Commissioner of Taxation (Cth) v Sun Alliance Investments Pty Limited

Commissioner of Taxation (Cth) v Sun Alliance Investments Pty Limited - [2005] HCA 70 - HCA 2005 case summary — Zoe

[10]

GLEESON CJ, GUMMOW, KIRBY, CALLINAN AND HEYDON JJ. The respondent ("Sun Alliance") appealed to the Federal Court[1] from the disallowance by the appellant ("the Commissioner") of its objection to an amended income tax assessment in respect of Sun Alliance's year of income ending 31 December 1997. The amendment reduced by more than $17 million certain capital losses claimed by Sun Alliance and consequently increased its taxable income. The losses in question had been incurred by Royal and Sun Alliance Insurance Australia Holdings Limited ("RSA") and, as permitted by the legislation, had been transferred to Sun Alliance. Sun Alliance was a wholly owned subsidiary of RSA. The losses were incurred in circumstances to which it will be necessary to refer in some detail.
The primary judge (Stone J) upheld the disallowance of the objection by Sun Alliance[2]. An appeal by Sun Alliance to the Full Court (Lee, Sundberg and Conti JJ) was largely successful[3] and the matter was remitted to the Commissioner for redetermination. The Full Court delivered a joint judgment. There is an appeal to this Court by the Commissioner and a cross-appeal by Sun Alliance.
Before turning further to consider the facts, something should be said of the provisions respecting capital losses upon which the litigation turns.
Part IIIA of the Income Tax Assessment Act 1936 (Cth) ("the 1936 Act") is headed "CAPITAL GAINS AND CAPITAL LOSSES" and comprises ss 160AX-160ZZU. The stated object of Pt IIIA is to provide for the inclusion in assessable income of net capital gains (ss 160AX, 160ZO(1)). Net capital losses are taken into account in accordance with s 160ZC but are not otherwise allowable as deductions (s 160ZO(2)). It is significant for this litigation that the application of Pt IIIA is confined to disposals of assets acquired on or after 20 September 1985 (s 160L(1)).
The present appeal and cross-appeal concern the treatment for income tax purposes of capital losses. The determination of the existence and amount of a capital loss requires a comparison between the reduced cost base of the asset (the disposal of which by the taxpayer has given rise to the claimed loss) and the consideration received in respect of that disposal (s 160Z). The advantage to the taxpayer in establishing such a loss lies, not only in reduction to the taxpayer's net capital gain for the relevant year of income, but also in its availability, provided for in s 160ZC, for the loss to be carried forward to the immediately following year of income, to be absorbed by capital gains or to increase the net capital loss for that year.
Sections 160Z and 160ZC have been rewritten in ss 104‑10 and 102‑5 of the Income Tax Assessment Act 1997 (Cth) ("the 1997 Act") respectively. This development is of no significance for the instant proceedings. The reason for this is to be found in s 1‑3(2) of the 1997 Act, which provides that, where the 1997 Act appears to express in a simpler and clearer style the ideas in the 1936 Act, those ideas are not, for that reason alone, to be taken to be different.
The notion of "reduced cost base" is critical to the determination of a capital loss. As defined in s 160ZH(3) of the 1936 Act[4], the reduced cost base of an asset is the sum of:

[38]

