Amalgamated Zinc (de Bavay's) Ltd v Federal Commissioner of Taxation

igo, who died on 15 November 1984. The executor/administrator of a deceased estate is deemed to be a trustee pursuant to s 6 of the Act. Section 95 of the Act provides so far as is relevant that the " "net income", in relation to a trust estate, means the total assessable income of the trust estate calculated under this Act as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions, ...". Mr Frigo, in his will, appointed the applicant as executrix and trustee. His will provided the two of the properties in his estate were to be subject to life tenancies, and upon termination of the life tenancies, those properties are to be transferred to an educational institution, The Mission of the Sacred Heart. His other assets were to be realised and distributed as legacies to two beneficiaries, including the testator's son, Paul. The grant of the life tenancies was in the following terms: " I GIVE my house and property known as 'Yallambi' together with the contents and all adjoining land situate at Farm Road, Bunya, aforesaid to my Executrix upon trust for LAURENCE HAYDEN and FLORENCE CLAIRE HAYDEN for their lives or for so long as either one of them shall reside at the aforesaid property. I DIRECT my trustee to maintain my property situated at Paisley Drive, Lawnton, Brisbane in the state of Queensland to apply the income thereof towards the payment of rates taxes general upkeep and maintenance of the farm property 'Yallambi'. UPON termination of the aforesaid life tenancy I DIRECT that the property at 'Yallambi' and the property situated at Paisley Drive, Lawnton, shall become part of my residuary estate. " Probate was granted on 29 May 1985. Paul Frigo initiated an action in the Supreme Court of Queensland under Part IV of the Succession Act 1981 claiming that the testator had failed to make adequate provision from the estate for the proper maintenance and support of his son. On 19 February 1988 Dowsett J of the Supreme Court of Queensland ordered that provision be made out of the estate for the son to the extent that he receive from the estate a total amount of $150,000.00 free of all debts, liabilities, duties, taxes and expenses, to be paid on or before the twenty-fourth day of March, 1988. His Honour further ordered that the executrix be at liberty to encumber the assets of the estate in an amount not exceeding $150,000.00 for the purpose of making that payment. The costs of the application of each of the parties was ordered to be taxed and paid out of the estate. The applicant, after taking advice from various people including the estate's solicitor and the estate's accountant, decided in all the circumstances that the estate should borrow the amount of $150,000.00 as provided for in the Supreme Court's order. That money was in fact borrowed from the applicant and her husband, with interest payable at two points above the Westpac indicator rate. It was said that borrowing in this way would have advantages to the estate, because to do so would avoid bank establishment and administration fees, account reviews and valuation fees, and the necessity for mortgage security. As at 28 January 1988, the executor had in hand an amount of $79,991.43 as cash held in various bank accounts. The material before the Tribunal, however, suggested that at that time there were debts of the estate of some $51,000.00, leaving approximately $29,000.00 available. Additionally, provision had to be made for income tax for 1988 and the legal expenses ordered to be paid out of the estate. The two properties the subject of the clause previously referred were a farm property, "Yallambi", at Farm Road, Bunya, and an industrial warehouse subdivided into eleven individual units at Paisley Drive, Lawnton. The farm property for the tax year ended 30 June 1988 showed a net loss of $3,400.17. It was submitted both before the Tribunal and before the Court by Mr McGill, Senior Counsel for the respondent, that in the years since the death of the testator, according to the tax returns lodged, the farm had never shown a profit and that the farm could not be regarded as an income producing asset. As against that, Mr Frigo had been accepted as a primary producer throughout the years before his death, with the advantage of averaging his income. At times the property had up to 100 head of cattle, and the property had all the improvements that a primary producer would normally have, including livestock handling yards, and facilities to spray, and that many acres of improved pastures had been developed. Concerning suggestions that the cash in the bank could be used partly to pay the amounts ordered by the Supreme Court to the son of the testator, or that the farm property