McNally and Commissioner of Taxation

[2006] AATA 538

Administrative

Appeals

Tribunal

 

DECISION AND REASONS FOR DECISION [2006] AATA 538

ADMINISTRATIVE APPEALS TRIBUNAL          № VT2005/101

TAXATION       APPEALS        DIVISION

Re:           WALTER McNALLY

Applicant

And:           COMMISSIONER OF TAXATION

Respondent

DECISION

Tribunal:       The Hon Howard Olney AM QC, Deputy President

Date:22 June 2006

Place:Melbourne

Decision:The Tribunal decides that:

1.the decision under review is set aside; and

2.the matter is remitted to the decision‑maker for reconsideration in accordance with the Tribunal’s findings and conclusions.

(sgd) Howard Olney

Deputy President

INCOME TAX –  retirement of partner from partnership – settlement of dispute following mediation – whether settlement sum is taxable as income – partnership accounting procedures – taxation liability for previous year’s “closing timing difference” and penalty for tax shortfall – whether shortfall was intentional or reckless.

Income Tax Assessment Act 1936 ss 226H, 226J

Allsop v Commission of Taxation (1965) 113 CLR 341

Commissioner of Taxation v CSR Ltd (2000) 104 FCR 44

REASONS FOR DECISION

22 June 2006  The Hon Howard Olney AM QC, Deputy President

1.      The applicant seeks review of the respondent’s decision to disallow the applicant’s objection against an assessment of income tax, and penalties, for the year ending 30 June 1998.

BACKGROUND

2.      The applicant is an accountant by profession.  His specialty is in the field of indirect tax.  In 1991 he became a partner in the firm of Duesbury.  He paid $160,000 by way of a capital contribution which sum he obtained by way of loan from Westpac Bank.  In 1994 the Duesbury partnership merged with the firm of Deloitte Touche Tohmatsu (Deloitte).  As a partner of Deloitte he was required to contribute $150,000 as a loan, which he borrowed from the National Australia Bank.

3.      For reasons which have not been explained, and which in the present context are not relevant, the applicant did not enjoy a harmonious relationship with some other partners at Deloitte, resulting ultimately in the Policy Board of the partnership resolving on 17 July 1997 that the applicant be removed as partner.

4.      Following his dismissal from the partnership the applicant engaged in discussions with representatives of Deloitte concerning his claim for a financial settlement.  Although legal proceedings were apparently contemplated, none were actually commenced rather, the parties agreed to refer their dispute to a process of mediation.  A mediator was appointed by mutual agreement.

5.      The mediation process was embarked upon in December 1997.  The Tribunal does not have any precise information as to the issues that were referred for mediation apart from the applicant’s assertion in his witness statement (exhibit 4, paras 31, 32):

31.      The principal aim of our negotiations in December 1997 was to present an ambit claim.  Essentially what I was after was a payout of $750,000, after the banks were paid out for the goodwill and capital loans.

32.      By that time I was concentrating more on the damage to my reputation and to the loss of pension benefits because by the time the negotiations had come around I had already been employed by the Fallon Group (an indirect tax consulting firm) and was receiving considerable professional income, so it would be increasingly less likely that I could have sued for loss of income or profit bearing in mind my departure in July 1997.

6.      The mediation conducted on 8 and 9 December 1997 resulted in the resolution of the dispute.  The terms of settlement were reduced to writing and signed by the parties.  The following is the full text of the document (the settlement agreement) as signed.

McNALLY v DELOITTE TOUCHE TOHMATSU

TERMS OF SETTLEMENT

1.This agreement is made between Walter McNally (WM) and Deloitte Touche Tohmatsu (the firm).

2.This agreement is conditional upon the Policy Board of the firm confirming clause 6 below and resolving by 22 December 1997 to revoke its resolution of 17 July 1997 that WM be removed as a partner of the firm, in consideration of the parties agreeing now that WM has retired from the firm as at 17 July 1997.

3.The firm agrees to pay WM the amount of $500,000 within two business days of the resolution of the Policy Board referred to above.

4.The firm is to obtain a discharge of that obligation by paying to the National Australia Bank such part of the capital of $150,000 that WM contributed to the firm that he has borrowed from the National Australia Bank.  WM directs the firm to pay the amount of $150,000 or such amount as is owing to the National Australia Bank as part of the return of his capital and $160,000 to Westpac Banking Corporation.

