Reliance Finance Corporation Pty. Limited v. Federal Commissioner of Taxation.

Judges:
Yeldham J

Court:
Supreme Court of New South Wales

Judgment date: Judgment handed down 19 February 1987.

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Yeldham J.

These are six appeals, heard together by consent, by Reliance Finance Corporation Pty. Ltd. ("Reliance") in respect of tax assessments for the years ended 30 June 1979 to 30 June 1984 inclusive. The appeals relate to the disallowance by the Commissioner of sums claimed as deductions for interest paid by Reliance to A.N. Scarf Investments Pty. Ltd. on moneys borrowed from it. The claim for deductions was made under sec. 51(1) of the Income Tax Assessment Act 1936 which provides that all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.

The Commissioner disallowed the amounts claimed in the relevant years and imposed penalties upon Reliance. At the hearing he indicated that he would not seek to pursue such penalties other than that for the year ended 30 June 1984. A challenge is made in the present appeal to the latter. Senior counsel for the Commissioner indicated at the outset that he would only formally submit that sec. 260 applied. No submissions were made to me in relation to the operation of this section or to its applicability to the facts of the case, and hence I do not propose to consider it further.

At all material times the governing director of the various companies in the Scarf group was Mr Alexander Nicholas Scarf who is now 88 years of age and in poor health. There was a network of companies, the ultimate holding company being A.N. Scarf Consolidated Pty. Ltd. Reliance was incorporated in 1957 and thereafter carried on business as a financier and moneylender. At all material times it had a large loan portfolio from which it earned substantial interest. Prior to May 1979 moneys were owed by Reliance to a number of companies and persons associated with Mr Scarf, these totalling $2,094,014.72. At this time Mr Scarf was concerned about the size of debts accruing due to the trustees of certain trusts established for the benefit of his grandchildren. In consequence he consulted his solicitor and accountant, Mr Foley, at one time a director and the secretary of Reliance, and thereafter a consultant to the group of companies, said in evidence (referring to the year 1979):

"Q. Did you make any recommendations to Mr Scarf as to the proposal to borrow from A.N. Scarf Investments Pty. Ltd.? - A. I did.

Q. What was that recommendation? - A. Well, the money that Reliance has been the money horse of the Scarf group of companies for many years and Reliance had been using the money interest free and it was decided that the money would be called up instead of - it was on call. It was suggested that the money be called up on a three month notice and lent to A.N. Scarf Investments.

Q. Did you say anything to Mr Scarf as to the advantages or disadvantages of that proposal so far as Reliance Finance was concerned? - A. Yes.

Q. What did you say to him? - A. Firstly, that there would be a tax deduction, because the money was to be lent - Reliance was to pay ten per cent interest on the money which had previously been interest free - it was ten per cent. The idea at the back of the origination of the scheme was to try and control the grandchildren, who had no appreciation whatever of what was going on. There would be a benefit towards the grandchildren; there would be less money flowing through to the grandchildren and also the money was - it was to be transferred - lent back to Reliance to the overseas trust and there would be an advantage while the notes were here in the country there would be no tax payable in Singapore.

Q. Was there any other advantage to Reliance itself as against other parties? - A. Well, Reliance had the use of the money, because it was - instead of it being on call A.N. Scraf Investments lent the money to Reliance for thirteen months so they would have the money there - they had thirteen months in which to arrange their affairs."

Although in cross-examination Mr Foley said that he believed that there was a written loan agreement between A.N. Scarf Investments and Reliance, senior counsel for the latter indicated

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that his instructions were that no such document existed but that the minutes of the companies recorded the agreement.

Meetings of the directors of the various companies of which Mr A.N. Scarf was governing director, and to which as at that date moneys were owed by Reliance, were held on 16 May 1979. Each company resolved that it lend the amount owed to it by Reliance to A.N. Scarf Investments Pty. Ltd. "on the basis that the same is lent interest free and repayable on three months' notice of demand". Cheques to carry into effect the loan transactions, the subject of the various resolutions, were prepared by an employee of Messrs Priestley and Morris, chartered accountants for the group. The transactions are verified by cheque butts and deposit books and bank pass sheets. The effect of them was that A.N. Scarf Investments Pty. Ltd. advanced to Reliance the sum of $2,094,014.72. Subsequently, Messrs Priestley and Morris calculated the amount of interest payable upon the loans for the period up to 30 June 1979, and thereafter calculations were made by them in respect of each financial year, and payments were made by Reliance to A.N. Scarf Investments Pty. Ltd. as trustee of the relevant trust for the grandchildren. In 1980 further moneys surplus to the requirements of other companies in the group were lent to A.N. Scarf Investments Pty. Ltd. and then advanced at interest by the latter to Reliance. Interest was calculated each year on the balances owing. Following upon the calculations (which were made by the accountants) cheques were drawn by Reliance and paid in the relevant year of income to A.N. Scarf Investments Pty. Ltd. The accounts of Reliance were audited each year by Priestley and Morris who verified the various balances. A.N. Scarf Investments Pty. Ltd. lent back to Reliance sums equivalent to the interest paid.

