Commissioner of Taxation v Lenzo - [2008] FCAFC 50 - FCAFC 2008 case summary — Zoe

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Commissioner of Taxation v Lenzo

[2008] FCAFC 50

Federal Court of Australia (Full Court)|2008-04-03|Before: Siopis JJ, Heerey J

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Source facts

Court

Federal Court of Australia (Full Court)

Decision date

2008-04-03

Before

Siopis JJ, Heerey J

Source

Original judgment source is linked above.

Judgment (49 paragraphs)

[1]

REASONS FOR JUDGMENT HEEREY J: 1 Sandalwood has long been a much-prized timber. In John Masefield's Cargoes, the 'Quinquireme of Nineveh from distant Ophir/ Rowing home to haven in sunny Palestine' carried a cargo not only of 'ivory, and apes and peacocks' but also 'Sandalwood, cedarwood, and sweet white wine'. 2 The respondent Mr Gino Lenzo invested in a project ('the Project') for growing sandalwood near Kununurra in Western Australia. Relying on Pt IVA of the Income Tax Assessment Act 1936 (Cth) the appellant Commissioner of Taxation disallowed most of Mr Lenzo's claimed deductions. Mr Lenzo's appeal against that decision was allowed: Lenzo v Commissioner of Taxation [2007] FCA 1402. The Commissioner now appeals to the Full Court of this Court. 3 Mr Lenzo's investment primarily took the form of pre-payment of maintenance fees over the 16 year life of the Project, together with related payments. This was organized in a way that involved, amongst other things, a loan from the promoters of the Project, a round robin between companies controlled by the promoters, and a partial cash repayment of his loan by Mr Lenzo in the tax year immediately following, a payment which was in effect funded by his taxation deduction of the previous year. 4 It has never been suggested that the Project was a sham. In common with most agricultural investments, there were inherent risks, but the Project could have been the subject of rational investment decisions on a purely commercial assessment. Indeed, in the years that have passed, the increase in the world price for sandalwood, especially in India, suggests that Mr Lenzo's investment might turn out to be a very profitable one. Nevertheless, as senior counsel for the Commissioner points out, Pt IVA does not pose the question whether a payment claimed as a deduction has been made either for a rational commercial project or for a tax-driven scheme. As the High Court has held, to approach the issue in this way is to create a 'false dichotomy': Commissioner of Taxation v Spotless Services Pty Ltd (1996) 186 CLR 404 at 415. 5 The primary facts are not substantially in dispute. In terms of Pt IVA they raise two issues: first, did the 'scheme', as identified by the Commissioner, give rise to a 'tax benefit' within the meaning of s 177C? Secondly, if so, did Mr Lenzo enter into the scheme for the purpose of enabling himself to obtain that tax benefit, within the meaning of s 177D? The latter question requires consideration of the eight statutory factors in s 177D.

[2]

The Project and its documentation 6 The promoters issued a Prospectus dated 31 March 1998. Investors were invited to lease a particular area or areas, each being one-sixth of a hectare, for the growing of trees. Investors would be liable for rent and maintenance fees. In return the manager, East Kimberley Sandalwood Co Limited (EKS), would plant and maintain trees on the investor's area. The investor would own the trees on the leased area and have the right to sell them when harvested. However, the marketing company Sandalwood Marketing Co Ltd (SMC) was available to sell the trees on investors' behalf for a commission. The trustee under the Prospectus was Professional Funds Management Pty Ltd (PFM). 7 To fund investments loans were offered to investors. The loans were repayable out of the proceeds of harvest of the trees. Investors were offered, on payment of annual fees, indemnity against any shortfall from harvest proceeds. 8 The Prospectus described the investment as 'speculative and long-term'. 9 A Lease and Management Agreement was executed by EKS, in its own right and as attorney and agent for investors. Fees were payable for the Initial Period, being the period of 13 months from 30 June 1998 (the date of execution of the Lease and Management Agreement). Payments were due on 30 June 1998 in the amounts of $10,000, as a maintenance fee, and $158, as rent, a total of $10,158 for each leased area. 10 Subject to the entitlement to make a prepayment on or before 1 July 1999 under cl 23.10 and cl 23.11, the annual maintenance fee and rent in respect of each leased area for each subsequent financial year after the Initial Period were respectively $1,397 and $158 multiplied by an inflation adjustment factor. They were payable before 30 June of each year. 11 The prepayment entitlements were as follows. The investor could pay a final outgoing in respect of management fees and rent on or before 1 July 1999. The amounts per leased area were $7,462 (maintenance fees) and $871 (rent), a total of $8,333 per leased area. Payment of those amounts would be a complete discharge of the obligations of an investor to pay ongoing annual maintenance fees and rent for the term of the Lease and Management Agreement. 12 Under the Loan Deed as contemplated in the prospectus, Arwon Finance Pty Ltd, a company associated with the promoters, agreed to lend to investors the funds required to meet the pre-payment of maintenance and rental obligations. These were, in respect of each leased area: (a) on 30 June 1998, the 'First Principal Sum' of $10,158 ($10,000 maintenance fees plus $158 rent); and (b) on 1 July 1999, the 'Second Principal Sum' of $8,333 (being the amount required to discharge the remaining obligations in respect of maintenance fees and rent). 13 In respect of the First Principal Sum the Loan Deed required the investor to make a partial repayment of principal in the sum of $3,047 per leased area on 30 September 1998 and to repay the balance ($7,111 per leased area) from the net proceeds of the harvest of the leased areas as and when the investor became entitled to receive such proceeds, but no later than 30 June 2014. Interest on the First Principal Sum was to be paid by one instalment on the date of repayment of the outstanding balance of that sum. 14 In respect of the Second Principal Sum, the investor also agreed to repay that sum out of the harvest proceeds, but again, no later than 30 June 2014. Interest on the Second Principal Sum was to be paid by instalments in arrears commencing on 30 September 2000 and thereafter annually. 15 Under an Indemnity Agreement, also contemplated by the Prospectus, a related company Intersure Services Pty Ltd agreed to indemnify the investor for any shortfall if harvest proceeds were insufficient to repay loans owing under the Loan Deed. The Indemnity Agreement required the investor to pay the first instalment of principal in respect of the First Principal Sum and the annual instalments of interest on the Second Principal Sum. Fees payable to Intersure were: (a) $535.24 by 30 June 1998; (b) $1,066.08 in years 2 to 8; (c) $800 in year 9; (d) $560 in year 10; (e) $280 in year 11; (f) $22 in years 12 to 15. 16 On 23 June 1998 Arwon and EKS executed an Offer to Loan under which Arwon made a binding offer to borrow the sum of $8,481,930 from EKS. 17 Under the terms of the Offer to Loan: (a) the offer could only be accepted by EKS by its advancing the sum of $8,481,930 on or before 30 June 1998; (b) repayment of the principal was to be made in the amounts and on the dates that principal repayments were to be made by investors in the Project; and (c) interest was to be charged at the rate paid by the investors less a margin of 1.5 per cent and the interest payments were to be made on the dates that interest payments were to be made by investors. 18 On 30 June 1998 Arwon and EKS implemented a round robin. EKS drew a cheque dated 30 June 1998 for $8,481,930 payable to Arwon. On the same date the cheque was endorsed in favour of EKS by a Mr John O'Brien, a director of PFM. The bank accounts of both EKS and Arwon (both at the same branch of St George Bank Limited) show a credit and a debit in the amount of $8,481,930 on 30 June 1998. 19 The round robin did not result in any funds being made available for the Project. It was purely a paper exercise. Immediately prior to the implementation of the round robin Arwon had paid up capital of $2 and total assets of $1,446. 20 EKS, Arwon and Intersure were related companies and under the control or ownership of the same individuals.

