• The impact of this case on ATO policy is discussed in Decision Impact Statement: Howard v Commissioner of Taxation (High Court (M115 of 2012) Full Federal Court (VID 76 - 77 of 2012)).

HOWARD v FC of T

Judges:
Middleton J
Perram J
Dodds-Streeton J

Court:
Federal Court of Australia, Melbourne

MEDIA NEUTRAL CITATION: [2012] FCAFC 149

Judgment date: 26 October 2012

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Middleton, Perram And Dodds-Streeton JJ

INTRODUCTION

1. These three appeals were heard together. It is convenient to address the issues that have arisen by reference to each relevant income year.

2005 INCOME YEAR

Assessable Income

2. In relation to the 2005 income year, the issue is whether the sum of $861,853.35, received by Mr Stephen Howard in that year as his share of an award of equitable damages made by the Supreme Court of Victoria (Warren J) in consequence of the determination in
Disctronics Ltd v Edmonds [2002] VSC 454 and
[2002] VSC 534, and confirmed on appeal in
Edmonds v Donovan (2005) 12 VR 513, was assessable income in his hands. Mr Howard accepted that the award had the character of income and was made in his favour. However, Mr Howard contended that he received the money awarded to him as trustee primarily arising from his fiduciary relationship as a director of Disctronics Ltd ('Disctronics'). The primary judge found in favour of Mr Howard on this issue.

3. The principles of law, and the factual context in which they are to be applied, are not in dispute. During the course of hearing, the dispute between the parties became considerably refined and primarily concerned whether Mr Howard had been in breach of his fiduciary duty owed to Disctronics.

4. Mr Howard and the Commissioner accepted certain principles of law to be applied:

• (a) a person holding a fiduciary position is entitled to engage in profit-making activities outside his fiduciary office;
• (b) a director who brings a business opportunity to a company of which he or she is a director cannot, if the company adopts it, subsequently withdraw it and exploit it for his on her own benefit, except with the company's informed assent;
• (c) a director is prohibited from placing his or her personal interests in conflict or potential conflict with the company of which he or she is a director, and must not take an unauthorised profit or benefit; and
• (d) there is no inconsistency in both being a principal in a transaction and being bound by fiduciary duties arising from the office of director.

5. We accept that each of these principles of law are well established by authority: see eg
Breen v Williams (1996) 186 CLR 71 at 137-8;
Regal (Hastings) Ltd v Gulliver [1967] 2 AC 134;
Warman International Ltd & Anor v Dwyer & Ors (1995) 182 CLR 544;
Grimaldi v Chameleon Mining NL (No 2) [2012] FCAFC 6;
Furs Ltd v Tomkies (1936) 54 CLR 583 at 592;
Chan v Zacharia (1984) 154 CLR 178 at 198; and
Noranda Australia Ltd v Lachlan Resources NL (1988) 14 NSWLR 1 at 15.

6. The primary judge carefully analysed the facts and made a number of findings. It is convenient to set out some salient facts as found by the primary judge:

• (a) In early 1999, Mr Howard and three others, Messrs Donovan, Quinert and Bucknall (all four collectively called 'the plaintiffs') investigated a proposal for funding the acquisition of a golf course by leasing it to a substantial tenant. Two other parties, Messrs Edmonds and Cahill ('the defendants') were invited to provide services in relation to the proposal, initially for a fee. The proposal evolved into a joint venture project to acquire and lease Kingston Links golf course, such that the tenanted course could be held or resold as a package, so realising a "day-1" profit. To succeed, the revised project would require a lessee of the course at a sufficient rent and an "equity participant", which "equity participant" would purchase the course (using borrowed funds secured on the land, and its own "equity" funds) at a price based on the capitalised value of the rent.
• (b) Messrs Howard, Donovan and Quinert were directors of Disctronics, a delisted public company with investable funds. In early July 1999, the director plaintiffs proposed among themselves that if the equity required was less than $1.5 million, Disctronics should be the purchaser. The driving force behind the proposal was Mr Donovan, who was ultimately in control of Disctronics.
• (c) The proposal was put to and adopted "as a possible investment opportunity" by an informal meeting of directors of Disctronics on 13 or 14 July 1999. The directors agreed that if Disctronics took up the investment any joint venture profit share accruing to them would be accounted for or rebated to Disctronics.
• (d) The introduction of Disctronics as purchaser was objected to by the defendants. Variations to the terms of the joint venture, still involving Disctronics as equity participant, were discussed between the plaintiffs and defendants but not adopted.
• (e) On 20 July 1999, joint venture terms were agreed. While the terms contemplated that an equity participant might "form part of our team", only the plaintiffs and defendants, not Disctronics, were named as joint venturers.
• (f) By the beginning of August 1999, a purchase price and a rent had been agreed in principle with the vendor and a prospective lessee, although no agreement had been executed by either. The vendor was represented by Mr Kevin Wood.
• (g) In the first week of August 1999, the plaintiffs and Disctronics asserted Disctronics' intention and "right" to become equity participant and purchaser. Disctronics acquired a subsidiary, Corwen Grange Pty Ltd, to play that role. The defendants disputed any such right. Negotiations ensued as to sharing of profits if Disctronics became purchaser, but no final agreement was reached.
• (h) Meanwhile, the defendants negotiated a purchase and lease of the golf course by a syndicate comprising themselves and a third party, Mr Buxton. In December 1999 a company called Kingston Links Country Club Pty Ltd ('KLCC'), which had the defendants and Mr Buxton as its directors, became the owner and lessor of the golf course.
• (i) In December 2000, Disctronics lodged a caveat on the title to the golf course land, claiming a constructive trust in its favour. In June 2001, proceedings for removal of the caveat, and for remedies consequent on the defendants' breach of fiduciary duties to the plaintiffs, were commenced in the Supreme Court of Victoria.
• (j) On 15 June 2001, Messrs Donovan, Quinert and Howard, of the one part, and Disctronics, of the other part, executed what was referred to as the 'litigation agreement' (in which the parties of the first part were referred to as "the directors" and Disctronics was referred to as "DL") in the following relevant terms:

