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7. Chapter 7 Income Tax: The Base

7.1. ‘Income’, as the starting-point for the formal legal structure of income taxation of persons, companies and other entities, is surrounded with problems of definition. The aims of this chapter are to clarify these, to suggest a logical framework into which some of the problems discussed in this and later chapters can be fitted, and to deal with specific issues of definition of general relevance. Specific issues relating peculiarly to business and professional income, and to employment income and investment income are dealt with separately in later chapters.

I. Problems of Definition

7.2. In the language of the present law, income tax is levied on ‘taxable income’, which is income in the meaning of the law (other than exempt income) derived during a period, normally one year, less (i) expenses in deriving that income and (ii) a number of other deductions reflecting equity considerations and particular social and economic policies. The phrase ‘net income’ is here adopted to refer to income less the first of these deductions, but before the second are subtracted.

The Concept of Income

7.3. The legal meaning of income is drawn very largely from judicial decisions— many of them borrowed from the United Kingdom—extended and refined by specific provisions. The primary characteristic of the tax law's approach has been to express what the word may be taken to mean in ordinary English usage. Some basic notions underlie the meaning. One of these is the idea of gains (in some contexts a receipt, in others a profit) from the carrying on of organised activity—an employment, a business or profession, or a business deal—directed to the making of gains. Another is the idea of gains derived from property which leave the property intact—a fruit of the tree as distinct from the tree itself. A third is the idea of compensation which substitutes for gains that would have been income. A fourth is the idea of gains periodically received. None of the ideas is sharp in its outlines, least of all the third and fourth. Thus compensation which substitutes for gains that would have been income must be distinguished from compensation for an asset that would have produced such gains. Gains periodically received must be distinguished from receipts of a fixed sum by instalments.

7.4. For analysis in terms of economic principles in which theory comes first and practicalities are wrestled with later, economists have sought a primary definition of income in any period that is a measure of the flow of an individual's actual and potential satisfactions. One of the most thorough-going efforts to this end is that associated with the American economist Henry Simons whose Personal Income Taxation, published in 1938, has had great influence in academic debate. That formulation centres upon ‘increases in economic power’ to command satisfactions.

7.5 The economists' definition would in general include in income all of the gains that the law includes: salary and wages; profits from a business or profession or business deal; interest, rent, dividends; compensation for income; and periodical receipts. But it also covers a great many gains that would probably not be reckoned as income in ordinary English usage, and have not been brought in, or have been brought in

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only to a very limited extent, by judicial and legislative extensions and refinements of that usage. The comprehensive tax base would include:

  • (a) capital gains: gains from the realisation of property, when the realisation is not an aspect of the carrying on of a business or a profession, or the carrying out of a business deal;
  • (b) bequests and gifts received;
  • (c) lottery and casual gambling winnings;
  • (d) retirement benefits and compensation for loss of office;
  • (e) compensation for physical injury to person received in a lump sum or for injury to reputation; and
  • (f) non-money income.

Some comment on each of these is called for.

7.6. Except to a limited extent resulting from the provisions of sections 26 (a) and 26AAA of the Income Tax Assessment Act, which define the base to include gains from the sale of property acquired for the purpose of profit-making by sale and gains made within a period of twelve months, capital gains (as defined in paragraph 7.5) are not included in the present base, though the introduction of a tax on such gains has been announced. The Committee's recommendations for the taxing of capital gains are set out in Chapter 23.

7.7 The present base does not include bequests and gifts received except where the receipt is one of a number received periodically, for example an annuity, or where, in the case of a gift, it is included as salary or wages or as a business gain or a gain from a profession. In Chapter 24 the Committee rejects the possible extension of the income tax base to include all bequests and gifts and proposes the continued taxation of property the subject of bequests and gifts on a separate basis.

7.8. Lottery and casual gambling winnings are not infrequently described as ‘windfall gains’, though the phrase has no very precise meaning. It suggests gains that are more or less unexpected. A quality of unexpectedness also belongs to some capital gains, but the Committee takes the view that this is not an argument for freeing capital gains from tax. However, taxing lottery and casual gambling winnings raises awkward problems, some of them administrative, others concerned with the deductions that should be allowed. There would be difficulties of enforcing the law with respect to casual gambling winnings. The problems associated with the allowance of deductions may be illustrated by asking how one would deal with the coins fed into a poker-machine. The Committee has no proposal to extend the tax base to include lottery and casual gambling winnings.

7.9. Retirement benefits and compensation for loss of office which are not periodically received are by an express provision included in the present base only to the extent of 5 per cent of the amounts involved. Were it not for this provision, a retirement benefit would be wholly included as a gain from an employment, while compensation for loss of office received in a lump sum—sometimes called a ‘golden handshake’—would be wholly excluded. Such compensation might be treated as embodying a capital gain if the notion of ‘property’ for the purpose of bringing capital gains to tax were broadened to include an office. Alternatively, it might be regarded as a substitute for salary which would have been earned and thus income. If any change is to be made in the existing law there is much to be said for treating retirement benefits and compensation for loss of office in identical fashion. Moreover,

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the best way of dealing with these receipts depends quite crucially on how the tax law treats superannuation benefits and life insurance proceeds, and the matter is further considered in Chapter 21.

7.10. Compensation for physical injury to person received in a lump sum or for injury to reputation is not at present included in the income base. In theory the compensation could be regarded as embodying a capital gain if the notion of property were made wide enough to extend to human capital. It would, however, be impossible to identify the gain, since the cost of acquiring human capital cannot readily be ascertained. Some of the compensation may be in respect of income already lost and in respect of a loss of capacity to earn income in the future, in which cases it could be regarded as a substitute for the income that would have been earned. To this extent, at least, it might be thought appropriate to include it in the base. If compensation is received in the form of periodical payments, it will be income as received, whether given for lost income or some other aspect of the taxpayer's loss. These matters are further considered in paragraphs 7.34–7.41.

7.11. The major item of non-money income currently omitted from the income base is imputed rent of the owner-occupied home. This omission is discussed later in paragraphs 7.42–7.57. But houses are not the only form of property that may yield flows of satisfaction to which imputed income might be attached. Works of art and consumer durables in general are other obvious examples. Inclusion in the tax base of imputed income from these latter items of property would of course involve great administrative problems, and is not proposed.

