London Australia Investment Company Limited v. Federal Commissioner of Taxation
Judges:Helsham J
Court:
Supreme Court of New South Wales
Helsham J.: Three separate appeals against decisions of the Commissioner of Taxation have been brought to this Court and heard together by consent. They stem from three disallowances by the Commissioner of objections to notices of assessment lodged on behalf of the appellant in respect of the years 1967, 1968 and 1969. The appellant's accounting and tax years are the calendar years, and in each of those three years the appellant sold certain shares, some at a profit and some at a loss, but with a nett surplus from such sales in each of the three years. The Commissioner brought the surplus in as assessable income in each year. The appellant claims that the amounts arising from the sale of shares should not be brought to income account for tax purposes, and objects to the treatment of the surplus on sales of shares as assessable income for such purposes. Each case raises the same problems. The amount involved in 1967 is $816,651, in 1968 $140,166 and in 1969 $413,263.
In order to arrive at a solution to the tax problem and in the light of the way the case was argued, it is necessary to find out what the business of the company during the relevant years was - what it did and how it did it. Relevant to this is the reason that lay behind its activities, or the operating policy which guided the general business operations; I do not believe that for the purpose of this decision it matters whether one refers to this as policy, principle, motive or philosophy. It is also relevant to ascertain and make findings as to the basis upon which certain particular transactions were carried out. The evidence comes from the documents tendered, from the oral and affidavit evidence of Mr. Harper, a director of the appellant at all material times, and from the oral evidence of Mr. McKinnon, an employee of the management company which advised the directors of the appellant, and who produced most of the material which went before the Board of the appellant at its regular Board meetings.
I should add that I have, in my reasons for judgment, pursued certain topics raised by the evidence and canvassed in argument, and made certain findings about them which are unnecessary if the ultimate view I have formed is the correct one. However, the main point of the case is a difficult one, and one about which judicial minds might differ. If I am wrong, it is desirable to have findings of fact on other matters that may then become relevant.
The picture that emerges from the evidence is this.
The appellant, to which I shall refer as ``the appellant'' or ``the company'', was incorporated in 1957 in New South Wales and commenced business in that year. Its initial subscribed capital was £1,000,000 divided into shares of £1 each, but this was subsequently increased, so that at all material times for the purposes of these appeals the subscribed capital was $7,500,000 divided into ordinary stock units of $1 each. Its primary object as stated in the first clause of the Objects clause in the memorandum of association was -
``3. The objects for which the Company is established are -
(1) To carry on the business of an investment trust company and to acquire and hold shares, stocks, debentures, debenture stocks, bonds, obligations, securities and evidences of indebtedness or of the right to participate in profits or assets or other similar documents issued or guaranteed by any company wheresoever constituted or incorporated, or by any government, sovereign ruler, commissioners, public body or authority, supreme, municipal, local or otherwise, whether at home or in any other part of the world and any options or rights in respect thereof and to buy and sell foreign exchange.''
That this comprised the primary object of the proposed activities of the company was reflected in an investment memorandum put out in London in August 1957 which described the objects of the company as follows -
``The principal object of the Company is to establish in Sydney an Investment Company of the Management type.
The general policy of the Directors will be to acquire investments in the equity of selected Australian industrial and commercial companies which are judged to be well managed and financially sound
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and which offer good prospects for long term investment. Funds will also be invested, but to a minor degree, in the equity of mining companies.''
The investment activity of the company was directed to Australia to the intent that the company should invest mainly or wholly in Australian securities. It was not a company listed on any Australian Stock Exchange, and the shareholders were largely United Kingdom residents. Some time after July 1960 the company became registered on the London Stock Exchange and an advertisement published by the company in connection with the application for listing stated -
``HISTORY AND BUSINESS . - The Company, which was registered in Sydney, N.S.W., on 21st August, 1957, as a public limited company with an issued share capital of seven subscribers' shares of £1 each, carries on business as an investment company of the management type. In September, 1957, 999,993 shares of £1 each were issued for cash at par. In July, 1959, 1,000,000 shares of £1 each were issued for cash at par to Stockholders on the basis of one new share for every £1 of Stock held, and 400,000 shares of £1 each were issued for cash at 23s. per share: since 31st December, 1959, the second and the final calls each of 5s. per share have been paid on these 1,400,000 shares and these shares have been converted into Stock. The Company has not established any place of business in the United Kingdom.
It was realised at the time of the original issue that there was a growing interest among United Kingdom investors in Australia's industrial and commercial expansion, and subscriptions to that issue were largely derived from the United Kingdom. The general policy of the Company has been to invest its funds in the securities of Australian companies quoted on Australian Stock Exchanges, and more particularly in those Australian securities for which there is no quotation or established market in the United Kingdom. Up to the present time by far the greatest part has been invested in ordinary stocks and shares, but certain investments have been made in debentures, notes and preference shares. Investment has also been made in the shares of companies registered outside Australia, a substantial portion of whose assets and business is within Australia, and also in the shares of one company registered in and trading mainly in New Zealand. The Directors have sought to place part of the funds in the securities of companies showing a high growth potential and a higher dividend yield than the established market leaders. A very small proportion of the funds has been invested in the securities of unquoted companies. At 30th June, 1960, after deducting amounts due to sharebrokers, a sum of £52,095 was held in cash. A full list of the investments held at the end of each year is published with the annual Report and Accounts.''
I have quoted these extracts because they are a convenient way of summarising what the company claimed it was proposing to do and was doing which can be tested against the mass of detailed evidence of the numerous transactions that have been examined during the course of the hearing.
