The Taxpayer and Commissioner of Taxation

[2005] AATA 949

Administrative

Appeals

Tribunal

 

DECISION AND REASONS FOR DECISION [2005] AATA 949

ADMINISTRATIVE APPEALS TRIBUNAL      )

)          QT2003/81

TAXATION APPEALS  DIVISION		)         QT2003/189-192
Re		The Taxpayer

Applicant

And COMMISSIONER OF TAXATION

Respondent

DECISION

Tribunal Deputy President Don Muller

Date29 September 2005 

PlaceBrisbane

Decision

The Tribunal:

1.  Sets aside the objection decisions in relation to the income tax years ending 30 June 1996 and 30 June 1997;
2.  Affirms the objection decisions for the income tax years ending 30 June 1998, 30 June 1999 and 30 June 2000, including the understatement penalty rate of 50%. 

................SIGNED..............................

D.W. MULLER

DEPUTY PRESIDENT

CATCHWORDS

TAXATION – attempt to take advantage of Division 10B by series of sham transactions – decisions to disallow claimed deductions affirmed – penalty affirmed

Income Tax Assessment Act 1936: Division 10B, ss 124K, 124L, 124M, 124R, 226G, 226H, 226J, 227(3)

Income Tax Assessment Act 1997:  Division 373 

REASONS FOR DECISION

Deputy President Don Muller        

1.This review relates to objection decisions covering income tax years ending 30 June 1996, 30 June 1997, 30 June 1998, 30 June 1999 and 30 June 2000.  In each of the first four tax years the Taxpayer Company (TC) claimed as a deduction an amount of $71,429 representing amortisation of $1M, claimed to be the value of its share in a patent.  In the tax year ending 30 June 2000, TC claimed $714,284 as being the residual value after the prior four deductions of $71,429 each.  (4 x $71,429 + $714,284 = $1M).

2.The claims for deductions were rejected on the grounds that the true value of the patent to TC was significantly less than $1M, among other grounds.

3.At the hearing TC was represented by the principal (Mr. P) of an accounting firm who was also the Director and sole shareholder of TC.  The Respondent was represented by Mr. Hack, SC.

4.TC in common with many other applicants for review at the Administrative Appeals Tribunal was a participant in an arrangement, devised and promoted by Mr. P that sought to take advantage of Division 10B of the Income Tax Assessment Act 1936 (the 1936 Act) and, with effect from the 1999 income year, Division 373 of the Income Tax Assessment Act 1997 (the 1997 Act).  Broadly, those provisions permit accelerated deduction of capital expenditure on industrial property.

5.It is not necessary for present purposes to consider separately Division 373 of the 1997 Act, the elements of that Division being relevantly identical to those that operate in Division 10B of the 1936 Act.

6.The operative part of Division 10B is s.124M. It permits the owner of a “unit of industrial property to which this Division applies” to deduct annually an amount based upon the amortised value of the property.  The term “unit of industrial property” is defined by s.124K(1) as meaning, relevantly,

“(a)     rights possessed by a person under a law of Australia as:

(i)        the grantee or proprietor of a patent for an invention

….

(iv)      a licensee under such a patent

….

and includes equitable rights in respect of such a patent … or in respect of a licence under such a patent.”

The Division applies, relevantly, by virtue of s.124L(1)(b) to the owner of a unit of industrial property who “incurred expenditure of a capital nature on the purchase of the unit of industrial property”.

7.It is important, in the context of this case, to note s.124R which governs the manner in which the cost to the owner of the unit of industrial property is to be determined.  Sub-section 124R(1)(b) has the effect that whilst, ordinarily, the cost is the expenditure referred to in s.124L(1)(b), that does not apply in the circumstances set out in s.124R(3).  That sub-section provides:

“(3)     Where, in the case of an owner referred to in paragraph 124L(1)(b):

(a)the Commissioner is satisfied, having regard to any connection between the owner and the person from whom the unit of industrial property concerned was purchased or to any other relevant circumstances, that the owner and that person were not dealing with each other at arm’s length in relation to the purchase;  and

(b)the expenditure of a capital nature incurred by the owner on the purchase of the unit of industrial property:

(i)exceeds the amount that was the cost of the unit to the last preceding owner of the unit;  or

(ii)does not exceed the amount that was the cost of the unit to the last preceding owner of the unit but exceeds the value of the unit at the time of the purchase;

the cost of the unit to the owner for the purposes of this Division shall be taken to be the cost of the unit to the last preceding owner of the unit or the value of the unit at the time of the purchase, which ever is the less.”

