Hill J

Federal Court

Judgment date: 17 July 1996

Hill J

Mr Madigan is a beneficiary of the Madigan Family Trust of which Dotel Pty Ltd is the trustee. In the relevant years of income, namely the years ended 30 June 1988 to 1991 inclusive, he was entitled either to the whole of the income of that trust estate, or in any event to take in default of an appointment to any other beneficiary, the balance of the income of the trust estate excluding specific amounts payable to specific beneficiaries not presently relevant.

By notice of amended assessment the Commissioner of Taxation included in Mr Madigan's assessable income as his share of the tax law income of the trust amounts greater than those which he had originally returned. The effect was to increase his taxable income and the tax payable thereon accordingly. The amended assessments, in addition to imposing the further amount of income tax, also included penalties referred to in the notices of amended assessment as ``Additional Tax for Incorrect Return''. Mr Madigan objected to the amended assessments but his objections were disallowed. He now appeals to this Court against the Commissioner's objection decisions.

At issue between the parties is the deductibility in full of various items as set out in a table prepared by the Commissioner in respect of each of the years in question claimed to be deductible to the trustee in the computation of the ``net income'' of the trust estate under s 90 of the Income Tax Assessment Act 1936 (Cth) (``the Act'').

|  Deductions claimed by  |  1988  |  1989  |  1990  |  1991  |
|  Madigan Family Trust   |        |        |        |        |
| Accountancy Fees        |    835 |    987 |   1285 |   1405 |
| Insurance               |    581 |      0 |   1162 |   1340 |
| Land Tax                |   5360 |   5882 |   8775 |   5543 |
| Rates & taxes           |   5987 |   2590 |   2419 |   3295 |
| Repairs & Maintenance   |    945 |  39746 |  23845 |   6635 |
| Interest                |    472 |     72 |      0 |      0 |
| Cleaning & Gardening    |     60 |    652 |   3008 |    975 |
| Others                  |    156 |    397 |    334 |   4780 |
| Depreciation            |      0 |      0 |    197 |    197 |
| Security                |      0 |      0 |      0 |    513 |
| Strata                  |    653 |    648 |    655 |    816 |
| Total per return        |  15049 |  50974 |  41680 |  25499 |
| Disallow repairs        |      0 |  32347 |   7610 |      0 |
| Adjusted total          |  15049 |  18627 |  34070 |  25499 |
| % Apply to Castlecrag   |     85 |     85 |     85 |     86 |
| Amount for Castlecrag   |  12789 |  15832 |  28959 |  21929 |
| 25% Business            |   3197 |   3958 |   7239 |   5482 |
| Allow (Rent)            |   7800 |   7800 |   7800 |   7800 |
| Propose to Disallow     |   4989 |  40379 |  28769 |  14129 |

Initially there was an argument between the parties as to whether the amounts of repairs and maintenance disallowed in the 1989 and 1990 years respectively were on capital account or on revenue account. That matter is no longer at issue between the parties and it is conceded that the Commissioner correctly treated the amounts claimed in those years as being capital to the extent shown in the schedule above under the heading ``Disallow repairs''.

Two issues thus remained for determination before me. The first was whether the Commissioner was correct in reducing the deductions claimed to the amount of rent as shown in the schedule, or whether the Commissioner should have allowed in full the totality of the deductions. The second matter at issue was whether the additional tax imposed by way of penalty in the amended assessments was correctly imposed. At the end of the hearing the Commissioner conceded that that additional tax was incorrectly imposed and that in due course, whatever the outcome of the substantive tax in dispute, I should remit the assessment to the Commissioner to be amended by deleting the additional tax.

The relevant facts are not in dispute. They are to be found either in admissions made on Mr Madigan's behalf in the applicant's statement of facts, issues and contentions or in an affidavit filed by a Mr Blizard who is one of the directors of Dotel Pty Ltd.

