Tax Brief. 11 February Amway of Australia v Commissioner of Taxation (No 2) [2003] FCA Facts

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1 Tax Brief 11 February 2004 Amway of Australia v Commissioner of Taxation (No 2) [2003] FCA 1533 The Federal Court s judgment in Amway of Australiav Commissioner of Taxation (No 2) [2003] FCA 1533 (19 December 2003) provided the first judicial analysis on what constitutes non-deductible entertainment under the former s51ae in the Income Tax Assessment Act, 1936 ( 1936 Act ) since its introduction in Facts These proceedings were brought about by Amway of Australia ( Amway ) by way of appeals against the Commissioner s disallowances of deductions for certain expenses it has incurred in hosting seminars known as Australian Leadership Seminars ( ALS ) and Go Diamond Seminars ( GDS ) during the 1988/89 to 1995/96 and 1994/95 to 1995/96 income years respectively. Amway was a retailer during the relevant period. But unlike most retailers it, did not have any retail outlets. Instead, it sold its products directly to the public via a network of individuals ( distributors ) in their capacity as commission agents. The business of an Amway distributor generally included the selling of Amway products and the recruitment or sponsorship of new downline distributors. Amway distributors earned commissions and points from their own sales as well as sales made by their downline distributors. They could rise progressively up the Amway distributorship hierarchy, ranging from Direct Distributors to Executive Double Diamond Direct Distributors, as they increased their business and met the relevant requirements. An ALS was held exclusively for Direct Distributors who had achieved a specified number of points in the previous financial year. It was held annually, in the first quarter immediately after the previous year, and generally went for a period of 6 days at a good quality venue in a holiday destination, mainly overseas. A GDS was for qualified Emerald Direct Distributors and was designed to encourage them to progress to the next (Diamond) level. They were held in the 1994/95 and 1995/96 income years. Each went for a period of 5 days, preceding the ALS in the same year, at a more luxurious venue to reflect the attendees higher ranking.

2 Both the ALS and GDS involved a mixture of structured business sessions, informal meetings, and a free day for leisure or recreational activities, including excursions and tours. The meals provided were substantial and alcohol was served at all dinners, which generally included at least one fancy dress party. Apart from their purpose of discussing current and future business developments in the Amway business, the trips provided distributors with a reward for past performance and motivation to greater performance in future. The parties had agreed to settle their dispute on the points of principle by reference to the ALS held in Bangkok in Included in its schedule were a fireworks display on the first night, 3 business sessions - 10:30am - 1:00pm, Saturday, 23 October 1993, 9:00am - 1:00pm, Monday, 25 October 1993, and 9:00am - 11:00am, Tuesday, 26 October and a full day tour and dinner on Sunday, 24 October A room was set aside from 10pm to midnight as a venue ( coffee shop ) for distributors to meet with Amway corporate staff to discuss business problems and issues. Stands were erected to displayed selected Away products and information related to those products. The total cost of the 1993 ALS was $1,426,615, made up mainly of airfares, accommodation and meals. Of this total cost, Amway had returned as non deductible entertainment the costs of all meals taken away from the venue, sightseeing tours, sporting and shopping excursions and 5% of total catering costs as an estimate of the non-meal costs (eg decorations and props) totalling $40,723. By the end of the hearing, Amway accepted that the non-deductible entertainment should include some non-business aspects of dinners and suggested an arbitrary apportionment of 50%, one night s accommodation for the leisure day allowed and any additional accommodation provided after the conclusion of the ALS. The Legislation The former s51ae was introduced to deny deductions for entertainment expenses incurred after 19 September 1985 under the then general deduction provision, s51 of the 1936 Act. It had ceased operation after the 1996/97 year of income when it was replaced by Division 32 of the Income Tax Assessment Act, 1997 ( 1997 Act ). S51AE(4) was the operative provision. It provided a general prohibition on a deduction being claimed under s51 for losses or outgoings to the extent that they were in respect of the provision of entertainment. The word entertainment was not defined but a reference to the term provision of entertainment was elaborated in s51ae(3). Broadly, S51AE(3) provided that a reference in s51ae to the provision of entertainment was a reference to the provision of entertainment by way of food, drink or recreation; or accommodation or travel in connection with, or for the purpose of facilitating, entertainment by way of food, drink or recreation, 2 Amway of Australia v Commissioner of Taxation (No 2) [2003] FCA 1533

