Commissioner of Taxation v Firth

Federal Court of Australia (Full Court)|2002-01-01|Before: Finn JJ, Hill J

Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules.

ON APPEAL FROM A JUDGE OF THE FEDERAL COURT OF AUSTRALIA

REASONS FOR JUDGMENT HILL J: 1 The issue in this appeal is whether some part of the interest payable on a loan from a third party used to purchase income producing assets is to be regarded as not an allowable deduction because the terms of the loan provided that the lender had only limited recourse against the borrower for repayment and accordingly was (except in a specific circumstance) limited to its rights against the property which was provided by way of security. 2 The facts are set out in detail in the judgment of Sackville & Finn JJ which I have had the privilege of having read in draft form. I adopt their Honours' statement of them for which I am grateful. 3 Two questions were said to be raised by the appeal. The first was whether s 8-1 of the Income Tax Assessment Act 1997 (Cth) permitted an apportionment of interest to be made in the present case, so that some part of the interest could be characterised as an amount paid by the borrower to obtain the limited recourse which the loan agreement gave him. The second question, which only required to be answered if the first question was answered in the affirmative, was whether that part of the interest which was so characterised was capital or on capital account so that it was precluded from deductibility. The question, how the apportionment was to be effected was not raised for us to decide as the parties had agreed that if apportionment was appropriate in the present case an amount of $353,021 out of the total interest paid of $1,268,277.60 was not allowable as a deduction. The way that figure was arrived at is set out in the judgment of Sackville and Finn JJ to which I have already referred.

Apportionment of interest and s 8-1 4 It is obvious from the language of s 8-1 itself that the section contemplates that losses and outgoings may be apportioned in the appropriate case. The section provides as follows: "8-1(1) You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. 8-1(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

