AustLII Home | Databases | WorldLII | Search | Feedback

Journal of the Australasian Tax Teachers Association

ATTA
You are here:  AustLII >> Databases >> Journal of the Australasian Tax Teachers Association >> 2005 >> [2005] JlATaxTA 1

Database Search | Name Search | Recent Articles | Noteup | LawCite | Help

Hill J, D G --- "The Interface Between Tax Law And Accounting Concepts And Practice As Seen By The Courts" [2005] JlATaxTA 1; (2005) 1(1) Journal of The Australasian Tax Teachers Association 1


THE INTERFACE BETWEEN TAX LAW AND ACCOUNTING CONCEPTS AND PRACTICE AS SEEN BY THE COURTS

JUSTICE D G HILL[*]

I INTRODUCTION

From time to time there is a call for the replacement of the present income tax base, and in particular the concepts of assessable income and allowable deductions, with a tax base founded upon the business accounts of the taxpayer.[1]Integration of tax and accounting rather than mere intersection might be thought to have a superficial attraction, at least for the corporate taxpayer.

First and foremost would be the saving in costs which are said to accrue in avoiding the need for two sets of business accounts to be kept, one for accounting purposes and one for tax purposes, and the need to reconcile the one to the other. A second, although less obvious advantage might be thought to rid taxation of the judge-made rules which have developed in tax law. No longer would antiquated legal concepts of income and the dichotomy of income and capital (emanating from concepts of trust law, the very domain of lawyers) obscure the income tax. In place of these arcane concepts would be substituted the more enlightened, practical and unambiguous concepts to be found in the practical experience of accountants and business people and perhaps economists.

However, the difficulties which face the proponents of the use of corporate accounts for tax purposes may prove insurmountable. Even if there were agreement on the accounting principles to be applied to an entity in every circumstance, the degree of flexibility in them would mean a potential loss of revenue. The greatest flexibility may perhaps be said to reside in the concept of materiality which to a lawyer suggests that almost any accounting treatment may be adopted as long as the outcome does not overall have a material impact. What is and what is not material leaves much room for discretion.

Perhaps some public companies are under sufficient pressure from shareholders to maximise profits, and thus dividends, to ensure that steps are not taken to defer profits, but the same cannot be said for non-public companies, which may prefer to reduce immediate profits and thus dividends in favour of increased capital growth, and one may doubt whether it could even be said for all public companies.

Nor is there agreement on all accounting principles within Australia, let alone agreement internationally on accounting standards where there is an ongoing conflict for supremacy between principles adopted in the United States and those applicable in European Union countries. And although the growth of accounting standards in Australia over the past 10 to 15 years has ensured that the coverage of the standards is quite extensive, it is unlikely that such standards either now or in the future will, at least unambiguously, cover the whole range of situations which may face the totality of taxpayers.

Nor is the apparent attraction of dispensing with what, to economists at least, are wrong- headed legal principles quite as attractive as it sounds. The consequence, at least on the margins (and the problems of the dichotomy of the income/capital distinction, for example, are likewise only on the margins) will be to replace legal controversy with accounting controversy. To the already high costs of tax litigation will be added the costs of a new layer of disputation: the need for expert accounting evidence in all cases — or, at the very minimum, in those cases where there is room for disagreement — and ultimately judges will still be there.

The present article therefore assumes the continued existence of the current tax base and seeks to analyse from the case law to date the way in which accounting principles intersect with taxation in the basic areas which the court decisions deal with. In the cases reference is often made to accounting principles and principles adopted by business people. I do not think that there is any suggestion in the cases that these are different things. Accordingly, unless the context otherwise requires I will use the expression ‘accounting principles’ or cognate expressions to cover both accounting principles and the principles applicable to business.

II THE BASIC CONCEPTS

As will be discussed below, questions of the relationship between general accounting and tax accounting have arisen both in the context of income derivation and in the context of losses or outgoings incurred. And it is these two areas which will be the focus of the present discussion. Indeed, these have also been the areas where the relationship to accounting has been most explored by the courts. However, these are not the only areas where accounting may impact the tax outcome. For example, the consolidation provisions make specific reference to accounting standards.[2]

The most obvious area outside the basic principles of income and general deductions where accounting principles must have great significance is that of capital allowances where ‘cost’ is a factor in the deduction — particularly depreciation. So, the diminishing value method described in s 40-70 of the Income Tax Assessment Act 1997 (Cth) (‘the 1997 Act’) takes as an element in the formula adopted the ‘base value’ of the asset, which is generally its cost. The prime cost method likewise commences with the ‘asset’s cost’. Where the issue of cost is complicated, the court could have regard to (and indeed might be greatly assisted by) accounting evidence designed to establish what the cost of the asset is. ‘Cost’ is also an important element in the computation of a capital gain.

Where a particular deduction is predicated upon expenditure being incurred ‘in respect of’ some particular activity (for example, the construction of capital works)[3]or expenditure ‘on’ something[4]or ‘in relation to’ some activity,[5]then accounting evidence would be of assistance in any allocation that might be necessary where the expenditure has multiple purposes.

While a distinction can, as already noted, be drawn between accounting principles on the one hand and accounting or business usage on the other, there is no doubt that business usage will be of assistance, perhaps even determinative, in areas of the tax law where business terms are used. The obvious example is the concept of ‘trading stock’, now defined in s 70A of the 1997 Act in what is merely an inclusory definition. Generally there will be little doubt as to what is trading stock and thus little controversy. However, business usage and both accounting theory and practice were found to be of assistance in Suttons Motors (Chullora) Wholesale Pty Ltd v Federal Commissioner of Taxation (‘Suttons Motors’)[6]in determining whether goods on floor plan were trading stock for the purposes of the long since repealed trading stock valuation adjustment deduction.[7]

The evidence in Suttons Motors was admitted without objection. The full High Court, Gibbs CJ, Wilson, Deane and Dawson JJ (Brennan J dissenting), did not suggest that there was any difficulty in the evidence being received. This would be consistent with the general rule that evidence cannot be adduced as to the meaning of ordinary English words, but can be of words used in a technical sense. The majority judgement said:

The ordinary meaning of the term ‘trading stock’ upon which s 6(1) builds is that which is attributed to it by legal and commercial people for accounting and other purposes. ... It is not necessary for present purposes however to explore the outer limits of the area covered by that ordinary meaning of the term. [8]

The issue of what is the cost of trading stock, like the issue of the cost of depreciable items, can also raise accounting issues. An example is the decision of Jenkinson J, then of the Supreme Court of Victoria, in Philip Morris Ltd v Federal Commissioner of Taxation[9]where the question of absorption costing arose in the context of s 31(1) of the Income Tax Assessment Act 1936 (Cth) (‘the 1936 Act’) which used the expressions ‘cost price’ and ‘cost’. That case raised, but did not ultimately resolve, the question of whether ingredients and partially finished goods should be treated as trading stock. The case was ultimately settled and the interesting issues it raised not decided. It is understood that some of these issues are presently before the Federal Court for decision.[10]

In summary it can be said that accounting evidence will be relevant in any area of income tax where the legislation uses the language of accounting or business (whether that is ‘cost’ or ‘cost price’ or ‘profit’), as well as in areas where it is necessary to allocate the amount of expenditure incurred for more than one purpose to only one of such purposes. The use of accounting concepts in the context of the general income or deduction provisions may be explained in the same way, although it can be argued that the accounting concepts actually in use differ not only from the statutory concepts applicable to deductions but also from those applicable to the derivation of income.

