Federal Commissioner of Taxation v. Kareena Hospital Pty. Limited.

Judges: Bowen CJ

Brennan J
Lockhart J

Court:
Federal Court of Australia

Judgment date: Judgment handed down 20 December 1979.

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Brennan J.: The taxpayer respondent (which I shall call ``Hospital'') carried on a profitable business, conducting a private hospital. Its shareholders and directors were Dr. and Mrs. Segal. The hospital premises were owned by Kareena Holdings Pty. Ltd. (``Holdings'') and they were leased to Hospital. Hospital also leased from Dr. and Mrs. Segal an area used as a car park for the hospital. The Segals were the shareholders and directors of Holdings, so that the assets employed in, and the conduct of, the business were entirely under their control.

They were put in touch with a company, International Clearing House Pty. Limited (``International'') which had accumulated trading losses deductible under sec. 80 of the Income Tax Assessment Act 1936. International was in voluntary liquidation and the liquidator was desirous of turning the deductible losses to advantage. An arrangement was made among International, Hospital, Holdings and the Segals which was carried into effect in a series of transactions which occurred on 31 January 1973, or shortly afterwards. The result of the arrangement was that International carried on the private hospital business for a period until the profits earned during that period exhausted the deductible trading losses.

The way in which that was done involved several steps. First, the assets of the business were vested in International. Hospital surrendered its lease of the hospital and of the car park area, whereupon Holdings granted a lease of the hospital to International. International leased the hospital plant and equipment from Hospital, and the car park from the Segals, at commercial rentals which were paid or credited monthly. Hospital advanced $120,000 to International on the security of an equitable charge, International paid Holdings $120,000 as a premium for the hospital lease, and Holdings paid Hospital $120,000 in discharge pro tanto of a debt which it owed to Hospital. Secondly, Hospital ceased to employ and International commenced to employ the hospital staff, with the exception of Dr. and Mrs. Segal. Thirdly, International opened bank accounts into which the fees and other income of the business were deposited. Some payments made by Hospital's debtors were banked to the credit of International's account, but in time International accounted to Hospital for the moneys so received.

From 1 February 1973 the business was carried on by International without interruption, and International continued to carry it on until the deductible losses were exhausted by the profits earned. Then the

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ATC 4670

leases of the business assets were terminated, the employees were again employed by Hospital, and the conduct of the business was resumed by Hospital.

The deductible losses of International were of the order of $113,000 but they were believed at first to be of the order of $120,000. The latter figure explains the amount advanced by Hospital to International and the amount paid by way of premium by International to Holdings. The objective which the arrangement was intended to achieve was the earning of profit by International to be set off against its deductible losses, and the payment of the amount of profit earned to Hospital as repayment of Hospital's loan. When it was discovered that the deductible losses were $7,000 less than anticipated, the lease was amended to provide for a premium of $113,000 and $7,000 of the loan was credited as repaid. The objective of the arrangement was explained in evidence by the Segals' accountant, Mr. Millar:

``Mr. Burchett: Then what was the next; assuming that, how did all this operate to achieve the objective? - International Clearing House Pty. Limited conducted business profitably. Out of surplus funds it repaid the secured debt to Kareena Hospital Pty. Limited.

So you say at that stage was a repayment of a loan and a capital receipt. Is that the objective? - The repayment of the secured advance to Kareena Hospital was a capital receipt in the hands of Kareena Hospital Pty. Limited.

That was an objective? - An objective, yes.

His Honour: As monies were available so reductions were made in the amount of the loan? - Yes.

And it was repaid to the hospital, the taxpayer? - Yes.

In effect out of the profits of the business? - Yes.

The profits not being taxable because of the tax losses? - Yes.

That was the idea? - Yes.

And in the end Kareena would have $113,000 as a capital receipt not taxable? - Yes.''