  Whereas

  • A. The directors were formerly members of a joint venture to acquire the Kingston Links Golf Course (KLGC) with others namely Christopher Edmonds (CT) [sic], Peter Cahill (PC) and Richard Bucknall (RB) to package an approved tenant and KLGC to an investor (the joint venture). The joint venturers agreed that the investor would be either a third party or DL;
  • B. On or about 14.07.'99 in London meetings of DL, the directors agreed that if the equity requirement to require KLGC was less than AUD$1.5m then the directors would seek to have DL become the equity participant and purchaser of KLGC (the "option"). The directors further agreed that if DL exercised its Option then the directors would rebate to DL any entitlement (whether on revenue or capital account) they may have as a consequence of their participation in the joint venture;

    …

  • H. The directors have concerns about their ability to fund from their own resources the anticipated costs of the proceedings. The directors are advised that the case to be put is compelling and the prospects of a favourable outcome are strong. The directors desire to prosecute the proceedings, as contemplated, which requires the directors to accept the litigation risk of being individual [sic] named plaintiffs with DL, in order to ensure that DL is afforded the opportunity of exercising its right to seek damages and compensation for the loss of its corporate opportunity and the wrongful appropriation of KLGC by CE, PC and others.

  Now, for good and valuable consideration, this agreement witnesses:

  • 1. DL shall pay all legal fees and disbursements associated with the prosecution of the proceedings, or either of them, to Mallesons, counsel, Oakley Thompson & Co including reasonable travel and accommodation costs;
  • 2. The directors have agreed with RB that he will not be liable for either any legal fees or disbursements associated with the prosecution of the proceeding or in relation to any damages or costs orders of any description in favour of CE, PC (or others);
  • 3. DL shall indemnify the directors (and for their obligation to RB) against payment of any order/s for costs, howsoever arising, in favour of CE, PC (or others) arising out of the prosecution of the proceedings or any damages they are found liable to pay to CE, PC (or others);
  • 4. In consideration of DL's promises set out in paras 1 and 3 hereof the directors, and each of them, assign absolutely into (sic) and to the sole use of DL, any award of damages (whether our revenue or capital account), costs or interest made in their favour as a consequence of their participation in the joint venture or arising out of the proceedings and the ultimate outcome thereof;

    …

• (k) In the Supreme Court of Victoria, judgment was given in favour of the plaintiffs at first instance and upheld on appeal.
• (l) Each of the directors of Disctronics, including Mr Howard, accounted to Disctronics for his share of the award.

7. Before going to the primary issue, we should say something briefly about the litigation agreement. The primary judge did not accept that the terms of the litigation agreement involved a recognition by Mr Howard of his own liability for taxation, or that the entering into of the litigation agreement involved conduct on his part which should be seen as inconsistent with his claim to have received the award of equitable damages as a fiduciary or trustee. Whether that conclusion is correct or not does not foreclose enquiry as to whether Mr Howard received the award beneficially or as trustee for Disctronics. That enquiry will involve an analysis of the facts to determine whether Mr Howard breached his fiduciary obligations to Disctronics.

8. Further, some reliance was placed upon by the Commissioner on recital B of the litigation agreement, seeking to characterise the 'agreed' position between the directors in terms of a contract. We doubt whether it is appropriate to characterise the 'agreed' position in terms of contract, but whether or not this is so is of no moment. The agreed position can be seen, at the very least, as reflecting an arrangement as to a course of action and of the contingencies upon which action would be taken - both as to investment by Disctronics and as to the consequential actions of the participants. We will return later to this aspect of the arrangement and its significance.

9. Finally, it was put by Mr Howard that whether the litigation agreement records an existing constructive trust arising from the fiduciary relationship between the directors and Disctronics, or evidences its absence by effecting an assignment of the rights to the fruits of the litigation (so constituting an express trust of those rights and of the award when and if made by the court), it nevertheless did vest the beneficial entitlement to the award in Disctronics. This was an argument not raised before the primary judge. In any event, it has no substance. The effect of the litigation agreement cannot be to prevent the award of equitable damages from being derived by Mr Howard in his hands beneficially: see
Booth v Commissioner of Taxation (1987) 164 CLR 159 at 167 (per Mason CJ).

10. The true enquiry must then be to analyse the factual findings of the primary judge to determine whether Mr Howard received the award of equitable damages beneficially or as trustee.

