Income Tax - S.108(1) Income Tax Assessment Act - whether forgiveness of a debt/release of an obligation by a company is equivalent to making an advance, loan or payment. Section 6(1) - whether forgiveness of a debt by a company amounts to a distribution to a shareholder or a credit to a shareholder as a shareholder.

Income Tax Assessment Act (1936): s.6(1) and s.108(1) Permanent Trustees Co. (N.S.W.) v. F.C.T. (1940) 2 AITR 109 Campbell v. Commissioner of Inland Revenue (N.Z.) (1967) 14 ATD 551

Mr G. Davies

Solicitor for the Applicant: Australian Government Solicitor

Counsel for the Respondent: Mr P.K. Searle

Solicitor for the Respondent: Mills Oakley and McKay

2. That the cross-appeal, as amended, be allowed to the extent necessary to order that the matter be remitted to the Tribunal to consider and determine whether or not the amount of $23,943 is assessable income of the taxpayer

(a) as a dividend

(b) as a deemed dividend

(c) as a reward for services

3. That the matter be so remitted.

4. That the Commissioner pay half the taxpayer's taxed costs of the

Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules.

This is an appeal, brought by leave out of time, by the Deputy Commissioner of Taxation ("the Commissioner") against Graeme A. Black ("the taxpayer") from a decision of the Administrative Appeals Tribunal ("the Tribunal") constituted by a Senior Member, in which it determined that for the years of income ended 30 June 1985 and 1986 respectively, the taxable income of the taxpayer "shall be reduced by the sums of $86,876 and $420 and additional tax for incorrect returns by sums to be determined upon receipt from the parties of details as to the calculations of additional tax as levied together with such submissions as they care to make within fourteen days of the date hereof", which was 4 October 1989.

2. The Commissioner's Further Amended Notice of Appeal was from that part of the decision whereby the Tribunal decided that in the year of income ended 30 June 1985 the Respondent's taxable income was excessive to the extent of $80,339.00 or alternatively to the extent of $34,500.00.

3. In her final submissions, counsel for the Commissioner sought the following orders:

1. that the appeal be allowed with costs;

2. that the cross appeal of the taxpayer be dismissed with

costs;

3. that it be declared that the Amended Assessment of the

taxpayer for the year ended 30 June 1985 was excessive

to the extent of $6,397.83 and no more and that the

assessment be reduced by that sum.

4. As the Tribunal found, the taxpayer, a gifted photographer, held 100 shares and his wife one share in a company ("Lens-co") which carried on a photography business from 1 July 1978. With effect from 1 July 1984 the business of that company was acquired by another company ("Print-co"), in which the taxpayer and his wife held 50 shares each.

5. The Tribunal observed that the hearing and presentation of evidence was made confusing by errors made in the presentation of accounting documents.

6. The evidence of the taxpayer was described as being "in many respects vague with particulars often being incomplete and his understanding of events limited - but not so limited as he would have had me believe" but the Tribunal accepted his evidence and that of his accountant as being "more probably than not accurate, except in so far as I shall hereafter otherwise indicate".

7. At all material times Lens-co carried on business from premises owned by the taxpayer which it occupied rent free. A loan account was maintained between Lens-co and the taxpayer, the balance in which fluctuated from time to time. When it was opened it acknowledged the taxpayer as a creditor for $40,277 as the price of assets which he had transferred to Lens-co. With the passage of the years the taxpayer came to be recorded in that loan account as a debtor.

8. The Tribunal also found that "towards 30 June 1984 decisions were taken which were to result in the transfer of the assets of the business of Lens-co to Print-co", in Lens-co deciding to forego the indebtedness of it and in the placement of Lens-co in liquidation, as a company stripped of assets and liabilities.

9. Later in its reasons, the Tribunal referred to the steps taken by the Commissioner to stay the liquidation of Lens-co and to raise assessments against it and advance his claims to be a creditor and found that no dissolution of the company had taken place.

