CMI Services Pty. Ltd. v. Federal Commissioner of Taxation

Judges:
Woodward J

Court:
Federal Court

Judgment date: Judgment handed down 31 August 1989.

Woodward J.

This is an appeal by the applicant against the disallowance of an objection to an assessment of income tax for the year ended 30 June 1984.

Nature of the appeal

The dispute concerns alleged profits on the sale of two properties in High Street, Belmont, a suburb of Geelong. The Commissioner asserts that the alleged profits, totalling $382,903, constitute assessable income either because they were profits ``arising from the sale by the taxpayer of any property acquired by him for the purpose of profit making by sale'' (the first limb of sec. 26(a) of the Income Tax Assessment Act 1936 (the Act) as it stood at the relevant time), or because they were income within ordinary concepts and so liable to tax pursuant to sec. 25(1) of the Act.

So far as sec. 25(1) is concerned, the Commissioner argues that the profit which the applicant derived as a result of the sale of the Belmont properties should be regarded as income because those realisations were acts done in what was truly the carrying on of its business. Put very generally, the allegation is that the buying and selling of real estate is part of the applicant's business of investing; see
London Australia Investment Company Ltd. v. F.C. of T. 77 ATC 4398; (1977) 138 C.L.R. 106.

Alternatively, it is put that the position of the applicant as a subsidiary of an insurance company, and the role which it has played in the investment of that company's funds resulting from its insurance business, have produced the result that its operations are effectively part of a business of insurance; and so any profits made are assessable in the same way as other profits made in the course of that business; see
The Chamber of Manufacturers Insurance Ltd. v. F.C. of T. 84 ATC 4315; (1984) 2 F.C.R. 455.

Counsel for the Commissioner did not abandon their argument under the first limb of sec. 26(a) of the Act, but did concede, in answer to a question from the Court, that they could advance no view of the facts and circumstances upon which they could succeed under that subsection if they failed under sec. 25(1). Accordingly I confine my attention to sec. 25(1).

It is contended on the part of the applicant that the properties which it holds have been acquired for purposes of long-term investment only and that, where sales have occurred, as in the cases before the Court, the resulting receipts are in the nature of capital and not income.

Relationship of applicant and parent company

CMI Services Pty. Ltd. (Services) is a wholly-owned subsidiary of the Chamber of Manufactures Insurance Ltd. (CMI). CMI, in turn, is wholly owned by the Australian Chamber of Manufactures (formerly the Victorian Chamber of Manufactures), an organisation of employers registered, at the relevant time, under the Conciliation and Arbitration Act 1904 which, by virtue of that registration, is a tax-exempt organisation

ATC 4849

pursuant to sec. 23 of the Act. CMI has operated in the general insurance field since 1914 and it is clear from the evidence that Services was incorporated on 7 October 1971 in order to serve as a property investment company through which supposedly surplus funds of CMI could be invested.

Property investment was decided upon because of its security, steady returns, and probable protection from the effects of inflation.

The reason for establishing a separate company was expressed by Mr Sutherland, a former managing director of both companies, as ``orderly housekeeping'' - it was neater and more convenient to keep property investments separate from the insurance and insurance-related activities of CMI. Until then the only properties owned by CMI had been those acquired for the housing of its activities or for the possible expansion of their housing. It was also suggested that ``CMI Services'' might not be immediately associated with a wealthy insurance company in the minds of potential vendors and their agents.

It was believed that the funds of CMI not required for insurance purposes would be better invested and controlled by the same experienced board members than returned to the Chamber of Manufactures, which has a regular turnover of leadership and no continuing access to skills in the property investment area.

At all relevant times, and indeed until very recently, the board membership of CMI and of Services was identical. I am satisfied by the evidence that board meetings were usually held in succession on the same day; that is to say, after completing a board meeting of CMI, the same persons present would then reconstitute themselves as the board of Services and hold a further meeting. There may have been occasions when separate and special meetings of the Services board were held, but if so this was rare.

Sources of evidence

In addition to a large quantity of documentary material which was put before me by consent of the parties, I had oral evidence from a number of board members and officers of the applicant and two independent expert witnesses called on behalf of the respondent. I have no doubt that the witnesses for the applicant gave truthful accounts of their parts in the conduct of the applicant's operations over a number of years since its formation. Some of them had better memories than others of events going back 10 years or more. I was particularly impressed by the evidence given by Mr Sutherland, who was secretary of Services from its incorporation until he became general manager early in 1975 and managing director five years later. He also held the same offices with CMI from the same dates. He retired as managing director of both companies on 6 July 1984. Thus he was a senior executive of the companies at all the most relevant times.

Purpose of applicant

I am satisfied by the evidence of Mr Sutherland and the other witnesses that, when the company was incorporated, its purpose was to purchase commercial or industrial properties, mainly in Victoria but not in the central business district of Melbourne (which was seen as too expensive), for purposes of investing funds of the parent company believed to be surplus to its requirements. The moneys for the purchases were to be lent by the parent company to Services which, during its early years, paid a nominal rate of interest; but after it had become established, this rate was raised by stages to what is at present the normal market rate. It was intended that each property purchased would be held indefinitely; that is to say it would be held as long as it continued to provide, and to promise for the future, a satisfactory return by way of rent, after allowance for outgoings, without presenting any major problems in its management.

Purchase of properties

Decisions about the purchase of properties seem always to have been made by the CMI board and recorded in the minutes of that board under the heading ``CMI Services Pty. Ltd.'' No doubt this was because the funds being committed were those of CMI, which would be lent to Services. Each decision to negotiate purchase was based on a written recommendation from CMI management. After 1977 they were normally signed by Mr Redman, who was then engaged as property officer for CMI and later appointed property manager. (Services employed no staff; it paid CMI for the use of its employees.) A favourable decision authorised management to proceed to purchase up to a prescribed figure. There seems

ATC 4850

to have been only one occasion when a recommendation by management was not accepted by the board.

The same resolution to authorise purchase would then appear in almost identical terms in the minutes of a meeting of the Services board - not, as one might expect, the meeting which followed immediately, but the next meeting several weeks later. In some cases this apparent decision of that later date could be followed by a note to the effect that negotiations had already been successfully concluded - which made those minutes of the Services board read rather oddly. However the reality of the situation was clear. The decision to purchase was made by CMI, not Services.

