Hyde and Ors and Commissioner of Taxation
[2007] AATA 1800
•21 September 2007
Administrative Appeals Tribunal
DECISION AND REASONS FOR DECISION [2007] AATA 1800
ADMINISTRATIVE APPEALS TRIBUNAL )
)No WT200300265-267
) WT200400041-42 ) WT200400310
TAXATION APPEALS DIVISION ) Re ANDREW PHILIP HYDE
WILLIAM REGINALD WEBBER
FREDERICK RICHARD FERDINANDSApplicants
And
COMMISSIONER OF TAXATION
Respondent
DECISION
Tribunal Mr A Sweidan, Senior Member Date21 September 2007
PlacePerth
Decision The Tribunal affirms the decisions under review. ...........[Sgd Mr A Sweidan]...........
Senior Member
CATCHWORDS
Income Tax – deductions “Freedom Express’ franchises – whether amounts paid for franchise and other fees deductible – whether outgoings incurred in gaining or producing assessable income or in carrying on a business – whether capital
LEGISLATION
Income Tax Assessment Act 1936 (Cth) s51(1)
Income Tax Assessment Act 1997 (Cth) s8-1
CASES
Australian Trade Commission v Disktravel [1999] FCA 1399,
Cliffs International Inc v FCT (1979) 142 CLR 410
Clowes v Commissioner of Taxation (Cth) (1954) 91 CLR 209
Commissioner of Taxation v Brand (1995) 31 ATR 326
Commissioner of Taxation v Broken Hill Pty Company Ltd (2000) 179 ALR 593 Commissioner of Taxation v Cooke (2004) 55 ATR 183,
Commissioner of Taxation v Emmakell Pty Ltd (1990) 22 FCR 157
Commissioner of Taxation v Krakos Investments Pty Ltd (1995) 61 FCR 489
Commissioner of Taxation v Lau (1984) 6 FCR 202Commissioner of Taxation v Sleight (2004) 136 FCR 211
Commissioner of Taxation v Walker (1984) 84 ATC 4553,
Enviro Systems Renewable Resources Pty Ltd v ASIC (2001) 80 SASR 1
FCT v South Australian Battery Makers Pty Ltd (1978) 140 CLR 645
Federal Commissioner of Taxation v Roberts (1992) 37 FCR 246
Ferguson v FCT (1979) 26 ALR 307
Fletcher v Federal Commissioner of Taxation (1991) 173 CLR 1
Hallstroms Pty Ltd v FCT (1947) 72 CLR 634
Hope v The Council of the City of Bathurst (1980) 144 CLR 1
Macquarie Finance Ltd v Commissioner of Taxation (2004) 210 ALR 508
Madison Pacific Property Management and Ors v Australian Securities Commissioner 30 ACSR 218
Magna Alloys & Research Pty Ltd v Federal Commissioner of Taxation (1980) 33 ALR 213
Merchant v Commissioner of Taxation 99 ATC 4221
Milne v FCT (1976) 133 CLR 526
Puzey v Commissioner of Taxation (2002) 50 ATR 595; (2003) 53 ATR 614
Radaich v Smith (1959) 101 CLR 209;
Sleight v Commissioner of Taxation (2004) 136 FCR 211
Steele v Deputy Commissioner of Taxation (1999) 197 CLR 459
Sun Newspapers Ltd v Commissioner of Taxation (Cth) (1938) 61 CLR 337
Texas Co (Australasia) Ltd v Federal Commissioner of Taxation (1940) 63 CLR 382
Ure v FCT (1981) 34 ALR 237
Vincent v Federal Commissioner of Taxation [2002] FCAFC 291
Vincent v Commissioner of Taxation (2002) 124 FCR 350REASONS FOR DECISION
21 September 2007 Mr A Sweidan, Senior Member
BACKGROUND
1. The applicants claimed deductions in their income tax returns for the 1997, 1998 and 1999 years relevantly to these proceedings as follows: -
Applicant 1997 1998 1999 Hyde $45,000 $40,000 $13,169 Webber $41,200 $ 4,552 Ferdinands $40,000
The claimed deductions were disallowed by the Commissioner who also disallowed objections to the relevant assessments. The applicants have applied to the Tribunal for a review of the Commissioner’s decisions.
2. The deductions claimed by the applicants in 1997 and 1998 were for franchise fees payable in advance on entering into Master Franchise Agreements with Freedom Express Australia Pty Ltd (Freedom Express Australia). The applicant Hyde entered separate franchise agreements in 1997 and 1998. The applicants Webber and Ferdinands entered franchise agreements in 1998, although each invested in a different version of the Freedom Express franchise, as discussed below.
3. A small part of the deductions claimed by the applicants Hyde and Webber in 1999 are in relation to fees payable in that year. Most of the deduction claimed is for prepaid interest, reduced value of trading stock/cost of goods sold, and costs of a “sales provider.” The position in 1999 is separately discussed below.
ISSUES FOR THE TRIBUNAL’S DETERMINATION
4. The issue is whether the applicants are entitled to the deductions claimed for their expenditure by reason of the expenditure being deductible under S51(1) of the Income Tax Assessment Act 1936 (1936 Act) or s8-1 of the Income Tax Assessment Act 1997 (1997 Act); and, if so, whether Part IVA of the 1936 Act applies to disallow the deductions.
HISTORY OF FREEDOM EXPRESS AUSTRALIA
The formation of Freedom Express and agreements with third parties
5. The evidence before the Tribunal showed that the Freedom Express group came into existence in late 1996 to early 1997. There is no evidence that the Freedom Express name was associated with the business of personal development seminars and products before early 1997.
6. It is necessary to set out in some detail the history of various agreements entered into by the group in 1997 as these are relevant to the agreements on which the applicants’ claimed deductions are based.
7. The Freedom Express trade marks were registered in February and March 1997.
8. In 1997, Freedom Express and Freedom Express Australia made a National Licence Agreement (undated, but stamped 20 February 1997) by which:
(a)Freedom Express granted to Freedom Express Australia an exclusive licence to use the Freedom Express System and Freedom Express Image to conduct a National Operation within Australia for the supply of some or all of the Freedom Express Products and the granting of licences to conduct Freedom Express Outlets (Clause 2.1);
(b)the term of the licence agreement was 22 years (Clause 1.1);
(c)Freedom Express agreed to pay a licence fee, being a percentage (to be determined) of the Gross Profit from the sale of Freedom Express Products through the business conducted by Freedom Express Australia under the licence (Clause 3.1);
(d)Freedom Express undertook obligations including:
(i)to disclose the Freedom Express System to Freedom Express Australia as necessary;
(ii)to provide services of management guidance and operations review as it should think fit;
(iii)to provide a Manual setting out operational and promotional methods, practices and procedures generally in relation to the Freedom Express System;
(iv)to supply such of the Freedom Express Products as may reasonably be required;
(v)to take reasonable action to protect the Freedom Express System and the Freedom Express Image (Clause 4);
(e)Freedom Express Australia undertook duties including:
(i)to maximize sales coverage by the appointment of master licensees within Australia; and
(ii)to engage in advertising, promotion and marketing in support of the business (Clause 5).
9. On 28 February 1997, Freedom Express entered a Purchase Agreement with Wenald Enterprises Pty Ltd under which Freedom Express agreed to purchase various products, including all copyright, licences and other rights, owned by Wenald Enterprises for use and reproduction in Australia and New Zealand.