A Income Derived

1 Cash or Accrual Accounting

It is not surprising that the relevance of accounting principles and evidence arose early in the High Court tax jurisprudence in the context of cash or accrual accounting.[11]In some jurisdictions, such as the United States, the question is dealt with statutorily.[12]However the Australian legislation is silent and does no more than include in assessable income that income which is ‘derived’ by the taxpayer in the year of income.[13]Commissioner of Taxes (SA) v The Executor Trustee & Agency Company of South Australia Ltd (‘Carden’)[14]is today generally thought to stand for the proposition that an ordinary sole practitioner practice (in this instance a medical practice) must account for tax on a cash basis.[15]However the issue was not directly that. It was whether, in the last year of practice up to the date of death of the taxpayer, it was open to the Commissioner to assess the executor of the taxpayer upon an earnings basis and if so whether unpaid fees which had been rendered in the former period should have been brought to account. The High Court answered the first of these questions in the affirmative[16]and the latter in the negative[17]and in so doing affirmed that the deceased in the previous year properly accounted for tax on a cash basis. There was an incidental question of whether the Commissioner could reopen the assessment of the previous year to bring to account the book debts and an issue about apportionment of deductions.[18]

It seems that until that decision professional persons had been permitted to return income on a cash received basis, although there was no court authority to the effect that they had a right to be assessed on that basis. It is interesting to note that Latham CJ, dissenting, was of the view that the question of the method of accounting to be adopted by taxpayers was one to be answered solely by reference to the statute in question and not by reference to accounting practice. Accordingly, his Honour said:

It has frequently been argued that the ascertainment of income is a “business” matter, so that, for example, a court must take “profits” as determined by business men, with such deductions as are reasonable and proper from a business point of view, and must then apply income tax provisions to profits so ascertained. (Contentions as to allowances for depreciation of plant, &c., provide a good illustration.) Warrington LJ, referring to an argument of this character, in Inland Revenue Commissioners v Von Glehn ... said:- “The question whether this deduction is to be allowed is one that must be determined by the rules regulating the assessment of income tax and not by rules regulating what may be allowed in the preparation either for a company, an individual, or a firm, of the balance-sheet or the profit and loss account. A firm or a company carrying on business may within certain limits treat as a deduction from profits such sums as it pleases, but for the purposes of income tax the deductions which may be allowed from the gross profits are strictly regulated by the Income Tax Acts”. If the relevant Act deals with a matter in a particular manner, it is quite immaterial that taxpayers prefer to deal with it in another manner. It is for this reason that I have based my judgment entirely upon the statute and upon decisions which seem to me to be in point.[19]

Dixon J, with whose judgement Rich and McTiernan JJ agreed, was of a different view. His Honour, in passages which are so well-known as not to require repetition, discussed the rival methods of ascertaining income and held that in the period to the end of the last complete year of income the cash receipts method provided the substantially correct reflex of the taxpayer’s income.[20]However, the rule that the receipts basis provided a ‘fair and appropriate foundation’ for estimating professional income was subject to the qualification that there be continuity in the practice of the profession.[21]The broken period up to the date of death stood upon a different footing, for it was not a complete period forming part of a continuous practice.[22]The period was subject to a special assessment required under the relevant South Australian legislation.[23]Without any real explanation it was said that it was thus open to the Commissioner in that period to adopt the earnings basis.[24]

Dixon J in his judgement notes that the tendency of judicial decisions to that time was to place increasing reliance upon the principles and practices of commercial accountancy.[25]His Honour said that unless the statute made specific provision the question of cash or accrual accounting depended upon appropriateness.[26]His Honour then said:

The reasons which underlie the practice of estimating for taxation purposes the income from trade or manufacture by means of a commercial profit and loss account consist in the impracticability of computing income in any other way and in the adoption for fiscal purposes of recognized commercial principles ... The result is that a tax upon the profits or income of such a business must be understood as a tax upon the profits or income computed according to the system, because, according to common understanding and commercial principles, that is the method of determining the profits ...

In the language employed by the statute in describing the subject of the tax, I am unable to find any special guidance or anything distinguishing the South Australian statute from other income tax legislation in reference to the choice between the accrual and the receipts basis of calculation.[27]

The passage I have cited would appear to bring about the result, absent any particular statutory provision, that accounting practice would be determinative of the issue of income derivation at least. However, it is interesting to note that it would appear that there never was any accounting evidence before the Supreme Court of South Australia from which the appeal was taken by way of a special case.

It was not until 1970 in Henderson v Federal Commissioner of Taxation (‘Henderson’)[28] that the High Court returned to considering the question of cash or accrual accounting. The question in that case was the appropriateness of adopting an accrual basis by the accounting firm of Bird and Partners in Western Australia. It arose in part because the change of accounting from a cash to an accruals basis had the consequence that book debts outstanding as at the commencement of the year in which the change took place were never brought to account for tax purposes.[29]

It is not clear from the report whether accounting evidence was given in Henderson, despite what had been said in Carden. The Commissioner’s argument, at first instance, as reported, was that the ‘proper construction of the Act cannot be determined by the method of accounting used’.[30]Gross income derived is not the same as profits, which is the accounting concept. Barwick CJ, with whose judgement McTiernan and Menzies JJ agreed, had little difficulty in concluding that the partnership in Henderson presented a different picture from the sole medical practitioner in Carden. Nor did his Honour accept the proposition that it was open either to the Commissioner or the taxpayer to elect which method of accounting could be adopted. The only appropriate method to be adopted in the particular case was accrual accounting which his Honour saw as requiring bringing to account ‘only fees which have matured into recoverable debts’.[31]There was no basis for some principle of estimation of work in progress.[32]

The concentration on ‘recoverable debts’ in Henderson led inevitably to the question which arose in Commissioner of Taxation (Cth) v Australian Gas Light Co (‘Australian Gas Light Co’),[33]that is, the question of when fees can be considered to have matured into recoverable debts, in this instance whether or not a gas company reticulating gas to consumers was required to bring to account gas delivered to consumers where the gas meter had not yet been read. The full Court of the Federal Court, Bowen CJ, Fisher and Lockhart JJ, answered the question in the exceptional circumstances of the case in the negative because under the relevant legislative scheme unbilled gas had not matured into a recoverable debt until the meter was read.[34]

There have been a number of later cases which have considered the issue of cash versus accrual accounting in particular situations. These include: Commissioner of Taxation v Firstenberg,[35]Commissioner of Taxation v Dunn[36]and Barratt v Commissioner of Taxation[37]and Dormer v Federal Commissioner of Taxation.[38]In each of them, except perhaps Dormer, expert evidence was given.

What is significant for present purposes is that there seems to have been, by the time Barratt came to be decided, a shift in jurisprudential thinking on the place accounting evidence has in determining the issue of income derivation. The Dixon view, which on my reading of it had the consequence that accounting evidence was determinative of how the Act operated when the issue was income derivation, appears to have given way to the view that such evidence would be persuasive only. Gummow J in Barratt (with whose views Northrop and Drummond JJ agreed) adopted what had been said on the point by Davies J in Dunn:

Although ordinary accounting principles and practice are not determinative of the issue, they are relevant and may be influential, as Dixon J in Carden’s case ... and Barwick CJ, Kitto and Taylor JJ in Arthur Murray (NSW) Pty Ltd v Commissioner of Taxation (Cth) [1965] HCA 58; (1965) 114 CLR 314 at 318 pointed out.[39]

The difference is not unimportant, although it appears not to have been noticed, at least until the judgement in BHP[40]to which reference will shortly be made. The question may be posed whether, assuming uncontroverted accounting evidence on the issue of income derivation, it would be open to a court to reject that evidence and decide an income derivation question in a way contrary to accounting practice. That has never happened and I doubt it ever will.[41]It can be said that the results in each of the cases involving the application of cash or accrual accounting would be accepted by accountants as representing the appropriate accounting treatment. But if, in fact, a court will always find consistently with accounting principle then it may be preferable to return to the Dixon formulation.

2 Payment in Advance of Performance of Contractual Obligations

The issue of the appropriate tax treatment of monies paid in advance of the performance of contractual obligations was decided by the High Court in Arthur Murray referred to above. Accounting evidence in that case was not given. Rather the case proceeded on an agreed statement of fact which was, to say the least, specific in its terms. So far as appears from the report of the decision, the statement was to the effect that the parties agreed that according to established accounting and commercial principles, and whether in the case of persons selling goods or performing services, amounts received in advance of the goods being delivered or services being performed are not regarded as income.

