DiStefano and Commissioner of Taxation (Taxation) - [2023] AATA 1697

DiStefano and Commissioner of Taxation (Taxation) [2023] AATA 1697 (16 June 2023)
Division: TAXATION AND COMMERCIAL DIVISION

File Number(s): 2021/0683
Re:Angelo DiStefano
APPLICANT

AndCommissioner of Taxation
RESPONDENT

DECISION
Tribunal:Deputy President Bernard J McCabe
Member Lee Benjamin
Date:16 June 2023
Place:Sydney

The objection decision is set aside. The Tribunal decides in substitution that the taxpayer's claim for deductions in respect of interest and other outgoings on the property should be allowed in the 2017 year of income.
........................................SGD................................
Bernard J McCabe, Deputy President
Catchwords
Relevant income producing activity – Loss or outgoing – Tax deductions – Subjective intention
– Rental property
Legislation
Income Tax Assessment Act 1997
Income Tax Assessment Act 1936
TR2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following
the cessation of, relevant income earning activities
Cases
Bonaccordo v Commissioner of Taxation [2009] ATC 10-092
Clough Ltd v Commissioner of Taxation [2021] FCAFC 197
Commissioner of Taxation v Cooper (1991) 21 ATR 1616
Commissioner of Taxation v Day (2008) 236 CLR 163
Commissioner of Taxation v Payne (2001) 202 CLR 93
Fletcher v Federal Commissioner of Taxation [1991] HCA 42; (1991) 173 CLR 1
Ormiston and Federal Commissioner of Taxation [2005] AATA 978
Spassked Pty Ltd v Commissioner of Taxation (No 5) [2003] FCA 84; (2003) 197 ALR 553
Steele v Deputy Commissioner of Taxation [1999] HCA 7; (1999) 197 CLR 459; (1999) 41 ATR
139
Temelli v Federal Commissioner of Taxation [1997] FCA 756; (1997) 97 ATC 4716
REASONS FOR DECISION
Deputy President Bernard J McCabe
Member Lee Benjamin
16 June 2023

Mr Angelo DiStefano says he incurred losses or outgoings in connection with a rental property in the 2017 year of income. The controversy in these proceedings arises out of the fact the property had not been tenanted since 2012, and it appeared to be uninhabitable during the relevant year of income. The Commissioner points out the property has remained vacant in subsequent years. After allowing deductions in earlier years of income, the Commissioner decided in the 2017 year that enough was enough. The claim for deductions in respect of the holdings costs of the property was disallowed.
After reviewing the material, we are satisfied the objection decision under review must be set aside. We decide in substitution that the objection is allowed. We explain our reasons for that conclusion below.

Background

Mr DiStefano is an experienced businessman who worked in a senior management position at a large company. His statement (exhibit one) records his long history of investing in rental properties: at [8]-[10]. On 31 August 2006, he purchased a house located in Anna Bay, a coastal town north of Sydney. He funded the purchase with money borrowed from a bank. The borrowings were secured by a mortgage over the property.
The house is situated at a desirable location on the oceanfront. Occupants of the house can access the beach from the front yard. As Mr DiStefano explained in his statement (at [13]):
It is right on the beach. It is among the first group of properties north of Sydney to have direct beach access from the front yard thus demanding a higher rental return. The property also offered the option of seeking higher weekly rentals by making it available to holiday makers.
Mr DiStefano said the house only earned the anticipated very high rentals for a few weeks each year. In the years that immediately followed the purchase, the house proved difficult to rent outside these periods. It was empty for long stretches in those early years: at [13]. He said the property was visited by vandals and it became apparent there was a real risk of damage if it were left unattended. A long-term tenant moved into the property in 2010. (There was no lease agreement in evidence, but nothing appears to turn on that.) The tenant moved out in 2012: transcript at p 28. The applicant has not received rental income from the property since 2013. The property has been vacant from that point.
The applicant has continued to pay interest on the mortgage although he has made little progress in reducing the principal. (He continues to owe around $1.3 million.) He has also continued to meet the cost of land tax, council rates and insurance. He says these costs are all losses or outgoings incurred in connection with the rental property.
There is no reason to doubt Mr DiStefano purchased the property with the intention of renting it out, albeit that he also had it in mind to redevelop the property in due course.

