FIRTH v FC of T

Judges:
Hely J

Court:
Federal Court

MEDIA NEUTRAL CITATION: [2001] FCA 1300

Judgment date: 13 September 2001

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Hely J

These proceedings are an appeal by the applicant against the disallowance of an objection to an assessment of income tax for the year ended 30 June 1999.

2. The applicant claimed a deduction under s 8-1 of the Income Tax Assessment Act 1997 (Cth) (``the Act'') in the sum of $1,268,277.60 for interest expenses incurred by him during that year of income in respect of thirty-seven protected equity investment loans (``PEILs'') provided by Equity Margins Ltd (``EML'').

3. Under each of the PEILs, the applicant borrowed money for the purpose of purchasing shares in National Australia Bank, Commonwealth Bank of Australia and St George Bank Ltd. The loans were taken out in three tranches, the first tranche being on 28 May 1999 ($2,465,020), the second tranche on 15 June 1999 ($2,225,703) and the third tranche on 16 June 1999 ($2,278,781.25). The term of each loan was about one year. The interest rates applicable to the PEILs ranged from about 17.3 percent per annum to 19.3 percent per annum. The interest was paid at the time each loan was taken out. On the maturity of each loan the applicant paid the loan amount in full.

4. Each of the PEILs was a limited recourse loan, in the sense that EML's rights of recovery of the principal in respect of the loan were limited to enforcement against the shares bought with the monies which the applicant had borrowed. The loan terms for the PEILs included the following:

``7 Limited recourse

7.1 EML's recourse against the client in respect of any amounts owing in respect of a loan is limited to the amount which EML can obtain by enforcing its rights in respect of the secured assets (to the extent that they relate to the approved stocks for that loan) but this limit does not apply if any of the following occur:

• (a) the client has breached a material undertaking given to EML (other than the obligation to repay the loan);
• (b) a material representation made or warranty given by the client under these terms was or becomes incorrect or misleading; or
• (c) EML has relied on a statement or some conduct of the client which in EML's reasonable opinion was materially false or misleading.

7.2 Notwithstanding anything in clause 7.1, EML may prove for the total amount outstanding on a loan and otherwise participate in the winding up or bankruptcy of the client if another creditor initiates those proceedings.''

5. The Commissioner contends that a portion of the interest paid by the applicant is not deductible under the general deduction provisions, as some portion of the interest payable by the applicant in respect of the loans was payable to obtain the limited recourse provided by the terms of those loans.

6. In the Commissioner's reasons for decision disallowing the applicants objection, the following appears:

``The ATO view is that part of the interest charged in these products is a capital protection fee and is not deductible under the general deduction provisions. The purpose of this fee is to give the taxpayer capital protection in the event of a share price fall.

The capital protection fee ensures that the borrower is protected from liability to repay the principal if the market value of the shares fall below their original purchase price.

It is the Office view that the capital protection fee is not deductible because it is

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incurred for a purpose other than to service or maintain the borrowed funds. It loses its character as a deductible cost of producing the expected income.''

7. The Commissioner has apportioned the interest paid by the applicant on the basis of a Benchmark Rate calculated and published by the Commissioner. The Benchmark interest rates have been calculated as the average between the Reserve Bank Bulletin Indicator Lending Rates for ``Personal Unsecured Loans'' and ``Credit Cards''. The resultant rate is a high rate of interest. The applicant challenged the Commissioner's entitlement to apportion the interest paid by the applicant, but did not challenge the method of apportionment should apportionment be held to be appropriate.

8. The Commissioner has calculated that an amount of $353,021 (out of the total interest claimed of $1,268, 277.60) is not allowable as a deduction on the basis that there should be an apportionment between interest and the capital protection fee and upon the basis that the Benchmark Rate provides an appropriate mechanism for determining the portion of the interest paid which ought to be regarded as a capital protection fee.

