EFGA, EFGT, ELFIC, EFGS and Amayana
71 The disputed interest expenses for EFGA, EFGT, ELFIC, EFGS and Amayana are as set out in Table 2 in [8(3)] of the Commissioner's written submissions, which is reproduced in [9] above. In the case of ELFIC and EFGS, the interest relates to borrowings by those companies from EFGA: in the case of EFGA, the interest relates to borrowings from EFGT and Amayana; in the case of EFGT, the interest relates to a borrowing from FGL; and in the case of Amayana, the interest relates to a borrowing from FBGTA.
72 The primary judge found that each of the relevant respondents incurred its interest expenses on loan funds which it employed in its business for the purpose of producing assessable income (Reasons [176] - [178], [185], [189], [194], [198]). Further, in relation to each of EFGA, EFGT, ELFIC and EFGS the loan funds on which the interest was incurred were used as the circulating capital of its business. It followed that the interest incurred by EFGA, EFGT, ELFIC, EFGS and Amayana is deductible under s 8-1 of the 1997 Act or s 51(1) of the 1936 Act. In respect of EFGA, see Reasons [179] - [185]; see also Reasons [118] - [125] in respect of EFGA's business activities of lending to, amongst others, ELFIC and EFGS. In respect of EFGT, see Reasons [195] - [198]; see also Reasons [145] in respect of EFGT's business activities of lending money to EFGA. In respect of ELFIC, see Reasons [6], [25], [176] - [178]. In respect of EFGS, see Reasons [25], [191] - [194]. In respect of Amayana, see Reasons [33], [52], [186], [189].
73 On these appeals, the Commissioner said first that the primary judge failed to apply correctly the principles expressed in Ure v Federal Commissioner of Taxation (1981) 50 FLR 219 and Fletcher v Federal Commissioner of Taxation (1991) 173 CLR 1. According to the Commissioner, the primary judge should have found that the taxpayers had failed to establish that the interest was incurred -
(1) in gaining or producing assessable income;
(2) in the course of carrying on their respective businesses;
(3) for the purpose of gaining or producing assessable income through the conduct of their respective businesses.
74 Second, even if the claimed interest expenses were incurred for the purpose of gaining or producing assessable income, those expenses were of a capital nature. In this respect the Commissioner said that:
(1) The primary judge erred in relying on Australian National Hotels Ltd v Federal Commissioner of Taxation (1988) 19 FCR 234 (Reasons [200]) to find the interest revenue in nature;
(2) the respective taxpayers incurred the interest to serve the purposes of FGL;
(3) the respective taxpayers incurred the interest expense with respect to funds intended to be employed by way of permanent capital.
75 Contrary to how the Commissioner predicated his submission in [74] above, the question is not whether the claimed interest expenses were incurred for the purpose of gaining or producing assessable income. As Hill J warned in Kidston Goldmines Ltd v Commissioner of Taxation (1991) 30 FCR 77 at 85, a warning he repeated in Commonwealth of Taxation v Roberts and Smith (1992) 37 FCR 246 at 257:
'[T]here is a danger … in substituting for the words of the subsection language which does not appear in it. The statutory issue is whether the interest outgoing was incurred in (ie in the course of) the income-producing activity or, in the case of the second limb of the subsection, whether the interest outgoing was incurred in (ie in the course of) the business activity which is directed towards the gaining or producing of assessable income'
not whether the interest expenses were incurred for the purpose of gaining or producing assessable income. See too Magna Alloys & Research Pty Ltd v Federal Commissioner of Taxation (1980) 33 ALR 213 at 215-216 per Brennan J.
76 The Commissioner's contention that the primary judge failed to apply the principles expressed in Ure and Fletcher correctly is misconceived.
77 In Ure, the appellant had borrowed at commercial rates of interest and on-lent the borrowed moneys at 1 per cent per annum either to his wife or to a family company. The taxpayer argued, unsuccessfully, by reference to the use to which the moneys were put, being an income-producing use, that the whole of the interest on the borrowed funds was deductible. The court apportioned the interest allowing a deduction equivalent to the income to be derived by the on-lending.
78 In the course of their judgment, Deane and Sheppard JJ said (at 230):
'The fact that money is re-lent at a lower rate of interest than the rate at which it was borrowed does not necessarily mean that the liability to pay the interest cannot properly be seen as having been incurred wholly in earning the assessable income and as being of neither a private nor domestic nature. Even where no business is carried on, circumstances can obviously exist in which money borrowed wholly for the purposes of earning income by way of re-lending can only, in the event, be re-lent at a rate of interest lower than the rate payable in respect of the original loan. Again, notwithstanding the fact that it may always have been intended to re-lend borrowed money at a rate of interest lower than that payable in respect of the original borrowing, the liability to pay the interest may plainly have been wholly incurred in earning assessable income where it is expected or hoped that the re-lending will also lead to assessable income in another form being derived or preserved, such as, for example, dividends on shares held in the company to which the money is lent at a favourable rate. Yet again, plain miscalculation or lack of business understanding or anticipated subsequent lending at higher rates could conceivably lead to the position where it was plain that a liability to pay interest on borrowed money at a higher rate than the rate payable in respect of an immediate re-lending had been incurred wholly in earning assessable income.' (Emphasis added.)
