Wisheart & Ors. v. Commissioner of Inland Revenue.

Wild CJ

Supreme Court of New Zealand

Judgment date: Judgment handed down 11 September 1969.

Wild C.J.: This is a case stated directly to the Supreme Court under sec. 32 of the Land and Income Tax Act 1954. The three objectors (whom I will call respectively W, M, and K) were at the relevant times partners in a firm of solicitors. They entered into certain transactions to which the Commissioner seeks to apply sec. 108 of the Act. That section, before an amendment in 1968 which does not affect this case, read as follows-

``108. Agreements purporting to alter incidence of taxation to be void-Every contract, agreement, or arrangement made or entered into, whether before or after the commencement of this Act, shall be absolutely void in so far as, directly or indirectly, it has or purports to have the purpose or effect of in any way altering the incidence of income tax, or relieving any person from his liability to pay income tax.''

It is first necessary to set out some background. For a number of years W and M practised in partnership with a senior partner who retired from the firm on 31 March 1964. During the following year down to 31 March 1965, W and M continued as partners in equal shares. On 1 April 1965 they formed a new partnership with K whom they had previously employed as a solicitor. Under the new partnership the profits were, for the 5 years to 31 March 1970, to be divided in the proportions of 5/12ths to W, 5/12ths to M, and 2/12ths to K; and from 1 April 1970 the three partners were to share equally. All these successive arrangements were recorded in deeds of partnership in normal form. Within a few months of the execution of the deed of 1 April 1965, however, W and M altered the sharing arrangements in the firm and brought K on to a one-third share equally with themselves. K was credited with this one-third share for the full year ending 31 March 1966.

With the approaching retirement of their senior partner on 31 March 1964, W and M, each with a young family and both facing the obligation to pay out a substantial sum in goodwill, discussed the formation of trusts for their respective families, M drafted a deed which W approved. In the form finally adopted and so far as material, the deed provided-

(a) for the capital to be held until the death of the survivor of the husband and wife for the children or grandchildren in such shares as that survivor should by will appoint, with provision in default of appointment; and

(b) for the income until the date of distribution to be applied (i) to pay the wife such sum as would be required to bring her annual income up to £156; (ii) while the husband continued to support himself to pay the remainder of the income for the benefit of the wife, children and grandchildren; (iii) from the time when the husband became unable to support himself and so long as he should elect, to pay the income to the husband and the wife in such shares as the trustees should think fit; and (iv) from the death of the husband for the wife and grandchildren.

At the time they decided to form these trusts W and M also decided to make use of a company called Marlborough Developments Ltd. This company (which I shall call ``Marlborough'') had been formed by W in 1961 for the purpose of investing in land, but the scheme then in mind had fallen through and Marlborough had never been operated. W and M decided that the shareholding, which was held equally by W and his wife, should be taken over by their respective family trusts in equal shares.

It is against that background that the questions in this case arise. They relate to transactions involving the objectors and

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Marlborough in regard to three matters which I shall deal with in the order in which the transactions took place. They affect the taxable incomes of the objectors respectively for the years ending 31 March 1965 and 1966. It will be convenient to refer to the first of those years as ``the first income year'', and to the second as ``the second income year''.

The first transaction relates to an insurance agency. Correspondence put before the Court by M, who gave oral evidence on behalf of the objectors, showed that the law firm as then constituted had resigned an agency for another insurance company in November 1961 and become chief agent at Blenheim for the South British Insurance Co. Ltd. This company had a branch office at Nelson but not at Blenheim. At Blenheim it had a resident inspector who attended to the writing of cover notes, the completion of policies, and the settlement of claims. The insurance company's premium accounts, however, were sent out from its Nelson office and premiums due by persons in the Marlborough district were generally received at the office of the law firm as chief agents and paid by the firm into the insurance company's bank account. The firm received a commission on the total premium income of the insurance company in the Marlborough district and this commission became part of the firm's profits. In evidence, M said that there was little work in running the agency: merely the writing out of receipts for premiums by a cashier or receptionist, and the bankings in the insurance company's bank account. In cross-examination, however, he said that W and he himself would have done a certain amount, basically in attracting business and advising the local representative on various matters. That this was the case is borne out, I think, by a letter written by the then senior partner to the South British Insurance Co. Ltd. in November 1961. In informing that company of the firm's resignation from its earlier insurance agency he said, ``We will do our best to build up the company's business in our district''. Another feature of the agency which M described in evidence as a substantial advantage to the firm and its clients was that the insurance company would keep in force all policies covering interests under security to the firm's clients and would not cancel them without reference to the firm. In return the firm was to protect the company for unpaid premiums.

