Revenue borrowings issue
55 When the Lewisham Properties were sold in the 2013 income year, Abacus was paid $48,009,738.87 out of the proceeds of sale. Of that amount, $18,861,669.52 was applied to the repayment of the principal owing from the drawdowns by Lewisham Estates on the Abacus Facility Agreement and $5,772,315.78 was applied to pay capitalised interest on those drawdowns. Two million dollars was paid on account of the cancellation amount payable pursuant to cl 4 of the Call Option Agreement, which had the effect of cancelling the call option in respect of the Lewisham Properties. The balance of $21,375,753.57 was applied by Abacus in discharge of debts owed by other members of the Demian Group under the Facility Agreement. Consequently, the amounts paid to Abacus out of the proceeds of sale exceeded the repayment of the drawdowns and capitalised interest of Lewisham Estates by $23,375,753.57 (the excess amount). In issue was whether a portion of the excess amount is deductible from the net income of the Lewisham Estates Trust for the 2013 income year as "revenue borrowings". The applicants contended that an "applicable" proportion of the excess amount has a revenue character on the basis that:
(a) it was not in dispute that Lewisham Estates was in the business of property development or that the Lewisham Properties were its trading stock;
(b) those properties were purchased by Lewisham Estates between 2003 and 2005 and financed through borrowings from Capital Finance, Perpetual Trustee and National Australia Bank;
(c) because those borrowings were used by Lewisham Estates to fund the purchase of its trading stock, viz, the Lewisham Properties, those borrowings formed an "integral part" of Lewisham Estates' business and part of the process by which Lewisham acquired its trading stock and thus were of a revenue character;
(d) in 2010, Lewisham Estates repaid the Capital Finance and National Australia Bank loans using two drawdowns on its facility with Abacus: on or around 30 July 2010, it drew down $8,703,431.38 (plus an amount for Abacus' fees, costs and expenses), which it used to repay the Capital Finance loan; and on 3 August 2010, it drew down $1,350,350 which it used to repay the National Australia Bank loan;
(e) the amounts borrowed from Abacus, at least to the extent of the drawdowns to repay the National Australia Bank and Capital Finance, had the same character as the original borrowings and were on revenue account; and
(f) the excess amount paid to Abacus has a revenue character to the extent to which the drawdowns from the Abacus facility were used to discharge Lewisham Estates' borrowings from Capital Finance and the National Australia Bank because to that extent, the excess amount is attributable to the discharge of those revenue borrowings.
56 The applicants accepted that not all of the access amount was revenue in nature. However, it was contended that 53.3% of the excess amount should be treated as revenue in nature on the basis that percentage amount is the same proportion that the revenue drawdown of Lewisham Estates from the Abacus facility ($10,053,791.38) to repay the National Australia Bank and Capital Finance bore to the total principal drawdowns ($18,861,669.52). 53.3% of the excess amount translates to a deduction claim of $12,459,923 if Abacus did not hold a 50% equitable interest in the Lewisham Properties, or $6,229,961.50 if Abacus held a 50% equitable interest and Lewisham Estates only had a 50% interest in the Lewisham Properties.
57 The applicants relied on The Texas Co (Australasia) Ltd v Federal Commissioner of Taxation [1940] HCA 9; 63 CLR 382 (Texas); Avco Financial Services Ltd v Commissioner of Taxation (Cth) [1981] HCA 6; 150 CLR 510 (Avco); Federal Commissioner of Taxation v Hunter Douglas Ltd (1983) 14 ATR 629 (Hunter Douglas); Thiess Toyota Pty Ltd v Commissioner of Taxation [1978] 1 NSWLR 723 (Thiess Toyota); and Federal Commissioner of Taxation v Cadbury-Fry Pascall (Aust) Ltd (in vol liq) (1979) 10 ATR 55 (Cadbury-Fry Pascall) in support of their submissions.
