Case Q50
Judges: HP Stevens ChBR Pape M
TJ McCarthy M
Court:
No. 1 Board of Review
B.R. Pape (Member)
The first issue which falls to be decided in this reference is whether the trustee (hereinafter referred to as the taxpayer for the purposes of Div. 6 of Pt. III of the Act) was carrying on business as a share trader during the year ended 30 June 1977. If this issue is decided in the affirmative, a secondary issue arises as to whether the purchase and sale of shares in a public company incorporated in Norfolk Island formed part of its business of dealing in shares.
2. There were four other issues also raised by the notice of objection. Of these the claim for an investment allowance and a claim for a trading stock valuation adjustment were abandoned during the course of the hearing of the reference. The third issue, which was on an alternative basis, was that if the net income of the trust estate was as ascertained by the Commissioner, then no assessment should have been made under sec. 99. Instead the beneficiaries of the trust estate should have been assessed under sec. 97 of the Act. The final issue relates to the imposition of additional tax of $60,279 under sec. 226 of the Act.
3. The taxpayer is a proprietary company incorporated in New South Wales. By a deed of settlement created on 28 February 1976, the taxpayer was appointed trustee of a discretionary trading trust estate. On or about 5 March 1976 the taxpayer, in its capacity as trustee, acquired a number of businesses which I infer had previously been carried on by the directors of the taxpayer in partnership. These businesses included an electrical contracting business, the construction of swimming pools, the hiring of plant, a retail lighting business, a hardware store and interests in a hotel and service station. They were carried on with some success during the year of income, returning a net profit of $201,040 on the net assets employed of $190,969 as at 30 June 1977. The same cannot be said in respect of its activity in buying and selling shares. The profit and loss account disclosed the taxpayer incurred a net loss of $800,056 for the year ended 30 June 1977. This net loss arose from the following activities of the taxpayer:
Net profit from general $
trading 195,825
Dividends and interest
received 5,215
-------
201,040
Net loss from share
trading (1,001,096)
---------
$(800,056)
----------
4. I have set out below a statement, prepared from the financial statements included in Exhibit A and from Exhibits B, D and F. It shows how the net loss from share trading in both listed and unlisted shares was supposedly financed.
(b) Purchase of cheque books per Exhibit D
(c) Balance of brokers account at 30 June 1977 per Exhibit B
(d) Balance of account per Exhibit F
5. In its 1977 income tax return, the taxpayer claimed that the following transactions constituted its business of share trading and formed part of its assessable income and allowable deductions in arriving at its taxable income for the year.
Listed Unlisted Total
Assessable income $ $ $
Sec. 25(1)(a) proceeds of sale (net) 5,869 1 5,870
Sec. 28(2) stock on hand 6,168 - 6,168
------ --- ------
12,037 1 12,038
Deduct
Allowable deduction
Sec. 51(1) purchase of shares
(inc. stamp duty and brokerage) 13,134 1,000,000 1,013,134
------ --------- ----------
Contribution to tax loss $(1,097) $(999,999) $(1,001,096)
------ --------- ----------
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6. The results of the taxpayer's activities in buying and selling shares listed on the stock exchange are conveniently summarised below:
Mining and
Industrial oil Total
$ $ $
Number of stocks sold 11 7 18
Number of stocks purchased 14 18 32
Number of stocks on hand 30.6.77 3 14 17
Number of stocks on hand 30.6.78 1 7 8
Gross sales proceeds 2,125 4,013 6,138
Less brokerage 116 153 269
------ ------ ------
Net sales proceeds $2,009 $3,860 $5,869
------ ------ ------
Deduct
Cost of shares sold
Purchase price 3,740 8,791 12,531
Brokerage and stamp duty 187 416 603
------ ------ ------
3,927 9,207 13,134
Deduct stock on hand 30.6.77 1,372 4,796 6,168
------ ------ ------
$2,555 $4,411 $6,966
------ ------ -------
Loss from share trading $(546) $(551) $(1,097)
------ ------ -------
Realised loss on sales (459) (127) (586)
Loss attributable to valuation
of stock (87) (424) (511)
----- ------ ------
$(546) $(551) $(1,097)
----- ------ ------
7. Of the 32 stocks bought and the 18 stocks sold during the period to 30 June 1977 only one realised a small profit after allowing for brokerage and stamp duty. I think the evidence establishes that the taxpayer turned over most of its stock of shares and the net assets employed in the activity about once during the period. However in achieving this level of activity the taxpayer incurred a loss of $1,097 of which $511 was for the loss in value of stock on hand and $586 was from realised losses on sales. The significant fact about the loss of $586 was that $575 related to expenses of brokerage and stamp duty. In other words about 98 per cent of this loss was attributable to the cost of buying and selling the shares, rather than to variations in share prices. Nevertheless of the loss of $11 attributable to variation in prices of stock, profits attributable to price increases of $219 were realised, which offset the price decreases of $230. The overall loss of $1,097 was represented by:
$ $
Profits from price increases 219
Less brokerage and stamp duty 371 (152)
---
Losses from price decreases 230
Add brokerage and stamp duty 184 (414)
---
Brokerage and stamp duty on stock
sold where price was unchanged 20 (20)
--- ---
(586)
Loss in value of shares on hand (511)
------
$(1,097)
------
8. It appears from the cash account recorded in Exhibit D, that the taxpayer received dividends from listed companies of $85 and incurred expenditure of $4 in purchasing cheque books. I infer that these dividends were included in dividends and interest of $5,215 which was returned as assessable income and the $4 in the claim for bank fees of $613.
