PM Roach SM
Administrative Appeals Tribunal
P.M. Roach (Senior Member)
The applicant claims a deduction of $25,000 against assessable income in the assessment of his taxable income for the year of income ended 30 June 1986. The claim is made on the basis that during that year of income he paid $25,000 to Associated Midland Corporation Limited: a finance company formerly called ``Associated Securities Finance Limited''. I shall refer to it as ``Associated Securities''. The case was argued on both sides on the basis that the payment was made pursuant to a guarantee. As will appear hereafter that was not quite correct.
2. The applicant has been engaged in the real estate industry since 1969. In 1971 he came to be employed as a real estate salesman by a company which he controlled. The company (``SALESCO'') held a real estate licence and the applicant was a licensed real estate salesman employed on salary. He was to continue to be employed by SALESCO until about 1976 although, from about 1974, he was not in regular receipt of income from that source.
3. Being concerned to improve his financial position, he joined with one other to establish a land development company (``GSD''); and with another to establish yet another land development company (``GHD''). The applicant and his wife became holders of unspecified numbers of shares of ``A'' and ``B'' class respectively. What distinguished the classes of shares was not established. The husbands became directors of the companies in which they were involved. In each case very little capital was introduced by way of paid-up capital - possibly only $2 for each company. The directors in each case also arranged loans from themselves to the companies and, as required, other loans to the companies from finance companies. The finance companies in all instances made it a condition of the making of their loans that the directors should provide their personal guarantees in relation to both principal and interest. Without funds being so provided the projects contemplated could not have proceeded.
4. However, funds were so made available and, between them, the two companies were able to successfully and profitably carry out something like 12 subdivisional projects. The directors were rewarded for their efforts by receipt from the companies of ``management fees''. I accept that the applicant also benefited indirectly in that SALESCO was able to earn greater commissions and thereby ensure its capacity, at least in earlier years, to pay a salary to the applicant. In addition, there was always in prospect the derivation of further assessable income by the directors by way of directors' fees and dividends on their shares. It was said that the companies retained profits as well as distributing dividends and that, in general terms, whatever amounts were distributed, were loaned back to the companies.
5. In the early 1970s GHD embarked upon the project which within time was to result in disaster. With funds made available by a finance company supported by the guarantees of the directors, land considered suitable for subdivision was acquired at a cost of the order of $30,000. Proposals for subdivisional development were submitted for local government approval and approval obtained. By early 1973 construction was under way only to be halted for some months by adverse weather conditions compounded by a land-slip. There then followed a ``green ban'' placed on the project by the Builders Labourers' Federation. By the time that ban had been lifted and another contractor found, expenditure had risen to something of the order of $100,000. Then a ``stop notice'' was issued by the local council on the basis that the period within which construction had to be completed had elapsed. The matter was appealed to the Local
ATC 735Government Appeals Tribunal and the outcome of those proceedings was that an amended development proposal was submitted to the council. The amended proposal did not meet with the council's approval but an appeal which followed was successful and ultimately work resumed. It was 1978 before the subdivisional works were complete and sales could commence. Although no figures were placed before me I am well satisfied that, by that date, the project was already in parlous condition. The evidence of the applicant was that, throughout the period, the amounts advanced by the finance company in relation to the financing of the original purchase and of later development had been accumulating interest at the rate of 22% per annum. (The documents only refer to 20% p.a.) On 17 October 1975 the applicant and his co-director entered into a continuing guarantee with Associated Securities to answer for the ``debt default or miscarriage'' of GHD. The guarantee was given in conjunction with the execution of a memorandum of mortgage of even date. On 27 July 1976, in association with an agreement for variation of the mortgage, the terms of the guarantee were similarly varied.
6. As the project of GHD had got into deeper and deeper trouble the activities of the applicant came to be modified. From 1976 he came to be employed by another company in which he was interested which was operating a real estate agency; and from 1981 forward he came to be employed by yet another similar company also operating a real estate agency.
