Davies and Commissioner of Taxation

[2005] AATA 767

Administrative

Appeals

Tribunal

 

DECISION AND REASONS FOR DECISION [2005] AATA 767

ADMINISTRATIVE APPEALS TRIBUNAL      )

)     No QT2004/162-165

TAXATION APPEALS DIVISION		)
Re		KENNETH DAVIES

Applicant

And COMMISSIONER OF TAXATION

Respondent

DECISION

Tribunal Senior Member B J McCabe

Date11 August 2005

PlaceBrisbane

Decision The objection decision under review is affirmed.

..............................................

SENIOR MEMBER

CATCHWORDS

TAXES AND DUTIES – Income tax and related legislation – deductions claimed for defamation litigation – expenses related to defamation litigation held to be eligible deductions incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for that purpose – expenses not deductible beyond the cessation of partnership – the nexus between the expenses and the business ceased in the years of income under review – decision under review affirmed.

Income Tax Assessment Act 1997 (Cth)

Commonwealth Bank Ltd v Davies [2003] QSC 470

Steele v Deputy Commissioner of Taxation (1999) 197 CLR 459; (1999) 161 ALR 201; (1999) 73 ALJR 437; (1999) 99 ATC 4242; (1999) 41 ATR 139; [1999] HCA 7

Commissioner of Taxation v Roberts (1992) 37 FCR 246; (1992) 108 ALR 385; (1992) 92 ATC 4380; (1992) 23 ATR 494

Herald and Weekly Times Ltd v Federal Commissioner of Taxation (1932) 48 CLR 113; [1933] VLR 112; [1932] ALR 46; (1932) 6 ALJR 314; (1932) 2 ATD 169

Strong and Co v Woodfield [1906] AC 448; (1906) 75 LJKB 864; (1906) 95 LT 241; (1906) 22 TLR 754; (1906) 5 TC 215; [1904-7] All ER Rep 953

Commissioner of Taxation v Ash (1938) 61 CLR 263; (1938) 5 ATD 76

Evans and McLean v Davies (unreported, Supreme Court of Queensland (Full Court), No 77 of 1990, Brisbane, 7 September 1990)

Placer Pacific Management Pty Ltd v Federal Commissioner of Taxation (1995) 95 ATC 4459; (1995) 31 ATR 253

Federal Commissioner of Taxation v Brown (1999) 99 ATC 4600; (1999) 43 ATR 1; [1999] FCA 721

Federal Commissioner of Taxation v Jones [2002] FCAFC 41; (2002) 117 FCR 95; 2000 ATC 4135; (2002) 49 ATR 188; [2002] FCA 204

REASONS FOR DECISION

11 August 2005   Senior Member McCabe

introduction

1.      Mr Kenneth Davies is the applicant in these proceedings. He was a member of a firm of accountants in Townsville between 1984 and 1989. During that time, the partnership was sued for defamation as a result of a letter the applicant had written concerning the conduct of a rival firm. An award of damages was made against the applicant’s firm. The firm’s financial position deteriorated after the applicant left to take a seat in parliament. The members of the firm sought a loan from the Commonwealth Bank to meet the obligations arising out of the court case. The Bank made a facility available. The facility was subsequently replaced by a loan that was renegotiated on several occasions. The applicant was a party to the loan although he claimed he was not liable. The other partners subsequently became bankrupt and the bank has looked to the applicant to repay the outstanding loan.

2.      The applicant claimed deductions in respect of the loan repayments and servicing costs. The claim was disallowed in the years ending 30 June 1998, 1999, 2000, 2001 and 2002. The applicant has asked the Tribunal to review the objection decision in relation to those years of income.

3.      The dispute in this case revolves around the proper characterisation of outgoings in respect of a loan used to fund litigation: s 8-1 Income Tax Assessment Act 1997 (ITAA97). Can those outgoings be said to have been incurred in gaining or producing assessable income or have been necessarily incurred in carrying on a business for that purpose?

