Lean and Commissioner of Taxation
[2008] AATA 519
•20 June 2008
Administrative Appeals Tribunal
DECISION AND REASONS FOR DECISION [2008] AATA 519
ADMINISTRATIVE APPEALS TRIBUNAL )
) No NT2006/0335
TAXATION APPEALS DIVISION ) Re DAVID LEAN Applicant
And
COMMISSIONER OF TAXATION
Respondent
DECISION
Tribunal Mr P W Taylor SC, Senior Member Date 20 June 2008
PlaceSydney
Decision The decision under review is set aside. The matter is remitted to the Commissioner for reconsideration in accordance with the direction that the misappropriation loss claimed by the Applicant is, as to the amount of $2,315,157, a deduction permitted by Income Tax Assessment Act 1997 s 25-45. .................[sgd].............................
Mr P W Taylor SC
Senior Member
CATCHWORDS
TAXATION – income tax – deductions – taxpayer transferred US share sale profits to Hong Kong for trading and investment – funds misappropriated – misappropriation loss characterised as being of capital nature –deduction not allowable under s 25-40 – deduction allowed under s 25-45 to the extent US share sale profits had been included in assessable income – entitlement to deduction not affected by s 79D ITAA36 – decision under review set aside and matter remitted to the Commissioner with the direction that the misappropriation loss claimed by the Applicant is, as to the amount of $2,315,157, a deduction permitted by Income Tax Assessment Act 1997 s 25-45
Income Tax Assessment Act 1936 – ss 25, 26, 71, 79D, 160AFD
Income Tax Assessment Act 1997 – ss 6-1, 6-5, 8-1, 15-15, 25-40, 25-45
Taxation Administration Act 1953 – s 14ZZK
Taxation Ruling IT 2228: Income Tax: Futures Transactions
Charles Moore & Co (WA) Pty Ltd v Federal Commissioner of Taxation (1956) 95 CLR 344
Thiel v Commissioner of Taxation (1990) 171 CLR 338
Kirkwood v Gadd [1910] AC 422
Smith v Capewell (1979) 142 CLR 509
Ferguson v Federal Commission of Taxation (1979) 79 ATC 4261
Firth v Federal Commissioner of Taxation (2001) ATC 4615
Commissioner of Taxation v Osborne (1990) 26 FCR 63
Thomas v Federal Commissioner of Taxation (1972) 46 ALJR 397
Crawford v Federal Commissioner of Taxation (1993) 93 ATC 5234
Federal Commissioner of Taxation v Myer Emporium Ltd [1986-1987] 163 CLR 199
Commissioner of Taxation (NSW) v Ash (1938) 61 CLR 263
Case V24 (1988) 19 ATR 3117
FCT v Montgomery (1999) 198 CLR 639
Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337
XCO Pty Ltd v Federal Commissioner of Taxation (1971) 124 CLR 343
Steinberg v Federal Commissioner of Taxation [1972-1975] 134 CLR 640
Clowes v Federal Commissioner of Taxation (1954) 91 CLR 209
Official Receiver in Bankruptcy v Federal Commissioner of Taxation (Fox’s Case) (1956) 96 CLR 370
Federal Commissioner of Taxation v Whitfords Beach Pty Ltd (1982) 150 CLR 355
Atlas Maritime Co SA v Avalon Maritime Ltd (The Coral Rose) (No.3) [1991] 4 All ER 769; [1991] 1 WLR 917
Idoport Pty Limited and Anor v National Australia Bank Limited and Ors; National Australia Bank Limited v OAMPS Limited and Ors [2004] NSWSC 695
Burton v Arcus (2006) 200 FLR 1
EHL Burgess Pty Ltd v Federal Commissioner of Taxation (1988) 80 ALR 639; (1988) 88 ATC 4517
Re Grima and Federal Commissioner of Taxation (2000) 44 ATR 1046; [2000] AATA 199
Re Applicant and Federal Commissioner of Taxation (Case 15/2004) (2004) 58 ATR 1059; [2004] AATA 1293
Trustees Executors and Agency Co Ltd v Reilly [1941] VLR 110
McDowell v Baker (1979) 144 CLR 413
Nordland Papier AG v Anti-Dumping Authority (1999) 93 FCR 454; 161 ALR 120
Jennings Constructions Pty Ltd v Workers' Rehabilitation & Compensation Corporation (1998) 71 SASR 465
Workers’ Compensation Board (Qld) v Technical Products Pty Ltd (1988) 165 CLR 642
Law Society of NSW v Bruce (1996) 40 NSWLR 77
Wonall Pty Ltd v Clarence Property Corporation Ltd (2003) 58 NSWLR 23
Technical Products Pty Ltd v State Government Insurance Office (QLD) (1989) 167 CLR 45
Daly v Sydney Stock Exchange Ltd [1982] 2 NSWLR 421
REASONS FOR DECISION
20 June 2008 Mr P W Taylor SC, Senior Member 1.In early 2001 Mr Lean was led to believe Mr Shayne Heffernan was a reputable, and highly successful, securities trader and investment fund manager. He reputedly operated in Hong Kong in association with Equity-1 Ltd, Our World Exchange Ltd and International Trading Brokers Ltd. Mr Lean first invested $5,000. Our World Exchange Ltd acknowledged this as a deposit to its Our World Exchange Fund, and soon reported its impressive growth. Mr Lean decided to make a more substantial investment. He exercised share options in the United States and had his US stockbrokers transfer the share sale profits to a Hong Kong bank account nominated by Heffernan. Two share sale profit transfers, totalling about $4.63m, were made in July and August 2001.
2.In early 2002 Mr Lean was repaid $150,000. By June 2002 the only documentary evidence Mr Lean had of any trading or investment relating to his funds was a “margin deposit statement” for Equity-1 Ltd recording trading losses of AUD$1,367,566 on the Hong Kong Futures Exchange in September 2001. He concluded the balance of his funds had been used by Heffernan to operate a Ponzi scheme and was irrecoverable. He has not since recovered any more of his original $4.63m.
3.Mr Lean included in his 2002 assessable income (which totalled $2,825,256) a net capital gain of $2,791,833 from the US share sale profits. He claimed deductions of $4,972,671 – consisting of (i) the $1,367,566 “trading loss” indicated in the September 2001 “margin deposit statement”, (ii) a $3,287,749 misappropriation by Heffernan, and (iii) a $317,356 loss related to US share trading.
4.The Commissioner’s 12 May 2006 Notice of Assessment disallowed all three of the claimed deductions. The assessment resulted in Mr Lean having an outstanding tax liability of $1,309,196. Mr Lean’s 3 July 2006 Objection disputed the Commissioner’s disallowance of the $3,287,749 misappropriation deduction claim. On 28 August 2006 the Commissioner confirmed the disallowance. The basis of the disallowance was that:
(a)the $3,287,749 misappropriation loss was not deductible under s 8-1 of the Income Tax Assessment Act 1997 (“ITAA97”) because it was either not a loss incurred in carrying on a business or profit making undertaking, or was a loss of a capital nature,
(b)alternatively, even if the misappropriation loss was otherwise deductible under ITAA97 s 8-1, both it and each of the trading losses (the disallowance of which had not been challenged in the Objection) were only deductible to the extent of any foreign assessable income because of s 79D of the Income Tax Assessment Act 1936 (“ITAA36”).
5.In the review proceedings Mr Lean relied on four contentions to support his deduction claim for the Hong Kong losses. These were that:
(a)the alleged $1.367m trading loss and the misappropriation loss were each deductible under the general deduction provisions in ITAA97 s 8-1 and gave rise to a total deduction of $4,630,345;
(b)alternatively, the $4,630,345 loss (again including its two separate components) was a loss that arose from carrying on a profit-making undertaking and was deductible under ITAA97 s 25-40;
(c)alternatively, the misappropriation loss was “caused by theft … or misappropriation” by an agent and was deductible under ITAA97 s 25-45, to the extent of $2,803,052 - the latter being the amount of the assessable income to which it related;
(d)the US share sale profits were foreign income and any loss was a foreign loss, consequently ITAA36 s 79D did not preclude deduction of the $2.8m loss under ITAA97 s 25-45, and the balance of the loss was a general deduction that could be carried forward to subsequent income years.
Objection and disallowance – available Grounds: Taxation Administration Act 1953 s 14ZZK(a)
6.The taxpayer’s contentions in the review proceedings relate to both of the “misappropriation” and “trading” losses he claimed in his 2002 return. They also relied on ITAA97 s 25-45. Therefore they went beyond the grounds raised in the 3 July 2006 Objection. But neither challenging the Commissioner’s disallowance of the “trading loss”, nor relying on ITAA97 s 25-45, involves any new factual information. Accordingly, on his application, and without opposition from the Commissioner, I ordered that Mr Lean should be permitted to rely on all of the contentions I have summarised above.
The money transferred to Hong Kong and claimed to have been Lost
7.Mr Lean’s various transfers to Hong Kong were acknowledged in four “Australian Dollar E-ceipt” documents. These documents were all under the letterhead of Our World Exchange. The first two E-ceipts recorded receipt of AUD $4,995 and AUD$517,416, on behalf of Mrs Lean. They stated the money had been credited to a numbered account (61-20F-10691-10) in her name and deposited to the Our World Exchange Fund. The third and fourth E-ceipts related to the August 2001 transfer and acknowledged receipt of AUD$4,112,898.59 / US$2.060,640.34. They stated the funds had been credited to two different numbered accounts ((AUD E-ceipt: 61-20F-11193-10) and (USD E-ceipt: 61-20F-11193-20)) in Mr Lean’s name and had been deposited to a “private client” account.
8.In mid October 2001 Mr Lean obtained a statement for the Our World Exchange Fund account no. 61-20F-10691-10 in his wife’s name. It reported a 30 per cent monthly compound growth rate since May 2001 and an account balance of $1,097,312. He arranged to make a number of transfers and adjustments to the accounts:
(a)he “transferred” the Our World Exchange Fund account into a “private client” account with the same name and number,
(b)he changed the name of the USD private client account (61-20F-11193-20) to Berkley Commodities Ltd, SA,
(c)he caused Ike and Doowitt Investing Pty Ltd to deposit AUD$10,000 to the Berkley Commodities account no. 61-20F-11193-20.
9.Mr Lean says that until February 2002, he regularly discussed “trading” and other supposed investment activities with Heffernan involving the “private client” account. Mr Lean requested documents confirming the details of the transactions. None was provided.
10.On 14 January 2002 Mr Lean faxed a withdrawal request, on a form he appears to have been given by International Trading Brokers Ltd, for the return of $600,000. This request related to the account no 61-20F-10691-10. This account had been in his wife’s name until at least 17 October 2001. The withdrawal request said the account holder was “Planan Trust” and asked for the funds to be paid to “Ike & Doowitt Investing Pty Ltd as TRUSTEE for the PLANAN TRUST”. (This suggests yet another change in the account names, but neither party attributed any significance either to the change or to any transactions it might have reflected.)
