The case of
Hance v Federal Commissioner of Taxation [2008] FCAFC 196, involved two Taxpayers, both individuals, who sought to participate in a Managed Investment Scheme
(MIS).
As participants in the MIS, the Taxpayers would lease separate lots of land and engage a management company, AIMA Limited (AIMA), to grow almonds on this land and to ultimately harvest and sell them.
Each investor would be liable to pay a number of separate initial and ongoing fees with the expectation of an income stream once the almonds were harvested and sold.
Until the point of sale, each investor would own the almonds grown on their individual land. Although AIMA would be delegated responsibility for doing all things necessary to bring the almonds to market, there would be a facility for investors to monitor the effectiveness of the company's management and individual investors could opt out of a pooled sale of their harvested almonds.
The Taxpayers applied for a private ruling from the Commissioner that the various outgoings they would incur as participants in the MIS were deductible under section 8-1 of the Income Tax Assessment Act 1997 (1997 Act) on account of being outgoings incurred in the course of running a business.
The Commissioner ruled that, although the net proceeds of sale of almonds under the scheme would be assessable income under section 6-5 of the 1997 Act, the various outgoings, other than interest, were not allowable deductions pursuant to section 8-1 of the 1997 Act. The Taxpayers challenged this ruling. Given the matter was to proceed as a "test case", with the agreement of both sides the matter was heard at the first instance in the Full Federal Court, which is generally considered the final court of appeal in most tax matters.
The Commissioner's arguments
In arguing that the outgoings claimed by the Taxpayers were not deductible, the Commissioner argued that among other things:
- The Taxpayers' outgoings in connection with the MIS were properly characterised as payments of capital or of a capital nature which are not deductible under section 8-1 of the 1997 Act.
- The advantage the Taxpayers sought through their participation in the MIS was the acquisition of a passive interest in the MIS which granted them a right to a share in profits of the scheme, and that this cannot properly be characterised as a business.
- The Taxpayers would have negligible involvement in the day-to-day running of the MIS and were not in a position to exercise any real control over AIMA, and as such, they were not active participants in a business.
The Taxpayers' arguments
In arguing that the outgoings claimed were deductible, the Taxpayers argued that among other things:
- Under the terms of the MIS they were each carrying on a business for the purposes of gaining or producing assessable income, and the outgoings they incurred as participants in the MIS were incurred in the course of carrying on this business.
- The Commissioner had not identified a trust relationship arising from the MIS so as to suggest that the Taxpayers' involvement was truly passive.
- The relevant outgoings claimed were not of a sort that would ordinarily be regarded as being capital in nature.
The Court's determination
The Court found in favour of the Taxpayers.
The Court held that the Taxpayers were carrying on a business: the indicators of this included the fact they were not totally excluded from the operation of the MIS, they maintained ownership of almonds harvested from their land until the sale of the almonds and there was an ongoing requirement for the payment of fees with the expectation of periodic profits.
The fact that the Taxpayers delegated most of the day-to-day operation of the MIS to AIMA did not detract from the conclusion that the Taxpayers were carrying on a business. In this sense, the Taxpayers were the equivalent of a "silent partner" in a commercial enterprise in which they participated but had limited involvement. There was nothing to suggest that this was not a legitimate business arrangement.
The Court agreed that the actual outgoings incurred by the Taxpayers were of a sort that would ordinarily be regarded as being revenue in nature and that this characterisation was not displaced by the fact they were incurred as participants in the MIS rather than a more conventional business structure.
The aftermath
The Full Federal Court's decision represents a significant win for the MIS industry. By confirming that participants in an MIS are carrying on a business, the Court has knocked away one of the key planks underlying the Commissioner's ruling TR 2007/8. The Commissioner states in his Decision Impact Statement (DIS) on the decision that he accepts this aspect of the case and that TR 2007/8 will be withdrawn.
However, while ostensibly backing off, the Commissioner does state in the DIS that the fact the taxpayers retained ownership of the produce (ie the almonds) of the MIS was critical to the decision and that it will be looking for this feature to be present in any future circumstances that seek to rely on the decision.
Moreover, given the potentially wide implications of the decision and the political sensitivity of its subject matter, it is in our view likely that the taxation treatment of the non-forestry MIS sector will be the subject of government review and may eventually be regulated by statute. Practitioners will be aware that this is already the case for forestry MISs.
Finally, in reaching its decision, the Court placed considerable reliance on information contained within the PDS and other formal documents associated with the MIS. So, as a practice point to take from this decision, potential investors in MIS should be advised to seek independent professional advice regarding the proposed investment to determine whether outgoings incurred will be deductible and, in general terms, whether the arrangement "stacks up".
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