79 At 232 their Honours said:
'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.' (Emphasis added.)
80 And at 233 their Honours concluded:
'One of the most difficult aspects of the problem of characterizing an outgoing is the assessment of what, if any, weight is to be given to indirect objects which a taxpayer had in mind in incurring the outgoing. Such objects form part of the relevant circumstances by reference to which the problem of characterization must be resolved. There is however no rigid principle which can be applied in determining what, if any, weight should be given to them. In the ordinary case, such as, for example, where the immediate object achieved by the outgoing is the production of assessable income which is commensurate with the amount of the outgoing or where it is clear that the outgoing was for the purchase of stock-in-trade or the acquisition of services or hire of equipment used in earning assessable income, indirect objects or motives of a personal or domestic character will plainly not prevent the characterization of the outgoing as having been incurred in earning assessable income (see, for example, Cecil Bros. Pty. Ltd. v. Federal Commissioner of Taxation [(1964) 111 CLR 430]; Federal Commissioner of Taxation v. Phillips [(1978) 36 FLR 399]. In other cases, the immediate object or effect of an outgoing will not suffice either to explain or to characterize it. In such cases, indirect objects or motives can assume a sometimes decisive importance.' (Emphasis added.)
81 Fletcher concerned a complicated arrangement whereby a partnership borrowed money for the purpose of funding an annuity. The result of the arrangement was that if the arrangement were not terminated, the partnership would, in the early years, have a large net loss, which would be available to the partners to deduct against their other income. In the later years, however, there would be corresponding large amounts of assessable income to be taken into account in calculating the net income of the partnership and thereby, through s 92, to be included in each of the partner's assessable income.
82 Fletcher, like Ure, was a case where the issue of characterisation arose under the first limb of s 51(1). In a unanimous judgment of all seven justices of the High Court, the court pointed out that the process of characterisation involved in resolving an issue under s 51(1) will be commonly possible without reference to the taxpayer's subjective thought processes. In other cases motive may be a relevant fact, at least where the outgoing has been voluntarily incurred. Reference was made to what was said in Magna Alloys & Research at 218 - 219 per Brennan J. Thus motive could be relevant to a case where no assessable income could be identified at the time the outgoing was incurred, or where the relevant assessable income was less than the amount of the outgoing. Reference was made to Ure. The court remitted the case to the Tribunal to make findings of fact as to whether the parties intended that the arrangement would be terminated before assessable income was derived.
83 In the course of its reasons in Fletcher, the court said (at 18 - 19):
'[I]t is commonly possible to characterize 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 so in a case where the outgoing gives rise to the receipt of a larger amount of assessable income. In such a case, the characterization 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 characterize the whole outgoing as one which was incurred in gaining or producing assessable income. If the outgoing can properly be wholly so characterized, 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" [Cecil Bros Pty Ltd v Federal Commissioner of Taxation (1964) 111 CLR 430 at 434].
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 characterization 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. Where that is so, it is a "commonsense" or "practical" weighing of all the factors which must provide the ultimate answer. If, upon consideration of all those factors, it appears that, notwithstanding the disproportion between outgoing and income, the whole outgoing is properly to be characterized 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 characterized 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.'
84 A more recent decision of a Full Court of this Court which held that the primary judge did not err in taking into account evidence as to the subjective purpose of the taxpayer in relation to the acquisition by it of shares, carrying dividend rights, in a related company with funds borrowed from its parent company, where the issue before this Court was the deductibility of the interest on the borrowing, was Spassked Pty Ltd v Commissioner of Taxation (2004) 136 FCR 441. The taxpayer was born out of the implementation of a complex structure designed to avoid what was called a 'dividend trap', the loss of the inter-corporate rebate on group dividends received by a company through interest incurred on borrowings to acquire the dividend-producing shares. In the result, there could be no loss in the taxpayer company available to be transferred to another group company because the interest deduction would be offset by the dividend received; to the extent that the dividend it received was franked, the company would have no ability to declare a dividend so to pass the benefit of the franking credit through intermediate companies to an individual shareholder because it had no company law profits absent other income.
85 In the course of their judgment, Hill and Lander JJ said (at [76] and [78]):
'Ordinarily, where a taxpayer borrows money for the purpose of acquiring shares carrying rights to a dividend the interest on the funds borrowed will be deductible without reference to subjective matters. But, equally, where no dividends are derived by the taxpayer from the investment and especially where, as here, it appears that no dividend was intended to be paid on those shares for an indefinite time, the result would be very different, for in such a case the occasion of incurring the interest in the year of income would not be found in gaining or producing assessable income at all. In the present case the question whether dividends were to be paid on the shares acquired by Spassked was the subject of considerable evidence and a conclusion was drawn which was adverse to the appellants.
…
Submission one - did the learned primary judge err in considering subjective purpose?
We have dealt with this matter in the above discussion of the law. From that discussion it follows that the learned primary judge did not err in taking into account, in the limited way his Honour did, evidence adduced by the appellants as to the subjective purpose of Spassked and particularly in relation to the acquisition by it of the shares in GIH.'
