Case R105

KP Brady Ch

JE Stewart M
DJ Trowse M

No. 2 Board of Review

Judgment date: 5 October 1984.

K.P. Brady (Chairman), J.E. Stewart and D.J. Trowse (Members)

The taxpayer in these references is a proprietary limited company acting as trustee for a family trust. The references relate to the years of income ended 30 June 1980 and 1981. Three issues call for our examination. The first question is whether the trustee was engaged in the above years in carrying on a business of primary production for the purpose of gaining assessable income. The Commissioner was of the view that it was not so engaged and disallowed farm losses of $27,942 and $26,048 respectively. Secondly, on the basis that there was a business of primary production, a further question arises as to whether all the expenditures claimed were properly deductible. Thirdly, and subsidiary to the first issue, is the question that, if the Commissioner acted properly in disallowing the taxpayer company's claims, was he correct in raising assessments against the trustee under the provisions of sec. 99A of the Assessment Act?

2. The ``specified beneficiaries'' of the trust were the children of a married couple; we shall call the husband M, and his wife N. In the Deed of Settlement which established the trust and which was dated 12 June 1975, M and N were described consecutively as the ``Guardian'', the ``Appointor'' and as ``Additional Members of the Class of General Beneficiaries''. All those terms were defined in Clause 1 of the Deed. They were also directors of the trustee company, which we shall call AB Pty. Ltd., together with their accountant who was in public practice, and a lawyer.

3. In order to enumerate the relevant facts, it is necessary to go back in time to the year 1972. In that year M and N were in partnership selling cosmetics, vitamins and cleaning products direct to consumers in their homes. It seems that the business was a very successful one. With a view to expanding their business interests, they decided to buy a farm and commissioned an agricultural consultant to act for them. As a result of his endeavours they purchased, in March 1972, a property of approximately 570 acres from a farmer, whom we shall call C, for a purchase price of $47,364. Of that amount, $10,000 was payable as a deposit with the balance payable over seven years as from the date of possession.

4. It seems that the property could be developed either for beef cattle or for sheep. The word ``develop'' is used advisedly because the carrying of the property was very low at the time of purchase, stemming from the fact that no pasture improvement had taken place on it for many years. M and N were told by the consultant that, with the implementation of a suitable pasture improvement programme, and by re-fencing the property to reduce the size of the paddocks and so control grazing better, the capacity could be improved substantially. Ultimately the decision was made to continue to run sheep. Accordingly, an initial purchase of some 18 month old Merino wethers was made in

ATC 695

approximately June 1972, followed by a further purchase of 700 wethers some few months later. The vendor, C, was invited to remain on the property to look after the sheep and this he did whilst he was completing a new home in the township of X, and for a year or so afterwards. His takes involved ``going round the sheep'', checking on them and moving them as grazing demands required. It is appropriate to mention here that neither M nor N had any knowledge of farming and the supervisory work was done by the consultant, with the more mundane tasks being performed in the first instance by C, and subsequently on a part-time basis by a neighbouring farmhand. It seems that M and his wife and three sons visited the property every second weekend or so, when they checked out in a general way how matters were progressing and performed some minor tasks.

5. Some detail should also be provided in regard to the property itself. It was located close to the township of X, which is situated adjacent to a main highway some 80 kilometres from the State's capital city. The land was contained in some eight titles. Aerial photographs tendered by the taxpayer's counsel showed the property to be like a human foot in shape, with the ``toe'' adjoining the southern end of the township. What we have termed the ``toe'' was referred to by M as ``the town paddock'' and covered an area of approximately 95 acres. It contained a dam and, unlike the rest of the property, it had a town water entitlement. It comprised titles separate from those relating to the rest of the property, and in fact comprised five Crown allotments of between approximately 18 and 20 acres each in the original parish plan. Some time in 1976 it seems that a re-zoning took place and effected the ``town paddock'' in that approximately one-third was zoned residential A and the balance zoned for subdivision into small farmlets.

6. By early 1973 there were approximately 1,500 sheep on the property, and over the next few years the pastures were progressively improved and the carrying capacity increased. By 1975 the farm had been put on a profitable basis, as evidenced by the following annual trading results:

      Year ended 30 June 1972 -     719    loss
                         1973 -   9,004    loss
                         1974 -   3,403    loss
                         1975 -   3,264    profit

7. In that latter year a trust was established for M and N and their family by a deed of settlement dated 12 June 1975. By an agreement in writing dated 1 March 1976, the assets of the farming business (other than the land), and the assets of the direct selling business, were sold to a company, AB Pty. Ltd., as trustee of the MN Family Trust, and the company agreed to discharge the liabilities of M and N which related to those businesses. The stated purpose of the sales of the two businesses was to put all income-producing activities of M and N into the one entity, with the attendant advantage of being able to divert income amongst members of the family. The accounts of the trustee company for the four months March/June 1976 disclose that there was a loss incurred in that period of $4,500 on sheep trading. However, sales of wool amounted to $8,332 and, after taking account of expenses, the profit on the farm operation came out at a figure of $2,333. The direct selling business, now under the ownership of the trustee company, also continued to make good profits.

8. The balance sheet of AB Pty. Ltd. at 30 June 1976, which was tendered in evidence by the Commissioner's counsel, together with all other annual accounts of the company up to the years of income in issue, provided details of the assets purchased from M and N and of their business liabilities which it had agreed to discharge. The amount due as a result of the agreement of 1 March 1976, presumably was included in M and N's loan accounts with the company. The balance sheet also reflected the debt due to C for the balance of the purchase price of the property. However, we were not advised of any novation in regard to that debt, and it remains unclear how it came to be included in AB Pty. Ltd.'s accounts.

9. On 1 July 1976 the farm property was sold to AB Pty. Ltd. for a consideration of $244,000. That price was based on a valuation undertaken by an officer of the Valuer-General's office on 20 November 1975, when the capital value of the property was determined at that figure. A copy of the Contract of Sale of Land between M and N as joint vendors and AB Pty. Ltd. as purchaser was tendered in evidence. It set out the price of $244,000 but provided no details as to how payment was to be made. On the same day, 1 July 1976, a Transfer of Land document was completed whereby C, as the registered proprietor of the land, transferred, at the direction of M and N, all their interest in the

ATC 696

said land to AB Pty. Ltd. It seems that the balance amount due to C by M and N was not paid over to him (or his legal representative) until some months later, on 17 December 1976.

10. Despite the fact that the property was not conveyed to AB Pty. Ltd. until December 1976, it was brought into the company's accounts at 30 June 1976. It seems to have been included by way of a general journal entry which, simultaneously with bringing the property into account as a fixed asset, categorised the debt comprising the property's purchase price as loans due to M and N.

