Heerey J

Stone J
Edmonds J

Full Federal Court, Sydney


Judgment date: 13 July 2007

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Heerey & Edmonds JJ

1. In 1989 a company called 410 Chapel Road Pty Ltd completed the construction of an office block on land which it had acquired in Bankstown, New South Wales. Acquisition and construction were financed by a loan secured by a mortgage over the property. The company soon defaulted in the payment of interest due under the mortgage. In 1991 the mortgagee entered into possession of the property and receipt of the rents. The mortgagee finally sold the building in 2000, by which time the mortgage debt had vastly increased due to the accumulation of unpaid capitalised interest.

2. At all times Chapel Road was a wholly-owned subsidiary of R & D Holdings Pty Ltd. In July 1997 50 per cent of the shares in R & D changed hands.

3. The present appeals from the decision of Finn J
(R & D Holdings Pty Ltd v Deputy Federal Commissioner of Taxation (2006) ATC 4472) concern R & D's claims for deductions for losses said to have been incurred by Chapel Road in the 1997, 1998 and 1999 tax years. The losses were constituted by the excess of mortgage interest over rental income. R & D says these losses were transferred to it in accordance with (for the 1997 year) s 80G of the Income Tax Assessment Act 1936 (Cth) (the 1936 Act) and (for the 1998 and 1999 years) Div 170-A of the Income Tax Assessment Act 1997 (Cth) (the 1997 Act).

4. His Honour found that Chapel Road incurred the losses in all three years. He upheld R & D's claims for the 1997 year. However, as a consequence of the change in ownership of R & D, Chapel Road was required to satisfy the "same business" test in the 1998 and 1999 years as it did immediately before the change in ownership of R & D, but failed to do so. Thus R & D's claims failed for those years.

5. The present appeals are brought by the Commissioner in respect of the 1997 year and by R & D in respect of the 1998 and 1999 years. The Commissioner, by notice of contention, seeks to uphold his Honour's conclusion for the 1998 and 1999 years on the same ground as raised in his 1997 year appeal, namely that Chapel Road incurred no loss or outgoing.

6. The issues argued on the appeals may be summarised as follows:

  • 1. In the years in question did Chapel Road suffer any loss or outgoing?
  • 2. If yes to 1, was such loss or outgoing incurred by Chapel Road in gaining or producing assessable income?
  • 3. In the 1998 and 1999 years did Chapel Road carry on the same business as it had immediately before the change of ownership in R & D in July 1997?
  • 4. Were R & D's claims for the 1998 and 1999 years "reckless" and "not reasonably arguable" so as to warrant the imposition of penalties?

7. Questions 1 and 2 arise in all three appeals, that is to say the Commissioner's appeal NSD 1790 of 2006, and R & D's appeals NSD 1798 and 1799 of 2006. Questions 3 and 4 arise in R & D's appeals.

The property and the mortgage

8. Chapel Road acquired the property in June 1987 for $3.37 million. It constructed a seven floor commercial office block. To fund acquisition and construction it borrowed $12.3 million, later extended to $14 million, from Burns Philp Trustee Company Limited as trustee for Estate Mortgage Trusts. The loan was secured by a mortgage over the property.

9. In late 1989 Chapel Road appointed Raine & Horne as agent for the letting and managing of the building.

10. On 19 March 1990 the Estate Mortgage loan was refinanced by a loan of $14 million from Mercantile Mutual Life Insurance Company Ltd secured by a registered first mortgage loan over the property. The loan was for a term of two years with an interest rate of 21.5 per cent, reducible to 17.5 per cent on payment within seven days of the due date.

11. At the time of the Mercantile Mutual loan Chapel Road had obtained a valuation of $17.5 million for the property. About 60 per cent of the building was leased although some tenants had the benefit of rent-free periods.


12. The rent received did not cover the interest and other outgoings. Chapel Road failed to pay the interest due on 31 March and 30 April 1990.

13. On 17 May 1990 Mercantile Mutual gave notice to tenants that it was exercising its

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rights under s 63 of the Real Property Act 1900 (NSW) (the RP Act) to enter into receipt of the rents. The notice directed tenants to pay rent directly to Mercantile Mutual's agent Dyson Austen & Co.