At about the same time as they decided to form their respective family trusts and to transfer to them in equal shares the shareholding in Marlborough, W and M approached the Nelson manager of the South British Insurance Co. Ltd. and requested him to arrange a transfer of their chief agency to Marlborough. The manager apparently asked for an application in writing and, on 20 April 1964, W wrote him the following letter on behalf of the firm-

``Following the verbal discussions which the writer has had with you in the matter we now hereby formally apply to your Company for the Chief Agency at Blenheim to be transferred to Marlborough Developments Limited a Company set up for the purpose of purchasing real property in Marlborough. The shares in this Company are to be held in the names of Trustees for the children of myself and (M) and although the Company will hold the Agency it will continue to be administered through our office and as far as we are concerned may be advertised in precisely the same manner as formerly.

We would appreciate it if this matter could be dealt with as soon as possible as we wish the transfer to take effect from the 1st April, 1964.''

On 11 May, W wrote the Nelson manager again requesting a reply and saying:

``It is of the utmost importance for (M) and myself that this matter be finalised as soon as possible in order that it may take effect from the 1st April last.''

On 30 June the manager replied to the firm in the following terms-

``In reply to your letters of the 20th April and 7th May, and confirming my conversation with (W) on the 25th instant, I have pleasure in advising you that Marlborough Developments Ltd., have now been registered as our Chief Agents for Blenheim with the Underwriters Association.

It is understood that our arrangements with you will continue, that is that all policies covering interests which are under security to your clients will be kept in force, and will not be cancelled without prior reference to your good selves. It is of course also understood that in the event of our being unable to collect unpaid premiums on such policies, you will protect us.''

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In the meantime, on 29 May, the M family trust was set up, M's mother as settlor providing a sum of £100 and the trustees appointed being W and M's wife. The deed establishing the W family trust was executed on 21 September. W's father as settlor paid £10 to the trustees who were M and Mrs. W. The two deeds were in similar form and followed the provisions already outlined. M agreed in evidence that in each case the settlor was introduced in the hope of preventing sec. 84A of the Act from depriving the father of his special exemption in respect of dependent children. On 18 September, W transferred his shares in Marlborough to the W family trust, and Mrs. W transferred her shares to the M family trust.

During the first income year, and notwithstanding the transfer of the chief agency to Marlborough, the law firm's cashier and receptionist continued as in previous years to write out receipts on the South British Insurance Co. Ltd.'s receipt forms for premiums received for that company, and to pay the amounts so received into the bank account of the insurance company. In evidence, M said that he and W intended to make a charge against Marlborough for the use of the firm's staff when they took out a survey of the time involved. However, they never did fix a charge. The South British Insurance Co. Ltd. rendered a statement to Marlborough at the law firm's post office box address each month showing the commissions due and the office allowance. Marlborough did not have its own bank account in this first income year and the commissions were paid into the law firm's trust account to the credit of Marlborough. In this way Marlborough received for the first income year £536.12.9 for insurance commission. It also received £41.13.4 noted in Marlborough's profit and loss account as office hire. M explained in evidence that this was to cover any space used in running the agency. In fact Marlborough provided no space. It had neither staff nor premises. It was the law firm's premises that were used for running the agency.

As already noted, K was brought into the law partnership as an equal one-third partner from the beginning of the second income year. During that year the W and M family trusts both transferred to Mrs. K 166 shares in Marlborough. Each trust thereafter held 834 shares, and Mrs. K. 332 shares. During that second income year Marlborough received £571.10.0 for commission on the insurance company's business, which sum was apparently paid direct into Marlborough's bank account. The receipting and banking of premiums was still done at the premises of the law firm by the same cashier and receptionist who (as will be seen) had now become employees of Marlborough.

