Risby Forest Industries Pty. Ltd. & Anor v. Federal Commissioner of Taxation

Judges:
Lockhart J

Court:
Federal Court

Judgment date: Judgment handed down 29 August 1988.

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Lockhart J.

There are three questions in these two appeals, being heard together by consent, which arise out of the payment of $89,328.60 by Risby Forest Industries Pty. Ltd. (``the company'') to its former managing director, Charles Arthur Risby (``Mr Risby''), on 31 December 1982. I shall, for convenience, refer to the company and Mr Risby together as ``the taxpayers''. Mr Risby retired in June 1982 as managing director of the company after 50 years service with it. The payment was expressed to be made in recognition of Mr Risby's contribution to the success of the company during those years.

The company claimed the amount of the payment to Mr Risby of $89,329 (to the nearest dollar figure) as a deduction for the year ended

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31 December 1982. The Commissioner disallowed the deduction on the ground that it did not qualify for deduction under para. 78(1)(c) of the Income Tax Assessment Act 1936 (``the Act'') or, alternatively, that the full amount of the payment was unreasonable under sec. 109 of the Act. The Commissioner also included the full amount of the payment to Mr Risby as assessable income in his hands.

The first question in these appeals is whether the Commissioner's exercise of discretion conferred by sec. 109 is liable to review on the ground that it was affected by a mistake of law or that he took extraneous reasons into consideration or excluded from consideration some factors which should have affected his decision, thus invoking the test formulated by Dixon J. in
Avon Downs Pty. Limited v. F.C. of T. (1949) 78 C.L.R. 353 at p. 360.

Section 109 of the Act provided, at the relevant time:

``109 So much of a sum paid or credited by a private company to a person who is or has been a shareholder or director of the company or a relative of a shareholder or director, being or purporting to be -

• (a) remuneration for services rendered by that person; or
• (b) an allowance, gratuity or compensation in consequence of the retirement of that person from an office or employment held by him in that company, or upon the termination of any such office or employment,

as exceeds an amount which, in the opinion of the Commissioner, is reasonable, shall not be an allowable deduction and shall, for the purposes of this Act other than the purposes of Division 11A of Part III and Division 4 of Part VI, be deemed to be a dividend paid by the company on the last day of the year of income of the company in which the sum is paid or credited.''

It is common ground that sec. 51 is not available as a source of deduction to the company of the payment of $89,329 and that the only source of deductibility could be para. 78(1)(c) which allows a deduction of:

``(c) Sums which are not otherwise allowable deductions and are paid by the taxpayer during the year of income as pensions, gratuities or retiring allowances to persons who are or have been employees or dependants of employees, to the extent to which, in the opinion of the Commissioner, those sums are paid in good faith in consideration of the past services of the employees in any business operations which were carried on by the taxpayer for the purpose of gaining or producing assessable income.''

The Commissioner conceded at the hearing that all elements of para. (c) were satisfied and that, if sec. 109 is inapplicable, then the company is entitled to the deduction claimed.

The second question is whether the receipt by Mr Risby of the sum of $89,329 answers the description of a dividend paid to him by the company out of profits derived by it from any source (para. 44(1)(a) of the Act).

The third question arises if the second question is answered in favour of Mr Risby. This question is whether the receipt by Mr Risby of the $89,329 is of the nature of income within the scope of subsec. 25(1) or is of a capital nature.

The nature of the receipt by Mr Risby is not necessarily determined by the nature of the payment by the company. If sec. 109 operates to deny the company the deduction otherwise available under para. 78(1)(c), the payment is deemed to be a dividend paid by the company, but not necessarily deemed to have been paid out of profits (see
F.C. of T. v. Comber 86 ATC 4171; (1986) 64 A.L.R. 451 per Bowen C.J. at ATC p. 4173; A.L.R. p. 452, per Fisher J. at ATC p. 4177; A.L.R. p. 458, per Lockhart J. at ATC p. 4180; A.L.R. p. 462). If the payment is truly characterised as a payment out of the company's profits then the deemed dividend paid to Mr Risby will be a dividend paid by the company out of profits within the meaning of para. 44(1)(a) of the Act and, therefore, will be assessable income in his hands. If sec. 109 does not apply to deny the deduction to the company and to deem the payment a dividend, and the payment is made otherwise than out of the company's profits the character of the receipt in Mr Risby's hands may be of an income or capital nature, a question to be answered by the facts of the case.

The facts

Risby Forest Industries Pty. Ltd. (``the company'') was founded in 1844. It has always

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ATC 4686

been a family company. The great-grandfather of the applicant, Charles Arthur Risby, was the company's founder and there has been continuous family involvement with the company since then. Mr Risby's great-grandfather, grandfather and father were all managing directors of the company. Mr Risby was managing director of the company from 1957 until he retired from that position in 1982 after 50 years service with it. He was then 65 years of age. Mr Risby's eldest son, Anthony Risby, succeeded him as managing director of the company.

The company is the parent company of certain subsidiaries. The company changed its name from Risby Brothers Proprietary Limited to its present name in 1968.

The company has always been involved with the timber industry. The activities of the company have included timber getting, saw-milling, timber processing, the sale and distribution of timber products and road construction.

Mr Risby joined the company in 1932 during the great depression. At that time the company was not prospering, and it ran at a loss for about a decade. The turnover at that time was $60,000 to $70,000 per annum. On Mr Risby's retirement in June 1982 the company's turnover was in excess of $14m. per annum.

In the late 1930s, following his initial employment in the company's dispatch office, Mr Risby was appointed to the position of manager of the company's Collins Street Saw and Planing Mills and Joinery Factory and he retained that position until he left on war service in 1941. He returned from war service in 1945 and took up his previous position together with additional responsibility for the saw-milling and forestry side of the company's business. In 1950 he was appointed manager of the company's total operations which included its retailing division, and was given responsibility for the development of a new division called Interstate Marketing.

Economic conditions during the 1950s were favourable for the company's business and Mr Risby played a major role in expansion of that business, controlling and managing all the company's operations. The company's success in expanding its business occurred particularly in relation to its interstate trade. During that period the company substantially increased its market share and profitability. Mr Risby was appointed managing director in 1957 and the expansion in the company's activities continued thereafter.

Mr Risby worked on average in excess of 50 hours a week for many years including the period of his appointment as managing director. He said that he cannot recall ever being absent on sick leave.

As well as his direct involvement with the company as managing director, Mr Risby was involved in the timber industry over many years including membership of the Tasmanian Timber Association Executive for some 14 years; of the Radiata Pine Council of Tasmania, of which he was the first chairman and in which he served two terms; and the Australian Radiata Pine Association. He was involved in conferences relating to the timber industry. He was deputy chairman of the Rural Fires Board and chairman of the Hobart Special Fire Area from 1968 to 1975. Mr Risby held positions in various companies, with which the company was connected, such connections resulting in financial benefits for the company.

It is plain that Mr Risby had considerable managerial skill and expertise and was a leader in his field of saw-milling, processing and marketing the products of hardwood timber. It is plain also that the company's affairs were managed conservatively for many years so as to build up its assets for the benefit of its shareholders.

