Case X85

YFR Grbich SM

Administrative Appeals Tribunal

Decision date: 16 October 1990.

Dr Y.F.R. Grbich (Senior Member)

This case concerns the deductibility of losses incurred in futures trading. The applicant claims deductions under sec. 51 of the Income Tax Assessment Act 1936 and the so-called ``capital gains tax'' provisions in Pt IIIA. The applicant is a research scientist. These losses arise from his spare-time activities, an isolated adventure with Share Price Index futures.

2. On 16 April 1987 the applicant deposited $4,000 with a member of the Sydney Futures Exchange. On 27 April 1987 the applicant opened a contract to buy one June Share Price Index future for $181,700. The very next day, on 28 April 1987, the applicant ``closed out'' this future for $178,000. This constituted a loss of $3,700 plus commission of $83. The Commissioner decided his loss was not deductible. The Commissioner disallowed his objection and the Tribunal now has to decide whether this loss is deductible.

3. There were also minor amounts dealing with magazine expenses of $200 and interest received from his futures broker of $20.24, which was accidentally shown as a deduction. Counsel for the Commissioner conceded a deduction for both of these items.

4. The Share Price Index future on which the applicant made his $3,700 loss is an exotic creature and a comparatively recent innovation. Unlike normal futures they do not provide a mechanism for hedging or speculating against normal market fluctuations for a given commodity or share (see the High Court on futures and straddles in
Darlington Futures Ltd. v. Delco Australia Pty. Ltd. (1986) 161 C.L.R. 500 at p. 503). Rather, such futures provide a mechanism for participants to speculate against the general rise or fall in the value of the share market. In this case, it was a general rise or fall in the value of all shares based on the Australian Stock Exchange All Ordinaries Index. On the one hand, such futures provide a highly speculative form of ``investment'' to those with risk capital. On the other hand, they provide a mechanism by which those who trade in real share issues or underwrite such issues can hedge against the risk of general falls in market prices. They allow those who embark on a new venture to manage at least one element of risk in a project, a general fall in share prices. Being based on fluctuations at the margin of share prices, they provide a highly spectacular investment for the high roller and, at the same time, fulfil a useful economic function.

5. In this particular case the applicant put his $4,000 up front, made his own decision on when to move and then he plunged into the market. He sold his futures just one day later. This particular futures contract had a life span of two months. The applicant gave evidence that he was in futures trading for the long term but that an unfortunately timed announcement by the United States President, who was obviously not properly apprised of the activities of this significant Australian capitalist, sent share market prices tumbling and his long-term plans were thwarted. This was his only futures transaction during the relevant tax year, though the applicant gave evidence that he had engaged in another transaction some four years previously. After this transaction he lost so heavily that he withdrew from the market to lick his wounds and has remained away since, preferring to invest his hard-earned money in building a more solid, if less spectacular investment, house for his family. He gave evidence that he had prepared for this transaction by attending a seminar and reading books and that he was a serious trader.

6. The main question for decision is whether the loss made by the applicant can be characterised ``capital'' within the meaning of sec. 51 and hence falls within the classes of expenditure which are not deductible under the ``traditional income'' provisions (as distinguished from the expenditures which are quarantined under the ``capital gains tax'' provisions in Pt IIIA).

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7. The essence of the Commissioner's argument was that the transaction involving Share Price Index futures trading was a gambling transaction. Since the parties to the futures contract did not intend to make or accept delivery of the physical goods represented in the contract, the Commissioner argued it was a contract of gaming or wagering (Knox C.J. in
See v. Cohen & Anor (1922-1923) 33 C.L.R. 174 at p. 180 and Lord Denning M.R. in
Wilson Smithett & Cope Ltd. v. Terruzzi (1976) 1 All E.R. 817 at p. 819).

8. The applicant taxpayer argued that the short life span of this transaction was typical of trading in the futures market and that normal distinctions between traders and speculators were not appropriate in this context. Almost all futures transactions, he argued, are short term and most of them are closed before maturity. He argued that this transaction was distinguishable from gambling transactions because it had important economic benefits to society.