The second transaction in question relates to the hire of dictating machines. In September 1964, W and M needed two of these machines for their law firm and they decided that these should be leased by Marlborough from the company supplying the machines, and then leased by Marlborough to the firm. The arrangements with the supply company were made by W, and M said in evidence that he thought the supply company were under the impression that they were dealing with the law firm. That explains why the name of the firm was typed in as hirer in the two hire agreements, Marlborough's name later being overwritten in ink. As M explained the transaction in evidence:

``We put a small-the company put a small premium on to the rental it itself paid and the idea was that this would assist to increase the amount of income in the hands of Marlborough Developments Ltd. and therefore in the hands of the family trusts. We paid-the partnership paid £2 a week. The company paid £1.13.6 a week.''

I think that this passage, recording exactly what M said in evidence before the Court, reflects the true position. The result of it was that the law firm thenceforth paid 6/6d per week more for the machines than it would have done if it had hired them from the supply company. The 6/6d weekly found its way in half shares through Marlborough to the two family trusts. The ``small premium'' was in fact just under 20%.

The third matter in issue relates to a service agreement between the law firm and Marlborough under which the latter, for a consideration, took over no less than the provision of all the office accommodation, equipment, library and staffing services the firm would require from the beginning of the second income year. The background of this conception, as explained in evidence by M, was his family circumstances, the trend (as he saw it) of young men ``moving in and out of partnerships fairly freely'', increasing

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mechanisation in solicitors' offices, the administrative advantages of divorcing the administration side of an office from the operations side, and the thought that the income from Marlborough could be used to assist retiring partners ``without the necessity for their being any longer inter-meddled in the affairs of the partnership''. The objects in view were sought to be achieved by three different but related transactions.

First, by a deed of assignment dated 31 March 1965 (when the partnership between them was dissolved and replaced by a partnership including K), W and M assigned to Marlborough the lease of their office premises which then had four years of a five year term to run. The consideration was £300, which amount was fixed on the footing that the leasehold depreciated in value by £75 in each year.

Secondly, by another deed on the same date W and M sold to Marlborough their office plant, furniture, library and equipment, which they had used in carrying on their practice. The price for this was £1,700, which had been the value fixed when W and M had dissolved partnership a year earlier with their retiring senior partner. The deed evidencing the sale of this equipment provided that the price should be payable on demand, and Marlborough covenanted that it would give security over the equipment whenever called upon to do so. There was no provision for interest on the purchase money.

Shortly before 31 March 1965, M had informed the firm's staff that their employment would be terminated as from 31 March and that, as from 1 April, they would be employed on the same terms and conditions by Marlborough. That was the background to a third deed, dated 1 April 1965, and made between Marlborough of the one part and W, M and K of the other part. This deed was declared to continue in force until determined by either party by at least 6 months' notice in writing. In it Marlborough covenanted to provide the law firm with satisfactory premises; to keep the premises in good order and repair and to pay rates, insurance and other outgoings including electric power and office cleaning; to provide proper furnishings, fittings and floor coverings; to provide an efficient staff comprising three typists, one receptionist, two law clerks, one accountant, and one book-keeping machine operator; to provide a law library comprising New Zealand Statutes and Regulations, Halsbury's Laws of England, New Zealand and Gazette Law Reports, Weekly Law Reports, ``and all text books necessary or desirable for the practice of law in Blenheim'' and to keep that library annotated and up to date; to provide not less than four typewriters, ten dictating machines, two book-keeping machines, and one adding machine, and to maintain these in good order and condition; and to provide all stationery and forms required by the law firm in its practice. On their side, W, M and K covenanted to take good care of the premises, fittings and machines, and to advise Marlborough in the event of any maintenance or repairs being required. They were to pay Marlborough £8,520 per annum. M explained in evidence that he fixed this consideration by estimating what the outgoings of the firm would be, and adding 15% to cover profit and contingencies. In cross-examination he said that this margin was to supply family income which would have continued in the event of the death or retirement of a partner. He agreed that the administrative advantages of the service agreement could have been achieved without giving Marlborough that net income. He admitted that he knew of no similar service agreement in any other law firm in New Zealand.