11. As to the involvement of the parties to the joint venture, the primary judge made the following findings at [74] to [77]:

• 74. … In its origins, the concept of investing in a golf course, engaging a stable, long-term, tenant, and then on-selling the course for a day-one profit was Donovan's, or perhaps Solette's. It was not Disctronics'. Neither was it in Disctronics' normal line of business. At the outset at least, Donovan was not under any obligation to involve Disctronics in that concept, or to offer the investment opportunity to Disctronics.
• 75. Had Donovan implemented his concept, as originally devised with the assistance of Bucknall, then, Disctronics could have claimed no interest in the resulting investment. When, as Warren J found, Quinert and the applicant (and possibly also Solette) were included in what her Honour found to be a joint venture in May or June 1999, the position was no different. The investment then envisaged had nothing to do with Disctronics.
• 76. On the applicant's case, the position was different from at least when the directors of Disctronics met in London over the period 12-14 July 1999. Had they procured the Board to resolve to make the investment contemplated, then, at least as between the three individuals involved and Disctronics, the proposed investment would have belonged in equity to the latter. … The applicant contends that the directors did enough then, and later, to preclude themselves from later asserting, as against Disctronics, that the investment opportunity belonged to them rather than to it. Although not made by the Board as such, the decision provisionally (ie subject to the equity requirement falling within a certain limit) to involve Disctronics in the proposed investment was made by all directors in a context in which they had come together for the purposes of a Board meeting. The decision was made by them in their capacities as Board members. The decision was communicated contemporaneously to Edmonds (and, inferentially, by him to Cahill). That Disctronics would be the purchaser if the equity requirement was within the specified limit was known to all six venturers when the joint venture was formed on 20 July 1999. Once it became known that the equity requirement was within that limit, Quinert, on behalf of himself, Donovan and the applicant, notified Edmonds on 4 August 1999 that Disctronics would take up the opportunity to be the purchaser. According to the applicant, by that stage at least, it was no longer open to him to assert, as against Disctronics, the right to insert some other purchaser into the proposed transaction with Kingston Links for the purpose of securing, for himself, the originally-intended day-one profit.
• 77. To the extent that it is significant, I would find that there is no doubt about the reality of the intention of Donovan, Quinert and the applicant to make the opportunity to purchase the golf course available to Disctronics. They made their decision so to proceed in what were plainly the interests of Disctronics rather than of themselves, they identified the source of funds which would be used, they informed their co-venturers of the condition under which the opportunity would be taken up by Disctronics, and they caused Disctronics to be issued a share in the company which was to be the nominee under the contract of sale, Corwen Grange. Indeed, it was the reality of their insistence upon Disctronics being the purchaser, and the refusal of Edmonds and Cahill to accept that, that ultimately led to the disintegration of the joint venture of 20 July 1999.

12. It is apparent from the above findings that:

• • the original proposal was in reality that of Mr Donovan, not Disctronics;
• • Disctronics was a vehicle for the implementation of an agreement entered into by the six joint venturers;
• • the involvement of an opportunity to be given to Disctronics would arise once it became known that the equity requirement was within the agreed limit;
• • Mr Howard did all he could to proceed in the interests of Disctronics; and
• • the failure of Disctronics to become involved was because of the actions of Messrs Edmonds and Cahill, and ultimately of the vendor in not accepting the offer put on behalf of Mr Howard (which was to involve the subsidiary of Disctronics, Corwen Grange Pty Ltd).

13. Whatever the source of the fiduciary duty said to arise, it seems to us that the current issue can be determined by focussing on the content of that duty and the position of Mr Howard. Unlike the position in the Supreme Court proceedings, we are not concerned with Disctronics' rights as against Messrs Edmonds and Cahill, nor the rights and obligations of the joint venturers. The focus before us is upon the obligation of Mr Howard to Disctronics, which was not a question requiring determination in the Supreme Court proceedings.

14. It was submitted by Mr Howard that once Disctronics had adopted the project as a potential investment, it was incumbent on the directors to do what was in their power to preserve that company's opportunity to invest. It was said to be inconsistent with their fiduciary duties to Disctronics to conduct themselves, in their personal capacity as participants on their own account in the joint venture, in a manner which conflicted with the interests of Disctronics.

15. Mr Howard argued that there was no simple contingency according to which Disctronics would, or would not, make the investment. It was argued that the factual context was that Disctronics had available to it $1.5 million in non-operational investment funds. The price at which the "investor" would acquire the golf course was not an independent, objective fact dependent on external events: it was a matter for negotiation among the joint venturers.

16. It was then submitted that this circumstance put the directors of the joint venture in a position of immediate and unresolvable conflict of duty and interest. The interest of the joint venturers was, to secure the highest possible purchase price from an investor: the higher the price, the larger their individual share of profit. The interest of Disctronics was diametrically opposed: it sought to secure the lowest (and to it, the most advantageous) price. It was the duty of the directors to do all in their power to advance Disctronics' interest, and to do so at the expense of their own interest (and that of their joint venturers).

17. It was contended by Mr Howard that the directors could not simply stand by and wait to see whether the price to a potential investor would fall below $1.5 million (so that Disctronics would invest and they would "rebate" their profit shares), or would exceed that sum so that they could take their share of the consequently enlarged project profit free of obligation to Disctronics. It was their duty to Disctronics to use their best endeavours to negotiate the lowest price, and one within Disctronics' reach.

