Commissioner of Taxation v Radilo Enterprises Pty Ltd [1997] FCA 22 (3 February 1997)

CATCHWORDS

INCOME TAX - objection to assessment - whether a dividend paid on non-redeemable, non-cumulative convertible preference shares was a "debt dividend" under s46D of the Income Tax Assessment Act 1936 .

Income Tax Assessment Act 1936 (Cth) ss46, 46A, 46C, 46D, 67AA; sub- ss46C(1), 46C(5), 46D(1), 46D(2); para46D(2)(c)

Taxation Laws Amendment (Company Distributions) Act 1987 (Cth) (No. 58 of 1987)

Halsbury's Laws (4th Ed), Vol 32 para 106

The Oxford English Dictionary, 2nd Ed (Oxford: Clarendon Press, 1989) Vol 5

The Macquarie Dictionary (NSW: Macquarie Library, 1981)

P.J. Norman, "Debt Dividends: The Test Case" (1996) 5 Taxation in Australia 10.

N.J. O'Bryan, "Preference Share Financing" (1986) 1 BLB 53

C.L. Pannam, The Law of Money Lenders in Australia and New Zealand (1964)

M. Pickering, The Problem of the Preference Share (1963) 26 MLR 499

Bond v Barrow Haematite Steel Co [1902] 1 Ch 353

Brick and Pipe Industries Ltd v Occidental Life Nominees Pty Ltd [1992] 2 VR 279

Consolidated Fertilizers Ltd v Deputy Commissioner of Taxation [1992] FCA 224; (1992) 107 ALR 456

FCT v W E Fuller Pty Ltd [1959] HCA 41; (1959) 101 CLR 403

FCT v Spotless Service Ltd [1996] HCA 34; 96 ATC 5201

Hendy (Inspector of Taxes) v Hadley [1980] 2 All ER 554

Henry v Great Northern Railway Co [1857] 27 LJ Ch 1

Herbert v The King [1941] HCA 12; (1941) 64 CLR 461

James v FCT [1924] HCA 34; (1924) 34 CLR 404

Re The Isle of Thanet Electricity Supply Co Ltd [1950] 1 Ch 161

Linhart v Elms (1988) 81 ALR 557

Mills v Meeking [1990] HCA 6; (1990) 169 CLR 214

Riches v Westminster Bank Ltd [1947] AC 390

COMMISSIONER OF TAXATION V RADILO ENTERPRISES PTY LTD

NG229 OF 1996

LEE, SACKVILLE, LEHANE JJ

SYDNEY

3 FEBRUARY, 1997

IN THE FEDERAL COURT )

OF AUSTRALIA )

NEW SOUTH WALES )

DISTRICT REGISTRY )

GENERAL DIVISION ) NO. NG229 OF 1996

ON APPEAL FROM A JUDGE OF THE FEDERAL COURT OF AUSTRALIA

B E T W E E N: COMMISSIONER OF TAXATION

Appellant

and

RADILO ENTERPRISES PTY LTD

Respondent

MINUTE OF ORDER

THE COURT: LEE, SACKVILLE, LEHANE JJ

DATE OF ORDER: 3 FEBRUARY, 1997

WHERE MADE: SYDNEY

THE COURT ORDERS THAT:

The appeal be dismissed with costs.

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

IN THE FEDERAL COURT )

OF AUSTRALIA )

NEW SOUTH WALES )

DISTRICT REGISTRY )

GENERAL DIVISION ) NO. NG229 OF 1996

ON APPEAL FROM A JUDGE OF THE FEDERAL COURT OF AUSTRALIA

B E T W E E N: COMMISSIONER OF TAXATION

Appellant

and

RADILO ENTERPRISES PTY LTD

Respondent

CORAM: LEE, SACKVILLE, LEHANE JJ

DATE : 3 FEBRUARY, 1997

PLACE: SYDNEY

REASONS FOR JUDGMENT

LEE J:

This is an appeal from a judgment of a Judge of this Court (Davies J) in which his Honour ordered that the decision made by the appellant ("the Commissioner") on an objection to the assessment of income tax payable by the respondent ("Radilo") be set aside and the matter remitted to the Commissioner for the objection to be allowed and the assessment amended.

In August 1988 the Reserve Bank of Australia ("the RBA"), pursuant to supervisory powers exercised by it in respect of banks trading in Australia, formulated a rule, or guideline, which required the banks to maintain a "capital adequacy ratio" between "qualifying capital" and "risk weighted assets". The ratio was expressed by the RBA as a percentage, namely, 8 per cent.

As at May 1991 the capital adequacy ratio of the Australia & New Zealand Banking Group Limited ("the ANZ") exceeded 8 per cent but the margin was narrow and the ANZ decided that it should strengthen its capital base, in particular its "Tier 1", or "core" capital, by offering for subscription 6,000,000 fully paid, non-redeemable, non- cumulative converting preference shares ("the shares"). Under the RBA guidelines, redeemable preference shares were regarded as Tier 2 "supplementary capital".

In May 1991 the ANZ issued a prospectus in which investors were invited to subscribe for the shares at a price of $100 per share ("the issue price") being $1 for the par value of the share and a $99 premium.

The shares were entitled to a dividend "calculated at the fixed rate of 13.25% per annum on the issue price" payable by half-yearly instalments of $6.625 per share. The instalments were payable on 11 January and 11 July each year. The dividend payable on the shares ranked ahead of any dividend payable on ordinary shares and was to be paid until such time as the shares were converted to ordinary shares. In the event of a winding up of the ANZ the shares were to rank ahead of ordinary shares in any return of capital, including the amount paid as a premium. Holders of the shares had limited voting rights and no right to participate in any issue of shares by the ANZ to holders of ordinary shares.

Pursuant to the Articles of Association of the ANZ dividends were to be declared and to be payable only to the extent that there were distributable profits sufficient to meet the dividend in full or in part. No dividend was to be declared or paid if, in the opinion of the Directors, the payment of any dividend would breach, or cause a breach, of the capital adequacy requirements. If a dividend was paid in part only, the shareholder had no claim to the balance of the unpaid dividend and the balance would not be added to the payment of any succeeding dividend.

