(1) Concept of a Business
Three areas that need to be determined are:
1. Are you carrying on a business?
2. The precise nature and scope of the business;
3. Establish the relationship between the business and the receipt ie that the receipt is a product of or an incident of carrying on the business – then ordinary income.
If you satisfy all three what you get is income under ordinary concepts, and is included in your assessable income.
S6(1) ITAA36 AND 995-1(1) ITAA97:
“Business” is defined as “including any profession, trade, employment, vocation or calling, but does not include occupation as an employee”. Essentially, therefore, income from business is income that is not persona exertion income, is not income from property and is income derived from carrying on a business. The question whether particular activities constitute a business is very much one of fact and degree and is left for the Courts to decide.
Indicators of a Business
Evans v FC (1989) – It is necessary that the activity be undertaken for the purpose of profit
Facts: Taxpayer had credited his successful gambling as the explanation of his sudden increase in wealth during a Tax Office audit of his affairs. This was accepted by the Commissioner who then claimed that the proceeds of his gambling were assessable because Evans was carrying on a business.
Held: Hill J; that the taxpayer’s activities did not amount to a business because he did not try to maximize his return. On the facts, the court found the taxpayer’s activities lacked system and organization essential to characterize it as a business.
[extra] Hill J went on to say that, “the question of whether a particular activity constitutes a business involves questions of fact and degree. Although both parties referred to comments made in decided cases, each of the cases depends upon its own facts and in the ultimate is unhelpful in the resolution of some other and different fact situation. There is no one factor that is decisive of whether a particular activity constitutes a business. There are a multitude of things which together make up the carrying of the trade.
What the Courts look for to determine whether a business:
(i) the extent to which the taxpayer’s activity is characterized by system and organization
(ii) the scale on which the taxpayer conducts the activities
(iii) the extent to which the taxpayer’s activities involve sustained regular and frequent transactions
(iv) whether talent has been turned to account for profit
(v) whether the taxpayer conducted the operations with a profit motive
(vi) the commercial character of the transactions themselves
(vii) characteristics or quantities of the property dealt in, and
(viii) inherent characteristics of the taxpayer.
Ferguson v FC (1979) – In distinguishing between a business and a hobby, courts placed considerable importance on the extent of the system and organisation involved.
Facts: Taxpayer was a naval officer who wished to engage in primary production activities upon his retirement. Whilst still in the navy, Ferguson leased five cows for four years to be pastured and bred by a management company.
Held: FC; Taxpayer was engaged in a (“preliminary”) business of primary production. Fisher J felt it significant that “the venture as a whole had a commercial flavour, was conducted systematically and…in a business-like manner.
FCT v Walker (1985) – Walker a taxpayer who began with only one angora goat was held to be in the business of goat breeding, largely because the court was satisfied on the facts that the taxpayer was conducting his activities in a “businesslike” way. The taxpayer was found to be in business even though the venture was not particularly successful and was of such a small scale.
Thomas v FCT (1972) – Scale of activities
Facts: Taxpayer was primarily a barrister, but he also argued that he was a primary producer. On land near to the house, he planted macadamia nuts, avocado and pear trees. He knew when planting the trees that it should be some years before he would get a return, but after that he expected to make about $3,000 pa eventually. He set up an irrigation system, the trees initially grew fairly well, but later there was a fire and frost and the trees were destroyed. He claimed the loss.
Held: HC; that a man may carry on a business even though he does so in a small way. The court held he was not growing trees as a hobby, they said on the evidence there was a significant commercial purpose involved. The court formed that view based on the scale the trees were planted, which was much greater than his domestic needs and the fact that he expected to get some return in the future. In regard to the lack of his business efficiency or competency, the court said that did not lead to the conclusion that he was not carrying on a business. The court said many persons seek to commence a business of which they have not had any previous experience in the area. It was held he was carrying on a business, albeit in a small way. As Walsh J observed in Thomas v FC of T, “a man may carry on a business although he does so in a small way”. Thus, in FC of T v JR Walker the taxpayer was held to be in the business of goat breeding even though he began with only the one goat. However it is clear that the courts are influenced by the size and scale of a taxpayer’s activities and that, in general, the smaller the sale of the activities the more likely the courts are to characterize them as the pursuit of a mere hobby or pastime, rather than a business.
(2) Taxation of Business Income
ITAA 1997, ss 6-5, 10-5, 15-15 / ITAA 1936, s 21A
Having identified a business, the next step is to determine which of the proceeds of that business are assessable as not all business receipts are necessarily income in character.
