CASE 42/95

Members:
BJ McMahon DP

Tribunal:
Administrative Appeals Tribunal

Decision date: 17 July 1995

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BJ McMahon (Deputy President)

The applicant is a chartered accountant and is presently employed as a taxation consultant. In the 1988 and 1989 fiscal years, he had an investment partnership with another accountant associated with his professional firm who has since died. The partnership invested in an area of 40 acres upon which was planted a forest of radiata pine. The method of investment will be referred to later in these reasons. During the year ended 30 June 1988, the partnership incurred an outgoing of $140,000. The question to be determined in this application is whether the applicant is entitled to a deduction of $70,000 under sub-section 92(2) of the Income Tax Assessment Act being his half share of that outgoing in that year. A consequential matter arises for decision in relation to the 1989 year, when a carry forward loss was claimed and disallowed.

2. The deduction was claimed under s 51(1). It is the respondent's contention that the outgoing was of a capital nature and that accordingly it does not fall within the terms of that sub-section. In the alternative, the deduction is claimed under sub-section 51(2), the outgoing being said to have been incurred in the purchase of stock for use by the partnership as trading stock.

3. In 1987 the applicant became involved in the marketing of forestry interests. Through his accountancy firm, he was asked to assist in the taxation aspects of proposed ``private offer documents'' and a proposed prospectus for marketing forestry investments. In the course of this work he met an entrepreneur who gave evidence on the hearing of this application. The latter's evidence was that he had been involved in all aspects of the preparation, planting, maintenance and harvesting of plantation trees for more than 40 years. The applicant's evidence was that although he had picked up a knowledge of forestry processes through his taxation advisings, he relied entirely upon the entrepreneur to confirm yields, prices, markets and so on, in relation to particular proposed investments.

4. The plantation in question was brought to the attention of partners and managers in the accountancy firm by an associated company which had also had dealings with the entrepreneur. As a result of this information which was circulated in August 1987, the applicant and his investment partner had a number of meetings and discussions with the entrepreneur and with others associated in the general marketing proposals for plantations, such as the one the applicant had in mind.

5. A document was produced by the applicant which, he said, was prepared by the entrepreneur at one of their meetings. This was denied by the entrepreneur who did not recognise the document as being in his own handwriting. It was produced from the custody of the deceased partner's widow. I do not question the genuineness of the document. It may well have been prepared by one of the other accountants who attended the series of meetings and somehow found itself in the possession of the deceased partner. At any event, it illustrates what was in the applicant's mind and in the mind of his investment partner at the time the transaction was entered into.

6. The document indicates that there could be first thinnings on 20 acres of advanced trees which would net a certain income and first thinnings on another 20 acres of less advanced trees would bring in another stipulated net figure. The document indicates that these sums would be readily available as soon as the investment was made. In year 5, a further harvest would yield further moneys and in year 10, the whole of the remaining plantation could be clear felled and could be disposed of. It was clear from the applicant's evidence however, that although these matters may have been discussed, there was no fixed intention on the part of himself or his investment partner to make any of the exploitation choices that had been recorded. As he said in evidence: ``When we signed, our intention was to make a profit.

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We kept our options open. We might re-market, we might take off some trees, we did not know at that stage''.

7. During the course of negotiations, the entrepreneur told the applicant that the forest was one of the properties he was considering putting into his prospectus. He suggested that it might be possible, if the applicant and his partner took a lease, to realise a quick profit by marketing the forest in 5-acre lots through the prospectus. Alternatively, they could take the first thinning and then market the thinned forest through a subsequent prospectus in the 1989 tax year. Clearly these were also options that were considered. There is no evidence that the proposals were further advanced beyond the consideration stage.

8. The applicant and his partner determined to proceed and to decide upon methods of profit realisation subsequently. The question then arose as to the way in which the acquisition was to be structured.

9. The applicant believed that if the partnership purchased the freehold and onsold the trees through the prospectus, he and his partner could be assessable on the gross value of the trees with no deduction for their outlay. This would be because of the combined effect of ss 36 and 124J. The deductions for amortisation under the latter section are available only where trees are felled. It is not necessary for the purposes of this decision to examine whether the applicant's perception of the combined effect of those 2 sections was correct. It is sufficient to note that the decision to structure the acquisition in a particular way was largely driven by taxation considerations.