10. On 1 May 1985 the directors of Lens-co resolved to recommend "that the unappropriated profits of the company be distributed in total to current shareholders" and a general meeting of shareholders so resolved.

11. On 15 August 1986 the Commissioner advised the liquidator as follows:

"On the basis of the return and/or information

furnished there is no income tax owing in

respect to income derived by the company up to

the date of liquidation.

Provided sufficient funds are retained to meet

income tax payable on any taxable income

derived during the course of winding-up,

action may proceed to distribute the assets of

the company and finalise the liquidation."

12. By letter dated 8 January 1987 the Commissioner informed the liquidator that its letter of 15 August had been "issued in error and is herewith retracted" and that "no clearance can be granted to finalise the liquidation at this stage", because Lens-co was under investigation. The liquidator replied immediately, contending that the liquidation had been finalised.

13. On 8 July 1987 the Commissioner issued to the taxpayer the amended assessments, the subject of challenge before the Tribunal and of this appeal. They increased taxable income previously assessed as follows:

"Year of Income Ended 30 June 1985 1986

$ $

Taxable income as previously

assessed 69,124 48,759

Loans/Advances from (Lens-co)

considered to be dividends 110,174 -

Value of benefits derived from

employment (use of company cars for

private purposes) included in

assessable income 1,800 1,720

Omitted interest income from

included in assessable income 208* -

Profit from the sale of shares

derived at the 1986 income year

excised from assessable income (1,210)

Profit from the sale of shares

included in the assessable income 1,238**

Taxable income as shown in attached

notice 180,096 51,717

* By agreement the objection is to be allowed in $195.

** The adjustment was not objected to."

14. The Tribunal observed that the key issue in the amendment related to the sum of $110,174, identified as "Loans/Advances from (Lens-co) considered to be dividends". It then set out the figures relating to the loan account as follows:

"Year ended 30 June 1979 ($40,277) Change ($40,277)

30 June 1980 ($2,336) Change $37,941

30 June 1981 $17,398 Change $19,734

30 June 1982 $45,937 Change $28,539

30 June 1983 $78,036 Change $32,099

30 June 1984 $92,674 Change $14,638

30 June 1985 NIL Change ($92,674)

The transactions and events giving rise to a 'Nil'

balance at 30 June 1985 constitute the main issues upon

this reference."

"35. I am satisfied that the change in the

loan account balance in any one year was a

reflex of both debits and credits to the loan

account made in relation to that year of

income. I am also satisfied that in relation

to all advances made to at least 30 June 1984,

by which date nett indebtedness stood at

$92,674, that at the time any advance

contributing to that liability was made it was

not intended that the moneys advanced should

never be repaid.

36. I find that, during the year of income

ended 30 June 1985, the balance due and owing

by" (the taxpayer) "to Lens-co on loan account

moved in accordance with the following table:"

(the taxapayer's) "Loan Account

Debit Credit Dr. Balance

$ $ $

1/7/84 Opening Balance 92,673.58

30/6/85 Journal 8503 3,361 96,034.58

Journal 8503 10,000 106,034.58

Journal 8503 6,000 112,034.58

Journal 8503 15,000 127,034.58

Journal 8504 17,000 110,034.58

Journal 8506 23,942.75 86,091.83

Journal 8512 4,040 82,051.83

Journal 8517 80,339 1,712.83

Journal 8513 1,712.83

37. The figure brought to account by the Commissioner

was not the $110,034 appearing in the last table but

$110,174. The difference is to be explained by an

adjustment to the figures for 'Advances' (cf. below).

38. THE ADVANCES

I am satisfied that four advances ($3,500, $10,000,

$6,000 and $15,000) were made. I also find that the

account in that regard is not inaccurate by reason of the

circumstance that, in bringing to account $3,361, the

accountant set off $139 against a cheque drawn for $3,500

by reason of a credit due to (the taxpayer) in respect of

a cheque for $139 previously debited to his account. I

accept that the opening balance had been overstated by

$139 and that the effect of the set-off was to correct

that overstatement."

