Hancock v Federal Commissioner of Taxation

(1961) 108 CLR 258
35 ALJR 228
[1961] ALR 839

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(Judgment by: Menzies J)

Between: Langley George Frederick Hancock
And: Federal Commissioner of Taxation

Court:

Judges: Fullagar J
Dixon CJ
Kitto J

Menzies JWindeyer J

Subject References:
Income tax (Cth)

Judgment date: 8 August 1961

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Judgment by:
Menzies J

At the beginning of the time with which we are concerned (i.e., the first half of 1949), the taxpayer, George Hancock, and his son, L. G. F. Hancock, were minority shareholders in Mulga Downs Pty. Ltd., a pastoral company owning and operating the Mulga Downs station near Wittenoom Gorge in Western Australia. The original majority shareholder was one Wittenoom, for whom the appellant George Hancock had in the first place managed the station, but upon the death of Wittenoom the majority shareholding passed to members of the Lefroy family. The paid up capital was 18,945 shares of one pound each, of which the Lefroys held 11,210, and the taxpayer 6,730, his son L. G. F. Hancock 1,000 and Mrs. L. Y. M. Hancock 5. These last can be disregarded, so that when I speak of the Hancocks I mean George and L. G. F. Hancock. The company was in a strong financial position and in February 1949 had, in addition to the station and stock, Commonwealth bonds to a face value of 17,500 pounds, a credit with Dalgety & Co. Ltd. of 5,400 pounds, and was owed 5,000 pounds by the appellant. The profits for the year ending on 30th April 1949 were estimated at about 24,000 pounds, and it seems that its anticipated profits for the year to end on 30th April 1950 were of the same order. (at p292)

It was in these circumstances that Mr. H. K. Watson, who is a chartered accountant and taxation consultant and who with his wife owned all the shares in a share-dealing company, Rowdell Pty. Ltd., asked L. G. F. Hancock, whom he knew socially, about the possibility of acquiring the Hancock shares in Mulga Downs and was told that the Hancocks would be much more interested in becoming the holders of all the shares in that company. Some time after this conversation, Rowdell, by a letter dated 15th February 1949, put forward to the Hancocks the proposition that it should purchase the Hancock shares for 23,000 pounds and the Lefroy shares for 40,000 pounds with a view to taking 50,000 pounds out of Mulga Downs by way of dividends during May 1949 and then selling all the shares for 21,000 pounds, giving the Hancocks the first refusal to purchase. It was pointed out that this offer "would enable the Hancocks in due course to acquire all the issued capital of Mulga Downs without any cash outlay at all over and above their present resources. Indeed, at the conclusion of all the purchases and sales the Hancocks' cash position would be about 2,000 pounds better off than it is today". It was also stressed that the sale to Rowdell Pty. Ltd. at the prices mentioned "would give the Lefroys and the Hancocks a substantial capital profit on which income tax would not be chargeable". It would also give Rowdell a profit of 8,000 pounds, although this was not adverted to. (at p293)

The proposition thus put forward was, after some negotiation and with minor adjustments, carried out, and on 30th April 1949 18,937 shares in Mulga Downs Pty. Ltd. were transferred by the Hancocks and the Lefroys to Rowdell and one share to Watson, making the shareholding of the company as follows:

Rowdell Pty. Ltd - 18,937 shares.

George Hancock - 1 share.

L. G. F. Hancock - 1 share.

Mrs. L. Y. M. Hancock - 5 shares.