58 In Texas the taxpayer, an oil company, purchased its petroleum products from its parent or related companies in the United States. As its share capital was insufficient to meet its requirements for working capital, the taxpayer was allowed to delay payments in respect of the purchases in order to provide it with funds large enough for its needs. Before payment was made, the rate of exchange moved against Australia and increased the outlay in Australian pounds for the products. It was held that the increased outlay was deductible as part of the cost of the purchase of trading stock and hence on revenue account. In the words of Starke J at 450, the additional amounts were "outgoings incurred in connection with the trading operations of the taxpayer: the purchase of the stock in which it traded". See also Latham CJ at 427 and Dixon J at 468-9.
59 The issue in Avco was whether exchange gains and losses made by a finance company in the repayment of moneys borrowed by it in the ordinary course of its business for lending to its customers were on revenue or capital account. The exchange gains and losses were held to be on revenue account. Gibbs CJ reasoned at 518:
Where a taxpayer carries on the business of borrowing and lending money, the moneys used for that purpose are analogous to trading stock - the taxpayer in effect deals in the money. Exchange gains and losses, regularly and frequently made and incurred, in the course of making repayments of borrowed money which is used by a taxpayer in making loans in the course of its finance business are outgoings made in the day to day conduct of the business and for the purpose of carrying on the business as a going concern... the additional moneys paid as a result of the unfavourable exchange variations - the exchange losses - were part of the price by which the appellant obtained the money which it used to make a profit - part of the process by which the appellant obtained regular returns.
The majority (Mason, Aickin and Wilson JJ) at 527 similarly reasoned that:
The essence of the business of a finance company… is the borrowing and lending of money, the rates of interest payable on money lent being significantly higher than the rates payable on the money borrowed, for it is from the difference in the rates that the company generates its profit, after making provision for bad debts…
Exchange gains and losses are an ordinary incident of overseas borrowings by a finance company. If an overseas loan, the proceeds of which are to be used in the Australian business of the finance company, is to be repaid in the foreign currency, the company has, in the first instance, to exchange the foreign currencies for Australian dollars, and later to buy the foreign currency with Australian dollars. Exchange gains and losses are therefore an incident of borrowing.
The majority continued at 530:
The true principle is that in the case of a finance company which borrows money overseas in the ordinary course of its business and not for some special purpose, the added cost of repayment in foreign currency caused by the devaluation or depreciation of the Australian dollar is an additional cost of the borrowing and, like other costs of the borrowing, is an allowable deduction under s. 51(1).
In that regard, no distinction was drawn between the borrowing of moneys for the purpose of on-lending and the borrowing of moneys for the purpose of repaying loans previously borrowed for on-lending. As the majority explained at 532 "[i]n each instance the transactions are continuously and regularly entered into in the ordinary course of the finance company's business; they are an integral part of that business".
60 In the course of reasoning, the majority also stated that there is an important distinction between the borrowing and repayment of loans of a finance company in the ordinary course of its business and the borrowing and repayment of loans by a manufacturing or trading company. The majority said at 527:
In general the finance company's borrowings provide money which it turns over at a profit. Borrowing otherwise than for on-lending or for the payment of funds borrowed for on-lending, that is, borrowing undertaken for capital rather than revenue purposes, as in [Commercial & General Acceptance Ltd v Commissioner of Taxation (Cth) [1977] HCA 47; 137 CLR 373 (CAGA)] is an exception to the general rule. On the other hand, borrowing by a manufacturing or trading company is often undertaken to strengthen the capital or profit-earning structure of the company. A finance company usually borrows in order to increase its working capital which is then turned over at a profit; the manufacturing or trading company frequently borrows to strengthen its permanent capital.
CAGA is authority that where a borrowing is undertaken to strengthen the capital or profit earning structure of the taxpayer, the repayment of the borrowing is an expenditure on capital account.
