ELMSLIE & ORS v FC of TJudges:
The four references before the Court raise two questions concerning the operation of the capital gains provisions (Part IIIA) of the Income Tax Assessment Act 1936. The questions are the same in each case. Briefly, they are whether shares allotted to each applicant after 20 September 1985, the date from which Part IIIA has operation, were assets acquired ``under a contract'' made before that day and therefore immune from capital gains tax; and if so, the true ``cost base'' of the shares.
The four applicants are Alan Robert Elmslie, Charles Frederick Moore, Allan Richard Moyes and John Harrison Valder. Immediately before the events giving rise to this case, the applicants were partners together in a firm of stockbrokers, Valder Elmslie and Company. The stockbroking business was commenced in 1967 by Mr Valder as a sole trader. Six months later Mr Elmslie became a partner in the business. It became known as Valder Elmslie and Company (``Valder Elmslie''). The business continued to operate under that name until 30 August 1985. In the meantime, Mr Moore (1974) and Mr Moyes (1980) became partners.
Each of the partners was a member of the Sydney Stock Exchange. Until April 1984 stockbroking businesses were allowed to be conducted only by individuals who were members of the exchange and carried on business as sole traders or in partnership. In April 1984, the Stock Exchange rules were altered to enable non-members to own up to one-half of a stockbroking firm and to permit corporate membership. I gather that, about that same time, the Stock Exchange announced that the rules would be further relaxed on 1 April 1987 so as to permit a stockbroking business to be wholly owned by a non-member. In April 1984 foreign interests could acquire shareholdings in Australian stockbroking businesses only within the limits imposed by the Foreign Takeovers Act 1975; that is, single foreign interests were limited to a maximum of 15% and total foreign holdings to 40%. However, in December 1984 the Commonwealth Treasurer announced a change in policy, raising to 50% the maximum permitted foreign shareholding. He also stated that the situation would be reviewed prior to 1 April 1987.
In late 1984 the partners in Valder Elmslie commenced discussions with Christopher Colin Grubb, a representative of Jardine Fleming (Australia) Limited (``JFA''), an investment manager. This company was a subsidiary of Jardine Fleming Holdings Limited (``Jardine Fleming''), a Hong Kong merchant bank owned by Jardine Matheson Holdings Limited, a long established Asian trader, and Robert Fleming Holdings Limited, a United Kingdom investment company.
On 30 April 1985, the four applicants held a meeting at which they decided to form a company, to be known as Valder Elmslie Limited, to take over their business. They agreed that they each would be directors of the new company and that, if possible, it would be established, and take over the business, by July 1985.
In May 1985, Mr Moore and Mr Moyes had discussions in Tokyo and Hong Kong with executives of the Jardine Fleming group. During the course of the Hong Kong meeting, Alan Howard Smith, the Managing Director of Jardine Fleming, offered to pay $400,000 for a one-half interest in the partnership and to-
``accept a five times average profit multiple as the basis of a formula for purchasing the remaining 50% of the business.''
Mr Moore and Mr Moyes telephoned Mr Valder and Mr Elmslie, who were in Sydney. They agreed to the proposal. On the following day, Mr Moore told Mr Smith that the partners
ATC 4966of Valder Elmslie were happy with the terms he proposed. They shook hands on the deal and Mr Smith asked Mr Grubb to prepare Heads of Agreement setting out the agreed terms.
On 12 June, Mr Moore issued a press release on behalf of Valder Elmslie and JFA announcing their intention ``to establish a joint corporate membership of the Sydney Stock Exchange subject to receiving the approval of regulatory authorities''. The release said that the new firm would be known as Valder Elmslie Jardine Fleming Limited and would be owned equally by the present partners of Valder Elmslie and the Jardine Fleming group. The directors would comprise the four Valder Elmslie partners plus Mr Smith and Mr Grubb. At about the same time, Mr Moore prepared an information sheet for distribution to Valder Elmslie staff.
On or about 18 June 1985, Valder Elmslie acquired a two-dollar shelf company, Emiala Pty Limited. Mr Moore and Mr Moyes each became the registered holder of one share. The existing directors immediately resigned. The four Valder Elmslie partners, and Messrs Smith and Grubb, were appointed in their place. A general meeting was convened for 25 June. That meeting resolved to change the name of the company to Valder Elmslie Jardine Fleming Limited (``VEJF''), to increase its share capital and to substitute new Articles of Association. Notice of these resolutions was given to the National Companies and Securities Commission.
In early June 1985, Mr Grubb submitted to Mr Moore a draft document. The draft was discussed by the Valder Elmslie partners and referred to Law and Milne, the firm's solicitors, for advice. It was amended in some respects before a final version of the document was signed by Mr Moore on 28 June and by the other signatories (Messrs Valder, Elmslie, Moyes and Grubb) on 3 July 1985. This document is lengthy. But, as it is central to the applicants' case, I will set it out, omitting only irrelevant machinery matters.
"Heads of Agreement
Basis of agreement between Jardine Fleming (Australia) Pty Limited (JF) and Valder Elmslie and Company (VE) whereby it is intended to establish an equally owned corporate membership of the Sydney Stock Exchange to undertake the broking of Australian equities worldwide.
(1) The name of the member corporation to be Valder Elmslie Jardine Fleming Limited (VEJF) and to be owned as to 50% by JF and 50% by Messrs. Valder, Elmslie, Moore and Moyes.
(2) VEJF will acquire the existing businesses of VE subject to the payment by JF of $400,000 in recognition of the goodwill attributed to the partners of VE and conditional upon Messrs. Valder, Elmslie, Moore and Moyes reinvesting all or part of this sum as their capital contribution to VEJF.
(3) VEJF will acquire the existing assets and business of VE as at 31st August 1985 at audited book value.
(4) The partners of VE will be fully responsible for all outstanding liabilities including contingent liabilities and be entitled to all prior income of VE as at 31st August 1985 except that all reasonable costs incurred as formation expenses of VEJF will be reimbursed to either VE and/or JF by VEJF.
(5) VEHF will be capitalised at $1,200,000. The value of the net assets acquired from and/or capital subscribed by the partners of VE and JF will be $600,000 from each party. This sum to be contributed by way of equity or subordinated debt as agreed, but in any event to be subscribed in the same form and ratio by all shareholders.
(6) The Board of Directors will be Messrs. Valder, Elmslie, Moore and Moyes, existing partners of VE and Messrs. Smith and Grubb, directors of JF, with JF having the right to appoint two additional directors.
(9) Additional capital requirements as determined by the Board are to be met equally and in the same form, by the partners of VE and JF.
(10)(a) Messrs. Valder, Elmslie, Moore and Moyes agree to sell and JF agrees to buy (subject to paragraph 19) all shares in VEJF and associated companies held by Messrs. Valder, Elmslie, Moore and Moyes at 31st December 1990. (b) This Agreement is based on the understanding that if appropriate Messrs. Valder, Elmslie, Moore and Moyes will be offered the opportunity to continue an equity participation in VEJF or in the JF(A) Group beyond this date. (c) The partners of VE and JF agree to investigate the introduction of equity participation by employees other than the partners of VE on terms and conditions to be agreed by the shareholders. (d) The partners of VE have the option to require JF to remove any reference to the names Valder and Elmslie in their Australian operation beyond 31st December, 1990.
(11) The consideration to be paid by JF in the acquisition of the shares of Messrs. Valder, Elmslie, Moore & Moyes as at 31/12/1990 or such other date thereafter as permitted is to be net tangible assets including outstanding subordinated loans at audited valuation on 31st December 1990 plus an amount equal to five times audited average annual after tax earnings of VEJF Limited and associated companies as agreed annually by the Directors for the five years ending 31st December 1990, apportioned pro rata to shareholders.
(12) In the period to 31st December 1990 any transfer of or entitlements to shares held by and between Messrs. Valder, Elmslie, Moore and Moyes will be a matter for discussion between all shareholders with Messrs. Valder, Elmslie, Moore and Moyes ranking ahead of JF in the disposition of such shares until 31st December 1990.
If JF wishes to sell shares or entitlements to shares they must be offered in the first instance to Messrs. Valder, Elmslie, Moore and Moyes.
Any transfer of shares by JF within the JF group shall be a matter for discussion between all shareholders but will not be subject to shareholders' approval.
(18) The annual salary packages of Messrs. Valder, Elmslie, Moore and Moyes, which will be at market rates, will be determined by shareholders' mutual agreement but will exclude mortgages. Annual profit sharing for employees will also be determined by shareholders' mutual agreement.
(19) For so long as legislation or Government policy prohibits the acquisition of additional shares by JF then the provisions contained in this agreement concerning the acquisition of additional shares by JF are inoperative.
(20) This Heads of Agreement is subject to the signing of a formal agreement as between the partners of VE and JF."
