Network Finance Limited v. Federal Commissioner of Taxation.

Judges:
Sheppard J

Court:
Supreme Court of New South Wales

Judgment date: Judgment handed down 22 October 1976.

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Sheppard J.: This is an appeal from the refusal of the Commissioner to allow, in respect of the income year ended 30th June, 1972, deductions for interest and certain charges ($307,378 and $4,896 respectively) paid during the year in question in respect of a loan made by Mellon National Bank and Trust Company, to whom I shall refer hereafter as ``Mellon'', to the appellant, to whom I shall refer hereafter as ``Network''. The deduction was claimed pursuant to sec. 51(1) of the Act. It is conceded by the Commissioner that the deduction would be allowable but for the provisions of Division 3A of Part III of the Act. The question to be determined is therefore whether the provisions of that Division operate to deprive Network of the deduction to which it is otherwise entitled.

Network carries on business as a finance company principally in the provision of loan funds secured by mortgage over real estate. Mellon (now known as Mellon Bank N.A.) is a large American banking company with branches overseas.

In 1970 Mr. Campbell, who is deputy chairman of Network, had formed the view that for a company to succeed in the finance industry in Australia it must have a significant association with and the backing of a substantial commercial bank. During a visit by him to the United States in 1970 he met with the executives of Mellon and discussed with them an association with Network. Ultimately that association came about. From a legal point of view it is evidenced in at least two documents, those being documents which are involved in the decision to be made in this case. The two documents are a letter of agreement dated 8th July 1971, by which moneys were agreed to be advanced by Mellon to Network, and a convertible note which is dated 15th July 1971. By the former document Mellon agreed to lend to Network a total sum of $6,000,000 upon the terms of the letter of agreement. The letter contained a table providing for the instalments by which the loan would be taken down and repaid. That table was varied by a supplementary letter of agreement dated 5th August 1971. The agreement provided for the payment of interest, and it is in respect of the payment of the interest under that agreement in the income year ended 30th June 1972 that the deduction is claimed.

The convertible note was made, not with Mellon, but with a subsidiary of that company, Mellon Bank International, to which I shall refer as ``International''. It recited that International was the holder of a convertible note in the sum of $1,100 created by resolution of the board of directors of Network on 9th July 1971. A number of covenants, terms, conditions and provisions were then set out. The first provided for the repayment of the principal on and not before 1st July 1978 and continued, ``and subject as aforesaid the Company (Network) shall not be entitled to repay the said principal moneys so as to cause the option contained in Clause 4 hereof to lapse''. There was a provision in cl. 2 for the payment of interest. Clause 4 provided for an option for conversion to shares. The provisions of that clause are, so far as they are relevant, in the following terms:

``The Company hereby grants to the Noteholder an option to apply for and have issued to the Noteholder One million one hundred thousand (1,100,000) ordinary shares (or stock units) of Fifty cents (50¢) each in the capital of the Company each credited as paid to One-tenth of one cent (0.1¢) per share and bearing the condition that the balance of Forty-nine and nine-tenth cents (49.9¢) payable on each share shall be called up by the Company within one (1) month of the date of issue. The Noteholder may exercise this option in whole at any time or in part from time to time by delivering to the Company a notice of exercise of option in the form attached to this Convertible Note duly executed by the Noteholder together with this Convertible Note Certificate to the Company, together with nominations in writing of the nominees of the Noteholder (if any) and a form of subscription for shares in form attached hereto duly executed by the Noteholder or the nominee/s of the Noteholder. The Company will within fourteen (14) days of receipt of the exercise of option pursuant to the said notice: -

• (a) Cause to be issued to the Noteholder certificates for the number of shares for which this option has been exercised; and
• (b) Return this Convertible Note Certificate, endorsed to reflect the extent of the Noteholder's exercise of this option.

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And thereafter this option shall be only exercisable for that number of shares (including pro rata benefits, if any, granted by Clauses 5 and 7 hereof) remaining subject to this option or any parts thereof. This Note shall ipso facto be and become redeemed to the extent to which the shares issued on exercise of the option are paid on issue and the extent of such redemption shall be endorsed from time to time on the Convertible Note Certificate.''

It is plain upon the face of the evidence of Mr. Campbell that from a commercial point of view the transactions would not in all probability have been entered into unless the parties to them were agreed that both should be entered into. In that sense it is correct to say that the transactions had a commercial relationship. Mr. Campbell was asked about that relationship and he gave the following evidence.

