Federal Commissioner of Taxation v. The Myer Emporium Ltd.

Judges:
Mason ACJ
Wilson J
Brennan J
Deane J
Dawson J

Court:
Full High Court

Judgment date: Judgment handed down 14 May 1987.

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Mason A.C.J., Wilson, Brennan, Deane and Dawson JJ.

The Myer Emporium Ltd. ("Myer") is the parent company of a group of companies ("Myer group") which carry on business predominantly in the areas of retail trading and property development. On 20 February 1981 Myer acquired Margosa Ltd., a shelf company incorporated in the Australian Capital Territory. The name of the company was later changed to Myer Finance Ltd. ("Myer Finance"). Myer Finance then undertook the greater part of the financing activities carried on for the Myer group, which had previously been carried out by Myer.

On 6 March 1981, Myer lent $80,000,000 to Myer Finance. The loan was made pursuant to a loan agreement ("the loan agreement") which provided that the principal would be repaid to Myer "on but not prior to the 30th day of June, 1988" and that, in the meantime, Myer Finance would pay interest to Myer at the rate of 12.5% p.a. on the dates and in the amounts set out in Schedule 1 of the loan agreement. Under that Schedule, the first payment of interest was to be made on the day of the loan and was to be in the amount of $82,192 which represented three days' interest. This amount was duly paid by Myer Finance to Myer. The loan agreement provided (cl. 5) that Myer had the right during the term of the loan:

"... to sell, transfer or assign the Principal Amount and/or the interest payable or prepayable... provided that it shall give written notice of such sale, transfer or assignment to the Borrower."

On 9 March 1981, Myer assigned to Citicorp Canberra Pty. Ltd. ("Citicorp") "absolutely the moneys due or to become due as the interest payments and interest thereon... pursuant to" the loan agreement. The consideration for the assignment was the sum of $45,370,000 which was paid by Citicorp to Myer on that day. Whether this sum was income or capital in the hands of Myer is the principal question in this appeal. The sum was calculated on the basis of the outstanding interest payable under the loan agreement which was then discounted at the rate of 16% p.a. Myer gave notice of the assignment to Myer Finance which thereafter paid the interest due under the loan agreement to Citicorp. Myer remained entitled to the repayment of the principal sum of $80,000,000 by Myer Finance in accordance with the terms of the loan agreement.

The loan agreement and the related assignment of interest formed part of a wider reorganization within the Myer group. During 1980 the board of directors of Myer had considered reorganizing the Myer group so that the property and retail arms would be separated. The reorganization proposal included a property trust, but this was abandoned after an announcement by the government of a forthcoming change to the

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taxation treatment of property trusts set up as part of company reorganizations. Myer's advisers suggested a reorganization that would maintain, in their view, the benefits of the original proposal while including taxation or other financial benefits intended to counter the costs of the reorganization.

The proposal had four aspects, one of which was the financial arrangement set out above. First, Myer would remain the parent and holding company of other companies in the Myer group. Secondly, all trading operations would be transferred to Myer Melbourne Limited and would become divisions of that company, thereby eliminating the costs involved in operating numerous subsidiary companies carrying on parallel activities. Thirdly, all property assets would be placed under Myer Shopping Centres Limited. Fourthly, Myer would enter into a financial arrangement with an organization whereby an income stream within the Myer group would be sold for a lump sum. It was intended that the transaction would be arranged in such a way that the income stream which was sold would provide to Myer a lump sum payment which would be a non-taxable capital receipt.

Citicorp's parent company had indicated to Myer's advisers that a company in the Citicorp group would be willing to pay a lump sum of the order of $42,000,000 - the amount was later increased - for the acquisition of an income stream from Myer. The financial benefits to Myer as summarized by its financial advisers, Hill Samuel Australia Limited, were expressed in a review dated 28 August 1980 of the Citicorp proposal in these terms:

"Financial Benefits

The financial benefits of the Citicorp proposal can be illustrated by considering the example of an interest stream of $10m p.a. for seven years. Under this proposal, Myer would give up $70m over the seven year period; however, after-tax Myer would give up only approximately $38m. In return for giving up this amount over seven years, Myer will receive a lump sum payment of approximately $42m. Thus, Myer will receive a greater sum than it gives up and will receive that greater sum at an earlier date. This amounts to a negative cost of financing . The net present value of this benefit and the interest savings would be approximately $9m after tax."

