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J & G KNOWLES AND ASSOCIATES PTY LTD v FC of T

Members:
BH Pascoe SM

Tribunal:
Administrative Appeals Tribunal

MEDIA NEUTRAL CITATION: [2000] AATA 846

Decision date: 22 September 2000

BH Pascoe (Senior Member)

These are applications to review decisions of the respondent to disallow objections against amended assessments of fringe benefits tax for the period 1 July 1986 to 31 March 1987 and the years ended 31 March 1988 and 1989. The decisions were affirmed by decision of this Tribunal on 21 May 1998 [98 ATC 2205] (AAT 464, 21 May 1998) and an appeal to the Federal court from that decision was dismissed by Sundberg J on 4 August 1999 [99 ATC 4788] (VG 253 of 1998). On appeal from that decision, the matter was remitted to the

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Tribunal by the Full Court of the Federal Court on 3 March 2000 (2000 ATC 4151).

2. At this further hearing before the Tribunal the applicant was represented by Mr G.T. Pagone QC with Mr M. Flynn and the respondent by Mr G.J. Davies QC with Ms J. Davies. No further evidence was led at the hearing.

3. The background facts of this matter were set out in the joint judgement of Heerey, Merkel and Finkelstein JJ as follows [at 4152-4153]:

  • ``3. The material facts are not in dispute. In 1976 the appellant was appointed as trustee of the Knowles Investment Unit Trust. The trust had been established to conduct the business of constructing, selling and managing retirement villages. The directors of the appellant are Graham Knowles, John Knowles, Russell Knowles and Ian Ball. The beneficial interest in the trust fund is divided into units. Each director established a discretionary trust in which he and his family are beneficiaries. The trustee of each family trust holds 25 per cent of the units in the unit trust.
  • 4. During the period to which the assessments relate, each director was paid a salary. The salary was paid at the rate of $31,588 per annum except for the twelve months ending 10 June 1981 when it was increased to $32,756, except in the case of John Knowles who was paid $31,557.
  • 5. The appellant maintained a chequing account. Each director was authorised to operate that account. Certain of the funds in that account, including funds provided on overdraft, were used by the directors to meet their, or their family's private expenses. A director would either draw a cheque for a particular expense or he would give the account for that item to the accounting staff who would arrange for a cheque to be drawn, signed by one of the directors, not necessarily the director who had requested that the cheque be drawn, and delivered to the payee.
  • 6. The appellant employed a full-time accountant, Mr Saul. One of his responsibilities was to ensure that money paid to meet the directors' expenses was properly accounted for. Initially all payments were recorded in a purchase analysis report. At the end of each annual accounting period the amounts paid at the request of a particular director were debited to the loan account of the trustee of that director's family trust. Mr Saul said that in the books of account of the unitholder, the money would be shown as having been lent to the director.
  • 7. There was no relationship between the amount of money each director requested be paid and the personal effort involved in working as a director. Nor was there any relationship between the amount paid at the request of one director and the amount paid at the request of the others. The following table, which sets out the balance of the loan account due on various dates, demonstrates this: 
                               30.6.86     30.6.87     30.6.88     31.7.88
J Knowles Family Trust     $767,426    $772,726  $1,243,472  $1,446,594
G Knowles Family Trust     $467,310    $519,372  $1,494,783  $1,569,845
R Knowles Family Trust     ($72,195)    $37,980    $558,285    $614,312
I Ball Family Trust         $35,025     $83,358    $369,171    $384,763
                         ----------  ----------  ----------  ----------
                         $1,197,566  $1,413,436  $3,655,711  $4,015,514
  • 8. The amended assessments included the taxable values of the loans calculated in accordance with the Act. Those values and the FBT payable are shown in the following table: 
    Period                 Loan Benefit        FBT      Additional Tax
1/7/1986 - 31/3/1987     $152,548      $70,172.08     $35,220.62
1/4/1987 - 31/3/1988     $320,362     $156,977.38     $47,308.25
1/4/1988 - 31/3/1989     $150,972      $73,976.28      $7,498.97

    ATC 2072

  • ...''

