CASE 17/93
Members:P Gerber DP
Tribunal:
Administrative Appeals Tribunal
Dr P Gerber (Deputy President)
Some time in early 1988, the taxpayer (``T'') sold a house property in Sydney for some $1.82 million and looked for various avenues of investing some $800,000 of those proceeds. He obtained the services of one Roy M, an investment adviser, who prepared a portfolio for T (exh 1). Included in the diverse portfolio was a proposed investment of some $95,550 in a business - Ovatech - specialising in producing pure bred exotic cattle by means of super-ovulation and embryo transplants.
2. Acting on the advice, on 28 June 1988 T entered into a number of agreements in relation to the investment in Ovatech.
``(i) A Service Agreement with Ovatech in which T is referred to as `the Breeder' and Ovatech as `the Manager'. This agreement provided inter alia:
- 1. For a fee of $95,550.00 (the Procuration and Transplant fee) paid by the Breeder to the manager the Breeder does hereby employ the Manager upon the terms and conditions set forth herein.
- 2. In consideration of the said Procuration and Transplant fee paid by the Breeder the Manager shall render to the Breeder the following services WITHIN TWELVE MONTHS of the date of this agreement:
- a) The Manager shall procure a Surrogate Cow for the purpose of carrying each Embryo selected by the Breeder.
- b) The Manager shall take all steps necessary to prepare each Surrogate Cow for the Embryo transplant.
- c) The Manager shall arrange for the mating or insemination of the Donor Cows and shall procure from the Donor Cows the Embryos chosen by the Breeder.
- d) The Manager shall implant the Breeder's said Embryos into the Surrogate Cows.
- e) The Manager shall agist and Manage the said Surrogate Cows until 12 months have expired from the date of this Agreement.
- 3. The Breeder shall be at liberty to take possession of the Surrogate Cows at the expiry of 12 months from the date of this Agreement provided that he shall return the said Surrogate Cow in good health and condition to the Manager when its calf reaches the age of seven months or beforehand if he so desires.
- 4. At all times during the term of this Agreement the Manager shall Manage the Breeder's Embryos, the Surrogate Cows and their calves in accordance with the reasonable directions of the Breeder.
- 5. The Manager acknowledges that as from the date of procuration, and at all times thereafter, the Embryos referred to herein and the calves born pursuant to the implantation of those Embryos are the absolute property of the Breeder.
- 6. The Manager guarantees that the Breeder may take delivery of one surrogate cow in respect of each Embryo described herein....''
Attached to the agreement was the following schedule:
- (ii) A Management Agreement (not relevant for present purposes) pursuant to which the Manager agreed, for a fee of $300 per embryo procured, amongst other things, to agist and manage the surrogate cows, deliver them of their calves, to tattoo each live calf soon after birth and register same on the appropriate Stud Register.
- (iii) A Loan Contract with Beneficial Finance Corporation limited, pursuant to which T borrowed some $99,450 (made up of $95,550 due to Ovatech under (i) above and $3,900 due to Ovatech under (ii) above).
- (iv) A Goods Mortgage with Beneficial Finance Corporation Ltd, the `goods' mortgaged being the 13 embryos set out in the Schedule to the Service Agreement."
3. Part of the ``T'' documents is a copy invoice from Ovatech dated 28 June 1988 to Beneficial Finance Corporation Ltd, setting out the 13 cattle embryos together with title description ``or any other embryos in substitution therefor and the calves born as a result of the gestation of such embryos''. The amount billed is $99,450.00.
4. In his 1988 tax return, T claimed an amount of $95,550 as a deduction as set out below:
"Net Primary Production Income (Loss)
On 28 June 1988, the taxpayer entered into a Deed of Lease and Management (copy attached). Funds introduced were provided by a first instalment of $19,895.98 prior to 30 June 1988, the balance plus interest repayable over 22 months being provided by Beneficial Finance Corporation Limited.
Through the Deed of Lease and Management, the purpose of the taxpayer is to carry on the business of cattle breeding using artificial insemination and embryo transplant techniques utilising semen and eggs from the progeny of Angus, Holstein,
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Brahman and Brangus cattle originally bred in North America.The programme is a continuing one, and budget projections indicate income will exceed expenses in the 1989/90 year, and become very profitable in the 1990/91 and subsequent years.
