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CASE Y36

Members:
P Gerber

Tribunal:
Administrative Appeals Tribunal

Decision date: 8 July 1991

Dr P Gerber (Deputy President)

The applicant is a company engaged in the abalone fishing business. In brief compass, in June 1987, the company borrowed - for present purposes - some $400,000 used to pay a single premium life insurance policy on the lives of its only two directors and shareholders, Mr and Mrs Nemo. The insurance policy was surrendered in January 1988 for an amount less than the premium paid. The questions to be resolved on this reference are whether the following are allowable deductions: (i) the

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commercial bill charges on the $400,000 borrowed to acquire the life policy; (ii) the loss incurred on surrender of the insurance policy.

2. The ``T'' documents disclose that in its 1987 return, the company claimed a deduction for commercial bill discount charges which included an amount of $29,021 referable to $400,000 borrowed (by way of a commercial bill acceptance facility provided by a bank) to obtain what is colloquially known as an insurance bond. In its tax return for the following year, the applicant similarly claimed an amount for discount charges which included an amount of $30,552 referable to the abovementioned borrowing. In addition, $49,508 was claimed in that return as a ``loss on sale'' of the insurance bond. On 19 April 1990, the respondent issued amended assessments in respect of the 1987 and 1988 income years, disallowing the applicant's claims for the abovementioned amounts. Hence this reference.

3. Mr Nemo commenced abalone diving in 1983. In 1984, the applicant company was formed to run that business. Mr and Mrs Nemo became managing director and director respectively. At all relevant times, the couple were the company's only shareholders, each holding 24 $1.00 ordinary shares, and were its only employees. During the years in question, the only business carried on by the applicant was abalone fishing.

4. By 1987, the sale price of abalone had risen significantly, so much so that the major part of the sale proceeds, hitherto used to repay the debt owed on the purchase of the abalone diving licence, were available for other things. It also became apparent during the hearing that Mr Nemo was not unmindful of the fact that a significant increase in profits might well mean a significantly higher tax liability unless some precautionary measures were set in train. So in early June 1987, Mr Nemo sought advice from a firm of eminent accountants on what was referred to as ``diversification of investment outside the fishing industry''.

5. Having received certain advice, Mr and Mrs Nemo, in their respective capacities as managing director and director of the applicant, signed and applied the applicant's common seal on 22 June 1987 to a document headed ``National Mutual Managed Investment Plan Proposal Form'' in which it was proposed that the applicant deposit $400,000 in National Mutual's (The National Mutual Life Association Limited) Managed Investment Plan. That document described Mr Nemo as the ``Life to be Insured'', Mrs Nemo as the ``Second Life to be Insured'', and the applicant as ``Proposer (Owner)''. It also contained the following:

``I/We propose to National Mutual to provide insurance on the conditions set out in the Managed Investment Plan Policy and confirm the truth and accuracy and completeness of all statements in writing given in support of this Proposal which shall, subject to law, form the basis of the contract of insurance.''

6. In order to acquire this insurance bond, the applicant entered into an agreement with the Australia and New Zealand Banking Group Limited (``the ANZ Bank'') on 23 June 1987, the terms of which are evidenced by a document headed ``Fixed Rate Commercial Bill Facility Agreement'' (``the facility agreement''). Suffice it to say for present purposes that as a result of the applicant entering into that agreement, it obtained $500,000 from ANZ, $400,000 of which was paid directly to NML on the following day, the remaining $100,000, with which I am not concerned, was used to re-finance the abalone fishing licence loan. ANZ's security for the ``advance'' consisted of an unlimited guarantee from Mr and Mrs Nemo, supported by registered mortgages over several title deeds, and a Deed of Defeasance with registered assignment over the NML insurance bond.

7. Mr Nemo deposed before me that at the time the applicant entered into the facility agreement, the intention was for the applicant to use the after tax profit from both the NML bond and the abalone fishing business to liquidate the debt on the facility agreement, and obtain an ``asset'' prior to the termination date of that agreement (24 June 1992), after which date it was the applicant's intention to ``sell'' that ``asset'' within three years. The reason for this, he said, was based on the advice of his accountant that ``if the bond was allowed to run for more than eight years, there may have been some tax evasion (sic), but if it was sold within the eight year period that wouldn't be the case''. A similar statement appears in a schedule signed by Mr Nemo which formed part of the applicant's 1987 tax return:

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``During the year the company borrowed funds from the A.N.Z. Bank to purchase an insurance bond specifically with the intention of using the bond as an income producing investment.