From at least 1986 a house at 9 The Scarp, Castlecrag had been rented by the trustee to Mr Mark Madigan, Mr Madigan's father. In 1986 Mr Madigan would have been around 16 years of age. The rent payable was $150 per week. Mr Blizard was unable in his evidence to cast light upon the basis upon which this rent had initially been set because at the time he had not been a director of the trustee company. The rent of $150 per week continued in each of the four years in issue. It is common ground between the parties that the figure of $150 was approximately twenty-five percent of the market rental of the property. It is conceded for the applicant that:

``... the trustee had determined that each child of the said Mark Madigan being beneficiaries of the trust could have occupation use and enjoyment of the Castlecrag property without fee or reward because it constituted a trust asset and because it was in the trustee's power to remit the beneficiaries and/or any of them to do so. The rental charged to the said Mark Madigan was assessed by the trustee as a fair contribution for the area provided at Castlecrag to one resident for his portion.''

In an affidavit read without objection Mr Blizard said:

``In setting the rental of the house to the father at the rate of $150.00 per week, a rent which I believed (and my co-director concurred in my belief) was below market rental, I intended (and my co-director concurred) to provide accommodation to the father on advantageous terms. I believed (and my co-director concurred) that in leasing the house to the father, we would have a very good tenant who could be expected, not only to pay the rent, but to keep the house and its curtilage in the best possible condition and that this renting of the house to the father would also enable me and my co-trustee to avoid incurring the expense of engaging an agent to collect the rent and to supervise the tenant and the condition of the premises and the administration of a rent bond. The benefit so granted was at all relevant times restricted to the provision to the father of a residence at a

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low rental. The lease was granted to ensure that the trust derived consistent income.''

The affidavit evidence was a little inconsistent with Mr Blizard's oral evidence. In his oral evidence Mr Blizard indicated that the only discussions he had had in the time he was a director of the trustee with his co-director was merely to note that the rent in question was lower than market value. The oral evidence at least would leave me in some doubt as to whether there was any discussion as to the advantages of letting the house to Mr Mark Madigan because he would look after it.

Mr Blizard's co-director of the trustee company is a well-known Sydney solicitor. He did not give evidence. There is no doubt that he would have been well aware that without more it would have been a breach of trust, for which he as a director of the trustee company could be liable, to let a trust property to a tenant not being a beneficiary of the trust estate at a rental which was at a gross undervalue in comparison to a fair market rent. The only explanation that there could be for so doing was that the transaction would operate to the benefit of persons who were beneficiaries of the trust. Those persons were of course the children of Mr Mark Madigan of whom Anthony was the senior in age and who, it may be assumed, generally lived with their father. This is consistent with the admission contained in the statement of facts, issues and contentions, and leads me to the conclusion that in letting the house to Mr Mark Madigan at the undervalue the trustee had two purposes. One purpose was to provide a benefit in the form of accommodation to Mr Mark Madigan's children who were beneficiaries of the trust. The other purpose was to obtain assessable income in the amount of $7,800 per annum.

Although I have no doubt that Mr Blizard would have had in mind the fact that Mr Mark Madigan would clearly look after a property in which he and his children resided and which ultimately was held for the benefit of those children, I do not think that this was a matter which really affected the trustee in letting the property to Mr Madigan or affected the rent which Mr Madigan was called upon to pay. The reality of the matter was that the rent had been set before Mr Blizard became a director and the question of increasing it did not arise, although Mr Blizard and the co-director were aware that the rental was considerably less than market rental and had discussions from time to time to this effect.

It is the submission made on behalf of Mr Madigan that in these circumstances the Commissioner was obliged to allow as a deduction the totality of outgoings relating to the Castlecrag house, and was not permitted to apportion those outgoings as he did between what the Commissioner saw as an income earning purpose on the one hand and a non- income earning purpose on the other, allowing as a deduction twenty-five percent of the outgoings or the amount of the assessable income whichever was the greater.

It requires but a cursory perusal of the language of s 51(1) of the Act to reach the conclusion that the section permits, indeed in the appropriate case requires, an apportionment. Section 51(1) provides:

``All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.''

