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CASE 1/2010

Members:
B Tamberlin QC DP
SE Frost SM

Tribunal:
Administrative Appeals Tribunal, Sydney

MEDIA NEUTRAL CITATION: [2010] AATA 78

Decision date: 3 February 2010

B Tamberlin QC, SE Frost (Deputy President, Senior Member)

1. These reasons concern Notices of Objection brought by Mr Holmes against amended assessments in respect of income years dated 30 June 1999 to 30 June 2003 and by Waffles Pty Ltd (Waffles) in respect of the disallowance of objections against notices of amended assessments for the same years. For the purpose of these reasons and to preserve confidentiality, certain details have been changed and in some cases names have been replaced with pseudonyms.

The issues

2. The issues raised for determination in these applications are:

  • (a) Whether the entirety of payments made pursuant to an agreement Trader Pty Ltd (Trader) had with Desert Enterprises Pty Ltd (Desert), a Hong Kong entity, which was admitted to be a sham arrangement, were solely for the benefit of Mr Holmes, as determined by the Commissioner, or whether they were only partly for his benefit, in which case the amended assessments were excessive;
  • (b) Whether the liability of Waffles for tax, penalties, and interest were "present legal obligations" of Waffles as at 30 June in each income year and whether those liabilities were to be taken into account in determining the net assets and "distributable surplus" within the meaning of s 109Y of Income Tax Assessment Act 1936 (the 1936 Act). If so, then the contention is that there was no distributable surplus in any of the relevant years and the assessments are excessive and should be set aside.
  • (c) Whether the formula for determining "distributable surplus" in s 109Y(2) of the 1936 Act permits the payments made by Waffles to Desert, which were claimed as deductions, to be "added back" to the Company's assets at the end of the year of income in question.
  • (d) Whether the penalties are excessive in circumstances where Mr Holmes contends that he did not know and did not approve the ongoing transactions with Desert, taking into account that he made disclosures to the Respondent that subsequently led to the amended assessments and that he cooperated with the Respondent.

Factual background

3. Mr Holmes is a business man and in 1980, he established Trader Pty Ltd (which later became Waffles). This company engaged in international and domestic trade and involved Mr Holmes travelling overseas frequently.

4. In 1992, Mr Holmes met Ms Smith, an accountant who carried on business as a consultant. They commenced a personal relationship in 1994 which ended in 2004. During 1994, Ms Smith began working full-time for Waffles. In March 2000 she was appointed director of Waffles. Between 1999 and 2004, Ms Smith had also acted as financial controller. From mid-1995, Ms Smith managed the Applicant's personal and Waffles financial affairs and the Applicant gave evidence that he unreservedly trusted Ms Smith to the extent he would sign blank cheques and leave them with her when he travelled, as well as giving her his electronic password for his bank account. During 1996 and at the suggestion of Ms Smith, Mr Holmes engaged Mr Avery as the Company's tax accountant and to act as his tax agent.

Desert arrangement

5. In early 1999, Mr Holmes and Ms Smith met with Mr Avery to discuss the Company's financial affairs and in the course of that meeting, Mr Avery suggested that Waffles' tax difficulties might be fixed using a commission arrangement, which became what is known as the Desert arrangement. On 21 May 1999, whilst Mr Holmes was overseas on business, an

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amount of $180,000 was deposited into his Bank One bank account. This transaction was not authorised by him. He became aware of the deposit only when later advised of it by Ms Smith. She told him that $150,000 was to be repaid to Waffles as a loan.

6. Mr Holmes initially agreed with this transaction and he gave evidence, which we accept, that he advised Ms Smith that future transactions must be stopped. Mr Holmes believed that no further transactions of this nature would take place. It was not until 2004 that he says he became aware of subsequent payments by Waffles to Desert and the fact that deposits had been made into his personal account under the "Desert arrangement". Mr Holmes became aware of these deposits as a result of investigations carried out by his present accountant Mr Jones.

7. The deposits into Mr Holmes's bank accounts in each year of income which were made as a result of the Desert arrangement are set out below:

Year of income Date of deposit Amount Account into which deposit made
1999 21 May 99 $180,000 Holmes Bank One
2000 12 May 00 $72,000 Holmes Bank One
  28 June 00 $115,200 Holmes Bank One
  29 June 00 $45,000 Holmes Bank One
    $232,000  
2002 19 July 01 $87,075.92 Holmes/Smith Bank Two

8. On about 3 June 1999, Mr Holmes became aware that an amount of $150,000 was transferred from his Bank One bank account to the account of Waffles. On 22 May 2000, Ms Smith transferred $80,000 from the Applicant's Bank One bank account to Waffles' account. Mr Holmes did not recollect that transaction. In May 2000, Mr Holmes sold a property at Market Street, Sydney. After signing the settlement documents, he left the mechanics of the settlement to Ms Smith and expected that the sale proceeds would discharge the mortgage on the property to Bank Three. In fact, the sale proceeds were banked into Waffles' account and credited against the director's loan account. The Market Street mortgage of approximately $300,000 was subsequently discharged partly using funds from the Desert payments.