8.The background and steps in the arrangement devised by Mr. P were as follows:

(i)In about 1988, an inventor, DLF, invented a “reversible drill” for use in the mining and oil industry.  He, or one of his companies, was issued with a patent on 10 April 1991 for a term of 16 years commencing on 31 October 1988.  However, he was having trouble exploiting his invention commercially.

(ii)In the early 1990s Mr. P came into contact with DLF, who was seeking to raise funds to manufacture and market his invention.

(iii)DLF estimated that he needed about $600,000 to begin to manufacture and market his invention.

(iv)Mr. P devised an arrangement whereby DLF could sell his patent to investors, with the option of later buying the patent back from the investors.

(v)The interest in DLF’s patent was divided into 32 parts, each worth 1/32 of the total value of the patent.

(vi)TC paid $63,000 to a DLF company for two of the 1/32 parts of DLF’s patent.  That is, $63,000 for 1/16 of the total value of the patent

(vii)Five of Mr. P’s employed accountants were each given a “bonus” by Mr. P of a 1/5 share in one of the 1/32 shares in the patent.

(viii)The balance of the twenty-nine 1/32 shares were apparently sold by Mr. P to investors for $27,500 each.  That is, for a total of about $800,000.

(ix)Mr. P paid about $600,000 to DLF.

(x)The transfer of the shares in the patent from DLF’s company to the investors was claimed to have been done by means of a number of complicated transactions from company to company and eventually to the investors.

(xi)During the course of the transactions Mr. P divided the interest in the patent into 16 million shares and he assigned a total value of $16M to the patent.  That is, each share was “worth” $1.  Each of the original 1/32 shares in the total value of the patent had a new “value”  of $500,000.

(xii)Each investor who had bought a 1/32 share in the patent for $27,500 became the proud owner of 1/32 of a patent said to be worth $16M.  That is, $500,000 each.

(xiii)TC claimed to have a share in the patent worth $1M (1/16 of the total).

(xiv)Each of the accountant employees of Mr. P claimed to have a share worth 1/5 of $500,000.  That is, $100,000 each.

(xv)There was also a final contract in which each investor agreed to sell the 1/32 share, “worth” $500,000, back to DLF at any time within four years for $27,500 and thereafter for a slightly higher price.

9.The attraction of the arrangement from the point of view of the investors was that for a one-off outlay of $27,500 they each claimed a deduction of about $38,500 per year which they intended to continue to do for over ten years, representing annual amortisation of the $500,000.

10.The attraction for DLF was that he received $600,000 to manufacture his invention and he could buy it back any time he liked for, or near, the original price of $27,500 per share.

11.TC claimed amortisation in the following amounts:

For the tax year ended 30 June 1996     $ 71,429

For the tax year ended 30 June 1997     $ 71,429

For the tax year ended 30 June 1998     $ 71,429

For the tax year ended 30 June 1999     $ 71,429

For the tax year ended 30 June 2000     $714,284

Total deductions claimed  $1,000,000

12.At least three of the employees of Mr. P claimed amortisation in the following amounts:

For the tax year ended 30 June 1997     $ 7,692

For the tax year ended 30 June 1998     $ 7,692

For the tax year ended 30 June 1999     $ 7,692

For the tax year ended 30 June 2000     $76,923

Total deduction claimed  $99,999

13.One of the employees claimed $76,904 for the tax year ending 30 June 2000, making his total claim for amortisation over the four years $99,980.

14.The claims for deductions for the years 1996, 1997, 1998, 1999 and 2000 were eventually investigated and disallowed.  An understatement penalty of 50% was initially imposed on TC and the other investors, which was later reduced to 40% in the case of the accountant employees and to 10% for the investor clients of Mr. P.

15.In the latter half of 2004, the Tribunal heard “test cases” in relation to four of Mr. P’s client investors.  The Tribunal heard evidence over six days.

16.The evidence proved to my satisfaction the following:

(i)The contracts by which ownership of the patent was to pass from DLF to the investors were couched in legal terms and dressed up to look like legal documents.  However, they in fact failed to transfer ownership, or part ownership, of the patent to any of the investors.

