Henderson v Commissioner of Taxation

[7]

It oversimplifies this case to regard it as turning simply on the distinction between calculating a taxpayer's income on an earnings and on a cash basis. The case concerns the income of the taxpayer Henderson; but the question arises in relation to income derived by him as a partner in a firm of public accountants. It is the method of calculating the income of the partnership business which is really in question. For this reason the case has implications for the future; and for other people than the taxpayer. So far as the taxpayer himself is concerned - and after all it is his tax which is in question before me - his return of income derived by him during the relevant years stated the actual amount which had been paid to him, said to be as his share of the profits of the partnership earned in the year. His case might, at first sight, therefore seem simple. It might be said that throughout the period of his membership of the firm he returned as part of his assessable income the sum he actually received in any year as his share of the partnership profits: that in the years in question that is so just as it was in earlier years. Looked at in this way, it may seem immaterial that the amount he was paid was at one time calculated on the basis of the firm's receipts and at another on the basis of its earnings - because, as a taxpayer, he has always returned as his income whatever moneys he had actually received each year by virtue of his being a partner. However, in computing the profits of the partnership business available for distribution in respect of the years in question, earnings, not actual receipts, were taken as the basis of calculation. The business was at relevant times increasing year by year. In each of the years in question the taxpayer and other persons entitled to share the profits received amounts which in total amounted to more than the total of the sums actually received by the firm during the relevant year. The firm had borrowed money to enable a distribution of more money than had actually come in.

[13]

The law, ignoring the firm, looks to the partners composing it; any change amongst them destroys the identity of the firm; what is called the property of the firm is their property, and what are called the debts and liabilities of the firm are their debts and their liabilities. It could equally well be said that what is called the income of the firm is income of the partners; and that it is distributable among them according to the terms, express or implied, of the agreement between them. It would, however, be pedantic to quarrel with the provisions of the Act (s. 90) by which "net income" in relation to a partnership, means the assessable income of the partnership, calculated as if the partnership were a taxpayer, less all allowable deductions except the concessional deductions and deductions allowable in respect of losses of previous years. Whatever objections, verbal or in legal theory, may be made to speaking of a firm as if it were a legal person, there is no difficulty in the concept for accountancy and business purposes. Accountants are accustomed to what is called the "accounting entity convention" in relation to a partnership business, or I suppose, to any distinct enterprise. The Act requires that the collective income of the firm, as an association of persons carrying on business as partners, is to be treated as if the partnership were a taxpayer. But the Act does not subject it to tax. Section 91 provides that "a partnership shall furnish a return of the income of the partnership, but shall not be liable to pay tax thereon". From a partnership return it will appear that the partnership, considered as if it were a taxpayer, has either gained what the Act calls a "net income" or sustained what it calls a "partnership loss". Whichever it be, it is carried into the assessable income of each individual partner according to his share of it. In the case of net income it is added to his income from other sources in determining his taxable income of the relevant year. This is because, using the words of Rose's Case [1] the part of the Act which deals with partnerships is based upon the view that the collective income earned by the partnership belongs according to their shares to the partners regardless of its liberation from the funds of the partnership, that is, its actual distribution. As I understand the case for the Commissioner he says that, just as a taxpayer who is a partner can be taxed on his share of the partnership profit for a particular year although it was retained in the partnership funds and not then paid out to him, so he is not to be taxed in respect of amounts actually paid him as his share of partnership profits which, according to what the Commissioner regards as proper accountancy, were not properly so described. There is no suggestion that the amount received by the taxpayer was not properly determined as his share of the aggregate income of the firm if the way in which that was calculated was permissible for income tax purposes. 1. (1951) 84 C.L.R. 118. 2. (1951) 84 C.L.R., at p. 124.

[28]