[3]

Mr Lenzo's involvement in the Project and his claimed deductions 21 Mr Lenzo applied for two leased areas. On 30 June 1998 he executed an Application Form, a Power of Attorney in favour of EKS, a Loan Deed and a Deed of Indemnity. On the same date he paid the First Principal Sum (ie $20,316, being initial maintenance fees and rent for his two areas). Arwon advanced this sum to Mr Lenzo by paying it to EKS on his behalf. He also paid in cash an Indemnity Fee of $535 and $652 for two shares in SMC. 22 As already mentioned, the Lease and Management Agreement dated 30 June 1998 was executed by EKS as manger, PFM as trustee, SMC as marketing company and EKS as attorney and agent for the investors named in the schedule, among them Mr Lenzo. He was recorded as the grower for two leased areas (C104 and C105). 23 On 30 September 1998 Mr Lenzo was due to pay $6,094 to Arwon being the first repayment due in respect of the First Principal Sum as required by the Loan Deed. However, apparently he in fact paid $7,506. Nothing turns on this discrepancy. 24 For reasons not apparent from the evidence Mr Lenzo did not take up his entitlement to borrow the sum due for the Second Principal Sum. Instead he borrowed that amount from the ANZ Bank and repaid the Second Principal Sum ($16,666 for his two areas) on 25 June 1999. He later repaid the ANZ loan. 25 The deductions in dispute are: (a) for the year ended 30 June 1998 (i) Maintenance Fees $20,000 (ii) Rent $315 (iii) Indemnity Fee $535 (b) for the year ended 30 June 1999 (i) Interest of $1,152 on the $20,316 loan (ii) Indemnity Fee $1,066 (c) for the year ended 30 June 2000 (i) Interest of $885 on the $20,316 loan (ii) Indemnity Fee $1,066. 26 The Commissioner points out three significant features of Mr Lenzo's participation in the Project which are relevant for present purposes. 27 First, Mr Lenzo's actual exposure was limited to the instalment of $6,094 on 30 September 1998 (as already mentioned, he in fact paid $7,506), the annual payments of interest on the Second Principal Sum commencing on 30 September 2000 (in the event replaced by his ANZ loan) and the annual Indemnity Fees. 28 Secondly, the cash Mr Lenzo introduced to the Project was limited to the cash payments he made in respect of the loan and the indemnity. Of the $20,316 ostensibly paid on his behalf by EKS, only $7,506 was ever made available for growing and marketing sandalwood. EKS could not have access to the difference between the two amounts until receipt of the harvest proceeds or 30 June 2014, whichever came earlier. 29 Thirdly, Mr Lenzo's tax savings would pay for his $7,506.

[4]

The relevant terms of Pt IVA 30 The present proceedings arise under the provisions of Pt IVA of the Income Tax Assessment Act 1936 (Cth), the relevant parts of which provide: '177F(1) Where a tax benefit has been obtained, or would but for this section be obtained, by a taxpayer in connection with a scheme to which this Part applies, the Commissioner may: ... (b) in the case of a tax benefit that is referable to a deduction or a part of a deduction being allowable to the taxpayer in relation to a year of income - determine that the whole or a part of the deduction or of the part of the deduction, as the case may be, shall not be allowable to the taxpayer in relation to that year of income; and, where the Commissioner makes such a determination, he shall take such action as he considers necessary to give effect to that determination.' 31 Section 177A, the interpretation provision of Pt IVA, sets out a number of relevant definitions. They include the following: '"scheme" means: (a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and (b) any scheme, plan, proposal, action, course of action or course of conduct.' 32 The definition of 'scheme' should be read together with the provisions of s 177A(4) and (5) which respectively provide: '(4) A reference in this Part to the carrying out of a scheme by a person shall be read as including a reference to the carrying out of a scheme by a person together with another person or other persons. (5) A reference in this Part to a scheme or a part of a scheme being entered into or carried out by a person for a particular purpose shall be read as including a reference to the scheme or the part of the scheme being entered into or carried out by the person for 2 or more purposes of which that particular purpose is the dominant purpose.' 33 The circumstances in which a taxpayer is said to have obtained a tax benefit in connection with a scheme are set out in s 177C, which relevantly provides: '(1) Subject to this section, a reference in this Part to the obtaining by a taxpayer of a tax benefit in connection with a scheme shall be read as a reference to: (a) an amount not being included in the assessable income of the taxpayer of a year of income where that amount would have been included, or might reasonably be expected to have been included, in the assessable income of the taxpayer of that year of income if the scheme had not been entered into or carried out; or (b) a deduction being allowable to the taxpayer in relation to a year of income where the whole or a part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer in relation to that year of income if the scheme had not been entered into or carried out; and, for the purposes of this Part, the amount of the tax benefit shall be taken to be: ... (d) in a case to which paragraph (b) applies - the amount of the whole of the deduction or of the part of the deduction, as the case may be, referred to in that paragraph.' 34 Section 177D is the core provision which identifies schemes which have resulted in a tax benefit as being schemes to which Pt IVA applies. That section provides: 'This Part applies to any scheme that has been or is entered into after 27 May 1981, and to any scheme that has been or is carried out or commenced to be carried out after that date (other than a scheme that was entered into on or before that date), whether the scheme has been or is entered into or carried out in Australia or outside Australia or partly in Australia and partly outside Australia, where: (a) a taxpayer (in this section referred to as the relevant taxpayer) has obtained, or would but for section 177F obtain, a tax benefit in connection with the scheme; and (b) having regard to - (i) the manner in which the scheme was entered into or carried out; (ii) the form and substance of the scheme; (iii) the time at which the scheme was entered into and the length of the period during which the scheme was carried out; (iv) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme; (v) any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme; (vi) any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme; (vii) any other consequence for the relevant taxpayer, or for any person referred to in subparagraph (vi), of the scheme having been entered into or carried out; and (viii) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in subparagraph (vi); it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for the purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme or of enabling the relevant taxpayer and another taxpayer or other taxpayers each to obtain a tax benefit in connection with the scheme (whether or not that person who entered into or carried out the scheme or any part of the scheme is the relevant taxpayer or is the other taxpayer or one of the other taxpayers).'

[9]

