AGC (INVESTMENTS) LIMITED v FC of TJudges:
Full Federal Court
Beaumont, Gummow and French JJ
AGC (Investments) Limited appeals from the dismissal by Hill J. of its application to review a decision of the Commissioner of Taxation disallowing an objection by the appellant against an assessment of income tax for the year of income ended 30 September 1987 (see 91 ATC 4180). The appellant claims that the amount of the taxable income assessed by the Commissioner should be reduced by excluding the sum of $45,068,073 which was described as ``profit from sale of investments'' in an adjustment sheet accompanying the notice of assessment. The basis of the assessment was that in the year ended 30 September 1987 (a substituted accounting period for the year of income ended 30 June 1987) the appellant sold, at a profit, several parcels of shares in listed public companies and thereby derived income, as understood in ordinary usage, which income was thus said to be assessable by virtue of the provisions of s. 25(1) of the Income Tax Assessment Act 1936.
The background facts
The appellant was incorporated in 1965. At all material times, it was a wholly owned subsidiary of AGC (Insurances) Limited (``AGC (Insurances)''), itself a wholly owned subsidiary of Australian Guarantee Corporation Limited (``AGC''). The affairs of AGC (Insurances), the appellant and AGC (Securities) Limited (another subsidiary of AGC (Insurances)) were administered as a single unit, known as the ``AGC Insurance Division'' of the AGC group of companies. The appellant had no separate staff or premises and its operations were administered by staff employed by AGC (Insurances).
Over a considerable period AGC (Insurances) advanced substantial amounts to the appellant with a view to their investment by the appellant in, inter alia, the acquisition of a portfolio of shares in listed public companies. An advance account was established for this purpose. By March 1983, the amount owed by the appellant to AGC (Insurances) on this account was $23,250,000. By September 1987, the account stood at $91,683,103.55.
The appellant's share portfolio was managed by Westpac Investment Management Pty. Limited (``Westpac Management''). As at 30 September 1986, the portfolio included shares in some 51 companies. The shares had a market value of $85,909,940. In mid September 1987 (shortly before the stock market slump which occurred in the following October) the appellant decided to commence selling the portfolio and to reinvest the proceeds of sale in fixed interest securities. In the 12 months to 30 September 1987, the appellant sold its holdings in 33 companies, realising the sum of $79,413,638. (This figure does not include sales made as a consequence of a take-over offer.) The sales represented approximately one-half of the value of the portfolio. The surplus achieved on realisation being the ``profit from sale of investments'' mentioned in the adjustment sheet accompanying the notice of assessment, was $45,068,043 in total.
The evidence with respect to the appellant's investment activities
Evidence of the appellant's investment activities was given by William Russell Gates, at material times an employee of Westpac Management; and by Robert Alick Robson and Donald Duncan Crisp, both formerly employed by the AGC Group. Mr. Gates, who was employed by Westpac Management from 1981, managed the appellant's share portfolio between 1981 and 1987. Mr. Robson was Chief Executive Officer and Group General Manager of AGC from 1983 to June 1987, when he was appointed Managing Director of AGC. Mr. Crisp was employed by AGC (Insurances) from 1966 in several capacities. From 1983, he was its General Manager. Documentary evidence, mainly in the form of the business records of the AGC Group, (which was the principal evidence available with respect to the period prior to 1981) was also relied on.
The evidence revealed that the history of the appellant's investment activities was as follows.
(1) In a memorandum dated 1 December 1966 on the subject of ``Investments'' written by the appellant's then General Manager to its Chairman of Directors, it was stated that the appellant held a portfolio of equity shares to the value of $1.8 million. The General Manager went on to say:
``Anticipating a cash flow of approximately $1 million during the current year's operations and having in mind that funds on deposit with A.G.C. are now over $8.2 million, or 54% of our total funds, I have been discussing with the Investment Management Department of the Bank of New South Wales the question of the further investment of our funds in equity shares.
Their recommendation is that the market at the present time is particularly attractive for long term investments in the equity market and they recommend that we take further advantage of this opportunity. With dividend yields averaging 4.75% on a diversified equity portfolio the return is equivalent to an earning of over 8.26% taking into consideration the tax relief on this investment.
In our discussions it was at first thought that we would invest our cash flow on a monthly basis but, subject to the availability of funds, the Bank recommend that consideration be given to the investment of the whole of our cash flow of upwards of $1 million during the next two months to take advantage of the present market conditions.''
(2) In an internal memorandum concerning the affairs of the appellant written on behalf of Westpac Management which is undated, but apparently written after 30 September 1975, it was stated under the sub-heading ``Aims'':
``Capital growth with approximate income return of 5% as [sic] cost.''
Under the subject ``Restrictions'', it was stated, inter alia:
``Sales over $100,000 to be referred to General Manager AGC Insurances or General Manager AGC Group - in their absence we can proceed using our own discretion.''
The following was also stated:
If equity market becomes particularly attractive at any time company will consider making additional funds available for investment.
Apart from this no new money is available, purchasers are financed by proceeds of sales. Company is agreeable to approximately $20,000 being made available to allow for special situations from time to time.
Method of Operation:
Portfolio was originally formed within A.G.C. and we acted in an advisory capacity from 17/3/64 until approximately June 1967 when we assumed management. In May 1965 portfolio was transferred into name T.G.I. (Investments) Pty. Ltd. Later changed to A.G.C. (Investments) Limited.
No firm policy was ever effected and difficulty was obtained in finding out just where the portfolio and available funds stand. However, since assuming complete management in 1967 we have had a clearer picture, and contributions are supplied usually at our request if and when funds are available.