9. Gains and losses from gambling or wagering transactions are not subject to income tax:
Brajkovich v. F.C. of T. 89 ATC 5227,
Babka v. F.C. of T. 89 ATC 4963. The Commissioner pointed to the many factors which showed that this particular transaction in futures was not conducted in a systematic, organised and business-like way. This included the scale of the transaction, the fact that the taxpayer's activities were not related to other activities of a business-like character, the fact that it depended more on chance than the reward for skill and judgment, the fact that it was more properly characterised a hobby or pastime. The applicant argued that, since he had engaged in one previous such transaction in 1983, this established him as a bona fide futures trader, even though he carried out no activities until the 1987 year and only one in that year. The applicant said that he intended to carry out a course of futures trading and that it was only the unexpectedly large loss, the subject of this application, which intervened and caused him to withdraw. He indicated that the activity depended on his own skill and judgment and he did not depend on the skill of his futures broker through a managed account. While he agreed that it was a high risk ``investment'' and that he himself had not protected his position, he emphasised the fact that he had read books, been to seminars and relied on his judgement.

10. I find as a matter of fact that this was an isolated transaction, that it was speculative in nature but that it relied on skill and judgment and, further, that it relied on the organised application of that judgement. I find that the profit was made by committing the original stake to the income-earning process. It might be thought that, in the context of the large loss in this case, the skill and judgment criterion lies strangely. If it had been mere bad fortune which caused the applicant's loss then, other things being equal, it would not be deductible as a wagering loss but, since it did so depend on his judgment, a judgment which turned out to be wrong, it is thereby rendered deductible.

11. Assuming, on the Commissioner's behalf, that from the applicant's standpoint the futures purchase was highly speculative, it must still be analysed in the context of the total transaction. Such speculative positions are necessary so that bona fide producers of real goods and services can take up opposing positions which allow them to insulate themselves from the risks of market fluctuations. Such risks can be factored out of investment by hedging through this particular type of futures transaction. The applicant was insistent that this transaction be characterised ``speculation'' and not ``gambling''.

12. I do not think that an important issue such as this should be settled by an empty exercise in word games, in juggling round labels like ``gambling'' or ``speculation'' or ``business'' in a vacuum as if this helped to clarify the hard decisions. In giving coherence to the important concept of income in the brave new world after Myer and Pt IIIA, we must go back to the underlying reasons for the rule. In times of great change it is more important than ever to assert basic principles, and to look at the underlying reason for the rules administered by this Tribunal. It is important to locate the Tribunal in a modern, mass decision-making, self-assessing tax system. When the legislature lays down broad rules these predicate discretions, not only for bureaucrats, judges and tribunal members, but also for self-assessing taxpayers who must use those rules as a basis of numerous day-to-day decisions. In this context it is important that the

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Tribunal both encourage bureaucrats and itself contribute to the coherent structuring of that discretion so that the law develops in a systematic and orderly fashion. It is important that such structuring be guided by the broader economic framework in which the tax system must operate.

13. Neither the main deduction provisions in sec. 51 nor the derivation provisions in sec. 25 use the term ``business'' to demarcate income and capital. In the past, the concept of ``business'' did two overlapping but distinct jobs. First, it demarcated isolated transactions on capital account from the recurrent transactions on income account. Second, it excluded transactions which were essentially non-commercial (including wagering) transactions. Because the two questions involved similar criteria, it was not necessary to sharply differentiate them. Such differentiation now becomes significant. In the context of deductions, the essential question is whether an expenditure is in whole or in part incurred to produce something other than assessable income. The essential question in the gambling cases is whether, by granting deductibility to the expenditure, the tax system is subsidising the personal ``consumption'' activities of the taxpayer. It may seem strange, but I understand that there are Australians who view the losing of money at the racecourse or on other forms of gambling as a leisure pursuit.

