Case A15

Judges:
JL Burke Ch
RC Smith M
RE O'Neill M

Court:
No. 1 Board of Review

Judgment date: 27 February 1969.

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J.L. Burke (Chairman), R. C. Smith and R. E. O'Neill (Members): In this reference the Commissioner maintains that pursuant to sec. 23F(18) of the Income Tax Assessment Act 1936-1965 a sum of £533 interest derived by the Trustees of X Provident Fund from a loan of £5,000 to C Pty. Ltd. is not exempt from income tax. Sub-section (18) of sec. 23F reads:-

``(18) Income (other than a dividend to which sub-section (16) of this section applies) derived by a superannuation fund from a transaction is not exempt from income tax by virtue of sub-section (15) of this section if the parties to the transaction were not dealing with each other at arm's length in relation to the transaction and that income is greater than the income that might have been expected to have been derived by the fund from the transaction if those parties had been dealing with each other at arm's length in relation to the transaction.''

2. Y and his wife were co-trustees of the Fund and were its only members. Y. a qualified accountant, entered upon public practice on 1 June 1960. In the same month X Pty. Ltd. was incorporated, its shareholders and directors being Y and his wife; the company then established the Fund and it has made contributions to the Fund in respect of both Y and his wife.

3. C Pty. Ltd. was incorporated on 20 March 1963 for the purpose of taking over the business of a printery theretofore conducted by a partnership of three and managed by an employee, H. The issued and paid up capital of C Pty. Ltd. was 3,200

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ordinary shares of £1 each beneficially owned in 1963 as to 2,240 shares by Z Pty. Ltd.; as to 560 shares by H who was appointed managing director; and as to 400 shares by one of the former partners.

4. X Pty. Ltd. owned one-fifth of the shares in Z Pty. Ltd. As Z Pty Ltd. owned 70 per cent of the shares in C Pty. Ltd. the result was that Y's family company, X Pty. Ltd., had a 14 per cent indirect interest in C Pty. Ltd. Neither Y nor his wife, whether in their own right or as Trustees of the Fund, was a shareholder or director of the borrower, C Pty. Ltd.; but Y was that company's auditor and financial adviser. C Pty. Ltd. had no shareholding or other financial interest either in X Pty. Ltd. or in the Fund; nor did H, the managing director of C Pty. Ltd., have any such interest.

5. The bulk of the moneys making up the loan of £5,000 by the X Provident Fund was in fact paid over for the purposes of the printery business in January 1963 in anticipation of the takeover by C Pty. Ltd. which was not incorporated until March. Nothing turns on this circumstance for it became clear at the hearing that both the company and the Trustees of the Fund were agreed that the indebtedness for the loan and interest had become the company's responsibility. For the purpose of this reference we proceed as if the loan had been made direct to C Pty. Ltd.

6. No statement of the assets and liabilities of the business in January 1963 was put before us but there is information that a week or so after its incorporation C Pty. Ltd. acquired from the vendors of the printery stock for £800; two motor cars for £1,200; and plant and machinery for £5,500. In the next three months before 30 June 1963 new plant was purchased at a cost of about £8,200. At 30 June 1963 the balance sheet showed creditors for hire purchase debt in respect of plant as £11,400 approximately including about £2,300 unexpired hiring charges. Periodic instalment payments to hire purchase creditors included both principal and interest calculated at flat rates of 8 per cent, 9 per cent and 10 per cent each equivalent to a simple interest rate of about 16 per cent, 18 per cent and 20 per cent per annum.

