CASE 48/97
Members:J Block SM
Tribunal:
Administrative Appeals Tribunal
J Block (Senior Member)
The Applicant sought the review of a decision by the Respondent dated 21 July 1995 disallowing an objection dated 2 March 1995 against the Applicant's tax assessments for each of the income years ended 30 June 1989, 1990, 1991, 1992 and 1993.
2. The Respondent was represented by Mr J. Davis of the Australian Taxation Office. The Applicant appeared personally throughout the hearing; written argument was prepared and submitted after the conclusion of the hearing by Mr Roger Hamilton of Counsel on behalf of the Applicant. The Tribunal received into evidence the T Documents filed under section 37 of the Administrative Appeals Tribunal Act 1975. In addition, the Tribunal accepted into evidence exhibits tendered by both parties; references to exhibits in this matter are confined to those which are most relevant or which were most often referred to, and being in particular:
- (a) Exhibit A1 - additional material presented to the AAT on 3 March 1997. This exhibit consisted of 15 separate documents; Exhibit A1.3 is entitled ``Reconciliation of $115,000 Common- wealth Bank loan''; Exhibit A1.6 is ``[V] Creditors details''; Exhibit A1.9 is an ``Invoice details listing showing sale of consumables to [E Co.]''.
- (b) Exhibit A7 is a letter dated 18 September 1990 from Westpac Banking Corporation to the Applicant approving an overdraft facility of $5,000.
- (c) Exhibit A13 consists of additional material tendered by the Applicant at the resumed hearing on 19 May 1997.
- (d) Exhibits R1 and R3 are documents relating to the reinstatement of B by the Australian Securities Commission.
ATC 502
Transcript references will be referred to by the abbreviation ``TS'' preceded by a number which refers to the date on which that Transcript was recorded, while the number after each reference to TS is a reference to the relevant page of the transcript. For example, ``3/3/97TS121'' refers to page 121 of the Transcript for 3 March 1997. These Reasons contain a number of extracts from the evidence, and there are also references to documents, all of which have been edited so as to preserve anonymity; edits are indicated by square brackets.
3. Shareholdings in the relevant companies:
There are two private companies associated with the Applicant which are relevant for the purposes of these Reasons.
A company which is referred to as ``B'' was incorporated or acquired ``as a vehicle for the private investments'' of the Applicant. Its twenty issued shares were originally held as to 95% (19 shares) by the Applicant and as to 5% (one share) by the Applicant's then wife; (see T Documents page 2). B was apparently the trustee of a family trust; however that trust was at some point in time wound up, although there was no evidence as to precisely how and when this was achieved.
A second company, which is referred to as ``V'', was incorporated or acquired as a trading company. Its 100 issued shares were originally held as to 51% by the Applicant, 48% by B as trustee for the Applicant's family trust previously referred to, and as to 1% by the Applicant's then wife; (see T Documents page 2).
Subsequently, and in accordance with an agreement reached between the Applicant and his former wife, she transferred her shares in each of B and V to the Applicant's son. In consequence of such transfers, the issued shares in V were held as to 51% by the Applicant, 48% by B (originally, although not thereafter, in a trust capacity) and as to 1% by the Applicant's son (T Documents page 272). In turn, B's issued share capital was held as to 19 shares by the Applicant and as to one share by the Applicant's son. The evidence before the Tribunal indicated in relation to two dividends distributed by B (referred to later in these Reasons) a different capital structure for B but these documents were plainly incorrect.
The Outline of Applicant's Arguments (``the Outline'') submitted to the Tribunal on 7 July 1997 includes a contention that the one share in B held by the Applicant's former wife, and subsequently transferred to his son, was in fact held as a nominee for the Applicant; that submission was later withdrawn in the ``Reply to Commissioner's Response'' (the ``Reply''), submitted to the Tribunal on 4 August, 1997 and correctly so in the view of the Tribunal since this allegation was never at any time raised in the hearing.
4. V operated in the early 1980s as a supplier of computers, software, recruitment and consulting services. In April 1985, an agent employed by V in Indonesia defrauded the company of about $US50,000. To accommodate this loss, V secured additional working capital from the Westpac Bank in the form of a facility, dated 26 April 1985, in respect of an overdraft of $30,000 and a term loan of $50,000 (4/11/96TS19). After incurring trading losses in each of 1986 and 1987, V required further funds in order to repay the Westpac loan. In 1987, the Commonwealth Bank of Australia (``CBA'') advanced to V a combined business loan and overdraft facility of $90,000; (see T Documents pages 88-89).
V's trading problems were exacerbated in March 1988 when a major creditor, ``BR'', reduced its trading terms from 90 days to 30 days. By 30 June 1988, V owed $83,192 to creditors, apart from its outstanding indebtedness to CBA (Exhibit A1.6). It was apparent that V could not continue trading with a reasonable expectation of being able to pay its debts within agreed payment terms. The Applicant did not wish to liquidate V, stating:
``The Applicant: I chose to keep the - the entity going and pay off some of the creditors. I chose to keep it - a company alive that I'd - I put eight years into.''
(4/11/96TS86, In 26-33)
``The Applicant: as guarantor for [V] then in the event that [V] was unable to meet its debts I had to meet - repay the loan to the bank, which is what situation it was in.''
(3/3/97TS115, In 13-15)
The following letter dated 1 July 1988 was sent to V's creditors by the Applicant's accountant, referred to as ``AM'' (T Documents page 363-364):
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``1st July, 1988
ALL CREDITORS IN THE MATTER OF [V] TRADING AS [L]
On an investigation of the books & records of the above it appears that the company is insolvent and is unable to continue trading in accordance with the companies code.
Due to a re-organisation of the business the directors are confident they can operate profitably.
Since [V] is unable to continue trading it is proposed that an associated company [B] trade as [L] and pay a royalty for the use of [ V's] mailing lists and goodwill. The charges to [B] are to be a fixed charge of $200 per month for services rendered and a 4% royalty on sales. In this way income will be generated by [V] which will be tax free (due to accumulated losses) and will be available in its entirety for equal distribution to creditors.''
