Phillips v. Federal Commissioner of Taxation.

Waddell J

Supreme Court of New South Wales

Judgment date: Judgment handed down 6 May 1977.

Waddell J.: Before the Court are two appeals which have, by consent, been heard together. One is against the assessment made of the appellant's liability to income tax for the year ended 30th June 1972, the other against the assessment made for the year ended 30th June 1973.

The appellant has, since the 1st July 1971, been a partner in the firm of Fell & Starkey who have at all relevant times practised as chartered accountants throughout Australia. Their practice involved auditing, accounting, secretarial work, the giving of taxation and managerial advice, the conduct of liquidations, receiverships and similar type of work and the maintenance of share registers. The firm has been a member of an international partnership Whinney, Murray, Ernst and Ernst, the other partners being a firm in the United States and a British firm.

In assessing the taxpayer's income for the 1972 year the Commissioner added an amount of $3,263 representing his share of deductions claimed in the partnership return amounting to $375,217, which the Commissioner had disallowed. In the assessment for the 1973 tax year the Commissioner added the sum of $5,905 representing the taxpayer's share of deductions claimed in the partnership return amounting to $470,954. The deductions represented secretarial charges and interest. The taxpayer objected to each assessment. The objection was disallowed and being dissatisfied he required that his objection be treated as an appeal and forwarded to this Court.

The deductions disallowed were for moneys paid or accrued due to the First Meritable Trust (the ``Trust'') which had been set up by Fell & Starkey to provide the partnership with secretarial and other services as from the 1st August 1971 in the following circumstances.

Late in 1970 some of the senior partners were considering the establishment of a separate legal entity to carry out various activities previously carried out by the partnership. This proposal was described in a letter of the 30th November 1970 written to the Deputy Commissioner of Taxation in the following terms:

``In recent years there has developed an increasing concern by all partners of this firm and indeed all members of the profession about the liabilities we are facing at the moment and which are likely to grow in the future. Since the recent well publicised case against an audit firm, the implications of the judgment in Evatt v. M.L.C. and the large number of legal suits brought against professional accountants overseas, particularly in the U.S.A., the likelihood of legal action being taken against the firm and individual partners has increased. The potential liability cannot be limited by incorporation and although some protection can be afforded by professional indemnity insurance this is extremely costly, it is impossible to estimate required cover and the relevant policies are subject to considerable doubt as to their complete effectiveness in certain cases.

Consequently, it is considered most desirable to diminish the assets held beneficially by the firm and its individual partners and increase the assets held for the benefit of their families outside the possibilities of loss to litigation minded clients and third parties.

At present the firm has 31 partners and approximately 300 staff and its basic function is to provide auditing, accounting, taxation and financial advisory services to clients which can be described as its true

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professional activities. In addition, the firm provides services of a nature which are more frequently provided by commercial organisations. Such services include maintenance of company share registers, personnel selection, production engineering and planning, electronic data processing, typing, printing and copying and clerical assistance for a variety of clients.

Under the Charter and By-laws of the Institute of Chartered Accountants in Australia no person may be a partner and participate in profits from or contribute capital for any activity carried on by the firm as such unless that person is a member of the Institute. The foregoing `commercial type' activities need not be carried on by a firm of Chartered Accountants and it is now proposed to divorce certain of these activities from the firm to be carried on by a separate entity.

The proposed entity to conduct these operations is a Unit Trust, the units in which will be held by the wives, family trusts and/or family companies of partners. In some instances the units may be held by the partner himself. The Trustee of the Unit Trust will be Fellstar Holdings Pty. Ltd. and the Manager will be Fellstar Secretariat Pty. Ltd. No partner will be a director of or a beneficial owner of any share in these companies. Fair and reasonable fees will be charged to the Unit Trust by these companies for their services as manager and trustee.

Funds to be used by the Unit Trust will be provided direct by the unit holders and by way of bank overdraft, and will not be financed by any loans from the firm. The Unit Trust through its manager will employ its own executive staff who will be responsible for its operation, administration, staff supervision etc. It is envisaged that the Unit Trust will sell its service to Fell & Starkey and direct to the business community in competition with existing commercial enterprises. It is estimated that the activities will produce a net profit in a full year of between $160,000 and $190,000.

