Case U7

Members:
IR Thompson DP
JE Stewart SM
DJ Trowse M

Tribunal:
Administrative Appeals Tribunal

Decision date: 17 December 1986.

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I.R. Thompson (Deputy President), J.E. Stewart (Senior Member) and D.J. Trowse (Member)

The application for review in these proceedings is in respect of the respondent's decision to treat as taxable income of the applicant in the year ended 30 June 1980 an amount received by it from the Australian Industrial Research and Development Incentives Board ("the Board"), to refuse to allow a deduction in respect of bonuses alleged to have accrued and been payable within that year and to impose additional tax on account of an incorrect return having been lodged. When, pursuant to sec. 185 of the Income Tax Assessment Act 1936 ("the ITA Act") the applicant lodged with the respondent its objections against assessment, it stated the amount alleged to have been wrongly treated as income as $87,717. However, at the commencement of the hearing the parties tendered an agreed statement that the amount in issue was $76,126. The amount in issue in respect of the disallowed deduction was $10,100. At the hearing no evidence was adduced relating to the disallowed deduction and Mr P.J. Lanigan, of Counsel, who represented the applicant expressly abandoned that part of the application. The amount of additional tax imposed was $4,499. The power of the Administrative Appeals Tribunal to review the respondent's decision derives from sec. 189(2) of the ITA Act (as amended by the Taxation Boards of Review (Transfer of Jurisdiction) Act 1986 ("the Transfer of Jurisdiction Act"), sec. 223(1) of the Transfer of Jurisdiction Act and sec. 25 of the Administrative Appeals Tribunal Act 1975.

2. The primary facts relating to the amount of $76,126 are not in dispute. On 24 October 1979 the applicant entered into a written agreement with the Commonwealth of Australia in respect of a project grant which the Commonwealth had agreed to make available to the applicant under the provisions of the Industrial Research and Development Incentives Act 1976 ("the IRDI Act"). The applicant was to undertake research on a specified project and to expend on that research a total of $1,179,000 over a period of approximately three years. The project grant was to be half of the expenditure incurred by the applicant in compliance with the requirements of the agreement. The agreement provided for the applicant to prepare written reports on the technical progress of the project and to give details of expenditure on it as at 31 December 1979, as at the end of every six months thereafter and also on completion or termination of the project. A copy of each such report was to be forwarded to the Board, at the latest within 45 days of the date to which it

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related. Within 30 days of the preparation of each report the applicant was required to submit a claim for payment of the research grant in respect of the expenditure incurred on the research project during the period covered by the report. The Board was required to approve payment of a grant upon being satisfied as to the applicant's compliance with the relevant requirements of the agreement. The estimated completion date for the project was 30 June 1982. In the event the project took considerably longer to complete than had been anticipated; it was not completed until 1984. From the start the terms of the agreement relating to reporting by the applicant and approval of grant by the Board were not strictly complied with. Reports were prepared and sent to the Board only at the end of each financial year; approval of grant was made by the Board only once a year following its receipt of each report.

3. In September 1979 when the agreement was being negotiated the Acting Director of the Board wrote to the Managing Director of the applicant stating:

"The Board would like to offer a payment of up to $150,000 progress grant to your company to enable the project to be appropriately advanced.

This payment is offered on the understanding that your company recognises that it is an amount which should be credited against anticipated expenditure and consequent grant entitlement on the project, and will become repayable in part or in whole, as provided for in Clause 3 of the Agreement, if the project is not subsequently proceeded with to the extent attributable to the payment.

If you would like to take advantage of this progress grant offer it would be appreciated if you would enter the amount requested on the attached Form 12, complete the form in other respects, and return it together with the signed agreement to the Board at the above address."

The applicant accepted that offer and in or about October 1979 $150,000 was paid to it by the Commonwealth.

