Leggett and Ors and Commissioner of Taxation
[2007] AATA 1737
•3 September 2007
Administrative Appeals Tribunal
DECISION AND REASONS FOR DECISION [2007] AATA 1737
ADMINISTRATIVE APPEALS TRIBUNAL )
) No WT200300125; WT200300179
TAXATION APPEALS DIVISION ) and WT20040010-11 Re WAYNE HENRY LEGGET; JACOBUS DE BLANK and ROBERT JAN RENTING Applicant
And
COMMISSIONER OF TAXATION
Respondent
DECISION
Tribunal Mr A Sweidan, Senior Member Date3 September 2007
PlacePerth
Decision The Tribunal affirms the decisions under review.
...........[Sgd Mr A Sweidan].............
Senior Member
Administrative Appeals Tribunal
ADMINISTRATIVE APPEALS TRIBUNAL )
) No: WT200300125
TAXATION APPEALS Division )
Re: WAYNE HENRY LEGGETT
Applicant
And: COMMISSIONER OF TAXATION
RespondentDIRECTION [2007] AATA 1737
TRIBUNAL:Mr A Sweidan, Senior Member
DATE:19 September 2007
PLACE: Perth
The Tribunal made a decision in this application on 3 September 2007: [2007] AATA 1737.
It has come to the Tribunal’s attention that there is an obvious error in page one of the Decision.
Accordingly, the Tribunal directs the Registrar, pursuant to subsection 43AA(1) of the Administrative Appeals Tribunal Act 1975 (Cth), to alter page one of the Tribunal’s Decision so that the applicants last name is corrected to “Leggett”.
……[Sgd Mr A Sweidan].......
Senior Member
CATCHWORDS
Income Tax – deductions – Satcom Electronic Commerce – whether amounts paid for acquisition of Franchise deductible – whether capital – whether taxpayers carrying on a business – whether outgoings incurred in the production of income
LEGISLATION
Income Tax Assessment Act 1936 (Cth) s.51(1)
Income Tax Assessment Act 1997 (Cth) s.8-1CASES
Sleight v Commissioner of Taxation (2004) 136 FCR 211
Commissioner of Taxation v Cooke (2004) 55 ATR 183
Commissioner of Taxation v Lau (1984) 6 FCR 202 at 221
Commissioner of Taxation v Emmakell Pty Ltd (1990) 22 FCR 157
Puzey v Commissioner of Taxation (2002) 50 ATR 595; (2003) 53 ATR 614
Commissioner of Taxation Brand (1995) 31 ATR 326
Commissioner of Taxation v Walker (1984) ATC 4553
Australian Trade Commission v Disktravel [1990] FCA 1399
Madison Pacific Property Management and Ors v Australian Securities Commissioner 30 ACSR 218
Merchant v Commissioner of Taxation 99 ATC 4221
Magna Alloys & Research Pty Ltd v Federal Commissioner of Taxation (1980) 33 ALR 213
Fletcher v Federal Commissioner of Taxation (1991) 173 CLR 1
Clowes v Commissioner of Taxation (1954) 91 CLR 209
Milne v Commissioner of Taxation (1976) 133 CLR 526
Vincent v Federal Commissioner of Taxation [2002] FCAFC 291
Enviro Systems Renewable Resources Pty Ltd v ASIC (2001) 80 SASR 1 at [36], [43], [44]
Steele v Deputy Commissioner of Taxation (1990) 197 CLR 459
Ferguson v FCT (1979) 26 ALR 307 at 311
Hope v The Council of the City of Bathurst (1980) 144 CLR 1
Commissioner of Taxation v Sleight (2004) 136 FCR 211 at [47]-[50]
Travel Vision International Pty Ltd and Ors v Australian Trade Commission [1998] AATA 11
Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) CLR 295 at 309
Ronpibon Tin NL v FCT (1949) 78 CLR 47
Ure v FCT (1981) 34 ALR 237
REASONS FOR DECISION
3 September 2007 Mr A Sweidan, Senior Member BACKGROUND
1. The applicants Messrs Leggett, De Blank and Renting claim to be entitled to income tax deductions for expenses they incurred as franchisees of Satcom Electronic Commerce Services Pty Ltd (“Satcom Electronic”) as follows:-
a)Leggett: $32,000 claimed in the income year 30 June 1997 in respect of his acquisition of one franchise.
b)De Blank: $15,500 claimed in the income year 30 June 1998 in respect of the acquisition of one franchise by the partnership JA & D De Blank.
c)Renting:
$16,000 claimed in the income year 30 June 1997 in respect of the acquisition of one franchise by him and his wife.
$16,000 claimed in the income year 30 June 1998 in respect of the acquisition of one franchise by him and his wife.
2. In respect of each franchise acquired, the claimed deduction comprised the franchise fee of $30,000 plus $2,000. The composition of the $2,000 has been variously described by the applicants. Messrs Leggett and Renting treat it as a payment for legal and administration expenses and include the whole of $2,000 as part of the claimed deductions. Mr De Blank includes only one half of $1,000 as part of his claimed deduction. He describes the $2,000 in his affidavit as a $1,000 management fee and an instalment fee of $1,000. The Business Opportunity Disclosure Documents (“BODD”) issued by Satcom Electronic referred to further below refer only to $1,000 for outgoings.
3. The respondent disallowed the claimed deductions and subsequently disallowed the applicants’ objections to the relevant income tax assessments. The applicants now seek a review of those decisions.
ISSUES
4. The issues in these proceedings are:
(a)whether the claimed deductions are allowable under s 51(1) of the Income Tax Assessment Act 1936 or s 8-1 of the Income Tax Assessment Act 1997; and
(b)whether, if the claimed deductions are allowable under s 51(1) or s 8-1, Part IVA of the 1936 Act applies and, consequently the respondent was entitled to make determinations disallowing them pursuant to s 177F of the Income Tax Assessment Act 1936.
evidence – satcom project structure and documentation
- satcom electronic business opportunity disclosure document
5. It is not in dispute that the initial BODD was structured so that a sub-franchisee arrangement would be implemented immediately upon execution of the Franchise Agreement. The summary contained in the initial BODD (“initial BODD”) states:
“SECS is now granting franchise rights to market its electronic commerce services to CGO throughout Australia. The franchise has been structured so that the franchisee may have an active or passive involvement in the business activity. Franchises will be granted on the basis of a commitment to pay the annual franchise fees. No amount is payable for the grant of the franchise itself. Franchise fees should be 100% tax deductible (see enclosed tax opinion). The first year’s annual franchise fee is $30,000 followed in subsequent years by annual franchisee fees based on net profit. SECS is prepared to loan up to $20,000 of the first year’s fees at an interest rate of 7% P.A. secured by the franchise and unless the franchisee assigns the franchisee the $20K loan is repayable only out of net profit. The franchisee is required to pay the other $10,000 of the first year’s annual franchisee fee plus $1,000 in outgoings at the time of application. However, a short term credit facility is available in relation to this $11,000.”
6. According to the evidence of the applicants’ witness Mr Donaghey the investment was initially structured in the same manner as other franchise investments which had been offered by the Satcom group. The franchisee could initially sub-franchise the franchise to a sub-franchisee. The sub-franchisee would be obliged to market the electronic commerce services to corporate and government organisations (CGO) on behalf of the franchisees.
7. Mr Donaghey testified that in May 1997 the Australian Securities and Investments Commission (“ASIC”) conducted a review of the franchising structure which was completed in September 1997. ASIC advised Satcom Electronic that the sub-franchising arrangement resulted in the investment falling outside of general exemptions afforded by the Corporations Law. It was therefore decided that the structure of the investment would be changed and a revised BODD would be provided to investors. Franchisees were given the option of continuing under the varied arrangement or alternatively were given the opportunity to cancel their franchise and have their money refunded. It appears that no sub-franchise agreements were ever executed.
8. The sub-franchisee was replaced by an “Accredited Sales Agent” in a further BODD dated August 1997 (“revised BODD”).
9. Mr Donaghey said that it was always the intention of Satcom Electronic that the obligations of the Accredited Sales Agent would be documented in an Accredited Sales Agent Agreement. However no written agreement was ever completed or entered into with any of the Accredited Sales Agents.
10. The applicants were initially provided with the following BODDs:
(a)Leggett - initial BODD;
(b)De Blank - revised BODD; and
(c)Renting - initial BODD.
Mr Leggett and Mr Renting subsequently received revised BODDS as part of the Franchise documentation provided for their execution after they had applied for franchises.
11. The summary contained in the revised BODD states:
“SECS is now granting franchise rights to market its electronic commerce services to CGO throughout Australia. Franchises will be granted on the basis of a commitment to pay the annual franchise fees. No amount is payable for the grant itself of the franchise. For details of tax deductibility of the franchisee fees see enclosed tax opinion. The first year’s annual franchise fee is $30,000 followed in subsequent years by annual franchise fees based on income. SECS is prepared to loan up to $20,000 of the first year’s fees at an interest rate of 7% P.A. secured by the franchise and unless the franchisee assigns the franchise the $20K loan is repayable only out of the franchisee income. If it takes advantage of this loan the franchisee is required to pay the other $10,000 of the first year’s annual franchisee fee plus $1,000 in outgoings at the time of application. However, a short term credit facility is available in relation to this $11,000.”
12. The initial BODD described the franchise operation in the following terms:-
“SECS, the Franchisor is granting up to a maximum of two thousand (2000) Franchises each for a period of ten years.
Under the terms of the Franchise a Franchisee will operate a business of marketing the electronic commerce services to CGO. Each Franchisee will be authorised to enlist a maximum of fifty (50) CGO to become users of the electronic commerce services. The franchise business will earn revenue by providing the electronic commerce services to CGO.
THE FRANCHISE OFFER
The Franchisor will be responsible for the operational aspects of the service to CGO including provision of the electronic commerce services, marketing support, subscriber training and support, new services development and administration. In return the Franchisee will pay an annual fee to the Franchisor. The electronic commerce services identified for sale by the Franchisees to CGU include the following:-
·electronic mail
·electronic marketing
·electronic trading.”
13. In contrast, the revised BODD described the franchise operation in the following terms:-
“SECS, the Franchisor, is granting up to a maximum of two thousand (2000) Franchises each for a period of ten years.
Under the terms of the Franchise, a Franchisee will operate a business of marketing the electronic commerce services to CGO. Each Franchisee will be allocated two hundred and fifty (250) CGO. Each Franchisee will be authorised to enlist a maximum fifty (50) from this allocation to become subscribers of the electronic commerce services. The franchise business revenue is subscription moneys paid by these subscribers. The Franchisee must make a minimum of 25 calls every six months and report the result of those calls to the Franchisor.”