Firstly, it was important that Mellon become a substantial shareholder in Network. It was contemplated that it would take up twenty five per cent of Network's issued capital. This would come from the sale to International of the entirety of the shareholding of one major shareholder, the proportional reduction of the shareholding of three other major shareholders and the issue of the 1,100,000 shares which are referred to in cl. 4 of the convertible note. To the extent that these shares were not taken up the proportion of shares held would be less, but, by reason of its acquisitions from the other major shareholders, International would nevertheless be a substantial shareholder in Network. Mr. Campbell continued:

``It was very important of course that in securing Mellon's interest in the Network company that hand in hand with that would be an indication by Mellon to continue to support the company in a number of ways.

And one of these ways would have been provision of loan funds, stand-bys, back-to-back letters of credit and things of that nature.

We were very mindful though that because of exchange risks associated with loans that it could be more important to us, particularly in the short to medium term, for Mellon's presence for the purpose of local raising.

That is local raisings in Australia so that Network could compete with other finance companies in Australia that were affiliated with local trading banks, and that was a dominant consideration in securing Mellon as a stock holder, just as the nominating of the provision of loans, stand-bys and things of that nature.

All of the things which I have mentioned did in fact subsequently happen: stand-bys were granted by Mellon, Mellon granted a loan at the same time of six million, a further loan later, in 1973 a stand-by of five million, which I am pleased to say was not used.

Network's ability to raise funds in Australia was immediately enhanced when Mellon became a stockholder in Network and the response of the public and institutions and others to its local debenture prospectus raisings was immediate, the reaction was immediate, the prospectuses were filled very quickly, and in my opinion this was substantially brought about by the presence of Mellon in the Network company.

And this included their appointing an officer of the bank on to the Board of the company and therefore it can be assumed, I think by those dealing with the company, that some of the bank's disciplines were being applied by the company thus making depositors' deposits with the company more secure and things of that nature.''

This view of things is reflected in a letter dated 5th August 1971, written by Network to the Sydney Stock Exchange, and which contained the following statements:

``The Directors wish to advise that Mellon National Bank and Trust Company of Pittsburgh, Pennsylvania, has acquired, through its wholly-owned subsidiary Mellon Bank International, 17% of the equity capital of Network's Finance Limited, plus an option to acquire 3% additional, for a total of 20%.

The 17% stockholding was acquired by the cash purchase of 2,109,000 fully paid ordinary 50¢ stock units from the principal stockholders of Network. Of these, 860,000

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stock units were acquired from Lockheed Aircraft International, Inc., being the whole of that Company's stockholding. The balance was acquired at par from 3 other organisations, Hooker Corporation Limited, The Prudential Assurance Company Limited and The Fidelity International Corporation (The Fidelity Bank) and represented a reduction by each of these stockholders of approximately 19% of their interests.

Mellon Bank also acquired from Lockheed Aircraft International, Inc. an option to take up at par a further 476,000 ordinary stock units. The option is expected to be exercised this month to achieve Mellon Bank's 20% interest in Network.

Simultaneous to its stock purchase, Mellon Bank agreed to make a loan to Network of U.S. $6 million on the security of Debenture Stock ranking pari passu with existing issued Debenture Stock.

Network has also issued to Mellon Bank International a Convertible Note to the face value of $1,100 giving that Bank the future right (option) to subscribe for 1,100,000 ordinary 50¢ stock units payable to 0.1¢ by redemption of the Convertible Note, the balance of 49.9¢ being payable in cash within one month of the issue of such stock units. The option is exercisable at any time within a period of seven years and carries the normal pre-emptive rights of participation, during its currency, in general issues, etc. made to all ordinary stockholders.''

The percentages mentioned in the letter are not precisely in accord with those mentioned in Mr. Campbell's evidence, but the difference is of no consequence.

The option to take up shares conferred by the provisions of the convertible note was exercised. On 2nd July 1973 International took up 800,000 shares in Network with the result that the indebtedness of $1,100 was reduced by $800. On 28th April 1975 International took up a further 190,000 shares in Network, further reducing the indebtedness by $190. On 28th April 1975 International sold the unredeemed balance of the note to Hooker Investments Pty. Limited. On 20th June 1975 that company exercised the option to take up the balance of the shares thus extinguishing the indebtedness referred to in the convertible note.

