Robert Richards tackles the ATO about two footballers' cases; wonders why engineers can't claim their tools; and looks at the case of a casino and its lessor
Bring tax law into the twenty-first century
The High Court decided the case Maddalena v FC of T (31 August 1971) in the days when the High Court was not opposed to deciding tax cases, and when its judgements were succinct and understandable.
That case involved an electrician who was also a part time professional footballer. He sought deductions for his expenses in seeking and obtaining a contract with a new club (different to the one to which he was already contracted).
The High Court decided that Maddalena was not entitled to any such deduction.
This was because the High Court (per Justice Mason) said that Maddalena was just an employee and that monies spent on obtaining a new employment were not allowable deductions.
The Federal Court has recently considered whether payments somewhat analogous to but not the same as those made by Maddalena, could be claimed as tax deductions by two full-time professional footballers (Spriggs v FC of T, Riddell v FC of T, Federal Court, 23 November 2007).
Those cases (which were test cases) involved management fee payments made by the footballers to management companies. The footballers claimed tax deductions for those payments. The ATO claimed those payments were not tax deductible.
Justice Gordon, who decided the cases, disagreed with the ATO. Her Honour concluded that the footballers were carrying on businesses and that the management fees were incurred by them in those businesses.
More importantly, she rejected the ATO's argument the footballers incurred those management fee expenses at a point 'too soon to be properly incurred in gaining assessable income'.
She also rejected the argument that the management fee expenses were not deductible, being outgoings of capital or of a capital nature. This was because the fees were paid not to establish the footballers' businesses, but to assist them to exploit their talents as professional footballers.
A new era
The ATO, in denying the footballers their claims for tax deductions, sought to rely upon Maddalena (not-withstanding that the facts were distinguishable). Justice Gordon, however, did not believe that decision was presently relevant. She said: 'Maddalena concerned an era of professional sportsmen and women which bears little or no resemblance to professional sportsmen in the twenty-first century'.
While I do not believe that comment was decisive (as was suggested by some newspaper reports) it does serve as a reminder that some of the older tax cases have reached their use-by date.
There are two obvious examples.
First is the concept that a company's central management and control (which might determine if a company is an Australian resident) is normally decided by where the directors meet. (Koitaki Para Rubber Estates Ltd v FC of T, High Court, 21 April 1941).
But I feel that test is somewhat artificial in an age of mobile telephones, email and video conferencing.
As a consequence, when I want to make sure a company cannot be deemed to be a resident of Australia (assuming that is my objective) I draft a company's constitution to make it quite clear that directors' resolutions are invalid unless made by a quorum of directors at a meeting. I also cause a majority of the directors to be persons who are non-residents of Australia and make sure that directors' meetings are held outside Australia. In this way I can say despite changing eras in this case the traditional view should prevail. The problem is that clients might take the advice once or twice but then drift into bad habits.
Secondly, as a general principle, the case law does not allow medical practitioners to income split (Peate v FC of T 12 August 1964, Gulland, Watson and Pincus v FC of T 18 December 1985).
The courts seem to be influenced by some sort of professional snobbery they say it is alright for a plumber to income split but that you cannot compare a plumber with a doctor. That will never do.
That approach, however, ignores the facts. A plumber has a ute, tools and perhaps an apprentice. A doctor now has, apart from the surgery, employees (a nurse and a receptionist). Most importantly, the simple stethoscope has been augmented by an array of computer tools. Even the simple thermometer is now some sort of computer.
There is no essential difference for tax purposes between a plumber and a doctor, and both should be allowed to income split.
Engineers alienated in personal income tax
I looked at the rules preventing people splitting personal services income and the 'results test' in INTHEBLACK (October 2007 pp6768). In particular, I examined a decision of the Administrative Appeals Tribunal in Skiba v FC of T (Administrative Appeals Tribunal, 27 August 2007). Since then there has been a Federal Court test case.
These cases are significant because given that the company tax rate is so much lower than the top personal tax rate, and given the absence of any sufficient distribution provisions, taxpayers have an obvious incentive to try to cause their income to be derived by a company rather than by themselves personally.
Alternatively, they may want to split income between members of their family group, in which case they might want to cause their investment or business income to be derived by a trust. This is quite easy to do.
However, for most taxpayers their principal source of income is not investment nor business income but rather personal services income. And the Income Tax Assessment Act 1997 by its Division 86 makes it quite hard to alienate personal services income. Furthermore, even if a taxpayer escapes Division 86, they still have to worry about Part IVA of the Income Tax Assessment Act 1936.
To escape Division 86 taxpayers will have to show they or their service entity carried on a 'personal services business'. Normally that means (unless a 'results' test can be satisfied) that the individual or the service entity must satisfy one of 'an unrelated clients test', an 'employment test' or a 'business premises test'.
But if more than 80 per cent of the personal service income comes from just one source Division 86 can only be avoided if the individual or service entity satisfies a 'results test'.
To satisfy the 'results test' the income must have been paid for the production of a result; the individual or the personal service entity must have been required to supply the plant, equipment or tools necessary to perform the work; and the individual or that entity must be liable for the cost of rectifying any defective work.
The ATO has tried to limit the availability to a taxpayer of the 'results test' to a taxpayer. Yet many people believed the ATO was being too stringent in doing so.
The ATO has now by way of funding a test case caused the Federal Court to consider that test.
