FEDERAL COURT OF AUSTRALIA Watson v Deputy Commissioner of Taxation [2008] FCA 1173 TAXATION – deferral of losses from non-commercial business activities – appellant runs business as financial planner – appellant became partially disabled but continued to run business although expenses exceeded commission and fee revenue – whether benefits paid under income protection policy in respect of appellant's partial disability are part of the assessable income from the business activity – inclusion of insurance payments would result in assessable income from business activity – held – insurance payments not part of assessable income from business activity, so there were losses from non-commercial business activity properly deferred TAXATION – deferral of losses from non-commercial business activities – whether there is a difference between assessable income from business and assessable income from business activity Income Tax Assessment Act 1997 (Cth) ss 35-10, 35-30, 35-35, 35-55 New Business Tax System (Integrity Measures) Bill 2000 (Cth) Insurance Contracts Act 1984 (Cth) Insurance Contracts Regulations 1985 (Cth) BHP Petroleum (Timor Sea) Pty Ltd v Minister for Resources (1994) 49 FCR 155 followed Watson v Secretary, Department of Family and Community Services (2003) 128 FCR 564 followed Federal Commissioner of Taxation v Murry (1998) 193 CLR 604 cited Ferguson v Federal Commissioner of Taxation (1979) 26 ALR 307 cited Commissioner of Taxation v Eskandari (2004) 134 FCR 569 followed Hope v The Council of The City of Bathurst (1980) 144 CLR 1 cited Federal Commissioner of Taxation v Smith (1981) 147 CLR 578 cited Carapark Holdings Ltd v Commissioner of Taxation (1966) 115 CLR 653 followed Federal Commissioner of Taxation v Myer Emporium Ltd (1987) 163 CLR 199 cited Kidston Goldmines Ltd v Federal Commissioner of Taxation (1991) 30 FCR 77 cited Lees & Leech Pty Ltd v Commissioner of Taxation (1997) 73 FCR 136 cited Warner Music Pty Ltd v Commissioner of Taxation (1996) 70 FCR 197 cited Federal Commissioner of Taxation v Dixon (1952) 86 CLR 540 cited G.P. International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1989) 170 CLR 124 considered Dufty v City Mutual General Insurance Ltd [1977]Qld R 94 cited Fidelity and Casualty Co of New York v Mitchell [1917] AC 592 cited Pocock v Century Insurance Co Ltd [1960] 2 Ll Rep 150 cited Sergent v GRE (UK) Ltd [2000] Ll Rep 1R 77 cited Beverley v Tyndall Life Insurance Co Ltd (1999) 10 ANZ Ins Cas 61-453 cited QBE Insurance Ltd v Jande (1995) 8 ANZ Ins Cas 61-270 cited CRAIG WATSON v DEPUTY COMMISSIONER OF TAXATION SAD 63 of 2007 MANSFIELD J 8 AUGUST 2008 ADELAIDE IN THE FEDERAL COURT OF AUSTRALIA SOUTH AUSTRALIA DISTRICT REGISTRY SAD 63 of 2007 BETWEEN: CRAIG WATSON Appellant AND: DEPUTY COMMISSIONER OF TAXATION Respondent JUDGE: MANSFIELD J DATE OF ORDER: 8 AUGUST 2008 WHERE MADE: ADELAIDE THE COURT ORDERS THAT: 1. The appeal be dismissed. Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules. IN THE FEDERAL COURT OF AUSTRALIA SOUTH AUSTRALIA DISTRICT REGISTRY SAD 63 of 2007 BETWEEN: CRAIG WATSON Appellant AND: DEPUTY COMMISSIONER OF TAXATION Respondent JUDGE: MANSFIELD J DATE: 8 AUGUST 2008 PLACE: ADELAIDE REASONS FOR JUDGMENT INTRODUCTION 1 This appeal concerns the tax payable by Mr Watson on his income for the financial year ended 30 June 2004. Mr Watson appeals from a decision of the Deputy Commissioner of Taxation (the Commissioner) made on 7 February 2007. 2 The Commissioner decided in relation to the financial year ended 30 June 2004 that payments Mr Watson received under a personal income protection insurance policy were not assessable income from his business activity as a financial planner. His business activity otherwise operated at a loss for that year of income, but it would not have done so if Mr Watson could have included the income from the personal income protection insurance policy as assessable income of the business. The loss suffered in the operation of the business was then treated as a deferred expense, capable of being carried forward, but not capable of being a deduction against his other assessable income, namely the income from the personal income protection insurance policy. That decision was made under Div 35 of the Income Tax Assessment Act 1997 (Cth) (the ITAA 1997) headed "Deferral of losses from non-commercial business activities". 3 Mr Watson contends that the decision of the Commissioner was wrong. THE FACTS 4 Mr Watson was born in 1959. In 1984, he commenced working as a self-employed financial planner. He took out income protection insurance at that time, as he says partially to replace the commission or income which he would lose if he could not continue to work in his business through illness or injury. He has maintained that insurance since that time. He has conducted his business as a sole trader at all material times. It involves advising clients on their life insurance and investment needs, recommending an insurance or investment strategy, assisting and implementing the resulting strategy, and monitoring the performance of that strategy and its continued appropriateness to the client's evolving needs. Those activities generally fall within the description of a financial planning business. Mr Watson received remuneration by those activities both from fees paid to him by his clients and from commissions paid by investment institutions with which he arranged for his clients to make investments. 5 Initially, Mr Watson was an agent of the life insurance company National Mutual, but after some years he became an authorised agent of its subsidiary National Mutual Financial Planning. As a result, he was able to recommend financial products other than those provided by National Mutual. From July 1992 he became a "sub-agent", but nothing turns upon that changed description or the changed structure of his relationship with National Mutual Financial Planning. In 1995, following the de-mutualising of National Mutual, the French insurance company AXA took a controlling interest in National Mutual and from 1999 National Mutual Financial Planning became known as AXA Financial Planners. In July 2002, Mr Watson ceased being an authorised representative of AXA Financial Planners and became an authorised representative of Financial Lifestyle Solutions. 6 From 1995, the policy terms for Mr Watson's income protection insurance were changed. It is common ground that it is the form of policy for income protection cover taken from 3 January 1996 which is the applicable policy. It is a policy of income protection known as "Professional Income Protection" or "PIP". 7 Unfortunately, later in 1996, Mr Watson fell ill. He was diagnosed as having a brain tumour for which he underwent surgery in November 1996. He had a period of total incapacity for work as a result, but then recovered well enough to return to his former business activities, but with somewhat reduced capacity. He had some short term memory difficulty, inability to concentrate and a tendency to confuse words and sporadic quite debilitating seizures. He was diagnosed with a further brain tumour in mid-2004 which was treated by radiotherapy. He nevertheless returned to most of his business activities but at a reduced volume of activity, and he now concentrates on servicing existing clients rather than representing new clients because of his ongoing problems. 