KKQY and Commissioner of Taxation (Taxation)

KKQY and Commissioner of Taxation (Taxation) [2019] AATA 204 (19 February 2019)
Division:TAXATION & COMMERCIAL DIVISION
File Number: 2018/0638
Re:KKQY
APPLICANT

AndCommissioner of Taxation
RESPONDENT

Decision
Tribunal:Deputy President Britten-Jones
Date:19 February 2019
Place:Sydney

The Tribunal affirms the decision under review
.........................[sgnd]............................
Deputy President Britten-Jones
CATCHWORDS
Taxation – income tax – Division 7A of Part 3 of the Income Tax Assessment Act 1936 - loan by company to a shareholder – loan not repaid – deemed dividend for repayment shortfall – consideration of whether earlier loan was varied or terminated – deductibility of legal fees – whether legal fees of a capital nature or on account of revenue – liability to penalty under s 284-74 of the Taxation Administration Act 1953 – recklessness – whether to remit penalty under s 298-20 of the Taxation Administration Act 1953 – decision under review affirmed
LEGISLATION
Income Tax Assessment Act 1936, Division 7A, ss 109D, 109E and 109N
Income Tax Assessment Act 1997, s 8-1
Taxation Administration Act 1953, ss 284-75, 284-80, 284-85 and 298-20
CASES
Commissioner of Taxation v Sara Lee Household and Body Care (2000) 201 CLR 520
Tallerman & Co v Nathan’s Merchandise (Vict) (1957) 98 CLR 93
Concut Pty Ltd v Worrell (2000) 176 ALR 693
Morris v Baron & Company [1918] AC 1
Martech International v Energy World Corp [2006] FCA 1004
Seven Cable Television v Telstra (2000) 171 ALR 89
Hallstroms Pty Ltd v Commissioner of Taxation (1946) 72 CLR 634
Commissioner of Taxation v Day (2008) 236 CLR 163
John Fairfax and Sons v Federal Commissioner of Taxation (1959) 101 CLR 30
Federal Commissioner of Taxation v R & D Holdings Pty Ltd (2007) 160 FCR 248
BRK (Bris) Pty Ltd v Federal Commissioner of Taxation (2001) 46 ATR 347
Hart v Commissioner of Taxation (2003) 131 FCR 203
REASONS FOR DECISION
Deputy President Britten-Jones
19 February 2019

