Jennings Industries Limited v. Federal Commissioner of Taxation.Judges:
Full Federal Court
Bowen C.J., Woodward and Fitzgerald JJ.
This is an appeal by leave from a judgment of the Supreme Court of Victoria by the taxpayer Jennings Industries Limited. The respondent Commissioner of Taxation issued a notice of assessment on 23 April 1975 in respect
ATC 4289of income derived by the taxpayer in the year ended 30 June 1974. The taxpayer objected and the Commissioner issued an amended assessment on 15 July 1977. The sum of $153,457 was included in the taxpayer's assessable income in reliance upon sec. 26AAA of the Income Tax Assessment Act 1936, as amended (``the Act''), on the basis that that provision applied to part of a total profit of $160,628 derived by the taxpayer from the sale of shares in Tower Property Development Pty. Ltd. (``T.P.D.''). A further objection by the taxpayer was referred to a Board of Review which upheld the Commissioner's assessment. The taxpayer appealed to the Supreme Court of Victoria under sec. 196 of the Act. On 30 September 1983, the Supreme Court dismissed the taxpayer's appeal with costs and increased the Commissioner's assessment to accord with the taxpayer's total profit of $160,628. The Supreme Court found it unnecessary to consider sec. 26AAA of the Act, because it concluded that the taxpayer had failed to establish ``that the Commissioner was not entitled to make the said assessment pursuant to Section 25 alternatively Section 25(1) in combination with Section 26(a) of the Act''. It is from that judgment of the Supreme Court that the present appeal is brought by leave granted on 20 December 1983. The Supreme Court's power to increase the assessment has not been called in question.
The taxpayer acquired its initial shares in T.P.D. as a result of an approach from Investment and Merchant Finance Co. Ltd. (``I.M.F.C.'') in 1971. The taxpayer was a construction company which also engaged in other business activities including land development and the construction and sale of homes and other buildings. I.M.F.C. was the beneficial holder of T.P.D.'s issued share capital which consisted of two shares of $1 each. T.P.D. owned a site in Grenfell Street, Adelaide which included land at 45 Grenfell Street. By the end of 1971 the proposal was that the taxpayer and I.M.F.C. would engage in a joint venture involving the construction and letting of a commercial building on the land at 45 Grenfell Street and that each of the taxpayer and I.M.F.C. would subscribe for and own one-half of the issued ordinary shares in T.P.D. which was to be the owner of the building.
The shares in T.P.D. which the Supreme Court held yielded the taxpayer a taxable profit when they were subsequently sold were issued to the taxpayer on 15 February 1972 under a written agreement dated 4 February 1972 between the taxpayer, I.M.F.C. and T.P.D. There is no suggestion that that agreement did not accurately record the true bargain and relationship between the parties. Provision was made in the agreement to accommodate the disposal by T.P.D. of assets other than the land at 45 Grenfell Street and the satisfaction by T.P.D. of existing liabilities. It was agreed that the taxpayer and T.P.D. would enter into a construction agreement for the erection by the taxpayer of a large commercial building on the site of 45 Grenfell Street. The taxpayer and I.M.F.C. were to subscribe for 125,000 and 124,998 ordinary shares in the capital of T.P.D. respectively. Each of the taxpayer and I.M.F.C. was to hold one-half of T.P.D.'s total issued ordinary capital of 250,000 $1 shares whilst T.P.D. was indebted in respect of any borrowings under the agreement, and each was to appoint an equal number of the directors of T.P.D. Each was to have a right of first refusal in respect of any sale of the other's ordinary shares. Cathaust Investments Pty. Ltd. (``Cathaust''), a subsidiary of I.M.F.C., was to apply for and have allotted to it 250,000 $1 ``Z'' special shares carrying a basic fixed cumulative preference dividend of 8% per annum.
