Hadrian Fraval Nominees Pty Ltd and Commissioner of Taxation - [2013] AATA 127

[2013] AATA 127

Division TAXATION APPEALS DIVISION

File Numbers

2010/2281

2010/2437

Re

Hadrian Fraval Nominees Pty Ltd

APPLICANT

And

Commissioner of Taxation

RESPONDENT

DECISION

Tribunal
Egon Fice, Senior Member

Date 12 March 2013

Place Melbourne
The Tribunal affirms the objection decisions of the Commissioner of Taxation dated
16 April 2010 relating to the 2004 and 2005 income years.
.....[sgd Egon Fice]...................................................................
Egon Fice, Senior Member
TAXATION – research and development activities – research and development expenditure – research and development deductions – tax offset – the meaning of expenditure incurred – expenditure incurred not at arm’s length – eligible feedstock expenditure – substantiation of research and development expenditure – burden of proof – depreciation assets – company books as evidence – penalties – remission of penalties
Corporations Act 2001 (Cth) s 1305
Income Tax Assessment Act 1936 (Cth) ss 51, 73B, 73B(1A), 73B(1AB), 73B(2B), 73B(12A), 73B(14), 73B(31), 73BA, 73BC, 73BD, 73BE, 73BG, 73BH, 73IA, 73I, 73J, 73Y, 160ZH, 226G, 226H, 226J, 226K, 226L, 226M
Income Tax Assessment Act 1997 (Cth) ss 8-1, 40-25, 40-100, 40-105, 40-110, 67-30, 70-45
Industry Research and Development Act 1986 (Cth) ss 39AA, 39L, 39S, 39T
Taxation Administration Act 1953 (Cth) ss 14ZW, 14ZZK, 284-75, 284-80, 284-85, 284-90, 284-220, 284-225, 298-20
Alcan (NT) Alumina Pty Ltd v Commissioner of Territory Revenue (2009) 239 CLR 27
Allen (As Trustee of the Allen's Asphalt Staff Superannuation Fund) v Federal Commissioner of Taxation (2010) 80 ATR 849
Aurora Developments v Federal Commissioner of Taxation (2011) 196 FCR 457
Australian Securities and Investments Commission v Rich (2005) 191 FLR 385
Australian Securities and Investments Commission v Rich (2009) 236 FLR 1
A W Furse No 5 Will Trust v Federal Commissioner of Taxation (1990) 21 ATR 1123
Coles Myer Finance Ltd v Federal Commissioner of Taxation (1993) 176 CLR 640
Commissioner of Taxation v Dixon (Trustee) (2007) 67 ATR 87
Federal Commissioner of Taxation v AXA Asia Pacific Holdings Ltd (2010) 189 FCR 204
Federal Commissioner of Taxation v Citylink Melbourne Ltd (2006) 228 CLR 1
Federal Commissioner of Taxation v Dalco (1990) 168 CLR 614
Federal Commissioner of Taxation v James Flood Pty Ltd (1953) 88 CLR 492
Federal Commissioner of Taxation v Traviati (2012) 205 FCR 136
GEC Marconi Systems Pty Ltd v BHP Information Technology Pty Ltd (2003) 128 FCR 1
Gibson Motor Sport Merchandise Pty Ltd v Robert James Forbes [2005] FCA 749
Granby Pty Ltd v Federal Commissioner of Taxation (1995) 129 ALR 503
Minister for Aboriginal Affairs v Peko-Wallsend Ltd (1986) 162 CLR 24
MLC Ltd v Deputy Commissioner of Taxation (2002) 126 FCR 37
Nielsen Development Laboratories Pty Ltd v Federal Commissioner of Taxation (1981) 144 CLR 616
Norman v Federal Commissioner of Taxation (1963) 109 CLR 9
North Ryde RSL Community Club Ltd v Federal Commissioner of Taxation (2002) 121 FCR 1
QFL Photographics Pty Ltd and Commissioner of Taxation [2010] AATA 758
Re Hains (deceased); Barnsdall v Federal Commissioner of Taxation (1988) 19 ATR 1352
Explanatory Memorandum to the Income Tax Assessment Amendment (Research and Development) Bill 1986
Guide to the R & D Tax Concession (August 2010)
Mahoney, Berger, and Wolff, Century 21 Accounting (Australian Edition, South Western Publishing and Co, 1972)
Seddon NC and Ellinghaus MP, Cheshire and Fifoot's Law of Contract (9^thAustralian ed, LexisNexis Butterworths, 2008)
The Shorter Oxford English Dictionary (3^rd ed, 1983)
REASONS FOR DECISION
Egon Fice, Senior Member
12 March 2013

Hadrian Fraval Nominees Pty Ltd (HFN) registered with the Industry Research and Development Board (R & D Board) (now called Innovation Australia and referred to as AusIndustry) a project entitled Environment Friendly House using Hybrid Lighting and ASP Biometric Intruders System for the 2004 income year and a continuation of that project referred to as Solar Transmission into Buildings in the 2005 income year. The purpose of this registration was for HFN to obtain income tax concessions in accordance with s. 39AA of the Industry Research and Development Act 1986 (IRD Act). That section of the IRD Act states the objects of Part IIIA are to complement the tax incentives provided by sections 73B, 73BA and 73I of the Income Tax Assessment Act 1936 (ITAA 1936).
In its 2004 income tax return which was lodged with the ATO on 13 October 2004, HFN claimed a research and development tax offset in the amount of $224,862.90. In its 2005 income tax return, HFN claimed a tax offset in the amount of $174,118.00.
The Commissioner of Taxation (the Commissioner), in accordance with s. 39L of the IRD Act, requested the R & D Board provide to him a certificate stating whether the particular activities which had been carried on by HFN during the income years in question were research and development activities. On 5 December 2007 AusIndustry notified the Commissioner and HFN that the activities undertaken by HFN under the registered projects did not satisfy the definition of research and development activities in s. 73B (1) or 73B (1AB) of the ITAA 1936. On 18 December 2007 HFN lodged requests with AusIndustry seeking reconsideration under s. 39S of the IRD Act. In a letter dated 22 August 2008 AusIndustry notified the Commissioner that it had affirmed its original decision. HFN then lodged an application with the Administrative Appeals Tribunal (AAT) for review of AusIndustry's decision pursuant to s. 39T of the IRD Act.
HFN's application for review before the AAT was resolved with the Tribunal making the following consent decision on 15 September 2009:
1.the decision of the respondent dated 12 August 2008 be set aside and there is substituted for that decision a decision that:
2.the following activities undertaken by the applicant in the 2003-04 to 2004-05 years of income in the project entitled "Environment Friendly House using Hybrid Lighting and ASP Biometric Intruder System" (the Project) satisfy the definition of research and development activities as defined under s 73B(1) of the Income Tax Assessment Act 1936 (the Act):
(a)Activity 1: Acquire a licence to use nanotechnology and complete the R & D of the product (1 July 2003 to 30 June 2005);
(b)Activity 5: Produce a collector to efficiently introduce light into light guides (1 July 2003 to 30 June 2005);
(c)Activity 6: Produce an azimuth controller of the collector (1 January 2004 to 30 June 2004); and
(d)Activity 7: Testing and optimisation of System (1 July 2003 to 30 June 2005);
3. the following activities in the Project do not satisfy the definition of research and development activities under s 73B(1) of the Act:
(a)Activity 2: Acquire the right to use Intranet platform and integrate the system;
(b)Activity 3: Acquire the right to use Facial Recognition biometrics and incorporate into the system; and
(c)Activity 4: Acquire the right to smart-house controller and integrate into the system;
4. the following technology, acquired by the applicant for use in the Project, in the 2003-04 to 2004-05 years of income, satisfies the definition of core technology under s 73B(1AB) of the Act:
(a)technology embodied in US Patent 6,983,093B2 ("Fluid Light Guide having hydrophobic aerogel cladding layer") acquired from Translight LLC on or about 8 July 2003; and
(b)technology embodied in patent application 2002951376 ("Lighting System") assigned by Rofin Australia Pty Ltd to the applicant on or about 24 July 2003;
5. within 21 days of this decision, the respondent shall issue a certificate to the Commissioner of Taxation stating that the activities listed herein at para 2 are research and development activities; and
6. within the 21 days of this decision, the respondent shall issue a certificate to the Commissioner of Taxation stating that the technology listed herein at para 4 is core technology.
After receiving the determination made by AusIndustry under s. 39S of the IRD Act and upon completing an audit, the Commissioner notified HFN on 23 January 2008 that its 2004 income tax return had been adjusted to remove the research and development tax offset claimed and to increase the carry-forward losses resulting from the research and development deduction. The result was to increase HFN's carry-forward losses to $236,487.00 as at 30 June 2004. It also provided a notice to HFN seeking repayment of $225,563.99 paid to HFN on 23 November 2007 as a result of the incorrect offset claim. On 1 February 2008 the Commissioner also issued a notice of assessment and liability to pay a penalty in the amount of $168,647.15.
In addition, on 10 September 2008 the Commissioner notified HFN that its claim for the R & D tax offset for the 2005 income year was disallowed. The Commissioner also notified HFN that it was liable for a shortfall penalty in accordance with s. 284-75 of Schedule 1 of the Taxation Administration Act 1953 (the TAA). The Commissioner issued an income tax adjustment sheet disclosing that the R & D expenditure claimed in the amount of $272,016 had been disallowed on the grounds that it was ineligible. The tax offset claimed in the amount of $174,118 was not available and was therefore reduced to nil. The Commissioner issued a notice of assessment and liability to pay a penalty of $106,101 for the 2005 income year on 24 September 2008.
On 18 November 2009 the Commissioner issued notices to HFN under s. 73IA (1) of the ITAA 1936. Section 73IA (1) provides that the Commissioner may give to an eligible company a written notice specifying the amount of a tax offset allowable to the company under s. 73I. The notices stated that the tax offset allowable to HFN for the 2004 and 2005 income years was $0.
On 19 November 2009 HFN lodged with the Commissioner an Objection to the s. 73IA Notices for the 2004 and 2005 income years in accordance with s. 14ZW(1AAA) of the TAA. Section 73IA (2) of the ITAA 1936 provides that if an eligible company is dissatisfied with the notice, it may object in the manner set out in Part IVC of the TAA.
On 16 April 2010 the Commissioner issued HFN with Notices of Objection Decision for the 2004 and 2005 income years. These decisions of course took into account the Consent Decision made by the Tribunal on 15 September 2009 regarding activities which satisfied the definition of research and development activities under s. 73B (1) and those activities which satisfied the definition of core technology under s. 73B (1AB). Regarding the 2004 income year, the Commissioner found that HFN was not entitled to choose the R & D tax offset pursuant to s. 73I of the ITAA 1936. The Commissioner found that the expenditure did not meet the requirements of s. 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) as an allowable deduction. A penalty at the rate of 25% was imposed on the tax shortfall for the 2004 income year. As for the 2005 income year, the Commissioner found that HFN was only entitled to choose the R & D tax offset under s. 73I of the ITAA 1936 for consultancy expenses in the amount of $53,548. The Commissioner again found that the remaining expenditure did not meet the requirements of s. 8-1 of ITAA 1997 as an allowable deduction. He imposed a 25% penalty on the tax shortfall amount.
HFN's claimed R & D expenditure for the 2004 income year totalled $599,633 which was made up in accordance with the following table:

30 June 2004 Expenditure

Expenditure denied by Commissioner

Expenditure allowed by Commissioner

Aerogel tubing and aerogel technology licence fee (Described more generally as ‘Materials’ and ‘licence fee’)

$479,907

R & D consulting contract

$55,000

Consultant assistance with experimentation

$39,625

Travel expenses

$1320

$6885

Depreciating assets used in R & D project

$3312

Rent for facilities used for experimentation on R & D project

$11,055

Utilities used in experimentation processes in R & D project

$815

Motor vehicle expenses

$1714

Total

$592,748

$6885

HFN's claimed R & D expenditure for the 2005 income year was made up in accordance with the following table:

30 June 2005 Expenditure

Expenditure denied by Commissioner

Expenditure allowed by Commissioner

Aerogel tubing (referred to as materials or Coated fiber optic coils)

$166,246

Aerogel technology licence fee

$36,232

Poly Optics consulting

$53,548

R & D Consulting contract

$198,604

Telephone

$382

Depreciating assets used in R & D project

$3312

Rent for facilities used for experimentation on R & D project

$10,224

Utilities used in experimentation processes in R & D project

$812

Motor vehicle expenses

$2199

Total

$418,011

$53,548

RESEARCH AND DEVELOPMENT DEDUCTIONS GENERALLY

Section 73B of ITAA 1936 provides that certain expenditure on research and development activities may be deductible. Insofar as it is relevant, it provides:
(1AAA) The object of this section is to provide a tax incentive, in the form of a deduction, to make eligible companies more internationally competitive by:
…
The benefits of the tax incentive are targeted by being limited to particular expenditure on certain defined activities.
The expression eligible company is defined to mean a body corporate incorporated under a law of the Commonwealth or of a State or Territory.
While s. 73B (1AB) and (1) of ITAA 1936 define the expressions core technology and research and development activities, I need not refer to those given the consent decision made on 15 September 2009 in which the parties accepted the claimed activities which fell within each of those expressions.
Section 73B (14) deals with the deduction for research and development expenditure. It provides:
[Deduction for non-contracted expenditure] Deduction for research and development expenditure. Subject to this section, where:
(a) an eligible company incurs research and development expenditure (other than contracted expenditure) during a year of income; and
(b) the aggregate research and development amount in relation to the company in relation to the year of income is greater than $20,000,
the amount of that expenditure multiplied by 1.25 is allowable as a deduction from the assessable income of the company of the year of income.
Section 73BA deals with deductions for certain assets used for the purposes of carrying on research and development activities. An entitlement to a deduction under this section is set out in subsection (2) which provides:
If an eligible company has a notional Division 40 deduction for a section 73BA depreciating asset for a year of income, the company is entitled to a deduction under this section for the asset for the year of income.
Section 73BA (3) provides for the amount of the deduction in the following way:
If the eligible company's aggregate research and development amount for the year of income is more than $20,000, the deduction is equal to the notional Division 40 deduction multiplied by 1.25. If not, it equals the notional Division 40 deduction.
Section 73BA (7) provides that if expenditure is deductible under this section, it is not deductible under any other provisions of ITAA 1936.
The meaning of notional Division 40 deduction is set out in s. 73BC (1) as follows:
An eligible company has a notional Division 40 deduction for a section 73BA depreciating asset for a year of income if it would be entitled to a deduction under section 40-25 of the Income Tax Assessment Act 1997 for the asset for the year of income assuming the changes set out in this section were made.
In summary, the four changes that are made to s. 40-25 of ITAA 1997 are:
(a)the references to using the asset or having it installed ready for use for the purposes of producing assessable income or for a taxable purpose are regarded instead as references to using the asset for the purposes of carrying on by or on behalf of the eligible company of research and development activities;
(b)if the eligible company was entitled to a deduction under Division 40 of ITAA 1997 for the s. 73BA depreciating asset for any period before the start of the first period for which the company would be entitled to a deduction for the asset under s. 73BC, the same method for working out the decline in value as the company was using for the asset for the earlier period is used;
(c)in working out the cost of the s. 73BA depreciating asset, any amount of expenditure that would otherwise form part of that cost is to be ignored or treated in some other way if ss 73BD or 73BE so provide for the purposes of s. 73BC; and
(d)Division 40 of ITAA 1997 applies as if s. 73BA of ITAA 1936 and s. 40-25 and Subdivision 328-D of ITAA 1997 had not been enacted.
Section 73BG of the ITAA 1936 provides that it has effect for the purposes of working out, under s. 40-100, 40-105 and 40-110 of ITAA 1997, the effective life of the depreciating asset of an eligible company.
TAX OFFSET INSTEAD OF A DEDUCTION
An eligible company can choose a tax offset instead of a deduction under ss 73B, 73BA, 73BH or 73Y. Section 73I provides:
(1)An eligible company can choose a tax offset instead of a deduction under section 73B, 73BA, 73BH or 73Y for year of income (the “tax offset year”) if it is eligible to make that choice (see section 73J).
(2)The choice must be made in the company's return of income for the tax offset year.
(3)The eligible company's tax offset for the tax offset year is 30 cents for each dollar that the company could, apart from subsection (4), deduct for that year under section 73B, 73BA, 73BH or 73Y.
(4)An eligible company cannot deduct any amount under section 73B, 73BA, 73BH or 73Y for the tax offset year if it chooses the tax offset for that year.
As Dr P Bender of counsel, who appeared on behalf of HFN, submitted, the effect of choosing a tax offset rather than a deduction means that an eligible company may, where it would have been entitled to 125% deduction, be entitled to receive a refundable tax offset calculated by multiplying 30% (0.30) by 125% (1.25) which results in a refundable offset of 37.5% of eligible expenditure. The refundable tax offset rules are set out in Division 67 of ITAA 1997. In essence, a taxpayer may get a refund of tax offsets that are subject to the refundable tax offset rules if the total of those offsets exceeds the amount of the income tax that the taxpayer would have to pay if he or she had not got those tax offsets (s. 67-30 of ITAA 1997).
To be eligible for a tax offset, the eligible company must satisfy s. 73J of ITAA 1936 which provides:
(1)An eligible company is eligible to choose the tax offset for the tax offset year if:
(a)it could, apart from subsection 73I(4), deduct an amount under section 73B, 73BA, 73BH or 73Y for that year; and
(b)its aggregate research and development amount for the tax offset year exceeds $20,000; and
(c)the aggregate research and development amount for the tax offset year of the company and of taxpayers with which it is grouped (while they are grouped in that year) is not more than $1,000,000; and
(d)the R&D group turnover of the company for that year is less than $5,000,000.
(2)An eligible company is not eligible to choose the tax offset for the tax offset year if an exempt entity, the affiliates of an exempt entity, an exempt entity together with its affiliates, or 2 or more exempt entities, at any time during the tax offset year, legally or beneficially own, or have a right to acquire, the legal or beneficial ownership of:
(a)interest in the company that carry between them the right to exercise, or control the exercise of, at least 25% of the voting power in the company; or
(b)interests in the company that carry between them the right to receive at least 25% of any distribution of income or capital by the company.
ISSUES

