Emu Bay Railway Co Ltd v Federal Commissioner of Taxation

Judges: Latham CJ
Rich J
Starke J
McTiernan J

Williams J

Subject References:
Taxation and revenue
Income tax
Assessment
Deductions
Outgoings incurred
Income insufficient to pay interest

Legislative References:
Income Tax Assessment Act 1936 No 27 - s 51

MELBOURNE

Judgment by:
Williams J

WILLIAMS J. The case stated raises the question whether in calculating the taxable income of the appellant company for the purposes of Federal income tax in respect of the financial year 1940-1941 the sum of PD13,333 13s. 6d. should be allowed as a deduction from its assessable income upon the ground that this sum was an outgoing incurred in gaining or producing the assessable income within the meaning of s. 51 of the Income Tax Assessment Act 1936-1940. This sum represented the interest at the rate of 5 per cent per annum on PD266,673 irredeemable debenture stock issued by the appellant pursuant to the provisions of a trust deed dated 7th April 1925 which accrued due during the accounting period, namely, the twelve months ending 31st December 1939, adopted by the appellant and accepted by the respondent as the year of income for the purpose of calculating its assessable income for the financial year in question.

The circumstances leading up to the execution of the trust deed are set out in the case stated and in the recitals to the deed and I need not re-state them. The deed was made between the appellant of the one part and the trustees of the other part and relates to the issue of 4 per cent irredeemable debenture stock limited to PD130,900 and of 5 per cent irredeemable debenture stock limited to PD267,064. It incorporates a number of the provisions contained in an earlier indenture dated 11th July 1899 referred to as the "principal Indenture". These provisions, which include, inter alia, the events upon which the power of sale vested in the trustees under clause 16 of the trust deed becomes exercisable, do not form part of the case, but the Court has been informed that they are not relevant to the determination of the case and that the principal indenture contains certain detailed provisions relating to the exercise by the trustees of their powers and other matters of a purely administrative or machinery kind. As the Court is called upon to construe the trust deed in order to answer the questions asked, I should have preferred that the whole and not some of its provisions should have been placed before the Court and I should have liked to know at least what these events are.

The appellant is a company which carries on in Tasmania the business of operating certain railways. The general nature of irredeemable debenture stock issued by a company operating a public utility, whether it is a railway, canal, bridge, dock or any other form of public utility, has been discussed in several cases. The interest and the capital of the debt are usually but not invariably charged on the undertaking of the company, the interest being made payable, whilst the company is a going concern, only out of the net earnings of the company, but also being made a prior charge on the assets of the company if any event, such as liquidation, should occur to put the company out of business: In re Glyn Valley Tramway Co ^[F12] , at pp. 470, 471. While the company continues to carry on the business, the charge of the undertaking is construed to be a charge of the undertaking as a going concern, so that, although the trustees for the stock holders may be entitled to appoint a receiver of the net revenue if the interest falls into arrears, the receiver is not appointed, like an ordinary receiver, to manage and carry on the business of the company, but is more in the nature of a treasurer appointed to receive the revenue and make the disbursements in their proper order as the revenue comes in from the carrying on by the company of its business. See Attree v Hawe ^[F13] , at p. 348. In Gardner v London Chatham and Dover Railway Co [No. 1] ^[F14] Lord Cairns said:"The undertaking, so far as these contracts of mortgage are concerned, is, in my opinion, made over as a thing complete or to be completed; as a going concern, ... as a fruitbearing tree, the produce of which is the fund dedicated by the contract to secure and to pay the debt. The living and going concern ... must not, under a contract pledging it as security, be destroyed, broken up, or annihilated. The tolls and sums of money ejusdem generis-that is to say, the earnings of the undertaking-must be made available to satisfy the mortgage; but, in my opinion, the mortgagees cannot, under their mortgages, or as mortgagees-by seizing, or calling on this Court to seize, the capital, or the lands, or the proceeds of sales of land, or the stock of the undertaking-either prevent its completion, or reduce it into its original elements when it has been completed" ^[F15] .

In the same case, Turner L.J. said:"It may be asked why the undertaking was assigned by the debenture, if the security was to be limited to the funds of the undertaking only. This question admits, I think, of a very ready answer. The assignment of the undertaking was necessary for the protection of the debenture creditors against other claimants upon the property of the company" ^[F16] .

In Attree v Hawe ^[F17] , James L.J., in delivering the judgment of the Court of Appeal, said in a case where there was no conveyance or assignment of anything to the stock holder or to any trustee for him: "There is no debt, except, indeed, as to the annual interest; the capital cannot be called in, and cannot be paid off" ^[F18] . Later he said: "The result is that the debenture stock is a charge upon the net profits and earnings of a trading corporation, and is no more land, tenement, or hereditament, or any interest in land, tenement, or hereditament, or charge or incumbrance affecting land, tenement, or hereditament, than the share stock in such corporation is, or a bond or other debt due from a man who has got real property is" ^[F19] .

