Case M63

Judges:
HP Stevens Ch

CF Fairleigh QC
JR Harrowell M

Court:
No. 1 Board of Review

Judgment date: 4 September 1980.

H.P. Stevens (Chairman)

The question for decision in these references is whether or not it would be reasonable, in terms of sec. 23F(16), to exempt from income tax certain private company dividends received by the trustees of a Superannuation Fund in each of the years ended 30 June 1975 to 1978 inclusive.

2. Prior to 1958 an individual was carrying on business as a sole trader in relation to two overseas firms with whom he had oral agreements. For one he operated on the basis of a salary and commission related to sales made on its behalf. In respect of the other he purchased goods from them and distributed them on a wholesale basis. It was decided to incorporate a company to take over the second set of activities and this was done on 26 March 1958. The capital of the company was £10,000 divided into 40,000 shares of 5/- each ``with power for the Company to increase or reduce such capital and to issue any part of its capital original or increased with or without any preference priority or special privileges or subject to any postponement of rights or to any conditions or restrictions and so that unless the conditions of issue shall otherwise expressly declare every issue of shares whether declared to be preference or otherwise shall be subject to the power hereinbefore contained''.

3. The subscribers to the Memorandum and Articles of Association were the individual and his wife. The individual subscribed for 1 A class share and his wife 1 B class share. In this regard Art. 4 provided, inter alia:

``The initial capital of the Company is £10,000, divided into: -

  • (a) 5,000 `A' Class shares of 5/- each
  • (b) 5,000 `B' Class shares of 5/- each
  • (c) 5,000 `C' Class shares of 5/- each
  • (d) 5,000 `D' Class shares of 5/- each
  • (e) 5,000 `E' Class shares of 5/- each
  • (f) 15,000 shares of 5/- each

There shall be attached to the `A' Class, `B' Class, `C' Class, `D' Class, and `E' Class shares the special rights privileges and conditions following, that is to say: -

  • (i)...
  • (ii) The `A' Class, `B' Class, `C' Class, `D' Class, and `E' Class shares shall confer on the respective holders thereof the right only to such dividends as the Directors may from time to time determine as they think fit in respect of each such class of shares.
  • (iii)...
  • (iv) The Directors may at any time determine that a dividend be paid to the holders of any one or more class or classes of shares to the exclusion of the holders of any other class or classes of shares.
  • (v) The declaration and payment of a dividend to the holders of any class or classes of shares in accordance with any such determination or stipulation as aforesaid shall to the extent thereof satisfy their rights resulting from the said determination or stipulation.
  • (vi) Any such determinations and stipulations as aforesaid shall be binding upon all members of the Company.''

As will become apparent full advantage was taken of the rights to pay differential dividends. The individual was under the Articles to be Governing Director (Art. 60-68) and pursuant to Art. 68 he ``shall have to the exclusion of general meetings and the Board full authority to determine'' inter alia, ``(a) who shall be admitted as shareholders'' and ``(e) what dividend shall be paid on the shares and when such dividend shall be declared''.

4. In its first return of income for the period 26 March 1958 to 30 June 1958 the company showed a gross profit on trading of £1,328.18.8 and expenses of £1,819.11.8 (including wages to the individual, his wife, his son and his daughter totalling £828). It also showed a service fee from the individual of £993.15.0 on account of the fact that the company's staff and facilities were utilized to perform the services from which the individual received the salary and commission on sales referred to in para. 2. The individual said the amount of the fee was a yearly figure estimated on a conservative basis in conjunction with a firm of accountants. It will be later seen that a valuer took into account as a factor that this fee provided a substantial profit to the company but there was no evidence before the Board that this was in fact so.


ATC 442

5. These first accounts also showed as included in the expenses of £1,819.11.8 Superannuation £300. A schedule to the return indicated this comprised contributions for the individual £200 and his wife £100 and that these ``and the Superannuation Deed have been approved as advised by the Deputy Commissioner of Taxation in his letter dated 3, October, 1958''. In fact the Deed was not executed until 11 August 1958 - the trustees being the individual, his wife and a Chartered Accountant. The Deed recited that whereas the company with the object of establishing a fund had set aside in its books prior to 30 June 1958 an amount of £300 and ``it is desired that eligible employees should have the right to pay to the Trustees contributions thereunder and the Company also proposes to set apart in the books of the company or pay to the present Trustees or other the Trustees for the time being the amounts from time to time as hereinafter provided for to be held as part of the Fund'' and then went on to make a number of provisions. An eligible employee was defined to mean certain persons ``and who shall have been declared by the Company by notice in writing to the Trustees to be an employee entitled to be admitted to the Fund''. Following the amendment to the Superannuation Fund provisions applying as from the year ended 30 June 1966 the original Deed was adjusted by deed of 30 March 1966 - however such do not affect the provisions of the original Deed referred to above.