Having resolved by consent the activities said to be research and development activities and core technology, the remaining issues between the parties can broadly be described as:
(a)substantiation of the expenditure claims;
(b)whether HFN incurred expenditure in relation to the materials, licence fees and consultancy services in the relevant income year;
(c)was the aerogel coated tubing and licence acquired by HFN purchased at arm's length;
(d)were the consultancy services said to have been incurred by HFN incurred directly in respect of the relevant research and development activity;
(e)whether HFN was able to substantiate its use of the materials in each income year for the purposes of determining its eligible feedstock expenditure under s. 73B (1) of ITAA 1936;
(f)whether HFN exercised reasonable care for the purposes of s. 284-75 (1) of Schedule 1 of the TAA; and
(g)if the answer to (f) is in the negative, whether there are grounds for remission of penalty pursuant to s. 298-20 of Schedule 1 to the TAA.
BURDEN OF PROOF
Mr N Evans of counsel, who appeared on behalf of the Commissioner, submitted that HFN bears the onus under s. 14ZZK (b)(iii) of the TAA of showing that the notices the Commissioner issued under s. 73IA (1) of ITAA 1936 should not have been made or should have been made differently. Section 14ZZK (b)(iii) provides:
On an application for review of a reviewable objection decision:
(a)…
(b)the applicant has the burden of proving that:
(i)      …
(ii)     …
(iii)    in any other case – the taxation decision concerned should not have been made or should have been made differently.
In fact, as Mr Evans submitted, HFN's grounds of objection did not contend that no notice should have been made. Therefore, its objections should be construed as contending that the notices should have been made differently to the extent of showing a particular amount of offset available, other than nil.
Although Mr Evans referred me to a number of cases dealing with the burden of proving that the assessment, in the case of a taxation decision concerning an assessment, was excessive, while I accept that those cases establish principles which are well-known in taxation law, there is no need for me in this matter to state those principles. That is because, as I understood Dr Bender, this was not a contentious issue. I agree with Mr Evans' submissions that HFN bears the onus of proving, on the balance of probabilities, that the decision made by the Commissioner regarding tax offsets in the 2004 and 2005 income years should have been made differently.
HFN'S RESEARCH AND DEVELOPMENT ACTIVITIES
Dr Hadrian Fraval, who is a director and shareholder of HFN, made a witness statement dated 11 October 2011 in which he set out in some detail the research and development activities of HFN in the income years in question. Dr Fraval is also the managing director and a shareholder of Rofin Australia Pty Ltd (Rofin).
Dr Fraval explained that Rofin is a company which specialises in building light sources which have forensic applications. During the 1990s, Rofin also started making liquid light guides for use with their forensic lights.
As Dr Fraval explained, a light guide is a glass or plastic tube filled with a high refractive index liquid or solid. When light is focused on the end of the tube, it is transmitted along its length due to the differential refractive index between the tubing and the core material. Refraction is the bending of light when it enters into a type of medium in which it changes its speed. It is bent when it moves from a medium in which it travels at a faster speed (for example air) into a medium in which it travels at a slower speed (for example water) resulting in internal reflection at the interface between the two materials.
The amount of light which is reflected depends on the refractive indexes of the two mediums through which the light passes. The refractive index is calculated by dividing the speed of light in a vacuum by the speed of light when it is travelling through the particular medium. Light is reflected when it hits the boundary of a lower refractive index medium at a sufficiently steep angle. There is a particular angle at which total reflection occurs. This is the principle on which liquid light guides function. The liquid in a liquid light guide has a high refractive index compared to the tubing. The light travels from the high refractive index of the liquid to the lower refractive index of the tubing creating a bending of the light. This bending enables light to be reflected along the length of the tubing. It travels down the tubing in this way.
In about 1996 an American company called Fibreoptic Technology Inc (FTI) was making glass fibre light guides. Rofin and FTI formed a joint-venture to conduct further work on light guide technology. A joint-venture limited liability company was formed in America which was called Translight LLC (Translight). Rofin and FTI each owned 50% of the shares in Translight upon its formation. Subsequently, Dr Fraval's brother, Mr Hanafi Fraval, who was also working on the light guide project in America for Translight, was given a 5% shareholding in Translight.
In 1996 Translight conducted experimental work on light guides. Its work included using different core materials for the light guides with a particular type of polymer tubing called tetra fluoro ethylene hexafluoro propylene (known as FEP tubing). Although FEP tubing is very expensive, it is the only polymer with a sufficiently low refractive index to cause the light to travel long distances along the tubing.
From about 1998 Translight conducted experiments involving cheap Ionimer tubing which had an internal zinc-based formulation. The zinc coating made materials adhere to the tube more easily. Translight experimented with different coatings placed on the inside of the Ionimer tubing to create a skin of air by coating the inside of the length of tubing with a substance called aerogel to trap air and lower the refractive index of the tubing. Aerogel is a silica gel with unique properties.
According to Dr Fraval, in 1999 FTI offered to buyout Rofin's 50% shareholding in Translight. In the course of negotiations, Rofin exercised its option to buy out the shares held by FTI by making a slightly higher offer than that made by FTI. FTI was required by the joint-venture agreement to accept Rofin's offer. Rofin purchased FTI's shareholding in Translight in about June 2000 although Hanafi Fraval retained his 5% shareholding.
Dr Fraval testified that after the Translight buyout, no further activities were conducted by Translight in America. The directors of Rofin arranged for all of Translight's records, inventories and other equipment to be shipped to Australia from America in late 2000. Included in the materials which were shipped from America to Australia were coils of Ionimer tubing coated with aerogel. The total weight of tubing shipped from America to Australia was said to be 1197 pounds.
In 1998 or 1999, Rofin together with an unrelated company, Poly Optics Australia Pty Ltd (Poly Optics), conducted a project in Hong Kong which involved installing light guides produced by Poly Optics. Those light guides did not have liquid core, but rather had a solid acrylic core. Some 120,000 metres of polymer light guides produced by Poly Optics were installed in the Hong Kong building. According to Dr Fraval, Rofin and Poly Optics became involved in a dispute over costs and that was eventually resolved by commercial arbitration although Rofin's financial resources were depleted by the dispute. It resulted in Rofin ceasing research work with aerogel coated light guides and instead focused on making medical application products.
Dr Fraval said that in early 2003, he decided to focus on a project using light guides in his spare time. He planned to use HFN as the vehicle to conduct research and development on this project.
Dr Fraval said that his project was aimed at developing an environmentally friendly lighting system for residential houses that used solar technology for lighting in daytime and conventional lighting at night. The project was combined with a biometric security system. He said that one of the major objectives of the project was to produce light guides and light collectors in combination which would have a low cost. His aim was to use low-cost tubing coated with aerogel to make light guides and for those light guides to operate in conjunction with the newly designed light collector.
Broadly, Dr Fraval said the system was designed to have a light collector which would be installed on the roof of the house. It would focus sunlight into a light guide which channelled light to a distribution box. The distribution box would feed the light into a number of other light guides, transporting the light into different rooms around the house. It was proposed that a device called a holographic diffuser would be placed at the end of the light guide so that light rays were spread in a number of different directions to light the entire room.
Prior to entering upon the project, HFN needed to obtain a licence from Translight to use its Patent regarding fluid light guides having a hydrophobic aerogel cladding layer. It entered into an agreement with Translight whereby it paid a total licence fee of US $75,000. The fee was said to be for use of the patent over a three-year period.
To conduct the project, HFN needed to use Translight's Ionimer tubing coated with aerogel. The licence fee agreement between HFN and Translight included the acquisition of part of the stock of Ionimer tubing which at that time was held at Rofin's premises. Dr Fraval said HFN purchased additional Ionimer tubing from Translight in the 2005 income year at a cost of $166,246. HFN also acquired a patent held by Rofin which was described as a Lighting System Patent. This patent was apparently assigned to HFN for the nominal sum of $1.
According to Dr Fraval, he commenced work on the project in about July 2003. HFN did not employ any other persons on the project and he worked during evenings and at weekends at his home. That work essentially involved developing a light collector and the light guides.
Dr Fraval constructed a prototype light collector which was a lens/mirror combination. It was designed to track the apparent movement of the sun, due to the earth's rotation, so that light remained focused on the light guide throughout the day. However, the azimuth controller, which was designed to track the apparent movement of the sun, became too complicated for use in buildings and was not practicable. It was subsequently abandoned. In 2004 Dr Fraval experimented with a Fresnel lens on a frame which he had constructed. In early 2005 he experimented with the light collector by fitting it to the roof of his house.
In July 2003 Dr Fraval said that he also worked on light guides which would transfer light from the collector throughout the house. He used the Ionimer tubing which was then stored at Rofin's business premises in Dingley. He simply took lengths of tubing as he needed them for experimentation. After about five or six weeks Dr Fraval said he realised there were problems with tubing lengths beyond 2 metres. He could not get the light to travel beyond about 2 m and a 10 m length of tubing would produce no light at all. He also had difficulty in producing consistent lighting with the shorter lengths of tubing. He identified one of the problems as the unevenness or roughness of the aerogel coating on the inside of the tubes. This caused him to seek the assistance of a consultant, Mr Michael van der Matten.
Dr Fraval said he knew Mr van der Matten from his time when he worked in Spain. He had previously told Dr Fraval that he had a background in coating materials and knowledge and experience with material coating problems. Dr Fraval said he told Mr van der Matten that HFN could only afford around £5000 – £6000. Apparently Mr van der Matten was then domiciled in the United Kingdom and said he wanted to be paid in pounds sterling. Later, in September 2003, Dr Fraval said that Mr van der Matten sent HFN an invoice for £14,350 for his consultancy services and he agreed that HFN should pay that amount. Mr van der Matten ceased to be involved in the project in about February or March 2004.
Dr Fraval said that he experimented with various techniques to improve the smoothness of the aerogel coating up until early 2005. In around February or March 2004, he decided to experiment with solid core polymer light guides instead of liquid light guides which he had been using up until that time and which did not work. He contacted Mr Edmond Joseph of Poly Optics seeking his assistance to conduct some testing of the Ionimer tubing using a solid core polymer. Some of the tubing held at Rofin was shipped to Poly Optics' premises in Queensland in 2004. The remainder of the tubing was shipped to Poly Optics by the end of 2004, other than a small amount which Dr Fraval said he kept in Melbourne for his own experiments. Mr Joseph conducted a number of tests on the Ionimer tubing, filling it with a polymer core. He regularly sent pieces of the tubing which he had filled to Dr Fraval so that he could analyse the results. The majority of the work conducted by Mr Joseph was in the 2004 calendar year. Testing had completely ceased by the end of the 2005 income year at which time HFN did not own any tubing which had not been used for experimentation. Once the tubing was used for experimentation, it was not able to be sold commercially.
In about mid-2003 Dr Fraval also spoke with Mr Ian Bennett who then had a company called Licere Nominees Pty Ltd. Licere later changed its name to R & D Consulting Pty Ltd (R & D Consulting). In July 2003 R & D Consulting entered into a contract with HFN for the provision of assistance with the project. A key element of R & D Consulting's work was to research and test the incorporation of light guides and the light collector into the building panels of a building. R & D Consulting was at that time apparently involved in building constructions using a product called a Scallan Wall. It was planned to build conduits within the Scallan Wall panels of the building so that light guides could be fed through the conduits into different rooms in a house. It appears that in about early 2004, there were misgivings about using a Scallan Wall and prefabricated wall panels from another company were being considered. According to Dr Fraval, R & D Consulting managed and subcontracted the design, research, development and testing of the integration of the light guides and light collector into these wall panels.
HFN received an invoice for $55,000 from R & D Consulting for the 2004 income year in accordance with its agreement. It received two further invoices in 2004 for the amounts of $137,609.80 and $80,854.92.
SUBSTANTIATION OF R & D EXPENDITURE
As I have indicated above, s. 73B of ITAA 1936 enables a taxpayer to claim a deduction in respect of certain research and development activities in Australia. Section 73B (14) creates a deduction in respect of research and development expenditure. The expression, research and development expenditure, is defined in s. 73B (1) in the following way:
research and development expenditure, in relation to an eligible company in relation to a year of income, means expenditure (other than core technology expenditure, interest expenditure, feedstock expenditure, excluded plant expenditure or expenditure incurred in the acquisition or construction of a building or of an extension, alteration or improvement to a building) incurred by the company during the year of income, being:
(a)contracted expenditure of the company;
(b)salary expenditure of the company, being expenditure incurred on or after 1 July 1985; or
(c)other expenditure incurred on or after 1 July 1985 directly in respect of research and development activities carried on by or on behalf of the company on or after 1 July 1985;
and includes any eligible feedstock expenditure that the company has in respect of related research and development activities.
Substantiation of R & D expenditure has two aspects. The first is whether the claimed expenditure was incurred directly in respect of a R & D activity. The second is whether the applicant for a claim involving research and development expenditure in fact incurred a pecuniary liability.
As Mr Evans submitted, there are no statutory rules relevant to the substantiation of claims for deductions under s. 73B. Nevertheless, he submitted that what is required of an applicant to substantiate and therefore discharge its burden of proving the claimed expenditure must be considered in the context of the expenditure being research and development expenditure for the purposes of s. 73B(1). He referred to the definition set out in s. 73B(2B) regarding research and development activities. In particular, he referred to s. 73B(2B)(b)(ii) which provides:
the uncertainty of obtaining the outcome can be removed only through a program of systematic, investigative and experimental activities in which scientific method has been applied, in a systematic progression of work (based on principles of physical, biological, chemical, medical, engineering or computer sciences) from hypothesis to experiment, observation and evaluation, followed by logical conclusions.
Mr Evans also referred to the Guide to the R & D Tax Concession Part C2, an Australian Taxation Office publication, which provides guidance regarding recordkeeping requirements for companies to substantiate their claims. He submitted that companies intending to claim the R & D tax offset should maintain adequate contemporaneous records which substantiate the carrying on the claimed research and development activities and the incurring of expenditure in relation to those activities. In addition, Mr Evans submitted that the inherent systematic, investigative or experimental nature of activities called for a degree of record keeping beyond that capable of being credibly described without the aid of primary records kept for the purpose of capturing the details of those activities. He submitted that where HFN sought to rely on Dr Fraval's memory due to lack of records, I should be reluctant to find that HFN has discharged its onus of proof.
Mr Evans also pointed to the fact that Dr Fraval had considerable R & D experience through his role as the Managing Director of Rofin which had previously claimed the

R & D tax offset. He should therefore be familiar with recordkeeping requirements necessary for eligible research and development claims in general and in relation to claiming the R & D tax offset in particular.
THE MEANING OF EXPENDITURE INCURRED
The definition of research and development expenditure, to which I have referred above, uses the expression expenditure incurred. Also, s. 73B (14), which deals with an allowable deduction, refers to where an eligible company incurs research and development expenditure….
Putting aside for the moment issues regarding the nature of the claimed activities themselves, the Commissioner contended that that HFN did not in fact incur materials, licence and consultancy services expenditure in the course of its research and development activities, principally because HFN's liability was conditional or contingent and therefore HFN was not, as a practical matter, definitively committed to that expenditure. As to other expenditure, the Commissioner contended that HFN had failed to substantiate the contested items of purported expenditure.
Mr Evans submitted that the meaning of the word incurred as it is used in s. 73B has the same meaning as the courts have given to the same term in the former s. 51 (1) of the ITAA 1936, and subsequently to the successor provision, s. 8-1 of the ITAA 1997. He summarised the principles as follows:
(a)an outgoing in the form of an undischarged liability can qualify for deductibility if it has fallen due in the relevant year of income, even though it may not be paid until a later year (Federal Commissioner of Taxation v Citylink Melbourne Ltd (2006) 228 CLR 1 at 36–38, a decision of Crennan J with whom Gleeson CJ, Gummow J, Callinan J and Heydon J agreed; Coles Myer Finance Ltd v Federal Commissioner of Taxation (1993) 176 CLR 640 at 662–663; Nielsen Development Laboratories Pty Ltd v Federal Commissioner of Taxation (1981) 144 CLR 616 at 623 (… there can be no warrant for treating a liability which has not "come home" in the year of income, in the sense of a pecuniary obligation which has become due, as having been incurred in that year.); Federal Commissioner of Taxation v James Flood Pty Ltd (1953) 88 CLR 492 at 506);
(b)the critical question is whether the taxpayer was, as a practical matter, definitively committed or completely subjected to discharge the liability in the future (Citylink at 37 referring to the judgement of Deane J in Coles Myer at 670–671);
(c)a liability will not have been incurred if some condition affects its coming into existence (Crennan J in Citylink at 40–41);
(d)apart from merely theoretical contingencies, which, for practical purposes, can be treated as certain to be satisfied, an undischarged liability affected by a contingency will not give rise to one which can be said to have been incurred (Coles Myer at 670–671; Citylink at 37–38; James Flood at 507–508); and
(e)there must be a presently existing [enforceable] liability, although actual payment might occur only at some uncertain time in the future (Citylink at 38).