During Mr Risby's term as managing director of the company he received a salary below the level appropriate to his expertise and experience. In 1982 he received a salary of $56,000, a figure below the salary which an executive outside the company would have been paid.

Mr Risby was a member of the company's superannuation schemes. The evidence is somewhat sparse as to the details of the schemes. Upon his retirement Mr Risby received superannuation benefits from three different funds to each of which he contributed, but the principal contributions to which were made by the company.

Certain ``Keyman'' life assurance policies over the life of Mr Risby were taken out by the company in 1968 with the AMP Society. This was done on the suggestion of the AMP Society

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ATC 4687

and was a hedge for the company against the possibility of Mr Risby's death before he retired from the position of managing director. It was an amount intended for use by the company as an offset against any increased salary which it would have had to pay to obtain a suitable external senior executive. It was also intended to be applied towards payment of other costs which would result from Mr Risby's death including the costs of further staff training and of searching for a new senior executive or executives.

After Mr Risby retired as managing director of the company, its board decided to pay him the surrender value of the ``Keyman'' insurance policies as a gratuity in respect of his long service with the company. Under the ``Keyman'' insurance scheme three policies were taken out. The risk commenced on 7 June 1968 and the total sum assured by all three policies was $150,000. The total annual premium in respect of the policies was $6,159.66. The premiums were regularly paid by the company to maintain the policies and their surrender value steadily increased over the years until they were surrendered on 20 September 1982 after Mr Risby had retired as managing director. The total amount received by the company, following surrender of the three policies, was $89,328.60. This was received on or about 21 September 1982 and paid into the company's general bank account. The company did not claim any deductions for income tax purposes in respect of the premiums paid to the company to maintain the policies.

The minutes of a meeting of the board of directors of the company held on 1 September 1982 record:

``It was resolved that the key-man insurance policies entered into by the company on the life of Mr C.A. Risby should be surrendered. It was further resolved that the proceeds, expected to be approximately $90,000, should be paid to Mr C.A. Risby on his retirement in recognition of his contribution to the success of the company during his fifty years of service.''

That board meeting was attended by Mr Anthony Risby (Mr Risby's eldest son) as acting chairman, Mr J.L. Risby (another son of Mr Risby), two other directors and the company's secretary. Mr Risby did not attend the meeting; nor did he play any role in its deliberations or decisions that day. Nor did he seek or induce the company or the board to make the payment in question in these proceedings to him. He said it would have been improper for him to have done so and I accept his evidence as truthful. Mr Risby was aware that the company's board proposed to discuss the question of paying him a gratuity, but he did not know when the meeting would be held.

On 31 December 1982 the sum of $89,328.60 was paid by the company to Mr Risby by crediting that amount to his deposit account with the company. Although he retired as managing director in June 1982 he has continued to serve as chairman of the company.

Mr Risby holds a substantial number of shares in the capital of the company. One of the company's largest shareholders is a family company (Mawhera Investments Pty. Limited) in which Mr Risby holds 25% of the shares, his wife 25% and his three children (2 sons and a daughter) equally between them the remaining 50%.

In addition to his salary as managing director, Mr Risby was provided from time to time with a motor car which, for the last twenty years, has been a Mercedes-Benz. He usually retained each car for about five years and it appears that the cars were purchased and sold on terms favourable to the company. He has retained the use of a company car since his retirement as managing director. As noted above, he is still the chairman of directors.

During the last 12 or 14 years of his office as managing director Mr Risby travelled overseas at the company's expense about seven or eight times, generally in the conduct of the company's business affairs. His wife travelled with him on about half of those overseas visits which were for periods of approximately four to six weeks.

The assessment process

The evidence relating to the process of assessment of the taxpayers and the disallowance of their objections is the key to some of the issues in the case, so it is necessary to recite it in some detail.

The solicitors for the taxpayers wrote a letter dated 11 December 1987 to the Australian Government Solicitor in these terms:

``We note that one matter in issue in these proceedings is the alleged formation of an

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opinion by the Commissioner that the amount in dispute was an excessive benefit within the meaning of Section 109 of the Act.

We seek full particulars of the following:

• (a) The facts, matters and things taken into account by the Commissioner in forming his opinion;
• (b) The reasons for the formation of the opinion by the Commissioner; and
• (c) The process by which the Commissioner reached his opinion.''

The Australian Government Solicitor furnished those particulars by letter dated 30 December 1987 which reads as follows:

``Re: Risbys

I refer to your request for particulars dated 11 December 1987. You have requested particulars as follows and I answer as follows:

• (a) The facts, matters and things taken into account by the Commissioner in forming his opinion.
• The Commissioner took into account the following matters:
  • (i) That on retirement, the company or superannuation funds controlled by it paid to C.A. Risby:

          Long service leave and
            holiday pay                               54,130
          Risby Forest Industries Staff
            superannuation plan                       52,896
          Risby Bros. Super Fund                     141,444
          Risby Bros. Provident Fund                 123,533
          Retiring gratuity                           89,329
                                                     -------
                                                     461,332
                      

  • (ii) The Group Certificate issued to C.A. Risby by the company for the year ending 30 June 1982 shows a gross salary of $56,284.00.
  • (iii) Income Tax Ruling IT 294 at para. 16 sets out the method of calculation of the maximum benefit considered reasonable by the Commissioner in terms of Section 23F(2)(h) of the Income Tax Assessment Act (ITAA).
  • (iv) The appropriate calculation for a salary of $56,284.00 is 302500 + 2 (56284 - 53000) = 309068.
  • (v) The total payments made to C.A. Risby in terms of Section 223F(2)(h) [sic] was $316,872.00.
• (b) The reasons for the formation of the opinion by the Commissioner.
• Section 109 of the ITAA provides that a termination payment paid to a shareholder or director is deductible only to the extent to which the commissioner [sic] considers reasonable. The reasonableness of such a payment is measured against the Commissioner's guidelines under Section 23F(2)(h) to wit IT 294.

The Commissioner noted:

• (i) a reasonable payment in accordance with Section 23F(2)(h) is $309,068.
• (ii) the payment to C.A. Risby of $317,873 from the companies [sic] superannuation funds, and

the opinion was formed that the additional payment of $89,329 was in excess of that considered reasonable.

• (c) The process by which the Commissioner reached his opinion:
• The opinion in this case was formed by Ian Godden, a compliance officer, having regard to IT 294. On 12 April 1985 he put a submission to his supervisor, special examinations, Mr John O'Reilly. O'Reilly agreed with the view expressed by Mr G. Denehey, then Assistant Deputy Commissioner that a company assessment be issued to Risby Forest Industries Pty. Ltd. to exclude the amount of $89,329.60 [sic].
• This was excluded on alternate bases under Section 78(1)(c) or Section 109 of ITAA. The assessment was accordingly issued.

2. I enclose a copy of IT 294 for your reference.''

The reference to IT 294 is to Taxation Ruling IT 294 which is a Ruling of the Commissioner setting out:

``guidelines which will operate in the income year 1982-83, and subject to any

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necessary adjustments in subsequent years, for the purpose of determining the income tax deductions allowable for contributions by employers to superannuation funds established and maintained to provide superannuation benefits for employees and/or their dependants.''

