STEELE v DFC of TJudges:
Full High Court
MEDIA NEUTRAL CITATION:
 HCA 7
Gleeson CJ, Gaudron and Gummow JJ
The principal issue in this appeal concerns the deductibility, for income tax purposes, of interest where the borrowed money has been used to purchase and hold a capital asset intended to be developed for income-producing purposes.
2. In respect of the year of income ending 30 June 1987, the appellant claimed but was denied a deduction for interest, and certain other relatively minor outgoings, under s 51(1) of the Income Tax Assessment Act 1936 (Cth) (``the Act''). An objection by the appellant to the respondent's assessment was disallowed. The other outgoings were rates and rents. It is common ground that the decision in relation to the interest will apply equally to those other amounts. The disallowance by the respondent of the appellant's objection to the assessment was referred to the Administrative Appeals Tribunal (``the Tribunal'') pursuant to s 187 of the Act. The respondent's decision was substantially upheld, although it was varied in certain respects. An appeal to the Federal Court was dismissed by RD Nicholson J.
3. The facts may be summarised as follows.
4. For a number of years before 1980 the appellant had been engaged, both as an owner of businesses and in a managerial capacity, in the catering and hospitality industry. In 1980, having recently sold a business, she was looking for a new opportunity. She observed that a property near Perth Airport, named ``Tibradden'', was for sale. The area of the property was 7.4 hectares. The land was being used for purposes associated with horse racing. The improvements on the land included twelve brick stables, horse exercise paddocks, feed preparation rooms, a training ring, a breaking-in ring, and two houses. They were in good condition. The appellant investigated the possibility of using Tibradden for agistment and as a site for motel development. She was informed that zoning would not be a problem. She also made enquiries about some adjoining land, owned by a public authority, which was leased by the company which owned Tibradden.
5. In December 1980 the appellant contracted to purchase the property for $1 million. A deposit of $5,000 was paid. A further payment of $95,000 was to be made on 8 January 1981. The balance of $900,000 was to be paid on 8 January 1982. The contract of sale obliged the appellant to pay interest on the unpaid purchase money from 16 December 1980. The appellant took possession on 18 December 1980.
6. The interest in dispute in these proceedings was interest paid to the vendor on the unpaid balance of purchase money, and on moneys owing to a finance company and, later, a bank, on the security of Tibradden. The issue between the appellant and the taxation authorities formally arose in relation to her assessment to income tax in respect of the year ended 30 June 1987. She claimed deductions amounting to $909,649 in respect of losses said to have been incurred in that year and in each of the six
ATC 4245previous years. The losses were said to have arisen mainly from the interest payments and, to a minor extent, the rates and rents, referred to above.
7. From December 1980 until May 1987, when she sold her then remaining interest in the property, the only business conducted on the property was that of agisting horses. At the same time, the appellant pursued, actively and in a variety of ways, the possibility of using the land for motel and residential development.
8. In July 1981 the appellant engaged a firm of architects to prepare schematic designs for 80 townhouses. The proposal was described as ``Residential Development with Community Facilities, Restaurant, Office Accommodation, Recreation Sports and Riding''. She also entered into negotiations with Mr Williams, a business associate who was the managing director of a construction company, for a possible joint development of the property. In December 1981 the appellant and Mr Williams, having received engineering advice, applied to the local council for planning approval in respect of the construction of 40 units of motel- style accommodation, including administration and restaurant facilities, together with 110 free- standing units which could be either self- contained or serviced from the motel administration centre. The application was refused on grounds related to zoning and sewerage requirements. In January 1982 the appellant sold half of her interest in Tibradden to Mr Williams for $650,000. There was a collateral agreement which required Mr Williams to pay a specified additional sum ``if the project proceeds to profitable completion''.