A meeting of creditors of V was held on 25 July 1988, in order to consider the letter by AM and the proposals contained in it. Approximately one half of V's creditors did not attend the meeting, and the proposals were not accepted (4/11/96TS33). A creditor who is referred to as ``TM'' was V's largest creditor, with a claim of $19,766 as at 30 June 1988. It was never repaid in whole or in part because, in the Applicant's words, ``they never pursued it'' (4/11/96TS35, In 12). V's second largest creditor, ``BR'', had a claim in an amount of $13,930 as at 30 June 1988; it had the benefit of a guarantee by the Applicant and in monthly instalments received payment of its claim; indeed final instalments were paid after the commencement of the hearings; (Exhibit A1.6).
Although creditors of V did not approve the proposal by AM dated 1 July 1988, it was nonetheless proposed that certain assets of the business conducted by V (and being inventory and debtors) should be transferred to B. According to the Applicant:
``The Applicant: [AM], who was preparing the accounts of [V] and [B], said: the Trust has effectively ceased in 1985, why don't you use [B] trading in its own right to take over the business and continue on. The alternative was to put [V] into liquidation....
Mr Block: Because [B] is clean? - The Applicant: Yes. [B] at that point had zero debts and $20 assets so it was absolutely clean.''
(3/3/97TS119, In 14-17, 31-31)
The following document entitled ``Draft Agreement'' between B and V was prepared by the Applicant; (T Documents page 253):
``DRAFT AGREEMENT
between
and
Both companies registered in the state of New South Wales
Whereby:
1. wishes to acquire the trading assets and business of .
2. wishes to retain equity in certain intellectual property.
It is hereby agreed:
3. will acquire the inventory and trade debtors of as at 30 June
1988 at book valuation;
4. will acquire the right to use the trading name of and to have
unfettered and exclusive access to the clients and suppliers of ;
5. will acquire the right to use all software programs designed and
developed by ;
6. will provide advice and guidance in the use of such software and
such marketing support as is requested by [B] during the life of
this Agreement;
In consideration thereof:
7. agrees to pay to [V] a licence fee of $500.00 per calendar
month;
8. agrees to pay to [V] consulting fees of $500.00 per calendar
month;
9. agrees to pay a royalty of five (5) pre centum of sales
achieved;
This Agreement will terminate in five (5) years from this date or in the
event that either party is liquidated or placed under a scheme of
administration.
Dated at Sydney this first day of July 1988.
........................ ........................
For and on behalf of For and on behalf of ''
There was no evidence before the Tribunal as to whether the Draft Agreement was in fact executed and stamped. It seems that at least as between V and B, and however informally, the inventory and debtors of V were treated by the Applicant as having been made over to B in consideration of an aggregate amount of $33,000, and that V retained certain intellectual property; (4/11/96TS30-2).
5. The 1989 Commonwealth Bank Loan:
In March 1989, the Applicant received a loan from CBA in an amount of $115,000. That loan which is referred to as the ``1989 loan'' was made to the Applicant personally because CBA was not prepared to make a loan facility available to V.
The 1989 loan was refinanced by subsequent loans, all made to the Applicant. Accordingly, the deductibility of interest on the 1989 loan is a central issue in this matter.
CBA informed the Applicant that the loan was:
``a Personal Credit line of $115000 to takeover the debts of [V] and provide for working capital for your new business''
(T Documents page 79).
A diary note by a Senior Loans Officer of CBA, ``LK'', on 8 March 1989 stated:
``[The Applicant] called by appointment to discuss transferring the above loans to his own name. Company has now disbanded and he is now working for [E Co.] as a Logistics Manager. He also requested a Small Loan to assist with his new family Company [B] Pty Limited.''
(T Documents page 81)
The Applicant contended in the Outline that the loan officer's description of the process was simply a lay person's description of what the end result would be, and not of the actual process. In the Reply, however, the Applicant agreed that the diary notes were written by LK after personally meeting with the Applicant. In addition, an Internal Memorandum, dated 17 March 1989 and written by the Manager of the Applicant's branch of CBA, stated:
``We advise that a P/C/L of $115000 was recently approved to [the Applicant] to takeover the debts of [V]''
(T Documents, page 78).
Another document prepared by CBA on 13 July 1990, after further meetings with the Applicant, stated:
``[V] is now virtually non trading, its debts having been taken over by [the Applicant] to his personal name.''
(T Documents page 83)
As no evidence to the contrary was adduced, the Tribunal does not accept the Applicant's contention, and holds that the Bank applied the funds as recorded by LK in her diary notes.
The exact path taken by these funds through the relevant entities and being the Applicant, B and V was a source of confusion throughout the proceedings. But this confusion resided only in the records and the minds of the Applicant and his tax agent; to CBA, the purpose of the loan was clear: it lent $115,000 personally to the Applicant from which it immediately recovered the remainder of the outstanding debt owed to it by V (see Exhibit A1.3).
Conflicting accounts prepared by the Applicant and his tax agent, a professional accountant who is referred to as ``M'', make it almost impossible to reconstruct the intended course of the loan through the Applicant's companies before CBA was repaid. Exhibit A13.8 is a ``personal note prepared for discussion with manager of CBA in March, 1989 re [V] restructuring'' and was admitted at the resumed hearing on 3 March 1997. It records, inter alia, that:
``Proposed
[Applicant] borrows $125,000
ATC 505
Purchases shares in [B]
[B]: 1. Pays [V] for stock and furniture - 25,000
2. Loans [V] 75,000 to discharge Com Bank
3. Invests $25,000 in securities.''
(Exhibit A13.8)
Mr Davis argued, and the Tribunal agrees, that the Applicant failed to prove either the veracity of the contents of this handwritten proposal or that it was ever used in discussions with the relevant officers of CBA. At the time of the grant of the 1989 loan, V was indebted to CBA in an amount of nearly $110,000. It is thus clear that the only amount of free capital available from that loan for any purpose (whether working capital or otherwise) was approximately $4,000, and that was the amount made available by CBA.
The Applicant contended that the 1989 loan was applied as to $10,500 paid directly to V, while $102,322 was received by the Applicant and onlent interest free to B, and used by B to pay V for the business assets acquired on 1 July 1988 (T Documents pages 276, 326; 4/11/96TS94).