Generally, Dr Bender agreed with Mr Evans regarding what is meant by the expression incurred in relation to expenses for research and development activities. He submitted that an expense is incurred when a present liability to pay the money has come into existence, or in other words, the taxpayer has become "completely subjected" or "definitively committed" to the liability. An expense can be incurred even when it has not been paid.
Dr Bender submitted that the Commissioner's contention that the expense was not incurred was in fact a contention that the expense did not exist. He disputed that contention and submitted that the books kept by the company, particularly its financial records, are prima facie evidence of what is contained in those documents. He referred to s. 1305 (1) of the Corporations Act 2001 which deals with the admissibility of books in evidence. It provides:
A book kept by a body corporate under a requirement of this Act is admissible in evidence in any proceeding and is prima facie evidence of any matter stated or recorded in the book.
Dr Bender submitted that an invoice provided by Mr van der Matten; Westpac Bank documents of some payment being made in respect of the invoice; and the accounting records of HFN which record the expense of $39,625 in respect of Mr van der Matten's consulting services are books within the meaning of s. 1305 (1). Dr Bender directed my attention to the reasons for decision of Austin J in Australian Securities and Investments Commission v Rich (2009) 236 FLR 1 at [82] where his Honour said:
In my view the true meaning of the words "prima facie" lies between the alternatives identified in the defendants' submission. The statement in s. 1305(1) that the company's books are prima facie evidence of a matter stated or recorded in them does more than merely to convey that they are the starting point to proof or a "first view". All other things being equal, the fact that a matter is stated in a book kept by a company is sufficient to prove that matter in civil proceedings. That does not reverse the onus of proof in the proceedings in any general way, but it means that the tendering of the book is evidence of the matter recorded in it, and that the matter will be thereby proven unless other evidence convinces the tribunal of fact to the contrary, on the balance of probabilities.
With respect to Dr Bender, he did not point out what Austin J said regarding the purpose of s. 1305 (1). His Honour referred to the explanatory memorandum to the Companies Bill 1981 which introduced the provision. He also referred to his earlier decision in Australian Securities and Investments Commission v Rich (2005) 191 FLR 385 at [225] where he said:
This is a new provision based on s-sec 156(3) of the Ontario Business Corporations Act. It is an evidentiary provision that is intended to expedite legal proceedings where books are to be introduced in evidence. This provision obviates the need to call witnesses to prove that the books are books of the corporation when this fact is not in question or to prove transactions recorded in books or when these matters are not in dispute.
His Honour also said, at [82]:
In my view it would be open to the tribunal of fact to find that the prima facie evidence constituted by the company's books is outweighed by other evidence (including evidence adduced by the proponent of the books, even if the opponent does not give evidence about them); or by some quality or characteristic of the books themselves, even if there is no other evidence. In particular, if a book has the appearance of a draft or (being electronic) has a file title indicating that it is the draft, that alone may be sufficient (all other things being equal) for the tribunal of fact to reject the book as evidence of the matter stated in it, notwithstanding that the book is prima facie evidence of that matter; a fortiori if, in addition to having the appearance of a draft, the book contains inconsistencies or ambiguities or the matter otherwise demands explanation.
Austin J then concluded, at [82]:
Therefore s 1305(1) allows a company's books to be introduced into evidence as they are, without any "authenticating" evidence by any witness, and allows the books to be relied upon to prove transactions recorded in them. But it does not elevate matters contained in the books to a plane of probative value that requires the court to disregard the context in which the matters relied on appear in the tendered document. If, for example, there is some doubt as to whether a particular transaction is "recorded" in a book because of some uncertainty about the status of the document or ambiguity about what it contains, s 1305(1) does not overcome the problem.
The problem, as I see it, with attempting to apply s. 1305 (1) of the Corporations Act in taxation cases, is the onus of proof cast on the taxpayer by the TAA. Following the Commissioner making an Objection Decision, with which the taxpayer plainly disagrees and seeks review before the Tribunal, where the taxpayer relies on company books as evidence of a payment or disbursement having been made and which is the subject of the Objection Decision, it necessarily follows that such an entry in the books of account of the company is in dispute.
Furthermore, because the onus is on the taxpayer to prove that an assessment is excessive or, in this case, the decision should have been differently made, were the taxpayer permitted to simply rely on an entry in the company books despite the Commissioner having rejected the entry, an onus would then be placed on the Commissioner to adduce evidence to support his rejection of the taxpayer's claim. This is impermissible as was explained by the High Court of Australia in Federal Commissioner of Taxation v Dalco (1990) 168 CLR 614. Brennan J said, at 624–625:
… Absent such a confining of the issues for determination, the Commissioner is entitled to rely upon any deficiency in proof of the excessiveness of the amount assessed to uphold the assessment, though the taxpayer is limited to the grounds of his objection. In Gauci v. Federal Commissioner of Taxation (44), Mason J. said:
“The Act does not place any onus on the Commissioner to show that the assessments were correctly made. Nor is there any statutory requirement that the assessments should be sustained or supported by evidence. The implication of such a requirement would be inconsistent with s. 190(b) for it is a consequence of that provision that unless the appellant shows by evidence that the assessment is incorrect, it will prevail.”
That view, expressed in a dissenting judgment, now prevails: Macmine Pty. Ltd. v. Commissioner of Taxation (45); McCormack's Case (46).
With respect to Dr Bender, for the reasons I have set out above, I do not accept his submissions regarding the application of s. 1305 (1) of the Corporations Act to this matter.
CONSULTANCY EXPENDITURE
The expenditure which needs to be examined under this heading is that relating to the consultancy services said to have been provided by Mr van der Matten and by R & D Consulting Services.
Mr van der Matten consultancy services
As the Commissioner pointed out, the only document relating to the expenditure incurred by HFN in respect of Mr van der Matten's consultancy services was an invoice dated
8 September 2003 in the amount of £14,350. That document describes the services provided as:
Engineering services in connection with solar tiles and solar pave using Glass reinforced concrete GRC) in your "Environmentally friendly house" development project.
With respect to Mr van der Matten, the above description is unhelpful, surprisingly so considering the substantial cost invoiced to HFN. It was left to Dr Fraval to provide further details of the work conducted by Mr van der Matten. According to Dr Fraval, he began discussions with Mr van der Matten about coating problems with tubing soon after those coating problems arose in July or August 2003. He said he explained to Mr van der Matten that the project involved collecting light using a light collector on a house roof which would feed the light into light guides for distribution around the house. Apparently Mr van der Matten immediately told Dr Fraval that he should look at the encasement of the light collector made out of glass fibre reinforced cement (GFRC). According to Dr Fraval, there were problems with integrating a light collector on a house roof because roofing tiles could expand and contract which might result in damage to the light collector.
Mr van der Matten sent to Dr Fraval what he described as materials demonstrating what GFRC could do and how it could be used to integrate a light collector into the roof of a house. Dr Fraval attached to his witness statement those materials which comprised a number of photographs depicting the use of GFRC in a number of applications, although none included a light collector. They also included a number of schematic drawings showing a solar collector panel (possibly a photovoltaic panel) attached to a water storage unit which appeared to have no relevance at all to the research and development activities being conducted by Dr Fraval. Included amongst the materials is a guide which is intended for persons involved in the production of GFRC for an entity described as Cem-Fil and a number of papers dealing with various aspects of GFRC. None of these papers deal with light collectors. Dr Fraval claimed that the work involved in integrating a light collector into the roof of the planned environmentally friendly house related to Activity 5 of the R & D plans.
With respect to Dr Fraval, he seems to have conflated the project which he described as the Environment Friendly House with an eligible activity. The word project is defined as: to plan, contrived or design (something to be done, or some action to be carried out) while the word activity means: the state of being active; the exertion of energy, action… anything active (The Shorter Oxford English Dictionary). Section 73B of ITAA 1936 makes it clear that the benefits of the tax incentive are targeted by being limited to particular expenditure on certain defined activities.
I find nothing in the invoice provided by Mr van der Matten or the documents attached to Dr Fraval's witness statement which relates to Activity 5. That Activity is the production of a collector to efficiently introduce light into light guides. Nor, for that matter, does it appear to relate to Activity 6 which, it will be recalled, was to produce an azimuth controller for the collector. In fact, logically and practically, until the design and structure of the collector and an azimuth controller (if that were to be used) had been finalised, there was no purpose whatsoever in undertaking any analysis of the kind of material which might be used in the roof of the house to permit stable and secure instalment of those devices.
Although Dr Fraval also said that Mr van der Matten gave assistance regarding the aerogel coating and problems having that adhere effectively to the tubing, there is no evidence from Mr van der Matten regarding this problem. Other than Dr Fraval's very general statement about discussing the aerogel coating with Mr van der Matten, there was no evidence that this activity, if it is in fact an activity, would satisfy the description of Activity 1. The evidence does not permit me to find that Mr van der Matten made any contribution to Activity 1.
I should also mention that although Dr Fraval approached Mr van der Matten for the purpose of giving evidence at the hearing of this matter, he declined to do so. Furthermore, the description used on the invoice said to have been issued by Mr van der Matten on 8 September 2003 refers to engineering services. There was no evidence before me which indicated that engineering services of any kind were provided to Dr Fraval. While I accept that the description on the invoice may be overly general in nature, given the fee of £14,350 (A$39,625), it is not unreasonable to expect a far more detailed and accurate description of the work conducted.
In the course of cross-examination, Dr Fraval was asked whether Mr van der Matten provided him with any material which documented the work he performed. Dr Fraval answered by referring again to the GFRC product and the fact that its use would allow the collector (the Fresnel lens) to be supported by a non-metallic substance. As for the aerogel coating on the inside of the Ionimer tubes, Dr Fraval said: and the second part of what he offered was his background. Dr Fraval said Mr van der Matten had knowledge of coating and that he could bounce ideas off him to improve the coating of the tubing. When asked again specifically regarding the use of GFRC whether there was any direct reference by Mr van der Matten to the use of that material for the purposes of developing, or housing, the collector, he answered: This is background information, which is to show the use of this material in applications similar to what I would call a roof solar collector, but it's – there is not anything specifically about my collector in it.
Dr Fraval confirmed that Mr van der Matten did not consult to HFN on anything other than housing the solar collector and the light guides. When it was put to him that there was no specific reference to either of these matters in the invoice issued by Mr van der Matten, Dr Fraval said: Well, solar tile is exactly what I was making. It's exactly the descriptive of incorporating a solar collector in the tiles of a house. It's exactly what I was doing.
With respect to Dr Fraval, Activity 5 refers to the production of a collector, not its installation in a building. As I have already said, any questions about installation in a building would only arise following the construction of a properly functioning collector. Logically, there was no purpose in even examining this material at this early stage of research because the size and shape of a properly functioning collector and an azimuth tracking device could not be determined in advance. In fact, as it transpired, Dr Fraval was never able to make this light collection system function. If the claimed expenditure was in fact incurred as a consequence of Mr van der Matten's consultancy (and I make no finding about that), it was not expenditure incurred directly in respect of the research and development activity described as Activity 1 or Activity 5.
R & D Consulting services
In his witness statement Dr Fraval said he spoke to Dr Ian Bennett, who worked for Licere Nominees Pty Ltd, about the project in mid-2003. Licere later changed its name to R & D Consulting (I have used the name R & D Consulting interchangeably with Licere in these reasons). He said that HFN entered into a written contract with R & D Consulting in about July 2003 under which HFN agreed to pay R & D Consulting $55,000 for consulting assistance with the project. In his witness statement Dr Fraval said that the contract summarised the services which R & D Consulting was to initially provide and these services were set out in Schedule A and Schedule B of the contract. He said the work conducted by R & D Consulting was part of Activity 1, Activity 5 and Activity 7 of the R & D Plans.
Despite what was set out in the written contract between HFN and R & D Consulting, what in fact transpired bears little, if any, resemblance to the contract. In fact, Mr Evans submitted that the invoices issued by R & D Consulting to HFN were inadequate to describe the work performed. He was particularly critical of the lack of detail given and the substantial amounts finally invoiced. Furthermore, he submitted that consultancy services provided by R & D Consulting appeared to have been subcontracted to other parties. He described the records provided by subcontractors and Dr Bennett's evidence as vague and inconclusive.
In his written statement which was taken into evidence, Dr Bennett referred to the HFN project which he said involved using light guides to light the interiors of buildings with natural sunlight transmitted through the light guides. He described the work which R & D Consulting was to do in the following way:
R & D Consulting's role was to manage the project to design, develop and test the integration of the light guides into a building. R & D Consulting did not do any design and development work itself. R & D Consulting located and subcontracted this work to other building and engineering specialists.
The written agreement purported to have been entered into between R & D Consulting and HFN on an undisclosed date in 2003 is a curious document. Under the heading Background is a sentence which states that HFN was developing the product set out in Schedule A of the contract. There is also a sentence which states that HFN wished to engage the services of R & D Consulting to provide the services set out in Schedule B of the contract. Under the definitions section, Product means the product described in Schedule A of the contract. Clause 2 (a) of the contract provides that HFN agreed to engage the services of R & D Consulting and that R & D Consulting agreed to provide the services described in Schedule B of the contract in order to fully develop the Product. Clause 2 (b) of the contract provides for a consideration of $55,000 (exclusive of GST) per year to be paid to R & D Consulting. The contract says nothing about its term nor is there any provision for bringing the contract to an end. It contains numerous "boilerplate" clauses, most of which have nothing whatsoever to do with the terms of the contract.
Schedule A of the contract contains the following:
The research will be in assisting in the management, work flow and integrated systems required to build in all the aspects of an environmentally friendly economic building being undertaken by the Corporation [HFN]. Currently no such total system exists anywhere in the world predominantly because the building industry is very slow to uptake new technology. Sub contracts and licences will be implemented by Licere to handle various aspects of the research such as Scallan Wall and integration of electrical conduits etc. at the time of the pouring of the concrete in situ; the bringing of natural light into a building by tubes conveying sunlight; biometric access and security systems linked to security centres; smarthome wireless whole house technology; built in voice over IP for telephony, conferencing and IP driven video. In addition, Licere has association with building company DTC Construction who will help implement.
In the marketing phase Licere has associates who currently own and are building 700 low cost homes in Shepparton and a resort development with the retail value of $300m. If your development is successful the entire system can be implemented in these projects.
Schedule B sets out the following:
Arrange for the incorporation of the HFN solar collector and light-guide into a low cost building system. This will initially be done together with a company Ladyhill Pty Ltd and 7 Stars Building Products Pty Ltd. (Currently being formed).
It is the intention to Research the incorporation of the Light-guides and solar collector into the Building panels.
Draft drawings are attached.
I should also point out that Schedule B is in a different font to Schedule A, and it does not contain a page number at the top of the page as do all of the other pages in the contract. In the course of his cross-examination Dr Fraval was asked whether both Schedule A and Schedule B were attached to the contract when it was executed. He said that to his knowledge they were. Mr Evans then referred Dr Fraval to Schedule B of the contract and in particular the statement indicating that draft drawings were attached. He was asked whether he recalled drawings being attached to the contract when it was signed, and he answered no. When asked who produced the drawings, he said they were produced by somebody that Mr Bennett had engaged, a draftsman from his company. He also agreed that Dr Bennett gave him the drawings after R & D Consulting had been engaged by HFN. Mr Evans then asked Dr Fraval how come it was that if the drawings were given to him by Mr Dr Bennett after his engagement, that schedule formed part of the contract on the date was signed. Dr Fraval responded by stating that those were subsequent drawings and he did not believe that the drawings were attached at the time of the contract because he did not recognise them as such. He added: And it doesn't make sense for him to have made drawings before we even had a contract. I mean, there was no possible way that he could have made the drawings on the work and then had a contract. It just doesn't make sense.