Services acquired its first property at a date after its incorporation which is now uncertain but was probably early in 1974. It then purchased three further properties in 1974, one in 1976, five in 1977, three in 1978 and seven in 1979. Three further properties were acquired in 1980 and three more between 1981 and 1984. Only one has been acquired since 1984. Thus, in total, 27 properties have been purchased by the applicant since its inception. Of these, 16 have been sold in circumstances which will require closer attention later in these reasons, one was in the process of being sold at the time of hearing, and 10 are still held by the applicant.

No guidelines for the purchase of properties have been laid down by the board of CMI at any time; but the chairman of the board on 14 February 1980 addressed a memorandum to the general manager, Mr Sutherland, in the following terms:

``in considering what properties the CMI may purchase for investment, the following criteria are a useful check-list and, although we probably have one of our own, you may care to pass it on to Mr R. Redman for reference.

The property generally accord to the following criteria:

  • 1. It is of sound and fairly recent construction.
  • 2. The location is very good with surrounding property fully let or close to fully let.
  • 3. Major tenants are strong.
  • 4. Rentals are below current market value with scope for increase.
  • 5. Car parking is more than ample.

Some of the statements are a bit subjective, but I think they are useful.''

Some 18 months earlier the newly appointed property officer, Mr R.J. Redman, had prepared a check list for himself which ran as follows:

``1. Location

  • (a) Main Road exposure.
  • (b) Convenience to Arterial roads and highways.
  • (c) Surrounding properties - quality, general feel.
  • (d) Land composition, slope, views, drainage, shape.
  • (e) Location in relation to competition from other similar properties.
  • (f) Zoning - consider if use is appropriate.
  • (g) Established area for use land is put?
  • (h) Potential increase in popularity.
  • (i) Increasing or declining population - labour pool.
  • (j) Is Street proposed to be closed for purposes of a pedestrian shopping mall?

2. Improvements

  • (a) Age and Life Expectancy.
  • (b) Quality and Efficiency.
  • (c) Highest and best use (Architectural obsolescence).
  • (d) Consider such aspects as -
    • Cracked wall, concrete, damp proof course.
    • Signs of leaking.
    • Spouting.
    • Paintwork.
    • Roof construction.
    • Light - natural and electrical.
  • (e) Note if heating, air conditioning, mechanical ventilation available - who maintains. Note if building is sprinklered.

    ATC 4851

  • (f) Floor coverings - check resistance to wear, life expectancy - who maintains.
  • (g) If lift provided - check condition and who maintains.
  • (h) Check plumbing, if possible and electric wiring.
  • (i) Check wall alignments, steel framing and door fit.
  • (j) Possibility of expanding.
  • (k) Is Property connected to the M.M.B.W. mains sewer.

3. Tenant

  • (a) Strength of tenant, private or public company.
  • (b) Does Guarantee form part of the Lease?
  • (c) Is Tenant sufficiently strong as to be recognised by the Board?

4. Lease Term

  • (a) Length of the term of Lease and options.
  • (b) Check outgoings to be paid by Lessee - Rates, Land Tax, Insurances, maintenance of building, roller doors, other machinery, air conditioning etc.
  • (c) Check Rent Review Clause, method of determining new rent, and intermittencies.

5. Rent Level

  • (a) Too high - too low, investigate the area.
  • (b) Potential increases possible.
  • (c) Check other alternative areas to gauge rental level.
  • (d) Have regard to concrete areas, additional land areas.
  • (e) Are Car Parking facilities taken into account - (Is Car Parking sufficient for tenants requirements)?

6. Asking Price

  • (a) Is return adequate?
  • (b) Consider overall value for money.
  • (c) Consider Contract terms.

7. General Aspects

  • (a) Marketability.
  • (b) Cost in use.
  • (c) Overall attractiveness.
  • (d) Conception of prestigiousness.
  • (e) Capital Gain Potential.''

Review of properties held

After the loss incurred in the sale of 140-142 Barkers Road, Hawthorn (No. 1 below) it was decided that there should be a review, by the CMI board, of Services' property holdings at six-monthly intervals. A typical entry on the minutes of Services read:

``Review of Properties

It was reported that on 19th August, 1983, Management submitted to The Board of the Principal Company, a Schedule of properties owned by C.M.I. Services Pty. Ltd. detailing on each property the Original Cost Price, the present Estimated Market Value, the Current Rental, the current Net Yield on Cost Price and estimated Market Value and the unexpired period of the current lease.

The Property Manager also attended the above Meeting and gave a verbal report on each property...''

Having heard the explanations of many of those who participated in these reviews, I am satisfied that they were provided for information rather than action, and were no more than a prudent consideration of the performance of Services, which enabled the board also to keep its finger on the pulse of the rental market and then to determine which types of property were likely to prove the best investments.

There was no evidence that any sale of property was determined upon by the board as a result of such a review. If a sale was ever decided upon following such a review (as occurred in relation to the subject properties on 30 July 1982) it was because an express recommendation to sell, from management, was submitted to the board at the same meeting. Every sale that took place originated from such a recommendation, which was usually in writing. Although it was obviously possible for a board member to query the retention of a property following a general

ATC 4852

review, there was no evidence that it had actually happened.

History of the buying and selling of properties by the applicant

The following are the properties (excluding the subject properties) which the applicant has purchased since its incorporation in 1971. All prices quoted are taken to the nearest $1,000.

1. 140-142 Barkers Road, Hawthorn

This property was recommended for purchase by the applicant in November 1973 for $249,000 and, presumably, was purchased early in 1974. It had recently been renovated and was in excellent condition. The summary report to the board stated that the property was well located and in good order and that the return of 8.5% by way of rents was ``satisfactory but could be improved''. However expectations were not realised and on 16 June 1978 the board of CMI decided that the property should be sold. The minutes of that day record the decision in these terms:

``It was decided that due to its loss in capital value and unsatisfactory current net return the property at 140-142 Barkers Road, Hawthorn be disposed of and that an approach be made to the existing tenants with a proposition that they form a consortium to purchase the property for $250,000. Should this proposition be not accepted, the property is to be offered for sale.''