9. In January 1982 a further application was made to the local council, and the development was approved in principle. Later in that year a new architect was engaged, and a revised motel development plan, including livestock stables and a yearling sales complex, was prepared, and was approved by the council. The appellant and Mr Williams completed the purchase of Tibradden and took title in accordance with the contract. In 1982, and during 1983, they negotiated with Southern Pacific Hotel Corporation Ltd for the sale to that company of an interest in, and management rights over, the proposed motel. Those negotiations ultimately fell through. In 1984 the taxpayer and Mr Williams fell into dispute about the project. This resulted in litigation, and an order of the Supreme Court of Western Australia for partition or sale of the property. The property went to auction in December 1986. The appellant was the successful bidder. In May 1987 she sold a half interest, and she sold her remaining half interest some eighteen months later.
10. While these things were going on, the land was being used for the commercial agistment of horses. The income derived from that activity was modest. The Tribunal accepted as approximate estimates of the appellant's one half share in such income figures which amounted in total, from 1981 to 1987, to $28,943.
11. The Tribunal made the following finding as to the appellant's purpose in acquiring Tibradden:
``We accept that in 1979, [the appellant], having sold her business, was looking round for an investment which would provide her a good income. However, we reject [her] assertion that her equestrian interests played any role in her initial search. Indeed, we are satisfied that when she discovered that Tibradden was on the market, her interests were focused on its commercial possibilities as a motel site, and the fact that the property was presently used for agisting horses was merely fortuitous. We therefore accept as accurate - and accurately reflecting [her] intention - the answer she gave... as to how she intended to use Tibradden, viz: `my intention was to build a motel and operate it by myself. It was my belief that another motel business in that area would be profitable, given the proximity to the airport and the city'. The fact that Tibradden was used for agistment purposes was thus a lucky coincidence - lucky in the sense that it coincided both with her own interests, as well as contributing, however modestly, to the holding costs whilst the motel plans were being developed. It also provided accommodation and an occupation for [her] sister.''
12. The manner in which those findings are expressed appears to reflect an emphasis placed by the appellant's counsel on certain aspects of the facts which was rather different from the emphasis placed in this Court. It reflects, and responds to, an argumentative suggestion that what was important in securing the deductibility of the interest was the income-earning activity
ATC 4246involved in the agistment business. That is not the way the case was put in this Court.
13. The Tribunal also pointed out that, when the appellant purchased Tibradden, she had not undertaken any feasibility studies, or costing, of the development of the site. Exactly what such development would involve, how much it might cost, who might join her in the enterprise, and what might be done if development proved to be commercially unattractive or impractical, remained to be considered. One estimate of development costs later received was of the order of $9.7 million. These considerations were regarded as of relevance to the concept of ``commitment'', to which further reference will be made below.
14. The Tribunal summarised the appellant's purposes, in language which assumed particular significance in the Federal Court, as follows:
``The [appellant] incurred interest on a loan to secure `Tibradden' for a dual purpose, one to derive assessable income from the agistment activities - an affair of revenue - and the other to develop a profit-yielding structure of a future business enterprise - an affair of capital.''
15. On that basis, the Tribunal concluded that there should be an apportionment of the interest and other outgoings, the appellant being allowed a deduction in an amount equal to her share of agistment income and being denied a deduction in respect of the rest, which was the greater part.
16. At first instance in the Federal Court, RD Nicholson J substantially upheld the Tribunal's decision, although he allowed the appeal in so far as it related to penalty tax, which is no longer in issue.
17. Section 51(1) of the Act at the relevant times provided:
``All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.''
18. The appellant argued that the interest was an outgoing wholly incurred in gaining or producing the assessable income referred to in the first part of the provision, and that it was not to any extent an outgoing of capital or of a capital nature. The majority in the Full Court of the Federal Court held that the interest was an outgoing of a capital nature, and on that ground rejected the appellant's claim. In this Court the respondent supported that conclusion but argued, alternatively, that the first limb of s 51(1) was not satisfied, and that it was unnecessary to rely upon the exception.
An outgoing of a capital nature?