14. Each BODD contained projected cash flows on a pre-tax basis from a franchise for a 10 year period. No explanation of the projections or the assumptions on which they were based was included.
15. No information was provided in the BODDs as to how the franchises were to be allocated to franchisees.
16. The application form in the initial BODD states the following:
[FRANCHISE APPLICATION]
SATCOM ELECTRONIC COMMERCE SERVICES
I, WE ________________________________________________________________________
ADDRESS ____________________________________________________________________
__________________________________________________________TEL _______________
HEREBY APPLY FOR ________________ SATCOM ELECTRONIC SERVICES FRANCHISE/S
* FIND ATTACHED A CHEQUE FOR $ _________ BEING FIRST YEAR FRANCHISE FEE PLUS OUTGOINGS
OR
* I/WE WISH TO BORROW $ _________ OF THE FIRST YEAR FRANCHISE FEE AND THEREFORE ATTACH A CHEQUE FOR $ ________ (BEING FRANCHISE FEE PLUS OUTGOINGS)
I understand that I will grant Satcom Business Exchange Pty Ltd a Sub-Franchise to operate my Franchise Business. This will remain in effect until I/We have successfully completed the training course and demonstrated the financial and other requirements required by Satcom.
I agree and acknowledge that upon signing of this application form by Satcom or its agent, a binding agreement will be deemed to have been entered into between myself and Satcom, and furthermore I will be bound to complete execution of the Franchise Agreement and Sub-Franchise contract documents in standard form, prepared by Clayton Utz, and also (where relevant) the standard form Funding Agreement. I undertake to execute and return those documents within 7 days of being requested to do so by Satcom.
17. The application form in the revised BODD states the following:
[FRANCHISE APPLICATION]
SATCOM ELECTRONIC COMMERCE SERVICES
I, WE ________________________________________________________________________
ADDRESS ____________________________________________________________________
__________________________________________________________TEL _______________
HEREBY APPLY FOR ________________ SATCOM ELECTRONIC SERVICES FRANCHISE/S
* FIND ATTACHED A CHEQUE FOR $ _________ BEING FIRST YEAR FRANCHISE FEE PLUS OUTGOINGS
OR
* I/WE WISH TO BORROW $ _________ OF THE FIRST YEAR FRANCHISE FEE AND THEREFORE ATTACH A CHEQUE FOR $ ________ (BEING FRANCHISE FEE PLUS OUTGOINGS)
I agree and acknowledge that upon signing this application form by Satcom or its agent, a binding agreement will be deemed to have been entered into between myself and Satcom, and furthermore I will be bound to complete execution of the Franchise Agreement in standard form and also (where relevant) the standard form Funding Agreement. I undertake to execute and return those documents within 7 days of being requested to do so by Satcom.
Entering The Franchises
18. The applicants each deposed to signing up for franchises and produced documents as follows:
Leggett
19. Leggett deposed that on 24 June 1997 he completed a franchise application form contained in the (initial) BODD and forwarded it to Satcom Electronic and paid $12,000 to acquire one franchise.
20. In support of this, Leggett produced the following:-
(a)Franchise Application form dated 24 June 1997;
(b)a copy of the cheque forwarded to Satcom Electronic together with a periodical payment request;
(c)a signed and undated Execution Sheet;
(d)Franchise Agreement with Satcom Electronic Commerce Services Pty Ltd as Trustee for the SECS Unit Trust for a franchise to establish and operate a business marketing the Satcom Electronic system;
(e)Funding Agreement with Satcom Electronic Commerce Services Pty Ltd as Trustee for the SECS Unit Trust for an advance of $31,000 which was to assist in discharging the Initial Annual Franchise Fee;
(f)Allocated Prospects List of Franchise SECS0496;
(g)Franchise Certificate for Franchise Number SECS0496;
De Blank
21. De Blank deposed that prior to 30 June 1998 he completed a franchise application form contained in the BODD and forwarded it to Satcom Electronic and paid $10,000 to acquire one franchise.
22. In support of this, De Blank produced the following:-
(a)A letter dated 22 July 1998 from Satcom Electronic enclosing for execution franchise documentation for Franchise Number SECS1332 which commenced on 30 June 1998;
(b)Franchise Agreement with Satcom Electronic Commerce Services Pty Ltd as Trustee for the SECS Unit Trust for a franchise to establish and operate a business marketing the Satcom Electronic system;
(c)a signed and undated Execution Sheet;
(d)Funding Agreement with Satcom Electronic Commerce Services Pty Ltd as Trustee for the SECS Unit Trust for an advance of $31,000 which was to assist in discharging the Initial Annual Franchise Fee;
(e)Franchise Certificate for Franchise Number SECS1332; and
(f)A letter dated 2 October 1998 from Satcom Business Exchange Pty Ltd enclosing a list of Allocated Prospects and an Options List with which De Blank could elect to have a Satcom Accredited Sales Agent market Satcom Electronic services on his behalf.
Renting
23. Renting deposed that he completed franchise application forms contained in the (initial) BODD for the 1997 and 1998 financial years and forwarded them to Satcom Electronic and paid $1,000 in respect of each franchise acquired. His franchises were as follows:-
(a)for one franchise acquired in the 1997 financial year, Franchise Number SECS0136; and
(b)for one franchise acquired in the 1998 financial year, Franchise Number SECS0524.
24. In support of this, Renting produced the following:-
(a)Franchise Application Form dated 24 June 1997;
(b)Franchise Application Form dated 1 July 1997 and authority to release payment dated 24 June 1997;
(c)Statement from Satcom Electronic recording certain repayments of short term loan;
(d)Special Funding Agreements for the 1997 and 1998 financial years;
(e)A letter dated 8 June 1998 from Satcom Electronic enclosing franchise documentation for Franchise Number SECS0524 which commenced on 31 July 1997;
(f)A letter dated 14 April 1998 from Satcom Electronic enclosing franchise documentation for Franchise Number SECS0136 which commenced on 30 June 1997;
(g)a signed and undated Execution Sheet;
(h)Franchise Agreement with Satcom Electronic Commerce Services Pty Ltd as Trustee for the SECS Unit Trust for a franchise to establish and operate a business marketing the Satcom Electronic system;
(i)Funding Agreement with Satcom Electronic Commerce Services Pty Ltd as Trustee for the SECS Unit Trust for an advance of $31,000 which was to assist in discharging the Initial Annual Franchise Fee;
(j)Franchise Certificates for Franchise Numbers SECS0524 and SECS0136;
(h)Allocated Prospects Lists of Franchises SECS0524 and SECS0136;
(i)A letter dated 2 October 1998 from Satcom Business Exchange Pty Ltd enclosing a list of Allocated Prospects and an Options List with which Renting could elect to have a Satcom Accredited Sales Agent market Satcom Electronic services on his behalf.
The franchise agreement
25. Each franchise agreement made between the applicants and Satcom Electronic as Franchisor included the following recitals by way of background:
RECITALS
A.The Franchisor has designed and developed the System to assist corporate, government and other organisations by linking buyers and sellers of products and services electronically.
B.The Franchisor has agreed to grant the Franchisee a franchise to market the System on the terms and conditions hereinafter contained.
26. By clause 2.1 of the Franchise Agreement, the Franchisor granted to the Franchisee from the Commencement Date (referred to in item 1 of the Schedule) for the Franchise Term of 10 years (defined clause 1.1) an exclusive franchise to establish and operate the Franchised Operation to market the System to the Allocated Prospects using the Franchise Procedures, provided that the number of subscribers was not to exceed 50 for the time being.
27. Under clause 2.1 the consideration for the grant of franchise was:-.
(a)the payment by the Franchisee on or before the Commencement Date of the “Initial Annual Franchise Fee”, defined in clause 1.1 as the fee of $30,000 stated in item 2 of the Schedule; [It is not specified who the Franchisee is to pay];
(b)the payment by the Franchisee to the Franchisor of the “Ongoing Annual Franchise Fees”, defined in clause 1.1 as the fees payable as described in item 3 of the Schedule as: “In the second to tenth Years, inclusive, the amount equal to 40% of the Income of each of those particular Years.”
28. By clause 2.2 of the Franchise Agreement, the Franchisor covenants not to grant any other person a license or franchise to market the System to the Allocated Prospects allotted to the Franchisee.
29. Franchised Operation is defined in clause 1.1: “means the business of marketing the System to Allocated Prospects with a view to enlisting them as Subscribers which business the Franchisee is licensed to conduct as set out in this Agreement.”
30. System is defined in clause 1.1: “means the on-line electronic commerce services system which incorporates a range of electronic commerce applications on but not limited to the Internet, including electronic mail, electronic marketing and electronic trading, identified by the Logo, the Trade Mark, and certain financial and other electronic configurations, designs, layouts and colour schemes, distinctive signs, particular types of equipment and formulated methods of operation covering business practices and policies, together with such changes and enhancements thereto as may be implemented by the Franchisor from time to time;”.
31. Allocated Prospects is defined in clause 1.1:”means 250 telephone subscribers within the Commonwealth of Australia which are corporate, government and/or other organisations allocated by the Franchisor to the Franchisee the details of which names and telephone numbers will be notified to the Franchisee in writing within 3 months of execution of this Agreement by the Franchisor (which names so notified are deemed to be incorporated into this Agreement);”.
32. Franchise Procedures is defined in clause 1.1:”means all of the procedures required by the Franchisor to be fulfilled from time to time in respect of the conduct of the Franchised Operation, including, but not limited to, manuals, brochures and any other documents detailing the required or desired procedures applicable to the conduct of the Franchise;”.
33. Income is defined in clause 1.1: “means all monies received for subscription by the Franchisor from Subscribers”.
34. Subscribers is defined in clause 1.1: “means Allocated Prospects who are enlisted as subscribers to the System pursuant to the Franchise;”.
35. By clause 2.3 of the Franchise Agreement, the Franchisee acknowledges that the Franchised Operation will be carried on by it for the duration of the Franchise Term.
36. The covenants made by the Franchisee included:-
(a)By clause 7(b) of the Franchise Agreement, the Franchisee undertook to manage, control and promote the Franchised Operation and to use its best endeavours to promote the interests of the Franchisor and Franchisee.