9. Of the $412,000 deposited into the Applicant's bank account, $230,000 (55.8 percent) was deposited back into Waffles' bank account. This amount was credited to the director's loan account and was available for the benefit of both directors, that is, to Mr Holmes and Ms Smith. Ms Smith benefited from those funds by causing Waffles to pay amounts to herself or for her benefit and debiting the loan account.

10. The evidence of Mr Holmes's current accountant, Mr Jones, which was not contested, is that more than half of the payments, debited to the loan account, were payments for the benefit of Ms Smith. The remaining $182,000 of Desert payments in the Applicant's Bank One bank account, were used to discharge the Market Street mortgage and the funds from the sale of the Market Street property were paid to Waffles and credited to the director's loan account.

11. Mr Holmes gave evidence that he generally paid for all of the living and entertainment expenses of both himself and Ms Smith while they lived together.

12. There were payments from Waffles as follows:

  • (a) On 26 March 2001, Ms Smith without the knowledge or authority of Mr Holmes, caused Waffles to draw a cheque for $14,519.80 and this was claimed as a deduction for overseas travel by Waffles.
  • (b) On 28 March 2001, Ms Smith without the knowledge or authority of Mr Holmes, deposited the cheque into their joint Bank Two account.

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    (c) In June 2001, a customer of Waffles rang Mr Holmes and asked for a loan of $15,000 to replace a bobcat. After consulting Ms Smith as to whether the loan could be made, she informed him that it could and he left the arrangements with respect to this with Ms Smith. Waffles subsequently paid $15,000 to this customer and claimed a deduction for that amount during the 2001 year of income.
  • (d) On 9 November 2001, Ms Smith without the knowledge or authority of Mr Holmes, caused $15,000 to be deposited into Mr Holmes's Bank One account.
  • (e) On 14 November 2001, Ms Smith caused Waffles to draw a cheque for $27,241.07 that was claimed as a deduction for purchases of materials by Waffles.
  • (f) On 19 November 2001, Ms Smith without the knowledge or authority of Mr Holmes, deposited the cheque into their joint Bank Two account.
  • (g) On 28 April 2003, Ms Smith without the knowledge or authority of Mr Holmes, caused Waffles to draw a cheque for $7,953.27 and deposited it into Mr Holmes's Bank One account.

13. After the relationship with Ms Smith ended in 2004, Mr Holmes became aware that Waffles had understated its assessable income and he made a voluntary disclosure to the Commissioner. In June 2006, Mr Holmes became concerned that Waffles had not properly identified that amount of understated taxable income and instructed his solicitor to make a further disclosure. At that time, the extent of the further understatements was unknown and the Commissioner was informed an accountant had been engaged to determine what they were.

14. On 22 June 2006, Mr Holmes's solicitor wrote to the Commissioner informing the Commissioner of the Desert arrangements. On 28 June 2006, the Commissioner advised Mr Holmes he would be subject to an audit and on 2 August 2006, Mr Holmes and his solicitor met with officers of the Commissioner and informed them that Waffles was still unable to identify the details of the understated taxable income.

15. On 21 August 2006, the solicitor wrote to the Commissioner informing him of the details of the Desert transactions and on 6 November 2006, the accountant for Mr Holmes wrote to the Commissioner disclosing details of the other transactions and payments referred to above as requested by the Commissioner.

Table of shortfall and penalty amounts - Mr Holmes

16. The following table sets out the calculations of penalties for each of the relevant income years for each tax shortfall amount relevant to the Waffles applications:

Income year Adjustment to taxable income Tax shortfall Percentage penalty Penalty amount
1999 Increase of $119,511.00 (as a result of the Desert arrangement) $57,737.83 15% via s 226J and s 226Z ITAA36 $8,660.67
2000 Increase of $232,200.00 (as a result of the Desert arrangement) $112,339.64 15% via s 226J and s 226Z ITAA36 $16,850.94
2001   $43,578.00 (as a result of the Desert arrangement) $21,073.68 15% via s 284-90 and s 284-225(2) of the TAA53 $3,161.05
    $7,260.00 (share of overseas travel payment) $3,521.10 60% via s 284-90 and s 284-225(1) of the TAA53 $2,112.66