3 irrespective of whether business discussions or transactions had occurred. Recreation was defined in s51ae(1) to include amusement, sport and leisuretime pursuits generally. The general prohibition in s51ae(4) was subject to a number of exceptions in s51ae(5). Most relevantly, s51ae(5)(g)(iii) provided that s51ae(4) did not apply to a loss or outgoing incurred by a taxpayer in respect of the provision of entertainment to a person ( recipient ) who was performing services for it and where a deduction would, but for s51ae, be allowable to the recipient if it were incurred by the recipient. In addition, it must not be a purpose of the taxpayer or the recipient, in relation to the provision of the entertainment, to enable or facilitate the provision of entertainment to a person other than the recipient. Pursuant to s51ae(10), s51ae(5)(g) had no application, in relation to the provision of entertainment to a person that was in respect of, or incidental to, the person s attendance, while undertaking deductible travel, at a seminar other than an exempt training seminar or a seminar referred to in s51ae(1)(a) of the definition of eligible seminar and the entertainment provided was not accommodation or travel or by way of food or drink otherwise than at a meal during the occurrence of, or part of, the whole or a part of the seminar. If the reader s head is now spinning, be comforted that the judge noted at this point he was dealing with something that was an exception to the exception to the exception to the prohibition, and so qualifies for a deduction or four negatives make a positive. Seminar was defined in s51ae(1) to include a conference, convention, lecture, meeting (including a meeting for the presentation of awards), speech, questions and answers sessions, training session or educational course. Section 51AE(1)(a) of the definition of eligible seminar which excludes a seminar other than an exempt training seminar from being an eligible seminar referred to a seminar where it would be concluded that the sole or dominant purpose of the seminar was to enable participants, or prospective participants, in a particular business to give/receive information relating to the business to/from or discuss matters relating to the business with other particulars, or prospective participants, in the business or other persons. Pursuant to s51ae(11), a reference to deductible travel was a reference to travel undertaken by a person in circumstances where, if the person incurred expenditure in taking meals by himself or herself in the course of undertaking that travel, a deduction for the expenditure would, but for s51ae, be allowable to that person under s51. Entertainment There was no dispute between the parties that the ALS expenses were, by and large, s51 expenditure. 3 Amway of Australia v Commissioner of Taxation (No 2) [2003] FCA 1533

4 Counsel for Amway submitted that due to the peculiar structure of the Amway business, the ALS provided valuable forums for the dissemination of important business and product information to attending distributors and the exchange of important business information amongst attending distributors. It was deliberately structured to include some informal business and social events to provide business information exchange and networking opportunities in an informal, stress free and relaxed environment. It was submitted that s51ae(4) did not exclude from deductibility the cost of the provision of food, drink and recreation per se but the provision of entertainment by way of food, drink or recreation. As the word entertainment was not defined, it should bear its ordinary meaning. While conceding that a deduction for the cost of the non-business aspects of dinners was prohibited, it was submitted that the provision of meals consisting of food and drink when the recipient was away from home lacked the diversion or amusement element to constitute entertainment. Counsel for the Commissioner emphasised on the holiday location, lavish venue and the insubstantial content of the business sessions, which only took up a small part of the total duration of each ALS. It was argued that each ALS was recreational in essence, a social event with some token business tacked on, and was therefore an entertainment in itself with the result that a deduction for all of its costs should be denied under s51ae(4). It was submitted that the word entertainment included the provision of hospitality, including hospitality by way of food and drink and therefore the provision of hospitality, including hospitality by way of food and drink, was entertainment. It followed that any substantial function where food or drink was provided would be entertainment. It was further submitted that even if there may be occasions where the food and drink provided was not entertainment, it should not be extended to situations where the provision went beyond mere sustenance. Gyles J rejected the primary submission in respect of entertainment made on behalf of Amway. He found that the word as used in s51ae(4) was intended to pick up the following concepts of entertainment as defined in the Macquarie Dictionary, 3rd ed: (1) to hold the attention of agreeably; divert; amuse. (2) to receive as a guest, especially at one s table; show hospitality to. He also rejected the submission made on behalf of the Commissioner that each ALS was an entertainment simpliciter. He said he was satisfied that, from Amway s perspective, an ALS was solely for business purposes, designed to enable communication with and amongst its distributors and to motivate them to greater efforts in future periods, and therefore all its associated costs were genuine business expenditure. He rejected the Commissioner s criticism that the content of the business sessions were insubstantial and commented that it was appropriate for the Amway business. Indeed, he found that it was difficult to conceive a better 4 Amway of Australia v Commissioner of Taxation (No 2) [2003] FCA 1533

