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DRAM NOMINEES PTY LTD v FC of T

Members:
BH Pascoe SM

Tribunal:
Administrative Appeals Tribunal

MEDIA NEUTRAL CITATION: [2006] AATA 957

Decision date: 10 November 2006

BH Pascoe (Senior Member)

1. These are applications to review decisions of the Commissioner of Taxation (the respondent) in relation to objections lodged by Dram Nominees Pty Ltd (Dram) (the applicant) against assessments of income tax for the years ended 30 June 1995 to 30 June 2000 inclusive. The assessments were issued in September and October 2001 following an audit of the applicant's affairs. Objections to the assessments were lodged by letter dated 19 July 2002 in which depreciation, interest and other expenses relating to rental income included were claimed. By letter of 17 December 2003, the respondent allowed the objections in part by the allowance of small amounts of depreciation on furniture and fittings in each of the years ended 30 June 1996 to 30 June 2000 inclusive.

2. At the hearing, the applicant was represented by Mr J. Morgan of counsel. The respondent was represented by Ms H. Riley of counsel. Evidence was given by Mr and Mrs McKenzie-Smith, directors of the applicant, Mr R. Macdonald, an architect and by Mr T. Brain, a retired builder.

3. This matter has a long history going back to 1984. It was the applicant's case that it purchased properties known as 9A and 9C Blackburne Square in Berwick, Victoria under a contract dated 3 December 1984. Property 9A was a shop on the ground floor of the building adjoining 9B. In 1984 property 9C was simply the air space above this ground floor on which a second storey could be erected. The purchase price of both properties was stated as $60,000. The vendor was an associated company, Tropa Dion Pty Ltd. The contract provided for payment of a deposit of $6,000 with the balance payable on 3 September 1990. The purchaser was entitled to rent and profit from the property from date of settlement. A transfer of the property was dated 18 March 1991 and Dram was registered as the proprietor on 19 March 1991. A permit for erection of the upper level was issued in October 1984 showing an estimated cost of $42,000 in the name of Tropa Dion Pty Ltd. While the directors of the applicant had believed the construction of the upper level took place in 1987, evidence at the hearing demonstrated that it was underway in February 1985. Alterations to the shop front of 9A were undertaken in October 1988. The council permit showed the estimated cost at $4,000 while the directors' estimate was $15,000 including work outside the actual premises.

4. No occupancy of the upper storey appeared to have occurred until April 1990 when a permit was issued for use of the premises as a dental surgery with possession given to the tenant from 1 July 1990 and some fit-out works completed by the applicant. The relevant lease was in the name of the applicant notwithstanding that settlement of the original purchase price did not appear to have taken place.

5. The major problem in this case is that the applicant has not been able to produce evidence

ATC 2506

of actual payment of the purchase price nor of the precise amount or payment of the subsequent capital expenditure. While some evidence of borrowing and the existence of a bank overdraft was provided, there was no direct evidence connecting the borrowings and interest paid to specific expenditure on the property. The applicant's case was very much a matter of it being reasonable to assume that it incurred expenditure as estimated and borrowed the funds for that expenditure.

6. An initial hurdle is that the contract of sale in December 1984 showed Dram as the purchaser. However, that company was incorporated on 5 November 1984 as Harrybal Pty Ltd and did not change its name to Dram until 7 March 1985 some three months after the date shown on the contract of sale. The original directors were Mrs McKenzie-Smith and a Mr J.S. Balharry, said to be a friend of the McKenzie-Smiths. While it was said that he was the nominee of Mr McKenzie-Smith until resignation on 6 May 1995 and replaced by Mr McKenzie-Smith, it appeared to be readily accepted that the original name of the company was a play on the name of Mr Balharry. The suggestion by the respondent that the error in the actual name of the purchaser on the contract of sale indicated that the contract had been backdated to December 1984 to avoid stamp duty was strongly denied by Mr and Mrs McKenzie-Smith. They believed that the company had been incorporated solely for the purpose of owning the specific property and had always been considered as having the name of Dram. They could not explain the reason for its incorporation as Harrybal Pty Ltd.