It is not the intention of the company to maintain the bond in excess of eight years and therefore obtain the taxation benefits under Section 26AH of the Income Tax Assessment Act but rather to draw the bond on a yearly basis therefore creating a taxable income stream under that same Section.

It is the intention of the company to completely withdraw the policy prior to year eight of its term. Therefore, deductibility of the interest paid on the borrowed funds is claimed under Section 51(1) as necessarily incurred in earning assessable income.

The interest paid is not capital or of a capital nature but was incurred in obtaining an income producing asset.''

8. In the Schedule that formed part of the documents (which I will refer to hereafter as ``the policy''), issued to the applicant on 10 July 1987, the $400,000 was described as a ``single premium (initial investment)'', and the commencement date of the policy was stated to be 23 June 1987. The policy was described as ``Managed Investment Plan - Flexible Security Plan (FSP) Insurance Policy''. The principal obligation of NML was set out as follows:

``NATIONAL MUTUAL AGREES subject to the General Conditions and the Special Conditions hereinafter contained that if the FSP Single Premium specified in the Schedule is duly paid and this Policy duly discharged is produced to National Mutual

IT WILL PAY TO THE Policyowner on the death of the last surviving Life Insured specified in the Schedule or on the survival of any of the Lives Insured to the FSP Maturity Date an amount equal to the Balance of the Accounts

PROVIDED ALWAYS THAT the amount paid on the death of the last surviving Life Insured if it occurs before the Life Insured attains the age of ten years shall be equal to the aggregate of the FSP Single Premium and any Additional Premiums which have been received in respect of this Policy with interest thereon at a rate of not less than 4 per centum per annum compounded yearly.''

9. The ``FSP Maturity Date'' was stated to be 23 June 2052 (by which date Mr and Mrs Nemo would be aged 95). The special conditions provided for the establishment of four accounts, which represented the number of units allocated in the insurers' investment account at unit prices, an additional premium investment account, a realised units account and a bonus unit account. The special conditions went on to provide for the ``FSP Single Premium'' (the $400,000) to be allocated as a number of units in the investment account after deducting initial charges. In the applicant's case, those initial charges amounted to $10,377.26 leaving $389,622.74 to be allocated to the investment account as 18,800.557 units at the then unit price of $20.724.

10. It is a material fact that at the time the applicant took out its policy, the assets of the NML Managed Investment Plan Fund contained a substantial share portfolio. The State Manager of Financial Services for NML, Mr Birchall, who was called by the applicant, explained the complexities of the NML policy and related matters. He also gave a break-down of the Fund's assets at the relevant time. 

      (a)  Australian share portfolio          34.5%
      (b)  International share portfolio       27.0%
      (c)  Redeemable preference
           shares                              16.6%
      (d)  Cash                                13.8%
      (e)  Property in the way of
           property trusts                      3.6%
      (f)  Fixed Interest                       1.2%
      (g)  Other (not elaborated upon)          3.3%
                                              ------
                                              100.0%
                                              ------

11. As a result of the collapse of the share market in September/October 1987, the value per unit in the Fund went down significantly. The Nemos watched the downward trend in the market and the consequent diminution in the value of their units with some alarm. On 12 January 1988, they decided to surrender the policy to minimise the applicant's loss. The proceeds of the surrender, $350,491.57, were paid directly to ANZ under the security arrangements associated with the facility agreement.

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12. Special condition C8 provided that ``the surrender value of the Policy is the Balance of the Accounts calculated using Release Values of Units as specified in the Calculation Provisions''. Calculation provision P9 (``P9'') provided that ``the Release Value of an investment Portfolio shall be the Value of that Investment Portfolio less the total amount of brokerage commission stamp duty legal and other costs that National Mutual considers would be incurred in the sale of the investments held at that time''. Mr Birchall explained that the amount deducted by NML pursuant to P9 in the case of the applicant's surrender was $3,545.10. That amount represented a 1% reduction in the then current unit price ($18.644) when calculating the amount equal to the balance of accounts. He went on to explain that the $350,491.57 proceeds from surrender of the policy were made up as follows: 

      (a) Investment Account
          18,800.557 units @ $18.458/
          unit (reduced by 1%)=           $347,020.68

      (b) Bonus Units Account
          188.042 units @ $18.458/
          unit=                             $3,470.89
         (approx. 1 bonus unit
          for every investment account
          unit)
                                           -----------
                                           $350,491.57
                                           -----------

13. Since no units had been realised during the term of the policy and no additional premiums had been paid, there were no balances in those accounts to be taken into consideration when calculating the balance of accounts at the time of surrender. The 188.042 units in the bonus units account had been credited to that account under NML's practice at the time to annually credit approximately one bonus unit for every 100 investment units held in the Plan Fund. That practice was the method adopted at the time by NML's actuaries to distribute any surplus arising from ``Ordinary Life Insurance Policies'' as provided for in Special condition C9.