The preamble to the Ruling states:

``It will be appreciated that the guidelines contained in the statement are in the nature of general rules appropriate to the general run of cases and are in no way intended to supplant the express provisions of the Income Tax Assessment Act. Cases may arise in which, because of particular circumstances, it would not be appropriate to apply the guidelines. Such cases will have to be determined in the light of their own particular circumstances.''

IT 294 also says that:

``4. These guidelines will apply only to superannuation funds that are exempt from income tax under section 23F of the Income Tax Assessment Act...''

Section 23F, prior to its amendment by Act No. 47 of 1984 and its subsequent repeal by Act No. 138 of 1987, exempted from income tax the income of certain superannuation funds including funds whereby:

``(h) the benefits that any employee has, or the dependants of any employee have, the right to receive from the fund are not excessive in amount having regard to -

• (i) the remuneration paid to the employee for services rendered by him to his employer;
• (ii) the period of the service rendered by the employee to his employer;
• (iii) the benefits, pensions and allowances that have been, are being or may be provided for the employee or his dependants from any other fund to which this section applies in relation to the year of income or has applied in relation to a previous year of income; and
• (iv) any other matters that the Commissioner considers relevant; and...''

As a result of a request made to the Commissioner pursuant to the Freedom of Information Act 1982 for copies of all documents held by the Commissioner which were relevant to the issues in this proceeding, the taxpayers received a number of documents which were in evidence before me. They are extensive and need not be set out in full. I propose to extract the most relevant material in those documents.

The opinion of an officer of the Commissioner which ultimately led to the assessments was formed by Mr Ian Godden, a compliance officer. In that memorandum Mr Godden described the general nature of the business of the company (para. 1) and the payments made to Mr Risby on his retirement (para. 2). He stated that the two questions to be answered were:

``(a) whether the full amount of partial payment of the gratuity is an allowable deduction to the company; and

(b) whether all or part of the payment is assessable in the hands of Mr C.A. Risby''

(para. 4).

He made reference to an interview with Mr Hugh Denny, the public officer of the company and the material that emerged therefrom (para. 5). He considered at some length the question whether the payment of the $89,329 ``qualified for deduction to the company'' and was income or capital in the hands of Mr Risby and referred in that connection to certain decisions of Income Tax Boards of Review. He concluded that from his understanding of Case R104,
84 ATC 692 that para. 78(1)(c) and subsec. 109(b) operated in tandem: ``i.e. the reasonable amount is calculated under sec. 109(b) with sec. 78(1)(b) restricting the deduction to the company to that amount'' (para. 11).

Paragraphs 12 and 13 of Mr Godden's memorandum read as follows:

``(12) This case does not however make it clear as to whether or not one section can be operated alone i.e. use sec. 78(1)(c) to reduce the claim while leaving the payment to the individual untouched as a retirement gratuity taxable under sec. 26(d).

(13) In either case the payment must be examined to see whether it was paid in `good faith' in consideration of past services and what is a reasonable amount. Comment in CCH Vol. 3 page 22,773 paragraph 38-425 indicates that the words `in good

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faith' mean no more than `real' or `genuine' as opposed to `colourable' or `a sham'. Turning again to CCH Vol. 4, in calculating reasonableness of remuneration, such matters as period of employment, size of gratuities generally paid, past services which have gone unrecompensed for lack of funds, and the company's profitability should be taken into account. Page 32,574.''

In para. 14 Mr Godden referred to a letter from Price Waterhouse & Co., the company's accountants (dated 22 March 1985) which he summarised.

The letter from Price Waterhouse is in the following terms:

``We refer to your recent enquiries to the company secretary regarding ex gratia payment made to Mr C.A. Risby on his retirement.

The factors that the directors took into account in resolving to pay Mr Risby this amount are as follows:

• 1. As a major shareholder and Managing Director in the Family company Mr Risby had never drawn a salary commensurate with the position he held and responsibility he carried. For example an ordinary Mill Manager recruited on the open market about the time of Mr Risby's retirement was paid $34,000 p.a. compared to $56,000 paid to the Managing Director.
• 2. Mr Risby was an acknowledged leader in the Timber Industry and at one time the chairman of the Forestry Commission remarked that Mr Risby's only problem was that he was so far ahead of his contemporaries.
• 3. Mr Risby was responsible for the turnover of the company increasing from $5,000,000 in 1979 to over $12,000,000 in 1983 and profits in 1983 exceeded $1,000,000 which was far above the industry average for that year.
• 4. Investment by the company at Mr Risby's instigation in Tasmanian Softwoods Pty. Ltd. and Tasmanian Pulp and Forest Holdings Pty. Ltd. proved very profitable to the company, after initial difficulties were overcome largely due to Mr Risby's skill.
• 5. Funds for the payment were provided by a Key Man Insurance Policy, the proceeds of which were not required as Mr Risby had successfully planned for a successor for himself as Managing Director.

In the light of the above the directors felt an obligation to provide a further sum to Mr Risby as a gratuity over and above his superannuation entitlement.''

The memorandum of Mr Godden continued from para. 15 as follows:

``(15) From a perusal of the file it appears that Mr C.A. Risby has been Managing Director of the company since the mid-sixties so he has had a number of years to raise the profitability to an extent where the company could pay him a reasonable wage. Since the year ended 31 December 1980 the taxable profit figures have been: tax years 1981 - $675,086; 1982 - $515,623; 1983 - $9,476; 1984 - $319,222 (returns are lodged on calendar year basis i.e. 1980-83). The 1983 figure is as a result of the $89,329 payment. It is considered that a reasonable salary could have been paid during these years if it was considered warranted. Acceptance of this type of argument leads to the situation whereby associated directors could forgo reasonable salaries (and the tax bills) in the expectation of receiving handsome gratuities at retirement date which attract tax on only 5%. In fact this was the reason for the introduction of sec. 109(b).

(16) It should also be noted that the method for calculation of maximum end benefit for lump sum purposes had not changed for a number of years prior to 1983 tax year i.e. was based on the final average salary of the last three years of service. The end benefit could have therefore been influenced by salary increases in those years.

(17) There is nothing to suggest that the company was not in the position to pay more in the past years than it did. Rather it is felt that Mr Risby probably received fringe benefits such as motor vehicle, large company super contributions, trips away on company business etc., to more than recompense him for any perceived short-fall.

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(18) As mentioned in paragraph 13, CCH Vol. 4 states that factors such as length of service, past services which were unrecompensed should be considered. In fact the letter from Price Waterhouse appears to have touched every facet mentioned but without any real support e.g. while Risby's skill may have helped increase turnover between 1979 and 1983 what happened during the period from 1960s to 1979 when he was also M.D.?

(19) It is considered that there are no valid reasons why:

• (a) the salary of the managing director should have been kept down; and
• (b) why an extra gratuity, on top of the other retiring allowances paid, should be allowed as a deduction to [the] company.