5 method of achieving the designed objectives. He was also of the view that, from a business perspective, the criticism on behalf of the Commissioner on the desirable location and lavish scale of accommodation and hospitality was misplaced, as they were necessary to attract sufficient attendance and have the desired motivational outcome. On the above basis, his Honour concluded that all food, drink and recreation provided during an ALS, (as opposed to the ASL itself) was, regardless of whether it was lavish or for mere sustenance, entertainment pursuant to s51ae(4). Accordingly, it was necessary to: consider, in respect of food, drink and recreation, the exceptions to s51ae(4) and examine and, if necessary, apportion the other ALS costs pursuant to s51ae(4). Travel Gyles J then went on to consider if expenditure for travel to and from, and accommodation at, each ALS was in connection with or for the purpose of facilitating the provision of entertainment by way of food, drink or recreation in terms of s51ae(3)(b). He commented that the language of that paragraph was somewhat awkward but concluded that the meaning of the phrase in connection with should be determined in the context in which it appeared. He was of the opinion that it required, in the context of s51ae(3)(b), some form of purposive link between the accommodation and travel and the entertainment by way of food, drink or recreation. His Honour was of the opinion that each ALS provided the opportunity for the attendees to combine business and pleasure. Although he was mindful that the hospitality afforded to the attendees was neither slight or insignificant, he was satisfied that, from Amway s perspective, it was designed to motivate and attract attendances and was ancillary to their business purposes. Accordingly, he concluded that the travel and accommodation provided to the distributors was not in connection with, or for the purpose of facilitating, the entertainment provided by way of food, drink and recreation. Exception for Employees and Service Providers Gyles J then turned his attention to s51ae(5)(g) which provided an exception to the general deduction prohibition of entertainment by way of food, drink and recreation in s51ae(4). He rejected the submission on behalf of the Commissioner that the exception would not apply to the provision of entertainment to a group situation on the basis that the singular includes the plural. He also pointed out that s51ae(10) expressly related to s51ae(5)(g) and expressly referred to seminars which were, by implication, multi-person events. His Honour noted that although the arguments of the hearing centred around the distributors, who were without doubt agents, not employees, of Amway, the 5 Amway of Australia v Commissioner of Taxation (No 2) [2003] FCA 1533

6 paragraph should have equal application to employees. Section 51AE(5)(g) was designed to allow a deduction for entertainment provided to people who had a contract of service or a contract for services with the taxpayer, in genuine situations which were not devised effectively to entertain a third party. He was of the opinion that an ALS fell squarely within this exception. He then proceeded to consider the operation of s51ae(10)(a), which restricted the application of s51ae(5)(g) to, inter alia, a loss or outgoing incurred by the taxpayer to the extent that it was in respect of the provision of entertainment to a person that is in respect of, or incidental to, the person s attendance, while undertaking deductible travel, at a seminar to which paragraph (a) of the definition of eligible seminar in s51ae(1) applied, regardless of its duration, not being the provision of entertainment consisting of accommodation or travel; or entertainment by way of food or drink except at a meal during which, or during part of which, the whole or a part of the seminar occurs. (His Honour did not consider s51ae(10)(a)(i)(a) as it was not contended on behalf of Amway that an ALS was an exempt training seminar as the definition is confined to employees.) His Honour was of the opinion, based on his reasoning on s51ae(5)(g), that a distributor attending an ALS was undertaking deductible travel within the definition in s51ae(11) and an ALS was a seminar within the extended definition in s51ae(1). Gyles J then turned his mind to whether or not an ALS was a seminar referred to in the definition of eligible seminar in s51ae(1)(a). He noted that s51ae(1)(a) contained a sole or dominant purpose test and concluded that in situations where there was more than one purpose, as was in the present case, it should be interpreted to mean the most influential purpose. He was of the opinion that the principal, and therefore dominant, purpose of the seminar fell within the purpose described in sub-paragraphs (i), (ii) and (iii) of the definition - to give/receive information relating to the business to/from or to discuss matters relating to the business with other participants, or prospective participants, which was defined to include agents, in the business or other persons. He therefore concluded that an ALS was such a seminar. His Honour then considered the exception contained in s51ae(10)(a)(i)(d). In relation to the subsection generally he found its meaning obscure because of the structure of it and did not get any assistance from the explanatory memorandums. He read this paragraph as exempting the provision of food and drink from the application of s51ae(4) only if it was provided at a meal during part of which the whole or part of a seminar occurs (though a literal reading seems to suggest otherwise). He discounted the view that an ALS was itself a seminar for the purpose of s51ae(10)(a)(i)(b) and (D). Instead, he found that, even with a liberal interpretation, it would require a certain focus, formality and structure for a seminar to come within those provisions. Accordingly, he concluded that only the business sessions, as against the ALS as a whole, satisfied those requirements. As the business sessions only ran for between 2 to 4 hours a day and no meal was included in any of those sessions, his Honour concluded that this exception did not apply. 6 Amway of Australia v Commissioner of Taxation (No 2) [2003] FCA 1533