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2002		   $28,620.00 (share of payments for materials) $10,112.46 60% via s 284-90 and s 284-225(1) of the TAA53 $6,067.46
2003   $7,953.00 (share of overseas travel expense) $1,638.57 15% via s 284-90 and s 284-225(2) of the TAA53 $240.58
Total   $439,122.00   $206,423.28
(disputed amount by Holmes) 		  $37,093.36
(disputed amount by Holmes)

17. The most significant payments in relation to the affairs of Mr Holmes and Waffles were the transactions with Desert between 1999 and 2001. These transactions involved in excess of $600,000 of Waffles monies being paid to Desert with 90 percent of the monies returned to Australia. This money was paid into Mr Holmes's personal account and he did not declare the payments as received. These payments had been described as "marketing expenses" and deductions were claimed in respect of them by Waffles. In fact the transactions were acknowledged to be "shams", there were no such services ever provided by Desert in return for its retention of 10 percent of the transferred monies.

18. In August 2007 following the voluntary disclosures and an audit performed by the Commissioner, amended assessments were issued for the four year period for Waffles and Mr Holmes. They disclosed significant shortfalls in taxation paid by Waffles and Mr Holmes. Penalties were imposed at varying rates taking into account the voluntary disclosures. On 10 September 1007, Notices of Objection were made in respect of the amended assessments and penalties imposed for both Waffles and Mr Holmes. The Commissioner disallowed all objections.

19. Waffles accepts the decision of the Commissioner as to the taxation shortfall found against it and its complaint relates to penalties. Mr Holmes challenges both the shortfalls and the penalties.

20. In summary, the applications for review made by Mr Holmes concern whether five notices of amended assessment of income tax in respect of the relevant income years, namely 1999 to 2003, are excessive by reason of treating certain payments to him as dividends under Division 7A of the 1936 Act. The applications for review by Mr Holmes also involve the question of whether penalties imposed in respect of each "deemed" dividend resulting in tax shortfall amounts in the amended assessments are excessive.

21. We now turn to the four specific issues set out in [2] above, but for reasons which will become clear, we will address them in the following order.

Issue (b) - Section 109Y - Whether income tax, penalties, and interest are "present legal obligations"

22. The determination of this issue turns on the meaning of the expression "present legal obligations" where it occurs in the definition of "net assets" in s 109Y(2) of the 1936 Act. Under s 109C(1), a company is taken to pay a dividend to an entity at the end of the company's year of income if the company pays an amount to the entity during the year and a reasonable person would conclude in all the circumstances that the payment is made because the entity has been a shareholder or associate at some time. Section 109Y is concerned with the proportional reduction of dividends so they do not exceed a distributable surplus. The amount of the dividend is calculated under the section by reference to "net assets" of the Company, which are defined for relevant purposes as meaning:

"the amount (if any), at the end of the company's year of income, by which the company's assets (according to the company's accounting records) exceed the sum of:

  • (a) the present legal obligations of the company to persons other than the company; …" [Emphasis added]

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(i) Income tax

23. The submission of the Applicant is that as at 30 June in each of the years of income, the liability to pay income tax on the taxable income for that year is a "present legal obligation" even though the amount is not yet calculated or "due and payable", either because there is no assessment or the due date fixed by operation of s 204 of the 1936 Act has yet to arrive.

24. Section 204 is concerned with the date on which the tax payable by a taxpayer for a year of income becomes "due and payable". It relevantly provides that if a taxpayer's return of income is lodged on or before the due date for lodgement, then the tax payable becomes due and payable in respect of the year of income within 21 days after a notice of assessment is given to the taxpayer.

25. The contention of the Commissioner is that the expression "present legal obligation" in so far as it refers to tax is a reference to ascertained or assessed tax. It is an expression that is not defined in the 1936 Act therefore making it necessary to consider its meaning in light of the relevant case law.

26. The Commissioner contends that "present legal obligation" is to be interpreted in accordance with its legal meaning and requires an obligation enforceable by legal action that is presently existing.

27. The starting point for determination as to the meaning of the expression "present legal obligation" is the language used. As a matter of language, the expression "obligation" is wide-ranging and covers more than the expressions "due", "payable", "due and payable" or "debt".

28. In
Whitney v Inland Revenue Commissioners [1926] A.C. 37 at 52, Lord Dunedin referred to the operation of taxation legislation as follows:

"Now, there are three stages in the imposition of a tax: there is the declaration of liability, that is the part of the statute which determines what persons in respect of what property are liable. Next, there is the assessment. Liability does not depend on assessment. That exhypothesi, has already been fixed. But assessment particularizes the exact sum which a person liable has to pay. Lastly, come the methods of recovery, if the person taxed does not voluntarily pay."

29. These remarks are apposite in the present case.

30. The meaning of the expression was considered by this Tribunal in reasons for decision of Senior Member Beddoe in
Re Fresta and Federal Commissioner of Taxation 2002 ATC 2061; [2002] AATA 337 where he decided that an unassessed tax liability fell within the expression "present legal obligation". This decision is directly on point.

