CASE 1/99

Members:
AM Blow QC
AF Cunningham M

Tribunal:
Administrative Appeals Tribunal

Decision date: 5 February 1999

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AM Blow OAM, QC (Deputy President) and AF Cunningham (Member)

The applicant is appealing against a decision of the respondent to disallow an objection against a notice of amended assessment dated 3 March 1994 to include an amount $18,013.03 in the applicant's assessable income for the tax year ending 30 June 1991.

2. The dispute between the parties concerns a policy of life insurance which we will refer to as a ``PQ'' policy. The relevant insurance company issued a number of PQ policies over a short period during the tax year ending 30 June 1990. The PQ policy was a modification of an existing investment policy which included death cover, modified so that the death cover was reduced to zero. The reduction in death cover to zero resulted in a reduced premium. The maximum term of the policy was 35 years. The insurer did not require a policy holder to have an insurable interest in the life assured. After the payment of the second annual premium, a policy holder was able to borrow up to 92.5% of the cash value of the policy from the insurer. The policy could not be surrendered with any return to the policy holder until it had been in force for two years. If debts by way of loans taken out by a policy holder, plus accrued interest thereon, accumulated to an amount which exceeded the cash value of the policy, the policy would lapse. Such lapsing was referred to as ``journal surrender''.

3. As originally marketed, the policy had an ``accelerated surrender value''. This meant that on the day after each anniversary of the issue of the policy, the cash value attributed to the policy was increased to a value which it would not normally have had until the end of that new policy year.

4. When an agent sold a 35 year PQ policy on behalf of the insurer, and the premium was to be paid yearly, the insurer paid the agent commissions comprising 60% of the annual premium in respect of the first year, 20% of the annual premium in respect of the second year, and 12% of the annual premium in respect of each of the third, fourth and fifth years. However both the first and second years' commissions (totalling 80% of the amount of an annual premium) were paid by the insurer to the agent upon the issue of the policy. Subject to certain eligibility criteria, the insurer also paid bonuses to the agent. Such bonuses totalled 52% of the amount otherwise payable by way of commission.

5. The applicant purchased a 35 year PQ policy with a premium of $100,000 per annum. Provided the premium was payable annually, the agent who sold the policy was thus entitled upon the issue of the policy to $80,000 as the commissions for the first 2 years of the policy, and to a further 52% of $80,000 (i.e. $41,600) by way of bonuses in respect of the sale of the policy, making a total entitlement of $121,600.

6. At or about the time he signed the proposal for the policy, the applicant made an arrangement with the insurer's agent. It was agreed that the applicant would pay $8,833.50 of the annual premium from his own funds; that he would pay the balance of the annual premium at a later date; and that the agent would give him the amount of that balance, which of course was more than $30,000 less than the amount receivable by the agent by way of commission and bonuses. All such payments were subsequently made. The payment of the balance of the annual premium by the applicant had the effect of converting the policy into one for which the premium was payable annually. That change entitled the agent to receive immediately the whole of the commissions and bonuses totalling $121,600. Under the terms of the policy the applicant was thereafter able to finance the payment of the annual premiums by borrowing the required amounts from the insurer against the security of the cash value of the policy. The result was that, apart from the applicant's first premium payment of $8,833.50, the policy was in effect self-funding.

7. During the second year in which the PQ policies were in force, the insurer became concerned as to their potential cost to it. It decided to take action to get the PQ business off its books. It reduced the bonus rate on all PQ

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policies. It also wrote to all owners of PQ policies in Tasmania advising them that the projected surrender value of the policy at the 25 month mark was less than the surrender value at the 24 month mark, and that the third year's premium was due at that time. It also advised that if the policy holder was contemplating early cancellation of the policy, he or she would be better off if he or she did not pay the third premium. It specified the maximum amount the policy holder could borrow against the policy at that time, and the net amount payable to the policy holder after the payment of stamp duty. In the applicant's case, he was advised that the maximum amount he could borrow was $127,278, and that the net proceeds payable to him after stamp duty would be $126,842.53. It made an ``express service'' offer, to the effect that it would make available to the policy holder a cheque for the net loan value on the same day that the second annual premium was paid. It advised that if the policy holder chose to take the maximum loan available on the policy, and did not pay any interest which accrued on the loan, the policy would lapse in few months' time.

