• The impact of this case on ATO policy is discussed in Decision Impact Statement: Watson v Deputy Commissioner of Taxation (SAD 76 of 2009).

WATSON v DFC of T

Judges:
Dowsett J
Stone J
Bennett J

Court:
Full Federal Court, Brisbane (heard in Adelaide)

MEDIA NEUTRAL CITATION: [2010] FCAFC 17

Judgment date: 4 March 2010

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Dowsett, Stone and Bennett JJ

Introduction

1. At first instance the appellant ("Mr Watson") appealed against a decision of the respondent (the "Commissioner') disallowing claimed deductions from his assessable income for the income year ended 30 June 2004. The primary Judge dismissed his appeal. He now appeals against that decision. In the relevant year Mr Watson derived income from two sources. The first was his business as a financial planner. The other comprised payments pursuant to a personal income protection insurance policy (the "policy"). Such payments (the "policy income") were payable because Mr Watson has been, since 1996, partially incapacitated for work. During the 2003-2004 year his business traded at a loss. In effect the present question is whether or not such loss may, for tax purposes, be set off against the policy income, thus reducing his taxable income.

Legislation

2. Although taxable income is generally the difference between assessable income and allowable deductions, there are circumstances in which the Income Tax Assessment Act 1997 (Cth) (the "Act") provides otherwise. For present purposes Div 35 of the Act provides:

• " 35-5 Object
  • (1) The object of this Division is to improve the integrity of the taxation system by preventing losses from non-commercial activities that are carried on as businesses by individuals (alone or in partnership) being offset against other assessable income.
  • (2) This Division is not intended to apply to activities that do not constitute carrying on a business, for example, the receipt of income from passive investments.
• 35-10 Deferral of deductions from non-commercial business activities
  • (1) The rule in subsection (2) applies for an income year to each business activity you carried on in that year if you are an individual, either alone or in partnership (whether or not some other entity is a member of the partnership), unless:
    • (a) one of the tests set out in section 35-30 (assessable income test), 35-35 (profits test), 35-40 (real property test) or 35-45 (other assets test) is satisfied for the business activity for that year; or
    • (b) the Commissioner has exercised the discretion set out in section 35-55 for the business activity for that year; or
    • (c) …
  • Note: This section covers individuals carrying on a business activity as partners, but not individuals merely in receipt of income jointly. Compare the definition of partnership in subsection 995-1(1).
  • Rule
  • (2) If the amounts attributable to the business activity for that income year that you could otherwise deduct under this Act for that year exceed your assessable income (if any) from the business activity for that year, or your share of it, this Act applies to you as if the excess:
    • (a) were not incurred in that income year; and
    • (b) were an amount attributable to the activity that you can deduct from assessable income from the activity for the next income year in which the activity is carried ON.

  …

• ---

  ATC 10707

  35-30 Assessable income test
• The rule in section 35-10 does not apply to a business activity for an income year if:
  • (a) the amount of assessable income from the business activity for the year; or
  • (b) you started to carry on the business activity, or stopped carrying it on, during the year - a reasonable estimate of what would have been the amount of that assessable income if you had carried on that activity throughout the year;

  is at least $20,000.

• 35-35 Profits test
  • (1) The rule in section 35-10 does not apply to a business activity … for an income year (the current year) if, for each of at least 3 of the past 5 income years (including the current year) the sum of the deductions attributable to that activity for that year (apart from the operation of subsection 35-10(2)) is less than the assessable income from the activity for that year.

  …

• 35-50 Apportionment
• …
• 35-55 Commissioner's discretion
  • (1) The Commissioner may decide that the rule in section 35-10 does not apply to a business activity for one or more income years if the Commissioner is satisfied that it would be unreasonable to apply that rule because:
    • (a) the business activity was or will be affected in that or those income years by special circumstances outside the control of the operators of the business activity, including drought, flood, bushfire or some other natural disaster; or
    • Note: This paragraph is intended to provide for a case where a business activity would have satisfied one of the tests if it were not for the special circumstances.
    • (b) the business activity has started to be carried on and, for that or those income years:
      • (i) because of its nature, it has not satisfied, or will not satisfy, one of the tests set out in section 35-30, 35-35, 35-40 or 35-45; and
      • (ii) there is an objective expectation, based on evidence from independent sources (where available) that, within a period that is commercially viable for the industry concerned, the activity will either meet one of those tests or will produce assessable income for an income year greater than the deductions attributable to it for that year (apart from the operation of subsection 35-10(2))."

