Case S74
Judges: MB Hogan ChP Gerber M
GW Beck M
Court:
No. 3 Board of Review
Dr P. Gerber (Member)
The issue in this reference involves a tax minimisation scheme in which the relevant events, in order of appearance, occurred as follows. On 19 October 1978, Syndrome Pty. Ltd. (henceforth referred to as ``the trustee'') is established to act as trustee for the Munchhausen family, consisting at that time of Dr Munchhausen, his wife and two children. The trust is empowered, inter alia, to borrow money and invest its funds in real estate. In January 1979, the trustee enters into a ``Phillips'' type of arrangement with Dr M, servicing his practice, collecting debts etc. In October 1979, the trustee acquires Blackacre, a spacious home in large grounds, with a grass tennis court and swimming pool. Its choice was determined by Dr and Mrs M for its suitability as their home, as well as its proximity to the medical practice. In short, I find as a fact that it was at all times the predominant intention of the parties that the property would become the matrimonial home for the family. Notwithstanding the pious protestations to the contrary, I have concluded that the somewhat complex and eccentric arrangements entered into had as their main or dominant purpose the overall reduction of the incidence of tax. The income of the trust would be derived from (i) the rent from the property and (ii) the services provided through the ``Phillips'' arrangement; its (hopefully deductible) outgoings would consist of interest paid on the funds borrowed to acquire Blackacre as well as the usual outgoings associated with commercial letting, such as rates, repairs etc. Since the trustee borrowed virtually the whole of the purchase price for the acquisition of Blackacre, the end result was a substantial loss in the year now under review (1980), the kind of loss customarily associated with what has become known in the trade as ``negative gearing''. The trustee claimed the whole of the interest ($14,251), depreciation, rates etc. ($3,695), as well as $1,136 for ``repairs''. All were disallowed at first instance. On objection, the Commissioner allowed an amount of $6,915 for interest, the whole of the items claimed for depreciation, rates etc. ($3,695), as well as $600 for ``repairs''. No further objection was lodged against the amended assessment, so that the grounds of the one and only objection and the Commissioner's decision thereon form the only basis of review. The amount of interest the Commissioner allowed is equivalent to the amount of rent received. I am not persuaded that such an arbitrary ``set-off'' has any warrant. Similar ``happy coincidences'' were cited as having succeeded in
Ure
v.
F.C. of T.
81 ATC 4100
and
F.C. of T.
v.
Groser
82 ATC 4478
. However, I do not consider these cases to be authority for this proposition. In
Groser,
there was a letting between family members clearly of a private kind lacking any form of commercial reality.
Jenkinson
J. would have allowed (in the alternative) an amount by way of deduction equivalent to the nominal amount of ``rent'' ($2 per week) received. He did so in purported reliance on
Ure.
Both cases, however, make it clear that any apportionment made in accordance with sec. 51 must be made between what can properly be regarded as incurred in the production of assessable income and what cannot be so regarded. The ``purposive'' test had its origin in
Ure
at first instance (80 ATC 4264), where
Lee
J., after an exhaustive analysis of the authorities, from
Ronpibon Tin N.L. and
Tongkah Compound N.L.
v.
F.C. of T.
(1949) 78 C.L.R. 47
to
F.C. of T.
v.
South Australian Battery Makers Pty. Ltd.
78 ATC 4412
, concluded that the interest paid in that case was deductible only to the
ATC 537
extent that it was incurred in gaining the assessable income to which it was related. In that case, the Commissioner had allowed a total deduction of an amount equal to the interest received. This amount was not disturbed on appeal since the appellant had not shown that the assessment was excessive (sec. 190), Lee J. concluding:``No argument has been addressed to me that if the Commissioner was entitled to apportion, he should have allowed a greater amount...''
(at p. 4278)
In the circumstances, I do not consider these cases as authority for setting off expenditure against income. The initial test of apportionment must always relate to income earning purpose and private or domestic purpose if these can be established; cf.
F.C. of T.
v.
Kowal
84 ATC 4001
. It is only if these two purposes are in hotchpot that the Commissioner (or a Board on review) can apply such a rule of thumb, although the better view is that in that situation, a taxpayer fails because he is unable to quantify the extent the property is used in the production of assessable income.