Accordingly it is submitted that:

• (a) the gratuity of $89,329 is in consequence of the retirement of Mr C.A. Risby, and as it was paid after his date of retirement, cannot be allowable under sec. 51 i.e. not incurred in gaining or producing assessable income;
• (b) any amount allowable as a deduction will be allowed by virtue of sec. 78(1)(c);
• (c) the superannuation payment received by Mr Risby should be accumulated with the gratuity in deciding a `reasonable amount' to be deducted for a retiring allowance under sec. 78(1)(c) as in Case R104, 84 ATC 691;
• (d) the `reasonable amount' be the end benefit calculated by reference to the table in IT 294 and in this instance be accepted as $317,873 due to discussion between company and this office (actual calculation less than $310,000 for end benefit maximum);
• (e) the gratuity of $89,329 not be accepted as a `reasonable amount' and the amount not be allowed as a deduction under sec. 78(1)(c) i.e. argue that the amount is not being paid in good faith in consideration of the past services of the employee;
• (f) alternatively, that the amount is unreasonable under sec. 109(b); with the deduction being disallowed to the company and it being deemed to be dividends which leads to it being taxable in full in the hands of C.A. Risby;
• (g) for a decision as to whether sec. 109(b) has to be applied in this case or whether sec. 78(1)(c) can be invoked by itself. Case R104, 84 ATC 691 indicates that the reasonableness test can be done by sec. 109 with the deduction being disallowed by sec. 78(1)(c).''

The Commissioner issued his original notice of assessment to Mr Risby on the basis returned by him, namely, that 5% of the sum of $89,329 was assessable income pursuant to sec. 26(d) of the Act. A notice of amended assessment was issued to Mr Risby dated 22 July 1985 including the remaining 19/20ths of the sum of $89,329 as assessable income. Mr Risby lodged his objection on 7 August 1985 and notice of disallowance of the objection issued on 10 March 1986.

The Commissioner issued his notice of assessment to the company on 1 May 1985 denying the deduction of the sum of $89,329. The company objected by notice of objection dated 9 May 1985. The Commissioner disallowed the company's objection.

The process within the Australian Taxation Office, so far as is presently relevant, which led to the Commissioner's disallowance of the company's objection, may, like the assessment process, be spelt out from the documents which were produced by the Commissioner under the Freedom of Information Act 1982. Those documents include certain handwritten notes dated 11 June 1985 of an officer of the Department of Taxation which are in the following terms:

``Following the disallowance of a claim for $89,329 in respect of a retiring gratuity paid to Mr C.A. Risby, during the company's `83 financial year, the company has objected and advanced the following grounds in support of their deduction:

• (1) The amount is allowable under section 51(1) and/or section 78(1)(c).
• (2) It was a loss or outgoing incurred in gaining or producing assessable income and is an allowable deduction.
• (3) Alternatively it is a loss or outgoing necessarily incurred by him in carrying on business for the purpose of gaining or

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  ATC 4692

  producing assessable income and is an allowable deduction.
• (4) It is not a loss or outgoing of capital, or of a capital private or domestic nature.

Against the above and in support of our action the following points are made.

(1) [sic] There appears to be adequate case law to support the contention that a payment made `solely in consideration of past services... would not be deductible under section 51(1)' para. 1041, page 482, 1985 Australian Master Tax Guide and Case E3
T.B.R.D. Vol 5.

(2) [sec] According to the Minutes of the Directors Meeting held on 1 Sept 1982, the payment was made to `Mr C.A. Risby on his retirement in recognition of his contribution to the success of the company during his fifty years of service' fol. 4, INVE FILE.

(c) On the '83 company return, L30 and in C.A. Risby's individual return, Mr Risby retired on 30 June 1982. As the payment was proposed and paid after the retirement date and in respect of past services (refer fol. 24 INVE FILE in which a fuller list of reasons for the payment have been given) it cannot be argued that the payment was made for section 51 purposes.

(d) It is accepted that section 78(1)(c) is applicable and the payment is an allowable deduction under this section. Further it is accepted that the payment was `paid in good faith in consideration of the past services of the employee'.

(e) However section 109 has been invoked and the payment exceeds an amount which, in the opinion of the Commissioner, is reasonable when taken into account with the other amounts received by Risby at retirement viz. $317,873 (refer fol. 30 INVE FILE). Authority for combining all retirement receipts is per Case R104, 84 ATC 691 (copy fols. 5 & 6 INVE FILE).

It is therefore submitted

• (i) taxpayers have presented no new information which influences our original decision
• (ii) while the deduction is allowed under section 78(1)(c), the amount of the deduction is determined by application of section 109(b)
• (iii) amount of deduction allowed under sec. 78(1)(c) by virtue of s. 109(b) is `nil'
• (iv) objection be disallowed in full.''

It is para. (d) and (e) and the submission that follows them which are practicularly relevant to this appeal.

Those notes appear to be those of the relevant assessor. They may have been prepared on 6 June 1985: see the document which is Folio H5 in the documents produced under the Freedom of Information Act 1982. In any event, the officer who determined the objection recommended that it be disallowed in full.

Another officer looked at the matter on 8 July 1985 and Folio H5 bears a note:

``The objection adds nothing to the knowledge held when the original decision was taken. I can find no reason why that decision was incorrect.''

Another officer of the Department; who appears to have been the supervisor, Special Examinations, also looked at the matter and made a note (Folio H7): ``I agree that the objection should be disallowed in full''. In the result the company's objection was disallowed in full.

Also included in the documents produced under the Freedom of Information Act 1982 is a memorandum dated 26 June 1985 from the acting supervisor, Special Examinations of the Department of Taxation relating to Mr Risby's objection. The memorandum covers some 3.5 pages, the material parts of which read as follows:

``Deductibility of the payment by the company has been examined and it has been decided that while the payment was made in good faith in consideration of past services and therefore allowable under section 78(1)(c), the payment when taken in conjunction with other retirement payments received by C.A. Risby from super funds, exceeded an amount considered reasonable by the Commissioner under section 109(b). The claim for deduction of $89,329 has since been denied to the company. Support

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for this action is found in R104 84 ATC p. 691.

...

In this case the gratuity was paid in recognition of past services (per Directors Meeting minutes) and as a result of virtual underpayment for his contribution (per agents letter in support of payment, fol, 23-24 Inve File). As stated in R103 p. 685, the principle is the following `The test applied in those decisions was in substance whether the amount received in a lump sum was part of the consideration for the services rendered in the office or employment. If it was, then it was income although payment was deferred. If it was not, then it was a capital amount'.

The company has argued that the payment was for services rendered.

In view of the previous it is submitted please [sic]:

• (a) the payment is a deemed dividend per section 109(b);
• (b) as C.A. Risby was a resident shareholder, the first limb of section 44 is covered;
• (c) case law indicates that dividends may be paid from accumulated profits (income) even when `deemed' during a loss year - the second limb of section 44 is therefore satisfied;
• (d) alternatively, section 26(d) operates to exclude deemed dividends as a lump sum payment;
• (e) the reasons for the payment establish a relation between the payment and the taxpayer's employment sufficiently to catch the payment within the general conception of income; and
• (f) $89,329 is correctly assessable in full under section 25(1) and/or section 44.

In view of reversals of decisions it may be deemed expedient to obtain a ruling from Appeals and Advisings prior to the issuing of amended assessment.

For your decision.''