To ensure that International played its part in achieving this objective, Dr. and Mrs. Segal became its directors. A scheme of arrangement for International was approved and the winding up stayed by orders of the Supreme Court of New South Wales. There was no change in the membership of International. The equitable charge which International gave to Hospital as security for its debt ensured that the profits which it earned found their way to Hospital in due course. It was, indeed, some time before the accounts between International and Hospital were settled, but it appears that profits equal to International's deductible losses were earned by 31 July 1973, for Hospital resumed the conduct of the business on 1 August 1973.

On or shortly after 31 January 1973, when International's deductible losses were believed to be of the order of $120,000, cheques for $120,000 were circulated around the three companies in a round robin, as it is called. On 9 april 1973, after the deductible losses were ascertained to be of the order of $113,000, a reverse round robin of cheques for $7,000 occurred, in reduction of Hospital's loan to International, of the premium paid on the lease granted by Holdings to International, and of the amount by which Holdings' debt to Hospital had been reduced.

International, in the respective periods 1 February to 30 June 1973 and 1 to 31 July 1973 earned profits from carrying on the hospital business, and those profits were, in substance, the source of International's repayments to Hospital. Leaving out of account the lease premium of $113,000 paid by International to Holdings, and certain legal expenses associated with the grant of the lease by Holdings and the borrowing from Hospital, the profit which International earned in the first period was $103,203, and in the second period $13,115. By amended assessments, the appellant Commissioner assessed the respondent to tax by adding these amounts to its taxable income for the income years ended 30 June 1973 and 30 June 1974 respectively. In consequence of these additions, he further assessed the taxpayer to tax under Div. 7 of the Income Tax Assessment Act 1936 in respect of the same income years. The respondent unsuccessfully objected to the

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ATC 4671

two amended assessments and to the two Div. 7 assessments, but on appeal to the Supreme Court of New South Wales, Sheppard J., sitting in the Administrative Law Division, allowed each of the respondent's appeals. The Commissioner appeals to this Court.

The appellant, relying upon sec. 260 and 19 of the Income Tax Assessment Act, furnished particulars of the taxpayer's derivation of the income in dispute, contending:

``The income was derived from the private hospital business (alleged by the taxpayer to have been conducted by it as manager for International Clearing House Pty. Limited) and therefore was derived from all persons and companies which made payments or incurred debts which properly formed the income of that business in the relevant periods.''

The appellant's submission is that the taxpayer's assessable income was reduced by the arrangement above described and each of the transactions into which Hospital, Holdings, International and Dr. and Mrs. Segal entered, on or after 31 January 1973, and that, by force of sec. 260, he is entitled to disregard the arrangement and the consequent transactions. He submits that, upon the sweeping away of the arrangement and the transactions, the respondent's assessable income is seen to include the assessable income which International received in the conduct of its business.

It does not avail the Commissioner to say that, but for an arrangement, income would have been derived by a taxpayer; the Commissioner's case is not advanced unless, upon sweeping away the arrangement, a derivation of income by the taxpayer is revealed. As Lord Denning said in
Newton v. F.C. of T. (1958) A.C. 450 at p. 467 :

``But the ignoring of the transactions - or the annihilation of them - does not itself create liability to tax. In order to make the taxpayers liable, the Commissioner must show that moneys have come into the hands of the taxpayers which the Commissioner is entitled to treat as income derived by them.''

In
Hancock v. F.C. of T. (1961) 108 C.L.R. 258 Dixon C.J. said at p. 281:

``Section 260 is directed against the validity of arrangements designed to avoid taxation where, but for the cover the arrangement would give, taxation would fall.''

Taxation falls upon taxable income (sec. 17), and where the Commissioner relies upon sec. 260 to increase a taxpayer's assessable income, it must appear that, without the cover of the relevant arrangement, assessable income is derived by the taxpayer.

