FC of T v HART & ANOR

Members:
Gleeson CJ
McHugh J
Gummow J
Hayne J
Callinan J

Tribunal:
High Court of Australia

MEDIA NEUTRAL CITATION: [2004] HCA 26

Decision date: 27 May 2004

Gleeson CJ and McHugh J

The issues in this appeal, and the relevant facts, are set out in the reasons of Gummow and Hayne JJ. We agree that the Commissioner's appeal on the Pt IVA issue should succeed, and that the question relating to the deductibility, in the circumstances, of interest upon interest (which was answered by all four members of the Federal Court in favour of the respondents) does not arise.

2. It is convenient to begin a consideration of Pt IVA, in its application to the present problem, by reference to a matter on which Gyles J, at first instance, and all the members of the Full Court were in agreement. It relates to the tax benefit that was obtained by the respondents. An accurate understanding of that benefit is important to a resolution of the difference of opinion between Gyles J and the Full Court on the ultimate outcome.

3. It is part of the scheme of the Income Tax Assessment Act 1936 (Cth) that, as a general rule, interest on money borrowed to finance the purchase of a taxpayer's private dwelling house is not an allowable deduction, and interest on money borrowed to finance an investment property, such as a dwelling house to be let for rental purposes, is an allowable deduction. [1] cf Steele v DFC of T 99 ATC 4242 ; (1999) 197 CLR 459 . That being so, other things being equal, it may make commercial sense for a taxpayer who is considering the relative levels of borrowing to be undertaken for the purposes of acquiring a residential property, and an investment property, respectively, to arrange for the latter to be more highly geared than the former. If such a taxpayer took out two separate loans, and the terms of the loan for the investment property were different from the terms of the loan for the residential property in that they provided for a higher ratio of debt to equity, and for payments of interest only, rather than interest and principal, during a lengthy term, then ordinarily that would give rise to no adverse conclusion under s 177D. It may mean no more than that, in considering the terms of the borrowing for investment purposes, the taxpayer took into account the deductibility of the interest in negotiating the terms of the loan. How could a borrower, acting rationally, fail to take it into account?

4. The argument for the respondents is that, stripped of immaterial complexities, in essence there is little more to the present case than that. The respondents wanted to borrow money for two purposes: to buy a new house; and to

ATC 4602

finance the retention of their former home as an income-producing property. They simply arranged for the second part of the borrowing to be more highly geared than the first, and it would not be concluded that their dominant purpose was other than to borrow money to enable them to buy a new house and retain their old house as an investment.

5. The appellant says there is much more to it than that. The tax benefit cancelled by the appellant in the s 177F determination (putting to one side the compound interest question) was a benefit of the kind referred to in s 177C(1) as ``a deduction being allowable to the taxpayer... where... a part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer... if the scheme had not been entered into or carried out''. As Hill J correctly pointed out, [2] Hart & Anor v FC of T 2002 ATC 4608 at 4618-4619 [ 41]; (2002) 121 FCR 206 at 221 [ 41] . the definition of the scheme is important, because any tax benefit identified must be related to the scheme, as must any conclusion of dominant purpose, and also the ultimate determination. The significance of the definition of the scheme extends beyond a question of procedural fairness to the taxpayer. It is central to the application of ss 177C, 177D and 177F. However, the identification of the tax benefit is also of central importance. In this case, the benefit in question was not the deduction for interest on that part of the loan referable to the investment property (referred to in the evidence as loan account 2). It was part of that deduction. It was described by Hill J [3] 2002 ATC 4608 at 4620 [ 49]; (2002) 121 FCR 206 at 223 [ 49]. as ``the amount of interest representing the difference between the interest payable on the principal sum applied to refinancing Jerrabomberra [ the sum the subject of loan account 2] calculated as if there had been rateable principal and interest payable on that sum and the interest in fact claimed as a deduction''.