86 A little later, in relation to the issue of whether Spassked was carrying on a business of a holding company, their Honours said (at [84], [85]):
'It can be accepted that a holding company can itself carry on a business, which may be referred to as the business of a holding company: Brookton Co-operative Society Ltd v Commissioner of Taxation (Cth) (1981) 147 CLR 441 at 469-470. The taxpayer in Total Holdings on the facts of that case was held to carry on such a business.
…
His Honour found, it would seem, that Spassked was not carrying on such a business. Indeed it was more likely on the facts that it was IEL which was the holding company carrying on a business than Spassked. What is clear here is that the only assessable income which Spassked could possibly derive were the dividends it might receive from GIH if it were allowed to receive any dividends. Despite a submission on behalf of the appellants that Spassked was acting to further the ends of the corporate group (presumably the group of which it was the holding company, although in reality Spassked was acting to further the ends of IEL) this would not, of itself, make the interest it incurred deductible. The present case is wholly different from EA Marr & Co where the intermediate holding company leased items of plant from a finance company and made the plant available to the subsidiaries rent free.'
87 Gyles J agreed with Hill and Lander JJ, but in the course of his judgment said (at [127], [128]):
'Some business decisions are good, some are bad. Indeed, with the benefit of hindsight some may be seen as negligent or even profligate. The point may be made by considering the arm's length external borrowing by the IEL Group to make the corporate acquisitions in question. Some of those acquisitions might have been successful and some might have failed. In hindsight, some may have been doomed to failure. However there would be little doubt as to the deductibility of interest on all of those borrowings.
The same principle does not apply to purely intra-group arrangements with no external aspect. All of the relevant arrangements were between companies with the same beneficial ownership. Many of the companies involved, including Spassked, had no external role at all. The arrangements involving those companies were inherently variable at the will of the ultimate board of directors. They do not reflect the exercise of business judgment in the relevant sense. Thus, the requisite connection or relationship between the outgoing and the earning of assessable income is not to be inferred but must be positively established. The trial judge found that that had not been done. I agree. Further, the inherently variable nature of the arrangements explains why the one error by the trial judge was of no consequence in the result.'
88 The Commissioner relied on what his Honour said concerning 'purely intra-group arrangements with no external aspect' at [128] in support of his argument in the present case, but what his Honour said has to be understood in the context of the facts of Spassked, which bear no correlation to the facts of the present case. In my view, what his Honour said in this passage from his reasons was not in recognition of some dichotomy of principle between purely intra-group transactions and those with external parties, particularly where the terms and conditions of the purely intra-group transactions exhibited features of a kind that might be expected to exist between parties dealing with each other at arm's length. (See what his Honour said on the same topic in the subsequent case of Macquarie Finance Ltd v Commonwealth of Taxation (2005) 146 FCR 77 at [254].) If I am wrong in my view of this passage from his Honour's reasons then, with respect, I would have to disagree with it; such a dichotomy certainly cannot be supported by reference to any authority and, in any event, it would be impossible to support the dichotomy in point of principle; only in point of fact.
89 The facts of the present case, as found by the primary judge, bear no correlation to the facts in Ure, Fletcher or Spassked. Moreover, they exhibit none of the features relied on in those cases to warrant going beyond 'the obvious commercial explanation' for incurring the interest, such as by recourse to 'indirect objects or motives' or 'subjective purposes'. Indeed, as Brennan J said in Magna Alloys & Research at 225:
'Given a sufficient identification of what the expenditure is for and the character and scope of the taxpayer's income-earning undertaking or business, the question whether expenditure is incurred for the purpose of carrying on a business or for the purpose of gaining or producing assessable income does not depend upon the taxpayer's state of mind. The relationship between what the expenditure is for and the taxpayer's undertaking or business determines objectively the purpose of the expenditure.'