For present purposes the case is significant for two passages which, on one view at least, are contradictory in the way they regard the role of accounting evidence. In the first passage,[42] Barwick CJ, Kitto and Taylor JJ, though they referred to the importance of the general understanding among practical business people of what may constitute income and accountancy, then noted that the question nevertheless depended ‘basically’ upon the judicial understanding of the meaning which the words convey to those (presumably business people) who observe the relevant distinction (that is, as to when income is derived).[43]Bookkeeping was ‘but evidence of the concept’.[44]

In the second passage,[45]however, their Honours appear to have reverted (assuming there is any inconsistency) to the views of Dixon J in Carden. After noting that a different situation existed with deductions where, as we shall see, the Act is said to lay down rules inconsistent at least to some degree with accounting principles, their Honours emphasised that the 1936 Act laid down no test for the derivation of income.[46]Had it done so, then commercial and accounting practice clearly could not be a substitute for such a test. However, their Honours then observed:

The word “income”, being used without relevant definition, is left to be understood in the sense which it has in the vocabulary of business affairs. To apply the concept which the word in that sense expresses is not to substitute some other test for the one prescribed in the Act; it is to give effect to the Act as it stands. Nothing in the Act is contradicted or ignored when a receipt of money as a prepayment under a contract for future services is said not to constitute by itself a derivation of assessable income. On the contrary, if the statement accords with ordinary business concepts in the community – and we are bound by the case stated to accept that it does – it applies the provisions of the Act according to their true meaning. [47]

3 Accrual Accounting Where the Debt Otherwise Recoverable is in Dispute

The English legislation has no difficulty dealing with the situation where there is a bona fide third party dispute either as to the amount which a taxpayer is to derive in the year of income or as to the quantum of a deduction otherwise allowable in that year. The relevant legislation permits the accounts of the year to be reopened and adjusted to include additional amounts as income either where what is claimed to have been derived as income is ultimately increased or where the quantum of a deduction is later reduced. The problem in Australia is the tight time limits for amending assessments to be found in s 170 of the 1936 Act.[48]

A case which demonstrated the problem for the then Papua New Guinea legislation, which was couched in similar terms to the 1936 Act, is Commonwealth-New Guinea Timbers Ltd v Chief Collector of Taxes (PNG) (‘Commonweath-New Guinea Timbers’).[49]In that case there had been an agreement between the taxpayer and the Australian government that if Australian customs duty was payable on the taxpayer’s timber products on importation into Australia the Commonwealth would pay the taxpayer a subsidy not greater than the duty paid. In each year the taxpayer had returned as income the amount it claimed to be entitled to as a subsidy.[50]In so doing the taxpayer acted in accordance with established accounting principles.[51]The Commonwealth, however, denied liability to pay the taxpayer the amounts to which the taxpayer claimed to be entitled. Ultimately the Commonwealth paid in the 1961 tax year an amount in respect of claims for the 1958 and 1959 tax years. It was not obliged to do so.[52]In the 1961 year the taxpayer wrote off the balance of the amount it had not been reimbursed. The Commissioner included in the 1961 year the amount received from the Commonwealth but disallowed the deduction for the write-off. The taxpayer continued in later years to include as income amounts it claimed in those years to be entitled to be paid by the Commonwealth. It later requested the revenue authorities in Papua New Guinea to amend the assessments of these later years to exclude from assessable income the amounts to which the taxpayer claimed to be entitled in those years.

The result was a disaster for the taxpayer. It was held that because the taxpayer had no enforceable claim against the Commonwealth the amounts received from the Commonwealth were only income in the year of receipt.[53]No deduction was allowed for the written-off amounts as there had been no debt owed to the taxpayer which it could write off.[54]No amendment to the later year assessments was authorised to reduce the taxpayer’s liability to tax in those years[55]because the power to reduce the taxpayer’s liability could only be exercised to correct an error in calculation or mistake of fact and here the correction arose because of a mistake of law.[56]The comparable provisions of s 170(9) of the 1936 Act dealing with amendments, where an estimated amount has been included in assessable income where that income was derived from an operation or series of operations the profit or loss of which was not ascertainable ,were also held inapplicable.[57]

The result offends both common sense and equity. Not surprisingly it is criticised by the late Professor Parsons in his text, somewhat by way of understatement, as being ‘inconvenient’.[58]

BHP[59]was the first occasion when it became necessary for a court in Australia to consider when income is derived by an accruals based taxpayer in circumstances where there was a dispute between the taxpayer and a purchaser from the taxpayer as to the amount invoiced by the taxpayer for the sale of a commodity. Accounting evidence was led and not cross-examined upon by the Commissioner. That evidence was to the effect that in the circumstances of the case it would be incorrect to bring to account as a profit in the financial statements of the taxpayer the disputed amounts until the dispute was resolved.[60]The resolution of the dispute took some years, during which time there had been a hotly contested arbitration extending over some 43 days and thereafter an application for judicial review of the arbitrator’s award to the Supreme Court which was ultimately settled.

At first instance Kenny J held that the whole of the disputed amount was income in the year the commodity was supplied (or the year in which invoices were rendered, there being little practical difference between those two times).[61]Her Honour’s decision might at first sight appear to involve an application of the principle that a jurisprudential analysis of income derivation must take precedence over accounting principle. However, a closer analysis shows that the primary judge was of the view that the accounting evidence was irrelevant because the expert accountant had proceeded upon a wrong analysis of the contractual arrangements.[62] On appeal, the full Court by majority (Hill and Heerey JJ) was of the view that her Honour had misunderstood the accounting evidence and accepted it as relevant.[63]The case was decided, ultimately, in accordance with that evidence. The Court left open the question of whether there was really a difference between the approach to accounting evidence taken in the Australian Gas Light Co and that taken by Dixon J in Carden and Barwick CJ in Henderson.

Gyles J delivered a separate concurring judgement. His Honour noted that Kenny J had taken the view that the price for the gas was one indivisible sum when it was not.[64]His Honour, having stated his agreement with the majority of the Court that in the case where there was a bona fide dispute, the vendors derived income only when that dispute was resolved,[65]then commented:

The question is whether that general principle is to be applied in the present case and, if so, how. It is not clear to me that the primary judge would disagree with that general principle, or with the opinion of Professor Walker to that effect. Rather, I take the primary judge to have declined to apply that general principle to a case where the dispute on the part of the purchaser is as to only one element of the calculation of a total price. In those circumstances, the primary judge preferred to apply another, and more basic, general principle – namely, that (depending upon the contract and other circumstances) the price for a commodity which is delivered is derived on revenue account no later than the time of delivery. It seems to me that her Honour took the view that it is not possible to apportion or dissect the price or consideration for the supply of the gas under the present contracts. I do not agree with the submission of the appellants that, on its face, this can be seen to be an error in principle and contrary to authority. It can just as easily be asserted (as it was by counsel for the respondent) that the primary judge was applying orthodox principle.[66]

The majority judgement made no comment on what the situation would have been if it had not been possible to apportion or dissect the price or consideration.

The comment of Gyles J will, perhaps, generate further litigation in a future case, assuming that it is accepted by the Commissioner. For my part, and as presently advised, I am not sure that I think there is any reason to believe that there is the distinction which his Honour drew or that the rule that derivation occurs on sale of trading stock is a more ‘basic general principle’ than the rule that derivation will occur only on resolution of a bona fide dispute. It is not easy to imagine a case where the question will arise. However, let it be assumed that the purchase price or consideration is such that the whole of it depends upon a formula, and there is a constituent of the formula about which there is a bona fide dispute. There are then two possibilities. The parties may agree that there is, on any view, a minimum figure payable or they may be in total disagreement about the price or consideration. I would imagine that if there were agreement about a minimum figure accounting, evidence would show that the proper treatment would be to bring the agreed figure in as income and defer, until the dispute is resolved, the balance. If that is so, then I see no reason why the courts would take any different view. If the whole of a single undissected purchase price is in dispute then the accounting evidence would presumably be that income was not derived until the dispute was resolved, whether by litigation or agreement. I do not see why the courts should not be guided by that evidence just as they are when there is a purchase price with multiple components. And the fact that the ordinary income tax rule is that income from the sale of trading stock is brought to account when the stock is sold does not seem to me to matter in such a case.

It is interesting to consider the consequences had the decision at first instance been affirmed. As it happens, on the facts in BHP the amounts that the taxpayers actually recovered were ‘more or less’ as invoiced. I say ‘more or less’ because the evidence suggested that there had been a series of invoices for different amounts so that the amount actually recovered represented the amount last invoiced and not necessarily the amount first invoiced.[67]If it be assumed that the amount actually recovered had been more — or less — than the amount invoiced then a number of questions arise. If it were more, the taxpayer would have understated its income and be liable to additional tax by way of penalty; if less, the taxpayer would presumably not be entitled to a deduction for a write off of the debt for the reasons given in Commonwealth-New Guinea Timbers[68]and there would be a difficult question of whether it would have been entitled to a deduction under s 51(1) of the 1936 Act. Further, the taxpayer would have had to pay the tax notwithstanding that the dispute deferred the time for payment for some years. Indeed, if it did not it would run the risk of being put into liquidation by the Commissioner. To repeat the views of Professor Parsons, the result would indeed have been ‘inconvenient’ to the taxpayer.

At the time of writing it is not known if the Commissioner proposes to seek leave to appeal the decision of the Federal Court from the High Court.

4 The American ‘Claim of Right’ Doctrine

In BHP, reference is made in passing to US cases and particularly to the ‘claim of right’ doctrine adopted in that country.

