Elberg, Liliana v Commissioner of Taxation
[1998] FCA 388
•20 APRIL 1998
FEDERAL COURT OF AUSTRALIA
TAXATION - income tax - deductions - legal expenses incurred by a doctor in defending criminal charges arising out of conduct of her medical practice - whether legal expenses were incurred in gaining or producing assessable income or carrying on business for that purpose - whether expenses were of capital or of a capital, private or domestic nature.
Income Tax Assessment Act 1936 (Cth) s 51(1)
Putnin v Commissioner of Taxation (1991) 27 FCR 508 applied
The Herald and Weekly Times Limited v The Federal Commissioner of Taxation (1932) 48 CLR 113 applied
Federal Commissioner of Taxation v Snowden & Willson Proprietary Limited (1958) 99 CLR 431 considered
Magna Alloys and Research Pty Ltd v Federal Commissioner of Taxation (1980) 49 FLR 183 considered
Commissioner of Taxation v Rowe (1995) 60 FCR 99 considered
Hallstroms Proprietary Limited v The Federal Commissioner of Taxation (1946) 72 CLR 634 considered
LILIANA ELBERG v COMMISSIONER OF TAXATION
VG 669 of 1996
JUDGE: MERKEL J
DATE: 20 APRIL 1998
PLACE: MELBOURNE
IN THE FEDERAL COURT OF AUSTRALIA
DISTRICT REGISTRY
VG 669 of 1996
ON APPEAL FROM THE TAXATION APPEALS DIVISION OF THE ADMINISTRATIVE APPEALS TRIBUNAL CONSTITUTED BY DEPUTY PRESIDENT B M FORREST
BETWEEN:
LILIANA ELBERG
AND:
COMMISSIONER OF TAXATION
JUDGE:
MERKEL J
DATE OF ORDER:
20 APRIL 1998
WHERE MADE:
MELBOURNE
THE COURT ORDERS THAT:
The appeal from the decision of the Administrative Appeals Tribunal (AAT) be allowed.
The decision of the AAT be set aside.
The matter be remitted to the AAT
(a)to determine the quantum of the deduction for legal expenses which is to be allowed; and
(b)to otherwise determine the taxpayer’s application for review in accordance with law.
The respondent pay the applicant’s taxed costs of and incidental to the appeal.
Note:Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules.
IN THE FEDERAL COURT OF AUSTRALIA
DISTRICT REGISTRY
VG 669 of 1996
ON APPEAL FROM THE TAXATION APPEALS DIVISION OF THE ADMINISTRATIVE APPEALS TRIBUNAL CONSTITUTED BY DEPUTY PRESIDENT B M FORREST
BETWEEN:
LILIANA ELBERG
AND:
COMMISSIONER OF TAXATION
JUDGE:
MERKEL J
DATE:
20 APRIL 1998
PLACE:
MELBOURNE
REASONS FOR JUDGMENT
BACKGROUND
The applicant (“the taxpayer”) is a medical practitioner who earned her income as a doctor in private practice and as a medical officer employed by the State of Victoria to provide medical services to intellectually disabled residents at Caloola Training Centre. In about September 1991 the taxpayer was charged with fifty-four counts of dishonestly obtaining property by deception, contrary to s 81 of the Crimes Act 1958 (Vic). The charges, which related to the period from 26 July 1990 to 11 July 1991, alleged that the taxpayer obtained property by deception by holding herself out to be present on duty at the Centre and obtaining payment therefor when, in fact, she was not on duty at the Centre but was deriving income from her private practice. The charges were subsequently dismissed.
In the course of defending the charges, the taxpayer incurred legal expenses of $52,800 in the year of income ended 30 June 1992, and $60,000 in the year of income ended 30 June 1993. The Commissioner allowed the deduction of the expenses for the year of income ended 30 June 1992 but denied the deduction claimed for the legal expenses of $60,000 incurred in respect of the year of income ended 30 June 1993.
The taxpayer objected to her assessment for the year of income ended 30 June 1993 and the respondent (“the Commissioner”) disallowed the objection. The taxpayer applied to review the Commissioner’s decision to disallow the objection but the Administrative Appeals Tribunal (“the AAT”) affirmed the decision. The taxpayer has appealed from the decision of the AAT to the Court.
The issue arising on the appeal is whether the AAT erred in law in concluding that the legal expenses of $60,000 were expenses of a capital nature and were therefore not deductible under s 51 of the Income Tax Assessment Act1936 (Cth) (“the ITAA”).
THE DECISION OF THE AAT
In the proceedings before the AAT, the taxpayer claimed that the legal expenses were outgoings necessarily incurred in carrying on the business of a medical practitioner for the purpose of gaining or producing assessable income and that they were not outgoings of capital, nor of a capital, private or domestic nature. The quantum of the claim was also in issue but was put to one side pending determination of the deductibility issue.