To correct an error of £2,000 in the computation of the firm's salary bill and to provide a further £600 for additional staff, the deed was varied soon afterwards by amending the consideration to £1,120 payable by monthly instalments. M agreed in evidence that these instalments provided all the money that Marlborough needed to supply the services.

The effect of the service agreement with Marlborough is shown up by a comparison of the law firm's accounts for the first and second income years. Though there was little change in the day-to-day conduct of the firm's practice, and virtually none in the work and responsibilities of the partners themselves, a not insubstantial part of the income produced was diverted from them through Marlborough to the two family trusts and Mrs. K. The firm's gross receipts (excluding disbursements) increased from the first to the second income year by £3,964 but the total net return to the three objectors went up by only £337. Most of the difference appears in the accounts of Marlborough which, on a

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capital of £2,000, achieved in the second income year a return of over 100% in making a profit of £2,064.

It is desirable to explain how Marlborough was operated. During the first income year the directors were W and M and their respective wives. During the second income year the directors were Mrs. W, Mrs. M and Mrs. K. M conceded in evidence that during the two years the directors never made a policy decision against the wishes of the partners for the time being in the law firm. As from the beginning of the second income year Marlborough's responsibilities under the service agreement were attended to by the man who had been the accountant in the law firm, he too becoming an employee of Marlborough. He dealt with the staff, but M said in evidence that he had never granted any increase in salary to any employee without first discussing it with the partners in the law firm.

In the first income year the interests of the W and M family trusts in Marlborough were the same as the interests of W and M in the law firm. In the second income year the interests of the W, M and K families in Marlborough were the same as the interests of W, M and K respectively in the law firm up to 30 June. At that point, as already mentioned, K's share in the partnership was doubled but no adjustment was made in his wife's shareholding in Marlborough. During the first income year the profit of Marlborough, after allowance for taxation, was £457.11.4, and an amount of £379.15.0 was distributed approximately equally to the two family trusts. In the second income year Marlborough's profit, after provision for taxation, was £1,474.4.8, depreciation having been allowed in the accounts at £717.18.0. During that second year, £702.10.0 was spent in cash on the purchase of additional plant and equipment. Some £1,320 was distributed to the shareholders by way of dividend or advance, the total distributions being in exact proportion to the respective shareholdings. M agreed in evidence that the whole of the amounts paid out by Marlborough to the W and M family trusts were spent on family expenses in connection with the children of the two families.

The case stated records that the Commissioner considered that the transfers of the shares in Marlborough; the transfer of the chief agency for the South British Insurance Co. Ltd. to Marlborough and its subsequent receipt of commissions; the hiring by Marlborough of dictating machines from the supply company and the re-hiring to the law firm; and the deeds covering the assignment of the lease of the law firm's premises, the sale of its equipment, and the supply of staff and equipment, were all void under sec. 108. Accordingly the Commissioner considered that, for the first income year, Marlborough's gross receipts (less its expenses excluding accountancy fees) should be added to the income of the law firm; and, for the second income year, Marlborough's gross receipts (less its expenses excluding accountancy fees and director's fees) should also be added to the income of the law firm. On this basis he made amended assessments in respect of the income of the respective objectors. The objectors having made objections which were disallowed, the Commissioner was required to state a case.

In the case stated the Commissioner makes two alternative contentions. The first is that the assessments just mentioned were properly made and should be upheld. Alternatively, the Commissioner's contention is that, the transactions in question being void, the amount of £55.10.0 paid by the law firm to Marlborough for rental of the dictating machines in the first income year, and the amount of £11,136.17.7 paid by it to Marlborough for service charges in the second income year, should each not be allowed as deductions; and that the insurance commissions received by Marlborough in the two years should be added to the assessable income of the firm for those years. It will be seen that this alternative contention involves depriving the law firm of deductions in respect of those normal outgoings for rent, salaries and the like which were covered by the service agreement with Marlborough. The Commissioner invites the Court, if it upholds that alternative contention, to exercise its power to amend or increase the assessments.

