Content area
The Full Federal Court has adopted inconsisent approaches to determining when profits realized from the sale of leased equipment by companies who are in the business of leasing such equipment constitute income. The leading cases in this area are Memorex Pty Ltd versus FCT (1987), FCT versus Cyclone Scaffolding Pty Ltd (1987), FCT versus GKN Kwikform Services Pty Ltd (1991), and FCT versus Hyteco Hiring Pty Ltd (1991). The different results in these cases stem from different determinations by the court of the taxpayers' relevant businesses and what constituted the ordinary incidents of those businesses. It is evident that the court has not been consistent in its approach to the determination of these essential facts. In 2 of the cases, the court characterized the relevant businesses broadly, while in the other 2 cases, a narrow characterization was adopted. The inconsistent approach of the court will inevitably lead to practical uncertainties.
In recent years, the Full Federal Court has considered a number of cases in which the central issue concerned whether profits arising from the sale of equipment by companies whose business included leasing such equipment constituted income. The leading cases in this area are Memorex Pty Ltd v FCT,(1) FCT v Cyclone Scaffolding Pty Ltd,(2) FCT v GKN Kwikform Services Pty LTD(3) and FCT v Hyteco Hiring Pty Ltd.(4)
Although there are clear similarities in the facts of these cases,(5) the court has made distinctions between them when reaching its decisions. For example, in Memorex and GKN Kwikform the court ruled that the profits were of an income nature, whereas in Cyclone Scaffolding and Hyteco Hiring the court ruled that the profits were of a capital nature.
The purpose of this article is to examine these cases to determine on what basis the court reached its different conclusions.
THE GENERAL PRINCIPLE DERIVED FROM THE MYER EMPORIUM DECISION
Before examining the cases listed above, it is appropriate to examine the celebrated decision of the Full High Court in FCT v Myer Emporium Ltd(6) as the decisions in the Full Federal Court cases are, in effect, merely applications of the principles developed by the High Court in that case.
In Myer Emporium, the Full High Court confirmed the well established canon of taxation law that a profit or gain realised by a taxpayer in the ordinary course of carrying on its business activities is income in nature.(7) This conclusion was justified on the following basis:
"Because a business is carried on with a view to a profit, a gain made in the ordinary course of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the character of income."(8)
The High Court went on to state that a profit or gain realised outside the ordinary scope of a taxpayer's business may also constitute income if the profits arose from a transaction "entered into by the taxpayer with the intention or purpose of making a profit". In a joint judgment the court stated:
"if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer' s business."(9)
The court went on to state that:
"The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit making by the means giving rise to the profit."(10)
The essence of the Myer Emporium decision is that it is the existence of a profit-making intention on the part of a taxpayer which determines whether a profit realised by the taxpayer is income. Where the profit arises from the ordinary business activities of the taxpayer, that intention is inferred. However, where the profit arises outside the taxpayer's ordinary business activities it is necessary to separately establish that profit-making intention by examining the taxpayer's subjective intention at the time of entering into the relevant transaction.
In determining whether a profit realised by a taxpayer who conducts a business is income, it is necessary to first identify what the business actually is. This will invariably be a question of fact and will depend upon the taxpayer's activities. Once the business has been identified, it is then necessary to determine whether the profit in question was realised in the ordinary course of that business. If it was, the profit is inherently income in nature. If it was not, then the profit will only be income where it arises from a transaction entered into by the taxpayer with the intention of making a profit.
The Memorex, GKN Kwikform, Cyclone Scaffolding and Hyteco Hiring cases all consider the application of the first aspect of the Myer Emporium decision, that is, whether a profit has been realised in the ordinary course of a taxpayer's business.
THE FULL FEDERAL COURT CASES
Memorex was a company which sold and leased computer equipment and advised on the design of computer packages. Memorex's principal activity involved selling new equipment. However, it also leased equipment which it typically sold to its customers at the end of the lease periods. Often the previously leased equipment was sold for more than its original cost resulting in profits. However, those profits were not included as income in its tax returns. Memorex treated the equipment it leased as I depreciable plant and included the difference between the depreciated values of the equipment sold and the proceeds received on sale, up to the original cost of each item, as a balancing charge assessable under s 59(2) of the Act.
