G Hughes M

Administrative Appeals Tribunal


Decision date: 26 November 2004

G Hughes (Member)

This is an application by Emmanuel Economedes (the applicant) to review a decision by the Commissioner of Taxation (the respondent) to disallow a deduction under s 51(1) of the Income Tax Assessment Act 1936 (Cth) (the 1936 Act) or s 8-1 of the Income Tax Assessment Act 1997 (Cth) (the 1997 Act) in respect of interest paid on a loan, the proceeds of which had been lent to a company to enable that company to purchase a business.

2. The matter was heard on the papers with the agreement of the parties. The material before the Tribunal comprised the documents lodged by the respondent under s 37 of the Administrative Appeals Tribunal Act 1975 (T1-T7) and:

  • • an undated, statement of facts and contentions by the applicant, which was received by the Tribunal on 23 April 2004
  • • a written statement, dated 22 April 2004, prepared by the applicant
  • • a witness statement, dated 22 April 2004, prepared by Mr F. Gerardson, the applicant's accountant
  • • ANZ Bank Loan Statements for 22 June 1989 to 19 July 1990
  • • a copy of the Prescribed Contract of Sale for Business dated 31 May 1989, for the business known as Gaby's Charcoal Chicken
  • • ANZ Bank Diary Notes (pp1-5) dated 30 May 1989 to 29 June 1989 with regard to

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    the applicant and his wife's purchasing the business Gaby Charcoal Chicken
  • • ANZ Bank Letter of Offer to the applicant and his wife dated 19 June 1989
  • • copy of the applicant's 1990 income tax return
  • • ASIC Historical Company Extract dated 12 January 2004
  • • ASIC Form 507 dated 6 August 1991, incorporating Report as to Affairs by the Liquidator dated 21 March 1991
  • • a statement of facts and contentions, dated 6 May 2004, by the respondent.

3. The applicant and his wife borrowed $55,000 from ANZ Bank (the Bank) on 22 June 1989 and on-lent the proceeds to Tenth Close Nominees Pty Ltd (the Company). The Company was controlled by the applicant and his wife. The funds were used by the Company to purchase a business known as ``Gaby's Charcoal Chicken'' (the Business).

4. The loan agreement was unwritten. The applicant asserts that there was an understanding that the Company would pay interest to them at least equivalent to the interest expense they incurred to the Bank. The applicant further asserts that there was an understanding that the Company would make sufficient profits to make further payments to them as interest or dividends.

5. The loan repayments were made by the Company directly to the Bank for the period 22 June 1989 to 26 March 1990, at which time the Business ceased trading and proceedings were commenced to wind it up. The applicant and his wife were required to repay the loan to the Bank, and did so over a period of 7 years. The applicant is seeking a deduction in respect of interest payments made during that period in the following amounts:

    * Year ended 30 June 1991    $3818.00

    * Year ended 30 June 1992    $2960.00

    * Year ended 30 June 2003    $2390.00

    * Year ended 30 June 2004    $2203.00

    * Year ended 30 June 1995    $2173.00

    * Year ended 30 June 1996    $2369.00

    * Year ended 30 June 1997    $2146.00

    * Year ended 30 June 1998    $1749.00

6. Other issues originally in dispute between the parties have been resolved.

7. The claim for a deduction was based on the applicant's assertion that the interest payments were incurred in gaining or producing his assessable income. As such, the applicant claimed that the deductions were allowable under s 51(1) of the 1936 Act or under s 8-1 of the 1997 Act.

8. The claim for a deduction was disallowed by the respondent on the basis that the only income derived by the taxpayer as a result of the loan to the Company was his salary from the Company. There was ``no expectation of a profit being made by way of higher interest rate charged on the loan to the Company than apply to the borrowed funds''. The respondent relies upon Case 51/97,
97 ATC 543 in support of the contention that there is an insufficient nexus between a taxpayer's salary from a company and borrowings which the taxpayer has on-lent to that company.