11.The standard printed terms of the withdrawal request form indicated that requested funds would be returned within about 45 days. There was delay, which Heffernan blamed on the banks. He promised to transmit the $600,000 amount in 12 amounts of $50,000, supposedly to avoid “banking enquiries”. He repaid only $150,000.
12.Ultimately, the only significant document Heffernan provided in response to Mr Lean’s requests for confirmation of his trading activities was a “margin deposit movement” statement issued by Standard Capital Commodities Ltd. This statement was addressed to Equity-1 Ltd and related to September 2001 trading on the Hong Kong Futures Exchange. The trading result it reported is summarised in the following table. (I have added into the table an AUD conversion column and a trading summary note.)
Table 1
Futures Trading statement for Equity-1 Ltd HKD AUD Opening balance 785,608 194,689 Deposit / withdrawal 7,505,550 1,860,019 Exchange Fee / Levy (7,084) Commission (57,120) Swap Int / Option Prem 0 Trading P & L (5,454,280) Trading SummaryNote Total loss & expenses (5,518,484) (1,367,566) Buy contracts 36,640,241 Sell contracts 35,288,585 Closing Balance 2,772,793 687,151 Futures Floating P & L (1,365,800) Options value 0 Equity 1,406,600 348,582 Margin Requirement 2,875,000 Available Margin (1,468,007) 13.Mr Lean said that when Heffernan gave him this statement he told him it covered trades that had been done on his behalf by Equity-1 Ltd. Mr Lean has, therefore, assumed the futures trading loss in the statement related to his funds. Having made that assumption, the history of his fund transfers to Hong Kong, including the $150,000 repayment, can be summarised in the following table. As can be seen, this requires some (comparatively minor) correction to the misappropriation loss originally claimed. It also reveals the need to reduce the total deduction claim to take account of the amount repaid in 2002.
Table 2
Lean Transfers to Hong Kong and Calculation of Trading and Misappropriation Losses Date Description AUD USD 14-May-01 NAB Brisbane transfer less bank fee - transfer to One World Exchange Fund a/c - a/c Therese Lean 4,995 11-Jul-01 US share sale net proceeds less transfer fee - transfer to One World Exchange Fund a/c 517,416 261,709 24-Aug-01 US share sale net proceeds less transfer fee - transfer to “Private Client” a/c 4,112,898 2,060,640 19-Nov-01 NAB St Ives transfer - transfer by Ike and Doowitt Investing Pty Ltd 10,000 Total value of transfers to Hong Kong 4,645,309 Balance of funds provided by Lean personally 4,635,309 Balance of funds attributable to US share profit 4,630,314 - comprising Sep-01 “trading loss” claim 1,367,566 Mar-02 “misappropriated” loss claim 3,262,748 Adjustment Feb/Mar-02 Repaid from HK 150,000 Total “loss” (from US share profits) 4,480,314 2,322,349 Total “loss” from all funds 4,495,309 Mr and Mrs Lean’s share trading partnership
14.The principal contention underlying the $4.63m deduction claim was that the loss occurred in the course of a share trading business or plan carried out by Mr Lean. He had indeed undertaken share trading activities for some years before the 2001/2002 income year. In 1987 he had formed a share trading partnership with his wife. In 1997 they started trading in US shares, using an account in his wife’s name with a US broker, and margin loans. This foreign share trading was not included in Mr Lean’s tax returns until amended returns for the years 1998 to 2001 were submitted with the 2002 tax return. In the amended returns the US share trading was disclosed as a partnership activity and the share trading losses were claimed, as to 50 per cent of the total, in each of their individual returns. In the 2002 return, Mr Lean’s Hong Kong activities were separately disclosed. They were described as an “investment operation own account” conducted under the name “David Lean Hong Kong Trading”. Those activities were treated as wholly attributable to Mr Lean. The trading details, and loses claimed, included in Mr Lean’s various returns are summarised in the following table.
Table 3
1998 1999 2000 2001 2002 2002 2002 US p'ship with Mrs Lean HK Total Trading income 93,427 25,248 23,251 15,544,380 6,414,571 35,288,585 41,703,156 Trading expenses 113,744 30,270 38,565 15,627,271 6,672,465 36,640,241 43,312,706 Interest / other costs 5,132 9,785 14,247 12,566 59,461 3,303,659 3,363,120 Net profit -25,449 -14,807 -29,561 -95,457 -317,355 -4,655,315 -4,972,670 15.On the basis that the trading income and expenses included in Mr Lean’s amended 1998 – 2000 tax returns reflect only his half share of the partnership activities, the total partnership share trading income in 1998 was about $180,000. It was significantly more modest in 1999 and 2000. In his affidavit evidence Mr Lean suggested that the initial US trading was typified by trades between US$20,000 and US$300,000 on an account that varied between US$200,000 and US$400,000. It is difficult to reconcile that suggestion with the total income in the 1998 – 2000 years, and perhaps it really only applies to the 2001 year. The evidence does not disclose the value or frequency of the individual US share trading transactions before that year.
16.The US share trading was certainly very substantial in the 2001 year. This is suggested by the reported income, and corroborated by a transaction listing included in the evidence. The listing recorded over 100 transactions between 10 May 2001 and 30 June 2001. These accounted for the preponderance of the partnership’s approximate $31m share trading income for the year.
17.Taken in isolation, the limited details of the trading activities in the individual years before 2001, especially the relatively modest trading volumes, and the contrast with those achieved in the later months of 2001, might not justify the conclusion that Mr and Mrs Lean’s US share trading amounted to carrying on on a business in the earlier years. But it is certainly the case that Mr Lean began to take a more active interest in share trading from about June 2000 onwards. The more modest volume of transactions in the earlier years can be viewed as indicating the preliminary stages of the business. The losses incurred in those years can be regarded as the impetus for the greater application, endeavour and assistance that occurred from June 2000 onwards, without indicating that the increased activities in that year marked the real commencement of their share trading business. I am inclined to that view.
18.Irrespective of the proper characterisation of Mr and Mrs Lean’s US share trading activities prior to the 2001 tax year, it is readily apparent that they then assumed an entirely different scale. Beginning in about June 2000 Mr Lean had approached various companies that offered advice, educational services and research relating to share trading. He came into contact with a company that provided research and a share trading system. In November 2000, at a total cost of about $10,000, he became a subscriber to the share trading system offered by Metashare International Pty Ltd. He acquired various software licences to the company’s share trading products, and also to share data services offered by other companies. He attended monthly meetings of Metashare’s “user group” of customers.
19.In December 2000 Mr Lean was encouraged to acquire a foreign company for the purpose of facilitating his North American share trading activities. In late December 2000 he received documents relating to the incorporation of Berkley Commodities Limited SA, a company incorporated in the Republic of Panama. The documents also included a power of attorney, in favour of Mr Lean and dated 20 December 2000. Mr Lean understood that he had “acquired” the company - a conclusion that is not self evident from the contents of the documents he actually produced. Although Mr Lean used the name in connection with the Hong Kong private client account, nothing in the evidence suggests its role was other than as a mere nominee for him.
Introduction to Heffernan and Equity-1 Ltd – distinction from the us share trading partnership
20.In January 2001, at one of the Metashare user group meetings, one of the Metashare employees approached Mr Lean for a private and confidential meeting outside the company’s offices. This private meeting was to inform him about a supposedly successful international trader. This trader turned out to be Mr Heffernan. He was portrayed to Mr Lean as an experienced trader who reputedly produced “unprecedented earnings of 20 to 40% per month for select international investors”. This remarkable performance was said to be attributable to his use of “technologically superior, secret trading program systems and highly efficient methods of investment funds management”. Mr Lean was told that Heffernan conducted the businesses known as International Trading Brokers Ltd with associated trading entities including Our World Exchange Ltd and Equity-1 Ltd. He had an Australian representative, ABL Investments Pty Ltd.
21.Curious to investigate Mr Heffernan’s reputed success, on 11 May 2001 Mr Lean submitted a new account approval form addressed to Our World Exchange Ltd. He asked for the account to be in his wife’s name “to prevent any confusion or conflict” with investments in his own name that were on behalf of their partnership. On 14 May 2001 Mr Lean arranged for $5,000 to be transferred from his National Australia Bank account to an account operated by ABL Investments Pty Ltd. On 15 May 2001 he received an “E-ceipt” acknowledgment of the deposit of $4,995 on the letterhead of Our World Exchange. A few days later he received by email a username and password for internet access to an Our World Exchange Account.
22.Mr Lean’s explanation for opening the One World Exchange Fund account in his wife’s name strongly points to a deliberate intention to distinguish between the US share trading partnership business, and the Hong Kong relationship with Heffernan. This distinction is reflected in the fact that the US share trading, was funded by margin loans and that this trading continued, indeed significantly increased, before the first US share option exercise transaction at the beginning of July 2001. The distinction between the US and Hong Kong activities is also reflected in Mr Lean’s 2002 tax return, and its different description of the two businesses. It is particularly indicated by the fact that the whole of the Hong Kong losses, but only 50 per cent of the US trading losses, were taken up in Mr Lean’s 2002 tax return.
23.Throughout the remainder of May and June 2001 Mr Lean regularly monitored the website of International Trading Brokers Ltd. The website purported to report the profitable growth of his account, without reporting any details of particular transactions. He was also in regular internet and telephone contact with Heffernan. These discussions did not directly involve Mr and Mrs Lean’s US share trading partnership, and presumably concerned Mr Lean’s Our World Exchange Fund account. But the total volume of the partnership US share trading activity in May and June 2001 was in the order of AUD$31m. This dramatic increase in activity is consistent with Mr Lean having his own significant interest in share trading and points to the likelihood that his frequent discussions and contact with Heffernan related to more than his modest $5,000 initial investment.
Developing the relationship with Heffernan – July 2001 onwards
24.Mr Lean was impressed by Heffernan and the apparent growth of the $5,000 investment in his Our World Exchange Fund account. He foreshadowed to Heffernan an increase in his investment by exercising some Microsoft stock options. He said that after reducing his loan commitments, he would place part of the anticipated $500,000 proceeds with Heffernan. Heffernan encouraged him to make the full amount available. Mr Lean required at least its partial return in the short term and Heffernan promised to return it within six months, explaining that the trading strategy in his trading programs required money to remain invested for that minimum period. Heffernan also invited Mr Lean to attend a trading seminar in the Philippines in August 2001.
25.Thus encouraged, Mr Lean made the first of his share sale proceeds transfers (in an amount of AUD$517,416) on 11 July 2001. This was acknowledged by Our World Exchange as having been credited to the existing Our World Exchange account in his wife’s name. The funds were described as having been “deposited” to the Our World Exchange Fund.
