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Federal Court of Australia - Full Court Decisions |
Last Updated: 26 July 2002
Hart v Commissioner of Taxation [2002] FCAFC 222
INCOME TAX - whether taxpayer entitled to a deduction of compound interest on a split loan taken for purchase of a new family home while retaining former family home as a rental property - whether compound interest, like ordinary interest, an allowable deduction under s 51(1) Income Tax Assessment Act 1936 (Cth) or s 8-1 Income Tax Assessment Act 1997 (Cth).
INCOME TAX - whether loan arrangement where split into a home loan portion and an investment loan portion resulting in an overall tax benefit is a scheme to which Pt IVA Income Tax Assessment Act 1936 (Cth) applies - dominant purpose considered having regard to the eight factors in s 177D(1) Income Tax Assessment Act 1936 (Cth) - commercial purpose of transaction weighed against income tax advantage.
Income Tax Assessment Act 1936 (Cth) ss 51(1), 177A(1), 177C(1), 177D, 177F(1)
Income Tax Assessment Act 1997 (Cth) s 8-1
Lunney v Federal Commissioner of Taxation [1958] HCA 5; (1958) 100 CLR 478 cited
Handley v Federal Commissioner of Taxation [1981] HCA 16; (1981) 148 CLR 182 cited
Federal Commissioner of Taxation v Cooper (1991) 29 FCR 177cited
Fletcher v Federal Commissioner of Taxation [1991] HCA 42; (1991) 173 CLR 1 discussed
Ure v Federal Commissioner of Taxation (1981) 34 ALR 237 cited
Federal Commissioner of Taxation v Phillips [1978] FCA 27; (1978) 20 ALR 607 cited
Federal Commissioner of Taxation v Roberts & Smith [1992] FCA 363; (1992) 37 FCR 246 cited
Magna Alloys and Research Pty Ltd v Commissioner of Taxation [1980] FCA 150; (1980) 49 FLR 183 discussed
Federal Commissioner of Taxation v Peabody [1994] HCA 43; (1994) 181 CLR 359 referred to
Inland Revenue Commissioners v Brebner [1967] 2 AC 18 discussed
Commissioner of Taxation v Spotless Services Ltd [1996] HCA 34; (1996) 186 CLR 404 discussed
Commissioner of Taxation v Consolidated Press Holdings Ltd [2001] HCA 32; (2001) 179 ALR 625 cited
Eastern Nitrogen Ltd v Federal Commissioner of Taxation [2001] FCA 366; 2001 ATC 4164 considered
Attorney-General's Department v Cockcroft (1986) 10 FCR 180 cited
Frank Lyon Co v United States (1978) 435 US 561 referred to
Metal Manufactures Ltd v Federal Commissioner of Taxation 99 ATC 5229 referred to
Federal Commissioner of Taxation v Metal Manufactures Ltd [2001] FCA 365; 2001 ATC 4152 considered
TRUDY AMANDA HART & RICHARD MERALLES HART v COMMISSIONER OF TAXATION
N 1615 OF 2001
HILL, HELY & CONTI JJ
26 JULY 2002
SYDNEY
IN THE FEDERAL COURT OF AUSTRALIA |
|
NEW SOUTH WALES DISTRICT REGISTRY |
|
BETWEEN: |
TRUDY AMANDA HART FIRST APPELLANT RICHARD MERALLES HART SECOND APPELLANT |
AND: |
COMMISSIONER OF TAXATION RESPONDENT |
JUDGES: |
HILL, HELY & CONTI JJ |
DATE OF ORDER: |
26 JULY 2002 |
WHERE MADE: |
SYDNEY |
1. the appeal be allowed.
2. the orders made by the primary Judge on 2 November 2001 be set aside and in lieu thereof it be ordered that:
(a) the objection decisions of the respondent be set aside.
(b) the applicants' objections dated 2 April 1999 and 16 December 1999 be allowed.
(c) the matter be remitted to the respondent to assess in accordance with law.
(d) the respondent pay the applicants' costs.
3. the respondent pay the appellants' costs of the appeal.
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 |
|
BETWEEN: |
TRUDY AMANDA HART FIRST APPELLANT RICHARD MERALLES HART SECOND APPELLANT |
AND: |
COMMISSIONER OF TAXATION RESPONDENT |
JUDGES: |
HILL, HELY & CONTI JJ |
DATE: |
26 JULY 2002 |
PLACE: |
SYDNEY |
HILL J
INTRODUCTION
1 The appellants, Mr and Mrs Hart, ("Mr and Mrs Hart"), appeal against the judgment of a Judge of this Court, affirming objection decisions of the respondent Commissioner of Taxation ("the Commissioner") in relation to amended assessments for the year of income ending 30 June 1997 and assessments in relation to the year of income ended 30 June 1998.
2 At issue in the appeals is whether the appellants were each entitled to a deduction of what may be said to be relatively small amounts of interest in each tax year being part of larger amounts of interest paid to Permanent Custodian Limited ("PCL") in respect of a loan made to them jointly by PCL in the amount of $298,000. The application to the Court was brought as a test case and the Court has been advised that the Commissioner does not seek any order for costs in the event that the appeal is unsuccessful. By agreement, no cost order was made by the learned primary Judge below.