Dr Fraval's attention was drawn to the fact that the page containing Schedule B was not numbered and he was asked if he could provide an explanation for that. Dr Fraval said he could not. The apparent disconnect between Schedule B and Schedule A becomes obvious when one looks at the detail contained in each. Putting aside the references to biometric access and security systems which are not the subject of HFN's claim following the agreement reached on 15 September 2009, Schedule A refers to R & D Consulting having an association with the building company, DTC Construction, which it was said would assist with the implementation of the light guide technology. According to Dr Bennett, R & D Consulting subcontracted the design and development work on the Scallan Wall, which was to house the light guides, electrical wires and other systems used in the building, to DTC Constructions. Schedule B makes no reference to the biometric access and security systems but simply refers to the solar collector and light guide system. Furthermore, it refers only to Ladyhill Pty Ltd (Ladyhill) and 7 Stars Building Products Pty Ltd (7 Stars) as the entities he intended to use to assist with the incorporation of the solar collector and light guide into a low cost building system.
In his written statement, Dr Bennett testified that the initial plan for the building project was to use the Scallan Wall to integrate light guides into a building. However, the Scallan Wall concept was abandoned in about 2004 when this form of construction failed. At that time, DTC Constructions was involved in a project on Glenferrie Road, Malvern. According to Dr Bennett, it was then (about 2004) that R & D Consulting engaged sub-contractors to begin experimentation with another type of fibreglass wall. He said that R & D Consulting managed this phase of the project and sub-contracted the design, development and testing work to the 7 Star group and to Mr Steven Morgan as the engineer. The statement made in Schedule B that the incorporation of the HFN solar collector in the light guide into a low cost building system would initially be done with Ladyhill and 7 Stars is plainly something which was not contemplated in 2003 when the contract was said to have been made. According to Dr Bennett, this only occurred following the failure of the Scallan Wall project.
The drawings attached to the contract referred to in Schedule B also contain a number of anomalies. Despite the evidence given by Dr Fraval and Dr Bennett that the initial concept envisaged a concrete wall (Scallan Wall) and later, after the contract had been entered into, a modified fibreglass wall, the drawings depict a 4 mm thick render system over a 50 mm extruded polystyrene outer cladding fixed to a timber stud wall. Furthermore, although Dr Fraval referred to Mr van der Matten's glass fibre reinforced concrete roofing, the drawings refer to Colorbond roofing, which is a metal product. In fact labels on the drawings are also inaccurate, for example, where reference is made to extruded polystyrene, on the same drawing different sections of the wall are pointed to.
It is fair to say that nothing in the contract provides me with any confidence that the parties involved contracted at arm's length and that the development of the collector and light guides had reached the stage where any realistic work could have been done by way of research and development involving the incorporation of this equipment in a house. This in turn raises serious questions about the invoices rendered by R & D Consulting to HFN and the payment of those invoices.
Despite what was contained in the contract, it appears R & D Consulting issued two invoices to HFN, the first on 4 November 2004 in the amount of $137,609.80 inclusive of GST; and the second on 30 November 2004 in the sum of $80,854.92 inclusive of GST. Both invoices contain the same statement of work carried out which is as follows: Consultancy and project management in relation to your development of natural sunlight into buildings including integration into kit buildings. According to Dr Bennett, there was a further invoice in the amount of $110,000 which R & D Consulting issued to HFN in September 2004. Dr Fraval makes no mention of that invoice in his witness statement. The description of work conducted by R & D Consulting on that invoice states: Research and Development carried out on your behalf as per our Agreement. Dr Bennett said in his witness statement that this invoice was in respect of the light guide project. He said he could not recall the details of how the amount on the invoice was calculated. However, he said he believed that this invoice was subsequently withdrawn and replaced by the two invoices referred to by Dr Fraval.
In his witness statement, Dr Fraval said that HFN received an invoice for $55,000 from R & D Consulting in the 2004 income year. He said HFN no longer had a copy of that invoice. He said that the invoice had not been paid by 30 June 2004 but was subsequently paid by way of a set-off of liabilities in about the 30 June 2006 financial year. That in itself is contrary to clause 5.16 of the contract which provides that unless expressly provided otherwise, a party had no right of set-off against payment due to another party. No explanation was given for disregarding this clause in the contract.
Dr Fraval said in his witness statement that Poly Optics, R & D Consulting, HFN and Rofin each had amounts owing between themselves during that year. He said he also had amounts owing to him personally from Rofin as well as amounts from HFN. He then said the $55,000 owed to R & D Consulting by HFN was paid as part of the set-off arrangement between Poly Optics, R & D Consulting, HFN, Rofin and himself. He said he did not understand the accounting details of how the set-off arrangement was implemented. In his witness statement Dr Bennett said that around that time, R & D Consulting was doing research and development work for Poly Optics. He said Poly Optics owed R & D Consulting money and he understood there was a relationship between Poly Optics and HFN. He then said: I recall that somehow an offset was done of the $55,000 amount owed by HFN to R & D Consulting in relation to amounts that were owed between HFN, Poly Optics and R & D Consulting. I do not recall details of how the offset was done.
Dr Bennett was cross-examined on his understanding of the set-off arrangement for the payment of the $55,000 invoice. He said he believed that R & D Consulting owed money to Poly Optics. HFN owed money to R & D Consulting. He then said: That's – that's and I am trying to explain here that – and in a clumsy way that I don't recall the details of how that offset was done. When it was pointed out to Dr Bennett that in his witness statement, he said that R & D Consulting was doing research and development consulting work for Poly Optics and that in fact he had previously stated that Poly Optics owed R & D Consulting money, he said that was incorrect and that his statement was the wrong way round. At this point Dr Bender pointed out that Mr Sachlan Fraval, another of Dr Fraval's brothers, who was an accountant, provided a better explanation of the set-off in his witness statement.
Mr Sachlan Fraval lodged with the Tribunal a witness statement which was admitted into evidence. He set out in a table the amount of money owed by one entity to another amongst Rofin, Poly Optics, HFN and R & D Consulting. He recorded that Poly Optics owed some $102,000 to R & D Consulting; HFN owed some $58,000 to Poly Optics; and HFN owed $55,000 to R & D Consulting. In describing how the set-off worked, Mr Sachlan Fraval said that the $55,000 debt and invoice from R & D Consulting was settled against the amount payable in the Poly Optics books to R & D Consulting. In his witness statement Dr Fraval said that Poly Optics was an unrelated company. The resultant is simply that Poly Optics' debt to R & D Consulting was decreased by $55,000.
In his witness statement Dr Bennett also said that R & D consulting started out charging HFN the $55,000 amount but subsequently found that the actual cost of the project was significantly higher. He said agreement was reached with HFN to charge the actual costs for subsequent invoices. Dr Bennett referred to the two invoices issued in November 2004 and said that those amounts were for work conducted by R & D Consulting in relation to the light guide project. Dr Bennett did not refer to biometric access and security systems.
In the course of cross-examining Dr Fraval and Dr Bennett, Mr Evans attempted to obtain a more precise description of the work conducted by R & D Consulting for which the invoices subsequently issued. However, despite significant effort, very little was achieved. In my opinion, this goes to the heart of the problem regarding whether expenditure said to have been incurred by HFN for consultancy services provided by R & D Consulting should be allowed by the Commissioner. Rather than reciting the entire cross-examination, I have selected a number of the more significant passages which clearly illustrate the problem.
When Mr Evans pointed out to Dr Fraval that the contract between HFN and R & D Consulting services provided for the payment of $55,000 per year and nothing further, Dr Fraval said: That's correct, and this is over and above the terms of that agreement. When he was asked why he did not go back to Dr Bennett referring to the contractual amount, he said: Well, I could have done, and I am sure I did discuss the amount of money, because it was considerable, and the opportunity was, in my opinion, worth paying for. He was then asked what he was paying for with respect to the $137,000 amount. Dr Fraval said: I was paying for the opportunity to put the collector and light guide into a number of buildings that were scheduled to be built. When asked what the specific project was, he said: My recollection was it was a project in Shepparton. Dr Fraval was then taken to the second invoice in the amount of $80,854.92. He was asked to explain what he recalled about his reaction to that invoice. He said: So this is the same. It's just a follow on from the previous invoice and it's for the same activity, but in addition to it. Dr Fraval was asked whether he asked for a breakdown of either of those invoices and he said he did not.
In the course of his re-examination Dr Fraval was referred to the $55,000 contractual payment and asked what services would be provided for that in a general sense. He said: They were – they were going to assist me in finding – and as – as they did with the – the collector house, into the house, into the wall scenario we talked about earlier on. But they were also going to find for me partners or companies that could help me with doing other aspects of the – the house, or the envisaged house, which was both a security-related thing, and a energy efficiency related project. But obviously, as it turned out, they only were – were really involved in the – the building side of it.
Dr Bennett's cross-examination was confusing and unenlightening. He confirmed that at the time HFN was conducting its research and development activities on the light collector and light guides, R & D Consulting was working with the Scallan Wall construction for DTC Constructions and with Ladyhill, although he was not certain about whether the 7 Star group had been formed at that time. He said: It was our idea to initially to try to get it – the lighting into the Scallan Wall project, and then later we decided we would like to put it into the fibreglass panelling. Dr Bennett confirmed that the Scallan Wall project was disastrous for R & D Consulting and cost it a lot of money. When asked about the nature of the project concerning DTC Constructions, he responded: It – as I recall there was [sic] seven townhouses in Toorak, south – in Malvern East, near the corner of Glenferrie Road and High Street, Malvern Road area. And it was the first experiment that I know of, certainly in Melbourne, of the Scallan Wall technology, which was – originated in Brisbane, in Queensland. When asked to describe the nature of the work that R & D Consulting did for DTC Constructions, Dr Bennett said: We – we were bringing the technology development from a fellow called Patrick Scallan in Queensland to DTC Constructions to actually build one of these new type of buildings in East Malvern. That was the role. And because it was semi-experimental, we thought it was an ideal opportunity to try and bring in the conduits and see if we could address light as well as things like electricity and other services that were being provided through the Scallan Wall, because if the walls are built without that being taken into account, then all the labour saving goes out the window because you then have to re-drill for the services to go through that new wall.
When he was referred to the decision made in 2004 to cease using the Scallan Wall for the purposes of the light guide, Dr Bennett said: And, like, we had real engineering problems with Scallan Wall. The walls started to buckle, and we had to make corrective engineering measures to correct it. He was then asked whether it was correct to say that when R & D Consulting's contract with HFN commenced, the work for the light guides into the building was all done with the Scallan Wall, he responded: Yes, except we were – we kept waiting and waiting and waiting for Mr Fraval to deliver the product. We – we had, sort of, made allowances for things and, unfortunately – I can't explain why. I can't even remember why, but I know there were huge delays which became quite embarrassing to us because we had workmen on the site and it was a difficulty. Dr Bennett was then referred to the biometric access and security system which formed part of the project. When he was asked whether that was part of HFN's project, he said: It all gets very confusing. There’s a biometric high security technique that was being developed, I believe, by Rofin, who are connected to HFN, and I can't recall which of the entities was dealing with the biometric security, but it was to do – I know it was adopted in police forces and a number of players around the world.
Finally, Mr Evans explained that what he was trying to understand by his cross-examination was what HFN got for its money. He asked whether the fee paid to R & D Consulting by HFN included work in relation to the Smart home wireless, whole-house technology and he responded: Yes and no. The "yes" is that it's in the package that they're joining the group, but "no" in the sense that it's, kind of, incidental from HFN's point of view. What they were interested in is the work that the engineers were doing in relation to the conduits and the gels, and things like that, that we – that we reported on. And, of course, we did prepare reports, none of which mention any of the other technologies. They’re only related to the light guides.
According to Dr Fraval, in 2004 R & D Consulting's work on the wall panels slowed down and the work was never finished because he was never able to give Dr Bennett any working light guides to test in the wall panels. Despite this statement by Dr Fraval, Dr Bennett said in his witness statement that: Some initial experiments were done using Scallan Wall. In cross-examination Dr Bennett was asked whether HFN had ever provided to R & D Consulting a working light guide and he responded: I believe our people did, but I – I never received one myself. But I know that I was on several occasions asked to give him a call and see where they were. When again asked that question in cross-examination, Dr Bennett said: Look – look, what you're asking are the specifics, and that – that was all handled by the engineers, not by me. I – I was the office jockey. You know, I’m – I’m in the background. I can’t recall ever getting one myself, but I do believe that some of our team did get the light guides eventually, but it was a very frustrating time for them.
When the Scallan Wall project was abandoned, Dr Bennett said that R & D Consulting engaged subcontractors to begin experimenting with another type of fibreglass wall. In his witness statement Dr Bennett said there was significant design and experimentation conducted on the fibreglass walls from about 2005. There were difficulties with this method in being able to get the light guides to successfully transmit light through a wall. He said various experiments were done with designs and materials used in the walls. For example, acrylic conduits and propylene conduits were experimented with as the conduits that would house the light guides in the wall panels. Glass polymer reinforced cement was also trialled as part of the experimentation process. He said the research and development of this part of the HFN project was conducted in Geelong by subcontractors of R & D Consulting. Dr Bennett said R & D Consulting's subcontractors built around three or four prototypes. The prototype wall panels had conduits integrated for the light guides. Despite all of that, Dr Bennett then said: R & D Consulting and its subcontractors had enormous difficulties caused by delays in waiting for working light guides from HFN and Hadrian Fraval. We needed the working light guides to be able to test the prototype wall panels that were built with integrated conduits for the light guides.
Attached to Dr Bennett's witness statement were three documents described as Reports 1, 2 and 3. The reports are undated but were signed by Dr Bennett. These reports were said to have been reports provided to HFN during the course of the project which were prepared by R & D Consulting in conjunction with its subcontractors.
Report 1 states that R & D Consulting had evaluated the concept of creating conduits within the Scallan Wall house. The report does not say that any experimentation was conducted with the conduits which might house the proposed light guides. In fact, the report simply states: We have started to look at various systems for conduit formation…. The report refers to 3 systems of conduit formation; the split wedge, polypropylene or acrylic conduit, and polystyrene insert. The report simply explains what those systems are. In the penultimate paragraph, the report states: Obviously this work is dependent on getting the Aerogel light-guides in a timely fashion. Please advise when these will be sent to us. By way of confirming that no experimentation had been conducted with the insertion of conduit in the Scallan Walls, a report from DTC Constructions dated 31 December 2004 states, in its final paragraph: A range of conduits will be tested for strength and flexibility. Despite this evidence, in his cross-examination Dr Bennett said that experimentation with conduits was undertaken at the time the homes were being constructed at the Glenferrie Road Malvern location. This evidence is clearly inconsistent with the DTC Constructions report.
Report 2 appears to deal with the fibreglass walls. It stated that the split wedge conduit seem to work for short distances of 1 to 2 m but not with longer lengths and it was not the correct option to use. Similarly, problems were encountered with the polystyrene insert. R & D Consulting found that the polypropylene or acrylic conduit was suitable. In fact, what was used was 12 mm round thin-walled electrical conduit. It needed to be tested in terms of feeding the light guide through the conduit when R & D Consulting was able to get samples from HFN. R & D Consulting also considered another option, that being to create a channel in the inner wall surface allowing the light guide to be inserted directly into the wall and then to have the channel closed over with mortar filling to encase the light guide. With respect to Dr Bennett, the evaluation of these methods of inserting conduit to house light guides is rudimentary. Furthermore, it is clear that R & D Consulting had not received any light guides from HFN at this stage. Plainly, there could be no evaluation undertaken at this point in time. The statement dealing with the split wedge and polystyrene inserts conduit appears to be fabrication. Dr Fraval had not provided any light guides to Dr Bennett and therefore it could not have been possible for R & D Consulting to have conducted testing of any form of conduit. As Dr Fraval said in his witness statement: The work was never really finished as I was never able to give Ian Bennett any working light guides to test in the wall panels.