7.12. Goods produced for one's own consumption or services performed for oneself are currently excluded from the income base. Whatever the case in economic theory for their taxation, it would be administratively impracticable and the Committee has no proposals to change the present position.

7.13. Other instances of non-money income that would be included in the comprehensive tax base may be found in the fringe benefits an employee receives from his employer. The gain may be in the form of goods received, services received, relief from an obligation that would ordinarily have been incurred or valuable rights.

7.14. The general rule of the income tax law is that a gain must be valued by reference to the amount of money that could be obtained for it. On this principle of valuation, a made-to-measure suit is likely to be valued at the price it would bring as a second-hand suit. A service one receives from another, such as the use of a motor-car or a residence available only to oneself or free holiday travel as an airline employee, has no value. Similarly the relief from the payment of interest enjoyed by a person who has an interest-free loan has no value; nor has a person's right to take up shares in a company, if not assignable, unless there is a way in which he can make the benefit of the right available to somebody else.

7.15. This general rule is, however, qualified in important respects by section 26 (e) of the Act, but only in relation to income gains that are rewards for services rendered. This provision substitutes ‘the value to the taxpayer’ for the test of value under the general rule. The special rule certainly limits the tax-planning possibilities opened up by the general provision, but its operation is not entirely clear. It has not prevented the offering and accepting of fringe benefits in substitution for cash, under employment contracts. Some of these benefits are certainly taxed; but to the extent that they are valued for income tax purposes below what would be paid for them in cash outside the income-producing relationship, the equity of the tax system is seriously affected.

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There may be a form of collusion between employer and employee by their splitting the saving of tax that attends a full deduction to the employer of the cost of providing the benefit and a lesser amount being included in the income of the employee. There is, however, no easy solution to the problem of making adequate provision. In many instances, the fringe benefit is so interwoven with the normal performance of the services for which the fringe benefit is a reward that the element of gain may be very difficult to identify. The commonplace illustration is the use of a motor-car for both employment and personal purposes. The question of the taxation of fringe benefits is explored in Chapter 9.

Deduction of Expenses

Expenses Incurred in Deriving Income

7.16. Besides questions of what should or should not be included in income, a host of problems arise over the identification and measurement of the expenses incurred in deriving income that have to be deducted before a figure for net income is reached. It is common to both the existing tax law and to the theory of a comprehensive tax base that such deductions be made.

7.17. A prime problem here is to achieve a practical application of the distinction between an expense in deriving income (which gives rise to a deduction) and consumption expenditure (which should not unless by some special concessional provision). Some expenses, such as for entertainment and travel discussed in Chapter 9, often involve elements of both. Drawing the distinction becomes very subtle when, for example, equipment is used which, in its luxuriousness, exceeds the commercial needs of business: as, for example, when an expensive car is employed where a more modest vehicle would serve just as well.

7.18. Very important areas of controversy arise over costs of travel to and from work and child-minding expenses. These are not now regarded as expenses of deriving income, though it is often argued that they should be. They are further examined in paragraphs 7.58–7.75. Extended to its logical conclusion, the argument leads to a notion of expense in deriving income that would include almost all personal expenditure, even that on food and clothing, in which event the income tax base would largely disappear.

7.19. Expenses in deriving income include the depreciation or amortisation of investment expenditure on assets that deteriorate through use. Issues that arise in relation to the deduction of this expenditure are considered in Chapter 8.

7.20. Certain expenses that would not usually be thought of as consumption expenditure or investment expenditure on non-deteriorating assets are denied deduction. Examples are the cost of moving business operations or of moving home to a new place of work: the cost does not relate wholly to current income, and there is no obvious asset to which depreciation might be applied. These expenses are considered in Chapters 8 and 9.

Other Deductible Expenses

7.21. From ‘net income’ as the term is used here the tax law authorises a whole series of further deductions before the taxable income is reached to which the prescribed rate scale is applied and liability determined. These are generally known as concessional deductions and for the most part are so called in the Act. They include dependant allowances, medical and education expenses, zone allowances, life

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insurance and superannuation premiums, and gifts to charities. They primarily reflect considerations of equity as well as particular social and economic policies. They are discussed in Chapters 12, 21 and 25.

Exempt Income

7.22. The income base is qualified by a number of express exemptions. Some of these are aspects of the taxation of foreign income and of the income of non-resident taxpayers dealt with in Chapter 17. Others may accord special treatment to particular industries and activities and are discussed in Chapters 19, 20 and 25. Questions of equity are raised by the exemption of child endowment and some scholarships and pensions. The possible inclusion in the tax base of child endowment, scholarships and pensions, where they are grants by government, is considered in Chapters 12 and 13. Receipts of alimony are usually exempt. As a correlative of this there is no deduction for their payment: the equity of this arrangement is discussed in Chapter 10.

Annual Accounting

7.23. The income tax base, like the comprehensive tax base, relates to a selected period. For the income tax base the period of account is normally one year and is referred to as the year of income.

7.24. Where the income is that of an individual and the rate structure is progressive, any unevenness, or bunching, of the amounts of income derived in different years will result in more tax being payable than would be the case if a longer period of account were adopted. The present law has some provisions directed to overcoming the consequences of bunching. Averaging of income is allowed to primary producers and special provisions having a similar effect apply to authors and inventors. These illustrations of averaging are examined in Chapters 14 and 18. There would be administrative and compliance costs in the wider application of averaging: the wider application of averaging is considered in Chapter 14.

7.25. A strict application of annual accounting would work unfairly where a loss has been suffered for a year. Subject to some limitations, the present law allows a loss in one year to be applied to reduce net income of a later year, though not the net income of an earlier year. The treatment of losses is analysed in Chapters 8 and 16.

7.26. Under a system of annual accounting the timing of an income gain or expense in deriving income will affect the amount of net income. The questions, in the language of the law, are when an income gain is ‘derived’ and when an expense is ‘incurred’. Derivation and incurring, in turn, depend on the method of accounting, cash or accruals, held appropriate to the income. Broadly, cash accounting involves actual receipt and actual payment. Accruals accounting involves entitlement to receive and obligation to pay. There are problems as to what is a sufficient right to receive or a sufficient obligation to pay under the accruals method, for example whether a provision for long-service leave in the accounts of a business is an expense. These matters are considered in Chapter 8.