4. The question in issue was whether the loans were benefits ``in respect of the employment'' of the directors having regard to the provisions of sections 16(1), 18, 136(1) and 148(1) of the Fringe Benefits Tax Assessment Act 1986 (``the Act''). In the original decision of this Tribunal, it was found that the loans constituted loan fringe benefits under the Act and it was stated in the final paragraph of the decision [at 2213]:

``14. In my view there is a clear nexus, causal relationship between the advances or loans and employment of the four directors. It was in that capacity as a director that each was able and permitted to make `drawings' from KIUT. The structure of the group was established in such a way that the directors were not owners. In my view, this is a case where the directors have to accept the consequences of that structure. It was in their capacity as directors and directors only that they borrowed money from the company of which they were directors. I do not go so far as to say, and the issue is not before me, that it may be possible to regard the `drawings', as some witnesses described the amounts involved, as income of a director. However, they were clearly a benefit and employment was the principle connecting reason for such benefits so as to render the benefit as provided in respect of the employment. Employment was the discernible link with the benefit and while the Act does not require this link to be the sole or even dominant one, there was no other formal or enforceable entitlement which gave rise to the benefit.''

5. The Full Court, at paragraph 19 of its decision, set out the summary by Sundberg J of the Tribunal's findings as [at 4156]:

``...

  • • The directors were not the owners of the applicant's business (Saul 450).
  • • They had no vested interest in or entitlement to income, profits or capital of the business (Saul 496; Unit Trust Deed 29, Family Trust Deeds 760, 791, 821).
  • • The loans were made to meet the directors' private expenses (J Knowles 466; Ball 479).
  • • Each director was a `sole cheque signatory' to the applicant's account (J Knowles 465; Saul 500).
  • • Each was authorised as a director to withdraw funds at any time for private needs without approval from the other directors (J Knowles 466; Ball 476; G Knowles 484, 485; Saul 500).
  • • The amounts withdrawn were determined entirely by the directors' individual needs and not by the needs of unitholders (Saul 451).
  • • The directors could not obtain access to the applicant's money as shareholders or as beneficiaries of the unit trust (Ball 479).
  • • The only way they could obtain money in the way they did was in their capacity as directors (Ball 476-477, 479, 480).
  • • At the time the loans were made the applicant had insufficient funds to make returns of capital (Saul 447-449, 452; Wardle 460; J Knowles 472).
  • • The capital distributed occurred well after the funds were borrowed (J Knowles 467, 737; Saul 502).
  • • The loans were not made in proportion to any ownership share (Saul 500, 510).
  • • There was no formal or enforceable entitlement to the loans other than the employment relationship.

The trial judge concluded that, on those facts, it was open to the AAT to determine that there was a causal relationship, or a discernible and rational link, between the loans and each director's employment and that no error of law had been demonstrated. In arriving at this conclusion his Honour rejected the appellant's submission that the AAT had misunderstood its `ownership' contention.''

The ``ownership'' contention referred to was the primary argument of the applicant that the four directors regarded themselves as owners of the business and the loans were equivalent to drawings from the business in advance of capital or income distributions.

6. In its decision on the appeal from that of Sundberg J, the Full Court said [at 4158-4159]:

``30. The AAT said that the phrase `in respect of the employment of the employee'

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required `a nexus, some discernible and rational link between the benefit and the employment'. It held that, on the facts found, there was `a clear nexus, causal relationship between the advances or loans or employment of the four directors' because it was in their capacity as directors that each director was `able and permitted' to make the relevant withdrawals from the bank account of the unit trust. In reality all that the AAT did was to establish that there was a causal relationship between the loans and the employment. The trial judge accepted that the AAT did not err in law in approaching the matter in that manner. In our view, however, the AAT failed to consider whether, notwithstanding that causal link, there was a sufficient or material relationship or connection between the loans and the employment.

31. By engaging in an inquiry that established that there was a causal relationship between the loans and the employment without inquiring whether there was a sufficient relationship between the two, the Tribunal erred in law. Accordingly, unless the facts found by the AAT obliged it to find in the Commissioner's favour in any event, the case must be remitted to the AAT for its reconsideration.

32. As matters presently stand, the evidence that was given by the directors was to the effect that the reason why the loans were provided was because the directors were, for all practical purposes, treating the assets of the unit trust as their own. The conclusion of the AAT, that the directors had no entitlement to the loans as `owners' of the trust fund did not resolve the matter.

