Federal Commissioner of Taxation v. McArdleJudges:
Full Federal Court
Davies, Gummow and Lee JJ.
This is an appeal from a judgment of a single Judge of the Court who, on 11 March 1988, allowed an appeal against an assessment of income tax directed to the income of the respondent, John Walter McArdle, for the year ended 30 June 1982 [reported at 88 ATC 4222]. The learned trial Judge upheld Mr McArdle's objection to the assessment, allowed the appeal and ordered that the appellant, the Commissioner of Taxation, pay the costs of the proceedings.
The issue arises under sec. 26(e) of the Income Tax Assessment Act 1936 (Cth) (``the Act'') which at the relevant time read:
``The assessable income of a taxpayer shall include -
- (e) the value to the taxpayer of all allowances, gratuities, compensations, benefits, bonuses and premiums allowed, given or granted to him in respect of, or for or in relation directly or indirectly to, any employment of or services rendered by him, whether so allowed, given or granted in money, goods, land, meals, sustenance, the use of premises or quarters or otherwise:
- Provided that this paragraph shall not apply to any allowance, gratuity or compensation which is included in paragraph (d), which is an amount to which section 26AC or 26AD applies or which under any provision of this Act is deemed to be a dividend paid to the recipient;''
This provision was subsequently amended by Act No. 47 of 1984 applying to allowances, gratuities, compensations, benefits, bonuses and premiums derived on or after 1 July 1983. The provision was further amended by Act No. 41 of 1986 to reflect the introduction of the Fringe Benefits Tax. However, the first paragraph of the provision remains identical to that as appeared when the Act was enacted in 1936.
We mention the history of the section to emphasise that it must be interpreted and applied having regard to the part which it has played in the Act over many years.
The provision brings into a taxpayer's assessable income the value to him of all allowances etc. given or granted to him in respect of or in relation to any employment of or services rendered by him. One effect of the provision is to overcome the principle enunciated in the United Kingdom in
Tennant v. Smith (1892) 3 T.C. 158 that a perquisite of office is not taxable unless it can be turned to pecuniary account. See also
Abbott v. Philbin (1961) A.C. 352.
Under sec. 26(e), it is not the benefit itself which is assessable income but only the value thereof to the taxpayer. That may be a trite point to make but it is, we think, of considerable significance for the present appeal.
We would emphasise again that the provision requires the identification of an allowance, gratuity, compensation, benefit, bonus or premium allowed, given or granted to the taxpayer and requires a calculation to be made of the value thereof. The application of sec. 26(e) in the latter respect was discussed by Bowen C.J. in Eq. in
Donaldson v. F.C. of T. 74 ATC 4192. At p. 4207, his Honour said:
``Where what is given is freely transferable, its value may be found by determining what a willing but not anxious purchaser might pay for it. Where what is given is subject to restrictions, its value may be found by determining what a willing but not anxious
ATC 4053purchaser, who would, if he bought it, be subject to the same restrictions, might pay for it. Where, as here, what is given to the employee is subject to restrictions and conditions which he alone can fulfil, valuation is more difficult.... Section 26(e) speaks of `value to the taxpayer'. This is a notion familiar in valuing to determine compensation for resumption purposes. In a case such as the present under sec. 26(e) I consider it is appropriate in ascertaining value to the taxpayer to determine what a prudent person in his position would be willing to give for the rights rather than fail to obtain them. (cf.
Pastoral Finance Association Limited v. The Minister (1914) A.C. 1083 at p. 1088.)''
Donaldson's case is of particular interest in that the Commissioner had included in the taxpayer's assessable income a value which he had placed upon certain options to take up ordinary stock units in the employing company at various future dates subject to compliance with certain terms and conditions. The options had been granted under a scheme which contained detailed provisions for the granting of options to take up stock units at specified prices after certain periods of service. One of the arguments put for the taxpayer was that the taxpayer had received only a future expectancy that he might, in the future, gain a benefit, but that he had not presently received any benefit. It was submitted that no value could be placed upon the rights acquired, or no value which could be ascertained in monetary terms. These objections to the assessment were rejected by Bowen C.J.in Eq.
