Case W105
Members:PM Roach SM
Tribunal:
Administrative Appeals Tribunal
P.M. Roach (Senior Member)
These references were argued on the basis that during the years of income ended 30 June 1985 to 1987 (inclusive) the applicant company (App-co) sold some shares; that it sold them at a profit; and that the issue before the Tribunal for determination was whether the Commissioner was correct in his contention that the profit so derived constituted assessable income. The company disputed the claim. The amounts in dispute were as follows:
Year ended 30 June 1985 1986 1987
$51,355 $415,279 $529,842
2. But an examination of the evidence showed that the profits in question were not only derived as profits on the sale of ordinary shares and preference shares but also as gains coming to hand upon the redemption at maturity of fixed interest investments. Whether App-co is liable to be assessed in relation to any part of those profits depends upon the circumstances established in the evidence. It is a question which is not to be resolved in favour of either the Commissioner or the applicant by simply purporting to adopt the result in any other case for any other company or for any other company carrying on the same basic class of business as App-co.
3. What the evidence has established is that App-co was incorporated several decades ago as a company limited by guarantee. It was incorporated under the Companies Act 1899 of the State of New South Wales. The objects clause of its memorandum of association, in force at all material times, commenced with a somewhat unusual preamble which stated:
``The objects for which the Company is established are all or any of the following:
- The company having power to do all or any of the matters herein mentioned.''
went on to specify a wide range of activities which, according to the preamble:
``may be carried out in a full and ample a manner and construed in as wide a sense as if each of the paragraphs hereof defined the objects of a separate and independent Company.''
4. There then followed specification of a wide range of ``objects'', including the purchase and leasing of land and the construction, maintenance and alteration of buildings and other works (J); raising and borrowing of moneys (L); lending of moneys (M); dealing in promissory notes, bills of exchange, debentures and other negotiable transferable instruments (N); and the carrying on of any other business which may seem to the company capable of being conveniently carried on in connection with the above or calculated directly or indirectly to increase the value of all rendered profit of any of the company's property or rights (U). Among such clauses was a provision empowering App-co:
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``(K) to invest and deal with any of the moneys of the company not immediately required for other purposes thereof in such manner as may from time to time be determined with power to acquire or hold shares with a [sic] paid up or contributing in any association or company of whatsoever nature or wheresoever incorporated and with power from time to time to vary or realize any investments.''
5. But, notwithstanding the range and breadth of the ``objects'' as specified, I am satisfied that the dominant purpose for which the company was brought into existence was that it should pursue the object specified in cl. 3(A) which was:
``to undertake and carry on and transact the business of Insurers and Assurers in all branches of insurance and assurance and, in particular and without prejudice to the generality of the foregoing, to undertake and carry on and transact:
...''
I am satisfied that at all material times that has been the principal objective pursued by App-co.
6. Members of the company were liable to contribute to the assets of the company upon winding up. Such contribution was not to exceed $2. App-co was so organised that each policyholder became a member and membership ceased when a member ceased to have a policy of insurance with App-co.
The sections
7. What was particularly significant about the organisation of App-co was that it was structured to operate in sections. Article 9 provided:
``The business of the company shall be managed in two Sections namely, A Section... and C Section... by committees elected in accordance with these Articles of Association.''
Clause 11 provided:
``The members of A and C Sections may meet together for the despatch of the business of their respective Sections and the Articles herein contained as to general meetings and votes of members shall as far as possible apply to such meetings except that the committee of the Section shall take the place of the Board of Directors and the Chairman of such committee shall take the place of the Chairman of Directors and the Convener of the Section shall take the place of the Secretary.''
Clause 12 provided:
``The A & C committees respectively may from time to time determine the different classes to be undertaken by the respective Sections and shall from time to time fix or cause to be fixed the rates and basis of premium which shall be paid by members in respect to the classes of insurance.''