H. K. Watson - 1 share.

(at p293)

Payment for these shares was made as follows: (1) 40,000 pounds by bank cheque obtained by Rowdell to A. L. B. Lefroy on 30th April in full payment for the Lefroy shares. (2) Rowdell's cheque for 2,500 pounds of 30th April to the Hancocks in part payment for their shares. (3) Rowdell's cheque for 21,000 pounds of 3rd June 1949 to the Hancocks in payment of the balance for their shares. (at p293)

The financing of these payments was a work of art. On 22nd April, by arrangement with Rowdell, the Lefroy directors had retired and George Hancock, the only remaining director, appointed L. G. F. Hancock a member of the board. On 23rd April 1949 Mulga Downs sold its Commonwealth bonds to a face value of 17,500 pounds to Rowdell for 17,300 pounds payable on 27th May 1949 and a promissory note by Rowdell was given for this amount. Rowdell then sold these bonds to a face value of 17,000 pounds for 16,786 pounds 17s. 6d., which was paid to the credit of its account. On 30th April 1949 Mulga Downs declared a dividend by a resolution of the directors as follows: "That after the registration of the aforesaid transfers in the Register of Members there be declared and paid to the members then standing in the Register, according to their respective rights and interests, a further dividend of 3,500 pounds out of the profits of the year ended 30th April, 1948 and an interim dividend of 21,500 pounds out of the profits of the year ended 30th April, 1949, viz:-

(at p294)

It is to be observed that of this dividend Rowdell received 24,990 pounds 14s. 11d., which it banked. As Rowdell's bank account was in credit to the extent of 1,845 pounds 11s. 2d. prior to the receipt of the foregoing amounts, the account was sufficiently in credit to meet the Lefroy cheque for 40,000 pounds and the Hancock cheque for 2,500 pounds and leave a credit balance of about 1,100 pounds, but there remained to be paid the promissory note for 17,300 pounds and the 21,000 pounds balance of purchase money for the Hancock shares. To enable these payments to be made, Mulga Downs on 27th May 1949 distributed 25,000 pounds by way of dividends, of which Rowdell again received 24,990 pounds 14s. 14d. This distribution was as to 2,500 pounds out of profits for the year ended on 30th April 1949 and as to 22,500 pounds out of the anticipated profits for the year ending 30th April 1950. To complete the transaction, the Hancocks purchased 18,938 shares in Mulga Downs from Rowdell for 21,000 pounds. This occurred on 2nd June 1949 and about this purchase a further word must be said. The original proposal of 15th February was that the Hancocks should have the "first right of refusing our offer to sell all the shares at that figure of 21,000 pounds" and it was emphasized, as appears from the passage from the letter quoted earlier, that this would enable the Hancocks to obtain all the shares without any cash outlay. When the formal agreement between Rowdell Pty. Ltd. and the Hancocks was drawn up and executed, however, the option to purchase was omitted in accordance with the following explanation which Rowdell gave in a letter dated 14th April 1949 to R. A. Long, the Secretary of Mulga Downs:

"Moreover, since the position is rather complicated and uncertain at the moment, we are disinclined to give any binding option at any fixed price until after Mulga Downs has held its Annual Meeting and paid out its Dividends. The position will then have clarified so that there will then be no possible room for dispute as to the precise nature and extent of the assets and liabilities of the Company at the time when the option is granted. For example, we may finally decide to take out a dividend of, say, only 40,000 pounds instead of the 50,000 pounds as is our present intention. In such case the price we would want for our shares would then be 31,000 pounds and not 21,000 pounds."

Fullagar J., who heard the taxpayer's appeal and from whose decision this appeal is brought, decided nevertheless that "there was an understanding (perhaps a contract) that Rowdell would, after "milking" Mulga Downs of a further 25,000 pounds, sell the whole of the shares in that company to the Hancocks for 21,000 pounds". This was clearly the case, and at a general meeting of Rowdell on 2nd June 1949, the chairman reported that "as anticipated the Hancocks desired to buy the 18,938 1 pound shares in Mulga Downs Pty. Ltd. for the sum of 21,000 pounds", and it was resolved "that the seal of the Company be affixed to the various transfers of shares aggregating 18,938 in Mulga Downs Pty. Ltd. for the sum of 21,000 pounds to Messrs. G. Hancock and L. G. Hancock and Miss K. L. Hancock and Mrs. S. L. Sharpe". Miss K. L. Hancock and Mrs. S. L. Sharpe were daughters of George Hancock and he arranged for the transfers that were made to them. From the foregoing account of the transactions, it is apparent that what had been proposed by Rowdell on 15th February 1949 was actually carried out with the minor adjustment that L. G. F. Hancock sold his shares for 3,500 pounds instead of for the 3,000 pounds that had originally been offered. (at p295)