The proposed activities of the Unit Trust through its manager are set out below:

(a) employ service personnel as follows:

Messengers, filing clerks, machine operators, typists,
receptionists, administration personnel and share clerks, and
provide these services to F. & S. and any other outside firm for a
fee based on cost of direct salaries per working week, plus 50%.
This is in keeping with the rate of fee charged by commercial
firms for similar services. The Unit Trust will be liable for
superannuation, holiday and sick pay, payroll tax, workers
compensation, insurance, management salaries and expenses

Estimated to produce profit of between                      $85,000 -  $100,000

(b) Undertake photocopying, duplicating and printing for F.& S.,
    and other firms at normal commercial rates.

Estimated to produce profit of between                       $10,000 -  $13,000

(c) Organise local and interstate staff training courses,
    seminars etc., by specialist training officer and staff including
    all travel and accommodation arrangements.

Estimated to produce profit of between                        $8,000 -  $10,000

(d) Lease furniture and equipment to F. & S. at normal
commercial rates.

Estimated to produce profit of between

                           $20,000 -  $25,000
(e) Make unsecured loans to F. & S. at normal interest rates
    on such loans (e.g. 10% p.a.) to assist in providing working

Estimated interest between                                   $20,000 -  $22,000

(f) Act as insurance agents for F. & S. and other clients.

Estimated commission between                                 $17,000 -  $20,000
Estimated net profit after all expenses under
conditions and existing level of business for a full year -
between                                                   $160,000 -  $190,000

Would you kindly confirm that the foregoing income will be assessed as income of the Unit Trust and its unit holders under the provision of Div. 6 of the Income Tax Assessment Act and, to the extent that payments in respect of the foregoing will be made by Fell & Starkey, be allowed as deductions to that firm.''

The Commissioner did not reply to this letter until the 23rd June 1971 when he informed Fell & Starkey that it was ``not practicable to accept that the scheme that you have described would be effective for the purposes of the Income Tax Assessment Act''. The officer dealing with the matter had verbally informed one of the partners of this decision some days before the letter reached them.

In the meantime the proposed trustee, Fellstar Holdings Pty. Limited (hereinafter called ``Holdings'') and the proposed manager, Fellstar Secretariat Pty. Limited (hereinafter called ``Secretariat'') were incorporated in Victoria on the 22nd December 1970. Not long after incorporation a Mr. Langley and a Mr. Curtis, both partners in a Melbourne firm of solicitors, each became directors of Holdings and they together held one share each, there being only two issued shares in the company. Shortly after incorporation a Mr. Harrison and a Mr. Rothwell became the directors of Secretariat, each holding one share, there being only two issued shares. Neither of these persons was then a partner in Fell & Starkey but Mr.Harrison had been a partner in David Fell & Company in Melbourne prior to the merger of that firm with Fell & Starkey. At about this time a trust deed was prepared. The parties were Holdings as trustee, Secretariat as manager, and, collectively, persons who became unit holders. The trust to be constituted was to be called the First Meritable Trust. Provision was made for the lodging of $100 cash by Secretariat to establish the trust, and for the lodging of cash by other persons and for the creation and issue of units of $1 each equal to the amounts lodged until, in the opinion of Secretariat, sufficient funds had been lodged for the purposes of the trust. Provision was made for the lodging of further moneys if required at a price per unit related to the existing value of the fund. The trustee was given a wide power of investment of the fund including in chattels personal and in particular in articles which might be used as office furniture or equipment and in any business undertaking acquired or commenced by the trustee at the request of the manager.

After advice had been received from the Commissioner of Taxation that he could not commit himself to accept the proposal, steps were taken to establish the trust and the trust deed was executed on the 30th June 1971. Shortly afterwards 100 units were issued to Secretariat. On about the 15th July a circular was sent to all partners attaching a summary of the method of establishing and maintaining the trust as a service organisation for the partnership and an application form for units. Each partner was asked to notify the partners in charge of his office that he consented to the scheme being put into operation. It was stated that there would be three allotments of units, the first on the 30th July, the second on the 31st October and the third on the 31st December 1971. The number of units for which a partner or his nominee might apply, depending upon whether he was a full or fractional partner, were also stated. The circular went on to say:

``4. The date set for the commencement of the Trust's operations is 1st August, 1971 and we would like to be in a position to bank all cheques relating to all the transactions in all locations on Friday, 30th

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July. It is proposed that all cash transfers involving Fell & Starkey will be done through the firm's bank account in Melbourne.

