CASE Y20

Members:
BJ McMahon

Tribunal:
Administrative Appeals Tribunal

Decision date: 6 May 1991

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BJ McMahon (Deputy President)

This is an application to review an objection decision rejecting the applicant's claim to be entitled to a deduction of $32,723 in the year of income ended 30 June 1987. The amount represents one year's interest paid in advance on a sum borrowed to acquire an asset. The applicant's case is that the asset was intended to be income bearing and consequently the payment of interest fell within the terms of the first limb of s 51(1) of the Income Tax Assessment Act (``the Act'').

2. The applicant is a pharmacist. In partnership with another person, he owns and operates 11 pharmacies which employ approximately 100 people. As a result of buying out former partners and acquiring additional pharmacies, the applicant has run up a significant commercial debt. Evidence was given that his life is insured for a total sum of approximately $1.5 million. The policies are owned by others. The proceeds are intended to discharge the commercial indebtedness and to allow his interest in the partnership to be acquired in the event of his premature death.

3. In the last week of June 1987, the applicant had discussions with a man he described as his insurance consultant. As a result of these discussions, it was agreed that he would purchase a security (which I will refer to as a policy) issued by a leading life assurance company for $200,000. This sum was

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described as a premium and was the first and only payment made to acquire the policy. It was explained to the applicant that bonuses under the policy would be taxed at a beneficial rate unless the policy was acquired with a view to it being surrendered within 10 years. Notwithstanding this, the applicant said in evidence that it was his intention to allow the policy to run only for a couple of years. He thought that the value of the policy would increase in the short term, principally through increases in the stock market values and good management on the part of the insurer. On surrendering the policy, the increase would be applied to reduce his commercial indebtedness, after having suffered tax at the beneficial rate.

4. In order to acquire this policy, the applicant borrowed the whole sum of $200,000 from a leading finance company. He executed a document described as ``mortgage of life insurance policy or bond'', the schedule of which sets out some of the principal terms of the arrangement. The mortgage was dated 26 June 1987 and the loan advanced on that day was repayable on 30 June 1992. The document provided for payment of interest on the 30th day of each month at the higher rate of 20 per cent per annum, provided that if payment was made on time and all other covenants and provisions in the mortgage observed, then interest at the rate of 18 per cent per annum would be accepted in lieu. The policy was charged with the applicant's obligations under the document in favour of the finance company.

5. Notwithstanding the fact that the agreement was to pay interest monthly, the applicant arranged with the finance company to pay one year's interest in advance. Prior to the end of June 1987, it was agreed between the applicant and the finance company that in consideration of this advance payment, the rate of interest would be reduced for that year to approximately 16 per cent per annum. The applicant said in evidence that he considered he thereby received a commercial advantage. However an analysis of the mathematics makes this a doubtful proposition. The amount paid ($32,723) was provided from a cheque drawn on the applicant's bank account and it must be assumed the money was therefore readily available to the applicant. Had he used that amount as part payment for the policy and borrowed the remainder, the interest on $168,000 for the 1987/88 year at the rate of 18 per cent per annum would have been less than the interest which he in fact paid on a borrowing of $200,000 at a rate of 16 per cent per annum. It is true that he would have had some cash flow advantage during the 1987/88 year through not having to find monthly payments of interest. If these are discounted back, however, it will be seen that the commercial advantage, if any, is quite marginal. The applicant freely agreed that in addition to the perceived commercial advantage, his purpose was to obtain a taxation advantage by paying the interest in advance. In my view, if this was not his sole purpose it was certainly his dominant purpose to achieve a deduction of $32,723 in the year of income, during the last week of which it was paid.

6. The policy document describes the security as ``managed investment plan - flexible security plan (FSP) insurance policy''. The principal obligation of the insurer is set out in these words -

``[Insurance company] agrees subject to the General Policy Conditions and the Special Conditions hereinafter contained that if the FSP Single Premium specified in the Schedule is duly paid and this Policy duly discharged is produced to [insurer] it will pay to the policy owner on the Life Insured's death or survival to the FSP Maturity Date an amount equal to the Balance of the Accounts provided always that the amount paid on the Life Insured's death, if it occurs before the Life Insured attains the age of ten years shall be equal to the aggregate of the FSP Single Premium and any Additional Premiums which have been received in respect of this Policy with interest thereon at a rate of not less than 4 per cent per annum compounded yearly.''