14. Mr Birchall informed the Tribunal that the performance history of the Plan unit price was such that it would be reasonable to say at the time the applicant took out the policy that it was attracting a high return on funds invested. NML introduced the Managed Investment Plan in October 1982. As at 30 June 1985 the unit price was $14.05. By 30 June 1986 the unit price had increased to $16.815 and by 30 June 1987 it had again increased to $20.753. Over those two years, he said, there was an annualised return of approximately 20%.

15. In summary, the applicant submits that:

  • (a) as the intention was to create a taxable income stream from several partial surrenders of the insurance bond, ``interest'' on borrowings made for the purpose of acquiring that bond is deductible under section 51(1) of the Income Tax Assessment Act (``the Act''); and
  • (b) since the bond was acquired as an income producing asset to be surrendered after a relatively short time, the loss on surrender is also deductible under section 51(1).

Section 51(1)

16. 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.''

17. I will deal with the issues of deductibility of the ``interest'' and the loss on surrender of the bond seriatim.

The ``interest'' claim

The first limb of section 51(1): incurred in gaining or producing assessable income

18. In
Ure v FC of T 81 ATC 4100, Deane and Sheppard JJ held (at pp. 4109-4110):

``In a case such as the present where the outgoing claimed as a deduction is interest paid on borrowed money, one cannot ordinarily look to the direct object or advantage which the outgoing was intended to achieve for the reason that that will ordinarily be the receipt of the borrowed money which is likely to be neutral in character. One must, of necessity, look more to the objects or advantages which the application and use of the borrowed money

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were intended to gain (
F.C. of T. v. Munro (1926) 38 C.L.R. 153 at p. 197). Where there is a difference between intended and actual use of the borrowed money or a change in use, difficulties may arise in determining what are the relevant objects or advantages which the payment of interest was calculated to procure.''

19. While the discount charges under the bill facility are not regarded in the same way as interest in terms of the timing of the liability (cf
Coles Myer Finance Ltd v FC of T 91 ATC 4087), I consider the abovementioned statements of their Honours are equally applicable to this situation, that is, the discount expense may be incidental and relevant to the gaining of assessable income where the discounted proceeds obtained from the acceptance of the bills of exchange are laid out for the purpose of gaining that income. It is therefore necessary to determine what, if any, assessable income was obtained from the use of those proceeds, that is, the purchase of the insurance bond.

20. It is clear from the statement in the applicant's 1987 return that its advisers at that time contemplated that the intended proceeds from yearly partial surrenders of the insurance bond would be assessable income under section 26AH of the Act.

21. Section 26AH(6) includes as assessable income, amounts of bonuses received under a policy, that but for this section, would not be included in the assessable income of the taxpayer of any year of income. It is therefore necessary to consider whether any other provisions of the Act would render such amounts assessable.

22. Mr Griffiths, of learned counsel for the applicant, submitted that the realisation of any profit from the surrender of an income producing asset would be ``taxable upon normal concepts''; a reference presumably to the assessability of such amounts under section 25(1). Mr Graham, of senior counsel for the Crown, on the other hand submitted that there was nothing before me to suggest that the bond was acquired for the purpose of profit-making by sale, or that its acquisition formed part of a profit-making scheme, and that the surrender of the bond was a mere realisation of a capital asset in the classic sense used by Lord Justice Clerk in
Californian Copper Syndicate Ltd v. Harris (1904) 5 TC 159. On this issue, their Honours, Mason ACJ, Wilson, Brennan, Deane and Dawson JJ in a joint judgment in
FC of T v The Myer Emporium Ltd 87 ATC 4363 held at pp. 4366-4367:

``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 (
F.C. of T. v. Whitfords Beach Pty. Ltd. 82 ATC 4031 at pp. 4036-4037, 4042; (1982) 150 C.L.R. 355 at pp. 366-367, 376). The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit.''

23. In this case, however, there is no question of the applicability of that principle as there was no profit or gain from the transaction which could be included as assessable income - as a result of the surrender of the bond, the applicant received some $49,508 less than it paid for it.

