CASE 10/96

Members:
BJ McMahon DP

Tribunal:
Administrative Appeals Tribunal

Decision date: 18 January 1996

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BJ McMahon (Deputy President)

This is an application to review decisions on objections against assessments of income tax and additional tax issued in respect of the years ended 30 June 1986 to 1991 inclusive. The decisions concern claims for payment of interest and borrowing expenses which were disallowed.

2. An individual. whom I will refer to as the proprietor, substantially owns a number of companies engaged in related fields in an industry. Seeking premises in which to house one of these companies, he fixed upon an industrial site in an inner suburb of Sydney. The property was owned and occupied by the applicant, a company that had been incorporated in 1971. The applicant was then a wholly owned subsidiary of a company, which I will refer to as the parent. The proprietor initiated discussions with officers of the parent with a view to obtaining ownership of the premises.

3. There was evidence that the proprietor wished to acquire title to the real estate for various reasons. However, what was finally agreed, and what was recorded, was a contract made on 6 September 1985 between the parent and the proprietor under which the parent agreed to sell all the issued shares in the applicant to the proprietor. Having acquired ownership of the applicant the proprietor would, of course, be in a position to dispose of the applicant's property, or deal with it in any way that suited his purposes.

4. The contract of sale was made subject to certain conditions. One of these was that approval be obtained from the local council to a development application identified in the contract and to a subsequent building application. Other conditions related to the financing of the purchase of the shares. There were 3 relevant financial arrangements.

5. The total price of the shares was $600,000. It was a condition of the agreement that the parent advance to the proprietor the sum of $295,000 at an interest rate of 14.5% per annum for the first year (variable in terms of the contract for subsequent years) and that repayment of such advance would be secured by a mortgage over the property to be given by the applicant in favour of the parent. This advance of $295,000 was then to be paid by the proprietor, on settlement, to the parent in part payment of the purchase price.

6. The second component consisted of a sum of $270,000. This had previously been loaned by the applicant to the parent. It was a condition of the contract that prior to settlement, the parent was to repay the sum, the applicant was to lend it to the proprietor interest free, and the proprietor was then to pay it to the parent on account of the purchase price of $600,000.

7. The third component of the purchase price was made up of a loan of $40,000 from a client of the proprietor's solicitors (``the solicitors' loan''). This amount was loaned to a trust company associated with the proprietor which, in turn, on lent the money to him to enable him to pay it to the parent on account of the purchase price under the contract.

8. Although the loans were all made to the proprietor, subsequently interest was paid by the applicant on the first and third components to the parent and to the solicitors' client. Claims for deduction of these interest payments are the subject of the present proceedings, together with refinancing charges.

9. The acquisition of the shares was completed on 3 April 1986. Thereafter, it was arranged that one of the proprietor's companies should take over the premises as tenant and pay a commercial rent to the applicant during all the relevant years. On 16 April 1987, the applicant and the tenant company obtained a commercial bill facility for $300,000 from Australia and New Zealand Banking Group Limited, secured by a mortgage over the property. The proceeds of this loan were used for the purpose of enabling the proprietor to repay his loan from the parent. Upon this happening, the proprietor's liability to the parent was discharged and he then became indebted to the applicant for the same amount.

10. On 16 January 1989 the applicant borrowed $500,000 from Advance Bank Australia Limited, repayment of which was again secured by a mortgage over the property. The proceeds of this loan were largely used for the purpose of enabling the applicant to repay the ANZ Bank loan and the solicitors' loan. The applicant continued to be indebted to the Advance Bank during the remainder of the relevant years. Borrowing costs were incurred in these years in connection with the re-writing of the obligations.

11. Between 3 April 1986 and 16 April 1987 (``the first period''), loan obligations lay only between the proprietor and the parent and the

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solicitors' client. The applicant was under no legal obligation to pay interest. After that date it became the principal borrower from each of the banks in turn. No clear explanation was given why the applicant made what amounted to voluntary payments of interest during the first period. In his evidence the accountant who advised the applicant in subsequent years surmised that the whole of the group's obligations were looked at towards the end of each financial year and that the applicant was debited with a proportionate part of the group's interest liability through journal entries. I must assume, however, that a conscious decision was made by the applicant to make these interest payments for whatever reason. The debits have been accepted as part of the applicant's financial accounts, certified to in the usual manner by the directors, including the proprietor. The applicant, of course, continued to pay interest after the first period because by then it had a legal obligation to make these payments to the respective banks.

