AAT Decision 11944

Unreported 23 May 1997 AAT

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(Decision by: Gerber P, DP)

AAT Decision 11944.

Tribunal:

Member:
Gerber P, DP

Subject References:
INCOME TAX
allowable deductions
whether sham interest on sham loans are an allowable deduction

Legislative References:
Income Tax Assessment Act 1936 - s 51(1)

Hearing date: 17 March 1997 & 19 March 1997
Decision date: 23 May 1997

Melbourne

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Decision by:
Gerber P, DP

1. This is an audit case. The issue is whether claimed interest payments and other expenses associated with two rental properties are allowable deductions in the years 1991, 1992, 1993 and 1994 respectively. In order to follow the Commissioner's position, the following table was provided for the benefit of the Tribunal.

COMPARISON OF ASSESSMENTS AFTER ALLOWANCE OF CITIBANK AND COMMONWEALTH BANK INTEREST

* The penalty calculation in the original amended assessment omitted to include a per annum component.

COMPARISON OF ASSESSMENTS AFTER ALLOWANCE OF CITIBANK AND COMMONWEALTH BANK INTEREST.

COMPARISON OF ASSESSMENTS AFTER ALLOWANCE OF CITIBANK AND COMMONWEALTH BANK INTEREST.

COMPARISON OF ASSESSMENTS AFTER ALLOWANCE OF CITIBANK AND COMMONWEALTH BANK INTEREST.

2. At the conclusion of the hearing, counsel for the Commissioner advised the Tribunal that his client was prepared to make some concessions with respect to what has been referred to as "other rental expenses" and provided me with a calculation of what the respondent was now prepared to concede. The final allowable deductions as conceded are set out below:

3. It will be seen that the Respondent now accepts that the Applicant incurred some "other rental expenses" in each of the years of income ended 30 June 1991, 1992 and 1994. Having allowed some $4,191.00 of "other rental expenses" in the year of income ended 30 June 1993 at the audit stage, the Respondent was not, on the evidence, prepared to increase the amount from that source.

4. The amounts of "other rental expenses" the Respondent allowed have been calculated as follows:

30 June 1991 - 90% of "other rental expenses" allowed for year of income ended 30 June 1993.

30 June 1992 - 95% of "other rental expenses" allowed for year of income ended 30 June 1993.

30 June 1994 - 105% of "other rental expenses" allowed for year of income ended 30 June 1993 (adjusted to allow for the reduction in rental income returned in comparison to year of income ended 30 June 1993).

5. The interest and other rental deductions referred to above relate to two rental properties - 48 Albany Drive, Mulgrave and 11 Green Avenue, Mulgrave.

6. Historically, the taxpayer and his (then) wife purchased their first domestic home at 45 Solomon Street, Mount Waverley on 10 March 1982. A copy of the title deed indicates that the couple mortgaged the property to the Commonwealth Savings Bank, said mortgage being entered on the title deed on 12 July 1982. It is this property which appears throughout the various property deals as the anchor, securing the various borrowings that took place.

7. Turning to the 48 Albany Drive property, this was purchased on 24 April 1986 for $78,000 and registered in the names of the taxpayer and one Afsaneh Malekzadeh (the taxpayer's then wife) as joint proprietors. A mortgage to the State Bank of Victoria was registered on the same day and discharged on 12 February 1990, the loan being purportedly refinanced by way of a loan of $55,000 by a company - Advanced Logic Industries Pty Ltd (deregistered as of 15 May, 1995) - at 19.5% interest per annum .

8. The 11 Green Avenue property was purchased on 22 October 1990 for $108,000 and registered in the name of the taxpayer. This property appears to have been initially financed by way of a loan of $100,000, advanced by Citibank Savings Ltd, secured by way of first mortgage over the domestic home at Solomon Street, Mount Waverley. This mortgage was discharged in December 1992, being paid out from a loan of $135,000 from the Commonwealth Bank, once again secured by way of first mortgage over the Mount Waverley property (exh 1) (photocopy of the Certificate of Title). It appears that, having paid out the Citibank Savings loan, the taxpayer was left with some $40,000 odd in cash, which was conceded to have been used for private purposes, including some extensions to the Mount Waverley property. The same exhibit indicates that on 3 May 1994, the Commonwealth Bank mortgage was discharged, the bank taking a new mortgage over the same property to secure a loan of $125,000. It is part of the Commissioner's case that this loan was used to discharge the mortgage over the Mount Waverley property. However, exhibit 1 would suggest that this mortgage remains undischarged, at any rate as of 26 June 1996, the date of the search. On the other hand, the taxpayer maintains that as a result of some "refinancing", he obtained a loan of $110,000 (or $100,000) from Advanced Logic Pty Ltd, secured over the Green Avenue property, interest again being fixed at 19.5%. Just when this "loan" was said to have taken place is uncertain.