7. When the subdivision was ready for sale the situation of GHD was so desperate that the company even contemplated the construction of ``spec'' homes with a view to recouping sufficient to discharge its obligations to Associated Securities. Draft mortgages were prepared with a view to providing further funding to enable that project to proceed but nothing came of it when it was discovered that it was proposed that all interest which had accrued to date would be capitalised. Very shortly after that prospect was abandoned the finance company went into receivership. From about that point the applicant resigned as a director of GHD and thereafter ceased to be directly involved in its affairs. His belief is that Associated Securities took control of the property and proceeded to effect a sale by auction as mortgagees. He also believes that his co-director and fellow guarantor became bankrupt at about the same time.
8. For his part, nothing more was heard of the matter until he was served with proceedings out of the Supreme Court of New South Wales instituted by Associated Securities and which claimed against him $338,280.28, together with interest thereon at the rate of 20% per annum being $91 01 per day after 30 June 1983 plus costs. He defended those proceedings, alleging impropriety in the conduct and exercise by the mortgagee of its power of sale. The proceedings did not come to trial.
9. Instead, in March 1986, pursuant to terms of settlement which had been set forth in writing but which were not produced in evidence before me, $25,000 was paid in full satisfaction of all claims and demands between Associated Securities and the applicant. The applicant will be entitled to the deduction he seeks if he can satisfy the requirements of either or both of the positive limbs of sec. 51(1) of the Income Tax Assessment Act 1936 (``the Act'') and, at the same time, avoid the operation of any of the negative provisions of that subsection.
10. Section 51(1) of the Act provides:
``All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.''
11. The applicant's counsel sought principally to rest his case on the second positive proposition. To succeed in that argument, he would have to establish either that the provision of guarantees was a ``business'' of the applicant or was so integral a feature of another business as to be a recognised incident of that other business. As the provision of guarantees was not something undertaken by the applicant for reward, then the giving of guarantees was clearly not a business of itself. Therefore, the question becomes whether the giving of guarantees was a characteristic of some other business of the applicant. The answer to that question is ``no''. The applicant
ATC 736did not carry on any business. He was an employed salesman. He was a shareholder and director in and possibly ``manager'' of GHD and also GSD. He received management fees for his services to those companies (other than services in providing guarantees). He could hope to receive director's fees and dividends in the future. But he could not be fairly said by reason of those matters to be in business. That being so, he is not directly assisted by the authority of cases such as
Reed's Brewery Co. v. Male (1891) 3 T.C. 279 (a case in which a brewery company was allowed to claim as deductions bad debts suffered in respect of loans made to their customers on the security of public houses); or
Jennings v. Garfield (1962) 40 T.C. 365 (in which a firm of solicitors which had guaranteed in the ordinary course of its business a bank overdraft for a client, was allowed a deduction in relation to the sum paid under the guarantee).
12. However, that would not matter if the applicant could establish that the liability he suffered arose ``in the course of'' derivation of assessable income. He contended that that requirement of the first limb was satisfied in that, as the entirety of his relationship with GHD was directed to the generation of assessable income; and as the provision of guarantees by him was a prerequisite to the borrowing by GHD necessary for it to generate the funds essential to its activities, which activities it was hoped would generate assessable income for the applicant, that that was enough. On that basis he claimed that he could point to decisions such as Case A58,
69 ATC 330 and
Lunt v. Wellesley (1945) 27 T.C. 78. In the former case the holding company of a brewery group was allowed a deduction on guarantees given by it in relation to the indebtedness of licensees who were tenants of one subsidiary and customers of another. In the latter a director of a film-producing company was allowed a deduction for moneys paid in discharge of a guarantee given in relation to the producing company in order to enable it to complete a film. Failure to complete the film would have been disastrous to the guarantor's reputation and future professional prospects in the industry as an artistic film producer - and thereby his income-producing activities.