This case involves consideration of the deemed dividend payments regime under Division 7A of Part 3 of the Income Tax Assessment Act 1936 (the 1936 Act). Under the regime, a shareholder may be taken to have received a dividend if an amount is lent by the company to a shareholder and the amount repaid in a given year is less than the minimum yearly payment.
On 19 December 2017, the respondent decided that the applicant had received a deemed dividend in the 2012 income year, that certain legal fees were not deductible and that the applicant was liable for an administrative penalty. The applicant has applied to the Tribunal for an order setting aside that decision. The facts were generally not in dispute. For the reasons that follow I have decided to affirm the decision of the respondent.
The Company Loans to the Applicant
At all material times, the applicant was a shareholder or associate of a shareholder of the Company.
On 1 April 2005, the applicant entered into a Deed of Loan with the Company (the 2005 Loan Agreement) the material terms of which were as follows:
(a)The Company agreed to provide a facility of $3 million to the applicant to be advanced in two tranches, the first of $2.15 million on the date of the 2005 Loan Agreement and the second of $850,000 to be advanced upon later events;
(b)the facility was repayable one year after the date on which the interest of the applicant in the property of the Trust was due to vest, being 6 September 2011;
(c)interest was payable on the facility at the rate of 1% above the National Australia Bank charged rate from time to time on commercial loans above $100,000;
(d)the facility was secured by the applicant’s interest in the Trust.
On 13 April 2007, the applicant and the Company entered into a Settlement Deed (2007 Settlement Deed) the material terms of which were as follows:
(a)the applicant agreed to repay the Company the monies advanced under the Loan by instalments but always subject to the minimum repayment obligations under Division 7A of the 1936 Act; and
(b)the applicant agreed to execute amended loan documents to ensure the Loan was on terms compliant with Division 7A of the 1936 Act.
On 21 November 2007, the Chief Financial Officer of the Company wrote to the applicant regarding the execution of the Division 7A compliant loan agreement as follows:
Further to our last discussion on this matter in early October, and quite apart from your explicit obligations under the April 2007 Settlement Deed to execute the loan documents amended in accordance with the Settlement Deed, your failure to execute this document will incur undesirable income tax ramifications for you that are beyond [the Company’s] control to mitigate. If the documents are not executed prior to the lodgement of [the Company’s] next tax return (January 2008), the Company is under a legal obligation to the ATO to disclose that it has made a non-compliant payment to an associated person. The relevant payment is the $2.15 million that was loaned to you in 2005. As this payment will be deemed a dividend to you…you will be assessed at the highest marginal tax rate on the entire $2.15 million payment, requiring you to pay income tax of around $1 million plus penalties and interest.
…
It may be that you are concerned about the repayment obligations that are by necessity included in the amended loan agreement. If so, there may be ways to cater for those obligations that we can explore closer to the next repayment due date. However in the meantime, I urge you to properly consider your position in relation to this matter and execute the loan agreement I forwarded to you on 12 September 2007.
On 23 November 2007, the applicant and the Company entered into a Loan Agreement (2007 Loan Agreement) the material terms of which were as follows:
(a)the Loan was confirmed and recorded as having a balance at 30 June 2006 of $2,162,000;
(b)interest was to accrue on the Loan at the benchmark interest rate as determined by the Commissioner under Division 7A of the 1936 Act (then 8.05%);
(c)the Loan was repayable in annual instalments of principal and interest commencing on 30 June 2006 and ending on 30 June 2012 as determined in Schedule 2 to the 2007 Loan Agreement;
(d)the final repayment date determined in Schedule 1 to the 2007 Loan Agreement was seven years from the date of the original advance, being 1 April 2005.
In August 2009, the applicant and the Company entered into an Amendment Agreement which recorded the balance of the Loan as at 1 July 2008 at $1,437,882, provided that the Loan was to be secured by certain property owned by the applicant and provided for the Loan to be repaid in instalments paid annually until 2030 (being 25 years from the date of the original advance) so as to conform with the requirements of Division 7A of the 1936 Act (2009 Amendment Agreement).
In November 2010, the applicant and the Company entered into a Further Amendment Agreement which recorded the outstanding balance of the Loan as at 1 July 2010 as $1,361,000.14, provided for the applicant to make a loan repayment of $589,869.75 and provided for the applicant to make repayments of $428,871.94 on or before 30 June 2011 and 30 June 2012 so as to conform with the requirements of Division 7A of the 1936 Act (2010 Amendment Agreement).
In the 2012 income year, the applicant paid only $150,000 of the repayments due under the 2010 Agreement, leaving $278,871.94 in unpaid repayments due in that year (repayment shortfall).
It is the repayment shortfall of $278,871.94 which has been deemed to be a dividend by the Respondent.
Legal Fees
At all material times, the applicant was a beneficiary of the Trust. Over the years ending 30 June 2012 and 30 June 2013, the applicant commenced and pursued proceedings in the Supreme Court of NSW against (inter alia) the trustee of the Trust (the Trustee) and the Company. During these years the applicant incurred legal fees with respect to his dispute with the Trustee and the Company (amongst others).