90 In concluding that the claimed interest expenses were deductible, the primary judge made the following findings:
(1) As to ELFIC, he found that the fact that interest expenses were significantly greater than the income it derived was a reflection of the financial difficulties experienced by ELFIC's external customers in the late 1980s which resulted in diminished returns to ELFIC on the circulating capital deployed in its business. Further, his Honour held (Reasons [176]): 'It does not follow that, because the core business was being wound down, the interest expenditure incurred in continuing the business was not wholly expended in carrying on the business'. In this latter respect, he relied on what Beaumont J and Hill J said in Unilever Australia Securities at 165 and 187 respectively, in contrast to what a Full Court of this Court said in Coal Developments (German Creek) Pty Ltd v Commissioner of Taxation (2008) 166 FCR 140 at [19] in respect of expenditure incurred after the business has been sold, or has otherwise ceased to be carried on by the taxpayer: Reasons [176] - [178];
(2) as to EFGA, he found that for essentially the reasons outlined in relation to the claim by ELFIC to deduct its interest expenses that the interest incurred by EFGA on its borrowings from EFGT was deductible. The expenditure was calculated to effect from a practical and business point of view the continuing provision of funds at interest to the Finance group subsidiaries to enable them to maintain their businesses as going concerns until they could be disposed of or closed down as part of the wind-up operation. That provision of funds was the central function which EFGA had assumed in the conduct of its business: Reasons [185];
(3) as to Amayana, he found that the reasons already outlined in respect of the claims for deductions in respect of interest by ELFIC and EFGA compel the same conclusion as to the claim for interest by Amayana. The funds which Amayana had borrowed had been used to derive assessable income in the form of interest from EFGA. The interest which Amayana had been required to pay represented the recurrent or periodic cost to it of securing those funds. There was, he considered, a frequent and often nice exercise of business judgment in conducting the affairs of Amayana and those of the related party borrowers from it. Moreover, Amayana's liability to pay interest to FGL was tied to Amayana's own income-producing purposes. He did not regard Amayana's prospect of receiving that income in the form of interest as 'illusory' at the time when the interest was charged: Reasons [189];
(4) as to EFGS, he found that the reasons outlined above in relation to the claim made by ELFIC for a deduction in respect of interest applied with equal force to the corresponding claim by EFGS. The money borrowed from EFGA was used in the course of the business of EFGS which included the derivation of income and during the wind-up the realisation of loans to external customers and other interest-bearing assets. These considerations were reinforced by the accession of EFGS during the wind-up to the management of the Finance group's interest in the 'Akron' bloodstock joint venture: Reasons [194];
(5) as to EFGT, he found that:
'For the reasons already explained in respect of the claims by EFGA and Amayana to deduct interest, I have concluded that the similar claim by EFGT should have been allowed. The money which EFGT had borrowed from FGL was genuinely advanced to borrowers and deposit and interest was genuinely charged on it. Except for the interposition of the security structure, those transactions essentially continued the same income-producing activity which had been carried on since 1986. I do not regard the creation of the security structure or the purpose for which it occurred as having any relevant bearing on the entitlement of EFGT to claim a deduction for interest expenses actually incurred': Reasons [198].
91 The Commissioner submitted that the primary judge's conclusions are based only on the observed continuation of funding activities after January 1990; that his Honour's reasoning does not constitute a commonsense or practical weighing of all the factors to provide the ultimate answer: cf., Fletcher at 19. After January 1990, the purpose of those same funding activities had changed. According to the Commissioner, his Honour ought properly to have concluded that the interest outgoings claimed by the respective taxpayers were not properly to be characterised as genuinely and not colourably incurred in gaining or producing assessable income: cf., Fletcher at 19.
92 The Commissioner again observed, as he did in relation to the first issue, that:
(1) After 1990 EFGA ceased to charge a margin over its cost of funds to ELFIC and to EFGS: Reasons [123];
(2) the employment of funds advanced to ELFIC and to EFGS was not profitable for EFGA as it had been before 1990: Reasons [124];
(3) EFGA carried on its activities after 1990 at the direction of others, including, ultimately, FGL: Reasons [124];
(4) the internal provision of loan funds to ELFIC and EFGS from 1989 was not part of a coherent course of conduct but occurred as individual responses from time to time to external exigencies created by circumstances of the external financial climate: Reasons [228].
93 It was submitted by the Commissioner that further funds, originating with FGL, were provided, through EFGA, only to facilitate the management and disposal of the Finance group's assets without any real intention or expectation of profit but to protect and maximise the interests of the Foster's Group as a whole.
94 According to the Commissioner, having regard to those matters, the taxpayers' claimed interest expenses were colourably incurred in terms of its connection to the purpose of gaining or producing assessable income. From 1990 each ceased to employ the funds it borrowed with any intention or expectation of making a profit. Rather, the evidence showed that the interest which continued to be charged by EFGA and the other companies in the funding chains had a different purpose:
(1) To protect FGL from the risk that equity funding would become available to third party litigation creditors of the companies in the Finance group (before the security structure was put in place in or about October 1991);
(2) interest was referred to as necessary for taxation and statutory requirements, maintained for technical reasons and as a notional cost of capital. The main concern was to ensure that inter-company accounts matched. Ultimately, then, it was preferable to book the interest on the debts owing by EFGA and later, EFGT, to notionally balance out the additional costs to FGL in funding the Finance group;
(3) as well as because of previously expressed concerns with respect to litigation creditors, EFGA's request for interest-free funding in April 1991 was rejected and the practice of charging interest on debt it owed was maintained because of the adverse impact interest-free funding would have on FGL's ability to pay a dividend (which would be reduced by the interest expense FGL would otherwise have to bear as the ultimate source of funding to the Finance group).
95 In addition, the Commissioner pointed to EFGT having:
(1) Commenced lending to EFGA in or about October 1991, some months after EFGA acknowledged, by its request for interest-free funding, that it would be unable to meet future funding costs;
(2) functioned as nothing more than a funding conduit to EFGA to secure funding provided by FGL for the purposes of protecting FGL from third party litigation creditors of Finance group companies.
96 Finally on this issue, the Commissioner submitted that Amayana's prospects of profitably employing funds it borrowed from FGL were even more remote than EFGTs. Furthermore, Amayana's interests were consistently sacrificed in the interests of FGL. It was left with unsecured debt when the security structure was established to facilitate the interests of FGL. Subsequently, it acquired EFGA's debts to EFG Financial in order to facilitate the sale of the latter. There was no basis in the evidence for the primary judge's finding (Reasons [189]) that there was a frequent and often nice exercise of business judgment in the conduct of Amayana's affairs.
97 The respondents contended that the Commissioner's contention, referred to in [91] above, concerning the conclusion the primary judge ought to have reached in the face of Fletcher, was incorrect for two substantive reasons.