ATC 254
9. The buying and selling of the listed shares was carried out by the firm of public accountants under instructions from U, a director of the taxpayer. However this activity was initiated by X, the principal of this firm of accountants, because he was of the view that there were certain fiscal advantages to be obtained if the taxpayer could be classified as a share trader. The task of implementing this plan fell to Y, who had recently commenced employment with X, after immigrating to Australia. X was an accountant by profession and had no experience of share trading, other than for his own private purposes. I infer that because he had been a non-resident, he had no experience in dealing with shares on Australian stock exchanges. For this service, X said a fee of about $750 was rendered to the taxpayer. It would seem that this fee was included in the accountancy fees of $2,660 claimed by the taxpayer as about $2,000 was charged by X for accounting services.
10. Initially I was much attracted to the view that the evidence established that the taxpayer did not deal in listed shares with any purpose as to profit making. It was more concerned with demonstrating a level of activity rather than showing a profit. To use a colloquial expression, it was prepared ``to wash'' $6,000 through the stock exchange to give it the appearance of being a share trader. I think this is supported by the brokerage expenses it incurred, and the amount of the fee paid to X, and the fact that it was prepared to allow a person inexperienced in share trading to act on its behalf. The dividends received of $85 were in my view incidental to this plan. In other words the taxpayer spent $1,325 (brokerage and stamp duty of $575 and accountancy fees of $750) in ``washing'' $6,000 through the stock exchange to give the impression it was a share trader.
11. Nevertheless, the proceeds from the sale of shares were used to purchase further shares such that as at 30 June 1977 about 80 per cent both in the number and value of stocks on hand were represented by shares in mining and oil exploration companies. The sale of these shares did in a number of instances realise a profit in the next year. I think it is this factor which tips the scales in favour of the taxpayer in being classified as a dealer in listed shares, even though the motive in engaging in share trading was to obtain a fiscal advantage. However the motive as to why the taxpayer engaged in share trading is an irrelevant consideration: see
XCO Pty. Ltd.
v.
F.C. of T.
71 ATC 4152
;
(1971) 124 C.L.R. 343
;
Loxton
v.
F.C. of T.
73 ATC 4001
. Therefore I find as a fact that the taxpayer was engaged in carrying on the business of trading in
listed
public company shares during the year of income.
12. I now turn to consider whether the 1,000 ``C'' class shares in S Ltd. which were purchased for $1,000,000 and sold for $1 formed part of the taxpayer's business of share trading.
Walsh
J. in
Investment and
Merchant Finance Corp. Ltd.
v.
F.C. of T.
71 ATC 4140
at p. 4150;
(1971) 125 C.L.R. 249
at pp. 270-271
said:
``I do not assert, of course, that shares are always trading stock in the hands of their owner; and even where the owner is a dealer in shares the circumstances may show that particular shares are not trading stock . But when shares are bought by a dealer in shares and it is intended that they are to be resold and that this will probably occur in the not distant future, I do not think they are to be denied the description of trading stock, either because the trader expects or intends that they will be sold at less than their cost price or because he seeks to obtain a commercial advantage from the transaction otherwise than from a profit on the resale, that is, an advantage from an expected dividend and from an expected taxation benefit.''
(Emphasis added.)
13. A brief description of the background to this transaction is helpful in understanding how the taxpayer intended to achieve this loss of about $1 million. First a company R Ltd. subscribed for 1,000 ``C'' class shares of $1 each at a premium of $999 per share in S Ltd. R Ltd. then purported to sell these shares to the taxpayer for $1 million. A Ltd. then subscribed for ten redeemable preference shares of $1 each in S Ltd. Next S Ltd. paid a dividend out of its share premium reserve of $999,000 to A Ltd. on condition that it settled a sum of $996,000 on a trust estate UVW no. 2 whose beneficiaries were identical to those of the taxpayer. A further sum of $2,500 was also required under the
ATC 255
terms of the payment of the dividend to be settled on a trust estate M1 for the benefit of X and his family. The sum of $996,000 which had been settled on C as trustee for the UVW no. 2 trust was then lent to the taxpayer. These funds together with $4,000 which had previously been deposited in a bank account on Norfolk Island were used to pay for the shares in S Ltd. which had been purchased from R Ltd. Finally the shares in S Ltd. were sold to M2 for $1, thereby purporting to realise a loss of $999,999.14. All of these transactions took place on Norfolk Island on 22 June 1977. With the exception of the taxpayer all of the companies and trusts involved in the transactions were companies incorporated or trusts settled in Norfolk Island pursuant to instructions given by X. The details concerning those transactions have been carefully referred to by the Chairman, Mr. H.P. Stevens, in his reasons for decision and it is unnecessary for me to repeat them.