In September 2011, the applicant commenced proceedings in the Supreme Court of NSW (2011 NSW Supreme Court Proceedings) seeking urgent interlocutory relief in relation to the vesting of the Trust. The final relief sought in the 2011 NSW Supreme Court Proceedings, as set out in the statement of claim and numerous amended statements of claim, was to the following effect:
(a)orders that the Trustee provide accounts and other information concerning the Trust and the Company;
(b)directions that the Trustee misconducted themselves or otherwise breached the Trust;
(c)orders removing the Trustee and appointing a replacement trustee; and
(d)orders for the taking of accounts of the Trust.
On 31 October 2014, the applicant filed a statement of claim in the Federal Court (the 2014 Federal Court Proceedings) seeking the following relief:
(a)the voiding of the trust deed;
(b)an accounting of the profits made by the Trustee, the Company and its subsidiaries;
(c)a constructive trust in favour of the beneficiaries of the Trust;
(d)a further accounting of profits on the part of the Trustee; and
(e)a further constructive trust in favour of the beneficiaries of the Trust.
The relevant legal fees (Legal Fees) are those incurred by the applicant in the year ending 30 June 2012 of $193,466 and in the year ending 30 June 2013 of $113,897.
The issues
There are three issues in this proceeding:
(a)whether the applicant received a deemed dividend in the 2012 income year in the amount of $278,871 under s 109E and s 109Z of the 1936 Act which forms part of the applicant’s assessable income under s 44 of the 1936 Act;
(b)whether the applicant was entitled to deduct Legal Fees incurred in connection with the 2011 NSW Supreme Court Proceedings in the 2012 and 2013 income years under s 8-1 of the Income Tax Assessment Act 1997 (1997 Act); and
(c)whether the applicant was correctly assessed to an administrative penalty of $62,745 in the 2012 income year under s 284-90 of Schedule 1 of the Taxation Administration Act 1953 (Cth) (Administration Act) and, if so, whether that penalty should be remitted in whole or part.
The Deemed Dividend
The issue as to whether a dividend is deemed to have been paid to the applicant requires an assessment of the loan terms between the applicant and the Company and whether there was compliance with those loan terms.
The starting point in the legislative scheme is s 109D of the 1936 Act which provides relevantly:
109D Loans treated as dividends
Loans treated as dividends in year of making
(1) A private company is taken to pay a dividend to an entity at the end of one of the private company’s years of income (the current year) if:
(a)the private company makes a loan to the entity during the current year; and
(b)the loan is not fully repaid before the lodgement day for the current year; and
(c)…
Certain loans are excluded from the operation of s 109D including loans which satisfy the criteria set out in s 109N which provides relevantly:
109N Loans meeting criteria for minimum interest rate and maximum term not treated as dividends
Criteria
(1)A private company that makes a loan to an entity in one of the private company’s years of income is not taken under section 109D to pay a dividend at the end of the year of income because of the loan if, before the lodgement day for the year of income:
(a)the agreement that the loan was made under is in writing; and
(b)the rate of interest payable on the loan for years of income after the year in which the loan is made equals or exceeds the benchmark interest rate for the year; and
(c)the term of the loan does not exceed the term (the maximum term) for that kind of loan worked out under subsection (3).
There is no dispute that the terms of the 2007 Loan Agreement satisfied the s 109N criteria such that there is no deemed dividend under s 109D. The dispute arises when one considers s 109E which provides relevantly:
109E Amalgamated loan from a previous year treated as dividend if minimum repayment not made
Amalgamated loan treated as dividend in first year in which payment is less than minimum yearly repayment
(1) A private company is taken to pay a dividend to an entity at the end of one of the private company’s years of income (the current year) if:
(a)the private company made an amalgamated loan to the entity in an earlier year of income; and
(b)the amalgamated loan is not repaid at the end of the current year; and
(c)the amount (if any) paid to the private company during the current year in relation to the amalgamated loan falls short of the minimum yearly repayment of the amalgamated loan worked out under subsection 5 for the current year; and
(d)Section 109Q does not apply in relation to the current year.
Amount of dividend
(2) The amount of the dividend is taken to be the amount of the shortfall mentioned in paragraph (1)(c), subject to section 109Y.
What is an amalgamated loan?
(3) For the purposes of this Division, a private company is taken to make a loan (the amalgamated loan) to a single entity during a year of income if the private company makes one or more loans (constituent loans) to the entity during the year, each of which:
(a)is not fully repaid before the lodgement day for the year; and
(b)would cause the company to be taken under section 109D to pay a dividend to the entity at the end of the year, apart from section 109N; and
(c)has the same maximum term for the purposes of that section.
The amount of the amalgamated loan is the sum of the amounts of the constituent loans that have not been repaid before the lodgement day for the year of income in which the amalgamated loan is made.
Subject to what I say below, there is no dispute in relation to s 109E(1)(a) that the Company made a loan to the applicant in an earlier year of income.
There is no dispute in relation to s 109E(1)(b) that the loan, the subject of the 2007 Loan Agreement, was not repaid at the end of the “current year”, namely as at the end of the 2012 financial year.