(d) a provision of this Act prevents you from deducting it." That apportionment is contemplated appears from the words underlined. 5 Section 8-1, which is in similar terms to that of its predecessor, s 51(1) of the Income Tax Assessment Act 1936 (Cth) ("the 1936 Act") is necessarily expressed in language of generality, for it provides for the deduction of the large variety of losses or outgoings which may be described compendiously as normal working outgoings or normal business expenses: Federal Commissioner of Taxation v Riverside Road Pty Ltd (1990) 23 FCR 305 at 311. It is expressed relevantly in two subsections, the first of which may be referred to as involving the positive tests of deductibility and the second the negative tests excluding a loss or outgoing from being deductible. 6 The positive tests require that there be a connection between the loss or outgoing on the one hand and the assessable income or business on the other. The nature of that connection has been expressed in different ways in the cases. It is sometimes said that there must be a "perceived connection" between the loss or outgoing and the assessable income or business: Federal Commissioner of Taxation v Hatchett (1971) 125 CLR 494 at 499. In other cases it has been said that the expenditure must be "incidental and relevant" to the operations or activities regularly carried on by the taxpayer for the production of income: Ronpibon Tin NL v Federal Commissioner of Taxation (1949) 78 CLR 47 at 56, Federal Commissioner of Taxation v Smith (1981) 147 CLR 578 at 586. These ways of describing the connection that is a necessary prerequisite to deductibility are but part of the process of identifying the essential character of the expenditure in order to determine whether a particular loss or outgoing is in fact incurred in gaining or producing the assessable income or in carrying on a business which more directly contributes to the gaining or production of the assessable income: Lunney v Federal Commissioner of Taxation (1958) 100 CLR 478 at 499. 7 If the loss or outgoing has some connection with the assessable income or the business which more directly gains or produces the assessable income but in addition some connection which is not that described in the section it will be necessary to apportion the loss or outgoing at that point. 8 The negative tests in subs (2) will exclude the loss or outgoing from deductibility where the whole or some part of the loss or outgoing falls within one or more of the four stated exclusions. If the loss or outgoing falls within any of the four stated exclusions but only in part, it will be necessary for there to be an apportionment in order to see how much of the loss or outgoing is excluded from deductibility. 9 Both the question whether a loss or outgoing has the necessary connection with the assessable income or business and the question whether it is excluded from deduction under subs (2) require characterisation of the loss or outgoing. The task of characterisation will involve enquiring what the loss or outgoing was for: Colonial Mutual Life Assurance Society Ltd v Federal Commissioner of Taxation (1953) 89 CLR 428 at 454, Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634. 10 The normal case will seldom give rise to any difficulty in answering this question. There is unlikely to be a difficulty in the normal case in determining what an amount paid by way of rent, or what an amount paid as salary will be for. In the normal case where an outgoing is consideration for some legal obligation assumed by the payee the question generally will be answered by considering the legal obligations which arise and it will be unnecessary to look outside the terms of the contract. Other questions will arise where the payment was voluntary. And even where an outgoing was made to secure performance of a legal obligation it may sometimes be necessary to go outside the terms of the contractual obligations to determine, in the language of Dixon J in Hallstroms at 648 "what the expenditure was calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process." 11 A case where it was necessary to go beyond the legal rights and obligations for the purposes of seeing whether interest incurred by the taxpayer as an outgoing fell within the first limb of s 51(1) of the 1936 Act was Ure v Federal Commissioner of Taxation (1981) 34 ALR 237. In that case the taxpayer borrowed money at a commercial rate of interest and on- lent the money to a member of his family at a low rate (1%) of interest. No doubt it was true that the interest was the price of the money borrowed and that the money borrowed had been used in gaining or producing assessable income in the form of interest on the money on-lent. But clearly that was not the whole story. The purpose of the borrowing could not fairly be said to be only the production of the 1% interest derived from the lending. It included, as well, a family purpose (and a taxation purpose). Accordingly the interest allowable as a deduction was not the whole of the interest incurred. What was deductible was only so much of that interest as equalled the interest paid to the taxpayer on the on-lending. 12 It is not necessary in the present case, any more than it was in Federal Commissioner of Taxation v BHP Co Ltd (2000) 179 ALR 593, see particularly at 601-2 to go outside the contractual arrangements entered into by the taxpayer to determine what the payment made by the taxpayer was for. Neither party suggested otherwise. 13 However, there is a particular difficulty which arises where the question is whether an outgoing of interest is deductible. Interest is the price of money which is borrowed. It is "the return or consideration or compensation for the use or retention by one person of a sum of money belonging to, in a colloquial sense, or owed to another.": Re Farm Security Act 1944 of the Province of Saskatchewan [1947] SCR 394 at 411-12, (PC) referred to by the full Court in BHP. It is, referable to a sum borrowed or agreed to be borrowed. Without a borrowing (or agreement to borrow) there can be no interest. But to note that interest is the price of borrowing a sum of money tells little about the deductibility of the interest and in particular, little about the relationship between the interest outgoing and the gaining or production of assessable income (or the business directed at the gaining or producing of assessable income). It is necessary to go further and to enquire what the borrowed funds are used for: cf Federal Commissioner of Taxation v Munro (1926) 38 CLR 153. Hence the deductibility of interest is normally to be determined by looking at the purpose of the borrowing. That in turn will ordinarily require regard to be had to the use to which the borrowed funds are put. It is not necessary to consider here the difficult case which will arise when the purpose of the borrowing and the use to which the borrowed funds are put may be seen to differ, or to resolve which of these two tests will then be the appropriate test to be applied, cf the situation which arose in Riverside Road where the business acquired with the borrowed funds was sold but the interest liability continued. 14 While it is no doubt true that the rate of interest which will be charged by a lender to an arms length borrower will vary depending upon both matters personal to the borrower, (eg the credit standing of the borrower and the terms upon which the loan is made eg whether the loan is made with or without security and the nature of the security), the terms upon which the loan is made will have little significance in determining whether the interest payable under that loan is deductible. This is because it is the use of the money once borrowed that will normally chart the connection between the interest and the assessable income or business. 15 In the normal case where no part of the interest or other amounts payable by the borrower to the lender is paid for a particular term of the loan agreement, interest will be the consideration for the borrowing of the principal sum upon the terms which the parties have agreed. The fact that in one case the remedies of the lender may be different from the remedies of a lender in another case does not require the conclusion that some part of the interest should be attributed to some consideration said to be able to be inferred from a difference in interest rates on the two loans (if indeed here any such difference existed) or a difference in the terms of the loan as such. In the ordinary case interest unapportioned is not consideration for separate obligations on the part of the lender or separate advantages conferred upon the borrower. It is a composite and unapportioned consideration for the lender being kept out of the funds borrowed for the term of the loan and for the borrower having access to those fund during the course of the borrowing. I say the ordinary case because the present case does not raise the kind of problem which may arise where there is a pre-payment of interest, or where interest is paid between parties not at arm's length and at a non-commercial rate: eg Ure, and Federal Commissioner of Taxation v Ilbery (1981) 58 FLR 191and see per Gleeson CJ, Gaudron and Gummow JJ in Steele v Deputy Commissioner of Taxation (1999) 197 CLR 459 at 470. 