Case U140

Members:
PM Roach SM

Tribunal:
Administrative Appeals Tribunal

Decision date: 26 June 1987.

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P.M. Roach (Senior Member)

The question in this reference can be so shortly stated as to be seemingly simple: Did the "taxpayer's principal business consist of the lending of the money...?" Another way of expressing the issue is to ask whether, out of its taxable income of $6,167 for the year of income ended 30 June 1982, the applicant was obliged to distribute by way of dividend $2,997 in order to effect a "sufficient distribution" which would be sufficient to avert an assessment pursuant to Div. 7 of the Income Tax Assessment Act ("the Act").

2. The applicant company (borrower) was incorporated in the Australian Capital Territory on 17 June 1981. Its first income tax return embraced the fiscal year ending 30 June 1982 and by that return it disclosed that it had derived assessable income as follows:

PROFIT AND LOSS STATEMENT

                                                     $              $
      Interest from related corporations           397,316
      Interest from others                          35,299
      Rents                                         46,076      478,691
                                                   -------    ---------
      Unrealised exchange loss                     568,060
      Interest                                     455,567
      Other expenses                                16,907    1,040,534
                                                   -------    ---------
      Net loss                                                $(561,843)
                                                              ---------
    

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After adjustments for the exchange loss and other items, a taxable income of $6,167 was shown as having been derived for that year. That was not disputed. The Commissioner assessed the company on that basis as liable to pay income tax amounting to $2,836.82.

The balance sheet to the same date showed:

                                                       $                $
      Authorised capital                                             10,000
                                                                     ------
      Share capital and reserves -
      ISSUED CAPITAL                                                      2
      RESERVES                                                      436,295
      UNAPPROPRIATED LOSSES                                        (565,346)
                                                                   ---------
                                                                   (129,049)
                                                                   ---------
      Represented by -
      NON-CURRENT ASSETS
      Land and buildings                         1,250,000
      Plant, fittings and equipment                 56,519        1,306,519
      CURRENT ASSETS -
      Cash                                               2
      Other debtors                                  8,902
      Owing by holding company                   3,289,962
      Unclaimed borrowing expenses                  15,686        3,314,552
                                                                  ---------
                                                                  4,621,071
                                                                  ---------
      LESS NON-CURRENT LIABILITIES -
      Loans - secured                                             4,000,000
      LESS CURRENT LIABILITIES -
      Other creditors and accruals                 178,557
      Provision for income tax                       2,837
      Provision for proposed dividends                 666
      Provision for unrealised exchange loss       568,060          750,120
                                                                  ---------
                                                                  4,750,120
                                                                  ---------
      Net assets *                                                $(129,049)
                                                                  ---------
      

(^*The reference in the accounts to "net assets" followed by a figure presented in brackets - $() - seems to be the accounting equivalent of a legal fiction. The accounts showed that, to the extent of $129,049, the company lacked the means to discharge its liabilities notwithstanding the fact that freehold land had been brought to account "at directors valuation".)

3. Having assessed the company to income tax the Commissioner on the same day gave notice to borrower that a "sufficient distribution" for the purposes of Div. 7 of the Act was $2,997, being 90% of taxable income less income tax thereon ($6,167 less $2,836). The company disagreed and contended that the Commissioner had erred in treating the entirety of its income ($6,167) as having been derived "as income from property". The company contends that its income should have been treated wholly as "income from personal exertion" as defined by the Act.

4. The facts relevant to the difference between the Commissioner and the applicant are that a group of companies wanted to have the use of moneys which were available to be borrowed from overseas. It was decided that the applicant-company (borrower) should be incorporated with a view to it entering into a loan transaction whereby it would borrow those moneys from overseas. Having so borrowed, it would (inter alia) lend to other companies in

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the group. The borrowing from overseas was arranged. $A4,000,000 was borrowed pursuant to an agreement with an overseas entity ("lender"). The agreement was entered into on 13 August 1981. The parties to the agreement were the overseas entity which was to make available the funds ("lender"); the applicant ("borrower"); and other, identified companies within the group to which borrower belonged ("the guarantors"). It is quite unnecessary to recount in detail the terms of the overseas borrowing. It is sufficient to note that the borrowing was to be the equivalent of $A4,000,000 to be advanced in an overseas currency. Borrower was to be the person entitled to receive the moneys advanced and the person primarily liable to effect repayment. The other companies in the group who were parties to the agreement became liable as guarantors to answer for the "debt default or miscarriage" of borrower. To ensure performance of their obligations in the event of default in performance by borrower, the guarantors supported their covenants by providing securities by way of mortgage of real estate in favour of lender.

5. Having borrowed the $A4,000,000 - even though that might only have been possible with the assistance of the guarantors - borrower applied the moneys to income-producing purposes. In a single transaction it lent $3,289,961 to one of the guarantors. It lent other moneys at interest to unrelated corporations. It invested further moneys in the purchase of a block of partially equipped and furnished flats. The result was that by 30 June 1982 it is undisputed that borrower had derived assessable income by way of interest from the borrowing guarantor in the sum of $397,316 (83%); it had derived interest from unrelated corporations in the sum of $35,299 (7.4%); and it had derived rents of $46,076 (9.6%).