4. The agreement was made pursuant to the provisions of sec. 30 of the IRDI Act. That section was contained in Div. 2 of Pt III of the Act. Section 30 provided authority for the Board to enter into an agreement on behalf of the Commonwealth "for and in relation to the making of a grant of financial assistance... in respect of proposed expenditure... in respect of" a research project incurred by the other party. Such a grant was known as a project grant. Section 33 of the Act authorised the Board to include in an agreement for a project grant a provision for repayment to the Commonwealth of the whole or part of a grant, if there was breach of the agreement. The agreement between the Board and the applicant contained such a provision. It also contained provision for repayment of any moneys paid as project grant in excess of the total moneys payable as determined in accordance with a provision of the agreement that the amount of the grant was not to exceed 50% of the net expenditure of the applicant on the project.

5. Section 35 of the Act contained provision relating to the payment of "advances" in respect of research grants. Subsections (1) and (2) were at all material times as follows:

"35(1) The Board may, in its discretion, authorize the payment to a company of an advance in respect of a grant that may become payable to the company.

(2) Where an advance has been made to a company in pursuance of sub-section (1) in respect of a grant, the company is liable, if the grant does not become payable or the amount of the grant is less than the advance, to repay to the Commonwealth, upon demand being made by the Treasurer, the amount of the advance or so much of the advance as exceeds the amount of the grant, as the case may be."

In spite of the terms in which the Acting Director of the Board offered payment of up to $150,000 to the applicant, that is to say as a "progress grant", there can be no doubt that, when that amount was paid to the applicant, the payment was made in pursuance of sec. 35; the agreement for payment of grant contained no provision for its payment and it was not otherwise authorised by the Act.

6. It was agreed between the parties at the hearing that during the 1980 tax year the expenditure which the applicant incurred on the research project was such that the amount of the project grant to which it was entitled under the agreement in respect of that expenditure was $73,874. It was agreed also that that

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amount, if received, was assessable income of the taxpayer. We have no doubt that that was so (see sec. 26(g) of the ITA Act and
Reckitt & Colman Pty. Ltd. v. F.C. of T. 74 ATC 4185).

7. Mr Lanigan presented the applicant's case in the alternative. First, he submitted that the amount of $150,000 was paid as a loan and that, until an amount of grant was approved and set off against the loan, none of it was income. In the alternative he submitted that the money was a prepayment of the grant but that, because it was repayable if the expenditure upon which entitlement to receive it depended was not incurred by the applicant, it was not income of the applicant until such time as that expenditure was incurred. Mr P. Richards, of Counsel, who represented the respondent, submitted that the amount of $150,000 was paid not as a loan but as a grant having the character of a subsidy and that from the moment of its receipt it was assessable income. He based his argument on sec. 25(1) of the ITA Act and also on sec. 26(g) of that Act. Section 26(g) read:

"26. The assessable income of a taxpayer shall include -

• ...
• (g) any bounty or subsidy received in or in relation to the carrying on of a business (other than subsidy received under an agreement entered into under an Act relating to the search for petroleum), and such bounty or subsidy shall be deemed to be part of the proceeds of that business."

8. The evidence placed before the Tribunal consisted of the applicant's return of income for the year ended 30 June 1980 with the schedules that accompanied it, the original assessment and amended assessments with adjustment sheets and notice of objection, a copy of the agreement and copies of a number of letters written to the applicant by the Board in September 1979, December 1980, January 1982, October 1982 and December 1982 respectively. Also tendered was a monograph entitled "Definition and Recognition of Revenue in Australia" by Professor C.A. Martin and Mr R.J. Coombes. Oral evidence was given by A, a Director of the applicant, B, a chartered accountant who was Chairman of the Board of Directors of the applicant in 1980 and C, a chartered accountant who does a great deal of audit work and whose firm was appointed auditor of the applicant on 30 June 1980.

9. A, who is a professional engineer, gave brief evidence relating to the applicant's entering into, and its performance of, the agreement. He had no knowledge of the manner in which the $150,000 paid to the applicant by the Board was accounted for. B gave evidence that, when that money was received, it was paid by the applicant into an interest-bearing bank account separate from its operating bank account and that it was entered in the applicant's books of account as a debit to bank and a credit to the Board. B said that he had taken the view at that time that the applicant was indebted to the Board in respect of it and that the entries in the applicant's accounts reflected that view. The interest which accrued had been credited to the Board in those accounts; B said that the Board had expressed surprise at that, as other recipients of such advances had not followed that course.