18. We do not accept this is a correct analysis, nor one that accords with the conclusion reached by the primary judge as to Mr Howard's role or fulfilment of his obligation to Disctronics. The evidence, as accepted by the primary judge, was that Mr Howard was responsible to have Disctronics accepted as equity participant by the other joint venturers. In that case, and only in that case, did Mr Howard agree to rebate his share of the "day-1" profit to Disctronics. Otherwise, as the primary judge found at [77], Mr Howard proceeded in the interests of Disctronics rather than his own. Mr Howard's obligation to Disctronics only involved Mr Howard using his reasonable endeavours to have it become purchaser, which obligation he discharged.

19. Therefore, the only expectation of Disctronics was to be a potential purchaser, if and when there was a secured sale price and a tenant's agreement for a long-term lease. There was no expectation that Disctronics was to have any other role. Disctronics was only a vehicle to be used in the event of certain contingencies occurring. This is not to suggest that each director did not owe obligations to Disctronics imposed by legislation and the general law. However, those obligations must be seen in the context of what was the true and only interest that Disctronics had in the implementation of the joint venture, should certain contingencies eventuate. Putting it another way, Disctronics could have had no expectation that Mr Howard would work towards a certain price being accepted. Disctronics' only interest arose when and if the equity required was less than $1.5 million. In the end, the defendants (Messrs Edmonds and Cahill), despite all of the endeavours of Mr Howard, were not prepared to accept Disctronics as equity participant and purchaser.

20. In these circumstances, there could be no conflict of interest in the way contended for by Mr Howard, and no breach of Mr Howard's fiduciary duty to Disctronics. Accordingly, the award of damages in question had the character of assessable income in Mr Howard's hands, and was not received by him as trustee.

21. Therefore, we would uphold the appeal of the Commissioner in respect of the income year 2005.

Costs and Penalty

22. We now turn to two other issues which remain relevant to the 2005 income year:

• (a) whether there should be deducted from the amount of the award made in the Supreme Court the costs incurred in gaining it; and
• (b) whether Mr Howard is liable (if at all) to penalty on the basis that he acted with intentional disregard of the law.

23. Mr Howard argued that the amount assessable should be reduced by Mr Howard's share of the legal costs incurred in prosecuting the Supreme Court proceedings. The Commissioner accepted that if the compensation proceeds were assessable to Mr Howard and he incurred any costs, he would have been entitled to a deduction for those costs. However, the Commissioner contended there was no evidence that Mr Howard paid any costs. Rather, they were paid by Disctronics (which presumably claimed a deduction), and so were not deductible by Mr Howard. We accept the Commissioner's contention.

24. The only evidence is that Disctronics expended an amount in excess of $1.2 million in legal fees and disbursements in relation to the Supreme Court proceedings. There is no evidence to demonstrate Mr Howard incurred any expenses (by way of reimbursement of Disctronics or otherwise), or that, in any event, such occurred in the 2005 income year.

25. As to the penalty, the Commissioner imposed a penalty at a base rate of 75% of the tax shortfall, with no remission. This penalty was imposed on Mr Howard on the basis that he intentionally disregarded the law in failing to include the sum of $861,853.35 in his assessable income. This seemed to be based upon the Commissioner's view that Disctronics was being used as a tax effective vehicle for Messrs Donovan, Quinert and Howard, with little belief in their version that they were always acting as directors of Disctronics, and that the award of equitable damages was income in the hands of Disctronics, not their own.

26. Mr Howard has the onus of proving that the penalty assessment was excessive: see s 14ZZO(b)(i), Taxation Administration Act 1953 (Cth) ('the TAA'). The primary judge, having accepted Mr Howard's arguments below on the primary issue, did not need to consider penalty.

27. Mr Howard has given evidence that at all times (which we take to include the time at which or before he lodged his 2005 tax return) he was cognisant of his obligation as a fiduciary to account for and remit profits made by him to Disctronics. This included the award made in the Supreme Court. Mr Howard stated he (and Mr Quinert) understood, and were advised, that this obligation extended to the whole amounts received under the award. In his affidavit sworn 27 May 2010, Mr Howard gave evidence as follows at [20](e):

Mr Quinert and I have at all times been cognisant of the obligation of a fiduciary to account for, and remit, profits made by a fiduciary to the entity that owns the corporate opportunity, We understood, and were advised, that this obligation extended to the whole of the amounts received and not merely the post-taxation amount. This belief was based upon the fact that once Disctronics exercised its entitlement to pursue the corporate opportunity then no entitlement to profit or income could have lawfully existed in favour of the directors. It was the obligation of the directors not to be in conflict with their duty of loyalty to, and to act in the best interests of, Disctronics.

28. In addition, Mr Howard has, throughout the trials in the Supreme Court and before the primary judge, maintained his acknowledgement of his fiduciary duties.

29. In this circumstance, there is sufficient evidence to conclude that there was no intentional disregard of the law, and Mr Howard does not have a level of culpability which attracts the most serious sanction available under the graduated penalty regime. As his Counsel said, Mr Howard gave consideration to the amount to be included in his return, took proper and competent advice, and acted according to that advice in lodging his return (and in a manner consistent with Mr Howard's own view of his legal responsibilities to Disctronics).