10. On 23 May 1997, The Seminar Company Australia Pty Ltd (The Seminar Company), Terence Butler and Tamara Butler (as trustees of the Butler Family Investment Trust and also each in his or her own right), Mark Thomas McClusky, and Equitable Funds Management Limited (EFML) made an agreement titled Freedom Express Heads of Agreement, which included:
(a)the parties recited that following negotiations commencing in about November 1996 in respect of the development, establishment, marketing and operation of a franchise system known as Freedom Express, and the ownership, control, management and funding of the Freedom Express Group (defined as meaning Freedom Express Pty Ltd, Freedom Express Australia, Freedom Express Management and Freedom Express Finance), the parties wished to set out their agreements in respect of the Freedom Express Project;
(b) EFML/the Freedom Express Group agreed:
(i)to purchase from the Butlers all of the shares issued in Freedom Express (Clause 2.2);
(ii)to purchase from The Seminar Company the Seminar Company assets, including recordings in which The Seminar Company held intellectual property rights and goods and merchandise including audio and video tapes (Clause 2.2);
(iii)to appoint the Butlers as consultants to the Freedom Express Group for 5 years for a consulting fee of $300,000 per year together with a performance bonus based on net sales (Clause 2.4);
(iv)to engage Mark McCluskey to assist Terry Butler for 2 years (Clause 2.5);
(v)to set up a telemarketing room in Queensland to be managed and directed by Freedom Express Marketing in consultation with Terry Butler (Clause 2.6);
(c)the parties further agreed that EFML (or its nominee) should have 100% legal and beneficial ownership of Freedom Express, the Freedom Express Group and control of three companies to be formed and owned on a 50/50 basis by the Butlers and EFML to conduct businesses including the business of marketing and sale of products outside Australia; the business of procuring, owning and dealing in rights; the business of arranging, marketing, conducting and presenting seminars (Clause 3);
(d)the parties agreed to enter formal agreements containing the terms of the heads of agreement (Clause 6).
11. There is no evidence that further agreements were made as contemplated in the Heads of Agreement.
12. In 1997, Freedom Express made a series of agreements with various speakers and authors, including
(a)Founders Agreements, under which Freedom Express appointed those speakers as, and the speakers agreed to be, founding members of an advisory board to Freedom Express for a period of 5 years from 1 July 1997, and to provide endorsement, support and services in accordance with the agreement.
(b) Seminars Agreements under which, among other things,
(i) each speaker agreed
a.to conduct a tour or tours in the period of 5 years from 1 July 1997, in which the speaker would conduct one or more seminars;
b.to endorse the Freedom Express Concept, the Freedom Express System and Freedom Express Products (as mutually agreed);
c.to allow Freedom Express to use his photograph, image and endorsement during the 5 year tour period to promote the Freedom Express Concept, System and Products; and
d.to make himself available to promote the tour and seminars;
e.to grant Freedom Express an exclusive right to record each seminar, and a first right of refusal to acquire exclusive copyright for Australia for the recording; and
(ii) Freedom Express agreed
a.to pay fees to the speaker, to be responsible for all costs, and to pay all reasonable expenses;
b.to pay commission of 20% of the retail selling price of Freedom Express Products sold at seminars.
(c) Licence Agreements under which
(i)speakers and authors granted to Freedom Express certain exclusive rights for Australia in relation to specified works for a period of 20 years; and
(ii)Freedom Express agreed to pay royalties (generally 10% of gross receipts);
(d)a Distribution Agreement in relation to the works of one speaker (Roger Dawson) under which Freedom Express was entitled to purchase and distribute that person’s works in Australia.
13. On 1 March 1998, Freedom Express and Freedom Express Australia made an extension of the National Licence Agreement, under which Freedom Express granted rights
(a)to supply Freedom Express Products in specified export territories (initially the United Kingdom and Canada); and
(b)to supply Freedom Express Products to Master Franchisees for re-supply by sales agents or distributors approved by Freedom Express in those export territories ; and
(c)to grant sub-licences for supply or re-supply of Freedom Express Products in the export territories. (Clauses 2.2, and Schedule)
14. On 22 June 1998, Freedom Express Australia made Approved Distributor Agreements with 4 companies, under which Freedom Express Australia appointed the approved distributor to be a non exclusive distributor for the sale of Freedom Express Products in the United Kingdom and the USA (Clause 1.2 and definition of Territory in clause 10 and the Schedule). The approved distributor was
(a) to order products from Master Franchisees (Clause 2.2); and
(b)to sell products it purchases from a Master Franchisee only to exclusive customers of that Master Franchisee (Clause 5).
Graeme Mitchell, director of Freedom Express Australia also signed as director of each of the Approved Distributors.
Marketing Of The Freedom Express Franchises
The Freedom Express Offers
Outline of the changing project offers
15. Three different versions of the Freedom Express franchises were marketed in 1997, 1998 and 1999.
16. There are 4 versions of an Information Memorandum in evidence. The T documents (at T2, V1/131) contain an early version not referred to by any of the applicants. The 3 later versions, referred to in the affidavits filed on behalf of the applicants, have been referred to in affidavits filed on behalf of the applicants as the 70,000 series, the 80,000 series, and the Freedom Express 98. For convenience, these reasons adopt those names (it should be noted that Freedom Express 98 is referred to in the applicants’ contentions as FX98).
17. Copies of the 3 later versions were produced in evidence.
18. In 1996 or 1997, Freedom Express Australia issued an information memorandum dated 13 December 1996, which offered applicants “the opportunity to carry on a business of promoting and marketing Freedom Express products, services and events under the Freedom Express System and Freedom Express Image.”
19. Benefits offered to applicants included:
(a) low initial cash outlay of $10,000;
(b) an income guarantee for the first 2 years;
(c) a possible tax deduction of up to $45,000;
(d) a possible tax saving of up to $21,915 (@ 48.7% tax rate);(e)net projected cash flow before tax of $998, rising to around $9,500 in year 10;
(f)a 20 year licence;
(g)ability to appoint a management and service company to develop and manage the business; and
(h)ability to borrow on a limited recourse basis most of the funds to cover the initial investment costs, with a loan of $36,300 repayable only from the proceeds of the business.
Applicants were also offered the opportunity to borrow $6,000 of the initial cash outlay.
20. Agreements offered to applicants included a warranty offered by Freedom Express Management Pty Ltd to pay the amount by which the gross profit of the business was less than $9272 into a clearing account to be dealt with as though it was profit of the business.
The 70,000 Series Agreements And Arrangements
The 70,000 Series Information Memorandum: Common T documents, T 5 at V1/190
21. In early 1997, Freedom Express Australia issued the 70,000 Series Information Memorandum offering applicants the “opportunity to carry on a business of promoting and marketing Freedom Express products, services and events under the Freedom Express System and Freedom Express Image as defined in the Master Licence Agreement.”
22. The executive summary of the 70,000 Series Information Memorandum stated:
“This Executive Summary allows the astute business person to quickly determine how, through the acquisition of a Freedom Express Master Licence, they will retain vital working capital within their present business by converting a tax liability into a growing, franchised business asset.
Acquisition of a Freedom Express Master Licence requires an initial cash outlay of $10,000 which, according to KPMG Chartered Accountants,… should enable the investor to claim an immediate tax deduction of $45,000. A $45,000 tax deduction will result in a tax refund of up to $16,200 (based on a tax rate of 36%) or $21,915 (based on a tax rate of 48.7%).”
And further stated:
“Features of acquiring a Freedom Express Master Licence are:
Entirely self funding after payment of the initial $10,000
Positive cash flow immediately”
23. Applicants were invited to enter agreements including a Master Licence Agreement, Management and Marketing Agreement, and a (limited recourse) Loan Agreement. The Master Licence was offered for a “territory [which] comprises a block of business and private telephone listings spread over all States of Australia.”
24. Freedom Express Australia also issued the 70000 Series (Franchise) agreements - a Master Franchise Agreement, Loan Agreement and Master Franchise Application. There is no evidence that a separate Information Memorandum was issued corresponding to the franchise documents.