The document was signed by each of the applicants on his own behalf and by Mr Grubb on behalf of JFA. Under the signatures are the words: ``This Agreement is dated 28th June 1985.''
The transaction contemplated by this document required approval by the Foreign Investment Review Board (``FIRB'') under the Foreign Takeovers Act. Mr Moore wrote to FIRB, seeking approval, on 4 July. On 11 July, he applied for the admission of VEJF as a corporate member of the Sydney Stock Exchange. On the same day he sought a dealer's licence for the company, under the Securities Industry Code. Apparently, both these applications were granted in late July. On Friday, 30 August, Valder Elmslie ceased trading. On the following Monday, 2 September, VEJF commenced trading, from the same premises and using the staff who had formerly worked for Valder Elmslie. Mr Moore's affidavit details the numerous things that were done to facilitate this change. I need not set them out. It is sufficient to say that they included the recruitment of additional senior staff, some reorganisation of office space, notifications to clients and changes in banking arrangements. Although Mr Moore and Mr Moyes remained the sole shareholders in VEJF, Mr Grubb was actively involved in all these changes. By 2 September, VEJF was fully equipped to take over Valder Elmslie's business operations, and did so.
However, FIRB had not yet made a decision on Mr Moore's application for approval. Neither had the parties executed the formal agreement contemplated by cl. (20) of the Heads of Agreement document. The latter matter was progressed on 17 September 1985, when Law and Milne forwarded to Mr Moore execution copies of three documents. One document was a deed. It recited the parties' agreement for JFA to enter into the business of stockbroking in Australia with the Valder Elmslie partners. It contained covenants by each of the parties to procure the incorporation of the new company, VEJF, and by each of the applicants to subscribe for 75,000 one dollar shares in the company and to lend VEJF $75,000 by way of a subordinated loan. The deed also provided that, in consideration thereof, JFA would pay $100,000 to each applicant.
The second document was styled ``Shareholders Agreement''. It made detailed provisions for the management of VEJF. The agreement provided a mechanism to ensure that there was always boardroom parity between the Valder Elmslie directors, on the one hand, and the Jardine Fleming directors on the other. In relation to the second issue in these cases, the value of the shares issued to each of the applicants by VEJF, it is important to note the terms of cll. 10 and 13 of this agreement. Clauses 10(1), (2) and (3) provided:
``(1) Subject to sub-clauses (4), (5) and (6) of this clause, Valder, Elmslie, Moore and Moyes hereby agree to sell and Jardine Fleming agrees to purchase all the shares held by the said Valder, Elmslie, Moore and Moyes in VEJF Limited as at the 31st December, 1990.
(2) Notwithstanding sub-clause (1) of this clause, Jardine Fleming may, at its discretion offer all or some of the Valder Elmslie Partners the opportunity to retain some part or all of their equity in VEJF Limited, PROVIDED THAT should any of the Valder Elmslie Partners to whom such an offer is made decline to accept it, Jardine Fleming shall purchase that party's shares in accordance with sub-clauses (1) and (3) of this clause.
(3) The consideration to be paid by Jardine Fleming for the acquisition of the shares of Valder, Elmslie, Moore and Moyes is to be the net tangible assets at audited valuation on 31st December, 1990 plus an amount equal to five (5) times the average annual after tax earnings of VEJF Limited as agreed annually by the Directors for five (5) years ending 31st December, 1990, apportioned on the basis of the number of shares held by the shareholder compared with the total number of shares then on issue.''
Subclause (4) dealt with the situation that would arise if legislation or Government policy prohibited the acquisition by JFA of additional VEJF shares, or if Stock Exchange regulations prevented VEJF's continuing membership with an increased JFA shareholding. Subclause (5) permitted JFA to acquire the additional shares through a nominee. Subclauses (6) and (7) dealt with the situation that would occur if JFA failed to purchase the remaining VEJF shares by 3 December 1992. Subclause (8) provided for repayment to selling shareholders of any subordinated loans.
Clause 13 governed the situation that would arise if any party wished to sell his/its VEJF shares. If the party wishing to sell was one of the Valder Elmslie partners, the shares had to be offered first to the other Valder Elmslie partners. If no other Valder Elmslie partner wished to purchase the shares, they had to be offered to JFA. If none of those parties accepted, the shares could be sold to a stranger, but not on terms more favourable than those offered to the previous offerees and only provided that the acquisition by the stranger would not put VEJF in breach of Stock Exchange requirements. The clause went on to make similar provision in relation to any sale by JFA, requiring that company to give first offer to the Valder Elmslie partners.
The Shareholders Agreement provided that VEJF ``shall acquire'' the assets and business of Valder Elmslie as at 31 August 1985 by a separate deed. This was the third document forwarded for execution. It was called a ``Purchase Agreement''. It provided for the sale of the Valder Elmslie business by the four applicants to VEJF, the price being the value of the tangible assets disclosed in the firm's accounts less long service leave allowance.
Each of the three agreements was eventually executed. Each bears the date, 12 September 1985. But none was executed on that day. As I have said, it was not until 17 September that Law and Milne sent the execution copies to Mr
ATC 4969Moore. Their covering letter referred to these documents as being ``for signature by yourself and Mr Moyes''. The solicitors commented that they understood that ``the other parties will be executing these agreements upon receipt of Foreign Investment Review Board approval''. It is not clear whether the ``other parties'' referred to by the solicitors included Mr Elmslie and Mr Valder. But it seems that Mr Elmslie immediately executed all three agreements, along with Mr Moore and Mr Moyes. On 20 September, the secretary of VEJF wrote to Law and Milne returning ``the three partly executed agreements as requested''. He said he understood that Mr Valder, VEJF and Jardine Fleming would complete execution upon receipt of FIRB approval. Insofar as it relates to Mr Valder, this statement is inconsistent with Mr Moore's evidence. He deposed that Mr Valder was overseas at the time and the agreements were signed by Mr Moyes, on his behalf, under Power of Attorney. The original agreements are in evidence. Two of them purport to have been executed on behalf of Mr Valder by Mr Moyes as his attorney, the other by Mr Elmslie as attorney.
On 25 October the Commonwealth Treasury notified Mr Moore of FIRB approval of the transactions. Three days later all the proposed shareholders applied to VEJF for an allotment of shares. Mr Elmslie and Mr Valder each applied for 75,000 shares. Mr Moore and Mr Moyes, who each already held one share, applied for 74,999 shares and JFA applied for 300,000 shares.
A VEJF directors' meeting was held on 7 November 1985. It was attended by Mr Elmslie, Mr Moore, Mr Moyes, Mr Grubb and representatives of Law and Milne and Stephen Jaques Stone James, the solicitors acting for JFA. Executed copies of the three agreements were exchanged. During the course of discussion someone, Mr Elmslie did not recall who it was, said:
``The agreements should be dated the date that the last draft was resolved, that is, 12 September, which is before the introduction of capital gains tax.''
This was done. All the agreements were dated that day. Apparently while this was being done, the Stephen Jaques Stone James representative said: ``A condition providing for FIRB approval should be included''. This was also done. Someone inserted a handwritten clause, at the end of each of the Shareholders Agreement and the Purchase Agreement, to the effect that the agreement is conditional upon FIRB approval of the transactions set out. [I have mentioned the circumstances concerning the back-dating of the agreements because it is important to the case that the agreements were not executed before 20 September 1985. However, in fairness to the applicants, I should say immediately that each applicant revealed the true situation to the Commissioner. Each applicant lodged with his 1988 taxation return a statement under s. 169A of the Income Tax Assessment Act concerning the share transaction. Each statement reveals that the agreements were executed on behalf of JFA on 6 November 1985. Each says that the agreements were ``incorrectly'' dated 12 September.]
During the course of the 7 November meeting, the directors resolved to allot shares in accordance with the applications dated 28 October. The shares were duly issued and a Return of Allotment Shares was filed with the National Companies and Securities Commission.
The VEJF shareholdings remained unchanged for almost two years. On 1 April 1987 the rule change permitting 100% non- member ownership came into force. It seems that, about the same time, requirements under the Foreign Takeovers Act were relaxed in such a manner as to permit a stockbroking business to be wholly owned by foreign interests. So the way was clear for JFA to acquire the applicants' VEJF shares, as previously agreed. JFA decided to do so sooner than the date (December 1990) specified in the Shareholders Agreement. Sometime around the middle of 1987, JFA made an agreement with each applicant. The agreements are not in evidence. But the cases have been conducted on the basis that the transactions were as shown in the Adjustment Sheets attached to the various Notices of Amended Assessment. These documents state that Mr Elmslie and Mr Valder each sold their 75,000 shares in VEJF to JFA on 24 July 1987 for $1,275,000 and that Mr Moore and Mr Moyes each sold their shares, apparently in August 1987, for $1,822,475.
