Case N65

Judges:
KP Brady Ch
LC Voumard M
JE Stewart M

Court:
No. 2 Board of Review

Judgment date: 21 August 1981.

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K.P. Brady (Chairman); L.C. Voumard and J.E. Stewart (Members)

Between November 1971 and late 1973, the taxpayer, a pharmaceutical chemist, endeavoured to bring together as a group under his control a total of 12 pharmacies, operating in State A (5), State B (4), State C (2) and State D (1). This reference concerns only the State B part of the operation, although the modus operandi in other States appears to have been similar. In State B, each pharmacy was divided into two sections, one a dispensary and the other a ``non-professional'' section where cosmetics and other general merchandise were sold. The dispensaries were under the control of a registered pharmacist; the non-professional sections were operated by companies effectively

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controlled by the taxpayer. He was the owner of two of the State B dispensary sections of the business, the other two being owned, so we were told, by a Mr. K who was employed by the taxpayer as manager of a State A pharmacy owned by the taxpayer. The two State B dispensaries described as owned by Mr. K were in fact conducted by a manager whom he employed.

2. Companies controlled by the taxpayer, and in which he held shares through a holding company, held licences granted by the proprietor of a chain of department stores, and it was pursuant to those licences that the four State B businesses operated in areas set aside in the four stores. The stores performed a number of services for the dispensary and non-professional businesses, in return for a fee.

3. The reason for these arrangements was to be found in the Medical Act of State B as in force at the relevant time. By sec. 108A, which was added by a 1969 amendment, provision was made as to the ownership of pharmacies. Subsection (1) of that section, the others not being relevant for present purposes, read:

``108A(1) - Save as otherwise provided in sub-section (3) the following provisions shall apply with respect to the ownership of every chemist and druggist's business, namely:

• (a) The owner of the business or, if the business is owned by more persons than one, each of the owners shall be a registered pharmaceutical chemist;
• (b) A body corporate shall not own or have any proprietary interest in the business;
• (c) A pharmaceutical chemist may own not more than two such businesses but may in addition be a partner in a partnership owning one other such business;
• (d) A partnership of pharmaceutical chemists may own not more than three such businesses and shall have at least as many partners as businesses.''

4. It will be seen that para. (b) and (c) of sec. 108A(1) are of special relevance in relation to the kind of operation sought to be set up by the taxpayer. Although the taxpayer considered it commercially expedient to structure the State B shops as he did, it appeared that he sought to control, at least in part, more than the two businesses permitted by sec. 108A(1)(c) of the Medical Act. It also appeared that sec. 108A(1)(b) might have been breached in that companies under the control of the taxpayer, and conceivably the company owning the stores in which the shops were located, had a proprietary interest in the businesses. In any case, the Pharmacy Board instituted an inquiry into the matter. After a hearing that extended over eight days, a finding given on 24 April 1974, pronounced both the taxpayer and Mr. K guilty of conduct discreditable to a pharmaceutical chemist. In the case of the taxpayer, this was said to consist in conspiring to bring about breaches of sec. 108A of the Medical Act with resultant financial gain to himself. In Mr. K's case it was found that he was an accessory to a conspiracy to bring about breaches of the said sec. 108A. The Board cancelled the taxpayer's registration and ordered the removal of his name from the register. Mr. K's registration was suspended for 90 days. Following these decisions, the businesses carried on at the four sites in State B collapsed. It should, however, be added that, as a result of subsequent proceedings, the taxpayer's registration as a pharmaceutical chemist was restored.

5. The finding of the Pharmacy Board also ordered that the taxpayer and Mr. K pay two-thirds of that Board's legal costs. In addition, of course, both the taxpayer and Mr. K incurred costs on their own account. No information was put before us as to the individual shares of any legal expenses, but it appears that the taxpayer, or one of his companies, saw to the payment of both his own and Mr. K's legal costs and the total two-thirds of the Pharmacy Board's costs. The reason for this was said to be that the taxpayer felt under a moral obligation to Mr. K, for he (the taxpayer) had ``talked Mr. (K) into'' participating in the scheme, which had collapsed before Mr. K had had a chance to derive any profits from it.

6. In his return of income for the year ended 30 June 1975, the taxpayer claimed to deduct the sum of $12,306, being legal expenses incurred by him in and about the Pharmacy Board proceedings in 1974. The

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claim was made under sec. 51(1) of the Income Tax Assessment Act 1936 (``the Act''), which reads:

``All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.''

The Commissioner allowed a deduction of $50 pursuant to sec. 64A of the Act, but otherwise disallowed the claim. This had the effect of reducing by $12,256 the loss disclosed in the 1975 return, and deemed to be incurred in terms of sec. 80(1) of the Act in the year ended 30 June 1975, and available as a deduction in the year ended 30 June 1976, pursuant to sec. 80(2). The taxpayer objected to the disallowance reflected in his notice of assessment for the 1976 year; the Commissioner disallowed the objection, and the matter is now before this Board for review.

