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FLETCHER & ORS v FC of T

91 ATC 4950

Judges:
Mason CJ

Brennan J
Deane J
Dawson J
Toohey J
Gaudron J
McHugh J

Court:
Full High Court

Judgment date: Judgment handed down 14 November 1991


Mason CJ, Brennan, Deane, Dawson, Toohey, Gaudron and McHugh JJ: These proceedings involve a challenge to the correctness of 14 income tax assessments issued by the respondent Commissioner of Taxation (``the Commissioner'') to one or other of the four appellants (``the taxpayers'') in respect of tax years within the period 1982-1985 (``the tax years''). In each of the returns giving rise to the assessments, the particular taxpayer claimed a deduction for his or her share of the net loss allegedly sustained in the relevant tax year by a partnership called ``Annuity Investments Partnership No. 18'' (``the partnership''). In each assessment, the Commissioner disallowed the claimed deduction. Objections by the taxpayers against the assessments were all disallowed by the Commissioner. The taxpayers appealed to the Administrative Appeals Tribunal. The Tribunal (``the First Tribunal'') affirmed the Commissioner's decision in relation to each objection on the ground that the claim to the deduction should be disallowed pursuant to the general anti-avoidance provisions of Pt IVA of the Income Tax Assessment Act 1936 (Cth) (``the Act''). An appeal by the taxpayers to the Full Court of the Federal Court (Lockhart, Wilcox and Burchett JJ.) was upheld on the ground that Pt IVA had been either relied upon by the Commissioner in making the assessments or disallowing the objections nor raised in the course of the hearing before the First Tribunal. The consequence was that the decision of the First Tribunal was vitiated by a denial of procedural fairness. The Full Court (``the First Full Court'') ordered that the matter be remitted to the Tribunal for further hearing. An application to this Court for special leave to appeal from the decision of the First Full Court was refused.

When the appeals from the Commissioner's disallowance of the objections again came before the Administrative Appeals Tribunal, the Tribunal (``the Second Tribunal'') was differently constituted. No further evidence was led and the Second Tribunal dealt with the matter on the material which had been before the First Tribunal, making some further findings of fact upon that material. In their joint reasons for decision, the three members of the Second Tribunal stated that they were ``satisfied that there was ample evidence'' before the First Tribunal to found ``its decision with respect to the application of Pt IVA''. However, the Second Tribunal found it unnecessary to reach a decision of its own in


91 ATC 4952

relation to either Pt IVA or the more specific anti-avoidance provisions of Subdiv. D of Div. 3 of Pt III (in particular, s. 82KL) of the Act which had been relied on by the Commissioner at all stages of the proceedings. The Second Tribunal found against the taxpayers on the ground that certain outgoings of interest, which were the basis of the partnership's claimed net loss in each of the tax years, had not been deductible in any event. The taxpayers again appealed to the Full Court of the Federal Court (Lockhart, Wilcox and Lee JJ.). The argument before the Full Court (``the Second Full Court'') was confined to the question whether, putting to one side the effect of Pt IVA and s. 82KL, the outgoings of interest were deductible pursuant to the provisions of s. 51(1) of the Act. It was common ground that, if that question were answered in the taxpayers' favour, the matter would need to be yet again remitted to the Administrative Appeals Tribunal to deal with the outstanding questions relating to Pt IVA and s. 82KL. The Second Full Court held that the outgoings were not within s. 51(1) and dismissed the appeal. The present appeal to this Court is from the decision of the Second Full Court.

It should be mentioned that the Commissioner initially relied upon an argument that the contractual arrangements pursuant to which the outgoings of interest were made should be disregarded on the ground that they were ``shams''. Alternatively, the Commissioner relied on an alleged doctrine of ``fiscal nullity'' to disregard the effect of those arrangements. The arguments of ``sham'' and ``fiscal nullity'' were, however, rejected by the First Tribunal and the First Full Court and thereafter dropped out of the case. As has been seen, separate arguments based on Pt IVA and s. 82KL of the Act lie in the wings awaiting determination in the event that the taxpayers are held to be otherwise entitled to claim as a deduction their share of the partnership loss. It is common ground between the parties that the only question which now arises for the determination of this Court is whether, putting to one side the Commissioner's outstanding arguments based on Pt IVA and s. 82KL, the whole or some part of the alleged outgoings of interest should be treated as deductible under s. 51(1) of the Act in calculating the net income or loss of the partnership for the tax years.

The facts

Since an appeal to the Federal Court from a decision of the Administrative Appeals Tribunal lies only on a question of law,[1] the basic factual findings for the purposes of this appeal from the judgment of the Second Full Court are those made by the Second Tribunal. While the Second Tribunal made some additional findings of its own, it adopted the summary of the relevant facts which had been set out in the joint judgment of the First Full Court and which is now accepted as correct by all parties to the proceedings. Accordingly, the following statement of facts is, subject to some minor variations and additions, gratefully extracted from that joint judgment.[2]

The story commences in mid-1982. The taxpayers are two married couples, Mr. and Mrs. Fletcher and Mr. and Mrs. Dunlop. The four were partners in a business of subdividing and selling land at Killarney Vale on the Central Coast of New South Wales (``the land partnership''). Mr. Fletcher and Mr. Dunlop were builders and some lots were sold by the land partnership with houses already constructed upon them. Both the land partnership and the individual taxpayers employed the accountancy and taxation services of Mr. B.F. McGrath, a public accountant then practising in The Entrance (a Central Coast town) as B.F. McGrath & Co.

In late May or early June of 1982, Mr. McGrath had a meeting with Mr. Fletcher and Mr. Dunlop at which he showed them a brochure put out by a company named Annuity Investments Pty. Limited (``Annuity Investments''). The brochure advertised the availability of what it called ``Future Cash Benefits''. Three different ``investment plans'' were offered, spanning terms of 15 years, 20 years and 25 years respectively. They involved an initial investment of cash and subsequent transactions which included borrowings of money at substantial rates of interest and investment in the purchase of rights under an annuity agreement which would yield increasing annual payments over the period of the selected ``plan''. Features common to all three plans were that income tax deductions were said to be available in each of the first five years, that no further cash contributions would be required from the investor and that no


91 ATC 4953

money would be actually received back until the last five years of the plan. Mr. McGrath explained the contents of the brochure to the two men and expressed the view that tax benefits would be available to the taxpayers if they subscribed to one or other of the investment plans.

