FEDERAL COURT OF AUSTRALIA Dormer v Federal Commissioner of Taxation [2002] FCA 537 TAXATION – assessment of income – where sole practitioner returns income on a cash receipts basis and business transferred to a partnership which returns income on an accruals basis – whether debts of sole practice assessable when received – whether Henderson applies Income Tax Assessment Act 1936 (Cth) Taxation Laws Amendment (Self Assessment) Act 1992 (Cth) Commissioner of Taxation (Cth) v Henderson (1970) 119 CLR 612 distinguished JOHN FREDERICK DORMER v FEDERAL COMMISSIONER OF TAXATION A 18 OF 2001 GYLES J SYDNEY (HEARD IN CANBERRA) 30 APRIL 2002 IN THE FEDERAL COURT OF AUSTRALIA AUSTRALIAN CAPITAL TERRITORY DISTRICT REGISTRY A18 OF 2001 BETWEEN: JOHN FREDERICK DORMER APPLICANT AND: FEDERAL COMMISSIONER OF TAXATION RESPONDENT JUDGE: GYLES J DATE OF ORDER: 30 APRIL 2002 WHERE MADE: SYDNEY (HEARD IN CANBERRA) THE COURT ORDERS THAT: 1. The application to set aside the objection decision is dismissed. 2. The objection decision is varied by remitting all of the tax shortfall penalties imposed by the amended assessments for the years ended 30 June 1998 and 30 June 1999. 3. The applicant should pay the respondent's costs of the proceeding. 4. Liberty to apply as to the form of these orders. 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 DISTRICT REGISTRY A18 OF 2001 BETWEEN: JOHN FREDERICK DORMER APPLICANT AND: FEDERAL COMMISSIONER OF TAXATION RESPONDENT JUDGE: GYLES J DATE: 30 APRIL 2002 PLACE: SYDNEY (HEARD IN CANBERRA) REASONS FOR JUDGMENT 1 This is an application by John Frederick Dormer ("the applicant") to set aside or vary an objection decision of the Federal Commissioner of Taxation ("the Commissioner") made on 28 February 2001, disallowing the applicant's objection to two notices of amended assessment. Short Facts 2 The facts in this matter are not in contention. It is convenient to set out the outline of facts common to the Statement of Facts, Issues and Contentions of each party. 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. 3 Because of the way in which the argument developed, it is convenient to set out certain clauses of the Sale Agreement: "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. …" 4 It is common ground that, notwithstanding the description "Joint Venture", the applicant and Messrs Grainger and Platt practised in partnership. 5 One fact upon which the respondent sought to rely was the existence of a letter written by the applicant to former clients of John Dormer and Associates on or around 30 July 1997, attaching a bill for work in progress as at 30 June 1997 and requesting that the debts identified be paid to the applicant and not to the new joint venture. The letter was in the following terms: "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." 6 In relation to the issue of additional taxation through penalty rates being applied, it was common ground that this case is governed by the Income Tax Assessment Act 1936 (Cth) s 226G, which states, "226G. Subject to this Part, if: (a) a taxpayer has a tax shortfall for a year; and (b) the shortfall or part of it was caused by the failure of the taxpayer or of a registered tax agent to take reasonable care to comply with this Act or the regulations; the taxpayer is liable to pay, by way of penalty, additional tax equal to 25% of the amount of the shortfall or part." 7 Under the Taxation Laws Amendment (Self Assessment) Act 1992 (Cth), failure to comply with this standard results in a 25% penalty for the taxpayer. It was conceded by the respondent that the recklessness standard in s 226H nor the intentional disregard of law standard in s 226J were relevant or applicable in this case. 8 The primary issue for consideration is whether the applicant was correct in not returning the income received by him in the years ended 30 June 1998 and 1999 which represented fees earned in the year ended 30 June 1997. 9 During the hearing, the arguments were substantially more refined and confined than the written submissions suggested. I will concentrate upon those arguments. Applicant's Submissions 10 It is submitted for the applicant that the starting point for the inquiry in the present case is which basis of accounting is calculated to give a substantially correct reflex of the applicant's income for the relevant years. The applicant relies on Commissioner of Taxation (Cth) v Dunn (1989) 89 ATC 4141 where, in the case of a sole trader, the cash receipts basis was found to be the correct accounting method to produce a "true reflex of the taxpayer's income for the period" (Dunn at 4151 per Davies J; see also Commissioner of Taxation (SA) v Executor Trustee and Agency Co of South Australia Ltd (Carden's case) (1938) 63 CLR 108 at 158). The applicant submits that the operation of his business prior to the year ended 30 June 1998 made a cash receipts basis appropriate. However it is argued that the fundamental change in his business operation and receipt of income from the 1998 financial year necessitated a change to the accruals method of accounting. 11 It was then submitted that the income received by the applicant in any one year cannot be 'streamed' or apportioned such as to calculate assessable income by the cash receipts method in respect of some income and the accrual method in respect of other income. Counsel for the applicant submitted that to do so would be contrary to the principle established in Commissioner of Taxation (Cth) v Henderson (1970) 119 CLR 612 ('Henderson'), as this would not produce a proper reflection of the income received. 