5.The firm releases WM from the restrictive covenants in s. 16 of the Partnership Agreement.

6.In all other respects the Partnership Agreement is affirmed as between the parties except that the firm releases WM from any future liability under clause 21B of the Partnership Agreement and acknowledges that WM has satisfied his obligations for professional indemnity claims for the two years after his retirement.

7.WM releases the firm from all claims he has told the firm of through his solicitors and all claims arising from his ceasing to be a member of the firm.

8.These terms are confidential to the parties.

(The document as originally typed was amended by several handwritten deletions and insertions.  The above text expresses the terms of the document as amended prior to execution).

7.      On 24 December 1997 Deloitte wrote to the applicant in the following terms:

24 December 1997
Mr Walter McNally
76 Gibbs Street

EAST MELBOURNE 3002

Dear Wal

Further to the terms of settlement negotiated at the mediation and executed by the various parties, I confirm that:

·The resolutions specified in paragraph 2 & 6 of the Agreement have been passed by The Board of Partners.

·In accordance with paragraph 4, the firm has discharged part of the obligation by paying your capital of $150,000 to the National Australia Bank Ltd and $160,000 to Westpac Banking Corporation Ltd.

·The balance of monies owing, namely $190,000 have been deposited into your bank account.

I believe the only matters outstanding relate to taxation and I understand John Milne has sent you a Statement of your position at 30 June 1997.  Based on my review this Statement is incorrect, in that John has impacted the full extent of the Capital Reconstruction.  John is currently on leave and I suggest you do not attempt to complete your taxation return until you talk to John following his return from leave on the 12 January 1998.

Yours sincerely

M R BROADFOT

for and on behalf of

R L MERRETT

8.      In his income tax return for the year ending 30 June 1998 the applicant did not disclose any income from the Deloitte partnership.  Indeed, his return showed no net taxable income and the respondent’s initial response was to refund an amount in respect of a credit for 1998 provisional tax.  However, by letter dated 29 November 2002 the Australian Tax Office wrote to the applicant (in part) as follows:

Dear Sir,

INCOME TAX: Share of Net Partnership Income from the Deloitte Touche Tohmatsu Partnership (“DTT”) for Year Ended 30 June 1998

I refer to previous correspondence and telephone conversations with your taxation agent in relation to your share of net income from DTT for year ended 30 June 1998.

In your 1998 income tax return you left the partnership label blank, indicating that you were not entitled to a share of net income from a partnership.

The 1998 DTT partnership income tax return disclosed that your share of the partnership net income was $557,521.  Information received from DTT confirms your 1998 income share entitlement and indicated that you retired from the partnership as from 18 November 1997.

Your interest in net income of the partnership was composed as follows:

$	$
Gratuitous partnership profit distribution	230,000
Allowance	1,333
Inter group dividends (grossed up)	1,312
Non deductible items	1,986
Tax timing differences that were deducted from 1997 accounting income and assessable in 1998	322,890	557,521

Additionally, your share of imputation credit is $472 and you are entitled to a deduction of $11,660 for your share of non recoverable professional indemnity claims.

In terms of section 92(1) of the Income Tax Assessment Act 1936, the amount of $557,521 is your individual interest in the net income of the partnership.

(No explanation has been offered for the reference to 18 November 1997 in the third paragraph of this letter).

9.      On 10 May 2004 the respondent issued to the applicant a notice of assessment of income tax for the year ended 30 June 1998.  The assessment included as income an amount of $559,219 which Deloitte had calculated as the individual interest of the applicant in the net income of the partnership.  The assessment also contained significant debits by way of penalties and interest.  The most relevant items included in the net income assessed were the sums of $190,000 (to which reference is made above) and $322,890 referred to as “opening timing differences” (which are explained below).

10.     On 9 July 2004 the applicant gave notice of objection to the assessment of 10 May 2004.  On 15 December 2004 the respondent gave notice that the objection had been disallowed.  On 11 February 2005 the applicant applied to the Tribunal for review of the objection decision.

TIMING DIFFERENCES EXPLAINED

11.     In the respondent’s reasons in relation to the disallowance of the objection decision the following explanation in relation to the “opening timing differences” items of $322,890 is provided:

Deloitte incudes the value of work performed but yet unbilled as income for accounting purposes.  This work in progress (‘WIP’) is not assessable for income tax purposes until the relevant invoices have been issued.  Together with other timing differences such as prepayments, opening and closing balances of WIP are entered on the partnership income tax return reconciliation statement in order to calculate the net income of the partnership for tax purposes.