Royal Insurance plc ("RIPLC") was a company incorporated in England and the beneficial owner of all the issued shares in Royal Australia Holdings Limited ("RAHL"). In an agreement ("the Merger Agreement") dated 8 October 1992 ("the merger date"), RIPLC agreed to sell its entire shareholding in RAHL to RSA (then styled "Sun Alliance Australia Limited"). As consideration, RSA agreed both to pay RIPLC a sum of $A125 million and to issue to it an allotment of fully paid ordinary shares in RSA. This would, after issue, represent 40 per cent of the issued ordinary share capital in that company. Prior to the Merger Agreement, the beneficial owner of all of the issued shares in RSA had been Sun Alliance Holdings Limited ("SAHL").
The Royal and Sun Alliance Group ("the RSA Group"), which represented a merger between the Royal Group and the Sun Alliance Group, was thus formed, with RSA as its Australian holding company.
As at the merger date, Phoenix Securities Pty Limited ("Phoenix") and Sun Alliance Insurance Ltd ("SAIL") were wholly owned subsidiaries of RSA. The shareholding of RSA in these companies pre‑dated 20 September 1985. However, the 40 per cent change in ownership of RSA that was contemplated in the Merger Agreement, coupled with various other developments that had occurred between 1985 and the merger date, resulted in a change in the majority underlying interests in RSA. As a result of this, the shares held by RSA in both Phoenix and SAIL were, by operation of s 160ZZS of the 1936 Act[10], deemed to have been acquired by RSA after 19 September 1985 (specifically, on 8 October 1992) for a consideration equal to their market value on that date. The market value of the shares in Phoenix on 8 October 1992 was $28,477,898, and that of the shares in SAIL $98,728,974.
The present appeal by the Commissioner and cross-appeal by the taxpayer relate to capital losses claimed by RSA upon its disposal of shares in both Phoenix and SAIL. As already noted, these losses were subsequently, in part, transferred to the taxpayer, which was itself a wholly owned subsidiary of RSA[11]. It is important to note, for purposes of what follows, that RSA's years of income ended on 31 December.

[39]

Until its dissolution in 1997, Phoenix conducted a business of equity investments. This was consistent with the practice of insurance groups holding equities in separate vehicles to attract a tax rebate under s 46 of the 1936 Act. Phoenix held shares in companies listed on the Australian Stock Exchange. Prior to 1992, no formal accounts were prepared at the entity level for companies then in the Sun Alliance Group, of which Phoenix was one.
However, after the merger, shifts in the value of the shares held by Phoenix were reflected in its accounts, in accordance with Australian Accounting Standards Review Board requirement AASB 1010, as increments and decrements in its asset revaluation reserve. The affidavit evidence of Mr Harold Bentley, the Chief Financial Officer of RSA, suggests that it was the practice of the RSA Group to value those shares on a monthly basis and that these valuations disclosed significant monthly fluctuations in the value of Phoenix's portfolio of investments.
In this Court, the Commissioner contended that, as at the merger date, the shares held by Phoenix were valued at cost at $8,928,016. They were then revalued at the time of the merger to a market value of $20,728,138, reflecting what was said to be an unrealised gain in Phoenix's asset revaluation reserve of $11,800,122.
However, to accept this particular description of the method by which the accretions in the value of Phoenix's share portfolio were recorded is to misunderstand the accounting systems that had been adopted by the Sun Alliance Group before the merger date. Prior to the financial year ended 31 December 1986, investments were stated in the accounts of the Sun Alliance Group at their historical cost. Thereafter, in the period between 31 December 1986 and 31 December 1992, assets were revalued and increases or decreases in value were taken to an asset revaluation reserve on an annual basis. In other words, at the merger date (8 October 1992) and reflected in its management accounts, Phoenix's investments had last been revalued at 31 December 1991.
The figures upon which the Commissioner relies were taken from an analysis of Phoenix's investments that had been undertaken subsequently by Arthur Andersen upon instructions from the Australian Government Solicitor. However, it is also true that a reconstructed balance sheet for Phoenix as at the merger date had been prepared in response to an information request from the Commissioner.
In any event, Phoenix's investments were progressively realised during the period from 1994 to 1996 inclusive for an aggregate sum of $30,159,729. This yielded a realised profit of $21,231,714.
On 30 October 1992, less than a month after the merger date, Phoenix declared and paid a dividend of $12 million to RSA, sourced only from its retained profits and gains on investments realised prior to the declaration of the dividend. Subsequent to this, as at 31 December 1992, the retained profits of Phoenix were $438,842, and the balance in its investment realisation reserve was $2,621,991.
Phoenix's after-tax operating profit for the financial year ended 31 December 1993 came to $1,103,542. Given that there was no distribution made to RSA in 1993, it began the financial year ended 31 December 1994 with retained profits amounting to $1,542,384. This, when added to its after‑tax operating profit for that financial year of $4,313,187 and allowing for the transfer from this sum of $3,235,228 to its investment realisation reserve, left sufficient from which to declare and pay to RSA a dividend of $650,000 on 25 May 1994. The retained profits of Phoenix at the end of the financial year ended 31 December 1994 thus amounted to $1,970,343.
For the financial year ended 31 December 1995, Phoenix's after-tax operating profit was $2,774,904, with $1,604,683 transferred to its investment realisation reserve. Taking into account its retained profits from the previous financial year, the total sum available to Phoenix for appropriation was $3,140,564, of which $3,100,000 was paid on 28 December 1995 as a dividend to RSA and $40,564 kept as retained profits.
In the following financial year, that ended 31 December 1996, Phoenix reported an after-tax operating profit of $18,897,352 and transferred from its investment realisation reserve a sum of $7,461,902. It was thus able early in September 1996 to pay to RSA a dividend of $20,891,449.
There is no dispute that the dividends paid by Phoenix attracted the rebate provided for in s 46 of the 1936 Act. However, in the present appeal, Sun Alliance submitted that the facts outlined above were sufficient to establish that the dividends paid to RSA after 30 October 1992 were attributable to profits derived by Phoenix after the merger date; it followed that par (b) of s 160ZK(5) was not satisfied.
Phoenix was liquidated on 30 December 1997. RSA received $5,835,661 in respect of its Phoenix shareholding. In estimating the capital loss incurred as a result of this, RSA reduced the cost base of its shares in Phoenix by attributing only the dividend of $12 million paid on 30 October 1992 to profits derived before the merger date. The capital loss claimed by RSA thus came to $10,642,237. It will be necessary later to return to this in detailing the substance of the Commissioner's response to RSA's self‑assessment.