The Commissioner contended that the legal expenses were of a capital nature as they were incurred to protect the taxpayer’s “structural asset”, being her right to practice as a medical practitioner. There was some support for that view as the taxpayer’s former accountant had written to the Commissioner in support of her claim for deductibility of the legal expenses, stating, inter alia, that:
“If the taxpayer had have been [sic] convicted of this charge the taxpayer’s right to practice would have been withdrawn and the taxpayer would not have been able to derive assessable income.”
At the hearing in the AAT the taxpayer claimed to have no knowledge of the letter and disputed the suggestion by the Commissioner that her primary concern arising from the charges was the protection of her right to practice. After considering a number of decisions of the Courts and of the Tribunal in relation to the deductibility of claims for legal expenses, the AAT concluded:
“In examining the character of the advantage sought, (Sun Newspapers) the Tribunal is required to look objectively at the nature of the offence and the surrounding facts to determine if the structural asset is at risk. The offences were of a serious nature, alleging dishonesty. Section 81 of the Crimes Act 1958 (Vic) provided:
“81. (1) A person who by any deception dishonestly obtains property belonging to another, with the intention of permanently depriving the other of it, is guilty of an indictable offence and liable to imprisonment for a term not exceeding ten years.”
There seems little doubt that faced with the charges, the taxpayer was concerned about her reputation, her income source as well as the potential consequences of a conviction. Loss of an income source at the centre was a factor although against the backdrop of financial constraints at the centre and the likelihood she would eventually have to resign her employment indicate that protecting that source of income was a less important consideration.
While the taxpayer asserted at the hearing that the possibility of deregistration was not a consideration in incurring legal costs to defend the charges, looking at the facts of the matter, I think it probable that the taxpayer, faced with serious charges and with a private medical practice from which she derived in excess of fifty per cent of her income, was anxious to protect her right to practice from any impingement. That this was an object in view in defending the charges (including briefing two counsel) is I think clear enough from all of the material before the Tribunal.
Cases such as Magna Alloys and Putnin v Federal Commissioner of Taxation are instances where the proceedings giving rise to the claim for a deduction arose out of the day to day activities of the taxpayer but did not imperil the taxpayer’s ‘profit yielding subject’ nor secure for the taxpayer any enduring or tangible asset. While in the present case the offences arose out of the performance of the taxpayer’s duties and activities under her employment contract at the centre, they were at the time perceived to represent a risk to her right to practice and impelled the taxpayer to undertake the expense she did. I do not think the expenses could be classified as purely a working expense arising out of daily business activities. The expenses were in large measure to protect an enduring benefit.
Consequently I do not think that it can be said the legal expenses were peripheral to the taxpayer’s right to practice. This conclusion also distinguishes the present case from cases such as Federal Commissioner of Taxation v Rowe where the taxpayer was earning recurrent payments solely as an employee. In the present case more than half the taxpayer’s income was derived from her private practice.
For these reasons and given that the burden of proof imposed upon the taxpayer under s 14ZZK Taxation Administration Act 1953 has not been discharged, the decision under review is affirmed.”
THE SUBMISSIONS OF THE PARTIES
Senior counsel for the taxpayer challenged the AAT’s finding of fact made against his client in relation to protecting her right to practice but contended that, in any event, the Tribunal erred in law in applying a subjective rather than an objective approach to s 51 in respect of the legal expenses. It was contended that the present case was indistinguishable from the decision of the Full Court of the Federal Court in Putnin v Commissioner of Taxation (1991) 27 FCR 508 in which the Full Court allowed the deductibility of legal expenses incurred by an accountant, in defending a charge against him that as a liquidator, he had conspired with a debtor and another, to defraud the Commonwealth. In Putnin the Full Court:
accepted that the taxpayer might, if he had been convicted, have incurred professional censure and cancellation of his registration as a trustee in bankruptcy or as an official liquidator but treated such consequences as indirect consequences that might or might not have happened;
concluded that such consequences were neither the object of the prosecution nor would they inevitably have followed upon its success;
in allowing deductibility, placed great emphasis on the fact that the criminal proceedings arose from the activities by which the taxpayer had earned his income, being the mode of his performance of the particular task carried out in the course of business operations and concluded that something of that kind is quite removed from capital and held accordingly, that the legal expenses were deductible under s 51.
