Taxation Law I - Summary - Tax 3 PDF

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Deductions Tax payable equals: (s 4‐10 ITAA97) (Taxable Income * Tax Rate) – Tax Offsets Taxable income equals (section 4‐15 ITAA97): o Assessable Income - Deductions  Deductions equals: o General deductions (section 8‐1) (pretty much any type of expense); AND o Specific deductions (section 8‐5) (Consider these first) o Broadly, a deduction is an expense of the TP which is deductible for tax purposes as it is incurred in gaining or producing income that is assessable for the tax purposes. o Expenses may be deductible under both the general deduction provision and a specific deduction provision. In this case, s 8-10 provides that the expense should be deducted under the “most appropriate” section, but as a general rule of statutory construction, the specific rule should apply over the general rule. In any case, s 8-10 makes it clear that an expense can only be deducted once. o Case law or ruling which refer to s 51(1) are equally applicable to s 8-1.  

GENERAL DEDUCTIONS  The general deduction rule in s 8-1 has the potential to apply to any type of expense. In order to claim a deduction for an expense under s 8-1, we have to satisfy the positive limbs of s 8-1 and we can't fall within any of the negative limbs of 8-1. General deduction rule (s 8-1 ITAA 97) A TP can deduct from assessable income:  A loss or outgoing  Incurred during the year to the extent that it is: s 8-1 [positive limbs  establish a connection between the loss & assessable income]  Incurred in gaining/producing assessable income; OR  Necessarily incurred in carrying on a business for the purpose of gaining/producing assessable income (In a business context as long as there‘s a connection between the expense and a business purpose, then it will be deductible, and in a non-business context is there a connection between the expense and your income earning activity.) BUT NOT to the extent that it is: s 8-1(2) [negative limbs  no deduction if you satisfy any of these]  Capital or capital in nature; or [capital allowance!!!]  Private or domestic in nature; or  Incurred in gaining/producing exempt income; or

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Specifically denied by another provision of the Act

POSITIVE LIMBS  Incurred in gaining/producing assessable income; OR  Necessarily incurred in carrying on a business for the purpose of gaining/producing assessable income  Nexus requirement (you must have an expense that is incurred in carrying on a business for the purpose of producing income)  ‗In gaining or producing assessable income‘ is to be interpreted broadly as ‗in the course of earning assessable income‘. See Charles Moore. 1. Losses incurred in the course of gaining or producing assessable income. Charles Moore (1956) (page 358) o The normal operations of the company were that everyday an employee would take the daily earnings to the bank. One day the employee was robbed and the company sought a deduction for this loss. The commissioner argued that the loss was not sufficiently connected to the production of assessable income by the TP. This then went to the high court, and they said that ‗in gaining or producing assessable income‘ is to be interpreted broadly as ‗in the course of earning assessable income‘. In this case, the TPs normal business operations included taking the money to the bank and since the loss was incurred in this normal business operation, then it was incurred in the production of assessable income and satisfied the positive limbs (thus it will be deductible). They're saying as long as it‘s in the course of earning assessable income, then it‘s likely that the positive limbs will be satisfied. 2.

Expenses incurred to reduce future expenditure (through increased business efficiency, for example). W Nevill (1937) (page 365) o Also focused on the term necessarily incurred. What if it doesn't increase future income, but rather it reduces future expenditure? o TP had two MD's, and found this wasn't working out so they terminated one director and made a compensation payment to him. Issue was whether they could claim the compensation payment as a deduction. o They argued that this would save on future salary costs, which would have been deductible anyway (so this should also be deductible) and also argued that this would improve business efficiency which would increase assessable income. o The high court said it is ok to take an overall approach as no expense directly increases assessable income, so you need to look overall if this expense is going to make the business better. o Therefore, an expense which improves the TPs overall business efficiency and operation would be incurred in gaining or producing assessable income. Further, an expense that reduces TP’s future deductible expenditure is incurred in gaining or producing assessable income.