16 It would be strange if it was necessary in order to determine the question of the deductibility of interest to examine each clause of a loan agreement, and having determined which clause conferred an advantage upon the borrower then apportion some part of the interest payable to that advantage. Apart from the fact that it would then, presumably, be necessary to look at those terms which conferred a detriment upon the taxpayer and attribute to them some negative value, and apart from the considerable difficulties of apportionment which would arise, parties to the normal loan agreement do not approach the bargain which they desire to enter in this way. For example, an unsecured loan will undoubtedly confer upon the borrower an advantage in that, the absence of security will ensure that no asset of the borrower is encumbered. But it would not be factually or contractually correct to say that some part of the interest (presumably reflecting the difference in commercial interest rate between a secured and an unsecured loan) was paid for the agreement of the lender not to require security. It is no more correct here to say that some part of the interest which the borrower agreed to pay to the lender was consideration for the agreement on the part of the lender not to pursue remedies under a personal covenant to repay against the borrower. The unallocated consideration which represented the cost of the borrowing was here paid as consideration for the lender advancing for the term of the loan the principal sum borrowed. It was not in part consideration paid for some agreement which was a consequence of the terms of the loan. 17 Parties to a loan could, if they wished, agree that in addition to the lender making funds available to the borrower the lender would, for a separate consideration, confer upon the borrower some additional advantage. There is nothing, for example to prevent a borrower agreeing to pay to a lender a consideration for agreeing not to pursue personal remedies against the borrower in the event of default in repayment of the loan. Nor would there be anything which would prevent a borrower agreeing to pay the lender a sum of money in consideration of the lender agreeing not to require a particular security. In such a case the amount paid would not, at least contractually, be solely consideration for the amount advanced to the borrower, but rather in whole or in part consideration paid for a separate advantage conferred by the lender upon the borrower. But that is not the present case. 18 In Federal Commissioner of Taxation v Phillips (1978) 78 ATC 4361 Fisher J pointed out that it was "only if the taxpayer obtains, for a consideration which is identifiable and qualifiable, an additional advantage unconnected with the business activity that it can be said that portion of his expenditure is laid out for a purpose other than the acquiring of assessable income." While his Honour's comment may require some qualification in the light of the judgement in South Australian Battery Makers, it remains nevertheless true that it would be difficult to imagine a case where there could be said to be an advantage over and above the advantage specifically contracted for obtained by a taxpayer in a commercial transaction for consideration where the consideration was neither attributable to that advantage nor identifiable unless, at least, the consideration was grossly excessive. The present is not such a case. 19 The difference is not merely one of form. It is one of substance. It is derived from the answer which is given in a particular case to the question what the interest is paid for. It is derived by looking at the circumstances of the bargain the whole of which, here, are reflected in the written agreements, arrived at between the lender and the taxpayer 20 While the issue of quantum is not relevant directly to the present issue before the Court, the peculiarity of the calculation does make it clear how difficult it would be to attribute some part of the interest as relating to an agreement which is a consequence of the loan terms, rather than a separate agreement. The computation made by the Commissioner was made by reference to what was said to be a "benchmark" rate calculated as the average between the Reserve Bank Bulletin Indicator Lending Rates for "Personal Unsecured Loans" and Credit Cards. As an average rate it takes no account of the business expectations of the lender or the personal characteristics of the borrower. Nor does the rate take any account of the value of the security or the nature of the security. The higher the margin of security and the safer the security is the less significance would be the need to proceed under the personal covenant. In fact, as it appeared, the taxpayer repaid the loans personally rather than permitting the lender to proceed against the securities which were largely shares in the major banking institutions. One might think that a lender offered security over shares where there was a considerable margin of security and little likelihood of the shares decreasing in value would place little value upon the personal covenant. The case would be different if there was but a small margin of security (or none at all) and there was a real likelihood that during the term of the loan the security might decline in value. 21 We were taken to what was said in the High Court in Ronpibon Tin at 59 on the question of apportionment of undissected expenditure. This was in support of a proposition that the fact that apportionment might be difficult did not prevent an apportionment being made in a case where apportionment was required. Ronpibon Tin was a case where expenditure was incurred in the course of business activities directed in part towards the gaining and producing of exempt income and in part towards the gaining and producing of assessable income. Latham CJ, Rich, Dixon, McTiernan and Webb JJ said: "It is perhaps desirable to remark that there are at least two kinds of items of expenditure that require apportionment. 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. Of this directors' fees may be an example. With the latter kind there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income. It is an indiscriminate sum apportionable, but hardly capable of arithmetical or ratable division because it is common to both objects. In such a case the result must depend in an even greater degree upon a finding by the tribunal of fact." 22 That is a quite different case to the present. The question, what the expenditure which the taxpayer sought to deduct in Ronpibon was for, was clearly answered in that case. For example, one item was director's fees paid for the series prepared by the directors. That question having been answered, the statutory question which required apportionment in Ronpibon was the extent to which the expenditure sought to be claimed as a deduction related to assessable income. That apportionment was required to be made on the basis of what was a fair and reasonable apportionment of the sum claimed so as to determine the extent of the outgoing so far as it related to that part of the taxpayer's business which was directed at the gaining of assessable income (which was deductible) and the extent of the outgoing so far as it related to that part of the taxpayer's business which was directed at gaining exempt income (or none at all, where the business had, in effect, ceased). In the present case the Commissioner wishes to apportion at the earlier stage, namely at the stage of identifying what the expenditure was for in a case where the parties had not contracted for separate advantages, but for a single, undissectable advantage. No doubt where parties to an agreement do contract for severable advantages and for separate considerations an apportionment will be possible with the result that a deduction will only be available for that consideration or that part of the consideration which relates to an advantage of a revenue nature which fulfils the criteria for deductibility under s 8-1. But whether the contract is severable or indivisible and thus whether an apportionment is required or not will depend upon the terms of the contract and the nature of the advantage sought to be gained under it. 23 Because I am of the view that an apportionment is not required in the present case it is unnecessary that I consider whether if some part of the interest is to be attributed to a notional agreement on the part of the lender not to pursue remedies under a personal covenant, that part of the interest would be an outgoing of capital or of a capital nature. That question requires an examination of the essential character of the expenditure. Again however the determination of the essential character of an outgoing requires there to be answered the question what the expenditure is for. 24 In Steele, a majority of the High Court were of the view that the interest in that case was not on capital account. Their Honours were of the view that ordinarily at least, interest would be on revenue account, although they left open the possibility that in a particular case interest could be held to be on capital account. 25 By characterising that part of what was said to be interest as consideration for an agreement on the part of the lender not to enforce repayment of the loan by way of the personal covenant the Commissioner implicitly seeks to assert that which the parties themselves regard and have nominated as interest, was not in truth interest at all. 26 If it was correct to regard some part of the interest agreed upon by the parties as being not a consideration for the use by the taxpayer of the money borrowed but as consideration for an agreement by the lender not to pursue personal rights of recovery the question whether the consideration was of a capital nature would fall to be determined by the application of the well known tests enunciated by Dixon J in Sun Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 at 363. The first of these tests, "the character of the advantage sought" is, perhaps, the most significant, as the High Court noted in GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124 at 137. Under this test it will be important to consider whether the advantage was of a lasting character.