The state of the property and Mr DiStefano’s stewardship

When the long-term tenant moved out in 2012, she reported an extensive list of defects with the property. Mr DiStefano said in his statement that he had a building inspection completed by Accurate Building Inspections in January 2013. The report confirmed the property was in very poor condition. He recorded the conclusions of the report as follows (at [22]):
…the property was in below average condition and had water damage. The report recorded structural damage, conditions conducive to structural damage, major defects in the non-structural elements of construction, serious safety hazards, and moisture ingress. The report contains photographs of damage. The report also suggested that I engage the services of a structural engineer to assess the property. The report clearly put an end to the notion of the house being re-rented quickly.
We reviewed the report in question. We are satisfied Mr DiStefano has summarised it accurately. He gave evidence that the property was vandalised on several occasions over the years it has been vacant, and it continues to decline.
Mr DiStefano said he consulted his cousin, who was an architect, about options for the property. He also spoke with another relative who was a qualified electrician and project manager/builder: transcript at p 29. Those conversations occurred in the first half of 2013. Mr DiStefano recalled they considered various possibilities for renovating or redeveloping the property. He said he was focused on increasing the rental income he derived.
Mr DiStefano said he made limited progress towards realising any of these options because of distractions in his business and personal life. The distractions began when his elderly father suffered a stroke in July 2012. The applicant visited his father in the hospital every day in the six months that followed. The hospital was located some distance from the applicant’s home. He said he was engaged in this activity for up to 70 hours per week: transcript at p 29. In December 2012, Mr DiStefano Senior moved in with the applicant and his family so the applicant could care for his father: exhibit one at [18]-[20]. Mr DiStefano Snr required round-the-clock care. The applicant was also required to travel extensively for his work as a senior manager of a large company. The company had hundreds of employees located in offices around Australia and overseas. It was a demanding job that required long hours and extended periods away from his family responsibilities, including his carer commitments to his father. He said he felt “burnt out” by 2014 with all his commitments: exhibit one at [29].
Interestingly, while the applicant said he was “burnt out” by 2014 as a result of his commitments so that he was unable to finalise plans for the Anna Bay property, he continued to make other large real estate purchases: transcript at p 32.
In any event, the applicant recounted undertaking work on the property during 2014, which included removing trees and commencing modifications on the garage: exhibit one at [31]. He said he continued to have discussions with the architect and the other relative involved in preparing plans for various options. Over time, Mr DiStefano accumulated an extensive collection of design drawings for the proposed development: T documents at pp 252ff. He also had the property surveyed in late 2014 in anticipation of lodging a development application with the council. He commissioned a bushfire assessment in April 2015 which would be required for the development application: T documents at pp 242ff. Mr DiStefano also recalled receiving quotes in June 2015 from a contractor in connection with the supply of a drainage system: exhibit one at [37]-[38]. He subsequently arranged (in October 2015) for a report from Parker Scanlon, a consultant, about the environmental impact of a development: T documents at pp 289ff.
Mr Josifoski, counsel for the Commissioner, questioned Mr DiStefano about the extent of his activities in relation to the property in the lead up to the 2017 year of income and subsequently. Mr DiStefano’s evidence suggested he was pressing ahead with plans to bring the renovated property back on-line as a rental asset albeit his progress was slowed by his other commitments and personal circumstances. Mr Josifoski suggested the only work done in relation to the property was carried out by the applicant’s two relatives, the architect and project manager. Mr DiStefano agreed those individuals were the “point men” in relation to the property who carried out much of the investigatory work, but he insisted he remained the decision-maker: transcript at p 32.
Mr DiStefano said there were other developments that got in the way of bringing the rental property back onstream in the lead up to and during the 2017 year of income, including:
·Challenges in the applicant’s business. The business the applicant worked for was dependent on the mining industry. When the mining industry experienced a downturn in 2015, he said there was a significant impact on the profitability of the business. That forced Mr DiStefano to spend even longer hours trying to rationalise the business as it was financially squeezed: exhibit one at [40]. He says the business was ultimately sold under pressure from its bankers: at [54].
·Mr DiStefano Snr experienced worsening health: at [46].
·Mr DiStefano recalled he began to experience depression around 2015: at [47], [53]. He began to receive treatment for depression in early 2017 (Electronic Hearing Book at p 1095).
That did not stop the applicant from lodging the development application with the local council in the latter part of 2015 – although the applicant’s oral evidence makes clear most of the work in relation to the development application was undertaken by his relatives. The application envisaged building a new residence on the property and other improvements. The cost of the work was expected to exceed $800,000. The council gave its approval in February 2016: exhibit one at [49].
Mr DiStefano confirmed in cross-examination that “nothing meaningful” happened in relation to the property between the date of the development approval in February 2016 and 30 June 2017: transcript at p 34. He said that was partly because of his mental health, but also because he no longer had access to the funds that would be required to proceed with the development after his business ran into difficulty: transcript at p 35. He acknowledged he owned several other properties and that he received significant dividends from his company at the time, but he insisted there were financial reasons for the slow progress on the Anna Bay work: transcript at pp 36, 38-39.
Mr Josifoski questioned the applicant about the finances of the business where he worked. Mr Josifoski suggested the business was not in such serious trouble at the time that it created a genuine obstacle to making progress on the development. Mr DiStefano insisted his financial situation was impacted by the state of the business. We are satisfied from his evidence that the business was in difficulty at the time, and it may subsequently have been in such poor shape that it was sold at a loss: transcript at p 47. We accept the applicant was effectively made redundant and had to look for other work.
In October 2019, the applicant advised the Commissioner it was still his intention to work on the property with a view to bringing it back into the rental market. The Commissioner points out that work did not start as advised. Mr DiStefano said he offered his advice to the Commissioner on the basis of an expectation Mr DiStefano would benefit from consulting work he was doing for a company that was expecting to float. He said he did not receive the shares he expected to receive in 2019 and 2020 in connection with that float. That meant he was unable to commence the work on the property as indicated.