It seems that Citicorp was able to set-off the interest payments that it received from Myer Finance as a result of the assignment from Myer to Citicorp against accumulated tax losses which were available to it. Had it not been for the availability of the tax losses, the transaction would have had no attraction for Citicorp. The tax liability on the interest payments, in the absence of the tax losses, would have reduced the net worth of the future interest payments to an amount less than the amount of the consideration payable by Citicorp to Myer.

The assignment of the right to interest was an integral part of the Myer group reorganization. It formed part of the financial arrangement set up to replace the aborted property trust. The loan would not have been given to Myer Finance if Citicorp had not been in a position to take the assignment of the right to interest. The accounting and legal advice, including the opinion of counsel, were all given on the instructions that the assignment would follow the loan, and that this arrangement was part of a larger reorganization of the Myer group. The minutes of the directors' meeting dated 23 February 1981, and the attached report: "A summary of Proposed Citicorp Fund Raising and Related Matters", dated 20 February 1981, treated the financial arrangement as involving both the loan and the assignment. The correspondence between Myer and the National Bank of Australasia Limited in respect of the daylight loan to obtain the $80,000,000 proceeded on the footing that the assignment would follow the loan. Mr Tope, a director of Myer, in his evidence agreed that apart from the initial interest payment of $82,192 it was never intended that Myer receive any of the interest from the loan, because at the time Myer made the loan it intended and had arranged to sell the right to the interest.

The Commissioner of Taxation assessed the sum of $45,370,000 as income in the hands of Myer under sec. 25(1) of the Income Tax Assessment Act 1936 (Cth) ("the Act"). Myer appealed against the Commissioner's disallowance of its objection to the Supreme Court of Victoria. The Commissioner relied upon sec. 25(1) and, alternatively, sec. 26(a) of the Act. The Commissioner also argued that, if neither of these sections applied, sec. 260 would apply to make the sum assessable. Murphy J. found that at all material times Myer had intended to assign for a lump sum the right

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to the future income stream arising from the loan. He was satisfied that the motivating purpose of the transaction was for Myer to obtain working capital to enable it to diversify. The ability of the company to obtain capital from public borrowings was limited by its debenture trust deed, and the transaction was the most feasible way, in the view of the board of directors of Myer, for the company to raise the working capital it sought. His Honour held that the sum was not income in the hands of Myer and that sec. 260 of the Act had no application.

On appeal to the Full Court of the Federal Court (Fox, Lockhart and Jenkinson JJ. 85 ATC 4601), Murphy J.'s decision was upheld. The Court held that the receipt of $45,370,000 was of a capital nature and therefore was not income under sec. 25(1) of the Act, that neither limb of sec. 26(a) had any application because no profit could be discerned, and sec. 260 did not apply because there was no "antecedent transaction" evident. Major elements in the Court's reasoning to the conclusion that the sum was capital were findings that the assignment was not made in the ordinary course of Myer's business and that the sum was not received in substitution of interest. The Federal Court concluded that the agreement between Myer and Citicorp operated to assign all Myer's entitlement to receive interest under the loan and was therefore to be characterized as a capital receipt. In the words of Lockhart J., "the rights of the taxpayer under the loan agreement were converted to a capital amount", although his Honour conceded that if it had been an agreement to assign payments as they fell due, the amount may well have been income.