The Applicant contended further that B acquired trade debtors for $18,347 and inventory for $13,085, aggregating at $31,522, (which does not fully accord with the amount of $33,000 referred to previously), and that in respect of the balance of the available funds, $63,800 was lent by B to V leaving a balance of $4,000 as working capital in B; (T Documents page 3, 276, 326; 4/11/96TS94; 3/3/97TS108).
This breakdown does not however appear to accord with Exhibit A1.3, also tendered by the Applicant, which reads as follows:
``RECONCILIATION OF $115,000 CBA PERSONAL CREDIT LINE DISBURSEMENTS
Account Number [1] -- [the Applicant] Personal Credit Line
$ $
14-Mar-89 0.00 Opening Balance:
14-Mar-89 36388.33 36388.33 DR Transfer to [V] Small Business
Loan a/c no. [2]
14-Mar-89 73696.96 110085.29 DR Transfr (sic) to [V] Fully Drawn
Loan a/c no. [3]
14-Mar-89 4914.71 115000 DR Transfer to [the Applicant] Cheque
a/c no. [4]
14-Mar-89 115000 DR Closing Balance
Account Number [4] -- [the Applicant] Cheque Account
$ $
14-Mar-89 0.00 Opening Balance:
14-Mar-89 4914.71 CR 4914.71 CR Transfer from a/c no. [1]
14-Mar-89 170 4744.71 CR Loan Charge
15-Mar-89 4000 744.71 CR Transfer to [B]
21-Mar-89 46.4 698.31 CR Loan Stamp Duty''
The Applicant in his evidence accepted that the overall effect of the 1989 loan was that it enabled V to repay the remainder of its 1987 loan from CBA, leaving only a small balance retained by the Applicant amounting to approximately $4,000. See in this context the following extracts from the Transcript:
``Mr Davis: If I can just recap there was $115,000 from the bank? - The Applicant: Mm.
Mr Davis: The bank took 110 and included in that was the loan from [B] to [V] for 75, the balance of $35,000, which is the purchase of assets. Then there must be another 5,000 which is what [the Applicant] retained from 115. So the total of all those will come to 115.
Mr Block: Did you follow that? - The Applicant: Yes, and that's the - a detailed breakdown which I provided to you here. That's the reconciliation of the loans.
Mr Davis: But the effect of all this is that the bank gets its money back. What you are questioning is whether it should have been reflected - all you are really talking about it (sic) book entries, are not you? - The
ATC 506
Applicant: That's correct, yes.''(3/3/97TS109-110)
``Mr Block: ... to say that you lent [B] which in turn lent [V] money, well, I suppose on a book entry basis is arguably right but in fact all that ever happens is the Commonwealth says; we will lend you 115, we are owed 110, so you can have five. Would you agree with that, is that accurate? - The Applicant : Yes. That's accurate.''
(3/3/97TS122)
``Mr Davis: If the bank took the $110,000 there is no way that you could lend that money to B because the bank had already taken it. It was not there to put into B to lend back to V? - The Applicant: Well, we could've done - we could've done a round robin of cheques and paid stamp and all that on it, well, the net result is the same, it's all done through journal entries.''
(3/3/97TS128)
In summary on this point, the Tribunal finds as a matter of fact that of the 1989 loan, only $4,914.71 was retained by the Applicant and that the balance was used to discharge V's indebtedness to CBA.
6. During the years 1988 to 1990, further amounts aggregating $18,000 were lent progressively to the Applicant from the Bank of New Zealand and the Royal Bank, (and in respect of the Royal Bank in an amount of $4,000), and onlent by the Applicant to B; computer statements detailing the Bank of New Zealand account were tendered as Exhibit A1.2; (see also T Documents page 276; 4/11/96TS44). The Tribunal did not receive evidence as to how these loans were utilised, the Tribunal notes however that as set out in the Outline, the Applicant does not claim a deduction in respect of the Bank of New Zealand loan.
On 2 August 1990, the Applicant refinanced his outstanding debts to both CBA and Bank of New Zealand by securing a Westpac commercial bill facility of $132 000 (T Documents page 327); on 18 September 1990, Westpac approved an overdraft facility of $5,000 to assist the Applicant with the clearance of his debts (see Exhibit A7).
7. The Applicant's conflicting company loan accounts:
The Tribunal was presented with conflicting evidence as to the amounts of the Applicant's personal loan accounts in relation to B and V. Accounts (``the accounts'') prepared by M in relation to V's tax return for the year 1989 showed, under ``current liabilities'', a loan account of $104,932 owing by V to the Applicant; (see T Documents page 142). M informed the Tribunal that he and the Applicant had erred in the preparation of these accounts, and gave evidence as to how the mistake was made:
``Mr Block: if I asked you this question, are those returns correct, what would you answer me? - M : At - at the time that I prepared those returns, yes, they were correct, yes.
Mr Block: Were they signed as correct? - M : They were signed as correct as well.
Mr Block: Am I now to understand that you are now saying that they are wrong? - M : Well, subsequent to doing returns, at the time that I did the returns I hadn't the full history that I've now got through reading the meetings from November last year and getting the full history of -
Mr Block: You mean the hearing, the transcript of the hearing? - M : Well The hearing, yes, yes.
Mr Block: So, what you are now saying is that in the light of the transcript of the hearing, and you read the whole of the transcript? - M : Well I did, yes.
Mr Block: In the light of that you now think that you have got it wrong? - M : Well In - in respect of the loan accounts, in respect to the income and expenses that's - that still remains correct.
Mr Block: They are right, right? - M : Well It's just in respect of the loan accounts.
Mr Block: But it is not only you who got it wrong, is it, it is you and [the Applicant]? - M : Yes, because at the time when we prepared the returns I think we both went through that we had it right and thought they were prepared as such. But subsequent to that really what should have happened with [ V] there should have been a credit loan account in [V] to [B] and in [V] accounts there should have been a debit loan account to [B] but in fact what had happened when I prepared the returns for [V] and [B] there was no inter-loan account done at all, it was
ATC 507
all credited to the credit balance of [the Applicant].''(3/3/97TS153, In. 9-31)
``Mr Block: So, sorry, page 142 is in your handwriting, not [the Applicant's]? - M : No, but I've - I've taken my draft - I've taken my tax return from his draft set of accounts that he prepared, that was the initial year. Subsequent to that all - all other years have in fact been done off the - flowed through the bank statements themselves. But the '89, [the Applicant] had already prepared a draft set of accounts and I used that as the basis to prepare the '89 return.''