26.In his affidavit Mr Lean described the purpose of his investment as “trading”, but the few documents he was able to produce suggested that he was merely a contributor to a fund. Under such an arrangement all of the trading activities would be conducted by Our World Exchange Ltd and would be its trading activities rather than those of the contributors to the fund.
27.Mr Lean said in his oral evidence he understood that the Our World Exchange Fund account was intended to operate as part of a pooled fund. It was a fund that provided capital growth and the investor clients generally had no direct involvement with its operation and trading activities. But he regarded his circumstances as something of an exception. The proposal for his July 2001 share profit transfer grew out of discussions with Heffernan about his interest in setting up his own share trading scheme. Heffernan suggested that an interim arrangement would give Mr Lean the opportunity to work with Heffernan and learn something of his trading methods and operations. Because they were in such regular conduct, Mr Lean regarded himself, and thought Heffernan regarded him, not so much as one of the ordinary pooled investors, but as someone who was heading towards achieving private client status. The end result of this was Mr Lean’s understanding that, apart from his initial $5,000 investment in May 2001, he did not really think he was part of a “pooled fund”. He claims he thought that his funds were not mixed with those of other clients and that, because of his regular discussions with Heffernan, he had a fair degree of control over trading and investment decisions.
28.I do not accept this explanation. It is quite contradicted by Mr Lean’s basic understanding of the “pooled” nature of the Our World Exchange Fund. That understanding, and the fundamental difference between the Our World Exchange Fund account and the “private client” account, is evidenced by the fact that Mr Lean maintained the Our World Exchange Fund account until October 2001. The significance of that understanding, and the retention of the Our World Exchange Fund account, is underscored by the discussions between Mr Lean and Heffernan in August 2001.
29.In August 2001 Mr Lean attended Heffernan’s trading seminar in the Philippines. In their previous discussions Heffernan had made Mr Lean aware of the purported distinction between his “small” investors and “private clients”. Mr Lean understood that, although his Our World Exchange Fund amount did not satisfy the “private client” investment criteria, Heffernan regarded him as someone who was likely to move to “private client” status. Because of that expectation Heffernan was willing to discuss investment matters with him to a greater extent than was the case for other small investors. At the August 2001 seminar Heffernan elaborated on the “private client” account concept. “Private clients” were “sophisticated investors” whose investment funds exceeded US$1m. They did not require prospectus disclosures and could participate in joint ventures, Initial Public Offerings and “additional highly profitable ventures” Heffernan could make available.
30.At a subsequent private meeting during the course of the August 2001 seminar, Heffernan offered Mr Lean a “partnership” relationship in a “Trade the World” account. Mr Lean said Heffernan told him this “private client” account arrangement was to be a true partnership in which all decisions would be made jointly. Somewhat inconsistent with that claim of true partnership, Heffernan also promised that the account would be in Mr Lean’s own name and that he would be able to “maintain full control” of the account. Nevertheless, on the basis of these “partnership” assurances from Heffernan, Mr Lean arranged for the exercise of further share options in the US and the 24 August 2001 transfer of AUD$4,112,898 of the share sale proceeds. This amount was belatedly acknowledged by Our World Exchange Ltd as having been deposited to a “private client account” in Mr Lean’s own name.
31.In fact, the notion of a “partnership” considerably oversimplifies the scenario that Heffernan laid out to Mr Lean. Heffernan conveyed to Mr Lean something in the nature of a grand scheme. This involved gathering a group of private clients with whom he could form strong and close relationships. This group of private clients would pursue a range of activities and ventures. This included share trading, but was purported to extend well beyond it into taking up initial public offerings, making company acquisitions, acquiring or developing businesses and making other investments in particular projects. Ultimately, the assets and businesses acquired would be sold into a publicly floated company. In this way the “private client” investors would make money both from share trading and from the sale to the foreshadowed public company.
32.This grand strategy involved the use of Equity-1 Ltd. Mr Lean said he saw this company as “synonymous with Shayne”. He claimed it was just a company vehicle that Heffernan was using and something into which, according to Mr Lean’s understanding, he had “wrapped” up their relationship. However, Mr Lean well understood that Equity-1 Ltd was also the vehicle for the “private client pool” involving 17 other investors. Mr Lean believed he was one of this group of people. He was investing heavily and thought that he was “part of the company”. Somewhat paradoxically, however, he realised he was neither a director nor a shareholder of Equity-1 Ltd.
33.According to Mr Lean’s understanding, Heffernan’s longer term strategy with Equity-1 Ltd and the private client investors involved share trading and business acquisitions. Mr Lean discussed various proposals with Heffernan, and also saw evidence of activity that he interpreted as consistent with the implementation of the strategy. In late 2001 Equity-1 Ltd, for example, made a takeover offer for Admiralty Resources NL. Heffernan told Mr Lean he thought Admiralty Resources NL was significantly undervalued. He told Mr Lean that the company was unaware of the real value of its South American mineral deposits, and that the takeover would result in an “unprecedented financial windfall” for his investors. There was discussion about Equity-1 Ltd establishing, or participating in, a number of other ventures ranging from nanotechnology and fuel cell development to wind power generators and a paper mill. There was also discussion about Equity-1 Ltd acquiring an ASX listed discount brokerage company, and two other ASX listed resource companies – Kimberly Oil NL and SMC Gold Ltd.
34.Heffernan and Equity-1 Ltd’s interest in the acquisition of Admiralty Resources NL, SMC Gold Ltd and Kimberly Oil NL seems to have been most intense, at least according to Mr Lean’s understanding, between September 2001 and December 2001. Mr Lean said that related activities, or at least the appearance of them, dwindled on, at various stages of supposed progress, until Heffernan left Hong Kong in March 2002.
35.In the meantime, in December 2001, Heffernan had encouraged Mr Lean to agree to switch a substantial part of his funds from USD into Euros. Mr Lean agreed, but never obtained any written confirmation that it had been done. Heffernan also encouraged Mr Lean to become involved in trading in “contracts for differences”. He told Mr Lean that he had established an account with Saxo Bank for this kind of trading. Mr Lean was able to get access to an internet site that confirmed the existence of such an account in Equity-1 Ltd’s name, but he could not obtain any evidence of individual trading activity and certainly no evidence of any trading having been carried out on his behalf. Mr Lean got the impression that Heffernan had actually carried out trading without his prior approval, but he never obtained any specific details.
36.By December 2001 Mr Lean was becoming increasingly concerned at Heffernan’s failure to provide him with any documents confirming the trading activities that he claimed to have carried out. That failure was accompanied by various excuses about poor administrative systems and posted documents going astray. In January 2002 Mr Lean demanded the return of AUD$600,000 from Heffernan. Excuses and delays followed the request. It was not until March 2002 that Mr Lean finally received the repayment of $150,000. Even then Mr Lean received, from other sources, information suggesting that these repayments had been funded from “investments” made by others, rather than reflecting the actual return of his own funds.
37.The ambitiously diverse range of activities Heffernan portrayed to Mr Lean, the supposed “pool” of private client investors, and the mechanism of a public float to realise the potential value of Equity-1 Ltd’s proposed acquisitions, combine to suggest the unlikelihood that Equity-1 Ltd was in any sense ever portrayed as conducting its activities on Mr Lean’s behalf. The suggestion is further encouraged by Mr Lean’s evidence that he thought he was “part of the company”.
38.Nevertheless, Mr Lean says that Heffernan told him that each of Equity-1 Ltd’s various trading accounts with brokers was linked directly back to an individual private client. He claims he thought Heffernan was trading on his personal behalf and was not to pool his funds with those of other private clients, except for bigger transactions. He claims always to have believed that in relation to his “private client account” Heffernan and Equity-1 Ltd were just one and the same and synonymous with his relationship with Heffernan.
39.This last claim might have had some arguable basis if Mr Lean had been under the impression that his relationship with Heffernan was indeed personal and direct. However, his evidence does not permit such a specific finding to be made. Mr Lean said he thought Heffernan was “trading as an agent for me or in a business arrangement with me”. This disjunctive expression “or in a business relationship with me” is telling. It is particularly significant in the light of his understanding that he was “part of the company”. It reveals that Mr Lean did not ever have, and was certainly not able to convey in his evidence, any clear understanding of the precise nature of his relationship with Heffernan.
Were there any trading losses?
40.Apart from the E-ceipts, the October 2001 statement for the Our World Exchange Fund account, and regular assuring verbal reports, Mr Lean obtained no real evidence of any trading or investment activity that was carried out on his behalf. The September 2001 “margin deposit statement” for Equity-1 Ltd recorded trading losses of AUD$1,367,566 on the Hong Kong Futures Exchange in September 2001. But the view that this trading loss relates to Mr Lean personally rests entirely on statements Mr Lean attributes to Heffernan.
41.In fact, there is no objective evidence to link Mr Lean’s funds with Heffernan’s claim that the September 2001 futures trading was carried out on Mr Lean’s behalf. The September 2001 statement records amounts in HKD. But when regard is had to the equivalent AUD amounts, there is simply no correlation with the amounts Mr Lean provided. Nor did Mr Lean give any evidence directly linking himself with the trading transactions identified in the statement. In fact the context in which he gave evidence about the September 2001 statement suggests Heffernan gave it to him after January 2002, in the context of attempting to explain his failure to return Mr Lean’s funds. As such, the explanation was really an attempt to deflect Mr Lean from concern about the misappropriation of his funds, by claiming that there had been a genuine trading loss.
42.There is, as he ultimately accepted in his oral evidence, no available documentary evidence to demonstrate Mr Lean incurred any trading losses in relation to the funds he provided to the entities apparently associated with Heffernan. In the absence of credible objective evidence of genuine trading activities the most likely explanation for the loss of Mr Lean's funds is that they were misappropriated by Heffernan. This conclusion is enhanced by the fact that on 30 January 2003 the Australian Securities and Investment Commission (ASIC) issued an investor warning in relation to Equity-1 Ltd. The ASIC warning was addressed to investors contemplating sending money overseas either to Equity-1 Ltd or to its related organisations, ITB Limited and Our World Exchange. The ASIC warning (which does not appear to have taken into account the money Mr Lean provided) reported that several hundred investors had transferred more than $3.5 million to Equity-1 Ltd in response to promises of returns of 30 per cent on international share trading. ASIC advised that although Equity-1 Ltd was registered as a foreign company in Australia it was not licensed in Australia to offer any financial advice or financial products of any kind. The ASIC warning went on to report advice from the Hong Kong Securities and Futures Commission that Equity-1 Ltd had no actual presence in Hong Kong, but was using a “mail forwarding facility” to give the appearance of having a Hong Kong-based presence and operation. In these circumstances, Mr Lean’s view that Mr Heffernan was simply operating a Ponzi scheme, is consistent with the available information and is the preferable conclusion to draw from the circumstances. Mr Lean did not incur any trading losses. His money was simply misappropriated.
