FLETCHER & ORS v FC of TMembers:
P Gerber DP
Y Grbich SM
B Barbour SM
Administrative Appeals Tribunal
Dr P Gerber (Deputy President), Dr Y Grbich (Senior Member), B Barbour (Senior Member)
This case has been remitted to the Tribunal by the High Court in a decision reported as
Fletcher & Ors v FC of T 91 ATC 4950. The principal issue involves the deductibility of interest incurred by a partnership on money borrowed as part of a wider annuity scheme.
2. The facts in this long drawn out epic have been adequately set out in the decision of the High Court, which we gratefully adopt. The nub of the decision of that Court was to the effect that the Tribunal (referred to as ``the Second Tribunal'') had failed to determine whether, ``... on a common-sense assessment of all the evidence, the contractual arrangements to which the partnership became a party were intended and expected to run their full course...'' (at p 4961). Put another way, was it more probable than not that the parties intended to activate the ``default'' mechanism built into the loan agreements, which, by defaulting some time in the eleventh year of the 15-year plan, and after having benefited from the substantial taxation advantages of the scheme up to that time, they could escape the almost confiscatory consequences which would result if the agreement were permitted to run its full course.
3. It is thus fair to say that the applicants were on notice that their purpose and intent in entering into this scheme was central to the successful outcome of their application, an issue which became clearly identified by the judgment of the Federal Court on the appeal by the taxpayers from the decision of ``the First Tribunal'' (88 ATC 4834; Case V3 88 ATC 113).
4. At the hearing before this Tribunal, Mr Raphael, appearing for all applicants, advised the Tribunal that none of his four clients was available to give evidence. Several reasons were advanced, the main one being the issue of costs. Mr Raphael said that the substantial outlays involved in this litigation to date had left the parties without the means to pay for their representation. Mr Raphael was at pains to point out that he was appearing on a ``fee declined'' basis as amicus tribunalae. Mr Fletcher, a builder, had recently suffered considerable loss due to a fire in his business premises and could not afford to take the time off to give evidence at this hearing, and Mrs Dunlop suffers from multiple sclerosis to an extent that requires the constant attendance of her husband.
5. Whilst the Tribunal is sympathetic to the parties' plight, Mr Raphael failed to provide any reason why none of these applicants appeared on the occasion of the proceedings before ``the Second Tribunal'' (Case W118 89 ATC 922), i.e. at a point in time when the parties and their advisers must have been aware that their intention had become a key issue in these proceedings.
6. In the result, the Tribunal is once again asked to determine ``intent'' from the bare bones of the transcript without the opportunity of observing the witnesses who gave their evidence.
7. Doing the best we can on the meagre material available, it is clear, as noted by the High Court (at p 4961) that the question of whether the outgoings of interest were incurred on the basis or in the expectation that the 15-year plan would in fact run its full course is a question of fact, a determination which involves consideration, not only of the purpose and intent of those who advised the taxpayers, but of the taxpayers themselves. In this context, we note, however, that in its decision, the High Court (at p 4961) expressly approved ``the Second Tribunal's'' statement that the acts and intentions of the taxpayers' agents ``must be imputed to the principals''.
8. In a thoughtful submission, Mr Raphael took the Tribunal through the evidence of the applicants and their professional advisers given before ``the First Tribunal'' hearing (Case V3 88 ATC 113). The broad thrust of his submission was that the applicants were mainly interested in obtaining superannuation, and that tax objectives did not loom large in their thinking. Thus he submitted that the evidence of
ATC 2048Mr McGrath, the accountant (at pp 13, 18-19), Mr Dunlop (at pp 75, 83, 93-94, 105, 115-116 tr) and Mr Fletcher (at pp 130, 140 and 146 tr) were sufficient for the applicants to have discharged their onus of proof. This evidence, it was said, indicated that Mr McGrath recommended the annuity scheme because he was concerned that his clients had no superannuation, and were not interested in ``insurance type super''. This view is said to find further support in the evidence that McGrath gave Messrs Fletcher and Dunlop the brochures to take home to read and to discuss the scheme with their wives, after explaining that he (McGrath) thought the investment would yield a good return, adding that there was an additional bonus of a tax deduction in the first five years: ``the icing on the cake''.
9. Mr Raphael submitted that Mr Dunlop's evidence of his wife's ill health, and the fact that they did not yet have any superannuation clearly supported Mr Dunlop's assertion (at p 93 tr) that: ``We were only interested in the superannuation.'' Mr Raphael referred the Tribunal to that part of the transcript in which Mr Dunlop deposed as to his awareness of the additional tax benefit, adding that, in his mind, this was merely ``an additional benefit to the superannuation investment''.
