Desalination Technology Pty Ltd and Commissioner of Taxation
[2013] AATA 846
[2013] AATA 846
Division TAXATION APPEALS DIVISION File Number(s)
2012/4583
Re
Desalination Technology Pty Ltd
APPLICANT
And
Commissioner of Taxation
RESPONDENT
DECISION
Tribunal Deputy President S E Frost
Date 29 November 2013 Place Sydney Objection decision set aside; objection allowed in full.
.............[sgd]...........................................................
Deputy President S E Frost
CATCHWORDS
INCOME TAX – research and development expenditure – tax offset – whether expenditure "incurred" – decision set aside – objection allowed in full
LEGISLATION
Income Tax Assessment Act 1936 – s 73B(14), 73J
CASES
Coles Myer Finance Ltd v Federal Commissioner of Taxation (1993) 176 CLR 640
Federal Commissioner of Taxation v Citylink Melbourne Ltd (2006) 288 CLR 1
Federal Commissioner of Taxation v James Flood Pty Ltd (1953) 88 CLR 492
Hooker Rex Pty Ltd v Federal Commissioner of Taxation (1988) 79 ALR 181
New Zealand Flax Investments Ltd v Federal Commissioner of Taxation (1938) 61 CLR 179
Nilsen Development Laboratories Pty Ltd v Federal Commissioner of Taxation (1981) 144 CLR 616
W Nevill and Company Limited v Federal Commissioner of Taxation (1937) 56 CLR 290SECONDARY MATERIALS
-
REASONS FOR DECISION
Deputy President S E Frost
29 November 2013INTRODUCTION AND ISSUES
The main issue in this case is whether Desalination Technology Pty Ltd, referred to in these reasons as the taxpayer, or as “DST”, is eligible for a tax offset for the 2009 income year in respect of research and development (R&D) expenditure. The answer to that question will depend on whether the expenditure was “incurred” during the relevant year.
If the taxpayer is not eligible for a tax offset then there is a second issue that needs to be addressed. That is the question of administrative penalty, which the Commissioner assessed at the rate of 50 per cent, having concluded that the taxpayer had a tax shortfall that resulted from recklessness as to the operation of a taxation law. If administrative penalty is payable then a question will also arise as to whether it should be remitted to any extent.
BACKGROUND
In the relevant income year tax offsets were available to an “eligible company” that incurred R&D expenditure of more than $20,000. The company could choose to take the offset in preference to a tax deduction provided it satisfied specified criteria in s 73J of the Income Tax Assessment Act 1936 (1936 Act). One of those criteria was that it could deduct the amount under, relevantly, s 73B of the 1936 Act. It could only do that if it had “incurred” the expenditure: s 73B(14). If it had, then the tax offset was equal to 125% of the expenditure amount, multiplied by 30%.
The taxpayer was an “eligible company” as defined.
The amount claimed by the taxpayer as a tax offset was $363,281. Of that amount the Commissioner allowed only $56,236. The balance was disallowed because the Commissioner came to the view that the corresponding expenditure amount had not been “incurred”.
THE CIRCUMSTANCES SURROUNDING THE CLAIM
The circumstances surrounding the tax offset claim were explained by Mr Garth Davey and Mr Colin Kofoed. Mr Davey is perhaps best described as an inventor; Mr Kofoed is an accountant and a registered tax agent. Mr Davey has been a director of the taxpayer since 29 June 2007. Mr Kofoed was a director from incorporation in June 2007 until January 2008. Since then he has been an alternate director. At all relevant times he has been the accountant and tax agent for the taxpayer.