Other notes appear on the file relating to the Commissioner's consideration of Mr Risby's objection, but nothing turns on them for present purposes. Mr Risby's objection was disallowed.

It has not been easy, from the documents made available under the Freedom of Information Act, to place in chronological sequence the steps taken within the Department by its officers in the assessment process and in the process of considering the objections lodged by both the company and Mr Risby. The difficulty has been compounded by the fact that the Commissioner called no officers of the Department to give evidence.

The Commissioner's discretion

The first question is whether the company has established that, on the material before the Commissioner when exercising his discretion under sec. 109, he failed to consider the question to which the section is directed or made a mistake of law or took some extraneous reason into consideration or excluded from consideration some factor which should have affected his decision. This is the test formulated by Dixon J. in Avon Downs Pty. Limited v. F.C. of T. (1949) 78 C.L.R. 353 at p. 360 which has been consistently applied by the High Court and inferior courts in Australia: see, for example,
Giris Pty. Limited v. F.C. of T. 69 ATC 4015; (1969) 119 C.L.R. 365 per Barwick C.J. at ATC p. 4018; C.L.R. p. 374, and Windeyer J. at ATC p. 4024; C.L.R. p. 384;
F.C. of T. v. Brian Hatch Timber Co. (Sales) Pty. Limited 72 ATC 4001; (1972) 128 C.L.R. 28 per Barwick C.J. at ATC p. 4003; C.L.R. p. 45, Windeyer J. at ATC p. 4010; C.L.R. p. 57 and Owen J. at ATC p. 4011; C.L.R. p. 59, and
Kolotex Hosiery (Australia) Pty. Limited v. F.C. of T. 75 ATC 4028; (1975) 132 C.L.R. 535 per Barwick C.J. at ATC p. 4031; C.L.R. p. 541, Gibbs J. at ATC pp. 4048-4049; C.L.R. pp. 567-568 and Stephen J. at ATC p. 4054; C.L.R. p. 576.

The taxpayers chose to appeal to the Supreme Court of Tasmania rather than to seek a review of the Commissioner's decision before a Board of Review. The Administrative Appeals Tribunal has, since 1986, taken the place of the Boards of Review as the reviewing authority in taxation matters. If the company had elected to have the assessments reviewed by a Board of Review it would have been entitled to place before the Board any relevant material bearing on the question of the exercise of discretion by the Commissioner under sec.

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ATC 4694

109, and the Board would have stood in the place of the Commissioner in the exercise of statutory discretions under the Act. The question for the Board of Review would have been whether the decision of the Commissioner was the correct or preferable one in the circumstances of the case, or in effect how ought the Commissioner's discretion to have been exercised on the facts before the Board. By electing to appeal to a Supreme Court, the company placed itself in a position where it had to overcome the initial hurdle of establishing that the Commissioner's exercise of discretion miscarried in the sense mentioned in the Avon Downs case (supra). It is only after this has been established that the Court may reach its own conclusion on the material before it without referring the matter back to the Commissioner.

The following passage from the judgment of Gibbs J. in the Kolotex Hosiery case (supra) at ATC p. 4049; C.L.R. p. 568 defines the material which courts should consider when deciding whether a review of the Commissioner's conclusion is justified:

``[the court]... should consider the question on the basis of the material which was before the Commissioner even though further material is before the Court -
Federal Commissioner of Taxation v. Brian Hatch Timber Co. (Sales) Pty. Limited (1972) 128 C.L.R. at 59. However, it would appear to me that once it is decided that the conclusion of the Commissioner should be disturbed, for example, on the ground that it was based on error, it is right for the Court to reach its final conclusion as to whether or not the Commissioner ought to be satisfied by reference to all the material before the Court, because if the matter were referred back to the Commissioner to reconsider the question he would obviously be entitled and bound to consider all the information then available.''

The operation of sec. 78 and 109

Section 109 appears in Div. 7 of Pt III of the Act, a Division which relates to private companies. As was observed in F.C. of T. v. Comber (supra) the purpose of Div. 7 is to place additional obligations on private companies so as to discourage such companies from refraining from distributing income which, if received by an individual shareholder, would be assessable to tax at his or her personal rate (per Fisher J. at p. 456) and to prevent the avoidance of tax by accumulating profits in a private company (per Lockhart J. at p. 460). Section 109 is not the source of any deduction to a private company; it denies a deduction that would otherwise be available. Paragraph 78(1)(c) allows a deduction to a taxpayer when the taxpayer qualifies for the deduction by satisfying the tests mentioned in the paragraph. If the Commissioner considers that the payment by a private company, which would otherwise qualify for deduction under para. (c), exceeds an amount which in his opinion is reasonable then the constraints imposed by sec. 109 operate to deny the deduction to the extent of the excess, which for the purposes of the Act (other than certain purposes irrelevant to this case) is deemed to be a dividend paid by the taxpayer on the last day of the year of income in which the sum is paid or credited. There is therefore a plain nexus between para. 78(1)(c) and sec. 109. For a deduction to be allowable under para. 78(1)(c) the Commissioner must form the opinion that the sums in question are paid in good faith in consideration of the past services of the employees in any business operations which were carried on by the taxpayer for the purpose of gaining or producing assessable income. The Commissioner's power to form an opinion under sec. 109 that the relevant payment exceeds a reasonable amount is in terms unlimited since no criteria are specified governing the exercise of the discretion. Obviously the discretion must be exercised reasonably and in conformity with the purpose for which the power was conferred.

The formation by the Commissioner of an opinion under para. 78(1)(c) is discrete from the opinion which he may form under sec. 109. Once the integers specified in para. (c) have been established the relevant payment qualifies as a deduction. Section 109 may then operate to deny the deduction, but its application is not confined to para. (c). There may, however, be a degree of overlap in some cases between the factors to which the Commissioner has regard under para. (c) and the factors to which he will have regard under sec. 109.

I see no objection in principle to the Commissioner exercising his two discretions on the one occasion. Indeed, this would I should think be common practice with the

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ATC 4695

Commissioner's assessors. It was the course taken in the present case. However, where the Commissioner adopts this course, the risk of committing an error of law is increased because each of the two determinations under para. 78(1)(c) and sec. 109 is in the end separate from the other. It is only when the Commissioner has decided that the relevant payment was made in good faith in consideration of the employee's past services in the taxpayer's business operations that the deduction is prima facie allowable under para. 78(1)(c). The Commissioner may then consider that the deduction is denied because it is unreasonable in amount under sec. 109. As will emerge from my reasons for judgment below, the determinations under para. 78(1)(c) and sec. 109 must in law be made sequentially, and not in the alternative.

Identification of the decision under appeal

This case involves an unusual feature, namely, the task of identifying the relevant decisions of the Commissioner which are the subject of these appeals. Usually the decision under challenge is made in the assessment process and leads to the assessment itself. In the present case the decision of the Commissioner disallowing the company's claim for deduction was made and the notice of assessment was issued to the company denying the deduction. In the case of Mr Risby the notice of amended assessment was issued to him including the remaining 19/20ths of the sum of $89,329 as assessable income following a decision to that effect.

