Case L35

Judges: MB Hogan Ch
DP Gerber M

GW Beck M

Court:
No. 3 Board of Review

Judgment date: 20 June 1979.

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Dr. G.W. Beck (Member): The facts in these references are quite simply stated. The taxpayers are brothers and are shareholders of a company (Hotelcoy) that in January 1970 purchased an hotel for $50,000. Their father was the controlling mind of the company and he attended and gave evidence. At the time of the purchase of the hotel the parents of the taxpayers already owned in partnership the freehold of three hotels and they also had an engineering business. The father gave evidence in a convincing manner and seemed to me to be a reliable witness. The Board was told that at the time of purchase Hotelcoy intended to operate the hotel, and an offer was made to a man known to be reliable to manage it. This man refused, but offered to ``buy the business'' for $15,000 plus an adjustment for the licence fee in respect of the period that was yet to run if he were granted a lease. After some hesitation this offer was accepted and the $15,000 was described in the legal documents as the consideration for certain furniture and fittings to the extent of $5,500 and consideration for a lease of $9,500. This $9,500 was credited to a ``Capital Profits Reserve Account'' in the books of the company and in 1974 tax year a resolution was passed to declare a dividend to be satisfied by shares with face value $9,500 and charged to the ``Capital Profits Reserve''. Each taxpayer received shares of face value $4,750 and in due course the Commissioner assessed them on these amounts. The taxpayers maintain that ``the dividend is not a dividend taxable under sec. 44'', and, their objections having been disallowed, they have come to the Board.

2. According to sec. 6 ``dividend'' includes:

``(a) any distribution made by a company to any of its shareholders, whether in money or other property;

(b) any amount credited by a company to any of its shareholders as shareholders; and

(c) the paid-up value of shares issued by a company to any of its shareholders to the extent to which the paid-up value represents a capitalisation of profits,''

but does not include -

``(d) moneys paid or credited by a company to a shareholder or any other property distributed by a company to shareholders (not being moneys or other property to which this paragraph, by reason of sub-section (4), does not apply), where the amount of the moneys paid or credited, or the amount of the value of the property, is debited against an amount standing to the credit of a share premium account of the company;

(e) moneys paid or credited, or property distributed, by a company by way of repayment by the company of moneys paid up on a share except to the extent that -

• (i) if the share is cancelled or redeemed - the amount of those moneys or the value of that property, as the case may be, is greater than the amount to which the share was paid up immediately before the cancellation or redemption; or
• (ii) in any other case, the amount of those moneys or the value of that property, as the case may be, is greater than the amount by which the amount to which the share was paid up immediately before the repayment exceeds the amount to which the share is paid up immediately after repayment; or

(f) a reversionary bonus on a policy of life-assurance;''

The relevant subsections of sec. 44 are worded as follows:

• Sec. 44(1) - The assessable income of a shareholder in a company (whether the company is a resident or a non-resident) shall, subject to this section and to section 128D -
  • (a) if he is a resident - include dividends paid to him by the company out of profits derived by it from any source...

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• Sec. 44(2) - Subject to the succeeding provisions of this section, the assessable income of a shareholder shall not include dividends paid by a company wholly and exclusively out of profits (not being profits that are included in the assessable income of the company by reason of section 26AAA) arising from the sale or re-valuation of assets not acquired for the purpose of re-sale at a profit or from the issue at a premium of any instrument that is a convertible note for the purposes of Division 3A (not being a convertible note in relation to which sub-section (1) of section 82S or sub-section (1) of section 82SA has effect or has at any time had effect) if the dividends paid from such profits are satisfied by the issue of shares (other than redeemable shares) of the company declaring the dividends.

