Can the courts take some responsibility for negative gearing?

The negative gearing issue in Australia has descended into a political slug match where rational debate is near impossible. False claims abound and incontestable facts are contested.

The question raised here is whether the courts could have taken a different approach to the one they ultimately took, and therefore stopped negative gearing “at its birth”. And, the more practical question is whether it is too late for the courts to intervene to stop this practice.

The deductibility of most expenses related to making taxpayers' income is determined under the general deduction provision. The current version (section 8-1 of the Income Tax Assessment Act 1997) contains very few words, and therefore contains little guidance from the parliament. 

It essentially says that expenses incurred to make assessable income are deductible. This means that the parliament has largely left rule-making in this area to the courts, mostly the High Court, but from around 25 years ago, the Full Federal Court (Special leave to appeal a tax matter to the High Court is rarely allowed).

This means the courts had a choice on what the rules or principles are (were). 

The standard negative gearing situation is where a taxpayer incurs expenses in making rent from property, dividends from shares, etc, and at the time of incurring the expenses, the taxpayer knows that the expenses will be more than the income from the investment. 

In other words, there is full taxpayer knowledge of a loss and deliberate action to pursue the loss (or no action to prevent the loss). In addition, the taxpayer knows that the expected capital appreciation in the investment helps compensate for the loss and this capital appreciation is deliberately pursued. Further, the tax shelter is deliberately pursued.

In the standard situation, the courts had two choices in their approach to the deductibility of negative gearing expenses (the biggest being interest). 

First, and this is what the courts decided, is to say that the amount of income from an expenditure is not relevant to deductibility of the expenditure. As long as the expenditure is directed at making current income and the current income is a market value income, that is sufficient for deductibility. 

The fact there is a partial motive of getting a tax benefit and that there is the pursuit of capital appreciation in the investment does not undermine full deductibility. This approach has also been supported by the principle that it is not up to the Australian Tax Office (ATO) or the court to tell the taxpayer how much to spend in making their assessable income.

Second, the courts could have adopted an approach along the lines that the taxpayer's purpose or objective in incurring the expenditure was not really 100% to make the current return on investment. Instead, the court could have noted that the expense is partly to obtain the tax advantage of protecting the non-investment income (for most taxpayers, salary) from tax. 

Pursuing the tax advantage is not an assessable income producing purpose or objective. In addition, the expense was also partly directed at making the capital appreciation in the investment, again, a non-income producing objective that would support deductibility. Viewing the expenses in this second light would reflect the reality of the situation.

After taking this second approach, apportionment of the expenses into their deductible and non-deductible components would necessarily follow. One obvious approach would have been to only allow a deduction up to the amount of income returned so that no loss arises (and no negative gearing arises).

I would submit that if the courts had struck down negative gearing in the 1980s, the parliament would not have enacted legislation to permit open-ended negative gearing.

The second approach would not have involved a revolution in judicial thinking, though it may have challenged a few tax principles. This approach has been used under the general deduction provision in aggressive tax planning cases (tax shelter cases) involving attempts to obtain large tax losses on an “investment” to protect other income from tax. 

The courts have struck these down by only allowing a deduction up to the level of current income so that no tax loss is obtained. This is based on a recognition that the taxpayer has a non-income producing objective in incurring the expenditure.

The second approach would also have drawn some support from the approach taken in the “existence of business cases”. Without a profit motive, a taxpayer will usually not be found to be in business. 

Such a finding denies the taxpayer deductions for expenses (and receipts are not taxed). Is it not the case that the negative gearer does not have a profit motive for the investment?

In the late 1970s and mid 80s, when the courts were required to deal with negative gearing, the practice was not as widespread as today. While we will never know this for sure, I would submit that if the courts had struck down negative gearing in the 80s, the parliament would not have enacted legislation to permit open-ended negative gearing. 

It is very likely that the parliament would have kept an eye on judicial developments so as to ensure that the negative gearing denial rule did not prevent tax losses on a business from being used against other income, but otherwise, parliamentary intervention would have been minimal.

It is too late for the courts to stop the practice. Even if a case got to the Full Federal Court today, it is very unlikely that the court would overturn or vary the relevant deduction principles. 

In any event, just getting a negative gearing case to court necessarily requires the ATO to bring forward a case, and I see no appetite on the part of the ATO to do this (see paragraphs 16 and 42-46 of Taxation Ruling TR 95/33).

So, respectfully, the answer to the question posed must be yes. The court was faced with a choice and it decided to go a particular way. It is true that the non-deductible path may have been problematic and would have challenged some deductibility principles, but nevertheless, it was open to the court.

Dale Boccabella is an associate professor of taxation law at UNSW Business School.

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