2. To complete the factual narrative, the trustee entered into two leases, both executed on 8 December 1979. One lease purported to lease the whole of Blackacre to Dr M, whilst the other lease purported to lease one room of Blackacre to the ``Johann Strauss Munchhausen Practice'' (sic). When I drew Mr Pose's attention to this apparent anomaly, he readily conceded that these legal estates might create some difficulties for him. For good measure, the agreements were ``off the peg'' leases and inappropriate to the particular requirements of these parties. For example, each ``tenant'' was required to clean the pool, creating a kind of aquatic Box and Cox plot involving the prospect of two tenants colliding in the pool whilst cleaning it. In the instant case, there is no evidence which lease came first. I therefore propose to ignore
both.
What is left? The crude facts are that the relationship between the trust and Dr M was indubitably that of landlord and tenant and that the family occupied the whole of the premises. The copious evidence adduced has satisfied me that the rent paid was at all material times the ``going'' or commercial rent. Indeed, it was, if anything higher in view of the additional rent for the so-called home office. The trustee was not in breach of trust when he acquired the property and/or leased it to the M family and whatever he received as rent was properly classified as income of the trust. I am further satisfied on the evidence that if the trust were a private person (as were the taxpayers in
Ure v. F.C. of T.
81 ATC 4100,
F.C. of T. v. Kowal (supra)
and
Groser (supra)),
an apportionment of 10% ``business'' and 90% ``private or domestic'' would be appropriate. This would follow from my finding that the predominant purpose of acquisition and user was to provide appropriate accommodation for Dr M and his family. This would, on one view, result in only 10% of the impugned expenditures being allowable deductions. The question in this case however is: Do different consequences flow from the fact that the taxpayer is a trust? In
Case
J31,
77 ATC 288
, I ventured to ask rhetorically ``whether the first limb of sec. 26(a) can be applied to a trust fund''. The case went on appeal (
Securities
&
Management (Nominees) Pty. Limited.
v.
F.C. of T.
78 ATC 4674
) where the question was answered in the affirmative, albeit by way of
obiter dicta,
since the point was not raised in the objection with that pellucid clarity which
David Hunt
J. was able to perceive in
Henry Comber Pty. Ltd.
v.
F.C. of T.
85 ATC 4450
. The point was, however, fully argued and the relevant authorities are set out in the judgment. Be that as it may, it is one thing to hold that a trust or corporation can have a profit-making purpose caught by sec. 26(a), or a tax avoidance purpose annihilated by sec. 260 or an enterprising business purpose as in
F.C. of T.
v.
Whitfords Beach Pty. Ltd.
82 ATC 4031
, and quite another to hold that a trust
-
acting within its powers and objectives
-
can have a private or domestic purpose and/or user. It is unhelpful to state the obvious, viz. that the mind of the company is the mind of its directors and managers ``who represent the directing mind and will of the company. The state of mind of these managers is the state of mind of the company and is treated by the law as such''; per
Denning
L.J.,
H.L. Bolton (Engineering) Co. Ltd.
v.
T.J. Graham
&
Sons Ltd.
(1957) 1 Q.B. 159
at p. 172
. Be that as it may, if a company buys a house and leases it, the Commissioner can hardly deny the cost of, say, the repairs on proof that the tenant is the company's managing director. Nor can it matter that that was the company's ``purpose'' at the time of acquisition;
a fortiori
if the rent charged is the commercial rent, as in this case.
ATC 538
I am not persuaded in the present state of the law that, for tax purposes, different consequences would flow, depending on whether the tenant is a director, a shareholder, a cestui que trust or a stranger if each pays the commercial rent. It is surely significant that in none of the recent apportionment cases - Ure, Kowal and Groser - was the arrangement an arm's length transaction and the income derived the product of a commercial arrangement. Indeed, one might well ask whether the deduction in Kowal (a son acquiring and letting the family home to his mother) would have been apportioned if the rent had been the commercial rent? Outgoings are excluded to the extent that they are losses ``of capital, or of a capital, private or domestic nature...'' (sec. 51(1)). Applied to this case I have concluded that the outgoing of interest disallowed is neither of a capital nature, nor private or domestic. Indeed, the concept of a company (or a trust) having a private or domestic purpose seems to me to strike at the fundamental jurisprudence which lies at the root of the whole theory of corporate personality, viz. that a corporation is an entity distinct entirely from its incorporators. IfSalomon v. Salomon & Co. (1897) A.C. 22 is to be overturned, I do not believe it is the function of a Board of Review to do so. A recent income tax ruling, as reported in CCH No. 40, [i.e. the summary to Report No. 40, CCH Australian Income Tax Rulings ] 25 July 1985 states:
``Sometimes a family trust is established to acquire what is in fact the private residence of the beneficiaries of the trust. The trustee normally lets the residence to one or both parents at a commercial rental and the family occupies the residence as the family home. The trustee lodges a return of income disclosing the rental as assessable income and claims deductions for the losses and outgoings attributable to the residence. Income from other sources is channelled into the trust to absorb the losses arising from the rental of the residence to the parents.