7 Gyles J considered that all other costs of the 1993 ALS such as freight, stationery, meeting room expenses, gifts and product samples were not entertainment by way of food, drink and recreation and therefore deductible under s51. Implications The decision has several potentially significant effects on the deductibility of entertainment expenditure. It has already attracted adverse comment from the profession (see Australian Financial Review 30 January 2004). First, Gyles J seems to have held that sustenance (any food and drink) will be entertainment which is contrary to the position in the ATO s ruling on the topic (see TR 97/17 paras 11-24). If so, much of that ruling and current understanding of the law may need to be reconsidered. The ATO tried to finesse this problem by arguing that the whole meeting was entertainment but this was rejected by the judge. Secondly, Amway was denied a deduction for parts of its costs because only the business sessions and not the ALS as a whole was considered to be a seminar referred to in s51ae(10)(a)(1)(d). Despite the omission of the equivalents of s51ae(5)(g) and s51ae(10) in Division 32 of the 1997 rewrite, Gyles J s interpretation of seminar, which was (and continues to be in s32-65(1) of the 1997 Act) widely defined to include a conference, convention, meeting, etc, may still be of relevance to the interpretation of what constitutes a seminar and seminar expenses in s32-65 and s32-35 of the 1997 Act respectively. In this respect, it is curious that his Honour found that an ALS was a seminar referred to in s51ae(10)(a)(i)(b) but not s51ae(10)(a)(i)(d). This was despite the fact that he was satisfied that an ALS was a means by which Amway management communicated directly with the network of distributors in order to both impact and receive relevant information as to products and processes, including the way of doing business. It was a means by which the distributors communicated with each other, formally and informally, in order to both impart and receive relevant information as to products and processes, including the way of doing business. (paragraph 82). More relevantly, his Honour does not appear to have considered the application of the provision on the continuity of eligible seminar in s51ae(2) (now seminar in s32-65(2) of the 1997 Act) that any break during a seminar for the purpose of a meal, rest or recreation shall not be taken to affect the continuity of the seminar. Does this mean that elaborate apportionments will be required whenever a seminar is the basis on which a deduction is claimed in future? Say, for example, Amway had agreed to deduct a day's accommodation costs to exclude the one free day of leisure activities (which in the case of the 1993 ALS fell on a Sunday) that was allowed for in each ALS. This was accepted by the judge without comments. At the moment many taxpayers assume that the costs of the whole period of the seminar are deductible. 7 Amway of Australia v Commissioner of Taxation (No 2) [2003] FCA 1533

8 Thirdly, the repeal and non-replacement of s51ae(5)(g) and (10) in the 1997 Act was done on the basis that the provisions had little or no scope for operation. Gyles J quoted the Explanatory Memorandum to the 1997 Act to that effect but held the view to be mistaken. As a result the 1997 Act has made substantive changes to prior law which are detrimental to taxpayers. The current law thus needs to be reconsidered if the intention of maintaining the status quo of the 1936 Act is to be given effect. Finally, it is interesting to note that the Commission did not attempt, in the case that the costs of the ALS were deductible to Amway, to assess the distributors under s21a of the 1936 Act. 8 Amway of Australia v Commissioner of Taxation (No 2) [2003] FCA 1533

9 This article written by Anita Yuen appeared in the March 2004 edition Vol 38 (8) of Taxation in Australia, the journal of the Taxation Institute of Australia. These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation Greenwoods & Freehills Pty Limited (ABN ) Sydney ANZ Tower, 161 Castlereagh Street, Sydney NSW 2000 Australia Ph , Fax Melbourne 101 Collins Street, Melbourne VIC 3000, Australia Ph Fax Perth QV.1 Building, 250 St Georges Terrace, Perth WA 6000, Australia Ph Fax Amway of Australia v Commissioner of Taxation (No 2) [2003] FCA 1533