ITAA 1997 - SECT 6.5
Income according to ordinary concepts (ordinary income)
(1) Your assessable income includes income according to ordinary concepts, which is called ordinary income.
Note: Some of the provisions about assessable income listed in section 10 5 may affect the treatment of ordinary income.
(2) If you are an Australian resident, your assessable income includes the * ordinary income you * derived directly or indirectly from all sources, whether in or out of Australia, during the income year.
(3) If you are a foreign resident, your assessable income includes:
(a) the * ordinary income you * derived directly or indirectly from all * Australian sources during the income year; and
(b) other * ordinary income that a provision includes in your assessable income for the income year on some basis other than having an * Australian source.
(4) In working out whether you have derived an amount of * ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct.
(a) Normal proceeds of a Business
Gains flowing from “trading” transactions or which are received as the “ordinary proceeds” or “ordinary incidents” of a business activity are generally income in nature. On the other hand, gains arising from the “mere realization of a capital asset” are usually capital in nature. Where the taxpayer has a profit motive, this will usually point to an activity being a business. There is, however, no determinative rule as to what is required for activities to constitute a business, and it will always be a question of fact and degree.
In order to determine whether a receipt is the normal product of a business, it is necessary to determine:
1. the precise nature and scope of the business, and
2. the relationship between that business and the receipt (to determine whether the receipt is produced by or is an incident of the business)
GP International Pipecoaters v FCT (1988) – precise nature and scope of the business
Facts: the taxpayer was a joint venture company incorporated for the sole purpose of carrying out a contract with the State Energy Commission of Australia which required the taxpayer to erect a pipe-coating plant complex. Under the contract, the Commission paid the taxpayer $4.675m “establishment” costs in three equal instalments, to enable the taxpayer to erect the plant complex without having to borrow money for that purpose. The taxpayer argued that the money was capital in character and therefore not assessable as ordinary income.
Held: FFC; on the facts held that the $4.675m was assessable income under ordinary concepts, reaching this conclusion basically because of the way it defined the scope of the taxpayer’s business:
“We believe that, if a company is brought into existence for the sole purpose of performing one contract for profit, and particularly if the life of the contract is comparatively short … then all payments made under the contract are likely to be income rather than capital receipts in the hands of the company. The business of such a company is the performance of the contract, and the receipts are in the ordinary course of that business.”
The High Court upheld this decision.
Facts: The taxpayer had a 45 year lease granted by the NSW government to carry on business of resort operator. The taxpayer derived its returns primarily from skiers using its lift facility, its accommodation, restaurants and other facilities in the town such as transport. Taxpayer decided in order to increase the use of its facilities, to begin building apartments. It would sub-let the apartments at a premium, to recover its costs plus a profit in respect of the building of the apartment. It could only sub-let, as it only had a lease itself from the government. It would grant the leases for one-off premium, for the period of its own lease, and no rent was payable.
Held: The court said the transactions were repetitive and recurrent and were carried on for a number of years. Taxpayer was in business of carrying on business as a property developer i.e. question of fact. The court said in this case the taxpayer was carrying on the business of developing the land, as a developer, and in that context the premium was income and assessable as ordinary income.
FCT v Cyclone Scaffolding (1987) – Receipts not held to be ordinary income.
Facts: Taxpayer owned scaffolding equipment which it hired to the public, although it occasionally sold scaffolding equipment to governmental and semi-governmental authorities. The taxpayer usually made special purchases of equipment for the purposes of these sales but, on occasion, it also sold some of its hiring equipment. In addition, the taxpayer also “sold” plant where hirers lost or destroyed the equipment, because under the terms of its hiring contracts, the hirer was required to pay the taxpayer’s current list price for any equipment loss or destroyed.
Issue: The Commissioner unsuccessfully attempted to assess the company on the basis that the amounts received from sales of equipment and from payments by hirers for replacement equipment were assessable income.
Held: The Full Federal Court said the compensation money had to be looked at in the context of the activities as a whole. It was then clear that the money was received for disposal of part of taxpayer’s profit making apparatus i.e. sale of the taxpayer’s income producing assets and therefore capital. It is distinguished from Memorex where the company had extended its business. Cyclone was not in the business of losing scaffolding and making money out of it. They did not sell leased equipment, it had simply been lost and the receipts were simply compensation for the loss of their profit-making assets. The receipts were held not to be ordinary income.
