Firth v Commissioner of Taxation

• in carrying on a business of investing in shares; alternatively

• investing in shares for those dual purposes, although ultimately counsel were in agreement that it was unnecessary for the disposition of this appeal for me to determine whether any business carried on by the applicant in the relevant year was that of a share trader. 12 Paragraph 13 of the applicant's affidavit of 20 April 2001 is as follows: "13 I have built up this share portfolio since I began buying and selling shares in 1993. In 1993, I decided to start building up a share portfolio with a view to accumulating a portfolio which would produce sufficient dividend income to fund me once I retire. I then did and still do own rental properties, but decided to focus my efforts on shares given that the obligations which I had as a landlord, the relatively low rates of return and the lack of liquidity made property a less attractive way to acquire a stream of income, when compared to the share market." In cross-examination the applicant accepted that his main object in purchasing and selling shares was to accumulate a portfolio which would produce sufficient dividend income to fund him on retirement, but another object was to enable him to have a source of income which was independent of the income derived by him from his practice as a solicitor. He wanted to try and accumulate wealth outside the legal practice. Part of the wealth accumulation process was to make profits on the sale of the shares as the opportunity presented itself. 13 According to summaries provided by the applicant's counsel, which were not the subject of challenge by counsel for the Commissioner, during the year of income the applicant made a total of 102 purchases of parcels of shares for a total cost of $11,150,173.63, and made a total of 180 sales for total proceeds of $5,764,147.08. During that year the applicant derived dividends from his shareholdings in the sum of $893,432 (including income attributable to imputation credits). During the year of income the market value of the applicant's holding of shares increased from $13.048 million to $18.778 million, while the applicant's net equity in shares increased from $1.964 million to $7.649 million. During the year of income the applicant made gains from sales of shares of $1,009,658 and net gains (over losses) of $654,304. 14 The applicant has been engaged in the purchase and sale of shares from 1993 until the present day. He spends on average about 10-14 hours a week on his share trading activities and, in his estimation, at least half this time would be spend on trading on his own account, with the balance being devoted to other entities in which he is interested or with which he is connected. He has regular and frequent discussions with his broker, he reads the financial press, securities newsletters and other information in relation to the stockmarket. The applicant employs businesslike systems, strategies and analyses in buying and selling shares. 15 The applicant's profession is that of a solicitor. Whether in addition he carried on a business of trading or investing in shares (it is common ground that for present purposes, it does not matter which) is a question of fact. The test to be applied in forming a conclusion on that issue is both subjective and objective. Regard is to be had to the nature and extent of the activities undertaken and the purpose of the individual engaging in them: Federal Commissioner of Taxation v Shields (1999) 99 ATC 4,783 (O'Connor J); (1999) 99 ATC 2,037 (Mr J Block). 16 The applicant did not regard himself as a share trader in the year of income, and he lodged a return on the basis that profits derived from the sale of shares were capital gains. However, his share market activities were much more than a mere hobby, and his activities involved more than mere speculation. Decisions to buy and sell were undertaken after and on the basis of considerable analysis. The volume, magnitude, repetition and regularity of the applicant's buying and selling activities and the business-like systems, strategies and analyses employed by the applicant in buying and selling shares create an overall impression in my mind that the applicant was in business in the year of income in trading or investing in shares, and I so find. 17 Section 8-1(1) of the Act provides: "You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income." 18 That provision is qualified by s 8-1(2) which provides in part: "However, you cannot deduct a loss or outgoing under this section to the extent that: (a) it is a loss or outgoing of capital, or of a capital nature; ..." These provisions are substantially the same as s 51(1) of the Income Tax Assessment Act 1936 (Cth). If a taxpayer incurs a recurrent liability for interest for the purpose of furthering his present or prospective income-producing activities, whether those activities are properly characterised as the carrying on of a business or not, generally the payment by him of that interest will be an allowable deduction: Federal Commissioner of Taxation v Total Holdings (Aust) Pty Ltd (1979) 43 FLR 217, 224. 