Income of Particular Industries and Activities

7.27. The present law contains a number of special provisions that affect net income arising from the conduct of particular industries and activities or the tax payable in relation to them; and the operation of the general provisions poses special problems in relation to these and other industries and activities. In certain instances, incentives

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are given through exemption of income receipts and favourable treatment of expenses. Various industries and activities, including primary production, mining, superannuation and life insurance, and general insurance, are examined individually in a series of later chapters.

Income Moving Through Intermediaries

7.28. The determination of net income as explained in this chapter is the primary step in ascertaining the amount of income on which tax is levied, whether the income is that of an individual, a trust estate, a partnership or a company.

7.29. A trust estate has income and may be a taxable entity distinct from its beneficiary. Where there is a beneficiary presently entitled to the income, the income is taxed to the beneficiary; though where the beneficiary is a child, the tax may in effect be paid for him by the trustee. Where, however, there is no beneficiary presently entitled, the income is taxed to the trustee as if it were the income of an individual or, in some circumstances, at a special rate of 50 per cent.

7.30. A partnership has income but the income is treated as income of its members in accordance with their interests in the partnership. A partnership is not a taxable entity distinct from its members.

7.31. The taxation of trusts and partnerships is considered in Chapter 15.

7.32. The income of a company is taxed to the company and is taxed again to shareholders when distributed to them. This system is examined in Chapter 16.

International Aspects

7.33. In general, the bases of Australia's jurisdiction to tax income are residence of the taxpayer and source of the income. Foreign-source income of a non-resident is beyond that jurisdiction. International aspects are referred to in a number of chapters, more especially in Chapter 15 in relation to trusts and partnerships, Chapter 16 in relation to companies, and Chapter 17 where issues of general application are considered.

II. Specific Issues

Compensation for Physical Injury to the Person

7.34. Compensation in a lump sum for personal injury is not included in income. The compensation is a composite receipt of a number of elements. These may include income already lost as a result of the injury, capacity to earn income in the future, pain and suffering and diminished expectation of life. Except perhaps for the first, none of the elements has an income character, whether by virtue of the ordinary usage of the word or the specific provision in section 26 (j) dealing with receipts by way of insurance or indemnity. Compensation for income already lost is income, but it is arguable that there is no such element in the compensation receipt: so far as the amount of compensation takes account of income already lost, this is only for the purpose of determining the amount of the loss of capacity to earn that resulted from the injury. The resolution of the question is, for the present, unlikely, because of the difficulties placed by the present law in the way of dissecting or apportioning composite receipts. These difficulties are considered later in paragraphs 7.101–7.102.

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7.35. So long as compensation received in a lump sum for personal injury is not included in income, the amount of compensation given by the Courts in personal injury cases will continue to be calculated on the basis that what has been lost as a result of the impairment of capacity to earn is the present value of what would have been earned less the present value of the tax that would have been paid on that amount. This results from the application of the principle in Gourley's Case.note The Court in applying the principle must estimate the deductions and concessions likely to have been available to the injured person and, presumably, what he might have done by way of tax planning to minimise his tax liability. The principle is sometimes criticised on the ground that the person who caused the injury receives a benefit at the expense of all other taxpayers who must make up the loss to revenue. The Committee does not see the matter in these terms, involving as they do notions of ensuring a full penalty for his wrongs on the person who caused the injury which, in the conditions of compulsory insurance of motor vehicle and industrial accident liabilities, are inappropriate. However, the Committee does not regard the application of the principle as sufficient in itself to justify the exemption of lump-sum receipts from tax. It is not intended as a substitute for tax: it is rather a consequence of the absence of tax. Moreover, the application of the principle cannot be precise even when a case comes to trial. There is no way of assessing the significance of the principle in out-of-Court settlements.

7.36. Where compensation for personal injury is received in a series of periodical payments, the amounts received are included in income without regard to whether they are for lost earnings, for loss of earning capacity or for pain and suffering. Thus periodical payments of workers’ compensation are included in income. There are, therefore, important tax implications in the recent proposal of the Committee of Inquiry into Compensation and Rehabilitation in Australia, that injury and sickness compensation be universally paid in periodical amounts. The Bill currently before Parliament preserves to some extent the system of lump-sum awards, but their role in compensation for physical injury has been significantly reduced.

7.37. The continuing exclusion from income of compensation for physical injury must rest primarily on the importance of the element of non-economic loss reflected in the compensation. Whatever the theory of the comprehensive tax base may suggest, it would be a significant departure from accepted ideas to include in income amounts received which are in respect of physical suffering and disability as distinct from being for the reduced capacity of a person to earn which may attend that suffering and disability.

7.38. If it were sought to separate the element of compensation for non-economic loss and to tax the remainder, this could only be done by some arbitrary apportionment. The award of damages by a Court or the award of a lump sum under workers’ compensation will not show the breakdown; and a lump sum payable under an accident insurance policy is expressed simply as an amount of money.

7.39. The taxing of that part of the compensation apportioned to the element representing a substitute for income would lead, in the case of compensation assessed by a Court or tribunal, to a considerable increase in the level of awards. Gourley's Case would no longer apply and awards would be made on predictions about the gross income of the injured person.

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[?] Committee for these reasons does not propose any change in the present [?] tax receipts of compensation for physical injury.

Compensation for Injury to Reputation

[?] compensation for injury to reputation is also a composite receipt covering a [?] of elements. Some of these are concerned with income that would have been [?] with the feelings of the person injured. The compensation is invariably in the form of a lump sum. In the Committee's view there is no ground for distinguishing such compensation from compensation for injury to the person, and it proposes that it too be excluded from income.