5. Each partner will be posted a Fell & Starkey cheque payable to him for $8,000 (or the pro rata amount if he is not a full partner) which amount will be debited to his current account. Please do not bank this cheque until Friday, 30th July.

6. Unit holders cheques for application money must be in Melbourne by Thursday, 29th July at the latest and will be banked on Friday, 30th July. Transactions between the Unit Trust and Fell & Starkey will take place in Melbourne on the same date.''

All partners concurred in the proposal and units were issued in accordance with their respective entitlements. With the exception of one partner who subscribed for units personally each partner's entitlement was issued to his wife or one of his children or a company as trustee for a family trust or to a company as beneficial owner. The summary attached to the circular was set out in question and answer form. Some of these should be quoted:

``Why should F. & S. have a service organisation

1. To move assets away from partners to minimise consequences of successful litigation.

2. To reduce taxes; income tax during your lifetime and death duties upon your death.''

``Why should the service organisation be a unit trust

1. To avoid control by participants.

2. To ensure ease on admission, retirement, expulsion and divorce of partners.

3. To avoid company tax.''

``Who may be a member

1. A trust for the benefit of a partner's wife and/or members of his family; (the trustee should not be a partner or the firm's Nominee company)

2. A partner's wife or other relative;

3. A partner.''

``Where does unit holder get the money from to pay for units

Wholly from unit holder's own funds. If the nominated unit holder does not possess adequate funds to take up the units, funds may be provided by gift or loan from bank etc. If loans are made by a partner to the unit holder you will not achieve the objective of reducing your assets and it is considered that the taxation benefits will be frustrated.''

``Where does the money go to

1. Capital passes -

From the unit holder
  the unit trust                      (subscription)
  Fell & Starkey                    (purchase of assets,
                                        advances etc.)
    the partner                      (reduction of capital,
   the unit holder                    (gift, repayment of
                                           existing loan)

2. Income passes

From Fell & Starkey
  the unit trust                     (fees for services,
                                      plant hiring charges,
                                      insurance premiums,
                                      interest, profit on
                                      subletting premises)
  the unit holder                    (distribution)''

``Applications for units

If the scheme is approved, you will be invited to nominate applicants for units by 30th July. An additional units will be available for subscription at a later date. The applicant's cheque for the initial issue must be in the hands of Fellstar Secretariat Pty. Ltd. in Melbourne by 29th July to facilitate an orderly flow of funds. These cheques will not be presented for payment before 2nd August, 1971. These applications will enable the fund managers to enter into a contract for the purchase of all office equipment, furniture and furnishings, (including partitions). F. & S., having thereby sold these assets, will be able to permit a reduction in capital on 29th

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July, 1971. Funds will be transferred from the firm's bank account in Melbourne to meet these cheques on presentation. The funds released by the firm's capital may then be used by the partners in any manner they wish but many no doubt will wish to make gifts to their nominated unit holder or to repay existing loans from their wives. If necessary, these arrangements should be effected by 30th July, 1971 so that the unit holder's cheque can be met on presentation on 2nd August, 1971.''

There is also a summary of advantages and disadvantages of the proposal.

The taxpayer's personal motivation in accepting the proposal, so far as it may be relevant, was that he saw it as the basis upon which the partnership to which he was about to be admitted was going to operate from the 1st August. However, he said that the matters which were set out in the letter of the 30th November were certainly very significant in the minds of all the partners at that time, those matters dealing primarily with the concern the partners had over the protection of their assets and the opportunity to continue business in the event of litigation being brought against them successfully for negligence and an award being made for damages in excess of their professional negligence cover or, what they thought to be more likely at that time, the possibility that professional indemnity insurance might not be available at a sensible cost. The partners had very much in their mind the large award of damages made during 1970 against Price Waterhouse & Co. in favour of Pacific Acceptance Corporation Limited.

On the 30th July 1971 the directors of Secretariat resolved that in pursuance of the operation of the Trust a number of undertakings be carried out by it on behalf of the Trust. These included the business of providing all the services which were subsequently performed for Fell & Starkey. The resolution is in general terms. On the same day Secretariat purchased for the Trust from Fell & Starkey the whole of its furniture, office machines, partitions and other equipment for the total sum of $198,973. The whole of the non-professional staff employed by Fell & Starkey had been given notice to terminate their employment on the last day of July 1971 and had been offered fresh employment by Secretariat on behalf of the Trust from the 1st August and had all accepted that offer. On the 1st August the directors of Secretariat resolved that the Trust offer its services in relation to the lease of office furniture and equipment, the provision of clerical and secretarial staff and share registry services at certain rates specified in the resolution. Such an offer was made, and Fell & Starkey accepted these services at these rates. The Trust has not provided such services for any other party. On the 2nd August the directors of Secretariat resolved that 220,000 units to the value of $220,000 be issued.