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24. Next, one needs to consider whether any amount received by the applicant was assessable income pursuant to section 26(i), which provides:

``[The assessable income of a taxpayer shall include] any amount received as or by way of bonus other than a reversionary bonus on a policy of life assurance;''

25. In Case J54,
77 ATC 475, Board of Review No 2 held that section 26(i) included as assessable income bonuses on policies of life insurance other than reversionary bonuses on such policies. I consider that the ``bonus'' in the instant case is a reversionary bonus, that is, a bonus paid on maturity, forfeiture or surrender, as opposed to, for example, an annual bonus payable in praesenti in cash: cf Case Q74
(1965) 15 TBRD 346. There is therefore no amount assessable pursuant to section 26(i) in this case.

26. In light of the non-applicability of sections 25(1) and 26(i), it is therefore necessary to consider whether any amounts that were received are assessable income pursuant to section 26AH of the Act.

27. In the circumstances it is probably instructive to set out the relevant provisions of that section.

  • Bonuses on short-term life policies

``Sec. 26AH(1)

In this section, unless the contrary intention appears -

  • `agreement' means any agreement, arrangement or understanding, whether formal or informal, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings;
  • `assurance year', in relation to an eligible policy, means the period of 12 months commencing on, or on any anniversary of, the date of commencement of risk of the policy;
  • `date of commencement of risk', in relation to an eligible policy, means the date of commencement of the period in respect of which the first or only premium paid under the policy was paid or, if the first or only premium was not paid in respect of a period, the date on which that premium was paid;
  • `eligible period', in relation to an eligible policy, means the period of 10 years commencing on the date of commencement of risk of the policy;
  • `eligible policy' means a policy of life assurance in relation to which the date of commencement of risk is after 27 August 1982;
  • `eligible reckoning date', in relation to an eligible policy, means the date of commencement of an assurance year that, for the purposes of an application of sub-section (13), is the premium increase year referred to in that sub-section.

Sec. 26AH(2)

...

Sec. 26AH(3)

This section applies to any amount received after 27 August 1982 under an eligible policy.

Sec. 26AH(4)

For the purposes of this section, but subject to sub-section (5), a taxpayer shall be taken to have received an amount under or in relation to an eligible policy although the amount is not actually paid to the taxpayer but is re-invested or otherwise dealt with on his behalf or as he directs.

Sec. 26AH(5)

...

Sec. 26AH(6)

Where, during the eligible period in relation to an eligible policy, a taxpayer receives an amount (in this sub-section referred to as the `relevant amount') under the policy as or by way of a bonus, being an amount that, but for this section, would not be included in the assessable income of the taxpayer of any year of income, the assessable income of the taxpayer of the year of income in which the relevant amount is received shall include -

  • (a) if the relevant amount is received during the first 8 years of the eligible period - an amount equal to the relevant amount;
  • (b) if the relevant amount is received during the ninth year of the eligible period - an amount equal to two-thirds of the relevant amount; or

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  • (c) if the relevant amount is received during the tenth year of the eligible period - an amount equal to one-third of the relevant amount.

Sec. 26AH(7)

Sub-section (6) does not apply to any amount received by a taxpayer in a year of income under an eligible policy where -

  • (a) the amount is received in consequence of -
    • (i) the death of the person on whose life the policy was effected; or
    • (ii) an accident, illness or other disability suffered by the person on whose life the policy was effected;
  • (b) the eligible policy is a superannuation policy within the meaning of Division 8; or
  • (c) except where the policy was effected, purchased or taken on assignment with a view to it being forfeited, surrendered or otherwise terminated, or to it maturing, within 10 years - the amount was received by the taxpayer by reason of the forfeiture, surrender or other termination of the whole or a part of the policy in circumstances arising out of serious financial difficulties of the taxpayer.

Sec. 26AH(8)

Where -

  • (a) sub-section (6) would, but for this sub-section, apply to an amount (in this sub-section referred to as the `relevant amount') received by a taxpayer by reason of the forfeiture, surrender or other termination of the whole or a part of an eligible policy; and
  • (b) the Commissioner, having regard to -
    • (i) the total amount of premiums paid under the eligible policy;
    • (ii) the total amounts received by the taxpayer or by any other person under the eligible policy and the total amounts of bonuses included in the amounts so received;
    • (iii) the amount of the surrender value of the eligible policy at the time when the forfeiture, surrender or other termination occurred; and
    • (iv) such other matters as the Commissioner considers relevant,

    is of the opinion that it would be unreasonable for sub-section (6) to apply to the relevant amount or to a part of the relevant amount,

sub-section (6) does not apply to the relevant amount, or to that part of the relevant amount, as the case may be.

Sec. 26AH(9)-(14)

...''

