Merkel J

Federal Court

Judgment date: 13 August 1997

Merkel J


On 23 July 1988 the applicants (``the taxpayers'') contracted to purchase, and on 4 October 1988 acquired, a vacant block of land at 6 Wyuna Court, Wheelers Hill (``the Wyuna Court land'') for the price of $146,000. The taxpayers intended, eventually, to construct on the land a luxury home which they proposed to rent. The issue arising on the taxpayers' appeal to the Court is whether the interest paid by the taxpayers, during the financial years ending 30 June 1989, 1990 and 1991, on the loan made to them to enable the acquisition of the land was deductible under s 51(1) of the Income Tax Assessment Act 1936 (``the Act'').

Background facts

At all material times the taxpayers conducted a jewellery business. In 1983 they acquired, as their first investment property, a building at 175-179 Sydney Road Brunswick which was tenanted by the Commonwealth of Australia. The acquisition was financed by a loan from the Bendigo Building Society (``the Society'') which was secured by a mortgage over the building (``the mortgage loan'').

By 1988, the taxpayers, who resided in Wheelers Hill, had become interested in acquiring, as a rental investment, a luxury home in Wheelers Hill. After they were unable to acquire a satisfactory home they decided to buy the Wyuna Court land. In May 1988, the taxpayers applied to the Society for a loan of $180,000.00, inter alia, to acquire the Wyuna Court land. In their application, the taxpayers stated that the purpose of the loan was:

``Extra loan on existing loan to reduce our income for taxation purposes.''

The loan application was approved. On 4 October 1988 the taxpayers' existing mortgage loan with the Society was increased by $180,000 which was applied, inter alia, to pay the purchase price for the Wyuna Court land. Interest was paid to the Society on both the original and the additional borrowing from the Society.

Later in 1988 the taxpayers decided to acquire a larger home for themselves in Wheelers Hill. On 25 November 1988 they agreed to acquire a residential property at 45 Coniston Drive for $540,000. The property was tenanted until July 1989. In December 1988 the taxpayers made a further application to the Society for an increase of $300,000 on their existing mortgage loan to enable the acquisition of Coniston Drive. In the application under the heading ``General Remarks'', the following statement, apparently written by an officer of the Society, appeared:

``Has bought home at 45 Coniston Drive Wheelers Hill for owner-occupation, + for tax reasons is mortgaging Sydney Road.''

The two comments on tax ``purposes'' and ``reasons'' to which I have referred suggest that, initially, the taxpayers thought that the interest may be deductible if paid on a loan secured by a mortgage over the Sydney Road property. At all events, I am satisfied from those comments and the evidence given by Mr Temelli that the taxpayers were acutely conscious of the tax implications of the proposed loans and the need for an investment or business intention of some kind if the interest paid on the additional loans made to them by the Society was to be tax deductible.

In about 1992 the taxpayers acquired, as a further investment, tenanted shops in the Wheelers Hill area.

The proposed luxury home on the Wyuna Court land was never built. Initial plans were prepared for the home, early in 1989, by an architect who was a family friend of the taxpayers. The first costing for the home was prepared in December 1992, but only after a tax audit by the Commissioner had raised queries about the deductions of interest claimed by the taxpayers in respect of the Wyuna Court land.

The taxpayers' evidence as to their intention to acquire the Wyuna Court land for rental purposes was challenged by counsel for the Commissioner.

I make the following findings of fact in respect of the Wyuna Court land:

  • 1. Prior to the acquisition of the land the taxpayers believed that the rental of a luxury residence in Wheelers Hill would be a desirable investment for them to make. The taxpayers had no prior experience of an investment of this kind.