In the event the property was sold for $218,000. This represented a capital loss of over $30,000. Asked why it was sold, Mr Redman said:

``this property was initially leased to one consortium which eventually went bankrupt... it was a medical suite, a building of two levels, a brick veneer building of individual doctors' suites... That was eventually achieved after a long period of time, but there was a constant movement of doctors. There was approximately twenty of them in all... It was a very difficult property to manage. The rentals were difficult to obtain, never mind achieve any sort of increase, and the building had faults, particularly with the plumbing, and it required a lot of work constantly. Consequently, the net return was very low, very poor indeed, and we had to eventually sell the property on terms. It was a very difficult property to sell.''

2. 555-557 Whitehorse Road, Nunawading

This was purchased in February 1974 for $169,000. It was sold in 1988 for $910,000. Explaining this sale, Mr Redman said:

``It had also a fairly chequered career as far as tenants were concerned. One of the tenants was a billiard table manufacturer who went bankrupt... We found that the building was suffering structural problems approximately 6 to 12 months prior to the time... it was sold, and the return had been less than adequate.''

3. 202 Whitehorse Road, Blackburn

This property was purchased in August 1974 for $369,000 and is still in the applicant's portfolio. Mr Redman said:

``It is a good property. We have got no intention of selling it.''

4. 150 Thistlethwaite Street, South Melbourne

This was bought for $286,000 in 1974 and sold for $661,000 in November 1986. By way of explanation for this sale, Mr Redman said:

``That property... was leased to Kilpatrick Green on a long term lease... It was a building which was specifically useful to them. They are electrical engineers. They were actually tenants of a building which adjoined our own office building, and we had a reasonably good rapport with them. They indicated close to the end of the term of the lease they were not willing to remain. In fact, their business had out-grown the premises. Being a specialized property, in a sense, it would appear that it was difficult to re-let. The land was irregular. The office itself needed a large amount of renovation work and the roof needed completely repairing or renewing. There was also evidence of movement in the building. Mainly for the risk of non-continuance of income we decided - and at that particular time that was a fairly depressed period, indications were it would take a long time to re-let - we decided to sell the property with the existing tenant there,... it did eventually become vacant at the end of the term of the lease.''

ATC 4853

5. 26 Glentanna Street, Kedron (Queensland)

This property was purchased in November 1976 for $169,000 and was sold in February of 1989. It was also occupied by Kilpatrick Green and was purchased specifically for them. They recently vacated the premises. Mr Redman said:

``It meant that we had a price to renovate the building to bring it to a level which would bring the same return, which would have meant quite detailed work, and at that time the indications were it would also be very difficult to re-lease. There were other buildings in that street which were for lease.''

Asked if the fact that the property was in Queensland had any bearing on the decision to sell, Mr Redman said:

``Yes, certainly. The difficulty there - that is the only property which we have in that state. There was a difficulty of management.''

6. 6-10 Leonard Avenue, Noble Park

This property was purchased in July 1977 for $813,000. It was sold in April 1988 for $1,375,000. Mr Redman said:

``That property was similar to the Half Case at Belmont occupied by Permewan Wright on an overage system of rental. The rental achieved from the building was not consistent with the amount of increase one would normally expect from this type of building...''

An overage system of rental is one where a comparatively low base rate of rental is fixed, with provision for it to increase in proportion to the turnover of the lessee's business.

7. Corner Maude and Vaughn Streets, Shepparton

This was bought for $676,000 in 1977 and sold for $1,033,000 in 1985/86. Mr Redman explained that this and the next two properties on the list, in Wangaratta and Lilydale, were all leased to Dunlop Australia Limited on a 21-year lease, which included an option to purchase. The properties had been bought by the applicant subject to these leases and, when Dunlop decided to exercise the options in each case, there was nothing which the applicant could do to prevent the sale of all three properties. Appropriate sale prices were negotiated.

11. 395-397 Station Street, Box Hill

This property was purchased in February 1978 for $623,000 and is still retained by the applicant.

12. 4 University Place, Clayton North

This was bought for $214,000 in July 1978 and is still in the applicant's portfolio.

13. 23-25 Normanby Road, Notting Hill

This was also purchased in July 1978 and is retained by the applicant. The purchase price was $515,000.

14. 439-441 Warrigal Road, Moorabbin

This was bought in March 1979 for $218,000 and is retained by the applicant.

16. 114-116 James Street, Templestowe

This was acquired for $987,000 in August 1979 and sold recently. Mr Redman explained that this was another property which was leased to Permewan Wright on an overage basis and which had not lived up to expectations.

17. 587-593 Church Street, Richmond

This property, purchased in September 1979 for $489,000, is still in the applicant's portfolio.

18. 285-287 Chapel Street, Prahran &

19. 10-12 Cato Street, Prahran

These adjoining properties were purchased together in November 1979 for $1,270,000 and were sold in May 1985 for $2,900,000. Mr Redman explained that the property was leased to three tenants and the major tenant vacated. He said:

``We found that we could not obtain a tenant to fill that shop. The only way that we could deal with it was to - well, there was a lot more interest shown in the purchase of the property, and merely for continuance of income we decided that we would sell.''

Later he said,

``... it seemed to me an obvious decision that we were getting a price that was better than we would normally expect and... it was reasonable that I would recommend that we sell.''

ATC 4854

20. 660 Whitehorse Road, Mitcham

This was bought in December 1979 for $1,033,000. It was sold in June 1982 for $1,075,000. Mr Redman said:

``That property was sold for a number of reasons. It had had a number of tenants in it. Many movements in the tenants coming and going. There was one bankruptcy... access was difficult. We initially thought there would be a split in the roadway to bring cars through coming from the city, but it never transpired. The number of tenants in the building meant that management of the building was difficult. Rental payments were not made at the right time. It was a difficulty so-recovering moneys.''

21. 302 Davis Road, Wetherill Park (N.S.W.)

This was purchased in January 1980 for $647,000 and is retained.

22. 132-136 High Street, Maryborough

This was bought in December 1980 for $304,000 and sold in July 1986 for $559,000. Mr Redman explained:

``That property was purchased together with number 23 as a package. It is a country property in a small town. The rent reviews were not commercial... One was 5 years and one was 3 years. There were two tenants, in there, good tenants, but long review periods. That particular time was a fairly depressed time... we were anxious that the rental income would not keep pace with inflation.''

