Sheil v. Federal Commissioner of Taxation.

Judges:
Derrington J

Court:
Supreme Court of Queensland

Judgment date: Judgment handed down 3 November 1986.

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Derrington J.

This is an appeal by the abovenamed taxpayer against the rejection of his objections against the disallowance of certain deductions claimed by him in the tax year ending 30 June 1977. The appeal relates to a number of items.

The first two are related and concern a loan obtained from Midland Credit Ltd. (``Midland''). Deductions were claimed for interest and charges in the sum of $48,934 and for borrowing charges in the sum of $6,088. The circumstances are slightly complex so that a complete understanding requires a short narrative.

The appellant is a medical practitioner and a member of the Australian Senate although the latter vocation is largely irrelevant to the present issues. At all relevant times he owned a complex of buildings at Milton in Brisbane where he engaged in his medical practice in one building, carried on the business of a private hospital in a neighbouring building, and leased another neighbouring building to a family company, Fermoy Pty. Ltd. (``Fermoy''), by which he, his wife and his brother, all medical practitioners, as the shareholders, conducted a surgical private hospital. Fermoy owned no assets other than this business and supporting assets.

In his capacity as a senator, he was approached by a gentleman, Mr Wilson, with a scheme for commercial rabbit breeding, and, in the course of providing assistance in approaches to government departments, he himself took up a financial interest in the venture. A company was formed, Thumpa Industries Pty. Ltd. (``Thumpa Australia'') which acquired land for the conduct of the venture. However, it met with strong bureaucratic opposition and it was decided to terminate the venture in Australia and pursue it in the United States of America. To that end Mr Wilson travelled there and set up the infrastructure of the business, including the incorporation of an American company, Thumpa Industries Inc. (``Thumpa America''). Whereas Thumpa Australia had a shareholding equally divided between the appellant and Mr Wilson, Thumpa America had a shareholding which, at the relevant time, had a shareholding of 1,000 shares held by the appellant, 1,000 shares held by Mr Wilson, and 900 shares held by an American company who was a stranger to them both. The interest of an American

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ATC 4734

shareholder was a requirement of the law of that country.

For the purpose of setting up the business operations in the United States, substantial moneys were required. The American shareholder provided a part, and the appellant produced the rest in the manner which will be described later. He did this by arranging a loan from Midland after extensive attempts to obtain finance from a number of sources, always on his own account. When the time came for the execution of the loan documents, he found that they were prepared upon the basis that the loan was to be advanced by Midland to Fermoy with a guarantee by himself and his wife. He was persuaded to enter this arrangement for convenience upon the basis that Fermoy would be his ``nominee'' or ``agent''.

Indeed, the subsequent train of events are all completely consistent with the limitation of Fermoy to this role. It did not receive the moneys advanced by Midland by way of loan but, at the direction of the appellant, it in turn directed the funds to be paid by Midland to Thumpa Australia through the latter's bank account at Wynnum. While it made payments of interest, they were all immediately reimbursed to it under arrangements made by the appellant, and there is no expense associated with the loan which was borne by it. When the loan was repaid, the funds came from the appellant. Although the Commissioner, not unreasonably, questioned whether the loan was made to any person other than Fermoy and consequently whether interest payments were made by any other person, particularly the appellant, however, under close scrutiny the evidence completely supports the appellant's claim in this respect and the Commissioner's counsel made no serious claim to the contrary.

The loan was made in three stages, there being one advance of $250,000 on 11 June 1976, $70,000 on 31 August 1976 and $30,000 on 28 January 1977. With the exception of $50,000 withheld from the first advance, all the moneys were sent by Thumpa Australia to Thumpa America where Mr Wilson was invested with control of the enterprise and disposition of the moneys, including the organisation of the financial structure. As it has been indicated, the loan funds from Midland were directed to Thumpa Australia which received them as an interest free loan from the appellant and credited to his loan account. The $50,000 retained by it was used in two ways, the payment by way of reimbursement to Fermoy of most of the instalments of interest to Midland for the first year and, as an incidental use, the reduction of its own overdraft whilst the moneys were held. These payments representing interest instalments paid to Midland via Fermoy were debited against the loan account of the appellant in the books of Thumpa Australia.