7. The financial position as disclosed in the balance sheet at 30 June 1963 was far from attractive to a lender. At that date the company's liabilities exceeded its assets by £374:-

 Bank overdraft and
   trade creditors                     7,821
 Hire purchase                        11,459
   less unexpired
   charges  2,282                      9,177
 Loan                                  2,870
 Loan from X Provi-
   dent Fund                           5,000            24,868
                                    --------
 Debtors and stock                    10,699
 Plant, etc., less de-
   preciation                         13,795            24,494
                                   --------             --------
           Deficiency                                      374
      

8. The bank overdraft which stood at £3,097 was secured by floating charge over the company's assets. From the financial position at 30 June 1963 the inference we draw is that the company was living from hand to mouth so far as concerned its cash needs. That inference confirms oral evidence by both H and Y that without the loan of £5,000 there would have been very great difficulty in keeping the business going. In its first three months of trading up to 30 June 1963 the company sustained a trading loss of £1,024.

9. From the oral evidence of Y and H we find that the conditions governing the loan were orally agreed between Y as Trustee of the Fund and H as managing director of the borrowing company and were: that the loan should be for an indefinite period no date being fixed for repayment; that regular periodic payments in reduction of principal were not stipulated; that no security of any kind should be given; and that the loan should carry interest at 15 per cent simple interest per annum on the amount of principal outstanding from time to time.

10. It follows from this finding that we accept the oral evidence that the loan agreement, Exhibit B, which was made out by Y and executed by C Pty. Ltd. on 3 June 1963, did not contain the real bargain and was not intended by either party to be binding. Its provisions were not in fact observed by C Pty. Ltd. and the Trustees of the Fund never sought to enforce them. We treat Exhibit B as having no material bearing on this reference and hence we need make no further mention of it.

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11. In making the loan it seems clear to us that Y, who was thoroughly familiar with the financial position of the printery, was relying on his judgment that H, who was the active force in managing the production and sales of the business, had the ability and will to build up its financial strength at least to the point where at some future date it would be able to repay the principal and interest. As the reward for risking the Fund's money on such terms as were extended to the borrower Y required that the loan should carry interest at 15 per cent per annum. H's evidence, which we accept, is that he had fought hard against Y's insistence that the rate of interest should be 15 per cent, but in the end he accepted it because his inquiries satisfied him that no cheaper money could be got on the same conditions.

12. On numerous occasions H pressed Y to reduce the rate of interest. Y's counter to H's arguments was that not only was the company irregular in paying interest and frequently in arrears but also that it had not made any payment in reduction of the principal. However Y finally yielded and by letter dated 26 October 1964 the Trustees of the Fund advised the company ``that the Trustees have decided that as from 1 October 1964 interest on your loan will be reduced to 13 per cent per annum''. Y gave two reasons for reducing the rate: (a) to ease the difficulty the company was having in paying interest and (b) the change made by Act No. 110 of 1964 effective in respect of income derived by a superannuation fund from 23 October 1964 onwards.

13. Up to 30 June 1964 the total interest charge due to the Fund at 15 per cent per annum was £1,163.10.0; actual payments made by the company up to that date totalled £1,038.10.0 Hence at 30 June 1964 the company was in arrears in respect of interest to the extent of £125. For the year ended 30 June 1965, the year with which this reference is concerned, the interest due to the Fund was £675 calculated as follows:-

15 per cent per annum on
   5,000 for 3 months to
   30.9.64                                 187.10.0
13 per cent per annum on
   5,000 for 9 months to
   30.6.65                                 487.10.0
                                           -----------
                                           675.0.0
                                           -----------
      

Payments of interest made to the Fund during the year ended 30 June 1965 totalled £800 as follows:-

14 October 1964            266.13.4
21 April 1965              417.16.0
7 June 1965                115.10.8
                           -----------
                           800.0.0
                           -----------
    

14. In assessing the Fund to income tax the Commissioner treated £267 received 14 October 1964 as exempt under sec. 23(j)(i) which was repealed by sec. 5 of Act No. 110 of 1964. However he applied sec. 46(5) of Act No. 110 in respect of £533 made up of the two receipts of £417.16.0 on 21 April 1965 and £115.10.8 on 7 June 1965. Section 46(5), the terms of which do not differ in any material respect from those of sec. 23F(18), applied to income (other than private company dividends) derived during the period 23 October 1964 to 30 June 1965 by a superannuation fund.