Over the years the accountancy business grew greatly and continued to grow; and some change occurred in the character of the work done; and more of the work was done on a credit basis, instead of the customers paying for it as it proceeded. In 1964 the partners, or the managers for them, decided that in the conditions which had come to prevail it would be better if the partnership income tax return were rendered on an earnings, or accrual, basis instead of as theretofore on a cash receipts basis. One of the matters which led them to this conclusion is said to have been a looking to the future, to the time when one or more of the senior partners would retire. It was apparently thought that by keeping the accounts of the partnership on an earnings basis each member of the firm would only receive and be taxed upon a remuneration proportionate to his contribution to the total earnings, and furthermore that neither a retiring partner nor continuing partners would suffer if a retirement occurred when there was a large sum outstanding for work done but not yet paid for. These matters were, I have no doubt, in the minds of those who decided to change the basis on which the accounts of the firm were kept. But I have not seen that they necessarily dictated a change in the method of calculating income for taxation purposes. It would no doubt be convenient if accounts kept for determining the internal affairs of the partnership, that is the relations of the partners one to another, were on the same basis as accounts kept for the purpose of recording partnership income for fiscal purposes. But, as I see it, the two do not have to correspond. The financial arrangements to be made when a partner retires or dies, and the firm is thereupon re-constituted, depend upon the agreement made or to be made between the partners to meet that situation. Nevertheless that situation, and the arrangements made by the partners to meet it, can obviously give rise to taxation problems, as for example in Commissioner of Taxation v. Happ [1] . However, these questions do not arise in this case. Their only importance is that the partners thought it convenient or helpful for the regulation of their financial relations one with another, then and in the future, to adopt for the purposes of their business a new mode of accounting. And that seems to me to be a good reason why they should be permitted to adopt that mode for fiscal purposes also, if it be one which accords with the Act and truly reflects the assessable income of the partnership "calculated as if the partnership were a taxpayer".

[61]

It appears that, at one time, it was common to take no account of stock-in-trade or work in progress for income tax purposes; but long ago it became customary to take account of stock-in-trade, and for a simple reason. If the amount of stock-in-trade has increased materially during the year, then, in effect, sums which would have gone to swell the year's profits are represented at the end of the year by tangible assets, the extra stock-in-trade which they have been spent to buy; and similar reasoning will apply if the amount of stock-in-trade has decreased. So to omit stock-in-trade would give a false result. It then follows that some account must be taken of work in progress. Suppose that the manufacture of an article was completed near the end of an accounting period. If completed the day before that date, the article, if not already sold, has become stock-in-trade; if completed the day after that date it was still work in progress on that date. It could hardly be right to take that article into account in the former case but not in the latter. I do not know when it became customary to take into account work in progress, but it appears that that has been customary for many years, and it is not disputed that, at least in all ordinary cases, that must now be done [3] . These propositions relate to "work in progress" as a synonym for tangible things, goods in process of manufacture from raw materials, things which when completed will become stock-in-trade. Accountancy theories differ as to the method of valuing such work. But "work" in that sense does not connote abstract activity, work done and labour expended. It denotes concrete tangible things, work on hand. But the ambiguity of the word "work" and the attraction for accountants of the phrase "work in progress" can I think mislead. In my opinion it is a mistake to suppose that the notion of the value of work in progress, in the sense of things uncompleted by a manufacturer or craftsman, can be simply transferred to uncompleted services by a tradesman or the practitioner of some profession, and to assume that it can there be applied in the calculation for taxation purposes, of income derived. I realize that in accountancy there is a similarity of a sort between unfinished goods and uncompleted services, and that the latter are sometimes described as work in progress. No doubt accounts can be kept in which a value is ascribed to uncompleted tasks by persons engaged in the practice of various trades and professions and rewarded by fees. Such accounts may be useful for many purposes, especially in the case of several persons practising a profession in association. The contribution of each to the earning of the collective income can be shewn by such accounts. And they may be useful in relation to the terms on which a partner retires from or a new partner enters a firm. But it is one thing to record when, and by whom, work is done which will produce income: it is another to say when income, the rewards of such work, was derived. I am aware that the expression work in progress has been used in some cases in arriving at the taxable income from fees for professional services: e.g., Wetton, Page & Co. v. Attwooll [1] . Nevertheless I think that services rendered for fees do not result in income derived within the meaning of the Act until the fees are either paid or payable. This of course may be before an account for payment is rendered. For example, a physician may be entitled in law to be paid for attendances upon his patient before his treatment of him for his illness has been completed and he has sent him a bill. What he is thus entitled to be paid forms part of his income calculated on an earnings basis; but not for work in progress, but for work done. Similarly an accountant engaged to conduct a continuous audit may be entitled to be paid for the hours he has spent and for his attendances, although he only asks to be paid periodically. But when a professional man is, according to the terms of his engagement, not to be paid until his task is completed, I do not think he can be said to have earned anything by that task until then. A lawyer retained to write an opinion or draw a deed cannot ordinarily say that he has earned any income by his work until he has produced the result of it. Similarly with an auditor employed to give a certificate, an architect to prepare plans, an accountant to produce a balance sheet. A half-written legal opinion, a deed drawn in part only, plans unfinished and still on the drawing board, an incomplete balance sheet, are not like goods in course of manufacture. When completed they are not valuable because of their physical properties, but for the information they convey or the legal effect they produce. 1. [1960] 1 W.L.R. 510; [1960] 2 All E.R. 110; [1961] 1 W.L.R. 739; [1961] 2 All E.R. 167. 2. [1961] 2 All E.R., at p. 171. 3. [1961] 2 All E.R., at p. 172. 4. [1963] 1 W.L.R. 114; [1963] 1 All E.R. 166.