Counsel for the Commissioner challenged that this whole arrangement had been demonstrated, for the surviving records of Thumpa Australia were limited to annual financial statements and the appellant's accountant, Mr Cavaye had died recently. However, although the appellant was understandably vague about these things, he asserted that in reality he had made the interest payments out of the $50,000 so retained and for which he was liable for repayment to Midland. In this he is supported by reference to the annual financial reports of Thumpa Australia for the financial years of 1976 and 1977. On a comparison between those two years, his loan account, after adjustment for other recognisable debits and credits, shows a reduction in the latter year approximately equal to the interest payments made by Thumpa Australia, and there is no other explanation for such a substantial reduction. Although it shows other interest payments of its own, that company does not report in its profit and loss account any interest payments corresponding to those which are in question; and as the loan from the appellant to that company was interest free, there was no obligation upon the latter to make the payments from its own funds and no reason why it should. Finally there is no item in the financial papers in any way contrary to the appellant's claim.

There were two instalments of interest not paid by Thumpa Australia, probably because it was in overdraft in its bank account at the time and, so far as one can see, these were made by the appellant personally by way of payment to Fermoy, following the process of reimbursing it for its payment to Midland. It is the total of these interest payments made either by the appellant personally or charged against him by Thumpa Australia which is the subject of the first issue, for the Commissioner has disallowed the appellant's claim for a deduction in respect of the total sum.

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ATC 4735

The second issue is the disallowance of a claim of $6,088 for borrowing charges concerning the loan. The Commissioner argues that the latter is not demonstrated to have been expended, and there is considerable point in this argument. There is no supporting documentary material whatever save that counsel for the appellant points to an item in the appellant's personal ledger showing a payment of $6,792 to the solicitors for Midland and it is understandable that this may well have been for various costs relating to legal and other matters required in the loan transaction, as is customary. However, the amount does not correspond, and the payment is shown to have been in the preceding financial year, 1976, which is consistent with the time of the transaction. Although some reasonable latitude should be given for the appellant's difficulties in proof consequential upon the death of his accountant, this is a significant single item, the payment of which should be easily proved from the appellant's own papers which would be expected to have been preserved for this appeal, particularly as his accountant was alive until recently. Moreover, there does not appear to be the same difficulty from destruction of papers such as was the case with Thumpa Australia. The appellant's evidence was generally vague and imprecise on this issue also, which is understandable concerning complex financial matters so long ago; and he is manifestly in honest, if understandable, error concerning the arrangement of his financial matters by his advisers at the time. His belief that he paid the disputed sum is probably the result of confusion with his payment made in the preceding financial year. In the result, this expenditure in the relevant period has not been proved.

It is necessary now to return to a narration of the remaining history of the loan transaction. Although Thumpa Australia showed the advance of $300,000 which it made to Thumpa America as an interest free loan, the funds really went to Mr Wilson who, acting apparently within the general authority given to him by the appellant, applied half of it to the subscriptions for their shares by each of the appellant and himself, and that capital, together with that supplied by the American shareholder, was then used by Thumpa America in setting up and operating its business. Although it is not easy to draw inferences from the financial report of Thumpa America which was tendered, they appear to support the proposition that the moneys were used to subscribe capital because the papers speak of the subscription for shares by the associated American subscriber for a purchase price which would be consistent with the use of the subject sum for a similar purpose. Those papers also speak of the shareholding referred to above, and it is consistent with the application of the funds in this way. Unfortunately the venture was a failure, so that it was unable to repay the ``loan'' or any interest, the burden of all of which then fell upon the appellant in later years.

For his part, he entered into the loan transaction with Midland and the arrangement for the payment of interest with certain vague and loosely defined intentions. His evidence in this respect, although unsatisfactory, was an honest reflection of the lack of depth of analysis of the situation at the time, compounded by difficulty with memory and some understandable honest rationalisation with the passage of time. That intention was firstly that he should be the real borrower from Midland and, stripped of its legal technicalities, that is a reasonable assessment of what took place in that direction. His intention as deposed to was that he would then personally advance the money to Thumpa America as a ``grub-stake'', which he could not reasonably define by way of a distinction between the advancement of capital by way of subscription for shares or otherwise, as distinct from a loan. He does not seem to have considered his obligation to subscribe for shares but may have believed that only a nominal shareholding was intended because of the loans which he believed would have been available to the company through this process. Of course, the prima facie legal situation was that he made an interest free loan to Thumpa Australia which then made a similar loan to Thumpa America. Again this divergence is understandable because he apparently, and no doubt with some justification, treated Thumpa Australia as his own and merely a convenient vehicle for the process as recommended by his advisers. It will be convenient to refer compendiously to this transaction as a loan by him to Thumpa America where that does not affect the discussion. Most importantly, he intended and expected that Thumpa America would be such

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ATC 4736

a fecund source of profit that within a year it would from its profits take over the payment of interest to Midland and, by the time of expiration of the three year loan be also in a position to pay out the entire debt of $350,000 to Midland which included the $300,000 which it had received from those funds and the $50,000 which had been retained to pay the first year's interest.

In this view of affairs he was in error in a number of ways, but the two most significant features are that through the intervention of Mr Wilson the funds did not go to Thumpa America as a loan, which had to be repaid, but rather as capital, which did not; and in any case the funds which were remitted did not include the $50,000 retained to pay the first year's interest. Presumably and consistently he expected that the company would assume responsibility for that also. Although it is not easy to divine what he intended, it appears that he expected that the loan together with the interest would be repaid by Thumpa America itself rather than that he should repay it out of dividends received by him as a shareholder. Among other indications of that, he says that he did not know of and did not expressly authorise the use of the funds by Mr Wilson as a subscription for their shares, which marries with an intention that the loan and interest be repaid by the company. Nevertheless, the probability is that Mr Wilson was his agent with general authority to do what he did. There was no real attempt to suggest the contrary, for the absence of an express authorisation is not a denial of implied authority, and there was no evidence suggestive of any action on the appellant's part such as one might expect had there been conduct in excess of authority. Ratification was of course unnecessary if the act came within the authority originally invested in the agent even if that authority be only general or implied.

It is preferable to approach this complex question first upon the basis that the transactions had been as the appellant intended them to be. Even putting aside the technical questions introduced by the intervention of Thumpa Australia in the process, this state of affairs as intended by the appellant produces two major issues, the first being whether his payments were an expenditure by him on the interest as distinct from his making of a loan to Thumpa America, which might be implied by his intention, so that that company would repay the entire loan including that part of it retained for the payment of the first year's interest. The second issue is whether the interest payments are deductible in so far as they related to the production of income for Thumpa America rather than that of the appellant; cf.
F.C. of T. v. Munro (1926) 38 C.L.R. 153.

In respect of the first question, it is difficult to comprehend how a payment by the appellant of a sum which he had admittedly incurred, but for the benefit of another person and which he expected that other to repay at a later stage, could be regarded as an ``outgoing'' which he has incurred; for just as an outgoing might be incurred when his liability arises though it may not have been discharged by the taxpayer in the relevant tax year (
F.C. of T. v. James Flood Pty. Ltd. (1953) 88 C.L.R. 492), conversely where a payment out is intended to be matched by an immediate appropriate indebtedness to the payer by another person, there is no real outgoing. It probably does not alter the position as the Commissioner argues that the payment by the appellant was not from his own funds so much as from a reserve held back from the loan which it was intended that Thumpa America would repay, for he was primarily liable to repay that to Midland; but it does have relevance that he expected that it would be Thumpa America and not himself who would repay. His position might be regarded as analogous to that of Fermoy which had directly borrowed the money from Midland and become primarily liable to pay the interest but did not have an outgoing in that respect because it was matched by an identical obligation to it by the appellant. The point is not for what purpose the ``payments'' by the appellant were made but whether they were an outgoing in character; and in the circumstances posited, they were not.

