Hadrian Fraval Nominees Pty Ltd and Commissioner of Taxation [2013] AATA 127 | Case summary

Hadrian Fraval Nominees Pty Ltd and Commissioner of Taxation [2013] AATA 127 | Case summary | Zoe

[38]

Hadrian Fraval Nominees Pty Ltd (HFN) registered with the Industry Research and Development Board (R & D Board) (now called Innovation Australia and referred to as AusIndustry) a project entitled Environment Friendly House using Hybrid Lighting and ASP Biometric Intruders System for the 2004 income year and a continuation of that project referred to as Solar Transmission into Buildings in the 2005 income year. The purpose of this registration was for HFN to obtain income tax concessions in accordance with s. 39AA of the Industry Research and Development Act 1986 (IRD Act). That section of the IRD Act states the objects of Part IIIA are to complement the tax incentives provided by sections 73B, 73BA and 73I of the Income Tax Assessment Act 1936 (ITAA 1936).
In its 2004 income tax return which was lodged with the ATO on 13 October 2004, HFN claimed a research and development tax offset in the amount of $224,862.90. In its 2005 income tax return, HFN claimed a tax offset in the amount of $174,118.00.
The Commissioner of Taxation (the Commissioner), in accordance with s. 39L of the IRD Act, requested the R & D Board provide to him a certificate stating whether the particular activities which had been carried on by HFN during the income years in question were research and development activities. On 5 December 2007 AusIndustry notified the Commissioner and HFN that the activities undertaken by HFN under the registered projects did not satisfy the definition of research and development activities in s. 73B (1) or 73B (1AB) of the ITAA 1936. On 18 December 2007 HFN lodged requests with AusIndustry seeking reconsideration under s. 39S of the IRD Act. In a letter dated 22 August 2008 AusIndustry notified the Commissioner that it had affirmed its original decision. HFN then lodged an application with the Administrative Appeals Tribunal (AAT) for review of AusIndustry's decision pursuant to s. 39T of the IRD Act.
HFN's application for review before the AAT was resolved with the Tribunal making the following consent decision on 15 September 2009:
1. the decision of the respondent dated 12 August 2008 be set aside and there is substituted for that decision a decision that:
2. the following activities undertaken by the applicant in the 2003-04 to 2004-05 years of income in the project entitled "Environment Friendly House using Hybrid Lighting and ASP Biometric Intruder System" (the Project) satisfy the definition of research and development activities as defined under s 73B(1) of the Income Tax Assessment Act 1936 (the Act):
  - (a) Activity 1: Acquire a licence to use nanotechnology and complete the R & D of the product (1 July 2003 to 30 June 2005);
  - (b) Activity 5: Produce a collector to efficiently introduce light into light guides (1 July 2003 to 30 June 2005);
  - (c) Activity 6: Produce an azimuth controller of the collector (1 January 2004 to 30 June 2004); and
  - (d) Activity 7: Testing and optimisation of System (1 July 2003 to 30 June 2005);
3. the following activities in the Project do not satisfy the definition of research and development activities under s 73B(1) of the Act:
  - (a) Activity 2: Acquire the right to use Intranet platform and integrate the system;
  - (b) Activity 3: Acquire the right to use Facial Recognition biometrics and incorporate into the system; and
  - (c) Activity 4: Acquire the right to smart-house controller and integrate into the system;
4. the following technology, acquired by the applicant for use in the Project, in the 2003-04 to 2004-05 years of income, satisfies the definition of core technology under s 73B(1AB) of the Act:
  - (a) technology embodied in US Patent 6,983,093B2 ("Fluid Light Guide having hydrophobic aerogel cladding layer") acquired from Translight LLC on or about 8 July 2003; and
  - (b) technology embodied in patent application 2002951376 ("Lighting System") assigned by Rofin Australia Pty Ltd to the applicant on or about 24 July 2003;
5. within 21 days of this decision, the respondent shall issue a certificate to the Commissioner of Taxation stating that the activities listed herein at para 2 are research and development activities; and
6. within the 21 days of this decision, the respondent shall issue a certificate to the Commissioner of Taxation stating that the technology listed herein at para 4 is core technology.
After receiving the determination made by AusIndustry under s. 39S of the IRD Act and upon completing an audit, the Commissioner notified HFN on 23 January 2008 that its 2004 income tax return had been adjusted to remove the research and development tax offset claimed and to increase the carry-forward losses resulting from the research and development deduction. The result was to increase HFN's carry-forward losses to $236,487.00 as at 30 June 2004. It also provided a notice to HFN seeking repayment of $225,563.99 paid to HFN on 23 November 2007 as a result of the incorrect offset claim. On 1 February 2008 the Commissioner also issued a notice of assessment and liability to pay a penalty in the amount of $168,647.15.
In addition, on 10 September 2008 the Commissioner notified HFN that its claim for the R & D tax offset for the 2005 income year was disallowed. The Commissioner also notified HFN that it was liable for a shortfall penalty in accordance with s. 284-75 of Schedule 1 of the Taxation Administration Act 1953 (the TAA). The Commissioner issued an income tax adjustment sheet disclosing that the R & D expenditure claimed in the amount of $272,016 had been disallowed on the grounds that it was ineligible. The tax offset claimed in the amount of $174,118 was not available and was therefore reduced to nil. The Commissioner issued a notice of assessment and liability to pay a penalty of $106,101 for the 2005 income year on 24 September 2008.
On 18 November 2009 the Commissioner issued notices to HFN under s. 73IA (1) of the ITAA 1936. Section 73IA (1) provides that the Commissioner may give to an eligible company a written notice specifying the amount of a tax offset allowable to the company under s. 73I. The notices stated that the tax offset allowable to HFN for the 2004 and 2005 income years was $0.
On 19 November 2009 HFN lodged with the Commissioner an Objection to the s. 73IA Notices for the 2004 and 2005 income years in accordance with s. 14ZW(1AAA) of the TAA. Section 73IA (2) of the ITAA 1936 provides that if an eligible company is dissatisfied with the notice, it may object in the manner set out in Part IVC of the TAA.
On 16 April 2010 the Commissioner issued HFN with Notices of Objection Decision for the 2004 and 2005 income years. These decisions of course took into account the Consent Decision made by the Tribunal on 15 September 2009 regarding activities which satisfied the definition of research and development activities under s. 73B (1) and those activities which satisfied the definition of core technology under s. 73B (1AB). Regarding the 2004 income year, the Commissioner found that HFN was not entitled to choose the R & D tax offset pursuant to s. 73I of the ITAA 1936. The Commissioner found that the expenditure did not meet the requirements of s. 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) as an allowable deduction. A penalty at the rate of 25% was imposed on the tax shortfall for the 2004 income year. As for the 2005 income year, the Commissioner found that HFN was only entitled to choose the R & D tax offset under s. 73I of the ITAA 1936 for consultancy expenses in the amount of $53,548. The Commissioner again found that the remaining expenditure did not meet the requirements of s. 8-1 of ITAA 1997 as an allowable deduction. He imposed a 25% penalty on the tax shortfall amount.
HFN's claimed R & D expenditure for the 2004 income year totalled $599,633 which was made up in accordance with the following table:

[57]

An eligible company can choose a tax offset instead of a deduction under ss 73B, 73BA, 73BH or 73Y. Section 73I provides:
- (1) An eligible company can choose a tax offset instead of a deduction under section 73B, 73BA, 73BH or 73Y for year of income (the "tax offset year") if it is eligible to make that choice (see section 73J).
- (2) The choice must be made in the company's return of income for the tax offset year.
- (3) The eligible company's tax offset for the tax offset year is 30 cents for each dollar that the company could, apart from subsection (4), deduct for that year under section 73B, 73BA, 73BH or 73Y.
- (4) An eligible company cannot deduct any amount under section 73B, 73BA, 73BH or 73Y for the tax offset year if it chooses the tax offset for that year.
As Dr P Bender of counsel, who appeared on behalf of HFN, submitted, the effect of choosing a tax offset rather than a deduction means that an eligible company may, where it would have been entitled to 125% deduction, be entitled to receive a refundable tax offset calculated by multiplying 30% (0.30) by 125% (1.25) which results in a refundable offset of 37.5% of eligible expenditure. The refundable tax offset rules are set out in Division 67 of ITAA 1997. In essence, a taxpayer may get a refund of tax offsets that are subject to the refundable tax offset rules if the total of those offsets exceeds the amount of the income tax that the taxpayer would have to pay if he or she had not got those tax offsets (s. 67-30 of ITAA 1997).
To be eligible for a tax offset, the eligible company must satisfy s. 73J of ITAA 1936 which provides:
- (1) An eligible company is eligible to choose the tax offset for the tax offset year if:
  - (a) it could, apart from subsection 73I(4), deduct an amount under section 73B, 73BA, 73BH or 73Y for that year; and
  - (b) its aggregate research and development amount for the tax offset year exceeds $20,000; and
  - (c) the aggregate research and development amount for the tax offset year of the company and of taxpayers with which it is grouped (while they are grouped in that year) is not more than $1,000,000; and
  - (d) the R&D group turnover of the company for that year is less than $5,000,000.
- (2) An eligible company is not eligible to choose the tax offset for the tax offset year if an exempt entity, the affiliates of an exempt entity, an exempt entity together with its affiliates, or 2 or more exempt entities, at any time during the tax offset year, legally or beneficially own, or have a right to acquire, the legal or beneficial ownership of:
  - (a) interest in the company that carry between them the right to exercise, or control the exercise of, at least 25% of the voting power in the company; or
  - (b) interests in the company that carry between them the right to receive at least 25% of any distribution of income or capital by the company.

[63]

Dr Hadrian Fraval, who is a director and shareholder of HFN, made a witness statement dated 11 October 2011 in which he set out in some detail the research and development activities of HFN in the income years in question. Dr Fraval is also the managing director and a shareholder of Rofin Australia Pty Ltd (Rofin).
Dr Fraval explained that Rofin is a company which specialises in building light sources which have forensic applications. During the 1990s, Rofin also started making liquid light guides for use with their forensic lights.
As Dr Fraval explained, a light guide is a glass or plastic tube filled with a high refractive index liquid or solid. When light is focused on the end of the tube, it is transmitted along its length due to the differential refractive index between the tubing and the core material. Refraction is the bending of light when it enters into a type of medium in which it changes its speed. It is bent when it moves from a medium in which it travels at a faster speed (for example air) into a medium in which it travels at a slower speed (for example water) resulting in internal reflection at the interface between the two materials.
The amount of light which is reflected depends on the refractive indexes of the two mediums through which the light passes. The refractive index is calculated by dividing the speed of light in a vacuum by the speed of light when it is travelling through the particular medium. Light is reflected when it hits the boundary of a lower refractive index medium at a sufficiently steep angle. There is a particular angle at which total reflection occurs. This is the principle on which liquid light guides function. The liquid in a liquid light guide has a high refractive index compared to the tubing. The light travels from the high refractive index of the liquid to the lower refractive index of the tubing creating a bending of the light. This bending enables light to be reflected along the length of the tubing. It travels down the tubing in this way.
In about 1996 an American company called Fibreoptic Technology Inc (FTI) was making glass fibre light guides. Rofin and FTI formed a joint-venture to conduct further work on light guide technology. A joint-venture limited liability company was formed in America which was called Translight LLC (Translight). Rofin and FTI each owned 50% of the shares in Translight upon its formation. Subsequently, Dr Fraval's brother, Mr Hanafi Fraval, who was also working on the light guide project in America for Translight, was given a 5% shareholding in Translight.
In 1996 Translight conducted experimental work on light guides. Its work included using different core materials for the light guides with a particular type of polymer tubing called tetra fluoro ethylene hexafluoro propylene (known as FEP tubing). Although FEP tubing is very expensive, it is the only polymer with a sufficiently low refractive index to cause the light to travel long distances along the tubing.
From about 1998 Translight conducted experiments involving cheap Ionimer tubing which had an internal zinc-based formulation. The zinc coating made materials adhere to the tube more easily. Translight experimented with different coatings placed on the inside of the Ionimer tubing to create a skin of air by coating the inside of the length of tubing with a substance called aerogel to trap air and lower the refractive index of the tubing. Aerogel is a silica gel with unique properties.
According to Dr Fraval, in 1999 FTI offered to buyout Rofin's 50% shareholding in Translight. In the course of negotiations, Rofin exercised its option to buy out the shares held by FTI by making a slightly higher offer than that made by FTI. FTI was required by the joint-venture agreement to accept Rofin's offer. Rofin purchased FTI's shareholding in Translight in about June 2000 although Hanafi Fraval retained his 5% shareholding.
Dr Fraval testified that after the Translight buyout, no further activities were conducted by Translight in America. The directors of Rofin arranged for all of Translight's records, inventories and other equipment to be shipped to Australia from America in late 2000. Included in the materials which were shipped from America to Australia were coils of Ionimer tubing coated with aerogel. The total weight of tubing shipped from America to Australia was said to be 1197 pounds.
In 1998 or 1999, Rofin together with an unrelated company, Poly Optics Australia Pty Ltd (Poly Optics), conducted a project in Hong Kong which involved installing light guides produced by Poly Optics. Those light guides did not have liquid core, but rather had a solid acrylic core. Some 120,000 metres of polymer light guides produced by Poly Optics were installed in the Hong Kong building. According to Dr Fraval, Rofin and Poly Optics became involved in a dispute over costs and that was eventually resolved by commercial arbitration although Rofin's financial resources were depleted by the dispute. It resulted in Rofin ceasing research work with aerogel coated light guides and instead focused on making medical application products.
Dr Fraval said that in early 2003, he decided to focus on a project using light guides in his spare time. He planned to use HFN as the vehicle to conduct research and development on this project.
Dr Fraval said that his project was aimed at developing an environmentally friendly lighting system for residential houses that used solar technology for lighting in daytime and conventional lighting at night. The project was combined with a biometric security system. He said that one of the major objectives of the project was to produce light guides and light collectors in combination which would have a low cost. His aim was to use low-cost tubing coated with aerogel to make light guides and for those light guides to operate in conjunction with the newly designed light collector.
Broadly, Dr Fraval said the system was designed to have a light collector which would be installed on the roof of the house. It would focus sunlight into a light guide which channelled light to a distribution box. The distribution box would feed the light into a number of other light guides, transporting the light into different rooms around the house. It was proposed that a device called a holographic diffuser would be placed at the end of the light guide so that light rays were spread in a number of different directions to light the entire room.
Prior to entering upon the project, HFN needed to obtain a licence from Translight to use its Patent regarding fluid light guides having a hydrophobic aerogel cladding layer. It entered into an agreement with Translight whereby it paid a total licence fee of US $75,000. The fee was said to be for use of the patent over a three-year period.
To conduct the project, HFN needed to use Translight's Ionimer tubing coated with aerogel. The licence fee agreement between HFN and Translight included the acquisition of part of the stock of Ionimer tubing which at that time was held at Rofin's premises. Dr Fraval said HFN purchased additional Ionimer tubing from Translight in the 2005 income year at a cost of $166,246. HFN also acquired a patent held by Rofin which was described as a Lighting System Patent. This patent was apparently assigned to HFN for the nominal sum of $1.
According to Dr Fraval, he commenced work on the project in about July 2003. HFN did not employ any other persons on the project and he worked during evenings and at weekends at his home. That work essentially involved developing a light collector and the light guides.
Dr Fraval constructed a prototype light collector which was a lens/mirror combination. It was designed to track the apparent movement of the sun, due to the earth's rotation, so that light remained focused on the light guide throughout the day. However, the azimuth controller, which was designed to track the apparent movement of the sun, became too complicated for use in buildings and was not practicable. It was subsequently abandoned. In 2004 Dr Fraval experimented with a Fresnel lens on a frame which he had constructed. In early 2005 he experimented with the light collector by fitting it to the roof of his house.
In July 2003 Dr Fraval said that he also worked on light guides which would transfer light from the collector throughout the house. He used the Ionimer tubing which was then stored at Rofin's business premises in Dingley. He simply took lengths of tubing as he needed them for experimentation. After about five or six weeks Dr Fraval said he realised there were problems with tubing lengths beyond 2 metres. He could not get the light to travel beyond about 2 m and a 10 m length of tubing would produce no light at all. He also had difficulty in producing consistent lighting with the shorter lengths of tubing. He identified one of the problems as the unevenness or roughness of the aerogel coating on the inside of the tubes. This caused him to seek the assistance of a consultant, Mr Michael van der Matten.
Dr Fraval said he knew Mr van der Matten from his time when he worked in Spain. He had previously told Dr Fraval that he had a background in coating materials and knowledge and experience with material coating problems. Dr Fraval said he told Mr van der Matten that HFN could only afford around £5000 - £6000. Apparently Mr van der Matten was then domiciled in the United Kingdom and said he wanted to be paid in pounds sterling. Later, in September 2003, Dr Fraval said that Mr van der Matten sent HFN an invoice for £14,350 for his consultancy services and he agreed that HFN should pay that amount. Mr van der Matten ceased to be involved in the project in about February or March 2004.
Dr Fraval said that he experimented with various techniques to improve the smoothness of the aerogel coating up until early 2005. In around February or March 2004, he decided to experiment with solid core polymer light guides instead of liquid light guides which he had been using up until that time and which did not work. He contacted Mr Edmond Joseph of Poly Optics seeking his assistance to conduct some testing of the Ionimer tubing using a solid core polymer. Some of the tubing held at Rofin was shipped to Poly Optics' premises in Queensland in 2004. The remainder of the tubing was shipped to Poly Optics by the end of 2004, other than a small amount which Dr Fraval said he kept in Melbourne for his own experiments. Mr Joseph conducted a number of tests on the Ionimer tubing, filling it with a polymer core. He regularly sent pieces of the tubing which he had filled to Dr Fraval so that he could analyse the results. The majority of the work conducted by Mr Joseph was in the 2004 calendar year. Testing had completely ceased by the end of the 2005 income year at which time HFN did not own any tubing which had not been used for experimentation. Once the tubing was used for experimentation, it was not able to be sold commercially.
In about mid-2003 Dr Fraval also spoke with Mr Ian Bennett who then had a company called Licere Nominees Pty Ltd. Licere later changed its name to R & D Consulting Pty Ltd (R & D Consulting). In July 2003 R & D Consulting entered into a contract with HFN for the provision of assistance with the project. A key element of R & D Consulting's work was to research and test the incorporation of light guides and the light collector into the building panels of a building. R & D Consulting was at that time apparently involved in building constructions using a product called a Scallan Wall. It was planned to build conduits within the Scallan Wall panels of the building so that light guides could be fed through the conduits into different rooms in a house. It appears that in about early 2004, there were misgivings about using a Scallan Wall and prefabricated wall panels from another company were being considered. According to Dr Fraval, R & D Consulting managed and subcontracted the design, research, development and testing of the integration of the light guides and light collector into these wall panels.
HFN received an invoice for $55,000 from R & D Consulting for the 2004 income year in accordance with its agreement. It received two further invoices in 2004 for the amounts of $137,609.80 and $80,854.92.

