Case V117

PM Roach SM

Administrative Appeals Tribunal

Decision date: 22 July 1988.

P.M. Roach (Senior Member)

The applicant (James) is a barrister who, like other barristers before him, executed a guarantee and, like some of those others, had to face the prospect of paying the price of doing so. As a result in his income tax return for the year of income ended 30 June 1983 he claimed a tax deduction in the sum of $8,194.

2. Over some years the applicant and his friend (John) were together interested in a company engaged in processing silver impregnated materials and liquids to recover their silver content and market it. The company, which I shall refer to as ``Labrador'' overall had a successful history and in some years was highly profitable. John had the more substantial interest in the company, not only controlling over 50% of the share capital but also because John and his wife were full-time employees of the company. James on the other hand was pursuing his professional career as a barrister but serving as a director of Labrador. At 30 June 1980 James held 4,500 and John controlled 17,301 of the 34,600 issued $1 shares in the capital of Labrador. The trading and profit and loss account for the 12 months to 30 June 1980 showed a profit for the year of $916,418; accumulated profit brought forward of $59,253; and, after providing for income tax of $409,354, represented accumulated profits to 30 June 1980 at $531,717. Together with issued capital of $34,600, shareholders' funds stood at $566,317. Those shareholders' funds were represented by a diversity of assets. Significant among them were stock on hand $277,374; moneys on deposit $400,000; freehold land and buildings $89,784; and a boat $54,000. Significant among liabilities were current liabilities to the bank ($132,508) and sundry creditors ($308,056) and a non-current liability to the bank ($62,145).

3. Although in the coming year Labrador was to pay substantial dividends ($145,320), none the less, before the year of income ended, its fortunes were in decline, although not yet irreversibly so. By 30 June 1981 a trading loss for the year of $398,830 had been recorded; accumulated profits had been reduced from $531,717 to $23,221 and shareholders' funds had been reduced from $566,317 to $1,428. The $400,000 which had been on deposit 12 months before had gone, as had the boat. However, the cost of freehold land and buildings had risen from $89,784 to $277,955.

4. I am satisfied that the principal causes of that decline were twofold: destruction by fire of the second of two old factory buildings in November 1980 with consequent losses arising from relocation and from loss of stocks; and a more serious factor, the substantial decline in the world price for silver. In April 1981 James transferred all but 100 of the shares held by him to his family company (Famco) at a price of $50,600. The price was credited to his loan account with the company. Famco acted as trustee of a trust which existed to benefit the family of James. I also find that by 30 June 1981 construction of a new factory building was substantially under way. It was said on the first day of the hearing that the cost of

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construction was to be of the order of $400,000. No supporting evidence was then produced but the documents produced next day suggest that the applicant may have been in substantial error in that regard. Even so I am satisfied that the company was committed to substantial expenditure in relation to the new building and that the funds which on the previous 30 June might have seemed to be available and sufficient to provide for such a construction were no longer available.

5. In consequence of the changed circumstances, approaches were made to the Commonwealth Trading Bank for finance and, on 30 June 1981, the bank made an offer to provide a bills discounted facility of $340,000 gross, subject to its usual terms and conditions: a facility fee of 0.5% payable six-monthly in advance until clearance of the facility; usage fee 2.5% per annum: discount at market rates; and clearance of the facility by the end of May 1982. The security required was stated to be directors' guarantees from James and John (but not from the third director then resident in Melbourne); a first mortgage over the factory site; a mortgage over other land of no great value owned (inter alia) by John and Mrs James; ``mortgage (second or third as the case may be) over both Directors' homes''. An establishment fee was claimed which the bank advised ``has been charged to companies account to-day''. One difficulty for the directors in meeting those requirements was that the private residence of the family of James was owned by Famco: the family company which since April 1981 had been a substantial shareholder in Labrador. The home was already subject to mortgage.