The partnership distribution statement issued to each partner by Deloitte after year-end discloses the accounting share of profit calculated through to the taxation share of net income.  To arrive at a partner’s share of the net income of the partnership, the net accounting share of profit is shown plus/minus the share of permanent differences, such as non-allowable deductions.  Then, a partner’s share of opening timing differences is added and his/her share of closing timing differences is subtracted as the final step in the tax reconciliation.

To explain Deloitte’s method in more detail, the first point to note is that Deloitte, upon the entry of a new partner, does not include opening timing differences in its calculation of that partner’s share of the net income of the partnership at the end of the partner’s first financial year.  This is because at the beginning of the partner’s first year with Deloitte, he/she has no interest in Deloitte’s net assets including timing differences.  The opening timing differences are shared among all of the partners who were Deloitte members as at the beginning of the year so that the total net income of the partnership is distributed to partners and taxed.  However, at year-end, a partner is a continuing partner which entitles him/her to a share of Deloitte’s net assets including closing timing differences such as WIP.

The second point is that Deloitte does not include closing timing differences in its calculation of an exiting partner’s share of the net income of the partnership at the end of that partner’s last financial year.  The rationale for this method is the same as the one explained above.  When a partner retires during the year, Deloitte includes his/her share of opening timing differences in its calculation.  However, at year-end (30 June) the retired partner no longer has a share in closing timing differences as his/her entitlement to a share in the net assets has terminated.  The closing timing differences are included in the net income calculation of the remaining partners.

The third point to note is that Deloitte’s method of not including opening timing differences in its calculation of a new partner’s share of the net income of the partnership often results in a new partner having a ‘notional’ tax loss in his/her first year notwithstanding Deloitte having a net distributable profit overall.  This is because Deloitte’s method includes only billed fees but allows all tax timing deductions for tax reconciliation purposes.  Deloitte avoids the outcome of a new partner having a tax loss by adjusting that partner’s closing timing differences in the first year and by reversing the adjustment in the following year.  This results in the new partner returning no tax loss in the first year but in the second year a contra adjustment reduces his/her share of the net income of the partnership.  No tax overall is avoided year by year as the other partners effectively bear the opposite side of these adjustments so that the total partnership net income is distributed to partners and taxed in their hands each year.

Overall, Deloitte’s method ensures that a partner’s entire share of timing differences is included in his/her share of the net income of the partnership.

12.     The applicant has not taken issue with any aspect of the respondent’s explanation of the accounting process involved in the calculation of opening timing differences nor is there any issue as to the actual sum calculated.  The same sum had been claimed as “closing timing differences” in the applicant’s 1997 return.  The issue between the parties is whether or not the settlement arrived at following the mediation had any bearing upon the applicant’s taxation liability with respect to the amount in question.

THE PARTNERSHIP AGREEMENT

13.     There are a number of provisions in the partnership agreement which regulated the rights and obligations of the members of the Deloitte partnership that have some bearing upon the matter presently under consideration.  In particular clauses 14 (Retirement of Partners), 15 (Removal and Termination), 16 (Retirement from Appointments and Restrictive Covenants) and 17 (Entitlement upon Ceasing to be a Partner) are of relevance.

14.     Clause 14 provides for several different circumstances in which a partner may retire from the partnership.  Clause 14(A) deals with a partner who has completed 20 years as a partner whilst clause 14(B) deals with a partner who has attained 62 years of age.  Neither of these sub-clauses applies to the applicant.  Nor does clause 14(C) which provides that a partner shall be entitled to retire on 30 June in any year on giving not less than 12 months notice in writing to the Policy Board, but the Board may in its decision permit a partner to retire on less than 12 months notice.  Clause 14(D) provides:

Notwithstanding the foregoing the Policy Board may in its discretion permit any Partner to retire on a date other than the 30 June.

Of further significance in the present case is clause 14(E) which provides:

A Partner retiring in terms of sub-clauses (A) and (B) of this Clause shall be, and a Partner retiring in terms of sub-clauses (C) and (D) of this Clause or being removed pursuant to Clause 15 of this Agreement may at the discretion of Policy Board be, entitle to participate in the partner Retirement Plan.