The Commissioner's decision

3. If s 35-10(2) is engaged, outgoings attributable to a business activity, which would otherwise be allowable deductions in the relevant year, may, in that year, be set off only against assessable income from that business activity. The respondent (the "Commissioner") decided that Mr Watson's policy income was not income from his business activity, and that his business deductions could not be offset against such income for tax purposes.

Mr Watson's business activity

4. The policy commenced in 1996. At that time Mr Watson's business involved advising clients on their life insurance and investment needs, recommending insurance or investment strategies, assisting in, and implementing the resulting strategies and monitoring their performance and continued appropriateness. He described his business as that of financial planning. Mr Watson received remuneration by way of fees paid by clients and commissions paid by investment institutions with which he arranged client investments. Mr Watson was initially an agent of a life insurer to which we will refer to as "NML Life". After some years, he became an authorized agent of a subsidiary to which we will refer to as "NML Planning". This enabled him to recommend financial products other than those provided by NML Life. In 1995 the National Mutual organization was de-mutualized. A controlling interest was acquired by the French insurance company AXA. From 1999 NML Planning became known as AXA Financial Planners. In July

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ATC 10708

2002 Mr Watson terminated his association with AXA Financial Planners and became an authorized representative of Financial Lifestyle Solutions.

The policy

5. The policy replaced similar arrangements which Mr Watson had made when he first became self-employed in 1984. The various documents evidencing the policy disclose that:

• • it was an income protection policy;
• • there was a "waiting period" of two weeks;
• • Mr Watson's occupation was that of financial planner/agent;
• • in the two years preceding the application he had derived net annual income, before tax, in the amount of $25,000 and $30,000 respectively;
• • the "benefit period" is "65", apparently a reference to the age at which disability payments will cease; and
• • the weekly benefit is shown as $410, apparently calculated by reference to Mr Watson's previous income.

6. In the policy "total disability" is defined as follows:

"If the person insured is totally disabled, we will pay you the weekly benefit. We will pay you at the end of each fortnight for which you are entitled to be paid. The person insured is totally disabled if, because of an injury or sickness, he or she:

• • cannot do at least one of the income producing duties of his or her occupation;
• • is not working; and
• • is following the advice and under the regular care of a medical practitioner."

7. The insurer is to decide whether the insured's total disability is caused by an injury or sickness, based on medical and other evidence. The word "injury" means "accidental bodily injury". The word "sickness" means "sickness or disease".

8. Partial disability is dealt with in cl 4 as follows:

"If the person insured has been totally disabled for 14 days and then he or she does some work - but is partially disabled - we will pay you a reduced weekly benefit. However, you will not be entitled to be paid before the end of the waiting period.

How much we pay

The amount we pay is worked out by applying the formula

A − B A

×  C

A equals the person insured's pre-disability income

B is the person insured's average weekly income during the period for which he or she is partially disabled.

C is the amount in box 5 in the Schedule, as varied in any way."

9. The term "partially disabled" is defined as follows:

"The person insured is partially disabled if, immediately after being totally disabled for at least 14 days, he or she is able to perform one or more income producing duties of his or her occupation but not all of them, or is working in another occupation, and - because of the disability - the amount the person insured earns for the work he or she does is less than the amount of his or her pre-disability income ;

The person insured must be under the regular care and attendance of a medical practitioner."

Mr Watson's incapacity and its effects

10. In 1996 Mr Watson was diagnosed as having a brain tumour. He underwent surgery and, for some time, was incapacitated for work. He recovered sufficiently to resume business activities, but with reduced capacity. He had short-term memory difficulty, inability to concentrate, a tendency to confuse words and occasional seizures. A further tumour was diagnosed in mid-2004. He was treated with radio-therapy. He subsequently resumed his business activities but, again, at a reduced level. Because of his ongoing health problems, he now concentrates on servicing existing clients rather than advising new clients. His insurer obviously accepts that he is at least partially incapacitated. Mr Watson claims that he was informed by his insurer that:

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ATC 10709

"When a proposal is received by underwriting, their occupation is considered when accepting someone as a risk for an income protection policy with an own occupation clause.

If a person changes their occupation while on claim and earns income, then the income earned does reduce their benefit. The test for this is whether the income has been earned through personal exertion.

Thirdly, if a client is working in their usual occupation but at a reduced income due to their disability, there is no obligation on the client to seek other work."