After discussion, the taxpayers decided to make an investment in the annuity scheme. On 23 June 1982, each couple completed an application to invest $25,000 - $12,500 by each taxpayer - in the scheme. The total investment of the taxpayers therefore amounted to $50,000. Each of the applications was for the 15-year plan. The applications were addressed to ``The Managing Partner, Annuity Investments'' at an address in Sydney. They were accompanied by bank cheques (totalling $50,000) for the subscription moneys and were sent to that address by Mr. McGrath. The address was the office of a firm called Crennan & Co., which held itself out as carrying on business as ``financial and taxation consultants''.

Evidence was given before the Tribunal by Mr. Malcolm Tucker of a Wagga Wagga (N.S.W.) firm of accountants called J.A. Crowl and Associates. He said that that firm, after taking actuarial and legal advice, had created a series of pro forma documents available to be used - ``put into the office word processor as a package'' - as needed in particular cases. Upon receipt of the investment applications signed by the taxpayers, Mr. Robert Watson of Crennan & Co. contacted J.A. Crowl and Associates. That firm then prepared the documents relating to the taxpayers. The documents included a partnership agreement, two loan agreements and an annuity agreement. The partnership agreement was sent to the taxpayers, through Mr. McGrath, for execution. The other documents were retained by J.A. Crowl and Associates.

The partnership agreement was in the form of a deed dated 30 June 1982. The parties to it were the taxpayers and a company named Jimal Nominees Pty. Limited (``Jimal'') which was associated with Annuity Investments. Upon execution, it established a partnership between them. The capital of the partnership was stated to be $50,001: $50,000 contributed by the taxpayers (in return for which they were each allocated 5,000 ``ordinary units'') and $1 subscribed by Jimal (in return for which it took one ``special unit''). Subject to a preferential payment out of profits of $1 per annum to Jimal, the taxpayers were to bear the profits and losses of the partnership in proportion to the number of ordinary units held, that is to say, in equal shares. The deed included a provision (cl. 21) appointing Jimal as the first Managing Partner of the partnership. Clause 23(1) provided that, subject to ``any resolution of a general meeting [of the partners] and to any regulation made or direction given by the committee [of management] the `Managing Partner' shall have control of the policy and management of the business of the partnership''. By cl. 23(3), the Managing Partner was ``empowered to enter into and sign contracts, arrangements and agreements of any nature whatsoever in connection with and incidental to the business of the partnership''. In particular, by cl. 23(4), the Managing Partner was empowered to borrow money for the purpose of carrying on the partnership business and to pledge the partnership assets by way of security.

The first of the loan agreements was between the partnership and a company called Doowarf Nominees Pty. Limited (``Doowarf'') which was also associated with Annuity Investments. Under it, Doowarf convenanted to lend to the partnership the sum of $2,000,000. Interest at the rate of 18 per cent per annum was payable by the partnership annually in advance. The capital was to be repaid, along with interest for each of the then current years, by three instalments due respectively on 30 June 1994, 30 June 1995 and 30 June 1996. The agreement was unusual in that it absolved the borrower from any personal liability for payment of either the principal sum or interest thereon. Clause 5 relevantly provided:

``5.(a) In order to secure to the Lender performance by the Borrower of his obligations under this Agreement, the Borrower hereby agrees to execute and enter into in favour of the Lender, upon the Lender's request and at the cost of the Lender, a charge and/or other security (as the Lender may require) over any property or interest in any property acquired by the Borrower with the principal sum or any part thereof, to secure repayment of the principal


91 ATC 4954

sum and interest provided for pursuant to this Agreement.

(b)...

(c)...

(d) The Lender hereby agrees that in the event of default by the Borrower any claim under this Agreement for either principal or interest repayments shall be limited to the value of the security taken under this Clause and the Lender shall have no further recourse against the Borrower in the event of any deficiency in the security.''

The effect of this agreement was to create an obligation to pay to Doowarf interest in the amount of $360,000 in each of the first 12 years of the 15-year plan. The interest liability was to reduce in subsequent years as repayments of principal were made. But it was not intended that the partners should themselves find the money required for payments of interest. That was to come from two other sources, namely, the second loan agreement and the annuity agreement.

The second loan agreement was between the partnership and a company called Eromdim Nominees Pty. Limited (``Eromdim'') which was also associated with Annuity Investments. This agreement provided that Eromdim would advance to the partnership on 30 June in each of the years 1982 to 1986 inclusive the sum of $190,000 together with the amount of interest then payable (to Eromdim) under the agreement. The interest payable by the partnership under the agreement was at the rate of 18 per cent per annum and was payable in advance. The principal of the Eromdim loan was repayable by instalments due on 30 June in each of the years 1992, 1993 and 1994. Once again, there was a clause - in the same terms as that in the Doowarf loan agreement - confining the rights of the lender in the event of default ``to the value of the security'' and absolving the taxpayers and Jimal of personal liability to repay the capital of the loan and interest thereon.

The annuity agreement was made between the partnership and Annuity Investments. It was a simple document whereby, in consideration of the payment to it of $2,020,000, Annuity Investments agreed to pay to the partnership the sum of $170,000 in each of the first five years following the agreement, the sum of $600,000 in each of the second five years and the sum of $1,119,000 in each of the final five years. The agreement contained an undertaking by Annuity Investments to redeem the annuity in whole or in part at any time after the expiration of 23 months from the date of the agreement; such redemption to be made within 21 days from the receipt of a notice of redemption given by the partnership. The redemption price was set out in an appendix to the agreement, being $24,000 at the end of year two and rising by specified steps to $80,000 at the end of year 10.