The Commissioner took the view that the capital gain derived by each applicant was assessable in the year of sale; that is, the financial year ended 30 June 1988. In the cases
ATC 4970of Messrs Elmslie and Valder, he calculated the amount of the gain by deducting from the sale price the sum of $86,700. In the cases of Mr Moore and Mr Moyes he calculated $86,699, because they each took one share before 19 September 1985. The amount of the deduction was computed by taking the amount payable on allotment, $75,000 or $74,999, and indexing it in accordance with the Consumer Price Index formula contained in s. 160ZJ of the Income Tax Assessment Act.
Each applicant objected to the amended assessment. The Commissioner disallowed all the objections. Each applicant requested him to refer his decision to the Court pursuant to s. 187(b) of the Act. He did so. The parties agreed that all four references should be heard together, the evidence in each case being evidence in the others subject to relevance. As events transpired, the evidence was mainly documentary. Several affidavits were read but only two witnesses were cross-examined. They were the accountants who gave evidence for each side concerning the value of the shares at allotment date.
The application of Part IIIA: the issue
As I said at the beginning, the primary question in the case is whether the shares allotted to each applicant after 20 September 1985, namely on 7 November 1985, were assets acquired by the applicants under a contract made before that day, and thus excluded from capital gains tax under Part IIIA of the Income Tax Assessment Act. Part IIIA was added to the Act in 1985, consequentially upon an announcement made by the Treasurer on 19 September 1985. The Government's announced policy was to leave untaxed assets acquired by taxpayers on or before that day.
Division 1 of Part IIIA (ss. 160A-160K) contains definitions and interpretive provisions. Division 2 (ss. 160L-160Y) specifies the application of the Part, Division 3 (ss. 160Z-160ZN) deals with the determination of capital gains and losses; and Division 4 (ss. 160ZO-160ZQ) the manner in which those gains and losses are to be treated. The remainder of the Part is presently immaterial.
The general principle underlying the application of Part IIIA is stated in s. 160L(1):
``(1) Subject to this section, this Part applies in respect of every disposal on or after 20 September 1985 of an asset, whether situated in Australia or elsewhere, that-
- (a) immediately before the disposal took place, was owned by-
- (i) a person (not being a person in the capacity of a trustee) who was a resident of Australia; or
- (ii) a person in the capacity of a trustee of a resident trust estate or of a resident unit trust; and
- (b) was acquired by that person on or after 20 September 1985.''
Each applicant disposed of his shares to JFA after 20 September 1985; namely in 1987. Each applicant is an Australian resident. Consequently, s. 160L(1)(a) is satisfied. The critical question in each case relates to s. 160L(1)(b): whether the asset, the parcel of shares, was acquired by the relevant applicant on or after 20 September 1985.
Section 160M(5)(a) provides that, for the purposes of Part IIIA-
``an issue or allotment of shares in a company constitutes an acquisition of the shares by the person to whom they were issued or allotted...''
As is common ground, the subject shares were allotted on 7 November 1985. On this basis, the Commissioner argues that s. 160L(1)(b) applies. But the applicants refer to s. 160U, a section providing rules for determining the time of acquisition or disposal of assets for the purposes of Part IIIA. In particular, they rely on s. 160U(3) which reads:
``Where the asset was acquired or disposed of under a contract, the time of acquisition or disposal shall be taken to have been the time of the making of the contract.''
The applicants' counsel contend that, although the shares were allotted after 20 September, they were allotted under a contract made before that date; namely the Heads of Agreement document executed on 28 June and 3 July 1985. Accordingly, 3 July 1985 is the time of acquisition of the shares; s. 160L(1)(b) is not satisfied and there is no liability to capital gains tax. Counsel for the Commissioner disagree. They argue it is not correct to say that the shares were acquired ``under'' the Heads of Agreement. As the argument developed, it had two aspects: whether the Heads of Agreement document had immediate contractual force, as
ATC 4971distinct from being a document in which prospective contractors noted the terms of their likely future agreement; and, if so, whether it is correct to say that the shares were allotted under this agreement.
The application of Part IIIA: whether the Heads of Agreement document had immediate contractual force
Counsel for the applicants accept that the formal allotment of shares was made in response to the applications dated 28 October 1985 and after the exchange of the executed agreements that took place on 7 November. But they say that these steps merely implemented the partners' existing contractual commitments under the Heads of Agreement document. They argue that this document was intended to have contractual force. They point out that, at the foot of the document, the parties chose to call it ``This Agreement'', that it was signed by, or on behalf of, all parties and was specific in key respects. Clause (1) stated the name of the new corporate entity and provided for 50% ownership by JFA and 50% by the four applicants. Although the agreement did not distribute this 50% interest between the applicants, counsel say it effectively gave each of them a one quarter share of that interest, or one eighth of the shares in the new company. Their stated reason was that the agreement was made between JFA and Valder Elmslie, a firm in which each applicant held a one quarter share. Moreover, say counsel, cl. (5) fixed the capital of the new company - $1,200,000. $600,000 was to be contributed by JFA and $600,000 by the applicants, meaning $150,000 each. The clause left undetermined the distribution of this sum, as between equity and subordinated debt, but counsel say this did not matter. What was important was that the subscription was to be ``in the same form and ratio by all shareholders''. The parties contemplated that the new company would be in existence by, and acquire the assets and business of Valder Elmslie as at 31 August 1985 (cl. (3)).
Counsel point out that, after the execution of the Heads of Agreement, the parties took steps to implement its terms. VEJF was restructured. Valder Elmslie terminated its business on 30 August, surrendering its office accommodation, staff and client contacts to the new company. What would be the position, ask counsel, if between 1 September and 19 September, JFA had sought to withdraw? They suggest that JFA would have been estopped from denying that it had committed itself to participating in the new company on the terms set out in the Heads of Agreement, including the term that each applicant have a one eighth interest. In support of that suggestion, they refer to the decision of the High Court of Australia in
Waltons Stores (Interstate) Ltd v Maher (1987-1988) 164 CLR 387. In the application of the Income Tax Assessment Act to private transactions, counsel argue, the Commissioner must take the interparties situation as he finds it, with all applicable estoppels.
Counsel for the applicants accept that the Heads of Agreement document was expressly made subject to the signing of a formal agreement: see cl. (20). But they say that, nonetheless, the document created contractual rights and obligations; it fell within the first or second class of case discussed by the High Court in
Masters v Cameron (1954) 91 CLR 353 at 360:
``Where parties who have been in negotiation reach agreement upon terms of a contractual nature and also agree that the matter of their negotiation shall be dealt with by a formal contract, the case may belong to any of three classes. It may be one in which the parties have reached finality in arranging all the terms of their bargain and intend to be immediately bound to the performance of those terms, but at the same time propose to have the terms restated in a form which will be fuller or more precise but not different in effect. Or, secondly, it may be a case in which the parties have completely agreed upon all the terms of their bargain and intend no departure from or addition to that which their agreed terms express or imply, but nevertheless have made performance of one or more of the terms conditional upon the execution of a formal document. Or, thirdly, the case may be one in which the intention of the parties is not to make a concluded bargain at all, unless and until they execute a formal contract.''
The best evidence, say counsel, that the parties intended to be immediately bound by the Heads of Agreement document is what they did immediately thereafter, and before the exchange of the formal agreements on 7 November; this behaviour is consistent only with a belief by the
ATC 4972parties that they had already entered into a binding arrangement.
There is some inconsistency in the authorities about the admissibility of evidence of surrounding circumstances in connection with an issue whether or not a particular document was intended to constitute a binding contract. The matter was discussed by the New South Wales Court of Appeal in
Air Great Lakes Pty Ltd v KS Easter (Holdings) Pty Ltd (1985) 2 NSWLR 309. After referring to other approaches in some cases, Hope JA at 319 stated the two approaches he thought worthy of serious consideration:
``One is that, where intention to contract is a live issue and evidence is available as to mutual actual intention, that evidence may be adduced to establish that intention. If a finding of intention to contract results, but not otherwise, the document or documents which have been signed should be construed and dealt with in the light of that conclusion of fact. The other approach is that the document or documents which have been signed are first construed in the same way as if they were contracts. Apart from cases falling within recognized exceptions, extrinsic evidence may be looked at only in those cases where it would be permittible to do so in construing an admitted contract, and then, as regards intention, only for the purpose of ascertaining a presumed intention. On this approach it is only in cases falling within one of the recognized exceptions that evidence as to actual intention is admissible.''
Hope JA adopted the second approach. By a process of analysis of the subject document, he reached the conclusion (at 321) that it was a contract of the second class referred to in Masters v Cameron. The other members of the Court reached the same conclusion, but using the first approach identified by Hope JA: see per Mahoney JA at 332-334 and per McHugh JA at 334-337.
