HART & ANOR v FC of T

Judges:
Gyles J

Court:
Federal Court

MEDIA NEUTRAL CITATION: [2001] FCA 1547

Judgment date: 2 November 2001

Gyles J

Introduction

1. These are appeals pursuant to Pt IVC of the Taxation Administration Act 1953 (Cth) against certain objection decisions by the respondent Commissioner of Taxation. They are by way of test cases. There are two issues. The first is the deductibility of certain interest pursuant to s 51 of the Income Tax Assessment Act 1936 (Cth) (``the ITAA 1936'') and s 8-1 of the Income Tax Assessment Act 1997 (Cth) (``the ITAA 1997''). The second is whether Pt IVA of the ITAA 1936 has been properly invoked.

Short facts

2. Richard Meralles Hart and Trudy Amanda Hart (``the applicants'') were the owners of a property at 5/103 Bicentennial Drive, Jerrabomberra, in the Australian Capital Territory (``the ACT'') (``the Jerrabomberra property''). The purchase of the Jerrabomberra property was financed in substantial part by a borrowing from the ANZ Banking Group Limited (``ANZ''). The applicants resided at the Jerrabomberra property up until about 8 October 1996, when they acquired a property at 4 Aland Place, Fadden, in the ACT (``the Fadden property''), which they used thereafter as their residence. The applicants then used the Jerrabomberra property for the purpose of deriving rental income.

3. In order to acquire the Fadden property, borrowed funds were arranged by Austral Mortgage Corporation Pty Ltd (``Austral''). Austral marketed a facility called the ``Wealth Optimiser Loan'', a loan specifically designed for persons wishing to finance the acquisition of an income-producing asset and a private residence. The features of the loan facility offered included:

(a) The provision for one loan only to be made. The principal amount under the loan was the total of the amounts required to finance the acquisition of the two types of assets. The interest payable over the term of the loan was calculated on the lump sum principal amount. Only one monthly repayment need be made.
(b) The option to split the loan into two portions or loan accounts - respectively, a ``home loan'' account and an ``investment loan'' account.
(c) The option, at the call of the borrower, to allocate the monthly repayment to either the home loan account or the investment loan account, or to both. If allocated wholly to the home loan account, interest on the investment loan account continues to accrue and is capitalised monthly. As no portion of the repayments is allocated initially to the investment loan account, the amount outstanding on that portion of the loan does not begin to reduce until the home loan account is fully paid off. As a result, the borrower pays off the home loan account much faster and the total amount of interest paid on home loan account is less than would have been the case if the borrower had applied the payments to both loan accounts. Correspondingly, the investment loan account takes longer to pay off. As all the interest is accrued on the investment loan account and there is no repayment on

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account of principal, the interest on that loan account is greater than would have been the case if the borrower had applied the payments to both loan accounts as there is no reduction of the principal sum on the investment loan account. The difference is described by the respondent as ``further interest''. The borrower claims as a deduction the interest accruing on the investment loan account. As that interest is not paid at the time that it accrues, interest becomes payable on the capitalised interest (``compound interest'' or ``additional interest'').

4. Pursuant to arrangements with Austral, on 8 October 1996, the applicants (with Mrs Hart's mother, Emma Rose Aldin, as third party mortgagor), borrowed $298,000 (``the loan amount'') from Permanent Custodian Limited (``PCL''), for a period of 25 years on the following terms:

(a) The loan was a variable rate principal and interest loan;
(b) At the request of the applicants, the loan amount was split between two accounts, styled ``Loan Account 1'' and ``Loan Account 2'', and applied in the following manner:
- (i) As to the sum of $202,888 to Loan Account 1: to the acquisition of the Fadden property and the repayment of moneys owed by Mrs Aldin to St George Bank; and
- (ii) As to the sum of $95,112 to Loan Account 2: to the repayment of moneys owed to ANZ by the applicants on the Jerrabomberra property;
(c) Interest, calculated on the daily loan balance (being the aggregate balance of Loan Account 1 and Loan Account 2) outstanding at any time, was payable monthly in arrears and debited to Loan Account 1 and Loan Account 2 according to the balance outstanding in respect of the relevant loan account; and
(d) At the request of the applicants, all payments of principal and interest were to be applied in reduction of Loan Account 1 until the repayment in full of that loan account while interest in respect of Loan Account 2 was to be capitalised.
(e) Repayments were set at $2,533, payable monthly in arrears, based on the current interest rate applied to the loan amount over the period of the loan of 25 years and was subject to adjustment if the interest rate changed.

5. Repayment of the loan (on both accounts) was secured by registered first mortgages over the Jerrabomberra and Fadden properties and a property owned by Mrs Aldin.

6. In the income years ended 30 June 1997 and 30 June 1998 (respectively, ``1997'' and ``1998'' or, together, ``the relevant years of income''), as the applicants had elected to allocate the whole of their monthly repayments to the home loan account and repaid amounts of principal and interest to PCL in reduction of Loan Account 1, interest unpaid on Loan Account 2 was capitalised and compound interest was debited to Loan Account 2. In the relevant years of income, the total amount of interest which accrued but remained unpaid in respect of Loan Account 2, was $5,488 for 1997 and $7,385 for 1998. These amounts included compound interest of $134 for 1997 and $630 for 1998.

7. In their respective tax returns for the relevant years of income, the applicants each claimed a deduction of $2,677 (for 1997) and $3,305 (for 1998), being one half of the interest accruing but unpaid on Loan Account 2 but not including compound interest. The latter figure of $3,305 was approximated and under- estimated. A more accurate calculation would have yielded the sum of $3,377.

8. On 27 March 1999, Trudy Hart lodged objections in respect of the relevant years of income, claiming additional deductions of $67 (for 1997) and $336 (for 1998), being one half of the compound interest which accrued in respect of Loan Account 2. Richard Hart lodged the same objections on 2 April 1999.

9. On 22 October 1999, the respondent determined, pursuant to the provisions of s 177F of the ITAA 1936, that the compound interest was not allowable to the applicants as deductions in the relevant years of income. Additionally, on 3 November 1999, the Commissioner issued to each of the applicants a notice of amended assessment, increasing the applicants' taxable income for 1997 by the sum of $29.

10. On 16 December 1999, Richard Hart lodged an objection against the 1997 income year amended assessment, claiming a further

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deduction of $29, and an amended objection against the 1998 income year original assessment, now claiming a deduction of $387 for 1998. Trudy Hart lodged the same objections 18 December 1999. These objections were made as a result of an invitation of the respondent.

11. On 7 February 2000 the respondent made objection decisions in respect of each of the applicants' objections. The objection in respect of 1998 was allowed to each in part by allowing a further deduction of $22 (reducing $387 to $365) to reflect the difference between the respondent's view that the applicants' claim should be limited to $3,327 (and not $3,692, as the applicants were claiming) and the amount the applicants had under-claimed in their 1998 tax returns at $3,305. The other objections were disallowed, such that neither the compound (or additional) interest, nor the further interest, was allowable to either of the applicants as a deduction in the relevant years of income.

Issues

12. The first issue is whether the further and additional interest incurred by the applicants is an allowable deduction under s 51(1) of the ITAA 1936 for 1997 and under s 8-1 of the ITAA 1997 for 1998. I If so, the second issue is whether the respondent was authorised to make determinations under s 177F(1) of the ITAA 1936 in respect of the relevant years of income cancelling tax benefits alleged to have been obtained by each of the applicants in connection with a scheme to which it is alleged Pt IVA of the ITAA 1936 applies.

Issue 1 - Deductibility

13. Section 51(1) of the ITAA 1936 provided as follows:

``51(1) [Deductions for losses and outgoings] All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.''

14. Section 8-1(1) and (2) of the ITAA 1997 are as follows:

``8-1 General deductions

(1) You can deduct from your assessable income any loss or outgoing to the extent that:

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

(c) it is incurred in relation to gaining or producing your exempt income; or

(d) a provision of this Act prevents you from deducting it.''

