CASE 14/98

BH Pascoe SM

Administrative Appeals Tribunal

Decision date: 28 July 1998

BH Pascoe (Senior Member)

This is an application to review a decision of the respondent to disallow an objection to the assessment of income tax based on the applicant's income for the year ended 30 June 1996. The dispute related to the disallowance on a deduction of interest amounting to $7310 being 50% of the interest on a bank overdraft in the joint names of the applicant and his wife.

2. At the hearing the applicant was represented by Mr J McInnes, an accountant, and the respondent by Ms A Richards of Counsel. No evidence was given. However there was no significant dispute about the facts of the case although it was submitted by the respondent that, for the applicant to discharge the onus of proof imposed by s 14ZZK of the Taxation Administration Act 1983, more specific evidence would be required. Pursuant to s 14ZZE of the Taxation Administration Act the applicant requested that the hearing be in private.

3. The facts set out in the submission for the applicant were as follows:

``1. The Applicant is a senior equity partner in a large well known legal practice (`the firm') and has been a partner of that firm for some years.

2. As a partner, the Applicant is entitled to share in the profits of the firm and his share of the income (subject only to normal adjustments between accounting profits and taxable income) represents assessable income for income tax purposes.

3. The Applicant has assigned 40% of his income from the firm under a Deed of Assignment and accordingly only 60% of the income from the firm is assessable in his hands.

4. The firm has working capital requirements in connection with unbilled work and fees billed but not collected. To assist in the funding of these working capital requirements partners do not draw their full entitlement to profits with the result that they effectively advance funds to the practice to enable the business of the firm to continue. This is evidenced by the following

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summary of movements in the Applicant's Current Account with the firm for the year ended 30th June 1996 which is the year of income to which this application relates.
Balance of undrawn profits as at 1st July 1995       $96,408
  Add (deduct)--
Share of partnership profits for the 1995/96 year    513,286
Drawings during the 1995/96 year                    (419,249)
Balance of undrawn profits as at 30th June 1996     $118,445
Average balance during the 1995/96 year             $107,427

5. The Applicant has an overdraft account with the Macquarie Bank which solely for domestic convenience he operates as a joint account with his wife. The prime purpose for arranging an overdraft facility with the Macquarie Bank was to refinance an overdraft facility that the Applicant had with Westpac Banking Corporation. The overdraft facilities with Westpac and the Macquarie Bank go back for many years. The Applicant's drawings from the firm are normally deposited in this account. The account is used to meet domestic and other living expenses, payment of interest on the overdraft account and other borrowings from the Macquarie Bank, payment of income tax, capital and other expenditure in connection with a rental property and other general disbursements. The bank statements covering the operation of this overdraft account during the year ended 30th June 1996 the overdrawn balance was $129,342 and at the 30th June 1995 the overdraft balance was $147,763.

An overall summary of movements in the account is set out below-

Balance of undrawn profits as at 1st July 1995   (147,763)
  Add (deduct)--
Deposits                                          451,390
Payments                                         (432,969)
Balance of undrawn as at 30th June 1996          (129,342)

During the 1995/96 year the highest overdrawn balance was $151,044 and the lowest overdrawn balance was $88,525. The average balance during the year would have been in excess of $100,000 overdrawn. During the 1995/96 year interest of $14,620 of interest was charged on the overdraft account and the Applicant claimed one half of this (i.e. $7,310) as being properly deductible for income tax purposes. It is clear that while the major part of the overdraft balance represented a `hard core' of debt there were funds deposited into the account during the year which were well in excess of the total borrowings on the account at any time during the year.

6. Included in the payments that formed a part of the overdraft balance during the 1995/96 year were payments of interest on the Applicant's other borrowings from the Macquarie Bank of $26,260 and $5,159 (a total of $31,419). The Respondent in an Audit Case Report dated 14th February 1997 acknowledges that interest on these borrowings is properly deductible for income tax purposes.''