31. In
Re Fresta, the only issue was whether a provision made for income tax should be taken into account as a present legal obligation. The Senior Member said at [31] and [32]:

  • "[31] However, as at 30 June 1998, the taxable income of the company was ascertainable, albeit that it may not have been actually ascertained. Given that the taxable income had been established by the facts it was also possible to calculate tax payable on that taxable income in accordance with the current rates of the Company tax.
  • [32] It follows, in my view, that there was a clear liability for income tax as at 30 June 1998 event though the tax would not be payable until assessed."

32. Senior Member Beddoe considered a number of authorities including
Jones v Federal Commissioner of Taxation (1998) ATC 4897 at 4900-01, where Branson J drew a distinction between the existence of an obligation sufficient to found a debt on the one hand and the existence of a debt that is due, whether or not payable on the other hand. Her Honour noted that in
Commissioner of Stamps (WA) v The Western Australian Trustee Executor and Agency Co Ltd (1925) 36 CLR 98 the High Court observed that an obligation to pay income tax at the rate declared existed from the moment the Income Tax Act became law and it was this Act itself which imposed obligations on the deceased during his lifetime, although the amounts to be paid had not been ascertained or included in any assessment during his lifetime.

33.

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After considering these, among other, authorities, Senior Member Beddoe concluded:

"[36] So instructed I am satisfied that as at 30 June 1998 the Company had a present legal obligation for tax on its taxable income so that the calculation of 'net assets' should take into account the provision for income tax (properly ascertained) as a present legal obligation."

34. Accordingly, he set aside the decision under review and remitted the matter to the Commissioner to reconsider the objection.

35. The Commissioner submits that this decision should not be followed because it contains no analysis for what constitutes a "present legal obligation" and in particular does not refer to relevant High Court authority as to when income tax is due. The Commissioner refers to
Clyne & Anor v Deputy Commissioner of Taxation & Anor 81 ATC 4429; (1981) 150 CLR 1 and seeks to distinguish the reasoning of Branson J in Jones supra on the basis that the Bankruptcy Act there under consideration referred to all debts and liabilities "both present or future certain or contingent" and is not limited to "present legal obligation".

36. In Clyne (at 8), Gibbs CJ observed that:

" the word 'due' is ambiguous and that it could mean 'owing', although not payable until some future date, or it could mean presently payable."

His Honour also noted that the Act referred to the expression "due and payable" and considered that this phrase was used to indicate a change of meaning so that "due" in such a phrase must mean owing. He noted that s 17 of the Act provided that income tax is levied and shall be paid on the taxable income derived during the year of income by the particular person. To him this suggested that tax is due in the sense of owing once the taxable income during a year of income has been derived as there then arises a legal liability to pay it. This is notwithstanding the fact that the extent or amount of the liability still remained to be ascertained and that payment was due to be made in the future. His Honour referred to a number of cases including the Commissioner of Stamps (WA) case referred to above and
Re Mendonca;
Ex Parte Federal Commissioner of Taxation(1969) 15 FLR 256. He noted that other decisions supported the proposition that tax was not due until assessed and considered that this might be the correct view for most practical purposes.

37. Mason J (with whom Aickin and Wilson JJ agreed) said at 16-17:

"However the correct view in my opinion is that income tax is due when it is assessed and notice is served of that assessment and that the tax does not become payable before the date fixed by s. 204. … I recognize that on other occasions members of this Court have said that 'tax is a debt due and owing, although not payable, notwithstanding that no assessment has been made', in the words of Gibbs J. in
Re Mendonca;
Ex parte Federal Commissioner of Taxation [50] , at p. 259. This approach can be traced back to the majority decision of this Court in
Commissioner of Stamps (W.A.) v. West Australian Trustee, Executor and Agency Co. Ltd. (Mortimer Kelly's Case) [51].[1] Refer particularly to pp. 105, 116 and 118 I think that the decision is to be explained on the footing that it was held that a debt for income tax not assessed until after the deceased's death was a 'debt due by the deceased' for the purposes of Acts imposing death and probate duties."

