The Taxpayer and Commissioner of Taxation

[2009] AATA 906

Administrative Appeals Tribunal

DECISION AND REASONS FOR DECISION [2009] AATA 906

ADMINISTRATIVE APPEALS TRIBUNAL      )

)          No 2008/3027-30

TAXATION APPEALS DIVISION		)
Re		THE TAXPAYER

Applicant

And COMMISSIONER OF TAXATION

Respondent

DECISION

Tribunal Senior Member Bernard J McCabe

Date25 November 2009

PlaceBrisbane

Decision Pursuant to s 42D of the Administrative Appeals Tribunal Act 1975, the Tribunal remits the objection decision under review to the respondent for reconsideration within 90 days in accordance with the written reasons.

......................[Sgd]........................

Senior Member

CATCHWORDS

TAXATION – Income Tax – assessable income – whether income of personal services entity is personal services income – personal services income – whether personal services entity conducting personal services business – personal services entity not conducting personal services business – objection decision affirmed

TAXATION – Income tax – allowable deductions – whether deductions can be claimed for personal services income – remitted for reconsideration

TAXATION – Administrative penalties – penalties for statements – whether there was a shortfall – whether shortfall resulted from false or misleading statement – statement reckless – question of shortfall remitted for reconsideration

Income Tax Assessment Act 1997 (Cth) ss 84-5(1), 86-15(1), 86-15(2), 87-15(3)

Taxation Administration Act 1953 (Cth) ss 14ZZK(a), 284-75 in Sch 1, 284-90 in Sch 1

REASONS FOR DECISION

25 November 2009 Senior Member Bernard J McCabe         

1.      This case turns on the interpretation of the provisions in the Income Tax Assessment Act 1997 (“the Act”) that deal with the tax treatment of personal services income. The Commissioner of Taxation says income received by a company controlled by the taxpayer during the 2003, 2004 and 2005 years of income is really personal services income that should be assessable in the hands of the taxpayer. The Commissioner has issued an amended assessment and imposed a penalty on the basis that the taxpayer was reckless. The taxpayer asked the Tribunal to reconsider the decision.

2. The taxpayer sought leave at the outset of the hearing to amend the grounds of his objection pursuant to s 14ZZK(a) of the Taxation Administration Act 1953
(“the TA Act”). His representative, Mr O’Brien, asked the Tribunal to consider a range of other deductions that might be available to the taxpayer. Mr Aftanas, for the Commissioner, did not object to the amendment. I agreed the taxpayer would be permitted to deal with those other matters provided he was able to supply evidence to support his contentions.

3. The objection decision should be remitted to the Commissioner for the purposes of reconsideration pursuant to s 42D of the Administrative Appeals Tribunal Act 1975 (“the AAT Act”). I will explain my reasons and the terms of the remittal below.

The facts

4.      The taxpayer is an horticulturist. He provides advice to businesses that cultivate crops of trees. He provides that advice through the medium of a company that I will refer to as “Farmco”. The taxpayer is a director of Farmco along with his wife. He is its primary shareholder. Farmco has entered into a consulting relationship with a commercial enterprise that manages tree crops as part of an investment scheme. I will call that company “Treeco”.

5.      

The consulting agreement between Farmco and Treeco was signed on

1 March 2001. I was provided with a copy of the agreement: Exhibit 1 at 89ff. The taxpayer explained in his evidence that the agreement between the two companies replaced an earlier agreement that he had entered into with Treeco in his own name.

6.      The 2001 agreement between Farmco and Treeco described the services to be supplied by Farmco. These included:

1.    Identify and review suitable land for growing Paulownia as and when required.

2.    Continually monitor farm management practices to ensure best practice methods are always being employed.

3.    Document procedures including

(a) Field Records

(b) Position Descriptions

(c) Property Staff Manual

4.    Review and monitor staffing requirements on all properties.

5.    Review and monitor the capability and suitability of permanent staff recommending suitable staff training, both in-house and external where appropriate.

6.    Review and monitor equipment levels and efficiencies including the irrigation systems.

7.    Implement Work Place and Health and Safety practices on all properties.

8.    Monitor expenditure levels on all properties.

9.    Regularly liaise with Property Managers and their staff.

10.  Conduct Property Managers meetings on a regular basis (minimum every 1-2 months), co-ordinating all reporting requirements to the Board of Directors.