Sub-underwriting is referred to us for decision.
We must advise company what action to take regarding sales, new issues and other entitlements.
Company handles its own book-keeping and settlements, and securities are held in their own name. Our action is to place orders on their behalf.''
(3) The regulatory framework created by the enactment of the Insurance Act 1973 required AGC (Insurances) to have an authority to carry on the business of an insurer. In February 1977, discussions took place between Mr H.E. Wood, then its General Manager, and the Insurance Commissioner. The discussions included consideration of the relationship between the parent company and the subsidiaries. In a letter dated 2 March 1977 the Insurance Commissioner wrote to Mr Wood confirming his agreement under sub-s. 30(2) of the Insurance Act that for the purposes of liquidity and spread of assets of AGC (Insurances), he
ATC 4242would be prepared to accept the three subsidiaries, including the appellant, ``as if they were an integral part of'' AGC (Insurances). In later years the Insurance Commissioner gave approvals under s. 30(2) of the Insurance Act allowing loans from AGC (Insurances) to the appellant to be treated as part of the assets of AGC (Insurances) for the purposes of the Insurance Act.
(4) In a letter to Westpac Management dated 26 January 1978, Mr. Wood confirmed the ``continuity of [Westpac's] management of our investment portfolio'' and went on to say:
``We have requested our tax advisers to report on the effect that the decision in the London/Australian investment case may have on our investments. If we are to be taxed on the principles set out in the judgment we may as well face these issues and exploit all forms of gain from our equity operation. We shall inform you their advice and the policy we should like to follow.
Notwithstanding the above we feel it is important that you should fully exploit the cyclical fluctuations in the share market by capitalising on market highs for sales and repurchasing at the bottom of any depressed period.
The point we make is that if we sell any stock the reinvestment does not have to be made immediately unless the decision to sell was made with the intention of replacing the stock sold. (Emphasis added)
The main recommendations in your submission with which we agree are:
- 1. Consolidation of the share portfolio with a view to reducing the number of stocks to approximately 50, each to have a minimum holding of.5%.
- 2. Investments be directed to preference and ordinary shares rather than fixed interest securities.
- 3. Special submissions to be made from time to time in regard to special opportunities which may be presented for investment in Government or semi- Government securities.
- 4. The equity portfolio be compounded by reinvestment of earnings.
- 5. Additional funds be provided to take up any rights entitlement and if rights be sold the proceeds will be available for reinvestment.
- 6. Proceeds from sales be available for reinvestment: (funds from such sales and the sale of rights will be held by us pending reinvestment).
- 7. The Bank only refer purchases of stock within the authorised total investment allocation in excess of $100,000.
In addition to the above we should like you to refer to us for approval any proposed sales which will create a capital loan in excess of $10,000 for approval.
Purchases of preference shares or Government and semi-Government security be referred before purchase.''
London Australia Investment Company Limited v FC of T 77 ATC 4398; (1976-1977) 138 CLR 106, a decision of the High Court in September 1977, a company invested in shares with a view to the production of income from dividends. During the years 1967, 1968 and 1969, the company engaged in a continuous large scale activity in the buying and selling of shares and had substantial surpluses in those years representing the difference between the net proceeds of the sale of the shares and the average cost of the shares sold. The Commissioner included those amounts in the company's assessable income for those years. At first instance, Helsham J. had held that the profits were properly treated as income within s. 25. An appeal to the High Court was dismissed by a majority (Gibbs and Jacobs JJ., Barwick C.J. dissenting). Gibbs J. said (at ATC 4403; CLR 117):
``Helsham J. found that during the three years in question it was an integral part of the taxpayer's business to deal in shares, in the sense that the switching of investments was desirable to produce the best dividend returns and was indeed necessary if the taxpayer's policy of investing in shares with growth potential was to be adhered to. In my opinion it is impossible to controvert that finding; it was clearly right. 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
ATC 4243frequently 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.''
Jacobs J. said (at ATC 4411; CLR 130-131):
``I do not think that a conclusion on scale by itself provides the answer; but it is very important evidence tending to show a business of acquiring and disposing of shares and it was some evidence from which a purpose of thereby making a profit might be inferred. It was for the appellant to rebut the latter inference. In my opinion it has not done so. It has in its favour the very important circumstance that the source of the funds was the subscribed capital of the company. But this is only part of the evidence. The evidence taken as a whole strongly supports a conclusion that a purpose or intention or expectation implicit in the carrying into effect of its investment policy was that shares acquired would be resold if and when an occasion arose which would make it desirable so to do and an element of desirability was that there would be greater financial benefit in disposing of the shares at an enhanced value than in retaining them. The fact that enlargement of dividend income was the dominant purpose does not gainsay the existence of a concurrent purpose of resale if and when that resale would throw up a profit which could be used to enlarge the dividend income. The massive scale of the activities in the years in question practically compels the inference that the investment policy was one which in its inception and throughout the course of carrying it into effect would in the expected state of the rising market require frequent and regular realisations of shares whenever they rose in market price before dividends from them were increased.)''
(5) By letter dated 24 July 1978, Mr. Wood wrote again to Westpac Management saying that AGC's taxation advisers had advised that the decision in London Australia ``would not be applicable to our operations and we would like you to plan our investment portfolio accordingly''.