could have been sold to discharge that obligation, it is relevant that the Supreme Court ordered on 19 February 1988 the payment of the $150,000.00 to be made by 24 March 1988. Mrs Hayden said, of one of the factors influencing her decision to borrow the funds to pay Mr Paul Frigo: " ...I was concerned to put into effect what I perceived to be the wish of Mr Frigo that the two properties be preserved for the ultimate benefit of the MSC. I knew as well that Mr Frigo in his lifetime had admired the work of the MSC and in particular was fond of my brother Fr. Brian Cunneen who was a member of that order. " The appeal in this Court has to be conducted on the basis of the findings of fact made by the Tribunal below. The context in which the appeal has to be determined appears from the following paragraphs of the Tribunal's reasons for decision: " 10. The essence of the applicant's case is that the $150,000 was borrowed because the executors (sic) were required by the terms of the will to maintain the corpus for the benefit of the residual beneficiary which had been devised the whole of the estate subject to life interests and legacies. The residual beneficiary is a religious charitable organisation. The terms of the Will became subject to the order of the Supreme Court but I accept the executor's evidence that she was concerned to preserve the estate as a viable venture for the benefit of the residual beneficiary. I also accept her evidence that the funds were borrowed from the executors for the advantage of the estate as compared with an armslength borrowing from a lender such as a bank. The moneys were borrowed in accordance with and to satisfy the order of the Court so as to maintain the income producing assets of the estate. 29. The applicant borrowed funds from her husband and herself for the purpose of maintaining the capital structure of the income producing activities of the estate, albeit, as Mr McGill argued, those income producing activities were not very successful in producing income. But the funds were not used for that purpose. They were applied to a non-income producing purpose - the satisfaction of the Supreme Court order. The use of the funds was not therefore connected with the income producing activities and the interest outgoing claimed does not fall within either of the positive limbs of section 51 of the Act. " (emphasis added) The words of both limbs of s 51(1) of the Act is a well ploughed field. Under the first limb, expenditure will be deductible if it is incurred "in the course of gaining or producing the assessable income": see Amalgamated Zinc (de Bavay's) Ltd v Federal Commissioner of Taxation (1935) 54 CLR 295 at 303 per Latham CJ and 309 per Dixon J. In Ronpibon Tin NL v Federal Commissioner of Taxation (1949) 78 CLR 47, the judgment at 56-57 said: " For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words 'incurred in gaining or producing the assessable income' mean in the course of gaining or producing such income. " The reference to the necessity that the expenditure be "relevant and incidental" to the gaining or producing of assessable income focuses on the nature or character of the outgoing and the connection of the outgoing with what does in fact gain or produce assessable income. In Charles Moore & Co. (W.A.) Pty Ltd v Federal Commissioner of Taxation (1956) 95 CLR 344, Dixon CJ, Williams, Webb, Fullagar and Kitto JJ said at 351: " ...the phrase 'incidental and relevant' when used in relation to the allowability of losses as deductions do not refer to the frequency, expectedness or likelihood of their occurrence or the antecedent risk of their being incurred, but to their nature or character. What matters is their connection with the operations which more directly gain or produce the assessable income. " See also Commissioner of Taxation (Cth) v Riverside Road Lodge Pty Ltd (In Liqn.) (1990) 23 FCR 305 at 312 and the cases there referred to. In Lunney v The Commissioner of Taxation of the Commonwealth of Australia (1958) 100 CLR 478, Williams, Kitto and Taylor JJ said at 499: " ...to say that expenditure on fares is a prerequisite to the earning of a taxpayer's income is not to say that such expenditure is incurred in or in the course of gaining or producing his income. Whether or not it should be so characterised depends upon considerations which are concerned more with the essential character of the expenditure itself than with the fact that unless it is incurred an employee or a person pursuing a professional practice will not even begin to engage in those activities from which their respective incomes are derived. " Later, at 501, in words that have a relevance in the circum- stances of this case, their Honours said of expenditure incurred by