Mr Foley said under cross-examination that part only of the money borrowed at interest by Reliance was used in the moneylending side of the business and earned interest, no interest being received by it on other moneys which had been borrowed at interest but lent out to related corporations and other persons interest free. He said:

"Q. The lending by Reliance remained the same as it had prior to 16 May? - A. Yes.

Q. In other words, of those moneys borrowed some portion was lent out to the Scarf companies free of interest and some of it was used in the moneylending transactions? - A. The companies were charged interest if it was lent out for a joint venture - the joint venture would pay interest to Reliance.

Q. But the other companies, which were referred to I think in the balance sheets as `related corporations' and the other category was `other persons'? - A. Yes.

Q. These were cupboard companies in which Mr Scarf had an interest? - A. Correct.

Q. After 16 May Reliance continued to lend those companies money free of interest? - A. Yes.

Q. And it was only in the moneylending side of the business that interest was charged when dealing with outsiders? - A. Yes.

Q. The amount which was lent to related corporations and other persons varied from time to time? - A. Correct.

Q. As did the amount which was lent to what are called trade debtors, it varied from time to time? - A. Correct.

Q. No day to day record was kept, was it, to show what money was lent at interest and what money was lent interest free? - A. There was a complete record of all moneys in the ledgers for all different companies."

Senior counsel for the Commissioner submitted that interest paid on borrowed moneys was not deductible under sec. 51(1) in respect of such moneys as were not used by Reliance to gain assessable income, and that there was no evidence upon which any apportionment could be made whereby some of the interest paid could be claimed as referable to interest earned.

Interest incurred in borrowing money to secure working capital is normally allowable as a deduction under sec. 51(1) - see
The Texas Co. (Australasia) Ltd. v. F.C. of T. (1939-1940) 63 C.L.R. 382 at p. 468;
F.C. of T. v. Total Holdings (Australia) Pty. Ltd. 79 ATC 4279 at pp. 4281-4283; and
Magna Alloys & Research Pty. Ltd. v. F.C. of T. 80 ATC 4542.

In the present case I have come to the conclusion that Reliance is entitled to a deduction in relation to that portion of the

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ATC 4149

interest paid on moneys borrowed which were in turn lent out at interest, but that it is not entitled to any deduction in relation to interest paid on those moneys borrowed upon which, when lent out, no interest was gained. In the case of a moneylender, an outgoing for interest is plainly desirable and appropriate from the point of view of the pursuit of its business ends (see the tests laid down in the majority judgment in Magna Alloys, at pp. 4560-4561). In addition that portion of the moneylending business of Reliance from which it received income could not have been conducted without recourse to the borrowing upon which it in turn paid interest. But it is clearly only the interest paid to borrow moneys upon which interest was or was to be earned which falls within sec. 51(1). In coming to this conclusion I do not overlook the statement in
Ronpibon Tin N.L. & Anor v. F.C. of T. (1949) 78 C.L.R. 47 at p. 60 to the effect that the matter in issue is whether the interest in fact paid is deductible, not how the amount of interest paid was calculated. In the latter case the High Court (in a judgment which was approved by the Judicial Committee of the Privy Council in
I.R. Commr (N.Z.) v. Europa Oil (N.Z.) Ltd. (1971) A.C. 760 at p. 772) said that "the question of fact is therefore to make a fair apportionment to each object of the companies' actual expenditure where items are not in themselves referable to one object or the other. But this must be done as a matter of fact and therefore not by this Full Court". Earlier the Court had said that there must be "some fair and reasonable assessment of the extent of the relation of the outlay to assessable income" and "the Court must make an apportionment which the facts of the particular case may seem to make just".

In my opinion the appropriate course to take is that submitted by senior counsel for Reliance, namely to apportion the interest in respect of which a deduction should be allowed by contrasting the proportion of the assets of Reliance that are income producing with the proportion that are not. A table derived from the evidence, with explanatory notes appended, was attached to the written submissions and I set it out in full as an annexure to this judgment. I accept it as accurate. Item 11 in the table is the percentage to be applied, being the sum of trade debtors and fixed and other income assets divided by total assets at each balance date. The application of that percentage to the interest paid gives as a resulting figure (in line 13) the deduction which is to be allowed.