7. The ``FSP Maturity Date'' is 26 June 2043, when the applicant would have been aged 93. The special conditions provide for the establishment of several accounts which represent the number of units allocated in the insurer's investment account at certain unit prices, any additional premium investment accounts, a realised units account and a bonus unit account. Prices for these investment units are quoted regularly in the financial press. The special conditions go on to provide for the payment of upfront charges to the insurer, for methods of withdrawal from the policy by way

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of partial surrender, and for establishing the surrender value. Briefly, this would normally be the market value of the units at the date of surrender. If any surplus arises due to an accretion in value or due to a crediting of bonuses, then the policy holder is entitled to participate in them.

8. The applicant understood that these surpluses would be taxed pursuant to s 26AH of the Act, subject to rebates provided for by s 160AAB of the Act.

9. Section 26AH came into effect in 1984. It provides for the taxing of amounts paid as or by way of bonuses under life assurance policies taken out after 27 August 1982 and which are not subject to tax under any other provision of the income tax law. Section 160AAB, inserted in the Act by the same amending Act that introduced s 26AH, provides a rebate of tax at the rate of 30 per cent in respect of amounts included as assessable income under s 26AH.

10. Section 26AH sets an eligible period for policies of 10 years where the risk commenced after 7 December 1983. It then goes on to provide for a sliding scale of taxation liability depending upon when bonuses are received. it does not subject to tax amounts received under a policy of life assurance where the amount is received as a result of the death of, or an accident, illness or other disability suffered by the person on whose life the policy was effected. The section does not apply to amounts received as a result of the forfeiture, surrender or other termination of the whole or part of a policy in circumstances arising out of serious financial difficulties of the taxpayer, unless the policy was effected, purchased or taken on assignment with a view to it being forfeited, surrendered or otherwise terminated or to it maturing within 10 years. These exclusions are specified in sub-sections 26AH(6) and (7). As the applicant relied upon the exclusions, it is convenient to set out those 2 sub-sections. They are in the following terms -

``26AH(6) Where, during the eligible period in relation to an eligible policy, a taxpayer receives an amount (in this sub-section referred to as the `relevant amount') under the policy as or by way of a bonus, being an amount that, but for this section, would not be included in the assessable income of the taxpayer of any year of income, the assessable income of the taxpayer of the year of income in which the relevant amount is received shall include -

• (a) if the relevant amount is received during the first 8 years of the eligible period - an amount equal to the relevant amount;
• (b) if the relevant amount is received during the ninth year of the eligible period - an amount equal to two-thirds of the relevant amount; or
• (c) if the relevant amount is received during the tenth year of the eligible period - an amount equal to one-third of the relevant amount.

26AH(7) Sub-section (6) does not apply to any amount received by a taxpayer in a year of income under an eligible policy where -

• (a) the amount is received in consequence of -
  • (i) the death of the person on whose life the policy was effected; or
  • (ii) an accident, illness or other disability suffered by the person on whose life the policy was effected;
• (b) the eligible policy is a superannuation policy within the meaning of Division 8; or
• (c) except where the policy was effected, purchased or taken on assignment with a view to it being forfeited, surrendered or otherwise terminated, or to it maturing, within 10 years - the amount was received by the taxpayer by reason of the forfeiture, surrender or other termination of the whole or a part of the policy in circumstances arising out of serious financial difficulties of the taxpayer.''

11. The applicant's submission was that he had done no more than that contemplated by the sub-section. The wording of the sub-section specifically refers to cases where premature said, he intended to terminate the policy prior to the expiry of 8 years. The loan agreement was for 5 years but could have been rolled over at the end of that time. He would not, he said, have rolled it over for any period longer than 3 years. He accepted that the consequence of premature surrender was a taxation liability. He considered, however, that as he was entitled to

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a deduction for the prepayment of interest, he would still be financially better off. It was his case that as his conduct would have given rise to the creation of taxable income from an asset, interest on borrowings made for the purpose of acquiring that asset should be characterised as revenue outgoings.

