Commissioner of Taxation v La Rosa

I certify that the preceding eleven (11) numbered paragraphs are a true copy of the Reasons for Judgment herein of Justice Carr.

ON APPEAL FROM A JUDGE OF THE FEDERAL COURT OF AUSTRALIA

BETWEEN: COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA

AND: COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA

merkel J: 12 I agree with the orders proposed by Hely J and with the reasons his Honour has given for making those orders.

I certify that the preceding one (1) numbered paragraph is a true copy of the Reasons for Judgment herein of Justice Merkel.

ON APPEAL FROM A JUDGE OF THE FEDERAL COURT OF AUSTRALIA

BETWEEN: COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA

AND: COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA

REASONS FOR JUDGMENT HELY J: 13 The respondent ('the taxpayer') is a person who was involved in drug dealing. He failed to lodge income tax returns for the seven years of income ended 30 June 1990 to 30 June 1996 inclusive. The appellant ('the Commissioner') issued Notices of Assessment pursuant to s 167 of the Income Tax Assessment Act 1936 (Cth) ('the ITAA') in relation to each of those years. 14 This appeal concerns the financial year ended 30 June 1995, and a sum of $220,000 which was included by the Commissioner in the taxpayer's income for that year. The taxpayer contended that the $220,000 was not his money, but was money provided to him by the Australian Federal Police when he was acting as an agent provocateur in a controlled operation, but which was stolen from him.

The AAT's decision 15 The Administrative Appeals Tribunal ('the AAT') did not accept the taxpayer's contention as to the source of the $220,000. The AAT made the following factual findings: (a) the taxpayer was carrying on a business of dealing in drugs; (b) the sum of $220,000 belonged to the taxpayer. It was the accumulated proceeds from drug dealings accumulated for use in the business; (c) the sum of $220,000 had been buried in the taxpayer's backyard and dug up for an intended drug deal in May 1995; (d) the sum of $220,000 was stolen from the taxpayer during the intended drug purchase by unknown persons; (e) the money was lost during activities directly connected with the carrying on of the taxpayer's illicit drug dealing business; and (f) the money was lost during operations to acquire trading stock. 16 On the basis of those findings, the AAT concluded that whilst the sum of $220,000 had been properly included (as part of the default assessment process) in the Commissioner's calculation of unexplained funds derived by the taxpayer during the year ended 30 June 1995, which resulted in his taxable income being assessed at $446,954 for that year, a deduction pursuant to s 51(1) of the Act not previously allowed by the Commissioner should be allowed for the sum of $220,000 stolen during that year. The AAT relied on Charles Moore & Co (WA) Pty Ltd v Federal Commissioner of Taxation (1956) 95 CLR 344. That was a case where deductibility was allowed in respect of a sum of money stolen at pistol point whilst being taken from the taxpayer's retail store to the nearby bank for depositing. In the present case, the AAT considered that it was not to the point that the drug dealing business was illegal. Rather, what mattered was the connection of the robbery with the drug purchase operation which was directly connected with the gaining or production of the taxpayer's assessable income. The AAT followed the reasoning in Charles Moore (supra) in holding that the amount stolen was not a loss of capital or of a capital nature. Furthermore, it did not consider that the loss could be characterised as one incurred in the course of receiving a future supply of drugs (an enduring benefit) which would be of a capital nature because the evidence was that the money was lost during operations to acquire trading stock.

The proceedings at first instance 17 The Commissioner appealed to a single judge of the Court from that decision. One of the principal matters argued at first instance was whether the deductibility of the stolen monies was precluded as being contrary to public policy. The primary judge accepted the Commissioner's submission that there is a recognition in Australian taxation law that s 51(1) may be limited by public policy considerations. 18 The primary judge identified the relevant public policy as being that the policy of the law should support the enforcement of State and Federal criminal laws prohibiting the possession and selling of prohibited drugs. His Honour then said: '83 The question then arises whether the allowance of the claimed deduction would have the effect of not supporting the public policy so ascertained. The question is whether the legislative intent of deterring crime would be frustrated by the allowance of the right to claim the deduction. 84 In my opinion the allowance of the deduction is an encouragement towards and a reward for engagement in illegal conduct. But is it a frustration of the state policy reflected in the criminal law (to use the language of Tellier)?' 19 The primary judge expressed his conclusions on this issue as follows: '95 Ormiston J in Mayne Nickless applied public policy to disallow deductibility of fines and penalties and so prevent frustration of the legislative intent to punish and so avoid the diminishment or lightening of that punishment. Fines and penalties are an expression of legislative intent. Counsel for the Commissioner accepts that here the loss or outgoing is not of that character: it is not itself something prohibited by Statute. Nor is it something which will frustrate enforcement of the criminal law. 96 There is an apparent contradiction between the law allowing deductibility on the one hand and imposing severe controls on the other. That may be a reason for Parliament to preclude deductibility. But is it a circumstance in which the law can invoke public policy as a limitation? 97 Once the circumstances in issue are removed from frustration of a legislatively defined penalty, the scope for intervention lacks clear boundaries of principle. The allowance of a deduction for monies expended on a criminal business, in circumstances where the income of that business is taxable, is consistent in principle and with the ITAA. Present authority supporting the imposition of a public policy limitation does not extend beyond instances of fines and penalties. No basis of principle is readily apparent to extend that basis. Courts should not do so in the absence of such apparent principle because to do so would arguably attract the aura of the function of legislation. There is no basis for doing so where there is no frustration of criminal enforcement. Such encouragement to criminal activity as a deduction may provide is not a frustration to criminal enforcement: it is arguably an anomaly to which Parliament should give attention. 98. In my view the public policy argument made for the Commissioner cannot succeed.' 20 Other issues arose at first instance, some of which are pursued on this appeal. There is also a cross appeal.