LEASE AND MANAGEMENT FEES
No. Breed
4 Angus Cattle Embryos 30600
3 Brahman Cattle Embryos 22950
3 Brangus Cattle Embryos 22950
3 Holstein Cattle Embryos 22950
LESS MANAGEMENT FEES PREPAID -3900 95550
Request for Ruling under Section 169A
The Taxpayer requests a ruling on the allowability of the above net primary production income of ($95,550). Enclosed are the various Agreements in relation to the above."
5. The Commissioner disallowed the claimed deduction ``as not considered to be engaged in carrying on a business'' (see Notice of Assessment - ``T6'', p 13 of exh A). T objected, the objection decision was considered and disallowed. In his Statement of Reasons for Decision as shown in the ``T'' documents, the Commissioner claimed:
- (1) The fees were paid while the taxpayer was preparing to engage in the carrying on of business as a primary producer. Acquiring the embryos, implantation into the surrogate cow and raising the cattle progeny is only the preparatory stage of setting up the business.
- (2) The progeny, once delivered to the Taxpayer for either outright sale or further breeding is considered the correct point in time in which the carrying on of the business of primary production commences.
- (3) The expenditure came at a point too soon in regard to the gaining and producing of assessable income. Furthermore the expenditure is of a capital nature and not within the (sic) section 51(2), because it was not incurred in the purchase of stock.
6. At the hearing, Dr Sorensen of counsel, who appeared for the respondent, added further reasons why the claim could not succeed: The payment to Ovatech, he submitted, was made for the purpose of reducing the taxpayer's taxable income.
7. T gave evidence before the Tribunal and denied that the investment with Ovatech was made for the purpose of reducing his taxable income. Thus, he was asked by Mr Sorensen:
``You told my friend that the main reason for the investment was to do with purely investment, maintaining portfolio and so on. Do you recall that? - Mm.
Is it not the case that you had a tax problem? - Not that I recall, no.
So you say that there was no tax minimisation purpose in this arrangement? - Not as a central purpose. If there had been, I would have been consulting at least with my accountant or my solicitor or somebody else. This was one of those situations where I was looking at various investments, this was one of them. I was relying heavily on the investment adviser and I no more would have gone to my accountant to find out about whether I should buy a particular property or property trust for this or anything else. In other words, the tax aspect wasn't looming large in my mind at this point. I really had sold the house, I had money and there was a decision to be made as to what to do with funds.
You do not recall in a meeting with Mr M coming to the view that there was something like $40,000 tax to be paid and that you expressed a desire to eliminate that if you could? - In my discussions with Mr M when tax came up, obviously if there is any investment that I can get involved with that helps to minimise my tax - tax implications are important - but it wasn't looming all that large in my mind and the amount of money of $40,000 to pay was not something too onerous for me to pay, so it wasn't - I didn't view myself as having a tax problem.
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Can I put that to you again because I don't believe we had an answer to the question. Do you recall discussing with Mr M that there was an amount of tax of approximately $40,000 and that you wanted to eliminate it if you could? - I don't recall the words or the - I imagine that the discussion could have centred in that area, I mean, his job as a financial adviser, he was involved as far as I understand in discussions with lots of people about minimising tax in principle; I think that loomed large in his mind. At the time it wasn't a big issue for me because I didn't view that I had a specifically large problem here. I am sure that ideas of tax came up in the discussion but to go back to that time and for me to remember specifically whether I said that, I wasn't there to, I wasn't seeing him in order to remove a tax problem because I didn't have a real tax problem. I was there to see him as to work out what I could do with this sum of money. That's basically what the discussion centered on. I'm sure tax came up but I wouldn't want to put an extra weight on that as an issue.''
(pp 16-18 tr)
I accept his evidence as truthful, notwithstanding that the written advice he received from Roy M and tendered by Dr Sorensen without objection (exh 1) makes it clear that his adviser was keenly alive to T's tax position in 1988, noting that a deduction of $95,550 would substantially reduce T's tax liability.
