Case B11

Judges:
JL Burke Ch
RC Smith M
RE O'Neill M

Court:
No. 1 Board of Review

Judgment date: 27 February 1970.

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J. L. Burke (Chairman), R. C. Smith and R. E. O'Neill (Members): The taxpayer acquired a house (A) under the will of his grandmother who died in 1939. He and his family resided in the house until August 1964 when he bought a new home (B). He decided not to sell A although the proceeds therefrom would have been enough to enable him to pay for B. Instead he borrowed $22,000-$12,000 at 7½% per annum from a trustee company on the security of A and $10,000 at 6½% per annum from a life assurance company on the security of B. Of the $22,000 borrowed, $18,276 was applied towards the purchase of B and $3,724 to the repayment of a bank loan which had been used for renovations and extensions of A. As had been his intention when he decided to retain A, he leased it to a tenant for a term commencing at or about the time he vacated that house and took up residence in B.

2. Against $1,965 rent from A included as assessable income in his return for the year ended 30 June 1966, taxpayer claimed deductions including $1,536 interest paid in respect of the borrowed moneys. In assessing the taxpayer the Commissioner disallowed the claim for interest, but upon objection he allowed $260 for interest attributable on an apportionment basis to so much ($3,724) of the borrowed moneys as had been applied in paying off the bank loan which had been expended on A. The claim of the taxpayer before the Board is that he is entitled, pursuant to sec. 51(1), to a deduction of the balance of $1,276 interest.

3. Before the Board the taxpayer pointed out that the facts of his case differ substantially from those in
F.C. of T. v. Munro (1926) 38 C.L.R. 153. There, Munro carried on business in Melbourne, occupying for that purpose part of land and a building owned by him. Other parts of the premises were leased to tenants. With the object of starting another business in Sydney, Munro formed a company with a capital of £20,000 divided into 20,000 shares of £1 each. He borrowed from a bank about £30,000, repayment of which with interest was secured by mortgage on the Melbourne property. He applied the borrowed money as to £20,000 for shares in the Sydney company and directed that 18,000 £1 shares should be allotted to his sons as a gift, leaving only 2,000 for himself. The remaining £10,000 of the borrowed money he loaned to the company free of interest. Munro's claim for deduction against rent received of interest paid by him was unanimously rejected. His claim fell to be decided under the Income Tax Assessment Act 1922 in which sec. 23(1)(a) permitted deduction of ``all losses and outgoings... including... interest... actually incurred in gaining or producing the assessable income'', but sec. 25(e) of which prohibited deduction of ``money not wholly and exclusively laid out or expended for the production of assessable income''.

4. At pp. 170-171 Knox C.J. appears to have upheld the Commissioner's disallowance on the basis that any deduction was prohibited by sec. 25(e). Thus his Honour said at p. 170 -

``The prohibition enacted in this section is absolute; and the first question therefore is whether the amounts which the respondent claims the right to deduct were wholly and exclusively laid out or expended for the production of his assessable income. It is quite clear that the money borrowed from the bank was not so laid out or expended, for nine-tenths of the amount was applied directly or indirectly for the benefit of his two sons-directly as to the £18,000 paid for the shares given to them, and indirectly as to the advances made to the company, in which they held nine-tenths of the shares.''

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ATC 48

Further on in his reasons he said at p. 171-

``In this case the assessable income of the taxpayer was in no way referable to the transaction with the bank out of which the liability to pay interest arose, and the loan by the bank was in no way instrumental in or conducive to the production of the assessable income or that part of it which consisted of the rents of the freehold property. The respondent was, before the mortgage was given, entitled to the whole of these rents, and he did not gain them nor were they produced in consequence of the payment of interest. The interest was paid, not for the purpose of gaining or producing assessable income of the taxpayer, but for the purpose of satisfying pro tanto a debt which the taxpayer had incurred with a view, not to the production of his assessable income, but to the production of income by the company for the benefit of its shareholders. The debt having been incurred for a purpose wholly unconnected with the production of assessable income of the respondent, I think it impossible to say that the interest paid on the amount of the debt was money wholly and exclusively laid out or expended for the production of his assessable income.''

5. At p. 204 Higgins J. said-

``Where rents are received from property, and an overdraft is obtained by the taxpayer on the security of the property for the purposes of another enterprise or speculation, the interest paid by the taxpayer cannot be treated as a deduction from the rents for the purpose of the Income Tax Acts. The position is, to my mind, so obvious that I should serve no useful purpose by amplifying my reasons. I have read the judgment of the Chief Justice as to the merits, and I respectfully concur therewith, both as to reasoning and as to result.''

6. At p. 210 Rich J. simply said: ``... I agree that the Commissioner arrived at the right conclusion''. At pp. 217-218, after setting out the facts and the provisions of sec. 23(1)(a) and sec. 25(e), Starke J. said-

``The interest paid in this case was upon moneys borrowed for the purpose of contributing capital on the part of the taxpayer and his son to a newly-formed company. It was not an outgoing by means of which the taxpayer procured the use of money whereby he made any income.''