Mr. Tucker was, at the relevant time, a director of each of Jimal, Doowarf and Eromdim. Following its incorporation in April 1982 he had, for a short time, also been a director of Annuity Investments. The person acting as secretary of each of these companies, Mr. Trevor Hattersley, was an employee of Mr. Tucker's firm (J.A. Crowl and Associates). The annuity agreement and the two loan agreements were each partially executed in Wagga Wagga before 30 June 1982. On that day, Mr. Tucker drove to Canberra with Mr. James Crowl of the firm. He there completed the execution of the documents mentioned above. He also signed three bills of exchange which are relevant to this case.

The first bill was drawn on Doowarf by the partnership in the sum of $2,000,000. Doowarf accepted this bill. That was intended to be a payment by Doowarf to the partnership in satisfaction of the loan agreement between those parties. On behalf of the partnership, Mr. Tucker then endorsed the bill to Annuity Investments. That represented the bulk of the annuity purchase price. Annuity Investments then endorsed the bill back to Doowarf. That was in satisfaction of an arrangement between those two companies whereby Annuity Investments had agreed to lend Doowarf $2,000,000 for 15 years at 18 per cent interest. The second bill was for $190,000. It was drawn by the partnership on Eromdim and represented the first payment of loan moneys under the agreement between those parties. Eromdim accepted the bill and Mr. Tucker, on behalf of the partnership, then endorsed the bill to Doowarf towards payment of the first year's interest due from the partnership to Doowarf under the Doowarf loan agreement. Doowarf endorsed the bill to Annuity Investments which then endorsed the bill to Annuity Investments which then endorsed it to Eromdim. The third bill had a value of $170,000. It was drawn by the


91 ATC 4955

partnership on Annuity Investments, being the first year's annuity payment. This bill was accepted by Mr. Tucker on behalf of that company and endorsed to Doowarf in payment of the balance of the first year's interest due from the partnership to Doowarf under the Doowarf loan agreement. In turn Doowarf endorsed the bill back to Annuity Investments.

The effect of all this activity was that all three bills ended up in the hands of the original drawee so that nothing actually passed under them. The only money which did pass by the end of June 1982 was the $50,000 paid by the taxpayers. The bank cheques for that amount were paid into the bank account of Jimal which paid out the $50,000 to a company called Trans City Holdings Limited, a ``money market manager'', where it was held to the account of Annuity Investments. Of that amount, $30,000 was retained by Annuity Investments as an ``Establishment Cost''. The balance of $20,000 constituted the balance of the sum of $2,020,000 payable by the partnership to Annuity Investments as consideration for the grant of the annuity. The overall result of the actual payment of $50,000 by the taxpayers and of the ``round robins'' of bills of exchange was that a total of $20,000 was available for actual investment for the purposes of the overall ``plan''. Mr. Tucker gave evidence that, on 30 June in each of the years 1983, 1984 and 1985, he carried out similar ``round robins'' with bills of exchange, in order to effect the ``payments'' required by the two loan agreements and the annuity agreement.

The members of the First Full Court annexed to their joint judgment two documents which were in evidence before the First Tribunal and which summarised the effect, in terms of cash flow and perceived taxation ramifications, of the various transactions to which the partnership was a party. Copies of those documents constitute Schedule A (Cash Flow) and Schedule B (Taxation Ramifications) to this judgment. In so far as cash flow is concerned, Schedule A indicates that, ignoring the one dollar contributed by Jimal in 1982, the inwards flow of cash to the partnership tallied precisely with the outwards flow in the first 10 years (i.e. 1982-1991). During the final five years, the projected cash flow to the partnership would, if the scheme ran for that long, exceed cash flow from the partnership by $34,080 in each year (except in 1994 in which the projected ``cash surplus'' was $34,071). The taxation ramifications document (Schedule B) is concerned with the relationship between projected interest outgoings and projected annuity receipts in each of the 15 years of the plan. Presumably, no other revenue outgoings or receipts were expected. In it, the annuity income is adjusted to exclude the capital (or ``undeducted purchase price'') component of the receipts under the annuity agreement[3] and the interest outgoings are adjusted so as to include only so much of the total interest as should be attributed to the adjusted annuity income. Schedule B calculates the net income or loss of the partnership for tax purposes by reference to the excess or deficiency of adjusted annuity income when compared to the adjusted outgoings of interest. It discloses a projected and very substantial net loss (varying between $247,674 and $387,894) in each of the first five years, much smaller net losses (varying between $10,019 and $13,469) in each of the next five years and very substantial net income (varying between $504,250 and $854,236) in each of the last five years.

Was there any relevant outgoing of interest?

Before both the Second Tribunal and the Second Full Court, the case was conducted on both sides on the basis that, once the questions of sham and fiscal nullity were resolved against the Commissioner, the amounts payable under the loan agreements in respect of the tax years were properly to be seen as having been paid by the ``round robins'' of bills of exchange and as therefore being outgoings ``incurred'' by the partnership. The Second Tribunal and the Second Full Court dealt with the matter on the basis that so much was common ground. Thus, in its reasons for decision, the Second Tribunal referred to the purported payments of interest by the ``round robins'' as ``expenditure'', ``interest payments'' ``expenditures incurred by a partnership'' and ``outgoings''. The Second Full Court referred to the interest in the tax years in similar terms, expressly noting that the argument before it ``was confined to the question of the correctness of the Tribunal's decision that s. 51 did not operate to render the interest payments deductible'' (emphasis added). In this Court, the Commissioner sought to move from that common ground and to maintain that there were, in fact, no outgoings


91 ATC 4956

of interest incurred by the partnership in any of the tax years. The so-called ``loans'' by Doowarf and Eromdim to the partnership were, so it was argued, ``effected by `payments' which were not supported by cash'' with the consequence that ``[n]o advance of money was made upon which interest could accrue''. There is a short answer to that argument.

The fact that the relevant ``payments'' were purportedly made by ``round robins'' of bills of exchange which were not supported by equivalent amounts of cash and which all ended up in the hands of the original drawees does not, once arguments of sham and fiscal nullity are rejected, necessarily preclude those ``payments'' from being effective and legally binding. Depending upon the circumstances, they could constitute counterbalancing set-offs of credit and debit amounts. Prima facie, it would seem that they so operated in the circumstances of the present case. Whether they did is, however, a mixed question of law and fact. The Commissioner has, by his conduct of the case, allowed that question to be effectively resolved by default against him in both the Tribunal and the Federal Court. In the circumstances of these already over-protracted proceedings, it is now too late for him to raise the argument for the first time in this Court.