Mr Davey has been involved in R&D activities for over 45 years. In that time he has explored and developed new technologies in relation to diesel engines, power generators, and the transportation of large equipment items including mobile transformers and substations. As he explained in his affidavit sworn on 7 March 2013 (Exhibit A1):
[24] As the number of research and development projects with which I was involved grew and became more complex from about 1996 onwards it became necessary for me to have access to more very expensive computers and other equipment …
[25] In order to better facilitate the financing of these items, to segregate them from the companies actually conducting research activities and to better manage and allocate the cost [of] their usage to various projects, I was advised by Kofoed to establish a new structure in which to hold them. To this end STR Developments Pty Ltd (STR) was registered to act as the trustee for the Davey Family Trust which was to own these assets and equipment. …
Mr Davey appears to have been constantly looking for what he described as “the best way to conduct research and development activities”. In around July 2006 Mr Kofoed suggested to him a structure that he had apparently used for other clients and which he said was in common use where R&D activities were involved. Mr Davey’s affidavit continues:
[32] Broadly, the structure involved establishing a new company to act as the project manager for all of the various projects being undertaken in the group. That company would also coordinate the use of labour and equipment for the various projects and to ensure suitable premises were available.
[33] Another company would be formed to hold the technology and patents and to carry out research and development using the labour and equipment to be provided through the project manager. I commented that this is what was already happening …
[34] A separate company also would be formed with a view to it exploiting the technology under license. And also a Unit Trust would be established so that investors would have a direct interest (as opposed to an interest in a company) in the successful exploitation of the technology.
[35] When external investors subscribed moneys to particular projects the funds were split into allotments of shares and units amongst these bodies. The moneys subscribed to the unit trust and the exploitation company were to be made available to the technology company for it to use in meeting its expenses, including costs associated with the filing for patents and to pay the project management company.
[36] I was happy with this structure as it offered protection for the patents and I thought that separating the different technologies into different (sic) would make it easier to borrow. I also thought that each technology would appeal to a different type of investor and separating them would make it easier to attract investors.
[37] This structure was used for subsequent inventions and was also incorporated into the manner in which earlier inventions were held. …
The structure was put into effect with the registration of Innovative Design Technologies Group Pty Limited (IDTG) on 6 July 2007. IDTG shared the same business address as the taxpayer and in the relevant income year it also had the same directors as the taxpayer. IDTG was “to act as a project manager for all research and development projects and to coordinate the use of labour and equipment for the various projects”[1]. One of the projects related to the development of a flash evaporator desalination unit for the purpose of combating salinity problems in the Murray Darling Basin and elsewhere. The taxpayer, DST, which had been registered on 7 June 2007, applied for a patent over the evaporator.
[1] Exhibit A1 [38]
Mr Davey prepared an R&D Plan setting out the research that DST needed to conduct in relation to the evaporator. Soon afterwards, in July 2007, according to Mr Davey, DST “contracted with IDTG so as to obtain the labour and equipment it required to complete the [R&D] Plan”[2].
[2] Exhibit A1 [57]
The R&D work itself was carried out by Mr Davey and others as employees of Davey Technology Pty Ltd[3], a company established by Mr Davey. The workers recorded the number of hours they spent undertaking R&D activities. The value of the time they charged became the basis of the fee invoiced by IDTG to the taxpayer, generally on a monthly basis.
[3] Exhibit A1 [58]
During the relevant year, IDTG issued monthly invoices totalling $1,065,625 to DST. Of the total amount invoiced, DST paid $149,964. The balance of $915,661 was debited to an inter-company loan account between IDTG and the taxpayer. To this day the balance has not been paid.