After objections were lodged by the company and Mr Risby the Commissioner considered them and disallowed them, though at different times. Since the objections were disallowed there was no necessity for any amended assessment (in the case of the company) or further amended assessment (in Mr Risby's case) to issue.

In my view the relevant decisions of the Commissioner in this case were those made by him when disallowing the objections, not when earlier issuing the assessments. It is the decision of the Commissioner disallowing a taxpayer's objection which the taxpayer may request the Commissioner to refer to the Federal Court (previously a Supreme Court) (sec. 187). The referral of the Commissioner's decision on the objection to the Court ``constitutes the instituting by the taxpayer concerned of an appeal against the decision'' (subsec. 189(3)). Similar provisions apply to references to the Administrative Appeals Tribunal (sec. 187 and subsec. 189(2)). Where the Court hears the appeal it ``may make such order in relation to the decision to which the appeal relates as it thinks fit, including an order confirming or varying the decision'' (sec. 199).

It is clear, therefore, that the subject matter of the appeals to the Court is the decision of the Commissioner on a taxpayer's objection. Emphasis is given to this point by the recent legislative history of sec. 199. Prior to its amendment by sec. 88 of Act No. 48 of 1986 which took effect on 1 July 1986, sec. 199, so far as relevant, read:

``... The Supreme Court hearing an appeal under section 197 may make such order as it thinks fit, and may by such order confirm, reduce, increase or vary the assessment.''

The precise ramifications of this amendment to the Court's powers in income tax appeals need not be considered in this case, but what the amendment highlights is that under the present form of sec. 199 it is the Commissioner's decision on the objection which is the substratum of the appeal.

The point is important in this case because there was a significant change in the reasons for the Commissioner's decisions disallowing the objections of the company and Mr Risby from his earlier reasons for denying the deduction to the company and including the sum of $89,329 in the assessable income of Mr Risby when assessing them to tax. For reasons which appear later, it is not possible to consider the later decisions of the Commissioner without reference to the earlier decisions. I turn first to these earlier decisions.

The Commissioner approached his task of assessment by considering together the application of para. 78(1)(c) and sec. 109. He adopted this course after considering whether it was permissible, and decided that it was permissible on the facts of the present case and in light of a decision of the Board of Review, Case R104, 84 ATC 691. That case has to be read together with the decision of the Board of Review in an associated matter reported as Case R103,
84 ATC 682. I have read both of these decisions. Although reference is made in

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ATC 4696

them to these two statutory provisions, I cannot discern from them support for the Commissioner's having adopted the course which he did.

The Commissioner had regard to Taxation Ruling IT 294, to which reference has been made earlier, which sets out ``guidelines'' to operate in the relevent income tax year for the purpose of determining deductions allowable for contributions by employers to superannuation funds established and maintained to provide superannuation benefits for employees and/or their dependants. The Ruling is not directly applicable to para. 78(1)(c) or sec. 109; but it deals with a closely related matter, and I see no objection to it being used by the Commissioner as a guide. It was not irrelevant to his task under sec. 109. The application of the table produced a figure of $309,068 as the maximum benefit permissible; but the Commissioner accepted that the excess of $8,805 (the difference between $317,873 and $309,068) was reasonable following discussions between the Commissioner's officers and officers of the company. The whole of the $89,329 was considered by the Commissioner to be unreasonable in amount under sec. 109.

The Commissioner did not slavishly apply Ruling IT 294, though it played an important part in his consideration of the matter before him. He had regard to the material before him including the letter from Price Waterhouse and the results of the discussion with Mr Denny, the public officer of the company. He also had access, of course, to his file in the matter. He formed the view that the salary of Mr Risby had been kept low and that the company had been in a position to pay him a higher salary in previous years than it had in fact paid him. The Commissioner concluded that Mr Risby received ``fringe benefits'' such as the use of a motor vehicle, large company superannuation contributions and overseas visits on company business and that they more than recompensed him ``for any perceived short-fall''. In all the circumstances the Commissioner concluded that there was no valid reason why the salary of Mr Risby had been ``kept down'' and why an extra gratuity in addition to the other retiring allowances paid to him should be allowed as a deduction to the company. The Commissioner formed the view that the whole amount of the payment in question was unreasonable under sec. 109 and failed to qualify for deduction under para. 78(1)(c). The Commissioner concluded that the amount of the payment in question was in all the circumstances so unreasonably high that it was not paid in good faith and in consideration of Mr Risby's past services to the company.

The evidence does not produce a clear picture as to exactly what the Commissioner did in forming his opinions. The reason for this is that the Commissioner chose to consider the application of para. 78(1)(c) and sec. 109 together and on the one occasion. It is clear, however, that he did not separate in his own mind (in referring to the Commissioner's mind I mean of course the minds of his officers who participated in the assessment process) the exercises required by each provision and failed to draw any relevant distinction between the two. In my opinion the Commissioner's decisions under para. 78(1)(c) and sec. 109 were erroneous in law.

Although as a matter of first impression it might appear to be open to the Commissioner to form an opinion that the amount of a payment is unreasonable under sec. 109 - for example, where the amount of the payment is so obviously excessive that it must be unreasonable - and deny a deduction on that basis without previously forming a view as to the deductibility of the payment under sec. 78(1)(c), there is authority to the contrary. In
W.J. & F. Barnes Pty. Ltd. v. F.C. of T. (1957) 96 C.L.R. 294, Fullagar J. observed that sec. 109 appeared to assume that there is an amount otherwise deductible under sec. 51 or para. 78(1)(c):

``and, to authorise the Commissioner, if he forms a certain opinion, to reduce the amount of the deduction in a case where the paying of the sum in question is to a shareholder or director of the company or a relative of a shareholder or director''

(at p. 306).

His Honour said (at p. 310):

``The important point is that s. 109 presupposes a payment which apart from s. 109 itself, would be an allowable deduction to the company. Unless there is a payment of that character, the Commissioner is neither commanded nor authorised to form any opinion under that section. It is the reasonableness of the payment as a reward

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ATC 4697

for services that he must consider, and it would be absurd to require him to consider that question if the amount paid were, as a matter of law and apart altogether from its reasonableness, not deductible.''

That case concerned the Commissioner's power to amend an assessment, but in reaching its conclusion the Court had to consider sec. 109 of the Income Tax Assessment Act 1936-1946, which was not materially different from the present sec. 109 as to the formation of the Commissioner's opinion. The Court also referred to para. 78(1)(c) of the Act, which in its then form, as at present, required the Commissioner to form an opinion as to the good faith of the payment. The remarks of Fullagar J. in relation to the scope of the Commissioner's authority indicate, not merely that the Commissioner need not form an opinion under sec. 109 that the amount of the payment exceeds a reasonable amount unless that payment was otherwise deductible, but that in his Honour's view the Commissioner would not be empowered to do so.

Kitto J. similarly proceeded on the basis that sec. 109 depended upon the Commissioner forming an opinion as to an amount that ``actually is an allowable deduction apart from the section'' (at p. 314), observing that the Commissioner could not form an opinion on which sec. 109 operated ``unless it can be affirmed that the payments to which it related were allowable deductions under s. 51 or s. 78(1)(c)'' (at p. 314). Dixon C.J. said that the application of sec. 109 presupposed that the payment to which it was applied was otherwise deductible, but indicated that in his view it was not necessary for the Court to determine whether the fact of payments being otherwise allowable deductions was ``a necessary condition of the application (of sec. 109) or even of so much of it as relates to allowability'' (at p. 303).