8. On 20 February 1991 the applicant paid the second annual premium of $100.000, borrowed the maximum loan available under the policy, and received a cheque for $126,842.53 from the insurer, representing the proceeds of that loan after the deduction of stamp duty. The applicant did not make any payments of interest or principal in respect of the loan. On 17 September 1991 the amount owing in respect of the loan and interest reached the cash value of the policy, which lapsed. That is to say, there was a ``journal surrender''. The applicant has not subsequently made any payment to the insurer by way of principal or interest in respect of the loan, nor has he been called upon to do so. The applicant received a net gain of $26,842.53 as a result of the transactions of 20 February 1991. After deducting his initial payment of $8,833.50, it is clear that the transactions relating to the policy have resulted to a net return to him of $18,009.03 (not $18,013.03 as originally calculated). The Commissioner contends that this gain constitutes assessable income. The applicant contends that it does not.

9. At all material times the applicant carried on business as a real estate agent. The life assured under his PQ policy was that of his daughter, a young child. The purchase of the policy was not a transaction in the ordinary course of the applicant's business as a real estate agent. He gave evidence, which we accept, that he had in mind when purchasing the policy that he would use it to fund his daughter's tertiary education. We infer that he contemplated surrendering the policy. Mr. Loader, who appeared for the respondent, made a submission to the effect that the greatest benefit obtainable under the policy could be obtained by surrender or lapse long before the daughter was due to complete her secondary education; that the applicant, as an experienced businessman, must have realised this; and that we should not accept that he intended to retain the policy for as long as he suggested that he intended to. We reject that submission. We accept evidence that was given by the applicant to the effect that he did not undertake calculations as to the benefits that could be obtained as a result of the surrender or lapsing of the policy at future dates because he was not sufficiently interested in obtaining such information.

10. The relevant legislative provision contained in the Income Tax Assessment Act 1936 (``the Act'') is as follows:-

``25(1) The assessable income of a taxpayer shall include-

• (a) where the taxpayer is a resident-
• the gross income derived directly or indirectly from all sources whether in or out of Australia; and
• (b)...

which is not exempt income, an amount to which section 26AC or 26AD applies or an eligible termination payment within the meaning of Subdivision AA.''

The critical question for us is whether the applicant's gain of $18,009.03 was ``income'' within the meaning of s. 25(1)(a). None of the exceptions referred to are relevant.

11. The gain that the applicant made as a result of his purchase of the PQ policy, the loan on the security of that policy, and the subsequent lapsing of the policy arose from an isolated series of commercial transactions outside the ordinary course of his business. In
FC of T v Myer Emporium Ltd 87 ATC 4363 at 4367; (1987) 163 CLR 199 at 211 the High Court laid down the following proposition:

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``... a receipt may constitute income, if it arises from an isolated business operation or commercial transaction entered into otherwise than in the ordinary course of the carrying on of the taxpayer's business, so long as the taxpayer entered into the transaction with the intention or purpose of making a relevant profit or gain from the transaction.''

12. The High Court derived that proposition from two cases. The first was
Californian Copper Syndicate v Harris (1904) 5 T.C. 159. In that case the copper syndicate bought a mining property, not for the purpose of deriving an income from mining operations thereon, but for the purpose of reselling it at a profit. Although the transaction was an isolated one, the profit on re-sale was held to be income. The Lord Justice-Clerk, (the Right Honourable J.H.A. Macdonald) drew a distinction between a realisation or change of investment and ``an act done in what is truly the carrying on, or carrying out of a business''.

13. The second case was
Ducker v Rees Roturbo Development Syndicate [1928] AC 132. That case concerned a company whose main business was the grant of manufacturing licences, but which acquired and sold foreign patents in connection with the same invention that was the subject of the manufacturing licences. The House of Lords held that its receipts from the sale of the patents constituted income.