4. It was submitted for the applicant that the interest claimed was an allowable deduction under s 51(1) of the Income Tax Assessment Act 1936 (``the Act''). The primary argument was that the overdraft was primarily attributable to the undrawn profits of the applicant's firm which had been retained to fund the firm's working capital. It was said that there may have been no need for the applicant to utilise the overdraft facility if he had drawn all of his profit entitlement from the firm. Alternatively it was submitted that the overdraft could be attributable to the need to borrow funds over several years to meet the costs of interest payments on an investment property and which interest payments were properly deductible. It was further submitted that the applicant was carrying on a business and, pursuant to the respondent's Taxation Ruling IT 2582 was entitled to a deduction for interest incurred in borrowings to meet income tax liabilities. It was argued that the firm was a large business enterprise conducted as a partnership to satisfy statutory and professional requirements and, therefore, limited in making external borrowings to fund working capital and distribution of full profits to partners. Mr McInnes considered that the special factors

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relevant to the tax liability of partnership profits should allow a consistent approach with that of corporate taxpayers in recognising interest on funds borrowed to meet income tax liabilities. It was submitted, finally, that the claim of 50% of the interest on overdraft was a conservative estimate of the proportion attributable to the derivation of assessable income based on the various business activities for which the applicant had used the borrowed funds.

5. For the respondent it was submitted that the applicant had not satisfied the onus of proof in that balance sheets and accounts of the firm for the relevant period had not been provided nor full details of the establishment and operation of the bank overdraft. In any event, it was submitted that the interest expense claimed was not incurred to earn assessable income and was of a capital, private or domestic nature. It was said that the amounts expended from the overdraft account were for living expenses, income tax etc. and unrelated to the partnership business. Although the respondent accepted that there may well have been undrawn profits from the firm there was no nexus which could be attributed to the interest on funds borrowed to meet private expenditure. It was acknowledged that, if the partnership had financed its working capital by borrowings and paid the full profit shares to partners, the interest on such borrowings would have been deductible. However, it was said that the factual position in this case was quite different. The applicant's submission on the commercial equivalence of the firm in question and a company was said to have ignored the significant legal difference between a partnership and a corporate entity and to have ignored the true facts of this case.

6. It is clear from the many decisions of the Courts that, in determining the essential character of an interest outgoing, it is necessary to look to the uses to which the borrowed funds were put. In a joint judgment of the High Court in
Fletcher & Ors v FC of T 91 ATC 4950 it was said (at p 4958):

``... To the extent that the outgoings of interest incurred in the borrowing can properly be characterised as of a kind referred to in the final limb of s 51(1), they must draw their character from the use of the borrowed funds. See
FC of T v Munro (1926) 38 C.L.R. 153, at p. 197; Ure 81 ATC 4100 at pp. 4103, 4109, (1981) 50 F.L.R., at pp. 223, 232; 34 A.L.R., at pp. 241, 249.''

Hayden v FC of T 96 ATC 4797, Spender J was considering the deductibility of interest on borrowings by an executor to pay a lump sum of $15,000 for testator's family maintenance while maintaining the capital structure of the income producing activities of the estate. After reviewing many decisions of the Courts, his Honour said (at p. 4804):

``Fletcher (supra) teaches that the focus must be on the use to which the borrowed funds are put. Here, the borrowed funds were used to discharge an obligation by the estate. I can see no difference in the present case from a case where an individual taxpayer, in order to discharge an obligation such as school fees, borrows funds on which interest is paid rather than sell income- producing assets and from the proceeds discharge the obligation. The paying of school fees requires funds, on which interest might be otherwise earned; that fact does not make interest on funds borrowed for the purpose of paying the school fees deductible. The discharge of the obligation is a purpose quite independent of the property.

In my opinion, the fact that the borrowing of funds permitted income-producing assets to remain as part of the estate so that the income stream to the estate was not diminished, does not bring the interest on borrowings within a loss or outgoing under s 51(1) of the Act.''