19 The applicant contends, and the Commissioner accepts, that the interest incurred by the applicant in the relevant year of income in respect of the PEILs falls within par (a) or (b) of s 8-1(1) of the Act. However, as noted earlier, the Commissioner contends that a portion of the interest is not deductible under the general deduction provisions on the ground that it is an outgoing of capital, or of a capital nature. As the wording of s 8-1(2) makes clear, a loss or outgoing is not deductible to the extent that it is a loss or outgoing of capital or of a capital nature. This both authorises and requires that an apportionment be made where the outgoing has a double aspect: see Ronpibon Tin NL v Federal Commissioner of Taxation (1949) 78 CLR 47 at 55; Ure v Federal Commissioner of Taxation (1981) 2 FCR 237 at 242 (per Brennan J) at 247, 250 per Deane and Shepherd JJ. 20 Ure v Federal Commissioner of Taxation was a case in which the taxpayer borrowed monies at rates of up to 12.5 percent per annum with the object of onlending those monies to his wife and family trust at an interest rate of 1 percent per annum. At 242 Brennan J observed that if the borrowed monies had been laid out solely for the purpose of gaining assessable income, the interest would be wholly deductible. As a matter of fact, the monies were laid out partly to obtain a return of 1 percent per annum, and partly for private or domestic purposes, hence apportionment of the interest charge was required. At 250 Deane and Sheppard JJ observed that the outlays of interest can be seen as serving a number of objects indifferently; the predominant, although indirect objects were of a private and domestic nature. 21 In determining whether an outgoing is deductible one needs to determine the reason for which the outgoing is paid - what is the advantage sought to be obtained by the expenditure in question? Here, the outgoing is described in the terms of the agreement of the parties as interest on the loans. This is not a case in which it was or could be contended by the respondent that the interest, or some part of it, is not "interest in the real sense of the word": cf Commissioner of Taxation v Broken Hill Pty Co Ltd (2000) 179 ALR 593 at [39] per Hill J. Rather, this is a case in which the interest is properly characterised as such, as it is a return or consideration or compensation for the use or retention by one person of another's money, even though the rate of interest payable is higher than might otherwise the case because of the terms of the loan, and in particular, its character as a non-recourse loan. 22 In Steele v Deputy Commissioner of Taxation (1999) 197 CLR 459 Gleeson CJ, Gaudron and Gummow JJ said at 470: "As was explained in Australian National Hotels Ltd v Commissioner of Taxation, interest is ordinarily a recurrent or periodic payment which secures, not an enduring advantage, but, rather, the use of borrowed money during the term of the loan. According to the criteria noted by Dixon J in Sun Newspapers Ltd v Federal Commissioner of Taxation it is therefore ordinarily a revenue item. This is not to deny the possibility that there may be particular circumstances where it is proper to regard the purpose of interest payments as something other than the raising or maintenance of the borrowing and thus, potentially, of a capital nature. However, in the usual case, ... where interest is a recurrent payment to secure the use for a limited term of loan funds, then it is proper to regard the interest as a revenue item, and its character is not altered by reason of the fact that the borrowed funds are used to purchase a capital asset." Although recurrence is a relevant consideration, it would not alter the situation if the parties chose to have interest paid in a lump sum: see Commissioner of Taxation v Broken Hill at [37]. 23 The passage in the decision in Steele which I have emphasised above was accompanied by a footnote referring, by way of example, to Parsons, Income Taxation in Australia (1985), par 6.111. In that paragraph, Professor Parsons said: "A payment of interest at a rate beyond any commercial rate, more especially when made to an associated person, raises the question whether an inference should be drawn that some part of the purpose of the payment of interest is other than the service of the loan and, in this part, not relevant but private or domestic, or not a working or maintenance expense but a capital expense." 24 Thus the fact that the amounts paid by the applicant under the loans were "interest" properly so called, is not necessarily determinative of the issue whether the outgoings were wholly on revenue account or whether a portion of the outgoings was on capital account. 25 The Commissioner contends that there were at least two advantages sought to be obtained by the applicant by the payment of interest on the PEILs. One advantage was to raise or maintain the funds with which to purchase the shares. The other was the limited recourse feature of the PEILs, such that the applicant had the option at the end of the term of the loan of delivering up the shares rather than repaying the loan from his own funds. In the Commissioner's submission, the interest was paid, at least in part, to obtain the advantage that the applicant was protected from being required to pay the sum borrowed in full. That is submitted to be an advantage of an enduring rather than a recurrent nature, and was something other than the raising or maintaining of the borrowing. It was an advantage inconsistent with a basic element of a loan transaction, which is that the borrowed sum will be repaid: see, eg, Federal Commissioner of Taxation v Radilo Enterprises Pty Ltd (1997) 72 FCR 300 at 313. 26 This is not a case, as was Ure v Federal Commissioner of Taxation (supra), where the borrowed monies were laid out in part for the purposes of gaining assessable income, and in part for other purposes. It was that factor which, at least in the judgment of Brennan J at 242, was critical to the issue of apportionment. Here the monies were borrowed and laid out for the sole purpose of acquiring shares in furtherance of the applicant's income producing activities. 27 In Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634 at 638 the High Court said: "What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process". 28 There may be cases in which the disproportionate or excessive nature of expenditure may suggest that the outgoing was not made for the purpose of obtaining assessable income or for the purposes of the business incurring the expenditure: W D & H O Wills (Aust) Pty Ltd v Commissioner of Taxation (1996) 65 FCR 298 at 329. But it is not to the point that finance to acquire the shares may have been obtained more cheaply if it had been raised on different terms, if the conclusion is otherwise reached that the expenditure was incurred in gaining assessable income. 