Case V30

Members:
PM Roach SM

Tribunal:
Administrative Appeals Tribunal

Decision date: 15 January 1988.

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P.M. Roach (Senior Member)

These references for determination before the Tribunal arise out of the affairs of a partnership as carried on during the years of income ended 30 June 1983 and 1984 by a married couple. During 1980 the applicants resided in their family home in suburban Sydney. He was employed as a technical officer in the State Public Service and she was fully occupied with her domestic duties. The couple had two children of pre-school age and, as commonly happens, a mortgage. They were looking for a suitable opportunity to enlarge the family income. They had in mind using the experience and talents of the wife as a trained primary/infants' teacher. To that end they looked for an opportunity to purchase a child-minding business or similar and their enquiries led them to become interested in the purchase of such a business opportunity in a suburb well distant from their then home. The opportunity arose in the way of the purchase of an existing developed site on a single title property. The site comprised a domestic residence and separate kindergarten premises licensed for 22 children. Having investigated the matter, they sold their existing residence. In doing so, they paid out the existing mortgage on that property and realised their equity of approximately $80,000. With that arranged they committed themselves to the purchase of the new property and business. Although the presentation of evidence was less than ideal, on balance, I am satisfied that they entered into a contractual commitment to purchase an estate in fee simple in possession in real estate held by way of registered title under the provisions of the Real Property Act 1900 at a price of $120,000; and that, in addition, they purchased the goodwill of the business and plant and equipment used in its operation for a further $20,000 - a total purchase price of $140,000. The purchase was made possible when they borrowed $68,000 from a credit union. The borrowing was secured on first mortgage of the real estate. I accept that, having regard to its

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location and the existence, proximity and use of the child-minding facilities, the new home was less valuable and less attractive than the former residence. I am also satisfied that they added to the ``partnership'' of marriage a new dimension. They also became ``partners'' in business in the sense provided for in both the Partnership Acts and the Income Tax Assessment Act 1936 (``the Act'').

2. The business made heavy demands upon the energies of the wife for very little return. For the years of income ended 30 June 1983 and 1984 respectively they found that, after paying wages to third parties $8,298 and $12,091; and allowing the wife a salary in each year of $7,600; and paying mortgage interest of $10,913 and $13,444, the partnership returned a net loss of $8,906 and $10,791 respectively which was apportioned between them equally.

3. In the latter part of the calendar year 1983, the husband was transferred in his employment to another part of the State. With that in prospect the applicants determined to sell the property and the business of the partnership and, after many months, they were successful in doing so. The husband left Sydney to take up his new position during December 1983 and on or about 18 December 1983 the wife and children vacated the home to make way for tenants. I find that from 18 December 1983 tenants occupied the former family residence and continued to do so until completion of the sale of the property. By 29 April 1984 a contract was entered into for the sale of the freehold at a price of $125,000; and for the sale of goodwill at $20,000 and of plant, fittings, chattels and fixtures at $5,000 - in all $150,000. The sale was finalised in July 1984.

4. When, in April 1984, the Commissioner assessed the 1983 income tax returns of the applicants, he substantially disallowed the claimed partnership losses and adjusted the returns of the applicants accordingly. The applicants objected. After considering the objections, the Commissioner partially allowed both and thereon advised the husband that his tax liability had been reduced and advised the wife that her taxable income had now been assessed at such a sum as did not attract any liability to tax. Both applicants requested that the decisions upon the objections be referred for independent review and both matters were duly submitted to the Tribunal to determine the only remaining question, namely whether the partnership would be entitled to claim a deduction in full for the mortgage interest paid of $10,913 instead of $5,457 only.