11. Settlement of the balance amount due to C was effected by AB Pty. Ltd. obtaining a mortgage loan of $100,000 from O, a large insurance company, on the security of the farm property. Repayment was over a period of 10 years. After payment was made to C, and after settlement of legal costs, the balance of $77,412 was placed at call with a merchant banking firm and was drawn progressively during 1977 as and when the trustee company was in need of funds. Its balance sheet at 30 June 1977 reveals a long-term loan of $100,000 due to O, and also that the debt due to C had been paid out. The accounts for that year, in accordance with the accountants' standard practice, contain separate statements of income and expenditure for the direct selling business and the farm operation. From a reading of those statements it seems that all interest on the loan had been charged against the farm operation. That fact is of interest in the light of comments which we will make later in this narrative regarding the stated uses to which the loan funds were put.

12. The expectation of future profit-making on the farm operation, which seemed a realistic hope in 1975, was disrupted in the years 1976-1978 by losses to sheep occasioned by attacks from dogs. M outlined the problem in his examination-in-chief in the following terms:

``As mentioned previously, because of our proximity to the town of [X], and also with the increase of building of residences in the town of [X], [X] being an industrial country town as well as a farming town because of the... and other industrial companies there, they were taking on labour because a lot of building of houses was taking place during that time, and with it brought an increase in the number of domestic dogs, and a phenomenon that occurs from time to time, so I was led to beleve at the time, is that dogs for sport start attacking sheep, and once they get a taste of blood it attracts other dogs to follow them and domestic dogs were hunting in packs; it was not feral or other predators; it was just ordinary dogs.''

13. As a result of the dog attacks, 500 sheep were killed in the 1975/76 year and induced the loss of $4,500 previously mentioned. A further 200 sheep were killed in the 1976/77 year and again induced a loss on sheep trading; in that year it amounted to $1,800. With the farm operation absorbing all of the interest cost, a net loss resulted amounting to $12,798.

14. The losses of sheep through the dog attacks continued, but at a much reduced scale in 1977/78, and a profit of $1,403 was made on sheep trading. Interest of $13,737 was paid to O, and again was totally charged to the farm operation. The balance sheet of the trustee company at 30 June 1978 reveals that the loan from O had been reduced to $95,000 and that a new loan of $60,000 had been secured from P, a public company. We will refer to that loan later on when speaking of the uses to which those loan funds were said to be put.

15. It seems that attempts were made to overcome the dog attacks over a period of some time by setting traps and by shooting them, but they persisted to such extent that the decision was made in approximately August 1977 to quit sheep grazing altogether. By June 1978 all sheep had been sold.

16. Cattle grazing was considered as an alternative activity, but the market was seen to be depressed and the decision was ultimately taken to breed Appaloosa horses as that activity was gaining in popularity in the area due to the buoyancy of the market. The town paddock, or ``toe'' of the property, was seen as the most suitable location for the operation, and the appropriate improvements by way of yards and fencing were effected on the consultant's advice at a cost of approximately $10,000.

17. It seems that the first horse, a thoroughbred mare, was purchased in October 1976 at a cost of $1,750. Shortly afterwards, an Appaloosa mare with a foal at foot that was later to become the operation's stallion, was purchased at a cost of $1,900. M informed us that there were at that time two distinct directions one could take in the Appaloosa breeding industry; first, breeding progeny for

ATC 697

displaying at horse shows and, secondly, breeding speed horses for sprint racing. He stated in his evidence that:

``We could see, and we had read through magazines from the United States that Appaloosa sprint racing was a much more viable and profit-making concern than was Appaloosas for just show horses, so we decided to breed for speed, and to that end as well as Appaloosa mares, we purchased thoroughbred mares that came from sprinting stock.''

18. At 30 June 1977 M considered that there were seven Appaloosas on the property; also he informed us that non-Appaloosas were then being accepted for agistment. The part-time worker, of whom mention was made earlier, was kept on with the change in the operation. He regularly checked on the water supply to the troughs and fed the horses twice a day and generally cared for them; additionally, he maintained the property on a day-to-day basis.

19. It seems that a measure of success was initially achieved with the horse business. In early 1977, a second horse, a thoroughbred mare, was purchased for $750 and was joined with a locally owned stallion for which a service fee was paid. A foal was born and was sold for $750. A second thoroughbred mare was purchased at a cost of $1,100, followed by the purchase of a pure Appaloosa mare, again at a cost of $1,100. The accounts at 30 June 1978 reveal that the natural increase during the year amounted to three, and that a profit of $1,950 was made on that part of the trust's activities. With no sales or deaths during that year, stock of horses at the year's end amounted to 10 and had a value of $8,695. The stock comprised six mares, a colt, a foal, a stallion and a work horse. The accounts also confirm that no sheep were on hand as at that date.

20. In the following year, 1978/79, two foals were born and two sales were made, including one of the brood mares, at a total value of $1,250, and a profit of $1,405 was said to be made. Accordingly, the stock of horses at 30 June 1979 was again 10, and the value placed on them was $8,850.

21. M stated that about mid-1979 he commenced to have misgivings as to the future profitability of the horse breeding business. He advised us that the popularity of Appaloosa breeding had grown to such an extent that there was a glut of horses on the market, with a consequential adverse effect on sale prices and profits. The decision was therefore taken to quit that aspect of the trust's business. The accounts for the 1979/80 year (the first of the two years in issue before us) reveal that a gross trading loss of $50 was incurred on the horse breeding activity resulting from sales of foals for $1,850. Natural increase equated losses through deaths (2), and so the stock of horses amounted to seven at 30 June 1980, on which was placed a value of $6,950.

22. Later in the 1980 calendar year (and thus in the second year of the two years in issue), the decision was taken to sell all of the property other than the town paddock where the horse breeding activity was being conducted. The area, the subject of sale, totalled approximately 475 acres. The sale was effected in late 1980, and possession given to the purchaser in January 1981. The price obtained was $124,000.

23. In that same year ended 30 June 1981 the accounts disclose that one foal only was born. That increase was more than matched by two deaths. One horse was sold for $225. Accordingly, five horses remained at the year's end and a value was placed on them of $650 only, leading to a gross trading loss of $2,075.

24. Subsequent to the 1981 year of income, the remaining 95 acres were sold following upon the re-zoning of that part situated close to the town as residential and the remainder as small farmlets. The net proceeds from such sales amounted to $84,000. The remaining horses were sold some time in 1982 at a substantial loss.

25. Can it be said that the trustee company, AB Pty. Ltd. was carrying on a business of primary production in the years of income ended 30 June 1980 and 1981? It seems clear that M and N were carrying on a business of primary production, namely sheep farming, in the years leading up to the date when they sold it to the trustee, i.e. March 1976. Also we consider that the trustee was subsequently carrying on a business; first, that of sheep farming in the latter part of 1975/76, then that of sheep farming combined with horse breeding in 1976/77 and 1977/78, and solely horse breeding in 1978/79. It seems also that the Commissioner regarded the various operations in the same light and allowed deductions to the taxpayer company as claimed. However, can it now be said that a business continued to be carried on in the years

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in issue, when the decision had been made early in the first of those years to quit the operation and sell off the greater part of the property and generally let the operation wind down, in the full realisation that no profit henceforth could reasonably be expected?