11. The primary Judge considered that it was unclear whether Mr Watson had acted upon this advice in continuing to operate his business. His Honour also considered that it was unclear whether such advice fully and correctly explained Mr Watson's entitlements under the policy in the event that he ceased to conduct the business. In any event, Mr Watson has received payments pursuant to the policy since 1 October 1996, calculated by reference to his partial incapacity for work. From 1997 to 2004 his gross fee and commission income decreased, particularly in the financial year ended 30 June 2000 and thereafter. His expenses remained fairly constant until the financial year ended 30 June 2003 when they also dropped significantly. His business expenses exceeded his fee and commission income in the financial years from 30 June 2001 to 30 June 2004. For some years the benefit derived by him under the policy has been of the order of $25,000 per year. In the financial year ended 30 June 2004 Mr Watson's income and outgoings were:

Income from his financial planning business (apart from the policy)	$ 9,896.00
Expenses	$14,554.00
Net Loss	$ 4,938.00
Policy income	$25,719.00

12. Thus, if Mr Watson may set off his business outgoings against his policy income, his taxable income will be $20,781. However the Commissioner has determined that he may only set off his business deductions against the amount of his business income ($9,896). On that basis, and subject to any other available deductions, his taxable income is the amount of his policy income, $25,719.00. The balance of his business deductions may be set off against income from his business activity in later years.

Non-commercial business activity

13. Division 35 is headed "Deferral of losses from non-commercial business activities". According to s 35-5(1) as it stood in 2004, the object of the Division was to prevent losses from such activities, carried on as businesses, being offset against other assessable income. The New Business System (Integrity Measures) Bill 2000 led to the insertion of Div 35 into the Act. In the explanatory memorandum which accompanied the Bill it was said that:

• "1.7 In administering the tax law, the concept of what constitutes carrying on a business has been found to be very difficult to administer and resource intensive. Often a case by case approach is the only way to ensure this concept is complied with.
• 1.8 A broad interpretation of the current law has resulted in significant revenue leakage from individual taxpayers claiming deductions for unprofitable activities. The Tax System Redesigned described many of these activities as hobbies and/or lifestyle choices. Further, even those that have business characteristics (under existing tax law) are often unlikely to ever be profitable.
• 1.9 The law is being changed following the Government's adoption of recommendation 7.5 in A Tax System Redesigned which was intended to limit the extent to which non-commercial losses in an income year can be used to reduce the tax paid on other income in that year. The change, which is one of a number of integrity measures, will simplify and introduce certainty into the law as it relates to the treatment of allowable deductions attributed to certain business activities."

14. It is significant that the memorandum refers both to "unprofitable activities" and "non-commercial losses".

15. Pursuant to s 995-1 " business includes any profession, trade, employment, vocation or calling, but does not include occupation as an

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ATC 10710

employee". The term "business activity" is not defined. Although the term "non-commercial" is not defined, it is clear that the term is used in Div 35 to describe a business activity to which the rule in s 35-10(2) (the "rule") applies, that is a business activity to which none of subparas (a), (b) and (c) of s 35-10(1) applies. Mr Watson does not suggest that any of those paragraphs applies to his situation. It follows that the rule applies to Mr Watson's business activity for the 2003-2004 income year. The remaining question is as to the effect of its application. In order to determine whether the rule applies and the effect of its application, one must identify the business activity carried on by the taxpayer in a relevant income year. See
G.P. International Pipecoaters Pty Ltd v Federal Commissioner of Taxation 90 ATC 4413; (1989) 170 CLR 124 at 138-139 and
Warner Music Australia Pty Limited v Commissioner of Taxation 96 ATC 5046; (1996) 70 FCR 197 at 210.

Assessable income from Mr Watson's business activity for the income year 2003-2004

16. It is common ground that the claimed deductions are attributable to Mr Watson's business activity for the 2003-2004 income year. Whether or not those deductions, in total, exceed the amount of his assessable income from that business activity for that year depends upon the amount of that income. The term "assessable income" includes "income according to ordinary concepts". See s 6-5(1). It is common ground that Mr Watson's income from his business is assessable income, and that his policy income is also assessable income. The point in dispute is whether the policy income is assessable income from his business activity for the income year 2003-2004.

17. In effect, Mr Watson's case is that his policy income was "from" the policy he entered into whilst carrying on his business in 1995-1996. He asserts that he paid the premiums and held the resulting contractual rights in the course of conducting his business (or "business activity"). He submits that effecting and maintaining income protection insurance was part of the conduct of the business of financial planning, or at least incidental or related thereto. He submits that his main purpose in carrying on his business was to be financially self-sufficient. His premium payments were allowed as deductions for tax purposes. He treated them as an expense of his business. Mr Watson has not paid any premiums since he first received payments under the policy on 31 October 1996.