Primary Judge's reasoning 44 As his Honour noted at [120], the purposes to be considered are those attributable to 'relevant persons who entered into or carried out the scheme or any part of the scheme'. Section 177D(b) is not concerned with attributing a purpose to 'the scheme': Commissioner of Taxation v Hart (2004) 217 CLR 216 at [63]. The test of purpose is objective and not to be answered in whole or in part by reference to actual subjective purposes. If there is more than one purpose to be imputed, the question is whether the tax benefit purpose was the dominant purpose. By that is meant the 'ruling, prevailing, or most influential purpose': Federal Commissioner of Taxation v Spotless Services (1996) 186 CLR 404 at 416. The importance of setting aside subjective purposes, whether they favour the taxpayer or the Commissioner's position, was emphasised in the joint judgment of Gummow and Hayne JJ in Hart at [65] where, speaking of the structuring of the loan in issue in that case, their Honours said: 'Of course the loan was structured in the way it was in order to achieve the most desirable taxation result. But those are statements about why the respondents acted as they did or about why the lender (or its agent) structured the loan in the way it was. They are not statements which provide an answer to the question posed by s 177D(b). That provision requires the drawing of a conclusion about purpose from the eight identified objective matters; it does not require, or even permit, any inquiry into the subjective motives of the relevant taxpayers or others who entered into or carried out the scheme or any part of it.' (Original emphasis.) 45 The learned primary judge in the present case observed at [121] that the question posed by s 177D(b) is 'holistic. Each of the eight specified factors must be taken into account. But the decisionmaker, being the Commissioner, or a judge on appeal from the Commissioner, is not required to award points for each factor like a judging panel in an ice skating competition.' The enumerated factors identify essential elements associated with entry into and implementation of the scheme in question and are to be considered together. 46 As to factor (i) (the manner in which the scheme was entered into or carried out) his Honour said that the marketing of the scheme as set out in the Prospectus supported the proposition that it was to be a serious commercial project. There was evidence that it did not need to rely on tax benefits in order to provide a sufficient financial return to qualify as an 'investment grade product'. His Honour considered the tax benefits as marketed were 'subordinate to reasonably based commercial returns albeit those returns, being high, carried a corresponding level of risk': at [122]. 47 His Honour did not consider the timing of Mr Lenzo's execution of the documents on 30 June (also relevant for factor (iii)) as a factor to which he should attribute great weight. His Honour said at [123]: 'If there is a significant commercial benefit to be derived from an investment and an associated tax benefit, entry into the investment scheme on 30 June 1998 with a view to obtaining the tax benefit in that year is entirely consistent with a predominately commercial purpose.' 48 As to the round robin his Honour said at [124]: 'The round-robin upon which much emphasis was placed by the Commissioner carries with it the negative connotations traditionally associated with such apparently artificial transactions. I accept that Mr Lenzo's lack of awareness of that transaction is immaterial. However the significance of it for the assessment of a dominant purpose of obtaining a tax benefit for Mr Lenzo is not apparent. In a sense it overlaps with the question whether a tax benefit was obtained given the alternative of external financing to individual growers. It was not as though they were being offered non-recourse loans by Arwon. While the round-robin is a factor which in combination with other matters might support an inference of a dominant tax purpose, it is not determinative of the existence of such a purpose. Moreover it may be seen as an incident of the much more significant commercial purposes achievable with or without a tax benefit.' 49 As to the relatively small amount of actual cash outlaid by Mr Lenzo, his Honour said at [127]: 'What was created by the loans was a real liability with a known non-recourse exit. … While the high level of initial outlay measured by liability and the smaller amount of the actual payment made by Mr Lenzo may be taken into account as indicative of a tax benefit purpose, it does not in my opinion establish that as a dominant purpose against the overall purpose of the scheme.' 50 As to factor (ii) (the form and substance of the scheme) his Honour considered that the form and substance of the arrangements were the same. There was no suggestion of sham in relation to any of the agreements entered into. They were not 'complex or artificial, save for the round-robin transaction' but were similar to other arrangements in agricultural managed investment schemes which EKS carried on for commercial gain. Notwithstanding the Commissioner's submissions relating to the timing of the payment of management fees, it could not be said that the payments were for anything other than the services which EKS agreed to provide under the Lease and Management agreements. There was also expert evidence that the project had been established, operated and managed during its life in a professional, commercial and business like manner. 51 Mr Lenzo's 'passivity' was not indicative of a dominant tax benefit purpose. 52 As to factor (iii) (the time at which the scheme was entered into and the length of the period during which it was carried out) his Honour accepted that entry into the scheme on 30 June 1998 may be indicative of a tax purpose. But the Project was not merely a paper exercise concluded at the end of the financial year to generate paper liabilities, the liabilities were real and were incurred in relation to a serious commercial project with a fifteen year lifetime. His Honour said at [130]: 'The prospect of a commercial return would justify it without reference to any taxation benefits'. 53 As to factor (iv) (the result that but for Pt IVA would be achieved) his Honour said at [131] the mere fact that a taxpayer pays less tax does not demonstrate that Pt IVA applies: see Hart at [53]. 54 As to factor (v) (change in financial position of the taxpayer) his Honour said at [133] that the change in the financial position was not limited to tax benefits but included the prospect of a commercial return. The evidence was that this was a real prospect although attended by the usual risks of any agricultural cultivation scheme. Forecast returns were not merely speculative. 55 As to factor (vi) (change in financial position of persons who had a connection with the taxpayer) there were no relevant changes in the financial position of persons other than Mr Lenzo. I note here that factor (vi) seems to be concerned with persons who had some kind of pre-existing connection with the taxpayer such as connections of a business, family or other nature. The 'persons' would not, in this context, include such persons as the manager of the project. 56 As to factor (vii) (any other relevant consequences) his Honour thought there were no other such consequences. 57 As to factor (viii) (the nature of the connection referred to in (vi)) as mentioned, there was no relevant connection with other persons. 58 His Honour concluded at [137]: 'Taking all these factors together and the transaction overall, I accept that there were tax benefits to be derived from the way in which the investment structure was set up. Aspects of the investment structure were indicative of a purpose of deriving a tax benefit from the scheme. I do not accept however, having regard to the factors already mentioned, the significant returns which could reasonably be expected from a moderately successful outcome to the project, independent of any tax benefits, and the ready availability of alternative financing arrangements to Mr Lenzo that it would be concluded that he or the manager or promoter entered into or carried out the scheme for the dominant purpose of enabling him to obtain a tax benefit in connection with the scheme.'

[10]

Conclusion 59 The judgment under appeal was not a discretionary one. The learned primary judge had to apply the terms of s 177D to facts which, as already noted, were not substantially in dispute. No credibility issues arose. It is accepted that the purpose of which s 177D speaks is entirely an objective one. 60 The approach to be taken on this appeal is that stated by Gibbs ACJ, Jacobs and Murphy JJ in Warren v Coombes (1979) 142 CLR 531 at 551: ' …the established principles are, we think, that in general an appellate court is in as good a position as the trial judge to decide on the proper inference to be drawn from facts which are undisputed or which, having been disputed, are established by the findings of the trial judge. In deciding what is the proper inference to be drawn, the appellate court will give respect and weight to the conclusion of the trial judge, but, once having reached its own conclusion, will not shrink from giving effect to it. These principles, we venture to think, are not only sound in law, but beneficial in their operation.' 61 Reading the reasons as a whole, one is compelled to the conclusion that his Honour erred in placing too much emphasis on the genuine commercial nature of the Project. In particular, a central feature of the scheme was the round robin which is explicable only on the basis of obtaining tax benefits. I do not understand how the round robin could be seen as an 'incident of the much more significant commercial purposes achievable with or without a tax benefit'. The round robin had nothing to do with growing or marketing sandalwood. 62 Linked to the wholly artificial round robin device were the tax benefits that Mr Lenzo was to obtain, compared with actual cash outlays, and the timing of transactions on the last day of the financial year. Why were all the transactions, and in particular the round robin, carried out on 30 June and not on any one of the other 364 days in the year? The choice of that day had nothing to do with sandalwood production. It had everything to do with maximising the tax benefits for investors. 63 The Project itself was genuine and could have been implemented in a manner clearly outside Pt IVA (for example, prepayment of maintenance fees and rent would ordinarily be deductible in the year of payment). However, the way the scheme was structured and put into effect in my view points to Mr Lenzo's dominant purpose being the obtaining of tax benefits. 64 As at 1998, the purpose of Mr Lenzo's entering into the scheme was, objectively considered, to obtain an immediate, large tax deduction with little cash outlay. If in 16 years the investment was to turn a commercial profit, as could well be the case, so much the better. Part IVA applies.

[20]

