were not present. Section 226(2) should be read as if the words ``actually incurred by him'' were followed by the words ``for the purpose described in the claim'' (cf. Taxation Ruling IT 2012 para. 16). This implication is necessary in order to give effect to the rule of statutory construction referred to by Barwick C.J. in
  Tickle Industries Pty. Ltd. v. Hann & Anor. (1973-1974) 130 C.L.R. 321 where his Honour said at p. 331:

• ``It is, in my opinion, a sound rule of statutory construction that a meaning of the language employed by the legislature which would produce an unjust or capricious result is to be avoided. Unless the statutory language is intractable, an intention to produce by its legislation an unjust or capricious result should not be attributed to the legislature.''

• (c) The decision of the No. 3 Board in Case P88,
  82 ATC 423 in relation to the application of sec. 226(2) to a claim by a partner for his share of partnership loss was correct and should be followed.
• (d) The decisions of this Board in Cases P120-P122 were anomalous and capricious. Where, apart from the relevant deduction claimed in the partnership return, the partnership was left with a net income for tax purposes, sec. 226(2) could apply to a partner's claim in his return, but not if the partnership would otherwise have a loss.
• (e) Section 226(2) can apply to notional expenditure as well as actual expenditure. The object of sec. 226(2) is to cover all deductions in the same way as it covers assessable income and it therefore covers such deductions as losses of previous years and depreciation. (This submission is obviously untenable and I need not deal with it.)

8. The first submission on behalf of the Commissioner was that the burden of proof placed by sec. 190(b) upon the taxpayer had not been discharged because the taxpayer had offered no evidence. This would invariably be a formidable submission as I think it would be a rare case where a taxpayer could succeed in showing an assessment was excessive merely on the basis of submissions advanced by his counsel, without any concession by the Commissioner as to the facts. Taxpayer's counsel argued that the Board could take into account the material forwarded to the Board by the Commissioner pursuant to reg. 35(1). But this material is analogous to party and party correspondence. The transmission of the file is not an admission by the Commissioner of the truth of the details in the returns lodged or that the documents supplied to him evidence the real legal relationships involved.

9. In this reference the Commissioner is entitled to say, and does say, there is no evidence proving either the existence of a

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partnership for income tax purposes, or that the relevant expenditure claimed in the partnership return in fact represented interest which was actually incurred. The Commissioner is also entitled to rely on a basis, other than that shown in the adjustment sheet, in order to ``defend'' his assessment, provided such other basis is consistent with the assessment. For example, suppose a taxpayer's return discloses a purchase of property and a sale of the property eighteen months later at a profit which is claimed to be non-taxable; the Commissioner assesses the profit relying on sec. 26AAA and the matter eventually comes before a Board; the taxpayer offers no evidence and merely submits that sec. 26AAA could not apply. In such a case the taxpayer would fail because the assessment could be supported by reference to sec. 26(a) or 25 or perhaps even sec. 26AAA (see sec. 26AAA(3)).

10. Counsel for the Commissioner sought to use sec. 190(b) to justify the imposition of additional tax on an alternative basis by submitting there was no evidence that assessable income was not omitted from the return. I think the answer to this submission is that the adjustment sheet, whilst not part of the notice of assessment, does provide evidence of the process of assessment, although the Commissioner is entitled to ``defend'' the assessment before a Board or Court on a different basis. It is one thing to say, for example, that an assessment made pursuant to sec. 26AAA might be subsequently justified by resort to sec. 26(a); it is another thing to say that an assessment relying on sec. 26AAA was never made. Applying that distinction here, the Commissioner in the original assessment disallowed the taxpayer's claim for his individual interest in a partnership loss and thereby assessed his taxable income as $35,843. Additional tax of $7,385.88 was imposed because the Commissioner applied sec. 226(2) in respect of the taxpayer's claim for his individual interest in a partnership loss. Accordingly, if the Commissioner now sought to include omitted income, he would need to issue a notice of amended assessment, the taxpayer would have his rights of objection and appeal, and any review by the Board of the Commissioner's decision upon such objection could only be the subject of a reference separate from the present reference.

11. It may also be mentioned that sec. 190(b) does not impose any burden on a taxpayer in relation to questions of law. Such questions of law as arise in a reference or an appeal will be decided by a Board of Review (but not conclusively) or by a Court. Section 190(b) merely imposes upon a taxpayer the requirement to provide a factual basis sufficient to show the assessment is excessive, assuming that factual basis does not emerge from the evidence of a witness called by the Commissioner or from the file of documents forwarded to the Board by the Commissioner. Although the taxpayer in this reference has not adduced any evidence, there is evidence before the Board of the partnership and individual returns lodged and of the basis of the Commissioner's application of sec. 226(2).

12. The Commissioner is certainly entitled to rely on sec. 190(b) so as to defeat the deduction claimed by the taxpayer for his individual interest in a partnership loss. However, if the submission of taxpayer's counsel as to the proper construction of sec. 226(2) is correct, the combination of returns, notice of assessment and accompanying adjustment sheet are sufficient to indicate that the Commissioner must have made an error of law when he included additional tax in the tax assessed. The notice of assessment, when read with the returns, shows on its face that the Commissioner did not include omitted income. Nor was it suggested that lodgment of the taxpayer's return did not comply with his tax agent's lodgment programme. Thus if the basis upon which the Commissioner in fact relied to apply sec. 226(2) is not correct, there is no other basis upon which additional tax could have been properly imposed.