27 It is difficult I think, for the reasons I have already stated, to dissociate any part of the interest payable from the borrowing of the money. That being so, it is difficult to see the character of the advantage sought as being anything different from that obtained by payment of interest, that is to say, the use of the funds borrowed. Just as the money borrowed was available for the term of the loan (twelve months) so the advantage of immunity from personal suit lasted for the same period. However, it was submitted by the Commissioner that immediately the loan was entered into the borrower was relieved of the personal obligation and thus secured a once and for all advantage, an advantage which the taxpayer received each time a loan was made to him on terms that the lender would not pursue the personal obligation to repay. Given that the taxpayer entered into loans periodically during the relevant time, it is hard to see the consideration payable here as any different from the periodical consideration paid for the moneys advanced to him. While periodicity is not necessarily determinative of the revenue nature of an outgoing it is certainly very relevant. Recurrence is the idea found in the second test in Sun Newspapers ("the manner in which it is to be used") and plays a part also in the third test, (namely "the means adopted to obtain it").

28 Counsel for the taxpayer sought to rely upon the decision of the full Court of this Court in Australian National Hotels Ltd v Federal Commissioner of Taxation (1989) 19 FCR 234, where it was held that premiums payable to obtain indemnity against exchange losses, which losses were themselves on capital account, were nevertheless themselves on revenue account and thus deductible. The majority of the full Court, Bowen CJ and Burchett J drew an analogy between the premium on the policy in that case and the premium payable on insurance of assets of a business. In both cases the advantages sought were not enduring (although the advantage continued for the term of the policy) and the cost of protecting those assets was a recurring cost of the business.