The decision in Donaldson's case was consistent with that of the House of Lords in Abbott v. Philbin (1961) A.C. 352. In that case, an employee had, in 1954, received options at the price of £1 for every 100 shares to acquire 2,000 shares at the market price then ruling, namely 68s. 6d. per share. The options were non-transferable and were said to expire after 10 years or the earlier death or retirement of the employee. Eighteen months later, on 28 March 1956, the taxpayer applied for and was allotted 250 shares at the option price of 68s. 6d. per share. The market price was then 82s. per share. The difference between the current market price and the amount paid for the shares including a proportionate part of the price of the options was included in the taxpayer's assessment to income tax for the year 1955-1956. It was held that the benefit of the option contract was a perquisite which fell to be taxed only in the year 1954-1955 and that the subsequent increase in the price of the shares was adventitious and not assessable. Viscount Simonds said, at pp. 365-367:
``My Lords, I cannot entertain any doubt that, when the company granted the option to the appellant, he acquired something of potential value. I do not think that it matters whether it falls into the category of proprietary or contractual right or into some dim twilight that divides those juristic conceptions. We are concerned with a taxing statute whose language is to be reconciled with the law of England and Scotland alike, and the chosen words `perquisite or profit whatsoever' are as wide and general as they well could be. I can concede no relevant limitation of their meaning except in the oft cited words of Lord Watson in Tennant v. Smith (1892) A.C. 150 at p. 159, that they denote.
- `something acquired which the acquirer becomes possessed of and can dispose of to his advantage - in other words, money - or that which can be turned to pecuniary account.
How, then, can it be said that an option to take up shares at a certain price is not a valuable or at least a potentially valuable right? Its genesis is in the desire of the company to give a benefit to its employees and at the same time, no doubt, to enhance their interest in its prosperity. It is something which the employee thinks it worth his while to pay for: not a large sum truly, but ¶20 deserves a second thought. And it is something which can assuredly be turned to pecuniary account.
My Lords, as I have said, the argument for the Crown appeared to demand for its success that the grantee of the option did not acquire a perquisite at the date of the grant. There could not be one perquisite at the date of the grant and a second perquisite when the shares were taken up. Therefore, the Crown's case, in my opinion, fails at the initial step. But there are other grave difficulties in the way of its success. The taxable perquisite must be something arising
ATC 4054`therefrom', that is, from the office, in the year of assessment. I do not want to embark on the notoriously difficult problem as to the year to which for the purpose of tax a payment should be ascribed if it is not expressly ascribed to any particular year. But I do not find it easy to say that the increased difference between the option price and the market price in 1956 or, it might be, in 1964 in any sense arises from the office. It will be due to numerous factors which have no relation to the office of the employee, or to his employment in it. The contrast is plain between the realised value, as it has been called, of the option when the shares are taken up (though the realisation falls short of money in hand) and the value of the option when it is granted. For the latter is nothing else than the reward for services rendered or, it may be, an incentive to future services. Unlike the realised value it owes nothing to the adventitious prosperity of the company in later years. On this ground also I should reject the claim of the Crown.''
Subsequent to Donaldson's case, sec. 26AAC was introduced into the Act dealing specifically with the acquisition by a taxpayer of shares in a company under a scheme for the acquisition of shares by employees. It is unnecessary for us to discuss the terms of that section in any detail. One effect of the section is to postpone the assessment of any benefit to the time of the taking up of shares or to the time when any right to take up shares is disposed of. The sum brought to account as assessable income is to be calculated having regard to the value of the shares at that time. Section 26AAC(10) provides:
``For the purposes of pararaph 26(e), the acquisition by a taxpayer of a share in a company, or of a right to acquire a share in a company, under a scheme for the acquisition of shares by employees shall be deemed not to be an allowance, gratuity, compensation, benefit, bonus or premium allowed, given or granted to him.''
The provisions of sec. 26AAC do not affect the general principles applicable to sec. 26(e).