15.     If the partnership Policy Board, on the recommendation of the Chief Executive Officer, resolves that it is in the best interests of the partnership that a partner be removed from the partnership, upon notice in writing of such resolution being given to the partner concerned, he thereupon ceases to be a partner (clause 15(A)).  A resolution of the Policy Board that a partner be removed from the partnership is not valid or effective unless the subject partner has been given an opportunity at the meeting at which the resolution is passed of speaking on his own behalf, of producing such evidence as he considers appropriate and of being represented by another partner that he has nominate (clause 15(B)).  There has been no suggestion in this proceeding that the resolution of 17 July 1997 to remove the applicant from the partnership was invalid or ineffective for any reason associated with the provisions of clause 15.

16.     Clause 16 provides, inter alia, that a partner ceasing to be a partner, for whatever reason, shall sign a Deed of Covenant in a form set out in the Partnership Manual, and whether or not he signs such Deed, to be bound by its terms which restrict the former partner from using certain names associated with the partnership and also from soliciting business from any clients of the partnership which the former partner had serviced whilst an employee or partner of the partnership (clause 16(B)).

17.     Clause 17 provides, inter alia:

(A)Upon a Partner ceasing to be a Partner otherwise than upon his death he shall be entitled to be paid by the firm the following:

(i)the amount of his capital account as at the date of his ceasing to be a Partner;

(ii)his share of profits for the period from the end of the last completed year prior to the date of his ceasing to be a Partner up to such date; and

(iii)his share of other undrawn profits (if any).

(B)      …

(C)For the purpose of determining the amount payable in accordance with sub-clauses (A) and (B) of this Clause the balance sheet of the Firm as at the end of the last completed year and the profit and loss account for the current year shall be the basis of settlement between him or his legal personal representatives (as the case may be) and the remaining Partners.

(D)Any share of undrawn profits payable in accordance with sub-clauses (A) and (B) of this Clause shall be paid by the Firm at the time or times their shares of such undrawn profits are paid to the remaining Partners and pro rata with them.

(E)The amount of the capital account payable in accordance with sub-clause (A) of this Clause shall be paid by the Firm on the date of the Partner ceasing to be a Partner or the following day.

18.     Clause 21 deals with matters relating to claims for damages against the partnership or any one or more of the partners in relation to the conduct of the partnership business.  Of particular relevance is sub-clause 21(B) which is referred to in paragraph 6 of the settlement agreement.  The sub-clause provides:

(B)      Upon any Partner ceasing to be a Partner whether on retirement, death, removal or for any other reason the remaining Partners shall indemnify such former Partner and his legal personal representatives and shall keep him and them indemnified against liability for any amount which may be payable by the Partnership (in excess of any indemnity insurance actually recovered by the Partnership) in respect of any claim for damages for negligence or default PROVIDED that such indemnity by the remaining Partners shall not extend to any such liability in respect of work carried out by or on behalf of the Partnership up to the date on which such former Partner ceased to be a Partner and while he was a Partner and in respect of which a claim shall be made within two years after he shall have ceased to be a Partner.  In the event that the remaining Partners shall decide to settle any claim for damages for negligence or default without awaiting legal proceedings or the outcome of legal proceedings then such settlement shall be accepted by and be binding on such former Partner and his legal personal representatives.

19.     Each Partner is bound to adhere to and be bound by the terms and conditions of the Partners Manual (clause 24 (A)), section D.6 of which makes provision for a Partner Retirement Plan.  Partners who retire in accordance with the provisions of clause 14 (A) or (B) become entitled to a share of the income of the partnership in accordance with the detailed provisions of the retirement plan.  In the case of a partner who gives notice pursuant to clause 14(C) or is permitted to retire pursuant to clause 14(D) or is removed pursuant to clause 15, the Policy Board may in its discretion determine to offer the partner a lump sum and/or a share of income of such amount as the Policy Board may determine and/or such other consideration as it may think fit in consideration of the partner’s past services to the partnership (Partner Retirement Plan; clause 13).

THE SETTLEMENT

20.     It is appropriate to consider the settlement agreement in the context of the respective rights and obligations of the disputing parties and also of the claims made or foreshadowed.  It is not appropriate to take account of the process of negotiation engaged in during the mediation process nor any comments or advice that the mediator may have proffered during that process.

