Commissioner of Taxation v GKN Kwikform Services Pty Ltd

[1991] FCA 151

Re: COMMISSIONER OF TAXATION
And: GKN KWIKFORM SERVICES PTY LIMITED
Nos. G560-562 of 1990
FED No. 151
Taxation
91 ATC 4336/21 ATR 1532

COURT

IN THE FEDERAL COURT OF AUSTRALIA

NEW SOUTH WALES DISTRICT REGISTRY
GENERAL DIVISION
Davies(1), Beaumont(2) and O'Loughlin(3) JJ.

CATCHWORDS

Taxation - business of hiring out scaffolding equipment - profits arising from compensation for failure to return all equipment hired - whether profits were assessable revenue or capital profits - whether the profits derived were a regular expected and ordinary incident of the carrying on of the business.

Income Tax Assessment Act 1936 (Cth) - s.25(1)

HEARING

SYDNEY

#DATE 17:4:1991

Counsel for the appellant: D. Bennett QC

with Mr S. McMillan

Solicitor for the appellant: Australian Government Solicitor

Counsel for the respondent: A.H. Slater

Solicitors for the respondent: Mallesons Stephen Jaques

ORDER

The appeal be allowed with costs.

The orders made by the trial Judge be set aside and substitute therefor orders that the applications to the Court be dismissed with costs.

Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules.

JUDGE1

These are appeals from a judgment of a single judge of the Court. His Honour upheld appeals against assessments of the taxable income of GKN Kwikform Services Pty Limited ("Services") in respect of the years of income, 1 May 1984 to 30 April 1985, 1 May 1985 to 30 April 1986 and 1 May 1986 to 31 December 1986.

1. Services was one of a number of companies in the GKN Group. Another company, GKN Kwikform Sales Pty Limited ("Sales"), handled the sale of scaffolding components to purchasers in the building and related industries and sold scaffolding to other companies in the group including Services. The business of Services was to hire out scaffolding equipment to users in the building industry.

2. The scaffolding held and hired out by Services was undoubtedly plant and was so treated by Services and accepted by the Commissioner. The provisions of s.54 of the Income Tax Assessment Act 1936 (Cth) ("the Act") were applied in respect thereof. We are not concerned with the fact that, as it was not practicable to keep track of each individual item of equipment, accounting means were adopted to calculate the depreciation. There is no disagreement between the parties in these appeals as to the basis upon which any figures were calculated or as to the figures themselves. I therefore need not discuss Federal Commissioner of Taxation v. Cyclone Scaffolding Pty Ltd (1987) 18 FCR 183 in which the majority decision turned on the appropriateness of the accounting system adopted.

3. The issue in the dispute arises from the fact that there was a regular leakage of scaffolding due to the failure of hirers to return all the amounts hired. A short-return rendered the hirer liable to pay to Services, in addition to the hiring fee, compensation for the items not returned. Each hiring agreement contained a provision in or to the effect that "on termination of hire the hirer shall forthwith pay to the Company an amount sufficient to cover all losses at the then current list price for such lost items and any other costs and expenses which the Company may incur as the result thereof." The amount received by Services under this clause was, in the 1985 year, $837,781.00, being 5.71% of total receipts of Services' business, in the 1986 year it was $1,133,697.00, being 3.26% of total receipts, and in the 1986 year ending December 1986 it was $828,688.00, being 3.25% of total receipts.

4. The issue does not involve the total of these sums. We are concerned only with the profits that inevitably arose. The current list prices charged for non-returns were Sales' current prices and, as those prices increased from time to time over the subject and prior years, the receipt of the compensation resulted in profits being the excess over the cost of the lost scaffolding. The profit was $442,088.00 in the first year, $749,049.00 in the second year and $586,460.00 in the third year. These profits were the result of an accounting calculation based on FIFO and an average cost. The existence of the profits and their quantification are agreed. The issue in these appeals is whether the profits were assessable revenue, as the Commissioner contends, or capital profits, as is contended on behalf of Services.

5. Evidence was called that the clause I have mentioned was inserted in the hiring agreements, not with a view to making a profit, but with a view to imposing a stiff penalty which would encourage the return and discourage the non-return of all items of equipment hired. That is a factor to be taken into account; but it is equally true that the inclusion of the clause in the contracts of hire and its implementation in the event of short-returns had the inevitable and known consequence that the compensation received for short-returns would be greater than the cost price to Services of the goods which were hired.

6. Services did not have to make a profit on short-returns. It could have charged for short-returns the cost price of the goods which were lost. In this event, no part of the compensation received would have been treated as income. But it chose to make a profit, partly for the reason that, by doing so, short-returns were discouraged. For the purposes of income tax, the reason why a businessman wishes to make a profit is irrelevant. What is important under s.25(1) of the Act is whether the profit derived was a regular and ordinary incident of the carrying on of the business undertaking.

