FEDERAL COURT OF AUSTRALIA Dormer v Federal Commissioner of Taxation [2002] FCAFC 385 TAXATION – Income tax – Taxpayer carried on sole practice as an accountant, computing his income tax liability on a cash received basis – As from 1 July 1997, taxpayer carried on practice, in same premises and with substantially the same staff, in partnership with two former employees – Partnership's tax return was submitted on an accrued earnings basis – After commencement of partnership business, taxpayer received payments for work done by him during his period of sole practice – Whether such receipts are assessable income. Commissioner of Taxation (Cth) v Henderson (1970) 119 CLR 612 distinguished JOHN FREDERICK DORMER v FEDERAL COMMISSIONER OF TAXATION A23 of 2002 WILCOX, SPENDER and COOPER JJ 29 NOVEMBER 2002 SYDNEY (HEARD IN CANBERRA) IN THE FEDERAL COURT OF AUSTRALIA AUSTRALIAN CAPITAL TERRITORY A23 of 2002 DISTRICT REGISTRY ON APPEAL FROM A JUDGE OF THE FEDERAL COURT OF AUSTRALIA BETWEEN: JOHN FREDERICK DORMER APPELLANT AND: FEDERAL COMMISSIONER OF TAXATION RESPONDENT JUDGE: WILCOX, SPENDER AND COOPER JJ DATE OF ORDER: 7 NOVEMBER 2002 WHERE MADE: CANBERRA THE COURT ORDERS THAT: 1. The appeal be dismissed. 2. The appellant pay to the respondent his costs of the appeal. Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules. IN THE FEDERAL COURT OF AUSTRALIA AUSTRALIAN CAPITAL TERRITORY A23 of 2002 DISTRICT REGISTRY ON APPEAL FROM A JUDGE OF THE FEDERAL COURT OF AUSTRALIA BETWEEN: JOHN FREDERICK DORMER APPELLANT AND: FEDERAL COMMISSIONER OF TAXATION RESPONDENT JUDGE: WILCOX, SPENDER AND COOPER JJ DATE: 29 NOVEMBER 2002 PLACE: SYDNEY (HEARD IN CANBERRA) REASONS FOR JUDGMENT THE COURT: 1 This is an appeal against a decision of a judge of the Court (Gyles J) in an income tax case. His Honour dismissed an application by the appellant, John Dormer, to set aside an objection decision made by the respondent, Federal Commissioner of Taxation ("the Commissioner"), but he varied the decision by remitting penalties imposed by the Commissioner. There is no cross appeal; so the only issue we have had to determine is the correctness of his Honour's decision that the relevant income was assessable income pursuant to the Income Tax Assessment Act 1936, as "simplified" by the Income Tax Assessment Act 1997. 2 The appeal was heard in Canberra on 7 November 2002. At the conclusion of argument, we announced our view that the appeal must fail. We ordered that the appeal be dismissed with costs and stated we would give reasons later. These are our reasons. The facts 3 Gyles J noted that the facts of the matter were not in contention before him. In his reasons for judgment, he set out an outline of facts that had been agreed between the parties. We will take the same course: "1. In the years up to and including the year ending 30 June 1997, the Applicant had carried on an accounting business as a sole trader, trading as John Dormer and Associates. 2. In the years up to and including the year ending 30 June 1997, the Applicant returned the business income of John Dormer and Associates on a cash basis. 3. By an agreement dated 18 April 1997 (the Sale Agreement), the Applicant agreed to sell one third of John Dormer and Associates to Terence John Grainger (Grainger) and one third of John Dormer and Associates to Anthony William Hampden Platt (Platt). By clause 1 of the Sale Agreement, the sale was to take effect from 1 July 1997. 4. Under the terms of the Sale Agreement, all clients of John Dormer and Associates were billed their work in progress as at 30 June 1997 and became debtors of John Dormer and Associates (Clause 5 of the Sale Agreement). The debtors of John Dormer and Associates were not sold under the Sale Agreement and were retained by the Applicant (Clause 4 of the Sale Agreement). 5. The Applicant, Grainger and Platt entered an agreement dated 18 April 1997, headed 'Joint Venture Agreement' (the Agreement). 6. The Agreement contained, inter alia, the following provisions: Recitals: A. […] B. The parties wish to form a Joint Venture whereby each of Dormer Grainger & Platt will introduce into the Joint Venture the one third interest they then own in the practice of John Dormer and Associates. C. The Practice of John Dormer and Associates will thereupon cease and the Joint Venture shall commence on the terms and conditions hereafter contained. Clause 2. Joint Venture The Parties shall enter into a joint venture whereby: (a) Each Party shall introduce therein his one third interest of the Former Practice. (b) The parties thereafter shall conduct the Joint Venture under the name of Dormer Grainger Platt on the terms herein appearing. (c) The profits arising from the Joint Venture shall be shared by the parties in the manner hereinafter described. Clause 5 The object of the Joint Venture is for the Parties to use their respective interests in the Former Practice to establish by way of Joint Venture a substitute accountancy practice and with the intent of creating an income stream for the benefit of the parties. Clause 7 The Joint Venture on behalf of the Parties shall receive all monies, assets, rights and property in the nature of income which shall be derived from or in respect of the Joint Venture and shall pay or cause to be paid therefrom all expenses and outgoings incurred in respect of the Joint Venture. 