15. It is clear that what the taxpayer's advisers sought to exploit was the absence of a counterpart to sec. 60 of the
Companies Act,
1961 (N.S.W.) in the Norfolk Island
Companies Ordinance
. Section 60 it will be recalled restricts the use of the share premium account for the payment of dividends to those which are satisfied by the issue of shares to members. The section does not permit the payment of a cash dividend. In so far as S Ltd. was concerned it was permitted to pay a cash dividend out of its share premium account: see
Drown
v.
Gaumont British Picture Corporation
(1937) Ch. 402
. Once this purported dividend of $999,000 was paid, the net assets of S Ltd. were substantially reduced such that $1 was considered by the taxpayer to be a realistic price for the sale of the shares.
16. There was a paucity of evidence about the affairs of S Ltd. It appears to have been incorporated as a public company under the Norfolk Island Companies Ordinance on or about 20 June 1977. U, who was a director of the taxpayer and who instructed X's firm to purchase the shares, had not the slightest knowledge of any matter concerning the buying and selling of these shares. The extent of his knowledge is shown at p. 59 of the transcript:
``Q. Before Y went to Norfolk Island, you told me you did not know the name of the company you were buying the shares from? - A. That is correct.
Q. Did you know the name of the company in which you were buying the shares? - A. No.
Q. When did you find that out? - A. I do not recall.
Q. Do you know at the moment? - A. I do not know that I do. I do not recall who it was, it may have been indicated to me at some stage but I do not recall at this point in time.
Q. Do you know what assets the company had that you were buying the shares in? - A. No.
Q. Do you know what liabilities it had? - A. No.
Q. Did you know either of those things? - A. No.
Q. Did you know who its directors were? - A. No.
Q. Did you know what business it carried on, if any? - A. No.
Q. Did you know how long it had been incorporated? - A. No.
Q. Did you know who the other shareholders were? - A. No.''
The purchase of these shares is completely at odds with the type of shares the taxpayer was engaged in buying and selling. It was predominantly engaged in the buying and selling of mining and oil stocks. It is impossible to classify S Ltd. as either a mining or industrial stock as there is no evidence it carried on any activity, other than the allotment of shares at a premium and the payment of so-called dividends out of a share premium account.
17. In
F.C. of T.
v.
St. Hubert's Island Pty. Ltd.
78 ATC 4104
at pp. 4116-4117
Jacobs
J. said:
``There must be a relationship between the property and the business whereby it can be said that the property bears the description of one or another of the kinds enumerated, not in a general sense, but in specific relation to the business which was or is carried on. Thus property, being
ATC 256
trading stock, must be an asset of a business of trading in that stock.''(Emphasis added.)
The evidence surrounding the buying and selling of the shares in S Ltd. clearly shows that it did not form part of the assets of the taxpayer in dealing in mining, oil and industrial stocks. This conclusion finds support from the cumulative effect of the following facts:
- (a) S Ltd. was incorporated under instructions from X for the purpose of carrying out transactions described in para. 13.
- (b) The purchase of the shares in S Ltd. was the sole transaction in an unlisted company.
- (c) S Ltd. carried on no commercial undertaking.
- (d) The transaction was not recorded in the share trading ledger Exhibit D.
- (e) It was the only transaction entered into in which the result was known beforehand.
- (f) U, the director of the taxpayer, had no knowledge of S Ltd. or its affairs.
- (g) It was the only transaction in which debt funds were purportedly used to finance the purchase of the shares.
- (h) The size of the funds ($1 million) required to finance the transaction in comparison with the funds employed in dealing in listed shares are inconsistent with the evidence that it was only prepared to commit $20,000 for share trading purposes.
In my view it was an isolated transaction of which the purchase of those shares formed no part of the assets of any business carried on by the taxpayer. It was a transaction pre-rigged to produce a loss, per
Rogers
J. in
Deane
v.
F.C. of T.
;
Croker
v.
F.C. of T.
82 ATC 4112
at p. 4121
.
18. As one of the conditions for the payment of the dividend of $999,000 by S Ltd. A was obliged to settle the sum of $2,500 on a trust for the benefit of X. I am sceptical as to whether the payment of dividend can be conditional. Being an appropriation of profits it follows in my view that it must be an unconditional payment. The amount of $2,500 was X's fee for arranging the transactions described in para. 13. The balance of $500 retained by A appears to have been for the fee charged by the public accountant (Z) on Norfolk Island for implementing the scheme in accordance with the ``mud plan'' to use the words of Z. Thus the $4,000 which was deposited in the Norfolk Island bank account ended up being used as follows:
$
Subscription for shares in
S Ltd. 1,000
Payment of X's fees 2,500
Payment of Z's fees (retained
by A) 500
------
$4,000
------
By spending $4,000 the taxpayer sought to gain an allowable deduction of $1 million under sec. 51(1) for the purchase of the shares. Here the cost of implementing this transaction amounted to two-thirds of the capital the taxpayer had committed to buying and selling industrial, mining and oil shares. I think the way in which these funds of $4,000 were employed shows that the shares acquired formed no part of the business of share dealing. To finance the purchase of shares in S Ltd. it supposedly borrowed 99.6 per cent of the purchase price, whereas in its dealings with listed shares they were financed from the taxpayer's own funds.
