Treatment of forgiven or abandoned debts
79 Assuming, contrary to my finding, that there was a loss in the 1988 or 1989 tax years, and accepting that by some time prior to December 1994, it was improbable that the trust debts, upon which the loss was based, would ever be called up, it is necessary to determine the tax consequences. The Commissioner submits that I should apply by analogy the decision of Hill J in Warner Music Australia Pty Ltd v Commissioner of Taxation (1996) 70 FCR 197. In that case the taxpayer was, in November 1985, served with two sales tax assessments for the periods from 1 January 1982 to 31 May 1985 and from 1 February 1982 until 31 May 1982. The assessments were in the amounts of $599,087.72 and $564,544.69, together with additional tax in each case. The taxpayer objected to the assessments and sought an extension of time in which to pay. The extension was disallowed, and the decision to disallow challenged pursuant to the Administrative Decisions (Judicial Review) Act 1977 (Cth) (the "ADJR Act"). The Commissioner sought to recover the debt in the Supreme Court of New South Wales. The proceedings under the ADJR Act were resolved by consent orders in 1987. The dispute between the parties was ultimately settled in 1991. The Commissioner agreed to accept $650,000 in full satisfaction of the taxpayer's liability under the two assessments, waiving all rights to recover the amounts initially assessed, without admitting the correctness of the taxpayer's arguments. The taxpayer then claimed the total amounts assessed, excluding the additional tax, as income tax deductions for the year ended 30 November 1985. The Commissioner allowed the claim. The unpaid liability for sales tax had not previously appeared in the taxpayer's accounts, but it had been noted in the directors' report, with an indication that there had been an objection, and that in the opinion of the directors no amount was payable. In subsequent years similar notes appeared. The Commissioner sought to include that part of each assessment which he had foregone as income received by the taxpayer in the 1991 tax year.
80 In June 1987 two further sales tax assessments were issued for the periods 1 June 1984 to 30 June 1985. One was for $4,197,209.20 with additional tax. The other was for the amount of $87,210 with additional tax. The amounts assessed were not paid. An extension of time was sought. The Commissioner refused the application, and an application was made pursuant to the ADJR Act. The taxpayer lodged objections against both assessments. The objections were overruled. The taxpayer appealed, in respect of the larger assessment to this Court, and in respect of the smaller, to the Administrative Appeals Tribunal. The proceedings concerning the refusal of the extension of time were settled upon the taxpayer agreeing to pay $1 million to the Commissioner who agreed not to commence recovery proceedings with respect to the balance until the proceedings had been determined. The proceedings in this Court were determined in favour of the taxpayer, as were the proceedings in the Administrative Appeals Tribunal. The Commissioner refunded the amount of $1 million to the taxpayer. The taxpayer claimed income tax deductions for the 1987 year in the amounts of the two assessments. The claims were allowed. The taxpayer returned the amount of the refund as assessable income. The Commissioner assessed that amount to income tax.
81 Expert accounting evidence was led concerning the proper accounting treatment of the disputed sales tax assessments. In order to understand the reasons given by Hill J, it is necessary to know something about that evidence.
82 One accounting witness said that once a sales tax assessment had been issued and become payable, liability should be recognized in the balance sheet of the taxpayer, whether or not the assessment is challenged. The witness then considered whether the assessment should be an "expense" item in the profit and loss account, and whether there should be a corresponding "receivable" item in the balance sheet, representing the contingent right to have the assessment expunged in the event of a successful objection and appeal. Hill J said at 202:
It is, no doubt, obvious that the question whether a receivable should have been recognised in the balance sheet involved a question of judgment, depending upon factors such as the likelihood of success in contesting the assessment. Also relevant, no doubt, would be matters such as materiality and prudence in the preparation of the accounts. If (the taxpayer) had had a high expectation of success for its objection, in (the accountant's) view this would have justified recognition of a receivable in an amount equal to the liability. In such a case it would, no doubt, be wrong to recognize the liability as an expense in the profit and loss account.'
83 The same accountant said that in the event of forgiveness or waiver of the liability, the initial entry recording the liability should be reversed and any corresponding asset written back.
