Sleight v Commissioner of Taxation  FCA 896
In Sleight v. Commissioner of Taxation  FCA 896, Nicholson J of the Federal Court has allowed the claims for deductions by the taxpayer in connection with his investment in a "tax effective investment scheme." Moreover, his Honour has held that Part IVA of the Income Tax Assessment Act 1936 (Cth) (the "1936 Act") had no application.
In the 1995 year of income, the taxpayer claimed deductions for management and administration fees for services provided to the taxpayer and his partner; and indemnity fees and interest. These fees were incurred in connection with his investment in a tea tree oil cultivation project (the "Project"). In this regard, the taxpayer and his then wife purchased in 1995 two parcels of 500 A class $1.00 shares in the Northern Rivers Land Company Limited (the "Land Company") with an attached "right to occupy" a "farm." Pursuant to the application form to purchase the shares, the taxpayer and his then wife agreed inter alia:
- to engage in the business of growing trees to produce tea-tree oil on land leased by the Land Company;
- have the Land Company, as their agent, enter into a management agreement (the "Management Agreement") with Northern Rivers Plantation Management Limited (the "Management Company");
- pre-pay one year’s management fees to the Management Company;
- purchase tea- tree seed from the Management Company;
- apply for finance from the Northern Rivers Finance Company Limited (the "Finance Company");
- be indemnified against any inability of their tea-tree business to meet interest and principal payments under the Loan Agreement with the Finance Company; and
- be bound by a Deed between the Management Company, Inteq Custodians Limited (the "Trustee"), the Finance Company and Mobandilla Cotton Management Limited.
The taxpayer had claimed the above deductions from the Project in 1995. Determinations were made that such deductions were not allowable under Part IVA. The taxpayer made a series of objections against these determinations, which were unsuccessful. This resulted in the taxpayer appealing to the Federal Court.
The two main issues raised in the appeal were:
- Whether the amounts for the management fees, administration fees, interest and loan indemnity fees were deductible under s51(1); and
- Whether Part IVA operated to disallow the claimed deductions.
Nicholson J allowed the appeal holding that the amounts for the management fees, administration fees, interest and loan indemnity fees were deductible under s51(1) and that Part IVA did not apply.
The Court held that the taxpayer was entitled to the relevant deductions on the basis that he was carrying on a business. The Commissioner advanced several arguments to support his contention that for the purposes of s51(1) the taxpayer was not conducting a business of his own, growing, harvesting and selling oil from his own trees on his own land. These arguments and the responses of the Court are provided below.
(a) No identifiable area of land
The Commissioner argued that the taxpayer had no interest in an identifiable area of land or trees he could call his own. In particular, it was argued that even though the documentation provided that the taxpayer had an identifiable area of land, the Board had an absolute discretion to relocate a member’s farm to wherever it may determine. Nicholson J observed that there was no evidence that the Board actually exercised this power. Moreover, his Honour noted that based on Commissioner of Taxation v. Emmakell Pty Ltd (1988) 22FCR 157 at 161-163 ("EmmakellI") even if the taxpayer’s farm could not be identified, this did not mean or support the inference that no business was being carried on.
(b) Pooling of oil for sale
The Commissioner argued that there was no point in the taxpayer having land or trees of his own as the combined effect of the Management Agreement and the Prospectus were that the Manager was obliged to pool for sale oil from the taxpayer’s trees with that of each other grower and market and sell all such oil. Also, reliance was placed on the fact that the Trustee was obliged to distribute a pro rata portion of the proceeds of such sales of oil depending on the number of taxpayer’s farms rather than by reference, for example, to volume, prices and quality.
Nicholson J relied on Emmakell where it was recognised that the manager’s right to aggregate the produce of a plantation with that of another also managed by the manager was appropriate to facilitate operations. In the current circumstances, Nicholson J observed that if the yield was not pooled and each individual farmer had a separate harvest and production of oil, there would have been practical difficulties in the Manager marketing the product (see paragraph 48).
(c) Absence of control or obligation
The Commissioner relied on certain provisions of the Management Agreement to argue that the taxpayer had no control of or obligations in respect of his individual interests. In this regard, the factors used to support the argument and the responses of the Court are set out below:
- The taxpayer’s right to terminate the Management Agreement was limited- the Court stated that the right was not unqualified, but was not a limited right.
- The taxpayer had no control of his or her individual interest- the Court relied on the phrase in clause 4 of the Management Agreement which described "management services" that the Manager shall provide services to the Grower’s Farms "subject to the terms and conditions of this Agreement and subject to such instructions as it may from time to time receive from the Grower" to contradict the submission that the Grower had no control of his or her individual interests.