38. In the Full Court decision in
Commissioner of Taxation v Kavich (1996) 68 FCR 519 at 527, Lockhart J with whom Lee J agreed, said:

"Fundamental to his Honour's reasoning was his acceptance of the principle enunciated in Re Mendonca that an obligation to pay income tax is incurred before assessment to tax. As indicated earlier in the passages cited from the judgments of Gibbs J in Mendonca and Gibbs CJ in Clyne's case, his Honour was of the view that income tax is due in the sense of owing once the taxable income during the year of income has been derived because there then arises a legal liability to pay it. In my view, as indicated earlier, the reasoning of Mason J (Aickin and Wilson JJ agreeing), that income tax is not due until it is assessed and notice is served of that assessment, shows that before an assessment has been made the obligation imposedc on a

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taxpayer by the Assessment Act is to pay income tax at a future date when the tax has been assessed and a notice of that assessment has been served. There was, in my opinion, no relevant obligation incurred before the date of Mrs Kavich's bankruptcy to which the additional tax under s 207 can attach to answer the description of a debt or liability to which she became subject before discharge by reason of an obligation incurred before the date of her bankruptcy." [Emphasis added]

39. Although s 82 of the Bankruptcy Act refers to present or future liabilities, the reasoning underlying their Honours' judgment provides support for the conclusion that the obligation to pay the tax arises when the taxable income has been derived as a consequence of its imposition and not only after the tax is quantified as a tax due and payable on or after assessment.

40. The earlier authorities were comprehensively reviewed by the Full Court in
Commissioner of Taxation v Jones 99 ATC 4373; (1999) 86 FCR 282, which was a decision in relation to the Bankruptcy Act. After referring the High Court decisions in Mendonca, Clyne and the Federal Court decision in Kavich, the Full Court concluded at 290:

"While it is true that income tax is an annual tax which is usually assessed annually by reference to taxable income, it is also a tax which, in the event of bankruptcy can be assessed by reference to the period from the commencement of the income tax year until the moment of bankruptcy. Hence, for present purposes it can be said that as at the moment of bankruptcy there exists an obligation to pay income tax on the taxable income derived from the commencement of the year of income until the commencement of the bankruptcy, which only matures as a debt due and payable after assessment under s168. In our opinion, her Honour was correct, therefore in concluding that the Commissioner was entitled to prove in the bankruptcy." [Emphasis added]

41. We note that the Commissioner sought to rely on some observations of Santow J in his dissenting judgment in the case of
Orica Ltd v CGU Insurance Ltd (2003) 59 NSWLR 14 at [96]-[97], a case concerning liability under an insurance policy relating to workers compensation. In our view these remarks are of no assistance in the present circumstances because they were made in a completely different context and were clearly made by way of passing observation. In our view, predominant weight ought to be given to the considered remarks of the Courts referred to above which lend strong support to the Applicants' submissions on this point.

42. Income tax is imposed by the Income Tax Act 1986 (the Tax Act) and is payable for each year by an individual, company, or other entity at the rates declared in the Income Tax Rates Act 1986. This liability for tax is not imposed by the assessment. Tax is "payable" on "taxable income" which is assessed by reference to the assessable income for a particular income year.

43. As at the end of a particular financial year, the tax obligation is imposed in respect of income derived during that year. Accordingly, there is as at the end of that year (that is, 30 June) a then present obligation, notwithstanding that payment is due at some future time. Therefore, it can be said that there is a then binding obligation on the taxable person or entity as at the end of the financial year even though the amount has not been quantified. The obligation on the person or entity is to pay the true amount of tax payable. This amount is fixed as at the end of the financial year and can be calculated by reference to the provisions of the Act having regard to what occurred during that year. Under s 204, the tax for a year of income becomes due and payable 21 days after the due date for lodgement or 21 days after a notice of assessment is given to the taxpayer.

44. The Act uses different language in relation to the imposition of tax on income and the time at which the tax becomes due and payable. The obligation to pay tax arises by operation of the Act itself and not by issue of the notice of assessment. In that sense there is as at the last moment of the last day of any financial year a statutory duty which must be met at a later date when the amount is correctly determined or quantified through the

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assessment process. Nothing that the taxpayer does after 30 June in the relevant financial year can alter the amount of tax that is to be paid.

45. As at the close of the financial year therefore, there can properly be said to be a present but unquantified obligation to pay tax which is not owing in the sense of "due and payable" until after lodgment or assessment in accordance with the provisions of the Act.

46. The obligation to pay tax as at 30 June is at that moment a present obligation and not a future obligation or an obligation dependent on a contingency. The liability therefore is to be determined as at the end of the financial year because that is the date from which the obligation operates.

47. For the above reasons, we conclude that the obligation to pay tax at the amount subsequently properly ascertained, assessed and determined, is a present legal obligation as at the end of the financial year in respect of which the income is derived and, within in the meaning of s 109Y(2) of the 1936 Act.

48. A consequence of this is that the amount of tax as duly and correctly assessed must be deducted from the net assets in accordance with the formula under s 109Y(2) of the 1936 Act.

(ii) Penalty

49. Penalties were imposed under both the current regime (Division 284 in Schedule 1 to the Taxation Administration Act 1953 (TAA)) and the former regime (Part VII of the 1936 Act) dealing with penalties. The current regime talks of "administrative penalty", while under the former, a taxpayer was made liable to pay, "by way of penalty, additional tax", although nothing turns on this difference in language.

