Marbren Pty. Limited v. Federal Commissioner of Taxation.

Lusher J

Supreme Court of New South Wales

Judgment date: Judgment handed down 18 October 1984.

Lusher J.

This is an appeal by the taxpayer Marbren Pty. Limited (called the appellant) against the disallowance by the Commissioner of an objection by the company against the disallowance of an item of interest amounting to $18,000 in the company's return for the year

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ended 30 June 1981 as not being considered an expense or outgoing incurred in earning or producing income.

The claim for the deduction of interest relates to an amount of $18,000 said to be a liability of the appellant to the Commonwealth Trading Bank of Australia under the terms of a loan by the Bank for funds made available by the Bank to a wholly-owned subsidiary, Brenmar Building Company Pty. Limited (hereinafter called Brenmar), for that company's purposes. The two companies are related in the manner now outlined.

The appellant was incorporated on 11 May 1960 and Brenmar on 29 March 1973, the directors of the appellant, Mabel Florence Humphery, Brent Humphery and Mark Humphery, being mother and two sons respectively. The directors of Brenmar are Mark Humphery and his wife Judith Humphery, who were also the subscribers. Following meetings of the directors of the appellant on 3 June 1973 and 13 December 1973, the appellant applied for and was allotted 4,000 shares of $1 each in Brenmar, the same being held by Mark and Judith Humphery as trustees for the appellant, 300 of the shares being held by Mark and Judith, 1,850 by Mark and 1,850 by Judith. A document (Ex. J) dated 13 December 1973 signed by Mark and Judith Humphery declared that ``the shares in (Brenmar) acquired by 13 December 1983 are to be held in trust for'' the appellant.

According to the return for the year ended 30 June 1981 the business or income producing activity of the appellant was stated as ``property owners''. The attached balance sheet lists certain land and building as ``fixed assets'' and under the heading ``Investments'' there is the item ``shares in associated company, $4,000''. The directors' report attached to the return sets out the principal activities of the appellant as property rental and management.

Prior to the incorporation of Brenmar, Mark Humphery was an employee of a building company. Following the incorporation of Brenmar and between 1973 and 1977, Brenmar carried out a number of construction jobs in the building industry. It encountered financial difficulties as a result of a refusal by Newcastle University to pay for a substantial amount of work done and arbitration proceedings are now on foot in relation to that. These proceedings commenced in 1976 and although, according to Mr. Humphery in evidence, an estimate of the time that the arbitration was to take was given as 12 days, it has dragged on since then and the litigation is still not complete. According to an Interest Note (infra) in the return, Brenmar has not traded since 1976 and has been under a scheme of arrangement and this was conceded. Mark Humphery was responsible for the day-to-day decisions of both companies, in discussion with his mother.

It is against this background that I turn to the arrangements with the Commonwealth Trading Bank of Australia at its North Ryde branch, which has led to the claim for the deduction of interest by the appellant.

Exhibit D is a mortgage under the Real Property Act, dated 19 March 1975, whereby the appellant as mortgagor being the registered proprietor of certain land therein described, in consideration of advances or accommodation granted or to be granted at the appellant's request to Brenmar as debtor by the Bank as mortgagee, for the purposes of securing to the Bank the moneys lent to the Bank, mortgaged to the Bank the appellant's estate and interest in the land. The mortgage contained, inter alia, a covenant by the mortgagor appellant in respect of the payment of the moneys and interest (covenant A1 and 7). Furthermore, by its terms (F) the debtor, Brenmar, agreed to the terms and conditions of the mortgage and the debtor covenanted that it would pay to the Bank the moneys secured. The document was signed by the three parties, Brenmar signing as debtor. The covenant by the mortgagor appellant as to payment was that ``the mortgagor will at such time or times and in such manner as may at any time and from time to time be agreed in writing between the mortgagor and the Bank and in default of any such agreement on demand pay to the bank...''. There is no evidence of any such agreement in writing or of any demand on the appellant.

It was common ground that moneys were thereafter advanced by the Bank to Brenmar at the appellant's request. On 9 July 1981, which is subsequent to the year of income under consideration viz. year ending 30 June 1981, the Bank wrote to Brenmar in the following terms:

``9 July 1981

The Secretary

Brenmar Building Company Pty. Ltd.