6. The persons initially admitted to the Fund were the individual and his wife whilst, during the 1977 year, the son was admitted. Thus only shareholders are and have been members of the Fund. A person who was employed by the company in a senior position (being sent on at least one overseas trip to the company's main principal) for almost 20 years was never admitted and it was suggested this was due to his health and doubts as to whether he would remain. In this regard it is mentioned that this individual shareholder was also said to be in bad health - a doctor for assurance purposes telling him he had only a short life span - and this was a factor taken into account by the valuer. The evidence as when this occurred was not precise - it happened 3-4 times in the late 1950's to early 1960 - and I am not prepared to find it happened after he had become a member of the Fund. There was no evidence that employees of the company ever were made aware of the existence of the Fund.

7. After the incorporation of the company shares were allotted and, as at October 1958, the shareholdings were:

                                                     Trustee
      Individual       Wife       Trustee Son       Daughter       Total
        9801 A        2001 B          100 C           100 D       12,002
          

During the 1959 year dividends were declared only on the C and D class shares. In December 1959 400 E class shares were allotted to the Fund - no other shareholders participating - and the cost £100 journalized against the amount of the Current A/C with the company (comprising £295 of the initial £300 contribution and journalized interest and further contribution at 30 June 1959). On 28 April 1960 a dividend was declared as follows:

    A           B            C           D           E           Total

   245         50           287         287        1150          2019
        

The E dividend representing 56.90% of the total on a shareholding interest of 3.22%. This dividend, additional contribution and interest were journalized and as at 30 June 1960 the balance of the Current A/C was £2,013.7.11.

8. In early December 1960 additional shares were issued viz.:

            
          A           B            C            D            E           Total

Before
issue   9,801       2,001         100          100           400        12,402

Issue   6,799       1,999         100          100         3,400        12,398
       ------       -----         ---          ---         -----        ------
       16,600       4,000         200          200         3,800        24,800
       ------       -----         ---          ---         -----        ------
          

The cost to the Fund of the 3,400 shares (£850) was again journalized. After these shares were issued a dividend of £2,300 was declared on 28 December 1960 and one of £150 on 27 April 1961 - the break up thereof was:

     A           B           C           D            E           Total

    208         220         362         362         1,298         2,450
        

This dividend (representing 52.98% of the total on a 15.32% holding) plus the interest was journalized and the Current A/C balance as at 30 June 1960 was £2,614.13.3 - as at 30 June 1961 it was £2,393.

9. A further dividend was declared on 28 December 1961 viz.:

      A           B           C           D            E           Total

     250         464         395         395         1,396         2,900
          

This time the dividend of £1,396 (48.14% of total) was paid to the Fund and, after the purchase of bonds, the Fund had a bank account balance of £1,824.13. - as at 30 June 1962. On 16 July 1962 a further loan of £1,700 was made to the company whilst on 8 August and 19 December 1962 bonds were purchased. An analysis of the Cash Book of the Fund indicates as at 19 December 1962 (if all cheques presented) it was in an overdrawn situation. In December 1962 a further issue of shares was made viz.:

           A           B           C           D           E            Total
           -           -         1,800       1,800       5,200          8,800

After
issue  16,600        4,000       2,000       2,000       9,000         33,600
        

This increased the Fund's proportion to 26.78% and the cost £1,300 was shown in the Cash Book (20 December 1962) whilst on 15 January 1963 the company paid the Fund £500 and on 1 March 1963 £1,300. No bank statements were produced so it is not known whether the 20 December 1962 payment cheque was presented prior to the above receipts.

10. Dividends declared after the above issue of shares were:

              A         B         C         D         E         E         Total
                                                                %

28.12.62     700       400       200       200       900       37.50      2,400
30.12.63     498     1,000       500       500     1,350       35.08      3,848
31.12.64     350     1,300       610       610       154        5.09      3,024
              $        $          $         $         $         %           $

30.12.66     139       300       250       250       405       30.14      1,344
29.12.67   1,000     2,760       250       250       540       11.25      4,800
          

ATC 444

With the exception of the amounts of £154 and £540 the dividends were journalized and as at 30 June 1968 the Current A/C balance was $14,291.