The 70,000 Series Master Franchise Application - (Affidavit of applicant Hyde at annexure APH 1)
25. By executing the Master Franchise Application, the applicant (as Master Franchisee), and Freedom Express Australia, Freedom Express Finance, and Freedom Express, separately agreed to be bound by the terms of:
(a)the 70,000 Series Master Franchise Agreement; and
(b)the 70,000 Series Loan Agreement
on the basis that those agreements were executed on the commencement date.
The 70,000 Series Master Franchise Agreement - (Common T Documents, T7 at V2/248)
26. By the 1997 Master Franchise Agreement, Freedom Express Australia, as Franchisor, in consideration of the applicant as Master Franchisee paying the establishment fee, and agreeing to enter the agreement, granted to the Master Franchisee an exclusive licence to use:
(a)the Freedom Express System; and
(b)the Freedom Express Image;
to conduct one Freedom Express Outlet supplying Freedom Express Products to Specified Customers during the term of and subject to the agreement. (clause 2.1)
27. Clause 1.1 set out the term of the agreement (20 years from the Commencement Date) and defined other significant terms, including:
(a)the Commencement Date means the date of execution of the agreement as set out in the Master Franchise Application;
(b)Freedom Express Products means goods and/or services authorised by the Franchisor from time to time for supply in a Freedom Express Outlet;
(c)Freedom Express Outlet means a business conducted under licence from the Franchisor supplying some or all of the Freedom Express Products;
(d)Specified Customers means “the telephone subscribers within the country (Australia) allocated to the Master Franchisee by the Franchisor upon execution of this agreement (and being a total number of 4,000 subscribers) and notified to the Master Franchisee in writing”.
28. The Master Franchisee agreed to pay to the Franchisor the following Franchise Fees, with all fees for the first year of the agreement payable in advance on the Commencement Date:
(a)establishment fee of $1,300;
(b)annual franchise fee of $10,125 for the first year and 2% of gross profit during each subsequent year;
(c)annual service fee of $11,250 in the first year and 1% of gross profit during each subsequent year;
(d)annual marketing fee of $12,375 in the first year and 1.5% of gross profit in each subsequent year;
(e)annual hire fee $1,125 in the first year and 0.5% of gross profit in each subsequent year;
(f)training fee of $10,125 payable in relation to the first twelve months only.
Total of Franchise Fees was $46,300 in the first year and 5% of gross profit during each subsequent year.
29. The Franchisor’s obligations included:
(a)to provide services of management guidance and operations review and to provide relevant data and information as may be necessary (clause 5.1);
(b)to provide training to the Master Franchisee and its employees, agents and contractors within the first year (clause 5.2);
(c)to advertise the Freedom Express Image, the Freedom Express Product and to arrange special events, promotional activities, incentives and offers for the marketing of the Freedom Express Image and Products (clause 5.3);
(d)to make a copy of the manual available for hire to the Master Franchisee (clause 5.4);
(e)to supply to the Master Franchisee upon the Franchisor’s prices, terms and conditions of supply prevailing from time to time, Freedom Express Products as may be required for the franchised business, subject to availability (clause 5.5);
(f)to take reasonable steps to protect the Freedom Express System and Freedom Express Image (clause 5.6); and
(g)to provide promotional literature if requested and if available (clause 5.7).
30. By clause 6, the Master Franchisee undertook certain obligations, principally to conduct the franchised business efficiently and commercially so as to preserve and enhance the franchised business, the Freedom Express Image and the Freedom Express System. Further, the Master Franchisee agreed:
(a)to at all times personally manage and control the franchised business (clause 9.1); and
(b)to make a minimum number of customer calls of 4% of specified customers (that is, 160 calls) within each period of six months during the term (clause 11).
The Master Franchisee was permitted, in its absolute discretion, to appoint an Approved Sales Agent or Trained Personnel to sell Freedom Express Products though the franchised business subject to the obligation to retain the authority to direct and control such Agent or Trained Personnel (clause 9 and definitions of Approved Sales Agent and Trained Personnel).
31. The Master Franchise Agreement further provided in Clause 12 that the Franchisor warranted that the gross revenue during the period from the commencement date to 30 June 1999 would be not less than $10,996 provided that the Master Franchisee made the minimum customer calls during that period. In the event that the franchised business did not obtain the minimum gross revenue, the Franchisor would pay the Master Franchisee 60% of the amount by which the gross revenue for the initial period was less than the minimum gross revenue (defined in the agreement as “the Shortfall”).
The 70,000 Series Loan Agreement
32. By the Loan Agreement between Freedom Express Finance and the Master Franchisee, Freedom Express Finance agreed to lend $36,300 to the Master Franchisee on the commencement date of the Master Franchise Agreement (clause 2.1, and definitions of Advance and Commencement Date in clause 1.1). The Master Franchisee irrevocably authorised and directed Freedom Express Finance to apply the proceeds of the advance in payment to the Franchisor of the franchise fees (clause 2.2).
33. The Master Franchisee agreed to repay the advance and interest on the last day of each quarter during the term of the Master Franchise Agreement by making loan repayments of 85% of the gross profit in the first year, and 75% of the gross profit in each subsequent year (clause 3.1 and definitions of Loan Repayment and Payment Date).
34. Interest on the advance was to be paid at the rate of 5.5% per annum (calculated monthly) or an amount equal to the loan repayment, whichever was the lesser amount (clause 4).
35. By clause 3.2, the Master Franchisee was not required to repay the advance and interest in any way other than as provided in clause 3.1. Further, in clause 7, the loan agreement expressly provided:
“The obligations of the Master Franchisee under this agreement are entered into not as personal obligations with the intent of binding the Master Franchisee personally, but entered into for the purpose only of ensuring repayment to the lender of the advance and interest thereon in accordance with clauses 3 and 4 and of binding the property charged in terms of clause 6.”
36. By clause 5, the Master Franchisee exclusively and irrevocably authorised and directed the Lender to invoice and collect the Gross Revenue (defined by reference to the Master Franchise Agreement as “the aggregate gross income and remuneration received by or on behalf of the Master Franchisee in the conduct of the Franchised Business, before payment of income or other taxation.”) from Specified Customers on behalf of the Master Franchisee and to pay that revenue into a Clearing Account. The Master Franchisee further irrevocably authorised and directed the Lender to apply the whole of those funds in the Clearing Account
(a)to pay the cost of Freedom Express Products and the cost of freight and packaging; and then
(b)to pay Approved Agent’s sale fees (if any); and then
(c)to pay Franchise Fees to the Franchisor; and then
(d)to repay the loan repayment to the Lender; and then
(e)to pay the balance to the Master Franchisee.
The Master Franchisee further irrevocably authorised and directed the Lender to receive any payment made under the warranty and to apply that payment as if it was Gross Revenue.
37. By clause 6 the Master Franchisee charged the whole of the Master Franchisee’s interest in the franchised business, the Master Franchise Agreement and any money which may be received or become recoverable from the Franchisor or the Lender, and all moneys standing to the credit of the Master Franchisee in the Clearing Account, as security.
38. The limited recourse loans were provided by Freedom Express Finance. The limited recourse loans in respect of franchise fees were effected by journal entries without the provision of actual cash.
39. Accordingly, Freedom Express Australia was never put in funds in the significant amounts contemplated by the master franchise agreements.
40. Freedom Express Australia issued two further information memoranda before June 1998 - the 80,000 Information Memorandum and the FE98 Information Memorandum.
The 80,000 Series Agreements And Arrangements
The 80,000 Series Information Memorandum: Common T Documents T8, V2/269
41. The 80,000 Series Information Memorandum offered the opportunity to “share in the lucrative industry of sales and motivation training, seminars and related product sales with some of the worlds most acclaimed and sought after business leaders.”
