De Simone and Commissioner of Taxation
Document type: Decision Impact Statement
Venue: Administrative Appeals Tribunal (VT 2005/304 & 305)
Judgment date: 13 August 2008
Date published: 11 March 2010
Decision outcome: Partially favourable

Summary of decision:
Outlines the ATO's response to this case which concerned whether a claimed partnership loss arising from the applicants' investment in Jolson - The Musical was deductible

Overview of facts:
On or about 30 June 1999, the applicants became partners in a partnership formed to produce a theatrical production of Jolson - the Musical . Each partner was intended to contribute $500,000 towards production costs, of which $400,000 was to be borrowed on a limited recourse basis from a finance company associated with the promoter, Mr Brereton. The partnership was to be managed by a company, who would agree with another company to produce the show. The applicants decided to share equally ($250,000) in the one partnership share, each purportedly borrowing $200,000 from the financier, and contributing $50,000 each in cash. | Under the production services and licence agreement, the partnership was liable to pay the production company a fee for the grant of the production licence and the provision of production services, and was entitled to 60% of the net profits after the running costs were recouped. | The production did not run for the intended period during the 2000 income year and did not generate the profits expected by the information memorandum. Production costs for the limited season were funded by ticket sales and the cash contributed by the partners. | While the partnership accounts showed that the loan funding was contributed by the partners, no evidence existed of loan agreements being executed or of payments being made by the finance company to the production company to fund the costs of production. | Each applicant claimed a deduction of $250,000 in his income tax return for the year ended 30 June 1999 as his share of the partnership loss. | At the hearing before the Tribunal, the applicants were given an adjournment to arrange for Mr Brereton to give evidence about the scheme, including the loan facility. At the resumed hearing over 3 months later, Mr Brereton did not attend to give evidence, and the applicants could not show that a summons had been properly served on him, nor that he would later voluntarily attend to give evidence. Accordingly, the Tribunal proceeded to determine the case without granting any further adjournment. | Issues decided by the tribunal | The partnership incurred expenditure in the 1999 income year equal to the cash contributed by the partners in gaining income from the production or in carrying on a business of musical production. However, the partnership did not incur any outgoing equal to the amount of the purported loan financing. Accordingly, each applicant was only entitled to a deduction for a partnership loss of $50,000 (paragraphs 13 to 15). | In the alternative, if the applicants were entitled to a deduction of $250,000 for the partnership loss, Part IVA of the Income Tax Assessment Act 1936 (ITAA) would apply to disallow the deduction. It could be objectively concluded, looking at the factors in section 177D of the ITAA, that Mr Brereton and the partners entered into the scheme purporting to borrow funds to increase partnership expenses beyond that actually incurred for the purpose of obtaining a tax benefit by inflating the amount sought to be deducted. However, it is appropriate to make a compensating adjustment under subsection 177F(3) to allow the applicants a deduction of $50,000 for the moneys actually incurred by them (paragraph 16). | The Tribunal accepted that penalty of 50% was not payable by the applicants under section 226L of the ITAA, on the basis that they did not enter into the scheme for the subjective purpose pf paying no or less tax. However, penalty of 25% is payable under section 226G, on the basis that the applicants' tax shortfalls were caused by their failure to take reasonable care in relation to the partnership losses claimed (paragraph 19). | The applicants appealed to the Federal Court in relation to the disallowance of the partnership loss and also claimed that they were denied procedural fairness by the Tribunal deciding not to grant a further adjournment of the hearing to enable Mr Brereton to give evidence. The Commissioner did not appeal against the allowance of part of the partnership loss, nor against the reduction in penalties. | The Court (Jessup J) [2009] FCA 446 dismissed the appeal on 9 May 2009. His Honour agreed that the Tribunal had erred in finding that the partnership did not incur any outgoing equal to the amount of the purported loan financing. The partnership came under an immediate obligation to pay the production services fee when the agreement was entered into (paragraph 8). However, there was no error of law involved in the Tribunal's decision in relation to Part IVA (paragraph 11). His Honour also found that there was no denial of natural justice by the Tribunal in refusing a further adjournment (paragraph 24). | The Full Federal Court [2009] FCAFC 181 dismissed the applicant's appeal from the decision of Jessup J on 22 December 2009. The applicants did not seek special leave to appeal to the High Court.

Issues decided:
The partnership incurred expenditure in the 1999 income year equal to the cash contributed by the partners in gaining income from the production or in carrying on a business of musical production. However, the partnership did not incur any outgoing equal to the amount of the purported loan financing. Accordingly, each applicant was only entitled to a deduction for a partnership loss of $50,000 (paragraphs 13 to 15). In the alternative, if the applicants were entitled to a deduction of $250,000 for the partnership loss, Part IVA of the Income Tax Assessment Act 1936 (ITAA) would apply to disallow the deduction. It could be objectively concluded, looking at the factors in section 177D of the ITAA, that Mr Brereton and the partners entered into the scheme purporting to borrow funds to increase partnership expenses beyond that actually incurred for the purpose of obtaining a tax benefit by inflating the amount sought to be deducted. However, it is appropriate to make a compensating adjustment under subsection 177F(3) to allow the applicants a deduction of $50,000 for the moneys actually incurred by them (paragraph 16). The Tribunal accepted that penalty of 50% was not payable by the applicants under section 226L of the ITAA, on the basis that they did not enter into the scheme for the subjective purpose pf paying no or less tax. However, penalty of 25% is payable under section 226G, on the basis that the applicants' tax shortfalls were caused by their failure to take reasonable care in relation to the partnership losses claimed (paragraph 19). The applicants appealed to the Federal Court in relation to the disallowance of the partnership loss and also claimed that they were denied procedural fairness by the Tribunal deciding not to grant a further adjournment of the hearing to enable Mr Brereton to give evidence. The Commissioner did not appeal against the allowance of part of the partnership loss, nor against the reduction in penalties. The Court (Jessup J) [2009] FCA 446 dismissed the appeal on 9 May 2009. His Honour agreed that the Tribunal had erred in finding that the partnership did not incur any outgoing equal to the amount of the purported loan financing. The partnership came under an immediate obligation to pay the production services fee when the agreement was entered into (paragraph 8). However, there was no error of law involved in the Tribunal's decision in relation to Part IVA (paragraph 11). His Honour also found that there was no denial of natural justice by the Tribunal in refusing a further adjournment (paragraph 24). The Full Federal Court [2009] FCAFC 181 dismissed the applicant's appeal from the decision of Jessup J on 22 December 2009. The applicants did not seek special leave to appeal to the High Court.

ATO view of decision:
The ATO accepts that it was open to Jessup J to find that the Tribunal had erred in law in finding that the partnership had only incurred the cash component of the production services fee for the purposes of section 8-1, and then to find that the production services and licence agreement created a presently existing obligation to pay the production services fee to the production company. | The ATO also accepts that it was open to the Tribunal on the facts of the case to find that it was appropriate to make a compensating adjustment under subsection 177F(3) to allow the applicants a deduction of $50,000 for the moneys actually paid by them (consistent with the approach taken in Commissioner of Taxation v Sleight [2004] FCAFC 94), and to find that section 226L did not apply.

Administrative treatment:
Implications on current Public Rulings & Determinations | None.

Legislative references: Income Tax Assessment Act 1936 92 177D 177F(1) 177F(3) Income Tax Assessment Act 1997 8-1
Case references: Commissioner of Taxation v Starr 164 FCR 436 2007 ATC 5447 67 ATR 923
Subject references: Partnership loss Incurred Part IVA Tax avoidance scheme