33. Whether or not there is a sufficient connection between each director's employment and the loans to the unitholders to attract FBT was a question of fact for the Tribunal to determine. The material before the AAT pointed in two directions. The first was that the directors drew upon the assets of the unit trust because ultimately the trust was established, and its assets were to be held and applied, for their benefit and that of their families. The second is that it was agreed between the directors that, as an incident of their directorship, each of them were entitled to draw upon the appellant's funds by way of loans for their personal benefit. In the first case it is unlikely that there would be a sufficient connection with the employment, while in the second the loans are likely to be an incident or product of it.

34. Further, the AAT also found that while salaries paid to the directors were `equal' they were low and `that the availability of interest free funds for personal use may well have been seen as additional and useful recompense for such modest salaries'. If in fact interest free funds were provided as `additional... recompense for... modest salaries' then that is likely to constitute a sufficient connection.

35. On a fair reading of the AAT's reasons it only decided that the employment of the directors was a cause of the loan. The fact that the four persons in question were directors of the appellant explains how, but not why, they were able to make the withdrawals. In those circumstances it was open to the AAT to conclude that the loans were not fringe benefits if it applied the correct legal test. Accordingly, it is appropriate to allow the appeal and to remit the matter back for further hearing before the AAT.''

7. For the applicant, it was submitted that there was not a sufficient or material relationship or connection between the loans and the employment. It was said that any benefit from the loans flowed from the relationship between the unitholders and the unit trust rather than the relationship of employer and employee. It was suggested that a useful test for determining why the loans were made is to ask whether a director of the applicant who had no beneficial interest in or family connection with one of the unitholders would have been permitted to receive a similar substantial, interest free and unsecured loan. The lack of any relativity to work performed was stressed with two of the directors continuing to draw loans during a period when they were not working in the business. It was submitted that the ability to draw loans was an incident of the family trust unitholders' ownership and control of the unit trust and the directors' effective control as beneficiaries and appointors of the unitholders, which continued regardless of whether they were performing services as employees. Mr Pagone maintained

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that there was no evidence before the Tribunal of the adequacy or inadequacy of the directors' salaries nor evidence of any design by the directors or their advisers that loans should provide recompense for services the directors performed. He submitted, further, that advances to unitholders in respect of their relationship as beneficiaries in the unit trust was consistent with the applicant's relationship with the trust property whereas loans to arm's length parties unrelated to the unitholders would have been in breach of the applicant's duty as trustee. The inequality of the loans was said to demonstrate the ability to draw funds from the business as in a partnership and that the loans demonstrated a relationship as owners rather than employees. It was said that the applicant had sufficient assets with which to fund the loans and that the funds primarily came from interest free cash surpluses from the deferral of settlement on units purchased which had been resold in the meantime. The applicant considered that there was an onus on the respondent to demonstrate that the loans were an incident of directorship.

8. The respondent submitted that there was an onus on the applicant to demonstrate that there was no sufficient or material connection between the employment and loans. It was, however, submitted that there was a sufficient or material connection between the employment relationship and the loans. In particular, the respondent relied on the following:

  • (a) the directors controlled the applicant's business through their office of directors;
  • (b) the capacity and authority to draw on the applicant's funds to pay their private expenses was conferred on the directors as an incident and product of their office;
  • (c) the loans were not made as an incident or product of distributable profits, whether capital or income and were not made pursuant to trustee's resolutions;
  • (d) the loans were paid out of the applicant's overdraft facility and the interest thereon claimed as a deduction. This was said to be recognition by the applicant that the loans were an incident or product of the employment of the directors in the operation of the business.

It was submitted that the directors were able to enjoy the benefit of interest free loans in the circumstances where their agreed salary was low having regard to the size and operation of the applicant's business and in the circumstances where the benefit was available to be enjoyed irrespective of whether or not profit was made that could be distributed to the ultimate owners of the trust structure. It was said that salaries paid to the directors was not related to the amount of work performed but were clearly an incident or product of employment and that the right to access interest free funds to meet personal expenditure was, similarly, an incident or product of the office of director. Mr Davies argued that the fact that the loans were made on a day to day basis by the unilateral actions of the individual directors for amounts that were not equal strongly suggested a sufficient or material connection between the loan and employment.

9. As stated by the Full Court, the material before the Tribunal ``pointed in two directions'' (paragraph 33). It was said that [at 4158-4159]:

``... The first was that the directors drew upon the assets of the unit trust because ultimately the trust was established, and its assets were to be held and applied, for their benefit and that of their families. The second is that it was agreed between the directors that, as an incident of their directorship, each of them were entitled to draw upon the applicant's funds by way of loans for their personal benefit. In the first case it is unlikely that there would be a sufficient connection with the employment, while in the second, the loans are likely to be an incident or product of it.''