58 Mactier Street

Narrabeen N.S.W. 2101

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Dear Sir,

Your Advance Account Brenmar Building Company Pty. Ltd. Balance Debit $111,287.46

As you are aware your account at this office has been irregular for some considerable time.

The Bank has so far been very patient and tolerant but it is disinclined to allow what must be considered an unsatisfactory situation to continue indefinitely. Twelve months ago the balance of your account was Debit $96,667 but with accruing interest and charges now stands at $111,287.46. As you can see the debt is escalating at a rapid rate and with a current interest rate of 16.5% applying it will continue to do so.

Please telephone the writer to arrange an appointment for a mutually convenient time to discuss the matter and the implementing of a reduction programme.

We mention that we have also written to the third party mortgagors, Marbren Pty. Ltd. informing them of the present situation.

Yours faithfully

D.H. Gunton


On the same day the Bank wrote to the appellant as follows:

``9 July 1981

The Secretary

Marbren Pty. Limited

Adwill Place

Blenheim Road

North Ryde N.S.W. 2113

Dear Sir,

Advance Account

Brenmar Building Company Pty. Ltd.

Balance Debit $111,287.46

The debt on the above account, which is secured by a mortgage over your property 22-26 Blenheim Road, North Ryde, is steadily increasing as interest is not being met. Current interest rate is 16.5% and debt will continue to increase unless a reduction programme is commenced.

We have written to the debtor company requesting commencement of a reduction arrangement. If they are unable to do so you may feel it appropriate to initiate a repayment programme in order to protect your own interests. We would be happy to retain any such repayments in a separate reduction account so that your rights can be recognised.

We would be pleased to discuss the matter with you.

Yours faithfully

D.H. Gunton


On 22 January 1982 the Bank wrote a letter to the appellant in the following terms, the same being read on to the transcript:

``The Secretary

Marbren Pty. Limited,

Adwill Place, Blenheim Road,

North Ryde.

Dear Sir,

Due to a further upward movement in interest rates generally the Commonwealth Trading Bank of Australia has found it necessary to increase the interest rates applicable to bridging loans and advances of $100,000 and over.

Would you kindly note that from 20 January 1982, the interest applicable to your account will be as follows:

Account No. 140-550 Name: Brenmar Building Co. Pty. Limited Interest Rate: 18 per cent

Yours faithfully

D.H. Gunton, Branch Manager.''

By letter dated 17 February 1982, which was also read on to the transcript, the Bank wrote as follows:

``Mrs. M.F. Humphery,

Marbren Pty. Ltd.

Adwill Place, Blenheim Road,

North Ryde.

Dear Mrs. Humphery,

I refer to our recent discussions regarding the Account, Brenmar Building Co. Pty. Limited.

I am pleased to inform you that subject to your lodging $26,000 in a separate Account and undertaking to meet accruing interest as well as reductions to the debt, the interest rate will be reduced to 14.35%.

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I am enclosing a copy so that you may forward to your accountants, John P. Walker & Co.

Thank you for your help and co-operation.

Yours sincerely,

D.H. Gunton, Manager.''

A statement of account with the Commonwealth Trading Bank of Australia, North Ryde, was tendered. This showed the name of an account as being Brenmar Building Company Pty. Ltd., 3rd Party Mortgagor's Reduction Account. Underneath that there appears in another block on the document containing, ``Brenmar Building Company Pty. Ltd., C/o The Manager, Commonwealth Bank, North Ryde, N.S.W. 2113''. In another block there is an account number given as 127-209 and in a further block, p. 1. The statement commences with a credit entry on 24 February 1982 of the sum of $26,000 by cheque followed by subsequent credit payments, concluding on 24 September 1982 when the account showed a credit of $36,218.66. A deposit book with the same bank was tendered the duplicates showing payments to the credit of Brenmar Building Company Pty. Ltd. No. 2 Account, Brenmar Building Company Pty. Ltd. and Brenmar Building Company Pty. Ltd., 3rd Party Mortgagors Reduction Account. These payments commenced on 24 February 1982 and concluded on 27 January 1984. The deposits correspond with the credit amounts on the statement for the period of the latter. The deposit of $26,000 on 24 February 1982 comprised cheques being from the appellant $10,000, M. Humphery $6,000 and May Humphery Pty. Ltd. No. 2 $10,000. This deposit was to the credit of Brenmar Building Company Pty. Ltd. No. 2 account. The deposit of $1,000 on 17 March 1982 was by cheque drawn by M.F. Humphery for $1,000 deposited to the credit of Brenmar Building Company Pty. Ltd. and thereafter the deposits were cheques drawn by the appellant and after a further deposit to the credit of the Building Company and two more to the No. 2 account, the rest are to the credit of the 3rd Party Mortgagors Reduction Account.