84 Another accounting witness said that in a relevant United States standard, the definition of liability had, as the key issue, 'whether management believed that payment of the amount of the liability was probable, either at the time of the original assessment or subsequent thereto.' Of this proposition, Hill J said at 203:
'It is clear from his evidence that there could, at least, be occasions, in his view, where there could be an offsetting asset which, if the view was taken that the whole of the assessment was capable of being overturned on appeal, could be equal in amount to the amount of the liability. … In other words, if a taxpayer owed the Commissioner a sum of money and the taxpayer believed that it would be wholly successful on appeal so that there was a receivable in an amount equal to the amount of the assessment, the two amounts could be netted off. …'
85 The Commissioner advanced the proposition that:
'… the Court should recognise a general principle of taxation law that the assessable income of any taxpayer should include the gain or benefit derived by that taxpayer by the reduction or extinction of a liability in respect of which a deduction had been allowed under the Income Tax Assessment Act 1936 (Cth) … in a previous year.'
86 Hill J considered that such a proposition was inconsistent with the earlier decision of the Full Court in Commissioner of Taxation v Rowe (1995) 60 FCR 99, a decision which was subsequently upheld on appeal by the High Court in Commissioner of Taxation v Rowe (1996-1997) 187 CLR 266. In those circumstances Hill J said (at 205):
'The real issue between the parties is whether the release of (the taxpayer) from its liability to pay sales tax constituted income in ordinary concepts by virtue of that release constituting a gain or profit forming part of its business income. There are two steps in the resolution of this issue. The first involves the question whether the amount released involved a gain to (the taxpayer) so as to constitute a profit. The second is whether this profit or gain was on revenue account.'
87 At 210, his Honour observed:
'The cumulative effect of these provisions is that service of a notice of assessment of sales tax gives rise to a statutory liability which may be recovered by the Commissioner. … That liability operated to reduce the actual assets of (the taxpayer) from the moment of time that the notice of assessment issued. While there may be difficulty in a lawyer comprehending the concept of a notice of appeal against an income tax assessment as being property … no doubt it is possible to talk, in commercial terms, of a company having an offsetting right through the objection and appeal procedure whereby a company might hope to bring about a situation that the liability to pay sales tax is extinguished. But whether that is correct or not, (the taxpayer) had a continuing liability to the Commissioner of Taxation until the 1991 income tax year when, as a result of compromise or court decision as the case may be, it was freed from that liability. In a legal sense, at that point of time (the taxpayer) made a gain. The fact of that gain is not in any way to be diminished by reference to possible accounting treatment. It cannot be the law that the fact that one taxpayer forms a view that its chances of success on an objection are high and another taxpayer forms the view that its chances of success on a sales tax objection are low, that the consequences of being released from the sales tax liability would differ. In my view, it is unarguable that (the taxpayer) made a gain when the sales tax liabilities to which it remained subject until the 1991 income tax year, were released.
Once it is accepted that there was a gain, then the question is whether that gain should be characterised as income in ordinary concepts in the year in which the gain was made.'
88 Although there was no substantial body of expert accounting evidence in this case, both Mr Steele and Mr Arnold gave some evidence. Mr Steele's evidence is of principal significance. Of his methods in preparing financial statements for Nommack Nominees, he said at par 25:
'Financial Statements were prepared … as specific purpose compilation reports for the sole use of the trustees and to satisfy the requirements of the trust deed. No audit was conducted and there was no requirement to prepare more complex and onerous general purpose financial statements. Financial statements were prepared on an accruals basis. Trading income was brought to account when earned and expenses brought to account and matched against that income irrespective of the period incurred. Expenses of developments were generally capitalised as either work in progress or stocks of completed units. Expenses related directly to rental income were isolated to rental property accounts. Net rental income is rental income less rental property expenses. Entity maintenance expenses such as accountancy and administration (unless of course the expenses related directly to a construction project or rental) were not otherwise specifically allocated.'
89 In pars 37-38 concerning the debt of $1,700 owed by Nommack (No 41) he said:
'37. … In presenting the accounts for the year ended 30 June 1995 a decision was made that this debt might not be collectible and it was therefore written off. It was determined that the collection of the debt was most likely uncommercial and even though I believe it was never formally released, it was at the time prudent accounting practice for the debt to be written off to show a true and fair view of the financial asset position of the trust.
38. It is usual accounting practice to apply the "doctrine of conservatism" in the preparation of financial accounts. That is, I will generally take a less than optimistic view of the value of assets, particularly if estimated realisation amounts will be less than cost.'
90 Of the treatment of the loss associated with the Elizabeth Street project, he said at pars 95-97:
'95. In my opinion the accounting methodology which has been adopted is correct. Based on my understanding of the facts that Messrs Theeman and Adler (as Nommack No 75) were acquiring sites with a view to obtaining the development approvals (and no more) - it would have been appropriate and indeed correct for the land to be treated as trading stock as opposed to investments and any profit or loss to be ordinary trading income as opposed to a capital gain.