Memorex v FCT (1987)
Facts: The taxpayer carried on business as a supplier of computer equipment. It bought the equipment from its American parent company and then either sold it or leased it out to customers. Some goods which were on lease were sold to the customers, and some leased equipment was also “sold” to its finance company to secure borrowings by the company. The taxpayer treated equipment which it leased to customers as depreciable plant and, if it sold the leased equipment for a consideration greater than the depreciated value, the depreciation recouped was brought to account as assessable income under s59 ITAA36. The Commissioner took the view that where the leased goods were sold for a price higher than their cost, the excess was an assessable profit under s25(1) or 26(a) and succeeded in his assessment.
Held: The FFC decided, that there had been a downturn in the economy, such that the company was having troubles selling computer equipment. The company then went to customers and said, rather than you paying out a great lot of money for the equipment, we will install it in your premises and lease it for a little while, and when things improve and you make enough money, then you can buy it. This became the modus operandi by which they were moving their trading stock. The court said that the nature of the business had changed. They had branched out into the business of leasing and selling the leased equipment. The Court found the nature and scope of the business had actually changed as a result of a downturn in business.
(b) Isolated Transaction or Undertaking
This deals with isolated transactions where one goes past mere realization of an asset, but appears to cover something less than actually carrying on a business. The court sometimes describes it as “a venture in the nature of trade”. Strictly speaking, you are not carrying on a business, but because it has such a commercial flavour, it is considered to constitute an isolated business venture such that it is considered to be income.
Scottish Australian Mining Co v FCT (1950)
Facts: Company had incorporated in 1859 and acquired properties in the Newcastle area for mining operations. In 1924 there was no more coal left, so the company decided to sell the land off. The taxpayer incurred considerable expense in building roads and subdividing the site and dedicating other parts of the land for schools, parks etc, and made quite a large profit on the sale of the land.
Issue: It went to the High Court as to whether the taxpayer was liable for tax on the profits.
Held: HC ruled that the profit was not assessable. It was held not to be income as it was simply part of the process of realizing a capital asset to the best advantage. He said the facts would have to be strong before a court would be induced to hold a company which had not purchased or otherwise acquired land for the purpose of profit making by sale was engaged in the business of selling land and not merely taking the necessary steps to realize the land to best advantage. The important factors in the case were:
• taxpayer had not acquired the land for the purpose of dealing with the land and had held onto the land for a long period of time;
• court gave the concept of “a mere realization to best advantage:
• the decision has the scope of restricting what would be ordinary income;
• a pretty broad restriction, much could escape being income under this principle
• a more recent case has greatly restricted the ‘mere realisation’ rule – see FCT v Whitfords Beach (below).
FCT v Whitfords Beach (1982)
the company had purchased a large tract of land outside Perth in 1954 so that the members of the company could continue to enjoy access to their fishing shacks on the beach. As time passed the land appreciated substantially and the shareholders of Whitfords Beach Pty Ltd decided to sell the land. They did so by arranging to sell for $1.6m their shares in Whitfords Beach Pty Ltd to a syndicate of 3 companies, all of which were property developers. The transfer of shares was completed and the new company appointed two of the purchasers as managers of its land for 15 years with powers to do all that was necessary to subdivide, develop and sell the land. The company then procured the re-zoning of the land. The first subdivided lots were sold. The managers anticipate a profit of $7m once completed. The Commissioner assessed Whitfords Beach to tax on the profits from the sale of the land that arose from sales during the years 1972-1975.
Held: HC unanimously upheld the assessment. Gibbs CJ held that the profits made by the company from the venture were assessable as income from carrying on a business-like transaction designed to realize a profit, that transaction being the development and sale of the company’s only substantial asset. HC held that the property developers “profit” was assessable as ordinary income under s25(1) ITAA36. Gibbs J took the view that the “mere realization” doctrine in Scottish Australian Mining would have applied had the takeover by the developers in 1967 not occurred. However, the takeover meant that Whitfords was “transformed from a company which held land for the domestic purposes of its shareholders to a company whose purpose was to engage in a commercial venture with a view to profit … after December 1967 [Whitfords] became a company which existed solely for the purpose of carrying out the business operation on which the new shareholders had decided to embark when they acquired their shares.” The High Court held it to be a one-off business venture.