18. A major aspect of Mr Watson's submissions is that Division 35 was not intended to apply to his situation. Although the basis for this submission is not fully articulated, it seems to involve the assertion that the moneys received pursuant to the policy were in fact received from Mr Watson's business, and that such business was not "non-commercial". As we have already observed, that term is used in s 35-10 to describe the business activities upon which the section operates in accordance with its terms. In general usage, and apart from the provisions of the Act, the term may mean many things. In particular, it may describe a business activity which has not made a profit in previous years and is not expected to do so in the future. We doubt whether Mr Watson can derive any support from the assertion that his business activity was not "non-commercial".

19. Mr Watson also relies upon the observation of Fullagar J in
Federal Commissioner of Taxation v Snowden & Wilson Pty Ltd (1958) 99 CLR 431 at 444 who observed that, for the purpose of determining whether an outgoing was necessarily incurred in connection with the conduct of a business "for practical purposes … within the limits of reasonable human conduct, the man who is carrying on the business must be the judge of what is 'necessary'".

20. That proposition may be conceded for present purposes. However the passage deals with deductions, not income. Mr Watson submits that observations concerning the circumstances in which business outgoings may be deducted from assessable income in calculating taxable income may, in some way, inform a decision pursuant to s 35-10 as to whether income is derived from a business activity. The logic of that proposition escapes us.

21. Mr Watson also refers to other litigation in which he has been concerned in connection with social security benefits. He says that the

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ATC 10711

Court will have to consider those proceedings. We are not entirely sure why that should be so. The case is reported as
Watson v Department of Family & Community Services (2003) 128 FCR 564 and is a decision of Finn J. The headnote states:

"Mr Watson carried on business as a financial planner, but became partially disabled as a result of illness. He continued his business at a loss, and was entitled to weekly benefits under an income protection insurance policy. He and his wife were refused benefits under the Social Security Act 1991 (Cth), on the ground that the income from this policy caused him to exceed the statutory threshold. His contention that his business losses should be taken into account was rejected by the Administrative Appeals Tribunal. Section 107(5)(1) provides that "If a person carries on a business, the person's ordinary income from the business is to be reduced by … losses and outgoings that relate to the business …". On appeal,

Held, dismissing the application: notwithstanding the factual nexus between the applicant's business and the weekly income received from the policy, the weekly payment could only be said to originate in a source other than the applicant's business."

22. Mr Watson seems to submit that to the extent that the decision may be inconsistent with his present submissions, we should not follow it. We accept that the decision does not bind us, and that we must decide this case on its merits.

23. Mr Watson submits that the policy was an income-producing asset, and that he held the contractual rights under the policy "against loss in his business, as part of his business activity". He submits that the policy income is "from" his business activity, "just like interest … 'from' a deposit held as part of the business activity". Mr Watson seeks support for this proposition in the decision of the High Court in
Federal Commissioner of Taxation v Smith 81 ATC 4114; (1981) 147 CLR 578 especially at 583. That case is authority for the proposition that payments pursuant to a disability insurance policy constitute income for tax purposes because they replace income. However the case says nothing about the present question. Similarly, we derive no assistance from the decision in
Kidston Goldmines Ltd v Commissioner of Taxation 91 ATC 4538; (1991) 30 FCR 77. Alternatively, Mr Watson submits that even if "the Policy was not held to be part of his business activity …", the policy income was nonetheless "from" such activity. This submission involves the assertion that Mr Watson took out the policy because he was self-employed in his business, and derived policy income only because his capacity to work in that business was impaired.

24. It is simply incorrect to say that Mr Watson held his rights under the policy "against loss in his business". The proposition implies some limitation upon the way in which he may apply policy income, but there is no such limitation. The income belongs to him absolutely. Further, we see no basis for concluding that he would lose his right to such income if he ceased to carry on his business. As to the submission that his decision to be self-employed motivated his taking out the policy, as much may be conceded. However that proposition does not lead to the conclusion that his policy income was "from" his business activity. In Smith, the taxpayer was an employed medical practitioner at a hospital. It could not sensibly be said that payments received by him pursuant to his policy were "from" the hospital or his employment at the hospital. The payments came "from" the insurer pursuant to the policy.