8 Mr Watson made a claim under the PIP policy for periodic partial disability payments. It appears to be accepted by the insurer, and not disputed by the Commissioner, that Mr Watson is partially disabled from working. At one point (unspecified as to date), he sought some advice from the insurer about his situation and was informed, according to his note, in the following terms: When a proposal is received by underwriting, their occupation is considered when accepting someone as a risk for an income protection policy with an own occupation clause. If a person changes their occupation while on claim and earns income, then the income earned does reduce their benefit. The test for this is whether the income has been earned through person exertion. Thirdly, if a client is working in their usual occupation but at a reduced income due to their disability, there is no obligation on the client to seek other work. It is unclear whether that information has prompted Mr Watson to continue operating his financial planning business. It is also unclear whether that information, in the event that Mr Watson ceased running his financial planning business, fully and correctly describes the way in which the amount of his entitlements under the PIP policy would be assessed. 9 Ultimately, but not without some difficulty, the claim under the PIP policy was accepted and the amount of Mr Watson's entitlements under it resolved. Partial incapacity payments commenced on 1 October 1996. For the last several years, Mr Watson has continued to receive payments at a rate applicable to his ongoing partial incapacity for work. 10 In the financial years from 1997 to 2004, Mr Watson's gross fee and commission income in his business decreased somewhat, particularly from financial year ended 30 June 2000 and then quite dramatically in the last few years up to 30 June 2004. His business expenses remained more or less constant until the financial years ended 30 June 2003 and 30 June 2004 when they too had dropped quite significantly. He had a shortfall of fee and commission income against business expenses in each of the financial years from 30 June 2001 to 30 June 2004. In each of those years, and indeed for some years previously, he had received benefits under his PIP policy in the order of $25,000 per year. It is not necessary to set out the precise details except for the year of income in dispute. 11 In the financial year ended 30 June 2004, Mr Watson's income from his financial planning business (putting aside his partial disability payments under the PIP policy) was $9896, and his expenses $14,554, producing a net loss of $4938. He sought to include as the income of the business his payments from his income protection policy of $25,719. That would then have meant Mr Watson's taxable income for that year included business income of $35,615 and, after business expenses and other deductions, his taxable income would have been $20,781. The Commissioner excluded the partial disability payments under the PIP policy from his business income and determined for that financial year to defer the business loss of $4938 in accordance with Div 35 of the ITAA 1997. Consequently, the Commissioner assessed Mr Watson's taxable income as including his full PIP policy income of $25,719 (subject to any other appropriate deductions). 12 There are a few other matters of fact to note, as they were referred to in the submissions. Mr Watson gave evidence that his financial planning business activities included what he described as "non-financial planning business activities" but more accurately are incidental and related activities. Those activities included obtaining the appropriate licences and professional and statutory registrations, undertaking training in financial planning, securing premises and equipment and consumables to carry on the business, incidental and necessary travel, securing business finance and banking facilities, and obtaining insurance including for loss to premises or equipment, professional indemnity insurance, and of course his income protection insurance. He said his main purpose in carrying on his business was to be financially self-sufficient by carrying on business as a financial planner. 13 Finally, I note that since payments under PIP policy first commenced on 31 October 1996, under the terms of the policy, Mr Watson has not been obliged to make any further premium payments. In his own accounts, he treated the premiums as an expense of his business and the policy as an asset of his business. In his claims and dealings with the insurer, including extensive reporting activities, he has reported it in that way. He has also in the period before his illness and up to the time when his obligation to pay annual premiums ceased claimed, and been allowed, a deduction against the commission or fee income he derived from carrying on his business in respect of the premiums he has paid. THE PIP POLICY 14 As there were submissions about the significance of the terms of the PIP policy, it is convenient at this point to note some of its terms. It is described as "an income protection insurance policy" which, according to the schedule, insured Mr Watson to pay him weekly benefits if he suffered total disability through injury or sickness. The relevant clause provides as follows: If the person is totally disabled, we will pay you the weekly benefit. We will pay you at the end of each fortnight for which you are entitled to be paid. The person insured is totally disabled if, because of an injury or sickness, he or she: v cannot do at least one of the income producing duties of his or her occupation; v is not working; and v is following the advice and under the regular care of a medical practitioner. The policy specified the rate of payment for total disability in the following terms: The amount we pay you depends on why we are paying you. The weekly benefit we pay if the person insured is totally disabled or suffers a specific injury or sickness, is based on a percentage (up to 75%) of his or her average income when you applied for this policy. It is called "the benefit" and is set out in box 5 in the Schedule. It may vary in the ways set out in clauses 10 and 12. As long as the details given about the person insured's income on the Application form were full and accurate, the amount of your benefit won't go down, even if the person insured's actual income goes down. (Underlining and emphasis in policy.) That amount of the average income was specified at $410 per week when the policy was applied for, and has been adjusted according to the increasing claim option since that time. 15 There is then provision for the commencement and termination of payments. Commencement of payments starts at the end of the waiting period of two weeks (specified in the schedule), commencing from when a medical practitioner first examines the person insured and certifies that he or she is totally disabled. The waiting period is adjusted from time to time if there are brief intermittent returns to work. Payments cease when the person insured stops being totally disabled, or when the benefit period or the cause of the disability ends, or of course when the insured person dies. There is also provision for circumstances in which payments may be made following a return to work, depending upon whether the return to work is to be full-time work for at least six months. In that event, a claim for further payments would be treated as a separate claim. 