23. 35-37 Murphy Street, Wangaratta

This was bought in December 1980 for $325,000 and is retained.

24. Corner Chapman Avenue and Marine Parade, Merimbula (N.S.W.) (``Kalindo Lodge'')

This property was purchased in June 1981 for $515,000. It was in the process of being sold at the time of hearing. Mr Redman explained that this was partly due to a change of directors of the applicant. The recently appointed directors have decided that the property will not be used for purposes of the employees of CMI, which had been one possible use of the property envisaged at the time of purchase. Further, as Mr Redman said:

``There were a lot of repairs that needed doing to it. Development in Merimbula has recently been very strong and a recent visit to the area showed that we needed to spend money merely to keep our occupancy rates up.''

25. 1-3 Mitchell Street, 2-8 Pall Mall, Bendigo

These adjacent properties were purchased in September 1982 for $661,000 and sold in April 1986 for $930,000. Mr Redman said:

``That property was sold because we had problems with tenants. The area of Pall Mall, Bendigo used to be the main thoroughfare. It still is the main thoroughfare of traffic, but pedestrian traffic is really reduced. The whole centre of retail has moved to a street at the back of Pall Mall... It meant that the business carried on in that location were not able to maintain their profit ratio,... the capital base was threatened.''

26. 22 Stanford Road, Oakleigh

This property was purchased in September 1984 for $961,000 and is still retained.

27. 200 Whitehorse Road, Blackburn

This was bought in 1987 and is retained.

(Note: The figures shown above for the purchase and sale prices are, for the most part, taken from regular reviews of properties held by the applicant which were presented to board meetings. Some of them appear inconsistent with figures from other sources, but nothing turns upon any such discrepancy.)

The Belmont properties

The two properties which are the subject of this action were bought separately but sold together. Number 118-122 High Street, Belmont was bought in November 1977 for $408,171 and number 107-121 High Street, on the opposite side of the highway, was bought on 5 April 1979 for $1,029,259. The properties were sold together in September 1983 for $1,820,333 - leaving a profit, the amount in dispute in this case, of $382,903. The property at 118 High Street was at all relevant times occupied by Bristol Paints Pty. Ltd., and Mr Sutherland, who made the recommendation to the board that the property be purchased, said in his report:

``The property is excellently located in a very good commercial area. CMI's Geelong

ATC 4855

representative has inspected the property and states that it appears well-built and in good condition. With a rent review in August 1978 the rent should increase by a minimum of 10% which would make the return on investment 11.1%... I recommend that Management be authorised to bid up to $395,000 for the property.''

It was Mr Redman, the recently appointed property officer of the applicant, who reported on the property at 107 High Street a year later. In his summary he said:

``Excellent location on Princes Highway in growing residential suburb of Geelong. First-class principal tenant on long term lease with guaranteed regular reviews. Very good potential for rental growth in the Anderson's store... the Andersons' area is easily sub-dividable into small units which would substantially increase the rental. On the present basis the rent is expected to increase to at least... $50,000 per annum from May 1979 which would give a net yield on the current asking price in May 1979 of 11.4%.

Building replacement cost alone is estimated to be in excess of $1,000,000 therefore replacement of whole property on todays market would call for substantially higher rentals to achieve the same return.

The property officer has inspected the property and recommends it as having excellent growth potential. It is suggested that if possible the Company negotiate to secure the property at a price between $1,050,000 and $1,060,000 to give a net yield of 9.5%...''

However the expectations of Mr Redman and the board were not realised, and on 12 July 1983 Mr Redman prepared a report for Mr W.R. Turnbull, who was then the assistant general manager and secretary of both companies, under the heading ``Offer $1.9 million for Belmont Properties''. He began by saying:

``The offer of $1.9 million for Half Case, Andersons and Bristol Paints, Belmont, can be considered as being only fair.''

After setting out details of the original purchase and current and expected rental returns together with a calculation of yields, Mr Redman, under the heading ``Problems Associated With These Properties'' said this:

``1. The Half Case turnover for year ending 30 June 1983 was $3,254,071 well below overage turnover of $5 million. Turnover has hardly increased from $3 million since 1977. Increase in rentals rely on the minimum clause of 15% every five years (i.e. 3% per annum).

2. The Bristol Paints store is overlet at $78,000 per annum (equivalent to $8.95 per square foot) - correct rent would be approximately $6.50 per square foot i.e. $56,725 per annum. Also the lease has only until August 1986 to run.

3. The Andersons' lease expires 1 June 1984.

4. Both buildings are subject to insufficient depth of footings in very damp clay soils. Both buildings have experienced either cracked walls or cracked concrete slab.

5. Belmont, being a Geelong suburb is in a particularly depressed economic climate at present and yields have blown out considerably.''

Mr Redman concluded his report with a recommendation as follows:

``Principally in view of the expected slow increase in growth of the Half Case Warehouse and only limited balance term of lease to Bristol Paints, the writer recommends acceptance of the offer of $1.9 million, resulting in a total capital gain of $408,562 (less expenses) whilst both properties have achieved an average net yield of approximately 12.5% per annum since purchase, and internal rates of return are 18.87% per annum for Bristol Paints and 15% per annum for the Half Case/Andersons' property.''

Mr Redman explained in his evidence that ``internal rates of return'' involve a combined calculation of rental return and capital gain.

Previously, on 30 July 1982, Mr Redman had recommended to the board of CMI that consideration be given to disposing of the Belmont properties. This recommendation was accepted and authority was given for the sale. This was noted in the minutes of the following meeting of the Services board on 17 September 1982. However it took about a year to negotiate

ATC 4856

a sale, and the execution of contracts was reported to a Services board meeting on 16 September 1983.

In my view there were two main reasons for the sale of the Belmont properties. The first was that the rent returns had not achieved the expected levels and were likely to decrease rather than increase. The two important factors here were that the Half Case Warehouse business had not prospered and it was clear that no overage payments would be forthcoming; and a review of Bristol Paints' rent, on the expiry of its lease in about two and a half years, was likely to result in a significant reduction when local standards were applied.

The second reason, which seemed to loom larger in the minds of board members, was that the foundations of both buildings, particularly the Andersons/Half Case building, were insecure and could result in the future problems with neighbours as well as tenants. The structural problems also cast a doubt over the security of the moneys invested.