There is no dispute in relation to s 109E(1)(c) that the amount of $150,000 paid to the Company during the 2012 financial year (the current year) in relation to the loan fell short by $278,871.94 of the minimum yearly repayment which was $428,871.94.
The respondent contends that the amount of the repayment shortfall is treated as a dividend pursuant to s 109E(2). The applicant disagrees and says that the relevant loan was made in 2005 pursuant to the 2005 Loan Agreement and that it was not an amalgamated loan as defined in s 109E(3). The applicant contends that there was no new loan in 2007 and that, properly construed, the 2007 Loan Agreement was a variation of the earlier loan made in 2005 (namely the 2005 Loan Agreement).
This then becomes the critical issue. Counsel for the applicant said (quite appropriately) in his oral submissions:
So, we don’t dispute that if you find that it is a new agreement, as opposed to a variation of the old agreement, then, clearly, we have a deemed dividend on the basis that we have an amalgamated loan and the applicant failed to make the relevant payment that was required in total. So, the amount that’s at issue, we don’t dispute, but the parties agree on what the deemed dividend is.
Applicant Contentions - Variation or Termination of the 2005 Loan Agreement?
The applicant says that the starting point is the 2005 Loan Agreement made on 1 April 2005. This loan did not satisfy the requirements of s 109N or any other provision in Sub- division D of Division 7A. Consequently, at that point in time, the loan would have given rise to a dividend under s 109D. The applicant recognised this and took steps to “convert the loan to a complying loan.” This is apparent from the Confidential Settlement Deed dated 13 April 2007 in which the applicant agrees to repay the Company the loan advanced to him by the 2005 Loan Agreement by certain instalments and agrees to execute amended loan documents to ensure the loan advanced to him by the 2005 Loan Agreement is on terms compliant with Division 7A of the 1936 Act.
The applicant relies upon the terms of the 2007 Loan Agreement to support his contention that it amounts to a variation of the original loan and not a new loan agreement. The 2007 Loan Agreement refers to the original advance which was the loan of $2.15 million being the First Tranche referred to in the 2005 Loan Agreement. The final repayment of 30 June 2012 is expressed to be seven years from the date of the original advance, namely 30 June 2005. There is no express reference to the 2005 Loan Agreement in the 2007 Loan Agreement but the applicant says that its terms indicate that it is a variation only and not a new agreement. The applicant also relies upon the fact that there is no evidence of new funds being exchanged as a result of the 2007 Loan Agreement and that there is no evidence of the 2005 Loan Agreement being discharged. Consequently, the applicant contends that there was only one loan made in 2005 and that the terms of that loan were amended in 2007.
Respondent Contentions - Variation or Termination of the 2005 Loan Agreement?
The respondent contends that there is a clear intention, manifest in the terms of the 2007 Loan Agreement, to bring to an end the previous loan agreements between the Company and the applicant and to ensure that all existing advances from the Company to the applicant were to be taken as made and to be repaid on the terms of the 2007 Loan Agreement. The respondent relies upon the recitals to the 2007 Loan Agreement which state that the loan “is to be advanced by the Company to the Borrower” and “will be due and owing by the Borrower”. Further, the respondent relies upon the entire agreement clause which provides:
Notwithstanding anything said or written prior to the signing of this by the parties or their authorised representatives, this Loan Agreement constitutes the entire agreement between the parties and supersedes any prior agreement.
The respondent also refers to the 2009 Amendment Agreement and the 2010 Amendment Agreement both of which provide that “the Loan … was made pursuant to an agreement between the Company and the Borrower dated 23 November 2007”. This suggests that there was a new loan in 2007 which superseded the 2005 loan.
Consideration - Variation or Termination of the 2005 Loan Agreement?
A contract may be varied or terminated by consent. It is a question of the intention of the parties. Both parties referred to the decision of Commissioner of Taxation v Sara Lee Household and Body Care[1] where it was held by the plurality that:
when the parties to an existing contract enter into a further contract by which they vary the original contract, then, by hypothesis, they have made two contracts. For one reason or another, it may be material to determine whether the effect of the second contract is to bring an end to the first contract and replace it with the second, or whether the effect is to leave the first contract standing, subject to the alteration.
[1] (2002) CLR 520, 533.
In Tallerman & Co v Nathan’s Merchandise (Vict) (Tallerman) [2], Taylor J said:
it is firmly established by a long line of cases… that the parties to an agreement may vary some of its terms by a subsequent agreement. They may, of course, rescind the earlier agreement altogether, and this may be done either expressly or by implication, but the determining factor must always be the intention of the parties as disclosed by the later agreement.
[2] (1957) 98 CLR 93, 144.
In Concut Pty Ltd v Worrell[3], the High Court referred favourably to the Tallerman decision where it was held that a variation could, depending on the intention of the parties, bring about (a) the termination of a contract altogether, (b) its partial termination, or (c) the addition of terms without any termination.
[3] (2000) 176 ALR 693, [19].