5. In relation to the 1984 returns of income both applicants objected to the action of the Commissioner in reducing to $6,722 the claims of the partnership to deduct $13,444 in respect of mortgage interest. After considering the objections, the Commissioner disallowed both. The Commissioner in due course referred to the Tribunal for determination a request from the wife that her objection be referred for independent review, but there was no such reference made in relation to the husband. There was some suggestion that the husband may not have been duly served with the notice disallowing his objection, but whether that be so or not, it is at least clear that nothing is presently before the Tribunal for determination in relation to the assessment of the husband to 30 June 1984. As the Commissioner's representative indicated at the hearing that three years had yet to elapse from the due date for payment of tax pursuant to the 1984 assessment against the husband, the right of the husband to make a request for a reduced assessment has been drawn to his attention.

6. At the hearing it was due to the attentiveness of the Commissioner's representative, that the circumstance that the residence had been let from 18 December 1983 forward was brought under notice. As a result, at the conclusion of the hearing it was conceded for the Commissioner that so much of the interest paid as was attributable to the period 18 December 1983 to 30 June 1984, should be wholly allowed.

7. Be that as it may, the case for the applicants is put on the basis that the partnership - not the individuals - is in any event entitled to a deduction for the entirety of the interest paid. They say that they had invested the bulk of the equity realised from their former home in order to provide themselves with a new residence and, to the extent necessary, had borrowed other moneys - the whole of the moneys borrowed - for no other purpose than to acquire and conduct the partnership business. Conversely, the Commissioner contends that, in so far as the freehold which the individuals purchased and over which they gave security for the moneys borrowed was applied indifferently to private purposes (as a residence) and income-earning

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purposes (as a site for the business), there should be an apportionment and that that apportionment should limit the deduction to 50% of the expense incurred. That basis of apportionment relies on the view of the husband that the total outlay of $140,000 should be apportioned as to residence $70,000; nursery premises $50,000 and nursery goodwill $20,000. An alternative view of the matter might be to consider apportionment on the basis that, as to $20,000, a deduction should be allowed as if to that extent the moneys borrowed were applied in the purchase of goodwill; and as if the balance of the borrowings were applied in the purchase of the freehold title.

8. The Commissioner's representative proposes that the present case is indistinguishable from the circumstances considered in Case B11,
70 ATC 46 and argues that therefore the claim should be refused. In that case the taxpayer - an individual - had owned and occupied a private residence. He decided to purchase a new home but not to sell the former home, although the proceeds of its sale would have been sufficient to enable him to purchase the new residence. Instead he borrowed moneys on the security of the old home and used them to purchase the new residence. As had been his intention when he decided to retain the former home, he leased it on an income-producing basis. He claimed a deduction in relation to the interest paid under the mortgage on the now income-producing property. The Taxation Board of Review held - correctly in my view - that the application of the principles laid down by the High Court of Australia as long ago as 1926 in
F.C. of T. v. Munro (1926) 38 C.L.R. 153 required that the claim be disallowed. The moneys borrowed had been used, not to generate income, but to provide a private residence.

9. In Munro the taxpayer carried on business in Melbourne and, in the course of that business, used land and premises there for income-producing purposes. The taxpayer then formed a new company to pursue new income-producing purposes. To raise capital for the new company he borrowed from the bank. He did so using the Melbourne properties as security. Of the $60,000 so borrowed he loaned $20,000 to the new company free of interest; he caused $36,000 to be paid to the company for shares to be allotted to his sons as gifts and took up shares for himself with the remaining $4,000. Under the legislation of that time, sec. 25(e) of the Income Tax Assessment Act 1922 prohibited the deduction of ``money not wholly and exclusively laid out or expended for the production of assessable income''. For that reason alone the taxpayer's claim failed. However, Isaacs J. said at pp. 197-198 that:

``The taxpayer had already acquired and held his property (in Melbourne) as a rent-producing property to the full extent. Nothing more was necessary to gain or produce that income. Then he chose for his own purposes quite alien to that property to borrow money and incur a personal obligation to repay it with interest. So far, also, the property stood complete as a rent-producing instrument. But because he secured his personal debt by means of that complete rent-producing instrument he contends that the discharge of the obligation was `actually incurred in gaining or producing' the rentals it yielded. The simple position is that the property and its rentals existed before the loan and remained intact and unaltered after the loan. Had the money borrowed been expended on the property so as to increase the rentals or so as to prevent depreciation which would have reduced the rentals, then it could have been properly said that the interest had been a means of gaining or producing the assessable income. But in employing the borrowed money for purposes independent of the property, leaving its condition entirely unaffected, that result cannot be postulated.''