12 Finally, and in the alternative, it is submitted by the applicant that penalties applied by the Commissioner in relation to tax shortfalls should be reduced to nil. It was submitted that where the applicant has taken all reasonable steps in returning his income tax, then s 226G will have no operation. Although the evidence in this regard was rather scant, counsel referred me to some parts of the applicant's affidavit which it was said supported the contention that the applicant took all reasonable care and skill. These were: 7. In November of 19976 I engaged the service of Mike Hehir, Barrister and Solicitor of Suite 1, 19 Bowman Street MACQUARIE, ACT, for advice about the sale of my practice to Grainger and Platt. … 21. During the year ended 30 June 1999, I received payments totalling $4695.00 from debtors of John Dormer and Associates. It was my understanding of the tax laws relating to income tax that these payments were not required to be included in my assessable income for the year ended 30 June 1999 or any other year." 13 Counsel for the applicant relied on excerpts from the Second Reading Speech to the Taxation Laws (Self Assessment) Bill 1992 (Cth) which describes the reasonable care standard in s 226G as "an honest and genuine attempt to correctly determine their taxable income" and states that the test requires, "…a taxpayer to exercise the care that a reasonable ordinary person would be likely to have exercised in the circumstances of the taxpayer to fulfil the taxpayer's tax obligations." 14 The applicant also pointed to Taxation Ruling TR 94/4 which states at [6]: "The reasonable care test requires a taxpayer to take the care that a reasonable, ordinary person would take in all the circumstances of the taxpayer to fulfil the taxpayer's tax obligations. Provided that a taxpayer may be judged to have tried his or her best to lodge a correct return, having regard to the taxpayer's experience, education, skill and other relevant circumstances, the taxpayer will not be liable to pay penalty." 15 It was submitted that penalties should not be applied in this case as the applicant was a practising accountant, familiar with taxation, who was entitled to assume that Henderson would apply to his post June 1997 situation, and that to take that view is not a failure to take all reasonable care and skill. Commissioner's Submissions 16 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. The point of departure for counsel for the Commissioner is whether or not Henderson can properly be applied to the facts here. It was submitted that that decision applied only to a continuing business where there remained one source of professional income for the taxpayer. In this case, it was argued, there existed in the relevant years two businesses, John Dormer and Associates and Dormer Grainger Platt both operating concurrently. It was conceded by counsel that the former was only carried on to the extent that it was receiving monies due to it for work performed prior to 1 July 1997. However it was submitted that the clear existence of two sources of income for the applicant supported the calculation of income based on 'streaming'. It was argued that the facts disclose that the two businesses were not one continuing operation, particularly relying upon the terms of the Sale Agreement. 17 In the alternative, it was submitted that even if I were to accept the applicant's principal contention, the disputed income was derived in the year ended 30 June 1998. The respondent relied upon the letter attaching a bill for work in progress sent by the applicant to former clients of John Dormer and Associates on or around 30 July 1997. The date of this letter being in the year ended 30 June 1998, it was argued, indicates that the debts were accrued in that year as debts accrue from the date they become recoverable. Reliance was placed on the discussion of work in progress by Barwick CJ in Henderson at 650-651. 18 With respect to the issue of penalties, the respondent accepted that it was appropriate for me to evaluate the subjective elements of the test outlined in s 226G. Counsel submitted that there was no evidence that the applicant had sought or obtained legal advice in relation to the question at issue here and that, in effect, he ran the risk involved in raising an untenable argument. Henderson 19 Henderson concerned a taxpayer who was a partner in a large firm of accountants. Up to and including the year ended 30 June 1964, the partnership had calculated its income on a cash receipts basis but from the following year it utilised the accruals method of calculation. The result was that the sum of $179,530 which was treated in the partnership books as being received after 30 June 1964 in payment for work done in the year ended 30 June 1964, was not taken up as assessable income in any year. The Commissioner contended that the earnings for the years ended 30 June 1965 and following should have been calculated on a cash basis and assessed the individual taxpayers as such. The primary judge (Windeyer J) rejected that contention and found that the accruals basis was appropriate. However, he held that the cash received after 30 June 1964 in relation to fees then due was assessable. 20 The substance of the decision of the Full High Court, so far as is relevant, can be gathered from the following extract from the judgment of Barwick CJ (agreed in by McTiernan J and Menzies J) 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." Decision 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. Penalty 25 As may be apparent from my discussion of the merits of the case, in my view there is substance to the contention that the principle in Henderson was applicable. That was a landmark decision when delivered, and has stood for many years. Neither counsel suggested that the present question has been resolved (or considered) in any later authority. In my opinion, the applicant did not fail to exercise reasonable care, and no penalty should be imposed. Orders 26 The application by the taxpayer to set aside the objection decision is dismissed. However, the objection decision should be varied by remitting all of the penalties imposed by the amended assessments. The applicant should pay the respondent's costs of the proceeding. Although the applicant succeeded as to penalty, he failed in the real contest as to the application of Henderson in relation to which the costs were, in substance, incurred. I certify that the preceding twenty-six (26) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Gyles. Associate: Dated: 30 April 2002 Counsel for the Applicant: G Corr Solicitor for the Applicant: Powrie & Co Counsel for the Respondent: C Erskine Solicitor for the Respondent: Australian Government Solicitor Date of Hearing: 23 April 2002 Date of Judgment: 30 April 2002