Imputed Rent of the Owner-Occupied Home

7.42. At present one very large item of non-money income—imputed rent of the owner-occupied home—is omitted from the income base and thereby escapes tax altogether. This has not always been so. In the earliest years of Federal income tax, from 1915 to 1923, 5 per cent of the capital value of an owner-occupied residence was included in assessable income; deductions were allowed against this amount for expenses by way of repairs, rates and land taxes, and mortgage interest. In 1923, however, the provision for including imputed rent was discontinued; repairs and mortgage interest became non-deductible, but the owner-occupier was still permitted a tax deduction for rates and land taxes. This remains the situation today, with two qualifications. In 1973 a ceiling of $300 was placed on the amount of rates and land taxes an owner-occupier might deduct, and the deduction was henceforth to be confined to a principal place of residence. More recently a scheme has been introduced, restricted to home-purchasers in the lower and middle income ranges, making some portion of interest paid on home loans tax deductible. Where the combined actual income of husband and wife is $4,000 or less, the whole of interest paid on a principal residence is deductible. On incomes above $4,000 the deduction is reduced by 1 per cent for each $100 of the excess, disappearing altogether when income reaches $14,000.

7.43. Only a few countries, including West Germany and Sweden, treat the rental value of the taxpayer's own home as income for tax purposes. In West Germany, for example, the basis of valuation varies between one-family homes and other types of housing. For one-family homes, 3 or 3½ per cent of the assessed value is used (depending on the date of erection) to determine the rental value; for other types of housing, a rental value is established by comparison with the market rental value of dwellings of equivalent standard. Deductions are allowed for mortgage interest, taxes on real property, depreciation, repairs and maintenance, and insurance.

7.44. The arguments for imputation merit some consideration though, as will appear, the Committee does not propose to recommend that imputed rent be taxed. A substantial inequity between home-owners and tenants is involved under the present Australian system. And though a case can perhaps be made for treating home-ownership specially favourably on the grounds that widespread ownership is socially desirable and good housing benefits the whole community, it is questionable whether exempting imputed rent is an appropriate way of encouraging home-ownership. For one thing, low-income tenants are exluded from the benefits of non-imputation; for another, home-purchasers may in fact be made worse off because of the higher prices they must pay for their homes in the face of greater public demand for housing.

7.45. If imputed rent is to be taxed, the amount subject to tax can be calculated in one of two ways:

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  • (a) The first way involves the determination of the gross rental value of the home. From this repairs, depreciation, and local rates are deducted to arrive at a figure representing net rental value. A further deduction of interest on money borrowed and invested in the home is then made in order to establish the net rental of the owner's equity. This is the amount subject to tax.
  • (b) The second way avoids some of the complexities of the first, though, in the result, it involves elements of arbitrariness. A percentage of the capital value of the home is assumed to be the net rental value. Interest on money borrowed is then deducted and the residual is the amount subject to tax.

Whichever method is adopted there is the prospect, especially when borrowing has been made at a high interest rate, that the imputed rent will be a negative figure.

7.46. However the calculation is done the taxing of imputed rent is open to two major criticisms, one concerned with hardship for some taxpayers, the other with administration.

7.47. Where the owner's equity in his home is substantial, a considerable amount of non-cash income could well be involved. In times of high interest rates, annual imputed rent on a house with a capital value of $40,000 may amount to $4,000. If this is added to a retired person's investment income of, say, $6,000 and the total amount of $10,000 is taxed, hardship may result. The inclusion of imputed income in the income tax base will, it is true, make possible some reduction in rates of tax, but the reduction may not be enough to obviate hardship in many cases. One could visualise similar difficulties arising for other classes of taxpayers: for example, a widow with young children may have been left the family home, now freed of mortgage by the proceeds of an insurance policy taken out by her husband, but she may have only modest cash income and few other assets.

7.48. Employee taxpayers with imputed rent, whose employment income is subject to the system of collecting tax by instalment, would not be as conscious of the hardship if the taxing of imputed rent were keyed in some way into the instalment system. There will be administrative problems in doing this; but if it were not done and employees had to pay tax on assessments, the system of collecting tax by instalments would be seriously weakened.

7.49. The adoption of the second way of calculating imputed rent avoids some administrative difficulties at the cost of a certain degree of arbitrariness. But the difficulties inhering in the determination of capital value in the second way are no less than the difficulties of determining gross rental value in the first. Both ways involve defining and applying principles for determining whether money borrowed has been invested in the home.

7.50. Either way poses administrative problems in that it creates a demand for valuation services, a need for a verifiable record of valuation that the taxpayer may quote in his tax return, and a mechanism by which the taxpayer may contest that valuation. The existing State valuation services throughout Australia provide valuation information on a variety of bases. But the information collected is not always relevant or consistent. In New South Wales, for example, the Valuer-General values only the unimproved capital value of residential land: the provision of both improved capital value and assessed annual value was discontinued in 1973. By contrast, the Victorian system employs both net annual value and unimproved capital value. A further problem is the revision of valuations over time—not necessarily annually—to ensure they reflect current market values.

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7.51. If the first way of calculating imputed rent is preferred, there would be administrative problems in regard to depreciation allowances and repairs. The problems of depreciation allowances and deductions for repairs are considered in wider context in Chapter 8.

7.52. Difficult problems arise when interest, to be deductible, must be shown to be related to a particular kind of income. Taxing imputed rent would multiply the occasions when these problems have to be resolved. The availability of a deduction of interest would open up avenues of tax planning for the well-advised who will consolidate their debts into the borrowing for home finance.

7.53. The Committee recognises the arguments for including imputed rent in the tax base; but having regard especially to the administrative difficulties it is not prepared to recommend a change in the law to this end.

7.54. The Committee does however propose that the deduction for rates and land taxes, now limited by amendments in 1973, be further reduced and eventually abolished. It is a relic of the time when imputed rent was included in the income tax base. No doubt the availability of the deduction is of some financial benefit to local governments in providing an indirect form of Federal financial assistance. However, the Australian Government is already making direct grants to local governments, and any revenue difficulties for these governments arising from the abolition of the deduction could be dealt with by extending such grants.

7.55. The Committee also proposes that the recently introduced deduction of interest on home loans be discontinued. Allowing such a deduction accentuates the inequity resulting from the failure to tax imputed rent. There is, indeed, some irony in this: the reason given in paragraph 7.52 for not taxing imputed rent is the complexity involved in the allowing of a deduction for interest on a home loan and the opportunities for tax planning to which it gives rise.