a taxpayer in order to travel from his home to his place of business: " ...even if it were possible - and we think it is not - to say that its essential purpose is to enable a taxpayer to derive his assessable income there would still be no warrant for saying, in the language of s. 51, that it was 'incurred in gaining or producing the assessable income' or 'necessarily incurred in carrying on a business for the purpose of gaining or producing such income'. " It is accepted by the Commissioner that where moneys have been borrowed to acquire income producing assets or to pay business expenses or provide general working capital, it can readily be accepted that interest on such loans is deductible. In Federal Commissioner of Taxation v Total Holdings (Australia) Pty Limited (1979) ATC 4,279, Lockhart J, (with whom Northrop and Fisher JJ agreed), said at 4,283: " If a taxpayer with a continuing business incurs a liability for interest being incidental to or connected with the operations or activities regularly carried on for the production of income, the interest is an allowable deduction. The circumstance that each item of expenditure cannot be traced to a particular item of income does not prevent the deduction of the expenditure. See Ward & Co. Ltd. v Commr. of Taxes (N.Z.) (1923) A.C. 145 at p. 148; Amalgamated Zinc (De Bavay's) Ltd v F.C. of T. (1935) 54 C.L.R. 295 at p. 307; W. Nevill & Co. Ltd. v F.C. of T. (1937) 56 C.L.R. 290 at p. 305; and The Texas Co. (A'sia) Ltd. v F.C. of T. (1939-40) 63 C.L.R. 382 per Starke J. at p. 451. In my opinion if a taxpayer incurs a recurrent liability for interest for the purpose of furthering his present or prospective income producing activities, whether those activities are properly characterised as the carrying on of a business or not, generally the payment by him of that interest will be an allowable deduction under sec. 51. See F.C. of T. v Munro (1926) 38 C.L.R. 153; The Texas Co. (A'sia) Ltd. v F.C. of T. (supra); F.C. of T. v Green (1950) 81 C.L.R. 313 per Latham C.J., McTiernan, Webb, Fullagar and Kitto JJ. at p. 319; and Usher's Wiltshire Brewery Ltd v Bruce [1915] AC 433. " In determining the essential character of the outgoing, it is necessary to look to the use to which the borrowed funds are put. In Fletcher v The Commissioner of Taxation of the Commonwealth of Australia (1991) 173 CLR 1 at 19, in the joint judgment of Mason CJ, Brennan, Deane, Dawson, Toohey, Gaudron, McHugh JJ, the High Court said: " 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 characterized 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: see Federal Commissioner of Taxation v Munro (1926) 38 C.L.R. 153, at p. 197; Ure (1981), 50 F.L.R., at pp. 223, 232, 34 A.L.R., at pp. 241, 249. " (emphasis added) The Court had said, at p 17: " 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 characterization of either the whole or part of the outgoing for the purposes of the sub-section; see, e.g., W. Nevill & Co. Ltd. v Federal Commissioner of Taxation (1937), 56 C.L.R. 290, at pp. 301, 308; Federal Commissioner of Taxation v South Australian Battery Makers Pty Ltd (1978), 140 C.L.R. 645, at p. 660; John (1989), 166 C.L.R., at p. 426; Magna Alloys & Research Pty Ltd v Federal Commissioner of Taxation (1980), 49 F.L.R. 183, at p. 189; 33 A.L.R. 213, at pp. 218-219; Ure, (1981), 50 F.L.R., at pp. 231-232; 34 A.L.R., at pp. 248-249; Federal Commissioner of Taxation v Ilbery (1981), 58 F.L.R. 191, at pp. 199-201; 38 A.L.R. 172, at pp. 179-180. 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: (See, e.g., Ronpibon Tin (1949), 78 C.L.R., at p. 57; John (1989), 166 C.L.R., at p. 426) or that the outgoing is a 'cost of a step taken in the process of gaining or producing income' (see John (1989, 166 C.L.R., at p. 427) 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. " In Ure v Federal Commissioner of Taxation (1981) 34 ALR 237, Brennan J, as he then was, said at 241: " Section 51 requires that a deductible expenditure be incurred 'in' gaining assessable income, that is to say, it must be incidental and relevant to the gaining of that income: Ronpibon Tin NL and Tongkah Compound NL v FC of T (1949) 78 CLR 47 at 56; 4 AITR 236 at 244. An outgoing of interest may be incidental and relevant to the gaining of assessable income where the borrowed money is laid out for the purpose of gaining that income: FC of T v Munro (1926) 38 CLR 153 at 170, 171, 197; Texas Co (Australasia) Ltd v FC of T (1940) 63 CLR 382 at 468; 2 AITR 4 at 44. The laying out of the borrowed money for the purpose of gaining assessable income furnishes the required connection between the interest paid upon it by the taxpayer and the income derived by him from its use. " Deane and Sheppard JJ said at 249: " In the ordinary case where the income which is expected to flow from an outgoing offers an obvious commercial explanation for incurring it the relevant characterization can readily be determined by reference to the gaining or producing of that income. In the more complex case however, where there is no such obvious commercial explanation, the solution of the problem of characterization must be derived from a weighing of the many aspects of the whole set of circumstances including direct and indirect objects and advantages which the taxpayer sought in making the outgoing. Some of those circumstances may point in one direction, some in the other. In such a case, as was said by the Privy Council in BP Australia Ltd v FC of T (1965) 112 CLR 386 at 397; 9 AITR 615 at 623 in relation to the question whether a particular outgoing was of income or capital according to ordinary concepts, it is 'a common sense appreciation of all the guiding features which must provide the ultimate answer'. In a case such as the present where the outgoing claimed as a deduction is interest paid on borrowed money, one cannot ordinarily look to the direct object or advantage which the outgoing was intended to achieve for the reason that that will ordinarily be the receipt of the borrowed money which is likely to be neutral in character. One must, of necessity, look more to the objects or advantages which the application and use of the borrowed money were intended to gain: FC of T v Munro (1926) 38 CLR 153 at 197. " On behalf of the respondent it was argued that the "use" to which the moneys were put was the payment of a legacy to a legatee of a deceased estate pursuant to a court order. The occasion of the outgoing, it was submitted, was not found in whatever is productive of assessable income, and it does not have the character of being incurred in gaining or producing assessable income. The case for the Commissioner proceeds on the premise that there is no connection between the borrowing and the activities which gain or produce the assessable income, other than the fact that the borrowing preserves the income producing assets. The contention by the applicant is that if the borrowing of funds has the effect of preserving income producing assets, that is a sufficient connection to make the interest on those borrowed funds deductible under the first limb of s 51(1). The applicant relies on the decision in Begg v Federal Commissioner of Taxation (1937) ATD IV 57; Public Trustee v Commissioner of Taxes (1938) NZLR 436; and Yeung v Federal Commissioner of Taxation (1988) ATC 4,193. In Yeung, Davies J was concerned with whether interest on moneys borrowed to allow a partnership to repay moneys previously advanced to the partnership on capital account was deductible under s 51(1) of the Act. Davies J said at 4,204: " I am prepared to accept that from the partnership's point of view, what occurred was that two of the partners decided to withdraw funds from the partnership. It does not materially matter whether those funds were loan funds or capital which the partners had invested in the properties. The notional payment out to Dr and Mrs Yeung and the borrowing of an amount from Ozanu Pty Ltd necessarily effected a change in the capital interests which each of the partners had in the partnership. What the partnership achieved by the borrowing from Ozanu Pty Ltd was the maintenance of the income earning properties. Funds were withdrawn, but were replaced by loan funds and the income-earning properties remained held by the six members of the family. In an income-earning enterprise, both income (sic, loan) and equity capital may be invested in assets directed to the earning of income. In such an event, if equity capital is repaid and loan capital replaces it, interest payable on the loan capital will ordinarily be an allowable deduction from the income derived from the assets. This is because the assets held represent the equity and the loan capital and, if the assets are directed to the earning of income, then both the loan capital and the equity capital which they represent are devoted to the earning of assessable income. " In Commissioner of Taxation v Roberts and Smith (1992) 37 FCR 246, the Full Court of the Federal Court was concerned with claims for deduction of interest incurred by partners of solicitors who had borrowed moneys to allow a reduction of capital for existing partners in the firm. Hill J, with whom Jenkinson and O'Loughlin JJ agreed, said at 260: " The provision of funds to the partners in circumstances where that provision is not a repayment of funds invested in the business, lacks the essential connection with the income producing activities of the partnership or, in other words, the partnership