Income from illegal activities 21 In MacFarlane v Commissioner of Taxation (1986) 13 FCR 356 Burchett J, sitting as a member of a Full Court, said at 380-381 that there is a body of authority which justifies the proposition that the illegal nature of a receipt does not deny its taxability. His Honour said that it has been pointed out that to hold otherwise would be to favour dishonest businesses over honest ones. In Partridge v Mallandaine (1886) 2 TC 179 at 181 Denman J said: '… in my opinion, if a man were to make a systematic business of receiving stolen goods, and to do nothing else, and he thereby systematically carried on a business and made a profit of ₤2000 per year, the Income Tax Commissioners would be quite right in assessing him if it were in fact his vocation. There is no limit as to its being a lawful vocation, nor do I think that the fact that it is unlawful can be set up in favour of these persons as against the rights of the revenue to have payment in respect of profits that are made.' Other cases referred to by Burchett J where the proceeds of illegal transactions were considered to be assessable income include Minister of Finance v Smith [1927] AC 193, which involved the proceeds from bootlegging liquor in Ontario, and Mann v Nash [1932] 1 KB 752 where the profits of an illegal trade, being unlawful gaming, were held taxable. In Mann v Nash at 758 Rowlatt J said: 'The revenue authorities, representing the State, are merely looking at an accomplished fact. It is not condoning it, or taking part in it. It merely finds profit made from what appears to be a trade, and the revenue laws say that profits from a trade are to be taxed.' Burchett J also placed reliance on Lindsay v Commissioners of Inland Revenue (1933) SLT 57 (illegal export of whisky to the USA). In that case some members of the Court expressed reservations as to whether the profits of crime could be assessable to income tax as the profits of a trade. Burglary, for example, was said not to be a trade or business. But in Lindsay the profit was derived from the marketing of a commercial article in the United States which was 'trade', even though fraudulent breaches of the law were necessarily inherent in it. Finally reference was made by Burchett J to S Southern v AB [1933] 1 KB 713 where Finlay J held that the profits arising from a wholly illegal business of street betting were assessable to income tax. 22 Professor Parsons, in his work Income Taxation in Australia, in the context of a discussion of income according to ordinary usage, summarised a number of propositions (at p 26). Proposition 1 is as follows: 'An item of an income character is derived when it has "come home" to the taxpayer. The presence of illegality, immorality or ultra vires does not preclude derivation.' 23 The decision of Burchett J and the authorities to which his Honour refers, support Professor Parsons' Proposition 1. A consequence of Proposition 1 is that the tests as to whether an amount is assessable income under s 25(1) of the ITAA are the same for amounts received from legal and illegal activities. Where a receipt is derived from an isolated illegal transaction, whether the proceeds are assessed as income under s 25(1) of the ITAA will depend on the circumstances of each case. But where a taxpayer systematically engages in an illegal activity, and the elements of a business such as organisation, repetition, regularity and view to a profit are present, then the proceeds from that activity will be income according to ordinary concepts. 24 That is the view which has been accepted by the Supreme Court of the United States. In Commissioner v Tellier (1966) 383 US 687 Mr Justice Stewart in delivering the opinion of the Court said at 691: 'We start with the proposition that the federal income tax is a tax on net income, not a sanction against wrongdoing. That principle has been firmly imbedded in the tax statute from the beginning. One familiar facet of the principle is the truism that the statute does not concern itself with the lawfulness of the income that it taxes. Income from a criminal enterprise is taxed at a rate no higher and no lower than income from more conventional sources. '[T]he fact that a business is unlawful [does not] exempt it from paying the taxes that if lawful it would have to pay.' United States v Sullivan, 274 U.S. 259, 263. See James v United States, 366 U.S. 213.' 25 It is also the view which has been accepted in Canada. In Erdelyi v R (2003) WL 5729 Mogan TCJ said: 'Many cases have established the principle that the proceeds of crime or an illegal activity will have the character of 'income' for purposes of the Income Tax Act. This principle is illustrated in the following circumstances: fictitious invoices (R. V. Poynton (1972), 72 D.T.C, 6329 (Ont. C.A.)); theft from an employer (Hughes v. R., [1996 CarswellNat 1337 (T.C.C.)] Tax Court of Canada, May 2, 1996, Court File 95-3046-I); illegal bookmaking operation (R. v. Christensen (1983), 83 D.T.C. 5359 (B.C. S.C.)); misappropriation of funds by a lawyer Buckman v. Minister of National Revenue (1991), 91 D.T.C. 1249 (T.C.C.)); misappropriation of funds by treasurer of municipality (Taylor, Tax Court of Canada, May 10, 1995, Court File 93-238-G); illegal gratuities received by a member of parliament (Gravel v. Minister of National Revenue (1992), 92 D.T.C. 1935 (T.C.C.)); and proceeds from drug trafficking (Neeb v. R., [1997 CarswellNat 67 (T.C.C.)], Tax Court of Canada, January 9, 1997, Court File 94-260-G).'