(b)By clause 7(c) of the Franchise Agreement, the Franchisee undertook to employ sufficient competent trained staff effectively to conduct the Franchised Operation and to devote sufficient time and attention to the Franchised Operation.
(c)By clause 7(d) of the Franchise Agreement the Franchisee agreed to commence the Franchised Operation from the Commencement Date. That date is defined in clause 1.1: “means the date referred to in Item 1 of the Schedule, being the last day of the month that the application for the Franchise is received by the Franchisor”.
(d)By clause 7(o) “to ensure all payments made or to be made by Subscribers or users of the System in respect of the Franchised Operation and arising during the conduct thereof shall be made in favour of the Franchisor … shall on no account retain any such monies from the Subscribers but shall deliver all such monies to the Franchisor forthwith.”.;
(e)By clause 7(q) the Franchisee irrevocably authorised and directed the Franchisor to apply the funds deposited in the Clearing Account in the manner set out in clause 15,
37. By clause 4.3 the Franchisee warrants that:
“…the Franchisee has taken independent legal advice (at the cost of the Franchisee) and will provide a certificate to the Franchisor signed by a solicitor in the form or substantially in the form of Annexure D or will provide a certificate to the Franchisor signed by the Franchisee in the form or substantially in the form of Annexure E.”
38. The Franchise Agreement made provision for the training of franchisees so that they could acquire the knowledge and experience necessary to conduct the Franchised Operation. Clause 8 relevantly states:
“8. TRAINING AND ASSISTANCE
8.1 At the request of the Franchisee, the Franchisor will make such arrangements as it in its absolute discretion deems fit to make available to the Franchisee or to the Franchisee’s designated representative such advice, training and materials as are necessary to enable the Franchisee to acquire the technical competence required to conduct the Franchised Operation in the Franchisee’s own right and the Franchisee hereby agrees that the Franchisee or the Franchisee’s designated representative will be available to receive such advice and training and any further advice and training as the Franchisor may from time to time require. The Franchisee hereby acknowledges that the Franchisor may charge its reasonable costs associated with providing such advice and training and the Franchisee hereby agrees to pay the same to the Franchisor within 7 days of receiving the Franchisor’s invoice in respect thereof.”
39. The Franchisee was required by clause 9.1 of the Franchise Agreement to make the Minimum Prospecting Calls, defined by clause 1.1 as “direct telephone canvassing calls to at least 25 of the Allocated Prospects for the time being within each successive period of 6 months during the Franchise Term the first such period to commence on the Commencement Date”. The obligation to make the Minimum Prospecting Calls was only to apply at any time during the Franchise Term when there were less than 50 current Subscribers. The Franchisee is deemed to have complied at anytime there are 50 current Subscribers. This obligation could be fulfilled by either:
(a)the Franchisee personally;
(b)the Franchisee’s designated representative; or
(c)an Accredited Sales Agent defined in clause 1.1 as “a person who is approved by the Franchisor to market the System to the Allocated Prospects for/and on behalf of the Franchisee.”.
40. Further, clause 9.2 required the Franchisee to provide the Franchisor with such evidence as the Franchisor reasonably requires in order to be satisfied that the Franchisee or the Accredited Sales Agent had made the Minimum Prospecting Calls.
41. Clause 10 of the Franchise Agreement states the following with respect to the appointment of Accredited Sales Agents:
“10.ACCREDITED SALES AGENT
10.1The Franchisee in its absolute discretion may appoint one or more Accredited Sales Agents to contact Allocated Prospects with a view to enlisting them as Subscribers, and the Franchisee may dismiss Accredited Sales Agents and appoint other Accredited Sales Agents.
10.2If the Franchisee appoints an Accredited Sales Agent the Franchisee shall supervise the Accredited Sales Agent and retain the right to direct and exercise control over the Franchised Operation and the Accredited Sales Agent.
10.3The Franchisor shall approve as an Accredited Sales Agent any party who is sufficiently experienced or trained and is competent and of sufficiently sound financial standing to perform efficiently and effectively the functions of the Accredited Sales Agent.
10.4If the Franchisee fails to make the Minimum Prospecting Calls in accordance with clause 9.1 or to report to the Franchisor in accordance with clause 9.2, the Franchisor may appoint one or more Accredited Sales Agents to canvass Allocated Prospects and market the System to them on behalf of the Franchisee.
10.5Where an Allocated Prospect is enlisted as a Subscriber pursuant to clause 10.4 the Accredited Sales Agent who enlisted the Subscriber shall be entitled to receive a fee as agreed between the Accredited Sales Agent and the Franchisor which fee shall be paid in the manner referred to in clause 15.2.”
42. By clause 14.1 of the Franchise Agreement, the Franchisee was required to keep books of account and records and to operate finance and accounting systems “as are required by law or to explain effectively the financial position of the Franchised Operation”. The Franchisee was further required to make these books or records available for audit by the Franchisor in accordance with clause 14.2.
43. By clause 15 of the Franchise Agreement, the Franchisor was obliged, inter alia, to:
(a)provide to the Franchisee during the Franchise Term the services set out at page 7 of the BODD [clause 15.1(a)(i)], being:
· New Services Development outlined as service definition, systems design and systems development;
· Marketing Support Services outlined as marketing literature, corporate advertising and franchisee training;
· Provision Of Service outlined as hardware systems, software systems and communications infrastructure;
· Subscriber Training and Support outlined as help desk operations and training; and
· Administration Services outlined as management, revenue collection and accounting services.
(b)prepare and forward invoices or otherwise render accounts to Subscribers and collect all Income payments from Subscribers i.e. all moneys received for subscription from Subscribers. (clause 1.1 definition of Income and clause 15.1(ii);
(c)set up the Clearing Account and deposit all Income payments into the Clearing Account. The Clearing Account means a bank account set up by the Franchisor for the purposes of clause 15. [clause 1.1 (Clearing Account definition) and clause 15.1(a)(iii) and (iv)];
(d)continue to develop the System and to charge subscribers at commercial rates [clause 15.1(b)];
(e)provide the Franchisee an account to 30 June in each year in respect of the income generated over the preceding 12 month period with reasonable details of how such Income was calculated [clause 15.1(c)];
(f)provide advice, information and training to the Franchisee in relation to the conduct of the Franchised Operation [clause 15.1(d)];
(g)provide information, advice and training to the Franchisee relating to the improvements and enhancements to the System [clause 15.1(e)];
(h)make available to the Franchisee improvements in and developments to any industrial and intellectual property belonging to the Franchisor which are relevant to the conduct of the Francished Operation [clause 15.1(f)]; and
(i)enable the Franchisee to consult with executives and officers of the Franchisor [clause 15.1(g)].
44. The Franchisor was to deal with the proceeds in the Clearing Account as follows:
(a)At the expiration of every month from the Commencement Date, the Franchisor shall pay from the funds held in the Clearing Account, the fees of the Accredited Sales Agent up to a maximum of 10% of the Income received from each Subscriber enlisted by the Accredited Sales Agent for that month [clause 15.2];
(b)At the expiration of every quarterly period referred to in clause 7(a)(ii) the Franchisor shall apply funds held in the Clearing Account after deducting the amount(s) referred to in clause 15.2 in payment of any instalment of the Ongoing Annual Franchise Fee which is then owing, to the Franchisor for its own use absolutely [clause 15.3];
(c)At the expiration of every 12 month period as referred to in clause 15.1(c) the Franchisor shall apply funds held in the Clearing Account after deducting the amount(s) referred to clauses 15.2 and 5.3 in making payments in the following order, priority and manner:
(i)first, as to 50% of the balance then remaining, in payment in accordance with the provision of the Funding Agreement of any amount then owing under the Funding Agreement, to the Franchisor for its own use absolutely;
(ii)second, as to the balance then remaining, in payment of any amount then due and payable to the Franchisor under or in connection with this Agreement or the Funding Agreement, to the Franchisor for its own use absolutely;
(iii)third, as to the balance then remaining, to the Franchisee for its own use absolutely;
(d)In consideration of the Franchisee entering into this Agreement the Franchisor shall hold all monies paid into the Clearing Account in trust for the parties entitled to them under clauses 15.2, 15.3 and 15.4
45. By clause 29 of the Franchise Agreement the Franchisee was to pay the Franchisor on or before the Commencement Date the sum of $1,000 in respect of the Franchise for administration, legal costs and stamp duty in relation to this Agreement and the Funding Agreement.
the funding agreement
46. The franchise application form in the BODDs provided Franchisees with the opportunity to enter into a limited-recourse loan with Satcom Electronic for the advance of funds in satisfaction of part of the Initial Annual Franchise Fee. A Funding Agreement was executed by each of the applicants to give effect to this arrangement.
47. The recitals of each Funding Agreement stated the following by way of background:
RECITALS
A.Satcom has agreed to grant the Borrower the Franchise on the terms and conditions contained in the Franchise Agreement.
B.Satcom has agreed to advance the Principal Sum to the Borrower to assist the Borrower to pay Satcom the Initial Annual Franchise Fee on the terms and conditions contained in this Agreement.
48. By clause 2.1 of the Funding Agreement, Satcom Electronic agreed to advance the Principal Sum to the Borrower on the Advance Date upon the terms and conditions contained in the Funding Agreement.
49. Principal Sum was defined in clause 1.1: “means the sum described in Item 1 of the Schedule”, being the sum of the loan monies agreed upon by Satcom Electronic and the Borrower.
50. Advance Date was defined in clause 1.1: “has the same meaning as Commencement Date”. Commencement Date is defined by reference to the Franchise Agreement at clause 1.1 being: “means the date referred to in Item 1 of the Schedule, being the last day of the month that the application for the Franchise is received by the Franchisor.
51. According to clause 2.2 of the Funding Agreement, the advance of the loan monies was to be achieved by way of ledger entries in the books of account of both Satcom Electronic and the Borrower. Clause 2.2 relevantly states:-
“For the purposes of commercial ease and efficacy, rather than have Satcom pay the Principal Sum to the Borrower on the Advance Date and the Borrower as franchisee under the Franchise Agreement repay the same to Satcom as franchisor on the Advance Date, Satcom hereby agrees at the request of the borrower to enter a debit in its books of account for the amount of the Principal Sum as a debt due and owing to Satcom by the Borrower (subject to clauses 6 and 7) and to credit in its books of account the amount of the Principal Sum as payment in part or full of the Initial Annual Franchise Fee, and the Borrower hereby agrees to reciprocate these entries in the Borrower’s own books of account.”
52. By clause 3 of the Funding Agreement the Borrower agreed to the advance of the Principal Sum being made in the manner set out in clause 2.2.