28. At the hearing, Mr Griffiths submitted that the insurance bond was not in fact a policy of life insurance, so that section 26AH of the Act was not applicable. He submitted further that whatever the language used in the agreement, its substance was one of ``investment'' not ``insurance'', having adduced evidence through Mr Birchall that in fact the insurance component of the bond was negligible.

29. This submission with respect to an insurance bond, the terms of which appear to be at least extremely similar if not identical to the one before me, was closely examined by Deputy President McMahon in Case Y20,
91 ATC 243 at pp. 247-248:

``... In arguing that the policy was not a life policy, the applicant relied upon a passage in the judgment of Windeyer J in
The National Mutual Life Association of Australasia Limited v FC of T (1959) 11 ATD 523 at 528-529; (1958-1959) 102 CLR 29 at 43 -

  • `Baron Parke's often-quoted description of `the contract commonly called life-assurance' in
    Dalby v. The India and London Life-Assurance Company 15 C.B. 365, at 387 [139 ER 465, at p. 474] was not when he gave it a comprehensive definition; it was probably not intended to be; it certainly is not today. It was merely a description of the usual form of a whole of life policy. Today several other forms of contract, equally properly called life insurances, form a great part of the business of all life offices. The generally recognised differences between the

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    various classes of insurance arise partly from essential differences in the nature of the contracts, partly from an insistent emphasis of distinctions which are the historical result of different forms of insurance having become commercially available in different periods of history and having been, for the most part, originally made available by insurance offices conducting one class of business only. In Bunyon on Life Insurance it is said that `The contract of life insurance may be further defined to be that in which one party agrees to pay a given sum upon the happening of a particular event contingent upon the duration of human life in consideration of the immediate payment of a smaller sum or certain equivalent periodical payments by another'.'

15. The definition in Bunyon was also referred to with approval by the New Zealand Court of Appeal in
Marac Life Assurance Limited v Commissioner of Inland Revenue (1986) 1 NZLR 694 at 697.

16. The applicant relied upon the condition in the policy that the amount payable on the life insured's death or survival to maturity date was an amount equal to the balance of the accounts. It was said that a characteristic of a life assurance policy was that a sum certain should be payable `upon the happening of a particular event contingent upon the duration of human life'. An obligation to pay the balance of accounts meant that the issuing house took no risk, which was a characteristic of a life assurance policy. It seems to me that this argument must fail for 2 reasons.

17. Firstly, the principal insurance contract obligation quoted above clearly provides for payment of a guaranteed minimum amount in the event of death prior to the age of 10 years. It may be speculated that this was included in the terms of the policy to ensure that it was a life assurance policy. The benefits available to policy holders under s 26AH are in respect only of policies of life assurance. Furthermore the document uses the terminology appropriate to life assurance policies in its references to the `life insured' and to terms such as `premium' rather than `investment', `maturity date' rather than `repayment date', and `surrender value' rather than `current market value'. In its own terms, it contains sufficient of the traditional elements of a life assurance policy to characterise it as such.

18. Secondly, the argument put by the applicant, in my view, involves an unnecessarily narrow reading of the quoted passage. As Windeyer J observes, the traditional definition was merely a description `of the usual form of a whole of life policy' current at the time Dalby's case was decided in 1854. There are constant changes in the nature of financial products being offered in the market. Life assurance policies, no less than what might be called cash box investment trusts or managed investment plans, are regularly produced in flexible forms to meet different needs. So long as there is a contingency dependent upon the life insured's death, then the policy can be properly characterised as a life assurance policy. It is not necessary, in my view, that such a policy must guarantee payment of a specified sum. So long as the contractual obligations are set out and the sum payable is ascertainable, then the essential character of the policy is established.''

30. If that conclusion by the learned Deputy President is not sufficient to decide this issue, further reference may be made to the judgment of McMullin J in Marac (supra) at p. 711:

``The name `bond' may be an unorthodox way of describing a policy of life assurance. But the use of that label is not determinative of the character of the document. That is to be determined by resolving what legal relationships the terms of the bond create. It was not said that the documents were a sham; mere masks to cloak the true nature of the transactions. Therefore, one is obliged to adopt the approach now well settled by authority and to consider their substance which is that which results from the legal rights and obligations of the parties ascertained upon ordinary principles:
Re Securitibank Ltd (No 2) [1978] 2 NZLR 136.

It was inevitable that, with the emergence of a greater measure of public perception, increasing sophistication and competition in the marketing of policies with the need to make them more attractive, and the

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influence of fiscal considerations, that the ways in which life insurance would come to be marketed would differ from those employed when Bunyon was written. But the different techniques which life assurance companies now employ in marketing their policies do not alter the character of a document said to be a life policy, if essentially the document provides for a fund the payment of which is contingent upon the contingency of life.''