The deductibility of a business loss arising by theft 26 As the ITAA stood at the relevant time, income tax was levied on the taxable income derived by a person during the year of income: ITAA s 17. In calculating taxable income, assessable income (s 25) was taken as a base and allowable deductions (s 51) were deducted from it: ITAA s 48. 27 Whether the occasion for a loss or outgoing lies in business operations so as to be deductible under s 51(1) requires a judgment about the nexus between the loss or outgoing and the business operations: Commissioner of Taxation v Jones (2002) 117 FCR 95 at 98 par [9]. If there is that proximity then the loss or outgoing is deductible by force of the statute unless, the loss or outgoing is of capital or of a capital nature, or, as the Commissioner contends, unless there is some overriding but unexpressed principle flowing from public policy considerations which produces a different result. 28 Leaving aside illegality considerations, a loss by theft or arising from theft is a loss for the purposes of s 51(1) of the ITAA: see Charles Moore (supra). Whether losses of that kind which are incurred in connection with the conduct of a business are deductible will depend upon their relevance to and connection with the income producing activities. 'It is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce the assessable income': Ronpibon Tin NL & Tongkah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47 at 57. 29 The AAT characterised the $220,000 loss as one incurred in the course of gaining or producing assessable income because it was lost during a robbery connected with a drug purchase operation directly connected with the respondent's illicit drug dealing business. Again, leaving aside illegality considerations, on the factual findings made by the AAT, that was a correct characterisation of the loss. The occasion of the loss was the theft of money intended to be applied in connection with the purchase of trading stock for the respondent's business as a dealer in drugs. The risk that losses of that type will be sustained was inherent in the activities under consideration. The question then is whether the loss was a capital loss. 30 In Guinea Airways Ltd v Federal Commissioner of Taxation (1949) 83 CLR 584 a taxpayer whose business was that of an air transport company maintained large stocks of general stores and spare parts for the maintenance and repair of its aeroplanes. The stocks were destroyed when Japan invaded New Guinea, and the taxpayer claimed to be entitled to deduct as a loss under s 51(1) the difference between the cost price of the goods destroyed and the amount received by way of compensation for the loss. The claim was rejected because the loss was of a capital nature. The Court distinguished between stock in trade (the loss of which would be deductible) and a permanent stock of spare parts which forms part of the profit yielding subject. At 592-593 Kitto J said: 'In this sense they were held in reserve, just as money for the purchase of spare parts when needed might have been kept in a bank or in a safe. If money so kept had been lost, e.g., by the failure of the bank or the destruction of the safe, the loss could not be regarded as other than a capital loss. … In a case such as the present, however, money is not stock in trade, and neither are spare parts and stores bought with it; and if either money or goods be lost while held as a fund or stock to meet future needs, the loss is a loss on capital account. In my opinion the company's contention based upon s. 51(1) was rightly rejected.' 31 Professor Parsons comments on this decision at [6.56] as follows: '[6.56]Guinea Airways is concerned not with relevance, but with the character of the loss as a working loss and, in this regard, with the character of the asset as a revenue asset or a capital asset. The maintaining of a large stock of spare parts which is 'beyond any requirements for prospectively immediate use' (at 590), in the view of Latham C.J., following Dixon J. at first instance, gave the spare parts the quality of capital assets, and the loss was thus a capital loss. Kitto J. held the spare parts were capital assets as items 'acquired before they were actually needed' (at 592), an explanation which would make spare parts capital in much wider circumstances than those contemplated by Latham C.J. And the extension by Kitto J. of the same idea to cover cash kept in a safe to meet future needs is at odds with the view taken later in this Volume that cash, if held for use in the derivation of income, is always a revenue asset.' 32 Whether money is held as a revenue asset or as a capital asset or on private account depends on the circumstances of the holding. A taxpayer who stores money in the ground or in a safe or in the bank may hold the money as capital if it is part of the structure of the business, or if it is held for use when needed in the business and is in the nature of a capital reserve. At [6.62] Professor Parsons says: 'At some point the holding of money as cash, like the holding of spare parts in Guinea Airways (1950) 83 CLR 584, becomes a holding which is part of the structure of the business. A taxpayer who stores money in his safe or hides it, whether to thwart the Commissioner or because he does not trust banks, may hold the money as capital, not a revenue asset, but the source of the money has no bearing. … And provided money is not held in the bank account in such an amount that it may be regarded as stored, like the spare parts in Guinea Airways, it should be regarded as a revenue asset and not a capital asset.' On the AAT's findings, the stolen cash was at the point of loss, earmarked for use in connection with the acquisition of drugs as trading stock. Cash so held for use in the derivation of income is circulating capital and a revenue asset: Parsons (supra) 337-339. 33 Thus, illegality considerations apart, the AAT was correct in allowing a deduction for the $220,000 stolen from the taxpayer. The Commissioner's submission that the loss was on capital account should be rejected.

The crime 34 Counsel for the Commissioner identified the crime allegedly committed by the taxpayer on the occasion of the loss as follows: - Mr La Rosa attempted to possess a prohibited drug contrary to s 6 of the Misuse of Drugs Act 1981 (WA) read with s 33; and - Mr La Rosa attempted to have in his possession a prohibited import contrary to s 233B(1)(a) of the Customs Act 1901 (Cth) read with s 237. 35 Section 6 of the Misuse of Drugs Act 1981 relevantly provides: '6(1) … a person who - (a) with intent to sell or supply it to another, has in his possession; (b) … (c) … a prohibited drug commits an indictable offence …' Section 33(1) of that Act provides that a person who attempts to commit an offence commits, if the principal offence is an indictable offence, the indictable offence. 36 Section 233B(1) of the Customs Act 1901 (Cth) creates a series of offences in relation to narcotic goods more than one of which might be potentially applicable to the circumstances of the present case. For example, s 233B(1)(ca) provides: '(1) Any person who: (ca) without reasonable excuse (proof whereof shall lie upon him) has in his possession any prohibited imports to which this section applies which are reasonably suspected of having been imported into Australia; shall be guilty of an offence.' Section 237 provides that any attempt to commit an offence against the Act shall be an offence against the Act, punishable as if the offence had been committed. 37 In the Commissioner's submission, the occasion which caused the loss was an unlawful criminal act, because it was an attempt on the part of the taxpayer to obtain possession of drugs, the possession of which would, in the circumstances, constitute an offence. Counsel for the taxpayer did not dispute that submission, subject to the qualification that the taxpayer had not been found guilty of an offence.