6. Acting on the advice of James, arrangements were made for the security to be provided. James believed that to give a guarantee otherwise than for reward would not entitle the guarantors to income tax deductions in the event of the guarantees being called and loss suffered. That being so, it was agreed by Labrador, shortly prior to execution of securities to the bank, that in consideration of the provision of such guarantees and security, Labrador would pay John 1/2% of $330,000, James 1/4% of $330,000, and Famco 1/4% of $330,000; such payments to be made at the expiration of the 12-month bill facility; and that Labrador would provide a charge over its assets in favour of the guarantors.

7. At that point I observe that I accept that the prospect of loss being suffered seemed sufficiently remote that no arrangements were made for other shareholders or the third director to assume responsibility to the bank, or to James and John; or for a basis to be agreed for contributions to be determined between James and John and the interests they respectively represented and their associates, perhaps so as to align responsibilities under the guarantees and securities to entitlements, vis-a-vis Labrador. On 13 August 1981 Labrador and Famco executed first mortgage security over the factory site and home respectively. On the same day James and John executed a standard form of bank guarantee in favour of the bank in relation to all indebtedness to the bank on the part of Labrador however and whenever arising. Not surprisingly, attempts made by James to secure modification of the terms of the bank's dealings had been unsuccessful.

8. I am satisfied that at that date it was still thought that the world price for silver could recover and restore the fortunes of Labrador. More particularly, I am satisfied that it was thought that the net worth of the company could only be improved by completion of the construction of the factory and that, when so complete, shareholders' funds would have a positive value. However, such confidence or hope as then existed was soon blighted. By November 1981 the directors resolved not to suffer Labrador to further pledge its credit. By 8 December 1981 the company gave notice pursuant to the Companies Act 1961 convening a meeting of creditors with a view to a resolution being passed to wind up the company. The meeting was duly held and the resolution duly passed. The result was that from 21 December 1981 a liquidator took charge of the affairs of the company to conduct a creditors' voluntary winding up.

9. Once it was recognised that liquidation was almost inevitable, James moved to protect the position of all those who might be liable to the bank on account of the company. On 13 November 1981 he belatedly arranged for the deed of charge promised the previous August by Labrador to be provided in favour of Famco, Mrs James, John and himself. The costs of expenses involved in the taking of the charge and which were brought into account in the computation of the loss claimed as a deduction by James were $1,475.

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10. James also looked ahead to the possibility of future problems: particularly the losses likely to flow if the premises of Labrador were sold by the bank as mortgagee or by the liquidator without either being amenable to the directions and requirements of the guarantors. James judged that such courses of realisation would be precipitated if Labrador failed to pay any of the bills on their maturity. The bills were due for payment as follows:

      10 February 1982       $80,000
      15 February 1982       $80,000
         31 March 1982       $70,000
            3 May 1982       $55,000

How the sum of those bills ($285,000) was to be reconciled to the facility figure of $340,000 was not explained.

11. As a result of those deliberations it was decided that funds would be raised which would enable the bills to be met and which would result ultimately in the guarantors becoming subrogated to the rights of the bank in relation to the liquidator. How this was achieved was not precisely explained. It is sufficient to say that the liquidator ultimately acknowledged the claim of the guarantors to the proceeds of the sale of the factory. Just who controlled and influenced the sale was not explained. The proceeds came to hand following a settlement effected on 27 June 1983. What use of the property was made by the liquidator in the interim and how the rents and profits of the property were applied was not explained.

12. But in November 1981 those matters lay well in the future. At that time the immediate problem was how to raise the required funds. To that end it was proposed that security for any lender would be provided by way of mortgage security of the family home of James. That could only be provided by Famco. Famco as a guarantor had interests of its own to protect, just as did John and the others committed. To what extent Famco and Mrs James might have been directly concerned is not known. It is possible that they had only provided mortgage security over real estate. A further consideration was the possibility of contribution as between James, John and Famco. Such a finding might have ultimately depended upon the application of equitable principles in a contribution action before the courts. (cf.
Albion Insurance Co. Ltd. v. Government Insurance Office (N.S.W.) (1969) 121 C.L.R. 342 and in particular Kitto J. at pp. 350-352.) However, in the circumstances, no claims were made which gave rise to any such dispute. I hold that it is not necessary that I should make a determination as to what might have happened in that regard in order to determine the issues before me.