The members of the Federal Court differed in their reasons for concluding that the $45,370,000 was not a profit and that sec. 26(a) did not apply. Fox J. said the sum was best seen as recompense for deprivation of interest on the loan. Lockhart J. held that the sum was capitalization of Myer's entitlement to interest. There was, in his Honour's opinion, no profit-making undertaking or scheme that had a nexus with the sum paid by Citicorp to Myer. Jenkinson J. found that the difference between the $80,000,000 lent to Myer Finance and the value of the right to repayment of that amount at a future date must be brought into account to determine whether the $45,370,000 was a profit. His Honour said: "There is nothing in the evidence to suggest that, if that obligation were valued, the amount received by Myer from Citicorp would be found to exceed that value." In his Honour's view the "application of a business conception to the facts" (see
F.C. of T. v. Becker (1952) 87 C.L.R. 456 at p. 467) disclosed no profit.

The questions before this Court are:

• (1) whether the amount of $45,370,000 was income in the hands of Myer under sec. 25(1) of the Act in its then form;
• (2) alternatively, whether the amount was assessable income of Myer under sec. 26(a) of the Act in its then form; and
• (3) alternatively, whether the assignment to Citicorp fell within sec. 260 of the Act.

In this Court argument in the first instance was limited to questions (1) and (2) above.

The Commissioner submits that a gain made by a taxpayer as the result of a business deal or a venture in the nature of trade is income of the taxpayer, even if the transaction that yields the gain is outside the ordinary course of business. According to the argument, the amount falls within either sec. 25(1) or the second limb of sec. 26(a). The taxpayer makes two responses to this argument:

• (1) that a gain made as the result of a business deal or a venture in the nature of trade is not income unless it is made in the ordinary course of carrying on a business; and
• (2) that the realization of a capital asset is capital, not income, the amount received by Myer representing the receipt of a capital asset.

Although it is well settled that a profit or gain made in the ordinary course of carrying on a business constitutes income, it does not follow that a profit or gain made in a transaction entered into otherwise than in the ordinary course of carrying on the taxpayer's business is not income. Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the character of income. But a gain made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction

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entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circumstances of the case. Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer's business. Nor does the fact that a profit or gain is made as the result of an isolated venture or a "one-off" transaction preclude it from being properly characterized as income (
F.C. of T. v. Whitfords Beach Pty. Ltd. 82 ATC 4031 at pp. 4036-4037, 4042; (1982) 150 C.L.R. 355 at pp. 366-367, 376). The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit.

The celebrated decision in
Californian Copper Syndicate v. Harris (1904) 5 T.C. 159 makes the point. There, the Copper Syndicate bought a mining property for the purpose of exploiting it so that the Syndicate could resell it at a profit. The profit was held to be income because the Syndicate never intended to work the property with a view to deriving income from mining operations on the property. The transaction, though one which the Syndicate was authorized to enter into under its articles of association, and therefore one which fell within the business which it was empowered to carry on, was an isolated transaction. Nonetheless the profit was income. The Lord Justice Clerk (the Right Honourable J.H.A. Macdonald) drew a distinction between a mere realization or change of investment and "an act done in what is truly the carrying on, or carrying out, of a business". His Lordship went on to express the distinction in this way (at p. 166)

"Is the sum of gain that has been made a mere enhancement of value by realising a security, or is it a gain made in an operation of business in carrying out a scheme for profit-making?"

This test was approved by the Privy Council in
Commissioner of Taxes v. Melbourne Trust, Limited (1914) A.C. 1001 at p. 1010 and was applied by the House of Lords in
Ducker v. Rees Roturbo Development Syndicate Ltd. (1928) A.C. 132 at p. 140. There a company was formed primarily for the purpose of acquiring, developing and exploiting an invention relating to a centrifugal turbine pump by way of granting manufacturing licences under patents. In the course of its business the company acquired additional English and foreign patents in connection with the invention. Although its main business was the grant of manufacturing licences, the company always contemplated the possibility of a sale of its interest in the foreign patents. Receipts from the sale of that interest were held to constitute income. Lord Buckmaster stated (at pp. 141-142) that this was not "a mere accidental dealing with a particular class of property" but "was part of their business which, though not of necessity the line on which they desired their business most extensively to develop, was one which they were prepared to undertake".

