Case S74

Judges: MB Hogan Ch
P Gerber M

GW Beck M

Court:
No. 3 Board of Review

Judgment date: 30 August 1985.

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Dr G.W. Beck (Member)

The facts in this case have been largely set down by my colleague, Dr Gerber. Those facts paint a picture of a professional man, a medical specialist, determined to arrange his affairs in a manner that was fiscally most advantageous to him. There is, of course, no impediment to such action except restraints imposed by the Income Tax Assessment Act itself and there is nothing in the Act that denies a professional taxpayer the right to be employed by a family trust which, in effect, operates the practice. (See
F.C. of T. v. Phillips 78 ATC 4361 and
Gulland v. F.C. of T. 84 ATC 4587 .) The main point at issue here is whether expenditures that would unarguably be of a private nature if met by a professional individual can be claimed by the trust that employs him when the individual and his wife are the only directors of the corporate trustee and the individual, his wife and his family are the only users of the trust assets that result from the expenditures and the only beneficiaries of the trust.

2. Dr M (as my colleague calls the professional individual) searched for ten months for a house that suited the family

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purposes and which, as he put it, ``would show a good appreciation''. After the house was bought for $205,946 by the family trust in October 1979 it was rented to Dr M and the relevant income and expenditure statement to 30 June 1980 which accompanied the tax return lodged by the trustee was as under:

      ``Gross Rentals Received                        $6,915



      Less Expenses:

       Borrowing Expenses

         (Amortised)                    $513

       Depreciation (as

         below)                        2,054

       Interest on loans

         (First Mortgage)             14,251

       Insurances                        255

       Rates                             873

       Repairs and

         maintenance

         including gardening           1,136

                                       -----

                                                    19,082

                                                    ------

                    NET LOSS                      ($12,167)

                                                  --------''
            

NET LOSS

Counsel for the taxpayer emphasised that the rental charged was the going commercial rate and there was evidence to support this contention. The house has seventeen rooms plus garages, porches and terraces, a pool and a tennis court. Dr M, a surgeon, does not see patients there, and the specific use of the one room for which there was a second lease from the trust (see Dr Gerber's reasons) was not clear to me. I have been unable to find any basis for accepting that this house played a part in the business carried on by the trust. The Commissioner has in fact allowed the trustee full deductions for borrowing expenses $513, depreciation $2,054, insurance $255 and rates $873 and part deductions of $6,915 in respect of interest and $600 for repairs.

3. It is to state the obvious to say that the taxpayer here, i.e. the corporate trustee, has no mind. In
Smorgon & Ors v. F.C. of T. & Ors 76 ATC 4364 Stephen J. refers at p. 4368 to the attribution to corporations of a state of mind ``by recourse to the so-called organic theory'' and he refers to the words of Denning L.J. in
H.L. Bolton (Engineering) Co. Ltd. v. T.J. Graham & Sons Ltd. (1957) 1 Q.B. 159 at p. 172: ``The state of mind of these managers is the state of mind of the company and is treated by the law as such''. Later, at p. 173, Denning L.J. adds: ``the intention of the company can be derived from the intention of its officers and agents''. In the circumstances here the intention and purpose of the trustee was the intention and purpose of Dr M and his wife, the only directors. There were wide powers given under the trust deed and no impediment to their acting as they wished in the purchase. Their purpose was, I believe, almost totally to secure a suitable family residence and only quite incidentally to secure a building to be used by employees of the trust for business purposes or as a ``growth'' asset for the trust. For the arrangement to be financially advantageous to Dr M and his family it was not essential that the capital value of the house increase - nice though that might be - but it was essential that the year by year costs be deductible from the income generated for the trust by Dr M performing professional work. The evidence of a real estate man called by the taxpayer reinforces my view that financial reality proscribes the view that the building was acquired as an investment from which income in the form of net rents would flow. On the basis of the figures in the return the annual loss would be $18,250 or 8.86% of the capital cost of the house even when full commercial rents were charged. As interest was the major component of the costs only when the borrowing was substantially repaid could there be any chance of breaking even. There was no evidence of a budget of repayments or of sources from which the trust would reduce the borrowings even in the long term. There was nothing beyond a broad statement about Dr M's service agreement providing income for the trust to purchase equipment and vehicles ``for further lease, for generation of cash flow, and to use this money to invest in real estate''. In the absence of tax advantages the capital value of the house had to increase at more than 8.86% per year to avoid the trust asset position actually getting worse year by year. It is impossible to accept that the acquisition of a ``good investment asset'' was of itself the predominant reason for the purchase. I am left with the view that Dr M wanted this house for himself and his family as a domestic residence and he wanted a tax set-off against his professional earnings (in whatever hands those earnings might fall for assessment) for a large proportion of the costs of providing the house. Throughout his evidence Dr M's answers seemed to me to reflect this. At one stage he