Apart from the question of value, the general effect of sec. 26(e) was described by Neaves and Wilcox JJ. in
F.C. of T. v. Smith 86 ATC 4463; (1986) 67 A.L.R. 455; At ATC p. 4467; A.L.R. pp. 460-461, their Honours said:
``The leading authority upon sec. 26(e) is
F.C. of T. v. Dixon (1953) A.L.R. 17; (1952) 86 C.L.R. 540, a case in which the Full High Court of Australia considered the assessability of `make up' pay provided by a soldier's peace time employer during the period of his war service. By majority, the Court held that the payments were assessable, as being `income' within the meaning of sec. 25; but all members of the Court held that sec. 26(e) was inapplicable. In their joint judgment two members of the majority, Dixon C.J. and Williams J. (A.L.R. at p. 20; C.L.R. at pp. 553-554) said this of sec. 26(e):
- `There can, of course, be no doubt that the sum of ¶104 represented an allowance, gratuity or benefit allowed or given to the taxpayer by Macdonald, Hamilton & Co. Our difficulty is in agreeing with the view that it was allowed or given to him in respect of or in relation, directly or indirectly, to any employment of or, services rendered by him. It is hardly necessary to say that the words `directly or indirectly' extend the operation of the words `in relation... to'. In spite of their adverbial form they mean that a direct relation or an indirect relation to the employment or services shall suffice. A direct relation may be regarded as one where the employment is the proximate cause of the payment, an indirect relation as one where the employment is a cause less proximate, or, indeed, only one contributory cause. It may be conceded also that the proviso has an effect upon the construction of para. (e) of sec. 26, but the effect is only to show that the allowance may be in consequence of a retirement from or termination of the office, not to show that a mere historical connection, as it may be called, is sufficient. We are not prepared to give sec. 26(e) a construction which makes it unnecessary that the allowance, gratuity, compensation, benefit, bonus or premium shall in any sense be a recompense or consequence of the continued or contemporaneous existence of the relation of employer and employee or a reward for services rendered given
ATC 4055either during the employment or at or in consequence of its termination.'
Two subsequent cases, each decided by single Justices of the High Court, emphasise that it is not sufficient to activate sec. 26(e) that there be, at the date of the receipt by the taxpayer of money or other benefits, a relationship of employee and employer or of provider and recipient of services between the taxpayer and the payer of the money: see
Hayes v. F.C. of T. (1956) 96 C.L.R. 47;
Scott v. F.C. of T. (1967) A.L.R. 561; (1966) 117 C.L.R. 514. It is also necessary that the money be received by the taxpayer in such a capacity and not otherwise.
The question in the present case is whether, as the appellant contends, the employment of the taxpayer by the bank is, at least, `one contributory cause' of the payment by the bank to him of the relevant money or whether, as is said on his behalf, the relationship has no causal connection with the payment.''
We turn now to the facts of the case. As these were discussed at length in the reasons for judgment of the trial Judge, we need mention only salient points thereof.
Mr McArdle commenced employment with the Delhi group of companies in 1967. As the result of a transfer of assets in 1978 from Delhi International Oil Corporation (``Delhi International'') to Delhi Petroleum Pty. Ltd. (``Delhi Australia''), Mr McArdle was employed by Delhi Australia from the start of 1979. He obtained rapid promotion and became managing director of Delhi Australia, in which capacity he had virtually complete control of the Australian operations.
In 1975, Delhi International established a stock option plan. Certain employees of the group, including Mr McArdle, were granted options to acquire stock in Delhi International. We need not go into the details of the stock option plan. The options granted under it would have been covered by the provisions of sec. 26(e) but for the operation of sec. 26AAC(10). A stock option agreement between Delhi International and Mr McArdle was executed on 15 December 1975 whereby Mr McArdle was granted an option to purchase on the terms and conditions set out in the agreement, which were the terms and conditions of the stock option plan, 3144 shares on the common stock of the company.
On 21 July 1977, 19 July 1979, 29 February 1980 and 13 March 1980, Mr McArdle received additional options under stock option agreements which were substantially in the same terms as the agreement of December 1975.
On 25 October 1979, 29 February 1980 and 13 March 1980, Mr McArdle entered into a limited stock appreciation rights agreement with Delhi International. We need not discuss the details of these agreements save to say that each provided an alternative to the exercise of the stock options previously granted and provided, in lieu, that if the stock option holder desired to exercise it, he would receive a cash payment equal to the excess of the value of the stock over the exercise price of the option.