7. It will be convenient to consider the matter under separate headings, namely -

• (a) Were the outgoings paid or discharged by or on behalf of the taxpayer?
• (b) Are the outgoings, including such part thereof as relates to Mr. K, allowable deductions to the taxpayer pursuant to either positive limb of sec. 51(1), or are they disqualified as being outgoings of a capital nature?
• (c) Are the outgoings precluded from deduction because they represented a penalty?

But before moving on to that, we must notice a discrepancy between the amount claimed as a deduction and the details of payments given to support it. The only details consisted of entries in accounts maintained by solicitors F & Co. (Exhibit B), who acted for the Pharmacy Board, and solicitors R & Co. (Exhibit C), who acted for the taxpayer. We were told that amounts of $10,712.22 and $2,000 passing through their respective accounts represented the taxpayer's outgoings that were the subject matter of his claim, but since they add to $12,712.22, and the claim as made in the 1975 return was to deduct legal expenses of $12,306, and since, moreover, no evidence was led to explain the difference of $406.22, the discrepancy raises doubts as to the real amount paid out as legal expenses. A listing (Exhibit D) of relevant items from the cashbook, prepared by the taxpayer's accountant, did not really take the matter any further. Other problems arising out of Exhibits B and C are referred to later.

Were the outgoings incurred by the Taxpayer?

8. As we have said, the taxpayer's business structure included a number of companies which he controlled. These included an administration company and a holding company. Exhibit B, reflecting payments of $10,712.22 to the Pharmacy Board, shows that $2,000 was received from Messrs. R & Co., $2,000 was received from the administration company and the balance, $6,712.22, was shown as having been received from the holding company in four separate cheques, three of $2,000 and one of $712.22. Likewise, of five payments of $500 each made to Messrs. R & Co., we were invited to treat the latest four as made by the taxpayer. Yet to do so ignores an earlier (9 September 1974) payment to Messrs. R & Co. of $500, described in Exhibit C as ``C & D (presumably costs and disbursements) on account ch(eque) Fr(om)'' the holding company. This may have related to another matter, but no reason was given for ignoring it. The four payments said to be the correct ones were each of $500, received by the solicitors (as far as one can make out from an indistinct photocopy) on four dates between 12 March and 3 April or 3 May 1975. Each was described as ``Ch(eque) fr(om) you''. The name of the taxpayer appeared in handwriting at the top of the sheet.

9. Naturally the taxpayer and his accountant were questioned closely about these payments, and whether in fact the taxpayer had personally paid the amounts in question. The evidence of the taxpayer's accountant on this point was somewhat vague and confusing. In respect of the cheques in favour of Messrs. F & Co. he said: ``Those cheques were presented at (the taxpayer's) bankers''. Likewise of the

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cheques in favour of Messrs. R & Co., he said: ``All of those cheques have been honoured at (the taxpayer's) bank''. Yet in cross-examination he made the statement that the taxpayer did not have a personal bank account, but rather that the one bank account was used for all the entities in the taxpayer's group. The taxpayer likewise stated that there was only one bank account for the group, and that it was in the name of the holding company. As an aside, this does not account for the fact that solicitors F & Co. recorded one cheque as received from the administration company and others from the holding company. More importantly, perhaps, the witness assumed that the cheques drawn in favour of solicitors R & Co. were drawn by the holding company. These matters raised the question how payments made out of the group's single bank account were debited to the taxpayer or other person/entity whose liability they were drawn to meet. The cash book was kept in columnar form, but on the pages tendered as Exhibit 1 nothing appeared to indicate any allocation of the four payments made to solicitors F & Co. against the taxpayer. In short, the witness could not explain how much, if any, of the amounts treated as legal expenses was in fact paid by or on behalf of the taxpayer. The taxpayer asserted that he recalled making out the cheques concerned, but again he was not able to give a satisfactory explanation of how he, as opposed to others of the entities he controlled, incurred or paid the legal expenses in issue, nor of the manner in which the claim was quantified for inclusion in his return of income for the year ended 30 June 1975. There was just no evidence of the allocation of the charges by means of book entries or otherwise. In the result, the taxpayer has not satisfied us that he personally paid or bore the legal expenses that form the subject of his claim, and for that reason, if for no other, we have concluded that his claim must fail.

Were the outgoings of a Capital Nature or a Revenue Nature?

10. We were referred to a number of cases which have considered the various criteria by which, hopefully, one might distinguish outgoings on revenue account from outgoings on capital account. Having considered and reconsidered them, we are of the opinion that the outgoings, being incurred (if they were incurred by the taxpayer) in an endeavour to preserve intact the business structure that the taxpayer had set up in State B, represent outgoings of capital or of a capital nature. It follows that they are excluded from deduction. It is not necessary to do more, by way of support for this conclusion, than refer to the judgment of Dixon J., as he then was, in
Sun Newspapers Ltd. and Associated Newspapers Ltd. v. F.C. of T. (1938) 61 C.L.R. 337 at pp. 359-364. There, his Honour described the distinction between ``the business entity, structure, or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay'', then discussed various tests - the once and for all test, the enduring benefit test, and character of the advantage sought - and went on:

``There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.''