Submissions

15. The contention for the respondent, having referred to general principles to be deduced from
Ronpibon Tin NL & Tongkah Compound NL v FC of T (1949) 8 ATD 431; (1949) 78 CLR 47,
Fletcher & Ors v FC of T 91 ATC 4950; (1991) 173 CLR 1 (``Fletcher'') and
Ure v FC of T 81 ATC 4100; (1981) 50 FLR 219; 34 ALR 237 (``Ure''), is that the question to be asked is whether the incurring of the additional interest and further interest is incidental and relevant to the gaining of assessable income by way of rental from the investment property, and in this case should be answered ``no''.

16. It was submitted for the respondent that the borrowed funds have been used for two separate and discrete purposes, the first being the refinancing of the investment property and the second being the acquisition of the residential property. The funds have not been used solely for the purpose of gaining assessable income. They were used in part only for that purpose. The liability to pay the additional interest and the further interest is the direct consequence of the allocation of the repayments to the home loan portion. The advantage obtained by the applicants from the capitalisation of the interest on the investment loan portion is the reduction by an equivalent sum of the principal amount outstanding on the home loan portion. Properly characterised, the additional interest and the further interest is not

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``incidental and relevant'' to the production of assessable income from the investment property. The incurring of the additional interest and the further interest can be explained only by reference to the direct object of reducing the balance on the home loan portion of the loan in priority to that of the investment loan portion. It is submitted that the characterisation of the additional interest and the further interest cannot properly be effected by reference to the fact alone that such interest accrued in respect of the investment loan portion. It is submitted that there is more than one object of the incurring of the interest in respect of the investment loan portion and that that part of the interest payable on the (capitalised and unpaid) interest payable on the investment loan portion is incurred otherwise than for the purpose of deriving income from the investment property. It is incurred to enable part repayment to be made of the home loan portion. While the further interest is incurred on the investment loan portion, it is only incurred to enable greater repayments to be made on the home loan portion than otherwise would be possible. Accordingly, neither the additional interest nor the further interest is deductible, as they are not incurred in the course of gaining or producing the assessable income. Alternatively, the additional interest and the further interest are of a private character. Accordingly, it is necessary to apportion the interest in respect of the investment loan portion by dissecting out additional interest and the further interest from what can properly be regarded as incurred in gaining or producing assessable income and not as being of a private or domestic nature. The additional interest and the further interest should be excluded as a non-deductible outgoing.

17. The submissions for the applicants commenced by pointing out that interest on Loan Account 1 (the home loan) was not a deduction and was never claimed and that, with respect to Loan Account 2 (the investment loan), the Commissioner conceded that the simple interest was an allowable deduction in each year excepting the further interest.

18. It was submitted for the applicants that, like the interest in
Firth v FC of T 2001 ATC 4615 at 4619 [21]; [2001] FCA 1300 at [21] (``Firth''), this is a case in which the interest, both simple and compound, is properly characterised as interest: namely, a return, consideration or compensation for the use or retention by one person of another's money. Interest is, ordinarily, a recurrent or periodic payment that secures the use of the borrowed money during the term of the loan. It is proper to regard the interest as a revenue item. The character is not altered by reason of the fact that the borrowed funds are used to purchase a capital asset (see
Steele v DFC of T 99 ATC 4242 at 4248-4249; (1999) 197 CLR 459 at 470 (``Steele'') citing
Australian National Hotels Limited v FC of T 88 ATC 4627 at 4632-4633; (1988) 19 FCR 234 at 239-241). If a taxpayer incurs a recurrent liability for interest for the purpose of furthering his present or prospective income-producing activities, generally the payment by him of that interest will be an allowable deduction (see Firth at ATC 4618 [ 18]; FCA [18], applying
FC of T v Total Holdings (Australia) Pty Ltd 79 ATC 4279 at 4283; (1979) 24 ALR 401 at 406, (1979) 43 FLR 217 at 224).

19. It was submitted that the respondent's contention that the compound interest outgoings were incurred not to gain assessable income but to achieve a reduction in the balance of, and the non-deductible interest in respect of, the home loan, being Loan Account 1, wrongly substitutes a motive or purpose test for the correct test in this case in determining whether expenditure is incurred in gaining or producing assessable income, namely, whether there is a relevant connection between the advantage sought by the making of the expenditure and the taxpayer's income-earning undertaking or business (Brennan J in
Magna Alloys & Research Pty Ltd v FC of T 80 ATC 4542 at 4548; (1980) 49 FLR 183 at 191, Sackville J in
NMRSB Limited & Ors v FC of T 98 ATC 4188 at 4204-4205; (1998) 81 FCR 378 at 399). Purpose is relevant where the expenditure is voluntary. It was submitted that this is not a case involving voluntary payments: the applicants were legally obliged under contract to pay the compound interest if they did not pay interest on Loan Account 2. The contract obliged the applicants to appropriate all payments to the home loan once they made the election. The contractual obligation to make payments meant that they were not voluntary. Therefore, Ure and Fletcher are not relevant because those cases dealt with outgoings which were voluntarily incurred (and not made pursuant to any legally binding contract). It was

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submitted for the applicants that the only advantage sought and obtained by them in respect of the compound interest outgoings was the same as that sought and obtained by them in respect of the simple interest outgoings, namely, the continued use and retention of the loan funds they had applied in retaining the Jerrabomberra property as an income producing property. As it is conceded by the respondent that the latter outgoings had a relevant connection between the advantage sought by the making of the expenditure and the applicants' income-earning undertaking and was deductible, the applicants submit that the same applies to the compound interest outgoing.

20. It was submitted that the capitalisation of interest on the investment account does not work any reduction in the principal amount outstanding on the home loan account. What actually works that reduction is the non- deductible payments made by the applicants which they and the lender are contractually obliged to apply in the reduction of the home loan account. Indeed, the capitalisation of interest on the investment account works no advantage to the applicants but rather contractually obliges them to bear compound interest. The compound interest is the cost incurred by the applicants for having the continued use of the funds used to refinance the Jerrabomberra property. Thus there is clearly a relevant connection between the compound interest and the Jerrabomberra property for the purposes of the Act, as there is between the capitalised interest and that property.

Decision

21. None of the authorities cited by counsel are particularly instructive as to resolution of the present problem. Thus, the argument has effectively been assertion against assertion said to be based upon general principles. Indeed, counsel were not able to refer me to any case in which payment of interest upon capitalised interest has been considered from a taxation point of view.

22. If, as a matter of principle, for taxation purposes, interest upon capitalised interest bears the character of the simple interest which has been capitalised, then it follows that the applicants should succeed, as it is accepted that simple interest on Loan Account 2 is deductible. It is not self-evident that this must always be so. There is ordinarily a choice as to whether to pay simple interest as it falls due. Put another way, the incurring of compound interest depends upon a decision not to pay simple interest as it falls due. Sometimes such a decision will be compelled by impecuniosity. That case can be left aside. Take a case where a private individual has the means to pay simple interest as it falls due on an investment loan, but chooses to purchase an object of art instead. It is not clear beyond argument that interest upon interest would be deductible as being incurred for the purpose of gaining or producing assessable income in those circumstances (cf Steele at ATC 4248-4249; CLR 470-471).

23. However, in the present case, the contractual arrangements did not contemplate such a choice. Once the initial election occurred, all amounts paid by the applicants on account of the loan were to be applied in reduction of interest and principal of Loan Account 1. It followed that until such time as the principal amount allocated to Loan Account 1 was repaid, interest accruing on Loan Account 2 would, of necessity, be capitalised and would be charged upon the whole principal sum allocated to Loan Account 2.

24. The following passage from the judgment of the High Court in Fletcher (at ATC 4957-4958; CLR 18-19) is a helpful analysis for present purposes:

``... it is commonly possible to characterise an outgoing as being wholly of the kind referred to in the first limb of s 51(1) without any need to refer to the taxpayer's subjective thought processes. That is ordinarily so in a case where the outgoing gives rise to the receipt of a larger amount of assessable income. In such a case, the characterisation of the particular outgoing as wholly of a kind referred to in s 51(1) will ordinarily not be affected by considerations of the taxpayer's subjective motivation. If, for example, a particular item of assessable income can be earned by making a lesser outgoing in one of two possible ways, one of which is a loss or outgoing of the kind described in s 51(1) and the other of which is not, it will ordinarily be irrelevant that the taxpayer's choice of the method which was tax deductible was motivated by taxation considerations or that the non-deductible outgoing would have been less than the deductible one. In such a case, the objective relationship between the outgoing actually

ATC 4715
made and the greater amount of assessable income actually earned suffices, without more, to characterise the whole outgoing as one which was incurred in gaining or producing assessable income. If the outgoing can properly be wholly so characterised, it `is not for the Court or the commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent'.