The reasoning of Fullagar and Kitto JJ. in Barnes' case has the consequence that the Commissioner is required, prior to directing his mind to the amount which would be a reasonable payment under sec. 109, to have concluded that the payment was otherwise deductible under sec. 51 or para. 78(1)(c). If para. 78(1)(c) were in issue, prior to reaching an opinion in relation to sec. 109, the Commissioner must have concluded that the payment was in fact made in good faith and in consideration of the past services of the employee to whom it was paid in business operations carried on by the taxpayer for the purpose of gaining or producing assessable income.

In
Henry Comber Pty. Ltd. v. F.C. of T. 85 ATC 4450 at p. 4456, Hunt J. rejected a submission that the amount paid by a private company could be tested by sec. 109 before it was tested by sec. 78(1)(c) as ``clearly wrong'', referring to Barnes' case as authority that ``sec. 109 operates only to take away what is elsewhere made an allowable deduction; until a payment is otherwise made an allowable deduction (such as by sec. 78(1)(c)), sec. 109 has no operation at all''.

In my opinion the Commissioner's alternative approaches and conclusions with respect to para. 78(1)(c) and sec. 109 vitiated the exercise of his power under sec. 109. Having concluded or ``argued'' that the payment was not made in good faith and, hence, was not deductible under para. 78(1)(c), the Commissioner was not authorised to form an opinion under sec. 109. The Commissioner relied on sec. 109 as an alternative without having first formed the opinion of deductibility that is an essential prerequisite to his forming an opinion under that section. The Commissioner later conceded good faith, and hence prima facie deductibility under para. 78(1)(c), but maintained a determination under sec. 109 which he was not initially empowered to make.

The Commissioner's decision under para. 78(1)(c) and sec. 109 are vitiated for another reason.

Mr Godden referred to the necessity for the payment to Mr Risby to be made in good faith in consideration of his past services in the company's business operations. He submitted that it could (or should) be argued that the payment was not so made (para. (e)). In my view the material before the Commissioner could not reasonably be said to support a finding that the sum of $89,329 was not paid by the company to Mr Risby in good faith in consideration of his past services in the company's business. It is a severe finding to make, or to suggest that it could or should be argued. A suspicion of absence of good faith surrounding the payment pervades Mr Godden's memorandum and inevitably, in my

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ATC 4698

view, coloured his submission that the deduction be disallowed. At some later stage, either in the assessment process itself or when consideration was being given to the company's objection, the Commissioner abandoned the finding of absence of good faith without any further material having been before him for consideration. As mentioned earlier, the Commissioner expressly disclaimed any absence of good faith at the commencement of this hearing.

As Mr Godden's views were expressed and submissions made without differentiating between para. 78(1)(c) and sec. 109 his findings based on absence of good faith tainted his ultimate recommendations as to both statutory provisions.

It is possible, though unlikely, that Mr Godden's submission that absence of good faith be ``argued'' was not accepted by his supervisor, Special Examinations, Mr John O'Reilly or by Mr G. Denehey, then Assistant Deputy Commissioner both of whom played roles in the decision to deny the deduction to the company (see para. (c) of the letter from the Australian Government Solicitor of 30 December 1987 mentioned earlier). If this were so, then it does not assist the Commissioner's case because there is no suggestion in the evidence that any of the Department's officers involved in the assessment process, except Mr Godden, made any analysis of the question of reasonableness of the payment under sec. 109 either at all or independently of Mr Godden's views and submissions, as expressed in his memorandum. The rational conclusion from the evidence is that Mr Godden's superiors simply accepted his views and submissions as to the reasonableness of the whole amount of the payment of $89,329, views and submissions which did not distinguish betwen para. 78(1)(c) or sec. 109, and which were formulated on the basis that the payment was not made, or that the Commissioner should argue that the payment was not made, in good faith.

If the relevant decisions with which this case is concerned were those made by the Commissioner when the assessments were issued they would have reflected error of the kind to which the Avon Downs case is directed. For reasons given earlier, the decisions with which this case is concerned are those made by the Commissioner when disallowing the objections of the company and later of Mr Risby. The evidence shows that, although the Commissioner no longer asserted absence of good faith with respect to para. 78(1)(c), he made no fresh or independent determination of the reasonableness of the payment of the sum of $89,329 as required by sec. 109. He simply adopted the earlier decision that the whole amount of the payment was excessive and unreasonable without undertaking a second and independent review of the question. I need not repeat the evidence concerning the decision-making processes which led to the disallowance of the objections except to mention the note on Folio H5 made by an officer of the Department of Taxation which states:

``The objection adds nothing to the knowledge held when the original decision was taken. I can find no reason why that decision was incorrect.''

I note that there was no material before the Commissioner when considering the objections of the company and Mr Risby additional to the material before him when making his previous decisions which led to the assessments.

Accordingly, the Commissioner's decisions on the objections were tainted by the same errors which vitiated his earlier decision under sec. 109 arising from his global treatment of para. 78(1)(c) and sec. 109 to which reference was made earlier, namely, the absence of differentiation between the two provisions in which the perceived absence of good faith was an element which led to the decision as to the payment being unreasonable.

I conclude this aspect of the case by saying that I have not examined the Commissioner's processes of assessment microscopically or with an eye eager to detect error. The processes of assessment must be examined carefully in tax appeals where the exercise of discretion by the Commissioner is the subject of challenge before the Court but not overzealously or minutely. Indeed the courts must approach this task, in my view, broadly and sensibly.

Consequences of disturbing Commissioner's exercise of discretion

Having found that the conclusion of the Commissioner that the payment of the sum of $89,329 was wholly excessive should be disturbed, I shall reach my own conclusion as to whether or not the Commissioner ought to be

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ATC 4699

satisfied as to the reasonableness of the amount of the payment made to Mr Risby by reference to all the material before the Court. The Commissioner conceded that, if his conclusion should be disturbed, the company is entitled to a deduction for the payment under para. (c). As in Kolotex Hosiery Australia (Sales) Pty. Limited v. F.C. of T. (supra), all parties in the present case put their submissions on the basis that, once this Court decides that the Commissioner has been in error, the appeal should be decided by the Court by reference to all the material before the Court.

I mentioned earlier that sec. 199 was amended by Act No. 48 of 1986 so that the Court's earlier power on hearing an appeal, to ``make such order as it thinks fit, and... by such order confirm, reduce, increase or vary the assessment'' was deleted and the present power to ``make such order in relation to the decision to which the appeal relates as it thinks fit, including an order confirming or varying the decision'' substituted. For the Court to reach its own conclusion as to whether or not the Commissioner ought to be satisfied, by reference to all the material before the Court, that the payment in question is or is not reasonable, in whole or in part, is in my opinion within the power conferred on the Court by sec. 199. The Commissioner did not contend to the contrary.