9. As quantum is not in issue, it is unnecessary to go into the detail of any of the calculations. But I should record for the purposes of comparison, that the Benchmark Rate calculated by the respondent for the month of June 1999 was 13.15 percent, whereas interest rates of between 18.1318 percent and 18.2253 percent were payable by the applicant on PEILs drawn down in June 1999.

10. The interest rate charged on the PEILs varied from day to day (and sometimes within a day) and from stock to stock. The applicant asked EML what the interest rate would be on each loan but did not enquire of EML how the amount was made up. It was his belief that the interest rate payable was higher because the loans were limited recourse loans, but he did not make any enquiry about how much higher.

11. The applicant's income tax return of the year ended 30 June 1999 was prepared on the basis that his gains and losses on sales of shares were on capital account. In the applicant's outline of preliminary submissions the applicant contended that his activities in relation to shares involved him:

• - in carrying on a business of trading in shares; alternatively
• - in carrying on a business of investing in shares; alternatively
• - investing in shares for those dual purposes,

although ultimately counsel were in agreement that it was unnecessary for the disposition of this appeal for me to determine whether any business carried on by the applicant in the relevant year was that of a share trader.

12. Paragraph 13 of the applicant's affidavit of 20 April 2001 is as follows:

``13 I have built up this share portfolio since I began buying and selling shares in 1993. In 1993, I decided to start building up a share portfolio with a view to accumulating a portfolio which would produce sufficient dividend income to fund me once I retire. I then did and still do own rental properties, but decided to focus my efforts on shares given that the obligations which I had as a landlord, the relatively low rates of return and the lack of liquidity made property a less attractive way to acquire a stream of income, when compared to the share market.''

In cross-examination the applicant accepted that his main object in purchasing and selling shares was to accumulate a portfolio which would produce sufficient dividend income to fund him on retirement, but another object was to enable him to have a source of income which was independent of the income derived by him from his practice as a solicitor. He wanted to try and accumulate wealth outside the legal practice. Part of the wealth accumulation process was to make profits on the sale of the shares as the opportunity presented itself.

13. According to summaries provided by the applicant's counsel, which were not the subject of challenge by counsel for the Commissioner, during the year of income the applicant made a total of 102 purchases of parcels of shares for a total cost of $11,150,173.63, and made a total of 180 sales for total proceeds of $5,764,147.08. During that year the applicant derived dividends from his shareholdings in the sum of $893,432 (including income attributable to imputation credits). During the year of income the market value of the applicant's holding of shares increased from $13.048 million to $18.778 million, while the

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applicant's net equity in shares increased from $1.964 million to $7.649 million. During the year of income the applicant made gains from sales of shares of $1,009,658 and net gains (over losses) of $654,304.

14. The applicant has been engaged in the purchase and sale of shares from 1993 until the present day. He spends on average about 10-14 hours a week on his share trading activities and, in his estimation, at least half this time would be spend on trading on his own account, with the balance being devoted to other entities in which he is interested or with which he is connected. He has regular and frequent discussions with his broker, he reads the financial press, securities newsletters and other information in relation to the stockmarket. The applicant employs businesslike systems, strategies and analyses in buying and selling shares.

15. The applicant's profession is that of a solicitor. Whether in addition he carried on a business of trading or investing in shares (it is common ground that for present purposes, it does not matter which) is a question of fact. The test to be applied in forming a conclusion on that issue is both subjective and objective. Regard is to be had to the nature and extent of the activities undertaken and the purpose of the individual engaging in them:
FC of T v Shields 99 ATC 4783 (O'Connor J);
99 ATC 2037 (Mr J Block).

16. The applicant did not regard himself as a share trader in the year of income, and he lodged a return on the basis that profits derived from the sale of shares were capital gains. However, his share market activities were much more than a mere hobby, and his activities involved more than mere speculation. Decisions to buy and sell were undertaken after and on the basis of considerable analysis. The volume, magnitude, repetition and regularity of the applicant's buying and selling activities and the business-like systems, strategies and analyses employed by the applicant in buying and selling shares create an overall impression in my mind that the applicant was in business in the year of income in trading or investing in shares, and I so find.