26. That the activities did in fact diminish is reflected in the following income and expenditure figures for the farm operation for the years in issue when, it will be noted, operating costs were few in number, and nominal in amount:

                                       30 June              30 June
                                        1980                 1981
         Income                           $                    $
      Agistment                         4,382                3,315
      Loss on horse trading               (50)              (2,075)
      Phosphate refund                     -                   104
                                       ------               ------
                                       $4,332               $1,344
                                       ------               ------
         Less expenses                    $                   $
      Farm supplies                       708                 226
      Superphosphate                    2,060                  -
      Fodder                               61                  -
      Poisons and sprays                   95                  -
      Horse breaking                      105                  -
      Selling expenses     -
        horses                            127                  -
      Tractor expenses                    387                  30
      Farrier                              40                  -
      Stud fees and levies                347                  -
      Freight                              43                  90
      Veterinary supplies
        and services                      322                  25
      Salaries                          5,349                  -
      Supervision fee                      -                3,070
      Depreciation                        603                 521
      Rates                               307               1,738
      Insurance                           955                 758
      Electricity                          84                  40
      Telephone                           106                  97
      Interest                         20,185              20,279
      Borrowing expenses                  390                 518
                                      -------             -------
                                      $32,274             $27,392
                                      -------             -------
         Net Loss:                    $27,942             $26,048
                                      -------             -------

27. With the direct selling business continuing to make good profits (that business, it will be recalled, was purchased by the trust in March 1976, concurrently with the farming business), the above losses were offset against those profits in arriving at the trust's net income. It is the Commissioner's action in disallowing those losses that forms the basis of the taxpayer company's objection, and of this review.

28. It is convenient to proceed to deal with each of the three matters that have to be decided under separate headings. In considering each of them, we shall refer to such further facts as seem to be relevant to the question being examined.

Whether a business of primary production was being carried on by the taxpayer:

29. Whether or not a business is carried on is a question of fact, and the question whether a taxpayer ceases to carry on business is also a question of fact. It is therefore necessary to examine closely the operations of the taxpayer at the time when cessation is alleged to have taken place. The Commissioner's counsel contended that, if there had ever been a business of breeding horses, it had well and truly ceased prior to the year of income ended 30 June 1980. He contended that there were no breeding activities after mid-1979, and that the decision so taken was part of a policy to avoid, or at least minimise, trading losses. He also pointed to the fact that there were no further purchases of bloodstock after mid-1977, and that after the 1976/77 year no serious attempt was made to build up the breeding stock to a commercial level. He also alluded to the fact that the services of the stallion were never advertised, nor was there any attempt to sell progeny in Queensland where the market for Appaloosa sprint horses was said to exist. At first glance, it could be said that a number of the above arguments seem to go more to the matter of business efficiency than to whether the business continued to exist, but as ``the determination [of a business] is eventually based on the large or general impression gained'' (see
Martin v. F.C. of T. (1953) 90 C.L.R. 470 at p. 474), all the arguments advanced by the Commissioner's counsel may be said to be relevant.

30. The Commissioner's counsel referred us to
Inglis v. F.C. of T. 80 ATC 4001, where the matter of cessation of primary production operations was in issue. There, the taxpayer and her husband had conducted a sheep grazing business (subsequently changing over to cattle) on 1,300 acres of land situated not far from Hobart. They had acquired the property in 1950. In the 1960s they had become involved in protracted litigation with their bank, with actions in the Supreme Court of the Australian

ATC 699

Capital Territory, the Supreme Court of Tasmania and the High Court of Australia, and the demands placed upon them by that litigation caused them to reside in Melbourne for a time, and later in Canberra, where both found employment. By the end of the 1969 year, no pastoral, grazing or agricultural activities were carried on by them and no stock belonging to them was carried on the property. For the 1951 to 1972 income years, the Commissioner assessed the taxpayer and her husband on the basis that they were carrying on a grazing business. However, commencing with the year ended 30 June 1973 he considered that a business was no longer being carried on. The taxpayer appealed in her personal capacity, and also in her capacity as executrix of the will of her late husband, against assessments issued to her and her husband for the years ended 30 June 1974 and 30 June 1975, in which deductions said to have been incurred in carrying on a business on the property were disallowed. Those deductions, whilst more limited in extent than those claimed in the instant case, comprised a number of similar expenditures such as interest, rates, telephone and borrowing expenses.

31. The taxpayer, Mrs. Inglis, argued that a business was in fact carried on upon the property at least up to the end of the income year ended 30 June 1972, and that she and her husband always maintained an intention of carrying on that business but were forced to leave the property, and for a time to leave it unstocked, always intending to go back and carry on the business as they had done in the past.

32. The case was heard in the first instance in the Supreme Court of New South Wales (77 ATC 4305). There, Sheppard J. found that no business existed in the relevant tax years, and dismissed the taxpayer's appeal. He was of the view that the evidence was clear that by the end of 1969 all pastoral activities had ceased on the property. Also, he considered that, since there had been no activity in the years leading up to the years of income in issue, the taxpayer's alleged intention to return to the property to recommence the pastoral operation was not sufficient to establishing the existence of a business in the 1973/74 and 1974/75 tax years. That decision was subsequently confirmed by a unanimous decision of the Federal Court.

33. In our view, however, the Inglis decision is far from conclusive of the matter. We say that because of the marked differences in the factual situation which appertained there and which appertains in the instant case. The Federal Court in Inglis, and earlier in
Ferguson v. F.C. of T. 79 ATC 4261, stated that the determining factor in concluding whether a business is carried on or not is the degree of activity associated with it. In Inglis it was found that there was no activity; no pastoral, grazing or agricultural pursuits had been followed for some years. Likewise, no stock, with the possible exception of some strays, had grazed on the property since 1969. Also, all of the land was the subject of two contracts of sale.

34. Those facts are to be contrasted with the present situation where there was at all times during the two years of income in issue breeding stock on the property. Also, sales were made in both years giving rise to assessable income and, at least according to the accounts, foals were born both in 1980 and in 1981. Also, M, in giving his evidence, stated that pasture improvement took place in the spring of 1979 preparatory to bringing cattle on to the property (which activity, however, was not pursued). Furthermore, we consider that the expenditures on salary and supervision fee paid to the part-time farmhand mentioned earlier in this narrative supports M's contention that a business undertaking was still being conducted on the property in the years of income in issue, notwithstanding the decision taken to quit the horse breeding operation at some future stage. We therefore are of the view that a business of primary production was being carried on in both 1979/80 and 1980/81.

35. We adhere to that belief notwithstanding that the scale of operation was doubtless less than desirable, also that it could have been carried on more efficiently than in fact it was; in other words, the Commissioner's counsel could well have been right in some of the evidentiary points that he made.