6. At later dates, by a novation, the loans within the group were reorganised so that instead of one company within the group being liable to borrower for the whole of the moneys borrowed and interest thereon, individual companies in the group became liable in varying amounts for both principal and interest. Later still the available balance of the original $4,000,000 was advanced on loan to individual borrowers within the group. Later again there was one further borrowing from overseas by borrower with the moneys again being on-lent within the group at interest.

7. The question for determination in this reference arises in the following way. Section 104(1) of the Income Tax Assessment Act ("the Act") provides:

"Subject to this section, a private company which is not, by section 105A, to be deemed to have made a sufficient distribution in relation to the year of income is liable to pay additional tax upon the undistributed amount at..."

Section 105A(1) provides:

"For the purposes of this Division, a private company shall be deemed to have made a sufficient distribution in relation to a year of income if it has, during the prescribed period, paid in dividends... an amount not less than the excess of the distributable income of that year of income over the retention allowance in respect of that distributable income."

Section 103(1) provides:

"In this Division, unless the contrary intention appears -

• ...
• `the distributable income', in relation to a private company, means the amount ascertained by deducting from the taxable income of the company -
  • (a) the tax payable under this Act... in respect of the income of the year of income;
  • (b)...; and
  • (c)...
• `the reduced distributable income', in relation to a private company, means the distributable income of that company reduced by so much of the amount of any income derived from property as is included in the distributable income;
• ...
• `the retention allowance', in relation to the distributable income of a private company of a year of income, means the retention allowance ascertained in accordance with section 105B in respect of that distributable income."

Section 105B provides:

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"The retention allowance of a private company in respect of its distributable income of a year of income is the aggregate of -

• (a) 70% of the reduced distributable income; and
• (b) 10% of so much of any income of the company (other than dividends received from other private companies) derived from property as is included in the distributable income."

In so far as those phrases incorporate reference to terms and phrases defined in sec. 6 of the Act it is necessary to have regard to that section. Section 6(1) provides:

"In this Act, unless the contrary intention appears -

• ...
• `income from personal exertion' or `income derived from personal exertion' means income consisting of earnings, salaries, wages, commissions, fees,... the proceeds of any business carried on by the taxpayer..., but does not include -
  • (a) interest, unless the taxpayer's principal business consists of the lending of money, or unless the interest is received in respect of a debt due to the taxpayer for goods supplied or services rendered by him in the course of his business; or
  • (b) rents or dividends;
• ...
• `income from property' or `income derived from property' means all income not being income from personal exertion."

8. In this case it is common ground (although it was not appreciated that that was so by the Commissioner until during the hearing) that the taxpayer did not carry on the business of a money-lender in the year of income ended 30 June 1981. To that date, apart from the temporary placement of funds not immediately needed for other purposes at interest with unrelated institutions, there was but one loan.

9. Rather the issue is whether in terms of the definition of "income from personal exertion" it can be said that "the taxpayer's principal business consists of the lending of money...". The taxpayer's contention is that from the date of the overseas borrowing, or at least from the date of the loan to the borrowing guarantor, it had most of its assets invested by way of a loan or loans of money either to related corporations or to unrelated institutions and, even excluding from account loans to unrelated institutions, most of its assets were tied up in the loan to one borrower; and that the moneys invested in income-producing activities other than loans (cost of land and buildings $873,950) were relatively small (21% of cost of assets - the balance being loans); and returned a lesser rate of return (5.3% - cf. 13% on loans); and represented less than 10% of its assessable income for the year.

10. The Commissioner's representative responded to that contention by proposing that, even if interest constitutes the larger and, indeed, predominant part of the taxpayer's assessable income so as to be its "principal" source of income, it does not follow that the actions of the applicant in the way of "lending of money" constituted a "business", let alone the "principal business" of the applicant. In that regard the respondent sought to find some assistance in pointing to the circumstance that it was always intended that the "end user" of most of the funds borrowed from overseas would be companies in the group other than borrower; that (as the documents show) "it was originally intended that the advance be made to (one of the guarantors) but at a late stage of the negotiations it was decided that the advance be made to (borrower)"; and that borrower could not have borrowed without the assistance of other companies in the group. Despite those considerations the fact remains that lender only advanced moneys to borrower. Furthermore, borrower was a distinct legal entity (albeit fictional) in its own right and not to be either confused or identified with other bodies corporate, even though they might be so closely related as to be considered to constitute a "group".

11. As to whether the scale of its activity was such as to warrant it being described as a "business", I find it unhelpful to consider "the primary production" cases or the "commencement of business" cases. The former group is largely given over to a determination as to whether a personally pleasurable activity is to be characterised as a

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"business" generating an entitlement to tax deductions; or as a "hobby" giving rise to no such entitlement. The latter group is largely concerned not so much with the question as to whether a "business" exists, as with the question as to "when" the business commenced. Neither is particularly helpful in considering the affairs of a legal fiction such as a limited liability company in relation to a transaction so closely allied to the generation of assessable income as lending money at interest.

