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CASE 1/2005

Members:
GA Barton M

Tribunal:
Administrative Appeals Tribunal

MEDIA NEUTRAL CITATION: [2004] AATA 1304

Decision date: 7 December 2004

Associate Professor GA Barton (Member)

The applicant, an individual taxpayer, applied for review of the respondent's decisions to disallow his objections to his amended assessments to income tax for the years ended 30 June 1997 and 30 June 1998. By s 14ZZK(b)(i) of the Taxation Administration Act 1953, he had the burden of proving that the assessments are excessive.

2. In the 1997 year the applicant sold shares that he had acquired after 19 September 1985, at a capital gain. The respondent reduced the cost base of the shares for the purposes of Part IIIA of the Income Tax Assessment Act 1936 (``the Act'') by $37,308. This adjustment increased the applicant's net capital gain for the 1997 year and so produced a tax shortfall for that year. The respondent charged additional tax of 25% of the shortfall pursuant to s. 226K of the Act. The applicant submitted that the amount of $37,308 was correctly included in the cost base of the shares pursuant to s. 160ZH(1)(c) of the Act and, in any event, the additional penalty tax should be remitted because it was reasonably arguable, when his 1997 return was lodged, that that amount was correctly included in the cost base of the shares. The applicant made a further submission that certain amounts which he did not include in the cost base of the shares, pursuant to s 160ZH(1)(c) of the Act, when he completed his return, be now included in the cost base of the shares.

3. In the 1998 year, the applicant and the trustee of his family trust sold post 19 September 1985 shares at a capital gain. The respondent reduced the indexed cost base of the shares by $329,716 and increased the consideration for the shares by $3,057,537, for the purposes of Part IIIA of the Act. The consideration was increased pursuant to s. 160ZD(2)(c) of the Act. These adjustments produced a tax shortfall in the applicant's return for the 1998 year. The respondent charged additional tax of 50% of the tax shortfall attributable to the increased capital proceeds of the shares, pursuant to s. 226H of the Act, and 25% of the tax shortfall attributable to the reduction of the indexed cost base of the shares, pursuant to s. 226K of the Act. The applicant submitted that the additional tax be remitted and that certain amounts, which were not included in the indexed cost base of the applicant's and the trustee's shares, should now be included.

4. The Tribunal had before it the ``T documents'' (T1-T112) lodged by the respondent pursuant to s 37 of the Administrative Appeals Tribunal Act 1975, the respondent's statement of facts and contentions, the respondent's amended statement of facts and contentions and the respondent's written submissions. The respondent was represented by Mr J.D. Allanson of counsel who tendered the following documentary exhibits:

  • R1 - copy of a standard transfer of certain shares
  • R2 - a copy of a standard transfer of certain other shares
  • R3 - draft taxation determination TD 2001/D11

The applicant and four witnesses for the applicant, testified at the hearing. The witnesses are referred to below as A B C and D. The applicant was represented by Dr J T Schoombee of counsel who tendered the following documentary exhibits:

  • A1 - the applicant's witness statement
  • A2 - the applicant's supplementary witness statement
  • A3 - A's witness statement
  • A4 - A's supplementary witness statement
  • A5 - B's witness statement
  • A6 - B's supplementary witness statement
  • A7 - E's statement
  • A8 - C's witness statement
  • A9 - C's additional witness statement
  • A10 - D's witness statement
  • A11 - a copy of page 7, The Valuation of Businesses, Shares and Other Equity, 3rd edition by Wayne Lonergan
  • A12 - a company prospectus (for a particular company)
  • A13 - a company annual report for 1996 for a particular company
  • A14 - a company annual report for 1997 for a particular company
  • A15 - a corporate constitution for a particular company
  • A16 - the memorandum and articles of association of a particular company
  • A17 - a document headed ``CCV Share Price by month'' for a particular company.

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The Tribunal had the applicant's statement of facts and contentions, amended statement of facts and contentions, outline of submissions and submissions in reply to the respondent's supplementary submissions.

Both the parties lodged a statement of issues and referred the Tribunal to various authorities.

A directions hearing was held in this matter on 4 May 2004 and, on 10 May 2004, the applicant filed supplementary submissions on the reviewability of ``general interest charges'' imposed and the respondent filed submissions on remission of interest on 28 May 2004.

5. The applicant was a director and shareholder in a proprietary company that conducted a franchise business (``the proprietary company''). The corporate trustee of the applicant's family trust (``the trustee'') was also a shareholder in the proprietary company and the applicant is a director and shareholder of the trustee.

6. The applicant and his co-directors resolved to raise capital by offering listed shares to investors in a new company (``the new company'') that had acquired all the issued shares in the proprietary company. The new company was formed on 21 April 1995.

7. Prior to the formation of the new company, the proprietary company contracted with a company and a partnership to surrender the rights they had previously acquired from the proprietary company, to market and promote franchises relating to the proprietary company's business. The agreements were styled ``Surrender of Sub-Franchisor Agreement''.

8. The agreement with the company on 27 January 1995 was for the amount of $1,400,000 comprising a cash payment of $1,050,000 and the issue of fully paid shares to the value of $350,000 by the new company to be formed. The agreement was contingent on the formation of the new company, its listing on the Australian Stock Exchange and a subscription of capital to acquire the assets and undertaking of the proprietary company and to pay the consideration under both surrender agreements, i.e. the agreement with the company and with the partnership, prior to 30 June 1995 (T7).

9. On 3 May 1995 an agreement was entered into with the company to amend the agreement of 27 January 1995 by deleting the condition relating to the listing of the new company on the Australian Stock Exchange and by providing for the payment of $1,050,000 for the goodwill of the business carried on by the company under the sub-franchisor agreement and for the issue of 700,000 shares fully paid to $0.20 in the new company for the surrender of the sub-franchisor agreement (T8).

10. On 27 October 1995 the agreement with the company was further amended by changing the date by which the conditions were to be fulfilled from 30 June 1995 to 31 December 1995 (T12).