7. For the year ended 30 June 1998, the Applicant returned his share of income from Dormer Grainger and Platt. This income was calculated on an accruals or earnings basis. The 1998 Amended Assessment 8. During the year ended 30 June 1998, the Applicant received payments totalling $76,045.00 from debtors of John Dormer and Associates. These payments were not included in the assessable income of the Applicant for the year ended 30 June 1998 or any other year. 9. Following a limited audit of the taxation affairs of the Applicant, on 11 October 2000, the Respondent issued to the Applicant an amended assessment for the year ended 30 June 1998. This amended assessment included in the assessable income of the Applicant for they year ended 30 June 1998 an amount of $76,045.00, being the amount of the payments from debtors of John Dormer and Associates received during that year. The 1999 Amended Assessment 10. During the year ended 30 June 1999, the Applicant received payments totalling $4695.00 from debtors of John Dormer and Associates. These payments were not included in the assessable income of the Applicant for the year ended 30 June 1999 or any other year. 11. On 11 October 2000, the Respondent issued to the Applicant an amended assessment for the year ended 30 June 1999. This amended assessment included in the assessable income of the Applicant for the year ended 30 June 1999 an amount of $4695.00, being the amount of the payments from debtors of John Dormer and Associates received during that year. Additional Tax 12. The amended assessments for the years ended 30 June 1998 and 1999 included tax shortfall penalties, imposed in terms of Section 226G of Part VII of the Income Tax Assessment Act 1936. Objections 13. The Applicant lodged a valid notice of objection dated 13 November 2000 against the amended assessments for the years ended 30 June 1998 and 1999. 14. By letter dated 28 February 2001, the Respondent disallowed the objections." 4 Gyles J also quoted much of the Sale Agreement referred to in para 3 of the agreed statement of facts. The extract was as follows: "IN THE FOLLOWING CIRCUMSTANCES A. Dormer conducts an accounting practice in the ACT known as John Dormer & Associates ('the Practice'). B. The Parties intend to form a Joint Venture as of 1 July 1997 and to be known as Dormer Grainger Platt (Joint Venture) and for the purpose thereof each of Grainger and Platt have agreed to acquire a third interest in the Practice. C. Each of the Parties shall then introduce into the Joint Venture his one third share of the Practice. NOW THIS AGREEMENT WITNESSES AS FOLLOWS: 1. Sale Dormer shall sell to each of Grainger and Platt a one third interest in the Practice presently solely conducted by him, on 30 June 1997 but with effect from 1 July 1997. 2. Consideration for Sale Dormer shall receive from each of Grainger and Platt the sum of $145,000 for the sale of a one third of the Practice, which respective sums shall be paid to Dormer on 30 June 1997. 3. Conditions of Sale The sale provisions contained in clause 1 hereof are conditional upon each Party introducing into the Joint Venture, his one third interest in the Practice. 4. Treatment of Debtors Debtors of the Practice will not be transferred or sold and will be retained by Dormer. The Parties will cause the Joint Venture to collect the debtors of the Practice which exist as at 30 June 1997, at no cost, and to pay those fees to Dormer within 7 days of collection. It is agreed that any payments from clients will, be applied first as to the oldest outstanding debt and so on. 5. Work in Progress Work in progress as at 30 June 1997 will be billed to all clients by John Dormer & Associates and will then become a debtor of the Practice. 6. Sale of Assets by Sproatley To assist with the buy-in of the practice, Sproatley will transfer to the Management Unit Trust established for the purposes of the Joint Venture the existing plant and equipment, fittings and fixtures owned by it. Sproatley acknowledges that the transfer of the existing plant, equipment, fittings and fixtures to the Management Unit Trust shall be for a consideration of $15,000, to be paid equally by Dormer, Grainger and Platt. 7. Leases by Sproatley The Management Unit Trust will take over: (a) the lease of the Photocopier and Facsimile Machine currently with Canon as from 1 July 1997. (b) Payment of the CCH subscription as from 1 July 1997. 8. Introduction to Clients Dormer agrees to introduce both Platt and Grainger to all clients of the Joint Venture as soon as possible and to ensure that an introduction has been made by 31 December 1997. …" 5 Gyles J noted it was common ground that, notwithstanding the description "Joint Venture", the appellant practised in partnership with Messrs Grainger and Platt from 1 July 1997. 