98 First, as the primary judge found, the explanation for why in relation to ELFIC and EFGS the interest expenses exceeded the income derived in the years in question lies in the adverse economic and commercial factors which affected their businesses and not in the independent pursuit of some objective other than the production of assessable income: Reasons [176], [194]. The evidence is clear. The affairs of ELFIC and EFGS were conducted to maximise the financial return from their business: Reasons [36]. According to the respondents, there can be no issue as to the application of the Fletcher principle or Ure to ELFIC and EFGS. I agree with this submission.
99 The same conclusion is to be drawn in relation to the affairs of EFGA, EFGT and Amayana. There can be no suggestion that the affairs of those companies were conducted for any objective other than to achieve the greatest possible financial return from their businesses: Reasons [36]. The losses sustained by them are to be explained by the economic circumstances which affected their businesses, and not by the independent pursuit of some non-income production objective. Again, I agree with this submission.
100 According to the respondents, for EFGA, EFGT and Amayana there is a second compelling reason why the Commissioner's reliance upon Fletcher and Ure is misconceived. In relation to those companies, there was no 'disproportion' between the outgoing and the income produced. For the period from 1990 to 1998, for each of those companies the interest incurred substantially equalled or was less than the interest accrued which was recognised and returned as assessable income: see Appendix 3, Table 3 for EFGA; Appendix 3, Table 8 for EFGT; Appendix 3 Table 9 for Amayana. In those circumstances, the Fletcher and Ure principles are inapplicable.
101 The respondents submitted that the matters referred to by the Commissioner noted at [92] to [96] above do not demonstrate that the interest expenses of EFGA, EFGT, ELFIC, EFGS and Amayana were 'colourably incurred'. Again, I agree. As the primary judge found in relation to each of those companies, the interest was the recurrent or periodic cost to each company for securing the use of loan funds: see [72] above.
102 Finally, on this aspect of the issue, the respondents submitted that the Commissioner incorrectly submitted (see [96] above) that there was no basis in the evidence for the primary judge's finding that there was a frequent and often nice exercise of business judgment in the conduct of Amayana's affairs. They observed that at trial they produced a number of witnesses who had responsibility for controlling, managing and undertaking the companies of the Foster's Group so far as they related to the affairs of the Finance group; they referred in particular to Mr O'Grady, Mr Johnson and Mr Tan. They submitted it was open to his Honour on the basis of that evidence to conclude as he did at [189] of his Reasons. The Commissioner did not challenge this evidence on the appeal.
103 In summary, what the Commissioner seeks to do under the umbrella of cases such as Ure, Fletcher and Spassked, and contrary to established authority of the cases referred to below, is introduce into the test for deductibility under s 8-1(1) notions of motive and subjective purpose going to the ultimate end to which the business activities of the relevant respondent companies were directed and how best to achieve that objective, rather than accept that the question of whether expenditure is incurred for the purpose of carrying on a business is to be determined objectively by reference to the relationship between what the expenditure is for and the taxpayer's undertaking or business: Magna Alloys & Research at 225 per Brennan J (see [89] above).
104 As Dixon J said in Federal Commissioner of Taxation v Midland Railway Co of Western Australia Ltd (1952) 85 CLR 306 at 313:
'[W]hat governs the issue is the business purposes for which the outgoing was incurred from the point of view of the taxpayer company. The controlling factors are those which arise from the character of the business or undertaking and the relation which the expenditure or the liability to make it bore to the carrying on of the business or the gaining of assessable income.'
And as Brennan J responded at 222 in Magna Alloys & Research:
'Once the "controlling factors" are ascertained, the business purposes for which an outgoing is incurred may be determined. In that step towards characterization, the taxpayer's state of mind has no part to play. His purpose or motive is not a controlling factor of the purpose to be attributed to the incurring of the expenditure. But in ascertaining the controlling factors, the taxpayer's state of mind may have a significant evidentiary role to play, and by leading to the ascertainment of the controlling factors, it may even be the determinative element in characterizing expenditure in a particular case. Nevertheless, the taxpayer's state of mind - whether intention, or purpose, or motive - is evidentiary only.
What the taxpayer has in mind may bear upon "the character of the business or undertaking" in showing the scope of his business or undertaking. The taxpayer is at liberty to determine for himself what the scope and nature of his business or undertaking shall be and how it shall be conducted, the Act having no effect upon those matters but taking "the result of the taxpayer's activities as it finds them": per Williams J in Tweddle v FC of T (1942) 7 ATD 186 at 190; 2 AITR 360 at 364. Fullagar J, referring to the operation of "necessarily" in the second limb of s 51(1), said in Snowden & Willson Pty Ltd, supra, (99 CLR at 444; 7 AITR at 317): "It means for practical purposes that, within the limits of reasonable human conduct, the man who is carrying on the business must be the judge of what is 'necessary'." And thus what the taxpayer says are the character and scope of his business or undertaking is evidence of what its character and scope are in fact.' (Emphasis added.)