30. Neither party before us developed any argument as to alternative penalties, although Mr Howard did argue that no penalty should be imposed. Significantly, the Commissioner did not seek to argue, in the event that Mr Howard demonstrated that he did not intentionally disregard the law, for any lesser penalty. In the Amended Notice of Appeal of the Commissioner it was only contended that the administrative penalty (namely that at the rate of 75% of the tax shortfall) was properly assessed.

31. It was argued by Mr Howard that if the Court came to the view that he was assessable on the compensation received by him, no penalty was properly payable: Mr Howard had returned his income on the basis that he had a fiduciary duty to account to Disctronics for the compensation, a duty he had always acknowledged and in fact performed. It was contended that Mr Howard did not act in intentional disregard of the law; he did not act recklessly; and he did not fail to take reasonable care. Further, it was contended that the basis on which Mr Howard returned his taxable income was a reasonable position to take, as the judgment below and the arguments on appeal were said to illustrate.

32. We see merit in these contentions of Mr Howard. In any event, as the Commissioner has not succeeded in having the penalty imposed upheld, and has not sought to otherwise seek any alternative penalty, the appeal of the Commissioner in relation to penalty in respect of the 2005 year will not be upheld. The consequence will be that no penalty will be imposed.

2006 INCOME YEAR

33. In relation to the 2006 income year there are two issues:

• (a) whether the amounts received by Mr Howard from the Esparto Trust are assessable income; and
• (b) whether, if so, an administrative penalty should be imposed.

Assessable Income

34. During the 2006 income year Mr Howard, an Australian resident, had applied to his benefit by, or received from, the Esparto Trust amounts totalling, in all, $6,339,733. There is neither a question that immediately prior to their distribution to him this was property forming part of the Esparto Trust estate nor that he was, at that time, a beneficiary of the Esparto Trust.

35. Section 99B(1) of the Income Tax Assessment Act 1936 (Cth) ('the Act'), in terms and subject only to its proviso, required Mr Howard as a resident beneficiary to return this as income. It provided:

Where, at any time during a year of income, an amount, being property of a trust estate, is paid to, or applied for the benefit of, a beneficiary of the trust estate who was a resident at any time during the year of income, the assessable income of the beneficiary of the year of income shall, subject to subsection (2), include that amount.

36. If Mr Howard was to avoid the otherwise inevitable operation of s 99B(1) it was only through the gateway of s 99B(2). Relevantly, it provided:

The amount that, but for this subsection, would be included in the assessable income of a beneficiary of a trust estate under subsection (1) by reason that an amount, being property of the trust estate, was paid to, or applied for the benefit of, the beneficiary shall be reduced by so much (if any) of the amount, as represents:

• (a) corpus of the trust estate ( except to the extent to which it is attributable to amounts derived by the trust estate that, if they had been derived by a taxpayer being a resident, would have been included in the assessable income of that taxpayer of a year of income );
• …
• (c) an amount:
  • (i) that is or has been included in the assessable income of the beneficiary in pursuance of section 97

  (Emphasis added.)

37. There is no dispute that the amounts received by Mr Howard were part of the corpus of the Esparto Trust estate, directly, therefore, engaging subs (2)(a). The first question is the operation of the (emphasised) parenthetical excision to that subsection. The excision requires the positing of a hypothesis and the posing of a question premised on that hypothesis. The hypothesis posited is that the amount received by the Esparto Trust estate was derived by a resident taxpayer; the question posed on its assumption is whether that resident taxpayer would have been required to include the amounts it received as assessable income. This former is a fiction, in this case, because the amounts derived by the trustee of the Esparto Trust were not derived by a resident (the trustee being resident in the Isle of Jersey) and because, being a trustee, the amounts were not derived by a taxpayer (cf. s 99).

38. The answer to the latter is that if the Esparto Trust estate had been a resident taxpayer the amount received by it would have been included in its assessable income. This is because those amounts were received by it as the beneficiary of yet another trust called the Juris Trust. That trust was also resident in the Isle of Jersey. Maintaining in one's mind (as best one can) that one is to treat the Esparto Trust estate as a resident taxpayer this second layer trust requires one, once more, to apply the provisions of s 99B(2)(a). This time Mr Howard's (genuine) role as a resident taxpayer is subsumed by the hypothesis that the Esparto Trust estate is a resident taxpayer. Correspondingly, the Esparto Trust estate's (original) role as a hypothetical resident taxpayer is now supplanted by the Juris Trust estate's role as a hypothetical resident taxpayer.

39. A similar process of reasoning then ensues. It was not in dispute that the distribution by the trustee of the Juris Trust to the resident taxpayer, whom the Esparto Trust estate was hypothesised to be, was a distribution of corpus. Consequently, perhaps with some sense of déjà vu, one finds oneself back in the parenthetical excision to s 99B(2)(a).

40. There, having grasped the initial hypothetical transformation of the Esparto Trust estate into a resident taxpayer, one is now required (as part of that hypothesis's inevitable working through) hypothetically to treat the Juris Trust estate as a resident taxpayer and to ask whether the amounts received by it would have been included in such a resident taxpayer's assessable income.