42. The substance of the offer was, however, largely unchanged from that contained in the 70,000 Series Information Memorandum. The 80,000 Series Information Memorandum again offered the opportunity to carry on a business of promoting and marketing Freedom Express products, services and events under the Freedom Express System and Freedom Express Image (at Part 6, V2/284). applicants were offered “Freedom Express Master Franchise territories… which entitle the owner to participate in the expansion of the Freedom Express System around Australia.” A territory was said to be “a block of telephone listings spread over all States of Australia. Each territory will incorporate computer allocated telephone listings. The number of telephone listings in each Master Franchise territory will be allocated in multiples of 1,000 with a minimum of 4,000.”
43. Master Franchisees were offered a 2 year “Income Performance Guarantee” of at least $2,749 in the first two years for each 1,000 telephone numbers allocated (that is, $10,996 for the minimum of 4,000 numbers), if:
(a)the Master Franchisee directly canvassed at least 4% of telephone listings in their territory in each 6 month period; or
(b)the Master Franchisee appointed at least one Approved Sales Agent.
44. Master Franchisees were offered Limited Recourse Loans from Freedom Express Finance in the following general terms:
(c)the advance was a minimum of $31,200 for each Master Franchise, plus $7,400 for each additional 1,000 telephone numbers;
(d)the amount of repayment was to be limited to 85% of Gross Profit earned in the first year, and then 75% of Gross Profit;
(e)interest was at 5.5% or the amount of the actual repayments, whichever was lower.
45. Projected cash flows were given for the first 3 years only. The cash flows in the first 2 years were the amount of the Income Guaranteed (Part 7(e), V2/288)). Cash flows were based on certain assumptions set out in Part 7(g), including an average of 400 phone calls a year from the third year.
46. Further more detailed income projections were given at Part 8. Those projections show that in later years franchise fees (5% of Gross Profit) are projected to be less than $400.
The 80,000 Series Master Franchise Application: Common T documents, T9 at V2/321
47. The Master Franchise Application permitted a Master Franchisee to apply for Specified Customers in multiples of 1,000 with a minimum of 4000.
48. By executing this application, the applicant as Master Franchisee, and Freedom Express Australia, Freedom Express Finance, and Freedom Express Pty Ltd, separately agreed to be bound by the terms of:
(a)the 80,000 Series Master Franchise Agreement; and
(b)the 80,000 Series Loan Agreement
on the basis that they are agreements executed on the commencement date.
The 80,000 Series Master Franchise Agreement: Common T Documents T9, V2/301
49. The 1998 Master Franchise Agreement was in substantially the same terms as the 1997 Master Franchise Agreement. In particular:
(a)the Franchisor granted to the Master Franchisee an exclusive licence to use the Freedom Express System and Freedom Express Image to conduct one Freedom Express Outlet supplying the Freedom Express Products to Specified Customers during the 20 year term of the agreement (clause 2.1);
(b)the Master Franchisee was obliged to make Minimum Customer Calls of 4% of the Specified Customers within each 6 months of the term (clause 11);
(c)the Franchisor offered a performance warranty under which it would pay the Shortfall of 60% of the amount by which Gross Revenue for the Initial Period (to 30 June 1999) was less than the specified Minimum Gross Revenue of $2,749 per 1,000 Specified Customers (clause 12). The warranty is subject to the proviso that the Master Franchisee makes the Minimum Customer Calls. Although the Information Memorandum said that condition was relieved where the Master Franchisee appointed an Approved Sales Agent, that relief is not found in the Master Franchise Agreement.
50. Overall fees were less than under the 70,000 Series agreements. The change in the allocation of Specified Customers, permitting multiples of 1,000 with a minimum of 4,000, is reflected in the table of fees which replaces fixed fees with a table of fees per Specified Customer. Fees for the first year of the agreement were payable in advance on the commencement date:
(a)establishment fee of $1,200;
(b)annual franchise fee of $2.25 for each Specified Customer for the first year and 2% of gross profit during each subsequent year;
(c)annual service fee of $2.50 for each Specified Customer in the first year and 1% of gross profit during each subsequent year;
(d)annual marketing fee of $2.75 for each Specified Customer in the first year and 1.5% of gross profit in each subsequent year;
(e)annual hire fee $0.25 for each Specified Customer in the first year and 0.5% of gross profit in each subsequent year;
(f)training fee of $2.25 for each Specified Customer payable in relation to the first twelve months only.
The total franchise fees were $10.00 per Specified Customer, or $40,000 for the minimum of 4,000 Specified Customers, in the first year and 5% of gross profit during each subsequent year.
The 80,000 Series Loan Agreement
51. The 80,000 Series Loan Agreement was in substantially the same terms as the 70,000 Series Loan Agreement. It differed in that the amount of the advance was $1,200 plus $7.50 for each Specified Customer (a total of $31,200).
The Short Term Loan Agreement: Affidavit of Hyde annexure APH 15; Affidavit of Webber annexure WRW 14
52. Freedom Express Finance offered short term loans to applicants for the payment of Franchise Fees. By a Short Term Loan Agreement, Freedom Express Finance agreed to lend funds on terms including:
(a)the applicant irrevocably authorised and directed Freedom Express Finance to pay the proceeds of the advance to Freedom Express Australia (as Franchisor) in payment of franchise fees under the Master Franchise Agreement;
(b)the applicant agreed to repay the advance and interest by consecutive monthly instalments, beginning the month following the commencement date of the Master Franchise Agreement.
53. The limited recourse and short term loans were provided by Freedom Express Finance. The limited recourse loans in respect of franchise fees were effected by journal entries without the provision of actual cash.
54. Accordingly, Freedom Express Australia was never put in funds in the significant amounts contemplated by the master franchise agreements.
THE FE 98 AGREEMENTS AND ARRANGEMENTS
The FE98 Information Memorandum: Common T documents, T10, V2/325
55. The FE98 Information Memorandum was promoted in the 1999 tax year (Affidavit of Mitchell at page 2, paragraph 2). It must also have been promoted in the 1998 year, as the applicant Ferdinands before the Tribunal who invested under this memorandum did so by agreements made on 29 and 30 June 1998.
56. The FE98 Information Memorandum differs from the earlier documents in providing substantial information on franchising, and also in contemplating greater use of the internet in the delivery of products and services. It also states that Freedom Express has already expanded its business and proposed to further expand it by offering further Freedom Express Master Franchises.
57. In stating the business of Freedom Express, it says:
“Freedom Express owns an extensive library of world class content with exclusive marketing and intellectual property rights and has exclusively contracted speakers of universally acclaimed stature. The telemarketing and seminar sales systems upon which the Freedom Express is constantly evolving and is being enhanced to accommodate greater awareness of market conditions… The defining difference is the inclusion of specific information about hot business opportunities such as Internet technology and electronic commerce for those wishing to start a business.”
58. Under the Heading “The Master Franchise Explained” the Information Memorandum says:
“(a)Master Franchises are now offered entitling the Master Franchisee to participate in further expansion of the Freedom Express business around Australia;
(b)Freedom Express will licence Master Franchisees on a non-exclusive basis to exercise the right to engage in the business of offering, selling and distributing goods and services in Australia to Specified Customers;
(c)under the Master Franchise Terms, Freedom Express has authority to exert a significant degree of control over the Franchised Business;
(d)it may reasonably be expected that a Master Franchisee is or will be substantially dependent on goods or services supplied by Freedom Express or a person associated with Freedom Express;
(e) at the time of printing there were more than 1,000,000 Specified Customers;
(f)each Master Franchise will include the right to sell Freedom Express products and services to distributors approved by Freedom Express who will be permitted to resell Freedom Express Products. Approved Distributors are permitted to sell to an exclusive target market of 2,500 potential customers who are not part of the Specified Customers and may be located outside Australia.”
59. Master Franchisees could operate more than one outlet.
60. The Information Memorandum did not provide cash flow projections but stated those projections and “financial sensitivities” were available from Freedom Express “to determine the amount of activity required to achieve the desired level of income from the franchised business.”