- The taxpayer did not have effective control over the operations carried out on his land, as that control was exercisable only by the Growers as a group- the Court observed that while the taxpayer’s interests may have been coordinated with interests of other Growers, it was necessary for commercial reasons that such coordination occur so as to provide the Management Services to the Grower in an efficient and cost effective way (see paragraph 58).
(d) Manager’s role and remuneration was uncommercial
The Commissioner argued that the Manager was not an independent contractor engaged to act on the taxpayer’s behalf. Clauses 4.4 and 4.5 of the Management Agreement provided that the Manager had the powers of an independent contractor and that all contracts or other arrangements that the Manager entered into for the purpose of providing Management Services were entered into as principal and not as agent. In support of this contention it was argued that:
- The Manager had by June 1997 management of at least 3000 farms;
- The calculation of the management fee which the Manager received showed that the Manager and not the taxpayer stood to gain from the success of the Project; and
- As there were no external borrowings because moneys advanced by the Finance Company to investors were in turn borrowed from the Manager or the Land Company, it made the arrangement less commercial.
Nicholson J, however, stated that the factual circumstances did not show that the taxpayer’s involvement lacked commercial genuineness. His Honour considered that each of the above considerations could be explained in terms of attaining the commercial objectives of the Project. Indeed, his Honour stated that the presence of these factors explained why the Manager would be commercially motivated to attain the objectives of the Project (see paragraph 67).
(e) Nature of the taxpayer’s interest
The Commissioner argued that the farms were only roughly identifiable and that the trees were neither planted for nor managed on behalf of the taxpayer or his individual business (they were managed in "field blocks"). The Court, however, stated that the evidence showed that the farms were identifiable and that given the extent of Block B3 (which was the land where the farms was located) it made commercial sense for the land to be managed in this way.
(f) Limited involvement of taxpayer
A number of arguments were raised by the Commissioner in relation to the taxpayer’s limited involvement in the Project. These were that:
- The taxpayer only undertook limited activities in respect of the Project- the Court, however, stated that there was no authority to support the proposition that a person could not carry on a business unless actively engaged in it and that it is open for management to take place through managers. In any event, the evidence showed that the taxpayer did visit the Project both before and after investing.
- The taxpayer was distanced from the Project because the Management Agreement was executed under a power of attorney on his behalf- the Court agreed with the taxpayer that there was no suggestion that the Management Agreement was not validly executed on his behalf. The evidence showed that the taxpayer had read the Management Agreement and furthermore, in Cooke v. Commissioner of Taxation  FCA 1315 ("Cooke") the same method of execution of the Manager did not lead to any adverse conclusion against the taxpayer.
- The taxpayer had not communicated or negotiated with the financier- the Court did not consider that any adverse inference could be drawn from this fact.
- The taxpayer treated the income statements received in an "unbusinesslike" manner ("sham argument")- the Court observed that the evidence showed that the taxpayer visited the plantation from time to time and took an interest in the financial statements and accordingly, it could not be concluded that it was a sham.
- The taxpayer’s funds were not at risk under the Loan Agreement- the Commissioner argued that the taxpayer, save for one prepayment of interest by September 1996, was not obliged to make further payment and the taxpayer’s funds were not at risk for management fees or payments of principal or interest on the Loan. The taxpayer accepted that its funds were not at risk for management fees or payments of principal and interest on the loan. However, the taxpayer argued that he remained at risk because his net cash outlay, after allowing for deduction, was $3,500 and these funds were at risk all the times. Furthermore, it was noted that this case was one where the tax savings did not exceed the net cash outlay. The Court accepted that Federal Commissioner of Taxation v. Lau (1984) 6 FCR 202 ("Lau"), Emmakell and Cooke show that loan arrangements of the type at issue in the present case do not result in a lack of commerciality.
(g) Expenses as outgoings of Capital
The Commissioner argued that the losses and outgoings at issue were capital or of a capital nature. That is, that the taxpayer’s initial outlay was for a right to a proportionate share of the overall proceeds of the sale of oil produced by the Project. The three features of the case that were relied upon were:
- That the oil produced from the Project was to be pooled;
- The taxpayer had a right to a pro rata share of the proceeds of sale according to the number of farms and the respective rights of the manager and the Finance Company to a share of the proceeds; and
- The taxpayer had no further payment obligations in respect of the Project after his initial cash outlay.
