Leggett and Ors and Commissioner of Taxation
[2007] AATA 1624
•1 August 2007
Administrative Appeals Tribunal
DECISION AND REASONS FOR DECISION [2007] AATA 1624
ADMINISTRATIVE APPEALS TRIBUNAL )
) Nos WT200100429; TAXATION APPEALS DIVISION ) WT200100379 – 380;
WT200100254 – 256;
WT200100294
Re WAYNE HENRY LEGGETT;
GARY KEITH WATSON;
FREDERICK FAIGENBAUM; and
STEPHEN JARVISApplicants
And
COMMISSIONER OF TAXATION
Respondent
DECISION AND REASONS FOR DECISION
Tribunal Mr A Sweidan, Senior Member Date1 August 2007
PlacePerth
Decision The Tribunal:
1. Sets aside the decision under review in application number WT2001000294 by the applicant Stephen Jarvis;
2. Affirms the decisions under review in the remainder of the above applications, being those by the applicants Faigenbaum, Leggett and Watson except in relation to the imposition of penalties; and
3. Remits the matters to the respondent for the issue of amended assessments in accordance with the Tribunal’s decisions.
............(Sgd. A Sweidan)................
Senior Member
CATCHWORDS
Income Tax – allowable deductions – managed investments – “Satcom Financial Services” – whether amounts paid as “franchise fees” and related costs deductible – whether capital – whether business carried on by applicants
LEGISLATION
Income Tax Assessment Act 1936 s 51(1)
CASES
Amalgamated Zinc (de Bavay’s) Ltd v Federal Commissioner of Taxation (1935) CLR 295
Australian Trade Commission v Disktravel [1999] FCA 1399; [1999] FCA 48
Calder v Federal Commissioner of Taxation (2005) 59 ATR 655; (2005) 61 ATR 267
Clowes v Commissioner of Taxation (1954) 91 CLR 209
Commissioner of Taxation v Brand (1995) 31 ATR 326
Commissioner of Taxation v Cooke (2004) 55 ATR 183
Commissioner of Taxation v Emmakell Pty Ltd (1990) 22 FCR 157
Commissioner of Taxation v Hart (2004) 217 CLR 216
Commissioner of Taxation v Lau (1984) 6 FCR 202
Commissioner of Taxation v Sleight (2004) 136 FCR 211
Commissioner of Taxation v Spotless Services Ltd (1996) 186 CLR 404
Commissioner of Taxation v Walker (1984) 84 ATC 4553
Dan and Ors v Federal Commissioner of Taxation 2000 ATC 4350
DFCT v Richard Walker 95 ATC 4067
Drake v Minister for Immigration & Ethnic Affairs (1979) 24 ALR 577
Eastern Nitrogen Ltd v Federal Commissioner of Taxation (2001) 108 FCR 27
Enviro Systems Renewable Resources Pty Ltd v ASIC (2001) 80 SASR 1
Equuscorp Pty Ltd v Glengallan Investments Pty Ltd (2004) HCA 55
Fabry v Federal Commissioner of Taxation 2003 ATC 4885
Federal Commissioner of Taxation v Consolidated Press Holdings (2001) 207 CLR 235
Federal Commissioner of Taxation v Cooke (2004) 55 ATR 183
Federal Commissioner of Taxation v Jackson (1990) 21 ATR 1012
Federal Commissioner of Taxation v Peabody (1994) 181 CLR 359
Federal Commissioner of Taxation v Sleight [2004] FCAFC 94
Ferguson v Federal Commissioner of Taxation (1979) 26 ALR 307
Fletcher v Federal Commissioner of Taxation (1988) 19 FCR 442; (1991) 173 CLR 1
Fletcher & Ors v Federal Commissioner of Taxation (1988) 84 ALR 295
Hope v The Council of the City of Bathurst (1980) 144 CLR 1
Hopkins v Commissioner of Taxation of the Commonwealth of Australia [2007] FCA 23
Madison Pacific Property Management and Ors v Australian Securities Commissioner 30 ACSR 218; (1999) 30 ACSR 218
Magna Alloys & Research Pty Ltd v Federal Commissioner of Taxation (1980) 33 ALR 213
Milne v Commissioner of Taxation (1976) 133 CLR 526
Minister for Immigration and Ethnic Affairs v Pochi (1980) 31 ALR 666
Peabody v Federal Commissioner of Taxation 40 FCR 531
Puzey v Commissioner of Taxation (2002) 50 ATR 595; (2002) 194 ALR 615; (2003) 53 ATR 614 and (2003) 131 FCR 244
Ronpibon Tin NL v Federal Commissioner of Taxation (1949) 78 CLR 47
Sleight v Commissioner of Taxation (2003) ATC 4801; (2004) 136 FCR 211
Starr v Commissioner of Taxation of the Commonwealth of Australia [2007] FCA 23
Steele v Deputy Commissioner of Taxation (1999) 197 CLR 459
Stevenson v Federal Commissioner of Taxation 91 ATC 4476; (1991) 29 FCR 282
Travel Vision International Pty Ltd and Ors v Australian Trade Commission [1998] AATA 11
Ure v Commissioner of Taxation (1981) 34 ALR 237
Vincent v Commissioner of Taxation (2002) 51 ATR 8; (2002) 124 FCR 350 and (2002) ATC 4490
Vincent v Federal Commissioner of Taxation [2002] FCAFC 291
REASONS FOR DECISION
1 August 2007 Mr A Sweidan, Senior Member Background
1. The applicants claim to be entitled to income tax deductions for expenses they incurred as franchisees of Satcom Financial Services Pty Ltd (“Satcom”) as follows: -
(a)Stephen Jarvis: $30,000
claimed in the income year ended 30 June 1995 in respect of his acquisition of one franchise and comprising a franchise fee;
(b)Wayne Leggett: $31,000
claimed in the income year ended 30 June 1996 in respect of his acquisition of one franchise and comprising a $30,000 franchise fee and $1,000 for administration and legal expenses [identified as “outgoings” in the BODDs (see paragraph 3 below)] and pursuant to the short term portion of his Funding Agreement;
(c)Gary Watson:
$62,000 claimed in the income year ended 30 June 1996 in respect of the acquisition by him of 2 franchises comprising a $30,000 franchise fee for each franchise and $1,000 outgoings for each franchise;
$31,000 claimed in the income year ended 30 June 1997 in respect of his acquisition of one franchise comprising a $30,000 franchise fee and $1,000 outgoings;
(d)Fred Faigenbaum:
$30,000 claimed in the income year ended 30 June 1995 in respect of his acquisition of one franchise comprising a franchise fee;
$65,000 claimed in the income year ended 30 June 1996 in respect of his acquisition of 2 franchises comprising $64,000 franchise fees and $1,000 administration and legal expenses;
$65,832 claimed in the income year ended 30 June 1997 in respect of his acquisition of 2 franchises comprising $60,131 franchise fees, $4,000 administration and legal expenses, $1,617 interest on loan and $84 sub- franchise fee;
The claimed deductions were disallowed by the Commissioner, who then disallowed objections by the applicants. The applicants now seek a review by the Tribunal of the objection decisions.
Issues
2. The issues in these proceedings are:
(a)in the applications by Messrs Leggett and Watson and Dr Faigenbaum, whether the claimed deductions are allowable under s 51(1) of the Income Tax Assessment Act 1936;
(b)if the claimed deductions are allowable under s 51(1), whether the applicants obtained tax benefits in connection with a scheme to which Part IVA applies. In the case of Dr Jarvis his claimed deduction can only be considered for disallowance under Part IVA, as the Commissioner does not rely on s 51(1) due to his assessment having been issued out of time.
Evidence – Satcom Documents
3. Satcom issued a Business Opportunity Disclosure Document 1995 (1995 BODD) and a Business Opportunity Disclosure Document 1996 (1996 BODD). Satcom also issued a Business Opportunity Disclosure Document in the 1997 financial year which was identical in its terms to the 1996 BODD. The cover page of each BODD describes the investment as a “Tax Effective Investment”.
4. The front sheet of the 1995 BODD describes the content as a “Business Opportunity”, a “Financial Services Franchise” and a “Tax Effective Investment”. The summary contained in the BODD states:
“Satcom is now granting exclusive franchise rights to market financial services to accounting firms in certain geographic areas throughout Australia. The franchise has been structured so that the franchisee need have no active involvement in the business activity whatsoever. 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 fee is $30,000 followed by annual fees based on net profit. The franchisor is prepared to loan up to $20,000 of the first year’s fee at an interest rate of 8% p.a. secured by the franchise, repayable only out of net profit. ”
5. The 1996 BODD further states at the conclusion of that summary that:
“The franchisee is required to pay the other $10,000 of the first year’s franchise 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. The 1995 BODD described the franchise operation in the following terms:-
“Satcom Financial Services Pty Ltd (“the franchisor”) is granting up to a maximum of one thousand and forty (1040) franchises each for a period of ten years.
Under the terms of the franchise each franchisee will operate a business of marketing the Satcom electronic financial services to Accounting Firms.
Each franchise will be allocated a franchise area. Each Franchisee will operate a business of encouraging the use of Satcom Financial Services by Accounting Firms in the franchise area. Each Franchisee will be authorised to enlist a maximum of eight (8) Accounting Firms at any point in time as members of the franchise business activity.