11. The agreement with the partners on 23 May 1994 was for the payment of $972,520.00 by the new company comprising a cash payment of $729,390.00 and the issue of fully paid shares to the value of $243,130.00 (T5). The agreement was subject to the conditions that the new company be formed and listed on the Australian Stock Exchange and that it raise sufficient capital to acquire the assets and undertaking of the proprietary company, and to pay the consideration under the agreement that was to be concluded with the company, prior to June 1995. This agreement was replicated on 10 January 1995 (T6) save that the conditions were to be fulfilled by 30 June 1995.

12. On 3 May 1995 an agreement was entered into with the partners to amend the agreement of 10 January 1995 by deleting the condition relating to the listing of the new company on the Australian Stock Exchange (T9) and, on the same day, an agreement was entered into with the partners to further amend the agreement of 10 January 1995 to provide for the payment of $729,390 for the goodwill of the business carried on by the partners under the sub-franchisor agreement and for the issue of 486,260 shares fully paid to $0.20 in the new company for the surrender of the sub-franchisor agreement (T10).

13. On 16 October 1995 the agreement with the partners was further amended by changing the date by which the conditions were to be fulfilled from 30 June 1995 to 31 December 1995 (T11).

14. The applicant testified that the surrender of the sub-franchisor agreements by the company and by the partners was vital for the float of the new company. He stated further that to the best of his recollection, it had been made clear to him, that certain individuals associated with the partnership and the company were unwilling to agree to the surrender of the sub- franchisor agreements at the consideration that

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was eventually contracted for. So he promised them certain incentive payments to obtain their consent to the contracts. The amount of these incentive payments and the circumstances in which they were made are discussed below at para. 17.

15. The new company was formed on 21 April 1995. On 26 April 1995 the directors of the new company resolved to acquire 100% of the issued shares in the proprietary company on the basis of 376,275 shares fully paid to $0.20, for one share in the proprietary company. The applicant and the trustee owned 156 of the 200 issued shares in the proprietary company. They accepted the new company's offer of 26 April 1995 to acquire their shares (T109, T110) and deferred any capital gain, for income tax purposes, on this exchange of shares, by electing the relevant ``roll-over'' relief. The effect of the exchange was that the applicant and the trustee together acquired 78% of the ``pre-float'' issued shares in the new company.

16. Shares in the new company were listed on the London Stock Exchange on 30 November 1995 and on the Australian Stock Exchange in February 1997.

17. The incentive payments referred to in para. 14 of these reasons were paid as follows. On 28 February 1996 the trustee issued a cheque in the amount of $400,000 (T13, T15) to an individual who beneficially owned half the issued shares in the company that had contracted for the surrender of its sub- franchisor agreement with the proprietary company. Between 1 February 1997 and 2 December 1997 the trustee issued cheques in the total amount of $400,000 to a company that beneficially owned the other half of the issued shares in the company that surrendered its sub- franchisor agreement. These payments were made against invoices for services and commission (T16, T17, T18, T22, T35, T57, T59). In relation to the partners who surrendered their sub-franchisor agreement with the proprietary company, on 15 February 1996 the applicant issued a cheque in the amount of $350,000 to an individual who was a director of one of the corporate partners (T14).

18. In the year ended 30 June 1997 the applicant sold 4,913,181 of his shares in the new company to broaden the shareholder base. In the year ended 30 June 1998 he sold 39,414,628 of his shares in the new company and the trustee sold 3,577,805 of its shares in the new company, in the course of the applicant's retirement as chairman of the new company.

19. The share sales in the year ended 30 June 1998 were approximately one third to clients of certain financial consultants and one third indirectly to each of the managing director and the legal director, of the new company, in a management buy-out. The clients of the financial consultants bought at $0.408 per share. The managing director, who is the applicant's brother, bought shares as trustee of his family trust at $0.30 per share. The other purchaser was the corporate trustee of the legal director's family trust, also at $0.30 per share. The circumstances of these sales are as follows.

20. On 4 July 1997 the applicant, by an agreement signed on his behalf by the legal director of the new company, agreed to sell 14 million shares in the new company to clients of certain financial consultants at $0.408 per share (T28, T29). It was agreed by the parties that the nominated stockbroker would raise contract notes for each participating client for the price of the shares agreed to be purchased, brokerage of 0.5% and stamp duty. These amounts were to be lodged with the stockbroker by 1 August 1997. The applicant agreed to pay the financial consultants a handling/placement fee of $0.008 per share sold (T29). On 25 July 1997 the applicant transferred 14,330,000 shares in the new company at $0.408 per share to clients of the financial consultants (T79).

21. Prior to July 1997 the intended parties to the management buy-out approached their bank (``the bank'') to finance the buy-out. On 5 May 1997 the bank made a submission for its investment in two share financing unit trusts based on a price of $0.40 per share (T20). This proposal was not proceeded with after certain changes to the income tax treatment of franked dividends were announced later that month in the Federal Budget (T23). On 13 June 1997 the bank's business banking manager produced a credit memorandum proposing that the purchasers be granted 3 year fixed rate loans (``interest in arrears'') of $4.3 million each to acquire the shares at an initial settlement price of $0.30 with the balance of the purchase price ($0.10) to be carried on the applicant's finance (T23).

22. In July 1997 the bank made loans of $4.3 million to each of the purchasers in the management buy-out. The loans were for a

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fixed term of 3 years at a fixed interest rate (T104, T105). The guarantors of the loans included the applicant and the trustee (T37, T38). The securities for the payment of the loans included a registered mortgage over the applicant's home held by the trustee, a registered mortgage over a property held by the trustee of a property trust associated with the applicant and a letter of undertaking given by the applicant to provide additional securities to the bank should the lending to security ratio fall below 71% and to advise the bank of any future encumbrances or other major changes to his asset ownership (T104, T105, T41, T48, T49, T50). The loans were drawn down on 1 August 1997 (T56). In December 1999 the applicant applied the capital proceeds from the sale of certain shares to reducing the balance of each loan to $3.8 million (T87).