19. It is difficult to find any commercial advantage which could accrue to the taxpayer or the beneficiaries by selling the shares in S Ltd. at a loss of about $1 million. Assuming for the moment that the taxpayer is properly assessable under sec. 99, what commercial advantage could be obtained by realizing a loss of $1 million, so as to achieve a current and future income tax benefit of $650,000 (at a marginal rate of 65 cents in the dollar)? The taxpayer would still be out of pocket by $350,000. There could only be a commercial advantage to the taxpayer if its income tax benefit from the loss exceeded $1 million dollars. Alternatively if the beneficiaries are properly assessable under sec. 97 there was no net income of the trust estate available to be distributed on any basis, computed either for trust accounting or tax purposes. If there was no net income available for distribution, no commercial
ATC 257
advantage could conceivably be gained by the beneficiaries. It would seem that the only commercial advantage which could arise would be if the loan of $996,000 was treated as a gift. Such a proposition was not advanced by counsel for the taxpayer and for good reason as it would expose the taxpayer to a very substantial liability to gift duty.20. The purported borrowing of $996,000 from the Norfolk Island trust UVW no. 2 to finance the purchase of the shares in S Ltd. exposed the trustee to a liability for which it either had no right or a limited right to be indemnified out of the assets of the trust estate.
Jacobs on Trusts
(4th ed.) p. 2102 et seq.;
Vacuum Oil Co. Ltd.
v.
Wiltshire
(1945) 72 C.L.R. 319
;
Re Staff Benefits Pty. Ltd. and the Companies Act
(1979) 1 N.S.W.L.R. 207
;
Octavo Investments Pty. Ltd.
v.
Knight
(1979-1980) 144 C.L.R. 360
. First there was a breach of his duties as trustee to which I will later refer which disentitled it to any right of reimbursement or indemnity out of the trust assets. Secondly, if there was no breach of trust, its right of indemnity was limited to the extent of the net assets of the trust estate. As at 30 June 1977 the net tangible assets of the trust estate which were available to indemnify the trustee amounted to $127,077. On these figures the trustee was exposed to a shortfall in its indemnity cover of $868,923 ($996,000 less $127,077) which would have to be met out of its non-trust assets. Bearing in mind that the taxpayer was carrying on business as a trustee it is impossible in my view to characterise a transaction which resulted in a planned loss of about $1 million and the dissipation of the net assets of the trust estate (including intangible assets of $68,877) as one which was necessarily incurred in carrying on business as a share trader.
General Share trading
trading Listed Unlisted Total
$ $ $ $
Net profit/(loss) 201,040 (1,097) (999,999) (800,056)
Net assets employed as
at 30 June 1977 190,969 4,984 (995,999) (800,046)
Return on net assets
employed 105% - - -
21. The evidence in my view establishes that it was never intended that the purported loan of $996,000 which was said to be interest free and repayable on demand was intended to be repaid by the taxpayer. In cross-examination U said at p. 58 of the transcript:
``Q. You thought that at some stage in the future you would have to repay the $1,000,000? - A. That is the understanding I have.
Q. And that you would repay it and never see it again? - A. If it was paid in that form it would never be seen again.
Q. So let us get this quite clear, your understanding in 1977 of the situation is that at some time in the future you may be called upon to repay that $1,000,000 and if that occurs, you will have to pay it and will never see it again? - A. I understand that there is a liability of $1,000,000 there and at this point in time we still have that liability.
Q. That was not quite what I asked you. You understood in 1977 that this was a liability that one day you would have to repay? - A. At some point in time there would have to be some arrangements made about removing that liability.
Q. By repaying it? - A. I do not know.
Q. Would you be horrified if X were to ring you tomorrow and say, look, that $1,000,000, I have a demand for it, you are going to have to write a cheque for it this week? - A. It would cause me some consternation, yes.
Q. Cause you some horror, would it not? - A. Yes.
Q. You would say to him, I thought you fixed all this up so that would not happen would not you? - A. Yes.
Q. And you would be annoyed with him for having not raised it in such a way as to ensure that did not happen? - A. Yes.
ATC 258
Q. And it is fair to say, is it not, that you appreciated that the transaction being entered into on Norfolk Island in June was not going to involve you in any outlay of funds? - A. That is correct.
Q. Other than X's fees? - A. That is correct, yes.
Q. Your sole purpose in entering into it was to reduce the income tax of [the taxpayer]? - A. That is correct.''
(The emphasis is mine.)