11. In March 1969 cl. 4 of the Articles of Association was amended to, inter alia, introduce a new class of shares - called Group 1 shares and 200 of such shares were issued to a Norfolk Island entity (for tax advantages etc.) - a Norfolk Island Share Registry was set up and all shares transferred thereto (reducing the Fund's proportion to 26.63%). The next two dividends declared were:

           A       B       C       D       E       E       Group 1       Total
           $       $       $       $       $       %         $             $

31.3.69   250     250     250     250     540    13.34     2,500         4,040
7.4.70    250     250     250     250     540    13.34     2,500         4,040
          

Thereafter no dividends were declared on the Group 1 shares until their transfer to the individual's wife - recorded in the share register as being 29 October 1975 but apparently treated as being earlier. The next four dividends were:

                  A       B       C       D       E       E       Total
                  $       $       $       $       $       %         $
28.4.71          250    1,250    250     250     540    21.26     2,540
28.4.72           -       -      250     250      -       -         500
27.4.73          332    1,000    500     500     330    12.40     2,662
29.4.74          664    1,500    600     600     480    12.48     3,844
        

12. The individual transferred 2,000 of his A shares to his son and daughter (1,000 each) and on 26 July 1974, transferred the balance to a Nominee Company. Subsequently declared dividends have not differentiated between the classes of shares being as follows:

                     Nominee
Date        Rate     Company     Wife     Son     Daughter     Fund     Total
             c          $         $        $         $           $        $

30. 4.75    36        5,256     1,512    1,080     1,080       3,240   12,168
 6.11.75    30        4,380     1,260      900       900       2,700   10,140
31.12.76    52.5      7,665     2,205    1,575     1,575       4,725   17,745
17. 3.78    41.72     6,091     1,752    1,251     1,252       3,755   14,101
15.11.78    47        6,862     1,974    1,410     1,410       4,230   15,886
          

It was said the amounts declared were only such as to constitute sufficient distributions in terms of the provisions of Div. 7 of the Act. In this regard tendered Div. 7 notifications for the years ended 30 June 1974, 1975 and 1976 showed required distributions (after small excess distributions) of $11,986, $9,753 and $17,735 respectively.

13. Although the Fund's books of account record only annual contributions by the company (the sole contributor) on behalf of the individual $400, wife $200 and lately son $200 (who is now a Director) the company's returns of income have for many years claimed Superannuation deductions well in excess of those figures. The relevant claims for the last few years have been 1973 $4,188, 1974 $4,188, 1975 $5,385, 1976 $5,385, 1977 $5,585, 1978 $5,586 and 1979 $15,308. It would appear the company pays premiums to an assurance institution but, as there is no reference thereto in the Fund's books and the individual was vague in relation thereto it cannot be found that whatever policies etc. exist, belong to the Fund. The last known balance of the Fund


ATC 445

with the company is that as at 30 June 1978 viz. $56,000. It was not stated what the precise basis on which the current account balance was held by the company but the Fund returned and the company claimed, interest thereon - the 1979 interest claim being $6,720.

14. In view of the fact sec. 23F(16) directs the Commissioner to have regard to, inter alia, the cost to the Fund of the shares on which dividends are paid evidence was led from a chartered accountant as to what would have been a proper arm's length valuation of the shares in the company as at each of the dates shares were allotted to the Fund. The person concerned, from the firm of Chartered Accountants who apparently lodged the requests for reference, said he only received instructions to make the valuation the day before the hearing took place and that there had been no conference with him concerning the valuation to be made. Although he was allowed to be present (as an expert witness) during the giving of evidence by the individual it was clear that his valuation was based not on that evidence but was the subject of prior written notes to which he referred to in the witness box. He said the appropriate values were December 1959 42c, December 1960 16c and December 1962 20c. He deposed that he had had regard, inter alia, to the company's accounts for the years ended 30 June 1959 to 1963, the fact it was a minority interest (with the directors able to issue other shares without the Fund participating), the fact that discretionary dividends could be paid, to information given him that quotas were hard to obtain, to tariff matters, to information concerning efforts to exclude the company from the relevant market, to the contacts being personal to the individual and to information that the individual's health was suspect. He said he had ignored the fact that the individual was still active and that the company had prospered. Reference was made to averaging up to 5 years past profits (the company's taxable income for 1959 was $4,508 increasing to $9,812 for 1963) and to a capitalisation rate of 25% - also used 20% rate but no significant difference - but no details of his calculations were placed before the Board.

