Case Q118

Judges: HP Stevens Ch

BR Pape M
TJ McCarthy M

Court:
No. 1 Board of Review

Judgment date: 22 November 1983.

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B.R. Pape (Member)

I have had the advantage of reading the reasons for decision prepared by my colleague Mr. T.J. McCarthy. He has set out the facts and issues in these references in a most lucid way and it is therefore unnecessary for me to repeat them. Whilst I agree with his conclusion that the receipt of the retiring allowances by A and B falls to be included in their respective assessable incomes pursuant to sec. 26(d), I find myself in the unfortunate position of dissenting on the question of whether the retiring allowances of $145,000 are an allowable deduction under sec. 78(1)(c) to X Pty. Ltd.

2. At the outset I find the evidence established that the retirement of both A and B from the company was one which was contrived. It enabled A and B to be brought within the provisions of sec. 78(1)(c). On 30 April 1980, the company's business was ``transmitted'' to X N.S.W. Pty. Ltd. All that happened was that entries were made in the journal transferring the assets and liabilities to X N.S.W. Pty. Ltd. in accordance with the resolution of the directors on 30 April 1980. There was no written contract for sale of the business in evidence. Nor was there any evidence of what the purchase price of the business was other than the net assets were to be transferred at book value - excluding the real property which was purportedly sold at valuation. The employees of X were unaware that their employment had been terminated and from 1 May 1980 were employees of X N.S.W. Pty. Ltd. It appears they were told that there had been a ``reorganization'' and one employee who gave evidence was under the impression that there had been a change of name. Their entitlements to long service leave were not prejudiced as they were protected by the operation of sec. 4(II)(c) of the Long Service Leave Act 1955 (N.S.W.). Consequently both A and B's entitlement to long service leave were protected as a result of the ``transmission'' of the business to X N.S.W. Pty. Ltd. In any event it was not contested by the Commissioner that there had not been a sale of the business.

3. The submission by counsel for the Commissioner that if there had been a retirement by A and B, then the payments

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were not made in their capacity as former employees but in their capacity as directors had a good deal of force. I was initially attracted to it. A reading of the minute of the directors' meeting held on 30 April 1980 at 11.00 a.m. would in my view show that prima facie the retiring allowances were paid to A and B in their capacity as directors. However I think the evidence warrants a contrary conclusion. Whilst not inconceivable, I find it difficult to accept that the directors at the relevant time, one being an accountant and the other a solicitor would have knowingly breached sec. 129(1)(a) of the Companies Act 1961 (N.S.W.). This subsection provides -

``It shall not be lawful -

• (a) for a company to make to any director any payment by way of compensation for loss of office as a director of that company... or as consideration for or in connection with his retirement from such office;''

Further if the payments were to be regarded as payments to directors there was no evidence that any of the matters contained in sec. 129(5) were satisfied. It is settled law that (a) the section does not extend to payments made to persons who are directors in connection, not simply with the office of director, but also with some employment held by the director and (b) the section does not apply to payments which the company is obliged, under contract, to make, but only to payments which the company, not being obliged to make proposes to make.
Dow Securities Pty. Ltd. v. Manufacturing Investments Ltd. (1981) CLC ¶ 40-715 ; (1980-1981) 5 A.C.L.R. 501 at p. 507 ;
Taupo Totara Timber Co. Ltd. v. Rowe (1978) A.C. 437 .

4. I think it must be recognised that in the case of a proprietary company such as X Pty. Ltd. the distinction between shareholder, director and employee becomes blurred so far as the practical operation of the business is concerned. Nevertheless in law they are quite distinct and separate legal capacities. The evidence established that the time spent by A and B in developing the business caused it to experience a growth in turnover from $4,000 in 1963 to about $1 million for the 10 months to 30 April 1980. I find that the salaries paid to A and B after taking into account the hours worked and the executive status of A were not ``competitive'' with those paid to other employees.