In Cross v Imperial Continental Gas Association ^[F20] , where again there was no assignment, Romer J. (as he then was), after referring to the judgment of the Court of Appeal in Attree v Hawe ^[F21] , said: "It follows that the debenture stock did not constitute a specific charge upon the German property, and that, in as much as no interest upon it is in arrear, there is no debt due to the debenture stockholders" ^[F22] .

The trust deed in the present case expressly provides for the creation of two charges over the assets of the appellant in favour of the holders of the 4 per cent and the 5 per cent stock. The holders of the 4 per cent stock have a prior charge over the assets referred to in the first schedule, and they share pari passu with the holders of the 5 per cent stock in the floating charge over the assets other than those comprised in the first schedule created by clause 10 of the trust deed. The trust deed contains in the second schedule the terms and conditions on which the 4 per cent stock is to be issued and in the third schedule the terms and conditions on which the 5 per cent stock is to be issued. These schedules also contain provisions for the issue of stock certificates under the seal of the company to the holders of each class of stock, but these certificates do not contain any covenant between the appellant and each individual stockholder, so that the contractual relations existing in respect of each class of stock are contained in the trust deed, the parties to the contract being the appellant and the trustees: In re Dunderland Iron Ore Co Ltd ^[F23] .

The second schedule states that the 4 per cent stock and interest is to be a first charge on all the property described in the first schedule and that the stock (a specific reference to interest is omitted) is also to be a charge on the other property and assets for the time being of the company ranking pari passu with the 5 per cent stock. The third schedule states that the 5 per cent stock (there is again no specific reference to interest) is to be charged and rank pari passu with the 4 per cent stock as a first charge upon all the property and assets of the company subject only to the prior charge for securing the 4 per cent stock on the property described in the first schedule thereto including a certain leasehold interest but is to rank pari passu with the 4 per cent stock on the other property of the company. But each class of stock confers upon its holders a right to the payment of both principal and interest, so that a charge of the stock on the company's assets without any express reference to interest would include a charge to secure both principal and interest, and it must have been intended that the 4 per cent stock holders would have the same charge for interest over the property referred to in clause 10 of the trust deed as they have over the property comprised in the first schedule. But any doubt is removed by the provisions of the trust deed itself, which expressly charge the assets of the company with the capital and interest owing on both classes of stock and clause 16 expressly provides, in the event of a sale, for the payment of arrears of interest out of the proceeds of sale. Clause 11 refers to the interest on the 5 per cent stock so far as the same shall be payable, but in the context of the whole of the trust deed, these words must relate, in my opinion, to the rights of the 5 per cent stock holders during the period of ten years ending 31st December 1933.