96. In my opinion if a taxpayer is buying with the intention of making profit by reselling rather than intending to hold the asset, the former mentioned is trading and ought properly to be brought to account as ordinary trading income.
97. Due to the nature of the losses as well as the change in legislation under the Income Tax Assessment Act, and out of an abundance of caution, I sought advice each year concerning the deductibility of the income against the losses which were accumulated within (the Sydney trust). I initially received verbal advices in this regard from Mr Les Priddle and thereafter I received written advice from Cleary Hoare.'
91 A number of letters of advice are attached. They canvassed aspects of taxation law as it applies to trusts but offered little practical advice specific to the Sydney trust. At par 98 Mr Steele said:
'The seeking of these advices was viewed by myself as prudent, especially after the implementation of the trust loss provisions (by way of amendment to the ITAA) in 1995. Based on the advices which I received from Cleary Hoare, I advised Mr and Mrs Weyers that in each year in question they were entitled to the deduction of any income in the (Sydney trust) from prior years and from the net amount of prior year losses. I also recall that I sought specific reassurance from Cleary Hoare in relation to the transitional provisions in regard to the controller of the trust. I was therefore of the view that the legislation applied as at the date on which it was implemented and had no retrospective operation.
92 In par 99 he referred to other advice but its content is unclear.
93 In cross-examination Mr Steele said that he would not apply the doctrine of conservatism so as to write off debts owed by a company. He said that 'Assets tend to be written down, liabilities tend to be written up.' Mr Steele also said that if a debt was forgiven, the forgiveness might be treated as the debtor's income. Such treatment was not dependent upon the borrowing having been shown as "current". He said that if a creditor ceased to exist, he would nonetheless leave the debt in the debtor's books if it remained legally payable. He also said that he would take legal advice as to the appropriate treatment. He also would apply the doctrine of conservatism.
94 Mr Steele was asked about steps taken to identify the circumstances in which the trust debts arose. He said that his role was not to audit the books, implying that he had more or less accepted the records provided to him. He had been advised that if he wrote off the liabilities in this case, 'there will be consequences'. He understood that to be a reference to tax consequences. In effect he considered that if there was any chance that the liabilities could be called in, prudence dictated that they be kept on the books. This seems to suggest that if there is no chance of their being collected, they may be written off. At a meeting held on 26 April 1996 the matter was specifically discussed with Mr Priddle and Mr Collie. It was decided that the trust debts should stay in the accounts. He would not write off a debt owed to a company which had been deregistered.
95 Mr Steele said, concerning his understanding of the Weyers' position in connection with the trust losses and liabilities:
'Well, my understanding of it was that the client effectively - this is going to sound a little bit unusual but sort of owned the - he effectively had both sides of the equation here. He had a right of indemnity anyway, in respect of these liabilities, so he had acquired that, I think from the previous trustee, and in a sense you might say that - you might say in a sense that he had both sides of the ledger.'
96 Mr Steele was asked if some provision ought to have been made for paying the trust debts and replied:
'Well, I think - my understanding is if the liabilities were in fact called and Mr Weyers had a right of indemnity against the trust assets which would have been his loan accounts.'
97 Mr Steele may have been referring to the continued presence in the trust accounts of the trust debts and the certainty that they would not be called up because of the fact that Cherrybrook had purportedly received an assignment of the right to indemnity previously held by Nommack (No 75), the actual debtor.
98 Mr Steele did not consider the operation of any limitation statute.
99 He was asked questions about advice which he had received in preparing tax returns for the Sydney trust. He may have consulted another accountant about some aspects, but his advice came primarily from Mr Priddle and Cleary Hoare, of which firm Mr Collie was a member. I will consider that advice in more detail in a moment. It was, perhaps, unfortunate that Mr Steele should have continued to seek advice from Cleary Hoare in view of Mr Collie's involvement in the acquisition of the Sydney trust by the Weyers.
100 Mr Steele and the Weyers did not discuss the way in which the trust debts might have been paid if called up. Mr Steele said that 'generally you don't have to ring creditors and ask them if they want payment. They normally demand it.' He said that had the debts been demanded he thought that the Weyers would have paid them because 'The Weyers had always paid their debts, to my knowledge.' This seems to be inconsistent with his earlier evidence concerning the indemnity. He was asked about assets from which Nommack Nominees might have paid the debts. His answer was:
'What assets might - I don't think Nommack had any right to any assets because it hadn't incurred the liabilities, had it?'
101 He was then asked, and answered:
'What trust property of which you were aware might Nommack have looked to, as trustee in the first instance, to meet any call if one were ever made by a liquidator of Rothwells or Media Portfolio? --- Well, my understanding would be that it hadn't incurred the liabilities, why would it have any access to the assets?
