Robert Richards takes the tax office to task over home loan unit trusts; employee expenses; interpreting the GST; and work in progress.
Tax Office tough on home loan unit trusts
Interest expenses incurred to purchase a private dwelling are not tax deductible. But obviously particularly given the extent to which some home owners borrow to purchase a family home tax-deductible home loan interest is a dream many taxpayers might have.
The decision in F C of T v Janmor Nominees Pty Limited (Full Federal Court, 17 September 1987) indicated this dream was not necessarily an impossibility. There the court allowed a unit trust to claim a tax deduction for interest expense incurred by it on a borrowing it made to buy a home that it leased to someone associated with it. The court also held that the-then-section 260 (for reasons that are still presently relevant) was not applicable.
More particularly, the trust was a service trust that provided administrative services to a surgeon. The interest expense incurred by it, which was more than the rent received from the lease of the house to the surgeon, was offset by it against the assessable income received by it as a consequence of it proving those administrative services. The Full Federal Court allowed it a deduction for that interest expense and said that section 260, which was the-then-applicable anti-tax avoidance provision, was not applicable.
To many taxpayers that decision might have seemed of limited benefit, since it specifically concerned a trust already in receipt of other income. If a taxpayer was a personal exertion taxpayer not in receipt of any other income (or significant other income) the Janmor Nominees decision might have appeared irrelevant to the taxpayer (that taxpayer not having other income that could be offset against interest expense incurred on the purchase of a house that was occupied by the taxpayer).
Innovative tax planners, however, soon found a solution to that difficulty. Those planners developed a concept of what is now called home loan unit trust arrangements.
Those alternative arrangements involved a taxpayer borrowing to purchase units in a unit trust. The trust would purchase a property that would then be leased to the taxpayer or to the taxpayers family. The taxpayer would claim a deduction for his or her interest expense incurred on those borrowings to acquire those units.
This, initially at least, such as is the case for negative gearing in general, would exceed any income that would have been derived from the investment in the unit trust.
Despite what it might now claim, the Tax Office was not initially opposed to these sorts of arrangements. I can personally vouch to attending tax industry conferences where these sorts of arrangements were explained in the presence of the most senior of taxation officers, who accepted these explanations with benign smiles.
Perhaps this was because there was a quid pro quo to those home loan unit trust arrangements. Although those arrangements might have allowed taxpayers to deduct interest expense indirectly used to purchase a family residence (particularly important in those days of high interest rates) those who entered into such arrangements could not also claim the main residence capital gains tax exemption on sale of that residence.
Tax Office attitudes to home loan unit trust arrangements seems to have changed after the introduction in 1999 of the discounted capital gains tax rules.
Perhaps it thought the penalty taxpayers now suffered as a consequence of not being allowed a main residence exemption did not compensate for any advantage they might have gained by reason of allowed interest deductions. Whatever the reason, on 20 September 2001 the Tax Office issued its first taxpayer alert. That alert was directed against home loan unit trust arrangements. The Taxation Office said these arrangements seemed artificial and lacking commerciality in design and execution, and also raised questions as to the application of the general anti-tax-avoidance provisions contained within Part IVA.
The Tax Office subsequently supplemented this alert with Taxation Ruling 2002/18. In that ruling it said that it would not allow deductions for interest expense incurred on the purchase of units in unit trusts that purchased a home and leased this to the unit holder or to the family of the unit holders.
It claimed this was the case for both general deductibility purposes, and because of its conclusion that Part IVA applies to such arrangements. The Tax Office made a blanket conclusion that the reasonable expectation was that such an arrangement would not continue once it became tax positive.
Recently a taxpayer has challenged the Tax Offices disallowance of interest expenses incurred by the taxpayer, who was a party to such an arrangement. That case (Tambone v F C of T, Administrative Appeals Tribunal, 29 May 2006) is, however, not a good example of how these arrangements were normally implemented.
That case concerned a taxpayer who with his wife owned certain land. A unit trust was formed and the taxpayer acquired units in that unit trust.
Mr and Mrs Tambone then transferred their land to the trust. Mr and Mrs Tambone (and not the trust) then borrowed to fund the construction of a house on the land.
Later, further units in the unit trust were issued to Mr Tambone. However, the evidence for how those units were paid for was lacking. This arrangement was significantly different to proper home loan unit trust arrangements.