22. These transactions raise the issue of whether the taxpayer was entitled to be indemnified out of the trust assets for the liabilities it incurred. It claims that the liability it incurred to R Ltd. for $1 million in purchasing the 1,000 ``C'' class shares in S Ltd. was discharged by using the funds of $996,000 it borrowed from the UVW no. 2 trust. The evidence clearly establishes that the trust assets were insufficient to either indemnify or reimburse the trustee for the purported liability to R Ltd. or its indebtedness to the UVW no. 2 trust. It seems to me that the taxpayer was in breach of its duties as trustee when it purported to buy and sell these shares so as to realise a loss of about $1 million and in purporting to borrow $996,000 to finance the transaction. These purported liabilities were in my view improperly incurred.
``In the management of the trust business a trustee should exercise the same diligence and prudence as an ordinary prudent man of business would exercise in conducting that business if it were his own.''
See Jacobs' Law of Trusts 4th ed. at para. 1714.
Thus if the trustee is liable to the trust estate for breach of trust so that he cannot enforce his right owing to his own default, his creditors will have no higher right than the trustee.
23. Accordingly if the trustee had no right of indemnity or reimbursement out of the trust assets can it be said that the expenditure claimed by the trustee of $1 million was an outgoing necessarily incurred in carrying on the trust business? Is the calculation of the net income under sec. 95 worked out on the presumption that in respect of sec. 51(1) deductions the trustee is entitled to be reimbursed or indemnified out of the trust assets for the outgoing to satisfy the test of being incurred? It seems to me that the answer to such a question must be in the affirmative. I would therefore find:
- (a) that because the trustee had no right to be indemnified or reimbursed out of the trust assets for the purported expenditure of $1 million in purchasing the shares in S Ltd., it was not an outgoing necessarily incurred in carrying on the trust business;
- (b) alternatively I would also find for the reasons already given that the purchase of the shares in S Ltd. did not form part of the assets of the trust estate in dealing in shares.
24. Before dealing with the submission of senior counsel for the Commissioner in relation to ``sham and fiscal nullity'', I think it is important to deal with the submissions of counsel for the taxpayer in respect of the application of sec. 97 of the Act. I do so because if it is found that the taxpayer in its capacity as trustee has no liability to income tax it will be unnecessary to consider whether sec. 226 has any operation.
25. There was tendered in evidence a minute of a meeting of the directors of the taxpayer in its capacity as trustee held on 30 June 1977 which purported to record a resolution distributing the income of the taxpayer amongst its beneficiaries. I would reject this evidence as U said there was no such meeting (at p. 53). This must in my view be so, as the taxpayer's primary submission is that there was no net income of the trust estate capable of being distributed. Its claim was that a tax loss of $826,544 had been incurred. Moreover I would reject counsel for the taxpayer's submission that para. 31 of the objection permitted the argument to be raised that cl. 1(b) of the trust deed operated to make an automatic distribution of the net income of the trust as at 30 June 1977. Even if it could be said that such a contention was open on the ground of objection, cl. 1(b) of the deed would not, in my view, assist the taxpayer as it refers to the income which the trustee stood possessed of on the vesting day. Until the vesting day the interests of the beneficiaries are contingent and as such they are not presently entitled to a share of the net income of the trust estate. The power to distribute income of the trust
ATC 259
estate prior to the vesting date is granted to the trustees by cl. 6(i) of the trust deed. The evidence establishes that the taxpayer did not exercise its discretion in the manner prescribed by cl. 6(i) prior to 30 June 1977. Nor can I find any power in the deed to appoint income amongst the beneficiaries in default of appointment before the end of the year of income. As at 30 June 1977 there were no beneficiaries who had a ``present title in possession to a share of the income of a trust estate'' - not, it be noticed, to a share of the net income of a trust estate per Kitto J. inUnion Fidelity Trustee Co. of Australia Ltd. v. F.C. of T. 69 ATC 4084 at p. 4090; (1969) 119 C.L.R. 177 at p. 188 . I might add that the notice of objection did not challenge the opinion of the Commissioner that it was unreasonable that sec. 99A should be applied. I therefore find that because the taxpayer had not exercised its discretion as provided by sec. 101 the net income of the trust estate is properly assessable as if it were the income of an individual in accordance with the provisions of sec. 99.
26. Where a discretionary trustee returns a tax loss, a trustee is incapable of exercising his discretion to pay or apply any net income of the trust estate before the end of the year of income. Yet if the Commissioner later ascertains that there was a net income of the trust estate the trustee is given no opportunity under the Act to exercise his discretion to pay or apply that income to the beneficiaries. Consequently the trustee falls to be assessed under either sec. 99 or 99A. These sections in effect impose a tax on the undistributed net income of the trust estate. It is anomalous that the Act grants the Commissioner under sec. 105AA the power to determine a further period in which a private company may pay dividends to avoid the imposition of undistributed profits tax but does not allow a discretionary trustee an opportunity to exercise his discretion to distribute the net income of the trust estate to avoid the operation of sec. 99 or 99A. Although Grbich, Munn and Reicher in Modern Trusts and Taxation at p. 248 suggest the following solution:
``Although the quantum of the trust income may be unknown at the end of the year `present entitlement' will be established if the trustee resolves to distribute income amongst beneficiaries by way of proportionate allocation.''
