FEDERAL COURT OF AUSTRALIA Commissioner of Taxation v Sydney Refractive Surgery Centre Pty Limited [2008] FCAFC 190 TAXATION – taxpayer corporation receives award of damages for injury to business reputation by defamatory publications – damages calculated by reference to taxpayer's loss of profits attributable to the defamatory publications – whether damages received by the taxpayer constitute 'income according to ordinary concepts' for the purposes of s 6-5 of the Income Tax Assessment Act 1997 (Cth) Income Tax Assessment Act 1997 (Cth) s 6-5 British Transport Commission v Gourley [1956] AC 185 cited Cullen v Trappell (1980) 146 CLR 1 cited Eisner v Macomber 252 US 189 (1920) referred to Liftronic Pty Ltd v Commissioner of Taxation (1996) 66 FCR 175 distinguished London and Thames Haven Oil Wharves Ltd v Attwooll [1967] 2 All ER 124 distinguished Polone v Commissioner of Internal Revenue 505 F3d 966 (9th Cir 2007) cited Roemer v Commissioner of Internal Revenue 716 F2d 693 (9th Cir 1983) cited Rubber Improvement Ltd v Daily Telegraph Ltd [1964] AC 234 cited Sydney Refractive Eye Surgery Centre Pty Ltd v Beaumont [2004] NSWSC 164 discussed Sydney Refractive Surgery Centre Pty Ltd v Commissioner of Taxation (2008) 247 ALR 313 affirmed Tourism Holdings Australia Pty Ltd v Commissioner of Taxes (2007) 210 FLR 80 cited United States v Kaiser 363 US 299 (1960) approved Upenieks v Canada [1995] 1 CTC 8D cited Welch v Helvering 290 US 111 (1933) approved Whyte v Morin [2008] BCWLD 3470 cited Z-Tel Communications Inc v SBC Communications Inc 331 FSupp2d (ED Tex 2004) cited Richard A Posner, Economic Analysis of Law (5th ed, 1998) COMMISSIONER OF TAXATION v SYDNEY REFRACTIVE SURGERY CENTRE PTY LIMITED (ABN 59 074 156 335) NSD 601 of 2008 RYAN, EDMONDS & GORDON JJ 18 DECEMBER 2008 SYDNEY IN THE FEDERAL COURT OF AUSTRALIA NEW SOUTH WALES DISTRICT REGISTRY NSD 601 of 2008 ON APPEAL FROM A SINGLE JUDGE OF THE FEDERAL COURT OF AUSTRALIA BETWEEN: COMMISSIONER OF TAXATION Appellant AND: SYDNEY REFRACTIVE SURGERY CENTRE PTY LIMITED (ABN 59 074 156 335) Respondent JUDGES: RYAN, EDMONDS & GORDON JJ DATE OF ORDER: 18 DECEMBER 2008 WHERE MADE: SYDNEY THE COURT ORDERS THAT: 1. The appeal is dismissed. 2. The appellant pay the respondent's costs of the appeal, to be taxed in default of agreement. Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules. The text of entered orders can be located using eSearch on the Court's website. IN THE FEDERAL COURT OF AUSTRALIA NEW SOUTH WALES DISTRICT REGISTRY NSD 601 of 2008 ON APPEAL FROM A SINGLE JUDGE OF THE FEDERAL COURT OF AUSTRALIA BETWEEN: COMMISSIONER OF TAXATION Appellant AND: SYDNEY REFRACTIVE SURGERY CENTRE PTY LIMITED (ABN 59 074 156 335) Respondent JUDGES: RYAN, EDMONDS & GORDON JJ DATE: 18 DECEMBER 2008 PLACE: SYDNEY REASONS FOR JUDGMENT THE COURT: 1 The question on appeal may be simply stated: are compensatory damages for defamation received by a corporation "income according to ordinary concepts" and assessable under s 6-5 of the Income Tax Assessment Act 1997 (Cth) ("the ITAA97") if calculated solely by reference to lost profits attributable to the defamatory publications? The learned primary judge answered that question in the negative, allowing the appeal of the respondent taxpayer, Sydney Refractive Surgery Centre Pty Ltd ("SRSC"), against the disallowance of its objection to the decision of the appellant, the Commissioner of Taxation ("the Commissioner"), that the sum of $812,726.00 received by SRSC in compensatory damages for defamation was assessable: Sydney Refractive Surgery Centre Pty Ltd v Commissioner of Taxation (2008) 247 ALR 313. We agree the answer to the question presented is no. Whether a payment of compensatory damages is assessable must be determined by looking to the nature of the cause of action in respect of which the payment is made, rather than the way in which damages are calculated. Accordingly, the appeal must be dismissed with costs. 2 The relevant facts are not in dispute and were set out at length by the primary judge: (2008) 247 ALR 313 at [11]-[38]. On appeal, only a brief summary is required. On 18 March 2004, the Supreme Court of New South Wales entered judgment for $844,624.00 ("the sum") on a jury verdict in favour of SRSC for defamation: Sydney Refractive Eye Surgery Centre Pty Ltd v Beaumont [2004] NSWSC 164. That sum was paid to SRSC in the 2004 tax year. After the Commissioner included the sum (less $31,898 allowed as costs) as assessable income, SRSC objected. When that objection was disallowed, SRSC instituted these proceedings. 