10. Finally, Mr Raphael submitted that the evidence of Mr Fletcher, and the fact that the word ``Superannuation'' was written on the cheque butt (exhibit O) supported his submission that the applicants were interested only in superannuation.
11. After the decision of ``the Second Tribunal'' had been appealed to the Full Federal Court (90 ATC 4559) and thence to the Full High Court, the latter held that ``the Second Tribunal'' had failed to determine whether the taxpayers intended the 15-year plan to run its full course. In the result, the matter was remitted back to the Tribunal for a common-sense evaluation of all the evidence. Accordingly, in the absence of any further evidence, we were compelled to consider the full transcript of evidence given before ``the First Tribunal'' at length.
12. Turning to the evidence of McGrath, the applicants' accountant, it appears that he advised his clients (or rather Messrs Dunlop and Fletcher) that it was high time that they arranged some form of superannuation for themselves. We are asked to accept that it was in pursuit of a suitable superannuation scheme that McGrath contacted Messrs Crennan & Co and obtained the brochures relating to the scheme now in issue.
13. In reply to Deputy President Bannon QC's question as to how much McGrath proposed his clients should invest in the scheme, the witness replied:
``$25,000, which is the figure that is shown as an example in the brochure. I did not suggest that that was the sum that they should invest. I was merely using that because it was the example shown in the brochure and they would be more easily able to follow it. So that for the investment of $25,000, they would receive a total of some $85,000 of the last five years of the annuity, which at that time, as I said to them, seemed pretty good odds. I also told them that in the first five years of the annuity, there would be a tax deduction, and that this was an added bonus for the superannuation. I gave them the brochures to take home, look at, read, discuss it with their wives, and told them that in consideration of it, they were to look at the superannuation side of the investment and to look on at any tax advantage as being purely icing on the cake. But if they did not see it as a good investment, that they should reconsider and we would look out for something else.''
14. McGrath frankly conceded that he had previously advised his clients - who looked like facing a substantial future tax liability as a result of a successful land subdivision - that they should seek some expert advice ``on how they could minimise their tax'' (p 37 tr). To the extent that McGrath claimed ignorance of his clients' potential tax liability, we reject this evidence as highly implausible. The witness is a qualified and practising accountant, he admitted to having read the relevant brochures and was clearly aware of the tax advantages the scheme offered its participants. When it was put to McGrath in cross-examination that the dominant purpose of his clients entering into this scheme ``was to overcome what was obviously a pressing taxation problem they were confronting'' (p 65 tr), the best the witness could come up with was the reply that ``at that stage we did not know whether they had one or not''. Against that background, we reject McGrath's testimony that the scheme offered primarily a superannuation benefit, and
ATC 2049that the tax saving was ``mere icing on the cake... of secondary importance''.
15. Further support for our view on McGrath's lack of credibility on the key issue of ``purpose'' is to be found in his apparent lack of concern for the soundness of the superannuation aspect of the scheme (the annuity) as evidenced both by his failure to undertake any of the normal enquiries as to the creditworthiness of Annuity Investments Pty Ltd, Eromdim and Doowarf and to recommend that his clients pursue further enquiries. He was thus content to rely on a prospectus and the few conversations he had with Mr Crennan. Again, McGrath made no enquiries as to whether the company would be able to provide the annuity in 11 years. Yet he stated in cross-examination that it was the cash-in-the-hand benefit to be received no earlier than year 11 which was the main purpose of his clients entering the scheme. The two couples outlaid $25,000 each, of which only $10,000 went into the annuity investment. For this $10,000 ``at risk'', they gained $85,000 over the last five years - postponed for 10 years - from a group of little-known companies, and largely capitalised by a round robin of bills of exchange. Such circumstances would put a genuine investor in an annuity at notice.
16. It was conceded that McGrath consulted an actuary, one Latham, as to the structure of the annuity, indicating that a loan would be made by a finance company to an annuitant to purchase the annuity, with provision for an ability to surrender the annuity and repay the loan after, say, 10 years (p 264 tr). Latham gave the following evidence (at pp 264-265 tr):
``Mr Latham: As far as I can recall there seemed to be some tax implications involved but I never understood them.
Mr Rolfe: No, but from what he told you were the tax implications that for the first ten years the annuitant was not going to be getting anything in cold hard cash?
