Odyssey International Pty. Ltd. v. Federal Commissioner of Taxation.
Judges:David Hunt J
Court:
Supreme Court of New South Wales
David Hunt J.
These are appeals by Odyssey International Pty. Ltd. against assessments made by the Federal Commissioner of Taxation for the financial years ended 30 June 1980, 1981 and 1982. By consent, the appeals were heard together. They concern the profits made by the taxpayer on the sale of six properties which the Commissioner says are assessable pursuant to sec. 26(a) of the Income Tax Assessment Act 1936. Only the first limb of sec. 26(a) has been argued, that the taxpayer had acquired the properties with the dominant purpose of reselling them ultimately at a profit.
The evidence led in the appeals proceeded upon the very sensible basis that most of it was not in dispute - a welcome change in the Commissioner's attitude for which those advising him in these proceedings deserve the highest commendation. Such an approach leads to a useful concentration upon what are (and always have been) the real issues, without the irritating, pettifogging and technical objections which are so often forthcoming in such appeals and which are calculated to distract everyone concerned in the appeal (including the trial Judge) from those real issues.
The "directing mind and will" of the taxpayer company is and was Mr John Patrick Babet. He has been in the insurance industry since he left school. The taxpayer company was incorporated in 1976 under the name of Babet Intersure Pty. Ltd., changing its name to Odyssey International Pty. Ltd. in 1978. It has carried on business since its incorporation as an insurance broker, earning its income from commissions. Mr Babet had previously been in business with another broker in a company named Babet Mortlock (Strata Plans) Pty. Ltd. That company did not trade immediately following the severance of business relations between the two partners in 1976. In 1980, Mrs Babet purchased Mr Mortlock's shares, and in the same year that company changed its name to Babet Intersure Pty. Ltd. (that is, the taxpayer's former name). It has since 1980 also carried on business as an insurance broker, and it is controlled by Mr Babet.
The taxpayer had since its incorporation invested its available funds on the short term money market. During the period in question, insurance brokers were not required to deposit premiums received by them from their clients in a trust account pending their accounting to the insurers. The industry practice (which the taxpayer adopted) was to invest those premiums and to earn income upon them during the credit period which was allowed by the insurers during which the brokers held that money in trust. Up to 180 days' credit was allowed by the insurers. The experience of the taxpayer itself was that 50% of its own clients would pay it within 60 days, and that most would have paid within 90 days. Commissions payable upon those premiums were as high as 25%, but they averaged 15% or slightly more. The taxpayer in its accounts treated the premiums owing to the insurers as liabilities and the amounts received from the clients as assets. Despite some confusion in the evidence of Mr Babet on this point (he was certainly not familiar with accounting terms and practices, and he played no part in the accounting side of the taxpayer's business), I am satisfied that the taxpayer did not in its accounts treat the commissions owing on those premiums as income until the premiums were actually paid by it to the insurers.
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In 1978, Mr Babet decided to divert the taxpayer's investments from the short term money market towards the acquisition of rent-producing real estate. He gave evidence that he intended such investments to build up a strong asset base for the taxpayer in order to provide a "nest egg" upon his retirement and thus to be long term in nature. During March and April of that year, the taxpayer purchased three residential units, leased them out but then sold them all late in 1979 and during 1980, as follows:
- (i) Neutral Bay (Unit 2) - purchased 2 March 1978 for $41,500, with finance of $30,000 for three years with a promise of "roll-over" finance at the conclusion of that period; leased for six months, tenant ejected and unit re-leased; sold 15 February 1980 for $69,750. Adjusted profit $26,928.
- (ii) Glebe - purchased 31 March 1978 for $42,500, with finance of $25,000 for three years with a similar promise; leased throughout; sold 6 August 1980 for $76,950. Adjusted profit $33,705.
- (iii) Neutral Bay (Unit 15) - purchased 28 April 1978 for $40,500, with finance of $27,000 for three years with a similar promise; leased for six months, continued on holding-over clause; sold 4 December 1979 for $69,750. Adjusted profit $28,040.