Partnership outgoings

Under Div. 5 of Pt III of the Act, a partnership must furnish a return of the income of the partnership in respect of a tax year but is not liable to pay tax thereon (s. 91). The net income or loss of a partnership for the tax year is calculated as if the partnership were a resident taxpayer, that is to say, by the subtraction of allowable deductions from assessable income (s.90). A resident individual partner's share of the ``net income'' or ``partnership loss'' so calculated constitutes assessable income or an allowable deduction for the purpose of calculating the taxable income derived or the loss (for tax purposes) incurred by that partner in the tax year (s. 92). It follows that the question whether the adjusted amounts of interest payable under the two loan agreements in the present case were wholly or partly deductible under s. 51(1) arises in the context of the calculation of the net income or loss of the partnership for tax purposes and falls to be answered on the basis that the partnership itself was a resident taxpayer. The interest of each of the taxpayers in the availability of that deduction is indirect in that it will be reflected in any ``net income'' or ``loss'' of the partnership to be shared among them - as assessable income or as an allowable deduction - for their tax purposes.

It was submitted on behalf of the taxpayers that, in considering whether the relevant amounts of interest were allowable as deductions in the present case, the Second Tribunal and the Second Full Court had mistakenly ignored the fact that that question arose in the context of the calculation of the net income or loss of the partnership for tax purposes in respect of the tax years. The Second Tribunal, so it was said, had mistakenly approached the question on the basis that what was involved was a claim by the taxpayers to a direct deduction of the outgoings in question. In our view, that contention should not be accepted. It is true that the reasons for decision of the Second Tribunal contain some statements which are worded in terms more appropriate to a consideration of a direct claim of a deduction for interest by the individual taxpayers. The language used by the Second Tribunal in that regard must, however, be read in a context where Jimal's entitlement was limited to a fee of $1 per year and where the practical impact of a partnership entitlement to a deduction would be felt in the resulting reduction or increase in each taxpayer's share of partnership net income or loss. In that context, it is not really surprising that the reasons of the Second Tribunal should speak on occasion as if individual partners would be directly entitled to the benefit of a partnership deduction notwithstanding that the strict position is that the partnership itself is entitled to make any such deduction in calculating its overall net income or loss and that it is that overall net income or loss which is shared among the individual partners.

Section 51(1) of the Act

Section 51(1) of the Act provides:

``All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a


91 ATC 4957

capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income''

(emphasis added).

Two introductory points should be made about s. 51(1). The first is that, as the words ``to the extent to which'' make plain, the sub-section contemplates apportionment. In their joint judgment in Ronpibon Tin N.L. and Tongkah Compound N.L. v. F.C. of T.,[4] Latham C.J., Rich, Dixon, McTiernan and Webb JJ. pointed out that there are at least two kinds of outgoings which require apportionment for the purposes of the sub-section:

``One kind consists in undivided items of expenditure in respect of things or services of which distinct and severable parts are devoted to gaining or producing assessable income and distinct and severable parts to some other cause. In such cases it may be possible to divide the expenditure in accordance with the applications which have been made of the things or services. The other kind of apportionable items consists in those involving a single outlay or charge which serves both objects indifferently.''

As their Honours also pointed out,[5] what represents the appropriate apportionment in the case of such items of expenditure is essentially a question of fact. The second introductory point to be made about s. 51(1) is that the reference in it to ``the assessable income'' is not to be read as confined to assessable income actually derived in the particular tax year. It is to be construed as an abstract phrase which refers not only to assessable income derived in that or in some other tax year but also to assessable income which the relevant outgoing ``would be expected to produce''.[6]

The taxpayers' reliance in the present case is upon the first limb of s. 51(1). That being so, the issue between the parties on this appeal resolves itself into the question whether, and if so to what ``extent'', the outgoings of the amounts of interest payable to Doowarf and Eromdim under the two loan agreements were, for the purposes of s. 51(1), incurred during the tax years by the partnership ``in gaining or producing the assessable income'' and were not ``of a capital, private or domestic nature''. As has been mentioned, the taxpayers restrict the amounts claimed as partnership deductions by excluding the proportion of the outgoings of interest which should be attributed to the non-assessable ``undeducted purchase price'' component of any annuity payments.

The question whether an outgoing was, for the purposes of s. 51(1), wholly or partly ``incurred in gaining or producing the assessable income'' is a question of characterisation. The relationship between the outgoing and the assessable income must be such as to impart to the outgoing the character of an outgoing of the relevant kind. It has been pointed out on many occasions in the cases that an outgoing will not properly be characterised as having been incurred in gaining or producing assessable income unless it was ``incidental and relevant to that end''.[7] It has also been said that the test of deductibility under the first limb of s. 51(1) is that:

``it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income.''[8]

So to say is not, however, to exclude the motive of the taxpayer in making the outgoing as a possibly relevant factor in characterisation for the purposes of the first limb of s. 51(1). At least in a case where the outgoing has been voluntarily incurred, the end which the taxpayer subjectively had in view in incurring it may, depending upon the circumstances of the particular case, constitute an element, and possibly the decisive element, in characterisation of either the whole or part of the outgoing for the purposes of the sub-section.[9] In that regard and in the context of the sub-section's clear contemplation of apportionment, statements in the cases to the effect that it is sufficient for the purposes of s. 51(1) that the production of assessable income is ``the occasion'' of the outgoing[10] or that the outgoing is a ``cost of a step taken in the process of gaining or producing income'' [11] are to be understood as referring to a genuine and not colourable relationship between the whole of the expenditure and the production of such income.