All the foregoing financial material was tendered without objection, no doubt as offering some explanation as to the nature of the transaction in question. Only portion of the $26,000 was paid by the appellant.

I turn now to the appellant's return for the year ending 30 June 1981 and the deduction claimed. This return was prepared by Mr. Walker, a Chartered Accountant. Mention has been made of certain items in the balance sheet. At the foot of the page which contains the balance sheet as at 30 June 1981 and after the balance has been ruled off, there appears the following:

``Contingent Liability. The Company has executed a Deed of Guarantee with its bank to secure the borrowing of an associated company prior to 30 June 1980. The Bankers have now indicated that they would in the near future look to the mortgagee (sic) for loan repayments.''

The Operating Statement for the same year attached to the return, under the heading of Expenditure, lists the item the subject of this appeal as follows: ``Interest $18,000''. In a separate sheet also, attached to the return appears the following:


      Interest -             Commonwealth Trading Bank,
                             North Ryde           $18,000

Interest Note

A contingent liability has been disclosed in this and previous years by the Company. This liability arose when the wholly-owned subsidiary of the Company borrowed funds from the Commonwealth Trading Bank prior to 30 June 1976. The loan was secured by a mortgage over land and building of Marbren Pty. Limited.

The borrowing company has not traded since 1976 and has in fact been under a scheme of arrangement as a result of disputes arising from arbitration and as yet not resolved.

The Commonwealth Bank has now indicated that it will be seeking to exercise its rights within the terms of the loan. Prudent business practice has been exercised and an amount of interest with respect to the loan has been accrued. The amount of interest has been calculated as follows:

      Borrowing by Subsidiary prior to           $
          30/06/1976                           80,000
      Less: Loan Balance estimate
          30/06/1981                          116,000
      Accumulation due to interest             36,000
      Interest Accrued - half only            $18,000

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It was agreed and read on to the transcript that in the appellant's return for the year ended 30 June 1980 there appeared under the heading ``Contingent Liability'' the following:

``The Company has executed a Deed of Guarantee with its bank to secure the borrowings of another company prior to 30 June 1980. No claim to date has been made on Marbren Pty. Ltd., in respect of this guarantee.''

A minute of the appellant dated 7 December 1980 recorded that up to that date the Bank had made no formal claim on the appellant.

Mr. Walker was called by the appellant, he was the accountant for both companies, although he did not prepare Brenmar's returns until later. He took over the accountancy work for the appellant at the end of the calendar year 1981 or early 1982 and the return was lodged on 10 February 1982. He brought into the books of the appellant company the shares in Brenmar as an asset. It was he who calculated the amount of interest and prepared the above note concerning it. He said that reflected his opinion at that time. He was asked in chief:

``Q. On what basis did you conclude that $18,000 was the appropriate amount to bring to account in that financial year? A. After a lot of consideration, because I did not know the starting amount of the loan...''

After a question from myself as to the basis for it, he continued:

``I do not remember all the reasons now but from the report that I mentioned in the previous answer we were looking at $118,000 and the offer by the bank to bring it back below $100,000. I could have brought in any number of figures. You would subsequently find it would get up into something of the order of $35,000, I think it was but I brought in what I thought was a reasonable figure at that time because I had nothing better to work on.''

He first became aware of the existence of the mortgage when he first took over the responsibility of the appellant's books. He knew of it from correspondence but he did not think he saw the mortgage until much later.

In cross-examination Mr. Walker agreed that he had formulated the sum of $18,000 under the heading ``Current Liabilities'', the item being trade creditors and accrued charges. He said he had to accrue it as a double entry and he said that there was no cash payment in the year of income of that sum of $18,000 but an accrual. The witness was shown the interest note and asked whether it reflected his instructions.

``Q. I take it that what you have there reflects your instructions. I take it that draft reflected your instructions at the time of the preparation of this return? A. I would not put it that way.

Q. Do you say you drafted something that was out of conformity with your instructions? A. It was a decision reached after a lot of discussion.