(3/3/97TS155, In. 8-13)
A balance sheet (the ``balance sheet'') for B as at 30 June 1989 is contained in T Documents pages 286; see also page 288; 4/11/96TS77-78. The balance sheet was apparently confirmed by B on 13 September 1989, although the Applicant stated that this was a ``notional'' date, and that the meeting was not held on this date (3/3/97TS137).
The balance sheet and the accounts differ substantially as to the Applicant's claim. Reduced to its essentials, the Applicant had, pursuant to the accounts, a substantial claim (in excess of $100,000) against V. By contrast, the balance sheet records a substantial claim of a similar amount against B, while B in turn had a claim against V in an amount of $69,436; (see T Documents page 288; 4/11/96TS79).
The accounts in effect accord with the utilisation of the 1989 loan, namely that it was used almost entirely to discharge V's indebtedness to CBA; this being so, the Applicant would have a corresponding claim against V. The Applicant's argument is that he received the funds from CBA and onlent them to B which utilised them in part to pay for the assets acquired from V, and in part by way of loan to V.
The Tribunal considers that the conflict between the accounts and the balance sheet should be resolved in favour of the accounts which were prepared by M, a professional accountant; the balance sheet by contrast seeks to record a flow of funds the veracity of which is doubtful. It seems likely that the Applicant sought to reconstruct the loan account so as to reflect it against B rather than V since to do so offered to give him a better chance of deductibility. The Tribunal does not accept M's explanation of error, having regard to the fact that between the preparation of accounts and his claim of error he had read the first day's Transcript.
Having regard to section 14ZZK of the Taxation Administration Act 1953, the Tribunal considers that the Applicant contends for a flow of funds which is not borne out by the facts, because he thought (by way of afterthought) that the flow of funds reflected in the balance sheet offered a better prospect of deductibility.
8. Trading activities of V:
Between 1 July 1988 and 1 July 1989, the Applicant has stated that V was ``fully dormant for a year'', whereas B continued to run the hardware and consumables business during this time; (4/11/96TS47).
Whatever the legal effect of the Draft Agreement, several of its features were subsequently adopted as between B and V. From July 1988, V provided consulting services to the client base of B which had commenced trading as ``L''; and V apparently received income from royalties, consulting fees and rent paid to it by B (4/11/97TS62).
There was no clear evidence before the Tribunal as to how and to what extent V's creditors received payment. TM received nothing at all, while BR was paid in full by the Applicant personally. The Draft Agreement does not in its terms provide for any assumption of V's liabilities by B.
From 1 July 1989, and in consequence of the termination of his full-time employment, the Applicant resumed work for V. By providing consultancy services on the acquisition of computer hardware systems, V was able, according to the Applicant, to generate funds which were used to repay some of its debts. In October 1989, V's consultancy services were ceased and V, in the Applicant's words, ``effectively disappeared from there'' (4/11/97TS57).
Ultimately, as the Applicant stated, V was never able to derive any income:
``Mr Block: Remember that your case depends on your being able to establish to the satisfaction of the Tribunal that there is a sufficient connection between the loan and the derivation of income. Now, the question is income from where. One thing is sure, there was not ever, right up until today, any income from [V], is that not so? - The Applicant: This is correct.''
(4/11/97TS49)
ATC 508
[see also CBA diary notes referred to in paragraph 5].
V was deregistered by the ASC on 24 June 1993 for failure to comply with certain reporting obligations (see T Documents pages 367-368). The Applicant stated that he does not intend to seek to have V reinstated as the software which is its major asset is now essentially valueless (4/11/96TS60).
9. Trading activities of B:
From 1 July 1988, B continued to trade as a reseller of computer supplies, and secured additional revenue by procuring a tenant for a subdivision of its office space and by providing office services (4/11/96TS54-55,71-2; T Documents page 175). B was deregistered by the ASC on 24 June 1993, also for failure to comply with certain reporting obligations (T Documents page 365). On 18 November 1996, the Supreme Court of New South Wales, on the application of the Applicant, ordered that the registration of B be reinstated pursuant to Section 574(3) of the Corporations Law; (Exhibits R1 and R3).
There was conflicting evidence as to whether B's 1988 tax return had been, or should have been, lodged, and as to whether the failure to lodge such a return would cause the ASC to again seek to have that company deregistered. The Tribunal accepts that B had been reinstated by the time that the hearings had concluded.
10. Income generated by V and B:
In January 1994, Company Income Tax returns of each of V and B for the years 1989 to 1993 were prepared by M. The income and losses of V and B, as well as their combined profit or loss for each year, are shown below:
+---------------------------------------+
| | V | B | Combined |
|---------------------------------------|
| 1989 | $10,238 | ($16,657) | ($6,419) |
|---------------------------------------|
| 1990 | $14,485 | ($13,971) | $514 |
|---------------------------------------|
| 1991 | $13,854 | ($13,626) | $228 |
|---------------------------------------|
| 1992 | $13,978 | ($11,602) | $2,376 |
|---------------------------------------|
| 1993 | $12,133 | ($11,032) | $1,101 |
+---------------------------------------+
The Applicant stated in evidence that B continued to trade after its deregistration, and that it made a profit of $1859 in 1994, and an interim profit of $1556 for the first half of 1995 (4/11/96TS63).
11. Dividends distributed by B:
The Directors Report of B, dated 30 September 1993, declared that:
``2. Dividends paid since the end of the previous financial year:
Included in a previous report $0.00
Not included in a previous report, nil.
The directors recommend that an interim dividend of $13.00 per share (total amount of $1300.00) be paid out of the results for the current (93-4) financial year.''
(T Documents page 312; see also pages 264, 323)
The Directors Report of B, dated 30 September 1994, declared that:
``3. Dividends paid since the end of the previous financial year:
Included in a previous report $1300.00
Not included in a previous report, nil.
The directors recommend that an interim dividend of $10.00 per share (total amount of $1,000.00) be paid on March 31, 1995 out of the results for the current (94-95) financial year.''