The deductibility of the losses or outgoings

The general deductions provision is found in s 8-1 of the Income Tax Assessment Act 1997 (ITAA97). That section provides:
(1) 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.
The parties agree the applicant’s case must be considered under the first limb of the test. There is no doubt the amounts claimed are losses or outgoings. The issue is whether they could be said to be “incurred in gaining or producing assessable income”. Of course, there was no assessable income from the property after 2013 because the property was untenanted after it fell into disrepair. The real issue here is whether the holding costs of the property – the losses or outgoings in question – have lost their connection with the earning of assessable (in this case, rental) income. As the High Court explained in its unanimous judgment in Fletcher v Federal Commissioner of Taxation [1991] HCA 42; (1991) 173 CLR 1 at [23]:
The question whether an outgoing was, for the purposes of s.51(1), wholly or partly "incurred in gaining or producing the assessable income" is a question of characterization. The relationship between the outgoing and the assessable income must be such as to impart to the outgoing the character of an outgoing of the relevant kind. It has been pointed out on many occasions in the cases that an outgoing will not properly be characterized as having been incurred in gaining or producing assessable income unless it was "incidental and relevant to that end" See, e.g., Ronpibon Tin (1949) 78 CLR, at p 56; Charles Moore and Co. (W.A.) Pty Ltd v. Federal Commissioner of Taxation [1956] HCA 77; (1956) 95 CLR 344, at p 350; Lunney v. Commissioner of Taxation (1958) 100 CLR 478, at p 497; John (1989) 166 CLR, at p 426; Ure v. Federal Commissioner of Taxation [1981] FCA 9; (1981) 50 FLR 219, at pp 223, 231; [1981] FCA 9; 34 ALR 237, at pp 241, 248; Riverside Road (1990) 23 FCR, at pp 311-312. It has also been said that the test of deductibility under the first limb of s.51(1) is that "it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income" See, e.g., Ronpibon Tin (1949) 78 CLR, at p 57; John (1989) 166 CLR, at p 426.
The Court pointed out (at [21]) the reference to “the assessable income” in s 51(1) of the Income Tax Assessment Act 1936 (ITAA36):
…is not to be read as confined to assessable income actually derived in the particular tax year. It is to be construed as an abstract phrase which refers not only to assessable income derived in that or in some other tax year but also to assessable income which the relevant outgoing "would be expected to produce"…
Hill J explained in Commissioner of Taxation v Cooper (1991) 21 ATR 1616 (at 1634):
It should be noted at the outset that the subsection does not express the right to a deduction in terms of outgoings incurred to earn income…
One reason why the subsection is not so expressed is that there will be many cases where the outgoing incurred may relate not to the year of income in which the outgoing is incurred, but to an earlier or later year. The words "the assessable income" as used in the subsection, refer to the assessable income of the taxpayer generally, without division into annual accounting periods: AGC (Advances) Ltd v FCT (1975) 132 CLR 175 at 189; 5 ATR 243 per Barwick CJ and 196-7 per Mason J. Another reason is that no income might be derived at all as a result of an outgoing being incurred.