13. Being concerned to confine the ultimate loss in the interests of all, and being concerned to protect Famco from loss even at his own expense, James arranged that Famco would provide the family residence as security for additional borrowings. To do so on 20 December 1981 he wrote from his chambers to the secretary of Famco. In that letter he shortly stated the background in the way of giving the guarantees and that it seemed ``likely that the guarantors will be called upon''. He went on to say:

``It has seemed to me desirable to make arrangements with a view to enabling the guarantors to pay out the bank on the maturity dates for various bills with a view to avoiding any increase in the liability to the bank. It is anticipated that John will have available from the sale of his house, some $140,000 and in addition will repay to Famco or myself the $30,000 lent to him last year. I have arranged with (Solicitors) to borrow a further $100,000 upon the security of (the family residence) and if Famco will agree to that further borrowing, I undertake to pay all the additional costs to the trust which arise out of that further borrowing. I also agree to indemnify the company as trustee in respect of any loss it may suffer as a result of entering into the guarantee.''

On the same day the directors of Famco (James and his wife) resolved in writing to accept the offer of James.

14. On 9 January 1982 by deed of variation of mortgage Famco increased the amount charged against the family residence from $100,000 to $200,000, with the interest rate being increased from 151/2% net to 17% net. James and Mrs James guaranteed the performance by Famco of its obligations under that mortgage.

15. In order to be in a position to raise the additional borrowings it was necessary for Famco to pay out amounts owing under the

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existing mortgages. That obliged Famco to pay penalty interest amounting to $2,125: an amount taken into account by James in the computation of the loss claimed as a deduction. In addition the legal costs, stamp duty and other disbursements attending the granting of the further mortgage amounted to $2,572: also claimed in the computation of the disputed loss. Having taken up the mortgage for the additional $100,000 there was an ongoing liability to interest: also taken into account at $9,974 net in the computation of the loss claimed.

16. The moneys so raised were not immediately needed to meet the bills. Some of the moneys were placed with the Commonwealth Trading Bank at interest to ensure that sufficient funds would be available to meet the bills on the day they fell due and other moneys were invested on deposit with Esanda at interest. The interest reserved was brought to account in the loss calculation.

17. Once the sale of the factory was completed during the year of income ended 30 June 1983, it became absolutely clear that there would be no amount recovered by the guarantors from Labrador. Of course, it followed that there was then no prospect that either the applicant or Famco would ever receive the fee promised them in August 1981 as the price to be paid to them for the giving of the guarantees. Taking the view that the fact of loss was now certain and that the loss suffered might thereafter be increased but could not be reduced, James claimed a deduction for $8,194 in his income tax return for the year of income ended 30 June 1983. In doing so, he said:

``I claim that loss to have occurred in the year ended 30 June 1983 as it was in June 1983 that the securities held over Labrador properly were realized and the fact of ultimate loss ascertainable [sic]. I note however that further loss viz. $3,750 will occur in the period June/December 1983, that is the loss arising from the difference in interest rate between that payable on the $100,000 invested with Esanda Limited and that payable under the mortgage over my home [sic] on that sum (which mortgage will fall due for repayment on 1.1.84).

(The amount involved in this period is only $100,000 because I used $25,000 of the original sum borrowed for private purposes after it became available on the realization of the Labrador assets.)''

18. James first bases his claim to the deduction sought by relying on the provisions of sec. 51(1) of the Income Tax Assessment Act 1936 (``the Act''). That subsection 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.''