The arrangement between DST and IDTG, referred to by Mr Davey as a “contract”, was not initially in writing. At that time, he said, it was a “verbal agreement”[4]. The detail of the arrangement, he said, is reflected in a “Service Agreement” dated 14 May 2010 which was provided to the Australian Taxation Office (ATO) when the Commissioner raised queries about the taxpayer’s tax offset claim. Mr Kofoed, responding to the queries on behalf of the taxpayer, explained in a letter dated 30 November 2010 to the ATO[5]:
The agreement was dated 14 May 2010. This agreement simply evidenced in writing the long standing and clear agreement between the parties which had operated for some years. The effects of the agreement are obvious from the way in which the parties had operated in the past. …
[4] Transcript P-18, lines 34-35
[5] T6-57 [18]
The Service Agreement[6] reads as follows:
[6] ST4-102
Service Agreement
This Service Agreement is dated the 14th day of May 2010. It is executed this day to formalise the agreement between the parties which has been understood and operating between the parties since the inception of the project. This agreement is made between
Innovative Design Technologies Group Pty Ltd (ACN 126 418 657) of 19 Speedwell Street, Somerville, Victoria.
(IDTG)
and
Desalination Technology Pty Ltd (ACN 125 846 996) of 19 Speedwell Street, Somerville, Victoria.
(DST)
IDTG has coordinated and sub contracted Research and Development work on behalf of DST and continues to do so on an ongoing basis.
IDTG has rendered monthly invoices for that work, and will finance that work on behalf of DST on an ongoing basis.
The nature of the research and development project precludes DST making full settlement of monthly invoices as they are rendered.
The purpose of this agreement is to define the terms of trading between DST and IDTG, and to define the remedies available to IDTG should DST breach those terms of trading.
Terms of Trading
IDTG will continue to finance research and development work on behalf of DST. IDTG will render detailed monthly invoices to DST setting out work done and the monthly amount due.
DST will make such reductions in the total amount outstanding as funds received from investors, loan funds received, and any amounts DST may receive from other sources will prudently allow.
IDTG has the option at its absolute discretion to convert all or any part of monies outstanding under this agreement to an interest free loan, or to take equity in the project equivalent to any part of those outstanding monies. Any equity in the project will be valued at the current price sought from investors at the date of conversion.
Neither DST nor IDTG shall assign, further subcontract or delegate its rights or obligations under this agreement without the prior consent of the other party.
Termination
This agreement may be terminated by either party given 30 Days notice in writing.
Upon termination all amounts payable under the terms of this agreement will become payable in full.
This agreement will be protected from termination and demand for immediate payment in the event that IDTG becomes bankrupt, unable to pay its debts, insolvent, or enters into an arrangement with its creditors.
Disputes
Any dispute under this agreement which cannot be resolved within 30 days shall be submitted to third party arbitration. Failing resolution at arbitration the matter will be resolved by the courts in the State of Victoria.
This agreement shall be construed, governed and enforced on accordance with (sic) the laws of the State of Victoria and shall take effect as a sealed instrument within that state.
[Signed and executed for and on behalf of IDTG by Anthony Vernon Scott Gall, Director;
Signed and executed for and on behalf of DST by Garth Davey, Director]
Also relevant is a minute of a meeting of directors of DST which took place on 16 July 2007. That minute[7] is as follows:
It was noted that a new company Innovative Design Technology Group Pty Ltd had been created to facilitate and co ordinate and finance Research and Development for the group.
It was noted that IDTG would render Monthly invoices to each member of the group for R&D work carried out on their behalf.
It was further noted that cash flow for the company would be uncertain for the foreseeable future with funds incoming from R&D tax offsets and investors being received on an uncertain and irregular basis.
It was further noted that to simply treat invoices from IDTG as trade creditors would reflect badly to potential investors and lenders as no normal trading terms could be adhered to with any certainty.
It was therefore resolved that any invoice received from IDTG, after verification, be charged to a come and go loan account with that company. The invoices will be treated as fully paid as at the date it is rendered and the payment due to IDTG be more properly treated as a longer term borrowing for financing purposes. Investors and financiers would be therefore (sic) of the nature of funding received, and the company would avoid the risk of being considered insolvent due to its inability to meet trade credit commitments.
Funds received from investors and R&D tax offsets will be paid to IDTG in reduction of the loan account balance until exploitation of the technology enables payment in full.
[Signed as a correct record by Garth Davey.]