41. In this case, having penetrated two layers of trusts - first the Esparto Trust; then the Juris Trust - one encounters for the first time a non-trust relationship. The trustee of the Juris Trust received non-trust distributions from another Jersey company called Esparto Ltd. Although the process of conjoining Mr Howard to the amounts paid by Esparto Ltd seems complicated, in reality it is not. Section 99B(2)(a) will simply apply as many times as there are interposed layers of trusts. Each application of s 99B(2)(a) leads to a hypothetical question about whether the amounts received by the trust estate would have been assessable income if they had been earned by a resident taxpayer. Once an answer to that question is known at the level of the deepest trust the answer cascades back up to the original (genuine) resident taxpayer. To unpick that slightly: if the Juris Trust estate had been a resident taxpayer and the amounts received by it had been assessable income, then the amounts received by the Esparto Trust, although corpus, would have fallen within the parenthetic excision in s 99B(2)(a) and would have been assessable income in its hands. This, in turn, provides the affirmative answer to the question posed by s 99B(2)(a) as to whether the amounts received by the Esparto Trust estate would have been assessable income on the hypothesis that the Esparto Trust estate was a resident taxpayer. But it is that answer on that hypothesis which applies to Mr Howard himself. What is revealed therefore is not complexity but repetition.

42. Once that is understood the question simply becomes whether the amounts received by the Juris Trust estate from Esparto Ltd would have been assessable income had it been (as it certainly was not) a resident taxpayer.

43. What amounts did it receive? It received the proceeds of a share buy-back which occurred when Esparto Ltd purchased its own shares back from the trustee of the Juris Trust. In some circumstances, a share buy-back may (depending on price) return to a shareholder not only capital but profits. Put another way, with care a distribution of profits may take at least the form of a return of capital. Through s 159GZZZP(1) the Act operates to reverse that effect by deeming the proceeds of such a share buy-back (beyond, inter alia, the paid-up capital) to be a dividend paid out of profits. The identification of the correct version of s 159GZZZP(1) was the subject of an irrelevant debate between the parties. It was irrelevant because they were ad idem that, whatever its form, it had been engaged and that the deeming required by it had been enlivened. In the present context it provided that "[f]or the purposes of this Act" the purchase price of a share buy-back of the kind which both sides agreed Esparto Ltd had engaged in:

is taken to be a dividend paid by the company:

• (c) to the seller as a shareholder in the company; and
• (d) out of profits derived by the company; and
• (e) on the day of the buy-back occurs.

44. It was not in dispute before this Court that this section had been engaged and that it therefore deemed the trustee of the Juris Trust to have received a dividend from Esparto Ltd paid out of profits. Why did this matter? It mattered because of s 44(1) of the Act which provided:

The assessable income of a shareholder in a company (whether the company is a resident or a non-resident) includes:

• (a) if the shareholder is a resident:
  • (i) dividends (other than non-share dividends) that are paid to the shareholder by the company out of profits derived by it from any source; and
  • (ii) all non-share dividends paid to the shareholder by the company; and
• (b) if the shareholder is a non-resident:
  • (i) dividends (other than non-share dividends) paid to the shareholder by the company to the extent to which they are paid out of profits derived by it from sources in Australia; and
  • (ii) non-share dividends paid to the shareholder by the company to the extent to which they are derived from sources in Australia.

45. It was within the interstices of this provision that the second debate in the 2006 appeal lay. For the Commissioner the argument was that one came to questions posed by s 44(1) with the baggage of the hypothesis demanded by the parenthetic excision in s 99B(2)(a); that is, one was to consider the position of a resident shareholder under s 44(1)(a) not because the Juris Trust estate was a resident taxpayer - it was not - but because s 99B(2)(a) required the making of the assumption that it was. Consequently, that hypothetical resident taxpayer would have been required to include in its assessable income the dividends paid out of the profits deemed by s 159GZZZP(1) to have existed and by s 44(1)(a)(i) to have been assessable. The cascading effect of s 99B(2)(a) then conveyed that conclusion upward through the two layers of trusts back to Mr Howard.

46. Mr Howard submitted, on the other hand, that this was not so. The fact was that the trustee of the Juris Trust was a non-resident being situated in the Isle of Jersey. What was in play was, therefore, the situation expressly contemplated by s 44(1)(b), that is, the position of a non-resident shareholder. Since it was not in dispute that the profits of the company in question (Esparto Ltd) were derived from sources outside Australia, it followed that s 44(1)(b)(i) could not apply and the amounts could not be assessable income.

47. The Commissioner's submissions are to be preferred. Mr Howard's argument depends for its efficacy upon ignoring the hypothesis explicitly erected by the parenthetic exception in s 99B(2)(a). In terms one is to consider whether the amounts received by the Juris Trust estate, if they had been received by a resident taxpayer, would have been assessable. Mr Howard's submission requires one to disobey that injunction and to assume that the notional testing of the quality of the amounts required by s 99B(2)(a) is to occur on the basis that the notional taxpayer is non-resident.

48. This is precisely, however, what s 99B(2)(a) does not say. Mr Slater QC who, with Mr Carmichael and Mr McInerney of Counsel, appeared for Mr Howard, submitted that it was accepted doctrine that deeming provisions such as s 99B(2)(a) were to be construed strictly and then "only for the purpose for which they are resorted to":
Federal Commissioner of Taxation v Comber (1986) 10 FCR 88 at 96. So much may be accepted. But the purpose contemplated by s 99B(2)(a) is the assessment under the Act of a taxpayer having the qualities of a resident taxpayer and receiving the amounts in question.