General deduction for loss incurred in carrying on business – itaa97 s 8-1
43.My conclusion that the Mr Lean’s evidence does not establish he suffered any trading losses removes the possibility of the $1.367m deduction claim being allowed on that basis. Conversely, the same evidence demonstrates that Mr Lean has certainly lost, as a result of misappropriation, the net balance of the amounts he provided to Heffernan (that is, the $4.495m amount identified in Table 2 set out earlier in these reasons). Mr Lean contends that this misappropriation loss is a permissible general deduction.
44.Earlier in these reasons I described the transfer of the Our World Exchange Fund account to the private client account. I also referred to the various apparent changes of name to the private client account. These changes might, conceivably, require more consideration, and examination of the reality underlying them, if it was proper to conclude that they occurred after the misappropriation of the US share sale proceeds. But I do not consider that such a finding should be made. The evidence suggests that there was never any substance in any of Heffernan’s claims. His pretended 30 per cent per month compounding returns is fanciful – at least as anything other than a short lived aberration. His supposed grand scheme of a “private client” investment pool was characterised by an imprecision that speaks eloquently of its status as invention and its explanation as deception. The preferable conclusion is that Mr Lean’s funds were misappropriated when they were received. The intention to do so existed from the outset, as did the intention to avoid their return. The misappropriation and losses should therefore be regarded as having occurred soon after he transferred the share sale proceeds in July and August 2001.
45.Under the general deduction provisions in ITAA97 s 8-1 a taxpayer may make certain general deductions from assessable income for losses or outgoings that were either (i) incurred “in gaining or producing … assessable income” or (ii) “necessarily incurred in carrying on a business” for the purpose of producing assessable income. Some misappropriation losses may satisfy one or other of these criteria and be deductible. If a misappropriation loss has been incurred “in the course of” an activity that forms part of the conduct involved in “gaining or producing assessable income” it is available as a general deduction: Charles Moore & Co (WA) Pty Ltd v Federal Commissioner of Taxation (1956) 95 CLR 344 at 349-350.
46.Mr Lean contends his payments to Heffernan’s nominated Hong Kong bank account were made “in the course of gaining or producing assessable income”. Alternatively, the loss of the money occurred in carrying on a business for the purpose of producing assessable income. That business was said to be either a new business he was starting using Heffernan’s services, or it was an expansion of the share trading business he had been conducting in previous years. On either characterisation of his conduct, he contends the misappropriation of the share sale profits was a deductible loss.
47.Mr Lean’s contention that his relationship with Heffernan was merely an extension of his existing share trading business is contradicted by the fact that business was conducted in partnership with his wife. As I have set out earlier in these reasons, when Mr Lean made his transfers to Hong Kong he used an account created in his wife’s name, at least prior to 24 August 2001. This was for the specific purpose of distinguishing the Hong Kong activities from those of the partnership business. That distinction was later reflected in the 2002 tax return he lodged.
48.The characterisation of activities as constituting “carrying on a business” is partly objective, in the sense that it requires consideration of the nature and extent of the conduct. It is also partly subjective, in the sense that it requires consideration of the taxpayer’s purpose. In relation to objective conduct, the concept of “carrying on a business” implies repetitive conduct, typically for an income or profit making purpose: Thiel v Commissioner of Taxation (1990) 171 CLR 338 at 347-348, 352 and 358; Kirkwood v Gadd [1910] AC 422 at 431; Smith v Capewell (1979) 142 CLR 509 at 517-518. It also connotes some element of organisation and systematic pursuit of the business purpose. Consistent with that requirement, the extent of the activity involved, both as to frequency and value, is a relevant consideration, although neither of these measures is, on its own, determinative of characterisation as a business: Ferguson v Federal Commission of Taxation (1979) 79 ATC 4261 at 4264. In the case of an individual taxpayer and a business they carry on, it will involve an element of personal endeavour: Firth v Federal Commissioner of Taxation (2001) ATC 4615 at [14]-[15]; even though the direct business activities are principally carried out by agents: Ferguson v Federal Commission of Taxation (1979) 79 ATC 4261 at 4265. In relation to the taxpayer’s subjective conduct, an actual purpose of profit making is a highly relevant consideration. Where that purpose exists, the taxpayer’s underlying motives, and their subjective belief about the proper characterisation of their endeavours, is not determinative: Ferguson v Federal Commission of Taxation (1979) 79 ATC 4261 at 4265; Firth v Federal Commissioner of Taxation (2001) ATC 4615 at [15]-[16].
49.Mr Lean cannot show that he actually derived any investment income from the matters he discussed with Heffernan. Neither can he show that any investment transactions actually occurred. But his conduct could satisfy the requirements of ITAA97 s 8-1 without evidence that any income has been derived. The point at which a person begins to carry on business may be difficult to identify with certainty, but it should necessarily be regarded as occurring before income is first generated. Losses and outgoings which occur in the period between commencement of the business and before the successful generation of income, are nevertheless deductible: Commissioner of Taxation v Osborne (1990) 26 FCR 63 at 68 – citing Thomas v Federal Commissioner of Taxation (1972) 46 ALJR 397 at 400-401 and Ferguson. Similar reasoning applies to the characterisation of losses and outgoings incurred in the course of deriving assessable income. Expenses incurred for the relevant purpose will be deductible even if the intended income will not be derived until some time in the future: Crawford v Federal Commissioner of Taxation (1993) 93 ATC 5234. Based on this analogy, Mr Lean contended it did not matter in the present case whether or not Heffernan had actually invested any money on his behalf. Instead, it was sufficient that Heffernan received the money with general instructions to hold it on his behalf and to apply it for authorised investment purposes.
50.Mr Lean says the conclusion that his activities constituted a share trading business was accepted by the Commissioner and was not relevantly in dispute. That is certainly true of the partnership share trading in the US, but the characterisation of the partnership’s activities is not relevant to the loss of the funds provided to Heffernan in Hong Kong.
51.I described earlier in these reasons the nature of Mr Lean’s investment in the Our World Exchange Fund account. After doing so I rejected Mr Lean’s evidence that this was an investment account that was to be applied for the purpose of share trading activities conducted on his behalf. I found that the proper conclusion to derive from his evidence was that the Our World Exchange Fund was characterised as a “pooled” fund whose trading activities were portrayed as carried out by Our World Exchange Ltd, without direct involvement of the individual contributors. It necessarily follows that those individual contributors could not be regarded as directly carrying on the business of share trading, at least they could not be so characterised merely because of their participation as investors in the fund.
52.However, Mr Lean’s explanation for his participation in the Our World Exchange Fund equally clearly shows that his participation in the fund was for the purpose of profit. It was, at least in relation to his initial investment, likely to be a short term arrangement explicitly for the purpose of profit making. In these circumstances, even if the investment should be regarded as a singular transaction of short term duration, and thus not evidence of the conduct of a business, the anticipated profit from the Fund’s activities would constitute income according to ordinary concepts. This conclusion flows from application of the reasoning of the High Court in Federal Commissioner of Taxation v Myer Emporium Ltd [1986-1987] 163 CLR 199 at 209 and 213.
53.I also described above the nature of Mr Lean’s “private client” arrangement with Equity-1 Ltd and Heffernan. Mr Heffernan variously described this arrangement in terms that suggested agency, partnership, business arrangement, collective or “private client pool”. Mr Lean recognised that all of the purported activities of this group were carried out in the name of Equity-1 Ltd, apparently as part of the grand scheme to achieve a public float of the assets and businesses that it was to acquire. Even in relation to the prospect of individual trading transactions on behalf of individual private client investors, Heffernan’s representation to Mr Lean was that Equity-1 Ltd held the accounts (with sharebrokers, for example) in its own name, but internally “tied” different accounts to the individual clients concerned.
54.I do not consider that Mr Lean’s evidence about the private client account arrangements merit it being described as anything more than a means for opportunistic transactions that might from time to time include share trading activities. The breadth and vagueness of Heffernan’s representations lack the qualities of regularity and specificity that are ordinarily required to characterise the private client account deposit as itself involving the conduct of a business. Furthermore, the appearance that all trading activities were to be carried out by Equity-1 Ltd, against the background of the vague entitlement and beneficial interest of the supposed group of “private client” investors, hampers any conclusion that any business involved in Equity-1 Ltd’s activities was being carried on by Mr Lean.
55.The vague and expansive generality of Mr Lean’s description of his “private client” arrangement with Heffernan does, however, comfortably establish that its purpose was to derive profit, from both trading and capital investment as opportunities presented themselves to Heffernan. Profit so derived would, for the reasons given in Federal Commissioner of Taxation v Myer Emporium Ltd [1986-1987] 163 CLR 199 at 209 and 213, readily constitute ordinary income.
56.The criteria for determining the deductibility of a misappropriation loss as a general deduction under ITAA97 s 8-1 were discussed in Charles Moore & Co (WA) Pty Ltd v Federal Commissioner of Taxation (1956) 95 CLR 344. In that case the taxpayer was a major department store and was clearly “carrying on a business for the purpose of gaining or producing … assessable income”. But the reasoning that determined the decision in the case is equally applicable to both of the criteria in ITAA97 s 8-1(1)(a) and (b). The taxpayer claimed a deduction for the store’s daily takings that had been stolen, at gun point, from an employee who was en route to deposit them with the taxpayer’s bank. The High Court held the loss was a loss incurred “in gaining … assessable income” and was not a loss of a capital nature. This was principally because the expression “in gaining … assessable income” should be construed as meaning “in the course of gaining … assessable income” and should be given a wide application. The deduction could not be disallowed on the narrow basis that the stolen takings were past income and had, by definition, already been received. Rather, the relevant enquiry was about the nature of the activity being undertaken at the time of the theft and its character in relation to the operation of the business. If the activity was “incidental and relevant” to the conduct of the business it satisfied the description of being undertaken “in the course of” gaining assessable income. The High Court considered that banking the daily takings was “an essential, or at all events highly expedient” part of the business: 95 CLR at 350.
57.The unanimous joint judgment in Charles Moore also referred to a passage in the judgment of Rich J in Commissioner of Taxation (NSW) v Ash (1938) 61 CLR 263 at 277. There Rich J had referred to the deductibility of a loss that was “a natural or recognized incident of a particular trade or business”. In Charles Moore the Court explained that this reference was not referring to the actual contemporary probability of the risk eventuating. It was simply concerned with the nature of the risk and whether or not it could be regarded as sufficiently connected with the “operations which more directly … produce the assessable income”: 95 CLR at 351.