31. I might add that section 26AH only includes amounts received by way of a bonus on insurance policies. As noted earlier in relation to section 26(i), the only component of the $350,491.57 received on surrender of the bond which could be described as received by way of a bonus was the $3,470.89 which represented the balance of the bonus units account.

32. I do not propose to stand in the respondent's shoes and form an opinion that, for the purposes of section 26AH(8), it would be unreasonable for the $3,470.89 bonus to be included in the applicant's assessable income by virtue of section 26AH(6). For reasons that will become apparent below, I do not see this as a case for the exercise of such a discretion.

33. Having found that there was income of $3,470.89 which is assessable pursuant to section 26AH, it is necessary to consider whether the purpose of laying out the discounted proceeds obtained from the acceptance of the bills of exchange was to gain that income. In
Fletcher & Ors v FC of T 90 ATC 4559 at pp. 4563-4564, the Federal Court gathered together the authorities on the relevance of purpose in relation to section 51(1):

``In our opinion the test to be applied in determining whether expenditure qualifies for deduction under the first limb of sec. 51(1) is to ascertain the `essential character' of the expenditure, as stated by Williams, Kitto and Taylor JJ. in Lunney at A.T.D. p. 412; C.L.R. p. 497, Brennan J. in Magna Alloys at ATC p. 4546; A.L.R. p. 217, Toohey J. in Ilbery at ATC p. 4667; A.L.R. pp. 179-180, a Full Court of this Court (Forster, Fisher and Spender JJ.) in
F.C. of T. v. Brixius 87 ATC 4963 at p. 4965; (1987) 16 F.C.R. 359 at p. 361 and French J. in
Riverside Road Pty. Ltd. (in liq.) v. F.C. of T. 90 ATC 4031 at p. 4041.

The critical question in the present case is whether purpose is relevant in determining the essential character of the interest payments. The question has been considered by this Court in a number of cases: Magna Alloys per Brennan J. at ATC pp. 4545-4553; A.L.R. pp. 216-227; Ure v. F.C. of T. 81 ATC 4100; (1981) 34 A.L.R. 237; Ilbery at ATC pp. 4667-4668; A.L.R. pp. 179-181;
F.C. of T. v. Creer 86 ATC 4318; (1986) 65 A.L.R. 485;
Anderson v. F.C. of T. 89 ATC 4982 at pp. 4990-4991; and Riverside Road at p. 4041.

In Ure, Brennan J. said at ATC p. 4104; A.L.R. p. 241:

  • `An outgoing of interest may be incidental and relevant to the gaining of assessable income where the borrowed money is laid out for the purpose of gaining that income (F.C. of T. v. Munro (1926) 38 C.L.R. 153 at pp. 170, 171, 197;
    Texas Co. (Australasia) Ltd. v. F.C. of T. (1940) 63 C.L.R. 382 at p. 468). The laying out of the borrowed money for the purpose of gaining assessable income furnishes the required connection between the interest paid upon it by the taxpayer and the income derived by him from its use.'

Toohey J. cited this passage with apparent approval in Ilbery at ATC p. 4667; A.L.R. p. 180.

In Ilbery, Toohey J., with whose reasons for judgment Northrop and Sheppard JJ. agreed, said at ATC p. 4667; A.L.R. pp. 179-180:

  • `When the High Court in
    Ronpibon Tin N.L. v. F.C. of T. (1949) 78 C.L.R. 47 said at p. 56:
    • `For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end,'

    that was not to exclude the notion of purpose. As Brennan J. pointed out in Magna Alloys at p. 4547:

    • `Though purpose is not the test of deductibility nor even a conception relevant to a loss involuntarily incurred, in cases where a connection

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      between an outgoing and the taxpayer's undertaking or business is affected by the voluntary act of the taxpayer, the purpose of incurring that expenditure may constitute an element of its essential character, stamping it as expenditure of a business or income-earning kind.'

    Conversely, I would add, purpose may stamp the outgoing as one having no relevant connection with the gaining or producing of assessable income.'

It is clear from Toohey J.'s judgment in Ilbery that the purpose of the taxpayer was, in his Honour's view, an important consideration on the facts of that case.''

34. Whilst I am mindful that the High Court has recently heard an appeal from the joint judgment of the Federal Court in Fletcher (supra) and reserved its decision, I am bound by the current law until it is changed. I therefore consider myself bound to treat purpose as a relevant consideration in characterising the subject payments.