These propositions were argued to find support in Vincent v. Federal Commissioner of Taxation 2002 ATC 4490 ("Vincent"); Clowes v. Federal Commissioner of Taxation 76 ATC 4001 ("Clowes"); Milne v. Federal Commissioner of Taxation 76 ATC 4001 ("Milne") and Enviro Systems Renewable Resources Pty Ltd v. ASIC (2001) 36 ACSR 762 ("Enviro").
Nicholson J observed that Clowes, Milne and Enviro were distinguishable from the current circumstances. In this regard, in Clowes the investor in that case acquired a right to an aliquot share in nine-tenths of the net proceeds of marketing; the investor did not acquire ownership of the land or the trees; the company that the payment was made to was not the agent of the taxpayer; and the company performed the contract independently. Milnes was held by the High Court to be indistinguishable from Clowes and Enviro Systems involved the characterisation of an arrangement as a franchise or a managed investment scheme and did not involve the application of the 1936 Act.
Nicholson observed in relation to Vincent that the Court had recognised it was necessary to examine the circumstances of each agreement which nominates a consideration for services to be performed to determine whether the payments are on revenue account. In this regard, consideration must be given to what, as a practical, commercial matter, the expenditure was calculated to achieve (see Hallstroms Proprietary Limited v. Federal Commissioner of Taxation (1946) 72 CLR 634) and also to the tests in Sun News Limited and Associated Newspapers Limited v. Federal Commissioner of Taxation (1938) 61 CLR 337 to determine whether an expense is of a capital nature (that is, it is necessary to consider the character of the advantage sought; the manner in which it is used; and the means adopted to obtain it).
Based on the above case law, his Honour considered that the payments were to secure ongoing services to be provided by the Manager and to advance the business and therefore, they were not of a capital nature (see paragraph 82).
(h) Disproportion between Outgoings and Income
The Commissioner argued that there was little commercial advantage in the taxpayer’s investment in the Project, as there was a disproportion between the taxpayer’s outgoings and assessable income. This contention was supported by Fletcher v. Commissioner of Taxation 173 CLR 1 where the Court accepted that where the outgoing gives rise to the receipt of a larger amount of assessable income it is commonly possible to characterise an outgoing as being wholly of the kind under s51(1)(a). In this regard, the Commissioner inter alia argued that the taxpayer had no prospect of obtaining any income for the future even on the Project’s own budgeted projections. The Commissioner attempted to support such an argument on material that the projected amount and price were high and could be expected to decline. The evidence, however, showed that the prospect of obtaining a high yield from the Project was achievable from healthy trees on a well-managed plantation.
Further, it was contended by the Commissioner that the amount of the deductions far exceeded the cash outlay and resulted in a tax saving which funded the cash contribution required of the taxpayer. The taxpayer argued that the total claim of deductions in respect of the three investments (including the Project) was around $56,000. This left a total taxable income of $4,800. Without the deductions the tax payable would have been around $20,000. His cash outlay was about $23,500. The consequence was that his total cash outlay had exceeded his deductions by around $3,500. The Court accepted on this evidence that the taxpayer from the investment did not get a tax generated cash surplus, as although the cash outlay of $23,500 generated more than twice as much in deductions, the actual "tax saving" $20,000 was less than this cash outlay. That is, there was a cash loss.
On the basis of the above, the Court did not accept the arguments of the Commissioner and stated that the whole outgoing was properly characterised in gaining or producing assessable income. Nicholson J noted that the commerciality of the investment was also supported by the fact that the taxpayer’s investment in the Project involved him taking up shares in the Land Company from which dividends were to be expected.
Nicholson J’s approach to the application of Part IVA to the current transaction was based on decided caselaw (see paragraphs 95-96). His Honour identified the relevant "scheme" as the making and implementation of the various agreements that comprised the Projects. The parties to the scheme were stated to include the taxpayer and his wife, Mr Hooker of the Management Company, the Land Company, the Finance Company, the Manager, the Trustee, Warwick Young and Prospectus and Project Management Services Pty Ltd.
The "tax benefit" relied upon was the taxpayer’s proportion of the deduction of $25,445 claimed by the partners in 1995.
Nicholson J discussed each of the eight criteria under s177D(b) and concluded that Part IVA had no application to the present circumstances. A discussion of each criteria is provided below.
(a) Section 177D(b)- 8 criteria
(1) The manner in which the scheme was entered into or carried out (s177D(b)(i))
The Commissioner’s major arguments in relation to the manner that the scheme was entered into or carried out were:
- That the taxpayer was not actively engaged in the business.
- That about 80% of the amounts claimed as deductions in the 1995 income year came, not from the taxpayer, but from the Finance Company, associated with the person that the amounts were to be payable to (that is, the Management Company and Land Company).