10. B said that the applicant kept a separate sub-account in respect of the research project and prepared a statement of that account each month. Each time it credited the project account and debited the Board's account with half the amount of the expenditure incurred on the project in the preceding month. The applicant tried to keep its drawings from the interest-bearing bank account to half the amount of the expenditure which it was incurring on the research project. However, he conceded that it had not been able to do so precisely and the amounts drawn from the interest-bearing bank account had not matched exactly the amounts shown in the applicant's accounts as having been debited against the Board. He conceded also that all the money was available for use by the applicant as it saw fit.

11. B gave evidence that some years ago he had been the National President of the Australian Society of Accountants. As such he had been a member of the Joint Standing Committee of that Association and the Australian Institute of Chartered Accountants. One of the responsibilities of that body, he said, had been to set accounting standards to be observed by accountants practising in Australia. Consequently, he was familiar with the Australian accounting standards. He said that a statement by Professor Martin and Mr Coombes in their monograph that "revenue

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may not be recognised until it is `earned"' was correct. In that context "recognised" meant brought into the account; so that money received could not be regarded for the purposes of accounting as income or revenue until whatever needed to be done for it to have the status of income or revenue had in fact been done. In the instant case, he said, until money had been expended by the applicant on the research project, the money received by it from the Board had not been earned; when expenditure was incurred on the research project, the money received from the Board was earned only to the extent for which the agreement provided.

12. C expressed a similar opinion as to the correct manner of accounting for the $150,000 received by the applicant from the Board, although he commented that there had been no need for the applicant to open a separate bank account for it. He said that it would not have been correct to treat the whole of the $150,000 as revenue in the 1980 year, as it had not all been earned in that year. The applicant had had to spend money on the research project in order to earn any part of the $150,000. If the Board had not been shown as a creditor for the balance remaining unearned, the accounts would not have reflected accurately the applicant's liability to repay that balance. He regarded the receipt not as a loan but as an advance of the money payable by way of grant. Referred to the provision in the agreement that approval of payment of grant would be given only after expenditure had been incurred and reported, he said that technically it was probably not correct to credit the income before the grant was approved. However, it was not improper for that to have been done as it was understood that the grant would be approved. From a practical accounting point of view, entries would probably be made when the expenditure which earned the grant was incurred, even if the formal documentation of approval of the grant was not received until later. That was proper where no reason was known to exist why approval should not be given. It was the method of accounting commonly used by companies eligible for grants from the Export Development Grants Board.

13. Mr Lanigan submitted that the payment of the $150,000, although referred to in the Act as an advance, was in fact a loan made by the Board to help finance the applicant while it was getting its research project under way. It was not to be repaid in cash if the project proceeded; the repayments were to be absorbed by the grant. However, if the project did not proceed or did not proceed to the point where the whole of the $150,000 had been absorbed by approved grant, it would be repayable in cash by the applicant. The transaction, therefore, had the character of a loan. As the first approval of grant was made in December 1980, none of the $150,000 was income in the 1980 year. To the extent that some of it was used for the research project work during that year, the applicant had utilised loan money.

14. Mr Richards submitted that the $150,000 could not be regarded as having been paid as a loan. Section 35 of the Act provided for payment "of an advance in respect of a grant". He referred the Tribunal to
Smart v. Lincolnshire Sugar Co. Ltd. (1937) 20 T.C. 643 (H.L.). That was a case in which payments of what were referred to in the relevant legislation as advances were made to a sugar manufacturer. Subsidies were already being paid to sugar manufacturers but, because the price of sugar had fallen very low, they were unable to pay to the farmers from whom they bought sugarbeet a price which made it worthwhile for the farmers to grow that crop. Legislation was, therefore, enacted providing for "weekly advances" to be paid to the manufacturers for one year; the purpose of the legislation was to enable the manufacturers to pay a reasonable price to the farmers. The advances were not to be repayable by any manufacturer unless either the price of sugar rose above a specified figure, in which case the amounts of the advances were to be recovered from future subsidy payments, or the manufacturer ceased to carry on business.