Counsel for the Commissioner contended that the Court was bound by the findings of fact upon which the AAT’s decision was based and submitted that the AAT correctly applied the law to the facts so found. It was said that it was clear from the evidence that the advantage sought to be achieved by the taxpayer was the protection of her right to practice and that expenditure for that purpose had always been accepted as an expenditure on capital account. It was sought to distinguish Putnin’s case from the present on the basis that the charges in the present case did not arise out of the medical activities of the taxpayer as a doctor but rather, arose out of alleged conduct extraneous to those activities. Accordingly, so it was said, the AAT did not err in law in arriving at its decision.
THE ISSUES
The Commissioner is clearly correct in contending that the Court is bound by the findings of fact made by the AAT, if those findings were open on the material before it: see Collins v Minister for Immigration and Ethnic Affairs (1981) 58 FLR 407 at 410-411. The findings as to the taxpayer’s motives were clearly open on the material before the AAT.
However the findings have a more limited effect on the outcome of the taxpayer’s appeal than was contended by the Commissioner. It was not, and could not be, disputed that the immediate object of the taxpayer in defending the charges was to secure their dismissal. The charges were undoubtedly of a very serious nature and if upheld, had the potential to give rise to serious personal and professional consequences for the taxpayer. Those consequences included possible imprisonment, severe harm to her personal and professional repute, loss of her employment with the State of Victoria and disciplinary proceedings before the Medical Practitioners Board of Victoria under the now repealed Medical Practitioners Act 1970 (Vic). The disciplinary proceedings could have resulted in a reprimand, imposition of conditions, limitations or restrictions on practice, suspension, deregistration and/or imposition of a fine.
Although the AAT appeared to accept evidence given by the Registrar of the Board that, in the event of a conviction there was little likelihood of deregistration and the more probable outcome was a reprimand or a short suspension of practice, there was nothing highly improbable or unlikely about the finding made by the AAT, that it was:
“probable that the taxpayer, faced with serious charges and with a private medical practice from which she derived in excess of fifty per cent of her income, was anxious to protect her right to practice from any impingement.”
However, that finding is to be understood in the context in which it was made. It was a finding that protection of the right to practice was “an object in view in defending the charges” (emphasis added). The AAT accepted that the offences arose out of the performance of the taxpayer’s duties and activities under her employment contract at the Centre, and that the taxpayer was concerned generally with the consequences of a conviction, but added that the charges:
“were at the time perceived to represent a risk to her right to practice and impelled the taxpayer to undertake the expense she did.”
In my view, the AAT did not, by its findings, intend to say that the risk to professional practice was the only matter that impelled the taxpayer to incur legal expense in defending the charges. Rather, on a fair reading of the reasons as a whole, the approach taken by the AAT was that, as protection of the taxpayer’s right to practice was one of the objects in view in defending the charges, that was sufficient to characterise the expenditure incurred as expenditure of a capital nature and not as “purely a working expense arising out of daily business activities”.
In determining whether the AAT erred in law, two related issues need to be considered. The first is whether the legal expenses were outgoings incurred in gaining or producing assessable income within the first limb of s 51(1) of the ITAA, or were necessarily incurred in carrying on a business for the purpose of gaining or producing such income under the second limb of s 51(1). The second is whether the legal expenses were outgoings of capital or of a capital private or domestic nature. The AAT appears to have merged the two issues and that may have led it into error in its conclusions.
THE LAW - DEDUCTIBILITY OF LEGAL EXPENSES.
In The Herald and Weekly Times Limited v The Federal Commissioner of Taxation (1932) 48 CLR 113, the High Court considered the deductibility of damages paid in respect of defamatory material published by a proprietor and publisher of an evening newspaper and of amounts incurred by way of costs in contesting the claims of persons defamed. The amounts paid were held to be deductible as an ordinary incident of the business of conducting a newspaper. Gavan Duffy CJ and Dixon J said at 119:
“When it appears that the inclusion in the newspaper of matter alleged by claimants to be defamatory is a regular and almost unavoidable incident of publishing it, so that the claims directly flow from acts done for no other purpose than earning revenue, acts forming the essence of the business, no valid reason remains for denying that the money was wholly and exclusively expended for the production of assessable income.”
Rich J said at 121:
“Publication is at once the source of income and the cause of liability. Payments subsequently made by way of compensation in respect of this liability or for costs to escape such liability relate back to publication. As publication is the common source of income and liability, the necessary connection between the carrying on of the business of the newspaper and the liability which causes the expenditure is complete.”
McTiernan J, at 127, said that the source of the liability for costs and damages was the publication with the consequence that that liability was “part of the true cost of publication.”
In Federal Commissioner of Taxation v Snowden & Willson Proprietary Limited (1958) 99 CLR 431 advertising and legal costs incurred by a corporate taxpayer in defending complaints made in Parliament and in an inquiry by a Royal Commission in relation to the integrity and fairness of the conduct of the taxpayer’s business were held to be deductible under s 51(1) as incurred in and incidental to the carrying on of the business. The non-recurrent expenditure although, inter alia, in defence of attacks which were calculated to affect adversely the goodwill of the taxpayer, were held not to be of a capital nature.