15. The Tribunal referred to some of the entries in the loan account, as follows:

"THE $4,040 AND $1,712

I accept that the credit of $4,040 was a

credit of a dividend which had been provided

for in the accounts to 30 June 1984. I find that

the $1,712.83 also represented a dividend distribution

as provided for in Journal entry 8513 as

'Being to distribute the remaining

unappropriated profits to the shareholders

on closure of the business as dividends.'

The amounts so credited to the loan account

were in fact included in the figure returned

by the Applicant as dividends derived. In consequence,

to that extent there has been a double-counting."

"44. THE $80,339

The proposed final act to close off the

operations of Lens-co was the action taken by

Lens-co to implement a resolution of directors

of Lens-co of 30 June 1985 recorded in the

following terms:

'SHAREHOLDERS LOAN:

It was resolved that the loan by the

shareholders from the company be forgiven

in view of the fact the company no longer

was trading and that it holds sufficient

reserves to absorb cancellation of the

debt and has no material effect on the

closure of the company prior to liquidation.

It was further resolved that the debt be

written off to a debt foregone account.'

I propose to consider in detail the

significance of what was done in consequence

of that resolution.

45. That resolution was given effect to by a

further Journal Entry:

'Debt Foregone Account Dr $80,339

Shareholders Current Account Cr $80,339

Being a transfer Balance out

of Shareholder's account

upon forgiveness of the debt'

46. On these things being done the Balance

Sheet of Lens-co to 30 June 1985 was as

previously set out. It was stripped of both

assets and acknowledged liabilities and was

therefore understood to be in a condition to

persuade a liquidator to assume responsibility

for the formal winding up.

47. To appreciate the significance of the

resolution to 'forego', it is appropriate to

compare in financial terms the decisions

respectfully contended for by the parties

after giving effect to all other financial

transactions. In doing so, in the following

table I have taken into account:

(a) the liability of" (the taxpayer) "to

Lens-co at $80,339;

(b) the circumstance that after the sale

of the business it was inappropriate

to retain 'goodwill' as an item of

value in the Balance Sheet;

(c) the financial position contended for

by the "(Commissioner).

"48. In the comparative tables following the

objective is to express the financial position

of the company in Balance Sheet terms

according to the respective contentions of the

parties immediately prior to the passage of

the resolution to forego.

49. BALANCE SHEET OF LENS-CO

(Immediately prior to resolution to 'forego')

Figures according to: Taxpayer Commissioner

SHAREHOLDERS FUNDS

Ordinary Shares $101 $101

Capital Realisation

Reserve $95,000 $95,000

Goodwill ($15,000) ($15,000)

Unappropriated Profits

Reserve ($92,152)

$80,101 ($12,051)

ASSETS

Shareholder's Loan $80,339 $80,339

$80,339 $80,339

LIABILITIES

Bank $238 $238

Tax $92,152

$80,101 ($12,051)

50. Upon the evidence presented before me the

resolution to 'forego' and the action taken on

the part of Lens-co in writing up its books of

account to give effect to that resolution

constituted nothing more than a unilateral act

on the part of Lens-co whereby the company

declared its intention to remit the debt due

to it by" (the taxpayer) "and adopted accounts

intended to reflect that decision. On the

face of it, although that was done when

Lens-co was substantially controlled by" (the

taxpayer), "it was not done in such a way as

to confer any right upon him against the

company such as would have entitled him to

resist a claim for payment of the debt. There

is no basis in the evidence before me for"

(the taxpayer) "to contend that he was

released, whether by Deed under seal or by any

agreement for which consideration was given,

or that he so acted in consequence of the

company's representations as to be entitled to

allege an estoppel. Once that is recognised,

it follows that nothing has passed to" (the

taxpayer). "His liability to the company

remains as it was. He may cease to be liable

to pay the company by force of law by reason

of the effluxion of time, but he was not so

released by reason of either the passage of

resolution or the action taken by the company

in writing up its books of account.

