CASE 56/95

Members:
BJ McMahon DP

Tribunal:
Administrative Appeals Tribunal

Decision date: 8 November 1995

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BJ McMahon (Deputy President)

This is an application to review an objection decision by the respondent to disallow an objection against a notice of assessment issued in respect of the year ended 30 June 1992. That assessment disallowed a claim for ``loss on guarantee'' of $10,000 said to have been paid by the applicant in that year and reduced the carry forward losses for the 1991 income year, which resulted from a ``guarantee loss'' of $269,366 being disallowed. The moneys were paid by the applicant, so it was said, to discharge liabilities of a company which carried on a business of manufacturing confectionery. Whether the applicant is entitled to the deductions claimed, depends upon the way in which his financial relationship with the company and its shareholders is to be viewed.

2. Early in 1989, the applicant's accountant gave certain advice to the company after carrying out a survey on its costings. At that time he did not see any of the financial accounts

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of the company and was not aware of its exact financial position. He said in evidence, however, that he was given to believe that it was a good business and that it would be a suitable acquisition for the accountant and another person who could supply necessary finance. On the basis of this limited acquaintance with the company's affairs, the accountant decided to proceed with the acquisition of the company. Naturally, he was anxious to assure himself of its financial support in the future.

3. In November 1989, the accountant first approached the applicant to discuss whether he ``would be interested in an opportunity to participate in a business of sweet making with me''. At that time, the accountant said that in his estimation, once the company succeeded in the plans he had for it, he thought an income of between $40,000 and $50,000 could be provided for the applicant. This was a figure and concept that was to recur many times throughout their conversations and in evidence before the Tribunal. The applicant's principal occupation at the time was that of a property developer. The prospect of a steady cashflow of the order discussed between the applicant and the accountant appears to have been the basis for all his future actions in relation to the company. In his evidence, the applicant said that initially he turned down the proposal ``as I was not prepared to invest in a business unless I managed or participated in it''. According to the accountant's evidence, the proposal was initially rejected by the applicant without reasons.

4. As the applicant at first declined to become involved, the accountant decided to proceed alone. On 14 December 1989, he entered into a deed with the vendors of the shares in the company. The whole of its issued capital, comprising 400,000 ordinary shares of $1 each fully paid, was acquired for $1. However, the accountant purchaser undertook an obligation to the vendors to procure their release from guarantees they had given under certain equipment leasing agreements and under a bank overdraft which the company had with First bank. If he was unable to procure a release of any guarantee, the deed provided that he was to indemnify the vendors against their liabilities under those guarantees. In support of that indemnity, he charged all of his property, including the subject shares, in favour of the vendors.

5. After taking possession of the company and its business, the accountant found that its financial situation was worse than he had expected. At first, he financed its purchases and other outgoings through cashflow. Gradually, however, he came to realise that this would not be a sufficient source to keep the company afloat. He therefore again approached the applicant.

6. At the time, the accountant was ill and had undergone surgery on a number of occasions in hospital. By the end of January 1990, the financial position of the company was quite unsatisfactory. The accountant said that he was desperate to obtain financial support from the applicant whom he asked to pick him up at home. They had certain discussions and visited the company's premises but clearly did not come to any conclusion as to the basis upon which the applicant would participate in the business. On that occasion, the accountant said ``we went to look at the business, we were in a deep hole, we discussed mainly what we would do in relation to the business. We decided that [the applicant] would be involved in marketing and that I would do the accounts. We did not discuss the precise role that he was to play. We did not discuss any financial arrangements. The main purpose of our meeting was to keep the business going''.

7. It has since been the applicant's claim (at any rate in these proceedings) that he reached an agreement with the accountant who was acting on behalf of the company that the applicant would enter into a joint venture with the company and that the contributions which the applicant made were to be raised in the manner I will describe. The applicant was an unsatisfactory witness. He gave his evidence in an evasive manner and on many occasions sought to qualify his answers so as to give him an escape if those answers were shown to be wrong. More importantly, his evidence was quite inconsistent with allegations he made in a Statement of Claim issued in proceedings between him and Second bank, to which I will later refer. It is hard to resist the conclusion that the applicant's version of events has changed so as to meet the exigencies of any situation in which he found himself at any particular time. Wherever there has been a conflict in the evidence given by the applicant and the

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accountant I have preferred the evidence of the accountant.

8. As a result of the meeting in January 1990, the 2 men went to a branch of Second bank where the applicant was known. An account was opened in the name of the company and the bank agreed to provide overdraft accommodation to $100,000 provided that, in due course, a mortgage in support of the company's obligations was given by the accountant and his wife over their house.