Bridging finance was to be procured and the agreement recorded that it was believed that not less than $4,250,000 would be required for a period of up to 6 months after the date of practical completion of the building. Longer term finance was to be obtained from the Commonwealth Superannuation Board and Partnership Pacific Limited (``P.P.L.'') or some other lender. By letter dated 31 December 1971 to T.P.D., the Superannuation Board, which had been requested to provide a loan of $3.5m., had offered to lend $2.8m. or 60% of the final valuation on completion of the project, if higher, and its offer had been accepted. The loan was to be secured by mortgage and was to be made on completion of the project, if higher, and its offer had been accepted. The loan was to be secured by mortgage and was to be made on completion of the project for a term of 25 years. The loan was to be repaid by 15 consecutive annual payments commencing on 1 July 1983 with a final payment on the maturity date of the loan. Interest was to be paid half-yearly on the first days of January and July in each year during the term of the loan. Interest rates were to vary throughout the loan and were related to T.P.D.'s gross income from the building. The loan was conditional upon leasing arrangements being satisfactory to the
ATC 4290Superannuation Board and a satisfactory final report from its valuer. The agreement of 4 February 1972 required T.P.D. to seek to borrow a further $750,000 from P.P.L. for a maximum of 8 years from a date not earlier than the date of practical completion. If P.P.L. made such a loan, the agreement provided that, upon application by P.P.L., 250,000 $1 fully paid 8% fixed cumulative preference shares in T.P.D. to be paid for in cash by P.P.L. on application were to be allotted to it, provided that P.P.L. and Cathaust agreed that Cathaust would, at the option of P.P.L., purchase the preference shares from P.P.L. upon the termination of the loan. The taxpayer and I.M.F.C. were to guarantee the repayment of the bridging finance and T.P.D.'s other borrowings were to be guaranteed ``to the extent of 100%'' by I.M.F.C. and ``to the extent of 50%'' by the taxpayer.
Recital G of the agreement of 4 February 1972 was as follows:
``G. IMFC has prepared and AVJ (the taxpayer) has accepted a 25 year Projected Cash Flow in relation to the construction and operation of the office building a copy of which is attached hereto and marked `D'.''
Surprisingly, the ``25 year Projected Cash Flow'' document is missing and was not before the Supreme Court. However, whatever its details, it is possible to discern its general operation from other material.
In broad terms, the agreement of 4 February 1972 provided that the maximum dividends payable by T.P.D. on its ordinary share capital were not to exceed the respective amounts specified in the ``25 year Projected Cash Flow'' and that any additional profits available for distribution after payment of such dividends and dividends on the preference shares and ``Z'' special shares were to be paid as further dividends on the ``Z'' special shares. The taxpayer was given the right (which in the event was not exercised) to require I.M.F.C. to take a head lease of the building for the term of the borrowing from the Superannuation Board, 25 years. In that event, the rental under the head lease was to be sufficient to enable T.P.D. to pay all liabilities, including operating expenses in respect of the building and dividends on the preference ``Z'' special shares, but no dividend on the ordinary shares until ``the ninth full year of operation'', i.e. after the borrowing other than from the Superannuation Board had been repaid, and thereafter the dividend on the ordinary shares was not to exceed a specified maximum rate. On either approach, the taxpayer was to participate only to a limited extent in profits from the income from the building during the 25 year period. In the event, the taxpayer elected not to require that I.M.F.C. take the head lease and thus stood to share in accordance with the agreement on the basis of the ``25 year Projected Cash Flow''. The evidence indicated that that would yield the taxpayer a return over the 25 year period which would average 28% per annum on its investment, although in the early years after dividends commenced it would receive considerably less and in the later years considerably more. After 25 years, the ``Z'' special shares would carry no right to more than the fixed dividend at 8% and there would be no limit on the dividend which might be declared on the ordinary shares.
The circumstances leading up to the agreement of 4 February 1972 were explored in evidence in the Supreme Court. There was some documentary evidence and oral evidence from some only of the taxpayer's officers who were involved in the material events which were then about 12 years in the past.