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said when referring to his search for the house ``I did not really know how much I wanted to pay''. There was in this answer no reference to the state of affairs of the trust or to its commercial objective. Of course he sought a house that would appreciate in value; so does virtually every rational property buyer. But, predominantly, he wanted a house that would suit him and his family.

4. Because there was no evidence that the costs of providing and renting the house to Dr M were necessarily incurred in carrying on the business of the trust - and, indeed, no such claim was made in the objection (see infra) - the taxpayer's case was put under the first limb of sec. 51(1). Rental income was derived and deductions were therefore allowable to the extent they were incurred in deriving that income. Since
Ure v. F.C. of T. 81 ATC 4100 , when determining deductibility one must look at the object of the expenditure and any apportionment under the principles laid down in
Ronpibon Tin N.L. & Tongkah Compound N.L. v. F.C. of T. (1949) 78 C.L.R. 47 is made on the basis of the assessed income earning objects on the one hand and non-income earning (usually private) objects on the other. Following Ure the same line of reasoning has appeared in cases such as
Deane & Croker v. F.C. of T. 82 ATC 4112 ,
F.C. of T. v. Groser 82 ATC 4478 , and
F.C. of T. v. Kowal 84 ATC 4001 . These were, however, all cases dealing with individual taxpayers and one can readily recognise that individuals can have different purposes, notably purposes relating to a business or income earning activity and purposes relating to the taxpayer's life as a private individual. Given the circumstances of the case under consideration here an apposite question is: Can an incorporated trustee operating in accordance with a trust deed ever have a purpose that causes expenditure to fall outside sec. 51(1)? For reasons that follow I have determined that such a trustee/taxpayer can, and this determination has critical consequences for expenditure claimed by Dr M's family trust.

5. A taxpayer is a person deriving income and a person includes a company (sec. 6). Trusts are not persons and are never taxpayers. This is made clear by, for example, the wording of the definition of ``net income'' in sec. 95(1) and by sec. 98(1). Division 6 as a whole makes it abundantly clear that only trustees and beneficiaries are assessable on income from trusts and hence only trustees and beneficiaries are taxpayers under that Division. The taxpayer here is not the Dr M family trust; it is the company Dr Gerber calls Syndrome Pty. Ltd. It is an ordinary corporate taxpayer whose mind reposed in Dr M and his wife and whose purposes - for reasons set out in para. 3 supra - are the purposes of Dr M and his wife. I have already indicated my belief (based on the evidence as I interpret it) that their purpose was predominantly to secure a domestic residence financed in part by favourable tax consequences of the arrangement undertaken.

6. Syndrome Pty. Ltd. was operating within the terms of the trust deed when it acquired the house and leased it to Dr M and this seems to have clouded the issue. However, I think that aspect is irrelevant to the outcome. I suggest a trustee taxpayer (i.e. a ``person'', either natural or incorporated) can have a purpose that falls outside sec. 51 even when that person is complying with trust terms. Take, for example, a trust that established a fund to feed the pigeons of Brisbane. The income of the trust would certainly be assessable to a trustee and no cost of pigeon food would be deductible. In such circumstances the deduction does not fail because of the exceptions clause in sec. 51(1) - i.e. the clause which denies deduction to expenditure of a private or capital nature - but because the expenditure simply falls outside the positive limbs of sec. 51(1). The trustee/taxpayer carrying out his trust obligation to feed pigeons is neither carrying on business nor earning assessable income.