15. I make two comments in respect of this ``valuation'':

  • (i) A court will reject the valuation of shares in a private company made by its auditor ``for instance, if the expert... took something into account which he ought not to have taken into account, or... interpreted the agreement wrongly, or proceeded on some erroneous principle...'' (per Denning L.J. in
    Dean v. Prince (1954) 1 All E.R. 749 at p. 758 applied by Megarry J. in
    London Borough of Hounslow v. Twickenham Garden Developments Ltd. (1970) 3 All E.R. 326 at p. 350). It is a grave error for a valuer to rely on all that he is told by his client or all that is given in evidence, without making a judicious selection of material.
  • (ii) If there was to be any discrimination, the facts of the April 1960, December 1960 and December 1961 dividends show such discrimination to be in favour of the Fund. One might also be pardoned for thinking that, where the members of the Fund are the governing director of the company and his wife discrimination against their interests would be negligible - although to an outsider ``buying'' in it would be different.

I take the matter no further for I am prepared to accept that shares allotted to the Fund were not allotted at any under value in relation to those allotted to other shareholders.

16. For the Fund it was argued that sec. 23F(16)(a) was satisfied because all shares were fully paid, (b) was also satisfied because a proper ``cost'' was paid (see para. 14-15 above) and (e) was met since no shares had been issued in satisfaction of a dividend or part thereof. This left sec. 23F(16)(c), (d) and (f) to be covered and, with regard to (c) and (d) it was said the quantum of the dividend was irrelevant and that the only factor was the percentage holding of the shares in the company by the Fund. It was submitted, after reference to the decisions in Cases A38, 39, 40, 41 and 77,
69 ATC [pp. 225, 229, 233, 421 respectively], Case B15,
70 ATC 61 and Case E56,
73 ATC 442, that there was no magical percentage to be applied to all cases and the present percentage did not offend. It was also submitted that there were here no ``neutral'' factors against the taxpayer and that if there were, it rested only in the fact the senior employee referred to in para. 6 had


ATC 446

not been made a member. No specific reference was made to the provisions of sec. 23F(16)(f).

17. On the other had the Commissioner's representative placed strong emphasis upon the decisions in Cases A38 and 39, 69 ATC (supra) and Case B15, 70 ATC 61 (all decisions of this Board as then constituted). In the first case where shares were allotted at less than full value it was also said (at p. 227):

``... the facts that the company is the only contributor to the Fund and that the Fund's shareholding entitles it to one-fifth of all distributed profit combine to persuade us against concluding that it would be reasonable to exempt from tax the dividend of $400 received from the private company.''

In the second case it was said that the fact contributions of members and the company were equal was favourable to the claim but that this (at p. 229):

``... is overwhelmed by the facts that the $600 dividend received by the Fund is one-quarter of the $2,400 paid as dividend by the company and that the whole of such $600 enures only to the benefit of the two director-shareholders.''

Case B15 (supra) was more complicated in its facts and the Fund's receipt of 18.5% and 17.27% respectively was only one of the factors leading the majority to conclude that it would not be reasonable to exempt the dividends but nevertheless was relied on. The Commissioner's representative said that since the Board had regarded 20%, 25% and 18.5% and 17.27% as not complying then it followed the 26.63% in each of the years here could not fail to be held to be excessive. I take he meant that the percentage was such as to make it unreasonable to exempt the dividends.

18. I do not propose to embark on a consideration of what is or is not an acceptable percentage. This will vary according to the facts of each particular case. However, I do not think that, in a private company where the company is the sole contributor and the shareholder/directors are the only members of the Fund, a 26.63% holding and a 26.63% share of dividends declared is a reasonable one.

19. Although I am of the above view, I would express my decision in this case on the basis that, having regard to the totality of the evidence including:

  • (a) the existence of the power to discriminate;
  • (b) the manner in which (a) has been used;
  • (c) the fact one result of (b) has been to enable the Fund to acquire the 26.63% holding;
  • (d) the lack of evidence as to why the particular issues to the Fund were made when they were and as to the size thereof;
  • (e) the fact the company is the sole contributor;
  • (f) the fact the sole members are director/shareholders; and
  • (g) the fact there is no evidence employees generally were made aware of the existence of the Fund let alone given an opportunity to join,

I am of the opinion that it would not be reasonable to exempt the dividends arising from the 26.63% holding from income tax.

20. For the above reasons I would uphold the Commissioner's decision on the objections and confirm the assessments at issue.


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