FC of T v JD Roberts; FC of T v Smith 92 ATC 4380, the Full Federal Court was concerned with deductibility of interest on borrowings of $125,000 by a partnership for the purpose of allowing five partners to withdraw $25,000 each and, thereby, reduce the net worth of each partner's interest in the partnership. In the leading judgment, Hill J referred to his judgment in
Kidston Goldmines Ltd v FC of T 91 ATC 4538 and the tests of purpose of borrowing and application of the funds and said (at p. 4388):

``While acknowledging the usefulness of both the concepts of use to which the funds are put and of subjective purpose, I warned in that case of the danger in substituting for the words of s. 51(1) language which does not appear in it. It is a warning to which I

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adhere. The issue continues to be whether the interest outgoing was incurred in the income producing activity or, in a case falling to be tested under the second limb, in the business activity which is directed towards the gaining or producing of assessable income. As the cases, including Kidston, all show, the characterisation of interest borrowed will generally be ascertained by reference to the objective circumstances of the use to which the borrowed funds are put. However, a rigid tracing of funds will not always be necessary or appropriate: cf
FC of T v Total Holdings (Australia) Pty Limited 79 ATC 4279 and the discussion of tracing in the context of s. 51(1) in Parsons, Income Taxation in Australia, Law Book Co, 1985 at 348ff.

For example, let it be assumed that there are undrawn partnership distributions available at any time to be called upon by the partners. The partnership borrows from a bank at interest to fund the repayment to one of the partners who has called up the amount owing to him. That partner uses the moneys so received to purchase a house. A tracing approach, if carried beyond the payment to the partner, encourages the argument raised by the Commissioner in the present case that the funds were used for the private purpose of the partner who received them. But that fact will not preclude the deductibility of the outgoing. The funds to be withdrawn in such a case were employed in the partnership business; the borrowing replaces those funds and the interest incurred on the borrowing will meet the statutory description of interest incurred in the gaining or production by the partnership of assessable income.''

7. In this case, the simple facts are that the applicant borrowed money from the bank for the purpose of meeting private expenditure personal income tax payments, capital expenditure and interest on an investment property. The fact that he could have sought full payment of his profit share from the firm and required the firm to borrow money in order to do so does not make the interest on his borrowings deductible. Whether it is the purpose or reason for the borrowing by him or the application of the borrowed funds, the answer must be the same that the funds were borrowed and applied primarily for private expenditure. It is not to the point that the applicant could have borrowed money to lend to the firm in order to provide it with funds for working capital and allow it to pay out profit shares in full. This is not what happened. The applicant's argument is equivalent to that in Hayden's case (supra) that, in order to protect an income earning asset, funds were borrowed to meet a non-income producing expense.

8. An alternative submission of the applicant was that the overdraft could be seen as attributable to the cumulative cost of interest paid on the applicant's separate investment property. It is accepted that, during the year in question, $31,419 was expended in such interest from the overdraft account. However, it is difficult, if not impossible to say what, if any, particular part of the interest paid on the overdraft related to this expenditure. As set out in the applicant's statement of facts, the overdraft at 1 July 1995 was $147,763. During the year $451,390 was deposited to the credit of the account and payments of $432,969 debited so that the balance of the overdraft was reduced over the year by $18,421 to $129,342. How can it be said that any one dollar of interest was incurred in relation to any one item of expenditure during the year. The facility was a revolving credit facility where, as set out in the applicant's statement, the borrowing varied between $88,525 and $151,044 during the relevant year. It can be argued readily that the amount of the overdraft at 1 July 1995 had been fully repaid by the funds deposited during the year and further funds borrowed and repaid during the year. Even if there was evidence that the payment of the interest related to the investment property increased the overdraft when debited to the account it is likely that deposits made soon after restored that overdraft to its previous balance. Certainly it is not possible to say that interest paid on the overdraft during the year ended 30 June 1996 related to interest expenditure of a prior year. It may well have been possible for the applicant to have borrowed funds over several years to meet commitments on the investment property, maintained such borrowings in a separate account and, therefore, identify the interest paid on such borrowings. However, he did not. He used a general overdraft account where the bulk of the funds expended related to private and domestic expenditure and the interest paid was for the use of that facility. While the decision in

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Palvestments Pty Limited
v FC of T (1965) 13 ATD 527 was concerned with a more limited question of whether any part of overdraft interest related directly to income from dividends (s. 50(a)) for the purpose of calculating a rebate under s. 46, Menzies J (at p 529) questioned ``how... can it be said that any particular part of the interest paid upon the overdraft account during the year... directly related to the dividends received in that year''. In the same way I must ask, in the circumstances of an overdraft such as this, how can it be said that any particular part of the interest on the applicant's overdraft can be identified as relating to any particular expenditure made during the year?