- The effect of the Indemnity agreement was that an investor would not be at risk for any more funds other than those advanced in the first two years- the Court stated that the existence of the indemnity showed also the commercial character of the Project, as it reflected the promoter’s confidence that there would be a return from tea-tree oil sales to fund the indemnification (paragraph 106).
- The fact that there was no external borrowing and the existence of round robin payments- the Court stated, however, that this was present in Lau and Emmakell and did not affect the genuineness of the transactions.
- That the taxpayer was not required to and did not take any further part in the operation of the Project, other than execute documents. This issue was sought to be taken further by additional factors discussed above in relation to s51(1)- the Court questioned the relevance of this to the commerciality of the investment.
- That the taxpayer was paid commissions to secure investors and the money to pay him was provided for in the financing structure of the Project- the Court agreed with the taxpayer that this had no consequence for the proposition that a commercial enterprise was being conducted.
- The taxpayer argued that the arrangements were not complex nor artificial. The agreements were entered into on an arm’s length basis and were entirely commercial.
On the basis of the above factors, the Court stated that the manner in which the scheme was entered into and carried out could be explained by commercial reasons in which tax benefits played a significant but not dominating part. In this regard, the Court distinguished the present facts from Hart v. Federal Commissioner of Taxation (2002) 21 FCR 206 ("Hart") where the manner the scheme was formulated, entered into and carried out was only explicable by the taxation consequences.
(2) The form and substance of the scheme (s177D(b)(ii))
Reliance was placed on a number of factors discussed above in relation to the form and substance of the scheme. For example, that the taxpayer was a passive investor; the moneys came from the internal book entries; the debt beyond the second year was never to be paid by the taxpayer and may never be repaid; the taxpayer’s economic and legal interest was to a pro rata payment from the pooled proceeds of sales of oil from all trees; and, the returns upon the investment were not likely to be high. The Court agreed with the taxpayer that the absence of high returns did not necessarily mean that a business was not being conducted. His Honour stated, at paragraph 117, that the reality of the present case was that the form and substance were the same.
(3) The time at which the scheme was entered into and the length of the period during which it was carried out (s177D(b)(iii))
It was agreed between the taxpayer and the Commissioner that the time that the arrangements were entered into was to be determined by the moment at which the taxpayer and his wife entered into the Project. The Court stated that the evidence showed that the scheme involved a "flurry" of activity around the end of the tax year directed at obtaining a deduction in that year. The Court considered that the evidence on this criterion was against the taxpayer.
(4) The result in relation to the operation of the Act that, but for Part IVA, would be achieved by the scheme (s177D(b)(iv))
In the transaction, the taxpayer became entitled in 1995 to deductions totalling $12,722 (management, administration, indemnity fees and interest) and in 1996 deductions of $2,009 in respect of interest.
(5) Any change in the financial position of the relevant taxpayer that has/will or reasonably expected to result, from the scheme (s177D(b)(v))
The Commissioner relied on the following factors to show the change in financial position of the taxpayer and support the argument that the project was not commercial:
- The reduction in the taxpayer’s taxable income by $12,722;
- The partners did not have to contribute any more money to the Project, as all further payments required under the agreements were met from the oil sale proceeds;
- The tax savings from the 1995 deductions were able to cover the interest and principal payments in the 1996 year and enabled the partners to retain a total surplus;
- The taxpayer acquired an interest from the arrangements which reduced the incidence of income tax that would have to be paid on taxable income but for the entitlement to a scheme deduction;
- The smallness of income distributions from the Project; and
- The partnership obtained commissions from the moneys paid by investors.
The taxpayer argued that the financial result of the Project was that he suffered a cash loss of $3,531 and that he could only profit if the Project was a commercial success.
Nicholson J held that the above arguments of the Commissioner were as consistent with the commerciality of the Project as with any dominant purpose of acquiring a tax benefit. His Honour noted the factor relating to the recoupment of the cash outlay and payment of interest and principal in 1996 was one that could potentially go against the taxpayer, however, there was no evidence to support such a finding in the current circumstances.
(6) Any change in financial position of any person that has or had any connection with the relevant taxpayer, being a change that has resulted/will result/may reasonably be expected to result from the scheme (s177D(b)(vi))
The Commissioner noted how the Land Company, Mr Hooker and associated companies were able to raise funds from investors, which enabled them to exercise an option over certain land, purchase that land and establish a tea-tree plantation. It was argued that these parties were able to raise such funds because investors were attracted to the tax deductions which funded their initial cash outlays while leaving investors with a cash surplus. Further, it was argued that promoters and their agents received payments of brokerage or commissions out of money contributed by the Project investors.
