Federal Court reminds us of the complexity of income tax deductibility, and what it means to carry on a business.

In Watson as trustee for the Murrindindi Bushfire Class Active Settlement Fund v Commissioner of Taxation [2019] FCA 228 (Watson), the Federal Court ruled that an investment trust established to hold funds received as compensation for victims of the black Saturday bush fires could not deduct administrative expenses associated with the trust’s operation.  

The case confirms that determining whether you are entitled to an immediate income tax deduction for an outgoing is a question that continues to confront the courts, advisors, and taxpayers alike. No two cases are the same, and it continues to be a question to which reasonable minds differ.

The case is also a useful refresher on the question of whether a taxpayer is carrying on a business. Whether a business is being carried on is important in many aspects of the tax laws, not only in the context of income tax deductibility, but also to qualify for other tax relief (such as the small business capital gains tax (CGT) concessions).

Key facts

To compensate victims of the Murrindindi Bushfire, under an out-of-court settlement the trust was established to invest the monies received from the settlement into term deposits (and other securities) before distribution to the victims.

The trustee of the trust was a partner in Maurice Blackburn Lawyers, and that firm conducted the trust’s day-to-day management and administration as that firm acted for some of the victims’ privy to the settlement.

The trust derived assessable interest income from its investments and incurred various outgoings associated with its administration.  

The outgoings (which totalled just over $4 million in the relevant year) included:

  • costs of Maurice Blackburn relating to depositing the settlement monies, setting up systems to administer the trust, assessing the claims of beneficiaries to receive compensation, and the overall administration of the Trust; and

  • professional fees paid to legal counsel and medical practitioners as part of the administration of the trust.

The test for income tax deductibility

Under section 8-1 of the Income Tax Assessment Act 1997 a loss or outgoing is deductible to the extent that:

  • it is incurred in gaining or producing your assessable income (first limb); or

  • it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. (second limb)

However, a loss or outgoing is not deductible if it is capital or capital in nature.

The second limb requires carrying on a business.                                                                

The test for carrying on a business

The legislation does not define the expression and it is a question of fact and degree. Courts have held that key considerations include:

  • systematic and organised activities;

  • profit making intention;

  • scale and regularity of activities; and

  • commercial character and significant commercial activity.

Contentions in Watson

Under the first limb, the trust submitted that the income producing activity (being the derivation of interest income) was integrally connected to the incurring of the administration costs – the trust would not have derived the interest without the trust being managed and administered in the way it was.

Under the second limb, the trustee submitted that he was carrying on a business in administering the trust and the integral investment activities. The business activities included development of internal processes, implementing practices to monitor costs of administering the trust, and delegation of responsibilities to Maurice Blackburn staff to perform necessary functions.

The trustee also argued that the outgoings were necessarily incurred in carrying on a business as the conduct that was productive of the assessable income was the administration of the trust and its day-to-day management.

Findings by the Court

The Court determined that the trust did not satisfy either the first or the second limb and therefore the trust was unable to claim an income tax deduction.

First limb

The first limb was not satisfied on the basis that a large amount of the outgoings (such as the costs of assessing the entitlements of various benefactors) related to the distributions by the trust to victims and not to the derivation of income from bank deposits. That is, the outgoings lacked a sufficient connection with the trust gaining or producing its interest income. 

The Court also confirmed that the statutory question is a not a “but for” test.  The Court rejected the taxpayer’s contentions that, “but for” the administration of the trust, the trust would not have derived interest income.

Second limb

The second limb was not satisfied because the trust was not carrying on a business.

A significant element to this issue was the supervisory role of the Supreme Court in being able to oversee and scrutinise the trust’s activities under the terms of the out-of-court settlement.  This weighed against a business being carried on having regard to the “wide survey and exact scrutiny” of the trust’s activities. The Trust’s derivation of interest income was not driven by commercial factors but instead the trustee’s overarching obligations under the settlement with the bushfire victims.

Furthermore, the Court reached its conclusions despite there being other elements to the trust’s makeup which suggested the possibility of a business undertaking (such as the systematic and organised way which the trust was run and the scale of its activities).

Key take aways

  1. Do not assume that regular expenses and outgoings associated with the administration of an entity will be deductible - there must be a sufficient (but not necessarily direct) connection between the relevant outgoings and the gaining or producing of income.

  2. Do not undertake a “but for” analysis in deciding entitlement to an income tax deduction – the statutory test is not whether the generation of assessable income is conditional on you incurring certain expenses.

  3. If the only income derived is passive income such as interest or rent, it may be more difficult to satisfy the positive limbs of the income tax deduction enquiry, particularly as passive investment activities may not constitute the carrying on of a business.

  4. The test of carrying on a business requires an assessment of various factors and depending on context some factors carry greater force than others. In this instance, the trust’s raison d’être and its limited discretion with respect to commercial decision making (considering the Supreme Court’s overarching authority) was detrimental to the trust’s submissions.  

  5. Some of the ATO’s view on when a business is being carried on can be found in TR 2019/1, which we recently discussed here. While this Ruling is instructive, it must be relied upon cautiously as its application is limited to corporate taxpayers and whether they are “small business entities” for the purposes of the small business CGT concessions.

For more information please contact:

Edward Hennebry
T +61 3 9611 0113
E: ehennebry@sladen.com.au

Daniel Smedley
Principal | Accredited Specialist in Tax Law
M +61 411 319 327|  T +61 3 9611 0105
E: dsmedley@sladen.com.au

Neil Brydges
Principal Lawyer | Accredited Specialist in Tax Law
M +61 407 821 157 | T +61 3 9611 0176
E: nbrydges@sladen.com.au