The contention for the objectors, as set out in the case stated, is that the transactions in question do not fall within sec. 108, being capable of explanation by reference to ordinary family or business dealing; and that, if sec. 108 does apply, the Commissioner cannot arrive at a taxable situation without reconstructing, which sec. 108 does not permit. The objectors also contend that sec. 108 does not apply to future profits or to a deduction.

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Counsel conceded that, in view of
Elmiger v. Commr. of I.R. (1967) N.Z.L.R. 161, he could not maintain that contention at all in regard to future profits or in that form as to a deduction, but he said he would contend that the circumstances did not justify disallowing the deductions claimed.

Having stated the facts and the opposing contentions I must now reach a decision on each of the three matters in issue. I approach this by enquiring first in regard to each in turn whether sec. 108 applies to render void the arrangements in question. The section avoids the arrangement ``in so far as, directly or indirectly, it has or purports to have the purpose or effect of in any way altering the incidence of income tax, or relieving any person from his liability to pay income tax.'' In applying that section the principles, if I may re-state part of what I adapted in
Marx v. Commr. of I.R. (1969) N.Z.L.R. 464, from the leading case of
Newton v. Commissioner of Taxation (1958) A.C. 450, are these:

``3. The word `purpose' relates not to the motives of the parties but to the end in view. The word `effect' means the end accomplished. The whole set of words denotes concerted action to the end of altering the incidence of income tax or effecting relief from income tax.

4. The purpose and effect is ascertained by examining the overt acts by which the arrangement was implemented. If on that examination it can be predicated that it was so implemented as to alter the incidence of or bring about relief from tax then it is within the section even if there were other purposes as well. It is enough if that was one of the purposes.

5. If it cannot be predicated that the arrangement was implemented in that way so as to alter the incidence of or bring about relief from tax, but it is capable of explanation by reference to ordinary business or family dealing without necessarily being labelled as a means of altering the incidence of or relief from tax, then it is not caught by the section.''

As to the insurance agency, Mr. Chilwell contended that the transfer from the law firm to Marlborough was capable of explanation as ordinary family dealing. He described the agency as an advantage of a capital nature capable of producing its own income, and he said that it is ordinary family dealing to transfer an income earning asset to one's family or to some intermediary on their behalf. Alternatively, he contended that the transfer was capable of explanation by reference to ordinary business dealing without necessarily being labelled as a means of altering the incidence of or relief from tax. I think the normal insurance agency, as held by some firms of solicitors in New Zealand, may well be regarded as an advantage of a capital nature capable of producing its own income. But one must look at the particular facts and the evidence. In the case of this chief agency the law firm had work to do and a service to provide in order to earn the commission it received. Its employees had to receive premiums from anyone who chose to pay at the office of the firm in Blenheim rather than to the insurance company in Nelson. They had to issue receipts and bank the money. The insurance company evidently thought it right to contribute to the cost of the office space used. That space was the firm's office space. In addition, the partners themselves did a certain amount not only in attracting business but also in advising the insurance company's local representative on various matters. In truth, therefore, it was the actual carrying on of the practice by the partners and the staff they employed that produced the income that the commission represented. Looking, then, at the overt acts by which the arrangement was implemented, including the correspondence and the transfer of the agency to Marlborough coupled with the transfers of shares in that company, I think it must be predicated that the end in view, and the end accomplished, was an alteration of the incidence of the tax exigible on the income produced by the practice so that it would fall on Marlborough as well as the partners, with consequential relief from liability for the latter. In my view, therefore, sec. 108 applies to render void the transfer of the insurance agency by W and M, as the partners in the law firm at the time, to Marlborough.