It is to be observed that the convertible note does not refer to the loan agreement but that the loan agreement makes reference to the note. This is to be seen from the provisions of cl. 7(b) and (i) and 8(a) of the loan agreement. These are as follows:

``7. The Company hereby makes the following representations and warranties:

(b) The borrowing of the loan and the performance of the terms thereof and hereof, and the execution and issue of the Notes, the Debenture Stock to be issued hereunder and the Convertible Note Certificate to be issued by the Company to Mellon Bank International in the principal sum of One Thousand one hundred Australian dollars (\ca\1,100), carrying interest at Eight and one quarter per centum per annum (8-¼% p.a.) and conferring on the holder thereof an option to have allotted to it up to One million one hundred thousand (1,100,000) ordinary Fifty cent (50¢) shares in the capital of the Company, are each within the incorporated powers of the Company and have each been duly authorized by all necessary corporate action on the part of the Company.

(i) The borrowing of the loan and the performance of the terms of the loan by the Company, and the execution and issue of the aforementioned Notes, Debenture Stock Certificates and Convertible Note Certificate by the Company, will not (i) constitute a violation or contravention of any term, condition provision or restriction contained in the Trust Deed, the Memorandum and Articles of Association of the Company or any agreement or instrument to which the Company is a party or by which it is bound, or constitute a default thereunder, or (ii) violate the provisions of any law, regulation, order, writ or decree of any court or governmental instrumentality.

8. The obligation of the Bank to make the first loan advance hereunder is subject to the following conditions precedent:

(a) The Bank shall have received copies of all corporate resolutions of the

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Company authorizing the borrowing of the loan and the performance of the terms thereof and the execution and issue by the Company of the aforementioned Notes, Debenture Stock Certificates and Convertible Note Certificate, as well as any other actions which require corporate authorization, certified by the Secretary of the Company within five days preceding the date of such advance.''

The principal provisions of the Division of the Act in question are contained in sec. 82R. It provides in subsec. (3) that an outgoing consisting of interest or a payment in the nature of interest under a convertible note to which the section applies shall be deemed not to be an allowable deduction from the assessable income of the company. Section 82R(1) provides that it applies to a convertible note issued by a company, not being of a class therein referred to. It is not necessary to refer to those classes.