Where it appears that had the parents acquired the residence in their own right the losses and outgoings attributable to the residence would have been private or domestic expenditure, the Commissioner will not accept that the rent is assessable income of the trustee or that the losses and outgoings are allowable deductions.''
If this represents good law and applies to this case, I am comforted in the knowledge that my error will be remedied by higher authority.
3. In the circumstances, it is a pity that Dr Munchhausen did not come to us and inform us frankly that his predominant purpose was to reduce the incidence of his tax. Instead, he went out of his way to challenge our credulity. For example, one ``reason'' advanced for the trust acquiring Blackacre was his ``fear'' that he could be successfully sued by patients and denuded of his assets. This notwithstanding that he was wholly indemnified against malpractice claims by one of our largest medical defence organisations. It is an imaginative plea, but it must fail.
4. It follows from the above that this taxpayer, despite itself, must succeed on the issue of interest.
5. That leaves the issue of repairs. As already pointed out, the Commissioner allowed an amount of $600 after objection. The taxpayer is now seeking the allowance of the balance. It is charitable to say that the ``evidence'' relating to this item was sparse, as the following will illustrate.
``[Q.] There is an amount in issue, perhaps if I can just ask you about that, in relation to repairs and maintenance, the amount claimed in the return of income was some $1,136 of which the Commissioner has allowed only $600. Can you explain what the total amount was, the $1,136? - [A.] I did not come prepared for it, I am sorry, but I am going very much from memory now. It is all written down in my journal at home. I can only pick out a couple of items to give an example. I cannot document it at this moment because I have not got my journal in front of me, but I can say that the property had been unoccupied for, I think, some two years, maybe even more... A couple of things come to mind is that the air-conditioner certainly required servicing, I can remember that... Another `definite' is that the house was built in about 19-- or about 28 years before and the whole electrical system used, which is copper wires, wires inside a copper pipe, and I know that I got Geelong electrical services to come and do some electrical work
ATC 539
because underneath the house the previous people had done up to the kitchen area, and there were wires sticking out of the wall which looked unsafe, and I was not prepared to fiddle with them. So I know that I got an electrician in to go through the whole place because I had children... there were certain aspects that appeared dangerous. I know that was another one, but there were little bits and pieces like this that I know, but I cannot take it any further than that. That is all I can remember, but they are the ones that stick in my mind.''
Clearly, on the above evidence, all the repairs which Dr M was able to recall fall classically into the
Law Shipping
variety
(
The Law Shipping Co. Ltd.
v.
I.R. Commrs
(1923) 12 T.C. 621
) and should not have been allowed by the Commissioner. Can this matter be cured by the administrative processes of review? Section 195 empowers a Board to ``confirm, reduce, increase or vary the assessment''. A taxpayer is limited to the grounds of his objection and it is the Commissioner's decision on that objection which comes before a Board for review. In the instant case, the Commissioner allowed (wrongly) some $600 out of a total claim of $1,136. Does an objection against that decision open up the
whole
of the amount claimed or only the balance which has been disallowed on objection? The matter could have been put beyond all doubt if the taxpayer had lodged a further objection against the amended assessment, but this it did not do.
6. It seems that a taxpayer can withdraw his/its objection before the Commissioner has decided it
(
Higgs
v.
F.C. of T.
84 ATC 4680
). However, having once embarked upon a reference to a Board of Review, can a taxpayer resile from proceeding with the determination or otherwise limit the range of the Board's enquiry? The point is, as far as I know,
res integra.
Starting from first principles, sec. 193(1) casts upon a Board of Review ``the duty or function of making assessments, determinations and decisions in lieu of the assessments, the determinations and the decisions of the Commissioner which it reviews.''
(
F.C. of T.
v.
West Australian Trustee Executor and Agency Co. Ltd.
(1929) 43 C.L.R. 20
, per
Dixon
J. at p. 23). The effect of the Board's exercise of its powers pursuant to sec. 193(1) is that the Commissioner's assessment ceases to exist and is replaced by the Board's assessment
(
Krew
v.
F.C. of T.