I can deal with the second and third matters together, bearing in mind that the arrangements as to the dictating machines affected only the first income year, and the arrangements relating to the service agreement only the second. I need waste no words on these. Each was patently a scheme of tax alteration and relief as surprising, when found within the legal profession, as it was bold. Neither set of transactions can be explained

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on any other basis than that the purpose and the effect was to provide for the partners in the law firm an inflated deduction for tax purposes while at the same time diverting a corresponding amount to the families of the respective partners. I hold that sec. 108 applies to avoid both the hiring of the dictating machines by Marlborough to the firm and the various transactions which led to and included the service agreement.

The next question is whether, when the transactions relating to each of the three matters in turn are put aside, a tax liability falls on the objectors. As to the insurance agency Mr. Chilwell contended that, even if the transfer to Marlborough is void, that does not expose a situation where money is found in the hands of the objectors. He relies on the circumstance that Marlborough itself cannot be put aside, having been in existence long before any of the transactions in question, and that avoidance of the transfer of the agency still leaves the actual fact that the commissions were paid to Marlborough and not to the law firm. Allowing the avoidance of the transfer of the agency, he says that it is impermissible reconstruction to assume that the agency passed from the law firm as constituted before 1 April 1964 to the new partnership formed on that date, and that it is even further reconstruction to assume that K acquired a third share in the agency when he became a partner a year later. This argument was based, of course, on the well-established principle that sec. 108 is an annihilating provision only and that annihilation of the actual transaction impugned is not enough to impose a tax liability which could only arise from another transaction into which the taxpayer might have entered but did not in fact enter.

I think that Mr. Chilwell's contentions overlook the nature of the insurance agency and the income it produced. Though that income had to be earned it did not depend, as do the costs for a solicitor's services to a private client or a medical practitioner's fees for treating a patient, on individual service in the case in point. The income came in, as I have said, because the practice was carried on. It endured for the firm, however constituted, so long as the work was done. Accordingly, when the transfer of the agency to Marlborough is set aside what is left is a situation in which the commission is seen as continuing to be earned by the carrying on of the law firm's practice by the partners for the time being and the staff they employed. It was part of the income of the firm. That it was in fact regarded as the income of the partners for the time being, whoever they were, is evident from the correspondence with the insurance company. Though the former senior partner had just retired from the firm there is no hint in that correspondence of any need for him to notify the insurance company of his relinquishment of his share of the agency, or of his assent to the purported transfer to Marlborough. Quite clearly W and M regarded themselves as succeeding to the agency on 1 April 1964 for the simple reason that it belonged to the firm and they were the firm. In the same way they would have regarded K, when he was admitted to partnership on 1 April 1965, and K would have regarded himself, as becoming entitled to his share of the commission earned from the agency just as he became liable for his share of the firm's running expenses. I accept Mr. Richardson's contention that the situation is akin to that in
Peate v. C. of T. (1967) 1 A.C. 308, where, speaking of the argument that attributing the income of Westbank Ltd. to the partnership of doctors amounted to substituting contracts not in fact made, the Judicial Committee said (at p. 333)-

``In so far as patients did in fact contract to pay Westbank for the treatment they received, treating the income of Westbank as that of the doctors does not in their Lordships' opinion require any substitution of any contract for that made by the patient. The sums received by Westbank from such patients were, as were the fees earned by the doctors employed by Westbank at a salary, part of the income of the doctors who were, if the existence of Westbank is disregarded, in receipt of income jointly.''

The fact that Westbank Ltd. was annihilated by the operation of the section in Peate's case (supra) and that Marlborough cannot be annihilated in the present case does not, I think, affect the result. In
Clarke v. F.C. of T. (1932) 48 C.L.R. 56, the company that was intended to receive the moneys there in question had been formed some months before the transaction and could not be annihilated. In fact the moneys were paid to the taxpayer himself and not to the company but Fullagar J., referring to that point when dealing with Clarke's case in
F.C. of T.