(ii)Apart from the $27,500 paid by each of Mr. P’s clients, no investor incurred any expenditure in the course of this exercise.  It was unclear as to whether Mr. P. or TC actually paid $63,000 or not.  They certainly did not incur expenditure in the amounts claimed, such as $100,000, $500,000 or $1M as the case may be.

(iii)The employees of Mr. P. who were involved in this arrangement claimed that they had each incurred a debt of $100,000 to a company which loaned each of them $100,000.  However, the company was a creation of Mr. P.  It had no funds and it forgave the debts.

(iv)None of the so-called contracts for transfer of ownership were done at arm’s length.  Every transaction and every document was prepared by Mr. P.

(v)The valuation of $16M for the patent, between 1996 and 2000, was absurdly high.  If the project had eventually been successful, perhaps the value of the patent could have reached that figure.  The evidence given to the Tribunal was to the effect that DLF had refused substantial offers for the patent in 1991/92 but by 1996 he would have parted with it for $1M.  Eventually it became worthless.

17.At the end of the six days of evidence, Mr. Hack provided the Tribunal with extensive submissions which covered, among other things, the matters mentioned in paragraph 16 above.

18.When Mr. P was called upon to respond to Mr. Hack’s submissions, he conceded that the transactions had been a sham.

19.The substantive decisions to disallow the claimed deductions are not now in issue.  TC seeks review of the Commissioner’s decision to impose a penalty at the rate of 50%.

20.The amended assessments the subject of each application for the years ended 30 June 1996 and 30 June 1997, were made later than the four years in which amendments are permissible in the terms of subsection 170(2) of the Income Tax Assessment Act 1936.

21.Consequently, the Commissioner does not contest the applications in relation to the 1996 and 1997 years.  The decisions under review in relation to 1996 and 1997 will be set aside.

22.The Commissioner is not seeking to increase the rate of penalty in relation to this application by TC.

23.Mr. P has submitted on behalf of TC and his accountant employees that the penalty should be reduced to zero, or at the very least reduced to the 10% imposed on his client investors.  He submitted that:

(i)On 26 February 1997, Mr. P applied for a Private Binding Ruling on behalf of one of his client investors.  The Commissioner declined to give a PBR and therefore TC and the accountant employees should not have to pay a penalty.

(ii)Mr. P acted on advice from an officer of the Australian Taxation Office, Allan O’Neill, given in May 1997.  Accordingly, Mr. P acted on the spoken advice from Mr. O’Neill and consequently no penalty should be payable.

(iii)Mr. P acted on the advice of a senior counsel with expertise in tax matters.

(iv)There is a discretion to remit the penalty under s.227(3) of the Income Tax Assessment Act 1936.

24.I have read the advice given by the senior counsel to Mr. P but I have not been furnished with the instructions that were given to the senior counsel before he prepared the advice.  The advice, dated 26 February 1997, contains the following:

“I have been asked to review a proposal to be forwarded to the Australian Taxation Office in respect of a finance funding arrangement deriving from Querist’s attempt to raise funds to develop and promote an automatic reverse drilling and flushing adapter.  I am asked to look at the documentation and express an opinion as to the sustainability of it, with particular reference to Part IVA of the Income Tax Assessment Act and my brief is so limited.

It is presumed that any taxpayer who is prepared to invest $30,000.00 odd in what is a highly speculative investment, has available investment funds of that magnitude which they would otherwise be looking to invest in some other format, if not this particular investment.

While the investment is in one sense highly speculative, in the sense that many of these types of research and development projects never get off the ground, there would seem to be some optimism that the underlying invention at the base of this company’s promotion, has the potential to reap enormous financial rewards.  As such, there is clearly a commercially justifiable reason why anybody with the available funds may be prepared to invest them in this type of venture which, while being undoubtedly high risk, has the potential to be enormously productive of high return.

Quite simply, the dominant purpose of this tax payer who is minded to invest in this proposal, is a commercial inclination to invest a certain amount of money in the most beneficial way.

There is no doubt the particular investor covered in the proposal will derive a tax benefit as defined in Part IVA, but as the proposal correctly points out, compared to the tax benefits that could be derived from the negatively geared share plan, the tax benefit component in the current financial year would be less than under the negatively geared share investment plan.  When so seen as an alternative form of investment, it is perhaps correct to suggest as the proposal does, that there is no tax benefit in entering this scheme, if it be a scheme at all, for Part IVA.  Even if that were a wrong assumption, it is clear the reason one would prefer this investment to the negatively geared share plan is the prospect of a rich reward if the invention is successful and that of itself would suggest that the dominant purpose of entering this scheme is the prospective commercial benefit, not the tax benefit.