I will return to this group of transactions later.
Also in 1978, Mr Babet decided that the taxpayer's business had expanded to an extent which made it necessary to obtain larger premises than those which it rented in O'Connell Street, Sydney. He also planned to install a computer, and this required additional space. Mr Babet lived on the northern side of the Harbour; the introduction of transit lanes at that time with the resulting traffic problems on the Harbour Bridge, together with parking problems in the city, led him to choose North Sydney for the purchase of a building for new business premises. Mr Babet gave evidence that the taxpayer acquired this property because renting was a waste of money and he thought that the building would supplement the taxpayer's other real estate investments. It was thus to be another long term investment.
The property, consisting of a dilapidated two-storey terrace house in Walker Street, North Sydney, was purchased by the taxpayer on 14 April 1978 for $96,000. No finance was involved. The property was renovated at a substantial cost, and the taxpayer's business was moved from O'Connell Street to Walker Street. The ground floor was let to a lighting company. A computer was installed in July of that year. The property was then sold to the lighting company on 11 March 1980 for $303,000. The adjusted profit was $171,940.
After the decision had been made in November 1979 to sell the Walker Street property, Mr Babet looked for other premises for the taxpayer's business. A property consisting of a two-storey house in West Street, North Sydney was purchased by the taxpayer on 12 December 1979 for $190,000. No finance was involved. Mr Babet gave evidence that the taxpayer acquired this property for its new business premises and also as a long term investment. The property was, however, zoned as residential only, although it had been used as a film studio and office. A development application by the taxpayer for use as commercial premises was lodged with the North Sydney Council in January 1980 and rejected on 4 March, leading to litigation in the Land and Environment Court in which the taxpayer was unsuccessful. The taxpayer also made unsuccessful representations to the Minister for Local Government concerning its zoning problems. The taxpayer continued to carry on its business in this property throughout these difficulties, and until 1984. Eventually, as part of a group reorganisation, the property in West Street was on 31 March 1981 transferred to the taxpayer's associated company, Babet Intersure Pty. Ltd., for $400,000. The adjusted profit was $200,672.
In the meantime, on 3 October 1980, the taxpayer purchased a property in Falcon Street, North Sydney for $145,000, with finance of $100,000 by way of a 180 day bank bill pending longer term financial arrangements. Mr Babet gave evidence that the taxpayer acquired this property for its new business premises. This property was a duplex, of which one part had been used as a boarding house and the other part was leased to a naturopath. Mr Babet was told at the time of its acquisition that, although zoned only residential, the property was expected to be rezoned commercial; at the least, he was told, it could be used in accordance with its existing use. Pending resolution of the zoning problems, Mr Babet
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said in evidence, the building was repaired and renovated to be suitable for use as commercial premises. Early in 1981, the building was leased for a term of one year with a three year option. In June, the bank bills by which the purchase had been financed were rolled over for a further 180 days. When the new draft local environmental plan for North Sydney was released later that year, Mr Babet concluded that it would not be possible to conduct the taxpayer's business in the Falcon Street property. In fact, it never was. Arrangements were made in December for further short term bank accommodation. The draft plan was also adopted by the council in December 1981. The property was sold on 12 February 1982 for $195,000. The adjusted profit was $30,003.The taxpayer's associated company, Babet Intersure Pty. Ltd., purchased a property in Nicholson Street, North Sydney on 10 December 1981 for use as business premises, but it too ran into zoning difficulties and was subsequently sold at a considerable loss. No claim was made by that company for a taxation deduction in relation to that loss. Eventually, in April 1984, the taxpayer's business was moved from West Street to premises on the Pacific Highway, North Sydney.
The Commissioner argued that Mr Babet's evidence as to the purpose of long term investment for which the plaintiff had purchased each of these properties should not be accepted.