The Commissioner issued an assessment in which he included the profits from the sale of the leased equipment in Memorex's assessable income under s 25(1) of the Act on the basis that the profits arose From an overall business operation which included, as one of its parts, the selling of leased equipment.
Before the Full Federal Court, Memorex made two principal submissions. Memorex's first submission was that a profit on the sale of equipment would only be income in nature and therefore assessable under s 25(1) if the equipment was acquired for the purpose of resale at a profit. Memorex submitted that it had acquired the equipment for leasing purposes rather than resale purposes. Memorex's second submission was that it was really carrying on two separate businesses. The first business was a business in which it sold equipment and the second business was a business in which it leased equipment. The equipment which it leased constituted capital assets of the second business and the profit arising from the sale of such assets should therefore not be treated as income in nature.
The court (comprising Davies, Pincus and Einfeld JJ) held that Memorex's profits were of an income nature. This conclusion was reached on the basis that Memorex's business was identified as a business of distributing computer equipment and that the profit realised from the sale of the computer equipment was a profit which arose out of the ordinary course of that business.
The court held that it was not necessary to separately determine that the equipment was acquired by Memorex for the purpose of resale at a profit. In relation to this aspect of the decision, Davies and Einfeld JJ stated:
"it is well settled that, if goods are traded in the ordinary course of a business of trading in such goods, the trade in particular goods may be on revenue account whether or not the goods were or were not traded in with an expectation of profit."(11)"
This passage echoes the approach in Myer Emporium, which dictates that the actual purpose of the taxpayer in entering a transaction is only relevant where that transaction is outside the ordinary scope of the taxpayer's business.
In characterising Memorex's business, the court formed the view that Memorex's leasing operations did not constitute a separate business but were part of its overall business. In this respect, Davies and Einfeld JJ stated:
"The evidence shows that the [taxpayer] had only one business, that of distributing computer equipment, the distribution involving not only the supply of equipment but also advice as to the nature of the equipment required, the design of the equipment packages and the service of the equipment when supplied. The equipment that was supplied was ordinarily equipment which was designed and structured for the needs of the particular customer. The [taxpayer] did not have a business in which it held standard pieces of equipment in stock and hired that equipment out to one customer after another. It normally supplied equipment for a particular requirement and supplied that equipment, at the customer's option, either by outright sale or by lease."(12)
Having determined that Memorex's business consisted of the distribution of computer equipment, the court concluded that the profits from the sale of the previously leased equipment were realised in the ordinary course of that business. In this context, Davies and Einfeld JJ stated:
"There is no analogy between this case and the case of plant or equipment that a taxpayer may have and may use as part of the structure of an enterprise. The subject goods were part of the goods in which the [taxpayer] was dealing. When it was profitable or financially convenient to do so and the customer agreed, the goods were leased, rather than sold outright. But they were destined for sale or other disposal by the taxpayer sooner or later, either to the customer, another customer, an overseas affiliate or perhaps if they had no value at all, by scrapping."(13)
The decision in Memorex turned upon the fact that the business concerned was identified broadly as being a business of distributing computer equipment. This broad classification inevitably led to the conclusion that the profits from the sale of the equipment were income in nature notwithstanding that the equipment had previously been leased.
The Cyclone Scaffolding and GKN Kwikform cases involved companies which carried on businesses of leasing scaffolding whereas the Hyteco Hiring case involved a company which carried on a business of leasing forklift trucks. The taxpayers in the Cyclone Scaffolding, GKN Kwikform and Hyteco Hiring cases differed from the taxpayer in the Memorex case in that they all conducted businesses in which they held standard pieces of equipment in stock and hired that equipment out to one customer after another.
In all three cases the relevant taxpayers realised profits from the sale of their leased equipment. In each case the fundamental question became whether the profits were part of the ordinary proceeds of the business of leasing the equipment. In Cyclone Scaffolding and Hyreco Hiring the court held that the profits were not part of the ordinary proceeds of the taxpayers' businesses, whilst in GKN Kwikform the court held that they were.
One of the features of the Cyclone Scaffolding and GKN Kwikform cases was that the scaffolding equipment was frequently damaged or not returned. Cyclone Scaffolding's hire agreements provided that in such cases there was a deemed sale of the equipment at Cyclone Scaffolding's "list price" (which always exceeded the original price paid for the equipment). GKN Kwikform's hire agreements provided that customers who failed to return the taxpayer's scaffolding were required to pay the taxpayer the "current list price" of the scaffolding as "compensation".
