CASE 49/95

Members:
BH Pascoe SM

Tribunal:
Administrative Appeals Tribunal

Decision date: 1 September 1995

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BH Pascoe (Senior Member)

This is an application to review decisions of the respondent dated 16 August 1994 to disallow objections lodged by the applicant against an amended assessment and an assessment of income tax based on income of the years ended 30 June 1992 and 30 June 1993 respectively.

2. The issue in this case is whether an amount of $30,000 in each of the years paid by the applicant to a company, A Pty Ltd, under agreements to indemnify the company for losses incurred was deductible. The applicant was not represented at the hearing and the respondent was represented by Mr G Davies of counsel. The only evidence was given by the applicant himself.

3. A Pty Ltd was incorporated in June 1991 with the applicant and his wife as the two shareholders and directors. In September 1991 the company acquired the plant, equipment and

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goodwill of a special accommodation home for the aged. The negotiations for the acquisition had been conducted by the applicant and the deposit under the contract was paid personally by the applicant. On 15 September 1991 the applicant entered into an agreement with A Pty Ltd under which he agreed to pay to the company the amount of any operating loss suffered by the company to a maximum of $30,000. In turn, the company agreed to pay to the applicant a percentage of any profit before tax being 50% of the first $60,000, 20% of the next $40,000 and 10% of any balance of profit. The agreement related to the year ended 30 June 1992 only unless extended at the discretion of the applicant. On 16 June 1992 a further agreement between the applicant and A Pty Ltd was entered into under which the guarantee to indemnify losses was extended to 30 June 1993. The consideration by the company was the same share of any profits but continuing until 30 June 2010 or earlier disposal of the shares held by the applicant in the company or disposal of the business by the company. There was provision for a consideration of one dollar for the further agreement.

4. The applicant is an accountant employed by a professional association. In his evidence he stated that he had come to the view in early 1991 that Australia had reached the bottom of the recession and that it was a good time to invest in real estate. In order to make such an investment he needed a source of cash flow and decided that aged care would be profitable and a growth area. He then commenced negotiations to acquire the business, a special accommodation unit in an outer suburb of Melbourne, for $240,000, being $75,210 for plant and equipment and $164,790 for goodwill. He believed that the existing business was being mismanaged with the then proprietor having cash problems. In his view the negotiated purchase price was some 60% of prior sale prices for aged care beds. In negotiations with the owner of the building for a lease of the premises he became aware that the owner was in some financial difficulties and considered the possibility of purchasing the building. However he did not proceed with that purchase being concerned to protect his own home and personal assets in the event of a failure to generate sufficient income from the business to service the necessary borrowing. Whilst he argued that he had every expectation and confidence that the business would be profitable, he felt responsible to the company to guarantee the performance of the business. As he anticipated a good income and cash flow from the business, he sought a means of directing part of this to himself before tax in order to use for the purpose of negatively gearing future real estate purchases. He accepted that he could have derived income from the company as salary, directors fees, accounting fees and/or dividends but these would have involved prior payment of tax by way of tax instalment deductions or company tax and he sought to obtain the gross income to be used to offset the negative gearing of property acquisition. He stressed that these arrangements were designed to minimise the exposure of the family house to the risk of unsuccessful future property acquisitions. His wish was to structure the business to provide income and benefits to his family with protection of family assets. On behalf of the company, A Pty Ltd, the applicant applied to the Commonwealth Bank and was granted a loan of the full amount of the purchase price, $240,000. Security was provided in the form of a charge over the assets of the company and a mortgage over the private residence of the applicant and his wife.