19. It was common ground in this Court that the question whether the interest incurred by the appellant was an outgoing of a capital nature is a question of law. This is of significance, because the appeal to the Federal Court from the Tribunal was brought under s 44 of the Administrative Appeals Tribunal Act 1975 (Cth) and was ``on a question of law''. In the Full Court of the Federal Court, the majority decided that the dispute between the parties should be resolved, adversely to the appellant, upon this issue of law. It was also common ground that the facts as summarised above, including the Tribunal's findings as to the appellant's purpose in acquiring Tibradden, were to be accepted as the facts on which the question of law was to be decided.
20. It is not in dispute that the interest incurred by the appellant related to borrowings (or deferred payments) wholly used to purchase and hold a capital asset, Tibradden. Nor is it in dispute that the appellant's purpose in acquiring Tibradden was entirely commercial; she intended to develop it and use it for the purpose of gaining or producing assessable income. The majority in the Full Court of the Federal Court held that, since the advantage sought by the payment of interest was the acquisition of a capital asset, that determined the character of the payments, subject to one qualification which, in the events that occurred, never became relevant. The qualification was expressed as follows:
``... Had the project proceeded and a motel been opened, of course, that advantage would then have been achieved; and if the loan had not been paid off, but had been continued, the advantage thereafter sought by further payments of interest would have been the continued availability of the sum borrowed to support from period to period
ATC 4247the use of the capital asset in income- gaining activities.''
21. This reasoning was regarded as being supported by the decision of the Privy Council, on an appeal from the Court of Appeal of Hong Kong, in Wharf Properties Ltd v Commr of Inland Revenue (Hong Kong).
22. Three preliminary matters should be noted. The first is an established principle as to the meaning and effect of s 51(1), which is of direct relevance to the second main issue on the appeal, but which is also of indirect relevance to this first issue. It concerns the meaning of the expression ``the assessable income'' in the first limb of s 51(1). The principle is not in dispute. It was summarised in Fletcher & Ors v FC of T
``... [A] point to be made about s 51(1) is that the reference in it to `the assessable income' is not to be read as confined to assessable income actually derived in the particular tax year. It is to be construed as an abstract phrase which refers not only to assessable income derived in that or in some other tax year but also to assessable income which the relevant outgoing `would be expected to produce'.
... It has also been said that the test of deductibility under the first limb of s 51(1) is that:
- `it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income'.''
23. The legislative history together with the background of judicial interpretation, was examined in Ronpibon Tin NL and Tongkah Compound NL v FC of T.
24. The second matter to be noted is that it only becomes necessary to consider the exceptions to s 51(1) if it has already been concluded, or accepted by hypothesis, that one or other of the positive limbs applies. Leaving aside the agistment income, which was not relied upon in this Court to support the deductibility of other than a small part of the interest, the present case was not said to fall within the second limb of s 51(1). However, it is not difficult to imagine examples of property development, and pre-construction liability for interest, which would fall within that limb, and which could give rise to an issue as to the application of the same exception as is presently under consideration. The present appeal was argued on the basis that it was the first limb that was relevant. Thus, the question is whether interest outgoings which, by hypothesis, were incurred in gaining or producing assessable income, in the sense outlined above, were outgoings of a capital nature. The majority in the Full Court of the Federal Court did not find it necessary to make a decision as to the validity of the hypothesis. That would have involved an issue of fact and the subject-matter of the ``appeal'' to the Federal Court was limited to ``a question of law''. However, they indicated that they were favourably inclined towards the arguments advanced by the appellant on the point. It was submitted in this Court that, in their reasoning as to the application of the exception, the majority failed to recognise the full significance of the hypothesis. As will appear, that turned upon the existence of a connection implicit in the phrase ``in gaining or producing the assessable income''. That requirement is not to be disregarded in considering whether the interest was an outgoing of a capital nature.