10. The applicant decided therefore that the transaction should be effected by way of lease. There is no question that the rental to be reserved under the lease corresponded with the estimated value of the trees. This had been independently assessed by an insurance company, as was noted at one of the meetings with the entrepreneur. The valuation was ultimately accepted by the applicant's bank which advanced the whole of the $140,000 to be paid in advance in the manner to which I will later refer. The correspondence between the total amount of rent and the value of the trees, is also supported by the evidence of the entrepreneur to which I will later refer.

11. The applicant's evidence was that he and his partner chose to prepay the rent because of the expectation that, one way or the other, they would receive a significant amount of income within a few months. That income would be sufficient to either repay in full a loan from the bank or to reduce it to a lower amount that could be repaid either out of their salaries, or at the latest, out of the second thinning 5 years after the investment commenced. He said: ``The way we saw it, we can either take a short term profit and get out within months or use the timber proceeds to clear the rent liability [ meaning the bank loan] no later than 5 years into the 20-year lease''. The bank loan may of course be viewed as a self-inflicted liability. Undertaking a debt to repay the bank an amount corresponding with the total amount of rent reserved in the lease, came about only because of a decision on the part of the partners to pay the rent in advance. There would have been no liability to clear if this course had not been adopted.

12. His evidence was that he was conscious of the taxation deductions available as the result of prepaying the rent, but that he and his partner were of the view that any tax advantages were not significant when compared with the commercial advantage of using the projected income to reduce long term rent liabilities. These liabilities were rent reserved of $7,000 per annum for 20 years. I find it hard to accept this reasoning and to agree that the transaction was predicated upon ordinary commercial considerations. This view is based not only upon the economics of the arrangement, but also upon the terms of the lease and other documents that were executed in connection with the investment. As will be seen, some of the elements of the lease are inconsistent with what the applicant now says was his contemporary intention when the lease was executed.

13. At the same time that they entered into the lease, the applicant alone took an option to acquire the freehold. In consideration of the sum of $100, the entrepreneur's company (the owner of the freehold and the lessor under the associated lease) granted the applicant an option to acquire the land for the sum of $1600, the option being exercisable on or before 30 June 1991, a period of some 3½ years after the date of both the option and the lease. The applicant's evidence was that the price, in his view, was a reasonable estimate of the value of the fee simple in reversion, due to the long term of the

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lease and the landlord's expectation that he would be receiving cleared land at the end of the lease. The applicant said that he took the option because he thought he might want to replant the forest after clear felling and that this was not practical within the 20-year term of the lease. His investment partner did not participate in the option because he was not interested in replanting. The relatively low option exercise price indicates that the great bulk of the value of the land and the trees upon the land, was reflected in the total rental payable, rather than in the value of the freehold reversion.

14. The applicant said that his understanding at the time of signing the lease was that the forest was to be maintained by another company associated with the entrepreneur. However, no formal maintenance agreement was ever executed. Some thinning took place later on apparently after many disagreements. There has subsequently been litigation between the applicant on the one hand and the entrepreneur and his companies on the other, concerning a purported exercise of the option to purchase and concerning representations said to have been made by the entrepreneur to the applicant. The applicant has continued to manage the forest since 1989, employing local contractors where necessary. Apart from the felling and sale of approximately 5 acres of timber in 1989, there has been no other felling. Some maintenance has been carried out, leaving the cuttings to rot in the forest. Some 60 to 70 per cent of the trees originally acquired, are still standing.

15. The entrepreneur's evidence was largely unchallenged and I have no reason to reject any of it. He said that his company had been prepared to sell the land to the applicant and his investment partner for $100,000. However, it was the applicant who had proposed that there should be a long term lease. There were commissions payable to the chartered accountancy firm and related companies totalling almost $40,000. It was therefore agreed that the rent would be set at $140,000. The entrepreneur added that it was the intention of the parties that the land would be clear felled (by which he meant the removal of all commercially saleable trees from the land) at some time in the future. A 20-year lease was chosen because it afforded the lessee the choice of deciding when to clear-fell the trees on the subject land. The sum of $140,000 also corresponded with the value of the trees in other forests of comparable age in the same area. At that time the value of the trees was between $3,500 and $4,000 per acre. The unimproved value of the land at the time, without trees, would have been approximately $200 to $300 per acre.

16. The registered lease created a leasehold estate in favour of the applicant and his investment partner without any reservation to the lessor company. The entrepreneur said that he took no part in the instructions that were given to solicitors for the drafting of the lease. He said that this was left to those who were generally involved in the forestry marketing venture in which the solicitors were engaged on the legal side. It does not seem to me to matter whether the lessees or the lessor ultimately have instructions to the solicitors. Both parties accepted the terms on an informed basis.