It is convenient to take the group of three residential units together. Mr Babet conceded that one of the many considerations which probably led the taxpayer to purchase the properties was that they would increase in value. He explained the short period which had elapsed between the acquisition and sale of these units by the pressing need of the taxpayer and its associated company to obtain funds following a loss of $124,000 which the associated company had suffered in relation to its deposit with Associated Securities Ltd. when that company went into receivership on 8 February 1979. The money which had been deposited with A.S.L. represented premiums for which the associated company was obliged to account to insurers on behalf of its clients. The two residential units in Neutral Bay were put up for sale later in 1979, and the unit in Glebe in April 1980. An additional financial pressure upon the taxpayer at this time was the purchase of the computer in November 1978 and its installation in July 1979.
The Commissioner submitted that these investments could never have been intended to be for a long term period as Mr Babet had claimed. There was, the Commissioner said, neither the company funds available for long term investment nor the return from such an investment as to make it financially worthwhile unless the increase in resale value of the units were to be taken into account. I have already remarked upon Mr Babet's unfamiliarity with accounting terms and practices; he exhibited an almost complete incomprehension of the company accounts lodged with the taxpayer's taxation returns. That statement is not intended as a criticism of Mr Babet. Accounting was not his job, and it certainly was not his strength. Throughout his evidence, Mr Babet stuck firmly to his assertion that the taxpayer's contribution to the purchase price of these three units had come from the company's funds. That contribution totalled $42,192 and was paid out during May and June 1978. Counsel for the taxpayer pointed out that the taxpayer's tax return for the previous financial year shows that, as at 30 June 1977, it owed $416,762.52 to trade creditors, being the insurers on whose behalf it had received premiums from its clients. At an average commission of 15% in relation to those premiums, the taxpayer would have been entitled to treat approximately $62,500 of that sum as its own, which should therefore be added to the funds otherwise shown as being available to it for those investments. That was not, of course, the way in which the commission was treated in that way in fact. In the same period, however, the taxpayer also paid out $96,000 for the Walker Street property, and a further $20,000 to $30,000 thereafter for the costs of renovating that property. Whatever Mr Babet's no doubt honestly held belief may be as to the source of the funds used for the taxpayer's investment in real estate at that time, I am satisfied that a substantial part of those funds came from the premiums which the taxpayer had use of for 90 days or more before being obliged to account to the insurers, and which it had previously invested in the short term money market.
The Commissioner argued that a sensible businessman in Mr Babet's position would not
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have taken the risk that there would always be funds coming in to the taxpayer's hands to replace that which had continuously to be paid out to the insurers, and that such a sensible businessman would necessarily regard any long term investment in real estate using those premiums as unsafe in those circumstances. In other words, the Commissioner asked me not to accept Mr Babet's evidence upon the basis that it was inherently improbable. In my view, the attitude which the Commissioner sought to attribute to this hypothetical sensible businessman in Mr Babet's position would have been an unduly cautious one at the time in question. The taxpayer's business had grown quite rapidly. There was, as Mr Babet said in evidence, always a large surplus of cash to be invested from these premiums. Counsel for the taxpayer fairly described his client as virtually awash with cash funds at the time. It would in my view have been a quite reasonable assumption for a sensible businessman in Mr Babet's position to have made at the time that he could expect there always to be a substantial cash flow from premiums to replace that which had to be paid to insurers.In the light of Mr Babet's lack of comprehension of the taxpayer's accounts, however, I would normally have expected a witness to be called who could explain what had been seen at the time to be the source of the funds available to the taxpayer for long term investments. The company accountant and financial controller at the time was a Mr Burt, who (according to the unchallenged evidence of Mrs Babet) did participate in discussions preceding the purchase of each of the various properties. However, Mr Burt (according to the unchallenged evidence of Mr Babet) left Australia at the end of last year, having misappropriated a vast sum of money from the taxpayer's associated company, Babet Intersure Pty. Ltd. The taxpayer certainly has had considerable misfortune in relation to the production as witnesses of a number of people who would otherwise have been expected to give evidence in these appeals on its behalf. Counsel for the Commissioner referred to them as having been lost in "the North Sydney triangle", but nevertheless he did not challenge their unavailability. In those circumstance, I am not prepared to draw an inference against the taxpayer in relation to this issue. Nor am I prepared to reject Mr Babet's evidence upon the basis that a long term investment was inherently improbable because of lack of available funds for that purpose.
