J & G Knowles & Associates Pty Ltd v Commissioner of Taxation

1 April 1988-31 March 1989 $150,972 $73,976.28 $7,498.97

The Commissioner disallowed the applicant's objection to the amended assessments. Applications to review that decision were dismissed by the Administrative Appeals Tribunal. The applicant appeals from the Tribunal's decision.

2 The basic facts were not in dispute. The applicant is and has been since 1976 the trustee of the Knowles Investment Unit Trust ("KIUT"). KIUT is part of the Knowles Group. The units in the unit trusts and the shares in the companies within the Group are owned by four family discretionary trusts. Each discretionary trust was established for the benefit of the family of one of the four directors of the applicant - Graham Knowles, John Knowles, Russell Knowles and Ian Bell. They were the directors of each of the companies in the Group, including the applicant. The Group's main activity was developing, marketing and managing retirement villages. The Group had what was said to be a unique method of selling and repurchasing retirement units. The initial sale of a unit was at or near cost. When the purchaser left the unit the Group would repurchase it at or near market value, with payment to be made at the end of a period equal to the time the former occupier had lived at the unit, but not exceeding eight years from the vacation of the unit. The Group would immediately resell the unit. All receipts and payments by members of the Group were dealt with through one bank account in the applicant's name, with one centralised accounting system. The Group's building construction business was funded by borrowings. The bank account was in overdraft during the whole of the relevant period. 3 Prior to and during the relevant period the applicant advanced amounts to the four directors and their wives to meet private expenditure. A director could sign cheques and withdraw funds at any time without obtaining the approval of the other directors. John Knowles gave evidence of the rationale behind the advances. The directors treated themselves as the effective owners of the Group and thus entitled to its profits and assets. Each drew money from the Group as he saw fit "with the general concern to ensure that there was equality between us". Drawings were not related to the work done by each of them. Money was taken from the business even by a director who was not at the time working for the Group. At the end of each accounting period the advances were transferred in the books of KIUT to loan accounts in the names of the family discretionary trusts, and in the accounts of the trusts were treated as loans to beneficiaries. On 1 August 1988 the loans to the family trusts were extinguished by a capital distribution of $7 million. A further amount of $921,367 was distributed equally between the family trusts by another unit trust of which the applicant was trustee. The trustee of each family trust distributed $1,980,342 equally between the relevant director and his wife. The capital distributions were treated in the books of the family trusts as being lent back to KIUT. 4 The loan account balances varied significantly between directors. The following table shows the balances at various dates. 30.06.86 30.06.87 30.06.88 31.07.88

J Knowles Family Trust $767,426 $772,726 $1,243,472 $1,446,594

G Knowles Family Trust $467,310 $519,372 $1,494,783 $1,569,845

R Knowles Family Trust ($72,195) $37,980 $558,285 $614,312

I Ball Family Trust $35,025 $83,358 $369,171 $384,763

In the years ended 30 June 1997, 1988 and 1989 the applicant paid each director a salary of $31,558.

5 By s 66(1) of the Fringe Benefits Tax Assessment Act 1986 ("the Act") tax imposed in respect of the "fringe benefits taxable amount" of an employer of a year of tax is payable by the employer. The expression "fringe benefits taxable amount" is defined in s 136(1) as

"the sum of the taxable values, in relation to the year of tax, of all the fringe benefits in relation to the employer in relation to the year of tax."

Section 136(1) defines "fringe benefit" as including

"a benefit provided … to the employee … by … the employer … in respect of the employment of the employee …."