The position may, however, well be different in a case where no relevant assessable income can be identified or where the relevant assessable income is less than the amount of the outgoing. Even in a case where some assessable income is derived as a result of the outgoing, the disproportion between the detriment of the outgoing and the benefit of the income may give rise to a need to resolve the problem of characterisation of the outgoing for the purposes of the sub-section by a weighing of the various aspects of the whole set of circumstances, including direct and indirect objects and advantages which the taxpayer sought in making the outgoing. Where that is so, it is a `commonsense' or `practical' weighing of all the factors which must provide the ultimate answer. If, upon consideration of all those factors, it appears that, notwithstanding the disproportion between outgoing and income, the whole outgoing is properly to be characterised as genuinely and not colourably incurred in gaining or producing assessable income, the entire outgoing will fall within the first limb of s 51(1) unless it is either somehow excluded by the exception of `outgoings of capital, or of a capital, private or domestic nature' or `incurred in relation to the gaining or production of exempt income'. If, however, that consideration reveals that the disproportion between outgoing and relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective and that part only of the outgoing can be characterised by reference to the actual or expected production of assessable income, apportionment of the outgoing between the pursuit of assessable income and the pursuit of that other objective will be necessary.''

25. In my opinion, the interest upon capitalised interest does bear the same character for taxation purposes as the interest which was capitalised in the present circumstances. The payment of interest secures the use of borrowed money during the term of the loan. To the extent that the outgoings of interest incurred can be properly characterised as of a kind referred to in the first limb of s 51(1), they must draw their character from the use of the borrowed funds (see Fletcher at ATC 4958; CLR 19). Here, there is no issue as to that, as the funds were used to maintain an income earning asset. The capitalisation of interest was a feature of the contractual arrangement which cannot be severed. The same can be said of the failure to reduce the principal on Loan Account 2 in the first years. This meant that, in truth, the rate of interest on that part of the loan apportioned to Loan Account 2 was much higher than the rate of interest on that part of the loan apportioned to Loan Account 1. It may well be that the true rate of interest would be well in excess of market rates. This was not explored. This interest differential in itself is not a reason to deny deductibility. It was actually incurred in each year. That liability has no extraneous or collateral aspect.

26. In the present case, it may well be that in the future the compound interest on Loan Account 2 will exceed the assessable income earned from the property. However, that does not detract from the character of the payment as interest with a sufficient link to assessable income unless the contractual provisions are ignored. This cannot be done. There is no claim of sham or nullity. Despite a certain air of unreality about the transaction, the relevant payments of interest (both additional and further) were deductible pursuant to s 51(1) of the ITAA 1936 and s 8-1 of the ITAA 1997 respectively by each applicant.

Issue 2 - Scheme to obtain tax benefit - Part IVA

27. The second issue involves the following questions, in particular, whether:

(a) A ``scheme'' within the meaning of section 177A(1) of the ITAA 1936 was entered into or carried out;
(b) The applicants, in connection with any such scheme, obtained a ``tax benefit'' within the meaning of s 177C(1) of the ITAA 1936; and
(c) It would be concluded, on the basis of the matters referred to in s 177D(b) of the

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ITAA 1936, that one or more of the persons who entered into or carried out the scheme or any part of the scheme did so for the dominant purpose of enabling the applicants to obtain that tax benefit in connection with the scheme.

28. The relevant sections of the ITAA 1936 are as follows:

``177A(1) [Definitions] In this Part, unless the contrary intention appears:

...

``scheme'' means:

(a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and

(b) any scheme, plan, proposal, action, course of action or course of conduct;

...

177C(1) [Obtaining a tax benefit] Subject to this section, a reference in this Part to the obtaining by a taxpayer of a tax benefit in connection with a scheme shall be read as a reference to:

...

(b) a deduction being allowable to the taxpayer in relation to a year of income where the whole or a part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer in relation to that year of income if the scheme had not been entered into or carried out;

...

and, for the purposes of this Part, the amount of the tax benefit shall be taken to be:

...

(d) in a case to which paragraph (b) applies - the amount of the whole of the deduction or of the part of the deduction, as the case may be, referred to in that paragraph;

...

177D This Part applies to any scheme that has been or is entered into after 27 May 1981, and to any scheme that has been or is carried out or commenced to be carried out after that date (other than a scheme that was entered into on or before that date), whether the scheme has been or is entered into or carried out in Australia or outside Australia or partly in Australia and partly outside Australia, where:

(a) a taxpayer (in this section referred to as the ``relevant taxpayer'' ) has obtained, or would but for section 177F obtain, a tax benefit in connection with the scheme; and

(b) having regard to:

(i) the manner in which the scheme was entered into or carried out;

(ii) the form and substance of the scheme;

(iii) the time at which the scheme was entered into and the length of the period during which the scheme was carried out;

(iv) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme;

(v) any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme;

(vi) any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme;

(vii) any other consequence for the relevant taxpayer, or for any person referred to in subparagraph (vi), of the scheme having been entered into or carried out; and

(viii) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in subparagraph (vi),

it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for the purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme

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or of enabling the relevant taxpayer and another taxpayer or other taxpayers each to obtain a tax benefit in connection with the scheme (whether or not that person who entered into or carried out the scheme or any part of the scheme is the relevant taxpayer or is the other taxpayer or one of the other taxpayers).

...

177F(1) [Commissioner's discretion to cancel tax benefit] Where a tax benefit has been obtained, or would but for this section be obtained, by a taxpayer in connection with a scheme to which this Part applies, the Commissioner may:

...

(b) in the case of a tax benefit that is referable to a deduction or a part of a deduction being allowable to the taxpayer in relation to a year of income - determine that the whole or a part of the deduction or of the part of the deduction, as the case may be, shall not be allowable to the taxpayer in relation to that year of income;

...''

29. The respondent contends that the scheme is all the steps leading to and the entering into and the implementation of the loan arrangements between Austral and the applicants, including:

(a) the marketing of the ``Wealth Optimiser Loan'' to the applicants;
(b) the splitting of the loan into the home loan portion and the investment loan portion;
(c) the acceptance by Austral of capitalisation of interest on the investment loan portion, on the basis that it receives another predetermined amount in reduction of the home loan portion;
(d) the election by the applicants to allocate the whole of the repayments to the home loan portion until that portion of the loan has been paid; and
(e) the consequential incurring of an amount of additional interest and further interest on the investment loan portion.

Alternatively, the scheme is said to be the provision in the loan for the division into two portions and the direction of the repayments to one or other portion and the direction by the applicants of the repayments to the home loan portion. The parties to the scheme are alleged to be the applicants, and/or Austral and/or its directors, and/or PCL and/or its directors.

30. The respondent contends that the tax benefit is either of the following:

(a) if all the interest on the investment loan portion is deductible (including the additional interest and the further interest), the tax benefit is the difference between:
- (i) the interest incurred on the investment loan portion; and
- (ii) the interest that would have been incurred on the investment loan portion if the applicants had allocated the total minimum payment proportionally across both accounts.
Under this scenario, the tax benefit for each of the applicants would be $96 for the 1997 year and $365 for the 1998 year;
(b) if the additional interest is not deductible but the further interest is deductible, the tax benefit is the difference between:
- (i) the interest the applicants would have incurred on the investment loan portion if the applicants had a conventional interest only investment loan; and
- (ii) the interest the applicants would have incurred on the investment loan portion if the applicants had operated the accounts as separate conventional principal and interest loans.
Under this scenario the tax benefit for each of the applicants would be $29 for the 1997 year and $50 for the 1998 year.