The important proposition to be derived from Californian Copper and Ducker is that a receipt may constitute income, if it arises from an isolated business operation or commercial transaction entered into otherwise than in the ordinary course of the carrying on of the taxpayer's business, so long as the taxpayer entered into the transaction with the intention or purpose of making a relevant profit or gain from the transaction.

Several different strands of thought have combined to deter courts so far from accepting the simple proposition that the existence of an intention or purpose of making a profit or gain is enough in itself to stamp the receipt with the character of income. The first was the notion that the realization of an asset was a matter of capital, not income. The second was the apprehension that windfall gains and gains from games of chance would constitute income unless the concept of income, apart from income from personal exertion and investments, was confined to profits and gains arising from business transactions. And the third notion, itself associated with the idea that the carrying on of a business involves a systematic series of recurrent acts or activities, was that a gain generated by recurrent transactions is income, whereas a gain generated by an isolated transaction is capital.

In the United Kingdom, Schedule D of the Income Tax Act 1918 (U.K.) reinforced these

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notions. The Schedule seemingly confined the concept of income to (a) profits or gains from any trade, profession, employment or vocation, and (b) annual profits and gains from investments, though "trade" is defined so as to include every "manufacture, adventure or concern in the nature of trade". These provisions naturally provoked the question: Was a profit made on an isolated transaction of purchase and sale income, if the purchase was made with the intention, or for the purpose, of making the profit, even though the transaction was not one entered into in the course of carrying on a business?

In
Jones v. Leeming (1930) A.C. 415, the House of Lords answered this question in the negative. There was a finding that the taxpayer never meant to hold the land bought as an investment. Nevertheless it was found that the transaction "was not a concern in the nature of trade". This led to the conclusion that a profit on an isolated sale, not being an adventure in the nature of trade, was a capital accretion (at p. 430). Central to the reasoning was the view that in order to constitute a trading or business transaction, an element of recurrence or repetition is needed and that the intention or purpose of making a profit or gain is not enough. Viscount Dunedin said (at p. 423):

"The fact that a man does not mean to hold an investment may be an item of evidence tending to show whether he is carrying on a trade or concern in the nature of trade in respect of his investments, but per se it leads to no conclusion whatever."

And Lord Buckmaster (at p. 420) discounted the suggestion that a profit made on the sale of an asset acquired in the expectation that it would rise in value (and presumably result in a realized gain) is income. To him all that was involved in such a case was the realization of a capital asset.

On the other hand in
Edwards (Inspector of Taxes) v. Bairstow (1956) A.C. 14 joint venturers who engaged in an isolated transaction of buying and selling a complete spinning plant, with a view to making a profit, having no intention of using the plant or deriving income from it, were held liable to income tax on the profit made on resale. Lord Radcliffe concluded (at pp. 36-37) that it was a profit from an adventure in the nature of a trade because the joint venturers had no intention of using the machinery and therefore did not buy it to hold as an income-producing asset or to consume it or for the pleasure of enjoyment; and, instead of having any intention of holding the plant, they planned to sell it even before they bought it. This they did, making a net profit, as they hoped and expected to do. In his Lordship's opinion this was "inescapably, a commercial deal in second-hand plant".

In rejecting the argument that the profit was not income because it arose from an isolated transaction, Lord Radcliffe observed (at p. 38):

"... that circumstance does not prevent a transaction which bears the badges of trade from being in truth an adventure in the nature of trade. The true question in such cases is whether the operations constitute an adventure of that kind, not whether they by themselves or they in conjunction with other operations, constitute the operator a person who carries on a trade. Dealing is, I think, essentially a trading adventure, and the respondents' operations were nothing but a deal or deals in plant and machinery."

The judgments in some of the English decisions naturally reflect the language of the United Kingdom statutory provisions, which have no precise counterpart in this country. However, over the years this Court, as well as the Privy Council, has accepted that profits derived in a business operation or commercial transaction carrying out any profit-making scheme are income, whereas the proceeds of a mere realization or change of investment or from an enhancement of capital are not income;
Ruhamah Property Co. Ltd. v. F.C. of T. (1928) 41 C.L.R. 148 at pp. 151-152, 154;
McClelland v. F.C. of T. 70 ATC 4115 at pp. 4120-4121; (1970) 120 C.L.R. 487 at pp. 495-496;
London Australia Investment Co. Ltd. v. F.C. of T. 77 ATC 4398 at pp. 4402-4403; (1977) 138 C.L.R. 106 at pp. 115-116; and see Whitfords Beach.