50. Under the former regime, s 226J provided:

"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 this 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."

51. The term "tax shortfall" was defined in s 222A as follows:

" tax shortfall , in relation to a taxpayer and a year, means the amount, if any, by which the taxpayer's statement tax for that year at the time at which it was lowest is less than the taxpayer's proper tax for that year."

52. The term "statement tax" was defined as:

" statement tax , in relation to a taxpayer, a year and a time, means the tax that would have been payable by the taxpayer in respect of that year if it were assessed at that time on the basis of taxation statements by the taxpayer after allowing the credits claimed by the taxpayer."

53. The term "proper tax" was defined as:

" proper tax , in relation to a taxpayer and a year, means the tax properly payable by the taxpayer in respect of that year on the taxpayer's taxable income after allowing credits properly allowable to the taxpayer."

54. The term "taxation statement" relevantly means the income tax return lodged by the taxpayer.

55. In summary, the tax shortfall is the difference between the tax payable in accordance with the tax return as lodged and the tax properly payable.

56. There is a reduction in penalty for voluntary disclosures to the Commissioner. Section 226Z provides for an 80% reduction in the penalty if the disclosure was made before the Commissioner informed the taxpayer that a tax audit was to be carried out.

57. Under the current regime, which applies for the 2001 and later years of income, penalties for tax shortfalls are determined under Division 284 in Schedule 1 to the TAA. Section 284-75(1) 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 the hit; and

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

58. The table in s 284-90 sets out the base penalty amount, which varies depending on whether the taxpayer intentionally disregarded the law, was reckless, or failed to take reasonable care. Section 284-220 then provides for increases, and s 284-225 for reductions, to the base penalty amount.

59. Both sets of provisions (that is, both the former and the current regime) make the taxpayer liable to the penalty (or, as it was described under the former regime, "additional tax") as an automatic consequence of the existence of the relevant state of affairs. This is so, albeit that the Commissioner is required (by s 227 of the 1936 Act, or s 298-30 in Schedule 1 to the TAA) to make an assessment of the amount of the penalty or additional tax. In other words, the distinction between the timing of the imposition of the liability to pay and the time when the amount is due and payable exists with respect to penalty just as it does with respect to income tax: see [42] to [44] of these reasons.

60. However, there is a significant difference in principle between the position with respect to income tax and that with respect to penalty. The amount of income tax payable on a person's income for a financial year cannot change after the end of the financial year: it is simply the product of the taxable income derived, multiplied by the applicable rate. That is not the case with penalty. The penalty is calculated as the shortfall amount multiplied by what might be described as the "culpability rate", that is, 25% for lack of reasonable care, 50% for recklessness, and 75% for intentional disregard of the law. To that extent the penalty might be regarded as a fixed amount, in the same way as income tax. But, in fact, the amount of penalty is not capable of objective determination at the time of lodgment of the tax return (that is, when the false or misleading statement is made which triggers the liability to the penalty) in the same way that the amount of income tax payable is capable of objective determination at the end of the financial year. The amount of penalty ultimately imposed is subject to a number of additional factors or additional events (or, in other words, contingencies) which are not capable of being known at the time when the liability to the penalty arises. These contingencies include:

  • • the taxpayer takes steps to prevent or obstruct the Commissioner from finding out about the shortfall amount (s 284-220(1)(a) in Schedule 1 to the TAA);
  • • the taxpayer becomes aware of the shortfall amount but does not tell the Commissioner about it within a reasonable time (s 284-220(1)(b));
  • • the taxpayer makes a voluntary disclosure about the tax shortfall after notification of a tax audit (s 284-225(1));
  • • the taxpayer makes a voluntary disclosure about the tax shortfall before notification of a tax audit (s 284-225(2));
  • • the Commissioner decides to remit all or a part of the penalty (s 298-20(1)).

61. In the case of the first two of those contingencies, the penalty amount may be increased; for the last three, the penalty amount may be reduced. It follows that, while the liability to the penalty is triggered upon the making of the false or misleading statement, the amount of penalty payable is not a fixed or an ascertainable amount at that time. For that reason it cannot then be regarded as a "present legal obligation"; it can only be so once it has been quantified and notified to the taxpayer. In our view, the penalty (or additional tax) became a "present legal obligation" of Waffles when the Commissioner issued to Waffles a notice of assessment of penalty, and not before. The evidence is that Waffles was notified in August 2007 of the amounts of penalty payable in respect of each of the relevant income years. This is when those amounts became a "present legal obligation" of Waffles.