(1971) 45 A.L.J.R. 324
at p. 326
). It follows that the statement that a Board ``stands in the shoes of the Commissioner'' does not mean that the Board must wear those shoes if they are clearly the wrong size (whether too large or too small). In making assessments and dealing with references, we are exercising a statutory authority and a statutory duty, which we are bound to carry out. We are therefore in a different position from judges deciding an issue
inter partes.
Our obligation is wider than that. We must exercise our judgment on the material before us. Indeed, we may obtain any material which we think is necessary and which we think we ought to have (cf.
R.
v.
Income Tax Special Commissioners
;
Ex parte Elmhirst
(1936) 1 K.B. 487
per Lord
Wright
M.R. at p. 493;
T.A. Miller, Ltd.
v.
Minister of Housing and Local Government
&
Anor
(1968) 2 All E.R. 633
per Lord
Denning
M.R. at p. 634), and, whilst the Commissioner is not obliged to give the taxpayer any particulars (and rarely does), he is bound to supply particulars of his reasons for his decision on the objection to the Board. The position is, therefore, that once a taxpayer has sought a reference to a Board of Review, he has embarked upon a review process from which he can no longer resile, nor can he prevent the Board from altering the assessment against his interest. In
Elmhirst,
Lord
Wright
M.R., in examining a not dissimilar statutory scheme in the United Kingdom observed (at pp. 500-501):
``It would indeed be a curious position if, notice of appeal having been given by the taxpayer in the hope of reducing his assessment, he should be able, when the information elicited shows quite conclusively that the assessment, so far from being an overcharge, was an undercharge, to prevent the Commissioners (for the Special Purposes of the Income Tax Acts) from estimating or valuing or assessing his liability according to the true facts which have been elicited, or that they should be debarred from proceeding further to develop the facts so as to ascertain the true position.''
In the result, I have concluded that, as a mere administrative tribunal, and doing over again the work of the Commissioner, we can, inter alia, increase a taxpayer's liability, provided that the Commissioner had the power to do so.
ATC 540
In the instant case, the Commissioner is not precluded from increasing the taxpayer's liability by virtue of sec. 170(3) since there had not been a full and true disclosure with respect to the repairs. I can therefore see no good reason why a Board of Review should not be in the same position and correct what is perceived to be an error on the part of the Commissioner, resulting in a loss of revenue. I would disallow the amount of $600 previously allowed. Neither the Commissioner nor a Board of Review can grant indulgences. On this point Mr Faigenbaum, of learned counsel for the Commissioner submitted:``It is no part of the Commissioner's case in this case to win it and strive for an increase in the assessment. The Commissioner is merely seeking to defend the assessment that he has made, although he does acknowledge that the basis upon which he does seek to defend that assessment logically ought to result in an increase of the assessment generally and the disallowance of all the claims for the expenses.''
I do not believe that this is a concession which is open to counsel. It is the duty of the Commissioner of Taxation to collect all revenue lawfully due, not to give it away.
7. The usual arguments based on sec. 260 and ``sham'' were advanced. Because the taxpayer had the choice of entering into the arrangement which it did, sec. 260 can have no application. On the issue of sham, whilst it is true that the two leases have an air of unreality about them, I find that there was no intention to dissemble. I do not believe that a sham can come about by muddleheadedness. The scheme as a whole was exactly what it gave the appearance of being
-
a lawful arrangement to reduce the incidence of tax. This is not a ``sham'' even within the extended meaning so much favoured by the Commissioner. It seems that ``sham'' is a concept not readily understood. The Leary scheme
(
Leary
v.
F.C. of T.
80 ATC 4438
) constitutes, to my mind, a classic example of ``sham''. It is therefore interesting to speculate why that argument was not raised at any point of this scheme's long journey through the courts, from the Supreme Court of Western Australia (80 ATC 4012), through the Federal Court, to its final resting place in the High Court of Australia, where leave to appeal was refused. That scheme was a far cry from the arrangement entered into by this taxpayer. At no time were any acts done or documents executed by these parties ``which were intended by them to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties (intended) to create'' (per
Diplock
L.J.,
Snook
v.
London
&
West Riding Investments Ltd.
(1967) 2 Q.B. 786
at p. 802
).
8. The result is as follows:
$
Income to which no beneficiary is
presently entitled per amended
assessment dated 20 November
1981 7,872
Add: Repairs expenditure allowed
and now disallowed 600
-----
8,472
Deduct: Interest disallowed and
now allowed ($14,251 - $6,915) 7,336
-----
Income to which no beneficiary is
presently entitled i.e. taxable
income to the trustee taxpayer $1,136
------
9. I would amend the assessment accordingly.
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