3 In the Supreme Court proceedings, the jury found that the defendants had defamed SRSC by publishing false and misleading statements in April and May 1998 about the nature and quality of laser eye surgery services provided by SRSC. After a separate hearing on quantum which was concluded in 2004, Studdert J assessed damages on a lost profits basis by: (1) determining the number of surgical procedures that SRSC would have performed but for the adverse impact of the defamatory publications; (2) multiplying that number by the average gross revenue per procedure to establish the total lost gross revenue; (3) subtracting the costs that would have been incurred by SRSC in performing those procedures in order to establish the total lost net revenue; and (4) subtracting the amount that SRSC would have had to pay in taxes on that net revenue in order to determine total lost profits. Although SRSC also put its damages case on a reduction in value (ie lost goodwill) basis, the trial judge noted that SRSC had stopped trading in 1999 and that, in the absence of any sale of the business, there was insufficient evidence of a loss in capital value: (2008) 247 ALR 313 at [23]. 4 The fourth step is important. The parties to the Supreme Court proceedings, as well as the judge, all proceeded on the basis that the damages award itself would not be assessable as ordinary income even though the lost profits that it represented would clearly have been taxed as income. The English view (described by the primary judge as the Gourley principle referring to British Transport Commission v Gourley [1956] AC 185), which has drawn the approval of the High Court in this country, is that notional tax savings must be taken into consideration when calculating damages in order to ensure that the plaintiff is not overcompensated for its loss: British Transport Commission v Gourley [1956] AC 185, approved in Cullen v Trappell (1980) 146 CLR 1; see also Rubber Improvement Ltd v Daily Telegraph Ltd [1964] AC 234. Applying the Gourley principle, Studdert J reduced the damages to be awarded to SRSC by 36 percent, which represented the estimated amount of tax that SRSC would have had to pay had it in fact performed the additional surgical procedures and been paid for them. 5 As the primary judge in this case noted, if the Commissioner's position as to the assessability of the remaining sum were accepted, it would lead to a result inconsistent with the Supreme Court judgment and would mean, in effect, that SRSC would have to pay tax twice. Although this unfortunate possibility of inconsistent judgments does not eventuate here given the view we have formed, the fact that it exists at all is less than satisfactory. We therefore adopt the primary judge's observation that "[t]his case may be a further illustration of the need to consider procedural changes designed to enable a court to determine the impact of taxation on a damages award once and for all and to encourage the parties to take steps in an appropriate case to ensure that this is done": (2008) 247 ALR 313 at [10]. 6 Both before the primary judge and on appeal, SRSC contended that whether a payment constitutes income in the hands of a taxpayer must be determined by its character (ie what the payment was for) rather than the manner in which the amount was calculated. The Commissioner accepted that the character of the payment is the issue but submitted that the manner of calculation in some cases will shed light on the character of the payment and that this was one of those cases. To put it in more concrete terms, the Commissioner acknowledged that, had damages in this case been awarded, for example, on an at large or lost goodwill basis, then those damages would not have been income. On the other hand, where, as here, damages are awarded solely by reference to lost profits, the Commissioner's view was that the character of the payment will be different. 7 As counsel for SRSC, Mr Smark SC, observed, however, it would be curious if the character of a payment in the hands of a taxpayer were transmutable in this way. He relied on an analogy to telescopes, asking rhetorically why it should be that the assessability of a damages award should depend on the level of specificity of calculation, such that when the lens is set at a lower resolution (eg an at large or undifferentiated award) the character of the payment appears one way, but when it is brought into greater relief its nature somehow changes. 