23. On 30 July 1997 the applicant transferred 12,167,120 ordinary shares in the new company to his brother as trustee of his (the brother's) family trust at $0.30 per share (T42, T45). On the same day the applicant transferred 12,238,140 ordinary shares in the new company to the corporate trustee of the legal director's family trust at $0.30 per share (T43, T44).

24. On 30 July 1997 the trustee transferred 1,788,900 ordinary shares in the new company to the applicant's brother as trustee of his (the brother's) family trust at $0.30 per share (T47) and 1,788,900 ordinary shares to the corporate trustee of the legal director's family trust at the same price (T46).

25. On 27 October 1997 the applicant's brother as trustee for his family trust, acquired 5 ordinary shares in the new company from the trustee and 373,075 shares from the applicant (T81).

26. On 27 October 1997 the corporate trustee of the legal director's family trust acquired 306,293 ordinary shares in the new company from the applicant (T82).

27. On 1 August 1997 the applicant and the trustee concluded a bonus agreement with the corporate trustee of the legal director's family trust (T52). If the average sale price of shares in the new company exceeded $0.30 per share on the Australian Stock Exchange during July 2000, the corporate trustee agreed to pay the applicant and the trustee a bonus equal to the excess, up to a maximum of $0.10, plus interest, on 31 July 2000, in respect of each share in the new company acquired from them. No bonus agreement was concluded between the applicant, or the trustee, and the applicant's brother as trustee of his family trust.

28. Although the bank's credit memorandum (T23), referred to in para. 21 of these reasons, is based on a management buy-out at $0.40 per share (an initial price for $0.30 with a further $0.10 carried by the applicant on his terms), the Tribunal finds on all the evidence, including the bonus agreement with the corporate trustee of the legal director's family trust, that the management buy-out occurred at $0.30 per share.

29. It was not disputed that the taxable income of the trustee for the year ended 30 June 1998 was distributed to the applicant and that the trustee resolved that should the respondent amend the trust return to increase the trustee's taxable income, such increase was to be deemed distributed to the applicant on 30 June 1998. So any adjustments to the cost base and capital proceeds for the shares in the new company, sold by the trustee in that year, will be reflected in the applicant's personal assessment to income tax for the year ended 30 June 1998.

30. The income tax returns of the applicant for the years ended 30 June 1997 and 30 June 1998, and the income tax return of the trustee for the year ended 30 June 1998, were prepared on the basis that the cost base in the 1997 year, and the indexed cost base in the 1998 year, of their shares in the new company included the amount of $400,000 paid by the trustee in instalments between 1 February 1997 and 2 December 1997 to the company referred to in para.17 of these reasons (``the incentive payment'') (T2, T61, T71).

31. Section 160ZH of the Act prescribes the cost base and indexed cost base of an asset as follows:

``160ZH(1) [Determination of cost base] Subject to the following provisions of this section, for the purposes of this Part, the cost base to a taxpayer of an asset is the sum of:

  • (a) the amount of any consideration in respect of the acquisition of the asset;
  • (b) the amount of the incidental costs to the taxpayer of the acquisition of the asset;
  • (ba) except where the asset is a personal- use asset of the taxpayer - the amount of the non-capital costs to the taxpayer of the ownership of the asset;

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  • (c) the amount of any expenditure of a capital nature incurred by the taxpayer to the extent to which it was incurred for the purpose of enhancing the value of the asset and is reflected in the state or nature of the asset at the time of disposal of the asset;
  • (d) the amount of any expenditure of a capital nature incurred by the taxpayer to the extent to which it was incurred in establishing, preserving or defending the taxpayer's title to, or a right over, the asset; and
  • (e) the amount of the incidental costs to the taxpayer of the disposal of the asset.

160ZH(2) [Determination of indexed cost base] Subject to the following provisions of this Part, the indexed cost base to a taxpayer of an asset is the sum of:

  • (a) the indexed amount of any consideration in respect of the acquisition of the asset;
  • (b) the indexed amount of the incidental costs to the taxpayer of the acquisition of the asset;
  • (ba) except where the asset is a personal- use asset of the taxpayer - the amount of the non-capital costs to the taxpayer of the ownership of the asset;
  • (c) the indexed amount of any expenditure of a capital nature incurred by the taxpayer to the extent to which it was incurred for the purpose of enhancing the value of the asset and is reflected in the state or nature of the asset at the time of disposal of the asset;
  • (d) the indexed amount of any expenditure of a capital nature incurred by the taxpayer to the extent to which it was incurred in establishing, preserving or defending the taxpayer's title to, or a right over, the asset; and
  • (e) the indexed amount of the incidental costs to the taxpayer of the disposal of the asset.''

32. It was not disputed by the parties and the Tribunal finds that shares in the proprietary company and in the new company are assets for the purposes of Part IIIA of the Act.

33. It was common cause between the parties that the relevant provisions in s 160ZH are those in ss 160ZH(1)(c) and (2)(c).

34. The applicant testified that he agreed orally to make the incentive payment at some time prior to January 1995 (A2). It was not contested at the hearing that the applicant became legally liable to make the incentive payment and that it constituted expenditure of a capital nature. So the Tribunal finds that the incentive payment was an amount of expenditure of a capital nature incurred by the applicant prior to January 1995, when he was a shareholder in the proprietary company and before he exchanged his shares in that company for shares in the new company in April 1995.