[72]

The definition of research and development expenditure, to which I have referred above, uses the expression expenditure incurred. Also, s. 73B (14), which deals with an allowable deduction, refers to where an eligible company incurs research and development expenditure....
Putting aside for the moment issues regarding the nature of the claimed activities themselves, the Commissioner contended that that HFN did not in fact incur materials, licence and consultancy services expenditure in the course of its research and development activities, principally because HFN's liability was conditional or contingent and therefore HFN was not, as a practical matter, definitively committed to that expenditure. As to other expenditure, the Commissioner contended that HFN had failed to substantiate the contested items of purported expenditure.
Mr Evans submitted that the meaning of the word incurred as it is used in s. 73B has the same meaning as the courts have given to the same term in the former s. 51 (1) of the ITAA 1936, and subsequently to the successor provision, s. 8-1 of the ITAA 1997. He summarised the principles as follows:
- (a) an outgoing in the form of an undischarged liability can qualify for deductibility if it has fallen due in the relevant year of income, even though it may not be paid until a later year (Federal Commissioner of Taxation v Citylink Melbourne Ltd [2006] HCA 35; (2006) 228 CLR 1 at 36-38, a decision of Crennan J with whom Gleeson CJ, Gummow J, Callinan J and Heydon J agreed; Coles Myer Finance Ltd v Federal Commissioner of Taxation [1993] HCA 29; (1993) 176 CLR 640 at 662-663; Nielsen Development Laboratories Pty Ltd v Federal Commissioner of Taxation [1981] HCA 6; (1981) 144 CLR 616 at 623 (... there can be no warrant for treating a liability which has not "come home" in the year of income, in the sense of a pecuniary obligation which has become due, as having been incurred in that year.); Federal Commissioner of Taxation v James Flood Pty Ltd [1953] HCA 65; (1953) 88 CLR 492 at 506);
- (b) the critical question is whether the taxpayer was, as a practical matter, definitively committed or completely subjected to discharge the liability in the future (Citylink at 37 referring to the judgement of Deane J in Coles Myer at 670-671);
- (c) a liability will not have been incurred if some condition affects its coming into existence (Crennan J in Citylink at 40-41);
- (d) apart from merely theoretical contingencies, which, for practical purposes, can be treated as certain to be satisfied, an undischarged liability affected by a contingency will not give rise to one which can be said to have been incurred (Coles Myer at 670-671; Citylink at 37-38; James Flood at 507-508); and
- (e) there must be a presently existing [enforceable] liability, although actual payment might occur only at some uncertain time in the future (Citylink at 38).
Generally, Dr Bender agreed with Mr Evans regarding what is meant by the expression incurred in relation to expenses for research and development activities. He submitted that an expense is incurred when a present liability to pay the money has come into existence, or in other words, the taxpayer has become "completely subjected" or "definitively committed" to the liability. An expense can be incurred even when it has not been paid.
Dr Bender submitted that the Commissioner's contention that the expense was not incurred was in fact a contention that the expense did not exist. He disputed that contention and submitted that the books kept by the company, particularly its financial records, are prima facie evidence of what is contained in those documents. He referred to s. 1305 (1) of the Corporations Act 2001 which deals with the admissibility of books in evidence. It provides:

[87]

With respect to Mr van der Matten, the above description is unhelpful, surprisingly so considering the substantial cost invoiced to HFN. It was left to Dr Fraval to provide further details of the work conducted by Mr van der Matten. According to Dr Fraval, he began discussions with Mr van der Matten about coating problems with tubing soon after those coating problems arose in July or August 2003. He said he explained to Mr van der Matten that the project involved collecting light using a light collector on a house roof which would feed the light into light guides for distribution around the house. Apparently Mr van der Matten immediately told Dr Fraval that he should look at the encasement of the light collector made out of glass fibre reinforced cement (GFRC). According to Dr Fraval, there were problems with integrating a light collector on a house roof because roofing tiles could expand and contract which might result in damage to the light collector.
Mr van der Matten sent to Dr Fraval what he described as materials demonstrating what GFRC could do and how it could be used to integrate a light collector into the roof of a house. Dr Fraval attached to his witness statement those materials which comprised a number of photographs depicting the use of GFRC in a number of applications, although none included a light collector. They also included a number of schematic drawings showing a solar collector panel (possibly a photovoltaic panel) attached to a water storage unit which appeared to have no relevance at all to the research and development activities being conducted by Dr Fraval. Included amongst the materials is a guide which is intended for persons involved in the production of GFRC for an entity described as Cem-Fil and a number of papers dealing with various aspects of GFRC. None of these papers deal with light collectors. Dr Fraval claimed that the work involved in integrating a light collector into the roof of the planned environmentally friendly house related to Activity 5 of the R & D plans.
With respect to Dr Fraval, he seems to have conflated the project which he described as the Environment Friendly House with an eligible activity. The word project is defined as_: to plan, contrived or design (something to be done, or some action to be carried out)_ while the word activity means: the state of being active; the exertion of energy, action... anything active (The Shorter Oxford English Dictionary). Section 73B of ITAA 1936 makes it clear that the benefits of the tax incentive are targeted by being limited to particular expenditure on certain defined activities.
I find nothing in the invoice provided by Mr van der Matten or the documents attached to Dr Fraval's witness statement which relates to Activity 5. That Activity is the production of a collector to efficiently introduce light into light guides. Nor, for that matter, does it appear to relate to Activity 6 which, it will be recalled, was to produce an azimuth controller for the collector. In fact, logically and practically, until the design and structure of the collector and an azimuth controller (if that were to be used) had been finalised, there was no purpose whatsoever in undertaking any analysis of the kind of material which might be used in the roof of the house to permit stable and secure instalment of those devices.
Although Dr Fraval also said that Mr van der Matten gave assistance regarding the aerogel coating and problems having that adhere effectively to the tubing, there is no evidence from Mr van der Matten regarding this problem. Other than Dr Fraval's very general statement about discussing the aerogel coating with Mr van der Matten, there was no evidence that this activity, if it is in fact an activity, would satisfy the description of Activity 1. The evidence does not permit me to find that Mr van der Matten made any contribution to Activity 1.
I should also mention that although Dr Fraval approached Mr van der Matten for the purpose of giving evidence at the hearing of this matter, he declined to do so. Furthermore, the description used on the invoice said to have been issued by Mr van der Matten on 8 September 2003 refers to engineering services. There was no evidence before me which indicated that engineering services of any kind were provided to Dr Fraval. While I accept that the description on the invoice may be overly general in nature, given the fee of £14,350 (A$39,625), it is not unreasonable to expect a far more detailed and accurate description of the work conducted.
In the course of cross-examination, Dr Fraval was asked whether Mr van der Matten provided him with any material which documented the work he performed. Dr Fraval answered by referring again to the GFRC product and the fact that its use would allow the collector (the Fresnel lens) to be supported by a non-metallic substance. As for the aerogel coating on the inside of the Ionimer tubes, Dr Fraval said: and the second part of what he offered was his background. Dr Fraval said Mr van der Matten had knowledge of coating and that he could bounce ideas off him to improve the coating of the tubing. When asked again specifically regarding the use of GFRC whether there was any direct reference by Mr van der Matten to the use of that material for the purposes of developing, or housing, the collector, he answered: This is background information, which is to show the use of this material in applications similar to what I would call a roof solar collector, but it's - there is not anything specifically about my collector in it.
Dr Fraval confirmed that Mr van der Matten did not consult to HFN on anything other than housing the solar collector and the light guides. When it was put to him that there was no specific reference to either of these matters in the invoice issued by Mr van der Matten, Dr Fraval said: Well, solar tile is exactly what I was making. It's exactly the descriptive of incorporating a solar collector in the tiles of a house. It's exactly what I was doing.
With respect to Dr Fraval, Activity 5 refers to the production of a collector, not its installation in a building. As I have already said, any questions about installation in a building would only arise following the construction of a properly functioning collector. Logically, there was no purpose in even examining this material at this early stage of research because the size and shape of a properly functioning collector and an azimuth tracking device could not be determined in advance. In fact, as it transpired, Dr Fraval was never able to make this light collection system function. If the claimed expenditure was in fact incurred as a consequence of Mr van der Matten's consultancy (and I make no finding about that), it was not expenditure incurred directly in respect of the research and development activity described as Activity 1 or Activity 5.

[93]