29 The analogy between the facts of the present case and the facts in the Australian National Hotels case is not a perfect one. Insurance premiums, even those designed to protect capital assets are part of the recurring costs of a business and are, in the sense the word is used in the cases, "periodical" just as rent and interest are. It can be said that there is a difference between such periodical expenditure on the one hand and expenditure to obtain protection against suit until repayment of a loan or default in such repayment as the case may be. However, where borrowings are a regular part of the activities of a share investor (the question whether the taxpayer here was a share-trader was left undecided, although his Honour found that he employed businesslike systems, strategies and analyses in buying and selling shares and carried on a business in so doing, whether that business was investment or share-trading) the analogy is quite close. The short term nature of the loans is also a relevant factor, just as the short term nature of some, at least of the petrol solo restraint covenants was in BP Australia Ltd v Commissioner of Taxation (1965) 112 CLR 386. In that case the appellant secured immunity against petrol stations purchasing stocks from competitors for periods up to 15 years, with the average being for a term of five years. While the length of time was said by the Privy Council not to be a deciding factor in that case, their Lordships did indicate that had the freedom from competition been only for two or three years that fact would have pointed towards the expenditure being recurrent and thus on revenue account.

30 However, the real reason why the interest here was not on capital account rests on a simpler basis. It is that even if it can be said that some part of the interest did relate to securing freedom from personal suit, the real character of the payment was no different from the real character of the balance of the interest paid. It lay in the securing of funds to permit the acquisition by the taxpayer of income producing assets. It was, on revenue and not on capital account for the same reason as the balance of the interest paid by the taxpayer was.

31 I would, accordingly, dismiss the appeal with costs.

I certify that the preceding thirty-one (31) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Hill.

ON APPEAL FROM A JUDGE OF THE FEDERAL COURT OF AUSTRALIA

sackville & finn jj: 32 The question on this appeal is whether portion of the interest expenses incurred by the respondent ("taxpayer") in respect of so-called protected equity investment loans ("PEILs") should be regarded as having been incurred on capital account and as such not deductible by the taxpayer under the general deduction provisions of the Income Tax Assessment Act 1997 (Cth) ("ITAA"). The contention of the appellant ("the Commissioner") is that portion of the interest expenses was referable to the limited recourse feature of the PEILs and, to that extent, was an outgoing of capital or of a capital nature.

the proceedings 33 The proceedings before the primary Judge, Firth v Commissioner of Taxation [2001] ATC 4,615, were by way of an appeal by the taxpayer against an "appealable objection decision" whereby the Commissioner disallowed an objection to an assessment of income tax for the year ended 30 June 1999: see Taxation Administration Act 1953 (Cth), ss 14ZZ(c), 14ZZN, 14ZZO and 14ZZP. The taxpayer, who is a solicitor, had claimed a deduction under s 8-1 of the ITAA in the sum of $1,268,277.60 for interest expenses incurred by him during the year of income. Those interest expenses had been incurred in respect of 37 PEILs provided by Equity Margins Limited ("EML"), totalling some $6.97 million. The proceeds of the loans were used to purchase shares in three banks, namely the National Australia Bank, the Commonwealth Bank of Australia and St George Bank Ltd. The interest rates applicable to the PEILs varied from about 17.3 per cent per annum to about 19.3 per cent per annum. 34 The Commissioner determined that portion of the interest paid by the taxpayer had been paid in order to gain the benefit of the limited recourse feature of each PEIL - that is, the benefit of terms which limited EML's right of recovery of the principal of each loan to an amount obtained by enforcing its rights against the shares bought by the taxpayer with the borrowed funds. The Commissioner apportioned the interest paid by the taxpayer on the basis of a "Benchmark Rate" published by the Commissioner. The Benchmark Rate was calculated by reference to the Reserve Bank Bulletin Indicator Lending Rates for personal unsecured loans. The Benchmark Rate so calculated for June 1999 was 13.15 per cent per annum, while the interest rates on PEILs drawn down by the applicant in that month varied between 18.13 per cent and 18.23 per cent per annum. The Commissioner disallowed $353,021 out of the total interest deduction of $1,268,277.60 claimed by the taxpayer. The amount disallowed represents the difference between the interest paid by the taxpayer and the interest that would have been paid had the interest been set at the Benchmark Rate. Before the primary Judge the Commissioner characterised the portion of interest disallowed as a "capital protection fee". 35 The taxpayer objected to the assessment and the Commissioner disallowed the objection. The primary Judge set aside the Commissioner's objection decision and ordered that in substitution therefor the taxpayer's objection be allowed. 36 It should be noted that the taxpayer did not dispute, either before the primary Judge or on the appeal, the Commissioner's approach to apportionment if it were to be held that apportionment were appropriate. In other words, the taxpayer accepted that if apportionment of interest between the revenue and capital components of the interest paid pursuant to the PEIL agreements was required, the Benchmark Rate could be used for the purpose.

the legislation 37 Section 8-1 of the ITAA provides as follows: "(1) You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. (2) However, you cannot deduct a loss or outgoing under this section to the extent that: (a) it is a loss or outgoing of capital, or of a capital nature; or … (3) A loss or outgoing that you can deduct under this section is called a general deduction." As the primary Judge observed, sub-ss 8-1(1) and (2) substantially reproduce s 51(1) of the Income Tax Assessment Act 1936 (Cth) ("ITAA 1936").