Each share was to be converted to a fully paid ordinary share on 11 July 1995 and, at the same time, additional fully paid ordinary shares were to be allotted according to a formula. The effect of the formula was that the number of additional ordinary shares to be allotted was to be calculated by dividing the issue price by an amount which reflected a 10% discount to the prevailing weighted average sale price of fully paid ordinary shares in the ANZ sold on the Australian Stock Exchange ("the Stock Exchange") during the five days preceding the conversion date. If the price of the ordinary shares was constant or was on an upward trend over the five day period, the converted share and additional ordinary shares allotted would be likely to have a market value in excess of the issue price on the day of conversion. If, however, the price of the ordinary shares was falling over the five day period, the value of the converted shares and the additional shares allotted on the conversion date could be less than the issue price. The Directors of the ANZ had power, in their discretion, to postpone the conversion date from 11 July 1995 to 11 July 1996, 11 July 1997 or 11 July 1998.

If a dividend payable on the shares was not paid in full within 30 days of the date on which the dividend was payable, a holder of the shares was entitled to call upon the ANZ to convert the shares to ordinary shares forthwith. In this case, the "conversion date" would be a date 30 days after the entitlement to convert arose.

The premium paid for the shares was to be used to pay up the par value of additional ordinary shares issued on the conversion date.

The prospectus informed investors that the ANZ had been advised by the Australian Taxation Office ("ATO") that dividends payable on the shares would be regarded by the ATO as "debt dividends" and that the "inter-corporate dividend rebate provisions" would not be available to "corporate investors".

The shares were listed on the Stock Exchange and traded. In 1994 Bain Securities Ltd ("BSL") obtained 199,700 shares by purchasing the shares on the Stock Exchange at $118.50 per share. On 15 December 1994 Radilo was incorporated as a wholly owned subsidiary of BSL. On the same date BSL transferred to Radilo beneficial ownership in 100 of the shares. His Honour was informed that this was done for the purpose of setting up a test case and that the parties agreed that the case should be determined as if BSL had retained the shares.

On 11 January 1995 Radilo received the half-yearly dividend payable on the shares, namely, $663.

In February 1995 Radilo lodged an income tax return for the period 15 December 1994 to 11 January 1995 in which the dividend paid on the shares was returned as the assessable and taxable income of Radilo. On 9 February 1995 the Commissioner issued a notice to Radilo which advised that income tax had been assessed on the taxable income set out in the return and that the amount of tax payable was $218.79.

On 13 February 1995 Radilo objected to the assessment on the ground that, pursuant to s46 of the Income Tax Assessment Act 1936 (Cth) ("the Act"), it was entitled to a rebate equal to the amount of the tax assessed.

On 17 February 1995 the Commissioner disallowed the objection and Radilo "appealed" to this Court from that "appealable objection decision".

The sole issue on the "appeal" before his Honour, and on this appeal, is whether, in the circumstances of the case, the entitlement of Radilo to a rebate under s46 of the Act was excluded by the terms of s46D of the Act, in that the dividend received by Radilo from the ANZ was a "debt dividend" as defined in s46D.

Section 46D of the Act, in relevant respects, is as follows:

"46D(1) In this section, unless the contrary intention appears:

...

'commencing time' means 1 o'clock in the afternoon, by legal time in the Australian Capital Territory, on 10 December 1986;

'finance' includes money raised by the issue of shares;

'finance arrangement', in relation to a company, means an arrangement entered into or carried out by any of the parties to the arrangement for the purpose, or for purposes that included the purpose:

(a) of enabling the company or an associate of the company to obtain finance (whether by way of renewal or otherwise); or

(b) of enabling the company or an associate of the company to obtain an extension of the period for which finance was obtained under an earlier arrangement;

'loan' includes the provision of credit or any other form of financial accommodation;

...

46D(2) A dividend is a debt dividend for the purposes of this section if, and only if:

(a) the dividend is paid to a shareholder after the commencing time in respect of a share in a company (whether the company is a resident or a non-resident);

(b) the dividend is paid:

(i) in respect of a share issued after the commencing time; or

(ii) under a finance arrangement entered into after the commencing time; and

(c) having regard to:

(i) the manner in which the amount of dividends in respect of the share was to be calculated;

(ii) the conditions applicable to the payment of dividends in respect of the share; and

(iii) any other relevant matters;

the payment of the dividend may reasonably be regarded as equivalent to the payment of interest on a loan.

46D(3) A shareholder is not entitled to, and shall not be allowed, a rebate under section 46 or 46A in respect of:

(a) a debt dividend paid before 1 July 1987; or

(b) the unfranked part of a debt dividend paid on or after 1 July 1987."

The critical provision for the purposes of this case is para46D(2)(c) of the Act.

It was not in issue that, as his Honour held, the words "may reasonably be regarded" are part of the description of a "debt dividend" for the purpose of s46D and that the words do not confer a decision-making power to be exercised according to the discretion or opinion of the Commissioner. The proper application of the section requires a determination to be made, as a question of fact, whether a reasonable person having regard to objective facts, may regard the payment of the dividend as equivalent to the payment of interest on a loan. (cf. FCT v Spotless Services Limited [1996] HCA 34; 96 ATC 5201 at 5210.)

Nor was it in issue that some investors, including institutional investors, and some investment advisors may have regarded a purchase of the shares as an investment in a fixed return security and not an investment in "equities".

The Commissioner submitted that his Honour erred in failing to apply to s46D a construction in which the character of the dividend for the purpose of that section was to be determined by having regard to the circumstances relevant to the receipt of the dividend by Radilo and not the circumstances relevant to the payment of the dividend by the ANZ. It was said that the whole of the subdivision, of which s46D was part, was directed to the taxation of dividends received by a taxpayer and was not concerned with the character of dividend payments as made by a corporation.

In so far as that submission restates the principle that the whole of the contents of a statute provide the context in which a provision thereof is to be construed, it is unexceptionable. But if the submission contends that the meaning of a word used in s46D is governed or controlled by the context of the subdivision in which s46D appears, that submission must be rejected. The primary step in construing a section is to determine the ordinary meaning of the words used and in this case, where s46D was inserted to correct a perceived mischief, proper construction of the section must also have regard to the purpose of the amendment, as well as the context provided by the Act. (See: Mills v Meeking [1990] HCA 6; (1990) 169 CLR 214.)

