The Chamber of Manufactures Insurance Ltd. v. Federal Commissioner of Taxation.

Judges:
Bowen CJ
Woodward J
Northrop J

Court:
Full Federal Court

Judgment date: Judgment handed down 10 May 1984.

---

Bowen C.J., Woodward and Northrop JJ.

This is an appeal from a judgment of the Supreme Court of Victoria upholding the right of the Federal Commissioner of Taxation to include in the assessable income of the taxpayer an amount of $4,663,384, being the net profit from the sale of certain investments.

The facts of the case are set out fully in the judgment of Brooking J. in the Supreme Court.

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ATC 4316

They can be conveniently summarised as follows.

The taxpayer is an insurance company. Seventy per cent of its business is in the field of workers' compensation. It holds 50% of the issued capital of a life insurance company, but offers no such insurance itself.

It has been the custom of the taxpayer in recent years to retain a proportion of its premium receipts in readily accessible accounts from which it can meet the normal calls upon its funds for claims and expenses. The managing director of the taxpayer referred to these moneys as the ``hard core'' of its funds. They are held on short term deposit and money regularly flows in and out of this ``hard core''. In the taxpayer's balance sheet for 30 June 1980 these deposits were included under the description ``Cash and Deposits - $6,751,070''. Of this sum some $0.9m. was made up of cash and $5.8m. was the ``hard core'' of deposits. In the 1979 balance sheet the ``Cash and Deposits'' entry stood at $8.6m., and in 1978 it was $13.9m. The managing director said in evidence that the ``hard core'' is typically about $8m. During the year in question it fluctuated between $5.9m. and $14.4m.

In addition to these moneys, the taxpayer has, over a number of years, invested in shares, fixed interest securities and property. The shares are mainly in listed public companies, but also in unlisted companies and subsidiaries of the taxpayer. In 1980 this investment portfolio of the taxpayer was shown as:

                                   Cost
                                     $
      Fixed interest            37,499,000
      Shares                    48,419,000
      Property                  20,065,000
      

Evidence from the managing director showed the taxpayer's dealings in shares to have been very modest before the employment of a full-time investment officer in 1972. Even in 1974 and 1975, sales of shares produced only small profits. In later years, net profits from the sale of shares were:

                    $
      1976       287,000
      1977        20,000
      1978       306,000
      1979       494,000
      

Then, in 1979-1980, the year of income to which this appeal relates, shares in 20 companies were sold at a profit and in 10 companies at a loss, yielding a net profit of $4.6m. Of these sales, the shares in Innkeepers Ltd., sold at a profit of $0.9m., represent something of a special case because the taxpayer held almost 50% of the shares in that company, purchased in the previous three or four years, and was represented on its Board.

Apart from a small panel-beating business purchased in 1964, this short-lived interest in Innkeepers Ltd., which operated a group of motels, was the only investment which the managing director of the taxpayer could point to in support of a claim that the taxpayer had been diversifying its business in recent years. The truth of the matter was, as Brooking J. found, that the taxpayer had been diversifying its investments, but not (to any real extent) its business.

The reasons why the taxpayer sold so many of its shares in 1979-1980 - to a total value of $10.9m. - were, first, that the share market was high and a number of the shares seemed to have little or no remaining capacity to act as a cushion against inflation. Secondly, there had been ``cut throat competition'' in workers' compensation insurance in recent years, and this had affected the taxpayer's income from premiums. Finally, there was a cloud hanging over the whole field of workers' compensation in that there seemed to be a distinct possibility that such insurance might be confined, by legislation, to government insurance offices; if this happened, the cash flow represented by premiums would dry up. These were all found by Brooking J. to have been motivating factors in the 1979/80 sales of shares, and those findings were not challenged before us.

In the case of the near-50% holding in Innkeepers Ltd., there were other factors involved, in that the taxpayer had to respond to a specific take-over offer, and some difficulties may have been foreseen in the future management of that group of motels.

The proceeds of all these sales went into fixed interest securities where, it seems, they have since remained. The same conversion occured in the year after the relevant year of income, when further substantial sales were made. These fixed interest securities were said by the managing director to have the advantages of stable value, predictable high interest rates and staggered turnover due to different maturity

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ATC 4317

dates and were readily realisable in case of need.

It is clear that at no time, apart possibly from these two years, has the taxpayer sold shares (or fixed interest securities) with any thought in mind of meeting insurance claims or paying expenses; and no such payments were in fact made in these years either.

Before leaving the sales of investments in the relevant year, it should be noted that about $5m. worth of fixed interest securities were also sold to enable shares to be purchased in the Sovereign Hotels chain. These securities yielded a net profit of $0.3m. The hotels were sold in a later year.