31. As to the matters referred to in subs 177D(b), the respondent's submissions were as follows:

(i) The manner in which the scheme was entered into or carried out

• By entering into the scheme, the applicants were able to borrow moneys for two separate and discrete purposes: one private and one business, but under the form of one loan and to repay those moneys in a manner which produced additional tax deductions over and above those that would have been available had the loans been taken out separately.
• Such was the intention and purpose of the Wealth Optimiser Loan and it was so advertised and marketed by Austral.

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(ii) The form and substance of the scheme

• The form and substance of the scheme was to convert non-deductible interest into deductible interest.
• This was achieved by authorising the borrower to allocate the whole of the repayment to repayment of the home loan portion first thereby accruing additional and further interest on the unpaid investment loan portion and thereby increasing the amount of deductible interest than otherwise would have been available had the loans been paid off proportionately.

(iii) The time at which the scheme was entered into and the length and period during which the scheme was carried out

• The loan was taken out on 8 October 1996 and was based on the 25 year term. The tax benefits obtained from converting the non deductible interest to deductible interest (by increasing the debt on the investment account) were promoted as allowing the home loan account to be paid off in ``as at least 5 to 6 years''. The tax benefits, however, would continue beyond the repayment of the applicants' private account until the total loan was repaid after 25 years.

(iv) The result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme

• The obtaining of a tax deduction for a greater amount of interest than otherwise would be allowable.

(v) Any change in the financial position of the relevant taxpayer that has resulted, will result, that might reasonably be expected to result from the scheme

• The obtaining of tax deductions to which the applicants would otherwise not be entitled.

(vi) Any change in the financial position of any person who has, or who has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or might reasonably be expected to result from the scheme

• Austral has obtained a financial benefit in the form of a slightly higher interest rate charged for the loan arrangement, otherwise there is no financial benefit. Austral is receiving repayments calculated by reference to the total indebtedness over the term of the loan. As the interest is accruing at the same rate, the extra interest paid on the investment account equals the reduction in interest that would have been paid on the private account. Therefore, it generally receives the same cash flow as it would have received if the loans were not split.

(vii) Any other consequence for the relevant taxpayer, or for any person referred to in sub-paragraph (vi), of the scheme having been entered into or carried out

• The applicants may be able to pay off their home loan portion in a substantially shorter time than otherwise would have been the case. However, the debt on the investment loan portion grows at an increasing rate during this time. The mortgage on the private residence is and remains as security for the whole loan and is liable to remain as security until the total liability has been repaid.

(viii) The nature of any connection (whether of a business family or other nature) between the relevant taxpayer and any other person referred to sub-paragraph (vi)

• None beyond the commercial relationship of lender and borrower.
• Having regard to the facts referred to above it is submitted that a reasonable person would conclude that the dominant purpose of each or either of the applicants, and/or Austral and/or its directors in entering into and carrying out the scheme was to derive the tax benefits. In the circumstances, the Commissioner was entitled to make the determination under s 177F(1) of the ITAA 1936.

32. The applicants accept that at least the broader scheme identified by the respondent in its statement of facts and contentions is a scheme for the purposes of Pt IVA having the parties identified. It submitted that any contention that, in entering into or carrying out the ``scheme'' so identified, any of Mrs Aldin, Austral, Mark Bonaventura (a director of Austral), PCL or any of its relevant officers had a dominant purpose of enabling each of the applicants to obtain a tax benefit in connection with the scheme has no foundation and should be rejected. Each acted out of her, his or its own self interest or out of the interest of her family

ATC 4719

or his employer and it was submitted that the findings should be:

(a) in the case of Mrs Aldin, her dominant purpose in entering into or carrying out the ``scheme'' so identified was to assist her daughter and son-in-law raise finance to purchase the Fadden property as their home and to retain the Jerrabomberra property as an investment property without having to pay mortgage insurance;
(b) in the case of Austral and Mark Bonaventura, in entering into or carrying out the ``scheme'' so identified each had the dominant purpose of advancing Austral's business interests by generating fee income for Austral for arranging the financing; and
(c) in the case of PCL and its relevant officers, in entering into or carrying out the ``scheme'' so identified all had the dominant purpose of deploying funds available for lending on first mortgage security so as to advance PCL's business interests by generating interest income.

33. It was submitted that the prediction upon which the respondent's reasonable expectation is based and upon which the contended tax benefits in connection with the ``scheme'' as identified are calculated is that, but for the applicants entering into the ``split'' loan facility with PCL, they would have entered into a ``credit foncier loan'' facility in respect of the Jerrabomberra property (and presumably a similar facility in respect of the Fadden property). While that prediction is undoubtedly a possibility, as was said in the joint judgment in the High Court in
FC of T v Peabody 94 ATC 4663 at 4671; (1994) 181 CLR 359 at 385 (``Peabody''):

``... A reasonable expectation requires more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable for it to be regarded as reasonable.''

34. It was submitted that, having regard to the evidence of the applicants, in particular that one of the main advantages they saw in the ``Wealth Optimiser package'', as opposed to alternative financing arrangements they had inquired about or investigated at the time, was that it gave them ownership of their home (the Fadden property) faster than the other alternatives, the prediction upon which the respondent's reasonable expectation is based is not sufficiently reliable to be regarded as reasonable. A much safer prediction is that the applicants would have borrowed to retain the Jerrabomberra property as an income-producing property on an ``interest only'' basis, thus maximising their available resources to reduce the home loan on the Fadden property as quickly as possible.

35. As to the indicia referred to in s 177D(b), it is submitted generally that the subjective state of mind of the applicants is not relevant for the purposes of Pt IVA (see
FC of T v Spotless Services Limited & Anor 96 ATC 5201 at 5209-5210; (1996) 186 CLR 404 at 421-422 (``Spotless Services'');
CPH Property Pty Ltd & Ors v FC of T 98 ATC 4983 at 4999; (1998) 88 FCR 21 at 41 per Hill J;
Metal Manufactures Ltd v FC of T 99 ATC 5229 at 5277 (``Metal Manufacturers'') per Emmett J;
Eastern Nitrogen Ltd v FC of T 2001 ATC 4164 at 4178; (2001) 108 FCR 27 at 45 (``Eastern Nitrogen'') per Carr J, with whom Lee and Sundberg JJ agreed).

36. As to the particular indicia, the applicants' submissions were as follows:

(i) The manner in which the scheme was entered into or carried out:

1. The applicants approached Austral and discussed various loan products with Austral's representative, Kylie Lenihan, including the loan facility.
2. The loan facility was represented to the applicants as having had the following attributes by both Ms Lenihan and Austral's loan facility brochure, namely:
- (a) two separate loan accounts, a home loan account and an investment loan account, requiring one overall monthly repayment;
- (b) the terms of the loan facility agreement could be negotiated to require the lender to direct all repayments in reduction of the home loan account in priority to the investment loan account;
- (c) the home loan is non-deductible and the home loan account can be repaid first;
- (d) the investment loan interest is deductible and this interest capitalises whilst the home loan account is being repaid if it is repaid in priority to the
  
  ATC 4720
  investment loan account under the terms of the loan agreement;
- (e) the home loan account could be paid off within 5 or 6 years;
- (f) the applicants had the right to apply, subject to satisfactory valuation, to have their home released as a security for the remaining investment loan account debt once the home loan account debt was repaid in full;
- (g) the loan facility had negative gearing benefits;
- (h) there could be a saving of thousands of dollars in interest on the applicants' home loan compared to alternative home loan products;
- (i) the loan facility had a charge-free redraw facility which other products in the market place did not have;
3. The applicants considered the following to be the most advantageous attributes to them of the loan facility in their particular circumstances:
- (a) the ability to service a loan applied for two uses: to purchase a home and refinance an investment property, using only one monthly repayment (as compared with the need for two repayments under the facilities available from their existing financier, the ANZ Bank) was more convenient to the applicants (both applicants);
- (b) the repayments due under the loan facility each month were less (and thus more affordable for the applicants) than the monthly repayments required to be made under an alternative two-loan facility (such as one from the ANZ Bank) (both applicants);
- (c) the loan facility would enable one loan facility statement for the two loan accounts to issue each month rather than two separate statements under an alternative two-loan facility from the ANZ Bank, which was more convenient to the applicants (both applicants);
- (d) the applicants would be able to own their own home, that is, to pay off their home loan account, much sooner (in 5-6 years) than under an alternative 25 year home loan product, with a possibility of having the mortgage to the lender, PCL, discharged at that time (Richard Hart only);
- (e) the interest on the investment component of the loan was deductible (Trudy Hart only); and
- (f) Austral presented a positive attitude in assisting the applicants to buy a new home and refinance their old home for use as an investment property (Trudy Hart only).
4. It is submitted that having regard to the manner in which the ``scheme'' as identified was entered into or carried out, a reasonable person would not conclude that in entering into or carrying out the scheme the applicants had a dominant purpose of obtaining a tax benefit.