Thus a deduction will be allowable only to the extent that the positive limbs of the section are satisfied and will be denied ``to the extent to which'' the negative limbs of the section operate to disallow it. Two different kinds of item present themselves for apportionment in an appropriate case as illustrated by
Ronpibon Tin NL & Tongkah Compound NL v FC of T (1949) 8 ATD 431 at 436-437; (1948-1949) 78 CLR 47 at 58-59. Some items will be undivided items of expenditure which are capable of dissection into parts and others will involve a single outlay or charge serving indifferently the object of gaining or producing assessable income and some other object outside the scope of s 51(1). The expenditure in the present case falls within the latter category.

Counsel for Mr Madigan conceded that if the house property had been made available for the occupancy of a beneficiary without charge, none of the items in question could have been deductible at all. The submission was that once there was to be found payable a rental of a substantial amount (substantial as contrasted

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with insignificant or nominal), albeit that rental was only twenty-five percent of market value, there was as a matter of law no room for apportionment under s 51(1). In my opinion there is no such principle of law and no support for such a principle in the case of
FC of T v Janmor Nominees Pty Ltd 87 ATC 4813; (1987) 15 FCR 348 upon which counsel relied for this proposition.

In that case a trustee incurred interest on an arm's length borrowing used to purchase a house which was then let to the father of beneficiaries of a trust at commercial rates. In the circumstances of the case the Full Court of this Court rejected the approach of the Commissioner that the interest should be deductible only up to the extent of the rental received but no further. In that case no apportionment was permitted, albeit that the lease transaction was motivated by familial considerations.

Janmor Nominees depended wholly upon its own facts and particularly the fact that the rental transaction was on an arm's length basis. Both Fisher J (at ATC 4815; FCR 349) and Lockhart J (at ATC 4818; FCR 354) were at pains to point out that the purchase and lease of the property in question was carried out in a business-like way. Lockhart J (at ATC 4821; FCR 357), with whose reasons Jenkinson and Fisher JJ both agreed, rejected apportionment in that case while recognising the potential for it in other cases. His Honour said:

``... The mere fact that the interest payments exceed the receipts of rent cannot justify the severance sought by the Commissioner and reflected in the amended assessment.''

The present case is not one where the only relevant fact is the excess of the outgoings over the assessable income derived in the year of income. Had that been the only matter, the outgoings may well have been deductible in full. There is more to the facts of the present case. Here there is a rental struck at only twenty-five percent of market rental in circumstances where the only explanation for such a transaction is to be found in the relationship between those occupying the premises on the one hand and the trustee on the other, as reflected in the trust deed.

Deductibility under s 51(1) involves a matter of characterisation. What is to be determined is the essential character of the expenditure in respect of which a deduction is sought. In the ordinary case where premises are let out at an arm's length rent expenditure incurred in gaining or producing that rent would be seen objectively to be an allowable deduction. Such expenditure will have been incurred in, that is to say in the course of, gaining or producing assessable income in the nature of rent. To adapt the language of Menzies J in
FC of T v Hatcheft 71 ATC 4184 at 4186; (1971) 125 CLR 494 at 498 (and referred to by Lockart J in Janmor Nominees), the occasion of the outgoing would be seen in the rent which is being derived.

Matters of motivation or purpose will generally be irrelevant in determining the characterisation of an outgoing. But where the circumstances are such that the outgoings in question are considerably in excess of the assessable income derived, and furthermore it is known that the assessable income derived is but a small fraction of an arm's length assessable income, it will be necessary to consider the facts further to determine whether the outgoings in question are properly to be characterised as expenditure incurred wholly in gaining or producing assessable income or whether the expenditure in part should be characterised differently: cf
Fletcher & Ors v FC of T 91 ATC 4950 at 4957; (1991) 173 CLR 1 at 17 ff. Although that case merely concerned interest, the principles laid out in the unanimous judgment of all seven members of the High Court have application to the present facts.