Lord Dunedin in Morris v Baron & Company[4] said:
the difference between variation and rescission is a real one, and is tested, to my thinking, by this: In the first case there are no such executory clauses in the second arrangement as would enable you to sue upon that alone if the first did not exist; in the second you could sue on the second arrangement alone, and the first contract is got rid of either by express words to that effect, or because, the second dealing with the same subject matter as the first but in a different way, it is impossible that the two should be both performed. When I say you could sue on the second alone, that does not exclude cases where the first is used for mere reference, in the same way as you may fix a price by a price list, but where the contractual force is to be found in the second by itself.
[4] [1918] AC 1, 25-26.
There is no express statement of rescission in the 2007 Loan Agreement, although there is the statement in clause 11 of Schedule 3 that “this Loan Agreement constitutes the entire agreement between the parties and supersedes any prior agreement.” This statement is not determinative of the issue.[5] The question is whether the 2007 Loan Agreement, by implication, rescinds the 2005 Loan Agreement and is intended to entirely replace its terms.
[5] Seven Cable Television v Telstra (2001) 171 ALR 89, [132].
French J considered the issue of an implicit discharge of an earlier agreement (albeit in the context of an employment contract) in Martech International v Energy World Corp[6] and stated:
[6] [2006] FCA 1004, [159]-[162].
There was no express agreement to discharge the agreement of May 1999. If it was discharged, that discharge flowed, as a matter of implication, from the arrangements made on 24 September 2000. Professor Carter, in an essay on termination written for the 2nd edition of The Law of Contract (ed M Furmston), Butterworths, London, 2003, identified, at pp 1320–1, two cases of consensual discharge by implication which may be paraphrased thus:
(1) Where the parties to a contract enter into a second contract which is inconsistent with an intention that the contract by which the parties were originally bound should remain in force (at p 1321):
then, what one party alleges to be a mere variation of the contract may go so much to the root of the original agreement that the parties’ intention to terminate the original agreement may legitimately be inferred, for example, because it is impossible for both agreements to be performed.
(2) When the conduct of the parties to an agreement is such that an agreement to terminate or abandon the former contract may be inferred or where their conduct creates an estoppel.
The agreement of May 1999 was in the nature of an employment agreement notwithstanding that it took the form of an agreement for the provision of services under a consultancy arrangement. It is a particular application of the general case of consensual discharge by subsequent inconsistent agreement that an employment agreement may be discharged by sufficiently substantial change to the terms and conditions of employment. In Chitty on Contracts, 28th ed, Sweet & Maxwell, London, vol 2, 1999, para 39–152, it is said:
A termination of a contract of employment by agreement occurs also where there is an agreed change in the terms and conditions of employment, for instance by way of promotion, which is sufficiently fundamental to constitute the rescission of the original contract and its replacement by a new contract in differing terms.
In Quinn v Jack Chia (Aust) Ltd[1992] 1 VR 567 , Ashley J reviewed a number of authorities relating to changes to the terms of employment and when such changes would amount to discharge of a subsisting employment agreement. He accepted, at 576, the proposition in Federated Mutual Insurance Co of Australia Ltd v Sabine [1920] SALR 284 that:
where employer and employee agree to an alteration in the employee’s duties and responsibilities which is profound, a court should be more ready to hold (unless the original contract of employment provided for the contingency) that a new contract has replaced the old; or at least that the old contract as varied, contained terms objectively appropriate to the new relationship created.
A contract under which a person is employed, whether directly or through a corporate entity controlled by that person, may be discharged by sufficiently significant changes to the duties and/or the remuneration of the person so employed. A discharge will occur when the changes are significant, not able to be accommodated by the terms of the original contract and not contemplated by the parties when the original contract was made. Whether there has been a discharge or a variation of the original agreement depends upon the intention of the parties discerned by reference to the terms of their second agreement. It is, as Dixon CJ and Fullagar J said in Tallerman, “a matter of degree”.