16 There is a separate clause dealing with partial disability. It featured significantly in the submissions. It provides: If the person insured has been totally disabled for 14 days and then he or she does some work – but is partially disabled – we will pay you a reduced weekly benefit. However, you will not be entitled to be paid before the end of the waiting period. How much we pay The amount we pay is worked out by applying the formula: A – B x C A A equals the person insured's pre-disability income. B is the person insured's average weekly incomeduring the period in which he or she is partially disabled. C is the amount in box 5 in the Schedule, as varied in any way. Meaning of partially disabled The person insured is partially disabled if, immediately after being totally disabled for at least 14 days, he or she is able to perform one or more income producing duties of his or her occupation but not all of them, or is working in another occupation, and – because of the disability – the amount the person insured earns for the work he or she does is less than the amount of his or her pre-disability income. The person insured must be under the regular care and attendance of a medical practitioner. (Underlining and emphasis in original.) It is not necessary to note the multiplier as the amount of the relevant partial disability payments is not in issue. 17 The terms "income" and "pre-disability income" are also defined in the following way: Income If the person insured owns part, or all, of a business or practice, income is money generated by the business due to the person insured's own activity, after all expenses in earning that income have been deducted. If the person insured is employed, his or her income is the total package, including commissions, regular bonuses and fringe benefits. Income does not include investment or interest income. … Pre-disability income means the person insured's highest average weekly income in any 12 month period over the 3 years immediately before he or she became totally disabled. 18 There is provision for an increasing payment for total disability or partial disability by the lower of any annual percentage increase in CPI and 6% and in the case of partial disability, as well as increasing the benefit, the insured person's pre-disability income will also be increased in the same way. THE LEGISLATION 19 The 2003-2004 income tax return for Mr Watson was lodged on 13 April 2006. The assessment was issued on 5 June 2006. It treated the "business loss" of $4938 as deferred non-commercial business loss. Mr Watson objected to that assessment. The objection was disallowed on 7 February 2007. The application to this Court is made pursuant to s 14ZZ(c) and Div 5 of Pt IVC of the Taxation Administration Act 1953, and in accordance with s 175A of the ITAA 1936. 20 As counsel for Mr Watson said, the heart of this case is whether Mr Watson's income protection insurance income is income from his business activity so that s 35-10(2) of the ITAA 1997 does not defer "and effectively deny" deductions for some of his business expenses. 21 At the relevant time, Div 35 of the ITAA 1997 provided: This Division prevents losses of individuals from non-commercial business activities being offset against other assessable income in the year the loss is incurred. The loss is deferred. It sets out a series of tests to determine whether a business activity is treated as being non-commercial. The deferred losses may be offset in later years against profits from the activity or, if one of the tests is satisfied or the Commissioner exercises a discretion, against other income. … Operative provisions 35-5 Object (1) The object of this Division is to improve the integrity of the taxation system by preventing losses from non-commercial activities that are carried on as *businesses by individuals (alone or in partnership) being offset against other assessable income. (2) This Division is not intended to apply to activities that do not constitute carrying on a *business, for example, the receipt of income from passive investments. 35-10 Deferral of deductions from non-commercial business activities (1) The rule in subsection (2) applies for an income year to each *business activity you carried on in that year if you are an individual, either alone or in partnership (whether or not some other entity is a member of the partnership), unless: (a) one of the tests set out in section 35-30 (assessable income test), 35-35 (profits test), 35-40 (real property test) or 35-45 (other assets test) is satisfied for the business activity for that year; or (b) the Commissioner has exercised the discretion set out in section 35-55 for the business activity for that year; or (c) the exception in subsection (4) applies for that year. Note: This section covers individuals carrying on a business activity as partners, but not individuals merely in receipt of income jointly. Compare the definition of partnership in subsection 995-1(1). Rule (2) If the amounts attributable to the *business activity for that income year that you could otherwise deduct under this Act for that year exceed your assessable income (if any) from the business activity for that year, or your share of it, this Act applies to you as if the excess: (a) were not incurred in that income year; and (b) were an amount attributable to the activity that you can deduct from assessable income from the activity for the next income year in which the activity is carried out. (3) … Exceptions (4) The rule in subsection (2) does not apply to a *business activity for an income year if: (a) the activity is a *primary production business, or a *professional arts business; and (b) your assessable income for that year (except any *net capital gain) from other sources that do not relate to that activity is less than $40,000. (5) A professional arts business is a *business you carry on as: (a) the author of a literary, dramatic, musical or artistic work; or Note: The expression "author" is a technical term from copyright law. In general, the "author" of a musical work is its composer and the "author" of an artistic work is the artist, sculptor or photographer who created it. (b) a *performing artist; or (c) a *production associate. 35.15 Modification if you have exempt income … 35.20 Modification if you become bankrupt ... 