(6) By letter dated 25 September 1981, Mr. Wood wrote to Mr. Gates at Westpac Management, confirming that it had been agreed ``in principle'' that the ``guidelines'' in the letter dated 26 January and 24 July 1978 should continue, subject to two qualifications: (1) Westpac need only refer purchase of stock ``within the authorised total investment allocation'' in excess of $200,000; (2) Sales transactions ``involving a capital loss'' need not be reported.
(7) In his affidavit evidence, Mr. Gates said that in 1981 he had a conversation with Mr. Wood in which Mr. Wood said that the appellant was not a trader in shares and that shares should be purchased only with a view to long-term dividend growth. In his affidavit, Mr. Gates said:
``In considering an investment the matter which I regarded as being of dominant importance was the present and prospective future yield on the investment. I regarded as desirable investments those where I thought that the dividend income would increase over time, matching or exceeding the rate of inflation. While I was concerned not to invest in securities which were likely to diminish in market value, I did not at any time take into account as part of the prospective yield on an investment the capital gain which might be realised by disposing of the investment. My instructions in connection with the management of the portfolio were expressly, and were always understood by me to be, that the investments were long term investments, not to be realised except in the event of some catastrophe affecting the company in which the investment was held or by reason of any event such as a takeover.''
(Mr. Gates was not cross-examined on either of these passages in his affidavit.)
(8) In his affidavit, Mr. Robson gave evidence that in 1983, Mr. Wood stated to him:
``We have placed our funds for investment with Westpac Investment Management. It is important to us that we are continuing investors and that we are not seen as traders in shares. All shares purchased should be
ATC 4244treated as long term investments and not traded in the short or medium term. As a rule we only sell when we have to, for instance during takeovers.''
In cross-examination, Mr. Robson said:
``[T]he view given to me at my induction into the company by Mr Wood was that we were virtually constrained in the investments - in AGC Investments to being long term holders, that the most frequent event of disposal was in response to a takeover offer. That both the requirement of the insurance commissioner and workers compensation Licence - as well as taxation advice received, was that we should not confuse this activity with anything that could be, in any sense, considered to be trading and, for that reason, disposal would be a very rare and exceptional event so that there was no regular pattern in any way of discussion of disposal of shares.''
(9) In his evidence, Mr. Crisp said that in 1983 Mr. Wood informed him of the following:
``AGC Investments is not a trader in shares. It was set-up to invest funds provided by Insurances in securities which ensure long term dividend investment income and maximise potential asset growth.''
(Mr. Crisp was not cross-examined upon this passage in his affidavit.)
(10) By letter dated 10 May 1983 to Westpac Management, Mr. Crisp wrote as follows:
We refer to recent discussions with the Administration Manager concerning guidelines for the investment portfolio handled by you.
Guidelines previously issued indicated that funds available to you for reinvestment were made up of dividends received and capital profits during the year. We advise you that on the criteria set out the investment portfolio can be increased to a total of $24m. The amount invested by you up to the 31st March, 1983 is $20.5m therefore you have funds available for investment of $3.5m up to and including the 30th September, 1983 at which time you will be advised of funds available for investment to 30th September 1984. (Emphasis added)
The provisos to the above investment allocation are as follows:
- 1. The Bank is to refer purchase of stock on individual investments for amounts in excess of $200,000.
- 2. Sales Transactions involving a small capital loss need not be reported.
- 3. The investment allocation of $3.5m for the next six months is of course only a guideline. The investment of these funds is subject to your judgment on market conditions applying from time to time and reference to us as outlined in (1) above.
All contact with the Company involving our investment portfolio is to be made through the Administration Manager, Mr. R. Culbert. Please do not hesitate to contact either Mr. Culbert or myself should you have any queries on these guidelines.''
(11) In his oral evidence, Mr. Crisp said that these standing instructions remained in force until the end of 1987 save that, in 1986, the limit of $200,000 was increased to $500,000.
(12) The records of the appellant's share sales do not go back earlier than 31 December 1970, although there were transactions prior to that date. A schedule of those investments prepared by Mr. Gates indicated that the turnover in publicly listed shares acquired by the appellant was low. Of 81 acquisitions, 26 were held for a period exceeding 15 years, 20 for between 10 and 15 years, and a further 14 for between 5 and 10 years. It was his practice not to sell ordinary shares which he had purchased in the portfolio except in consequence of a takeover offer or by occasional divestment. New equities were acquired from time to time and existing equities extended by additional acquisitions, bonus issues or the taking up of rights. In some cases rights attached to existing shareholdings were disposed of by sale rather than being taken up.
