Case S75

Judges:
KP Brady Ch
JE Stewart M
DJ Trowse M

Court:
No. 2 Board of Review

Judgment date: 29 August 1985.

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K.P. Brady (Chairman), J.E. Stewart and D.J. Trowse (Members)

In these references, which relate to the years of income ended 30 June 1981 and 1982, we are called upon to determine the amounts of two taxpayers' individual interests in the net income of a partnership, the partnership having incurred losses in both years as a consequence of paying a salary to one of the partners.

2. The partners were a husband and wife, and we shall call them A and B. The business carried on by the partnership was the sale and repair of bicycles. We were informed that B, the wife, was the main operative in the business, and ran the shop and worked a full 40-hour week. In contrast, her husband was employed outside the business throughout both years of income; he worked for a proprietary company as an electrician. He apparently repaired customers' bicycles at nights and at weekends as his contribution to the family business.

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ATC 545

3. In recognition of the time spent by B in the business, she was paid a salary. That salary amounted to $17,000 in the first of the years under review and $17,490 in the following year. On the other hand, A did not receive any salary from the partnership.

4. A summary of the profit and loss statements which accompanied the partnership tax returns, and which were tendered in evidence, is as follows:

                                     1980/81              1981/82
                                        $                    $
      Sales                          94,631              119,814
                                     ------              -------
      Gross profit                   22,705               32,049
                                     ------              -------

      Less
      Salary                         17,000               17,490
      Other expenses                 13,926               19,292
                                     ------               ------
                                     30,926               36,782
                                     ------               ------
      Net loss                       $8,221               $4,733
                                     ------               ------

      Distributed equally
             - to A                   4,111                2,366
             - to B                   4,110                2,367
                                     ------               ------
                                     $8,221               $4,733
                                     ------               ------
      

5. Dealing first with the 1980/81 year of income, the amount of $8,221 was shown as a net loss in the partnership return for that year, and in the distribution statement forming part of that return, an amount of $4,111 was shown as A's 50% share of the loss, whilst B's share was reflected in a deduction from her salary of $17,000 to give a net income figure of $12,890. Consistency with that approach was maintained in submitting details of income in the individual partners' returns. The Commissioner, however, in processing the partnership return, saw the matter in a different light. For he disallowed the deduction claimed for the salary payments to B, and regarded the partnership as having a net income as opposed to a net loss, and computed it as amounting to $8,779, i.e. gross profit of $22,705 less other expenses of $13,926. Then, on the basis that B's salary reflected simply an alteration in the distribution of the income of the partnership, he treated the full amount of $8,779 as the income of B, and in keeping with that view he disallowed the proportionate share of the loss claimed in A's return. Similar treatment to the appropriate figures was accorded in the subsequent year's returns. Both A and B duly objected to the action taken by the Commissioner and, upon those objections being disallowed, the matter has come before this Board for review.

6. At the hearing, neither taxpayer entered an appearance and both were represented by their tax agent. By consent of the parties, the references for both years were heard concurrently.

7. The agent informed us that there was no written partnership agreement but that it was the partners' wish and their understanding that the business profits would be shared equally between them after payment of a salary to B. He contended that the salary that was paid was realistic and was in keeping with salary levels paid in the town where the business was conducted. Those levels might be considered to be higher than in the city because of the town's isolation and consequent high cost of living. In any event, the amount was not contested by the Commissioner's representative, and we accept that the salary payments made to B in both years were appropriate in all of the circumstances.

8. The tax agent was unsure whether B's salary was paid regularly throughout both years or was made by way of one payment some time prior to the end of each financial year. His belief tended towards the latter practice. Some support for that belief is reflected in the manner in which the salary receipt was shown in B's taxation returns for both years in issue. Whilst described as ``Partners Salary'', it was shown under the heading of ``Any Other Income'' and it would seem that no instalments of tax were ever deducted.