The applicant argued the Anna Bay house was purchased as an investment property that would be rented out. We have no difficulty with that claim; there is no evidence to suggest otherwise. But the investment property had ceased yielding assessable income several years before the year of income in question. The applicant says that was nothing more than a lull, and he expected and intended the asset would become productive again. Unfortunately, he says, events conspired to prevent him from undertaking the work required to put the property back on the rental market over an extended period. He insists the temporary cessation of income-producing activity did not change the character of the asset or the character of the losses or outgoings. Nor did it break the nexus between the losses and outgoings and the prospect of earning assessable income.
Mr Craig, who appeared for Mr DiStefano, referred to the Commissioner’s ruling TR2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities. Mr Craig said the ruling conveniently summarised the correct approach. It focused on the deductibility of borrowings in particular cases. While the holding costs sought here include other outgoings, Mr Craig says the analysis is the same. The ruling quotes the High Court’s judgment in Steele v Deputy Commissioner of Taxation [1999] HCA 7; (1999) 197 CLR 459; (1999) 41 ATR 139 from which the ruling distilled (at [9]) the following propositions:
…interest incurred in a period prior to the derivation of relevant assessable income will be ‘incurred in gaining or producing the assessable income’ in the following circumstances:
·the interest is not incurred ‘too soon’, is not preliminary to the income earning activities, and is not a prelude to those activities;
·the interest is not private or domestic;
·the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost;
·the interest is incurred with one end in view, the gaining or producing of assessable income; and
·continuing efforts are undertaken in pursuit of that end.
Mr Craig says the applicant in this case acquired the property for use in generating rental income. That much is evident from a subjective purpose he articulated in his evidence, and which was apparent from his conduct. It is also evident from the facts about the use of the property once it was acquired. We were told there is no reason to suppose the objective had changed even though the property had become, in the short term, uninhabitable. The applicant’s commitment to the objective was demonstrated by his (admittedly slow) progress towards obtaining the necessary approvals for renovation work in the period immediately prior to the 2017 year of income. The fact the applicant made virtually no progress beyond obtaining development approval in the relevant year was attributable to unfortunate circumstances rather than a waning of any commitment to the objective. Mr Craig emphasised the period of time between the outgoings and the prospect of deriving assessable income was not so great that the nexus between the expenditure and the objective was broken.
Mr Josifoski began his submissions with a reference to the High Court’s judgment in Commissioner of Taxation v Day (2008) 236 CLR 163. In that case, Gummow, Hayne, Heydon and Kiefel JJ explained (at 175):
The terms of s 8-1(1)(a) of the ITAA and its predecessors… have not been regarded as materially different... They refer to a relationship between expenditure incurred and what is productive of assessable income, which is to say the connection necessary for deductibility…. The words “incurred in gaining or producing … assessable income”, appearing in the section, have long been held to mean incurred “‘in the course of’ gaining or producing” income, as was observed in [Commissioner of Taxation v Payne (2001) 202 CLR 93 at 99-101].