THE FRANCHISE OFFER
The Franchisor will be responsible for the operational aspects of the service to Accountants including the provision of software, member support, technical support, licensing and agency requirements, commission distribution, billing, new services development and software development. The Franchisor will also provide initial and ongoing training and marketing literature to the Franchisee. In return the Franchisee will pay an annual fee to the Franchisor.
The Financial Services identified for development and introduction to Accounting Firms on the Satcom Network include the following: Asset Accumulation Products : Tax Effective Products : Superannuation : Retirement Products : Finance.”
7. The 1996 BODD contains the same description save for the inclusion of personal insurance as being a further financial service identified for development and introduction to accounting firms on the Satcom Network.
8. The 1995 BODD provides the following description of Satcom’s planned activities for the 1995 year:
“During 1995, Satcom will continue the process of establishing offices in some of Australia’s other mainland capital cities and the marketing strategy will be implemented. Initial services on offer will be those already tried and proven in Western Australia: A.S.C. Database Access: Registered Business Names: Land Titles. During 1995 Satcom will introduce its first financial services facility to its corporate services network members. The first financial services facility will be a comprehensive personal and corporate risk management facility (ie. personal insurance). This will be followed by additional financial services “Modules” introduced one at a time until a comprehensive range of financial services facilities is available to Satcom network members.”
9. The 1996 BODD provides a similar description for the 1996 year:
“During 1996, Satcom will market its new software and services operating under Windows 95. Initial services on offer will be those already tried and proven: A.S.C. Database Access: Registered Business Names: Land Titles. Also during 1996 Satcom will introduce a selection of financial services together with access to the internet. The financial services facilities will be introduced in ‘modules’ on a one at a time basis until a comprehensive range of financial services facilities is available to Satcom Network Members.”
10. 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.
11. Each BODD stated (at page 24): “Satcom Financial Services Pty Ltd is a subsidiary of Satcom Business Exchange Pty Ltd …..”
12. Each BODD (at page 29) contained information as to how franchises were to be allocated. Each detailed the availability of the 1,040 franchises by State or Territory franchise areas, beginning with New South Wales, as follows: -
“1. FRANCHISE AREA N.S.W. (NEW SOUTH WALES)
There are 2762 Accounting Firms in the N.S.W. Franchise area. Satcom is granting up to a maximum of 394 Franchises in this area. The first Franchise allocated will be numbered N.S.W.001. The last will be numbered N.S.W.394”….
and so on for Victoria, Queensland, South Australia, Australian Capital Territory, Tasmania, Northern Territory.
13. Page 16 of the BODD explained:
“The Franchisee will not be authorised to operate the Franchise Business until he has specifically completed the Satcom Financial Services Franchise Training Course and demonstrated the financial and other requirements …. required by Satcom. Until such time Satcom Business Exchange Pty Ltd (“The Sub-Franchisee”) will operate the Franchise Business…
…
Whilst Satcom Business Exchange Pty Ltd acts as sub-franchisee for more than one Franchisee in a franchise area each new member enlisted by it will be allocated to the franchise number with the least number of members. If two or more Franchises have the same lowest number of members then the new member will be allocated to the Franchise with the lowest franchise number”.
14. The applicants deposed to signing up for franchises and produced documents as follows.
Jarvis
15. Dr Jarvis deposed that he entered the “Project” by completing an application form contained in the BODD. He forwarded the completed application form to the “Project” and did not retain a copy. He took up one franchise in the “Project”.
The franchise application form in each BODD provides:-16.
“Satcom Financial Services
I, WE __________________________________________________
ADDRESS ________________________________________________
___________________________________ TEL _______________
HEREBY APPLY FOR ________________ SATCOM FINANCIAL SERVICES FRANCHISE/SPLEASE NUMBER ALL THE STATES 1-7 IN ORDER OF YOUR PREFERENCE: 1 HIGHEST 7 LOWEST;
NSW VIC QLD SA ACT TAS NT
HOWEVER SATCOM WILL ALLOCATE ACCORDING TO AVAILABILITY* FIND ATTACHED A CHEQUE FOR $ _________ BEING FIRST YEAR FRANCHISE FEE/FEES PLUS OUTGOINGS
OR
* I/WE WISH TO BORROW $ _________ OF THE FIRST YEAR FRANCHISE FEE/FEES AND THEREFORE ATTACH A CHEQUE FOR $ ________ BEING FRANCHISE FEE/FEES 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 and Sub-Franchise contract documents in standard form, prepared jointly by Phillips Fox and Irdi & Associates, 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. In support of the above, Dr Jarvis produced the following: -
(a) a Quicken Find account register report dated 28 June 2004 recording fees and charges of $11,000 on 1 July 1995;
(b)a letter dated 14 August 1995 from Satcom attaching for execution franchise documentation for franchise number QLD 004 applied for on 29 June 1995 and which commenced on 30 June 1995;
(c)Franchise Agreement with Satcom as trustee for the Satcom Financial Services Unit Trust (the franchisor) for a non-exclusive franchise to establish and operate a business of introducing and encouraging up to eight accountancy firms to utilise the franchisor’s specialised on-line electronic communications network system:
(d)Sub-franchise Agreement with Satcom as trustee for the Satcom Financial Services Unit Trust and Satcom Business Exchange Pty Ltd granting Satcom Business Exchange Pty Ltd (the sub-franchisee) a non-exclusive franchise to establish and operate the Franchised Operation as its own business:
(e)Funding Agreement with Satcom as trustee for the Satcom Financial Services Unit Trust for an advance of $20,000 which was to assist in making payment of the Initial Annual Franchise Fee.
Leggett
18. Mr Leggett deposed that prior to 30 June 1996 he completed the application form. He forwarded it to Satcom and did not retain a copy. He paid $12,000 cash. The remaining $20,000 was financed through a loan offered by the “Project” to acquire one franchise.
19. In support of the above, Mr Leggett produced the following:-
(a)A letter dated 30 June 1996 from the sub-franchisee acknowledging his application for a franchise and advising it had been approved and the documentation is in process;
(b)Franchise Agreement with the franchisor for a non-exclusive franchise [NSW 363] to establish and operate a business of introducing and encouraging up to eight accountancy firms to utilise the franchisor’s specialised on-line electronic communications network system:
(c)Sub-franchise Agreement with the franchisor and the sub-franchisee granting the sub-franchisee a non-exclusive franchise [NSW 363] to establish and operate the Franchised Operation as its own business:
(d)Funding Agreement with Satcom as trustee for the Satcom Financial Services Unit Trust for an advance of $31,000 to discharge the Initial Annual Franchise Fee for franchise number NSW363 and requiring payment of eight instalment amounts of $1,000 and a final instalment amount of $3,000 the last due and payable on 25 March 1997.
Watson
20. Mr Watson deposed that: -
(a)in March 1996 he paid $22,800 for two franchises in the “Project” and borrowed the balance of $40,000. On 30 April, 1996, he became franchisee of NSW169 and NSW170;
(b)in the 1997 year he purchased an additional franchise for a cash outlay of $11,000 which he agreed to pay by instalments and borrowed the balance of $20,000. On 30 April, 1997, he became franchisee of VIC323.
21. In support of the above, Mr Watson produced the following:-
(a)Credit Union statements payments totalling $33,800 during the period 6 June 1996 to 25 September 1997.
(b)Two letters dated 24 June 1996 from Satcom attaching for execution franchise documentation for 1996 franchise numbers NSW169 and NSW170 which commenced on 30 April 1996;
(c)Franchise Agreements with the franchisor for non-exclusive franchises [NSW 169, NSW 170 and VIC 323] to establish and operate a business of introducing and encouraging up to eight accountancy firms to utilise the franchisor’s specialised on-line electronic communications network system;
(d)Sub-franchise Agreements with the franchisor and the sub-franchisee granting the sub-franchisee non-exclusive franchises to establish and operate the Franchised Operations as its own business.
(e)Funding Agreements with Satcom as trustee for the Satcom Financial Services Unit Trust each for an advance of $20,000 to assist in discharging the Initial Annual Franchise Fee in respect of each of the franchises NSW 169, NSW 170 and VIC 323. With respect to the cash component of the initial franchise fee for 1997 franchise, Mr Watson elected to pay instalments under the relevant funding agreement, comprising 4 instalments of $1,000 and 1 of $7,000.
Faigenbaum
22. 1995 Franchise
In the 1995 financial year Dr Faigenbaum paid $11,000 in cash to acquire one franchise in the “Project”, being franchise number VIC 102, and borrowed the $20,000 balance of the Initial Annual Franchise Fee. He completed a franchise application form and forwarded it to Satcom.
23. 1996 Franchise
In the 1996 financial year Dr Faigenbaum paid $2,000 in cash as a deposit to acquire two franchises in the “Project”, being franchise numbers NSW 325 and NSW 288, and elected to borrow the Initial Annual Franchise Fee. He completed two franchise application forms and forwarded them to Satcom.
24. 1997 Franchise
In the 1997 financial year Dr Faigenbaum paid $2,000 in cash as a deposit to acquire two franchises in the “Project”, being franchise numbers VIC 299 and VIC 300, and elected to borrow the Initial Annual Franchise Fee. He completed two franchise application forms and forwarded them to Satcom.