25. The third matter concerns the qualification, quoted above, by which the Full Court expressed the opinion that the interest paid by the appellant would have ceased to be capital in nature, and would have been on revenue account, if and when a motel had been built on the land and had commenced to produce income. There are some problems involved in this reasoning. The interest in question was on funds borrowed (including deferred instalments of purchase price) to fund the acquisition and holding of real estate. Tibradden was, and would have remained, a capital asset, even if, as a consequence of a motel development, (presumably funded by further borrowings), it had become income- producing. There would have been no change in the purpose of the original borrowing. A capital asset was acquired for the purpose of gaining or producing assessable income. If it were otherwise, the first limb of s 51(1) would not
ATC 4248have been satisfied, and the exception would not have arisen for consideration. The immediate purpose of the borrowing, and the application of the borrowed funds, was, and would have remained, the acquisition of a capital asset. In so far as the ultimate objective was to use the capital asset in the gaining or production of assessable income, that objective was there from the beginning. This is not a case in which real estate was acquired by a purchaser who had a number of alternative possible uses in mind, some of an income-producing nature and others of a different nature. The finding of fact was that the appellant's intention was to build a motel and conduct a profitable motel business. That is why she bought the land. It is not clear how it can be said that the purpose of the borrowing would change when, at some unspecified time, her original intention in acquiring the land came closer to fulfilment. To use the words of the Tribunal, Tibradden was acquired by the appellant as ``an investment which would provide her a good income''. The Full Court's view was that the character of the interest paid on moneys borrowed to purchase that investment would change either once it commenced to produce income or perhaps at some unidentified earlier stage. However, the nature of the investment, which was in commercial real estate, remained, and would remain, constant.
26. In Texas Co (Australasia) Ltd v FC of T
``... Some kinds of recurrent expenditure made to secure capital or working capital are clearly deductible. Under the Australian system interest on money borrowed for the purpose forms a deduction. So does the rent of premises and the hire of plant.''
27. The reference to ``the Australian system'' may have been intended to contrast the position in the United Kingdom, where what fell to tax were the profits of a business activity, rather than taxable income calculated as assessable income less allowable deductions as defined in s 51(1) and its precursor.
28. The present case does not raise problems, of the kind that have been considered elsewhere, relating to pre-payment of interest, or payment of interest, between the parties not at arm's length, at a non-commercial rate. Here interest was paid on ordinary commercial terms for the use of money expended to acquire and hold Tibradden. The case was decided in the Tribunal, and in the Federal Court, and argued on both sides in this Court, on the footing that there was no material difference between the interest paid to the vendor on the unpaid balance of purchase moneys and the interest paid to the finance company and later to the bank. It was all treated as interest on money borrowed for the purpose of purchasing and holding Tibradden.
29. As was explained in Australian National Hotels Ltd v FC of T,
ATC 4249the present is an example, where interest is a recurrent payment to secure the use for a limited term of loan funds, then it is proper to regard the interest as a revenue item, and its character is not altered by reason of the fact that the borrowed funds are used to purchase a capital asset. The fact that the asset has not yet become, and may never become, income- producing may be relevant to a decision as to whether the case falls within the first limb of s 51(1). However, once it is determined, or accepted by hypothesis, that the interest is, during the relevant year, an outgoing incurred in gaining or producing the taxpayer's assessable income, (even though no assessable income is derived during that year, and no such income may ever be derived), the circumstance that the capital asset has produced no income is not a reason to conclude that the interest is an outgoing of a capital nature.
30. The decision in Travelodge Papua New Guinea Ltd v Chief Collector of Taxes,
31. The decision of the Judicial Committee of the Privy Council in Wharf Properties Ltd v Commr of Inland Revenue (Hong Kong)
32. Lord Hoffmann, delivering the judgment, said:
``Thus, while the question of whether money is intended to be used for a capital or revenue purpose is inconclusive as to whether its receipt is a revenue receipt or an addition to the company's capital, the purpose of the loan during the period for which the interest payment was made is critical to whether it counts as a capital or revenue expense. In the present case, during the whole of the two years in question, the loan was clearly being applied for the purpose of acquiring and creating a capital asset rather than holding it as an income- producing investment. It follows that the interest was being expended for a capital purpose.''
