Newsletter June 2005

Welcome to the fourth edition of the Flint Forensics Pty Ltd semi-annual newsletter. This newsletter is to help keep you informed of the latest developments relevant to Life Policies and personal and commercial litigation support. It is a free service provided by Flint Forensics Pty Ltd.

Index

• Life Insurance
• FICS
• High Court Judgements
• Federal Court Judgements
• Litigation Matters
• Personal Injury
• New Additions to FlintForensics.com.au
• Administrative and Marketing Changes

Life Insurance

Depreciation - Add it back or not?

Should depreciation be added back or not? You might think that this is simple, well it's not when you have two experts debating the issue in front of a judge, a person really needs to understand the principles behind depreciation and how it applies to the terms of the policy definition on income.

Many insurance company's add back depreciation. Why? I have recently debated this issue with counsel and other experts in the field.

Some experts in the field say it is a legitimate expense and should not be added back.

In my opinion, I say, add depreciation back. Why?

Because it is underwriting internal practice, well maybe it can be accepted as an add back. Because depreciation needed to be added back to support the level of benefit insured, well maybe yes it is added back. One problem arises in that it is not written in the contract (i.e. the policy document or application form) and therefore has to be debated on an accounting and policy terms and conditions basis.

In my opinion the rationale in adding back depreciation is as follows:

• depreciation is used by accountants and tax officials to allocate a reduction in the value of an asset over time for such things like wear and tear and technical obselscense,
• the amount of depreciation is treated as a reduction in the carrying value of an asset (i.e. orginal cost $400 and depreciation $100, the carrying value/written down value is $300),
• depreciation is associated with a capital item, an asset and not revenue,
• depreciation allows for a reduction in the value of an asset to be claimed now as opposed to deferring it to date of sale or disposal,
• depreciation is a non-cash item.

Looking at a simply definition of income where income is income less expenses in deriving that income as a result of your own activity or also known as personal exertion.

Firstly, in my opinion, the charge/expense for depreciation is not a result of a person's own activity.

Secondly, would anyone say the profit or loss resulting from the sale/disposal of an asset was a result of a person's own activity? Definitely not.

The profit or loss from the sale/disposal of an asset is dependent on two things. The amount of depreciation already deducted from the orginal cost of the asset (i.e. known as carrying value or written down value) and the sale price.

To illustrate this point I have two scenarios:

Scenario one and two above illustrate the bringing forward of any future profit or loss on the ultimate sale/disposal of an asset. Depreciation is an unrealised expense item and only ever realised upon sale/disposal when a balancing adjustment is made. Depreciation and profit or loss on the sale of assets are interrelated and therefore have the same treatment in the financial assessment of income protection claims.

In my opinion, depreciation is not an expense that is associated with deriving income from a person's own activity and should be added back to an income protection financial assessment, unless otherwise stated in the policy document.

Legal Precedent - Excess Superannuation

Superannuation is deemed income when you look at the definition of a salaried employee. There is no policy guidance on whether superannuation should be added back to a self employed person, however, in my opinion the precedent has been set with the definition of income for the salaried employees.

Advocates of income splitting have received a boost after a court ruled that superannuation contributions made by a private company for its "mum and dad" owners were not a tax avoidance strategy.

The Administrative Appeals Tribunal (AAT) in Ryan and Commissioner of Taxation [2004] AATA 753 has decided that part IVA of the ITAA 1936 did not apply to an arrangement where a service company was established and controlled by the taxpayer and his wife.

The company paid salary and wages to them as well as made superannuation contributions on their behalf. The superannuation contributions made for the wife of the taxpayer were in excess of the salary paid to her. The Commissioner argued that the arrangement was a scheme where the dominant purpose was to avoid tax.

The AAT decided that the arrangement, which included the payment of salaries and superannuation contributions in excess of the salary paid to the wife, did not provide a tax benefit as envisaged by Part IVA.

This ATO test case provides us with comfort that there is no real issues in principle adding back superannuation to an insured's earnings. In my opinion, this transaction is a eligible add back under the policy document and a legitimate income splitting arrangement. I assume that in this case it was proven that the level of salary paid to the insured's spouse was legitimate, however if the salary was in excess of an appropriate remuneration level, then under the underwriting guidelines, the excess would be treated as an eligible add back, however for tax purposes it would not be legitimate, but that's another story.

Legal Precedent - Personal Services Income of Entity Attributable to Employees.

How do we relate the Personal Services Income ATO case to financial assessments of Income Protection Claims?