105 For the foregoing reasons, there was, in my view, no error in the primary judge's conclusion that the interest expenses claimed by EFGA, EFGT, ELFIC, EFGS and Amayana as deductions were incurred by each of them in carrying on business for the purpose of gaining or producing assessable income and that, in consequence, the requirements for deductibility under s 8-1(1) are satisfied. It remains to consider the requirements of s 8-1(2) to which I now turn.
106 Notwithstanding satisfaction of the requirements of s 8-1(1), s 8-1(2)(a) will deny a deduction for a loss or outgoing if it is, inter alia, a loss or outgoing of capital, or of a capital nature.
107 The Commissioner says that the fact that an outgoing is called or labelled 'interest' does not determine its character as an outgoing on revenue account; that it is necessary to determine the 'essential character' of the liability; that in doing so, the nature of the advantage sought is the chief, if not the critical factor in determining the essential character: Commissioner of Taxation v Citylink Melbourne Limited (2006) 228 CLR 1 at [148] per Crennan J (with whom Gleeson CJ, Gummow, Callinan and Heydon JJ agreed); GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124 at 137; that the nature of the advantage is to be determined objectively: St George Bank v Commissioner of Taxation (2008) 69 ATR 634; and essential character is to be considered from a practical and business point of view: Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634 at 648.
108 So much may be accepted, although there are nuances which come out of the labyrinth of cases that have been decided by the courts of this country over nearly 100 years of federal income tax legislation on the capital/income distinction in the context of the construction and application of s 51(1) (s 8-1) that, arguably, give lie to its accuracy or, at best, entitle one to criticise it as an over-simplification. More importantly, as a statement of principle it takes us nowhere. As has often been said of the distinction, it is not so much the principles that are in doubt, but the application of those principles to a given set of facts.
109 The Commissioner accepts that ordinarily interest will be on revenue account if incurred in the course of an income-producing activity. In Texas Company (Australasia) Ltd v Federal Commissioner of Taxation (1940) 63 CLR 382 at 468 Dixon J said;
'Some kinds of recurrent expenditure made to secure capital or working capital are clearly deductible. Under the Australian system interest on money borrowed for the purpose forms a deduction. So does the rent of premises and the hire of plant. No doubt the difficulty of assigning an outgoing to capital or income is often very great.'
This passage has been repeatedly relied on over the years.
110 It will be a rare case where interest incurred by a company in raising money which it uses as capital or working capital in the course of its business is found to be of a capital nature. That there may be particular circumstances where that occurs was recognised in Steele v Deputy Commissioner of Taxation (1999) 197 CLR 459 at [29] where Gleeson CJ, Gaudron and Gummow JJ said:
'As was explained in Australian National Hotels Ltd v Commissioner of Taxation [(1988) 19 FCR 234 at 239 - 241], interest is ordinarily a recurrent or periodic payment which secures, not an enduring advantage, but, rather, the use of borrowed money during the term of the loan. According to the criteria noted by Dixon J in Sun Newspapers Ltd v, Federal Commissioner of Taxation [(1938) 61 CLR 337 at 359-363], it is therefore ordinarily a revenue item. This is not to deny the possibility that there may be particular circumstances where it is proper to regard the purpose of the interest payments as something other than the raising or maintenance of the borrowing and thus, potentially, of a capital nature,' (See, for example, RW Parsons, Income Taxation in Australia at [6.111].)
111 At that time, the High Court was unable to refer to any judicial authority which exemplified this possibility for the simple reason that there was none; hence the Court's reference to the circumstance postulated in the learned author's work. Since that time, Full Courts of this Court have considered factual situations in two cases, one involving a finance company and the other a bank, where it was concluded that the circumstances were such that interest outgoings incurred by the taxpayer on moneys borrowed and used in the course of carrying on their finance/banking businesses were nevertheless of a capital nature: Macquarie Finance Ltd v Commissioner of Taxation (2005) 146 FCR 77; St George Bank Ltd v Federal Commissioner of Taxation (2009) 176 FCR 424. While the Commissioner seeks to rely on these cases, or at least the first in support of his contention that the interest expenses in the present case are, for each of the relevant respondent taxpayers, of a capital nature and therefore not deductible, thankfully it is not necessary to 'drill down' into the processes of reasoning which led to the conclusion reached in each of those cases; the facts of the present case are so far removed from the facts in those cases as to make that reasoning irrelevant.
112 More importantly for present purposes, was what was said in the joint judgment in the High Court in Steele in the passage that immediately followed the extract reproduced in [110] above. Their Honours said (at [29]):
'However, in the usual case, of which the present is an example, where interest is a recurrent payment to secure the use for a limited term of loan funds, then it is proper to regard the interest as a revenue item, and its character is not altered by reason of the fact that the borrowed funds are used to purchase a capital asset. The fact that the asset has not yet become, and may never become, income-producing may be relevant to a decision as to whether the case falls within the first limb of s 51(1). However, once it is determined, or accepted by hypothesis, that the interest is, during the relevant year, an outgoing incurred in gaining or producing the taxpayer's assessable income [or in carrying on a business for that purpose], (even though no assessable income is derived during that year, and no such income may ever be derived), the circumstance that the capital asset has produced no income is not a reason to conclude that the interest is an outgoing of a capital nature.' (Emphasis added.)