These doubts of the board as to the suitability of the properties for investment purposes tended to be confirmed when it took some 12 months to find a buyer for them.

There had been problems with the foundations of the Andersons/Half Case building in 1980. These had resulted in cracking, which was repaired at a cost of a few thousand dollars. But problems recurred in 1981-1982, when Andersons complained of a bad crack in one wall, and oral reports, later confirmed in writing, were received by management from a consulting engineer. Because the properties were sold, it is not clear just how serious the structural problems proved to be; the engineer's reports were fairly reassuring. However I am satisfied that board members were seriously concerned by these problems, and they probably played the major role in the decision to sell the properties. The board was advised that it would get a better result if the two properties were sold together.

I am satisfied by the oral evidence and all relevant written material that, at the time the Belmont properties were purchased and sold, the board of Services saw itself as engaged in a business of purchasing properties for long-term investment purposes and not in the business of buying and selling real estate for the purpose of profit-making. The Belmont properties were numbers 10 and 15 in the chronological list of properties purchased. When the second of the two properties was purchased on 5 April 1979, none of the other properties then purchased had been sold, although one, in Barkers Road Hawthorn, was sold some two months later. Only this, and one other property at 660 Whitehorse Road, Mitcham, had been sold before the two Belmont properties were sold in September 1983.

Obviously it was within contemplation that any property purchased would ultimately be sold. Common sense dictated that if a property was not producing reasonable returns, or appeared to be moving in that direction, or was presenting serious management problems, its sale would have to be seriously considered. But in the case of each purchase I am satisfied that property specualtion was not in the minds of the board members and the hope and expectation was that the property would be retained for a considerable number of years in Services' portfolio.

Factors considered by the board of CMI in determining to make loan moneys available included:

On this last point it is clear that there was never any fixed lower limit for yield, below which a property would not be purchased or an existing property would be sold; but Services existed to make profits from property investments, while at the same time protecting its capital base. Since the yield was a measure of profitability and directly affected the capital value, it was obviously a very important consideration.

Evidence given on this issue by the four officers of Services and CMI most involved in the buying and selling of property at the relevant times was as follows:

ATC 4857

Mr W.D. McPherson - chairman of directors since June 1980 - previously director

In his affidavit, Mr McPherson said:

``the Applicant's function was to act as one of the CMI group's investment companies and the Applicant's policy was thus one of acquiring investment properties suitable for the maximization of long term income and the maintenance of capital value.

The disposal of investments was in the main generated by market trends and physical conditions. Thus properties were not sold unless the Applicant received an unexpected offer of purchase which exceeded the market expectations of the investment, and thereby dictated that the investment should be realized and the proceeds converted into another investment, or if it was thought that the property was causing or was likely in future to cause real problems.

The properties in High Street, Belmont were sold because in the case of the property at 118-122 High Street, Belmont the income produced was not at a satisfactory level and in the case of that property and the property at 107-121 High Street, Belmont the building was structurally defective and there was therefore an unknown liability for the future costs of repairs.''

Under cross-examination, Mr McPherson gave the following evidence:

``Mr Graham: When it came from time to time to consider whether a property should be retained, one matter always looked at in those circumstances was current yield on current market value, was it not?... Yes.

If the circumstances was that, in the view of the board, the current yield was inappropriate, in the sense of being too low, that would be a reason for at least considering the disposal of the property would it not?... Not the only reason.

I said a reason?... A reason.

Perhaps I can rephrase that, because the question may not be quite accurate. In the case of the Belmont properties, the position was that the board expected that the rental of one property would not be sustained because it was an above market rental being paid by a tenant whose term was not far off expiring, so that rental was not expected to be sustained; is that right?... Correct.

In the case of the other property, a consideration which influenced the board to dispose of the property was that the rent was geared to the turnover of the tenant, but the turnover was not living up to expectations?... Correct.

So in that sense, also, the yield from that property was not expected to be sustained or to keep pace with the market; is that right?... Correct.''

Earlier Mr McPherson was asked:

``Mr Graham: Has there been any change in the policy of CMI Services since 30 June 1984 as to the retention of properties?... Not that I know of.

Has there been any change in its policy as to the reasons which might actuate CMI Services to dispose of properties?... No.

We note in the list that is before you that a number of properties have been sold since 30 June 1984. Is it your recollection that a number of properties that were held by CMI Services prior to 30 June 1984 have since been sold?... Yes.

Were all those sales in conformity with the CMI Services' ordinary policies and criteria?... Yes.

His Honour: If the trend continues it would seem as though, first of all, that CMI Services' activities will gradually reduce and eventually the company will run out of properties. Is there any current intention of winding down the operations?... There is no current intention of winding down. I think it is a reflection of exact market conditions. As you know, there has been a property boom and we have taken advantage of it where and if possible. Hence, I would think that also means that if properties available for purchase were available for purchase [they would be] at a premium price.

Mr Graham: I understand from that answer that the dispositions that have taken place since 30 June 1984 have been a reaction to the boom in the property market?... I would think so, yes.

Taking advantage of enhanced values over and above what the properties were

ATC 4858

purchased for?... That is what you would expect us to do.''

Mr C.L. Harwood - managing director 1984-1988, general manager 1982-1984, previously assistant general manager.

In cross-examination Mr Harwood gave the following evidence:

``Of course in the event that any property in the portfolio of CMI Services either ceased to produce what the board regarded as an adequate yield, or looked likely as though it would cease to produce an adequate yield, that would be a reason for considering the sale of that property, would not it?... It would be considered, yes.

No doubt there are numbers of reasons why a yield might be seen to be inadequate or likely to become inadequate, but one would be that the rental which could be obtained for the particular property was not able to be sustained as against rentals which might be obtained elsewhere in Victoria, do you agree with that?... That would have to be considered.

And that would be a reason for considering the disposition of a property?... Yes, once determining what you considered to be an adequate return.''

Mr G.P. Sutherland - managing director 1980-1984, general manager 1975-1980.

Mr Sutherland, in cross-examination, was asked:

``Mr Sutherland, when you were associated with the management - participated in the management of CMI Services, it purchased quite a lot of real property?... Correct.

Were the purchases of property made for any particular period of time?... No. They were like most property investments, met certain criterias and they were basically - they were purchased with the view to holding them as long as one received an adequate return, as long as the buildings were good buildings and did not need excess maintenance, their location was still good, the tenants were adequate tenants, financial tenants who could pay the rents which were required.''