Since the 1st August 1971 Fell & Starkey has obtained all the non-professional staff which it has required from Secretariat in accordance with the terms mentioned. It has hired all its office plant, furniture and equipment from Secretariat on these terms. Secretariat has provided share registry services for the partnership which has enabled it to provide these services for its clients. Also Secretariat has effected, as agent, certain insurance business previously effected by the partnership.

The rates agreed upon for the above services are, I think, established by the evidence to be realistic and not in excess of commercial rates. The rate fixed for the provision of staff was that adopted by a client of the partnership which was engaged in the general hire of office personnel to the public at large. The rate fixed for hire of plant and furniture and equipment represents a return of only some 6% to 8% on funds employed which cannot be said to be excessive. The rate charged for share registry services, which may be compared with that charged for the hire of staff, cannot, on the evidence, be said to be excessive. But, of course, the outgoings of the partnership were increased by having these services provided by the Trust instead of providing them itself.

After the 1st August 1971 Secretariat rendered monthly accounts to Fell & Starkey which were either paid by cheque or accrued in accordance with a subsequent arrangement. This arrangement was as resolved by the directors of Secretariat on the 23rd August 1971, namely that amounts owing to the Trust by Fell & Starkey, whether on current account or for a fixed term, should bear interest at the rate of 10% per annum calculated and charged monthly and that Fell & Starkey be requested to enter into an agreement whereby amounts due by them to the Trust were a first charge on the debtors of Fell & Starkey. This

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arrangement was varied by reducing the rate of interest to 8½% per annum with effect from the 1st September 1972. In fact the charges made by Secretariat were allowed to accrue in a substantial sum and it was the interest on this sum which the Commissioner disallowed as an outgoing in the return of the partnership. The initial sum of $220,000 subscribed by the unit holders only moderately exceeded the purchase price of the assets which the Trust acquired from the partnership. This surplus was absorbed into payments of salaries of the staff engaged by Secretariat.

According to the evidence of the taxpayer, ``one of the underlying objectives of the creation of the Trust arrangement was that there should be a debt owed by the partnership to the Trust and that this debt should in due time be secured against the assets of the partnership, particularly the debtors''. It was in order to create this indebtedness that the charges made by Secretariat to the partnership were permitted to remain unpaid. Such a situation, of course, served one of the fundamental purposes of the arrangement which was to reduce the assets of the partnership. It also, according to the taxpayer, served another purpose which was to permit a distribution of profits which the partnership otherwise could not have afforded to have made. These profits resulted from the changeover by the partnership in its tax returns from a cash basis to an accrual basis in consequence of the decision of the High Court in
Henderson v. F.C. of T. 70 ATC 4016; (1970) 119 C.L.R. 612. In requiring the partnership to make this change the Commissioner allowed the partnership not to bring into account in its returns debtors for fees owing and unpaid at the 30th June 1970. In June 1970 fees of this character which had been paid were able to be credited to the current account of each of the partners, a full partner apparently being credited with some $6,000-odd, and as funds were made available from the Trust these fees were able to be withdrawn by the partners. Another purpose was also served and that was to enable the partnership more readily to accrue working capital which it required for carrying on its practice, for instance for payment of the salaries of professional staff and other outgoings. Finally, the partnership gained a secure source of working capital which it could, in effect, borrow at interest rather than provide from retained profits. In these circumstances the amounts owing from time to time by the partnership to the Trust which the Trust permitted to remain unpaid at interest should properly be regarded as working capital of the partnership. The charge over the book debts of the partnership mentioned above was in fact given by the partnership to the Trust. The interest paid by the partnership from time to time has been varied by agreement with Secretariat to match the prevailing rate.

The only other activity which was taken over by the Trust from the partnership related to the effecting of insurances and the earning of commission on them. The details need not be stated but the re-arrangements made involved Secretariat earning some of the commission which formerly was earned by the partnership.