25. In support of the above, Dr Faigenbaum produced the following: -
(a)a cheque in the sum of $11,000.00 for payment of the franchise fee in respect of franchise VIC102;
(b)The following letters received from Satcom;
(i)a letter dated 12 August 1996 attaching for execution franchise documentation for franchise number NSW288 which commenced on 30 June 1996;
(ii)a letter dated 22 April 1997 advising that his application for a franchise with Satcom has been approved and that documentation is in process;
(c)Funding Agreements with Satcom as trustee for the Satcom Financial Services Unit Trust each for an advance of $20,000 which was to assist in discharging the Initial Annual Franchise Fee for the franchise. With respect to the 1996 and 1997 franchises Dr Faigenbaum elected to pay the cash component of the initial franchise fee by instalments under the relevant funding agreement, comprising:-
(i)in respect of each of NSW 325 and NSW 288, 8 instalments of $1,000 and 1 instalment of $3,000;
(ii)in respect of each of VIC 299 and VIC 300, 9 instalments of $1,222.
(d)Franchise Agreements with Satcom as trustee for the Satcom Financial Services Unit Trust for a franchise to establish and operate a business of introducing and encouraging up to eight accountancy firms to utilise the franchisor’s specialised on-line electronic communications network system;
(e)Sub-franchise Agreements with the franchisor and the sub-franchisee granting the sub-franchisee a non-exclusive franchise to establish and operate the Franchised operation as its own business.
The Franchise Agreement
26. By clause 2, the Franchise Agreement provided:
“2. BACKGROUND
2.1 The Franchisor has developed a specialised on-line electronic communications network system which incorporates certain hardware, financial services software and other features designed specifically to assist and accommodate the accountancy profession.
2.2 The System as identified by the Trade Mark, has been developed by the Franchisor for use by it in providing for the use and enjoyment of certain proprietary rights in the Trade Mark, financial and other electronic configurations, certain designs, layouts and colour schemes, distinctive signs, particular types of equipment and formulated methods of operation covering business practices and policies.
2.3 The System can at present only be successfully operated by the Franchisor and requires the Franchisor to incur expenditure in respect of the provision of the Franchisor’s Services.
2.4 The Franchisee wishes to be granted by licence the right to introduce and encourage accountancy firms to use the System to its fullest potential for the Franchise Term commencing on the Commencement Date and which the Franchisor has agreed to do subject to the terms and conditions hereinafter contained.”
27. By clause 4.1, of the Franchise Agreement the franchisor granted to the “Franchisee as and from the Commencement Date [as stated in item 3 of the Schedule] a non-exclusive franchise to establish and operate the Business within the Territory … using the Franchise Procedures”.
28. Relevantly, terms were defined as follows: -
(a)“Business” “means the introduction of accountancy firms by the Franchisee to utilise the System (subject to the limitation that the Franchisee shall only be permitted to introduce and maintain up to eight (8) accountancy firms to the System at any one point in time during the Franchise Term) and the continued encouragement by the Franchisee of those accountancy firms to extensively use the System in consideration for which the Franchisee will be entitled to receive the net receipts generated by the Franchisor from the use of the System by the accountancy firms less the Franchisor’s reasonable proportion of its expenses in providing the Franchisor’s Services” (clause 3.1.2) ;
(b)“Territory” “means the territory outlined in item 8 if the Schedule”, i.e. [named State or Territory of Australia] (clause 3.1.19);
(c)“Franchise Procedures” “means all of the procedures laid down by the Franchisor from time to time in respect of the operation of the Business including but not limited to manuals, brochures and any other documents detailing the required or desired procedures applicable to the conduct of the Franchise” (clause 3.1.10);
(b)“System” means the system set out in clause 2.1 (above) including such changes and enhancements to the system as shall be implemented by the Franchisor from time to time” (clause 3.1.18);
(c)“Franchised Operation” means the Business which the Franchisee is licensed to carry on under the Franchise Agreement (clause 3.1.12).
29.The Franchise Agreement made provision for the sub-franchise as follows: -
(a)by clause 5.1.4 the franchisee represented to the franchisor and the franchisor acknowledged that “the Franchisee enters into this Agreement with the initial intention of sub-franchising the Franchised Operation to Satcom Business Exchange Pty Ltd (ACN 009 381 917) upon the terms and conditions contained in a sub-franchise agreement to be dated even date herewith and to which the Franchisor has agreed”;
(b)clause 20.1 provided:
“As and from the Commencement Date, and until the Franchisor in its absolute discretion is satisfied as to technical competence of the Franchisee to undertake and carry on the Franchised Operation, the Franchisee agrees that it will contemporaneously herewith enter into a contract of sub-franchise (“the Sub-Franchise Agreement”) for the Franchised Operation with Satcom Business Exchange Pty Ltd (ACN 009 381 917) upon the terms and conditions contained in the Sub-Franchise Agreement the form and content of which has already been approved of by the Franchisor and Franchisee prior to the execution of this Agreement.”
(c)clause 10.1 provided:-
“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 and training necessary so as to enable the Franchisee to acquire the technical competence necessary to conduct the Franchised Operation in the Franchisee’s own right and the Franchisee hereby agrees that it or its designated representative will make himself available to receive such advice and training and any further advice and training as the Franchisor may from time to time prescribe. The Franchisee hereby acknowledges that the Franchisor may charge its reasonable costs associated with the providing of such advice and training and the Franchisee hereby agrees to pay the same to the Franchisor within seven (7) days of receiving the Franchisor’s invoice to that effect”.
30.The franchisee’s payment obligations were as follows:
(a)payment by the franchisee of the Initial Annual Franchisee Fee of $30,000 for the Franchisor’s Services [clause 4.1.1, clause 3.1.14 (definition of Initial Franchise Fees) and item 5 of the Schedule];
(b)payment of the Ongoing Annual Franchise Fees for the Franchisor’s Services to be provided in years 2 to 10 of the Franchise Term, being an amount equal to 40% of the net receipts (not defined) generated from the Franchised Operation, subject to interest upon failure to pay [clause 4.1.2, clause 3.1.15 (definition of Ongoing Annual Franchises Fees) and, item 6 of the Schedule];
(c)by clause 15.1 the franchisor agreed to provide the “Franchisor’s Services” during the Franchise Term at commercial rates (not specified).
“Franchisor’s Services” “means the services performed on revenue account by the Franchisor so as to ensure that the System operates commercially within all of its franchised areas (including the Territory) and which services include (but are not limited to) those set out on page 11 of the Disclosure Document” [clause 3.1.13].
31.Pursuant to clause 9, the franchisee’s obligations included: -
(a)pay the annual franchise fees at the times and in the manner stipulated by the Franchise Agreement [clause 9.1];
(b)actively promote the Franchised Operation within the Territory and to use the Franchisees best endeavours in the conduct of the Franchised Operation to promote the mutual business interests of the franchisee and franchisor [clause 9.2];
(c)employ sufficient competent staff to effectively conduct the Franchised Operation and to devote sufficient time and attention to the Franchised Operation [clause 9.3];
(d)commence the Franchised Operation by the Commencement Date [clause 9.4];
(e)comply with the Franchisor’s procedures, manuals, plans and other documents [clause 9.13];
(f)abide by the provisions of the Franchising Code of Practice [clause 9.16];
(g)ensure payments made by end users of the System in respect of the Franchised Operation and arising during the conduct of thereof are made in favour of the Franchisor [clause 9.17]; and
(h)perform and observe the terms and conditions in respect of the Funding Agreement [clause 9.18].
32. In addition, by clause 14, the franchisee was obliged to “keep such books of account and records, and operate such finance and accounting system for the Franchised Operation as are required by law” and to make such books of account and records available whenever reasonably required by the franchisor for audit to confirm the franchisor’s rights in respect of any payments to be made under the agreement.
33. Pursuant to clause 15, the franchisor’s covenants included: -
(a)to provide its services in a proper and professional manner at commercial rates [clause 15.1];
(b)to continue to develop the System “by introducing asset accumulation products, tax effective products, superannuation products, retirement products, finance products and such other products as may be … of benefit to the Franchised Operation and to charge out such products to end users at commercial rates” [clause 15.2];
(c)to abide by the provisions of the Franchising Code of Practice [clause 15.3];
(d)by clause 15.4:
(i)“to provide to the Franchisee an accounting to the 30th June in each year … of the net receipts of all income received by the Franchisor from the utilisation of the System by the accountancy firms the subject of the Franchise and
(ii)further to provide to the Franchisee a statement of the Franchisor’s expenses incurred in providing the Franchisor’s Services and an explanation as to the basis upon which the relevant proportion of the same has been allocated to the Franchisee and
(iii)to pay to the Franchisee as soon as is reasonably practicable after the said 30th June in each year … the Franchisee’s entitlements pursuant to clause 3.1.2 of this Agreement less the applicable amount of the Ongoing Annual Franchise Fees payable by the Franchisee to the Franchisor (if any)”
[This provision does not appear in the 1995 version of the Franchise Agreement: see FF11/V1/99. Indeed there appears to be no clause in that version providing for the payment (as opposed to an accounting) of the franchisee entitlements.]
(e)to provide advice, information and training to the franchisee in relation to the conduct of the Franchised Operation and the System as it deems appropriate [clauses 15.5 and 15.6].
34. By clauses 6.3 and 32, provision was made for the provision of a certificate from a solicitor and acknowledgement by the franchisee of the taking of independent legal advice in respect of the terms of the agreement.