Section 82L of the Act contains a large number of definitions. It is necessary that I should refer to some of these. They are ``instrument'', ``note'' and ``convertible note''. Those definitions are as follows:

```instrument' includes debenture, bond, certificate, receipt or any other document or writing;

`note' means a note or other instrument issued by a company that evidences, acknowledges, creates or relates to a loan to the company;

`convertible note' includes a note issued by a company that provides, whether in pursuance of or by virtue of a trust deed or otherwise -

• (a) that the amount of the loan to the company that is evidenced, acknowledged or created by the note or to which the note relates -
  • (i) whether with or without interest;
  • (ii) whether at par or not;
  • (iii) whether at the option of the holder or owner of the note or of some other person or not;
  • (iv) whether in whole or in part; or
  • (v) whether exclusively or otherwise;

  is to be or may be converted into shares in the capital of the company or of another company or is to be or may be redeemed, repaid or satisfied by -

  • (vi) the allotment or transfer of shares in the capital of the company or of some other company, whether to the holder or owner of the note or to some other person;
  • (vii) the acquisition of such shares, whether by the holder or owner or by some other person, otherwise than as mentioned in the last preceding sub-paragraph; or
  • (viii) application in or towards paying-up, in whole or in part, the balance unpaid on shares issued or to be issued by the company or by some other company, whether to the holder or owner or to some other person; or
• (b) that the holder or owner of the note is to have, or may have, any right or option to have allotted or transferred to him or to some other person, or for him or some other person otherwise to acquire, shares in the capital of the company or of some other company.''

The critical provision for the purposes of this case is contained in sec. 82L(2) which is in the following terms:

``Where the combined effect or operation of two or more related instruments, whether issued at the same time or not, would have the effect or operation of a convertible note, those instruments shall, for the purposes of this Division, be deemed to be together a convertible note.''

The Commissioner's submission is that the loan agreement and the convertible note are related instruments for the purposes of that sub-section and are to be regarded together therefore as a convertible note. On this basis, so it is submitted, the provisions of sec. 82R operate to deny to Network the deduction for interest which it would otherwise have.

Network's submission is that the documents are not, within the meaning of the section, related. It further submits that even if they are related their combined effect or operation does not have the effect or operation of a convertible note; the note itself operates as such in its own terms and without reference to the loan agreement.

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The starting point for the Commissioner's submission is the definition of ``convertible note'' earlier set out. It was submitted that if there were, for example, a loan by one company to another of $100,000 and a provision in the instrument evidencing the loan whereby the borrower could satisfy part of the indebtedness, e.g. $10,000, by the issue of 10,000 shares of $1 each in its capital, the Division would operate so as to deprive the borrower of any deduction for interest no matter that only $10,000 part of the indebtedness could be satisfied by the issue of shares. It was said that this conclusion arose by reason of the use of the words in para. (a)(iv) of the definition of convertible note, ``whether in whole or in part'', and the consequential provisions of para. (a) (vi) (vii) and (viii). Reliance was also placed upon the alternative extremely wide provisions of para. (b). It was then said that the two instruments in question, the loan agreement and the note, were commercially related because one would not have in fact been entered into without the other. As I have said, that is clearly so on the basis of the evidence given by Mr. Campbell and the letter written to the Stock Exchange. Reliance was also placed upon the three clauses referred to in the loan agreement, 7(b) and (i) and 8(a), to reinforce the submission that there was at least a commercial relationship between the two. The next step taken by the Commissioner was to read the definition of ``convertible note'' in the light of the provisions of sec. 82L(2) as applied to the present transactions and to say that the two instruments should be read together - really as one - so that there were three parties, a loan of $6,001,100, and an entitlement on the part of one of the parties to the shares referred to in the convertible note in respect of part of the indebtedness.

It is to be seen that assuming such a transaction were comprised in one document, it is not the same transaction as is comprised in the transaction supposed in the Commissioner's example earlier referred to. This is because there are two separate loans, one made by Mellon and the other made by International. It is only in respect of that made by International that satisfaction may be obtained by the issue of shares.

Counsel for Network contended that the expression ``related instruments'' had a more confined meaning than that attributed to it by the Commissioner. He said that it involved a legal relationship and was confined to a case where, in respect of the same indebtedness, one had to put two or more documents together for the purpose of seeing what the real transaction was. If a combination of the documents revealed that the loan could be satisfied in whole or in part by the issue of shares in the borrower, the transaction would be within the section and interest paid on the loan (or at least that part of it which could be satisfied by the issue of shares) could not be the subject of a deduction. But counsel for Network made what I regard as a more fundamental submission than that. It was that sec. 82L(2) had no operation in a case where one instrument was, within the definition, itself a convertible note. In his submission the only purpose of the provision was to enable the Commissioner to combine documents for the purpose of seeing whether documents which, if read alone did not comprise a convertible note, became a convertible note when put together. In my opinion that submission is sound.

The provisions of the Division strike one as having been carefully drawn. Care has been taken in sec. 82L to define with clarity a number of expressions including such simple ones as ``instrument'', ``issued'' and ``note''. When one finds the word ``related'' in sec. 82L used in subsec. (2) one's immediate reaction is to look for a definition of it. It is not there, and one asks the question why a draftsman who has taken so much care in defining the various expressions used in the Division has not seen fit to give the word ``related'' a definition as well. One's puzzlement at this situation is removed if one gives the word the meaning contended for by Network. It simply means two or more instruments connected with each other; that is a dictionary meaning of the word. So that what the section envisages is two or more instruments or documents which, by reason of the relationship which they bear to each other or the connection that they have with one another, themselves operate together to have the effect or operation of a convertible note.

In the present case the convertible note and the loan agreement each stands on its own feet. Each relates to an entirely different indebtedness. Effect is given to the provisions of the legislation if a deduction for interest is

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denied in respect of interest payable upon the loan evidenced by the convertible note. That is the loan, to use the language of para. (a) of the definition of ``convertible note'', that is evidenced, acknowledged or created by the note or to which the note relates; and, in terms of the definition of ``note'', the convertible note relates to a loan to the company (Network), that is the loan of $1,100.

There are many other things that could be said about the substantial distinction that exists between the two transactions and the independence of the one from the other, notwithstanding that commercially it is unlikely that one would have been entered into without the other. Much was made of these matters by counsel for Network. I do not find it necessary, however, to deal with his submissions otherwise than by saying that I am of the view that they are sound.

I am of opinion that the only convertible note in the present case is the document entitled such made between Network and International. I am satisfied that it is not permissible for the Commissioner to seek to combine that note with the loan agreement pursuant to the provisions of sec. 82L(2). Accordingly I conclude that the provisions of Division 3A of Part III do not operate to disentitle Network to the deduction for interest which it has claimed. The appeal is therefore allowed. The amended assessment in question is remitted to the Commissioner for adjustment by him in accordance with this decision. I order the Commissioner to pay the appellant's costs of this appeal.