(c) ‘Extraordinary’ Transactions
FCT v Myer Emporium (1987) - established that gains made from isolated or extraordinary transactions may nevertheless still be of an income nature where they arise from business operations or commercial transactions entered into by taxpayers with the intention or purpose of making a profit. This principle has become known as the “first strand” of Myer. For the first strand of Myer to apply, the taxpayer must have a significant purpose (although not necessarily the sole or dominant purpose) of making a profit from the transaction at the time of entering into it. Where this requirement is absent, the first strand of Myer has no application.
Facts: (“Myer”) had decided to diversity its operations. To obtain in funding for this diversification, Myer entered into a prearranged series of transactions under which Myer sold certain shares in subsidiary companies to an associated company for $80m, then on 6 March lent that $80m to Myer Finance Ltd at an interest rate of 12.5%pa. As arranged, three days later on 9 March 1981, Myer assigned to Citicorp Canberra Pty Ltd (“Citicorp”) for seven years and three months the moneys due or to become due as the interest payments …” on Myer’s loan to finance. In return, Citicorp paid Myer a lump sum of $45,370,000. Citicorp had tax losses available to wipe out any tax liability on the interest payments from Finance. The court found as a fact that all the transactions were interlocked and interrelated, and that Myer would not have made the loan to Finance if Citicorp had not agreed in advance to take the assignment of income and pay the lump sum of $45.37m to Myer.
Held: The HC held that the $45.37m received by Myer from Citicorp was income under the ordinary income provision and endorsed the basic principle in Californian Copper Syndicate as interpreted in Whitfords Beach. What they sold was the income producing right (like selling a building), the right to interest. The High Court said if you carry on a business and you enter into a transaction not in the ordinary course of business, but an extraordinary transaction in the context of your business, in the course of your business with the purpose of making a profit, then it will be ordinary income.
Westfield v FCT (1991)
Facts: The taxpayer’s main activity was design, construction and management of shopping centres. The taxpayer had acquired land for $450,000 – originally taking an option for the purpose of itself establishing a shopping centre and, after that had lapsed, taking a further option in order to block development on the site by a rival. The taxpayer ultimately sold the land to AMP for $735,000, on the basis that AMP would employ the taxpayer to design and construct the shopping centre which AMP proposed to build on the site.
Held: The profit made on the sale to AMP was held to be non-assessable. Hill J reiterated that the Myer doctrine did not mean that every profit made by a taxpayer in the course of carrying on business activities must be of an income nature. Hill J outlined a principles that govern the application of the first strand of the Myer doctrine:
(1) Where the transaction which generates the profit is “not an activity in the ordinary course of business, or, for that matter, an ordinary incident of some other business activity”, the profit will not be assessable as ordinary income unless the transaction was “commercial” and at the time the transaction was entered into the taxpayer had “the intention or purpose of making a relevant profit”.
(2) The purpose of profit-making must exist in relation to the particular operation which gives rise to the profit, and by the very means by which the profit was in fact made.
This is really not a separate topic at all, more just an example of the rule.
It deals with how they deal with certain assets.
London Australia Investment Co v FCT (1977) - The so-called “banking and insurance cases”, illustrate one group of cases in which the courts have considered that the activities connected with making and realizing investments can generate ordinary usage income. In the activities of such institutions, assets which to other taxpayers might be considered to be investments and hence capital, are apparently revenue assets of the business.
Facts: Taxpayer was an investment company. It invested in shares in order to obtain dividends. In order to maintain a desired yield, it was necessary from time to time to sell the shares which had risen in value and accordingly paid a lower yield (ie where the Price Earnings ratio too high).
(Similarly, in banking and insurance companies, when they have to keep reserves for payments, the funds are often invested in shares and short term investments etc. When they are called upon to pay claims, run on cash at bank, etc, they have a policy of going back to those investments and realising the shares. Invariably, there shares which are sold are the ones which the yields have dropped, which are usually ones which have risen in value. End result is they make a profit.
Issue: What is the nature of such profit – is it a capital profit?
In effect, it is a normal operation, a normal profit arising form the way the business is carried on. They have been held to be of an income nature. However they were not trading stock.
Held: Court looked at fact that the company has a specific policy which means that in the ordinary course of business you will from time to time be realising these assets at an enhanced value, making profits, and it will therefore be assessable ordinary income.
