Topic 4 – Deductions (general and specific) and Trading Stock

Deductions Deductions are made up of General deductions (s. 8-1(1)) plus Specific deductions (s. 8-5) minus Exclusions (s. 8-1(2)) When looking at an expense to see if it is deductible against assessable income, you must first ascertain whether you are entitled to a general or specific deduction, and whether any exclusion provisions apply to deny the deduction.

General deductions General deductions are provided for by s 8-1 ITAA 97. S 8-1(1) states that you can deduct a loss or outgoing to the extent that it satisfies one or other nexus requirements in s 8-1(1)(a) or s 8-1(1)(b). When looking at an expense to see if it is deductible against assessable income, you must first ascertain whether you are entitled to a general or specific deduction, and whether any exclusion provisions apply to deny the deduction.

S8-1(1) contains the two positive limbs.

At least one of these must be proved to apply before any amount is deductible as a general

deduction.

S8-1(2) contains four negative limbs.

If any of these apply the deduction will be denied.

NB: When looking at a possible amount as a general deduction, you must consider first the positive

limbs and prove one of them AND then look at the negative limbs to make sure that none apply.

1. First define if there is a loss or outgoing 2. Must be incurred in 3. The expense must be a real one. 4. Must relate to Taxpayer's own income 5. Assessable income need not be actually be produced in current period of deductibility 6. May be subject to Apportionment

Exclusion – s 8-1(2) ITAA 1997

Under s 8-1(2), even if the positive limbs are satisfied, a deduction is still not allowable to the extent that the loss of outgoing is:

Of capital or capital in nature

Is of a private or domestic nature

Is incurred in relation to gaining or producing exempt income

A provision of the Act prevents it being deducted

S 8-1 – general deductibility – the positive limbs Look at the loss or outgoing and see if it can satisfy one or both of the first two positive limbs of s 8-1. Generally, both limbs can apply in many instances. BUT

under the first limb, the loss or outgoing MUST be incurred in gaining or producing assessable income whereas

Under the 2nd positive limb it is the business which must be carried on for the purpose of gaining or producing the assessable income and the loss or outgoing must be necessarily incurred in carrying on that business.

o Charles Moore & Co v FCT (1956): Department store employee went to bank to deposit takings for day. Was robbed on the way to bank. Court held TP company was entitled to deduction because they suffered loss in the ordinary carrying on of their business.

o The second limb is different to the first in that it must be necessarily incurred in carrying on a business

o Does ‘necessarily incurred” change the nexus test? Ronpibon Tin Magna Alloys & Research (1980) Does not mean required Means adapted or appropriate

FC of T v Snowden & Willson Pty Ltd,

WD & HO Wills (Australia) Pty Ltd v FC of T, (1996), To apply either of the positive limbs it is necessary to establish a connection or ‘nexus’ between the loss or outgoing and the assessable income.

General deductions

(1) You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

Under s 8-10, there is no double deduction

Under s 8-1(1) (a) You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income;

The key connection is that an expense must produce assessable income

There must be a nexus o Amalgamated Zinc (1935) – loss or outgoing to come within the initial part of the

subsection should be productive of the assessable income, or be expected to produce assessable income

o If operation has ceased - no ass. inc.

Future assessable income o Finn (1961) o The assessable income may be:

Ceased business - provided related to passed business Placer Pacific (1995), Steele (1999), Jones (2002) Temporary cessation allowed Current income Future income

Section 8-1(1)(b): Necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income

• In Carrying on a Business • Easier test • Nexus test still applied - Incidental and relevant

• Pre-commencement of business expenditure generally not deductible • Softwood Pulp and Paper Ltd v FC of T • Griffin Coal Mining Company Ltd v FC of T • Goodman Fielder Wattie Ltd v FC of T

• Second limb doesn’t apply to personal exertion • Includes any profession, trade, employment, vocation or calling. But doesn’t

include occupation as employee – s 995-1 ITAA 97 • FCT v Maddalena Travelled between clubs to secure contract. Could he

claim travel expenditures between clubs? HCA said difference between doing work and going to work; was not deductible.