11. We are satisfied that the principal object of the expenditure in issue was to preserve the taxpayer's existing business organisation from dislocation and impairment. This included the endeavour to prevent the loss of the taxpayer's, and Mr. K's, registration as pharmacists. As previously noted, the Pharmacy Board's findings led to the collapse of the State B businesses; it is fair to say that the outgoings here in question were aimed at preventing that collapse - that is, they were aimed at preserving intact the existing business structure, the ``profit yielding subject''. The expenditure could not properly be characterised as an expenditure upon the process of operating that subject or, to adopt a statement made by Menzies J. in
John Fairfax & Sons Pty. Ltd. v. F.C. of T. (1958-59) 101 C.L.R. 30 at p. 49, the

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outgoing had the character of an outgoing in the course of maintaining or preserving the taxpayer's business rather than that of a working expense in the carrying on of his business. For that reason the amount of legal expenses is not an allowable deduction within the scope of sec. 51(1), being rather an outgoing of ``capital or of a capital nature''.

12. It might be objected that the outgoing now under consideration ought to be held to be deductible on the ground that it was similar to the legal expenses in question in
F.C. of T. v. Snowden & Willson Pty. Ltd. (1958) 99 C.L.R. 431. In that case the Full High Court held that costs of advertising, and legal expenses incurred by the taxpayer company in connection with allegations about its method of carrying on its business, and the proceedings of a Royal Commission before which it appeared were ``necessarily incurred in carrying on a business for the purpose of gaining or producing'' income and were, moreover, of a revenue nature. The amount was therefore an allowable deduction under sec. 51(1). But this conclusion, we think, was arrived at on the basis that the matters provoking the expenditure were no more than incidental to the taxpayer's business. Thus, at p. 436, Dixon C.J. was at pains to point out that:

``The case does not appear... to depend... upon anything but an understanding of what in fact and according to the ordinary conduct of affairs is incidental to the conduct of a business.''

In the case before us what was at stake was the continued existence of the business and the retention of the taxpayer's right to carry on business as a pharmaceutical chemist. These matters are far more fundamental.

13. It might be necessary to add a qualification to what has been said in para. 10-12 because, on the assumption that (contrary to the finding expressed in para. 9) the taxpayer did incur the expenses involved, a question arises whether, to the extent that they were paid in respect of Mr. K, they should be deductible on the authority of
Magna Alloys & Research Pty. Ltd. v. F.C. of T. 80 ATC 4542. It should be said at once that, as there was no evidence as to the amount of expenses attributable to Mr. K's part in the Pharmacy Board's inquiry, and as no basis of apportionment was suggested to us, we are not in a position to deal separately with what might have been Mr. K's costs. But looking at such costs from the taxpayer's point of view, we doubt that they could be regarded as being of a character different from the taxpayer's own costs; that is, while recognising the force of what the Federal Court said in Magna Alloys case as to voluntary outgoings incurred for the benefit of an employee, we would in any event deny the deductibility of these outgoings on the ground that they take the character of a capital outgoing.

Are the outgoings precluded from Deduction because they represented a Penalty?

14. Counsel for the Commissioner submitted that a statutory body such as the Pharmacy Board had no authority to impose penalties in the absence of some empowering statute. Section 96(3) of the Medical Act was, he submitted, the source of this power for it provided in part:

``(3) If on any inquiry by the Board a pharmaceutical chemist is found -

• ...
• (e) to have been guilty of any other conduct discreditable to a pharmaceutical chemist -

the Board may inflict any one or more of the following penalties -

• ...
• (ii) require such pharmaceutical chemist to pay the costs of and incidental to the inquiry by the Board concerning such conduct
• ...''

From this it was argued that so far as the order of the Pharmacy Board relating to its costs imposed a liability on the taxpayer, the effect of
I.R. Commrs. v. Warnes & Co. Ltd. (1919) 2 K.B. 444, and
I.R. Commrs. v. Von Glehn & Co. Ltd. (1920) 2 K.B. 553, was, as Brennan J. put the argument in the Magna Alloys case (supra) at p. 4554, that the non-deductibility of criminal penalties extends to the costs incurred in defending the proceedings in which the penalty was imposed. The Federal Court in Magna Alloys cast doubt upon this proposition and, as we consider that the taxpayer's claim should fail for other reasons, and as, in any event, the relevant amount is both unascertained and

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unascertainable, we find it unnecessary to express an opinion on the matter.

15. For the reasons given, we would uphold the Commissioner's decision on the objection and confirm the assessment before the Board.

Claim disallowed