14. On 23 May 1990 Mercantile Mutual gave notice under s 57(2)(b) of the RP Act in respect of the defaults. Non-compliance with the notice provided a trigger to the mortgagee's power of sale under s 58 of that Act.

Management of the property

15. On 5 June 1990 Mr Andrew Richardson of R & D wrote to tenants noting the new rental arrangements but indicating that the property would "continue to be managed" by his company and Raine & Horne.

16. In January 1991, according to Mr Richardson, Mercantile Mutual asked him if a single agent, Jones Lang Wooten, should replace the two existing agents in order to save expense. Mr Richardson's evidence was that he agreed, provided JLW kept him fully informed and provided management reports on the property.

17. JLW were duly appointed by Mercantile Mutual as its agent. His Honour found (at [90]) that thereafter Mercantile Mutual was a mortgagee in possession.

18. In the following years Mercantile Mutual through its agent JLW collected the rents and paid the outgoings of the building from those rents. It supplied Chapel Road with annual reports on collections and outgoings.

19. At the beginning of the 1992 tax year the loan debt exceeded $20 million. By the end of the 1997 tax year it had grown to over $65 million and daily interest liability then exceeded $38,000.

Sale of the property

20. Mercantile Mutual made an unsuccessful attempt to sell the property in 1997. Finally it effected a sale in November 2000 for $11.75 million. By this time the debt to Mercantile Mutual exceeded $100 million.

1. Losses and outgoings of chapel road


21. Section 51(1) of the 1936 Act, applicable to the 1997 tax year, relevantly 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,... ."

22. Section 8-1 of the 1997 Act, applicable to the 1998 and 1999 tax years, is not materially different. It includes the alternative criteria of losses and outgoings being "incurred in gaining or producing the [in the 1997 Act 'your', ie the taxpayer's] assessable income" or "being necessarily incurred in carrying on a business for the purpose of gaining or producing such [1997 Act 'your'] assessable income". Both provisions exclude losses of capital, and losses of a capital nature or of a private or domestic nature.

Trial judgment

23. His Honour summarised the contentions of R & D (at [103]-[104]) and the Commissioner (at [105]-[111]). The latter's case before his Honour, and repeated before us on appeal, was fairly encapsulated as follows (at [112]):

"The Deputy Commissioner's general characterisation of Chapel Road was that there was no income producing activity of the company and a fortiori no business of the company. For more than a decade - effectively the entire time that it was the mortgagor of the land - Chapel Road was irretrievably insolvent, had no prospect of ever paying the accumulating excess interest, made no attempt to do so and carried out no activities. The augmentation of the excess interest debt in no way contributed to the derivation (or even the possibility of derivation) of any assessable income."

24. In rejecting the Commissioner's case his Honour noted that in its 1992 to 1997 returns Chapel Road claimed, in addition to liabilities for interest, other deductions under the 1936 Act in respect of its ownership of the property: repairs and maintenance (s 53 and 51(1)), depreciation (s 54), capital allowances (Div 10D), rates and taxes (s 72) and other miscellaneous expenses (s 51(1)). In the proceeding before his Honour the Commissioner had initially taken the position

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that such expenses were not properly deductible. However, in the end the Commissioner accepted that such expenses were deductible, as was such part of Chapel Road's interest obligation as was discharged in each year by Mercantile Mutual's application of net rental income.

25. His Honour (at [115]) considered it was "artificial" to fragment the interest liability of a given year into that part which was discharged by the mortgagee's monthly application of net rental income and that part which was not. We agree. Chapel Road's interest liability was one and indivisible. It originated from, and was defined by, the terms of the mortgage and was not calculated by reference to expenses that Chapel Road or a mortgagee in possession might incur for expenses such as maintenance or, for that matter, receipts such as rental income. On the Commissioner's argument, if interest liability exceeded rental income plus expenses by only one dollar, that dollar would not be deductible.

26. His Honour noted (at [117]) that there was no suggestion that Chapel Road entered into the original Estates Mortgage loan or the Mercantile Mutual refinancing in order to generate transferable losses for R & D. Nor has it been suggested at any stage of these proceedings that the loans were a sham or otherwise subject to anti-avoidance provisions.

