ADMINISTRATIVE APPEALS TRIBUNAL - TAXATION APPEALS DIVISION

[2005] AATA 479

Re Cachia and Federal Commissioner of Taxation

R Hunt, Senior Member

26 May 2005 - Sydney

R Hunt, Senior Member. Mr Cachia, the applicant, applied to the tribunal for review of the Commissioner's decision to deny him tax relief for legal expenses incurred in seeking damages or compensation related to dealings with unit trusts. Mr Cachia had acquired 57,397.21 units in the Westpac Real Property Growth Trust in January and February 1985. Mr Cachia received income from his holdings until his units were redeemed against his wishes around 15 March 1992. As part of the redemption arrangements and merger of the Growth Trust with Westpac Property Trust, Mr Cachia received 29,441 units in Westpac Property Trust. These transactions took place despite Mr Cachia's objections. Mr Cachia unsuccessfully sought damages or equitable compensation through the courts. In his tax return for the tax year ending 30 June 2002, Mr Cachia claimed a deduction of $61,000 for tax losses of earlier income years. For the year ending 30 June 2003, Mr Cachia claimed a deduction for legal expenses of $108,376 and prior years tax losses of $28,260. On 2 April 2004, the Commissioner issued a notice of assessment for the 2003 year that included adjustments to deductions as a result of an audit. Mr Cachia objected to this assessment and the Commissioner disallowed the objection, notifying Mr Cachia of this decision and the reasons on 31 May 2004. The tribunal has reviewed the objection decision and finds that it should be affirmed for the reasons set out below.

Issues

2 The issues before the tribunal were whether, in respect of the year ended 30 June 2003, Mr Cachia was entitled to:

• a deduction under s 8-1 of the Income Tax Assessment Act 1997 (Cth) (the ITAA 1997) for legal expenses of $108,376; and

• a deduction under Div 36 of the ITAA 1997 for tax losses of prior years of $28,260.

Facts and evidence

3 Mr Cachia told the tribunal that the facts concerning his dealings with Westpac and certain trusts, which lead to his dispute with the Commissioner, were correctly set out in the judgment of Hely J in Cachia v Westpac Financial Services Ltd (2000) 170 ALR 65. In February 1992, Westpac Financial Services Ltd, as manager of the Westpac Growth Trust and Westpac Property Trust, circulated information with a notice of a general meeting to give effect to its recommendations. Proposals included merger of the Growth Trust and the Property Trust and amendment of the Growth Trust deed to the effect that unitholders be deemed to have requested redemption of their units and to have accepted units in the Property Trust in full satisfaction. Meetings of both trusts approved the resolutions in March 1992. This meant that Mr Cachia no longer had an investment in the Growth Trust and received units in the Property Trust. He took legal action to compensate him for the loss of his initial units and income from that source.

4 Mr Cachia placed importance on his intentions and claimed that he instituted his legal action "related to my income producing investment in the Westpac Property Trust … for the purpose of increasing my income from the Trust …". The trust deed of the Growth Trust had empowered the distribution of income. After the merger, he was receiving less income than he thought he should. Mr Cachia further stated that his investment in the Property Trust was not free of capital gains tax, unlike his initial investment. He had not invested to obtain a capital gain although he realised that a capital gain might eventuate. His purpose was to generate income.

5 Mr Cachia argued that his legal expenses should be characterised as having an income character as the litigation sought to recover and increase assessable income. He also claimed that there were other aspects pointing to an income nature of the expenses. These aspects were that any damages award would have been taxable, he was defending his income, that although there were capital features of the matter the income aspect prevailed, the unit price would not have increased as a result of his action and that, if the value of the units changed, this would be at some time in the future. Mr Cachia also detailed several arguments about capital gain and explained that he was seeking income rather than a capital gain. He suggested that if the law was unclear the taxpayer should have the benefit of the doubt.

6 In respect of the tax year ended 30 June 2003, Mr Cachia claimed that his legal expenses with Westpac were income related and that he should be able to carry forward "unclaimed deductions" in any subsequent year. Mr Cachia claimed that the amount of legal expenses was not disputed and that the amount of "unclaimed-deductions/losses" of $28,260 was also not disputed.

7 In respect of the year ended 30 June 2002, Mr Cachia later sought review of the Commissioner's decision of 16 December 2004 that he was not entitled to a deduction of $61,000 under Div 36 of the ITAA 1997 for tax losses of prior years. The tribunal directed on 16 December 2004 that, on the present application, the tribunal was dealing with the objection decision dated 31 May 2004 in respect of the 2003 tax year.

Legislation

8 Section 8-1 of the ITAA 1997 provides, in part:

(1) You can deduct from your assessable income any loss or outgoing to the extent that:
(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a *business for the purpose of gaining or producing your assessable income.