7. The present is a clearer case even than Memorex Pty Limited v. Federal Commissioner of Taxation (1987) 77 ALR 299, in which the judgment went against the taxpayer. In the present case, there is no doubt that what occurred was a regular and ordinary incident of Services' business. In Memorex, it was necessary to examine the facts and to pay regard to what was said in cases such as Gloucester Railway Carriage and Wagon Co. Ltd v. Inland Revenue Commissioners (1925) AC 469 before coming to that conclusion. Once that finding had been made, the Court considered that the profit derived was assessable in accordance with the principle enunciated in Californian Copper Syndicate v. Harris (1904) 5 TC 159 and the many decisions of the High Court of Australia applying that principle.

8. As was said by Mason A.C.J., Wilson, Brennan, Deane and Dawson JJ. in Federal Commissioner of Taxation v. Myer Emporium Ltd (1987) 163 CLR 199 at 209:-
   

"Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the character of income."

Their Honours went on to emphasise the distinction drawn by the Lord Justice Clerk in Californian Copper Syndicate v. Harris between, on the one hand, an act done in what was truly the carrying on, or carrying out of a business and, on the other, a mere realisation or change of investment.

1. In Services' case, profit-making resulting from the enforcement of the compensation clause was a regular incident of Services' business of hiring out scaffolding. It was put by counsel for Services that the sums received on short-returns were of a capital nature for they were compensation for the loss of scaffolding which, in the hands of Services, was a capital asset. Remarks in Federal Coke Co. Pty Ltd v. Federal Commissioner of Taxation (1977) 34 FLR 375 at 401-2, and in G.P. International Pipecoaters Pty Limited v. Federal Commissioner of Taxation (1990) 64 ALJR 392 at 396 were relied upon. But it is not sufficient to show that the cause of the receipts was the non-return of plant. It is necessary to apply the principles I have mentioned, which have been enunciated in so many cases, many of which were mentioned in Memorex. Two recent examples are R.A.C. Insurance Pty Ltd v. Federal Commissioner of Taxation (1990) 90 ATC 4737 and Federal Commissioner of Taxation v. Employers' Mutual Indemnity Association Ltd (1990) 90 ATC 4787. The High Court recently repeated the principle in G.P. International Pipecoaters Pty Limited v. Federal Commissioner of Taxation. The Court said at 398:-
   

"But it cannot be accepted that an intention on the part of a payer and a payee or either of them that a receipt be applied to recoup capital expenditure by the payee determines the character of a receipt when the circumstances show that the payment is received in consideration of the performance of a contract, the performance of which is the business of the recipient or which is performed in the ordinary course of the business of the recipient."

And so, in the present case, it is crucial that the non-return of scaffolding was a regular, expected and ordinary incident of Services' business and that the profits derived therefrom.

1. By way of analogy, it is relevant to consider BP Australia Ltd v. Federal Commissioner of Taxation in which a petrol company paid moneys to petroleum retailers in exchange for exclusive ties. At first instance, (1964) 110 CLR 387, McTiernan, Windeyer and Owen JJ. held that the sums paid were paid to secure capital assets, petroleum sites. However, Dixon C.J. and Kitto J. held that the sums paid were deductible. At p 410, Dixon C.J. emphasised that the taxpayer "was engaged in a continuous process of business expenditure." The minority view was upheld by the Judicial Committee, (1965) 112 CLR 386. The opinion of their Lordships, delivered by Lord Pearce, emphasised at pp 398-9 that the payments were not made once and for all but were of a recurrent nature made to meet a continuous demand in the trade. Likewise, in Federal Commissioner of Taxation v. Ampol Exploration Ltd (1986) 13 FCR 545, Lockhart and Burchett JJ., Beaumont J. dissenting, held that certain expenditure was an allowable deduction under s.51(1) of the Act and was not of a capital nature. At p 562, Lockhart J. said:-
   

"The true legal character of the expenditure was that of the ordinary business activity of the taxpayer as a petroleum exploration company. ... The payments in question were in truth part of the outgoings of the taxpayer in the course of carrying on its ordinary business activities. It was not expenditure incurred for the purpose of creating or enlarging a business structure or profit-yielding or income-producing asset."

1. The basal distinction between receipt or outgoing on capital account and the receipt or outgoing on revenue account was enunciated in Dixon J. in Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337. At p 359, his Honour said:-
   

"The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay, the difference between the outlay and the returns representing profit or loss."

This principle accords with the cases I have mentioned above. The profits which Services derived from short-returns were not of a capital nature in this sense. The profits did not go to the business structure or entity but were a part of the regular returns resulting from the manner in which Services operated its business. Cf. Allied Mills Industries Pty Ltd v. Federal Commissioner of Taxation (1989) 20 FCR 288 at 303-4, 311-2.