the facts 38 There was no dispute as to the primary facts. 39 The taxpayer borrowed the funds under an agreement designated as a "Protected Equity Investment Loan", for the purpose of buying shares in the three banks. The PEILs were taken out in three tranches: 28 May 1999 ($2,465,020); 15 June 1999 ($2,225,703); and 16 June 1999 ($2,278,781.25). The term of each PEIL was for about one year. Under the terms and conditions of the PEILs (cl 3.1) interest was payable in advance on or before the draw down date. In fact, the taxpayer paid the interest at the time each loan was taken out. He repaid the loans in full at maturity, refinancing the loans from another source. The value of the shares the taxpayer had acquired by means of the PEILs increased substantially over the term of the loans. 40 The interest rate charged in respect of each PEIL varied depending on the date of drawdown and the stock to be acquired by the taxpayer. There were even slight variations in the interest rate applicable to loans in respect of the same stock where the loans had been drawn down on the same day. 41 The terms and conditions applicable to each PEIL were the same. The proceeds of a loan could be used by the taxpayer in or towards acquiring "Approved Stocks" or for other business or investment purposes (cl 2.3). However, any use of the proceeds otherwise than for the acquisition of Approved Stocks, required EML's prior consent; moreover, the maximum number of different kinds of Approved Stocks had to be determined by EML (cl 2.2). Where the proceeds were to be applied in or towards the purchase of Approved Stocks, EML was authorised to pay the proceeds of the loan direct to a broker to acquire the shares on behalf of the taxpayer (cl 2.5). 42 As already noted, interest on each loan was payable in advance (cl 3.1). Such interest was not refundable (cl 3.2). The taxpayer was also required to pay a non-refundable establishment fee of one per cent of the aggregate amount of all loans (cl 3.4). Each loan was to be for a fixed term of twelve months or such other term as was agreed (cl 4.1). 43 Not less than seven days prior to the Repayment Date, the taxpayer had to notify EML which of the repayment options he wished to adopt. The options included repaying the loan out of his own funds (cl 4.2(a)) or repaying the loan out of the proceeds of sale of the Approved Stocks (cl 4.2(b)). Clause 4.4 provided as follows: "Where clause 4.2(b) is to apply in relation to a Loan, EML will procure that the Approved Stocks for that Loan are sold. The proceeds of sale (net of brokerage, stamp duty and any other costs of sale) will be applied by EML in or towards payment of the Secured Liabilities and any amount remaining will be paid to the Client." 44 Clause 7 established the "limited recourse" character of the loans: "7. Limited recourse 7.1 EML's recourse against the Client in respect of any amounts owing in respect of a Loan is limited to the amount which EML can obtain by enforcing its rights in respect of the Secured Assets (to the extent that they relate to the Approved Stocks for that loan) but this limit does not apply if any of the following occur: (a) the Client has breached a material undertaking given to EML (other than the obligation to repay the loan); (b) a material representation made or warranty given by the Client under these Terms was or becomes incorrect or misleading; or (c) EML has relied on a statement or some conduct of the Client which in EML's reasonable opinion was materially false or misleading. 7.2 Notwithstanding anything in clause 7.1, EML may prove for the total amount outstanding on a loan and otherwise participate in the winding up or bankruptcy of the Client if another creditor initiates those proceedings. 7.3 The limit on EML's recourse under clause 7.1: (a) does not release the Client from its obligations under these Terms; (b) does not in any way affect EML's right to recover personally from the Client interest, costs or Taxes in connection with these Terms; and (c) does not prevent EML from obtaining equitable relief in connection with these Terms (other than an order requiring repayment of all or some of the amounts owing in respect of a Loan)." The expression "Secured Assets" was defined to include Approved Stocks which had been acquired beneficially by the taxpayer with the proceeds of a loan under the PEIL. 45 The primary Judge found that the taxpayer had inquired of EML what interest rate would be applicable to each loan. The taxpayer had understood that the interest rate payable under each PEIL was higher because the loan was a limited recourse loan, but he did not inquire how much higher the interest rate was.

the primary judge's reasoning 46 Before the primary Judge (as on the appeal) the Commissioner did not dispute that the interest incurred by the taxpayer in the relevant year of income in respect of the PEILs fell within either par (a) or (b) of sub-s 8-1(1) of the ITAA. That is, the Commissioner accepted that the interest constituted an outgoing that had been incurred in gaining or producing the taxpayer's assessable income or, alternatively, in carrying on a business for the purpose of gaining or producing the taxpayer's assessable income. 47 Presumably by reason of this concession, the parties were in agreement that it was unnecessary for the primary Judge to make a finding as to whether the taxpayer had carried on business as a share trader in the relevant year of income. (The taxpayer had prepared his taxation return for the year on the basis that his gains and losses on sales of shares were on capital account.) Nonetheless, notwithstanding the parties' agreement, the primary Judge specifically found that, having regard to the nature and extent of the taxpayer's share trading activities, the taxpayer was in the business of trading or investing in shares during the relevant year of income. 48 The primary Judge noted that the Commissioner's contention was that portion of the interest was not deductible because it was an outgoing of capital, or of a capital nature. His Honour accepted that sub-s 8-1(2) of the ITAA both authorises and requires apportionment of an outgoing where it has a "double aspect". The first question that had to be determined was the reason for which the outgoing was paid. The question was this: "what [was] the advantage sought to be obtained by the expenditure in question?" 49 His Honour considered that this was not a case like Federal Commissioner of Taxation v Broken Hill Co Pty Ltd (2000) 179 ALR 593, where the so-called interest payments were not interest in the true sense of the word. The liability incurred by the taxpayer was properly characterised as interest because it was (at 4,619) "a return or consideration or compensation for the use or retention by one person of another's money, even though the rate of interest payable [was] higher than might otherwise [be] the case because of the terms of the loan, and in particular, its character as a non-recourse loan." 50 The primary Judge recognised that the fact that the liability incurred by the taxpayer was properly characterised as interest was not determinative of the issue of whether the outgoings were wholly on revenue account or were partly on capital account. His Honour's approach is summarised in the following passage (at 4,620): "From a practical and business point of view, there is only one advantage sought to be obtained by the interest outgoing, and that is to raise and service working capital for the applicant's business on the terms and conditions of the PEILs, including the limited recourse provisions of clause 7. The existence of clause 7 does not require a conclusion that there were multiple purposes underlying the interest obligation, when the evident and sole purpose of the borrowing was to raise and service working capital for the business on acceptable terms. A loan on the terms of clause 7 may involve a greater risk to the lender, which would ordinarily be reflected in a higher interest rate, but that does not mean that the transaction should be artificially broken down into one involving a multiplicity of purposes when, as a matter of commercial substance, there was but one purpose." 51 His Honour then considered whether if (contrary to the conclusion he had already reached) part of the interest was referable to the non-recourse feature of the PEILs, the outgoing was of capital or of a capital nature. He rejected the Commissioner's contention that the taxpayer derived an enduring advantage from the non-recourse nature of the PEILs (at 4,620): "The monies derived from the PEILs are capital receipts. If and to the extent that a borrower is excused from repaying a liability on capital account, it may be appropriate to characterise the advantage thereby obtained as an enduring one. However, the non-recourse feature of the PEILs only entitled the applicant, on the maturity of a loan, to surrender the shares acquired with the proceeds of the loan in full satisfaction of what would otherwise be his personal liability to repay the loan in question. Unless the applicant exercises that option (and in relation to the loans made in the relevant year of income, he did not) then the payment of interest at a higher rate has not produced any continuing advantage or benefit to the applicant enduring beyond the term of the loan. … The advantage which the applicant derived from the non-recourse character of the PEILs was a transient advantage which flowed from the ephemeral nature of a loan for a term of one year. …[T]he cost of securing that advantage implicit in the payment of a higher interest rate is as much a revenue cost as the portion of the interest which reflects the costs of raising or maintaining the loan."