The word "employee" means, amongst other things, a "current employee". A "current employee" is an employee within the meaning of Div 2 of Pt VI of the Income Tax Assessment Act 1936. Section 221A of that Act, which is in Div 2 of Pt VI, defines "employee" as a person who receives, or is entitled to receive, salary or wages. The words "salary or wages" include payments made by a company by way of remuneration to a director of the company. The word "employment" is defined in s 136(1) of the Act as including "the holding of any office or appointment, the performance of any functions or duties, [and] the engaging in of any work". The words "in respect of", in relation to the employment of an employee, include "by reason of, by virtue of, or for or in relation directly or indirectly to, that employment". Section 148(1) provides in part:

"A reference in this Act to the provision of a benefit to a person in respect of the employment of an employee is a reference to the provision of such a benefit:

(a) whether or not the benefit is also provided in respect of, by reason of, by virtue of, or for or in relation directly or indirectly to any other matter or thing;

(h) whether or not the benefit is provided as a reward for services rendered, or to be rendered, by the employee."

"Where a person (in this subsection referred to as the 'provider') makes a loan to another person (in this subsection referred to as the 'recipient'), the making of the loan shall be taken to constitute a benefit provided by the provider to the recipient and that benefit shall be taken to be provided in respect of each year of tax during the whole or a part of which the recipient is under an obligation to repay the whole or any part of the loan."

"the taxable value, in relation to a year of tax, of a loan fringe benefit provided in respect of the year of tax is the amount (if any) by which the notional amount of interest in relation to the loan in respect of the year of tax exceeds the amount of interest that has accrued on the loan in respect of the year of tax."

7 The single issue for decision by the Tribunal was whether the loans were benefits "in respect of the employment" of the directors. According to the Tribunal, the applicant's principal contention was that the directors regarded themselves as owners of the Group's business. It was said the evidence showed that the borrowed funds were regarded as equivalent to capital of the business drawn by its owners, and that this was demonstrated by the ultimate extinguishment of the loans by a capital distribution. 8 The Tribunal acknowledged that the words "in respect of the employment of the employee" in the definition of "fringe benefit" in s 136(1) require a nexus between the benefit and the employment. It concluded that that nexus existed:

"In my view there is a clear nexus, causal relationship between the advances or loans and employment of the four directors. It was in that capacity as a director that each was able and permitted to make 'drawings' from KIUT. The structure of the group was established in such a way that the directors were not owners. In my view, this is a case where the directors have to accept the consequences of that structure. It was in their capacity as directors and directors only that they borrowed money from the company of which they were directors. … [The drawings] were clearly a benefit and employment was the principal connecting reason for such benefits so as to render the benefit as provided in respect of the employment. Employment was the discernible link with the benefit and while the Act does not require this link to be the sole or even dominant one, there was no other formal or enforceable entitlement which gave rise to the benefit."

9 The applicant's related contention was that the case should be treated in accordance with Taxation Ruling No MT 2019, dealing with fringe benefits tax in relation to shareholder employees of family private companies and directors of corporate trustees. Reliance was placed on par 19 of the Ruling, which is as follows:

"As a general rule, where there are no facts or circumstances which positively indicate that a loan to a shareholder/employee is associated with that person's employment and the loan is consistent with his or her status as a shareholder, it would ordinarily be inferred that the loan was made by virtue of the shareholding. This approach recognises that major shareholders of a family company may obtain loans from the company on a view that these are merely as a return of their own money rather than a reward for any services rendered to the company."

In the course of dealing with this submission the Tribunal made some further findings of fact. It said:

"Firstly, the directors are not shareholders or unit holders. They may be regarded as controllers of KIUT but that control stems from their role as directors of [the trustee of] KIUT, presumably as directors of the corporate trustees of the family trusts and, to a degree, as appointors in each of the family trusts. However they were not, themselves, owners. Secondly, if the loans were to be regarded as consistent with a status of owners, it would be expected that the loans would be in proportion to the ownership share. They were not, given the lack of pattern, consistency or cumulative amounts of the loans. Thirdly, the applicant was in no position to return money to its owners. The ability to make loans was said to be the result of surplus cash generated by the method of operation of the business. But this was relatively short term surplus cash. It was required to be paid to vendors at the end of an agreed period and, at all times during the relevant period, the group had substantial borrowings and the bank account was in overdraft. Further, the group and KIUT incurred a loss in the year ended 30 June 1987, made a profit in the year ended 30 June 1988 but not sufficient to offset prior year losses and incurred a further loss in the year ended 30 June 1989. It was said that the loans were equivalent to drawing out capital of the business and this was demonstrated by their extinguishment from the capital distribution on 1 August 1988. However, approximately 75% of this capital distribution was from unrealised profits and, while this [proportion] may have demonstrated an increase in asset value of KIUT, was not represented by any cash surplus or provided an ability to make cash distributions. The realised profit proportion of the capital distribution represented some 44% only of the loan balances immediately prior to the resolution and the journal entry for the capital distribution."