113 The analysis and conclusion manifest in this passage from their Honours' reasons may be enough to conclude this aspect of the issue in favour of the respondents. Nevertheless, in deference to the Commissioner's submissions, I turn to address them in the context of the primary judge's findings.
114 The primary judge held that the interest was revenue in nature, because even if the loan principal is properly to be regarded as a capital asset in the hands of the lender, the interest paid to secure that capital sum or keep it in circulation is on revenue account: Reasons [200]. The authority the primary judge relied on was a passage from the judgment of Bowen CJ and Burchett J, in Australian National Hotels Ltd v Commissioner of Taxation (1988) 19 FCR 234 at 240, where their Honours said:
'If the capital is raised by loan, an investment of the borrowed moneys in a business will ordinarily remain an investment of capital, and the same consequences will follow. But there is a special feature of loan capital, which flows from the ephemeral nature of a loan. The cost of securing and retaining the use of the capital sum for the business, that is to say, the interest payable in respect of the loan, will be a revenue item. It creates no enduring advantage, but on the contrary is a periodic outgoing related to the continuance of the use by the business of the borrowed capital during the term of the loan.'
115 The Commissioner had argued that the debtor companies incurred the interest expense so as to protect FGL's position as an unsecured creditor of the Finance group, to preserve the full rebate on dividends flowing to FGL and to achieve a 'balancing out' of additional costs incurred by FGL in funding the Finance group. But the primary judge held that the extraneous purposes the Commissioner identified did not disentitle the debtor companies from claiming the interest expense on revenue account: Reasons [199], [200].
116 The Commissioner submitted that the primary judge erred in his conclusion on this issue. The Commissioner referred to Macquarie Finance at first instance (2004) 210 ALR 508 where Hill J referred to Australian National Hotels in the course of deciding that interest on money that Macquarie Finance borrowed was capital in nature. At [63] his Honour said:
'The emphasis their Honours place is on "the ephemeral nature" of the loan. In the circumstances of the present case the close relationship between the notes and the preference shares, as well as the fact that MBL can ensure the loan is never repayable but that an investor is left commercially only with MBL preference shares, can be seen to produce a different result. The present case is not concerned with the cost of acquiring or maintaining a loan of an ephemeral character, but rather with the cost of a capital raising which so far as MBL is concerned is the cost of a permanent injection of capital. The circumstance that the capital is in the present conditions used to make loans to Macquarie Leasing is not determinative.'
117 The Commissioner in his submissions observed that a majority of the Full Court (French and Gyles JJ) upheld Hill J's decision. Although French and Gyles JJ preferred to uphold the decision on the basis that the interest was not deductible under s 8-1(1), they agreed that it was also capital in nature. In a persuasive reasoned analysis, Hely J dissented on both limbs.
118 The Commissioner submitted that, like the loans in Macquarie Finance, the loans here manifest the features of permanent capital, rather than debt. The funds borrowed by EFGT, Amayana and EFGA were poured into the 'tottering subsidiaries', at FGL's direction to protect the investment FGL had been forced to make following withdrawal of EFGA's external funding lines; cf., Levin & Co Ltd v Commissioner of Inland Revenue [1963] NZLR 801. None of the taxpayers were seeking to derive income for itself or to conduct business for that purpose but to maximise profits in the interests of FGL and its shareholders. The funding was provided in what was, in effect, the informal liquidation of the Finance group in circumstances where there was an insufficiency of shareholders' funds and no profits for distribution. The funding was needed to shore up the insufficiency in shareholders' funds long enough to secure an orderly realisation of the residual assets and provided as necessary to meet the weaknesses in the capital structures of ELFIC and EFGS whilst limiting equity funding to optimise recoveries in the light of possible claims by litigants. The interest incurred on those funds was not, then, incurred for the purpose of earning assessable income. Further or alternatively, properly characterised, the claimed interest deductions were expenses of a capital nature.
119 There are a number of difficulties with the Commissioner's submissions, most, if not all of which, stem from his attempt to assimilate the 'essential character' of the interest expenses claimed by the relevant respondent taxpayers in the present case with the interest outgoings of the taxpayer under review in Macquarie Finance.
120 First, while Hill J (at first instance) approached the deductibility of the interest in Macquarie Finance from an holistic basis - looking at s 8-1 as a whole - the majority on appeal approached the issue on a bifurcated basis - first by reference to s 8-1(1) and only then by reference to s 8-1(2). Both held that the interest payments on the notes were not incurred by Macquarie Finance Ltd ('MFL') in gaining or producing assessable income nor necessarily incurred in carrying on a business for that purpose: French J at [103], [104]; Gyles J at [255]. Here, the primary judge found that the interest expenses claimed by the relevant respondent taxpayer did satisfy the requirements of s 8-1(1), a finding with which I am in total agreement. That being so, what was said in the joint judgment in the High Court in Steele at [29] (see [112] above), comes into play and the fact that no income, or less income than the interest outgoing, is produced in the relevant year of income 'is not a reason to conclude that the interest is an outgoing of a capital nature'.
121 Second, the factual matters which the Commissioner asserted assimilates the loans to the relevant respondent taxpayers in the present case to the loan in Macquarie Finance do not withstand scrutiny.