9. The applicant disputes the conclusion by the respondent that the sole purpose of lending the money to the Company was to earn a salary or wage from the Company, and the further conclusion that there was no real prospect of the applicant earning interest or dividend income. In particular, he relies upon
FC of T v Total Holdings (Aust) Pty Ltd 79 ATC 4279 in support of three propositions, namely:

  • • it is sufficient if the relevant income-producing activities are prospective only;
  • • it is sufficient if expenditure is incurred in relation to the management of an income- producing enterprise of the taxpayer; and
  • • shares by their very nature are capable of producing dividends to the taxpayer.

10. The applicant further claims that the respondent's interpretation of Case 51/97 is selective and ignores the fact that the case turned on its facts; namely, that the taxpayer in that instance was unable to demonstrate any real prospect of earning interest or dividend income.

11. The respondent asserts that, for the purposes of s 51(1) of the 1936 Act or s 8-1 of the 1997 Act, the interest payments made by the applicant were neither incurred ``in gaining or producing assessable income'' or ``necessarily incurred in carrying on a business for the purpose of gaining or producing'' the applicant's income. The respondent's Statement

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of Facts and Contentions includes the assertion that ``At no time did the Applicant have any expectation that the interest paid by the Applicant to the ANZ Bank could or would be productive of assessable income derived by the Applicant''. The respondent further asserts that at all material times, the applicant's assessable income was derived as a result of his provision of services to the Company as an employee.

12. The respondent seeks to distinguish Total Holdings by confining it to facts which it regards as clearly distinguishable.

13. The respondent relies upon
FC of T v Munro (1926) 38 CLR 153 which held that the incurring of interest on capital, lent interest-free to a Company of which the taxpayer was one of the shareholders, was not incurred in gaining or producing assessable income of the taxpayer but rather that of the company and its shareholders.

14. The respondent also relies upon
Sheil v FC of T 86 ATC 4731 in which it was held that interest incurred on a loan on-lent by the taxpayer's family company to another company partly owned by the taxpayer was not deductible. Although the appellant in that case increased his chances of receiving greater dividends from the company, this was only secondary and incidental to the purpose of the loan, which was to produce greater income for the company. The respondent argues that Derrington J distinguished Total Holdings on the basis that the case had involved a holding company which carried on the whole of part of its business through a subsidiary.

15. The respondent further relies upon
P & G Rocca Pty Ltd v FC of T 2002 ATC 4543, in which it was held that expenses incurred in respect of borrowed monies on-lent by a taxpayer to a unit trust under an unwritten loan agreement were not deductible, as the payments were not incurred by the taxpayer in the course of gaining or producing assessable income. The respondent emphasises the Federal Court's reference in that decision to
Steele v DFC of T 97 ATC 4239 which, according to the respondent, cast doubt upon the deductibility of interest on borrowed monies on-lent to another company interest free, and also to Total Holdings which was distinguished by the Court on the basis that it applied to circumstances where the investment by a holding company in a subsidiary constituted part of the taxpayer's business activities.

16. The applicant, in response, draws an analogy between the facts of the present dispute and the facts as they existed in Total Holdings. The applicant asserts that the present facts are analogous to a situation in which a parent company lends funds to a wholly owned subsidiary in the expectation that the subsidiary will become profitable and pay dividends to the parent company. The applicant emphasises that he and his spouse owned 100 per cent of the Company and were the sole beneficiaries of any profits earned by the subsidiary.

17. The applicant further distinguishes Munro on the basis that the taxpayer held only a 10 per cent interest in the company to which the loan in that case was made. Similarly, the applicant distinguishes Sheil and Rocca on the basis that other shareholders were involved.

18. I accept the applicant's evidence, as set out in his witness statement dated 22 April 2004, that he had an expectation, when on- lending the borrowings to the Company, that the borrowing would result in interest and dividend income being received from the Company at least equal to the interest expense incurred in repaying the loan. Logic would suggest that this must have been the applicant's intention. It is unlikely that the money would have been on-lent, or the Business subsequently purchased by the Company, if there had been no expectation of a profit being derived from the investment. The applicant's intention must have been to derive more than a salary from the Company. I am not persuaded by the respondent's submissions to the contrary.