27. His Honour's reasoning may be summarised as follows:

  • • Generally speaking, where borrowed money is laid out for the purposes of gaining assessable income that furnishes the required connection between the interest paid upon it by the taxpayer and the income derived from its use:
    Federal Commissioner of Taxation v Munro (1926) 38 CLR 153 at 170-171;
  • • What is incidental and relevant is determined not by reference to the certainty or likelihood of the outgoing resulting in the generation of income but to its nature and character, and generally to its connection with the operations which more directly gain or produce assessable income:
    Commissioner of Taxation v Smith 81 ATC 4114; (1981) 147 CLR 578 at 586;
  • • "Outgoing" does not require an actual disbursement:
    Federal Commissioner of Taxation v James Flood Pty Ltd (1953) 88 CLR 492 at 506. Interest which has not been discharged by payment but rather capitalised can still be a loss or outgoing:
    Hart v Commissioner of Taxation 2002 ATC 4608; (2002) 121 FCR 206 at [23] et seq;
  • • The terms of the mortgage meant that each periodic liability, whether paid or capitalised, represented the cost of the money borrowed for the preceding month and was "payable for its period":
    Commissioner of Taxation (Cth) v Citylink Melbourne Ltd 2006 ATC 4404; (2006) 288 ALR 301 at [146]. Thus losses or outgoings would occur monthly across the life of the loan and were thus allocated or apportioned to the relevant years of income;
  • • Throughout the whole period of Chapel Road's ownership of the property assessable income was produced as originally intended, albeit from 1991 through the interposition of Mercantile Mutual as mortgagee in possession;
  • • Although Chapel Road could not repay the "continually swelling" principal sum, the nature and character of its interest liability did not change, nor did the purpose for which it had laid out the borrowed moneys;
  • • The relatively insignificant amount of income compared with the great increase of the principal sum only illustrated the "dramatically losing character" of the loan for Chapel Road in the circumstances;
  • • There is no assumption, express or implied, in s 51(1) or s 8-1 that the deductibility of an outgoing in the year in which it is accrued depends on it being met in due course.

The appeal

28. On the appeal the Commissioner argued that there was no "loss or outgoing". The relevant provisions did not apply to a liability which has not been and will not be discharged. A "loss" is something which depreciates the taxpayer's financial position; the accrual of interest did not do so in the present case because Chapel Road's financial condition was "irretrievably lost, and was beyond the point at which it could sustain further loss". Therefore Chapel Road was not, "as a practical matter", definitely committed or completely subjected to

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any discharge of its "jurisprudential liability" for interest accruing on the mortgage in the loss years.

29. The Commissioner's argument involves reading into the text of the relevant provisions a substantial qualification which, as far as we are aware, has never before been suggested. Certainly there is no direct authority for such an argument, although one would think there must have been many irrecoverable losses for which deductions were allowed for transferee companies since s 80G was introduced into the 1936 Act in 1984. No doubt there are other contexts in which genuine but "irretrievable" losses have been allowed.

30. As Finn J pointed out (at [140]), the Commissioner's argument that an obligation will only be allowed when payment in the future is a certainty

"... seeks to transform what may be a well-founded factual assumption in a given case as to what will happen in the future, into a legal prerequisite of deductibility."

31. The structure of the income tax system has as one of its foundation stones the obligation of taxpayers to lodge returns within a specified, limited period after the end of each tax year: 1936 Act s 161(1), 1997 Act s 3-10(1). As the experience of this case illustrates, in Australia property investment and loan decisions made in good faith by arm's length investors and lenders may have outcomes very different from those envisaged. Property values and interest rates fluctuate, at times wildly. It would be unfair and unworkable to make claims for losses in taxpayers' returns conditional on the accuracy of their prediction as to future events. Such an intention should not be imputed to Parliament in the absence of clear expression.

32. The interest liability of Chapel Road was not an illusory one, nor a sham. Amongst other things, it could have been relied upon to found a creditor's petition for winding up.

2. Incurred in gaining or producing income

Commissioner's argument

33. The Commissioner argued that any loss or outgoing was not incurred by Chapel Road in gaining or producing assessable income. The second limb of the statutory tests (incurred in carrying on a business) was not applicable because Chapel Road was not carrying on a business. As will be seen, we agree with the last-mentioned proposition, which will be discussed in the context of the loss transfer issues. The question is whether Chapel Road's losses satisfied the first limb. It would seem that this point was not raised as a separate issue before his Honour.