The proposition that a mere realization or change of investment is not income requires some elaboration. First, the emphasis is on the adjective "mere" (Whitfords Beach, at ATC pp. 4046-4047; C.L.R. p. 383). Secondly, profits made on a realization or change of investments may constitute income if the investments were initially acquired as part of a business with the intention or purpose that they be realized subsequently in order to capture the

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profit arising from their expected increase in value - see the discussion by Gibbs J. in London Australia, at ATC pp. 4403-4404; C.L.R. pp. 116-118. It is one thing if the decision to sell an asset is taken after its acquisition, there having been no intention or purpose at the time of acquisition of acquiring for the purpose of profit-making by sale. Then, if the asset be not a revenue asset on other grounds, the profit made is capital because it proceeds from a mere realization. But it is quite another thing if the decision to sell is taken by way of implementation of an intention or purpose, existing at the time of acquisition, of profit-making by sale, at least in the context of carrying on a business or carrying out a business operation or commercial transaction.

If Myer's decision to assign to Citicorp the moneys due or to become due under the loan agreement had been unrelated to and independent of its decision to enter into the loan agreement, the argument that the assignment amounted to no more than the realization of a capital asset would perhaps have had more force, though, as will appear later, we do not consider that the respondent's argument would have prevailed even in such a situation. However, in the actual circumstances, as we have stated them, the consideration received for the assignment is necessarily income. This conclusion may for present purposes be demonstrated by distinguishing the facts in
I.R. Commrs v. Paget (1938) 2 K.B. 25 on which Myer strongly relied. The Court of Appeal held that the proceeds from the sale of coupons were capital in the hands of Miss Paget. Lord Romer (at p. 45) said this would be the case even if Miss Paget had only sold the right to interest for one or a few years. But Miss Paget had not acquired the bond coupons with a view to sell her right to interest on the coupons.

Myer also relied strongly on the statement made by Dixon and Evatt JJ. in
C. of T. (Vic.) v. Phillips (1936) 55 C.L.R. 144 at p. 156:

"It is true that to treat a sum of money as income because it is computed or measured by reference to loss of future income is an erroneous method of reasoning (cf.
Californian Oil Products Ltd. (in Liquidation) v. Federal Commissioner of Taxation [(1934) 52 C.L.R. 28, at pp. 46, 49, 51];
Van den Berghs Ltd. v. Clark [(1935) A.C. 431, at p. 442]). It is erroneous because, for example, the right to future income may be an asset of a capital nature and the sum measured by reference to the loss of the future income may be a capital payment made to replace that right. Or, again, the computation may be done for the purpose of ascertaining what capitalized equivalent should be paid for the future income."

There the taxpayer was employed as the governing director of a company under a contract which specified his term to be of ten years' duration and that his remuneration was to be at the rate of 12.5% of net profits. The company disposed of its business and Mr Phillips' services were dispensed with. It was agreed between the company and Mr Phillips that the sum of £20,301, being 12.5% of the company's estimated net profits in the unexpired term of ten years, should be paid to him, in monthly instalments, as compensation. The monthly payments were held to be of an income nature. Dixon and Evatt JJ. said (at p. 156): "No prima facie reason exists for regarding as instalments of capital annual payments which are taken in place of the contractual rights such a contract gave." Their Honours pointed out (at pp. 156-157) that the total amount of the compensation was not the present value of the future contractual payments but merely their sum, noting that in these circumstances even receipt of a lump sum might be regarded as of the same nature as the ingredients of which it was composed.