21.     Although the applicant was aware for sometime prior to 17 July 1997 that moves were underway to either secure his retirement or to have him removed from the partnership, it was not until the Policy Board resolved to remove him on 17 July 1997 that he had any specific basis for a claim against the partnership.  However, once the original resolution to remove him was passed he ceased to be a partner but nevertheless was entitled to payment of the various amounts referred to in clause 17(A) of the partnership agreement, notably:

i.the amount of his capital account as at the date of his ceasing to be a partner;

ii.his share of profits for the period from the end of the last completed year prior to the date of his ceasing to be a partner up to such date; and

iii.his share of other undrawn profits (if any).

These entitlements did not change by reason of the subsequent revocation of the Board’s resolution to remove the applicant and its agreement that he had retired as of 17 July 1997.  The Board’s acceptance of the applicant’s retirement was within the scope of its powers pursuant to clause 14(D).  Similarly, the Board’s discretion under the Partner Retirement Plan to offer the applicant a lump sum payment and/or share of income remained the same in the case of retirement pursuant to clause 14(D) as it had in the case of the applicant’s removal pursuant to clause 15.  To the extent that as a result of the settlement the applicant was to be regarded as having retired from the partnership rather than having been removed, he achieved at least one of his principal aims namely to protect his professional reputation.

22.     There does not appear to have been any dispute as to the applicant’s entitlement to receive payment of the two sums of $150,000 and $160,000 to which reference is made in paragraph 4 of the settlement agreement.  The applicant’s evidence was that the $160,000 had been contributed by him as a capital payment upon becoming a partner in Duesbury; and he said that following the amalgamation of Duesbury with Deloitte he was required to advance $150,000 to the firm by way of loan.  Subsequent correspondence from Deloitte in the period preceding the mediation suggests that he applicant’s capital account stood at $150,000.  There is no material before the Tribunal from which it can form a view as to the status of the earlier contribution to Duesbury.  The settlement agreement provides no assistance in this regard, rather it tends to confuse the issue.  As originally typed the final sentence of paragraph 4 reads:

WM directs the firm to pay the amount of $150,000 to the National Australia Bank and $160,000 to Westpac Banking Corporation as part of the return of his capital.

Prior to signature, this sentence was amended to read:

WM directs the firm to pay the amount of $150,000 or such amount as is owing to the National Australia Bank as part of the return of his capital and $160,000 to Westpac Banking Corporation.

No explanation has been forthcoming as to why, or at whose insistence, the sentence was amended but in its final form it suggests that only $150,000 of the settlement sum was intended as a return of capital. The respondent does not however claim that the $160,000 paid to Westpac is assessable as income.

23.     The settlement provided for the payment of a single sum for which it secured a release from the applicant of “all claims he has told the firm of through his solicitor and all claims arising from his ceasing to be a member of the firm”.  The payment of $500,000 was not the only consideration for the settlement.  Apart from the money, the partnership released the applicant from the restrictive covenants applied pursuant to clause 16 and also released him from any future liability under clause 21(B) relating to claims for damages for negligence or default.  Whilst the monetary value of the release from “all claims arising from (the applicant) ceasing to be a member of the firm” would be capable of quantification (although it was never precisely quantified) the same cannot be said of “all claims he has told the firm of through his solicitors”.

24.     In a memo dated 29 January 1997 Mr Bob Merrett, on behalf of Deloitte, made a without prejudice proposal to the applicant concerning his retirement from the partnership.  Although no retirement date had been agreed it was contemplated that for the purpose of the proposal it would be no later than 31 March 1997.  The details of the proposal are not presently relevant.  On 21 February 1997 Messrs Herbert Geer and Rundle, solicitors acting for the applicant, wrote to the Chief Executive Officer of Deloitte advising that the offer contained in the memo of 29 January 1997 was not acceptable to the applicant.  The letter proceeded to advance a counter‑offer, again on the basis that the applicant would leave the partnership on or before 31 March 1997.  The counter‑offer contemplated a payment to the applicant of a significantly greater sum than that outlined in the memo of 29 January 1997.  Deloitte’s solicitors, Blake Dawson Waldron, replied to the counter‑offer by letter to Herbert Geer and Rundle dated 26 March 1997 in which it is asserted that the counter‑offer “is extravagant and far outside the firm’s guidelines and beyond any reasonable range”.  On 24 June 1997 Blake Dawson Waldron wrote to Messrs Slater and Gordon, who were then acting as the applicant’s solicitors, making a further offer of a payment conditional on the applicant ceasing as a partner of the firm on 30 June 1997.  The offer was open for acceptance until 4pm on 27 June 1997.  The offer was not accepted.