business. Likewise, the interest incurred on the borrowing will not be incidental and relevant to the partnership business. " Hill J, at 258, expressed the view that: " ...the result reached in Yeung (supra) seems clearly correct if the case is viewed simply as one involving a borrowing to fund the repayment of moneys originally advanced by a partner and used as partnership capital, particularly given that the original funds were used to purchase the rental property. " His Honour referred, at 258, to "the difficult case of Begg v DFC of T...". Begg v Federal Commissioner of Taxation (supra) and Public Trustee v Commissioner of Taxes (supra) are two cases factually similar to the present. In Begg, Reed AJ held that interest paid on moneys borrowed by an executor to pay succession and estate duties and other outgoings for the general administration of the estate were deductible, because the effect of the borrowing was to preserve the assets and thereby retain the income which would otherwise be lost if the assets were sold. His Honour said at 269: " ...one effect of the borrowings was to preserve most of the assets in the form in which they were at the testator's death. It is clear from the evidence that, if the executors had sold some of the assets to pay the duties, the income producing value of the estate must have dropped. They were under no obligation to sacrifice the estate; indeed, the course which they adopted was one which was within their powers, and which prudence dictated. Executors, who have power to postpone the sale of an estate, and have also powers to borrow money to pay duties and meet other outgoings, would be failing in their duty if they were to pursue a course which would involve the estate in heavy losses of capital values, and also deprive it of assets producing income at good rates of interest. To act in such a way as to avoid such an undesirable course is to save portion of the income from extinction. In this case income so saved was certainly being earned when the executors became entitled to the property; but the very circumstances under which they acquired the estate imposed a liability, the satisfaction of which would necessarily reduce that income. Borrowing money on the security of the estate kept it intact, and the payment of interest on the borrowed money kept the loans alive, and so enabled the estate to continue to produce income. " As well as borrowing to pay succession and estate duties, the executors did not pay legacies but instead paid interest on the unpaid legacies. Reed AJ said of this outgoing, at 270: " As regards the interest paid on the legacies, I am unable on the evidence to find that it played a sufficiently substantial part in the production of assessable income, and I can see no ground for allowing it as a deduction. " There seems to me an inconsistency in allowing the interest on borrowings and not allowing the interest paid on the unpaid legacies. Each amount of interest was as a consequence of a decision which preserved the income-producing assets and, if the interest on the borrowings for the payment of obligations by the estate were tax deductible, so too is interest paid on the legacies, the effect of which was to maintain the income-producing corpus of the estate. In Public Trustee v Commissioner of Taxes (supra), the majority of the Court of Appeal of New Zealand held that interest payable upon money borrowed by an executor and trustee for the purpose of paying death duties upon the estate of his testator is, where the money borrowed enables the trustee to pay out of the estate the amount of the death duties and leaves the money so borrowed or its equivalent in capital assets in the estate to be employed in the production of income, therefore deductible in computing the assessable income of the estate. Myers CJ said at 452: " The borrowed money was employed, it has been suggested, not in the production of income, but in the payment of a debt or charge. That, however, is not, to my mind, the true position. I think that the suggestion involves a confusion of ideas: it confuses the purposes of expenditure with the result of such expenditure. As Dixon, J., said in Herald and Weekly Times, Ltd. v Federal Commissioner of Taxation (1932) 48 C.L.R. 113: 'The question whether money 'is expended in and for the production of assessable income cannot be determined by considering only the immediate reason for making a payment and ignoring the purpose with which the liability was incurred Ibid., 118. " To similar effect was the judgment of Barker J in Williams v Commissioner of Inland Revenue (1988) 12 TRNZ 16. I am respectfully unable to reconcile the decision in Begg or the decision in Public Trustee with the decision of the High Court