In respect of the second question, the appellant encounters immediately the proposition first advanced in F.C. of T. v. Munro (supra), where the basic circumstances were very similar to the present case and where it was held that the incurring of an interest outgoing on capital which was lent interest free to a company in which the taxpayer was one of the shareholders was not incurred in gaining or producing assessable income of the taxpayer but rather that of the company and its shareholders. It is not relevant that the Act at

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ATC 4737

that time contained a provision that a deduction was not allowable in respect of money not wholly and exclusively laid out or expended for the production of assessable income for, although that was of consequence in respect of other circumstances, it had no place in the discussion of the issues germane to the instant case. On the point in issue, Knox C.J. said at p. 171: ``The interest was paid, not for the purpose of gaining or producing assessable income of the taxpayer, but for the purpose of satisfying pro tanto a debt which the taxpayer had incurred with a view, not to the production of his assessable income, but to the production of income by the company for the benefit of its shareholders.'' At p. 217-218, Starke J. said: ``The interest paid in this case was upon moneys borrowed for the purpose of contributing capital on the part of the taxpayer and his son to a newly formed company. It was not an outgoing by means of which the taxpayer procured the use of money whereby he made any income... Under these circumstances the deduction ought not to be allowed.''

This reason is consistent with the reasoning of Dixon J. (as he then was) in
North Australian Pastoral Co. Ltd. v. F.C. of T. (1946) 71 C.L.R. 623 where he said at p. 635: ``This last suggestion seems beside the point. For the companies paying the dividends are independent entities taxable as such and no deduction would be allowed in the appellant's assessment for expenses incurred by the appellant for the purpose of the earning of profits for those companies.'' It is true as it was observed by Meares J. at first instance in
Total Holdings (Australia) Pty. Limited v. F.C. of T. 78 ATC 4286 at p. 4288 that this observation was made in the consideration of the amount of dividend rebate any taxpayer was entitled to under sec. 46, as it then was, and whether the expenditure there under consideration was directly attributable to the dividends. Meares J. found that it was not a view which could be comfortably attributed to the relationship between a holding company and its wholly owned subsidiary, and this view is, with respect, quite correct; that distinction flows from the particular relationship referred to in the latter case, and there is no reason why the general principle enunciated by Dixon J. should not have application to the position where, as here, there are other shareholders in the company which received an interest free loan from the taxpayer.

It is true that as the result of his loan adventure, assuming that it was a loan, the appellant here increased his chances of receiving greater dividends from the company, but that was only secondary and incidental to the purpose of the loan which was to produce greater income for the company. Because the company had other substantial shareholders, neither its income nor its business were the income or business of the appellant. This is in marked distinction from the position of a holding company which carries on the whole or part of its business through a subsidiary as was the position in the Total case (supra - affirmed on appeal). The practicality of the point is underlined by the circumstances in that case where the taxpayer ceased to provide the interest free loan when it sold half its interest in the subsidiary, and it then began to charge interest at commercial rates. In the result, if the present transaction had been a loan, it was not an outgoing for the purpose of producing taxable income for the appellant.

The views expressed above may appear to be in conflict with certain obiter dicta of high authority in
Ure v. F.C. of T. 81 ATC 4100 at p. 4108; (1981) 50 F.L.R. 219 at p. 230 where in a joint judgment Deane and Sheppard JJ. in the Full Federal Court said: ``Again, notwithstanding the fact that it may always have been intended to re-lend borrowed money at a rate of interest lower than that payable in respect of the original borrowing, the liability to pay the interest may plainly have been wholly incurred in earning assessable income where it is expected or hoped that the re-lending will also lead to assessable income in another form being derived or preserved, such as, for example, dividends on shares held in the company to which the money is lent at a favourable rate.'' There is no discussion of the various considerations here, and the comment was probably inspired by the Total case which also had passed through the Full Federal Court only two years previously. If that is the case, and the observations are limited to that type of case, there is no conflict.