The Prospectus 69 The promoters issued a prospectus dated 31 March 1998. The prospectus identified the 'Manager' of the Project as East Kimberley Sandalwood Co Ltd ('EKS'), the 'Marketing Company' as Sandalwood Marketing Co Ltd ('SMC') and the 'Trustee' as Professional Funds Management Pty Ltd ('PFM'). Investors (referred to as 'Growers') were invited to lease one or more areas for the growing of sandalwood trees, each area being one-sixth of a hectare. The investment was described as 'speculative and long-term'. The investors were to pay rent and maintenance fees. Loans were offered to investors through Arwon Finance Pty Ltd ('Arwon') in order to fund the investments, although investors were not required to accept the offer. The loans were to be repayable out of the proceeds of harvest of the sandalwood trees. In return for annual fees, investors were offered an indemnity against any shortfall from harvest proceeds. 70 The prospectus explained that each investor would engage the Manager to plant and maintain the sandalwood and host trees on the leased areas. The investor would own the trees on his or her leased areas and have the right to sell them personally when the trees were harvested. However, the Marketing Company was prepared to sell the trees on the investors' behalves in return for a commission. Harvest was expected to occur after 15 years. 71 The investor was to pay application moneys and annual rental payments and maintenance fees in respect of his or her leased areas. There was an option to prepay, on 1 July 1999, all annual contributions by a single payment of $8,333 per leased area. Arwon, a company associated with EKS, would make loan funds available to approved applicants for application moneys and annual contributions. Investors borrowing funds from Arwon could enter an agreement with another related company, Intersure Pty Ltd ('Intersure'). Under the indemnity agreement, for an annual fee, they would be indemnified against any liability under the loan agreement, to the extent that the harvest proceeds were insufficient to repay moneys borrowed from Arwon. 72 The prospectus included a section headed 'Taxation benefits'. This section recorded the advice of Messrs Ernst & Young that, subject to the qualifications expressed in the report, investors should be able to claim a taxation deduction for: · the application money of $10,158 for each leased area; · the annual contributions; and · interest on funds borrowed and the annual indemnity fee (if applicable). 73 The advice from Ernst & Young expressed the opinion, on certain assumptions, that: · rental fees incurred by an investor would be deductible under s 8-1 of the Income Tax Assessment Act 1997 (Cth) ('ITAA 1997'), being expenditure incurred in gaining or producing assessable income or necessarily incurred in carrying on business for the purpose of producing assessable income; · management fees would similarly be deductible pursuant to s 8-1, since no part of the expenditure seemed to be of a capital nature (except fees relating to land degradation activities which were fully deductible in the year incurred); and · interest paid to a lender and the yearly premium paid for the indemnity would also be fully deductible under s 8-1. 74 Ernst & Young drew attention to the provisions of Part IVA of the ITAA 1936 and pointed out that the High Court in Federal Commissioner of Taxation v Spotless Services Ltd (1996) 186 CLR 404, had held that a particular course of action could both be 'tax driven' and 'bear the character of a rational commercial decision'. However, the firm expressed the belief that: 'it will be inherently more difficult for the Commissioner of Taxation to attack arrangements which have a valid commercial purpose or purposes. If the Grower's dominant purpose is not to obtain a tax benefit but is the pursuit of a commercial purpose, such as the derivation of assessable income from farming activities, then Part IVA should not apply. The fact that a project of this nature has an establishment phase during which expenses are incurred and income is obtained at a subsequent time is not an artificial arrangement. It is the nature of the industry which results in the tax position. We believe that a strong argument can be mounted to show that the venture is a genuine commercial venture with a long term perspective. The eight matters to which the Commissioner must have regard under Section 177(D) requires a balancing of the commercial elements and tax elements of the scheme. As long as the commercial elements predominate and any tax benefit is not the "key" to the whole transaction, we believe it would be difficult for the Commissioner to apply Part IVA.' 75 Ernst & Young recorded that their opinion was based on the assumption that the investor would be carrying on business by his or her involvement in the Project and that, by entering into a finance arrangement, the investor intended the investment to run its full course until harvest and sale of the produce.

[22]

Mr Lenzo's Participation 78 Mr Lenzo's entry into the Project was effected by an 'Application Form', which he signed and dated 30 June 1998. He applied for two leased areas in the Project and enclosed payment of $20,316, being application moneys of $10,158 in respect of each leased area. He also enclosed payment of $652 in respect of two shares in the Marketing Company, SMC. 79 On 30 June 1998, Mr Lenzo also executed a Power of Attorney, by which he appointed EKS (and its duly authorised attorneys) as his attorney. EKS was authorised on Mr Lenzo's behalf to execute the Lease and Management Agreement and any variation thereof, as well as any documents reasonably considered necessary to complete the application. 80 The Lease and Management Agreement was dated 30 June 1998. The parties to the Agreement were said to be EKS as Manager, PFM as Trustee, SMC as Marketing Company and each of the persons named in the schedule. Mr Lenzo was recorded in the schedule as the grower for two leased areas (C104 and C105). The Lease and Management Agreement was executed by EKS as Manager and 'as attorney and agent on behalf of each relevant grower'. 81 The Lease and Management Agreement provided (cl 4) that the rent payable to the Manager for each leased area was $158 for the 'initial period', being 13 months from the commencement date of 30 June 1998. For each financial year thereafter, the rent was $158 per leased area, subject to an inflation adjustment factor (Schedule, Item 3.2). The maintenance fee for the initial period was $10,000 and $1397 for each financial year thereafter (except the last), subject to an inflation factor (cl 13.2; Schedule, Item 2.1). 82 The investor was to pay an annual contribution each year after the initial period, comprising rent, the annual maintenance fee and any insurance premiums. The investor could, however, elect to pay the annual contributions by pre-paying the aggregate of any rent and maintenance fees on or before 1 July 1999 (cl 23.10). The amount so payable was $871 per leased area in respect of rent and $7,462 per leased area in respect of maintenance fees, a total of $8,333 (Schedule, Items 9.1, 9.2). If the investor made such an election, receipt by the Trustee of the amounts to be pre-paid completely discharged the investor in respect of any obligation to pay rent and management fees during the term of the Agreement (cl 23.11). 83 In addition to the other agreements, on 30 June 1998 Mr Lenzo executed a Loan Deed with Arwon and an Indemnity Agreement with Intersure. Under the Loan Deed, Arwon agreed to advance Mr Lenzo a 'First Principal Sum' of $20,316 (in respect of both leased areas) on 30 June 1998 and a 'Second Principal Sum' of $16,666 on 1 July 1999 (cl 2.1, Schedule Items 3A, 3B). The purpose of the advances was to: 'enable the Borrower to subscribe for the Leased Area in the … Project … and thereby become a party to the Project Agreements.' 84 The First Principal Sum was repayable in two instalments (Schedule, Item 4). The first instalment of $3,047 per leased area ($6,094 for two leased areas) was payable on 30 September 1998. The second instalment of $7,111 per leased area ($14,222 for two leased areas) was payable on the date Mr Lenzo was entitled to receive the net proceeds from the harvest and, in any event, no later than 30 June 2014. (The Loan Agreement records different amounts for the second instalment of the First Principal Sum, but nothing of substance seems to turn on this discrepancy.) The Second Principal Sum was repayable at the same time as the second instalment of the First Principal Sum. Interest was payable on the balance of the First Principal Sum (that is, on the balance of $14,222) on the date Mr Lenzo repaid the balance. Interest was payable on the Second Principal Sum on 30 September in each year until repayment of that Sum. 85 Under the Indemnity Agreement, Intersure provided an indemnity to Mr Lenzo against any shortfall between the amounts borrowed from Arwon (except the part of the First Principal Sum repayable on 30 September 1998 and the interest payable on the Second Principal Sum) (cll 1.1.14, 4.1). The approximate fees for the indemnity for both leased areas payable to Intersure were (cl 3.1, Schedule): · $535 by 30 June 1998; · $1,066 in years 2 to 8; · $800 in year 9; · $560 in year 10; · $280 in year 11; and · $22 in years 12 to 15. 86 By a letter dated 14 July 1998, EKS confirmed to Mr Lenzo that his application for two leased areas had been accepted on 30 June 1998. The letter informed him that he was entitled to claim a deduction of $20,850 in his 1998 income tax return in accordance with an attached schedule. The schedule does not appear to have been in evidence, or at least was not reproduced in the Appeal Book.

[24]

1999 Taxation Year 89 On 12 October 1998, Mr Lenzo paid the first instalment due in respect of the First Principal Sum. The amount due, as specified in the documentation, was $6,094. However, Mr Lenzo in fact paid $7,506, a sum which corresponds to uncorrected figures in portions of the Loan Deed. The balance of the First Principal Sum ($14,222) was not repayable until harvest of the sandalwood trees or 30 June 2014, whichever occurred earlier. Similarly, the interest in respect of the balance of the First Principal Sum was not payable until harvest or 2014. 90 Mr Lenzo also paid the following amounts during the 1999 taxation year: · on 12 October 1998, $648 in respect of shares in SMC; and · on 29 June 1999, $1,066 by way of indemnity fees to Intersure. 91 In addition, on 25 June 1999, Mr Lenzo applied for and was successful in obtaining a loan from the ANZ Banking Group ('ANZ') in the amount of $16,666. This came about, according to the primary Judge's findings, because Arwon advised Mr Lenzo, before the Second Principal Sum was advanced to him, that it had been exploring alternatives for clients to refinance their loans. As his Honour pointed out, the ANZ loan appeared to be on less advantageous terms than that available to Mr Lenzo from Arwon and did not attract the benefit of Intersure's indemnity. His Honour speculated that the Project might have required more funding or, alternatively, that there might have been a concern that Arwon's involvement made the scheme more vulnerable to attack under Part IVA of the ITAA 1936. Be that as it may, he was unable to make any finding as to why Mr Lenzo opted to refinance through ANZ. 92 Mr Lenzo used the proceeds of the ANZ loan to pay the Second Principal Sum of $16,666 on 25 June 1999. As has been explained, payment of this amount covered Mr Lenzo's liability to pay maintenance fees and rental for the remainder of the Project. Mr Lenzo thereupon became entitled to claim a proportionate part of the prepaid maintenance fees and rental in the 1999 taxation year and each of the nine succeeding years of the project: see ITAA 1936, s 82 KZM. 93 Mr Lenzo claimed the deductions for the 1999 taxation year totalling $3,884, comprising the following: · indemnity fees of $1,066; · interest of $1,152 in respect of the balance of the First Principal Sum that remained outstanding after 12 October 1998; and · a proportion of the pre-paid maintenance fees and rent, amounting to $1,666. The primary Judge found that Mr Lenzo under-claimed interest and bank fees, as the interest on the Arwon loan actually amounted to $1,345. That amount was not actually paid by Mr Lenzo, as payment of the interest on the balance of the First Principal Sum was deferred until harvest (or 2014).