7.56. If the deduction for rates and land taxes were abolished, some of the tax advantage owner-occupiers have over tenants would disappear. The advantage might be reduced still further if a deduction were allowed to tenants for some part of the rent they pay. The allowance of such a deduction would be novel: so far as the Committee is aware, a concession of this kind is available only in Columbia. Because of the limit on deductibility, the advantage would generally remain with the owner-occupier; though where because of interest payments imputed rent is a negative amount, the advantage would move to the tenant.

7.57. The Committee has not explored in detail the administrative feasibility of a rent deduction but considers it worthy of serious examination. The amount of the rent deduction would seek to express the net rent element in what is paid by the taxpayer. It would be necessary of course to proceed by way of allowing a fraction of the rent paid, since the taxpayer would not be in a position to know the expenses incurred by the landlord. A ceiling would need to be placed on the amount deductible, perhaps related to the number of persons dependent on the taxpayer and living with him: the Committee would not wish to encourage the over-consumption of housing further than may be inherent in the continued exemption of imputed rent. There would, it is true, be difficulty in separating out a payment for rent in a composite payment for provision of rent and services: for example, where the accommodation is a serviced flat or where lodging and board are involved. However, the ceiling on the amount deductible might justify ignoring the element of service.

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Cost of Travel to and from Work

7.58. The present law, in general, denies a deduction of expenses of travel between home and work. In some circumstances, however, costs of travelling between home and work are regarded as expenses in deriving income and thus deductible. The principle applied in these circumstances requires that the home be in some sense a base of income-earning operations so that the travel can be regarded as travel between bases of operation. The application of the principle is not always clear and consistent, more especially where the bases of operation are aspects of different income-earning activities: the taxpayer may conduct his own business at home and also travel to a base of operations where he is an employee. The application of the principle is obscure where the taxpayer is, for example, a building worker: it is inappropriate to speak of him as having a base of income-earning operations, since his place of work may vary from day to day. The application of the principle may at times appear generous to the self-employed taxpayer where, for instance, he uses his own car in his business or profession. If the denial of a general deduction is to continue, a stricter definition and application of the law as to those costs of travelling between home and work which are to be regarded as expenses in deriving income would seem to be indicated.

7.59. In denying a deduction of expenses of travelling between home and work, the present law treats them as a form of consumption. Arguably they ought not to be so treated, since they are a prerequisite to the earning of income. But the same could be said of many other expenses whose deduction is currently denied, such as outlay on basic food, clothing and shelter. In the Committee's view a general deduction for expenses of travelling between home and work can only be justified as a concession.

7.60. A general deduction is denied in the United Kingdom and other English-speaking countries. There is however a deduction of general application but limited in several respects in a number of European countries. In Sweden, for example, the expenses are deductible where the taxpayer lives more than 2 kilometres from his place of work. The deduction for the most part covers only the cost of the cheapest means of transportation. A person who drives a car may deduct the cost of a bus or train fare; but should the saving in time resulting from the use of his car be more than 1½ hours a day, a deduction for the actual costs of operating the car is allowed.

7.61. The case for giving a concessional deduction in this area of consumption rests on the circumstances that the incidence of such expenditure, unlike expenditure on basic necessities, varies noticeably between individuals in a way that cannot be wholly explained by personal preference. For some taxpayers, admittedly, there may be a fairly clear choice between more expensive housing plus modest travel expenses and less expensive housing plus considerable travel expenses. But this would be far from generally true.

7.62. Variation in the incidence of travel expenses may arise:

  • (a) because one taxpayer has to meet his own expenses of travel while another has the means of travel provided for him by his employer; or
  • (b) because one taxpayer faces high costs of travel while another does not: the former may live a considerable distance from his place of work, or may be forced to use expensive means of transport because public transport is not available at all or not available when he has to travel (e.g. a shift worker), or may require special means of transport because he is disabled.

7.63. The Committee acknowledges the horizontal inequities that may thus arise. In the case of (a) there is clearly also a vertical inequity in that those receiving the benefit

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of free travel are likely to be concentrated in the higher income groups. But in this instance the inequities will disappear if the Committee's recommendations on the taxing of fringe benefits are implemented. It might be claimed that there is a vertical inequity in relation to (b) because lower income earners tend to live further from their places of work than those with higher incomes. It is doubtful, however, if such a claim can be substantiated. The case for a general deduction must therefore rest on the horizontal inequity involved in some taxpayers having heavier travel costs than others.

7.64. If a general deduction were allowed, some control would obviously need to be imposed on the amount deductible so as to deny a deduction of extravagant expenditure, for example on a chauffeur-driven limousine. One possibility would be to limit the deduction to expenses in fact incurred in using public transport. This might have a collateral advantage for State and local government finances but would lead to a new set of inequities—between taxpayers who are in a position to use public transport and taxpayers who are not. A way of overcoming this problem would be to allow expenses of other modes of travel where public transport is not available but to limit the deduction to some notional amount that might be thought reasonable in the circumstances. There would of course be administrative problems in fixing such notional amounts, and an inevitable element of arbitrariness. Other administrative problems would be involved in assessing the expenses of the private transport adopted—most often a motor vehicle in respect of which running costs and depreciation would be claimed. In some instances there would be a claim of a composite deduction, involving both private and public transportation, for example where a car is used to reach the nearest railway station. If it were thought that the concession should be extended to those using private transport when public transport is available, the administrative problems associated with assessing the expenses of private transport would be multiplied.

7.65. In the Committee's view the administrative costs of allowing the deduction outweigh any possible equity advantages, and accordingly it does not recommend that a deduction be allowed for costs of travel to and from work. There are special situations, however, for which some other provision might have to be made. Thus under the present sales tax law, tax concessions are available to a disabled person who incurs special expenses by having to use his own car to travel to work. If the continuance of such a concession is not thought appropriate under the value-added tax recommended by the Committee, an alternative form of subsidy—if necessary a direct grant—could be employed. Other special situations, such as the shift worker or the person called on to work in an area remote from any form of public transport, will already have been mitigated to the extent that wages include a loading for time or location of work.

Child-Minding Expenses

7.66. Other illustrations of expenses which, while not expenses of deriving income, are peculiarly prerequisites to the earning of income may be found in relation to child-minding. There are circumstances where a parent in order to be free to go to work must arrange for the minding of children.