(T Documents page 319)
The Applicant also gave evidence as to why these dividends were paid:
``Mr Block: And what made you want to distribute dividends out of these companies, what motivated you - out of [B], I should say, bearing in mind that if you analyse [ B's] accounts, its accounts for 1994 and 1995 would show an overall loss? - The Applicant: Certainly but it - was cash flow positive and it had cash sitting idle in the bank and there was no other use for it at that time and my son said: give me some money, dad, so.
Mr Block: But why would you give it to him - it seems odd that you would distribute the money by way of dividend, an unfranked dividend at that, when you would both have to pay tax on it. Were you receiving any accounting or other professional advice? - The Applicant: No.''
(4/11/96TS63, In 25-34)
``Mr Block: It is rather an odd way of going about getting your son $65 and $50? - The Applicant: Well, no it's not when you consider his elder brother - there are two sons, one who is a - is a trader in the share market and generates dividends and profits
ATC 509
and whatever and the other was in a - living with me and getting no benefit, I guess, and - having given him the shares -''(4/11/96TS63, In 20-24)
``The Applicant: I think there was a psychological element in this, having busted my butt for five years to get the company profitable, I wanted to prove to myself and to my son that it was. I guess that's probably the only rationale you could give to it. It's been a long haul.''
(4/11/96TS65, In 4-9)
As at all relevant times there were 20 issued shares in B, dividends of $13 per share and $10 per share would not have amounted to total amounts of, respectively, $1300 and $1000. Furthermore, B's creditors ledger shows that the Applicant was credited with interim dividends of $1235 on 31 March 1994 and $950 on 31 March 1995 (T Documents page 276). These accounts treat the Applicant as holding 95 rather than his actual 19 shares in B and were, as the Applicant admitted, erroneous (19/5/97TS22, In 6-9):
``Mr Block: So the maximum [the son] could ever have got by way of dividend was $10 and $13? - The Applicant: That is correct.
Mr Block: And the maximum you would have got is 19 times 10 and 19 times 13? - The Applicant: 13, that's correct.''
The dividends were declared at a time when B was deregistered and the control of the company had been vested in the ASC. Moreover, in the tax return prepared for B for the year ending 30 June 1996, no dividends were recorded (see Exhibit 1.7). Furthermore, paragraph 9 shows that B's accounts record an overall loss at the time that these two dividends are said to have been paid.
In response to these anomalies in the payment of B's dividends, the Applicant stated:
``The Applicant: The question was raised, how could [B] pay a dividend when it had accumulated losses and I accept this is a valid point as also I accept that there are errors in the way that it was treated in the account. Nevertheless the amounts were paid which otherwise could have been recorded as directors' fees and they were declared in my tax returns for the period. So I did in fact derive benefit from [ B].''
(19/5/97TS63 In 13-18)
The following are the notes written by an ATO representative after a telephone conversation with the Applicant's tax agent on 17 October 1994:
``I asked T/A where the dividend income was that he referred to in the objection letters as the tax rtns show no dividend income.
T/A stated that he was referring to the potential to pay dividend income when the company turned the loss into a profit.
He also said that he thinks in 93/4 that the company did pay dividend income.''
(T Documents page 120)
There is as set out previously some degree of confusion as to the dividends. There is a discrepancy between the aggregate amounts shown and the amounts at $13 per share and $10 per share respectively which would have been shown in relation to the correct capital structure of B. As to whether B had a capacity legally to pay any dividends at all is open to some doubt. The Tribunal does not accept the Applicant's explanation as to why the dividends were declared, namely, a desire to put small amounts into the hands of one of his sons, especially considering the tax effect from his own point of view. The Tribunal considers that the Applicant is likely to have been motivated by consideration of the interest deductibility of his various loans.
12. In summary, the Tribunal was presented with two conflicting sets of accounts. According to the first set, prepared by M, the proceeds of the 1989 loan were used directly by the Applicant in order to discharge V's indebtedness to CBA. According to the second set of accounts, prepared at a later time by the Applicant and recorded in the balance sheet, the proceeds from the 1989 loan were onlent to B, which were then used in part to pay for the assets acquired from V, and in part by way of loan to V. For the reasons stated above in paragraph 7, the Tribunal does not accept the veracity of the second set of accounts and considers the true course of events to be that as reflected in the first set of accounts.
The characterisation of the claimed outgoings is therefore to be determined on the basis of the version of events as recorded in the first set of accounts. Nonetheless, as the main thrust of the Applicant's legal argument depended upon the second set of accounts it is perhaps appropriate
ATC 510
for the Tribunal to also consider the legal consequences of the second set. As it shall be seen, it is the Tribunal's view that the legal result is the same on both sets of accounts.13. Section 51 of the Income Tax Assessment Act 1936 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''
(emphasis added)
The Applicant relies in the present case upon the first limb of s. 51(1) as emphasised; it was also agreed between the parties that the exclusionary provisions of the section are not applicable. This being so, the issue between the parties is whether the outgoings of interest payable under the 1989 loan and subsequent loans were incurred by the Applicant in ``gaining or producing the assessable income''.
In relation to the subsequent loans, it should be noted from the outset that the Applicant acknowledged that each of the Westpac, Royal Bank and BNZ loans were used to retire his previous borrowings. The deductibility of the interest repayments under the subsequent loans will therefore depend on the deductibility of the original 1989 loan: per Hill J in
FC of T v JD Roberts; FC of T v Smith 92 ATC 4380 at 4388 (... ``the character of refinancing takes on the same character of the original borrowing...'').
14. Characterisation of the outgoing based on the first set of accounts:
Deductibility under s. 51(1) requires the identification of the essential character of the expenditure to determine whether it is an outgoing incurred in gaining or producing the assessable income. An outgoing will only be said to be ``incurred in gaining or producing assessable income'', and hence deductible, if it bears a sufficiently close connection with the activities by which the assessable income is produced.
In the case of
Fletcher & Ors v FC of T 91 ATC 4950, the Full High Court explained the requisite connection in the following familiar terms [at 4957]:
``The question whether an outgoing was, for the purpose of s. 51(1), wholly or partly `incurred in gaining or producing the assessable income' is a question of characterisation. The relationship between the outgoing and the assessable income must be such as to impart to the outgoing the character of an outgoing of the relevant kind. It has been pointed out on many occasions in the cases that an outgoing will not properly be characterised as having been incurred in gaining or producing assessable income unless it was `incidental and relevant to that end'. It has also been said that the test of deductibility under the first limb of s. 51(1) is that:
`it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income.'''