8. T's evidence was to the effect that he believed that his adventure into Ovatech would be a profitable long term investment, a belief, I consider, that was based on faith rather than knowledge, since I am satisfied that he had made only the most cursory investigation into the viability of this enterprise before embarking on it.
9. It was common ground that Ovatech did produce 13 live calves for T, albeit the financial return from this herd was ``somewhat disappointing... fairly poor''. Up to this point in time, T has received some $5000 in all from (i) flushing out one of the cows and selling the ova and (ii) the sale of one calf. T attributes this poor result to the drought and the depressed state of the cattle industry. He claimed that when he made his initial investment in 1988, the market was ``bullish''.
10. The applicant called one Box, the Managing Director of Ovatech, who explained to the Tribunal the highly technical process involved in super ovulation and embryo transplants. Suffice it for present purposes that I accept that the process is both expensive and involves a high degree of technical knowledge and skill. Mr Box was hopeful that T would derive considerable future income from his investment as conditions improve. He estimated that ``over a life of seven or eight year program, we can expect returns of 22% per annum of the original investment''. Mr Hargreaves, who appeared for the applicant, put some questions to the witness so subtle that no one noticed that they had just that suggestion of being ``leading'':
``The agreements were made in June of 1988 and thereafter performed by your company and the performance was achieved, as I understand it, by you, as you call it, sourcing genetics and implanting those into surrogate cows? In T's case, did you obtain some of the genetics from America? - Yes.
Is it the case that you obtained two of the embryos which were implanted for him from Selex Trading Inc in North America? - Yes.
Was it the case that on the successful implanting of those two embryos, that you paid Selex Trading a total sum of $3000 Australian, or $1500 per embryo? - Yes, Sir.
...
In respect of each of those further 11 embryos, did you make some payment to anyone? -Yes, we'd normally pay a royalty on those to the owners of the cattle.
Now, in Dr Sernik's case, do you tell the Tribunal that the royalties which you paid for the 11 embryos we have referred to were the sum of $1000 each? - Yes, Sir.''
11. Mr Box was an impressive witness not shaken in cross-examination. He readily agreed that other businesses which flourished in this industry in the 1980's had all since collapsed, a fact he attributed to their lack of expertise.
12. Addresses were short and to the point. It was submitted by Mr Hargreaves that the claim was allowable under either limb of sec 51(1) of the Income Tax Assessment Act 1936. He submitted that T's case was ``akin to the case of
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Commander Ferguson [Ferguson v FC of T 79 ATC 4261] and on that basis the claim for deduction should be allowed''. I disagree. The taxpayer in that case, whilst still serving in the Australian Navy, had for some time entertained the idea of buying a property and going into cattle raising as a full-time occupation on his retirement from the service. In 1973, at a time when he was looking for a way of making a start on cattle production, a grazier friend brought to his notice a brochure on Charolais cattle put out by a cattle leasing company which stated that the company would lease half-bred Charolais cattle to persons wanting to build up a herd. The brochure indicated that the leased cows would be kept on a cattle station under the control of a management company, but that investors could, if they wished, keep the leased cattle on their own property. Having discussed the matter with friends, the taxpayer decided to make application for a lease of five head of cattle, and entered into two agreements on the same day. The first agreement was with the leasing company whereby he sub-leased from that company five identified half-cross Charolais heifers for a term of four years, commencing on 21 June 1973. The second agreement was with the management company whereby the company agreed to take in to be agisted and depastured for and on behalf of the taxpayer the five identified heifers, their progeny and descendants for a period of ten years. Under the lease agreement, the leasing company warranted that each of the five heifers would deliver a calf within 12 months from pure bred Charolais semen or as the result of being joined to a pure bred Charolais bull and the taxpayer agreed to pay by way of rent during the term of the lease $33 a month for each of the five heifers, payable monthly in advance, and to insure the leased heifers against death or loss from any cause. The agreement also provided that the taxpayer should be deemed to have the beneficial ownership of any cattle born during the term of the lease. By the management agreement, the management company was obliged to agist the five identified heifers, their progeny and descendants, tend and care for them and maintain a high standard of animal husbandry. In his return for the year ended 30 June 1973, the taxpayer claimed deductions for 12 months rent paid to the leasing company and the insurance premiums on the five heifers.