19. Furthermore, I draw no adverse implications from the fact that the applicant's loan to the Company was undocumented. In this regard, I accept the evidence of the applicant's accountant, Frederick Gerardson, to the effect that it is common commercial practice for small business clients to borrow funds from a bank and to on-lend these funds to a family company to enable the company to operate a business. I also accept Mr Gerardson's opinion that it is common commercial practice for such loans to be undocumented and for such arrangements to be entered into by individuals in the expectation of receiving further interest or dividend income from the family company in their capacity as shareholders, thereby enabling them to make capital repayments.

20. I find that there is a sufficient nexus between the on-lending and the expectation of

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profit. I am supported in my finding by the decision in Total Holdings, in which Lockhart J significantly observes (at 4283):

``In my opinion if a taxpayer incurs a recurrent liability for interest for the purpose of furthering his present or prospective income-producing activities, whether those activities are properly characterised as the carrying on of a business or not, generally the payment by him of that interest will be an allowable deduction under sec 51.''

21. On the above basis, it is not relevant whether income was actually derived from the business. Rather, it is relevant to consider whether there was a reasonable expectation that income would be derived in the future. This interpretation is supported by Taxation Ruling IT 2606, published subsequent to the decision in Total Holdings, which states (at paragraph 9):

``As a general rule, interest on money borrowed to acquire shares will be deductible under the first limb of subsec 51(1) where it is expected that dividends or other assessable income will be derived from the investment. Such an expectation will usually exist as shares by their very nature are inherently capable of generating dividends, whether in the short or long term. However, such an expectation must be reasonable and not a mere theoretical possibility: there must be a prospect of dividends or other assessable income being received.''

22. I accept that the applicant, who had the benefit of an accountant's advice when he entered into the on-lending arrangement, had grounds for believing there was more than a mere theoretical possibility of deriving dividends or other assessable income. In Total Holdings, Lockhart J further stated [ATC at 4282]:

``For expenditure to constitute a deduction under sec 51, it is not necessary that the taxpayer carries on a business. It is sufficient for the purposes of the first limb of the subsection that the expenditure be incurred in relation to the management of the income-producing enterprise of the taxpayer.''

23. It is clear from the nature of the relationship between the taxpayer and the Company, including the fact that the taxpayer had effective control of the Company that the purpose of the on-lending was to manage an income-producing enterprise.

24. Munro can be distinguished on its facts. The respondent cites the comments of Knox CJ (at 171):

``The interest was paid, not for the purpose of gaining or producing assessable income of the taxpayer, but for the purpose of satisfying pro-tanto a debt which the taxpayer had incurred with a view, not to the production of his assessable income, but to the production of income by the company for the benefit of its shareholders.''

25. This statement must be put into context, however, by an earlier sentence:

``It is quite clear that the money borrowed from the bank was not... laid out or expended [wholly and exclusively for the production of his assessable income], for nine-tenths of the amount was applied directly or indirectly for the benefit of his two sons - directly as to the £18,000 paid for the shares given to them, and indirectly as to the advances made to the company, in which they held nine-tenths of the shares.''

26. It is clear the judgment in Munro centred not on the fact that the loan was inherently incapable of being categorised as having been made for the purpose of gaining or producing assessable income of the taxpayer, but rather on the fact that nine-tenths of the money was applied directly or indirectly for the benefit of third parties.

27. Sheil, also relied upon by the respondent, likewise must be viewed in its context. The respondent refers to the following statement by Derrington J [ATC at 4737]:

``It is true that as a result of his loan adventure, assuming that it was a loan, the appellant here increased his chances of receiving greater dividends from the company, but that was only secondary and incidental to the purpose of the loan which was to produce greater income for the company. Because the company had other substantial shareholders, neither its income nor its business were the income or business of the appellant. This is in marked distinction from the position of a holding company which carries on the whole or part of its business through a subsidiary as was the position in the Total case.''