The limited stock appreciation rights were only exercisable if a tender or exchange offer was on foot for at least 40 per cent of the company's common stock. Upon such exercise the stock options abated to the extent of the exercise of the limited stock appreciation rights. The limited stock appreciation rights provided a conditional means for the employee to have access to any pecuniary benefit that may be available to the employee by exercise of the stock options granted to him under the stock option plan. Whether the grant of the limited stock appreciation rights constituted the bestowal of a fresh benefit upon Mr McArdle is by no means certain. They may have been no more than a means of acquisition of the fruit of the benefits already granted. They were conceived as a manner of receiving the pecuniary worth of the stock options already granted.
The new arrangements were entered into because of difficulties which were foreseen for the stock option plan under the Securities Exchange Act (U.S.), which required officers of companies to disgorge profits made at or about the time of a take-over. There were negotiations on foot for a merger between CSR Limited and Delhi International, which was a Delaware corporation. This merger took place in late 1981 when CSR Limited acquired the shares held by Delhi International in Delhi Australia.
Under his limited stock appreciation rights agreements, Mr McArdle became entitled to
ATC 4056exercise certain rights during a period which commenced on 28 October 1981 and expired shortly thereafter. It was explained to Mr McArdle and to other employees of Delhi Australia, by letter of 15 October 1981, that the limited stock appreciation rights had to be exercised during a ``window'' period. It was thought that, during this period, employees of the company could exercise their limited stock appreciation rights without subsequently being called upon under the American Securities Exchange legislation to give up their profits. The letter of 15 October 1981 advised all Delhi officers not to exercise their stock options but to exercise the limited stock appreciation rights for cash, resulting in a cancellation of the stock options.
Unlike other employees of Delhi Australia, Mr McArdle, after taking taxation advice, exercised neither his stock options nor his limited stock appreciation rights but negotiated with Delhi International to surrender those options in consideration of a payment by Delhi International of the sum of $1,100,000. An agreement dated 11 November 1981 was executed by Mr McArdle and Delhi International and read:
``SURRENDER OF STOCK OPTIONS AGREEMENT
THIS AGREEMENT made this 11th day of November 1981, between DELHI INTERNATIONAL OIL CORPORATION (`Company') a Delaware Corporation, and John W. McArdle, a person employed by the Company or one of its subsidiaries.
WHEREAS the Company has entered into with John W. McArdle certain STOCK OPTION AGREEMENTS and LIMITED STOCK APPRECIATION RIGHTS AGREEMENTS as set out in the Schedule `Exhibit A' attached hereto and the Company now desires to obtain from John W. McArdle the surrender of all of his rights under the said agreements.
NOW, THEREFORE, John W. McArdle does hereby surrender all of his rights under the said agreements and the company does hereby contemporaneously cancel all rights under the said agreements. In consideration hereof the Company shall pay to John W. McArdle into a bank account nominated in Australia, the sum of 1,100,000 Australian dollars within 30 days of the date hereof.
IN WITNESS WHEREOF, the Company has caused this Agreement to be signed by its duly authorized officer and John W. McArdle has duly signed this Agreement on the day and year first above written.
John W. McArdle
DELHI INTERNATIONAL OIL CORPORATION
- 1. Stock Option Agreement dated 15 December, 1975 as amended by Amendment letter dated 7 June, 1976
- 2. Stock Option Agreement dated 21 July, 1977
- 3. Stock Option Agreement dated 19 July, 1979 as amended by Amendment letter dated 2 October, 1979
- 4. Limited Stock Appreciation Rights Agreement dated 25 October, 1979 all as amended by Amendment letter dated 28 February, 1980
- 1. Stock Option Agreement dated 29 February, 1980
- 2. Limited Stock Appreciation Rights Agreement dated 29 February, 1980
- 3. Stock Option Agreement dated 13 March, 1980
- 4. Limited Stock Appreciation Rights Agreement dated 13 March, 1980.