13. The issue in that case was whether the taxpayer was carrying on a business of primary production. A majority of the Board of Review found against the taxpayer: per Mr Burke, Chairman, because the taxpayer did not actively take part in the raising of cattle and having regard to the scale of activity conducted on his behalf; per Mr Fairleigh QC because as a matter of construction of the two agreements, it could not be said that the taxpayer had possession or effective control of any cattle during the relevant years. An appeal to Sheppard J was dismissed (
Ferguson v FC of T 78 ATC 4010). A further appeal to the Full Court of the Federal Court (79 ATC 4261) was allowed on the basis that a person may conduct a business, although of a limited nature, the activities of which are preparatory to or in preparation for the conduct of another business on a larger scale. In the present case, the taxpayers preliminary activities, in building up a herd which would ultimately be used as the basis of a business of primary production when he acquired his own property, were sufficient in themselves to amount to the carrying on of a business. The payments made by the taxpayer were necessarily incurred in carrying on that business within the meaning of the second limb of sec. 51.
14. It is in my view significant that the taxpayer in Ferguson, eo instanti with the signing of the two agreements became the sub- lessee of five identified half-cross Charolais heifers for a term of four years. In the instant case, nothing happened on 28 June 1988 other than the signing of a few agreements. This taxpayer neither owned nor leased any stock, either actual or notional. All he had to show at the end of the day was a liability to a finance company and an obligation on the part of Ovatech to obtain some surrogate cows at some future time and prepare them for 13 embryo transplants. Indeed, the taxpayer could not even take possession of the surrogates until 12 months from the date of the Service Agreement. In other words, it seems to me that the expenditure - to use the words of Menzies J in
FC of T v Maddalena 71 ATC 4161 at 4163 - comes at a point too soon to be properly regarded as incurred in gaining assessable income or in carrying on a business for that purpose.
15. Indeed, if one looks at other decided cases dealing with this species of primary
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production, in each and every case the taxpayer had reached a stage well beyond a future right. Thus inFC of T v Walker 85 ATC 4179 the taxpayer acquired a pure bred Angora goat with a view to breeding from her and selling the progeny. He depastured the goat at a stud farm and all decisions in relation to the animal were taken by the operators of the farm. He claimed as deductions, not the price of the goat, but the incidental expenses incurred in the breeding activities. The expenses, originally denied deduction by the Commissioner, were allowed on appeal on the basis that the goat breeding activities constituted the carrying on a business of primary production. Again, in FC of T v Walker 84 ATC 4553 (a different taxpayer), taking the facts from the headnote [at pp 4553-4554]:
``The taxpayer, a medical practitioner, became interested in a project for developing a pure bred herd of exotic cattle using the technique of ovum transplants. He joined a partnership (Wintara) set up in April 1976 to carry on the business of cattle breeders and pastoralists. The partnership entered into an agreement to lease six heifers from G Pty. Ltd. for ovum transplant purposes and also to lease a number of recipient cows. The partnership was guaranteed 48 progeny from the transplant operations, which were expected to have a value of some hundreds of thousands of dollars. The lessor arranged for the necessary operations and care of the cattle.
The taxpayer provided $68,300 to the partnership venture, most of which he had borrowed from a company associated with the lessor, as had the other partners.
...
The Commissioner took the view that there was an overall arrangement which had been entered into without regard to its commercial viability with a tax advantage as the only motive or purpose and with the preconceived agreement to achieve that end result by exploiting sec. 36 and 36A for a purpose other than that intended.
The trial Judge (
Walker v FC of T 83 ATC 4168) found that the activities of the two partnerships amounted to the carrying on of the business of cattle breeders and pastoralists and that the expenditure incurred by the partnerships was deductible under sec. 51(1).''