17. Section 8-1(1) of the Act provides:

``You can deduct from your assessable income any loss or outgoing to the extent that:

• (a) it is incurred in gaining or producing your assessable income; or
• (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.''

18. That provision is qualified by s 8-1(2) which provides in part:

``However, you cannot deduct a loss or outgoing under this section to the extent that:

• (a) it is a loss or outgoing of capital, or of a capital nature;
• ...''

These provisions are substantially the same as s 51(1) of the Income Tax Assessment Act 1936 (Cth). If a taxpayer incurs a recurrent liability for interest for the purpose of furthering his present or prospective income- producing activities, whether those activities are properly characterised as the carrying on of a business or not, generally the payment by him of that interest will be an allowable deduction:
FC of T v Total Holdings (Aust) Pty Ltd 79 ATC 4279 at 4283; (1979) 43 FLR 217 at 224.

19. The applicant contends, and the Commissioner accepts, that the interest incurred by the applicant in the relevant year of income in respect of the PEILs falls within par (a) or (b) of s 8-1(1) of the Act. However, as noted earlier, the Commissioner contends that a portion of the interest is not deductible under the general deduction provisions on the ground that it is an outgoing of capital, or of a capital nature. As the wording of s 8-1(2) makes clear, a loss or outgoing is not deductible to the extent that it is a loss or outgoing of capital or of a capital nature. This both authorises and requires that an apportionment be made where the outgoing has a double aspect: see
Ronpibon Tin NL & Tongkah Compound NL v FC of T (1949) 8 ATD 431 at 434-435; (1949) 78 CLR 47 at 55;
Ure v FC of T 81 ATC 4100 at 4104-4105; (1981) 34 ALR 237 at 242 (per Brennan J) at ATC 4108, 4110; CLR 247, 250 per Deane and Shepherd JJ.

20. Ure v FC of T was a case in which the taxpayer borrowed monies at rates of up to 12.5 percent per annum with the object of onlending those monies to his wife and family trust at an interest rate of 1 percent per annum. At ATC

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4104; ALR 242 Brennan J observed that if the borrowed monies had been laid out solely for the purpose of gaining assessable income, the interest would be wholly deductible. As a matter of fact, the monies were laid out partly to obtain a return of 1 percent per annum, and partly for private or domestic purposes, hence apportionment of the interest charge was required. At ATC 4110; ALR 250 Deane and Sheppard JJ observed that the outlays of interest can be seen as serving a number of objects indifferently; the predominant, although indirect objects were of a private and domestic nature.

21. In determining whether an outgoing is deductible one needs to determine the reason for which the outgoing is paid - what is the advantage sought to be obtained by the expenditure in question? Here, the outgoing is described in the terms of the agreement of the parties as interest on the loans. This is not a case in which it was or could be contended by the respondent that the interest, or some part of it, is not ``interest in the real sense of the word'': cf
FC of T v Broken Hill Pty Co Ltd 2000 ATC 4659 at [39]; (2000) 179 ALR 593 at [ 39] per Hill J. Rather, this is a case in which the interest is properly characterised as such, as it is a return or consideration or compensation for the use or retention by one person of another's money, even though the rate of interest payable is higher than might otherwise the case because of the terms of the loan, and in particular, its character as a non-recourse loan.

22. In
Steele v DFC of T 99 ATC 4242; (1999) 197 CLR 459 Gleeson CJ, Gaudron and Gummow JJ said at ATC 4248-4249; CLR 470:

``As was explained in Australian National Hotels Ltd v FC of T, interest is ordinarily a recurrent or periodic payment which secures, not an enduring advantage, but, rather, the use of borrowed money during the term of the loan. According to the criteria noted by Dixon J in Sun Newspapers Ltd and Associated Newspapers Ltd v FC of T it is therefore ordinarily a revenue item. This is not to deny the possibility that there may be particular circumstances where it is proper to regard the purpose of interest payments as something other than the raising or maintenance of the borrowing and thus, potentially, of a capital nature . However, in the usual case,... where interest is a recurrent payment to secure the use for a limited term of loan funds, then it is proper to regard the interest as a revenue item, and its character is not altered by reason of the fact that the borrowed funds are used to purchase a capital asset.''