[27]

THE PRIMARY JUDGMENT 98 Mr Lenzo filed an appeal against the disallowance decision on 3 May 2005. The hearing of the appeal took place before the primary Judge on 3, 4 and 5 October 2006. His Honour delivered judgment on 7 September 2007. 99 The primary Judge recorded that the Commissioner accepted that, independently of Part IVA of the ITAA 1936, Mr Lenzo would have been entitled to the deductions claimed by him under s 8-1 of the ITAA 1997. The Commissioner had also conceded that the deductions of $1,666 in respect of the pre-paid maintenance fees and rent claimed in the 1999 and 2000 taxation years, and the interest incurred on the ANZ loan in the 2000 taxation year, were allowable. However, the remaining deductions were in dispute. 100 The primary Judge also recorded that the Commissioner did not dispute that the Project was a 'serious commercial venture', nor that the agreements and liabilities entered into by Mr Lenzo were all genuine. His Honour found that Mr Lenzo, a practising accountant, had undertaken a 'due diligence process' about investing in the Project. Mr Lenzo was aware of the taxation implications, but had formed the opinion that the Project would show strong financial returns and was an appropriate addition to his asset portfolio. However, his Honour observed that Mr Lenzo's subjective motives and purposes were not material in deciding whether, for the purposes of s 177D(b) of the ITAA 1936, it could be concluded that a dominant purpose of his entry into the Project was to secure a tax benefit. 101 The primary Judge accepted the evidence of an expert that the Project was 'properly conceived and generally properly managed'. His Honour also accepted evidence that the fees charged were 'reasonable', although he acknowledged that this was a qualitative rather than quantative assessment. His Honour further found that: 'there was considerable cause for optimism about the future of Indian sandalwood as a commercial export product notwithstanding that the project itself had risks'. 102 His Honour accepted the Commissioner's formulation of the scheme relevant to the 1998 taxation year, for the purposes of s 177A(1) of the ITAA 1936, as follows: '(a) The Prospectus and the making and implementation of the Application Form, the Lease and Management Agreement, the Loan Deed, the Offer to Loan between the Lender and the Manager, the Indemnity Agreement and the Trust Deed and the acts carried out and the course of action undertaken pursuant to that form and those agreements, including the round robin involving the Manager and the Lender on 30 June 1998'. 103 The Commissioner had also formulated two alternative schemes, designated (b) and (c). His Honour also accepted these as schemes for the purposes of Part IVA of the ITAA 1936. Each alternative followed the formulation of the primary scheme, but scheme (b) omitted the reference to the prospectus and scheme (c) omitted the references to the prospectus and the trust deed. 104 The schemes formulated by the Commissioner continued in the 1999 and 2000 taxation years, insofar as they were relevant to the advance of the First Principal Sum, the interest payable under the Loan Deed and the fees payable under the Indemnity Agreement. His Honour pointed out that the variation in the loan arrangements with the introduction of ANZ, explained why the Commissioner was not contending that the deductions claimed for interest on those borrowings should be disallowed. It was the ongoing interest on the loan from Arwon and the indemnity fees for 1999 and 2000 that represented the continuing elements of the scheme. 105 The primary Judge identified the first question as whether, by entering into the scheme, Mr Lenzo obtained a tax benefit in relation to it. His Honour rejected a submission on behalf of Mr Lenzo that had he not invested in the plantation project, he would have obtained a similar tax benefit by putting money into his self-managed superannuation fund. His Honour considered that the relevant deduction for the purposes of s 177C(b) of the ITAA 1936 was for payment of lease and management fees and indemnity fees. The: 'superannuation counterfactual [was] extraneous to the alternatives which are to be considered for the purposes of s 177C(1)(b).' 106 His Honour considered that a relevant counterfactual involved Mr Lenzo borrowing the money needed to finance his involvement with the Project from a source other than Arwon. His Honour addressed the counterfactual as follows: '[Mr Lenzo] could have borrowed from the ANZ Bank from the outset. Alternatively, he could have used his own funds and obtained the same deduction. The Loan Deed was an element of each of the alternative schemes defined by the Commissioner. A loan from the ANZ Bank from the outset would have supported Mr Lenzo's investment in the plantation scheme to the same effect as the borrowing from Arwon. On that basis the deduction claimed in respect of the 1998 year would have been allowable or might reasonably be expected to have been allowable in relation to that year of income if the scheme had not been entered into or carried out. I do not consider therefore that Mr Lenzo gained, by entering into the scheme, a tax benefit in respect of his borrowings that he could not reasonably have been expected to obtain otherwise.' 107 This conclusion was enough to warrant allowing Mr Lenzo's appeal, since, in the absence of a finding that he had obtained a tax benefit in connection with the scheme, Part IVA could not apply. Nonetheless, his Honour went on to consider whether the objective test of purpose stated in s 177D was satisfied. He considered that the question posed by s 177D(b) is 'holistic', although each of the eight specified factors must be taken into account. 108 The primary Judge made observations in respect of each of the eight factors set out in s 177D(b). He accepted that some elements of the scheme indicated a desire to obtain a tax benefit. These included: · the entry into the scheme on 30 June 1998 (the last day of the taxation year); · the execution of pro forma documentation on that date; and · the high level of initial outlay measured by liability (giving rise to a deduction) and the smaller amounts of actual payments by Mr Lenzo. 109 On the other hand, his Honour considered that: · the marketing of the Project as set out in the prospectus suggested that it was 'a serious commercial project' that did not need to rely on tax benefits to provide a sufficient financial return to qualify as an investment grade product; · the timing of Mr Lenzo's execution of the documents was not a matter of great weight, since: 'entry into the investment scheme on 30 June 1998 with a view to obtaining a tax benefit in that year is entirely consistent with a predominantly commercial purpose'; · the significance of the round robin in relation to the existence of a dominant purpose of obtaining a tax benefit was 'not apparent': 'It was not as though they were being offered non-recourse loans by Arwon. While the round-robin is a factor which in combination with other matters might support an inference of a dominant tax purpose, it is not determinative of the existence of such a purpose. Moreover it may be seen as an incident of the much more significant commercial purposes achievable with or without a tax benefit'; · although the Arwon loans created 'a real liability with no non-recourse exit'; · over the first three years of the Project, Mr Lenzo had made cash outlays of $29,073 (apparently including the payment of the Second Principal Sum by means of the ANZ loan) against deductions of $29,938, suggesting that tax avoidance was not the dominant purpose against the overall purpose of the scheme; · the form of the scheme was neither complex nor artificial, except for the round robin, and was similar to other management investment schemes carried on by EKS for commercial gain; · the Project had been managed in a professional and business-like manner; · the Project was not merely a paper exercise concluded at the end of the financial year to generate paper liabilities, since the liabilities were real and were incurred in relation to a serious commercial undertaking; and · the mere fact that a taxpayer claims a tax benefit does not mean that Part IVA of the ITAA 1936 applies. 110 His Honour expressed his conclusion on this issue as follows: 'Taking all these factors together and the transaction overall, I accept that there were tax benefits to be derived from the way in which the investment structure was set up. Aspects of the investment structure were indicative of a purpose of deriving a tax benefit from the scheme. I do not accept however, having regard to the factors already mentioned, the significant returns which could reasonably be expected from a moderately successful outcome to the project, independent of any tax benefits, and the ready availability of alternative financing arrangements to Mr Lenzo that it would be concluded that he or the manager or promoter entered into or carried out the scheme for the dominant purpose of enabling him to obtain a tax benefit in connection with the scheme.'