I would have thought that Tambone should not have been entitled to a deduction for interest expense as a matter of basic tax law. He borrowed to fund the construction of the house not to acquire units in the unit trust. As a consequence, he would not be able to show that he borrowed for the purposes of producing assessable income. The test is that one determines the deductibility of borrowing expenses by looking to see where the funds were borrowed from.
As a consequence, I would have thought this matter could have been dismissed by the tribunal in a one-paragraph judgment. However, the tribunal went further and decided that Part IVA would have denied a deduction to Tambone in any event. With respect to the Tribunal, I find its Part IVA analysis somewhat superficial and as a consequence, disappointing.
But what I find most disappointing about this decision is the way the Tax Office approached the issue. It seems to me the Tax Office has adopted a policy so far as tax alerts are concerned, of simply bullying taxpayers into submitting to its alerts. I say this given that before the tribunal Tambone was represented by his accountant, while the Tax Office was represented by senior counsel (and a very tax-experienced senior counsel at that) as well as a junior. The way the Tax Office approaches these arrangements and I have another example seems contrary to the claim it makes in its charter that it acts in a fair and professional manner. Although the charter is of course just a PR document rather than a document of legal substance.
Customs behaviour not a new tradition
Readers might have clients who have incurred expenses fighting to keep their employment. For example, they may have had to defend themselves before some disciplinary board (such as might be the case if they are employed in the armed forces). Or they might have to argue that they had employment contracts that protected them from dismissal.
If they are involved in such arguments they most probably would have incurred legal costs and legal costs can be very expensive.
Such expenses will only be deductible if they arose from the performance by the taxpayer of his or her employment. There have been two recent cases that illustrate this principle. The first was the decision of the Federal Court (Day v F C of T, 30 May 2006).
Day was employed by the Customs Office. He had been charged and had engaged counsel to defend himself against three charges made against him under the Public Service Act 1923.
The first charge was that he had improperly used his Customs Office identification card. He presented his card at a Sydney local court in order to obtain information regarding a Customs search of his office workstation. Justice Emmett said that since the expenses were incurred by him as a consequence of him misusing his customs office identification to find out information regarding his own affairs, rather then the discharge of his duties as a customs cfficer, the expenses incurred by him in defending those charges were not deductible.
The second charge arose out of a complaint that he incorrectly completed his Customs Office attendance records (presumably saying that he had been on duty when he had not been). Here, since attendance records went to how a taxpayer carried out his employment duties, legal fees incurred by him in defending him against those charges were held to be deductible.
The third charge related to Federal Police and Customs interceptions of Days office and home telephone. Day bought action unsuccessfully seeking a declaration that those telephone interceptions were unlawful. Here as with the costs of defending the first charge Justice Emmett said that there was insufficient relationship between the charge and the taxpayers duties as an employee so as to cause those expenses to be deductible.
But this did not mean that Day was not entitled to deduction for those expenses. This was because of issue estoppel. Here Day was able to show that previously the Federal Court (constituted by some other judge) had made orders that allowed him to deduct legal costs that were incurred by him in respect of that third charge (albeit in some earlier year).
Justice Emmett held that as a consequence of that order the Tax Office was stopped from saying that those expenses were not deductible (and that it did not matter that in making the order the court had not investigated the facts and circumstances out of which the dispute arose, or the legal principles that governed the resolution of the dispute).
The second case that was a decision of the Administrative Appeals Tribunal concerned a police officer (Museth v F C of T, 2 June 2006).
Broadly, this involved a taxpayer who was an exam cheat. Readers might recall the widely publicised scam by which police officers looking for promotion would obtain copies of the exams on which promotions would be based in advance of taking the said tests.
As a consequence of Museth being part of this scam he was suspended from the police service. He incurred legal expenses defending himself against that dismissal, and successfully sought reinstatement as a police officer (albeit it on a junior grade). He then sought a tax deduction for those legal expenses.
The Administrative Appeals Tribunal held that the expenses were not deductible. This was because the legal expenses incurred by the taxpayer went to his efforts to regain employment with the police service. His dismissal from the service did not in any way detract from his day-to-day activities.
Accordingly, the Tribunal held that the legal costs incurred by him were not deductible.
A similar result might be reached regarding employment contracts generally. If an employee is to be dismissed, say because he or she failed to reach some performance criteria, legal costs in resisting that dismissal should be deductible. But if a taxpayer is dismissed for some personal reason and contracts often contain provision allowing someone to be dismissed if their activities might cause the employer to be brought into dispute legal expenses incurred in resisting that dismissal would not be tax deductible.