(e) Non-cash business benefit
FCT v Cooke and Sherden (1980)
Facts: Holidays provided by a manufacturer to retailers who achieved certain sales targets of the manufacturer’s goods were held not to be assessable under s25(1) or 26(e) ITAA36. The decision exposed gaps in the tax law coverage of business benefits, in that the decision indicated that non-cash business benefits, if structured appropriately so as not to be convertible into cash, could avoid taxation. To deal with this sort of problem, s21A was introduced into ITAA36 in 1988. Under s21A, a non-cash business benefit that is not convertible into cash is to be treated as if it is convertible to cash. (p281 ATL)
FCT v Cooke and Sherden is often an example of a gift-type payment. In that case the taxpayers were not assessed on the value of a holiday primarily on the convertibility issue – either because there was no income as the holiday was not convertible into cash, or it was income of nil value because that was the amount into which it could be converted. But the prize was undoubtedly the product of their business.
SECT 21
Where consideration not in cash
(1) Where, upon any transaction, any consideration is paid or given otherwise than in cash, the money value of that consideration shall, for the purposes of this Act, be deemed to have been paid or given.
(2) This section has effect subject to section 21A
SECT 21A
Non-cash business benefits
(1) For the purposes of this Act, in determining the income derived by a taxpayer, a non-cash business benefit that is not convertible to cash shall be treated as if it were convertible to cash.
(2) For the purposes of this Act, if a non-cash business benefit (whether or not convertible to cash) is income derived by a taxpayer:
(a) the benefit shall be brought into account at its arm's length value reduced by the recipient's contribution (if any); and
(b) if the benefit is not convertible to cash—in determining the arm's length value of the benefit, any conditions that would prevent or restrict the conversion of the benefit to cash shall be disregarded.
(3). . . .
(3) Trading Stock
ITAA 1997, Division 70
Definition of ‘trading stock’ as defined in s70-10 ITAA97:
(a) anything produced, manufactured or acquired that is held for purposes or manufacture, sale or exchange in the ordinary course of a business, and
(b) live stock.
The definition of “trading stock” in s70-10 ITAA97 focuses on the reason for which property is held by a taxpayer. For property to become trading stock it must be held for the purpose of manufacture, sale or exchange in the ordinary course of the taxpayer’s business.
The test is whether the item is held for re-sale in the ordinary course of the business.
• an asset which might be sold but only in extraordinary circumstances cannot be trading stock;
• an asset held by a taxpayer whose activities do not amount to a business, such as the home unit owned by an investor cannot be trading stock; and
questions can arise about whether and when raw materials, packaging materials, spare parts, consumables and so on, which are not held for sale per se, are within the definition of trading stock.
Tax Accounting For Trading Stock
The rules for bringing trading stock to account are found in s70-35. They operate by comparing the value of trading stock at the end of the year with that at the beginning of the year. Where the value of stock on hand at the end of the year exceeds the opening value of stock, the difference is included in assessable income under s70-35(2); where the value of stock on hand at the end of the year is less than the value at the beginning of the year, the difference is an allowable deduction. The closing value of stock for one income year becomes the opening value for the next year (s70-40).
ITAA 1997 s70.35
You include the value of your trading stock in working out your assessable income and deductions
(1) If you carry on a * business, you compare:
(a) the * value of all your * trading stock on hand at the start of the income year; and
(b) the * value of all your * trading stock on hand at the end of the income year.
(2) Your assessable income includes any excess of the * value at the end of the income year over the value at the start of the income year.
(3) On the other hand, you can deduct any excess of the * value at the start of the income year over the value at the end of the income year.
ITAA 1997 – s70.40
Value of trading stock at start of income year
(1) The value of an item of * trading stock on hand at the start of an income year is the same amount at which it was taken into account under this Division or S328 E (about trading stock for small business entities) at the end of the last income year.
Expenses are deductible under s8-1 ITAA97 when they are incurred by a taxpayer. In the case of expenses incurred to acquire trading stock, an amount will be reincluded in assessable income under s70-35 ITAA97 if the stock remains on hand at the end of the income year. The ATO issued Taxation Ruling IT 2670, putting the view that trading stock is “on hand” when the taxpayer is in a position to dispose of the stock on its own behalf.
Australasian Jam Co v FCT (1953)
It would be very easy to manipulate your taxable income by purchasing a whole lot of trading stock just before 30 June, if it was not for the closing stock provisions. To work it out, assume sales of $500.