(iii) Interest

62. The general interest charge, or GIC, is dealt with in Part IIA of the TAA, comprising ss 8AAA to 8AAH. Sections 8AAB(4) and (5) set out the provisions in the various taxation laws that deal with liability to the GIC. The table in s 8AAB(4) includes a reference to s 204 of the 1936 Act, which specifies (as noted above) when tax becomes due and payable. Section 204(3) provides:

"If any of the tax or shortfall interest charge which a person is liable to pay remains

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unpaid after the time by which the tax or charge is due to be paid, the person is liable to pay the general interest charge on the underpaid amount for each day in the period that:
  • (a) started at the beginning of the day by which the tax or shortfall interest charge was due to be paid; and
  • (b) finishes at the end of the last day on which, at the end of the day, any of the following remains unpaid:
    • (i) the tax or shortfall interest charge;
    • (ii) the general interest charge on any of the tax or shortfall interest charge."

63. It will be seen that a person's liability to the GIC accrues on a daily basis as a direct consequence of the fact that tax remains unpaid after the due date. The GIC therefore, in our view, becomes a "present legal obligation", for the purposes of the calculation in s 109Y, on each day on which tax that should have been paid, remains unpaid.

Summary in relation to Issue (b)

64. In summary, we conclude that, for the purposes of the formula in s 109Y(2), the "present legal obligations" of Waffles at the end of any of the relevant years of income include:

  • (a) income tax on the income derived during that year of income; and
  • (b) GIC that accrues in respect of any day during that year of income on which an amount remains unpaid after its due date;

However the amounts of penalty imposed in respect of those years of income did not become "present legal obligations" until August 2007, that is, during the 2008 income year.

Issue (c) - "Adding back" the Desert payments

65. The question to consider is whether the distributable surplus of Waffles should be increased by the amounts wrongly claimed as deductions arising from the payments to Desert under the Desert arrangement.

66. The Applicants submit in paragraphs 102 and 103 of their written submissions:

  • "102. There is no basis in the definition of 'distributable surplus' in s 109Y(2) to 'add back' these amounts. The provision requires the calculation to take the accounts as they stand at 30 June. There is no general warrant to reconstruct the accounts so that they reflect the Respondent's conception of the various transactions. The Respondent is only permitted to substitute a value of an asset if he considers that the company's accounting records 'significantly undervalue its assets'. The respondent does not content that the assets were significantly undervalued, nor does he content that this is what he did.
  • 103. Accordingly, the calculation of the distributable surplus does not permit any 'adding back' the amount of the disallowed deductions claimed by Waffles."

67. In response, the Commissioner submits that he has a general power to revalue assets, and that he did so by "incorporating the Desert payments" (paragraph 59 of the Commissioner's written submissions).

68. In their Submissions in Reply, the Applicants submit:

  • "1. The Respondent contends that by 'adding back' the amount of the payments by Waffles to Desert in each relevant year he substituted the value of an 'undervalued asset' or 'overvalued liability' in accordance with the terms of s 109Y(2).
  • 2. This cannot be correct as a matter of logic. No asset of Waffles could possibly be 'undervalued' (let alone 'significantly' undervalued) as at 30 June by the amount of the payments. The cash assets of the company are what they are. By its very nature cash, or a credit balance on a bank account, cannot be 'under valued ', the value of $100 cash is $100. The company's 'cash' asset represented by its credit bank balance might be less because the payments were made, but that does not mean the asset is undervalued. No other asset's value could logically be affected by the payment.
  • 3. Similarly, the liabilities of Waffles cannot possibly be overvalued. The undisputed evidence is that the payments were accounted for as an expense (i.e. recognition of the amount paid ). That did not and could not either give rise to a 'liability' or alter the value of an existing liability - a liability is by definition the recognition of an obligation to pay : see for e.g. Government of India,
    Ministry of Finance (Revenue Division) v Taylor [1955] AC 491 at 508-509 per Viscount Simonds.

  • ATC 113

    4. The ability to substitute the true value of an asset or liability is manifestly directed toward a situation where an asset's or liability's value in the balance sheet is significantly less, or greater, than its market or true value. For example, the value of a block of land might appear in the accounts at cost but in reality the market value is 'significantly' higher.
  • 5. What the Respondent seeks to do is reverse the effect of the payments. That is something altogether different from substituting the true value of an undervalued asset or overvalued liability. There is simply no warrant on any reading of s 109Y(2) for such a step.
  • 6. Rather, the plain and unambiguous words of s 109Y(2) takes (sic) the assets and liabilities of the company as they stand at 30 June for the purpose of calculating the distributable surplus. In other words, given that any 'payments' (as defined in s 109C) made by the company during the year must logically reduce by an equivalent amount an asset (usually cash) of the company, s 109Y(2) inherently assumes that the payments will result in a lower 'cash' asset at the end of the year than if the payments had not been made.
  • 7. If Parliament had intended that the "payments" made by the private company were to be treated as not having been made for the purposes of calculating the 'distributable surplus' (i.e. added back) it could quite easily have done so." (original emphasis)

69. We accept, as a general proposition, that the "net assets" component of the formula in s 109Y(2) will be derived directly, and without adjustment, from the company's assets and provisions "according to the company's accounting records". However, that general proposition is displaced "if the Commissioner considers that the company's accounting records significantly undervalue or overvalue its assets or undervalue or overvalue its provisions": effectively a proviso to the normal operation of the definition.

