Re Insomnia (No 2) Pty Limited and Insomnia (No 3) Pty Limited v the Commissioner of Taxation of the Commonwealth of the Commonwealth of Australia [1987] FCA 42 (17 February 1987)

FEDERAL COURT OF AUSTRALIA

Re: INSOMNIA (No. 2) PTY LIMITED and INSOMNIA (No. 3) PTY LIMITED
And: THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF THE COMMONWEALTH OF
AUSTRALIA
No. V G57 of 1986
Income Tax

COURT

IN THE FEDERAL COURT OF AUSTRALIA
VICTORIA DISTRICT REGISTRY
GENERAL DIVISION
Fisher J.
Lockhart J.
Neaves J.

CATCHWORDS

Income Tax - Allowable deductions - Curran scheme - Claim for deduction of share of loss alleged to have been incurred by partnership on share trading - Bonus shares issued by private companies in satisfaction of dividends declared out of capital reserves - Whether partnership entitled to the dividends - Whether partnership engaged in business of trading in shares - Whether shares trading stock - No sale of shares effected in financial year - No evidence that partnership had valued shares at market selling value - Other deficiencies in carrying out the scheme - Deduction not allowed.

Income Tax Assessment Act 1936 (Cth), ss.28, 31, 51, 92

HEARING

ADELAIDE
17:2:1987

ORDER

The appeals be dismissed.

The appellants pay the respondent's costs of the appeals.

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

DECISION

Insomnia (No.2) Pty. Limited (formerly Ipswich Electrical Pty. Limited) and Insomnia (No.3) Pty. Limited (formerly Hawkins Appliances Pty. Limited) have appealed to this Court against a judgment of the Supreme Court of Victoria (Murphy J.) dismissing their appeals against the disallowance by the Commissioner of Taxation of the Commonwealth of Australia ("the Commissioner") of objections against their assessments to income tax in respect of the year of income ended 30 June 1977.

2. Each of the taxpayers lodged a return in respect of the relevant year of income, Insomnia (No.2) Pty. Limited returning a loss of $2,694 and Insomnia (No.3) Pty. Limited a loss of $2,549. The amount of the loss in each case reflected the carrying into the taxpayer's accounts for income tax purposes pursuant to sub-s.92(2) of the Income Tax Assessment Act 1936 ("the Act") of its share, in each case an amount of $30,963, of a loss of $516,039 said to have been incurred on share trading in the relevant year by a partnership, Baseline Share Traders ("Baseline"), in which the taxpayer was a partner. The Commissioner assessed each taxpayer to tax on the basis that the partnership had not incurred a loss on share trading, whether of $516,039 or any other amount, and disallowed each taxpayer's claim in relation thereto.

3. In May and June 1977 Mr Peter Graeme Hutchins, a Melbourne accountant, was negotiating in Brisbane for the purchase of a group of companies, which included the taxpayers under their former names. Those companies constituted a profitable partnership under the name "Kennedys". As a result of the negotiations, Mr Hutchins and Adelaide Investments Pty. Limited, a company controlled by Mr Hutchins, acquired in June 1977 the whole of the shares in each of the companies in the Kennedy group.

4. Mr Hutchins was aware of the fiscal advantages which would be available if the affairs of the companies in the Kennedy group and other companies which he controlled could be structured so as to make apposite the decision of the High Court in Curran v. Federal Commissioner of Taxation [1974] HCA 46; (1974) 131 CLR 409 ("Curran's case").

5. On 27 June 1977 Mr Hutchins set about forming the partnership, Baseline. The members of the partnership were the former Kennedy group of companies together with another company, Casuarina Beach Pty. Limited. Between that date and 29 June 1977 Mr Hutchins was engaged in frantic activity for the purpose of completing by 30 June 1977 all the steps necessary to achieve his goal, namely to create for or with these companies, as he said, a mirror image of the Curran scheme.