It can make a big difference. It revolves around the definition of income. If a person operates a business they are able to claim more deductions than that of an individual/employee. Therefore, reducing the earnings as a result of a person's own activity.

I am currently looking at a case now where the insured is stating that he was an employee, however, his income tax returns show he conducted a business. The issue in this matter is that he was conducting a business pre implementation of GST. Post GST with the new PAYG legislation, it is highly likely that the insured would not of been carrying on a business and therefore, not entitled to the level of deductions he thus claimed. However, the rules at that time we can conclude that the insured was carrying on a business. The insured is trying to argue unsuccessfully that he was an employee because it provides him with a higher benefit entitlement and failing the amendement of his income tax returns, we can only accept that he was carrying on a business.

Personal services income of entity attributable to employee - Nguyen and Anor and Commissioner of Taxation [2005] AATA 876

This was an appeal by the taxpayer against the decision of the Commissioner to disallow his objections against the inclusion in his taxable income of the 2002 and 2003 income years of an amount attributed to him under s86-15.

The taxpayer and three other information technology personnel were employed by a company (Vivi) owned by the taxpayer and his wife. During the relevant income years Vivi provided the services of the individuals to four and three firms respectively, including Icon Recruitment Pty Ltd (Icon). Under Vivi's contracts with Icon, the taxpayer and another employee were specified to provide services to the ATO and Centrelink respectively and fees were payable at an hourly rate based on time sheets. In the case of the taxpayer, he was under the supervision of the ATO, subject to an annual performance evaluation in the same way as an employee and, in practice, had no scope for substitution or delegation.

In these circumstances the Tribunal was not satisfied that the Icon contracts were result based contracts and, as those contracts generated 43% and 32% respectively of Vivi's 2002 and 2003 income, it concluded that more than 75% of Vivi's income during those years was not for producing a result. Accordingly, Vivi did not satisfy the results test in s87-18(3) and was therefore not carrying on a personal services business.

In relation to the unrelated clients test, the Tribunal indicated that "It is not necessary for me to address that submission as that matter is not properly before me."

Legal Precedent - Personal Services Income - "Results Test" not satisfied.

Another example of a taxpayer not passing the personal services business test and being denied income tax deductions, thus increasing his taxable income. What is also can show the financial assessors, that if more information is known about the business, a field audit maybe able identify times where persons are claiming tax deductions in situations where they are not legally entitled and thus decrease the benefit payable.

Personal Services Income – "results test" not satisfied: Dibarr Pty Ltd v Commissioner of Taxation [2004] AATA 1030

In this matter the taxpayer applicant has been unsuccessful in their application for a review of the Commissioner's refusal of an application for a personal services business determination. In order to determine whether the taxpayer was carrying on a personal services business, the AAT considered whether the taxpayer had satisfied the "results test" in section 87-15 of the ITAA 97 (by virtue of being an independent contractor).

Taking into account the individual and aggregate effect of the below listed elements, the Tribunal formed the opinion that the taxpayer was paid in arrears for labour supplied by it to its only client on a month by month basis and not to produce a result. Accordingly, the Tribunal concluded that the taxpayer did not satisfy the results test in section 87–18(3)(a).

The elements considered by the Tribunal in reaching their decision were as follows:

0. the taxpayer was paid monthly in arrears according to services supplied by it to its only client;
0. the taxpayer was paid periodically according to time spent on projects for which it is engaged by its only client;
0. the taxpayer had only one client during the year of income;
0. the taxpayer's only client reimburses it for out-of-pocket expenses (such as travel, meals, accommodation and car parking expenses);
0. the arrangement between the taxpayer and its client Campbell Brothers Ltd was enduring and ongoing;
0. the taxpayer could not delegate to a third party any of the services to be provided to Campbell Brothers Ltd without the consent of a proper officer of Campbell Brothers Ltd. The taxpayer did not possess an independent discretion in carrying out a task for its own business interests and was not retained simply to produce a result;
0. the taxpayer moved seamlessly from one project to another.

In addition, the Tribunal was not satisfied that "unusual circumstances" existed to justify the making of a personal services business determination.

Service Trusts - ATO Guidelines

We are familiar with the terms income splitting and happy with adding back income as a result of a legimate income splitting arrangement. Last edition I discussed some legal cases which allow us to treat say, distributions from a trust for a spouse not associated in the earnings of personal exertion income to be attributed to the insured.

The landscape is changing.

The Commissioner of Taxation has since announced on 2 June 2005 that the Tax Office is about to issue a set of guidelines as to what service trust arrangemetns will be acceptable to it and what service trust arrangement will not.