53. By clause 4.1 of the Funding Agreement, interest would be charged at the direction of Satcom on the “Short Term Portion”, that is the portion of the Principal Sum defined in Item 3 of the Schedule. By clause 4.2 it was agreed that interest would accrue on the Long Term Portion of the loan on a daily basis at the Rate.
54. Long Term Portion was defined by clause 1.1: “means that portion of the Principal Sum referred to in Item 2 of the Schedule;”.
55. The Rate was defined by clause 1.1: “means the rate of interest stated in Item 4 of the Schedule”, i.e. 7% per annum.
56. By clause 5.1(a) the Short Term Portion was due and repayable in the amounts and the dates set out in the Execution Sheet (which is not defined in the Funding Agreement but is apparently incorporated by reference). The Execution Sheet, inter alia, set out the details of the monthly instalments by which the Franchisee/Borrower had elected to repay the Short Term Portion.
57. Pursuant to clauses 5.1(b) and 5.2(a) of the Funding Agreement, the Long Term Portion and interest thereon was to be paid “by paying to Satcom an amount equal to one half of the Franchisee Income derived by the Franchisee in each Year until the Long Term Portion and interest thereon was repaid in full. “Year” is not defined and Franchisee Income is defined by clause 1.1 as: “…the Income less the Ongoing Annual Franchise Fee and any fees payable to the Accredited Sales Agent”
58. The import of clause 5.5 of the Funding Agreement seems to be that each applicant as Borrower irrevocably authorised the Franchisor, as lender “to deduct and set-off against any monies otherwise due and payable to the borrower by the Franchisor under the terms of the Franchise Agreement” the amounts due under the Funding Agreement.
59. The Funding Agreement clearly operated as a limited-recourse loan. By clauses 5.6, 6 and 7 the Borrower was discharged from any liability for the outstanding amounts owed to Satcom Electronic in the event that the Borrower failed to repay the Long Term Portion and any interest which had accrued. Further, the Borrower was discharged from liability if the Borrower did not derive any Franchisee Income. Clause 7.2 relevantly states:
“In relation to the liability of the Borrower to repay to Satcom the Long Term Portion and interest thereon, subject to clause 7.4 of this Agreement if the circumstances are such that the Borrower has not derived, or does not derive, any Franchisee Income during the period that the Borrower remains the Franchisee under the Franchise Agreement, or has not derived, received or recovered, or does not derive, receive or recover any income, proceeds or sum as described in clauses 5.2 or 5.3, then, in those particular circumstances, but not otherwise, Satcom hereby forever release and discharges the Borrower from all liability to repay the Long Term Portion and interest thereon.”
THE EXECUTION SHEET
60. The Execution Sheet is included in the Franchise Documentation provided to each applicant. No specific mention is made of it in the letter from Satcom which accompanied the Franchise Documentation. It is not mentioned in the BODD or the Franchise Application. It is not defined in the Funding Agreement although it is referred to. The Execution Sheet sets out loan details and the election to repay the Short Term Portion of the Principal Sum by monthly instalment as well as stating :-
“EXECUTION SHEET
By their execution of this Execution Sheet:
____________
of
(“Franchisee”)
and
Satcom Electronic Commerce Services Pty Ltd ACN 007 650 269 as trustee of The SECS Unit Trust (“SECS”) separately agree to be bound by the terms of the following documents in the form attached which are incorporated herein by reference and executed as deeds”
A. Franchise Agreement between SECS and the Franchisee; and
B Funding Agreement between SECS and the Franchisee.”
evidence of consideration and inquiries by the applicants
61. With regard to their entry into the Satcom Electronic arrangements, the applicants each deposed to the following considerations and inquiries:
Leggett
62. Leggett deposed that:
(a)he had historically participated in a number of similar tax effective investments: [7];
(b)he had participated in the Satcom Financial Services Project in 1996 and was familiar with the Satcom brand. He understood that many accountants were already using Satcom’s services. Mr Leggett believed that “it was obvious that Satcom recognised an opportunity to capitalise on the developing e-commerce market and individuals could participate and become franchisees and market the services of the Project to corporate and government organisations, creating a liaison and relationships with them.” : [8];
(c)David Meredith, the Marketing Manager for Satcom, was an old acquaintance of his who approached him about an investment opportunity in Satcom: [9];
(d)he conducted his own research on the merits of the investment and in particular how the SupplySearch product offered by Satcom Electronic operated. He also considered the business plan prepared by Mr Baker, an accountant from Burns & Baker, which he adopted for use with his own clients. Mr Leggett deposed that he considered the opinion of Robert O’Connor QC which supported his belief that the business expenses of the franchise were deductible: [10], [11], [12], [13], [19], [26];
(e)he understood that SupplySearch operated by allowing users to find and sell products. He believed that the business could grow exponentially because this was a ground breaking product: [11], [12], [13];
(f)he understood that the Commonwealth Bank was a major supporter of SupplySearch: [14];
(g)he understood that the Satcom Electronic investment had a similar structure to the “Satcom Financial Services Project” and therefore “provided the same funding model as the Satcom Financial Services Project in that it was based around a franchising model”. Mr Leggett stated that he looked at the investment opportunity for a lengthy period and was excited about it due to his involvement in the Satcom Financial Services Project. He believed that SupplySearch would be a greater commercial success because it “enabled any subscriber to buy or sell any product, anytime, anywhere in the world…”: [15], [16];
(h)he was satisfied that the business was commercially viable following discussions with Ron Gallagher and David Meredith and after visits to the Satcom offices in Osborne Park. Mr Leggett states that “David demonstrated to me the effective outcome determined by various numbers of subscribers each year, based on assumed annual fees”. He also states that they “discussed the project projections in the IM and conducted due diligence in relation to the profit projections. I formed the view that the projections were quite conservative and that the business could do much better than projected.”: [17], [20], [21];
(i)he was advised by Ron Gallagher that Satcom had shifted its focus to the US where they had potential customers such as NASA who were interested in using SupplySearch. Mr Leggett was also provided with a disk which “modelled exactly how it was going to work and demonstrated the benefits of the product.”: [37], [38];
(j)he had clients who were involved in the information technology and related industries who participated in the investment because “they were of the view that it was a phenomenal opportunity”. He therefore came to the conclusion that it would provide a worthwhile return. Mr Leggett states that he was aware that the ATO had conducted an audit of Satcom’s activities but had not received any indication that the deductions he had claimed from his investment in the Satcom Financial Services franchise were not deductible: [22], [25];
(k)the investment would provide him with a stream of cash flows over the term of the investment. This was convenient because he wanted to participate in a business which would provide income in the long term. He believed that there would be a sound commercial business even though the major returns would only be derived towards the end of the investment: [23], [24];
(l)he understood that each franchisee could do their own marketing or they could appoint their own sales agent. It seemed prudent to him that Satcom Electronic have day to day control of the franchise given that they were the experts. This allowed Mr Leggett to focus on his existing financial planning business. It was explained to him that the arrangement with the sales agent would operate in the following manner, “[if] there are 1000 franchisees that signed on the marketing rights and I was franchise number 300 for example, then I would get the 300th, the 1300th customer and the 2300th customer and so on until every customer had been allocated. If there were only 10 franchises I would get every 10th customer.”: [35];
(m)he believed that after completing the application form he would be a franchisee and be bound by the Franchise Agreement and Funding Agreement. He also understood that he would share in the benefits and risks of the business: [36]; and
(n)the payment of the franchise fee would enable him to exclusively operate a business of promoting and marketing the “Project’s system” to a list of 250 telephone numbers within Australia being corporate or government organisations: [36].
De Blank
63. De Blank deposed that:
(a)he understood marketing strategies by reason of his involvement in the building industry and various business ventures including property subdivisions, liquor stores and property development. He had also taken many marketing seminars and self development programs. DeBlank also states that he understood and could relate to the investment because, in his words, “I live inside my computer, I live on the Internet, I understand the processes and opportunities, my banking is electronic my thinking is electronic.”: [19];
(b)that he became aware of the investment through family friends who introduced him to John Goldie. He states that he attended a meeting with Mr Goldie at which he was “given a broad picture of the future business opportunities of the Project, that is, future income of about $65,000 over 10 years coupled with future growth of the industry”. He was provided with a copy of the BODD and a business plan which had been prepared for him by Mr Goldie: [10], [16];
(c)a strong motivating factor for his decision to invest in a Satcom Electronic franchise was because his family friends were confident of its potential. He chose a Satcom Electronic franchise over other investments which he and his wife were considering: [12], [16];
(d)he had been using computers for several years and therefore was proficient at them. He understood the opportunities that came from networking through the internet and thought that the products offered by Satcom Electronic were similar to the software products which he had been trained on in 1996. Mr De Blank also states “I thought that the Project was a good opportunity for people to make good contacts with other people and to transact business and for me to expand my own businesses. I thought that this was an absolutely fantastic idea, I knew about it and decided to invest.”: [14];
(e)he believed that the investment would generate an income of $65,000 over 10 years, but understood that in the beginning years the investment would only generate small amounts of income which would increase over subsequent years: [16];
(f)he considered the projections in the BODD and believed them to be quite good. DeBlank however concedes that he did not attempt to confirm the projections with any third parties or external source. He did seek the advice of his accountant who advised him that the business expenses were deductible. DeBlank deposes that his accountant considered and affirmed the information contained in the report from Robert O’Connor QC. He told his accountant that he was aware of the taxation benefit from investing in a franchise but that his dominant purpose for investing was to generate a future income stream to support his retirement: [17], [18];
(g)he believed that he would receive a future income of $65,000 over 10 years: [10], [16], [17];
(h)he believed that after completing the application form he would be a franchisee and therefore bound by the Franchise Agreement and Funding Agreement. DeBlank also believed that the payment of the franchise fee would enable him to exclusively operate a business of promoting and marketing the “Project’s system” by marketing the products to his allocated companies, government and other organisations: [25]; and
(i)he appointed an approved sales agent because all his time was committed to running his existing business. He wanted the approved sales agent to grow the franchise business in the preliminary years so that he could take control of the franchise in the future when he would be retiring from his existing business: [26].