Nonetheless, it is commonly possible to characterise an outgoing as being wholly of the kind referred to in the first limb of s. 51(1) without any need to refer to the taxpayer's subjective thought processes. That is ordinarily


91 ATC 4958

so in a case where the outgoing gives rise to the receipt of a larger amount of assessable income. In such a case, the characterisation of the particular outgoing as wholly of a kind referred to in s. 51(1) will ordinarily not be affected by considerations of the taxpayer's subjective motivation. If, for example, a particular item of assessable income can be earned by making a lesser outgoing in one of two possible ways, one of which is a loss or outgoing of the kind described in s. 51(1) and the other of which is not, it will ordinarily be irrelevant that the taxpayer's choice of the method which was tax deductible was motivated by taxation considerations or that the non-deductible outgoing would have been less than the deductible one. In such a case, the objective relationship between the outgoing actually made and the greater amount of assessable income actually earned suffices, without more, to characterise the whole outgoing as one which was incurred in gaining or producing assessable income. If the outgoing can properly be wholly so characterised, it ``is not for the Court or the commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent''.[12]

The position may, however, well be different in a case where no relevant assessable income can be identified or where the relevant assessable income is less than the amount of the outgoing. Even in a case where some assessable income is derived as a result of the outgoing, the disproportion between the detriment of the outgoing and the benefit of the income may give rise to a need to resolve the problem of characterisation of the outgoing for the purposes of the sub-section by a weighing of the various aspects of the whole set of circumstances, including direct and indirect objects and advantages which the taxpayer sought in making the outgoing.[13] Where that is so, it is a ``commonsense'' or ``practical'' weighing of all the factors which must provide the ultimate answer.[14] If, upon consideration of all those factors, it appears that, notwithstanding the disproportion between outgoing and income, the whole outgoing is properly to be characterised as genuinely and not colourably incurred in gaining or producing assessable income, the entire outgoing will fall within the first limb of s. 51(1) unless it is either somehow excluded by the exception of ``outgoings of capital, or of a capital, private or domestic nature'' or ``incurred in relation to the gaining or production of exempt income''. If, however, that consideration reveals that the disproportion between outgoing and relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective and that part only of the outgoing can be characterised by reference to the actual or expected production of assessable income, apportionment of the outgoing between the pursuit of assessable income and the pursuit of that other objective will be necessary.

In the present case, the outgoings of interest in the tax years were incurred in the borrowing of money. The funds borrowed did not constitute assessable income. To the extent that the outgoings of interest incurred in the borrowing can properly be characterised as of a kind referred to in the first limb of s. 51(1), they must draw their character from the use of the borrowed funds.[15] That use was, in the case of the proceeds of the Doowarf loan, in the payment of the purchase price under the annuity agreement and, in the case of the proceeds of the Eromdim loan, towards the repayment of interest in respect of both the Doowarf and Eromdim loans. If the assessable income actually derived under the annuity agreement in each of the tax years had been at least equal to the actual outgoings of interest, there would, in the absence of any other deductible expenses, have been little difficulty in characterising those outgoings as wholly incurred in gaining or producing that assessable income. In fact, however, the assessable income derived from the annuity in each of the tax years was less than one-eighth of the adjusted outgoings of interest in that year.

The material before the Court does not disclose the precise chain of reasoning underlying the Commissioner's disallowance of the claim by each of the taxpayers to a deduction in respect of the alleged partnership loss in each of the tax years. Notwithstanding the rejection by the First Full Court of the arguments based on sham and fiscal nullity, the Commissioner apparently did not contend before either the Second Tribunal or the Second Full Court that there should be included in the assessable income of any of the taxpayers in respect of any of the tax years an amount


91 ATC 4959

representing a share of net income of the partnership in respect of that tax year. Nor did either the Second Tribunal or the Second Full Court indicate a view that any such amount should properly have been included in the assessable income of any of the taxpayers. In a context where the rejection of arguments of sham and fiscal nullity would appear to leave the partnership in receipt of assessable income (i.e. the adjusted receipts under the annuity agreement) and where there were no outgoings other than interest, it arguably follows that there is implicit in the decision of both the Second Tribunal and the Second Full Court the view that, in the assessment of the net income or loss of the partnership in each of the tax years, a deduction in respect of interest should be allowed to the extent of the amount of assessable income derived by the partnership in that tax year. Be that as it may, that is the approach which was adopted on behalf of the Commissioner in this Court where it was conceded that a deduction for interest outgoings should be made in the calculation of the net income or loss of the partnership to the extent necessary to produce a nil result. That concession was, in our view, properly made. As has been seen, the outgoings of interest represented the cost of the partnership's borrowing for the purchase of the rights under the annuity agreement. To the extent that the partnership's outgoings of interest in a particular tax year did not exceed assessable income actually derived by the partnership under the annuity agreement in that tax year, they are properly to be characterised as incurred in gaining or producing that assessable income and were therefore deductible (pursuant to s. 51(1)) in the calculation of the net income or loss of the partnership for tax purposes. Beyond that point, the mere relationship between outgoings actually incurred and the much smaller amounts of assessable income actually derived does not suffice, without more, to answer the question whether, and if so to what extent, the adjusted outgoings of interest are properly to be characterised as incurred in gaining or producing assessable income. That question must be answered by reference to a common-sense appreciation of the overall factual context in which the outgoings were incurred. It necessarily involves a consideration of the contents and implications of the overall contractual arrangements to which the partnership became a party and pursuant to which the outgoings of interest became payable. As will be seen, it also encompasses a consideration of the purpose which the members of the partnership, and those who advised them or acted on their behalf, had in view in incurring the outgoings.