7.67. Under the present law child-minding expenses as such are not deductible. Section 82D involves a related concession. It allows a deduction of $364 when, during the year of income, a housekeeper is engaged wholly in keeping house for a taxpayer and in caring for a dependant of the taxpayer where that dependant is (i) a child of the taxpayer, under 16 years of age; or (ii) any other child under 16, or an invalid relative (narrowly defined), for whom a dependant deduction can be claimed; or (iii) a spouse who is an invalid. A deduction is allowed to a married taxpayer only where the

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housekeeper is engaged in caring for a spouse in receipt of the invalid pension, except in special circumstances. The Commissioner has a discretionary power to determine these special circumstances. If, for example, a wife has deserted her husband and the husband has engaged a housekeeper who keeps house and also cares for his dependent children, the circumstances will be sufficient for the Commissioner to exercise his discretion and allow the deduction. On the other hand, where a husband and wife both work and engage a full-time housekeeper to care for their dependent children, the Commissioner has taken the view that there are not sufficient grounds to justify a deduction for the housekeeper. It thus appears that while the section may incidentally give a concession in a case where child-minding is a prerequisite to the earning of income, it is not specifically directed to that situation.

7.68. Some countries have provisions that are so directed. For instance, child-minding expenses are deductible in the United States under certain conditions. The main requirement is that the child-minding expenses are necessary for the taxpayer to be employed or to seek employment. The child must be a dependant under 15 years of age for whom the taxpayer is entitled to claim a dependency exemption or, if the dependant is over that age, he must be physically or mentally disabled. The deduction is available to a taxpayer who is raising a child alone, for whatever reason. It is also available to married couples where both are gainfully employed or seeking such employment or where one spouse is disabled. The maximum deduction is $400 per month; however, for services provided outside the home—in a creche, for example— the maximum is $200 per month for one child, $300 for two children, and $400 for three or more children. The deduction is reduced by 50 cents for each dollar of the taxpayer's gross income in excess of $18,000. Expenses are not deductible if paid to a relation of the taxpayer.

7.69. In the Committee's view there should be some concession in the law, not because of any policy of encouraging persons with responsibilities to children to seek employment, but in order that those who are employed, whether through choice or necessity, might be assisted in meeting the costs of discharging the responsibilities of caring for children when the services of others must be employed. The need for a concession will be the less if the government provides child-minding facilities directly by way of free or subsidised creches and the like. It cannot be anticipated, however, that such facilities will ever be universally available. The need will be the less, too, if generous child-endowment grants are made. But such grants will favour all parents and not provide specially for those who must incur the expenses of child-minding.

7.70. The Committee recommends that the concession be available to a married couple both of whom are working, to a married couple where one works and the other is an invalid, and to the head of a one-parent household who works. A number of other questions arise as to the scope of the concession. These relate to the nature of a qualifying expense, the amount of expense that may be recognised in respect of each child, the age at which the concession ceases, the scaling down of the expense where the earning of income is on a part-time basis or extends to only part of the year, and the protection of the Revenue when the expense involves payment to a relative.

7.71. Where the child-minding is incidental to the provision of education, there is no need to give a concession if there is an appropriate concession available for expenses of education. The question then arises as to the correlation between the child-minding expense concession and the education expense concession. The Committee has, in paragraphs 12.32–12.34, proposed that the present concession for education expenses in respect of dependants be related only to a taxpayer's expenses by way of fees for

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tuition, be limited by a ceiling of $600 in respect of each dependant, and involve a tax rebate rather than a deduction from income. In the Committee's view the child-minding expense concession ought to be framed as an extension of the education expense concession. Its function is to give a tax concession in respect of the expenses of the pre-school and out-of-school care of a child which a taxpayer is by his employment precluded from providing himself.

7.72. If the child-minding expense concession is framed as an extension of the education expense concession, it follows that the limit of $600 will cover both education and child-minding expenses in respect of the same child where both kinds of expenses are incurred.

7.73. The age at which a child ceases to attract the concession might be set at 14 years. The scaling down will need examination: where a parent is employed for only part of the year, some scaling down would seem to be called for. Where the person to whom the payment is made is a relative, protection of the Revenue will require provisions of the kind at present applied generally to payments between associated persons (section 65).

7.74. In the Committee's view, in line with its thinking on the education expense concession, the function of the concession proposed should be seen as assistance in meeting special costs of discharging parental responsibilities. The concession should seek to give similar assistance to all taxpayers concerned, whatever their position on the income scale. The expense should therefore be the subject of a rebate of tax at a rate which, like the education rebate, might be set at 40 per cent. This means that somebody incurring $600 in child-minding expenses which qualify for concessional treatment will save $240 in tax.

7.75. There will be need of some provision to determine the correlation between the child-minding concession and the related concession, discussed in paragraph 7.67, provided by section 82D in the case of a housekeeper. An appropriate provision would require that where that concession is given in circumstances involving the care of a child, it be available only as an alternative to the child-minding concession.

Expenses of Income-Earning Activities Carried on at Home

7.76. Considerable administrative difficulties have arisen under the present law in regard to expenses associated with an income-earning activity which is in some degree carried on at the taxpayer's residence. Such expenses are deductible under the general provision allowing deduction of expenses in deriving income.

7.77. The present law, though by no means settled, would appear to draw a distinction between overhead expenses, such as interest and repairs to the residence or rent, and expenses directly connected with the income-earning activity, such as light, heating and depreciation on furniture. In regard to the former, the allowance of a proportion of the overheads requires that the room in which the income-earning activity is conducted should have been used in a manner that could not be described as a domestic use: ‘A study does not cease to be part of a taxpayer's home because it is used by the taxpayer for the pursuit of activities from which he earns his income’.note If the study were to be held to change its character from domestic to non-domestic when it is used for such activities, one would have to concede that a bedroom ceases to be part of a home because the taxpayer solves his most difficult business problems in bed. The Committee is conscious of the need to draw a line that involves an objective test and is as determinate as possible. There is a distinction, it is true, between a barrister who prepares a brief for the next day in his study and a lecturer who reads the latest literature. But the barrister will on occasions read the latest literature and the lecturer may be preparing a lecture for the next day. A test in terms of the activities pursued in the room is unmanageable. The non-domestic-use test appears to the Committee to be the appropriate one.