(13) In his affidavit, Mr. Crisp gave evidence of the history of the advance account between 1 March 1983 and 30 September 1987 as follows:
EXTRACT OF AGC (INSURANCES) LIMITED ADVANCE ACCOUNT WITH AGC (INVESTMENTS) LIMITED FOR THE PERIOD 1ST MARCH 1983, TO 30TH SEPTEMBER, 1987 March 1983 Brought forward 23,250,000 cr March 1983 Receipt 500,000 23,750,000 cr March 1983 Receipt 250,000 24,000,000 cr April 1983 Receipt 250,000 24,250,000 cr June 1983 Receipt 250,000 24,500,000 cr August 1983 Receipt 150,000 24,650,000 cr September 1983 Receipt 350,000 25,000,000 cr September 1983 Receipt 2,000,000 27,000,000 cr October 1983 Disbursement 250,000 26,750,000 cr October 1983 Receipt 250,000 27,000,000 cr February 1984 Receipt 1,000,000 28,000,000 cr March 1984 Receipt 3,000,000 31,000,000 cr April 1984 Receipt 500,000 31,500,000 cr May 1984 Receipt 2,000,000 33,500,000 cr June 1984 Receipt 6,450,000 39,950,000 cr June 1984 General Journal 50,000 40,000,000 cr December 1984 Receipt 2,000,000 42,000,000 cr March 1985 Receipt 1,000,000 43,000,000 cr March 1985 Receipt 3,000,000 46,000,000 cr June 1985 Receipt 3,000,000 49,000,000 cr June 1985 Receipt 1,500,000 50,500,000 cr July 1985 Receipt 2,000,000 52,500,000 cr August 1985 Receipt 4,000,000 56,500,000 cr September 1985 Receipt 1,735,000 58,235,000 cr September 1985 Receipt 2,000,000 60,235,000 cr October 1985 Receipt 1,765,000 62,000,000 cr November 1985 Receipt 4,000,000 66,000,000 cr December 1985 Receipt 1,000,000 67,000,000 cr January 1986 General Journal 4,661,350.27 71,661,350.27 cr (Dividend) January 1986 Disbursement 2,000,000 69,661,350.27 cr March 1986 Receipt 2,025,000 71,686,350.27 cr March 1986 General Journal 2,661,350.27 69,025,000 cr April 1986 Disbursement 1,000,000 68,025,000 cr April 1986 General Journal 975,000 69,000,000 cr September 1986 General Journal 9,000,000 60,000,000 cr October 1986 General Journal 2,000,000 62,000,000 cr March 1987 General Journal 7,690,643.55 69,690,643.55 cr March 1987 General Journal 5,000,000 64,690,643.55 cr June 1987 General Journal 9,993,900 74,684,543.55 cr July 1987 Disbursements 5,089,800 79,774,343.55 cr August 1987 Journal 15,138,280 94,912,623.55 cr September 1987 Journal 4,270,480 99,183,103.55 cr September 1987 General Journal 7,500,000 91,683,103.55 cr ------------------
(14) The following details of the loan account repayments by the appellant were given:
Transaction Amount Details Date 31.10.83 $250,000 Repayment of temporary advance made earlier in month. 28.1.86 $2,000,000 Part payment of the dividend declared at the previous AGM. The funds were used by Insurances to purchase Bank bills on 28/1/86. 31.3.86 $2,661,350 Remainder of the dividend declared at the previous AGM. The funds were deposited on the Short term money market pending investment in Bank bills. 1.4.86 $1,000,000 After reviewing the balance of the loan account on 31/3/86, a decision to reduce it was taken. The funds were with AGC Ltd on deposit until 10/4/86 when Bank bills were purchased. (Emphasis added -- see below) 22.9.86 $9,000,000 Reduction of balance to the level existing at September, 1985. These funds were used by Insurances to buy Bank bills on 22/9/86 and 26/9/86. (Emphasis added -- see below) 12.3.87 $5,000,000 Part payment of the Dividend declared at the previous AGM used to buy Bank bills on 12/3/87. 30.9.87 $7,500,000 Repayment of advances to AGC Investments for investment in fixed interest securities pending receipt of proceeds from sale of shares. ---------------
(15) From time to time Mr. Gates advised the appellant with respect to offers of new issues of shares by companies in which the appellant already held shares. On several occasions, the advice referred to the particular shareholding in question as ``a sound long term investment and as such, well fits the investment criteria of [the appellant]''. Reference was also made from time to time by Mr. Gates, in his correspondence with the appellant, to his concern to obtain an increasing dividend yield on investments if possible.
(16) In May 1984, Mr. Robson asked Mr. Crisp to review the investment strategies of the AGC Insurance Division. In a memorandum on the subject dated 29 May 1984, Mr. Crisp referred, by way of background, to the ``constraints... placed upon our ability to invest funds/assets by the licensing/authorisation provisions imposed by the Federal Insurance Commissioner and by the Workers' Compensation Commission of New South Wales''. It was said, in respect of ``current strategies'' that to ``comply with licensing/authorisation requirements and a prudent investment strategy we have a spread of investments''. It was stated that the Insurance Group's equity investment was carried by the appellant; that these investments were principally managed by Westpac Investment Management; and that after consultation with Westpac it was agreed that the Investment Managers were free to sell and purchase securities on behalf of the Group. Additionally any profits produced from these operations could be reinvested.
The memorandum went on to say:
``We seek long term dividend producing shares.
The overriding instruction to Westpac is that they must conduct the portfolio in a manner to ensure AGC (Investments) cannot be classed as a trader.''
(17) By letter to Mr. Crisp dated 25 November 1986, Mr. Gates wrote of the appellant's investment policy as follows:
``Further to our conversation this morning, I wish to confirm my recommendation that the portfolio continue to place overwhelming emphasis on first class industrial shares rather than seek a higher immediate yield and buy shares of a lesser quality.
I have strictly adhered to high quality shares since I took over management of the portfolio five and a half years ago and believe the results have amply justified this stance.
As you are aware, share prices generally have advanced quite strongly over the past few years, in fact at a faster rate than earnings and dividend growth per share.
The affect [sic] of this has been that dividend yields have fallen such that the average dividend yield on industrial shares at the moment is 3.7% compared with 4.4% a year ago and 4.9% two years ago.
I am recommending that we continue to buy basically the same type of shares but point out that we will have to accept a lower immediate running yield. I remain confident that the quality industrial shares will continue to show above-average earnings and dividend growth per share and believe the long term interests of the portfolio remain best served by staying in the quality area. (Emphasis added)
As a result of the portfolio accepting a number of takeover offers last year, $3.5 million more was realised from sale of shares than was spent on purchases. Added to this, I assume, was approximately $3 million of dividend income which was available for investment but which was not spent by us.