When the taxpayer was approached by I.M.F.C. in 1971, some but by no means all of its directors, notably its managing director, advocated a diversification by the taxpayer which would involve it in leasing instead of immediately selling some of the buildings which it erected. Others on the taxpayer's board opposed such a course. The managing director and those of similar mind considered that the I.M.F.C. proposal provided a suitable opportunity to initiate their policy. The project offered the taxpayer profit on the building contract, income eventually from the dividends resulting from rental income earned by T.P.D., and an increase in value in the shares as a result of any increased value of the site at 45 Grenfell Street. Expert advice obtained by the taxpayer supported the view that the building should be fully let within 6 months of completion and that, when fully let, the estimated net income would be approximately $535,000 per annum which, when capitalised at 8.75%, gave the building a value of $6,294,117, a sum considerably in excess of the anticipated cost.
The managing director wrote a memorandum in the following terms to his co-directors on 16 December 1971.
``CAPITAL APPROPRIATION - 45 GRENFELL STREET, ADELAIDE
I recommend taking half the capital in Tower Property Development Pty. Ltd. for the sum of $125,000.
- A building contract of $3.7 million.
- Dividends of up to $125,000 per annum over 25 years.
- Possible capital realisation $1 million at end of 25 years.
Costs and Implications -
- Joint and several guarantees through Tower Property Development Pty. Ltd. of
- 1st mortgage for 25 years of $3.5 million @ 9.2% with an escalation clause;
- 2nd mortgage for 10 years of $750,000 @ 10%.
I consider that the position as to who takes the head tenancy should be left for discussion by the AVJ board when the question is brought forward after Christmas.''
The board decided to proceed with the project on 23 December 1971 and its decision was notified to I.M.F.C. by a letter written that day.
The managing director's memorandum referred to a loan from the Superannuation Board of $3.5m. As already noted, the Superannuation Board only offered $2.8m. firmly and its offer was made after the taxpayer's board's decision. There is no record of consideration having been given to the possible resulting shortfall in the proposed borrowing arrangements prior to the execution of the agreement dated 4 February 1972, nor was there any further development of the taxpayer's attitude toward the project generally revealed by the evidence.
Soon after the taxpayer acquired its share in T.P.D., an English company, ``British Land'', sought to purchase ``the project'' but was rebuffed.
Prior to the end of 1972, that step was regretted, at least by some officers of the taxpayer and perhaps also by I.M.F.C. An attempt to re-interest British Land failed. In February 1973, agents were appointed to seek out potential purchasers. By May 1973, the National Mutual Life Association of Australasia (``N.M.L.'') emerged as a potential purchaser, and a contract with N.M.L. dated 28 November 1973 was subsequently signed. At the instance of N.M.L.'s solicitor, the sale did not relate to the land at 45 Grenfell Street, but to shares in T.P.D. The building was apparently not completed when the sale took place.
However, the transaction was not a simple sale of the shares in T.P.D. which had already been issued. The total consideration payable by N.M.L. was approximately $6.3m. most of which was required to pass to T.P.D. to discharge its liabilities. Provision was made for the purchase money to be paid by a number of instalments and a final payment on 28 February 1974. The taxpayer and I.M.F.C. were required to utilise each instalment to subscribe for further shares in T.P.D. at par, thus providing it with the funds which it needed. On completion, N.M.L. was entitled to receive a transfer of all the issued shares in T.P.D. in exchange for the final payment. The agreement with N.M.L. also required that a subsidiary of I.M.F. take a head lease of the building for 65 years and that the taxpayer guarantee the performance of the head lease.
The entire foundation of the taxpayer's claim that its profit on the resale of the T.P.D. shares was not taxable was its contention that the sale constituted the realization of an asset acquired as an investment. This contention was in turn based upon the proposition that the taxpayer's dominant if not sole intention with respect to the initial shares in T.P.D. when it acquired them was to retain them for the benefit of the dividends which they were anticipated to produce consequent upon the receipt of rental income from the building by T.P.D. By reference to this proposition, it was argued for the taxpayer:
- (i) that the acquisition and sale of the taxpayer's initial shares in T.P.D. did not take place in the course of any business which the taxpayer carried on - subsec. 25(1) of the Act;
- (ii) that the taxpayer's initial shares in T.P.D. were not acquired by it with the main or dominant purpose of profit-making by sale - para. 26(a), first limb; and
- (iii) that the taxpayer's profit in respect of its initial shares in T.P.D. did not arise from the carrying on or carrying out of any profit-making undertaking or scheme - para. 26(a), second limb.