6. In the Federal Court, there were concurrent findings that such a tax benefit had been obtained by the respondents. Hill J, with whom the other members of the Full Court agreed, said that the finding of Gyles J on the point should not be disturbed. [4] 2002 ATC 4608 at 4620 [ 49]; (2002) 121 FCR 206 at 222-223 [ 49]. That finding turned upon what was found to be a reasonable expectation as to what deduction would have been allowable if the relevant scheme had not been entered into or carried out. Gyles J based his finding as to that expectation on the information given to the respondents about the proposed loan, which invited them to compare the financing of a home loan and an investment/ business loan using ``standard financing arrangements'', on the one hand, with the ``wealth optimiser structure'' that was ultimately adopted, on the other. [5] Hart & Anor v FC of T 2001 ATC 4708 at 4723 [ 41]; (2001) 189 ALR 584 at 603 [ 41] . The identification of the tax benefit, and the identification of the scheme, are inter-related. The benefit was not the whole of the interest on loan account 2 (the investment part of the borrowing); it was that part of the interest which resulted from the special, or non- standard, features of the arrangements between the lender and the borrowers. Those were the features to which the respondents were invited to pay attention in deciding whether to enter into the particular transaction. Those features, which defined the ``wealth optimiser structure'' and distinguished it from ``standard financing arrangements'', were definitive of the scheme in connection with which the tax benefit, identified by all four members of the Federal Court, was obtained.

7. Gyles J found that there was no evidentiary basis for accepting, as a realistic possibility, that, if the respondents had not taken up the offer of the ``wealth optimiser structure'', they could have arranged finance, on the terms applicable to loan account 2, for their investment property. He said: [6] 2001 ATC 4708 at 4724 [ 43]; (2001) 189 ALR 584 at 603 [ 43].

``There is no support in the evidence for the proposition that the [ respondents] would have financed the home by a credit foncier arrangement, and the investment property by a separate interest only loan for a fixed term in relation to which no capital repayments are made and where the only payments which are made are interest payments. There is no evidence as to the availability of such interest only loans on terms which would suit [ the respondents] or any similar borrower. Indeed, there is no evidence that interest only loans are made for periods of twenty five years or anything like it. Having in mind inflation, it is most unlikely that any such loan would be available. Furthermore, there is not any evidence as to precisely how a package of that sort would be tailored to suit the budget of the [ respondents]. A feature of a credit foncier loan is the certainty of the periodic payments for the whole of the period, subject to some variation if interest rates change. This is a feature of the Austral loan as well as the

ATC 4603

posited `ordinary financing arrangements' with which it was compared [ by Austral]. The actual loan was a credit foncier arrangement with fixed periodic payments over twenty five years. It was only one loan with one interest rate. This is the true comparison. The contractual provisions involving the split between Loan Accounts 1 and 2 are an artificial feature of the arrangements.''

8. Hill J, in the Full Court, with whom Hely J and Conti J agreed, described the finding of Gyles J on the question of the tax benefit as a finding that, but for the ``wealth optimiser structure'', the respondents would have borrowed on the basis that (whether there was one borrowing or two) the borrowing would be on terms that the respondents would have made monthly repayments of principal and interest, so that interest would have been spread rateably over the total of the borrowed moneys in the proportion that these moneys were used to purchase the new home and refinance the Jerrabomberra property. [7] 2002 ATC 4608 at 4619-4620 [ 47]; (2002) 121 FCR 206 at 222 [ 47]. This finding, Hill J held, should not be disturbed. [8] 2002 ATC 4608 at 4620 [ 49]; (2002) 121 FCR 206 at 222-223 [ 49].

9. The point of departure between the reasoning of Gyles J and that of the Full Court concerned the application of s 177D to the facts of the case. In that respect, the Full Court accepted an argument that Gyles J appeared to have found that the scheme was to be defined in a way that omitted the actual borrowing. [9] 2002 ATC 4608 at 4623 [ 64]; (2002) 121 FCR 206 at 226 [ 64]. The members of the Full Court were correct to insist that it is inappropriate to exclude the fact of borrowing from the putative scheme. The tax benefit in question was the obtaining of part of a deduction of interest on borrowed money. A taxpayer is not allowed such a deduction for agreeing to a term in a contract of loan, or giving a direction about allocation of payments, or taking some other step in the exercise of rights conferred under the contract. The definition of ``scheme'' in s 177A is wide, but it must be related to the tax benefit obtained. The deduction here was for the incurring of a liability to pay interest on borrowed money. The tax benefit in connection with the relevant scheme was part of an allowable deduction for interest. This, it seems to us, is what was meant by references in the judgments in the Full Court to the scheme being capable of standing on its own feet. The judges were making the point, which is undoubtedly correct, that, where the tax benefit in question is part of an allowable deduction for interest, a search for the purpose of a scheme, identified in a manner that does not include the borrowing, is not an undertaking that conforms with the requirements of the legislation. In a given case, a wider or narrower approach may be taken to the identification of a scheme, but it cannot be an approach which divorces the scheme from the tax benefit. Here, the borrowing was an indispensable part of that which produced the tax benefit. A description of the scheme that did not include the borrowing would make no sense.