58.In rejecting Mr Lean’s claim for a general deduction under ITAA97 s 8-1 the Commissioner relied on the discussion of aspects of futures trading in Taxation Ruling IT 2228. Paragraph 36 of the ruling discusses the difference between contract losses and misappropriations by brokers. It opines that where the loss arises from the misappropriation of an amount deposited with a broker, essentially as security for contract losses, the misappropriation loss is not appropriately characterised as a loss incurred “in carrying on a business”. This opinion may not be entirely consistent with the judgment in Charles Moore. If the provision of security was a pre-condition of the taxpayer’s trading entitlement with the broker, this opinion arguably takes too narrow a view of the conduct that properly falls within the description of being “incidental and relevant” to the ordinary conduct of the business (of trading in shares or futures).
59.The information and acknowledgements Mr Lean was given by Heffernan do not justify the view that he had provided his funds merely as some form of security, unrelated to the intended investment activities. The evidence is that Mr Lean’s funds were provided for the purpose of actual investment, in either the Our World Exchange Fund or the “private client” account with Heffernan. Mr Lean’s evidence suggests that the activities supposedly contemplated for, at least, private client account clients could have included futures trading, but activities of that kind by no means characterised the intended activities. As promoted by Heffernan both the Our World Exchange Fund and the pooled fund of private client investors were to be involved in actual trading activities, not just to stand as security.
60.Once the funds are properly understood as having been provided to Heffernan for profit making purposes including actual trading activities, there is a close parallel with the reasoning in the Charles Moore judgment. Money to be used for the purpose of conducting share trading and other investment activities would have to be provided to the person directly involved in effecting the trading and investment decisions. Consequently, the risk of misappropriation is as much inherent in such a business activity as was the robbery in Charles Moore. As Mr Lean’s counsel submitted, the present circumstances merely take the reasoning in Charles Moore from the prosaic example of a retail shop’s daily takings and apply it to the kind of dealings that are commonplace in financial services businesses. In both instances entrusting money to an employee, agent or intermediary is a necessary incident of conducting the income producing activity and the risk of misappropriation is inherent.
61.Nevertheless, the distinction drawn in Taxation Ruling IT 2228, between losses incurred in actual trading and losses attributable to misappropriation by a broker or trader, is relevant to the proper characterisation of the loss as either capital or revenue. This characterisation of the loss is critical to its deductibility as a general deduction, because ITAA97 s 8-1(2)(a) precludes deduction of losses and outgoings “of capital, or of a capital nature”. The Commissioner says the absence of evidence of actual trading activities characterises Mr Lean’s Hong Kong funds as capital. The Commissioner says the circumstances are analogous to those in Case V24 (1988) 19 ATR 3117. In that case no deduction was allowed in respect of the unrecovered balance of funds misappropriated by a solicitor. The taxpayer had provided money to the solicitor to purchase a quantity of gold bullion. The bullion was supposedly to be immediately on sold for a profit, but the entire proposal was fraudulent. Although the solicitor repaid a substantial part of the stolen money, the taxpayer claimed a deduction for the unrecovered balance. The deduction claim was disallowed on the basis that the misappropriated money was capital and could not, therefore, qualify as a deductible loss incurred in gaining or producing assessable income.
62.The essential basis for the disallowance of the general deduction in Case V24 (1988) 19 ATR 3117 was that the money allocated for the purchase of the hypothesised gold bullion remained a capital asset unless and until it was actually applied to the purchase transaction. Characterisation of a loss or expense as being of a capital nature requires an understanding and application of the criteria that determine the nature of capital items. This question, though fundamental, has long been described as one of peculiar difficulty, and one resolved more by analogical reasoning than strictly logical dictate: FCT v Montgomery (1999) 198 CLR 639 at 661. An accepted generality is that expenditure is of a capital nature if it is not recurrent and is applied towards the purchase of property or rights that are of enduring benefit to the taxpayer and either add to the general value of their property or enhance their ability to generate income: Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 at 354-355. Similarly, a loss may be regarded as being of a capital nature if it is the result of a singular kind of transaction or event and does not involve the loss of property or money that is directly traceable to assessable income: see Charles Moore & Co (WA) Pty Ltd v Federal Commissioner of Taxation (1956) 95 CLR 344 at 351. Essentially, the distinction between items of capital and revenue account is between the structure of the income producing undertaking and the process by which its activities are carried out. The generality of this essential distinction, of course, belies the difficulties that can arise in its practical application: Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 and 359 and 360. That difficulty is particularly acute in the present case where the actual loss is not the direct result of either an expenditure or a liability that was knowingly incurred by the taxpayer for a particular purpose. Nevertheless, the required characterisation must be determined, and it requires an application of the concept of ordinary “concepts and usages” in their application to the basic distinction between capital and revenue items: FCT v Montgomery (1999) 198 CLR 639 at 661.
63.Mr Lean contended that it was entirely artificial and wrong to characterise the misappropriation loss as being of a capital nature merely because no actual trading activities had been undertaken by Heffernan. Implicit in this contention was the proposition that Mr Lean had provided his funds for “trading” purposes and that if the money had been misappropriated after any authorised activities had in fact occurred, then the funds would certainly have been characterised as working capital and their loss would have been regarded as being of a revenue nature.
64.The difficulty with this contention is the ambiguity inherent in the arrangements promoted by Heffernan, Mr Lean’s imprecise understanding of what they really involved and the apparent structure of the entities supposed to have been involved. The $517,416 July 2001 transfer was allocated to an Our World Exchange Fund account. As I set out earlier in these reasons Mr Lean understood that this was a pooled fund to which other investors contributed. Typically those investors were not intended to have any direct involvement in the fund’s supposed investment and trading decisions. The inference is that whilst the funds Mr Lean provided to Our World Exchange Ltd would be used in trading and investment decisions for the benefit of the fund, the actual investment activities were to be carried on and out by Our World Exchange Ltd.
65.I also referred earlier to Mr Lean’s understanding that he had a particular relationship with Heffernan that recognised the likelihood of his moving to “private client” status. Mr Lean claimed, though in rather general and imprecise terms, that this led to him having a more direct involvement in the Our World Exchange Fund activities. This understanding may well have been fostered by Heffernan’s interest in securing a greater investment from Mr Lean, and thus led to him encouraging contact and discussion. But I doubt that it really was understood by Mr Lean as altering the nature of the Our World Exchange Fund account investment or as giving him any direct involvement in its application. In any event, it is highly unlikely that this understanding existed when the July 2001 investment was first made. It is not reflected in any of the account documents. Nor did Mr Lean give any evidence of particular Our World Exchange Fund investments or decisions that he characterised as made, or instructed to be made, on his personal behalf. In addition, the evidence discloses that he maintained the Our World Exchange Fund account until October 2001, three months after he opened the private client account in his own name. I consider that the proper conclusion to draw is that the funds Mr Lean deposited to the Our World Exchange Fund account were not really intended to be used to trade on his own behalf. Rather, they were in the nature of a capital contribution that gave him an interest in the pooled investment fund that was to be applied by Our World Exchange Ltd. His interest was in the nature of a capital investment and his anticipated profit would arise from growth in the value of the fund.
66.I explained earlier my reasons for concluding that Mr Lean’s funds were probably misappropriated very soon after they were first paid to Equity-1 Ltd, Our World Exchange Ltd or International Trading Brokers Ltd. That applies to the $517,416 July deposit. I consider it most likely that those moneys were misappropriated shortly after 11 July 2001. I also find, for the reasons referred to in the preceding paragraph, that the misappropriation gave rise to a loss of a capital nature.
67.Mr Lean’s $4.112m August 2001 deposit to a “private client account” with Our World Exchange Ltd was portrayed by Heffernan as giving rise to the possibility of a wide range of investment activities. It was by no means confined to either securities or futures trading. The discussion of a “partnership” between Heffernan and Lean included possible involvement in “joint ventures, Initial Public Offerings and additional highly profitable ventures”. The generality of the proposal, and the absence of clear evidence of more limited instructions from Mr Lean to Heffernan leads to the impression that the “private client account” was a means for facilitating any kind of investment opportunity that presented itself and was recommended by Heffernan to Lean. It was not restricted to “ordinary” trading activities and was open to participation in capital investment opportunities. Indeed, the prospect of investments of that kind was a significant aspect of the proposal. In addition to the generality of Heffernan’s portrayal of likely “private client” activities, it is again clear that all of its portrayed activities were to be carried out by Equity-1 Ltd. Mr Lean understood that he was “part of the company”, though he was not able to convey any objective information to demonstrate the real justification for that belief or to quantify the interest he claimed to have.
68.In my opinion, the breadth and generality of the activities Heffernan portrayed for “private clients” do not permit Mr Lean’s $4.112m August 2001 deposit to be characterised as a revenue item. It was simply an amount that could be resorted to for any of a very wide range of possible investment activities. That range appears to have been limited only by the subjectivity of Mr Heffernan’s preferences and assessment of the potential profitability of individual proposals. In these circumstances, it is proper to conclude that the subsequent misappropriation by Heffernan represents a loss of a capital nature. It follows that Mr Lean was not entitled to a general deduction under ITAA97 s 8-1 in relation to the August 2001 deposit.
Loss from profit-making undertaking or plan – ITAA97 s 25-40
69.Under ITAA97 s 15-15 a taxpayer’s assessable income includes certain profits derived from carrying out a profit-making undertaking or plan. The qualification that the section only applies to “certain profits” refers to the fact that it does not apply to profits that are assessable as ordinary income under ITAA97 s 6-5 – that is, to “profits” that would constitute “income according to ordinary concepts”: ITAA97 s 15-15(2). In turn, ITAA97 s 25-40 permits deduction of losses “arising from the carrying on or carrying out of a profit-making undertaking or plan” if any such profit would have been included in the taxpayer’s assessable income by the operation of ITAA97 s 15-15.
70.Mr Lean’s alternative reliance on the deduction permitted by ITAA97 s 25-40 necessarily assumes, therefore, that any profit and gains derived from his Hong Kong investments with Equity-1 Ltd and Our World Exchange Ltd, would have been assessable under ITAA97 s 15-15 alone, and would not have formed part of his “ordinary income” under ITAA97 s 6-5.
71.The expression “profit-making undertaking or plan” appears disjunctive, but the concept of a plan is implicit in the notion of carrying on an undertaking. It is fundamental to the application of the section: XCO Pty Ltd v Federal Commissioner of Taxation (1971) 124 CLR 343 at 349 and 350. The section does not apply to losses incurred in the mere realisation of a capital asset: Steinberg v Federal Commissioner of Taxation [1972-1975] 134 CLR 640 at 671 and 699. The plan requirement involves some element of intention and structure, but it may involve considerable flexibility and discretion to take advantage of opportunities as they arise. Ultimately, conduct may answer the description of being an undertaking or plan that satisfies the conceptual requirements of ITAA97 s 25-40 merely because it contemplates dealings that are to be carried out for a “settled purpose” to make a profit: Steinberg v Federal Commissioner of Taxation [1972-1975] 134 CLR 640 at 699-700 and 714-715.
