Firth v Commissioner of Taxation

REASONS FOR JUDGMENT 1 These proceedings are an appeal by the applicant against the disallowance of an objection to an assessment of income tax for the year ended 30 June 1999. 2 The applicant claimed a deduction under s 8-1 of the Income Tax Assessment Act 1997 (Cth) ("the Act") in the sum of $1,268,277.60 for interest expenses incurred by him during that year of income in respect of thirty-seven protected equity investment loans ("PEILs") provided by Equity Margins Ltd ("EML"). 3 Under each of the PEILs, the applicant borrowed money for the purpose of purchasing shares in National Australia Bank, Commonwealth Bank of Australia and St George Bank Ltd. The loans were taken out in three tranches, the first tranche being on 28 May 1999 ($2,465,020), the second tranche on 15 June 1999 ($2,225,703) and the third tranche on 16 June 1999 ($2,278,781.25). The term of each loan was about one year. The interest rates applicable to the PEILs ranged from about 17.3 percent per annum to 19.3 percent per annum. The interest was paid at the time each loan was taken out. On the maturity of each loan the applicant paid the loan amount in full. 4 Each of the PEILs was a limited recourse loan, in the sense that EML's rights of recovery of the principal in respect of the loan were limited to enforcement against the shares bought with the monies which the applicant had borrowed. The loan terms for the PEILs included the following: "7 Limited recourse 7.1 EML's recourse against the client in respect of any amounts owing in respect of a loan is limited to the amount which EML can obtain by enforcing its rights in respect of the secured assets (to the extent that they relate to the approved stocks for that loan) but this limit does not apply if any of the following occur: (a) the client has breached a material undertaking given to EML (other than the obligation to repay the loan); (b) a material representation made or warranty given by the client under these terms was or becomes incorrect or misleading; or (c) EML has relied on a statement or some conduct of the client which in EML's reasonable opinion was materially false or misleading. 7.2 Notwithstanding anything in clause 7.1, EML may prove for the total amount outstanding on a loan and otherwise participate in the winding up or bankruptcy of the client if another creditor initiates those proceedings." 5 The Commissioner contends that a portion of the interest paid by the applicant is not deductible under the general deduction provisions, as some portion of the interest payable by the applicant in respect of the loans was payable to obtain the limited recourse provided by the terms of those loans. 6 In the Commissioner's reasons for decision disallowing the applicants objection, the following appears: "The ATO view is that part of the interest charged in these products is a capital protection fee and is not deductible under the general deduction provisions. The purpose of this fee is to give the taxpayer capital protection in the event of a share price fall. The capital protection fee ensures that the borrower is protected from liability to repay the principal if the market value of the shares fall below their original purchase price. It is the Office view that the capital protection fee is not deductible because it is incurred for a purpose other than to service or maintain the borrowed funds. It loses its character as a deductible cost of producing the expected income." 7 The Commissioner has apportioned the interest paid by the applicant on the basis of a Benchmark Rate calculated and published by the Commissioner. The Benchmark interest rates have been calculated as the average between the Reserve Bank Bulletin Indicator Lending Rates for "Personal Unsecured Loans" and "Credit Cards". The resultant rate is a high rate of interest. The applicant challenged the Commissioner's entitlement to apportion the interest paid by the applicant, but did not challenge the method of apportionment should apportionment be held to be appropriate. 8 The Commissioner has calculated that an amount of $353,021 (out of the total interest claimed of $1,268, 277.60) is not allowable as a deduction on the basis that there should be an apportionment between interest and the capital protection fee and upon the basis that the Benchmark Rate provides an appropriate mechanism for determining the portion of the interest paid which ought to be regarded as a capital protection fee. 9 As quantum is not in issue, it is unnecessary to go into the detail of any of the calculations. But I should record for the purposes of comparison, that the Benchmark Rate calculated by the respondent for the month of June 1999 was 13.15 percent, whereas interest rates of between 18.1318 percent and 18.2253 percent were payable by the applicant on PEILs drawn down in June 1999. 10 The interest rate charged on the PEILs varied from day to day (and sometimes within a day) and from stock to stock. The applicant asked EML what the interest rate would be on each loan but did not enquire of EML how the amount was made up. It was his belief that the interest rate payable was higher because the loans were limited recourse loans, but he did not make any enquiry about how much higher. 11 The applicant's income tax return of the year ended 30 June 1999 was prepared on the basis that his gains and losses on sales of shares were on capital account. In the applicant's outline of preliminary submissions the applicant contended that his activities in relation to shares involved him: - in carrying on a business of trading in shares; alternatively