7. There was no evidence provided as to the payment of the deposit of $6,000 or the balance of $54,000. It was suggested that the balance of the purchase price could have been paid in September 1990 as required under the contract with the transfer not registered until March 1991. It was further suggested that the vendor Tropa Dion Pty Ltd could have owed money to Dram and the liability offset. It was submitted that the total amount of the purchase price must have been funded directly or indirectly by commercial debt.

8. While the building permit for the construction of the upper floor was issued in the name of Tropa Dion Pty Ltd, the then registered owner of the property, it was submitted that no entity other than Dram would have incurred the costs of construction in view of the contract entered into prior to such construction. Mr Brain was the builder who has retired and did not possess any of the relevant records of the work in 1985. It would appear that he based his recollection of the cost and the name of his client solely on the building permit which had been shown to him. He did believe that the estimated cost shown on the permit would have been close to the actual cost. Mr and Mrs McKenzie-Smith believed that construction cost was in the region of $100,000. They were supported by Mr Macdonald who based his estimate by calculating likely current day costs and deflating them to 1985 values. While Mr Macdonald did extensive calculations it remained an estimate performed some 20 years after the event. As such, this evidence was of little assistance in establishing the probability of the actual expenditure incurred in 1985, the identity of the entity which incurred the expenditure and whether funds for the expenditure were from interest bearing loans.

9. A further difficulty with the applicant's estimate of expenditure in 1984/1985 is that the annual returns lodged with the National Companies and Securities Commission for the years ended 30 June 1986, 1987 and 1988 showed its non-current assets at $55,000, $56,463 and $56,462 respectively. All these returns were lodged by the applicant's then accountants. If the evidence of the McKenzie-Smiths was to be accepted some $106,000 had been expended by that time with a liability for a further $54,000 incurred as the balance of the purchase price. It would be expected that a balance sheet would have shown non-current assets at some $160,000 not $56,463. Unfortunately, no actual balance sheets for this period were produced.

10. The next difficulty with expenditure on the building is that there is no specific evidence of the expenditure on the shop front to 9A in 1988 and the fit out on 9C in 1990. The applicant's evidence of an estimated cost of $50,000 for the fit out was supported by the estimates of Mr Macdonald. However, there is considerable doubt as to the actual work carried out at that time. Mrs McKenzie-Smith believed that, in addition to the erection of internal

ATC 2507

partition walls, air-conditioning and plumbing works were installed at that time. On the other hand, Mr Brain was of the firm view that the basic kitchen and toilet plumbing and air-conditioning was part of the work done in 1985. In a letter of 18 June 1990, the applicant's solicitors wrote to the solicitor for the incoming tenant stating that their client had agreed:

To complete the following works prior to occupation by your client on 1st July 1990:

  • (a) The construction of walls;
  • (b) Brick work on the entrance and on the stairs and other places;
  • (c) Attendance to hard plastering;
  • (d) Attendance to air-conditioning to ensure that it is operating correctly and with minimum noise.

One invoice dated 25 November 1990 was produced for an amount of $2,600 for removal and replacement of air-conditioning duct work and fitting of new outlets to two rooms. All of this would appear to indicate that the air-conditioning unit and ducts had been installed prior to the work in 1990. It would appear that Mr Macdonald's estimate of a likely cost of $50,279 in 1990 is overstated as a result of him basing his assumptions of work done on the recollection of the directors.

11. Unfortunately, no accounting evidence was provided notwithstanding that formal accounts had been prepared by a reputable accounting firm for each of the relevant years. The first accounts produced in evidence were for the year ended 30 June 1990 where the balance sheet showed the cost of land and buildings at $91,149 and furniture and fittings at $2,195. At 30 June 1991 the land and buildings cost had increased to $116,168. At 30 June 1992 that figure had increased to $256,168. There was no evidence as to what expenditure in the year ended 30 June 1992 could have resulted in the increase of $140,000. Assuming the accounts were prepared from appropriate books and records, it may have been expected that details of the amount included in the asset account could have been provided by an accountant notwithstanding the length of time which has passed. At the hearing Mr Morgan produced a set of what were described as model accounts. The author and provenance of these accounts was not clear. They appeared to have been produced in an attempt to reconcile the estimated capital expenditure on the premises and borrowings by Dram. It has to be said that they added little to the evidence needed to satisfy the onus of proof given that their starting point was the reasonable assumptions arising from the memories of Mr and Mrs McKenzie-Smith.