• Deduction generally allowed even after business ceased • Amalgamated Zinc Ltd. v FCT (1937), • AGC (Advances) Ltd v FC of T,(1975), (go to next slide) • BUT: If time lapse was considerable may be different

• Placer Pacific Management Pty Ltd (1995) • FC of T v Brown [1999]. • FC of T v Jones 2002

• Illegality does not deny deduction • La Rosa (2003) – TP was drug dealer. In 1996 convicted and sentenced to 12 years

imprisonment. After conviction, commissioner looked into tax affairs and noticed hadn’t done tax for seven years. Default assessments were issued. Included in TP’s income were money earned from income as drug dealer. Money had been buried in backyard, were stolen, and TP claimed deduction for loss. Court said based on Charles Moore case, TP entitled to deduction for loss – incurred in carrying on business of drug dealing. Upheld on appeal to Federal Court.

• now excluded by s 26-54 – denies deductions that pertain to illegal activities if the TP has been convicted of an indictable offence

• Second limb cannot apply to personal exertion • Maddalena (1971)

AGC (Advances) Ltd v FC of T (1975)

This case departed from the Amalgamated Zinc decision and involved a break in the

continuity of a business.

A company had carried on a business of providing finance by way of loans and hire purchase arrangements. Because it was trading unprofitably, it entered into a scheme of arrangement with its creditors, suspending its business operations for approximately one year. When the period expired the company was taken over by AGC Ltd — its name, premises and clientele were changed, and it resumed financing activities.

AGC Ltd. sought deductions for losses incurred in relation to debts, due to it by clients of the old business, which could not be recovered.

The Commissioner rejected this claim on the basis of the Amalgamated Zinc decision. That it there was no continuing business.

The High Court however determined otherwise and suggested that Amalgamated Zinc may have been wrongly decided.

The court commented: "the liability to make the workers' compensation payments [the subject of Amalgamated Zinc] was undoubtedly a liability which was incurred in the gaining of assessable income upon the mineral-recovering activities"...the obligation to make the payments was a business liability which sprang out of the carrying on of the business which had yielded assessable income.

On a construction of the section which included expenditures which related to the gaining of assessable income 'generally', it might properly have been said that the later payments of compensation had been incurred as a cost of gaining the assessable income which had already been returned and taxed."

Barwick CJ in AGC was "not satisfied that, in order to be deductible, the loss which flows from carrying on a business carried on to gain assessable income need necessarily occur in a year when the company is actively carrying on that business" but, in any event, his Honour was of the view that the present facts satisfied the idea of a "continuing" business despite the substantial break in that continuity

He said: "There was no change in the nature of the business at all. I conclude that in point of fact it was the same business which was carried on after a break, a break which it might be noted was not for the purpose of abandoning the business but rather to enable its continuance."

Loss or outgoing

Outgoing are a voluntary action

– FCT v Ilbery (1981) – deductions were denied for the relevant outgoings on the basis that the court found there was no objective income producing purposes of the TPs

Losses are involuntary eg. embezzlement

– Charles Moore v FCT (1956)

– FCT v La Rosa (2003)

Incurred/in

‘Incurred’ - Commonwealth Aluminium Corporation Ltd v FCT (1977) 77 "... ..a liability will be

a loss or outgoing which has been incurred within the meaning of s8-1(1) even though it

remains unpaid provided the taxpayer has completely subjected itself to the liability".

'In' - In FCT v Payne (2001) HCA 3 – the word in meant in connection with the derivation of

assessable income. Since this case, s 25-100 has been enacted

Expense must be real

In FCT v Ogilvy and Mather Pty Ltd (1990) 21 ATR 108, 90 ATC 4836, Jenkinson J in the Federal Court

held that an advertising agency that booked advertising time and sought to be paid by clients, could

not claim a deduction on the basis that if the clients did not pay, they (the client) were legally liable

until they defaulted. The agency's liability had not yet arisen.

Taxpayer’s own income

In FCT v Munro (1926) 38 CLR 153 a taxpayer borrowed money and on-lent it to a company in which it was a shareholder. The High Court denied the claim for the deduction. This decision is to be contrasted with FCT v Total Holdings (Australia) Pty Ltd 9 ATR 885, 79 ATC 4279 where a deduction was allowed for interest paid on moneys lent to a wholly owned subsidiary.

