Federal Commissioner of Taxation v. Westraders Pty. Limited.

Members: Barwick CJ
Mason J

Murphy J
Aickin J
Wilson J

Tribunal:
Full High Court

Decision date: Judgment handed down 5 August 1980.

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Murphy J.

This case arises out of what the taxpayer, Westraders Pty. Limited, acknowledges is a sophisticated tax avoidance scheme.

A company, Jensen Mining & Investment Limited (Jensen), engaged in massive share trading and by 1975 had acquired millions of dollars of shares. Many of these were in companies whose main assets were undistributed profits. It ``dividend-stripped'' these companies and disposed of the stripped shares at their reduced value to partnerships (including itself). The other members of the partnerships had entered them only to avoid taxation by incurring fictional losses in order to claim allowable deductions and reduce their taxable income from other sources. In 1975, Jensen established five such partnerships. The particular partnership which Westraders joined was called Jenspart Trading Company (Jenspart). On 27 June 1975, Jenspart bought shares from Jensen at $111,284, and sold them on the market the same day at $125,200 (which may be treated as the market value). An actual profit of several thousand dollars was made, and there was also a small profit from other share trading. In all, a profit of $9,072 was made, of which Jenspart's share was $349. Jenspart claims to have incurred a fictional loss of $6,463,484 by claiming that the shares Jensen disposed of were acquired not at $111,284 but at $6,584,513, which was the cost of the shares when Jensen originally acquired them. Westraders claimed a deduction of $248,844, being its proportionate share of the claimed ``Tax Loss in Share Trading Partnership''.

The Act provides for valuation of trading stock in various circumstances. Section 31 of the Income Tax Assessment Act 1936 (Cth.), as amended provides that the value of each article of trading stock to be taken into account at the end of the year of income shall be, at the taxpayer's option, the cost price or market selling value or the value at which it can be replaced. Where a business or part of a business is transferred, the valuation of trading stock is market value or, if that would be inappropriate, the Commissioner's assessment (see sec. 36(8)). Where the disposal is to a partnership of which the taxpayer is a member, if a taxpayer retains an interest (of at least one quarter of its value) in the stock disposed of, as here, the taxpayer and the purchaser (that is, the partnership) may elect to use a value for the stock on the purchaser's acquisition at either the market value or the value ``that would have been taken into account at the end of the year of income if no disposal had taken place'' (see sec. 36A(2)). The issue is whether the election on which Westraders relies was validly made under sec. 36A(2). I share Mr. Justice Wilson's view that these provisions do not apply to a disposition in the ordinary course of a taxpayer's business. In the peculiar circumstances of this case, the setting up of such partnerships and dispositions to them of stock (being shares) for tax avoidance purposes had become (as the trial judge found) part of Jensen's ordinary business at the time of the disposal in question. The trial judge also found:

``Early in May, 1975 Jensen made plans for another business activity, namely the promotion of partnerships. This new business was intended to take advantage of the deemed price provisions of sections 36 and 36A. In order that the desired result might be achieved, it was necessary for Jensen to be a member of the partnership, and to bring into the partnership shares which by some process had suffered a considerable diminution in value since their acquisition by Jensen. These shares had to be trading stock in a business carried on by Jensen. The shares transferred to Jenspart answered this

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ATC 4369

description, having been acquired for the purpose of sale in Jensen's business as a share trader.''

For this reason, the election was not validly made and the appeal should be allowed.

There is an aspect of this case which troubles me. I state my views on it tentatively because no argument was addressed to it. The ``stock'' Jensen disposed of to Jenspart was materially different to that which Jensen originally acquired, even if its description had not changed. Jensen's business was dividend-stripping. It acquired shares in companies, then caused the companies' assets to be sold and the proceeds disposed of by way of dividends. The companies were left as shells, the shares being worthless or nearly so. The stock was changed so materially that the value of shares in the stripped companies was less than 2% of the original cost. This can be compared with a jeweller in the business of buying and selling old rings who purchases a considerable number of rings with valuable stones which he removes, leaving none or only the almost worthless chips which once surrounded the main stones, and disposes of the valuable stones in some way. The rings divested of their valuable stones are still trading stock but now worth only a small fraction of the original rings. If the jeweller then disposes of the rings as part of the sale of whole or part of the business or some more elaborate scheme, as in this case, to a partnership of which he is a member, it would be absurd to apply the election provision in sec. 36A to allow the value of the stoneless rings to be deemed to be the cost of the original rings. This is basically what has been asserted in this case. Shares subjected to a dividend-stripping operation may be trading stock (see
Investment and Merchant Finance Corporation Ltd. v. F.C. of T. 71 ATC 4140 (F.C.) ; (1971) 125 C.L.R. 249 ;
F.C. of T. v. Patcorp Investments Ltd. 76 ATC 4225 ; (1976) 51 A.L.J.R. 40 ), just as rings stripped of their stones may be. It is not commonsense to treat the worthless or nearly worthless shares left after a dividend-stripping operation as if they were the same stock as the shares held before the operation, so that the cost of the original shares is treated as the value ``that would have been taken into account at the end of the year of income if no disposal had taken place''.