12. The primary issue in this case was the claim for interest deductions on loans obtained to finance expenditure on rented premises. The first record of any interest bearing borrowings was approval of a bank overdraft of $25,000 for working capital on 23 August 1989. This implies that no such borrowings were made to finance the deposit on the purchase or the building of the upper storey. If expended, it must be assumed that these amounts were funded from related party borrowings. It is accepted that subsequent interest bearing borrowings could have been used to repay the related party borrowings. The overdraft was increased to $50,000 on 21 December 1989. The next bank document was a bank statement in March 1992 showing a then overdraft of $200,025. Mrs McKenzie-Smith said that Dram had regularly arranged bank bill facilities with the Commonwealth Bank although, again, there is no objective evidence of this.

13. In April 1991, Dram borrowed $150,000 on a solicitor's mortgage. This was replaced in August 1993 by a mortgage of $165,000 through another solicitor, increased to $185,000 in November 1997 and to $245,000 in October 2000. All were secured over Dram's property at Blackburne Square. The balance sheet of Dram at 30 June 1992 showed a further secured loan of $140,000. The evidence was that this was a loan from Mr Balharry from funds obtained by a solicitor's mortgage over his personal real estate in March 1992. This loan together with a further $63,200 personal non-interest bearing loan from Mr Balharry was said to have paid off the bank overdraft. The loan secured over the property of Mr Balharry was increased to $160,000 in July 1993. Evidence showed that the loan secured by Mr Balharry over his property increased to $200,000 in October 1995 to $225,000 in July 1997 and to $260,000 in July 1997. It is noted that the balance sheets of Dram show the loan from Mr Balharry at $188,981 at 30 June 1996, $184,741 at 30 June

ATC 2508

1997, $180,695 at 30 June 1998, $176,325 at 30 June 1999 and $172,132 at 30 June 2000. This would indicate that the loans to Dram by Mr Balharry did not increase to any significant extent from the recorded $184,777 at 30 June 1992.

14. There were many references to Mr Balharry in the evidence from the applicant. Initially, he was a director of Dram and said to be a nominee of Mr McKenzie-Smith. He was said to be a close friend of the McKenzie-Smiths. The original name of Dram was clearly a play on the name Balharry. He was said to have mortgaged his personal property to provide finance to Dram. For reasons which were not satisfactorily explained, Mr Balharry was not called to give evidence. Such evidence would be expected to have assisted in the problem of the original name of the company and that loans from him were for the purpose of refinancing the purchase and improvement of the property. While I do not go so far as to find that it is likely that his evidence would not have assisted the applicant, his absence raises a hurdle against the applicant discharging the onus of proof.

15. As indicated earlier, the absence of any expert accounting evidence was noticeable. Given the long history of this matter, it might have been expected that a proper examination of the books and records of the company could have led to a clearer explanation and possible reconciliation of the figures shown in annual returns and balance sheets.

16. From the evidence presented, I am satisfied that Dram acquired the premises, expended money on improvements to the premises and borrowed money at interest to finance at least part of such expenditure. The first question then to be dealt with is what amount is reasonable to accept as the capital expenditure incurred. I am not satisfied that Dram actually expended $60,000 on the purchase of the property. Firstly the date of purchase is clearly in doubt and secondly there is no evidence of payment of either the deposit or the balance of the purchase price to an associated company. In addition, and based on the evidence of subsequent expenditure, it is difficult to accept that a $60,000 purchase price was included in the balance sheet of the company at 30 June 1991. This date was well after the date of the last major expenditure on the property.