…

(2) However, you cannot deduct a loss or outgoing under this section to the extent that:
(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

(c) it is incurred in relation to gaining or producing you *exempt income or your *non-assessable non-exempt income; or

(d) a provision of this Act prevents you from deducting it.

9 Division 36 of the ITAA 1997 deals with treatment of tax losses of prior years. See further discussion under "prior year losses" below.

Consideration

Deductibility of legal expenses

10 Mr Cachia argued strongly that his object or intention in taking legal action should determine the character of his expenditure for tax purposes. However, intention is not the only determining factor. For a legal expense to be deductible, it must satisfy both subsections of s 8-1 of the ITAA 1997. That is, it must meet the positive requirements in s 8-1(1) and the negative requirements in s 8-1(2) as set out above. In Mr Cachia's case, the legal expense must not be an outgoing of capital or of a capital nature and the expense must be incurred in gaining or producing his assessable income.

An outgoing of capital, or of a capital nature

11 Both parties referred to the same line of cases and authorities in making their argument before the tribunal. These authorities indicate that the character of legal expenses is determined by the character of the advantage which is sought to be gained by incurring the expenses. In an oft-quoted statement from the High Court decision in Hallstroms Pty Ltd v FCT (1946) 72 CLR 634 at 647; 8 ATD 190 at 194-195, Dixon J said:

The claim is to deduct legal expenses, and legal expenses, we may assume, take the quality of an outgoing of a capital nature or of an outgoing on account of revenue from the cause or the purpose of incurring the expenditure. We are, therefore, remitted to a consideration of the object in view when the legal proceedings were undertaken, or of the situation which impelled the taxpayer to undertake them.

12 The next step, therefore, is to identify the advantage being sought by Mr Cachia in his litigation. The intention of a taxpayer in incurring an expense can be important. This is particularly so where the outgoing is voluntary and "the man carrying on the business must be the judge of what is "necessary"": see FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431; 11 ATD 463; [1958] ALR 523 as noted with approval in Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276; 80 ATC 4542; 33 ALR 213. Further, in Magna Alloys (at ATR 283; ATC 4548; ALR 220 per Brennan J) the Federal Court said:

When the question is whether expenditure has the character of capital or of a revenue payment … the advantage for which the expenditure was incurred must be identified and the manner in which it "is to be relied upon or enjoyed" must be considered. …

13 There is no doubt that Mr Cachia incurred legal expenses in connection with his struggle against Westpac. Although he wished to increase his income, the litigation concerned a capital asset which had been redeemed and a capital asset which replaced the first asset upon the redemption and merger. I have taken this description of Mr Cachia's aims from his evidence and from the facts set out by Hely J in the Federal Court judgment, which Mr Cachia told the tribunal accurately sets out the facts.

14 From the judgment of Hely J, I have discerned that Mr Cachia wanted payment of what he thought was the true value of his units. Such a payment would clearly be a capital sum and not revenue. The advantage Mr Cachia sought to gain is of a capital nature. The basis for bringing the suit against Westpac was for inadequate compensation for the redemption of his units in the Westpac Real Property Growth Trust. Mr Cachia claimed compensation for the difference between the true value of his units in the Growth Trust (including the imputed value of having capital-gains-tax-free status) and the value of what he actually received.

15 As well, Mr Cachia wanted a sum by way of damages. The damages sought were for misleading and deceptive conduct according to the facts set out in the Hely J judgment. The damages claim was not for lost income although doubtless Mr Cachia would say that the conduct complained of led to a loss of income. Any claim for misleading and deceptive conduct relates to the lost units in the Growth Trust and, in my view, thereby takes on a capital nature. If Mr Cachia had received damages, it would have been for the realisation of the Growth Trust units and clearly of a capital nature. Any element of the legal expenses for such a claim therefore is not of a revenue nature.

16 Mr Cachia also claimed equitable compensation related to an amendment to the Growth Trust deed and what he perceived as expropriation of Mr Cachia's property in the trust or his units. In my view, this claim was also about property and not about income generated by the property. This is so even though Mr Cachia would doubtless see a connection to his loss of income in all these claims. If Mr Cachia had received compensation for the expropriation it would have been for the loss of his asset or for its true value and would have been of a capital nature. Any element of the legal expenses for such a claim also therefore takes on a capital nature.

17 In sum, the character of Mr Cachia's legal action, in my view, takes on the character of the investment rather than the character of any income Mr Cachia's investment might have generated. It follows that Mr Cachia's legal action was of a capital nature and not of a revenue nature. He cannot in consequence succeed in his claim that his legal expenses were a deductible expense.