(ii) The form and substance of the scheme:

1. The form and substance of the ``scheme'' as identified is one and the same, namely, a loan facility which contains two loan accounts, a home loan account and an investment loan account.
2. The loan facility has a number of features, which include:
- (a) the ability to negotiate an express term of the loan agreement which enables all repayments to be directed by the lender, PCL, towards the reduction of one loan account in priority to the other account. Here the lender, PCL, was contractually obligated to apply all repayments made by the applicants to the reduction of Loan Account 1 and only when it was repaid in full, to then apply all repayments in reduction of Loan Account 2;
- (b) a redraw facility that enables repayments made in excess of the minimum stipulated repayments under the loan agreement to be redrawn for the applicants' use;
- (c) a right to ask Austral to procure PCL to discharge its mortgage over the applicants' home once the home loan account (Loan Account 1) was repaid in full if the valuation of the investment property was sufficient to secure the outstanding debt under the investment loan account (Loan Account 2) under Austral's prudential guidelines;
  
  ATC 4721
- (d) a rate of interest which was competitive with that of equivalent products in the market, such as ANZ Bank's investment loan products;
- (e) the ability to repay one loan account in respect of which the interest expense was non-deductible (namely, Loan Account 1), in about one-third to about one-quarter of the time that it would take under most alternative loan products.
3. It is submitted that the form and substance of the ``scheme'' as identified would not enable a reasonable person to conclude that in entering into or carrying out the scheme the applicants had a dominant purpose of obtaining a tax benefit.

(iii) The time at which the scheme was entered into and the length of the period during which the scheme was carried out:

1. The ``scheme'' as identified was entered into when the applicants were looking for finance to enable them to purchase a new home and to refinance their existing home at a time when its use was expected to change from that of a home to that of an investment property.
2. The length of the ``scheme'' as identified was 25 years, which is a standard time for a home loan and for a line of credit loan facility to be used to finance a home purchase and an investment property purchase.
3. It is submitted that there is nothing about the timing or duration of the ``scheme'' as identified which would assist a reasonable person in concluding whether in entering into or carrying out the scheme the applicants had a dominant purpose of obtaining a tax benefit.

(iv) The result in relation to the operation of the Act that, but for Part IVA, would be achieved by the scheme

1. But for the operation of Pt IVA the applicants would each be entitled to a deduction for the compound interest under s 51(1) of ITAA 1936 or s 8-1 of ITAA 1997 in the 1997 ($67) and 1998 ($387) income years for the reasons addressed earlier in these submissions.
2. But the quantum of those deductions, and the corresponding tax savings, is de minimis relative to the amount borrowed under the loan facility: $298,000, relative to the total amount of interest payable under it: $27,267 (9.15% × $298,000) per annum, and relative to the investment loan component of the interest liability under the facility: $5,488 from 8.10.96 to 30.6.97 and $7,385 for the 12 months ended 30.6.98.
3. In context, this objective fact could not on any view be said to be indicative of the applicants entering into or carrying out the ``scheme'' as identified for the dominant purpose of obtaining those deductions; indeed, it strongly indicates the contrary.

(v) Any change in the financial position of the applicants that has resulted, will result, or may reasonably be expected to result from the scheme

1. The applicants incurred a liability of $298,000 to PCL in respect of their borrowing under the loan facility, discharged a liability to the ANZ Bank in respect of the Jerrabomberra property in the sum of $95,112 and acquired an asset in the form of the Fadden property for $155,000.
2. Additionally, over or within the term of the loan facility, they will make monthly repayments of principal and payments of interest aggregating $2,533 (indicative only).
3. Additionally, they will derive rental income from the Jerrabomberra property.
4. It is submitted that these objective facts would not lead a reasonable person to conclude that the dominant purpose of the applicants in entering into or carrying out the ``scheme'' as identified was to obtain a tax benefit.

(vi) Any change in the financial position of any person who has any connection with the applicants, being a change that has resulted, will result or may reasonably be expected to result, from the scheme:

1. There is no evidence to suggest any such change occurred here.
2. The only person having any connection with the applicants identified as a party to the scheme is Mrs Emma Aldin, Mrs Hart's mother.
3. Save for signing the form of acceptance of the loan and attending at the office of an independent solicitor to sign a mortgage document in respect of her property at

ATC 4722
Fadden, Mrs Aldin had no role in the scheme.
4. Mrs Aldin offered up her home at 6 Corser Close, Fadden and guaranteed the applicants' liability as collateral security under the loan facility but otherwise her financial position was relevantly unaffected by the ``scheme'' as identified.
5. It is submitted that these objective facts would not lead a reasonable person to conclude that the dominant purpose of the applicants, or Mrs Aldin for that matter, in entering into or carrying out the ``scheme'' as identified was to obtain a tax benefit.

(vii) Any other consequences for the applicants, or for any other person having connection with the applicants, of the scheme having been entered into or carried out:

1. ``Other consequences'' in this context means consequences other than fiscal or financial consequences: Eastern Nitrogen at ATC 4181; FCR 49.
2. The evidence suggests that there were no consequences for the applicants, or Mrs Aldin, of the ``scheme'' as identified having been entered into or carried out other than the fiscal and financial consequences already identified above.
3. It is submitted that this objective fact does not assist in the conclusion the reasonable person is required to draw under s 177D(b).

(viii) The nature of any connection between the applicants and any person having a connection with them

1. The only person having any connection with the applicants identified by the respondent as a party to the ``scheme'' as identified is Mrs Emma Aldin, the mother of Trudy Hart.
2. Mrs Aldin's role was limited to offering up to her daughter and son-in-law a mortgage over her own home to further secure the applicants' indebtedness under the loan facility.
3. This is a common role of parents assisting children borrowing from financial institutions.
4. It is submitted that this objective fact does not assist in the conclusion the reasonable person is required to draw under s 177D(b).

37. In conclusion, the applicants' submission was that, having regard to these eight objective matters, a reasonable person would not conclude that, in entering into or carrying out the ``scheme'' as identified, the applicants had a dominant purpose of obtaining a tax benefit. Indeed, one of these objective facts, namely (iv), the result, in relation to the operation of the Act that, but for Pt IVA, would be achieved by the scheme, points strongly against any such conclusion, because the allowable deductions and the corresponding tax savings to the applicants sought to be cancelled in reliance on s 177F are de minimis relative to the loan facility and the interest obligations thereunder.

38. It was submitted that, having regard to the eight objective matters, a reasonable person would conclude that, in entering into or carrying out the ``scheme'' as identified, the dominant purpose of the applicants was to raise finance which would enable them:

(a) to purchase a new home, the Fadden property;
(b) to retain the existing home, the Jerrabomberra property, as an income- producing investment property; and
(c) to pay off that part of the loan used to purchase the Fadden property in about one- third to one-quarter of the time it would take under most alternative loan products.

39. It was accepted that the applicants were aware of the tax advantages inherent in the structure of the loan facility, in particular that the interest on Loan Account 2, the investment loan account, was an allowable deduction and, indeed, took that into account in their decision to use the ``Wealth Optimiser'' package does not, it is submitted, mitigate against this conclusion. As was said by Sackville J in
WD & HO Wills (Australia) Pty Ltd v FC of T 96 ATC 4223 at 4255; (1996) 65 FCR 298 at 338, albeit in respect of a different scheme:

``... Without taxation benefits, the proposal still made commercial sense.''

It was submitted that the same can be said of the proposal which the respondent seeks to impugn in the present case. In this respect, it stands in contrast to the scheme in Spotless Services, where, in the joint judgment of the High Court at ATC 5210; CLR 422, their Honours said:

``Without that benefit (exemption under s 23(q)), the proposal would have `made no sense'...''