Before turning to the language of s46D it is helpful to refer to some of the background which led to the introduction of that provision. In a statement made on 7 April 1986, the then Treasurer drew attention to difficulties created for the revenue by the issue of redeemable preference shares. It was said that such share issues, particularly those of short term, could be used by a corporation as a substitute for obtaining finance by borrowing, but with a different tax consequence. For income tax purposes, a corporation incurring debt by borrowing and paying interest on the loan could deduct the interest as an outgoing of its business and the person receiving that interest received assessable income. Dividends were not a deductible outgoing for the corporation paying the dividend and the rebate under s46 of the Act made the dividends, in effect, tax-free when received by a corporation to which the rebate applied.

The Treasurer pointed out that, where both companies were "fully taxable", the use of redeemable preference shares to obtain funds instead of borrowing was revenue neutral. But where the "borrower" was a "tax-loss company", it could gain an advantage by issuing redeemable preference shares, as the "lender" would receive a tax benefit and may be prepared to "lend" at a substantially lower interest rate than the market rate. Such a "cash-flow" advantage to the parties would represent a corresponding loss to the revenue. (See: N.J. O'Bryan, "Preference Share Financing" (1986) 1 BLB 53.) The Treasurer also noted that redeemable preference shares could be used for "tax avoidance purposes", an example of which was said to be investment in offshore companies located in "tax havens", dividends paid by such a company to a corporation resident in Australia being "tax free".

These concerns led to the enactment of s46C of the Act by Act 61 of 1987. Section 46C was designed to counter the use of short-term redeemable preference shares and other similar forms of "share finance". The section applied to a "debt dividend", being a dividend paid to a shareholder under a "short-term finance arrangement" which met certain other conditions: sub-s46C(1). A "short-term finance arrangement" was one entered into for a purpose that included enabling the company to obtain finance for a period not reasonably likely to exceed 2 years. The definition of "debt dividend" in s46C used language identical to that incorporated in para46D(2)(c); that is, having regard to the three specific criteria, the payment of the dividend could "reasonably be regarded as equivalent to the payment of interest on a loan".

Sub-section 46C(5) denied a shareholder a rebate under s46 or s46A in respect of a "debt dividend". However, s67AA of the Act permitted the company paying the "debt dividend" to claim a deduction as if the payment were interest.

On 10 December 1986, the Treasurer made a further announcement concerning redeemable preference shares. This announcement was made before s46C had been enacted (although it had been announced that the new section would operate from 7 April 1986). The Treasurer stated that the Government had become aware of attempts to avoid the effect of the proposed s46C. Accordingly, it had been decided that for all redeemable preference shares issued on or after 10 December 1986, dividends would be treated as equity income, but would not be eligible for the s46 rebate when received by companies.

Following the Treasurer's latter announcement, the Taxation Laws Amendment (Company Distributions) Act 1987 (Cth) (No. 58 of 1987) introduced s46D into the Act. Under the amendments effected by that Act, dividends falling within the scope of s46D were excluded from s46C, so as not to qualify for deduction under the then proposed s67AA. (See now the definition of "debt dividend" in sub-s46C(1).)

The Explanatory Memorandum which accompanied the Bill gave the following explanation for the amendments:

"Clause 7: Dividends paid instead of interest

The amendments proposed by clause 7 will insert a new section - section 46D - in the Principal Act. This section, in conjunction with the amendments proposed by clauses 6, 9 and 10 of the Bill, will give effect to the measures announced on 10 December 1986 to deny the inter-corporate dividend rebate on certain dividends paid, in effect, in substitution for payments of interest under financing arrangements.

Under the present income tax law, section 46 effectively frees from tax dividends that are included in the taxable income of a resident company. Where dividend stripping is involved, section 46A operates to limit the rebate of tax that a company otherwise may be allowed under section 46. As indicated in the notes on clause 6, new section 46C - which is proposed to be inserted in the Principal Act by the Taxation Laws Amendment Bill (No. 5) 1986 that was introduced into the House of Representatives on 28 November 1986 - will operate to deny the intercorporate dividend rebate where a dividend is paid, rather than interest on a loan, under a short-term finance arrangement involving the provision of finance for a period of two years or less. As also noted earlier, such dividends will generally be deductible to the company that issued the relevant shares.

The amendment proposed by this clause will operate to the same broad effect as those described above by denying the intercorporate dividend rebate in relation to a dividend the payment of which may reasonably be regarded as equivalent to the payment of interest on a loan. However, new section 46D will apply regardless of the term of the loan or finance in connection with which the dividend is paid, and no deduction for the dividend will be allowed to the company that issued the relevant shares. As indicated in the notes on clause 6, the amendment proposed by that clause will ensure that dividends that fall within the scope of section 46D will be excluded from the operation of the proposed section 46C so as not to qualify for deduction under the proposed section 67AA."

It will be seen that the Explanatory Memorandum, unlike the Treasurer's earlier announcements, did not expressly refer to redeemable preference shares as the specific matter of concern in intercorporate "financing arrangements". Nonetheless, the earlier history shows that part of the mischief at which the legislation was aimed was the tax advantage obtained by using redeemable preference shares as a means of raising finance.

The legislation as it emerged from the process I have described dealt with "debt dividends" in both ss46C and 46D. Under s46C the expression "debt dividend" is limited to a dividend paid under a "short-term finance arrangement", that is, an arrangement entered into for the purpose of enabling the company to obtain finance for a period that is not likely to exceed 2 years. A dividend is only a "debt dividend" if, in addition, having regard to the indicia set out in paras(d), (e) and (f) of the definition, "the payment of the dividend may reasonably be regarded as equivalent to the payment of interest on a loan". This additional requirement is framed in terms identical to those used in para46D(2)(c).