in Federal Commissioner of Taxation v Munro (1926) 38 CLR 153. Munro was decided by reference to s 23(1)(3) of the Income Tax Assessment Act 1922-1925, but I do not think that consideration material in relation to the conclusion to which each of Knox CJ, Isaacs, Higgins, Rich and Starke JJ came. Each judge was of the view that where money borrowed on the security of rent-producing property was used for a purpose whereby no income is produced, the interest paid thereon was not a permitted deduction under s 23(1)(3) of the Income Tax Assessment Act (1922-1925). Isaacs J said at 197: " It is said for the respondent that, since it was necessary to pay the interest if the taxpayer wished to retain his right to have the income from the property, it was interest by which that income was gained or produced. I am not able to accept that view. The taxpayer had already acquired and held his property as a rent-producing property to the full extent. Nothing more was necessary to gain or produce that income. Then he chose for his own purposes quite alien to that property to borrow money and incur a personal obligation to repay it with interest. So far, also, the property stood complete as a rent-producing instrument. But because he secured his personal debt by means of that complete rent-producing instrument he contends that the discharge of the obligation was 'actually incurred in gaining or producing' the rentals it yielded. The simple position is that the property and its rentals existed before the loan and remained intact and unaltered after the loan. Had the money borrowed been expended on the property so as to increase the rentals or so as to prevent depreciation which would have reduced the rentals, then it could have been properly said that the interest had been a means of gaining or producing the assessable income. But in employing the borrowed money for purposes independent of the property, leaving its condition entirely unaffected, that result cannot be postulated. " Fletcher (supra) teaches that the focus must be on the use to which the borrowed funds are put. Here, the borrowed funds were used to discharge an obligation by the estate. I can see no difference in the present case from a case where an individual taxpayer, in order to discharge an obligation such as school fees, borrows funds on which interest is paid rather than sell income-producing assets and from the proceeds discharge the obligation. The paying of school fees requires funds, on which interest might be otherwise earned; that fact does not make interest on funds borrowed for the purpose of paying the school fees deductible. The discharge of the obligation is a purpose quite independent of the property. In my opinion, the fact that the borrowing of funds permitted income-producing assets to remain as part of the estate so that the income stream to the estate was not diminished, does not bring the interest on borrowings within a loss or outgoing under s 51(1) of the Act. It was submitted on behalf of the applicant as a subsidiary submission that the outgoing was properly allowable under the second limb of s 51(1) of the Act, and that in any event the Tribunal failed to give sufficient reasons concerning this submission which had been made before the Tribunal. It is difficult to see what business, if any, was being carried on by the executor. A fair reading of the reasons of the Tribunal indicates that the Tribunal was conscious of the need to evaluate the claimed outgoing under both limbs of s 51(1) of the Act, and the characterisation of the use to which the borrowed funds was put was fatal to the taxpayer's arguments under either limb. In Ronpibon Tin NL v Federal Commissioner of Taxation (1949) 78 CLR 47, the High Court (Latham CJ, Rich, Dixon, McTiernan and Webb JJ) said at 56: " The word 'business' is defined by s 6(1) to include profession, trade, employment, vocation or calling, but not occupation as an employee. The alternative in s. 51(1) therefore covers a wide description of activities. But in actual working it can add but little to the operation of the leading words, 'losses or outgoings to the extent to which they are incurred in gaining or producing the assessable income'. No doubt the expression 'in carrying on a business for the purpose of gaining or producing' lays down a test that is different from that implied by the words 'in gaining or producing'. But these latter words have a very wide operation and will cover almost all the ground occupied by the alternative. " The application should be dismissed with costs, to be taxed if not agreed. I certify that this and the preceding eighteen (18) pages are a true copy of the reasons for judgment herein of the Honourable Justice Spender. Associate Date: 9 August 1996