12. The respondent argued that notwithstanding the applicant's evidence, it could not be predicated at the commencement of the policy that it would be prematurely surrendered. As it happened, the units dropped considerably in value after the stock market declined in September 1987. On 6 March 1989 the applicant decided to surrender the policy in full. He received its current value, which was then $185,857.72. The amount outstanding on the loan was $209,730.51, leaving a shortfall of $23,872.79 which he had to pay. Because of the drop in value no tax was payable under s 26AH. In reply, the applicant pointed out that even if the policy had not been surrendered he would submit that any bonuses would not be reversionary bonuses on a life policy and thus be exempt from tax pursuant to s 26(i). The nature of reversionary bonuses for that purpose was discussed in Case Q74 reported at
15 TBRD 346 at 348. Thus whatever was received by way of bonus would have been taxable. The quality of the asset as an income bearing investment would not have been diminished.

13. The applicant's second argument in the alternative was that at the time the arrangement was entered into, the policy could not be described as a life policy. Accordingly any bonuses payable under that policy would be assessable under s 26(i) or under s 25.

14. I will deal with this submission first. In arguing that the policy was not a life policy, the applicant relied upon a passage in the judgment of Windeyer J in
The National Mutual Life Association of Australasia Limited v FC of T (1959) 11 ATD 523 at 528-529; (1958-1959) 102 CLR 29 at 43 -

``Baron Parke's often-quoted description of `the contract commonly called life-assurance' in
Dalby v. The India and London Life-Assurance Company 15 C.B. 365, at 387 [139 ER 465, at p. 474] was not when he gave it a comprehensive definition; it was probably not intended to be; it certainly is not today. It was merely a description of the usual form of a whole of life policy. Today several other forms of contract, equally properly called life insurances, form a great part of the business of all life offices. The generally recognised differences between the various classes of insurance arise partly from essential differences in the nature of the contracts, partly from an insistent emphasis of distinctions which are the historical result of different forms of insurance having become commercially available in different periods of history and having been, for the most part, originally made available by insurance offices conducting one class of business only. In Bunyon on Life Insurance it is said that `The contract of life insurance may be further defined to be that in which one party agrees to pay a given sum upon the happening of a particular event contingent upon the duration of human life in consideration of the immediate payment of a smaller sum or certain equivalent periodical payments by another'.''

15. The definition in Bunyon was also referred to with approval by the New Zealand Court of Appeal in
Marac Life Assurance Limited v Commissioner of Inland Revenue (1986) 1 NZLR 694 at 697.

16. The applicant relied upon the condition in the policy that the amount payable on the life insured's death or survival to maturity date was an amount equal to the balance of the accounts. It was said that a characteristic of a life assurance policy was that a sum certain should be payable ``upon the happening of a particular event contingent upon the duration of human life''. An obligation to pay the balance of accounts meant that the issuing house took no risk, which was a characteristic of a life assurance policy. It seems to me that this argument must fail for 2 reasons.

17. Firstly, the principal insurance contract obligation quoted above clearly provides for payment of a guaranteed minimum amount in the event of death prior to the age of 10 years. It may be speculated that this was included in the terms of the policy to ensure that it was a life assurance policy. The benefits available to policy holders under s 26AH are in respect only of policies of life assurance. Furthermore the document uses the terminology appropriate to life assurance policies in its references to the ``life insured'' and to terms such as

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``premium'' rather than ``investment'', ``maturity date'' rather than ``repayment date'', and ``surrender value'' rather than ``current market value''. In its own terms, it contains sufficient of the traditional elements of a life assurance policy to characterise it as such.

18. Secondly, the argument put by the applicant, in my view, involves an unnecessarily narrow reading of the quoted passage. As Windeyer J observes, the traditional definition was merely a description ``of the usual form of a whole of life policy'' current at the time Dalby's case was decided in 1854. There are constant changes in the nature of financial products being offered in the market. Life assurance policies, no less than what might be called cash box investment trusts or managed investment plans, are regularly produced in flexible forms to meet different needs. So long as there is a contingency dependent upon the life insured's death, then the policy can be properly characterised as a life assurance policy. It is not necessary, in my view, that such a policy must guarantee payment of a specified sum. So long as the contractual obligations are set out and the sum payable is ascertainable, then the essential character of the policy is established.