61. The Information Memorandum stated the total minimum running costs, including establishment fees and first year fees prepaid, was $11,200. Freedom Express offered financial help by a loan facility of up to $8,700, with an additional facility of up to $7,500 for each additional Master Franchise. Two loan options were available:
(a)Option A, under which a Master Franchisee could obtain a Warranty under which the Master Franchisee would be required to pay 55% of Gross Profits to the Lender and Freedom Express would warrant payment of the balance of quarterly repayments for the term of the loan (up to 15 years);
(b)Option B, under which the Master Franchisee was liable to make fixed quarterly repayments over the 15 year term of the loan, with interest at 7%.
FE98 Master Franchise Application
62. The FE98 Master Franchise Application includes a series of questions to be answered by applicants, including:
(a)the time the applicant has available to fulfil commitments as a Master Franchisee (section 2);
(b)preferred distribution method (including from supplier direct to customer) (section 4);
(c)whether the applicant wishes to appoint an approved distributor (section 5);
(d)preferred training location and times (section 6);
(e)number of franchises requested.
63. The application set out a franchise fees table under which each Master Franchisee was required to pay:
(a)a once only establishment fee of $1,200;
(b)annual franchise fee of $2,250 for the first year, and 6% of gross profit in later years;
(c)annual service fee of $2,500 for the first year, and 3% of gross profit in later years;
(d)annual marketing fee of $2,750 for the first year, and 4.5% of gross profit in later years;
(e)annual hire fee of $250, and 1.5% of gross profit in later years; and
(f)training fee of $2,250 for the first year only.
Total : $11,200 for one franchise, and 15% of gross profit.
All fees for the first year and the establishment fee were to be paid in advance on the Commencement Date of the agreement.
64. Section 17 contained the application by which the Master Franchisee:
(a)applied “to Freedom Express Australia Pty Ltd as trustee for the Freedom Express Australia Unit Trust and to Freedom Express Australia Pty Ltd” to be granted the Master Franchise and to be provided the warranty (if applicable); and
(b)applied to Freedom Express Finance to be provided with the Loan(s).
It provided, among other things:
(a)where the application for a Master Franchise was accepted a separate Master Franchise Agreement in respect of each Master Franchise was immediately formed on the Commencement Date;
(b)where the application for a Warranty was accepted, a separate Warranty in respect of each Master Franchise was immediately formed on the Commencement Date;
(c)where the application for a Loan was accepted a separate Loan in respect of each Master Franchise was immediately formed on the Commencement Date.
The FE98 Master Franchise Agreement
65. Under the FE98 Master Franchise Agreement, Freedom Express Australia as Franchisor granted to an applicant (Master Franchisee) a non-exclusive licence to use:
(a)The Freedom Express System;
(b)The Freedom Express Marks; and
(c)The Freedom Express Image,
to conduct one Freedom Express Outlet offering, selling or distributing the Freedom Express Products within Australia to Specified Customers. (Clause 5)
66. Clause 41.1 set out the term of the agreement (20 years from the Commencement Date) and defined other significant terms, including:
(a)the Commencement Date means the date of execution of the agreement as set out in Section 21 of the Master Franchise Application;
(b)Freedom Express Products means goods and/or services authorised by the Franchisor from time to time for supply in or through a Freedom Express Outlet;
(c)Freedom Express Outlet means a business conducted under licence from the Franchisor for the supply of any, some or all of the Freedom Express Products;
(d)Specified Customers means “the telephone subscribers within Australia specified by the Franchisor upon execution of this Master Franchise Agreement and notified to the Master Franchisee.”
67. The obligations on the Franchisor were set out in clause 7 and were substantially the same as those under the 70,000 and 80,000 Series Agreements.
68. The obligations on the Master Franchisee were also substantially the same as in the 70,000 and 80,000 Series Agreements: see clauses 8, 10.3, 11, 12, 14, 17, 18 and 20. There was, however, no longer an obligation to make a minimum number of customer calls.
69. By clause 14, a Master Franchisee may supply Freedom Express Products by one or more of the following:
(a)personally or through employees who are Trained Personnel;
(b)through an Approved Distributor (defined in clause 41.1 - see below);
(c)by way of and strictly in accordance with any systems, methods or arrangements (if any) specified by the Franchisor from time to time in the Manual.
70. Approved Distributor was defined to mean a person who was approved in writing by the Franchisor to:
(a)purchase Freedom Express Products from the Master Franchisee for resale; or
(b)sell Freedom Express Products as agent on behalf of the Master Franchisee.
Clause 15 dealt with the appointment and approval of Approved Distributors. The FE98 Information Memorandum said that Approved Distributors may resell to persons outside Australia. Approved Distributor Agreements appoint Approved Distributors for the United States and the United Kingdom.
71. The Master Franchise Agreement provided for the Franchisor to grant to the Master Franchisee a warranty regarding Gross Profits during the period of the loan. These provisions are discussed below in the context of the Loan Terms.
72. The Master Franchise Agreement also contained
(a)a Call Option under which, with the consent of Freedom Express, the Franchisor might purchase the Master Franchise, or require it to be sold to a nominee, upon terms including:
(i)the option may be exercised in the period from the beginning of the second to the end of the fifth year after the commencement date;
(ii)consideration for the sale of 20% of the average Gross Revenue from the Commencement Date to the date of exercise of the option, plus the amount of the loan and interest then outstanding (clause 23); and
(b)a Put Option under which, with the consent of Freedom Express, the Master Franchisee might surrender the Master Franchise to the Franchisor, upon terms including:
(i)the option may be exercised any time after the end of the fifth year after the Commencement Date;
(ii)consideration for the surrender would be the greater of 20% of the average Gross Revenue from the Commencement Date to the date of exercise of the option, or the amount of the loan and interest then outstanding (clause 24).
The FE98 Loan Terms
73. Freedom Express Finance agreed to lend to a Master Franchisee an advance of $8,700 for the first or only Master Franchise granted, otherwise $7,500 for a Loan Period of 15 years (clauses 4 and 16.1).
74. A Master Franchisee was offered this finance under 2 loan options:
(a)Loan Option A: a Master Franchisee selecting this option was required to also apply for a warranty from the Franchisor. If the application and Loan Option A were accepted by the Lender, and the warranty was accepted by the Franchisor, then the Master Franchisee was required to repay the loan on each Payment Date (the last day of each quarter) during the Loan Period, by paying 55% of Gross Profit (clause 5.2).;
(b)Loan Option B, under which the Master Franchisee was required to pay specified Loan Repayments on each payment date during the Loan Period. The Loan Repayment amounts were $235.95 for the first or only Master Franchise granted, and otherwise $203.42 (clause 6).
75. If Freedom Express Australia accepted the warranty, then in consideration of the Master Franchisee paying the Warranty Fee set out in the application:
(a)it warranted to the Master Franchisee that in each year of the Loan Period, 55% of the Gross Profits for the year would be not less than the total of the Loan Repayments for that year - that is, $235.95 for the first or only Master Franchise granted, and otherwise $203.42 (Master Franchise Agreement, clause 21.1); and
(b)it agreed to pay to the lender, or cause to be paid to the lender or otherwise satisfied, the amount by which 55% of the Gross Profits was less than the total of the Loan Repayments for that year (Master Franchise Agreement, clause 21.2; Loan Terms clause 5.3).
Otherwise, by clauses 5.5 and 8, repayment of the loan was to be made only from profits derived from the franchised business.
76. By clause 21.3 of the Master Franchise Agreement, the Master Franchisee was obliged to reimburse the Franchisor for the payments made to the Lender by paying 55% of the Gross Profit to the Franchisor after the loan had been repaid in full.
77. By clause 21.5 of the Master Franchise Agreement, the Franchisor could issue a default notice for specified defaults, including failing to attain Gross Revenue for a year of at least $250. Where the Franchisor had issued a Default Notice, it was not obliged to pay or satisfy any shortfall in respect of that year (clause 21.4, 21.5).