Mr Josifoski said it followed from Day and Payne that it was not enough to establish a causal connection between the outgoings and the assessable income. As Hill J explained in Cooper (at 1634):
It will often, therefore, be necessary to analyse with some care what the operations or activities are that are regularly carried on by the taxpayer for the production of income, and to determine whether the outgoings (or where relevant the losses) are incidental and relevant to those operations or activities.
Mr Josifoski also referred to the judgment of the Full Court in Clough Ltd v Commissioner of Taxation [2021] FCAFC 197. In that case, Thawley J suggested (consistent with the reasoning of Hill J in Cooper) that “it is relevant to ask what the outgoing is calculated to effect from a practical or business point of view”: at [50]. His Honour continued (at [51]):
The “occasion of the loss or outgoing” is not necessarily temporally restricted to the immediate causes for the payment, albeit contemporaneous events will be directly relevant and of significant, and on occasion decisive, weight. Questions of causation (including for example whether a payment would have been made were it not for the existence of a particular circumstance) and purpose are relevant, but the ultimate object is one of characterisation having regard to all of the relevant circumstances – see: Fletcher at 17. As the High Court observed in Payne, the word “purpose” is not employed in s 8-1(1)(a).
We accept Mr DiStefano had the subjective intention of earning assessable income in the future when he incurred the loss or outgoing in the 2017 year of income. (It is not as if the asset was lost and he has been left with an ongoing burden that he needed to service.) The existence of such a subjective purpose is relevant to our deliberations because there was no assessable income produced. While his motive might assist us it does not relieve us of the obligation to look to all the facts and circumstances and ask whether incurring the loss or outgoing “was calculated to effect” the earning of assessable income. The answer to that question will be ‘No’ if there is only a “colourable relationship between the whole of the expenditure and the production of income”: Spassked Pty Ltd v Commissioner of Taxation (No 5) [2003] FCA 84; (2003) 197 ALR 553 at 599 per Lindgren J.
We do not understand there to be a substantial disagreement between the parties as to these principles. The difference between the parties lies in the application of the principles to the facts in this case.
While the applicant relied on the contents of TR2004/4, Mr Josifoski referred to several authorities which were said to illustrate the operation of the relevant principles. He pointed to:
·The decision of the Federal Court in Bonaccordo v Commissioner of Taxation [2009] ATC 10-092. In that case, the taxpayer purchased a neighbouring property in 2004 using borrowed funds. He placed a sign on the property advertising it for rent and even fielded a few enquiries from prospective tenants. He did not list the property with a real estate agent. He said he wanted to control the leasing process himself because he was concerned to identify a tenant that would not upset an animal breeding program he was conducting on his adjoining land. The property remained untenanted for three years, including in the year of income in question. Tamberlin J concluded (at 2950-2951) the taxpayer did not make “sufficient efforts to indicate that the property was available to rent and I am not persuaded that the purpose of any of the expenditure was to produce income.” In reaching that conclusion, his Honour emphasised (at 2949):
…the importance of adopting a practical commercial commonsense approach to determination of the question of whether sufficient and genuine attempts were made to rent the property so as to provide the necessary connection with the production of rental income.
·The Tribunal’s decision in Ormiston and Federal Commissioner of Taxation [2005] AATA 978 where an inexperienced property investor acquired a property with the intention of renting it out following modest renovations. The planned renovations did not come to fruition quickly because of a lack of proper planning and problems in the taxpayer’s personal life. The Tribunal accepted the holding costs were deductible in the circumstances. The Tribunal noted there was no doubt about the taxpayer’s intention in acquiring the property. Mr Josifoski pointed out Mr DiStefano was not an inexperienced property investor like the taxpayer in Ormiston, and the delay in this case was even longer than in Ormiston.