35. Section 160ZH of the Act does not limit the expenditure referred to in ss 160ZH(1)(c) and (2)(c) to expenditure incurred after the relevant asset was acquired by the taxpayer. So in the circumstances of this matter, there are two avenues by which the amount of the incentive payment may be included in the cost base or indexed cost base of the applicant's shares in the new company. If s 160ZH(1)(c) operated to include the amount of the incentive payment in the cost base of the applicant's shares in the proprietary company, then it would have been carried over into the applicant's cost base for his shares in the new company as part of the consideration for their acquisition for the purposes of s 160ZH(1)(a). This would have occurred by operation of s 160ZZPA(2)(g) as modified by s 160ZZPC, when the applicant elected ``roll-over'' relief, pursuant to s 160ZZPC, on the exchange of his shares in the proprietary company for shares in the new company. The other possibility is that if s 160ZH(1)(c) did not operate to include the amount of the incentive payment in the cost base of the applicant's shares in the proprietary company, it may have operated to include that amount in the cost base of his shares in the new company. So the relevant legislation requires the Tribunal to determine, for the purposes of ss 160ZH(1)(c), whether the amount of the incentive payment was included in the applicant's cost base for his shares in the proprietary company, failing which, whether that amount was included, by s 160ZH(1)(c), in his cost base for his shares in the new company.

36. By ss 160ZH(1)(c) and (2)(c) the amount of the incentive payment is to be included in the cost base or indexed cost base of the applicant's shares to the extent to which it was incurred for the purpose of enhancing the value of the shares

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and was reflected in the state or nature of the shares at the time of their disposal.

37. ``State'' is defined in the 3rd edition of the Macquarie Dictionary as `` 1. the condition of a person or thing, as with respect to circumstances or attributes. 2. condition with respect to constitution, structure, form, phase, or the like''. ``Nature'' is defined in the same dictionary as `` 1. the particular combination of qualities belonging to a person or thing by birth or constitution; native or inherent character''.

38. A share in a registered company is a species of transferable personal property, which does not include an interest, legal or equitable, in the assets of the company. See, for example, the
Birkenhead, Lancashire and Cheshire Railway Co. v Pilcher 5 Ex. 114 at 125;
Poole v Middleton (1861) 29 Bead. 646 at 650-651;
Re Rose, Rose v Inland Revenue Commissions [1952] Ch. 499 at 507, 514;
Woodlands v Hind[1955] 2 All E.R. 604 at 605. In relation to the transfer of shares, Millet J in
Macmillan Inc. v Bishopsgate Trust (no. 3) [1995] 3 All E.R. 747, [1955] 1 W.L.R. 978 at 992, describes them as a special sub-species of chose in action with its own rules. On appeal, [1956] 1 All ER 585; Lord Justice Aldous, at 620 described shares as property ``in the nature of a chose in action which is immovable in the sense that it remains at the place of the company's incorporation'';
Gambotto & Anor v WCP Limited & Anor (1995) 13 ACLC 342; (1994-1995) 182 CLR 432 and the cases cited;
Salomon v A. Salomon & Co. Ltd [1897] A.C. 22;
Macaura v Northern Assurance Co. [1925] A.C. 619 at 626, 630, 633;
Hood-Barrs v IRC[1946] 2 All E.R. 768 (C.A.) 775;
Short v Treasury Commissioners [1948] A.C. 534 at 545.

39. The nature of a share was described by Farwell J, in his decision in
Borland's Trustee v Steel Bros & Co Ltd [1901] 1 Ch. 279 at 288, as follows:

``[A] Share is the interest of a shareholder in the company measured by a sum of money, for the purpose of liability in the first place, and of interest in the second, but also consisting of a series of mutual covenants entered into by all the shareholders inter se in accordance with section 16 of the Companies Act, 1862. The contract contained in the articles of association is one of the original incidents of the share. A share... is an interest measured by a sum of money and made up of various rights contained in the contract, including the right to a sum of money of a more or less amount.''

As was said by the High Court in
Pilmer & Ors v The Duke Group Ltd (in liq) & Ors (2001) 19 ACLC 1,172 at 1,177; (2001) 180 ALR 249 at 256, the reference to measuring the interest of a shareholder by a sum of money is no longer apt under Australian corporations law which no longer includes the concepts of par value and authorised capital.

40. The Borland formulation focuses on the rights and obligations accruing to a shareholder, vis-à-vis other shareholders and the company, from the constituent documents of the company. It omits the rights and obligations of shareholders arising from corporations legislation and their proprietary rights. Farwell J cited the decision in
New London and Brazilian Bank v Brocklebank (1882) 21 Ch. D. 302 with approval. It is noteworthy that Holker LJ, in the passage referred to by Farwell J, at [1901] 1 Ch. 289, viewed the corporate constitution as the terms and conditions on which the shares were purchased and did not say that the relevant rights and obligations constituted the shares. Both approaches are somewhat anomalous because if the rights and obligations are terms extraneous to the shares, the shares have no substance and if they constitute the shares, there is the problem of accommodating ``obligations'' as property. For this reason, a share has been described as an indivisible bundle of rights and the obligations that attach to it, as burdens or incidents of the shareholding, see
Re Rose, Rose v Inland Revenue Commissioners [1952] Ch 499 at 513, 514;
Archibald Howie Pty Ltd v Commissioner of Stamp Duties (NSW) (1948) 77 CLR 143 at 154, 157; contrast
Inland Revenue Commissioners v Crossman [1937] AC 26 at 69-70. Theoretically the state or nature of a share is variable from corporation to corporation, from share to share and from time to time. At a practical level, commercial necessity, securities regulation and convenience may dictate some characteristics of a share. The extent to which an issued share may transmute depends on the extent to which relevant provisions of the constituent documents of the company may be validly changed, see
Gambotto & Anor v WCP Limited & Anor (1995) 13 ACLC 342

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; (1994-1995) 182 CLR 432.

41. The evidence of the applicant was that the incentive payments, including the incentive payment under consideration, regardless of what they were ascribed to in the documents associated with their payment, were directed at ensuring that the contracts for the surrender of sub-franchisor agreements were executed because they were transactions that were indispensable to the successful listing of the new company on the London and Australian Stock Exchanges. He submitted that because the surrender contracts were fulfilled and the proprietary company reacquired valuable assets, and because the shares in the new company were listed, the incentive payments were incurred for the purpose of enhancing the value of his shares in the new company and they were reflected in the state or nature of the shares in the new company when he disposed of them.