Whether fines and penalties are deductible 38 Section 51(4) was inserted into the ITAA in 1984. The subsection provides: 'A deduction is not allowable under subsection (1) in respect of: (a) an amount, however described, payable or expressed to be payable, by way of penalty under a law of the Commonwealth, a State, a Territory or a foreign country; or (b) an amount ordered by a court, upon the conviction of a person for an offence against a law of the Commonwealth, a State, a Territory or a foreign country, to be paid by a person.' 39 Prior to the enactment of s 51(4) there were a number of Australian cases which assumed or held that fines and penalties apparently incurred in the earning of assessable income were not deductible under s 51(1): Federal Commissioner of Taxation v Snowden & Willson Pty Ltd (1958) 99 CLR 431; Magna Alloys & Research Pty Ltd v Federal Commissioner of Taxation (1980) 49 FLR 183; Mayne Nickless Ltd v Commissioner of Taxation [1984] VR 863; Madad Pty Ltd v Commissioner of Taxation (1984) 4 FCR 420. 40 The reason fines and penalties were held not to be deductible derives from the nature of a fine or penalty as a punishment or personal deterrent. They are not expenses of trading, even though the conduct penalised found its nature in business considerations. In Magna Alloys (supra) at 214-215 Deane and Fisher JJ said, by way of obiter, that it is difficult to understand how it can be maintained as an unqualified proposition that the nature of a penalty severs it from the expenses of trading. Recurrent penalties for parking infringements incurred by a delivery man and per diem penalties for unlawfully using premises for business purposes in contravention of zoning requirements are not, for example, logically severed from the expenses of trading. The same can be said of fines imposed for actually engaging in some unlawful activities, such as illegal bookmaking or soliciting, for the purposes of earning assessable income. 41 At 215 Deane and Fisher JJ said: 'If, when the matter directly arises for decision in the Australian courts, it is to be held that all fines and penalties are to be denied deductibility under the Act, it would seem preferable that it be on the basis of some perceived overriding consideration of public policy which precludes deductibility. Even in that event, however, it would not necessarily follow that, as a matter of overriding principle, a deduction should be refused in respect of a taxpayer's costs of defending the proceedings in which the penalty was imposed upon him.' (citations omitted) 42 In Mayne Nickless Ormiston J had to consider the deductibility of fines and penalties of two kinds. First, fines and penalties imposed for traffic offences imposed on the taxpayer itself; second, fines and penalties imposed on employees of the taxpayer or upon independent contractors which were paid by the taxpayer for legitimate business reasons. 43 Deductibility of expenditure in payment of fines and penalties imposed directly on the taxpayer was denied upon the basis of the traditional analysis that the nature of a penalty and the character of the expenditure take such outgoings outside the expense of trading. At 878 Ormiston J said: 'The fine or penalty no doubt arises out of acts performed in the course of the taxpayer's business, but the obligation to pay the fine or penalty derives from the law itself and the need to pay a fine or penalty ought not to be characterised as being either incidental or relevant to the gaining or producing of assessable income, nor should it be characterised as an outgoing which was clearly appropriate and adapted for the purpose of gaining or producing the assessable income of a business.' Ormiston J came to this conclusion on the basis of authority, and it is at least implicit in his reasons that but for the weight of that authority he might have come to a different conclusion. 44 As to the second, Ormiston J held that the 'occasion' of the payments made by the taxpayer on behalf of employees and subcontractors could be found in what was productive of assessable income, and the relevant necessity for the taxpayer to pay them was imposed not by the law, but by commercial considerations which are not outside the scope of s 51(1). His Honour therefore proceeded to consider whether public policy considerations expressly or impliedly referred to in the earlier authorities would deny the right to a deduction for fines and penalties imposed on employees and subcontractors, as well as those imposed on the company itself. His Honour's conclusion was that the policy of the law denies the right to claim these fines and penalties as deductions on the ground that it would frustrate the legislative intent in that the punishment imposed would be or would be seen to be diminished or lightened. 45 In Madad (supra) the Full Court held that a pecuniary penalty imposed upon a company in respect of resale price maintenance is not an allowable deduction, notwithstanding that it was incurred as a result of its trading activities. The decision was based upon Federal Commissioner of Taxation v Snowden & Willson Pty Ltd and the cases therein referred to, and particularly on the notion that a penalty, by its nature, is not a trading expense. The Full Court said that the approach adopted in these cases 'may well have its origins in public policy'.