ATC 4723

taking up what was said by Beaumont J in his dissenting judgment in the Full Court of this Court below. The contrast between this case and Metal Manufactures, on the one hand, and a case like Spotless Services on the other, is exemplified in the findings made in those cases. In Spotless Services (at ATC 5210; CLR 423 of the joint judgment in the High Court), their Honours (Brennan CJ, Dawson, Toohey, Gaudron, Gummow and Kirby JJ) said:

``... viewed objectively, it was the obtaining of the tax benefit which directed the taxpayers in taking steps they otherwise would not have taken by entering into the scheme.''

(emphasis added)

In Metal Manufactures Emmett J found at 5281 that:

``The Arrangements would not have been entered into if there had been no increase in current liabilities of the Taxpayer during 1987.''

(emphasis added)

Likewise here, the proposals would not have been entered into by the applicants had they not decided to purchase a new home and retain the existing home as an investment property. To suggest that, those considerations aside, the applicants would nevertheless have entered into the proposals for the tax benefits they carried has no foundation in fact or judgment.

Decision

40. If the existence of either the broader or narrower scheme contended for by the respondent is established, in my opinion, it can be concluded that each applicant has obtained a tax benefit in connection with the scheme, namely, a deduction being allowable to each taxpayer for each year of income for interest incurred, part of which would not have been allowable, or might reasonably be expected not to be allowable, to the taxpayers if the scheme had not been entered into or carried out, namely, that part attributable to the appropriation of all payments to Loan Account 1 compared with that which would have been attributable if the payments were apportioned rateably between the two accounts in proportion to the capital debt. This includes both additional interest and further interest. The existence of a broad scheme is accepted by the applicants. In my opinion, the narrower scheme propounded is also properly seen as part of a scheme and so a scheme within the principles established in Peabody.

41. It is more probable than not that any alternative financing which the taxpayers would have chosen would not have included the payment of interest upon capitalised interest upon a loan in relation to the investment property. Such a feature would inevitably mean that the true rate of interest was well above the ordinary rate of interest. No evidence has been led by the applicants to establish that this was a feature of any other alternative finance available to them. Indeed, the evidence that each of them gave as to the analysis of alternatives indicates that the appropriation of the repayments to the residential account leading to early repayment of capital, with the consequent increase in interest, paid upon the investment loan, was not present in the alternative loan packages which they considered. In this respect, the document provided by Austral to the applicants as to the features of the loan is instructive. It stated the objective as:

``... [t]o compare the financing of a home loan and an investment/business loan(s) using standard financing arrangements with the Wealth Optimiser structure.''

42. This document, and the tables attached to it, illustrate what the respondent called a ``credit foncier arrangement'', with the loan split between residential and investment properties described as ``ordinary financing arrangements''. It is clear enough that interest upon interest was not a feature of what was there described. The schedules attached to the explanation provided by Austral to the applicants, comparing the Wealth Optimiser with standard finance, demonstrate that $169,474 of additional interest would be paid on Loan Account 2 in the Wealth Optimiser package compared with standard finance, assuming an interest rate of 9.15% and a loan of $120,592. The table also showed a tax benefit (because of the increased interest), at the rate of 48.50% over the period, of $82,196. The explanation included:

``[Y]ou potentially obtain $169,474 in increased deductible interest, over and (sic) what you would have been entitled to under standard financing should the loan extend to the full term

- Wealth Optimiser structure may provide you with the potential tax savings shown in column O of $82,196. If those savings are applied as principal

ATC 4724
repayments it will reduce the term of the Wealth Optimiser loan accordingly.''

43. There is no support in the evidence for the proposition that the applicants would have financed the home by a credit foncier arrangement, and the investment property by a separate interest only loan for a fixed term in relation to which no capital repayments are made and where the only payments which are made are interest payments. There is no evidence as to the availability of such interest only loans on terms which would suit these applicants or any similar borrower. Indeed, there is no evidence that interest only loans are made for periods of twenty five years or anything like it. Having in mind inflation, it is most unlikely that any such loan would be available. Furthermore, there is not any evidence as to precisely how a package of that sort would be tailored to suit the budget of the applicants. A feature of a credit foncier loan is the certainty of the periodic payments for the whole of the period, subject to some variation if interest rates change. This is a feature of the Austral loan as well as the posited ``ordinary financing arrangements'' with which it was compared. The actual loan was a credit foncier arrangement with fixed periodic payments over twenty-five years. It was only one loan with one interest rate. This is the true comparison. The contractual provisions involving the split between Loan Accounts 1 and 2 are an artificial feature of the arrangements.

44. The evidence of the applicants was that most of their investigation, by way of comparison, took place with the ANZ Bank with whom they had an existing relationship. One of the alternatives available was to take out an interest only loan for the investment property. They did not ask for an estimate of the level of repayments in relation to alternative ANZ Bank packages because they had concluded that the repayments required for two separate loans with the ANZ Bank, whether by way of credit foncier or by way of interest only loan, would be greater than the repayments required under the Austral Wealth Optimiser loan.

45. It is then necessary to consider the application of s 177D(b). It is accepted by both parties that the section poses an objective rather than a subjective test so far purpose is concerned. This is to be judged, however, by considering the actual circumstances of the case under the relevant headings. Counsel have addressed each of the heads to be considered. They have drawn attention to various aspects of the matter, against a backdrop of essentially undisputed facts. An important part of those facts is the document from Austral making a comparison between the Wealth Optimiser loan and ``ordinary financing arrangements'' to which I have referred in discussing the question of tax benefit. One striking feature of the schedules to this Austral explanation is that after seven years the principal of $120,592 on Loan Account 2 has increased to $233,085. Adjusting the proportions to the present circumstances, this amount can be assumed to be more than the investment property is likely to be worth at that time. This result is only tenable because of the security provided by the residential property (and the third party mortgage). It is obvious that it would be necessary for the security over the other properties to be maintained whilst the principal on Loan Account 2 increases as interest is capitalised during the seven years of non- payment of interest on Loan Account 2 and after Loan Account 1 is discharged. It is also obvious that the tax deductibility of the further and additional interest which is paid by virtue of capitalisation is an attractive feature of the scheme from the point of view of the borrower.

46. Pamphlets produced by Austral (whether all seen by these applicants or not) stress the tax advantages of the Wealth Optimiser Loan, including the following references: ``a tax efficient loan'', ``a tax reduction system which should prove popular in the 1997 financial year'', ``gives dramatic tax savings as it often enables you to pay off your home loan within five years'', ``increase your negative gearing benefits'', ``you obtain increased deductible interest on your investment loan portion'' plus specific references made to the capitalisation of interest during the period that all repayments are appropriated to the residential loan.

47. In one aspect, the gist of the scheme lies in the availability of the unencumbered residential property to act as security for the grossly inflated investment loan account after the period of capitalisation of interest and, for that matter, to provide a margin of security during the period of capitalisation as the investment loan account principal increases. Put another way, the scheme depended upon interest being deferred (although incurred and

ATC 4725

deductible for tax purposes) in order to enable what purported to be capital payments to be made in relation to the other loan. The effect was that tax deductions were achieved in relation to that which purported to be a capital payment on Loan Account 1 by reason of the interest which was charged upon interest on Loan Account 2. Thus, the real effect and substance of the arrangements was to make the payment of interest on the capital sum paid in reduction of the residential loan deductible for taxation purposes.

48. It can hardly be seriously doubted that a purpose of both Austral and the ordinary borrower in entering into a transaction such as that in issue here would be to take advantage of the tax benefits claimed and demonstrated by Austral, namely, the deductibility of all interest, including additional and further interest. This was a significant advantage of the product. On the other hand, there is substance in the submission for the applicants that, if the scheme is considered broadly, there were advantages to them apart from tax deductibility of such interest. The deferment of payment of interest on Loan Account 2 meant that the residential loan could be paid off quickly, which was an advantage in itself, although this advantage would, in most cases, be more apparent than real due to the necessity to maintain security for the, by then, inflated investment loan account. This, however, left open the availability of deductions for all interest paid thereafter, including interest on capitalised interest. Other claimed advantages of flexibility and the like were asserted but not established, when compared with other products.