The principles applicable are not new. Indeed they have been applied by single judges in two cases in the Supreme Courts of the States before taxation jurisdiction was conferred on this Court, as well as in cases in the Boards of Review. Thus in
FC of T v Groser 82 ATC 4478, Jenkinson J expressed the view that in a case where outgoings grossly exceeded assessable income and the assessable income was at a gross undervalue by way of a rent of $2 per week, an apportionment of outgoings should be made between what could properly be regarded as incurred in gaining or producing that rental and what could not be so regarded. However, on the facts of the case his Honour ultimately disallowed the whole of the deductions on the basis that the $104 per week received was in fact not assessable income.

FC of T v Kowal 84 ATC 4001, the property in question was rented to the taxpayer's mother for $10 per week when the

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commercial rent would have been $50 per week. An apportionment of outgoings was ordered so that eighty percent of the outgoings was found to have the relevant characteristic of having been incurred in earning assessable income with the balance being non-deductible. In the course of the decision reference was made to the well-known decision of the Full Court of this Court in
Ure v FC of T 81 ATC 4100, as well as the decision of Jenkinson J to which reference has already been made in Groser.

The decision of the Full Court of this Court in Ure, while distinguishable from the present case, is not uninstructive. In Ure the taxpayer had borrowed money at commercial rates of interest up to 12.5 percent per annum and on- lent them at 1 percent to his wife or a family company. He sought to deduct the whole of the interest. The Court held in the circumstances that it was necessary to apportion the interest outgoing between that which was properly regarded as incurred in gaining or producing assessable income and not of a private or domestic character, and that which had the necessary character of being incurred in gaining or producing assessable income. The leading judgment was given by Deane and Sheppard JJ who said (at 4108):

``In considering the deductibility, pursuant to sec. 51(1), of the interest paid by the taxpayer, it is important to be mindful of the fact that an outgoing which is claimed to have been incurred in earning assessable income is only deductible, pursuant to the subsection, `to the extent to which' it was so incurred and `to the extent to which' it cannot properly be characterized as being of a private or domestic nature. Where an outgoing was partially so incurred or should be partially so characterized, the subsection requires apportionment between what, not being of a private or domestic nature, should properly be regarded as incurred in earning the assessable income and what should not.

The fact that money is re-lent at a lower rate of interest than the rate at which it was borrowed does not necessarily mean that the liability to pay the interest cannot properly be seen as having been incurred wholly in earning the assessable income and as being of neither a private nor domestic nature....

In the present case however, there is neither suggestion of miscalculation or lack of business understanding nor suggestion of anticipation or hope of income being derived by the taxpayer either in another form or by way of interest at a higher rate.... The explanation of the lending at the lower rate is to be found in private and domestic considerations.''

The same can be said here. The fact that the outgoings exceeded the rent is of itself, as Janmor makes clear, not of great significance. The fact that the rental received was not identical with market value might also not preclude the deduction of the outgoings. For example, a property may be let to a good tenant at a lower than market rent on the basis that the tenant will look after the property. The mere fact that the rental is thus below market rental will not preclude deductibility of the whole of the outgoings. But where the circumstances are such that the explanation for the low rent lies in the private relationship which the persons occupying the premises have to the trustee, it is not possible to say that the whole of the outgoings have the character of outgoings incurred in gaining or producing assessable income. The explanation is to be found rather in private or non-income earning considerations.

Accordingly, in my view, the case was one appropriate to apportion. No submissions were made that the apportionment was calculated on an incorrect basis. Indeed it was conceded that if an apportionment was at all possible it had been correctly made.

I would therefore set aside the objection decision in respect of the additional tax by way of penalty as conceded by the Commissioner but not otherwise. As both parties were in part successful in the proceedings, I am of the view that there should be no order as to costs.


(1) Appeal allowed in part.

(2) Objection decision set aside and in lieu thereof it be ordered that the applicant's objection to additional tax by way of penalty be allowed but that otherwise the assessment be confirmed.

(3) No order as to costs.

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