The company at all relevant times had no place of business and no employees in Australia. It was managed by a management company, Anglo-Australian Corporation Pty. Limited (A.A.C.) and later by Australian United Corporation Limited (A.U.C.) in the sense that those companies provided accounting, secretarial and management services and provided detailed advice and recommendations to the Board concerning the company's investment business. Mr. Harper, as an employee of A.A.C. and general manager of A.U.C. as well as a director of the appellant since 1962, is in a strong position to give evidence as to what went on in the business of the appellant during the relevant time, and how it went about conducting that business, both as to this and as to what policies were guiding the directors and lying behind the business decisions made by them. This is relevant material in which to consider share transactions during the relevant years because, as I have said, it is the surplus proceeds arising from disposals of shares
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that has given rise to the dispute here. And while it is true to say that Mr. Harper could only give evidence as to the motives that guided his approach to business decisions, and his belief as to those which guided his co-directors, I believe that such evidence coming from a director closely associated with management advice can be treated as some evidence of a fact in issue, namely what was the business policy underlying the company's activities in dealing with its shares generally and in relation to certain specific transactions. Such policy can be inferred from other evidence, such as what the company did, what advice was tendered to it, and so on. But it is also permissible to weigh such inferences in the light of the evidence of Mr. Harper, so that where conflicting inferences may be drawn the Court is in a better position to adopt that which is the correct one. The way in which I think the evidence of Mr. Harper can be used is no less the case where the person who was chairman of directors over the relevant period is dead, as is another director (Sir Maurice Hutton) whose suggestions in 1967 as to company policy gave rise to buying and selling activities that may have contributed to the problem that now falls to be solved (see transcript pp. 21, 58, 70-4, 91, 95).I should add that in order to obtain an accurate picture of what the company did and why, and as a step in assessing the evidence of Mr. Harper, it is relevant to look at the accounting methods of the company in the light of the provisions of its articles of association. Concerned in this is article 121 which was at the times involved in the following terms -
``(a) All moneys realised on the sale or payment off of any capital assets of the Company in excess of the price at which such assets stand in the books of the Company at the time (hereinafter called `the book price') shall except in the case of partial realisation of an asset when such moneys may be used to write down the book price of the remainder of the asset until it is reduced to nil be carried to the credit of an account called `Provision for diminution in value of Capital Assets' which provision shall not except as hereinafter mentioned be available for any other purpose. There shall also be carried to the credit of such reserve any other sums representing accretions to capital including for this purpose sums resulting from the writing up of the book values of any capital assets. The Directors may at any time and from time to time at their discretion transfer from the `Provision for diminution in value of Capital Assets' to a reserve to be called the `Capital Reserve' the whole or part of the sum standing to the credit of `Provision for diminution in value of Capital Assets.'
(b) The `Capital Reserve' shall not be available for dividend, but may be transferred to the `Provision for diminution in value of Capital Assets' or used to meet depreciation or contingencies or for improving any property of the Company of for such other purpose as the Directors in their discretion think conducive to the interests of the Company. Any loss on the sale of capital assets may be carried wholly or partially to the `Provision for diminution in value of Capital Assets' or the debit of the `Capital Reserve' or may be charged wholly or partially against other funds of the Company as the Directors may in their discretion determine.''
The evidence shows that the company took into its annual balance sheets during the relevant period (no doubt in the light of the provisions of sec. 342 of the Companies Act, 1961) under the heading ``Capital Reserves'' an amount shown as Investment Fluctuation Reserve being ``nett surplus arising from adjustments to the company's portfolio'' being the surplus from sales of shares, using a method of computing that surplus that has not been the subject of any criticism by the Commissioner. Indeed, the Commissioner, in relation to one argument put by the taxpayer as an objection to the assessments, submits that the company calculated the surplus on the sale of shares by the correct method. That method can be described thus.
The company, as part of its activities, bought and sold shares. But the shares it sold in any one tax year were not necessarily
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bought in that year, in whole or in part. Nor were all the shares held in each company necessarily acquired at one time or for one price per share. Similarly, shares in any one company sold during a tax year were not sold in the one parcel for the one price per share. So the accounting method used was to take the average cost of the shares and compare it with the nett proceeds of sale in each case calculated with reference to the number of shares sold in the relevant year; the result was shown as the pecuniary gain or loss in that year resulting from the sale of shares in each company, whether the total shareholding or only a parcel of shares held by the appellant in the particular company had been disposed of. For example, a number of shares bought before 1967 were sold in that year and similarly with the other years in question. They are set out in Exs. D, E and F, listed under the names of the companies concerned. These documents show that shares in thirty-three different companies (and rights to shares in an additional four companies) bought before or during 1967 were sold in 1967, shares in thirty-seven companies (and rights to shares in one) bought before or during 1968 were sold in 1968, and shares in eighteen companies (and rights to shares in three) bought before or during 1969 were sold in 1969; some of these overlap, in the sense that some shares bought before 1967 were sold in 1967 and 1968, and similarly shares in three companies were sold in both 1968 and 1969. However, the computation of the surplus is done in the same way, namely by taking the average cost of the shares in each company - the amount actually outlaid by the appellant in purchase - calculating that cost with reference to the number of shares in that company sold during the year, and comparing that calculation with the actual proceeds received for that number of shares. 80,000 B.H.P. shares were acquired from 1958 to 1966 (or 1962 to 1966) at an average cost of $5.24790; 25,000 were sold in 1967; the cost of those shares was therefore computed at $131,197.51; they were sold for $353,743.14; the surplus was therefore taken into the accounts at $222,545.63. So with the other sales during the three years. Not all were sold with a computed surplus; there were deficits on disposals in some cases, computed in the same way. It is the nett results of the disposals (surpluses less deficits), that comprise the three amounts I have mentioned earlier, and which this case is about. Each nett figure, being the surplus in each of the three years in question, has been carried into the company's accounts and balance sheets to the credit of an investment fluctuation reserve as I have said. The taxpayer objects to being assessed with these sums included as taxable income.In an affidavit sworn in connection with these appeals Mr. Harper gave evidence about most of the disposals made during the years in question, giving so far as he was able reasons for the purchase of the shares in the first place and for their disposal. He used records of the company to supplement his own recollection. He was examined and cross-examined about the activities of the appellant in general and about some of the disposals in particular, special emphasis being placed by counsel for the Commissioner upon the disposal of shares in fourteen different companies which for one reason or another were considered worthy of special attention by him. There is with the papers schedule of those companies, and a reference to the pages of the transcript where each is dealt with. I do not propose to go over the evidence in detail; the shares in each of those companies, or such shares in each company as were disposed of were disposed of at a profit, in most cases after the shares had been held for a relatively short time (in some instances as short as one or two months) and in other cases in circumstances arousing suspicion. I say ``arousing suspicion'' because the Commissioner sought to rely upon those disposals in one or both of two ways, either as showing that the motives which guided the company in its business operations and hence in the disposal of its shares were not those claimed by Mr. Harper to be the ones operating on the minds of the directors, or as showing that the transactions in relation to these shares fell into a category of dealing that brought the proceeds of their disposal to tax under sec. 26(a) of the Income Tax Assessment Act. It is convenient firstly to turn to the general activities of the appellant and the motives which guided