34. The Commissioner accepted that interest is ordinarily deductible because it is "a recurrent or periodic payment which secures, not an enduring advantage, but, rather, the use of borrowed money during the term of the loan":
Steele v Deputy Federal Commissioner of Taxation 99 ATC 4242; (1999) 197 CLR 459 at [29].

35. It was also not in dispute that, in the case of expenditure by way of interest on a borrowed amount, it is the purpose of the borrowing which will provide the nexus which characterises the expenditure as being "in gaining" assessable income. However, in the present case the Commissioner argued that although the borrowing originally had the requisite nexus with assessable income, by the time the claimed transferable losses accrued that nexus was "long lost". By the beginning of the 1992 tax year the company had lost possession of the property, the principal debt substantially exceeded the value of the company's total assets and by 1997 it was almost six times that value.

R & D's argument

36. R & D point out that the Commissioner does not identify the point in time at which the nexus was lost. It says that no such assertion was made before Finn J and thus no finding of fact was invited or made.

37. In this context R & D say that the point was abandoned at the trial and point to his Honour's judgment at [105]. However, that paragraph is dealing with a quite different point, namely the deductibility of other expenses such as maintenance and rates and so much of the interest as was discharged from rentals.

Breaking the nexus

38. A recent line of cases supports the proposition that a loss or outgoing may be deductible even if it is incurred some years after the associated business, or the taxpayer's involvement in it, has ceased:
Placer Pacific Management Pty Ltd v Federal Commissioner

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of Taxation
95 ATC 4459,
Federal Commissioner of Taxation v Brown 99 ATC 4600; (1999) 43 ATR 1,
Federal Commissioner of Taxation v Jones 2002 ATC 4135; (2002) 117 FCR 95 and
Guest v Commissioner of Taxation 2007 ATC 4265. In Placer the claimed deduction was for a payment in settlement of litigation in respect of defective goods supplied. In the other cases it was for interest on a business-related loan.

39. That the gap in time may be considerable is demonstrated by the following table:

Case Cessation Deduction
Placer 1981 1989
Brown 1990 1994
Jones 1993 1998
Guest 1991 1998

40. The concept of a break in the nexus was applied in
Commissioner of Taxation v Riverside Road Lodge Pty Ltd (in liq) 90 ATC 4567; (1990) 23 FCR 305. In 1970 the taxpayer company borrowed money to acquire land and construct a motel. There were repayments and further borrowings. In 1979 the taxpayer transferred the property to the trustee of a unit trust, the beneficiaries of which were the shareholders in the taxpayer. The consideration for the transfer was the current value, payable on demand, interest free. The trustee then leased the property back to the taxpayer, which continued to conduct the motel business. The disputed deduction was for interest on pre-1979 loans incurred after the transfer.

41. The Full Court (Northrop, Wilcox and Hill JJ) observed (at 314) that the case was not one where the activities of the taxpayer in operating the motel ceased during any relevant year of income. However, in 1979, as a result of the sale and lease-back, the character of the activities of the taxpayer changed. Before, it was an owner/operator of a motel; afterwards it was an operator of a motel owned by others and of which it was only a tenant. The Full Court disagreed with the view of the trial judge that the 1979 change was not sufficient to change the relationship between the interest payments and the business activity. The interest outgoings ceased to be "relevant and incidental" to the business activities engaged in by the taxpayer after 1979. They had "no real connection at all with the business of running a rented motel" (at 315).

42. In Brown the taxpayers borrowed money to fund the purchase of a delicatessen. They sold the business in 1990 but the proceeds were not sufficient to discharge the loan. They continued to pay interest until the loan was discharged in 1995. The Full Court (Lee, RD Nicholson and Merkel JJ) upheld the decision of the trial judge that there was a sufficient connection between the occasion for the payment of interest and the carrying on of the business. On the appeal, the Commissioner had argued that once the business had ceased the payment of the interest was not to be found in the carrying on of the business but in the voluntary decision of the partnership not to repay the loan and to continue to pay interest installments (at [15]).