The problem, as I see it, is that in a situation where a company purports to have incurred a liability, where that liability is to a related entity or party, and the liability is in itself by way of a notional loan to the company, the question which inevitably arises is whether that liability can be said to have been definitively incurred at that time or whether it is conditional upon the company being able to pay at some future date. This is of course particularly so where the transaction itself is not documented but simply recorded in the accounts. This is further exacerbated in this case by the fact that the accounts of HFN for the 2004 income year disclose its cash balance at $12.
On 20 October 2004 HFN received a tax offset payment from the ATO in the amount of $228,315.59. Despite that receipt, there is no evidence in the accounts of the payment of rent in arrears for the 2004 income year, or payment for the 2005 income year. In fact, there is no indication that any payment in respect of rent or repayment of the notional loan ostensibly used to pay the rent was repaid in 2006 income year. In my opinion, this raises the serious question as to whether that liability was definitively incurred in the years it is recorded in the accounts. There was no other evidence which would support a definitive liability having been incurred in the 2004 and 2005 income years for the so-called rental payments. There was no evidence of a repayment date for the loans. On that basis, I must find that HFN has not discharge its onus of substantiating the incurring of R & D expenditure by way of rent in either the 2004 or 2005 income years.
UTILITIES AND TELEPHONE EXPENSES
HFN claimed expenses for the use of utilities being electricity, gas, and water; and telephone expenses in its research and development activities. HFN claimed $815 for use of utilities in the 2004 income year; and $812 for use of utilities and $382 for use of telephone in the 2005 income year. In calculating the expenses which relate to utilities, Dr Fraval said in his witness statement that he took into account a portion of the rates paid on his home. Dr Fraval did not have invoices for water and electricity for the 2004 income year. He testified that he used the figures for water and electricity in 2005 income year for the purposes of that calculation. He provided invoices for rates, gas, electricity and water for the 2005 income year.
Dr Fraval testified that he used electricity, gas and water in his work on the R & D project which he did at home. He said he used filtered deionised water to clean the tubes and that he used gas-fired central heating and electricity for all electrical equipment used in the project such as pumps and light sources, heating of materials, storing materials and sonification of the aerogel. He said he proportioned those expenses to about 14% of the total utilities bill for each year.
As I have already said above, Dr Fraval said that these expenses were also paid by way of notional loan by him to HFN. The general ledger printout for the 2004 income year discloses utilities expenditure of $815.23 and the 2005 income year has utilities expenditure of $811.85. There is no telephone expenditure recorded for the 2004 income year and the 2005 income year has an entry in the amount of $382.41.
The same problem arises with these expenses as with the notional expenditure for rent. I am unable to identify from the accounts that these amounts were in fact included in
Dr Fraval's loan account with HFN although the general ledger would not balance if there was not a credit entry in another account. There is also insufficient evidence for me to establish that these liabilities were definitively incurred as stated in the accounts. In that respect, I must again find that HFN has not discharged the onus of proving, on the balance of probabilities, that these expenditures were incurred in the income years stated.
TRAVEL EXPENSES
Dr Fraval claimed a total of $8205 which he said was incurred directly in respect of the
R & D project in the 2004 income year. The Commissioner allowed Dr Fraval’s expenses amounting to $6885 but refused the remainder. Despite the fact that Dr Fraval's diary entries of this travel indicate that it was undertaken in the 2003 income year, the Commissioner allowed this expenditure except for an amount referred to as travel allowance which, although not described by the Commissioner in his reasons for decision on the objection decision, appear to be for daily living expenses including food. While it is not clear to me why the expenditure was allowed at all, as it was not incurred in the claimed year of income, I do not see it as my duty to overturn that decision. The definition of research and development expenditure in s. 73B makes it clear that the expression means expenditure incurred by the company during the year of income. For that reason alone, I cannot accept that the claimed balance, $1320, was expenditure incurred in the year of income being the 2004 income year. That is despite the fact that the general ledger records travel expenses of $8205.49 as at 30 June 2004. It is simply incorrect on Dr Fraval's evidence.
PENALTIES
The Commissioner imposed penalties on HFN for the 2004 and 2005 income years pursuant to s. 284-75 (1) of Schedule 1 of the TAA which provides:
(1) You are liable to an administrative penalty if:
(a)you or your agent makes a statement to the Commissioner or to an entity that is exercising powers or performing functions under a taxation law; and
(b)the statement is false or misleading in a material particular, whether because of things in it or omitted from it; and
(c)you have a shortfall amount as a result of the statement.
Section 284-80 of the TAA sets out when a taxpayer may have a shortfall amount. Item 1 of the table under that section refers to a tax related liability for an accounting period worked out on the basis of the statement which is less than it would be if the statement were not false or misleading.
In his objection decision for the 2004 and 2005 income year, the Commissioner said that HFN's statements regarding claimed expenditure were false and misleading in a material particular as they could not be substantiated. In both income years, the Commissioner determined that HFN should pay a base penalty amount of 25% for lack of reasonable care. This is in accordance with the requirement set out in s. 284-85 of the TAA which provides that the first step is to work out the base penalty amount under s. 284-90. If the base penalty is not increased under s. 284-220 or reduced under s. 284-225, then the base penalty is the amount of the penalty. Section 284-90 (1) contains a table which is to be used in working out the base penalty amount. Item 3 under that table, which attracts 25% of the shortfall amount penalty, provides:
3 Your shortfall amount or part of it resulted from a failure by you or your agent to take reasonable care to comply with a taxation law
Prior to the introduction of Division 284 into Schedule 1 of the TAA in 2000, the provisions dealing with penalty for shortfall were found in ss. 226G, 226H, 226J, 226K, 226L and 226M of ITAA 1936. Section 226G dealt with penalty tax where the shortfall was caused by lack of reasonable care. It provided:
Subject to this Part, if:
(a)a taxpayer has a tax shortfall for a year; and
(b)the shortfall or part of it was caused by the failure of the taxpayer or of a registered tax agent to take reasonable care to comply with this Act or the regulations;
the taxpayer is liable to pay, by way of penalty, and additional tax equal to 25% of the amount of the shortfall or part.
In construing s. 226K in Federal Commissioner of Taxation v Traviati (2012) 205 FCR 136, Middleton J made it clear, at 143, that the starting point in interpreting tax legislation is to consider the text itself. He referred to the High Court of Australia decision in Alcan (NT) Alumina Pty Ltd v Commissioner of Territory Revenue (2009) 239 CLR 27 where Hayne, Heydon, Crennan and Kiefel JJ said:
This court has stated on many occasions that the task of statutory construction must begin with a consideration of the text itself. Historical considerations and extrinsic materials cannot be relied on to displace the clear meaning of the text. The language which has actually been employed in the text of legislation is the surest guide to legislative intention. The meaning of the text may require consideration of the context, which includes the general purpose and policy of the provision, in particular the mischief it is seeking to remedy.
Although Middleton J was considering the differences between ss. 226G and 226K, he said this about the expression reasonable care at 144:
… Reasonable care suggests an objective test, but the particular (and subjective) circumstances relevant to the taxpayer are to be considered in applying the test. So the taxpayer must exercise the care that a reasonable person would be likely to have exercised in the circumstances of the taxpayer.
Greenwood J comprehensively dealt with the meaning of the expression reasonable care as used in Division 284 of the TAA in Aurora Developments v Federal Commissioner of Taxation (2011) 196 FCR 457. He referred to the Revised Explanatory Memorandum to the 2000 Bill and concluded, at 465:
It follows as a matter of principle that the reasonable care test calls upon a taxpayer to exercise the care that a reasonable person would be likely to have exercised in the circumstances of the taxpayer in fulfilling the taxpayer's tax obligations. The test looks to whether such a person would have foreseen, as a reasonable probability or reasonable likelihood, the prospect that the action or step or the failure to act or take an affirmative step would result in a shortfall amount and in determining that question, a relevant factual enquiry is whether the taxpayer made the reasonable attempts a person in the position of the taxpayer ought to have taken so as to comply with the provisions of a taxation law.
Greenwood J also provided two observations from authorities which he said might usefully be noted. The first was from the Federal Court decision in North Ryde RSL Community Club Ltd v Federal Commissioner of Taxation (2002) 121 FCR 1 where Spender, Finn and Merkel JJ referred to the fact that the Administrative Appeals Tribunal did not identify any other step that the taxpayer ought to have taken but did not take, or any step it did take that it ought not to have taken. He therefore said, at 466:
…Therefore, one question to be answered in determining whether the taxpayer and its advisers took reasonable care is whether, on the facts, there are steps that the taxpayer ought to have taken but did not take or steps that it did take that it ought not to have taken.
The second observation made by Greenwood J was from the Federal Court decision in MLC Ltd v Deputy Commissioner of Taxation (2002) 126 FCR 37, a decision of Hill J. His Honour said, at 466:
… Hill J observed at [53] that "a taxpayer who relies upon expert advice as here where the advice is held generally in the industry and does not conflict with any statement made by the Commissioner… is not required to obtain a ruling to guard against an allegation that the taxpayer has not exercised due care".
Mr Evans submitted that HFN or its tax agents failed to take reasonable care in preparing its 2004 and 2005 income tax returns, having regard to the relevant circumstances including, but not limited to, the directors' level of knowledge, education, experience and understanding of the tax laws as well as the size of the claims.
Dr Bender submitted that to determine whether the penalties were appropriate, each item of expenditure needed to be considered independently.
Dr Bender submitted that HFN had an invoice and accounts to support the expenditure for the consulting fees of Mr van der Matten. He said that if the expenses were not deductible under s. 73B because of lack of substantiation, then HFN could hardly have acted with the lack of reasonable care when it had documentation to support that expenditure. The problem with that submission is that one needs to look at precisely what the invoice, which is dated 8 September 2003, stated. It referred very broadly to engineering services in connection with solar tiles and solar pave using glass reinforced concrete. There was no evidence of any engineering services provided nor did the description on the invoice fit within any of the registered activities for the 2004 income year. Although Dr Fraval said in evidence that he discussed the original aerogel coating with Mr van der Matten, there is nothing in the invoice which would even suggest that was one of the services which Mr van der Matten provided.
In my opinion, this is not the case of where HFN simply got it wrong. There was no basis in the documentary evidence which would enable substantiation of the invoiced expenditure as being referable to any of the registered activities in the 2004 income year. Furthermore, Dr Fraval is no stranger to making R & D claims, having done so in the past. I have no doubt that he was fully aware of the substantiation requirements demanded by the Commissioner in such claims. I find that HFN did not take the care a reasonable person in the circumstances of HFN (through Dr Fraval) would have taken in making a R & D claim for this expenditure. At the very least, I would have expected HFN to obtain a detailed invoice from Mr van der Matten regarding the work he claimed to have done, particularly having regard to the substantial sum of money involved.
As for the R & D Consulting expenditure, Dr Bender submitted that HFN had a contract and invoices supporting those consulting fees. Regarding the written contract, as I have indicated above, what R & D Consulting claimed to have performed in respect of the