There was some suggestion that the appellant's intention was that the advance would stimulate Thumpa America into becoming a profitable organisation more quickly than would otherwise be the case so

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ATC 4738

that he could then sell his interest, presumably at a capital gain; and that this justifies deductibility. If this were his purpose then the interest is not deductible as a means of acquiring capital gain: cf. the discussion in
F.C. of T. v. Total Holdings (Aust.) Pty. Ltd. 79 ATC 4279 at pp. 4285-4286; (1979) 43 F.L.R. 217 at p. 228. However this would not determine the principal point unfavourably to the appellant in that he also spoke of his expectation of income from the transaction.

Any later payments made by him personally are largely irrelevant to the determination of his original intention because it appears that these became necessary only because the reserve of $50,000 had been used up under his direction and Thumpa America was not making such later payments as he had expected.

The conclusion necessarily is that Munro's case has application here so that, if the moneys had been lent to Thumpa America, even if they had constituted an outgoing of the appellant, the purpose would not have been for the production of assessable income by the appellant. Although it has not been argued, it appears further that, because the moneys were not appropriated in the way the taxpayer intended then, in these circumstances, the interest can hardly be claimed as a deduction upon the basis of the use intended.

That leads into the next problem. The true analysis of the circumstances is that while he had one intention the appellant undertook liability for the interest payments in the first instance and, through an arrangement with Thumpa Australia, had the funds sent to Mr Wilson who was authorised to appropriate them in the business as he saw fit and he appropriated them in a way which was different from that which the appellant intended. The difficulty which arises where interest is paid on money which is borrowed for one purpose but in fact used for another was recognised but not discussed in Ure v. F.C. of T. 81 ATC 4100 at pp. 4109-4110; (1981) 50 F.L.R. 219 at p. 232. There is no overwhelming reason why it should not be related to the actual use to which the money is put just as it cannot be related to the use to which it is not put, as it has been shown above. Despite the appellant's intention, his authorised agent in fact applied part of it for the subscription of shares by the appellant himself designed to return him an income by way of the expected dividends from profits.

The incidental question has been raised whether the agent's action involved the direct use of the funds sent by Thumpa Australia to purchase the shares or whether he borrowed those funds from Thumpa America after they had been received from Thumpa Australia. Despite the paucity of evidence and the general disregard of detail in the arrangements, the general context and common sense suggests that he had a general personal authority from the appellant as well as authority as manager of the company and that he chose to receive the funds in the first instance as agent for the appellant rather than to go through any elaborate and circular movement of the funds through the company. There is nothing in the company's balance sheet to suggest such a loan. The answer is that although the funds may have passed from the appellant through the books of Thumpa Australia with the expectation that they would go to Thumpa America, they were sent to Mr Wilson who, within his authority from the appellant, diverted them to the latter's use. The net result was that by his arrangement with it Thumpa Australia sent the funds and thereby the appellant acquired his shares; and thereby he incurred his liability for interest. The nexus is sufficient. It is wholly consistent with sec. 51 of the Act that a deduction should be made in this way despite the personal intention of the appellant, for it was also his intention that the practical application of the moneys and the arrangement of the company structure should be left in the hands of his agent, Mr Wilson.

The incurrence of liability for interest for the purchase of shares productive of income is a valid deduction for the taxpayer, but there is no foundation laid for justifying moneys provided for Wilson's purchase of shares so his part of the capital provision, and appropriate interest, must be disregarded. In respect of the appellant's portion, while there are cases where interest on money borrowed for the purchase of shares may not be deductible, e.g.
Associated Newspapers Ltd. v. F.C. of T. 5 A.T.D. 87, in the present case the investment was clearly for the purpose of recovering income by way of dividend, and the cost of it is deductible: F.C. of T. v. Total Holdings (Aust.) Pty. Ltd. 79 ATC 4279; (1979) 43 F.L.R. 217;
XCO Pty. Ltd. v. F.C. of T. 71 ATC 4152; (1971) 124 C.L.R. 343;
F.C. of T. v. Patcorp Investments Limited 76 ATC 4225; (1976) 140 C.L.R. 247;
Magna Alloys & Research Pty. Ltd. v. F.C. of T. 80 ATC 4542; (1980) 49 F.L.R. 183.