14. With the introduction of the so-called ``capital gains tax'' and parallel shifts in judicial concepts, the nature of the first job has changed decisively. The job of the ``income'' concept is now predominantly to demarcate, on the one hand, profits taxable at full income tax rates and enjoying full deductibility with, on the other hand, those ``sheltered'' profits subject to privileged treatment under Pt IIIA (including indexation and deferral) and quarantined so that expenditures or losses can only be deducted against capital profits.

15. The leading High Court decision in
F.C. of T. v. Myer Emporium Ltd. 87 ATC 4363; (1987) 163 C.L.R. 199 moves the focus of the income test decisively. The key question is no longer whether profit arose from the normal business of the taxpayer and whether there was repetition. The joint judgment says it clearly (at ATC pp. 4366-4367; C.L.R. p. 209):

``Although it is well settled that a profit or gain made in the ordinary course of carrying on a business constitutes income, it does not follow that a profit or gain made in a transaction entered into otherwise than in the ordinary course of carrying on the taxpayer's business is not income. Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the character of income. But a gain made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circumstances of the case. Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer's business. Nor does the fact that a profit or gain is made as the result of an isolated venture or a `one-off' transaction preclude it from being properly characterized as income.''

16. As a result of the Myer decision the periodicity of the return is less critical than it used to be. Lumpy returns can also constitute income and, a fortiori, lumpy expenditures can constitute deductible revenue items, provided they satisfy the essential criterion. The essential criterion is whether the transaction was commercial. In the case of assets, this translates into whether they were acquired or subsequently mobilised for the purpose of profit making. The line demarcating mere realisation from income earning is whether the asset was acquired or used to make a profit. The essence of this test is that the profit was to be made from committing the asset itself to the income-earning process. It is whether the asset was from the outset or became part of that income-earning process, as opposed to part of the permanent capital structure which made income earning possible.

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17. Against the unanimous reasoning of a Full High Court in Myer, we have the enigmatic dicta of the Full Federal Court in
F.C. of T. v. Spedley Securities Ltd. 88 ATC 4126 at p. 4130. The Federal Court appears to be limiting Myer to its own particular facts when it says:

``The case [Myer] is strong authority for what it decides, but it may only have taken a different view of the facts than had the lower courts.''

18. The High Court's dicta in Myer seems to me unusually clear. As a subordinate Tribunal, we must give full weight and full credit to the fully reasoned decision of a unanimous High Court. The redefinition in Myer is a response to the changing function of the income concept after the introduction of Pt IIIA and it follows a coherent evolution of authority through
Steinberg v. F.C. of T. 75 ATC 4221; (1975) 5 A.T.R. 565;
F.C. of T. v. St Hubert's Island Pty. Ltd. (in liq.) 78 ATC 4104; (1977-1978) 138 C.L.R. 210 and
F.C. of T. v. Whitfords Beach 82 ATC 4031; (1982) 12 A.T.R. 692. It is a very deliberate and carefully considered response to the conceptual problems disclosed in
Cliffs International Inc. v. F.C. of T. 77 ATC 4217; (1977) 7 A.T.R. 465 and earlier decisions. Let me make three observations about the taxation of ``capital'' profits. First, most so-called ``capital gains'' are now deemed to be ``income'' under the Act. Part IIIA operates by deeming all profits on the disposal of an ``asset'' to be taxable income. The main issue for sec. 25 nowadays is whether they are ``traditional income'' subject to full tax under the Act, or the new form of ``sheltered income'' subject to more gentle tax treatment (including indexation and deferral) under Pt IIIA. Second, it is very easy to be misled by presenting the terms ``capital gain'' and ``income'', defined in the earlier decisions, as if they were a fundamental unchanging star in the sky, a star which is not responsive to wider changes in the statutory structure. It is necessary to be cautious about those who drive wedges between what the High Court, the legislature and most economists currently call ``income'' and some mythical connotation of ``income'' drawn from the dawn of history and known only to the high priests who purport to unlock its ``true'' meaning from a confused body of case law. In my experience, earlier generations suffered more confusion about its meaning than we do today. Such historicism does nothing to increase the clarity or the policy responsiveness or the relevance of the working law. In the economic tradition of Haig, Simons and the Carter Commission in Canada, colourfully referred to in common parlance as the ``even playing field'', all profits are ``income''. Myer simply moves sec. 25 somewhat nearer to this ideal. The ideal concept of income connotes the increase in a taxpayer's spending power between two points of time and, in this sense, income includes so-called ``capital gains''. It is difficult to insist that the two concepts are mutually exclusive. Third, it is not accurate, after the earlier authorities and split decisions just cited, to suggest that the authorities before Myer had established clear principles which were abandoned in Myer. In decisions like
London Australia Investment Co. Ltd. v. F.C. of T. 77 ATC 4398; (1976-1977) 138 C.L.R. 106 and
Californian Copper Syndicate v. Harris (1904) 5 T.C. 159, profits on the realisation of the permanent structure of an enterprise were frequently held to be ``income'' in situations where the asset itself was committed to the profit-earning process. The test was suffering from serious incoherence. Myer merely refocused the criterion by which the capital/income decision would be made in a more coherent way. Far from holding that ``any receipt by a business would necessarily be of [a traditional] income nature'', it holds that this depends ``very much on the circumstances of the case'' and will still need to satisfy the test ``that the taxpayer's purpose in entering into the transaction [including the realisation of the asset] was to make a gain''.