It would be appreciated if you could confirm that the amount available for investment in 1986/87 is approximately $10.5 million, which is the total of the above two amounts plus expected dividend income of around $4 million this year.''
(18) By letter dated 26 June 1987, Mr. Crisp wrote to Mr. Gates as follows:
``I have been requested by our Managing Director, Mr. RA Robson, to discuss with you the most appropriate way of securing the unrealised capital gain now held within the share portfolio.
The Board consider that such action is appropriate as the share market now has reached a high level and it is possible that share values could fall following the election. (Emphasis added)
In consultation with you I would seek to determine:
- 1. A strategy to successfully dispose of the existing share portfolio prior to 30/9/87 and;
- 2. a plan to reinvest a significant proportion of the funds received from the sell off operation.
I am aware that you will be unavailable until 7th July and propose to telephone you to confirm the contents of this letter.''
(19) Mr. Gates and Mr. Crisp met on 22 July 1987 and on 23 July 1987 Mr. Crisp wrote to Mr. Gates confirming that-
``[t]wo distinct scenarios are to be considered:
- (1) A complete disposal of the share portfolio, and
- (2) a disposal of selected lower performing or lower quality equity holdings.''
(20) Mr. Gates replied to Mr. Crisp by letter dated 24 July 1987 advising on practical aspects of the two ``scenarios''. In the course of his analysis, Mr. Gates expressed the view that ``with a few exceptions the portfolio is comprised of companies that will demonstrate long term earnings and `franked' dividend growth''.
The inferences drawn by the primary Judge
At the trial, there was no substantial dispute about the primary facts. The dispute between the parties centred on what inferences should properly be drawn from the primary facts. His Honour said (at 91 ATC 4180 at 4193):
``... the integration of the business activities of the applicant with the affairs of Insurances, the place which the assets of the applicant occupied as part of a reserve fund for the insurance business of Insurances and perhaps also the scale of its activities, raise an inference that the necessary profit purpose existed. No evidence was adduced of any resolution of the board of the applicant, or for that matter Insurances, which would rebut such an inference...
The letter of 26 January 1978, with its reference to the desire to `fully exploit the cyclical fluctuations in the share market' makes it clear that at least as at that date, the applicant did have a purpose of profit making in acquiring its portfolio, and confirms the inference which would arise from its insurance association.
The question then remains whether the evidence shows in respect of the applicant's activities after 26 January 1978 that it changed direction from being a company carrying on an investment business after that date, so that at least in respect of so much of its portfolio as was thereafter acquired it became a mere investor? The evidence does not satisfy me that it did.''
Hill J. went on to say (at 4193-4194):
``It is true that Westpac Management did not generally seek to take advantage of the cyclical trends of the market, and that, having regard to the size of the portfolio the value of sales was relatively small, but capital growth remained at all times of significance. The applicant seems to have been concerned at all times to ensure that it was not a share trader and went to some pains to communicate this to Mr Gates. I accept that the applicant was concerned to obtain increasing dividend yields. Indeed this was particularly so when its parent company was incurring substantial underwriting losses. But, the desire for dividend yield does not exclude a purpose of profit making by sale, where the investment is made with the knowledge that the sale may be required to provide funds (albeit not on a day to day basis, but only perhaps in the event of a catastrophe or a running down of particular insurance business) for the purposes of the insurance business of its parent. This is particularly so when the applicant's funds were all provided on a short term basis of loans repayable on demand.''
His Honour was of the view that, for present purposes, the evidence of Messrs. Robson and Crisp was more significant than that of Mr. Gates. Hill J. said (at 4194):
``The evidence of Messrs Robson and Crisp makes it clear that the applicant was not intended to be a share trader, but it stops short of denying the profit making purpose of the applicant. The fact that the shares were not to be traded in the short or medium term, and were to be treated as long term investments is not inconsistent with the conclusion that the shares were acquired with a profit making purpose. Indeed, as Mr Crisp acknowledged, asset growth was always an aim of the applicant. No doubt increasing dividends over the medium to long term almost invariably bring asset growth, but in the circumstances of the present case one may ask rhetorically whether asset growth was an end in itself, or merely a means to ensuring that realisations would, if made, be at a profit.''
His Honour concluded (at 4194):
``It follows, that the applicant has not satisfied the burden of showing that its original profit making purpose was displaced. In my view the applicant was carrying on a business, that business being integral to the insurance business of its parent, and in the course of this business it acquired a portfolio of shares having at the time of acquisition a profit making purpose in so doing. It realised a large part of that portfolio to preserve the gain which had accrued to it, and the profits it made in so doing were income in ordinary concepts.''
The consideration of the decided cases by Hill J.
Hill J. referred to the decisions of the High Court in the London Australia case and in
FC of T v Myer Emporium Ltd 87 ATC 4363 at 4366-4367; (1986-1987) 163 CLR 199 at 209-210, for the proposition that ``profits made on the realisation of investments will be income where the investments are acquired as part of a business and where in addition there was at the time of acquisition an intention or purpose that they be realised subsequently at a profit'' (at 4191).