4. I note the Commissioner did not persist with an argument (referred to in the statement of facts and contentions) that the applicant’s refusal to acknowledge the debt prior to 1993 meant the expenditures were not incurred within the meaning of s 8-1 of ITAA97.

the material before the tribunal

5. The Tribunal was provided with the documents required under s 37 of the Administrative Appeals Tribunal Act 1975. Mr Davies represented himself and gave evidence. Both parties provided written submissions. Mr Davies provided some additional submissions after the matter was adjourned in which he sought to clarify some questions of fact. The respondent filed a brief response but asked me to afford it the opportunity to elicit further evidence and perhaps make fresh submissions if I proposed to rely on the applicant’s late material. As it happens, I do not think the additional material adds anything to the case.

6.      The following documents were also tendered in evidence:

·Applicant’s reply to the respondent’s statement of facts, issues and contentions (exhibit 2);

·A letter from the applicant to the Tribunal dated 14 November 2004 with annexed financial information and statements (exhibit 3);

·A letter from the applicant to the Tribunal dated 17 November 2004 (exhibit 4);

·Deed of partnership dated 2 July 1984 with annexed documents (exhibit 5);

·Supreme Court of Queensland Judgment of Carter J - No 237 of 1986 dated 28 November 1989 (exhibit 6);

·Full Court of the Supreme Court of Queensland Judgment of Macrossan CJ, Shepherdson and de Jersy JJ – No 77 of 1990 dated 7 September 1990 (exhibit 7);

·A letter from the applicant to Mr Webb dated 24 May 1998 (exhibit 8);

·A letter from Mr Webb to the applicant dated 28 May 1998 (exhibit 9);

·ATO form - Request for an extension of time to lodge an objection – lodged by the applicant, undated (exhibit 10);

·A letter from the applicant to Mr Arthurs dated 2 June 2002 (exhibit 11);

·A letter from the applicant to ATO Adelaide dated 2 June 2002 (exhibit 12);

·A letter from the applicant to Mr Ellis dated 15 August 2002 (exhibit 13);

·Email correspondence from the applicant to Mr Causley dated 15 December 2002 (exhibit 14);

·Letter from Ms Coonan to Mr Causley dated 17 December 2002 (exhibit 15); and

·Applicant’s Notice of Amended Assessment for the year ending 30 June 1997 (exhibit 16).

the factual background

7.      The factual background to the dispute was set out in the decision of White J in Commonwealth Bank Ltd v Davies [2003] QSC 470.

8.      The applicant entered into partnership with two other accountants and commenced practice in Townsville in 1984. The firm traded as Tower, Hart and Davies.

9.      The applicant wrote to a rival firm of accountants on 29 November 1984. The letter, which was written on the letterhead of Tower, Hart and Davies, alleged the recipient of the letter was acting unethically in its dealings with a former client of Mr Davies. 

10.     The recipient of the letter issued a writ alleging defamation. The applicant was named as first defendant and the partnership as second defendant. The other partners were not aware of the letter in question until the firm was sued.

11.     White J noted in her judgment that the firm received legal advice to the effect that the costs of the action and any damages were not covered under the terms of the professional indemnity policy. White J said that advice was wrong – the insurers were liable to pay under the policy, provided they were given notice of the action. The insurers were not informed until some time later and declined to indemnify the firm because of the delay.

12.     The case did not come to trial until November 1989. In the meantime, the applicant had given notice of his intention to resign from the partnership in March 1989 when he decided to run for a seat in parliament. He was subsequently elected to parliament at the end of 1989. He had ceased his involvement in the firm at the time of giving notice of his intention to resign. He said the firm was trading profitably at that point.

13.     Carter J gave judgment for the plaintiffs and awarded $95,000 in damages at the conclusion of the trial in November 1989. The applicant and his partners subsequently appealed and the matter was set down for a new trial. The plaintiffs in the original action had pressed for payment of the damages and costs in the interim. The firm had some cash flow problems and increased its overdraft. The firm approached the Commonwealth Bank for a loan to meet its obligations arising out of the litigation. The bank extended the facility on several occasions. The applicant was a party to those loans.

14.     The firm’s financial position deteriorated. Two of the other partners were bankrupted and the bank looked to Mr Davies for repayment of the loans.  He denied liability at first and declined to make any repayments. The issue was resolved in the bank’s favour by the decision of White J in Commonwealth Bank Ltd v Davies in 2003. He now accepts he is liable to repay the loans.