The deductibility of legal expenses paid by a taxpayer company in defending criminal charges against certain of its directors and agents, was carefully considered by the Full Court of the Federal Court in Magna Alloys and Research Pty Ltd v Federal Commissioner of Taxation (1980) 49 FLR 183. The criminal charges related to the alleged payment of secret commissions, by several of the taxpayer’s directors and its agents, in the course of the taxpayer’s business. The taxpayer claimed as an allowable deduction under s 51(1), $280,000, being legal costs incurred in defending the various defendants, some of whom (not including the taxpayer) were convicted. There was evidence that the principle motive or purpose, viewed subjectively, of the expenditure of the money, was to defend the three directors. The legal costs were held to be allowable deductions as:
the conduct which was the subject of the charges involved the taxpayer’s way of carrying on business; and
the taxpayer’s motive in incurring the expenditure was not the critical criterion for deductibility under s 51(1); rather, the issue, on the facts of a case such as Magna Alloys was whether the expenditure was apt, and according to Deane and Fisher JJ, was also viewed as apt, to serve the business purposes of the taxpayer.
In discussing the role of the subjective motive of the controllers of the company, Brennan J said, at 192-3:
“...in Federal Commissioner of Taxation v Midland Railway Co. of Western Australia Ltd. (38) Dixon J., referring to a number of considerations which bore upon the deductibility of the payments there in question, said:
“The second consideration is that what governs the issue is the business purposes for which the outgoing was incurred from the point of view of the taxpayer company. The controlling factors are those which arise from the character of the business or undertaking and the relation which the expenditure or the liability to make it bore to the carrying on of the business or the gaining of assessable income.”
Once the “controlling factors” are ascertained, the business purposes for which an outgoing is incurred may be determined. In that step towards characterization, the taxpayer’s state of mind has no part to play. His purpose or motive is not a controlling factor of the purpose to be attributed to the incurring of the expenditure. But in ascertaining the controlling factors, the taxpayer’s state of mind may have a significant evidentiary role to play, and by leading to the ascertainment of the controlling factors, it may even be the determinative element in characterizing expenditure in a particular case. Nevertheless, the taxpayer’s state of mind - whether intention, or purpose, or motive - is evidentiary only.” (Footnotes omitted)
His Honour then, at 193-4, gave examples of how the subjective motive of a taxpayer may affect identification of the controlling factors, but made it quite clear at 194 that:
“...the evidentiary effect of a taxpayer’s state of mind is to be distinguished from the objective purpose of expenditure incurred.”
His Honour concluded at 196:
“Given a sufficient identification of what the expenditure is for and the character and scope of the taxpayer’s income-earning undertaking or business, the question whether expenditure is incurred for the purpose of carrying on a business or for the purpose of gaining or producing assessable income does not depend upon the taxpayer’s state of mind. The relationship between what the expenditure is for and the taxpayer’s undertaking or business determines objectively the purpose of the expenditure. In cases to which a reference to purpose is required or appropriate, objective purpose will be found to be an element in determining whether expenditure is incurred in gaining or producing assessable income or in carrying on business. If the purpose of incurring expenditure is not the gaining or producing of assessable income or the carrying on of a business, the expenditure cannot be said to be ‘incidental and relevant’ to gaining or producing assessable income or carrying on business; or to be incurred ‘in the course of gaining and producing’ assessable income or of carrying on a business; nor can the undertaking or business be seen to be ‘the occasion of’ the expenditure.
In the present case, the character and scope of the taxpayer’s business is known without reference to its state of mind. Equally, it is objectively certain that the relevant expenditure was incurred to defray the legal costs of the directors and agents in the criminal proceedings brought against them. The connexion between the legal services thus acquired and the taxpayer’s business neither requires nor permits reference to the taxpayer’s state of mind. The nature of that connexion is to be found in the objective facts found by his Honour or not in dispute between the parties.”
Deane and Fisher JJ at 205 said:
“What is required is that the relevant expenditure be appropriate and adapted for the ends of the business carried on for the purpose of earning assessable income.”