The Short Term Loan Agreement
78. Freedom Express Finance also offered a short term loan. The Master Franchisee authorised and directed the lender to pay the proceeds of the loan to the Franchisor in payment of franchise fees under the Master Franchise Agreement.
79. The loan was repayable in specified instalments.
80. The limited recourse loans in respect of franchise fees were effected by journal entries without the provision of actual cash.
81. Accordingly, Freedom Express Australia was never put in funds in the significant amounts contemplated by the master franchise agreements.
THE INVESTMENTS BY THE 3 APPLICANTS
82. The affidavits of the applicants show:
(a)The applicant Hyde made a (70,000 Series) Master Franchise Application bearing commencement date 6 October 1997 by which he agreed to be bound by the following agreements on the basis that they were executed on the commencement date:
(i) 70,000 Series Master Franchise Agreement;
(ii) 70,000 Series Loan Agreement
The applicant Hyde also executed an 80,000 Series Master Franchise Application bearing commencement date 7 April 1998 by which he agreed to be bound by: -
(iii)a Master Franchise Agreement and
(iv)a Loan Agreement (neither of which is annexed);
and also:
(v)a Short Term Loan Agreement for $6,000 dated 7 April 1998;
(b)The applicant Webber made a (80,000 Series) Master Franchise Application bearing commencement date 7 April 1998 by which he agreed to be bound by the following agreements on the basis that they were executed on the commencement date:
(i) 80,000 Series Master Franchise Agreement;
(ii) 80,000 Series Loan Agreement;
and also(vi)a Short Term Loan Agreement for $3,250 dated 7 April 1998;
(c)The applicant Ferdinands made a (FE 98) Master Franchise Application bearing commencement date 30 June 1998 by which he applied for 4 franchises, 4 loans, and 4 warranties and agreed to be bound by the following:
(i) FE 98 Master Franchise;
(ii) FE 98 Loan Terms;
and also(iii) a Short Term Loan Agreement dated 29 June 1998 for $6,000.
83. Accordingly, the fees payable by the applicants were:
Fee Hyde 1997 Hyde1998 Webber Ferdinands Establishment fee $1,300 $1,200 $1,200 $1,200 Annual franchise fee $10,125 $9,000 $9,000 $9,000 Annual services fee $11,250 $10,000 $10,000 $10,000 Annual marketing fee $12,375 $11,000 $11,000 $11,000 Annual hire fee $1,125 $1,000 $1,000 $1,000 Training fee $10,125 $9,000 $9,000 $9,000 Totals $46,300.00 $41,200.00 $41,200.00 $41,200.00
84. Hyde and Ferdinands claimed deductions for the franchise fees paid (i.e. all fees except the establishment fee). The applicant Webber claimed a deduction for all the fees including the establishment fee.
BUSINESS ACTIVITY
EVIDENCE
Management and control of the franchise business
85. The terms of the 70,000 and 80,000 Series Master Franchise Agreements required the applicant to personally manage and control the franchise business subject to the right to appoint any one or more Approved Sales Agents or Trained Personnel to sell Freedom Express Products through the franchised business. Appointment of an Approved Sales Agent or Trained Personnel was subject to the obligation to monitor, direct and control their sales and distribution activities (clause 9 and definitions of Approved Sales Agent and Trained Personnel).
86. None of the applicants (all of whom provided both affidavit and oral evidence) claims that he personally carried out any sales activity:
(a)The applicant Hyde states that he appointed a sales agent, and personally carried out no sales activity:
(b)The applicant Webber states that he entered into an agreement to authorise the appointment of an approved sales agent:The document annexed at WRW 13 to his affidavit, however, does not choose any one or more of the 6 Approved Sales Agents listed on that form.
87. The applicant Ferdinands states that he chose to appoint a sales agent “to initially market my business for me.” (Affidavit at page 8, paragraph 43) In his application for a Master Franchise, he has ticked yes to appointing Approved Distributors. However, he produces no other document appointing an agent or Approved Distributor - the Master Franchise Agreement, clause 15, requires an appointment agreement between the Master Franchisee and the Approved Distributor.
88. Further, Clause 15.5 of the Master Franchise Agreement required the Master Franchisee to monitor, direct and control any Approved Distributor’s activities in respect of the supply of Freedom Express Products. Ferdinands provided no evidence of supervising the activity of any Approved Distributor.
89. None of the applicants has produced any document setting out the terms of appointment of a Sales Agent.
90. None of the applicants provided any evidence of supervising the activity of sales agents, for example by monitoring the number of calls made to ensure that the applicant met his obligations under the agreement.
Activity by sales agents and approved distributors
91. There is no evidence of activity by specific Sales Agents: -
(a)in October 1997, it appears that telemarketing had not yet begun. Apparently, Freedom Express was considering engaging an American telemarketing firm to begin a campaign from the United States and “launch” Freedom Express.
(b)a subsequent document, headed “NEWS” indicated that Approved Sales Agents were to begin training in mid-January, 1998 whilst “Newsletter #3” purportedly supplied an authorization form for Approved Sales Agents
(c)on 28 August 1998 the applicant Hyde was provided with an activity statement for the year ended 30 June 1998 for each of the 2 franchises he then held. Those statements record:
(i)for the 1997 Master Franchise Agreement, activity of:
(1)23 telephone numbers dialled; and
(2)24 brochures/flyers posted;
(ii)for the 1998 Master Franchise Agreement, activity of:
(1)21 telephone numbers dialled; and
(2)21 brochures/flyers posted;
The statements do not state who carried out the recorded activities. Nor do they record any sales revenue received in relation to either agreement;
(d)subsequent statements provided to the applicants contained no records of activity.
(e)In this respect applicants’ witness Mr Mitchell annexes two spreadsheets evidencing sales activity (see pages 16‑17, paragraph 33 and page 901, annexure GM 39). Those spreadsheets apparently relate only to the 1998 year (the numbers relevantly match those sent to the applicant Hyde for that period). These spreadsheets record between 20 and 30 Calls for each franchisee and about the same number of brochures sent. Specifically they show:
(i)Mr Hyde (franchise no. 79011) had 23 calls made and 24 brochures sent (at 945);
(ii)Mr Hyde (franchise no. 89021) had 21 calls made and 21 brochures sent (at 949);
(iii)Mr Webber (franchise no. 89042) had 27 calls made and 27 brochures sent (at 949);
(iv)there is no record for the franchise held by Mr Ferdinands;
(f)gross revenue of $153,104 is recorded against approximately 780 Master Franchisees (at 963);
(g)no sales are recorded in respect of these applicants.
92. At the end of the “initial period” on 30 June 1999, the applicants Hyde and Webber had made no sales and received no sales revenue under the 70,000 and 80,000 Series Master Franchise Agreements. By the “performance warranty” in clause 12 of each agreement, subject to the terms of that clause, each applicant was accordingly entitled to have the Franchisor pay to him the Shortfall. That is, the Franchisor was required to pay 60% of the Minimum Gross Revenue (a sum of $6597.60) by paying that sum to Freedom Express Finance under the Loan Agreement to be applied as if it was Gross Revenue
93. The activity recorded for each applicant did not meet the Minimum Customer Calls requirement (4% of the 4,000 Specified Customers, or 160 calls within each period of 6 months) under either the 70,000 or 80,000 Series Master Franchise Agreements. Compliance with that Minimum Customer Calls requirement was a condition for the payment of the Shortfall under the Performance Warranty. Each of the applicants Hyde and Webber was, however, purportedly credited with $10,996 under the performance warranty for each Master Franchise held. From this sum were deducted:
(a)costs of “Approved Sales Provider”;
(b)costs of goods sold; and
(c)fees.