14. In Myer Emporium the taxpayer was a company that lent $80 million to an associated company for a period of 7 years at interest. Three days after making the loan, by previous arrangement, it assigned to an unassociated financier the right to receive the interest payments. The financier paid a consideration of $45.37 million representing the value of the right to receive the interest payments. The High Court held that the consideration of $45.37 million constituted assessable income in the year of its receipt under s. 25(1)(a) of the Act. Although the assignor was the holding company of a group which carried on business mainly in the areas of retail trading and property development, and the relevant payment arose from an isolated transaction entered into otherwise than in the ordinary course of the carrying out of its business, that transaction was entered into with the intention or purpose of making a profit or gain by receiving the consideration for the assignment.

15. In Myer Emporium (at ATC 4367; CLR 210) the High Court, speaking of the situation where a taxpayer engaged in business makes a profit or gain as the result of an isolated venture or ``one-off'' transaction outside the ordinary course of that business, said this:

``... The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit.''

16. The Full Court of the Federal Court of Australia followed Myer Emporium, and applied it in a taxpayer's favour, in
Westfield Limited v FC of T 91 ATC 4234; (1991) 28 FCR 333. In that case, the business activity of the taxpayer involved the design and construction of shopping centres, their leasing and management. It carried out such activities on its own land, on the land of others, and on joint venture land. It purchased some land which by itself was unsuitable for development as a shopping centre, but which could have been used for a shopping centre development in combination with adjacent land, not owned by the taxpayer. The taxpayer's purpose in purchasing the land was to keep out a competitor, and if possible to participate in the development of a shopping centre on that land and adjacent land, as owner of the purchased land. It did not purchase the land with the intention of reselling it. Eventually it sold the purchased land to the owner of the adjacent land, and entered into contracts with that purchaser for the design and construction of a shopping centre. It made a profit on the sale. The Full Court held that the profit did not constitute assessable income. The principal judgment was that of Hill J, with whose reasons the other members of the Court (Lockhart and Gummow JJ) agreed. The essential reasons for the Full Court's conclusion appear in the following passages in the judgment of Hill J (at ATC 4243; FCR 343-345):-

• ``Once it is clear that the activity of buying and selling, which generated the profit, was not an activity in the ordinary course of business, or, for that matter, an ordinary incident of some other business activity, the profit in question will only form part of the

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  assessable income of the appellant, by virtue of its being income in accordance with the ordinary concepts of mankind, if the appellant had a purpose of profit-making at the time of acquisition. What is meant by `profit-making' in this context?
• Sheppard J [the judge at first instance] was of the opinion that there was, in the relevant sense, an overall scheme of `profit-making'. The scheme of profit-making was said to be a scheme to achieve participation in the development of a shopping centre. However, in my opinion, that is not enough in the circumstances of this case. First, the obtaining of the contract to construct and manage the centre is not, of itself, relevantly a scheme of profit-making, it is a scheme for deriving assessable income, which income is derived from the performance of the work under the building and management contracts. Second, where a transaction falls outside the ordinary scope of the business, so as not to be part of that business, there must exist, in my opinion, a purpose of profit-making by the very means by which the profit was in fact made. So much is implicit in the decision of the High Court in Myer....
• ...
• While a profit-making scheme may lack specificity of detail, the mode of achieving that profit must be one contemplated by the taxpayer as at least one of the alternatives by which the profit could be realised.... But, even if that goes too far, it is difficult to conceive of a case where a taxpayer would be said to have made a profit from the carrying on, or carrying out, of a profit- making scheme, where, in the case of a scheme involving the acquisition and resale of land, there was, at the time of acquisition, no purpose of resale of land, but only the possibility (present, one may observe, in the case of every acquisition of land) that the land may be resold. The same may be said to be the case where s. 25(1) of the Act is involved. As the court observed in Myer, in the passage already set out, the property which generates the gain, must be acquired in an operation of business or commercial transaction:
  • `for the purpose of profit-making by the means giving rise to the profit.''' (emphasis added)

17. Mr. Loader submitted on behalf of the respondent that what Hill J said in the passages we have quoted was obiter, the views of only one judge, and wrong. He relied on a commentary in relation to His Honour's judgment in Taxation Ruling TR92/3 at paragraphs 51-58 which made those assertions. But those assertions are all wrong. What His Honour said was not obiter: the taxpayer succeeded in that case for the very reason that, whilst it acquired the relevant land for the purposes of profit-making, it did not then have a purpose of profit-making by the means that ultimately gave rise to the profit. In Westfield (at ATC 4235; FCR 334), Lockhart J and Gummow J each specifically agreed not only with the orders proposed by Hill J, but also with His Honour's reasons. What His Honour said is consistent with the passage we have quoted from Myer Emporium in paragraph 15 above, and must therefore be taken to represent the law in this country. The relevant paragraphs in Taxation Ruling TR92/3 are wrong and should be rewritten.