Renting
64. Renting deposed that:
(a)he was involved in the original Satcom Corporate Services Project in 1994 and that his accounting practice was using the corporate services software and interface provided by Satcom. Renting further states that the Satcom services enabled him to provide information to clients to assist in making sound business decisions and assisted him in preparing client tax returns in an efficient and cost effective manner: [11], [12];
(b)he commenced using Satcom’s services in the mid 1990’s. He states that he “immediately saw the benefits that the Internet could provide to my accountancy practice and decided to acquire, amongst other things, Internet capabilities from Satcom which enabled me to obtain information from ASIC, business name registration details and land title searches.” Mr Renting deposes that he adopted Satcom’s services as they began to evolve and that they are still in use at his accounting practice today. Based on this, he understood that Satcom had a good track record in developing and operating technology products: [13], [14], [20];
(c)as a result of his involvement with Satcom he was mailed a BODD. He did not meet with any Satcom representatives and instead formed the view that the investment was a reasonable opportunity with sound financial returns based on his own accountancy skills and expertise. He considered the terms of the BODD and the opinion of Robert O’Connor QC which confirmed his belief that the business expenses were deductible. He believed the business would be commercially viable in the long run. He also believed that the projections contained in the BODD were conservative when compared with the projections of other investment projects. Mr Renting deposed that an investment in a Satcom Electronic franchise carried less risk than agricultural business investments which were available at the time: [15], [16], [17], [18], [23];
(d)the success of the business depended on “market penetration and how many people took up the electronic services product”. Based on Mr Renting’s meetings with Ron Gallagher of Satcom, Mr Renting understood that Satcom was having problems with market penetration but was assured by Mr Gallagher that this issue would be resolved in the future. He understood from these conversations that Satcom Electronic’s products and services were gradually being accepted in the market. Mr Renting therefore believed that the franchise would become a profitable business in future years: [17], [31];
(e)he assumed that Satcom Electronic was adequately resourced to deliver the outcomes represented in the BODD: [21];
(f)the business “could be susceptible to risks such as low penetration into the market place, correct market requirement interpretation by the product developers and skills of the computer programming teams.”: [26]; and
(g)the franchise fee would enable him “to exclusively operate a business of promoting and marketing the products to the allocated list of 250 corporations and government organisations using the system implemented by the Project.” However, it was always his intention for an Accredited Sales Agent to manage the franchise business on his behalf given that he had his own accountancy practice and therefore did not have time to devote to the day to day operation of the franchise:[27], [28].
business activities
65. Each applicant was provided with a list of 250 CGO’s. It is evident from paragraph [25] and JDB9 of Mr Renting’s affidavit that the lists were provided with a covering letter from Satcom on or about 2 October 1998. The applicants each acknowledged as much in cross-examination. The letter stated:-
“Your franchise agreement permits a Satcom Accredited Sales Agent (ASA) to market to these CGO on your behalf. Alternatively you may market to these CGO yourself, but only after completing the mandatory training as stipulated by the franchisor and then solely at the discretion of the franchisor.
To enable you to exercise your option as to who markets to your prospects we have enclosed an “Options List”. Please tick the appropriate box to indicate your choice and return in the enclosed “REPLY PAID” envelope. Should we have not received your “Options List” within the next 14 days we will allocate an ASA for you.”
66. The evidence is that the Franchisor generated income from franchise and administration fees, comprising actual cash payments made by Franchisees, in accordance with the following table:
Financial Year Ended 30 June 1995 1996 1997 1998 Franchise Fees 0 0 142,439 19,274,876 Administration Fees 0 0 0 1,402,900 67. Amounts owing by Franchisees by reason of the limited-recourse loan arrangement referred to earlier are summarised in the following table:
Financial Year Ended 30 June
1995 1996 1997 1998 Franchisee Loans 15,531,200 38,374,479 Unearned Franchise Fees (14,947,561) (23,812,685) Unearned Income (885,000) (939,600) Net Amount owing by/(to) Franchisees (301,361) 13,622,194 68. In contrast to the amounts of revenue generated by the Franchisor from the annual franchise fees, the evidence shows that the activities of the Satcom group as a whole (whether related to Satcom Electronic or other services offered by Satcom), only generated income from the sale of its good and services in accordance with the following table:
Financial Year Ended 30 June
1995 1996 1997 1998 $145,602 $614,659 $648,522 $766,858 69. The Franchise Financial Statements provided to the applicants and produced in evidence recorded the following outcomes in contrast to the gross income projected in the BODDs:
Gross Income per Franchise
Projected (as per Satcom Electronic BODDs)
And
Actual (as per individual Financial Statements)Year BODD
(Accredited Sales Agent is retained and loan option)1997
Leggett
SECS0496WHL11/130, 133 and 134
1998
De Blank
SECS1332JDB11/157, 158
1998
Renting
SECS0524RJR17/213, 215
1998
Renting
SECS 0136RJR17/212, 214
1
500
0.00
0.00
0.00
0.00
2
1,800
0.00
0.00
0.00
0.00
3
4,320
300.00
N/A
N/A
N/A
70. Satcom Electronic’s various reports to franchisees were put before the Tribunal by the applicants.
Witnesses
71. As well as the evidence of each of the applicants, the Tribunal had before it evidence from the following witnesses called for the applicants: -
Dr Colin Ash (exhibit A1);
Mr Patrick Donaghey (exhibits A4; A5);
Mr Nigel Simpson (exhibits A2, A3);
Mr Graham Speak (exhibits A6, A7).
72. The following witnesses were called by the respondent: -
Mr Roger Clarke (exhibits R1 - R5);
Mr Tim Hantke (exhibit R9);
Mr Greg Meredith (exhibits R6 - R8).
73. The detail of the evidence of the above witnesses is referred to further below. The respondent submitted that the effect of each witness’s evidence may be summarized as follows:-
(a)Dr Ash was asked to comment upon the reasonableness of the assumptions in respect of the revenue projections in the revised BODD. He noted the two assumptions which underpin the revenue projections, namely the amount of subscribers projected to be enlisted by the Project and the amount of the subscription fee projected to be charged to enlisted members.
(b)Dr Ash concluded, that the 2,000 projected subscribers in 1997 “may have been a little optimistic given that it was a fairly new idea”. Subsequent projected numbers of subscribers were conservative in his view.
(c)Dr Ash further concluded, that the expected subscription fee was reasonable noting, however: “…. The B2B e-procurement market was in its infancy at the time these projections were made and therefore unable to be tested in the market at that time…”
(d)In cross-examination, Dr Ash expressed the further view: “Now my thinking was, all the way along, was that the number of subscribers would be the key to all of this. So if you did go towards having 2000 franchisees you’re likely to run into big trouble in trying to have those projected figures for each franchisee. My view would be that you would be better selling off franchises as the market evolved. So you’re not going for the maximum, which they put a limit on in their prospectus, but you are going for something like 100 subscribers and test the waters that way. In other words, you are evolving the number of franchisees as you went. That seemed to me to be a plausible way of selling the product, in a marketplace that was untested.”
74. Accordingly, it is submitted by the respondent that Dr Ash did not, in effect, support the reasonableness of the assumptions contained in the revised BODD. It is clear that his view was based upon the further assumption that the Project would be conducted in a manner that was commercially appropriate to the new technology that Satcom was seeking to introduce. It is noted that Dr Ash was not presented with any evidence of the manner in which Satcom proposed or did introduce its Franchises to the market. The Tribunal agrees with the respondent’s contentions and finds that the evidence of Dr Ash is, for the reasons indicated, of little if any assistance to the applicants.
75. Mr Donaghey’s evidence was directed to: -
·the background to the Project;
·the projections and the franchise structure;
·his involvement with Satcom;
·the development of Satcom’s electronic commerce product up to July,1998 when it was officially launched;
·the product attributes and involvement of Satcom in various initiatives in 1999 and 2000;
·development of the product;
·marketing undertaken by Satcom;
·reasons why the Project was not successful.
76. The respondent’s witness Mr Clarke undertook an extensive review of the material produced by Mr Donaghey. On the basis of his analysis, Mr Clarke concluded that, although a version of the software existed in May, 1997, it was never in a version that was capable of being commercially applied, “in the sense of delivering services that someone was prepared to pay for”, (Clarke Report Exhibit R1, Summary, especially at pages 4-5). To the extent that the product was made available to the market, it was made available without charge or for a limited subscription fee (Clarke Report Exhibit R1, section 10).
77. It was submitted by the respondent that Mr Clarke’s carefully detailed analysis of the evidence ought to be accepted in preference to that of Mr Donaghey where they are in conflict. Mr Donaghey’s evidence was restricted to assertion which it was contended was not, as Mr Clarke’s review demonstrates, supported by the evidence. As the applicants bear the burden of proof, the onus was on them to produce any further evidence by which Mr Donaghey’s assertions might be supported. No such evidence was tendered.
78. With respect to Mr Clarke’s evidence, the respondent further submitted that: -
·he provided extensive evidence of his obvious and relevant expertise;
·he precisely identified his instructions and the material relied upon in forming his opinions;
·he examined the evidence produced by Mr Donaghey by reference to a series of precise questions, giving an answer to each. In giving each answer, Mr Clarke precisely identified the material relied upon in arriving at it.
Mr Donaghey made no attempt to provide any detailed response to Mr Clarke’s analysis or point to contrary evidence.
The Tribunal accepts the respondent’s submissions and finds that, for the reasons stated by the respondent as set out above, Mr Clarke’s evidence should be preferred to that of Mr Donaghey.
79. Mr Simpson, a financial planner, gave his opinion of the commercial merits of an investment in the Project based on the content of the revised BODD. He calculated internal rate of return on a before tax before finance basis as shown by the projected returns to franchisees over the life of the franchise. He considered the Project to be attractive to an investor based upon statements made in the BODD as outlined at. He compared his calculated rate of return with the rate of return available from other investments, and included some material about geared funds and the risks inherent in the Project.
80. In cross-examination, Mr Simpson stated that: -
·he had not listed the Project’s tax effectiveness amongst the features which would make it attractive to an investor;
·by reason of the Project’s tax effectiveness, the only risk to the prospective investor was that tax deductions would not be allowed;
·before recommending that a client invest $30,000 in the Project, he would have made further inquiries about the electronic commerce product the subject of the Project and the services to be provided in return for the investment.
81 In the Tribunal’s view it is clear that, as submitted by the respondent, Mr Simpson’s evidence was, in effect, that the commercial merits of the Project could not be judged by the BODD alone.
82. The respondent further referred to the Further Witness Statement of Mr Meredith dated 31 July, 2006 and his Note dated 15 February, 2007 (exhibits R7 and R8). Both comment upon the views expressed by Mr Simpson, concluding, at [43]-[44] of the Further Witness Statement:
“In my opinion, based on the financial information detailed … a potential investor would not be in a position to properly evaluate the future returns from an investment in the franchise from a profitability and risk perspective.