ATC 2358

28. The respondent asserts that because the applicant did not own all the shares in the Company, he cannot be considered to be in a position analogous to a holding company. Derrington J's observations must, however, be put into context by the preceding sentence, in which his Honour explains the distinction on the basis that Total Holdings ``should not have application to the position where, as here, there are other shareholders in the company which received an interest-free loan from the taxpayer''.

29. True it is that the applicant's wife in the present dispute was also a shareholder in the Company, a point which the applicant's submission tends to disregard. Nevertheless, I consider that the distinction being drawn by Derrington J in Shiel turned on the question of effective control as an indicator of the primary purpose of the loan. In the present case, the applicant had effective control of the Company and this assists in distinguishing between cases such as Munro and Sheil where the benefits owing to the taxpayer were relatively incidental, and Total (and the present case) where the benefits (in the form of anticipated income) were, by virtue of the level of control, more readily classifiable as the primary purpose.

30. Similarly, I do not consider that Rocca, on close analysis, supports the respondent's contentions. While Mansfield J held that there was no sufficient nexus between the payments of interest by the applicant and the applicant's production of assessable income, the circumstances in that case were quite different to the present case. The monies were on-lent by the taxpayer to a related company to enable that company to purchase a property (``the Darlington property'') with a view to future development. Over a period of 5 years, the applicant failed to secure a right to occupy the property and no interest was paid to the applicant. Until the development of a store on the property, no lease arrangements were effected.

31. Mansfield J stated [ATC at 4556-4557]:

``... [T]he critical question in this matter is whether, in those circumstances, the payment of the outgoings was incurred in, or in the course of, gaining or producing assessable income of the applicant. Despite the purpose for which the Darlington property was acquired, the applicant did not secure any right to occupy the Darlington property in the years of income to which this application relates. There was no formal written, or, on the evidence, oral agreement to lease the Darlington property during those years. Ultimately, in August 1995, Accor leased the Darlington property to the nominee company of the Marlows. In the meantime, no payment in the nature of a rental payment was made by the applicant to Accor, or journalised. No arrangement was recorded or made that the applicant would pay the rates and taxes and other outgoings in respect of the Darlington property during those years. No journal entries were made to record in the books of Accor any liability in respect of those outgoings.

Those matters lead me to conclude that there is no sufficient nexus between the payments of interest by the applicant, and the payments of other outgoings in respect of the Darlington property, in the financial years under consideration and the gaining or producing assessable income of the applicant.''

32. In other words, his Honour's findings were based not upon the fact of the on-lending, but on the circumstances surrounding the activities in question. His Honour went on to say [ATC at 4557]:

``... As the evidence stands, until the actual development of that store, no lease arrangements were, or were to be, entered into between the applicant and Accor. Whether the claimed deductions were paid by the applicant in, or in the course of, gaining or producing assessable income must be determined against the particular facts as they existed, and not against some other theoretical arrangement between the applicant and Accor which they might have entered into, but did not enter into.''

33. The facts in the present case are less contentious. The applicant has a realistic expectation of a return on his investment in the short term, albeit an expectation which was to remain unrealised. The contingencies and obstacles which existed in Rocca did not exist in this case.

34. It is also instructive that h Mansfield J, in distinguishing Total Holdings, stated [ATC at 4557]:

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``... Those activities [in Total Holdings] of the taxpayer were found to be designed to render the subsidiary profitable as soon as commercially feasible, and to promote the generation of income by the subsidiary and its subsequent derivation by the taxpayer and in turn its parent. The investment in the subsidiary was said to be part of the taxpayer's business activities.''

35. The facts in the present case are more analogous to the facts in Total Holdings than to the facts in Rocca. As I have stated, the applicant's investment in the Company was designed to render the Company profitable as soon as possible.

36. For the above reasons, The Tribunal sets aside the decision under review and in substitution decides to allow the objection lodged against notice of assessment of income tax for the years ended 30 June 1991 to 30 June 1998 inclusive in full.

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