Case U159

Members:
DJ Trowse M

Tribunal:
Administrative Appeals Tribunal

Decision date: 4 August 1987.

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D.J. Trowse (Member)

The matters in issue in these references relate to the 1984 year of income and concern an investment of $10,000 made by the applicant in July/August of 1983. The applicant contends that the outlay resulted in the acquisition of plant and equipment which was used for the purpose of producing assessable income and that, accordingly, the loss emanating from its disposal represents an allowable deduction under any one of sec. 51(1), 52 or 59 of the Income Tax Assessment Act ("the Assessment Act"). The deductibility of interest paid on moneys borrowed to fund that investment and one other also requires attention.

2. At the hearing the applicant, an auditor with a government instrumentality and part-time registered tax agent, presented his own case and gave evidence under oath. Whilst some of that evidence was inconsistent with information previously supplied to the respondent, I accept the applicant as a witness of truth. It is my conclusion that such conflict arose because of the very general terms used by the applicant in the presentation of his case plus the lack of an in-depth understanding of the relevant provisions of the Act. The Commissioner was represented by one of his officers.

3. It seems that in about June 1983 the applicant was introduced to B by a mutual friend L and that, as a result, he was engaged to prepare the 1983 income tax returns for a partnership consisting of B and his wife, as well as their individual returns. A copy of the partnership return tendered at the hearing revealed that it was engaged in the business of manufacturing clothing and that that activity had commenced in November of 1982. Also disclosed in the depreciation schedule attached thereto and prepared for the period to 30 June 1983 were details of various sewing machines and sundry items of plant used in that business. The collective depreciated value of that equipment as at 30 June 1983 was an amount of $16,397.

4. In addition to the meeting previously referred to, other conferences between B, L and the applicant ensued within a period of some days and it appears that the subject matter of those discussions related to an offer to L and the applicant to acquire an interest in the business being conducted by the partnership. In the first instant, they were invited to join the partnership, but that was declined. Finally, it was decided that a limited company would be a more appropriate vehicle and that the three of them would be equal shareholders in the venture. It seems that the plan was to expand the existing operation to include retail sales and that each of the parties would be made responsible for different aspects of the business; B was to be in charge of production, L sales, and the applicant management and finance. Notwithstanding those decisions, it was agreed that the implementation be delayed until the end of August to provide L with the opportunity of determining whether he could raise the necessary funds to be so involved. A negative result caused his withdrawal and this, together with cash flow problems then being experienced by B and the applicant, frustrated the plan in its entirety.

5. Furthermore, it appears that the applicant and B had entered into separate negotiations whereby it was proposed that the applicant purchase from the partnership the plant described in the depreciation schedule for a consideration of $10,000. According to the applicant's evidence the intention was that the plant be leased back, first to the partnership, and then to the company upon its incorporation, and that the rental be the greater of $2,500 p.a. or one-third of the operating profit. The rental was to be payable at the conclusion of the financial year. It was further alleged that final agreement on that proposal was reached on 8 July 1983 and that the resultant liability of $10,000 was discharged by the making of various instalment payments throughout the period 8 July 1983 to 5 August 1983. A copy of a receipt issued by B on partnership letterhead

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ATC 932

and which formed part of the documents before the Tribunal read as follows:

"Receipt

This is to certify I have received from [the applicant] of [applicant's address] an amount of $10,000 for plant and equipment as detailed in the depreciation schedule supporting this firm's 1982/83 income tax return.

Dated this fifth day of August 1983.

(Signed) B"

For reasons which will become apparent in due course, it should be appreciated that the acquisition of the plant was a package deal and that no separate costings had been allocated to individual items.

6. It also appears that the applicant made two other advances to the partnership in August, one of $1,000 and the other of $1,500, and that these represented short-term loans at interest to assist with the completion of a large order then in progress. During the 1984 financial year the applicant received interest of $240 on these advances and it is to be observed that that amount had been brought to account as assessable income in the preparation of his 1984 return.