Since the taxpayer is a company, its purpose has to be determined by reference to the minds of those who controlled it:
F.C. of T. v. Whitfords Beach Pty. Ltd. 82 ATC 4031; (1982) 39 A.L.R 521. The onus of proof lies upon the taxpayer; para. 190(b) of the Act. Statements by the taxpayer's officers as to what they intended have to be ``tested most closely and received with the greatest caution'':
Cox v. Smail (1912) V.L.R. 274 at p. 283;
Jacob v. F.C. of T. 71 ATC 4192 at p. 4194; (1971) 45 A.L.J.R. 568 at pp. 569-570.
The primary Judge considered ``high'' the ``chances that one or more of the following conclusions are correct'':
- (a) that the shares in T.P.D. from which the taxpayer derived capital accretion on sale were acquired by it for at least two purposes, one to obtain a building contract in furtherance of its profit-making building construction business, the other for permanent investment for dividend yield and that the latter purpose was not dominant;
- (b) that the share acquisition was for the purpose of profit-making by sale;
- (c) that the dominant purpose of the share acquisition was to secure the building contract for its profit-making building construction undertaking so that such acquisition was an integral part of that undertaking;
- (d) that the share acquisition and sale was in the course of the taxpayer's ordinary income producing building and development business;
- (e) that the share acquisition was for the purpose of carrying on or carrying out of a profit-making undertaking of property investment, entailing receipt of income from office space rentals and alternatively the acquisition and disposal of properties themselves when returns, values and the market dictated or advised.
The various ``chances'' seem to be merely a formulation in the language of subsec. 25(1) and para. 26(a) of different theoretical possibilities in respect of the basic elements of the transaction which was the subject of the agreement of 4 February 1972. Such theoretical possibilities in part overlap and in part are inconsistent. Nonetheless, his Honour's conclusion in the passage quoted, taken with his judgment as a whole, must be read as a finding that he was not satisfied with the taxpayer's evidence concerning its intention when it initially acquired the T.P.D. shares.
The taxpayer submitted that there was no express rejection of the oral evidence of its witnesses and further that, if such a rejection is to be implied, the reasons deducible from the judgment of the learned primary Judge for such a course reveal errors both in his Honour's understanding of the evidence and in his appreciation of his role. It was said that his Honour reviewed the prudence of the taxpayer's business decisions and the reasons for them with the advantage of hindsight and rejected evidence as to what was done because he disagreed with commercial assessments which had in fact been made. The taxpayer asked that we review the evidence for ourselves and arrive at out own factual conclusion.
There are obvious difficulties in what is asked by the taxpayer. In the first place, it is not apparent that the criticisms of the judgment below are generally well founded. In the second place, even if the reasons given by the primary Judge for rejecting some of the evidence were inappropriate, it would not inevitably follow that that evidence should be treated as accepted. Thirdly, it is not clear that it is open to this Court in the circumstances to review the evidence and arrive at its own conclusion: cf.
F.C. of T. v. Nixon 80 ATC 4297; (1980) 43 F.L.R. 376.