The arrangements made on the 1st August 1971 probably passed unnoticed by clients of the partnership and others dealing with it. The same persons were engaged in carrying out the work of the partnership subject, of course, to the usual staff changes. The same plant, equipment and furniture and furnishings were used. Accounts for fees were rendered in the same way and were not, in consequence of the change of arrangements, varied in amount. The partnership occupied the same premises except that it made available, at a charge to the Trust, in its Melbourne and Sydney offices space for the Trust's managers and for the employees engaged in the share registry activities.

The partnership had before 1st August 1971 maintained professional indemnity insurance for which it paid a high premium and which provided a very large amount of cover. As to this amount it is sufficient to say that it would seem to be highly improbable that any claim or claims against the partnership would exceed this amount. After the 1st August 1971 this insurance was extended to cover Secretariat and Holdings as well as the partnership and in 1972 the amount of cover was substantially increased.

Part of the information supplied by the partnership to the Commissioner was the following question and answer:

``Q. Did partners in Fell & Starkey finance the Unit Trust in any way directly or indirectly?

A. Subscriptions for units by unit holders were made from their separate funds. These

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separate funds were available in part or whole either from their own resources, cash gifts from the partners, loans including bank overdrafts, proceeds from the sale of assets, and quarterly distributions of profits of the Trust.''

The last part of the answer is a reference to the use by unit holders of dividends paid on the units to provide part of the money required to subscribe for the later two issues. In the case of the taxpayer, before the setting up of the Trust his wife had obtained an overdraft from ANZ Trading Bank and she had advanced that money to him. This was done on or about the 5th July 1971. He had used the moneys lent to put capital into the partnership. Then somewhere around the 25th July he received a cheque for superannuation moneys in respect of his period as an employee of the partnership. These moneys were used to repay in part the loan which his wife had made to him and she was then able to use the money repaid to subscribe for units in the Trust. In each of the tax years the taxpayer paid interest to his wife on the moneys which remained outstanding. The taxpayer said in his evidence that a number of the partners had told him that he had made a gift to his wife of the money required to buy the units. There were some who had pre-existing loans of the type which existed between his wife and himself and those were repaid and the funds made available to the wife to subscribe for units. He doubted whether any of the partners had lent money to their wives to enable them to take up the units. He said that it was fair to say that probably a significant part of the later allotments of units were financed to some extent from the distribution of profits on the first issue of units although it was not a deliberate policy to match distribution of profits on the one hand with new allotments of units on the other. He said that his wife had 3,000 units as at the 30th June 1972, that her dividend on these during the first year was $1,016 and that her dividend during the second year was $1,800 upon the 5,600 units which she then had, that is, at a rate in excess of about 30%. It is, I think, clear enough that, after allowing for the relatively small amounts of interest which the taxpayer paid his wife, in each of the two years the establishment of the Trust and its employment by the partnership to provide services which the partnership had previously provided for itself had the effect of decreasing the income of the taxpayer and increasing the income of his wife. It is to be noted that the number of units in respect of which each partner might nominate the applicants was proportional to his interest in the partnership.

What is in issue basically in this appeal is, of course, the validity so far as the taxpayer is concerned of the deductions mentioned in the return of the partnership which the Commissioner disallowed. To illustrate the questions raised it is only necessary to take the deductions claimed for the 1972 year. The total of $375,217 was made up of $275,961 for hire of staff, $53,975 for share registry services, $35,533 for asset rental and $9,747 for interest on moneys owing from time to time by the partnership. Clearly, if the Trust had not been set up to perform services for the partnership, the partnership would have incurred the greater part of these sums as outgoings for wages, depreciation on assets and replacement of assets, and interest on moneys borrowed for the purpose of working capital, for example, on overdraft. On one view, what is in issue is whether the partnership was entitled to deduct so much of the outgoings in question as represent the profit made by the Trust on the activities involved. On another view, it is whether the partnership was entitled to deduct any part of these outgoings.

The assessments are supported for the respondent on two grounds. Firstly, it is submitted that the deductions which were disallowed were either not deductible or not fully deductible under sec. 51 of the Income Tax Assessment Act. Secondly, it is submitted that the transactions involved in the establishment of the Trust and the employment of its services attract the application of sec. 260 of the Act with the consequence that either the outgoings should be wholly disregarded or disregarded to the extent that the profit earned by the Trust is included in their amount.