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  • 2. The taxpayers acquired the Wyuna Court land as an investment with the intention that, eventually, a luxury residence would be built on that land for lease to an appropriate tenant. The taxpayers intended to finance the building by a further loan, the term and details of which remained to be determined. However, the taxpayers expected that the interest on the loan would exceed the rental that might be paid.
  • 3. Apart from forming a general impression as to the financial viability of the proposed investment the taxpayers did not at any relevant time prior, or subsequent, to the acquisition obtain any detailed information as to the financial feasibility of the proposed investment project. No information was obtained as to the project's cost, likely tenants or rentals, or as to the extent and cost of borrowings.
  • 4. The reason for the lack of enquiry as to the financial feasibility of the project was that that information was only necessary when the taxpayers decided to proceed with the building of a home on the land.
  • 5. At the date of the acquisition of the land in 1988, and at all relevant times thereafter, the taxpayers had not made a decision to proceed with the building of a home. The primary reason for leaving that matter in abeyance was the taxpayers' uncertainty as to the continuation of the Commonwealth's tenancy of the Sydney Road building. It was fairly clear to the taxpayers that their financial capacity to service the interest payable on the loan which would be necessary to proceed with the Wyuna Court project depended on the continuation of the Commonwealth's tenancy of the Sydney Road building. As a consequence the question of whether and, if so when, a residence was to be built by the taxpayers at Wyuna Court remained uncertain.
  • 6. When the Wyuna Court land was acquired any uncertainty as to its future development was not of concern to the taxpayers. They were confident that vacant land in the area would retain its value; the taxpayers believed that during the 1980s the value of vacant blocks in Wheelers Hill had increased in value from $30,000 to $150,000.

In my findings any references to the ``relevant times'' relate to the period commencing in early 1988 and concluding on 30 June 1991, being the end of the last of the three financial years with which the appeal is concerned.

The contentions of the parties

Counsel for the taxpayers contended that approximately $150,000 was borrowed by the taxpayers as part, and for the purposes, of the taxpayers' business of acquiring real estate for investment. As the borrowing was necessary to acquire the Wyuna Court land for rental purposes the taxpayers were, so it was said, entitled to claim the interest paid in respect of that borrowing under both limbs of s 51(1) of the Act.

Counsel for the Commissioner disputed that the taxpayers had the requisite purpose or intention but contended that in any event:

  • • there was not a sufficient nexus between any income earning activity in relation to the Wyuna Court land and the outgoings claimed to be deductible under s 51(1); and
  • • interest paid as a holding cost, prior to the land having any capacity to earn income, was an outgoing of capital or of a capital nature.

Certain other issues were raised in the original applications of the taxpayers but the parties agreed that if I accede to the Commissioner's contentions in relation to s 51(1) then it must follow that:

  • • the Commissioner has correctly disallowed the taxpayers' objections to the amended assessments in respect of the interest claimed in relation to the Wyuna Court land; and
  • • the applications of the taxpayers in respect of the years of income ended 30 June 1989, 1990 and 1991 are to be dismissed.

The law

In two recent decisions the deductibility, for income tax purposes, of interest paid and other holding costs incurred in respect of property acquired for future development was considered. In
Steele v FC of T 97 ATC 4239 and
Wharf Properties Ltd v Commr of Inland Revenue (Hong Kong) 97 ATC 4225; [1997] 2 WLR 334 the Full Federal Court and the Privy Council respectively held that such outgoings, at least to the extent that they were incurred as holding costs prior to the construction of the proposed development, were on capital rather

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than revenue account and therefore not deductible for income tax purposes.

In the present case the anterior issue to that which arose for decision in Steele and Wharf Properties is whether there is a sufficient nexus between the outgoing incurred and the relevant income earning activity.

In considering this question in Steele, Burchett and Ryan JJ referred at 4243 to:

``... the proposition that a sufficient connection, for the purposes of s 51(1), between an outlay and the prospect of income requires a degree of commitment to the relevant income producing activity: Inglis v FC of T 80 ATC 4001 at 4004, per Brennan J, at 4008, 4011, per Davies J; Softwood Pulp and Paper Limited v FC of T 76 ATC 4439 at 4450 et seq.; Goodman Fielder Wattie Ltd v FC of T 91 ATC 4438 at 4448; (1991) 29 FCR 376 at 387; FC of T v Brand 95 ATC 4633 at 4646, 4649.''