35.25 Application of division to certain partnerships … 35-30 Assessable income test The rule in section 35-10 does not apply to a *business activity for an income year if: (a) the amount of assessable income from the business activity for the year; or (b) you started to carry on the business activity, or stopped carrying it on, during the year – a reasonable estimate of what would have been the amount of that assessable income if you had carried on that activity throughout the year; is at least $20,000. 35-35 Profits test (1) The rule in section 35-10 does not apply to a *business activity (except an activity carried on by one ore more individuals as partners, whether or not some other entity is a member of the partnership) for an income year (the current year) if, for each of at least 3 of the past 5 income years (including the current year) the sum of the deductions attributable to that activity for that year (apart from the operation of subsection 35-10(2)) is less than the assessable income from the activity for that year. (2) For a *business activity you carried on with one or more others as partners, the rule in section 35-10 does not apply to you for the current year if, for each of at least 3 of the past 5 income years (including the current year) the sum of your deductions (including your share of the partnership deductions) attributable to that activity for that year (apart from the operation of subsection 35-10(2)) is less than your assessable income (including your share of the partnership's assessable income) from the activity for that year. 35-40 Real property test … 35-45 Other assets test … 35-50 Apportionment … 35-55 Commissioner's discretion (1) The Commissioner may decide that the rule in section 35-10 does not apply to a *business activity for one or more income years if the Commissioner is satisfied that it would be unreasonable to apply that rule because: (a) the business activity was or will be affected in that or those income years by special circumstances outside the control of the operators of the business activity, including drought, flood, bushfire or some other natural disaster; or Note: This paragraph is intended to provide for a case where a business activity would have satisfied one of the tests if it were not for the special circumstances. (b) the business activity has started to be carried on and, for that or those income years: (i) because of its nature, it has not satisfied, or will not satisfy, one of the tests set out in section 35-30, 35-35, 35-40 or 35-45; and (ii) there is an objective expectation, based on evidence from independent sources (where available) that, within a period that is commercially viable for the industry concerned, the activity will either meet one of those tests or will produce assessable income for an income year greater than the deductions attributable to it for that year (apart from the operation of subsection 35-10(2)). CONSIDERATION 22 The respective contentions identify a clear point of distinction. Put shortly, Mr Watson contends that the income by partial disability payments received from his PIP policy should have been included in the assessable income of his business for the financial year ended 30 June 2004 (as it had been in previous years). Then, by the application of one of the tests set out in ss 35-30 or 35-35, the rule in s 35-10(2) would not apply to the income year ended 30 June 2004. Each of ss 35-30, 35-35 and 35-10(2) relate to the circumstances in which, if the expenses attributable to the business activity exceed the assessable income from the business activity for the year, the loss should be disregarded in determining the taxpayer's taxable income, although the loss may be carried forward. 23 The issue therefore is whether the payments for partial disability under the PIP policy received in that financial year are part of the assessable income "from the business activity" for that year. If they are, then under s 35-30(a) the assessable income from the business activity for that year would be at least $20,000, and would also exceed its expenses. Alternatively, the payments under the PIP policy, if included in each of the five years from 30 June 1999 to 30 June 2004 inclusive, would mean that at least three of those previous five years including that current year (in fact on the evidence it would cover each of the previous five years), the sum of the deductions would be less than the "assessable income" from the activity, that is the business activity, for that year. It would then fall within the exception called the profits test in s 35-35. If either alternative applied, then the rule in s 35-10(2) would not apply and the expenses of the business would be fully deductible in that year of income. 24 Consequently, Mr Watson contends that the gateway provided by s 35-10(1) through which the assessment must pass before the deferral rule provided for in s 35-10(2) activates was simply not entered and the Commissioner erred in treating the deferral rule in s 35-10(2) as available at all. It would also follow that the so called deferred excess of $4938 would not be a deferral of losses from a non-commercial business activity because the amounts attributable to the business activity for the year ended 30 June 2004 which could be deducted would not exceed the assessable income from the business activity, as the revenue of the business activity would include the income from the PIP policy. 25 The PIP partial disability payments received by Mr Watson for the year ended 30 June 2004 are clearly part of his assessable income: see Federal Commissioner of Taxation v Smith (1981) 147 CLR 578. That is common ground. So too is the nature of Mr Watson's business activity during that year. It was that of a financial planner, although (as he says) that required administration and regulation compliance activities, each of which did not directly result in the earning of income. That was the activity he engaged in during the financial year ended 30 June 2004, and in earlier years, for the purpose of profit: cf Commissioner of Taxation v Murry (1998) 193 CLR 605 at [54] (Murry). 26 The Commissioner contended that the partial disability income is not income from that business activity but is income from the PIP policy, because its source is a contractual entitlement. The contention must be more refined than that. For it is generally possible to ascribe each source of income of a business to a particular document or transaction. In the case of a financial planning business, if fees are earned by commissions from entities with which funds are placed, then those fees will have a contractual foundation; so too will fees earned from clients of the business. Bank interest on deposited surplus funds is income from funds held in a bank under certain contractual terms. 27 The Commissioner also contended that the use of the term "from the business activity" as distinct from the term "from the business" had some special significance. It was said that it was a narrower concept than the expression "from the business". 28 The contrast between the scope of the two expressions was said to be illustrated by BHP Petroleum (Timor Sea) Pty Ltd v Minister for Resources (1994) 49 FCR 155 (BHP Petroleum) and Watson v Secretary, Department of Family and Community Services (2003) 128 FCR 564 (Watson) on the one hand, and cases such as Murry; Hope v Bathurst City Council (1980) 144 CLR 1 (Hope), and Ferguson v Federal Commissioner of Taxation (1979) 26 ALR 307 (Ferguson) on the other. 