Members of the sections were empowered to elect committees to administer the affairs of the sections (cl. 23). The directors of App-co were to be three in number; the chairmen for the time being of the A and C committees and a third director elected by all members at the annual general meeting each year (cl. 70). Each section was to open and operate a separate banking account or accounts (cl. 99) to be under the control of their respective committees (cl. 100). In addition, the company was to operate general banking accounts under the control of the directors (cl. 101):
``All moneys paid into or standing in the general banking accounts may be drawn out and invested in such manner and upon such securities as the directors may determine and the moneys represented by such investments together with the amounts standing to the credit of such general banking accounts shall be called the General Fund of the company.''
8. The committee of each section was to receive, control and deal with all income and receipts arising from or out of the business of the section of which it was the committee (cl. 97).
``All claims and the expenses of management of each Section shall be paid in the first place out [sic] the current year's income and receipts of such Section and in case of deficiency such deficiency shall be made good out of the reserve account hereinafter described of the Section in respect of which such deficiency occurs.''
(Clause 98.)
9. Clause 104 provided that:
``At the end of each year all moneys over and above such as required to discharge the
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liabilities of the Section at such time and which the committee of the Section intended to distribute by way of rebates to members shall be credited to the General Fund of the company. In the event of additional moneys at any time being required in the General Fund in order that the company may have therein sufficient money to fulfill its legal obligations the A & C Committees shall pay to the General Fund such moneys as they shall respectively be called on so to do by the directors of the company in anticipation of what may be due to be paid over at the end of the then current year.''
The articles of association went on to provide:
``Clause 105 - The secretary of the company shall in the books of the company keep separate accounts; one for each Section and each of the such accounts shall show the amount of money contributed and withdrawn to or from the General Fund by each Section and the account of the A Section in such books shall be called the A Reserve Account and the account of the C Section in such books shall be called the C Reserve Account.
Clause 106 - Each Section shall be entitled to a refund from time to time from the General Fund of such sum or sums of money as may be required to make up any deficiency as aforesaid but the total amount of such sum or sums so required as aforesaid from the General Fund shall not exceed the amount standing to the credit of such Section's reserve account.''
Other articles went on to provide for the debiting of such refunds against the reserve accounts of the sections; and
``Clause 108 - The interest and income of the company derived from its General Fund after debiting the general expenses of the company not payable by the Sections respectively shall immediately prior to the end of each year be paid to the credit of the reserve accounts in the respective Section in proportion to the respective credit balances in the reserve accounts in the Sections of the commencement of such year.''
10. Income tax assessed against the company was to be paid out of the general fund and debited to the reserve accounts of the sections in proportion to the taxable income of each section (cl. 109).
11. The articles concluded by providing:
``Winding-up (Clause 124)
In the event of the company being wound up any surplus moneys or assets of the company other than such as shall stand to the credit of the banking accounts of the Sections respectively shall be realised on and paid to the credit of the banking accounts of each Section in proportion to the credit of the reserve account of each Section respectively and all moneys then standing to the credit of the banking accounts of each Section shall be distributed amongst the members of such Sections pro rata in accordance with the moneys paid in by them respectively to each Section for premiums in accordance with a scheme to be approved of by the Chief Judge in Equity of the Supreme Court of New South Wales or such other Judge of that Court as may have or shall acquire jurisdiction in the matter.''
12. But pending dissolution - and there was no suggestion in the evidence that dissolution had ever been contemplated - the benefits which members were entitled to were limited. As policyholders they were entitled to be indemnified in accordance with the terms of their policies; and as members of sections they were entitled to rebates upon premiums paid. Those rebates varied according to the profitability of the respective sections. The amount available by way of rebate was dependent upon there being a surplus after providing for all liabilities, both known and contemplated (including unnotified claims) and provision for inflation. It was also influenced by the profitability of the management of the general fund and by decisions taken as to the amounts to be distributed by way of rebate as an alternative to being transferred to the general fund. Policyholders who ceased to be members were none the less entitled to rebates.
13. The practice of the section committees was to meet in the fourth quarter of each financial year after the accounts to the end of the third quarter were available for consideration and to then make judgments as to the amount to be made available as rebates and the amount to be carried to the reserve account.