Accordingly from an investment decision perspective, as risk and return are inexorably linked, without being able to reasonably assess both of these factors from the information … I am unable to form a view on the reasonableness of the returns projected…”
83. As noted above, following cross-examination, Mr Simpson was substantially in agreement with Mr Meredith’s statement quoted above.
84. Mr Speak’s evidence was directed to the reasonableness of the franchise fee charged to franchisees. His evidence was based on the revised BODD. In his Witness Statement dated 22 January, 2007 (exhibit A7), he referred to the Franchise Agreement and Mr Donaghey’s affidavit without identifying any part of those documents upon which he relied for the views expressed by him.
85. Mr Speak’s affidavit and witness statement expressed support for the reasonableness of the franchise fee. However, in examination in chief before the Tribunal, he stated that he understood the BODD to be an introductory document designed to solicit interest. His belief was that those expressing interest would then conduct their own due diligence, as to the existence of the software and the like.
86. Mr Speak did not, in effect, support the reasonableness of the franchise fee but did so subject to further due diligence.
87. It should also be noted that Mr Clark’s Statement dated 26 July, 2006 and notes dated 6 February, 2007 contain specific comments on Mr Speak’s evidence (exhibits R3 and R5).
88. The respondent’s expert witness Mr Hantke has extensive experience of franchising and business management. His evidence provided a comparison between the usual features to be found in a franchise and the features of the Satcom Electronic Commerce franchises. In his view:
·“this was a franchise system without substance”;
·the year 1 annual franchise fee, on the basis of the proposed franchisee income of $100 in year 1, was not reasonable;
·the year 1 Annual Franchise Fee was the equivalent of an “up front” Franchise Fee;
·“the franchise had financial merit to the applicants largely as a result of the tax deductibility of the year one annual franchise fees and expenses”.
89. The Tribunal agrees with the submissions of the respondent as set out above as to the effect of the evidence given by the witnesses referred to.
Applicant’s contentions regarding s51(1) of the ITAA 1936 and s8-1 of the ITAA 1997
90. The applicants contended that their purpose in obtaining a franchise was for the purpose of carrying on a business of marketing the on-line electronic commerce services system, which incorporates a range of electronic commerce applications, to allocated prospects with a view to enlisting them as subscribers to derive assessable income therefrom. The applicants said that they appointed the ASA, to undertake their business to derive assessable income therefrom.
91. It was argued that pursuant to the Franchise Agreement, the applicants had clearly incurred the obligation to make the payment of the relevant fees for the purposes of carrying on their franchise, and that the evidence supports the view that the applicants had at 30 June 1998, commenced to carry on a business via the ASA.
92. It was contended that the Franchise Agreement and the agreement between the Franchisor and the ASA obliged the ASA to perform all the duties of the franchisee under the Franchise Agreement on behalf of the franchisees. If the franchisees were not satisfied with the ASA’s performance, by clause 10.1 of the Franchise Agreement, the franchisees were empowered to remove the ASA and conduct the Business on their own behalf. It was submitted that that there is nothing in the Franchise Agreement which precludes the franchisee from appointing another party as their ASA.
93. The applicants relied on the following cases to support their argument that expenditure incurred on marketing and management fees and annual franchise fees is revenue in nature rather than capital where the taxpayer is carrying on a business and has employed a “manager” or has incurred the relevant fees in the course of deriving assessable income (see Sleight v Commissioner of Taxation (2004) 136 FCR 211, Commissioner of Taxation v Cooke (2004) 55 ATR 183, Commissioner of Taxation v Lau (1984) 6 FCR 202 at 221 per Beaumont J, Commissioner of Taxation v Emmakell Pty Ltd (1990) 22 FCR 157, Puzey v Commissioner of Taxation (2002) 50 ATR 595; (2003) 53 ATR 614, Commissioner of Taxation Brand (1995) 31 ATR 326, Commissioner of Taxation v Walker (1984) ATC 4553, Australian Trade Commission v Disktravel [1990] FCA 1399, Madison Pacific Property Management and Ors v Australian Securities Commissioner 30 ACSR 218, Merchant v Commissioner of Taxation 99 ATC 4221).
94. It was contended that the above authorities concerned similarly structured managed investment schemes where the taxpayer was not actively involved in the business.
95. The applicants claimed that the fees paid by them were incurred in the gaining or production of assessable income, or necessarily incurred in carrying on a business for the purpose of gaining income. The income in this case was to be derived from marketing the electronic commerce system and enlisting subscribers to use the system.
96. In characterising the applicants’ payment of the relevant fees it is necessary to identify what the expenditure was for (Magna Alloys & Research Pty Ltd v Federal Commissioner of Taxation (1980) 33 ALR 213. According to the applicants upon a consideration of the evidence, it is clear that “the expenditure was incurred to undertake a franchise business of marketing and encouraging corporate and government organisations to use the System.”
97. The applicants said that the respondent’s contentions that the applicants were not “actively” involved and therefore not themselves carrying on a business are misguided. According to the applicants that is the point of appointing a “manager”. It was submitted for the applicants that in Lau, Brand, Sleight, Madison Pacific, Disktravel, Emmakell, Walker, Puzey and Cooke, the taxpayers were passive and did not actively make decisions or hold the business records. The applicants contended that the critical point is that the applicants had the power to dismiss the “manager”. The power existed for the franchisee to dismiss the ASA (cl 12.1.3).
98. The applicants contended that the facts in the case of Madison Pacific are similar to the facts in this case. Similar to this case so it was said Madison Pacific involved a managed investment scheme which offered to investors the opportunity to obtain franchise rights in a residential tenancy property management business relating to a randomly selected territory. Like in this case, the offer to investors for a franchise territory came with it an invitation to have the territory managed by a manager related to the franchisor and the opportunity to finance their investment in the franchise through a limited recourse loan from a lender related to the franchisor and the manager. The Full Federal Court, whilst considering whether the offer to the investors constituted a prescribed interest for the purposes of the Corporations Law and whether it was exempt from issuing a prospectus, concluded that the structure of a manager being appointed to manage the franchise and the services to be provided by the manager in that case (which it was argued are similar to those provided by the ASA here) fell within the scope of the definition of franchise in the Corporation Regulations and were therefore exempt from issuing a prospectus. In effect according to the applicants, the Full Federal Court found the managed investment scheme in that case to be an effective franchise structure.
99. Justice French rejected the Commissioner’s [ASIC] contention in that case that the franchisees were not carrying on a business (either themselves or through a manager/agent) to satisfy the definition of franchise. He concluded (at [70]):
“The ultimate responsibility for carrying on the business, albeit the business may in effect be created by the manager, is that of the franchisee. The ultimate legal liability, save to the extent that it can be avoided by the manager contracting in its own right, remains with the franchisee. The franchisee has a power to give directions to the manager concerning the general conduct of the business. The manager plainly has legally enforceable obligations to the franchisee and the agreement may be terminated for breach or not renewed upon the expiry of its term.”
100. Justice Carr, in support of French J’s conclusions, opined (at [122]) that:
“I do not think that there is any doubt that offering to provide and providing the services of property management to lessors of residential properties in return for fees would constitute a business. It may be accepted that the arrangement in this matter is different from the traditional franchise arrangements which surfaced in the three cases which gave rise to the promulgation of the franchise exemption. However, over a decade has passed since those decisions. Business methods, and particularly franchising methods have evolved considerably over that period of time. In my view, there was a relevant business which the franchisee was given the option of conducting either in person or by an agent. The fact that the circumstances may have made it highly unlikely that any agent other than Madison Pacific Management would be appointed by a franchisee, does not, in my opinion, alter the characterisation of the rights conferred upon the franchisee”. [emphasis added].
101. The applicants argued that having regard to the Madison Pacific decision it would be inconsistent to find in this case that the franchisees were not carrying on a business. The Tribunal notes in this regard that, whilst taking the view that each of the franchised businesses may have been a small one, his Honour Justice Carr at [125] remained of the opinion that the point [was] … that at any particular time there can be identified a business activity carried on on behalf of a particular franchisee which can be characterised as its [the franchisee’s] business.
102. The applicants claimed that the Disktravel case offers further support to a finding that the Franchisees were carrying on a business. At first instance the Administrative Appeals Tribunal held that the licensees in that case were entitled to an Export Market Development Grant for its overseas expenditure on the basis that it had incurred eligible expenditure in the carrying out of its operations and that the range of expenses incurred was “qualifying export development expenditure” within the meaning of the Export Market Development Grants Act 1974. The Tribunal was of the opinion that the licensees in that case were carrying on a business during the claim year through a manager, and the objective purpose of the licensees in that case in incurring the expenditure was for the purpose of export marketing in an attempt to gain sub-licenses. The applicants point out that these findings were not disturbed on the appeal to the Federal Court or the Full Federal Court notwithstanding that the Full Federal Court found that the agreement did not provided the licensees with any disposal of the industrial property rights (the basis upon which the licensees were to derive revenue from their business).
103. According to the applicants to the extent that the applicants’ subjective purpose is relevant to the characterisation of these outgoings (Fletcher v Federal Commissioner of Taxation (1991) 173 CLR 1), it does not differ from this purpose. They said that this is not a case where it can be said objectively that at the time of the investment there was no prospect of obtaining a sum of assessable income greater than the outgoings (see forecast projections in the business opportunity disclosure document). Nor is this a case where it can be said that at the time of the outlay it was not expected that the Project would run its course. They claimed that the evidence demonstrates that it was reasonable for the applicants to expect that they would earn assessable income for the duration of the Project.
104. The applicants submitted that the required nexus between the outlays and the gaining of income is confirmed by the business opportunity disclosure document, the Project Agreements and by the evidence of Pat Donaghey, Dr Colin Ash and Nigel Simpson which according to them showed that these were clearly a reasonable basis to expect to derive income from their participation in the Project. In fact the franchisees did derive assessable income.
105. It was contended that the evidence of Pat Donaghey and the expert Graeme Speak, shows that that software was in existence at 30 June 1997. The expert called by the respondent, Roger Clarke, gave evidence that a version of the software which is identified with an integer greater than 1, for example 1.0 or 2.0, signifies that the software has been released, as opposed to software which is identified with an integer greater less than 1, such as 0.2. Roger Clarke in his review of the software of the Project said that the software existent in the Project was identified as version 1.0 which it was claimed was an admission that the software of the Project was in existence prior to the project being marketed. Further, in the absence of Mr Clarke testing the software for its capabilities his evidence that no “significant” software existed was said to be of no weight. The Tribunal has already indicated above that it accepts the evidence of Mr Clarke and the applicants’ contentions are accordingly rejected.