the submissions 52 The Commissioner submitted that the limited recourse feature of the PEILs was a distinct advantage which was sought to be obtained by the payment of interest at a higher rate than would have been the case without that feature. This advantage was distinct from the raising and maintaining of the borrowed money. The taxpayer was protected from personal liability for the sums borrowed since EML was limited (except in specified circumstances) to taking enforcement action against the secured assets. The limited recourse feature was inconsistent with one of the basic features of a loan transaction, namely that the borrower must repay the principal sum. 53 According to Mr Shaw QC, who appeared with Mr Moshinsky for the Commissioner, it was "obvious" that the interest rate was higher than it would have been had the "non-recourse" provisions not been present. There was therefore nothing artificial in isolating the limited recourse feature as a distinct advantage sought to be obtained by the payment of a higher rate of interest. The interest outgoing was referable to two objects, namely the raising and maintenance of working capital and the limited recourse feature. There was a single outlay, but the outlay was apportionable because it served both objects indifferently. 54 Mr Shaw contended the terms and conditions of the PEIL agreements were critical in this case. While the practical business effect of the arrangement could be taken into account, under the PEIL agreements the non-recourse provisions formed part of the consideration for the promise to pay the interest. This proposition was supported by the very name of the loan product: Protected Equity Investment Loan. 55 On the second issue, the Commissioner submitted that portion of the taxpayer's liabilities for interest attributable to the non-recourse provision was to be regarded as on capital account. The loans themselves were on capital account. The limited recourse provisions of the PEILs had a lasting quality because they conferred on the taxpayer the benefit of not being required to pay the whole of the principal sum borrowed in full if the shares purchased fell in value. That advantage could not be regarded as "transient or "ephemeral"; the taxpayer had been relieved forever from the obligation to repay part of the principal. In any event, the benefit conferred by the limited recourse nature of the loan was a "one-off" advantage enjoyed by the taxpayer upon the maturity of the loan. 56 Mr Edmonds SC, who appeared with Mr Richmond for the taxpayer, supported the reasoning of the primary Judge. He accepted that the majority judgment in Steele v Federal Commissioner of Taxation (1999) 197 CLR 459, had recognised that in particular circumstances the purpose of interest payments might be something other than the raising or maintenance of the borrowing. Mr Edmonds contended, however, that what the majority had in mind was a payment of interest in excess of commercial rates, for example to an associated company. Here the interest rate was not excessive. There was in truth only one advantage to the taxpayer by incurring a liability to pay interest: the raising and servicing of working capital for the taxpayer's business on the terms and conditions of the PEILs. 57 Secondly, Mr Edmonds submitted that, even if the payment of interest by the taxpayer secured the advantage of the limited recourse feature of the PEILs, that advantage simply protected the taxpayer's working capital from erosion until the expiration of the loan agreements - that is, for a period of about one year. This was merely a transient advantage which flowed from the ephemeral nature of the loan. The cost of securing that protection was as much a revenue cost as the cost of protecting a foreign currency loan by hedging or insurance (cf Australia National Hotels Ltd v Federal Commissioner of Taxation (1988) 19 FCR 234).