51. The situation is therefore quite unlike

the situation considered by the Supreme Court

of New Zealand in Campbell v. Commissioner of

Inland Revenue (N.Z.) ((1967) 14 ATD 551)

where debts of shareholders were forgiven by

Deeds of Forgiveness. In those circumstances

the execution and delivery of the Deeds

conferred an immediate financial benefit upon

the persons in whose favour the Deeds were

executed. But no such advantage was conferred

here. If any advantage is to come to the

Applicant it seems likely that it will come in

consequence of the belated decisions of the

Commissioner to raise assessments against the

company and advance his claims to be a

creditor of the company."

16. In the course of argument before the Court neither counsel sought to challenge any finding of fact made by the Tribunal.

17. However, counsel for the Commissioner submitted that the Tribunal, even though it made the finding set out in paragraphs 50 and 51 it, "failed to consider that what in fact had happened was that the debt was discharged by performance, and the manner in which it was performed was by the company meeting that obligation," that is, "the company satisfying that debt by writing off that debt against the proceeds of the sale". In any event, counsel submitted that the Tribunal failed to consider s.6(1) and s.44.

18. The final paragraph of the Tribunal's reasons read:

"55. CONCLUSION

On the principal issue, taxable income

was excessive to the extent of $86,231

($110,174 - $23,943). That being so, the

determination of the Tribunal is that for the

years of income ended 30 June 1985 and 1986

respectively taxable income shall be reduced

by the sums of $86,876 and $420 and additional

tax for incorrect returns by sums to be

determined upon receipt from the parties of

details as to the calculations of additional

tax as levied together with such submissions

as they care to make within fourteen days of

the date hereof."

19. The Commissioner's primary submission was that the Tribunal erred in law in reducing the taxpayer's assessable income as it did, and that it should have held that the amount of $80,339 was deemed to be a dividend, by operation of s.108(1) of the Assessment Act as it stood at the relevant time. It then read as follows:

"108(1) If amounts are paid or assets

distributed by a private company to any of its

shareholders by way of advances or loans, or

payments are made by the company on behalf of,

or for the individual benefit of, any of its

shareholders, so much, if any, of the amount

or value of those advances, loans or payments,

as, in the opinion of the Commissioner,

represents distributions of income shall, for

the purposes of this Act other than the

purposes of Division 11A of Part III and

Division 4 of Part VI, be deemed to be

dividends paid by the company on the last day

of the year of income of the company in which

the payment or distribution is made."

20. The finding by the Tribunal that this was not a case where loans or advances were made to the taxpayer with no idea of repayment, which is not challenged by the Commissioner, is fatal to any contention that the loans or advances themselves should be deemed to be dividends (See Case No.69 (1950) TBRD Vol.1 p 260 at p 263).

21. There was also the finding by the Tribunal, set out above, that there was no basis for a conclusion that the taxpayer was released by Lens-co from his debt and that his liability to it remains.

22. Despite this finding, the Commissioner submitted that the action of Lens-co in writing off the taxpayer's debt against the proceeds of sale should be treated as if the company had in fact made an advance or loan to him to enable him to repay his debt to it. In my opinion, it is not permissible to construe the deeming provisions of s.108(1) so as to embrace forgiveness of a debt, on the basis that it produced the same effect as would have flowed from a different transaction. If the Parliament had intended to produce such a result, it would have been easy to include in the section a reference to a debt being forgiven or an obligation released. It is not open to regard the forgiveness of the taxpayer's debt as a payment made by the company on behalf of, or for the individual benefit of, the taxpayer within the meaning of the section.

23. In the alternative, the Commissioner sought to rely upon s.6(1) of the Act, which read as follows:

"'dividend' includes-

(a) any distribution made by a company

to any of its shareholders, whether

in money or other property;

(b) any amount credited by a company to any

of its shareholders as shareholders; and"

24. So far as paragraph (a) is concerned, there simply was not a distribution made by Lens-co to the taxpayer. The word "distribution" involves, at the least, a dealing out or bestowal. What Lens-co did here can amount, at best from the Commissioner's point of view, not to a distribution but to an indication that it forewent the receipt of payment from the taxpayer.