The other point which the Commissioner made was that the return on such real estate investments was not such as to make them worthwhile. He drew attention to the fact that the taxpayer's associated company had been receiving 12% upon its investment with Associated Securities Ltd., but in view of that company's disastrous collapse such a return of 12% is of little assistance by way of comparison. The Commissioner finally suggested that 10% should be accepted as the return available on the short term money market at that time. By comparison, the return which the taxpayer in fact received from one of the units was as low as 3.3%. However, according to a contemporary document of Mr Babet's (described as a feasibility study and not challenged as to its authenticity), the return which he anticipated upon another of the units after the finance had been repaid was just under 9.5%. Added to this is the undoubted conventional wisdom of that time (which was before the present explosion in interest rates) that, even on a financed basis, the increase over the years in the value of the premises would be matched by an increase in equity (if the finance was being paid off) or an opportunity to repay the loan at a time when it would be considerably cheaper to do so (because of inflation). On the other hand, an investment in short term loans would see a constant depreciation in the real value of the capital sum invested. I am not prepared to infer that a long term investment was inherently improbable because of what, it was suggested, must have been seen at the time to be a poor return on the amount invested.
I turn next to the three North Sydney properties, which I will have to deal with separately.
Mr Babet gave evidence that, as the upstairs of the Walker Street property was more than sufficient for the immediate requirements of the taxpayer and in order to help offset the costs of acquisition and renovation and the A.S.L. loss, it was decided to lease out the ground floor for one to two years. When no tenant was forthcoming for that period, Mr Babet accepted the advice of the real estate agent to offer the more normal period of a three year lease with a three year option. In May 1979, such a lease
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was granted to Luxalite Lighting Pty. Ltd. In September of that year, that company offered to purchase the whole property from the taxpayer. Mr Babet said in evidence that he had no real desire to sell, but he put what he believed to be the market value upon the property and he was surprised when interest was maintained by the lighting company in purchasing it. In November, the lighting company stated that it wished to proceed with the purchase, and an even higher price was negotiated. Mr Babet gave evidence that he was still reluctant to sell, but in agreeing to do so he took into account the additional staff which the taxpayer had employed by that time, the lack of sufficient parking space, troubles with the operation of the computer indicating a need to install air-conditioning and the hope that cheaper business premises elsewhere in the area would leave a surplus to help offset the A.S.L. loss and the cost of the computer.None of that evidence was challenged by the Commissioner, but he repeated his argument that a sensible businessman in Mr Babet's position would not have taken the risk that there would always be funds coming into the taxpayer's hands to replace that which had continually to be paid out to the insurers, and that such a sensible businessman would necessarily regard any long term investment in real estate using premiums received as unsafe in those circumstances. I have already rejected that argument, and said that I would not reject Mr Babet's evidence upon the basis that a long term investment was inherently improbable because of lack of funds for that purpose.