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7.78. Under the latter test, a room devoted to an artist's studio or to a carpenter's workshop will attract a deduction for overheads. So too will a doctor's surgery. If it is thought that there might be doubt in any of these cases, the Act should expressly define non-domestic use.

7.79. In a case such as the doctor's surgery, the allowance could be justified on the ground that the room is used in a way that involves contact with the public. The Committee would, however, prefer the test to depend wholly on non-domestic use. The mere fact that a taxpayer occasionally sees patients, clients or customers at home should not attract the deduction. But where a room is set aside for such contacts, the use will clearly be non-domestic.

7.80. The observations in the last paragraph raise an issue whether exclusive non-domestic use of a room is necessary to attract the deduction. In the Committee's view a test in terms of exclusive use is appropriate. However, the Commissioner should be given a discretion to disregard minor use of the room for a domestic purpose.

7.81. Expenses more directly connected with the earning of income may, under the present law, be deductible even though no part of the home is devoted to a non-domestic use. Expenditure in providing light and heating exclusively for the taxpayer while he is engaged in work from which he derives incomes is, it seems, deductible. Depreciation on domestic furniture, carpets and curtains in a room where the taxpayer engages in work is allowed, subject to apportionment where the room is also used for other purposes. In the Committee's view these principles are unmanageable. The deductibility of expenses for light and heating and depreciation on items of ordinary domestic equipment should be determined by the same principle as applies to overheads. Deduction should be allowed only where the expenses relate to the deriving of income in a room exclusively devoted to a non-domestic use.

7.82. The deductibility of depreciation on items that are not ordinary items of domestic equipment (for example, a typewriter or a filing-cabinet or, more obviously, a lathe), the current expenses associated with such items (for example, electricity charges) and also the expenses associated with the use of a telephone should be left to the operation of the general provision unaffected by the special provisions proposed by the Committee.

7.83. The carrying out of the Committee's proposals will require some statutory amendments to displace, in regard to direct expenses, the interpretation of the general provision. The Committee suggests that the opportunity be taken not only to do this, but to establish a special code which will settle the law in this area in a form that will overcome the present uncertainties.

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Subscriptions to Trade and Professional Associations

7.84. The present law contains a special provision (section 73) in regard to subscriptions to trade and professional associations, which draws a distinction between a taxpayer carrying on a business and an employed person. The former may deduct the subscription, without limit on the amount, when membership of the association to which the sum is paid is a pre-condition of the taxpayer carrying on the business.

7.85. The employed person, and a taxpayer carrying on a business whose subscription is not a pre-condition, is entitled to a deduction limited to $42 of any periodical subscriptions paid by him in respect of his membership of any trade, business or professional association. There is a further provision under which an amount greater than $42 in respect of one subscription may be allowed, if the subscription is made to an association that incurs expenses in carrying out any activity on behalf of its members where those expenses would be deductible by the member if incurred by him directly.

7.86. Subscriptions that do not fall within the special provision relating to subscriptions may nonetheless be deductible under the general provision in regard to expenses in deriving income. Deduction under the general provision, while not limited in amount, may in other respects be narrower in its operation.

7.87. The special provision has the advantage of determinateness and, subject to the recommendation made below, should be retained. In cases where the subscription is less than $42, the test will be simply whether the payment has been made to a trade, business or professional association. On the other hand, there is some prospect that what is really private expenditure may attract a deduction: the association may offer some of the amenities of a club. Hence there may be need to protect the Revenue by a more restrictive definition of a qualifying association.

7.88. The limit of $42 may, with a fall in the value of money, be thought to have become too restrictive. That limit, it is true, can be exceeded in the circumstances described above; but except in the case of a taxpayer carrying on a business who is compelled to be a member, the calculation of the amount deductible involves a measure of complexity where the claim exceeds $42. An increase in the present ceiling of $42 is therefore recommended.

Income-Protection Insurance Premiums

7.89. Section 82H of the Act allows a deduction of amounts paid by a taxpayer as premiums for insurance against sickness of, or against personal injury or accident to, the taxpayer or his spouse or child. The amount of the deduction under the section is limited in that the total sum deductible for premiums and payments of the various kinds referred to in the section may not exceed $1,200. These premiums and payments include life insurance premiums and payments made to a superannuation scheme.

7.90. The question has been raised, in cases before Boards of Review, whether a premium for insurance against sickness or accident of the kind referred to in the section may not be deductible as an expense in deriving income. If it is so deductible, there will of course be no limit on the amount that may be deducted. The principles applicable in determining whether an insurance premium is deductible as an expense in deriving income are by no means clear. In some circumstances an expense directed to protecting a capital asset is deductible, though Australian judicial authorities in this respect are less helpful to the taxpayer than United Kingdom authorities. The question to be resolved is whether the expense, even though it relates to a capital asset, is a

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‘working expense’. An insurance premium of the kind now considered could be regarded as a working expense of protecting human capital, in this context the capacity to earn income. There seems, however, to be no basis for an assumption that the deductibility of the premium depends under the present law on whether the form of compensation is a lump sum, which will probably not be income, or periodical receipts, which certainly will be.

7.91. Two consequences flow from these views of the operation of the law as to expenses in deriving income. First, it may be easier for a self-employed person to obtain the deduction of the premium. Secondly, there is a prospect of asymmetry in that while a deduction is allowable for the premium a receipt of compensation in a lump sum under the present law may not be income.

7.92. The first consequence involves what might be considered an unfair discrimination between the self-employed and the employee. The second may be thought to involve an unacceptable cost to Revenue.

7.93. The Committee's proposals in relation to deduction under section 82H are dealt with in Chapter 21. Apart from any concession that may be available under provisions replacing section 82H, the Committee considers that there should be a further specific provision allowing a deduction in circumstances outside the concession. The specific provision should in its terms exclude the operation of the general deduction for expenses in deriving income in relation to premiums on income-protection insurance policies. The premium on such a policy should be made deductible, without limit on its amount, only if the policy provides that the compensation will be paid in periodical amounts during sickness or disability. A sum received in commutation of periodical payments under the policy should be expressly made assessable income.