The surrounding circumstances evidence tendered in Air Great Lakes concerned discussions that preceded the execution of the document whose status was in dispute. But it seems that the same principle applies to evidence of subsequent events that casts light on the parties' intention. In
Allen v Carbone (1975) 132 CLR 528 at 533, without commenting on the fact that they were subsequent events, the High Court made reference to happenings after the execution of an alleged contract, in determining that the parties had not intended the document to have contractual force. In
B Seppelt & Sons Ltd v Commissioner for Main Roads (1975) 1 BPR 9147, the New South Wales Court of Appeal took a similar course; but here the court specifically asserted its right to look at these events: see per Glass JA at 9149 and per Mahoney JA at 9155. In support of his position, Mahoney JA cited two judgments of Griffith CJ. In the first case,
Howard Smith & Co Ltd v Varawa (1907) 5 CLR 68, in determining that there was no contract, the High Court looked at evidence subsequent to the exchange of the cables that were said to constitute a concluded contract. Griffith CJ, with whom O'Connor J agreed, said at 78:
``In the present case we have nothing but written documents, to which I will now refer. It is plain that, the question being whether the parties had in fact concluded an agreement on 1st December, any statements or conduct on their part after that date inconsistent with the existence of a concluded contract are relevant for this purpose.''
In the other case,
Barrier Wharfs Ltd v W Scott Fell & Co Ltd (1908) 5 CLR 647, it was argued that the subsequent conduct of the parties showed that correspondence exchanged between them constituted a concluded contract. The High Court was not persuaded that it did; but all members of the Court were prepared to consider the evidence regarding the subsequent conduct in determining that issue. I think I should take the same course in this case.
There are, in my opinion, several reasons for accepting the submission that the Heads of Agreement document was intended to have immediate contractual force, notwithstanding that cl. (20) made it subject to the signing of a formal agreement. In the first place, it was a document prepared with some care. A draft document was submitted to Mr Moore by Mr Grubb in early June. Mr Moore went through the document with each of his partners, the other applicants. He consulted the firm's solicitors and a number of alterations were made. Although the evidence does not descend to detail, the alterations must have been approved by Mr Grubb before he executed the document on 3 July. Secondly, the document
ATC 4973was signed by each applicant on his own behalf and by Mr Grubb on behalf of JFA. If the parties intended that the document only serve the purpose of providing drafting instructions for those who had to prepare the formal agreement or agreements, this was unnecessary. Thirdly, although this is a minor matter, the parties called the document ``This Agreement''.
Fourthly, the document was comprehensive. In three of the cases to which I have referred, Seppelt, Howard Smith and Barrier Wharfs, the court gave the absence of agreement on important matters as a reason for concluding that the relevant document was not intended to have contractual force. The converse must also be true, although comprehensiveness is only one factor to be taken into account. So far as I can see, only two provisions of a later document were not stated in the Heads of Agreement: that the 50% interest in VEJF to be owned by the four applicants was to be shared equally between them; and the distribution, as between equity and subordinated debt, of the parties' capital contributions. I do not think that either of these omissions derogates from the conclusion that the document was intended to have contractual force. The first matter only concerned the applicants inter se. It was already covered by their partnership arrangement. They were equal partners in Valder Elmslie. The Heads of Agreement document opened with a reference to an agreement between JFA ``and Valder Elmslie and Company''. Underneath the signatures of the four applicants were the words ``representing Valder Elmslie and Company''. So the party who contracted with JFA was the firm itself. Whatever interest the firm acquired under the document would be split equally amongst the four partners unless they agreed otherwise. Only in that situation was an apportionment term necessary. The proportion of capital provided by way of equity, as distinct from subordinate debt, was a matter of no practical importance. As the proportion was to be the same for each shareholder, and their total capital contributions were agreed, it made no difference whether 90% of the contribution was equity and 10% subordinate debt, or whether it was the other way around. Nor would the proportion affect third parties. As I understand the parties' intention, the ``subordinate debt'' would be funds loaned by the shareholders and ranking after all other debts of the company in the event of a winding up. In practical terms, the subordinated debt would be indistinguishable from share capital.
Finally, the subsequent conduct of the parties is consistent only with a mutual belief that they were already contractually bound. I earlier referred to the action taken by Valder Elmslie to turn their business over to VEJF. It is true that, until 7 November, Messrs Moore and Moyes were the company's sole shareholders. But Mr Grubb and Mr Smith had been directors since 18 June, and were therefore entitled to receive information about the operations the company conducted from 2 September. Mr Grubb participated in the July decisions regarding new personnel and arrangements for the business changeover. He attended a board meeting on 16 September at which auditors and bankers were appointed, bank signatories authorised, a computer lease and a budget approved, and a decision made to seek additional office space.
The application of Part IIIA: when the shares were acquired
Counsel for the Commissioner do not concede that the document styled ``Heads of Agreement'' was intended to have contractual force. But they say that the question is really beside the point; the more important question is when each applicant acquired his one eighth interest in the share capital of VEJF. Counsel point out that an allotment of shares is, in law, an acceptance by an allotting company of the offer to take shares made to it by the applicant for allotment: see
Re Florence Land and Public Works Co (1885) 29 Ch D 421 at 426,
Commonwealth Homes and Investment Co Ltd v Smith (1937) 59 CLR 443 at 453. Counsel say that, in each case, a contract came into existence on 7 November 1985, when the board of directors resolved to allot shares in accordance with the applications dated 28 October 1985; in each case, this was the contract ``under'' which the shares were acquired. Counsel argue that it makes no difference whether the contract under which the allotment was made was a contract that the parties had previously agreed to make; the words ``under a contract'', in s. 160U(3), are to be narrowly interpreted, attention being confined to the immediately empowering instrument rather than a more remote source of authority. Counsel refer, by way of analogy, to the words ``under an enactment'' in the Administrative Decisions (Judicial Review) Act 1977 (see
Australian National University v Burns
ATC 4974(1982) 43 ALR 25,
Chittick v Ackland (1984) 53 ALR 143 at 153,
Australian Film Commission v Mabey (1985) 59 ALR 25) and ``under this lease'' discussed in
Chan v Cresdon Pty Ltd (1989) 168 CLR 242. In both Burns and Mabey it was held that the Administrative Decisions (Judicial Review) Act did not apply to a decision of a statutory authority brought into existence by a Commonwealth enactment; the impugned decision was made in the exercise of the authority's contractual capacity, rather than in exercise of a statutory power. In Chan the question was whether guarantors were liable to make payments to a lessor pursuant to a clause in a lease document whereby they agreed to guarantee performance of the lessee's obligations ``to be performed under this lease''. The lease was not registered and was therefore ineffectual to pass an estate or interest in the land. As the lessee had gone into possession of the land, it was liable to pay rent. But the High Court held this liability was not an obligation ``to be performed under this lease''. At 249-250 Mason CJ, Brennan, Deane and McHugh JJ said:
``The word `under', in the context in which it appears, refers to an obligation created by, in accordance with, pursuant to or under the authority of, the lease. The obligation which arose under the common law tenancy at will does not answer this description.''
It is important to note that the lessee went into possession of the land only because of the execution of the lease. The claim against the guarantors was for rental accrued during the period of possession. But the lease was not the immediate source of liability for rent, so the guarantee did not apply. It was not enough that, absent the lease document, there never would have been a liability for rent. In the same way, say counsel, it may be conceded that the arrangement between the applicants and JFA evidenced in the Heads of Agreement document was the background against which the applicants made their applications for allotment of shares on 28 October and the shares were allotted on 7 November; nonetheless the shares were allotted ``under'' the contract then made, not the earlier arrangement.
Counsel for the Commissioner also point out that VEJF was not a party to the Heads of Agreement document. They say that it is an incorrect use of language to speak of shares being allotted by a company under a contract to which the allotting company is not a party. An agreement between one of the present applicants and the other intending shareholders, whereby he promises to take shares and the latter promise to cause the company to allot shares to him, is not enough; such an agreement may have been the cause of the contract of allotment but cannot itself be the contract under which the allotment was made.
In the course of their submissions on this issue counsel for the applicants referred to cases applying the celebrated dictum of Lord Davey in
Salomon v A Salomon & Co Ltd  AC 22 at 57 that a ``company is bound in a matter intra vires by the unanimous agreement of its members''. The English Court of Appeal applied this principle in
Multinational Gas and Petrochemical Co v Multinational Gas and Petrochemical Services Ltd  Ch 258 in holding a company in liquidation not entitled to sue an associated company for breaches of duty towards the plaintiff company, the acts constituting the alleged breaches having been undertaken by direction of all members of the plaintiff. The principle has been applied to matters of internal management. In
Re Duomatic Ltd  2 Ch 365 Buckley J held that directors of a company were entitled to retain moneys drawn by them as directors' salaries, even though no resolution for payment of directors' salaries had ever been passed, because the only persons who were shareholders at the relevant time had approved the payments. In reaching this decision, Buckley J relied upon the decision of the English Court of Appeal in
Re Express Engineering Works Ltd  1 Ch 466, a decision which Bowen CJ in Eq treated as authoritative in
Re Compaction Systems Pty Ltd (1977-1978) CLC ¶40-313 at 29,309;  2 NSWLR 477 at 484.