Mr Latham: Yes.
Mr Rolfe: But for at least part of the first ten years the annuitant was going to be getting a tax benefit?
Mr Latham: Yes.
Mr Rolfe: But after the ten years things would change and the annuitant would then be in receipt of cold hard cash?
Mr Latham: Yes.
Mr Rolfe: And the tax benefits would be much less in those circumstances?
Mr Latham: Yes.
Mr Rolfe: So that it was in that context, I take it, that the accountant was discussing with you the ability to renegotiate the facility after, say, ten years?
Mr Latham: That was my understanding, yes.
Mr Rolfe: So as you understood it an annuitant who had the benefit of the tax deduction, say, for the first ten years could then bail out after ten years?
Mr Latham: That seemed to be the intention, yes.''
17. The lack of credibility of McGrath's evidence becomes even more apparent when regard is had to the urgency with which this scheme was implemented, i.e. it had to be in place before 30 June 1982. What, one may ask, was the urgency to introduce these parties into a superannuation scheme? Against that background McGrath's answer to Mr McMahon (p 45a tr) must be rejected.
``Mr McMahon: Did you consider it important that the documentation be completed by 30 June?
Mr McGrath: Oh yes.
Mr McMahon: Why did you consider it important?
Mr McGrath: Well, they wanted the tax - not the tax deduction for the contribution, but they decided they wanted to go into it and to get it done by 30 June. And that brought it 12 months closer as far as the annuity the other end was concerned. You wait another 12 months, you are 12 months further down the track.''
18. In summary, much of McGrath's evidence lacks plausibility and the main thrust of it is rejected. We find that the witness was clearly aware of the potential tax liability facing his clients and looked around for a scheme which would reduce that liability. Having obtained the brochure for the scheme now in dispute, he sought advice from an actuary as to the exact tax benefits it would provide, and the costs that would be incurred by his clients in the final five years. We find it significant that he
ATC 2050paid no attention to the soundness of the investment. Indeed, we are satisfied from a thorough reading of the transcript of evidence that McGrath had at no stage contemplated that his clients would remain in the scheme past the 10-year beneficial tax period.
19. We find that McGrath was the agent of the taxpayers - a matter not disputed - so that his acts and intentions, as set out in the previous paragraph, must be imputed to his clients. Whilst on one view, that finding may be thought sufficient to establish that there was no expectation that the scheme would run its full 15-year course, out of an abundance of caution - and paying heed to the views expressed by the Full High Court - we propose to examine the purpose and intention of Messrs Fletcher and Dunlop to the extent that they can be said to emerge from the transcript of their evidence at the hearing before ``the First Tribunal'' (Mesdames Fletcher and Dunlop did not give evidence).
20. Thus Mr Dunlop, one of the taxpayers, was asked by his counsel, Mr Hill QC, whether, when discussing the superannuation scheme with McGrath, there was any mention of a tax benefit. The witness replied ``no'', but then qualified his answer by adding:
``Sorry, there was a fringe benefit, or a benefit from the annuity that was - that was - was not actually our interest at the time, but there was a benefit with taking on the annuity investment.''
(p 74 tr).
21. It is not unfair to say that redolent throughout Dunlop's evidence is the suspicion that he doth protest too much. The witness is generally at pains to stress that the tax advantage was of no concern to him, it was ``a fringe benefit'', if there was such benefit, so much the better, but it in no sense influenced his decision to embark on this scheme.
22. The ``icing on the cake'' or ``fringe benefit'' evidence comes through as implausibly from the mouth of Dunlop as it reads in the transcript of the evidence of McGrath and, although we were denied the opportunity of seeing the witness, we reject this aspect of his testimony, the more so as his evidence continued to change under cross- examination, where he flatly denied that tax was ever even mentioned in his early meetings with McGrath (p 83 tr). Yet a few pages further on, he deposes:
``Mr Rolfe: He spent some time explaining the brochure to you?
Mr Dunlop: He explained the brochure to us and I virtually took it home and explained it to my wife.
Mr Rolfe: He explained to you that in addition to the annuity, which was some 11 years down the track, there were tax benefits in the meantime?
Mr Dunlop: As a bonus on the side, this is correct.
Mr Rolfe: Is that the way he described it, that the tax benefits were a bonus on the side?
Mr Dunlop: Not in those words, I am not sure what words he used but along those lines, that is correct.''