14. Over the years the fortunes of the sections fluctuated. For some 25 years prior to
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1974 both sections always returned a profit but, commencing with the 1975 year, there was a substantial increase in the levels of profitability - marred on two occasions by losses in A section. Rebates also varied but in the period 1948 to 1978, with one exception (A section 1975), a rebate was always allowed.15. In the decade to 30 June 1988 the position as to the operating profit and premium rebates in relation to each section was somewhat different. It was as follows:
A section C section
Year ended A section operating C section operating
30 June rebate profit rebate profit
% $ % $
1979 20 251,196 35 114,661
1980 15 (81,999) 33.3 157,747
1981 Nil 54,802 20 113,727
1982 Nil (1,159,509) Nil 220,056
1983 Nil 737,810 10 174,062
1984 Nil 348,227 Nil 10,554
1985 Nil 339,595 Nil 59,966
1986 Nil 100,181 10 158,098
1987 Nil 566,969 10 77,390
1988 * 707,681 * 171,562
*The figures were not provided.
The general fund
16. As the issues for determination arise out of the conduct of the general fund, I turn now to consider the evidence in relation to that. As has been seen, the surpluses judged to exist within the sections year by year were transferred to the general fund. They were there maintained as assets of the sections. Further, each section was entitled to have credited to it annually its share of the ``profits'' of the general fund. That sum was to be available to the sections for the purpose of calculating their profitability. In addition their respective shares in any net increase in the worth of the general fund was credited to them, or appropriately debited in the event of a net loss.
17. For many years prior to about 1980 the directors who had controlled the investment portfolio of the general fund had concentrated on fixed interest investments, whether by way of promissory notes, or preference shares, or debentures. Decisions to dispose of some of those investments, particularly those by way of preference shares and fixed interest investments, were to occasion quite substantial losses.
18. Upon the hearing the case for the applicant was first presented by way of an affidavit sworn by the secretary of App-co. His knowledge of the affairs of App-co was extensive and based upon an association with App-co going back to 1958. He exhibited to his affidavit many relevant documents, although falling short of being so comprehensive as to shed light on some of the matters to be hereafter referred to as imprecisely known. The deponent was cross-examined, after confirming that all of the matters deposed to in the affidavit were true and correct.
19. I accept the deponent as a truthful witness. On the evidence presented, I accept that when the sections realised on redemption or sale a surplus (or suffered a loss) of an investment, the profit (or loss, as the case may be) was brought to account as assessable income (or a deductible loss). It was not so with the general fund. I find that in the years in question the net realisations in excess of cost of the investment portfolio of the fund (over and above amounts acknowledged to be taxable) was as follows:
Year of income ended 30 June 1985 1986 1987
Net gain $51,355 $415,279 $529,842
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Those realisations came after taking into account liabilities for tax on the following gains:
Year of income ended 30 June 1985 1986 1987
Number of transactions 3 Nil 2
Number of investments 2 Nil 2
Section 26AAA $3,201 -- $55,634
"Capital Gain" -- -- $5,892
------ ------ -------
$3,201 -- $61,525
20. The evidence of the deponent was that for much of its history App-co had laid out the general fund in an investment portfolio which comprised investments which of their nature were likely to generate a regular and predictable income flow. They might be fixed interest securities or preference shares. From the late 1970s the pattern changed somewhat, and App-co increasingly invested in ordinary shares. The evidence indicates that the number of investments held in each category was as follows:
Year of income Fixed interest Preference Ordinary
ended 30 June investments shares shares
1981 70 81 24
1982 82 70 27
1983 98 87 27
1984 100 37 27
1985 98 28 33
1986 92 19 28
1987 64 12 22
1988 53 10 21
21. I accept that when the company came to increase its investments in ordinary shares it was still predominantly influenced by its concern to have a regular, reliable and substantially predictable income stream. I find that it was looking for substantial dividends and, preferably, for companies where there was a substantial prospect of rates of dividend being increased. However, to the same ends the company was also buying fixed interest securities and preference shares at a discount and holding them to maturity and then realising a gain against cost. In that way the company was able to profit on some low interest bearing securities at a time when it was suffering substantial losses on the disposal of other securities of similar character.