29 From a practical and business point of view, there is only one advantage sought to be obtained by the interest outgoing, and that is to raise and service working capital for the applicant's business on the terms and conditions of the PEILs, including the limited recourse provisions of clause 7. The existence of clause 7 does not require a conclusion that there were multiple purposes underlying the interest obligation, when the evident and sole purpose of the borrowing was to raise and service working capital for the business on acceptable terms. A loan on the terms of clause 7 may involve a greater risk to the lender, which would ordinarily be reflected in a higher interest rate, but that does not mean that the transaction should be artificially broken down into one involving a multiplicity of purposes when, as a matter of commercial substance, there was but one purpose. 30 If I am wrong in the views which I have so far expressed, and if part of the interest obligation is referrable to the non-recourse feature of the PEILs, the question arises as to whether the interest is to that extent an outgoing of capital or of a capital nature. 31 In G P International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1989-1990) 170 CLR 124 at 137, the High Court said: "The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure, for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid." (citations omitted) 32 The Commissioner contends that the applicant derived an enduring advantage from the non-recourse nature of the PEILs. The monies derived from the PEILs are capital receipts. If and to the extent that a borrower is excused from repaying a liability on capital account, it may be appropriate to characterise the advantage thereby obtained as an enduring one. However, the non-recourse feature of the PEILs only entitled the applicant, on the maturity of a loan, to surrender the shares acquired with the proceeds of the loan in full satisfaction of what would otherwise be his personal liability to repay the loan in question. Unless the applicant exercises that option (and in relation to the loans made in the relevant year of income, he did not) then the payment of interest at a higher rate has not produced any continuing advantage or benefit to the applicant enduring beyond the term of the loan. 33 The non-recourse nature of the PEIL protects the working capital raised by the loans against erosion by a diminution in the value of the shares securing the loans until the expiration of the term of the loan. In Australian National Hotels Ltd v Federal Commissioner of Taxation (1998) 19 FCR 234 (special leave refused: 63 ALJR 344) the taxpayer claimed to deduct insurance premiums paid to obtain indemnity against exchange losses in relation to a foreign currency loan which was a capital account. It was accepted that the exchange losses were themselves on capital account. The Court held that the premiums were deductible. 34 At 240-241 in the joint judgment of Bowen CJ and Burchett J, their Honours said: "The cost of securing and retaining the use of the capital sum for the business, that is to say, the interest payable in respect of the loan, will be a revenue item. It creates no enduring advantage, but on the contrary is a periodic outgoing related to the continuance of the use by the business of the borrowed capital during the term of the loan. If capital, whether or not raised by borrowing, is invested in a building which burns, or in securities which become worthless by the failure of the body which issues them, the loss is a capital loss. A careful business manager will protect his business against the loss of the capital invested in it by appropriate insurance, by the employment of security guards to patrol buildings or skilled staff to monitor investments, and by other measures. The advantage sought thereby is not an enduring one. No amount is added to the capital of the business. But during the recurring periods of insurance, the patrolling of premises, or the monitoring of securities, the continued availability of the capital investment by which the business earns its income is protected. The cost of protecting it is as much a revenue cost as the interest by which the capital, to the extent that it was borrowed, was obtained in the first place. Indeed, in the case of recurring expenditure, it is difficult to distinguish between expenditure which obtains and expenditure which maintains the investment." 35 At 241-242 their Honours continued: "It would not be logical to treat the price of obtaining the capital sum borrowed (the interest) as deductible, and not admit the deductibility of the price of securing that its use may continue to be enjoyed (the premiums for insurance without which it would not be safe to keep invested in Australian dollars for use in the business a sum repayable in Saudi Arabian riyals)." 36 The advantage which the applicant derived from the non-recourse character of the PEIL's was a transient advantage which flowed from the ephemeral nature of a loan for a term of one year. On the analogy of ANA, the cost of securing that advantage implicit in the payment of a higher interest rate is as much a revenue cost as the portion of the interest which reflects the costs of raising or maintaining the loan. 37 For these reasons the applicant's objection should have been allowed by the respondent. The appeal against the decision of the respondent is allowed. I certify that the preceding thirty-six (36) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Hely.

Counsel for the Applicant: R F Edmonds SC, R Goodridge

Solicitor for the Applicant: Blake Dawson Waldron

Counsel for the Respondent: B J Shaw, M Moshinsky

Solicitor for the Respondent: Australian Government Solicitor