17. Clear felling is defined in clause I as follows-

``1.1.4 `Clear-Felling' means the act of removing all commercially saleable Trees from the Leased Land after not less than two Thinnings or such greater number of Thinnings as may be agreed between the Manager and the Lessee which is intended by the Lessee to be the final removal of the said Trees as a commercial crop and which takes place at the direction of the Lessee to the Manager which shall be deemed to have occurred if the number of Trees shall be reduced by such removal to less than < > Trees per hectare or the Trees have been removed from seventy-five per centum (75%) of the Leased Land.''

18. The significance of this definition arises from the use of the term in paragraph 4.1-

``4.1 The Lessor hereby covenants with the Lessee that subject to the Lessee paying the rental and duly and punctually observing and performing the covenants, obligations and provisions in the Lease on the part of the Lessee to be observed and performed the Lessee shall and may peaceably possess and use the Leased Land during the Term without any interruption or disturbance from the Lessor or any other person or persons lawfully claiming through, by, from or under the Lessor PROVIDED THAT this Lease shall terminate upon Clear Felling and shall terminate upon the expiration of a period of twelve (12) months after deemed Clear

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Felling within the meaning of that phrase in the definition.''

19. Thus although the lease was expressed to be for a term of 20 years, it was to terminate whenever the lessees removed commercially saleable trees from 75 per cent of the leased land. There was no ``manager'', as such, who fulfilled the role referred to in the definition of clear felling. The absence of such a function does not impair the operation of the definition nor does the failure to specify the minimum number of trees per hectare make the definition inoperable. Upon termination of the lease, no provision was made for refund of any rent paid in respect of a period subsequent to the termination.

20. Rental was reserved by clause 2 in the following terms-

``2. The Lessor hereby grants and the Lessee agrees to accept the Lease of the Leased Land to the Lessee who hereby accepts the Leased Land during the Term hereof and upon paying the rental as provided under the terms of this agreement PROVIDED THAT the Lessor shall accept the sum referred to in Clause 8 of the Schedule hereto in full satisfaction of all Rent reserved or to be reserved pursuant to the provisions hereof.''

21. Clause 8 of the schedule simply specifies the sum of $140,000. As an alternative, clause 3 provides for payment of the rent in the usual way over the period of the lease. Provision is then made for periodic rent review based on movements in the Consumer Price Index.

22. The lessees are obliged to take out appropriate insurance and did in fact do so. In evidence, the applicant agreed that if the trees were destroyed by fire ``it would be our loss most certainly''.

23. Although the applicant may have contemplated disposing of the partnership's interest at a profit by way of sub-lease through a prospectus, the lease does not seem to have been designed with that option in mind. Clause 3.14 provides-

``3.14 not without the prior written consent of the Lessor duly given which consent shall not be unreasonably withheld, assign, transfer, demise, or part with possession of the Leased Land or any part thereof or by any act, matter or deed procure the Leased Land or any part thereof to be assigned, transferred, demised, or put into possession of any person other than Lessee PROVIDED THAT the Lessee shall not sub-let any part of the Leased Land.''

24. There are obvious internal contradictions within the terms of this paragraph. The proviso is absolute in terms, whereas the opening prohibition is modified by reference to the consent of the lessor which is not to be unreasonably withheld. It seems more likely than not that the proviso was deliberately added to a standard clause.

25. The respondent contends that the payment of $140,000 was not made in respect of 20 years' possession of the subject property and was therefore not a pre-payment of rent in accordance with the terms of the lease. He says that the payment was to acquire an interest in the trees. Reliance is placed upon clause 4.1 of the lease which provides for termination upon clear felling without any provision for a corresponding partial refund of rent. The respondent also relies upon the evidence of the entrepreneur, the tenor of the discussions leading up to the investment and the subsequent use to which the land has been put. The respondent submitted that the partners intended to obtain the benefit of the continued growth of the timber whilst it remained standing on the land and, therefore, the payment was made in connection with the acquisition of an interest in land. Such a payment is a capital payment, it was submitted. It was further submitted that because the partners were under no obligation to fell and remove timber immediately or at any particular time over the 20-year term of the lease, the presumption that they were acquiring an interest in the timber as a capital investment was strengthened.

26. The applicant contends that the payment of $140,000 is a pre-payment of rent in accordance with the terms of a registered lease, and accordingly is not an outgoing of a capital nature.