15. At first instance Finlay J. held that the advances were loans. The Court of Appeal decided that they were not. It looked at the substance of the payments and not the description and observed that it was not an ordinary mercantile transaction having the character of a loan but rather a statutory bargain. Lord Wright M.R. commented that the repayment for which provision was made was not such as one would expect in any case of a loan; nor were the terms of the Act such as one would have expected in the case of a loan. There was to be a very limited payment by

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reimbursements in a very limited state of things. Romer L.J. said that he considered the payment to be in the nature of a trading receipt because he had formed the opinion that "this sum is in the nature of a subsidy, paid in certain events in advance of the subsidies payable under the Act of 1925 for (the following two years) and in other events it is an additional subsidy". He said that it did not matter what the legislature called the sums that were paid. What had to be ascertained was what in truth and in fact they were.

16. In the House of Lords Lord Macmillan observed that, if the nature of a payment were to be determined solely by the terminology of the statute, there might be much to be said for the view adopted by Finlay J., "for the draftsman has done his best to persuade us that the payments were loans" by calling the payments "advances" and speaking of their "recovery" and of "remission" of any balance not recovered. However, it was his view that the question ought not to be decided on merely verbal arguments and that what was decisive was "that these payments were made to the company in order that the money might be used in their business". It was paid "with the very object of enabling them to meet their trading obligations". They were "intended artificially to supplement their trading receipts so as to enable them to maintain their trading solvency". He considered that it was irrelevant that at the time when the matter came before the Court it was known that the payments were irrecoverable and the contingency of repayment could no longer arise. He said:

"I prefer to rest (my judgment) on my view of the business nature of the sums in question which the Company received (in the tax year). I think that they were supplementary trade receipts bestowed upon the Company by the Government and proper to be taken into computation in arriving at the balance of the Company's profits and gains for the year in which they were received."

17. Mr Richards sought to persuade us that the matter decided in the Lincolnshire Sugar Co. Ltd. case was the very issue which we had to decide in these proceedings. We are unable to agree that that is so. The provisions of sec. 35 of IRDI Act must be construed in the context of the other provisions of Pt III of that Act. It is immediately apparent that the "advance" for which it provides is of a substantially different nature from that made to the sugar manufacturer in the Lincolnshire Sugar Co. Ltd. case. It is not paid in order that the payee may be able to meet his trading obligations or to maintain his trading solvency. We accept that we should regard decisions of the House of Lords from which the High Court of Australia or the Federal Court has not departed as so persuasive as to be effectively binding on us (see, for instance,
Public Transport Commission of N.S.W. v. J. Murray-More (N.S.W.) Pty. Ltd. (1975) 49 A.L.J.R. 302 where Barwick C.J. at p. 305 observed that as a general rule the Supreme Courts of the States should follow the decision of the English Court of Appeal where there was no relevant decision of the High Court of Australia). Nevertheless, we consider that the question which the House of Lords was required to decide was so substantially different from that which we have to decide in the present case that it does not require us to decide that the payment made under sec. 35 was not a loan.

18. However, we regard as most instructive the comment of Lord Macmillan and Romer L.J. that it mattered not what the legislature called a payment; what has to be ascertained in every case is what in truth the payment is. We note that the Board in its letter dated 21 September 1979 referred to the payment as a "progress grant" intended to enable to project "to be appropriately advanced". It is our understanding of sec. 35 that an advance cannot be made unless an agreement has been entered into for the payment of a grant. A grant could not be made under the agreement between the Board and the applicant until such time as the basis for calculating the amount of it existed. That could only be after the work on the research project had been done either wholly or in part. Section 35 is, we are satisfied, intended to enable the Board in such a case to prepay an amount which it considers will be covered by the grant when it is made. Because it is a prepayment, provision is made for repayment if no work is done or if the grant payable in respect of the expenditure properly incurred on work done is less than the amount prepaid. Applying the principle upon which both the House of Lords and the Court of Appeal came to the conclusion that the advances in the Lincolnshire Sugar Co. Ltd. case were not

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loans, that is to say having investigated what is the true nature of the payment, we have come to the conclusion that it was not a loan but a prepayment of the grant.