33. The three preliminary matters referred to earlier are all relevant to this reasoning, or, more accurately, to its application to the Australian legislation. In particular, the distinction between acquiring a capital asset and holding it as an income-producing investment, which may be related to the concept of calculating the profits of a business activity, is not one upon which the Australian legislation turns.
34. The majority in the Full Court of the Federal Court erred in deciding the case against the appellant upon the ground that the interest was an outgoing of a capital nature.
35. However, the respondent seeks to support the decision against the appellant on the basis that the first limb of s 51(1) was not satisfied. That gives rise to the second main issue in the appeal.
The first limb of s 51(1)
36. Leaving to one side the matter of the agistment income, the Tribunal decided against the appellant, in respect of the bulk of the interest payments, substantially upon the ground that the first limb of s 51(1) was not satisfied. However, as Carr J pointed out in the Full Court of the Federal Court,
37. RD Nicholson J, at first instance in the Federal Court, decided that it was open to the Tribunal to conclude that the first limb of s 51(1) was not satisfied. He said:
``... An outgoing may be precluded from deductibility if it is incurred at a point too soon before the commencement of the business or income producing activity...
The evidence showed that existing zoning did not permit the motel complex development. The applicant had made informal and preliminary inquiries about zoning, road closure and sewerage connection. The identity of the project varied. Initially townhouse units were included as strata units for investor purchase. A half interest was acquired in the property on 8 January 1982. In October 1982 the applicant approached Southern Pacific Hotels to take an equity interest in the project but the agreement was not carried through. [Further facts as summarised above were mentioned]. Finance for the motel complex, as distinguished from the purchase of the land, was never obtained. In my opinion the evidence relied upon for the respondent in this respect fully entitled the tribunal to conclude that there was an insufficiency of connection [to satisfy the first limb of s 51(1)], so that it did not err in law in reaching that conclusion.''
38. In the Full Court of the Federal Court, Burchett and Ryan JJ were critical of the reasoning of the Tribunal on the first limb of s 51(1). They took issue with statements to the effect that there were too many contingencies to say with any certainty that income would ever be derived from the project and that the appellant's aim was never more than an idea or hope. Their Honours observed that there does not have to be certainty that an endeavour will be crowned with success in order to justify a deduction under s 51(1).
``... These matters, of course, raise questions of fact; but it appears to us there is much to be said for the proposition that the Tribunal's own findings of fact... suggest it was not open to the Tribunal to find in this case a relevant lack of commitment.''
39. However, they found it unnecessary to express a conclusion as to whether the Tribunal's reasoning involved an error of law, because they went on to decide the case against the appellant upon the basis that the interest was an outgoing of a capital nature.
40. Carr J decided the appeal in favour of the appellant. He was satisfied that the reasoning of the Tribunal on the application of the first limb of s 51(1) was affected by errors of law and he proposed that the case should be remitted to the Tribunal for reconsideration of the application of the first limb of s 51(1). In that respect, Carr J acknowledged that the ultimate issue was one of fact, and he accepted that, even if the Federal Court came to the conclusion that the decision of the Tribunal involved legal error, nevertheless, it was not in a position to substitute its own findings as to the application of the first limb for those of the Tribunal.
41. Carr J said that the Tribunal had moved too quickly from the premise that the purpose of the loan funds borrowed by the appellant was to acquire a capital asset to the conclusion that there was not the necessary connection between the interest outgoing and the gaining or producing of assessable income. In that context, Carr J raised a consideration which did not appear to have been taken into account either by the Tribunal or by the other members of the Federal Court who had dealt with the case. He pointed out that it was extremely difficult to envisage any use of the property within the contemplation of the appellant which would not have produced assessable income. If the appellant had gone ahead with her plans to develop a motel complex then that would have produced assessable income. If, on the other hand, she had decided not to go ahead with the development, perhaps because it was too expensive, or because she could not find a suitable partner, then her only apparent alternative was to resell the land, or her interest in it. As things turned out, that is what happened. Having regard to the original purpose for which she acquired the land, Carr J said, any profit on a resale would have constituted assessable income. He considered that from the time the appellant acquired the land she had embarked on a profit-making undertaking or scheme. In those circumstances, the appellant's operations, were, in his view, sufficiently linked to the derivation of assessable income to be capable of falling within the first limb of s 51(1).