29 In my opinion, the extrinsic materials do not indicate an intention to distinguish between those two expressions. They are discussed by Stone J in Commissioner of Taxation v Eskandari (2004) 134 FCR 569 (Eskandari) at [14]-[17]. I respectfully adopt her Honour's observations. I shall not repeat them in these reasons. The relevant legislative intention which appears to have underpinned Div 35 was to distinguish between "activities which are essentially private or lifestyle choices" and those which involve "genuine business activities" (see para 228 of "Review of Business Taxation – a Tax System Redesigned", 1999). I also note, by way of illustration, that para 1.10 of the Explanatory Memorandum to the New Business Tax System (Integrity Measures) Bill 2000 (Cth) by which Div 35 came to be in the ITAA 1997 says: Division 35 does not change the existing income tax concept of what constitutes the carrying on of a business. The Division will apply within that environment to those individuals able to claim business deductions under the existing law on the grounds that they are carrying on a business and meet all existing tests of deductibility. 30 Paragraph 1.15, when comparing the key features of the proposed law and the current law, says that the change is to provide that the excess of deductions over assessable income from a business may be claimed against other income only if one of the tests is satisfied or the Commissioner exercises a discretion to permit it. 31 The cases referred to by senior counsel for the Commissioner about the nature of a business also do not support the contrast sought to be drawn. Murry at 604; Hope at 8-9; and Fergusonat 311 all describe in generally consistent terms what is involved in carrying on a business. They do not suggest that the activities undertaken in doing so, so that they may be called "business activities" are somehow outside or distinct from the business itself. 32 The decisions of BHP Petroleum and Watson also, in my view, do not support the contrast between the two expressions in s 35. 33 BHP Petroleum concerned the eligibility of certain taxpayers under the Petroleum Resource Rent Tax Assessment Act 1987 (Cth) to have their projects combined so that expenditure on one of the combined projects could be set off against revenue from another. Section 20 empowered the Minister to "… issue a combination certificate" if satisfied, having regard to specified factors, that the projects "are sufficiently related to be treated for the purposes of this Act as a single petroleum project". The application for the "combination certificate" had to be made "from" a person or persons who were together entitled to at least half of the receipts from the sale of marketable petroleum commodities produced in relation to each of the projects. The formal application, by oversight, omitted the name of one intended applicant whose entitlement was necessary to meet the one half eligibility criterion. In the circumstances, the Court (Beaumont, Jenkinson and Heerey JJ) found that the application had in fact been made by all the intended applicants, so that criterion was satisfied. Beaumont J at 170-171 explained that the word "from" had its ordinary meaning as indicating "the starting point, source or origin" of the application. That source had been clearly exposed by other communications. I do not, however, see any observations in the reasons which support the claimed contrast between "business activity" and "business". However, I think the meaning of the word "from" as discussed is equally applicable to that word in the phrase "from the business activity". 34 Watson concerned the claim of Mr Watson and his wife for benefits under the Social Security Act 1991 (Cth). Section 1075(1) provided that "if a person carries on a business, the person's ordinary income from the business is to be reduced by … losses and outcomings that relate to the business …". Mr Watson was refused benefits because the payments under the PIP policy were not part of his ordinary income from his financial planning business, so as to allow the reduction for the losses and outgoings of the business. Consequently, the statutory threshold for eligibility for benefits was exceeded. Mr Watson argued, in that case, that the benefits under the PIP policy had the same character as the income they replaced, particularly as (he claimed) he had to continue to work in the business or in some other remunerative employment as a prerequisite to being paid partial disability payments. Finn J at 569 upheld the conclusion that the payments under the PIP policy were not "ordinary income from the business". The contractual income was a surrogate for, and was payable because of, the reduced ordinary income from the business. The distinction drawn by Finn J is helpful in addressing the present appeal. In that regard, Finn J did not appear to place especial weight on the word "ordinary" in his reasoning. However, I do not think his Honour's views support the contrast between "business" and "business activity" which was contended for. 35 Eskandari is the only decision concerning Div 35 of Pt 2-5 of Ch 2 of the ITAA 1997 to which my attention was drawn. The taxpayer sought to set-off against his normal salary the losses incurred in his unrelated business activity as a registered migration agent. It was common ground that, unless he could bring himself within the exception to the application of s 35-10 provided by s 35-55(1)(b)(i), s 35-10 would prevent him from setting off those losses. Section 35-55(1)(b)(i) permitted the Commissioner to decide that the rule in s 35-10 does not apply to a business activity for a year or years of income if satisfied that it would be unreasonable to apply it because the business activity, in respect of the relevant income years, "because of its nature" would not satisfy one of the other tests imposed. Hence, the relevant issue was a narrow one: could s 35-55(1)(b)(i) apply because of the nature of the business, namely that it was in its start-up phase and the anticipated revenue stream would not come about for some two years or more. The taxpayer claimed that his new business had that nature because he charged only a modest initial fee, and then incurred significant expense, and would only receive the substantial part of his fee when the visa application was granted, possibly some years later. Stone J decided that the term "because of its nature" referred to an inherent feature of the taxpayer's business activity in common with business activities of that type. Unless the "lead time" before a substantial success fee became payable was a common or inherent feature of migration agent businesses, rather than a consequence of how the taxpayer chose to charge, the exception in s 35-55(1)(b)(i) could not apply and the Commissioner would not have a discretion to exercise. 