What was of critical importance was not the nature of the security for the borrowing, but the use to which the borrowed money was put.

10. Since that decision it has been clear that if a taxpayer borrows against income-producing assets in order to apply moneys to private purposes, the interest costs are not deductible. It matters not whether the private purpose is the acquisition of a private residence, a yacht or a racehorse. On the other hand, the interest paid on moneys borrowed and applied to income-producing purposes will be deductible whether the borrowing be secured or unsecured and, if secured, whether secured against private or business assets.

11. The result is that, if either applicant in these references had retained his old home and

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borrowed against it for the purpose only of acquiring the business, he would have been entitled to a deduction for the interest incurred. Again, if he had invested the proceeds of sale of the old home in the purchase of a new home and then borrowed on the security of the new home to purchase only the business, there would have been a similar entitlement. Conversely, if the old home had been sold and the proceeds of it used by the individual to first purchase the business; and the individual then had borrowed in the fashion of Munro against the assets of that business in order to purchase a new home, the costs of that borrowing would not be deductible. The same result would have arisen if he had only borrowed against the security of the new home or indeed had not provided any security at all.

12. That being so, it follows that when a person has enough money to only buy a residence or an income-producing asset, and has to borrow to be able to hold both the sequence of transactions can be of critical importance in the determination of tax entitlements and obligations. Indeed, very fine considerations of timing could be the turning point. But as Munro illustrated, the test is to be measured by reference to the application of the moneys, not by reference to the character of the property used to provide security for the borrowing.

13. If either applicant in this case had been able to purchase the business premises with borrowed funds without selling their original home, the Commissioner accepts that he would have been entitled to succeed. So, too, if he had purchased a new home with the proceeds of the old and then borrowed to purchase the business premises, using the new residence as security for the borrowings, the Commissioner accepts that he would have been entitled to succeed.

14. But as the representative for the Commissioner pointed out, neither of those circumstances occurred. Nor did what occurred match any of the scenarios previously referred to in these reasons by way of illustration. What occurred was that the applicants jointly purchased an interest in fee simple in real estate. That land was in a developed condition suitable for use in part for business purposes and in part for either private purposes (as a residence) or for business purposes (by way of letting). Initially it was used both for business and private purposes. The moneys borrowed were secured against the entirety of that indivisible interest in land. However, that circumstance is not in my view of any major significance. If anything, it is a circumstance which obscures the key issue. The problem would have been the same if the borrowing had not been secured by any mortgage or by any mortgage against the interest in real estate, but only by the personal covenants of the borrowers.

15. The problem arising in the present circumstances arises because the borrowing came to form part of a pool of money with which the interest in fee simple was purchased. Because that interest was one and indivisible it was not possible to first complete the purchase relative to the residence with the unborrowed moneys and then use the borrowed moneys to purchase the business-related interest. For that reason it is contended for the Commissioner that the interest costs of the borrowed moneys must be attributed in due proportion to both the purchase of the residence and the purchase of the business.

16. Resolution of the problem as so presented would require recourse to the principles of apportionment laid down by the High Court of Australia in
Ronpibon Tin N.L. and Tongkah Compound N.L. v. F.C. of T. (1949) 78 C.L.R. 47 and, more particularly, the principles stated to be applicable when the item of expenditure in question serves two objects indifferently. I have recently set forth at some length particulars of that decision and of the principles to be gleaned from it (cf. Case V15,
88 ATC 177). I do not repeat them here. It suffices to say that the responsibility of the Tribunal in such a case is to determine as a matter of fact ``what part or proportion (of the interest) is fairly and properly attributable to gaining assessable income''.