12. The applicant's case for deductibility of interest expenses and borrowing costs was put on 2 bases. In relation to the first period it was alleged that the applicant incurred expenditure on behalf of the proprietor in meeting the interest obligations on the loans from the parent and the solicitors' client because the proprietor had not drawn a salary from the applicant for services provided by him as a director or otherwise and that he had therefore made a ``salary sacrifice'' or ``remuneration package'' arrangement and that consequently payment of the interest on his behalf was deductible as it represented a benefit conferred on the proprietor as a working director.

13. In relation to both the first and subsequent periods, the applicant's claim was also put on the basis of an entitlement to deductions under s 51(1) of the Income Tax Assessment Act and particularly the second limb of that sub-section. The respondent's position was explained in a letter that he wrote to the applicant on 8 September 1993 when he stated that ``there appears to be no nexus between the incurring of interest and borrowing expenses and the derivation of assessable income by way of rents or from any other source by the company''.

14. Before dealing with the general question of deductibility of the interest payments under s 51, certain preliminary matters should be mentioned.

15. The assessments against which objections had been lodged contained amounts for additional tax under ss 222 and 223(1). One of the issues raised prior to the hearing was whether there should be a further remission of that additional tax pursuant to s 227(3). On the hearing, calculations were produced by the respondent showing how the additional tax had been arrived at. Section 14ZS of the Taxation Administration Act (as it existed at the relevant time) defines ineligible income tax remission decisions by reference to a formula based on a statutory rate of interest. The calculations put before me show that the amounts of additional tax and the applicable rates in each case were less than the statutory rate and that therefore the question of further remission is an ineligible income tax decision which I am not empowered to embark upon. This was put to the applicant's counsel shortly before the conclusion of the hearing and he was given an opportunity to reply later. This opportunity was declined after he had considered the position. On the material put before me, therefore, I find that the Tribunal has no power to remit further the additional tax that was imposed in the relevant assessments.

16. The second preliminary matter refers to the solicitors' loan. In my view the principles to be applied are the same in the case of both the parent's loan and the solicitors' loan. Both amounts were advanced ultimately to the proprietor only for the purpose of enabling him to acquire shares in the applicant company. I will therefore not deal with the solicitors' loan separately in these reasons.

17. The third preliminary matter to mention concerns any possible entitlement under s 67 for deduction of borrowing costs. Whatever the position may have been after the first bank loan, there can clearly be no entitlement under this section in relation to the first period as the expenditure was not incurred by a taxpayer (the applicant company) in borrowing money used by the taxpayer for the purpose of producing assessable income. The money was used by the proprietor for the purpose of acquiring shares in the applicant company.

18. The fourth matter to be dealt with concerns the claim that deductions for payments made during the first period could be justified as fringe benefits provided for the proprietor. I do not accept the evidence on this subject and

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do not accept that there was any such arrangement.

19. Evidence was tendered by way of affidavit (Exhibit D) from an accountant whose association with the proprietor was ``more social than professional in its nature''. The affidavit recounted various conversations between June and August 1985 that the deponent had had concerning possible ways of structuring the acquisition. None of these ways was finally adopted. One of the reasons why this was so was because of the introduction of capital gains tax at about the time that negotiations were taking place. The affidavit goes on to describe various discussions which the deponent said he had with the proprietor, in which it was suggested that the proprietor could have been paid a larger salary by the applicant so that he could fund the interest payable to the parent on his personal debt. At that stage it was proposed that he would get a tax deduction equal to his salary. However, this involved possible pay-roll tax implications, increased group tax and possibly an increase in worker's compensation premiums. The deponent in his affidavit said that he therefore suggested the possibility of a ``salary sacrifice''. He was not however the proprietor's professional advisor and was unaware whether his suggestion was subsequently adopted.

20. As evidence that there was an agreement to provide a fringe benefit to the proprietor of the amount of the interest the applicant company paid, I give no weight to the affidavit. The deponent was not required for cross- examination. The affidavit was admitted into evidence over objections, principally on the basis that it might provide some relevant material on the question of penalty. However, as has been noted, the question of remission of additional tax proved to be beyond the power of this Tribunal. The material in the affidavit is purely speculative. No attempt is made to link any of the suggestions said to have been made with the subsequent conduct of the applicant company or its treatment of outgoings in relation to the proprietor.

21. The affidavit provides no evidence of the existence of the arrangement which is now alleged.

22. In his affidavit, the proprietor said at paragraph 15-

``Funds advanced to me by [the applicant] in order that I could acquire the issued shares in the company, as detailed later on in this statement, were provided on an interest free basis in recognition for the services I rendered to the company and which had a direct effect in generating income for both [the applicant] and other entities in the group. These benefits were provided to me in lieu of a cash salary.''