If the income be derived from property, the overt acts by which the arrangement is implemented will enable the arrangement to be characterized as a means to avoid tax if the conditions expressed by Kitto J. in Hancock's case (supra) at p. 283, are fulfilled:

``(5) But the overt acts will enable the arrangement to be characterized as a means for the avoidance of tax, if they have included a transfer of property from the taxpayer in consequence of which income from the property, instead of being received as such by the taxpayer, has followed either of two courses: (i) a course which has carried it through the hands of other persons to the taxpayer, but so as to reach him with the character of capital; or (ii) a course which has amounted in effect to an application of the moneys by the taxpayer, and so has been a practical equivalent of a receipt by him followed by an expenditure by him.''

The operation of sec. 260 upon an arrangement of that kind is to avoid, as against the Commissioner, the transfer of the income-yielding property and

``(t)he result is that income which has followed either of the courses referred to in (5) is to be regarded as income to which the taxpayer was entitled. Consequently the receipt of the income by the transferee in pursuance of the arrangement is properly to be treated by the Commissioner as a derivation of it, as income, by the taxpayer.''

Bell v. F.C. of T. (1953) 87 C.L.R. 548 , Newton's case (supra), Hancock's case (supra) and
F.C. of T. v. Ellers Motor Sales Pty. Ltd. 72 ATC 4033 ; (1972) 128 C.L.R. 602 are cases of this kind. Mason J. explained two of these cases in
Cridland v. F.C. of T. 77 ATC 4538 at p. 4542; (1978) 52 A.L.J.R. 96 at pp. 98,99 :

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ATC 4672

``The Newton case and
Ellers Motor Sales Pty. Ltd. v. F.C. of T. 70 ATC 4008 ; (1969) 121 C.L.R. 665 : varied on appeal 72 ATC 4033 ; (1972) 128 C.L.R. 602 , were cases in which it was held that the moneys received by the taxpayers were or were deemed to be dividends, the impugned transactions being designed to endow the moneys received with a different character and failing in this purpose by reason of the destructive operation of sec. 260.''

Where a business previously carried on by a taxpayer produces assessable income, an arrangement by which the taxpayer discontinues carrying on the business in order to allow another to carry it on is not necessarily an arrangement to avoid tax. In
Europa Oil (N.Z.) Ltd. (No. 2) v. Commr. of I.R. (N.Z.) 76 ATC 6001 Lord Diplock who delivered the majority opinion said at p. 6009:

``Secondly, the description of the contracts, agreements and arrangements which are liable to avoidance presupposes the continued receipt by the taxpayer of income from an existing source in respect of which his liability to pay tax would be altered or relieved if legal effect were given to the contract, agreement or arrangement sought to be avoided as against the Commissioner. The section does not strike at new sources of income or restrict the right of the taxpayer to arrange his affairs in relation to income from a new source in such a way as to attract the least possible liability to tax. Nor does it prevent the taxpayer from parting with a source of income.''

However, in
Peate v. F.C. of T. (1964) 111 C.L.R. 443 , where doctors disposed of their practice and formed a company to provide medical services to patients, and in
Hollyock v. F.C. of T. 71 ATC 4202 ; (1971) 125 C.L.R. 647 , where a pharmaceutical chemist disposed of a share of his business to his wife, it was held that the operation of sec. 260 avoided the dispositions and left the taxpayer for taxation purposes in receipt of assessable income to which the disponee was legally entitled.

In Peate's case, where the doctors dissolved their partnership and allowed the company, Westbank Pty. Ltd., to carry on the business of providing medical services, each doctor's distributable share of the income received by Westbank was held to have been derived by him consequent upon the operation of sec. 260 Kitto J. agreed (at p. 471) with the effect which the trial judge ( Menzies J.) attributed to sec. 260 in the circumstances of that case:

``Menzies J. took the same view of the application of sec. 260 to the facts of the case. `What is left then,' he said, `is a group of doctors practising together but without any formal agreement of partnership, using Westbank to receive all fees paid, to provide services for the group, to pay group expenses and to make distributions of what remained in agreed proportions and using their family companies to receive those distributions and to pay the individual expenses of practice. On this basis the assessable income of the doctors as a group was the total of gross fees earned.' ((1962) 111 C.L.R., at p. 461.)