The basic question before Brooking J. was whether the net profits from sales of investments made in the year ending 30 June 1980 represented income within the meaning of subsec. 25(1) Income Tax Assessment Act 1936, for the reason that the acquisition and realisation of those investments was a normal step in carrying on the taxpayer's insurance business (see
Colonial Mutual Life Assurance Society Ltd. v. F.C. of T. (1946) 8 A.T.D. 137 at p. 145; (1946) 73 C.L.R. 604 at p. 620), so that those profits could be categorised as income within ordinary usages and concepts (C.M.L. case at A.T.D. p. 142; C.L.R. P. 615;
London Australia Investment Co. Ltd. v. F.C. of T. 77 ATC 4398; (1977) 138 C.L.R. 106).

His Honour found that:

• (a) these investments had an important bearing on the profitability of the taxpayer; in the year of income the operating profit before tax was $4.4m., investment income (including profits from sales) $7.4m. and net profit $7.7m.;
• (b) the shares and fixed interest securities were available to the directors to meet the claims of policy holders;
• (c) they were readily realisable liquid assets, and they were more readily available to meet claims than any other funds available to directors for that purpose, except the ``hard core'';
• (d) they accordingly constituted a reserve fund for the payment of claims, whatever the Board may have intended; and
• (e) the Board in fact intended that they should serve as a reserve fund to meet claims.

The first four of these findings were not really challenged on appeal, though it was said that the investments constituted only a ``passive'' reserve, available in the last resort; but the fifth finding (although not essential to the judgment) was challenged, because the essence of the managing director's evidence was that it was not contemplated or possible that shares would ever be sold to pay claims and expenses. He said that some of the fixed income investments could conceivably be sold for such purposes in an emergency, but not the shares. It was then argued that the securities purchased with the sale money from the shares took on a different character, because they were seen as a second line of defence after that time.

Brooking J. had advantage of hearing the managing director's evidence. He found him to be ``a shrewd man who was almost without exception well aware of the possible taxation implications of his answers to questions in the witness box''. Given the inherent improbability of a rigid preference for the sale of fixed interest securities whatever the state of the market, the obvious taxation advantage in the present case of alleging such a rigid preference (since the profit on fixed interest sales was almost negligible), the consistent gap in the years 1978-1980 of some $55-$60m. between the current assets and the current liabilities of the company, and the admitted concern of the Board about the future of its workers' compensation business, we believe Brooking J. was fully entitled to reach the finding which he did as to the Board's intention.

The investment portfolio, therefore, constituted the necessary reserve fund for the taxpayer's insurance business. It was, and was intended to be, immediately available for the purpose. No other funds of the taxpayer could be pointed to as fulfilling this role, because the ``hard core'' was the fund called upon, on a day-to-day basis, to meet normal commitments.

The general principle to be applied in cases such as this has been stated in many authorities. The principle is not limited to insurance businesses, but applies to all types of businesses. The position is stated in the London Australia Investment Co. case by Gibbs J. at ATC p. 4403; C.L.R. pp. 115-116:

``When a taxpayer sells one of its investments, the question whether the profit on the sale should be treated as capital or

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ATC 4318

income is to be answered by applying the tests stated in
Californian Copper Syndicate (Limited and Reduced) v. Harris ((1904) 5 Tax. Cas. 159, at pp. 165-166), in a passage which has constantly been cited, or repeated, with approval; see, e.g.,
Commissioner of Taxes (Vict.) v. Melbourne Trust Ltd. ((1914) 18 C.L.R. 413, at pp. 420-421);
Ruhamah Property Co. Ltd. v. F.C. of T. ((1928) 41 C.L.R. 148, at pp. 152, 165);
Australasian Catholic Assurance Co. Ltd. v. F.C. of T. ((1959) 100 C.L.R. 502, at p. 506) and
White v. F.C. of T. ((1968) 120 C.L.R. 191, at p. 222). The principle was stated as follows in Colonial Mutual Life Assurance Society Ltd. v. F.C. of T. ((1946) 73 C.L.R. 604, at p. 614):

• `Prima facie the depreciation in or accretion to the capital value of a security between the date of purchase and that of realization is a loss of or accretion to capital and is therefore a capital loss or gain and does not form part of the assessable income... But in the words of the Lord Justice Clerk in Californian Copper Syndicate v. Harris ((1904) 5 Tax. Cas., at p. 166) which have been so often quoted, `it is equally well established that enhanced values obtained from realization or conversion of securities may be so assessable, where what is done is not merely a realization or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business'.'