19. While it is necessary to be careful in extrapolating decisions from different statutory structures, this line of reasoning receives some support from the decision of the United States Supreme Court in
Corn Products Refining Co. v. Commissioner (1955) 350 U.S. 46. The taxpayer, who had a large-scale manufacturing operation in corn starch, corn syrup and like products made profits and losses trading in corn futures. The futures were acquired to assure its supply of trading stock at a stable price. The Supreme Court held that the profits and losses should be dealt with under the normal income tax provisions rather than receive sheltered treatment under the United States capital gains tax provisions. Clark J., delivering the

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judgment of the Court, held that the futures trading was an essential part of its income-earning business. The Court rejected the argument that the futures were acquired in the taxpayer's role as ``legitimate capitalist'' and hence that it fell under the United States capital gains tax provisions.

20. On the basis of these tests I characterise the taxpayer's expenditures, and the subsequent losses, as made on revenue account. The expenditure was of an income nature, the profit would very probably have been of an income nature and the resulting loss (arrived at by simple arithmetic) is a loss of an income nature.

21. But this is only the first question. The old business threshold test also did another job. It put non-commercial, personal enjoyment activity outside the tax base and, more particularly, did not sanction deductions on expenditures for such activity.

22. It seems to me that the case before me is right on the borderline. While the transaction clearly has commercial utility from the wider standpoint of the economy, from the applicant's standpoint it probably gets as near as one can in the business world to pure speculation. As I said, I put little weight on verbal arguments about whether the activity was ``speculation'' or ``gambling''. Such characterisation is the end product rather than the foundation on which we construct a superstructure of argument. The applicant's activity was of a highly speculative nature. The large rewards and losses to be made from this activity put it in the same category as gambling on horses. But in other essential respects the activity does not differ from the excitement and financial exposure which comes to an entrepreneur from any form of risky business activity. It might be argued that some of our leading entrepreneurs are engaging in highly speculative businesses, every bit as risky and perhaps more risky than the modest high rolling of the applicant. There is no suggestion that normal annual profits from these activities are not taxable and that normal expenses of the operation are not deductible. The element of risk and the ratio of rewards to the stake cannot thus be determinative. Once we leave behind the element of repetition as the essential indicia of demarcation of the borderline, we are forced back to the question whether the activity was essentially commercial in its nature, in the sense that it was part of the commercial world of buying and selling assets as part of the productive process. On balance, and I make this finding only on a weighing of competing indicia, I think it does fall within that commercial characterisation and accordingly is a revenue expenditure. Again, though doing a different job, the essential Myer test of whether the activity was commercial supplies a focus to the characterisation of the loss from the taxpayer's standpoint and colours the whole transaction. Accordingly, this is an expenditure of an income nature and deductible under sec. 51.