The sum of $2.15 million together with a further $12,000 was lent under the 2005 Loan Agreement. This amount of $2.162 million is the amount of the loan in the 2007 Loan Agreement. The parties are the same in both agreements. It follows that the two agreements deal with the same subject matter.
The 2007 Loan Agreement is a discrete agreement which provides for the amount of the loan and the dates for repayment of the principal and interest together with ancillary terms; it can be sued upon without reference to the 2005 Loan Agreement. The 2007 Loan Agreement goes beyond merely modifying or adding to the 2005 Loan Agreement; rather, it replaces all of its terms. For example, the term of the loan in the 2005 Loan Agreement is in excess of 7 years compared to the 7 year term in the 2007 Loan Agreement. The rate of interest payable under the two agreements is different. These terms are fundamental and go to the root of the loan agreement between the parties.
It can be said that, generally, the terms of the 2007 Loan Agreement are inconsistent with, and are expressed in a different way to, the 2005 Loan Agreement. It is not possible for both agreements to be performed according to their terms. The differences between the 2005 Loan Agreement and the 2007 Loan Agreement support the contention that, objectively judged, it was the intention of both parties to discharge the 2005 Loan Agreement. I consider that the so called variation of the 2005 Loan Agreement contended for by the applicant goes so much to the root of the agreement that the parties’ intention to terminate the original agreement may legitimately be inferred.
Part of the circumstances of entry into the 2007 Loan Agreement was the Confidential Settlement Deed dated 13 April 2007 which provided:
(1) [The applicant] agrees to repay [the Company] … the loan advanced to him by Deed dated 1 April 2005 by way of instalments set out in the Schedule hereto until December 2011 and thereafter by continuing instalments as provided in the said Schedule or at the option of [the applicant] by his payment of the balance then due at his election to be completed by June 2013, subject always to compliance with any minimum repayment terms required by clause 2 below.
(2) [The applicant] agrees to execute amended loan documents to ensure the loan advanced to him by Deed dated 1 April 2005 is on terms compliant with Division 7A of the Income Tax Assessment Act 1936.
The applicant relies upon the stated intention to execute “amended” loan documents in the Confidential Settlement Deed and in the email of 21 November 2007 to support his contention that the 2007 Loan Agreement is a variation to, as opposed to a rescission of, the 2005 Loan Agreement. However, the High Court in Seven Cable Television v Telstra[7] tells us that:
The question whether there has been a “variation” is dependent on the intention of the parties, objectively determined, from the words of the contract. Regard must be had to the nature and extent of any differences. It does not follow, that because the parties have asserted that their mutual intention was not to vary a contract, that what is otherwise a variation is converted into a non-variation.
[7] (2000) 171 ALR 89, [132].
The converse would also be true; namely, it does not follow that because the parties have asserted an intention to amend the loan document, that what does in fact occur amounts to an amendment as opposed to a rescission and replacement of the 2005 Loan Agreement. The focus needs to be on the terms of the 2007 Loan Agreement and the nature and extent of any differences compared to the 2005 Loan Agreement. In order to ensure that the loan was on terms compliant with Division 7A of the 1936 Act the parties entered into a new and discrete agreement which stood as a complete statement of the contractual obligations owed to each other. The 2007 Loan Agreement was not expressed to be, and nor was it in fact, an amendment or variation of the 2005 Loan Agreement.
The terms of the 2007 Loan Agreement and the circumstances in which it was entered establish that the intention of the parties was to rescind the 2005 Loan Agreement and replace it with the 2007 Loan Agreement. The 2005 Loan Agreement was discharged and replaced by the 2007 Loan Agreement.
Conclusion of Deemed Dividend
I conclude that the 2007 Loan Agreement provided for an amalgamated loan as defined in s 109E(3). Consequently, all the elements of s 109E(1) are satisfied such that the repayment shortfall with respect to the amalgamated loan is a deemed dividend.
Entitlement to Deduct Legal Fees?
The applicant contends that the Legal Fees are wholly deductible pursuant to s 8-1 of the 1997 Act. Alternatively, the applicant contends that the Legal Fees should be apportioned on a reasonable basis and a deduction should be allowed pursuant to s 8-1 for the portion which is not capital.
There is no dispute that the applicant incurred Legal Fees during the 2012 and 2013 income years in the amount of $193,466 (in 2012) and $113,897 (in 2013). Those legal expenses were incurred in connection with the 2011 NSW Supreme Court Proceedings.