[emphasis added]

Although recurrence is a relevant consideration, it would not alter the situation if the parties chose to have interest paid in a lump sum: see FC of T v Broken Hill at ATC [37]; ALR [37].

23. The passage in the decision in Steele which I have emphasised above was accompanied by a footnote referring, by way of example, to Parsons, Income Taxation in Australia (1985), par 6.111. In that paragraph, Professor Parsons said:

``A payment of interest at a rate beyond any commercial rate, more especially when made to an associated person, raises the question whether an inference should be drawn that some part of the purpose of the payment of interest is other than the service of the loan and, in this part, not relevant but private or domestic, or not a working or maintenance expense but a capital expense.''

24. Thus the fact that the amounts paid by the applicant under the loans were ``interest'' properly so called, is not necessarily determinative of the issue whether the outgoings were wholly on revenue account or whether a portion of the outgoings was on capital account.

25. The Commissioner contends that there were at least two advantages sought to be obtained by the applicant by the payment of interest on the PEILs. One advantage was to raise or maintain the funds with which to purchase the shares. The other was the limited recourse feature of the PEILs, such that the applicant had the option at the end of the term of the loan of delivering up the shares rather than repaying the loan from his own funds. In the Commissioner's submission, the interest was paid, at least in part, to obtain the advantage that the applicant was protected from being required to pay the sum borrowed in full. That is submitted to be an advantage of an enduring rather than a recurrent nature, and was something other than the raising or maintaining of the borrowing. It was an advantage inconsistent with a basic element of a loan transaction, which is that the borrowed sum will

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be repaid: see, eg,
FC of T v Radilo Enterprises Pty Ltd 97 ATC 4151 at 4161; (1997) 72 FCR 300 at 313.

26. This is not a case, as was Ure v FC of T (supra), where the borrowed monies were laid out in part for the purposes of gaining assessable income, and in part for other purposes. It was that factor which, at least in the judgment of Brennan J at ATC 4104; ALR 242, was critical to the issue of apportionment. Here the monies were borrowed and laid out for the sole purpose of acquiring shares in furtherance of the applicant's income producing activities.

27. In
Hallstroms Pty Ltd v FC of T (1946) 8 ATD 190 at 196; (1946) 72 CLR 634 at 638 the High Court said:

``... What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.''

28. There may be cases in which the disproportionate or excessive nature of expenditure may suggest that the outgoing was not made for the purpose of obtaining assessable income or for the purposes of the business incurring the expenditure:
WD & HO Wills (Australia) Pty Ltd v FC of T 96 ATC 4223 at 4248; (1996) 65 FCR 298 at 329. But it is not to the point that finance to acquire the shares may have been obtained more cheaply if it had been raised on different terms, if the conclusion is otherwise reached that the expenditure was incurred in gaining assessable income.

29. From a practical and business point of view, there is only one advantage sought to be obtained by the interest outgoing, and that is to raise and service working capital for the applicant's business on the terms and conditions of the PEILs, including the limited recourse provisions of clause 7. The existence of clause 7 does not require a conclusion that there were multiple purposes underlying the interest obligation, when the evident and sole purpose of the borrowing was to raise and service working capital for the business on acceptable terms. A loan on the terms of clause 7 may involve a greater risk to the lender, which would ordinarily be reflected in a higher interest rate, but that does not mean that the transaction should be artificially broken down into one involving a multiplicity of purposes when, as a matter of commercial substance, there was but one purpose.