6. Whether Mr Hutchins succeeded in carrying out effectively all the steps necessary was a matter which involved much of the hearing before the trial judge. However, in the ultimate his Honour did not base his decision upon the steps being ineffective. He found, in consequence of the decisions of the High Court in Federal Commissioner of Taxation v. Gulland, Watson v. Federal Commissioner of Taxation and Pincus v. Federal Commissioner of Taxation (1985) 62 ALR 545, that s.260 of the Act applied to render the arrangements void as against the Commissioner. The appeal to this Court was essentially against that finding although counsel for the Commissioner relied upon certain defects in Mr Hutchins' attempt to create a replica of the Curran scheme as being fatal to the taxpayers' case. It is in our opinion essential to investigate these defects because if Mr Hutchins had successfully created a replica of the Curran scheme the question would arise whether s.260 of the Act can be applied to deny a deduction otherwise allowable to Baseline under s.51 of the [1962] HCA 30; Act (Cecil Bros. Pty. Ltd. v. Federal Commissioner of Taxation (1964) 111 CLR 430 per Kitto J. at p 438. Federal Commissioner of Taxation v. Lau (1984) 6 FCR 202 espec. per Beaumont J. at pp 224-5).

7. It is necessary to set out in some detail the steps which Mr Hutchins took over this period of three days to achieve the result he intended. Stated briefly, he sought to establish Baseline as a partnership engaged in the business of trading in shares so that the shares it held would be trading stock of the partnership. Baseline was to acquire the shares in three "non public" companies which Mr Hutchins controlled, namely Marghelvi Pty. Limited, Givmarghelvi Pty. Limited and Luizzi Pty. Limited (re-named Umen Pty. Limited). Each of these companies was to amend its memorandum of association so as to increase its share capital and then to declare a dividend out of capital reserves, the dividend to be satisfied by an issue of bonus shares. The dividend would be exempt from tax in the hands of Baseline and the bonus shares would be brought into account as trading stock of the partnership at their par value. It was proposed that both the original shares and the bonus shares be sold by Baseline prior to 30 June 1977 at a price which, when account was taken of the price in fact paid for the original shares and the price notionally paid for the bonus shares, would produce a substantial book loss for the partnership. Each partner would then claim in its return of income its share of the loss returned by the partnership, relying upon the provisions of sub-s.92(2) of the Act.

8. Much needed to be done during the last few days of the year of income in an effort to achieve this result. The fact that Mr Hutchins conceived the plan and controlled directly or indirectly each of the companies involved enabled much to be achieved which otherwise would have been for practical purposes impossible of performance. Notwithstanding this, the activities of those few days were fairly described by the trial judge as "frenzied" and the paper work necessarily involved was extensive. There were, without doubt, many deficiencies in form which the trial judge described as "glaring".

9. The deed of partnership recited that it was made on 27 June 1977 and the seal of each partner was affixed in the presence of Mr Hutchins, described as "Director", and one Smith described as "Director/Secretary". The deed recorded that the parties mutually agreed to become partners in the business of traders and dealers in shares, stocks and other securities including the purchase and the sale of the same. By clause 4 Mr Hutchins was appointed the manager of the partnership business.

10. The authenticity of the deed was challenged at the trial on the ground that none of the parties had held a valid meeting at which a resolution was passed authorising entry into the partnership. The trial judge was, however, prepared to proceed on the basis that the deed was legally effective and nothing turned on the matter before us except as an illustration of the haste and lack of formality with which the scheme was carried into effect.

11. Forthwith upon the execution of the partnership deed, Mr Hutchins as manager gave instructions to a sharebroker to act as the partnership broker and to commence trading on its behalf in shares. It was crucial to Mr Hutchins' scheme that the partnership establish at the latest by 30 June 1977 that it was engaged in the business of trading in shares. To this end some 5,000 shares in Woodside Petroleum Limited were purchased at the cost of $4,271.35.