13. To those contentions the Commissioner's representative offered a twofold answer. First, it was said that the ``losses and outgoings'' in question were not incurred ``in the course of'' generating any assessable income. Secondly, it was said that, in any event, the expenditure incurred was an expense of capital or of a capital nature. As to the former point, the Commissioner's representative pointed to the decision in
Inglis v. F.C. of T. 80 ATC 4001, a decision of a Full Bench of the Federal Court of Australia. I do not find that that decision supports the proposition presently contended for. It certainly stands as authority for the proposition that expenses arising out of a non-income-producing period are not allowable for the simple reason that they have not been incurred ``in the course of'' income-producing activity. However, it is not authority for the proposition that if, during a period of non-business activity, expenses are met which arose earlier in the course of income-producing activities are not deductible. As was said in
Herald & Weekly Times Ltd. v. F.C. of T. (1932) 48 C.L.R. 113 - by Gavan Duffy C.J. and Dixon J. at p. 118:
``No point is made of the fact that the publication (giving rise to the liability) took place in a former year (to that in which the damages for defamation were paid), and properly so. The continuity of the enterprise requires that the expenditure should be attributed to the year in which it was actually defrayed.''
In my view that statement of principle is not to be confined to those carrying on business. I also observe that the decision of the majority of a Full Bench of the Federal Court in
Hooker Rex Pty. Ltd. v. F.C. of T. 88 ATC 4392 provides some support for the application of that principle in the circumstances of this case.
14. But, on the face of it, the submission is well founded in the decision of another Full Bench of the High Court of Australia in
Amalgamated Zinc (De Bavay's) Ltd. v. F.C. of T. (1935) 54 C.L.R. 295. There a company, long after it had ceased its mining activities, continued to bear and meet expenses in the way of workers' compensation premium contributions, liability to which arose out of its earlier income-producing activities. Although all Judges of the Court acknowledged that (as Latham C.J. said at pp. 303-304) ``expenditure which has a direct relation to income of a past year can be deducted in a later assessment year where it is of such a character that, in a continuing business, it must be met
ATC 737from time to time as a part of a process of gaining assessable income''. But the Court also held that where the income-producing activity had wholly ceased - as had happened in the present case before 1978 - then the deduction is not allowable because (to quote Starke J. at p. 307) ``... the expenditure had nothing whatever to do with the appellant's income in the years in question. It was connected with and incidental to its mining operations, which had ceased long before the years in which the deduction is claimed''.
15. I accept the authority of the decision but find considerable difficulty in understanding it. It is difficult to see why it should be that a taxpayer such as the applicant should be denied a deduction in 1986 only because his payee and putative creditor had not brought his claim to finality in earlier years. Because of those difficulties, I prefer to rest my conclusion upon the second submission.
16. Since the decision of the House of Lords in
Salomon v. Salomon and Co. (1897) A.C. 22, the legal system in force in this country has held firmly for most purposes to a distinction between a company as one legal entity, albeit a fiction, and its promoters or shareholders. The activities of GHD are conceptually distinct from those of the persons who controlled it even though the mind and will of GHD might only have been found in its controllers. So it is that a distinction must be made between on the one hand the endeavours of GHD to profit by subdivision; and on the other the endeavours of the applicant to profit as a shareholder in, and director of, and manager for GHD. As a limited liability company GHD had no liability to its creditors beyond its own assets and the applicant was not liable for GHD under any ordinary circumstances beyond any amount unpaid on the issued share capital standing in his name. However, in addition to subscribing for capital, the applicant also provided GHD with assets in the way of funds borrowed from the applicant. In relation to that investment GHD became indebted to the applicant as an unsecured creditor. In the circumstances of the case the applicant lost both the moneys subscribed as share capital and the moneys advanced on loan account. In neither case is he entitled to an income tax deduction because, in each case, the advance represented an advance of capital on his part. The moneys so advanced were to constitute the ``profit-yielding subject'' from which he hoped to profit by way of dividends, interest and management fees. had he been a dealer in shares or a money-lender he might have been entitled to deductions in relation to the loss of moneys he had invested, but that was not the case.
17. However, the commitment of the applicant to the projects of GHD did not stop at that point. He provided in yet a third way for the enlargement of the ``profit-yielding subject''. He enabled GHD to borrow by making himself contingently liable for any default or miscarriage on the part of GHD in relation to moneys borrowed. In that way his relationship to GHD was not to be distinguished from the situation which would have arisen had GHD been constituted as a company limited by guarantee rather than as a company limited by shares. In my view it was not to be distinguished in principle from the situation in which the claim by Hooker Rex (ante) in relation to the Shangri-la guarantee was disallowed.
18. In all the circumstances, in my view the determination of the Commissioner upon the objection must be upheld.