“To the extent that”

Loss or outgoing related to production of assessable income (Ronpibon Tin (1947)). Requires apportionment. This is so regardless of whether the different amounts are easy to calculate or not and is to be contrasted with the treatment of mixed gains under judicial principles of ordinary income: McLaurin v FCT (1961) 104 CLR 381,8 ATR180,12 ATD 273.

Nexus with income To apply either of the positive limbs it is necessary to establish a connection or ‘nexus’ between the loss or outgoing and the assessable income. Over the years the courts had established a number of tests to determine whether there is sufficient nexus between the loss or outgoing and the assessable income. These tests can best be described as:

• The incidental and relevant test

o To show a nexus an expense must be ‘incidental and relevant’ to earning assessable income

o Ronpibon Tin – outgoings must be incidental and relevant to that end o W Neville & Co v FCT (1937) – company was allowed a deduction for monies paid to

persuade a managing director to resign o Charles Moore & Co (WA) P/L v FCT

• Essential character test o Charles Moore o Herald & Weekly Times (1932) – TP published newspaper from which they derived

most of their assessable income. TP sued for defamation and settled some of their claims by way of compensation. Incurred substantial legal costs and argued these costs were to be deductible against assessable income. Agued the liability to damages arose by the way the TP did their business. Court said this expenditure flowed as a natural consequence from defamation case.

o Lunney v FC of T – (claim for deduction for travel costs for home to work. Court said to say expenditure on fares is a pre-requisite to the employment, have to look at essential character, court said these travel type expenses were a necessary consequence of living in one place and working in another – more of a private expenditure), Hayley v FC of T (1958).

• Form and legal rights test o FCT v Sth Aust Battery Makers (1978)

• Purpose test o Ure v FCT (1981) o Fletcher & Ors v FCT (1991)

• Perceived connection test o In FCT v Hatchett (1971) 125 CLR 494, Menzies J considered the case of a primary

school teacher who incurred expenses to obtain a higher certificate which led him to be moved to a higher pay scale and in addition incurred university fees. His Honour stated that ‘there must be a perceived connection between the outgoing and assessable income’.

o The Full Federal Court in Martin v FCT (1984) 15 ATR 808 did not think that Menzies J was attempting to substitute a new test.

o This view was supported by Ormiston J in FCT v Klan (1985) 16 ATR 176.

• Connection with employment test

o Finn (1961) – government employed senior architect. Tried to claim deductions for overseas travel costs that he incurred to bring himself up-to-date with his profession. Court said not correct to treat the acquisition of knowledge as capital.

o Wilkinson (1983) – obtaining of pilots license went beyond improving mind and body, there was a perceived connection between the outgoing and obtaining assessable income, in that the obtaining of the license made it inherently likely that he would be promoted and receive a higher salary

o Symone Anstis v FCT (1990) – TP received youth allowance as student. Was held that the university student was entitled to a tax deduction for her education expenses. Commissioner wasn’t happy about this and lodged appeal. High Court found in favour of student in 2010 appeal. Said TP was allowed a deduction for her study expenses pursuant to general deduction provisions, as long as it could be shown she was on youth allowance. Contrary to TR98/9 ruling

The negative limbs In addition to these two alternative positive limbs, section 8-1(2) ITAA97 indicates that even if the

positive limbs is satisfied, a deduction is still not available to the extent that the loss or outgoing is:

• Of capital or of a capital nature

• Is of a private or domestic nature

• Is incurred in relation to gaining or producing exempt income

• A provision of the Act prevents it being deducted.

The first negative limb – capital versus revenue expenses (s 8-12(2)(a)) Section 8-1(2)(a): not capital or of a capital nature.

• Capital test different to assessable income • A deduction is allowed if a particular loss or outgoing is “on revenue account” however a

deduction will not be allowed if a particular loss or outgoing is “on capital account”. Ask: What is capital? Need to look at tests developed by the courts.

• Once and for all test

– Vallambrosa Rubber Co Ltd v Farmer,(1910) it was noted that "capital expenditure is a thing that is going to be spent once and for all, and income expenditure is a thing that is going to recur every year".