36. We find support for our finding that there was a business in the decision of Rath J. in
Shepherd v. F.C. of T. 75 ATC 4244. In that case, the taxpayer, a married woman with a lifetime interest in horses, acquired a successful racehorse, and her subsequent prize moneys and betting wins were held to be not assessable on the basis that her activity was only a pastime. That was the finding of the Court because her

ATC 700

activities were not organised towards the production of profit. The learned Judge stated at p. 4253:

``The taxpayer has been intensely interested in horses and horse racing, not from the desire to make money, but because of her devotion to horses and the pleasure she has derived from training them.''

37. We feel that the converse situation applies in the instant case. M's evidence was that he was not interested in horses per se nor was any member of his family, but he saw the breeding of Appaloosas as a way of making good profits. Unlike Mrs. Shepherd, all his activities, and those of the trustee company that he headed, were motivated by a desire for profit; indeed, it was only because he saw the end to profit-making in the horse breeding activity that he had the company quit it.

Whether outlays incurred for interest and borrowing expenses are deductible:

38. The finding that we have arrived at, namely, that the taxpayer company was carrying on a business of primary production in both years under review, does not automatically mean that all of its outgoings are allowable deductions from the business's assessable income. The deductions that were claimed in both years included amounts for interest and borrowing expenses, and the capital moneys borrowed seem, on one view, to have been put to a variety of uses, some for business uses and some for non-business uses. From that basis, the Commissioner's counsel argued that a proportionate amount only of the above outlays was deductible. On the other hand, the taxpayer's counsel contended that all outlays were deductible as the funds were solely used to reduce the taxpayer company's indebtedness to M and N. It is to the first of those matters, namely the deductibility of the interest payments, that we now turn.

39. For interest to be deductible as an outgoing, it must comply with sec. 51(1) of the Assessment Act which is in the following terms:

``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...''

40. It was stated by the Federal Court in
F.C. of T. v. Total Holdings (Aust.) Pty. Ltd. 79 ATC 4279 at p. 4283 (on the basis of a long line of authority), that whether interest is actually incurred in gaining or producing assessable income is a question mainly of fact. That being the case, deductibility depends upon the use to which the loan funds are put (see Case B11, 70 ATC 46 at p. 49). Where loan moneys are partly used for the purpose of gaining assessable income or the carrying on of a business for that purpose, and partly for capital, private or domestic purposes, only a proportionate part of the interest incurred is allowable. It is worth noting that the form of security given on the borrowed money is totally irrelevant in determining whether interest payments are deductible or not.

41. If interest is incurred for the purpose of introducing capital into an income-earning business it is allowable as a deduction (see Total Holdings (supra) at p. 4283, also
The Texas Co. (A'asia) Ltd. v. F.C. of T. (1939-1940) 63 C.L.R. 382 at p. 468). In Total Holdings, it was said at p. 4283:

``If a taxpayer with a continuing business incurs a liability for interest being incidental to or connected with the operations or activities regularly carried on for the production of income, the interest is an allowable deduction. The circumstance that each item of expenditure cannot be traced to a particular item of income does not prevent the deduction of the expenditure.''

42. Tendered in evidence by the Commissioner's counsel was the loan application made to O by AB Pty. Ltd. under date of 7 April 1976. Therein, a loan of $100,000 at 14% per annum was sought over a term of 10 years. The security offered was M and N's private residence, and the farm property at X. M and N were to make themselves jointly and severally responsible for the loan. The stated purpose of the loan was:

``To pay out existing debt on farm, cost of farm improvements, pay out existing loan on residence and allow for costs re additions and extensions plus legal costs. Refer attached letter.''

The letter to which reference was made was addressed to O, and was in the following terms:

ATC 701

``Dear Mr....

Further to the enclosed forms I wish to detail the disposition of the $100,000 loan moneys:

      1.    Repayment to South British
            Assurance (1st mortgage on
            home)                              10,500
      2.    Repayment to [C] (Vendor
            of farm at [X])                    21,850
      3.    Extensions to home (...)           35,000
      4.    Renovations to residence at
            farm, to upgrade to standard
            suitable for resident manager       3,500
      5.    Reconstruction of internal fences
            to provide efficient movement of
            stock (presently sheep, and in
            future, cattle also). This will
            provide a raceway operating
            to all paddocks and greater
            efficiency in grazing, thereby
            increasing carrying capacity,
            and also reducing labour
            requirements                        7,000
      6.    Renovation of farm out-buildings,
            including woolshed and
            construction of fodder storage
            facilities                          6,000
      7.    Pasture improvement i.e.
            ploughing and resowing
            340 acres                           8,160
      8.    Legal and accounting fees,
            plus stamp duty                     8,000


[Signature of M]''

43. In cross-examination, M advised that the repayment to South British Assurance was not made, nor were the renovations to the farm residence and the woolshed, nor was the ploughing and resowing done. In point of fact, the repayment to the Assurance Company was made some 15 months later out of a further loan of $60,000 secured from P. By way of explanation he mentioned that some expenditure proposals had changed direction upon the decision to quit sheep and breed Appaloosa horses. He advised us too that the extensions to his home were not then done but were subsequently effected and paid for out of moneys due to him and his wife upon sale of the farm property to AB Pty. Ltd.

44. In due course, a mortgage instrument was drawn up and executed by AB Pty. Ltd. as mortgagor and O as mortgagee. It set out the principal sum to be $100,000 and the final repayment date to be 30 September 1986. The security for the loan was stated to solely comprise the farm property at X. The instrument stipulated that repayments of the principal sum were to be $1,250 per quarter and went on to state that:

``36. Notwithstanding anything to the contrary elsewhere herein contained or implied, the Mortgagor may on any interest payment date falling not less than one year after the date hereof repay to the Mortgagee the whole of the principal sum then remaining owing provided that the Mortgagor pays therewith, firstly interest to the date of payment on the amount so repaid, and secondly an amount (as consideration for the Mortgagee's agreeing to accept such early repayments) equal to interest on the amount so repaid for a period of six months at the acceptable rate of interest then payable by the Mortgagor hereunder.''

45. As mentioned earlier, the loan funds were received by AB Pty. Ltd. on 17 December 1976, and were employed to pay back the balance amount due by M and N to C, and to reduce the indebtedness due to M and N for the sale by them to the taxpayer company of the farm property and other assets. Over the years 1976 to 1980, interest and repayments of the principal sum were paid to O in accordance with the agreement. That situation continued until January 1981, when the balance of the principal sum was paid out in accordance with the terms of the mortgage deed upon sale of all of the farm property other than the town paddock and the improvements effected thereon.

46. Payment of ``an amount equal to interest'' on the balance of principal sum so repaid was effected in the 1980/81 income year in accordance with the contractual term detailed above. Accordingly, interest claimed as a tax deduction in that year as paid to O amounted to $13,976, of which $5,862 was paid in pursuance of that contractual term, leaving an amount of $8,114 as ``normal'' interest (or interest properly so called). Interest paid to O in

ATC 702

the previous year in issue amounted to $12,381 and represented ``normal'' interest only.

