Related party dealings and R&D Payments

The necessity for a payment extends to many areas of tax law. One example is the ability to claim R&D expenditure paid to associates.

The relevant provision for R&D expenditure is s 355-205 of the Income Tax Assessment Act 1997 (Cth) (ITAA97) which provides as follows:

(1) An R&D entity can deduct for an income year (the present year) expenditure it incurs during that year to the extent that the expenditure:

(a) is incurred on one or more R&D activities:

(i) for which the R&D entity is registered under section 27A of the Industry Research and Development Act 1986 for an income year; and
(ii) that are activities to which section 355-210 (conditions for R&D activities) applies; and

(b) if the expenditure is incurred to the R&D entity’s associate — is paid to that associate during the present year.” (emphasis added)

It is interesting to apply the earlier views on what constitutes a payment to this requirement. It should be that payment can be made in a number of ways, including through journal entries. But anecdotal evidence suggests that the Commissioner does not look favourably on that view. Perhaps it will be tested once a taxpayer makes a mistake. Until then, taxpayers must draw out large sums of Australian legal tender (physical cash) in order to make payments. Or cause their banks to make journal entries on their behalf. Which, although simple in theory, can be administratively difficult, particularly where large sums of money are involved or there are international transactions, or both. Instead, it might simply be easier to pay by cheque, or a related instrument such as a promissory note.

Legal tender

Australian currency is legal tender in Australia. Legal tender is a concept whereby the offering of legal tender to meet a financial obligation is, in the eyes of the law, sufficient to extinguish that obligation:

• all payments to meet a financial obligation must be made in legal tender unless the parties agree otherwise. Thus, a purchaser is required to pay the purchase price in folding notes and physical coins, unless agreed otherwise. Of course, this is often highly impractical and therefore, for a large purchase such as real property, the parties agree that the purchase price may be met by the tender of a bank cheque or electronic transfer. A cheque (and other bills of exchange) are money but not legal tender (because a creditor is not obligated under the law to accept a cheque). In the absence of agreement, a creditor does not need to accept a cheque and can demand legal tender; and
• there are “limits” on legal tender. For example, 5 cent coins can only be used to meet financial obligations not exceeding $5  (s 16 of the Currency Act 1965 (Cth)). Readers may recall a recent incident where a local resident, disgruntled with a parking fine handed out by the Council, attempted to pay the entire amount with 5 cent coins! The Council had the legal right to refuse all but $5 of that purported payment.

The amount tendered ought to be the precise amount to be paid unless a greater amount is tendered and change is requested but not demanded; it is arguable that a creditor is not obliged to give change.

When currency is deposited at the bank or with another financial institution, it loses its quality as currency. It becomes a chose in action, being a contract between banker and customer. Through that contract, the deposit holder can compel the bank to make payments to other banks.

Lower value, primarily consumer, fund transfers through ATMs, EFTPOS, and by means of internet payments, digital coins and stored value cards or similar mechanisms, are governed by contracts between relevant institutions, between each institution and its customers, and by self-regulatory codes of conduct which anticipate or forestall formal government regulation.

An electronic payment is therefore an activation of a series of legal relationships. It is not a payment of legal tender, and is not required to be accepted. However, it can be accepted by agreement between parties.

Promissory notes

A promissory note is not required to be accepted for payment: only Australian legal tender is. If the parties do not agree to use a promissory note, the presentment of one does not constitute payment. This is not a high threshold, but it is still a necessary condition.

Rocky Castle Finance Pty Ltd v Taylor is a South Australian case where parties purported to make payments with promissory notes. It was a managed investment scheme and “advances” were purported to be made with a promissory note. However, boilerplate clauses within the relevant documentation provided that payments had to be made into a bank account. As such, it was not open to argument that payment could be made by promissory note as the parties had agreed in the documents to make payment into an account. It is likely that, in the design of the scheme, this was an oversight by the drafter of the documentation. Rocky Castle Finance demonstrates when payment in a form other than legal tender is not accepted.

A promissory note is as “an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay, on demand or at a fixed or determinable future time, a sum certain in money, to or to the order of a specified person, or to bearer.

This definition contains three elements which set the promissory note apart from other negotiable instruments. First, the note must be an unconditional promise in writing (compare with a traveller’s cheque, for example). Second, the note is payable on demand or at a fixed determinable future time, which is different from an IOU which simply evidences the maker’s agreement that they owe something to a certain person. Third, the note operates directly between the person making the promise and the person receiving the note, whereas a bill of exchange, for example, involves a third party to whom the order to pay is given.

The default position with a promissory note is that the tender and acceptance of a promissory note is a conditional payment. The condition is that, when it is presented, it is honoured. When it is received, the creditor’s rights against the debtor are suspended (not extinguished, as is the case when legal tender is presented). If, on presentation, the promissory note is not honoured, the creditor’s rights against the debtor revive.

The principle is that a promissory note is given and taken in payment as its face value in money. It is not as merely given a right of action for the creditor to litigate a counterclaim per Lord Denning MR in Fielding & Platt Ltd v Selim Najjar.

“We have repeatedly said in this court that a bill of exchange or a Promissory Note is to be treated as cash. It is to be honoured unless there is some good reason to the contrary.”

A promissory note can also be an absolute, not just a conditional, method of payment. Whether it is absolute depends on the intent of the parties and is a question of fact.

In the Victorian Supreme Court case of Mobil Oil Australia Ltd v Caulfield Tyre Service Pty Ltd, the status of a bill of exchange as a payment instrument and the obligations of the person to whom the bill is “addressed” were considered. In the course of delivering his judgment in that case, Young CJ referred favourably to observations on the character of negotiable instruments, such as bills of exchange and promissory notes, made in several UK cases. These references include:

… the bona fide holder for value of a bill of exchange is entitled, save in truly exceptional circumstances, on its maturity, to have it treated as cash…

Bills of exchange are treated as cash, and unless there are exceptional circumstances where there is an action between the immediate parties to a bill of exchange judgment will not be held up by virtue of a counterclaim by the defendant and execution will not be stayed.

When one person buys goods from another … He may demand payment in cash; but if the buyer cannot provide this at once, he may agree to take bills of exchange payable at future dates. These are taken as equivalent to deferred instalments of cash.

Because of their use to effect immediate payment, promissory notes have found use in “round robin” transactions, and in particular a number of tax-driven schemes. This was noted by Hill J in FCT v Sleight:

“While a round robin is perfectly legally effective to create real relationships between parties, it must be said that it is a feature of many tax avoidance schemes where no real money is involved and may point to a tax avoidance purpose.”

That a particular form of legal rights has been used in a number of tax-driven schemes does not impugn the broader commercial efficacy of those legal rights. Trusts, debts, contracts, partnerships, companies and nearly all aspects of commercial law have been used in tax avoidance schemes. That parts of commercial law have been used from time to time for a particular purpose does not more broadly colour that law.

Accordingly, providing the promissory note is honoured when it is presented for payment, there should be no issue with the payment of the services by way of promissory note.

Anecdotally, the Commissioner has been comfortable with the use of promissory notes to satisfy the requirement for payment for R&D expenditure. This accords with the Commissioner’s comfort in a promissory note or bill of exchange constituting consideration in other contexts.