When they came to make submissions, counsel for the Commissioner mentioned
Herrman v Simon & Ors (1990) 8 ACLC 1,094 wherein the New South Wales Court of Appeal considered the limits of the Duomatic principle. Meagher JA at 1,096 described it as a doctrine ``that formalities may be disregarded if they have been waived by all shareholders acting in concert who want the same substantial result''. Counsel for the Commissioner say that Duomatic does not assist the applicants because it does not enable them to say that the shares
ATC 4975were issued to them under the Heads of Agreement. Although both incumbent, and all eventual, shareholders were parties to that agreement, they did no more than agree that the company would take certain action, namely allotment. The shareholders were not waiving the formality of allotment; on the contrary they envisaged this would happen.
During the course of their reply, counsel for the applicants submitted that the formula ``under a contract'' does not require privity of contract between the person from whom, and the person by whom, the asset was acquired. They referred to
Trident General Insurance Co Ltd v McNiece Bros Pty Ltd (1988) 5 ANZ Insurance Cases ¶60-873; (1987-1988) 165 CLR 107. I think this is so, but the only effect of the submission is that a particular type of contract is not to be excluded. The submission does not resolve the critical question in the case: whether the statutory formula ``under a contract'' encompasses a contract that envisaged, or provided for, the acquisition of the asset - or even required a party or parties to undertake the transaction that constituted the acquisition of the asset - but was not the means by which the asset was actually acquired. I have reached the conclusion that this question must be answered in the negative, with the result that the acquisition of the subject shares cannot be said to have taken place before 7 November 1985.
There are three reasons for my conclusion. They overlap. The first arises out of my consideration of the submissions of counsel based on the principle expressed by Lord Davey in Salomon and illustrated in cases like Multinational and Duomatic. It is true that, when the Heads of Agreement document was signed, Messrs Moore and Moyes were the only shareholders in VEJF. They agreed to the terms of the document. It is therefore arguable - I do not need to decide the point - that VEJF became bound by those terms. If it did, VEJF became obligated to accept share subscription offers by the people named in the Heads of Agreement document in the proportions there specified or implied. In other words, the company agreed to accept offers to take shares when they were made. Even if it be added that, by their adherence to the Heads of Agreement, each of the applicants agreed to apply for shares equal to one eighth of the company's issued share capital, this was no more than an agreement to enter into an allotment contract at a future date. It did not constitute an agreement that actually allotted shares. It was not intended to do so and could not do so. I say it was not intended to do so because the parties realised the necessity of obtaining FIRB approval before JFA could acquire shares in VEJF. They had not yet sought this. They plainly did not intend that the Heads of Agreement document would serve as the instrument allotting shares to JFA; there would have to be another agreement at a later date, when FIRB approval was obtained. Yet, if the Heads of Agreement document constituted an immediate allotment of shares to the partners in Valder Elmslie, the same reasoning would lead to the conclusion that it immediately allotted to JFA 50% of the shares in VEJF.
I say that the document could not constitute an allotment of shares because the directors had not yet decided how many shares would be issued. It was impossible to know how many shares would constitute 50%, or one eighth, of the issued capital. Although I accept that the parties intended that the Heads of Agreement document would have immediate force in respect of their relationship, they clearly expected that there would be a later transaction between each of them and VEJF wherein each would offer to subscribe for a parcel of shares, the numbers of which had yet to be agreed but would observe the proportions stated in cl. (5) of the Heads of Agreement. That clause spoke of equity or subordinated debt ``to be subscribed in the same form and ratio by all shareholders''. The parties to the document must have expected that each offer would be supported by an application form complying with the relevant Articles of Association and a tender of payment of the appropriate sum (otherwise the company would lack the agreed capital); and that this offer would be accepted by the directors, on behalf of the company, in a formal allotment resolution. The later contracts of allotment were an essential part of the plan agreed in June. They cannot be treated as unnecessary formalities and a conclusion reached that the source of the shares was the Heads of Agreement document.
The second reason for my conclusion arises out of the scheme of Part IIIA. The notions of acquisition and disposal of assets are fundamental to the operation of the Part. Section 160ZO(1) makes a ``net capital gain''
ATC 4976that ``accrued to a taxpayer in respect of the year of income'' part of the taxpayer's assessable income for the year. Section 160ZO(2) allows a ``net capital loss'' to be taken into account for certain purposes. For the legislation to operate satisfactorily, it is essential that taxpayers and the Commissioner be able to compute the amount of any capital gain or capital loss within a particular year. But it is not enough to ascertain the relevant year; acquisition has to be related to a particular quarter. Section 160ZJ provides for indexation of the cost base of an asset by reference to the number of the Consumer Price Index in respect of the quarter in which it was acquired. The system depends upon the acquisition date of an asset being capable of precise determination. Section 160U sets out the rules for determining that date. Where the asset was acquired otherwise than under a contract, and where no later subsection in s. 160U applies, the acquisition date is the date when the asset changed ownership (s. 160U(4)). Section 160U(3) substitutes a different rule where the asset ``was acquired... under a contract''. In that case the date of ``the making of the contract'' applies. It will be noted that the word ``contract'' is in the singular. The assumption is that a contractually-acquired asset will be acquired under only one contract, the date of which will precisely fix the date of acquisition of the asset. This assumption is irreconcilable with the notion that it is enough that there be a contract that envisages or requires the acquisition of the asset. In a particular case there may be several contracts that contemplate or require a party to acquire an asset. Those contracts may bear different dates. If subs. (3) extended to all those contracts, and not just to the contract that directly got in the asset, it would provide a multiplicity of dates in respect of one asset. Unless all the dates happened to fall within the same quarter, the legislation would become unworkable in relation to that asset. It seems to me that, for the legislation to work satisfactorily, it is necessary for the courts to confine the words ``under a contract'', in s. 160U(3), to the contract that directly effected the acquisition. It is necessary to disregard any earlier contract obliging one or both parties to the acquisition to enter into the immediately operative contract.
This approach is consistent with the interpretation given in decided cases to analogous phrases, such as ``under an enactment'' and ``under this lease''. I have already referred to some of these cases. They demonstrate that the word ``under'' usually imports a direct connection between the relevant act and the instrument. Chan is particularly telling. In that case, it was not enough that there was a contract (the lease) that envisaged that the lessee would go into possession and, indeed, required it to do so. It was not enough that, absent the lease, the lessee would not have gone into possession and the liability for rent not arisen. For the guarantors' liability to arise, the rental liability had to be incurred under the lease; that is, through its operation as an instrument that created a legal interest. In the same way, the contract under which an asset is acquired, within the meaning of s. 160U(3), is the contract through whose operation the asset changes ownership.
In my opinion, the time when the shares were acquired was 7 November 1985. It follows that Part IIIA applies to the shares and taxes the net capital gains derived by the applicants.
The determination of the net capital gains: whether the parties were dealing at arm's length
The computation of a net capital gain or net capital loss takes as its point of commencement the ``cost base'' of the asset to the taxpayer. In the present cases, the Commissioner took as the cost base of the shares the amounts actually paid by the applicants, $75,000 in the cases of Mr Elmslie and Mr Valder and $74,999 in the cases of Mr Moore and Mr Moyes. The applicants say this was wrong; the Commissioner should have applied s. 160ZH(9)(c) of the Act. That paragraph reads:
``(9) For the purposes of the application of subsection (1), (2) or (3) in determining the cost base, the indexed cost base or the reduced cost base to a taxpayer of an asset, if-
- (c) the consideration paid or given by the taxpayer in respect of the acquisition would, but for this paragraph, be greater or less than the market value of the asset at the time of the acquisition and the taxpayer and the person from whom the taxpayer acquired the asset were not
ATC 4977dealing with each other at arm's length in connection with the acquisition of the asset,
the taxpayer shall be deemed to have paid or given as consideration in respect of the acquisition of the asset an amount equal to the market value of the asset at the time of the acquisition.''
The person from whom each applicant acquired his shares was VEJF. The applicants say they did not deal at arm's length with VEJF in connection with those acquisitions; two of them held a one half interest in the company immediately before the allotment; all of them were directors; together, they formed a majority of the company's directors.