9. It would thus appear that at this point in time, the taxpayer owed the Commonwealth Savings Bank some $125,000, secured over the Mount Waverley property, and a further sum of $165,000 to Advanced Logic Pty Ltd, "secured" over the Albany Drive and Green Avenue properties, less any repayments he may have made during the relevant period, as to which there is no evidence. It is claimed by the taxpayer that Advanced Logic Pty Ltd held the title deeds as security, and that the reason the mortgages were not registered was due the perception that this would provide "some business advantages" (p3 tr). He did not explain what this "business advantage" was, nor did it become evident what business advantage arose from the taxpayer discharging bank mortgages in favour of mortgages to the company when the interest payable to the latter substantially exceeded the interest charged by the banks. There were no formal meetings of the directors of Advanced Logic Pty Ltd, hence there were no minutes which recorded these loans, and, given the total lack of formality by which this "refinancing" was said to have been effected, I frankly do not believe that the title deeds were ever handed over to the company as security. In other words, even assuming that the Applicant got his hands on monies belonging to the company, these could only be described as mere unauthorised and unsecured loans, giving the company no legal or equitable interest in the properties. In any event, I am satisfied that Advanced Logic Pty Ltd was at all relevant times a "two dollar company", its sole directors being the taxpayer and his (then) wife, the company's capital consisting of two shares valued at $2 each, held by the taxpayer and his (then) wife. The evidence satisfies me that this company at no time had any or any sufficient funds in the bank to advance the loans relating to the two properties, and that whatever monies may be said to have come into the taxpayer's hands bypassed the company's "books". Not to put too fine a point on it, the taxpayer helped himself to monies which belonged to the company. The bank statements of the company (exh 7), commencing February 1989 and ending November 1993, reveal merely desultory deposits and withdrawals which on only three occasions exceed three figures, the highest balance standing to the credit of the company at any time being approximately $3000 ( cf exh 7), reflecting an almost dormant business activity. (There are some four statements beyond that date in which the transactions are illegible). Looking at the company's tax return for 1991, its sole income - $29,801 - was said to have been derived from the interest "paid" by the taxpayer - payments which are not easily identified in the bank statements since the account is rarely more than two to three thousand dollars in credit. Yet the return showed that the loan to shareholders was a mere $6,500. To make the taxpayer's evidentiary task even more difficult, it seems that the company kept no books of accounts; certainly none were tendered.

10. In the result, I have concluded that the monies the taxpayer appropriated to himself did not emanate from the company; they were not "loans" accrding to ordinary concepts. For good measure, as already pointed out, I have been unable to identify any payments of interest to the company. To the extent that these "payments" appeared in the taxpayer's returns as allowable deductions and in the company's return as "income" (the company being in a loss situation), I find these were sham transactions, created solely for tax purposes.

11. I will now turn briefly to the sequence of events. The taxpayer arrived in this country from Iran with impressive qualifications in electronic engineering. He obtained further qualifications in this country and is currently lecturing in his specialty. Regrettably, he appeared before the Ttribunal on his own behalf with scant knowledge how to present his case. In the result, his evidence- in-chief was largely conducted by me acting as "counsel" in that his evidence was adduced by way of question and answer. Indeed, in the result much of the evidence proved to be largely irrelevant.

12. As already mentioned above, the taxpayer asserted throughout his evidence that what has been referred to as the "refinancing" of the Albany Drive and Green Avenue properties was achieved by way of a "loan" advanced by Advanced Logic Pty Ltd. That is, that the banks were paid out with the proceeds of this "loan".

13. The following took place in evidence in relation to the Green Avenue property:

The Deputy President : So the money was not really lent by Advanced Logic but by Citibank? --- Sir, if you realise, that property was unregistered security of the lender. Lender had to agree for me to get the $100,000, sir.

The Deputy President : I follow this. But effectively, all that Advanced Logic did in 1991 was to say: `You can go ahead and buy Green Avenue provided you get a loan from Citibank of $100,000?--- That's exactly, sir.

The Deputy President : So, really, Advanced logic lent you no money at all, they merely concurred, agreed that you could use ...?---That's exactly right, sir.

14. Having conceded that there was no loan strictu sensu from Advanced Logic Pty Ltd, the taxpayer nevertheless persisted in his original assertion that he not only owed $100,000 to the bank but an additional $160,000 ($165,000?) to the company.

The Deputy President : You owed two lots of money?---Yes, that's exactly right, sir. In average - in average at that time my loan was around - well, I say $210,000, sir. Out of this $210,000, $50,000 roughly $50,000 become for my personal use of my matrimonial house for personal use. In average, the rest become $160,000 loan which I claim during my financial year. I claim $160,000.