36 Counsel for Mr Watson, at the other end of the spectrum of submissions, contended that there should be symmetry between the concepts of "taxable income" and "allowable deductions", in particular those deductions falling within the second limb of the income nexus test specified in s 8-1(1)(b) of the ITAA 1997. If the premiums paid on the PIP policy were accepted as deductions by the Commissioner (as they apparently were), on the basis that they were necessarily incurred in carrying on the financial planning business, then payments made under the PIP policy should also be regarded as income received in carrying on the business. 37 Whilst that contention has a superficial attraction, I think it over-simplifies the position. The PIP policy was clearly to diminish the adverse consequences of illness or accident. The benefits under the PIP policy provided protection against income loss from the inability to fully conduct the business, and so to earn income from it. So the benefits under the PIP policy are a partial indemnity for, and as a substitute for, the reduced commission and fee income which Mr Watson suffered by reason of his illness. There is no need for a direct monetary correlation between the amount of the benefits and the foregone or lost commission and fee income: Federal Commissioner of Taxation v Smith (1981) 147 CLR 578 at 583. That does not, however, mean that the benefits under the PIP policy are part of assessable income from the business activity for the year in issue. 38 One submission of Mr Watson acknowledged that. He accepted it was necessary to take the extra step of regarding the business activity as encompassing the "related or incidental activities" which, in turn, include his "insurance activities". 39 Counsel for Mr Watson then submitted that the business activity of Mr Watson included his "insurance activities" as well as the range of other incidental administrative and professional matters referred to in [12] above. Counsel further submitted that the "insurance activities", by which he relevantly meant Mr Watson taking out the PIP policy and regularly paying the premiums on it and – in the event of an insured risk occurring – receiving the benefit of it, had the "significant commercial purpose" of securing a stream of income as a substitute for the business income that could be at risk if Mr Watson were injured or became ill. He also said there was a purpose of profit or the prospect of profit, because the potential benefits if an insured event occurred could be up to 75% of Mr Watson's earnings from the business and were much greater than the premiums payable from time to time. Counsel also relied upon the fact that, as the material showed, the PIP policy was taken out by many authorised representatives of National Mutual/AXA and by many other self-employed persons. 40 There may be a mix of reasons for a self-employed person taking out an income protection policy such as the PIP policy. In the event of catastrophic injury or illness, where the insured person would be unable to conduct the business previously operated, total disability payments would be received. It could not be said that such payments were for the purposes of the business; of necessity, if its operation were dependent upon the self-employed person, the business would cease to be operated. Nor could it be said in that circumstance that such payments were income received from the business. If the insured event involves a period of total incapacity and the insured person then resumed running the business, insurance payments may have enabled the insured person both to maintain a personal cash flow during the incapacity and to meet ongoing commitments (e.g. rental, lease and interest obligations) in relation to the business so that it could be maintained during the incapacity. Other facts may inform the understanding of the purpose or utility for the business of the policy: the nature of the business; whether there are other employees; who may be able to keep the business going to some degree despite the temporary or diminished capacity of the principal; whether the temporary or diminished capacity of the principal may be accommodated by the hiring of a temporary or part-time replacement. There will no doubt be other potential combinations of circumstances. 41 Whether particular payments in a particular year of income under an income protection policy are income from the business activity will depend upon the particular facts. In Carapark Holdings Ltd v Commissioner of Taxation (1996) 115 CLR 653 (Carapark), the benefits received by a holding company of an employer taken out on the life of an employee of a subsidiary company were part of its assessable income. The Court (Kitto, Taylor and Owen JJ) said at 663: … in general, insurance moneys are to be considered as received on revenue account where the purpose of the insurance was to fill the place of a revenue receipt which the event insured against has prevented from arising, or of any outgoing which has been incurred on revenue account in consequence of the event insured against, whether as a legal liability or as a gratuitous payment actuated only by considerations of morality or expediency. The fact that it was the holding company which took out the policy and received the benefits, rather than the subsidiary employing company, did not alter that position. As that passage indicates, the purpose of the taxpayer entering into the contract of insurance which produced the payment is relevant to identifying the relationship of the payment with the business. See e.g. Federal Commissioner of Taxation v Myer Emporium Ltd (1987) 163 CLR 199 at 217; cf Murry at 626 [54]. 42 The potential benefits under the PIP policy ranged from a relatively brief period of payments for total disability to long term payments for total disability. The Commissioner might readily have accepted the premiums paid as deductible expenses of the business of Mr Watson (as he apparently did). That would no doubt have been on the basis that a substantial purpose was to secure the ongoing operations of the business during a period of relatively brief incapacity. It does not follow that all benefits, in whatever circumstances, under the PIP policy are necessarily income received from the business. 43 To say that the PIP policy was to provide a substitute for income lost in the event of an insured event occurring, or that it was to provide for a substitute revenue stream for that which otherwise would have flowed from the business, is not to answer the critical question. Nor, in my view, is it sufficient to show that a substantial purpose of the insurance was to secure a revenue stream so as to enable the business to continue during a period of temporary incapacity. So much may be accepted (or assumed). 44 It is the particular benefits in the particular insured events which are in issue. 45 Mr Watson was not in the business of insuring, or taking insurance, against total permanent disability. Nor was he in the business of insuring, or taking insurance, against partial permanent incapacity, or at least permanent partial incapacity which so impaired him as to be unable to conduct the business otherwise than at a loss. His business was not taking out income protection insurance. 