Consideration on "allowable deductions"
113 The issues presently raised by the anomalous circumstances of this matter may seem distinctive. But considered from the standpoint of a primary judge, they are not "untrammelled by authority" (to use the respondent's description) that is binding on me. Their resolution, in consequence, is relatively straightforward.
114 I have, predictably, been taken to quite some number of appellate decisions in which differently nuanced descriptions of what might be comprehended by the language of s 51(1) or its equivalents have been emphasised by one or other of the parties (but particularly by the Deputy Commissioner) to its own apparent advantage or to the other's apparent disadvantage. I would have to say that that process illuminated what is already well known and well accepted. The generalised language in which judicial explanation of a statutory provision is cast often enough reflects the context in which that explanation is given with the consequence that it does not or may not capture all of the various possibilities that can be subsumed in that provision. Where, as here, the context is very distinctive more than usual care needs be taken in applying well-accepted statements that have been tailored with quite different contexts in mind.
115 As I earlier indicated, the Deputy Commissioner has focused in its submissions on the "excess interest" for the reason that that was all in the circumstances that could be transferred to the applicant under the loss transfer provisions of the 1936 and 1997 Acts. While it, doubtless, is the case that the ultimate question to be answered is whether the losses transferred were allowable deductions, it is artificial to fragment the interest liability of a given year into that part which was discharged by MMLIC's monthly application of the available net rental income and that part which was not and which in consequence remained capitalised. I do not accept that the correct characterisation of the interest payable in a given income year turns on whether each monthly liability was discharged in part, or was and remained capitalised. The anomaly in the bifurcation involved in the respondent's submissions is that, if it be the case that Chapel Road had an allowable deduction to the extent that the annual interest liability was discharged in a given income year, Chapel Road must be incurring a loss or outgoing in gaining or producing income. But the contrivance in this would be that Chapel Road would never be able to make a return other than a nil return. It would not, despite earning assessable income, be able to incur a tax loss. I note that the applicant's submissions presuppose that its interest liabilities were indivisible for s 51(1) purposes.
116 It has not been suggested that, when Chapel Road entered into the 1987 EMT loan or the 1990 MMLIC refinancing loan, its purpose was to generate transferable losses. On the evidence the purpose of the EMT loan - and hence of the MMLIC loan: Commissioner of Taxation v Roberts (1992) 37 FCR 246 at 257 - was to purchase and redevelop land by constructing an office block to be used to produce rental income. The money borrowed was used for that purpose.
117 There is a large body of authority to the effect that where borrowed money is laid out for the purposes of gaining assessable income this "furnishes the required connection between the interest paid upon it by the taxpayer and the income derived by [it] from its use": Ure v Federal Commissioner of Taxation (1981) 81 ATC 4100 at 4104; see generally Federal Commissioner of Taxation v Munro (1926) 38 CLR 153 at 170-171; Hart v Commissioner of Taxation (2002) 121 FCR 206 at [26]-[27]; reversed by the High Court but not on this point: see (2004) 217 CLR 216. The interest paid is thus "incidental and relevant" to the gaining of that income for the purposes of s 51(1) and s 8-1: Ronpibon Tin NL and Tongkah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47 at 56. I would note in passing that the "incidental and relevant" formula is commonly used to describe the necessary connection between the loss or outgoing incurred and the gaining or producing of assessable income, though it has been acknowledged that the formula does not constitute "an exclusive or exhaustive test" of the scope of s 51(1) requirement: Lunney v Commissioner of Taxation (1958) 100 CLR 478 at 497. Importantly, for present purposes, as was said by Gibbs CJ, Stephen, Mason and Wilson JJ in Commissioner of Taxation v Smith (1981) 147 CLR 578 at 586:
"What is incidental and relevant … falls to be determined not by reference to the certainty or likelihood of the outgoing resulting in the generation of income but to its nature and character, and generally to its connection with the operations which more directly gain or produce the assessable income."
118 It is appropriate to add that the advantage secured by incurring an interest liability on money borrowed and laid out for the purpose of gaining income, is "the use of borrowed money [for that purpose] during the term of the loan": Steele v Deputy Commissioner of Taxation (1999) 197 CLR 459 at [29].