13. The additional tax imposed by sec. 226(2), whilst called a tax and taking its place as a tax in the context of the Assessment Act, is in substance a penalty rather than a tax strictly so called, cf.
Re Dymond (1958-1959) 101 C.L.R. 11 . The penalty provided by the legislature is of such severity that it can scarcely be doubted sec. 226(2) should receive a strict construction and any ambiguities which the context does not resolve should be resolved in favour of the taxpayer.

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14. The Commissioner submits that in order to prevent absurdity, sec. 226(2) should be read as if the words ``for the purpose described in the claim'' followed the words ``actually incurred by him''. Perhaps the best way of testing this proposition is to consider some examples. Suppose a builder in his return of income claims as a deduction against his assessable income an amount of $100,000 for ``Timber Purchases'', but only $80,000 is actually incurred for business purposes, the remaining $20,000 being spent on timber used to provide an extension to the builder's own home. Could it be said that the claim in the return was really for ``expenditure incurred on timber for the purpose of gaining assessable income'' and therefore the amount actually incurred was only $80,000? If so, sec. 226(2) would apply to any claim for a deduction which is ultimately unsuccessful, for example, an unsuccessful claim by a teacher for overseas travelling expenses of $4,000. Whilst the overseas travelling expenses may in fact be $4,000, the amount of overseas travelling expenses incurred in gaining assessable income - the purpose described in the claim - may be nil. Surely sec. 226(2) would instead be concerned with a claim for a deduction for overseas travelling expenses of $4,000 when, say, only $2,000 was actually incurred. I do not think it is in any way a sufficient reply to say that the whole of the additional tax imposed on the teacher could be remitted. That seems to me to be absurd, although it was the view adopted by No. 2 Board (as then constituted) in Case M62
(1962) 12 T.B.R.D. 327 - a decision which Smith J. criticised in Cyprus Mines Corporation v. F.C. of T. 78 ATC 4468 at p. 4486.

15. Suppose the claim of $100,000 by the builder included an amount of $20,000 representing a gift made on personal grounds by the builder to his son who happened to be in business as a supplier of timber. Here it could be fairly said that the amount incurred for ``Timber Purchases'' was only $80,000 and sec. 226(2) could apply. However, suppose the claim was for ``Payments to Timber Suppliers'' and the amount of $100,000 claimed included the gift of $20,000 to his son, one of his timber suppliers. I do not see how sec. 226(2) could apply. These examples illustrate the proposition that in relation to deductions claimed in the return for expenditure incurred by a taxpayer, sec. 226(2) is not concerned with whether the deduction claimed is allowable or not, or whether the expenditure is actually incurred for the purpose described in the claim, but merely with whether the expenditure which is said to have been incurred has in fact been incurred.

16. In Cyprus Mines (supra) the deduction claimed was ``Donation - Library Board of W.A. - $166,666'' and in Rabinov & Anor. v. F.C. of T. 82 ATC 4517 the deduction claimed by each taxpayer was ``Donations - Ezroh Relief Fund - $25,000''. In both those cases the expenditure claimed was actually incurred, although it was held or conceded that all the necessary elements of a deductible gift were not present. In Rabinov, Jenkinson J. said at p. 4520:

``The word [actually] seems to me to have been employed to make plainly intelligible the contrast which is being drawn by the draftsman between that expenditure which has been said in the return to have been incurred and that expenditure which has in fact been incurred.''

(Emphasis added.)

17. It was submitted on behalf of the Commissioner that the decisions of this Board (as then constituted) in Cases P120-P122 gave rise to anomalous consequences. Where the result of disallowing overstated amounts in the partnership return was to convert a partnership loss into a partnership net income, sec. 226(2) could apply on the basis that assessable income was omitted from a partner's return (see
Benwerrin Developments Pty. Ltd. v. F.C. of T. 81 ATC 4524 ), whereas if the partnership loss remained a loss, the first limb of sec. 226(2) could not apply and, according to the above-mentioned Board decisions, sec. 226(2) was inapplicable. No doubt this is an anomaly, but I think the simple answer to it is that sec. 226(2) means what it says.

18. It was further submitted by counsel for the Commissioner that, in the case of a partnership, expenditure was incurred by the partners and this expenditure could be traced back to the deduction claimed by a partner for his individual interest in a partnership loss. This submission is plainly untenable. In respect of debts and obligations of a

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contractual nature, expenditure incurred on behalf of the partners is incurred jointly and not jointly and severally, see, for example
Crowe v. F.C. of T. (1958) 100 C.L.R. 532 per Fullagar J. at p. 536. In any event a partnership loss, as defined in sec. 90, is an artificial tax figure which is allocated to, or spread amongst, the partners in accordance with the provisions in Div. 5. A partner who claims a deduction for his individual interest in a partnership loss does not include in his return a deduction for expenditure incurred, much less a deduction for expenditure incurred by him. Accordingly, the Commissioner must have made an error of law in applying sec. 226(2) to the taxpayer.

19. Counsel for the taxpayer invited the Board to indicate its view on the amount which should have been remitted by the Commissioner pursuant to sec. 226(3), assuming sec. 226(2) was applicable. I am not prepared to accept that invitation where, as in this reference, no evidence was adduced by the taxpayer. Moreover, if sec. 226(2) is applicable, I would like to see how it is applicable before I expressed a view on the amount to be remitted. It is sufficient to say that sec. 226(2) has no application to the taxpayer so far as this reference is concerned.

20. For the above reasons, I would reverse in part the Commissioner's decision on the objection and reduce the assessment before the Board by excising the additional tax of $7,385.88.

Claim allowed in part