Accountants and work in progress
The way the tax law treats work in progress has practical difficulties for accountants both entering and leaving a partnership.
For accounting purposes, an accounting partnership, or other professional firm such as a legal firm, is likely to bring work in progress into account when calculating its profits for a year.
However, when the partnership returns income for taxation purposes, it is not obliged to bring work in progress into account. This is because, as (the then) Chief Justice Barwick said in Henderson v F C of T (High Court of Australia, 19 February 1970) only fees which have matured into recoverable debts should be included as earnings of a professional partnership and that it is an entirely inappropriate concept in relation to the performance of professional services as are accorded in an accountancy practice when ascertaining the income derived by a person or persons performing the work to bring work in progress into account.
These differences between what is bought to account for accounting purposes and what is bought to account for tax purposes are normally categorised as timing differences.
What this means in practice is that a new partner normally receives a tax benefit when joining a firm because he or she does not have to bring to account in his first year of partnership a share of work in progress of the partnership. If he has to pay for a share of the previous years work in progress he may be entitled to a deduction for his costs of acquiring that share (see section 25-95 of the Income Tax Assessment Act 1997).
Partnerships are often concerned that unless they have some mechanism for recovering from retiring partners their tax on their share of the work in progress of their final year of partnership (or can force them to pay tax on that amount) retiring partners might be able to escape paying tax on that share altogether. This is because when that share of the work in progress in finally bought to account for tax purposes by the partnership, the retiring partners will no longer be partners of that partnership. This might be to the disadvantage of the continuing partners.
As a consequence, professional partnerships normally expect a retiring partner to include within their assessable income of that year during which they retired as a partner some adjustment to reflect those timing differences.
I have often had doubts as to the effectiveness of such demands, going so far as to wonder whether they can in fact be ignored.
The decision in McNally v FC of T (Administrative Appeals Tribunal, June 2006) would appear to indicate that a partner should include within their assessable income amounts attributable to their final work in progress, notwithstanding that those amounts would not have been recovered when they retired.
That decision concerned someone who experienced a forced retirement from Deloittes (in July 1997). The tribunal there concluded (without explaining why) that the amount claimed by [McNally] in his 1997 income tax return as closing differences should have been returned as income in his 1998 return. But notwithstanding that decision my doubts remain.
GST and the interpretive vibe
As I have said previously (see for example Courts decide to strongly defend GST INTHEBLACK, May 2006, pp. 66-67) I think that as a matter of practice the courts are determined not to allow the goods and services tax to be eroded in the same way as they allowed the sales tax to be eroded. Taking a line from the film The Castle it seems that the courts want to interpret the GST system according to its vibes rather than by black-letter law.
Such was the case in the decision of the Full Federal Court in HP Mercantile Pty Limited v F C of T (8 July 2005, INTHEBLACK, September 2005, pp. 62-64).
Without reiterating the facts, there the Full Federal Court held against HP Mercantile because it decided that what the company argued for was against the legislative policy of the GST system.
On 16 June 2006 HP Mercantile sought leave to appeal from that decision to the High Court. This process is not automatic. In tax matters, before you can appeal to the High Court, the court first has to say whether or not it wants to hear the appeal.
There, in deciding the High Court should refuse to give the taxpayer leave (and notwithstanding that HP Mercantile argued strongly that the GST law should be interpreted according to its natural construction), Justice Gummow concluded that the statutory scheme and legislative context [of the GST law] carried the day for the Tax Office. The High Court (consisting of Justices Gummow and Kirby) seemed in a somewhat feisty mood. For example, Kirby noted the GST law had the convoluted title A New Tax System (Goods and Services Tax) Act. It could have been simply called the GST Act.
Although this is perhaps just a minor irritation, the wording adopted by the government for some cheap political purpose, it is an irritation that causes ongoing costs to the profession.
Gummow also seemed irritated by the use of the word you in recent tax legislation. This, as Gummow agreed causes problems in the construction of tax legislation. I understand that the use of the word you (which makes it very hard to write a proper letter) was adopted by the Tax Office after it road tested according to the Tax Office its 1997 tax legislation with Parramatta truck drivers.
I wonder how many of those truck drivers now take the time to read that legislation.