In this case, the trader, Jensen, was responsible for the stripping and the alteration in a commercial and realistic sense of the stock so that it should not be regarded as the same stock even though the description remains the same. It is another question when shares are drastically reduced in value by events beyond the control of those involved in a disposition of the shares.

Determining whether stock disposed of is the same as the original stock for the purpose of the election provision may raise questions of degree, which is no novelty. But in this case, the change was a qualitative one. The effect of the dividend-stripping was to divest the shares of their valuable quality and hence their value. The essence of this tax avoidance scheme was to get something of value which could be dealt with as trading stock, to do something to it to remove its valuable quality (and use it in some other way which does not concern us) and then dispose of the thing in its reduced state, using the election provision of sec. 36A to claim the original cost as its value for tax purposes. Jenspart sold the stock at its reduced value and now claims as an allowable deduction the fictional loss between the cost of acquiring it (using the original cost to Jensen of the shares in the unstripped company) and the sale price of the shares in the stripped company. This is a feat of modern magic, successful only because observers allow themselves to be deceived. In commercial reality, the asset-stripped shares Jensen disposed of (at $111,284) were not the same trading stock as the shares originally acquired by it (at $6,584,513).

In general, the provisions of the Income Tax Assessment Act are intended to apply to commercial realities. Some sections, for example, sec. 260, are directed specifically at tax avoidance. Other provisions contemplate application in a commercial and realistic way, not in artificial and contrived circumstances. Section 36A and ancillary sections were intended to deal in an orderly way with the tax consequences of the transfer of businesses in which there was trading stock. They were never intended to be used as a vehicle for artificial and contrived transactions for tax avoidance purposes. It is a mistake to hold that any circumstances (however artificial and contrived) which literally fit the words in sec. 36A therefore comply with them.

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ATC 4370

Elsewhere such transparent schemes have generally received no encouragement. The United States Supreme Court, for example, has stressed that a transaction will be disregarded if it is sham or unrealistic. In
Gregory v. Helvering, Commr. of Internal Revenue 293 U.S. 465 , the Court said of a claimed corporate reorganization:

``The whole undertaking... was in fact an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else.... To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.''

(p. 470.)

In
Commr. of Internal Revenue v. Court Holding Co. 324 U.S. 331 , it said:

``To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress.''

(p. 334.)

The transactions in this case are conceded to be a major tax avoidance scheme. The supporters of the scheme seize upon the bare words of sec. 36A and claim that these should be applied literally even if for purposes not contemplated by Parliament. The history of interpretation shows the existence of two schools, the literalists who insist that only the words of an Act should be looked at, and those who insist that the judicial duty is to interpret Acts in the way Parliament must have intended even if this means a departure from the strict literal meaning (see the somewhat acid debate by the House of Lords, 13 February 1980). It is an error to think that the only acceptable method of interpretation is strict literalism. On the contrary, legal history suggests that strict literal interpretation is an extreme, which has generally been rejected as unworkable and a less than ideal performance of the judicial function.

It is universally accepted that in the general language it is wrong to take a sentence or statement out of context and treat it literally so that it has a meaning not intended by the author. It is just as wrong to take a section of a tax Act out of context, treat it literally and apply it in a way which Parliament could not have intended. The nature of language is such that it is impossible to express without bewildering complexity provisions which preclude the abuse of a strict literalistic approach.

It has been suggested, in the present case, that insistence on a strictly literal interpretation is basic to the maintenance of a free society. In tax cases, the prevailing trend in Australia is now so absolutely literalistic that it has become a disquieting phenomenon. Because of it, scorn for tax decisions is being expressed constantly, not only by legislators who consider that their Acts are being mocked, but even by those who benefit. In my opinion, strictly literal interpretation of a tax Act is an open invitation to artificial and contrived tax avoidance. Progress towards a free society will not be advanced by attributing to Parliament meanings which no one believes it intended so that income tax becomes optional for the rich while remaining compulsory for most income earners. If strict literalism continues to prevail, the legislature may have no practical alternative but to vest tax officials with more and more discretion. This may well lead to tax laws capable, if unchecked, of great oppression.

The circumstances envisaged by Parliament for the operation of sec. 36A do not include a scheme such as this and I am not satisfied that the taxpayer has discharged the onus of proof that the assessment is excessive (see sec. 190(b);
Macmine Pty. Ltd. v. F.C. of T. (Cth.) 79 ATC 4133 ; (1979) 53 A.L.J.R. 362 ;
McCormack v. F.C. of T. (Cth.) 79 ATC 4111 ; (1979) 53 A.L.J.R. 436 ).

The appeal should be allowed.