The three agreements (the annuity agreement and the two loan agreements) to which the partnership became a party were carefully structured to give rise to a balanced or neutral cash flow during the first five years while giving rise to a very substantial surplus of adjusted interest outgoings over assessable income in those years (see Schedules A and B). As Schedule B indicates, the planned result was a very substantial partnership loss (for tax purposes) in each of the first five years and a proportionate tax deduction for the taxpayers in each of those years. In the second five-year period, the position projected by the two Schedules is that cash flow would remain neutral and that there would be a continued, but greatly reduced, excess of adjusted interest outgoings over assessable income with correspondingly reduced tax deductions for the taxpayers. The position of the first five years would, however, be drastically reversed during the last five years if the three agreements continued on foot during that period. Assessable income would greatly exceed adjusted interest outgoings, with the result that there would be very substantial partnership net income (varying between $504,250 in the eleventh year to $854,236 in the fifteenth year) which would represent assessable income to be shared among the taxpayers. That assessable income would, if actually derived, far exceed the comparatively small projected ``cash surplus'' of the partnership in each of the last five years ($34,080 in each of four years and $34,071 in the other year: see Schedule A). If an average marginal income tax rate of 30 per cent is assumed, the total tax payable by the taxpayers as a result of their shares of the partnership net income would, if the agreements were allowed to run their full course, exceed the partnership's projected ``cash surplus'' by well over $100,000 in each of the last five years.

In that context, it is not surprising that the agreements provided a mechanism whereby the adverse consequences to the taxpayers of the


91 ATC 4960

last five years of the ``plan'' could be avoided. As has been seen, in the event of default on the part of the partnership under the loan agreements at any time in the first ten years, the partnership would be under no liability to actually repay outstanding principal or to pay further interest. The entitlement of Doowarf and Eromdim would be limited by the express provisions of the loan agreements to recourse against ``any property or interest in any property acquired [by the partnership] with the principal sum or any part thereof'' of the relevant loan. The only property or interest in property which would answer that description would be the partnership's interest under the annuity agreement. In these circumstances, as the members of the First Full Court pointed out, it would ``clearly be advantageous'' to the taxpayers to ensure that the annuity and loan agreements did not run their full course. Indeed, it is difficult to avoid the impression that the whole structure of the ``investment plan'' was predicated upon an assumption that the various agreements would be effectively terminated at some time before the commencement of the last five years. In that regard, it is relevant to note that the evidence did not disclose how the $20,000 balance (being the result of the deduction of Annuity Investment's $30,000 fee from the amount actually invested by the taxpayers) could be expected to generate the projected surplus of about $34,080 of annuity receipts over all partnership outgoings which the partnership would theoretically be entitled to receive in cash in each of the last five years if the annuity agreement were to be permitted to run its full 15-year course. So to say is not to question the decision of the First Tribunal, confirmed by the First Full Court, that the agreements cannot be disregarded as shams. It is simply to recognise that the agreements were so framed that it lay within the control of the partnership effectively to terminate them prematurely and that it was clearly in the interests of the taxpayers to insist that the agreements in fact be terminated before the commencement of the eleventh year of the ``plan''.

If the adjusted outgoings of interest are, on a common-sense appreciation of all the relevant facts, properly to be characterised on the basis that they were made pursuant to contractual arrangements which were expected to be fully performed in accordance with their terms with the result that the total of the projected annuity payments would actually be received by the partnership, the total assessable income which the partnership would be expected to derive would exceed the total of the adjusted outgoings of interest by more than $1.7m (see Schedule B). On that basis, the adjusted outgoings of interest payable under the two loan agreements would properly be characterised as incurred in gaining or producing the totality of the assessable income payable under the annuity agreement over its purported 15-year term. So characterised, the adjusted outgoings of interest incurred in each of the tax years would be wholly deductible under the sub-section. On the other hand, if the reality of the situation be that the outgoings of interest were incurred on the basis that the three agreements would be effectively terminated at some time during the first 10 years of the 15-year ``plan'', the total of the anticipated adjusted outgoings of interest would far exceed the total of the anticipated assessable income under the ``plan''. On that approach, the excess of the adjusted outgoings of interest over assessable income in each of the tax years could not be explained by reference to surplus assessable income which was expected to be derived in subsequent years. To the contrary, it would be necessary to look for some other explanation of the planned expenditure of outgoings of interest which exceeded assessable income by more than $2.7m in the first 10 years of the scheme. That explanation would obviously be found in the operation and anticipated consequences of the three agreements in the context of a planned termination of them all during the first 10 years. In part, the explanation would lie in the provisions of the two loan agreements which enabled the partnership to participate in the overall ``plan'' without the individual partners being required to contribute more than the $20,000 (being the balance of the original $50,000) paid by the taxpayers and which enabled the partnership to walk away from the ``plan'' at any time without the individual partners being under a personal liability in relation to the payment of the principal (or interest) of the Doowarf or Eromdim loans. In part, it would be that found by the Second Tribunal and affirmed by the Second Full Court, namely, the very substantial personal income tax advantages which the taxpayers were expected to derive from the early years of


91 ATC 4961

the ``plan''. To the extent that the surplus of partnership outgoings of interest over annuity receipts in each of the tax years were to be so explained, the outgoings could not properly be characterised, for the purposes of s. 51(1), as incurred in gaining or producing assessable income or as not being ``of a capital, private or domestic nature''. It follows that, subject to the possible effect of Pt IVA and s. 82KL of the Act, the deductibility under s. 51(1) of the excess of the partnership's adjusted interest outgoings over the partnership's assessable income in each of the tax years turns upon whether those adjusted outgoings of interest are to be seen as payments made pursuant to a 15-year ``plan'' which could be expected to run its course or as payments made under a 15-year ``plan'' which was structured and expected to be terminated by the partnership before the commencement of its eleventh year.