Later, in dealing with the applicant's "ownership" contention, the Tribunal said:

"The simple facts are that the four directors were not owners of the business and had no vested interest in or entitlement to income, profits or capital of the business. Each was a contingent beneficiary as to income of a family trust with entitlements to income only if KIUT had a net income and the trustee of the relevant family trust resolved in its absolute discretion to distribute part or all of the trust's share of that net income to the director."

10 The first issue before the Tribunal was the proper construction of the expression "benefit provided … to the employee … by … the employer … in respect of the employment of the employee". That is clearly a question of law. For the applicant it was argued that there is a need for caution in the construction of the words "in respect of the employment". Despite observations in many cases about the expansive nature of the words "in respect of", they involve more than a mere connection between two things. The connection must be a relevant one, and whether the connection is relevant is to be determined by the context in which the words appear. Thus in State Government Insurance Office (Q) v Rees (1979) 144 CLR 549 at 561 Mason J, after referring to cases in which the words "in respect of" were said to have the widest possible meaning of any expression intended to convey some connection or relation between two matters, observed that "as with other words and expressions, the meaning to be ascribed to 'in respect of' depends very much on the context in which it is found". See also Workers' Compensation Board (Q) v Technical Products Pty Ltd (1988) 165 CLR 642 at 646‑647, 653‑653; Technical Products Pty Ltd v State Government Insurance Office (Q) (1989) 167 CLR 45 at 47, 51 and 55; Tooheys Ltd v Commissioner of Stamp Duties (NSW) (1960) 105 CLR 602 at 620. In reliance on this contextual approach, it was submitted that the purpose and object of the Act is to bring to tax non‑cash benefits that are part of an employee's reward for service to an employer. Thus, it was said, in order for a benefit to be provided "in respect of the employment", it must be part of the employment package; a sacrifice of money for some other reward. If the benefit in question does not flow from the work done by the employee, but has some other explanation behind it, it is not "provided in respect of the employment". 11 Section 26(e) of the Income Tax Assessment Act included in a taxpayer's assessable income the value to the taxpayer of all "allowances, gratuities, compensations, benefits, bonuses and premiums allowed, given or granted to him in respect of, or for or in relation directly or indirectly to, any employment of or services rendered by him …". The similarity between this provision and the definition of "in respect of" in s 136(1) of the Act is obvious. In Smith v Federal Commissioner of Taxation (1987) 164 CLR 513 a bank employee received $570 under the bank's scheme to encourage its employees to complete approved courses of study. The purpose of the scheme was to encourage the employees to increase their knowledge in subjects relevant to banking. It was held that the payment was within s 26(e). Wilson J said (at 519):

"The problem presented by the present case is whether the facts establish the requisite relationship between the benefit received by the appellant and his employment. It is not sufficient to find that the appellant received the benefit at a time when there was an employment relationship existing between himself and the bank. The mere temporal connection would not enable the payment to be characterised as a benefit given to him in relation directly or indirectly to his employment. … Toohey J finds it helpful to ask whether the benefit allowed, given or granted is a consequence of the employment of the taxpayer …. So do I. I also find it helpful to ask whether the benefit is a product or incident of the employment …."