5. Without the two amounts of $30,000 each included in the company's income of the years ended 30 June 1992 and 1993, the company would have disclosed losses from the business operations of $34,833 and $31,618 respectively. In his evidence the applicant stated that the economy had not recovered as soon as he had expected, staff problems were encountered and the business had not proved as profitable as expected. He stated that the company called up his guarantee on 14 June 1992 when it was realised that there would be no profit and also requested an extension for a further year. On 16 June 1992 the second agreement was executed. He could not recall why a consideration of one dollar was provided for in the agreement and accepted that this was never paid or accounted for. He also accepted that, although the second agreement provided for the company to be liable to pay a share of profit to him for the subsequent eighteen years and the company did derive a net profit of $41,775 for the year ended 30 June 1994 no such payment had been made. He stated that he and his wife had separated in

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late 1992 or early 1993 but had continued to run the business as partners. Under a settlement under the Family Law Act in early 1994 he had agreed to undo the agreement with the company. In part, this decision was influenced by the respondent's decision to disallow the deductions claimed under the two agreements.

6. The two amounts of $30,000 each were not paid as such in cash by the applicant. Both amounts were debited to a loan account in his name in the books of the company. During the year ended 30 June 1992 his loan account was credited with $80,050. $24,000 of this was the original deposit or the purchase of the business paid by the applicant on behalf of the company. A further $2,050 represented cash provided to the company by the applicant. The remaining $54,000 represented a somewhat unusual entry for an accountant to have made. The applicant explained it on the basis that it represented 50% of his calculation of the amount of security provided to the bank against the loan and represented by the jointly owned family house. He understood that the policy of the bank was to accept only 55% of the value of the business assets as security, or $132,000, which left the remaining $108,000 represented by the home. The book entry was made to treat 50% of that latter amount as owing to each of himself and his wife with the former amount only owing to the bank. Under cross-examination, the applicant agreed that these entries were probably inappropriate. During the year ended 30 June 1993 the applicant made further cash advances to the company totalling $10,000 which were credited to his loan account in the company's books.

7. The applicant submitted that the amounts of $30,000 in each of the years ended 30 June 1992 and 1993 were allowable deductions under section 51(1) of the Income Tax Assessment Act 1936 (``the Act''). He argued that the amounts were losses or outgoings incurred to produce assessable income. At the time that the agreements were entered into he had an expectation that the company would make profits and in turn provide him with an income.

8. For the respondent it was argued that deductions were not allowable under section 51(1). Firstly it was said that the manner in which the liability was discharged by debit to a loan account against credits to the account which were fictitious did not result in a loss or outgoing by the applicant. Secondly, it was said that the liability under the first agreement which operated for the one year only could not have produced income to the applicant. The payment would be required only if the company made a loss in that year and, thus, no derivation of income by the applicant could arise as a result of a payment. The second agreement purported to provide one dollar and the prospect of income in future years. This prospect was too remote to provide the nexus required between any payment and the derivation of assessable income. It was stressed that the applicant was in effective control of the company, the parties were not at arm's length and the applicant had the ability to vary the agreement at any time. In fact, in the year ended 30 June 1994, the first year in which the company made a profit, the agreement was apparently terminated for what were said to be other reasons. On this basis it was submitted that the amounts, if incurred, were of a capital nature. The respondent further submitted that the purported transactions were shams and that the written documents were never intended to operate as they were expressed. It was argued that there was never an intention for the company to pay out part of its profits. There was said to be no commercial reason for the agreement and the purported liability of the applicant was met by debits to a loan account which had been inflated by incorrect entries. Finally, it was submitted for the respondent that Part IVA of the Act applied if section 51(1) would otherwise operate to allow a deduction. The making of the agreements and the manner of discharge of the liabilities was said to be a scheme for the purpose of transferring losses of the company to the benefit of the applicant.

9. It is appropriate to deal with the question of section 51(1) first. If the answer to deductibility under this section is in the negative, there is no need to consider the other two heads of the respondent's argument. The only section put by the applicant as allowing a deduction was section 51(1) and it appears unlikely that any other provision of the Act could apply for this purpose. The section has been oft quoted but it is always worth reminding ourselves of the words used:

``51(1) 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

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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.''