25.     Apart from the without prejudice offer of settlement made on behalf of the applicant in Herbert Geer and Rundle’s letter of 21 February 1997, there is evidence of “claims (the applicant) has told the firm of through his solicitors” in the witness statement and oral testimony of Mr Mark Walter, a partner in Slater and Gordon.  At paragraph 4 of his witness statement, after referring to the mediation conducted on 8 and 9 December 1997 he said:

As part of that mediation process, a draft statement of claim was prepared on behalf of Mr McNally but not issued.  This statement of claim sought to set aside the resolution of the policy board of Deloitte and otherwise sought declarations that the actions of the policy board were unlawful and invalid and that Mr McNally should be entitled to be a partner of Deloitte.  The claim itself did not seek damages, but did seek the costs of seeking the relevant declarations from the Supreme Court of Victoria.

26.     The character of the settlement sum was determined by the contract the parties entered into at the time the settlement was negotiated.  It cannot be affected by any subsequent action taken by Deloitte in accounting for the payment in its books of account.  This was a case in which the applicant received what has been referred to in a number of judicial determinations as an “undissected” lump sum in settlement of a raft of claims, some contractual and capable of calculation and others of an unliquidated nature.  The principles upheld by the High Court in Allsop v Commission of Taxation (1965) 113 CLR 341 and later by the Full Court of the Federal Court in Commissioner of Taxation v CSR Ltd (2000) 104 FCR 44 are properly applicable in this case. In the CSR case the Court observed (at paragraphs 69,70) that:

…where, as here, there is an agreement between a payer and payee that is not a sham, the “how and why” of the receipt are determined by that agreement, and, in particular, by the nature of the consideration for which, according to the agreement, the money was paid.  In the present case, the conclusion cannot be avoided that the consideration was a release of causes of action some of which would have generated receipts of a non-income nature.

In CSR, as in Allsop, the agreed sum paid in settlement was treated as a payment of a capital nature.  The same applies in the present case.

27.     Consistent with established judicial authority, the Tribunal is of the view that no part of the settlement sum was taxable as income in the hands of the applicant and accordingly he was not in breach of his obligations under the income tax legislation by failing to return that sum or any part of it as income in his 1998 income tax return.  It follows that the applicant should not be subjected to any penalty by reason of the non‑disclosure of the settlement sum in his return.

THE OPENING TIMING DIFFERENCES

28.     The assessment of income tax issued by the respondent on 10 May 2004 included as part of the applicant’s taxable income the sum of $322,890 which was the same sum that had been allowed as a deduction as a “closing timing difference” in the applicant’s 1997 return.  There is no question that had the applicant remained a partner of the firm until 30 June 1998 this sum would have been included in his income tax return as income.  This had been the practice throughout the applicant’s membership of the partnership.  The question here is whether the applicant’s departure from the partnership provided a reason for not including the opening timing difference in his 1998 return.

29.     There appears to be no logical reason why the established practice in relation to timing differences, which the applicant had had the benefit of whilst a partner, should not be applied in relation to the final year of his tenure as a partner.  The issue is not one that had escaped attention in the lead up to the decision of 17 July 1998.  Deloitte’s memo to the applicant dated 29 January 1997 made reference to the timing differences.  It stated:

·Based on John Milne’s Tax Schedule you have accumulated Tax Timing Differences of :

WIP	$118,188
Prepayments	$  74,890
OER	$177,111
$370,189

As you are aware the Capital Reconstruction Proposal has a part of that crystallises part of the above Timing Differences as Permanent Difference.  I suggest that you do not participate in the total reconstruction proposal other than your sharing in the Permanent Differences.  This would result in the above being reduced by approximately $80,000.  However, following discussions with John Milne we can determine the precise amount.

I understand you do not require any assistance in planning the emergence of the above and in the ordinary course this will form part of your Taxable Income from 1996/97.

In their letter to Deloitte of 21 February 1997 Herbert Geer and Rundle said:

Mr McNally acknowledges that pension entitlements, tax timing differences and professional indemnity claims will all need to be addressed in more detail.

The question of taxation was also raised after conclusion of the settlement in the final paragraph of Deloitte’s letter of 24 December 1997 which is quoted in full in paragraph 7 of these reasons.