7. Only Isaacs J. specifically adverted to the application of sec. 23(1)(a). Thus his Honour said at pp. 197-198-

``I am unable to see how the interest referred to was `actually incurred in gaining or producing the assessable income'. `The assessable income' means the income which is taken as a basis as required by the introductory words of the section. It is said for the respondent that, since it was necessary to pay the interest if the taxpayer wished to retain his right to have the income from the property, it was interest by which the income was gained or produced. I am not able to accept that view. The taxpayer had already acquired and held his property as a rent-producing property to the full extent. Nothing more was necessary to gain or produce that income. Then he chose for his own purposes quite alien to that property to borrow money and incur a personal obligation to repay it with interest. So far, also, the property stood complete as a rent-producing instrument. But because he secured his personal debt by means of that complete rent-producing instrument he contends that the discharge of the obligation was `actually incurred in gaining or producing' the rentals it yielded. The simple position is that the property and its rentals existed before the loan and remained intact and unaltered after the loan. Had the money borrowed been expended on the property so as to increase the rentals or so as to prevent depreciation which would have reduced the rentals, then it could have been properly said that the interest had been a means of gaining or producing the assessable income. But in employing the borrowed money for purposes independent of the property, leaving its condition entirely unaffected, that result cannot be postulated. Nor is there any ground for attaching the loan to `the assessable income' arising from the business in Melbourne. That income and the whole Melbourne business were quite unaffected by the application of the money. In short, the interest paid to the bank was not paid to create any of the assessable income in question: it was incurred because, among other things, that income was in a manner of speaking already in existence.''

His Honour went on to say that even supposing that the interest fell within sec. 23(1)(a), it would be excluded by sec. 25(e).

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ATC 49

8. We concede that the facts in the present case differ from those in Munro's case. Here, when he committed himself to borrowing money, the taxpayer did not have any rent-producing property. The borrowing of the money in question was done according to the taxpayer's evidence for the purpose of enabling him to retain ownership of A so that he might have it available for letting for an income. If there were nothing more, one might say of the borrowed money that, in the words of Knox C.J., it was ``instrumental in or conducive to the production of the assessable income'' which consisted of the rents received and that the interest was paid ``for the purpose of satisfying pro tanto a debt which the taxpayer had incurred with a view... to the production of his assessable income''. Nor can one realistically say, adapting the words of Isaacs J., that in borrowing the taxpayer had ``his own purposes quite alien to that property'', i.e. A, which without the borrowing he could not retain and create as a rent-producing instrument.

9. But it is only part of the truth to say that the purpose of the borrowing was to enable the taxpayer to retain ownership of A with a view to leasing it. The rest of the truth is that the borrowing also enabled him to acquire ownership of B with a view to occupying it as a family residence. He might have achieved one or other of those purposes without borrowing. For instance, he could, without borrowing, have vacated A and leased it and himself have become a tenant of another dwelling in which event the rent he paid would surely not be deductible from rent received; or he could have sold A and used the proceeds to buy B for his own occupation, in which event he would not be liable for any interest. But without borrowing he could not both retain ownership of A for letting and acquire B for his residence. Then is the taxpayer on the facts as they actually are entitled to a deduction of a further part of the interest ascertained on some basis of apportionment as being ``the extent to which'' interest was ``incurred in gaining or producing'' rents from A? We think the answer must be No. Suppose he had decided that he would continue to live in A but would buy B for letting to tenants, and to finance the purchase of B he had to mortgage either or both A and B. In that situation, the converse of what in fact happened, we think that interest paid on the borrowed money could not be apportioned so as to disallow any part of it-the whole of the interest would qualify for deduction. So here, where money borrowed was applied in paying for B used as his private home, no part of the interest paid thereon is deductible.

10. As we see it, an outgoing incurred for interest on borrowed money is related directly and only to the principal in respect of which it is payable. Interest is in the nature of payment for use of the principal. Interest only comes into existence on account of the principal, and if interest can be said to be ``incurred in gaining or producing the assessable income'' (sec. 51) it can only be so related through the principal on which it is paid. Whether, in any particular case, interest is incurred in gaining assessable income must logically depend on the use to which the principal is put (see
12 T.B.R.D. 13 Case M13 and
14 T.B.R.D. 23 Case P23).

11. Although we were not asked to do so we have been at pains to give our reasons for rejecting the submissions made to us by the taxpayer in person in deference to and recognition of his honestly held conviction as to the soundness of his arguments. We would only add that the facts in the present case are virtually the same as those in
11 T.B.R.D. 38 Cases L38 and L71 decided by Board No. 3 and in
14 T.B.R.D. 31 Case P31 decided by Board No. 2. The decision in each of those three cases was against the taxpayer and, in our opinion, for the reasons we have given, the claim now before us also fails and we must confirm the Commissioner's amended assessment.

Claim disallowed