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ATC 4739

What might be done by the company with the moneys subscribed as capital is not relevant, assuming that they go to the furtherance of its business. On this view of the transaction, Munro's case (supra) is not apposite here. The result of these conclusions is that in respect of this item there is an allowable deduction to the extent of the cost of the money used to acquire the appellant's share of the proposed source of income.

The only material available demonstrates that half the funds sent by 30 September 1976 were appropriated to the appellant's subscription, i.e., one-half of $270,000 or $135,000. The proportionate amount of interest paid for that sum was about $18,875. The appeal on this item is therefore allowed in respect of a deduction of $18,875.

The remaining items are of minor importance. The first two relate to liquor supplies for entertaining purposes in the appellant's medical practice and private hospital respectively. The evidence was unsatisfactory in that, although he swore that he, his father and his brother, who were associated in enterprises which were conducted with some common administration, had all paid for their own private liquor separately, documentary support which should have been available was not produced. However, and that having been said, the appellant has deposed explicitly to this fact. It is not unreasonable and there is no indication to the contrary and in these circumstances his evidence should be accepted notwithstanding the quality of the supporting material.

The remaining argument of the Commissioner on this point is that there is no evidence that the allocation of liquor expenses between the two businesses of the appellant and that of Fermoy, in which he also had an interest, was correct. Since the total was deductible one way or the other between the three businesses and because the appellant gave evidence that the allocation of the liquor bill was undertaken on each occasion by those with knowledge of the relative usage, there is no reason why it should not be regarded as correct. It is not suggested that any benefit in the totality would have been achieved by an improper apportionment. While these arguments of the Commissioner are properly raised, the answers are sufficient and these items should be allowed also.

The next items are payments made to the appellant's father for administrative work in each of the appellant's two businesses. From his description of the work undertaken, the figures appear to be quite reasonable and there was no argument of any consequence to the contrary. They too should be allowed.

The next two items may be considered together because they relate to the residence of the appellant for which there are claims for depreciation of carpets and staff amenities. The carpets appear to be in two relevant areas, one in the general domestic portion in the house which was used for the interview of new staff, board meetings and the like, and the second in a part of the premises set aside for the use of staff members from the businesses who apparently had recourse to it for recreational purposes, ancillary to their work. The bulk of the relevant carpet would have been in the former section for which little allowance should be made for that part of its use related to deductibility must have been relatively very small. Further there is little evidence upon the appellant's expenditure in the purchase of the carpets and other relevant facts. Doing the best I can I allow $50 as a deduction for this item. The claim for staff amenities also has a difficulty in that they appear to have been installed prior to the purchase of the premises by the appellant. In addition, there is no evidence led supporting the quantum of the claim for this item, which must therefore be dismissed.

The remaining item relates to depreciation of what is alleged to be antique furniture. The evidence is that this claim relates to furniture used in the hospital business and that it is not antique furniture but rather ordinary furniture purchased through an antique dealer who provided such a service for the appellant. This is expressly deposed to and not controverted and there is no reason why the appeal in respect of this item should not be allowed.

In summary the following items are allowed by way of deduction for the relevant year:

                                                $
      Interest payments                    18,875.00
      Entertaining expenses for practice    1,341.00
      Management fee for practice -
        W.G. Sheil


         1,000.00

                                                $
      Entertaining expenses for hospital      488.00
      Management fee for hospital --
        W.G. Sheil                          1,000.00
      Depreciation on carpets --
        48 Birdwood Terrace                    50.00
      Depreciation on hospital furniture      193.00
      

Amendments appropriate to these findings are allowed without costs.

The appeal is allowed accordingly.

It is no criticism of any particular source, but the presentation of the appeal was extraordinarily laboured and extended by the appellant's pursuit of a number of matters unsuccessfully. For that reason his costs should be limited to two days. The respondent is to pay the appellant's costs of and incidental to the appeal limited in respect of the hearing to two days.