46 To draw that line is not to exclude from the business, or the business activities, related or incidental activities. There may be a range of income sources which qualify as assessable income from a business or from business activities even though they are in a sense incidental to its main activities. In Kidston Goldmines Ltd v Federal Commissioner of Taxation (1991) 30 FCR 77, the Court held that the investment of surplus funds from sales of gold on the short-term money market was an incident of the taxpayer's goldmining business. That case also decided that the interest received was not, however, exempt from income tax under the then s 23(o) of the ITAA 1936 as it was not income "derived from the working of a mining property". It was not sufficiently proximate to the activities which directly generated income by gold mining. The result turned on the particular statutory provision. Other illustrations are provided by Carapark; Lees & Leech Pty Ltd v Commissioner of Taxation (1997) 73 FCR 136 (Lees & Leech); Warner Music Pty Ltd v Commissioner of Taxation (1996) 70 FCR 197; Federal Commissioner of Taxation v Dixon (1952) 86 CLR 540 and G.P. International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1989) 170 CLR 124. To draw that line requires an assessment of the material circumstances at the relevant time or for the relevant period. 47 The purpose of Div 35 is clearly enough to limit the extent to which non-commercial losses from a taxpayer's business activities are used as tax deductions to reduce the tax paid on other income. The extrinsic materials indicate that it was designed to prevent the expenses of leisure activities or hobbies, or of activities ostensibly business-like but which are unlikely ever to make a profit, from generating tax deductible losses to be set off against other income. In that context, Mr Watson's circumstances – if the appeal is to be allowed – would fall within the reach of s 35-10(2) even though, in a sense, he would be an incidental object of its application. He has not engineered his present circumstances to get the benefit of a deduction against other income for what is, in essence, non-commercial expenditure. 48 Nevertheless, it is necessary to apply s 35-10(2) if, upon its proper construction and application and that of s 35-30 and s 35-35, it applies to him. 49 The relevant distinction which is drawn by s 35 is between assessable income from the business activity in a particular year and assessable income which is not from the business activity in a particular year. Income from a business activity must clearly have a connection with it. Beaumont J (with whom Jenkinson and Heerey JHJ agreed) in BHP Petroleum at 170-171 applied the normal sense of a starting point, source or origin. Finn J in Watson at 569 contrasted income from the business of Mr Watson and income that was a surrogate or replacement for income which might otherwise have been received. As noted above, such income may include income from incidental activities even though they are not, or not likely to be, recurrent (eg the interest on a temporary cash surplus, as in Kidston; or the proceeds of a life insurance policy, as in Carapark; or the cash incentive paid to take a long term lease, as in Lees and Leech. In certain circumstances, and in relation to a particular period, the assessable income of a business activity might also include for a time disability payments under a personal income protection policy. I do not need to decide that question. 50 However, in my view, it is clear that in respect of the financial year ended 30 June 1994, Mr Watson's payments under the PIP policy were unrelated to his business as a financial planner. They were to substitute for the income he may have earned in the business but for his partial disability. But there was no element of the business to which they were connected. Their only relationship to the business is that eligibility for the payments depended on the fact of ongoing partial incapacity to conduct the business as Mr Watson had previously done, and that the PIP policy quantified the contractual entitlement by reference to Mr Watson's income from the business, adjusted as agreed in the PIP policy. Those are merely events which the PIP policy was expressed to operate upon. The relevant payments under the PIP policy, however, had no causative connection with the business so that they could be regarded as income from the business or from the business activity. 51 Even if, initially, the benefits under the PIP policy could have been income from his business activity, at least while his capacity to continue to run the business was re-established, that is not the present position in respect of the relevant year of income. The taking out of the PIP policy may have been prompted by a range of sensible considerations, but the considerations for a taxpayer taking out such a policy will be but one piece of information relevant to the determination of whether benefits received under such a policy are part of the assessable income from a business activity in relation to a particular year of income. 52 The evidence is that Mr Watson's business expenses have been more or less constant for the years ending 30 June 2003 and 30 June 2004. In each of those years, his income from running the financial planning business (putting aside his insurance payments) has been significantly less than the expenses. His partial disability is apparently indefinite. He has not employed others, using the payments under the PIP policy, to work in the business to increase its income. No activities by him in the business, including the incidental or ancillary activities (such as record keeping, filing, banking, research, general administration tasks, insuring business assets and the like), have related to him continuing to receive the partial disability payments under the PIP policy. If he ceased running the business, or if he sold the business, his entitlement to partial disability payments under the policy would not change – although, depending on any other income earning activities he undertook, the quantum of those payments may be adjusted. 53 In his reply, Mr Watson alternatively argued that, because the insurer required Mr Watson to carry on his business so long as he was able, continuing his business became a condition of getting the insurance benefits. For reasons given below, if that were the insurer's position, I do not think it would be warranted under the policy (although of course the insurer has not had the opportunity of putting argument on the issue). I do not accept the premise that continuing the business, at what is now a significant annual loss, is a condition of eligibility for benefits under the PIP policy. 