In Steele their Honours concluded (at 4243) that the taxpayer had the requisite ``commitment'' in respect of the acquisition of certain grazing land for redevelopment as a motel and townhouse complex because

``... she obtained the Council's assent to a change of zoning, employed architects and engineers, entered into joint venture arrangements, and pursued the project with some tenacity until litigation with her collaborator put a complete stop to it. She demonstrated her `commitment' from the beginning by committing $1,000,000 to the venture plus the time, energy and considerable expense of the subsequent architectural and engineering work, and negotiations with the local Council, sewerage authority and prospective joint venturers and financiers. The matters, of course, raise questions of fact; but it appears to us there is much to be said for the proposition that the Tribunal's own findings of fact, set out in the various reasons in telling detail, suggest it was not open to the Tribunal to find in this case a relevant lack of commitment.''

The existence of the requisite nexus or degree of commitment in a particular case is a question of fact. However, the decisions clearly establish that the intent of the taxpayer alone is not sufficient to establish deductibility for outgoings or expenditures that are not of themselves productive of income, but are intended to lead in the future to the production of income. As was said by Brennan J in
Inglis v FC of T 80 ATC 4001 at 4004-4005; (1979) 40 FLR 191 at 195:

``In the present case, the expenditure for which deductions were claimed may have been incidental or relevant to the preservation of Lammermuir as a pastoral property. But expenditure on or in connection with Lammermuir does not become expenditure incurred in gaining or producing future assessable income merely because the taxpayer intends in the future to use Lammermuir to produce assessable income. If a capital asset is not being used to produce assessable income, though it is intended for use in the future to produce assessable income, expenditure in merely preserving the asset until it is so used is not deductible. Rather, being expenditure upon a capital asset not employed in producing income, it has the character of a capital outgoing. The expenditure related to Lammermuir appears unconnected with any activity for the production of future income, and does not qualify for deduction under the first limb of sec. 51(1).

Whether any of the outgoings qualify for deduction under the second limb of sec. 51(1) depends upon whether a pastoral business was being carried on during the relevant years: `the outlay must have been incurred in the carrying on of a business, that is, it must be part of the cost of trading operations' (per Menzies J., in John Fairfax & Sons Pty. Ltd. v. FC of T. The carrying on of a business is not a matter merely of intention. It is a matter of activity. Yet the degree of activity which is requisite to the carrying on of a business varies according to the circumstances in which the supposed business is being conducted. Little activity may suffice for carrying on a business which does not call for much activity, as in Thomas v. FC of T and in Ferguson v FC of T. It must be remembered that `(b)usiness is not confined to being busy; in many businesses long intervals of inactivity occur', as Lord Sumner observed in South Behar Ry Co. Ltd. v. IR Commrs. In Southern Estates Pty. Ltd. v FC of T, where the High Court was concerned with the concept of a taxpayer `engaged in primary production on any land'

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(within sec. 75(1) of the Act), McTiernan J. found against the taxpayer, saying:

`I am of opinion that upon the widest construction of which the word ``engaged'' admits, a person who merely has an intention to carry on the business of primary production is not engaged in it. No work which the partnership did on the land per se amounted to the maintenance of animals, nor was proximate to such business. The purpose for which the work was done did not result in the partnership going into the business of primary production.'

On appeal, Barwick C.J. said:

`I am unable to read ``a taxpayer engaged in'' as satisfied by one of whom no more can be said than that he intends to engage in.'

Although this was a case under sec. 75, it was regarded as a relevant authority by Walsh J. when he was considering whether the taxpayer in Thomas' case (supra) was carrying on business as a primary producer.''

(Footnotes omitted).

See also Davies J at ATC 4008-4011; FLR 202-206.

Softwood Pulp and Paper Limited v FC of T 76 ATC 4439 at 4450 on a similar issue Menhennitt J said:

``Everything that was done in this case, up till the time when the project ceased, was in my view entirely preliminary and directed to deciding whether or not an undertaking would be established to produce assessable income.

The project had not reached anything like the stage of doing anything in the course of gaining or producing assessable income. All that had happened was that certain tests had been made to ascertain whether or not the project would be feasible. Certain technical information had been acquired and certain steps had been taken to ensure that if the project did go ahead, supplies of timber, electricity, water and the like would be available. But that is as far as the project got. I reiterate that no one was committed, at all, to go on with the project, neither MacMillan nor the taxpayer nor anyone else. Nothing was done even to prepare plans or specifications for a mill, on the part of the taxpayer. What was done by Sandwell was for purposes of obtaining quotes for testing purposes. No decisions or even tentative decisions were taken even as to plant and equipment. In other words, the project did not approach in any way a situation which could be described as being the course of gaining or producing income. It was all completely anterior thereto and in those circumstances, it appears to me that any losses or outgoings which were in fact incurred by the taxpayer were in the course of investigations to see whether the project would be feasible, and the course of steps to ensure that if it did start there would be available supplies, and indeed so far as MacMillan was concerned in the course of it making up its mind whether it would go on with the whole matter at all. But they certainly were not, in my view, incurred in the course of gaining or producing assessable income.''