His Honour said (at 91 ATC 4190):
``The fact that the applicant is a subsidiary of an insurance company and is administered as part of that company, and that its assets are regarded by the parent as part of a reserve fund, to be available to meet liabilities in the event that that be necessary (even perhaps where the occasions of necessity may be rare indeed) assists in the characterision of the activities of the applicant as a business. It also enables an inference more readily to be drawn as to the profit making purpose of the applicant in undertaking its investment activities. That is not to say that it should thereby be taken as being an insurance company. It is not receiving premiums which require reinvestment to provide for claims, nor is it investing, as the Commissioner submitted, the funds of the insurance company. It is investing its own funds, albeit that those funds are provided by way of interest free loans, repayable on demand from the insurance company. Those funds represent the capital of the applicant, not the circulating capital of its parent insurance company.''
Hill J. distinguished, on its facts, the decision of the Full Court of this Court in
FC of T v Equitable Life and General Insurance Co. Ltd. 90 ATC 4438 where it was held that the profits made by the subsidiary of an insurance company on the sales of shares were not income.
GRE Insurance Limited v FC of T 92 ATC 4089, in which judgment was given after Hill J. decided the present matter, it was held that the profits made on the sale of equities by a subsidiary (``Unitraders'') of an insurance company (``GRE'') were income. Northrop, Davies and Jenkinson JJ. said (at 4093):
``... the activities of Unitraders were an integral part of the insurance business conducted by GRE. Although the equities were held by the wholly owned subsidiary rather than by GRE directly, the equities indirectly formed part of the funds representing the insurance reserves and part of the circulating capital of the business. Just as the prudent management of the investment portfolio of an insurance company ordinarily requires that some proportion of equities be held as well as government securities, mortgages and debentures, so in this present case, it was always an element of the investment strategy that a proportion of equities be held. And that strategy continued, the proportion varying whenever it seemed prudent from an investment point of view to vary the mix.
As the reason for holding the equities in Unitraders rather than GRE was to enhance the profits, the after tax profits, of the insurance business, we are unable to regard the activities of Unitraders as being other than an integral part of the insurance business, whose profits were by this technique increased.''
Their Honours went on to say (at 4094-4095):
``That is not to say that Unitraders should not be considered as a taxpayer in its own right. It was such a taxpayer and its activities should be so considered. Nevertheless, the part which a subsidiary plays in affairs which concern its holding company, or in the group in which both companies form a part, may throw light upon the character of the activities of the subsidiary. Thus, in Radnor, it was considered relevant that the taxpayer company was an instrument through which the holding company performed its obligations as a trustee. See the remarks of Hill J., 91 ATC at 4700. See also the remarks of Hill J. in AGC (Investments) Ltd v. FC of T, 91 ATC 4180 at 4190. In the present case, Unitraders was introduced into the affairs of GRE solely to ensure that the benefit of the s. 46 rebate would not be lost in the event that underwriting losses brought GRE to the position that it had no taxable income. Unitraders was a separate entity from GRE but its activities reflected, indeed formed part of, the overall business in which GRE was engaged.''
The conclusions and reasoning of Hill J.
His Honour's conclusions may be summarised thus:
- (A) The fact that the shares were not to be traded in the short or medium term, but were to be treated as long-term investments, was not inconsistent with the conclusion that the shares were acquired with a profit making purpose. Asset growth was always an aim of the appellant. The appellant had not satisfied
ATC 4250the burden of showing that its original profit making purpose was displaced.
- (B) The appellant was carrying on a business and that business was integral to the insurance business of its parent, AGC (Insurances); in the course of that business, the appellant acquired a portfolio of shares having, at the time of acquisition, a profit- making purpose; the appellant realised a large part of that portfolio to preserve the gain which had accrued to it; and the profits thus earned were income in accordance with ordinary concepts.
His Honour's reasons for these conclusions were, in essence, as follows:
- (1) The appellant was used as a vehicle for the investment of funds provided to it by its parent company, which carried on business as a general insurer. The criterion for investment, in the case of shares in listed public companies, was long term dividend investment income and the maximisation of potential asset growth.
- (2) It was essential that a general insurer have an adequate reserve fund, particularly where, as in the case of AGC (Insurances), workers' compensation insurance was undertaken so that claims might continue after the period in respect of which premiums were payable (``long tail'' insurance); such a reserve would ordinarily consist of short-term or liquid investments, but might also consist of listed shares.
- (3) AGC (Insurances) invested in public company shares by providing funds to the appellant to invest in those shares. All of those investments were viewed by AGC (Insurances) as part of the reserve fund of the insurance company, although they were held in the name of a separate legal entity, which was a wholly owned subsidiary. The share portfolio was established and maintained by AGC (Insurances) so as to provide for the possibility of claims being made against it in excess of its immediately available liquid funds. The Insurance Commissioner, at least until 1984, accepted that the assets of the appellant, including the shares, should be treated as part of the assets of AGC (Insurances) for the purposes of the Insurance Act 1973.
- (4) The investment policy of the appellant was that of a long-term investor seeking shares in companies that provided a reasonable yield together with medium and long-term growth potential. Although the appellant was not conducting the business of trading in the shares, the facts that the appellant was a subsidiary of an insurance company, and that its affairs were administered as part of that company and that the appellant's assets were regarded as reserves available to meet the liabilities of the insurance company, justified the inference of a profit-making purpose in undertaking the investment activities.
(For the sake of completeness, it should be noted that, at the trial, the Commissioner put an alternative submission that the profits were assessable under the second limb of s. 25A(1). Hill J. did not deal with this argument, possibly because it involved, as an essential ingredient, a conclusion that there was a profit-making purpose, so that his Honour's consideration of the possible operation here of s. 25(1) could also be applied to s. 25A(1). For the same reason, we do not need to consider the alternative argument.)