Neither the decision nor the discussion in Phillips is decisive of the present case. The transaction in Phillips was of a very different kind and, as in Paget, no question of a profit-making scheme arose. The point is that the consideration for an assignment of the right to future income may constitute income in a variety of circumstances. Many instances may be given of the sale of a capital asset for a consideration which is income in the hands of the seller. For the most part these are instances of the sale of a capital asset for periodic, regular or recurrent receipts, periodicity, regularity or recurrence being characteristics of an income receipt. See, for example,
Egerton-Warburton v. D.F.C. of T. (1934) 51 C.L.R. 568, where a property was sold in return for an annuity. But there is no reason for thinking that the conversion of a capital asset

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into an income receipt is confined to such cases.

The periodicity, regularity and recurrence of a receipt has been considered to be a hallmark of its character as income in accordance with the ordinary concepts and usages of mankind. Likewise, the need to distinguish capital and income for trust purposes and other purposes has focused attention on the difference between the right to receive future income and the receipt of that income, a difference which has given rise to the analogical difference between the fruit and the tree (see
Shepherd v. F.C. of T. (1965) 113 C.L.R. 385 at p. 396). Both the "ordinary usage meaning" of income and the "flow" concept of income derived from trust law have been criticized - see Professor Parsons, "Income Taxation: An Institution in Decay?" (The 1986 Wilfred Fullagar Memorial Lecture). For present purposes it is sufficient for us to say, without necessarily agreeing with these criticisms, that, valuable though these considerations may be in categorizing receipts as income or capital in conventional situations, their significance is diminished when the receipt in question is generated in the course of carrying on a business, especially if it should transpire that the receipt is generated as a profit component of a profit-making scheme. If the profit be made in the course of carrying on a business that in itself is a fact of telling significance. It does not detract from its significance that the particular transaction is unusual or extraordinary, judged by reference to the transactions in which the taxpayer usually engages, if it be entered into in the course of carrying on the taxpayer's business. And, if it appears that there is a specific profit-making scheme, it is pointless to say that it is unusual or extraordinary in the sense discussed. Of course it may be that a transaction is extraordinary, judged by reference to the course of carrying on the profit-making business, in which event the extraordinary character of the transaction may reveal that any gain resulting from it is capital, not income.

Myer's business at all relevant times was that of retailer and property developer. Before acquiring Myer Finance, Myer carried on business as a financier, though its business as a financier seems to have been confined to transactions relating to the Myer group. The transactions in question here were entered into by Myer in the course of its business. The transactions, more particularly the assignment, were novel in the sense that it was the first time that Myer had entered into such an arrangement. But this fact does not take them out of the course of the carrying on of Myer's profit-making business.

By no stretch of the imagination is it possible to describe the transactions, or the assignment standing on its own, as the mere realization of a capital asset. As we have seen, the assignment was not unrelated to and independent of the loan agreement. The two transactions were interdependent in the sense that Myer would not have entered into the loan agreement unless it knew that Citicorp would shortly thereafter take an assignment of the moneys due or to become due for a sum approximating the amount payable in consideration of the assignment. Indeed, from the viewpoint of Myer the two transactions were essential and integral elements in an overall scheme, that scheme being a profit-making scheme.

If the two transactions, namely the loan agreement and the assignment, are considered as separate and independent transactions, Myer's argument that no relevant profit arose from the assignment has compelling force. The consideration payable for the assignment reflected the true value of the chose in action which Myer assigned. But once the two transactions are seen as integral elements in one profit-making scheme, it is apparent that Myer made a relevant profit, that profit being the amount payable on the assignment. As a result of the two transactions Myer, having lent $80,000,000 on 6 March 1981 repayable in accordance with the terms of the loan agreement, had profited by 9 March 1981 to the extent of the first interest payment received on 6 March 1981 and the sum of $45,370,000 paid for the assignment, the principal on the loan being intact. Of course the value of the chose in action, the right to recover the principal sum, was substantially less than the amount of the principal sum because there was no obligation to repay until 30 June 1988. But this circumstance cannot affect the character of the consideration for the assignment. It exists in every case where money is lent for a fixed term.