49. I am satisfied that there would be no commercial rationale for the arrangements in issue without the borrower being able to deduct all of the interest incurred for taxation purposes. It would make no sense otherwise. This is borne out by the manner in which the product was presented by Austral.

50. The submission for the applicants is that nonetheless the arrangements, viewed broadly, involve an attractive loan on favourable terms which the tax benefits facilitate, but that it cannot be said that the arrangements were entered into for the dominant purpose of obtaining the tax deduction. It was said that the dominant purpose of the applicants was to finance the acquisition and holding of real estate on favourable terms. There is support for this approach in some passages in the authorities cited by counsel.

51. The construction and application of Pt IVA has now been authoritatively considered by the High Court on three occasions. It is necessary to analyse FC of T v Spotless Services Limited & Anor in both this Court (95 ATC 4775; (1995) 62 FCR 244) and the High Court (96 ATC 5201; (1996) 186 CLR 404), with some care, together with the prior decision of Peabody and the later decision of
FC of T v Consolidated Press Holdings Ltd & Anor 2001 ATC 4343; (2001) 75 ALJR 1150 (``Consolidated Press''). In Spotless Services, monies held by an Australian taxpayer were lent in the Cook Islands to the Cook Islands entity at a rate below that applicable to similar loans in Australia, but the transaction was profitable because of the exemption from tax in Australia by virtue of s 23(q) of the ITAA 1936. In the Full Court of this Court Cooper J (who gave the leading judgment for the majority) said (at ATC 4811-4812; FCR 288):

``Where the activity under consideration is a bona fide investment of capital funds the tax payable on the interest earned is, for the purpose of deciding whether or not to undertake any particular investment, a relevant consideration. Where the available alternative investments are all taxed at the same rate, the relevant and predominant considerations are the interest rate offered, the term of the investment and the risk of each of the available investments. Where all other things are equal the investment offering the highest rate of interest will be chosen. Where taxation rates on particular investments are different, the incidence of tax as a cost becomes one of the important matters for consideration in coming to an investment decision. For example, the treatment of income from gold mining operations as exempt income (s 23(o) of the ITAA) may be a factor which influences an investment in a gold mine returning income at a lower rate as a percentage of capital invested than an investment of the funds on deposit at a higher gross rate of return but subject to the payment of full income tax. Therefore, when investing outside Australia, the incidence of tax and the operation of any relevant double taxation treaties between Australia and the countries in which investment is being considered will be

ATC 4726
relevant to a decision to invest overseas or not. Where by the operation of the foreign taxation laws and the existing Australian taxation laws the net return after the payment of all applicable tax and other costs of the investment is higher investing offshore than within Australia, it cannot be said that, objectively, the dominant purpose of the investor investing offshore is to get a tax benefit; the purpose is to obtain the maximum return on the money invested after the payment of all applicable costs, including tax. In 1986, Australian tax was not payable on income derived in the circumstances specified in s 23(q) of the ITAA because it was exempt income. That situation has changed since the repeal of s 23(q).

As the dominant purpose of the taxpayers was not to obtain a tax benefit, the scheme identified was not one to which Pt IVA of the ITAA applied. In consequence the Commissioner was not entitled to exercise the power under s 177F to determine that the interest earned be included in the taxpayers' assessable income for the relevant year.''

Beaumont J (in dissent) said (at ATC 4797-4798; FCR 269-271):

``Moreover, in my view, that course of action was, in terms of its dominant purpose, fiscally or tax driven; this was so from the standpoint of all the parties to the arrangement, but especially from Spotless' point of view.

...

In my opinion, it follows from the `form' and the `substance' of this scheme (see s 177D(b)(ii)) that it would be concluded that Spotless entered into the scheme for the purpose of enabling it to obtain a `tax benefit' in connection with the scheme. The form and substance of the proposal, as the Information Memorandum and Stephens' letter made clear, was to take steps to ensure that the source of the interest be located in the Cook Islands in order that s 23(q) might be relied upon. This was done both ostensibly and, as I have said, as a matter of reality. The dominant purpose of doing this was to achieve a particular fiscal result in terms of Australian tax; that is to say, a tax benefit in the form of the exemption from Australian tax of the amount of the interest remaining after the Cook Islands withholding tax was deducted.

Given the declaration of intention of Spotless to invest the fund of $40 million short-term, for the purposes of s 177C(1)(a), in my view, it might reasonably be expected that interest of at least that actually earned would have been earned in Australia and would have been included in its taxable income.

It is true that the evidence indicates that Spotless considered, but rejected, some other off-shore propositions with possible (at least as perceived) fiscal advantages. There is no reason to suppose that Spotless would, in fact, have embarked upon any of these proposals. In any event, there would remain the question whether tax benefits under such propositions might themselves have been cancelled by the Commissioner.

On behalf of the respondents, it is submitted that this is not a case where the taxpayer has diverted an existing income stream in such a way that it will not attract tax. I agree, but it is plain that Pt IVA can operate in other circumstances.

Then it is said on behalf of the respondents that `[w]hat the taxpayers did was simply to invest surplus funds in a form of investment in respect of which the... Act provided certain consequences'. There is an echo here of the `choice' principle developed in the earlier jurisprudence of s 260 . In my opinion, such a principle has no place in Pt IVA. For one thing, as a matter of form and substance, the two provisions are quite different. Indeed one of the mischiefs sought to be remedied by the enactment of Pt IVA was the ineffectiveness of s 260 in important respects. Moreover, it is specifically provided by s 177B(1) that:

`... nothing in the provisions of this Act other than this Part... shall be taken to limit the operation of this Part.'

Furthermore, in my view, it is not a fair description of these transactions to suggest that the taxation aspects were merely incidental or consequential. The fiscal aspects were highlighted in the contemporary documentation. They were clearly at the forefront of the parties'

ATC 4727
consideration. Without taxation benefits, the proposal made no sense .

This is not to say that it is impossible to have a commercial reason, even a dominant one, for an investment offshore which will attract s 23(q), yet not be caught by Pt IVA. The dominant purpose of this particular investment is a question of fact - was it for tax reasons (as the Commissioner contends) or was it for commercial reasons (as in Peabody, as the respondents argue)? If the investment were, in terms of its dominant purpose, commercially actuated, one would expect readily to find a commercial justification for its adoption. But none appears. The interest rate was unattractive, being substantially less than the domestic rate. Moreover, there appeared to be a security risk in dealing with an offshore, Cook Islands bank. Hence the need to introduce security from Midland (a step not necessary if a similar domestic investment had been made). Further, the Cook Islands dealings were far more complicated, time- consuming (in executive travel time) and expensive in their execution than a similar domestic transaction. Why did the respondents choose to adopt such an `uncommercial' course with so many disadvantages? The reason could only be that given by the Information Memorandum. The `nature of the investment', that is, its essential feature, was not its commercial attraction, but its taxation benefits. Its dominant purpose was to offer a tax advantage by combining a nominal tax regime located offshore with the operation of s 23(q). In short, the scheme was tax driven . It had no commercial basis. It follows, in my view, that Pt IVA applied to it.''

(emphasis added)

52. In their joint judgment, their Honours Brennan CJ, Dawson, Toohey, Gaudron, Gummow and Kirby JJ in the High Court said (at ATC 5210; CLR 423):

``In those circumstances, a reasonable person would conclude that the taxpayers in entering into and carrying out the particular scheme had, as their most influential and prevailing or ruling purpose, and thus their dominant purpose, the obtaining thereby of a tax benefit, in the statutory sense. The scheme was the particular means adopted by the taxpayers to obtain the maximum return on the money invested after payment of all applicable costs, including tax. The dominant purpose in the adoption of the particular scheme was the obtaining of a tax benefit. In reaching the contrary conclusion, or, rather, placing the matter on a different footing, the majority of the Full Court fell into error. It is true that the taxpayers were concerned with obtaining what was regarded as adequate security for an investment made `off-shore'. However, the circumstance that the Midland Letter of Credit afforded the necessary assurance to the taxpayers does not detract from the conclusion that, viewed objectively, it was the obtaining of the tax benefit which directed the taxpayers in taking steps they otherwise would not have taken by entering into the scheme.''