I should also point out that Schedule B is in a different font to Schedule A, and it does not contain a page number at the top of the page as do all of the other pages in the contract. In the course of his cross-examination Dr Fraval was asked whether both Schedule A and Schedule B were attached to the contract when it was executed. He said that to his knowledge they were. Mr Evans then referred Dr Fraval to Schedule B of the contract and in particular the statement indicating that draft drawings were attached. He was asked whether he recalled drawings being attached to the contract when it was signed, and he answered no. When asked who produced the drawings, he said they were produced by somebody that Mr Bennett had engaged, a draftsman from his company. He also agreed that Dr Bennett gave him the drawings after R & D Consulting had been engaged by HFN. Mr Evans then asked Dr Fraval how come it was that if the drawings were given to him by Mr Dr Bennett after his engagement, that schedule formed part of the contract on the date was signed. Dr Fraval responded by stating that those were subsequent drawings and he did not believe that the drawings were attached at the time of the contract because he did not recognise them as such. He added: And it doesn't make sense for him to have made drawings before we even had a contract. I mean, there was no possible way that he could have made the drawings on the work and then had a contract. It just doesn't make sense.
Dr Fraval's attention was drawn to the fact that the page containing Schedule B was not numbered and he was asked if he could provide an explanation for that. Dr Fraval said he could not. The apparent disconnect between Schedule B and Schedule A becomes obvious when one looks at the detail contained in each. Putting aside the references to biometric access and security systems which are not the subject of HFN's claim following the agreement reached on 15 September 2009, Schedule A refers to R & D Consulting having an association with the building company, DTC Construction, which it was said would assist with the implementation of the light guide technology. According to Dr Bennett, R & D Consulting subcontracted the design and development work on the Scallan Wall, which was to house the light guides, electrical wires and other systems used in the building, to DTC Constructions. Schedule B makes no reference to the biometric access and security systems but simply refers to the solar collector and light guide system. Furthermore, it refers only to Ladyhill Pty Ltd (Ladyhill) and 7 Stars Building Products Pty Ltd (7 Stars) as the entities he intended to use to assist with the incorporation of the solar collector and light guide into a low cost building system.
In his written statement, Dr Bennett testified that the initial plan for the building project was to use the Scallan Wall to integrate light guides into a building. However, the Scallan Wall concept was abandoned in about 2004 when this form of construction failed. At that time, DTC Constructions was involved in a project on Glenferrie Road, Malvern. According to Dr Bennett, it was then (about 2004) that R & D Consulting engaged sub-contractors to begin experimentation with another type of fibreglass wall. He said that R & D Consulting managed this phase of the project and sub-contracted the design, development and testing work to the 7 Star group and to Mr Steven Morgan as the engineer. The statement made in Schedule B that the incorporation of the HFN solar collector in the light guide into a low cost building system would initially be done with Ladyhill and 7 Stars is plainly something which was not contemplated in 2003 when the contract was said to have been made. According to Dr Bennett, this only occurred following the failure of the Scallan Wall project.
The drawings attached to the contract referred to in Schedule B also contain a number of anomalies. Despite the evidence given by Dr Fraval and Dr Bennett that the initial concept envisaged a concrete wall (Scallan Wall) and later, after the contract had been entered into, a modified fibreglass wall, the drawings depict a 4 mm thick render system over a 50 mm extruded polystyrene outer cladding fixed to a timber stud wall. Furthermore, although Dr Fraval referred to Mr van der Matten's glass fibre reinforced concrete roofing, the drawings refer to Colorbond roofing, which is a metal product. In fact labels on the drawings are also inaccurate, for example, where reference is made to extruded polystyrene, on the same drawing different sections of the wall are pointed to.
It is fair to say that nothing in the contract provides me with any confidence that the parties involved contracted at arm's length and that the development of the collector and light guides had reached the stage where any realistic work could have been done by way of research and development involving the incorporation of this equipment in a house. This in turn raises serious questions about the invoices rendered by R & D Consulting to HFN and the payment of those invoices.
Despite what was contained in the contract, it appears R & D Consulting issued two invoices to HFN, the first on 4 November 2004 in the amount of $137,609.80 inclusive of GST; and the second on 30 November 2004 in the sum of $80,854.92 inclusive of GST. Both invoices contain the same statement of work carried out which is as follows: Consultancy and project management in relation to your development of natural sunlight into buildings including integration into kit buildings. According to Dr Bennett, there was a further invoice in the amount of $110,000 which R & D Consulting issued to HFN in September 2004. Dr Fraval makes no mention of that invoice in his witness statement. The description of work conducted by R & D Consulting on that invoice states: Research and Development carried out on your behalf as per our Agreement. Dr Bennett said in his witness statement that this invoice was in respect of the light guide project. He said he could not recall the details of how the amount on the invoice was calculated. However, he said he believed that this invoice was subsequently withdrawn and replaced by the two invoices referred to by Dr Fraval.
In his witness statement, Dr Fraval said that HFN received an invoice for $55,000 from R & D Consulting in the 2004 income year. He said HFN no longer had a copy of that invoice. He said that the invoice had not been paid by 30 June 2004 but was subsequently paid by way of a set-off of liabilities in about the 30 June 2006 financial year. That in itself is contrary to clause 5.16 of the contract which provides that unless expressly provided otherwise, a party had no right of set-off against payment due to another party. No explanation was given for disregarding this clause in the contract.
Dr Fraval said in his witness statement that Poly Optics, R & D Consulting, HFN and Rofin each had amounts owing between themselves during that year. He said he also had amounts owing to him personally from Rofin as well as amounts from HFN. He then said the $55,000 owed to R & D Consulting by HFN was paid as part of the set-off arrangement between Poly Optics, R & D Consulting, HFN, Rofin and himself. He said he did not understand the accounting details of how the set-off arrangement was implemented. In his witness statement Dr Bennett said that around that time, R & D Consulting was doing research and development work for Poly Optics. He said Poly Optics owed R & D Consulting money and he understood there was a relationship between Poly Optics and HFN. He then said: I recall that somehow an offset was done of the $55,000 amount owed by HFN to R & D Consulting in relation to amounts that were owed between HFN, Poly Optics and R & D Consulting. I do not recall details of how the offset was done.
Dr Bennett was cross-examined on his understanding of the set-off arrangement for the payment of the $55,000 invoice. He said he believed that R & D Consulting owed money to Poly Optics. HFN owed money to R & D Consulting. He then said: That's - that's and I am trying to explain here that - and in a clumsy way that I don't recall the details of how that offset was done. When it was pointed out to Dr Bennett that in his witness statement, he said that R & D Consulting was doing research and development consulting work for Poly Optics and that in fact he had previously stated that Poly Optics owed R & D Consulting money, he said that was incorrect and that his statement was the wrong way round. At this point Dr Bender pointed out that Mr Sachlan Fraval, another of Dr Fraval's brothers, who was an accountant, provided a better explanation of the set-off in his witness statement.
Mr Sachlan Fraval lodged with the Tribunal a witness statement which was admitted into evidence. He set out in a table the amount of money owed by one entity to another amongst Rofin, Poly Optics, HFN and R & D Consulting. He recorded that Poly Optics owed some $102,000 to R & D Consulting; HFN owed some $58,000 to Poly Optics; and HFN owed $55,000 to R & D Consulting. In describing how the set-off worked, Mr Sachlan Fraval said that the $55,000 debt and invoice from R & D Consulting was settled against the amount payable in the Poly Optics books to R & D Consulting. In his witness statement Dr Fraval said that Poly Optics was an unrelated company. The resultant is simply that Poly Optics' debt to R & D Consulting was decreased by $55,000.
In his witness statement Dr Bennett also said that R & D consulting started out charging HFN the $55,000 amount but subsequently found that the actual cost of the project was significantly higher. He said agreement was reached with HFN to charge the actual costs for subsequent invoices. Dr Bennett referred to the two invoices issued in November 2004 and said that those amounts were for work conducted by R & D Consulting in relation to the light guide project. Dr Bennett did not refer to biometric access and security systems.
In the course of cross-examining Dr Fraval and Dr Bennett, Mr Evans attempted to obtain a more precise description of the work conducted by R & D Consulting for which the invoices subsequently issued. However, despite significant effort, very little was achieved. In my opinion, this goes to the heart of the problem regarding whether expenditure said to have been incurred by HFN for consultancy services provided by R & D Consulting should be allowed by the Commissioner. Rather than reciting the entire cross-examination, I have selected a number of the more significant passages which clearly illustrate the problem.
When Mr Evans pointed out to Dr Fraval that the contract between HFN and R & D Consulting services provided for the payment of $55,000 per year and nothing further, Dr Fraval said: That's correct, and this is over and above the terms of that agreement. When he was asked why he did not go back to Dr Bennett referring to the contractual amount, he said: Well, I could have done, and I am sure I did discuss the amount of money, because it was considerable, and the opportunity was, in my opinion, worth paying for. He was then asked what he was paying for with respect to the $137,000 amount. Dr Fraval said: I was paying for the opportunity to put the collector and light guide into a number of buildings that were scheduled to be built. When asked what the specific project was, he said: My recollection was it was a project in Shepparton. Dr Fraval was then taken to the second invoice in the amount of $80,854.92. He was asked to explain what he recalled about his reaction to that invoice. He said: So this is the same. It's just a follow on from the previous invoice and it's for the same activity, but in addition to it. Dr Fraval was asked whether he asked for a breakdown of either of those invoices and he said he did not.
In the course of his re-examination Dr Fraval was referred to the $55,000 contractual payment and asked what services would be provided for that in a general sense. He said: They were - they were going to assist me in finding - and as - as they did with the - the collector house, into the house, into the wall scenario we talked about earlier on. But they were also going to find for me partners or companies that could help me with doing other aspects of the - the house, or the envisaged house, which was both a security-related thing, and a energy efficiency related project. But obviously, as it turned out, they only were - were really involved in the - the building side of it.
Dr Bennett's cross-examination was confusing and unenlightening. He confirmed that at the time HFN was conducting its research and development activities on the light collector and light guides, R & D Consulting was working with the Scallan Wall construction for DTC Constructions and with Ladyhill, although he was not certain about whether the 7 Star group had been formed at that time. He said: It was our idea to initially to try to get it - the lighting into the Scallan Wall project, and then later we decided we would like to put it into the fibreglass panelling. Dr Bennett confirmed that the Scallan Wall project was disastrous for R & D Consulting and cost it a lot of money. When asked about the nature of the project concerning DTC Constructions, he responded: It - as I recall there was [sic] seven townhouses in Toorak, south - in Malvern East, near the corner of Glenferrie Road and High Street, Malvern Road area. And it was the first experiment that I know of, certainly in Melbourne, of the Scallan Wall technology, which was - originated in Brisbane, in Queensland. When asked to describe the nature of the work that R & D Consulting did for DTC Constructions, Dr Bennett said: We - we were bringing the technology development from a fellow called Patrick Scallan in Queensland to DTC Constructions to actually build one of these new type of buildings in East Malvern. That was the role. And because it was semi-experimental, we thought it was an ideal opportunity to try and bring in the conduits and see if we could address light as well as things like electricity and other services that were being provided through the Scallan Wall, because if the walls are built without that being taken into account, then all the labour saving goes out the window because you then have to re-drill for the services to go through that new wall.
When he was referred to the decision made in 2004 to cease using the Scallan Wall for the purposes of the light guide, Dr Bennett said: And, like, we had real engineering problems with Scallan Wall. The walls started to buckle, and we had to make corrective engineering measures to correct it. He was then asked whether it was correct to say that when R & D Consulting's contract with HFN commenced, the work for the light guides into the building was all done with the Scallan Wall, he responded: Yes, except we were - we kept waiting and waiting and waiting for Mr Fraval to deliver the product. We - we had, sort of, made allowances for things and, unfortunately - I can't explain why. I can't even remember why, but I know there were huge delays which became quite embarrassing to us because we had workmen on the site and it was a difficulty. Dr Bennett was then referred to the biometric access and security system which formed part of the project. When he was asked whether that was part of HFN's project, he said: It all gets very confusing. There's a biometric high security technique that was being developed, I believe, by Rofin, who are connected to HFN, and I can't recall which of the entities was dealing with the biometric security, but it was to do - I know it was adopted in police forces and a number of players around the world.
Finally, Mr Evans explained that what he was trying to understand by his cross-examination was what HFN got for its money. He asked whether the fee paid to R & D Consulting by HFN included work in relation to the Smart home wireless, whole-house technology and he responded: Yes and no. The "yes" is that it's in the package that they're joining the group, but "no" in the sense that it's, kind of, incidental from HFN's point of view. What they were interested in is the work that the engineers were doing in relation to the conduits and the gels, and things like that, that we - that we reported on. And, of course, we did prepare reports, none of which mention any of the other technologies. They're only related to the light guides.
According to Dr Fraval, in 2004 R & D Consulting's work on the wall panels slowed down and the work was never finished because he was never able to give Dr Bennett any working light guides to test in the wall panels. Despite this statement by Dr Fraval, Dr Bennett said in his witness statement that: Some initial experiments were done using Scallan Wall. In cross-examination Dr Bennett was asked whether HFN had ever provided to R & D Consulting a working light guide and he responded: I believe our people did, but I - I never received one myself. But I know that I was on several occasions asked to give him a call and see where they were. When again asked that question in cross-examination, Dr Bennett said_: Look - look, what you're asking are the specifics, and that - that was all handled by the engineers, not by me. I - I was the office jockey. You know, I'm - I'm in the background. I can't recall ever getting one myself, but I do believe that some of our team did get the light guides eventually, but it was a very frustrating time for them_.
When the Scallan Wall project was abandoned, Dr Bennett said that R & D Consulting engaged subcontractors to begin experimenting with another type of fibreglass wall. In his witness statement Dr Bennett said there was significant design and experimentation conducted on the fibreglass walls from about 2005. There were difficulties with this method in being able to get the light guides to successfully transmit light through a wall. He said various experiments were done with designs and materials used in the walls. For example, acrylic conduits and propylene conduits were experimented with as the conduits that would house the light guides in the wall panels. Glass polymer reinforced cement was also trialled as part of the experimentation process. He said the research and development of this part of the HFN project was conducted in Geelong by subcontractors of R & D Consulting. Dr Bennett said R & D Consulting's subcontractors built around three or four prototypes. The prototype wall panels had conduits integrated for the light guides. Despite all of that, Dr Bennett then said: R & D Consulting and its subcontractors had enormous difficulties caused by delays in waiting for working light guides from HFN and Hadrian Fraval. We needed the working light guides to be able to test the prototype wall panels that were built with integrated conduits for the light guides.
Attached to Dr Bennett's witness statement were three documents described as Reports 1, 2 and 3. The reports are undated but were signed by Dr Bennett. These reports were said to have been reports provided to HFN during the course of the project which were prepared by R & D Consulting in conjunction with its subcontractors.
Report 1 states that R & D Consulting had evaluated the concept of creating conduits within the Scallan Wall house. The report does not say that any experimentation was conducted with the conduits which might house the proposed light guides. In fact, the report simply states: We have started to look at various systems for conduit formation.... The report refers to 3 systems of conduit formation; the split wedge, polypropylene or acrylic conduit, and polystyrene insert. The report simply explains what those systems are. In the penultimate paragraph, the report states: Obviously this work is dependent on getting the Aerogel light-guides in a timely fashion. Please advise when these will be sent to us. By way of confirming that no experimentation had been conducted with the insertion of conduit in the Scallan Walls, a report from DTC Constructions dated 31 December 2004 states, in its final paragraph: A range of conduits will be tested for strength and flexibility. Despite this evidence, in his cross-examination Dr Bennett said that experimentation with conduits was undertaken at the time the homes were being constructed at the Glenferrie Road Malvern location. This evidence is clearly inconsistent with the DTC Constructions report.
Report 2 appears to deal with the fibreglass walls. It stated that the split wedge conduit seem to work for short distances of 1 to 2 m but not with longer lengths and it was not the correct option to use. Similarly, problems were encountered with the polystyrene insert. R & D Consulting found that the polypropylene or acrylic conduit was suitable. In fact, what was used was 12 mm round thin-walled electrical conduit. It needed to be tested in terms of feeding the light guide through the conduit when R & D Consulting was able to get samples from HFN. R & D Consulting also considered another option, that being to create a channel in the inner wall surface allowing the light guide to be inserted directly into the wall and then to have the channel closed over with mortar filling to encase the light guide. With respect to Dr Bennett, the evaluation of these methods of inserting conduit to house light guides is rudimentary. Furthermore, it is clear that R & D Consulting had not received any light guides from HFN at this stage. Plainly, there could be no evaluation undertaken at this point in time. The statement dealing with the split wedge and polystyrene inserts conduit appears to be fabrication. Dr Fraval had not provided any light guides to Dr Bennett and therefore it could not have been possible for R & D Consulting to have conducted testing of any form of conduit. As Dr Fraval said in his witness statement: The work was never really finished as I was never able to give Ian Bennett any working light guides to test in the wall panels.
Report 3 opens by stating that R & D Consulting was still awaiting the receipt of light guides. It then stated: We understand you have encountered problems in producing longer lengths of the aerogel tubing. Please keep us advised on your progress. We are prevented from carrying out our experiments and design specifications until we physically trial feeding the light guides into conduits. The report also confirmed receipt of information regarding GRPC (glass-fibre reinforced polymer cement). It states that some initial investigations had been completed but it does not say what they were. The report concludes with the following: We are ready to do more on this project as soon as you can provide the light guides. We are stuck until you can provide them.
The total amount invoiced by R & D Consulting was $273,464.72 ($137,609.80 plus $80,854.92 plus $55,000). In cross-examination Mr Evans asked Dr Fraval if he asked Dr Bennett for a breakdown of the costs invoiced by R & D consulting. Dr Fraval said he did not. He said he simply accepted the costs proposed by Dr Bennett.
Logically, one would expect a serious and significant amount of experimentation to have been conducted given the amount invoiced by R & D Consulting. However, the evidence discloses that the most favourable view which can be taken of the work conducted by R & D Consulting is that three or four walls had conduit inserted for the purpose of carrying the light guides, if and when they were constructed by Dr Fraval. No breakdown of costs was provided by R & D Consulting. Furthermore, the evidence was that at least the $55,000 invoice was met by way of a set-off which, in the way it was explained by Dr Bennett and Mr Sachlan Fraval, was not in reality a set-off. The fact that Mr Sachlan Fraval was involved in preparing accounts not only for the Fraval related companies, but also other companies said to be independent of the Fraval family, is cause for grave concern. In my opinion, the evidence does not permit a finding that the expenditure Dr Fraval claimed was incurred by HFN for work conducted by R & D Consulting was in respect of or, for that matter, in any way related to, any of the Activities which it was agreed were research and development activities for the purposes of this claim.
Even if I am wrong about that, in my opinion it cannot be said that the activities which I have described above in respect of the R & D Consulting's consultancy role fall within any description set out under Activity 1, Activity 5, Activity 6 or Activity 7, being the agreed research and development activities for the purposes of HFN's claim. In its R & D plan, although not initially identified as systematic, investigative and experimental (SIE) or directly related (DR), in May 2007 it was agreed that Activity 1 and Activity 6 were DR activities while the other accepted activities were SIE. The significance of this is that the definition of research and development activities in s. 73B (1) includes SIE activities and other activities carried on for a purpose directly related to the carrying on of the activities described as SIE. Establishing a means of installing the collector and light guides in a house, whatever its form of construction, is not an activity which is directly related to Activity 5 or Activity 7 and therefore cannot be the subject of HFN's claim.
Although Dr Fraval explained to AusIndustry as early as December 2004 that he was developing a "smart" environmentally friendly house, he did not so much as suggested that any research and development was required regarding the installation of the light guides and collector system once that equipment was functioning. In fact, on the evidence before me it is safe to say that the collector and light guide system was being developed for the purpose of installing in any form of house, not simply houses constructed or purpose-built for using this technology. In a letter from HFN to AusIndustry dated 13 July 2005, which was in response to questions raised by AusIndustry in its letter of 10 June 2005, in identifying where each of the claimed R & D activities were undertaken, Dr Fraval answered:

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It is also of some interest to note that in the description contained in the patent there is a reference to the tubes being preferably long, continuous tubes of 50 to 100 feet and longer and about 5 - 14 mm in diameter.
In cross-examination Dr Fraval explained that the assignee of the patent, Enterprise Development Corporation, was Hanafi Fraval's company. Dr Fraval also explained that when Rofin purchased Translight, Translight assigned the rights under the patent to Rofin. However, an assignment document was not produced in evidence despite Dr Fraval indicating that it existed, subject to him finding it.
Dr Bender submitted that the Commissioner had made a suggestion that the aerogel patent was not held by Translight or was only issued in 2006.
As to the first point, Dr Bender submitted that Dr Fraval gave oral evidence that the aerogel patent was assigned to Translight from Enterprise Development Corporation which was Hanafi Fraval's company. Although Dr Bender then submitted that because it was not put to Dr Fraval that he was being untruthful about the assignment, it would amount to procedural unfairness if I were to find that there was no such assignment, this issue is not about procedural fairness. Rather, it is about whether Dr Fraval has discharged the onus of proving, on the balance of probabilities, that such an assignment took place. There are many possible reasons why Dr Fraval had formed the opinion that an assignment had taken place, not the least of which is the fact that he was of the view that Hanafi Fraval had agreed to the licence fee agreement purportedly made between HFN and Translight. For present purposes, I accept that there was such an assignment.
Dr Fraval testified that HFN entered into a contract with Translight on 8 July 2003. He said that the contract gave HFN a right to use the aerogel patent in return for a licence fee.
The agreement is an unusual document for a number of reasons. The cover sheet records that it is dated 8 July 2003. When one turns to the agreement itself, it purports to have been made on the [blank] day of [blank] 2004. Under the Definitions and Interpretation section, the Effective Date is defined to mean 7 July 2003. The parties to the agreement are said to be HFN (Licensee) and Translight Australia LLC (Licensor). The License (sic) is defined to mean the aerogel technology License for the development in bringing natural light into buildings. There is no reference to the patent held by Rofin unless one reads clause 4.1 (a) which contains a warranty to the effect that the patents have been assigned to Rofin. There is no explanation of what is meant by the expression the patents. Under the heading Grant Of License, clause 2.1 provides: The Licensor as legal and beneficial owner hereby grants to HADRIAN FRAVAL NOMINEES the licence fee as set out in clause 3.1 as and from the Effective Date upon the terms and conditions herein. This clause is unclear as one has to assume that the licensor in fact owns the patent rights. The reference to granting to HFN the licence fee makes no sense.
Clause 3 of the Agreement has the heading License Fee and Materials Cost. Clause 3.1 of the Agreement provides that HFN shall pay Translight a license fee of US$25,000 and materials currently held as Translight inventory in the sum of US$306,135 (sic). There is no explanation as to what the materials are which were held by Translight nor is there any definition of the word inventory. Clause 3.2 contains a reference to core technology but does not define what that means. There is no clause 3.3 as it appears to have been entirely deleted. Clause 3.4 provides:

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Clause 3.5 provides: The fee referred to in Clause 3.1 shall be paid on a one off basis.
Finally, the execution clause, while referring to THE Parties, only contains provision for signature by the authorised representative of HFN, and was apparently signed by Dr Fraval, but no provision for a signature by a representative of Translight.
Despite what is stated in the agreement regarding the licence fee, Dr Fraval said in evidence that the total licence fee was in fact US$75,000. He said there was a mistake in the contract. He said the contract should have said US$25,000 per annum. Dr Fraval said that during a visit from AusIndustry, he told the officer that the licence fee was US$75,000. He discussed that the amount should be written off over three years.
Dr Fraval was cross-examined at length about this statement. When asked whether he made a claim for US$75,000, Dr Fraval said that after discussing the matter with AusIndustry, the claim was made for US$25,000 which was for the first of the three years. Dr Fraval said that he had intended to alter the agreement document after it was brought to his attention, but he did not do so. With respect to Dr Fraval, it is not simply a matter of unilaterally altering an agreement between two legal entities, assuming of course that it is an agreement between two entities. There is also the added complication of what is set out in clause 3.5 of the agreement. When this was put to Dr Fraval in cross-examination, he said: The - the claim can only be done at 25,000 per year. The claim, as in - the AusIndustry/concession can only be claimed to 25,000 per year.
The explanation for this response is likely to be, as Dr Bender pointed out in his submissions, because the expenditure on this item was core technology within the meaning of s. 73B (1AB) of ITAA 1936. Section 73B (12A) deals with relevant core technology expenditure. It provides that where in the income year a company incurs research and development expenditure that is related to relevant core technology, there is an allowable deduction from the company's assessable income of the year of income so much of the amount worked out using the formula in subsection (12B) in respect of that core technology expenditure as does not exceed one third of the amount of that related research and development expenditure. However, that does not explain what is set out in clause 3.5 of the agreement.
When asked in cross-examination how he arrived at the $75,000 figure, Dr Fraval said it simply seemed reasonable to the three people involved, himself, Sachlan Fraval and Hanafi Fraval. Mr Evans then referred Dr Fraval to an invoice apparently issued by Translight to HFN dated 15 June 2004. The invoice is said to be for: license fees to use aerogel technology in the use of conveyance of natural light into buildings using fibre optics. The amount described as the licence fee is US$25,000 and the transfer of inventory to be used is said to be US$306,135. When asked who gave him this invoice, Dr Fraval responded: Sachlan Fraval.
In his amended witness statement dated 17 August 2012 Mr Sachlan Fraval referred to the licence agreement between Translight and HFN which appears to have been dated 8 July 2003. He said the document was prepared by Dr Fraval and that both he and Hanafi Fraval were given a copy of it. He said that Hanafi, Dr Fraval and he discussed the written document in a conversation during the 2003 calendar year, prior to the US$331,135 invoice being prepared by him. He also said that during those discussions, the three men each said that they agreed with the contents of the document. However, despite what was said by Mr Sachlan Fraval regarding who was responsible for drafting the 8 July 2003 document, in re-examination Dr Fraval was asked who agreed to that purported agreement on behalf of Translight and he said_: Hanafi and Sachlan Fraval_. When asked how they indicated their agreement, Dr Fraval said: They indicated their agreement by drafting this document.
Mr Sachlan Fraval was cross-examined about his statement regarding the written agreement. He was taken to paragraph 96 of his statement where he said that HFN purchased some aerogel tubing from Translight for US$306,135 during the 30 June 2004 year. He then said: HFN also agreed to pay a licence fee of US$75,000 to Translight for its use of the aerogel technology that was held by Translight. When it was pointed out to Mr Sachlan Fraval that the contents of the document with which he said all three men agreed said nothing about US$75,000 but only referred to US$25,000 and, furthermore, that clause 3.5 of the document said that the fee referred to in clause 3.1 would be paid on a one-off basis, he said: I don't agree - I don't recall that as being part of the discussions that we were talking about. So that - you're right, I would be confused if I was reading that, too, so. Mr Sachlan Fraval was also unable to provide an explanation for why the document appeared to state that the agreement was made in 2004.
I should also point out that attached to Mr Sachlan Fraval's amended witness statement was an invoice from Translight dated 15 June 2004 which appeared to be for the licence fee of US$25,000 and for the transfer of inventory in the sum of US$306,135. No explanation was given by Mr Sachlan Fraval for the issue of the invoice on 15 June 2004, almost a year after the parties purported to enter into the agreement. Nor was any explanation given for why that invoice issued when clause 3.4 of the agreement contemplated payment for the licence and inventory by way of a convertible note issued to the entity commercialising the rights to develop the product. While I accept that the purported agreement did not require HFN to pay the licence fee by issuing a convertible note, the structure of clause 3.4 of the licence agreement strongly suggests that payment would only occur following commercialisation of that developed product. In fact, in the course of Dr Fraval's cross-examination regarding a second invoice for aerogel tubing, he was asked how HFN intended to pay for that invoice. He said: Well, initially we had thought that we could pay it by - and it - well, in fact, Rofin wanted it that way -stroke Translight - that we pay by a convertible note, meaning that they would also have an involvement in the upside of what we did, and we were subsequently advised that it was not a good scenario in terms of the tax department, and it was later converted into a loan.
It is clear from the evidence that the licence fee of $75,000 only came about after discussions with AusIndustry and after the R & D claims had been made by HFN. It is sufficiently clear from the written document which was intended to set out the agreement between Translight and HFN that the licence fee was to be US$25,000. Clause 3.5 makes it clear that the amount was to be paid on a one off basis. Although Dr Bender submitted that the agreement was varied by oral agreement or that there was an oral agreement rectifying the previous written document, I cannot accept that submission given the sequence of events which occurred and the fact that clause 12.3 provides: This Agreement may be amended only in writing subscribed to by all parties.
I have no doubt that a contract can be varied by consent. I also have no doubt that a written contract may be varied by an oral contract even if a written contract contains a stipulation that it can only be varied in writing (see Cheshire and Fifoot's Law of Contract, Ninth Australian Edition, N C Seddon and MP Ellinghaus at 22.1 and 22.4). However a contract cannot be varied unilaterally but only by a further contract (see Gibson Motor Sport Merchandise proprietary Ltd v Robert James Forbes [2005] FCA 749 at [226], [248]). Moreover, as the authors of Law of Contract state, the existence of a contract of variation must be clearly demonstrated by reference to the usual rules of formation (at 22.3). While agreement must be established, and that may be inferred from conduct, consideration must also be established.
A comprehensive statement of the principles involved is set out in the decision of Finn J in GEC Marconi Systems Pty Ltd v BHP Information Technology proprietary Ltd [2003] FCA 50; (2003) 128 FCR 1. His Honour said, at 62:

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The agreement is said to be between Translight and HFN although there was no evidence before me other than the hearsay evidence of Dr Fraval and Mr Sachlan Fraval that Mr Hanafi Fraval, who Dr Fraval said was a director of Translight at that time, agreed to that arrangement. This is despite the fact that Mr Sachlan Fraval said in his witness statement that the licence fee was agreed to by Dr Fraval, Hanafi Fraval and himself at some time in the 2003 calendar year. Even if Mr Hanafi Fraval had agreed to the terms of the written document, there are more significant problems with this so-called agreement which render it unnecessary to resolve the quantum issue.
The document said to contain the agreement between Translight and HFN is, in my opinion, a document which was drawn up in 2004 and not 2003 as was stated. There is no other explanation for why 2004 appears as the year in which the agreement was made. The insertion of the 2003 dates in the agreement simply indicates that a later agreement drawn up in 2004 has been modified in an attempt to give the appearance of an agreement made on 8 July 2003. The conclusion I have reached that this document is a 2004 agreement which has been extensively modified to suit the purposes of the R & D claims is evident from the very poor editing which has made the document almost unreadable; and the reference to core technology in clause 3.2, an expression found in s. 73B of the ITAA 1936.
Perhaps the most significant problem facing HFN, at least with the written agreement between Translight and HFN, is the fact that the signature block at the end of the document only contains provision for the signature of a representative of HFN. This does not appear to be an inadvertent omission because immediately between the provision for signature by a representative of HFN and the end of the page on which it appears, there is a line drawn indicating the end of that document. In other words, the document never made provision for signature by the appropriate representative of Translight. Furthermore, although both Dr Fraval and Mr Sachlan Fraval gave evidence that Mr Hanafi Fraval agreed with what was contained in that document thereby evidencing an agreement between Translight and HFN, I had no evidence before me from Mr Hanafi Fraval to that effect. In fact, in the course of his cross-examination, Dr Fraval was asked who entered into the contract for Translight. He answered: Good question. He said he could not recall. However, his memory seemed to have improved by the time of his re-examination when he said that Hanafi and Sachlan Fraval agreed on behalf of Translight. There was no evidence before me that Mr Sachlan Fraval was a director or principal of Translight.
While it is clear from the evidence given by Dr Fraval under cross-examination that he understood that upon Rofin buying out the interests of FTI in Translight, the directors of Rofin became directors of Translight, the fact that Rofin and Translight were discrete legal entities appears to have escaped him, if he in fact drafted that document. While that may provide a reason for the single signature on the licence agreement, the document itself does not evidence a legally binding agreement between Translight and HFN. Furthermore, there was no evidence from Mr Hanafi Fraval which so much as suggested that he agreed to an oral variation of the first agreement if in fact there was such an agreement, nor was there any evidence of consideration having been provided for the varied agreement.
Dr Bender submitted that regardless of the problems which appear on the document described as a license agreement, it was either varied by oral agreement or there was an oral agreement rectifying the previous written document. He submitted that it was not the Tribunal's role to impugn the existence of an agreement by virtue of a lack of formality. He referred to a Tribunal decision in QFL Photographics Pty Ltd and Commissioner of Taxation [2010] AATA 758 at [41] - [49]. That was a case involving two related entities where the assets and liabilities of one entity were transferred to another and the transaction was evidenced from its financial records, including a journal entry.
Putting aside for the moment the problems of transferring (usually described as an assignment as was explained by Windeyer J in Norman v Federal Commissioner of Taxation [1963] HCA 21; (1963) 109 CLR 9 at 26) liabilities, Senior Member O'Loughlin said, at paragraphs [43] - [45]:

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While I accept Dr Bender's submission that it is not the Tribunal's role to dictate to an applicant the manner in which transactions ought be effected, the issue in this case is not lack of formality but rather whether the evidence supports the claim by HFN that it incurred liabilities in acquiring the licence and materials.
As to the passage I have quoted above, the Senior Member's reference to the so-called market value substitution rule or similar rules as an illustration of the manner in which parties entered a transaction or its terms is, with respect, incorrect. It does not go to whether legally enforceable obligations have been entered into. In fact, as he says in the extract I have quoted above, the Assessment Act substitutes values to be attributed to certain transactions where they cannot be said to have taken place at arm's length. It does not substitute legally enforceable obligations where none exist. Other examples may be found when dealing with the value of trading stock (ITAA 1997 s. 70-45) and for depreciation claims (ITAA 1997 Division 40).
I also have difficulty with Dr Bender's submission that an entry in the books of account of an entity constitutes the transaction itself. The books of account of an entity simply record a transaction. They are not evidence of a transaction. If that were the case, an auditor's role would simply disappear. Whatever is recorded in the books of account would be accepted at face value. However, reality is far from that. The very purpose of an audit is to ensure that all of the source materials used to record a transaction (ie evidence of the transaction) accord precisely with what is recorded in the books of account. By way of example, if a company records a $3000 balance in its cash account, an auditor should be able to go to a bank account statement and determine that its balance at the date recorded corresponds with the entry in the books of account. Put simply, the purpose of keeping financial records is to record the occurrence of each transaction which is undertaken by the entity. Without an underlying transaction, there can be nothing to record. Entries in accounts which have no apparent underlying source document are questionable and need to be examined very closely.
The key issue regarding the licence agreement is whether the evidence permits a finding, on the balance of probabilities, that HFN incurred expenditure in acquiring a licence to use the patented technology in the 2004 and 2005 income years. In the event that I am wrong about whether there was an enforceable written agreement between HFN and Translight regarding use of Translight's patent and for acquisition of the Ionimer tubing, for the purpose of the following analysis, I have assumed that HFN and Translight entered into an agreement in accordance with the terms stated in the 8 July 2003 document.
The High Court of Australia has on a number of occasions dealt with the concept of incurring expenditure in the context of deduction claims under s. 51 (1) of ITAA 1936 and s. 8-1 of ITAA 1997. I have already referred to those in paragraph [58] above. In the Coles Myer Finance case, the question which confronted the Court was whether bills of exchange and promissory notes issued by the applicant and sold at a discounted price resulted in the applicant incurring expenditure referable to the discount amounts on instruments which remained outstanding (in other words those bills which had not yet matured). The Court, following precedent, agreed that upon acceptance of each bill, the applicant became presently liable to pay the amount of the bill (its face value) on maturity. As for the promissory notes, upon receiving payment following the sale of promissory notes, the applicant immediately owed their face value although the amounts were not payable until the date of maturity. The plurality (Mason CJ, Brennan J, Dawson J, Toohey J and Gaudron J), after examining earlier authorities, said, at 663:

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The passage to which I have referred above where the plurality referred to the existence of a loss or outgoing being a loss or outgoing of revenue character is apparently derived from the Nilsen Development Laboratories case and of course from the fact that s. 51 (1) refers to ...losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, ... except to the extent to which they are losses or outgoings of capital or of a capital nature. This was made clear by McHugh J in the Coles Myer Finance case at 677, where he said: However, as I have already indicated, authority establishes that, for the purpose of s. 51 (1), a loss or outgoing is only incurred in the year of income if, during that year, the taxpayer has become liable to pay a pecuniary sum (39). Kirby J also referred to the fact that the taxpayer needed to be liable to pay a pecuniary sum in the Citylink case at 23 - 24, where he said: Deductibility is dependent on the fact that the taxpayer has become liable to pay a pecuniary sum (104). Although reasonably obvious, I should point out that the word pecuniary is defined in The Shorter Oxford English Dictionary as: 1. Consisting of money; exacted in money.
The 8 July 2003 agreement document provides that the licence fee of US$25,000 was payable from the Effective Date which is defined to mean 7 July 2003. However, as I have already said above, that document also provided that the licence fee may be paid by way of a convertible note, that is, in effect, converting a debt to equity in HFN. Included amongst the s. 37 documents was a letter from Translight to HFN dated 30 June 2004 which has the heading Convertible Note and which states: This is to confirm that Translight LLC is the holder of a convertible note in Hadrian Fraval Nominees Pty Ltd (or its commercialisation nominees).... The conversion to equity will be based on the amount of equity that the principal outstanding would buy as independently assessed in the entity carrying out the commercialisation if not Hadrian Fraval Nominees. The letter also refers to the amount of A$480,000 and interest at 6%. As Mr Sachlan Fraval explained in his amended witness statement, that figure was arrived at by converting the sum of US$306,135 and US$25,000 (US$331,135) into A$479,907.
Although Dr Bender submitted that any convertible note itself would have been a debt instrument, I cannot agree. He did not provide authority for that statement. In my opinion, a debt instrument is one which contains an obligation to pay money. The convertible note is plainly an instrument which converts an existing debt into equity. It carries no obligation to pay a sum of money, in fact it removes it.
In cross-examination Dr Fraval was taken to the 30 June 2004 letter dealing with the convertible note and he was asked what that document was. He answered: So this is the original version that we had intended to use for the payment, which is a convertible note from HFN to Translight, and this was later changed on advice to.... He said that document was drawn up by Sachlan Fraval and signed by him. When asked whether that note was issued by HFN to Translight, he said: I can't recall, to be honest. Yes. He was then asked whether the intention was to pay by way of convertible note and he answered: That's right.
In his witness statement, Dr Fraval said that the convertible note was issued by HFN during the 30 June 2004 year, the terms of which were signed by him on behalf of HFN and he referred to the document to which I have referred above. He said that the amount of the note was the equivalent of US$25,000 for the licence fee plus US$306,135 purchase price for the Ionimer tubing inventory. He then said that the convertible note was subsequently changed to a loan between HFN and Translight by agreement between those two parties. He said he could not recall the date on which the convertible note was changed to a loan. He said the loan asset held by Translight was subsequently transferred to Rofin at a time which, again, he could not recall.
In cross-examination Dr Fraval was asked when the change to a loan occurred. He said_: I cannot recall, exactly, the date of that - the change to a loan. But my memory was about 2005/6 - in that sort of time_. When asked how the change arose, he said: The change arose because of advice from somebody within the ATO, that this was not a method that they approved of, of payment for goods within the R&D tax concession regime. When asked to confirm that the agreement was changed to accommodate the