[40]

SAIL carried on the business of general insurance. Prior to the introduction of AASB 1023[12], which took effect for the RSA Group during the financial year ended 31 December 1992, SAIL's accounts were prepared in accordance with the above‑described practice and policy of the Sun Alliance Group. Put simply, there was not at the merger date a formal balance sheet available in respect of SAIL. However, in the period subsequent to the merger, it was the practice of the RSA Group, in accordance with AASB 1023, to recognise changes in the value of its investments as revenue or expenses in the profit and loss account; unrealised gains were transferred to an asset revaluation reserve known as the unrealised profits reserve.
At the time of the merger which resulted in the formation of the RSA Group, SAIL's assets included land and buildings located in Bridge Street, Sydney ("the Bridge Street properties"). The evidence of Mr Bentley suggests that RIPLC (heading the Royal Group) had a policy of not owning land and buildings, and that it considered the real estate investments contributed by RSA and its subsidiaries to the assets of the RSA Group to be an over-weighted risk within the RSA Group's asset portfolio. Therefore, in order to protect RIPLC from any risks and costs associated with holding the Bridge Street properties, all the potential gains and risks attendant upon that continued holding were acquired or assumed by a new company, Bridge Street Buildings Pty Ltd ("BSBPL"). This was wholly owned by SAHL.
The potential gains and risks thus identified were passed to BSBPL through, among other things, the Merger Agreement. The combined effect of cl 14 and Sched 10 of that instrument was that, if before 1 October 1999 the Bridge Street properties were sold for a price less than the valuation pertaining at the merger date, then BSBPL would make up the shortfall. Conversely, were the sale price to exceed the valuation pertaining at the merger date, then the excess would be paid to BSBPL. It should also be noted that, on 2 November 1992, SAIL, RIPLC, BSBPL and SAHL entered into an agreement under the terms of which SAIL granted a sale option over the Bridge Street properties to BSBPL.
As at the merger date, the Bridge Street properties were valued at $57,050,000. The historical cost of the properties was $29,550,000. So it was that, after providing for deduction of certain unrealised losses, a balance of $21,345,000 was recorded in the unrealised profits reserve in the Special Purpose Financial Report for SAIL for the financial year ended 31 December 1992.
On 31 August 1995, the Bridge Street properties were sold to a third party for a sum of $38,623,500. The difference between this amount and the $57,050,000 valuation pertaining on the merger date was thus met, pursuant to cl 14 and Sched 10 of the Merger Agreement, by BSBPL. As a result, there was realised the sum of $21,345,000, already identified as the unrealised gain at the time of the merger on the Bridge Street properties.
On 30 October 1992, SAIL declared and paid to RSA a dividend of $50 million.
The realised profits retained by SAIL at the merger date amounted to $9,562,000. Much of this was used to meet an operating loss of $7,732,000 incurred in the financial year ending 31 December 1993. Subsequently, in the years ending 31 December 1994 and 31 December 1995, SAIL earned after-tax operating profits of $11,896,000 and $1,266,000 respectively. These sums, combined with the balance of the profits retained at the merger date and the above-mentioned sum of $21,345,000, amounted to $36,337,176. In September 1996, the whole of that amount was distributed by SAIL to RSA as a rebatable dividend.
Thereafter, by an agreement dated 11 December 1996 and for a sum of $11,108,952, SAIL bought back from RSA all but two of the issued shares in SAIL held by RSA. In calculating the amount of the capital loss thus incurred by it, RSA applied s 160ZK(1B) and (5) and deducted from the reduced cost base of those shares a sum comprising the whole of the $50 million dividend paid on 30 October 1992 and $9,562,000 of the $36,337,176 dividend paid in September 1996. The capital loss claimed by RSA came to $28,058,022.