The whole of the balance was applied as loan repayment with no distribution to the Master Franchisee.
94. With regard to the FE98 Master Franchise held by the applicant Ferdinands, he had at 30 June 1999 failed to meet the Gross Revenue of at least $250 and Freedom Express was entitled to serve a default notice and suspend his warranty for that year. There is no evidence of a default notice, or of the applicant being required to meet the loan repayments for that year: and see pages 217 and 219, annexures FRF 19 and 20.
Other activity by the applicants
95. The applicants depose to no other activity, after making the application and paying the required fees, than
(a)receiving reports and brochures from the Freedom Express Group;
(b)calling to find out what was happening when, in about 2000, he stopped receiving regular updates and information (Hyde);
(c)inquiring about the expected income from the business (Hyde); and
(d)requesting financial statements (Hyde).
96. In particular, none of the applicants gives any evidence of attending any training or otherwise receiving training in the first year of their franchises. Although there is evidence of training workshops being made available to franchisees (affidavit of Mitchell at pages 3‑4, paragraph 8.5) it is limited to 4 workshops, each one day, in 4 different capital cities in April 1998. No applicant says that he attended any workshop or seminar.
Carrying out of agreements by Freedom Express Group
97. The Freedom Express Group undertook obligations under the 1997 and 1998 Master Franchise Agreements:
(a)to provide services of management guidance and operations review and to provide relevant data and information as may be necessary (clause 5.1);
(b)to provide training to the Master Franchisee and its employees, agents and contractors within the first year (clause 5.2);
(c)to advertise the Freedom Express Image, the Freedom Express Product and to arrange special events, promotional activities, incentives and offers for the marketing of the Freedom Express Image and Products (clause 5.3);
(d)to make a copy of the manual available for hire to the Master Franchisee (clause 5.4);
(e)to supply Freedom Express Products as may be required for the franchised business, subject to availability (clause 5.5);
(f)to take reasonable steps to protect the Freedom Express System and Freedom Express Image (clause 5.6); and
(g)to provide promotional literature if requested and if available (clause 5.7)
98. In his affidavit, applicants’ witness Mitchell deposes to meeting the franchisor’s obligations under the various versions of the Master Franchise Agreement: affidavit at page 5, paragraphs 11-12. He says there were, on average, 6 management staff and 5 full time employees, with temporary staff hired in times of peak activity (page 6, paragraph 14). At paragraph 27 (pages 11‑13) he purports to set out the activities of the Franchisor. However, the evidence is very general, and is not supported by documents.
99. The evidence of services provided by Freedom Express Australia in accordance with the agreements otherwise appears to be: -
Management guidance/operations review (Services fee 70,000 Series: $11,250; 80,000 and FE98: $10,000)
(a)Each applicant produced evidence of letters, reports and newsletters which he received up to around the second half of 1999:
(b)Franchisees were offered a separate licence, at no cost, to sell an electronic business card - the pROMo BizCard - on commission. Each applicant refers to promotional material for this product received from Freedom Express. This business card was not, however, a Freedom Express Product to be sold by them under the Master Franchise. The licence offered would entitle them to sell the business card on 15% sales commission for sales made directly, or on a 5% referral fee for business identified and referred...
(c)The evidence does not disclose any other activity or services provided by Freedom Express Australia to Master Franchisees and which might come under this heading.
Training (Fee, 70,000 Series: $10,125; 80,000 and FE98: $9,000)
(d)Mitchell gives evidence of training, conducted on 4 days - 6, 7, 8, and 9 April 1998 in Brisbane, Sydney Melbourne and Perth in April 1998 (one day in each state): see affidavit at pages 11‑13, paragraph 27. The applicant Hyde, at page 148, annexure APH 16, also includes a Freedom Express Newsletter with the program for that training. In each case, the program is from 7.00 am to 1.30 pm, with 9.00 - 9.45 designated as Existing Master Franchisee Training.
(e)The applicants give no evidence that any of them attended those events, or otherwise received training provided by the Freedom Express Group to Master Franchisees.
(f)There is no evidence of training events after 1 July 1998.
The Manual (Hire Fee 70,000 Series $1,125; 80,000 and FE98: $1,000)
(g)The applicants give evidence of receiving the training manual on computer disk;
(h)Mitchell exhibits copies of the manual to his affidavit;
Advertising, Incentives, Offers and Promotional literature (Marketing fee 70,000 Series $12,375; 80,000 and FE98: $11,000)
First limb - the purpose of the loss or outgoing
227. It is convenient to return to the first limb of s51/s8-1 and an alternative submission on behalf of the respondent that the outgoings were not wholly incurred for the purpose of gaining assessable income, but were, at least in part, incurred for the purpose of obtaining a tax deduction.
228. As already stated on the evidence before the Tribunal the Tribunal finds that the applicants were passive investors sharing in the profits of such business activities as were conducted by Freedom Express. As a result, there is in the Tribunal’s view no connection between the outgoings incurred by the applicants and the derivation of assessable income.
229. Further, and alternatively, the Tribunal finds that the occasion of the outgoings is to be explained by reference to the independent pursuit of an objective of obtaining a tax benefit for the applicant.
230. The decided cases show that the relationship between the outgoing and the assessable income must be such as to impart to the outgoing a character of an outgoing of the relevant kind. Where there is a disproportion between the outgoings incurred and the amount of assessable income, the question of the character of the outgoings must be answered by:
“a common sense appreciation of the overall factual context in which the outgoings were incurred. It necessarily involves a consideration of the contents and implications of the overall contractual arrangements … pursuant to which the outgoings … became payable. … it also encompasses a consideration of the purpose which the members of the partnership … had in incurring the outgoings.”
Fletcher v FCT (1991) 173 CLR 1 at 20-21.
231. In this case, each applicant only derived assessable income pursuant to the income guarantee or warranty in the year ended 30 June 1999. That is the only year in which income was said to have been derived. The income declared by Freedom Express for each applicant in the year ended 30 June 1999, as a result of the guarantee or warranty, compared with their claimed outgoings is set out below:
Applicant
Income to 30 June 1999 Outgoings (excluding establishment fee Hyde $2029 $2029.00 Webber $4,551.72 $4,551.72 Ferdinands $2,333.68 $40,000
232. Accordingly, here, for the amounts to be deductible, a ”commonsense” or “practical” weighing of all the factors ought to indicate that the relationship between the whole of the expenditure and the production of assessable income is "genuine and not colourable". The occasion of the loss or outgoing is not the earning of assessable income where the circumstances point to another purpose. See Fletcher at 17.1-18.2, 18.7-19.4 and Ure v FCT (1981) 34 ALR 237 per Brennan, J at 241, lines 20-31 and per Deane and Sheppard, JJ at 248-249, line 25 and 249, line 35-250.
233. The Tribunal notes that as a result of their entry into the Master Franchise Agreements, each applicant initially obtained tax deductions which, after making the cash payments required of him, resulted in a net cash surplus of: -
(a)in Hyde’s case, a cash saving in 1997 of $17,335.94 and a net cash surplus at 30 June 1999 of $11, 537.53
(b)in Webber’s case, a cash saving in 1998 of $5,246.17 and a net cash surplus at 30 June 1999 of $3,348.94
(c)in Ferdinands’ case, a cash saving in 1998 of $12,345.06 and a net cash surplus at 30 June 1999 of $6,345.06.
234. But for the Commissioner’s disallowance of the claimed deductions those cash surpluses would have been derived and, by reason of the limited recourse nature of the loans they took, retained by the applicants regardless of the outcome of their investment, as the applicants were aware. Indeed, in cross-examination, each of the applicants confirmed that the tax advantages afforded them the opportunity to participate.
235. Having regard to the principles set out above, the Tribunal finds that the claimed deductions were incurred by the applicants for the purpose of obtaining the tax deductions which facilitated their investment.