9. The remaining submission for the applicant relates to his carrying on a business and, therefore, coming within the second limb of s. 51(1). This argument was considered, also, by Spender J in Hayden's case (supra) but his Honour was of the view that the characterisation of the use to which the borrowed funds was put was fatal to the taxpayer's arguments under either limb of s. 51(1). The decision of the High Court in
Ronpibon Tin NL & Tongkah Compound NL v FC of T (1949) 8 ATD 431 was seen as authority for this view where the Court said (at p. 435):

``The word `business' is defined by s 6(1) to include profession, trade, employment, vocation or calling, but not occupation as an employee. The alternative in s. 51(1) therefore covers a wide description of activities. But in actual working it can add but little to the operation of the leading words, `losses or outgoings to the extent to which they are incurred in gaining or producing the assessable income'. No doubt the expression `in carrying on a business for the purpose of gaining or producing' lays down a test that is different from that implied by the words `in gaining or producing'. But these latter words have a very wide operation and will cover almost all the ground occupied by the alternative.''

It is accepted that the applicant in this case was carrying on business in partnership with others. However, in no way can it be said that the interest incurred on the bank overdraft was incurred in carrying on that business. The interest was incurred on funds used primarily for private or domestic purposes. Taxation Ruling IT 2582 refers in its preamble to companies and it is not clear whether the ruling itself is intended to extend beyond corporate taxpayers. It states that where a taxpayer carrying on a business for the purpose of gaining or producing assessable income and, in connection with that business, borrows money to pay income tax (whether to preserve the assets of the business, maximise the return on them, retain sufficient money to fund the business or otherwise) then it is considered that the interest incurred on those borrowings is a normal incident of conducting the business. The ruling is said not to apply to interest not connected with the carrying on of a business. I am unable to see how this ruling assists the applicant in this case. One of the purposes of the overdraft may have been to pay personal income tax but it is assumed that this was personal income tax of both the applicant and his wife and may well have been related to both income arising from the business and income from other sources. It is not possible to say that the overdraft interest was connected with the carrying on of the business by the firm other than in the very indirect way of reducing the requirement in part of paying to the applicant his full profit share. I am unable to find that the interest expense was an expense of carrying on a business for the purpose of gaining or producing assessable income and, again, in any event, was an expense of a private or domestic nature.

10. Given my finding that the interest claimed was not an expense incurred in gaining or producing assessable income nor necessarily incurred in carrying on a business for the purpose of gaining or producing such income and, in any event, was expenditure of a private or domestic nature, it is unnecessary to consider the respondent's submission on onus of proof. It is sufficient to say that if I had been able to see any direct nexus between the expenditure and the derivation of assessable income, the applicant would have needed to have provided more specific evidence demonstrating the applicable proportion of the interest incurred which could be said to have had satisfied that nexus.

11. In his application, the applicant also sought review of the decision to impose additional tax equal to 25% of the tax relevant to the disallowed interest under s. 226G of the Act. This section allows imposition of that

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percentage for failure to take reasonable care to comply with the Act. It was submitted for the applicant that the penalty was unreasonable and vexatious as there was a reasonable commercial reality argument for the claim. For the respondent, it was submitted that the imposition of additional tax could have been imposed at a higher rate under s. 226H or 226J in view of the fact that the applicant was a lawyer and his return of income was prepared and lodged by an experienced tax agent. It was said that there was no commercial reality in a claim for part interest on a joint personal overdraft used for private purposes. Having regard to the facts of this case including the fact that the overdraft account was a joint account, the claim was for 50% of the interest as a pure estimate of what may have been related to alleged business use and the claim was primarily based on a very indirect relationship with the working capital needs of the firm, I am not disposed to set aside or vary the decision of the respondent in relation to additional tax.

12. It follows that the decision under review should be affirmed.

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