The difficulty still before the Tribunal is that the material does not point clearly in either of the two directions. It was clearly agreed between the directors that each was entitled to draw funds by way of loans for their personal benefit. What is not clear is whether such drawings were an incident of their directorship. As indicated in the original decision of this Tribunal, the directors had no real understanding or appreciation of the legal structure under which they were operating the business.

10. In his evidence, Mr John Knowles, the eldest of the brothers and the founder of the business, stated in his witness statement [at 2207-2208]:

``9. Each of my two brothers, Ian Ball and I, have treated our respective interests in the Knowles Group through our trusts as being the effective owners of the Group and

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entitled to its profits and assets. We set directors' salaries during the relevant period but otherwise treated our respective interests as being equivalent to the owners of the assets of the Group. Each of us accessed money from the Group as and when we thought fit with the general concern to ensure that there was equality between us. The concern that each of us had was that we should be equal as owners and not equal by reference to the amount of work each had performed. In fact both Russell and Graham continued to take money from the business during times when they were not working or participating in the activities of the Knowles Group. Both Graham and Russell took time off to build their own houses and during those periods of time they borrowed monies from the Applicant even though they had not worked for some of the time. When my family trust took money from the Applicant it did so because I considered that it was a one fourth owner of the Group and therefore entitled to its assets. I was also aware of the fact that the Applicant had available to it surplus funds which it did not need for some years to come.''

In his oral evidence and in that of the other three directors, their relationship was seen in practical terms as a partnership. Their evidence would appear to support the first direction identified by the Full Court. However, it is appropriate to recall the words of Fullagar J in the High Court decision in
Pascoe v FC of T (1956) 11 ATD 108 where His Honour was considering the assessability of a profit arising from the sale of land and said (at page 111):

``Where a person's purpose or object or other state of mind in relation to a given transaction is in issue, the statements of that person in the witness box provide, in a sense, the `best' evidence, but, for obvious reasons, they must, as Cussen, J., observed in
Cox v Smail (1912) VLR 274, at p. 283, `be tested most closely, and received with the greatest caution'.''

11. The stress placed by the directors in their evidence on the equality as owners appears to be at variance with the fact that there were significant variations in the amounts of loan, varying from $384,763 to $1,569,845 as at 31 July 1988. There was no evidence as to why such a substantial difference occurred if there was ``general concern to ensure there was equality between'' the ``owners''. On the other hand, salaries were basically equal although the evidence was that, during parts of the period in dispute, some directors were not working in the business. Those salaries were clearly low relative to the size of the group's operations and the responsibilities of the directors and I have no difficulty in accepting that they were not an appropriate level of recompense for the duties performed as employees. However, there is no evidence which suggests that the availability of interest free funds was intended to provide additional recompense for these modest salaries. In the absence of any evidence to the contrary it could, perhaps, be seen that some additional source of income was required to allow the directors to fund a lifestyle well beyond that which their salaries would allow.

12. Given the caution with which the evidence of the directors themselves should be received when the issue of whether a taxable benefit arose from interest free loans to them is in question, it is appropriate to consider the evidence of Mr Saul, the financial controller of the applicant. One statement in his witness statement which may lead to the view that the loans were not funds applied for the benefit of the directors and their families as owners was in paragraph 24:

``24. The loans made by the Applicant to its directors and unit holders were part of the assets of the KIUT available as security for the borrowings of the Knowles Group and could be called up at anytime. They would obviously not be available if the moneys lent had been distributed as dividends, income, return of capital or otherwise given to the directors and unit holders absolutely.''

This indicates that the loans were regarded simply as short term loans of funds not otherwise available as distributions of capital and income to owners. On the other hand, the words used in the following paragraphs could lead to the view that the loans were not an incident of the directorships but an incident of ownership:

``27. The directors effectively owned the Group, although they operated through unit trusts. They controlled the whole Group as though they were partners. In substance it operated as a partnership. The four directors have always been the proprietors/owners of the business either as partners or beneficiaries. They did not start out as

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employees or join the present company as employees without ownership interest.

...

30. When accounting for these monies I believed that there was no relationship between the amount of money each director took out and the amount of personal effort of each director for the Group. I have done no accounting, through the books or otherwise, between the directors to account for personal effort or input.