The final matter relates to the question of the penalty for the year ended 30 June 1984, those imposed in relation to the earlier years not now being sought. The relevant section is sec. 223 which was amended with effect from 14 December 1984. The section entitles the Commissioner to impose a penalty where a taxpayer has made a statement "that is false or misleading in a material particular" or has omitted some matter or thing without which the statement in the return is misleading in a material particular. "False" in this context means "wrong" -
F.C. of T. v. Turner 84 ATC 4161 at p. 4164. See also
Australian Jam Company Pty. Ltd. v. F.C. of T. (1953) 88 C.L.R. 23.

The entries in the return for the relevant year which are relied upon by the Commissioner are those in the profit and loss account for the year ended 30 June 1984 which accompanied the return and which showed as income:

                                                   "$
      Interest    -    other persons          1,110,030
      Expenses, interest - other
      persons                                   474,922"
            

It was submitted that there was no indication in any of the accounts or any explanation that interest was being claimed in respect of moneys borrowed which were being used other than in the course of the business of Reliance.

I have come to the conclusion that the omission of any indication that portion of the interest claimed related to moneys borrowed which were used other than for purposes which came within sec. 51(1) was "false and misleading" in a material particular within the meaning of sec. 223. I should emphasize that there is no evidence nor indeed any suggestion that this was deliberately or fraudulently done, but nonetheless it does entitle the Commissioner to impose a penalty although, in my view, that which has been imposed is grossly excessive, especially in the light of my findings as to the deduction to which Reliance is in fact entitled in respect of the 1984 year.

I allow each of the appeals and remit each assessment to the Commissioner to be dealt with in accordance with my reasons. In the case of the assessment for the year ended 30 June 1984, he is to consider also what penalty is

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appropriate. The appellant has succeeded in part and failed in part. My present view is that it should receive 75% of its costs of the appeals, but I will not make that order so that counsel might have the opportunity to make submissions to me in relation to costs if they desire to do so.

On 3 September 1986 I reserved my decision in common law proceedings No. 17173 of 1985 in which the Deputy Commissioner of Taxation was plaintiff and Reliance was defendant. Those proceedings came before me initially by way of an appeal from the Master who had ordered the entry of judgment for the plaintiff in respect of tax allegedly owing in the years which are the subject of the appeals to which these reasons relate. I dealt with that matter in the fashion set out in the transcript of my judgment dated 18 September 1986 when an application for a stay was made. The common law proceedings will of course be resolved by my decision in the appeals in the Administrative Law Division. In due course the parties must bring in short minutes to dispose of such common law proceedings. I do not intend to deliver the judgment which I reserved in September 1986 because it is now unnecessary to do so.

ANNEXURE

                       Reliance Finance Corporation Pty. Ltd.


                   1979      1980       1981       1982       1983       1984
Funds employed      $         $          $          $          $          $
1. Shareholders'
   equity       1,113,001  1,250,306   155,625    157,625    283,052    529,928
2. Non-current
   liabilities    601,319    601,319   601,319    601,319    601,334    601,334
3. Total current
   liabilities  3,347,241  4,247,615 4,870,172  5,555,790  5,884,438  6,989,502
4. Total funds
   employed     5,061,561  6,099,240 5,627,116  6,314,734  6,768,824  8,120,764
5. A.N. Scarf Overseas
   Trust        2,117,572  3,069,195 3,428,811  3,878,330  4,263,633  4,648,941
6. % total funds 41.84%     50.32%     60.93%     61.42%     62.99%     57.25%

Assets
7. Trade
   debtors      1,490,582  4,123,696  4,477,807 4,988,096  5,627,333  6,816,941
8. Related corporations
   and others   1,972,950  1,898,567  1,012,279 1,118,084  1,095,174  1,150,240
9. Fixed assets
   etc.           (86,752)    78,977    172,233   139,030     46,267    153,613
10. Total
    assets      3,376,780  6,101,240  5,662,319 6,245,210  6,768,774  8,120,794
11. % assets
    income-producing
                  41.57%    68.88%     82.12%    82.10%      83.82%     85.84%
12. Interest expense
                  26,175     212,876    399,573   499,466    428,114    428,114
13. Proportional allocation
    to income-producing
    assets        10,882     146,629    328,139   410,046    358,846    367,475
14. Gross income 214,894     795,586    738,875   822,945    999,521  1,306,658
15. Pre-tax net
    profit        80,428     375,212   (212,231)    6,986    333,190    578,559
        

Notes: Lines 1-5, 7 from balance sheet items

• Line 6, line 5 / line 4
• Line 8, advances to related corporations and other persons
• Line 9, all assets other than lines 7 and 8
• Line 11, lines 7 + 8 / line 10
• Line 12, paid to the trustee of the Overseas Trust
• Line 13, line 11 x line 12
• Lines 14-15, from profit and loss statement