In determining whether a deduction for legal expenses is allowed, the nature of the expenditure must be considered. It is necessary to consider the object of the expenditure when the legal proceedings were undertaken.[8]
[8] Hallstroms Pty Ltd v Commissioner of Taxation (1946) 72 CLR 634, 647.
The object for which the legal expenses were incurred will be identified by the relief sought in the 2011 NSW Supreme Court Proceedings. That relief is set out in paragraph 14 above and related to the conduct of the Trustee. There is no monetary claim.
In order for an expense to be deductible under s 8-1(a) of the 1997 Act, the occasion for the outgoing must be found in whatever is productive of actual or expected income.[9] A narrow approach should not be taken to the question of what is productive of a taxpayer’s income.[10]
[9] Commissioner of Taxation v Day (2008) 236 CLR 163, [33].
[10] Ibid.
The question for the Tribunal is whether the object sought to be achieved in the 2011 NSW Supreme Court Proceedings was an object which finds its occasion in that which is productive of actual or expected income of the applicant.
The applicant says that the 2011 NSW Supreme Court Proceedings for which fees were incurred in 2012 and 2013 were preliminary to the 2014 Federal Court Proceedings in which a declaration of a constructive trust was sought together with orders that the Trustee (among others) was liable to account for profits earned. When these legal proceedings are looked at together the applicant contends that ultimately he was seeking to recover lost income and increase the income that came to him through his vested interest in the Trust.
The respondent says, first, that the Legal Fees were not incurred in gaining or producing assessable income and, second, that the Legal Fees were an outgoing of a capital nature.
Dixon J in Hallstroms Pty Ltd v Commissioner of Taxation (Hallstroms)[11] said:
What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.
[11] (1946) 72 CLR 634, 648.
The relevant distinction is that expenditure of a capital nature is directed to the character and organisation of the profit-earning business whereas expenditure on account of revenue is an incident in the operations by which it is carried on.[12] Dixon J concluded at 649 that the legal expenses incurred in the litigation were:
concerned with the reform of or the more effective establishment of the organisation by which income will be produced (the profit-yielding subject) and not with the means whereby that organisation will be used for that purpose.
[12] Ibid.
Further clarification as to the capital versus revenue distinction comes from the High Court decision of John Fairfax and Sons v Federal Commissioner of Taxation[13] where Menzies J said:
To make a payment to acquire or to defend the acquisition of a favourable position from which to earn income or to enter into arrangements that will yield income is not in general an outlay incurred either in gaining or in carrying on business for the purpose of gaining assessable income; such a payment in the case of a trading company, occurs at a stage too remote from the receipt of income to be so regarded. To be deductible an outlay must be part of the cost of trading operations to produce income, i.e., it must have the character of a working expense.
[13] (1959) 101 CLR 30, 48.
Menzies J concluded that the legal expenses were an outgoing of a capital nature and that “these were affairs of capital, relating as they did to the profit bearing subject rather than its operation.”[14]
[14] Ibid 53.
I conclude that the Legal Fees incurred by the applicant in relation to his litigation were of a capital nature and that they related to the profit bearing subject rather than its operation. The Legal Fees do not have the character of a working expense and are too remote from the potential receipt of income to be so regarded.
The litigation was concerned with the reform of the Trust and how it was to be managed. It was not concerned with the operations of the Trust that produced the income. Further, the Legal Fees were incurred in connection to the 2011 NSW Supreme Court Proceedings and not in connection with the 2014 Federal Court Proceedings. There is no evidence to suggest otherwise. I reject the applicant’s contention that the relief sought in the 2014 Federal Court Proceedings can inform the question of the object for which the Legal Fees were incurred in 2012 and 2013. That question is informed by the relief set out in the 2011 NSW Supreme Court Proceedings.
Even if I am wrong about that, the claim for an account of profits earned by the Trust in the 2014 Federal Court Proceedings does not, on the authorities referred to above, support the contention of the applicant that the Legal Fees were an outgoing incurred on account of revenue. If one leaves aside the 2014 Federal Court Proceedings, then the relief claimed in the 2011 NSW Supreme Court Proceedings goes to the reform of the Trust and the Legal Fees are therefore of a capital nature.