19. That being so, interest on moneys borrowed to pay the premium on a life assurance policy must be characterised as part of a private transaction and not as an outlay incurred in gaining assessable income within the meaning of s 51. The particular policy in this case was proposed by the applicant upon his own life. Unlike other insurance policies on his own life, it is owned by the applicant. Expenditure incurred in securing the benefits conferred by such a life assurance policy, whether it be the premium or interest on borrowings to fund the premium, partakes of an essentially private character. It is not sufficiently connected with gaining income and is thus not relevant. The fact that assessable income may indirectly flow does not make that expenditure deductible under s 51 any more than it makes deductible fares to and from home
Lunney v FC of T (1958) 11 ATD 404; (1957-1958) 100 CLR 478) or child minding expenses (
Lodge v FC of T 72 ATC 4174; (1972) 128 CLR 171). As Mason J pointed out in Lodge (at ATC 4176; CLR 176) the relationship between the operative parts of s 51(1) and the exception of ``private or domestic'' has not been discussed at length. There must be no doubt, however, about expenditure in or about obtaining a personally owned policy on one's own life, not in the course of any business. The expenditure here falls within the exception in s 51 and is properly characterised as private.

20. The applicant then argued that the policy could be viewed as part of a profit-making enterprise and could be regarded as an isolated profit-making transaction such as that referred to in
FC of T v The Myer Emporium Limited 87 ATC 4363 at 4367; (1986-1987) 163 CLR 199 at 211. This argument must also fail, because the transaction must be viewed as private, thus falling within the exception in the first limb of s 51(1) of the Act.

21. The applicant must also fail in his first submission, in my view, because the outgoing, the subject of the claim, was not paid for a relevant purpose. It was not incurred in gaining or producing assessable income. It was incurred for the purpose of gaining a taxation advantage.

22. Payment of the interest in advance was a choice made by the applicant. It was not in discharge of his contractual obligations. He made that choice, as he said in evidence, partly to gain a commercial advantage (which in my view is doubtful) but principally to obtain a taxation advantage. Whether or not the subsequent monthly payments of interest would have been deductible it is not to the point. The fact that he made this choice assists in a consideration of the purpose for the payment.

23. In
FC of T v Ilbery 81 ATC 4661 at 4668 Toohey J said -

``While it may not be for the Commissioner to tell a taxpayer how much he should spend on outgoings in the course of gaining an assessable income or whether he should incur those outgoings in one or more than one tax years, a question may still arise whether in respect of a particular year an outgoing incurred by a taxpayer can truly be said to have been incurred in gaining or producing the assessable income.''

24. Other observations of Toohey J as to purpose were quoted with approval by the High Court in
John v FC of T 89 ATC 4101 at 4105. That the purpose of a payment is a relevant consideration has been considered in many cases. The authorities were gathered by the

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Federal Court in
Fletcher & Ors v FC of T 90 ATC 4559 at 4563-4564 -

``In our opinion the test to be applied in determining whether expenditure qualifies for deduction under the first limb of sec. 51(1) is to ascertain the `essential character' of the expenditure, as stated by Williams, Kitto and Taylor JJ. in Lunney at A.T.D. p. 412; C.L.R. p. 497, Brennan J. in Magna Alloys at ATC p. 4546; A.L.R. p. 217, Toohey J. in Ilbery at ATC p. 4667; A.L.R. pp. 179-180, a Full Court of this Court (Forster, Fisher and Spender JJ.) in
F.C. of T. v. Brixius 87 ATC 4963 at p. 4965; (1987) 16 F.C.R. 359 at p. 361 and French J. in
Riverside Road Pty. Ltd. (in liq.) v. F.C. of T. 90 ATC 4031 at p. 4041.

