Taxation Ruling

IT 2384 (as amended 12/2/87)

INCOME TAX : "PREPAID INTEREST" TAX AVOIDANCE SCHEME

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FOI status:

May be releasedFOI number: I 1210466

PREAMBLE

On 4 December 1986 the High Court of Australia (Mason, Deane and Dawson JJ) refused an application made on behalf of Gwynvill Properties Pty Ltd for special leave to appeal to the High Court from the majority decision of the Full Court of the Federal Court of Australia (Neaves and Jackson JJ; Fisher J dissenting) in FCT v. Gwynvill Properties Pty Ltd reported at 86 ATC 4512; 17 ATR 844. The principal question at issue before the Full Federal Court was whether amounts of $69,271 and $1,500,000 paid by way of interest in the year ended 30 June 1978 under a loan agreement were allowable deductions in terms of sub-section 51(1) of the Income Tax Assessment Act. The latter amount represented interest payable in advance for 5 years.

2. Subordinate issues involved the application of section 67 of the Act to the abovementioned interest outgoings; the operation of section 260 of the Act to disallow the deductions claimed; and the application of the doctrine of fiscal nullity to render null and void, for income tax purposes, the notice to pre-pay interest and the pre-payment of interest.

FACTS

3. The essential facts of the case were as follows:-

(a)

The taxpayer, one of a number of companies in the Franklin's supermarket group, borrowed $2.4M from Herunda Finance Corporation Pty Ltd on 3 February 1978 with interest payable quarterly in advance at 12.25% for the period to 1 May 1978 and thereafter to maturity at 12.5%. The loan was unsecured and repayable in 25 years. On the same day the following events took place -

(i)

the loan funds were paid into a separate account opened for that purpose;

(ii)

the whole sum was then withdrawn and invested in the short-term money market for a period of seven days; and

(iii)

the taxpayer paid to Herunda an amount of $69,271.23 being the interest payable in advance to 1 May.

(b)

On 6 February 1978 Herunda gave notice to the taxpayer, in exercise of an option under the loan agreement, that it must pre-pay five years interest amounting to $1.5M. The pre-payment was made on the same day from funds provided by the internal banker for the group, F.G. Finance Pty Ltd. On the same day Herunda assigned its benefits under the loan to Franklins Selfserve Pty Ltd for $916,729. The assignment was funded by F.G. Finances.

(c)

On 10 February 1978 the $2.4M was withdrawn from the money market and paid, indirectly, to the extent of $2,215,000 to F.G. Finances. Thus the flow of funds within the group may be represented as follows:-

		$	$
3 February	Loan paid in		2,400,000
3 February	1st payment of interest	69,271.23
6 February	Prepayment of interest	1,500,000.00
6 February	Purchase of assignment	916,729.00
		2,486,000.23	2,400,000

4. The taxpayer carried on a substantial business as property owner and developer for the group, deriving the bulk of its income from rents. It was primarily involved with projects associated with the group's stores and funds for its investments were provided by F.G. Finances.

5. It was stated in evidence during the hearing of the appeal in the Supreme Court of New South Wales that a change in investment policy towards real estate and away from the group's stores in late 1977 led to the purchase of a number of income producing properties for an amount in excess of $2,000,000. Funds were provided at that time by F.G. Finances. However, it was further stated that at about the same time a decision was taken to seek "outside" funds to finance the acquisitions. Allegedly it was to achieve this end that the taxpayer entered into the arrangements outlined at paragraph 3 above.

6. The Supreme Court of New South Wales, Hunt J was able to conclude that, on the facts of the case, the loan was obtained for the purpose of producing assessable income and that the prepayments bore the essential characteristic of interest payable on a loan, being necessarily incurred in carrying on the taxpayer's business in term of the second limb of sub-section 51(1) of the Act. His Honour rejected submissions put to the Court by counsel for the Commissioner concerning the application of section 260 and the doctorine of fiscal nullity. The decision is reported at 85 ATC 4046; 16 ATR 143.

7. The Commissioner appealed to the Full Federal Court from the above decision of the Supreme Court and the appeal was upheld by a majority of the Full Federal Court.

8. The essential issue before the Full Federal Court, as indeed was the case before the Supreme Court, was whether the interest outgoings were "necessarily incurred" in terms of the second limb of sub-section 51(1) of the Act in carrying on the taxpayer's business. In seeking to determine this issue all three judges of the Full Federal Court adopted the objective characterization test enunciated in Magna Alloys & Research Pty Ltd v F C of T 80 ATC 4542; 11 ATR 276.

9. In applying the Magna Alloys test both judges in the majority accepted the findings of primary fact made by the primary judge. They differed from him, however, as to the proper conclusions to be drawn from those facts. In so doing they had regard to a number of objective circumstances surrounding the actual borrowing and payments of interest and were unable to conclude that the transaction as a whole was explicable as being appropriate to achieve the espoused business end of providing an outside source of funds. "The outgoings appear reasonably capable only of being seen as an attempt to obtain a large tax deduction for the borrower ... at a net cost to the group of some $86,000 odd......."per Jackson J.

10. Fisher J. in dissent, accepted the finding of the primary judge as to the desirability of the loan as determinative of the deductibility of the interest when viewed objectively. "The payment of interest under this loan was, viewed objectively, capable of being seen as 'desirable or appropriate' in pursuit of the taxpayer's business ends. ' Moreover the trial judge found that Mr Carnell (a director of the taxpayer company) saw it as desirable and appropriate". His Honour followed the unanimous decision of the Full Court of the Federal Court in Oakey Abbatoir Pty Ltd v F.C. of T (1984) 55 ALR 291 in rejecting the application of the doctrine of fiscal nullity in the matter. He also considered himself bound by decisions of the Full Court of the Federal Court and the decision of the High Court in Cecil Brothers Pty Ltd v F.C. of T (1964) 111 CLR 430 to hold that section 260 of the Act could not be used to deny a deduction otherwise allowable under sub-section 51(1).

11. The Court did not consider whether section 67 of the Act entitled the taxpayer to a deduction in respect of the interest payments.

RULING

12. While the decision turns on its own particular facts, it is considered that the approach adopted by both Neaves and Jackson JJ in applying the Magna Alloys test to characterise outgoings falling within the second limb of sub-section 51(1) has wide application. The Court's regard to the circular flow of funds and resultant effect on the group as a whole is also very relevant in a tax avoidance context for many other cases currently before the Administrative Appeals Tribunal and Courts.

13. Action should now be taken to resolve all "pre-paid interest" scheme cases where taxpayers have sought to rely on the second limb of sub-section 51(1) to overcome the perceived limitations in the Federal Court decision in F.C. of T v Ilbery 81 ATC 4661; 12 ATR 563. Taxpayers should be encouraged to withdraw Court appeals and Administrative Appeals Tribunal references involving "prepaid interest" schemes.

COMMISSIONER OF TAXATION
22 January 1987

References

ATO references:
NO 82/5981P2

Date of effect:
Immediate

Subject References:
PREPAYMENT OF INTEREST

Legislative References:
51(1)
67
260

Case References:
FCT v. Gwynvill Properties Pty Ltd
86 ATC 4512
17 ATR 844

Magna Alloys & Research Pty Ltd v F C of T
80 ATC 4542
11 ATR 276
Oakey Abbatoir Pty Ltd v F.C. of T
55 ALR 291
Cecil Brothers Pty Ltd v F.C. of T
(1964) 111 CLR 430
F.C. of T v Ilbery
81 ATC 4661
12 ATR 563