At its simplest the US ‘claim of right’ cases make it clear that while a taxpayer in dispute with a customer will not — until that dispute is settled — have to bring to account amounts invoiced but not paid. However as soon as payment takes place — and notwithstanding that the dispute is continuing — the taxpayer must bring to account the amount which it has received under a ‘claim of right’. The doctrine as stated by Brandeis J in the Circuit Court of Appeal for the 9th Circuit in North American Oil Consolidated v Burnet [69]is as follows:

If a taxpayer receives earnings under a claim of right and without restriction as to its disposition he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money and even though he may still be adjudged liable to restore its equivalent. [70]

The US cases do not turn upon accounting evidence.[71]Hence it is not clear whether accountants in the US would account that way. However, presumably there might be a need for a provision to take into account the estimated amount which may have to be repaid by the trader if the trading account was to give a full and true view of the trader’s affairs.

Professor Parsons in his text recommended adoption of the US model for the resolution of the type of problem which arose in BHP.[72]There is a problem, however, with the Professor’s discussion of the claim of right doctrine which may be noted here. The learned author, when stating the US doctrine suggests that in the case of an accrual basis taxpayer income will be derived when the taxpayer asserts a claim of right to recover the amount, whether or not that amount has been paid,[73]and that, where no such right is asserted, income will be derived when an amount which is in dispute is paid.[74]Certainly US law is clear that payment of an amount in dispute will result in the taxpayer deriving income, even though the taxpayer may later have to repay the amount. What is not clear from the US authorities to which reference is made in the text is the correctness of the first of these propositions. Indeed, Professor Bittker in his work takes the more common sense view that disputed income will only accrue when the dispute is resolved, rather than when a claim is made, and restricts the claim of right doctrine to the case where actual payment is made. [75]The first part of Bittker’s proposition accords with the law in Australia as now stated in BHP. The second part of the proposition, that dealing with payment of disputed amounts while the dispute continues, has not been the subject of any discussion in Australia.

Burchett J in Zobory v Commissioner of Taxation[76]refused to apply the claim of right doctrine (in its traditional formulation involving actual payment rather than claim) in Australia, noting that the unfairness of taxing a constructive trustee on monies received but not beneficially owned by the taxpayer — as was the case in Healy v Commissioner of Internal Revenue[77]; had been alleviated in the US by statute. One problem of adopting the claim of right doctrine in respect of payment of disputed amounts is clearly the question of whether Australian law would, as US law does,[78]allow the taxpayer a deduction if there is a need to repay. Another problem is of the kind discussed in Zobory. Australian taxation law has generally been thought to proceed upon the basis that it is only where a taxpayer has beneficially derived amounts that it can be said that the taxpayer has derived income. If amounts are received under a constructive trust[79]then it would seem to be the law in Australia that there has been no derivation.[80]If the obligation to repay did not arise by the application of trust law but in contract, should there be any different result? These problems are perhaps only on the fringe of the present article and accordingly will not be pursued further.

However, there remains an open question, in a case where a trader sells trading stock and in circumstances where there is a bona fide dispute, whether the trader derives income where some or all of the amount in dispute is paid by the purchaser under protest. If the view of Gyles J in BHP is correct, the answer to the question will at the least depend upon whether the purchase price is apportionable. If it is not apportionable, then his Honour would, it would seem, bring the whole of the consideration into account as income, notwithstanding that the amount properly payable may not be known for many years, and it will be irrelevant that the purchaser has made a payment. But assuming that the purchase price was not apportionable, there would remain for Gyles J, as well as for the other members of the Court in BHP, the question of whether payment would, in circumstances where there was a bona fide dispute, bring about derivation of income to the extent of the amount paid. There may even be a different result depending upon whether the payment is made to the vendor directly, or where there is payment into court.

5 Accrual Accounting and Trading Stock

There is no doubt that, both for ordinary accounting purposes and for the purposes of tax accounting, a trader in goods accounting on an accrual basis will bring to account income when the trading stock is sold. One common sense explanation for this is that once a sale takes place the trading stock sold must be taken out of the trading stock account for it will no longer be on hand and there will be a need for that stock to be replaced by the debt arising from the transaction of sale or, when the debt is paid, by the cash paid for the stock.

The question which arose in J Rowe & Son Pty Ltd v Federal Commissioner of Taxation[81] was whether, when trading stock was sold on terms, the whole of the sale price should be brought to account as income or whether income should be brought to account on a profit emerging basis (that is, as and when the purchase price came to be paid). Expert accounting evidence showed that general accounting practice was to bring to account the sale price of the goods at the time of making the contract, notwithstanding that at that time there was not an enforceable debt for the whole price.[82]The High Court followed the accounting principle. Indeed, Gibbs CJ adopted what might be called the Dixon approach in Carden, saying:

When the Act gives no directions on the point, the question when income is earned, and the method of accounting to be adopted for the purpose of ascertaining the income, depend upon business conceptions and the principles and practices of accountancy...[83]

Menzies J, with whose reasons Barwick CJ, McTiernan and Gibbs JJ had agreed, made the point perhaps elliptically, but certainly bluntly, when his Honour said:

It follows that I consider that the taxpayer’s main contention is opposed to ordinary principles of accounting, to the scheme of the Act and to authority. It must, therefore, be rejected.[84]

It is convenient to deal at this point with other Australian cases which have involved trading stock.

The first is Gasparin v Commissioner of Taxation[85]where the full Federal Court (Jenkinson, Spender and von Doussa JJ) was required to decide in the case of land sales whether income was to be brought to account when contracts were exchanged or only when the sale was settled. In that case there was no uniform accounting view. The Court held that the profit was to be brought to account only at completion for it was only then that the land ceased to be trading stock of the trader.[86]

The second is Farnsworth v Federal Commissioner of Taxation.[87]That case raised the question of when income was derived where trading stock (fruit) was, as part of a marketing scheme, mingled with the produce of other farmers for sale and growers received progress payment for their fruit in circumstances where the balance payable was still outstanding at the end of the year of income, although it could be estimated. The Commissioner’s argument that the estimated amount was income was rejected, notwithstanding that the trading stock had clearly, at the moment of delivery ceased to be trading stock on hand and to be reflected as such in the taxpayer’s trading account.[88]There does not seem to have been any accounting evidence before the High Court at least, for the matter proceeded in that Court on a case stated which made no reference to accounting principles. Dixon J noted that this was a case where the taxpayer should be taxed on a cash receipts, rather than on an accrual basis.[89]

The accounting method suggested in Farnsworth was likewise adopted in Federal Commissioner of Taxation v Squatting Investment Co Ltd[90]in the context of a war-time wool scheme where growers received deferred amounts in respect of their wool which had been stockpiled. A similar result was reached for trust accounting purposes in the related decision in Ritchie v Trustees Executors and Agency Co Ltd.[91]

Finally in this context reference may be made to Ballarat Brewing Co Ltd v Federal Commissioner of Taxation[92]where discounts and rebates allowed by a taxpayer on the sale of its products were taken into account in calculating income, notwithstanding that as at the end of the year of income the preconditions for those discounts or rebates had not been satisfied. Fullagar J made it clear that the question of the correct figure to take into account in calculating ‘sales’ (an estimate) was one which depended upon (and presumably therefore was to be decided conclusively by) the conceptions of business and the principles of accounting.[93]To fail to take into account discounts which were almost invariably given was to adopt a figure which would be misleading.[94]

6 Accounting for Long Term Transactions

Accounting evidence (other than of the taxpayer’s own books) does not seem to have been adduced in Federal Commissioner of Taxation v Thorogood,[95]a case often cited as supporting a profit emerging basis,[96]but actually not really deciding anything because of procedural difficulties. However Gibbs J in XCO Pty Ltd v Federal Commissioner of Taxation[97]did suggest that a profit emerging basis could be appropriate where a profit making scheme extended over a period of more than one tax year.[98]The question then is whether accounting principles will be relied upon to determine the method of calculation of profit where long term contracts have been entered into.

The question of accounting for profit from long-term construction contract was the subject of discussion in New Zealand in HW Coyle Ltd v Commissioner of Inland Revenue (New Zealand).[99]However, as the report notes, there was some difference of opinion then in the accountancy profession as to the appropriate method of accounting.[100]Two methods were used: the percentage of completion method or the completed contract method. The choice of method, so Holland J held, would vary depending upon the contract. Where there could be no accurate forecast as to whether there would be a profit or a loss it could be desirable to prepare accounts on a completed contract basis at least until such time as an accurate forecast was possible.[101]In other cases a percentage of completion method would produce an appropriate calculation of profit.[102]Not surprisingly it was held that the method to be adopted would turn upon the circumstances of each case and in particular the terms of the relevant contract.[103]

Perhaps the fact that the Commissioner issued a ruling on the tax treatment of long-term construction contracts brought about the result that there was little incentive to litigate the question. The ruling, IT 2450, rejected the completed contract method but permitted either the bringing to account of all progress and final payments received in the year (or billed or entitled to be billed) or an estimated profits basis from year to year

The subsequent case of V95[104]in the Administrative Appeals Tribunal was decided without accounting evidence and dealt with the tax treatment of a provision in the taxpayer’s accounts for work which might have to be performed during a contract’s liability period under a contract for manufactured hospital sterilisers.