However, out of an abundance of caution, the Court has considered the evidence for itself. The taxpayer's witnesses' oral evidence has not been ignored. In considering it, it has been kept in mind that although his Honour was satisfied of the honesty of the taxpayer's witnesses he commented on a number of aspects of their evidence, for example referring to ``the lapse of time and the fraying of memories''. A reading of the transcript shows that the oral evidence is unpersuasive where it is not supported by the documentation. It is often verbose, elliptical, unclear and inconsistent. Indeed, a number of criticisms may be levelled at the taxpayer's evidence overall, particularly concerning events during the period between the two agreements
ATC 4293under which the taxpayer first acquired its initial shares in T.P.D. and subsequently sold them and the explanations given for what was done. Some only of the directors of the taxpayer were called, a matter which might have little significance if discussions and decisions had been recorded. No witness was called from I.M.F.C., T.P.D., real estate agents who gave advice or were involved in attempts to procure tenants, N.M.L. (except its solicitor who devised the form of the transaction), or any of the lenders. No explanation was ever given for I.M.F.C.'s apparent change of direction at the same time as the taxpayer. There were no minutes in respect of the taxpayer, I.M.F.C. or T.P.D. for the period after 4 February 1972, and the only minutes in respect of the prior period were of decisions taken by the taxpayer's board to which sufficient reference has already been made. There were obvious gaps in the other documentation, particularly in the period after 4 February 1972. There was virtually no documentation which touched upon the decisions of the taxpayer and I.M.F.C. to sell or with respect to any discussions which took place concerning such a transaction.
The taxpayer's case is dependent on a conclusion that the sale to N.M.L. involved a departure from its intention when it acquired the initial T.P.D. shares. Attention was substantially concentrated both in the Court below and in argument before this Court on whether the evidence established that, when it acquired its initial shares in T.P.D. in February 1972, the taxpayer intended to retain them throughout the 25 year period from the completion of the building during which there was to exist a security in favour of the Superannuation Board supported by a guarantee from the taxpayer. The agreement of 4 February 1972 did not purport to prevent the taxpayer from disposing of its initial shares in T.P.D., but the taxpayer did commit itself by that agreement to an involvement in T.P.D. over the 25 year period and the agreement envisaged the receipt by the taxpayer of income by way of dividends on the shares during that period. Further, the terms of the bargain were such that, in a practical sense, the taxpayer's initial shares in T.P.D. would not have been readily saleable except perhaps to I.M.F.C. or in conjunction with I.M.F.C.'s and/or Cathaust's shares in T.P.D., especially after the completion of the building and the grant of security and guarantees to the Superannuation Board. A more commercially realistic possibility might be that the taxpayer initially had not made a firm decision as to what course it would follow and in particular had not excluded the possibility of a sale either of the building or of its shares in T.P.D. prior to the repayment of the bridging finance. There was no indication that that possibility had been contemplated in any of the documentation or oral evidence, it was not directly put to witnesses, and it may be questionable how consistent it really is with the agreement of 4 February 1972. On the other hand, one would not readily conclude that prudent and experienced businessmen would entirely overlook such a possibility, particularly in the context of the disagreement on the taxpayer's board concerning whether or not it should embark upon the project. Further, rejection of the taxpayer's witnesses' evidence that there was a change of mind and of their explanations for the change might perhaps support an inference adverse to the taxpayer: cf.
Steinberg v. F.C. of T. 75 ATC 4221 at p. 4231; (1975) 134 C.L.R. 640 at p. 694. Nonetheless, even if it was open to the primary Judge to conclude differently, the material overall did point to a conclusion that the taxpayer probably did intend to retain its initial shares in T.P.D. for 25 years. However, it would by no means necessarily follow from such a conclusion that the taxpayer's purpose when it acquired its initial shares in T.P.D. was not, or did not include, the ultimate sale of its interest in the project at a profit.
Part of the taxpayer's motivation in entering the agreement of 4 February 1972 pursuant to which it acquired its initial shares in T.P.D. plainly was to obtain the construction agreement in order to earn a profit. Further, insofar as the taxpayer had decided that it would or might retain its initial shares in T.P.D. for a period, it had the further intention to profit by reference to the income from those shares although only after a necessary delay of eight years. We are satisfied that the taxpayer also always expected and intended to profit by the realisation of its interest in the project. Sufficient reference has already been made to the different possibilities concerning when such a sale might take place. It is not certain that the taxpayer had a positive intention that it would realise its interest in the project by a sale of its shares in T.P.D. but the contrary is not established; a sale of shares was always in contemplation by the taxpayer at least as a possible method of realisation of its interest
ATC 4294in the project. Reference might be made again in this context to the taxpayer's managing director's memorandum of 16 December 1971.