[48]

It is for this reason that little assistance is to be found, for present purposes, in statements in cases such as Federal Commissioner of Taxation v Thorogood[22] and Carden's Case[23]. There, the question was whether the return of income on a cash basis or an earnings basis better discovered the gains which during the period of account have "come home to the taxpayer in a realized or immediately realizable form"[24]. This well-known statement by Dixon J in Carden's Case should not be taken, as it was in this case by the Full Court[25], as providing a test for determining the applicability in a given case of s 160ZK(5)[26].
The taxpayer rightly submitted in this appeal that the word "derived" in that sub‑section takes its meaning from its context. There is, as a consequence, some danger in seeking to rely upon those past authorities which have considered the content of the words "profits" and "derived" in isolation from each other.
One example of this may be found in the reliance by both the Full Court and the taxpayer in submissions on this appeal upon the decision of Lockhart J in QBE Insurance Group Ltd v Australian Securities Commission[27]. His Honour held that a particular accounting standard did not convert into profits that which was incapable of the conversion and was not inconsistent with the prohibition in company law upon payment of dividends except out of profits. The standard was designed to require companies carrying on the business of general insurance to bring into account unrealised gains or losses on investments. However, QBE was taken by the Full Court[28] as authority for the general proposition that an unrealised accretion to the value of an asset may constitute a profit only where it is "of a permanent character"[29]. It will be necessary to return to the matter of the correctness and width of this proposition later in these reasons. Presently, something should be said about the decisions of this Court in Evans v Deputy Federal Commissioner of Taxation (SA)[30] and Read v The Commonwealth[31]. Both involved some consideration of the compound concept "profits derived".

[53]