42. ``Reflect'' is defined in the 3rd edition of The Macquarie Dictionary as `` 1. to cast back (light, heat, sound etc.) after incidence 2. to give back or show an image of; mirror''.

43. The Tribunal finds that none of the rights that constituted the applicant's shares in the proprietary company and, subsequently, in the new company, was reflective of the incentive payments. There was no evidence before the Tribunal on which it could find that the applicant's shares in the proprietary company or in the new company, constituted a class of shares reflecting the amount of the incentive payments because they included a special or additional right attributable to such payments. The fact that the issued shares in the new company were listed on the boards of the London and Australian stock markets did not make the state or nature of the applicant's shares reflective of the amount of the incentive payments. The state or nature of the applicant's shares in the new company was indistinguishable from that of other issued shares in the new company. The Tribunal rejects the proposition that any causal link between the incentive payments and the listing of the issued shares in the new company makes the state or nature of the applicant's shares in that company reflective of the amount of the incentive payments for the purposes of ss 160ZH(1)(c) and (2)(c) of the Act. So the Tribunal finds that the state or nature of the applicant's shares in the proprietary company did not reflect the amount of the incentive payment when they were exchanged for shares in the new company, and the state or nature of the shares in the new company did not reflect that amount when the applicant disposed of them. In the light of this finding it is unnecessary for the Tribunal to consider whether the incentive payment was incurred for the purpose of enhancing the value of the applicant's shares in the proprietary company and in the new company and whether the indexed cost base of the trustee's shares in the new company included any part of the incentive payment.

44. The Tribunal finds that the amount of the incentive payment was not part of the cost base of the applicant's shares in the proprietary company for the purposes of s 160ZH(1)(c) of the Act and that it was not part of the indexed cost base of the applicant's or trustee's shares in the new company for the purposes of ss 160ZH(2)(a) or 2(c) of the Act.

45. The Tribunal finds on the same grounds that the other incentive payments referred to in para. 14 of these reasons, did not form part of the indexed cost base of the applicant's or trustee's shares in the new company for the purposes of ss. 160ZH(2)(a) and 2(c) of the Act.

46. The income tax returns of the applicant and of the trustee for the year ended 30 June 1998 were prepared on the basis of a management buy-out price of $0.30 per share in the new company. The respondent adjusted this amount to $0.408 per share pursuant to ss. 160ZD(2)(c) of the Act. This adjustment increased the applicant's net capital gain for the 1998 year by $3,057,537 (T2)

47. Section 160ZD(2) provides:

``Subject to subsection (2B), if a taxpayer has disposed of an asset and:

  • (a) there is no consideration in respect of the disposal;
  • (b) the whole or a part of the consideration received by the taxpayer in respect of the disposal cannot be valued; or
  • (c) the amount that would, but for this paragraph, be taken to be the consideration received by the taxpayer in respect of the disposal is greater or less than the market value of the asset at the time of the disposal and, in the case where the asset was disposed of to

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    another person, the taxpayer and that other person were not dealing with each other at arm's length in connection with the disposal;

the taxpayer shall be deemed to have received as consideration in respect of the disposal an amount equal to the market value of the asset at the time of the disposal.''

48. Section 160ZD(2B) is not relevant to this matter.

49. In circumstances where its provisions are met s 160ZD(2) operates automatically to substitute the market value of the relevant asset at the time of its disposal for the amount that would otherwise be taken to be the consideration received, or entitled to be received, by the taxpayer, for the purposes of Part IIIA of the Act.

50. It was not disputed by the parties and the Tribunal finds that in the course of the management buy-out of the new company in the 1998 year, the applicant and the trustee disposed of assets that are shares in the new company to other persons. So they will be deemed by s. 160ZD(2) to have received the market value of the shares at the time of the disposals if they were not dealing with those other persons at arm's length in connection with the disposals of the shares and the actual consideration for the shares was greater or less than their market value at the time of the disposals. The apparent purpose of ss. 160ZD(2)(c) is to ensure, for income tax purposes, that non-arm's length dealings for the disposal of assets to others occur at market value consideration, regardless of whether, in a particular case, the substitution of market value produces a capital gain or capital loss that is greater or smaller than any actual gain or loss on the disposal of the asset.

51. It is implicit in ss. 160ZD(2)(c) that arm's length dealings for disposals of assets to others, may, for income tax purposes, occur at greater or less than market value consideration.

52. The Act is silent as to the meaning of ``dealing with each other at arm's length'' and ``market value of the asset'' in ss. 160ZD(2)(c).

53. Section 160ZD(2) applies if a taxpayer has disposed of an asset and ss. 160ZD(2)(c) refers to the market value of that asset at the time of disposal. So if s 160ZD(2) applies in this matter, it applies to the sale of each share in the new company by the applicant and by the trustee in the course of the management buy- out. As the shares in the new company sold by the applicant and by the trustee in the 1998 year were of the same class, the Tribunal finds that the shares were of equal value at any particular time.

54. According to the CCH Macquarie Concise Dictionary of Modern Law (1988), parties to a transaction are at arm's length when they are not connected in such a way as to bring into question the ability of one to act independently of the other.

55. Section 160ZD(2)(c) requires the Tribunal to determine whether the management buy-out was a real bargain because the applicant, on behalf of himself and the trustee, dealt with his brother and the legal director, in relation to their indirect acquisition of his shares in the new company, in a way characteristic of a party bargaining at arm's length. His business and other connections to them are relevant to the Tribunal's finding but not per se determinative of the issue,
Barnsdell v FC of T 88 ATC 4565 at 4568, (1988) 19 ATR 1352;
The Trustee of the estate of the late AW Furse No 5 Will Trust v FC of T 91 ATC 4007 at 4014-4015;
Australian Trade Commission v WA Meat Export Pty Ltd (1987) 75 ALR 287;
Copperart Pty Ltd. v FC of T 93 ATC 4779 at 4798-4799;
Granby Pty. Ltd. v FC of T 95 ATC 4240 and
Collis v FC of T 96 ATC 4831.