61 Thiess Toyota and Cadbury-Fry Pascall were both cases in which a trader acquired trading stock in foreign currency. In Thiess Toyota the trader arranged for the financier to pay directly for the trading stock to be later reimbursed by the taxpayer. Movements in the exchange rate resulted in the trader making foreign currency gains and the gains were held to be on revenue account. Meares J distinguished CAGA from the case where a manufacturer or trader buys or sells stock in trade for a price payable in foreign currency which appreciates or depreciates before payment is made and held that the appellant's finance arrangements were "all part of a transaction relating directly to, and having the purpose of, the purchase of trading stock": Thiess Toyota at 728. Thiess Toyota was cited with approval by Gibbs CJ in Avco at 517-8. In Cadbury-Fry Pascall, the Australian taxpayer's English parent company purchased trading stock for the Australian taxpayer in foreign currency, with the Australian taxpayer repaying the parent company later. Movements in exchange rates saw the Australian taxpayer make a gain on the repayment to its English parent company and that gain was found to form part of its assessable income. Jenkinson J found that the credit facility was principally for the payment of liabilities in respect of the purchase of raw materials and the payments in reduction of the loan account were in substance part of the regular outlay of the taxpayer for the raw materials acquired by it for manufacture and it followed that the exchange gain was on revenue account: Cadbury-Fry Pascall at 61.
62 Hunter Douglas was a case where the taxpayer borrowed money in foreign currency to use in the course of its business, including to pay wages, payroll tax and for stock in trade. Exchange rate movements resulted in the taxpayer making exchange losses. It was held by majority (Fisher and Lockhart JJ, Franki J dissenting) that the exchange losses were not deductible by reason that the borrowings and exchange losses were not an integral part of the ordinary operation of the taxpayer's business of development, manufacture and marketing of window covering, home improvement, casual living, architectural and building products. After reference to Avco, Fisher J reasoned at 641-2:
The position is different where the company is not a finance company but a trading or manufacturing company which incurs exchange losses or gains otherwise than through the purchase of trading stock. Here the losses or gains will in the ordinary course be on capital account. For them to be on revenue account it is necessary for the taxpayer to establish that the additional expenditure to meet exchange losses was expenditure incurred in the process of producing its income, and in the words of Mason, Aickin and Wilson JJ in Avco set out above, as an integral part of that process. It is not sufficient, with all respect to the learned trial judge, to rely upon the finding that in fact the borrowed monies were used to satisfy day to day outgoings. The borrowings in such a case are prima facie an addition to the capital employed in the business.
…
… the borrowing of the moneys and the repayment thereof in this matter was expenditure in relation to the financing of the taxpayer's business by augmenting its working capital. It was money borrowed to pay liabilities incurred in carrying on and expanding the business, as part and parcel of the taxpayer's financial as opposed to its trading activities. The borrowings and their exchange losses were not an integral part of the ordinary operation of the taxpayer's business. They were borrowings arranged for special purposes…
Lockhart J similarly concluded at 645 that the borrowings were not "an integral part of the ordinary operations of the taxpayer's business so as to represent a matter of revenue rather than capital", citing Avco at 524-5 per Mason, Aickin and Wilson JJ.
63 Lockhart J at 643 referred to Avco and observed that, in general, loans and repayments of loans were on capital account. Lockhart J then referred to two exceptions to this "prima facie presumption", namely borrowings by finance companies to lend to their customers, and borrowings by trading companies to finance the purchase of trading stock. Lockhart J explained at 643:
Borrowings by finance companies in the ordinary course of their business or borrowings by trading companies to purchase trading stock are examples of expenditure incurred in the earning of a taxpayer's income and not for the purpose of enhancing the business or organisation of the taxpayer as an income earning entity. It is well established that such borrowings are revenue items.
…
Where a trading company buys goods which it turns over as trading stock gains or losses incurred are of a revenue nature. If moneys payable by a taxpayer are allowable deductions, in general any increase or decrease in those amounts caused by fluctuations in the exchange rate are likewise allowable deductions or assessable income as the case may be. If a trading company borrows money overseas in circumstances where the borrowing is a necessary part of and has the purpose of purchasing trading stock gains or losses will be revenue items.
and at 645:
Borrowing money to carry on business must prima facie be treated as augmenting the capital employed in the business. Borrowings by finance companies to then lend to their customers, and borrowings by trading companies to finance the purchase of trading stock, are exceptions to this general rule. Such borrowings are an integral part of the ordinary conduct of the company's business and are thus revenue, not capital, items. Moneys borrowed by a finance company are turned over by making loans to its customers.
