Case K16

Judges: MB Hogan Ch
P Gerber M

GW Beck M

Court:
No. 3 Board of Review

Judgment date: 27 April 1978.

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Dr. G.W. Beck (Member): The taxpayer is a credit union carrying on operations characteristic of such organisations. It borrows money at interest, sometimes for fixed terms but usually at call, from members and makes loans to members. Borrowings are from other sources in some circumstances and these sources include a body referred to as a ``league of credit unions'' and banks, but essentially the union marshals funds from members and makes these funds available to other members. Funds not required for lending to members are lodged at interest with the league or are otherwise placed to earn interest. At all times some funds are kept in readily available form to avoid liquidity problems when members' withdrawals are heavy, typically at Easter and Christmas according to evidence. The interest rate on funds lent to members is always significantly higher than that on funds lent elsewhere or held in interest bearing bank accounts for liquidity purposes.

2. In the tax year ended 30th June, 1974, the taxpayer earned $40,724 by way of interest on loans to members and $1,652 by way of entrance fees and interest from non-members. Section 23G, operative for the first time for 1974 tax year, provides (sub-sec. (2)) that interest paid to an approved credit union by its members is exempt, and accordingly only the $1,652 is assessable. Total expenditure by the credit union for the year was $40,507 and the matter in dispute between the taxpayer and the Commissioner was the amount of expenditure deductible under sec. 51 in respect of the $1,652 assessable income.

3. The amount of $40,507 was made up of:

Interest paid                  $24,190

Expenses agreed as applicable

to interest received from

members                         $5,533

Other expenses                 $10,784

                               -------

                               $40,507.
      

The Commissioner apportioned $34,974 ($24,190 + $10,784) on the basis of the ratio of assessable income to total income (i.e. $1,652 to $42,379) and allowed a deduction of $1,363. The taxpayer objected claiming that interest paid and directly related to funds provided on loan to members totalled $22,570, that interest paid in respect of funds invested elsewhere

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totalled $1,620 and was fully deductible, and that these amounts were respectively directly related to the two segments of income and should be eliminated from the calculation before making the apportionment (on basis $1,652 to $42,379) of ``indirect'' expenses. Before the Board the accountant for the taxpayer amended the figure for interest paid in respect of funds provided on loan to members to $21,902 and for the interest in respect of funds invested elsewhere to $2,149 because he had, since lodging the objection, obtained further analysis of month by month figures which enabled him to ``refine'' his calculation to some extent. He did not attempt to alter the basis of the calculation.

4. The comparative calculations after this ``refinement'' were as set out below:

                             Commissioner's                      Taxpayer's

                            Adjustment Sheet                    Calculation

                                    $                                $

Gross Income                     42,379                            42,379

Less Exempt Interest             40,727                            40,727

                                 ------                            ------

Assessable Income                 1,652                             1,652

                                 ------                            ------

Total Expenses                   40,507                            40,507

                                 ------                            ------

Less:

Expenses directly applicable

 to interest from

 members                          5,533             5,533

Interest paid to Members                           21,902

Interest paid to Others                             2,149          29,584

                                 ------            ------          ------

                                 34,974                            10,923

                                 ------                            ------

  Deductions claimed =

Interest paid to non-

members                                                             2,149

Proportion of indirect

 expenses 1652/42379 x 34,974     1,363

          1652/42379 x 10,923                                         426

                                  -----                             -----

                                  1,363                             2,575

                                  -----                             -----

Taxable Income (loss)               289                             (923)

                                  -----                             -----
      

5. If strictly interpreted, the provision of sec. 51(1) that ``all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income'' must be seen as requiring the analysis of each and every loss and outgoing that is not wholly directed to gaining or producing assessable income with a view to determining what part is so directed. When confronted with a multitude of relatively minor expenses which contribute to the gaining of assessable income in varying ways the Commissioner seems always to have adopted the expedient procedure of apportioning the total of the expenses rather than each insignificant expense. This procedure cannot be endorsed where the total includes one or more large individual expense and this is the situation in this case where $24,190 of the total expenses of $40,507 represents interest paid. I therefore consider that regardless of the method of apportionment that is finally adopted for interest expense on the one hand, and for the remainder of the expenses on the other, the two categories of expense need to be looked at separately. In this connection I find myself in complete agreement with the Chairman of No. 2 Board who, in (1964)
14 T.B.R.D. Case P48, observed:

``In his second submission Counsel for the club argued that the principles laid down in
Carlisle and Silloth Golf Club v. Smith (1912) 6 T.C. 48, 198 , and
Ronpibon Tin N.L. and Tongkah Compound N.L. v. F.C. of T. (1949) 78 C.L.R. 47 at p. 59 ; require that each outgoing should be considered on its own merits and apportioned accordingly, and that the rule of thumb approach adopted by the Commissioner was wrong. He said that the reasons of Mr. McCaffrey in (1959)
10 T.B.R.D. Case K104 were an example of the application of

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the right approach. The principle contended for by Counsel is clearly correct....''

In the case under review there is no evidence that the Commissioner looked at interest separately.

6. The Commissioner disputes the taxpayer's method of calculation of the extent to which interest expense contributed to assessable income. The Board, in effect, is asked to arbitrate on whether the taxpayer's method meets the criterion laid down in Ronpibon Tin N.L. v. F.C. of T. (1949) 78 C.L.R. at p. 59 that ``... there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income.'' The question therefore is whether the taxpayer's method of splitting the total interest paid results in a fair and reasonable reflection of the relationship between the parts of interest resulting from the splitting and the parts of total income i.e. exempt and assessable.