3. The Contract of Sale by which the hotel was acquired shows an apportionment of the sale price as follows:

      Land and buildings ............  $43,600

      Plant, furniture and

      furnishings ...................   $6,400

                                       -------

                                       $50,000

                                       -------
          

There was a clause requiring the purchaser to acquire, at valuation on the day of possession, the stock in trade. The Commissioner did not dispute that the purchaser acquired a business as a going concern as well as the real property and the sundry chattels. There was a licence fee paid in respect of the year ended 30 June 1970 of $2,049 and this fee puts beyond doubt that the property had a significant throughput of alcoholic beverages and, one must assume, a profit earning capacity arising therefrom. Now it is well settled in the discipline of accounting that an asset is represented by the present capitalised money value of its future financial benefits. It is also well settled that the value of a group of assets, taken together and functioning as ``a business'', is the capitalised expression (in money terms) of its future earning power. No purchaser of a business is interested in acquisition unless he forecasts an acceptable level of future earning power with some confidence, although the individual tangible assets of the business might have a market value for use as private accommodation, for example, or for use in other businesses. The point is that it is an economic fact that every business sold as a going concern, and operating so as to provide future profits, has at least one asset in addition to the tangible assets, viz. goodwill. In the hotel industry licences are restricted and as a result they have economic value, and I do not think it would be disputed that the right to hold a licence is an asset to an hotel businessman. There are in hotel businesses therefore at least two assets in addition to the tangible assets.

4. The group of assets which together constitute a profitable hotel business as a going concern therefore can be described as (a) some tangible facilities to enable the physical operations to be carried on, (b) a licence, or right, to carry on that business and (c) the earning power arising from the fact that paying customers come to the business, i.e. the goodwill. And it is clear that the absence of a licence to operate or the goodwill that brings customers will mean that even the best buildings, furnishings and so on will be worthless as assets in that business. The existence of goodwill and possession of a licence are indeed real assets.

5. Hotelcoy acquired a going concern and although there was no evidence as to its past performance it is an unavoidable inference that it was a profitable going concern when ``the business'' was so readily sold for a sum of money soon after Hotelcoy acquired it. In other words, it is contended that regardless of any apportionment shown on the contract of sale Hotelcoy actually bought (a) the land, buildings and other tangible assets, (b) the right to trade as an hotel (the licence) and (c) the right to enjoy the financial benefits arising from the existing goodwill. Part of the capital cost ($50,000) had to be in respect of the licence entitlement and goodwill, and to question this is to suggest that men of business are prepared to part with assets that will provide financial benefits in the future without requiring compensation. There are, then, two assets missing from the apportionment on the contract of sale.

6. When Hotelcoy granted a 5 year lease to a lessee it, in effect, gave the lessee the right to use (a) the physical facilities, (b) the entitlement to trade in alcohol and (c) the existing goodwill, for that period. The use of the physical facilities was to be paid for by a

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rental of $100 per week, and it is possible that some part of the $9,500 received by Hotelcoy was also in effect pre-paid rent for the physical facilities. It is, however, an economic certainty that some part of the $9,500 was for the licence and for goodwill for the term of 5 years. As the rental figure of $100 per week represents nearly 15% return on the net investment of Hotelcoy ($50,000 less $15,000 - and this was a high rate of return in pre-inflation 1970), it seems to me that none of the $9,500 was extra rent, and all was payment for the right to benefit from the licence and the goodwill for five years.

7. The $9,500 received was therefore wholly in respect of the sale of the right to use two capital items. There may have been some profit on the sale, but in the absence of information regarding the amount paid for these assets by Hotelcoy, it is not possible to determine this.

8. The controlling mind of Hotelcoy gave evidence that at date of purchase the company planned to operate the hotel, and this intention was not altered until some time after acquisition. According to the witness the change of mind resulted in the ``sale of the business of the hotel'' and it is the proceeds of this sale which were subsequently the source of distributions to two shareholders in the form of fully paid shares. It is my view that none of the amounts distributed is assessable because -

• (a) that part of the distribution that might come from profit is wholly and exclusively from profit on the sale of assets not acquired for resale at a profit and is thus excluded by sec. 44(2); and
• (b) the balance of the distribution is from the proceeds of the sale of capital assets (and, incidentally, contravenes the Companies Acts) and is therefore not a dividend according to the definition in sec. 6.

9. The only dividends dealt with by sec. 44 are those defined by sec. 6 (see para. 2). In this case there was no question of any amount being credited to the taxpayers and part (b) of the definition does not apply. Part (c) of the definition applies to the extent that the $9,500 contains profit, but it is my view that part (a) does not apply because this company did not make a distribution of its money or its property. A company's own shares are not part of its ``property'' (indeed, they are recorded on the opposite side of the balance sheet to company property) and shares only become ``property'' in the hands of shareholders. It is my contention that the word ``property'' in part (a) of the definition must be read as qualified by the word ``company''. It is on the basis of this interpretation of the definition that the view expressed in part (b) of the immediately preceding paragraph is adopted.