John W. McArdle''
According to Mr McArdle's evidence, which was accepted by the trial Judge, had Mr McArdle exercised his stock options during the period of negotiations for the merger and then sold the stock, he would have received a net $2,000,000. Mr McArdle calculated this figure on the stock market price of Delhi International shares at a time three months preceding November 1981. Mr McArdle did not, however, do so. Nor did he exercise his limited stock appreciation rights. There were doubts surrounding the application of sec. 16(b) of the Securities Exchange Act 1934 (U.S.) and doubts as to whether the so-called window provided a safe route. Moreover, Mr McArdle had
ATC 4057received taxation advice that a lump sum payment in consideration of the surrender of his agreement would place him in a favourable position under Australian income tax law.
Mr McArdle gave evidence that the sum that he received under his agreement of 11 November 1981 was $20,000, or $70,000 if another exchange rate be adopted, less than the sum he would have received had he exercised his limited stock appreciation rights. Mr McArdle gave evidence that he could not recall any specific calculation as to how the amount of $100,000 was calculated but that it was a lesser figure than the total sum payable under the limited stock appreciation rights. Mr McArdle gave this evidence:
``Did anybody else representing the company suggest that? - I believe, in the discussions, it would have been pretty obvious that the amount to be received could not be greater than the amount I would have received, otherwise there was no sense in the company doing it, and if it was substantially less, I would not be interested in doing it.''
As the agreement of 11 November 1981 provided, the $1,100,000 was paid to Mr McArdle in the year ended 30 June 1982. Mr McArdle ceased employment with the Delhi group of companies early in 1982.
The Commissioner included the whole $1,100,000 in Mr McArdle's assessable income for the year ended 30 June 1982. Before the trial Judge, the assessment was supported by reference to sec. 25(1) and 26(e) of the Act. No reliance was placed upon sec. 26AAC, apparently because of the Commissioner's view that the agreement of 11 November 1981, under which Mr McArdle surrendered his stock options and his limited stock appreciation rights and under which Delhi International cancelled those options and rights, did not amount to a disposition by Mr McArdle of those options and rights to a person not being an associate of the taxpayer, which sec. 26AAC(8) specifies as a precondition for inclusion of such a sum in the assessable income of a taxpayer. Whether or not that view is the correct one is not a matter for consideration in these proceedings.
Before the trial Judge, the principal argument put by counsel for the Commissioner was that the $1,100,000 was a benefit allowed, given or granted to Mr McArdle in respect of, for or in relation, directly or indirectly, to his employment. Reliance was placed upon the decision of the High Court in
Smith v. F.C. of T. 87 ATC 4883; (1987) 74 A.L.R. 411, in which Wilson, Brennan and Toohey JJ., Deane and Gaudron JJ. dissenting, held that an employee of a bank was assessable in respect of a payment of $570 received from his employer under an ``encouragement to study'' scheme. Before the trial Judge, much of the argument was directed to the question whether the alleged benefit of $1,100,000 was likewise given or granted in respect of, for or in relation, directly or indirectly, to Mr McArdle's employment. A similar argument was put on the appeal by Mr M.L. Robertson Q.C., with whom Dr I.J. Hardingham appeared for the Commissioner.
However, the first question is: what is it which is to be valued? Mr Robertson submitted that, in the year ended 30 June 1982. Delhi International gave to Mr McArdle in relation to his employment a benefit and that benefit had a value of $1,100,000. Mr Robertson submitted that that was the value of the benefit, for that was the sum paid. Mr Robertson submitted that the effect of the agreement of 11 November 1981 was that the previous arrangements between Mr McArdle and Delhi International were cancelled and that Delhi International granted to Mr McArdle a new benefit being a cash payment of $1,100,000.
But that is to take an unduly simplistic view of the agreement of 11 November 1981. On each side to that agreement there was consideration given, a quid pro quo. Mr McArdle surrendered rights having a value exceeding $1,100,000. Delhi International had advised against the exercise of the stock options and had recommended that Mr McArdle exercise his limited stock appreciation rights which, if exercised, would have resulted in a payment to him by Delhi International of more than $1,100,000. After taking advice. Mr McArdle preferred not to exercise those rights but to surrender his options and rights for a sum only a little less than the value thereof. He preferred to do so because of advice he had received, including advice as to Australian income tax law.
Each party to the agreement of 11 November 1981 gave value for that given by the other party. There was no evidence before the trial Judge that the sum agreed to be paid by Delhi
ATC 4058International under the agreement of 11 November 1981 and paid in the year ended 30 June 1982 exceeded the value of the rights which were surrendered by Mr McArdle under the agreement of 11 November 1981. In so far as there was any evidence on the point, it was to the contrary.
