High Court of Australia Menzies, J. Commissioner of Taxation (Cth) v Wells ORDER Order Appeal allowed. By consent, appellant to pay respondent's costs of the appeal. Assessment by Commissioner of Taxation confirmed. Usual order as to exhibits. Menzies, J The taxpayer, a partner in a firm of chartered accountants, Spry Walker & Co., claimed as a deduction in the assessment of his taxable income for the year ended 30 June 1967 a sum of $125 which he had, during the tax year, paid by way of premiums upon insurance policies upon the lives of his partners. Details of the payments were as follows:— 1. $59 of the premium upon a convertible temporary insurance for $20,000, without participation, on the life of R. A. Ringwood for five years from 2 August 1966, with the option to convert it to whole-of-life or endowment assurance without evidence of health. 2. $59 of the premium upon a temporary assurance for $20,000, without participation, upon the life of J. L. Blacket for five years from 4 August 1966. 3. $5 of the premium upon an accidental death policy for the period from 27 April 1967 to 27 April 1968 for $20,000 upon the life of R. D. Church. 4. $2 of the premium upon an accidental death policy for the period from 27 April 1967 to 27 April 1968 for $10,000 on the life of T. Duncanson. The foregoing policies were effected by agreement of the partners. The Ringwood policy was taken out by the taxpayer with Blacket and Church; the Blacket policy with Ringwood and Church; the Church policy with Ringwood and Blacket; and the Duncanson policy with Ringwood, Blacket and Church. There was also a policy for $20,000 on the life of the taxpayer taken out by Ringwood, Blacket and Church. The policies in which the taxpayer was interested as an insurer were owned and premiums were payable as follows:— 1. The Ringwood policy: The taxpayer 21/58ths Blacket 21/58ths Church 16/58ths; 2. The Blacket policy: The taxpayer 21/58ths Ringwood 21/58ths Church 16/58ths; 3. The Church policy: The taxpayer, Ringwood and Blacket in equal shares; 4. The Duncanson policy: The taxpayer, Ringwood, Blacket and Church in equal shares. Premiums were to be paid by individual partners' cheques. The first agreement relating to the taking out of insurance policies upon the lives of partners was made on 20 September 1966, before Duncanson was a partner. It was agreed as follows:— " Purpose of Policy All proceeds to be put towards the prompt payment-out of the Estate of the life assured if life assured dies Assignment prior to Expiration of Contract It was agreed that provision should be made for the life assured to have the policy on his life assigned to him one month before expiration of contract, to enable him to take up a convertible option if he so desires. " Later, on 1 May 1967, it was recorded as follows in relation to the two accidental death policies:— "Purpose of policy All proceeds to be put to the prompt payment-out of the Estate of the life assured if the life assured dies of the amount due to the deceased from the partnership. "NB Any sum in excess of this amount will be retained by the insurers." It was also recorded that the foregoing note also applies to the policies on the lives of Ringwood and Blacket as well as the taxpayer. Apparently it was with the following "Memorandum Re Partnership Finance" in mind that the polices were taken out:— "SPRY WALKER & CO., SOUTH AUSTRALIA MEMORANDUM RE PARTNERSHIP FINANCE 9. Death of a Partner (other than by suicide) Widow is to be paid— (a) Undrawn profits and capital (b) Goodwill: One year's purchase of the average for the last three years ended 30 June, net after partners salaries (notionally assessed at $20,000 until 30/6/65) after deducting— (i) Any jobs not in the firm's name at the date of death and lost to the firm; (ii) The following percentages for the number of years completed by partners other than RAR, PBW and JLB as a partner sharing in profits—thus, this reduction would apply to RDC and any AAP until that partner had completed five years as a profit sharing partner. 80% for only one year completed 60% for only two years completed 40% for only three years completed 20% if only four years completed Nil if five years completed as a profit sharing partner e.g. Value of Goodwill at 30/6/66 Salaries Net Profit y.e. 30/6/64 $43,190 $20,000 $23,190 65 59,006 20,000 39,006 66(say) 50,000 15,750 34,250 $96,446 Average $32,149 Less Balance Sheet Value 19,634 Difference $12,515 If for RAR, PBW or JLB 21/79 = $3327 RDC 16/79 = $2535 Reduced by 80% for RDC @ 1/7/66—admitted to profits 1/7/65(c) Work in process This to be the partner's share at the billing value as per the ledger …." This memorandum failed to distinguish clearly between the widow and the estate of a deceased partner. Notwithstanding some obscurity, I think I should treat it as providing for payments to be made to a widow if the deceased partner should leave a widow surviving. The Commissioner disallowed the deduction claimed. The taxpayer objected and his objection was referred to the Board of Review. At the hearing before the Board of Review the taxpayer gave evidence to the effect that in 1965 a partner of the firm had died and that the surviving partners were in the course of paying $600 monthly with interest over a period of five years either to the estate or to the widow of the deceased partner and that it was realized that, if another death were to occur while payments were continuing, "this would put a fairly severe strain on the finances of the partnership". The taxpayer said: "… whereas we felt we could handle the payment out of one partner without undue strain to partners, we felt that if a second death occurred in that period, this would be difficult to handle, and we did not wish, if we could possibly avoid it, to get into an overdraft situation with the bank." During the cross-examination of the taxpayer the following evidence was given:— MR. WEIR:—Do you agree that the position is that by paying the insurance premiums the partners are providing that if one partner dies the remaining partners will be able to acquire his share? In other words, where you previously had five partners sharing the assets, including goodwill, of the partnership you would then have four partners owning all the assets and the goodwill? A.