119 When, for s 51(1) or s 8-1 purposes, an interest liability has been "incurred" on a loan the monies of which have been laid out for the purpose of gaining income, it will be characterised as a "loss" or "outgoing" not only if the liability has been discharged by payment but also if it has been capitalised, even if this results for the future in interest being payable on interest: see Hart v Commissioner of Taxation, above, at [23] ff. As was said in Federal Commissioner of Taxation v James Flood Pty Ltd (1953) 88 CLR 492 at 506:
"The word 'outgoing' might suggest that there must be an actual disbursement. But partly because such an interpretation would produce very strange and anomalous results, and partly because of the use of the word 'incurred', the provision has been interpreted to cover outgoings to which the taxpayer is definitively committed in the year of income although there has been no actual disbursement."
120 Commonly, the more problematic question is when has a loss or outgoing been incurred or, to relate the question to s 51(1) and s 8-1, to what year of income is the loss or outgoing referable?
121 There is a large and in some respects not easily reconcilable body of case law on these questions: for a recent statement of some of the principles that are well settled, see City Link Melbourne Ltd v Commissioner of Taxation (Cth) (2004) 141 FCR 69 at [27]-[29]; and, on appeal, Commissioner of Taxation (Cth) v Citylink Melbourne [2006] HCA 35 at [122] ff. It is unnecessary for present purposes for me to enter in significant detail upon the case law much of which is directed towards losses and outgoings in "commercial" activities having characters and purposes far removed from the present.
122 It is useful by way of introduction to begin with Dixon J's well worn statement on s 51(1) in New Zealand Flax Investments Ltd v Federal Commissioner of Taxation (1938) 61 CLR 179 at 207:
"To come within [the] provision there must be a loss or outgoing actually incurred. 'Incurred' does not mean only defrayed, discharged, or borne, but rather it includes encountered, run into or fallen upon. It is unsafe to attempt exhaustive definitions of a conception intended to have such a various or multifarious application. But it does not include a loss or expenditure which is no more than impending, threatened, or expected."
123 Putting to one side the circumstances arising subsequent to the entry into the MMLIC loan (to which the respondent attributes decisive significance in negativing any connection between the excess interest and the gaining of assessable income), the terms of the interest liability assumed in the mortgage itself illuminate how the liability to pay interest should be characterised for s 51(1) purposes.
124 The mortgage contemplated that interest would be paid for the two year term of borrowing at either of two interest rates (depending on whether payments that were due were paid punctually or at all) unless the mortgage was terminated earlier by either the mortgagee or the mortgagor (by repaying the principal, etc in accordance with cl 7 of Annexure A to the mortgage). It could properly be said that at the time of entry into the mortgage, Chapel Road assumed a defeasible liability to pay the interest. But to say that all of the loss or outgoing attributable to the interest liability was then "incurred" for s 51(1) purposes would be to disregard how the mortgage itself contrived and structured the interest liability. It was (i) to be calculated on the daily balances of the principal sum or on such sum that remained outstanding; (ii) to be computed from the date on which the first advance was made; (iii) to be calculated and charged to the mortgagor on the last day of each month at the higher rate of interest, but be payable at the lower rate if the mortgagor made (inter alia) all payments due under the mortgage; and (iv) to be paid on the last day of each month; and (v) to be added to the principal on the last day of each month and bear interest thereafter.
125 The above regime contemplated that, for each month of the mortgage and at the end of each month, interest would be capitalised or paid (i.e. an actual loss or outgoing would occur), in respect of that month. Each periodic liability whether capitalised or paid represented the cost of the money borrowed for the preceding month. Given that these losses or outgoings would occur monthly across the life of the loan - i.e. the interest liability would come home monthly: Nilsen Development Laboratories v Federal Commissioner of Taxation (1981) 144 CLR 616 at 623 - the parties themselves created a means of allocating (or apportioning) losses or outgoings to the relevant years of income over the life of the loan. It could be said that they have in substance done for themselves what in Coles Myer Finance Ltd v Federal Commissioner of Taxation (1993) 176 CLR 640 was considered required to be done by way of apportionment over successive income years for s 51(1) purposes in the circumstances of that case: see esp 665-666.
126 Alternatively, it could be said that the mortgage agreement so structured the interest liability that the taxpayer only "completely subjected itself to" the outgoings or losses in respect of interest month by month: Federal Commissioner of Taxation v James Flood Pty Ltd, above, at 506. Each monthly liability was "payable for its period": Commissioner of Taxation (Cth) v Citylink Melbourne Ltd [2006] HCA 35 at [146].