3. Expenditure (damages) incurred as a common incidence of the industry. Herald & Weekly Times (1932) (page 362) o Herald was a newspaper publisher that incurred expenses in the form of damages with respect to libel claims made against it. o Issue: could they get a deduction for the damages incurred. o The court said that the publication of the alleged libel was done with the sole purpose of increasing newspaper sales (―the thing which produced assessable income‖). This would therefore increase AI (connection between the expense and the assessable income). o Court noted that the potential for libel claims was a regular and almost unavoidable incident of publishing (common incidence of the newspaper industry), which further strengthened the connection between the cause of the expense and the TP‘s business. 4. Expenditure incurred for a legitimate business purpose (defending reputation). Snowden & Willson (1958) (page 362) o Snowden & Willson  building company who sought to get a deduction for advertising expenses and legal fees in defending its reputation. o Court found that an expense is necessarily incurred where the expenditure is dictated by business purposes, those purposes being part of or incidental to the business itself. o In this case, the expenses were incurred in defending the TPs reputation and in enabling the continued operation of the business to gain or produce assessable income (which was clearly a legitimate business purpose). o Allegations of wrongdoing are an ordinary incident of business and expenses incurred in defending the TPs against such allegations are necessary for the continued operation of the business and therefore deductible. In other words, there is a sufficient connection between the expenditure and the earning of assessable income. o The taxpayer’s guilt or innocence in relation to the allegations is IRRELEVANT. 5. Expenses incurred relate to illegal business. La Rosa (2003) (page 364) o La Rosa was a drug dealer who was robbed of his cash and claimed a deduction for the loss of his money based on Charles Moore. o Court confirmed that the proceeds from an illegal business or activity may be assessable and corresponding expenses or losses deductible. The loss was deductible as it was necessarily incurred on carrying on the TP‘s business to gain or produce assessable income. o The money was stolen during the course of drug dealing (producing assessable income) and therefore satisfied the positive limbs of s 8-1. o Illegality is IRRELEVANT. o HOWEVER, s 26-54 was introduced which denies a deduction (page 364). 6. Legal expenses incurred in defending criminal charges of directors. Magna Alloys (1980) (CS 12.5) o The TP incurred legal expenses in defending itself and its directors in criminal proceedings. The TP was accused of paying illegal secret commissions to boost sales of its

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products. Court found that the legal expenses were necessarily incurred in carrying on a business to gain or produce assessable income. The court noted that ―necessary‖ does not mean the expense has to be unavoidable or essential. Expenses were deductible as the TP was inextricably involved in the proceedings and its reputation and interests were tied to the directors. It was therefore in their interests to pay for the legal expenses to defend the directors. The expenses were incurred not only in their own interests but also to protect the taxpayer’s business – it was a legitimate business purpose. Business judgment rule: an expense will be necessarily incurred in carrying on a business to gain or produce assessable income where the persons who run the business consider the expense desirable and appropriate in achieving business ends.

7. Legal expenses incurred in defending improper conduct charges. Day (2008) (page 361) o Day was a customs officer who was charged with a failure to fulfill his duties as an officer under the Public Service Act. Incurred legal expenses in defending himself against the charges. Charges related to private misconduct. o Court said that the legal expenses were incurred by the TP in gaining or producing AI as the occasion of the expenditure arose out of his income-producing activities. o What this meant was that because Day was a public servant, he was subject to Public Service Law – therefore, the charges could only be brought against him because he was a public servant, thus there was sufficient connection between the expense incurred and his income-earning activities. It was the TPs employment that exposed him to the charges that resulted in the legal expense being incurred. 8. Expenses related to income gained or produced in future years. Steele (1999) (page 366) o TP obtained a loan to purchase property to use in a business venture. The venture did not go ahead the TP did not gain or produce AI in relation to the property as intended. The TP sought a deduction for the interest expense incurred on the loan to purchase the property. o Court found that such expenses would be deductible if the TP could demonstrate that the expenses were incurred IN ORDER TO gain or produce AI. In this case, evidence showed that the TP had no other purpose in incurring the interest expense other than for the production of AI, thus it was deductible. o This case considered a deduction for interest expenses associated with the acquisition of an income-producing asset. o NB: in a business context, it could be argued that the business hasn’t commenced yet (expenses incurred in anticipation of future AI) and thus the expenditure would not be deductible. In an employment context you could also argue that the expenditure was incurred in setting you up to earn AI but not incurred IN earning AI. While the decision in Steele still stands, it is more likely to be deductible where the expenses relate to the acquisition of an income-producing asset and such expenses may be