(emphasis added)

Their Honours had said that they agreed with the conclusions of Beaumont J.

53. Earlier, their Honours had said (at ATC 5205; CLR 414):

``Part IVA is to be construed and applied according to its terms, not under the influence of `muffled echoes of old arguments' concerning other legislation. In this Court, counsel for the taxpayers referred to the repetition by the Privy Council in Commissioner of Inland Revenue v Challenge Corporation of the statement by Lord Tomlin in Inland Revenue Commissioners v Duke of Westminster that `[e]very man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be'. Lord Tomlin spoke in the course of rejecting a submission that in assessing surtax under the Income Tax Act 1918 (UK) the Revenue might disregard legal form in favour of `the substance of the matter'. His remarks have no significance for the present appeal. Part IVA is as much a part of the statute under which liability to income tax is assessed as any other provision thereof. In circumstances where s 177D applies, regard is to be had to both form and substance (s 177D(b)(ii)).''

54. At ATC 5206; CLR 415-416 their Honours said:

``The references in this passage [from the majority judgment] on the one hand to a `rational commercial decision' and on the other to the obtaining of a tax benefit as `the

ATC 4728
dominant purpose of the taxpayers in making the investment' suggest the acceptance of a false dichotomy....

...

A person may enter into or carry out a scheme, within the meaning of Pt IVA, for the dominant purpose of enabling the relevant taxpayer to obtain a tax benefit where that dominant purpose is consistent with the pursuit of commercial gain in the course of carrying on a business .

In his concurring judgment in Commissioner of Internal Revenue v Brown, Harlan J said:

`[T]he tax laws exist as an economic reality in the businessman's world, much like the existence of a competitor. Businessmen plan their affairs around both, and a tax dollar is just as real as one derived from any other source.'

Later, the United States Supreme Court stated that it could not `ignore the reality that the tax laws affect the shape of nearly every business transaction'. In Australia, State and Territory stamp duty laws have been a particularly significant factor in the shaping of business transactions. However, the tax laws are one part of the legal order within which commerce is fostered and protected. Another is Pt IV of the Trade Practices Act 1974 (Cth), which regulates or proscribes certain restrictive trade practices. In this broad sense, `[t]axes are what we pay for civilised society', including the conduct of commerce as an important element of that society.

A taxpayer within the meaning of the Act may have a particular objective or requirement which is to be met or pursued by what, in general terms, would be called a transaction. The `shape' of that transaction need not necessarily take only one form. The adoption of one particular form over another may be influenced by revenue considerations and this, as the Supreme Court of the United States pointed out, is only to be expected. A particular course of action may be, to use a phrase found in the Full Court judgments, both `tax driven' and bear the character of a rational commercial decision. The presence of the latter characteristic does not determine the answer to the question whether, within the meaning of Pt IVA, a person entered into or carried out a `scheme' for the `dominant purpose' of enabling the taxpayer to obtain a `tax benefit' .

Much turns upon the identification, among various purposes, of that which is `dominant'. In its ordinary meaning, dominant indicates that purpose which was the ruling, prevailing, or most influential purpose. In the present case, if the taxpayers took steps which maximised their after-tax return and they did so in a manner indicating the presence of the `dominant purpose' to obtain a `tax benefit', then the criteria which were to be met before the Commissioner might make determinations under s 177F were satisfied. That is, those criteria would be met if the dominant purpose was to achieve a result whereby there was not included in the assessable income an amount that might reasonably be expected to have been included if the scheme was not entered into or carried out.''

(emphasis added)

55. It is also important to note that in Spotless Services the Commissioner had defined the scheme both broadly and narrowly. The wider scheme involved the various steps involved in the investment, whereas the narrower scheme concentrated upon those steps which gave the tax advantage. Beaumont J held that his conclusion applied to both. The majority of the High Court in Spotless Services did not refer to this aspect of the matter, but appeared to accept the identification of the scheme by Cooper J (and the primary judge) which took in the whole of the proposal to invest in the Cook Islands and all steps in implementing it. The reference to wider and narrower schemes was an echo of an earlier question as to whether the Commissioner could extract certain elements from a wider scheme and treat those elements as a scheme. That question was answered in the affirmative by the High Court in Peabody.

56. The topic was returned to by the High Court in Consolidated Press at ATC 4360; ALJR 1164:

``Objection was also taken to what was said to be the artificiality of the selection of part of the overall transaction as the scheme. This, it was said, was not warranted by Peabody or Spotless. The artificiality was said to result from the fact that the overall

ATC 4729
transaction was for the clearly commercial purpose of financing the Group's participation in the takeover bid for BAT. However, as was held in Spotless, a person may enter into or carry out a scheme, within the meaning of Pt IVA, for the dominant purpose of enabling the relevant taxpayer to obtain a tax benefit where the dominant purpose is consistent with the pursuit of commercial gain in the course of carrying on a business. The fact that the overall transaction was aimed at a profit making does not make it artificial and inappropriate to observe that part of the structure of the transaction is to be explained by reference to a s 177D purpose. Nor is there any inconsistency involved, as was submitted, in looking to the wider transaction in order to understand and explain the scheme , and the eight matters listed in s 177D.''

(emphasis added)

57. The decision of the High Court in Spotless Services was something of a watershed in relation to tax minimisation, marking a decisive break from the authorities as to the scope and effect of the former s 260 of the ITAA 1936, influenced as they were by the Duke of Westminster doctrine. This was recognised by various commentators, although there was doubt as to all of the ramifications of the decision (see D Mossop, Tax Avoidance Legislation and the Prospects of Pt IVA (1997) Australian Tax Review 70; A Greenbaum, Anti- avoidance Principles - New Directions for Tax and Business Resulting from the High Court Decision in Spotless (1997) 25 Australian Business Law Review 142; J Azzi, Spotless: a Lesson in Form and Substance but not in Substance over Form (1998) 8 Revenue Law Journal 175; MJ Watts, Part IVA of the Income Tax Assessment Act after Spotless - a Brave New World? (1998) 72 Australian Law Journal 303). For present purposes, any doubts are set at rest by Consolidated Press.

58. These High Court authorities decide that it is the particular shape, form or structure of the scheme, rather than a general description of the transaction which is under scrutiny. In the present case, to concentrate upon the commercial object or outcome of the transaction as a whole is to focus on a false issue and make the same error as that of the Full Court in Spotless Services. It is appropriate to concentrate upon the narrower scheme propounded by the respondent, explained by reference to the wider transaction. When I consider the matters prescribed by s 177D(b) and, in particular, (i), (ii) and (iv), in the light of the findings I have made, the proper conclusion is that, as Beaumont J held in Spotless Services, without taxation benefits the particular form, shape or structure of this transaction made no sense. To take the words of Hill J at first instance in CPH Property (98 ATC 4983 at 5000; (1998) 88 FCR 21 at 42) (approved by the Full Court of this Court and the High Court):

``... a conclusion would be drawn that the dominant purpose... was to bring about the result that a deduction would be allowed... which, but for the scheme, would have been disallowed...''

Interest incurred in relation to payment of capital in repayment of a residential loan is not deductible and, if claimed, would be disallowed.

59. It is to be concluded that at least Austral and those taking the Wealth Optimiser Loan entered into the scheme for the purpose of enabling the taxpayer entering the transaction to obtain the tax benefit I have identified. I should say that my view would be the same if the wider scheme propounded by the respondent were adopted, as it is the particular shape, form or structure of the scheme which is to be considered. I should also say that I do not regard Eastern Nitrogen, relied upon by the applicants, as laying down any principle which is contrary to the foregoing, nor do I regard what I have held as inconsistent with the rather delphic remarks of McHugh J in Spotless Services at ATC 5211-5212; CLR 425. The respondent was entitled to make the relevant declarations under s 177F(1).

60. The proceeding will stand over to enable short minutes of order to be brought in to give effect to these reasons.

THE COURT ORDERS THAT:

1. The proceeding stand over to enable short minutes of order to be brought in to give effect to these reasons.

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