It is clear that the applicant was not carrying on any business during the relevant years. He was employed as an accountant on a salary and as director and secretary of A Pty Ltd for no remuneration. The reasons given by him for entering into the agreements I do not accept. Whilst somewhat vaguely expressed in his evidence and submission, they were said to be for the purpose of accessing cash flow from the company for the purchase of real estate in his own name and to protect his family and family home. However, the family home was already at risk as security for the bank loan to the company and the agreements put at risk $60,000 of the applicant's personal resources which might have been available otherwise for the benefit of the family. In his evidence the applicant stated that his initial projections of profitability for the business acquired by the company showed a break-even at 75% bed occupancy and a profit of $80,000 at 95% bed occupancy. If the higher level had been achieved the agreement would have caused the company to pay $32,000 to the applicant. This does not appear to be a significant reward for the risk apparently incurred. In not accepting his evidence, I have to contemplate what other reasons led to the agreements.

10. One view of the terms of the agreements is that they constituted a wager between the applicant on his own behalf and the applicant as the representative of the company. If he was wrong in his expectation of a profitable business he would pay to the company up to $30,000 in each year as reimbursement of losses. If he was right the company would pay him, on his projections, some equivalent sized amount. If 75% occupancy would produce a break-even result and 95% occupancy a profit of $80,000, then a possible but unlikely 100% would, I assume, produce a profit of some $100,000. This maximum figure would provide the applicant under the agreement's formula an amount of $38,000. In betting terms it would appear to provide even money odds. If this view is correct, then the loss of the applicant's wager would produce the same consequences for tax purposes as the loss of any one-off betting transaction.

11. However, if the agreements and accounting entries are accepted, the question remains as to whether section 51(1) allows a deduction for the two amounts of $30,000. In relation to the year ended 30 June 1992, I think not. The relevant agreement applied for that year only. If, as happened, the agreement required the applicant to pay any amount, it was because the company had incurred a loss. The expenditure by the applicant was simply not capable of gaining or producing any assessable income from such a loss or outgoing. The transaction was complete and at an end. The second agreement contemplated the possibility of a payment in respect of the year ended 30 June 1993 if the company incurred a loss and the possible payment to the applicant of a share of profits for the next eighteen years. Again the expenditure was not capable of producing income in the same year as these were mutually exclusive. The prospect of possible income in future years lends the character of capital to any payment as once and for all expenditure to obtain the possibility of a long term income stream. In fact, of course, no income can be pointed to as having been generated by the expenditure and none arose because the applicant terminated the agreement in the subsequent year when the company did make a profit. Consequently, I am unable to find that the two amounts of $30,000 had any nexus with any assessable income and section 51(1) does not allow a deduction. Although not necessary in these circumstances, I also find that the losses were of a capital nature. In answer to one of the respondent's submissions I do find that the losses were incurred by being debited to the applicant in the books of the company. Whilst another entry was incorrect and the result was that at 30 June 1993 the applicant owed the company some $23,950 rather than being owed $30,050, it is a debt which has been incurred by the applicant and recoverable by the company.

12. Given my findings that section 51(1) does not apply to allow a deduction, it is unnecessary to make any finding in relation to the respondent's submissions that the transactions were a sham or that Part IVA applies. In his submission, Mr Davies referred me to several decisions of the Boards of Review relating to claims for payments pursuant to guarantees entered into by taxpayers. It is no disrespect to

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counsel that I have not referred to these cases here. Whilst they provide some support for my decision, each case depends upon its particular facts, and I have no difficulty on the facts of this case in finding that the losses or outgoings claimed here were not incurred in gaining or producing assessable income and, in any event, were losses or outgoings of capital. Attributing the best of motives to the applicant for entering into the agreements they were to provide an injection of capital by him as founder and guiding hand of the company to offset losses incurred.

13. Although the objection lodged by the applicant against the amended assessment for the year ended 30 June 1992 included a claim that additional tax for incorrect return imposed in the amended assessment was excessive, no argument was put on this question at the hearing.

14. It follows from the foregoing reasons that the decisions under review are affirmed.