49. This is the orthodox understanding of the way in which the trust provisions in Div 6 of Pt III of the Act operate. Speaking, it is true, of the definition of the 'net income' in s 95 in relation to a trust estate (rather than s 99B(2)(a)), Barwick CJ described its operation this way:

The effect of the definition of the net income of the trust estate in s.95 is that the provisions of the Act are to be applied to the actual income of the trust estate as if it were the income of an individual deriving it.

(See
Union Fidelity Trustee Company of Australia Limited v Federal Commissioner of Taxation (1969) 119 CLR 177 at 181). It is true, no doubt, that s 95 is not the same as s 99B(2)(a) and it is certainly correct that Div 6 has received many amendments since the time of Union Fidelity. But the basic point it illustrates remains sound: Div 6, and its various hypothetical taxpayers, operate on an assumption that the fictions thereby engendered are to be assessed for tax under the balance of the Act. Mr Howard's submission that statutory fictions must be closely confined to the domain of their operation is, of course, correct. The difficulty, however, lies in the fact that that domain in the case of Div 6 generally, and in the case of s 99B(2)(a) in particular, is the whole Act. Once that is accepted, Mr Howard must be brought to s 44(1) on the hypothesis demanded by s 99B(2)(a) and no other; i.e., there must be an assessment of whether a resident taxpayer who derived the amounts received by the Juris Trust estate would have been required to include the amounts in its assessable income. Once that is accepted, s 44(1), together with s 159GZZZP(1), take their inevitable course and s 99B(2)(a) conveys that result through the overlying layers of trusts back to Mr Howard. That is the end of the matter.

50. A variant of Mr Howard's argument was to observe that the Commissioner's position involved, in effect, the piling one on top of the other of statutory fictions: the statutory fiction that the Juris Trust estate was a resident taxpayer; the statutory fiction that the proceeds of the share buy-back comprised a dividend paid out of profits; the statutory fiction that the Esparto Trust estate was a resident taxpayer, and so on. But there is, we think, nothing in this. It is the expected and ordinary operation of s 159GZZZP(1) that it would connect up with s 44(1). The only real question is whether the hypothesis raised by Div 6 of Pt III (here s 99B(2)) - that is, the need to create some kind of taxpayer when assessing the liability of trusts to income tax - is to be connected to the balance of the Act (here s 44(1)). For the reasons already given that question should be answered in the affirmative and the conclusions of the learned primary judge confirmed.

51. For completeness, some mention should be made of the alternative liability of Mr Howard under s 97. Section 99B(2)(c) (set out above) requires a reduction in the amount brought to tax under s 99B(1) for any amounts included in assessable income by reason of s 97. The learned primary judge analysed the position under s 97 in considerable detail. It is not necessary for us to do so because whatever is not included under s 97 will, by reason of the foregoing conclusion, be included by the necessary operation of s 99B(2)(c). That provision is a catch-all and, if necessary, as such is apt to catch the whole of the distribution to Mr Howard even if it be not brought to tax under s 97. It is likely, however, that Mr Howard's argument about the operation of s 97 likewise proceeds in disobedience to the similar express hypothesis demanded by s 99B(2).

Penalty

52. The Commissioner considered that the shortfall in Mr Howard's returned income for the 2006 year arose from an intentional disregard of a taxation law and therefore imposed upon him an administrative penalty of 75% of the shortfall under item 1 of the table in s 284-90(1) to Sch 1 to the TAA. Before the learned primary judge, Mr Howard challenged this determination and, in that regard, was successful:
Howard v Commissioner of Taxation (No 2) [2011] FCA 1421 at [183]-[199]. His Honour surveyed the facts which led Mr Howard to fail to return the proceeds of the share buy-back as income and, having done so, concluded that whilst intentional disregard was not shown, it was shown that the shortfall in Mr Howard's returned income arose from a failure to take reasonable care. His Honour therefore imposed the lesser administrative penalty of 25% on the shortfall amount under item 3 in the table to s 284-90(1). Item 3 imposed a 25% penalty if the shortfall amount "resulted from a failure by you or your agent to take reasonable care to comply with a taxation law (other than the Excise Acts)".

53. Before this Court both the Commissioner and Mr Howard challenged this conclusion. The Commissioner accepted the learned primary judge's findings of fact but sought to characterise them as involving recklessness on Mr Howard's part and therefore inviting a 50% penalty under item 2 of s 284-90(1).

54. The learned primary judge found these facts:

• • Mr Howard had obtained the advice of experienced Counsel in October 2005 as to whether the return of capital from Esparto Ltd to him via the Esparto and Juris trusts would be assessable income, and received advice that it would not be (at [186]-[187]);
• • at that time, however, it was not yet known that the return of capital would take the form of a share buy-back and hence Counsel was not asked to, and did not, advise on the operation of s 159GZZZP(1) (at [193]);
• • by March 2006, Mr Howard knew that the mechanism by which the capital would be returned would be a share buy-back (at [194]); and
• • despite that he did not obtain further advice (at [194]).

55. His Honour then rejected the proposition that such facts could show intentional disregard for the law. He noted that it had not been put to Mr Howard that he had recklessly turned a blind eye to the prospect that the Act might operate to bring the distribution into assessable income. His Honour's conclusion at [194] in that regard was this: "In these circumstances, I could not uphold the Commissioner's position that the applicant's shortfall amount resulted from his intentional disregard of the law. Neither did it result from his recklessness as to the operation of the law".