70. In this context, we do not place the same emphasis on the words "undervalue" and "overvalue" as do the Applicants. In our view, the proviso may be triggered in any case where the Commissioner considers that any amount representing "assets", or any amount representing "provisions", in the company's accounting records is overstated. It is not restricted to cases of inaccurate or unsustainable "valuations" of assets or provisions. For example, the proviso would be triggered if a company included in its "assets" an amount that is actually a liability - even if the amount of the liability is properly valued. It would also be triggered if a company omitted, from the total "assets" amount in its accounting records, certain categories of assets - even if they were properly valued. The question is simply this: does the Commissioner (or, on review, the Tribunal) consider that the value of the assets, as shown in the company's accounting records, is significantly understated or overstated? If the answer is "yes", then the Commissioner or the Tribunal standing in his place, may substitute a value that is considered appropriate.

71. Here, the assets of Waffles have been depleted by the payments to Desert under the Desert arrangement. But it does not follow that Waffles's assets have been understated, whether significantly or not. Once the payments to Desert were made, Waffles's assets were necessarily less than they were before the payments were made. Although the arrangement was a sham, there is no doubt that the funds moved from Waffles to Desert, and that, as a result, Waffles's assets were reduced. They were reduced to the amount reflected in the company's accounting records, which is their true value.

72. The proviso in the definition of "net assets" has not been triggered, and therefore there is no reason to "add back" the Desert payments for the purposes of the calculation in s 109Y.

Issue (a) - Extent of benefit to Mr Holmes from payments

73. The conclusions we have reached with respect to issues (b) and (c) may result in Waffles having no "distributable surplus" for any of the relevant income years. It is therefore

ATC 114

not appropriate to determine issue (a) at this stage.

Issue (d) - Penalties

74. If Waffles had no distributable surplus for any of the relevant years, and if, as a result, Mr Holmes's shortfall amount falls away, then penalty imposed on Mr Holmes will similarly fall away.

75. As far as the penalty imposed on Waffles is concerned, we are not persuaded that there should be any further reduction from the current levels.

76. In respect of the Desert arrangement, deductions were claimed that are not allowable. The base penalty amount was 75% of the shortfall (for intentional disregard of the law) but this was remitted in each case by 80% on account of the voluntary disclosures made prior to the commencement of the audit. This position should not be disturbed. In each case the company's return was lodged through Mr Avery, who was at the time the company's tax agent. Both the former and the current penalty regimes make a taxpayer liable to the penalty even if the false statement is made by the taxpayer's agent. A registered tax agent - particularly the one who advised on the arrangement - should know that a sham arrangement of the kind entered into does not give rise to allowable deductions as claimed. The agent either made, or approved the making of, the unsupportable claims, and in those circumstances the 75% penalty is entirely apt. There is no justification for further reduction beyond the 80% already allowed.

77. The remaining matters (overseas travel and payments for materials) are also instances of intentional disregard of the law. The returns were prepared by Ms Smith, who at the time was a director of Waffles. She knew the circumstances surrounding the claims and she knew the claims should not have been made. Mr Holmes, although he may not have closely reviewed the returns, nevertheless signed them.

78. The reduction of 80% from the 75% base penalty amount for the 2003 year is on the basis that the voluntary disclosure was made before the commencement of the audit. The reduction of 20% from the 75% base penalty amount for the remaining years is on the basis that the disclosure was made after notification of the audit, and that telling the Commissioner "can reasonably be estimated to have saved the Commissioner a significant amount of time or significant resources in the audit": s 284-225(1) in Schedule 1 to the TAA. There is no reason why any of these penalty amounts should be reduced further.

Decision

79. In respect of applications numbered 2007/5929-5933 (the Waffles penalty applications), the objection decisions are affirmed.

80. In respect of applications numbered 2008/4112-4116 (the applications by Mr Holmes), the appropriate course is to remit the objection decisions, under s 42D of the Administrative Appeals Tribunal Act 1975, to the Commissioner for reconsideration in accordance with these reasons.

81. For the purposes of s 42D(5) we allow the Commissioner 42 days to undertake that reconsideration and to take appropriate action under s 42D(2).

Footnotes

[1] Refer particularly to pp. 105, 116 and 118

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