43. Their Honours reviewed the case law, and in particular the decision of the High Court in Steele. They applied (at [20]) the statement of the High Court, adopting what was said by Lockhart J in
Federal Commissioner of Taxation v Total Holdings (Aust) Pty Ltd 79 ATC 4279 at 4283, that a taxpayer may be entitled to a deduction after a business has ceased, provided the occasion of a business outgoing is to be found in the business operations directed towards the gaining or production of assessable income generally. However, cessation of business may be of factual importance. Their Honours (at [24]) concluded that the trial judge was correct in determining that the occasion for the loss or outgoing in question was the payment of interest which the taxpayers were obliged (their Honours' emphasis) to pay under the loan contract.

44. As to the Commissioner's nexus argument, based on the taxpayers' "entitlement" to pay out the loan, their Honours said (at [27]-[28]) that the fact that the bank might, as a matter of practicability rather than legal obligation allowed early repayment did not alter the analysis. Their Honours continued:

"... In our view his Honour was correct in characterising the occasion for the liability in such circumstances as depending upon the terms of the contract rather than upon

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whether or not the partners might or might not have availed themselves of an opportunity to repay the loan on a particular day because of an indulgence shown by the lender on that occasion. In that regard, it is significant that the partners did apply the net proceeds of sale in repayment of the loan and his Honour did not appear to be prepared to find that the taxpayer and his wife had any other partnership assets which were available, had the Bank agreed, to discharge the loan when, or even after, the partnership business ceased.

28. Had the loan agreement in question been a 'roll over' business loan facility which entitled the taxpayer conducting the business, on the date of each monthly payment, to elect to repay the principal and thereby avoid incurring liability for interest or to 'rollover' the loan and continue to be liable for interest, that may have been a different situation. In that circumstance there may be considerable force in a contention that the occasion of the liability was the election to 'roll over' the loan on each monthly payment date, rather than any liability arising under the terms of the original loan agreement establishing the terms of the 'roll over' facility. In such a case the cessation of the business or sale of the income-producing asset acquired with the borrowed funds might properly be regarded as breaking the nexus in much the same was as certain post cessation interest payments were not allowed as deductions in Riverside Lodge. However, as explained earlier, that is not the situation in the present case."

45. In Jones a husband and wife conducted a trucking business in partnership. They took out a loan with the ANZ Bank in 1990. In 1992 the husband died. In 1993 the business ceased. The wife recommenced full-time employment as a nurse, using more than half her after tax income to repay the loan. In 1996 the wife refinanced the loan with another lender to obtain a lower interest rate. The Full Court (Beaumont, Finn and Sundberg JJ) upheld the wife's claim for deductions of interest for the years 1993-1998.

46. Their Honours (at [10]) rejected the Commissioner's argument that the taxpayer only became obliged to pay interest in the years in question because she chose not to repay the principal sum and that the "occasion" for the interest repayment was each periodic decision to keep the loan on foot. They did so for two reasons. First, the loan was for a fixed term and was not dependent on periodic decisions on the taxpayer's part to keep it alive. Secondly, she did not have the financial capacity to do so. Their Honours noted (at [11]) that "the borrowed funds and the interest on them were always referable to the former business".

47. Ultimately the question is a factual one:
Fletcher v Federal Commissioner of Taxation 91 ATC 4950; (1991) 173 CLR 1 at 18. Cessation of business may be of factual importance: Steele at [46].

48. Riverside Road is perhaps a hard case. Both before and after the sale and lease back the taxpayer carried on, at the same site and under the same name, the same income-earning activity of providing accommodation and meals. If a bystander had asked "What is Riverside Road's business?" the natural response would be "Running a motel" rather than "Running a motel on leasehold property".

49. It might be argued that the present case is stronger for the Commissioner than Riverside Road because not only did Chapel Road cease to carry on the business, but somebody else took it over. And the present case is to be contrasted with cases such as Brown and Jones where a business simply ceased but the business owner's mortgage liability continued.

50. Mercantile Mutual was not a trustee and was acting in its own interests. However, as Stone J demonstrates, it did not have an absolute right to deal with the income from Chapel Road's property as it saw fit. It was obliged to apply any income from the property in a particular way, namely by discharging liabilities, including Chapel Road's liability for interest. If any of the income was left over, it belonged to Chapel Road. The fact that - by a large margin - nothing was left over, does not change the ownership of that income. Chapel Road gained its income by reason of its ownership of the land which the tenants occupied and it incurred interest liabilities (and other expenses) in order to gain that income.