11.  Reporting to the Board of Directors.

7.      The agreement also set out the remuneration arrangements. The “consultancy fee” was described as “$50.00 per hour (plus GST)”, although it included a limit on the number of hours to be worked each month. The agreement noted that Treeco would provide a car, a laptop computer and meet the taxpayer’s reasonable expenses for travel and other costs that might arise out of the performance of his duties under the agreement.

8.      The body of the agreement also incorporated a termination clause. Amongst other things, the clause provided for termination of the consultancy arrangement if the taxpayer ceased to be involved in Farmco or did not take an active role in the provision of the services under the agreement to Treeco.

9.      The agreement was renewed in 2004. The terms were unchanged, although the rate of remuneration was increased.

10.     I was provided with copies of Treeco’s annual reports. They showed substantial amounts were paid to consultants in each of the years under review. There does not appear to be any dispute that those amounts were paid to Farmco. Farmco’s annual returns record consultancy income in each year of income that exceeds by a small amount the amounts that were paid by Treeco under the terms of the consultancy agreement. The financial statements were tendered in evidence: Exhibits 4.1, 4.2 and 4.3. The respondent distilled those figures into a table that it included in written submissions. I am satisfied a comparison of the figures in the various documents confirms Farmco earned:

·91% of its consultancy income from Treeco in the year ended 30 June 2003;

·99.2% of its consultancy income from Treeco in the year ended 30 June 2004; and

·97.3% of its consultancy income from Treeco in the year ended 30 June 2005. 

11.     There was some evidence that the taxpayer was also engaged to provide consulting services to another company when the contract with Treeco was signed. The 2001 contract with Treeco refers to the arrangement with the other company. In the course of his evidence, the taxpayer explained that the other company was associated with one of the principal shareholders in Treeco. That individual left Treeco shortly after the contract with Farmco was signed. The taxpayer said he was under pressure from the new management of Treeco to reduce his involvement with the other company. It appears he did so in short order. I am not aware of any evidence of substantial payments to Farmco that would make any difference to my analysis.

12.     The taxpayer says Farmco did derive other income in the years under review. In particular, it cultivated a crop of macadamia trees at a farm in Rosebank. It engaged labourers and independent contractors and incurred other expenses in connection with that work. The taxpayer himself was never engaged as an employee of Farmco, and he was never paid wages. He received some payments that were described as director’s fees. Treeco was the only substantial consulting client. The taxpayer was the only individual from Farmco who had any involvement with Treeco under the terms of the agreement. He did all of the consulting work himself. That is not surprising: the taxpayer apparently had a good reputation in the industry. He had extensive experience. It makes sense that Treeco should want his input. Over time, it appears he became so valuable to Treeco’s business that he was appointed a director of Treeco.

13.     Treeco sought the taxpayer’s advice in relation to a number of different aspects of its business. He had to travel to the various farming operations managed by Treeco in New South Wales and Queensland. He was also asked to inspect properties the company was considering acquiring. He took soil samples and appraised the suitability of those properties for cultivation. He inspected existing operations and discussed operational matters with personnel involved in the management of plantations. He wrote manuals and prepared regular reports. He was not required to provide his own equipment and his expenses in relation to these activities were all paid by Treeco.

14.     Mr O’Brien, for the taxpayer, argued the taxpayer was effectively dealing with Treeco’s investors. Treeco used the taxpayer’s input as part of its larger business of managing the cultivation and harvest of commercial tree crops for a range of investors. As its annual report makes clear, Treeco was effectively a promoter of an investment scheme. I do not accept there is any evidence that Farmco was dealing directly with Treeco’s investors directly. The contractual documents make it clear that Treeco engaged Farmco. None of the evidence I heard from the taxpayer persuaded me that the documents did not accurately describe the relationship.

The legislation

15.     Part 2-42 of the Act deals with taxpayers who alienate or divert income to a company where that income is derived from the provision of personal services by the taxpayer. Section 86-15(1) of the Act is the key provision. It says:

Your assessable income includes an amount of *ordinary income or *statutory income of a *personal services entity that is your *personal services income.

16.     

There is an exception to the rule in subsection (1) for income that is derived from a “personal services entity” that conducts a “personal services business”:

s 86-15(3) of the Act.

17.In order to decide this case, I must determine:

·Is the remuneration received from Treeco under the consulting agreement the “personal services income” of the taxpayer?