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R & D tax concession. He said he did his research sometime during the 30 June 2005 year. Mr Sachlan Fraval testified that he mentioned the problems to Dr Fraval who told him the convertible note should be changed to a loan. He then said: I believe that the "convertible" nature of the loan (sic) note was abandoned during the 30 June 2005 year by agreement between HFN and Translight that was made during discussions held between Hadrian, Hanafi and me. The note was ever (sic) converted into shares by HFN. I disclosed the $480,000 as a loan in the accounts of HFN for the 30 June 2005 year. 9. It should be apparent from the above that the evidence regarding the licence fee agreement purportedly made on 8 July 2003 was wholly unsatisfactory. It is unclear who drafted that document. However, accepting for the moment that there was such an agreement between Translight and HFN, then it would appear to be in the terms expressed in that document because, on its face, clause 12.3 provides that amendments can only be made in writing as agreed by all parties. Absent any evidence that Translight and HFN entered into an oral agreement for which consideration was given, I cannot conclude that the parties entered into an agreement to alter the terms of their written agreement so that the payment said to have been made by way of convertible note subsequently became a loan. Therefore, I cannot accept Dr Bender's submissions regarding oral amendments to those terms. Furthermore, I did not have in evidence any other document by which the terms of the purported agreement were amended. 10. The terms of the purported agreement clearly provided that payment of the licence fee as well as the cost of inventory may be made by way of a convertible note to any form of participation agreed. This of course is despite the fact that clause 3.1 of the document provides that the licence fee and the costs of inventory were to be paid from the Effective date. I understand that expression to mean that the US$25,000 and US$306,135 became due and payable on 7 July 2003 despite the fact that I have found the document was drafted in 2004. Putting aside that small problem, it is clear from clause 3.4 that if HFN issued a convertible note to Translight after July 2003, then the liability to pay the licence fee and the cost of inventory was extinguished. 11. On 30 June 2004 Dr Fraval signed a document on Translight letterhead paper as managing director of HFN acknowledging and agreeing that Translight was the holder of a convertible note in HFN. It appears that Dr Fraval treated that document as the convertible note because that was the evidence in his witness statement. While the document itself is plainly deficient as it appears to be open-ended with no conversion date noted, and the conversion broadly states that it will be to equity but does not set out, for example, any particular class of shares which would issue, there is no reason why that confirmation was not intended to extinguish HFN's liability to pay Translight the monetary sum for the licence fee and the cost of materials (tubing) it acquired. In fact, I find that it did. Therefore, as at 30 June 2004, it cannot be said that HFN was liable to pay Translight a pecuniary sum. It follows that at this point in time at least, it cannot be said that HFN incurred core technology expenditure in respect of the licence fee. 12. The evidence indicates that this problem was drawn to the attention of Dr Fraval and Mr Sachlan Fraval by Ms Beasley and Ms Van Gusen from the ATO. In his cross-examination Dr Fraval said: we were told this was not a preferred method that the ATO recognised. And, therefore, it was converted into a loan. In his witness statement Dr Fraval said he did not recall the date on which the convertible note was changed to a loan. In cross-examination, Dr Fraval said it was about 2005/6. Mr Sachlan Fraval said in his amended witness statement that he believed the convertible nature of what he described as the loan note was abandoned during the 30 June 2005 year by agreement made during discussions between Dr Fraval, Hanafi and himself. 13. There are other serious problems with the claims made by Dr Fraval and Mr Sachlan Fraval regarding the abandonment or change of the convertible note into a loan. Despite the letter of 30 June 2004 signed by Dr Fraval confirming that Translight was the holder of the convertible note, which, in accordance with the agreement, constituted payment and therefore discharge of any pecuniary liability to Translight, HFN nevertheless purported to treat the convertible note as a long-term loan from Translight. This is stated in the Commissioner's reasons for decision regarding the objection in respect of the 2004 income year which was issued on 18 November 2009. 14. Furthermore, attached to Mr Sachlan Fraval's witness statement is a number of what he described as reconstructed accounting records for the 2004 year. According to Mr Sachlan Fraval, Mr Christiansz, who was HFN's former accountant, had its records but following his conviction on fraud charges, HFN was unable to recover its documents. He said the accounts were reconstructed using some source documents and other information provided by Dr Fraval. He also said that an invoice was initially issued by Translight to HFN for the US dollar amount ($331,153) but that a second invoice was subsequently issued by Translight in the Australian dollar amount being $479,901. A copy of that second invoice was attached to his witness statement. However, curiously, although also dated 30 June 2004, the Australian dollar invoice in the amount of $479,907 refers only to the supply of coated fibre optic coils delivered to Poly Optics via Rofin Australia for use in natural sunlight research. There is no mention of the licence fee component which, according to the first invoice, is embedded in that sum. 15. As for the reconstructed accounts, they also contain anomalies. In the Statement of Financial Performance for the year ended 30 June 2004, if HFN incurred expenditure in acquiring the tubing material and the right to use the licence, one would ordinarily expect to see an expense item relating to the licence fee and the materials acquired by HFN. This is particularly so because Mr Sachlan Fraval and Dr Fraval maintained that the licence fee was payable annually in each of three years and the tubing material was intended to be consumed in the course of R & D activities. There is no such item in that statement. The explanation appears to be found in the General Ledger which is also a reconstructed document. In the account entitled Loan Translight, which is a liability account, there is a credit entry on 30 June 2004 for materials supplied in the amount of $480,000. Once again, there is no mention of the licence fee. The balancing entry (although short by $92.91 which appears to have been made up by adding this amount to one of the other entries in the General Ledger) is a debit in the amount of $479,907.09 on 30 June 2004 in an asset account called Environmental Home Development which is described as capitalised costs - materials used in R&D. In other words, that expenditure has been treated as the acquisition of a capital item. 16. If one then looks at the Statement of Financial Position as at 30 June 2004, which in fact is a Balance Sheet setting out the assets and liabilities of the company for the 2004 financial year, there is an entry described as Intangible assets in the amount of $479,907. It appears that, without any explanation, the capitalised costs of materials used in research and development, including the right to use the patent acquired by Translight, has become an intangible asset. The problem of course is that R & D expenditure, in order to attract concessional tax treatment, must be deductible against the revenue account. 17. Therefore, in my opinion, the attempt by Dr Fraval and Mr Sachlan Fraval to revive the pecuniary liability extinguished by the convertible note by converting the claimed liability of $480,000 into a capital item must necessarily fail. That expenditure is not deductible against revenue. In addition, it was a retrospective attempt to expunge from the agreement the convertible note clause because the ATO had subsequently advised Dr Fraval and Mr Sachlan Fraval that the claimed issue of the convertible note had removed the pecuniary liability of HFN to pay Translight the licence fee and for the materials it had acquired. It follows I must find that HFN did not incur core technology expenditure in acquiring the rights under the purported licence agreement. Accordingly, I need not determine whether the licence fee of US $25,000 was only payable on one occasion or whether that sum was payable in each of three years. 18. The considerations I have referred to above, save for the convertible note, apply equally to the 2005 income year where HFN claimed expenditure for the licence fee of $36,232. There is no such entry in the general ledger as at 30 June 2005. There was no other evidence of that expenditure having been incurred.

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Dr Bender submitted that the cost of the aerogel tubing would not be subject to a feedstock adjustment under the feedstock rules because no marketable or usable product was produced from the experimentation on the aerogel tubing. Nevertheless, and in the alternative, he submitted that the aerogel tubing was feedstock expenditure and would be deductible.
With respect to Dr Bender, I cannot accept his first submission but I do agree that claimed expenditure for aerogel tubing, if incurred, was feedstock expenditure and, to the extent that there is eligible feedstock expenditure, it is deductible. That is because on a careful reading of subsection (c) in the definition of research and development expenditure, it should be apparent that the other expenditure referred to is in respect of research and development activities and not the acquisition of materials. On the other hand, the definition of feedstock expenditure expressly refers to expenditure incurred in acquiring or producing materials or goods. It seems to me that the definitions set out in s. 73B (1) distinguish between the acquisition or production of materials used in R & D activities and other expenditure incurred in carrying out those activities. The reasons for this distinction are, essentially, as Dr Bender submitted. The R & D tax concession is limited to the net costs of feedstock by excluding from the concession the cost of any valuable products derived from processing or transforming that feedstock through R & D activities.
In this case, all of the R & D activities carried out in relation to the aerogel tubing did not produce a product of any value which could be sold. Therefore, the feedstock input exceeded the feedstock output by the claimed expenses in acquiring that tubing. If in fact those expenses were incurred in the income years in question, then that expenditure in its entirety would constitute eligible feedstock expenditure and hence fall under the definition of research and development expenditure.
In order to fully understand how HFN came to acquire the aerogel tubing, I need to set out some of the transactions which preceded this acquisition.
According to Dr Fraval, in about 1996 Rofin and FTI formed a joint-venture to conduct further work on light guide technology. At that time, FTI was making light guides which consisted of bundles of glass fibres. The joint-venture company formed was Translight. Although Dr Fraval said that Rofin and FTI each held 50% of the shares in Translight on its formation and that subsequently Mr Hanafi Fraval acquired a 5% shareholding in Translight, an agreement of sale document dated 11 July 2000 records that Rofin owned a 35% membership interest in Translight and the FTI Principals 60%. Presumably Mr Hanafi Fraval continued to hold his 5%.
In a letter dated 31 December 1999, the Principals of FTI wrote to Dr Fraval stating that they agreed to sell their entire membership interest to Rofin and Hanafi Fraval for US$400,000. This was because of their expressed concern about the future financing of Translight and that the possibility of future funding through an investment bank had not come to fruition. Rofin subsequently accepted that offer. The letter also contained a somewhat peculiar clause, which Mr Sachlan Fraval referred to as a put/call option, whereby if Rofin was unable or unwilling to accept the offer made, it would be deemed to have offered to sell its entire Translight membership interests to the FTI Principals on the same terms. In a letter dated 27 March 2000 Dr Fraval, on the behalf of Rofin, wrote to the FTI Principals indicating acceptance of the offer to sell.
The agreement of sale document discloses that the FTI Principals were prepared to sell their 60% membership interests for US$1 provided that Rofin paid out Translight's entire obligation to Citizen's Bank which amounted to some US$250,000 plus interest; and US$70,000 to be paid to FTI to satisfy its obligations (presumably loans or invoices issued by FTI) to that entity. In my opinion, what that agreement discloses is that the joint-venture vehicle, Translight, was not a commercial success and that the FTI Principals simply wanted to discharge their personal liabilities to the bank and be repaid their loans and invoiced expenses. The strong inference to be drawn from this agreement is that the FTI Principals had lost confidence in the ability of Translight to become commercially viable. No part of the sales price can be attributed to any assets held by Translight at that time.
In his witness statement Mr Sachlan Fraval made it clear that Translight had negative equity at that time in that its liabilities exceeded the value of its assets. Furthermore, a taxation return lodged in the US by Mr Sachlan Fraval on behalf of Translight for the 2000 income year discloses a loss of US$2080 and total assets at the end of that financial year of US$1,330,640. Inventories were said to comprise US $1,134,857 of total assets. According to Mr Sachlan Fraval, assets costing US$285,594 were transferred to Rofin by Translight after the takeover. There was no other evidence of this transfer. The sale agreement also defines the Business of Translight as the development, manufacture or sale of liquid light guides, large core polymer light guides, and aerogel coatings as related to optical fibres and light guides.
In cross-examination Dr Fraval said that he visited Translight's operation in the US on two occasions. He confirmed that he was not involved in development work on the aerogel tubing which was done by the employees of FTI. In fact, as the agreement of sale with Rofin confirms, the Translight business was conducted at FTI premises and that FTI employees were contracted to conduct that work.
Also, when it was put to Dr Fraval in cross-examination that despite four or five years attempting to develop the aerogel tubing, Translight was never able to successfully control the aerogels on the Ionimer tubing, he said that was true. When it was put to Dr Fraval that there was a real risk that it might not be able to achieve the surface smoothness and thickness of aerogel including adhesion in the course of experimentation he said: No. The answer to your question, which I tried to answer and you stop me, was I believe at - believed at that moment, when they made the offer they had broken through and made a good aerogel coating, which is why they made a big offer to us, that they had found a way to make it uniform. So we suspected they had all of that stock which they had made good aerogel tubing, and didn't want to sell it, because that would be contrary to the - what do they call it in - in America they call it fair - acting in good faith, that if they sold it - they put it on the market and they would then immediately increase the - the price that we could expect for our 50% to be sold for. So we believe - this is my supposition. We believe that they made us an offer at the time and they had got the tubing right, and we then thought - well, we analysed it and we thought, well, we actually do need this for ourselves, and we made the counter offer. Although Dr Fraval confirmed that when Rofin made the so-called counter-offer, it was based on its belief that Translight had succeeded, he agreed he did not have evidence of that.
Dr Fraval was also asked why Rofin was prepared to pay the amount he suggested without knowing whether the aerogel coated tubing worked. He said that he had knowledge that Translight had produced short lengths of the light guide which worked. He referred to 1 foot, 2 foot, 3 foot lengths. This is of course a far cry from what is set out in the patent which refers to 50 to 100 foot lengths.
Although Dr Fraval said in cross-examination that the offer from Translight was some AU$600,000 and that he believed that Rofin countered with AU$660,000 or AU$700,000, the documents do not support that evidence. As I have said above, Rofin agreed to purchase the FTI interests for US$400,000 which, on the exchange rate used by Mr Sachlan Fraval at that time, equates to AU$532,600. In fact, as the agreement for sale discloses, the FTI interests only required the payment of US$1 together with the total payment of US$320,000 to clear Translight's debts to the bank and FTI. On the then current exchange rate, that equals some AU$427,411. According to Mr Sachlan Fraval, FTI also took US$80,000 directly from Translight from receivables owing to it at the time. The agreement of sale does not reflect that payment. No payment was made by Rofin for any inventory held by Translight at that time. Furthermore, although the tax return for the 2000 income year prepared by Mr Sachlan Fraval disclosed net sales of US$341,587, in cross-examination he agreed that those sales had nothing to do with aerogel coated tubing. In fact, when asked whether Translight ever made any sales of aerogel coated tubing, his response was: No.
Despite that, Dr Fraval insisted that he felt the patent was worth the asking price for FTI's interests. The problem of course is that FTI's interests in Translight were acquired only on the basis that all of its liabilities to its bank and to FTI were discharged. Quite plainly, the FTI Principals placed no value on the inventory, seeking only the nominal sum of US$1. That was in fact confirmed in a letter Dr Fraval sent to the ATO in answer to its queries about the incurred expenditure. Dr Fraval said: This was "dead" inventory to Translight and by selling it to HFN it can commercially benefit in the long term.
Dr Fraval testified that after Rofin acquired the FTI interests in Translight, no further activities were conducted by Translight in the US. He said that the directors of Rofin arranged for all of Translight's records, inventory and another equipment to be shipped to Australia from the US in late 2000. Included in the inventory shipped to Australia were coils of Ionimer tubing coated with aerogel. All of the tubing shipped to Australia was 5 mm or 8mm diameter.
Mr Sachlan Fraval testified that the total cost of the aerogel tubing shipped to Australia was US$849,263. This of course is not to be confused with its value. The tubing plainly did not function as designed and Translight was left holding inventory which was valueless. He calculated, by weighing the tubing shipped to Australia, that the approximate total length of the tubing shipped was 37,406 feet. Mr Sachlan Fraval also said that the total cost of the aerogel tubing came from Translight's records kept in the US by employees of FTI. Despite the fact that the agreement of sale provided for Translight to give to Rofin a balance sheet by no later than 31 July 2000, and that the FTI Principals were required to deliver to Rofin and Translight all files, books, records and other materials in their possession relating to Translight including, without limitation, all corporate records of Translight and all documents relating to its business, no such documents were in evidence before me save for a list of aged creditors as at 31 October 2000. Mr Sachlan Fraval testified that he prepared the accounts and financial statements for Translight for the financial year ended 31 December 2000 and onwards.
Mr Sachlan Fraval also testified that those of Translight's assets which were transferred to Rofin were accomplished by way of book entries in the accounts of Translight and Rofin. The book entries are, by themselves, not evidence of any transaction but rather simply record a purported transaction. There was no evidence before me of what Rofin in fact paid Translight for those assets.
Mr Sachlan Fraval also testified that of the figure of US$1,134,857 said to be the value of inventory held by Translight, materials and inventory required in the manufacture of liquid light guides to the value of US$285,594 were transferred to Rofin during the 2000 calendar year. In cross-examination Mr Sachlan Fraval agreed that there were items to the value of about US$285,594 in the total inventory figure and they included some capital items which were called inventory but which in fact were not. Although Mr Sachlan Fraval agreed that because of the misdescription, the inventory figure was distorted, with respect, it also substantially invalidated the 2000 tax return lodged in the US. Schedule A of the 2000 US partnership income tax return deals with the cost of goods sold. Under that heading the entity was required to set out its inventory at the beginning of the year, the expenses incurred in dealing with or acquiring that inventory, and the inventory at the end of the year for the purpose of arriving at a figure for cost of goods sold. Clearly, the inclusion of significant capital items in the inventory figure is incorrect and it has distorted the partnership income tax return.
Furthermore, the inclusion of the aerogel tubing in the inventory figure in Schedule A suggests that this inventory was available for sale. However, as Mr Sachlan Fraval testified, no sales of aerogel tubing ever took place. I have no doubt that the reason for there being no sales was that the tubing did not function as a light guide in the way in which it was intended. In effect, Translight was left with tubing on which expensive research and effort was conducted but which did not result in a commercial product. Despite this, it continued to record the value of its inventory at cost. This is contrary to a fundamental and well-established accounting principle that if the value of items in an inventory declines, the loss should be recognised even though the merchandise has not been sold (Century 21 Accounting, Mahoney, Berger, and Wolff, Australian Edition, page 429). The aerogel tubing should have been recorded in its books of account at net realisable value and the loss written off.
While Mr Sachlan Fraval testified that the cost of the aerogel tubing which was shipped to Australia was US$849,263, my concern is that this was not the true value of that tubing as it did not function as it was intended. In fact, in the course of his cross-examination, Mr Sachlan Fraval was taken to a document which he drew up dealing with the make-up of the Translight aerogel inventory cost as at 30 November 2000. The largest component of costs is an expense incurred to Enterprise Development Corporation, Mr Hanafi Fraval's company, in the amount of US$398,700. The next highest expense is in the amount of US$206,649. 70 said to have been incurred by FTI. There is a further sum of US$60,011.11 said to be owed to FTI for previous years. FTI provided premises and personnel to work on the Translight products. There were also substantial expenses incurred which relate to the services of Mr Jeffrey Brinker and his associates.
In cross-examination Mr Sachlan Fraval was asked why he chose the cost items he did and attributed those solely to aerogel production. He simply said that it was his understanding that those items were related to aerogel production and he did not ask anyone at Translight about that. In fact, when he was asked whether the document setting out the make-up of Translight aerogel inventory cost on 30 November 2000 represented his understanding of the total amount Translight spent on the aerogel project, he said that was correct. When asked about the FTI figure of US$60,011.11, he described it as a balancing figure. He said it related to work that FTI was doing but he couldn't identify that work and he agreed that it was simply a figure used to balance the accounts. It is meaningless.
The circumstances of the acquisition of the Ionimer the tubing by HFN from Translight raise questions regarding whether those transactions were at arm's length. HFN claimed to have paid Translight $646,153 for tubing which was, on the evidence, valueless. Of course Mr Sachlan Fraval valued the aerogel coated Ionimer tubing by calculating the costs expended in producing that product. Furthermore, the costs taken into account by Mr Sachlan Fraval include almost US$400,000 for services provided by Mr Hanafi Fraval.
The arm's length provisions are set out in s. 73B (31) which provides:

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Dr Bender submitted that HFN and Translight were dealing at arm's length and that the parties were not related. He pointed out that Translight was 95% owned by Rofin and Rofin had no shareholding in HFN. Nor did HFN hold any shares in Rofin or Translight. He accepted that Dr Fraval was a director of Rofin but that the company was not controlled by him. While all of that is unquestionably correct, whether or not parties are related goes further than that. The relationship between entities other than formal interests also needs to be considered. As Dowsett J said in the Asia Pacific Holdings case, the relevant factors to consider when determining the relationship between parties includes identity of interests which might enable either party to influence or control the other, or induce either party to serve a common interest and so modify the terms on which strangers would deal.
It will be recalled that when Rofin purchased the interest of FTI in Translight, Dr Fraval was of the view that the directors of Rofin became directors of Translight. In the course of his examination in chief, he was asked: who were the directors of Translight? He answered: Well, at the time that it was bought out by Rofin, at that moment the other directors were the USA directors, far away, and the directors became the directors of Rofin. The directors of Translight were the directors of Rofin. Furthermore, Dr Fraval and Mr Hanafi Fraval are brothers. Mr Hanafi Fraval in fact was the only remaining director of Translight at the time of the buyout by Rofin. It was in Translight's interests that all of the expenditure incurred in developing the aerogel coated Ionimer tubing be recovered. It was also in the interests of HFN to acquire that tubing at as high a cost as could be reasonably justified given that it intended to conduct research and development work and claim the tax concessions. In other words, the parties plainly had a common interest in transferring the aerogel coated Ionimer tubing from Translight to HFN at a price which reflected, not the value of that tubing, but rather the costs which had been incurred in its development. In my opinion, the parties were not at arm's length.
As to the question whether the parties nevertheless dealt with each other at arm's length, the most telling indicator is whether HFN acquired something of value for the substantial price it paid for that tubing. That is because an uninterested party would have, without doubt, negotiated a price based on its value. It had no value at all as a light guide. Despite some four or five year's experimentation, the tubing did not function in a manner which permitted it to be used as a light guide. Translight never sold so much as one foot of that tubing. In fact, Dr Fraval referred to it as dead inventory. The directors of FTI placed a value of US$1 on the entire inventory held by Translight. In fact, Dr Fraval was asked in cross-examination whether he negotiated a price on behalf of HFN when purchasing the tubing. He answered: I didn't. No. He was then asked whether Translight at that time was able to sell the inventory to anybody else and he answered: To my knowledge, no.
In my opinion, the evidence plainly discloses that HFN and Translight did not deal with each other at arm's length in the transaction which resulted in HFN acquiring the aerogel coated Ionimer tubing. No bargaining took place regarding the value of that tubing which Dr Fraval was aware had no value as a light guide at that time. In fact, Dr Fraval was also aware that despite considerable experimentation, the tubing could not be made to function as a light guide. Even if that tubing was acquired solely for the purpose of experimentation, an independent party being aware of its history is highly unlikely to have paid what HFN paid for it. Therefore, if I were to find that HFN has incurred expenditure for the acquisition of the aerogel coated Ionimer tubing, in accordance with s. 73B (31), I must only take into account so much of that expenditure as I consider reasonable having regard to the matters set out in subsections (c) - (e).
Prior to examining the invoices which were apparently issued by Translight for the sale of the aerogel coated Ionimer tubing, I need to briefly mention Translight's statements of financial position prepared by Mr Sachlan Fraval for the financial year ended 2002 and the financial year ended 2004.
The 2002 statement of financial position (balance sheet) discloses the only asset of Translight as inventory to the value of US$849,263. The statement of financial position of Translight at 31 December 2004 sets out the comparative position in 2003 and 2004. While inventory is listed at US$849,263 for the 2003 financial year, it is at zero value at the end of the 2004 financial year. Presumably, that indicates the disposal of the entire inventory. However, at the end of the 2004 financial year, Translight had what is described as other financial assets to the value of US$850,000. Nothing is listed in the account under Current Assets described as Receivables or Debtors. That, under normal accounting principles, indicates that no payment was expected following the disposal of the inventories. Ordinarily, there would be such an entry if those assets were expected to be converted to cash or cash value within the next accounting period. Furthermore, accumulated losses increased from US$134,612 to US$135,374 in the 2004 income year. Given that the evidence was that Translight did not conduct any business activities after 2000, it appears that a so-called balancing entry was made to the accumulated profit/loss account in order to achieve a balance. In my opinion, it simply underscores the unreliability of these accounts.
The following invoices from Translight which are claimed to relate to the disposition of aerogel coated Ionimer tubing were in evidence before me:
- 15 June 2004 - to HFN - to license (sic) fees to use aerogel technology in the use of conveyance of natural light into buildings using fiber (sic) optics - US$331,135 (US$306,135 for tubing)
- 30 June 2004 - to HFN - to supply of coated fiber (sic) optic coils delivered to Poly Optics via Rofin Australia for use in natural sunlight research being inventory held at Poly Optics - $479,907
- 30 June 2004 - to Mosquito Free Pty Ltd - to aerogel coated light tube inventory to be used in your development of mosquito products inventory held by Poly Optics - $199,041.01
- 11 December 2004 - to HFN - to supply of coated fiber (sic) optic coils delivered to Poly Optics via Rofin Australia for use in natural sunlight research being the balance of inventory at Poly Optics - $166,246
- 12 December 2004 - to Poly Optics Australia Pty Ltd - to supply of coated fiber (sic) optic coils delivered to Poly Optics via Rofin Australia for use in research projects from inventory held at Poly Optics - $80,769
- 12 December 2004 - to Poly Optics Australia Pty Ltd - to supply of coated fiber (sic) optic coils delivered to Poly Optics via Rofin Australia for use in research projects from inventory held at Poly Optics - $199,041
- 12 December 2004 - to Poly Optics Australia Pty Ltd - to supply of coated fiber (sic) optic coils delivered to Poly Optics via Rofin Australia for use in research projects from inventory held at Poly Optics - $217,391
- 12 December 2004 - to Poly Optics Australia Pty Ltd - to supply of coated fiber (sic) optic coils delivered to Poly Optics via Rofin Australia for use in research projects from inventory held at Poly Optics - $56,493
- 18 June 2005 - to HFN - to supply of coated fiber (sic) optic coils delivered to Poly Optics via Rofin Australia for use in natural sunlight research being the balance of inventory at Poly Optics - $166,246
It should be immediately apparent that some of the above invoices appear to have been duplicated. The 15 June 2004 invoice to HFN is identical (taking into account the conversion rate to Australian dollars) in amount to the invoice issued to HFN on 30 June 2004. However, the invoices are not identical in respect of the items being invoiced. The first invoice includes the licence fee as well as the aerogel tubing while the second invoice is solely for the aerogel coated Ionimer tubing. Furthermore, while the second invoice refers to coils of tubing having been delivered to Poly Optics, the first invoice makes no such statement. There was no explanation for the difference.
In his amended witness statement Mr Sachlan Fraval testified that by about November 2003 all of the tubing stored at Rofin's premises had been collected and stored at the premises of Poly Optics in Queensland except for a small amount taken by Dr Fraval for HFN. He said he believed the amount of tubing kept by Dr Fraval in Melbourne was about one coil. He also said Dr Fraval had engaged Poly Optics to do some testing for him on the light guides he was trying to make with the tubing. Mr Sachlan Fraval provided an explanation in his amended witness statement stating that he simply converted the US dollar amount into the Australian dollar amount. He failed to explain why the Australian dollar amount invoiced made no reference to the licence fee.
It should also be apparent that the invoice issued to HFN on 11 December 2004 in the amount of $166,246 was again issued to HFN on 18 June 2005.
The third duplicated invoice is that issued to Mosquito Free Pty Ltd on 30 June 2004 in the amount of $199,041. It was also issued to Poly Optics Australia Pty Ltd on 12 December 2004.
In cross-examination Mr Sachlan Fraval was asked about the second duplicated invoice in the amount of $166,246. When it was pointed out to him that there was a different date on each invoice and he was asked to explain why that was the case, he said: No. I can't explain why there's a different date but it's the same goods just.... When it was pointed out that there were two invoices with the same goods he said: Well, one was reversed out, I assume.
Mr Sachlan Fraval provided an explanation for the third duplicated invoice in his witness statement. He said that the invoice related to aerogel tubing which was used in a project that Poly Optics was conducting for one of its clients, Mosquito Free Pty Ltd. In 2004 Mr Edmond Joseph, a director of Poly Optics, told him that Poly Optics wanted to purchase some of Translight's aerogel tubing held at Poly Optics' premises for use in that project. He said that he and Dr Fraval agreed and that Translight would invoice Mosquito Free directly. The invoice was prepared by Mr Sachlan Fraval and sent to Mosquito Free in about June 2004. He then said that the invoice was not paid and despite several telephone conversations with the principal of that company he was told that the invoice would not be paid because the company had no money. He then had discussions about the non-payment of the invoice with Mr Joseph and Mr Joseph said that Poly Optics would pay the invoice and he asked for a new invoice to be issued.
I hold serious doubts about the accuracy and validity of the invoices issued by Translight in respect of the aerogel coated Ionimer tubing. It is sufficient to say for the present purposes that disregarding the duplicated invoices, the total amount invoiced by Translight for aerogel coated Ionimer tubing, using the relevant exchange rate in late 2004, was approximately US$901,085. Translight's statement of financial position as at 31 December 2004 would suggest that inventory to the value of US$849,263 had been disposed of. In fact, given that the final invoice from Translight to HFN was issued on 18 June 2005, assuming the earlier invoice for the same amount issued on 11 December 2004 had been reversed out of the accounts, the statement of financial position as at

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31 December 2004 should have disclosed inventory remaining. It does not. As I have already indicated, the accounts are unreliable. 15. Having determined the dispute between HFN and the Commissioner as to the nature of the expenditure on aerogel coated Ionimer tubing for the purposes of s. 73B of ITAA 1936, that is whether the expenditure should be regarded as feedstock expenditure or research and development expenditure, I should address whether any expenditure was in fact incurred in acquiring tubing. This is a troubling issue given the long-standing association between HFN, Rofin, Translight, Poly Optics and Mosquito Free Pty Ltd. 16. In cross-examination Mr Joseph confirmed that Mr Sachlan Fraval held about 3% of the shares in Poly Optics and that he was a director between about 2001 to about 2009 or 2010. He confirmed that Poly Optics had a long association with HFN, Dr Fraval and Rofin. In his amended witness statement, Mr Sachlan Fraval did not disclose that he had been a director and shareholder of Poly Optics. Mr Joseph confirmed that the aerogel coated Ionimer tubing was shipped from Rofin to Poly Optics in Queensland in about 2004. He said he believed there were two shipments. He did not know how much tubing was left in Melbourne for HFN or how much of the tubing was sent to Poly Optics. He said Poly Optics had a substantial quantity but he did not know whether it was two thirds or three quarters or 90% of the total. He said that at the end of conducting experiments on behalf of HFN, he did not think that any tubing material was left over or, if there was, it was a very small quantity. 17. Mr Joseph was then asked to look at the four invoices addressed to Poly Optics, all of which were dated 12 December 2004. He could not explain why all four invoices were issued on the same day. Mr Joseph explained that what Poly Optics did with the tubing was to fill it with its monomer mixtures in an attempt to turn empty tubing into finished optic fibre. Mr Joseph was then asked whether the work done by Poly Optics was for the benefit of Poly Optics or was Poly Optics performing that work for somebody else. He responded: I don't understand who the somebody else is. Mr Evans then asked Mr Joseph whether Poly Optics was doing this work for another client and Mr Joseph answered: I am not even sure how to answer that. We've done the work for other customers over the years in trying to develop better products. So always I've had an open mind that if we could develop some new technology we would apply to any customer that needed it. So we didn't say, "Well, let's do this Poly Optics work on the aerogel tubing wholly and solely for - for the benefit of Hadrian Fraval Nominees". Our goal was to develop the technology, do the work, and see if there were applications for it anywhere. 18. Mr Joseph was then taken to paragraph 42 of his first witness statement where he said that Translight invoiced Poly Optics a total of $553,694 in 2004 for aerogel coated tubing which was purchased by Poly Optics from Translight. He agreed that of that sum, $199,041 or approximately $200,000 of that material was actually purchased by Mosquito Free. Mr Joseph was asked why he had made no mention of the purchase by Mosquito Free of some $200,000 of tubing in his witness statement when discussing the purchase of tubing by Poly Optics. He said: Because it formed part of the tubing that - Poly Optics took possession of the tubing from Translight and that was part of it. There was no discussion about Mosquito Free at that - at the time of writing the statement. We didn't discuss why the debt was transferred. It was part of the purchase that Poly Optics had to reconcile. When it was explained to Mr Joseph that it was not a purchase made by Poly Optics, Mr Joseph avoided directly answering the question stating that he could not do so because it did not make sense to him. When asked why Poly Optics subsequently agreed to assume liability for the $200,000 debt owed by Mosquito Free to Translight, he said_: It was part of the business relationship that we had with Translight and with Rofin_. 19. Mr Evans then put to Mr Joseph that setting aside the $200,000 worth of work performed for Mosquito Free, approximately $300,000 worth of materials remained at Poly Optics' site. Mr Joseph disagreed. Mr Evans explained that the material appeared to have been split three ways. There appeared to have been material used for the HFN R & D project, material used for Mosquito Free's R & D project and leftover material. Although Mr Joseph agreed that material was used for the HFN R & D project and material was used for the Mosquito Free R & D project, he maintained that all of the tubing had been consumed. When Mr Evans asked Mr Joseph whether work was performed for anybody else, he responded: Not as such but we had in the back of our minds, if we could make it work we could find many other people to do work for but we never got to that step. Mr Joseph was asked directly to identify anybody else for whom Poly Optics was performing work, and he responded: We don't have anyone else. 20. Mr Evans then asked why it was that Poly Optics paid about $300,000 for more tubing and he responded: I'm sorry, I'm confused. Mr Joseph was then taken through each of the invoices other than the invoice for $199,041 which he said was the Mosquito Free debt taken up by Poly Optics, and asked whether the tubing to which those invoices related was used for HFN and he said it was. He was then asked why Poly Optics was buying the material if the work was for HFN. Once again, Mr Joseph avoided answering questions stating he was confused. After Mr Evans repeated the question a number of times, Mr Joseph responded: Well, it was to be used for Poly Optics' benefit as well. I don't understand why we would have no benefit if we - as I said, if we could get a successful outcome and make good end emitting tubing we had multi-millions of dollars' worth of benefit available. 21. Curiously, after the luncheon adjournment, Mr Joseph said he had referred to his notes during the lunch break and that he had been confused with the questioning immediately prior to lunch. He then explained... I was getting a little confused with your questioning. We received approximately $1.2 million worth of tubing from Translight, and I've just gone back through some of our accounting records.... but I did check my notes and my notes show that we received around $1.2 million worth of tubing from Translight, of which the 553,000 approximately Translight invoice, which included the 199,000 for the Mosquito Free project. The - there was about $640,000 approximately of tubing which was the Hadrian Fraval Nominees tubing which we weren't invoiced for by Translight, so we used that material for the HFN work, and we did some other project work with the balance of the $553,000. There were several other things that we were working on at the time, so I was getting a bit confused on this morning's invoices. So the answer is: the HFN work was done on the tubing that was the other $640,000, not the 553,000 in the invoices. 22. Mr Joseph then briefly explained what some of those other projects were. He claimed these projects were being performed for other parties. When Mr Evans put to Mr Joseph that the invoices were for precise amounts, for example, the invoice for $56,493, and that the invoice might therefore have related to a particular project, Mr Joseph and said: no. He also explained that he could not recall the details of those invoices stating that he had an accounts team which look after that. He then said: I tried not to get involved in the accounts. 23. Mr Joseph was asked whether he was involved in relation to an R & D tax offset claim by Mosquito Free. It was put to him that he liaised directly with the ATO about Mosquito Free's R & D tax offset and, responding the same way as he did the previous question, Mr Joseph said: In what way? When the question was put to him again he agreed that he had contact with AusIndustry but not the ATO. He was then referred to a letter from Mr Peter Scott of Mosquito Free in which it was said: I confirm you can discuss my business affairs with Eddy Joseph and Sachlan Fraval with regard to all R&D carried out by Poly Optics. Despite that, Mr Joseph could not recall having discussions with the ATO regarding Mosquito Free's R & D tax offset claim. 24. Mr Joseph was also asked whether he was involved in any R & D projects with