His Honour concluded that the benefit was a product or incident or consequence of Smith's employment. Brennan J said (at 526):

"if the employment (or some aspect of the employment) is the reason or one of the reasons why the allowance is paid, the allowance falls within s 26(e). A reason which is an unsubstantial cause of the payment is immaterial …. But if an employee's employment is a substantial reason why the allowance is paid, it cannot be said that the allowance is merely personal or that the payment is made for reasons extraneous to - or ultra - the employment. As the requisite relationship may be indirect as well as direct, it is immaterial that there is another reason why the allowance is paid or even that the other reason is the dominant one."

His Honour went on to conclude that the allowance was paid "in consequence of" the employment, and thus was paid "in respect of … or in relation … to" the employment. Toohey J (at 533) said that the benefit must in some sense be a "recompense or consequence" of the employment. In his view the payment in question was a consequence of the employment.

12 A submission to the same effect as that advanced by the applicant was rejected in Smith. There it was argued that the payment was not within s 26(e) because it was not directly or indirectly a "reward for services to the bank". It was said that the relevant distinction was "between receipts and advantages that are truly rewards of employment or the product of income‑earning capacity and receipts of which employment or the rendering of services is a condition but not the operative cause". 13 Because the meaning of "in respect of the employment" depends upon the context, it is important to observe that a benefit is provided in respect of employment "whether or not it is provided as a reward for services": s 148(1)(h), and whether or not it is also provided in respect of some other matter or thing: s 148(1)(a). Thus the reward argument that was rejected in Smith must a fortiori be rejected here. A benefit is provided to an employee "in respect of the employment of the employee" for the purposes of the definition of "fringe benefit" if it is granted as a consequence of the existence of the employment relationship, or if the relationship is a reason why the benefit is provided, or is a cause of its provision. It does not matter that there is as well some other reason or cause for the grant, or that the grant is a consequence not only of the employment but of something else. The benefit does not have to be a reward for services rendered. 14 The Tribunal asked whether there was a "causal relationship" between the advances and the employment of the directors, and whether the employment was a "causal factor in the benefit". On another occasion it asked whether there was a "discernible and rational link between the benefit and the employment". Although the Tribunal did not refer to Technical Products Pty Ltd v State Government Insurance Office (Q) (1989) 167 CLR 45, that case, which concerned the words "damages in respect of such motor vehicle", is doubtless the source of the expression "discernible and rational link". See at 47, 48. The language the Tribunal used to describe the required relationship between the loans and the employment does not involve any misconstruction of the words "in respect of the employment".

15 The second issue before the Tribunal involved the application of the words "in respect of the employment" to the facts of the case. The appellant argued that the Tribunal was in error in deciding that the loan benefits were "in respect of employment". The respondent submitted that the Court could not entertain this argument because it raises no question of law within s 44 of the Administrative Appeals Tribunal Act 1976. 16 Whether the application of the law to the facts of a particular case is a question of law or of fact was considered in Collector of Customs v Pozzolanic Enterprises Pty Ltd (1993) 43 FCR 280. The Full Court held that the question whether facts fully found fall within a statutory provision properly construed is generally a question of law. However, an exception to this general proposition exists where a statute uses words according to their ordinary meaning and the question is whether the facts as found fall within those words. Where it is reasonably open to hold that the facts do fall within those words, the question whether they do or do not is a question of fact. Prima facie this would seem to cover the present situation. The words "in respect of the employment" are used according to their ordinary meaning, and the question is whether the loan benefits fall within that meaning. However, the Court identified an "exception to the exception" ‑ where the determination whether facts fall within the words of a statute involves making a value judgment about the range of facts the Act is intended to cover. In that case the determination will involve a question of law. In Pozzolanic the Court was concerned with the meaning of the words "operations … connected with … the rearing of live-stock". The Court said (at 288-289):

"The words 'connected with' are capable of describing a spectrum of relationships ranging from the direct and immediate to the tenuous and remote …. Although the words of the statute are construed according to their ordinary English meaning, that does not mean that their application to a set of facts is simply described as the matching of that set of facts with a factual description. There is necessarily a selection process involved. The range of relationships to which the words apply for the purpose of the Act depends upon a judgment about that purpose …. In the end this is not a process of fact finding. The facts are found. What is left is a value judgment about the range of the Act and that is a question of law."