6 There was evidence before Gyles J that, around 30 July 1997, the appellant sent a letter to each of the clients of John Dormer and Associates, apparently as of 30 June 1997. He attached to each letter an account for work in progress. He requested the amount shown on the account be paid to John Dormer and Associates, not to the new joint venture. The letters read: "With the formation of the new partnership on 1 July 1997 we have been instructed by our solicitors that we are to bill clients before 30 June 1997 for any work done for them since their last account and up until 30 June 1997. This is a legal requirement arising from the formation of the new partnership and is a once only occurrence. We would normally only bill you on completion of your income tax work for a year or on completion of a specific project. We regret any inconvenience this may cause." Contentions before Gyles J 7 The fundamental contention of the appellant, both before Gyles J and before us, is that this case is governed by the decision of the High Court of Australia in Commissioner of Taxation (Cth) v Henderson (1970) 119 CLR 612. The taxpayer in that case was a partner in a firm of accountants. Prior to the taxation year 1964-65, income tax returns of the partnership had been compiled on a cash receipts basis. During each of the subsequent two years, returns were compiled on an earnings basis. The issue before the High Court was the assessability of a sum of $179,530 that was received by the partnership after 1 July 1964 in respect of work done before that date. Windeyer J held the sum was assessable but the Full Court disagreed. Barwick CJ (with whom McTiernan and Menzies JJ agreed) said at 648-649: "However, the appellant's appeal remains to be dealt with. This arises out of the qualification which his Honour made to the computation made on an earnings basis of the partnership income derived in the year ended 30th June 1965. His Honour thought that in respect of this year the amount of fees earned but uncollected at the end of the year ended 30th June 1964, less the amount of unpaid obligations to the extent to which the fees were collected during the year ended 30th June 1965, should be added to the net fees earned during that year in order to arrive at the income derived by the partnership in that year. The occasion which prompted this course was that the partnership had computed its income for the year ended 30th June 1964 upon a cash received basis, the partnership had made its taxation return on that footing and the appellant had returned his income accordingly. The Commissioner had accepted these returns and assessed the appellant to income tax on the basis of them. Fees outstanding at the end of that year were thus not brought to tax in that year. If the partnership income were computed for the year ending 30th June 1965 upon an earnings basis and the relevant earnings were confined to the earnings of that tax year, those fees outstanding, which amounted to a considerable sum in the order of $179,000, if no other action should be taken, would be collected without ever being brought to tax. The reason that his Honour in those circumstances thought that these outstanding fees should be included in the earnings of the year ended 30th June 1965 was that the income of a continuing business such as that under consideration could not be regarded as '… an annual crop. It is merely so much of a continuous incoming as is attributable to a particular year …'. Referring to the exclusion by the partnership from its 1965 return of the fees outstanding at the end of the year 1964, his Honour said [at p 629 above]: 'It is this kind of result of changing from a cash basis to an earnings basis, and then regarding the next year in isolation, that prevents the partnership return for 1964/1965 being a true reflex of income. It is not a true reflex, simply because taking the income there shewn with the income shewn in the previous year the two together do not reflect the true income over the period of two years combined.' But, with due respect to his Honour, there cannot be any warrant in a scheme of annual taxation upon the income derived in each year of taxation for combining the results of more than one year in order to obtain the assessable income for a particular year of tax. Of course, the experience of a prior year may be reflected in the opening figures of the relevant year but they become and are figures of that year and not figures of two years in combination. Once it is decided that the partnership income derived in the year in question will be the net amount of its earnings of that year, it is, in my opinion, only the earnings of that year which can be included in the computation." 8 The appellant suggested to Gyles J that these reasons dictated, in the present case, the exclusion from assessment of the payments received by him in 1997-98 ($76,045) and 1998-99 ($4,695). Not to do so, it was said, would be to repeat the error made by Windeyer J in Henderson: the aggregation, in connection with a single tax year, of two different methods of accounting. 9 Counsel for the Commissioner submitted to Gyles J that the principle applied in Henderson had no application to this case; that decision applied only to a continuing business involving a single source of professional income for the taxpayer: his interest in the partnership. In the present case, it was argued, the taxpayer had two sources of income: the moneys owing to him in respect of his sole trader business, John Dormer and Associates, and his share in the partnership profits of Dormer Grainger Platt. 