Cyclone Scaffolding treated all its equipment as "trading stock" until the end of the year of income in which it had been purchased. Thereafter, the equipment was treated as depreciable plant. Cyclone Scaffolding found it impractical to keep account of every item of its equipment and, with the Commissioner's consent, adopted the practice of treating the last item of equipment which it acquired as the first item of equipment which it sold.(14)
The effect of this practice was that where the acquisitions of equipment in a given year exceeded the sales for that year, all the sales were treated as sales of trading stock. Where, however, the sales of equipment in a given year exceeded the acquisitions for that year, the sales were treated as sales of trading stock to the extent that there was trading stock, and the remaining sales were treated as sales of depreciated plant.
Cyclone Scaffolding dealt with the equipment it sold as follows:
* In respect of the equipment which it treated as trading stock, it claimed deductions under s 51(1) for the cost of the equipment and included the proceeds from sale in its assessable income under s 25(1).
* In respect of the equipment which it treated as depreciable plant, it included the payments it received, to the extent to which the estimated cost price of the equipment exceeded its depreciated value, in its assessable income under s 59(2) (but did not include any portion of the payments which exceeded the estimated cost of the equipment in its assessable income).
Like Cyclone Scaffolding, GKN Kwikform experienced a regular short return of scaffolding over the relevant years of income. As the current list price of the non-returned scaffolding invariably exceeded the original cost price, this resulted in GKN Kwikform making a profit. Over the years, the compensation payments received for non-returned scaffolding amounted to between 3.25 per cent to 5.71 per cent of its total business receipts.
GKN Kwikform treated the compensation payments, to the extent that they constituted a recoupment of previously claimed depreciation in respect of the scaffolding as balancing charges which were assessable under s 59(2) of the Act, but did not include any amount representing the difference between the current list price and the original cost of the scaffolding as income.
In both cases the Commissioner issued assessments in which he included the profits arising from the sale of the equipment as assessable income under s 25(1), on the basis that the profits were income according to ordinary concepts.
In Cyclone Scaffolding, a majority of the Full Federal Court (Bowen CJ and Beaumont J; Wilcox J dissenting) held in favour of the taxpayer. The majority were of the view that the taxpayer's substantial purpose in acquiring its equipment was to hire it rather than resell it at a profit and that therefore the taxpayer should not be assessable in respect of the profits. In particular, it was held that the Commissioner's acceptance of the accounting treatment of the scaffolding precluded him from contending that the proceeds on sale were income:
"The Commissioner can hardly accept the taxpayer's treatment of the equipment as plant or fixed capital at the end of the first financial year and at the same time contend that it should then also he regarded as trading stock or circulating capital."(15)
In delivering their judgment, the majority distinguished the decision in Memorex on the basis that in that case the equipment in question did not form part of the taxpayer' s plant or fixed assets as they did in this case.
In considering whether the profits constituted part of the ordinary proceeds of the business of the taxpayer in Cyclone Scaffolding, the majority stated:
"[The Commissioner] was content to accept the taxpayer's accounting method of treatment of the equipment but at the same time to seek to invoke the independent principle that a profit or gain emerging on the sale of assets as a regular event in the ordinary course of business may represent income...
Such an approach must, in our opinion, be rejected. The Commissioner has to decide what attitude he will adopt to the taxpayer's treatment or method taken as a whole. If, as here, the Commissioner accepts that treatment, it is not open to him then to ignore it by removing the case from its context and claiming that certain transactions have generated income as ordinarily understood. The vice in this approach is that the transactions relied upon by the Commissioner cannot be looked at in isolation. They should be seen as part of the whole scheme of the taxpayer's treatment of its activities. So regarded, the sales in question are treated as the disposal of pan of the taxpayer's profit-making apparatus and thus of fixed assets. Any profit thus accruing is on capital, not revenue account."(26)
Although the court adopted a broad view of the business of the taxpayer in Cyclone Scaffolding (that is, the business constituted a leasing and selling business), it was the accounting treatment which dictated that the profits we not realised in the ordinary course of that business. Indeed, this very point was noted by Hill J in the Hyteco Hiring case (see below). In this respect, the decision in Cyclone Scaffolding should be limited to its own particular facts and should be regarded as an aberration of the general principles enunciated by the Full High Court in Myer Emporium.