Mr R.J. Redman - property manager 1982- property officer 1977-1982.

Mr Redman said, in his affidavit:

``The Applicant's policy in relation to the acquisition of properties is and for the whole time that I have been associated with the Applicant has been centrally one of maximising returns as far as possible whilst at the same time maintaining a secure tenant - preferably of status - combined with strong lease covenants.

Accordingly a decision to sell one of the Applicant's properties is only made if it becomes apparent that rent returns are likely to fall, so as to threaten the capital value base of the property, or if the property experiences some other difficulty such as structural defects, failing services or continuing tenancy changes.

That policy was applied to the sale by the Applicant during the year of income ended 1984 of the two properties at High Street, Belmont which form the subject of this proceeding.''

When cross-examined, Mr Redman gave the following answer to a question on the relevance of potential capital gain when the applicant bought properties:

``Capital gain is an issue, if you like, of the process of rental and the primary reason we bought all property was for rental income, long-term holding. An aspect of property is that it changes in time, all property changes. It is possible that at some time in the future changes may occur, things might happen which might lead you to take the view that it may be better to realize the property, but certainly that is not - it is a general aspect only, it is not a major consideration.''

I turn now to consider, in more detail, the submissions of the parties and the applicable law. Counsel for the Commissioner relied upon the following propositions:

Counsel for the applicant dealt first with the respondent's second proposition. They conceded that the investment of premium income and the realisation of that in which the premium income is invested is normally an incident or a necessary feature of the conduct of an insurance business. However, they argued that if the asset is clearly part of the capital structure of the business - as in the case of an office building where the work of the company is performed - or is categorised and dealt with as an investment fund, separate from the reserve funds maintained by the insurance company to meet reasonably foreseeable contingencies, then it should be treated as being of a capital nature, and any profit on realisation should not be part of the company's assessable income.

They submitted further that it was no sufficient answer to this argument to say that the asset in question was legally available to meet claims, or that it improved the financial soundness or solvency or the respectability or prestige of the insurance company. The true test is whether the asset was acquired and held to provide a fund from which claims may be met. Thus the purpose of acquisition and the part played by the asset in the business of the insurance company are crucial.

In my view these submissions are soundly based. The question was left open in The Chamber of Manufactures Insurance Ltd. v. F.C. of T. (above) where, after finding that the investment portfolio at that time constituted the necessary reserve fund for the taxpayer's insurance business, which was, and was intended to be, immediately available for the purpose (84 ATC 4315; 2 F.C.R. 458), the Court went on to say, at ATC pp. 4318-4319; F.C.R. p. 460:

``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 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.''

In my opinion, if an insurance company uses surplus funds to set up and run another business, which is distinct from its insurance business, then those assets cease to be stamped with the identity of assets available to meet insurance claims; and this is so even if the second business is an investment business.

The vital question of fact to be determined in each case is whether the assets have genuinely

ATC 4860

ceased to be part of the reserves of the insurance company (in this case CMI), intended to be available for its insurance business. I am satisfied that the funds with which the subject assets were purchased were surplus to any requirements of the insurance business and would have been returned as dividends to the only shareholder of that business, the Australian Chamber of Manufactures, had that body not preferred to have the moneys re-invested under expert guidance. This serves to distinguish the present case from
R.A.C. Insurance Pty. Ltd. v. F.C. of T. 89 ATC 4780 (Lee J.), where moneys in question were retained by the insurance company and invested instead of being used for the benefit of insurers or transferred to an investment company similar to Services.

Services was never called upon to repay any loan from CMI for the purpose of paying out any actual or anticipated insurance claims. When a property was sold, the amount borrowed from the parent company was refunded, but any surplus from the resale which exceeded the amount of the loan was retained by Services. The evidence was that all moneys borrowed by Services from CMI have been repaid in recent years - presumably out of retained profits from rents and resales. The evidence is clear that the loan moneys were not required by CMI for its insurance purposes and, because they were tied up in real estate, they were not sensibly available for that business. Because of the time required to sell real estate it is not a practicable form of investment for moneys which may required to meet insurance claims. Readily realisable assets are always retained for that purpose.

The only suggestion in the evidence that the loans from CMI to Services, or CMI's shares in Services, formed part of CMI's funds available for insurance purposes, came from their inclusion in solvency calculations submitted each year by CMI to the Australian Insurance Commissioner.

For example, in a letter dated 21 October 1983 CMI said:

``We hereby request the items enumerated below be approved as assets for the purpose of the Solvency calculation in accordance with Section 30 of the Insurance Act 1973.''

The items included 5,000 shares in Services at an estimated value of $426,000 and unsecured loans to Services totalling $10,942,123.

As to these returns, submitted annually, Mr Sutherland explained that on one of his many visits to the office of the Commissioner it had been suggested that:

``for the sake of the record we should claim each year these particular assets under Section 30 and it is up to the Commissioner then whether he would allow them or disallow them.''

It never became necessary for the Commissioner to inform CMI whether he was prepared to allow them or not, although in the financial year 1984-1985, which presented special problems to the insurance industry, including CMI, the statutory solvency ratio would not have been achieved by CMI without bringing to account at least some of its sec. 30 assets, such as the shares in Services and loans to that company. Although this circumstance is clearly relevant for present purposes, I do not believe that it affects the reality of the situation - that the assets in question were not required for insurance purposes.

Mr Sutherland said also that there was some kudos to be gained by an insurance company from having a high level of assets disclosed, so CMI did not mind including figures relating to Services in such returns. However the fact remained that there was no contemplation that these funds could be called upon to meet insurance claims.

In the light of all the evidence, I find that the purchase of the Services properties, and the resale of the subject properties, did not form part of the investment activities of an insurance business, as claimed by the respondent, nor was it ``a mere adjunct to the business of CMI as an insurer''. On the contrary those purchases, in my view, did constitute an independent or free-standing investment operation, even though the buying of property was governed by the willingness of CMI to make the particular loan of surplus funds, and the decision, in principle, to sell the subject properties was made when the directors were meeting as the board of CMI.

Turning then to the respondent's first argument, that the business of Services includes the realisation of assets by means of property sales, counsel for the applicant argued that if:

ATC 4861

then the profit made on resale was of a capital nature.