The Sub-Franchise Agreement
35. By clause 4.1, clause 3.1.11 (definition of “Sub-franchise Term”) and Item 6 of the Schedule, the franchisee granted to the sub-franchisee commencing on the Commencement Date (being the Commencement Date as defined in the Franchise Agreement) “and expiring on the date of termination of the Franchise less one (1) day”, a non-exclusive licence to establish and operate the Franchised Operation within the Territory (specified in the Schedule) “separately identifying such activity in its books of account under the business name set out in Item 7 of the Schedule … using the Franchise Procedures.” Franchise Procedures was given the meaning as defined in the Franchise Agreement.
36. The sub-franchisee was obliged to pay Annual Sub-Franchise Fees, being “Ninety percentum (90%) of the amount payable by the Franchisor to the Franchisee pursuant to clause 3.1.2 of the Franchise Agreement”: see [clauses 4.1.1, 3.1.2, 3.1.10, Item 4 of the Schedule].
37. Clause 4.4 provided:
“The Franchisee acknowledges that the Sub-Franchisee has or will be granted additional sub-franchises by other franchisees of the Franchisor in respect of the use of the System and the Franchisee hereby consents to the same (irrespective of whether or not the additional sub-franchises are granted within or outside the Territory) provided always however and the Franchisee specifically acknowledges that whilst the Sub-Franchisee continues to act as sub-franchisee for more than one (1) franchisee each new accountancy firm enlisted by the Sub-Franchisee will be allocated to the franchise number with the least number of accountancy firms in the manner outlined and described on pages 16 and 29 of the Disclosure Document.”
38. By clause 5.1.2, the sub-franchisee acknowledged that it genuinely enters into the agreement to commence the Franchised Operation and to develop and promote same as the sub-franchisee’s own business.
39. By clause 9, the franchisor covenants with the franchisee that it has provided sufficient training and assistance to the sub-franchisee to enable the sub-franchisee to conduct the Franchised Operation as and from the Commencement Date.
40. The franchisee was authorised to terminate the Sub-Franchise Agreement on notice if the franchisee undertook the necessary training (pursuant to clause 10.1 of the Franchise Agreement) and satisfies the franchisor that it has acquired the technical competence to conduct the Franchised Operation in the franchisee’s own right [clause 12.1.1].
The Funding Agreements
41. Franchisees were given the option of entering into a financing arrangement with the Franchisor whereby part of the Initial Annual Franchise Fee would be loaned to them. This loan arrangement was achieved by way of Funding Agreements. There are differences between the 1995 and 1996 (first and second versions) Funding Agreements which do not however appear to be significant.
42. By clause 2, each Funding Agreement stated the following by way of background:
“2.BACKGROUND
2.1Satcom provides financial services to Australia’s accountancy profession using the System.
2.2 Satcom has granted to the Borrower the Franchise upon the terms and conditions contained in the Franchise Agreement.
2.3 The Borrower has requested that Satcom advance the Principal Sum to the Borrower to assist the Borrower in making payment of the Initial Annual Franchise Fee to Satcom which Satcom has agreed to do upon the terms and conditions contained in the Agreement.
2.4Repayment of the moneys secured is dependant upon the Borrower deriving Net Receipts provided however that should there not be any Net Receipts derived or insufficient Net Receipts derived by the Borrower from the Franchised Operation, Satcom has agreed to release the Borrower from the obligation to repay the moneys secured either partially or totally upon the terms and conditions contained in this Agreement.
2.5Notwithstanding that the Borrower may be released either partially or totally from the obligation to repay the moneys secured to Satcom, Satcom considers that there is significant commercial benefit in advancing the Principal Sum to the Borrower for the establishment and conduct of the Franchised Operation for the first (12) months.”
43. Subject to clauses 7 and 8 of the Funding Agreements, the franchisor agreed to advance on the Commencement Date (as defined in the Franchise Agreement), the Principal Sum being the sum described in Item 5 of the Schedule, upon the terms and conditions contained in the Funding Agreement [clause 4.1, clause 3.1.11]. Clauses 7 and 8 of the Funding Agreements provide for repayment and release respectively.
44. According to clause 4.2 of the Funding Agreements, the advance of the loan monies was to be effected as follows: -
“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 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 7 and 8 of this Agreement) and Satcom hereby agrees to credit in its books of account the amount of the Principal Sum as part payment of the Initial Annual Franchise Fee and the Borrower hereby agrees to reciprocate these entries in its own books of account.”
45. By clause 6 of the Funding Agreements, it was agreed that interest would accrue on the outstanding amounts of the loan on a daily basis at the Rate. The Rate is defined by clause 3.1.12 as the rate of interest stated in Item 6 of the Schedule, i.e. 8% per annum.
46. Apart from the instalment amounts the Principal Sum and all interest thereon payable (“the moneys secured”) was by clause 7.2 to be repaid from half of the Net Receipts derived by the Borrower. Net Receipts are defined by clause 3.1.10 as:
“…the amount (if any) that the Borrower as franchisee under the Franchise Agreement has or is entitled to receive under Clause 3.1.2 of the Franchise Agreement as at the 30th June in each year during the terms of this Agreement less any amounts paid to and/or owing to Satcom Business Exchange Pty Ltd (ACN 009 381 917) pursuant to the Sub-Franchise Agreement (if any) as at the 30th June in each year during the term hereof.”
47. The Funding Agreement operated as a limited-recourse loan by virtue of clauses 8.1 and 8.2 which discharged the Borrower from any liability for the outstanding amounts owed to Satcom in the event that the Borrower did not derive any Net Receipts. Clause 8.1 relevantly states:
“Subject to Clause 8.3 of this Agreement, if the Borrower has not or does not derive any Net Receipts during the period that the borrower remains the Franchisee under the Franchise Agreement then Satcom hereby releases and discharges the Borrower from all liability to repay the moneys secured.”
48. The applicants received correspondence from Satcom with instructions as to how the advance of loan monies was to be effected in the following terms:
“As you are aware, in your Franchise Application Form you made a request to borrow from Satcom. Satcom has considered your request and has agreed to this loan. The terms and conditions of that loan are set out in the Funding Agreement. Instead of Satcom paying to you a cheque in the amount of the loan and then you being required to repay the same to Satcom as part of your initial annual franchise fee we draw your attention to Clause 4.2 of the Funding Agreement which provides that both you and Satcom will make entries in our respective books of account to that effect. This information will, in due course, need to be provided to your Accountant.”
Consideration and Inquiries by the Applicants
49. With regard to their entry into the Satcom arrangements, the applicants deposed to the following considerations and inquiries:-
Dr Jarvis:-
(a)had acquired some information in relation to electronic data transfer. He had been using computers for over 20 years and had become literate with several computer languages. He had used the internet for accessing data and files involved in the running of a medical I.T. system in his practice and “therefore had a sound understanding of UNIX and Lynx based data transmission”. He is also responsible for “the IT component management and maintenance programme” at his medical centre;
(b)became aware of the Project through an advertisement. He contacted Satcom and was advised that it was a web based information data access enhancement for accounting practices;
(c)“immediately asked Satcom whether it was okay in terms of the taxation consequences”. He then contacted his accountant to “confirm the Project details and confirm the taxation consequences of the expenses”. His accountant was not entirely happy with the way the Project was set up. His accountant was of the view there could be some potential problems with the deductibility of the expenses. He was advised that if he took one franchise only he “would not be exposing himself to too great a risk”;
(d)had a meeting with a Satcom representative at the Satcom office and “we discussed the way the Project was set up and the products involved … He advised me that as it was a business the expenses were deductible and that they were already operating a similar business to accountants”. He was provided with a copy of the 1995 BODD;
(e)discussed it further with his accountant “who continued to advise him on the deductibility issue”. He considered the income projections in the 1995 BODD and was of the view that “the business presented a good level of income over the life of the Project … there was a reasonable chance of a web based business making a profit”;
(f)read the taxation opinion in the 1995 BODD and “thought the Project must therefore be all above board in regard to the deductibility of my expenses”;
(g)“chose to have a sub-franchisee manage the day to day operations of my franchise business”.
Mr Leggett:-
(a)David Meredith marketing manager for Satcom came to him in about February 1995 to advise him “of a unique investment opportunity for both myself and appropriate clients”. He provided a BODD and the tax opinion;
(b)studied Satcom and the Project and understood the Project was implemented to enable accountants to provide financial services and other information services. With their own research of the Project his firm determined that they should recommend it to some of their clients;
(c)considered other investments. One alternative was contributing to superannuation “in my view the two things were similar”;
(d)visited the offices of Satcom on a number of occasions late in 1995 and early 1996 and assessed their structure and met staff;
(e)as a financial planner utilised his own skills to consider the projections in the BODD and was of the view that they appeared reasonable and would provide a reasonable commercial return;
(f)states “the sub-franchisee would make a commission effectively from marketing the services of the Project on my behalf as the holder of the franchise business”. The role of the sub-franchisee to “facilitate the marketing of the business and run the actual services and then supervise the carrying out of those services” meant that he could concentrate on his job responsibilities “as well as benefit commercially from the Project”;
(g)states his views were bolstered by a favourable tax opinion from a reputable QC.
Mr Watson:-
(a)had knowledge and understanding in relation to electronic data transfer applications from his previous employment. “Based on this knowledge he believed the Project would be a successful venture” and “I could see myself deriving good profits over the 10 year time frame anticipated in the Project”. He believed that the demand for electronic data transfer was healthy and would continue to progress;
(b)was provided with a copy of the 1996 BODD by Mr David Serra-Safelin. He did not seek to confirm any of the representations made by Mr Serra-Safelin with his accountant or another third party because he trusted him. He used his basic financial analysis skills to look at the forecasted projections;
(c)paid attention to the taxation benefits and read the taxation opinion. He was aware that if he entered into one franchise he would be in a cash positive position. “Having chosen to enter into two franchises I realised I would be in a cash negative position”. In entering into a third franchise in 1997 he acted against his accountant’s advice who stated he would lose on his participation in the Project;
(d)decided to appoint a sub-franchisee: “the Project represented that appointing a sub-franchisee was the best way to conduct a business”, and “was comfortable with somebody else … running the franchise on my behalf”.