8 SRSC's point has merit. Taxation is an area of the law that particularly calls for the imposition of bright-line rules rather than fuzzy standards. We agree that adoption of the position contended for by the Commissioner would lead to all sorts of mischief. First, the adoption of a case-by-case approach would impair the ability of the court awarding damages to apply the Gourley principle. At best, it would mean that proceedings would be prolonged, with leave having to be granted to plaintiffs to reopen depending on the position subsequently taken by the Commissioner and the courts on the tax issue. This would deny finality to the party liable for the damages, because the full extent of the liability might not be known for years. Secondly, acceptance of the Commissioner's contention would encourage plaintiffs to withhold evidence and reframe damages claims in ways that might reduce the accuracy of the awards. Rather than leading evidence and making claims calculated by reference to lost profits, plaintiffs would have an interest in asking the courts to make at large awards based on estimates and undifferentiated lump sum awards encompassing both economic and non-economic loss so that they could avoid taxes: (2008) 247 ALR 313 at [43], [56]. Encouraging the calculation or specification of damages with less accuracy is not in the interests of the parties or of justice generally. Finally, the adoption of a fuzzy standard would increase the work of the Commissioner and the courts - many cases would lead to a private ruling request as to assessability or an objection decision, as well as possible requests for judicial review. Rather than furthering the protection of the revenue, the Commissioner's proposed approach would probably only benefit lawyers and accountants. 9 We consider that the better approach for the Commissioner, if he is of the view that damages awards for defamation ought to be assessable, is to seek a statutory amendment to that effect. That is what happened in the United States, where it was settled that compensatory damages for defamation and other non-physical injuries were not assessable as income under the Eisner v Macomber 252 US 189 (1920) definition until an amendment to the tax legislation was passed expressly making such awards assessable: see eg Roemer v Commissioner of Internal Revenue 716 F2d 693, 700 (9th Cir 1983), overruled by statute as recognised in Polone v Commissioner of Internal Revenue 505 F3d 966, 969 (9th Cir 2007). 10 In the meantime, the proper test was and remains to look at the character of the payment in the hands of the taxpayer: (2008) 247 ALR 313 at [45] and the authorities there cited. For an award of damages, that in turn requires an examination of the nature of the claim or cause of action in respect of which the payment was made. It is settled that an award of damages for personal injuries is not taxable: (2008) 247 ALR 313 at [65] and authorities there cited. 11 The question therefore is whether defamation constitutes a claim for personal injury. The Commissioner accepted that, with respect to a person, this could be so because natural persons can and do suffer injury to their personal reputations by way of hurt feelings and loss of standing in the community, among other things. On the other hand, it was not disputed that the nature of a corporation's claim for defamation is for a financial hurt only - injury to business reputation - because corporations have no feelings and can be injured only in their pockets. The Commissioner therefore submitted that where that injury is measured solely by reference to lost profits or income, defamation must be considered a claim for professional (ie non-personal) injury and therefore any award of damages in respect of that injury constitutes assessable income. 12 We do not accept the Commissioner's proposed distinction because it fails to give sufficient, or even any, proper consideration to the injury for which compensation is being paid. Instead, we agree with the learned trial judge that an award of damages in a defamation claim "is, in point of principle, for impairment of the plaintiff's earning capacity and not for loss of income as such": (2008) 247 ALR 313 at [69]. To put it another way, a corporation's business reputation, although not precisely the same as its goodwill, is in the nature of a capital asset: United States v Kaiser 363 US 299, 311 (1960) (acknowledging that the relevant principle remains that compensation for an injury to something that is not a part of gross income is not taxable, notwithstanding any difficulties in the application of that principle to something like reputation which is not an ordinary capital asset); Welch v Helvering 290 US 111, 115 (1933) (Cardozo J) ("Reputation and learning are akin to capital assets, like the good will