How can you say it hadn't incurred the liabilities when you had been putting them in the accounts for years? --- Yes, because those liabilities belong to a prior trustee, didn't they? They were incurred by prior trustees, isn't that exactly what the advice says?
How can you say, having told us solemnly for the last hour and a half or two hours that you recorded this debt because you were told that it was still owed, how can you say they hadn't incurred liability for it? --- Well, Nommack had. The previous trustee had incurred the - it was still a debt of the trust, but it had been incurred by the prior trustee.'
102 He agreed that Mr and Mrs Weyers had, after the meeting in December 1994, advanced moneys to themselves from the Sydney trust. He thought that somebody must have advised them in connection with that matter.
103 Concerning the origins of the trust debts, he said:
'I knew very little about these, you know, these particular, the depth of the transactions behind the scenes because they were in prior records prepared by previous accountants. But my understanding of it is that these liabilities, in effect that Mr Weyers had acquired the right of indemnity and therefore if these liabilities - in effect he owed these liabilities. It's a terrible - its not necessarily maybe a legal method of looking at it. It's the way I looked at it.'
104 Further cross-examination indicated that Mr Steele had no knowledge of the source of any indemnity to the Weyers. He later suggested that Nommack (No 75) had given the indemnity.
105 It is appropriate to say something about the various legal advices received by Mr Steele in connection with this matter. I have previously referred to exhibits 3 and 8 which are copies of a letter dated 21 December 1994 from Mr Priddle to Mr Weyers in which he advised that 'The transaction reflected in the Facilitation Agreement and the Deed of the Removal of Appointment of Trustee makes it clear at law that the new Trustee (and therefore the Trust) cannot in any way be liable for any debts of the Trust incurred before today.' At a meeting on 26 April 1996 Mr Steele raised with Mr Priddle and Mr Collie the proper accounting treatment of the trust liabilities. He received some information concerning those liabilities and was told that they should be kept on the books. He said that he enquired as to whether the liabilities were 'to be continued from here' and was advised that they should be, and that they were existing liabilities. He was told that they were still legally payable and that:
'(A)ny merging or write-off, or whatever, of these loans could give rise to adverse tax consequences, and that whilst they also remained on the books, there would be essentially no adverse tax consequences, and there was a technical argument, obviously between Mr Collie and Mr Priddle about a number of these things, which is beyond my understanding as a simple accountant. However it was quite clear, as a result of that meeting, that these were in fact liabilities of the trust, as perceived by my client, and they were to be in fact - were to remain on the books, and I took that advice, and it's as simple as that.'
106 He did not enquire as to whether the creditors still existed.
107 On 20 June 2001 Cleary Hoare advised in relation to liabilities to Ratic Investments Pty Ltd, Nommack (No 100) Pty Ltd and arising out of "Commercial Bills" as follows:
'We advise that under the documentation in which the above Trust was acquired, the rights of creditors under the liabilities were not acquired by Robert Weyers. What was acquired was the right to be indemnified out of the assets of the Trust in respect of those liabilities, which was acquired by Robert Weyers from the former Trustee.
The rights of creditors is a right to payment of the liability by the entity which incurred the liabilities, namely the former Trustee. Since the former Trustee has no assets to meet those liabilities and is not entitled to be indemnified out of the assets of the Trust, the assets of the Trust are not available for meeting the claims in respect of those liabilities.
However, the amounts owing in respect of those liabilities remain owing to the original creditors (they have not been assigned to Robert Weyers) and so the disclosure of those liabilities would remain as stated in the balance sheet.'
108 Both Mr Priddle and Cleary Hoare accepted that the debts remained owing by Nommack (No 75). Both, however, considered that Nommack (No 75) no longer had a right of indemnity as against trust assets. This appears to have been as a result of the purported successive transfers of the right of indemnity. The object of the exercise seems to have been to permit retention of the trust debts as liabilities in the accounts whilst protecting the trust assets from any call for indemnity in respect of such debts. I need hardly say that it is unlikely that Nommack Nominees could properly claim to be liable for the trust debts if there were no possible way in which they could be enforced against it. Accepting at face value the view that Nommack (No 75) released any claim to indemnity from the trust assets, it follows that Nommack Nominees and the trust itself (if one may use that term loosely) had no loss to apply against income. In that case there could be no question of the Sydney trust being liable for the debts. They clearly could not be called up as against any entity other than Nommack (No 75), and that company would have no recourse to trust assets.
