Isherwood & Dreyfus Pty. Limited v. Federal Commissioner of Taxation.

Meares J

Supreme Court of New South Wales

Judgment date: Judgment handed down 21 July 1978.

Meares J.: These are two appeals from two assessments by the respondent in respect of the twelve months period ending 31st August, 1973, and the period ending 31st August, 1974, this being the appellant's substituted accounting period.

The appellant carries on the business of importing and selling textiles, both wholesale and retail. It is wholly owned by Isherwood & Dreyfus Holdings Limited which company also wholly owns Isherwood & Dreyfus (Hong Kong) Pty. Limited. The appellant carries on business in Australia; the Hong Kong company carries on business in Hong Kong. Until the incorporation of the Hong Kong company the plaintiff purchased, inter alia, textiles from National Textiles Import and Export Corporation which is a mainland China State-owned corporation. Since the incorporation of the Hong Kong company, that company purchases textiles from the Chinese Corporation and in turn sells the same to the appellant at a mark-up of the order of ten per cent. The textiles so purchased are now shipped, as they have always been, to the appellant directly from Shanghai to Australia but the Chinese Corporation, since the incorporation of the Hong Kong company, now invoices that company which in turn invoices the Australian company at the increased price. The method of payment for the goods since the incorporation of the Hong Kong company has been for the appellant to open a letter of credit in favour of it, and such letter of credit is either partially transferred to the Chinese Corporation or the Hong Kong company opens its own letter of credit in favour of that corporation.

The appellant in its returns for the two years in question claimed, in arriving at its net profit, the total purchase price that it had paid to the Hong Kong company for textile goods purchased by that company from the Chinese corporation. The Commissioner disallowed as a deduction in both years the mark-up which the appellant paid to the Hong Kong company in respect of the said goods, amounting to $62,670 for the 1973 year and $102,755 for the 1974 year.

The evidence establishes that prior to the existence of the Hong Kong company, the appellant's managing director visited China once or twice each year and bought, inter alia, textiles from the Chinese corporation; that, after the incorporation of the Hong Kong company, he visited China in the same way but, instead of purchasing on behalf of the appellant, purchased textiles from the Chinese corporation on behalf of the Hong Kong company, of which he was also a director. He admitted that the effect of passing orders through the Hong Kong company was to increase the deductions which may be allowable for taxation purposes against the income of the appellant, and that the ultimate effect and purpose of the incorporation of the Hong Kong company was to increase the overall profitability of the holding company, Isherwood and Dreyfus Holdings Limited, as a result of the lower tax rate in Hong Kong on income earned by the Hong Kong company; and that apart from the expenses of the Hong Kong company's operations, which were not substantial, the whole of the differential between the price it received from the appellant for the goods purchased in China and the price it paid for such goods was available for dividends to the holding company. The directors of the Hong Kong company were apparently never paid any directors' fees and its sole business activity was that of purchasing goods for resale to the appellant at a profit.

It was claimed by the respondent that the outgoings representing the mark-up to the appellant on the textiles bought by the Hong Kong company were not claimable as deductions under sec. 51(1) of the Income Tax Assessment Act 1936-1975 which provides:

``All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions, except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.''

The right to a deduction under that subsection was not, Mr. McLelland, Q.C. for the defendant, submitted, to be determined only by the consideration for which it is paid, although he conceded that this was a relevant factor. In considering when a deduction is claimable, one must, he submitted, look not only at the expressed consideration but the whole of the surrounding circumstances. In this case the true character of the deduction

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disallowed was, he claimed, not an outgoing to produce assessable income but a payment made to diminish the appellant's taxable income and to save tax, and that one could go behind the legal effect of the transaction giving rise to the deduction which was simply money paid under a contract for the sale of goods. In this connection he relied, inter alia, upon
Scott v. F.C. of T. (1966) 117 C.L.R. 514 at p. 526 but particularly upon various passages from the judgments of Rich J. and of the Court in an appeal from his decision in
Robert G. Nall Limited v. F.C. of T. (1936-37) 57 C.L.R. 695. The subject of the appeal in that case was a sum of £2,000, portion of director's fees totalling £2,500 per annum payable to the governing director of the company. The deductions were disallowed by the respondent for five years on the ground that during these years the company had substantially disposed of its business, that the services justifying the remuneration were no longer needed and that, in reality, the governing director's remuneration ceased to be a reward for services performed on behalf of the company in gaining its income and became an annual payment out of the company's income enjoyed by him as an office holder as opposed to the capacity of shareholder. At p. 699 Rich J. said:

``When the company disposed of its business the services justifying the remuneration were no longer needed, and, in reality, the governing director's remuneration ceased to be a reward for services performed on behalf of the company in gaining its income and became an annual payment out of the company's income enjoyed by an office holder as opposed to a shareholder. I do not think that it is correct to treat the matter as one altogether depending on bona fides. In each year of income in respect of which the deduction is claimed the question must be, What was the reason or occasion for the payment? Was it laid out for the production of income or was it made for some other reason?''