The taxpayer argued that there was no relevant change in the financial position of any relevant person.
The Court held that the above argument regarding the utilisation of funds raised for the commercial purposes of the Project and to assist its establishment could not be assumed to have been made possible because of the attractiveness of the tax deductions to investors. In this regard, the change in position of the Land Company and promoters or their agents was consistent with the advancement of a commercial project as with a project to attain a tax benefit (paragraph 135). Further, the Court accepted the taxpayer’s evidence that the plantation was being conducted in a businesslike way and that the best efforts were being used to achieve the maximum yields from the plantation for investors to refute the Commissioner’s contention that the financial obligations of investors were structured so that they would be benefited with a tax deduction that was sufficient to fund the cash component of their obligations.
(7) Any other consequence for the relevant taxpayer, or any person referred to in subparagraph (vi), of the scheme having been entered into or carried out (s177D(b)(vii))
Broadly, it was argued by the Commissioner that the taxpayer did not have to pay anything further and was not at risk in the Project or the loan he entered into. The taxpayer argued that he remained at risk for the $3,500 deficit. It was noted that the taxpayer could potentially gain financially from sales commissions as a result of his participation in the Project, thus earning additional income. The Court stated that the result of this item was neutral.
(8) Nature of any connection between the relevant taxpayer and any person (s177D(b)(viii))
The Commissioner argued that there was no substantive legal connection other than contractual created by the Project documents and the taxpayer’s agreement to market the Project. The taxpayer argued that the Promoter had more extensive business connections as a result of the taxpayer’s group agency agreement to market other projects.
(b) Summary of Part IVA application
In summary, the Commissioner argued that the dominant purpose of the taxpayer in entering into the Project was to obtain a tax benefit in the form of deductions for fees and interest which allowed him to fund his participation in the scheme. Conversely, the taxpayer argued that it could not be concluded that the dominant purpose of the scheme was the acquisition of a tax deduction as the cash outlays exceeded the tax benefits and that the Project was a genuine commercial investment.
Nicholson J considered that the only factor that counted against the taxpayer was the "flurry" of activity to sign up to the project before the end of the financial year. The Court otherwise relied heavily on the fact that the taxpayer ended up in a "cash loss" situation to conclude that, even though the tax benefit was a significant element in his purpose for entering the scheme, it was not the "ruling, prevailing and most influential" purpose (paragraph 145).
It should be noted that the Commissioner also contended that the scheme in the present case was conceived and marketed for its tax effectiveness rather than the investment returns. In this regard, it was argued that the information brochure and Prospectus stated the tax effectiveness and the net cash position as a result of tax deductions available to participants in the Project regardless of the expected returns performance of the Project. The Court did not accept this argument, as on a reading of these documents they did not support the Commissioner’s contention.
(c) Other issues
The taxpayer raised other arguments against the validity of the determinations made by Mr D’Cunha, the Director of Small Business. The Court stated that there was no invalidity in the determinations.
While this case was a win for the taxpayer, the Commissioner has appealed to the Full Federal Court against the decision of Nicholson J. It is considered that the decision should not be seen as providing comfort for all taxpayers entering such arrangements given that the Court placed significant emphasis on the facts and the lack of "cash surplus" (that is, the "cash loss") in arriving at its decision that Part IVA did not apply. In this regard, the recent case of Puzey v. Federal Commissioner of Taxation  FCAFC 197 ("Puzey") should be contrasted in which the Full Federal Court concluded that the certainty of the cash surplus generated by the tax deductions indicated that the taxpayer’s dominant purpose was to obtain a "tax benefit" for the purposes of Pt IVA.
There have now been many investment schemes before the courts in recent years where essentially the same arguments get run over and over, reflecting the ATO’s position articulated in TR 2000/8. Sleight’s case is one in a long series of similar cases. The purpose of this litigation has been to clarify the tax treatment of investment schemes of the kinds marketed in recent years but we are not yet close to the end of the tunnel. The Commissioner has almost uniformly lost on the general issues of deductibility under ss 51(1) and 8-1, except where the scheme has not been implemented properly and relevant funds not actually paid. Surely the time has been reached for the Commissioner to give up on these general deduction issues and seek to get clarification on the application of Part IVA. Unfortunately it seems that clarification will only come when an investment scheme case makes its way to the High Court of Australia. Even then because the application of Part IVA depends on the particular facts of the case, a High Court decision may not end the uncertainty. In the meantime it seems that there will be more decisions and appeals.
This article written by Maree Yong appeared in the November 2003 edition Vol 38 (5) of Taxation in Australia, the journal of the Taxation Institute of Australia.