1. I would allow the appeals with costs. I would set aside the orders made by the trial Judge and would substitute therefor orders that the applications to the Court be dismissed with costs.

JUDGE2

The Commissioner of Taxation appeals from orders made by a single judge of the Court allowing appeals by the respondent taxpayer, G.K.N. Kwikform Services Pty. Limited ("GKN"), in respect of three assessments by the Commissioner. The income periods in question are the years 1 May 1984 to 30 April 1985, 1 May 1985 to 30 April 1986 and the period 1 May 1986 to 31 December 1986. The same issues arise in each appeal.

1. There was no dispute about the facts, which were found by the primary judge as follows. GKN carries on the business of hiring out scaffolding for use for support purposes inside and outside buildings under construction or renovation. GKN's business is substantial. It has in stock a very large number of the component parts of scaffolding. The ultimate lifespan of the scaffolding is unknown. It is not a practical possibility to keep track of the individual items of scaffolding equipment which GKN hires out to customers. The components are interchangeable and the age of individual components has no bearing upon their suitability for use by customers. The only practical way of keeping a record of the equipment is to treat as "equivalent" all items of the same kind, whenever they were manufactured. GKN's fixed asset register makes no distinction in terms of the dates of acquisition of individual items of equipment. Orders for the hire of scaffolding are filled from stock, according to the number of parts ordered but without reference to the age of those parts.

2. There is regular "leakage" or "short return" of items of scaffolding from the amounts ordered by customers for hire for particular jobs. Such short returns occur in three ways. First (rarely), GKN will make a sale of stock on hire to a customer, at the customer's request. It is the general policy of GKN not to sell its equipment. (GKN Kwikform Sales Pty. Ltd., a member of the corporate group of which GKN is a member, carries on the business of selling scaffolding.) Secondly, where comparatively insignificant items of equipment are not returned, GKN will simply disregard the loss and write it off. Thirdly, (and this is the subject of the present litigation), where a significant quantity of equipment is not returned at the completion of the hiring, the customer is charged an amount for the loss of the scaffolding calculated in accordance with the provisions of the contract of hire, which are set out below. Most of the leakage falls into this category. Equipment in the first category is referred to as "sales off hire", whilst equipment in the third category is referred to as "chargeable losses".

3. The present litigation is concerned with the appropriate treatment, for taxation purposes, of moneys received in the relevant income years in respect of the "chargeable losses". In GKN's 1985 financial year the amount of these losses was $837,781, being 5.71% of the total receipts of GKN's business. In its 1986 financial year, the amount was $1,133,697, being 3.26% of the total business receipts. In the 1986 year (ending December 1986) the amount was $828,688, being 3.25% of the total receipts. In the same years, the amounts received for "sales off hire" were $451,113, $331,850 and $417,317 respectively. (In fact, the amounts sought to be taxed were the sums of $442,088.00 in the first year, $749,049.00 in the second year and $586,460.00 in the third year, that is, somewhat less than the chargeable losses. We were informed by counsel that the reason for this may be explained by the following example. Assume an amount received under the liquidated damages clause, i.e. a chargeable loss, or notional proceeds of sale of an item of equipment, of $200.00; assume also a cost of acquisition of the item of $100.00; assume further that $80.00 has been allowed as a deduction under the depreciation provisions of the Act, so that the written down value is $20.00. On those assumptions, what has now been assessed is the sum of $100.00 arrived at by deducting the sum of $100.00, being the cost of acquisition, from the notional proceeds of sale of $200.00. In addition, the sum of $80.00, being the amount allowed for depreciation, has independently been assessed under s.59(2) of the Act.)

4. Reference has previously been made to the provisions of GKN's hiring agreement which deal with leakage. The terms of the hiring contract which applied in respect of hirings prior to 1985 read as follows:
   

"The Hirer shall be responsible for the equipment from the time the Hirer collects it from the Company's depot or from the time the Company delivers it to the Hirer's site (as the case may be) until the time the Hirer returns it to the Company's depot or until the time the Company collects it from the Hirer's site (as the case may be). An Inventory of equipment prepared by the Company shall be binding and conclusive between the Company and the Hirer and in the event of any discrepancy in items of equipment being disclosed by such Inventory on termination of hire the Hirer shall forthwith pay to the Company an amount sufficient to cover all losses at the then current list price for such lost items and any other costs and expenses which the Company may incur as a result thereof. The Hirer shall be responsible for repairing and maintaining the equipment in good order and condition having regard to the condition thereof at the date of commencement of hire and excepting only fair wear and tear and shall forthwith pay to the Company an amount sufficient to cover any and all losses costs and expenses the Company may incur as a result of the Hirer failing or omitting so to do."