In sub-s46D(2) the definition of "debt dividend" includes, but is not limited to, the payment of a dividend under a "finance arrangement". The term "finance arrangement" is defined to mean an arrangement for the purpose of enabling the company to obtain "finance", including money raised by the issue of shares: sub-s46D(1). This definition is not qualified by any reference to the terms of the arrangement.

As in s46C, the overriding requirement necessary to establish that a dividend is a debt dividend, is that having regard to the three specified indicia, "the payment of the dividend may reasonably be regarded as equivalent to the payment of interest on a loan".

For an occurrence to be said to be equivalent to another it must have equality in value or significance; or correspondence in import, characteristic or meaning; or have identical effect or be virtually the same thing. (See: The Oxford English Dictionary, 2nd Ed (Oxford: Clarendon Press, 1989) Vol 5: "equivalent".) In our opinion, Parliament has applied the word "equivalent" in ss46C and 46D in this sense in that there is a requirement that the circumstances under which the dividend is paid on a share in a company must correspond with the circumstances in which interest is payable on a sum borrowed.

Counsel for the Commissioner, submitted that sub-s46D(1) catches arrangements that are economically equivalent to the payment of interest. He contended that the question is whether "in substance" the dividend received is equivalent to interest.

The common meaning of interest is the money which accrues from day to day, calculated according to a fixed ratio of a sum lent, agreed to be paid under a contract of loan. But the word has a wider meaning which may include the compensation or damages to be paid to a person denied the use of a sum to which that person is, or becomes, entitled. Cardinal to either meaning is that interest be referable to a principal in money or an obligation to pay money. (See: Halsbury's Laws (4th Ed), Vol 32 para 106; Consolidated Fertilizers Ltd v Deputy Commissioner of Taxation [1992] FCA 224; (1992) 107 ALR 456 per Cooper J at 461-462.)

Sub-section 46D(2) does not require merely that the payment of the dividend be able to be regarded as equivalent to the payment of interest. It requires the payment to be able to be regarded as "the payment of interest on a loan". [emphasis added] The section applies if, in all the circumstances, a dividend paid on a share in a corporation corresponds with the payment of interest under a borrower and lender relationship.

It follows that for the purpose of s46D of the Act the relationship between a corporation that has issued a share and paid a dividend thereon and a corporate shareholder that has received the dividend must exhibit the characteristics which make the payment equivalent to the payment of interest on a loan. That is, for s46D to apply the payment of a dividend must perform the same function as the payment of interest on a loan having regard to the circumstances in which it is made. Section 46D is not directed to the equivalence in interest a taxpayer could have received if the taxpayer had been a lender of the monies paid for the shares on which the dividend is paid. Rather, it is concerned with the terms of the relationship between the share- issuing corporation and the subscribing taxpayer, which, objectively considered, determine whether the payment of the dividend corresponds to the payment of interest on a loan. (See: Hendy (Inspector of Taxes) v Hadley [1980] 2 All ER 554 per Vinelott J at 556.)

Employing the terms of s46D so construed to the facts of this case it is apparent that when regard is given to:

i) the manner in which the amount of dividends in respect of the shares was to be calculated;

ii) the conditions applicable to the payment of dividends in respect of the shares; and

iii) other relevant matters

all of the elements necessary to support a reasoned conclusion that the payment of the dividend to Radilo was equivalent to the payment of interest on a loan were not present.

The amount of the dividend was calculated as a fixed percentage of the sum subscribed for the shares and the amount was fixed at the time of subscription and to that extent the manner of calculation of the dividend corresponded with the calculation of interest (See: Henry v Great Northern Railway Co [1857] 27 LJ Ch 1 per Cranworth LC [1857] EngR 913; (44 ER 858 at 871)). However, that was only part of the circumstances relevant to the payment of the dividend, and to the determination whether such a payment was equivalent to the payment of interest on a loan.

The relationship between Radilo and the ANZ had no equivalence to the relationship between a lender and a borrower. By issuing the shares the ANZ obtained capital from subscribers to the issue. A subscribing shareholder had an entitlement to participate in any distribution made in the winding-up of the ANZ but no claim or entitlement to the repayment of the sum subscribed and the ANZ had no obligation to pay a money sum to the shareholder. The sum subscribed was not paid on terms that the shares issued by the ANZ were to be redeemed and the sum paid for the shares by the subscriber returned to the subscriber. Conversion of the shares to ordinary shares did not alter the position of a holder of the shares. Upon conversion of the shares the shareholder remained a subscriber to the capital of the ANZ and the ANZ had no obligation to pay a money sum to the shareholder. The effect of the conversion of the shares to ordinary shares, and allotment of additional ordinary shares, was to put the shareholder in the same position as a holder of ordinary stock and to extinguish the preferential right the shareholder had to the payment of dividends and to the repayment of capital on a winding-up. The fact that a holder of the shares could convert the shares to money by selling them on the Stock Exchange had no bearing on the nature of the relationship between the ANZ and the shareholder in respect of the sum subscribed so as to give that sum the character of monies lent.

A fixed dividend and the exclusion of the right to participate in any better distribution of the profits of a company are common terms in the contractual arrangements and relate to the issue of preference shares. However, unless other terms of the arrangement stamp an issue of preference shares as a "financing mechanism", the right to receive a fixed amount by way of dividend, will not, in itself, supply the ground for a conclusion that the dividend, when paid, may be regarded as equivalent to interest paid on a loan. (See: Bond v Barrow Haematite Steel Co [1902] 1 Ch 353 per Farwell J at 363.) In the usual issue of preference shares the payment of a fixed dividend is part of a package of shareholder's rights designed to encourage subscription to capital, in which the dividend to be paid, and the priority given to that class of share in the payment of dividends and in the return of capital in a winding up, are rights that are offset by limitation of voting rights, no right to participate in a greater distribution of profits, and perhaps, no right to participate in a distribution of surplus assets in a winding up. (See: In re The Isle of Thanet Electricity Supply Co Ltd [1950] 1 Ch 161; M. Pickering, The Problem of the Preference Share (1963) 26 MLR 499.) Something more must be present in the arrangement if the payment of a dividend is to be regarded as equivalent to the payment of interest on a loan.