10 The Commissioner alternatively contended that, even on an accrual basis, the disputed amounts were taxable. He said the moneys payable to John Dormer and Associates accrued due at the time the letters of 30 July 1997 were received; this was in the 1997-98 tax year. The decision of Gyles J 11 Gyles J held against the appellant. He said (at paras 21-24): "21. If the principle in Henderson is applicable, the adoption of an accruals basis for the years in issue by the partnership (which is not now in dispute) has the result that income received derived from work in the previous period is not assessable as it is not attributable to the year in question. 22. The contention for the Commissioner that Henderson only applies to a continuing business may be correct in a general sense, although that was not the point in Henderson, as the accountancy practice in that case was continuing. Counsel for the Commissioner placed emphasis upon the provisions of the agreement which had the effect that the benefit of the old business remained wholly in the hands of the applicant. He submitted that this business in effect remained on foot, albeit in order to collect debts rather than to do any further professional work. However, in the present circumstances, it seems to me that the accountancy practice as such did continue, and the substance of what occurred was that the applicant introduced two former employees as partners. Otherwise, the business carried on as before, with goodwill and assets transferred to the new partnership. Thereafter, no accountancy practice was conducted by the applicant. The receipt of outstanding fees does not constitute carrying on business. Furthermore, the analysis made on behalf of the Commissioner would be applicable to all changes in the constitution of a business partnership by the departure or admission of a partner (absent any special provisions of the partnership agreement), and would apply if, for example, a two person partnership, operating on a cash basis, admitted three new partners and changed to an accruals basis. 23. However, Henderson was a case of a continuing business conducted by the same taxpayers. A consequence of the decision was that business income was not taxed. That is somewhat of an anomaly, although the effect of this can be exaggerated, as the result of the change to an accruals basis brings income to account for tax which has not been received. In my opinion, the partnership is properly seen as a new venture which derives income which has no relationship with work done in the previous accounting period. The fact that the applicant derived income from that partnership which is calculated on an accruals basis has no necessary or logical connection with the receipt by him of monies owed to him by reason of his business activities in the previous period which, standing alone, would be taxable as cash received. There is nothing unusual about the one taxpayer receiving income from various sources which may be taxed in different ways. In my opinion, Henderson does not apply and the applicant fails in his challenge to the Commissioner's amended assessments of the amounts received in 1998 and 1999. 24. This conclusion makes it unnecessary to decide the correctness of the argument for the Commissioner as to the consequences of the taxpayer's letter to clients of 1997." The argument before us 12 The submissions put to Gyles J were repeated before us, with some elaboration. 13 In his written outline of submissions, counsel for the appellant, Mr Alan Powrie, referred to the legal effect of the "competing methods" of computation of income respectively known as the "cash" (or "cash receipts") and "earnings" (or "accruals") bases. He cited the explanation of the two systems given by Lord President Clyde in Inland Revenue Commissioners v Morrison (1932) 17 TC 325 at 330. He referred to a comment of Gyles J (at para 16 of his reasons): "It is now accepted by the Commissioner that, looked at in isolation, a cash receipts basis was appropriate for the period of the practice and an accruals basis is appropriate for the partnership practice". Mr Powrie contended it followed from this comment that the case "falls squarely within the principles enunciated in Henderson". 14 Mr Powrie argued the issue of a continuing business does not arise in this case "since the question is not one of 'continuum'. The issue is at what point does a taxpayer derive income. The answer to this question is dependent on whether or not a cash or accruals basis of accounting is used". 15 Mr Powrie submitted: "The Commissioner has no power to consent or refuse to consent to the adoption of a system. If in its formulation it brings in income which is admittedly income of another year, then it must necessarily be wrong because it simply is not measuring what the [Income Assessment Act] requires to be measured … It is obvious from the authorities … that income derived from a cash basis is so derived when it is received, whereas income derived on an accruals basis is derived once an account is sent out. In the instant case the applicant [sic] changed from a cash basis to an accruals basis, as and from 1 July 1997. Accordingly, as Barwick CJ said in Henderson there is 'no warrant to combine two different accounting systems to produce a hybrid of income'. … It is our submission that the conclusion reached by Gyles J is tainted with exactly the same flaw as the conclusion arrived at by Windeyer J, which was overturned, on appeal by the full High Court." 