42. Carr J concluded:
``In my view, the matter should be remitted to the Tribunal for it to consider the appellant's business activities as a whole from the time of acquisition of `Tibradden' to its disposal. In doing so, it should not focus on the horse agistment business for the purposes of contrasting it with the appellant's main objective. The appellant is entitled to have all of her activities taken into account as a whole. In my opinion, an important part of those activities was her purpose and plan to construct 80 townhouses for resale to investors. Any profit so realised would have to have been assessable income. Furthermore, the indications are that income was also to be generated from the management of those townhouses after such sale. The uncontested evidence points to a conclusion that the appellant's intention at all times in entering into the various transactions was to make a profit or gain.''
43. In deciding whether, in the present case, the interest was an outgoing ``incurred in gaining or producing the assessable income'', it is unnecessary to become involved in seeking to distinguish between the purpose of the taxpayer in borrowing the money and the use to which the borrowed funds were put.
44. There are cases where the necessary connection between the incurring of an outgoing and the gaining or producing of assessable income has been denied upon the ground that the outgoing was ``entirely preliminary'' to the gaining or producing of assessable income
45. As Lockhart J said in FC of T v Total Holdings (Australia) Pty Ltd:
``... [I]f a taxpayer incurs a recurrent liability for interest for the purpose of furthering his present or prospective income-producing activities, whether those activities are properly characterised as the carrying on of a business or not, generally the payment by him of that interest will be an allowable deduction under s 51....
I say `generally' as some qualification may be necessary in appropriate cases, for instance, where interest is paid by a taxpayer as a prelude to his being in a position whereby he may commence to derive income. In such cases the requirement that the expenditure be incidental and relevant to the derivation of income may not be satisfied.''
46. This is consistent with cases which have decided 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.
47. The respondent placed reliance upon the concept of commitment as an aid to the formation of a factual judgment, in a case such as the present, as to the sufficiency of the relevant connection between outgoing and income. The utility of that concept may vary with the circumstances of individual cases. The views of the majority in the Full Court of the Federal Court on the question are set out above. The present is not a case in which the appellant had in contemplation a variety of alternative possible uses of Tibradden, some of an income- producing nature and others not. There was no suggestion, for example, that she ever contemplated using the property for private or domestic purposes. That was never an option. As Carr J pointed out, whilst she was not financially committed to a motel development, and had not decided upon any particular development, she does not appear to have envisaged any use of or dealing with the property other than one which would produce assessable income.
48. The criticisms made by all the members of the Full Court of the Federal Court of the reasoning of the Tribunal upon the application of the first limb of s 51(1) are valid, and Carr J was correct to conclude that such reasoning involved errors of law.
49. However, the resolution of the issue ultimately involves a judgment of fact, even though questions of law are involved.
50. The following orders should be made. The appeal should be allowed. The orders of the Full Court of the Federal Court should be set aside. In lieu thereof, the appeal to the Full Court of the Federal Court should be allowed and the orders of RD Nicholson J, except in so far as they related to the matter of penalty, should be set aside. The decision of the Tribunal should be set aside. The matter should be remitted to the Tribunal for further hearing. It will be a matter for the Tribunal whether, if any application is made to it in that regard, either party should be permitted to lead further evidence on that rehearing. The respondent should pay the appellant's costs of the appeal to this Court, of the appeal to the Full Court of the Federal Court, and of the proceedings before RD Nicholson J.