72.In earlier sections of these reasons I have described the nature of Mr Lean’s July 2001 deposit to the Our World Exchange Fund account, and his understanding of the fund operations. I concluded from these descriptions that the actual trading and investment decisions were to be made by Our World Exchange Ltd and carried out in its name. This conclusion leads to the result that even if Mr Lean’s investment could be characterised as part of a “profit-making undertaking or plan”, it was not one that was carried on or out by him. A taxpayer is not entitled to a loss deduction under this section in relation to conduct that involves mere investment in an undertaking conducted by others: Clowes v Federal Commissioner of Taxation (1954) 91 CLR 209 at 217-218, 224; Official Receiver in Bankruptcy v Federal Commissioner of Taxation(Fox’s Case) (1956) 96 CLR 370 at 387.
73.A similar impediment exists in applying ITAA97 s 25-40 to Mr Lean’s private client account loss. Typically the “private client” activities were to be carried out by Equity-1 Ltd. But Mr Lean gave evidence to the effect that individual private clients could opt out of particular transactions. He also suggested that, at least in some circumstances, Equity-1 Ltd also conducted trading and made investment decisions for individual “private clients”. The potential for transactions of this latter kind makes it more difficult to characterise the hypothesised scheme as one that was carried on exclusively by Equity-1 Ltd.
74.But any recognition that Mr Lean’s “private client” account might potentially satisfy the description of an “undertaking or plan” gives rise to a more fundamental difficulty. It is that any such characterisation, given the generality of the criterion (as suggested in Steinberg v Federal Commissioner of Taxation [1972-1975] 134 CLR 640 at 699-700 and 714-715) tends, in any event, to also characterise any hypothesised profit as income according to ordinary concepts.
75.The relationship between ordinary income, and profit that is brought within assessable income because it is derived from “the carrying on or carrying out of a profit-making undertaking or plan”, was discussed in Federal Commissioner of Taxation v Whitfords Beach Pty Ltd (1982) 150 CLR 355. In their judgments, both Gibbs CJ and Mason J expressed the view that it was difficult to envisage situations where “profit” would be caught by the “undertaking or plan (scheme)” concept and yet not also fall within the concept of ordinary income in any event: see 150 CLR at 365 per Gibbs CJ and 383-384 per Mason J. More recently, in a discussion of the relationship between the predecessor provisions of ITAA97 ss 6-1 and 25-40 (ITAA36 ss 25 and 26(a)) in FCT v Montgomery (1999) 198 CLR 639 at 675 the High Court said
In Whitfords Beach the Court examined the relationship between s 25 and s 26(a) of the Act. Much of the detail of that examination does not bear directly on the questions that now fall for decision and need not be noticed. What is important for present purposes is that in Whitfords Beach it was necessary to resolve what was seen to be the overlap of s 25 (and its bringing to tax of income according to ordinary concepts) and transactions falling within one or other of the limbs of s 26(a). In particular, the second limb of s 26(a) (about profit-making undertakings or schemes) was not seen as adding words to the Act that would capture profits or receipts not otherwise brought to tax as income according to ordinary concepts.
76.The judgments in Whitfords Beach do not require the conclusion that profit from carrying on a relevant “undertaking or plan” will always fall within the concept of ordinary income. As Mason J observed, the legislative existence of the “undertaking or scheme” provision requires recognition of the contrary possibility: see 150 CLR 355 at 378. But the existence of a profit-making intention will generally be a strong indication that the resultant gain should be characterised as income according to ordinary concepts. This point is made in Federal Commissioner of Taxation v Myer Emporium Ltd [1986-1987] 163 CLR 199 at 209-210:
Although it is well settled that a profit or gain made in the ordinary course of carrying on a business constitutes income, it does not follow that a profit or gain made in a transaction entered into otherwise than in the ordinary course of carrying on the taxpayer's business is not income. Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the character of income. But a gain made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circumstances of the case. Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer's business. Nor does the fact that a profit or gain is made as the result of an isolated venture or a “one-off” transaction preclude it from being properly characterised as income (FCT v Whitfords Beach Pty Ltd (1982) 39 ALR 521 ; 150 CLR 355 at 366–7, 376). The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit.
77.Earlier in these reasons I described the nature of Mr Lean’s arrangements with Heffernan, and the activities that were contemplated in relation to both the Our World Exchange Fund account and as a “private client”. I concluded that they clearly involved conduct that was designed to produce income and that Mr Lean’s participation in the arrangements (by making the deposits and continuing his regular discussions with Heffernan) was for the same purpose. On that basis, any profit or gain Mr Lean might have derived from Heffernan’s proffered arrangements would have been assessable income according to ordinary concepts. ITAA97 s 25-40 does not therefore apply and does not permit any deduction of the kind claimed by Mr Lean.
Loss by theft or misappropriation by an agent – s 25-45 ITAA97
78.ITAA97 s 25-45 permits a taxpayer to deduct “a loss in respect of money” in the income year the tax payer discovers the loss if:
(a)the loss was caused by “theft, stealing, embezzlement, larceny, defalcation or misappropriation” by an employee or agent, and
(b)the money was included in the taxpayer's assessable income “either for the current year or for an earlier income year”.
79.Mr Lean submitted his 2002 tax return included an amount of $5,608,099 as capital gains from asset sales. Mr Lean contended that 50 per cent of the gains had been brought to account in his assessable income. Consequently, he claimed a deduction under ITAA97 s 25-45 of $2,804,049 in relation to the $3.262m misappropriation loss. (These amounts differ marginally from those set out earlier in paragraph 3 of these reasons. I have taken the amounts in that paragraph from the documents at T3-10, T7-28 & T10-57.) This claim overstates the potential deduction entitlement in relation to the misappropriation.
80.The net capital gains included in the 2002 tax return arose from gross US share sales in August ($4,939,752.63) and October 2001 ($740,567.24). The October 2001 sale proceeds cannot have any connection with the moneys transferred to Hong Kong in July and August 2001. It may be correct to assume that the sale proceeds attributed in the tax return to the August 2001 date actually include those for the July 2001 US share sale. Nevertheless, only part ($4.63m) of those total proceeds was transferred to Hong Kong. Any deduction under ITAA97 s 25-45 could not, therefore, be in the amount claimed, but would be limited to $2,315,157 – because only half of the net proceeds of sale was brought to account as assessable income. The amount of the possible deduction is the same, irrespective of whether or not the whole of the funds are assumed to have been misappropriated, or whether it is assumed that there was a genuine trading loss in the amount derived from the September 2001 “margin deposit movement” statement. This is indicated in the following analysis:
Table 4
US share sale proceeds transferred July and August 2001 4,630,314 HK transfer – component of 2002 assessable income 2,315,157 Scenario 1 - assumed misappropriation ($4,630,314) Less recoveries 150,000 Net balance of all funds misappropriated 4,480,314 Component attributable to assessable income 2,315,157 Potential ITAA97 s 25-45 deduction 2,315,157 Scenario 2 - assumed trading loss ($1,367,566) Amount transferred to Hong Kong 4,630,314 Less assumed trading loss 1,367,566 Recoveries applied to trading loss 150,000 Misappropriated balance of funds 3,112,748 HK transfer component of assessable income 2,315,157 Potential ITAA97 s 25-45 deduction 2,315,157 81.Neither Mr Lean’s Objection, the Commissioner’s decision, nor the argument in the review proceedings canvassed the correctness of concluding that Mr Lean’s misappropriation loss was attributable to theft by an agent. In fact, the true nature of Mr Lean’s relationship with Heffernan, Equity-1 Ltd, Our World Exchange Ltd and International Trading Brokers Ltd is obscured by the imprecision of Mr Lean’s oral evidence and the absence of any documentary evidence demonstrating the reality of their purported investment relationships and transactions.
82.Details contained in an investigator’s report Mr Lean obtained in 2006 reported that Equity-1 Ltd was a foreign company registered in Hong Kong and Australia, International Trading Brokers Limited had been incorporated in the Grand Turks and Caicos Islands and Our World Exchange Limited was an entity incorporated in Vanuatu. Despite the apparent formal status of these corporations the evidence suggests they did not act, in any sense, independently of Heffernan. On the contrary, the information in the investigator’s report details a history of misrepresentation by Heffernan involving the use of these corporate names to give an appearance of authenticity. That information should be understood in the light of the January 2003 ASIC investor warning, especially including the warning that Equity-1 Ltd had no genuine presence in Hong Kong. That history justifies a conclusion that Equity-1 Ltd and Our World Exchange Ltd were totally subservient to Heffernan and operated merely at his whim in the pursuit of his Ponzi scheme operation. As such they were, in a real sense, merely Heffernan’s agents, despite the novelty with which such a characterisation might be regarded in genuine relationships involving apparently similar commercial circumstances: see Atlas Maritime Co SA v Avalon Maritime Ltd (The Coral Rose) (No.3) [1991] 4 All ER 769; [1991] 1 WLR 917; Idoport Pty Limited and Anor v National Australia Bank Limited and Ors; National Australia Bank Limited v OAMPS Limited and Ors [2004] NSWSC 695 at [144].
83.Characterising the three corporate entities to which I have referred as Heffernan’s agents does not completely resolve the question of the capacity in which he or they held the money provided by Mr Lean. Earlier in these reasons I described the essential difference between his supposed investment in the Our World Exchange Fund, in relation to his July 2001 deposit, and his intended “private client” account investment, in relation to his August 2001 deposit.
84.A potential view of Mr Lean’s July 2001 deposit is that it gave rise merely to a debtor-creditor relationship with either Heffernan or his corporate agents, although one that gave him a contractual entitlement to share in the growth of the investments that were supposed to be made. However, Mr Lean’s evidence was that Heffernan described himself as a person who “manage(d) funds for two groups of investors”. Mr Lean himself referred to the Our World Exchange Fund as a “mutual fund pool” of investors. Both descriptions are consistent with the abbreviated reference to the various funds in the E-ceipts that Mr Lean was given. Finally, the evidence included a statement of terms and conditions for Our World Exchange Ltd as at 1 October 2001. Although the terms did not contain any mechanism for calculating the amount of any withdrawal entitlement, they were addressed to “Australian client” and referred to the client’s “investment” and their “initial capital”. They also stipulated that “profits must be held for a 6-month period” before being able to be withdrawn. These various descriptions encourage the view that the fund was indeed intended to operate as a mutual pool and that Our World Exchange Ltd held investors’ funds as agents - with a mandate to use them in investment and trading activities on behalf of the particular fund designated by the intending “investor”. On this basis Our World Exchange Ltd and Heffernan were, therefore, truly acting as Mr Lean’s custodial agents in relation to the funds he provided: see by way of analogy Burton v Arcus (2006) 200 FLR 1 at [60] and [81].