47. In our view, all of the above ``normal'' interest is deductible under sec. 51(1) because all of the loan funds were used by AB Pty. Ltd. in carrying on a business for the purpose of gaining assessable income. The transactions are somewhat convoluted and the accounts of the taxpayer company in several instances downright misleading, but what the taxpayer did with the loan funds was to reduce its considerable indebtedness, and so improve its liquidity position, or, in business terms, its working capital ratio. For when settlement was made on 17 December 1976, and it received the principal sum of $100,000 from O, it made available $21,141 to M and N by reducing the amounts of the debts due by it to them, and that sum was paid over to C in satisfaction of the balance amount that M and N owed to him under the contract of sale dated 29 March 1972. Before paying over that amount, the taxpayer company's solicitors deducted their costs of $1,447 from the balance sum, leaving an amount of $77,412 to be invested at call at 8½% per annum. That interest was subsequently brought into the company's assessable income. The call funds were progressively withdrawn during the calendar year 1977, and used to reduce the company's indebtedness to M and N. Accordingly, what the company did was to borrow at long-term and apply the borrowed funds to reduce its current liabilities. True it is that portion of those funds were repaid to M and N who used them for all kinds of private expenditures, but that use is irrelevant in determining whether the interest outlaid by the company on those funds is deductible in its hands under sec. 51.

48. In our view, however, the same arguments are not properly applicable to the payment of $5,862. It will be recalled (see para. 45) that the repayment of the balance of the principal sum which gave rise to the above payment stemmed from the reduction in the mortgagee's security following upon the sale of the greater part of the property. For practical purposes it could be said that the taxpayer company's only income-producing asset was the farm property. If the taxpayer had been a company other than one whose role was that of trustee, that asset would have been financed in accordance with standard business practice by moneys contributed by shareholders. As a company acting as trustee, the taxpayer's ``Trust Fund'' assumed the role normally played by shareholders' funds. Because all its profits had purportedly been distributed each year ever since the taxpayer company had commenced to act as trustee, the ``Trust Fund'' remained at that same figure of $100 which had been paid over to it by the settlor upon establishment of the trust. Lacking contributions of capital from shareholders, the purchase of the farm property was financed essentially by the long-term loan from O, which thus formed part of the company's fixed capital. We see the payment of $5,862 as an outgoing of a capital nature because that payment was made in order to free funds from a mortgage some 5¾ years prior to the date on which the mortgage was due to mature in ordinary circumstances. The fact that there was a consequential saving in the future of interest outlays was simply a by-product, or side-effect, of the withdrawal of capital. That interest saving, of itself, played no part in the decision taken to make the capital repayment. The payment of $5,862 was not of the kind where, at a time when interest rates are falling, a penalty is paid as part of terminating a mortgage loan borrowed at a high rate of interest in order to re-finance at a lower interest rate. In our view, too, the outlay of $5,862 was none the less of a capital nature because its incidence was dictated by the terms of the mortgage instrument. Accordingly, in our view, the outlay is precluded from deductibility because of the exclusionary words of sec. 51(1).

49. In taking the opposite view that the payment was properly deductible under sec. 51(1), taxpayer's counsel referred us to W.
Nevill & Co. Ltd. v. F.C. of T. (1937) 56 C.L.R. 290, and to
Anglo-Persian Oil Co. Ltd. v. Dale (1932) 1 K.B. 124. In the former case, a company which previously had been managed by one managing director appointed an additional managing director for a term of five years at an annual salary of $3,000. The system of joint management did not work out satisfactorily, and in the belief that its abolition would lead to increased efficiency, and with a view to saving his salary, an arrangement was made in the following year for the resignation of the additional managing director under which the company agreed to pay him a sum of $5,000 in consideration of cancelling his agreement. The company claimed to deduct that sum from its assessable income in the year of payment. It

ATC 703

was argued for the Commissioner that, in so far as the expenditure was directed towards current and future expenses by securing relief from the owner's contract to pay $3,000 for five years, it did not increase assessable income. However, the High Court rejected the Commissioner's contention and held that the sum of $5,000 was a loss or outgoing incurred in gaining or producing assessable income within the meaning of the then equivalent provision to sec. 51(1), Rich J. stating at p. 303:

``The company's purpose in effecting the transaction was to save the salary and at the same time to put an end to joint control. In such an expenditure I can see no characteristics which would make it referable to capital account.''

In the Anglo-Persian Oil Co. case, the facts were largely akin to those in Nevill. There, the company appointed agents to manage their business in what was then Persia and subsequently terminated that arrangement, the termination being arranged on the basis of a payment of $600,000. The sum was treated in the company's accounts as a revenue payment in calculating its profits and gains. In the Court of Appeal, Lawrence J. stated at pp. 139-140:

``It is not open to doubt that under ordinary circumstances where a trader in order to effect a saving in his working expenses dispenses with the services of a particular agent or servant, and makes a payment for the cancellation of the agency or service agreement, such a payment is properly chargeable to revenue; it does not involve any addition to or withdrawal from fixed capital; it is purely a working expense''

(emphasis added).

50. In the instant case, we believe that there was a withdrawal of fixed capital following upon the sale of the greater part of the property when the loan from O was consequentially repaid. On the evidence, we consider it at least arguable as to whether the outlay of $5,862 was incurred in deriving the taxpayer company's assessable income; regarding that as a moot point, we prefer to put our decision on the basis that the above outlay accompanied, and was a consequence of, a withdrawal of fixed capital, and so was an outgoing of a capital nature. Accordingly, in its essential character, it differed from the payments made in Nevill and in Anglo-Persian Oil Co. In arriving at our conclusion, we were assisted by the reasoning expressed in
Arizona Copper Company v. Smiles (1891) 3 T.C. 149,
Mallett v. Staveley Coal & Iron Co. Ltd. (1928) 2 K.B. 405 and Case No. 31
(1950) 1 T.B.R.D. 94.

51. Because the Commissioner's counsel placed considerable emphasis on the decision in
Ure v. F.C. of T. 81 ATC 4100, as supporting his arguments that all the interest was non-deductible, we consider it desirable to add some comment as to why we feel the decision is not to the point in the situation before us. The ratio of Ure may be said to be that, if money is borrowed at interest by a taxpayer and subsequently on-lent at a substantially lower rate of return, the Courts, in seeking to determine whether the taxpayer's purpose was to earn assessable income, may look beyond the immediate transaction and enquire into indirect objects sought by the taxpayer. In giving his judgment, Brennan J. said (at p. 4104):

``In the present case a question arises as to whether it can truly be said that the incurring of interest charges at rates of 7.5%, 8.5%, 10% and 12.5% per annum is incidental to the gaining of income by way of interest at the rate of 1% per annum. The answer to that question does not turn directly upon the disparity in interest rates, but upon an examination of the purposes for which the money was laid out. The disparity in interest rates is itself eloquent to suggest the existence of purposes ulterior to the earning of interest at the rate of 1% per annum, and the evidence confirms the existence of further purposes.''