ATC 4219
those activities, and to return to the special instances later.The company was an investment company, the primary object of its investment activities being to produce dividend income which it could distribute to shareholders. It also conducted a business of sub-underwriting, but this can be ignored for the purposes of the present case because profits from this activity were brought in for tax purposes in any event. There were certain tax benefits to be had by shareholders resident in the United Kingdom whose dividend income from the appellant was derived by the appellant from dividend sources in Australia; it is unnecessary to detail these tax benefits, but it is important not to overlook the fact that the obtaining of income from dividend sources in Australia was the primary and by far the largest source of income of the company. In order to produce this income the appellant invested in a number of shares in listed public companies in Australia from which it hoped or expected it could immediately or within a reasonable time obtain a dividend yield of 4% or better, (see e.g. transcript pp. 7, 59); dividend yield means return on shares calculated as a percentage of their market value. The total of the company's investment holdings was known as its share portfolio. Certain considerations governed the make-up of the appellant's share portfolio. One was the holding of an adequate number of shares in any company in which an investment was made, so that adequate supervision of the assets of the appellant could be ensured; this meant small parcels of shares were not as a rule held, and the number of companies in which investments were made was relatively small compared to the money invested; for example, for the year ending 31st December, 1967, the shareholders' funds, amounting to $10,446,997, was invested in 116 companies; for the year ending 31st December, 1968, shareholders' funds of $10,658,041 was invested in 96 companies; and for the year ending 31st December, 1969, shareholders' funds of $11,104,473 in 91 companies.
Another consideration governing the make-up of the company's share portfolio was a requirement that shares held should be readily marketable, so that they could be disposed of in the event that a change of investment became necessary or desirable; this was an aspect of security of capital, as explained by Mr. Harper at transcript p. 21; marketability was a relevant factor when considering acquisition of shares (transcript p. 82); it was an aspect of marketability that investments would be made in companies the market value of whose shares was not likely to decline (transcript pp. 48, 63). Another consideration was proportion; the company aimed at not permitting any one holding to exceed about five percent of its total investment. Another factor was the earning yield which is the profits of a company compared to dividend yield; it was desirable that companies in which shares were held should have current earning yields of one and a half to two times dividend yield, so that dividends were adequately covered (transcript p. 82).
Now, a number of things are bound up with this investment emphasis and policy. One is that the appellant was always interested in growth potential of shares, as it has been called. This was adverted to in the evidence on numerous occasions, and in relation to this company I am satisfied that the company was interested in shares with growth potential in the sense that that expression is defined by Mr. Harper as ``potential for growth in income from dividends'' (transcript p.11). But growth potential looked at in this way is very much the same thing as potential for increasing in market price - value or price appreciation will almost always be a reflection of what the public thinks is the likelihood of an increase in earning yield and hence increased dividend yield; the two go hand in hand. So that one could almost say as a matter of course that if there is an expectation of increased dividend yield there is an expectation of increased market price; and the converse is no doubt also true. Mr. Harper explained this and agreed that increased dividends or earnings and increased share prices are inseparably linked (transcript pp.12, 71, 74); and while no doubt Mr. Harper would have wished to be, like Humpty Dumpty, master of these words so that they meant just what he chose them to mean - neither more nor less - I do
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not think one can be so dogmatic (and certainly not scornful) about their use or meaning; indeed, the expression ``growth potential'', or a similar expression, was used in the company's activities from time to time to mean potential growth in market value. Notwithstanding all this, I am quite satisfied that to this company in relation to decisions about shares, growth potential meant the expectation of greater dividend yield, and that one of the considerations motivating purchase of shares by it was the growth potential of those shares in this sense. Equally, I am satisfied that the prospect of an increase in capital value alone was not a factor which guided the Board of the company in the purchase of shares. Both Mr. Harper and Mr. McKinnon have sworn that shares were never bought by the company for the purpose of profit-making by sale, or for the purpose or with the intention of selling them; nor were they bought with the expectation of increase in market value as the sole reason for purchase. I accept their evidence (see transcript pp. 78, 82, 84 and Mr. Harper's affidavit pars. 16 and 17).I find then that this investment company carried on business guided by the policy that such shares as were bought were purchased to be held as an investment to yield dividends either immediately or in the foreseeable future at a satisfactory level. This must be qualified in a certain respect, which I shall do in a moment. But basically it is correct and reflects the principle behind the business activities. Upon it the company bought and sold shares having in mind the various investment considerations to which I have already made reference.
In the conduct of the business in this way it was inevitable that shares would increase in market value - this was foreseen and desirable. If this happened without a corresponding increase in actual dividend, then the dividend yield on the shares would fall, or the yield expectation would fall, in some cases making such shares no longer a desirable investment for the company; this in turn might prompt a sale of the shares in question. If such a sale did take place at the increased market price then it was inevitable that there should be more funds available for reinvestment in the purchase of new shares, so enlarging the capital base of the company. This in turn would tend to increase the dividend income of the company if investment were made in shares having a more acceptable dividend yield. With the type of shares that the company chose to invest in, and the market climate that existed in 1967, 1968 and 1969, sales of shares did take place, the capital base of the company was enlarged, and the dividend income increased. I have already referred to the figures showing an increase in shareholders' funds in the three years; the corresponding dividend income was $478,406 for 1967, $515,314 for 1968 and $546,233 for 1969. But notwithstanding this I accept what Mr. Harper says, namely that the purpose of selling and buying shares was the improvement of the dividend return to the company from the capital employed in producing it (see transcript p.25).