23. The paragraph was drafted at a time when the applicant's case was being put on the basis that the loan from the parent had been made to the applicant who had on lent the money to the proprietor. By the time the matter came on for hearing, it was clear that the loan had been made directly from the parent to the proprietor. Material in the affidavit to the contrary is therefore plainly wrong. The remainder of the paragraph is self-serving. Such an allegation would normally need to be supported by contemporaneous records if one were to give it any credence.

24. In cross-examination, all the proprietor could say was that he had not been paid a salary by the applicant. There was no minute of any meeting of directors to which he could point to substantiate the agreement now alleged. Whilst it is understandable in proprietary companies that not all matters affecting the business of a company are necessarily recorded in minutes of meetings of directors, one would at the very least expect such an arrangement to be reflected in the company's accounts. There is no indication that this was done. Furthermore, of course, no fringe benefits tax return was lodged at any time by the applicant company. Apart from the ex post facto allegations made in Exhibit D there was no reference to any alleged fringe benefits arrangement until formal objections were lodged in September 1993. There was no indication in the applicant's return of income that such an arrangement was in existence at the time of the first period. There is in fact no contemporaneous evidence which I am prepared to accept that such an arrangement existed between the applicant and the proprietor. I am not prepared to accept that the applicant has discharged its onus on the unsubstantiated allegations of the proprietor.

25. The question of deductibility of interest will therefore depend upon an application of the second limb of s 51(1) to the above facts. The question of the deductibility of associated borrowing costs will depend upon the outcome

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of the claim for interest expenses claimed (
Ure v FC of T 81 ATC 4100).

26. The most recent and authoritative review of past cases and exposition of the law on the subject of deductibility of interest is to be found in the 2 cases,
FC of T v JD Roberts; FC of T v Smith 92 ATC 4380. Whilst various formulae of words have been used to assist in understanding the character of interest payments in certain circumstances, Hill J (with whom Jenkinson and O'Loughlin JJ largely agreed) reiterates the statutory language that must not be forgotten. At 4388 he referred to his decision in
Kidston Goldmines Ltd v FC of T 91 ATC 4538 and continued-

``While acknowledging the usefulness of both the concepts of use to which the funds are put and of subjective purpose, I warned in that case of the danger in substituting for the words of s. 51(1) language which does not appear in it. It is a warning to which I adhere. The issue continues to be whether the interest outgoing was incurred in the income producing activity or, in a case falling to be tested under the second limb, in the business activity which is directed towards the gaining or producing of assessable income. As the cases, including Kidston, all show, the characterisation of interest borrowed will generally be ascertained by reference to the objective circumstances of the use to which the borrowed funds are put. However, a rigid tracing of funds will not always be necessary or appropriate: cf
FC of T v Total Holdings (Australia) Pty Limited 79 ATC 4279 and the discussion of tracing in the context of s. 51(1) in Parsons, Income Taxation in Australia, Law Book Co, 1985 at 348ff.''

27. On the same page, His Honour points out that the character of refinancing takes on the same character as the original borrowing. Accordingly in the present case the loans from the ANZ Bank and the Advance Bank may be viewed in the same light as the original loan from the parent. The characterisation of the interest outgoing will normally be ascertained by reference to the objective circumstances of the use to which the original borrowed funds were put. These funds were laid out for the purpose of enabling the proprietor to purchase all the issued shares in the applicant. The loan from the parent was not a loan to the proprietor laid out for the production of the applicant's income from the receipt of rental income from the property. The business activity of the applicant was directed towards the gaining or producing of rental income. The borrowed funds were not outlaid in that business activity. They were outlaid by the proprietor in acquiring a capital asset. I am not concerned in the present proceedings with any deduction that is, or might have been, available to the proprietor in those circumstances.

28. In Roberts and Smith at 4387 Hill J said-

``The mere act of borrowing money, burdened with the obligation to pay interest, does not of itself gain or produce assessable income. The amount borrowed is not assessable income. What operates to gain or produce assessable income is the manner in which those moneys are used, so that the necessary connection between the outgoing for interest and the activities which more directly gain or produce assessable income will be found, in the ordinary case, in the use to which the borrowed funds are put...''