He puts his claim on the basis that in August 1981 he entered into the guarantee for the purpose of deriving assessable income by way of the fee of $825. He does not suggest that he was in the business of a financier or of a person providing guarantees. But he does say that the guarantee which was given was given in the course of deriving assessable income. He then argues that the fact that he became liable upon the guarantee by reason of the inability of Labrador to meet its commitments means that the expenses he thereafter incurred in consequence of that default all constitute ``losses and outgoings... incurred in gaining or producing his assessable income...''. Further, he says that no part of those expenses constituted losses of ``capital, or of a capital, private or domestic nature...''. In addition, he says that the additional losses he suffered following the agreement with Famco of November 1981 are just as surely losses and outgoings so incurred - the further losses being incurred in order to limit the losses to which he was already exposed.

19. In doing so he distinguishes the many other cases in which directors of companies have failed in their claims to have deductions for losses incurred by reason of guarantees given by them in relation to the companies of which they were directors. He says that in none of those cases was the provision of the guarantee itself intended to be a source of assessable income. Case V115,
88 ATC 733 and Case V116,
88 ATC 737 (decisions handed down this day) are instances of the types of case which he contends are to be distinguished.

20. The argument, however, is founded on a fallacy. Labrador and Famco are distinct legal

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entities from James. James and Famco had sought to profit from investment in Labrador. In that endeavour they invested moneys by way of share capital and, possibly, loan capital. In each case the objective was to derive assessable income: in the one case by way of dividends; in the other, by way of interest. When the problems of August 1981 arose and Labrador needed more capital, James and Famco might have contributed the moneys needed by way of subscribing for more shares or by way of advancing additional moneys on loan. Had they done so there would have been no argument but that the losses later experienced would have been non-deductible. Instead they arranged the provision of sufficient cash funds from a third party - the bank. They did so by undertaking responsibilities: under the mortgage in the case of Famco and the guarantee in the case of James. (They might have done so by subscribing for shares with nothing paid.) In my view by doing as they did, they were just as surely dealing with a transaction of capital or of a capital nature as if they had subscribed for further shares: whether or not as shares limited by guarantee or unlimited as the case might have been. To that extent the circumstances of James are not distinguishable in principle from the circumstances of the taxpayers in the cases already mentioned.

21. However, regard must be had to the most substantial difference pointed to by James: the expectation of the derivation of the fee. In my view the substance of the distinction is more apparent than real. The promise of a fee, which would have constituted assessable income, was an inducement to undertake a risk of a capital nature. That does not alter the nature of what was risked or the nature of what was lost. In my view there was no entitlement to a deduction pursuant to sec. 51(1) of the Act.

22. The second contention advanced by James is that the loss is allowable by force of the second provision of sec. 52 of the Act, which provides that:

``Any loss incurred by the taxpayer in the year of income... from the carrying on or carrying out of any undertaking or scheme, the profit (if any) from which... undertaking or scheme would have been included in his assessable income, shall be an allowable deduction:...''

There is little enough authority as to what the phrase ``any profit-making undertaking or scheme'' means. But if there may be some difficulty about precisely identifying what constitutes a scheme, in my view it is at least clear that the investment of capital, or of a capital nature, in circumstances such as this does not constitute an ``undertaking or scheme''. Every person who purchases shares in a company hopes to derive assessable income by way of dividends. If the company fails and he loses the moneys invested, that is a loss of capital. It is not to be suggested that it constitutes a loss suffered ``from the carrying on or carrying out of any undertaking or scheme'' simply because it was intended to generate assessable income. As much may be said of every person who invests on loan, whether to a bank, building society, finance company, commercial house or individual, in the expectation of deriving interest income - only to suffer the disappointment of seeing his capital lost. In my view no loss is allowable pursuant to the provisions of sec. 52 of the Act.

23. Having reached those conclusions I think it unnecessary, and undesirable, to embark upon a consideration of questions as to when, for the purposes of sec. 51 it would be said that any ``losses or outgoings'' were ``incurred'' and which of the losses suffered would have been allowable, and in what amounts, and in what years; or the question as to what would have constituted the ``loss incurred by the taxpayer in the year of income'' ended 30 June 1983.

24. The order of the Tribunal will be that the determination of the Commissioner upon the objection under review shall be upheld.

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