18 Mr Cachia has claimed that the quantum of his legal expenses was not disputed. This is not correct as was made plain at the hearing by the Commissioner's counsel. The reference to a specific amount of claim in the reasons for the objection decision is not an admission by the Commissioner that the amount of the claim was substantiated and agreed. Mr Cachia furnished copies of receipts for fees paid to the various courts in which he commenced legal action. As well, he has provided a Certificate of Taxation from the Federal Court for the cost of the Westpac case and a copy of a cheque made out by Mr Cachia in favour of the Australian Government Solicitor (AGS). I note that the Certificate of Taxation from the Federal Court is not good evidence that Mr Cachia actually made payment of the amount of costs set out in the certificate. Similarly, the copy of the cheque made out by Mr Cachia in favour of the AGS is not conclusive evidence that payment was made. There is no evidence before the tribunal that the cheque was received by the AGS and honoured by Mr Cachia. In any event, Mr Cachia has told the tribunal that all the expenses claimed were incurred in pursuit of Westpac in the matter of the trusts and I have already found that these expenses were on capital account and not on revenue account.

19 As the character of legal expenses takes on the quality of the advantage sought, the legal expenses are an outgoing of a capital nature and are excluded from deductibility by s 8-1(2)(a) of the ITAA 1997.

Incurred in gaining or producing assessable income

20 As well, I am not satisfied that the legal expenses were incurred in gaining or producing assessable income. In Ronpibon Tin NL and Tongkah Compound NL v FCT (1949) 78 CLR 47; 8 ATD 431; [1949] ALR 785, the High Court said that:

For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words "incurred in gaining or producing the assessable income" mean in the course of gaining or producing such income (at CLR 56-57; ATD 435; ALR 789) per Latham CJ, Rich, Dixon, McTiernan and Webb JJ.

In Magna Alloys, Deane and Fisher JJ said (at ATR 296; ATC 4559; ALR 235):

To the extent that the subjective element is relevant, what is important in the case of a voluntary outgoing is the identification of the advantage or advantages which the outgoing was intended to achieve on behalf of the taxpayer regardless of whether that advantage or those advantages were seen as the direct result of the outgoing or as indirectly flowing therefrom or of whether the pursuit of them should be seen as "purpose" or as "object" or as "motive".

21 In Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113; 2 ATD 169, the taxpayer was a newspaper publisher which incurred legal expenses in defending a defamation claim. In finding that the deduction was allowable, the court (at CLR 119; ATD 171-172) per Gavan Duffy CJ and Dixon J noted that the matter over which legal action was taken was unavoidably related to the production of income:

When it appears that the inclusion in the newspaper of matter alleged by claimants to be defamatory is a regular and almost unavoidable incident of publishing it, so that the claims directly flow from acts done for no other purpose than earning revenue, acts forming the essence of the business, no valid reason remains for denying that the money was wholly and exclusively expended for the production of assessable income.

22 In FCT v Rowe (1995) 60 FCR 99; 31 ATR 392; 95 ATC 4691; 131 ALR 622, the taxpayer incurred legal expenses in relation to an inquiry into the taxpayer's alleged misconduct. In holding that the expenses were deductible, Burchett J said (at FCR 113; ATR 404; ATC 4702-4703; ALR 634) that:

… I think these expenses should be recognised as incurred by the respondent in defending the manner of his performance of his duties. It was only by so justifying himself that he could make a successful defence against dismissal. When the matter is seen in this light, it falls squarely within the rule discussed in Putnin v FCT (1991) 27 FCR 508; 21 ATR 1245; 91 ATC 4097; 98 ALR 13. To adapt language there quoted (at FCR 511; ATR 1248-1249; ATC 4100; ALR 17) from Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113 at 117-119; 2 ATD 169 at 170-172, the liability in question was incurred, or the claim was encountered, because of the very act of performing the work by which the respondent earned assessable income. The activities which produced the assessable income were what exposed the taxpayer to the liability discharged by the expenditure. As the court said in Putnin (at FCR 513; ATR 1250; ATC 4102; ALR 19), so here, "the … proceedings arose from the activities by which the taxpayer earned his income, the mode of his performance of a particular task carried out in the course of business operations".

23 These cases illustrate that, in order to satisfy the positive limb of s 8-1, the legal expenses must be incurred in the course of gaining or producing assessable income and should arise from the very activities by which the applicant produces assessable income. Mr Cachia's expenditure lacks the required nexus between the legal expenses and any assessable income gained or sought. His loss or outgoing is not productive of assessable income: Amalgamated Zinc (de Bavay's) Ltd v FCT (1935) 54 CLR 295; 3 ATD 288; [1936] ALR 67.

Prior year losses

24 A deduction for tax losses of earlier income years is allowable under Div 36 where the loss provisions are met. Before the tribunal, Mr Cachia claimed "losses" or "deductions", using these terms interchangeably. Mr Cachia has admitted in his written submissions handed up on the day of the tribunal hearing that he does not understand the difference between losses and deductions. Accordingly, the tribunal has dealt with both losses and deductions below.