Whether other expenses incurred in the conduct of an unlawful business are deductible 46 All of the cases referred to above concern the deductibility of fines and penalties, and their outcome (save for the second category of fines and penalties referred to in Mayne Nickless) is based on the notion that a fine or penalty is a punishment imposed by law, and that expenditure on that account is to be distinguished from a trading expense. As Deane and Fisher JJ observed in Magna Alloys, fines regularly incurred as a result of steps taken to facilitate the conduct of a business prima facie appear to have the requisite nexus with the business operations so as to qualify for deduction under s 51 of the ITAA. Nonetheless the authorities deny entitlement to a deduction for expenditure of that type, and whatever the logic of the distinction, it is now too late (at least at the level of this Court) to change the rule which the Courts have adopted in that respect. But none of these authorities supports the more general proposition for which the Commissioner contends that expenditure (other than fines and penalties) which has the requisite nexus with the business operations should nonetheless not be deductible because those operations are unlawful and involve breaches of the criminal law. In Madad at 426, the Full Court made the following observations which are inconsistent with the Commissioner's contentions: 'A consideration which may be regarded as tending against this result [ie that penalties are not deductible] is the deductibility of expenses incurred in conducting illegal activities. Starting price betting, or brothel keeping, may be examples. The fact is, however, that the income from such sources is regarded as taxable, and deductibility of expenses flows almost necessarily. Fines imposed for conducting these activities would not, however, be deductible.' (citation omitted) 47 In an article by Richard Krever, 'The Deductibility of Fines Consideration From Law And Policy Perspectives' (1984) ATR 169, the author describes the rule against the deductibility of fines as introducing a significant anomaly into Australian tax law which allows a deduction for expenses necessarily incurred in carrying on a business in the sense that they are clearly appropriate or adapted for business ends. The honest truckie who inadvertently overloads cannot deduct the resulting fine even though the income earned as a consequence of the prohibited act is fully taxable. The paid assassin, on the other hand, can deduct the cost of his bullets and depreciate the cost of his gun. The fines imposed on the directors in Magna Alloys were not deductible, but the costs of the unsuccessful defence were deductible, and the illegal commissions which were given to Magna's customers were deductible as an ordinary business expense. 48 In the Commissioner's submission the policy of the law is not served by allowing a deduction to the respondent under s 51(1) for a payment or loss of funds in acquiring or attempting to acquire a substantial supply of prohibited drugs through a drug dealing. If allowed, the deduction will be given for an outgoing or loss that is clearly and sharply prohibited by the declared criminal law. Also the respondent will have obtained an advantage out of his own criminal wrongdoing. It is implicit in this submission that had the $220,000 not been stolen, but applied in the purchase of drugs for resale, the proceeds of such resale would be assessable income, but the cost of acquiring the trading stock would not be an allowable deduction. The words which I have emphasised have their origins in decisions in the United States of America to which I now turn.

United States decisions 49 In the United States applicable provisions allowed a deduction for 'all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business …' IRC Ợ 162(a) (1988); IRC Ợ 23(a) (1939). In the United States, the Courts adopt a non-deductibility of fines and penalties rule, but do so on public policy grounds. An expense may be disallowed if its allowance would contravene sharply defined Federal or State policy. The test of non-deductibility is the severity and immediacy of the frustration resulting from allowance of the deduction. Frustration of State policy is most complete and direct when the expenditure for which deduction is sought is itself prohibited by statute. If the expenditure is not itself an illegal act, but rather the payment of a penalty imposed by the State because of such an act, the frustration attendant on deduction would be only slightly less remote and would clearly fall within the line of disallowance. Deduction of fines and penalties frustrates state policy in a severe and direct fashion by reducing 'the sting' of the penalty prescribed by the State Legislature: Tank Truck Rentals v Commissioner (1958) 356 US 30. For similar reasons a tax deduction is not available for the proceeds of drug smuggling forfeited to the government: Wood v United States (1989) 863 F 2d 417. 50 In Commissioner v Tellier (supra) the United States Supreme Court held that with only a few limited and well defined exceptions, the basic rule is that there is no difference between a lawful and an unlawful business so far as entitlement to a deduction is concerned. Thus in an earlier case of Commissioner v Sullivan (1958) 356 US 27 the Supreme Court sustained an allowance of a deduction for rent and wages paid by the operators of a gambling enterprise, even though both the business itself, and the specific rent and wage payments there in question were illegal under State law. In the United States, it is only where the allowance of a deduction would frustrate sharply defined national or state policies proscribing particular types of conduct that its disallowance has been upheld. Deductions claimed by taxpayers for fines and penalties imposed on them for violating State penal statutes have been disallowed, because to allow a deduction in those circumstances would directly and substantially dilute the actual punishment imposed. 51 In 1982 the Internal Revenue Code was amended by the inclusion of s 280E which denies credits and deductions for 'any amount paid or incurred during the taxable year in carrying on any trade or business [that] … consists of trafficking in controlled substances …'.

Canada 52 In 65302 British Columbia Ltd v R [1999] 3 S.C.R 804 the Supreme Court of Canada allowed as a deductible expense an over-quota levy incurred by a taxpayer in respect of its egg-producing hens. Iacobucci J (Gonthier, McLachlin, Major and Binnie JJ concurring) rejected the proposition that the deductions of fines and penalties should be disallowed as being contrary to public policy. As a general principle, it is for Parliament, and not the Courts, to decide which expenses incurred for the purpose of earning business income should not be deductible. At par [56] Iacobucci J said: '… I note that in calculating income, it is well established that the deduction of expenses incurred to earn income generated from illegal acts is allowed. For example, not only is the income of a person living from the avails of prostitution liable to tax, but the expenses incurred to earn this income are also deductible: Minister of National Revenue v. Eldridge, [1964] C.T.C. 545 (Can. Ex. Ct.). See also Espie Printing Co. v Minister of National Revenue, [1960] Ex. C.R. 422 (Can. Ex. Ct.). Allowing a taxpayer to deduct expenses for a crime would appear to frustrate the Criminal Code; however, tax authorities are not concerned with the legal nature of an activity. Thus, in my opinion, the same principles should apply to the deduction of fines incurred for the purpose of gaining income because prohibiting the deductibility of fines and penalties is inconsistent with the practice of allowing the deduction of expenses incurred to earn illegal income.' 53 Of course the Canadian and American taxing statutes follow a different form from the ITAA, and whilst Iacobucci J referred to Australian cases, including Mayne Nickless, he did not find them helpful given the differences in the applicable taxation statutes. The converse is also true.