In my opinion this is correct. It means that sec. 260 renders the arrangement void as against the Commissioner so far as it gave Westbank the beneficial property in fees collected and gave the quality of a resolution of a board of directors to the decisions of the doctors as to disbursement. What remains is the income produced by an association of doctors, received by them jointly, and subject to division in agreed proportions so that, in the language of sec. 19, each doctor's distributable share was dealt with as he directed. It follows that each doctor must be considered to have derived his proportion of the income.''

And Taylor J. said (at pp. 476, 477):

• ``I have no doubt that the avoidance of the agreements made by the appellant with Raleigh'' [the taxpayer's family company] ``and Westbank produces a situation in which the Commissioner is entitled to say that what Westbank received it received in part on behalf of the appellant. The part which it can be said to have received on his behalf is the proportion of the total amount received ascertained by applying to that amount the percentage used in each of the income years under review for the calculation of the services fee paid to Raleigh.''

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  ATC 4673

In the Privy Council ((1966) 116 C.L.R. 38, at p. 46) the majority of their Lordships attributed to the fees received by Westbank the character of income of the doctors.

In Hollyock v. F.C. of T. (supra), Gibbs J. held that the entire income received by the pharmaceutical chemist constituted his assessable income once sec. 260 annihilated a transfer of a half-share of the business to his wife. His Honour there placed reliance upon the nature of the business (at pp. 4206; 657-658):

``An important feature of the case is that the business which the appellant declared that he held in trust was one that could lawfully be carried on only by a pharmaceutical chemist, so that it remained necessary for the appellant to carry on the business and his wife could not lawfully join with him in carrying it on. As Menzies J. said in Peate v. F.C. of T. ((1964) 111 C.L.R., at p. 460): `What, outside a profession, might be regarded as an ordinary business transaction may, within a profession, have an altogether different appearance.
Millard v. F.C. of T. ( (1962) 108 C.L.R. 336 ) provides another example of a case in which the business whose income was the subject of the arrangement avoided by sec. 260 - that of a bookmaker - could only be carried on by a person who had the necessary registration.''

In Peate's case (supra) Westbank, not being a registered medical practitioner, could not sue for fees for the medical and surgical services which were provided to patients; in Hollyock's case (supra) Mrs. Hollyock was not entitled to carry on the business of pharmaceutical chemist; and in Millard's case (supra) it was impossible for the taxpayer's company to obtain registration as a bookmaker. In each of these cases, it was held that the Commissioner was entitled to treat the taxpayer as receiving income which was the return from his own activities, although it was in fact received by another: a consequence which followed from the annihilation by sec. 260 of the arrangement which vested in a person other than the taxpayer the right to receive that income.

The present case is the converse of these cases, for in the present case International engaged in the income-producing activities and received the income which was the return from those activities. International was entitled to carry on the hospital business, and it did so. Although it had the benefit of the assets which had been employed in Hospital's business - leases of the hospital, of its equipment and of the carpark, and the goodwill of the business - International engaged in the activities of that business, employing its own staff for the purpose. Let it be assumed that sec. 260 would annihilate the transactions by which the assets of the business were transferred to or vested in International: the activities by which the income was earned would not be swept away, nor would they be deemed to be the activities of Hospital. Section 260 does not create fictional activity on the part of Hospital and it does not deem the income International earned to be a return from a fictional activity of Hospital. Section 260 does not substitute fiction for fact, as Lord Donovan observed in his dissent in Peate's case (supra) (116 C.L.R. at p. 55; and see
Bayly v. F.C. of T. 77 ATC 4045 at p. 4057 ). The income which International received was not the income of any business owned or carried on by Hospital, nor was it a return from any activity in which Hospital engaged. Section 260 cannot transform the income earned by International in carrying on its business into the assessable income of Hospital. The sums paid by International to Hospital were paid with funds received by International as income earned by its own activity, and sec. 260 does not deny the funds that character.

It follows that, in my judgment, the appeal should be dismissed with costs.