reasoning 58 It was common ground on the appeal that sub-s 8-1(2) of the ITAA, like its predecessor, s 51(1) of the ITAA 1936, contemplates apportionment of outgoings. As was said by the High Court in Ronpibon Tin NL v Federal Commissioner of Taxation (1949) 78 CLR 49, at 59, per curiam: "[T]wo kinds of items of expenditure…require apportionment. 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…. The other kind of apportionable items consists in those involving a single outlay or charge which serves both objects indifferently. … With the latter kind there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income. It is an indiscriminate sum apportionable but hardly capable of arithmetical or ratable division because it is common to both objects." See also Fletcher v Commissioner of Taxation (1991) 173 CLR 1, at 16-17, per curiam. 59 In the present case, no issue arises as to whether the taxpayer's liability to pay interest under the PEILs was incurred in the gaining of assessable income or in carrying on a business of trading in shares. The issue is whether the outgoings should be apportioned in part as outgoings on revenue account and in part as outgoings on capital account: Federal Commissioner of Taxation v South Australian Battery Makers Pty Ltd (1978) 140 CLR 645, at 654, per Gibbs ACJ (with whom Stephen and Aickin JJ agreed). 60 As Gibbs ACJ observed in Battery Makers, the classical statement of the principles to be applied in determining whether an outgoing is made on revenue account is that of Dixon J in Sun Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337. Dixon J said that there were three matters to be considered (at 363): "(a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment." 61 In Battery Makers, the question was whether portion of rent payable under a lease was on capital account. The rent had been calculated by reference to two components, one of which was a sum equivalent to six per cent on the unamortised capital cost of the land. The Commissioner's contention was that this component represented, in commercial substance, the fee for the grant of an option to a company associated with the lessee (the option exercise price reducing over the term of the lease). 62 Gibbs ACJ pointed out that the problem could not be resolved simply by applying the test laid down in Sun Newspapers. He identified (at 655) the "real problem" as not being to determine the character of the advantage sought once it had been identified, but to decide what was the advantage sought by the taxpayer by making the payments. In adopting this approach, his Honour implicitly followed that outlined by Fullagar J in Colonial Mutual Life Assurance Society Ltd v Federal Commissioner of Taxation (1953) 89 CLR 428, at 454: "The questions which commonly arise in this type of case are (1) what is the money paid for? - and (2) Is what it is really paid for, in truth and in substance, a capital asset?" See also FCT v Broken Hill, at 601, per Hill J (with whom Heerey and Merkel JJ agreed on this point). 63 In Battery Makers, Gibbs ACJ made several points. First, he accepted that if a taxpayer pays what is described as "rent" under a lease and if the only advantage sought is the right to possession under the lease, then provided what is called "rent" really answers that description, the outgoings are of a revenue nature. However, his Honour also pointed out (at 655) that the fact that payments are called "rent" and are made periodically does not necessarily mean that they are not, in part, outgoings of a capital nature. In Colonial Mutual Life, for example, it was held that a payment of ninety per cent of all rents from a building had been paid by the purchaser of the land to the vendor "in order to acquire a capital asset"; in other words, the "documents [made] it quite clear that these payments constititute[d] the price payable on a purchase of land": at 454, per Fullagar J. 64 Secondly, "the character of the advantage sought" means (at 656): "the character of the advantage sought by the taxpayer for himself by making the outgoings". In Battery Makers itself, this was the critical point, since the capital advantage was derived, not by the taxpayer, but by an associated company. 65 Thirdly, Gibbs ACJ (at 659) rejected the proposition that in every case the character of an outgoing must be determined by having regard only to the contractual or other legal rights that the taxpayer acquired in return for it. Such a proposition was inconsistent with the principle stated by Dixon J in Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634, where his Honour said (at 648) that "What is an outgoing of capital and what is an outgoing on account of revenue depends upon what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process" 66 Stephen and Aickin JJ, however, observed in their concurring judgment in Battery Makers, that Dixon J in Hallstroms v FCT had not intended to convey that practical business considerations are to be used to the exclusion of an analysis of legal rights. Their Honours put the point this way (at 662): "An examination of the legal rights obtained is essential to the characterization of expenditure, notwithstanding that in some cases it may not alone be sufficient to complete the process, because absence of enforceable rights is not decisive of the revenue character of a business outgoing" It follows that there will be cases where it is not necessary to go beyond the legal rights and duties of the parties as set out in a binding agreement: FCT v Broken Hill, at 602, per Hill J. 67 The principal issue in Steele v DCT, was whether interest paid on funds used to purchase and hold a capital asset, which was intended to be developed for income producing purposes, was deductible under s 51(1) of the ITAA 1936. The High Court, by majority (Gleeson CJ, Gaudron, Gummow and Callinan JJ, Kirby J dissenting), held that the interest was not an outgoing of a capital nature. 68 The joint judgment of Gleeson CJ, Gaudron and Gummow JJ endorsed the principle that, under Australian law, interest on moneys which are borrowed for the purpose of acquiring an income producing asset is deductible under s 51(1) of the ITAA 1936. Their Honours then explained why this is so (at 470): "As was explained in Australian National Hotels Ltd v Commissioner of Taxation (1988) 19 FCR 234 at 239-241, per Bowen CJ and Burchett J, 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 359-363it 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 interest payments as something other than the raising or maintenance of the borrowing and thus, potentially, of a capital nature: see, eg, Parsons, Income Taxation in Australia (1985), par 6.111. 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 use to purchase a capital asset". The reference in the judgment to Professor Parson's work is to a passage which includes the following statement: "A payment of interest at a rate beyond any commercial rate, more especially when made to an associated person, raises the question whether an inference should be drawn that some part of the purpose of the payment of interest is other than the service of the loan and, in this part, not relevant but private or domestic, or not a working or maintenance expense but a capital expense" 69 In resolving the issues presented by the present appeal, the starting point is the principle recognised in Steele v DCT, namely that interest payments on moneys borrowed to secure capital or working capital are generally on revenue account. While interest is generally paid on a recurrent basis, the fact that it is paid in a single lump sum will not necessarily or even usually displace the general principle: Sun Newspapers v FCT, at 362, per Dixon J; FCT v Broken Hill, at 603, per Hill J. In this case, the term of each loan was only about one year. In these circumstances, the pre-payment by the taxpayer of interest in a lump sum is not an indication, of itself, that the interest was not wholly on revenue account. 70 There are cases in which what is described as interest is not in fact a payment that can properly be so characterised. In FCT v Broken Hill, for example, where there was no loan, the payment of so-called interest was held to have the character of capital. As the joint judgement in Steele v DCT recognised, there may be particular circumstances where the purpose of interest payment is something other than the maintenance or raising of the borrowing. An example suggested by the judgment's reference to Professor Parson's work is where interest is paid at higher than commercial rates to an associate of the borrower; cf Ure v Federal Commissioner of Taxation (1981) 34 ALR 237. Since sub-s 8-1(2) of the ITAA specifically recognises that outgoings may be apportioned, interest payments of this kind, to the extent that they constitute outgoings of capital or of a private or domestic nature, are not deductible from assessable income. 71 The Commissioner submitted that in entering into the PEILs and in incurring and discharging his liability to pay interest, the taxpayer had two purposes, or sought to secure two advantages. One was to raise and maintain the borrowed funds. The other was to secure the advantage of the limited recourse feature of the loan. This allowed the taxpayer the option of repaying the loan out of the proceeds of sale of the Approved Stocks, in which case the lender's recourse against the taxpayer was limited in the manner provided for in cl 7. The latter purpose was said to be inconsistent with one of the basic features of a loan, namely that the principal sum is to be repaid by the borrower. 72 In the first place, it is not correct to say that the taxpayer was not obliged to repay the loans. The PEILs gave the taxpayer an option to repay the loans out of his own funds (an option he in fact exercised by refinancing the loans) or, relevantly, to repay the loans out of the proceeds of the sale of the Approved Stocks, in which case the limited recourse provisions of cl 7 applied. Obviously the taxpayer was very likely to avail himself of the second option if the value of the Approved Stocks fell over the life of the loans. If the value did not fall, the loans were very likely to be repaid in full, either out of the taxpayer's own funds (including funds obtained from any refinancing of the loans) or from the sale of the Approved Stocks. 73 More fundamentally, it is not in our view correct to say that a provision limiting a lender to recourse to particular funds or assets for repayment of an advance is inconsistent with the transaction being characterised as a loan. It is true that general descriptions in the authorities of the expression "loan" often state or assume that the financial liability of the "borrower" to repay the principal sum is an essential or at least indicative characteristic of a loan transaction: Brick and Pipe Industries Ltd v Occidental Life Nominees Pty Ltd [1992] 2 VR 279, at 321-322, per Ormiston J (whose decision was in substance affirmed by the Appeal Division: see at 371); Commissioner of Taxation v Radilo Enterprises Pty Ltd (1997) 72 FCR 300, at 313, per Sackville and Lehane JJ. These statements tend to be made in cases where the issue is whether the transaction in question is to be classified as a loan, but where the transaction has no limited recourse features. General descriptions emphasising the significance of the present obligation to repay can be helpful tools in classifying the legal nature of certain types of transactions, especially whether they should be regarded as loans. But the observations in these cases should not be understood as describing the essential ingredients of every loan transaction, in particular transactions involving limited recourse features. 74 It is well established that it is possible to have a contract of loan in which the parties agree that the lender is limited to recourse to particular funds or assets for repayment of the loan: Mathew v Blackmore (1857) 1 H & N 762, at 771-772; 156 ER 1409, at 1417, per curiam; The King v New Queensland Copper Co Ltd (1917) 23 CLR 495, at 501-502, per Isaacs J; De Vigier v Inland Revenue Commissioners [1964] 1 WLR 1073, especially at 1084, per Lord Upjohn; NZI Capital Corporation Pty Ltd v Child (1991) 23 NSWLR 481. In De Vigier v IRC, a case where moneys were advanced to trustees on terms that they should be repaid out of the trust fund, Lord Upjohn said (at 1084) that: "the mere fact that under the old forms of pleading, in the circumstances of this case, an action of debt for return of a loan would not lie, does not prevent the transaction being properly described as a loan." Where the lender's recourse is limited to particular funds or assets, the possibility that the funds or assets will be insufficient to recoup the advance in full is a risk incurred by the lender. That risk will ordinarily be reflected in the rate of interest charged on the moneys borrowed. Nonetheless, the limited recourse feature of the transaction does not alter its character as a loan. 75 The Commissioner's submissions focussed on the terms of the PEIL agreements. The submissions appeared to assume that the single factor elevating the interest rates above the "Benchmark" (however ascertained) was the limited recourse provisions of each agreement. Each agreement, however, contained many interrelated terms and conditions. The extent of the risk assumed by the lender was influenced, for example, by the particular stocks approved for the purposes of the agreement; the volatility of those stocks; the term of the loan; the fees payable by the taxpayer under the agreement; and the likely range of movement of the share market over the term of the loan. All of those factors would necessarily be reflected in the interest rate charged by the lender and agreed to by the taxpayer. Depending on the circumstances, an unsecured loan to an investor who intends to use the loan to acquire stocks might create as great or even a greater risk for the lender than a non-recourse loan to another investor who intends to invest in the same stocks. 76 In our view, the aggregate of the terms and conditions of each PEIL agreement, including the non-recourse provisions, constituted the basis on which the lender advanced funds to the taxpayer for the purpose of enabling him to acquire capital assets or working capital (depending on one's view of his activities). The relatively high interest rate doubtless reflected the lender's assessment of the risk that it was incurring in making an advance on all the terms and conditions of the agreement (as well as other commercial factors). There is, however, nothing in the agreement which suggests that any portion of the interest liability incurred by the taxpayer was attributable to a particular provision in the agreement. Nor is there anything in the agreement to suggest that the taxpayer's purpose in incurring the interest liability was otherwise than to raise and maintain the borrowing. The provisions of each PEIL agreement, including those governing the taxpayer's options concerning repayment and limiting the lender's remedies, were integral elements of the loan itself. The non-recourse provisions, in particular, were not distinct from the loan or severable from it. 77 That the taxpayer entered into the PEIL agreements doubtless evidences an intent on his part to have the benefit of a non-recourse loan rather than of some different type of loan facility and a willingness on his part to pay a higher rate of interest for a loan that included such a benefit. But insofar as the terms of the PEIL agreements reveal the taxpayer's purpose in incurring the particular interest liability, they indicate no more than that his purpose was to raise and maintain the borrowing for the purpose for which the loan was being sought, that is to acquire Approved Stocks. There was no finding made that evidence extrinsic to the terms of the contract itself modified that purpose. There is, in consequence, no basis for sub-s 8-1(2) of the ITAA applying so as to require apportionment of the interest liability incurred and discharged by the taxpayer. The outgoings of interest were revenue items.

CONCLUSION 78 In our opinion, the primary Judge was correct in concluding that the advantage the taxpayer sought to obtain by the outgoings of interest was to raise and maintain the loans. The outgoings were therefore on revenue account. There is no need to address the second issue considered by the primary Judge. 79 The appeal should be dismissed, with costs. I certify that the preceding forty-eight (48) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justices Sackville & Finn.

Counsel for the Appellant: Mr B J Shaw QC with Mr M K Moshinsky

Solicitor for the Appellant: Australian Government Solicitor

Counsel for the Respondent: Mr R F Edmonds SC with Mr M Richmond

Solicitor for the Respondent: Blake Dawson Waldron

At a glance

Court

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Before

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Judgment (27 paragraphs)

Parties

Legislation Cited (3)

Cases Cited (24)