Opening stock ($200) + purchasers in the year ($400) – what is left over at 30 June ($300), cost of goods sold is $300. (p71 D’s N)
Division 70 ITAA97 deals with trading stock. S70-10 is a definition – note “anything produced or bought for the purpose of resale in the ordinary course of business. Under Div 70, your assessable income includes any excess of the value of the stock at the end of the year over the value at the start of the year, in this case $300 (closing stock) less $200 (opening stock) which equals $100. That is included in assessable income. So here, assessable income is $500 sales plus $100 (difference in closing and opening stock).
S70-25 says it’s not capital so you get a deduction for it.
Section 70-45 says you can elect to value each item of trading stock on hand at the end of the income year at:
• its cost
• its market selling value, or
• its replacement price
S70-40 says whatever method you use to value your stock at the end of the year; you must use that same valuation method for your opening stock in the new year. By changing methods of valuation at the end of year, you can increase or decrease your taxable value. It allows you to accelerate or defer the recognition of taxable income, but it adjusts in next year.
Section 70-45 ITAA97 provides three alternative bases for valuing closing stock on hand:
• cost – Although there is no clear authority on the point, it appears that, where goods are purchased in a condition ready for sale, “cost” includes not only the invoiced purchase price but also costs such as freight, insurance and duty incurred in getting the stock into its condition and location at year end (ie the place where it is “on hand”). In the case of a retailer or wholesaler, the place where it is “on hand”).
• market selling value (which is not necessarily the same as market value) – There is no definition of the term “market selling value” in ITAA97, and there is little authority on the meaning of that term. However, based on the decision in Australasian Jam Co Pty Limited v FC of T it seems that the term means the amount which will be realized in the company’s own selling market in the ordinary course of business
• replacement value – There is no definition of the term “replacement value” in ITAA97 and there is little decided authority on the meaning of the term. It appears to be generally accepted that the term means the value at which the taxpayer can replace the goods on the land day of the year of income, and that, where goods are normally bought rather than manufactured, the value includes freight, insurance and other such costs which would have to be incurred to bring goods into their existing condition and location. (p810 ATL)
In each case it is the value net of GST that is taken into account (s70-45(1A)).
In addition to the three “normal” methods of valuing trading stock, s70-50 permits a taxpayer to elect to value an item of trading stock at lower than its cost, market selling value or replacement value, if the item of trading stock is obsolete and the real obsolescence value is reasonable.
(4) Compensation
ITAA 1997, ss 15-30, 20-20(2), 70-115
A compensation payment which replaces an amount which would have been ordinary income if received will be assessable as ordinary income under s6-5 ITAA97. Where the replaced amount would have been assessable as statutory income if received, and falls outside s6-5, the amount will be assessable as statutory income under s6-10 and 15-30.
(f) Cancellation of a “structural” agreement
The general principle here is that the compensation takes the character of the item it replaces. E.g. if the asset being compensated for is trading stock, then the compensation receipt will be income. Similarly, if compensation is for loss of a revenue asset, it will also be assessable.
Where it gets more difficult is where compensation is for cancellation of agreements. It is a question as to what place the agreement has in the whole structure as to whether the cancellation of the agreement or compensation for the cancellation of the agreement will constitute income or capital.
Van den Berghs v Clark [1935] – Compensation for the cancellation of an agreement affecting the fundamental structure of a business, or for the permanent loss of a fixed asset, is capital in character and not assessable at common law.
Facts: There the taxpayer (“Van den Berghs”) manufactured and sold margarine. The taxpayer agreed to “work in friendly allegiance” with a Dutch company, and the parties entered into agreements under which they set out the way in which profits and losses were to be shared, territories allocated, and various ancillary matters dealt with. In due course the parties fell out, the agreements were terminated, and the Dutch company paid Van den Berghs £450,000 in consideration of its release from the agreement.
Held: The House of Lords unanimously characterized the compensation payment as capital. The House of Lords said the agreements were not ordinary commercial contracts made in the course of carrying on their business such as contracts for the disposal of products. The agreements regulated the taxpayer’s activities, it went to the whole structure of the business in that it regulated the taxpayer’s activities, defined what they may or may not do and affected the whole of their business, and the compensation for cancellation of the agreement was therefore capital.
Similarly, compensation for the “permanent loss of a fixed asset” is capital in character and not assessable at common law.
Restriction On Ability To Carry On A Business
If you dispose of your whole business it is obviously a capital receipt. What happens if you do not get rid of your business, but restrict part of it in return for compensation.
Dickenson v FCT (1958)
Facts: Taxpayer owned a petrol station in Kingsgrove. He was approached by Shell, who was setting up a system of tied sites, by way of restrictive covenant. Taxpayer agreed to receive money for selling Shell products only, for 10 years.