·Is Farmco a “personal services entity”?

·If Farmco is a “personal services entity”, is it also a “personal services business” within the meaning of the Act? 

Is the remuneration received from treeco “personal services income”?

18.     The definition of “personal services income” is found at s 84-5(1) of the Act. The section says the income of an entity like Farmco will be regarded as assessable income in the hands of an individual “if the income is mainly a reward for your personal efforts or skills (or would mainly be such a reward if it was your income).” Section 84-5(1) goes on to provide several examples that are intended to illustrate the distinction. Example one is apposite. It reads:

NewIT Pty. Ltd. provides computer programming services, but Ron does all the work involved in providing those services. Ron uses the clients' equipment and software to do the work. NewIT's ordinary income from providing the services is Ron's personal services income because it is a reward for his personal efforts or skills.

19.     In this case, the consulting contract provides for remuneration on an hourly basis. Treeco provides all of the equipment required to do the job. The taxpayer was the only individual involved in the provision of the services, and there is clear evidence in the contract that Treeco regarded the taxpayer’s personal attention as an integral part of the transaction. I note the taxpayer had previously provided essentially the same services in his personal capacity. When asked in cross-examination why the corporate entity was introduced into the relationship in 2001, he was unable to offer a clear explanation. It is true that the contract required Farmco to produce some tangible products under the agreement, like manuals, but that does not change the substance of the agreement. Farmco was making money by supplying the taxpayer’s skill, advice and effort under a consulting agreement with Treeco. I am satisfied in the circumstances that the consulting fees paid to Farmco under the agreement constituted personal services income within the meaning of the Act.

Is farmco a “personal services entity”?

20.Section 86-15(2) of the Act provides:

A personal services entity is a company, partnership or trust whose *ordinary income or *statutory income includes the *personal services income of one or more individuals. (Emphasis in original.)

21.     Farmco is a company. Its income includes what I have already concluded is personal services income of the taxpayer. I am satisfied it is a personal services entity.

Is farmco a “personal services business”?

22.     The taxpayer claims Farmco was carrying on a “personal services business”. If he is right, the income derived under the consulting arrangement is not assessable income in the taxpayer’s hands.

23.     The applicable tests are found in s 87-15 of the Act and its associated provisions. The operation and interaction of those provisions is described helpfully in a diagram in s 87-5 of the Act.

24.     In this case, the Commissioner asserts there is no record of a “personal services business determination” in relation to Farmco or the taxpayer. Although there appeared to be some dispute over this in the correspondence passing between the parties, Mr O’Brien accepted at the hearing that there was no determination in force. I was not asked to consider whether a determination should be made.

25.     In the absence of a determination, I must consider the so-called “results test”. That test is referred to in s 87-15(2)(a) of the Act. The test applicable in this case is set out in s 87-18(3) of the Act, which provides:

A *personal services entity meets the results test in an income year if, in relation to at least 75% of the *personal services income of one or more individuals that is included in the personal services entity's *ordinary income or *statutory income during the income year:

(a)the income is for producing a result; and

(b)the personal services entity is required to supply the *plant and equipment, or tools of trade, needed to perform the work from which the personal services entity produces the result; and

(c)the personal services entity is, or would be, liable for the cost of rectifying any defect in the work performed.

26.      

I do not think Farmco can meet this test. I have already found that Farmco was not required to provide the plant, equipment or other tools of trade needed to perform the work contemplated under the terms of the consulting agreement.

Mr O’Brien argued that Farmco was in fact required to provide equipment in the form of a car and a laptop, but his client had the foresight to include a term in the consulting contract which shifted the obligation to Treeco. I do not accept that argument. The consulting contract defines the obligations which arise in the relationship. The contract allocates the obligation for providing plant and equipment to Treeco. I do not think one can look behind that set of obligations and speculate on what might have been if the contract had been negotiated differently.

27.     Given my conclusion in relation to the obligation to supply plant and equipment, I do not need to consider the other limbs of the test in s 87-18(3) of the Act. The next question I must answer arises under s 87-15(3) of the Act. That provision requires that I consider whether “80% or more of an individual's *personal services income … during an income year is income from the same entity…”.

28.     I am satisfied Farmco and the taxpayer are unable to satisfy the so-called “80% test” given the findings of fact I made in paragraph [10] of these reasons. In those circumstances, I accept the Commissioner’s central claim: the consulting income paid by Treeco to Farmco should be regarded as assessable income in the hands of the taxpayer.