There is no basis for apportionment as claimed by the applicant because I consider that the whole of the Legal Fees was capital in nature. Further, there was no evidence to support the extent of any claimed apportionment.
Penalty
Having found that the applicant is deemed to have been paid a dividend in 2012 in the amount of $278,871 which forms part of his assessable income, then it follows that the applicant has made a false or misleading statement in his tax return. This triggers a liability to an administrative penalty under s 284–75 of the Administration Act. The amount of the penalty is to be determined by reference to s 284–85. The penalty of 50% of the shortfall amount (as defined in s 995-1 of the 1997 Act) is based on a finding by the respondent that the shortfall resulted from recklessness as to the operation of a taxation law.
As highlighted in Federal Commissioner of Taxation v R & D Holdings Pty Ltd,[15] recklessness means something more than a failure to exercise reasonable care, but less than an intentional disregard of the Act. In that case, Heerey and Edmonds JJ approved the following statement by Cooper J in BRK (Bris) Pty Ltd v Federal Commissioner of Taxation[16]:
Recklessness in this context means to include in a tax statement material upon which the Act or regulations are to operate, knowing that there is a real, as opposed to a fanciful risk, that the material may be incorrect, or be grossly indifferent as to whether or not the material is true and correct, and that a reasonable person in the position of the statement-maker would see that there was a real risk that the Act and regulations may not operate correctly to lead to the assessment of the proper tax payable because of the content of the tax statement. So understood, the proscribed conduct is more than mere negligence and must amount to gross carelessness.
[15] (2007) 160 FCR 248, [70].
[16] (2001) 46 ATR 347, 364.
The circumstances of the entry into the 2007 Loan Agreement inform the issue of recklessness. It is apparent from the Confidential Settlement Deed dated 13 April 2007 that the applicant was aware of the need to ensure that the loan advanced to him in 2005 was on terms compliant with Division 7A of the 1936 Act. Further, it is apparent from the email received by the applicant on 21 November 2007 that he was aware of the repayment obligations that arose from the terms of the proposed 2007 Loan Agreement.
Schedule 2 to the 2007 Loan Agreement provided for an amount of interest and principal payable in the year ending 30 June 2012 in the sum of $427,613.69. Instead of paying this amount the applicant only paid $150,000 which resulted in the repayment shortfall of $278,871.94.
The applicant gave no evidence at the hearing so there is no explanation as to why the applicant did not comply with his repayment obligations. Further, there is no explanation as to why the applicant did not include the amount of the repayment shortfall in his 2012 tax return. In the absence of any explanation and in the circumstances of the Confidential Settlement Deed and the 21 November 2007 email I find that it is inherently probable that the applicant was aware of the deemed dividend and that it should have been disclosed to the respondent in his tax return. At the very least the evidence establishes that the applicant showed a disregard of, or indifference to, the consequences foreseeable from not disclosing the deemed dividend.[17] It follows that a finding of recklessness is appropriate in all of the circumstances.
[17] Hart v Commissioner of Taxation (2003) 131 FCR 203, [43].
In all of the above circumstances I am not satisfied that it is appropriate to remit the penalty in whole or in part. There is no evidence from the applicant to support a finding that his circumstances are such that the imposition of the penalty would be unreasonable or unjust.
Decision
The Tribunal affirms the decision under review.
The Tribunal affirms the decision under review.

67. I certify that the preceding 66 (sixty-six) paragraphs are a true copy of the reasons for the decision herein of Deputy President P Britten-Jones

.................[sgd]..................
Associate
Dated: 19 February 2019

Date of hearing: 5 November 2018

Counsel for the Applicant: Mr J Balazs

Solicitor for the Applicant: Balazs Lazanas & Welch LLP

Counsel for the Respondent: Mr S White SC & Mr M O’Meara

Solicitor for the Respondent: Australian Government Solicitor

[2019] AATA 204

19 February 2019

Key Legal Topics

Areas of Law

Tax Law

Statutory Interpretation

Contract Law

Legal Concepts

Statutory Construction

Contract Formation

Constructive Trust

Remedies

Appeal

Date of hearing:	5 November 2018
Counsel for the Applicant:	Mr J Balazs
Solicitor for the Applicant:	Balazs Lazanas & Welch LLP
Counsel for the Respondent:	Mr S White SC & Mr M O’Meara
Solicitor for the Respondent:	Australian Government Solicitor