[29]

Tax Benefit 113 The Commissioner contends that the primary Judge's conclusion that Mr Lenzo had not relevantly gained a tax benefit in connection with the scheme involves two separate errors: · first, his Honour did not determine whether, in the absence of the scheme, the deductions claimed by Mr Lenzo would not have been allowable or might reasonably be expected not to have been allowable (as s 177C requires); and · secondly, the 'counterfactuals' adopted by the primary Judge assumed that Mr Lenzo entered into the Lease and Management Agreement, which was part of the very scheme that s 177C(1)(b) mandates must be ignored. 114 Had the primary Judge not made these errors, so the Commissioner argues, he would have had to conclude that Mr Lenzo obtained tax benefits in connection with the scheme. In the absence of the Lease and Management Agreement, the Loan Deed and the Indemnity Agreement, Mr Lenzo simply would not have been entitled to the deductions that otherwise would have been allowable in respect of maintenance fees, rent, interest and indemnity fees. At the very least, on the counterfactual assumptions made by his Honour there would have been no indemnity fees payable (since there would have been no loan from Arwon and no Indemnity Agreement) and no interest payable (had Mr Lenzo provided the required funds himself). 115 The Commissioner contends that, in any event, the evidence does not support his Honour's conclusion that, in the absence of the scheme, Mr Lenzo would still have been entitled to claim the deductions claimed by him. His Honour's conclusion rested on the proposition that had Arwon not offered to lend Mr Lenzo the required funds, he could have financed his participation in the Project using his own resources or moneys borrowed from other financiers. According to the Commissioner, there is no evidence to support this proposition. Moreover, alternative forms of funding would have exposed Mr Lenzo to significantly greater risks if the Project failed. Thus the critical factual findings were flawed.

[33]

The Statutory Formulation 121 The tax benefits obtained by Mr Lenzo, on the Commissioner's case, comprise the deductions relating to the Project claimed in Mr Lenzo's returns in respect of the 1998, 1999 and 2000 taxation years, other than the proportion of pre-paid maintenance fees and rent and the interest paid to ANZ. In determining whether Mr Lenzo obtained a tax benefit in connection with the scheme for the purposes of s 177C(1)(b), three things should be noted about the statutory formulation. First, the question posed by s 177C(1)(b) has to be answered on the assumption that the scheme had not been entered into or carried out. Section 177C, unlike for example s 177D, does not refer to 'any part of the scheme'. Thus the question, in order to be answered as s 177C(1)(b) requires, must be approached by assuming that the entire scheme found by the Court was not entered into or carried out: cf FCT v Peabody, at 383-384, per curiam. It is not open to the taxpayer to point to what might reasonably be expected to have been done if only part of the scheme had not been entered into or carried out. In this case, for example, it is not open to Mr Lenzo to point to what could reasonably be expected to occur if the Loan Deed is ignored, but the remainder of the scheme is assumed to have continued intact. 122 Secondly, s 177C(1)(b) applies where the deduction would not have been allowable or might reasonably be expected not to have been allowable had the scheme not been entered into or carried out. As the High Court observed in FCT v Peabody, at 385: '[a] reasonable expectation requires more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable for it to be regarded as reasonable.' 123 Thirdly, s 177C(1)(b) presents what might be described, perhaps loosely, as a question of characterisation. For the Court to conclude that a taxpayer has obtained a tax benefit in connection with a scheme, it must find that a deduction is allowable to a taxpayer in relation to a year of income in circumstances where the whole or part of 'that deduction' would or might not have been allowable in the absence of the scheme. What does the expression 'that deduction' mean? 124 If the expression means the very deduction claimed by the taxpayer, in the sense of a deduction for the precise liability incurred by reason of the taxpayer's participation in the impugned scheme, the Commissioner would have little difficulty in persuading the Court that the taxpayer has obtained a tax benefit in connection with the scheme. By hypothesis, if there were no scheme (assuming the incurring of the liability was a consequence of the scheme) the taxpayer simply could not have claimed the identical deduction. 125 If the expression 'that deduction' has a wider meaning, it may be open to a taxpayer to satisfy the onus of showing the Commissioner's assessment is excessive by demonstrating that, had the scheme not been entered into or carried out, he or she would have or might reasonably be expected to have incurred a liability of the kind actually claimed as a deduction. For example, in WD & HO Wills (Aust) Pty Ltd v Commissioner of Taxation (1996) 65 FCR 298, the taxpayer argued that had it not entered the scheme (involving payment of insurance premiums by it to a 'captive' insurer), the taxpayer would have paid an equivalent sum in premiums to another insurer. On that hypothesis, even without the scheme, the whole of the deduction claimed by the taxpayer would have been an allowable deduction. The argument failed on the facts, but was accepted in principle: 65 FCR, at 329. 126 The better view is that s 177C(1)(b) should be given the wider interpretation. Otherwise, there would seem to be little point to the words 'or might reasonably be expected not to have been allowable' in the sub-paragraph. In the absence of the scheme, at least if it is defined to include the incurring of a deductible liability, the identical deduction would never be allowable. The wider view seems to be implicit in the approach taken in FCT v Peabody ([124] above), since in that case the High Court considered events that would have taken place if the relevant scheme had not been entered into. There would have been no point in undertaking the inquiry if, in the absence of the scheme, the deduction claimed by the taxpayer could not have been allowable. The wider view was also implicitly adopted in Federal Commissioner of Taxation v Consolidated Press Holdings Ltd (No 1) (1999) 207 CLR 235, at 261-262, where the High Court analysed the likely course of events had the taxpayer not entered into the relevant scheme. 127 The wider view is also consistent with the construction of s 177C(1)(a), the companion sub-paragraph to s 177C(1)(b), adopted by the High Court in FCT v Spotless Services. The Court in that case rejected a contention that the phrase 'that amount', as used in s 177C(1)(a), referred only to the amount of interest actually received by the Australian taxpayer from the offshore borrower under the impugned scheme. The Court considered (at 424) that the sub-paragraph referred to the amount 'produced from a particular source or activity'. In FCT v Spotless Services itself, the activity was the investment of $40 million (the sum invested by the taxpayer under the offshore scheme) and its employment to generate a return to the taxpayer. 128 By parity of reasoning, in determining whether the particular deduction claimed by the taxpayer would or might reasonably have been allowable, the Court must consider, in the absence of the scheme, what activity the taxpayer would have undertaken. The taxpayer can satisfy the onus of showing that he or she has not obtained a tax benefit in connection with a scheme if: · he or she would have undertaken or might reasonably be expected to have undertaken a particular activity in lieu of the scheme; and · the activity would or might reasonably be expected to have resulted in an allowable deduction of the same kind as the deduction claimed by the taxpayer in consequence of the scheme.