56. His Honour was, in our opinion, plainly correct so to conclude. In a slightly but not materially different context it has been held that the question of recklessness is objective but one which nevertheless requires either:

• (a) knowledge that there is a real as opposed to fanciful risk that the return may be incorrect; or
• (b) gross indifference to its correctness in circumstances where a reasonable person would see there was a real risk that the Act might operate to make the amount assessable income.

(see
Federal Commissioner of Taxation v R & D Holdings (2007) 160 FCR 248 at 261 [70] per Heerey and Edmonds JJ, at 270 [109] per Stone J). The learned primary judge's findings of fact do not provide direct material of either kind. Nor, in our opinion, do the facts as found by the learned primary judge provide material from which such inferences might reasonably be drawn. It was not put in this Court that it should have regard to any matters beyond those found by the primary judge. We do not need to consider, therefore, how far a taxpayer's sophistication might intrude upon an assessment of such matters.

57. Mr Howard's challenge to the primary judge's conclusion that he had not taken reasonable care in the preparation of his return for the 2006 income year centred around the issue by the Commissioner on 3 July 2006 of notices under s 264 of the Act to a firm of lawyers, Oakley Thompson & Co (with whom Mr Howard is a consultant). These notices had queried the source and nature of two international bank transfers on 13 March 2006 to Oakley Thompson & Co, including one of $5,528,817.

58. Oakley Thompson & Co responded to this inquiry on 7 August 2006. The precise terms of the letter were not put before this Court - indeed, we were told it was not produced in the appeal books. We have not seen it. An affidavit of Mr Howard of 27 May 2010 did, however, disclose its contents. According to this affidavit the letter showed that the funds received "are the remittance of a capital distribution from the Trustee of the Esparto Trust" and enclosed a letter from the trustees of the Esparto Trust which included the statement "on 10 March 2006 the Trustee used their [sic] discretion in making a Capital distribution to Mr Howard resulting in the sum of AUD 5,528,794.52 being remitted to Australia for Mr Howard's benefit". The actual capital distribution appears to have been very slightly different - $5,528,817 - and it is that sum together with a reduction in a debt owed by Mr Howard to the Esparto Trust that together make up the $6,339,733 claimed by the Commissioner to be assessable income.

59. It was not submitted to this Court that what was involved was a distribution of capital arising from a share buy-back. This is important and should be noted.

60. The gravamen of Mr Howard's argument is that despite telling the Commissioner the nature of what had occurred there was no subsequent demur by the Commissioner from that time (in August 2006) to the time when Mr Howard filed his return on 24 May 2007 about that which he had been told. That fact, taken together with the additional fact that Mr Howard had received the advice of Counsel in October 2005 that the distribution would not result in assessable income, made it reasonable to proceed on the basis that all was in order and thereafter (when no complaint was raised by the Commissioner about the August 2006 response) to proceed to file his return on the same basis.

61. The flaw in this argument is the one identified by the learned primary judge. Neither the advice obtained from Counsel nor the answer given to the Commissioner in August 2006 (at least so far as we were taken to it in the extract in Mr Howard's affidavit) referred to the fact that the return of capital proceeded from a share buy-back. It was the critical effect of s 159GZZZP(1) which transformed the distribution to income. The lack of reasonable care identified by the primary judge related to the failure of Mr Howard, once he was aware that return of capital was to be accomplished using the means of a share buy-back, to take further advice on the issue.

62. The Commissioner's silence in the face of the August 2006 letter says nothing about the reasonableness of Mr Howard in not seeking advice on the tax consequences of the share buy-back. For that reason, the primary judge's conclusion was, in our opinion, correct.

63. Against that conclusion Mr Howard rallied the point that lack of reasonable care had not been run below and that it was not, therefore, open to the learned primary judge to embrace the argument. There are, we think, two answers to this. The first is that the standard of reasonable care is an objective one and turns on a reflection upon the circumstances as known. The second is that the Commissioner did pursue a case of reckless indifference. We see no unfairness in the primary judge considering, effectively in the alternative, the lesser standard of lack of reasonable care on the same materials as the reckless indifference case.

DISPOSITION OF THE APPEALS

64. The question of whether the distributions were assessable income relevant to the 2006 income year was raised in this Court in Mr Howard's proceedings in VID 76 of 2012. This appeal also dealt with Mr Howard's challenge to the penalty decision. For the reasons we have given we would propose in VID 76 that Mr Howard's appeal be dismissed with costs. The Commissioner's challenge to the penalty for the 2006 year was contained in VID 77 and VID 78 of 2012. In VID 77 of 2012 we would propose that the appeal be dismissed with costs.

65. VID 78 of 2012 also dealt with the Commissioner's challenge in relation to the Kingston Links joint venture. For the reasons given, the Commissioner's appeal in relation to that venture should be upheld other than in relation to penalty. Insofar as VID 78 of 2012 deals with the penalty issue in relation to the Esparto Trust it should, however, be dismissed with costs.

66. However, whilst proposing these orders, we will give the parties the opportunity to file within 14 days separate minutes of proposed orders (including as to costs) in each appeal reflecting these reasons. In the event there is any disagreement as to the appropriate orders, the parties may contact the Court for further directions.