(See e.g., Ronpibon Tin (1949) 8 ATD, at p. 436).
Justice Hill in FC of T v JD Roberts & Smith 92 ATC 4380 explained what is meant by ``incidental and relevant'', or the ``required connection'' as follows (at 4386):
``... The expenditure must have the necessary connection with the operations or activities which more directly gain or produce assessable income so as to meet the statutory criterion that the outgoing be incurred in gaining or producing assessable income or in carrying on a business:... That is to say it must be `incidental and relevant' to that end:...''
(Emphasis in original)
In determining the deductibility of interest payments, it is clear that the borrowing of money is not of itself the production of income, and that the interest payments referable to the borrowed money, even where the borrowing occurs in a commercial context, are not always deductible. The deductibility of interest payments under a loan will generally depend upon the use of the borrowed money.
As Hill J stated in FC of T v JD Roberts & Smith at 4387:
``The mere act of borrowing money, burdened with the obligation to pay interest, does not of itself gain or produce assessable income. The amount borrowed is not
ATC 511
assessable income. What operates to gain or produce assessable income is the manner in which those moneys are used, so that the necessary connection between the outgoing for interest and the activities which more directly gain or produce assessable income will be found in the ordinary case, in the use to which the borrowed funds are put.''
But the analysis of the deductibility of interest payments does not only focus on use. Fletcher makes clear that, at least in cases (such as the present) where ``no relevant assessable income can be identified or where the relevant assessable income is less than the amount of the outgoing'', the task of characterisation is to be carried out by way of a common-sense appreciation of the entire factual context in which the outgoing was incurred. Their Honours state at 4958:
``... in a case where no relevant assessable income can be identified or where the relevant assessable income is less than the amount of the outgoing.... the disproportion between the detriment of the outgoing and the benefit of the income may give rise to a need to resolve the problem of characterisation of the outgoing for the purposes of the sub-section by a weighing of the various aspects of the whole set of circumstances, including direct and indirect objects and advantages which the taxpayer sought in making the outgoing. Where that is so, it is a `commonsense' or `practical' weighing of all the factors which must provide the ultimate answer.''
(footnotes omitted)
Moreover, their Honours emphasise that consideration of the entire factual context is to include consideration of the taxpayer's subjective motivations (at 4957):
``So to say is not, however, to exclude the motive of the taxpayer in making the outgoing as a possibly relevant factor in characterisation for the purposes of the first limb of s. 51(1). At least in a case where the outgoing has been voluntarily incurred, the end which the taxpayer subjectively had in view in incurring it may, depending upon the circumstances of the particular case, constitute an element, and possibly the decisive element, in characterisation of either the whole or part of the outgoing for the purposes of the sub-section.''
It is interesting to note that, taking into account the impact of subjective purpose, their Honours in Fletcher offer the following further elucidation of the nature of the connection which must be established for deductibility (at 4957):
``... in the context of the sub-section's clear contemplation of apportionment, statements in the cases to the effect that it is sufficient for the purposes of s. 51(1) that the production of assessable income is `the occasion' of the outgoing or that the outgoing is a `cost of a step taken in the process of gaining or producing income' are to be understood as referring to a genuine and not colourable relationship between the whole of the expenditure and the production of such income.''
(footnotes have been excluded)
Their Honours further state the following, in a passage which brings together precisely the notions of characterisation, the overall factual circumstances of the case, and the taxpayer's subjective purpose (at 4959):
``... the mere relationship between outgoings actually incurred and the much smaller amounts of assessable income actually derived does not suffice, without more, to answer the question whether, and if so to what extent, the adjusted outgoings of interest are properly to be characterised as incurred in gaining or producing assessable income. That question must be answered by reference to a common-sense appreciation of the overall factual context in which the outgoings were incurred. It necessarily involves a consideration of the contents and implications of the overall contractual arrangements to which the partnership became a party and pursuant to which the outgoings of interest became payable. As will be seen, it also encompasses a consideration of the purpose which the members of the partnership, and those who advised them or acted on their behalf, had in view in incurring the outgoings.''
The Tribunal ventures to comment that the requirement that the deductibility of outgoings be considered in the light of all the relevant circumstances, including the subjective purposes of the taxpayer, seems particularly appropriate in cases such as this one which involve haphazard accounting practices and incomplete records.
ATC 512
The task of the Tribunal in analysing whether interest payments are deductible, therefore, is to consider whether the interest outgoing was incurred in the activities which more directly produced, or were expected to produce, the assessable income of the Applicant. The Tribunal is to have regard to the uses for which the borrowed moneys were put, as well as the remainder of the circumstances surrounding the acquisition of the loan, including the purpose or purposes which the Applicant himself had in mind.
In the present case, the taxpayer submitted the following (at page 22 of the Outline):
``The taxpayer once again submits that the evidence shows his purpose in incurring the interest expense was to obtain access to funds to provide to his family company for the purpose of allowing it to continue in business, to become profitable and then to enable the company to pay dividends to him.''
The question that is raised is whether providing the borrowed moneys to V for the purpose of ``allowing it to continue in business'' is a use of the loan which satisfies the required connection for the purposes of section 51(1).
A case which considered a similar fact situation to the present was Case 26/94,
94 ATC 258, decided by Senior Member Ettinger. In that case the taxpayer claimed a deduction for interest incurred on a loan which was used to temporarily assist the taxpayer's family company out of its financial difficulties. The Tribunal disallowed the claim, stating at 266-267:
``The applicant submitted that the loan was to generate future income in the form of dividends from the company. The Tribunal is prepared to accept that one of the applicant's objectives in lending the $100,000 to the company was to ensure profitability so as to derive future dividends from the company.... The Tribunal finds the connection between the payment and the future income to be derived in this case so remote as to render the interest not a deduction under section 51(1) of the Act.
...
The Tribunal finds that the amount of $17,661, being interest and borrowing costs incurred by the taxpayer, was not incurred in gaining or producing the assessable income of the applicant. Rather, it was to assist the company to avoid liquidation by providing a short-term rescue package.''