Their Honours then went on to consider the relevance of the purpose or motive, viewed subjectively, of a taxpayer in incurring an outgoing for the purposes of s 51. Their Honours concluded at 208-9:
“It is implicit in what has been said that the distinction between immediate direct purpose or object and remote indirect purpose or object does not play an essential part in determining whether an outgoing is properly deductible pursuant to the second limb of s 51(1) of the Act. To the extent that the subjective element is relevant, what is important in the case of a voluntary outgoing is the identification of the advantage or advantages which the outgoing was intended to achieve on behalf of the taxpayer regardless of whether that advantage or those advantages were seen as the direct result of the outgoing or as indirectly flowing therefrom or of whether the pursuit of them should be seen as ‘purpose’ or as ‘object’ or as ‘motive’. Business outgoings may be properly and necessarily incurred in pursuit of indirect and remote, as well as direct and immediate, advantages. The fact that the business advantage sought is indirect or remote will not of itself preclude the pursuit of that advantage from characterizing the outgoing as an outgoing necessarily incurred in carrying on the relevant business.
The outgoings in the present case were not involuntary. They achieved the immediate purpose of those responsible for incurring them. That purpose was to provide legal representation for directors and agents of the taxpayer in respect of criminal prosecutions arising out of their actions in their respective capacities as directors and agents. The actions in question were performed on behalf of the taxpayer in the course of carrying on the taxpayer’s income-earning business and were plainly directed towards earning assessable income for the taxpayer. In this regard, the learned trial judge expressly found that the course of conduct upon which the directors and agents were engaged was not on their own behalf but on behalf of the taxpayer. ‘Their actions, and those of the agents, were,’ his Honour wrote, ‘the taxpayer’s actions. In this sense the taxpayer was compliant and implicated in all that occurred.’”
Deane and Fisher JJ concluded that the trial judge, in focusing upon the subjective motive of the taxpayer in deciding to incur the legal expenses, never answered the critical composite question of whether the outgoing was reasonably capable of being seen as desirable or appropriate from the point of view of the business ends of the taxpayer’s business, and if so, whether those responsible for carrying on the business so saw it. Their Honours then went on to answer that question at 212:
“The overall position in the present case can, in our view, be accurately summarized by saying that the directors intuitively saw the outgoings as not only being required in their own interests but as being desirable and appropriate in the pursuit by the taxpayer of its business ends. As has been said, the outgoings were reasonably capable of being so regarded. It follows that, subject to any question of disqualification resulting from their nature, the relevant outgoings were, for the purposes of s.51(1), necessarily incurred by the taxpayer in carrying on its business.”
I have set out extracts from the judgments in Magna Alloys at some length because the criticism made of the AAT in the present case is that it unduly focused on the subjective motive of a taxpayer rather than on the objective purpose of incurring the expenditure, and in doing so, failed to determine the broader “business ends” which the expenditure was apt, and viewed as apt, to serve.
The principles referred to above were considered by the Full Court in Putnin v Commissioner of Taxation (1991) 27 FCR 508. In Putnin, the taxpayer, an accountant, sought a deduction under s 51(1) in respect of the costs of his defence of a criminal charge arising out of his administration as a trustee in bankruptcy of a deed of arrangement in respect of an insolvent estate. The taxpayer contended that the expenditure arose from the necessity to defend his activities in a particular business operation by which income had been earned and that it was not of a voluntary nature. Thus, so it was said, the defence costs were outgoings incurred in gaining or producing assessable income within the first limb of s 51(1) and were also necessarily incurred in carrying on a business for the purpose of gaining or producing such income. The Full Court (Burchett, French and Lee, JJ) at 511, summarised the case of the taxpayer:
“The case put forward by the applicant was really a simple one. According to his contention, the expenditure arose out of his prosecution, in which he was defending his activities in a particular operation of business by which income had been earned. That operation of business was the administration of one estate out of many of which he was the trustee. It followed, he contended, that the costs of his defence were outgoings incurred in gaining or producing assessable income within the first limb of s 51(1), and, indeed, that they were also necessarily incurred in carrying on a business for the purpose of gaining or producing such income; and further that they were not outgoings of capital or of a capital, private or domestic nature.”
Their Honours, in reliance on Herald and Weekly Times Limited, observed at 511:
“It may be a natural incident of the conduct of the operations of a particular kind of business that claims of the commission of torts, or even crimes, may arise, although it is to be hoped not often, and have to be repelled.”
After citing from Herald and Weekly Times Limited their Honours said at 512:
“The only part of their Honours’ reasoning which is not directly applicable to the present case is the reference to the regularity of the claims against the newspaper. But this is not essential to the reasoning, as was made clear by Fullagar J in Commissioner of Taxation (Cth) v Snowden & Willson Pty Ltd (1958) 99 CLR 431 at 446. That was a case factually closer to the present, since the costs in question there related to a single piece of litigation, or rather to an enquiry, a Royal Commission appointed to investigate the allegedly unscrupulous conduct of the taxpayer’s business. Fullagar J said (at 446):
‘The expenditure was not recurrent, and it must be regarded as abnormal: it was not a continuing and unavoidable incident of the taxpayer’s business, as was the expenditure in Herald & Weekly Times Ltd v Commissioner of Taxation (Cth).’