The grounds of the appeal
The appellant now challenges these conclusions in three main ways:
- (i) It disputes the finding by his Honour that it was carrying on a business which was ``integral'' to the insurance business of its parent and attacks the conclusion that, in the course of this business, the appellant acquired the shares having a profit-making purpose at that time.
- (ii) The appellant says that his Honour should have held that it was engaged in a business of investment, in which the realisation of surpluses on disposal was no more than a known possibility, rather than its object.
- (iii) It maintains that its purpose was to produce a steady and growing dividend income; and that as a consequence, the profits were on capital, and not on revenue, account.
Our conclusions on the appeal
There is little, if any, difference in the submissions put by the parties with respect to the legal principles applicable here. The central issue in the litigation at first instance, and before us, was the true characterisation of the appellant's purpose in acquiring its share
ATC 4251portfolio. This is a question of fact, albeit of secondary fact. There is no real dispute about the primary facts, and little appears to turn on the credit of the individual witnesses called on behalf of the appellant. But the proper inferences to be drawn from the primary facts are contentious. On behalf of the appellant, it is said that the oral evidence of those concerned with the management of the portfolio demonstrates that the investments were acquired on a long-term footing and were realised, as a general rule, only in exceptional circumstances. The appellant says that this version of the events is fully supported by the contemporary documentation. On the other hand, the Commissioner contends, in accordance with the conclusion of Hill J., that in the particular circumstances of this case, especially when regard is had of the relationship between the appellant and AGC (Insurances) and in the light of the correspondence in 1978 concerning the possible impact on the appellant of the decision of the High Court in the London Australia case, the appellant failed to discharge the onus of establishing the absence of a profit-making purpose in acquiring the portfolio.
Although the resolution of this central issue will, in the end, depend upon an examination of all of the circumstances disclosed in the evidence, it is convenient to approach the matter by reference to the two main matters raised in argument before us. We will consider them in turn.
The relationship between the appellant and AGC (Insurances)
As has been noted, Hill J. placed considerable emphasis on the role of the appellant as the investment vehicle of the Insurance Division and it is clear from the banking and insurance cases that the need to maintain liquidity continuously in order to conduct this kind of business is the reason why profits generated by the purchase and sale of securities by banks and insurance companies are usually treated as income. For instance, in the
Colonial Mutual Life Assurance Society Ltd v FC of T (1946) 8 ATD 137 at 145; (1946) 73 CLR 604 at 620, Latham C.J., Dixon and Williams JJ. referred, with approval, to a statement in the English text Konstam as follows:
``... The buying and selling of investments is a necessity of insurance business; and where an insurance company in the course of its trade realises an investment at a larger price than was paid for it, the difference is to be reckoned among its profits; conversely any loss is to be deducted.''
Their Honours went on to say that, in this respect, there was no substantial distinction between the business of an insurance company and that of bank. They said (at ATD 145; CLR 620):
``The acquisition [by a bank or an insurance company] of an investment with a view to producing the most effective interest yield is an acquisition with a view to producing a yield of a composite character, the effective yield comprising the actual interest less any diminution or plus any increase in the capital value of the securities. Such an acquisition and subsequent realisation is a normal step in carrying on the insurance business, or in other words an act done in what is truly the carrying on of the business of the Society.''
But, in our opinion, the facts of the present case may be distinguished from the usual circumstances of an insurance company or a bank, where the need to buy and sell securities on a regular basis, in order to maintain liquidity, justifies the conclusion that this is a normal step in carrying on a banking or insurance business, with the consequence that the profits so earned are regarded as income. The evidence here indicates that there was no necessity for the appellant to buy the securities now in question in order to maintain the liquidity of AGC (Insurances).
The role actually played by the appellant in the Insurances Division was, we think, accurately stated in Mr. Crisp's memorandum dated 29 May 1984 which we have already mentioned. As this was an internal memorandum, there is no reason to suppose that it was not a correct statement of the general position and it is illuminating for present purposes. It will be recalled that the memorandum was addressed by Mr. Crisp, as General Manager of the Insurances Division, to Mr. Robson as General Manager of the AGC Group. Its subject was ``Insurances - Investment Strategies''. The purpose of the paper was stated to be ``to review the investment strategies now in place''. The first section of the paper dealt with background matters. Reference was made to the constraints
ATC 4252imposed by the Federal Insurance Commissioner and by the Workers' Compensation Commission of New South Wales. This meant, inter alia, that ``unrestricted asset/funds investment by AGC (Insurances)'' was not permitted. The second section of the paper dealt with ``Current Strategies'' as follows:
``2. CURRENT STRATEGIES:
To comply with licensing/authorisation requirements and a prudent investment strategy we have a spread of investments.
(a) A.G.C. (Securities) Limited:
- This company is placed in funds by A.G.C. (Insurances) Limited: the funds are advanced as first and second mortgages by Property Finance.
- On the Investment Control Report only the 10% interest being paid on the funds is reported. A specific profit contribution from AGC (Securities) is taken into AGC (Insurances) Group account only at March and September.
(b) A.G.C. (Investments) Limited:
- The Insurance Group's equity investment is carried by this company.
- These investments are principally managed by Westpac Investment Management Pty. Limited. After consultation with Westpac we have agreed the Investment Managers are free to sell and purchase securities on our behalf. Additionally any profits produced from their operations can be reinvested.
- We seek long term dividend producing shares.
- The overriding instruction to Westpac is that they must conduct the portfolio in a manner to ensure AGC (Investments) cannot be classed as a trader.
- Within the Investment Control Report we only show the dividends being received through AGC (Investments). An appreciation on capital gain value is not taken into account.