56. The applicant submitted, on a number of grounds, that the management buy-out by his brother and by the legal director occurred in dealings with him that were conducted at arm's length.

57. The applicant submitted that, on the evidence, the parties took precautions to ensure they were dealing with each other independently: the legal director did not give any legal or commercial advice to the applicant; the applicant had independent accounting advice; none of the parties had the capacity to influence or control the others; the parties were acting in their own commercial interests none of them subordinated his interest to that of any other party and there was no persuasion and co- operation amounting to collusion between the parties.

58. The applicant referred to the fact that the market for his 30% interest in the new company was very limited and that realistically the only

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way he could dispose of his interest was through an arrangement that included a management buy-out.

59. The applicant also referred to the fact that the sale of shares to clients of certain financial consultants were at arm's length and that the spouse of the legal director, who is a director of the trustee of their family trust, is risk averse. She did not testify at the hearing but the applicant tendered her statement as exhibit A7 which reads in part:

``I was expected by the (bank) to sign a personal guarantee for the loan to (trustee) of $4.3 million which was 30 cents per share. My husband explained to me that that was the maximum the bank would lend. I was concerned that we should not be at risk of losing our only asset, the family home, an asset of our family trust, registered in the name of (trustee) at the time. My husband persuaded me that the risk was low if we only paid 30 cents with no additional price because the Bank was likely to look to (applicant's) assets first if the deal went sour.''

60. The extent to which the applicant guaranteed, and his assets secured, the bank loans to fund the management buy-out, is set out at para. 22 of these reasons. The applicant submitted that these arrangements are explicable by his position as a major shareholder and founder of the new company wishing to sell all his shares and to receive a cash component of some $5.6 million (which was not subject to any finance, or security obligation on his part) from the financial consultants who had placed his shares with their clients.

61. The respondent raised a number of matters pertaining to the management buy-out to support his contention that the parties were not dealing with each other at arm's length.

62. The applicant and his brother had been business associates since 1990 and the applicant's brother was the managing director of the new company from April 1995. The legal director had been a business associate of the applicant (and the applicant's legal adviser) since 1992 and legal director of the new company since April 1995.

63. The applicant sold two thirds of his shares in the new company to entities of his brother and the legal director at $0.30 per share whereas the sale to the clients of the financial consultants was at a discount to market of $0.408 per share. These shares were transferred on 25 July 1997. On that day the closing price for shares in the new company on the Australian Stock Exchange was $0.520 per share (T76).

64. In the course of the management buy-out the applicant sold the majority of his shares in the new company to entities of his brother and the legal director at a price substantially lower than that paid by the clients of the financial consultants and by purchasers of shares in the new company on the Australian Stock Exchange (T76). Initially the applicant transferred the maximum number of shares he was permitted to sell without triggering the relevant takeover provisions under the Corporations Law. The applicant, his brother and the legal director, as directors of the new company, then agreed to the issue of 6 million ordinary shares in the new company at $0.50 per share. This issue increased the number of shares the applicant could transfer to entities of his brother and the legal director without triggering the takeover provisions under the Corporations Law and led to the further transfer of shares by the applicant and by the trustee referred to in paras. 25 and 26 of these reasons.

65. The respondent referred to the financial arrangements negotiated with the bank and the applicant's agreement to sell his shares at the price the bank was prepared to lend despite the fact that it was lower than the price paid by the clients of the financial consultants.

66. The Tribunal has given careful consideration to the evidence of how the applicant conducted himself in selling his shares in the new company to the entities of his brother and the legal director and it finds, on the balance of the probabilities, that he was not dealing at arm's length with the parties to those sales. The applicant on his own submission is an experienced businessman and when the Tribunal considered all the details of the management buy-out, including the applicant's financial accommodation of the purchasers, it found the inference that he was not dealing at arm's length irresistible.

67. Where an asset has been acquired or disposed of, the time of acquisition or disposal for the purposes of Part IIIA of the Act shall be ascertained in accordance with s. 160U. By s. 160U(3) where the asset was acquired or

ATC 112

disposed of under a contract, the time of acquisition or disposal shall be taken to have been the time of the making of the contract. According to the standard transfer forms used by the applicant and the trustee to transfer shares in the new company to the entity of the applicant's brother and of the legal director on 30 July 1997 (see paras. 23 and 24 of these reasons) the date of purchase of the shares was 11 July 1997. So the Tribunal finds that the time of disposal of the shares for the purpose of s. 160ZD(2)(c) is the 11 July 1997.

68. The respondent tendered copies of the standard transfer forms (R1, R2) used by the applicant and the trustee to transfer shares in the new company to the entity of the applicant's brother in October 1997, see para. 25 of these reasons. According to these documents the date of purchase of the relevant shares was 14 October 1997. The opening and closing price for a share in the new company on the Australian Stock Exchange on 14 October 1997 was $0.474 and $0.460 respectively on a volume of 222 986 (T76). The standard transfer form used by the applicant to transfer shares in the new company in October 1997 to the corporate trustee of the of the legal director's family trust (see para. 26 of these reasons) was not in evidence. The decision under review was made on the basis that the shares in the new company transferred by the applicant and the trustee in October 1997 were sold, pursuant to the management buy-out, on 11 July 1997. It was common cause between the parties that the transfer of some of the shares was delayed until October 1997 for reasons related to the takeover provisions of the corporations law. So the Tribunal finds that, for the purpose of s. 160ZD(2)(c), the time of disposal of all of the shares in the new company under the management buy-out agreement, including those transferred in October 1997, is 11 July 1997.

69. The opening and closing price for a share in the new company on the Australian Stock Exchange on 11 July 1997 was $0.435 and $0.435 respectively on a volume of 250 000 (T76).

70. The income tax returns of the applicant and the trustee for the year ended 30 June 1998 were prepared on the basis that the consideration on the disposal of shares in the new company in the management buy-out was $0.30 per share (T2, A10). The respondent determined in the decision under review that $0.30 per share was less than the market value per share in the new company on 11 July 1997 and that s. 160ZD(2)(c) deemed the applicant to have received market value on 11 July 1997 of $0.408 per share in the new company as consideration (T2).