Dr Faigenbaum:-
(a)read the BODD carefully with his accountant. He noticed there was an opinion from a tax expert “which confirmed my view that as all other business expenses are tax deductible so too would my expenses in relation to my Satcom business”.
(b) “early in 1995 [his] accountant Mr J Muntz introduced him to the Project”, apparently during a regular annual meeting they held to tell Dr Faigenbaum what tax situation he was in. At this time his accountant provided him with a copy of the 1995 BODD.
(c)compared the BODD with information memorandums for agricultural products and spoke to a guy from the Project at their offices. His accountant discussed the Project with his colleagues;
(d)thought the projections looked reasonable and he believed they were plausible and commercially achievable and his accountant and other colleagues were going to participate;
(e)did not have time to operate his franchise and “decided to have a sub-franchisee manage the day to day operation of my franchise. I thought this would focus the mind of the manager on making money for me”.
Business Activities
50. The franchisor generated income from franchise and administration fees, in accordance with the following table:
Financial Year Ended 30 June 1995 1996 1997 1998 $605,589 $8,640,461 19,287,206 2,110,234 51. Amounts owing by franchisees by reason of the limited recourse loan arrangement are summarised in the following table:
Financial Year Ended 30 June
1995
1996
1997
1998
Franchisee Loans
5,221,800
23,628,657
21,593,731
20,905,300
Unearned Franchise Fees
(6,444,411)
(17,507,918)
(1,970,712)
0
Net Amount owing by/(to) Franchisees
(1,222,611)
6,120,739
19,623,019
20,905,300
52. The sub-franchisee generated income from sales in accordance with the following table, but it is not known whether any part of this sales income relates to the Financial Services franchises:
Financial Year Ended 30 June
1995
1996
1997
1998
$145,602
$614,659
$648,522
$766,858
53. The Franchise Financial Statements provided to the applicants recorded the following outcomes in contrast to the gross income projected in the BODDs:
1995 Franchises - Gross Income per Franchise
Projected (as per the BODDs)
and
Actual (as per the applicants’ Franchise Financial Statements)
Year Ending
30 June
BODD page 19
“Business operated by sub-franchisee with loan option”
$
Jarvis
QLD004
SHJ7/170-171
SHJ6/167-168
$
Faigenbaum
VIC102
FF16/V3/649, 652, 655
$
1995
1996
2,400
Not produced
975.04
1997
3,000
Not produced
209.47
1998
4,800
Not produced
248.39
1999
7,200
Not produced
Not produced
2000
9,000
0.00
Not produced
1996 Franchises - Gross Income per Franchise
Projected (as per the BODDs)
and
Actual (as per the applicants’ Franchise Financial Statements)
Year Ending
30 June
BODD
page 19
“Business operated by sub-franchisee with loan option”
$
Leggett
NSW363
WHL8/172, 174-175
$
Watson
NSW169
GKW11
V2/478, 481, 485, 489
$
Watson
NSW170
GKW11
V2/479, 482, 486, 490
$
Faigenbaum
NSW288
FF16/V3/647, 650, 657
$
Faigenbaum
NSW325
FF16/V3/648, 654, 659
$
1996
2,400
0.00
0.00
0.00
0.00
0.00
1997
3,000
Not produced
209.47
209.47
209.47
209.47
1998
4,800
248.39
Not produced
248.39
248.39
1999
7,200
20.59
20.59
20.59
Not produced
2000
9,000
Not produced
0.00
0.00
Not produced
1997 Franchises - Gross Income per Franchise
Projected (as per the BODDs)
and
Actual (as per applicants’ Franchise Financial Statements)
Year Ending
30 June
BODD page 19
“Business operated by sub-franchisee with loan option”
$
Watson
VIC323
GKW11
V2/483, 487, 491
$
Faigenbaum
VIC299
FF16/V3/653, 658
$
Faigenbaum
VIC300
FF16/V3/651, 656
$
1997
3,000
44.59
209.47
209.47
1998
4,800
Not produced
248.39
248.39
1999
7,200
20.59
Not produced
2000
9,000
0.00
Not produced
54. Sub-Franchisees reports to franchisees consisted solely of gazettes and general newsletters detailing inter alia:
(a)activities generally;
(b)progress in preparing financial statements; and
(c)the development of new products and services to be marketed.
WITNESSES
55. As well as the evidence of each of the applicants, the Tribunal had before it evidence from the following witnesses called for the applicants: -
(a)Mr Neil Atchison (Exhibit A10)
(b)Mr Patrick Donaghey (Exhibits A8; A9);
(c)Mr Bruce Sherlock (Exhibit A4)
(d)Mr Nigel Simpson (Exhibits A11, A12);
(e)Mr Graham Speak (Exhibits A6, A7).
56. The following witnesses were called by the respondent: -
·Mr Roger Clarke (Exhibits R2 - R4);
·Mr Tim Hantke (Exhibit R1);
·Mr Sean McGing (Exhibit R8);
·Mr Greg Meredith (Exhibit R5 - R7).
57. The effect of each witness’ evidence, may in the Tribunal’s view be summarised as follows.
58. Mr Atchison is an accountant whose firm was, in about April 1998: -
“invited to take on the financial services products and the corporate services products….. As the financial services product was a relatively new concept, the firm was of the view that it would try the corporate services on offer and assess the services in anticipation of Satcom returning to follow up on the financial services” [6] .
…
“To the best of my knowledge, other than via some initial broad comments outlined in the annexed email … the Firm was never approached again by Satcom to purchase additional financial services …
59. The Tribunal is of the view that Mr Atchison’s evidence adds nothing to the case of either party. It is anecdotal. It neither evidences the existence of Satcom’s financial services product nor effective or successful marketing of it.
60. Mr Donaghey’s evidence is directed to: -
(a)the background to the Project;
(b)the projections and the franchise structure;
(c)his involvement with Satcom;
(d)the development of Satcom’s financial services software;
(e)marketing of the product;
(f)reasons why the Project was not successful.
61. Mr Clarke undertook an extensive review of the material produced by Mr Donaghey. On the basis of his analysis, Mr Clarke concluded that any software product that existed to support the franchisor’s operations had very limited functionality and was unlikely to be adequate to ensure the viability of the business: see Clarke report pages 1 and 2 and [6.3], [6.5], [7.5] and [9.7].
62. The Tribunal accepts Mr Clarke’s carefully detailed analysis of the evidence. Mr Donaghey’s evidence was restricted to assertions which were, as Mr Clarke’s review demonstrates, not 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 produced.
63. With regard to Mr Clarke’s evidence the Tribunal further notes that: -
(a)he provided extensive evidence of what was to the Tribunal his obvious and relevant expertise;
(b)he precisely identified his instructions and the material relied upon in forming his opinions;
(c)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.
64. Mr Donaghey made no attempt to provide any detailed response to Mr Clarke’s analysis or point to contrary evidence.
65. Mr Sherlock’s evidence was directed to the reasonableness of the assumptions upon which the profit projections in the franchisor’s BODD were based. His opinion was based on a complex series of assumptions which were not contained in the BODD. Mr Sherlock’s opinion was also based upon his extensive experience as a highly successful insurance salesman, and on the assumption that “the sales team engaged in the Project were experienced in the accounting and personal risk management industry”.
66. Mr Sherlock approached the question by starting with each year’s sales projections in the BODD. From there, he calculated the amount of life insurance premiums that would need to be written to achieve the projections. Having done so, he concluded “the insurance premiums projected to be written and the commission income projected to be derived by each franchisee … were in my view conservative and easily achievable based on my experience in the industry”.
67. Overall Mr Sherlock’s evidence was not helpful to the Tribunal. The Tribunal notes that the applicants did not consider their investment on the basis of the set of assumptions provided to Mr Sherlock. Neither was there evidence provided either to Mr Sherlock or the Tribunal to support his assumption that the franchisor had in place any sales team or a sales team of the calibre Mr Sherlock assumed.
68. Mr McGing is an actuary with 30 years’ experience in the life insurance and wealth management industry with particular interest in information technology as it affects life insurance and wealth management.
69. Like Mr Sherlock, Mr McGing evaluated the financial services business proposed to be operated by the franchisor using technology developed by it for that purpose. Mr McGing was asked to consider a series of questions directed to defining the nature of Satcom’s financial services business and its viability. In essence, he concluded: “… the likelihood of achieving and sustaining the required commission income to make the business viable was very low, given the restricted target client base for each franchisee and the difficulty in establishing and running a quality sales team”.
70. Mr Sherlock’s evidence was, fundamentally, anecdotal, based upon his personal experience as a highly successful salesman. It was narrowly based upon what was, in essence, an arithmetical exercise.
71. Mr McGing in contrast has extensive experience as an actuary studying business models in the financial services industry. His evidence was based upon a broad consideration of the factors affecting the viability of Satcom’s proposed financial services business. For these reasons, the Tribunal attaches more weight to Mr McGing’s evidence.