Counsel sought to distinguish the London Australia case (above) because there ``the nature of the business required or involved the sale of the shares at a profit''. They maintained that, in the present case, the properties purchased were ``part of the capital structure of the business that was carried on by Services'', and that capital structure had to be kept intact by purchasing properties that were likely, at least, to retain their value in real terms. The properties were not something to be turned over and dealt with in the operation of the business.

In London Australia (above, at ATC pp. 4403-4404; C.L.R. pp. 116-117) Gibbs J. referred to
California Copper Syndicate v. Harris (1904) 5 T.C. 159 at p. 166,
Colonial Mutual Life Assurance Society Ltd. v. F.C. of T. (1946) 73 C.L.R. 604 at p. 614, and
Western Gold Mines N.L. v. C. of T. (W.A.) (1938) 59 C.L.R. 729 at p. 740. His Honour said:

``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.''

Dealing with the facts before him, he said:

``although the company's business was to invest in shares with the primary purpose of obtaining income by way of dividends, the conduct of the investment business required that the share portfolio should be given regular consideration, and that shares should frequently be sold when the dividend yield dropped, which for practical purposes usually meant when the shares went up in value. The taxpayer systematically sold its shares at a profit for the purpose of increasing the dividend yield of its investments. The sale of the shares was a normal operation in the course of carrying on the business of investing for profit. It was not a mere realization or change of investment.''

See Jacobs J. to the same effect at ATC pp. 4409-4411; C.L.R. pp. 128 and 131.

I think it is true that the facts of the present case can be distinguished from those of London Australia. There the sales of investments were in accordance with an accepted principle and were regular. Here the sales resulted from an exercise of judgment in each case, based on a number of different factors, and at the time of the subject sales only two other properties had been sold, of the 25 that had been bought. These were numbers 1 and 20 above. The first was sold at a 12.5% loss after four years, and the other at a 4% profit after two-and-a-half years - a loss in real terms. In each case the difficulties in managing a number of tenants caused problems and led to low returns on investment. It was obviously sensible for Services, wishing to retain its capital structure, to cut its losses and quit these investments. No question of profitable trading was involved.

The subject properties were, as I have said earlier, sold for two main reasons. The first was poor returns on investment which were likely to get worse; the second was concern about structural stability. These factors influenced management and directors in differing degrees. Had structural stability been the only factor, the sale would not have had the appearance of ``a business operation, carried out in the course of the business of profit-making''.

On the other hand, I think London Australia makes it clear that, if one of a series of investments is sold by an investment company because it is not performing as well as others - particularly if the reason for that failure is that an increase in value has lowered the rate of return - then such a sale is in the course of the business of profit-making. I think this principle applies to a course of real estate transactions as well as to dealings in stocks and shares. As Menzies J. said, in
Australasian Catholic Assurance Co. Ltd. v. F.C. of T. (1959) 100 C.L.R. 502 at p. 509, ``the difference is one of degree rather than of character''.

In the present case I have found it difficult to determine the central question of fact. Having given careful consideration to all the evidence, I am satisfied that profit-making by sale formed no part of the reasons for acquisition of the subject properties; but I am left in some doubt as to the state of mind of the relevant officers of the applicant and CMI, on the general question of resales, both when the original purchases were made and when they decided to sell the Belmont properties. The question also remains,

ATC 4862

if they did then foresee further sales for reasons other than profit-making, whether the expectation of those sales, probably resulting in profit-making, makes such a sale ``a normal operation in the course of carrying on the business of investing for profit''.

I was urged by counsel for the respondent to take into account, when deciding these questions, all the sales which took place after that in question here. They referred to
Bwllfa and Merthyr Dare Steam Collieries (1891) Ltd. v. The Pontypridd Waterworks Co. (1903) A.C. 426,
National Provincial Bank Ltd. v. Bradberry (1943) 1 Ch.D. 35,
McCathie v. F.C. of T. (1944) 69 C.L.R. 1 and
F.C. of T. v. Harris 80 ATC 4238; (1980) 43 F.L.R. 36.

In my view the first two of these cases are clearly distinguishable, and provide no assistance here, because they are concerned with the finding of facts which would have involved conjecture or estimation at the time relevant events occurred, but which had been clearly established by the time of hearing. As Lord Macnaghten said in the first case cited, ``Why should [the arbitrator] listen to conjecture on a matter which has become an accomplished fact? Why should he guess when he can calculate?''

McCathie v. F.C. of T. is rather more to the point because it relates to a valuation of shares on a given date, and decides that events after that date may be relevant. Quoting from an earlier unreported decision of his own, Williams J. said:

``Values must be calculated in the light of circumstances which existed on the material date... but subsequent events can be taken into account in order to determine the proper weight to attach to such circumstances... The whole tendency of the courts is to admit evidence of any events prior to the date of trial which will throw any real light on the issues.''

However it must be noted that the subject of inquiry here was still objective and impersonal - a question of valuation. What I am concerned with is an inquiry into intentions and expectations.

In F.C. of T. v. Harris the inquiry was as to the nature of a payment made by a bank to a retired employee. It was a lump sum payment, as an act of grace, to compensate for a pension having been eroded by inflation. The question arose whether the payment should be seen as a periodic supplement to the pension, and so assessable to tax, or as an isolated gift which would not attract tax.

Bowen C.J. said, at ATC pp. 4243-4244; F.L.R. p. 45:

``The character of the receipt of $450 by Mr Harris in April 1976 has to be determined for income tax purposes as at the close of the income year ended 30 June 1976 in respect of which the assessment was made. In the light of the reason given by the bank in its memorandum dated 31 March 1976 for making the payment, namely, consideration of the problems caused by continuing high rates of inflation, it was evident that there existed the possibility, if inflation continued, that the bank would feel impelled by similar considerations to make further payments in subsequent years. If evidence of subsequent events is available which shows the possibility has become a reality, it is proper for the Court to have regard to the actual events, when assessing the position as it was in the income year ended 30 June 1976 (McCathie v. F.C. of T. (1944) C.L.R. 1). This may be summed up by saying the Court can conclude that when the payment of $450 was made, it was not only possible but likely that similar payments would be made in the future, or, in other words it was likely that the $450 was the first of a series of such payments while high rates of inflation persisted. This, of course, falls far short of concluding that there was any assurance or any certainty that such payments would be made. Furthermore, because of the somewhat arbitrary manner in which the distributions were made by the bank, the later payments do not as at 1976 assist in forecasting what the amount or basis of any future payments might be. The most that one can derive from consideration of the later payments is that the $450 was likely to be for Mr Harris the first of a succession of payments of uncertain amount arrived at by separate decisions of the bank taken from year to year.''