29. What is that necessary connection? Again at 4386 His Honour said-

``... The expenditure must have the necessary connection with the operations or activities which more directly gain or produce assessable income so as to meet the statutory criterion that the outgoing be incurred in gaining or producing assessable income or in carrying on a business:
Charles Moore & Co (WA) Pty Ltd v FC of T (1956) 11 ATD 147 at 149; (1956) 95 CLR 344 at 351;
FC of T v DP Smith 81 ATC 4114 at 4117; (1980-1981) 147 CLR 578 at 586. That is to say it must be `incidental and relevant' to that end:
Ronpibon Tin NL v FC of T (1949) 78 CLR 47 at 56, although as Williams, Kitto and Taylor JJ observed in Lunney at ATD 412; CLR 497, expressions of the kind (incidental and relevant are):

`... not used in an attempt to formulate an exclusive and exhaustive test for ascertaining the extent of the operation of the section; the words were merely used in stating an attribute without which an item of expenditure cannot be regarded as deductible under the section.'''

30. In the early case of
Begg v FC of T (1937) 4 ATD 257, the court looked to ``a real

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and substantial relation between the payment of the interest to the banks and the production of the income''. Although this decision has been subject to some criticism it still provides a useful way, although not an exclusive way, of characterising interest payments for s 51 purposes.

31. In the present case the applicant can say no more than that the incurring of interest by the applicant company was incidental and relevant to deriving its rental income because its tenant was another company controlled by the proprietor and that it is unlikely that it would have entered into this rental agreement unless the proprietor had acquired the whole of the shares in the applicant company. To my mind, payment of interest on moneys borrowed for the purpose of acquiring shares in a landlord company, whether that payment is made voluntarily by the landlord company as it was in the first period, or under compulsion of law as it was thereafter, lacks the essential connection with the company's income producing activities. The moneys borrowed were not expended by the applicant company in acquiring premises which it subsequently let. It is not open to me to find that this was the case when clearly the facts are to the contrary. It is not to the point to say that the acquisition might have been better structured from a tax point of view. I must take the facts as I find them. Economic equivalence is no basis for a claim for a tax deduction.

32. Counsel for the applicant relied upon 3 cases in particular (among the many cited) to illustrate a growing tendency to accept a broader view of this essential connection. In my view, none of the 3 cases affords much comfort to the applicant.

33. 
EA Marr & Sons (Sales) Ltd v FC of T 82 ATC 4654 does little more than establish, in the circumstances of that case, that it was possible to carry on a business by making available to members of the group plant and equipment leased by the parent company. There is no real issue in the present circumstances that the applicant company was carrying on a business and that accordingly deductibility should be looked at under the second limb of s 51(1). The view I have taken, however, is that the nexus is such that it would not bring advantage to the applicant whether the first or second limb were the applicable heading of deduction.

34. The second case relied upon was
FC of T v Reed 88 ATC 5014. Although in written submissions counsel contended that the Federal Court held that the taxpayer was entitled to his deduction, my reading of the report is that Foster J simply held there was no question of law available on the appeal and that on the facts as found by the Tribunal, the decision it reached was open to it. A case turning on its own facts in the unusual circumstances of Reed does not offer a great deal of support for the propositions put on behalf of the applicant in this case.

35. The third case upon which the applicant particularly relied was
McLennan v FC of T 90 ATC 4047. In that case a canegrower contributed a levy to a weir construction cooperative. The grower was allotted shares in the cooperative in proportion to his contribution. The amount collected from the levy was used by that cooperative in paying interest on a loan used to finance the weir. A Full Federal Court held that the mere fact that an outgoing was applied in the purchase of shares did not necessitate the conclusion that the outgoing was an outgoing of capital. The formation of the cooperative and the allocation of shares to persons who paid the levy was merely the mechanism for carrying into effect the arrangement between the canegrowers and the Water Resources Commission. Their Honours considered that the cooperative had a limited role and once its object was carried out it would have no assets and its sub strata would be gone. Accordingly the shares in that cooperative were worthless. This prompted Hill J to observe that the Commissioner's submission ``represented a triumph of form over substance'', an observation which was repeated by counsel for the applicant in the present proceedings. I do not agree that a preference for a finding of the facts as they were over a finding of the facts as they could have been, or even should have been, is a triumph of form over substance. This description of the Commissioner's attitude in the present proceedings can not be supported.

36. In my view, the present case can be clearly distinguished from the facts in McLennan. The cooperative was a mechanism with a defined object and a limited life. One can understand why it was possible to look through it in seeking to define the essential character of the payment for its shares. In the present case, the applicant company is a property owning

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company which had, and continued to have, an existence and substantial assets. Acquiring shares in such a company is quite different from acquiring shares in a purpose built cooperative, designed only to facilitate construction of a weir. The decision in McLennan does not, in my view, in any real sense diminish the quality of the essential connection with the income producing activities which must be shown by an applicant.

37. For these reasons the objection decisions under review are affirmed.