72. Mr Simpson, a financial planner, gave his opinion of the commercial merits of an investment in the Project based on the content of the BODD. He calculated an 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. 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.
73. 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.
74. Mr Meredith, by his Further Witness Statement dated 31 July, 2006 and his Note dated 15 February, 2007 (exhibits R6 and R7) commented on the views expressed by Mr Simpson. He noted, inter alia, that “an appropriate comparative IRR … should …. be considered on an after finance basis given the material impact on the return to investors … of the availability of the non-recourse loan …”. Mr Meredith concluded, at [37]-[38] 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…”
75. Mr Simpson’s evaluation of the commercial merits of the investment appears to be narrowly focused on the return indicated by the income projections, ie, he assesses profitability without assessing risk. Mr Meredith agrees with the calculated rate of return. However, he notes that the evaluation of the investment depends on risk as well as return. In the Tribunal’s view it is clear that in the absence of appropriate information in the BODD, risk could not be adequately assessed.
76. With respect to Mr Meredith’s evidence, his Witness Statement dated 31 July, 2006 (exhibit R5) contained an extensive analysis of the available accounts of the Satcom entities, the outcome of which was not challenged.
77. Mr Speak’s evidence was directed to the reasonableness of the franchise fee of $30,000. His evidence was based on the 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. Mr Speak’s affidavit and witness statement expressed support for the reasonableness of the franchise fee. However, in cross-examination, he stated that he understood the BODD to be an introductory document designed to solicit interest. Those expressing interest would then conduct their own due diligence, as to the existence of the software and the like.
78. 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 Financial Services 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 together with the favourable loan arrangements. The projected and actual earnings were modest and with growth options restricted (i.e. set number of clients per franchise territory) the financial benefit of this system largely revolved around the tax deductibility of the year 1 annual franchise fee”.
applicants’ Contentions and Submissions – s. 51(1)
79. The applicants’ purpose in obtaining a franchise in the Project was claimed to be for the purpose of carrying on a business of the introduction and encouragement of the System to accountancy firms to derive assessable income therefrom. The applicants also appointed the Sub-Franchisee, or manager, to undertake his Business to derive assessable income therefrom.
80. Assessable income was derived by the applicants in the years ended 30 June 1998 to 30 June 1999 from the introduction and encouragement of the System to accountancy firms.
81. Pursuant to the Franchise Agreement and the Sub-Franchise Agreement, the applicants have clearly incurred the obligation to make the payment of the relevant fees for the purposes of carrying on their franchises, and the evidence supports the view that the applicants had at the relevant 30 June date, commenced to carry on a business via the Sub-Franchisee.
82. The Sub-Franchise Agreement obliged the Sub-Franchisee 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 Sub-Franchisee’s performance, by clause 12.1.3 of the Sub-Franchise, the franchisees were empowered to terminate the agreement and remove the Sub-Franchisee and conduct the Business on their own behalf. There is nothing in the Franchise Agreement which precludes the franchisee from appointing a manager or sub-franchising the arrangement to another party. By clause 5.1 of the Sub-Franchise Agreement the franchisee had security in knowing that the Sub-Franchise would not sell or transfer the sub-franchise to a third party. This did not preclude the franchisee terminating the Sub-Franchise Agreement to undertake the franchise on their own behalf.
83. The applicants relied on the following authorities to support their claim 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 v Brand (1995) 31 ATR 326, Commissioner of Taxation v Walker (1984) 84 ATC 4553, Australian Trade Commission v Disktravel [1999] FCA 1399, Madison Pacific Property Management and Ors v Australian Securities Commissioner 30 ACSR 218, Merchant v Commissioner of Taxation 99 ATC 4221).
84. It was argued that these authorities concerned similarly structured managed investment schemes where the taxpayer was not actively involved in the business.
85. It was contended that the fees paid by the applicants were incurred in the gaining or production of assessable income, or necessarily incurred in carrying on a business for the purpose of gaining income. It was claimed that the income in this case was to be derived from the introduction and encouragement of accountancy firms to use the System.
86. 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 introducing and encouraging accountancy firms to use the System.
87. The applicants contended that the respondent’s contention that the applicants were not “actively” involved and therefore not themselves carrying on a business are misguided. That was said to be the point of appointing a “manager”. It was pointed out 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 critical point was claimed to be that the applicants had the power to dismiss the “manager”. The power existed for the franchisee to dismiss the Sub-Franchisee.
88. The applicants contended that the facts in the case of Madison Pacific are similar to the facts in this case. Similar to this case, 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. The offer to investors for a franchise territory came with it an invitation to have the territory managed and marketed 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 contended are similar to those provided by the Sub-Franchisee in the Project) fell within the scope of the definition of franchise in the Corporations Regulations and therefore exempt from issuing a prospectus. The applicants contended that in effect the Full Federal Court in that case found the managed investment scheme to be an effective franchise structure.
89. The applicants pointed out that his Honour Justice French rejected ASIC’s contention in the Madison Pacific 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.”
90. The applicants also referred to the judgment of his Honour Justice Carr, who, 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]
91. The applicants argued that in light of the Madison Pacific case, it would be inconsistent for a finding in this case that the franchisees were not carrying on a business. 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.
92. The applicants also contended 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 they had incurred eligible expenditure in the carrying out of their 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. These findings were not disturbed on the appeal to the Federal Court or the Full Federal Court. This was the finding notwithstanding that the Full Federal Court found that the agreement did not provide the licensees with any disposal of the industrial property rights (the basis upon which the licensees were to derive revenue from their business).
93. The applicants contended that 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. The applicants argued 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.
94. According to the applicants, the existence of 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 and Bruce Sherlock. They claimed that there was a reasonable basis to expect to derive income from their participation in the Project. In fact the franchisees did derive assessable income. It was argued that the Respondent has not provided any evidence to support the contention that it was “unreasonable” for the applicants to expect they would derive income from the Project.
95. While the Respondent contends that no software was in existence which was capable of providing the services to the accountancy firms, the applicants point out that the Respondent reached a conclusion that the “electronic network for accountants [was] already in operation” following an extensive audit of the operations of the Project [T1, p1]. The applicants argued that it is incongruous for the Respondent to now allege, and to adduce expert evidence, to suggest that no software was in existence which was capable of providing the services to the accountancy firms. Furthermore, the evidence of Pat Donaghey and the expert Graeme Speak, is that software was in existence at 30 June 1995. It was argued that, in the absence of the expert called by the Respondent, Roger Clarke, testing the software for its capabilities, his evidence that no “significant” software existed is of no weight and that his evidence should not be accepted.
96. On the question of capital expenditure the applicants argued 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 accountancy firms. (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).
97. It was also argued that, unlike Clowes and Milne, the franchisees appointed a “manager” to undertake their franchise to derive assessable income therefrom 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 Sub-Franchisee’s services, unlike in Clowes and Milne.
98. 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 to operate the business. Unlike in Puzey the participants of the Project 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 contended 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 accountancy firms with de jure control over the manager.
99. The applicants contended that the facts in the case of Vincent v Federal Commissioner of Taxation [2002] FCAFC 291 are dissimilar to the facts of this case. They claimed that neither in form nor in substance did the applicants acquire a capital asset in connection with the payment of the relevant fees. 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 accountancy firms for a period of 13 months. They contended that, like the management fee in Lau, Brand, Merchant, Puzey, Sleight, Cooke and Emmakell, the fees in this case are revenue in nature for a service period of 12 months. According to them, no enduring benefit would have been obtained by the applicants in relation to the payment of the relevant fees.
100. They also claimed that the amount of interest paid by the Applicant to Satcom Financial 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 (1999) 197 CLR 459, Sleight, Cooke).
Penalties
101. The applicants submitted that, in the event that the Tribunal is of the view that the expenditure claimed by the applicants is not properly allowable under the general deduction provisions of s 51(1) of the 1936 Act and the consequential non application of Part IVA of the 1936 Act, they are not liable to pay any penalties pursuant to s 224(2) of the 1936 Act.
Applicants’ contentions as to impact of decision on applicants
102. Given the personal circumstances of each of the applicants, it was submitted that the Tribunal’s decision will affect the applicants differently as follows:
(a)If the Tribunal finds that the deductions claimed by the applicants were not allowable under either limb of s 51(1) of the 1936 Act, it will have the following effect on the applicants:
(i)with respect to Jarvis: the Tribunal will have to set aside the decision of the Respondent in disallowing the objection as his assessment was issued more than four years from when the tax was originally due and payable. The provisions of Part IVA of the ITAA 1936 have no application to disallow the deductions claimed as Jarvis did not receive a tax benefit for the purposes of s 177C of the 1936 Act, by virtue of the Full Federal Court decision of Vincent;
(ii)with respect to the remainder of the applicants: the Tribunal will have to affirm the decision of the Respondent in disallowing the objections, save to the extent of the penalties.
(b)Further submissions were made as to the effect of a finding by the Tribunal in relation to the operation of Part IVA. However, for the reasons which follow, it is not necessary for the Tribunal to consider those submissions.
Respondent’s Section 51(1) Submissions and Tribunal’s Findings
103. The respondent says that the claimed deductions by the applicants Watson, Leggett and Faigenbaum were not allowable under s 51(1) of the Income Tax Assessment Act 1936. In the case of Jarvis, the Commissioner does not rely on s 51(1).