7. In recognition of the dispute on the deductibility of interest incurred by the applicant during this same year, it is essential that the means of financing the overall payout of $12,500 be considered. Although the evidence on this point was somewhat confusing, it seems that the sources were as follows:

                                            $
      Loan     -   Credit Union (X)       7,000
      Loan     -   mother                 3,600
      Loan     -   Bankcard               1,000
      Advanced by applicant                 900
                                        -------
      Total                             $12,500
                                        -------
      

In my understanding, those funds were applied in the following manner:

                                                        Loans to
         Source                   Plant                partnership
                                    $                      $
      Credit Union (X)            7,000                     -
      Mother                      2,100                  1,500
      Bankcard                       -                   1,000
      Applicant                     900                     -
                                -------                 ------
      Total                     $10,000                 $2,500
                                -------                 ------
    

8. The applicant asserted that the leasing arrangement between himself and the partnership continued until March 1984 and that the termination then occurring coincided with the disappearance of both B and the plant and equipment. Neither have since been located. Furthermore, it seems that, at some time prior to the above negotiations, B had borrowed $11,000 from another source and had granted as security for that advance a bill of sale over certain, but not all, of the items of plant described in the 1983 partnership depreciation schedule. It appears that the articles so secured had a written down value as at 30 June 1983 of $10,223. Needless to say, the applicant had not been advised of this transaction and did not become aware of it until well after the removal of all plant either by the holder of the bill of sale or others. The loss suffered by the applicant was total; not only was all plant missing, but there was no prospect of recovering any portion of the loan of $2,500.

9. In the preparation of his 1984 income tax return, the applicant claimed as deductions the $10,000 resulting from the loss of plant, the $2,500 being the irretrievable loan made to B, and the following amounts of interest:

                               $
      Credit Union (X)       1,105
      Credit Union (Y)         772
      Bankcard                  21
                            ------
      Total                 $1,898
                            ------
      

The interest to X relates to the $7,000 used to acquire an equity in the plant and includes amounts paid after the cessation of the arrangement, i.e. March 1984. It seems that the interest of $772 paid to Y referred to an amount borrowed and applied towards the purchase of a motor vehicle used for private purposes and that such claim had been made in substitution for interest paid on the sum of $3,600 advanced to the applicant by his mother. It appears that the applicant's mother had made other loans to her son and that the total interest charged for the year was $956 of which, according to my calculations, $740 or thereabouts relates to the loan of $3,600.

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ATC 933

10. In the raising of his original assessment, the Commissioner disallowed the claims for the losses totalling $12,500, indicating in the adjustment the opinion that these were of a capital nature. By an amended assessment issued some 20 months later, the Commissioner disallowed in full the interest to Y and reduced the claim for interest to X to $845. It seems that that amount represented the interest charged on the $7,000 for the period from advancement to 31 March 1984, i.e. the date when income producing activities came to an abrupt halt. In objecting to those adjustments, the applicant submitted that the sums of $10,000 and $2,500 were allowable deductions under the provisions of sec. 51(1), 52, or "otherwise of the said Act", and that the amounts of interest disallowed, or some portion thereof, qualified for deduction in terms of sec. 51(1). At the hearing, the applicant conceded that he was not entitled to any deduction for the loss of $2,500 lent to the partnership and thus that matter was no longer in issue.

11. In presenting the Commissioner's reasons for disallowing the loss of $10,000, his representative relied upon two contentions. The first was that the $10,000 represented a payment in advance and that the incorporation of a company to carry on the business was a condition precedent to the actual acquisition of the plant. The transfer of ownership to the applicant was to take place upon formation and, as that condition had not been fulfilled, the amount in question took the form of a prepayment as distinct from the purchase of plant. In the alternative, and having due regard to the earlier transfer of legal ownership to the grantee named in the bill of sale, it was submitted that B had no title to that plant and therefore was incapable of giving good title to the applicant. On that point, the representative referred the Tribunal's particular attention to sec. 21 of the Sale of Goods Act 1895-1972. Although both of those submissions were raised in opposition to the applicant's claims under sec. 51(1) and 52, it seems more probable that they were aimed to counter any possible argument under sec. 54 and 59 of the Assessment Act.