35. Since the applicant is a company, its purpose has to be determined by reference to the minds of those who control it: FC of T v Whitfords Beach Pty Ltd 82 ATC 4031. Mr Nemo said in evidence that the reasons why the NML policy was chosen as the means of a diversification of investment were that he ``had no experience in business, in the purchase of real estate or on the stock exchange, and it was described to me as an investment that would be professionally managed and at the time had a good return''. In cross-examination Mr Nemo admitted that:

  • (a) that advice was given to him in the form of a suggestion by his accountant during discussions held in May/June 1987 that the applicant should apply the surplus profits arising out of the abalone fishing business in prepaying what he described as ``interest'' on money borrowed to acquire the insurance bond;
  • (b) however, he said that his accountant did not explain to him how the insurance bond worked. He also stated that he was not told by anyone, and did not understand at any time, that any part of what the applicant was ``buying'' consisted, in whole or in part, of a life insurance policy;
  • (c) apart from the purchase of fishing equipment and the abalone licence the purchase of the insurance bond was the only investment the applicant had ever made;
  • (d) his accountant never suggested to him that the surplus profits should be applied in acquiring an asset without borrowing;
  • (e) his accountant had explained to him that the prepayment of what he described as ``interest'' would be tax deductible in the year of income ended 30 June 1987, and that was a matter which affected his decision to enter into the arrangement;
  • (f) entering the arrangement would have been a less attractive proposition to him if the applicant had had to find the sum payable to ANZ for the commercial bill facility out of his own resources rather than as a tax deductible payment by the applicant;
  • (g) the reason why he indicated to the manager of the Collinsvale branch of the ANZ Bank (John Doe) that he would take his business to Westpac if ANZ could not provide the accommodation that was eventually obtained, was that if he could not get that accommodation before 30 June 1987, at least in part, the exercise was going to be purposeless;
  • (h) during a conversation with ANZ manager for the Northern Tasmanian area (Bill Sykes) he indicated that the purpose of implementing the arrangement was to minimise taxation payable on the substantial income coming from the abalone diving business.

36. Bill Sykes was called by the respondent. The following is an extract from a diary note made by him on 8 June 1987:

``Nemo called at the Collinsvale Branch and advised that they were in the process of transferring their banking business to Westpac.

In the absence of the permanent Manager, the Second Officer, John Doe, phoned Area seeking assistance to retain business.

I subsequently phoned both Nemo and Mr Ahab, his accountant. Their plan is to borrow $500,000 on a CBFR facility and use the funds to clear existing borrowing $100,000 and purchase a National Mutual

ATC 366

Insurance Bond $400,000. The insurance bond is to be used as part security and they mistakenly thought we were not able to accept the bond as security.

The purpose of implementing the above is to minimise taxation payable on the substantial income received from Abalone diving.

The insurance bond attracts a high return on funds invested. The insurance company pay tax on the growth of funds at the rate of 30 cents in the dollar and a rebate is allowed by the Taxation Department of a similar amount to taxpayers who purchase such a bond and terminate in less than ten years.

The amount of appreciation in the Bond is assessed for taxation purposes when redeemed (whether partially or in full) on the following basis:

  • 1. Totally assessable if redeemed within eight years.
  • 2. Two thirds assessable if redeemed in the ninth year.
  • 3. One third assessable if redeemed in the tenth year.
  • 4. Tax free if redeemed after the tenth year.

No tax is payable in the event of the death of the life assured.

To offset the above, they can claim interest paid on the CBFR as the monies will partly be used to consolidate debts and provided they indicate at the outset their intention of redeeming the bond within eight years. This intention will be documented with the Taxation Department.

In effect, the exercise is to be used to direct cash that would normally be used to meet taxation liabilities into an accumulating investment which attracts a low marginal tax rate due to the rebate of tax already paid by the insurance company.''

37. Sykes in cross-examination conceded that he was unable to say which comments were written as a result of each of his discussions with John Doe, Mr Nemo or Mr Ahab. The admission of the document was objected to on a number of grounds, objections which might well have succeeded in a court of law. However, administrative tribunals have a greater latitude as to the admission of evidence, and upon reading the document, I am satisfied that none of the comments about the nature, tax consequences etc of the scheme can be attributed to John Doe. I therefore admitted the document. Doe's only involvement was the seeking of assistance from ``Area'' to retain the applicant's and Mr Nemo's accounts. The diary note, one would have thought, made the calling of Mr Ahab, the accountant, essential, if only to rebut the Sykes' note - which was part of the documents discovered before the hearing - to the effect that ``the purpose of implementing [this arrangement] is to minimise taxation payable on the substantial income received from Abalone diving''. The failure to call the accountant must give rise to the inference that, if called, he would not have assisted the applicant's case.