Counsel for the Commissioner argue that it is wrong to consider the situation in this way, that the position of each applicant must be separately assessed; no one of them was in a position to dominate the company. Counsel point out that JFA was entitled, under the agreements that were exchanged immediately before the 7 November allotment resolution, to exercise at a board meeting one half the total voting power; each applicant therefore had only one eighth of the voting power. No one applicant had power to dominate the decision of VEJF about the offers to take shares; neither did they do so; the number of shares to be allotted, and the allotment price, was already agreed between the intending subscribers. Counsel refer to
Barnsdall v FC of T 88 ATC 4565 wherein Davies J at 4568 emphasised the significance of the composite phrase ``not dealing with each other at arm's length''. This directs attention to the nature of the dealing. It is different to ``not at arm's length'', which concerns the nature of the relationship: cf.
Australian Trade Commission v WA Meat Exports Pty Ltd (1987) 75 ALR 287.
I understand the points made by the Commissioner's counsel, but I think it unreal to describe the share allotment as an arm's length transaction. The question is not the power of each applicant as against the other directors inter se but his power as against the company, the other party to the transaction. It is true that no one applicant could dominate the board of directors. But the position of each applicant should not be considered in isolation. The directors had already agreed on the number of shares that each subscriber would receive. It was that agreement that was being implemented on 7 November. And that was an agreement in relation to which each director had considerable influence. The smooth implementation of the matters stipulated in the Heads of Agreement document required consensus. If the directors had decided that each of the Valder Elmslie partners should take, say, 37,500 shares rather than 75,000, and JFA 150,000 shares rather than 300,000 (thus valuing the business, and each interest in it, at a figure only half that ascribed by the allotment) they could have done this. Similarly, they could have issued more shares than they did, thereby ascribing a higher cash value to the company and each of the subscribers' interests. The choice was that of the directors, and of each of them individually. The directors imposed their decision on the company. The dealings were not at arm's length. In making his assessments, it was therefore necessary for the Commissioner to consider what was the true market value of the shares on allotment day. If that figure differs from the amount actually paid, it must be substituted for that amount in determining the cost base.
The determination of the net capital gains: the true market value of the shares on allotment day
It is at this point that the accountants' evidence becomes relevant. The applicants called Alan Basil Bagnall, a chartered accountant with considerable experience in the valuation of businesses and company shares. Mr Bagnall prepared a report in which he valued a one eighth interest in VEJF at 7 November 1985 at $661,500. This figure is equal to $8.82 per share. He thought this was the true value of each of the shares acquired that day. In reaching that figure, Mr Bagnall made a number of important points that are beyond dispute. First, the effect of the announcements of April and December 1984 was to open up the stockbroking market to corporations and foreigners. But the announcements indicated that, until 1 April 1987, non-member shareholdings in stockbroking companies were not to exceed 50%. After 1 April 1987, non-member shareholdings could exceed 50%, but it was not clear whether this would apply to foreigners. In any event, it was reasonable to assume that, by then, most significant broking firms would have formed an association with a financial house. Consequently, a reputable Australian firm not
ATC 4978yet affiliated with a financial institution was, in 1985, in a position to command a premium price. Mr Bagnall referred to sales that had already occurred.
Mr Bagnall also pointed out that the assets of VEJF, at the time of allotment, included not only the goodwill attaching to Valder Elmslie, whose business it had taken over on 2 September, but also that connected with Jardine Fleming. Although Jardine Fleming had not obligated itself to deal exclusively through VEJF, and there were commercial reasons why it would sometimes choose other brokers, it was reasonable for any purchaser of VEJF shares on 7 November 1985 to assume that Jardine Fleming would do most of its Australian business through VEJF. In this connection I note that Mr Elmslie gave evidence, which was unchallenged, that he expected that the volume of business transacted by VEJF, having regard to the Jardine Fleming connection, ``could triple that of the partnership''. However, it should be added that Mr Bagnall made the point that the effect of deregulation was ``growing competition resulting in lower commissions''.
Mr Bagnall analysed Valder Elmslie's trading results. He noted that the profits for the previous three financial years were: year ended 30 June 1983, $177,000; year ended 30 June 1984, $233,000; year ended 30 June 1985, $479,000. He commented that these profits were struck after charging partners' remuneration, which amounted to $175,000 in 1985. [Only three partners were paid remuneration in that year, Mr Valder being heavily engaged in outside activities.] Mr Bagnall thought $175,000 too small a figure; a proper allowance for remuneration of three partners would be $270,000, thus reducing the 1985 profit to $384,000. He went on:
``It is necessary for present purposes to decide what the firm's future profitability might be. Normally, the average of the results of the previous three to five years would be taken as a basis, but such approach appears inappropriate on this occasion, partly because the Australian economy was depressed in 1983 and 1984, and partly because of the high rates of inflation in those years. Furthermore, the 1985 profit was substantially less than the profits earned in 1980 and 1981 ($536,000 and $677,000). We understand that the partnership expected to maintain its profitability at about the 1985 level, and, given the competition to associate with well established and reputable sharebrokers and the prevailing optimism, it is probable that a hypothetical purchaser would have accepted that future profits would continue at the level of $479,000, or $384,000 after adjustment for partners' remuneration.''
Mr Bagnall then turned to the business' future prospects. He noted the matters I have mentioned, especially the importance of the Jardine Fleming connection. He also referred to the company's trading result in its first full year of operation, the year ended 30 June 1987. The company's recorded profit in that year was $368,496 but Mr Bagnall said that, ``if allowance is made for (certain) non-productive expenditure, it would have been $1,132,000 before tax, or $577,000 after tax''. The ``non- productive expenditure'' included items of staff recruitment ($70,000), overseas travel ($89,000), electricity, periodicals, postage and printing ($25,000), stationery ($20,000), telecommunications ($35,000), salaries and superannuation of research department ($445,000), payroll tax ($20,000) and rent ($40,000). Apparently some of these expenses arose out of the establishment of a Melbourne office. But it is difficult to see why these items should be regarded as so extraordinary as to be disregarded when considering the true result in 1987. Mr Bagnall also referred to the prices paid by JFA to the applicants in 1987 in the transactions that gave rise to the subject assessments.
As I recently pointed out in Liverpool City Council v Commonwealth of Australia (10 November 1993, not yet reported), in valuing an asset as at a particular day it is not generally permissible to have regard to subsequent events. No attention should be paid to the 1987 profit or sales in determining the value of the VEJF shares as at 7 November 1985. It was permissible, however, for Mr Bagnall to take into account the company's prospects as at 7 November 1985, including the prospect of a tripling of its volume of business.
Mr Bagnall seems to have understood the matters just stated. Although he referred in his report to the 1987 events, they did not intrude into his actual valuation. He assessed the value of goodwill of VEJF, at 7 November 1985, as $4,692,000; this amount being calculated as follows:
Adjusted profit of Valder $ Elmslie for year ended 30 June 1985 384,000 Less tax at 49% 188,000 ------- 196,000 Capitalised at 10% 1,960,000 Less tangible assets at 30 June 1985 396,000 ------- 1,564,000 Tripled $4,692,000
Mr Bagnall then added in the paid up capital of the company ($600,000), to reach a figure of $5,292,000. One eighth of this figure is $661,500.
Mr Bagnall agreed in cross-examination that he had worked on the basis that the most likely purchaser of the parcel of shares under valuation, that is the parcel owned by any one applicant, would be a person already connected with the business and able to influence its direction; a merely passive investor (especially an investor taking only a minority interest) would seek a higher yield and, therefore, offer a lower price.
The valuer called on behalf of the Commissioner was Wayne Lonergan. Mr Lonergan is also an experienced chartered accountant with expertise in the valuation of businesses. Mr Lonergan treated each parcel of shares separately, regarding it as-
``a minority interest in the company's share capital (which) has no control over the underlying cash flow or assets of the company, nor does the holder have control over the timing, direction or quantum of reinvestment of the earnings, or dividend policy of the company.''
He rejected the possibility of valuing the shares by reference to the realisable value of the net tangible assets of the company, giving as his reason that this methodology was not usually used in respect of a share in a company that ``does not enable the owner to force the realisation of the assets of the company''. He thought that each of the parcels should be valued ``on the basis of capitalisation of future maintainable dividends''.
In order to determine likely future dividends, Mr Lonergan analysed some management forecasts. One of these forecasts was made on 8 January 1986, after the relevant valuation date, but I do not think this matters; it does not relate to any new event occurring after that date but merely analyses information that would have been available to the hypothetical purchaser on 7 November. Mr Lonergan's analysis shows a range of possible results, varying from a ``best case'' pre-tax profit of $1,510,000 to a ``worst case'' loss of $385,000. The results styled ``possible case'' are profits of $1,160,000 or $410,000 and ``poor/reasonable cases'' are a profit of $74,000 or a loss of $50,000. Mr Lonergan compared these figures with the Valder Elmslie 1985 result. He accepted Mr Bagnall's figure of $384,000 pre-tax profit after payment of proper partners' compensation. Because of their range, Mr Lonergan understandably did not consider the management forecasts very helpful.