12. Having formed the partnership and taken the first steps to establish it as trading in shares, it was necessary that the partnership acquire shares in companies which had the capacity forthwith to declare dividends out of capital reserves and make bonus issues of shares in satisfaction of such dividends. Fortunately Mr Hutchins had such companies available. He controlled the three private companies mentioned above, namely Marghelvi Pty. Limited, Givmarghelvi Pty. Limited and Luizzi Pty. Limited ("the private companies").

13. On 29 June 1977 each of the private companies declared a dividend in favour of "the members of the Company shown in the Register of Members of the Company as at the 28th day of June 1977 in the same proportions in which they hold shares in the capital of the Company", such dividends to be satisfied by the allotment of fully paid bonus shares. The speed at which this issue of bonus shares had necessarily to be made occasioned many practical difficulties and produced certain technical defects. In the first instance, each of the private companies had to increase its nominal capital. This required an amendment of the memorandum of association, an amendment which would not, in consequence of sub-s.21(3) of the Companies Act 1961 (Vic.), take effect until the appropriate resolution was registered by the Registrar of Companies and a certificate to that effect issued. These requirements had not been fulfilled before the bonus shares were allotted on 29 June 1977 and, in consequence, it became necessary, in relation to each of the private companies, to make application to the Supreme Court of Victoria for the validation of the allotments. Validating orders were made by Kaye J. on 12 April 1984.

14. A further problem was revealed in that Baseline was not on 28 June 1977 registered as a shareholder in any of the three private companies and was, therefore, not a member of any of those companies on that date so as to satisfy the terms of the relevant resolutions. The trial judge so found and, in consequence concluded that Baseline was not legally entitled to the dividends which were satisfied by the allotment of bonus shares. It followed that the taxpayers had not established the necessary circumstances to bring their cases within the purview of the decision in Curran's case. His Honour referred to Federal Commissioner of Taxation v. Patcorp Investments Ltd. [1973] HCA 17; (1976) 140 CLR 247 per Mason J. at first instance at pp 272-3 and, on appeal, per McTiernan J. at p 283, per Gibbs J. at pp.293-5, per Stephen J. at p.300 and per Jacobs J. at pp.302-4. The trial judge added that, even if Baseline was beneficially entitled to the dividend, it did not constitute "exempt income" under sub-s.44(2) of the Act and was, therefore, assessable (see Federal Commissioner of Taxation v. Patcorp Investments Ltd. (supra) per Gibbs J. at p 295).

15. Other defects in the procedures adopted by Mr Hutchins were identified to the trial judge and he found them to be proved and of substance. These additional procedural problems were as follows. The minutes of each of the private companies referred to the establishment of a share register at Darwin, upon which it was proposed, doubtless for the purposes of saving stamp duty, to record the purchases by Baseline of the shares in that company. The trial judge found that in each case such a register was not established and that the paper entries to the effect that such a register existed were misleading. Further, Mr Hutchins alone was present at the crucial directors' meeting of each of the three private companies, albeit in two capacities. The quorum under the articles of association of each of the companies was two and the trial judge said that there was support in law for the proposition that a director who meets with himself, even in another capacity, does not constitute a quorum of two. He referred to Equity Nominees Ltd. v. Tucker [1967] HCA 22; (1967) 116 CLR 518 at pp 522, 525-6 and Re Efron's Tie and Knitting Mills Pty. Ltd. (1932) VLR 8. Similar criticisms were made of the members' meetings of each of the private companies in that only Mr Hutchins was present whereas s.140(1)(a) of the Companies Act 1961 (Vic.) required that two members be present to constitute a quorum.

16. The next, and an essential, step in the chain of events necessary to attract the fiscal benefits of a Curran scheme was the sale prior to the end of the year of income by Baseline of the shares in the private companies. It may be noted in passing that the benefits of the decision in Curran's case were denied to taxpayers by the enactment of s.6BA of the Act effective from 17 August 1977. The contention of the taxpayers, denied by the Commissioner, was that the sale of the shares was effected on 30 June 1977 to Levart (Vic.) Pty. Limited, another company under the control of Mr Hutchins.