Q. Did it or did it not reflect your instructions from the taxpayer the note that you drafted? A. I doubt it very much.

Q. Is it not a bit curious, Mr. Walker? A. No, I am an accountant and they come to me for services.''

He said that ``Borrowing by subsidiary...'' referred to borrowing by Brenmar. He was then asked:

``Q. Did you check the balance of borrowings at any stage from any documents? A. There was nothing to check it from.

Q. So the answer to that is that you did not check it from any document, is it? A. The answer to your question is no.

Q. And similarly I take it it appears from the face of it that the figure $116,000 was an estimate and not a figure from any documentation? A. That is correct.''

He said that the Bank did not have any documentation to give him. He thought the Bank had sent it back to the archives.

He did not remember the precise reason. He was asked:

``Q. The way in which you approached it was to take an estimated figure called `the borrowings of the Company Brenmar prior to 30 June 1976, that is $80,000'. A. Yes.

Q. And you have estimated the balance of the loan as at 30 June 1981 at $116,000? A. Yes.

Q. You then subtracted those two figures?

A. One from the other.

ATC 4788

Q. And that gives you an amount of $36,000? A. Yes.

Q. And then you have written the words in relation to the $36,000 `Accumulation of Interest', do you see that? A. Yes.''

He said that he had not seen any documents which discriminated between principal and interest in the period in question. As to whether the principal was constant at $80,000 during the period he said he had been given different answers from different people around the figure of $80,000 and his calculation assumed the $80,000 was constant.

He was asked:

``Q. You did not offer a reason why you claimed only half this amount of money? A. No.

Q. And in particular no provision is made in the year of income in these accounts for the other half of this estimated interest accumulation? A. No provision, no.''

He said he did not provide for the other half.

This witness stated and it was the fact that there was no evidence of any payment during 1973 by the appellant for or in respect of taking up shares in Brenmar. He also stated that in the return for 30 June 1982 of the appellant in the operating statement in the expenditure the sum of $35,650 for interest paid on behalf of a subsidiary company had been written back. In answer to further questions on this he said it was a bit involved, but agreed that the effect of the figures in the 1982 return was that no claim is made for deduction of the sum of $32,000 as interest paid on behalf of a subsidiary in 1982.

Counsel for the appellant conceded in argument that no dividends had ever been received by the appellant from Brenmar and that Brenmar had never made a profit.

There was some cross-examination by counsel for the Commissioner as to the preparation of some of the minutes and other documents in evidence and as to whether there had been any payment by the appellant for the shares but no reliance was placed upon any of this evidence by counsel in his submissions.

The evidentiary material presented no conflict, and no submission as to the acceptance or rejection of any of the evidence of witnesses was made.

Section 51(1) of the Income Tax Assessment Act 1936 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 broad case made by the appellant was that the deduction came within both limbs of the subsection in that the interest was outgoings incurred in gaining or producing assessable income or was necessarily incurred in carrying on a business for the purpose of gaining or producing such income. The submission was that the appellant carried on the business activities of an owner of realty and shares with a view to receiving income and dividends.

It was submitted that the mortgage was given for funds to put the appellant's subsidiary into a financial position and to enable profits to ultimately be made and dividends declared and the fact that Brenmar made losses was of no effect.

The Commissioner's submission was that the transaction involving the three parties, that is the appellant, Brenmar and the Bank in a normal or business sense was really one of surety and guarantee by way of security so far as the appellant was concerned, that Brenmar was the customer of the Bank and the debtor to it for the loan for the funds, that it would never have been contemplated but the liability of the appellant was primary to that of the customer/debtor of the Bank who had borrowed the funds and covenanted to pay. Further, it was put that any liability of the appellant was no more than a contingency and in any event no liability or obligation to pay under the mortgage arose in the appellant until such time as a demand was made on it by the Bank. There was in fact no argument in writing between the Bank and the appellant as to the times of payment and no demand for payment had been made on the appellant.

In support of the Commissioner's submission, counsel pointed to the fact that the appellant's accountant so regarded the

ATC 4789

transaction as a contingency and guarantee to secure the borrowings of Brenmar as evidenced by the accountant's note on the balance sheet and the interest note attached to the return. The further submission for the Commissioner's counsel was that the figure for interest claimed on the evidence of Mr. Walker, the accountant, and the other material was completely speculative and guesswork and bore no relationship to any provable amount.