27. I will now turn to the legal basis upon which each party relies to support these contentions.

28. The general legal rule is that a tenant may not commit voluntary waste. This concept involves some positive act of injury to the property, diminishing its value for the person next in succession. It is a deliberate and active change to the property. An example of voluntary waste would be the opening and working of a mine on the land (``Land Law'' -

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Butt, second edition paragraph 1025). Another example would be the taking of valuable timber from demised land. In the lease presently under consideration, there is no express permission to fell and remove timber. Clearly the right to do so, however, is implied in clause 4.1. It was generally agreed by all parties that the right existed. Both the applicant and the entrepreneur assumed that to be the case. Accordingly, the applicant obtained a right over and above the right of exclusive possession conferred by the creation of a leasehold interest. The partnership acquired a profit à prendre, which is defined as a right to enter the land of another and take away some part of the soil or of the produce of the soil (Butt at paragraph 1646).

29. The cases establish that no deduction is available for the cost of acquiring a profit à prendre. In
Nizich & Anor v FC of T 91 ATC 4747 at 4754 French J, after discussing claims related to expenditure to acquire an interest in land, referred to the cost of acquisition of lesser interests and referred to a landmark Privy Council decision. He said-

``A similar approach is reflected in cases dealing with the acquisition of interests in land, short of full ownership, be they rights of access or profits à prendre necessary to enable income producing activity to be carried on. In
Kauri Timber Co. Ltd v. Commissioner of Taxes (NZ) [1913] AC 771, the Privy Council held there could be no question that the acquisition of the right to possess land and cut and remove timber growing on it `was just as plainly a capital on cost as if the land, with the timber upon it, had been bought outright'.''

30. The pre-payment of $140,000 was, in my view, principally attributable to the acquisition of an interest in the trees. The fact that there was no obligation on the part of the lessees to remove the trees early in the term of the lease, the fact that the lessees themselves had no firm intention to remove the trees but had merely discussed the possibility as one of the options. the fact that the lease is to terminate upon clear felling, all point to the fact that the reality of the transaction was that the $140,000 represented a payment for an acquisition of an interest in the trees. This is supported by the evidence of the entrepreneur which I accept.

31. More importantly, it is supported by the way in which the amount of the rent was calculated. $7,000 per year would be grossly disproportionate to the value of the land without the trees. The rental was therefore calculated with reference to the benefit to be obtained from the forest. Although the partnership could have paid the rent annually, it was accepted in the course of negotiations, that a pre-payment would be made and for this reason special provision was made in the lease. In fact the lessor acquired title, gave the option and executed the lease all on the one day. No doubt the moneys paid by the lessees were required by the lessor for payment to the vendor. Thus the entrepreneur lessor obtained the lump sum which he had in mind as the sale value of the enterprise. He received his asking price whether or not the money was described in those terms.

32. The way in which the amount of the rent was calculated by reference to the value of the trees, is a matter properly to be taken into account in characterising the payment. This was acknowledged by Fisher J in
FC of T v Creer 86 ATC 4318 at 4324, second column. This consideration assists in determining the true nature of the transaction.

33. After referring to the well-known tests enunciated by Dixon J in
Sun Newspapers Limited v FC of T (1938) 5 ATD 87 at 96; (1938) (61 CLR 337 at 363) Gibbs ACJ in
FC of T v South Australian Battery Makers Pty Ltd 78 ATC 4412 at 4417 said-

``However the present case cannot be resolved simply by applying these tests. The real problem in the case is not to determine the character of the advantage sought, once it has been identified, but to decide what was the advantage sought by the taxpayer by making the payments. If the only advantage sought was the right to possession under the lease, and what was called `rent' really answered that description, clearly the outgoings were entirely of a revenue nature. If on the other hand one advantage sought by the outgoings was the acquisition of a capital asset (the land and buildings), the fact that the payments were called `rent', and were made periodically, would not necessarily prevent them from being in part outgoings of a capital nature - see
Colonial Mutual Life Assurance Society Ltd. v. F.C. of T. (1953) 89 C.L.R. 428;
Poole and Dight v. F.C. of T. 70 ATC 4047; (1970) 122 C.L.R. 427; and
A.P.A. Fixed Investment Trust Company Ltd. v. F.C. of T. (1948) 8 A.T.D. 369 at p. 371.''

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34. Commenting on this passage, Fisher J said in Creer at page 4324 second column-

``His Honour acknowledged that to call something `rent' does not conclude the matter, but that it was necessary to determine whether what was called `rent' really answered that description. Likewise as he said `the fact that the payments were called ``rent'' and were made periodically, would not necessarily prevent them from being in part outgoings of a capital nature'. Nor in my opinion does it conclude the matter to find that that which the taxpayer sought was the right to possession under a lease. I read the Acting Chief Justice as saying that it is only if that which is sought is a leasehold interest and also that which is paid is properly called rent, then and then only is the outgoing necessarily on revenue account.''