104. The Respondent contended that the claimed deductions were outgoings of capital. In order to determine whether the claimed deductions were allowable, the Tribunal must consider what the outgoings were really for. True it is that the relevant outgoings were styled Franchise Fees and purportedly paid for Franchisor Services. However the question is to be answered by an analysis of all the rights and obligations of the applicants not by the way the outgoings were styled: Vincent v FCT (2002) 124 FCR 350 at [64], [65] and [67]. The purpose of the Initial Annual Franchise Fee is considered from a number of starting points set out below. The Respondent submitted that from each starting point one arrives at the conclusion that the applicants’ outgoings were capital outgoings and the Tribunal finds this to be so.
105. In the Tribunal’s view the evidence shows that the applicants were passive investors sharing in the profits of such business activities as were conducted. No distinct business, system or practice of the applicants is established. In the absence of any business, system or practice formed by the applicants, their outgoings are capital outgoings: Clowes v FCT (1954) 91 CLR 209 at 218; Milne v FCT (1976) 133 CLR 526 at 535; and Enviro Systems Renewable Resources Pty Ltd v ASIC (2001) 80 SASR 1 at [36], [43], [44]. This emerges from: -
106. Examination of the Franchise Agreement and the Sub-Franchise Agreement and the evidence of the applicants. Each treated the claimed outgoings as outgoings for an investment, as did their expert witnesses. Further, the applicants were unable to describe their business, its product, the activities to be undertaken by franchisees, how income was to be generated or the role of the sub-franchisee.
107. Even if activities to be carried out by or for an individual franchisee could be discerned, the Tribunal finds that, as submitted by the respondent, the necessary indicia of a business as outlined in Ferguson v FCT (1979) 26 ALR 307 at 311 and Hope v The Council of the City of Bathurst (1980) 144 CLR 1 have not been shown here (see the discussion of Hill and Carr JJ in Puzey v Commissioner of Taxation (2003) 131 FCR 244 at [46]-[49] and of Hill J (with whom Hely J agreed) in Commissioner of Taxation v Sleight (2004) 136 FCR 211 at [47]-[50]).
108. On the evidence before the Tribunal the applicants engaged in no activity beyond their initial entry into the agreements and despite the provision of vague and general financial and other reports which clearly called for enquiry, they made no such enquiry.
109. In the Tribunal’s view the arrangements presented to and entered into by the applicants lacked a business-like structure and the applicants’ entry into them lacked the necessary profit-making purpose.
And how was them using the internet going to make you money? … I don’t know the nitty gritty of it all but they pay a certain amount for using the services of that particular software package
…
Okay. So you didn’t have a lot of understanding of what is was that was being put to you?
… What they were marketing? No.
“Well, were they going to be selling financial planning services? … It could have been part of their software package. Yes. Their package overall. I wasn’t aware. Okay.”
151. Mr Watson said:
“What did you understand that you were investing in; was it the technology? … Well it was in a franchise which was using the technology and at that stage they were developing a technology so they could use computers to access the records in different departments for accountants to use and the like. How was that activity going to make money? … By the users of the software actually paying a service for every time they accessed the service.”
“These figures were based upon sales of financial planning services, weren’t they? … Well basically I think the sale of the software to allow for financial planning services to access the data through the internet.”
“…They were providing access to an access point using their software as far as [sic] understood it. Yes. And so what people were getting was access to financial services … Well, getting access to other services as well. Searches on titles, properties, things like that.
… Every time they accessed, supposedly, they were supposed to pay a fee.”
152. The exception was Mr Leggett who was in his own business of selling financial services and in discussions with Satcom personnel about his potential involvement in making sales for them.
153. It is clear that each applicant mistakenly believed that the sub-franchisee would be managing the franchise on his behalf rather than running its own business, as the Sub-Franchise Agreement provided. By contrast with the terms of the Franchise Agreement, Mr Leggett also mistakenly thought that the sub-franchisee was to run the actual services and supervise their carrying out.
154. The evidence shows that the business was conducted as a whole without complaint from the applicants. On the evidence this appears to be consistent with their understandings and intentions.
155. As noted above, in the Tribunal’s view the only feature which purportedly distinguished the business of one franchisee from another was an allocation of areas in which there were accountancy firms. There is no evidence that any of the applicants were actually allocated any accountancy firms. The annual franchise financial statements provided to the applicants contained no explanation of income and franchisor expenses figures given, how they were derived, from what activities or from whom.
156. Mr Watson and Dr Faigenbaum both had multiple franchises. In each case, the income shown was the same. It must have been obvious to them that they had been allocated a proportion of total income without reference to “amounts received by the franchisor from the utilization of the System” (see Franchise Agreement, clause 15.4) by accountancy firms allocated to them.
157. Newsletters provided to franchisees were in general terms. They were not confined to material in respect of “financial services franchisees” but covered Satcom’s whole range of business activities. Some contained no information about Satcom financial services at all.
158. Consistent with the applicants’ own evidence, the newsletters were expressed in terms of an investment. For instance the Satcom Franchisees Gazette, July 1997 referred to “profit share paid” and “first year’s dividend” whilst that of November, 1997 reported “another positive return is predicted on your investment with Satcom”.
159. Moreover, such activities as were reported indicated that the business was being conducted as a whole without regard to rights or obligations which might have been undertaken by the Franchise Agreement, eg:- There was reported recruitment of agents who were to participate in marketing the Satcom software, servicing the network with insurance products and marketing tax effective products that is, cutting across the purported franchise activities: Satcom Franchisees Gazette, November 1996; February, 1997. End of year update, December 2000 reported: “On behalf of Satcom Financial Services Franchises, we recently negotiated an Agreement with a company which provides software primarily to Australia’s accounting profession”. Although the Franchise Agreement prevented the franchisee from conducting his own business until trained to do so, the Satcom Franchisees Gazette, November, 1997, nevertheless suggested that franchisees themselves encourage accountants to use the System. In response to questioning by the Tribunal, Mr Donaghey also indicated that franchisees could add to Satcom’s business by making referrals.
The necessary indicia of a business are absent
160. According to the authorities, the indicia of a business are: -
·the activities undertaken by the taxpayer;
·the repetition and regularity of those activities;
·whether the activities are organized in a business-like manner;
·the structure through which those activities are conducted;
·whether the activities are carried out for a profit-making purpose –
Ferguson v FCT (1979) 26 ALR 307 at 311; Hope v The Council of the City of Bathurst (1980) 144 CLR 1 (and see the discussion of Hill and Carr JJ in Puzey v Commissioner of Taxation (2003) 131 FCR 244 at [46]-[49] and of Hill J (with whom Hely J agreed) in Commissioner of Taxation v Sleight (2004) 136 FCR 211 at [47]-[50].
161. The applicants’ purported business activities were limited to the following: -
For each franchise applied for, each applicant completed an application form which appeared in the BODD, as follows:
“I understand that I will grant Satcom Business Exchange Pty Ltd a Sub-Franchise to operate my Franchise business. …
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 [Financial Services Pty Ltd] and furthermore I will be bound to complete execution of the Franchise and Sub-Franchise contract documents in standard form………. and also (where relevant) the standard form Funding Agreement….”
Subsequently, each signed Franchise Agreements, Sub-Franchise Agreements and Funding Agreements forwarded for his execution;
None appears to have completed the Franchisee’s Statement or Solicitor’s Certificate also forwarded for execution;
162. Mr Watson made some general inquiries during the infancy of the Project.
163. On the evidence the applicants undertook no further activities with regard to their purported businesses. If they were in a business one would have expected further activity to be apparent at least in relation to the following:
(a)to ensure compliance with the rights and obligations contained in the Franchise Agreement and the Sub-Franchise Agreement;
(b)enquiries being made arising from the paucity of information provided to the applicants, none of which indicated that a business was being carried out on any individual applicant’s behalf.
164. None of the applicants took any steps to inform themselves of or to ensure that the obligations they had undertaken to the franchisor were being met by the sub-franchisee (in accordance with its adoption of those obligations by clause 10 of the Sub-Franchise Agreement). In this respect, particular regard ought to have been had to the franchisee’s covenants in clause 9 of the Franchise Agreement and clause 14 as to the keeping of accounts for the Franchised Operation.
165. Neither did the applicants seek to inform themselves of or to ensure the franchisor’s compliance with its obligations: -
(a)“to continue to develop the System by introducing [various] products” or ”to charge out such products to end-users at commercial rates” (Franchise Agreement, clause 15.2);
(b)to provide an annual accounting which included: -
(i)“the net receipts of all income received by the Franchisor from the utilization of the System by the accountancy firms”;
(ii)“a statement of the Franchisor’s expenses incurred in providing the Franchisor’s Services”;
(iii)“an explanation as to the basis upon which the relevant proportion of the same has been allocated to the Franchisee”
166. By contrast with the requirements of the agreements, annual franchise financial statements provided to the applicants contained no explanation of income and franchisor expenses figures given or how they were derived, let alone whether or how income was derived from utilisation of the System by any and what accountancy firms allocated to the applicant in question as a result of any and what activities.
167. Furthermore the applicants sought no information by which they could assess whether or how their purported businesses were being conducted, such as: -
·schedules of subscribing accountant firms;
·reports of the volume of transactions conducted in different periods; or
·proper financial statements.