12. In any event, the applicant's submission under sec. 51(1) may be disposed of without further delay. Irrespective of what description is afforded to the outlay of $10,000, it clearly has the character of capital and as such deductibility in terms of this subsection is precluded.

13. The applicant's submission under sec. 52 is dealt with in similar vein. It is well established that this section is complementary to sec. 26(a) as it then existed and which had the effect of rendering assessable profits arising from the sale by a taxpayer of any property acquired for profit-making by sale or from the carrying out of a profit-making undertaking or scheme. If those elements are present and a loss is incurred, sec. 52 provides that such a loss represents a permissible deduction. Having regard to the purpose of the payment, it is abundantly clear that those required features did not exist and thus the applicant's claim under this section is rejected.

14. On this same issue, the question finally emerged as to whether, bearing in mind the absence of any specific reference to sec. 59 in the objection, the applicant should be permitted to rely upon that section in the presentation of his case. In considering this matter, it is notable that the Commissioner had referred to that section in his regulation 35 statement, the purpose of which is to indicate the reasons for the disallowance of the applicant's claim, and that his representative at the hearing had come prepared to make submissions on this issue. It should be appreciated that sec. 190 of the Assessment Act was amended by sec. 81 of the Taxation Boards of Review (Transfer of Jurisdiction) Act and that in terms of that amendment this Tribunal has a discretion to extend the grounds of objection. The purpose of that change is to ensure that justice prevails as between the parties, and in my view such discretion should generally be exercised in favour of taxpayers unless it can be demonstrated that the Commissioner will be prejudiced by that decision. In this reference, it is apparent that the Commissioner has suffered no disadvantage in the presentation of his case and I am not able to perceive any reason for the denial of the applicant's request. On that basis I have allowed the extension.

15. Whether a deduction is permitted under sec. 59 is dependent on several requirements, the first being that depreciation has been allowed or is allowable under the Act. In this regard, the provisions of sec. 54(1), as they relate to this issue and which are set out hereunder, must be satisfied:

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ATC 934

"Depreciation during the year of income of any property, being plant or articles owned by a taxpayer and used by him during that year for the purpose of producing assessable income... shall, subject to this Act, be an allowable deduction."

Whilst it was accepted that the items of equipment came within the description of "plant", it was disputed by the Commissioner that ownership of the various articles had passed to the applicant. The reasons for such an attitude are as mentioned in para. 11 and which, for convenience, are repeated here in summary form. First, that the acquisition was subject to the incorporation of a company to conduct the business and as that condition remained unsatisfied the transaction was aborted. Secondly, because of the prior transaction whereby B had granted a bill of sale to a third party, the applicant never received title to those goods.

16. On the first of those submissions, it was not surprising to find that the applicant's evidence was in direct conflict with such a proposition. He maintained that the arrangement was that he acquire the plant listed in the depreciation schedule upon the payment of the agreed consideration and that those items be leased back to the partnership. Furthermore, the applicant asserted that the leasing arrangement was to be taken over by the company, if and when incorporated. I accept this evidence which to my mind is supported by the fact that the receipt issued by B made no reference to the existence of any conditions as between the parties.

17. I now turn to a consideration of the Commissioner's second submission and, in so doing, repeat that some but not all of the items of plant set out in the partnership depreciation schedule were subject to the bill of sale. The existence of the prior transaction between B and the third party was not disputed nor was the bill of sale or its validity. In defending his position the applicant appeared to rely solely upon the fact that he had entered into the arrangement in good faith and, on that basis, legal title to the plant had vested in him. Be that as it may, there is no doubt that the granting of the bill of sale had the effect of transferring full legal title to the other party. Clearly B had ceased to be the owner of those articles listed in the bill of sale and thus, to that extent, I reject the applicant's contention that he received good title. My conclusion is that, in the context of sec. 54(1), those articles were not owned by the applicant.

18. However, I take a different view of those items not included in the bill of sale and having as at 30 June 1983 a written down value of $6,174. In my opinion the applicant became the owner of those items of plant and in addition those articles were used by him during the year in question for the purpose of producing assessable income. Thus the Tribunal is satisfied that the requirements of sec. 54(1) have been met regarding those items of plant.