9. That mortgage was not given until some months later, nevertheless the bank provided the necessary accommodation immediately. On Folio T14-6 of the s 37 documents are set out a summary and copies of 19 cheques drawn between 25 January 1990 and 6 February 1990. Most of these were counter cheques, indicating that the company had not then been issued with a cheque book. I accept the evidence that those cheques were in favour of suppliers to the business who were then pressing for their accounts to be paid. The cheques were written out by the accountant and signed by both the accountant and the applicant. I have been asked to assume that every other cheque drawn on the account while the applicant was involved in the affairs of the company was for a similar purpose. For reasons to which I will later refer, I am unable to make this assumption.

10. There was never any agreement in writing between the applicant on the one hand and either the accountant or the company on the other hand. Indeed up until the hearing, the applicant's case was put in the alternative, namely that he had a joint venture agreement with either one or other entity. At the hearing, it was no longer suggested that any agreement he had was with the accountant. It was submitted that the evidence supported a joint venture agreement between the applicant and the company. In my opinion, there was never any such concluded agreement. The company subsequently went into liquidation. None of its financial or statutory records was put into evidence before me and no explanation was given why appropriate summonses could not have been issued for their production. From the company's point of view there is no evidence that it entered into any agreement which was recorded in the minutes of meetings of directors. In fact the applicant was unaware of the identity of the directors of the company, apart from the accountant.

11. The applicant alleges that in return for his contributions to the finances of the company, he was to obtain a certain percentage of its revenue. On various occasions, that percentage was expressed as 2½, or 3, or 4 per cent and the revenue was expressed as gross or net or taxable. Clearly there was no agreement to which either party could point. No acts were done in pursuance of any such agreement. No moneys were paid to the applicant at all. In evidence he said ``we never really got down to discussing a return as there was no profit''. If the agreement was that he should derive income from gross revenue, the existence of a profit would have been irrelevant. Yet this is the basis of the joint venture agreement which the applicant now alleges was in existence. There is nothing to support an allegation of such an agreement, except the applicant's evidence, which I am not prepared to accept without suitable corroboration.

12. What seems to have stuck in the applicant's mind was the mention of a possible income of $40,000 or $50,000 per year. Even at best, the accountant, in his evidence, said that such an income could not be promised to the applicant in under 3 years. In his (the accountant's) view, the agreement was that the applicant should become the major shareholder of the company. He was unclear whether that meant he was to obtain any particular percentage of the issued shares, ranging from 51 per cent to 95 per cent, although he agreed there was an obvious difference between them. Apart from the general intention that the applicant should be in control, it is clear from the evidence that no firm agreement was reached as to any particular definite percentage he was to take up. I accept the accountant's evidence that the arrangement was to be structured by way of a transfer of some of his shares to the applicant, rather than that there was a joint venture between the applicant and the company. The applicant does not appear to have addressed the exact way in which he was to achieve what he had hoped for. He said in evidence ``the figure that interested me was $40,000 or $50,000 per annum. That sounded quite nice to me. We would formalise that later''. The evidence leads me to believe that there was never any basis for an agreement on which either party could rely, except that there was a general understanding that the applicant should be a major shareholder in the company.

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13. Because of the ill health of the accountant, the applicant spent a considerable amount of time on running the company. According to the accountant, ``if he decided we didn't want to do something, that was that. He was controlling the working of the company''. The applicant hired and fired staff, placed orders, involved himself in contracts for maintenance of machinery and design of products and exclusively occupied an office in the company's premises.

14. The company was unable to keep within its overdraft limit of $100,000. By April, it was agreed with Second bank that the limit would be extended to $250,000 provided that the mortgage was executed and registered and provided that a written guarantee was given.

15. On 12 April 1990, a deed of guarantee was executed between Second bank on the one hand and the applicant, the accountant and the accountant's wife on the other hand. The accountant's wife was not a director of the company but was a co-owner of the house.

16. As the company's financial position worsened, more cheques were drawn on the overdraft account. These included cheques for outstanding payments of group tax and sales tax and cheques at the rate of $6000 per month, in reduction of the company's overdraft with First bank. In addition to these cheques, a sum of $10,000 was paid in the 1992 financial year. The applicant said that it was paid by him to discharge the company's rent obligation. He said that the money was held in a trust account by a solicitor and was disbursed by that solicitor on the applicant's instructions. However, in cross-examination it was clear that the applicant could not recall what instructions had been given, whether the moneys were paid to the company's landlord, whether the moneys were paid into the company's account with either First bank or Second bank, or whether the moneys were sent directly to the company. There is simply no acceptable evidence before me to assist in characterising this amount as a payment on revenue account.

17. As the company's fortunes declined, both the applicant and the accountant decided to abandon it, in a commercial sense. Exactly how this came about was left unclear. It was suggested that the original vendors exercised their rights under the deed of charge of December 1989 and retook possession of the shares in the company and of the company's assets. There was no real evidence, however, to explain precisely what happened.