Whether the policy of the law disentitles the taxpayer to a deduction in relation to the $220,000 54 It may well be that if an unlawful business was assessed on its income, and not permitted a deduction for its expenses, that persons would be deterred from engaging in an unlawful business, rather than in one which is lawful (although there is an element of unreality inherent in this proposition). To that extent the policy of the law in proscribing 'drug dealing' (to use a general term) may not be supported by allowing a deduction for, eg, the cost of acquiring trading stock in the form of prohibited drugs so as to enable the business of drug dealing to be maintained. 55 But the purpose of the ITAA is to tax taxable income, not to punish wrongdoing. The language of ss 17, 25, 48 and 51 of the ITAA is indifferent as to whether the income, loss or outgoing in question has its source in lawful or unlawful activity. Tax is imposed upon taxable income, not upon assessable income. There should not be a higher burden of taxation imposed on those whose business activities are unlawful than that imposed in relation to lawful business activities. Punishment of those who engage in unlawful activities is imposed by the criminal law, and not by laws in relation to income tax. 56 The ITAA specifies what deductions are allowable against assessable income. As a general principle it is for Parliament, rather than the Courts, to determine whether a loss or outgoing otherwise falling within s 51(1) should not be deductible on public policy grounds or otherwise. Section 51(4) affords an example of Parliament so prescribing. Sections 26-52 and 26-53 of the Income Tax Assessment Act 1977 (Cth) provide a further example. The effect of those sections is to deny any entitlement to a deduction in relation to bribes paid to public officials subject to the qualification, in the case of foreign officials that 'facilitation payments' (as defined in s 26-52(4)) are excluded from the notion of a bribe. The 'fine-tuning' which is inherent in this qualification is probably not something which could have been undertaken by a Court. 57 There is a rule, perhaps anomalous, that if taxable income is derived from unlawful activities, or from lawful activities pursued in an unlawful manner, fines, penalties and forfeitures imposed by the criminal law are not to be taken into account in the computation of taxable income. One explanation for this rule is that these punishments are imposed by law, and are, by their nature, outside the expenses of trading. That explanation involves a conventional application of s 51(1). Another possible explanation for the rule is that the general terms of the ITAA will not be construed so as to diminish or lighten the impact of any punishment imposed upon the taxpayer or others by virtue of other laws. That explanation may involve public policy considerations, and was the basis on which Ormiston J denied a deduction in Mayne Nickless for fines and penalties paid by the taxpayer but which had been imposed on its servants or contractors. I am content to assume, with respect, that the decision of Ormiston J was correct in this respect, as the thrust of the taxpayer's submissions was to distinguish that decision, rather than to challenge its correctness. 58 However, the existence of the rule to which I have referred does not lead to the conclusion that if the $220,000 had been applied in the purchase of drugs, that monies expended to acquire trading stock for the drug dealing business would not be deductible because of public policy considerations. The position is no different where the $220,000 was lost in the circumstances earlier described. The position would be otherwise if the loss was sustained by reason of forfeiture imposed by judicial decision or by operation of law. Allowance of a deduction for expenses incurred or losses sustained in the conduct of the drug dealing business does not frustrate the operation of the criminal law, nor will any sanction imposed by that law be diluted by the allowance of a deduction for business expenses or losses. Allowance of a deduction does not amount to a condonation of the taxpayer's activities. 59 Nor does the rule support the implication into the ITAA of an unexpressed qualification that a deduction otherwise authorised by s 51(1) will be denied if allowance of the deduction would frustrate federal or state policies proscribing particular types of conduct, however sharply defined. Insofar as the American authorities go beyond denying a deduction for expenditure incurred in meeting fines and penalties, or losses incurred as a result of forfeitures occurring by operation or force of law, then the American position goes beyond the position reached in Australian case law. 60 On one view of the matter, there may be a tension or inconsistency between the question which the primary judge posed at par 84 of his reasons (see 18 above), and the process of reasoning by which the primary judge reached his conclusion, and in particular par 97 of those reasons (see 19 above). Whilst I agree with what his Honour says at par 97 of his reasons, if and insofar as par 84 might suggest that some broader or more general enquiry is appropriate, then for the reasons already given, I would respectfully disagree. 61 The Commissioner submitted that one test for determining what may come within the public policy to disallow deductions may be seen from the policy expressed in s 3E of the Taxation Administration Act 1953 (Cth). By that provision the Commonwealth legislature has identified a class of offences which it defines clearly and sharply. In the Commissioner's submission, the occasion of the loss claimed by the taxpayer falls squarely within that class of offence. This submission should be rejected, as there is no relationship between the construction and operation of s 51(1) of the ITAA, and specific provisions of the Tax Administration Act which relax the operation of secrecy provisions which would otherwise bind the Commissioner. 62 Accordingly, the Commissioner's submission that the taxpayer is not entitled to a deduction in relation to the $220,000 because the policy of the law is not served by allowance of the deduction claimed, fails. 63 The Commissioner advanced other submissions as to why the requirements of s 51(1) were not met. The submissions were briefly put, with minimal elaboration. They are as follows.

The occasion of the loss was a proscribed crime 64 The Commissioner submits that the theft of the money did not occur in the gaining or producing of assessable income. The theft occurred in an illegal attempt by the taxpayer to effect an illegal transaction. The submission should be rejected, as it is inconsistent with the AAT's factual finding that the taxpayer was carrying on a business of dealing in drugs.

Not incurred 65 The taxpayer says that he intended to purchase $220,000 worth of prohibited drugs on the night, but instead the 'deal' turned out to be a set-up by other criminals who intended to rob the taxpayer of his money and succeeded in doing so. In these circumstances the Commissioner submits that there was no legal and commercial transaction for which the loss was 'incurred in gaining or producing of assessable income'. 66 This submission should be rejected for the same reason. The fact that the taxpayer was engaged in an illegal activity when the loss was sustained does not negate the fact that the loss was incurred in connection with the taxpayer's business of dealing in drugs.