R & D contract work bears little resemblance to the terms of the contract. Furthermore, the invoices issued by R & D Consulting were not in accordance with the contract. The amount claimed to be invoiced by Dr Bennett was the astonishing amount of approximately $273,464. In fact the sums of money invoiced were substantially in excess of the contract and despite the large sums invoiced, the invoice statements simply contained a one sentence description referring to consultancy and project management in relation to the development of natural sunlight into buildings. Also, HFN did not make any payments towards those invoices but rather, some of this expenditure was said to have been set off against expenditure owed to other entities, all of which were involved in R & D claims.
It will also be recalled that at the time these astonishing sums were invoiced by R & D Consulting, HFN had not managed to develop a light guide which was functional in terms of its intended purpose. The most that can be said about the work conducted by

R & D Consulting is that it claimed to have evaluated the concept of creating conduits within the Scallan Wall. No work was done with the light guides themselves as there were no light guides to work with. The description on the invoices issued by R & D Consulting bear no resemblance to the registered R & D activities. Finally, the expenditure said to have been incurred was said to have been discharged by a set-off arrangement as a result of what appears, in an unexplained way, to have been an arrangement between R & D Consulting and Poly Optics to provide aerogel tubing to Poly Optics. With respect to Dr Fraval, his experience with R & D activities would, in my opinion, have alerted him to the very doubtful nature of these transactions particularly regarding the substantiation of the expenditure said to have been incurred. I find that HFN did not take the care a reasonable person in its position would have taken when making an R & D claim for this expenditure.
Regarding the licence fee and cost of aerogel tubing expenditure, Dr Bender again submitted that HFN had objective documentary evidence, including invoices and accounting records of Translight and Rofin, to support the existence of the licence fee expenditure and the tubing expenses. He also referred to the fact that there was a contemporaneous report by AusIndustry to support the evidence given by Dr Fraval and Mr Sachlan Fraval that there was an issue with the licence fee which caused them to alter their R & D concession claim for the 2004 income year and to claim part of the fee in the 2005 income year. Dr Bender submitted that HFN took reasonable care because it took a recent approach to the deductibility of this expense.
With respect to Dr Bender, I cannot agree with this submission. The first point to make regarding the licence fee is that the only evidence of an assignment of the aerogel patent to Translight from Enterprise Development Corporation was Dr Fraval's oral evidence. The agreement granting a licence to HFN to use the patent was executed only by HFN. That in itself gives rise to serious doubts about its enforceability. Furthermore, the document is, with respect to the draftsperson, a very poor example of an agreement if it can be properly described as such. Regardless, HFN appears to have relied on it to demonstrate there was such an agreement and yet it attempted to disavow the fact that it stated the licence fee, said to be US$25,000, was to be paid on a one-off basis. Subsequently, it was submitted that there were a number of variations to the agreement made orally despite the fact that the agreement itself contained a clause indicating such variation was impermissible. As Finn J said in GEC Marconi Systems, at [218]:
For an alleged subsequent variation to be contractually effective notwithstanding non-compliance with the written modification requirement, it must itself otherwise satisfy the requirements of the ballot contract, i.e. "the terms of the arrangement must be certain, and… There must generally be real consideration for the agreement"…
There was no evidence of consideration for the varied agreement or that the parties, and in particular Translight, agreed to the oral variation. Neither Dr Fraval nor Mr Sachlan Fraval could speak for Translight.
To add to HFN's problem, the agreement contemplated payment for the licence fee and the aerogel tubing by way of a convertible note. This later, by the stroke of the pen in the accounts of HFN, became a loan after HFN was informed that the issue of the convertible note meant that a pecuniary liability ceased to exist. With respect to Dr Fraval, the artificiality of this entire transaction would have been apparent to a reasonable person in his position. Accordingly, I find that HFN did not take the care a reasonable person in the circumstances of HFN would have taken in making a claim for the licence fee expenditure in both income years in question. This finding applies equally to the $443,675 claim for aerogel tubing in the 2004 income year. It was also the subject of the convertible note and the subsequent purported loan.
I have found that the aerogel tubing in its entirety was in fact valueless. Despite coating some 37,000 feet of tubing with aerogel, Translight did not sell so much as one foot of that product which it held as inventory, which, in the US, is generally regarded as trading stock. In fact, in a letter from Dr Fraval to the Commissioner dated 31 July 2007 he described that tubing as a dead inventory to Translight. Of course the same description can be applied to that inventory when it was acquired by HFN. It was not a marketable product. On that basis, it is unrealistic to expect that any entity would acquire that inventory at cost if it were dealing at arm’s length with Translight. In fact, in cross-examination, in the course of being asked whether he asked any questions about the coating of the tubing of anyone at FTI when the tubing was purchased Dr Fraval said: If we had, with hindsight, been able to be a fly on the wall and found out that it wasn't the same value, we would have, obviously, had a much more rigorous negotiation regarding the price. Dr Fraval was clearly aware of that and hence the decision to attempt to recover the expenditure incurred in producing aerogel coated tubing. On that basis alone, it cannot be said that the claimed expenditure on the aerogel tubing was reasonable. I include in that the second invoiced amount of $166,246 claim in the 2005 income year. I find that HFN did not take the care a reasonable person in its circumstances would have taken in making a R & D claim for the expenditure said to have been incurred in acquiring aerogel coated tubing.