35. In my view the pre-payment described as rent does not really answer that description. The pre-payment was made for and in respect of an acquisition of rights as well as in respect of the right to exclusive possession. The value of the rights acquired, however, from a commercial point of view, far exceeds the value of the mere leasehold interest.

36. The facts in this case may be contrasted with the facts in 3 other cases involving pre- payments. They are
FC of T v Lau 84 ATC 4929,
FC of T v Solling and Pepper 85 ATC 4518 and
Brand v FC of T 95 ATC 4262.

37. In the lastnamed case, Nicholson J observed (at 4269) that voluntary pre-payment may not be unusual where the particular circumstances disclose a reason for pre- payment independent of securing a tax advantage. Some reasons were advanced by the present applicant in evidence. As I have indicated, I found them quite unconvincing. On the evidence before me, I have concluded that there was no commercial reason for making the prepayment except to gain a perceived taxation advantage.

38. The second distinguishing feature is that unlike the taxpayers in the other 3 cases, the partnership in this case sought and obtained a collateral advantage of a capital nature through the execution of the lease. As I have pointed out, the transaction granted a right to commit voluntary waste which would otherwise not have been available and which amounted to a profit à prendre - an advantage of a capital nature. The outgoing secured more than a mere right to exclusive possession of the land. What was said in these 3 cases, therefore, is of limited value in categorising the particular payment in this case. Here by pre-paying the rent, the character of the payment was changed from a deductible outgoing to a capital payment. That payment was made to acquire the profit à prendre which provided an enduring advantage to the applicant. Accordingly it is not available under sub-section 51(1) as a deduction.

39. Certain deductions by way of amortisation of the cost of acquiring a profit à prendre are available under s 124J upon the felling and removal of any of the timber. Although it was suggested by Professor Parsons (Income Taxation in Australia at paragraph 6.184) that s 124J may constitute a code which displaces s 51(1) where timber interests are concerned, I doubt that this is the case. Section 124J does not, for example, deal with the perceived inequities arising when timber is sold in an unfelled state. However, it is not necessary in the present application to consider this section and its effect on the present facts.

40. The alternative argument put by the applicant was that the $140,000 could be viewed as payment for trading stock. I have held that the payment was for or in respect of an interest in the standing timber. In my view, this could not constitute trading stock having regard to the lack of firm intention on the part of the partnership to take any of the timber within a reasonably short period after acquisition of the interest.

41. Professor Parsons summarises the position at paragraph 6.180-

``Deductibility of the payments in a
Stanton ((1955) 92 C.L.R. 630) situation is more doubtful. The payments may be deductible by reason of s 51(2) as costs of trading stock. A number of United Kingdom decisions and one Privy Council decision are relevant:
Golden Horse Shoe (New) Ltd v Thurgood [1934] 1 K.B. 548,
Stow Bardolph Gravel Co. Ltd v. Poole [1954] 1 W.L.R. 1503,
Hood Barrs v I.R.C. [1957] 1 W.L.R. 529,
Hopwood v C.N. Spencer Ltd (1964) 42 T.C. 169 and
Kauri Timber Co Ltd v C. of T. (N.Z.) [1913] A.C. 771. The issue as it appears in these cases is whether the payments are for a source from which the taxpayer may replenish his stock, or for stock which, conveniently, will be held

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where it stands until it is taken by the taxpayer. If the latter is the correct description the payments will be treated as costs of trading stock, and subject to deferral under s 28. Factors which point to the conclusion that the payments are costs of trading-stock are:

• (i) the passing of property to the taxpayer in the things - trees, blue metal, sand or gravel - to be taken from the land, if the property passes at the time of the agreement under which the payments are made;
• (ii) a short period within which the taxpayer is obliged or may be expected to remove the things from the land; and
• (iii) the circumstances that the things are `ripe' for taking.''

42. The fact is that pursuant to an intention formed at least 2 years after the acquisition, something like 12 per cent of the timber was felled. Subject to natural deaths, the remainder of the timber (less thinnings) is still standing almost 8 years after the acquisition. It seems to me that the forest can not be regarded in these circumstances as stock in trade, but rather as a source of trading stock. Payment for this source is not saved by sub-section 51(2) and remains a capital payment.

43. For these reasons the decisions under review are affirmed.