I think one can summarise this evidence by stating that the relevant business of the company consisted of investing money in share for the purpose of producing income to be paid as dividends to shareholders, safety and preservation of capital being a factor that influenced investment policy, but the underlying or basic factor being the use of shareholders' funds for the acquisition and retention of satisfactory income-producing shares. The law must be applied to a business of this nature in order to determine its tax liability.
This conclusion does not mean, however, that the buying and selling activity of the company was not considerable - in fact it was. The directors met each month and considered reports from the management company. The business of the company centred around its share portfolio, and the management company's activities were directed towards that share portfolio - ``when the management company did anything for London Australia it would be in relation to that share portfolio'' (transcript p. 9). The management company watched the portfolio in relation to what was going on in the market, prepared material for each Board meeting which covered not only the companies in which shares were held by the appellant but also those in which the
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appellant might be interested in investing. Documents prepared by the management company for use at each Board meeting included lists of purchases and sales and subscriptions to new issues during the previous month, analyses of share price index movements, share balances after authorised buying and selling, capital issues, a comprehensive analysis of the shares held as to price, income and earning yield, and other material giving information about the appellant's shareholdings; there were also from time to time comprehensive reports about particular shares in which recommendations as to sale, purchase or retention were made (see generally Mr. Harper's affidavit, Exs. 6, 7 and 10, transcript pp. 19-20, 58-69). The Board regularly had before it a very considerable and comprehensive body of information concerning the shares that had been sold and bought, that were held or might be held, actual and likely movements of those shares, and suggestions as to what should be done about them. Every month over the three years in question the Board made decisions about buying and selling and the appellant either bought or sold shares during every month. Mr. McKinnon said (transcript p. 91) -``Q. Taking those three years with purchases and sales in every month, or virtually every month, the directors were intent to make decisions about both purchases and sales every month, at every meeting?
A. Yes.''
Exhibit 16 shows that there were purchases in every month, and sales in every month except three. The figures extracted from the appellant's purchases and sales journals (Exs. G and H) show -
1967 Purchases 1,470,182.98
Sales 2,062,610.27
1968 Purchases 1,700,408.97
Sales 1,816,086.21
1969 Purchases 1,248,730.61
Sales 1,114,472.42
For comparison it might be mentioned that the total share investment of the appellant at cost over the same years was -
1967 9,813,896
1968 9,879,229
1969 10,530,040
There was over the period in question a continuous large scale activity in the buying and selling of shares. The resultant enlargement of the capital base of the company and income return over the three years in question I have already mentioned; this result was, naturally enough, considered desirable (transcript p. 25). Indeed, many of the reports and information coming to the Board from the management company referred to growth potential of shares as meaning likely capital appreciation in connection with recommendations for sales and purchases (see e.g. transcript pp. 12, 22, 23, 29, 60, 63, 66, 71, 74, 92-3 and Mr. Harper's affidavit).
But it is proper to reiterate that the investment policy considered by the Board best suited to further the interests of this investment company required this amount of buying and selling, and that sales and purchases of shares by the appellant were geared to dividend yield, and that the decisions were made with the object of ensuring the best dividend return upon the capital available pursuant to an investment policy I have tried to explain.
In reaching this conclusion I should add that I have not overlooked three matters which ought to be mentioned in connection with the share buying and selling operations of the appellant.
The first is that there were certain exceptions to the underlying policy behind the share acquisitions and sales. As I have said, the appellant aimed its share portfolio at a dividend yield of 4% - actual or potential. But it did buy, and sell, shares which had a much lower yield than this and which had little or no growth potential so far as yield was concerned. These shares were what had been termed market leaders, discussed by Mr. McKinnon at transcript pp. 87-9 and by Mr. Harper at transcript pp. 31/4, 62, 73. It was argued on behalf of the
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Commissioner that they fell into a special category, particularly the shares held in BHP, and could be looked at in isolation for taxation purposes if the main contention propounded on behalf of the Commissioner were to fail.It is true to say in one way that these market leaders fell into a special category so far as the company's activities were concerned, in that their yield was never 4%, and some were sold off at highly profitable figures. For example, some 76,701 (it may have been 80,000) BHP shares were bought between March 1962 and December 1965 at percentage yields running from 1.98% to 3.65%; 25,000 were sold off in 1967 at a profit of $222,545.63. Mr. Harper was asked about this (transcript pp. 30-6) and gave reasons for the sale. I accept what he says. I am satisfied that no special purposes or motives should be attached to the purchase and sale of these BHP shares, and that they fell within the parameters of the company's ordinary operations. These shares were not bought for profit making by re-sale, nor in pursuance of any profit-making scheme; on the question of taxability of profits they fall to be considered along with the company's other share operations. The same may be said, for example, of the company's shares in Western Mining Corporation Limited, 20,000 shares in which were bought in 1966; the dividend yield on these shares was apparently either 2.43%, with prospects that it would not increase and probably decrease as a yield over the next three years (transcript pages 41-3), or the shares purchased were on a deferred dividend basis for three years. All but 3,000 of these shares were sold within six to twelve months of purchase, resulting in a profit of $174,440.13. Although the reasons for sale are not very clear, (transcript p. 43) one can infer that a rise in price made the dividend yield or potential dividend yield even lower, and that this prompted sale. Giving full weight to the suspicion that must attend this transaction, I am not prepared to hold that it falls into any special category of dealing in shares outside the parameters of the company's ordinary business activities, and I believe that the profit falls to be considered in the same way as the profit from the sale of the BHP shares I have already referred to.
I have not overlooked the holdings of market leaders in reaching the conclusions I have reached as to the company's activities.