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v. Newton (1957) 96 C.L.R. 577, at p. 650-1, found it impossible to think that the position would have been different had the payment been made to the company. He said that when the arrangement had been stripped away it would have been manifest that the money had found its way (albeit in a devious way) into the pocket of the taxpayer. Again, in the later case of
Hancock v. F.C. of T. (1961) 108 C.L.R. 258, the High Court treated dividends paid to the transferee of shares purchased under an arrangement which the Court held void under the section as taxable income in the hands of the transferors. At p. 292, Kitto J. said-

``The consequence which sec. 260 produces is that the transfers of the 7,728 shares to Rowdell are to be treated as void, and Rowdell's receipt of the dividend moneys in respect of those shares is to be considered a receipt of the Hancocks' moneys by arrangement with them, and therefore as a derivation of those moneys by the Hancocks, with the character of company distributions still upon them.''

So, here, I think that Marlborough's receipt of the insurance commission during the two income years in question must on the facts of the case be considered as a receipt for and by arrangement with the law firm, and therefore as a derivation of income by the partners for the time being.

As to the dictating machines, Mr. Chilwell submitted that the hiring from the supply company to Marlborough must stand, and that annihilation of the re-hiring from Marlborough to the law firm does not allow the Commissioner to substitute a direct hiring from the supply company to the firm. On the same lines, and in respect of the second income year, he contended that annihilation of the service arrangement and the particular contracts implementing it did not warrant attributing to the law firm as newly constituted on 1 April 1965 the obligations as to office rent, library, plant, equipment and staff that were undertaken by Marlborough. He supported this with detailed argument that avoidance of the assignment of the lease to Marlborough did not justify an assumption that K would on 1 April 1965 have become a lessee with W and M; and that, as to the staff, their respective contracts of employment came to an end on the dissolution of the partnership between W and M on 31 March 1965, and that new contracts of employment by W, M and K with a staff changing from time to time could not be substituted for the contracts of employment of staff by Marlborough. He contended that if the sale of the plant and equipment to Marlborough were ignored that left W and M as the owners and that K could not be allowed, as the assessment against him did allow, his share of depreciation and insurance. Again, he pointed out that new plant costing £1,514.10.0 was in fact purchased by Marlborough in the second income year and he submitted that that purchase must stand unaffected by the annihilation of the service agreement.

For all this Mr. Chilwell relied on the case of
Cecil Bros. Pty. Ltd. v. F.C. of T. (1964) 111 C.L.R. 430 where the taxpayer, a retailer, bought its stock from a family company, formed independently some years earlier, at a price considerably higher than that company paid the manufacturer for the same stock. The Commissioner unsuccessfully invoked the Australian counterpart of sec. 108 to deny the taxpayer any greater deduction for tax purposes than the price the family company had paid the manufacturer. Apart from its different form, the Australian provision differs from sec. 108 (as it stood at the material time) in that it avoids arrangements only as against the Commissioner. It was for that reason that the Commissioner in the Cecil Bros. case did not claim to ignore the taxpayer's contract with the family company but only in effect to vary it by reducing the price paid by the taxpayer down to the price paid to the manufacturer. So much is clear from the judgments of Owen J. at first instance at p. 436 and of Menzies J., who delivered the principal judgment on appeal, at p. 441. Owen J. held that the section applied and that the Commissioner was entitled to make that adjustment. On appeal Dixon C.J. (with whom Kitto and Windeyer JJ. concurred) did not think on the facts that there was any arrangement falling within the section. Presumably their Honours regarded the case as one of ordinary business or family dealing, for that was the argument for the taxpayer. Menzies J. was prepared to assume that the section applied. On that assumption he held, nevertheless, that it did not show that the taxpayer's real outgoings for stock were less than it had paid. In this present case I think the position is different. Here I have held that sec. 108 does apply. It therefore renders absolutely void all the contracts between

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Marlborough and the law firm, and the next step is to enquire whether a taxable situation is revealed. It is not a question, as in the Cecil Bros. case (p. 441), of whether the Revenue can ``disregard part of the price actually paid for goods pursuant to contracts the validity of which remains unaffected''. It is a question whether, contracts upon which the objectors claim deductible expenses having been entirely obliterated because their purpose and effect was to relieve from liability to pay tax, a tax liability falls in the light of the facts exposed. In my opinion it obviously does, and that leads to the next question as to what that liability is. The law on that point was given by the Judicial Committee in Peate's case (supra), at p. 331:

``... the Commissioner was entitled to assess the appellant on the income he would have received... if the arrangements coming within section (108) had not been made....''