Regarding travel expenses, while the Commissioner allowed a substantial portion of those expenses, the small amount disallowed was in respect of what Dr Fraval described as travel allowance. In my opinion, Dr Fraval was well aware that the Commissioner would not allow this sum which was expenditure on daily living expenses including food. They are not directly related to R & D activities.
Dr Bender submitted that the depreciation expenses claim by HFN in respect of capital assets were reasonable as they were assets used in the research and development project. He also submitted that HFN acted with reasonable care because the assets were recorded in its accounting records and there was photographic evidence to support the existence of the fume cabinet. Having examined the notes made by Dr Fraval while conducting experiments at his home, it was not difficult to accept that the fume cabinet was necessary and used in the course of that work. I did not however have objective evidence regarding ownership or cost of the purchase or the date on which it was purchased. Regarding this item of expenditure, I find that HFN did not take the care a reasonable person in its circumstances would have taken in making a R & D claim for that expenditure.
As for the other capital items on which depreciation was claimed, there was no evidence that they were used directly in the R & D activities. For example, the electrical control box was likely never used as it was intended to be used in the environmentally friendly house as part of the control mechanism for remote control of the systems in the house. There was no evidence of any activities which remotely resemble what was its described use. Likewise, there was no evidence about how the computer and printer were used in or directly related to the R & D activities. Regarding these items of expenditure, I find that HFN did not take the care a reasonable person in its circumstances would have taken in making a R & D claim for that expenditure.
Dr Bender submitted that HFN's claim for rental expenses and utilities was reasonably based. He said there were objective documents substantiating the method by which the rental expenses and utilities were calculated. Although Dr Bender agreed that HFN did not have all the utilities invoices for the 2004 income year he said the liability for that year was recorded in the accounts of HFN and accordingly it exercised reasonable care in claiming those expenses. With respect, I cannot agree.
While I have no doubt that Dr Fraval conducted experiments at his home, the problem with the rental expense and utilities claimed expenditure goes to whether that expenditure was in fact incurred. As I have already mentioned above, a simple entry in the books of account indicating a notional loan does not substantiate the incurring of expenditure. When one looks at the circumstances of HFN at the time it incurred these claimed expenses, it was either in a position where it simply did not have the funds to meet those expenses or, when it did have the funds which could have been used to pay those expenses, it did not do so. In my opinion, it should have been apparent to Dr Fraval that HFN could not substantiate this expenditure by simply pointing to an entry in the books of account of HFN indicating a loan entry. In fact, when examining Dr Fraval's loan account entries in HFN's accounts, it is clear that adjustments have been made from time to time without explanation. Frankly, the accounts are in an unsatisfactory state. For those reasons, I find that HFN did not take the care a reasonable person in its circumstances would have taken in making R & D expenditure claims in respect of rent and utilities.
As for the claimed telephone expenses, other than entries recorded in HFN's books of account, there was no evidence of the expenditure claimed or, if there were telephone expenses, that they were directly related to the R & D activities he conducted at his home. In fact even the entries in the books of account do not enable identification of this specific item being credited to his loan account with HFN. I find that HFN did not take the care reasonable person in its circumstances would have taken in making a R & D claim to this expenditure.
REMISSION OF PENALTIES
Section 298-20 of the TAA provides that the Commissioner may remit all or part of the penalty. It does not set out the basis upon which the Commissioner should exercise his discretion.
When dealing with the discretion in s. 298-20 of the TAA, Collier J in Commissioner of Taxation v Dixon (Trustee) (2007) 67 ATR 87 at 97 referred to the High Court decision of Minister for Aboriginal Affairs v Peko-Wallsend Ltd (1986) 162 CLR 24, when Mason J said at 39-40:
What factors a decision-maker is bound to consider in making the decision is determined by construction of the statute conferring the discretion. If the statute expressly states the considerations to be taken into account, it will often be necessary for the court to decide whether those enumerated factors are exhaustive or merely inclusive. If the relevant factors – and in this context I use this expression to refer to the factors which the decision-maker is bound to consider – are not expressly stated, they must be determined by implication from the subject matter, scope and purpose of the Act. In the context of judicial review on the ground of taking into account irrelevant considerations, this court has held that, where a statute confers a discretion which is in its terms unconfined, the factors that may be taken into account in the exercise of the discretion are similarly unconfined, except in so far as there may be found in the subject matter, scope and purpose of the statute some implied limitation on the factors to which the decision-maker may legitimately have regard… By analogy, where the ground of review is that a relevant consideration has not been taken into account and the discretion is unconfined by the terms of the statute, the court will not find that the decision-maker is bound to take a particular matter into account unless an implication that he is bound to do so is to be found in the subject matter, scope and purpose of the Act.
Collier J also referred to the Explanatory Memorandum 2000 [35] which refers to a number of factors which the Commissioner should take into account when deciding to remit a penalty. Those factors included treating taxpayers in like circumstances consistently; considering a taxpayer's particular circumstances and compliance history; and tailoring the penalty to secure improvements in compliance behaviour. After completing a detailed analysis of cases dealing with the remission of penalties, her Honour referred to a number of considerations which she considered to be of assistance. She said, at [48]:
Fifth, the explanatory memoranda previously noted in this judgement support the conclusion that Parliament intended that the particular circumstances and compliance history of the taxpayer are of key importance in relation to the exercise by the Commissioner of his remission discretion. Reference in the Explanatory Memorandum 1992 to the flexibility of the Commissioner in relation to his remission discretion "to deal with hard cases that may arise" emphasises the exceptional nature of the exercise of the discretion, with reference to the circumstances of the taxpayer.
Mr Evans submitted that HFN had provided no material which disclosed any circumstances relevant to determining whether the penalties should be remitted. It provided no evidence of good compliance history nor had it provided evidence to show that the penalty was harsh having regard to its circumstances. Accordingly, the base penalty amount of the shortfall should not be remitted.
Dr Bender submitted that it would be appropriate to remit the penalties as it would be harsh and unreasonable to impose a penalty in the circumstances because the R & D concessions are intended to benefit taxpayers and encourage innovation. Furthermore, although the initial ATO audit was conducted in 2005, the AusIndustry assessment requested by the ATO was not completed until 2007 and it was not until 2009 HFN was informed that the assessment was denied on a basis other than that the project was not research and development. HFN had to lodge its 30 June 2005 income tax return in the interim. In those circumstances, Dr Bender submitted it would be harsh and unreasonable to impose penalties for the 2005 income year because the Commissioner had given no indication prior to the applicant lodging that income tax return that the treatment of the expenses in an income year were not appropriate on any basis other than that the activities did not constitute R & D activities.
In my opinion, the penalties in both income years should not be remitted. HFN, through the experience of Dr Fraval in making R & D tax claims, was well aware that the system relied on self-assessment. Furthermore, he was well aware of the need to substantiate the claimed expenditure said to have been incurred in the course of those activities. That of course includes keeping accurate records of expenditure and work conducted. In fact, the R & D tax concession application forms contain a declaration which was signed by Dr Fraval in each of the income years. It states:
I declare that I am an officer of the applicant company authorised to make this declaration. The company, while undertaking the activities described in this application, has maintained contemporaneous records, including an R&D Plan in accordance with the IR&D Board's Guidelines on R&D Plans 2001, that substantiate the carrying on of the activities. I further state that to the best of my knowledge and belief the information in this application is true and correct in material details, and that the activities and corresponding expenditure described in this application meet all prescribed eligibility requirements for the R&D Tax Concession.
Given that Dr Fraval signed the declaration and that he has had previous experience in making R & D tax concession claims, I find that it cannot be reasonably said that it would be harsh and unreasonable to impose penalties as the Commissioner has done. HFN should remain liable for the 25% base penalty amount of the shortfall in each of the income years in question.
CONCLUSION
On 18 November 2009 the Commissioner issued to HFN notices under s. 73IA of the ITAA 1936 stating that the tax offset allowable for the 2004 and 2005 income years was $0. HFN objected to those notices and on 16 April 2010 the Commissioner delivered his Objection Decision in respect of the 2004 and 2005 income years. The outcome of that decision for HFN was that, in respect of the 2004 income year, HFN was not entitled to choose the R & D tax offset under s. 73I of the ITAA 1936. The Commissioner also determined that the expenditure claimed was not an allowable deduction. He issued a penalty at the rate of 25% of the tax shortfall for that income year. For the 2005 income year, the Commissioner found that HFN was only entitled to choose the R & D tax offset for consultancy expenses and the amount of $53,548. The Commissioner found that the remaining claimed expenditure was not an allowable deduction and imposed a 25% penalty on the shortfall amount.
I have found that the claimed expenditure on consultancy services was not substantiated because that expenditure was not incurred directly in respect of a R & D activity. As for the technology licence fee in respect of the aerogel coated tubing, I have found that the claimed expenditure was not incurred because I have found that there was no enforceable agreement between Translight and HFN which resulted in a pecuniary liability or, if there was an enforceable agreement, the pecuniary liability was extinguished upon the issue of a convertible note. I have also found that if the convertible note was subsequently converted into a loan, HFN has not discharged its onus to establish, on the balance of probabilities, that the parties reached agreement orally to convert that liability into a loan liability following the issue of the convertible note. Even if they did, the evidence discloses that this expenditure was capitalised and is therefore not able to be set off against revenue.
In my opinion, HFN failed to substantiate the claimed expenditure in respect of the acquisition of the aerogel coated Ionimer tubing. The claimed expenditure for the 2004 income year was subject to the convertible note issued by HFN. Even if I were to accept that the convertible note was subsequently abandoned and replaced by a loan liability, given that HFN apparently capitalised that expenditure, even if it was incurred, it is not against the revenue account and is therefore not deductible. While the 2005 income year claimed expenditure was not subject to the convertible note, I have found that HFN has failed to discharge its onus of proving, on the balance of probabilities, that it incurred the claimed expenditure.
Although HFN claimed expenditure in the 2004 and 2005 income years for depreciation of assets used in the R & D project, I have found that it has failed to discharge the onus of proving, on the balance of probabilities, either that it owned the assets in those income years or that they were used in the R & D project. I have also found that HFN has failed to discharge its onus of proving that it incurred rent expenses, utilities expenses, telephone expenses and travel expenses in the income years in question.
The Commissioner imposed penalties on HFN for both income years at the rate of 25%. I have found that HFN did not take the care a reasonable person in like circumstances would have taken in making a R & D claim for expenditure it incurred. It was not able to substantiate that expenditure. Therefore, I have found that the Commissioner's decision to impose penalties in both income years was correct. I have also found that there was no basis for remission of those penalties. The Commissioner's decision to impose penalties was not harsh or unreasonable.
In my opinion, the decision made by the Commissioner on 16 April 2010 was correct. I affirm that decision.

I certify that the preceding 303 (three hundred and three) paragraphs are a true copy of the reasons for the decision herein of

Egon Fice, Senior Member

......[sgd]..................................................................
Associate
Dated 12 March 2013

Dates of hearing
13 - 16 March 2012;
20 - 22 August 2012

Counsel for the Applicant Dr P Bender

Solicitors for the Applicant Foster Nicholson Legal

Counsel for the Respondent Mr N Evans

Solicitors for the Respondent Australian Taxation Office,
Legal Services Branch

Division	TAXATION APPEALS DIVISION
File Numbers	2010/2281 2010/2437
Re	Hadrian Fraval Nominees Pty Ltd
APPLICANT
And	Commissioner of Taxation
RESPONDENT

Tribunal	Egon Fice, Senior Member
Date	12 March 2013
Place	Melbourne

30 June 2004 Expenditure	Expenditure denied by Commissioner	Expenditure allowed by Commissioner
Aerogel tubing and aerogel technology licence fee (Described more generally as ‘Materials’ and ‘licence fee’)	$479,907
R & D consulting contract	$55,000
Consultant assistance with experimentation	$39,625
Travel expenses	$1320	$6885
Depreciating assets used in R & D project	$3312
Rent for facilities used for experimentation on R & D project	$11,055
Utilities used in experimentation processes in R & D project	$815
Motor vehicle expenses	$1714
Total	$592,748	$6885

30 June 2005 Expenditure	Expenditure denied by Commissioner	Expenditure allowed by Commissioner
Aerogel tubing (referred to as materials or Coated fiber optic coils)	$166,246
Aerogel technology licence fee	$36,232
Poly Optics consulting	$53,548
R & D Consulting contract	$198,604
Telephone	$382
Depreciating assets used in R & D project	$3312
Rent for facilities used for experimentation on R & D project	$10,224
Utilities used in experimentation processes in R & D project	$812
Motor vehicle expenses	$2199
Total	$418,011	$53,548

Dates of hearing	13 - 16 March 2012; 20 - 22 August 2012
Counsel for the Applicant	Dr P Bender
Solicitors for the Applicant	Foster Nicholson Legal
Counsel for the Respondent	Mr N Evans
Solicitors for the Respondent	Australian Taxation Office, Legal Services Branch