Mr Lonergan then referred to a discovered document referring to a policy that VEJF ``will be expected to retain any earnings for at least the first three years. Thereafter it might consider dividends''. The identity, provenance and status of this document are obscure. It has not been tendered in evidence. The evidence does not indicate whether it existed prior to 7 November, or referred to a then-existing policy, or whether it arose out of a subsequent decision. Consequently, it is not apparent that this was a document that a hypothetical purchaser would have had in mind in considering how much to offer for a one eighth interest in the company on 7 November. But Mr Lonergan took the document into account. He deducted tax from the 1985 Valder Elmslie earnings, obtaining a post-tax profit of $200,000. He then assumed that, after year 4, VEJF would pay dividends equal to 45% of its after tax profit. On this basis future maintainable dividends would be $90,000. One eighth of this figure is $11,250. Adopting a capitalisation rate of 12%, Mr Lonergan calculated a value of $93,750 on a full dividend paying basis. But he deducted $27,021 because of the three year no dividend policy (3 years at $11,250 equals $33,750 less present value effect) leaving a final figure of $66,729.
Mr Lonergan stated that he had not ascribed any value to the agreement of JFA to purchase the Valder Elmslie partners' shares. His reasons were that this was a collateral agreement, not a right attaching to the shares; that the agreement would not necessarily be transferable and, if transferred, not necessarily on the same conditions; and there was no guarantee, in the
ATC 4980absence of the agreement, that JFA would seek to purchase the shares.
As will be apparent from my account of their valuations, the accountants are at issue on several points of principle, as well as in relation to matters of judgment. The most important issue of principle is whether the shares taken by each applicant on 7 November 1985 should be valued on a share of a going concern basis (as Mr Bagnall thought) or on the basis of the price available to a shareholder compelled to find a buyer for a parcel of only 12½% of the share capital (as Mr Lonergan argued). I have no doubt that Mr Bagnall's approach is the correct one. By treating each parcel of shares in isolation, Mr Lonergan accepts the prospect that the hypothetical buyer will be a person not already concerned with the company or involved (or intending to become involved) in its daily operations, a person purchasing the shares in the expectation of being permanently limited to the role of a small minority shareholder without any control over the company's direction or policy. As he accepts, such a person would buy the shares only for their income-earning potential. However, as the income of the company was so dependent upon the personalities and exertions of people over whom the purchaser had no control, the purchaser would regard the transaction as one involving high risk and justifiable only at a price that offered a high yield on the purchase price. As Mr Lonergan accepted, the result would be that the combined value of the four applicants' shares, amounting in all to 50% of VEJF, would be less than the value of JFA's 50% interest in the company.
It seems to me that this approach is incorrect. It ignores the fact that, on 7 November 1985, the people controlling VEJF were involved in restructuring its share register so as to provide a fair basis for its operations until the projected sale of the applicants' shares to VEJF in 1990. As cl. 13 of the Shareholders Agreement demonstrates, they were concerned to ensure that, during that time, the shares would be held by people actively concerned with the company's day-to-day operations. If, immediately after the allotment to him of his shares, one of the applicants had announced that he wished to sell them (for example, because he had decided to retire from stockbroking), he would have been required by cl. 13 to offer his shares to the other applicants, and then to JFA, before selling to someone else. Given the terms of cl. 13 and the nature of the company, it is highly unlikely that the other shareholders would have allowed the shares to be sold to a stranger.
In support of Mr Lonergan's approach, counsel for the Commissioner referred to the decision of Sheppard J in
St Helens Farm (ACT) Pty Ltd & Ors v FC of T 79 ATC 4161; (1979) 46 FLR 217 to value shares on an earnings basis. The High Court did not interfere with that approach (see 81 ATC 4040; (1981) 146 CLR 337), although Mason J at ATC 4059-4061; CLR 378-381 expressed reservations about its correctness. But that case concerned an investment company whose major asset was shares in a publicly listed company, The Broken Hill Proprietary Company Limited. It was a very different type of company from VEJF, a company whose fortunes depended upon the personal efforts of, and relationships between, a handful of directors. In my opinion VEJF falls into the class of company conveniently, although loosely, described in the authorities as a ``quasi-partnership''. In
Ebrahimi v Westbourne Galleries Ltd  AC 360 at 379 Lord Wilberforce identified three characteristics of such a company, this being relevant when considering the application in a particular case of the ``just and equitable'' winding up ground: an association formed or continued on the basis of a personal relationship, involving mutual confidence; an agreement or understanding that all or some of the shareholders will participate in the conduct of the business; and restriction on the transfer of members' shares. All these elements apply to VEJF - the last not in absolute terms, but through cl. 13 of the Shareholders Agreement. Where it becomes appropriate to make an order for one or more members of such a company to buy out oppressed members, as an alternative to winding up, it is usually appropriate to require valuation on an assets basis: see
Re Bird Precision Bellows Ltd  Ch 658. In that case Oliver LJ approved the following passage in the reasoning of the trial judge, Nourse J:
``I would expect that in a majority of cases where purchase orders are made under section 75 in relation to quasi-partnerships the vendor is unwilling in the sense that the sale has been forced upon him. Usually he will be a minority shareholder whose interests have been unfairly prejudiced by
ATC 4981the manner in which the affairs of the company have been conducted by the majority. On the assumption that the unfair prejudice has made it no longer tolerable for him to retain his interest in the company, a sale of his shares will invariably be his only practical way out short of a winding up. In that kind of case it seems to me that it would not merely not be fair, but most unfair, that he should be bought out on the fictional basis applicable to a free election to sell his shares in accordance with the company's articles of association, or indeed on any other basis which involved a discounted price. In my judgment the correct course would be to fix the price pro rata according to the value of the shares as a whole and without any discount, as being the only fair method of compensating an unwilling vendor of the equivalent of a partnership share.''
Similar comments may be made about a valuation of shares under s. 160ZH(9)(c) of the Income Tax Assessment Act that adopts the fiction that the taxpayer would be content to sell his/her shares to an unidentified hypothetical purchaser concerned only with the receipt of dividend payments. Wherever the company has characteristics similar to those identified by Lord Wilberforce, the approach espoused by Mr Lonergan will almost certainly yield a value less than that which would result if the valuer assessed the company as a going concern and divided its net value by the taxpayer's proportion of the company's shares. This is the course Mr Bagnall took in the present case. For reasons analogous to those expressed by Nourse J, it is the only fair way to value the share acquired by each of the applicants on 7 November.
The second matter of principle that arises out of Mr Lonergan's report is his use of the discovered document referring to future dividend policy. Mr Bagnall was unaware of this document. As I have said, its identity, provenance, status and date are all mysteries. If there was a firm understanding between the directors as to future dividend policy, it is surprising that it was not expressed in the Heads of Agreement document, one of the three agreements dated 12 September or a directors' resolution. In the absence of evidence that this policy was a matter likely to be taken into account by a hypothetical purchaser, no regard should be had to it in valuing the shares.
Thirdly, although Mr Lonergan noted the VEJF profit projections, he ignored them in his computation of value. He disregarded the assumption made by the parties that VEJF would return a higher profit than Valder Elmslie. I find this strange. The reason why the Valder Elmslie partners were prepared to surrender total control of their business, in favour of a 50% interest, was that they could thereby ``lock in'', as a shareholder, a major investment manager. Mr Lonergan noted, without criticism, a VEJF management forecast that the effect of the amalgamation would be to increase the 0.8% national market share that had been enjoyed by Valder Elmslie to 2.8%. JFA must also have been optimistic. In order to establish the agreements made on 7 November, it had already paid each Valder Elmslie partner $100,000 (more than his share was worth, on Mr Lonergan's estimate) plus one quarter of the value of the tangible assets; and it had contributed its own resources, expertise and contacts without charge. Difficult though the task was, it was Mr Lonergan's duty to attempt to determine the likely profits of VEJF, not simply to adopt the 1985 Valder Elmslie result.
Fourthly, there is an issue between the valuers as to the relevance of the JFA commitment to purchase the subject shares, at five times average annual earnings, by the end of 1990. Mr Lonergan left this out of account, on the basis that each applicant held the benefit of this promise collaterally to his shareholding and that it might not be assignable to a hypothetical purchaser. Nobody explained to me why it would not be assignable. But, in any case, it is necessary to remember the words of Williams J in
Abrahams v FC of T (1944) 70 CLR 23 at 31:
``the value to be ascertained is the value to the seller of the property in its actual condition at the relevant time... with all its existing advantages and all its possibilities...''