And although not a matter concerning market leaders, it might be convenient here to mention that I have also not overlooked transactions concerning the shares of twelve other companies in which the appellant held shares, which were the subject of close scrutiny on behalf of the Commissioner by means of cross-examination of Mr. Harper and reference to the documents. Together they are the shares in the 14 companies I mentioned earlier. I will not even attempt to summarise the evidence relating to these further twelve companies, but generally speaking it can be said that the shares acquired by the appellant in them were sold at a profit within a sufficiently short time after acquisition to excite suspicion that they were not bought and disposed of as part of the ordinary business activities of the appellant. It was submitted on behalf of the Commissioner that the appellant had not shown that the transactions in these shares fell to be dealt with in the same way as the rest of its share dealings, or that the profits from them were not income falling within the provisions of sec. 26(a) of the Income Tax Assessment Act. A list of the shares involved and a summary of the transactions with respect to them are conveniently set out in a document prepared by the Commissioner, headed ``Figures in support of the application of sec. 26(a)'', which is with the papers; the cross-examination of Mr. Harper about them runs from transcript p. 27 to p. 58. However, I have reached the conclusion that the transactions in relation to the shares of the fourteen companies that were singled out for special examination also come within the parameters of the plaintiff's ordinary business activities, and from a taxation point of view must be treated as one with the other buying and selling operations. No doubt decisions had to made concerning the purchase, and particularly the disposal, of investments, which decisions were not all identical; there were a number of factors involved in purchase, retention or disposal,
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and no two decisions were, I suppose, likely to be the result of the same emphasis being placed upon the same factors. But basically the dealings in these investments conformed to the motives lying behind the running of the business of the appellant as an investment company. I do not consider that the profits made from the dealings in the shares of the fourteen companies places them in a category of income under the Act different from that of the general profits made from share dealing activities.The second matter concerns what is known as the All Ordinaries Index, a figure calculated on stock exchange figures reflecting the market price fluctuation of all the ordinary shares listed on the market over any period of time - ordinary shares being the type of shares in which the appellant invested. Over the three years in question the all ordinaries index rose from 334.83 in January 1967 to 654.03 in December 1969, a quite extraordinary movement considering that it stood at 304.67 in January 1962. It is put as an explanation for the profits made on the sale of shares by the appellant that any sales of shares over this period would have ordinarily reflected the upward trend of prices as indicated in the all ordinaries index, and that the transaction must be looked at in this light. It is perhaps not irrelevant to bear in mind this indication of share market trends when considering the nature of the profits made by the company in its share activities. It could be said that the rising price of shares in the market place over the three years under review forced the company to sell its investments if it was to pursue its policy of ensuring a 4% dividend yield. Schedules by both sides to this dispute have been prepared and placed before me with the object of comparing the increase in market value of shares held by the appellant and its capital profits with the increase in the all ordinaries index. I think the state of the market is one factor explaining the course of business adopted by the appellant, and I have taken it into account in reaching the conclusions I have reached as to what the company was doing and why it was doing it.
The third matter concerns a change of activity in 1967 brought about by the suggestions of Sir Maurice Hutton. He made these suggestions in a memorandum enclosed with a letter to the chairman dated 22nd August 1967 (Ex 3.). Basically he suggested a greater turnover in the company's portfolio, up to 40% per annum, with the object of increasing the returns from shares, presumably by selling any low yielding shares and buying instead high yielding ones (transcript p. 70). This prompted at least one, and possibly two reports from the management committee to the directors (Exhibits 2 and 10) which recommended considerable sales of shares with specific details as to what shares should be sold and what retained; it was reflected in some share selling and buying activities of the company as a result (transcript p. 74). Mr. Harper was cross-examined at some length over this suggestion, and I think he agreed that the implementation of Sir Maurice's suggestions would have involved the enlargement of the capital base of the company. He answered these questions at transcript p. 70 -
``Q. Taking that up for a moment, Sir Maurice's recommendations involved the greater turnover of the shares held by the company, if implemented, did they not? A. Yes.
Q. That turnover in itself was thought by Sir Maurice to assist in the production of a higher dividend yield to the company, is that not so? A. Provided you sell the low yielding shares and buy high yielding shares, yes.
Q. So that in his recommendations, was the idea of enlargements of the capital base as mentioned in your affidavit? A That would follow, yes.
Q. And that would be obtainable where shares were sold at prices in excess of those at which they had previously been bought? A. In most cases we hoped and in other cases no doubt there would have been some losses as well''
and see generally transcript pp. 70-4. The reason was that to increase the dividend return low yielding stocks would be replaced with those showing or with a potential of showing a higher yield; insofar as this meant selling off shares that had increased in price and replacing them with shares that had a potential for increasing their market price,
ATC 4224
this is merely a re-statement of the same inter-relation between dividends and prices to which I have referred when discussing growth potential. The implementation of the Hutton suggestion may have involved taking advantage of the profit from the sale of shares that had gone up in price - had become ``overpriced'' or ``fully valued'' were expressions used - and enlarging the capital base of the company by buying shares that had growth potential. That this did happen is not very clear from the evidence notwithstanding what Mr. Harper said as set out above. However, the spotlighting of the Hutton suggestions was directed to two tax positions as I understand it. One was to throw up the essential nature of the business activities of the appellant. I will come to this later, but it was used to emphasise that the business of the company was concerned with the switching of shares to reap the dividend rewards. The other tax position was to bring the profits arising from the activities that followed the Hutton suggestions within the ambit of sec. 26(a) of the Act. For Mr. Harper said he believed that the big share adjustment which was suggested was put into effect (transcript p. 74 - Mr. McKinnon says so too, transcript p. 91) and that it was what he described as a ``once off operation'', not repeated (transcript p.72). It was argued that this amounted to the carrying out of a profit-making undertaking or scheme by the company and that any profits arising from it were taxable as income.Leaving on one side the difficulties of tying any profits to the implementation of the Hutton suggestions (the profits were not so quantified and this difficulty was not adverted to by counsel for the Commissioner), the argument fails. I do not believe that the suggestion and its implementation were any more than an intensification of the ordinary activities of the company based on the same business policy that it adopted before and after this interlude. As I have already said, the matters of dividend yield and market price went hand in hand, and if a change of investment for the purpose of maintaining dividend yield had sometimes a necessary, and no doubt desirable corollary of capital profit and capital base enlargement, then this was the company's business, and the Hutton activities no different. If this type of business activity taken as a whole amounted to a scheme within sec. 26(a), then so be it; but the Hutton activities did not yield profits that come into any category of income different from that made by the company on its other disposals of shares.