19. We turn, therefore, to consideration of Mr Lanigan's second line of argument. That argument proceeded on the basis that the advance of $150,000 was a prepayment of a grant. Mr Lanigan submitted that, because retention of the moneys prepaid was contingent upon the applicant disbursing moneys on the project, it could not properly be regarded as income until those outlays were made. Mr Richards sought to counter that argument first by relying on the decision in the Lincolnshire Sugar Co. Ltd. case that the advances in that case were a subsidy and therefore revenue or income in the hands of the sugar manufacturer. We accept that a grant paid under the IRDI Act is income in the hands of the grantee; the Supreme Court of New South Wales has held in Reckitt & Colman's case (supra) that that was so. But Mr Richards sought also to rely upon the Lincolnshire Sugar Co. Ltd. case for the proposition that prepayments of a grant is necessarily income in the year in which it is received. We are unable to accept that it is an authority for that proposition. First, in that case the "advances" were not prepayments of a grant or subsidy: they were the actual subsidy. Only if the price of sugar rose were they to be repaid by being set off against different subsidies payable later. Second, they were paid weekly in order, as Lord Macmillan found, to supplement artificially the sugar manufacturer's trading receipt and so enable it to maintain its trading solvency. The money was clearly revenue in the year in which it was received by the sugar manufacturer. The decision to that effect was related to the facts of the case.

20. The facts of the present case are very different. Although the applicant was not required to keep separately the money paid to it by way of the advance and could have used it in its normal trading operations, the grant had still to be "earned" by incurring expenditure on the research project. If the expenditure was not incurred, the money prepaid had to be refunded. Expenditure of the whole amount could have been incurred entirely within the 1980 year if the applicant had had the physical resources to undertake during that year work justifying the expenditure of $300,000. Indeed, under the agreement it had undertaken that it would expend in that year an amount of $647,200. But the agreement envisaged (cl. 3(3)) that the expenditure might in fact be less; in that event the applicant was required to notify the Board in writing immediately on becoming aware of the fact. In the letter dated 22 December 1980, by which the Board notified the applicant of approval of a grant of $60,065 in respect of eligible expenditure incurred in the 1980 financial year, no comment was made on the fact that the amount spent by the applicant in that year was substantially less than the amount which it had undertaken in the agreement that it would spend. Similarly, although the expenditure in the next two years also was well below that provided for in the agreement, no comment on that fact was made in the letters by which it notified the applicant that it approved grants for those years. We have come to the conclusion, therefore, that the Board did not require that the whole of the amount prepaid in the 1980 year should be "earned" in that year by the expenditure of double that amount on the project. It is our view that $76,126 of it was not so "earned" in that year.

21. In support of his submission that only so much of the $150,000 advance as was "earned" in the 1980 tax year by expenditure on the project should be treated as income of that year, Mr Lanigan relied on
Arthur Murray (N.S.W.) Pty. Ltd. v. F.C. of T. (1965) 114 C.L.R. 314. In that case fees had been paid to the taxpayer for specified numbers of dancing lessons to be given over future periods. Some of those lessons might not be given in the year in which the fees were paid. The Court held that they could not be regarded at the moment of their receipt as assessable income of the taxpayer but became such assessable income only when they were earned by the provision of those lessons. Referring to
C. of T. (S.A.) v. Executor Trustee and Agency Co. of South Australia Ltd. (1938) 63 C.L.R. 108 (Carden's case), in which Dixon J. had observed that in the assessment of income the object was "to discover what gains have during the period of account come home to the taxpayer in a realised or immediately realisable form", the High Court observed that the word "gains" was there used in the sense of net profits of the business and was not synonymous with "receipts". It related to amounts which had not only been received but had "come home" to

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the taxpayer. That required not only that the amounts received were unaffected by legal restrictions, as for instance by a trust or charge, but that the situation had been reached in which they might properly be counted as gains completely made, so that there was neither legal nor business unsoundness in regarding them without qualification as income derived.