If some investors, or others interested in the securities market, regarded an investment in the shares as an investment in a "fixed interest security" that perception had no bearing on the operation of s46D. Section 46D applies if, after consideration of all relevant facts, it may be objectively and reasonably concluded that the characteristics that are part of the payment of interest on a loan are present. The scope of the section depends upon the application of the proper construction of the words used to the particular facts of each case. Concepts such as "substitutability" or "equivalent product", used by economists to explain the nature and scope of markets, are not embraced by the ordinary meaning of the words used in s46D.

I agree with his Honour that, properly construed, s46D of the Act does not apply to the facts of the instant case and the appeal must be dismissed.

I certify that this and the preceding nineteen pages are a true copy of the Reasons for Judgment of his Honour Justice Lee.

Associate:

Date:

APPEARANCES

Counsel for the Appellant: A.H. Slater Q.C.

R.L. Hamilton

Solicitors for the Appellant: Australian Government Solicitor

Counsel for the Respondent: D.H. Bloom Q.C.

K.J. Burgess

Solicitors for the Respondent: Rosenblum & Partners

Date of Hearing : 27 September 1996

Date of Judgment : 3 February, 1997

IN THE FEDERAL COURT OF AUSTRALIA )

NEW SOUTH WALES DISTRICT REGISTRY ) No NG 229 of 1996

GENERAL DIVISION )

ON APPEAL FROM A JUDGE OF THE FEDERAL COURT OF AUSTRALIA

BETWEEN: COMMISSIONER OF TAXATION

Appellant

AND: RADILO ENTERPRISES PTY LTD

Respondent

CORAM: Lee, Sackville, Lehane JJ

PLACE: Sydney

DATE: 3 February, 1997

REASONS FOR JUDGMENT

SACKVILLE and LEHANE JJ:

Lee J has stated the facts and recounted the legislative history of s.46D of the Income Tax Assessment Act 1936 (Cth) (the "Act"). We adopt what his Honour has said on these topics.

The appeal concerns the dividend of $662.50, paid by the Australia and New Zealand Banking Group Ltd ("ANZ") to the respondent, Radilo Enterprises Pty Ltd ("Radilo"), in respect of the non-redeemable, non- cumulative converting preference shares ("CP shares") issued by ANZ in 1991. As Lee J has explained, each of the six million $1 CP shares was issued at a premium of $99. The question is that identified by the trial Judge, namely, whether Radilo, not being a private company, was entitled to a rebate on its dividend pursuant to s.46 of the Act, or whether that rebate was excluded by s.46D of the Act. The answer to the question turns on the definition of "debt dividend" in s.46D(2):

"(2) A dividend is a debt dividend for the purposes of this section if, and only if:

(a) The dividend is paid to a shareholder after the commencing time in respect of a share in a company (whether the company is a resident or a non-resident);

(b) the dividend is paid:

(i) in respect of a share issued after the commencing time; or

(ii) under a finance arrangement entered into after the commencing time; and

(c) having regard to:

(i) the manner in which the amount of dividends in respect of the share was to be calculated;

(ii) the conditions applicable to the payment of dividends in respect of the share; and

(iii) any other relevant matters;

the payment of the dividend may reasonably be regarded as equivalent to the payment of interest on a loan".

If the dividend paid to Radilo was a "debt dividend" within s.46D(2), s.46D(3) provides that Radilo, as a shareholder of ANZ, is not entitled to the rebate under s.46.

We note in passing that the evidence showed that other listed companies had issued converting preference shares similar, albeit not identical, to those issued by ANZ. Examples of converting preference share issues are given in an interesting article by Peter J Norman, "Debt Dividends: The Test Case" (1996) 5 Taxation in Australia 10. This appeal does not of course raise for consideration the terms of other converting preference share issues. However, the fact that such shares have apparently been issued by other companies suggests that the question raised by the present case may have wider significance.

Some Factual Matters

It is unnecessary to repeat the facts outlined by Lee J. However, several matters should be noted.

First, as Lee J has pointed out, ANZ offered the CP shares for subscription because it decided that it needed to strengthen its "core" or "Tier 1" capital. The Reserve Bank of Australia guidelines in force in 1991 required at least 50 per cent of a bank's capital to be Tier 1, comprising the "highest quality capital elements". The remainder (Tier 2) could consist of "supplementary" elements. The guidelines included the following:

"14 The core of a bank's capital is shareholders' funds. They represent a permanent and unrestricted commitment of funds; they are available to meet losses enabling a bank to continue operating whilst any problems are redressed; and they do not impose unavoidable charges against earnings. Shareholders' funds therefore represent capital resources which can best contribute resilience and flexibility to a bank experiencing difficulties. For that reason, a strong tranche of shareholders funds is required as the foundation of a bank's capital base.

15 Paid-up ordinary shares and non-cumulative irredeemable preference shares have the strongest claim for inclusion in 'core capital' as does any non-repayable premium arising from the issue of such shares".

As the documentary evidence makes clear, ANZ faced what seemed to be conflicting commercial needs: it wished to raise Tier 1 capital, yet sought do so in a manner that avoided diluting ordinary share capital at a time when the share price was thought to be depressed.

Secondly, each CP share was issued on terms requiring it to be converted, on the "Conversion Date", into one ordinary share, with the holder to be allotted additional ordinary shares in accordance with the "Conversion Formula". The par value of the ordinary shares was to be paid in full from ANZ's share premium account. While the CP shares remained unconverted, ANZ was obliged under s.191 of the Corporations Law to maintain a share premium account, which was available for the purpose of paying up the par value of the additional ordinary shares to be issued on conversion. The holders of the CP shares therefore were not to receive any payment from ANZ, other than the non-cumulative preferential dividend. They would, of course, receive ordinary shares on the Conversion Date, which they were free to dispose of in the market.