In GKN Kwikform, the Full Federal Court (comprising Davies, Beaumont and O'Loughlin JJ) considered that the excess of the compensation payments for non-returned scaffolding over its cost price was a profit of an income nature and hence assessable under s 25(1). According to the court, the compensation payments were a regular, ordinary and expected incident of the taxpayer's business of hiring out scaffolding.
In this respect, the court viewed the compensation receipts as having been received not for the disposal of the scaffolding, but rather as part of the consideration payable to the taxpayer under the hiring contracts. On this basis, the profits were clearly of a revenue nature. Davies J was of the view that the profits from the enforcement of the compensation clause were a regular, expected and ordinary incident of the taxpayer's business. A similar view was reached by Beaumant J who regarded the compensation payments as "an additional hiring fee" and which had the same revenue character as the standard hiring fees.
Although the Full Federal Court adopted a narrow view of what constituted the actual business (a business of hiring out scaffolding), the court adopted a broad view of what profits were realised as an ordinary incident of that business.
In the most recent of the four cases, Hyteco Hiring, the taxpayer conducted a business of hiring out forklift trucks which it generally owned. However, Hyteco Hiring also hired out some forklifts which it did not own but which were leased from a financier pursuant to finance leases. Hyteco Hiring generally acquired the ]eased forklift trucks at the end of the lease periods for their residual value (generally 20 per cent of the original cost). because the trucks were then five years old and could still be let to earn rental income. It did not purchase the trucks to resell them for a higher price.
Forklift trucks which were unsuitable for further hire were disposed of by company related to Hyteco Hiring on its behalf. In certain cases, the sale proceeds exceeded the cost of the forklift tuck to Hyteca Hiring (either because the forklift truck had been leased and acquired at its residual value, or the forklift truck had been acquired secondhand from another company).
The Commissioner issued assessments in which he included the profits from the sale of the forklift trucks in Hyteca Hiring's assessable income under s 25(1) of the Act. These assessments were issued on the basis that the sale of forklift trucks was an ordinary incident of the taxpayer's main business activity of leasing forklift trucks, or that Hyteco Hiring's business activities included the sale of forklift trucks.
Hytec Hiring contended that its business was the hiring of the forklift trucks and the profits realised on the sale of those trucks were capital profits as it was disposing of capital assets.
The Full Federal Court confirmed that the profits realised on the sale of the forklift trucks were not of an income nature and were therefore not assessable under s 25(1). Hill J (with whom Black CJ and Wilcox J concurred) delivered the judgment of the court. His Honour adapted the taxpayer's submission that Hyteco Hiring's business simply comprised the leasing of forklift trucks:
"On the evidence it would have been erroneous to characterise the business as being both the hiring of forklift trucks and the sale of such truck. The trucks were not purchased for the purpose of sale but for the purpose of leasing them out. This is so, notwithstanding that the sale of trucks no longer suitable for leasing can be said to have been inevitable or, at least, the only alternative to scrapping the when their useful life was over."(17)
His Honour then considered whether the profits on sale were nevertheless an ordinary incident of the leasing business. The Commissioner argued that the profits from the sale of the forklift trucks were an ordinary incident because th sales occurred on such a large scale and on such a regular basis. Hill J, however, dismissed this argument:
"neither regularity nor the scale of profits compel the result on the facts of the present case that the profits are income in ordinary concepts. While regularity of receipt may often indicate that particular amounts have the character of income, (cf FCT v Dixon (1952) 86 CLR 540 at 557), mere regularity an its own will seldom be determinative Regularity will be relevant, but not determinative of the question. In particular, regularity may be an indicator in a particular fact situation that a business is being carried on and in the result that the proceeds of that business are income...That, however, is not the situation here.
Nor can the magnitude of the profits made have great relevance to the characterisation of those profits as having the character of income...
[T]he words 'in the ordinary course of business' must be understood in their context. In particular, it does not follow from these words, as used by the High Court in Myer, that every gain made by a taxpayer carrying on a business and which has some relationship to that business will be taxable. To so hold would be to destroy completely the distinction between capital and income, blurred though such a distinction may sometimes be."(18)
In other words, Hill J recognised that not all proceeds of a business will be realised in the ordinary course of that business.