1. The corresponding paragraph in use in hiring contracts after 1985 was as follows:
   

"At the termination of the hiring all goods shall be returned to the Company in good condition excepting only fair wear and tear. All goods shall be deemed in good condition unless the Hirer notifies Company to the contrary within 24 hour of delivery of goods. The Hirer shall on demand pay in respect of any goods (damaged) or not so returned the then current selling price for the goods. Until such sum is paid hire charges shall continue to accrue and any and all other costs and expenses incurred by the Company as a result of such shortages or losses. The Hirer's responsibility for the preservation and safekeeping of the goods shall not be determined until the goods are physically handed over to the (Company) by the (Hirer)."

1. Speaking of this provision, the primary judge said:
   

"The receipt of money by the applicant under this provision is not a receipt of hiring moneys; it is a receipt of money intended to compensate him for the loss of the object hired. The consideration provided by the applicant for this receipt is not the provision of the goods on hire. It is, in my opinion, a forbearance from suing for the return of the goods or their value. The goods to which this consideration relates are part of the profit-earning capital of the applicant. They do not lose that character simply because they have been lost or disposed of by the customer. Such regularity of receipt of compensation as is established does not, in my view, operate in this case to confer an income quality in the profits. I am satisfied that the profits on 'chargeable losses', even though made in the course of the applicant's business operations, are earned on capital and not revenue account and are therefore not brought to tax under s 25(1) of the Act."

With respect, I have difficulty in accepting this analysis.

1. The general test in this area was recently stated by the High Court in G.P. International Pipecoaters Proprietary Limited v. The Commissioner of Taxation of the Commonwealth of Australia (1990) 170 CLR 124, at p 138, as follows:
   

"To determine whether a receipt is of an income or of a capital nature, various factors may be relevant. Sometimes, the character of receipts will be revealed most clearly by their periodicity, regularity or recurrence; sometimes, by the character of a right or thing disposed of in exchange for the receipt; sometimes, by the scope of the transaction, venture or business in or by reason of which money is received and by the recipient's purpose in engaging in the transaction, venture or business. The factors relevant to the ascertainment of the character of a receipt of money are not necessarily the same as the factors relevant to the ascertainment of the character of its payment."

1. It is, and could not be, disputed that the hiring fees themselves constituted income earned by GKN. The present question is whether amounts received from time to time by way of liquidated damages (it was not suggested that any penalty was involved), payable in respect of the failure to return equipment, also amounted to income.

2. It is true that the amount payable is fixed by reference to GKN's current selling price. But it cannot be said that the reference to current selling price means that the provision constitutes an agreement for the sale of the equipment. On the contrary, the provision proceeds upon the footing that the parts have been lost or destroyed, so that a sale is not practicable. In my opinion, the provision in question operates in accordance with its tenor, that is to say, as a liquidated damages clause inserted in the hiring agreement, as a genuine pre-estimate of the damage suffered by GKN from time to time, when its equipment is not returned to it. It follows, in my opinion, that the true character of amounts received by GKN under this type of clause is that of a receipt of an additional fee payable by the customer as part of the total consideration given by the customer for the hire of the goods. If, as I think, GKN received an amount in the nature of an additional hiring fee to compensate it for breach of the customer's obligation to return the equipment, it must follow that the receipt of this amount is income: it has the same revenue character, in essential respects, as the hiring fees themselves.

3. It is not necessary, in my view, to consider what might have been the position if, instead of a liquidated damages clause, GKN had contracted for the sale of the equipment to the hirer. The provision in question, as a matter of form as well as substance, cannot be described as an agreement for sale, either express or implied. The clause provides for the payment by the hirer of an additional sum or fee in a particular contingency, that is, the loss or destruction of the equipment. In my view, amounts received by GKN from time to time on this account should be treated as in the nature of an extra hiring fee, and thus income. Put differently, the receipt should be treated as analogous to an additional fee payable in respect of the hire of the goods, and thus income. It may be accepted, in this connection, that GKN prefers to recover the equipment rather than to use the liquidated clause. But the question here is to be determined by looking at the true character of the particular receipt, rather than considering the taxpayer's understandable preference that the goods be returned.

4. Reference was made in argument to the Memorex Case (1987) 77 ALR 299 and to the Cyclone Case (1987) 18 FCR 183. I agree with the primary judge that, for present purposes, both cases can be clearly distinguished on their own rather special facts.

5. I would allow the appeals with costs; I would set aside the orders made at first instance; in lieu thereof, it should be ordered that the applications be dismissed, with costs.

JUDGE3

I have had the advantage of reading drafts of the respective judgments of Davies and Beaumont JJ. As I am also of the opinion that the sums in question bear the hallmark of revenue it follows that I agree that the Appeals should be allowed with costs. I would also set aside the Orders made at first instance and confirm the assessments.