18. It is clear, however, that Second bank then called upon the applicant to meet his obligations under the deed of guarantee. Upon his failure to do so a personal account which he had with the same bank, was debited with the balance of the amount then owing by the company, namely $269,366. It is not necessary to follow what happened after that and to establish how the bank was ultimately satisfied. The applicant claims to be entitled to a deduction of this amount of $269,366 (and the $10,000) under s 51 of the Income Tax Assessment Act as part of his contribution to a joint venture which he alleges he had with the company.

19. Even if one accepts his version of events, his claim must fail for a number of reasons.

20. His counsel submitted that all outgoings on the company's account with Second bank were on revenue account and that there was consequently a ``continuous stream of deductions'' as each cheque was written on the overdraft account. Whether or not the company would have been entitled to claims for deductions is not to the point. The fact is that this claim is being made by the applicant. The first point to be made is that there is no evidence of the nature of any of the payments made on the account except for the first 19 cheques. The applicant was put to proof. In the circumstances, I do not consider this unreasonable. Clearly there were non deductible payments, such as group tax and sales tax and there were regular payments such as the $6,000 per month to reduce the overdraft on the company's account with First bank. There is no evidence whatever of the purpose for which the First bank overdraft was created.

21. The second point to make is that there was not a continuous stream of outgoings. Like all overdraft accounts, this was a come and go account. Deposits were made from cash receipts from time to time. The amount debited to the applicant's personal account was simply the final balance of the company's indebtedness.

22. The third and most important point to be made, however, is that payments under a guarantee are quite distinct from payments of the debt which is guaranteed. Repayment of a bank debt is characterised in a different way from the way in which bank debits were structured. The claim which the applicant

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makes to be entitled to deductions is 2 steps removed from the outgoings which are alleged to have been ordinary business expenses of the company.

23. The fourth point to make is that in any event payments made pursuant to a guarantee carry with them, by operation of law, a right of subrogation against the principal debtor and possibly against co-guarantors. Such payments therefore can not be regarded as outgoings. The fact that the applicant has not proved in the liquidation of the company or taken action against the accountant, or the accountant's wife to recover appropriate contributions, is irrelevant. Payments under a guarantee entitle the guarantor to pursue these remedies. This entitlement has an important effect upon the characterisation of moneys paid pursuant to a guarantee.

24. As I said in Case W26,
89 ATC 273 at 276-

``In most circumstances (unless in the course of carrying on a business) an amount paid pursuant to a guarantee will be a capital loss. The reason for this is that a payment to another of an amount on terms that someone else will return that amount to the payer is not deductible. It is an outlay, not an outgoing. Payment of moneys due under a guarantee results in the guarantor being then able to claim repayment of the money from the debtor. The payment out is not an outgoing since there is a right to repayment arising from subrogation to the rights of the creditor, who has received payment from the taxpayer guarantor. This is the principal reason why payments of this nature cannot be regarded as outgoings.''

25. In any event, whether a right of subrogation arose, the applicant has commenced proceedings in the Supreme Court against Second bank. He alleges in his Statement of Claim that he derived no benefit from the payments out by the company and that the bank illegally debited his account. If he has a right of recovery, the guarantee payment becomes an outlay for a different reason.

26. All the above observations have been made on the basis that even if one were to accept the applicant's version of events, his claim to be entitled to the deductions must fail. However, as I have indicated, I do not accept that there was in fact a joint venture agreement. On the basis of the vague evidence put before me, a true analysis appears to be that the applicant undertook a guarantee obligation in order to ensure the future profit of the enterprise of which he was to be the major shareholder. As the guarantee was given some 3 months after the overdraft account was opened, it may be more accurate to say that the guarantee was given so as to preserve the future profitability of the enterprise. Payments made pursuant to such a guarantee must be regarded as being of a capital nature. As was said in
John Fairfax & Sons Pty Ltd v FC of T (1959) 11 ATD 510 at 519; (1958-1959) 101 CLR 30 at 48-

``To make a payment to acquire or to defend the acquisition of a favourable position from which to earn income or to enter into arrangements that will yield income is not in general an outlay incurred either in gaining or in carrying on business for the purpose of gaining assessable income...''

27. Counsel for the applicant made lengthy submissions seeking to show that the relationship between the applicant and the company was not that of a partnership, an employer-employee, or an independent contractor. In view of the conclusions to which I have come, it will not be necessary to deal with those submissions, as I agree that none of them is appropriate in the circumstances. Further submissions were made as to the nature of joint ventures and the way in which they should be treated for tax purposes. Having regard to the conclusion I have reached that there was no such joint venture, it will not be necessary to deal with those submissions. A further submission was made that the matrix of facts could be viewed as a profit making scheme. In view of the finding of fact which I have made as to the nature of the relationship, it will not be necessary to discuss the possible application of principles expressed in
FC of T v The Myer Emporium Limited 85 ATC 4601.

28. For these reasons, the decision under review is affirmed.