Grollo Nominees Pty Ltd v Federal Commissioner of Taxation,[105]a decision of a full Court of the Federal Court comprising Sheppard, Foster and Whitlam JJ, was a case where accounting evidence was adduced in relation to long term construction contracts. The Court in that case adopted the view of accounting evidence that had been espoused by Gummow J in Barratt, to which reference has already been made. Their Honours commented in dicta that the emerging profits basis preferred by accountants did not seem one permitted by the Act.[106]

7 The Computation of Accounting Profit as Opposed to Assessable Income Less Allowable Deductions

Before turning to the impact of accounting principles on deductions there is what may be referred to as an intermediate question. It arose in Commissioner of Taxation v Citibank Ltd.[107]

Finance companies account for finance leases in such a way that each component of the lease ‘rental’ includes a finance element akin to interest and each such component includes a capital component. This method of accounting is known as the financial or actuarial method of accounting for financial transactions. The question was whether for the purposes of the 1936 Act a finance company could bring to account as income the finance element. The Commissioner required the taxpayer to bring to account as gross income the rental as received and take as a deduction against it depreciation as calculated under the Act. The advantage to the finance company (and thus disadvantage to the Commissioner) lay in the fact that there was a cap in the income tax law (s 57AF(2) of the 1936 Act) upon the amount upon which depreciation was allowed in respect of luxury cars. There was, no doubt, the added advantage that acceptance of the financial (or actuarial) accounting method would avoid the need for the making of the alternative computation which, otherwise, the Australian income tax law would require

At first instance Beaumont J was attracted to the adoption of the commercial approach to the computation of the finance company’s income.[108]On appeal, however, the full Court, (Jenkinson, Einfeld and Hill JJ) found that the financial method was inconsistent with the Act which requires there to be brought to account as assessable income amounts which are gross income, and there being offset against that assessable income amounts which were allowable deductions.[109]Once it was accepted (as indeed it had to be) that the rental instalments were gross income, there was no room for the adoption of an alternative approach designed to treat as assessable income a part of the gross income which commercial accounting principles recognised as the accounting profit.

III A DIFFERENT APPROACH TO DEDUCTIBILITY?

The relevance of accounting evidence to the issues of deductibility under s 51(1) of the 1936 Act or s 8-1 of the 1997 Act is much less clear. For simplicity I will hereafter refer only to s 51(1) as there is no relevant difference between that subsection and s 8-1 of the 1997 Act.

As will be demonstrated, the case law often makes it clear that accounting principles are irrelevant because legal concepts prevail over them. On the other hand sometimes accounting principles have been regarded as relevant where the legislation may not have suggested that to be the case. It is convenient in discussing the issues to divide the discussion so that it deals with the different concepts that are to be found in the general deductibility sections. However, as will be seen there is necessarily overlap. The issues to be discussed are:

∞ the quantification of a loss,

∞ the timing of a loss,

∞ estimates – the insurance cases,

∞ the deductibility of provisions for long service leave and annual holiday pay, and

∞ the question of whether the loss or outgoing is one of capital.

A The Quantification of Loss

There is no reason to doubt that if a question should arise as to whether a taxpayer incurred a loss for the purpose of either s 51(1) or s 8-1, accounting evidence could be resorted to both to determine whether there was a loss and to determine the quantum of that loss. As Kitto J said in considering whether a profit arose for the purposes of the then s 26(a) of the 1936 Act: ‘Whether a given amount is to be characterised as a profit ... is a question of the application of a business conception to the facts of the case.’[110]Likewise in the United Kingdom it is well established that: ‘The question of what is or is not profit or gain must primarily be one of fact, and of fact to be ascertained by the tests applied in ordinary business’,[111]although subject to the obvious proposition that the application of principles of commercial accounting must yield to any special income tax provision which requires a different result.[112]

The same can be said of the conception of ‘loss’. This having been said there have been no cases in Australia, of which I am aware, which have actually discussed the relevance of accounting principles directly to the question of establishing that there has been a loss or quantifying the amount of such a loss for the purposes of s 51(1).

Interestingly, however, the concept of loss was discussed by a full Court comprising Jenkinson, Olney and Sundberg JJ in Burrill v Commissioner of Taxation [113]in the context of s 70B of the 1936 Act dealing with losses arising from the disposal of a traditional security. The case came to the Federal Court on a case stated from the Administrative Appeals Tribunal and it does not seem that any accounting evidence had been adduced in the Tribunal or if it had, that it was referred to in the stated case. The decision, which depended upon the computation of a loss being made by reference to the face value of the security, rather than the market value of the security[114]may be criticised on commercial grounds for ignoring the time value of money. Be that as it may, the full Court suggested that the principle there discussed was as much relevant to s 51(1) as it was to s 70B.[115]

B The Timing of a Loss

What causes the difficulty in using accounting evidence in the context of deductions is the concept of ‘incurred’, for there can be no deduction for a loss or outgoing unless it can be said that that loss or outgoing has been incurred. For present purposes it is not necessary to say other than that the word ‘incurred’ has no particular technical meaning. It bears its ordinary meaning of ‘run into’, or ‘encountered’ or ‘fallen upon’ but does not extend to include a loss or expenditure which is no more than ‘impending, threatened or expected’.[116] That meaning and its relationship to accountancy principle is best dealt with in the discussion of the deductibility provisions.

A significant case in the context of s 51(1) is New Zealand Flax Investments Limited v Federal Commissioner of Taxation.[117]Indeed the legacy of the case is still with us. The facts are complicated. In short it can be said that the taxpayer had issued bonds entitling bond- holders to an initial fixed return while the taxpayer developed its flax business (including preparing the ground and planting flax and developing plant for milling it). At the end of this development period bondholders were entitled to a percentage return on flax sales. Investors could pay either cash or the face value of the bonds by instalments. Commissions were paid to salesmen of the bonds. The taxpayer took into its commercial accounts the proceeds of the bonds sold (that is, their face value) as revenue, whether or not received. It sought to offset against that revenue all the expenditure it was obliged to outlay on cultivation, plant et cetera. The Commissioner disallowed the deductions for outlays, although he left standing the revenue side of the account for taxation purposes.[118]

It was argued for the taxpayer that the taxable income should be ascertained in accordance with accounting principles.[119]It was held that it was not correct to treat as income derived the whole face value of bonds subscribed for, whether or not that amount had been paid.[120]Indeed, it was said that the bond proceeds were really consideration for services to be performed over time and thus were not income when received, thus anticipating Arthur Murray.[121]On the deduction side the obligation to pay interest to investors was a definite liability, contingent only upon the bondholders paying up the bonds.[122]Dixon J then said:

There is no reason why the future liability should not be treated as incurred, if otherwise it were proper to throw it against the revenue items, as it would clearly have been if the full face value of the bonds were included in the assessable income. But I find it difficult to say upon the information before us whether any of this liability should be considered as properly attributable to the years in question. There is, I think, no objection to the commissioner’s taking into consideration the actual events of the subsequent years in order to see whether, under a method of accounting by which only actual receipts from the bonds are included, the liability for interest would naturally be provided out of revenue from that source accruing in the year when the liability would be met, or whether safe or proper practice required for the purpose an appropriation and retention of part of the sums received in the accounting periods under assessment. In the same way I think that the commissions payable on the sale of bonds but deferred until the receipt of later instalments involve an outgoing ‘incurred’, but one which does not necessarily and as a matter of course fall into the assessment of the accounting period. [123]

His Honour indicated that the matter should be remitted to the Commissioner to be reassessed:

so as to enable him to include bond moneys received in the accounting periods and to allow whatever part, if any, of the deductions claimed for future interest and deferred commission appears referable to the accounting periods under assessment.[124]

The reference to referability did not re-emerge until Federal Commissioner of Taxation v Australian Guarantee Corp Ltd,[125]a case dealing with the deductibility by a finance company of interest on debentures where the interest was payable on maturity. It was held in that case that the taxpayer was entitled to the deduction progressively over the term of the debenture where the interest was then referable to that year.[126]Although the High Court granted special leave to appeal this decision, that leave was revoked when legislative amendments were introduced which rendered the significance of the decision immaterial.