I now turn to the income tax aspects of the foregoing transactions. In 1949 and 1950, Mulga Downs was making large profits and, as it was a private company, it would, unless it made sufficient distributions within the times limited, be liable to pay undistributed profits tax. Furthermore, whatever Mulga Downs were to distribute by way of dividend would attract heavy income tax in the hands of its shareholders had they remained as they were in February 1949. That state of affairs was, however, radically changed when Rowdell became the shareholder to whom dividends were to be distributed, because it was a share-dealing company and against any dividends that it might receive (which in the event approximated 50,000 pounds) it could offset a loss of 42,500 pounds if it were to sell for 21,000 pounds shares which it had purchased for 63,500 pounds. (at p296)

In these circumstances it seems to me that what was done was done pursuant to an arrangement between Rowdell, Mulga Downs and the Hancocks, which had the following purposes and effects:

(1)

that by distributing 50,000 pounds by way of dividends, Mulga Downs should make a sufficient distribution for the purposes of Div. 7 of Pt III of the Income Tax and Social Services Contribution Assessment Act so that no undistributed profits tax would be payable in respect of the years 1948 to 1950;

(2)

that substantially the whole of the dividends should be paid to Rowdell;

(3)

that instead of receiving the proportion of the dividends to which they would have been entitled had they not sold their shares to Rowdell, i.e., 20,400 pounds approximately, the Hancocks should receive 2,500 pounds in cash and the shares (after dividends) which had belonged to the Lefroys;

(4)

that what the Hancocks received should be capital, not income. (at p296)

Although it seems that the Hancocks did not realize that because Rowdell was a share-dealer, it would be able to set off its loss on the purchase and sale of the shares in Mulga Downs against the dividends it received from the company, it was an essential part of the arrangement that Rowdell should receive the dividends and that it should sell to the Hancocks for 21,000 pounds the shares which it was purchasing for 63,500 pounds. (at p296)

The conclusion of Fullagar J. that there was an arrangement which had the purpose and effect of avoiding the Hancocks' liability for tax is one with which I agree. Instead of receiving dividends as shareholders it was arranged that the Hancocks should receive capital. (at p296)

It was argued, however, that arrangement that the Hancocks should get the Lefroy shares after dividends plus 2,500 pounds from Rowdell instead of receiving dividends from Mulga Downs upon their own original shares (which is the true purpose and effect of the arrangement so far as the Hancocks were concerned) avoided no tax because what the Hancocks received was not income and so attracted no tax, but one of the points decided by Newton v. Federal Commissioner of Taxation [1958] AC 450 ; (1958) 98 CLR 1 was that in an appropriate case s. 260 applies to an arrangement to avoid receiving dividends. It is true, as was stressed for the appellant, that the Hancocks were not only concerned to avoid receiving taxable dividends; they wanted to become the holders of all the shares in Mulga Downs and, provided that the price was right, it did not matter to them that the company in which they became the only shareholders was a company from which the liquid assets had been withdrawn. It still owned the station and the stock which was what the Hancocks were particularly concerned to get. Again, however, Newton's Case [1958] AC 450 ; (1958) 98 CLR 1 decided that the section can apply if to avoid the receipt of taxable dividends is only part of the purpose and effect of the arrangement. I agree, therefore, with Fullagar J. that s. 260 applies, and as against the Commissioner that section avoided so much of the arrangement as had the purpose and effect of avoiding the Hancocks' liability to tax on the dividends that Mulga Downs was due to distribute. What was made void, therefore, as was the case in Newton v. Federal Commissioner of Taxation [1958] AC 450 ; (1958) 98 CLR 1 and Bell v. Federal Commissioner of Taxation (1953) 87 CLR 548 , were the transfers by the Hancocks to Rowdell, with the consequence that for taxation purposes the Hancocks must be treated as having remained the holders of 7,730 shares in Mulga Downs. (at p297)