19. Having so found, it is appropriate that I now move to an examination of the provisions contained in sec. 59(1) which are recited in the following terms:

"Where any property of a taxpayer, in respect of which depreciation has been allowed or is allowable under this or the previous Act, is disposed of, lost or destroyed at any time in the year of income, the depreciated value of the property at that time, less the amount of any consideration receivable in respect of the disposal, loss or destruction, shall be an allowable deduction."

As previously stated I am of the view that those items of plant not included in the bill of sale were the applicant's property in respect of which depreciation is allowable. I also conclude that such plant was lost to the applicant in the year of income and that the consideration received in respect of that loss was nil. However, when it is recognised that the acquisition had been negotiated on a package basis and that no separate costings had been applied to the individual items, the burden of establishing a cost figure presents a difficulty for the applicant. Fortunately, the Commissioner's representative accepted the suggestion that, should the problem arise, the cost of the plant in fact acquired be calculated in terms of the formula - depreciated value of plant actually acquired divided by depreciated value of all plant included in the schedule multiplied by 10,000. The application of that formula provides a figure of $3,766 and, in view of the agreed concession, I accept that amount as the cost of the plant owned and lost by the applicant during the 1984 financial year. My conclusion is that all of the relevant requirements of sec. 54 and 59 have been met

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ATC 935

and that the amount of $3,766 qualifies for deduction. The balance of $6,234 represents no more than a loss of capital.

20. The final issue for the Tribunal's consideration is whether, in terms of the first limb of sec. 51(1), the amounts of interest claimed were incurred by the applicant in gaining or producing his assessable income. It is the use to which the borrowed funds are put that is determinative of this issue (see comments of Brennan J. in
Ure v. F.C. of T. 81 ATC 4100). If it is established that the borrowings were used to acquire income producing assets then the interest on those funds is incidental and relevant to the gaining of assessable income. Furthermore, I am of the opinion that amounts of interest accrued after 31 March 1984, i.e. the date upon which the income producing activities ceased, are no longer connected with the gaining of assessable income, and for that reason such amounts are not allowable deductions. Authority for that view is found in the decision of the Federal Court in the case of
Inglis v. F.C. of T. 80 ATC 4001.

21. The amount of $7,000 borrowed from X was paid to B as part of the overall consideration of $10,000 for the supposed acquisition of plant. As previously decided, the cost attaching to the plant in fact acquired by the applicant and used for the production of assessable income has been agreed to be a figure of $3,766, and in making that allocation it needs to be appreciated that expenditure in excess of that amount had not resulted in the creation of any income producing asset. Against that background, it seems reasonable to conclude that part only of the $7,000 had been used to purchase the plant and that in the circumstances the relevant portion should be measured as a proportion of 3,766 over 10,000. Interest on that part of the borrowing for the period up to 31 March 1984 amounts to $318 and in my view it is that figure which qualifies as a deduction in terms of sec. 51(1).

22. Next for consideration is the deductibility of the amounts of interest paid to the applicant's mother during the year. As indicated in para. 7, the amounts borrowed totalled $3,600 of which $2,100 formed part of the $10,000 paid for plant whilst the balance of $1,500 was used to fund the interest bearing loan made to B. As was the case of the borrowing from X, my conclusion is that only part of the $2,100 was used in the acquisition of an income-producing asset and that that portion should be quantified by applying the same proportion referred to above. That provides a figure of $790 which at the agreed rate of 19% p.a. for the period from advancement to 31 March 1984 produces an interest charge of $104. In my opinion that amount is deductible and so is the interest calculated on the $1,500 for a similar period and which is calculated to be a figure of $186.

23. The loan moneys obtained from Y were used for private purposes and thus the applicant's claim that the interest on that borrowing was incurred in the gaining of assessable income has no substance.

24. For the above reasons the Tribunal varies to the following extent the Commissioner's determination on the applicant's objections:

• • the allowance of $3,766 which represents the loss on disposal of depreciated property; and
• • the allowance of interest on loan moneys received from X, $318, and from mother, $290.