Thirdly, both the trial Judge and counsel appeared to accept that the Conversion Formula, assuming a stable market price for the ordinary shares during the five trading days immediately preceding the Conversion Date, produced that number of shares which would have a market value of $111.11 ($100 x 10/9) on the Conversion Date. It is understandable that such an assumption should be made, since some of the contemporary documentation proceeded on precisely that basis. In fact, because the Conversion Formula requires fractions to be ignored, it does not produce a uniform value of shares on the Conversion Date, even assuming a stable market price for ordinary shares during the five day period immediately preceding the Conversion Date. For example, a "weighted average sale price" of $6.00 per ordinary share during the five day period yields, according to the Conversion Formula, 18 shares worth $108 (18 x $6.00). A weighted average sale price of $8.00 per share yields 14 shares worth $112 (14 x $8.00). In addition, as Lee J has pointed out, the Conversion Formula produces different results depending on whether the price of ordinary shares is falling or rising over the five day period. The result is that the holder of CP shares could not know in advance the precise value of the ordinary shares into which the CP shares would be converted on the Conversion Date.

Fourthly, the parties agreed that the buy-back offer made by ANZ in September 1994 was to be ignored, except insofar as it supported the Commissioner's contention that the CP shares attracted many investors who would otherwise have invested in fixed interest securities. It is not entirely obvious that the existence of such an offer is necessarily irrelevant to the question of whether the payment of a dividend after the date of the offer "may reasonably be regarded as equivalent to the payment of interest on a loan". The effect of a buy-back offer may be that a payment is made directly by the company issuing the non-redeemable preference shares to the shareholder. It also may be that s.46D(2) requires, or at any rate allows, events occurring before the payment of the dividend to be taken into account as "other relevant matters" under s.46D(2)(c)(iii). However, in the light of the agreement between the parties, we need not pursue this question.

The Commissioner's Submissions

The Commissioner's submissions were based on two linked propositions. The first was that s.46D(2) is concerned with promoting neutrality between economically equivalent financing arrangements. The subsection therefore catches dividends which, in substance, are economically equivalent to the payment of interest. The second proposition was that s.46D(2) is concerned only with the characterisation of the dividend received by the shareholders. Thus the issue of economic equivalence is to be determined from the perspective of the shareholder (in this case Radilo), rather than by reference to other aspects of the relationship between the company and the shareholder. In putting the Commissioner's submission in this way, Mr Slater QC, who appeared with Mr Hamilton, was doubtless conscious of the difficulty posed by the fact that ANZ was never obliged to repay to the shareholders the moneys subscribed for CP shares and, indeed, was bound (subject to provisions such as s.191 of the Corporations Law) to retain the funds subscribed as capital.

Equivalence - From Which Perspective?

The Macquarie Dictionary defines "equivalent" as follows:

"1. equal in value, measure, force, effect, significance, etc

2. corresponding in position, function, etc."

As Fox J observed in Linhart v Elms (1988) 81 ALR 557 (FCA/FC), a case involving the Extradition (Foreign States) Act 1966 (Cth), it is not easy to judge equivalence except by reference to some standard or purpose (at 571). See also Gummow J at 580; and Foster J at 585-586. Section 46D(2)(c) adopts the technique of identifying two specific criteria (s.46D(2)(c)(i) and (ii)) by reference to which the ultimate question - namely, whether the payment of the dividend may reasonably be regarded as equivalent to the payment of interest on a loan - is to be decided. However, these two specific criteria are followed by the direction in s.46D(2)(c)(iii) to take account of "any other relevant matters". Not only does this enlarge the field of inquiry but s.46D(2)(c) does not specify what weighting should be given to the specific criteria, as distinct from "any other relevant matters", or indeed whether any weighting process is to take place.

In our view, the starting point must be the question posed by the concluding words of s.46D(2)(c). The issue posed by the legislation is not whether the payment of the dividend may reasonably be regarded as equivalent to the payment of interest; it is whether the payment of the dividend may reasonably be regarded as equivalent to the payment of interest on a loan. Mr Slater's submission, that the question of equivalence must be assessed solely from the recipient's perspective, seems to us to be at odds with the statutory language.

Interest may be payable by one person to a second person without a loan having been made to the first person by the second. Familiar examples are the liability to pay interest on a judgment debt or the award of interest under statute, where a person has been wrongfully kept out of his or her money: see Riches v Westminster Bank Ltd [1947] AC 390, at 400, per Lord Wright. The last three words of s.46D(2)(c), by referring specifically to a loan, necessarily direct attention to the nature of the relationship between the company and the shareholder pursuant to which the dividend is paid. The relationship must be such that, having regard to all the matters specified in s.46D(2)(c), the payment of the dividend may reasonably be regarded as equivalent to the payment of interest on a loan.

We have not overlooked the fact that s.46D(1) defines "loan" to include "the provision of credit or any other form of financial accommodation". However, there is nothing in the extended definition which detracts from the conclusion that s.46D(2)(c) requires attention to be directed to the relationship between the company and the shareholder, pursuant to which the dividend is paid. The provision of credit implies a consensual transaction, such as the delivery of goods on terms permitting deferred payment or the granting of overdraft facilities by a bank: compare Herbert v The King [1941] HCA 12; (1941) 64 CLR 461, at 467, per McTiernan J. Similarly, in its statutory context, the expression "or any other form of financial accommodation" refers to a consensual arrangement between the person providing the accommodation and the recipient. Under a consensual arrangement for the provision of credit or financial accommodation a principal sum, or its substantial equivalent (by way of indemnity against a liability on maturing bills, for example, in the case of accommodation provided in the form of a bill acceptance facility), will ultimately be payable.

This view is consistent with the legislative history of s.46D and the objectives of the legislation. One of the principal concerns underlying the enactment of s.46C, which applied for a short period prior to the commencement of s.46D, was the benefit accruing to certain corporate "borrowers" through the issue of short term redeemable preference shares. The enactment of the more sweeping provisions of s.46D was accompanied by a withdrawal of the deduction in respect of that dividend, previously available to the company paying the debt dividend under s.67AA of the Act. Thus, the statutory scheme has an important impact not only on the recipient of debt dividends, but on the company paying such dividends. This suggests that s.46D(2)(c) should be construed as requiring the question of equivalence to the payment of interest on a loan to be assessed not merely by reference to the position of the shareholder, as the recipient of the dividend, but by reference also to the relationship between the company and the shareholder pursuant to which the dividend was paid.