The question whether the outgoings of interest were incurred on the basis or in the expectation that the 15-year plan would in fact run its full course is a question of fact. As such, the onus of proof in relation to it lay upon the taxpayers. In the circumstances of the present case, its determination involves consideration not only of the purposes of the taxpayers but also of the purposes of those who advised them and acted on their behalf and whose ``acts (and intentions)'' as agents must, as the Second Tribunal expressly pointed out, ``be imputed to the principals''. That question was clearly adverted to by both the Second Tribunal and the Second Full Court. There is however no express finding in relation to it in the reasons or judgment of either. It is arguable that a finding that the agreements would be prematurely terminated is implicit in some passages of the reasons of the Second Tribunal, in particular in the reference to the implications of the ``unexplained failure to call Mr Crowl'' which immediately follows a lengthy extract from the evidence of Mr Tucker (who executed the agreements and bills of exchange on behalf of the partnership) in the course of which, under cross-examination, he had acknowledged the taxation disadvantages of the last five years of the ``scheme'' and stated that he did not know whether ``the intention of the parties'' had been ``to get out of this scheme after 10 years''. It may also be arguable that such a finding is implicit in the Second Tribunal's express statement that it was ``satisfied that there was ample evidence'' before the First Tribunal to found ``its decision with respect to the application of Pt IVA'' since the presiding member of the First Tribunal (Mr Bannon Q.C.) had indicated the view that the projected ``profits'' of the last five years were a ``mirage'' and would never in fact be derived. Arguably, in a context where the overall effect of the 15-year plan would be, if it ran its full course, to yield a substantial surplus of assessable income over adjusted interest outgoings, such a finding was implicit in the statement of the Second Full Court to the effect that the Second Tribunal was ``justified'' in concluding that the ``whole exercise had, as far as the accountants were concerned, the dominant purpose of reducing the taxable income of their clients''. These aspects of the case were not, however, explored in argument in this Court where each side claimed to be entitled to succeed in any event. Nor was it suggested in argument that this Court should itself make any necessary further findings of fact.

It is obviously regrettable that the already protracted proceedings in this case should be permitted to enter yet a further phase. Nonetheless, the appropriate course in all the circumstances is to remit the matter to the Administrative Appeals Tribunal to enable the necessary further finding of fact to be made. If a finding is made that, on a common-sense assessment of all the evidence, the contractual arrangements to which the partnership became a party were intended and expected to run their full course, the adjusted outgoings of interest will be prima facie allowable as deductions pursuant to s. 51(1) of the Act in calculating the net income or loss of the partnership. In that event, it will be necessary that the Tribunal resolve the outstanding questions under Pt IVA and s. 82KL. If a finding is made that the contractual arrangements were intended and expected to be terminated before the last five years of the partnership, the result will be that the adjusted partnership outgoings of interest are not deductible under s. 51(1) to the extent that they exceeded the partnership's assessable income in each of the tax years. If the Tribunal considers that neither of those findings is the appropriate one, it will be necessary for it to make what is, in its view, the appropriate finding and to determine what follows from it in the light of these reasons for judgment.


91 ATC 4962

Accordingly, we would allow the appeal, set aside the orders of the Second Full Court and in lieu thereof order that the matter be remitted to the Administrative Appeals Tribunal for further hearing. It will be a matter for that Tribunal whether, if any application is made to it in that regard, either party should be permitted to lead further evidence on that rehearing.[16] There remains to be considered what, if any, order should be made as to costs. Neither party has enjoyed unqualified success in this Court. Indeed, as has been seen, success or failure upon the only question involved in the present appeal to this Court turns upon the Administrative Appeals Tribunal's finding on the outstanding question of fact. In these circumstances, it may be that the appropriate order as to costs is that each party should bear its own costs of the proceedings before both the Second Full Court and this Court. The parties should, however, be given an opportunity, if they so desire, to make further submissions on the question whether any different order as to costs should be made.


91 ATC 4963

FLETCHER AND OTHERS v. COMMISSIONER OF TAXATION SCHEDULE A (Cash Flow) ANNUITY INVESTMENTS PARTNERSHIP NO. 18 - CASH SURPLUS

                                           1982       1983       1984       1985       1986       1987       1988       1989       1990       1991       1992       1993       1994       1995       1996       TOTAL
                                       -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                             $          $          $          $          $          $          $          $          $          $          $          $          $          $          $          $

         INFLOW OF FUNDS

      Annuity                             170000     170000     170000     170000     170000     600000     600000     600000     600000     600000    1119000    1119000    1119000    1119000    1119000    9445000

      Loan from Doowarf                  2000000                                                                                                                                                              2000000

      Loan from Eromdim                   190000     190000     190000     190000     190000                                                                                                                   950000
      Partners Capital                     50001                                                                                                                                                                50001
                                       -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                         2410001     360000     360000     360000     360000     600000     600000     600000     600000     600000    1119000    1119000    1119000    1119000    1119000   12445001

         OUTFLOW OF FUNDS

      Purchase of Annuity                2020000                                                                                                         2020000

      Management Fees                      30000                                                                                                           30000

      Repayments of
      Principal & Interest
            -    Doowarf                    360000     360000     360000     360000     360000     360000     360000     360000     360000     360000       360000       360000       661400       1084920       1084920       7151240
           -   Eromdim                                                                           240000     240000     240000     240000     240000       724920       724920       423529                                   3073369
                                       -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                         2410000     360000     360000     360000     360000     600000     600000     600000     600000     600000       1084920     1084920      1084929       1084920       1084920      12274609
          CASH SURPLUS                     $    1         -         -         -         -         -         -         -         -         -         34080        34080       34071         34080         34080     $  170392