I have carefully reviewed the consideration of the eight statutory matters as canvassed in the proposal and in general terms have no difficulty with the considerations as set out in the proposal.  It is clear objectively viewed and when properly viewed within the statutory considerations, that this is not a proposal of the type which Part IVA was designed to prevent.”

25.I do not disagree with senior counsel’s advice that an investor who invests $30,000 in a speculative venture which has the potential to reap rich rewards, albeit with the possibility that eventually any loss may be mitigated by tax deductions, would not be participating in a scheme for the purposes of Part IVA of the Act.  However, senior counsel’s advice does not give the green light to an arrangement whereby sham transactions/transfers take place, nor to inflating the value of the investment, nor to claiming deductions of tens of thousands of dollars over five years or more, for an outlay of between zero and $30,000.

26.Mr P can take no comfort in this review from the fact that he obtained advice from counsel about a hypothetical situation which did not fully equate to the facts of this case.

27.As to the matter of the private Binding Ruling, Mr. P received this letter from Mr. O’Neill of the ATO.

“(1)  It is the opinion of the Commissioner that the nature of the request, and the information supplied, does not qualify as a Private Binding Ruling Request but rather, is considered to be a request for an ‘advance opinion’.  The reason why is that the request itself refers to a number of arrangements in general, and not to a specific taxpayer.

(2)  The evidence supplied does not support a valuation of $16million for the patent.  It is the decision of the Commissioner that in order to ensure compliance with the relevant legislation prescribed in the Income Tax Assessment Act 1936 (ITAA) that it will be necessary for an independent valuation to be obtained.  The arrangements for which will be put in place in the near future.

(3)  The Commissioner is unable to state categorically if Part IVA is applicable, or not, on the basis of the information supplied.

(4)  After reviewing all the relevant information, it is considered that further audit action is warranted.  This will be conducted by the SBI Audit Section, who will inform you of their requirements with respect to any audit activity.”

28.There is nothing in the above letter that could possibly be said to have encouraged Mr. P to go ahead with the arrangement.

29.One of the accountant employees of Mr. P gave evidence that in the course of a meeting between Mr. P and Mr. O’Neill, held in Mr. P’s office, he overheard Mr. P and Mr. O’Neill shouting at each other.  He said it was well known in the office that Mr. P and Mr. O’Neill had not reached an agreement about the acceptability of Mr. P’s arrangement.

30.In my view, this arrangement orchestrated by Mr. P was not a “scheme” within the meaning of that term in Part IVA of the Act.  This was not a case of tax avoidance by the minimisation of tax through legal means, although artificial and contrived and having no rationale other than obtaining a tax benefit.  This arrangement sought to evade tax by using the grossly inflated value of the patent, by claiming for expenditure which was never incurred and by claiming rights to the patent which they did not have, by means of sham transactions.

31.The relevant penalty provisions are contained in the 1936 Act and are:

·S.226G “lack of reasonable care” imposes a penalty of 25%;

·S.226H “recklessness” imposes a penalty of 50%

·S.226J “intentional disregard of the law” imposes a penalty of 75%

·S.227(3), discretion to remit the whole or part of the additional tax payable.

32.Mr. P and his employees were all accountants.  They must have known that:

·Even if they had legitimately acquired the intellectual property it could not possibly have had the value attributed to it.

·They could not possibly have been the owner of a unit of industrial property to which Division 10B applied because none of them ever incurred expenditure of a capital nature on the purchase.

33.I believe that a finding that Mr. P and his accountant employees acted with intentional disregard of the law would be reasonable.  However, the Commissioner has not sought to take the matter any further than to suggest “recklessness” and has also given the employed accountants a reduction from 50% to 40%.

34.In my view they are most fortunate to have been treated so leniently.

35.The objection decisions in relation to tax years ending 30 June 1998, 30 June 1999 and 30 June 2000 including the understatement penalty rates, are affirmed.

I certify that the 35 preceding paragraphs are a true copy of the reasons for the decision herein of Deputy President Don Muller

Signed:         .....................................................................................
           R. Link, Associate

Date/s of Hearing  26, 27 April 2005 
Date of Decision  29 September 2005
Applicant  Mr. P
Counsel for the Respondent     Mr. Hack