Section 260, however, does not impose tax liability; what it does is to enable the taxpayer's liability to tax to be determined without regard to so much of what has been done as is void against the Commissioner. As in this case I do not think that goes beyond the transfers from the Hancocks to Rowdell of the 7,730 shares in Mulga Downs, it is necessary, in order to determine their tax liability, to find out whether the Hancocks received anything which would be taxable income if, instead of having transferred their shares to Rowdell, they had retained them. (at p297)

In the first place, they received 2,500 pounds in cash. This, it seems it me, came to them through Rowdell from the profits distributed by Mulga Downs, and in accordance with the decision in Newton's Case [1958] AC 450 ; (1958) 98 CLR 1 and Bell's Case (1953) 87 CLR 548 that 2,500 pounds is taxable. Its taxability does not depend upon exactly tracing the sum received through the account of Rowdell back to the dividend cheque; it is sufficient that, in substance, the receipt was derived from the company's distribution of profits. (at p297)

The Commissioner, however, seeks to go further. First, it is contended for him that the Hancocks should be regarded as having received the whole of the dividends which Rowdell received in respect of the shares which ex hypothesi belonged to the Hancocks, i.e., 17,759 pounds in the case of the taxpayer. In support of this contention, reliance was placed upon that part of the decision in Newton's Case [1958] AC 450 ; (1958) 98 CLR 1 which decided that the taxpayers there must be regarded as having received that which Pactolus retained. As to this, the Privy Council said: -

"He (i.e., the Commissioner) cannot trace the balance of 102,414 pounds actually into their hands. It remained in the pocket of Pactolus Limited. It was ostensibly the profit of Pactolus on buying the shares. But when the transfer is ignored, that profit is seen to be nothing more nor less than remuneration which the original shareholders allowed Pactolus to retain for services rendered. The position is the same as if the shareholders had received it as part of the special dividend and then returned it to Pactolus as remuneration. The commissioner can therefore treat this 102,414 pounds also as income derived by the shareholders" (1958) AC, at p 468; (1958) 98 CLR, at p 11.

I think, however, it would be going far beyond that part of the decision, which was reached in the very special circumstances of that case, to regard the Hancocks as having received approximately 18,000 pounds of the dividends which Rowdell received and either retained or used to pay the Lefroys. Here the difference between 20,400 pounds and 2,500 pounds was clearly not remuneration for Rowdell's services. The fact is, of course, that the Hancocks forewent any cash benefit beyond 2,500 pounds in order to get the Lefroy shares, and it would be to depart from the facts to disregard what they did receive and to regard them as having received something else.

Furthermore, I can find no satisfactory justification for treating Rowdell as having acquired the Lefroy shares for the Hancocks by an application, with the authority of the Hancocks, of part of the dividends paid upon the Hancock shares. The Lefroy shares were bought by Rowdell, cum. div., for 40,000 pounds by a transaction which is not void against the Commissioner or at all; the same shares were sold, ex. div., by Rowdell to the Hancocks, together with the Hancock shares, again by a transaction which so far as it concerned the Lefroy shares was no t void against the Commissioner or at all. The avoidance as against the Commissioner of the sale of shares by the Hancocks to Rowdell does not enable me to say that Rowdell, with the authority of the Hancocks, applied dividends upon the Hancock shares as purchase money to buy the Lefroy shares for the Hancocks. Had there been an arrangement whereby the Hancocks allowed Rowdell to receive and retain or use all but 2,500 pounds of the dividends upon their shares in return for the transfer of the Lefroy shares, ex. div., I would have no doubt that the Hancocks would have been taxable upon the dividends that Rowdell received without the aid of s. 260, but I do not think that the application of s. 260 to the arrangement that was made produces that result. Although void against the Commissioner, the transfers from the Hancocks to Rowdell were valid as between the parties and as between them. Rowdell without more was entitled to the dividends it received upon the Hancock shares. It was by virtue of valid transfers inter partes and not by virtue of any authority from the Hancocks that Rowdell received the dividends that it did and to infer an application authorized by the Hancocks of their dividends is to infer something which did not take place and could not have taken place in the circumstances that as between them and so far as Mulga Downs Pty. Ltd. was concerned the shares belonged to Rowdell, not the Hancocks.