The critical question in the present case is whether purpose is relevant in determining the essential character of the interest payments. The question has been considered by this Court in a number of cases: Magna Alloys per Brennan J. at ATC pp. 4545-4553; A.L.R. pp. 216-227;
Ure v. F.C. of T. 81 ATC 4100; (1981) 34 A.L.R. 237; Ilbery at ATC pp. 4667-4668; A.L.R. pp. 179-181;
F.C. of T. v. Creer 86 ATC 4318; (1986) 65 A.L.R. 485;
Anderson v. F.C. of T. 89 ATC 4982 at pp. 4990-4991; and Riverside Road at p. 4041.

In Ure, Brennan J. said at ATC p. 4104; A.L.R. p. 241:

• `An outgoing of interest may be incidental and relevant to the gaining of assessable income where the borrowed money is laid out for the purpose of gaining that income (
  F.C. of T. v. Munro (1926) 38 C.L.R. 153 at pp. 170, 171, 197;
  Texas Co. (Australasia) Ltd. v. F.C. of T. (1940) 63 C.L.R. 382 at p. 468. The laying out of the borrowed money for the purpose of gaining assessable income furnishes the required connection between the interest paid upon it by the taxpayer and the income derived by him from its use.'

Toohey J. cited this passage with apparent approval in Ilbery at ATC p. 4667; A.L.R. p. 180.

In Ilbery, Toohey J., with whose reasons for judgment Northrop and Sheppard JJ. agreed, said at ATC p. 4667; A.L.R. pp. 179-180:

• `When the High Court in
  Ronpibon Tin N.L. v. F.C. of T. (1949) 78 C.L.R. 47 said at p. 56:

• `For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end',

that was not to exclude the notion of purpose. As Brennan J. pointed out in Magna Alloys at p. 4547:

• `Though purpose is not the test of deductibility nor even a conception relevant to a loss involuntarily incurred, in cases where a connection between an outgoing and the taxpayer's undertaking or business is affected by the voluntary act of the taxpayer, the purpose of incurring that expenditure may constitute an element of its essential character, stamping it as expenditure of a business or income-earning kind.'

Conversely, I would add, purpose may stamp the outgoing as one having no relevant connection with the gaining or producing of assessable income.'

It is clear from Toohey J.'s judgment in Ilbery that the purpose of the taxpayer was, in his Honour's view, an important consideration on the facts of that case.''

25. Counsel for the applicant sought to distinguish the present case from those cited by the Federal Court. He argued that it could not be said that the applicant's dominant purpose was to obtain a taxation advantage as the greatest benefit he could get would be a deduction of 57 cents in the dollar. What, it was asked, did he seek to gain from the other 43 cents? It was submitted that it was implicit in all other cases that were cited by the Federal Court that the tax advantage was equal to the extent of the deduction. In my view this is a doubtful proposition. No outgoing sought as a deduction under s 51 will normally result in a one for one reduction in the ultimate tax liability. It simply reduces the taxable income. I was also invited by counsel for the applicant not to put a gloss on s 51 and to hold that the fact that a person obtains a tax advantage is

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irrelevant. Reference was made to Ronpibon Tin NL v FC of T (1949) 8 ATD 431; (1949) 78 CLR 47 and Lunney v FC of T (1958) 11 ATD 404 at 411, 412; (1957-1958) 100 CLR 478 at 496, 497.

26. I do not feel at liberty to accede to this submission. I am of course bound by decisions of the Federal Court and the High Court. I am aware that special leave has been granted by the High Court to appeal from the judgment of the Federal Court in Fletcher. This however cannot diminish the authority of that decision in the meantime. I am therefore bound to take purpose into account in characterising the subject payment.

27. In the present case, the bunching of interest in advance must be given great weight and relevance. The purpose of the outgoing was freely acknowledged. Objectively, it cannot be explained except by reference to a perceived taxation advantage sought to be achieved in the last week of the financial year. It was central to the applicant's financial planning and to his calculation of the overall benefits that he would receive that he obtain this taxation advantage which he sought. The outgoing therefore was not incurred in gaining assessable income but in gaining an irrelevant object.

28. For these reasons the objection decision under review is affirmed.