Counsel for the taxpayer in this appeal sought, during the course of oral argument, to call this statement in aid, submitting that, though Read was a decision ultimately concerned with social security and therefore coloured by the considerations arising in that particular context, the authorities cited therein related, in the words of the Full Court[33], "to relevant concepts of income". However, to the extent that the decision in Read did refer to concepts of income, this manifested itself only in an assumption, apparent in the reasoning of Mason CJ, Deane and Gaudron JJ, that, in applying s 18 of the Social Security Act, the notion of capital profits is to be equated with that of capital gains, in the sense of realised capital gains[34].
This assumption may be contrasted with the proposition, established in a series of cases dealing with the prohibition against the payment of dividends by companies except out of profits[35], that the concept of profits in the context of company law is sufficiently broad to embrace unrealised capital profits. The meaning here of "profits" was said by Higgins J in 1910 not to be "rigid and absolute" and to be dependent upon the context in which it is being deployed[36]. There is nothing in the text of s 160ZK(5) to suggest that an equation similar to that drawn in Read should be adopted in construing that sub‑section. The present utility of the statements made in the course of deciding Read may therefore be doubted. Whether similar doubt attends what was earlier said in Evans is the subject of what follows.
At issue in Evans were the construction and application of s 16(b)(i)(1) of the Income Tax Assessment Act 1922 (Cth) ("the 1922 Act"). Subject to a presently immaterial proviso, that provision included within the assessable income of any resident shareholder in a company those dividends, bonuses or profits paid or distributed by the company to the shareholder out of profits derived by the company from any source. The relevant dividend in this case was a distribution made among its shareholders by Guinea Gold NL ("Guinea Gold") which consisted, in part, of shares in another company, New Guinea Goldfields Ltd ("NGGL"). Those shares had been acquired by Guinea Gold as part of the consideration for which it sold to NGGL certain gold mining leases it owned in respect of land in New Guinea. The total value of that consideration was exceeded by the amount which had been expended by Guinea Gold in connection with the leases.
The taxpayer was an Australian resident and a shareholder in Guinea Gold. On appeal to this Court, he submitted that, as the shares in NGGL did not contain any profits, their market value should not have been included in his assessable income. This submission was rejected by Rich, Dixon and Evatt JJ. In a statement upon which the Commissioner relied, their Honours said[37]:

[56]

In its submissions before this Court, the taxpayer argued that the answer to the question posed above lies in s 160ZLA(4) of the 1936 Act, which was enacted at the same time as s 160ZK(5)[38].
The essence of the taxpayer's submission is that, in referring expressly to a situation where rebatable dividends are paid out of revaluation reserves, s 160ZLA(4) operated to exclude from the ambit of the general terms in s 160ZK(5) the payment of such dividends.
It is unnecessary to set out the text of s 160ZLA(4). It was made clear in sub‑s (1) of s 160ZLA that the rebatable dividend adjustments provided for in that section were intended only to bear upon the application of ss 160ZA and 160ZL of the 1936 Act. The first of these sections addresses the capital gains tax consequences where a capital gain has accrued to a taxpayer because of the disposal of an asset, but where, as a result of that disposal, an amount ("the included amount") will also be included in the taxpayer's assessable income under a provision of the 1936 Act other than Pt IIIA. For the purposes of that section, the amount of a rebatable dividend adjustment in relation to a share was taken not to be able to constitute an included amount (s 160ZA(4A)(b)). In contrast, as to s 160ZL, a rebatable dividend adjustment in relation to a share is taken, for the purposes of determining the capital gains tax consequences of a return of capital by a company to its shareholders, to be a non-dividend payment by the company to the taxpayer.
Neither provision touched then upon the calculation, for the purposes of Pt IIIA, of the reduced cost base of an asset. It cannot be said then that s 160ZLA(4), as enacted, was intended in any way to affect the construction of s 160ZK(5). These two sub‑sections had, as the Commissioner rightly contended before the Full Court, "distinct and separate fields of operation"[39]. Accordingly, the submissions advanced by the taxpayer, both on this point and in relation to the wider proposition that s 160ZK(5) is engaged only where a company's profits are realised, must be rejected.

[61]