22. The Court referred to the fact that in the case stated with which it was concerned it was specifically stated as an agreed fact that, according to established accounting and commercial principles, in the case of a business either selling goods or supplying services, amounts received in advance of the goods being delivered or the services being supplied were not regarded as income. It commented:

"We have not been able to see any reason which should lead the courts to differ from accountants and commercial men on the point."

It further observed:

"Neither, apparently, has the Taxation Department seen any reason in principle, for we are told that the Department was accustomed to take the view we have expressed until an opinion grew up that to do so was in some way inconsistent with the judgment of this Court in the case of
Federal Commissioner of Taxation v. James Flood Pty. Ltd. (1953) 88 C.L.R. 492."

After considering what had been held by the Court in that case, their Honours said:

"In so far as the Act lays down a test for the inclusion of particular kinds of receipts in assessable income it is likewise true that commercial and accountancy practice cannot be substituted for the test. But the Act lays down no test for such a case as the present. The word `income', being used without relevant definition, is left to be understood in the sense which it has in the vocabulary of business affairs. To apply the concept which the word in that sense expresses is not to substitute some other test for the one prescribed in the Act; it is to give effect to the Act as it stands. Nothing in the Act is contradicted or ignored when a receipt of money as a prepayment under a contract for future services is said not to constitute by itself a derivation of assessable income. On the contrary, if the statement accords with ordinary business concepts in the community - and we are bound by the case stated to accept that it does - it applies the provisions of the Act according to their true meaning."

23. Mr Richards referred to the fact that in the Arthur Murray case the money prepaid might have been "earned" in the year in which the prepayment was received. Whether that was so is not clear from the report; but in
Country Magazine Pty. Ltd. v. F.C. of T. (1968) 117 C.L.R. 162 the amount prepaid could not have been "earned" in that year. Nevertheless, the High Court followed its decision in the Arthur Murray case. So clearly the applicability of the principles underlying that decision is not dependent on the recipient of the prepayment being able to "earn" the whole of it in the year in which it is received.

24. The facts of the present case are different from those in the Arthur Murray and Country Magazine cases in that what was prepaid was a grant and not the price payable under a contract for future services. At the time when the money was received, sec. 26(g) of the Income Tax Assessment Act 1936 provided that the assessable income of the taxpayer was to include any subsidy received in relation to the carrying on of a business and was to be deemed to be part of the proceeds of that business. We accept that the grant payable under the agreement was a subsidy. However, that, in our view, does not necessarily mean in the circumstances of the present case that, when it was prepaid, the amount of the prepayment was income in the year of the prepayment. Although there was a prepayment of grant, the grant might in fact never have become payable. In that event there would have been an obligation to repay what had been prepaid. The entitlement to receive the grant was to arise only when expenditure had been incurred by the applicant.

25. There is a close analogy between that situation and the situation of prepayment under a contract for future services. In each case there is a contract; in the present case it was made pursuant to a statute, providing for the applicant to perform certain research work and for the Commonwealth to pay a grant in direct proportion to the proper expenditure on that work. The facts in the present case are significantly different from those in Case T6,
86 ATC 141. There an insurance agent was

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liable to repay in certain circumstances part of the commission paid to him; it was argued that for that reason the commission was not income in the year in which it was received. The Board of Review found that the agent's liability to repay part of the commission, if it arose, would be the result of actions by persons other than himself and that he had done in the year when the commission was paid to him all that was required of him to "earn" it. By contrast, in the present case the applicant did not do in the 1980 year all that was required of it to earn the full amount prepaid to it. In those circumstances we consider that the principles underlying the decisions in the Arthur Murray and Country Magazine cases are applicable.

26. We are satisfied that only so much of the "advance" of $150,000 as was "earned" during the 1980 tax year was income derived in that year for the purposes of sec. 25(1) of the ITA Act, and that only that amount was a bounty or subsidy received in that year for the purposes of sec. 26(g) of that Act. Accordingly, we have varied the decision under review to the extent of deciding that $76,126 of the amount of taxable income shown in the respondent's notice of amended assessment was not taxable income of the applicant in the 1980 year. In consequence the additional tax of $4,499 must be reduced to the amount applicable only to the incorrect claim for deduction of bonuses amounting to $10,100.