25. Mr Watson submits that his situation is not within the intended ambit of operation of the legislation as outlined in the explanatory memorandum. He also submits that the Commissioner's interpretation of the relevant provisions in the present case would extend the operation of the legislation beyond the demonstrated parliamentary intention. We have some difficulty in understanding these submissions. It is clear that Parliament intended to "limit the extent to which non-commercial losses … can be used to reduce the tax paid on other income …". Mr Watson may not consider his business to be "non-commercial", but as we have said, if a business has not produced a profit for some years, and has no apparent prospect of doing so in the future, then its continued operation may well be described

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ATC 10712

as non-commercial. Mr Watson did not suggest that he had any expectation of profits in the future. As to Mr Watson's suggestion that the Commissioner's approach would cause unintended results in some cases, the exceptions identified in s 35-10(1), particularly the Commissioner's discretion under s 35-55, reduce the likelihood of such unintended results.

Some misconceptions

26. Mr Watson's submissions reflect several misconceptions as to the primary Judge's reasoning. First, he submits that his Honour wrongly concluded that there was no "causative connection" between his business activity and his policy income. Secondly, Mr Watson submits that the test of causative connection was wrongly used to narrow the scope of Mr Watson's business activity. Thirdly, he submits that the primary Judge erroneously considered that policy income could only be characterized as "from" his business activity if it were "ploughed back into the business".

27. The legislation does not speak of "causative connection". We consider that the primary Judge used that expression at [50] merely as an alternative description of the relationship implicit in the word "from". We see no reason to conclude that his Honour took an unduly narrow view of the nature of Mr Watson's business. We also do not accept that his Honour proceeded upon the basis that policy income could only be "from" the business activity if it were returned to the business. As Mr Watson submits, such an approach would confuse source with destination. The "error" is said to appear at [50]-[52]. As far as we can see, his Honour was merely identifying other circumstances in which different facts may have produced different results. We do not understand those paragraphs to reflect any aspect of his Honour's reasoning other than his conclusion that the policy income was not derived from Mr Watson's business activity.

Application of the rule

28. The primary question for present purposes is the meaning of the word "from" in the expression "assessable income … from the business activity for that year". In
BHP Petroleum (Timor Sea) Pty Ltd v Minister for Resources (1994) 49 FCR 155 at 170-171, Beaumont J said, concerning the use of the word "from" in connection with an application for the issue of a certificate, which application was to be "from a person …":

"In my opinion, … 'from' is intended to have its dictionary meaning, that is to say, to indicate the starting point, source or origin, of an application or request."

29. A similar meaning should be given to the word for the purposes of s 35-10(2).

30. Mr Watson's case proceeds upon the basis that the policy income will be "from" his business activity for the purposes of s 35-10(2) if it can be related in some way to the business which he has conducted since some time prior to 1995. We do not accept that submission. In our view the requirement is that the relevant income be "from" his business activity in the relevant income year. It is true that the phrase "for that year", when used for the second time in the subsection, may arguably qualify the words "assessable income", the words "business activity" or both. However s 35-10(1) makes it clear that the focus of the section is upon business activity in the relevant year. It is also relevant to note the subsequent references to "business activity for that year". Further, s 35-10(2) speaks of "amounts attributable to the business activity for that income year that you could otherwise deduct … for that year". Clearly, the relevant deductions must be both attributable to business activity for the relevant year and allowable as deductions for that year. We consider that the same approach applies to assessable income. The better view is that the deductions referred to in s 35-10(2) are those which are both attributable to business activity in the relevant year and allowable as such "for" that year. Similarly, the assessable income referred to in s 35-10(2) is income from business activity in that same year, which income is assessable income in that year. We do not mean to imply that any income must have been earned in the relevant year of income, or that any outgoing must have contributed to the earning of income in the year in question. It may be part of the conduct of a business in one year that payment for work done in a previous year falls due or is received. Similarly, outgoings may be incurred

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ATC 10713

which will produce income which will fall due or be received in a later year.

31. If the starting point or source of the assessable income must be the business activity carried on in that year, the extent and nature of that business activity must be identified before one can determine whether or not particular income is "from" it. The present question is whether Mr Watson received the policy income from his business activity in the sense that such activity was the origin of that income.

32. Mr Watson's business activity in the year 2003-2004 was reduced in comparison to his activities prior to his falling ill. As the High Court held in Smith, the amount of policy income may not be measured by reference to lost income, but it is nonetheless received in lieu of such income. Mr Watson submits that because such lost income would have come from his business activity in the 2003-2004 year, the policy income was also from that source. In our view, logic does not support that conclusion. The policy income was received because he was unable to undertake the full range of business activity which he would have undertaken had he not fallen ill. It was derived from his incapacity to conduct business activity, not from the activity which he actually undertook. It follows that such income was not "from" his business activity for the 2003-2004 income year.

Order

33. The appeal must be dismissed.