Burchett J adopted the same approach in Collector of Customs v Sharp Corporation (1994) 20 AAR 186, as did Carr J in Cowell Electric Supply Company v Collector of Customs (1995) 54 FCR 1 at 21.

17 The present case falls within the "exception to the exception". The words "a benefit … in respect of the employment", like the words "operations … connected with … the rearing of livestock", can describe a broad range of relationships. In determining whether a particular benefit is given "in respect of employment" it is necessary to make a value judgment as to whether the Act is intended to cover the particular relationship between the benefit and the employment. Accordingly, in applying the law to the facts the Tribunal was deciding a question of law, and the claim that it erred in so doing is a claim that it made an error of law. 18 In Nelson v Inspector-General in Bankruptcy (1997) ATC 4338 Finn J held that whether a benefit is "in respect of employment" is a question of law. His Honour came to this conclusion on the ground that the language of the definition of "fringe benefit" is "closely analogous to that found in s 26(e) of the Income Tax Assessment Act … and there is powerful authority holding it to be a question of law whether the facts found had, of necessity, to result in the conclusion that a payment was income because of s 26(e): see Federal Commissioner of Taxation v Holmes 95 ATC 4476 at 4477". A long line of cases establishes that whether undisputed facts of necessity lead to a particular conclusion is a question of law. See particularly Lombardo v Federal Commissioner of Taxation (1979) 40 FLR 208 and Commissioner of Taxation v Cooper (1991) 29 FCR 177. Holmes was such a case. However, the proposition for which these cases are authority is limited to the situation where the facts clearly fall within or outside the statute, that is to say, where "nobody could arrive at any other conclusion". Whether a particular benefit is "in respect of employment" will often not fall into this category - it is a question to which different answers could be given. On the reasoning in Lombardo, which is the leading case on the "necessity" principle, the question raised in the present case would be one of fact. When in Nelson Finn J came to ask whether the facts as found necessarily resulted in the conclusion that a fringe benefit had been received, he was unable to answer it because the Tribunal's reasons did not disclose why it had determined that a fringe benefit had been received. Because I do not regard the present case (or Nelson) as a necessity case, I have identified the question of law by application of Pozzolanic.

19 I have set out passages from the Tribunal's reasons in which various findings are made. I record below the more significant of them. The references in brackets that appear after a finding are to pages in the Appeal Books. The first six findings (some of mixed fact and law) were not in dispute.

· The directors were not the owners of the applicant's business (Saul 450).

· They had no vested interest in or entitlement to income, profits or capital of the business (Saul 496; Unit Trust Deed 29, Family Trust Deeds 760, 791, 821).

· The loans were made to meet the directors' private expenses (J Knowles 466; Ball 479).

· Each director was a "sole cheque signatory" to the applicant's account (J Knowles 465; Saul 500).

· Each was authorised as a director to withdraw funds at any time for private needs without approval from the other directors (J Knowles 466; Ball 476; G Knowles 484, 485; Saul 500).

· The amounts withdrawn were determined entirely by the directors' individual needs and not by the needs of unitholders (Saul 451).

· The directors could not obtain access to the applicant's money as shareholders or as beneficiaries of the unit trust (Ball 479).

· The only way they could obtain money in the way they did was in their capacity as directors (Ball 476‑477, 479, 480).

· At the time the loans were made the applicant had insufficient funds to make returns of capital (Saul 447‑449, 452; Wardle 460; J Knowles 472).

· The capital distributed occurred well after the funds were borrowed (J Knowles 467, 737; Saul 502).

· The loans were not made in proportion to any ownership share (Saul 500, 510).

· There was no formal or enforceable entitlement to the loans other than the employment relationship.