7. Where expenditure is a direct function of usage its allocation on a usage basis obviously meets the Ronpibon Tin criterion. It is beyond dispute that where a vehicle travels n kilometres in the process of earning assessable income, and travels m kilometres overall for the year, and fuel and oil costs total $ z the extent (fraction) of usage of the vehicle for tax deduction purposes is n/m and the sec. 51 deduction is n/m x z . A functional relationship between interest expense and money usage is not so evident as the relationship between motor vehicle expense and distance travelled, but it is implicit in the calculations put forward by the taxpayer that such a relationship exists, and I accept that this is so in businesses of the credit union type where the only commodity traded is money, the cost of which is expressed in interest.

8. In this case the taxpayer conceded that it was generally not possible to identify specific funds borrowed with funds lent and there was simply a pool of funds that was dealt with in the course of business. This pool of funds had a cost and an appropriate way of expressing this cost is as a percentage of borrowings. Here interest of $24,190 represents 7.13 per cent of the amount borrowed calculated as a simple average of the borrowings at the beginning and end of the year in question. The taxpayer presented figures to the Board showing the calculation of an average of borrowings on a month-by-month basis, and with this more accurate average as the denominator in the fraction the cost of borrowings during the year was 6.92 per cent. This I accept as the interest cost of borrowings. On the assumption that this is the average cost of funds acquired and then lent, it seems prima facie reasonable to apply the percentage to the average amount lent to members and thereby obtain an interest cost of earning the exempt income. The balance of interest paid could then be regarded as directly related to the assessable income. However, some modification of this procedure was necessary because there were some interest free funds available and some funds were applied to uses that did not earn interest.

9. The credit union had assets as set out below and those assets were funded by a mixture of borrowings and interest-free funds from share capital and reserves. The interest rate on borrowed funds was, as seen above, 6.92 per cent and had all assets been acquired with borrowing the interest expenditure would have been as shown against the classes of assets:

                                Average investment              Interest at

                                during the year.                 6.92%

                                       $                            $

      Fixed assets                  1,618                          112

      Current assets

      (non-interest earning)          520                           36

      Investments                  33,085                        2,289

      Loans to members            337,198                       23,334

                                  -------                      -------

                                  372,421                       25,771

                                  -------                      -------
      

However, interest expense in total was $24,190 and if it is assumed that all four classes of assets benefited pro rata from the use of interest-free funds, the interest paid in respect of each class was:

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      Fixed assets 24,190/25,771 x 112          =  $   105

      Current assets 24,190/25,771 x 36         =  $    34

      Investments 24,190/25,771 x 2,289         =  $ 2,149

      Loans to members 24,190/25,771 x 23,334   =  $21,902/$24,190
    

10. This split of interest paid is in agreement with that put forward by the taxpayer and shown above in para. 4. It could have been arrived at, less circuitously, by apportioning the total interest paid on the basis of the average investment in the various classes of assets as under:

      Fixed assets 1,618/372,421 x 24,190         =  $   105

      Current assets 520/372,421 x 24,190         =  $    34

      Investments 33,085/372,421 x 24,190         =  $ 2,149

      Loans to members 337,198/372,421 x 24,190   =  $21,902/$24,190
      

As already indicated, it is considered that in a business of the character of a credit union in which one expense is dominant in amount, and is tied specifically to the only product that is being dealt in, steps should be taken to separate that expense from the ``general'' or ``indirect'' expenses and to allocate it on a basis that, in the words of the learned judges in Ronpibon Tin N.L. v. F.C. of T . (1949) 78 C.L.R. is ``fair and reasonable''. I see no wider import in the words ``fair and reasonable'' than a requirement to achieve an apportionment that an informed individual would regard as logically supportable and which contains no apparent mathematical or other bias.

11. The Commissioner seems to have based his apportioning calculation on the procedure endorsed by Owen J. in
Adelaide Racing Club Incorporated v. F.C. of T. (1965) 114 C.L.R. at pp. 525-6 . In that case certain expenditure was clearly identified as ``having been incurred exclusively in the production of assessable income'' (i.e. it was ``direct'') and the balance was not identifiable as exclusively incurred for that purpose, although it contributed to the earning of assessable income. The part of this latter amount that was a sec. 51 deduction was calculated:

      Gross income other than exempt income

      -------------------------------------       x Apportionable expenditure.

      Total receipts from all sources
      

This method of apportionment appears to me appropriate for a bulk of indirect expenses.

12. The Commissioner's refusal to view interest paid as a direct expense is understandable, for the expense is not direct in the recognised accounting sense of clearly identifiable cause and effect. In spite of this, I think interest on borrowed funds is a direct expense of the lending income earned by credit unions. However, it seems to me that the question of directness of expenditure is not absolutely critical. If all the income of this credit union were assessable all the interest would be allowable as a deduction. Some income is not assessable and consequently some interest is not allowable; the determination of the extent of the deduction under sec. 51 is a measure of the degree of contribution to the gaining of assessable income and not a measure of how direct or

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indirect the expenditure is, although it is likely that degree of contribution and directness will bear on each other. It is conceded that a number of methods of apportionment could be devised and each method could have some good features. In the final analysis it is difficult to see this case as anything but an application of the Ronpibon Tin principle that what must emerge is a fair and reasonable assessment of the relation of the outlay to assessable income. The assessment of this relationship is indicated in para. 9 and 10.

13. In the light of this I conclude:

• (a) that interest paid $24,190, should be eliminated from indirect expenses before those expenses are apportioned on the basis of the relationship of assessable income to total income;
• (b) that interest totalling $2,149 should be allowed as a deduction.

However, in view of the constraints imposed by sec. 190, I direct only that the 1974 assessment be amended to the extent sought in the taxpayer's objection, i.e. by allowing a deduction for interest paid of $1,620 and for other expenses of $420.

Claim allowed in part