236. The evidence shows that the applicants entered into the arrangements described above, under which they carried out no business activities, received minimal services for the amount they had outlaid, and were apparently indifferent to the nature or conduct of business activities to be carried out on their behalf or the failure of their purported businesses to produce a single sale. When regard is had to the Master Franchise Agreements and Loan Agreements entered between the applicants and Freedom Express, the Tribunal finds that what was sought to be achieved by entering the agreements was not the commercial benefits which might arise under the agreements, but rather the pursuit of tax deductions. It is notable that each applicant asserted that he sought a long-term income stream by his participation but after entering into the agreements and paying the franchise fees his only action, as confirmed in cross-examination, was to pursue the tax deductions when disallowed.
The outgoings were of capital or of a capital nature
237. As set out above, despite the use of a “franchise” structure the arrangements did not on the evidence before the Tribunal lead to Master Franchisees themselves conducting the business of selling Freedom Express Products. Each Master Franchisee was only obtaining the opportunity to participate in the income (if any) which Freedom Express might produce from its business of marketing and promoting seminars and associated products.
238. It is the Tribunal’s opinion that initial franchise fees, including the establishment fee claimed by Webber only, were the cost to participants of obtaining an interest in the nature of an investment. By those fees, the applicants purchased the right to a designated allocation of any income which may be produced by Freedom Express. As such, they are therefore in the Tribunal’s view in the nature of capital.
239. Further and in the alternative, the Tribunal finds that the amounts payable by the applicants in the 1997 and 1998 years were outgoings of capital or of a capital nature and are therefore not deductible under either s51 or s 8-1.
240. The characterisation of an outgoing as capital or on account of revenue "depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process": Hallstroms Pty Ltd v FCT (1947) 72 CLR 634 at 648; Cliffs International Inc v FCT (1979) 142 CLR 410; FCT v South Australian Battery Makers Pty Ltd (1978) 140 CLR 645 at 655, 657, 659, 660, 662.
241. The fact that the outgoings were called “franchise fees” does not determine the proper characterisation of the payments. What the parties call a payment may have some relevance, depending on the circumstances of the case, but is not determinative: Vincent v Commissioner of Taxation (2002) 124 FCR 350, at [62]-[67]; Commissioner of Taxation v Broken Hill Pty Company Ltd (2000) 179 ALR 593 at [36]; Radaich v Smith (1959) 101 CLR 209; Commissioner of Taxation v Krakos Investments Pty Ltd (1995) 61 FCR 489 at 495–6.
242. The classic test for determining whether a loss or outgoing is on capital or revenue account is found in the judgment of Dixon J in Sun Newspapers Ltd v Commissioner of Taxation (Cth) (1938) 61 CLR 337 at 363:
“There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.”
243. In the present case, the Master Franchise Agreements provided for the payment of initial franchise fees, in advance, for the first year and including a training fee, and for later years an annual fee calculated as a percentage of the gross profit of the business. The annual fee for later years, however,
(a) was only payable if the business did produce a profit; and
(b)was limited to 5% of the profit (70,000 and 80,000 Series agreements) or 15% of the profit (FE98 agreement).
On the profits projected, the annual fees for later years would be only a small fraction of the initial fee: for example, an 80,000 Series Master Franchisee would need to earn a profit of around $600,000 to pay fees comparable to the first year; an FE98 Master Franchisee would need to earn over $65,000 for each franchise to pay fees comparable to the $10,000 fee for the first year.
244. This suggests that the initial franchise fees payable in the first year of a 20 year term are not simply the first instalment of a recurrent fee, paid for advantages or services to be provided or enjoyed wholly in the first year. Rather, despite the nominal allocation of the initial fee to particular services to be performed in the first year, it has in the Tribunal’s view the true character of an up front fee to purchase the franchise.
245. From a franchising perspective, respondent’s witness Mr Acheson notes (at page 18 of his report): “The fees were unusual in size and structure and the way they were bulked into the first year and then prepaid via the uncommercial loan”.
246. If it needs to be separately determined, the establishment fee claimed by Webber, was in the Tribunal’s opinion a cost of obtaining the investment. On the agreements it did not purport to be otherwise.
1999: The applicants Hyde and Webber are not entitled to the claimed deductions for outgoings, including interest, under s 8-1 of the Income Tax Assessment Act 1997
247. The applicants Hyde and Webber claimed deductions in the 1999 year in respect of outgoings for franchise fees, interest, and reduced value of trading stock, as follows:-
Fee Hyde Webber annual franchise fee $264 $131.95 annual service fee $132 $65.98 annual marketing fee $198 $98.96 annual hire fee $66 $32.99 prepaid interest $3,713 $1,716 reduced value of trading stock/cost of goods sold $8,796 $2,199.20 Approved Sales Provider $2,199.20 $13,169.00 $6,444.28
Save for the interest component, the amount claimed by the applicant Hyde is twice that claimed by the applicant Webber, reflecting the fact that Hyde had invested in two Master Franchises.
248. For the reasons given above, the Tribunal finds that the claimed outgoings for fees are not allowable under s8-1 of the Income Tax Assessment Act 1997. Some separate consideration must be given to the amounts claimed for reduced value of trading stock, cost of goods sold, and cost of approved sales provider. Finally, it will be necessary to consider the claim for interest.
249. The Tribunal finds that the claims in relation to trading stock, cost of goods sold, and cost of approved sales provider are clearly fictitious. There were no sales made on behalf of either applicant. The amounts set out for these “sales expenses” had the effect of reducing the guaranteed minimum income to the Shortfall. But they were not actually incurred and remain a fiction.
250. Ordinarily, interest will be an allowable deduction under s 8-1 of the Income Tax Assessment Act 1997 if it is incurred in the course of an income producing activity or business: Texas Co (Australasia) Ltd v Federal Commissioner of Taxation (1940) 63 CLR 382 at 468; Steele v Deputy Commissioner of Taxation (1999) 197 CLR 459.
251. However, as set out above, the fact that the payment is called “interest” does not determine the question. The Tribunal does not need to determine whether these amounts are properly described as “interest” in the circumstances of the Freedom Express loans. Australian income tax legislation does not require that an amount be interest or that there be a borrowing before what is called "interest" may be deducted. The question is whether the outgoing called "interest" was incurred by each applicant in either his income producing activity or his business: see Macquarie Finance Ltd v Commissioner of Taxation (2004) 210 ALR 508 at [47]. The necessary connection between the outgoing for interest and the activities which more directly gain or produce assessable income will be found, in the ordinary case, in the use to which the borrowed funds are put: Federal Commissioner of Taxation v Roberts (1992) 37 FCR 246 at 255.
252. In the present case, for the reasons set out above, the capital sums borrowed were not used for the purpose of gaining or producing assessable income. The interest on those borrowings does not come under either limb of s8-1 and is not deductible.
DECISION
253. The Tribunal finds that, for the reasons set out above the claimed deductions are not allowable under either limb of s51(1) of the 1936 Act or s8-1 of the 1997 Act because:
(i)the applicants were not carrying on a business and the claimed outgoings were not outgoings necessarily incurred in carrying on a business;
(ii)the claimed outgoings were not for the purpose of gaining or producing assessable income; and
(iii)in any event the claimed deductions were outgoings of capital, or a capital nature.
254. The Tribunal confirms the decisions under review.
I certify that the 254 preceding paragraphs are a true copy of the reasons for the decision herein of Mr A Sweidan
Signed: ..................[Sgd Ms C Skinner]......................
AssociateDates of Hearing 19 and 20 March 2007
Date of Decision 21 September 2007
Solicitor for the Applicant Wilson & Atkinson
Counsel for the Applicant Mr D Romano
Solicitor for the Respondent Australian Government Solicitor
Counsel for the Respondent Ms H Symon, SC
Mr J Allanson
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