Not a loss 67 The Commissioner submits that the loss by theft is not a loss for the purposes of s 51(1). A loss is 'a residual item arrived at after taking into account all relevant debits and credits'. In this case there was no payment out by the taxpayer of any sum and no computation: EHL Burgess Pty Ltd v Federal Commissioner of Taxation (1988) 19 ATR 1407 at 1414. In oral submissions, Counsel for the Commissioner accepted that this submission was inconsistent with the decision of the High Court in Charles Moore, and would not be one which the Court was likely to accept. It is rejected for that reason. There is nothing in the AAT's decision which would support a contention that any part of the monies stolen were recoverable from the unknown persons who were responsible for the theft.

Capital or capital nature 68 The Commissioner submits that any loss which may have been incurred in gaining or producing assessable income of the respondent was a loss on capital account and therefore precluded from deductibility under s 51(1) of the Act. Whether money has 'come home to the taxpayer so as to form part of [the taxpayer's] capital resources' (Charles Moore (supra) at 351) is essentially a factual question. 69 For the reasons earlier given under the heading 'The deductibility of a business loss arising by theft', this submission is rejected.

Findings of fact made with no evidence or insufficient evidence 70 The Commissioner submits that on the relevant material before it, the AAT was required to conclude that there was no evidence, or insufficient evidence that on the night in May 1995, $220,000 of the respondent's money had been in his physical possession and had been stolen from him during an intended drug deal directly connected with carrying on his drug dealing business. The consequential finding that the AAT was required to make was that there was no established factual basis upon which it could apply s 51(1) of the Act to allow a deduction of the alleged loss of the $220,000. 71 The AAT had before it direct evidence from the taxpayer that the sum of $220,000 was stolen from him on the night of 19 May 1995 whilst he was attempting to buy two kilos of amphetamine to replenish his dwindling stocks of 'speed'. It also had before it statements provided by Mr and Mrs Mahoney to the Australian Federal Police in relation to the robbery. Those statements repeat what they were told by the taxpayer in that respect, but were supplemented by observations of the movements of parties on the night and the physical state of the taxpayer at the end of the night. The statement of Mr Mahoney, in particular, describes the part which he played in connection with the attempted drug purchase on the night in question. Mr and Mrs Mahoney gave evidence before the AAT, but were not cross-examined in relation to the alleged robbery. 72 The contest before the AAT was not as to whether the $220,000 was stolen from the taxpayer in the circumstances which he recounted, but whether the funds stolen were his. The AAT did not believe the taxpayer's evidence in this respect. The AAT was 'of the opinion that the taxpayer's evidence cannot be relied upon as on a number of occasions he seemed to change his evidence when he thought that by so doing it would assist his case'. Nonetheless, the AAT accepted the taxpayer's evidence and that of his son-in-law, Mr Mahoney, that the money was stolen during an intended drug purchase in which Mr Mahoney had some personal involvement. The AAT was entitled to accept this evidence notwithstanding its earlier observations as to the general unreliability of the taxpayer's evidence. There is no legal error, or illogicality in proceeding in that way. That is particularly so as our attention has not been drawn to any cross-examination of the taxpayer, or of Mr or Mrs Mahoney in relation to the evidence which they gave as to the circumstances of the theft.

Conclusion 73 The appeal should be dismissed with costs.

Context 74 In the proceedings before the AAT, the taxpayer relied upon an affidavit which had been sworn by him in connection with an appeal against his conviction to the Court of Criminal Appeal, Supreme Court of Western Australia. In that affidavit, the taxpayer asserted that the source of the $220,000 which was stolen from him in May 1995 was monies provided to him by two NCA or AFP officers, Messrs Brewer and Coombes, which the taxpayer buried in his garden until it was dug up for use in connection with the attempted drug purchase. 75 The AAT records oral evidence given by the taxpayer that the $220,000 cash stolen during the year ended 30 June 1995 was not the taxpayer's money, but was money provided to him by the Australian Federal Police (when he alleges he was acting as an agent provocateur). The AAT also records a submission by the taxpayer that the $220,000 dug up from the taxpayer's backyard in May 1995, and later stolen, was not and never was his money, but belonged to the AFP so he should not be assessed on it, and in any event, he should receive a tax deduction for the sum stolen. 76 The AAT found that the amount stolen was money which the taxpayer had accumulated as the proceeds of his drug dealing. The AAT preferred the evidence of the taxpayer's son-in-law, Mr Mahoney to that of the taxpayer in regard to the origin of the stolen sum of $220,000. 77 The AAT referred to comments made by the Court of Criminal Appeal (WA) in relation to the taxpayer's affidavit referred to above. The Court said that the affidavit, if true, did not describe a controlled operation with a view to the identification and arrest of persons engaged in drug dealing with the applicant. Rather, the affidavit described illegal activity on the part of both the taxpayer and the AFP officers although the Court emphasised the officers concerned had deposed that the taxpayer's allegations are completely untrue. 78 The AAT made the following finding [984]: 'No independent evidence, which would enable any contrary conclusion about the taxpayer's activities involving members of the police force, has been presented and the Tribunal adopts the conclusions of the Court of Criminal Appeal above. The taxpayer has not satisfied the Tribunal that he was dealing in drugs as an agent. The affidavit (A1) is clear admission that the taxpayer was dealing in drugs. In his oral evidence, the taxpayer admitted being actively involved in drug dealing from some time in 1993.' 79 Neither Mr Brewer nor Mr Coombes was called to give evidence before the AAT. As it was the taxpayer's case that the source of the funds stolen in May 1995 was monies provided to him by these gentlemen, rather than the accumulated proceeds of his own drug dealing, then clearly the evidence of these gentlemen was at least potentially relevant. Whether it would have assisted the taxpayer may be quite a different question, particularly having regard to the observations of the Court of Criminal Appeal that the officers concerned had deposed that the taxpayer's allegations, as made in his affidavit, were completely untrue.