10. I reiterate this reasoning in summary as follows:

• (a) Hotelcoy, in addition to leasing the land and buildings for a rental of $100 per week, sold the right to use two assets for 5 years for $9,500;
• (b) because it is contrary to economic reality to consider that those two assets were cost free to Hotelcoy the apportionment of the total purchase price of the hotel was not correct;
• (c) in the absence of evidence as to the cost of these assets it is convenient to assume that the price paid by the lessee to Hotelcoy, $9,500, represents only a capital recovery to Hotelcoy and includes neither profit nor loss, but if some or all of this amount is regarded as profit it arises from the disposal of capital assets;
• (d) Hotelcoy's accountant committed an accounting error in crediting the $9,500 to a ``Capital Profits Reserve'', for the amount (or at least some part of it) should have been credited against the capital cost of the going concern acquired by Hotelcoy;
• (e) the distributions are not dividends under sec. 6 except to the extent that the distributions have come from a profit element that, as indicated above, cannot really be calculated;
• (f) because the assets were not acquired for resale, and because the dividends (to the extent they exist) were paid wholly and exclusively from profits on the sale thereof, and satisfied by the issue of non-redeemable shares, they are excluded from assessability by sec. 44(2).

11. It seems to me important to recognise that one cannot make a business asset passing from one person to another cease to exist by omitting it from a contract of sale,

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one cannot make something into a dividend for tax purposes simply by calling it a dividend, and furthermore, that neither the Commissioner nor the taxpayer can make something into a profit by choosing to call it profit. Hotelcoy bought in 1970 an hotel thereby acquiring the right to operate it (the licence) and the right to derive the fruits of the existing goodwill from that time on. It chose to recover some of the capital outlaid and it therefore sold the ``right to these two rights'' for 5 years for $9,500. There may have been an element of profit in this $9,500 but it is an economic certainty that it is not all profit. Neither the taxpayer nor the Commissioner seemed to appreciate this.

12. It is obvious that I consider that both parties were at least to some extent ``on the wrong tram'', but the onus is squarely on the taxpayer to set out the grounds of his objection and prove that the assessment is excessive, and in order to do this he must cover all relevant aspects in the objection and present the facts clearly. The taxpayers here were not helped by some unusual actions by those responsible for documenting and recording the transactions of Hotelcoy, and the objection did not even raise the possibility that some or all of the distributions were not dividends. This is perhaps not surprising when the books of the company indicated that it regarded the cost of the goodwill and the licence as nil, and the proceeds of the disposal were therefore entirely profit. This attitude was maintained at the hearing where in his opening remarks the Counsel for the taxpayer stated:

``The taxpayer says that it is not assessable income because the profit arose from the resale of an asset not acquired for the purpose of resale. The taxpayer, we would aim to show, claims that what is called a premium on the grant of a lease is in substance goodwill. What was sold was a hotel business for the sum of $15,000. That is what the purchaser of the business was prepared to pay for it and it was allocated by the taxpayer $5,500 depreciable items of plant and equipment and $9,500 goodwill.''

In fact, the company had no recorded asset ``goodwill'' and the $9,500 was regarded as all profit and credited to a profits reserve account. This ``all-profit'' assumption contrasts with the ``all-capital'' assumption in para. 10(c) above, and the actual position is probably somewhere in between. The taxpayers have had their position clouded by this treatment in the books of the company, but they are nevertheless on safe ground once it is accepted that a capital asset was acquired by Hotelcoy (I think there were two i.e. goodwill and the licence), that the asset remained unrecorded in the books of the company and that it was subsequently disposed of; and I do accept this. Even if the acquisition cost was nil, and the $9,500 thereby a profit, the shares issued from this profit source are excluded from assessability by sec. 44(2).

13. In accordance with the above reasons I direct that the assessable income of both taxpayers for the year ended 30 June 1974 be reduced by $4,750 and the assessments amended accordingly.

Claims disallowed