In that case the Court was concerned with the value of shares to a deceased estate. That was not necessarily the same as market value. But in considering the market value of the subject shares, it is necessary to ask oneself how much the vendor would have wanted to receive before parting with them. One of the advantages of holding the shares, to each of the sellers, was
ATC 4982the prospect of selling them to JFA before the end of 1990 at a price equal to five times the annual after tax earnings plus net tangible assets. A calculation made by counsel for the Commissioner shows that, even adopting Mr Lonergan's after-tax profit figure of only $200,000 per year and assuming no dividends in the first three years, the total receivable amount at 31 December 1990 would be $2,310,000. This would comprise tangible assets (paid up capital and accumulated profits) of $1,310,000 and a goodwill component of $1,000,000 (five years profits at $200,000). One eighth of $2,310,000 is $288,750. Even taking a high discount rate that reflects stockbrokers' risk margins, this entitlement was worth $93,000, as at 1 January 1986. At the Commonwealth bond rate of 15% it was worth $143,560; at 18%, $126,215; at 20%, $116,042; and at 22%, $106,837. Each of these figures is well above Mr Lonergan's $66,729.
Finally, there is a question about the $400,000 payment ($100,000 for each Valder Elmslie partner) referred to in cl. (2) of the Heads of Agreement document. The Purchase Agreement recited that this money had been paid and the case has been conducted on that basis. Mr Bagnall noted the fact of the payments but thought them irrelevant to the value of the shares. Mr Lonergan took the same approach. Contrary to the submission of counsel for the Commissioner, I think they were right to take that view. The valuers' task was to determine the value of what VEJF provided to each applicant on 7 November - 75,000 (or 74,999) shares in a company having the benefit of the combined resources, expertise and contacts of the four Valder Elmslie partners and JFA. It did not matter how VEJF acquired those assets. The $400,000 payment was related to that acquisition. It was part of what JFA gave - its own resources, expertise and contacts being another part - in return for the Valder Elmslie partners turning over their business to the new company. To put the matter another way, it seems that the parties thought that the contribution that Valder Elmslie made in kind was worth $400,000 more than the contribution made in kind by JFA. So they agreed to even matters out by JFA paying Valder Elmslie the $400,000 difference.
Under some circumstances, the amount of the payment might provide guidance as to the value of what VEJF sold on 7 November, its shares. However, as the figure was only an adjusting figure, in relation to contributions not monetarily quantified, it provides no assistance. Except on the view, for which no one has contended, that JFA made no contribution whatever to VEJF in relation to resources, expertise and contacts, it cannot be argued that $400,000 represented the net worth of Valder Elmslie. Unless one quantifies the value of JFA's contribution, it is impossible to say how much more than $400,000 Valder Elmslie's contribution was worth. The amount of the payment furnishes no assistance.
It will be evident from what I have said that I prefer the methodology adopted by Mr Bagnall to that of Mr Lonergan; although, adopting appropriate numbers, there may not be much difference in the result. But there are difficulties about Mr Bagnall's figures. In anticipation of the possibility that the Court would reach the conclusions just stated, Mr Lonergan helpfully prepared a table in which he set out the figures he would use if required to adopt Mr Bagnall's methodology, whilst making it clear that he thought it incorrect. The table is as follows:
" BAGNALLL ONERGAN'S Valuation Revision $000 $000 Valder Elmslie Profit for year ended 30 June 1985 479 479 Adjustment to increase partner salaries to market rate -- Add back actual partner salaries 175 175 -- Deduct market rate (per Bagnall) 270 270 Adjusted profit before tax 384 384 Less: Tax @ 49% 188 188 --- --- Valder Elmslie adjusted profit after tax 196 196 Value of Valder Elmslie business capitalised at: -- Bagnall 10% 1,960 -- Lonergan 16.6% 1,176 Less: Net tangible assets per statutory accounts 296 296 Market value of FF & E 100 100 Adjusted net tangible assets 396 396 Goodwill of Valder Elmslie business 1,564 780 ----- ----- VEJF Goodwill multiple 3 2 Goodwill of VEJF 4,692 1,560 Paid up capital 600 600 --- --- Value of VEJF 5,292 2,160 Value of 12.5% shareholding 662 270 Less: Discount for non-negotiability (25%) -- 67 Value of AR Elmslie's 12.5% shareholding applying incorrect basis of valuation 662 203"
It will be noted that there are three differences between Mr Bagnall's figures and Mr Lonergan's figures: the capitalisation rate, the goodwill multiplier and whether or not there should be a discount for non-negotiability. It will already be apparent that I reject Mr Lonergan's view that there should be such a discount.
I think the other two matters are connected. I accept that, in November 1985, everybody concerned with VEJF expected that the turnover of the company would be about three times that of Valder Elmslie. I also accept Mr Bagnall's statement that a three-fold increase in turnover would usually lead to more than a three-fold increase in profits, as economies of scale take effect. But, as Mr Bagnall pointed out, in November 1985 margins were under attack. The effect of the deregulation process commenced in April 1984 and likely to increase, rather than reduce, after November 1985 was to force brokers to accept lower rates of commissions. For a broker, the best way of countering this development was to increase sales volume - hence the trend towards formal links with financial institutions. I would be disregarding these matters if I assumed that a three-fold increase in volume would lead to a three-fold increase in profits, or better.
There is another objection to Mr Bagnall's decision to value the shares on the basis of a tripling of profits. Although this was a realistic prospect, it was only a prospect. The parties genuinely thought it achievable, but only with considerable effort on their part. I am prepared to value the subject shares on a ``quasi- partnership'' basis; that is, what they were worth to someone working in the business and able to influence its direction and operations. But such a person would know that much of what was necessary to reach the desired result had yet to be done. A person buying the shares on this basis would pay twice over; he/she would purchase the shares on the basis of a tripling of profits and then have to put in the hard work necessary to achieve that result. A vendor of the shares would believe that the prospect existed but would realise the effort necessary to achieve it. The vendor would have to reduce the price to allow the purchaser some reward for effort. Bearing these matters in mind, it seems to me reasonable to assume that the hypothetical parties would negotiate on the basis of a prospective doubling of profits and goodwill value.
In relation to the capitalisation rate, I note that Mr Bagnall himself regards 10% as high. In
ATC 4984his original report, immediately after setting out his valuation, he stated:
``One would be hard pressed to justify such valuation by normal criteria, but allowance must be made for the extraordinary optimism that pervaded sharebroking between 1985 and the sharemarket collapse in October 1987, by which time the partners had disposed of their shares. In addition, the value is modest when compared with the value placed on the company's goodwill when the shares were sold, less than two years later.''
In cross-examination Mr Bagnall said that, at the time, the ``upper level of capitalisation'' for a private company was about eight times earnings (12½%); but there were exceptions, mainly when public companies bought out private companies. In those cases there was-
``a tendency to lift the price above return of eight times profits. With that background and the expectations shown in the estimates, the enthusiasm of the partners to go into the deal as they explained it to me, it seems to me that 10% was justified.''
I accept Mr Bagnall's general comments about capitalisation rates at the time and the opportunity of obtaining a better rate where a public company was buying a private company. But I see difficulties about applying those comments to this case. First, there is a danger of double-counting. The ``expectations shown in the estimates'' are already taken into account in doubling the anticipated profit figure and, therefore, the value of goodwill. Secondly, Mr Bagnall's comment pays no regard to the agreement that JFA purchase the subject shares at five times annual average profit in 1990; that is, at a figure that adopts a capitalisation rate of 20%. It seems inherently unlikely that anyone would purchase shares at ten times earnings knowing that he/she would be obliged to sell them at only five times earnings in only five years' time. Any prudent purchaser would make a calculation, along the lines of that made by Mr Lonergan, of the present value of the moneys he could expect to receive before, and upon, the acquisition of the shares by JFA. I have already set out Mr Lonergan's figures. If I double them all, to take into account the prospective doubling of profit, the total receivable amount, for a one eighth interest in the company, is $577,500, a figure less than Mr Bagnall's valuation of $661,500. But this sum would be receivable over five years. I think it too harsh to adopt Mr Lonergan's preferred discount rate (25.43%). However, even at the then Commonwealth bond rate of 15%, the present value of the $577,500 was only $287,120. This is very close to the figure ($270,000) reached by Mr Lonergan by adopting a capitalisation rate of 16.66% and a goodwill multiple of two. I think these are the appropriate figures and that it should be determined that the value on 7 November 1985 of a parcel of 75,000 shares in VEJF was $270,000. That equals $3.60 per share.
In the result, each applicant fails on his primary submission that the capital gain derived from the sale of his VEJF shares was not subject to tax. But each applicant succeeds in his challenge to the cost base adopted by the Commissioner. In each case the amended assessment should be set aside and the matter remitted to the Commissioner for re-assessment on the basis that the cost base of the subject shares at 7 November 1985 was an amount equal to $3.60 per share.
Having regard to the result, I think that the appropriate order concerning costs is that the Commissioner pay to the applicants one half their costs of the references, such costs to be taxed on the basis of the four references constituting a single matter.