5. The extent of A's contribution to the business was in my view immeasurable. The evidence established that it was his innovativeness in developing a ``free fall glass'' system - resulting in a saving of 40% in the time required to cut glass - which significantly contributed to the development of the business. Again his development of the ``glass cutter'' was an innovation which I infer not only increased the productivity of the factory but resulted in patents being registered for commercial exploitation - ``Pure profits are solely the result of innovations'' - J. Schumpeter Theory of Economic Development (1934). These two examples by themselves in my view establish the bona fides of the payment of $85,500 to A. Similarly I find that the payment to B was bona fide.

6. I accept that the tax benefit of such payments being 46% of $145,500 ($66,930) was of critical importance to X Pty. Ltd. Nevertheless X Pty. Ltd. was still required to bear an after tax charge of $78,570 in arriving at its net profit after tax for the year. In my view whether or not X Pty. Ltd. sought a tax benefit of $66,930 is not determinative of the issue of whether these sums were paid in good faith in consideration of past services to persons who have been employees of the taxpayer. On an objective view the evidence established that both A and B had given valuable service to X Pty. Ltd. during the past 17 years. Without A the business would not have grown as it did. He was the key man. ``There can be a bona fide commercial transaction with the obtaining of a tax advantage as a main object'' see
I.R. Commrs. v. Goodwin (1975) 1 All E.R. 708 per Russell L.J. at p. 714 and referred to with approval by Viscount Dilhorne in
I.R. Commrs. v. Plummer (1979) 3 All E.R. 775 at p. 789 .

7. I now turn to deal with the operation of sec. 109 of the Act. This section provides -

``So much of a sum paid or credited by a private company to a person who is or has been a shareholder or director of the company or a relative of a shareholder or director, being, or purporting to be -

• (a) remuneration for services rendered by that person; or

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• (b) an allowance, gratuity or compensation in consequence of the retirement of that person from an office or employment held by him in that company, or upon the termination of any such office or employment,

as exceeds an amount which, in the opinion of the Commissioner, is reasonable, shall not be an allowable deduction and shall, for the purposes of this Act other than the purposes of Division 11A of Part III and Division 4 of Part VI, be deemed to be a dividend paid by the company on the last day of the year of income of the company in which the sum is paid or credited.''

It is clear that sec. 109 is unable to be invoked unless the sum paid or credited is an allowable deduction. In
W.J. & F. Barnes Pty. Ltd. v. F.C. of T. (1957) 11 A.T.D. 170 ; (1957) 96 C.L.R. 294 Fullagar J. said at A.T.D. p. 177; C.L.R. p. 310 -

``The important point is that sec. 109 presupposes a payment which, apart from sec. 109 itself, would be an allowable deduction to the company. Unless there is a payment of that character, the Commissioner is neither commanded nor authorised to form any opinion under that section. It is the reasonableness of the payment as a reward for services that he must consider, and it would be absurd to require him to consider that question if the amount paid were, as a matter of law and apart altogether from its reasonableness, not deductible.''

8. In my view the amounts paid to A of $85,000 (sic $85,500) and to B of $60,000 were reasonable in view of their respective lengths of service and the contribution they had both made to the profitability of the business carried on by X Pty. Ltd. The calculations which my colleague Mr. McCarthy has set out in para. 7 of his reasons confirm their reasonableness. Accordingly no part of the respective payments exceeds in my opinion an amount which is reasonable.

9. Accordingly I would first reverse the Commissioner's decisions on the objections against the assessment and amended assessment respectively served on A and B for the year ended 30 June 1980 by reducing the respective taxable incomes as follows:

      A       $19,855

      B       $36,480
          

Secondly I would reverse the Commissioner's decision on the objection against the assessment served on X Pty. Ltd. for the year ended 30 June 1980 and reduce the taxable income as ascertained in the amended assessment dated 22 April 1982 by $59,300.