23. Later, Dunlop was questioned by Mr Rolfe about the first year tax deduction of $123,543 (p 111 tr):
``Mr Rolfe: Well, what the document was telling you was that for year 1 you would have a tax deduction of $123,543, was it not?
Mr Dunlop: That is what it says here, yes.
Mr Rolfe: Well, that must have made some impact on you?
Mr Dunlop: I cannot recall how I felt at the time.
Mr Rolfe: If this was a legitimate scheme and you assumed it was, did you not?
Mr Dunlop: I assumed it was. I had complete faith in Mr McGrath.
Mr Rolfe: A tax deduction of $123,000-odd would be a very handy thing to have, would it not?
Mr Dunlop: It would be a very handy thing to have.
Mr Rolfe: It would have occurred to you at the time it would be a very handy thing to have?
Mr Dunlop: No, it did not occur to me at the time.
Mr Rolfe: You seriously say that, do you, Mr Dunlop?
Mr Dunlop: I seriously say that, yes.
Mr Rolfe: All right - that the ability to get a tax deduction of that magnitude was not something that had any impact on you at all?
Mr Dunlop: At that time I was not aware that we had a tax problem.
Mr Rolfe: I am not suggesting that you had a tax problem. What I am saying to you is: you were being told that you would have a tax deduction?
Mr Dunlop: This was one of the side benefits of the - or a bonus to this superannuation, this is correct.''
24. We reject Dunlop's evidence that his intention in entering into this scheme was for the annuity - approximately $85,000 - to be paid over the last five years of the 15 years, when it is clear that such annuity was less than the sum of just the first year's tax deduction. Dunlop's evidence that a tax deduction of such magnitude was a mere ``fringe benefit'' and/or that such benefit did not occur to him at the time he entered the scheme cannot be accepted.
25. In view of the fact that those advising Dunlop were, as we find, keenly alive to the advantages the scheme offered as a means of tax minimisation on the one hand, and the pie in the sky benefits it might yield as a ``superannuation'' scheme, involving as it did, large repayments of the principal borrowed by the mid-1990s, it is impossible to attach any greater credence to Dunlop's evidence than to the testimony of McGrath.
26. Mr Fletcher's first recollection of his discussion with McGrath was to the effect that he had been told that:
``it was a very good superannuation type annuity, superannuation, wherein the latter years - I think, 10 or 11 to 15, is very beneficial to you and at the start of it there is a tax deduction which is sort of like the icing on the cake sort of thing.''
(at p 129 tr).
27. Later, Fletcher described what he had been told by Mr McGrath:
``Just that in the latter years, year 11 to year 15, there was a really good return on the money that we put in and there was a tax deduction at the start of it which was rather good as well.''
(p 150 tr).
28. It is surprising that, although Fletcher alleged that his motivation for entering the annuity was to receive superannuation in years to come, he revealed a total lack of awareness of the liabilities involved in the partnership's borrowings of $2,950,000, although he expected to receive $17,000 per year from year 11 to year 15. This total unawareness and apparent lack of interest in establishing the precise terms of the scheme lends support to the conclusion that Fletcher showed no interest in, or knowledge of, the mechanics of the scheme because his accountant ``sold'' it to him on the basis of its potential tax advantages. We are satisfied that this was a highly significant incentive for Fletcher at a time when his income was likely to increase steadily once the subdivision sales were completed. Thus, under cross-examination, Fletcher agreed that the period after entering the scheme would be a period in which he would have an increased income, and that the various tax deductions available would have been of substantial benefit to him:
``Mr Rolfe: The annual tax deductions are set forth at the bottom of the page, are they not?
Mr Fletcher: Yes.
Mr Rolfe: And they are quite substantial, are they not?
Mr Fletcher: Yes.
Mr Rolfe: I take it, amongst other things, held attraction for you?
Mr Fletcher: Well, yes and no, because we did not think we had any tax to pay anyhow.''
29. The combination of this total lack of knowledge and/or interest in the superannuation scheme by the husbands, and the fact it was entered into at a time when the applicants' assessable income was likely to increase rapidly, lends substantial weight to our conclusion that the tax advantage the scheme offered was the dominant purpose why the applicants embarked upon it.