109 Mr Steele's approach to accounting methods was, in my view, influenced by his desire to ensure that the Weyers derived the benefit for which they had bargained. He was content to rely upon advice given by Mr Collie and Mr Priddle, notwithstanding their involvement in the Weyers' acquisition of the Sydney trust and their interest in ensuring that the Weyers obtained such benefit. Mr Steele conceded that there were accounting aspects which concerned him, and he claimed to have consulted another accountant. Yet there is no evidence of any request for detailed and independent legal or accounting advice or of the receipt of such advice. Mr Steele was unable to give any rational explanation as to how the Sydney trust, through Nommack Nominees, could have been liable, for accounting purposes, for debts incurred by the Nommack (No 75) whilst, at the same time, not liable to indemnify that company for such debts.
110 Mr Arnold said that in terms of accounting practice, a debt owed by a company which had been deregistered, might be removed from the creditor's accounts. As to the treatment of moneys owed to a company which was in liquidation, he said that he would check the question of liability and make inquiries as to what the liquidator intended to do. If the company to which money was owed had been deregistered, and if there was no notice of assignment of the debt or that the company had been acting as trustee, an accountant would be inclined to delete the liability from the accounts of the debtor. Mr Arnold agreed that at the time at which he made his statutory declaration (exhibit 9 - 16 December 1994), he did not expect that the debts owed to Media Portfolio, Ratic Investments and Nommack (No 100) would ever be paid. He said that notwithstanding this, he retained them in the accounts because '… there was no formal release. They were just carried forward as historical balances. There was no formal release of those debts.' If, as Mr Arnold conceded, it may be appropriate to write off an unclaimed debt in the books of a debtor, then this was a clear case for doing so.
111 The question is whether or not Nommack Nominees was entitled to set off income derived between December 1994 and 30 June 2002 against the accumulated losses incurred as a result of the trust debts. The question is not as to the proper treatment of the debts for accounting purposes, although that may give some insight into the problem. It is rather as to the continued existence of the debts in December 1994. The problem may be unusual, but that is because of the curiosity of the taxpayers' conduct. There is no suggestion that Nommack (No 75) lost anything, save that it incurred the trust debts which have not been paid. It is not remotely likely that they will ever be paid by that company, or that it will be indemnified for any such payment from trust assets. The taxpayers' case seems to be that even if Nommack (No 75) were to pay them, the trust assets would remain unaffected by such payment. The taxpayers argue that nonetheless, trust income may be set off against the losses. Such an unlikely situation invites close examination.
112 Whatever the position in 1988, by December 1994 the trust debts had ceased to exist as liabilities of the trust. That may have been because Nommack (No 75) had released its right to claim indemnity. Alternatively the passage of time, winding up or de-registration of relevant companies and possibly, the assignment of the debt by Media Portfolio, together with the absence of any demand, made it highly unlikely that such debts would ever be called in. That was almost certainly the situation as at the time of acquisition of the Sydney trust by the Weyers and as at June 1994. In those circumstances, to value them in the trust accounts at face value was to misrepresent the true position. The circumstances to which I have referred, and the Weyers' willingness to acquire the trust and inject money into it, suggest that from a commercial point of view, there was no possibility of the debts ever being called in. The accounts should have reflected that position.
113 Either of two approaches might be appropriate for present purposes. The first is that adopted by Hill J in Warner Music. His Honour there treated forgiveness of a debt as a gain which, if of a revenue nature, should be treated as income. If that approach were adopted in the present case, it would presumably be necessary for the Commissioner, if he still may, to re-assess the taxable income of the trust in one or more of the years prior to 1995 to reflect such gain. That gain would then go in reduction of the accumulated losses. The result would be that by December 1994, and probably by 30 June 1994, the accumulated losses would have ceased to exist.
114 The second approach, which I favour, would be to recognize that the trust debts and accumulated losses were over-valued in the accounts of the trust as at December 1994, and as at 30 June 1994 (after the right of indemnity had allegedly been released by Nommack (No 75). By that time, at the latest, they were worth nothing and should have been taken out of the accounts. That was so whether one treated the release by Nommack (No 75) as being effective or relied upon the history of the matter. It was factually incorrect to assert that the trust had suffered any loss as a result of the Elizabeth Street project, notwithstanding the position as it may have appeared in 1988 or as Mr Arnold saw it in 1994. To adopt the language of the accountants in Warner Music, management's belief as to the probability of the company having to pay the relevant debts proved to be unduly pessimistic. Such an approach is, in my view, more attractive than is any attempt to apply the Warner Music approach to the present case.