It is in this factual situation that the basic stands taken by each side become clear. But before proceeding to discuss them it is apposite to express my view that the general question of taxability of the realisation profits falls to be determined by reference to sec. 25 of the Act and not to sec. 26(a). By reason of my findings the share dealings over the three years cannot be fragmented and dealt with separately but must be looked at as a whole. And taken as a whole I have found that the shares were not property acquired by the taxpayer for the purpose of profit-making by sale; this was not the main or dominant purpose actuating the acquisition of the shares (see per Gibbs J. in
Jacob v. F.C. of T. 71 ATC 4192 at p. 4193; 45 A.L.J.R. 568). Nor do I believe that the profits obtained from a continuity of the business activity of the appellant over three years fall within the concept of profit arising from the carrying on or carrying out of any profit-making undertaking or scheme. The cases relating to the circumstances in which this basis of assessment is to be applied are reviewed by Stephen J. in his reasons for judgment in
A.C. Williams v. F.C. of T. 72 ATC 4157; 46 A.L.J.R. 581. It is unnecessary to say more than it does not apply here.
The appellant taxpayer says that it was not trading in stocks and shares and that its business consisted of investment with the intention of deriving income; if the business consists of investment for dividends, then the fact that the investor may make a capital gain is irrelevant, as is the fact that it carries on its investment business in a professional manner and on a large scale. As it was put by Windeyer J. in
Mercantile Credits Limited v. F.C. of T. 71 ATC 4015 at p. 4020; 123 C.L.R. 476 at p. 487 -
ATC 4225
``... and to my mind the acquisition of shares in a company which can later yield a dividend, as that term is defined in the Act, is prima facie the acquisition of a capital asset. Dividends when declared and received are income. The shares are capital; and the price paid for them is an out-going of a capital nature. That is as I see it. This is not a case of buying shares with resale for profit as the dominant purpose. If it were, sec. 26 would bring a profit to tax, or sec. 52 would make a loss an allowable deduction. Those provisions of the Act reflect basic economic doctrine embodied in ordinary concepts of capital and income. In saying that, it is not necessary to resort to the classical economists' theory of circulating capital or modifications of it. But neither sec. 26 nor sec. 52 bears directly on this case; for trading in shares was not the taxpayer's business.''
That situation, says the appellant, is one that applies here. The profits arise from the sale of capital assets, they are the proceeds of the realisation of shares not acquired for the purposes of sale at a profit (cf.
Charles v. F.C. of T. 90 C.L.R. 598) and are not income according to the ordinary concepts of mankind. Counsel for the appellant commends to me the reasoning of Mr. Coates, a member of the Taxation Board of Review No. 2 in Case C105, reported in
(1953) 3 T.B.R.D. 612 (he dissented from the view of the majority). That was a decision involving an investment company whose activities seemed to coincide closely with those of the appellant, and at a time when there was a general increase in the market level of shares. In forming the view that the gain made on a sale of investments constituted a mere enhancement of value of the capital of the company, Mr. Coates said (p. 622) -
``But if the realization of investments does not fall within this type of activity, if it represents merely a change of investment - a `substitution of one form of investment for another' each of which is acquired and held for the same purpose, viz., as a source for the derivation of income in the form of dividends or interest - then I think that any surplus which may result in the course of making this change is incidental and should be treated as an accretion of capital.''
It is difficult to sum up the argument for the appellant or to apply it in the present case in more felicitous language. The appellant submits that I should reach the same conclusion as did Mr. Coates.
The Commissioner, on the other hand, takes his stand upon the basis that it was part of the regular business of the company to buy and sell securities resulting in a gain to the company, and that the business really amounted to the production of dividends by the manipulation of the capital base; his argument is that the activities of the company were directed to a composite gain, and that any composite gain that results is income in the ordinary sense.
This argument takes as its starting point the well-known passage from the
Californian Copper case (Californian Copper Syndicate (Limited and Reduced) v. Harris (1904) 5 T.C. 159) which has been adopted and applied in England and Australia. In
Colonial Mutual Life Assurance Society Limited v. F.C. of T. 73 C.L.R. 604 in the reasons for judgment of the court prepared by Williams J. the following passage occurs (at p. 614) -
``Prima facie the depreciation in or accretion to the capital value of a security between the date of purchase and that of realization is a loss of or accretion to capital and is therefore a capital loss or gain and does not form part of the assessable income: Lomax v. Peter Dixon & Son Ltd. But in the words of the Lord Justice Clerk in Californian Copper Syndicate v. Harris which have been so often quoted, `It is equally well established that enhanced values obtained from realization or conversion of securities may be so assessable, where what is done is not merely a realization or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business.'''
While each case must be judged on its own facts, it is informative to see the way in which the principles so enunciated have been
ATC 4226
applied. In the Colonial Mutual Life Assurance Society case the business of the company was the assurance of lives and the investment of its funds. So far as the investment side of the business was concerned, the Court said (p. 613) -``The fundamental policy of the Society in investing its funds is based on buying sound securities in order to hold them until maturity.
The predominant if not the sole consideration in acquiring securities is to obtain the most effective interest yield during the period between the date of acquisition and that of maturity. The greater the effective interest yield from the investment of the premiums over the assumed rate of three per cent, the greater the net surplus available for distribution among the policy-holders and the more attractive the policies of the Society become to the public in comparison with those of its competitors. In the year ending 31st December 1940 the effective interest yield was £4 8s. 1d. per cent. In order to maintain and increase the effective interest yield securities are `switched' from time to time, that is to say some are realized and the proceeds of sale immediately re-invested in other securities; but the percentage of funds so switched is small in comparison with the total holdings.''