  • There was no real pattern or consistency to the amount of monies advanced to the unit holders. They could vary significantly from month to month and year to year, and in fact the accumulated balance of each of the 4 loans varies markedly. For example the balances at 30 June 1986 were as follows:
    • Canto$767426.00
    • Endow$467310.00
    • Furrow$72195.00
    • Ballian$35025.00

There has never been an `evening up' of the loans. From my perspective the directors have never appeared concerned that the individual accounts varied so widely. It was always assumed that they would be evened up from eventual income distributions one day in the future.

31. The loan accounts tended to fluctuate depending on the individual needs of the unit holders at any point in time. An example is the building of a house by one unit holder (Graham Knowles in one year) and by another unit holder (Russell Knowles) in the next year.

...

39. All of the loan accounts of the directors and unit holders were extinguished on 1 August 1998. At that time the Knowles Group had $1.7 million of realised capital reserves and $5 million in revaluation reserves. I formed the view (after consultation with Ian Ball) that the capital available to the Applicant could be used to extinguish the loan accounts. It was also my view that the loan accounts at that stage had become too large to explain and would attract negative queries from financiers as why borrowings were being taken out from the Group by the directors. Also leaving the loans on the balance sheet:

  • - would if the business got into difficulty, expose each of the beneficiaries to recovery action in respect of the loans; and
  • - tended to overstate the balance sheet as the Group balance sheet (which reflected the trading entities) had a high receivable which in essence was an internal loan to the unit holders themselves.

...

41. The moneys paid as loans could have been distributed as trust distributions year by year. The tax consequence if that had been done would have been that the amounts would be non-taxable being distributions of the corpus of the Trust. The loans had originally been taken in anticipation of profits being derived which would have paid out the loan. Due to very difficult trading the profits did not arise and the loan continued to build up as the Trust incurred substantial trading losses.

...''

13. Much was made by the respondent of the fact that the loans were made out of the applicant's overdraft facility and interest thereon claimed as a deduction. For the applicant, it was argued that the loans were made out of the interest free funds held on account of vendors under the delayed settlement arrangements and which had, temporarily, reduced the cost of borrowings. I do not accept that the interest on funds used to meet the loans was not claimed as a deduction. The interest free funds were a normal incident or product of the way in which the applicant carried on business. Such funds were appropriately banked and utilised in reducing the amount of borrowed funds. In the main, it would seem clear that loans to directors or their families were made from the bank overdraft thus increasing the interest costs. However, at its highest, this means that some interest expenditure may be regarded as having been incurred in non income producing activities and not allowable as a deduction. The taxable income of the applicant is not an issue before me, solely the question of fringe benefits tax. I am unable to accept that the incurring of interest provides any weight in attributing these loans to the employment of the directors.

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14. It is appropriate to consider a submission of the respondent that the applicant had an onus to prove that there was no sufficient or material connection between the employment and loans. Under section 14ZZK of the Taxation Administration Act 1953, in an application for review of a reviewable objection decision, the applicant has the burden of proving that the assessment is excessive. It may well be said that, in this matter, when there is some doubt on which way the evidence points, the applicant is required to prove clearly, on the balance of probabilities, that there was not the required connection with the role of director. However, at this end of the long history of this dispute and, having regard to the remittal by the Federal Court for the Tribunal to make a further finding of fact, I am reluctant to believe that any onus of proof lies with either party in relation to that finding. If I was to find a substantial or material connection with employment, then the applicant has failed and if I was to find that there was no such sufficient connection then the applicant succeeds.

15. On balance, having regard to the evidence as a whole and with the benefit of Their Honours' conclusion as to the law, I find that the loans in question were provided for the benefit of the four directors and their families in their capacity as ultimate owners of the business and its assets. On balance, I am satisfied that, while not actual owners in law, the four directors regarded themselves as such and that there was no agreement or intention that the loans were provided as an incident of their directorship. Consequently, on the basis of the law set out in the decision of the Federal Court, there was not a sufficient or material relationship or connection between the loans and the employment. Their directorship was the means by which the loans were made but the explanation of why they were made was the belief that the applicant was established and its assets were to be held and applied for the benefit of themselves and their families.

16. It follows that the decision under review should be set aside and the objection against the assessments of fringe benefits tax allowed.


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