10. However, we do not accept that Gyles J made the error attributed to him. Nor is such an error implicit in the appellant's argument in this Court. While the fact of the borrowing cannot be left out of consideration, it was what the mortgage broker described as the ``wealth optimiser structure'' of the loan arrangements that secured the tax benefit, that is, not the deduction of the interest on loan account 2, but part of that deduction.

11. Gyles J said: [10] 2001 ATC 4708 at 4724-4725 [ 47]; (2001) 189 ALR 584 at 604 [ 47].

``In one aspect, the gist of the scheme lies in the availability of the unencumbered residential property to act as security for the grossly inflated investment loan account after the period of capitalisation of interest and, for that matter, to provide a margin of security during the period of capitalisation as the investment loan account principal increases. Put another way, the scheme depended upon interest being deferred (although incurred and deductible for tax purposes) in order to enable what purported to be capital payments to be made in relation to the other loan.. Thus, the real effect and substance of the arrangements was to make the payment of interest on the capital sum paid in reduction of the residential loan deductible for taxation purposes.''

12. That description of the commercial substance of the transaction is closely related to what the appellant submitted, and Gyles J and the Full Court accepted, was the tax benefit obtained by the respondents. It was the tax benefit so obtained, and applied in reduction of the home loan, that was the wealth optimising aspect of the structure. It was the wealth optimising aspect of the structure, not divorced from the borrowing, but giving the borrowing its distinctive character, that constituted the scheme.

13. In applying s 177D, Hill J said: [11] 2002 ATC 4608 at 4623 [ 65]; (2002) 121 FCR 206 at 226 [ 65].

ATC 4604

``While the scheme did permit the borrowing of monies for the two purposes indicated, one private and the other income producing, the manner in which the scheme was formulated and thus entered into or carried out is certainly explicable only by the taxation consequences. By `manner' here I refer to splitting what might commercially be seen as one advance into the two separate advances with interest on the income producing advance being permitted to remain unpaid, to be capitalised and the capitalised amount then attracting the compound interest with the amount which would otherwise have gone towards payment of that interest being directed towards the repayment of the capital outstanding on the private advance.''

14. Notwithstanding that finding, the Full Court, after taking account of all the factors listed in s 177D, held that it would be concluded that the dominant purpose of the respondents in entering into or carrying out the scheme was the obtaining of borrowed money to purchase a new home and refinance what was to become a rental property. [12] 2002 ATC 4608 at 4624-4625 [ 73]; (2002) 121 FCR 206 at 228 [ 73]. We are unable to share that opinion.

15. As Hely J correctly observed in the Full Court, [13] 2002 ATC 4608 at 4625-4626 [ 81]; (2002) 121 FCR 206 at 230 [ 81]. the fact that a particular commercial transaction is chosen from a number of possible alternative courses of action because of tax benefits associated with its adoption does not of itself mean that there must be an affirmative answer to the question posed by s 177D. Taxation is part of the cost of doing business, and business transactions are normally influenced by cost considerations. Furthermore, even if a particular form of transaction carries a tax benefit, it does not follow that obtaining the tax benefit is the dominant purpose of the taxpayer in entering into the transaction. A taxpayer wishing to obtain the right to occupy premises for the purpose of carrying on a business enterprise might decide to lease real estate rather than to buy it. Depending upon a variety of circumstances, the potential deductibility of the rent may be an important factor in the decision. Yet, if there were nothing more to it than that, it would ordinarily be impossible to conclude, having regard to the factors listed in s 177D, that the dominant purpose of the lessee in leasing the land was to obtain a tax benefit. The dominant purpose would be to gain the right to occupy the premises, not to obtain a tax deduction for the rent, even if the availability of the tax deduction meant that leasing the premises was more cost- effective than buying them.