The Tax Office will allow taxpayers 12 months to comply with these guidelines. In the meantime most service trusts will not be expected to audit activity; that is, most existing service trust arrangements will be accepted until the expiration of the 12-month period.

However, practitioners who have implemented service trust arrangements where the service fee is $1 million or more, or where 50 per cent or more of the fees of the professional firm were paid to a service trust, still fact retrospective audit.

In practice this means that most small and medium sized practices can be confident that their existing service trust arrangements have been effective. However, large firms face retrospective audit.

I will talk more about the ATO Guidelines next edition and identify what impact these new guidelines have on financial assessments that you should be aware of.

FICS

Hot Items for an Issued Focus

The determination 12868 on 5 April 2005 is interesting as to looks at the issues pursuant to section 29 of the Insurance Contracts Act where the insurer tried unsuccessfully to avoid the policy. The complain to FICS was upheld. The legal principles discussed include:

• What is "fraud"?
• Non-disclosure and misrepresentation
• The effect of sections 12 and 13
• What is the duty of disclosure?
• Is it non-disclosure or misrepresentation?
• The underwriting decisions.

I recommend that determination be read to obtain a better understanding or the legal principles.

High Court Judgements

No matters of note.

Federal Court Judgements

No matters of note.

Litigation Matters

How facts are proved

Direct Evidence

Direct evidence is evidence of a fact that a witness can attest to having seen or done. A witness to a murder case may have see the accused stab the victim. In a fraud case, a bank officer may give evidence that they performed a particular transaction. A plaintiff may give evidence of how they fell on the floor of the supermarket and injured themselves. The fact in issue is proved once direct evidence is accepted by the court, without the need for any further inferences by the court.

Circumstantial Evidence

Circumstantial evidence is a fact which, when proved, allows the court to infer the existence of a fact in issue. Circumstantial evidence by its nature creates the need for an inference to be drawn from one conclusion of act to another. If X occurred, then Y must have occurred. In making its decision, the court may not draw this inference, even if it accepts the evidence that goes to make up the initial circumstance.

People often think circumstantial evidence is unreliable, or at least less reliable than direct evidence. However, many contested criminal cases are based largely, if not entirely, on circumstantial evidence. The strength of circumstantial evidence lies in its quantity. The more evidence, the more sense the jury can make of the case.

The Best Evidence Rule

This rule dictates that when evidence is tendered of a document or physical thing, it must be the thing itself or the original document that must be produced. Courts may hold that it it insufficient to tender a description of a thing or of the contents of a document if the original is available for production to the court, preferring primary to secondary evidence. In most jurisdictions, statute has rendered photocopies of documents admissible, whether or not the original can be obtained.

I always seek to view original documents or physical objects where relevant.

Judicial Notice

It is generally inappropriate for judges to conduct their own research into the facts, even of a general nature. However, in some circumstances, the court may absolve a party of the need to provide well-known facts, or to prove them with evidence. It is usually those common, taken-for-granted features of the environment, or aspects of human existence that are the subject of judicial notice. Sometimes the court will take judicial notice without any further inquiry on the matter. Such facts are often seen as "notorious" or "common knowledge of a general character", such as general history or current economic conditions in general.

As an expert, I never assume that the court will take judicial notice of any proposition. It is my job to educate the court.

I identify from my client's lawyers exactly what factual assumptions I am making to allow them to determine what could be given judicial notice and what should be subject of evidence. If the facts being addressed are controversial, and thus obejcted to by opposing counsel, then a court is unlikely to take judicial notice of them.

New Additions to Web Site

New Instruction Forms

I have updated the instruction forms. You can either print them out or simply unprotect the document by using the password "FLINTFORENSICS" and save the document to your desktop.

Administrative and Marketing Changes

Typing of Transcripts

Flint Forensics use Smartdocs Pty Ltd for the typing of transcripts. This occurs when taped interviews are conducted during the field audit process.

Corporate Membership of the Australian and New Zealand Institute of Insurance and Finance

Flint Forensics has again supported the insurance industry by once again becoming a Corporate Member of the Australian and New Zealand Institute of Insurance and Finance for 2005.

In the next edition, look forward to more from the issues of service trust and a discussion on motor vehicle expenses.

Talk to you soon,

Bruce Flint
Managing Director

FLINT FORENSICS PTY LIMITED - Assessment of Economic Loss, Expert Witness, Financial and Other Investigations, Income Protection Risk Management, Regulatory Investigation and Assessment, Training and Valuations

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