15. The amounts received in April and June 1965 totalled £533.6.8. Applying the October 1964 receipt of £266.13.4 against the sum of the arrears of £125 at 1 July 1964 and £187.10.0 interest charged at 15 per cent for the three months to 30 September 1964 leaves a balance of £45.16.8 accrued at 15 per cent up to 30 September 1964. That balance of £45.16.8 added to £487.10.0 interest charged at 13 per cent for the nine months to 30 June 1965 constitutes the £533.6.8 income derived during the prescribed period by the Fund. There may be an argument based on the presumption against retrospection (see Halsbury, 3rd Edn., Vol. 36 at p. 423 et seq.) that the statutory provision should not be construed so as to have effect in relation to interest accrued before 23 October 1964 but paid after that date. No mention was made of such an argument at the hearing and we refer to it merely to ensure that our conclusion in this case is not read as having any significance in respect of that point. For the purposes of this case we simply assume against the taxpayer that there is no substance in any such argument.

16. The assessment was defended on the grounds (a) that the lender, the Trustees of the Fund, and the borrower, C Pty. Ltd., were not dealing with each other at arm's

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length in relation to the loan of £5,000, and (b) that the income of £533 is greater than the income that might have been expected to have been derived by the Fund from the loan if those parties had been dealing with each other at arm's length in relation to it. Upon consideration of the evidence we have reached the conclusion that (b) does not apply and it is therefore unnecessary to consider (a). In brief we are satisfied that in the circumstances of this case the income of £533 which consists of £46 arrears of interest calculated at 15 per cent per annum and of £487 interest calculated at 13 per cent per annum is not greater than interest that might have been expected to arise from the particular loan even assuming that the lender and borrower were not dealing with each other at arm's length in relation to that loan.

17. In coming to that conclusion we have had particular regard to the precarious financial position of C Pty. Ltd. and to the terms and conditions upon which we have found the loan was made. We have already set out the facts relevant to those two aspects of the case and we think that they speak sufficiently for themselves as justifying our opinion that the amount of £533 interest calculated as above is not, to put it in a single word, excessive.

18. We think also that the history of subsequent borrowings by C Pty. Ltd. supports the conclusion we have reached. On 1 July 1965 C Pty. Ltd. repaid to the X Provident Fund the loan of £5,000. The means to make the repayment was a new unsecured loan of £12,000 not from the Fund, but from Y's family company, X Pty. Ltd. Again the interest rate was 15 per cent per annum. At the time this second loan was arranged the shares in the borrowing company C Pty. Ltd., were held as to 30 per cent by H, 30 per cent by X Pty. Ltd., with the remaining 40 per cent shared between two other shareholders. C Pty. Ltd. still had no shareholding or other financial interest in X Pty. Ltd., nor did either of the other two shareholders in C Pty. Ltd. have any such interest in X Pty. Ltd.

19. The second loan was negotiated only after H had failed to find any alternative source of finance for C Pty. Ltd. The bank refused to increase its overdraft limit; hire purchase companies would not re-finance the plant; a finance company engaged in leasing was not interested in buying the plant and leasing it back; factoring the debtors would have cost not less than 1 ¾ per cent per month and probably 2 per cent per month equivalent to 24 per cent per annum.

20. A year later in July 1966 C Pty. Ltd. repaid the abovementioned second loan and at the same time took from X Pty. Ltd. a third loan of £15,000 at 12 ½ per cent per annum. The lower rate of interest was the result of bargaining between Y and H which also led to C Pty. Ltd. giving security by way of a second mortgage over its assets and to its directors personally guaranteeing repayment of the loan.

21. The evidence as to these later loans strongly supports the view we have taken that C Pty. Ltd. could not in 1963 have borrowed £5,000 on any better terms than it got from the Fund. For these reasons we would uphold the taxpayer's claim.

Objection upheld