The question is whether, on those facts, it was reasonably open to the Tribunal to conclude that there was a "nexus" or "causal relationship" or "discernible rational link" between the loans and the directors' employment. See Pozzolanic at 291 and Cowell at 10 per Hill J. In my view it was.

20 The applicant submitted that the Tribunal had misunderstood its "ownership" contention. It was said that the Tribunal had treated the contention as if it were that the directors were in fact the owners of the Group's business, whereas in truth what was asserted was that the explanation for the loans was not to be found in the fact that the directors were employees but in the fact that "they are, if not owners then pretty much like them". While they were not owners of the business in law, and had "no vested interest in or entitlement to income, profits or capital of the business", they had "what one might refer to … as a vestible interest and therefore [were] to be regarded as being in a position where their dipping into the funds … flows from their position as people entitled to the benefit, and that's a bit like ownership". It was not actual ownership in law, but it was "pretty close to it". The Tribunal did not in my view treat the applicant as propounding an ownership in fact argument. What the Tribunal said was:

"It was said that the four directors regarded themselves as owners of the business and, although there was a formal legal structure of a unit trust in which the unit holders were the respective family trusts of the directors, the practical view of these non‑professionals was that they were the owners. … It was said that the evidence showed that the monies borrowed were regarded as equivalent to drawing of the capital of the business by owners and the ultimate extinguishment by a capital distribution demonstrated this.

For the respondent, Mr Davies agreed that the four directors regarded themselves as owners of the business …."

21 In its later discussion of the competing arguments the Tribunal distinguished between the applicant's "ownership" contention as described in the above passage and the Commissioner's "ownership per se" or "actual ownership" contention. The Tribunal rejected the applicant's submission in a passage which demonstrates that it did not misunderstand it:

"In my view, this is one of those not unusual cases of four businessmen who obtain and accept advice as to an appropriate legal structure within which to own and operate the business but do not understand the legal ramifications of the structure adopted and, in fact, ignore it in the day to day operations of the business.

The structure of the group was established in such a way that the directors were not owners. In my view, this is a case where the directors have to accept the consequences of that structure."

The Tribunal appreciated, but rejected, the applicant's "quasi‑ownership" claim. What it regarded as important was the ownership position in fact and in law. The Tribunal did not misunderstand the applicant's argument.

22 It was submitted for the applicant that the Tribunal failed to give any or any proper weight to the uncontested evidence of the directors that it was because they regarded themselves as owners of the business that they permitted the applicant to advance the loans to them. The Tribunal did not fail to give proper weight to this evidence. It was the linchpin of the applicant's case and, as I have indicated, was properly rendered, and was canvassed in the Tribunal's reasons in several places. But in any event that evidence could not have obliged the Tribunal to find that the only relevant relationship was the directors' "quasi‑ownership". As it was entitled to do, the Tribunal preferred the documentary evidence about the legal structure of the Group, the capacity in which the directors accessed the applicant's funds, and the evidence that when the loans were made the applicant had insufficient funds to make a return of capital. 23 The applicant also contended that the Tribunal failed to give any or any proper weight to the evidence of the applicant's accountant, Anthony Saul, who said that in his view "the moneys borrowed were the equivalent to the withdrawal of the capital from the business by an owner". It is true that the Tribunal did not in terms refer to Mr Saul's evidence on this point. But it had it in mind when it referred to the applicant's submission that "the monies borrowed were regarded as equivalent to the drawing of the capital of the business by owners". As with the evidence the subject of the preceding paragraph, Mr Saul's evidence could not have obliged the Tribunal to find that the only relevant relationship was the directors' "quasi‑ownership".

24 The applicant has shown no error of law on the Tribunal's part, and the appeal must be dismissed. I certify that the preceding twenty‑four (24) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Sundberg.

Counsel for the Applicant: G T Pagone QC and K P Hanscombe

Counsel for the Respondent: G J Davies QC and J Davies

Solicitor for the Respondent: Australian Government Solicitor