Clause 7 of the trust deed provides that "during the period of ten years ending on the 31st of December 1933 the interest on the 5 per cent stock shall be payable only out of the net income of the company from time to time available after payment of the interest upon the 4 per cent stock and after making proper provision for the upkeep of the company's railways rolling stock workshops buildings plant and tools including the setting aside of reasonable sums for depreciation and after paying the company's directors fees and the remuneration of the Trustees and discharging all other outgoings and making all other provisions properly chargeable against revenue and necessary to secure the efficient maintenance and working of the said railways and after the expiration of such period the interest on the 5 per cent stock shall be cumulative. In the event of any question dispute or difference arising at any time between the company and the trustees as to the amount of the net income of the company available as aforesaid at the close of any half-year ending on the 30th of June or the 31st of December in any year or as to there being none the same shall be referred to the arbitration and final decision of a single arbitrator resident in the State of Victoria to be agreed upon by the parties or failing agreement to be nominated by the President for the time being of the Institute of Chartered Accountants in England whose decision or award shall be conclusive and this provision shall be deemed to be a submission to arbitration within the meaning of and subject to the provisions of the English Arbitration Act 1889 or any statutory modification or re-enactment thereof for the time being in force." The third schedule provides that "the interest is to be at the rate of PD5 per cent per annum as from the 31st day of December 1923 and is to be payable half-yearly on the 1st day of April and the 1st day of October in each year the first payment for the period from the 31st day of December 1924 to 30th day of June 1924 to be made on 1st day of October 1924. The interest is to be a charge upon and payable only out of the net annual income of the company as defined in the trust deed subject to the prior charge thereon of the interest upon the 4 per cent stock. The interest is not to be cumulative until after the 31st day of December 1933." If clause 7 stood alone, it might be open to argument that the limitation of the right to receive payment of the 5 per cent interest to a charge upon what is defined as the net income of the appellant is confined to the period of ten years ending on 31st December 1933. But the covenant in clause 11 of the trust deed is quite explicit that the obligations of the appellant with respect to payment of the amount of the 5 per cent stock and interest thereon are set out in the third schedule, and that schedule clearly provides that the interest is to be a charge upon and payable only out of the net annual income of the appellant as defined in the trust deed, subject to the prior charge thereon of the interest payable upon the 4 per cent stock and that the interest is not to be cumulative until after 31st December 1933. When clause 11 of the trust deed and the relevant provisions of the third schedule are read together, it becomes apparent, I think, that the main purpose of clause 7, though it is somewhat inartistically worded, is to define the net income of the appellant on which the interest on the 5 per cent stock is charged and out of which it is payable. The clause states that, during the period of ten years, the interest on the 5 per cent stock shall be payable only out of the net income of the company, but it is here referring, I think, to the period during which the interest, so far as there is no net income available to pay it, is not to be cumulative. The third schedule, in dealing with the rights of the 5 per cent stock holders, is quite specific that the interest is to be payable only out of the net annual income of the company, and the statement in the clause that, after the expiration of the period of ten years, the interest shall be cumulative in itself implies that it is to be payable out of an annual fund which may be insufficient to meet it. The second limb of the clause provides for the reference to arbitration of disputes as to the amount of the net income of the company at the close of any half-year ending on 30th June or 31st December in any year, so that this limb is unlimited in point of time. There is also the strong presumption, arising from the nature of the appellant's business, that the interest should be in the nature of an annuity payable out of the profits of the concern.

But the third schedule consists of two paragraphs, the first of which relates to the payment of the interest out of the net income of the appellant, while the second relates to the charge of the interest, so far as it is cumulative and is not discharged out of the net income, upon the assets of the appellant, and the statement in that schedule that the interest is to be payable only out of the net annual income of the company is insufficient, in my opinion, to prevent arrears of interest calculated at 5 per cent per annum which accrue due and are not paid from that source from becoming charged on the company's assets.

Upon the whole context of the trust deed, including the third schedule, the conclusion I have reached is that the agreement between the appellant and the trustees is that, during the period ending on 31st December 1933, the 5 per cent interest is only to be paid in each year so far as there is, in that year, net income of the appellant available to pay it, but that, after 31st December 1933, while the interest in any year is only payable in that year to the extent to which there is such net income, if the net income is insufficient for this purpose any balance which remains unpaid will accumulate and be payable out of the net income of any subsequent year to the extent to which that income is sufficient for the purpose, and any balance of interest which has accrued due and remains unpaid becomes charged upon the assets of the appellant and the trustees are secured creditors for the arrears of interest, so that, in the event of the company going into liquidation or upon a sale by the trustees of the assets upon the happening of one of the events provided for in clause 16; whatever these events may be, these arrears will be recoverable out of the assets of the company.

The accounts of the appellant for the year ending 31st December 1939 show that its revenue for that year was PD98,379 3s. 4d., and that, after allowing for traffic expenses, maintenance, management, repairs, office expenses, etc, PD77,599 17s. 4d.; rates and taxes including income taxes PD3,206 6s. 11d.; interest PD811 19s.; depreciation PD8,754 16s. 7d.; provision for upkeep of rolling stock etc PD700; a balance to be carried down remained of PD7,306 3s. 6d., to which there was added a balance as at 31st December 1938 of PD79 16s. 7d., making the total to the credit of Profit and Loss Account of PD7,386 0s. 1d., out of which PD5,890 10s. and provisions for exchange PD1,479 2s. 7d. was required to pay the interest on the 4 per cent stock for the year, leaving a balance of PD16 7s. 6d. The case states that, for the twelve months ending on 31st December 1939, the appellant incurred a loss of PD63 as appears from its Profit and Loss Account annexed to its return for income tax; that for the same period its taxable income, if the deduction of PD13,333 13s. 6d. is not allowed, was PD6,675; and that, for the purpose of the assessment of the appellant to income tax for the financial year 1940-1941, the respondent assessed the appellant upon a taxable income of PD6,675 and issued a notice of assessment claiming that the sum of PD751 5s. was payable in respect of such income tax. The case does not explain how a loss of PD63 is converted into a taxable income of PD6,675, but I assume that this results from adjustments by way of diminution of the amounts charged against revenue in the Profit and Loss Account, and we were told during the hearing that the amount of taxable income was arrived at after allowing as a deduction the amount paid for interest but not the amount paid for exchange on the 4 per cent stock. The case also states that no part of the sum of PD13,333 13s. 6d. was, during the twelve months ending 31st December 1939, or has since been paid or credited to any holders of the 5 per cent stock.