16 Counsel for the Commissioner, Mr Chris Erskine, supported the reasoning by Gyles J. He emphasised his Honour's comment, in para 23 of his reasons (quoted at para 11 above), that "the partnership is properly seen as a new venture which derives income which has no relationship with work done in the previous accounting period". Mr Erskine submitted "there is nothing unusual about different types of income being treated differently, regardless of the time of derivation". He drew an analogy with payments to retiring partners, as to which he cited Stapleton v Federal Commissioner of Taxation (1989) 89 ATC 4818 and Federal Commissioner of Taxation v Grant (1991) 91 ATC 4608. Our views 17 We agree with the substance of Gyles J's reasoning. However, we have difficulty with his Honour's comment, in para 22 of his reasons, that "the accountancy practice as such did continue". With respect, having regard to the terms of the Sale Agreement, it seems more accurate to say that a new practice, operated by the three partners, immediately replaced the old practice carried on by the appellant alone. It seems the new practice was carried on in the same premises as the old practice and used the same staff, with the exception that two employees of the old practice, Messrs Grainger and Platt, became partners in the new practice. No doubt the partners in the new practice hoped to obtain the benefit of such goodwill as attached to the old practice; presumably, that is why Messrs Grainger and Platt each paid the appellant $145,000 for the opportunity of going into partnership with him. However, as a matter of law, it seems to us, the old "one-man practice" was replaced by a new partnership practice. 18 Despite the comment to which we have referred, Gyles J said, in para 23: "… the partnership is properly seen as a new venture which derives income which has no relationship with work done in the previous accounting period". That is obviously correct. Clause 4 of the Sale Agreement provided that debtors of the old practice "will not be transferred or sold and will be retained by Dormer". Even work in progress, as at 30 June 1997, was to be billed to clients by the old practice and "then become a debtor" of that practice: see cl 5 of the Sale Agreement. The only connection between the debtors of the old practice, including for work in progress at 30 June 1997, and the new practice was that the new practice was to act as debt collector for the old. 19 The statement made by Barwick CJ in Henderson about there being no warrant "for combining the results of more than one year in order to obtain the assessable income for a particular year of tax" strikes us as curious. It might have been thought, on the facts of Henderson, that the results of one year comprised both the cash received in that year in respect of income earned in earlier years (and not yet subjected to tax) and the income earned in the later year, upon which tax was being computed on an earnings basis. However, the correctness of Henderson is not an issue for us. We are bound by the decision. If it is in point, we must apply it to this case. The question, for us, is whether the approach adopted in that case applies to this case, as the appellant asserts and the respondent disputes. 20 We agree with Gyles J that the Henderson approach does not apply to this case. It was critical to Henderson that the receipts in issue were derived from the conduct of the same business (the accountancy partnership) as was then operating on an accrued earnings basis. That was not the situation in the present case. The business carried on by the appellant as from 1 July 1997 (the accountancy partnership with Messrs Grainger and Platt) was a different business from that undertaken by the appellant, as a sole trader, before that day. It is true that both businesses were accountancy practices and that the later business used the same premises and, substantially, the same employees as the first; but that is immaterial if the businesses were, in law, different businesses. 21 During the course of argument, it was suggested to Mr Powrie that, in terms of principle, the situation in this case is no different from that which would apply if a sole trader accountant, who had operated on a cash receipts basis, ceased professional practice and purchased a retail business that operated on an accrued earnings basis. Mr Powrie was asked whether he contended, in that situation, any moneys thereafter received in relation to the accountant's former professional practice would not be assessable income. Mr Powrie answered that question affirmatively. He said it was a consequence of the Commissioner's acceptance of a cash received basis for computation of assessable income that any moneys received by the taxpayer after cessation of the relevant business was not subject to income tax. 22 Although the essential features of the hypothetical case put to Mr Powrie must have occurred on countless occasions since 1937, Mr Powrie was not able to justify his response by reference to any decided case. His difficulty pointed up the lack of logic and principle in his primary submission. 23 For these reasons, we dismissed the appeal. I certify that the preceding twenty-three (23) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Court. Associate: Dated: 29 November 2002 Counsel for the Applicant: Mr A Powrie Solicitor for the Applicant: Powrie & Co Counsel for the Respondent: Mr C Erskine Solicitor for the Respondent: Australian Government Solicitor Date of Hearing: 7 November 2002