Held: HC held the receipt was capital. Dixon said the taxpayers business constituted a profit-yielding organisation of a definite structure, and he received the money as an inducement to change a major feature of it. Kitto J said it was capital. It was a lump sum payment for restriction to one brand of petroleum products. This was in the nature of a sale price for a substantial and enduring detraction from pre-existing rights.
Cancellation of Business Contracts
Heavy Minerals v FCT (1966)
Facts: Taxpayer Company had the right to a rutile mining lease, and entered into long-term contracts to supply overseas purchasers. After these contracts were entered into, the world rutile market collapsed, so the overseas purchasers negotiated a cancellation of their contracts & made lump sum compensation payments to the taxpayer.
Held: HC (single judge – Windeyer) held that the lump sum compensation payments made to Heavy Minerals were assessable. Windeyer J said the damages received as compensation for non-performance of a business contract stand on the same footing as the profits for the loss of which the damages are paid. There is no difference between whether money is earned as profit or paid as compensation for loss of the opportunity of earning that profit.
Where the cancellation of an agency contract results directly in termination of the taxpayer’s business, the payment will be capital in the recipient’s hands at common law.
Allied Mills Industries v FCT (1989) – Payment was income (not capital) and assessable.
Facts: Taxpayer carried on a business in various divisions; one of its divisions was a groceries and packaging divisions. In 1973 taxpayer obtained sale rights to distribute through its groceries and packaging division Peak Freans business. In 1975 Arnotts took over Peak Freans and re-negotiated the agreement. The taxpayer continued as a sole distributor but as an agent. In 1977 Arnotts decided it wanted to do the distribution itself, and parties agreed to cancel the distribution agreement. Taxpayer given $372,000 compensation for termination of agreement.
Issue: Matter went to Full Federal Court as to what was the nature of the receipt.
Held: Full Federal Court said the arrangements accounted for a substantial turnover of the division, but the company must be looked at as a whole, and whether those rights that were terminated constituted a structural asset of the company. Court said that in order for the contract to be a capital asset it must have substantial importance to the structure of the business as a whole. This is a matter of fact and degree.
Here, Allied was not parting with a substantial part of its business or ceasing to carry on business. Furthermore, the company was not disposing of part of the fixed framework of its business. The contracts here in themselves yielded profits; they did not simply provide the means of making profits. Held, the payment was income.
Reimbursement of Previously Deducted Expenses
Compensation for an amount that has previously been allowed as a deduction would normally be income, but not necessarily so. Just because taxpayer has received a deduction for an item does not mean reimbursement for that item will be income.
H R Sinclair v FCT (1966)
Facts: Taxpayer was a sawmiller & paid royalties for 4years to the Forestry Commission of Vic. Taxpayer claimed deductions for those payments. Royalties were paid under protest, because there was a dispute over how the statutory formula was supposed to work. The department eventually conceded it had got it wrong, and refunded $3,400.
Issue: Was whether the receipt was assessable as ordinary income.
Held: The High Court went to some lengths to point out that the mere refund of an allowable deduction does not of itself mean that the refund is of an income character. The question is whether it is of an income nature. But they went on and held that the refund was income, as the taxpayer was in the business of a saw miller.
Court said that in the capacity of running a sawmill business, he had paid the royalties out, and it was in that capacity that he had received the amount of the refund – an incidental receipt in the course of carrying on a sawmill business.
S20-20(2) – An amount you receive as recoupment of a loss or outgoing, which was previously deductible then the amount is an assessable recoupment if:
• you receive the amount by way of insurance or indemnity; and
• you can deduct an amount for the loss or outgoing for current year, or have deducted it for an earlier year.
This refers to a situation where you recoup an amount you previously claimed as a deduction, but it is only assessable if the recoupment is by way of insurance or indemnity is a restriction. A deductible amount was recouped, but as it was not recouped by way of insurance or indemnity, this section would not apply.
Section 20-20(3) does not have that qualification. An amount you received as recoupment of a loss or outgoing is an assessable recoupment if:
• you can deduct an amount for the loss or outgoing for the current year; or
• you have deducted or can deduct an amount for the loss or outgoing for an earlier year under a provision listed in s20-30.
Ie if you receive a recoupment for a loss or outgoing that is assessable even though the recoupment is not by way of insurance or indemnity, but only if the deduction was claimed under one of the provisions in s20-30. S20-30 does not list the general deductibility provision, only for limited sorts of expenses. See list. May make a difference to Sinclair’s case.