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Dr Bennett. He was also asked whether he was involved with Dr Bennett in an R & D project involving the Scallan Wall. He said he wasn't involved with Dr Bennett in that project but that he knew the Scallan Wall very well. When asked whether Mr Sachlan Fraval was involved in the project with the Scallan Wall, he said: Again, I think you would have to ask Sachlan but we all knew each other very well. What Sachlan's involvement directly with the Scallan Wall is I don't know the extent. They certainly knew each other and we had conversations together. I do recall a time when Ian Bennett and Sachlan Fraval came to the Gold Coast and we met with Pat Scallan but I was introducer more than the participant. I took them out to a building site where Scallan Wall had some of their prototype systems and I would introduce Scallan to the person whose premises the construction work was done on so that was my involvement in facilitating people. 25. Mr Joseph was also asked how many R & D projects in which he or Poly Optics was involved included participation by Mr Sachlan Fraval. He answered: I just can't recall. Bear in mind at the time Sachlan was a director and shareholder of Poly Optics and he was involved in looking after the financial management of Poly Optics and assisting in supervision to our accounting staff before accounting figures went to our accountants who were KPMG at the time. So Sachlan would have had an accounting involvement in everything that Poly Optics did but I can't recall how many were R&D and how many weren't and what things were and weren't R&D. Mr Joseph also agreed that he was aware of the project which R & D Consulting was undertaking regarding a totally environmentally friendly house. He said his involvement involved a few minor things and that he came down to Melbourne on one trip going to Geelong with Dr Bennett and Sachlan Fraval. 26. Mr Joseph's evidence was disturbing. I cannot accept that following the luncheon adjournment he referred to his notes, which were not produced, and was able to recall that Poly Optics conducted experimental work on the aerogel coated Ionimer tubing for clients other than HFN and Mosquito Free. His evidence prior to the adjournment was, emphatically, that it did not. He did not provide a satisfactory explanation for the precise figures in the three invoices (excluding the invoice to Mosquito Free) which were issued by HFN. I do not accept that he was confused by the questioning prior to the luncheon adjournment, which was simple and straightforward. Furthermore, his statement that about $640,000 worth of aerogel coated Ionimer tubing was the tubing on which Poly Optics worked for HFN was remarkable. It just so happens that HFN's statement of financial position at 30 June 2005 records the $640,000 sum as a liability and it was

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Mr Sachlan Fraval's evidence that this was made up of the two invoices which Translight gave to HFN for the acquisition of its tubing. 27. Perhaps the most disturbing aspect of this evidence and the evidence given by Mr Sachlan Fraval is his pervasive influence in a number of discrete entities, all of which have R & D tax concession claims. Furthermore, the evidence discloses that while these companies invoiced each other for materials or services, the invoice descriptions being vague although for substantial sums, payments generally appeared to be by way of set-off or, in one case, a convertible note. While it is not possible for me nor is it desirable that I should say anything further about this, I must say that the evidence most certainly does not encourage a finding that HFN has discharged its onus in this regard. 28. The amount claimed by HFN in the 2004 income year was $443,669 which, converted to American dollars is US$306,135. It will be recalled that this sum was invoiced together with an amount of US$25,000 for the licence fee and was the subject of a convertible note under an agreement between HFN and Translight said to have been made on 8 July 2003. For reasons I have already explained when dealing with the licence fee, the issue of the convertible note extinguished HFN's liability to pay a pecuniary sum to Translight for the aerogel coated Ionimer tubing. Furthermore, even if I were to accept that the convertible note was subsequently transformed into a loan, that would not assist HFN because, as its accounts clearly state, that expenditure was capitalised. Having treated that expenditure as the acquisition of a capital item, it could not be expenditure which was deductible against the revenue account. While I accept that capital items may generally be depreciated and that depreciation may be deducted against revenue, given that the evidence was that the tubing was all used up in experimentation, it would be artificial to treat it as a depreciating asset. In fact the artificiality of this entire transaction is underscored by the fact that the tubing is subsequently recorded in HFN's balance sheet as an intangible asset, which is plainly a misdescription. However, it is not my role to correct misdescriptions in the accounts. For the reasons I have set out above, I find that the claimed tubing acquisition expenditure of $443,669 was not incurred by HFN in the 2004 income year. 29. The $166,246 claim in the 2005 income year was not subject to the convertible note.

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Mr Sachlan Fraval's evidence was that in the 2005 financial year HFN purchased more aerogel tubing from Translight. He said he prepared the invoice in that amount and gave it to Dr Fraval on or about 11 December 2004. By way of contrast, when Dr Fraval was asked when he received the invoice for $166,246, he said it was in about June 2005. This was obviously a reference to the second invoice but there was no indication he had received the 2004 invoice in the same amount. Mr Sachlan Fraval said the sale price of that tubing was calculated by using an estimate of the aerogel tubing that had been used by HFN in its project as a proportion of the total amount of aerogel tubing that had been originally shipped to Australia. Dr Fraval also referred to the proportion of tubing remaining and he estimated that the amount received was about 7000 feet. When asked how this tubing was used, he said: Most of this was used by Poly Optics to do various things that they had been asked to do. This was already at Poly - at Poly Optics at that stage. 30. I should also briefly mention that there was some controversy about the amount of tubing which Dr Fraval in fact used in his experiments as opposed to what was consumed by Poly Optics. The total value of aerogel tubing delivered to Australia from Translight was claimed to be $1,129,520 (US$849,263). HFN claimed that it had paid a total of $646,153 for tubing and that figure was calculated on the proportion of the total tubing it acquired. In other words, it acquired some 57% of the total length of tubing delivered from Translight which Sachlan Fraval calculated as being some 37,000 feet. On that basis, it is reasonable to infer that HFN consumed approximately 21,000 feet of aerogel coated Ionimer tubing in the course of conducting its experiments by Dr Fraval and Poly Optics. 31. In re-examination Dr Fraval said that he used about 3000 feet in his experiments. In further cross-examination by Mr Evans, it was put to Dr Fraval that in working through his notes of the experiments he conducted, he calculated that Dr Fraval used approximately 70 m of tubing in his experiments. He was asked to explain why he claimed he used approximately 1000 m. His response was that it was not a complete record of everything that he did as he was doing this work in his spare time. Given that Dr Fraval agreed with questions from me that his experiments did not require large lengths of tubing at any one time - he suggested 10 m; I have considerable doubt as to whether Dr Fraval in fact used 1000 m of tubing in the course of his experiments. Given that the length of the tubing which could convey sunlight was critical in determining whether this product could be commercialised, I have no doubt that in the course of the experiments Dr Fraval conducted, he recorded the lengths of tubing on which he experimented. There would have been no point in him recording a satisfactory or an unsatisfactory experiment without stating the length of tubing he had used. 32. Dr Fraval was also asked how HFN intended to pay for the invoice. He said: It was - it was - it was not paid for, and it was - it was on Rofin's books - sorry - on HFNs books as a loan. When asked how HFN intended to repay the loan he said: HFN intended to pay part of it through the R&D tax concession, and part of it out of its own funds, or from my mortgage, basically. He was then asked whether the loan remained outstanding and he answered: That loan was paid by a - an amount of money I paid personally back to Rofin. I can't remember the exact amount, but I think it was 75,000 in one year, and a further amount of about 120,000 later, more recently. So there is still an amount outstanding, but I have paid some of it. 33. The first point to make about Dr Fraval's answers regarding the payment of the $166,246 is that it appears that the only means of repayment was through the receipt of the R & D tax offset. As with all of the loans between the related entities, nothing has been committed to writing and there is no way of determining, with any degree of certainty, the obligations to repay. By way of example, Mr Sachlan Fraval said in his amended witness statement that during the 30 June 2005 year, Translight transferred all of its assets and liabilities to Rofin. I had in evidence a statement of financial position (balance sheet) for Translight as at 31 December 2004. It disclosed non-current liabilities in the amount of US$885,374 said to be shareholders' loans (I make no comment about why shareholders would be lending the company money when they have in fact already paid for a capital interest). There were no current liabilities. At this point in time, the only shareholders in Translight were Rofin and Mr Hanafi Fraval. Putting aside the legal problems of assigning liabilities, one might logically question how Translight's liability to repay loans to Rofin can be transferred to Rofin. Although Mr Sachlan Fraval referred to the June 2005 trial balance for Rofin, there is no entry in that trial balance which discloses how the liabilities of Translight were accounted for in Rofin's accounts. 34. Mr Sachlan Fraval testified that he prepared the accounts for HFN for the 2005 financial year. In his witness statement Mr Sachlan Fraval said that the $166,246 was not paid for by way of convertible note. He said that $160,000 of this sum for inventory was paid by way of loan owed by Translight to Rofin. He said the remaining $6246 was paid by way of two amounts: $4231.50 through a credit to HFN's cashbook and $2014.57 through a credit to Dr Fraval's loan account with HFN. 35. There is no loan documented in respect of the $160,000 sum. There was no evidence regarding the terms of that loan or when repayment was due. In its statement of financial position as at 30 June 2005 HFN has recorded an increase in non-current liabilities of $160,000 which has been added to the previous $480,000. The balancing entry on the debit side of the ledger is an increase in what is described as intangible assets by $160,000. As I have already said above, HFN appears to have treated the acquisition of this portion of the aerogel coated Ionimer tubing as a capital item. It is therefore not deductible against revenue. It is not a loss or outgoing of a revenue character. In fact, it is not even clear on the objective evidence that HFN has become liable to pay a pecuniary sum to either Translight or Rofin. 36. As for the remaining amounts of $6246.00 and $2014.57, I was unable to find any such entries in the printouts of HFN's general ledger for the 2005 or 2006 income years. The $6246 figure is recorded in the trial balance as at 30 June 2005. I am not able to reconcile that with its absence in the general ledger. 37. In my opinion, HFN has not satisfied the onus of proving, on the balance of probabilities, that it incurred expenditure for the acquisition of aerogel coated Ionimer tubing in the 2004 or 2005 income years.

[149]

I have set out the changes which are made to s. 40-25 for the purposes of s. 73 BC (1) in paragraph 20 of these reasons.
Mr Evans submitted that there were no statutory rules relevant to the substantiation of claims for deduction under s. 73B. However, he submitted that what is required of an applicant to substantiate and therefore discharge its burden of proving the purported expenditure must be considered in the context of the expenditure being research and development expenditure for the purposes of s. 73B (1). He referred to s. 73B (2B) which sets out the definition of research and development activities including the fact that they are systematic, investigated and experimental activities in which scientific method has been applied in a systematic progression of work from hypothesis to experiment, observation and evaluation, followed by logical conclusions.
Mr Evans also referred to Chapter C 1-7 of the Guide to the R&D Tax Concession which provides guidance regarding the record-keeping requirements for companies to substantiate their claims for the R & D tax offset. He submitted that companies intending to claim the R & D tax offset should maintain adequate contemporaneous records which substantiate the carrying on of the claimed research and development activities and the incurring of expenditure in relation to those activities. I accept that submission because it would be impossible for the Commissioner to determine the eligible expenditure incurred in conducting research and development activities without contemporaneous records. Furthermore, given the nature of the scientific method which involves recording all material steps taken in the course of R & D activities, one would ordinarily expect contemporaneous records to have been kept, including expenditure incurred because on commercialisation of a product or process, those R & D expenses necessarily need to be taken into account.
Dr Fraval testified that the fume cabinet was owned by HFN during the 2004 and 2005 income years. He said it was used at his South Warrandyte home and at Rofin's premises in the experimentation he did on the Ionimer tubing. He said that the fume cabinet was used as part of his preparation of chemicals used in experiments. I had in evidence a folder comprising notes, photographs and charts which Dr Fraval said were records of his experimentation. Although the notes and documents are not in chronological order, the experiments conducted by Dr Fraval appear to have occurred in the 2004 and 2005 income years. Furthermore, given the descriptions of the chemicals used, I have little doubt that a fume cabinet would have been required to conduct the experiments safely.
However the problem with depreciating this capital item is that Dr Fraval no longer retained the invoice regarding its purchase. Even if I were to assume for the moment that the fume cabinet was the property of HFN, the depreciation schedule attached to his witness statement does not record the date on which it was acquired or its cost. However, there is an amount under the heading acquisitions during the year and an amount of $7000 beneath that, which suggests that the fume cabinet was purchased in the 2004 income year. Although under the heading Rate is written D, and the depreciation type is not stated although the figure 4 appears under the heading Years, the charge for the year is $1750 indicating the prime cost method is being used at a rate of 25% per annum. In fact the second year, the 2005 income year, also records a depreciation charge $1750 which indicates the prime cost method was used. However, the lack of documents evidencing the acquisition of this capital item by HFN, the date of acquisition and its cost necessarily mean that HFN has not discharged its onus of proof in respect of this claim.
Dr Fraval testified that HFN acquired an electrical control box which was owned by it during the 2004 and 2005 income years. He said he paid for that personally and it was credited to a loan account in his name with HFN. He said that the electrical control box was to be used in the environmentally friendly house as part of the control mechanism for remote control of the systems in the house. However, this project never got so far as to have research and development work conducted on the remote control systems of the house. In other words, this asset was never used for the purposes of carrying on by or on behalf of the eligible company, research and development activities. Therefore, I would disallow this claim in both income years.
According to Dr Fraval, HFN purchased the computer and printer during the 2004 income year. Dr Fraval testified that the invoice for both of these items was paid by him and subsequently credited to a loan account in his name with HFN. Amongst the materials which Dr Fraval relied upon was an invoice dated 20 July 2003 for a computer and associated equipment for a total amount of $2102.10. There is a hand written entry below that price indicating a delivery cost of $217.90 and a total of $2320.00 beneath that. Dr Fraval testified that he no longer had the invoice for the printer but that in any event, another printer was purchased on 30 June 2005 for $368. Attached to the documents relied on by Dr Fraval was a Westpac Visa card account indicating an entry on 13 July 2004 for $368 from Officeworks. The depreciation schedules for the 2004 and 2005 income years attached to Dr Fraval's witness statement indicate depreciation of $580 for the computer in the 2004 income year and $386.67 in the 2005 income year. I am unable to reconcile these figures with either the prime cost method or diminishing value method of depreciation. The first year appears to have been calculated using the prime cost method although the second year is something less than that. That is despite the fact that the accumulated depreciation at the end of the 2005 income year, being $1160, suggests that the prime cost method has been used.
In any event, regardless of any errors that might have been introduced into the calculation of the amount of depreciation claimed, there was no evidence before me that the computer and printer were used for the purposes of carrying on by or on behalf of HFN, research and development activities. Therefore, I would not allow a deduction for these capital items.