16. An appeal by the Commissioner to the Full Federal Court was dismissed by majority.
17. Again, in
Gallie & Anor v FC of T 85 ATC 4723 the two taxpayers, having become interested in a project for developing a pure bred herd of exotic cattle by means of super- ovulation, joined a partnership which entered into leases with a promoter of the scheme to lease a pure bred heifer suitable for ovum transplant purposes. The Commissioner, having denied the claimed deductions of the losses of the partnership, his decision was reversed on appeal (Lusher J), the expenditures being characterised as outgoings necessarily incurred in carrying on a business of cattle breeding.
18. In an earlier decision -
Hanlon v FC of T 81 ATC 4617 - the case again turned on an arrangement whereby a New Zealand organisation was to make nine donor Simmental heifers available, super-ovulate them, inseminate them with semen from a Simmental bull, transplant the embryos produced into recipient cows and procure the birth of a certain number of calves. Each donor heifer was leased to a syndicate consisting of the company and twelve individuals, including the taxpayer, the lessees being entitled to calves produced by the heifers. There was a separate lease in respect of each heifer, the consideration for each lease being $26,500. The taxpayer, together with two other individuals, entered into one such lease agreement on 29 June 1976. The Commissioner having denied the deduction, his decision was upheld by Board of Review No 2 (Case K51,
78 ATC 505) but reversed on appeal by Tadgell J.
19. It will be seen that in each of the above cases in which taxpayers had become involved in acquiring exotic breeds by the use of this new technology, it was a material fact that each claimant had owned or leased pure bred females. In the instant case, the taxpayer, far from having leased anything (notwithstanding the claim made in his return that he had ``entered into a Deed of Lease and Management'') could only point to a right to have some 13 surrogates implanted at some future date. Indeed, he could only take possession of the surrogate cows at the expiry of 12 months from the date of the Service Agreement. That, in my view, does not constitute a business of primary production, but rather involves an outgoing incurred well before
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any business could possibly be said to have commenced.20. In the alternative, it was submitted that the investment in Ovatech, rather than being a separate business ``was in fact part of a much wider business, the business of investing, and that being the business which started at some time around about, or before the Ovatech contracts were drawn''. With great respect, I find that this submission has no merit.
21. That concludes the case against the taxpayer. However, in case I am wrong in this, there is a further hurdle in the taxpayer's path. When one looks at the Service Agreement, there can be little doubt that as part of the overall arrangement, T acquired - albeit at some future date - some 13 embryos. The cost of such embryos is surely an outgoing of capital. Whilst I have no doubt that the management services provided by Ovatech are highly valuable and form a substantial component of the overall consideration, I have no means of separating the capital component from any expenditure which could be said to have been incurred in the production of T's assessable income. An attempt was made by Mr Hargreaves to salvage some revenue component by excluding the capital component said to be made up of the payment by Ovatech of $3000 to Selex Trading for two embryos said to have been implanted on behalf of the taxpayer and $11,000 ``royalties'' said to have been paid by Ovatech to a third party for the remaining 11 embryos. Dr Sorensen submitted ``First, that was simply the purchase price to Ovatech, it was not the amount paid by the taxpayer. The second matter is that what is a value, and what the taxpayer was seeking to acquire, was an implanted embryo, and those prices take no account of that. The fee paid was a procuration and transplant fee, so it is described. There is no capability, on the evidence, of identifying the extent to which any part of the $95,550 constituted a deductible item''. I agree with these submissions. It is not, perhaps, without some significance that Beneficial Finance Corporation Ltd was prepared to provide a loan of nearly $100,000 on the sole security of the 13 embryos which the taxpayer would become entitled to receive at some future time.
22. The respondent, in his statement of facts, issues and contentions, contended that:
``the applicant entered into a scheme with a dominant purpose of obtaining a tax benefit for the purposes of the Part IVA of the Act and accordingly the Tribunal should itself make a Part IVA determination.''
However, quite early on, Dr Sorensen freely admitted that his client had not himself made a Part IVA determination, and would only ask me to do so depending ``how the evidence turns out''. He did not refer to Part IVA in his address. In the circumstances, as I stated during the hearing, I do not intend to go on a frolic of my own and apply Part IVA. In any event, I am satisfied its necessary elements have not been made out for similar reasons to those I expressed in paragraph 7 above.
23. For the above reasons the objection decision in respect of the 1988 tax year is affirmed.
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