Mr Slater supported his argument that the matter was to be judged from the viewpoint of the investor by referring to the statutory context. In particular, he contended that s 46D is concerned with the characterisation of moneys received by a taxpayer for the purpose of ascertaining whether the moneys formed assessable income of the taxpayer and whether, on the basis that the moneys were "dividends included in its taxable income", the taxpayer was entitled to a rebate under s.46. However, if the question is whether a payment is a dividend, the answer is to be ascertained from the viewpoint of the payer and by reference to the character of securities which the payer has issued. Secondly, s.46D(2), as Mr Bloom QC, who appeared with Mr Burges for Radilo, pointed out, is concerned with "the payment of the dividend" rather than its receipt.

Relationship Between ANZ and the CP Shareholders

Once this construction of s.46D(2)(c) is accepted, the difficulty confronting the Commissioner becomes apparent. A loan involves an obligation on the borrower to repay the sum borrowed. The matter is put this way by Dr Pannam:

"A loan of money may be defined, in general terms, as a simple contract whereby one person ('the lender') pays or agrees to pay a sum of money in consideration of a promise by another person ('the borrower') to repay the money upon demand or at a fixed date. The promise of repayment may or may not be coupled with a promise to pay interest on the money so paid. The essence of the transaction is the promise of repayment. As Lowe J put it in a judgment delivered on behalf of himself and Gavan Duffy and Martin JJ: "'Lend' in its ordinary meaning in our view imports an obligation on the borrower to repay." [Ferguson v O'Neil [1943] VLR 30, at 32.] Without that promise, for example, the old indebitatus count of money lent would not lay. Repayment is the ingredient which links together the definitions of 'loan' to be found in the Oxford English Dictionary, the various legal dictionaries and the text books. In essence then a loan is a payment of money to or for someone on the condition that it will be repaid."

C L Pannam, The Law of Money Lenders in Australia and New Zealand (1964), at 6. See also Brick and Pipe Industries Ltd v Occidental Life Nominees Pty Ltd [1992] 2 VR 279, at 321-323, per Ormiston J.

In the circumstances of the present case, there was no relationship of lender and borrower between ANZ and the CP shareholders; nor was there anything that could reasonably be regarded as equivalent to such a relationship. In this respect, we agree with Lee J's analysis, and wish only to add a few observations.

Following conversion of the CP shares into ordinary shares, the shareholder acquired a different class of shares, which could be sold on the open market. In this way, the shareholder could recoup a sum close to the issue price for the CP shares. We leave to one side the fact that the market value of the ordinary shares issued on the Conversion Date was unlikely to be precisely equivalent either to the issue price or to a predetermined percentage of that price. We also put to one side the effect of the large volume of ordinary shares which would come on to the market immediately after the Conversion Date (assuming that virtually all CP shareholders chose to dispose of their converted ordinary shares rather than retain an equity investment in ANZ). The ability of the CP shareholders to recoup the issue price by a sale of the ordinary shares could not transform the relationship between those shareholders and ANZ into that of creditor and debtor, or something equivalent thereto.

The very point of issuing the CP shares was to increase ANZ's Tier 1 capital. It was central to the company's objective to ensure that the moneys received from CP shareholders represented a permanent and unrestricted commitment of funds to the company. There was no suggestion that ANZ had entered some collateral arrangement whereby it ensured that a third party would purchase the converted ordinary shares, or provided assistance for that purpose. Both before and after the Conversion Date ANZ retained, and was bound to retain, the funds subscribed by the CP shareholders. A portion of the moneys credited to the share premium account on issue of the CP shares would presumably be used in accordance with the terms of issue, to pay in full the par value of the ordinary shares. But the moneys subscribed would remain as capital of the company. In these circumstances, neither in form nor in substance could it be said at any time that ANZ had agreed or arranged to repay the moneys subscribed by the CP shareholders. Nor could it be said at any time that ANZ was a borrower from the CP shareholders. The ability of the shareholders to recoup their subscriptions derived from the marketability of the ordinary shares, a characteristic which the ordinary shares had in common with the CP shares prior to the Conversion Date.

Mr Slater resisted this conclusion on a ground not raised before the trial Judge. He submitted that, upon conversion of the CP shares, the subscription moneys were effectively repaid to the CP shareholders by ANZ. The repayment was not in cash, but in kind, in that the shareholders received shares which were paid up to par value out of the share premium account. Mr Slater accepted that, at law, the CP shareholders were not creditors of ANZ and that ANZ was to retain the funds subscribed. However, he submitted that the allotment and payment up of the shares, in effect, constituted a return of value by ANZ to the CP shareholders. ANZ could have issued the ordinary shares at a premium, but did not do so and thereby forewent value otherwise available to it. Mr Slater supported the argument by referring to authorities establishing that an issue of bonus shares involves the allocation of a dividend or share of profits to the shareholder and the application of the dividend or profit on behalf of the shareholder in payment of the new shares: Federal Commissioner of Taxation v W E Fuller Pty Ltd [1959] HCA 41; (1959) 101 CLR 403, at 419, per Fullagar J; James v Federal Commissioner of Taxation [1924] HCA 34; (1924) 34 CLR 404, at 416-417, per Isaacs J.

If viewed in isolation, the conversion of each CP share into one fully paid ordinary share and the allotment of additional fully paid shares to the CP shareholders might be regarded as ANZ issuing shares for less than their true value. However, the shares were allotted to the CP shareholders in satisfaction of their entitlement under the terms of issue of the CP shares, in accordance with the formula specified in those terms. Each CP shareholder paid a premium of $99 per share. The terms on which the ordinary shares were issued reflected the receipt by the company of the premium, all of which was to be retained as capital and was not to be returned to the shareholders. The formula for the allotment of ordinary shares took account of the amount subscribed by way of capital. Viewed as a matter of substance, ANZ received and retained subscriptions of capital from CP shareholders in order to increase its Tier 1 capital. This is not a case of a company allocating profits or dividends to satisfy the liability created by the allotment of bonus shares. Nor is it a case of a company simply borrowing money for the purposes of its business and repaying the lender in kind. As we have explained, it was an essential element of the arrangements relating to the CP shares that the moneys subscribed by CP shareholders be retained as capital by ANZ. No such restriction would apply to moneys raised by way of loan, or by an arrangement equivalent to a loan.