The accounting basis which has been employed in calculating profits and losses for the purposes of the Act is historical cost

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(
McRae v. F.C. of T. 69 ATC 4066; (1969) 121 C.L.R. 266 and see
Lowe v. Commr of I.R. (N.Z.) (1983) 15 A.T.R. 102) not economic equivalence (
Commr of I.R. (N.Z.) v. Europa Oil (N.Z.) Ltd. 70 ATC 6012; (1971) A.C. 760 at p. 772). And so a taxpayer who lends money for a stipulated period at interest is treated as exchanging the money lent for a debt of the same amount, unless the loan is made at a discount or premium, in which case there may be a gain or loss on capital account:
Lomax (H.M. Inspector of Taxes) v. Peter Dixon & Co., Ltd. (1943) 2 All E.R. 255. In the ordinary case, the debt is brought to account in the same amount as the money lent. The amount of the debt is not reduced because the lender is kept out of the use and enjoyment of the money lent for the period of the loan.

If economic equivalence were the appropriate accounting basis, the debt would be brought to account at the beginning of the period in an amount less than the amount of the money lent and would increase day by day until it equalled the amount of the money lent when the period expired. On that basis the right to interest on the money lent would be brought to account at the beginning of the period at a maximum figure reducing to nil when the period expired. The aggregate of the two amounts - the debt and the right to interest - would equal, throughout the period, the amount of the money lent, assuming that the rate at which the principal debt was discounted and the rate of interest payable on the principal debt were the same. On that basis, both the debt and the right to interest might be treated as capital assets.

But when a debt is brought to account in the same amount as the amount of the money lent, the right to interest on the money lent is not treated as an asset at all. It does not appear in either the balance sheet or the profit and loss account of the lender. The right to interest is not distinguished for accounting purposes from the interest to which it relates. So long as the amount of the principal debt is treated as equivalent to the amount of the money lent, the right to interest cannot be treated as an additional capital asset. The making of a loan does not immediately produce a capital gain equal to the present value of the interest to be paid. The right to interest is not a capital asset which is progressively transformed into income as and when the interest is received.

That is not to say that a right to interest is not an existing chose in action. It is an existing chose in action unless, perhaps, the borrower can avoid any liability for interest by repaying the loan: see
Norman v. F.C. of T. (1963) 109 C.L.R. 9; Shepherd, at pp. 395-396. But the interest which becomes due is not the produce of the mere contractual right to interest severed from the debt for the money lent. Interest is regarded as flowing from the principal sum (
Federal Wharf Co. Ltd. v. D.F.C. of T. (1930) 44 C.L.R. 24 at p. 28) and to be compensation to the lender for being kept out of the use and enjoyment of the principal sum:
Riches v. Westminster Bank Limited (1947) A.C. 390 at p. 400. A covenant to pay interest on a principal sum may, according to the terms of the lending agreement, be independent of or accessory to a covenant to repay the principal sum or the covenants may be integral parts of a single obligation, but it is of the essence of interest that it be referable to a principal sum: per Rand J. in Reference as to the Validity of Section 6 of the Farm Security Act, 1944, of the Province of Saskatchewan (1947) S.C.R. 394 at pp. 411-412. The source of interest is never the mere covenant to pay. Interest is not like an annuity. Annuity payments are not derived from the money paid for the annuity; they are derived solely from the annuity contract. And so, when a contractual right to be paid an annuity is sold for a price, the proceeds of sale are ordinarily capital in the hands of the vendor: Paget, at pp. 35, 44-45; cf.
Kelsall Parsons & Co. v. I.R. Commrs (1938) 21 T.C. 608 at p. 624. The vendor receives the price in exchange for a capital asset - the contractual right which produces payment of the annuity. If a lender who sells a right to interest severed from the debt were regarded as disposing of an income-producing right, Paget would indicate that the price should be treated as capital. But the contractual right is not the source of the interest to which it relates: a contractual right severed from the debt is not the structure which produces that income.

If the lender sells his mere right to interest for a lump sum, the lump sum is received in exchange for, and ordinarily as the present value of, the future interest which he would have received. This is a revenue not a capital item - the taxpayer simply converts future income into present income: see
Commissioner of Internal Revenue v. P.G. Lake, Inc. (1958) 356 U.S. 260 at pp. 266-267.