127 It is, perhaps, unsurprising that in some number of decisions courts have assumed or have accepted that interest which accrues from day to day is so apportionable: see Federal Commissioner of Taxation v Australian Guarantee Corporation Ltd (1984) 2 FCR 483; Commissioner of Taxation v Mercantile Mutual Insurance (Workers' Compensation) Ltd (1999) 87 FCR 536 at 552; see also Texas Co (Australasia) Ltd v Federal Commissioner of Taxation (1940) 63 CLR 382 at 468 where the "recurrent expenditure" of interest to secure working capital was described as clearly deductible; see also in relation to recurrent expenditure, Commissioner of Taxation (NSW) v Ash (1938) 61 CLR 263 at 282.
128 I have stated the above principles relating to s 51(1) and s 8-1 without considering the distinctive circumstances in which Chapel Road found itself in the 1992-1997 income years. Chapel Road's submissions proceed on the premise that they apply as of course to it and, in consequence, that the totality of its interest liability in and for each relevant income year was an allowable deduction to it which, in consequence, gave rise to the "excess interest" loss.
129 It is the correctness of this premise that the Deputy Commissioner's case challenges.
130 It is appropriate, initially, to have regard to the position in which Chapel Road found itself in the relevant tax years and the causes of that state of affairs. The company borrowed and laid out the borrowed moneys for the purpose of gaining assessable income. From the time the offices were first let until when the building was sold, assessable income was produced as originally intended albeit from 1991 through the interposition of MMLIC as mortgagee in possession. The effect of this interposition is considered later in these reasons. The original purpose of the borrowing did not change, let alone change to a purpose not involving the gaining of assessable income.
131 Chapel Road's difficulty, which became apparent close on the heels of the refinancing loan, was that its rental income did not meet, and relatively quickly became incapable of ever meeting, its interest liability. The resultant default and the steps taken by MMLIC first under the Real Property Act and then in entering into possession, placed Chapel Road's financial destiny in MMLIC's hands. The provisions of the Real Property Act and the terms of the mortgage (particularly the interest capitalisation provision) saw to that. The loan was in the circumstances a losing contract for Chapel Road. By the end of the first relevant income year the balance of its debt to MMLIC was almost $25 million and growing sharply. By that time or shortly thereafter it is likely that the value of Chapel Road's actual interest in the building was illusory, although I make no finding as to when this actually occurred it not being the subject of evidence before me.
132 Short of inducing MMLIC to write down the debt (which MMLIC would not do, though one can infer that MMLIC appreciated at least at some time during the relevant income years that the debt itself was a bad debt), the directors of Chapel Road had no ability to control the rising level of its debt. Notwithstanding their adventurous preparedness to declare in the company's financial statements that it was able to pay its debts, it is unlikely the directors could have procured a members' voluntary winding up of Chapel Road: cf Corporations Act 2001 (Cth) s 494 (declaration of solvency).
133 For its own purposes, MMLIC let this state of affairs continue. Chapel Road was manifestly incapable of paying its debt, though MMLIC both tolerated this and took no steps to ameliorate Chapel Road's plight. I do not suggest it was obliged to do so. But the building continued to be let and to generate rental payments which, as will be seen, were to be applied (subject to the payment of outgoings) on account of Chapel Road's interest liability under the mortgage.
134 Turning to the Deputy Commissioner's contentions, I would have to say that I do not consider that the atomistic or word by word treatment of the component parts of s 51(1) and s 8-1 reflected in its submission adequately acknowledges the symbiotic character of the language of these sections. Be this as it may, I am unable to accept the contentions advanced.
135 The moneys borrowed were laid out for the purpose of constructing a building and earning rental income from it. That purpose was effectuated and the building generated and continued to generate rents for which Chapel Road was assessable, as both parties have accepted in argument, until its sale in 2000. In light of what had happened, Chapel Road was obliged to pay interest on the use it was able to make of that money until the principal sum (including capitalised interest) was repaid or the loan arrangement was terminated. The use of the money enabled Chapel Road to construct the building and to earn, and to continue to earn, rental income. That was the advantage secured by incurring and continuing to incur the interest liability. Because Chapel Road could not repay the continually swelling principal sum, the interest liability persisted. Nonetheless, in my view, its nature and character did not change. Neither did the purpose for which the borrowed moneys were laid out change, though doubtless Chapel Road would have wished to, but could not, bring to an end the state of affairs in which it found itself. The interest liability, though capitalised in each income year, was incurred for the purposes of gaining assessable income. As I have earlier indicated, the actual interest liability which accrued in a given income year was referable to that year.
136 It may have been the case that that income was relatively insignificant when considered against the ballooning in the principal sum caused by capitalisation of interest. This, though, only demonstrated the dramatically losing character of the loan arrangement to Chapel Road in the circumstances.