18. It was submitted on behalf of the respondent that a profit or gain still constitutes assessable income even if it is derived by a taxpayer by a means not contemplated by that taxpayer when entering into the transaction. We were referred to
Hobart Bridge Co Ltd (In Vol Liq) v FC of T (1951) 9 ATD 273; (1951) 82 CLR 372, but that case runs counter to the proposition for which it was cited as authority. It concerned a company formed for the purpose of constructing a bridge, which formed a subsidiary company for the purpose of dealing in nearby land whose value was likely to be enhanced by the existence of the bridge. By legislation the State of Tasmania acquired the whole undertaking of the taxpayer company, including its shares in the subsidiary, for which it received compensation. It received a profit in respect of its shares in the subsidiary, but Kitto J who heard the case as a single judge, held that that profit did not constitute assessable income because, although the shares in the subsidiary had been acquired with a view to profit, the taxpayer had not contemplated profiting as a result of the realisation of those shares, but had only contemplated holding them as a capital asset for the production of dividends. His Honour took the view that there was no reason to draw any distinction between the sale of the shares and their compulsory acquisition.

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19. We were also referred to
Moana Sand Pty Ltd v FC of T 88 ATC 4897, a decision of the Full Court of the Federal Court of Australia. In that case the taxpayer company acquired some land in 1958 for the purpose of carrying on the business of working and/or selling the sand thereon. In 1979 the land was resumed by the Coastal Protection Board, which subsequently paid the taxpayer the value of the land and certain expenses. However findings of fact had been made that the land was acquired not only for the purpose of working and/or selling the sand, but also for the purpose of holding it until some future time when it became appropriate to sell it, though the former purpose was the dominant purpose. In consequence of the finding that the sale of the property was one of the purposes for which it was acquired, the Full Court held that the profit resulting from its resumption was income within the meaning of s. 25. The Full Court did not refer to the Hobart Bridge case in reaching its conclusion as to s. 25, though it did consider it in relation to s.26(a). In the light of the view taken by Kitto J in Hobart Bridge that no distinction should be drawn between a sale and a compulsory acquisition, we see Moana Sand as a case in which the taxpayer received a profit or gain by a means contemplated when entering into the transaction, i.e. the purchase of the land. It is not authority for the proposition that a profit or gain constitutes assessable income even if it is derived by the taxpayer by a means not contemplated by that taxpayer when entering into the transaction.

20. Mr. Loader submitted that we should follow Case 41/97,
97 ATC 437, a decision of Deputy President McDonald in which the facts were very similar to those of this case. The taxpayer was a schoolteacher who purchased an insurance policy and obtained a gain by obtaining a loan, making no payments, and allowing the policy to lapse. At 444, para. 25, Deputy President McDonald distinguished Westfield, saying this:

``... The factual situation in Myer and subsequent interpretations arising from it in cases such as Westfield Ltd v FC of T 91 ATC 4234 and
FC of T v Cooling 90 ATC 4472 are clearly distinguishable from the circumstances of the instant case where the taxpayer is not engaged in any type of business.''

21. That case may well be authority for the proposition that Westfield can be distinguished when a taxpayer is not engaged in any type of business, but in this case the taxpayer was engaged in a business. In our view nothing was said in Case 41/97 that provides any basis for us distinguishing this case from Westfield.