Prominent among a number of facts not in dispute are:

1. That the appellant is a private company, its business according to the return is stated as that of ``property owner''. Its income for the year in question was $17,547.37 from rents, less loss of $1,619 on a farm, leaving a balance of $15,928.37 as income. It also owned 4,000 shares in its subsidiary, Brenmar.

2. The loan by the Bank was made to Brenmar in 1975, at a time when apparently that company was then operating in building activities.

3. Brenmar ceased operations in 1976 and never traded thereafter. This appears specifically from the interest note (supra), and also Directors' Report attached to the return in para. (b)(ii) ``The Company is a holding Company for a wholly-owned subsidiary Brenmar Buildings Pty. Ltd. This company is under a scheme of arrangement and has been so since 1976. No accounts for the Company have been prepared since that date''.

4. The claim for the deduction of interest is made in the year ending 30 June 1981. In that year Brenmar was not carrying on business or trading nor did it produce nor was it likely to produce any income or declare any dividends.

In the circumstances of this case, I cannot understand how it can be said that the item of interest, assuming it to have been in fact paid and/or was outgoing within the meaning of sec. 51(1) can be said to have come within either limb of that section as being incurred in gaining or producing the assessable income or as necessarily incurred in carrying on a business for the purpose of gaining or producing such income.

In my opinion, in the light of the facts, a negative answer is to be given to the question posed by either of the two limbs of the section. In these circumstances and for these reasons, in my opinion, the appeal must fail. There are, however, two further considerations to be mentioned. The first is that, having regard to all the circumstances, the commercial reality of the transaction involving the appellant Brenmar and the Bank must surely have been as disclosed in the Report of the Directors, attached to the return (para. (1)), where it was stated in relation to contingent or other liabilities; ``A liability to the Commonwealth Bank of Australia for principal and interest amounting to $118,000, property of the Company was used as collateral to secure a loan for an associated Company. That Company is presently under a scheme of arrangement''.

This is consistent with the Interest Note (supra) attached to the return that ``... the wholly-owned subsidiary of the Company borrowed funds from the... Bank prior to 30 June 1976. The loan was secured by a mortgage and loan and buildings of Marbren Pty. Limited''.

It is also not inconsistent with the correspondence with the Bank previously mentioned. Finally, in my opinion, it is not in any way inconsistent with the tenor of the totality of the mortgage document. It is also noted that in the note attached to the Balance Sheet attached to the return that reference is made to a contingent liability in terms, ``the company has executed a Deed of Guarantee with its Bank to secure the borrowing of associated Company prior to 30 June 1980...''. This is obviously a reference to the mortgage document. It is also noted that no demand for payment was made on the appellant at any relevant time.

The second matter is that the method of computing the amount of interest is arbitrary and offers no real assessment of it. The appellant's counsel conceded that it was obviously questionable whether the figure was correct and that it could not be supported but that it was enough for the appellant to establish some outgoing was due and was then for the appellant and the Commissioner to work out a correct deduction. It is noted that it was conceded also that the principal was not a fixed mortgage amount outstanding over a given period. The figures as set out in the Interest Note (supra) referred to some borrowings by Brenmar and were all an estimate and not checked from any documentation as there was

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nothing to check it from and this included the Bank.

A number of authorities were relied upon by the appellant but on the view that I have reached on the facts there is little purpose in entering upon a discussion of them. However, it is to be mentioned that they included
Esquire Nominees Ltd. v. F.C. of T. 73 ATC 4114, (1973) 129 C.L.R. 177;
F.C. of T. v. Total Holdings (Aust.) Pty. Ltd., 79 ATC 4279;
F.C. of T. v. Snowden & Willson Pty. Ltd., (1958) 99 C.L.R. 431;
F.C. of T. v. James Flood Pty. Ltd., (1953) 88 C.L.R. 492;
F.C. of T. v. Manufacturers' Mutual Insurance Ltd. 31 S.R. (N.S.W.) 575, and more recently since the matter was reserved,
F.C. of T. v. E.A. Marr & Sons (Sales) Ltd. 84 ATC 4580, given in the Full Court of the Federal Court, 3 August 1984, an appeal from this Court.

Accordingly, for the reasons given, the appeal is dismissed with costs. The exhibits may be returned.

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