The material before the Court satisfies me that the Commissioner ought to be satisfied, by reference to that material, that the full amount of the payment of $89,329 was a reasonable amount to be paid by the company as an allowance or gratuity in consequence of Mr Risby's retirement from his office as managing director. I set out earlier the facts relating to Mr Risby's role in the company since he commenced employment with it in 1932. I will briefly restate the principal facts that lead me to the question that the amount of payment was reasonable.

The payment was not limited to the recognition of Mr Risby's contribution to the company's success during his period as managing director, that is since 1957, but was ``in recognition of his contribution to the success of the company during his fifty years of service'' (the relevant text of the board resolution of 1 September 1982). I pass over the early years of Mr Risby's association with the company as a junior employee. He held a responsible position in the late 1930s until he left on war service in 1941. He resumed his previous position, together with additional responsibilities in 1945 and continued in that position from 1950 when he became manager of the company's total operations. He was appointed managing director in 1957, a position which he held until he retired in 1982. From 1950 onwards the company's affairs prospered under Mr Risby's guidance and, in particular, the period after he became managing director saw a period of major expansion in the company's activities. He continued the company's policy of conservative management so as to build up assets which could be passed on and remain within the family through the shareholdings of the respective members of the Risby family. His involvement with organisations related to the timber industry also plainly advanced the interests of the company. Mr Risby obviously had considerable managerial skill and expertise and he received a salary distinctly below the level which would be paid to an outside executive performing a similar role to the role which he performed. Although Mr Risby was the highest paid executive within the company, I have a firm impression that Mr Risby and others associated with the company's management ran the company carefully and conservatively, including setting the payment of salaries of which the salary paid to the managing director was no exception.

In my opinion the gratuity paid to Mr Risby of $89,329 was a reasonable sum. The deduction of that amount should have been allowed by the Commissioner.

As sec. 109 does not apply it follows that the payment of the amount of $89,329 is not deemed to be a dividend paid by the company to Mr Risby.

The next question is whether the receipt of the amount of $89,329 by Mr Risby was of a capital or revenue nature. The character of the receipt in the hands of Mr Risby determines the answer to this question, but the character of the payment by the company cannot be ignored.

In my opinion the sum of $89,329 is properly characterised as having been paid out of the company's profits. The payment was made from the general funds of the company; but it corresponded in amount or substantially in amount with the proceeds of the surrender of

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ATC 4700

the ``Keyman'' life insurance policies taken out by the company over Mr Risby's life in 1968. It was a hedge for the company against the possibility of Mr Risby's death before he retired as managing director and was intended for use by the company to offset any increased salary that would have had to be paid to obtain a suitable senior executive from outside the family circle. It was also intended to be used to reduce other costs which would result from Mr Risby's premature death including the training of staff and searching for a new senior executive or executives to replace him. The company did not, however, claim the payments of premium by it in respect of the policies as deductions for income tax purposes.

Farwell J. said in
Bond v. Barrow Haematite Steel Co. (1902) 1 Ch. 353 at pp. 365-366 that the question whether there are profits available for distribution ``is to be answered according to the circumstances of each particular case, the nature of the company and the evidence of competent witnesses''.

As Gibbs C.J. observed in
F.C. of T. v. Slater Holdings Limited 84 ATC 4883 at p. 4888; (1984) 156 C.L.R. 447 at p. 460:

``In answering the question a starting point is provided by the well known definition of Fletcher Moulton L.J. in
Re Spanish Prospecting Co. Ltd. (1911) 1 Ch. 92 at 98: `Profits implies a comparison between the state of a business at two specific dates usually separated by an interval of a year. The fundamental meaning is the amount of gain made by the business during the year. This can only be ascertained by a comparison of the assets of the business of the two dates.'

I agree with the statements in
Re Income Tax Acts [No. 2] [1930] V.L.R. 233 at 245 and 250, that this dictum of Fletcher Moulton L.J. is not of universal application, and that each case must depend on its own circumstances.''

In my opinion, as the life policies were taken out by the company over the life of Mr Risby to meet what were perceived by its board of directors as being potential expenses of a revenue character, the fruits of the proceeds of the policy truly answer the description of profits of the company notwithstanding that they were received following the surrender of the policies rather than the premature death of Mr Risby.

My conclusion is not affected by the circumstance that during the income year ended 31 December 1982 the company experienced an accounting loss. The proceeds of the surrender of the life policies were received by the company from the AMP Society on 21 September 1982 and credited to an account ``Investments in Life Insurance Policies'' with the capital profit being brought to account as an extraordinary item in the profit and loss statement for the year. The sum of $89,328.60 was credited to Mr Risby's shareholder's deposit account following its receipt by him. The crediting of Mr Risby's deposit account was brought to account as an extraordinary item in the profit and loss statement for the year. In the end, the company had a taxable income of $9,476 (excluding the $89,329); a net profit became a loss of $123,855 but that was affected by unusual circumstances for the year; and the net assets were reduced for the year ended 31 December 1982. However, the payment was rightly treated by the Commissioner as having been made from accumulated profits.

I turn to the character of the receipt in Mr Risby's hands. Mr Risby retired in June 1982 as managing director of the company. The board resolved on 1 September 1982 that the policies be surrendered and that the proceeds be paid to Mr Risby ``on his retirement in recognition of his contribution to the success of the company during his fifty years of service''. The payment was made in fact on 31 December 1982. Although he retired as managing director in June 1982, Mr Risby remained chairman of the board. It is plain that he played no part in the decision of the company to pay him the gratuity in question in these proceedings. Mr Risby gave evidence, which I accept, that although he had some prior forecast that a resolution of the kind which was in fact passed would be passed he played no role in bringing about the result. It is very easy to be suspicious of payments made by family companies in these circumstances, especially when the new managing director of the company is the son of the person who is the recipient of the company's bounty. However, there is no suggestion of collusion between members of the family who were on its board, nor was there any improper conduct of any kind. Responsible people generally act responsibly and are well aware of the importance of remaining aloof

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ATC 4701

from decisions of corporations with which they are directly concerned from which they may receive benefit. Their aloofness is based as much on their desire to retain the respect of the other people involved in the decisions as any considerations of the law relating to fiduciary duties. That consideration is often overlooked these days when people are all too ready to imply covert understandings to decisions that are truly explicable on perfectly innocent grounds.

At any rate in this case the Commissioner has not suggested that the payment to Mr Risby was other than a voluntary payment made by the company to him in terms of the resolution which it passed on 1 September 1982, a decision in which he played no role whatever.

Mr Risby did not solicit the payment and he played no part in the decision to make the payment or in any calculation of the amount paid. There is no suggestion that Mr Risby had been prepared in earlier days to accept less than the salary which he deserved in anticipation of being paid a lump sum upon retirement to compensate him for that deficiency.

The receipt of the amount of $89,329 by Mr Risby was of a capital nature. It is common ground that in these circumstances sec. 26(d) of the Act (which was deleted from the Act by Act No. 47 of 1984) applied to include 5% of the amount of $89,329 in the assessable income of Mr Risby.

I would allow both appeals with costs. Although I make no formal order to that effect, I note the Commissioner's practice in cases of this kind is to issue an amended assessment to give effect to the Court's reasons for judgment.