25 A tax loss is explained in s 36-10 as follows:

(1) Add up the amounts you can deduct for an income year (except *tax losses for earlier income years).

(2) Subtract your total assessable income.

(3) If you *derived *exempt income, also subtract your *net exempt income (worked out under section 36-20).

(4) Any amount remaining is your tax loss for the income year, which is called a loss year.

26 A deduction for tax losses is allowed under s 36-15, which provides, in part, that:

(1) Your *tax loss for a *loss year is deducted in a later income year as follows if you are not a *corporate tax entity at any time during the later income year.

…

(2) If your total assessable income for the later income year exceeds your total deductions (other than *tax losses), you deduct the tax loss from that excess.

…

(5) If you have 2 or more *tax losses, you deduct them in the order in which you incurred them.

(6) A *tax loss can be deducted only to the extent that it has not already been deducted.

(7) If you cannot deduct all or part of your *tax loss in an income year, you can carry forward to the next income year the undeducted amount. You then apply this Subdivision to work out if you can deduct the tax loss in that income year.

27 It can be seen that in order to have a tax loss, a taxpayer must have deductions that are greater than assessable income (and exempt income) for that income year. Mr Cachia's income tax assessments from 1994 onwards are before the tribunal. His deductions in these years are never greater than his assessable income. In addition, Mr Cachia has not shown that he sustained a loss before 1994. Mr Cachia has referred to "unclaimed deductions" in his returns but has not taken the further step of calculating and demonstrating tax losses. The Commissioner's delegate has nevertheless looked at Mr Cachia's claim for losses by reference to the "unclaimed deductions" in the 2000 and 2001 years and prior year tax losses claimed in 2002 and 2003 and found that Mr Cachia still would not have losses that exceeded his assessable income. The tribunal agrees that Mr Cachia has not shown that he is entitled to a deduction under Div 36 in the year ended 30 June 2003.

28 Both parties have cited the tribunal's reasoning in AAT Case 5150 (1989) 20 ATR 3607; Case W52 (1989) 89 ATC 486 in support of their contentions about the tax losses or unclaimed deductions. Mr Cachia said the outcome of the case was immaterial. The case, in his view, illustrated that the law was so difficult to understand that even barristers were confused and he ought to be given the benefit of the doubt. In that case, which concerned the losses and allowable deduction provisions under the Income Tax Assessment Act 1936 (Cth) (the ITAA 1936), as amended, Bannon DP noted that s 80(2) and (2C) did not permit the taxpayer to elect in which years to offset previous losses but envisaged an order of application of losses. In my opinion, the reasoning in AAT Cae 5150, Case W52 does not assist Mr Cachia to establish losses. Mr Cachia also referred to the comments of Hunt J in Odyssey International Pty Ltd v FCT (1987) 18 ATR 705; 87 ATC 4333, commending the Commissioner's approach in not disputing matters outside the real issues. I find no fault with the respondent's conduct of the present case. The Commissioner has not distracted the tribunal by arguing matters beyond the real issues or by clouding the real issues. The issues are conceptually difficult particularly for a self-represented applicant but this is not the fault of the respondent and does not permit the tribunal to ignore the correct application of the ITAA 1997.

Unclaimed deductions

29 The Deputy President in AAT Case 5150, Case W52 also noted that the effect of s 166 of the ITAA 1936 was to impose a obligation on the Commissioner to allow deductions that come to his knowledge and which have not been claimed in income tax returns lodged under s 161: see George v FCT (1952) 86 CLR 183; 10 ATD 65; [1952] ALR 961and Bailey v FCT (1977) 136 CLR 214; 7 ATR 251; 77 ATC 4096; 13 ALR 41. Mr Cachia has disclosed unclaimed deductions in previous returns. It may be that he can substantiate these claims. However, he did not do so in the proceedings before the tribunal. If Mr Cachia wises to claim deductions for $77,051 in the 2000 year and $43,283 in the 2001 year, he may lodge an amendment request with the ATO. This is not a matter that the tribunal can decide in relation to the decision under review as it concerns the 2003 year only. Further, Mr Cachia indicated at the hearing that he had since received favourable treatment for these claims. It would be pointless to make an adjustment if this has already occurred.

30 Finally, Mr Cachia has not discharged his onus of proving that the assessment under review was excessive, which was the subject of his objection and thus the reviewable decision before this tribunal. It follows that the objection decision should be affirmed.

Decision

31 The decision is for the application of NT2004/167 only and does not include the application of NT2004/361. The tribunal affirms the objection decision made by the Commissioner of Taxation, dated 31 May 2004, denying the applicant, Mr Cachia, tax relief for legal expenses incurred in seeking damages or compensation in relation to a unit trust and a deduction for tax losses, in respect of the year ended 30 June 2003.