12. The question of the interrelationship between the definitions of "income from personal exertion" and "income from property" in relation to "interest" was the subject of consideration in a decision of the Full Bench of the High Court of Australia in
Commercial Banking Co. of Sydney Ltd. v. F.C. of T. (1950) 81 C.L.R. 263. Although the issue which brought that matter before the High Court of Australia by way of appeal was quite distinct from the circumstances giving rise to this case, it was none the less necessary for the High Court to determine whether "the taxpayer's principal business consisted of the lending of money" and it arose out of a reference to "the income of the taxpayer derived from property..." as used in sec. 20 of the Commonwealth Debt Conversion Act 1931. Dixon J. said (at pp. 303-304):

"The meaning of the expression `income... derived from property' in s. 20(2) is perhaps not beyond dispute, but I think it must be taken to refer to the distinction made by the Income Tax Assessment Act applicable to any given year with reference to which an assessment must be made between income from property and income from personal exertion. It is true that that distinction is not relevant to the taxation of a company except during the times when a further tax was payable upon the taxable income derived by any person from property. It is also true that in one sense ultimately all deductions are allowable from the income of a taxpayer derived from property in the same sense as all deductions are ultimately allowable from his income derived from personal exertion. The distinction, however, must be made for the purposes of rate in the case of an individual. Obviously sub-s. (2) refers to a distinction existing for the purposes of administering the Income Tax Assessment Acts. The purpose of the distinction is immaterial. It is therefore necessary to turn to the definition of `income from property' contained in the Income Tax Assessment Act.

The definition is, of course, `all income not being income from personal exertion'. That throws one back on the definition of `income from personal exertion'. It includes the proceeds of any business carried on by the taxpayer. But there is a special exclusion of interest unless the taxpayer's principal business consists of the lending of money or unless the interest is received in respect of a debt due to the taxpayer for goods supplied or services rendered by him in the course of his business. I think that if a taxpayer is brought within what I may call the `unless' clause, that is the exception to the exclusion of interest, the result is simply that his case is not governed by the peremptory exclusion of interest from income from personal exertion. In other words, it is not an absolutely necessary consequence that the interest is derived from personal exertion. It just becomes a question to be decided by a proper application of the rest of the definition of `income from personal exertion'.

In the present cases the bank claims that it does come within the `unless' clause because it is a taxpayer whose principal business consists of the lending of money. This the Commissioner denies. The matter must in some degree depend on an analysis of the business of banking or of the business of this particular bank but in the end it depends less on this than upon a proper understanding of the meaning of the provision. It is, of course, true that the lending of money is a most important part of the general business of banking. It is also true that the business of banking considered as a separate business and not as forming simply one example of the business of lending money is not easily capable of definition. But the plain object of this particular provision of the definition is to allow a taxpayer the benefit of the rate for personal exertion where in truth the obtaining of interest is the substantial propose of his business, if the interest is obtained by the lending of money. When, in ordinary understanding, what in point of law is interest is in substance a profit dependent upon the pursuit of organized business

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activities it is income from personal exertion. The word `principal' is introduced in order to exclude incidental and subsidiary activities in a business, but if the chief part of the business from which the profit is obtained consists of the lending of money that is enough. A banker's business may be said to be that of dealing in money. A great part of organized banking consists in the performance of services for customers which result in the banker having at his command large funds. But, extensive and important as those services are, and indispensable as they are to the acquisition of funds, if it stopped at that the banker would make no profit. The profit-making side of his activities is in putting out the money so as to increase it, and that substantially means to obtain interest. If attention is riveted upon the relations of the banker to his customer and the amount of work done in that respect it might be thought that to say that the principal business consists of the lending of money is to ignore all the business done with customers whose accounts are in credit as well as much else besides. But if attention is riveted on the activities of banking in which the money is used or laid out it would seem correct to say that the decisively profit-making side of the business is concerned with the lending of money."

(The emphases are mine.)

13. It may seem strange to compare as lenders, companies with the scale of activity appropriate to a major trading bank with its vast number of short and long-term borrowings, large and small, and frequently fluctuating balances on the one hand and a lender such as the applicant with a single, fixed-term borrowing. But those contrasting considerations have little relevance. As Dixon J. said:

"... attention (must be) riveted on the activities... in which the money is used or laid out..."

The matters to be considered relate to the "lending" activity: not the "borrowing", and the question to be asked in relation to each taxpayer in business and earning income by lending money is whether the lending of money is that taxpayer's "principal business". On taking into account the fact that most of its assets were invested in the way of loans (c. 79%) and that, after setting aside the "incidental" loans of temporarily surplus funds, its major investment was still by way of lending money (c. 71% on balance sheet figures; and c. 78% on cost of assets) even though only one loan was involved, I conclude that "the taxpayer's principal business (did) consist of the lending of money".

14. I would uphold the objection of the applicant.