71. ``Market value'' is the price at which a commodity, security or service is selling in the open market, according to the revised 3rd edition of the Macquarie Dictionary (2001). It has also been described as ``the price that would be negotiated in an open and unrestricted market between a knowledgeable, willing but not anxious seller, acting at arm's length'', Wayne Lonergan, The Valuation of Businesses, Shares and other Equity, 3rd edition (1998). Lonergan, in the same work, expresses the view that

``[O]wing to the complexities and interrelationships of the meaning of `value', the purpose of a valuation and the methodologies used, and the information available, only rarely will two different valuers value the same business, or shares in the same company, at precisely the same amount. This subjective component, although mitigated by professional judgement and experience, can never be eliminated.

Therefore, it may, depending on the purpose of the valuation, be appropriate to quote a range of values rather than a single figure in a valuation report.''

(A11)

72. The applicant's expert witness valued the shares in the new company sold in the management buy-out (``the shares'') in the range of values between $0.332 and $0.44 per share at the time of their disposal on 11 July 1997 (A10).

73. Section 160ZD(2), in circumstances where it applies, substitutes the market value of the relevant asset at the time of disposal for the consideration received by the taxpayer. So market value is used to calculate any capital loss or gain on the disposal, a calculation that would not be possible if ``market value'' in s. 160ZD(2) meant a range of values rather than a specific amount or price. In this regard the applicant submitted it would be correct for the Tribunal to determine that the market value of the shares is the lowest amount in the range, namely $0.332 per share, because, if the actual

ATC 113

consideration had been $0.332, s. 160ZD(2)(c) would not have applied as the consideration would not have been greater or less than market value. This submission rests on the proposition that, in the first instance,, the Tribunal may only determine a range of market values rather than a specific market value, for the purpose of s. 160ZD(2)(c). The Tribunal finds that, in this respect, the applicant's submission is misconceived. It is open to the Tribunal to determine a specific market value from all the evidence relating to the disposal of the shares, including evidence of a range of values at that time such as that quoted by the applicant's expert witness.

74. The respondent, in the decision under review, determined the market value of the shares at $0.408 per share at the time of their disposal on 11 July 1997, a value equal in amount to the price per share in the new company in the sale of 4 July 1997 to the clients of certain financial consultants, see para. 20 of these reasons. This sale, which involved a substantial parcel of shares in the new company, was concluded shortly before the management buy-out and it was negotiated on the understanding that the balance of the applicant's interests in the new company would be acquired by its principal managers, that is the applicant's brother and the legal director. The sale was integral to the applicant's withdrawal or retirement from the new company and it was not disputed by the parties, and the tribunal finds, that it was negotiated and concluded at arm's length.

75. The balance of the applicant's interests were acquired by management. The initial endeavours to finance this acquisition were based on a price of $0.40 per share (T20).

76. A price of $0.408 per share was a price discounted to market on 4 and 11 July 1997 (T76). It was not disputed by the parties and it was confirmed by the authorities they cited, in particular that by Lonergan (at p. 341), referred to in para. 69 of these reasons, that the price of a large parcel of the issued shares in a company may need to be discounted in order to attract a willing buyer.

77. The price of $0.408 per share is within the range of values for 11 July 1997 quoted in evidence on the applicant's behalf, see para. 70 of these reasons.

78. So the Tribunal finds that the market value of the shares at the time of their disposal for the purpose of s. 160ZD(2)(c), is $0.408 per share.

79. The proportionate amount of the incentive payment included in the cost base of the shares in the new company sold by the applicant in the 1997 year was $37,308, see para. 30 of these reasons. The respondent's decision to excise this amount from the cost base of the shares resulted in a tax shortfall of $18,904 in the applicant's income tax return for that year (T2).

80. The proportionate amounts of the incentive payment included in the cost base of the shares in the new company sold by the applicant and the trustee in the 1998 year were $299,284 and $27,167 respectively. These amounts were indexed to $302,277 and $27,439 in calculating the indexed cost base of the shares. The respondent's decision to excise these amounts from the indexed cost bases of the applicant's and the trustee's shares in calculating their net capital gains in the 1998 year, resulted in a tax shortfall of $159,862 in the applicant's income tax return for the 1998 year (T2).

81. The respondent charged the applicant additional tax in the amount of 25% of these tax shortfalls pursuant to s. 226K of the Act (T2).

82. Section 226K is included in part VII of the Act which applied in the years ended 30 June 1997 and 30 June 1998 to impose additional tax by way of penalty in certain circumstances.

83. Section 226K provides:

``226K Subject to this part, if:

  • (a) a taxpayer has a tax shortfall for a year; and
  • (b) the shortfall or part of it was caused by the taxpayer, in a taxation statement, treating an income tax law as applying in relation to a matter or identical matters in a particular way; and
  • (c) the shortfall or part, as the case may be, so caused exceeded whichever is the higher of:
    • (i) $10,000; or
    • (ii) 1% of the taxpayer's return tax for that year; and
  • (d) when the statement was made, it was not reasonably arguable that the way in which the application of the law was treated was correct;

    ATC 114

the taxpayer is liable to pay, by way of penalty, additional tax equal to 25% of the amount of the shortfall or part.''

84. A ``tax shortfall'' in relation to a taxpayer and a year, means the amount, if any, by which the taxpayer's statement tax for that year at the time at which it was lowest is less than the taxpayer's proper tax for that year, s. 222A(1) - ``tax shortfall.''

85. A taxpayer's statement tax means the tax that would have been payable by the taxpayer if it were assessed on the basis of the taxpayer's statements in the income tax return and after allowing credits claimed, s 222A(1) - ``statement tax''.

86. ``Proper tax'', in relation to a taxpayer and a year, means the tax properly payable by the taxpayer in respect of that year on the taxpayer's taxable income after allowing credits properly allowable to the taxpayer, s. 222A(1) - ``proper tax''.