considered to be ―too soon‖ in an employment or business context. 9. Expenses related to the production of AI in prior years. Placer Pacific (overrides Amalgamated Zinc) page 368 (and 367) o TP incurred expenses in satisfying obligations arising out of its previous business of manufacturing conveyor belts. Sought a deduction for the expenses. o Court allowed a deduction on the basis that they arose out of or were caused by the TP’s past activities of manufacturing conveyor belts, from which it produced AI. The fact that the business had since ceased was irrelevant. o In more recent cases (Brown and Jones) the court has also permitted TP‘s a deduction for interest expenses incurred on loans related to prior business activities which have since ceased. NEGATIVE LIMBS s 8-1(2) Any expense that satisfies any of the negative limbs may not be deductible. Note that s 8-1(2) provides that an expense is not deductible ―to the extent that‖ it satisfies any one of the negative limbs. This means that an expense may be partially deductible under s 8-1 where it only partially satisfies one of the negative limbs. 1. Capital or capital in nature s 8-1(2)(a)  No distinction in legislation – capital expense vs revenue expense. 2. Private or domestic in nature a. Day‐to‐day living expenses (clothing, food, shelter etc. Things you need to live on a day-to-day basis) b. Living vs earning assessable income (e.g. Cooper (1991)) 3. Incurred in gaining/producing exempt income (since you‘re not going to pay tax on the income, can‘t get a deduction for it) 4. Specifically denied by another provision 1. CAPITAL EXPENSES o An expense that relates to the TP‘s income-producing process will be a revenue expense, while an expense that relates to the TP‘s income-producing structure will be a capital expense. o Revenue expenses generally provide the TP with benefits in the current year while capital expenses generally provide the TP with benefits over a period of years. Tests to work out if it’s a capital expense: Sun Newspapers (Page 371)  Sun paid its competitor to use its plant and equipment for 3 years, effectively stopping its competitor from being open for 3 years and preventing the publication of a new rival for 3 years. Was the expense deductible?  High court concluded that the payment was a non-deductible capital expense as the TP had acquired a non-wasting capital benefit (an enduring benefit) by effectively shutting down its competitor.  Also, Dixon J reached same conclusion by distinguishing between expenses related to TP‘s income-producing process and expenses related to income-producing structure – the

payment strengthened or preserved the TP‘s business structure and, as such, was capital in nature. In Sun Newspapers, Dixon J set out the distinction between expenses related to business processes (revenue expenses) and expenses related to business structure (capital expenses). See page 372 for example of its use. Character of advantage sought o Does the expense give you a lasting/enduring benefit or a temporary benefit? o Lasting/enduring  capital expense (British Insulated & Helsby Cables – ‗enduring does not mean everlasting‘) o Temporary  revenue expense Manner in which it is to be used/enjoyed o Does the expense give you a one-off or recurring benefit? o Once-off  capital expense. o Recurrent and for short-term periods  revenue expense. Means adopted to obtain it o Did the TP acquire the benefit through a one-off or recurrent payment? o One lump sum  capital expense. o Recurrent payment  revenue expense. Applying these three tests to Suns Newspaper: the payment to shut down the rival for three years was still a capital expense because it did provide a lasting or enduring benefit even if it wasn't forever (British Insulated & Helsby Cables). And very importantly, they said that the ability to shut down a rival for three years is something that preserves or strengthens your business structure, so they made that connection to the TP's business structure, and said that it was therefore a capital expense. General principles from cases:  Capital expenditure is spent “once and for all” whereas revenue expenditure recurs every year: Vallambrosa Rubber  Expenditure which gives rise to an “enduring benefit” may be capital but “enduring” does not mean everlasting: British Insulated & Helsby Cables (1926)  Revenue and capital may be distinguished by looking at the taxpayer’s business entity (compare the acquisition of a means of production and the use of the means of production): Sun Newspapers o Capital expenses are those that relate to the acquisition of a means of production, where as non‐capital (revenue) expenses are those that relate to the use of your means of production  Substance over form approach o National Australia Bank (1965) (Lump sum payment held to be revenue expense) (CS 12.13); Colonial Mutual Life (1953) (Monthly ―rental‖ payments held to be capital expenses) (CS 12.14); Star City (2009) (Payment held to be capital based on substance rather than form) (CS 12.15) What this means is we take a substance over form approach. You‘re not just going to look at what the documents say the payment is for or what the legalities are for (the payment‘s ―form‖) - you're