Section 51 of the Income Tax Assessment Act 1936-1940 provides, so far as material, that all outgoings to the extent to which they are incurred in gaining or producing the assessable income shall be allowable deductions except to the extent to which they are losses or outgoings of capital. It has not, and could not, I think, be suggested in the present case that the debt of PD13,333 13s. 6d. if it was incurred in the accounting period, was not incurred in gaining or producing the assessable income or that it was an outgoing of capital, but counsel for the respondent has raised two contentions with respect to the section. The first contention is that the liability to pay interest on the 5 per cent stock in the accounting period was confined to the net income as defined by clause 7 of the trust deed available to meet it, and that, as there was only PD16 7s. 6d. available for this purpose, the amount of the outgoing incurred in the accounting period was not PD13,333 13s. 6d. but PD16 7s. 6d. or, in substance, nil. The second contention is that, even if the appellant incurred a liability of PD13,333 13s. 6d. in the accounting period, it did not discharge any part of that liability and the outgoings that can be deducted under the section are liabilities that have been actually discharged during the accounting period. I cannot agree with the second contention. Outgoings, which is a word of the widest import, must include debts. A taxpayer incurs a debt when it becomes due and owing, although it may not be immediately payable, so that debts incurred during the year of income are outgoings incurred in that year within the meaning of the section whether they are paid or payable in that period or not: West Ham Corporation v Grant ^[F24] .

As Luxmoore L.J. said in Absalom v Talbot ^[F25] , at p. 600:"In ordinary parlance `debt' is the proper description to be applied to money which is owing and remains unpaid, whether the due date of payment has arrived or not, as witness the well-worn phrase `debitum in praesenti solvendum in futuro'." Cf. Naval Colliery Co (1897) Ltd v Inland Revenue Commissioners ^[F26] , at p. 596; Inland Revenue Commissioners v Bagnall Ltd ^[F27] ; cf. also per Latham C.J. in W. Nevill & Co Ltd v Federal Commissioner of Taxation ^[F28] , at p. 302; per Dixon J. in Elder Smith & Co Ltd v Commissioner of Taxation (N.S.W.) ^[F29] , at p. 478 and New Zealand Flax Investments Ltd v Federal Commissioner of Taxation ^[F30] , at p. 207.

The substantial question is, therefore, whether the appellant incurred in the accounting period a debt of PD13,333 13s. 6d. or only incurred a debt to the extent to which it became liable to pay this sum as a going concern out of the net income for the year ending 31st December 1939. If the whole liability for the interest, although amounting to PD13,333 13s. 6d., was entirely confined to the net income of that year, so that, to the extent to which that income was insufficient to meet it, that liability was discharged, then the amount of the outgoings would no doubt be the amount of the net income; but the liability for the interest is not discharged in this manner, and the interest, to the extent to which it is not met, remains an actual debt due and owing by the appellant and charged on its future net income and its assets, although it is only payable in the particular ways already mentioned. It is apparent, I think, from the principles stated in the authorities which I have cited that, as each half-yearly payment of interest on the stock becomes due and owing, it creates a debt and the trustees become and remain secured creditors of the appellant for that amount of interest until it is paid.

Counsel for the respondent also contended that the trust deed on its true construction only conferred upon the holders of the 5 per cent stock a right to share in the distribution of the profits of the company to the extent to which interest had accrued due in the relevant period, and that this was a provision for payment out of taxable profits as distinguished from payment prior to the ascertainment of those profits. He relied on the decision of this Court in Commissioner of Taxation (W.A.) v Boulder Perseverance Ltd ^[F31] . The cases on this sort of question up to that date are collected in the report ^[F32] , and I shall simply add, in order to bring the matter up to date, that, as counsel pointed out, the case of British Sugar Manufacturers Ltd v Harris ^[F33] has since been reversed ^[F34] , and that there is a recent decision on the same subject matter: Utol Ltd v Inland Revenue Commissioners ^[F35] . But the present case is, in my opinion, completely distinguishable from the Boulder Perseverance Case ^[F36] on its facts. The 5 per cent stock holders are not entitled to any share in the profits of the company. They are entitled to interest on their money to be paid in a particular manner. So far as there is any analogy to that case, however distant, they are more in the position of the holders of the profit-sharing notes in respect of the ten per cent interest, which was admittedly a deduction from the assessable income.

For these reasons, I would answer the question asked in the affirmative on ground a and it then becomes unnecessary to deal with ground b.