22. We were also referred to
Steinberg v FC of T 75 ATC 4221; (1975) 134 CLR 640. However that case primarily concerned s. 26(a) of the Act, which provided that the assessable income of a taxpayer included ``profit arising from the sale by the taxpayer of any property acquired by him for the purpose of profit- making by sale, or from the carrying on or carrying out of any profit-making undertaking or scheme''. The case is therefore of limited use to us in determining whether the applicant's gain of $18,009.03 constitutes income. It is not authority for a general proposition that a profit or gain will always constitute assessable income regardless of whether the means by which it was derived were contemplated by the taxpayer when entering into the original transaction. However, as Hill J pointed out in Westfield at ATC 4242-4243; FCR 344, it illustrates that there can be cases in which taxpayers acquire assets with a view to profit without determining or limiting the means they might adopt to generate that profit. In that situation there is no scope for the application of the principle that the income will only be taxable if there was a purpose of profit-making by the very means by which the profit was in fact made. In Steinberg three judges, admittedly speaking in the context of s. 26(a) case, took the view that a profit would be taxable in that situation: Mason J at 73 ATC 4047; 134 CLR 670, Gibbs J at 75 ATC 4234; 134 CLR 699-700, and Stephen J at 75 ATC 4237; 134 CLR 704-705. In Westfield at ATC 4242-4243; FCR 344, Hill J derived from those passages the proposition that a profit may be taxable in that situation - where at the time of acquisition the taxpayer did not have a purpose of profit-making by the very means by which the profit was fact made, nor by any other specific means. For the purposes of this decision, we will assume that a profit made in such circumstances constitutes assessable income.

23. We therefore need to consider what intention, if any, the applicant had when he acquired the PQ policy. If his purpose was simply to profit from the policy, and he had no

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intentions as to how he would do that, the profit constitutes assessable income. If he proposed to profit by obtaining a loan, allowing the policy to lapse, and thus benefiting from the loan debt being extinguished, his gain constitutes assessable income. If his purpose in acquiring the policy was to make a profit by that means or in one or more other specific ways, with a final choice to made at a later date, his gain constitutes assessable income. But if he had in mind making a profit or gain in one or more specific ways other than by obtaining a loan, making no payments, and having the policy lapse, then the gain that he made as a result of that sequence of events does not constitute assessable income.

24. As we have said, we accept that the applicant had in mind when purchasing the policy that he would use it to fund his daughter's tertiary education when she reached that stage of her life. Little was said as to what means, if any, he proposed to use to take advantage of the policy. Although the applicant gave evidence, he was not asked whether he understood that, when a loan is obtained upon the security of a life policy, the policy will eventually lapse if the policy holder makes no interest payments. We expect he had sufficient commercial experience to know that. But policies normally lapse as a result of loan interest not being paid only as the result of inadvertence or impecuniosity. It is most extraordinary for a policy holder to allow a policy to lapse as a result of non-payment of interest as part of a profit-making scheme. There is no suggestion that deliberately causing the policy to lapse was discussed with the applicant, or considered by him, at the time of his purchase of the policy or at any time prior to its purchase. Rather, that course appears to have been contemplated for the first time as a result of the letter that the insurer wrote to the applicant and all other owners of PQ policies. We are therefore satisfied that, at the time of the purchase of his policy, the applicant had no intention of making a profit by obtaining a loan on the security of the policy and then allowing the policy to lapse. He did not intend those events to occur when a need arose for funds for his daughter's tertiary education, let alone in 1991.

25. The applicant was asked in his evidence in chief about how long he originally intended to keep the policy. He said that no particular date was mentioned, but that he was advised that five years would be ``a good time to focus on''. He said that was not really his intention. He said a number of times that he wanted to take advantage of the policy when his daughter reached the age when she might want to go to University. We infer that the method by which he contemplated taking advantage of the policy at that time was the surrender of the policy. The applicant clearly had sufficient commercial experience to know that, after a time, life policies can be surrendered and a cash payment received. During his cross-examination he said, ``I understood you could not cash a policy in at the beginning of a term, you had to wait until the end of the term...''. However we do not think that passage accurately reflects the understanding that he had when he took out the policy given his early evidence as how long he proposed ``keep the policy'' and a statement during his cross-examination that ``All I had to do is organise my premium every year and at the time that I required the money it would be available to me''.

26. Thus this was not a situation where a taxpayer intended to make a profit and had no intention as to the means by which the profit would be made. It is a case in which he had a specific intention to make a profit by means other than the means by which he eventually achieved a return on his original investment. On the basis of Westfield, it would follow that the return of $18,009.03 does not constitute assessable income.

27. For these reasons we have decided to set aside the decision under review and to remit the matter to the respondent for reconsideration in accordance with a direction that the applicant's benefit or gain resulting from the lapsing of his insurance policy did not constitute assessable income.