16. Even so, a transaction may take such a form that there is a particular scheme in respect of which a conclusion of the kind described in s 177D is required, even though the particular scheme also advances a wider commercial objective. In FC of T v Spotless Services Limited & Anor , Brennan CJ, Dawson, Toohey, Gaudron, Gummow and Kirby JJ, after noting that revenue law considerations influence the form of most business transactions, and that the presence of a fiscal objective does not mean that a person entered into or carried out a scheme for the dominant purpose of obtaining a tax benefit, said: [14] 96 ATC 5201 at 5206; (1996) 186 CLR 404 at 416.

``Much turns upon the identification, among various purposes, of that which is `dominant'. In its ordinary meaning, dominant indicates that purpose which was the ruling, prevailing, or most influential purpose. In the present case, if the taxpayers took steps which maximised their after-tax return and they did so in a manner indicating the presence of the `dominant purpose' to obtain a `tax benefit', then the criteria which were to be met before the Commissioner might make determinations under s 177F were satisfied.''

17. Their Honours went on to say of the facts of that case: [15] 96 ATC 5201 at 5210; (1996) 186 CLR 404 at 423.

``In those circumstances, a reasonable person would conclude that the taxpayers in entering into and carrying out the particular scheme had, as their most influential and prevailing or ruling purpose, and thus their dominant purpose, the obtaining thereby of a tax benefit, in the statutory sense. The scheme was the particular means adopted by the taxpayers to obtain the maximum return on the money invested after payment of all applicable costs, including tax. The dominant purpose in the adoption of the particular scheme was the obtaining of a tax benefit... It is true that the taxpayers were concerned with obtaining what was regarded as adequate security for an investment made `off-shore'. However, the circumstance that the Midland Letter of Credit afforded the necessary assurance to the taxpayers does not detract from the conclusion that, viewed objectively, it was the obtaining of the tax

ATC 4605

benefit which directed the taxpayers in taking steps they otherwise would not have taken by entering into the scheme .''

(emphasis added)

18. Let it be assumed that, in the present case, even if the ``wealth optimiser structure'' had not been available, the respondents would have borrowed money to buy their new home, and also borrowed money in order to retain their former home as an income-earning investment. The ``wealth optimiser structure'' depended entirely for its efficacy upon tax benefits generated by arrangements between the respondents and the lender that had no explanation other than their fiscal consequences. What ``optimised'' the respondents' ``wealth'' was the tax benefit earlier described: not the deductibility of interest as such; but the deductibility of additional interest on loan account 2 contrived by the particular form of the borrowing transaction.

19. It is for those reasons that we would allow the appeal. We agree with the consequential orders proposed by Gummow and Hayne JJ.

Footnotes

[1] cf Steele v DFC of T 99 ATC 4242 ; (1999) 197 CLR 459 .
[2] Hart & Anor v FC of T 2002 ATC 4608 at 4618-4619 [ 41]; (2002) 121 FCR 206 at 221 [ 41] .
[3] 2002 ATC 4608 at 4620 [ 49]; (2002) 121 FCR 206 at 223 [ 49].
[4] 2002 ATC 4608 at 4620 [ 49]; (2002) 121 FCR 206 at 222-223 [ 49].
[5] Hart & Anor v FC of T 2001 ATC 4708 at 4723 [ 41]; (2001) 189 ALR 584 at 603 [ 41] .
[6] 2001 ATC 4708 at 4724 [ 43]; (2001) 189 ALR 584 at 603 [ 43].
[7] 2002 ATC 4608 at 4619-4620 [ 47]; (2002) 121 FCR 206 at 222 [ 47].
[8] 2002 ATC 4608 at 4620 [ 49]; (2002) 121 FCR 206 at 222-223 [ 49].
[9] 2002 ATC 4608 at 4623 [ 64]; (2002) 121 FCR 206 at 226 [ 64].
[10] 2001 ATC 4708 at 4724-4725 [ 47]; (2001) 189 ALR 584 at 604 [ 47].
[11] 2002 ATC 4608 at 4623 [ 65]; (2002) 121 FCR 206 at 226 [ 65].
[12] 2002 ATC 4608 at 4624-4625 [ 73]; (2002) 121 FCR 206 at 228 [ 73].
[13] 2002 ATC 4608 at 4625-4626 [ 81]; (2002) 121 FCR 206 at 230 [ 81].
[14] 96 ATC 5201 at 5206; (1996) 186 CLR 404 at 416.
[15] 96 ATC 5201 at 5210; (1996) 186 CLR 404 at 423.

 

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