Other matters

29.     At the outset of the hearing, the taxpayer indicated he would like the opportunity to make submissions about deductions that might be available to reduce the amount of his personal services income in the event that his central argument was not accepted by the Tribunal. He also sought leave (which I granted) to expand the scope of his objection to put other claims for deduction in issue. I indicated to the parties that I would remit those matters to the Commissioner for consideration.

Penalties

30.     

That leaves the question of penalties. I asked the parties at the hearing whether it would be appropriate to reach a view about penalties if I decided against the taxpayer on the central issue but decided to remit other matters to the Commissioner for reconsideration. Mr O’Brien did not express a preference, but

Mr Aftanas said it was appropriate and convenient to deal with the question of penalties now as my decision (a) depended on the applicant’s conduct in making a claim that could not be sustained by reason of the operation of Pt 2-42 of the Act, and (b) would only impact on the rate at which the penalty was imposed. The fact that the quantum of the penalty might be reduced if the applicant was able to identify offsetting deductions is irrelevant.

31.Section 284-75 in Sch 1 to the TA Act provides:

(1)  You are liable to an administrative penalty if:

(a)   you or your agent makes a statement to the Commissioner or to an entity that is exercising powers or performing functions under a *taxation law; and

(b)   the statement is false or misleading in a material particular, whether because of things in it or omitted from it; and

(c)   you have a *shortfall amount as a result of the statement.

32. If the taxpayer in a given case meets the tests set out in s 284-75, the criteria for determining the appropriate rate of penalty are set out in s 284-90 of the TA Act.

33. Regrettably, I do not think I am in a position to finalise the question of penalties until after the Commissioner has considered the other matters which I have proposed to remit to him pursuant to s 42D of the AAT Act. Those matters may well affect the amount of the shortfall. Theoretically, at least, the amount of the shortfall might be reduced to nil. I cannot be satisfied at this point that there is “a shortfall amount as a result of the [false or misleading] statement”. Even so, on the assumption that a shortfall amount will be found to exist, it is convenient for me to deal with the balance of the issues now.

34.     Section 284-90 of the TA Act says a taxpayer is liable to a penalty equal to 25% of the amount of the shortfall if the “shortfall amount or part of it resulted from a failure by [the taxpayer or his] agent to take reasonable care to comply with a taxation law”. A higher penalty of 50% is imposed where the shortfall amount “resulted from recklessness by [the taxpayer or his] agent as to the operation of a taxation law”. Where the shortfall results from intentional disregard of the law, the penalty is assessed at 75% of the amount of the shortfall. The Commissioner says the taxpayer in this case was reckless.

35.     Taxation Ruling TR 94/4 defines recklessness as gross carelessness. I agree with that approach (although I note that Ruling has since been withdrawn). A taxpayer behaves recklessly if it should have been obvious to him (or to his agent) that his claim could not succeed given the clear state of the law.

36.     I am satisfied there was recklessness in this case. The law is clear. The concepts in issue are not especially complicated. The facts were straight-forward. The argument which lay beneath the taxpayer’s misleading statements to the Commissioner was obviously devoid of merit. The penalty was properly assessed at 50% of the shortfall.

37.     I was not referred to any evidence or arguments that would justify me exercising the discretion to remit any part of the penalty.

Conclusion

38. The objection decision should be remitted to the Commissioner for further consideration pursuant to s 42D of the AAT Act. That consideration should proceed on the basis of my finding that the taxpayer should have included personal services income in his assessable income in the years of income under review. The Commissioner should consider whether other deductions are available to the taxpayer and determine if there is a shortfall amount that would trigger the imposition of a penalty. If there is a shortfall amount, the decision to impose a penalty should take into account my finding that there was recklessness on the part of the taxpayer or his agent that would justify imposition of the penalty at the rate of 50%.

I certify that the 38 preceding paragraphs are a true copy of the reasons for the decision herein of Senior Member Bernard J McCabe.

Signed:.................................[Sgd].............................................
  Michael Buckingham, Associate

Dates of Hearing  17 November 2009
Date of Decision  25 November 2009
Advocate for the applicant        Mr D O'Brien
Solicitor for the applicant          Unrepresented    
Advocate for the respondent     Mr S Aftanas
Solicitor for the respondent      ATO Legal Services Branch