This is a defect in the Act which I think requires amendment so as to give a discretionary trustee the opportunity of exercising his discretion in the same circumstances as sec. 105AA operates.
Relationship of Div. 6 of Pt. III and sec. 226
27. So far I have referred to the company in its capacity as trustee as the taxpayer for the purposes of Div. 6 of Pt. III of the Act. Section 226 of the Act is included in Pt. VII of the Act under the heading of ``Penal Provisions and Prosecutions''. Subsection (2) of sec. 226 provides:
``Any taxpayer who -
- (a) omits from his return any assessable income;
- (b) includes in his return as a deduction for, or as a rebate in respect of, expenditure incurred by him an amount in excess of the expenditure actually incurred by him;
- ...
shall be liable to pay as additional tax an amount equal to double the difference between the tax properly payable by him and the tax that would be payable if it were assessed upon the basis of the return furnished by him, or the amount of $2, whichever is the greater.''
The thesis which requires examination is whether sec. 226(2) can have any operation as against trustees. Besides this question of substance is the adequacy of the grounds of objection to cover the point of substance. I will put this question to one side for the moment, to deal with the substantive issue. If Div. 6 of Pt. III is an exclusive code dealing with a trustee's liability to income tax can sec. 226 apply to trustees? In Union Fidelity Trustee Co. of Australia Ltd. v. F.C. of T. (supra), Barwick C.J. said at ATC p. 4086; C.L.R. pp. 180-181:
``Section 96 of the Act provides that except as provided in the Act a trustee shall not be liable as trustee to pay income tax upon the income of the trust estate. Other than the provisions in Div. 6 there are none which render the trustee liable as such to pay income tax on the income of
ATC 260
the trust estate. It may thus be said that the Division is the exclusive source of liability of a trustee to pay income tax upon the income of the trust estate.''
28. The taxpayer referred to in subsec. (2) of sec. 226 is unless there is a contrary intention a person who derives income. Section 254(1)(a) provides:
``With respect to every agent and with respect also to every trustee, the following provisions shall apply: -
- (a) He shall be answerable as taxpayer for the doing of all such things as are required to be done by virtue of this Act in respect of the income derived by him in his representative capacity, or derived by the principal by virtue of his agency, and for the payment of tax thereon.''
Whilst a trustee is not a taxpayer within the definition ascribed by sec. 6(1) of the Act, as he is not a person who derives income, is he answerable as taxpayer as provided by sec. 254(1)(a)? Prima facie it would seem that the trustee is answerable as taxpayer for the purposes of sec. 226. However the difficulty with such a result is that the trustee referred to in Div. 6 of Pt. III is a hypothetical person. Union Fidelity Trustee Co. of Australia v. F.C. of T. (supra) per Kitto J. at ATC p. 4090; C.L.R. p. 187:
``This is a sufficiently odd conclusion to make one suspicious of it; for not only is the intention highly unlikely that taxability in respect of a trust estate should depend upon so fortuitous and arbitrary a consideration as the residence for the time being of the trustee, but if that had been the intention some answer would almost inevitably have been provided for the obvious question: `What if there are several trustees of whom some are residents and some are non-residents?' The fault in the conclusion seems to me to be that it treats the expression in sec. 95 `calculated under this Act as if the trustee were a taxpayer in respect of that income' as equivalent to `calculated under this Act as if the trustee had derived that income (and no other) beneficially'. This, in my opinion, does less than justice to the precise wording of sec. 95 and pays too little attention to definitions which the Act provides.
In the light of the definition of `taxpayer' the expression `calculated under this Act as if the trustee were a taxpayer in respect of that income' may be expanded to read `calculated under this Act as if the trustee were a person deriving that income'. But the `as if' shows beyond question that the basis of the calculation is to be a hypothesis different from the actual fact. Since the fact is that the trustee derived the income, the hypothesis that it was derived by `a person' must be that it was derived not by the trustee but by a hypothetical person as to whom none of the facts is postulated which would make him a `resident' within the definition of that word in sec. 6(1). Unless a person is a `resident' of Australia he is by definition a `non-resident'.''
(Emphasis added.)
Thus I have reached the conclusion that sec. 226 can have no application to trustees liable to tax under Div. 6. ``[T]he trustee is not taxed as the person actually deriving the income but `as if' he was a person of unidentified residence deriving the income'' per Menzies J. at ATC p. 4092; C.L.R. p. 190 (supra) , (cf. sec. 216(c)).
29. Alternatively the trustee is only liable to tax on the share of the net income of the trust estate as if it were the income of an individual without deduction. It is inconceivable that the tax properly payable by the trustee can be worked out under sec. 226 when he may be liable to be assessed under sec. 98 and 99. The source of a trustee's liability is not in the calculation of the net income but upon the matters contained in sec. 98, 99 or 99A. These are matters to which sec. 226 makes no reference.
30. From a reading of the relevant paragraphs of the ground of objection they do not state in express terms the issue with which I have dealt.