The Commissioner also argued that this particular purchaser and sale fell into a pattern of dealing by the taxpayer in real estate - a purchase of property which was or had been residential with the prospect of rezoning or otherwise securing its commercial use, renovation and then disposal at a profit. (Reliance upon the second limb of sec. 26(a) was expressly disclaimed.) The three residential units at Neutral Bay and Glebe did not fit that pattern, so Walker Street would have had to be the first in the pattern to which the Commissioner referred. The Commissioner pointed to what he said were other real estate transactions with which the taxpayer had been concerned. There were indeed references in the evidence to the taxpayer's option to purchase a residential property in St Kilda (which was ultimately not taken up), a proposal by it to purchase a caravan park on Phillip Island (which was not proceeded with), a further proposal by it to purchase a property in Parramatta - which was to be rezoned - for use as a branch office and with "a potential for redevelopment" (the fate of which proposal was left completely unexplored), and an association between Mr Babet himself and a real estate agent named Taylor in a company called Mayrey Pty. Ltd., which appears to have purchased a number of properties (which on the unchallenged evidence of Mr Babet had been purchased for investment purposes but subsequently sold). None of these matters was investigated in the cross-examination of Mr Babet. If the Commissioner wishes to raise an issue which in the discharge of its onus of proof the taxpayer must explain, he has to do more than merely refer to the transactions in such a passing way. On the state in which these matters were left in the evidence, I can see nothing which needs to be explained by the taxpayer.
As the Commissioner relied upon the taxpayer's unexpected financial success in the sale of this Walker Street transaction as producing the incentive for the production of a profit-making purpose in one or both of the properties later acquired in North Sydney, I am not prepared to draw an inference against the taxpayer that the acquisition of this particular property in Walker Street formed part of the pattern to which the Commissioner referred. As to the effect of his unexpected success in relation to the Walker Street transaction upon Mr Babet's state of mind subsequently, however, I will return.
The next North Sydney property was that in West Street. This property was purchased shortly after the decision had been made to sell the Walker Street property (in which the taxpayer's business was being carried on) following the offer by the ground floor tenant to purchase it. Mr Babet conceded that the taxpayer had done rather well financially out of the sale of the Walker Street property. He had been surprised at how well it had done. He denied, however, that his decision for the taxpayer to acquire the West Street property was influenced by that fact. His overriding consideration, he said, was the need to find business premises for the taxpayer to use. The taxpayer's file in relation to the subsequent
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problems which it had concerning the zoning of this property is in evidence. There was no challenge to its authenticity. It shows overwhelmingly that the taxpayer fought long and hard to obtain a zoning which would have permitted it to continue using the property as its business premises. The Commissioner argued that all of these efforts did no more than establish that the taxpayer wanted the property to be rezoned for any commercial use, not necessarily its own.The last of the North Sydney properties was that in Falcon Street. Mr Babet well knew the problems in relation to its zoning when the property was acquired. Quite apart from what he was told at the time, he had himself already had considerable experience of such problems with the North Sydney Council. He told the taxpayer's bank that the location of the property allowed immediate renting for commercial usage (that is, the existing commercial usage) and that in the longer term the property had an extremely good potential for redevelopment. Mr Babet agreed in evidence that he had always had redevelopment in mind as one alternative if the property were rezoned. Commercial properties in that price bracket were, he said, very scarce in North Sydney. The taxpayer had leased the premises out because Mr Babet knew that it would probably take some years for the rezoning to take place. Mr Babet said that, if it were not rezoned, the taxpayer could sell the property. He denied that the other side of that risk was the prospect of selling the property at a substantial profit if it were rezoned.
The Commissioner accepted that the taxpayer's success or failure in these appeals depended upon my acceptance of Mr Babet's evidence as to the purpose for which each of the six properties was acquired. He also very properly conceded that no finding should be made that Mr Babet had attempted to deceive me in his evidence. What the Commissioner suggested was that Mr Babet's present belief as to the purpose for which these properties had been acquired is based only upon wishful thinking as to what should have been the situation.
Both parties agreed that I should not look at each transaction in isolation, and that the evidence in relation to each was relevant to my findings on the others. I should say at once that the only transaction about which I have felt any doubts is the last, that relating to the Falcon Street property.
I accept Mr Babet's evidence that the purpose for which the three residential units were purchased by the taxpayer was long term investment. He very honestly conceded that one of the many considerations which probably led the taxpayer to purchase these properties was that they would increase in value. He would have been foolish not to have conceded the existence of such an obvious consideration. An appreciation at the time of acquisition that the property could be sold at some time in the future at a profit if it were necessary or desirable does not, however, bring the profit subsequently made upon such a sale within sec. 26(a) where the taxpayer's dominant purpose in acquiring it was to retain the property as a revenue producing asset; the two considerations are not inconsistent or incompatible:
Buckland v. F.C. of T. (1960) 34 A.L.J.R. 60 at p. 62.