It is not sufficient for the Commissioner's purposes to point to the fact that so far as he is concerned the Hancocks were entitled to the dividends that went to Rowdell; he must show upon the actual facts that they received them or dealt with them; and a dealing with them is not to be inferred merely from the fact of their entitlement in the eyes of the Commissioner when as between the parties, and as between the parties and the company, Rowdell got nothing that it was not entitled to receive as a matter of right. Section 260 does not authorize the Court to make implications contrary to the facts to reconcile the actual state of affairs with the state of affairs vis-a-vis the Commissioner and the taxpayer resulting from its application. Notwithstanding the application of s. 260, the Hancocks obtained the Lefroy shares from Rowdell by purchasing them at an agreed price, which it can fairly be inferred was based upon asset backing. (at p299)

There are, however, two other ways in which what the Hancocks received over and above the 2,500 pounds might be regarded as taxable income. The first depends upon treating the arrangement as covering the acquisition by the Hancocks of the shares that were originally owned by the Lefroys and regarding the acquisition of the Lefroy shares as the receipt of a dividend. To do this would again seem to me to disregard the facts. Mulga Downs did not distribute the Lefroy shares and the Hancocks did not receive them as shareholders in Mulga Downs; the transfers by the Lefroys to Rowdell stand, as do the transfers from Rowdell to the Hancocks. Accordingly, I cannot accept this contention. (at p299)

This leaves for consideration the possibility of treating the 21,000 pounds which the Hancocks received as the balance of purchase price upon the sale of their shares to Rowdell as in part dividends which Mulga Downs distributed to Rowdell in respect of the Hancock shares. Upon an examination of what occurred, it does not seem to me possible to infer that the 21,000 pounds which Rowdell paid to the Hancocks on 3rd June was part of the company's profits. The payments that Rowdell made for shares totalled 63,500 pounds and that company made a profit of approximately 7,500 pounds, so that there had to be a fund of 71,000 pounds. This was provided from 50,000 pounds (approximately) dividends from Mulga Downs, and 21,000 pounds from the Hancocks for the purchase of the Mulga Downs shares. Upon the whole I am disposed to think that the substantial identity that can be established is that the dividends were used to pay the 40,000 pounds paid to the Lefroys, the initial 2,500 pounds paid to the Hancocks, and to provide the Rowdell profit, so that the 21,000 pounds which the Hancocks received on 3rd June really came from the money which they paid to Rowdell for the Mulga Downs shares. This would have appeared more obviously had the purchase price been 30,000 so pounds that the Hancocks would have had to provide money of their own. Even as it happened, however, it should not be overlooked that the 21,000 pounds exceeded so much of the dividends paid as could be attributed to the Hancock shares. (at p300)

Fullagar J. did not find that the initial 2,500 pounds paid to the Hancocks came out of the company's profits, but I regard the dealing with the company's Commonwealth bonds as doing no more than providing an advance against the dividend declared on 28th April so that it is a correct inference that the 40,000 pounds paid to the Lefroys and the 2,500 pounds paid to the Hancocks did come from the company's profits. His Honour did, however, find that the 21,000 pounds paid by Rowdell to the Hancocks on 3rd June did come from Mulga Downs profits, but I have already explained what I think happened to those profits and I add that if the Commonwealth bonds transactions are to be treated independently of the payment of dividends, then it was the promissory note for 17,300 pounds that part of the second dividend was used to pay. (at p300)

In the result I think the appeal should be allowed, that the amended assessment appealed from should be reduced by substituting for the 17,759 pounds added thereby the proportion of the 2,500 pounds paid by Rowdell Pty. Ltd. to the Hancocks on 30th April, to which the taxpayer was entitled as between himself and L. G. F. Hancock. I calculate this at 2,177 pounds.

For the reasons given in the earlier appeal I consider that this appeal should be allowed except as to 323 pounds. (at p300)