- Liquidities trading is undertaken through AGC Money Market operations in consultation with Mr David Hobbs.
- Preference share details are referred to us through a variety of brokers and via Westpac.''
The third section of the paper gave selected statistics on the current investment programme.
The final section of the paper gave some recommended strategies. It was suggested that the investment portfolio should be balanced as follows:
"(a) Investment in Category I assets as set the Workers' Compensation Commission comprising bank bills and Government bonds 10% (b) Investment in Category II assets as set by the Workers' Compensation Commission -- letters of credit 15% (c) Mortgages -- Securities 45% Domestic lending about 70% commercial lending about 30% with a maximum of $500,000 any one mortgage or group. Commercial lending to be limited to Sydney and Brisbane PF offices. (d) Investments in ordinary and preference shares 15-20% (Emphasis added) (e) Debentures and notes (AGC)15%"
It was stated that the recommended strategies were in essence a continuation of the current mixture of investments.
The report concluded as follows:
``Our existing strategy is returning a reasonable investment yield while still enabling us to operate within the terms of the license authorisations to which we are subject.''
As we have said, we are of the view that there is no reason to doubt that this statement of the role of the appellant in the Insurances Division was an accurate one. It must follow, we think, that it was not part of the corporate scheme that the appellant buy equities in order to maintain liquidity for the insurance operations of the AGC Group. The memorandum and the other evidence,
ATC 4253documentary and oral, to which we have earlier referred, demonstrate that it was at all times intended that the appellant invest long-term. Its subsequent conduct was consistent with this intention. As we have noted, 26 of the equities acquired were held for a period exceeding 15 years, 20 for between 10 and 15 years and a further 14 for between 5 and 10 years. This pattern of activity is inconsistent with an objective or purpose of acquiring the shares in order to provide liquid funds for the Insurance Division.
It may be accepted, as Hill J. found, that the appellant was the investment vehicle for the Insurances Division. But it does not necessarily follow that the investments made by the appellant were not made on a long-term basis. The evidence demonstrates that, in fact, the securities now in question were acquired with a view to their long-term capital growth.
The evidence also indicates that, insofar as liquid funds were required for the purposes of the insurance operations, they were found in sources other than the appellant's share portfolio. Reliance was placed, on behalf of the Commissioner, upon the circumstance that when, in April and September 1986, the appellant repaid AGC (Insurances) the sums of $1,000,000 and $9,000,000 respectively, the latter used these funds to acquire bank bills. Even if it be accepted, without finding, that these circumstances indicated a desire by AGC (Insurances) to obtain substantial funds in a liquid form at that time, it does not follow that the appellant's investment policy was not oriented towards long-term capital growth. With the possible exception of the correspondence in 1978 concerning the London Australia case, to which we now turn, the documentary and other evidence, taken as a whole, indicates that Westpac Management was instructed to achieve, and did achieve, the objective of long-term capital growth in the appellant's share portfolio.
The correspondence in 1978 concerning the London Australia decision
It will be recalled that, by its letter dated 26 January 1978, the appellant informed Westpac Management that the appellant was seeking advice as to the effect of the London Australia decision; and that, if the appellant were to be taxed accordingly, the appellant should ``exploit all forms of gain from our equity operation''. The letter added that, notwithstanding this, Westpac Management -
``should fully exploit the cyclical fluctuations in the share market by capitalising on market highs for sales and repurchasing at the bottom of any depressed period.''
On behalf of the Commissioner, much reliance is placed upon this passage to justify the inference, at the time of acquisition, of a purpose or intention on the part of the appellant, of profit-making by subsequent sale.
We have difficulty in accepting this submission. For one thing, the existence of such a purpose would be inconsistent with the well documented instructions to Westpac Management, before and after this letter and confirmed by the oral evidence, to acquire stocks with a view to long-term investment. For another, it will be recalled that the letter went on to explain the above passage as follows:
``The point we make is that if we sell any stock the reinvestment does not have to be made immediately unless the decision to sell was made with the intention of replacing the stock sold.''
When the letter is read as a whole, it appears that the appellant was not instructing Westpac Management to become a trader in shares; nor was it giving instructions that a system of ``switching'' securities in a regular organised and large scale fashion, as was done in London Australia, be embarked upon. Rather, against the background of the standing instructions to aim for capital growth in the long term, the appellant was making the point that if stocks were sold, it was not necessary to go into the market immediately to replace those stocks for their own sake; rather, regard should be had to ``cyclical fluctuations'' in deciding on what action to take and when to take it. These instructions are consistent with an objective of long-term capital growth.
In our opinion, when regard is had to the whole of the material in evidence, it should be concluded that the appellant has discharged the statutory onus of demonstrating, as a matter of proper inference from the facts, that at the time of acquisition, the shares in its portfolio were not acquired with an intention that they be realised subsequently at a profit. It must follow, in our view, that the surpluses realised in 1987 were on capital account.
We propose to allow the appeal.
THE COURT ORDERS:
1. Appeal allowed, with costs.
2. Order that the orders of Hill J. be set aside; in lieu thereof order (a) that the decision of the respondent disallowing the objection by the appellant to an assessment to income tax in respect of the year of income ended 30 September 1987 be set aside and that there be substituted a decision allowing the objection, so as to exclude from the amount of the taxable income assessed by the respondent the sum of $45,068,073 which was described in the adjustment sheet accompanying the notice of assessment as ``profit from sale of investments''; and (b) that the respondent pay the appellant's costs of the application at first instance.
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