22. In order to place in context the transactions to be considered later, it is appropriate to record the balance sheet figures for App-co. The figures for the years of income in question and the preceding year were as follows:
1984 1985 1986 1987
ACCUMULATED FUNDS $ $ $ $
-----------------
General reserve 3,278,575 3,678,137 3,936,415 4,580,774
Investment fluctuation
reserve 303,270 356,354 771,633 1,332,853
Asset revaluation
reserve 964,976 964,976
--------- --------- --------- ---------
3,581,845 4,034,491 5,673,024 6,878,603
--------- --------- --------- ---------
FIXED ASSETS 30,072 27,688 33,339 21,946
23. The figures in the balance sheets relating to fixed interest investments, preference shares and ordinary shares embrace investments in those classes not only in relation to the general fund but also in relation to the sections. That being so it is not possible to identify the figures relevant to only the general fund. That circumstance also limits the significance of the evidence which indicates that cost and market value in the period for the company (as distinct from the general fund) was as follows:
1984 1985 1986 1987
SHARES LISTED COMPANIES: $ $ $ $
-----------------------
Cost 3,797,050 5,707,446 4,643,392 5,218,689
Market value 4,863,046 8,326,185 6,754,962 7,724,005
--------- --------- --------- ---------
Surplus 1,065,996 2,618,739 2,111,570 2,505,316
SHARES OTHER COMPANIES:
----------------------
Cost 372,614 248,214 10,123 31,305
Market value N/A N/A N/A N/A
DEBENTURES LISTED:
-----------------
Cost 6,531,842 6,282,649 5,437,470 3,583,686
Market value 6,563,179 6,563,179 5,905,999 3,769,079
--------- --------- --------- ---------
31,337 280,530
24. One set of figures to be gleaned from the exhibits provided some indication of the number (but neither cost nor value) of investments in three basic categories. Unfortunately, the figures in some respects seem to be inconsistent and that seeming inconsistency was not explained. That being so, I have regard to the following table only as providing a broad indication of the number of investments and dealings in the portfolio held under each category:
Fixed
interest Preference Ordinary
investments shares shares
On hand 30/6/81 70 81 24
Disposed of 3 13 3
On hand 30/6/82 82 70 27
Disposed of 4 19 2
On hand 30/6/83 98 87 27
Disposed of 9 12 4
On hand 30/6/84 100 37 27
Disposed of 21 3 4
On hand 30/6/85 98 28 33
Disposed of 20 8 11
On hand 30/6/86 92 19 28
Disposed of 14 6 8
On hand 30/6/87 64 12 22
Disposed of 3 2 3
On hand 30/6/88 53 10 21
25. However, a table which gives a fuller indication of the realisation activities of App-co is the table following. It is so presented as to identify in parentheses the number of transactions giving rise to the profit or loss indicated and to present a reconciliation to the figures in dispute. It going only so far as it does, it of course stops short of recording the consequences for the taxpayer of the share market crash of October 1987 - a factor which might be considered to be of some significance in considering whether such losses as might have been sustained at that time or as a result of that crash belonged to revenue or capital account:
Fixed Preference Ordinary
interest shares shares Total Tax Balance
$ $ $ $ $ $
1979 (7) 8,061 (5) 16,419 24,480 (773) 23,707
1980 (4) 1,484 (11) 30,552
-(1) (1,450)
------- ------
34 30,552 30,586 (60) 30,526
1981 (6) 785 (4) 34,233 (2) 65,650
-(1) (16,963)
------ -------- ------
785 17,270 65,650 83,705
Those figures reconcile to the amounts in dispute as follows:
Year ended 30 June 1985 1986 1987
$ $ $
Gross profit 54,556 415,279 591,367
Less: taxable profit 3,201 61,525
------ ------- -------
Profit in dispute 51,355 415,279 529,842
26. The deponent presented explanations as to the circumstances which occasioned the realisations in question. Those explanations indicate that the circumstance which most influenced the decisions to realise the increased value available and to terminate particular investments was a change in control of the company.