At 645, Lockhart J contrasted the facts in Thiess Toyota and Cadbury-Fry Pascall, holding that the borrowings were not part of the process by which the taxpayer operated to purchase trading stock. His Honour concluded that the nature of the borrowings determined the nature of the exchange losses for fiscal purposes. As the principal purpose of the borrowing was to finance an expansion of the taxpayer company's business activities and to provide additional funds to increase its working capital for the purpose of avoiding a cash flow or liquidity problem during the period of expansion, the borrowings were on capital account and thus so too were the exchange losses.
64 Most recently, the High Court in Commissioner of Taxation v Sharpcan Pty Ltd [2019] HCA 36; 93 ALJR 1147 (Sharpcan) set out the test for determining whether an outgoing is incurred on revenue account or capital account as follows at 1154-5 [18]:
Authority is clear that the test of whether an outgoing is incurred on revenue account or capital account primarily depends on what the outgoing is calculated to effect from a practical and business point of view. Identification of the advantage sought to be obtained ordinarily involves consideration of the manner in which it is to be used and whether the means of acquisition is a once-and-for-all outgoing for the acquisition of something of enduring advantage or a periodical outlay to cover the use and enjoyment of something for periods commensurate with those payments. Once identified, the advantage is to be characterised by reference to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organisation and carrying on the business; between the implements employed in work and the regular performance of the work in which they are employed; and between an enterprise itself and the sustained effort of those engaged in it. Thus, an indicator that an outgoing is incurred on capital account is that what it secures is necessary for the structure of the business.
(footnotes omitted)
Applying the test to the facts in the present case, whether the excess amount is deductible in the first instance thus depends on the character of the original borrowings to acquire the Lewisham Properties and whether those borrowings were "an integral part of the ordinary operations of the taxpayer's business". That is, whether those borrowings were part of the process by which Lewisham Estates operated to purchase trading stock, or whether they were undertaken to augment Lewisham Estates' working capital.
65 The evidence concerning the borrowings was as follows:
(a) 72-76 Old Canterbury Road: Lewisham Estates entered into a contract to purchase this land for the sum of $1 million on 21 June 2003. On 18 August 2003, Lewisham Estates granted a mortgage in favour of National Australia Bank over the property (NAB mortgage), securing the sum of $700,000. The contract settled on 21 August 2003 and the mortgage was subsequently registered over the property;
(b) 62 Old Canterbury Road: Lewisham Estates entered into a contract to purchase this land for the sum of $510,000 on 8 January 2004. On 24 June 2004, Lewisham Estates granted a mortgage in favour of Perpetual Trustee, securing the sum of $408,000 (Perpetual mortgage) and the contract was settled on the same day. The mortgage was subsequently registered over the property;
(c) 78-90 Old Canterbury Road and 8 William Street: Lewisham Estates entered into a facility agreement with Capital Finance on 29 June 2005 for the purpose of acquiring both of these properties. On 4 August 2005:
(i) Lewisham Estates, as transferee, executed a transfer for 78-90 Old Canterbury Road for consideration in the sum of $8.6 million;
(ii) Shimden, as transferee, executed a transfer for 8 William Street for consideration in the sum of $525,000. Mr Demian's evidence was that Shimden purchased this property using funds advanced at the direction of Lewisham Estates under the Capital Finance mortgage and acquired the property as bare trustee for Lewisham Estates;
(iii) Lewisham Estates granted a mortgage over 78-90 Old Canterbury Road and also 8 William Street in favour of Capital Finance, securing the sum of $8.4 million (Capital mortgage);
(iv) the Capital mortgage was subsequently registered over the properties.