15. In support of these loans, some letters were made exhibits. The first (exh B) is a letter dated 12.6.1990, addressed to the taxpayer on stationery headed ADVANCED LOGIC INDUSTRY PTY LTD

Dear Sir,

I am pleased to advise you that your application to borrow $110,000 to purchase your investment property at 11 Green Ave Mulgrave has been approved and the fund is available from 25-6-1991. We hope that our service could assist in your investment.

Yours faithfully

(sgd) R Roshan

General Manager

16. It is an odd feature of the company's acceptance of the loan application that it is silent as to interest, duration and repayment.

17. The next letter, (exh C) dated 11-7- 1991, again on the company's stationary and addressed to the taxpayer states:

Dear Sir,

With reference to our telephone conversation dated 8-7- 1991 regarding loan interests establishment fee and legal costs paid by you during the financial year ended 30-6-91, details are as follows:

1- Interest paid on $45,000 - $8,672

Security 48 Albany Drive Mulgrave Vic 3170

2- Application Fee and legal costs

for purchase of 11 Green Ave Mulgrave Vic 3170 - $3,100

3- Interest paid on $110,000 - $21,129

Security 11 Green Ave Mulgrave Vic 3170

If you are interested to repay any one of the mentioned loans before the end of 5 years terms, a penalty equivalent to four month interest in each case is applicable. However we are prepared to negotiate the transfer to a new security, of course legal costs and establishment fee will be applicable on any loan transfer.

Yours faithfully

(sgd) R Rosher

General Manager

18. There is further correspondence between the company and the taxpayer. Thus exh D is a letter, in much the same terms as exh B, save that the figures are difficult to reconcile with the oral evidence of the taxpayer. Thus it is said that as of 29.6.1993 the taxpayer had paid the company some $10,725 in interest on the $55,000 loan and some $21,450 on the $110,000 loan. For good measure, repayment before the due date now attracts six months interest "in each case" and once again the company is willing to negotiate the transfer of the existing loans to new security, but "of course legal costs and establishment fee will be applicable on any loan transfer."

19. The final letter is also dated 29.6.1993:

"This is to certify that you have paid total loan interest amounting $32175 on properties at 48 Albany Dve Mulgrave and 11 Green Ave Mulgrave this financial year."

(sgd) R Roshan

20. Mr Roshan was unable to give evidence. I was informed that he was in the United States.

21. Much evidence and time was spent on the trading activities of Advanced Logic Pty during its lifetime. In the result, I do not believe much turns on this. It is claimed by the taxpayer that he engaged in "international trade ... the business was almost anything valuable, and particularly in real estate and high technology equipment."

22. Without going into details, what occurred can be briefly summarised: The company imported technological equipment from Taiwan, Japan, Iran, Dubai and Kuwait, the taxpayer sold the equipment locally, using the proceeds for his own purposes. It seems that most of the suppliers were never paid. To illustrate the difficulty I have with the evidence, herewith a short extract taken from the transcript.

The Deputy President : You start off with $4 and within 12 months [the company] can lend you $100,000?- --That's exactly right, sir. I answered that question.

The Deputy President : Well, no, you have not?---I said the money came via manufactured goods.

The Deputy President : Yes, but you have got to pay for those, How did you pay for them?---No, that was manufactured goods, sir, was the - the money came in Australia. I got manufactured goods without full payment of it. ... I sold the manufactured goods, then they became the source of money for the loan.

...

The Deputy President : But, of course, you still have to pay the people who manufacture ---?That's exactly right, sir. That's the whole thing.

The Deputy President : And how did you pay for them? How did you pay for the manufactured goods?---When they - in the same token, sir, I was importer and exporter as well. In many occasions I have sent goods to overseas. I can say - even if you want I can disclose it to you, sir. I have sent even kangaroo skins.

The Deputy President : But you must have paid for those as well?---For the interest, yes. Yes, sir.

23. As the evidence progressed, it became more and more bizarre. At one stage the taxpayer solemnly suggested that some Iranian suppliers received "interest" by way of kangaroo hides which he was ordered to ship to Taiwan.

Mr Tavolara : So Advanced Logic, who is in the business of computer technology of sorts and lending money, is then sending kangaroo hides through to Iran. Is that right?---Not to Iran, to Taiwan. That is the way they want it.

Mr Tavolara : So the people in Iran to whom Advanced Logic owed money, said to you, `Look, don't worry about paying us in money. You send to our friends in Taiwan goods in the form of kangaroo hides to the value - - -?---Yes. That is the interest paid that manner. Not the original money.