Their Honours went on to point out that not all of the proceeds of a business carried on by a taxpayer are income for the purposes of the Act; they will be so only if they are income `in accordance with the ordinary usages and concepts of mankind, except in so far as the Act states or indicates an intention that receipts which are not income in ordinary parlance are to be treated as income' ((1946) 73 C.L.R., at p. 615). However it is in my opinion established by this and the many other cases in which Californian Copper Syndicate v. Harris has been applied that if the sale in question is a business operation, carried out in the course of the business of profit-making, the profit arising on the sale will be of an income character. To apply this criterion it is necessary `to make both a wide survey and an exact scrutiny of the taxpayer's activities':
Western Gold Mines N.L. v. C. of T. (W.A.) ((1938) 59 C.L.R. 729, at p. 740). Different considerations may apply depending on whether the taxpayer is an individual or a company. In the latter case it is necessary to have regard to the nature of the company, the character of the assets realized, the nature of the business carried on by the company and the particular realization which produced the profit:
Hobart Bridge Co. Ltd. v. F.C. of T. ((1951) 82 C.L.R. 372, at p. 383) citing Ruhamah Property Co. Ltd. v. F.C. of T. ((1928) 41 C.L.R., at p. 154).''

In the application of this principle to the present case it is important to remember that in the C.M.L. case, the Full Court said at A.T.D. p. 144; C.L.R. p. 618:

``... the sounder view is that profits and losses on the realisation of investments of the funds of an insurance company should usually be taken into account in the determination of the profits and gains of the business.''

It should be noted that this view was expressed in terms which would cover all insurance companies, although its emphasis may have been affected by the fact that the company there in question was a life insurance company. The business of life insurance obviously is a special case because of the necessity to maintain an actuarial relationship between accumulated funds and liabilities, and to obtain a regular yield from investments, with surplus funds typically being distributed to policy holders in the form of bonuses.

It is important to remember also that the view, even as expressed, does not deny that in some cases profits and gains on the realisation of an investment of the funds of an insurance company should not be taken into account in the determination of the profits and gains of the business. Thus, for example, funds of an insurance company invested in the construction of a building to be used as a head office by that company will probably not attract income tax if the head office is subsequently sold for a profit.

Even in a case such as the present, the position might have been different had the taxpayer maintained two quite separate funds - the first acknowledged as a reserve fund and demonstrably sufficient to meet claims and

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ATC 4319

expenses in all reasonably foreseeable contingencies - the second categorised and dealt with as an investment fund. Whether profits from the sale of investments in the second fund were taxable would depend upon factors unrelated to insurance such as those referred to in the London Australia Investment Co. case.

The taxpayer attempted to show that, even apart from the ``hard core'' dealt with above, it did in effect maintain two separate funds, the first, consisting of fixed interest securities, being arguably a reserve fund and the second, consisting of shares, being clearly an investment fund. It contended that the profits taken into account by the Commissioner were profits on the sale of investments in the investment fund. For reasons already given, Brooking J. was entitled to reject the evidence suggesting that the taxpayer maintained such a distinction between the fixed securities and shares. There was no documentary support for any such distinction.

Although an insurance company which has 70% of its business in workers' compensation would seem to be in a better position than most general insurers to maintain that some of its investments were in truth divorced from its insurance business, and only to be considered as a reserve for that business in the event of some commercial catastrophe, the difficulty of the taxpayer in this case is that it only had the one reserve fund - the whole of its investment portfolio - and it did in fact sell the shares in question in order to have part of the fund more readily accessible to meet contingencies which it actually contemplated in its insurance business - a loss of premium income through cut-throat competition and a possible loss of all workers' compensation business. The fact that the sales were made with these considerations very much in mind brings them, we believe, clearly within the usual rule relating to insurance companies.

This being the case, we think that there is a sufficient nexus between the taxpayer's insurance business and all the profits from sales in the year of income to justify the levying of income tax upon them. If this had not been so, it would have been necessary to look more closely at the sales of the Innkeepers Ltd. shares and the fixed interest securities sold to purchase the Sovereign Hotels shares. All the other share sales were, we believe, impressed with the requirements of the insurance business, and so taxable as part of the income from that business, even if they had not been categorised as coming from the insurance company's reserve fund. In the event, we do not find it necessary to examine the Innkeepers Ltd. and Sovereign Hotels' transactions more closely.