87. The Tribunal has found that the incentive payment was not part of the cost base or indexed cost base of the applicant's and the trustee's shares in the new company for the purpose of s. 160ZH(1)(c) or (2)(c) and that, by s 160ZD(2)(c), the consideration on disposal of the shares in the management buy-out was $0.408 per share for the purposes of Part IIIA of the Act. The applicant and the trustee did not apply these provisions in accordance with the Tribunal's findings in their income tax returns for the relevant years so the applicant had a tax shortfall, in the 1997 and 1998 years, for the purpose of s. 226K(a). It was not disputed, and the Tribunal finds, that the part of the applicant's tax shortfall in each year attributable to their treatment of the income tax law in relation to the incentive payment, exceeded the threshold amounts prescribed by s. 226K(c). So the applicant is liable to pay additional tax of 25% of the amount of that part of the tax shortfall for each year if it was not reasonably arguable at the time when the applicant's and trustee's returns for the relevant years were lodged, that the incentive payment was part of their cost base or indexed cost base for their shares in the new company pursuant to ss. 160ZH(1)(c) or (2)(c) of the Act.

88. For the purposes of s. 226K(d), the correctness of the treatment of the application of a law is reasonably arguable if, having regard to the relevant authorities and the matter in relation to which the law is applied, it would be concluded that what is argued for is about as likely as not correct, s. 222C(1). ``Authority'' includes inter alia an income tax law and a decision of a court (whether or not an Australian court), s 222C(4).

89. Where the requirements of s. 226K(a)(b) and (c) are satisfied because the decision maker has decided that the income tax law applies differently from the taxpayer's application of that law, referred to in s. 226K(b) and (d), the decision maker is required to determine the cogency of the taxpayer's treatment of the law, having regard to the relevant authorities, some of which are listed in s. 222C(4), relative to that of the alternative applications and, in particular, that adopted by the decision maker. If, objectively, the decision maker finds the position adopted by the taxpayer to be substantially as sustainable and convincing, at the time it was taken, as its alternative, it is about as likely as not correct. Broadly this position will be reached where the taxpayer's treatment of the income tax law is consistent with that law's meaning according to established legal principles and, in particular, the decision maker is not prevented from adopting the taxpayer's treatment by binding legal precedents that are clearly not distinguishable on the facts.

90. The Tribunal finds that the applicant's and trustee's treatment of the incentive payment as part of the cost base and indexed cost base of their shares in the new company, for the purposes of ss. 160ZH(1)(c) and (2)(c), was not reasonably arguable for the purpose of s. 226K(d). After considering the meaning of ss. 160ZH(1)(c) and (2)(c) and the juridical nature of a share in a company as determined in the court decisions cited in these reasons, the Tribunal finds that it would not be concluded, for the purpose of s. 222C(1), that what was argued for by the applicant in regard to the incentive payment was about as likely as not correct.

91. So the Tribunal finds that the requirements of s. 226K are satisfied and the applicant is liable to pay the additional tax charged by the respondent for the 1997 and 1998 years pursuant to s. 226K.

92. Part of the applicant's tax shortfall in the 1998 year is attributable to the upward adjustment of the consideration for the shares in the management buy-out from $0.30 to $0.408 per share pursuant to s. 160ZD(2)(c). The

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respondent charged the applicant additional tax equal to 50% of the amount of this part of the tax shortfall pursuant to s. 226H of Part VII of the Act.

93. Section 226H provides:

``Subject to this part, if:

  • (a) a taxpayer has a tax shortfall for a year; and
  • (b) the shortfall or part of it was caused by the recklessness of the taxpayer or of a registered tax agent with regard to the correct operation of this Act or the regulations;

The taxpayer is liable to pay, by way of penalty, additional tax equal to 50% of the amount of the shortfall or part.''

94. ``Reckless'' means ``heedless of the danger or the consequences of one's actions; rash or impetuous'' according to the Oxford Dictionary of English, Second edition 2003. The Tribunal in
Jones v FC of T 2003 ATC 2024 determined that recklessness means more than mere carelessness, citing the conclusion of Devlin J in
Reed (Albert E) and Co. Ltd v London and Rochester Trading Co. Ltd. [1954] 2 Lloyd's Rep 463 at 475 that recklessness ``means deliberately running an unjustifiable risk.''

95. The Tribunal finds that the applicant's conduct in lodging his return for the 1998 year on the basis that s. 160ZD(2)(c) did not apply in the circumstances of the management buy-out of his interests in the new company, was rash and heedless of the income tax law and therefore reckless. The sales of his interests in the new company were complex transactions involving parcels of issued shares in the new company of considerable size and value. Two of the purchasers were entities of parties closely associated with the applicant and although the sales were concluded at more or less the same time, the placement with the financial consultants was at a price significantly higher than that paid by the other purchasers. There was no evidence before the Tribunal that the applicant's return was based on specific taxation advice and the risk the applicant took in dispensing with such advice was unjustified.

96. So the Tribunal finds that the requirements of s.226H of the Act are satisfied and the applicant is liable to pay the additional tax charged by the respondent for the 1998 year pursuant to s. 226H.

97. The respondent notified the applicant of amounts of tax shortfall interest payable, in the notices of amended assessment for 1997 and 1998 (T92, T93). The decisions under review do not refer to the interest charges, but even if they did, the Tribunal finds for the reasons it gave at paras. 78 to 81 of its reasons in Case 11/2004,
2004 ATC 220;
[2004] AATA 1041 that they are not part of the assessments and any decision of the respondent in respect of such charges is not a reviewable objection decision for the purposes of s. 14ZZA of the Taxation Administration Act 1953.

98. For the reasons set out above, the Tribunal finds that the applicant has not proved on the balance of the probabilities that his amended assessments to income tax for the years ended 30 June 1997 and 30 June 1998 are excessive for the purpose of s. 14ZZK(b)(i) of the Taxation Administration Act 1953. So the Tribunal affirms the respondent's decisions of 7 March 2002 under review.


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