66 The evidence established that Lewisham Estates borrowed funds which it used to acquire properties for the conduct of its property development business. However, the use to which the borrowed funds were put is not conclusive of the character of the borrowings: Hunter Douglas at 644 per Lockhart J. Merely because the borrowings were used to acquire the properties does not give the borrowings a revenue character. As the authorities make clear, for the borrowings to be on revenue account requires the finding that the borrowings were an incident of the commercial operations by which Lewisham Estates acquired its trading stock: Cadbury-Fry Pascall at 61; Hunter Douglas at 645 per Lockhart J. However, the evidence did not substantiate that the original borrowings were an incident of the process by which Lewisham Estates operated to purchase its trading stock, as distinct from borrowings made by Lewisham Estates to provide funds to enable it to conduct its business enterprise, which is an affair of capital. It follows from this conclusion that the excess amount is not deductible.
67 In case I am wrong I should deal with the next part of the argument, namely that the Facility Agreement was in substitution for the original borrowings and thus bears the same character (on the assumption they were borrowings on revenue account). The evidence was as follows.
68 On or around 12 June 2007, Lewisham Estates granted a mortgage to Equititrust Ltd (Equititrust) over 72-76 Old Canterbury Road, 8 William Street and 62 Old Canterbury Road, securing the sum of $865,000.
69 In 2009, the Demian Group suffered financial distress as a result of the global financial crisis. Lenders to the Demian Group commenced calling in their loans. This included Capital Finance and Equititrust in relation to Lewisham Estates' facilities secured over the Lewisham Properties.
70 On 31 March 2010, in order to re-finance the Demian Group's existing debt facilities, Lewisham Estates, Shimden and Summer Hill entered into the Facility Agreement with Abacus (Abacus Facility). The Abacus Facility had an initial facility limit of $20 million. On the same day, Lewisham Estates mortgaged each of the Lewisham Properties to Abacus. That mortgage was, in effect, an "all moneys" mortgage.
71 Also on 31 March 2010, Lewisham Estates, Shimden and Summer Hill (referred to as the "Borrowers") and Abacus executed a Payment Deed, which contained a collateralization clause as follows:
As a condition to Abacus entering into and making advances under the Facility Agreement, the Borrowers jointly and severally agree with Abacus as follows:
(a) each Borrower must, having applied any returns which they receive from the Projects or the Properties, including sales proceeds in respect of the Properties, in accordance with the Transaction Documents in full satisfaction of the Secured Moneys, apply any residual such returns as directed by Abacus to satisfy any amounts owing to Abacus by any of the Borrowers, Demian Holdings Pty Ltd, Riverland Estate Pty Ltd, Demian Investments Pty Ltd, West Apartments Pty Ltd, Belgrave Holdings Pty Ltd, and Charbel Demian (in each case, in whatever capacity);
…
(collateralization clause)
72 On 30 July 2010, Lewisham Estates, Mr Demian and other entities in the Demian Group entered into a Second Deed of Amendment, Restatement and Affirmation with Abacus, which amended cl 2.1 of the Facility Agreement to provide that the purposes of the Abacus Facility included the repayment of the amounts owing to National Australia Bank and Capital Finance, in addition to Equititrust (which was already included in cl 2.1 of the original Facility Agreement).
73 That same day, Lewisham Estates, Mr Demian and other entities in the Demian Group entered into a Guarantee and Indemnity with Abacus. Under cl 4, Lewisham Estates, as one of the guarantors, guaranteed the obligations of the borrowers under the Riverlands Facility Agreement, and under cl 3, it agreed that its obligations under that guarantee were "Secured Moneys" for the purposes of the Abacus Facility.
74 On 29 July 2010, Lewisham Estates drew down $8,744,541.38 from the Abacus Facility for the purpose of discharging the amounts owing under the Capital Finance facility, being a total of $8,703,431.38. On 30 July 2010, the Capital mortgage was discharged. On 3 August 2010, a further $1,350,350 was drawn down on the Abacus Facility for the purpose of repaying the amounts owing under the facility secured by the NAB mortgage. On 26 July 2010, the NAB mortgage was discharged.