52. In our view it would amount to a misinterpretation of the evidence to say that the taxpayer company in the instant case borrowed funds at 14% and applied them to reduce shareholder loans at call on which no interest was charged, and that that transaction was suggestive of the existence of an ulterior purpose. For, in the first place, it must be said that the amounts due to M and N were not loans at all (although they were so described in the company's accounts) but represented debts due to them for the unpaid proceeds from the sale of the farm property. Accordingly, the matter of charging interest on those funds does not arise. Also, a debt does not become a loan simply because it is called one. In the second place, and more importantly, there was an obvious commercial explanation for what took place,

ATC 704

and it is that attribute which distinguishes it from the situation which appertained in Ure.

53. As indicated earlier, a further borrowing of $60,000 was obtained in early 1978. The amount was obtained through a merchant bank, which we shall call T, from the P Staff Superannuation Fund. The application form that was completed by the taxpayer company was tendered in evidence by the Commissioner's counsel. It was dated 19 January 1978 and sought a loan of $60,000 on first mortgage at an interest rate of 13%. The period of the loan was originally for a period of two years with repayments being made of interest only during the currency of the loan. Subsequently the period was extended to three years, and the interest rate varied to 14%. The security offered was a mortgage over the private residence of M and N. The purposes of the loan as stated by M in his sworn evidence were to pay out a first mortgage borrowing of $10,000 to South British Assurance Co. and an unregistered second mortgage borrowing of $12,000 to the Commonwealth Bank and to provide liquidity to meet taxation commitments. It seems that settlement took place on 21 March 1978. For the years of income in issue the amounts of interest that were paid and claimed as deductions were $7,804 (1979/80) and $6,303 (1980/81). The balance sheet of the taxpayer company at 30 June 1981 showed that the capital borrowed, $60,000, was still outstanding, although, on the evidence adduced, it should have been repaid on 21 March 1981. Also, it is depicted under long term liabilities, whereas, on the evidence, it should more correctly be described as a current liability. No explanation was given as to those anomalies.

54. In order to establish the validity of the deductions claimed, we need to have deduced from the evidence the amount of the borrowed money that was laid out for the purpose of gaining assessable income. In Ure (supra) at p. 4104, Brennan J. stated the principal as follows:

``The laying out of the borrowed money for the purpose of gaining assessable income furnishes the required connection between the interest paid upon it by the taxpayer and the income derived by him for its use.''

The evidence falls short, we consider, of providing us with information of material kind as to the amount paid over and as to the identity of the recipient.

55. It seems to us that the amount which would have been made available at settlement would have been the net amount after the discharge of existing mortgages and the payment of all legal costs associated with the transaction. Unfortunately, no documentary evidence could be tendered because we were told that there had been two consecutive take-overs of the legal firm that had acted for the taxpayer company and, for reasons that remained unclear, the relevant file could not be obtained. Confusion was compounded by the lack of clarity in M's evidence when elucidation was sought on the matter, first by his own counsel and subsequently by the Commissioner's counsel in cross-examination. The following exchanges took place in his examination-in-chief:

``Q. Do you know how that $60,000 was disbursed? Can you recall that? - A. Yes, the money was firstly - it was to go to the loan accounts of the partners. It was paid into the trust account [AB Pty. Ltd.], and some money was used to pay off a loan of the partners to the South British Insurance Company.

Q. Was the amount of that loan debited against the partners' loan account? - A. Yes, it was.

Q. And do you know how much that was, approximately? Was that about $10,000? - A. Yes, it was. Yes.

Q. And there were some legal costs and expenses? - A. Yes.

Q. About $1,000, odd? - A. Yes.

Q. And the balance of $48,000 or $49,000, what happened to that? - A. That was paid into the Commonwealth Trading Bank of [AB Pty. Ltd.].

Q. And how was that $48,000 odd expended? - A. That was used within the trust business.''

The disbursement of the loan funds was later taken up in cross-examination, and the following exchanges ensued:

``Q. Do you see toward the foot of the first page [of the loan application] a statement of the existing mortgages? - A. Yes.

Q. Would you read what that said? - A. Existing mortgage, if any, on property:

ATC 705

$10,000 first mortgage South British, $12,000 unregistered second mortgage Commonwealth Bank.

Q. Did you inform [T] that one of the purposes of the loan from [P] was to discharge those two mortgages? - A. Yes.

Q. Did you also inform [T] that another purpose of the loan was to provide liquidity to [AB Pty. Ltd.] for taxation purposes? - A. Yes. For taxation purposes. I do not recall saying for taxing purposes in a letter, do you have that?

Q. If you look at the other document, the [T] letter, it is a letter from [T] to [P] Staff Investments Pty. Limited, do you see at the foot of the first page? - A. Yes.

Q. Does that help you refresh your memory about what you said to [T] about the purposes of the loan? - A. Yes.

Q. Do you agree you said the loan was required to consolidate those two mortgages you have referred to, and discharge them, and to provide liquidity for taxation, among perhaps other purposes? - A. No, it says there the loan is required to consolidate...

Q. Having refreshed your memory from [T's letter] what did you tell [T] was the purpose of the $60,000 loan? - A. The loan was required to consolidate these mortgages, and to provide liquidity for taxation et cetera. I do not know whether et cetera were my words, it was their words not mine.

Q. Thank you, and the two mortgages were mortgages over your private residence, is that right? - A. Yes.


Q. Now the [P] loan, you have given evidence to this effect, was actually used to pay out the South British Insurance Company, that is the house mortgage of $10,000; is that so? - A. It was lent to the company who in turn paid it to the partners for their own personal use, in payment of their loans to the trust, for the purchase of the businesses, farm and other.

Q. Your evidence yesterday was that the balance of $48,000 was paid to [AB Pty. Ltd.'s] bank account after paying out the South British Insurance Company. Do you recall that evidence? - A. Yes, I do.

Q. And that is correct, is it not? - A. That is correct.''

56. We are left in the position where we do not know what liabilities were in fact discharged and what was the amount of the loan paid over and to whom it was paid. Also, we remain unsure as to whether the second mortgage loan due to the Commonwealth Bank was paid out or re-financed per medium of the loan from P. Other aspects of that loan that puzzle us are its incorrect categorisation as a long-term liability in the taxpayer company's accounts, its apparent continued existence at 30 June 1981, whereas, according to its terms, it would have been repaid in March 1981, and its description in the taxpayer's annual balance sheets as ``Loan - [P] - [M and N], $60,000''. One possible interpretation of those latter words is that the funds were in fact borrowed by M and N.