17. The trial judge found that the evidence before him did not support, let alone establish, that a sale of the shares to Levart (Vic.) Pty. Limited occurred on 30 June 1977 or on any prior date. Counsel for the taxpayers did not challenge this finding of fact before this Court but contended, for the first time, that the loss was thrown up in the relevant year of income because Baseline had revalued the shares, being trading stock, in accordance with the provisions of s.31 of the Act. Counsel for the Commissioner objected to this line of argument because it had not been raised in the notices of objection or before the trial judge or in the notice of appeal to this Court. He also said that there was no evidence that Baseline had purported to revalue or, if it had, as to the market value of the shares.

18. As we are firmly of opinion that there is no substance in the submission, there is no necessity to consider the propriety of it being raised at this stage of the proceedings. Two provisions of the Act which deal with trading stock are relevant on the assumption that Baseline was trading in shares. So far as relevant, ss.28 and 31 provide:

"28(1) Where a taxpayer carries on any business,
the value, ascertained under this subdivision, of
all trading stock on hand at the beginning of the
year of income, and of all trading stock on hand
at the end of that year shall be taken into
account in ascertaining whether or not the
taxpayer has a taxable income.

(2) ....

(3) Where the value of all trading stock on hand
at the beginning of the year of income exceeds
the value of all trading stock on hand at the end
of that year, the amount of the excess shall be
an allowable deduction."

"31(1) Subject to this section, the value of
each article of trading stock (not being live
stock) to be taken into account at the end of the
year of income shall be, at the option of the
taxpayer, its cost price or market selling value
or the price at which it can be replaced."

19. The taxpayers' contention was based on the premise that the shares in the private companies, being trading stock, were on hand on 30 June 1977 and that Baseline had exercised its option to value those shares at market selling value. Such a contention must fail because it receives no support from the evidence. The share trading account of Baseline purported to disclose that the shares were not on hand at 30 June 1977, having been sold. As a consequence, the proceeds of the alleged sale were brought into account. However, on the assumption, which accords with the evidence, that they were on hand, there was no indication in the share trading account or otherwise in its income tax return that Baseline had exercised, in respect of these shares, the option given by sub-s.31(1).

20. It follows that, as Baseline had not sold the shares and had not exercised an option to value these shares on any basis permitted by sub-s.31(1) , the Commissioner would be entitled, if the shares comprised trading stock, which he denied, to value them at cost. This, in effect, he has done by denying Baseline the deduction which it claimed of the difference between cost and market selling value.

21. As we have said, the income tax return of the partnership and its accounts were prepared on the assumption that the shares in the private companies had been sold. This was the action of the partnership by which each partner, including each of the taxpayers, was bound by virtue of clause 8 of the partnership deed. It was not open to the taxpayers as partners to depart from the basis upon which the partnership accounts and income tax return were prepared.

22. Reference should also be made to the findings which the trial judge made as to the nature of the Baseline partnership. He clearly regarded the partnership as contrived and what was done in the way of purchasing shares in Woodside Petroleum Limited as simply an attempt to give colour to the picture which was to be painted of the partnership as a share trader. He found that Baseline had not become a share trader between 27 and 30 June 1977 so as to characterize the shares in the private companies as stock in trade.

23. We are not satisfied that his Honour's finding of fact should be disturbed as it was clearly open on the evidence. The evidence upon which the taxpayers relied is in stark contrast to the evidence in Curran's case, where the taxpayer had earlier established himself independently as a share trader. Here Baseline's share purchases were minimal and made solely for the purpose of seeking to qualify itself for the benefits of a Curran scheme.

24. The matters to which we have referred demonstrate that the taxpayers' appeals must fail. They have not discharged the onus which rests upon them of showing a sufficient factual basis to bring themselves within the decision of the High Court in Curran's case. In those circumstances the question whether, if that factual basis had been established, s.260 of the Act would have operated to render any part of the arrangements void as against the Commissioner does not arise and we express no opinion upon it.

25. The appeals must be dismissed with costs.