of an old partnership."); Z-Tel Communications Inc v SBC Communications Inc 331 FSupp2d 513, 533 (ED Tex 2004) ("Reputation is a very real capital asset to a business firm.") citing Richard A Posner, Economic Analysis of Law at 230 (5th ed, 1998) ("[R]eputation is a basis for inducing others to engage in market or nonmarket transactions with you."); see also Tourism Holdings Australia Pty Ltd v Commissioner of Taxes (2007) 210 FLR 80 at [23] ("A company's good reputation in an area where it does not carry on business is like a capital asset which has yet to be put to work."); Upenieks v Canada [1995] 1 CTC 8D at [4]-[5] (acknowledging that professional reputation is a capital asset); Whyte v Morin [2008] BCWLD 3470 at [80] (finding that professional reputation is a capital asset and that injury to reputation impairs future earning capacity). 13 A corporation's reputation is part of what enables it to earn money; an injury to that reputation diminishes its capacity to earn because it reduces the corporation's ability to induce others to do business with it, as Judge Posner observed. An award of damages for that injury is therefore no different from an award for the loss of an arm or any other injury impairing earning capacity. 14 In contrast, an injury that does not impair the plaintiff corporation's ability to earn, but instead simply frustrates its receipt of certain moneys (ie reduces its revenue) will be assessable. For example, suppose B trespasses on A's factory grounds, erecting a roadblock so that raw materials cannot be delivered, and A claims damages in respect of the diminished output (ie for the loss of use of the factory during the period of the roadblock). Or suppose that A has a contract for the supply of widgets by B, but C tortiously interferes and prevents the delivery, and A then claims damages based on the resale price of the widgets. In those cases, a damages award is not only measured by lost profits but is for lost profits (ie a substitute for revenue not received), and will therefore be assessable as income. This is the principle to be gleaned from London and Thames Haven Oil Wharves Ltd v Attwooll [1967] 2 All ER 124, and Liftronic Pty Ltd v Commissioner of Taxation (1996) 66 FCR 175. However, as the learned primary judge correctly noted ((2008) 247 ALR 313 at [72]-[76]), that principle does not apply here because a claim for defamation damages based on an injury to business reputation is a claim, regardless of how measured, for compensation for lost earning capacity resulting from damage to a capital asset. 15 It is true that the most appropriate method of measuring loss of earning capacity due to injury to a capital asset will of course depend on the circumstances. For example, in some cases there will be evidence of the corporation's value as a going concern before the injury (eg valuation, fair market sale, market capitalisation as reflected in share price) and after the injury (eg subsequent arm's length sale of the business as a going concern, later share price or valuation). In those cases, it might be best to assess damages based on the difference in value (assuming that there are no other confounding or contributing factors that could account for the difference). In other cases, however, such evidence may not exist (eg where the company ceases to trade), and thus a lost profits method may be the best or only approach that can be taken. However, as this analysis makes clear, the nature of the injury itself (and thus the character of the payment received by the taxpayer in compensation for it) does not and cannot change according to the way in which the resultant loss is measured or the evidence which is adduced based on the fortuitous or unfortuitous occurrence of subsequent events. 16 For those reasons, we find no error in the primary judge's conclusion that the award of damages for defamation did not constitute income within the meaning of s 6-5 of the ITAA97 notwithstanding that the amount was calculated solely by reference to lost profits. The appeal should be dismissed and the appellant should pay the respondent's costs, to be taxed in default of agreement. I certify that the preceding sixteen (16) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justices Ryan, Edmonds & Gordon. Associate: Dated: 18 December 2008 Counsel for the Appellant: Mr B Sullivan SC and Mr J Hmelnitsky Solicitor for the Appellant: Australian Government Solicitor Counsel for the Respondent: Mr K Smark SC and Ms L McBride Solicitor for the Respondent: Mallesons Stephen Jaques Date of Hearing: 21 November 2008 Date of Judgment: 18 December 2008