S15-30 if you receive an amount by way of insurance or indemnity for the loss of an amount that would have been included in your assessable income, but not as ordinary income it would be assessable.
S70-115 your assessable income includes an amount that:
• you receive by way of insurance or indemnity for a loss of trading stock; and
is not assessable as ordinary income under s6-5.
Apportionment Of Compensation Payments
Where a compensation payment wholly comprises income elements, the amount of the payment will be assessable in full – Allied Mills is authority.
If however the compensation payment is in relation to assessable and non-assessable (capital) items, the assessable items will only be assessable if it is possible to apportion the lump sum.
If the parties agree to allocate a lump sum to each head of liability then the amounts allocated to the income items will be assessable.
If the compensation payment is less than the amount claimed, but each of the claims is in respect of liquidated damages, then it is possible to apportion the amounts to each of the claims, and those amounts apportioned to income items will be assessable.
If the compensation payment is in respect of both liquidated and unliquidated claims and no allocation is made by the parties, then it is not possible to apportion the payment between the various items, and no part of the amount is assessable – authority McLaurin v FCT and Allsop v FCT
McLaurin v FCT (1961)
Facts: A fire caused by a railway engine resulted in considerable damage to both revenue and capital assets on the taxpayer’s property. The taxpayer duly issued a writ claiming £30,000 damages. McLaurin accepted £12,350 in full settlement of his claims. The Commissioner of Taxation attempted to assess McLaurin on the ground that at least £10,590 represented compensation for revenue losses.
Principle: The High Court indicated that it would be prepared to contemplate apportionment where, for example, a single payment or receipt of a mixed nature could be apportioned and an income or non-income nature attributed to portions of it. But while it might be appropriate to apportion where a payment or receipt is in settlement of distinct claims of which some at least are liquidated or are otherwise ascertainable by calculation, it could not be appropriate where (as in McLaurin’s case itself) the payment or receipt is in respect of a claim or claims for unliquidated damages only and is made or accepted under a compromise which treats it as a single, undissected amount of damages.
Held: In such a case the amount must be considered as a whole and accordingly no part of it was assessable.
Allsop v FCT
Facts: Taxpayer had paid permit fees to the NSW Commissioner for Motor Transport totalling over £45,850. The Act was later held to be invalid and the taxpayer sued for the amount of the fees. The matter was settled out of court whereby Allsop accepted £37,500 in full settlement of all claims of any nature which he had or might have against the Commissioner.
Principle: Barwick CJ and Taylor J in the HC held that Allsop could have claimed unliquidated damages in respect of certain unlawful interference with the appellant’s vehicles and his business operations by officers of the Department of Motor Transport, and in respect of these matters he may have had valid claims for unliquidated damages against the Commissioner. Therefore the amount received represented compensation. It seems to be accepted in the case that had the $37,500 been a refund only of the permit fees, it would have been assessable as in HR Sinclair v FCT. But here, it was not paid simply for the refund of permit fees, the release was compensation in that it covered any action the taxpayer might have, including general damages for unlawful interference by the government in its business.
Held: The High Court held the whole amount not assessable. The point is, if you have a lump sum payment in a settlement, which might include:
• loss of past income (income)
• loss of future earning capacity (capital)
• pain and suffering (capital)
• interest (income)
but without agreement as to how the figure was arrived at between the four heads, then the whole lump sum is treated as unassessable income. This is what happened in Allsop.
FC T v Spedley Securities (1988) – Applied principle from Allsop
Facts: Spedley (a merchant bank) had been engaged by Santos Ltd to secure a loan of A$65m for Santos, at a commission of 1 ¼% of the loan amount. Santos subsequently terminated Spedley’s contract because legislation introduced in the interim adversely affected Santos’ position. The Full Federal Court found on the evidence that there was “no adequate basis for saying that the release was illusory; on the contrary it was undoubtedly meaningful and of practical importance to Santos”. Accordingly, Spedley had received “a lump sum, the ingredients of which were not identified” but which included compensation for a capital asset (loss of goodwill/reputation).
Principle: Under these circumstances, there was “no basis for dissection or apportionment … [and] … in accordance with authority the whole receipt is to be treated as one of capital.
Held: The Full Federal Court held that, as in McLaurin and Alsopp, there was no basis for apportionment and therefore the whole amount is not assessable.