The sales of the investments, whether at maturity or from switching operations, resulted in a surplus in the year in question, there being the difference between the average cost of the securities and the amount received upon realization. It was held to be taxable as income according to the ordinary usages and concepts of mankind. The Court said (p. 620) -
``The acquisition of an investment with a view to producing the most effective interest yield is an acquisition with a view to producing a yield of a composite character, the effective yield comprising the actual interest less any diminution or plus any increase in the capital value of the securities.''
It is true that this was said with reference to an insurance company and a case where the whole or part of the surplus was taken into the company's accounts in calculating the effective interest yield.
In a dissenting judgment in
Ruhamah Property Co. Limited v. F.C. of T. 41 C.L.R. 148, Isaacs J. at p. 165 referred to the Californian Copper case in formulating the legal principles to be applied. His Honour said -
``But the point to be observed is that the liability to pay income tax does not depend on whether the business was a holding business or an investment business or a selling business: whichever it was, it was the company's `business'. It seems to be thought, and this in my opinion is one of the fallacies in the appellant's contention, that once it is established that there is a realization or change of investment and there is an end of the matter. That is not so: it may be all that and something more. If a company does that, and what is done is also `an act done in what is truly the carrying on, or carrying out, of a business'(F.C. of T. v. Melbourne Trust Ltd.), then the profits resulting are proceeds liable to income tax as the proceeds of a business. In Californian Copper Syndicate v. Harris there was no limited company, but the presence or absence of the condition is more readily ascertained in the latter case than where individuals are concerned.''
The principle enunciated in the Californian Copper case (supra) has been applied to banks, which deal with securities as part of their business activities, so as to render gains and losses taxable income or losses incurred in production of income (
F.C. of T. v. The Commercial Banking Company of Sydney 27 S.R. (N.S.W.) 231) as well as life assurance companies. In a case where an assurance company was taxed on the profits of a sale of its investments in realty (
Australian Catholic Assurance Company Limited v. F.C. of T. 100 C.L.R. 502), Menzies J. said (p. 505) -
``The main argument for treating the profits in question as assessable income is that they were profits from the carrying on of the taxpayer's life assurance
ATC 4227
business and were accordingly income according to ordinary concepts, and properly taxable as such. That they were profits from the carrying on of that business is, I think, an inescapable conclusion. The flats were bought as good investments and were sold to avoid their becoming bad investments, which was what was intended from the very first, although it was hoped and, indeed, expected, they would not have to be sold until a long time after 1951.''
After quoting from the Californian Copper case his Honour said (p. 506) -
``The distinction that I find in this quotation from the Lord Justice Clerk is between a profit which is in the carrying on of a business and a profit which is not, because a change of investments is made which is not in the course of carrying on a business at all, e.g. a doctor selling some shares and buying others, or because it constitutes the realization of the capital assets of a business which has come to an and, e.g., Scottish Australian Mining Co. Ltd. v. F. C. of T. or for some other reason. The instant case, it seems to me, is one where the enhanced values were obtained in the carrying on of the taxpayer's business.''
And at p. 508, referring to the decision of Webb J. in
Producers' and Citizens' Co-Operative Assurance Co. Ltd. v. F.C. of T. 95 C.L.R. 26 -
``It was argued there, as it was suggested here, that freeholds are in a special category and that cases dealing with the sale of investments such as shares or securities are not to be applied to a case where the investments realised are freehold properties. I am disposed to think that it may be easier to treat the profit made upon the sale of securities other than freehold as assessable income than to treat as such a profit made upon the sale of land. It seems to me, however, that the difference is one of degree rather than character. It was said here that if the profit which the taxpayer made is taxable, so is every other profit made by a taxpayer when it sells part of its real estate; but my decision falls far short of the acceptance of such a conclusion and rests upon the narrower ground that this taxpayer, as part of its ordinary investment business, bought real estate to obtain a high return and sold it profitably when it was found to be producing a low return, and so made a profit upon its buying and selling which I regard as income according to ordinary concepts, because in the ordinary course of carrying on business, the taxpayer must from time to time change its investments to use its funds to the best advantage. What it makes or loses in doing so is, I think, properly to be regarded as something to be taken into account, together with intermediate income, in deciding whether, overall, the investment produced a profit or a loss. Any profit realized on sale is of the same character as the annual income, and both go to make up the return.''
It seems to me that the reasoning in these cases is directly in point here. It was, during the three years in question, an integral part of the appellant's business to deal in shares, in the sense that switching of investments was desirable to produce the best dividend returns, indeed was necessary if the appellant's policy of investing in shares with growth potential was to be adhered to. I find it not relevant in this case to assert that the business of the appellant was an investment business with securities as its very capital, its structure, as it was put, and therefore different from a bank or assurance company, which could be said to be using its money through investment to assist its banking or assurance business - carrying on the business of investment within a banking or assurance structure; drawing a distinction between the profit yielding structure and the process of operating it may be useful as a means to solving some tax problems, but I do not believe it to be so here (cf.
Sun Newspapers Limited v. F.C. of T. 61 C.L.R. 337 at pp. 359-60 per Dixon J., as he then was
Strick (Inspector of Taxes) v. Regent Oil Co. Limited 1966 A.C. 295). Nor is it relevant to talk of dominant purpose of investment, i.e. to provide a dividend, when considering the application of sec. 25 of the Act. The fact is that the appellant as part of its business regularly and systematically
ATC 4228
bought and sold shares and used any favourable yield in its business; the evidence shows that a large part of the activities centred around the collation and assessment of materials and the making of decisions about share disposals, retentions, and purchases with a view to maintaining the optimum capital base or dividend return.In my view the taxpayer has not shown that the buying and selling of shares was no more than an incident in the business of producing dividends from investment in capital assets, something in the nature of a realization or change of investment only. Rather has it been shown that the activities of buying and selling were done as part of the business of the appellant in order to use to best advantage the shareholders' money; the profits which arise from such share movements are as much profits of the business as the income is; a layman would describe them in ordinary parlance as business profits of this investment company. So would I.