57. Not having been made aware of all relevant facts, we are of the view that the taxpayer has not discharged the burden of proof imposed on it by sec. 190(b) of the Act as regards the interest sums of $7,804 and $6,303 paid to P in the years of income in issue, and therefore the taxpayer's claims for deduction of those two amounts are disallowed.

58. Likewise, the borrowing expenses of $128 which relate to that loan and which were claimed in the year of income ended 30 June 1981, are also disallowed. In all other respects, the deductions claimed are allowed.

Raising of assessments to tax the consequential undistributed income:

59. Before dealing with the above matter, it is appropriate, we consider, to examine the ramifications of the Commissioner's action in disallowing the farm losses as tax deductions, and of this Board's subsequent action in allowing all of those losses other than interest of $7,804 in regard to 1979/80 year of income, and interest of $6,303, and ``an amount equal to interest'' $5,862 (see para. 48), and borrowing expenses of $128 in regard to the 1980/81 year of income.

First, the 1979/80 year of income

In that year, income was returned by the trustee company as follows:

      Net profit of direct selling       $
        business                       49,053
      Loss on farm operation          (27,942)
      Interest received                     4

That net income was purported to be distributed as follows:

      To M       14,115
      To N        7,000

(The word ``purported'' is used advisedly because the Meeting of Directors at which the appropriate resolution was passed was not held until 28 August 1980. It was conceded by the taxpayer's counsel that the distribution was out of time, and so invalid. It is understood that the Commissioner, as a matter of administrative practice, allows a period of two months immediately subsequent to the year of income to make a distribution, but because that practice is not sanctioned by the Assessment Act or the accompanying Regulations we must ignore it. We consider that we should mention too (if only in parentheses) that the taxpayer's notice of objection was incorrect in stating that the net income of the trust estate within the meaning of sec. 99A was nil. The ascertainment of that net income figure is not concerned with payments by way of distributions to beneficiaries; accordingly, the ``net income'' for the 1979/80 year was $21,115.)

In disallowing the farm loss of $27,942, the Commissioner added back that amount to the net income and assessed the trustee under sec. 99A. Consequent upon this Board's action in overruling the Commissioner's decision on the objection, save for the interest paid to P, the adjusted net income of the taxpayer company is varied as follows:

                                        $          $
      Net profit of direct
        selling business                         49,053
      Loss on farm
        operation                     27,942
      Less: Interest paid
        to P disallowed                7,804    (20,138)
      Interest received                               4
      Adjusted net income                       $28,919

Second, the 1980/81 year of income

In that year, income was returned by the taxpayer company as follows:

      Net profit of direct selling
        business                        45,840
      Loss on farm operation           (26,048)
      Interest received                      4

That net income was purported to be distributed as follows:

      To M                        10,796
      To N                         7,000
      To S, son of M and N         2,000

(As with the situation in the previous year, the appropriate resolution to distribute the above income was out of time, and so the distribution was invalid. Also, contrary to what was stated in the taxpayer's notice of objection, the ``net income'' was $19,796, and not nil.)

In disallowing the farm loss of $26,048, the Commissioner added back that amount to the net income and assessed the trustee under sec. 99A. Consequent upon the Board's action in overruling the Commissioner's decision on the objection, save for the interest and borrowing expenses referable to the loan obtained from P, and the ``amount equal to interest'' paid to O, the adjusted net income of the taxpayer is varied as follows:

                                                    $          $         $
Net profit of direct selling business                                  45,840
Loss on farm operation                                       26,048
Less: items disallowed -
             (i) Interest paid to P                6,303
            (ii) Borrowing expenses in relation
to loan from P                                       128
           (iii)``Amount equal to interest''       5,862     12,293   (13,755)
                                                   -----     ------
Interest received                                                           4
Adjusted net income                                                   $32,089

60. With the ``net income'' for each of the two years in issue adjusted to take account of our review of the amounts disallowed by the Commissioner, and of the invalid distributions made by the taxpayer company, the question arises as to the identities of the persons on whom assessments should be raised for the tax payable, the trustee or the beneficiaries, and, if the latter, which beneficiaries? A convenient starting point is to consider the terms of the deed of settlement, and it is to that document that we now turn.

61. The M and N family trust established by the deed was in the nature of a discretionary trust, with very wide discretionary powers given to the trustee. Clause 3(1) of the deed empowered the trustee at any time before the expiration of any accounting period to pay, apply or set aside all or any part of the net income of the trust fund for such accounting period to any one or more of the general beneficiaries. The term ``General Beneficiaries'' covered ``Specified Beneficiaries'' (who were stated to be the children of M and N), plus enumerated relatives of those children. The same clause permitted the trustee to accumulate income and to make allowances for income tax on the income applied or so set aside. Clause 3(2) stated that a determination to apply or set aside any amount for the benefit of any beneficiary could be effectually made by placing such amount to the credit of such beneficiary in the books of account of the trust fund, as well as paying the benefit over by cheque.

62. The effect of a determination not effectually made was spelt out in subcl. (4) of cl. 3, which stated:

``The Trustees shall hold so much of the net income of the Trust Fund for each Accounting Period as shall not be the subject of a determination effectually made in relation to such Accounting Period in trust successively for the persons described in sub-clauses (1), (2), (3) and (4) of Clause 4 hereof.''

63. Before examining the question of whether the distributions of the 1979/80 and 1980/81 income were effectually made, it is appropriate to study the definitions of the words ``the Trust Fund'' and ``Accounting Period'' used in the above subclause:

```the Trust Fund' shall mean the said settled sum all moneys investments and property paid transferred to or accepted by the Trustees as additions to the Trust Fund held by them pursuant to this Deed the accumulations of income hereinafter directed or empowered to be made all accretions and additions thereto from any source and the investments and property from time to time representing the said money investments property accumulations accretions and additions.''

```Accounting Period' shall mean each period of twelve months ending on the 30th day of June in each year provided first that the period commencing on the date hereof and ending on the 30th day of June next shall be an Accounting Period and secondly that the period commencing on the first day of July prior to the Vesting Day and ending on the Vesting Day shall be an Accounting Period.''

64. There is, we believe, no doubt that the purported distributions to M, N and S were invalid as a matter of taxation law, being out of time. But were they also invalid as a matter of trust law, and so assessable in the hands of the

ATC 708

trustee, or does cl. 3(4) save them and, through the operation of the deed, render ``the specified beneficiaries'' (the children of M and N) liable under sec. 97 (putting to one side for the moment any question as to whether those children or any one of them might be under a legal disability)?

65. In our view, the distributions were also invalid as a matter of trust law. We say this because the trustee, in making them, did not comply with the terms of the trust deed. Clause 3(1), to the extent that it is relevant, states:

``The Trustees may at any time before the expiration of any Accounting Period with respect to all or any part or parts of the net income of the Trust Fund for such Accounting Period, determine -

  • (a) to pay apply or set aside the same to or for any one or more of the General Beneficiaries living or in existence at the time of the determination...
  • (b) to accumulate the same;
  • (c)...''