In relation to sec. 51, it is submitted that each of the outgoings was incurred to make viable the unit trust, and that without these payments it could not have survived; to generate income in the Trust to advantage the family of the taxpayer which income would otherwise have been his; and to achieve an alternation in the disposition of the partnership earnings so as to achieve a splitting of income by channelling profits to the Trust. Such an outgoing, it is said, is not incurred ``in gaining or producing the assessable income''. The

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alternative argument is that if the deductions are in general terms comprehended within sec. 51, they are allowable only to the extent to which each was incurred in gaining that income or was necessarily incurred in gaining that income and should be apportioned to this extent. In effect so much of the outgoings as represents profits of the Trust should be disallowed. In my opinion both variations of this submission must be decided in accordance with the principles laid down by the Privy Council in
Europa Oil (N.Z.) Ltd. v. Commr. of I.R. (N.Z.) 76 ATC 6001; (1976) 1 All E.R. 503. In that case what was in issue was the taxpayer's right to deduct payments for the purchase of oil feed stocks in circumstances which were associated with complicated contractual arrangements between a number of companies concerned with the production, refining and sale of crude oil and its products. The consequence of the agreements was that the group of companies with which the taxpayer company was associated received a discount on the price paid by the taxpayer company for its feed stocks. There had been an earlier appeal,
Commr. of I.R. (N.Z.) v. Europa Oil (N.Z.) Ltd. 70 ATC 6012;(1971) A.C. 760, in which the question of the deductibility of the price of petroleum products purchased by the taxpayer had been in issue in relation to an earlier set of agreements which had much the same consequence. In the reasons of the majority in the later appeal, delivered by Lord Diplock, the question before the Board in this respect was stated as follows (76 ATC at 6007):

``In this appeal, as in the previous appeal, the particular expenditure claimed to be deductible under the section consists of moneys paid by the taxpayer company under contracts for the sale of goods whereby the property in the goods was transferred by the seller to the taxpayer company. The moneys so paid were stated in those contracts to be the price at which the goods were sold; and since the goods were acquired by the taxpayer company as stock-in-trade for its business of marketing petroleum products in New Zealand, there is no question that, if those contracts had stood alone, the whole of the moneys payable under them would be expenditure by the taxpayer company that was deductible under sec. 111. Those contracts, however, did not stand alone. They formed part of a complex of interrelated contracts entered into by various companies that were members of the Todd Group or the Gulf Group in connection with the same goods. The question in both appeals can accordingly be stated thus: is the legal effect - as distinct from the economic consequences - of the provisions of the relevant interrelated contracts such that when the taxpayer company orders goods under the contract of sale and accepts the obligation to pay the sum stipulated in that contract as the purchase price, the taxpayer company by the performance of that obligation acquires a legally enforceable right not only to delivery of the goods but also to have some other act performed which confers a benefit in money or in money's worth on the taxpayer company or some other beneficiary?''

The question in the present case may be stated to be whether the legal effect - as distinct from the economic consequences - of the provisions of the instruments and contracts relevant to the establishment of the Trust and its employment by the partnership are such that when the partnership employed the Trust to perform the activities in respect of which the outgoings were incurred, the partnership, and hence the taxpayer as one of the partners, acquired a legally enforceable right not only to the performance of the activities but also a right to have the profits of the Trust distributed to the unit holders, including among them the taxpayer's wife.

It is not contended for the respondent that any such right was acquired. As appears above, the respondent did not base either of the variations of this submission upon the legal character of the payment made pursuant to the agreement between the partnership and the Trust but upon what was said to be the purpose or motivation behind these payments. It is not suggested that the agreement between the partnership and the Trust and the issue of units in it should not be regarded as legally effective. In these circumstances it seems to me that it is the legal character of the payments in question which is decisive. It is, I think, clear that in engaging the services of the Trust and in accepting the obligations to pay for them at the rate stipulated, the partnership did not acquire any legally enforceable right otherwise than to the performance of those services. Clearly those services were employed in the partnership business and the payment made

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for them must be regarded as necessarily incurred in gaining the partnership income. Accordingly, the deductions claimed were allowable and the first submission for the respondent must fail.