24. When I asked the witness from what bank account the $100,000 "loan" was paid to him, he replied: "This money may have - might have - I'm trying to clarify this situation. It might have come from my cheque account, or, I'm not sure, sir, or one of my registered business accounts. I have several registered businesses as well, and it might have come from either of them, but definitely that money was paid - undoubtedly that money was paid from the goods sold. That's the reality, sir."

25. In summary, the evidence advanced by the taxpayer amounts to this: He imported manufactured goods, sold them in this country, and claims to have paid the interest on the monies owed to the world wide exporters "partially" with kangaroo hides. This was somewhat modified later in his evidence: ("The only way I could send money to them. Some part of the money was paid by direct deposit; there are some people there importing goods from Iran to here sell and they needed money there. I used to pay money here to get money there and vice versa. This is an activity which I don't think is illegal, I don't know. That's the way that people do.")

26. Pausing here, I find on the evidence that (i) the loan arrangement between Advanced Logic Pty and the taxpayer were "informal"; (ii) no monies, said to constitute interest owed to the company , was ever paid by the taxpayer to the company; (iii) to the extent that any attempt was made to pay anything to the overseas suppliers, I find that some kangaroo skins were indeed sent to Taiwan. However, it stretches the imagination to characterise these hides as "interest" payments, paid to the overseas suppliers. (When asked how the taxpayer paid the interest owing to Advanced Logic Pty Ltd company, he replied: "By very simple, Mr Tavolaro, by meeting the company's obligation to overseas sources. That simple"; (iv) there is no evidence of any arrangement by which the importers charged the company interest and/or were prepared to accept interest payments due to any delay in payment, let alone in kangaroo hides; (v) by the time the company went into liquidation, few - if any - importers had been paid for the goods consigned to the company.

27. In summary, I am satisfied that the taxpayer treated the company as his alter ego and simply helped himself to the proceeds from the sale of the goods the company imported to re-finance two investment properties, using the balance for personal purposes. In other words, he used monies which should have gone into the company's bank account for his own purposes. Being a director of a company, using that company funds to finance personal investments whilst leaving the company's creditors lamenting (apart from sending a few kangaroo hides to Taiwan) and describing such an activity as "loans" is a more benevolent description than I would have used. Nor did the taxpayer take much trouble to cover his tracks. Thus, the company's return for 1991 does not show as a current liability any amounts owing to the suppliers of the goods, yet this is in that year that it purported to lend the taxpayer some $110,000 ( cf exh B); alternatively it is said the company lent the taxpayer some $90,000 in 1989, ie shortly after the company was incoprorated with a share capital of $2..

28. It seems that the Gulf War put an end to this thriving import export business. When asked whether the company had ever operated a bank account, the taxpayer replied that he was a new Australian "with foreign habits". When pressed, he finally conceded that the company did keep a bank account, albeit he could not remember when the account was opened or what transactions went through the account. The taxpayer finally conceded that: "The money came via manufactured goods. These goods were sold. The money from the goods, [did] not necessarily went to Advanced Logic Industries account."

29. In the result, I am satisfied that Advanced Logic Industry Pty Ltd made no loans to the taxpayer and that the investment properties were financed or re-financed with funds misappropriated from a company of which the taxpayer was a director, the bulk of monies used for that purpose being owed to overseas suppliers. It follows that, in the absence of any loans, there can be no interest payments. That is the end of much of the claims.

30. That point was reached half way through the evidence. I can see no point in elaborating on the various conversations between the taxpayer and officers of the Commissioner during the audit process, or the evidence of the taxpayer's former wife, which does nothing to assist his claim.

31. I can see no good reason why I should interfere with the penalties imposed by the Commissioner pursuant to sec 223 of the Income Tax Assessment Act 1936 for the years 1991 and 1992, and pursuant to sec 226H together with sec 226X for the years 1993 and 1994.

32. I would affirm the decision on objection in each of the years under review, incorporating the further concessions made by the respondent during the hearing relating to "other expenses" relating to the two properties. I would merely add that one cannot help but feel sorry for the taxpayer, who is clearly a man of superior skills and intellect and will, no doubt, make a useful contribution to this country when he recovers from the mental illness which presently plagues him. (There is a medical cerificate on file indicating that the taxpayer is suffering from chronic schizophrenia). I find that he is not basically dishonest. The mess he is in is largely due to his illness, causing a break- up of his marriage, coupled with a near total absence of any business skills and a lack of awareness that what may pass as acceptable business practices in the bazaars in Iran are unacceptable in this country, a fact he himself recognised at one stage when referring to his "foreign ways". I merely wish to add that the respondent must have been aware that his ability to recover any tax owing - let alone penalties - is about as remote as the Tax Offices in all capital cities being simultaneously hit by meteorites from outer space. In the result, not insubstantial costs have been thrown away in proceedings the consequences of which can best be described as "academic".