In considering sec. 23(1)(a) and 25(e) of the then relevant Income Tax Assessment Act 1922, and particularly sec. 25(e) which provided that a deduction should not be made in respect of money not wholly and exclusively laid out or expended for the production of assessable income, Latham C.J. at p. 705 said:

``The words, therefore, must, I think, be given an interpretation which does not necessarily depend upon the object which some person or persons desire to achieve, though, in a case where natural persons are concerned, the object which they naturally have in their minds may properly be taken into consideration in determining whether a particular expenditure is made for the production of assessable income. If, for example, (to take a simple case) B was an employee of A working for a salary and A made a gift to him which was not connected in any way with the business and which was shown to be made for purely personal reasons, those facts would prevent the view being taken that the expenditure was made for the purpose of producing assessable income.''

At p. 706 he expressed the opinion that the question was whether there was a real connection between the expenditure and the income produced, and added:

``Where, therefore, in the case of the director of a company, there is evidence from which the conclusion may be drawn, and the conclusion is drawn, that there is a great disproportion between the expenditure and the services rendered in the business of the company, the expenditure cannot be regarded as being so made. This, in my opinion, is the effect of the decision in
Aspro Ltd. v. Commr. of Taxes, (1932) A.C. 683.''

Starke J. said at p. 708:

``Aspro Ltd. v. Commr. of Taxes (supra) is authority for the proposition that the amount of remuneration paid by a company or fixed by its articles of association is not conclusive of the question whether expenditure is incurred in gaining or producing the assessable income, but is a matter which can be inquired into by the taxing authority, or by an appellant tribunal upon appeal from him.''

Dixon J. was of the view that an outgoing or expenses cannot be brought within sec. 25(e) unless it is connected with the earning or derivation of income by the taxpayer, and said at p. 712:

``... when it is said that gaining or producing assessable income must be the purpose of the expenditure if its deduction is to be allowed, no more can be meant than

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that the circumstances of the transaction must give it the complexion of money laid out in furtherance of a purpose of gaining income.''

In his opinion it was the insufficiency of the connection between the outlay on the governing director's remuneration and the production of income that made the claim to the deduction unsustainable. But
Cecil Bros. Pty. Ltd. v. F.C. of T., (1964) 111 C.L.R. 430, sec. 51(1) was considered in relation to facts infinitely closer to the present case than those in Nall's case (supra). In that case in the relevant year the appellant purchased stock in trade from a family company, Breckler Pty. Limited, the shareholders of which were either shareholders in or relatives of shareholders in the appellant, at prices higher than those which would have been charged to it by its usual suppliers, thereby allowing the family company to make a profit. Purchases by the taxpayer from its usual suppliers for the relevant year would have been £19,777 less than the amount actually paid and its profits would have been correspondingly increased. The respondent disallowed this sum in its claim for deductions and increased its taxable income by that amount, relying, inter alia, upon sec. 51(1) and 260 of the Income Tax and Social Services Contribution Assessment Act 1936. Owen J., before whom the matter came on for hearing, said at p. 434:

``The fact that the taxpayer paid more for its purchases than it would have paid had it dealt direct with the manufacturers or wholesalers in order that Breckler Pty. Ltd. might make a profit out of the transactions does not, in my opinion, prevent the amount which it in fact paid from being regarded, for the purposes of sec. 51(1), as an outgoing incurred in gaining its assessable income. It seems to me that the contention really is that the taxpayer paid more for its goods than it should have. But `it is not for the Court or the commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent'. (
Ronpibon Tin N.L. and Tongkah Compound N.L. v. F.C. of T. (1949) 78 C.L.R. 47 at p. 60 and the cases therein cited.)''

and on the appeal Menzies J., with whom the rest of the Court agreed, dealing with sec. 51(1), said at p. 441:

``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. The Commissioner did argue unsuccessfully before Owen J. that, independently of sec. 260, the amount of £19,777 should not be regarded as an outgoing necessarily incurred in gaining or producing the taxpayer's assessable income. His Honour rejected this submission, relying upon Ronpibon Tin N.L. and Tongkah Compound N.L. v. F.C. of T. (supra). With this I agree.''