85.Similar reasoning applies to Mr Lean’s August 2001 deposit to his private client account. Mr Lean said that the share sale profit transfer was made to be held by Heffernan subject to the supposed “partnership” arrangement he believed he had arranged with Heffernan at the seminar in the Philippines. I described earlier in these reasons the generality and imprecision of Mr Lean’s understanding of this arrangement. It could not really be described as a partnership in any real sense. There is no suggestion that either Heffernan or any of his associated entities was either to contribute any funds or to benefit directly from Mr Lean’s funds. It was no more than a loosely described arrangement in which all transactions were typically to be carried out by Equity-1 Ltd. Sometimes it might act exclusively for Mr Lean’s benefit. Sometimes it would act for a pool of “private client” investors. All transactions were supposed to be subject to Mr Lean’s ultimate personal authority and approval, subject to Heffernan having some discretion within the limits of Mr Lean’s instructions. In those circumstances Heffernan and his companies always held Mr Lean’s money for his absolute benefit and subject to his instructions. They were, therefore, in relation to their custody and control of Mr Lean’s private client funds, his agents.
86.The Commissioner contends the money Heffernan misappropriated does not constitute a loss in respect of money “included in Mr Lean's assessable income”. The Commissioner says the US share sale profits lost their relevant characterisation as “income” once Mr Lean’s US brokers transferred the money to the Hong Kong bank account for the purpose of investment with Heffernan. The Commissioner says this contention is supported by the Federal Court decision in EHL Burgess Pty Ltd v Federal Commissioner of Taxation (1988) 80 ALR 639; (1988) 88 ATC 4517.
87.In Burgess the taxpayer was a company whose tangible assets had been realised into cash and most of its liabilities discharged. That process resulted in the company having a net asset value of about $3.8m. The company’s balance sheet included $4m cash at bank, $1.4m goodwill and a tax provision of $1.5m. The evidence did not disclose the extent to which current year income, or asset sale proceeds, had been applied to discharge the company’s other liabilities.
88.The shareholders in Burgess had arranged to sell their shares at a price equivalent to the company’s net asset value. On, or shortly after, settlement of the sale the purchaser (i) received a cheque for the taxpayer’s $4m cash at bank, (ii) delivered a cheque for the taxpayer’s $3.8m net asset value, (iii) appointed two directors to the taxpayer, (iv) deposited the $4m into the taxpayer’s bank account, (v) advanced the $4m as a loan by the taxpayer to another company and (vi) received payment of the $4m from the purported borrower. This sequence of events had the practical effect of an informal liquidation. The taxpayer contended the $4m constituted a misappropriation by its then new (but subsequently departed) directors. The taxpayer unsuccessfully claimed the $4m amount as a deduction against its tax year income of $3.4m.
89.The decision in Burgess concerned ITAA36 s 71. The section was the predecessor of ITAA97 s 25-45. It permitted deduction of losses incurred through an agent or employee’s misappropriations where the loss was “of, or in respect of, money … included in the assessable income of the taxpayer”. The Full Federal Court rejected the taxpayer’s deduction claim. The Full Court considered that the $4m loan made by the new directors, and ostensibly in the interests of the purchaser shareholders, was not a misappropriation by an employee or agent. The Court also doubted there was evidence the $4m loan was irrecoverable and considered the taxpayer had not established it had suffered a “loss” in any event. Even if there was a “loss”, since the settlement had occurred on 30 June, the Full Court was not satisfied that any “loss” had been discovered in the income year.
90.All of these reasons would have been sufficient to disallow the deduction claim. But the Full Court also considered that the $4m loan, even if it constituted a misappropriation, could not be characterised as “moneys that were to be, or had been, included in the assessable income” of the taxpayer. The Court commented on the fact that the taxpayer’s misappropriated cash represented its net tangible assets after the asset realisation process. The Court said that entitlement to the deduction permitted by ITAA36 s 71 required a tracing exercise “so that what has been misappropriated can be identified with that …. included in the assessable income”. The Full Court went on to say (at 80 ALR 647):
If income, when received, has been used to pay off the taxpayer's debts and so has left the taxpayer's hands, there can be no misappropriation of or in respect of that money. The benefit arising from the reduction in the liabilities of the taxpayer cannot be the subject of a relevant misappropriation. Likewise, income which has been or is to be included in the assessable income of a taxpayer, but has been dealt with in such a way that it has become mingled generally in the finances of the taxpayer and can no longer be traced or identified as income of that description cannot be the subject of a s 71 deduction. The section requires that the misappropriation be of or in respect of money that is or has been included in assessable income. That criterion must be established on the facts of the case. It should perhaps be added that the criterion may be established (as is demonstrated by the words “or has been”) although the loss has occurred after the derivation of the income, provided the identity of the money lost as assessable income has not been obliterated.
91.The difficulties that may be involved in the required “tracing” exercise are illustrated by the circumstances that arose in Re Grima and Federal Commissioner of Taxation (2000) 44 ATR 1046; [2000] AATA 199. There the taxpayers’ accountant had stolen money they paid to him for the purpose of superannuation investments. Over a 13 month period the taxpayers made six payments in amounts that varied from $10,000 to $30,000. The payments were made either from the taxpayers’ personal cheque account or from the bank account of their company. The taxpayers’ net rental income was over $150,000 in each of the relevant income years. But in the 1995 tax year the taxpayers had a net cash outflow and their superannuation payments in that year had in fact been funded (at least partly) by withdrawals from a term deposit. In the 1996 tax year the taxpayers’ rental income could not be accurately reconciled to the personal and company bank accounts.
92.The taxpayers unsuccessfully sought a deduction against their income for the misappropriated superannuation payments. The uncertain origin of the money they paid would have made it difficult to satisfy the tracing requirement implicit in ITAA36 s 71, and accepted in Burgess. Indeed, the Tribunal found that the “essential nexus” with the taxpayers’ income was lost once their rental and interest income had been paid into the respective personal, and company, bank accounts. As a consequence of these payments the money had thereby become “mingled in the general finances of the applicants”: see 44 ATR 1046 at [41]-[43].
93.But in Grima the Tribunal also made an additional finding, upon which the Commissioner places significant reliance in the present case. In making this additional finding the Tribunal “put aside” any mixing of funds and “accepted” that the funds the taxpayers used “did have the necessary character of money … included in … assessable income”. Nevertheless, the Tribunal found that once the money had been set aside for the specific purpose of a superannuation investment, and provided to the accountant to carry out that purpose, it lost its essential character of income “that is or has been” included in the taxpayer's assessable income either for the current or an earlier year: 44 ATR 1046 at [40]. The Commissioner relies on this finding and contends it has a direct analogy with Mr Lean’s conduct in the present case – in having his US brokers transfer the share sale profits to Heffernan’s bank account for investment purposes.
94.The Commissioner also relies on the Tribunal’s decision in Re Applicant and Federal Commissioner of Taxation (Case 15/2004) (2004) 58 ATR 1059; [2004] AATA 1293. In that case the taxpayer claimed a deduction for amounts he drew from a line of credit facility and paid to a foreign investment company to purchase shares. The evidence did not disclose whether the shares had actually been purchased, but the Commissioner conceded the taxpayer’s funds had been misappropriated. In the Tribunal proceedings the taxpayer claimed (for the first time) that the facility was actually in credit at the time of the payments (and that the payments had therefore been funded from income). The Tribunal held not only that the taxpayer was precluded from relying on this explanation, but also that the evidence proffered to support it did not, in any event, trace the payment amounts back to assessable income. However, the Tribunal went on to find that the deduction claim also failed because the taxpayer had first appropriated the money to the investment purchase and it was that “investment” amount, rather than income, that the agent subsequently misappropriated. The Tribunal agreed with the finding that had been previously made in Grima – namely, that “the taxpayers’ own act removed the causal link between the loss and the embezzlement or misappropriation” that was required by ITAA36 s 71.
95.Counsel for Mr Lean acknowledged that Case 15/2004 involved circumstances similar to those involved in the present case. But the critical difference in the present case is that all the misappropriated money (except an insignificant proportion of it) is directly traceable back to Mr Lean’s US share sale profits. Mr Lean’s counsel submitted it was “self-evidently unsound” reasoning to limit the application of ITAA97 s 25-45 to situations where the money retained its actual character as income at the time it was misappropriated. Counsel contended that such a limitation (i) did not pay sufficient regard to the fact that the section permitted a deduction for “loss in respect of money” and (ii) would severely restrict the scope of the section because, in practical reality, such a loss will characteristically derive from the misappropriation of a taxpayer's “general” funds, rather than from the theft of a specific sum that retains its character as “income” in the taxpayer's hands.
96.As Mr Lean’s counsel correctly submitted, ITAA97 s 25-45 is not limited to the deductibility of losses arising from the misappropriation of income. It permits the deduction of a loss “in respect of money” that is, or was, included as assessable income. It differs from its predecessor (ITAA36 s 71) in omitting from the expression “in respect of money” the words “of, or” that preceded the expression in ITAA36 s 71. Those disjunctive words in ITAA36 s 71 explicitly distinguished between a loss of money and a loss of something else that could be characterised as “in respect of money”. Their omission from ITAA97 s 25-45 does not, however, remove the distinction. Nor does it justify confining the factual circumstances that would otherwise satisfy the characterisation suggested by the width of the expression “in respect of money”. In Trustees Executors and Agency Co Ltd v Reilly [1941] VLR 110 Mann CJ said: “[t]he words “in respect of” are difficult of definition, but they have the widest possible meaning of any expression intended to convey some connection or relation between the two subject-matters to which the words refer”. This view has been repeated in many judicial comments: for example, McDowell v Baker (1979) 144 CLR 413 at 419; Nordland Papier AG v Anti-Dumping Authority (1999) 93 FCR 454; 161 ALR 120 especially at 126; Jennings Constructions Pty Ltd v Workers' Rehabilitation & Compensation Corporation (1998) 71 SASR 465 at 480-481. Although Mann CJ’s interpretation was said to go “somewhat too far” in Workers’ Compensation Board (Qld) v Technical Products Pty Ltd (1988) 165 CLR 642 at 653-654 that guarded reservation more highlights the importance of context than contradicts the potential width of meaning the expression may justifiably convey. The width of permissible association contemplated by the words “in respect of” should not be restricted unless there is a compelling reason to do so: Law Society of NSW v Bruce (1996) 40 NSWLR 77 at 84; Wonall Pty Ltd v Clarence Property Corporation Ltd (2003) 58 NSWLR 23 at 44-45. What the expression requires is a discernible link between the two subject matters in question, and one which is a rational conceptual connection for the purpose of the context in which the expression is used: Technical Products Pty Ltd v State Government Insurance Office (QLD) (1989) 167 CLR 45 at 47.