``I think that Courts should not interpret grounds of objection technically, narrowly or with rigidity, but at the same time I cannot escape the conviction that the grounds were not intended to cover the point that has been made and that they would not convey it to the Commissioner''
per Dixon J. in
A.T. Campbell & Co. Pty. Ltd. v. F.C. of T. (1950-1951) 82 C.L.R. 452 at p. 461 .
ATC 261
The point was not sought to be argued by counsel for the taxpayer. In my view it was one which was not permitted by the objection. The remarks of
Philip
J. in
Brown
v.
F.C. of T.
(1956) 11 A.T.D. 246
at p. 248
are apposite.
``It is a necessary result of sec. 190 that many assessments made on entirely wrong bases owe their force and validity solely to the fact that proper objection was not taken to them.''
Imposition of additional tax
31. If I am later found to be wrong in my conclusion that sec. 226 has no operation in respect of trustees I would make the following observation as to whether the transactions relating to the unlisted shares were a sham. Counsel for the taxpayer submitted that the purchase of the 1,000 ``C'' class shares in S Ltd. was evidenced by an oral agreement between the taxpayer and R Ltd., because the taxpayer had not executed any share transfer as at 22 June 1977 (at p. 76). The evidence establishes that the following documents were in fact all executed by the taxpayer some time in July 1977 (at pp. 64, 76).
Exhibit G6 Transfer of shares in S Ltd. by R Ltd. as transferor and the taxpayer as transferee.
Exhibit G7 Deed for the sale of shares in S Ltd. by R Ltd. as vendor.
Exhibit G19 Loan agreement for $996,000 by C Ltd. as lender and the taxpayer as borrower.
Exhibit G20 Deed for the sale of shares in S Ltd. by the taxpayer as vendor and M2 as purchaser.
Exhibit G21 Transfer of shares in S Ltd. by the taxpayer as transferor and M2 as transferee.
Accordingly there were no valid share transfers in existence at the time when the directors of S Ltd. purported to approve them in contravention of art. 34 of the articles of association. Moreover there is no evidence that either R Ltd., the taxpayer or M2 were ever registered as members of S Ltd. Again at the time when the taxpayer purported to buy the shares in S Ltd. for $1 million, the directors of S Ltd. had previously declared the dividend of $999,000 out of the share premium account so as to make the shares worth about $1,000. Clause 2(a) of the purported deed of sale of the shares from R Ltd. to the taxpayer (Exhibit G7) provided ``that should any of such prices not be such full value as aforesaid, then there shall be substituted for the said prices the amounts which are at the date of this Deed, the full value in money for such shares and all necessary adjustments shall be made accordingly''. These transactions which purported to create binding legal rights and obligations were to be discharged by a round robin of cheques. The exchange of the relevant cheques occurred simultaneously under the control of the bank manager. It was never intended by the parties to the cheques that they would be sued upon if dishonoured. In fact it was impossible for them to be dishonoured as they were processed simultaneously.
32. Lord
Wilberforce
in
W.T. Ramsay
v.
I.R. Commrs.
;
Eilbeck (Inspector of Taxes)
v.
Rawling
(1981) 1 All E.R. 865
at p. 871
said:
``For the Commissioners considering a particular case it is wrong, and an unnecessary self-limitation, to regard themselves as precluded by their own finding that documents or transactions are not `shams' from considering what, as evidenced by the documents themselves or by the manifested intentions of the parties, the relevant transaction is. They are not, under the Duke of Westminster doctrine or any other authority, bound to consider individually each separate step in a composite transaction intended to be carried through as a whole. This is particularly the case where (as in Rawling ) it is proved that there was an accepted obligation, once a scheme is set in motion, to carry it through its successive steps. It may be so where (as in Ramsay or in
Black Nominees Ltd. v. Nicol (Inspector of Taxes) (1975) STC 372 ) there is an expectation that it will be so carried through, and no likelihood in practice that it will not. In such cases (which may vary in emphasis) the Commissioners should find the facts and then decide as a matter (reviewable) of law whether what is in issue is a composite transaction or a number of independent transactions.''
ATC 262
The evidence in my view clearly establishes that the various transactions were not independent transactions but one composite transaction. Moreover I would find, as was admitted by U, there was no outlay of funds by the taxpayer, other than the amount of $4,000 deposited in the bank account on Norfolk Island. The bank purported to pay the dividend cheque of $999,000 before the cheque for the application and share premium moneys was cleared. In this sense no real money was at any stage created by the grant of overdraft accommodation. All the bank did was to allow the parties to make entries in the various bank accounts. As
Windeyer
J. said in
Albion Hotel Ltd.
v.
F.C. of T.
(1965) 115 C.L.R. 78
at p. 92
``... making entries does not make transactions''. Accordingly I find that the purported transactions taken both individually and collectively were shams. They were a mere facade. Consequently I would find that the taxpayer did not incur the expenditure of $1,000,000 in purchasing the shares in S Ltd. The only expenditure it could be said to have incurred was the $4,000 as referred to in para. 18.