51. As is discussed below in the context of the "same business" issue, Chapel Road was not carrying on a business. It would not have

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satisfied the second limb of the relevant sections, but it satisfied the first.

3. Carrying on the same business


52. His Honour set out at [147]-[149] the relevant loss transfer provisions of the 1997 Act, ss 165-13 and 165-210. Notwithstanding the Plain English drafting, they are rather complicated. It will be sufficient to note the essential statutory test identified by his Honour, namely whether Chapel Road carried on for the whole of the 1998 income year "the same business that it carried on immediately before" 17 July 1997 (the date of the share transfer in R & D). There was no operative difference for the 1998 year.

Trial judgment

53. His Honour cited the statement of the High Court in
Federal Commissioner of Taxation v Murry 98 ATC 4585; (1998) 193 CLR 605 at [54]:

"A business is not a thing or things. It is a course of conduct carried on for the purpose of profit and involves notions of continuity and repetition of actions."

54. His Honour noted his earlier findings to the effect that Mercantile Mutual entered into possession as mortgagee from early 1991 and continued in possession until the property was sold in November 2000. The property was managed for Mercantile Mutual by JLW as its agent. JLW engaged in activities to be expected of a manager of an office rental property such as upkeep, provision of services to tenants, receipt of rentals and payment of outgoings. JLW accounted for the net rental to Mercantile Mutual. The latter and JLW provided annual financial statements to Chapel Road. Chapel Road's financial accounts and tax returns identified the income it received and outgoings incurred including its interest obligations.

55. The mortgage empowered the mortgagee, on default by the mortgagor, to enter upon and take possession of and manage the mortgaged land, to lease it, to provide services to occupants of the land, to carry on any business on the land and to employ agents to effect any of the mortgagee's rights.

56. His Honour held (at [159], [172]) that the powers conferred by the mortgage and the RP Act were for the benefit and protection of Mercantile Mutual. In entering into possession, appointing JLW as its agent and carrying on a rental business Mercantile Mutual was not supplying services to Chapel Road, nor acting as Chapel Road's agent. Rather it was exercising powers primarily for its own benefit, albeit with due regard to the interests of Chapel Road, and subject to its duty to account to that company.

57. His Honour found (at [173]) that at the relevant times Chapel Road did not carry on a business at all at the property; Mercantile Mutual did. Chapel Road had no access to the business assets. Although Chapel Road's assets were being put to gainful use, it was not Chapel Road that was doing this but Mercantile Mutual.

R & D's arguments

58. R & D's case was largely based on provisions of the RP Act.

59. Section 57(1) provides that a mortgage has effect as a security but does not operate as a transfer of the land mortgaged.

60. Section 63(1), said to be unique in Australian Torrens System legislation, relevantly provides:

"Whenever a mortgagee ... gives notice of demanding to enter into receipt of the rents and profits of the mortgaged ... land to the tenant ... all the powers and remedies of the mortgagor ... in regard to receipt and recovery of, and giving discharges for, such rents and profits shall be suspended and transferred to the said mortgagee ... until such notice is withdrawn, or the mortgagee ... is satisfied, and a discharge thereof is duly registered."

61. Proceeding from these provisions, R & D argued that s 63 does not affect any assignment to a mortgagee who enters into possession, and entering possession does not otherwise cause the cessation of a business. Alternatively, any assignment of rights in relation to the business effected by entry of possession is only an assignment by way of security. In any case the rent remains assessable income of Chapel Road because it was applied with or dealt with on its behalf or as it directs.

Chapel Road was not carrying on a business

62. The provisions of the RP Act, and general law rules about the obligations of a

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mortgagee in possession, do not bear on the factual question whether Chapel Road was in July 1997 carrying on a business and, if so, whether it continued to carry on the same business at all time up until July 1999.

63. Carrying on a business, as his Honour pointed out, was not a matter of owning an asset, but of engaging in a course of conduct. In July 1997, and indeed from 1990, Chapel Road was the legal owner of the mortgaged land, but was not in possession of it and carried on no business. It could make no decisions about such matters as engaging tenants or carrying out repairs and maintenance.