In determining what that income would have been one can, of course, look back upon the taxpayer's actual income-earning activities in the period in question and the cases show that, in so doing, the Courts have been prepared to make assumptions as to what would have happened had the impugned arrangements not been made. Thus, as Mr. Richardson pointed out, in Peate's case (supra) (which was of the class I categorised in Marx's case (supra) as the ``spreading cases'') it was assumed that the doctors would have continued to practise in partnership if they had not entered into the elaborate arrangements under attack, and it was assumed that they would have paid the outgoings that the annihilated companies incurred. And in Elmiger's case (supra) (which, like the present aspect of this case, was a ``deduction case'') it was assumed that the appellants would have carried on their business in the same way and to the same extent whereas they might, had their advisers foreseen the Court's decision, have sold their business, reduced its scope or altered their methods. It must follow that the making of such assumptions is not contrary to the principle that the Court can look only at the actual facts exposed. Were it not so those decisions and others in favour of the Revenue would have been decided differently.

When the hiring of the dictating machines from Marlborough to the law firm in the first income year is put aside the remaining facts leave the firm carrying on its practice, and Marlborough paying £1.13.6 per week for machines hired from the supply company. But the facts also show that those machines were used not by Marlborough but exclusively by the law firm in the production of its income. If it is correct to hold, as I have held on the authority cited, that Marlborough's receipt of the insurance commission must be regarded as a receipt for and by arrangement with the law firm so as to make the commission the firm's income, then I can see no difference in principle in holding that Marlborough's expenditure on the machines hired for and used by the firm is to be seen as expenditure for and by arrangement with the firm so as to be the firm's expenditure. In Peate's case, the Judicial Committee, at p. 331, made the point (I substitute reference to the New Zealand sections) that sec. 108 has to be construed and applied with sec. 78 (which requires income tax to be assessed and levied on taxable income) and sec. 92 (which deems income dealt with on a person's behalf to have been derived by him though he has not actually received it). Peate's case, as I have said, was a ``spreading'' case. When the Judicial Committee's dictum is applied to a ``deduction case'' such as the present I think a reference to sec. 110 and 111, which allow as a deduction expenditure exclusively incurred in the production of assessable income, can properly be included in it with the other three sections. So applying it I conclude that in calculating its assessable income the law firm should be allowed as deductible the hire charge paid to the supply company for the machines that it used in producing that income. Its assessable income is then the ``profits or gains'' derived from its business, as contemplated by sec. 88(1)(a) of the Act.

In the second income year the setting aside of the assignment of the lease and the sale of plant and equipment to Marlborough leaves W and M as the lessees and owners. But this result and the avoidance of the service agreement between Marlborough and the three objectors still leaves the latter carrying on the practice in the shares agreed, occupying the same premises, using the plant and equipment, and served by the staff that in fact attended their offices and did their work. In that situation and by the same reasoning I think that Marlborough's expenditure, as in effect allowed in the assessments under

ATC 6050

objection, should be seen as the firm's expenditure, and allowed accordingly as deductible.

For these reasons the objections in my opinion fail. There is, however, one minor respect in which it seems that the assessments in the second income year require amendment. Both counsel agreed, I think, that if the sale of the plant and equipment to Marlborough were avoided, W and M remained the owners, and that there was in consequence no basis for an allowance to K of a deduction for a third share of the depreciation and insurance. On that footing those charges should therefore be shared equally by W and M and the three assessments amended accordingly.

I should record that this judgment was substantially prepared some time ago but completion and delivery has been withheld to await consideration of the judgments of the Court of Appeal just delivered on the taxpayer's appeal in Marx's case (supra).


The objections are disallowed and the questions in the case stated answered in accordance with this judgment. The objectors must pay the Commissioner's costs which I fix at $300.

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