[7] ST2-89
WAS THE ENTIRE INVOICED AMOUNT “INCURRED” BY THE TAXPAYER?
The parties submit, and I agree, that the cases dealing with the word “incurred” in the context of s 51(1) of the 1936 Act or the corresponding s 8-1(1) of the Income Tax Assessment Act 1997 (1997 Act) are relevant to the question arising under s 73B(14) of the 1936 Act.
Those cases say that an outgoing or expense is not “incurred” unless “a liability to pay money as an outgoing comes into existence”[8]. There must be a “presently existing liability”[9] to which the taxpayer is “definitively committed” and “completely subjected”[10].
[8] W Nevill and Company Limited v Federal Commissioner of Taxation (1937) 56 CLR 290 at 302
[9] Nilsen Development Laboratories Pty Ltd v Federal Commissioner of Taxation (1981) 144 CLR 616 at 627
[10] Federal Commissioner of Taxation v James Flood Pty Ltd (1953) 88 CLR 492 at 506
In New Zealand Flax Investments Ltd v Federal Commissioner of Taxation (1938) 61 CLR 179, Dixon J (as his Honour then was) said at 207:
“Incurred” does not mean only defrayed, discharged, or borne, but rather it includes encountered, run into, or fallen upon. It is unsafe to attempt exhaustive definitions of a conception intended to have such a various or multifarious application. But it does not include a loss or expenditure which is no more than impending, threatened, or expected.
To those disqualifying words “no more than impending, threatened, or expected” was added the word “contingent” by Sweeney and Gummow JJ in Hooker Rex Pty Ltd v Federal Commissioner of Taxation (1988) 79 ALR 181; (1988) 19 ATR 1241; 88 ATC 4392 at 4400. In Coles Myer Finance Ltd v Federal Commissioner of Taxation (1993) 176 CLR 640 Deane J also used the word “contingent”, at 670:
It does not follow from those cases, however [James Flood, Nilsen Development and Federal Commissioner of Taxation v The Northern Timber and Hardware Co Pty Ltd [1960] HCA 93; (1960) 103 CLR 650], that the fact that jurisprudential analysis discloses that a particular liability to make a future payment of money is contingent necessarily means that such a contingent liability cannot constitute or found a “loss or outgoing” which has been “incurred” for the purposes of s.51(1). To the contrary, the weight of authority supports the conclusion that, depending upon the circumstances, a liability to pay money can constitute, or give rise to, a “loss or outgoing” which is “incurred” within the meaning of that sub-section notwithstanding that the money is not payable until a future time and that the obligation to pay it is theoretically defeasible or contingent in that it is subject to a condition which remains unfulfilled. (Footnotes omitted)
Referring to those comments in Federal Commissioner of Taxation v Citylink Melbourne Ltd (2006) 288 CLR 1 at 37-38, Crennan J (with whom Gleeson CJ, Gummow, Callinan and Heydon JJ agreed) said:
Deane J considered that the critical question was whether the taxpayer was, as a practical matter, definitively committed or completely subjected to discharge of the liability in the future. His Honour recognised that on some facts it would be apparent that a condition giving rise to a theoretical contingency could be treated, for practical purposes, as certain to be satisfied. (Footnote omitted)
The Commissioner argues here that the payment of money by DST to IDTG is “contingent” on the occurrence of future events and for that reason DST is not “definitively committed” or “completely subjected” to the expenditure. The Commissioner’s written submissions include the following:
[32] The written Service Agreement dated 14 May 2010 is said to formalise the terms of the agreement between the applicant and IDTG in force at the relevant time.
[33] However, this agreement cannot be the source of a legal obligation for the applicant to make an outgoing. Nowhere in the agreement is the applicant obliged to pay IDTG any amount at all. Rather, it provides that the applicant does not have to pay the monthly invoices, due to “the nature of the research and development project” (page 1). If the applicant makes a payment to IDTG at all, it is only because the applicant has (1) received funds from investors, loan funds or amounts from other sources; and (2) decided that payment is “prudently” allowed (page 2). There is no date by which any payment is to be made, which is consistent with these substantial contingencies.