[69]

The assessable income of the partnership for the year 1964/1965 includes, in my view, at least part of the sum of $179,530 reducible apparently to $177,098 by setting off liabilities outstanding at 30th June 1964. The amount of $179,530 is said to have included an amount of $113,528 described as for work in progress at 1st July 1964. There is nothing to shew that that amount or any part of it was then presently payable. The only evidence of the debts outstanding and payable at that date is that they amounted to $66,002. If the then outstanding liabilities of the period ended 30th June 1964 (namely $2,432) be deducted, the earnings due to the partnership and unpaid at 1st July 1964 appear to have had a value of $63,570. This amount, or whatever amount was in truth the sum of the recoverable debts earned in the earlier year, would, if the income of both periods were being calculated on a strict earnings basis, be deductible in the calculation of the income of the year 1964/1965. But that was the transitional year; and, for the reasons I have given, when for taxation purposes a cash basis of accounting is abandoned and an earnings basis is adopted, the calculation cannot proceed as if an earnings basis had been in use throughout. An adjustment must be made, and this it seems to me involves a bringing to account, as earnings at the time when the new basis of accounting begins, all debts then collectable - that is all debts due and payable, excluding bad debts. What on an earnings basis would ordinarily be counted as the aftermath of the previous year is counted as part of the prima tonsura of the transitional year. Although the evidence specifically shews only a sum of $63,570 to be brought to account in this way, there would have to be added to it such part, if any, of the sum of $113,528 as represented debts recoverable at 30th June 1964. These two sums, $63,570 and such amount as was at the beginning of the year a recoverable debt arising from what was called work in progress, must, in the view I take, be brought to account as part of the assessable income of the year 1964/1965 as an adjustment made necessary by the change from a cash to an earnings basis. If the earnings basis had been constantly in use throughout, these amounts would have entered into the calculation of partnership income for the previous year and been deducted in the calculation for the year 1964/1965.

[80]

The appellant is a member of a partnership practising the profession of accountants under the firm name of C. P. Bird & Associates. This partnership constituted during the financial years 1963-1964, 1964-1965 and 1965-1966 his sole source of income. By it he was paid a salary and a bonus but received no distribution of the profits as such. Sections 90 and 91 of the Income Tax Assessment Act 1936-1966 Cth (the Act), however, required the appellant to pay income tax upon the full amount of his share of the income derived by partnership in each year of tax. In the years ended 30th June 1965 and 30th June 1966 respectively the partnership determined its profits on the basis of fees earned and accounts incurred during the year. It made its returns of partnership income on the same, i.e., on an earnings, basis. It distributed to its members, nineteen in all, the whole of this profit for each year by way of salary and bonuses, borrowing money to the extent to which its cash receipts for the year were inadequate to enable it to make this distribution. The appellant returned as his assessable income the amount thus received by him in each of these years from the partnership. But the respondent (the Commissioner) was of opinion that in respect of these tax years a "cash received and accounts paid" basis was the proper basis on which to ascertain the income of the partnership. Accordingly he assessed the appellant on the footing that he derived income in each of those tax years to the extent of his entitlement to a share of the partnership income so ascertained. With each of his assessments made under s. 166 of the Act the Commissioner served on the appellant an adjustment sheet disclosing the figuring by which he had re-adjusted the figures in the partnership return to represent a computation of the partnership income on a cash basis instead of an earnings basis. The result of this conversion was to treat the partnership as having in each of the tax years suffered a loss, a result to be expected in so far as the partnership had had to borrow money to distribute in cash profits calculated on an earnings basis.

Henderson v Commissioner of Taxation - [1970] HCA 62 - HCA 1969 case summary — Zoe

At a glance

Court

Decision date

Before

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Judgment (100 paragraphs)

Parties

Cited By (1)