When the above clause is read in conjunction with the definition of ``Accounting Period'', an obligation is seen to be placed on the trustee (in the event of making a distribution) to distribute it before 30 June of the year in question. Of course, the trustee has the discretionary power to make a distribution, or not make one - hence the use of the word ``may'' in the opening line of the clause - but, if it determines to make one, then it must be made prior to 30 June of that year.

66. It would seem to us that the taxpayer company's accounts, both at 30 June 1980 and 1981, were prepared on the basis that the resolutions of 28 August of 1980 and 1981 were validly made; in other words, that they were formally passed either on or before 30 June in those years. We believe that the amounts of M, N and S's loan accounts include the distributions which we regard as having been improperly made. We gain support for that belief in the fact that there is no accumulated fund representing the year's profit in the taxpayer company's balance sheet. We believe that there is no accumulation, because the profit was seen by the taxpayer's accountants to have been distributed in pursuance of the resolutions previously referred to. Accordingly, to the extent that the accounts indicate that valid distributions were made in those two years, they are misleading.

67. At first glance, it might be considered that the terms of cl. 3(2)(c), namely:

``a determination to pay apply or set aside any amount to or for the benefit of any beneficiary may be effectually made and satisfied (inter alia) by placing such amount to the credit of such beneficiary in the books of account of the Trust Fund''

could operate so as to preserve the validity of the accounting entries. However, we consider that the above subclause must be read subject to the opening words of cl. 3(1), viz.:

``The Trustees may at any time before the expiration of any Accounting Period with respect to all or any part or parts of the net income of the Trust Fund for such Accounting Period determine -

  • (a) to pay, apply or set aside...''

Because the trustee is a company, any determination made by it can only be made ``by a resolution of such corporation or company or by a resolution of its Board of Directors or governing body...'' as per cl. 17(4) of the trust deed, and for it to be effective as regards its net income it must comply with cl. 3(1) above, and be passed either on or before 30 June of the year under consideration. As regards the years of income in issue, the determinations were made subsequent to 30 June, and so are invalid.

68. Because of the view we hold that as at 30 June of both years of income in issue there were no valid determinations made of the trust's net income, it follows that there was, as at those dates, income to which no beneficiary could be presently entitled, or, to paraphrase the words contained in the judgment of Latham C.J. and Williams J. in
F.C. of T. v. Whiting & Ors. (1943) 68 C.L.R. 199, no beneficiary possessed a right of such a kind that he or she could demand payment of the income from the trustee, or direct the trustee to deal with it on his or her behalf.

69. Accordingly, if no other factor were involved, the taxpayer, AB Pty. Ltd., would be assessed on the adjusted net income of the two years under sec. 99A in its capacity as trustee. But the true position is that there is a further factor to which attention must be paid, and that factor is the ``fail-safe'' provision as contained in cl. 3(4) detailed earlier. Arising from the

ATC 709

operation of that provision, we consider that the trustee holds the amounts of net income of the trust fund for the years of income in issue, i.e. $21,115 and $19,796, in trust successively for the persons described in subcl. (1), (2), (3) and (4) of cl. 4 of the deed.

70. Clause 4 of the deed is the general provision which provides for the vesting of the trust fund. We do not consider that it is necessary for present purposes to detail its provisions, but the ``fail-safe'' clause looks to it to provide beneficiaries, in a situation where, as in the present case, no effectual determination by the trustee has been made. We consider that in the situation before us, cl. 4(2) can be invoked to provide the necessary beneficiaries; those beneficiaries are stated to be specified beneficiaries, and thus we hold that the effect of cl. 3(4) read in conjunction with cl. 4(2) is to have the taxpayer company hold the amounts of $21,115 and $19,796 in trust in equal shares for the three sons of M and N.

71. It was contended by the Commissioner's counsel that cl. 4(2) could not be invoked because one could not predicate whom the specified beneficiaries might be as at the vesting day, 30 June 2020; in other words, the trust power bestowed on AB Pty. Ltd. through the operation of cl. 3(4) was void for uncertainty. However, we do not share that view. The function of the latter clause is simply to deal with the net income of the trust for a given accounting period if, in that period, the trustee has failed to distribute it or accumulate it. In that situation, the trustee is empowered to hold that amount of net income in trust successively for certain persons, and the subclause directs the trustee to turn to the provisions of cl. 4(1), (2), (3) and (4) in order to establish whom those persons are. Clause 3(4) is not concerned with the vesting day, but only with the end date of the particular accounting period, which in the situation before us (because we are hearing two references concurrently) is 30 June 1980 and 30 June 1981. Accordingly, we consider that cl. 3(4) operates so as to have AB Pty. Ltd. hold the net income of the trust fund for those two years for the specified beneficiaries in existence as at those dates, namely the three sons of M and N. We consider that the above stated operation of the ``fail-safe'' clause gives effect to the settlor's primary intention of benefiting the children of M and N (see
McPhail & Ors. v. Doulton & Ors. (1971) A.C. 424 at p. 457).

72. Because of our action in disallowing the interest paid on the P loan, also the expenses incurred in borrowing those funds as well as the ``amount equal to interest'' paid to O, we have a situation where the ``net income'' (after adjustment) as defined in sec. 95(1) of the Act, for each of the two years in issue, is greater than the net income of the trust fund. We consider that each of the three specified beneficiaries, if under no legal disability and assuming that each was a resident of Australia at all relevant times, should be assessed as to his proportionate share of those adjusted net income figures, according to his share in the net income of the trust estate (see
F.C. of T. v. Belford (1952) 10 A.T.D. 105, also Case C36,
71 ATC 156). Accordingly, each would be assessed on an amount of $9,640 (one-third of $28,919) for 1979/80, and on an amount of $10,696 (one-third of $32,089) for 1980/81. In employing the above ``proportionate'' or ``fractional'' basis of calculation, we are aware that the matter is not free of debate, but we believe that the basis used is in line with the proper grammatical construction of the words ``so much of that share of the net income of the trust estate'' contained in sec. 97(1)(a)(i).

73. In giving his evidence, M stated that his sons, as at the date of the hearing, were aged 21, 19 and 16 years. Lacking precise information as to the dates of their births, we are unsure as to their respective ages as at 30 June 1980, and 30 June 1981. Hence we remain uncertain whether the eldest was under legal disability as at both of those end-of-year dates; it would seem to us that the two younger sons were under 18 years of age as at both dates, and as minors were under legal disability. Also, the evidence adduced was not sufficiently comprehensive to enable us to determine whether the latter sons were ``prescribed persons'' under the provisions of Div. 6AA of the Act.

74. Suffice it then to say that the taxpayer company's objections for the two years in issue are allowed, in that we determine that the assessments made under sec. 99A were raised in error against it and should be cancelled.

Claims allowed in part

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