I accept also Mr Babet's evidence that the purpose for which the Walker Street property in North Sydney was purchased by the taxpayer was a long term investment and for the company's use as business premises. There was really no serious challenge to his reason for wanting to move those business premises away from the central business district to North Sydney, and the purchase of premises in that area seems to me to have been a natural step to have taken once the taxpayer had decided to invest in real estate.
I accept also Mr Babet's evidence that the purpose for which the West Street property in North Sydney was purchased by the taxpayer was long term investment and for the company's use as business premises. The unexpected sale of its business premises in Walker Street made it imperative for the taxpayer to obtain new premises for that purpose. Everything which justified the purchase of the Walker Street property for the purpose still applied. Whatever unexpected profit had been made in the sale of that property, the dominant purpose of this acquisition was clearly to provide new business premises for the taxpayer itself. In my view, such a purpose would more likely than not have involved an intention to use the property as business premises for the long period of time. A sensible businessman in Mr Babet's position would have been unlikely to have planned constant shifts of his company's place of
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business simply in order to make profits on the resale of the premises which it occupied. It defies common sense that he would make such plans, for it would be so much simpler for a businessman in the position of the taxpayer to carry on such a project in relation to properties which were not being used as his own business premises. There was no suggestion that the taxpayer had paid a price for this particular property which was based upon its value as residential zoned only. There was thus no prospect of an immediate increase in value upon the anticipated rezoning. The renovations effected upon this particular property were not of the order of those effected upon the Walker Street property. This property was not in the run-down condition of either Walker Street or Falcon Street. The property was habitable as a boarding house, but not suitable as an office; it was renovated only to convert it to commercial use.I come finally to the Falcon Street property. I accept that one of the purposes for which this property was purchased was to use it for office accommodation as a back stop in the event that the West Street property could no longer be used by the taxpayer as business premises. That was, however, only one of a number of possible uses for which it was purchased. It certainly could not have been used for that purpose until the rezoning had been effected, and that rezoning was likely to take some years. There was a recognised risk that the property would not be rezoned. Mr Babet always had the possibility of redevelopment in his mind if it were rezoned. No long term finance was ever arranged. It is here, I feel, that some element of a profit-making purpose could have been engendered in Mr Babet's mind by the unexpected financial success which he had had in relation to the Walker Street property. Notwithstanding Mr Babet's statement (of general application) that his overriding consideration had always been to find an office for the taxpayer in the North Sydney area, I am not satisfied that the dominant purpose of the taxpayer's acquisition of the Falcon Street property was not ultimately to resell that property at a profit.
That finding - or, perhaps more properly, that non-finding - does not involve any conclusion that Mr Babet has lied. It is simply a lack of satisfaction on my part that what was obviously one of a number of purposes for the acquisition of Falcon Street was not the dominant one. That lack of satisfaction means that the taxpayer has not discharged its onus of proof in relation to that particular acquisition, but it does not cause me to doubt Mr Babet's evidence in relation to any of the taxpayer's earlier acquisitions.
It follows that the taxpayer must succeed in its appeals in relation to each of the six properties except the last. It is agreed by the Commissioner that the appeal against the Div. 7 tax assessed for the year ended 30 June 1980 (the proceedings numbered 919 of 1985) should be allowed if the appeal against the primary tax for that year is allowed.
ORDERS:
In each of proceedings 896, 917 and 919 of 1985 - I uphold the taxpayer's appeals; I order the Commissioner to pay the taxpayer's costs. In proceedings 918 of 1985 - I dismiss the taxpayer's appeal; I order the taxpayer to pay the Commissioner's costs.
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