Fixed interest securities
27. When examination of the exhibits brought under notice ``profits'' on maturity or redemption of fixed interest securities, the parties were invited to comment on the possibility that the Tribunal should find that, as to sums of $29,370; $12,566; and $42,070, they constituted ``profit'' on securities purchased at a discount as fixed interest securities; and to comment on the then unpublished decision since reported as Case W57, 89 ATC 517.
Having considered those submissions I am satisfied that, for reasons expressed in Case W57 (ante) the ``profits'' constitute assessable income within the scope of sec. 25(1) of the Act and that, as:
``(each) transaction (was) part of, or (was) incidental to the carrying on... of a business that includes buying and selling eligible securities''
by reason of the activities of the two sections of the company, sec. 23J of the Act does not operate to make that income non-assessable.
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Sales of shares
28. During the hearing much was made in argument for the Commissioner that expectations of increases in share values indicated an intention to realise those increased values by sale. No attention was given to the significance of any buying in of fixed interest securities at a discount with a view to holding them to maturity and thereby deriving a profit. However, the principal witness was so concerned to resist any suggestion of a dominant purpose of profit-making by sale that he would have almost have had it that the possibility was never contemplated, although in his affidavit he had said:
``The possibility of sale of an investment has, of course, always been recognised as one which is present, but the relevant criteria has been regarded as being, not whether the investment might realise a larger sum upon sale, but whether the income return upon original cost is likely to increase over time. (The company is), of course, cognizant that an increase in income return is likely to be matched with an increase in the capital value of the investment. That has, however, always been regarded by me, and discussions in which I have participated, as a merely consequential matter.''
I consider the affidavit to fairly state the relevant facts.
Much was also properly made of the circumstance that the entirety of the funds of the company were available to meet any claims which might arise in the course of the insurance business and that, moreover, situations had arisen in which the sections had suffered loss years which had necessitated them drawing in substantial amounts upon the credits held in their reserve accounts with the general fund.
29. I am satisfied that the selection criteria used by the directors in the management of the general fund involved the following considerations:
- investments (whether shares or fixed interest securities) which were likely to realise less than their cost were to be avoided;
- investments (whether shares or fixed interest securities) with the prospect of an increase in value were to be preferred;
- investments not likely to reliably and regularly produce substantial returns by way of dividend, or interest, or surpluses upon maturity were to be avoided;
- shares likely to produce dividends at increased rates were to be preferred;
- shares likely to produce increased dividends were likely to increase in value;
- shares likely to increase in value were to be preferred to those which would not be likely to so increase.
30. I am also satisfied that, more probably than not, no share under consideration was acquired with the expectation that, upon it realising an expected or hoped for increase in market value, the increased value would be realised by sale.
31. I accept that there were some sales of shares within 12 months of their acquisition. I accept that during the year of income ended 30 June 1985 and within 12 months of acquiring them, the applicant sold 3,840 shares and 3,840 options in relation to one company following a change in its management structure and that in the same year of income it also sold 1,570 units in a unit trust - the only such units to be sold in the period under review. The evidence does not enable me to say what amounts had been invested in those shares and units but, upon the evidence before me, there is no basis for finding that they were acquired for any dominant purpose of profit-making by sale. Similarly, during the year of income ended 30 June 1987 there was a sale at a substantial profit ($130,277) of 40,000 shares in one company. That sale was effected after a take-over was proposed. I am again satisfied that there is nothing in the evidence before me which warrants a finding that those shares were acquired for any dominant purpose of profit-making by sale.
32. Factors which weigh in the scales against the claim of the applicant are:
- that the profits were substantial - only because that is an indicator of market astuteness;
- that sales were quite frequent although, not regular;
- that no distinction was maintained (or asserted in argument) between its dealings
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in fixed interest securities, preference shares, and ordinary shares; and - that no evidence was presented to enable me to evaluate with substantial accuracy the scale or volume of selling activities measured against the full portfolio of the general fund.