The decision of the High Court in the later Coles Myer Finance Ltd v Federal Commissioner of Taxation (‘Coles Myer’)[127]showed the significance of referability, this time in the context of discounted bills or promissory notes. The taxpayer, a finance company, sold the bills or notes at a discount from face value around the end of the fiscal year. In the next financial year the taxpayer became obliged to pay to the purchasers of the bills the face value. It claimed to have incurred a loss at the time it discounted or sold the bills or noted, for at that time it became liable to pay the face value of the bill. The Commissioner argued that the taxpayer did not incur a loss until the year of income in which it became obliged to pay the holders of the bill the face value. The intermediate situation, which the High Court adopted, was that the loss on each transaction occurred progressively over the period of time from discounting of the bills or notes until the time for payment.[128]

Mason CJ, Brennan, Dawson, Toohey and Gaudron JJ said:

But it is not enough to establish the existence of a loss or outgoing actually incurred. It must be a loss or outgoing of a revenue character and it must be properly referable to the year of income in question. [129]

Later their Honours said:

Under s 51(1) a loss or outgoing is a deduction only to the extent to which it is incurred in gaining or producing the assessable income. That provision has been described as ‘a statutory recognition and application of the accountancy principle which as the accountants who gave evidence referred to as the matching principle’ ...

Apportionment of the cost over the two years of income therefore accords with both accounting principle and practice and the statutory prescription. [130]

Coles Myer was, to some extent, the opposite side of the coin to Willingdale v International Commercial Bank Ltd to which reference has been earlier made by way of a footnote. However in the English case the bills or notes were long term and sometimes designated in foreign currency with the result that the House of Lords was of the view that the profit did not arise until the Bank was obliged to pay the face value of them or until the Bank sold them on the market.[131]In that case the accounting evidence was that the Bank could either account for the profit progressively or could account for the profit at the time the bills or notes matured, so long as, in the latter case, it made a relevant disclosure of how it had accounted.[132]

The High Court in Coles Myer gave the example of the long-term discount transaction in support of the correctness of the approach it had adopted,[133]but made no reference at all to Willingdale . The High Court pointed out that to allow the discount at the time of commencement, particularly in the case of discount arrangements that continue over a long term, would distort the accounts of the taxpayer, as indeed it would.[134]But if ‘matching’ were a relevant principle of tax law, as it is of accountancy, it may well have been the case that the deduction should only arise at the end of the transaction when according to the House of Lords the profit arose.

One explanation of Coles Myer that appeals to me is that the case is one concerning the deductibility of a loss, rather than the deductibility of an outgoing. If the question arose when the finance company incurred the obligation to pay the face value of the paper which was discounted, the answer would in my view clearly be the date of sale or discounting. However, that is not the point of time at which the taxpayer incurred the loss; rather it can be said that the loss is incurred progressively over the period of the transaction. However, it must be said that in the course of the judgement the High Court drew no distinction between loss and outgoing. Further, the subsequent discussion of the case by Dawson, Toohey, Gaudron, McHugh and Kirby JJ in Federal Commissioner of Taxation v Energy Resources of Australia Ltd[135]would seem to be contrary to the view I have just expressed. Their Honours said:

So, in Coles Myer, the Court held that the difference between the discounted proceeds of an issue of promissory notes and the amount payable on their maturity was a loss or outgoing that was incurred when the note was issued. However, the majority in that case held that the cost of the discount was deductible in the year in which it was incurred only ‘to the extent to which it is incurred in gaining or producing the assessable income’ of that year. [136]

In discussing the problem in Commissioner of Taxation v Mercantile Mutual Insurance (Workers’ Compensation) Ltd,[137]I pointed out that while the facts of the case were concerned not with an outgoing but with the deductibility of a loss, the High Court did not seem to draw any distinction between the two, rather they noted that it was easier to conceive of a loss being incurred over time than of an outgoing being incurred over time. Whatever may be said of Coles Myer, however, the position would clearly seem to be that there may be some losses or outgoings which may be incurred wholly within the year of income but their deductibility may be limited to the extent that the loss or outgoing is incurred in gaining or producing the assessable income of that year.

No case otherwise has applied the referability test. The subsequent cases concerning prepayments,[138]both of which were cases of outgoings, appear to have limited the application of Coles Myer to the special case of financing transactions.

C The Insurance Cases and Estimates

One area where accounting practice has led to a sensible and commercial tax result is in the area of insurance, notwithstanding the view that is often expressed that s 51(1) is concerned with losses or outgoings which are ‘incurred’ and not with provisions for outgoings which might be incurred in the future.[139]

The first Australian authority to deal with the method of taxation accounting to be adopted by an insurance company was Commissioner of Taxation (NSW) v Manufacturers’ Mutual Insurance Ltd (‘Manufacturers’ Mutual’)[140]where it was held that pending claims were deductible where from a practical business point of view they would be paid and where a statement of affairs of the insurer would be inaccurate and misleading if they were not taken into account.[141]

Manufacturers’ Mutual was followed in RACV Insurance Pty Ltd v Federal Commissioner of Taxation (‘RACV’)[142]where it was held that the taxpayer which wrote liability insurance was entitled to a deduction of an estimate of the value of claims reported but not yet paid, and claims where the contingency insured against had happened but the claim had not yet been reported (often referred to as ‘claims incurred but not reported’).[143]The estimates were made on a sophisticated basis. Nevertheless the Commissioner submitted that it was only when the liability to indemnify the insured was actually determined, by settlement or court order, that there was a loss or outgoing which was incurred for the purposes of s 51(1).[144]

The case may be seen either as deciding that the total premiums paid in the year were not income, but that it was only such premiums as were left after a deduction of an estimate of claims incurred but not reported and claims reported but not paid, or as deciding that a provision for these two kinds of claims was deductible. The former approach would be consistent with the estimate for discounts and rebates taken into account in Ballarat Brewing discussed above. However, the reasoning proceeds upon the latter basis, namely that the estimate was a loss incurred in the year deductible under s 51(1). Menhennitt J made the following comments relevant to the accounting evidence:

The accountants who gave evidence said that in their opinion it would not give a true and fair view of an insurance company’s accounts if there were not included in the profit and loss account as a debit estimates of claims estimated but not paid. It was said further that for an insurance company carrying on business for profit to declare profits and pay dividends without taking such claims into account would not be proper and that if dividends were paid out without taking such estimated claims into account it could well lead to the company having insufficient moneys with which to pay outstanding claims and might lead to insolvency. It would also appear from the evidence that the insolvency in recent years of a large overseas insurance company was mainly due to inadequacy of estimate of outstanding claims. [145]

The Court also held that adjustments of the provisions in later years should the amount provided for be inadequate (or should there be an overprovision) would give rise to a further deduction or assessable income as the case may be. Reference was made to New Zealand Flax, to which reference has already been made, and Texas Co (Australasia) Ltd v Federal Commissioner of Taxation.[146]

RACV was followed in Commercial Union Assurance Company of Australia Ltd v Federal Commissioner of Taxation.[147]Both cases were accepted as correct by a full Court of the Federal Court (Hill, Sackville and Hely JJ) in Commissioner of Taxation v Mercantile Mutual Insurance (Workers’ Compensation) Ltd.[148]In that case the Court rejected an argument by the Commissioner that the deduction should be reduced having regard to the time which would be likely to elapse between the contingency insured and actual payment. The taxpayer was not required to discount to present value the amounts required to be paid in the future.[149]The Court held further that there was no general principle of tax law that no deduction could be obtained for a ‘provision’, so long as there was a loss or outgoing that was otherwise incurred.[150]In the insurance context there was a liability that was incurred when the contingency insured against happened and the deduction was an estimate of the amount which otherwise was unknown. Sackville J noted in his Honour’s judgement that there was a real possibility of distortion where the time value of money was not taken into account,[151]but the point not having been taken his Honour was content to reach the same conclusion as the other members of the Court.[152]

It has also been held that the principle in RACV is equally applicable to a self-insurer, so that such a taxpayer could deduct the value of its existing statutory liability to make future compensation payments to injured workers, as long (of course) as the estimates were bona fide and not unreasonable.