91 ATC 4964

------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- FLETCHER AND OTHERS v. COMMISSIONER OF TAXATION SCHEDULE B (Taxation Ramifications) ANNUITY INVESTMENTS PARTNERSHIP NO. 18 - STATEMENT OF NET INCOME AND PARTNERSHIP (LOSSES) FOR INCOME TAX 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 TOTAL ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ ASSESSABLE INCOME Annuity 170000 170000 170000 170000 170000 600000 600000 600000 600000 600000 1119000 1119000 1119000 1119000 1119000 9445000 Less U.P.P. 134667 134667 1344667 134667 134667 134667 134667 134667 134667 134667 134666 134666 134666 134666 134666 2020000 ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 35333 35333 35333 35333 35333 465333 465333 465333 465333 465333 984334 984334 984334 984334 984334 7425000 ALLOWABLE DEDUCTIONS Interest [Note (a)] 283007 309892 341618 379053 423227 475352 476014 476794 477715 478802 480084 412979 333796 240358 130098 5718789 ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- INCOME(LOSS) (247674) (274559) (306285) (343720) (387894) (10019) (10681) (11461) (12382) (13469) 504250 571355 650538 743976 854236 ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- DISTRIBUTION R.S. Fletcher (61919) (68640) (76571) (85818) (96974) (2505) (2670) (2865) (3096) (3367) 126063 142834 162590 185994 213559 C.E. Fletcher (61919) (68640) (76571) (85818) (96974) (2505) (2670) (2865) (3096) (3367) 126063 142834 162590 185994 213559 J.W. Dunlop (61918) (68640) (76571) (85817) (96973) (2505) (2670) (2865) (3095) (3367) 126062 142834 162589 185994 213559 L.A. Dunlop (61918) (68639) (76572) (85817) (96973) (2504) (2671) (2866) (3095) (3368) 126062 142833 162589 185994 213559 ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- (247674) (274559) (306285) (343720) (387894) (10019) (10681) (11461) (12382) (13469) 504250 571355 650358 743976 854236 ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Note (a) Interest has been apportioned at the rate of total assessable income of $7,425,000 to total income of $9,445,000 being 78.613% INTEREST INCURRED Doowarf Nominees 360000 360000 360000 360000 360000 360000 360000 360000 360000 360000 360000 360000 360000 305748 165492 5151240 Eromdim Nominees - 34200 74556 122176 178368 244674 245515 246508 247679 249062 250693 165332 64606 - - 2123369 ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 360000 394200 434556 482176 538368 604674 605515 606508 607679 609062 610693 525332 424606 305748 165492 7274609 ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- % claimed 78.613% Interest/Claimed 283007 309892 341618 379053 423227 475352 476014 476794 477715 478802 480084 412979 333796 240358 130098 5718789 -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------


Footnotes
[1]Administrative Appeals Tribunal Act 1975 (Cth), s. 44.

[2]See 88 ATC 4834 at pp. 4836-4839; (1988) 19 F.C.R. 442, at pp. 443-447.

[3]See the Act 1936-1982, s. 26AA and cf. ss. 27A(1) (definition) and 27H of the current Act.

[4](1949) 8 ATD 431, at p. 437; (1949) 78 C.L.R. 47, at p. 59.

[5]ibid., at ATD p. 437; C.L.R. p. 59.

[6]ibid., at ATD p. 436; C.L.R. p. 57; see also A.G.C. (Advances) Ltd. v. F.C. of T. 75 ATC 4057 at p. 4071; (1975) 132 C.L.R. 175, at pp. 196-197; F.C. of T. v. Riverside Road Lodge Pty. Ltd. (In Liq.) 90 ATC 4567 at p. 4574; (1990) 23 F.C.R. 305, at pp. 311-312; John v. F.C. of T. 89 ATC 4101 at p. 4105; (1989) 166 C.L.R. 417, at p. 426.

[7]See, e.g., Ronpibon Tin (1949) 8 ATD, at p. 436; (1949) 78 C.L.R., at p. 56; Charles Moore & Co. (W.A.) Pty. Ltd. v. F.C. of T. (1956) 95 C.L.R. 344, at p. 350; Lunney v. F.C. of T. (1958) 11 ATD 404 at p. 411; (1957-1958) 100 C.L.R. 478, at p. 497; John 89 ATC, at p. 4105; (1989) 166 C.L.R., at p. 426; Ure v. F.C. of T. 81 ATC 4100 at pp. 4103, 4109; (1981) 50 F.L.R. 219, at pp. 223, 231; 34 A.L.R. 237, at pp. 241, 248; Riverside Road 90 ATC, at p. 4574; (1990) 23 F.C.R., at pp. 311-312.

[8]See, e.g., Ronpibon Tin (1949) 8 ATD, at p. 436; (1949) 78 C.L.R., at p. 57; John 89 ATC, at p. 4105; (1989) 166 C.L.R., at p. 426.

[9]See, e.g., W. Nevill & Co. Ltd. v. F.C. of T. (1937) 4 ATD 187 at p. 193, 199; (1937) 56 C.L.R. 290, at pp. 301, 308; F.C. of T. v. South Australian Battery Makers Pty. Ltd. 78 ATC 4412 at p. 4420; (1977-1978) 140 C.L.R. 645, at p. 660; John 89 ATC, at p. 4105; (1989) 166 C.L.R., at p. 426; Magna Alloys and Research Pty. Ltd. v. F.C. of T. 80 ATC 4542 at p. 4547; (1980) 49 F.L.R. 183, at p. 189; 33 A.L.R. 213, at pp. 218-219; Ure 81 ATC, at p. 4103; (1981) 50 F.L.R., at pp. 231-232; 34 A.L.R., at pp. 248-249; F.C. of T. v. Ilbery 81 ATC 4661 at pp. 4666-4667; (1981) 58 F.L.R. 191, at pp. 199-201; 38 A.L.R. 172, at pp. 179-180.

[10]See footnote 8 above.

[11]See John 89 ATC, at p. 4105; (1989) 166 C.L.R., at p. 427.

[12]See, e.g., Ronpibon Tin (1949) 8 ATD, at p. 437-438; (1949) 78 C.L.R., at p. 60; Cecil Bros. Pty. Ltd. v. F.C. of T. (1962) 12 ATD 449 at p. 451-452; (1963-1964) 111 C.L.R. 430, at p. 434.

[13]See, e.g., Robert G. Nall Ltd. v. F.C. of T. (1936) 4 ATD 335 at pp. 338, 340, 342-343; (1936-1937) 57 C.L.R. 695, at pp. 699-700, 706, 708-709, 712-713.

[14]See, e.g., B.P. Australia Ltd. v. F.C. of T. (1966) A.C. 224, at p. 264; Hallstroms Pty. Ltd. v. F.C. of T. (1946) 8 ATD 190 at p. 195; (1946) 72 C.L.R. 634, at p. 648; F.C. of T. v. Foxwood (Tolga) Pty. Ltd. 81 ATC 4261 at pp. 4264, 4268-4269; (1981) 147 C.L.R. 278, at pp. 285, 293.

[15]See F.C. of T. v. Munro (1926) 38 C.L.R. 153, at p. 197; Ure 81 ATC 4100 at pp. 4103, 4109; (1981) 50 F.L.R., at pp. 223, 232; 34 A.L.R., at pp. 241, 249.

[16]See Administrative Appeals Tribunal Act, s. 44.


 



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