7.94. To the extent that the new section goes further in allowing a deduction than the general deduction now provides, it will involve a concession that calls for justification. In Chapter 21 the Committee offers, as justification for the deduction of contributions to a superannuation fund, that it is reasonable to allow the postponement of tax on income when expenditure of that income has been demonstrably deferred, provided there is some assurance that it will be brought to tax at a later time. The same justification may be offered for the deductibility of premiums under the Committee's present proposal.

7.95. It will be seen in Chapter 21 that the Committee proposes limits on the deductibility of contributions to a superannuation fund. There might seem, then, to be justification for restricting the amount of the deduction under the provision now proposed by the Committee. However, the availability of insurance will act as a brake. Underwriting practices already set limits on the total cover that an insured person may have: in many cases he will, for example, already be covered to a degree by a superannuation scheme of which he is a member. In the circumstances the Committee does not propose any limit on the deductibility of the premium. Were some limit imposed, there would be a case for allowing a deduction of excess premiums against receipts of compensation under the policy. This would introduce awkward administrative problems.

7.96. Consideration must also be given to payments to sickness and accident funds and to friendly societies that provide benefits by way of periodical payments on the incapacity of a member through sickness or accident. Where the benefits are provided exclusively on a periodical basis, payments and benefits should be given similar treatment to that proposed for income-protection insurance policies.

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Self-Education Expenses

7.97. Expenses of self-education are in some circumstances deductible as expenses incurred in deriving income. Though the judicial authorities are not always reconcilable, they suggest a distinction between, on the one hand, the expenses of education undertaken primarily for the purpose of entering on an income-earning activity or a substantial increase in standing in an existing income-earning activity (which are non-deductible) and, on the other, the expenses of maintaining knowledge or skill required for an existing income-earning activity or improving such knowledge or skill (which are deductible). There is an obvious grey area between the two: a doctor who takes a higher degree to enable him to practise as a specialist may be denied a deduction; an employee who undertakes studies to qualify for promotion may not. Expenses that do not relate to any income-earning activity—the pursuit of a general education or a hobby—are not deductible. They are regarded as consumption.

7.98. Those expenses denied deduction as expenses of deriving income because they relate to entry on an income-earning activity or substantial increase in standing could, in principle, be treated as costs of acquiring capital and as generating deductions by way of amortisation against income of the activity in future years. There are, however, no provisions that allow this treatment.

7.99. In 1972 a new section (section 82JAA) allowing a deduction was inserted in the Act intended to cover some of those expenses that are not of a consumption character but are denied deduction as expenses of deriving income because they are undertaken for the purpose of entering on an income-earning activity or a substantial increase in standing. The deduction is limited to expenses for fees, books and equipment in connection with a course of education provided by a school, college, university or other place of education. There is a ceiling on the amount deductible, and the deduction is reduced by any amount allowed under the provisions of section 82J, which relates to education expenses of dependants. Recently the ceiling under both section 82JAA and section 82J was reduced from $400 to $150.

7.100. Reference has already been made to the Committee's recommendations in regard to the education expense deduction for dependants. Under those proposals the ceiling on the concession would be raised to $600 and become a rebate of tax; also, the expenses involved would be confined to fees for tuition. In the Committee's view the self-education expense concession should be retained, with a limit of $400, and it should remain a deduction rather than become a rebate of tax. It is, in effect, the allowance, as a current deduction, of expenses which would in principle be deductible as capital costs subject to amortisation, but which are more conveniently treated in this way. The range of deductible expenses is already narrower than under the existing deduction for education expenses of dependants; the Committee therefore does not propose a reduction in the range of qualifying expenses as it does in relation to the concession for dependants’ education. To avoid double allowance of the self-education expense deduction and the proposed rebate for dependants' education, there should be provisions of the kind at present appearing in section 82JAA(3).

Dissection and Apportionment of Composite Receipts and Outgoings

7.101. An issue of general application arises when a receipt is composed of a number of elements, some of an income character and some not. In certain circumstances, not clearly defined in the legal authorities, the composite receipts may be dissected or apportioned so as to determine what part of the receipt is income. Dissection

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would appear to require that there has been some acceptance by the taxpayer in the course of the transaction of an amount as referable to the income item. Apportionment, it is said, is appropriate where the amount referable to the income item is ascertainable by calculation, but not, it seems, where the calculation involves a distribution of the receipt between items on the basis of a valuation of each item. The law as it stands might be thought to encourage practices in the settlement of claims to compensation and, in some cases, in the disposal of assets that will defeat the Revenue. Section 36 (relating to trading stock) and section 59 (relating to depreciable property) offer some protection, but more general provisions allowing apportionment on the basis of values would strengthen the law. Even when the parties have made a dissection of the composite amount, the Revenue may still need protection: it should not be open to the parties to make a dissection that is contrary to what would be a fair apportionment, so as to bring about a favourable tax result.

7.102. A similar issue arises when the taxpayer has paid an amount in part for a purpose that would attract deduction as an expense in gaining income and in part for a purpose that would not. The words of the general provision (section 51) purport to allow a dissection or apportionment. An outgoing is allowable ‘to the extent to which’ it is incurred in deriving income. But it is not clear in what circumstances a dissection or apportionment may be made. According to the authorities, it is only when a purpose other than the gaining of income is evident on the face of a transaction that it is proper to deny a deduction for that part of an outgoing incurred for this purpose. Where the transaction is a contract, it must be a part of the contractual arrangement ‘that … some advantage not … related to the production of assessable income was gained’. The words quoted are from the judgment of the Privy Council in a New Zealand appeal,note but would be thought as well to be a correct statement of the Australian law. The Committee would not wish to make the test of deductibility depend on the subjective purpose of the taxpayer. On the other hand, the character of a transaction should not depend exclusively on its form. It should be expressly provided that the character of a payment may be inferred from all the circumstances of the transaction and, where that character is in part a payment for a purpose which is not the gaining of income, an apportioned amount will be denied deduction. Such apportionment should be made ‘as the facts … may seem to make just’. The words quoted are from a High Court judgment:note they might be made the basis of the drafting of the proposed provision.