Remission of additional tax
33. Because I have found that the taxpayer was carrying on the business of dealing in listed company shares the net income should be reduced by $1,097. Consequently the additional tax imposed by sec. 226(2) is $239,691. It was pressed by counsel for the taxpayer that the Board should make a remission of the additional tax imposed. The Commissioner granted a remission of 75 per cent and I do not think that the evidence relating to the share transaction establishes that any further remission should be granted. On the contrary the evidence establishes that funds which would otherwise have been used to finance the payment of tax have been used to finance the trust's business (see para. 4). In essence the taxpayer has sought to finance the purchase of assets by submitting that there was no net income capable of being distributed to the beneficiaries. It is noteworthy that when sec. 226 was first enacted by the
Income Tax Assessment Act
1936, the highest marginal rate of tax imposed by the
Income Tax Act
1936 (the Rates Act) was 28.69 per cent (being 68.85 pence in the pound). Accordingly at that time the maximum average rate for primary tax and additional tax which was capable of being imposed was roughly about 86.07% of the taxable income. With the advent of high marginal rates of tax imposed during the period of the Second World War (the highest rate being 92.5 per cent), and the continuation of these high rates in the post war period, the maximum average rate of tax which could be imposed on a trustee under sec. 99 was something less than 65 cents in the dollar in 1977. When additional tax is imposed by sec. 226(2) as in this case the primary and additional tax totals $359,536.40, which is an average rate of 185.74 per cent. Without any remission, the tax so imposed in this case can in part be characterised as not so much a tax on income but a tax upon savings or accumulated wealth. This is particularly so when the taxable income equals or exceeds the net income for accounting purposes. Clearly in these circumstances a remission of 75 per cent is warranted. In these circumstances I would follow the views expressed by
Fullagar
J. in
Jackson (F.C. of T.)
v.
Gromann
(1946) 8 A.T.D. 317
at p. 319
:
``It is true that the legislature has left sec. 230 (sec. 226) as it originally stood in 1936, and presumably has done so deliberately, perhaps, as Mr. Gillard suggested, on the view that the heavier the tax the greater the temptation to evade it and therefore the greater need for a severe deterrent. I am not perfectly sure that I ought to take into consideration the very steep rise in the rates of tax, but I feel that it is just to do so, and on the whole I think that I am entitled to do so .''
(Emphasis added.)
The effect of the assessment is that the taxpayer is now required to pay primary tax of $119,845.40 together with additional tax of $59,923. In other words tax of $179,768.40 is payable on a taxable income of $193,574, which is an effective rate of 92.87 per cent. The effect of the additional tax is to increase the average rate of tax from 61.91 per cent to 92.87 per cent. Even with a remission of 75 per cent it can be seen that the penalties for claiming a deduction for expenditure when none existed are extraordinarily severe. The net tangible assets of the trust estate as disclosed by the balance sheet as at 30 June 1977 were $127,077. Against these net tangible assets
ATC 263
the Commissioner would seek to recover income tax and additional tax of $179,768.40.34. There was a paucity of evidence adduced to support the application for further remission. This has placed me in the unenviable position of having to decide this application without any real knowledge of the financial circumstances of the trustee. Whether it can be said that the additional tax of $59,923 would constitute a ruinous imposition is a matter for conjecture. On the evidence of the trustee's balance sheet at 30 June 1977 it seems that this would be so. However without further evidence of the terms of repayment of the liabilities to beneficiaries and related persons of $288,824, the trading results for later years and a statement of the net worth (cf. with the book value of the net tangible assets) I am compelled - albeit uneasily - to not make any further remission on the grounds that the additional tax would constitute a ruinous imposition such that the capital of the business would be denuded: see Jolly v. F.C. of T. (1935) 53 C.L.R. 206. If the loans from beneficiaries and related persons of $288,824 were treated as if they were corpus funds or long term liabilities instead of interest free loans repayable on demand, the net tangible assets would have been $415,901 and its working capital would have been $137,547 respectively. Moreover if the loan from an insurance company of $60,000 was treated as a long term liability the working capital would have been increased to $197,547. For good measure counsel for the taxpayer did not submit that the additional tax would be a ruinous imposition.
35. Nevertheless I think there are a number of factors which warrant the making of a further remission of the additional tax. First there is my finding that sec. 226 does not authorise the imposition of additional tax upon a trustee liable to tax under Div. 6 of Pt. III. On this ground alone I would remit the tax in full. Secondly if I am later found to be wrong in concluding that sec. 226 has no operation in respect of trustees, I would remit the tax in full because it is the beneficiaries who are in essence being penalised for the breaches of trust committed by the trustee. Whilst the directors of the trustee were also beneficiaries they were not the sole members of the respective classes of beneficiaries. In this respect I am not unmindful of the operation of sec. 254(1)(h):
``For the purpose of insuring the payment of tax the Commissioner shall have the same remedies against attachable property of any kind vested in or under the control or management or in the possession of any agent or trustee, as he would have against the property of any other taxpayer in respect of tax.''
36. Accordingly I would reverse the Commissioner's decision on the objection and amend the assessment by reducing:
- (a) the net income of the trust estate by $1,097;
- (b) the additional tax from $60,279 to nil.
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