17. In making that finding, I am conscious of the apparent harshness of an approach which, by reason of nothing more than the limitations of legal concepts as to the indivisibility of a particular title to land, would deny them the deductions they otherwise might have had. On the other hand, I bear it in mind that the same problem would have arisen - as in many respects it did in Ronpibon - had the land purchased been applied to two income-producing purposes - but with this distinction: that one purpose was to generate

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``assessable income'' and the other purpose to generate ``exempt income''.

18. However, that analogy draws attention to another matter. It is not something referred to in argument and is not the sort of matter which unrepresented taxpayers, without experience in the legal and taxation fields, would be likely to consider. The matter to which I refer is the circumstance that the borrowings of money, and the payments of interest flowing in consequence of them, were related to the partnership. That is significant because it must be remembered that Munro's case (ante) was not a case which turned upon the identity of the property over which security was given. It turned on the purpose and application of the borrowings. That test did not change because of the security given. In other words, it is more important to consider who borrowed the moneys, who used the moneys, who paid, and who was liable for the interest and how the moneys borrowed were used, than to consider what property was used to provide security for the borrowings.

19. In these circumstances, in so far as these applicants had a common interest in real estate, their legal relationship was no more than that of joint owners. In suffering that interest to be made available in part to be used for the purposes of a business - albeit a business conducted by themselves and so conducted in partnership - that relationship as joint owners did not change. But the relationship between the applicants in the conduct of the partnership business was a different relationship. In the course of that partnership each of them became accountable for the conduct of the other in circumstances where, but for the partnership, there would have been no such liability. Furthermore, had serious misfortune befallen either or both of them, such as might have resulted in bankruptcy, the significance of the difference would have become obvious. The rules laid down under the Bankruptcy Act 1966 (cf. sec. 141 et al.) for the identification of partnership rights and responsibilities and for determination of priorities between payment of creditors of the joint estate and creditors of the several estates of individuals would have made that distinction very real. That being so, it is appropriate to consider the evidence with those factors in mind.

20. I find that the goodwill, plant and equipment which was purchased for the business was purchased by the partnership, and was purchased with $20,000 borrowed by the partnership for that purpose. It became partnership property. The partnership borrowed that sum from or through the partners as individuals but on the basis which made the partnership liable to indemnify the individuals against liability for that interest. I further find that the balance of the borrowings were also made on the interest of the partnership and upon terms that the partnership was liable to indemnify the owners against liability to interest in relation to those borrowings so long as the partnership had the use of the required portion of the freehold premises.

21. Having so found, it is appropriate to say that those circumstances distinguish this case from Munro (ante). Further, that analysis of legal relationships accords with the understandable expectations of the parties. They had previously substantially owned a home. They transferred to another home of less appeal and value. If it could have been purchased separately it would have cost less than the equity they had in the previous property. In effecting the change they did, they were seeking to improve their financial situation. To what extent that would be achieved would depend upon their capacity to generate further net income which would exceed all the expenses of the borrowing to be undertaken. As they saw it, ``the business'', and only ``the business'', occasioned the cost of borrowing.

22. For those reasons I find that, as was claimed from the outset in the relevant returns, the partnership suffered the entire burden of interest on the borrowings and did so in such a way as to constitute the expenditure a loss or outgoing allowable pursuant to sec. 51(1) of the Act. Further, even if it should be considered that the interest liability constituted a loss or outgoing allowable pursuant to sec. 51(1) of the Act. Further, even if it should be considered that the interest liability constituted a loss or outgoing on the part of the applicants as distinct from the partnership, I determine that in these circumstances as a matter of fact the whole of the interest paid ``is fairly and properly attributable to gaining (the) assessable income''. Accordingly, the objections before me are to be upheld.