Cecil's case (supra) has been followed by the Privy Council in
Commr. of I.R. (N.Z.) v. Europa Oil (N.Z.) Limited, 70 ATC 6012 and
Europa Oil (N.Z.) Limited (No. 2) v. Commr. of I.R. (N.Z.), 76 ATC 6001. In the former case Lord Wilberforce, delivering the judgment of the majority of the Board, after pointing out at p. 6019 that the Crown is entitled to ascertain for what the expenditure was in reality incurred, proceeded:

``But secondly, a trader is entitled to conduct his business and to acquire his trading stock in his own way. It is not for the Crown to say that he might have acquired his stock at a lesser price and to deny him any deduction above what it considers he should have paid. This was the basis, as their Lordships understand it of the decision of the High Court of Australia in Cecil Brothers Pty. Limited v. F.C. of T. (supra).''


``In their Lordships' opinion, sec. 111 does not enable the Crown to disallow expenditure genuinely made whenever it can be found that some economic advantage accrues to the trader as a result of making the expenditure: after all, the trader is taxed on his profits and if he succeeds in obtaining what are effectively profits in such a way as not to pay tax on them, the Crown has other weapons. For a claim to disallow a portion of expenditure incurred in purchasing trading stock to succeed, the Crown, in their Lordships' judgment, must show that, as part of their contractual arrangement under which the stock was acquired some advantage, not identifiable as, or related to the production

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of, assessable income, was gained, so that a part of the expenditure, which can be segregated and quantified, ought to be considered as consideration given for the advantage. Taxation by end result, or by economic equivalence, is not what the section achieves.

This test, the strictness of which their Lordships consider should be emphasised, can only be satisfied after a rigorous and objective examination of the contractual arrangements under which the expenditure is made.''

In the latter case, Lord Diplock in delivering the judgment of the majority of the Board, said at p. 6009:

``In their Lordships' view the result upon the Commissioner's claim under sec. 111 is that it must fail. The true legal character of the whole of the expenditure claimed to be deductible is that of the purchase price of stock in trade for the Taxpayer Company's business of marketing petroleum products and nothing else. As such it is deductible in full in calculating the Taxpayer Company's assessable income from that business.''

and at pp. 6009-6010:

``In respect of these contracts the case is on all fours with Cecil Bros. Pty. Limited v. F.C. of T. (supra) in which it was said by the High Court of Australia at p. 434: `It is not for the Court or the Commissioner to say how much a taxpayer ought to spend in obtaining his income'; to which their Lordships would add: It is not for the Court or Commissioner to say from whom the taxpayer should purchase the stock in trade acquired by him for the purpose of obtaining his income.''

In both of the last two mentioned cases the Board's observations concerning New Zealand sec. 111 which was being considered would apply in my opinion with equal force to sec. 51(1) (supra).

Phillips v. F.C. of T., 77 ATC 4169, Waddell J., at p. 4178 stresses that it was the legal character of the payments in that case which was decisive; and in
The Federal Coke Company Pty. Limited v. F.C. of T., 77 ATC 4255, Bowen C.J., citing the Europa case No. 1 amongst other authorities, states at p. 4263:

``... but, where there is no statutory warrant for doing so, the Court cannot disregard certain of the facts or rearrange the facts or decide the case according to its view of the substance of the matter. It is not legitimate to disregard the separateness of different corporate entities or to decide liability to tax upon the basis of the substantial economic or business character of what was done.''

In the subject case it is clear that the appellant paid more for its purchases than it would have paid had it directly dealt with the wholesaler and that from a business point of view it did this in order that the Hong Kong company could make a profit out of the transaction which would result in an ultimate saving of tax payable by the parent company. But there is no doubt, in my opinion, that the true legal character of the arrangement between the appellant and the Hong Kong company was related to the supply of stock in trade for the appellant and nothing else, that under the circumstances of the authority of Cecil's case (supra) it is not for the respondent to say how much a taxpayer ought to spend but to consider only how much he has spent, and that, examining objectively the arrangements made, no part of the expenditure by the appellant can be segregated from the basic nature of the transaction and it matters not that the arrangement resulted in a tax saving for the benefit of the parent company.

As was pointed out in argument, to allow the type of deduction disallowed in this case by the respondent could lead to some surprising results, an example of which perhaps would be that in this case the appellant could have agreed to purchase stock from the Hong Kong company, purchased from the China Corporation, not at ten per cent more than the Hong Kong company had paid for the stock but at a more substantially increased price. But, as I see the position, I am bound by the decision in Ceil's case and the principles as followed and explained in the two Europa cases and I do not consider Cecil's case (supra) to be distinguishable on the ground that in that case the family company was not formed to be the intermediary between the taxpayer and its suppliers. Since the middle of last year, however, a sec. 31C has been added to the Income Tax Assessment Act 1936 by Act. No. 57 of 1977. That section deals with the

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purchase of trading stock by a purchase from a vendor who are not dealing with each other at arm's length in relation to the transaction. In that event for all purposes of the application of the Act the purchase price shall be deemed to be the amount ascertained in accordance with subsec. (2) of the section which in certain cases is the arm's length price of the article.

The appeal is allowed. The respondent will pay the costs of the appeal.

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