Equivalence

If attention is directed only to the criteria specified in s.46D(2)(c)(i) and (ii) of the Act, it may well be that the payment of the dividend could reasonably be regarded as equivalent to the payment of interest on a loan. However, such a conclusion is by no means clearcut. Some light is shed on the intention underlying these paragraphs of the Act by the Explanatory Memorandum accompanying the Taxation Laws Amendment (Company Distributions) Bill 1987. The Memorandum refers to the paragraphs as follows:

"
* by subparagraph (1) - the manner in which the amount of a dividend in respect of the affected share is to be calculated. In general terms, this requirement will be met in relation to any share that provides a return at a specified or determinable rate;

* by subparagraph (ii) - the conditions applicable to the payment of dividends. The conditions to be considered would include any providing a preferential return to the shareholder, or relating to any arrangements collateral to the issue of relevant shares. For example, where payment of a dividend on a share is conditional on collateral borrowings, the terms of such arrangements would be relevant for the purpose of determining whether the dividend paid constitutes a debt dividend under new section 46D. Other matters that would be relevant factors applicable to the payment of any dividend would include the terms of any financial arrangement to the effect that funds raised by the issue of shares were to be repaid to the lender at some time in the future (whether by the company redeeming the shares directly, or indirectly through the purchase of those shares by an associate)".

The manner in which the amount of the dividend was to be determined is consistent with the dividend being equivalent to the payment of interest on a loan. The dividend was calculated by reference to a specified percentage of the issue price, namely, 13.25 per cent per annum. However, the conditions applicable to the payment of dividends are rather more equivocal. The dividends payable on the CP shares were preferential (that is, they ranked above dividends payable to ordinary shareholders), but were non-cumulative. More importantly, they were payable only if the directors considered the distributable profits to be sufficient. Furthermore, the dividends could not be paid if the capital adequacy requirements would be breached. Interest on a loan is of course ordinarily payable by a borrower regardless of the profitability of the borrower's business. Consequently, the terms of the CP shares differ from the usual terms upon which interest is payable on a loan, although they may not differ in substance greatly from the terms applicable to interest payable on certain forms of subordinated indebtedness represented by securities which are likely to be classified as loans. As we have already said, the conditions applicable to the dividends did not include any collateral arrangements such as those referred to in the Explanatory Memorandum.

It is not necessary to consider what result would be reached if the only factors to be taken into account were those specified in s.46D(2)(c)(i) and (ii). Even if those factors suggest that payment of the dividends could reasonably be regarded as equivalent to the payment of interest on a loan, they must be considered together with "all other relevant matters". For the reasons we have given, those other matters lead to the conclusion that the relationship between the ANZ and the CP shareholders cannot reasonably be regarded as that of debtor and creditor. In our opinion, the consequence of that conclusion is that the payment of the dividend to Radilo cannot reasonably be regarded as equivalent to the payment of interest on a loan.

Economic Equivalence

It is implicit in what we have said that we do not think that the concept of economic equivalence, at least in the sense used by Mr Slater in his submissions, is particularly helpful in the circumstances of the present case. Although Mr Slater did not use the phrase "cross-elasticity of demand", he placed emphasis upon perceptions in the marketplace, in order to support the contention that the payment of dividends could reasonably be regarded as equivalent to the payment of interest on a loan. He submitted, for example, that the evidence showed that the CP shares were treated by ANZ and its advisers, and by other players in the marketplace, as an investment more in the nature of a debt than of equity.

In our view, the evidence was rather more equivocal than the Commissioner's submissions assumed. Certainly, some financial institutions expressed the view, at or before the time the CP shares were issued, that they were likely to be of interest primarily to fixed interest investors. This was because the CP shares carried an entitlement to a fixed, albeit non-cumulative, interest rate and, furthermore, the market value of the ordinary shares received at the Conversion Date was unlikely to vary substantially from the issue price of $100 per CP share, allowing for the "discount" in relation to the ordinary shares. It is also evident that some institutions, for their own purposes, classified the CP shares as fixed interest, rather than equity, investments.

However, the evidence reveals different perceptions in the marketplace. For example, Potter Warburg, an adviser to ANZ, pointed out in a letter of 27 March 1991, that the:

"principal two characteristics of the instrument in this respect are that it is non-redeemable and its servicing obligations are non- cumulative, thus giving it two of the key characteristics of equity".

(Emphasis supplied.)

The dividend rate for the CP shares was set above prevailing interest rates payable by corporate borrowers to compensate for the risk that dividends might not be declared by the ANZ. Potter Warburg also stated that the CP shares differed from conventional fixed interest instruments in that the income and principal components had a "substantially higher risk", although recognising that the instrument would be likely to appeal to fixed interest investors because of its "essentially fixed interest character".

More fundamentally, there was nothing to indicate that the practices and perceptions of the marketplace, insofar as they could be identified, reflected a view of the question posed by s.46D(2)(c) of the Act. It was not in dispute in the present case that s.46D(2) applies if, after regard is paid to the matters specified in s.46D(2)(c), the Court finds that a reasonable person could regard the payment of the dividend as equivalent to the payment of interest on a loan. A critical issue in resolving that question is whether the relationship between the company and the shareholder can reasonably be regarded as equivalent to that of debtor and creditor. The perceptions and practices of the marketplace, as revealed in the evidence in this case, do not seem to us to have a significant bearing on that issue.

Conclusion

We agree with Lee J that the appeal should be dismissed, with costs.

I certify that this and the preceding 18 pages are a true copy of the Reasons for Judgment of the Honourable Justices Sackville and Lehane.

Associate:

Date: 3 February, 1997

Heard: 27 September, 1996

Place: Sydney

Decision: 3 February, 1997

Appearances: Mr A.H. Slater QC and Mr R.L. Hamilton, instructed by the Australian Government Solicitor, appeared for the appellant.

Mr D.H. Bloom QC and Mr K.J. Burges, instructed by Rosenblum & Partners, appeared for the respondent.