The taxpayer's taxable income for the year ended 30 June 1980 originally had been assessed at $6,013,133, but by an amended assessment issued on 1 July 1982 the taxable income was assessed at $10,676,517 in consequence of the inclusion in the assessable income of the sum of $4,663,384 already referred to, being the net profit from the sale of certain investments. The amended assessment was made under sec. 170 Income Tax Assessment Act 1936. The taxpayer contends that it had made to the Commissioner ``a full and true disclosure'' for its assessment and that since the Commissioner had made an assessment after that disclosure, the Commissioner was prevented from amending the original assessment by increasing the liability of the taxpayer; see subsec. 170(3). What must be disclosed fully and truly by a taxpayer are ``all the material facts necessary for his assessment''. The taxpayer contends that in the present case there had been such a disclosure. This is not a case where the profit is made assessable income under sec. 26(a) of the Act and no question of ``purpose'' arises; cf.
A.L. Hamblin Equipment Pty. Ltd. v. F.C. of T. 74 ATC 4001; (1974) 130 C.L.R. 159, especially per Stephen J. at ATC p. 4011; C.L.R. p. 175.

In the present case, the relevant facts disclosed included the facts that the taxpayer carried on the business of insurance and that during the tax year ended 30 June 1980 it had realised investments of its funds resulting in an overall profit in the sum of $4,663,384. In W.
Thomas & Co. Pty. Ltd. v. F.C. of T. (1965) 14 A.T.D. 78; (1965) 115 C.L.R. 58, Windeyer J., in discussing the nature of full and true disclosure under subsec. 170(3), said at A.T.D. pp. 88-89; C.L.R. p. 75:

``I do not think it can be said that there has been a failure to make a full and true disclosure of all material facts simply because the Commissioner was not told everything that was elicited by examination and cross-examination before me. If the evidence contradicted anything of a material nature that the Commissioner had been told,

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ATC 4320

it could not be said that there had been a true and full disclosure. But, if it amounted only to explanatory detail confirmatory of a conclusion that he could and should have reached on the facts before him, then it cannot be said that there was a lack of true and full disclosure.''

During the hearing of the objection before the Supreme Court many further facts were elicited by examination and cross-examination, but that evidence amounted only to explanatory detail confirmatory of the facts disclosed by the taxpayer. It was not suggested that the taxpayer had been guilty of any misrepresentation in relation to the material which it had disclosed to the Commissioner. On the material so disclosed, the Commissioner, in applying the relevant law, should have come to the conclusion that the profit on realisation of investments was probably income within sec. 25 Income Tax Assessment Act. In this regard, it is interesting to note that by requisition dated 21 April 1981, being a date after the original assessment of tax had been issued, the Commissioner asked the following question of the taxpayer in relation to the tax year ended 30 June 1980:

``Profit on sale of investments $4,903,163

1. Advise the amount of any profits included in the above amount applicable to investments sold within 12 months of purchase.

Where applicable statements setting out details of property sold, its cost price, sale price, the dates of acquisition and sale and the manner in which the amount of profit has been calculated should be furnished.''

On 24 April 1981 the taxpayer answered the question: ``No investment bought and sold within 12 months.''

It is obvious the requisition related to sec. 26AAA Income Tax Assessment Act. That section has no application to the facts of the present case. For present purposes the difference between the stated profit of $4,903,163 and the actual profit of $4,663,384 is irrelevant.

The answer did not assist the Commissioner in determining the amended assessment. Nevertheless, by notice dated 1 July 1982, the Commissioner was able to issue the amended assessment accompanied by an adjustment sheet as follows:

                                              ``$
      Taxpayer income as
      previously assessed                 6,013,133
      Net profit on sale of
      investments included in
      assessable income add               4,663,384
                                        ------------
                                        $10,676,517
                                        ------------''
        

That adjustment was calculated from the material facts which previously had been disclosed by the taxpayer to the Commissioner. There was no material fact required by the Commissioner to make the amended assessment which had not been disclosed before the original assessment had been made. The evidence given before the Supreme Court was confirmatory of the material facts so disclosed and, on the findings made, the taxpayer was unable to show that its position represented an exception to the usual rule concerning insurance companies.

It follows, therefore, that under subsec. 170(3) Income Tax Assessment Act the Commissioner was prevented from issuing the amended assessment. Accordingly, the appeal should be allowed and the orders of the Supreme Court should be set aside. The matter should be remitted to the Commissioner for assessment according to law.

In the special circumstances of this case where the taxpayer has failed on its main contention but has succeeded on its secondary contention, there should be no order as to the costs of the appeal or of the Supreme Court proceedings.

THE COURT ORDERS THAT:

1. The appeal be allowed.

2. The orders of the Supreme Court of Victoria be set aside.

3. The matter be remitted to the Commissioner of Taxation of the Commonwealth of Australia for assessment according to law.

4. There be no order as to costs of the appeal or the proceedings in the Supreme Court of Victoria.