going to look at the substance and look at what are the payments actually for (the payment‘s ―substance‖). National Australia Bank page 374: lump sum payment to Commonwealth Government to become exclusive lender for 15 years. Was a deductible revenue expense. Importantly the payment was not considered to create a monopoly (because defense force members could go to other banks) or add to the structure of the TP's business. Page 374. ‗Monthly rental‘ payments treated as capital Colonial Mutual Life page 375: monthly rental payments held to be capital expense: "the socalled rental payments were in effect consideration for the acquisition of the land... If they are paid as parts of the purchase price of an asset forming part of the fixed capital of the company, they are outgoings of capital or of capital in nature." Rent charge to be paid monthly for 50 years. Verdict: capital expense, it is consideration for land acquisition. If paid as parts of the purchase price of an asset capital nature. Page 375. Star City page 375: exclusive license to operate casino, make upfront payment for licence plus payment as ‗prepaid rent‘ for first 12 years of land rental. Verdict: rent was related to the benefits that would be enjoyed in operating the casino under exclusive licence, rent is capital expense. 2. Private or domestic  Under s 8-1(2)(b) ITAA97, losses or outgoings of a private or domestic nature will not be deductible under s 8-1.  These are expenses incurred to put TP in a position to gain/produce assessable income and NOT incurred in gaining/producing assessable income (Cooper)  They are incurred regardless of the TP‘s income-producing activities: day to day living expense (eg food and shelter) Cooper: rugby player. Coach asked him to eat more meat, potatoes and drink more beer to improve fitness for the following season. Sought a deduction for additional food and alcohol costs. Verdict: Expenses incurred in putting him in a position to carry out his income-producing activities, rather than being incurred in carrying on of those activities. They were private or domestic in nature. The fact that he was told by his coach to consume more did not change the character of the expenditure, which was food and drink to sustain life. Additionally, the TP‘s income-producing activities did not include consumption of food and drink and, as such, the expenditure on food and drink was not related to the production of the TP‘s assessable income (even though it may be incurred in the course of gaining or producing AI). E.g. A food critic incurs expenditure on food and drink in the course of gaining or producing AI. Similarly, expenditure on food/drink incurred while a TP is required to travel overnight for work purposes is incurred in the course of gaining/producing AI: TR 98/9. Sample answer: The travel expenses of $3000 for travel between home and work is incurred to position the taxpayer to produce assessable income. It is not incurred in the course of gaining or producing assessable

income (Lunney; Hayley). Hence it does not satisfy any of the positive limbs in s8-1(1). However, even if it does satisfy the positive limbs it would not be deductible as it would be considered private in nature (Cooper). 3. Incurred in gaining or producing exempt or NANE income [don’t need this] page 378 4. Denied deductions [Division 26] Expenses that are NEVER deductible:  Penalties: s 26-5 Penalties under Australian Law  Statute & federal law e.g. transport/speeding fines, health & safety Act etc will NOT be deductible because they are penalties imposed by the law. Penalties imposed by sporting clubs/libraries are not considered a penalty under government law and as such arise in a private context and ARE deductible because s 26-5 does not apply.  Bribes to foreign public officials page 381: s 26-52  Bribes made to public officials: s 26-53  Expenditure related to illegal activities: s 26-54 (La Rosa)  Reimbursed expenditure: s 51AH ITAA36 (The denial of a deduction for reimbursed expenditure is logical as the TP is not actually out-of-pocket as a result of the expense. They are in the same economic position despite the expense pg. 383)  Rebatable benefits: s26-19 Govt introduced s 26-19 after Anstis which denies a TP a deduction for losses or outgoings incurred in gaining or producing a rebat...