On the second limb Menhennitt J said at 4451:

``However, as far as this case is concerned, it appears to me to be clear that for all the reasons I have given in relation to the first limb, the losses or outgoings here claimed by the taxpayer were not necessarily incurred in carrying on a business for the purpose of gaining or producing such income.

The critical point is that the company had not reached a stage remotely near the carrying on of a business. Even assuming that at some stage prior to the mill turning, the company could be said to be carrying on a business, in this case the company had not even approached the stage of making a decision about carrying on a business. All that had happened had been that certain investigations had been made to decide whether or not the business was feasible, and whether or not it was economically viable on a competitive basis, but nothing had been done which could be said to be carrying on a business or anything associated with or incidental to the actual carrying on of a business. Everything which was done was concerned with making a decision whether or not steps should be taken to set up a business, but no decision on even that matter had been reached.

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Accordingly, for those reasons I conclude that the taxpayer has not established that any part of the losses or outgoings claimed was necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.''

The requirement of the requisite degree of commitment to establish a sufficient nexus was also considered by Hill J in
Goodman Fielder Wattie Ltd v FC of T 91 ATC 4438 at 4447; (1991) 29 FCR 376 at 386-387 and by the Full Federal Court in
FC of T v Brand 95 ATC 4633 at 4646-4647 per Lee and Lindgren JJ and at 4649 per Tamberlin J.


The first issue arising as a question of fact is whether, in accordance with the principles to which I have referred, there is a sufficient connexion for the purposes of s 51(1) between the outgoings of interest and the prospective income producing activity from the Wyuna Court land, being the rental of a proposed luxury residence.

In my view the taxpayers did not have the requisite degree of commitment to the relevant income producing activity. At all relevant times until 30 June 1991 the issue of whether, and if so when, a residence would be built by them for income earning purposes remained to be determined. Pending that decision the payment of interest was a payment to preserve the land as a capital asset and, accordingly, was of capital or of a capital nature. Whilst it can be accepted that the acquisition of the Wyuna Court land and the preparation of plans early in 1989 is evidence of some commitment those steps fall short of a commitment to the income producing element of the project, being the building of the home. Further, although the evidence of a general intent to build a home for rental might also be accepted, even that evidence is undermined and weakened by the taxpayers' consciousness of the necessity for such an intent for tax purposes.

I am also not satisfied that, in June 1988 or at any relevant time thereafter, the taxpayers were conducting a ``business'' of investing in real estate. The taxpayers acquired the Sydney Road property in 1983. However, it was entirely speculative as to whether, and if so when, a further tenanted investment might be created or acquired by them. Further, the notion of building a luxury home for rental on vacant residential land is, in my view, so qualitatively different to the Sydney Road investment that it is not properly to be considered as part of a ``business'' in any event. In the present case, for the purposes of the second limb of s 51(1), the acquisition of the Wyuna Court land was a new investment project rather than the continuation or expansion of any existing business. Accordingly, in my view the claim under the second limb of s 51(1) fails, essentially on the basis of the same facts which led to the failure of the claim under the first limb.

The claim for deductibility of interest under s 51(1) must fail also for the reasons for decision in Steele and Wharf Properties. In each of those cases the respective claims for deductibility of holding, interest and development costs, incurred prior to the proposed investments having an income earning capacity, were held to be capital costs. In my view the relevant facts and tax deductibility issues arising under s 51(1) in relation to the Wyuna Court land are not relevantly distinguishable from each of these cases.

Accordingly, the applications by each of the applicants in respect of the years of income 30 June 1989, 1990 and 1991 are to be dismissed with costs.


1. The applications be dismissed.

2. The applicants pay the respondent's costs of and incidental to the Applications.

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