·The decision of the Federal Court in Temelli v Federal Commissioner of Taxation [1997] FCA 756; (1997) 97 ATC 4716. In that case, the taxpayer acquired vacant land on which they planned to build a rental property. They did not undertake a detailed analysis of the cost of the building project or take any concrete steps towards bringing it to fruition. The taxpayers were also aware of the need to demonstrate a connection between the outgoings and the income producing activity if the holding costs were to be deductible. Merkel J concluded at no point had the taxpayer committed to building rental accommodation on the property. His Honour cited the Full Court’s decision in Steele v Federal Commissioner of Taxation ((1997) 97 ATC 4239 at 4243 per Burchett and Ryan JJ) as he explained the nexus between the outgoing and the income producing activity was lost because the taxpayer did not exhibit “a degree of commitment to the relevant income producing activity”: Temelli at 4721. While the Full Court’s decision in Steele was subsequently appealed to the High Court, Mr Josifoski says there is no reason to doubt the validity of that part of the Full Court’s reasoning.
Those authorities make clear each case must be judged on its particular facts. The authorities also make clear that intention is potentially relevant, and that personal circumstances might be considered where progress towards executing a plan to produce assessable income is delayed – but there are limits. Ultimately, one looks to facts and circumstances that evidence a commitment to the ends of income production.
Mr Josifoski says we should give particular weight to the following facts and circumstances:
·the applicant borrowed a large amount of money to purchase the property. He has paid a significant amount of interest. He expects to spend even more if he is to renovate the property – yet he has made very little by way of rental income from that property and surely did not expect in 2017 that he would be able to earn anything any time soon;
·the applicant is an experienced property investor. He has multiple properties that he successfully rents out to tenants, and he is presumably aware of the taxation consequences of investing in property. His other properties are successfully managed and maintained without the sort of interruption experienced at Anna Bay;
·the applicant was assisted by relatives with relevant skills who could have progressed his plans for the property if he were seriously committed to the project notwithstanding his carer responsibilities.
When we have regard to all the circumstances, we are satisfied Mr DiStefano had done just enough to demonstrate he retained his commitment in the relevant year to the project that would ultimately yield assessable income (or, perhaps more accurately, his behaviour did not demonstrate he had at that point lost his commitment to that end). He made clear he originally acquired the property for rental purposes. While having limited success in attracting the sort of high-paying tenants he anticipated following the purchase, there is no reason to doubt he was making genuine efforts to market the property during that earlier period and he did have a long-term tenant at one stage. There is also no doubt that serious defects emerged in the property which made it practically uninhabitable: the note from the tenant in 2012 listing defects and the inspection report make clear the property was in a pitiable state. Mr DiStefano then took steps – slowly, but not so slowly as to invite questions about the genuineness of his purpose – towards lodging a development application. The application was approved in early 2016. It is clear nothing happened from then until before the end of the 2017 year of income. The taxpayer’s explanation for that lull in activity was called into question but we have no reason to doubt he was weighed down with carer responsibilities. Perhaps more importantly, he experienced difficulties in the business he was running that distracted him and ultimately impacted on his ability to finance the project. The Commissioner pointed out the taxpayer did not provide extensive evidence about the financial difficulties of the business but his account was sufficient to satisfy us that he was not able to progress the project in the short term.
In short, we are not satisfied the slow progress towards realising the project – and the lull in activity between February 2016 and 30 June 2017 in particular – suggest a want of commitment given the activities the taxpayer had been undertaking and the evident purpose of the original investment. It follows the nexus between the outgoings and the production of assessable income remained. We accept the delay in execution of the project could become untenable at some point: at such a point, the taxpayer would no longer be said to incurring outgoings in gaining or producing assessable income. But the taxpayer had not reached that point in the 2017 year of income. Whether he would succeed in making the same argument in subsequent years of income remains to be seen.

Conclusion

The objection decision is set aside. The Tribunal decides in substitution that the taxpayer’s claim for deductions in respect of interest and other outgoings on the property should be allowed.

38. I certify that the preceding 37 (thirty-seven) paragraphs are a true copy of the reasons for the decision herein of Deputy President Bernard J McCabe, Member Lee Benjamin

39.

...................................SGD.....................................
Associate

Dated: 16 June 2023

Date(s) of hearing:

20 July 2022

Counsel for the Applicant

Solicitor for the Applicant

Adam Craig

Mark Hamilton

Counsel for the Respondent:

Solicitor for the Respondent:

Keni Josifoski

Alexander Mossman, Jacinta Kezelos