30.     There is no basis to support the proposition that the applicant’s departure from the partnership could in any way affect his tax liability in respect of the amount that had been claimed as a deduction for closing time differences in his 1997 return.  The settlement agreement makes no reference to tax liability and in particular it does not include any provision that the partnership would indemnify the applicant against any such liability.  Apart from agreeing to pay the settlement sum, the partnership’s one financial liability to the applicant was its agreement to release him from future liability under clause 21(B) of the partnership agreement which in effect amounted to an agreement to indemnify him against relevant claims for damages for negligence or default.

31.     The Tribunal is of the view that the amount claimed by the applicant in his 1997 income tax return as closing timing differences should have been returned as income in his 1998 return.

PENALTIES

32.     Having regard to the conclusions expressed in the foregoing paragraphs the Tribunal is of the view that the applicant understated his income for the year to 30 June 1998 by the amount of $322,890, being the opening timing differences (as explained earlier in these reasons) for that year, and as a result the applicant had a tax shortfall for that year.

33.     The relevant sections of the Income Tax Assessment Act1936 dealing with the imposition of penalty tax where there has been a tax shortfall are ss 226H and 226J, which provide:

226H.  Subject to this Part, if:

a)taxpayer has a tax shortfall for a year; and

b)the shortfall or part of it was caused by the recklessness of the taxpayer or of a registered tax agent with regard to the correct operation of the Act or the regulations;

the taxpayer is liable to pay, by way of penalty, additional tax equal to 50% of the amount of the shortfall or part.

226J.  Subject to this Part, if:

a)a taxpayer has a tax shortfall for a year; and

b)the shortfall or part of it was caused by the intentional disregard by the taxpayer or by a registered tax agent of the Act or the regulations;

the taxpayer is liable to pay, by way of penalty, additional tax equal to 75% of the amount of the shortfall or part. 

34.     It cannot be doubted that the applicant was aware that there were taxation implications associated with his departure from the partnership.  The issue was clearly raised in Deloitte’s memo to the applicant of 29 January 1997 and again in Herbert Geer and Rundle’s letter to Deloitte of 21 February 1997 both of which are referred to in paragraph 29.  These exchanges took place before the original resolution to remove the applicant from the partnership and of course well before the settlement was negotiated.  Finally, the matter was again referred to in Deloitte’s letter to the applicant of 24 December 1997 which is quoted in paragraph 7.  The applicant apparently chose not to respond to the final sentence of the letter of 24 December 1997, having apparently decided to have nothing further to do with the partnership.  He proceeded to deal with his income tax affairs on the basis of his conviction that the settlement resolved everything and that the settlement sum was not assessable for income tax purposes.

35.     Whilst the applicant’s view that he was under no obligation to include either the settlement sum or the opening timing differences as income in his 1998 return was an opinion genuinely held by him, there is no evidence to suggest that his view was ever endorsed by any competent professional opinion.  Given his professional standing as a practising chartered accountant, albeit not one who practised in the field of income tax, the Tribunal is of the view that his failure to seek other advice as to the matters in issue was reckless and that the consequential tax shortfall was caused by his recklessness.  There is however no basis upon which to conclude that the applicant acted with any dishonest intention or with an intentional disregard of the Act or regulations.

CONCLUSIONS

36.     The Tribunal has reached the following conclusions:

a)no part of the settlement sum is assessable as income in the taxation year ending 30 June 1998;

b)the sum of $322,890 being the sum returned in the applicant’s 1997 income tax return as “closing timing differences” should have been included as income in his 1998 return; and

c)any tax shortfall caused by the applicant’s failure to include the opening timing differences as income in his 1998 return was caused by the applicant’s recklessness with regard to the correct operation of the Act and regulations but was not caused by an intentional disregard of the same.

DECISION

37.     The decision of the Tribunal is that the decision under review be set aside and that the matter be remitted to the decision maker for reconsideration in accordance with the Tribunal’s findings and conclusions as expressed in its reasons for decision.

I certify that the thirty‑seven [37] preceding paragraphs are a true copy of the reasons for the decision herein of

The Hon Howard Olney AM QC, Deputy President

(sgd)     Olympia Sarrinikolaou

Clerk

Dates of Hearing:  16 May 2006

Date of Decision:  22 June 2006
Advocate for the applicant:        Mr C. Wookey (Chartered Accountant)

Counsel for the respondent:       Mr P. Sest

Solicitor for respondent:            Australian Government Solicitor