15.     Mr Davies subsequently revisited his tax returns for the years 1997-2002. He wanted to claim deductions in respect of the costs associated with the loans he was (as of 2003) required by the court to repay. The respondent allowed the applicant to claim a deduction in the amount of $61,784 in respect of interests and costs in the year ended 30 June 1997 but has disallowed claims in respect of costs for the following years. The respondent’s reasons for the objection decision are set out at document T 2 pp 68-72.

the legislation

16. Section 8-1 of ITAA97 provides:

You can deduct from your assessable income any loss or outgoing to the extent that:

(a)  it is incurred in gaining or producing your assessable income; or

(b)  it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

17.     The applicant says the interest and loan service fees on the loans from the Commonwealth Bank have the necessary connection with the business of earning assessable income from the partnership. The respondent disagrees. The Commissioner adds that even if the interest and loan service fees were deductible prior to 1998, there is no evidence the expenses retained the nexus with the applicant’s business activities after that date. I will deal with each of these contentions in turn.

was there a nexus between expenditure on costs and damages and the income producing activities of the applicant?

18.     The High Court pointed out in Steele v Deputy Commissioner of Taxation [1999] HCA 7 that interest was the price one paid for the temporary use of loan money. In those circumstances, Gleeson CJ, Gaudron and Gummow JJ opined (at paragraph 29):

…it is proper to regard the interest as a revenue item, and its character is not altered by reason of the fact that the borrowed funds are used to purchase a capital asset.

19.     Not every borrowing will give rise to a deduction in respect of interest and fees, of course. Ms Brennan for the respondent pointed out that one determines whether an interest outgoing is deductible by looking at the purpose of the borrowing: see Commissioner of Taxation v Roberts (1992) 37 FCR 246 at 255 per Hill J. There must be a connection between the borrowing and the purpose of gaining or producing assessable income.

20.     Borrowings to fund the costs and liabilities associated with litigation may be deductible if it is possible to establish a connection between the business and the litigation.

21.     The leading case in relation to the costs and liabilities associated with defamation actions is the High Court’s decision in Herald and Weekly Times Ltd v Federal Commissioner of Taxation (1932) 48 CLR 113. The Court concluded the costs of defending and paying libel claims were a direct and inevitable cost of doing business for a media company: see Gavan Duffy CJ and Dixon J at 119.

22.     The applicant is not a media company. The connection between defamation actions and the work of an accountant is less obvious. But the link might still be established if it can be shown that the expenditure was “really incidental to the trade”: see Strong and Co v Woodfield [1906] AC 448 at 452 per Lord Loreburn L.C. The nexus will not be established if the applicant was off on a frolic of his own, albeit that he was using the firm’s letter head: see Commissioner of Taxation v Ash (1938) 61 CLR 263 at 280-281 per Dixon J.

23.     The Tribunal and the courts have dealt with a large number of cases in the years since Herald and Weekly Times was decided in which it has been necessary to characterise expenditure on litigation. Some of the conclusions are difficult to reconcile.

24.     Ms Brennan suggested the applicant’s assertions in the letter that triggered the litigation were gratuitous: paragraph 15 of the respondent’s submissions. In those circumstances, it was argued, the expenses of the litigation could not be said to be connected with the applicant’s gaining or producing assessable income.

25.     I disagree. The applicant was not gratuitously insulting the recipient of the letter. He was attempting to influence a former client who was, at least temporarily, moving to a competitor. As Macrossan CJ explained in the course of his judgment in Evans and McLean v Davies (unreported, Supreme Court of Queensland (Full Court), No 77 of 1990, Brisbane, 7 September 1990 at 34 – the appeal from the trial in the defamation case) the applicant:

…would perhaps have an interest in maintaining the firm’s professional standing in the eyes of their erstwhile client but, more clearly, they would have had an interest in regaining the client now or in the future.