23. Assuming I am wrong, the other major question to determine is whether, when this particular futures contract was ``closed out'', there was a relevant disposal for capital gains tax purposes. In this regard there is a recent decision of this Tribunal in Case X47,
90 ATC 382 on similar but not identical facts. That case concerned trading in United States Treasury Bond futures. Mr K.L. Beddoe found in that case that losses were deductible under sec. 51 but he found that the capital gains provisions in Pt IIIA did not apply. In this case I find that the Share Price Index future in question is an ``asset'' within the meaning of sec. 160A of the Act. The chose in action here is the applicant's right, on maturity of the future, to claim the return of his capital and any profits in accordance with the formula in the futures contract. This is, of course, to be distinguished from the underlying shares which are used as a basis for calculating the value of the future.

24. On the other essential element for the application of Pt IIIA, namely, whether there was a disposal of an asset, I find myself in the unfortunate position of diverging from the reasoning of that decision. On the facts outlined in Case X47 it is not entirely clear what ensued when the loss was made. I had similar difficulty in extricating the precise nature of the transaction which occurred when the future was ``closed down'', from the applicant in this case. Be that evidence as it may, it is clear the applicant transferred his contractual rights under the terms of the futures contract to his broker and received a cash credit in return. Like all other futures, there is a delivery date. But in the case of a Share Price Index future no commodity is delivered on this date. The futures contract is merely closed out automatically on the closing date. The Share

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Price Index future it seems is sold to anyone else in the market willing to meet his price. This is what I find, on the basis of the evidence, did happen in the case at hand. If there is no closing out before delivery date, there is a process, whose steps are not entirely clear from the evidence, in which it is closed out with an ``off-market'' transaction. Presumably the broker is buyer. On the basis of the evidence produced before the Tribunal, what happened at this time was that the applicant sold his future, through the offices of the member of the Sydney Stock Exchange, to a person or persons unknown. Be that evidence as it may, it is clear the applicant transferred his contractual rights under the terms of the futures contract to his broker and received a cash credit in return. On the basis of the evidence before me, there has been a change of ownership within the meaning of sec. 160M, either under the general words of sec. 160M(1) because ``a change has occurred in the ownership of an asset'' or under sec. 160M(2), because the applicant entered into a transaction or did another act or thing of like nature or, most particularly, because under sec. 160M(3)(b) a chose in action over property has been cancelled, surrendered, etc. Accordingly, I find that the provisions of Pt IIIA apply and that, had the deduction not been allowed under sec. 51, it would have been allowed under the loss provisions in sec. 160ZO.

Gambling and lottery wins are excluded from the operation of Pt IIIA by sec. 160ZB(2) and (3). In making this characterisation under sec. 160ZB(3) I would use the same criteria as I did under the income test. Accordingly, these losses would not be excluded.

25. It is strictly unnecessary for me to decide this question, but the issue arises whether, when losses are deductible under the normal income tax provisions, they are exempt under the provisions of Pt IIIA. It would not, of course, be possible, under sec. 82 or under general principles to double dip on deductions. But sec. 160L(3) seems to proceed on the assumption that all assets which are caught by the normal income provisions will be ``trading stock'' for the purposes of the Act. It is not at all clear that this assumption can be justified after
John v. F.C. of T. 89 ATC 4101 at p. 4107 (Mason C.J.) and p. 4117 (Brennan J.). There may indeed be isolated speculative transactions of a commercial character which would be taxable under the doctrine in Myer and whose expenditures and losses would be deductible, while the assets of the business would not constitute ``trading stock'' within the meaning of the Act.

26. The decision on the objection under review will be reversed and the deduction allowed.

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