[34]

A Tax Benefit in this Case? 129 In the present case, the primary Judge rejected Mr Lenzo's submission that he had not obtained a tax benefit from the scheme because, had he not invested in the Project, he would have contributed to his superannuation fund and claimed an allowable deduction of $28,420 for the contributions. His Honour correctly held that, on the assumption that Mr Lenzo would have contributed to superannuation, he would not have obtained 'that deduction' - that is, the allowable deduction actually claimed by him in respect of the 1998 taxation year. The conclusion is correct because the deductions claimed by Mr Lenzo in the 1998 year were for prepaid maintenance fees, rent and indemnity fees in respect of an investment in a sandalwood plantation. Part of Mr Lenzo's hypothetical contribution to his superannuation fund would have attracted a concessional deduction, but it would have been a deduction of quite a different character than that actually claimed by Mr Lenzo in respect of the 1998 taxation year. 130 The primary Judge considered the 'relevant counterfactual' to involve Mr Lenzo borrowing funds needed to finance his investment in the Project from a source other than Arwon. The alternative counterfactual hypothesis was that Mr Lenzo 'could have used his own funds and obtained the same deduction'. The difficulty with both of these counterfactuals is that they apparently dispense with part of the scheme (as found by his Honour), yet leave the balance of the scheme intact. 131 It will be recalled that all three versions of the scheme accepted by the primary Judge comprise the Application Form, the Lease and Management Agreement (to which Mr Lenzo was a party), the Loan Agreement, the Indemnity Agreement and the acts carried out pursuant to them, including the round robin of 30 July 1998. In the absence of the scheme as a whole (the hypothesis mandated by s 177C(1)(b)), there would have been no Project in which Mr Lenzo could have invested. Indeed, Mr Lenzo would not have completed the Application Form. Certainly, no moneys would have been payable by him pursuant to the Lease and Management Agreement, the Loan Deed or the Indemnity Agreement. Thus he could not have claimed allowable deductions in respect of maintenance fees, rent, indemnity fees or interest incurred in respect of the loan by Arwon. 132 Mr McCusker QC, who appeared with Mr Romano for Mr Lenzo, submitted that the relevant question is what would have occurred or was reasonably likely to occur if the scheme (as distinct from the Project) had not been entered into or carried out. Mr McCusker argued that his Honour had found in effect that even in the absence of the scheme, Mr Lenzo would still have invested in the Project, using either an alternative source of finance or his own funds. This contention assumed, as Mr McCusker accepted, that in the absence of the scheme the Project would still have been available for investment by investors who did not need or want funding on the terms offered by Arwon. 133 There are several difficulties with this submission. First, his Honour made no express finding that, in the absence of the scheme, Mr Lenzo would have invested in the Project. Indeed in oral argument, Mr McCusker seemed to retreat from an earlier suggestion that such a finding was implicit in his Honour's reasoning. 134 Secondly, his Honour made no finding that, in the absence of the scheme, the Project would have been, or might reasonably be expected to have been, available to investors on terms that would have created allowable deductions of the same kind as those claimed by Mr Lenzo. Mr McCusker correctly pointed to the fact that the scheme, as found by the primary Judge, is not a concept identical to the Project, in the sense of a commercial undertaking to cultivate and harvest sandalwood trees in the east Kimberley. It is also true that there was evidence that the Project would have offered reasonable commercial prospects without the tax advantages created by the scheme. However, that is a far cry from evidence supporting a finding that, without all the elements of the scheme (including the Lease and Management Agreement and the indemnity arrangements concerning the Arwon loans), the Project would or might reasonably be expected to have been available for investment on terms creating similar allowable deductions to those claimed by Mr Lenzo. 135 Thirdly, the Court was not taken to evidence that would justify a finding that, in the absence of the scheme, the promoters of the Project would have been willing and able to invite investors to participate in it. Obviously, resolution of the factual issue would depend on the terms on which the Project might have been offered, but this is a matter of speculation. 136 Mr McCusker also argued that the 'counterfactual' could be assessed by hypothesising that the Project was available on the terms in fact offered to investors, except that the Loan Deed would not be included. In other words, he contended that it could reasonably have been expected that all elements of the scheme would have been present, except the offer of the Arwon loan. For reasons I have explained, in assessing the 'counterfactual', s 177C(1)(b) requires the entirety of the scheme to be ignored. The statutory mandate is not fulfilled if part only of the scheme is ignored and the rest is assumed to continue intact. 137 In view of the conclusions I have reached, it is not necessary to consider whether his Honour misapplied the test laid down by s 177C(1)(a), insofar as he found that Mr Lenzo 'could have' borrowed funds from the ANZ or used his own moneys to finance his involvement in the Project. However, both the statutory language and the authorities suggest that the provision is not concerned with what the taxpayer could have done, in the sense that the taxpayer, had he been so minded, had the ability or resources to adopt a particular course. Rather, the provision is concerned with what the taxpayer would have done or what the taxpayer might reasonably be expected to have done. As the High Court explained in FCT v Peabody, the provision contemplates a reasonable prediction as to events that would have taken place had the scheme not been entered into. 138 I therefore conclude that his Honour was in error in finding that Mr Lenzo did not obtain a tax benefit in connection with the scheme.

[35]

Principles 139 The following propositions concerning the question of 'dominant purpose' were stated by Hill J (with whom Hely J agreed) in Commissioner of Taxation v Sleight (2004) 136 FCR 211, at 229-230 [67]: '(1) Part IVA does not authorise consideration of evidence of the subjective purpose or motivation of a particular person. The subjective state of mind of a person is not a matter listed in s 177D(b) to which regard may be had. … Rather the section requires consideration of the eight matters listed in s 177D(b) and no other matters. Hence the section seeks to establish the conclusion which would be reached by reference to what may be referred to as objective factors, that conclusion being however, a conclusion as to the purpose of a person who entered into or carried out the scheme … (2) The reference to dominant purpose in a case where more than one purpose is present is a reference to the "ruling, prevailing or most influential" purpose … (3) The conclusion as to dominant purpose may be reached not only with respect to the dominant purpose of the taxpayer, it may be reached by reference to the dominant purpose of any other person or persons so long as they are persons who entered into or carried out the scheme or any part of it … Likewise, the purpose of an adviser may be attributed to the taxpayer in an appropriate case … (4) It is possible to arrive at the conclusion as to purpose by making a global assessment of the facts, so long as it is clear that the relevant eight factors are taken into account … (5) Some of the eight factors (there is clearly some overlap among them) may point one way, others may point in the opposite direction, and some may be neutral: it is the evaluation of these matters, alone or in combination, some for, some against, that s 177D requires in order to reach the conclusion to which s 177D refers … (6) There is no inconsistency between a finding that the purpose of a person lay in the pursuit of commercial gain in the course of carrying on a business and a finding that the dominant purpose was to enable the relevant taxpayer to obtain a tax benefit …' (Citations omitted.) 140 There is no challenge to the findings of primary fact on the basis of which his Honour rejected the Commissioner's contention that it would be concluded that Mr Lenzo or the promoters entered into or carried out the scheme for the dominant purpose of enabling him to obtain a tax benefit in connection with the scheme. His Honour had to apply, as this Court does, the eight objective matters listed in s 177D(b) of the ITAA 1936. In these circumstances, as Heerey J notes, the approach to be taken by an appellate court is that stated by Gibbs ACJ, Jacobs and Murphy JJ in Warren v Coombes (1978) 142 CLR 531, at 551. See also Cabal v United Mexican States (2001) 108 FCR 311, at 362 [223]-[224], per curiam; Branir v Owston Nominees (No 2) Pty Ltd (2001) 117 FCR 424, at 435-438 [24]-[30], per Allsop J (with whom Drummond and Mansfield JJ agreed).

[36]

The Question 141 Each case arising under Part IVA must depend on its own facts. It is striking, however, that the present case has similarities to the investment in a tea tree oil farming project considered in Sleight. In that case, the Court unanimously held, contrary to the conclusions of the primary Judge, that a reasonable person would conclude that the investor had the dominant purpose of obtaining a tax benefit in connection with the scheme. 142 In the present case, the primary Judge pointed out that the Court in Sleight (at 231 [75]) placed some emphasis on the risks associated with the project, which in that case were acknowledged to be substantial. However, the Court in Sleight also placed emphasis on the fact that the financial structure (which included a management agreement providing for upfront fees, a loan agreement and an indemnity agreement) was not necessary to the success of the project: at 233 [80], per Hill J. Their Honours considered (at 233 [81]) that there was a difference between the form and substance of the scheme: 'In form there is an option whether to farm alone or to employ the management company. There is a management agreement and financing and interest payments. The form, involving prepayment of management fee and interest is, it may be concluded readily, designed to increase the taxation deductions available to an investor. The substance is, however, quite different …[T]he investor is a mere passive investor in what, once the tax features are removed, is a managed fund where no deduction would be available, or perhaps an alternative characterisation of the substance of the scheme is an investment in shares in the Land Company which at the expiration of 15 years is to own the tea tree plantation.' The Court in Sleight reached the conclusion it did notwithstanding that the tax savings in the first two years did not cover payments of interest and principal in those years: at 234 [87]-[88]. Further, the prospectus stated that returns, albeit modest, were expected within three years of commencement of the project. 143 In this case, as in Sleight, it may be accepted that the investment had a commercial purpose. The real question, as Hill J identified in Sleight (at 235 [92]) is which of the two purposes, tax or investment, should be taken to have predominated.