75 By a series of further amendments over the balance of 2010 to 2012, the facility limit of the Abacus Facility was progressively increased. By 17 July 2012, through the Ninth Deed of Amendment and Affirmation and Amendment to Call Option, the facility limit had been increased to $54,400,000, with provision made for a further $7,750,000 to be borrowed for specified purposes. The reason for the increase in the limit was not explained in the evidence, though it may be inferred that those amounts were used for a range of purposes relating to the activities of various entities in the Demian Group.
76 When the Lewisham Properties were sold in 2012, the collateralization clause was engaged and $23,375,723.55 was paid to Abacus to discharge debts of other entities in the Demian Group.
77 The applicants argued that the obligations of Lewisham Estates to Abacus as a result of the two drawdowns on the Abacus Facility on 29 July 2010 and 3 August 2010 were in "substitution" for its obligations to repay the loans from Capital Finance and National Australia Bank, within the meaning of that concept as explained in Thiess Toyota and Cadbury-Fry Pascall. It was submitted that the funds were advanced under those two drawdowns for the purpose of discharging the loans from Capital Finance and National Australia Bank, and those funds were used for that purpose. Consequently, so the argument went, the obligations of Lewisham Estates were also on revenue account for it. I disagree. The evidence did not substantiate that the Abacus Facility was a mere "substitution" for the loans to purchase the Lewisham Properties. Rather, the Abacus Facility was a key part of the capital profit earning structure of the whole group of Demian entities, which consolidated and restructured the former capital structure necessitated by the impact of the global financial crisis on the finance arrangements of the Demian entities, including Lewisham Estates' borrowings. Even if the original borrowings were on revenue account, the refinancing in 2010 was plainly undertaken to augment the capital of the Demian group and accordingly was on capital account.
78 Moreover, the excess amount paid by Lewisham Estates to Abacus when it sold the Lewisham Properties was an amount paid in discharge of an obligation in the nature of a guarantee. $23,375,723.55 was applied, not in the discharge of Lewisham Estates' indebtedness, but in discharge of debts owed by other entities in the Demian Group or in discharge of other obligations owed to Abacus. The payment was wholly separate from the acquisition of the Lewisham Properties and cannot be characterised as part of the costs of the purchase of the trading stock. Nor was the repayment an integral part of the process by which Lewisham Estates acquired that trading stock. Accordingly, no part of the excess amount bears the character of a revenue outgoing.
79 Finally, if I am wrong and the excess amount is deductible to the extent that it is referrable to the drawdowns of $8,703,431.38 and $1,350,350, an apportionment issue arises. The applicants contended that 53.3% of the excess amount should be treated as revenue in nature because that is the percentage expression of the proportion of the amounts drawn down from the Abacus Facility to repay the amounts secured by the NAB mortgage and the Capital mortgage bear to the total principal drawdowns.
80 In their joint judgment in Ronpibon Tin NL and Tongkah Compound NL v Federal Commissioner of Taxation [1949] HCA 15; 78 CLR 47, Latham CJ, Rich, Dixon, McTiernan and Webb JJ at 59 stated that there are at least two kinds of outgoings which require apportionment for the purposes of s 51(1) of the Income Tax Assessment Act 1936-1944 (Cth):
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 stated at 59, the appropriate apportionment of such items of expenditure is essentially a question of fact, requiring some fair and reasonable assessment of the extent of the relation of the outlay to assessable income.
81 Critically, for an indivisible outgoing to be apportionable, there must be a relevant connection between the outgoing and the business activities directed to the gaining or production of assessable income. Here, the excess amount related to the repayment of the debts of other entities in the Demian Group. How that amount related to assessable income was not explained by the applicants and, more particularly, it is not apparent how the basis of apportionment contended by the applicants achieves a fair result in yielding the portion of the excess amount having an income nature and the portion of the excess amount having non-income nature. Accordingly, this leads to the conclusion that no deduction is available for any part of the excess amount.