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ATC 4372

By a transaction consisting in the making of a loan and a sale of the right to interest on the money lent, the lender acquires at once a debt and the price which the sale of the right has fetched. The price of the right is the lender's compensation for being kept out of the use and enjoyment of the principal sum during the period of the loan and, like the interest for which it is exchanged, it is a profit. It is immaterial that the lender receives the profit not from the borrower but from the other party to the transaction, and it is immaterial that the profit is received immediately and not over the period of the loan.

In Paget, Lord Romer said (at p. 45) that the proceeds of the sale for a lump sum of an annuity are capital in the hands of the vendor and not income. That case bears some similarity to the present case, for Miss Paget sold interest coupons attached to foreign bearer bonds to dealers in those coupons, and the question was whether the price she received for the coupons was "income arising from securities in any place out of the United Kingdom". Had she received the interest to which the coupons related that interest would have been brought to charge, but the authorities which had issued the bonds - the City of Budapest and the Government of Yugoslavia - had defaulted in due performance of their interest obligations. The purchase price of the coupons was not interest nor were the benefits which purchase of the coupons conferred on the dealers. What Miss Paget sold was, as MacKinnon L.J. described it (at p. 48), "the possibility of making some money abroad" by accepting in lieu of the promised interest certain payment in local currency or a mixture of U.S. dollars and funding bonds. The coupons were the sole source of the possibility of making some money abroad; they were the sole source of the expectation of substitutionary payment. The substitutionary payment offered by the defaulting borrowers (or the expectation of obtaining that payment) on production of the coupons was not regarded as interest and the sale of the coupons was not by way of assignment of a right to interest but by way of transfer of the instruments of title to the substitutionary payment. The coupons had come to represent, like a contract to pay an annuity, the sole source of the expected payments. Lord Romer drew that analogy (at pp. 44-45), treating the sale for a lump sum of an annuity as an instance of a sale of a right to receive income in the future, the proceeds of which are not treated as income. Unlike the sale of the coupons in Paget, the sale of a right to interest severed from the debt is not a sale of a tree of which the future payments are the fruit. The present case may thus be distinguished from the view of the facts which was the foundation of the decision in Paget. If Paget is not to be distinguished in this way, we should be unable to accept its authority for the purposes of the Act.

In this case, the sale of Myer's right to interest produced an immediate cash receipt. For an outlay of $80,000,000 in the transaction Myer acquired a debt of $80,000,000 owed by Finance and $45,370,000 in cash from Citicorp. It has made a profit of $45,370,000. True it is that Myer will not now receive the interest which would have become payable to it during the period of the loan but that will be reflected only by an absence of the income by way of interest which would otherwise have been received in future years. Myer received the profit of $45,370,000 during the 1981 income year and that receipt forms part of its assessable income for that year.

What we have said leads to the conclusion that the amount in question formed part of the income of Myer under sec. 25(1) of the Act. A similar chain of reasoning would have led to the conclusion that the amount constituted assessable income under the second limb of sec. 26(a). The relationship between sec. 25(1) and 26(a) has been the subject of much previous discussion involving considerable differences of opinion about the extent (if any) to which the provision of the second limb of sec. 26(a) supplemented the provision of sec. 25(1) (see, e.g., Whitfords Beach, at ATC pp. 4044-4045; C.L.R. pp. 379-381). It is, however, unnecessary that we examine that question here since, as we have indicated, we consider that the amount in question in the present appeal constituted income of the taxpayer pursuant to both sec. 25(1) and 26(a).

For the foregoing reasons we would allow the appeal.

ORDER

Appeal allowed with costs.

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ATC 4373

Order that the order of the Full Court of the Federal Court dated 8 October 1985 be set aside and in lieu thereof order that the appeal to that Court be allowed with costs.

Further order that the order of the Supreme Court of Victoria dated 20 March 1985 be set aside and in lieu thereof order that the appeal to that Court be dismissed with costs.