9. Whilst it was stated as a ground of objection in B's (and A's) notice of objection that the salary payments that were made to her were allowable deductions to the partnership under sec. 51(1) of the Income Tax Assessment Act 1936, that particular ground was withdrawn at the hearing, the agent conceding that the abovementioned section could not apply. Because of that concession, it is not necessary to deal with the matter in any detail, but in the interests of completeness we quote with approval the following remarks of Mr R.J. Gale, Chairman of Board No. 3 as then constituted, in Case R59,
16 T.B.R.D. 271 at p. 274:

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ATC 546

``It is now so well established, in my opinion, that the so-called `salary' payable by a partnership to a partner and interest payable on capital or current accounts by a partnership to a partner are not allowable deductions to the partnership in determining the net income of the partnership for the purposes of ss. 90 and 92 of the Assessment Act as to render any additional comment by me superfluous (cf.
Rose v. Federal Commissioner of Taxation (1951) 84 C.L.R. 118; 9 A.T.D. 334;
Ellis v. Joseph Ellis & Co. (1905) 1 K.B. 324;
Federal Commissioner of Taxation v. Beville (1953) 10 A.T.D. 170 and Case No.
C22, 3 T.B.R.D. 142).''

10. The rationale of the principle has perhaps best been stated by Mathew L.J. in Ellis v. Joseph Ellis & Co. (supra) when he said at p. 329:

``The argument on behalf of the applicant in this appeal appears to involve a legal impossibility, namely, that the same person can occupy the position of being both master and servant, employer and employed. The deceased man in this case was a partner; and the arrangement made between him and his co-partners as to the payment of wages to him was really an agreement with regard to the mode in which accounts were to be taken between the partners, and to the share of profits to be received by him in excess of that received by the other partners in consideration of the work done by him.''

11. The provisions of the Assessment Act to which the learned Chairman alluded above are, to the extent considered relevant to this hearing, in the following terms:

``92. (1) The assessable income of a partner in a partnership shall include -

• (a) so much of the individual interest of the partner in the net income of the partnership of the year of income as is attributable to a period when the partner was a resident;...''

``90. In this Division -

• ...
• `net income', in relation to a partnership, means the assessable income of the partnership, calculated as if the partnership were a taxpayer who was a resident, less all allowable deductions except the concessional deductions and deductions allowable under section 80, 80AA or 82AAT;
• ...''

12. Thus, if we could assume for the purpose of argument that there was no salary payable to B, the respective interests of A and B in the net income of the partnership for the first of the two years in issue would be -

                                                    $
      Gross profit                               22,705
      Less expenses                              13,926
                                                 ------
                                                 $8,779
                                                 ------

      A's interest, 50%                          $4,389
      B's interest, 50%                          $4,390
      

However, a salary was in fact paid to B, and the effect of paying over that salary to her was to alter the original 50:50 basis of distribution of the partnership income; in other words, B became entitled to receive a larger slice than otherwise of the ``net income'' cake. A partnership agreement is of course open to variation from day to day, and such variations may be evidenced not only by writing but, as was the situation before us, by the conduct of the parties. Hence, in making the decision to pay a salary to B, both parties may be taken to have implicitly established an order of priority as follows:

• First, B should receive a determined amount of salary, because she devoted a 40-hour week to the business for which she would have received remuneration had she worked those same hours elsewhere.
• Secondly, after payment of that salary, and only after payment of that salary, both partners would share what profits remained on a 50:50 basis.

13. On the trading results of both years in issue, there were not sufficient funds to make the salary distributions to B. However, stemming from the priority agreed by the partners, there has been an alteration effected in the distribution of the partnership's income and therefore what distributable funds remained in both years must be taken to have been distributed to B. Hence, in our view, the Commissioner was correct in treating all of the distribution of $8,779 in the 1980/81 year as the income of B, also all of the distribution of

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ATC 547

$12,757 in the 1981/82 year. That same approach, we consider, was taken by this same Board, as then constituted, in Case T69,
18 T.B.R.D. 353.

14. Mention was made by the taxpayers' representative that, in making the distributions in the manner in which his firm did, it was only following the Commissioner's own administrative practice. Whilst sympathetic to that line of argument, we can only apply the Assessment Act in the manner in which we consider it should be applied, and that remains true even if our view runs counter to administrative practices adopted within the Taxation Office.

15. For the reasons given above, we uphold the Commissioner's decisions on the objections and confirm the assessments for both years in issue.

Claims disallowed