It may be assumed in favour of the taxpayer that its profit on the sale of its initial shares in T.P.D. cannot in these circumstances be brought within the first limb of para. 26(a). It may be further assumed that the second limb of that provision has no presently material operation if the taxpayer's profit is not income according to ordinary concepts. On this footing, it is unnecessary to consider the exact relationship between subsec. 25(1) and the second limb of para. 26(a): see Whitfords Beach, supra. It remains to decide whether the taxpayer's sale of its initial shares in T.P.D. was the mere realisation of an investment or whether it was an act done in what was truly the carrying on or carrying out of a business so that the profit was income under subsec. 25(1).
The latter is the correct analysis. An intention to retain the shares in T.P.D. for a lengthy period and to derive income from them during that period might tend to support a conclusion that the shares were an investment, particularly if the share acquisition itself constituted the entire transaction. Here it did not. It was an integral element of a wider transaction. Each aspect of the transaction and the transaction as a whole had profit as the motive. Although the taxpayer had not previously entered into other similar projects, and did not in the event enter into further such transactions for a substantial period after 1972 and then only infrequently, the agreement of 4 February 1972 was at the time contemplated as merely the first of a number of transactions. The policy at that time was that the taxpayer would lease instead of immediately selling some of the buildings which it constructed. The first transaction to give effect to the policy cannot properly be regarded as an isolated transaction merely because the policy was not thereafter fully effectuated. All profit from the project at 45 Grenfell Street, including profit on the sale of the shares in T.P.D., was profit from the taxpayer's diversified business. The sale of the shares was not a mere realisation of an investment at a profit but a step taken in the course of a new part of the taxpayer's ordinary business.
The conclusion which has been arrived at makes it unnecessary to consider the Commissioner's alternative argument in any detail. However, since it was fully argued, it is appropriate to state briefly why it is considered that it should be rejected.
The Commissioner argued that the subject of the sale by the taxpayer to N.M.L. was not merely the shares in T.P.D. initially allotted to the taxpayer but the additional shares in T.P.D. which the taxpayer acquired in performance of its agreement with N.M.L. Assuming that to be so, the Commissioner's claim falls down at the next step whether reliance be placed, as it was, on sec. 26AAA of the Act or, as it might have been but was not, on the first limb of para. 26(a). Were the correct conclusion that pursuant to the agreement with N.M.L. the taxpayer sold its additional shares in T.P.D. at a profit, it could scarcely be questioned that that was the purpose for which it acquired those additional shares in compliance with its obligation under the same agreement to obtain them for sale to N.M.L.
In our opinion, no profit resulted to the taxpayer from the additional shares in T.P.D. which it acquired in performance of its agreement with N.M.L. Commercially, the cost to the taxpayer included any loss in value to its initial shares in T.P.D. which was ``transferred'' from those shares (and any additional shares by then issued) each time the taxpayer received a further allotment of shares in T.P.D. See
F.C. of T. v. Becker (1952) 10 A.T.D. 77 at pp. 80-81; (1952) 87 C.L.R. 456 at pp. 467-468;
Executor Trustee and Agency Co. of South Australia Ltd. v. F.C. of T. (1962) 12 A.T.D. 520 at p. 524; (1962) 36 A.L.J.R. 271 at p. 275;
McRae v. F.C. of T. (1969) 15 A.T.D. 263; (1969) 121 C.L.R. 266;
XCO Pty. Ltd. v. F.C. of T. 71 ATC 4152; (1971) 124 C.L.R. 343;
A.L. Hamblin Equipment Pty. Ltd. v. F.C. of T. 74 ATC 4001 at p. 4011; (1974) 130 C.L.R. 159 at p. 174;
Bath and West Counties Property Trust Ltd. v. Thomas (1977) 1 W.L.R. 1423 at pp. 1432ff.
It is unnecessary to say more on this part of the case. For the reasons already given, the appeal should be dismissed with costs.