That case was the decision of Justice Allsop in IRG Technical Services Pty Ltd and Owen as trustee of the Owen Family Trust v D C of T (Federal Court, 5 December 2007).
The case involved two people (Green and Owen) who performed via labour hire companies engineering design work for Woodside Petroleum. They were paid an hourly rate, and had to submit time reports.
Both Green and Owen had agreed to provide outputs described as 'deliverables' (a commonly used term in the design and IT industries).
So far as Green was concerned those deliverables included reports for management, data sheets, specifications, wiring diagrams and layout drawings, and a cause and effect matrix. Owen considered as his deliverables requisition specifications, evaluation / recommendation reports, instrument flowmeter datasheets, flowmeter selection and clarification, and technical clarifications and reports.
Justice Allsop felt that neither Green's nor Owens's personal service entities had been paid to produce a result.
So far as Green was concerned Justice Allsop's view was that Green worked as a skilled engineer as part of coordinated team of engineers and was remunerated on an hourly rate for such work.
Justice Allsop also said: 'It would not be a reflection of substantial reality, however, to say that his income was for the results he produced. It was for his work as a skilled engineer, which work produced those results or outcomes, as a necessary professional consequence of the work of a lead instrument engineer on such a project.' One might say there is some illogicality here. Justice Allsop said Green's work produced results but that Green was not engaged to produce those results.
Justice Allsop reached a similar conclusion so far as Owen was concerned. He said that Owen's work 'was completed in an iterative fashion, through teamwork and coordinated skill and experience of a group of engineers working together'. Justice Allsop also said Owen did not produce his own documents but that 'he participated in the production of documents which were the product of coordination, cooperation and supervision in which not only he, but others signed off'.
Not only did Justice Allsop find that payments were not made to personal service entities for the production of a result but he also found that neither Green nor Owen nor their personal services entities were required to provide all the necessary tools and equipment for their work.
The concept of tools and equipment is obviously easy to ap-ply to plumbers and the like but less so to professionals. The ATO implicitly recognised this at paragraph 38 of its Taxation Ruling TR2001/8 where it indicated that whether a taxpayer should provide tools and equipment depended on the 'practice and custom' of the relevant industry.
Here Green and Owen had laptops. But that did not matter. Justice Allsop said that they were provided with the necessary equipment and tools the office (but an office is neither a tool nor equipment), a computer system, and the information on that system (also neither tools nor equipment) and did not have to provide them themselves.
This aspect of Justice Allsop's judgement is disappointing. In finding that neither Green nor Owen had to produce a result he looked to the policy of the legislation. But in finding they were not required to provide the necessary tools and equipment he arguably ignored the policy of the legislation unlike the ATO in TR 2001/8.
There remains an argument that the alienation of personal services provisions (and the controlled foreign compa-nies, the foreign investment fund provisions and part of the employee share scheme provisions) are ineffective altogether. This is because unless the courts decide their power of interpreting legislation extends to the rewriting of legislation, the general provisions of Income Tax Assessment Act 1997 are inadequate to tax one person on the income of another. This will be decided in an appeal to the Federal Court soon to be heard against the Administrative Appeals Tribunal decision Fowler v FC of T (21 September 2006).
At the time of writing this it is not known whether the taxpayers will appeal this decision. Although this decision is not good for computer programmers and the like, it did depend on specific facts, and some people will be able to point to factors that allow them to distinguish the decision.
Prepayments and part ivA
As I indicated in the November 2007 issue of INTHEBLACK (pp6768) taxpayers' experiences with Part IVA (the general anti-tax-avoidance rules contained within the Income Tax Assessment Act 1936) have generally not been pleasant. I placed most of the blame for this on those Western Australian taxpayers who have participated in mass-marketed agriculture schemes (an oddity of that state) and who insist on bringing hopeless cases to the courts. Even as I write this the Federal Court in Perth is considering another such case.
However, the decision in Star City Pty Limited v FC of T (Justice Gordon, Federal Court, 16 November 2007), apart from being a win for the taxpayer, injected some commercial sense into those anti-avoidance provisions. At the time of preparing this note its seems unlikely this case will be appealed.
Although the decision was of some 67 pages (and while Justice Gordon was highly critical of the parties providing her with a five-volume court book of some 2000 pages) the facts were conceptually simple.
Star City (Sydney's gambling den) made a prepayment of 12 years' rent for the right to occupy the land on which it was constructed. It claimed an outright deduction for that prepayment. The ATO did not want to allow it an outright deduction.
In particular the ATO argued that Part IVA prevented Star City from claiming a tax deduction for that pre-payment.
For Part IVA to apply there must first be a 'tax benefit' (in the current case to allow Star City a tax deduction that it would be unable to have, but for a tax scheme).
Justice Gordon said there was no 'tax benefit'. This was simply because it was not reasonable to assume that Star City could have structured the transaction in any other way but as a prepayment this is what the lessor wanted.
Furthermore, Justice Gordon recognised that 'It goes without saying that any rational economic actor will endeavour to minimise the tax consequences of a business transaction' and that 'for that reason, it must be shown not just that a tax benefit was received, but also that the 'dominant purpose' of the transaction was to obtain that tax benefit'.
Here the ATO was wrong to assume that Star City had unlimited freedom to frame the transaction. Rather, commercial considerations required payment of as much money as could be obtained to the lessor, as soon as it could be obtained.
Robert Richards CPA is a solicitor specialising in tax matters.
Reference: February 2008, volume 78:01, p. 68 71