17. At 30 June 1991, the balance sheet showed the cost of land and buildings plus furniture and fittings at $118,363. From the evidence, it is possible to reconcile and explain this figure. The estimate of building work done in 1985 shown on the council permit was $42,000. The applicant's estimate was $100,000. Whilst I am prepared to accept that it was likely that the actual cost may well have exceeded the original estimate, I am not prepared to accept that any overrun would have exceeded 20 per cent. On that basis a figure of $50,000 would appear reasonable as a probable cost. I am prepared to accept the applicant's estimate of $15,000 for the shop front and exterior improvements to 9A. Evidence was produced to show that Dram incurred a cost of $9,090 in January 1990 to the City of Berwick in relation to provision of car parking. The total of these three items is $74,090 leaving a balance of $44,273. While I have strong reservations in relation to the estimate of $50,000 for fit out costs in 1990, I am prepared to include that balance of $44,273 as costs incurred in the period up to 30 June 1991. This somewhat basic reconciliation leaves no room for inclusion of $60,000 for the purchase price. As indicated earlier, the figure showing in the 1992 balance sheet increased inexplicably by $140,000. The only suggested reason for this was that the secured loan through Mr Balharry was taken up in that year and the accountant assumed that the funds related to property additions and included the $140,000 on both sides of the balance sheet by the debit to land and buildings.

18. The consequence of the foregoing is that I am prepared to accept the evidence of Dram financing the capital expenditure of the property by interest bearing loans to the extent of expenditure totalling $118,363 by the commencement of the year of income to which this application relates. In each of the relevant years, I would, therefore, allow a deduction for interest incurred on such amount. In the absence of any direct evidence of such amount, it would seem that the appropriate course would be to allow as a deduction the proportion of the interest expense in each year in the same proportion as $118,363 bears to the total

ATC 2509

interest bearing liabilities at the commencement of the year. Such a calculation results in the following amounts of deductible interest:
Year Ended 30 June Interest Bearing Debt at 1 July Interest Incurred Per Cent Interest Deductible
1995 325,000 32,068 36.42% 11,679
1996 325,000 25,159 36.42% 9,163
1997 325,000 27,408 36.42% 9,982
1998 325,000 25,903 36.42% 9,139
1999 345,000 24,200 34.31% 8,302
2000 345,000 23,850 34.41% 8,183

19. The other issues raised by Dram in respect of the assessments for the relevant years were an alleged overstatement of rent received, deductions for additional expenses and depreciation and deduction of prior year losses.

20. The first issue was the answer of rental income. It was submitted for Dram that the amount had been overstated in the years ended 30 June 1997, 1998 and 1999 in the calculation of taxable incomes. While the evidence at the hearing supported the submissions it is noted that the amount of rental income included in the assessments agrees with the figures shown in the profit and loss accounts of Dram. Again, with no accounting evidence it is difficult to accept that such accounts, presumably prepared contemporaneously from the records of the company overstated actual rent received. Nevertheless, the evidence was that the premises known as 9C were vacant for some six months from July 1996 to December 1996 after the dentist tenant vacated. However, one month's rent should be included. The subsequent tenant occupied 9C from 1 January 1997 at a rent of $1,000 per month not the $1,347 per month included in the assessment. With reservations, I am prepared to accept that the total rental for these premises for the year ended 30 June 1997 was $7,347 rather than the $16,164 included in the assessment, a reduction of $8,817. For the years ended 30 June 1998 and 1999 the respondent conceded that the evidence showed that rent received had been overstated by $4,164 and $3,470 respectively.

21. It was submitted on behalf of Dram that deductions should be allowed for rates, land tax, insurance, repairs, rent collection costs, property management fees, corporate lodgement fees and accountancy costs. It was said that these should be allowed on an estimated increasing total amount. However, no evidence of actual expenditure was provided. Deductions for rates and insurances had been allowed in the assessments and there was no evidence that these amounts were incorrect. It was noted that the management of the premises was in the hands of Berwick Real Estate a business owned by Mr McKenzie-Smith and in which Mrs McKenzie-Smith was employed. Without evidence, there is no reason to accept that any charges in respect of that management were made. Again, in the profit and loss accounts of Dram, the only expense other than interest and depreciation shown in the relevant years was $1,412 for repairs in the year ended 30 June 1995 and $620 for bank charges in the year ended 30 June 1998. Whilst clearly the applicant did not rely on these accounts, these are the only expenses recorded. Consequently, I am prepared to accept that these two amounts can be allowed as a deduction.