The main attack upon the assessments therefore fails and the appeals are not to be upheld on this ground.
This conclusion makes it necessary to consider the second objection to the assessments argued in these appeals. It is an argument that assumes that the surplus on realization of securities is taxable as income of the appellant (as I have held) but disputes the method of calculation of that surplus.
I have already described the way in which the surplus was computed and credited in the appellant's books to an account known as the investment fluctuation reserve, and how the Commissioner accepted the company's figures and assessed the appellant to tax upon them; basically it can be said that the figures are the balance left in each year after subtracting the average cost of purchases from the actual proceeds of realization. But in each of the three years the proceeds of realization included sums arising from sales of bonus shares which had been issued to the appellant at some time as fully paid shares in right of its then holdings in the companies making the issues. For example, in 1967 it would appear that bonus shares in five companies issued between 1961 and 1966 as fully paid were sold, in 1968 bonus shares in seven companies issued between 1960 and 1967 were sold, and in 1969 bonus shares in two companies issued between 1963 and 1969 were sold. While the amounts received upon sale of these bonus shares were taken in as part of the total sales figures, no amount was taken in as representing the cost of these shares; yet the number of bonus shares was included for the purposes of calculating average cost - the average cost of shares in any one company sold was arrived at by dividing the total cost of acquisition of all shares in that company by the total number of shares held, including bonus shares. The argument is that the nominal value of these bonus shares should be included as part of the cost, so increasing, of course, the average cost, and decreasing the computed surplus on sales. One example makes this clear. 12,000 shares in Dodge Consolidated Industries Limited were sold in 1967, net proceeds $22,753.28; the actual cost of these shares was $19,913.83, making an average cost of $1.65948; because all the shares were sold the surplus was taken into the company's accounts as $2,839.45, being the difference between proceeds of sale and the cost. However, 3,000 of these 12,000 shares were issued as fully paid shares; if the cost of these were to be taken in as $1,500 (they were 50 cent shares) the average cost would have risen to $1.7845, and the surplus fallen to $1,339.45. It is said that a method of accounting which treats bonus issue shares as costing nothing is all very well for company purposes, but for tax purposes a cost figure equal to the amount paid up on the shares should be used as a basis of computing the surplus on sale. The argument is that if the appellant must pay tax on profits resulting from sales of shares in the relevant years, then the calculation must be made on a cost per share basis that attributes a cost factor is the paid up value of those shares.
The basis of the argument is simple enough, and relies on the legal theory lying behind the issue of bonus shares. The authorities establish that when bonus shares are issued out of a company's reserves, be it an assets revaluation reserve or a share premium reserve or otherwise, the process in
ATC 4229
law consists of a notional payment to or a crediting of the person to whom the shares are issued of an amount equal to the paid up value of the shares and a notional application by that person of a similar amount to discharge his liability to pay for the shares which are issued to him. In short it can be put that a shareholder receives a dividend and applies it to the purchase of a paid up share.The argument as put is that one must apply the legal theory lying behind bonus issues in the present case, assume that the appellant received dividends amounting to the paid up value of the issued shares, and applied the equivalent amount from its assets to acquire those shares. Now it is put that if the appellant had been taxed, as upon the receipt of a dividend, on the amount so notionally paid and applied in the acquisition of the bonus shares, then it would have been very difficult to argue that the amount so notionally applied was not to be treated as an expense incurred in acquiring the shares; otherwise the appellant would have been twice taxed in substance on the same item, taxed on the receipt of the shares and taxed on their disposal. The appellant was not taxed on the notional dividends applied in the acquisition of the shares because it was exempt income under sec. 44 of the Income Tax Assessment Act. That section, so far as relevant, provided at times material to this appeal -
``44(2)... the assessable income of a shareholder shall include dividends -
...
(b) paid wholly and exclusively out of...
(iii) profits arising from the sale or re-valuation of assets not acquired for the purpose of re-sale at a profit... if the dividends paid from such profits are satisfied by the issue of shares... of the company declaring the dividend.''
``Dividend'' is defined as including the paid up value of shares issued by a company to any of its shareholders to the extent to which the paid up value represents a capitalisation of profits.
The choice of whether or not in the circumstances of this case one is required for tax purposes to treat the bonus shares as having been acquired for the amount of the dividend notionally applied to get them seems to require a choice between legal theory and reality. In fact the bonus shares cost nothing, and the amount received upon their disposal went to swell the business profits of the appellant. This seems to me to be the reality of the situation. I incline to the view that whether the bonus shares came to the appellant as exempt income or not is irrelevant; I do not think that one can equate the liability or otherwise to pay tax upon the acquisition of shares with the cost of their acquisition; the fact that the Act operates upon the legal theory and in some instances turns it into a tax liability seems to me to have little or nothing to do with the cost of acquisition. And I suppose in the present case one might also apply the company theory to which the Justices of the High Court adverted in the case of
McRae v. F.C. of T. 69 ATC 4066; 121 C.L.R. 266, where it was pointed out that the amount of dividend credited in the issue of bonus shares had the effect of subtracting an equal amount from the value of original shares; therefore for no extra outlay the appellant in theory received the same return upon disposal of its shares that it would have received had there been no bonus issues.
When one is looking at business profits, determining whether they are assessable to tax as income of the business, and then ascertaining what the profits consist of, one is entitled to reach a conclusion on the actualities of the situation. I have held that the profits arising on the disposals of shares must be treated as income of the appellant's business. The bonus shares in fact cost nothing, and went to make up the profits when they were sold. It is upon that simple basis that they should be looked at in calculating what the profits were.
The appeals of the taxpayer will not be upheld on this ground.
This means that all three appeals will be dismissed.
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