106. The applicants claimed that this is not a situation where the character of the advantage sought was long lasting or enduring or that the character of the advantage was one in the nature of a passive investment. The franchisee had the power to make referrals of the System and undertake the encouragement and introduction of the System to corporate and government organisations. (cf. with Puzey in the second year, cf also with Clowes v Commissioner of Taxation (1954) 91 CLR 209 and Milne v Commissioner of Taxation (1976) 133 CLR 526).
107. It was argued that unlike in Clowes and Milne the franchisees here appointed a “manager” to undertake their franchise to derive assessable income there from over a 10 year period, as opposed to the applicants participating by investing a sum of money on the expectation of a capital increment at the conclusion of the Project. Furthermore, the applicants had the right to terminate the services of the ASA, unlike in Clowes and Milne.
108. The applicants pointed out that in Puzey on appeal, Hill and Carr J at [58] concluded that “there is no doubt that a contractual payment to a manager to manage such a scheme [managed investment scheme] would be deductible” notwithstanding that the taxpayer in Puzey was found not to be carrying on a business due to the restructuring of the scheme imposed by the Australian Securities and Investment Commission and the establishment of a trust too operate the business. Unlike in Puzey the participants here including the applicants were not unit holders in a unit trust entitled to a share of the profits (if any) of the trust. The trust in that case being the entity which was carrying on the activities of the project, engaging the manager and undertaking the sale of the harvested produce. It was submitted that the structure of this Project involves the applicants carrying on their own business, engaging a “manager” to undertake the introduction and encouragement of the System to corporate and government organisations with de jure control over the “manager”.
109. The applicants argued further that the facts in the case of Vincent v Federal Commissioner of Taxation [2002] FCAFC 291 are dissimilar to the facts of this case and that here neither in form nor in substance did the applicants acquire a capital asset in connection with the payment of the relevant fees. It was claimed that in both form and substance the applicants sought and obtained the relevant services (see Franchise Agreement and business opportunity disclosure document), in relation to the introduction and encouragement of the System to corporate and government organisations for a period of 13 months. Like the management fee in Lau, Brand, Merchant, Puzey, Sleight, Cooke and Emmakell the fees in this case so it was said are revenue in nature for a service period of 12 months. It was submitted that no enduring benefit would have been obtained by the applicants in relation to the payment of the relevant fees.
110. It was also argued that the amount of interest paid by the applicants to Satcom Electronic Commerce Services Pty Ltd is deductible under s 51(1) of the 1936 Act as it was necessarily incurred in the course of earning income, or necessarily incurred in carrying on a business (Steele v Deputy Commissioner of Taxation (1990) 197 CLR 459, Sleight, Cooke).
111. The applicants and the respondent made extensive submissions regarding the application of Part IVA of the 1936 Act. As the Tribunal has however concluded, for the reasons set out below, that the claimed deductions are not allowable under s 51(1) of the 1936 Act or s8-1 of the 1997 Act there is no need for it to further consider the application of Part IVA.
(b)Mr Leggett says: “I chose the option of having the Project appoint a sales agent”, [35];
(c)Mr Renting exhibits a blank “Options List Accredited Sales Agents” and says “It was always the case that I would hand over the management of my businesses to an Accredited Sales Agent provided by the Project”. As he does not depose to completing the Options List, it may be inferred that he did not formally do.
149. None of the applicants deposes to entering into any terms upon which the Accredited Sales Agent was engaged. Mr Donaghey deposes:
“Whilst it was always the intention to have the obligations of the Accredited Sales Agent documented in an Accredited Sales Agent Agreement, a written agreement was never completed and entered into by any of the Accredited Sales Agents” [35].
150. The evidence shows that none of the applicants sought to conduct their businesses before receipt in October 1998 of the above documents. In the case of Mr Leggett and Mr Renting, that was some 16 months after they had entered into the franchise arrangements. Although by the definition of “Allocated Prospects” in clause 1.1, of the Franchise Agreement, the franchisor was to provide the list “within 3 months of execution of this Agreement”, the franchisee was, nevertheless, obliged to commence the Franchised Operation from the Commencement Date, defined as the last day of the month that the application for the Franchise is received by the Franchisor.” (Franchise Agreement, clause 1.1, clause 7(d)).
151. The applicants received from the franchisor franchise financial statements and newsletters and reports concerning the franchisor’s activities generally. Only Mr Leggett received any income from his franchise (Leggett affidavit, WHL, page 134). Contrary to the terms of clause 15.1(c) of the Franchise Agreement he was given no details of how the income was calculated and he sought none.
152. The applicants received nothing by way of reports or otherwise from their Accredited Sales Agents. Neither did they intervene in the conduct of their purported businesses in order to ascertain what, if any, contact the Accredited Sales Agents had made with their Allocated Prospects.
153. Generally, in the Tribunal’s opinion the purported businesses and the way in which they were purportedly conducted lacked a businesslike structure.
154. This is most clearly seen with respect to the Allocated Prospects.
155. These comprised 250 telephone subscribers within the Commonwealth of Australia which are corporate, government and/or other organizations” (Franchise Agreement, clause 1.1, definition). Correspondence which accompanied the allocation advised: “Each franchise list is generated by a computer program which uses a formula to ensure all lists contain the same balance of potential subscribers” (Renting affidavit, RJR18, page 217).
156. The random, broadly based list provided was not in the Tribunal’s view consistent with the franchisor’s proposed business. Each BODD, on page 5, advised: “SECS has earmarked specific industry sectors and developed services to meet their needs”. The franchisee could not be certain of there being a suitable product to market to all or any of his Allocated Prospects.
157. Further, as both Mr Hantke and Mr Clarke point out, the geographic spread of the Allocated Prospects worked against the success of the business (Hantke Report, [4.09]; Clarke witness statement, 26 July, 2006, [6.5](4)) as did the allocation of prospects in a diversity of industry sectors with a diversity of business functions (Clarke witness statement, 26 July, 2006, [6.3]- [6.5]).
158. Additionally, the franchisee’s business was restricted to the subscription income available from 50 subscribers (Franchise Agreement, clause 2.1).
159. The BODDs and the Franchise Agreement contained, at best, broad descriptions of the nature of the product to be marketed and the services to be provided by the franchisor. Nevertheless, it appears from the evidence that the applicants incurred, without question, an Initial Annual Franchise Fee of $30,000: -
(a)without ascertaining the existence of product they were to market let alone details of the access they might have to the software for the purposes of marketing the product;
(b)without ascertaining the suitability of the product for the business purpose it was to fulfil;
(c)without any real understanding of the business purpose of the product;
(d)when the franchisor’s obligations with respect to maintaining and upgrading the product, or ensuring its security and integrity were nothing more than to “use reasonable efforts to continue to develop the System in such manner as may be determined by the Franchisor from time to time to be, in the Franchisor’s opinion, of benefit to the Franchised Operation (Franchise Agreement, clause 15.1(b)); cf. Mr Speak who emphasizes such matters as essential to the prudent marketer (Speak affidavit, 10 June, 2005, [10]-[11]);
(e)without ascertaining the amounts the franchisor proposed to charge subscribers;
(f)without making any inquiry as to the Franchise Procedures according to which the purported business was to be conducted (Franchise Agreement, clause 2.1);
(g)without making any inquiry as to the franchisor’s training requirements (Franchise Agreement, clause 8);
(h)without making any inquiry about the capacity of any Accredited Sales Agent to conduct the purported business or on what terms it would conduct the purported business;
(i)although the Accredited Sales Agent who was to perform the same marketing function as the franchisee would do so without the payment of any such fees.
160. It is clear from the evidence that had they made inquiries, the applicants Leggett and Renting would have discovered that the product upon which their marketing business depended did not exist. The letter, dated 22 October, 1997, which accompanied the first financial statements, for the year ended 30 June, 1997 advised: “The first Electronic Commerce Service should be ready for release to the market later this year or early in 1998” (Leggett affidavit, WHL11, page 129).
161. Mr Donaghey asserts that the product was “developed and was in a form capable of being launched and marketed to the relevant industries and corporate and government organizations in May 1997”, [42]. On the basis of his careful analysis of Mr Donaghey’s supporting material, the independent witness Mr Clarke (whose evidence as indicated above is accepted by the Tribunal in preference to that of Mr Donaghey) disagrees. He concludes that, although a version of the software existed in May, 1997, it was never in a version that was capable of being commercially applied, “in the sense of delivering services that someone was prepared to pay for”, (Clarke Report, see Summary, especially at pages 4-5). To the extent that the product was made available to the market, it was made available without charge or for a limited subscription fee.
162. Mr Donaghey asserts [79] that further evidence exists ”which substantiates the statements made herein” and complains that Mr Clarke would not be able to ascertain the software capabilities on the limited evidence available to him. However no such evidence was produced. Under the Taxation Administration Act 1953, section 14ZZK the applicants bear the burden of proof in this matter. Accordingly, they bear the onus of putting before the Tribunal all evidence necessary to prove their case.
The applicants are not assisted by cases, decided in quite different circumstances, which have held the appointment of a manager consistent with a finding of business
163. The Tribunal agrees with the respondent that comparison with cases which suggest that the appointment of a manager is not inconsistent with the conduct of business are of no assistance to the applicants.
164. As already noted, the applicants did not appoint a manager. They appointed an Accredited Sales Agent who they were bound to direct and control (Franchise Agreement, clauses 10.2, 9). There is therefore no comparison to be made on any level.
165. Further, if the applicants were not in a business at all, there is no requirement to consider the role of the Accredited Sales Agent. Accordingly, the question of whether the applicants were in a business at all must first be answered.
166. The Tribunal is of the view that the nature of these purported businesses precludes the applicants’ reliance on Puzey v Commissioner of Taxation (2003) 131 FCR 244 at [46]-[49] and Commissioner of Taxation v Sleight (2004) 136 FCR 211 which, in turn, relied upon principles expressed in Commissioner of Taxation v Lau (1984) 6 FCR 202 and Commissioner of Taxation v Emmakell (1988) 22 FCR 157. Conceptually, the businesses found in Puzey and Sleight are quite different from any business which might be found here. As Hill and Carr, JJ. pointed out in Puzey v Commissioner of Taxation (2003) 131 FCR 244 at [50]: “It is not possible to argue from the decision in a particular case that a person is carrying on business unless there is a complete identity of facts and that is seldom the case.” And see Commissioner of Taxation v Sleight (2004) 136 FCR 211 at [51], per Hill, J. (with whom Hely, J. agreed).