Taxpayer's contention 80 The taxpayer contends that he was denied procedural fairness by the AAT because he was not given a proper opportunity to call evidence from Messrs Brewer and Coombes to support his contention as to ownership of funds assessed to him, and because he was not corrected in what is said to have been a misapprehension on his part that material which he provided to the AAT had been admitted into evidence. 81 The taxpayer requested the AAT to issue a summons to bring Messrs Brewer and Coombes before the AAT to give evidence. It was put to the AAT by Counsel for the Commissioner that this may involve cutting across an anti-corruption commission inquiry which was then considering the content of the taxpayer's affidavit. At 633, the AAT gave its decision in relation to this aspect of the matter. The AAT announced its decision to the taxpayer, who was appearing for himself, in the following terms: '… the Tribunal is not prepared to issue a summons to bring Brewer and Coombes to the Tribunal. We have agreed to admit your own affidavit in the evidence, it's a sworn affidavit and you say in that what you want to say and we don't believe that it would warrant the cost and difficulty for the Tribunal and it's a rare occasion when we call a witness ourselves. If you wish to call them and issue a summons and organise the service of the summons on them, which would have to be personal service wherever they are, and pay their attendance money then you can seek that sort of a summons. MR LA ROSA: Well, perhaps - perhaps I can bring the sworn affidavits in with me when - next time we --- THE D. PRESIDENT: You can try and do that if you wish but your own affidavit covers --- MR LA ROSA: OK, that's fine. Yeah, if that covers it that's fine. THE D. PRESIDENT: --- and its primary evidence of what you are trying to say. MR LA ROSA: Yeah. THE D. PRESIDENT: I'm not saying that we are accepting your credibility or not in the affidavit but it's primary evidence and that's what you're putting before us. …' 82 The taxpayer presented the AAT with an affidavit by Mr D W Brewer sworn 4 March 1998 which was marked for identification '1'. That affidavit is not in evidence either before the AAT or before this Court, hence I do not know what it says. The transcript of the proceedings before the AAT suggests that the affidavit may have had something to do with the supply of money by the NCA to build an amphetamine factory. Marked for identification '3' was a summary of conclusions of J MacKaay, the Assistant Commissioner of Professional Standards. Again this document is not in evidence but the transcript of the proceedings before the AAT suggests that it may bear upon the question of whether the police were active in misconduct by supplying money and drugs. 83 The AAT declined to receive these documents into evidence upon the basis that the documents did not 'add anything to anything'. During the course of Mr La Rosa's closing submissions to the AAT he referred to these documents as if they were part of the evidence. 84 The primary judge rejected the taxpayer's complaints in relation to the failure on the part of the AAT to call Messrs Brewer and Coombes to give evidence on the basis that the probabilities are that their evidence would not have made any difference to the AAT's finding as to the taxpayer's lack of credibility, having regard to the reasons given by the AAT for its conclusion in that respect. With respect, to approach the matter in that way involves the application of the wrong test. If there was a denial of natural justice, it is sufficient if the error could have affected the outcome of the case: Bridges v Minister for Immigration & Multicultural Affairs (2001) 114 FCR 456 at [10]; Gibson v Repatriation Commission [2000] FCA 739. In the case of breach of the rules of natural justice, relief will normally be granted except where it is clear that the breach did not affect the outcome: Re Refugee Review Tribunal, ex parte Aala (2000) 204 CLR 82 per Gleeson CJ at [4], per Gaudron and Gummow JJ at [56] - [60], [79] - [81], per McHugh J at [104], per Kirby J at [172], per Callinan J at [211]. Whether the evidence would have affected the outcome is essentially a matter of speculation. 85 The primary judge also rejected the taxpayer's complaints in this respect on the ground that even if the AAT made a procedural error in not proceeding in the manner for which the taxpayer now contends, the truth of the statement made by the taxpayer in his affidavit does not affect the taxpayer's financial interests because a deduction was allowed for the $220,000. 86 Even if there has been a procedural fairness error on the part of the AAT, the truth or otherwise of the taxpayer's assertion as to the source of the $220,000 does not affect his income tax liability because of the allowance of a deduction for the stolen funds. A matter is not remitted to the AAT if it would be manifestly futile to do so: Arnott v Repatriation Commission (2001) 106 FCR 83 at [36], [1] and [2]. If the AAT were to accept the taxpayer's assertions as to the source of the $220,000 whilst that sum would be excised from his assessable income for the 1995 financial year, a necessary consequence would be a disallowance of the deduction which the AAT allowed for the corresponding amount. There would be no financial benefit which could accrue to the taxpayer from a remitter. Remitter to the AAT in these circumstances would be an exercise in futility. 87 In any event, I am not persuaded that the AAT was guilty of a denial of natural justice in either of the respects for which the taxpayer contends. The AAT made it plain that it was not receiving the documents marked for identification into evidence for reasons which it gave, and which have not been shown to be erroneous. The AAT made it plain that whilst the AAT was not prepared to assume the responsibility for calling Messrs Brewer and Coombes to give evidence, the taxpayer could do so if he wished. The taxpayer did not seek to pursue that course. 88 The taxpayer was not legally represented before the AAT, and at the time of his appearance before the AAT was serving a sentence of imprisonment. However, it has not been shown that the AAT improperly erected any barriers which prevented the taxpayer from putting forward relevant materials for consideration by the AAT. 89 The cross appeal should be dismissed with costs. I certify that the preceding seventy-seven (77) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Hely.

Counsel for the Appellant: Mr G Pagone QC, Mr L Price

Solicitor for the Appellant: Australian Government Solicitor