38. On the whole of the evidence, I am satisfied that the applicant's purpose in obtaining the impugned $400,000 was to purchase the insurance bond for the main or dominant purpose of gaining a substantial tax advantage and that the gaining of assessable income was merely incidental to the arrangement. As such, the discount charges are not allowable deductions under the first limb of section 51(1).

The second limb of section 51(1): necessarily incurred in carrying on a business for the purpose of gaining or producing such income

39. The finding on purpose has the same effect with respect to deductibility under the second limb of section 51(1). I would merely add that the discount charges incurred in relation to the purchase of the insurance bond could not be said to have been incurred in carrying on a business as that purchase was not within the ordinary course of the applicant's business; not could it be said to be a new part of the applicant's business. The purchase of the bond by a company that had not previously earned income from any activity other than abalone fishing is a far cry from cases, such as
Jennings Industries Ltd v FC of T 84 ATC 4288 and
Kosciusko Thredbo Pty Ltd v FC of T 84 ATC 4043, where it was held that various transactions which were in effect a different way of doing what the business had previously done, or were an extension of previous activities of the business, were part of the taxpayer's business, albeit a new part.

ATC 367

The exceptions

40. In light of my finding with respect to the positive limbs of section 51(1) it is strictly unnecessary for me to deal with the exceptions to section 51(1). Suffice it that I reiterate what I stated in Case S74,
85 ATC 534 at p. 538:

``the concept of a company (or a trust) having a private or domestic purpose seems to me to strike at the fundamental jurisprudence which lies at the root of the whole theory of corporate personality, viz. that a corporation is an entity distinct entirely from its incorporators.''

On that view, it follows that the amounts in issue in this case cannot come within the ``private or domestic'' exception contained in section 51(1).

41. However, I am of the view that the discount charges would, in any event, fall within the ``capital'' exception of the section. In the same way that the use of the borrowings had to be determined when trying to characterise the discount charges for the purposes of the positive limbs of section 51(1), it is necessary, when deciding whether the discount charges are of a ``capital'' or ``revenue'' nature, to look to the use made of the proceeds to which those discount charges relate. In this case, those proceeds were used to purchase an insurance policy insuring the lives of Mr and Mrs Nemo. It was conceded that it was always the intention of the directors, at the time the policy was taken out, to surrender the policy some time after five but before eight years. I am therefore satisfied that, in the circumstances of this case, the payment of a single premium to acquire an insurance policy, viewed as an investment of five to eight years' duration, is an affair of capital. To use the terminology of the various characterisation ``tests'', the payment, viewed from a practical and not a juristic analysis, ``procured a right of a permanent character'', ``created a lasting benefit'', had an ``enduring benefit'' and was ``once and for all''. In short, what was acquired bore the classic characteristics of a capital asset. It is self-evident that characterisation of such an asset does not change because it was sold within a year of acquisition because it had not performed to expectations. The discount charges which related to the proceeds must thus be seen as part and parcel of the acquisition of a capital asset, and are thus themselves an affair of capital.

The loss on surrender

42. For the same reasons given in respect of the discount charges, I find that the loss on surrender of the insurance bond does not satisfy either of the positive limbs of section 51(1). Having purchased the insurance bond with the purpose of gaining a tax advantage, the applicant cannot obtain a deduction under section 51(1) if it surrenders that bond at a loss. I would also reiterate my earlier comments with respect to the application of the ``private or domestic'' exception to the loss. So far as the capital exception is concerned, for similar reasons given in relation to the applicability of that exception to the discount charges, the loss on surrender is clearly a capital loss.

The application of Part IVA

43. Having reached the conclusion that the various claimed amounts are not deductible under section 51(1), I have not been persuaded that it is necessary for me to consider whether Part IVA of the Act applies in the circumstances; cf the Federal Court in Fletcher (supra). While I am mindful that the High Court has recently heard an appeal from the judgment of the Federal Court in Fletcher, the law must be taken to be as decided by the Federal Court until overruled. Given the lead time which inevitably occurs between hearing and decision in leading cases, it would be unreasonable to delay my decision, particularly as the unsuccessful party can safeguard its position by lodging a formal appeal.

44. For the above reasons, the objection decisions for both the 1987 and 1988 years of income are affirmed. The question in which year the interest payments may be claimed as a deduction becomes irrelevant.


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