33. On the other hand I am satisfied that although care was taken - not always successfully - to choose investments likely to at least maintain and to preferably rise in value, that objective was subordinate to the desire to achieve a substantial, reliable and regular income flow. In doing so it sought to hold assets in a form and with a value acceptable to both the company and to the Insurance Commissioner as providing sufficient reserves to enable the company to discharge any liabilities which might arise under policies of insurance it had issued.
34. That being so, I am satisfied that, if the applicant is liable to be assessed as the Commissioner contends, the liability to be so assessed must be by reason of one or more features of its activities to be considered independently of any subjective intentions on the part of those directing the affairs of the company. On that basis I take into account:
- that the applicant is a company;
- that the applicant is an insurer;
- that all of the resources of the company are available to meet its liabilities as an insurer;
- that sales and profit realisations were ongoing with a modest number of transactions in each year of the decade I have considered; and
- that the acquisition of assets which would fall in value was sought to be avoided and that increases in value were not only preferred but they were in fact often gained and sometimes - but far from frequently - realised.
35. On the other hand I bear in mind the words of Lord Macnaghten in which his Lordship said:
``Income tax, if I may be pardoned for saying so, is a tax on income.''
The statement may not have been very helpful in defining ``income'', but it provides a useful reminder that, statutory provisions apart, income tax is a tax upon income: it is not a tax upon capital gains.
36. In considering the question so posed, I particularly take into account the fact that the directors, as the persons responsible for the management of the general fund, had very substantial sums available for investment. That being so, it was to be expected that, as prudent fund managers concerned only in an investment capacity, their holdings within the portfolio should be widespread. That being so, any significance to be attached to the number of transactions as an indicator is to be discounted. The circumstance that a portfolio involves a wide spread of investments will always be likely to generate an increased number of transactions without thereby indicating a pattern of buying and selling indicative of the investor being in any business of dealing in such investments or of having undertaken any particular investment for the dominant purpose of profit-making by sale.
37. I also take into account the circumstance that, in so far as it could be done within the structure of a single legal entity, a clearly defined line of demarcation was established between the management of, and the investments of, the general fund and of the sections. Certainly, in my view, the applicant is not to be held liable only for lack of any such clear distinction between its trading insurance investments and its capital investments.
38. That being so the matter is to be viewed very much as if the general fund was the only activity of a separate legal entity seised of substantial moneys which it wished to invest at a profit, without engaging in any trade or business activity beyond that involved in maintaining its investment portfolio. It desired to avoid any loss such as would be suffered if it could not realise upon its investments at least cost and its preferred course was to acquire investments which, upon their realisation, would realise cost rather than less than cost; would realise a gain rather than their cost; and would realise a larger gain rather than a smaller one.
39. The question is whether the scale of the activities of App-co is such as to bring the profits derived on the occasion of the sale from time to time of some investments into calculation as assessable income. Whether the nature and scale of such activities as it engaged
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in gives rise to a revenue character in the transactions involves questions of fact and degree.40. I have considered in Case W6,
89 ATC 147 at some length many of the relevant principles. I do not propose to here repeat them. In my view, upon applying all the principles there expressed, in the circumstances of this case and upon the evidence presented before me, I am satisfied that the profits realised on the sale of shares are not liable to be brought to account as assessable income.
41. Accordingly, the assessments to some extent are excessive. The order of the Tribunal will be that the determinations of the Commissioner upon the objections under review shall be varied to reduce the taxable income of the applicant by $21,985; $402,713; and $487,772 in the years of income ended 30 June 1985, 1986 and 1987 respectively.
Postscript
Since the foregoing reasons were finalised the decision of the Federal Court of Australia in
CMI Services Pty. Ltd. v. F.C. of T. 89 ATC 4847 has come to hand. Nothing in that decision persuades me to alter the views I have expressed.
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