7. To the extent the purpose of Dr and Mrs M, being the minds of this taxpayer, was to provide themselves with a private residence or to save income tax the resultant expenditure similarly fails to satisfy the positive tests for deduction under sec. 51(1). The problem is to determine that extent. One could make an arbitrary assessment in the manner of the 80:20 proportions adopted by G.N. Williams J. in Kowal taking into account the various factors, subjectively weighted. I am reluctant to apportion in this way and prefer to allow deductions for the expenditure other than repairs to the extent of the income derived. I accept the evidence from the real estate men about the level of commercial rents for a property of this quality and in this location, and

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ATC 543

I accept the evidence of Dr M that it was always intended that the trust would charge a commercial rental. There is perhaps some logic in saying that the income earning purpose of Syndrome Pty. Ltd. is measured by this commercial rent.

8. Of the claimed expenditure of $17,946 (being all those expenses listed above in para. 2 except repairs $1,136) I would allow $6,915.

9. From the foregoing it will be obvious that I agree with Dr Gerber that the taxpayer's objection opens up for review the assessability of $6,915 of rental income and the deductibility of $19,082 of expenditures and depreciation. The objection to the original assessment reads as follows:

``NOTICE OF OBJECTION TO 1980 ASSESSMENT

We refer to the notice of assessment made No: 259806/008 issued 13th May, 1981 and in particular;

• (i) loss on rented property not allowed add $12,167

During November 1979 the taxpayer purchased a property situated at... for $205,946. The purchase of this property was financed by way of a $175,000 first mortgage at an interest rate of 12.75% over 22 ½ years together with a commercial bill for $50,000.

During the year ended 30th June, 1980 the property was rented out at $867 per month and this is assessable income under section 25 and section 26 of the Income Tax Assessment Act. Further the expenses claimed are fully deductible pursuant to section 51, 53 and 54 of the Income Tax Assessment Act and the loss on this property has been disclosed in full on the attachment forming part of the 1980 return of the M Family Trust.

Please treat this letter as a formal notice of objection to the notice of assessment and we request that an amended assessment be issued including the rental income pursuant to section 25 of the Income Tax Assessment Act and allowing the deductions in full pursuant to section 51, 53 and 54 of the Income Tax Assessment Act.''

As a result of the objection the Commissioner made a decision which he embodied in an amended assessment. The taxpayer did not lodge an objection to this amended assessment, but asked that only two items be referred to a Board in a latter worded as follows:

``Further to your notice of the 20th November, 1981 which indicated that our objection had been allowed in part. We advise that we are dissatisfied with this decision, in particular the following:

• (a) Interest on loans
• (b) Repairs & Maintenance

We request that in relation to these adjustments only, the matter be referred to a Board of Review for decision.''

Under sec. 187(1) the decision referred to the Board is the decision made by the Commissioner and that arises from the objection to the first assessment. That objection cannot, in my view, be narrowed by a letter seeking reference to a Board. The section refers to ``the decision'' and cannot be read as applicable to part of the decision. So far as the repairs and maintenance claim of $1,136 is concerned, none is allowable. It is worth noting that the Commissioner could further amend the assessment under sec. 170(2) because facts emerged at the hearing that put a different light on the repairs expenditure. It could not be said that the return disclosed all material facts. The amount of $600 already allowed to the taxpayer is not allowable for the reasons set out by my colleague.

10. Although it is not really necessary to proceed beyond these conclusions, I would observe that the Commissioner's submissions that the arrangements were a sham and fell under sec. 260 are not accepted. While sec. 260 is not quite dead, I would find it difficult to apply it in circumstances that do not fall clearly within the principles enunciated in
Jacques v. F.C. of T. (1923-1924) 34 C.L.R. 328 . I think this is in accord with the recently expressed views of the majority of the Full Federal Court in Gulland v. F.C. of T. 84 ATC 4587.

11. The amended assessment should be further amended to allow only $6,915 of the

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total claimed for depreciation and expenses other than repairs, and to allow none of the claimed expenditure on repairs and maintenance, $1,136. The effect of these changes is equivalent to totally rejecting the taxpayer's objection to the original assessment.

Claims allowed in part