30. If I am wrong in the views which I have so far expressed, and if part of the interest obligation is referrable to the non-recourse feature of the PEILs, the question arises as to whether the interest is to that extent an outgoing of capital or of a capital nature.

31. In
GP International Pipecoaters Pty Ltd v FC of T 90 ATC 4413 at 4419; (1989-1990) 170 CLR 124 at 137, the High Court said:

``The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure, for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid.''

(citations omitted)

32. The Commissioner contends that the applicant derived an enduring advantage from the non-recourse nature of the PEILs. The monies derived from the PEILs are capital receipts. If and to the extent that a borrower is excused from repaying a liability on capital account, it may be appropriate to characterise the advantage thereby obtained as an enduring one. However, the non-recourse feature of the PEILs only entitled the applicant, on the maturity of a loan, to surrender the shares acquired with the proceeds of the loan in full satisfaction of what would otherwise be his personal liability to repay the loan in question. Unless the applicant exercises that option (and in relation to the loans made in the relevant year of income, he did not) then the payment of interest at a higher rate has not produced any continuing advantage or benefit to the applicant enduring beyond the term of the loan.

33. The non-recourse nature of the PEIL protects the working capital raised by the loans against erosion by a diminution in the value of the shares securing the loans until the expiration of the term of the loan. In
Australian National Hotels Ltd v FC of T 88 ATC 4627; (1988) 19 FCR 234 (special leave refused:
89 ATC 4157; 63 ALJR 344) the taxpayer claimed to deduct insurance premiums paid to obtain indemnity against exchange losses in relation to a foreign currency loan which was a capital account. It was accepted that the exchange losses were

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themselves on capital account. The Court held that the premiums were deductible.

34. At ATC 4633; FCR 240-241 in the joint judgment of Bowen CJ and Burchett J, their Honours said:

``... The cost of securing and retaining the use of the capital sum for the business, that is to say, the interest payable in respect of the loan, will be a revenue item. It creates no enduring advantage, but on the contrary is a periodic outgoing related to the continuance of the use by the business of the borrowed capital during the term of the loan. If capital, whether or not raised by borrowing, is invested in a building which burns, or in securities which become worthless by the failure of the body which issues them, the loss is a capital loss. A careful business manager will protect his business against the loss of the capital invested in it by appropriate insurance, by the employment of security guards to patrol buildings or skilled staff to monitor investments, and by other measures. The advantage sought thereby is not an enduring one. No amount is added to the capital of the business. But during the recurring periods of insurance, the patrolling of premises, or the monitoring of securities, the continued availability of the capital investment by which the business earns its income is protected. The cost of protecting it is as much a revenue cost as the interest by which the capital, to the extent that it was borrowed, was obtained in the first place. Indeed, in the case of recurring expenditure, it is difficult to distinguish between expenditure which obtains and expenditure which maintains the investment.''

35. At ATC 4634; FCR 241-242 their Honours continued:

``It would not be logical to treat the price of obtaining the capital sum borrowed (the interest) as deductible, and not admit the deductibility of the price of securing that its use may continue to be enjoyed (the premiums for insurance without which it would not be safe to keep invested in Australian dollars for use in the business a sum repayable in Saudi Arabian riyals).''

36. The advantage which the applicant derived from the non-recourse character of the PEIL's was a transient advantage which flowed from the ephemeral nature of a loan for a term of one year. On the analogy of ANA, the cost of securing that advantage implicit in the payment of a higher interest rate is as much a revenue cost as the portion of the interest which reflects the costs of raising or maintaining the loan.

37. For these reasons the applicant's objection should have been allowed by the respondent. The appeal against the decision of the respondent is allowed.

THE COURT ORDERS THAT:

1. The appeal against the objection decision of the respondent communicated to the applicant by letter of 2 November 2000, be allowed.

2. The respondent pay the applicant's costs of these proceedings.

3. Liberty to either party to apply in relation to the form of orders within 21 days.