26.     His Honour continued (at 35):

They could, in the protection of their interest properly have felt justified in drawing to the attention of the client the comparison between the behaviour of their firm and that of the plaintiffs hoping that the client would note the comparison favourable to themselves and move, sooner or later, to bring the business back to them. …The publication did not relate to some collateral disparagement or scandal and was not made to a recipient having no involvement with the issue.

27.     The applicant’s attempts to secure a competitive advantage in writing a letter may have been unwise, but the letter was clearly written with a business end in mind. The applicant was angry that a client had been lured away to a rival. The fee income from the applicant was clearly assessable income in the hands of the partners. The applicant wanted the client back, and the letter was part of a strategy devoted to that end. The defamation action, the costs and the damages were incidental to the strategy, and therefore to the business of the partnership. The applicant was not off on a frolic of his own: he was – however ineptly – pursuing the interests of the partnership. It follows I accept the outgoings in respect of the litigation were deductible.

has the nexus between the expenses and the business ceased in the years of income under review?

28.     The respondent says the expenses ceased being deductible by 1998 even if they were properly deductible before that period. It says the connection between the applicant’s income producing activities and the loans had ceased prior to the 1998 year of income.

29.     Ms Brennan acknowledged in her submissions that a loan taken out to cover outgoings associated with a former business might still be deductible: see Placer Pacific Management Pty Ltd v Federal Commissioner of Taxation (1995) 95 ATC 4459 at 4464 per Davies, Hill and Sackville JJ. However she also referred me to the decision of the Full Federal Court in Federal Commissioner of Taxation v Brown (1999) 99 ATC 4600 which explored the limits of this proposition. In that case, a deduction was sought in respect of interest payments on a loan taken out to fund the purchase of a delicatessen business that had been sold three years before the year of income in question. Lee, RD Nicholson and Merkel JJ allowed the deduction in that case but observed (at 4606) it was important to consider:

…whether, as a result of the cessation [of the business], the occasion of the recurrent loss or outgoings in question was no longer to be found in the business operations directed towards the gaining or production of assessable income…

30.     Their Honours agreed (at 4608) with the trial judge’s observation that:

…there may come a period of time between cessation of business and the payment of interest which is such that, in all the circumstances of the case, the payment is no longer sufficiently proximate to the activities of the business to be deductible…with the consequence that those activities no longer provide the occasion for the outgoing.

31.     The respondent in this case says the outgoings in respect of the loan were no longer sufficiently proximate to the activities of the business. Ms Brennan in her submissions referred in particular to:

·The amount of time that elapsed between the time the loan was first taken out and the time when the applicant accepted liability to make payments on the loan.

·The fact the borrowings were incurred after the applicant ceased to be a member of the partnership.

·The fact the applicant refused to make payments on the loan notwithstanding a capacity to make at least some payments.

32.     I agree with the respondent’s contention that the nexus has been broken. The applicant did not make any payments or even accept liability under the loan agreement until the conclusion of the Supreme Court proceedings in 2003.  The amount of the debt increased substantially in the interim. The loan has remained on foot (or, at a minimum, the amount of the debt has remained so high) because of the taxpayer’s actions. Even if I accept that taking out the loan after the applicant resigned from the partnership is not fatal to his case, I do not think it can be said the applicant diligently sought to deal with his obligations under the loan agreement. His failure to do so means the link between the original purpose of the loan and the ongoing liability fades, and ultimately disappears: see Federal Commissioner of Taxation v Brown; cf Federal Commissioner of Taxation v Jones (2002) 117 FCR 95.

conclusion

33.     The objection decision under review is affirmed.

34. The hearing of this matter was held in private at the applicant’s request pursuant to s 14ZZE of the Taxation Administration Act 1953 (Cth). The applicant did not voice any concerns about the publication of his name or the name of the partnership at the hearing. I propose to give him the opportunity to do so. These reasons will be published in seven days from the date of decision subject to an application for the suppression of the applicant’s name.

I certify that the 33 preceding paragraphs are a true copy of the reasons for the decision herein of Senior Member B J McCabe.

Signed:         Associate:      Sam J Appleton

Dates of Hearing  1 March 2005
  22 March 2005
Date of Decision  11 August 2005

The applicant appeared in person.

The respondent was represented by Ms Brennan of counsel.