[37]

False Dichotomy 144 The joint judgment in FCT v Spotless Services (at 415) used the expression 'false dichotomy' in relation to a reference, on the one hand, to a 'rational commercial decision', and, on the other, to obtaining a tax benefit. The joint judgment pointed out that a person may enter or carry out a scheme for the dominant purpose of enabling the taxpayer to obtain a tax benefit, yet also seek commercial gain from the scheme. Their Honours recognised that the 'shape' of a transaction may be influenced by revenue considerations and that in the commercial world this is only to be expected. However, a particular course of action may be: 'both "tax driven" and bear the character of a rational commercial decision. The presence of the latter characteristic does not determine the answer to the question whether, within the meaning of Pt IVA, a person entered into or carried out a "scheme" for the "dominant purpose" of enabling the taxpayer or enabling a taxpayer to obtain a "tax benefit"' (at 416). Their Honours went on to say that much depends upon the identification among various purposes of that which is 'dominant' - that is, the ruling prevailing or most influential purpose. 145 One difficulty with the reasoning of the primary Judge in relation to dominant purpose is that he appears to have regarded the fact that significant returns could reasonably have been expected from the Project, independently of tax benefits, as critical to, if not determinative of, the question posed by s 177D(b). For example, in considering the manner in which the scheme was entered into or carried out (s 177D(b)(i)) the primary Judge minimised the significance of the timing of entry into the scheme, as follows: 'if there is a significant commercial benefit to be derived from an investment and an associated tax benefit, entry into the scheme on 30 June 1998 with a view to obtaining the tax benefit in that year is entirely consistent with predominantly commercial purpose.' Similarly, in considering the significance of the time at which the scheme was entered into (s 177D(b)(iii)), his Honour thought that the prospect of a commercial return would 'justify' the scheme without reference to taxation benefits. In his conclusion (reproduced [112], above), his Honour again stressed the significant returns that could be expected independently of any tax benefits. 146 It is true that the fact that the scheme has a commercial objective, in the sense of maximising returns to the investor, is relevant in determining the dominant purpose. It is also true that the fact that the scheme can be expected to produce a 'reasonable' return independently of the tax benefits is a factor, perhaps an important factor, to take into account. But the commercial viability of the arrangement (however that be assessed) provides no guarantee that, after taking into account all the matters identified in s 177D(b), it would not be concluded that the relevant person entered or carried out the scheme for the dominant purpose of obtaining a tax benefit.

[39]

Dominant Purpose 150 In these circumstances, it is appropriate to form my own view about the proper conclusion to reach on the question posed by s 177D(b) of the ITAA 1936. As the primary Judge remarked, although the eight enumerated matters must be taken into account, they cannot be considered independently of each other. Indeed some of the matters overlap. Nonetheless, it is convenient to consider the factors of major relevance to this case. (i) The manner in which the scheme was entered into or carried out (s 177D(b)(i)). 151 His Honour found that the Project was marketed as a serious commercial proposition. He also found that there was not an 'over-emphasis on tax benefits'. Nonetheless, the taxation benefits of the Project were clearly identified in the prospectus and were supported by the opinion of Ernst & Young that the foreshadowed deductions would be allowable. The estimated return for a self-funded investor was predicted to be 11.81 per cent per annum. However, the prediction was in respect of an investment described in the prospectus, for very good reasons, as 'illiquid' and 'speculative and long term'. In any event, as has been explained, the prospect of a return independently of tax benefits does not necessarily mean that the dominant purpose of the scheme was not to obtain a tax benefit. 152 The timing of the entry into the scheme is of considerable significance in this case. It is true that execution of documentation on the last day of a taxation year is not determinative of purpose. Nonetheless, as Hill J observed in Sleight, if the investment purpose had predominated, there would have been no need for a flurry of activity at the very end of the taxation year, with documents being executed on Mr Lenzo's behalf under the Power of Attorney. More particularly in this case, the documentation completed on that day generated a deduction of $20,836 for Mr Lenzo in the 1998 taxation year for a cash outlay of $535 (leaving aside his purchase of shares in the Management Company). It is difficult to understand the timing of the entry into the scheme, except as a means of enabling the investor to claim a substantial allowable deduction as early as possible. Had the investment purpose predominated, there would have been no need to execute the documentation until some months later. 153 The key to generating allowable deductions for investors was the 'round robin' of 30 June 1998, which nominally provided the 'funds' for Arwon to lend to the investors. There is no suggestion that the round robin was not a genuine transaction. Nonetheless, it was a paper transfer of funds plainly designed to ensure that investors could claim a substantial deduction for the taxation year ended 30 June 1998. I agree with Heerey J that it is difficult to see how the round robin can be regarded: 'as an incident of the much more significant commercial purposes achievable with or without a tax benefit.' The round robin is therefore clearly indicative of a predominant tax avoidance purpose: cf Sleight, at 232. '(ii) The form and substance of the scheme (s 177D(b)(ii)).' 154 The primary Judge considered that the form and substance of the scheme were the same. In a sense that is always so. However, the Project was presented as an opportunity for a passive investment in a sandalwood tree plantation due for harvest in 2014. Although the arrangements contemplated each investor incurring a large commitment to contribute to the Project on 30 June 1998, no funds were available to the Project until some months later. The available funds at that time comprised less than one third of the liability incurred by the investor. The balance of the liability so incurred was not repayable until harvest (or 2014) and, even then, only out of the proceeds of harvest. As Hill J remarked in Sleight (at 233): '[t]he particular shape the investment took was clearly fashioned in a way that would maximise the tax deductions.' (iii) The time at which the scheme was entered into and the length of the period during which the scheme was carried out (s 177D(b)(iii)). 155 As I have explained, the timing of entry into the scheme, in the circumstances of this case, is strongly indicative of the dominant purpose of obtaining a tax benefit. It is true, as the primary Judge noted, the Project was not merely a 'paper exercise' in that real liabilities were incurred and a genuine commercial activity (the sandalwood tree plantation) was undertaken. Nonetheless, the scheme was so structured that the bulk of the liabilities were not due for payment until harvest and the investors were protected against any shortfall from the proceeds of harvest. '(iv) The result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme (s 177D(b)(iv)). (v) Any change in the financial position of the relevant taxpayer that has resulted, with result, or may reasonably be expected to result from the scheme (s 177D(b)(v).' 156 One result of the scheme was that Mr Lenzo received tax deductions in the first three years of the scheme the net benefits of which exceeded his cash outlays in respect of the scheme. He received the advantage of his investment in the Project with his exposure to liability under the Arwon loan in effect protected against the risk of failure of the Project. Had Mr Lenzo elected to take up the Arwon loan to fund payment of the Second Principal Sum (as the scheme contemplated), he would have had the benefit of the investment at no (or very little) net cost to him and with the advantage of the indemnity against any shortfall in harvest proceeds. No doubt, as the primary Judge found, there were prospects of returns even without the tax benefits and virtually any sandalwood project would have generated some allowable deductions. But the structure of this scheme is explicable only as an attempt to maximise and bring forward all tax benefits to investors, thereby insulating them against the risks of the Project. 157 In my view, the factors I have identified justify concluding that Mr Lenzo entered into or carried out the scheme for the dominant purpose of enabling him to obtain tax benefits in connection with the scheme. As Heerey J has pointed out, the Project itself involved a genuine commercial undertaking and perhaps could have been implemented in a manner that would have created no issue as to the application of Part IVA, even if structured so as to generate allowable deductions. But the manner in which this scheme was presented and implemented manifests, in my opinion, the dominant purpose of obtaining tax benefits.

Commissioner of Taxation v Lenzo

At a glance

Court

Decision date

Before

Source

Judgment (49 paragraphs)

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Legislation Cited (2)

Cases Cited (13)

Cited By (4)