He nevertheless had no difficulty, as he had made clear (at 444), in finding the same sort of relation between the expenditure and the carrying on of the business as had been found in Herald & Weekly Times. He said: ‘The expenditure was incidental to the carrying on of the business.’”
In respect of the question of the relevance of subjective evidence their Honours distinguished between voluntary and involuntary expenditure and said at 512-513:
“The court, in Magna Alloys & Research, emphasised the distinction between involuntary expenditure (where the characterisation of the expenditure as falling within s 51(1), or not, can generally be determined without reference to the taxpayer’s motive or purpose) and voluntary expenditure (where the taxpayer’s purpose may assist in the task of characterisation): see per Brennan J (at 191), and per Deane and Fisher JJ (at 206-209). In Magna Alloys & Research, as Deane and Fisher JJ pointed out (at 209), the outgoings were not involuntary. The taxpayer plainly had a choice whether or not to underwrite the legal expenses of its directors and agents. In the present case, on the other hand, the taxpayer was himself the accused, and it would be a misuse of language to suggest that payments made in respect of his defence were incurred of his own volition. They were relevantly involuntary. It follows that the objective approach taken by Gavan Duffy CJ and Dixon J in Herald & Weekly Times is here the appropriate approach. The purpose to be attributed to the payment is the taxpayer’s purpose in the administration of the insolvent estate. That purpose was implicitly found by the Tribunal to be the pursuit of the taxpayer’s business (erroneously described as his ‘previous business’) when the expenditures were found to ‘outgoings ... of a previous business conducted by the applicant.’
Had, however, the costs been voluntarily incurred, the reasoning of Deane and Fisher JJ (at 211) would suggest they were necessarily incurred in carrying on the business of the taxpayer for the purpose of gaining or producing assessable income.”
More recently, in Commissioner of Taxation v Rowe (1995) 60 FCR 99 (which went on appeal to the High Court on an unrelated point), the Full Court considered the deductibility of legal costs incurred by a local government employee for representation before a statutory inquiry into allegations of the employee’s misconduct. Beaumont J, at 109, found the costs to be deductible on the basis that the inquiry was centrally concerned with day to day aspects of the taxpayer’s employment and therefore were incurred by him in obtaining assessable income. Burchett J, in a passage which is particularly pertinent to the present case, at 113, said:
“On the question of the deductibility of the expenses incurred by the respondent at the inquiry, I note that the Committee of Inquiry saw these expenses as incurred by him in defending himself from dismissal from his employment. That view of the matter is, of course, correct. However, at another level, I think these expenses should be recognised as incurred by the respondent in defending the manner of his performance of his duties. It was only by so justifying himself that he could make a successful defence against dismissal. When the matter is seen in this light, it falls squarely within the rule discussed in Putnin v Commissioner of Taxation (1991) 27 FCR 508. To adapt language there quoted (at 511) from Herald & Weekly Times Ltd v Commissioner of Taxation (Cth) (1932) 48 CLR 113 at 117-119, the liability in question was incurred, or the claim was encountered, because of the very act of performing the work by which the respondent earned assessable income. The activities which produced the assessable income were what exposed the taxpayer to the liability discharged by the expenditure. As the Court said in Putnin at 513, so here, ‘the ... proceedings arose from the activities by which the taxpayer earned his income, the mode of his performance of a particular task carried out in the course of business operations.’
To put the same point in another way, the cause or the purpose of the respondent’s incurring of the expenditure was his assertion that he had faithfully performed the duties by which he had earned assessable income.”
Drummond J (at 117) upheld the deductibility of expenditure on the basis that the taxpayer was seeking to preserve his employment and the consequential recurrent benefit of his salary for an uncertain period.
A recent example of a refusal of a claim for deductibility of legal costs in defending a criminal proceeding was in Schokker v Federal Commissioner of Taxation (1998) 98 ATC 4108 in which Nicholson J denied deductibility on the basis that :
“The gravamen of the dispute reflected in the criminal proceedings had nothing to do with the day-to-day work of the applicant.”
CONCLUSION - DEDUCTIBILITY OF THE TAXPAYER’S LEGAL EXPENSES.
In my view, as in Putnin, the present case is one which concerns expenditure which may relevantly be described as involuntary. Also, as in Putnin, and I would add Rowe, Magna Alloys, Snowden & Willson and Herald and Weekly Times, the expenditure arose out of proceedings in which the taxpayer was defending her activities in a particular operation of her business, in the present case, as a doctor, by which she earned her income. Whilst it is true that the aspect of her business out of which the proceedings arose did not relate to the core activity of medical treatment, there is simply no basis in principle, or on the authorities, for confining business activities to the core activity by which income is earned, rather than to the activities which constitute the conduct of the taxpayer’s business which enables income to be earned.