167. In those cases, the Court, relying on the reasoning in Commissioner of Taxation v Lau (1984) 6 FCR 202, found a business of the investor, growing and harvesting tree products. That business was a distinct business of the investor because the investor was granted a specific area of land and so an identifiable interest in specific trees. See Commissioner of Taxation v Sleight (2004) 136 FCR 211 per Hill, J. (with whom Hely, J. agreed) at [51]-[61] and per Carr, J. at [164]-[188]; Puzey v Commissioner of Taxation 2003 ATC 4782, per Hill and Carr, JJ. (2003) 131 FCR 244 at [51]-[54]; and see Lee, J. at first instance Puzey v Commissioner of Taxation (2002) 194 ALR 615 at [51]-[54].
168. The forestry investor in those cases could conveniently appoint and rely on the services of a common manager, co-ordinated with the provision of services to other investors: Commissioner of Taxation v Sleight (2004) 136 FCR 211 per Carr, J. at [184] and, at first instance, Sleight v Commissioner of Taxation 2003 ATC 4801, per Nicholson J. at [29]. That is because the forestry business is to produce product from growing, maintaining and harvesting a particular number of trees that is, the number of trees which can be grown on the investors’ identifiable plot. The needs of the individual investor’s business, and so the manager’s activities, are limited by those activities required for the production of the product by those trees. Moreover, the needs of the individual investor’s business are the same as the needs of other investors. They are the needs of the trees. Accordingly, the manager carries out the business of each individual investor when managing the plantation as a whole. For example, when harvesting the whole plantation, the manager, necessarily and identifiably, also harvests the individual investor’s trees.
169. Conceptually, one might find a business of the Satcom franchisee i.e. the marketing of Satcom’s electronic product. That business in theory is distinct from other businesses marketing the product because the individual franchisee was granted the right to market to a designated list of Allocated Prospects.
170. However, because it is only the Allocated Prospects which delineate the individual business of the Satcom franchisee from other businesses marketing the same product, the nature and requirements of the Satcom franchisee’s business are not satisfied by activities co-ordinated in common with other marketing activities. In the absence of evidence of activities directed to the franchisee’s own list of Allocated Prospects of which there is none, the existence of the franchisee’s business is not proved.
171. Unlike the forestry investor’s business, the nature and requirements of the Satcom franchisee’s business are not satisfied by the co-ordinated activities of a common manager. The forestry investor’s business is to produce product. The Satcom franchisee’s business is to introduce and encourage the use of Satcom’s product. The success of the Satcom franchisee’s purported business depends on the extent of the efforts made to convert an identifiable group of businesses into customers for Satcom’s product. Unlike the forestry investor’s trees, each list of Allocated Prospects comprised a wide variety of businesses with a similarly wide range of different requirements.
172. Neither in the Tribunal’s view does the decision in Madison Pacific Property Management & Ors v Australian Securities Commission (1999) 30 ACSR 218 assist the applicants’ contention that they were carrying on a business in their own right. That decision dealt with distinctly different legislation, namely, Chapter 7 of the Corporations Law dealing with “prescribed interests” and the exemption from the requirements of that Chapter for franchises. More particularly, it dealt with whether the components of the definition of “franchise” were met. The aspect of the definition of concern was whether the proposal for management by an approved manager was inconsistent with the franchisor/franchisee relationship contemplated in the definition. That is, whether the franchisee would be substantially dependent on services supplied by the franchisor. The Court held that the analysis of the legal rights and duties of the manager and the franchisee created by the management proposal were not inconsistent with the scheme of the documents which otherwise satisfied the definition of “franchise”. See French J at 231-233 and Carr J at 250-251.
173. Here, the answer to the question, whether or not each applicant was carrying on a business, depends on the evidence and an exhaustive survey of the facts and circumstances relating to each applicant. It cannot be arrived at by comparing the approach to and the decision on structures under consideration in other cases, particularly where the authority relates to points of narrow compass in the application of distinctly different legislation. To approach the question in this way is to misconceive the task of determining whether each of the applicants carried on a business as a franchisee. For the same reason, the Tribunal is of the view that the applicants cannot place reliance on the decision in the Disktravel litigation: Australian Trade Commission v Disktravel [1999] FCA 48 and Travel Vision International Pty Ltd and Ors v Australian Trade Commission [1998] AATA 11.
Fletcher’s case – first limb of section 51(1)
174. As noted earlier in these reasons the Tribunal only needs to consider whether the claimed deductions were incurred for the purpose of gaining or producing assessable income if it finds that : -
(a) the applicants were not in a business;
(b) the claimed deductions were not outgoings of capital.
175. The Tribunal finds, as set out above that the outgoings were of a capital nature and that the applicants were not in a business. However, the Tribunal will nevertheless proceed to consider whether the claimed deductions were incurred for the purpose of gaining or producing assessable income, in case the Tribunal’s view on the question of capital is wrong.
176. The authorities show that the determination of whether outgoings are, generally, deductible for the purposes of s 51(1) is a matter of characterization by reference to the advantage the outgoings seek to achieve. The outgoing must be incidental and relevant to gaining or producing assessable income. Put another way, the production of assessable income is the occasion of the outgoing: Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) CLR 295 at 309 and Ronpibon Tin NL v FCT (1949) 78 CLR 47.
177. As stated in the Fletcher case the relationship between the outgoing and the assessable income must be such as to impart to the outgoing a character of an outgoing of the relevant kind. Where there is a disproportion between the outgoings incurred and the amount of assessable income, the question of the character of the outgoings must be answered by:
“a common sense appreciation of the overall factual context in which the outgoings were incurred. It necessarily involves a consideration of the contents and implications of the overall contractual arrangements … pursuant to which the outgoings … became payable. … it also encompasses a consideration of the purpose which the members of the partnership … had in incurring the outgoings.”
Fletcher v FCT (1991) 173 CLR 1 at 20-21.
178. For amounts to be deductible, this ”commonsense” or “practical” weighing of all the factors ought to indicate that the relationship between the whole of the expenditure and the production of assessable income is "genuine and not colourable". The occasion of the loss or outgoing is not the earning of assessable income where the circumstances point to another purpose. See Fletcher at 17.1-18.2, 18.7-19.4 and Ure v FCT (1981) 34 ALR 237 per Brennan, J at 241, lines 20-31 and per Deane and Sheppard, JJ at 248-249, line 25 and 249, line 35 -250.
179. As indicated earlier, the Tribunal is of the view that, as contended by the respondent, the occasion of the applicants’ outgoings was not the production of assessable income but the income tax deductions which facilitated their participation, as follows:
(a)in Renting’s case, his tax savings after making the cash payments required of him, resulted in significant net cash surpluses: -
(i)in the 1997 year, of $1,792;
(ii)in the 1998 year, of $1,725.
Further, Mr Renting consciously spread his tax deductions across two years. On or about 24 June, 1997, he took up two franchises, by forms dated 24 June, and then 1 July, 1997, authorizing release of his $1,000 deposit for the second franchise on 1 July;
(b)in Leggett’s case, the resulting tax savings for the 1997 year substantially covered the cash payments required of him. He had a net cash deficit of $496.82;
(c)in de Blank’s case, the resulting tax savings for the 1998 year covered the total cash payments required of him and left him with a net cash surplus of $304.74.
See detailed calculations in the Respondent’s Statement of Facts and Evidence at [4].
180. The tax savings met, or substantially met the applicants’ required cash contributions. In Renting’s case, he obtained a significant cash benefit. By reason of the limited recourse nature of the loans the applicants took and retained the benefit of the tax savings regardless of the outcome of their investment.
181. Further, the Funding Agreement, by which the limited recourse loan was provided, was with the franchisor as lender. It was the lender for its own fees. In the Tribunal’s view the evidence shows that there was no commercial basis for the Initial Franchise Fee of $30,000 which was on the evidence manifestly only ever a notional charge.
182. In the terms used in Fletcher’s case (set out above) having regard to the “contents and implications of the overall contractual arrangements”, which are exhaustively set out above, the Tribunal concludes that the applicants’ outgoings make no business sense especially when as shown by the evidence simple inquiry would have revealed that the product in which they proposed to invest was not yet commercially viable. In the circumstances, the outgoings are in the Tribunal’s view more satisfactorily explained by the more certain and immediate tax deductions they purportedly secured, facilitating the investment.
183. As noted above the applicants seek to support the wisdom of the investment by the evidence of Mr Simpson. However, the Tribunal finds that that evidence amounts to endorsement of an unsupported rate of return, that is, the rate shown by a page of income projections behind which there is no demonstrated reasoning. The investor’s money was, on its face, to be risked on the attractiveness of the business idea with very little more.
184. Mr Simpson supposes an investor seeking to diversify his or her portfolio by the investment. This does not avoid the implications of the tax advantages the investment offered, combined with the limited recourse loan. They meant that the investment was offered with no investment risk as demonstrated by the evidence. The only risk to the investors’ funds was that the tax deductions which funded, or substantially funded, their investments might not be allowed.
185. In the end, the Tribunal concludes that as Mr Hantke said, “the franchise had financial merit to the applicants largely as a result of the tax deductibility of the year one annual franchise fees and expenses together with the favourable loan arrangements. The projected and actual earnings were modest and with growth options restricted (i.e. set number of subscribers) the financial benefit of this system largely revolved around the tax deductibility of the year 1 annual franchise fee”.
186. Accordingly, the claimed deductions are in the Tribunal’s opinion not allowable under either limb of s 51(1) of the 1936 Act or s 8-1 of the 1997 Act and as indicated earlier there is no need for the Tribunal to consider the application of Part IVA of the 1936 Act.
DECISION
187.The decisions under review are affirmed.
I certify that the 187 preceding paragraphs are a true copy of the reasons for the decision herein of Mr A Sweidan, Senior Member.
Signed: ........................[Sgd C Skinner].........................
AssociateDates of Hearing 28 February and 1 March 2007
Date of Decision 3 September 2007
Counsel for the Applicant Mr G K Robson
Solicitor for the Applicant Wilson & AtkinsonCounsel for the Respondent Ms H Symons QC
Ms L PriceSolicitor for the Respondent Australian Government Solicitor
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