The benefit which Mr McArdle received in the year ended 30 June 1982 was the benefit conferred by the agreement of 11 November 1981. In valuing that benefit, it is necessary to take into account the consideration provided on both sides of the agreement. The consideration provided by Mr McArdle was his surrender of the options and rights which he held. They had a value equal to or greater than the sum agreed to be paid by Delhi International.
Mr Robertson refrained from arguing that the documents recording the surrender of the stock options and the limited stock appreciation rights for the expressed consideration were a sham and did not argue that the documents did other than take effect according to their tenor. Mr Robertson restricted his argument to a contention that the new arrangement entered into by Mr McArdle and Delhi International was a new agreement which delivered a new benefit the value of which was the consideration expressed in the agreement. The argument did not identify the nature of the benefit granted other than by reference to the monetary sum payable under the agreement for surrender of Mr McArdle's vested rights.
Mr Robertson submitted that the effect of the agreement of 11 November 1981 was that the previously valuable rights were surrendered and cancelled and that a new benefit of $1,100,000 was substituted in their place. To look at the matter in that way is artificial. Any benefit granted to Mr McArdle in the year ended 30 June 1982 was the benefit granted to him by the entry of Delhi International into the agreement of 11 November 1981. It was the value of that agreement to Mr McArdle that must be valued, not the value of the liability imposed upon one party to the agreement or the sum subsequently paid by Delhi International pursuant to the agreement.
The trial Judge pointed out that, prima facie, the rights acquired by Mr McArdle on each occasion when he was granted options were benefits allowed, given or granted to him by his employer and assessable under sec. 26(e), subject to the operation of sec. 26AAC. His Honour pointed out that, had Mr McArdle exercised his options to acquire stock units, then subsec. 26AAC(5) would have required the net value of the stock units to be included in his assessable income. His Honour discussed
Constable v. F.C. of T. (1952) 86 C.L.R. 402, F.C. of T. v. Dixon (1952) 86 C.L.R. 540 and Smith's case, cited above. His Honour held that the agreement by Delhi International to pay the $1,100,000 was made by Delhi International, not in consequence of Mr McArdle's employment with the Delhi group, but in consequence of and as consideration for the surrender by Mr McArdle of his stock options and his limited stock appreciation rights. His Honour felt confirmed in this view by the approach taken by Bowen C.J. in Eq. in Donaldson's case, cited above and by Lord Radcliffe in Abbott v. Philbin, cited above. His Honour said:
``The taxpayer in entering into the surrender agreement can correctly be said to be enjoying `the fruits of the rights' and not the rights themselves.
Alternatively in the words of Lord Radcliffe he was engaged in `exploitation of a valuable right' earlier granted to him.''
We respectfully agree with his Honour that what occurred in the year ended 30 June 1982 was not the grant to Mr McArdle of a valuable benefit assessable under the provisions of sec. 26(e) of the Act but rather the exploitation by him rights received in previous years, the value whereof would have been assessable under sec. 26(e) in those years but for the operation of sec. 26AAC(10).
Had we been of the view that, in the year ended 30 June 1982, Delhi International granted to Mr McArdle a benefit of value, we would have thought that that value was assessable to tax under sec. 26(e). However, an analysis of what occurred in the year ended 30 June 1982 shows that what was done was not the grant by Delhi International to Mr McArdle of a valuable benefit in respect of, for or in relation, directly or indirectly, to the services he had rendered for the Delhi group. Rather Mr McArdle negotiated with Delhi International a means of exploiting the rights which had been granted to him by Delhi International in prior years.
Before the trial Judge and again on appeal, reliance was placed on sec. 25(1) of the Act. We need say no more about this matter than did the trial Judge, namely, that it was a capital receipt, being received as consideration for the surrender of valuable rights. The sum was not received by way of a reward for services and was negotiated as the consideration for the surrender of valuable rights.
The application of Pt IVA of the Act was not an issue before the trial Judge or in the appeal.
For these reasons, the appeal should, in our opinion, be dismissed with costs.