The “business” which enabled the taxpayer to earn her income as a doctor required her to apportion her time between her public income-earning activities as a doctor at Caloola Training Centre and her private practice, which was required to be conducted outside the time she spent at Caloola. That apportionment of time was integral to the particular operation of her medical practice in its two different aspects. In such circumstances, as was observed by the Full Court in Putnin at 511:
“It may be a natural incident of the conduct of the operations of a particular kind of business that claims of the commission of torts, or even crimes, may arise, although it is to be hoped not often, and have to be repelled.”
The AAT was clearly in error in concluding that the expenses were not to be classified as purely working expenses arising out of daily business activities, and in failing to characterise the expenditure as a natural incident of the conduct of the taxpayer’s business as a doctor. In my view, the AAT erred in law in taking too narrow an approach to that question. That narrow approach was one that had been rejected by the decisions in Herald and Weekly Times, Snowden & Willson, Magna Alloys, Putnin and Rowe.
The AAT also erred in law in the way in which it applied its finding as to the subjective motive of the taxpayer. The present case involves “involuntary” expenditure which is able to be characterised by reference to the necessary connection between the nature of the activities constituting the taxpayer’s business and the nature of the activities giving rise to the charges. In determining deductibility under either limb of s 51 there seems to be little or no role for the subjective evaluation of motive conducted in the present case by the AAT in such circumstances.
However if, contrary to my view, it is incorrect to view the expenses as involuntary, the AAT nevertheless erred in placing the emphasis it did on the subjective motive of the taxpayer. In most instances where serious criminal charges arise out of the conduct of a taxpayer’s professional practice, an object in defending such charges will almost inevitably be the necessity to do so because of the effect of possible professional disciplinary consequences that would follow upon a conviction. The consequences usually will range from a reprimand to the potential risk to the taxpayer’s right to professional practice. However that is merely one of the indirect objects in defending such charges. Other objects include the direct object of securing an acquittal, and to avoid any penalty, as well as to protect one’s personal and professional reputation. In my opinion it was unrealistic of the AAT to approach the issue of deductibility under s 51(1) by confining itself to its findings as to one of the taxpayer’s motives, being that of protecting her right to practice. As pointed out above, that motive ignores the purpose of defending the business activities that gave rise to the charges, and cannot lead to a denial of deductibility under either limb of s 51 in the present case. Accordingly, subject to the issue of whether the expenditure was of a capital, private or domestic nature, the expenditure was clearly deductible under s 51.
The Commissioner contended that if the appeal is successful then the matter should be remitted to the AAT as, inter alia, it did not decide whether the expenditure fell within the first and second limbs of s 51(1) of the ITAA. In my view it is implicit, if not explicit, in the decision of the AAT that it wrongly determined that issue against the taxpayer. As pointed out above, I am of the view that the AAT, in finding that the expense was not a working expense arising out of business activities, rejected the argument that the expense fell within the first or second limbs of s 51(1). The problem with the decision of the AAT is that it failed to consider separately the two related issues arising under s 51(1); whether the outgoing is within either limb of the section and if so, whether it falls within any of the exclusions. By merging the two questions into one the AAT failed to give proper consideration to the “business” aspect of the taxpayer’s case.
In any event, as I am satisfied that, subject to any question of disqualification by its nature, the expenditure clearly falls within s 51(1), there is no point in remitting the matter on that issue.
WAS THE OUTGOING OF CAPITAL OR OF A CAPITAL NATURE?
In Hallstroms Pty Ltd v The Federal Commissioner of Taxation (1946) 72 CLR 634 at 647, Dixon J said:
“The claim is to deduct legal expenses, and legal expenses, we may assume, take the quality of an outgoing of a capital nature or of an outgoing on account of revenue from the cause or the purpose of incurring the expenditure. We are, therefore, remitted to a consideration of the object in view when the legal proceedings were undertaken, or of the situation which impelled the taxpayer to undertake them.”
And in an oft-quoted passage, at 648, his Honour said:
“What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.”