His Honour went on to find that the fact that the payment in question was the first of a series was insufficient to conclude that it should be treated as income.

ATC 4863

Fisher J. arrived at the same conclusion. After referring to McCathie v. F.C. of T., he said:

``The limitation on the principle is thus that subsequent events can only be used to determine the weight to attach to circumstances which existed at the relevant date. This point, to which I attach significance in the present matter, was made clear by Bright J. in
John Martin (Elizabeth) Ltd. v. Commr of Land Tax (1965) S.A.S.R. 217 at pp. 224-225 when he stated as follows in respect of the use which could be made of subsequent happenings:

  • `The only relevance of the negotiations and contract is therefore the type of relevance referred to by Williams J. in the Daandine case, cited in McCathie v. Federal Commissioner of Taxation. The subsequent events cannot create an expectation which was not in existence at the relevant date, but the subsequent events `can be taken into account in order to determine the proper weight to attach' to circumstances in existence at the relevant date.'

In the present case the payments in subsequent years can, in my opinion, only be taken into account to confirm any suggestion made or indication given in relation to the first payment that the taxpayer could expect to receive in the future annual supplementations of his pension to compensate for the impact of inflation.''

Deane J., who dissented from the final conclusion of Bowen C.J. and Fisher J., said on the issue presently being considered:

``It is permissible to pay regard to the fact that such payments were made in the following tax years to confirm that the payments in question should properly be seen as having been made by the bank to the taxpayer as part of the second group of a series of such payments (see McCathie v. F.C. of T.).''

In the light of F.C. of T. v. Harris, I believe I should consider the sales made by Services after 1982-1983 in order to assist my determination whether the sale of the Belmont properties was, in truth, an isolated decision to dispose of a risky part of the company's capital structure, or whether it was merely the first decision in a natural and inevitable process of selling off properties which were failing to return a good rate of interest on their appreciated values - a process in which management problems would be taken into account, but poor current performance and possible loss of resale value would be paramount. I should say that evidence concerning these later sales was admitted subject to objection by counsel for the applicant. Having now considered the matter fully, I believe that objection cannot be sustained in the light of the authority cited.

In taking the later sales into account I am conscious of the fact that these are also the subject of dispute between the taxpayer and the Commissioner and that I was not given the same detailed evidence about each sale as would be likely if it were the immediate focus of attention. I can only look at them broadly, against the background of the other evidence.

Having done so, I find that the board of CMI was at all times concerned to behave prudently concerning its investments through Services. This meant that, while not attempting to wring the last dollar from its portfolio by constantly disposing of properties with below average performance, it recognised the desirability of selling, on reasonable terms, any properties which were performing distinctly below expectations and were not likely to improve.

It would also sell a property for which it received a particularly good offer, having regard to the property's present and expected performance. Mr Sutherland said that it was not the intention in setting up Services to sell properties to build up its capital base. He said:

``obviously if someone comes along with a very good offer... one must look at it... but in my time that did not happen.''

The conclusion I have reached is that the management and board of both CMI and Services genuinely hoped that, when properties were purchased, they would each provide a satisfactory investment over a number of years. However they recognised that, as their portfolio grew, there would be cases where their expectations were disappointed and it would be sensible to sell. The circumstances leading to such disappointments could include low returns because of difficulties with tenants or tenants' business failures. They might also include

ATC 4864

problems arising from physical circumstances such as structural failures of the buildings themselves or unhelpful nearby developments. A third circumstance which would cause a prudent investment manager to consider selling would be an upsurge in the property market, or an increase in value of the particular property, which was not properly reflected in higher rents, or which was not expected to be permanent.

I believe all these possibilities must have been present to the minds of management and board when properties were purchased between 1974 and 1982. I believe also that their intention was, at all times, to act prudently, though perhaps somewhat conservatively, in managing their property portfolio. There was a willingness to sell whenever it was sensible to do so having regard to the property's performance and the price available. My beliefs have been reached after seeing in the witness box a number of the very competent businessmen concerned; and those beliefs are confirmed by the more recent activities of the applicant. Of the 25 properties purchased between 1974 and 1982, two-thirds have been sold. Three of these were subject to options to purchase when they were acquired and so may be disregarded for present purposes, whatever might be decided about them in other proceedings in the light of more detailed evidence.

Nevertheless, I think the remaining figures indicate a course of conduct which tends to confirm what one would have expected anyway. The case is not as clear as London Australia (above) where Gibbs J. was able to find a systematic sale of shares at a profit for the purpose of increasing the dividend yield of its investments. I would rather describe the applicant's history as involving the quite frequent sale of properties, mostly at a substantial profit, for the purpose of protecting the rental yield of its portfolio. However, I would adapt the language of Gibbs J. in finding that the sale of the properties was a normal operation in the course of carrying on the business of investing for profit. It was an operation which was carried out in a professional, orderly and business-like way.

The subject sales were an early part of that operation and, if the present question had been decided at the end of the relevant financial year, it is possible that the issue might have been resolved in the applicant's favour. Although it must still be decided as at that time, later events have raised questions and suggested answers that might not have been seen so clearly if the Belmont sales had been regarded as an isolated occurrence, fitting into no pattern. The warp and woof of events have since disclosed a pattern, and I am satisfied that the Belmont purchases and sale have always been part of it. That pattern involves the expectation and intention at the time of purchase that the properties in question would be resold, in the ordinary course of the applicant's business, if their prospective yields, in relation to current market values, made it prudent to do so. That was a significant reason for the sale of the Belmont properties, in the sense that I am not confident that the structural problems would have led to their sale if the properties had been performing well. It follows that the profits derived from resale constituted income, within ordinary concepts.

I therefore believe that tax was correctly assessed in this case, the applicant's notice of objection dated 14 May 1985 was correctly disallowed, and the appeal must be dismissed with costs.

 

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