The case emphasises the distinction made between those activities which more directly produce assessable income and activities which, though expended for the ultimate purpose of gaining or producing assessable income, are carried out as a precursor to those activities which more directly produce assessable income. It is only expenses related to the former activities which bear the ``connection'' required for deductibility. Even when the later activities can be said to be ``necessary'' or ``essential'' to the former activities, and in order to earn income, they are not thereby deductible:
Lunney & Hayley v FC of T (1958) 11 ATD 404; (1958) 100 CLR 478. Such expenses are said to be too remote from the production of income to be deductible. As Northrop, Wilcox and Hill JJ stated in
FC of T v Riverside Road Pty Ltd (in liq) 90 ATC 4567 at 4575:
``The language of the section introduces, as Professor Parsons points out in his work Income Taxation in Australia, Law Book Company, 1985 (para 5-37 to 5-48), an element of contemporaneity. Thus, an outgoing may be precluded from deductibility if it be incurred at a point too soon before the commencement of the business or income-producing activity.''
In the case of
Sheil v FC of T; FC of T v Shiel 87 ATC 4430 the distinction between the operations which more directly produce assessable income and the goal of ultimate business success was also drawn. Thus the Full Federal Court said (at 4440):
``... One may concede for immediate purposes that the taxpayer had busied himself in procuring,... the provision of finance by Midland Credit with the overall object of enhancing the value of the business enterprise to be conducted... But what must be shown here is what Brennan J. called the required connection... between the outgoing... and gaining or producing assessable income.''
In the present case, the borrowing was made with the manifest primary objective of paying off the debts of V such that it may be allowed to remain in business. The Tribunal doubts that such an objective can ever be in itself sufficient for deductibility, but whether this is so in all
ATC 513
cases need not be decided here, for in the opinion of the Tribunal, the further circumstances of this case require the conclusion that the relevant outgoings cannot be characterised as sufficiently connected to the activities which more directly produced, or were expected to produce, the Applicant's income.The circumstances of the case suggest (and the Applicant was not able to establish otherwise), that at the time of the acquisition of the 1989 loan, V would never reach the point of profitability such as to enable the Applicant to derive income from it. Following the Indonesian defalcation, V was no longer viable. Despite efforts made to keep it trading, the facts suggest that it did not then, nor at any later time, offer any prospect of dividend income. It was not able to pay its debts at that time, and in fact a considerable part of its debts remained outstanding when it was eventually struck off. The 1989 loan was secured by the Applicant, therefore, to repay the debts of a company which offered no foreseeable prospect of producing income for the Applicant. As such, the interest payments under the loan cannot be regarded as sufficiently connected to the Applicant's income producing activities.
Moreover, the Tribunal notes that if it can be said that the 1989 loan was incurred with the object of ensuring the derivation of future dividends from V, thus benefiting the taxpayer, the loan is better characterised as being of a capital nature. Insofar as the loan allowed V to continue trading, it could be characterised as expenditure to safeguard the dividend-paying capacity of a company, and hence the value of the Applicant's share investment of that company. Such expenditure is concerned with the protection of the source of supply, rather than with the derivation of the dividends as such, and is therefore of a capital nature; Case No. F 36
(1955) 6 TBRD 211 per Owen (Chairman), Cotes and Webb (Members) at 213.
It is the view of the Tribunal, therefore, that the claimed outgoings are not deductible.
15. Characterisation of the outgoing based on the second set of accounts:
The Applicant delivered his legal argument on the basis of the second set of accounts, according to which the funds from the 1989 loan were onlent by the Applicant to B, and in turn directed by B to V, in part by way of a loan and in part by way of acquisition of assets. As stated previously, the Tribunal does not accept that these second accounts record the true course of events. Given that the Tribunal has not accepted the veracity of the second set of accounts, it is perhaps academic for the Tribunal to discuss the legal consequences that flow from them. Nevertheless, the Tribunal considers that such a discussion is merited by the Applicant's reliance upon these accounts in the presentation of his legal argument. Even if the second set of accounts were to be analysed according to the Applicant's submissions, however, the Tribunal considers that the outgoings lack the required connection for deductibility.
In the Outline, it was argued for the Applicant that, on the basis of the second set of accounts, the facts of this case fall squarely within the principle established by the Full Federal Court in
FC of T v Total Holdings (Aust.) Pty Ltd 79 ATC 4279, and also referred to paragraph 8 of Income Tax Ruling IT 2606 which states that ``where the facts of a case are substantially similar to those in Total Holdings a deduction for interest is allowable under s. 51(1) of the Act''.
In Total Holdings, the taxpayer claimed deductions for interest paid on borrowed funds that were on-lent interest free to its subsidiary, TAL. The Full Federal Court allowed the deduction, finding that the purpose of onlending was to bring profits to TAL more quickly, so that in due course profits would be received by the taxpayer by way of dividends or interest. It should be noted, however, that during the years that TAL was not a wholly owned subsidiary, Total Holdings received interest payments at commercial rates on the loan. This was one of several factors that assisted the Court in finding a connection between the loan and the derivation of income. As Justice Lockhart (with whom Northrop and Fisher JJ concurred) said at 4286:
``... It was regarded as appropriate to fund TAL primarily by interest-free loans, not only to place it in the best light so far as its accounts were concerned, but to minimise the tax consequences...
The loans by the taxpayer to TAL were repayable on demand. Thus it was within the power of the taxpayer, at any time it wished, to restructure the financing of TAL by calling up the loans and using the funds in
ATC 514
some other way, whether by taking up further shares in TAL or the making of loans at an appropriate rate of interest. Also, there was no guarantee that the many millions of dollars which the taxpayer had invested in TAL would ultimately produce a profitable trading entity.The activities of the taxpayer were designed to render TAL profitable as soon as commercially feasible and to promote the generation of income by TAL and its subsequent derivation by the taxpayer and CFP.''
(emphasis added)
Whether, as the Respondent submitted, the application of Total Holdings can be restricted to circumstances involving wholly owned subsidiaries need not be decided in the current matter; the focus of the present question is, as it must be, on the connection between the outgoing and the derivation of income.
As Deputy President Todd said in Case U134,
87 ATC 780 at 783-784:
``... The need remains for a sufficient nexus to exist between the expenditure and the income. Total Holdings was a case in which, given the existence of a not uncomplicated corporate and business structure, with interlocking company loans, the Court was able to discern the existence of the required nexus.''