137 It is, in my view, irrelevant that it was MMLIC, not Chapel Road, that continued the state of affairs in which the building remained income producing for the benefit of Chapel Road. MMLIC, seemingly, was unable to sell the property. The interest liability derived its nature, character and connection with the gaining of assessable income at the time the borrowed moneys were laid out and the liability began to accrue. Nothing which transpired in the period thereafter altered its nature etc. I should add, though it is otiose to say it, that the exhaustion of the borrowed moneys in the construction of the building did not alter the nature, etc of the interest liability. In this respect it makes no difference whether, thereafter, interest was capitalised in circumstances where a borrower either was unable to repay the mortgage or was not required to repay it.
138 The underpinning of all of the Deputy Commissioner's contentions is that because of Chapel Road's parlous circumstances, it suffered no loss or outgoing on account of its interest liability which itself did not contribute to, or arise from circumstances contributing to, the derivation of income (i.e. it was not in the relevant years "incidental and relevant to" the gaining of income). For the reasons I have given above, I reject the latter of these contentions because I do not accept that the nature and character, and the connection of, the interest liability to the gaining of rental income were as the Deputy Commissioner has contended. I would also add that I do not consider that, for Chapel Road, the liability for the "excess interest" (as the Deputy Commissioner would have it) can properly be treated as if it was a distinct interest liability with its own nature, etc from the monthly liability incurred under the mortgage agreement. It is the nature, etc of the latter alone which is of importance for the purpose of determining whether Chapel Road had allowable deductions in respect of its monthly interest liability.
139 It may well be said that Chapel Road was far beyond repaying its capitalised interest liability and was so in all of the relevant income years. It equally may well be said that the commercial reality was that its losses attributable to the capitalisation of interest would be without financial consequence to it in the sense that the "excess capitalised interest" was never able to be repaid. This said, those losses nonetheless represented legal liabilities that had not been discharged. They could have been relied upon in founding a creditor's petition to have Chapel Road wound up. At law, they were not sham or illusory liabilities.
140 The Deputy Commissioner's contention that there was no loss or outgoing is founded in part on the alleged "implicit assumption" in the cases that the deductibility of an outgoing in the year in which the obligation accrued is that it will in due course be met, i.e. that payment in the future is a certainty. This seeks to transform what may be a well-founded factual assumption in a given case as to what will happen in the future, into a legal prerequisite of deductibility. This, in my view, is how the respondent seeks to extract support from the comment of Ferguson J in Commissioner of Taxation (NSW) v Manufacturers' Mutual Insurance Ltd (1931) 31 SR (NSW) 575 at 585 relating to the deductibility of the calculated value of claims unmatured in the financial year in question, that "it is just as certain that some money will have to be paid". His Honour there was not concerned with, and was not addressing, whether the certainty of actual payment was a legal prerequisite to deductibility.
141 There is no such prerequisite. It is not an express requirement of s 51(1) or s 8-1. To insist upon it would introduce an unacceptable measure of uncertainty into these sections. It would require that the deductibility of losses could often turn on a fallible prophesy as to future events. And this would be so notwithstanding that deductions commonly have been allowable in respect of debts which were never later paid because of the onset of bankruptcy or liquidation: cf Oates v Federal Commissioner of Taxation (1990) 27 FCR 289 at 295.
142 The circumstances of this case, doubtless, provide an extreme example of inability to discharge a liability. But this does not assist the Deputy Commissioner. The articulation of the point at which an otherwise allowable deduction of a loss is to be transformed into a loss which is not allowable for the reasons relied upon by the Deputy Commissioner is obviously beset with no little difficulty. If it is to be the law that there is to be such a point, it is in my view the function of the legislature to identify it. It is not a matter for a court to add such a further and difficult implication and process of speculation into s 51(1) and s 8-1.
143 A distinct submission of the Deputy Commissioner is that the "excess interest" was of a capital nature and hence was expressly excluded from deductibility under s 51(1) and s 8-1. This submission appears to flow from the contention that the excess interest was not incidental and relevant to the derivation of any income of the company: (Respondent's Outline of Submissions pars 38-39). I have rejected the latter contention. I likewise reject the "capital nature" submission. Notwithstanding the financially disastrous position of Chapel Road given its circumstances and the terms of the loan, the interest outgoing was, and remained, "merely interest on a loan": cf Macquarie Finance Ltd v Commissioner of Taxation (2005) 146 FCR 77 at [111]; see generally Steele v Federal Commissioner of Taxation above, at 466-472.
144 My conclusion is, then, that in the relevant income years Chapel Road's monthly losses in respect of interest were allowable deductions.