(1) It is said that the loans here manifest the features of 'permanent capital' rather than 'debt' but apart from that bald statement, the manifestation is not explained by reference to any distinguishing criteria in characterising 'permanent capital', on the one hand, and 'debt' on the other, let alone identifying the criteria referable to 'permanent capital' exhibited by the loans to the relevant respondent taxpayers in the present case.
(2) It is said that the funds borrowed by EFGT, Amayana and EFGA were poured into:
(i) 'tottering subsidiaries' (a phrase taken from Levin); and
(ii) at FGL's direction to protect the investment FGL had been forced to make following withdrawal of EFGA's external funding lines.
The fact that the subsidiary borrowers were in financial difficulty at the time loans ('underlying loans') to them were made or that the underlying loans were made at the direction of the ultimate parent company does not convert the interest outgoings, on loans ('funding loans') made to fund the underlying loans, from outgoings of a revenue nature to outgoings of a capital nature. To suggest otherwise would be to deny deductibility for interest incurred on moneys borrowed to fund interest-bearing loans to borrowers in financial difficulty, or where such loans were made at the direction of the lender's parent. These matters are irrelevant to the issue of the characterisation of the interest outgoings on the funding loans as being on revenue or capital account.
(3) It is said that none of the relevant respondent taxpayers were seeking to derive income for itself or to conduct business for that purpose but to maximise profits in the interests of FGL and its shareholders. But it is not in dispute that the relevant respondent taxpayers did derive income for themselves, and in amounts approximating, or in some cases even exceeding, their annual interest outgoings; and that they did carry on business. Every subsidiary company that carries on business and derives income in the process is doing so for itself even though its profits ultimately enure for the benefit of its parent and its shareholders. Even if, as one would hope to be the case in a well-run business, the subjective motivation or purposes of those who controlled the relevant respondent taxpayers extended to maximising profits for the ultimate benefit of FGL and its shareholders, that would not convert what was otherwise be an outgoing of a revenue nature into one of a capital nature.
(4) The same comment can be made of the Commissioner's observation that the funding was provided in what was, in effect, the informal liquidation of the Finance group in circumstances where there was an insufficiency of shareholders' funds and no profits for distribution; as it can of his observation that funding was needed to shore up the insufficiency in shareholders' funds long enough to secure an orderly realisation of the residual assets to meet the investments in the capital structures of ELFIC and EFGS whilst limiting equity funding to optimise recoveries in the light of possible claims by litigants. There are business considerations which dictate how the business is carried on in pursuit of its business objectives. Even if all of these considerations were uppermost in the minds of those charged with responsibility in the decision-making process involved in the making of the underlying loans, as to which there is no finding, this would not alter the essential character of the interest on the funding loans in the objective circumstances as found, namely, that the loans were income-producing and made in the ordinary course of business of the relevant respondent taxpayers, irrespective of how those businesses may be described.
122 In making these submissions, the Commissioner placed considerable reliance on the decision of the New Zealand Court of Appeal in Levin, in particular for his submission that simply because the same activities of lending money were carried on after 1990 as were carried on before 1990, this was no foundation to characterise the post-1990 activities in the same way as the pre-1990 activities, where relevant circumstances had changed. As a matter of principle, so much may be accepted. However, not only is the factual context of Levin very different from the one under consideration in the present case, it concerned a totally different statutory context. Moreover, at the end of the day, the reason why the majority (Turner and McCarthy JJ) held that write-offs in respect of advances made after 1 August 1958 were not deductible whereas write-offs in respect of advances made prior to 1 August 1958 were deductible was that the taxpayer had not discharged the onus in respect of loans made after that date. In the words of McCarthy J at 844:
'I do not overlook that there is authority for the proposition that further loans advanced to salvage loans made in the course of the normal activity of a money-lending company partake of the nature of the original advances and do not thereby become capital; but the appellant here was in a somewhat different situation from that of the appellant in Calders Ltd. v Commissioners of Inland Revenue 1944 S.C. 433; (1944) 26 T.C. 213. Here the appellant had a large capital investment in Snowcraft, and moreover had a liability under its guarantee to the bank. Inevitably, one would think, when considering whether or not further loans would be advanced, the protection of the capital position of Snowcraft must have arisen in the minds of the appellant's directors and would have influenced them. But it is not necessary to go as far as that. The onus is on the appellant to show that those loans were not of the character claimed by the Commissioner, that is that they were not of a capital nature and were made wholly in the earning of the assessable income of the appellant. Whilst I am prepared to say that the appellant discharged that onus in respect of loans made up to 1 August 1958, it certainly has not discharged the onus in respect of loans made after that date. In these circumstances I find myself, as does Turner J., unable to say that the whole of the £75,000 is necessarily deductible. Whether all that sum or less should be allowed depends, as Turner J. points out, on a number of considerations which were not really canvassed before us.'
For these reasons, very little, if anything, can be drawn from the decision. It certainly does not support a conclusion based on the facts found by the learned primary judge that, while EFGA's money-lending activities prior to 1990 are conceded to be on revenue account, such activities after that time were on capital account.
123 For the foregoing reasons the interest expenses claimed by the relevant respondent taxpayers were not outgoings of a capital nature so as to be denied deductibility under s 81(2)(a).
124 It follows that this ground of the Commissioner's appeals cannot be sustained.