22. The next item of deduction which was sought was depreciation on the building costs. Given my earlier findings it is appropriate to allow such deduction in each of the relevant years. However, on the basis of such findings it should be limited to building costs of $50,000 in 1985, $4,000 in 1988 being the likely cost of actual building works and $44,273 in 1990 a total of $98,273. It is appropriate to remit the calculation of the deduction available to the respondent. The respondent allowed depreciation on furniture and fittings in the objection decision. While it may be that part of

ATC 2510

the above $98,273 includes plant such as the air-conditioning unit, there was no adequate evidence of the cost of such plant to provide a basis for depreciation at the rate applicable to such plant.

23. It was further submitted that a deduction should be allowed for costs of borrowing. While amounts borrowed by way of solicitor's mortgage may well have incurred borrowing costs, none were demonstrated as having been incurred in the relevant years. Some were demonstrated in the earlier years and it would be appropriate that a deduction for such costs be allowed in the same proportion as my finding in relation to interest deductions.

24. The final area of deductions sought was for losses carried forward from prior years. The evidence did not allow me to make any findings in relation to such losses. However, some findings can be made which bear upon this issue. Notwithstanding the alleged purchase of the property in December 1984 and the building of the upper floor in 1985, no tenant occupied the premises and no rent was derived until June 1989 for 9A and July 1990 for 9C. No adequate evidence was provided for whether the premises were available for rent or what efforts were made to find tenants. Given this long delay, it is possible that, prior to occupation by tenants, the premises were not held for the purpose of producing income. A further issue is that, under the terms of the contract for purchase, Dram was not entitled to any rent until settlement which appeared to have taken place in March 1991. Nevertheless, the leases in June 1989 for 9B and in July 1990 for 9C were in the name of Dram. It was conceded by the applicant that it did receive the rent from these dates although not clear on what basis it was so entitled. Given this background, I am not prepared to accept that Dram was entitled to any deductions prior to the occupation by tenants. Notwithstanding decisions such as
Steele v Deputy Commissioner of Taxation 97 ATC 4239; (1997) 154 ALR 438 the evidence does not satisfy me that at the time of expending money on building works other than the fit out of 9C in mid 1990, Dram had any expectation or ability to derive income from the expenditure. It was said that the expenditure including that in 1990 was financed by interest bearing bank borrowings. There is simply no clear evidence of such borrowings. Commencing at least from April 1991, interest deductions would be allowable together with depreciation and other expenses such as rates and insurance. Again, it is appropriate to remit the matter of calculation of any deduction for losses, if any, incurred prior to 1 July 1995 to the respondent.

25. The result of the foregoing is that the objections under review should be varied to the extent of reducing taxable income in case of the years ended 30 June 1995 to 30 June 2000 inclusive by:

  • (a) reductions in rent received set out in paragraph 20 of these reasons.
  • (b) allowances of deductions for interest incurred as set out in paragraph 18 of these reasons.
  • (c) allowance for deduction of expenses set out in paragraph 21 of these reasons.
  • (d) allowance of depreciation on buildings as a deduction as set out in paragraph 22 of these reasons.
  • (e) allowance as a deduction for losses carried forward from prior years, if any, as set out in paragraph 24 of these reasons.

As adjustments under (d) and (e) above are required to be remitted to the respondent, it is appropriate that the decisions under review should be remitted to the respondent with a direction to issue amended assessments in accordance with there reasons for decision. Liberty to apply should be granted for any further directions in the event of any dispute between the parties as to the correctness of the respondent's compliance with this decision and reasons therefore.


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