Total Holdings does not lay down any new proposition regarding deductions for loans incurred by associated companies; nor does it apply generally to all circumstances where someone borrows and on-lends interest free: Case S83,
85 ATC 612 per Chairman Stevens at 614. Total Holdings must be interpreted in accordance with other cases applying s. 51(1) of the ITAA, and must not replace the wording of the section itself. As Hill J stated in
Kidston Goldmines Ltd v FC of T 91 ATC 4538, at 4546:
``... there is a danger in substituting for the words of the sub-section language which does not appear in it. The statutory issue is whether the interest outgoing was incurred in (ie in the course of) the income producing activity,...''
The requirement remains for the taxpayer to adduce evidence which suggests that, given the use of the borrowed moneys and the other circumstances surrounding the loan and the incurring of the relevant expenses, the required nexus for deductibility exists such that the statutory criterion, namely that the expenditure be incurred in gaining or producing assessable income, is satisfied.
In the present case the Tribunal is of the opinion that the Applicant has failed to adequately demonstrate that the circumstances surrounding the loans were such as to give rise to the conclusion of a sufficient nexus between the outgoings and the derivation of income.
The following words of Member McCarthy in Case S83 (Supra) apply equally to the present case (at 616):
``... This case is not like Total Holdings where the carrying on of a relevant business by the taxpayer enabled various activities to be linked and considered together, under the umbrella of one income-producing activity, such that in all the circumstances the outgoing could be said to have the requisite connection with the operations which more directly gain or produce the assessable income.''
The Tribunal considers that, as in Case S83, the present case can be distinguished from Total Holdings because the use of the 1989 loan cannot be characterised as part of the more immediate sphere of activities carried out by the Applicant in order to produce his assessable income. In relation to that portion of the funds claimed to have been received by B from the Applicant and on-lent (interest-free) to V, the same conclusion is compelled as that which arises from the analysis of the first set of accounts: as the surrounding circumstances plainly show, V was no more in a position to prove itself a worthwhile investment for B than it was for the Applicant himself. Using the funds from the Applicant in such a manner, therefore, is far from an activity calculated to produce assessable income, either for B, or for the Applicant indirectly through B. In relation to that portion of the funds used to acquire the assets of V, the evidence brought by the Applicant in furtherance of the argument was far from satisfactory. For example, there was no evidence to show that the assets were in fact (or in law) transferred, and there was no evidence establishing the true value of these assets. It must be remembered in this context that the relevant agreement referred to previously in these Reasons was no more than an informal draft drawn by the Applicant between two closely associated companies, both controlled
ATC 515
by him, for the sale of certain assets of a business which had failed. Nor having regard to the circumstances of the transaction, was there any actual flow of moneys; on the contrary, the value assigned, which appears to have been arbitrary, was merely the subject of a book entry. In short, the Tribunal considers that the Applicant has failed to produce evidence sufficient to establish the required nexus.It should be emphasised at this point that it is not sufficient for the Applicant to simply point towards a purported use of the relevant funds, in this case, the acquisition by B of the assets of V, and claim that deductibility follows directly from such a use. As pointed out previously in these Reasons, the case of Fletcher requires the analysis of deductibility to extend to the broader circumstances of the case, including the direct and indirect objectives sought to be achieved.
And indeed, the second set of accounts when viewed in the light of all the surrounding circumstances suggest a purpose quite apart from that of ``injecting funds into [B] for its business with an expectation of improving its profits and of the derivation of dividend income from it'' (Outline, p 5). Even if the veracity of the second set of accounts is accepted, the Tribunal is of the view that the Applicant has failed to establish that the 1989 loan was secured for the ultimate purpose of putting into effect the course of events suggested by them. The Tribunal is instead drawn towards the conclusion that the 1989 loan was acquired by the Applicant for no other purpose than the repayment of V's debts. It appears to the Tribunal, thus, that if it can be said that the occasion and circumstances of the loan can be gathered under the ``umbrella of one activity'', that activity would not be the production of income but rather the repayment of debts.
Thus the Tribunal considers that, even leaving aside the dubious nature of the dividends actually declared by B, the interest outgoings and these dividends lack the required connection for deductibility. The Tribunal is of the view that the Applicant has failed to establish that there was a genuine, and not colourable, relationship between the incurring of the interest expenditure and the derivation of income by the Applicant.
Thus, even if the Applicant had succeeded in establishing that the 1989 loan was secured from CBA to be onlent to B, this does not affect the Tribunal's finding that interest payments under that (and subsequent) loans are not deductible.
16. Apportionment:
Notwithstanding that no question as to apportionment was raised before the Tribunal, given the adoption by the Tribunal of the first set of accounts, it is not possible to assign anything other than a single characterisation to the whole of the interest that was paid. Apportionment is not appropriate where there is no element within the outgoings that has the necessary relevance to or connection with income derivation; Sheil v FC of T; FC of T v Sheil 87 ATC 4430 at 4440.
17. Penalties:
There was little argument before the Tribunal as to penalties. The Tribunal considers that the level of penalties was in all the circumstances appropriate, having regard inter alia to the following matters:
- (a) to the failure of the Applicant to lodge returns on time;
- (b) to the fact that the Applicant does have accountancy training;
- (c) that the Applicant admitted that he had been careless in signing incorrect returns (4/11/96TS80, In 34-35);
- (d) to the fact that the dividends appear to have been motivated by an improper purpose; and
- (e) that returns were prepared in consequence of a failure to provide his tax agent with documents, such as draft accounts and minute books, required for the preparation of tax returns, and that the tax agent did not request these documents from the taxpayer (3/3/97TS171, In 3-36, 3/3/97TS174, In 13-19).
The discrepancies between the separate sets of accounts prepared by the taxpayer and his tax agent are directly attributable to the failure of the taxpayer to take care in preparing accounts for himself and his companies, and his failure to provide the tax agent with sufficient documentation to enable the preparation of accurate returns.
The taxpayer could not, therefore, be said to have taken reasonable care in claiming the disallowed deductions for interest. For these reasons, I believe that the 25% culpability component, and the per annum component,
ATC 516
imposed on the Applicant in this case is appropriate.18. Accordingly, the Tribunal considers that the objection decision under review was correct, and that it should be affirmed.
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