Hill J went on to state:
"What the present case is concerned with is a profit arising on a sale to third parties of the very apparatus with which the taxpayer conducted its business, not a profit from the process by which the taxpayer operated to obtain regular returns by means of regular outlays."(19)
In essence, Hill J found that the forklift trucks formed the very apparatus of the taxpayer's business of hiring out the forklift trucks. By classifying the forklift trucks in this way, Hill J concluded that the profits from their sale were not part of the ordinary proceeds of the business.
In Hyteco Hiring, the court adopted a narrow view of the taxpayer's business and a narrow view of what was an ordinary incident of that business. This narrow approach on both fronts led to the conclusion that the profits were capital in nature.
An important aspect of the Hyteco Hiring case is its consideration of the Memorex, Cyclone Scaffolding and GKN Kwikform cases.
Hill J explained the decision in the Memorex case as follows:
"the court upheld the conclusion, arrived at by the Administrative Appeals Tribunal, that profits made on the sale of the equipment were income in ordinary concepts...The Tribunal had found that the sales generating the profits in question were no different from the other sales made by the taxpayer, all being designed to turn to account and profit from the equipment. All the transactions were, in the view of the Tribunal, an integral part of the taxpayer's business to deal in computer equipment. This crucial finding was not disturbed."(20)
As noted above, Hill J regarded the decision of the majority of the court in Cyclone Scaffolding as turning upon the accounting treatment adopted. Once the scaffolding had been treated as depreciable plant, the Commissioner was prevented from treating the proceeds on the sale of that plant as part of the ordinary proceeds of the business.
On the other hand, his Honour regarded the decision in GKN Kwikform as turning upon the terms of the contract between GKN Kwikform and its customers:
"the amount received was not, in a strict sense, the sale price of the scaffolding. Rather the amount received was in the nature of an amount agreed upon between the parties as a genuine pre-estimate of the loss occasioned to the taxpayer by the non-return of scaffolding hired and the profit component was as much part of the proceeds of the hiring business as were the hiring fees paid by the customers."(21)
CONCLUSION
The different results in the Memorex, Cyclone Scaffolding, GKN Kwikform and Hyteco Hiring cases stem from different determinations by the court of the taxpayers' relevant businesses and what constituted the ordinary incidents of those businesses. It is important to note that these matters are both questions of fact. Notwithstanding that the court was differently constituted in each of the cases, it is evident from the cases s that the court has not been consistent in its approach to the determination of these essential facts. In Memorex and Cyclone Scaffolding the court characterised the relevant businesses broadly whereas in GKN Kwikform and Hyteco Hiring, the court characterised the relevant businesses narrowly. However, in GKN Kwikform, a broad interpretation was given to what constituted an ordinary incident of the business whereas in Hyteco Hiring a narrow interpretation was adopted.
Ignoring the aberration of the decision in Cyclone Scaffolding, the cases have not established any new principles of law and are merely examples of the application of the Myer Emporium principles. However, the cases are unsatisfactory because they provide no general guidance on the way in which the Full Federal Court will determine the essential findings of fact upon which the legal principles of the Myer Emporium decision are to be applied. The inconsistent approach of the court will inevitably lead to practical uncertainties.
1. (1987) 87 ATC 5034. 2. (1987) 87 ATC 5083. 3. (1991) 81 ATC 4336. 4. (1991) 92 ATC 4694. 5. Particularly Cyclone Scaffolding and GKN Kwikform. 6. (1987) 163 CLR 199.
7. This principle can be traced to the decision of Lord Justice Clerk in Californian Copper Syndicate v Harris (Surveyor of Taxes) (1904) 5 TC 159 at 165-166.
8. (1987) 163 CLR 199 at 209.
9. Ibid at 209-210.
10. Ibid at 210.
11. (1987) 87 ATC 5034 at 5042. Also note the comments of Pincus J at 5047.
12. Ibid at 5043-5044.
13. Ibid at 5044.
14. That is, it adopted a LIFO method of accounting.
15. (1987) 87 ATC 5083 at 5088.
16. Ibid at 5089.
17. (1992) 92 ATCl 4694 at 4699.
18. Ibid at 4700.
19. Ibid at 4702.
20. Ibid at 4701.
21. Ibid at 4702.
Copyright Law Book Company Ltd. Sep 1994