30. As the High Court noted on the appeal (at p 4957), the issue between the parties turns on the question whether, and if so to what extent, the amounts of interest payable by the partnership pursuant to the first loan agreement to a company - Doowarf Nominees Pty Ltd - and to another company - Eromdim Nominees Pty Ltd - pursuant to the second loan agreement were incurred during the relevant tax years by the partnership ``in gaining or
ATC 2052producing the assessable income'' pursuant to the first limb of sub-sec 51(1). That question, the High Court emphasised yet again, is a question of characterisation. This Tribunal must therefore examine the relationship between the expenditure and assessable income in this case.
31. A disproportion between the outgoing and potential income may itself raise doubts about whether it was spent to produce income. In making this characterisation, we were directed by the High Court to make a common- sense or practical weighing of all the factors.
32. As noted before, the question of fact for this Tribunal to resolve is whether the outgoings of interest were incurred in the expectation that the 15-year plan would run its full course.
33. To an objective observer, a consideration of the scheme suggests that its major advantage was the tax deductions in the first 10 years. This is confirmed by the evidence. Given the likely increase in the applicants' assessable income at that time, we are satisfied that their dominant purpose in entering into the scheme was the significant tax deductions available in these early years. It may well be that the taxpayers were not aware of the intricacies of the scheme. However, we are satisfied on the evidence as it emerges from the transcript, that their accountant was fully conversant with the scheme and the potential tax benefits it afforded those who participated in it; qui facit per alium facit per se. This awareness included, as we find, the knowledge that if the scheme were allowed to run its full course, the last five years would result in assessable income which would greatly exceed adjusted interest outgoings. The result would be very substantial partnership net income, representing assessable income in the hands of the partners which, if actually derived, would far exceed the comparatively small projected ``cash surplus'' of the partnership in each of the last five years. As the High Court noted:
``If an average marginal income tax rate of 30 per cent is assumed, the total tax payable by the taxpayers as a result of their shares of the partnership net income would, if the agreements were allowed to run their full course, exceed the partnership's projected `cash surplus' by well over $100,000 in each of the last five years.''
34. Put another way, the tax advantages clearly ceased to accrue in the last five years, and as the first Full Federal Court found (and the High Court underscored (at p 4960)) ``it would clearly be advantageous'' to the taxpayers to ensure that the annuity and loan agreements did not run their full course. Furthermore, the likelihood of the returns on the annuity, and the manner in which these were to be achieved in the last five years was unexplored and uncertain. It is tempting therefore to conclude that these features of this ``superannuation'' scheme are by themselves sufficient to establish that it was not ever in the contemplation of its imaginative creators, of those who sold it, and of those who adopted it with such enthusiasm, that it would be permitted to run its full course. It was precisely to avoid the punitive consequences which would follow if the scheme were allowed to run its full course that, built into it, was a ``self- destruct'' mechanism whereby, by the simple device of defaulting, the consequences of allowing the ``plan'' to run its full term could be avoided. The result of a default by the partnership at any time in the first 10 years would be that Doowarf and Eromdim would have recourse against ``any property or interest in any property acquired [by the partnership] with the principal sum or any part thereof'' and to that alone. It was a limited recourse loan. As noted by the High Court:
``The only property or interest in property which would answer that description would be the partnership's interest under the annuity agreement.''
(at p 4960).
35. In the result, applying a common-sense assessment of all the evidence leads to the conclusion that on the balance of probabilities: (i) the scheme now under review was constructed on the premise that the various agreements would be terminated at some time before the first 10 years had elapsed; (ii) the taxpayers' advisers were fully aware of the consequences that would flow from a failure to terminate these agreements at some time before the last five years; (iii) the dominant purpose of the applicants in entering into this scheme was directed to minimising a possible increasing tax liability arising from profitable subdivision sales; (iv) even though the applicants may not have understood the subtler details of the arrangement by which the adverse consequences which would be incurred by year 11 if the agreements were to run their full course could be avoided, all the participants
ATC 2053intended and expected that the arrangement to which the partnership became a party would come to an end once the tax benefit had been exhausted.
36. Put in terms of the deficit discovered by the High Court in the findings of ``the Second Tribunal'' and the decision of ``the Second Federal Court'', we have concluded that ``the outgoings of interest were incurred by the partnership on the basis and in the expectation that the 15-year plan would not, in fact, run its full course''.
37. For the reasons given above the Tribunal finds that the adjusted partnership outgoings of interest are not deductible under sub-sec 51(1) of the Income Tax Assessment Act 1936 to the extent that they exceed the partnership's assessable income in each of the years in dispute. On that view of the evidence, we do not need to consider whether, in the alternative, the scheme is ``caught'' by sec 82KL and/or Pt IVA.