In Magna Alloys it was contended by the Commissioner that the legal expenses were of a capital nature as they were designed to protect the goodwill, which was a capital asset of the business. In rejecting the claim, Brennan J said at 201:
“Nor was the expenditure an outgoing of a capital nature. The capital of the business was in no way increased by the expenditure incurred. True it is that the expenditure protected the reputation and goodwill of Magna’s business, but the attack which was made arose out of the day to day selling activities of that business and it was the business purpose of vindicating the methods by which it was conducted that brings the expenditure within s. 51(1). Though goodwill is a capital asset of a business it is frequently earned and maintained by the daily activities of those engaged in the business. The valuable if intangible asset of goodwill frequently grows out of activities the cost of which is a charge on revenue account (see Sun Newspapers’ case). Expenditure incurred in attempting to vindicate the business methods of the taxpayer, overcoming the obstacle to its trading which had been raised by the prosecutions is properly to be regarded as a cost on revenue account. (Footnotes omitted)
Deane and Fisher JJ said at 213:
“The question whether the outgoings were of a capital nature is, in our view, answered in the negative by the reasoning of the majority of the High Court of Australian in Federal Commissioner of Taxation v. Snowden & Willson Pty. Ltd. Except in the most indirect way, the criminal proceedings imperilled neither the business nor the capital assets of the taxpayer. As the learned judge at first instance point out, the gross revenue of the taxpayer continued to increase despite the difficulties with which the taxpayer was faced. The criminal proceedings in respect of which the outgoings were incurred arose out of the day to day business activities of the taxpayer. The outgoings did not involve the acquisition of any enduring or tangible asset. They represented expenditure incurred in carrying on the taxpayer’s business which should properly be seen as being of a revenue character.” (Footnote omitted)
Similarly in Putnin the Full Court rejected the argument, which was put in the present case, concerning the risk upon conviction of cancellation of the right to practice. The Court said at 513:
“In the argument presented to this Court, great emphasis was laid on the possibility that the taxpayer might, if he had been convicted, have incurred professional censure and cancellation of his registration as a trustee in bankruptcy or as an official liquidator. As a result, his partnership might have been dissolved. But these were all indirect consequences that might or might not have happened. They were neither the object of the prosecution, nor could it be said they would inevitably have followed upon its success. As in Magna Alloys & Research, the criminal proceedings arose from the activities by which the taxpayer earned his income, the mode of his performance of a particular task carried out in the course of business operations. Something of that kind is quite remote from capital, and the outgoings secured for the applicant no enduring or tangible asset.”
Further, as was pointed out by Burchett J at 114 in Rowe, when regard is had to the situation which impelled the taxpayer to undertake the costs of the legal proceedings, being the defence by the taxpayer of the day-to-day activities by which she earned her income, the expenses are on revenue, not capital, account.
Accordingly, for these reasons, in my view the Tribunal erred in concluding that the expenditure was of a capital or a capital nature.
WAS THE EXPENDITURE OF A PRIVATE OR DOMESTIC NATURE?
Counsel for the Commissioner contended that if the appeal was successful then the matter should be nevertheless remitted to the Tribunal as, inter alia, it did not decide whether the expenses were of a private or domestic nature. It is true that the AAT did not consider that issue. However, in my view, having regard to the conclusions I have arrived at in relation to s 51(1), it would not be open to the AAT to find that the expenditure was of a private or domestic nature. The same question was considered and rejected in Magna Alloys: see Brennan J at 200 and Deane and Fisher JJ at 212-213. As was pointed out by Menzies J in Federal Commissioner of Taxation v Hatchett (1971) 125 CLR 494 at 498:
“It must be a rare case where an outgoing incurred in gaining assessable income is also an outgoing of a private nature. In most cases the categories would seem to be exclusive.”
In the present case, as in Magna Alloys, the conclusion that the outgoings arose from the taxpayer’s professional activities in the course of carrying on her business as a doctor and are to be viewed as apt to serve the business ends of that business, plainly has the consequence that the expenditure was neither private nor domestic in nature. Accordingly, I do not accept that the matter should be remitted on this issue.
CONCLUSION
In my view the taxpayer is entitled to succeed on the appeal. However, it is correct to say, as counsel for the Commissioner did, that the Tribunal did not decide whether the quantum of the expenditure claimed was in fact incurred in respect of the relevant year of income. Accordingly it is appropriate to remit the matter to the AAT on that issue.
In the circumstances the following orders are appropriate:
The appeal from the decision of the AAT be allowed.
The decision of the AAT be set aside.
The matter be remitted to the AAT
(a)to determine the quantum of the deduction for legal expenses which is to be allowed; and
(b)to otherwise determine the taxpayer’s application for review in accordance with law.
The respondent pay the applicant’s taxed costs of and incidental to the appeal.
I certify that this and the preceding seventeen (17) pages are a true copy of the Reasons for Judgment herein of the Honourable Justice Merkel
Associate:
Dated:
Counsel for the Applicant: Mr D Meagher QC
with Mrs J BatrouneySolicitor for the Applicant: Mr Michael Rickards Counsel for the Respondent: Mr M Moshinsky Solicitor for the Respondent: Australian Government Solicitor Date of Hearing: 9 April 1998 Date of Judgment: 20 April 1998
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