It is convenient here to make reference to the decision of Newton J in Commonwealth Aluminium Corporation Ltd v Federal Commissioner of Taxation,[153]although it is not an insurance case. The Court held that the taxpayer was entitled to a deduction for a royalty payable in respect of mining carried out in the year in circumstances where the royalty had not been paid and indeed where it was not at the end of the year of income capable of calculation because it was based on average world value of aluminium which had not then been calculated.[154]It was held that the obligation to pay had crystallised and that the taxpayer was entitled to a deduction of a reasonable estimate of the amount of the liability.[155]

The question of what would happen should it turn out that too much was paid by way of royalty by a taxpayer in a case where the royalty was allowed as a deduction came to be considered in H R Sinclair & Son Pty Ltd v Federal Commissioner of Taxation[156]where it was held that the refunded amount was income in the year of receipt.[157]It is not certain whether the accounting treatment had an impact, but Owen J did note that the amount had been correctly shown in the taxpayer’s accounts as income of that year.[158]The Court did say, however, that the English decisions which deal with the problem by reopening the accounts for the year in which the initial deduction for the royalty was claimed might be more equitable but depended upon the special statutory provisions applicable there.[159]

D Annual Holidays and Long Service Leave

It is clear that no financial statements of a corporation would give a full and true view of its affairs unless a provision were made for annual holiday pay and long service leave accrued during the year. Yet it is equally clear that no deduction is available for income tax purposes for such a provision.

That no deduction was available for a provision in the accounts for annual leave was decided in Federal Commissioner of Taxation v James Flood Pty Ltd (‘James Flood’).[160]This was so because under the terms of the relevant industrial award no liability to pay the leave arose until an employee had commenced taking it, or had retired or died.[161]There was ‘at best an inchoate liability in process of accrual but subject to a variety of contingencies’.[162]A similar approach was taken to long service leave in Federal Commissioner of Taxation v Northern Timber and Hardware Co Pty Ltd.[163]

The issue was litigated again, both in the context of annual holiday pay and long service leave in Nilsen Development Laboratories Pty Ltd v Federal Commissioner of Taxation (‘Nilsen’).[164]A deduction was again denied. Barwick CJ explained the reason for the decision as being that no liability, in the sense of a pecuniary obligation which has become due had ‘come home’ in the year of income so that it could be said that the liability had been incurred.[165]The terms of the industrial award made it clear that there was no obligation on an employer to make any payment until the particular leave was entered upon by the employee or the employee retired or died.[166]There was, in other words, an entitlement to leave, not an entitlement to payment for leave.

Gibbs J in Nilsen repeated the distinction drawn in James Flood between the Australian and the United Kingdom legislation. In the United Kingdom the question is what are the profits or gains of a taxpayer. So, it is necessary in determining those profits to have regard to commercial principles.[167]By contrast, in Australia the issue is whether a loss or outgoing has been incurred.[168]The answer to that question is constrained by the legal meaning given to the word ‘incurred’. This has led to it being said that in Australia the question of the application of s 51(1) proceeds by way of a jurisprudential rather than a commercial analysis.[169]The Privy Council was not, it would seem, impressed by the Australian jurisprudential approach when it came to decide Commissioner of Inland Revenue v Mitsubishi Motors New Zealand Ltd (‘Mitsubishi’).[170]Indeed, their Lordships described it as being ‘an unusual approach to a taxing statute’.[171]

Mitsubishi concerned the deductibility in New Zealand by a motor car assembler of a provision for the anticipated costs of meeting future warranty claims. It was held that a legal obligation to make a payment in the future had accrued during the year of income and accordingly the provision was deductible under the New Zealand equivalent to s 51(1).[172]This accords with the accounting treatment which would be required. It is obvious from the decision that their Lordships were in agreement with the insurance cases to which reference has been made and with the idea that in New Zealand the tax treatment should follow the accounting treatment.

The comments of McHugh J in Coles Myer[173]make it clear also that his Honour finds the principles laid down in James Flood and Nilsen to be difficult. However, it would seem unlikely that the High Court will revisit the question of the deductibility of provisions for long service leave and annual holiday pay in the near future, if at all.

E Capital versus Income

It will be recalled that in Carden Dixon J noted that income was a concept of the world of business. So too is ‘capital’.[174]If accounting evidence can be presented to show whether a particular amount, or part of an amount, is income, can accounting evidence assist in determining whether an amount or part of an amount is capital?

Cases which raise the question whether an outgoing is of capital or is on capital account generally revolve around the classic formulation of Dixon J in Sun Newspapers Ltd v Federal Commissioner of Taxation[175]rather than accounting evidence directed at showing that the amount in question is capital or income. I have encountered accounting evidence in this context only once, and that was in my capacity as counsel for the taxpayer in Travelodge Papua New Guinea Ltd v Chief Collector of Taxes.[176]Actually it was not that either party in that case called accounting evidence. Rather the taxpayer had accounted for the interest payable before the taxpayer opened for business and, in what I understand to be the usual way, by capitalising the interest. However, the fact that the taxpayer had accounted in this way was not thought by the judge who heard the matter to be significant.[177]Nor was it thought by the High Court in Steele v Deputy Federal Commissioner of Taxation[178]to be important.

IV CONCLUSION

The most important areas where accounting principles and income tax intersect are the basic areas of derivation of income and incurring of losses or outgoings. It is clear that accounting principle is, if not determinative, very persuasive in both these areas, except so far as the question arises whether an amount has been incurred, where the Australian courts have sometimes, although not always, adopted a jurisprudential rather than a commercial analysis.

The courts will almost always find accounting principles useful as new questions arise. And this is as it should be. Of course, there will be a difficulty where accounting principles permit alternative methods of accounting to be adopted or where they are silent on the question.

There is much to be said for legislative intervention to adopt the English system permitting the reopening of assessments where the quantum of a deduction or the quantum of income derived is incapable of being ascertained because of a dispute in which the taxpayer is involved. Otherwise the courts appear to be moving towards the accounting approach of permitting a deduction for estimated liabilities and not including as income amounts which are really in dispute. But this approach requires the allowance of a further deduction should the estimate be too low or the bringing to account as income amounts previously deducted should the estimate be too high. It would be desirable if the legislation dealt with such matters specifically either in the context of the power of the Commissioner to amend assessments or in widening the deduction for bad debts so as to permit a deduction for amounts included as assessable income where the amounts are not receivable.


[*] Article based on a paper delivered by the late Justice Graham Hill to the 15th annual conference of the Australasian Tax Teachers Association, Wollongong, 31 January – 1 February 2003. The editor appreciates the contribution made by Ms Jennifer Farrell BA (UNSW) DipEd (Syd) LLM (UNSW) GradDipLegalPrac (College of Law), Research Assistant, Federal Court of Australia, in assisting to finalise this article.

[1] The idea of relating the tax basis to accounting concepts is not the same as the approach to be found in the present Australian legislation of referring to accounting rules in the course of legislative drafting, for example, the consolidation provisions do this in ss 705-70 and 705-90 of the Income Tax Assessment Act 1997 (Cth) and so too do the thin capitalisation rules in ss 820-315, 820-410, 820-470, 820-675, 820-680 and 820-950 of the same Act.

[2] The references are set out in note 1.

[3] See Income Tax Assessment Act 1997 (Cth) s 43-70(1).

[4] See, eg, Income Tax Assessment Act 1997 (Cth) s 43-70(2).

[5] See, eg, Income Tax Assessment Act 1997 (Cth) s 43-70(2).

[6] (1982) 82 ATC 4415, 4424–6 where the evidence is summarised by Tadgell J of the Supreme Court of Victoria. The taxpayer was successful ultimately on appeal to the High Court: [1985] HCA 44; (1985) 157 CLR 277.

[7] Income Tax Assessment Act 1936 (Cth) s 82D(1).

[8] [1985] HCA 44; (1985) 157 CLR 277, 281.

[9] (1979) 79 ATC 4352. Reference to the accounting evidence can be found at 4355–60.

[10] As at 1 February 2003.

[11] [1938] HCA 69; (1938) 63 CLR 108 (‘Carden’).

[12] 26 Internal Revenue Code 446.

[13] Income Tax Assessment Act 1997 (Cth) s 6(5). Note year of income is generally 1 July – 30 June (unless another period adopted under s 18: Income Tax Assessment Act 1936 (Cth) s 6(1).

[14] [1938] HCA 69; (1938) 63 CLR 108.

[15] Ibid 160

[16] Ibid 109.

[17] Ibid.

[18] Ibid.

[19] Ibid 133–4.

[20] Ibid 158–59.

[21] Ibid 158.

[22] Ibid.

[23] Taxation Act 1927-1935 (SA) s 42.

[24] [1938] HCA 69; (1938) 63 CLR 108, 160.

[25] Ibid 153.

[26] Ibid 154.

[27] Ibid 155–7.

[28] [1969] HCA 14; (1970) 119 CLR 612 (18 April 1969).

[29] [1969] HCA 14

[20]

[21] (Windeyer J); (1970) 119 CLR 629.

[30] See [1970] HCA 62; (1970) 119 CLR 612, 616.

[31] Ibid 650.

[32] Ibid.

[33] [1983] FCA 341; (1983) 74 FLR 13.

[34] Ibid 21.

[35] (1976) 76 ATC 4141.