[151]

HFN claimed rent expenses in the amount of $11,055.46 in the 2004 income year and $10,224.00 in the 2005 income year. Dr Fraval testified that he conducted his experiments at his home and therefore claimed HFN owed him rental for using his premises. He calculated the amount of expenditure on the basis of 22% of the total area of his home in the 2004 income year, which he determined by taking into account the size of the rooms which were taken up by HFN's R & D activities and some office space. In the 2005 income year, he calculated the rental charge based on 18% of the total floor area of his home. He also explained that the percentages of floor space he used to calculate utilities were less than those used for the rent because the rooms were specifically for the project and could not be used for any other activity at the time. He cited as an example there was equipment in the garage. The utilities percentage used was less because utilities could not be used in every room all the time.
Dr Fraval testified that $11,055.46 was reasonable rent for HFN to pay for use of the house and areas outside the house for his experiments. He said he no longer had the calculations for the rent. He calculated the rental expense at about 22% of the mortgage interest payment on his house in the amount of $49,589.02, which is $10,908.04. He nevertheless determined that $11,055.46 was a reasonable rent for HFN to pay to him for using the house and areas outside of the house for the experiments. Dr Fraval also testified that the amount of rent which HFN was charged in the 2005 income year was $10,224 based on about 18% of the mortgage interest charge although he no longer had the calculation used to arrive at an appropriate rent figure for that year.
Dr Fraval also testified that the amounts owed to him by HFN for both the rent and utilities in the 2004 and 2005 income years were credited to his loan account with HFN in those years.
In support of the rental claim, Dr Fraval referred to a joint account bank statement held with his wife. He marked on that bank statement the total mortgage payments (interest only) for the years in question. The problem with that statement is it is incorrect. The bank account to which Dr Fraval has referred is solely in the name of Mrs Fraval.
Putting aside for the moment the fact that Mrs Fraval appears to have paid the mortgage interest payments on their home, Dr Fraval nevertheless claimed that both rent and utilities in the 2004 and 2005 income years were credited to his loan account with HFN. While the general ledger for HFN as at 30 June 2004 discloses rental expenditure of $11,055.46, Dr Fraval's loan account with HFN simply has a credit balance of $64,351.80 with a single entry on 30 June 2004 accompanied by the description expenses incurred. The trial balance as at 30 June 2004, while containing the same entries, makes it reasonably clear that the accounts were balanced and that could only have been achieved by crediting the $11,055.46 to the loan account of Dr Fraval. The printout of the general ledger for HFN as at 30 June 2005 records rental expenses of $10,224.26. Dr Fraval's loan account simply has an entry made on 30 June 2005 again describing that entry as expenses incurred in the amount of $50,713.76. However, the trial balance as at 30 June 2005 discloses a credit balance of $90,517.92 in Dr Fraval's loan account. There are additional entries in the trial balance sheet for Dr Fraval's loan account which are not recorded in the general ledger. There is no explanation for these entries which leads me to repeat that the accounts of HFN are unreliable.
Regarding this expenditure, the Commissioner submitted that HFN had not satisfied its onus of proving, on the balance of probabilities, that the expenditure was incurred and that it was directly related to R & D activities. On the other hand, Dr Bender submitted that the Commissioner had accepted that the rent of a building partly used for R & D purposes was deductible as other expenditure within the meaning of research and development expenditure in s. 73B (1). Dr Bender referred to the ATO Guide to the R&D Tax Concession Part C 2. That document sets out at page 23 a list of expenses which would be accepted as being connected to eligible R & D projects. Included in that list is rent of a building used partly for R&D purposes. Although Dr Bender also submitted that as the rental expenses claim was not challenged in cross-examination, I must accept that those expenses exist, for reasons I have already stated above, I do not accept that submission. Similarly, I have explained why a simple entry in the accounts of an entity cannot be used to prove that expenses were in fact incurred when those expenses are disputed by the Commissioner.
The problem, as I see it, is that in a situation where a company purports to have incurred a liability, where that liability is to a related entity or party, and the liability is in itself by way of a notional loan to the company, the question which inevitably arises is whether that liability can be said to have been definitively incurred at that time or whether it is conditional upon the company being able to pay at some future date. This is of course particularly so where the transaction itself is not documented but simply recorded in the accounts. This is further exacerbated in this case by the fact that the accounts of HFN for the 2004 income year disclose its cash balance at $12.
On 20 October 2004 HFN received a tax offset payment from the ATO in the amount of $228,315.59. Despite that receipt, there is no evidence in the accounts of the payment of rent in arrears for the 2004 income year, or payment for the 2005 income year. In fact, there is no indication that any payment in respect of rent or repayment of the notional loan ostensibly used to pay the rent was repaid in 2006 income year. In my opinion, this raises the serious question as to whether that liability was definitively incurred in the years it is recorded in the accounts. There was no other evidence which would support a definitive liability having been incurred in the 2004 and 2005 income years for the so-called rental payments. There was no evidence of a repayment date for the loans. On that basis, I must find that HFN has not discharge its onus of substantiating the incurring of R & D expenditure by way of rent in either the 2004 or 2005 income years.

[174]

Mr Evans submitted that HFN or its tax agents failed to take reasonable care in preparing its 2004 and 2005 income tax returns, having regard to the relevant circumstances including, but not limited to, the directors' level of knowledge, education, experience and understanding of the tax laws as well as the size of the claims.
Dr Bender submitted that to determine whether the penalties were appropriate, each item of expenditure needed to be considered independently.
Dr Bender submitted that HFN had an invoice and accounts to support the expenditure for the consulting fees of Mr van der Matten. He said that if the expenses were not deductible under s. 73B because of lack of substantiation, then HFN could hardly have acted with the lack of reasonable care when it had documentation to support that expenditure. The problem with that submission is that one needs to look at precisely what the invoice, which is dated 8 September 2003, stated. It referred very broadly to engineering services in connection with solar tiles and solar pave using glass reinforced concrete. There was no evidence of any engineering services provided nor did the description on the invoice fit within any of the registered activities for the 2004 income year. Although Dr Fraval said in evidence that he discussed the original aerogel coating with Mr van der Matten, there is nothing in the invoice which would even suggest that was one of the services which Mr van der Matten provided.
In my opinion, this is not the case of where HFN simply got it wrong. There was no basis in the documentary evidence which would enable substantiation of the invoiced expenditure as being referable to any of the registered activities in the 2004 income year. Furthermore, Dr Fraval is no stranger to making R & D claims, having done so in the past. I have no doubt that he was fully aware of the substantiation requirements demanded by the Commissioner in such claims. I find that HFN did not take the care a reasonable person in the circumstances of HFN (through Dr Fraval) would have taken in making a R & D claim for this expenditure. At the very least, I would have expected HFN to obtain a detailed invoice from Mr van der Matten regarding the work he claimed to have done, particularly having regard to the substantial sum of money involved.
As for the R & D Consulting expenditure, Dr Bender submitted that HFN had a contract and invoices supporting those consulting fees. Regarding the written contract, as I have indicated above, what R & D Consulting claimed to have performed in respect of the

[176]

R & D Consulting is that it claimed to have evaluated the concept of creating conduits within the Scallan Wall. No work was done with the light guides themselves as there were no light guides to work with. The description on the invoices issued by R & D Consulting bear no resemblance to the registered R & D activities. Finally, the expenditure said to have been incurred was said to have been discharged by a set-off arrangement as a result of what appears, in an unexplained way, to have been an arrangement between R & D Consulting and Poly Optics to provide aerogel tubing to Poly Optics. With respect to Dr Fraval, his experience with R & D activities would, in my opinion, have alerted him to the very doubtful nature of these transactions particularly regarding the substantiation of the expenditure said to have been incurred. I find that HFN did not take the care a reasonable person in its position would have taken when making an R & D claim for this expenditure. 7. Regarding the licence fee and cost of aerogel tubing expenditure, Dr Bender again submitted that HFN had objective documentary evidence, including invoices and accounting records of Translight and Rofin, to support the existence of the licence fee expenditure and the tubing expenses. He also referred to the fact that there was a contemporaneous report by AusIndustry to support the evidence given by Dr Fraval and Mr Sachlan Fraval that there was an issue with the licence fee which caused them to alter their R & D concession claim for the 2004 income year and to claim part of the fee in the 2005 income year. Dr Bender submitted that HFN took reasonable care because it took a recent approach to the deductibility of this expense. 8. With respect to Dr Bender, I cannot agree with this submission. The first point to make regarding the licence fee is that the only evidence of an assignment of the aerogel patent to Translight from Enterprise Development Corporation was Dr Fraval's oral evidence. The agreement granting a licence to HFN to use the patent was executed only by HFN. That in itself gives rise to serious doubts about its enforceability. Furthermore, the document is, with respect to the draftsperson, a very poor example of an agreement if it can be properly described as such. Regardless, HFN appears to have relied on it to demonstrate there was such an agreement and yet it attempted to disavow the fact that it stated the licence fee, said to be US$25,000, was to be paid on a one-off basis. Subsequently, it was submitted that there were a number of variations to the agreement made orally despite the fact that the agreement itself contained a clause indicating such variation was impermissible. As Finn J said in GEC Marconi Systems, at [218]:

[178]

There was no evidence of consideration for the varied agreement or that the parties, and in particular Translight, agreed to the oral variation. Neither Dr Fraval nor Mr Sachlan Fraval could speak for Translight.
To add to HFN's problem, the agreement contemplated payment for the licence fee and the aerogel tubing by way of a convertible note. This later, by the stroke of the pen in the accounts of HFN, became a loan after HFN was informed that the issue of the convertible note meant that a pecuniary liability ceased to exist. With respect to Dr Fraval, the artificiality of this entire transaction would have been apparent to a reasonable person in his position. Accordingly, I find that HFN did not take the care a reasonable person in the circumstances of HFN would have taken in making a claim for the licence fee expenditure in both income years in question. This finding applies equally to the $443,675 claim for aerogel tubing in the 2004 income year. It was also the subject of the convertible note and the subsequent purported loan.
I have found that the aerogel tubing in its entirety was in fact valueless. Despite coating some 37,000 feet of tubing with aerogel, Translight did not sell so much as one foot of that product which it held as inventory, which, in the US, is generally regarded as trading stock. In fact, in a letter from Dr Fraval to the Commissioner dated 31 July 2007 he described that tubing as a dead inventory to Translight. Of course the same description can be applied to that inventory when it was acquired by HFN. It was not a marketable product. On that basis, it is unrealistic to expect that any entity would acquire that inventory at cost if it were dealing at arm's length with Translight. In fact, in cross-examination, in the course of being asked whether he asked any questions about the coating of the tubing of anyone at FTI when the tubing was purchased Dr Fraval said: If we had, with hindsight, been able to be a fly on the wall and found out that it wasn't the same value, we would have, obviously, had a much more rigorous negotiation regarding the price. Dr Fraval was clearly aware of that and hence the decision to attempt to recover the expenditure incurred in producing aerogel coated tubing. On that basis alone, it cannot be said that the claimed expenditure on the aerogel tubing was reasonable. I include in that the second invoiced amount of $166,246 claim in the 2005 income year. I find that HFN did not take the care a reasonable person in its circumstances would have taken in making a R & D claim for the expenditure said to have been incurred in acquiring aerogel coated tubing.
Regarding travel expenses, while the Commissioner allowed a substantial portion of those expenses, the small amount disallowed was in respect of what Dr Fraval described as travel allowance. In my opinion, Dr Fraval was well aware that the Commissioner would not allow this sum which was expenditure on daily living expenses including food. They are not directly related to R & D activities.
Dr Bender submitted that the depreciation expenses claim by HFN in respect of capital assets were reasonable as they were assets used in the research and development project. He also submitted that HFN acted with reasonable care because the assets were recorded in its accounting records and there was photographic evidence to support the existence of the fume cabinet. Having examined the notes made by Dr Fraval while conducting experiments at his home, it was not difficult to accept that the fume cabinet was necessary and used in the course of that work. I did not however have objective evidence regarding ownership or cost of the purchase or the date on which it was purchased. Regarding this item of expenditure, I find that HFN did not take the care a reasonable person in its circumstances would have taken in making a R & D claim for that expenditure.
As for the other capital items on which depreciation was claimed, there was no evidence that they were used directly in the R & D activities. For example, the electrical control box was likely never used as it was intended to be used in the environmentally friendly house as part of the control mechanism for remote control of the systems in the house. There was no evidence of any activities which remotely resemble what was its described use. Likewise, there was no evidence about how the computer and printer were used in or directly related to the R & D activities. Regarding these items of expenditure, I find that HFN did not take the care a reasonable person in its circumstances would have taken in making a R & D claim for that expenditure.
Dr Bender submitted that HFN's claim for rental expenses and utilities was reasonably based. He said there were objective documents substantiating the method by which the rental expenses and utilities were calculated. Although Dr Bender agreed that HFN did not have all the utilities invoices for the 2004 income year he said the liability for that year was recorded in the accounts of HFN and accordingly it exercised reasonable care in claiming those expenses. With respect, I cannot agree.
While I have no doubt that Dr Fraval conducted experiments at his home, the problem with the rental expense and utilities claimed expenditure goes to whether that expenditure was in fact incurred. As I have already mentioned above, a simple entry in the books of account indicating a notional loan does not substantiate the incurring of expenditure. When one looks at the circumstances of HFN at the time it incurred these claimed expenses, it was either in a position where it simply did not have the funds to meet those expenses or, when it did have the funds which could have been used to pay those expenses, it did not do so. In my opinion, it should have been apparent to Dr Fraval that HFN could not substantiate this expenditure by simply pointing to an entry in the books of account of HFN indicating a loan entry. In fact, when examining Dr Fraval's loan account entries in HFN's accounts, it is clear that adjustments have been made from time to time without explanation. Frankly, the accounts are in an unsatisfactory state. For those reasons, I find that HFN did not take the care a reasonable person in its circumstances would have taken in making R & D expenditure claims in respect of rent and utilities.
As for the claimed telephone expenses, other than entries recorded in HFN's books of account, there was no evidence of the expenditure claimed or, if there were telephone expenses, that they were directly related to the R & D activities he conducted at his home. In fact even the entries in the books of account do not enable identification of this specific item being credited to his loan account with HFN. I find that HFN did not take the care reasonable person in its circumstances would have taken in making a R & D claim to this expenditure.

[186]

On 18 November 2009 the Commissioner issued to HFN notices under s. 73IA of the ITAA 1936 stating that the tax offset allowable for the 2004 and 2005 income years was $0. HFN objected to those notices and on 16 April 2010 the Commissioner delivered his Objection Decision in respect of the 2004 and 2005 income years. The outcome of that decision for HFN was that, in respect of the 2004 income year, HFN was not entitled to choose the R & D tax offset under s. 73I of the ITAA 1936. The Commissioner also determined that the expenditure claimed was not an allowable deduction. He issued a penalty at the rate of 25% of the tax shortfall for that income year. For the 2005 income year, the Commissioner found that HFN was only entitled to choose the R & D tax offset for consultancy expenses and the amount of $53,548. The Commissioner found that the remaining claimed expenditure was not an allowable deduction and imposed a 25% penalty on the shortfall amount.
I have found that the claimed expenditure on consultancy services was not substantiated because that expenditure was not incurred directly in respect of a R & D activity. As for the technology licence fee in respect of the aerogel coated tubing, I have found that the claimed expenditure was not incurred because I have found that there was no enforceable agreement between Translight and HFN which resulted in a pecuniary liability or, if there was an enforceable agreement, the pecuniary liability was extinguished upon the issue of a convertible note. I have also found that if the convertible note was subsequently converted into a loan, HFN has not discharged its onus to establish, on the balance of probabilities, that the parties reached agreement orally to convert that liability into a loan liability following the issue of the convertible note. Even if they did, the evidence discloses that this expenditure was capitalised and is therefore not able to be set off against revenue.
In my opinion, HFN failed to substantiate the claimed expenditure in respect of the acquisition of the aerogel coated Ionimer tubing. The claimed expenditure for the 2004 income year was subject to the convertible note issued by HFN. Even if I were to accept that the convertible note was subsequently abandoned and replaced by a loan liability, given that HFN apparently capitalised that expenditure, even if it was incurred, it is not against the revenue account and is therefore not deductible. While the 2005 income year claimed expenditure was not subject to the convertible note, I have found that HFN has failed to discharge its onus of proving, on the balance of probabilities, that it incurred the claimed expenditure.
Although HFN claimed expenditure in the 2004 and 2005 income years for depreciation of assets used in the R & D project, I have found that it has failed to discharge the onus of proving, on the balance of probabilities, either that it owned the assets in those income years or that they were used in the R & D project. I have also found that HFN has failed to discharge its onus of proving that it incurred rent expenses, utilities expenses, telephone expenses and travel expenses in the income years in question.
The Commissioner imposed penalties on HFN for both income years at the rate of 25%. I have found that HFN did not take the care a reasonable person in like circumstances would have taken in making a R & D claim for expenditure it incurred. It was not able to substantiate that expenditure. Therefore, I have found that the Commissioner's decision to impose penalties in both income years was correct. I have also found that there was no basis for remission of those penalties. The Commissioner's decision to impose penalties was not harsh or unreasonable.
In my opinion, the decision made by the Commissioner on 16 April 2010 was correct. I affirm that decision.

Hadrian Fraval Nominees Pty Ltd and Commissioner of Taxation [2013] AATA 127 (12 March 2013)

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Judgment (188 paragraphs)

Hadrian Fraval Nominees Pty Ltd and Commissioner of Taxation [2013] AATA 127 (12 March 2013)

Legislation Cited (4)

Cases Cited (18)