I turn now to the respondent's submission in relation to sec. 260. Reference is made to the drawing up of the deed of trust of the 30th June 1971, the constituting of Holdings as trustee therein by the lodgment of $100, the assumption by the Trust of business activities performed for it by Secretariat, the engagement of the services of the Trust by the partnership, and to the circumstances that the Trust was established at the instigation of the partnership. It is then said that this total activity can be aptly described as:

``(a) an `agreement' between or among Fell & Starkey partners, Fellstar Holdings Pty. Limited and Fellstar Secretariat Pty. Limited;

(b) a `contract' between those entities;

(c) an `arrangement' made between those entities.''

the purpose or one of the purposes of which was to alter the incidence of income tax. A document tendered in argument shows, as has already been mentioned, that the income of the taxpayer was, as a consequence of the employment of the Trust, reduced and that he incurred a liability for tax which was less than what it would otherwise have been and, of course, it is clear that the income of his wife was increased by a sum which was related to the reduction in his income. It is said that, if it is relevant, it was one of the purposes of the partners to achieve such an alternation in the incidence of income tax. But it is said that such a purpose is also revealed on a consideration of the nature of the objective facts. It is pointed out that it is not necessary to invoke sec. 260 to establish that the tax purpose is the sole purpose. Alternatively, it is said that ``the effect of the setting up of the Trust with all steps taken incidental thereto and its interposition between the partners, the receipt of revenue, provision of services and charging of interest as aforesaid was to alter the `incidence' of income tax''. As a further alternative it is said that, if the incidence of income tax is not altered, the partners have been relieved from liability to pay income tax or the effect of the transaction has been to defeat, evade, or avoid liability by the partners, or to prevent the operation of the Act. Then it is said that as the general arrangement comes within sec. 260 it is void as against the Commissioner so far as it has or purports to have the above purpose or effect. Accordingly, at least the agreement between the partners and the Trust should be regarded as annihilated. The consequence of this may well be that, as was held to be technically the case by the New Zealand Court of Appeal in somewhat similar circumstances in
Wisheart v. C. of I.R. (N.Z.) 71 ATC 6001, in the two years in question the partnership cannot be held to have incurred any deductible expenditure resulting from the employment of staff to assist it in its practice or in relation to the hire of assets. It is suggested that if a finding is made in principle that sec. 260 applies, the parties should be invited to submit short minutes of a detailed order to be made or the assessments should be referred back to the Commissioner, no doubt with an intention that there should be allowed as outgoings of the partnership the expenditure actually incurred by the Trust in providing staff and assets for the Trust as was done in the case cited.

So far as this Court is concerned the submission in relation to sec. 260 is, I think, governed by the decision of the High Court in
Cecil Bros. Pty. Limited v. F.C. of T. (1962-64) 111 C.L.R. 430. In that case the taxpayer company, which carried on business as a retailer of shoes, had claimed a deduction for the purchase of stock from Breckler Pty. Limited at a price which, by agreement between the parties, was inflated. Breckler Pty. Limited was a company the shareholders in which were either shareholders in or near relatives of shareholders in the taxpayer company. It had been incorporated at a time when the business of the taxpayer company had been carried on by a partnership for the purpose of providing for the married children of the partners and for their children. The partnership had made similar purchases of stock from it. By the assessment in question the Commissioner disallowed the deductions claimed for purchase of stock from Breckler Pty. Limited. Two questions arose, firstly whether the deductions were allowable under sec. 51, it being submitted for the Commissioner that the outgoings should be apportioned to be limited to the amount which was necessarily incurred in carrying on the business and secondly, whether sec. 260

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applied, it being submitted for the Commissioner that the transactions of purchase of stock were void to the extent to which the excess payments reduced the taxpayer's assessable income. It was held that the whole of the purchase price of the stock in question was allowable under sec. 51. In this respect the decision is cited with approval in the
Europa Oil (No. 1) case, 70 ATC 6012 at 6019; (1971) A.C. 760 at 772. The leading judgment on the sec. 260 aspect was given by Menzies J., with whom Dixon C.J. and Kitto and Windeyer JJ. concurred. Taylor J. expressed the view that, assuming that the arrangement involved was one in which Breckler Pty. Limited was to buy goods needed for the taxpayer's business at a price at which those goods were available to the taxpayer and that the taxpayer should pay Breckler Pty Limited for those goods a greater price, he failed to see how the annihilation of the arrangement could, on the proved facts, be said to result in any increase in the taxable income of the taxpayer. Menzies J. assumed, without so deciding, that the arrangements which existed between the taxpayer and Breckler Pty. Limited, fell within sec. 260. He then said:

``I propose to decide this appeal upon the second ground of appeal for, assuming without deciding that the arrangement which did exist between the taxpayer and Breckler Pty. Ltd. fell within sec. 260, I have come to the conclusion that application of the section in the circumstances stated does not show that the taxpayer company's real outgoings for stock were £19,777 less than it had paid to its supplies, including Breckler Pty. Ltd. The application of sec. 260 here could not be regarded as invalidating the contracts between Breckler Pty. Ltd. and the taxpayer or as substituting the taxpayer for Breckler Pty. Ltd. in the contracts which that company made with the suppliers. The contracts, as made, stand, as his Honour recognized. His critical findings were expressed as follows: `What he' (i.e. the Commissioner) `has done is to treat as having no legal efficacy so much of the arrangement between the two companies as required the taxpayer to pay Breckler Pty. Ltd. amounts in excess of the price which it would have paid if it had made the purchases direct from the manufacturer or wholesaler and to regard those excess payments as though they had not been made. In my opinion he was entitled to do so in the circumstances of this case. The effect of the transactions was to relieve the taxpayer from a liability to tax which it would have otherwise have incurred and the Commissioner was entitled to proceed upon the footing that the steps taken to produce this result had not been taken'. ((1962) 111 C.L.R. at 436.) This means that sec. 260 has been regarded as a warrant for disregarding part of the price actually paid for goods pursuant to contracts, the validity of which remains unaffected. I do not think that section authorizes the Commissioner to substitute a different price for that actually paid in accordance with those contracts. Indeed, sec. 260 does not authorize the Commissioner to do anything; it avoids as against the Commissioner arrangements, etc. as specified and so leaves him to assess taxable income and tax on the facts as they appear when the avoided arrangements, etc. are disregarded. Here, it is not revealed that the taxpayer company's real outgoings for its supplies were £19,777 less than the price it paid or that the additional £19,777 was not paid or was a gift to Breckler Pty. Ltd. To arrive at any such conclusion would, I think, be an unauthorized reconstruction of what occurred and, moreover, would not be in accordance with the true facts. All that does appear is that the taxpayer company could have bought its requirements for £19,777 less than it did, but the disregard of what his Honour regarded as the tax-avoiding arrangement does not seem to me to warrant reducing whatever deduction is permitted by sec. 51.''

In my opinion this reasoning must be applied to the present case. The Commissioner cannot succeed under sec. 260 unless the effect of that section should be regarded as being to invalidate the contracts between the taxpayer and the Trust or as substituting the taxpayer for the Trust in the contracts which it made with the staff which it supplied to the taxpayer or as owner of the assets which it hired to the taxpayer or as the provider of the money which it lent to the taxpayer or as provider of the share register services which the Trust provided for the taxpayer. The agreement between the taxpayer and the Trust for the provision of services and assets must stand.

ATC 4181

Section 260 cannot be regarded as a warrant for disregarding part of the price actually paid for the hire of staff assets and services pursuant to that agreement, the validity of which remains unaffected. Finally, it should be added that on any view the agreement mentioned is the only part of the arrangement relied upon by the Commissioner which could be said to be capable of being annihilated. The instruments establishing the Trust and the companies do not of themselves have any of the purposes or effects mentioned in the section. Accordingly, the submission of the respondent under sec. 260 fails.

One further submission on behalf of the respondent remains to be discussed. It is submitted that part of the income derived by the Trust should be considered to be deemed to be derived by the partners pursuant to sec. 19 of the Act which provides:

``Income shall be deemed to be derived by a person although it is not actually paid over to him but is invested, accumulated, capitalised, carried to any reserve, sinking fund or insurance fund however designated, or otherwise dealt with on his behalf or as he directs.''

The income here in question is income earned previously by the partners for share registry supervision and for insurance commission. However, this income of the Trust was earned by it and was income to which it was absolutely entitled. On no view of the facts can it be said that it was received by the Trust at the direction of the partnership. To some extent the insurance business had previously been undertaken by the partners and was diverted to the Trust but that is not to say that the income actually received from such insurance business by the Trust was directed to be paid to it by the partnership. The same comment may be made as to the income derived from the share registry supervision.

For the foregoing reasons the appeals are allowed. The assessments of the taxpayer's liability for income tax in respect of the income derived by him during the years ended 30th June 1972 and 30th June 1975 are varied by deleting the income added to the income as returned in each case.

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