[36] (1989) 85 ALR 244.

[37] (1992) 36 FCR 222.

[38] [2002] FCAFC 385 (Wilcox, Spender and Cooper JJ, 29 November 2002).

[39] (1989) 85 ALR 244, 255.

[40] BHP Billiton Petroleum (Bass Strait) Pty Ltd & Esso Resources Pty Ltd v Federal Commissioner of Taxation [2002] FCAFC 433 (Hill, Heerey and Gyles JJ, 20 December [2002] FCAFC 433; 2002); 126 FCR 119.

[41] It can be argued that Grollo Nominees Pty Ltd v Federal Commissioner of Taxation (1997) 97 ATC 4585 presents a rejection of the absolute accounting principle rule. The case is discussed in the hearing ‘Accounting for long term transactions’. However the decision on the point was dicta.

[42] [1965] HCA 58; (1965) 114 CLR 314, 318. ‘The ultimate inquiry in either kind of case ... but evidence of the concept’.

[43] Ibid 318.

[44] Ibid.

[45] Ibid 319. ‘It was Dixon J’s understanding ... having finally acquired the character of income’.

[46] Ibid 320.

[47] Ibid.

[48] Income Tax and Assessment Act 1936 (Cth) s 170.

[49] (1972) 72 ATC 4048.

[50] Ibid 4051.

[51] Ibid.

[52] Ibid 4051–2.

[53] (1972) 72 ATC 4048, 4049.

[54] Ibid 4049.

[55] Cf Income Tax Assessment Act 1997 (Cth) s 170(4).

[56] (1972) 72 ATC 4048, 4049.

[57] Ibid 4049.

[58] R W Parsons, Income Taxation in Australia: Principles of Income, Deductibility and Tax Accounting (1985) paras 11.226–11.243.

[59] [2002] FCAFC 433; 126 FCR 119.

[60] [2002] FCAFC 433; 126 FCR 119, 127–8.

[61] Ibid 128.

[62] Ibid 129.

[63] Ibid 138.

[64] Ibid 150.

[65] Ibid 144.

[66] Ibid.

[67] (1972) 72 ATC 4048; 126 FCR 127.

[68] (1972) 72 ATC 4048; 126 FCR 127.

[69] [1932] USSC 118; (1932) 286 US 417.

[70] Ibid 424.

[71] See, eg, ibid 422.

[72] Parsons, above n 58, para 11.237.

[73] See, ibid, para 11.237, principle (1).

[74] 26 IRC §§ 41, 42(a).

[75] Boris I Bittker, Federal Taxation of Income, Estates and Gifts (2nd ed, 1992) 105–68.

[76] [1995] FCA 1226; (1995) 64 FCR 86, 94.

[77] [1953] USSC 57; (1953) 345 US 278.

[78] 26 IRC §§ 41, 42(a).

[79] The factual situation in Roxborough v Rothmans of Pall Mall Australia Ltd [2001] HCA 68; (2001) 185 ALR 335, if adapted, might suggest a case where the problem could arise without the illegality involved in Zobory.

[80] See Zobory [1995] FCA 1226; (1995) 64 FCR 86, 94.

[81] [1971] HCA 80; (1970-1) 124 CLR 421.

[82] Ibid 451–2.

[83] Ibid 452.

[84] Ibid 450 (emphasis added).

[85] [1994] FCA 1057; (1993) 50 FCR 73.

[86] Ibid 83.

[87] [1949] HCA 27; (1949) 78 CLR 504.

[88] Ibid 518–19.

[89] Ibid 519.

[90] (1953–4) [1954] UKPCHCA 2; 88 CLR 413.

[91] [1951] HCA 38; (1951) 84 CLR 553.

[92] [1951] HCA 35; (1951) 82 CLR 364.

[93] Ibid 369.

[94] Ibid.

[95] [1927] ArgusLawRp 80; (1927) 40 CLR 454.

[96] See, eg, ibid 458.

[97] [1971] HCA 37; (1971) 124 CLR 343.

[98] Ibid 351.

[99] (1980) 80 ATC 6012.

[100] Ibid 6019.

[101] Ibid.

[102] Ibid 6019–20.

[103] Ibid 6012.

[104] (1988) 88 ATC 631.

[105] (1997) 97 ATC 4585.

[106] Ibid 4587.

[107] (1993) 44 FCR 434.

[108] Ibid 442.

[109] Ibid 434.

[110] Federal Commissioner of Taxation v Becker [1952] HCA 77; (1952) 87 CLR 456, 467. See also XCO Pty Ltd v Federal Commissioner of Taxation [1971] HCA 37; (1971) 124 CLR 343 (Gibbs J) to which reference was earlier made in the context of the profit emerging basis.

[111] Sun Insurance Office v Clark [1912] AC 443, 455 (Viscount Haldane).

[112] Ibid. See also BSC Footwear Ltd v Ridgeway [1972] AC 544 and Willingdale (Inspector of Taxes) v International Commercial Bank Ltd [1978] AC 834.

[113] (1996) 96 ATC 4629.

[114] Ibid 4630.

[115] Ibid 4634.

[116] New Zealand Flax Investments Ltd v Federal Commissioner of Taxation [1938] HCA 60; (1938) 61 CLR 179, 207.

[117] [1938] HCA 60; (1938) 61 CLR 179.

[118] Ibid 180.

[119] Ibid 189–91.

[120] Ibid 180.

[121] Arthur Murray (NSW) Pty Ltd v Commissioner of Taxation (Cth) [1965] HCA 58; (1965) 114 CLR 314.

[122] [1938] HCA 60; (1938) 61 CLR 179, 207.

[123] Ibid 207.

[124] Ibid 208 (emphasis added).

[125] (1984) 84 ATC 4642.

[126] Ibid 4642.

[127] (1992–3) [1993] HCA 29; 176 CLR 640.

[128] Ibid 666.

[129] Ibid 663.

[130] Ibid 665–6.

[131] Willingdale (Inspector of Taxes) v International Commercial Bank Ltd [1978] AC 834.

[132] Ibid 852.

[133] (1992–3) [1993] HCA 29; 176 CLR 640, 666.

[134] Ibid.

[135] [1996] HCA 10; (1996) 185 CLR 66.

[136] Ibid 75.

[137] [1999] FCA 351; (1999) 87 FCR 536, 549ff.

[138] See, eg, Commissioner of Taxation v Woolcombers (WA) Pty Ltd [1993] FCA 631; (1993) 47 FCR 561 and Merchant v Commissioner of Taxation (1999) 99 ATC 4221, although the latter case was ultimately decided on another basis.

[139] (1984) 84 ATC 4642, 4657.

[140] [1931] NSWStRp 45; (1931) 31 SR (NSW) 575.

[141] Ibid 585.

[142] (1974) 74 ATC 4169.

[143] Ibid 4184.

[144] Ibid 4175.

[145] Ibid 4181.

[146] [1940] HCA 9; (1940) 63 CLR 382, 465–6.

[147] (1977) 77 ATC 4186.

[148] [1999] FCA 351; (1999) 87 FCR 536.

[149] Ibid 548.

[150] Ibid 549.

[151] Ibid 557–8.

[152] Ibid 557.

[153] (1977) 77 ATC 4151.

[154] Ibid 4164–5.

[155] Ibid 4166.

[156] [1966] HCA 39; (1966) 114 CLR 537.

[157] Ibid 537.

[158] Ibid 547.

[159] Ibid 543.

[160] [1953] HCA 65; (1953) 88 CLR 492.

[161] Ibid 504–5.

[162] Ibid 508.

[163] [1960] HCA 93; (1960) 103 CLR 650.

[164] (1981) 144 CLR 616.

[165] Ibid 623.

[166] Ibid 620.

[167] Ibid 628.

[168] Ibid.

[169] Ibid 629.

[170] (1995) 95 ATC 4711.

[171] Ibid 4714.

[172] Ibid 4716.

[173] (1992–3) [1993] HCA 29; 176 CLR 640, 679.

[174] In fact, in Carden Dixon J said, inter alia at 152–3: ‘Familiar but striking examples of this necessary reliance upon commercial principles and general business understanding may be found in the case law dealing with expenditure laid out for the purpose of trade, with outgoings on account of capital...’.

[175] [1938] HCA 73; (1938) 61 CLR 337, 359–65.

[176] (1985) 85 ATC 4432.

[177] Ibid.

[178] (1999) 99 ATC 4242, 4249 (Gleeson CJ, Gaudron and Gummow JJ).


AustLII: Copyright Policy | Disclaimers | Privacy Policy | Feedback
URL: http://www.austlii.edu.au/au/journals/JlATaxTA/2005/1.html