168. Similarly, the franchisee gazettes contained no details concerning the marketing of the System, of products introduced, or of how they were charged out to “end-users”. Indeed, the available information suggested that no electronic financial services product was ever introduced to the accounting market: -
(a)there was no assurance in the BODD that Satcom was in a position to provide the proposed services. At page 9: “Satcom will introduce a selection of financial services together with access to the internet. The financial services will be introduced in modules”. At page 10: certain broadly defined services had been “identified for development and introduction”. Similarly, at page 26, prospective investors were advised that there had been no trading by Satcom in the business of providing financial services. A 1996 brochure provided to the applicants referred to Satcom Internet Services including financial services information available at Satcom home page e.g. insurance services and tax effective investments, which could be investigated and tailored to specific client needs;
(b)subsequently, there was reference to a client needs analysis tool which was being introduced to accountants in October, 1997 but still apparently under development a year later.
169. The lack of activity apparent from the above did not prompt any enquiry or intervention by the applicants into the conduct of their purported businesses.
170. Having regard to the indicia of a business, the arrangements presented to and entered into by the applicants lacked a business-like structure. Indeed, they were, in essence, as submitted by the respondent and as the Tribunal finds, a commercial nonsense, having regard, inter alia, particularly to the following:
(a)prospective participants were to enter into a franchise arrangement which they would not be permitted to operate (Franchise Agreement, clauses 20, 5.1.4);
(b)their appointed sub-franchisee was the franchisor’s holding company (BODD, page 24);
(c)that sub-franchisee was purportedly to undertake all the work of the franchisee for 10% of the profit;
(d)the franchisor was lender of its own fees. The applicants borrowed most of the Initial Annual Franchise Fee from the franchisor by an advance which was to be effected by book entries and so, manifestly, without cash (Funding Agreement, clause 4.2). In the result, the applicants agreed to pay fees which had no commercial function.
171. Certainly, the BODD presented no business-like structure. It defines no discernible business. Whilst the Franchise Agreement is concerned with introducing and encouraging the use of a “specialized on-line electronic communications network system” (clause 2.1), the BODD appears to be concerned with both technology and financial services, both without explanation as to the precise nature of the purported business or how it was to be conducted.
172. The first year Franchise Fee of $30,000 was defined to be for services described at page 11 of the BODD (Franchise Agreement, clause 4.1). Save for a general description of the nature of the service to be provided, those services are wholly undefined. Moreover, as Mr Hantke points out, most of those services were of no direct use to the applicants as they did not intend to operate the franchise. In the end, the applicants were paying for purported Franchisor Services of value only to a sub-franchisee which was the franchisor’s holding company.
173. Mr Hantke questions the value of the $30,000 fee given the absence of any documented or existing franchise operating system, training program (which Mr Donaghey acknowledged did not exist) or marketing materials, the limited value of the interstate territories, the restriction on them and the absence of a selection system. Similarly, he expressed the view that projected returns were low relative to the size of the fee, from which a franchisee would expect a significant positive return in the first year, rather than the $100 projected by the BODD.
174. Mr Speak agreed that a prudent investor would not invest $30,000 on the strength of the BODD. Significant further enquiries as to the functions performed by the relevant software and its suitability for the purpose of marketing financial services would be required. He understood the BODD to be an introductory document, providing a high level description of the technology involved, which would be followed up by the provision of more detailed information to those who expressed interest. There is no evidence of any such inquiry by the applicants.
175. Both the Franchise Agreement and the BODD are silent as to Satcom’s business model. The contemplated financial services business was apparently that the technology in question would facilitate the sale of financial products, particularly insurance, to clients of accountants. The technology was to be used by accountants to obtain a quote from Satcom. Satcom would, in turn, refer the business to an agent accredited to sell the financial product in question. Commission payable to the agent in respect of the sale of the product would be shared with Satcom and the accountant.
176. As submitted by the respondent, in this model, there is clearly no place for a franchise structure. There is no activity which can sensibly be franchised.
177. In the Tribunal’s view, comparison with cases referred to by the applicants which suggest that the appointment of a manager is not inconsistent with the conduct of business are of no assistance to the applicants. These applicants did not appoint a manager. They appointed a sub-franchisee which was to conduct its own business (Sub-Franchise Agreement, clause 5.1.2).
178. Further, if the applicants were not in a business at all, there is no requirement to consider the role of the sub-franchisee. Accordingly, the question of whether the applicants were in a business at all must first be answered.
179. The Tribunal agrees with the respondent’s contention that the nature of these 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).
180. In those cases, the Court, relying on the reasoning in Commissioner of Taxation vLau (1984) 6 FCR 202, found a business of the investors, 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].
181. 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 being 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.
182. By contrast, a Satcom franchisee had no identifiable business of his own. He had no identifiable “trees” of his own. The Satcom franchisee was allocated a State territory along with other franchisees (Franchise Agreement, clauses 4.1, 3.1.19 and Schedule, item 8; BODD, page 29). When enlisted by the sub-franchisee, accountancy firms would be allocated amongst franchisees (Sub-Franchise Agreement, clause 4.4).
183. Evidence that the sub-franchisee, on behalf of all franchisees, was engaged in introducing and encouraging the use of the Satcom System by accountants does not prove the conduct of any individual franchisee’s business.
184. In the Tribunal’s view, consistent with the respondent’s contentions, the nature and requirements of the Satcom franchisee’s business are not satisfied by the co-ordinated activities of a common manager unlike the forestry investor’s business.. 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 by accountancy firms. The success of the Satcom franchisee’s purported business depended on the extent of the efforts made to convert an identifiable group of accountants and their clients into customers for Satcom’s financial services and the extent of efforts directed to maintaining their custom because the potential for use of the System and the consequent generation of income is not limited. Satcom proposed to introduce a range of financial services all of which could be made available to clients of each accountancy firm. However unlike the forestry investor’s trees, the demands of the accountancy firms and their clients are not necessarily uniform.
185. The decision in Madison Pacific Property Management & Ors v Australian Securities Commission (1999) 30 ACSR 218 does not in the Tribunal’s view assist the applicants’ contention that they are carrying on a business in their own right. That decision dealt with 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.
186. In this case 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. The Tribunal agrees with the respondent that 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 decisions 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 which the Tribunal considers to be of no application in this case.
Fletcher’s case – first limb of Section 51(1)
187. The Tribunal is of the view, as set out above, that : -
(a)the applicants have not established that they were carrying on any business; and, in any event
(b) the claimed deductions were outgoings of capital.
However, for the sake of completeness, and in case the Tribunal’s view on the question of capital is wrong, the Tribunal has also considered the question of whether the outgoings were incurred for the purpose of gaining and producing assessable income.
188. It is clear from the authorities 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 shown to 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.
189. 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.
190. 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.
191. The Tribunal agrees with the respondent’s submission that on the evidence the occasion of the applicants’ outgoings was not the production of assessable income but the income tax deductions which facilitated their participation.
192. In Faigenbaum’s case, his tax savings after making the cash payments required of him, resulted in significant net cash surpluses: -
·in the 1995 year, of $3,520;
·in the 1996 year, of $7,525;
·in the 1997 year, of $8,060.18.
193. As well, Dr Faigenbaum consciously spread his tax deductions across two tax years, as he acknowledged in cross-examination. On or about 24 June, 1996, he took up four franchises, by forms dated 24 June, 1996, 25 June, 1996 and then 1 July, 1997.
194. In Leggett’s case, the resulting tax savings for the 1996 year covered the cash payments required of him and left him with a net cash surplus of $291.92;
195. In Watson’s case, the resulting tax savings from his investments in the 1996 year and the 1997 year covered the total cash payments required of him and left him with a net cash surplus of $113.97.
196. The tax savings met, (or, considering Watson’s 1996 year participation only, substantially met) the applicants’ required cash contributions. In Faigenbaum’s case, he obtained a significant cash benefit. The Tribunal notes that by reason of the limited recourse nature of the loans, the applicants would have retained the benefit of the tax savings regardless of the outcome of their investment.
197. 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 set out above, the Tribunal agrees with the respondent that the applicants’ outgoings make no business sense. They are more satisfactorily explained by the more certain and immediate tax deductions they secured, facilitating their investment.
The Tribunal accordingly finds that the claimed deductions are not allowable under either limb of s 51(1).
Part IVA
198. Having regard to the findings of the Tribunal as set out above there is no need for the Tribunal to consider the application of Part IVA other than in relation to Dr Jarvis. However the Tribunal agrees with the proposition put on behalf of Dr Jarvis that, in light of the decision in the Vincent case (supra) and having regard to the Tribunal’s finding that the claimed deductions are not allowable under s 51(1) there is no room for the operation of Pt IVA and therefore his application must succeed as his amended assessment was issued out of time.
PENALTIES
199. The Tribunal accepts the contentions of the applicants that no penalties should be imposed on the applicant.
DECISION
200. The Tribunal finds that:
(a)In relation to Dr Jarvis the decision under review should be set aside and the relevant assessments cancelled.
(b)In relation to Dr Faigenbaum and Messrs Leggett and Watson the decisions under review are the correct or preferable decisions and are affirmed save in relation to the imposition of penalties and that the relevant assessments should be amended in that regard only.
I certify that the two hundred [200] preceding paragraphs are a true copy of the reasons for the decision herein of Mr A Sweidan, Senior Member
Signed: .....................(Sgd. Y Maker)...............................
AssociateDate/s of Hearing 21-23 & 26 February 2007
Date of Decision 1 August 2007
Counsel for the Applicant Mr K Robson and Mr D Romano
Solicitor for the Applicant Wilson & Atkinson
Counsel for the Respondent Ms H Symons and Ms L Price
Solicitor for the Respondent Australian Government Solicitor
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