[34] Any obligation for the applicant to make a payment under the Service Agreement is contingent upon the applicant receiving funds, and on the applicant deciding that it is prudent to use part [or] all of those funds to pay IDTG. This significant contingency precludes any amount being incurred under that agreement for the purposes of the [1936 Act].
True it is that the timing of the payments by DST to IDTG is conditional on two things – first, that DST receives funds from investors, lenders or other sources; and second, that even if it has the funds, DST considers it “prudent” to make a payment to IDTG[11]. Mr Davey conceded as much in cross-examination[12]. But the truth of that proposition does not render impossible the entirely different proposition that DST was definitively committed to IDTG in respect of the R&D expenditure.
[11] Service Agreement, Terms of Trading, paragraph 2
[12] Transcript, P-24, lines 27-39
The DST directors’ minute[13] acknowledges DST’s obligation to meet the charges invoiced to it by IDTG. It speaks of the “payment due” to IDTG. It notes that each invoice will be “treated as fully paid as at the date it is rendered”. There is no reason to treat them that way if there was no obligation to meet the expenditure in the first place. While it might be said against the taxpayer that the minute is unilateral and therefore does not speak for IDTG in relation to the arrangement, that argument ignores the fact that Mr Davey, who signed the minute on behalf of DST as a “correct record”, was also a director of IDTG.
[13] ST2-89
The Service Agreement, entered into on 14 May 2010 but said to reflect “the agreement between the parties which has been understood and operating between the parties since the inception of the project”, is consistent with the directors’ minute. While it is not the most tightly drafted agreement of its kind, it acknowledges that IDTG will “finance” the R&D work. In context, that can only mean that DST has a debt to IDTG for the value of the R&D work invoiced – IDTG has “financed” the work by lending the invoiced amount to DST so that the invoices are not outstanding. The balance sheet for DST as at 30 June 2009 shows an inter-company loan of just over $1 million to IDTG, which is a proper reflection of the situation as documented in the directors’ minute and the Service Agreement.
The Commissioner concedes in his written submissions that the lack of a fixed date for payment of a liability will not prevent a liability from having been incurred. Referring to Citylink Melbourne at 228 CLR page 40 [136], he provides an example by which a date for payment can be specified but subject to provision for early or late payment. He then submits that if no date (or range of dates) is provided at all, this will contribute to a conclusion that there is no presently existing obligation.
It seems to me, however, that DST’s liability to IDTG was created during the 2009 income year (in the sense that DST was definitively committed and had completely subjected itself to the expenditure), notwithstanding the fact that there were conditions affecting the timing of the discharge of that liability. I do not read the directors’ minute and the Service Agreement as leaving in any sense “contingent” the obligation placed on DST to pay the amounts that were invoiced to it. As Crennan J said in Citylink Melbourne at 228 CLR pages 40-41 [137]:
… A condition affecting the timing of the discharge of a liability (but not the creation of the liability) does not render the liability contingent in any business or commercial sense. (Footnote omitted)
CONCLUSION
The relevant expenditure was “incurred” by the taxpayer during the 2009 income year. There is no tax shortfall, and as a result the administrative penalty falls away.
The Commissioner’s objection decision is set aside. The objection is allowed in full.
I certify that the preceding 28 (twenty -eight) paragraphs are a true copy of the reasons for the decision herein of Deputy President S E Frost .........[sgd]...............................................................
Associate
Dated 29 November 2013
Date of hearing 10 July 2013 Counsel for the Applicant Mr P M Fraser Solicitors for the Applicant PricewaterhouseCoopers Counsel for the Respondent Ms C A Burnett Solicitors for the Respondent ATO Legal Services Branch
3