4. Penalties


64. No question of penalties arises in the 1997 year. For the 1998 and 1999 years R & D appeals against his Honour's finding that the tax shortfall was "caused by the recklessness of the taxpayer with regard to the correct application of (the) Act" (s 226H, 1936 Act) and that its position "was not reasonably arguable" (s 226K, 1936 Act). The concept of "not reasonably arguable" is defined in s 222C(1) which states that the correctness of the treatment of the application of a law

"is reasonably arguable if, having regard to the relevant authorities and the matter in relation to which the law is applied ... it would be concluded that what is argued for is about as likely as not correct."

"Authority" is defined to include the relevant income tax Act, intrinsic material of which account can be taken in interpreting that Act, the decisions of a court, Tribunal or board of review and public rulings.


65. Mr Richardson sought advice from his tax agents and an external advisor as to whether Chapel Road's losses could be transferred to R & D. However, the focus of the advice was on the question whether Chapel Road had allowable deductions. It was assumed that if there were such losses they would be transferable. No consideration was given to whether Chapel Road satisfied the same business test.

Trial judgment

66. His Honour (at [190]) was satisfied that Chapel Road and R & D and their advisors did not "positively engage" with the questions (i) whether Chapel Road was "carrying on a business" and (ii) what was the significance of Mercantile Mutual being in possession and managing the property, having regard to the effects of the law of mortgages. At best it was simply assumed that if Chapel Road had tax losses, those could be transferred to R & D.

67. Thus Chapel Road and R & D had no informed view, reasonable or otherwise, on the matter. Section 226K applied.

R & D's arguments

68. It was put that to be "reckless" within the meaning of s 226H the taxpayer must make a statement not caring whether it is true or false or without an honest belief in its truth:
R v McKinnon [1959] 1 QB 150 at 153,
Pollard v Director of Public Prosecutions (1992) 28 NSWLR 659 at 675. R & D accepted and adopted the view of the Commissioner in TR 94/4 that "reckless" had a meaning of "gross carelessness", or taking a risk. However, it submitted that he the court should be careful not to allow hindsight to affect its view of the merits of the taxpayer's arguments.

69. R & D noted that the Commissioner did not raise the mortgagee in possession s 63 point in its amended assessment or in argument at first instance, those matters being first raised by the trial judge. However, it accepted that this fact alone did not take the case outside s 226H.


70. In
Hart v Commissioner of Taxation 2002 ATC 4608; (2003) 131 FCR at [44] Hill and Hely JJ said that recklessness in the context of s 226H means something more than failure to exercise reasonable care, but less than an intentional disregard of the Act. Their Honours cited with approval what was said by Cooper J in
BRK (Brisbane) Pty Ltd v Commissioner of Taxation 2001 ATC 4111; (2001) 46 ATR 347 at 364:

"Recklessness in this context means to include in a tax statement material upon which the Act or regulations are to operate, knowing that there is a real, as opposed to a fanciful risk, that the material may be incorrect, or be grossly indifferent as to whether or not the material is true and correct, and that a reasonable person in the position of the statement-maker would see

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there was a real risk that the Act and regulations may not operate correctly to lead to the assessment of the proper tax payable because of the content of the tax statement. So understood, the proscribed conduct is more than mere negligence and must amount to gross carelessness."

As Hill and Hely JJ held, the test is an objective one but the mere fact that a claimed deduction is not allowable is not of itself sufficient to expose the taxpayer to a penalty.

71. As to the "not reasonably arguable" criterion, in
Pridecraft Pty Ltd v Federal Commissioner of Taxation 2005 ATC 4001; (2004) 213 ALR 450 at [108] Sackville J, with the concurrence of Ryan and Sundberg JJ, adopted the statement of Hill J in
Walstern v Commissioner of Taxation 2003 ATC 5076; (2003) 138 FCR 1 at [108]. That statement included the following propositions which apply in assessing whether a taxpayer's case was reasonably arguable:

  • • The test is objective, not subjective;
  • • There must be room for it to be argued which of the taxpayer's or decision-maker's position is correct so that on balance the taxpayer's argument can objectively be said to be one that, while wrong, could be argued on rational grounds to be right;
  • • The argument must clearly be one where, in making it, the taxpayer has exercised reasonable care;

72. His Honour correctly applied these principles. We do not see any error, particularly in the importance he placed on the failure of the taxpayer and its advisors to avert to the transfer of loss provisions.

5. Orders

73. All appeals should be dismissed. There should be no order as to costs.

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