54 Further, Mr Watson argued in his reply as another alternative that the expenses of $14,854 in the income year ended 30 June 2004 were all attributable to the fee and commission income of $9,896. The test for deductibility of expenses is in s 8-1 of the ITAA 1997. The approach of the High Court in Ronpibon v Federal Commissioner of Taxation (1949) 78 CLR 47 to the test for deductibility (in respect of s 51(1) of the ITAA 1936 – the legislative predecessor) is still applicable. However, the proposition that there should be a pro-rata apportionment of expenses between fee and commission income on the one hand and the payments under the PIP policy on the other is also premised upon the fact that Mr Watson was obliged to continue to operate the business as a condition of eligibility for those payments. In other words, he says he had to incur the expenses to receive the assessable income comprising the insurance payments. For the reasons discussed below, I do not accept the premise. 55 For those reasons, I conclude that, at least for the year of income in issue, the partial disability payments under the PIP policy were not assessable income from Mr Watson's business or his business activities as a financial planner. Accordingly, the appeal should be dismissed. 56 Finally, I wish to make some observations about the terms of the PIP policy. 57 I note the communication referred to at [8] of these reasons. As I there remarked, there was a suggestion in the evidence of Mr Watson that he understood that he must continue to run his financial planning business to be eligible to continue to receive benefits under the PIP policy at their current level. I do not think the PIP information from the insurer says that. 58 The definition of partially disabled is set out in [16] above. The PIP policy says that the insurer will stop paying partial disability payments as soon as the insured person stops being partially disabled. The meaning of partially disabled relevantly involves two elements: (1) that the insured person is able to perform some, but not all, of the income producing duties of his or her occupation or is working in another occupation; and (2) because of the disability, the insured person earns less for the work he or she does than the "pre-disability income". It does not say that the insured person must be working in his or her pre-disability occupation to be "partially disabled". It allows for the fact that he or she may not be doing so. Consequently, if Mr Watson were to cease running his business because he could only do so at a significant loss, he would nevertheless remain partially disabled. It appears to be accepted that he is not able to perform all of the income producing duties of the business. It also appears to be accepted that, because of that disability, he earns less than his pre-disability income. 59 Indeed, under the definition of "total disability" in [14] above, Mr Watson may qualify for benefits under the PIP policy on that basis. There may be no significant difference: see [63] below. Of course, Mr Watson for the reasons set out in [62] below should endeavour to secure or maintain a reasonable occupation or employment. 60 On the assumption that Mr Watson remains at his current level of partial disability, he is entitled to payments calculated in accordance with the PIP policy. It is neither appropriate, nor possible, to decide what his precise entitlement would be if he were to cease running his financial planning business because he could not do so profitably, or to run it in a way that reduced his overheads and other outgoings to more closely relate them to his capacity to earn income from that business. There may also be other reasons why Mr Watson continues to run his business even though he cannot do so at a taxable profit. 61 The policy itself, and the explanatory material sent by the insurer on 2 January 2002, indicate that the formula to determine the benefit level for partial disability is calculated by reference to average weekly income from time to time during the period of partial disability. It does not oblige the insured person to maintain the business being conducted at the time the disability arose. 62 There is an undated note taken by Mr Watson of a discussion with an officer of the insurer: Therefore, there is a requirement to work if capable. If the insured person returns to work at a reduced capacity, the income protection is replacement income (business related income). If expenses exceed other business income (ie ignoring the Income Protection benefit itself) then to sell off the business is against the intent of the insurance act and the insurance company would cease benefit until other work was obtained. In a practical sense, Mr Watson should take reasonable steps to "mitigate his loss". That obligation is one applicable to the measure of damages in all contracts. It does not apply as a term of the policy. Section 13 of the Insurance Contracts Act 1984 (Cth) implies a term that each party to an insurance contract will act towards the other party with the utmost good faith. It could be expected that Mr Watson should therefore act reasonably in relation to the business activities or employment which he chooses to undertake: Dufty v City Mutual General Insurance Ltd [1977]Qld R 94. The element of reasonableness is also explained in cases such as Fidelity and Casualty Co of New York v Mitchell [1917] AC 592; Pocock v Century Insurance Co Ltd [1960] 2 Ll Rep 150; and Sergent v GRE (UK) Ltd [2000] Ll Rep 1R 77. That obligation extends to an insurer in determining whether an insured was totally and permanently disabled: see Beverley v Tyndall Life Insurance Co Ltd (1999) 10 ANZ Ins Cas 61-453. Reference may also be made to regs 17 and 18 of the Insurance Contracts Regulations 1985 (Cth) and to the decision in QBE Insurance Ltd v Jande (1995) 8 ANZ Ins Cas 61-270. Ultimately, the wording of the policy is the critical element. 63 The current level of benefits under the PIP policy has apparently been acceptable to Mr Watson. The definition of "income" in the case of a self-employed person is the "money generated by [that person's] business due to the person insured's own activity, after all expenses in earning that income have been deducted". On the evidence, Mr Watson would have no income for the purposes of the policy. He would appear to be entitled to be receiving, and be receiving the maximum weekly benefits payable under the policy. It is not a requirement of the PIP policy that, to continue to be eligible to continue to do so, he must continue to operate his business at a significant annual loss. 64 It is, of course, up to Mr Watson whether he continues to operate his business as at present, or adapts the manner of its operation in some way, or endeavours to pursue some other income earning enterprise. It seems clear enough that he continues to be partially disabled from work, so it is a matter of applying the terms of the policy to calculate the amount of his ongoing entitlement to payments under the policy in the light of his ongoing earning capacity as reflected in his income. 65 In my judgment, for the reasons given, the appeal should be dismissed. I certify that the preceding sixty-five (65) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Mansfield. Associate: Dated: 8 August 2008 Counsel for the Applicant: FJ Morgan Solicitor for the Applicant: Rankins Solicitors Solicitor for the Respondent: H Symon SC and S Cole Solicitor for the Respondent: Australian Government Solicitor Date of Hearing: 17 December 2007 Date of Judgment: 8 August 2008