—I do not like it put in that way. I regard the partnership as a continuing business and I regard the necessity to keep it going as terribly important, the same as I would not want the accounting machines to be burned. We have to provide them and we have a staff of 65 now, and I regard it as a responsibility of the partners to take reasonable steps to ensure the financial stability of the business. The worst thing to happen is for a partner to die, because we have to go on with the business and provide the staff to do it. Apart from the fact that we lose the skill and ability of the deceased, we have to go on with the work. One cannot resign from an audit. Q.—Would not the position be that where five partners had previously owned the assets and goodwill of the business, four partners would become the owners? A.—A new partnership is constituted. Q.—Which would consist of four partners only? A.—True. The Board of Review, by a majority, allowed the taxpayer's claim. One of the majority said that "the expenditure was incidental and relevant to the taxpayer's continuing interest as a partner in the business which produced his assessable income and incidental and relevant to the gaining of such income" and was not of a capital nature. Another, in agreeing, said: "The outgoing with which this reference is concerned fell upon the taxpayer in his capacity as a partner in an accountancy practice. The course of action that gave rise to it was that formally determined by the partners in concert in the course of considering the business affairs of the partnership, and this gives it a business character directly related to the gaining of assessable income." The payments, if deductible, are so by virtue of s 51 of the Income Tax Assessment Act. They were not, as it was conceded, "incurred in gaining or producing assessable income", and the first question is whether they were "necessarily incurred in carrying on a business for the purpose of gaining or producing" assessable income. If so, it will be necessary to decide further whether they were outgoings of capital or of a capital nature. In the course of their careful arguments counsel referred me to the various observations that have been made from time to time upon what has been referred to as a second limb of s 51, and counsel for the taxpayer properly emphasized that the phrase, "necessarily incurred in carrying on a business" therein, has been understood to mean "plainly adapted towards carrying on a business" rather than "essentially necessary in carrying on a business". It is clear, however, that this limb only applies to outgoings incurred in business operations to gain assessable income. It is not sufficient that an outlay can be described as a business expense; it must have the character of an operating expense to obtain assessable income. The phrase "in carrying on a business" is equivalent to "in business operations". This, I think, follows from John Fairfax and Sons Pty Ltd v Federal Commissioner of Taxation (1959), 101 CLR 30, at pp 40, 47 and 48; 7 AITR 346, at pp 357, 362 and 363. See to Federal Commissioner of Taxation v Gordon (1930), 43 CLR 456, per Dixon, J., at p 462. Here the premiums were paid, not by the firm, or the members of the firm, in the course of carrying on the firm's accountancy business; they were paid by the taxpayer, in common with some but not all members of the firm, to ensure that there would be money available to meet the partnership obligations inter se upon the death of a partner. Perhaps in stating the purpose thus I do more than justice to the taxpayer's case, for it is apparent from the tables before me that, if Duncanson had died by accident on 30 June 1967, the $10,000 insurance moneys payable under the policy would simply have gone into the pockets of the other partners in equal shares because they would have been under no obligation to his estate or to his widow, if any. I was invited by counsel for the Commissioner to regard any policy moneys that might be yielded from the payment of the premiums as a capital provision to buy out the partnership interest of a deceased partner. However, it is not necessary for me to go that far and—in the absence of knowledge of the full terms of the partnership agreement—I refrain from doing so, although it may well be that the payments to be made were to take the place of the interest that the deceased partner had at the time of his death. My conclusion, that the premiums were not outgoings necessarily incurred in carrying on the business of the partnership, is, however, sufficient to require that I allow the Commissioner's appeal. The appeal is therefore allowed with costs.