97.The passage I cited earlier from the Full Federal Court decision in EHL Burgess Pty Ltd v Federal Commissioner of Taxation (1988) 80 ALR 639 included the observation that ITAA36 s 71 permitted a misappropriation deduction if the money “is or has been included in the assessable income [in the year of income]”. The Full Federal Court considered that the reference to prior year income in this disjunctive criterion necessarily contemplated the deductibility of a loss that occurred after the year in which the income had been derived. It justified the conclusion that the relevant connection required by the expression “in respect of” existed if the loss in question could be traced to money that had been included in assessable income. This view is equally applicable to ITAA97 s 25-45, which disjunctively requires that the discovered loss must be in respect of money that was included as assessable income in the income year of the discovery “or for an earlier income year”.
98.The Commissioner resisted this conclusion by contending that ITAA97 s 25-45 only permitted the deductibility of misappropriations where the loss had occurred in the year the income had been derived. According to the Commissioner this limitation was implicit in the notion of an “identity” (one of the expressions used by the Full Court in Burgess) between the loss and the character of the money as income. That identity would be lost once the money was appropriated to the taxpayer’s general purposes – as it would inevitably be if it was merely retained in general funds after the end of the income year.
99.This contention finds no support in the actual terms of ITAA97 s 25-45. The section does limit deductibility to the year of discovery, but it does not contain any limitation on either the year of the loss or the year in which the income was derived. The only limitation is that the loss must be “in respect of” money that was included in assessable income “for the income year, or an earlier income year”. Having regard to the permissible width of the expression “in respect of” this context cannot require an interpretation of the section that limits deductibility to losses in respect of money that was misappropriated in the same year that it was derived as income. Still less do the terms and context of the section require its limitation to loss “in respect of money” that actually retains its character as income at the time of the misappropriation.
100.In rejecting any narrow interpretation of the expression “in respect of” in its context in ITAA97 s 25-45 it is relevant to note the amplitude of the references in ITAA97 s 25-45(b) to the relevant causes of the loss. These are “theft, stealing, embezzlemement, larceny, defalcation or misappropriation”. To a large extent many of these words are synonymous, but some of them permit different connotations. Embezzlement is apt to refer to the diversion of property before it has come in the possession of an employer or principal: see Crimes Act 1900 (NSW) s 157. Theft, stealing and larceny are expressions apt to apply to property that is in the principal’s possession and is taken without authority by the agent or employee. Defalcation and misappropriation are terms perhaps most aptly directed to situations involving “a fraudulent deficiency”: see Daly v Sydney Stock Exchange Ltd [1982] 2 NSWLR 421 at 428 per Samuels JA. These latter words, in particular, readily apply to a situation where an employee or agent has been entrusted with property for some particular purpose and misapplies it in some unauthorised way, often dishonestly. The width of all these various expressions in ITAA97 s 25-45 further encourages the conclusion that the section is not confined to losses that occur as a result of the “theft” of money that retains its character as income, and has not, at that time, either been applied for any particular purpose or merely held as part of the taxpayer’s general funds. As counsel for Mr Lean submitted, to limit the section in this way would limit its potential application to an extent that is not expressed in the actual words of the provision.
101.The funds misappropriated by Mr Heffernan were, as to $4,630,314, demonstrably related to the share sale profits Mr Lean derived in the US in July and August 2001. There was no evidence of any further relevant “appropriation” or mingling of funds after they had come under Heffernan’s control. (I dismiss as irrelevant the small May and November 2001 transfers.) The net misappropriated amount of $4,480,314 (calculated in table 2 set out earlier) was a loss “in respect of” the US share sale profits. Those profits were included in the total US share sale profits Mr Lean disclosed in his 2002 tax return and 50 per cent of that total was included in his assessable income for the 2002 tax year. His assessable income therefore includes 50 per cent of the share sale profits that were transferred to Hong Kong and deposited with Our World Exchange Ltd. The amount that ITAA97 s 25-45 entitles Mr Lean to deduct is $2,315,157 – as indicated in Table 4 of these reasons.
102.A final limitation on the application of ITAA97 s 25-45 is that the misappropriation has been made by an agent or employee “other than an individual you employ solely for private purposes”. This limitation does not apply in the present case. Heffernan was not employed by Mr Lean. Furthermore, Mr Lean’s relationship with him was for the purpose of gaining assessable income and was not solely for private purposes.
Loss deductible against foreign capital gain
103.The parties were united on two propositions. The first proposition was that ITAA36 s 79D limits the deductibility of foreign losses to deduction against foreign income. The second proposition was that Mr Lean’s losses were foreign losses. They appeared to differ on whether, and if so to what extent, Mr Lean’s July and August 2001 US share sale proceeds should be regarded as “foreign income” for the purpose of ITAA36 s 79D.
104.The Commissioner’s submissions emphasised that the US share sale proceeds were, as capital gains, not taxable under US law. This impliedly recognised that the gains had been relevantly derived in the US and constituted a foreign capital gain. In fact, the Commissioner expressly conceded that if the Applicant was entitled to a deduction under ITAA97 s 25-45, its limitation to deduction against “foreign income” would have no practical consequence. This was because the Applicant had limited his deduction claim to the foreign income amount that had been included in the 2002 assessable income. The Commissioner’s contention, in relation to the operation of ITAA36 s 79D, was that it would have the effect of imposing a similar limitation even if the Applicant had made out his claim to a general deduction under either ITAA97 s 8-1 or 25-40. (The Commissioner conceded, however, that if the loss was available as a general deduction it would be able to be carried forward to later income years.)
105.I pointed out earlier in these reasons the fact that Mr Lean’s total 2002 US share sale proceeds (about AUD$5.6m) substantially exceeded the amount he deposited in Hong Kong (AUD$4.63m) and subsequently lost. Consequently, and contrary to the Commissioner assumption, there is a difference in the amount of the general deductions potentially available under ITAA97 s 8-1 or s 25-40, on the one hand, and the amount of the misappropriation deduction under s 25-45, on the other. But that potential difference has no ultimate practical significance in the present case, because of my earlier finding that the losses are capital losses and are not deductible under either ITAA97 ss 8-1 or 25-40.
106.In these circumstances, the Commissioner’s concession about the deduction amount available under ITAA97 s 25-45 would ordinarily warrant no further consideration of the foreign income issue. But some confusion arose in the course of the oral submissions.
107.The Applicant, at least at one stage of the final submissions, interpreted the Commissioner to contend that because the US share sale proceeds were not taxable in the US they could not be regarded as “foreign income” for the purpose of ITAA36 s 79D. The Applicant apprehended the Commissioner was, on that basis, intending to dispute the Applicant’s entitlement to any deduction. In the course of rebutting that apprehended submission (which I emphasise was not in fact made by the Commissioner) the Applicant’s counsel drew attention to the definition of “assessable foreign income” in ITAA36 s 79D and, more specifically, to the incorporated definition in ITAA35 s 160AFD(9). That latter definition was in the following terms:
SECT 160AFD Losses of previous years
…(9) In this section:
assessable foreign income, in relation to a taxpayer in relation to a year of income, means:
(a) foreign income that is included in the assessable income of the taxpayer of the year of income; or
(b) where:
(i) during the year of income, the taxpayer derives a profit or gain of a capital nature from sources in a foreign country; and
(ii) the whole or part of the profit or gain is included in the assessable income of the taxpayer of the year of income other than under Part IIIA of this Act or Part 3-1 or 3-3 of the Income Tax Assessment Act 1997 (about CGT);
the whole or the part of the profit or gain.
…
108.Counsel for the Applicant submitted that the effect of this definition was to permit a taxpayer’s “assessable foreign income” to include the whole of a foreign capital gain for the purpose of determining the scope of the foreign income deductions that were allowable. In counsel’s submission the exclusion in subparagraph 160AFD(9)(b)(ii) was simply intended to disregard the discounting provisions in Parts 3-1 and 3-3 of ITAA97. Counsel submitted that this conclusion was required because capital gains (including gains from foreign sources) could not be included in assessable income other than under the provisions of Parts 3-1 and 3-3. On this basis counsel contended that the general deduction claimed under ITAA97 ss 8-1 or 25-40 was not limited to the amount of the gain that had actually been assessed to tax in the 2002 year. Counsel ultimately submitted that, if his preferred interpretation of ITAA36 s 160AFD(9)(b)(ii) was not accepted, the Commissioner had, in any event, expressly conceded the Applicant’s entitlement to a deduction under ITAA97 s 25-45 was not affected by the provisions of ITAA36 s 79D.
109.The Applicant’s counsel’s ultimate submission is clearly correct. His former submission is, as I have said, unnecessary to determine, because of my finding that the Applicant is not entitled to a general deduction for the Hong Kong losses. But the former submission contains an inherent difficulty in its attempt to restrict the apparently literal meaning of subparagraph 160AFD(9)(b)(ii) of ITAA36. The Applicant’s submission about the proper interpretation of that provision seems to contradict the apparent literal meaning of the subparagraph. But that seeming contradiction applies equally to the parties’ common, and indeed the Commissioner’s expressly conceded, position that the limitations on deductions from foreign income did not apply to limit a deduction otherwise authorised by ITAA97 s 25-45.
110.The appearance I have referred to in the preceding paragraph arose only towards the end of the parties oral submissions. Nevertheless it was expressly raised and the Commissioner did not seek to depart from, or to dispute, the concession the Applicant correctly attributed to the Commissioner and to which I have referred. In these circumstances the Applicant has discharged his onus under s 14ZZK(b)(i) of the Taxation Administration Act 1953 of showing that the assessment was excessive. On the other hand, the proper interpretation of ITAA36 s 160AFD was not the subject of a detailed considered argument in relation to its potential application to a loss attributable to an agent’s misappropriation. In these circumstances I do not consider that it would be appropriate for the Tribunal either to embark on its own determination of that interpretation, or to deprive the parties of the opportunity to reconsider their position in relation to it. It may be that the Commissioner’s concession was entirely correct and that the Applicant’s 2002 assessment can be finalised in accordance with the findings I have made in relation to the application of ITAA97 s 25-45. To facilitate that prospect the appropriate direction, in addition to setting aside the decision under review, is to remit the matter to the Commissioner to assess the Applicant’s 2002 tax in accordance with these reasons.
DECISION
111.The decision under review is set aside. The matter is remitted to the Commissioner for reconsideration in accordance with the direction that the misappropriation loss claimed by the Applicant is, as to the amount of $2,315,157, a deduction permitted by ITAA97 s 25-45.
I certify that the 111 preceding paragraphs are a true copy of the reasons for the decision herein of Mr P W Taylor, SC, Senior Member
Signed: ...............[sgd].................................................................
AssociateDates of Hearing 19 July 2007 and 18 and 20 March 2008
Date of Decision 20 June 2008
Counsel for the Applicant Mr C Bevan
Solicitor for the Applicant Mr W Cannon, Blake Dawson
Solicitor for the Respondent Ms J Gatland, Australian Taxation Office
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