25. In my opinion, no amount was credited by Lens-co to the shareholder, as shareholder (emphasis added). The phrase "as shareholder" is to be read as "in the capacity of shareholder". Removal of a debit standing against the taxpayer constituted, at best for the Commissioner, an amount credited to the taxpayer in his capacity as a debtor of Lens-co, not in his capacity as a shareholder.

26. For these reasons, the appeal is dismissed, with costs.

27. The taxpayer instituted a cross-appeal against that part of the decision of the Tribunal by which it refused to allow the taxpayer's objections in relation to an amount of $23,943 which had been included in his taxable income.

28. The Tribunal referred to this amount as follows:

"40. THE $23,942

The sum of $23,942.75 was not the subject

of any clear explanation either.

However, it was the assertion of the

accountant - not controverted at all by

"(the taxpayer) - "that the moneys had

come to the hands of Lens-co from a

client who had twice paid. The

accountant was sure that, as between the

client and Lens-co, the money was not due

to Lens-co. He believed that there had

been some exchange of correspondence

between Lens-co and the client about it

but nonetheless, in face of that rather

extraordinary situation, he first

processed the transaction by a journal

entry in the following form:

30/6/85 Income Dr.$23,942.75

Loan - (taxpayer)

Being amount received from

advertising department twice

which has been set aside to

shareholders in the event of

pending recovery.

Later there were two other journal entries as follows:

30/6/85 Loan - (taxpayer) Dr.$23,942.75

General holding reserve Cr.23,942.75

Being adjustment to journal

8506 for amount received from

advertising department

30/6/85 Debt foregone account Dr.$23,942.75

Shareholders Loan Account

Being remaining balance of

debt foregone as per journal

41. I find that the $23,943 received by Lens-co constituted

assessable income of the company. It was paid to it for

services rendered. It may have been paid in error. It may

have been that it should have been refunded to the client.

It may have been retained dishonestly. But it still

constituted assessable income in the hands of the company.

As Rich, J. said in Permanent Trustees Co. (N.S.W.) v. F.C.T.

((1940) 2 AITR 109):-

'A windfall on account of revenue may quite well be

income'.

By treating the receipt in the course of trade as it was

treated, the result was that the assessable income of Lens-co

came to be understated. But in as much as that portion of

the profits of Lens-co was credited to" (the taxpayer), "the

taxable income of Lens-co may not have been effected.

Although the payment to" (the taxpayer) "was a 'windfall', it

constituted assessable income in his hands - whether it came

to him as a dividend, or deemed dividend, or as a reward for

services."

29. The Tribunal thus found that the taxpayer had been credited by Lens-co with the amount of $23,942, being the second payment by a client of the company in respect of an account already paid. It concluded that although a "windfall" it came to him as "a dividend, or deemed dividend, or as a reward for services".

30. It is difficult to deduce from this paragraph, which constitutes the whole of the Tribunal's reasons on this question, what facts the Tribunal found, precisely what opinion it formed and the course of reasoning which led to that opinion. These are matters of vital importance to the parties, and to the Court when it is called upon to identify and decide a question of law said to arise on appeal. In these circumstances, I am of opinion that the questions raised in the cross-appeal should be remitted to the Tribunal for its further consideration and determination.

1. that the appeal be dismissed, with costs.

2. that the cross-appeal, as amended, be allowed to the extent

necessary to order that the matter be remitted to the

Tribunal to consider and determine whether or not the amount

of $23,943 is assessable income of the taxpayer:

(a) as a dividend

(b) as a deemed dividend

(c) as a reward for services

3. that the matter be so remitted.

4. that the Commissioner pay half the taxpayer's taxed costs of

the cross-appeal.