It should also be noted, given the use of the word "payable", as distinct from "paid", in s 201(1), that the prohibition therein set down was directed to the declaration of a dividend, and not merely its payment[47]. This may account, in large measure, for Lockhart J's adoption in QBE of a requirement, where an unrealised accretion to the value of a company's assets is sought to be treated as a profit against which dividends may be declared, that that accretion in value be "of a permanent character". For, to repeat what was said by Mason J in Industrial Equity, just as it "would be productive of confusion and uncertainty if companies were to declare dividends against the possibility that profits not in existence at the time of declaration would or might be earned or received by the time the dividend was paid"[48], so would it be productive of confusion and uncertainty if companies were to declare dividends against profits that are subject to constant fluctuations.
But this is not to say that like considerations should be taken as providing a guide for the purpose of construing s 160ZK(5) of the 1936 Act. After all, that sub‑section speaks of distributions which "could reasonably be taken to be attributable to profits", rather than "dividend[s] ... payable ... out of profits", suggesting that the confusion and uncertainty contemplated above do not here constitute so pressing a concern as they do in the area of company law.
In MacFarlane v Commissioner of Taxation[49], in construing the phrase "dividends paid to him by the company out of profits derived by it from any source" in s 44(1)(a) of the 1936 Act, Beaumont J said there was "no reason, of logic or of experience, to import the technical requirements of the company law".
Moreover, as has already been demonstrated, there is nothing in the 1936 Act, not even in s 160ZLA(4), to render presently inapposite the notion, articulated in Evans, that the derivation of a profit may be established where such profit is ascertained. It might therefore be said that the application of par (b) of s 160ZK(5) in any given case requires the fulfilment of two key tasks: first, the ascertainment, by a process of computation and comparison, of a gain made by a company; and, secondly, the making of a determination as to whether a distribution by that company may reasonably be attributed to the ascertained gain. During the course of oral argument, counsel for the Commissioner submitted that ascription to an unrealised gain of the quality of permanence is more appropriately seen as going to the second of these tasks. It is not inherent in the nature of a profit, as that concept is employed in s 160ZK(5), that it should be of a permanent character.
In other words, fluctuations in the value of an unrealised gain would affect only the extent to which a subsequent distribution may reasonably be attributed to that gain. The Commissioner submitted that if, following the merger date, the unrealised gains as at that date in the value of the shares owned by Phoenix fluctuated, in the sense that they were constantly being eroded and restored, before being realised and distributed to RSA, then the amount of that distribution which would reasonably be attributable to profits derived before the merger would be the lowest point in the value of the gains between the merger date and the date of realisation. This proposition should be accepted as correct.
Nonetheless, the taxpayer contended that, even if this were so, an ascertained profit had not accrued to Phoenix at the time of the merger. To this contention we now turn.

[69]

It remains then to engage in that process of attribution required by par (b) of s 160ZK(5) in respect of the distributions made by Phoenix and SAIL. In doing so, several points should be noted. The first is that par (b) presents a question of characterisation of an amount which is the whole or a part of the distribution made by a company to the holder of the RDA share, as identified in par (a). Secondly, par (b) presents an inquiry as to the existence of a sufficient link between that whole or part of the distribution and profits derived by the company before a specified event (acquisition of the RDA share). Thirdly, that link may be described in terms of necessary causation but, as with all questions of causality, the starting point is the identification of the purpose (here the legislative purpose) to which the question is directed[53]. Fourthly, here, the legislative purpose of s 160ZK(5) is to ensure that a capital loss not be claimed where the result of the course of action described in the sub‑section is that there has been no economic loss to the taxpayer. Finally, the criterion of linkage in par (b), an attribution that is reasonable, is to be read and applied accordingly.
The evidence of Mr Robert Hardy, the Taxation Manager of RSA, indicates that it was the policy and practice of companies within the RSA Group to declare dividends from retained profits and realised gains on the sale of investments. As was previously adverted to in these reasons, the dividends paid by Phoenix and SAIL to RSA after 30 October 1992 were sourced in the retained and operating profits of both companies. As a consequence, the taxpayer submitted, those dividends could not reasonably be attributed to the unrealised gains which have been the focus of this litigation.
However, unlike s 44 of the 1936 Act, s 160ZK(5) speaks, not of "dividends paid ... out of profits derived" by a company, but of a distribution that "could reasonably be taken to be attributable to profits that were derived by the company" before the taxpayer's acquisition of shares in it. The inquiry contemplated by that provision is therefore not directed exclusively towards the identification of the source of funds from which a dividend is paid.
It is the concept of causation, rather than source, with which s 160ZK(5) is concerned. In determining whether the plaintiff's loss of employment was "attributable to" the provisions of the Local Government Act 1972 (UK), Donaldson J in Walsh v Rother District Council said[54]:

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