3 It suffices to say at this point that the Commissioner sought to argue both before the learned primary Judge and before us, that the amounts in dispute were not allowable deductions to the appellants in the income tax year ended 30 June 1997 under s 51(1) of the Income Tax Assessment Act 1936 (Cth) ("the 1936 Act") and in the income tax year ended 30 June 1998, under s 8-1 of the Income Tax Assessment Act 1997 (Cth) ("the 1997 Act"). Alternatively, the Commissioner submitted that if the amounts were otherwise deductible in the two income tax years, deductions were denied to them by the anti-avoidance provisions (Part IVA) of the 1936 Act. The Commissioner failed before the learned primary Judge on the first submission, but was successful on the second. Accordingly the Commissioner has filed a Notice of Contention claiming that his Honour erred in holding that the amounts in dispute were allowable deductions in the years of income but subject to Part IVA.
THE STATUTORY BACKGROUND
4 Section 51(1) of the 1936 Act and s 8-1 of the 1997 Act are in substantially similar terms. They are concerned with the deductibility of what may be called ordinary working expense of a business or, as in the present case, losses or outgoings which relate to the derivation of assessable income not being of a private or capital nature. There is no suggestion that there is any practical difference between them, notwithstanding that s 8-1 is written in the modern taxation drafting style which is supposed to be simpler to read and is directed at the ubiquitous "you", instead of the third person "taxpayer" referred to in the 1936 Act. Section 51(1) provides as follows:
"51(1) Deductions for losses and outgoings All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income."
5 The relevant sections in Part IVA are in the following terms:
177A(1) [Definitions] In this Part, unless the contrary intention appears:...
"scheme" means:
(a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and
(b) any scheme, plan, proposal, action, course of action or course of conduct;
...
177C(1) [Obtaining a tax benefit] Subject to this section, a reference in this Part to the obtaining by a taxpayer of a tax benefit in connection with a scheme shall be read as a reference to:
...
(b) a deduction being allowable to the taxpayer in relation to a year of income where the whole or a part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer in relation to that year of income if the scheme had not been entered into or carried out;
...
and, for the purposes of this Part, the amount of the tax benefit shall be taken to be:
...
(d) in a case to which paragraph (b) applies - the amount of the whole of the deduction or of the part of the deduction, as the case may be, referred to in that paragraph;
...
177D This Part applies to any scheme that has been or is entered into after 27 May 1981, and to any scheme that has been or is carried out or commenced to be carried out after that date (other than a scheme that was entered into on or before that date), whether the scheme has been or is entered into or carried out in Australia or outside Australia or partly in Australia and partly outside Australia, where:
(a) a taxpayer (in this section referred to as the relevant taxpayer) has obtained, or would but for section 177F obtain, a tax benefit in connection with the scheme; and
(b) having regard to:
(i) the manner in which the scheme was entered into or carried
out;
(ii) the form and substance of the scheme;
(iii) the time at which the scheme was entered into and the length of
the period during which the scheme was carried out;
(iv) the result in relation to the operation of this Act that, but for
this Part, would be achieved by the scheme;
(v) any change in the financial position of the relevant taxpayer
that has resulted, will result, or may reasonably be expected to
results, from the scheme;
(vi) any change in the financial position of any person who has, or
has had, any connection (whether of a business, family or other
nature) with the relevant taxpayer, being a change that has
resulted, will result or may reasonably be expected to result,
from the scheme;
(vii) any other consequence for the relevant taxpayer, or for any
person referred to in subparagraph (vi), of the scheme having
been entered into or carried out; and
(viii) the nature of any connection (whether of a business, family or
other nature) between the relevant taxpayer and any person
referred to in subparagraph (vi),
it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for the purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme or of enabling the relevant taxpayer and another taxpayer or other taxpayers each to obtain a tax benefit in connection with the scheme (whether or not that person who entered into or carried out the scheme or any part of the scheme is the relevant taxpayer or is the other taxpayer or one of the other taxpayers).
...
177F(1) [Commissioner's discretion to cancel tax benefit] Where a tax benefit has been obtained, or would but for this section be obtained, by a taxpayer in connection with a scheme to which this Part applies, the Commissioner may:
...
(c) in the case of a tax benefit that is referable to a deduction or a part of a deduction being allowable to the taxpayer in relation to a year of income - determine that the whole or a part of the deduction or of the part of the deduction, as the case may be, shall not be allowable to the taxpayer in relation to that year of income;
..."
THE FACTS
6 The facts were not in dispute.
7 Mr and Mrs Hart at all times owned a property at Jerrabomberra in the Australian Capital Territory ("the Jerrabomberra property") in which they resided and which had been acquired with the assistance of a loan from the ANZ Banking Group Ltd ("ANZ"). They wished to purchase a property in Fadden, also in the Territory ("the Fadden property") as a residence in place of the Jerrabomberra property. They proposed that they retain the Jerrabomberra property and rent it out. It was necessary, therefore for them to obtain finance both to repay the mortgage on the Jerrabomberra property and to assist with the purchase of the Fadden property.
8 While they were looking at possible houses for purchase and use as a residence in place of the Jerrabomberra property they obtained from the office of a real estate agent a brochure produced by Austral Mortgage ("Austral") and advertising what the brochure referred to as "Wealth Optimiser". As will be explained in greater detail shortly, Wealth Optimiser was the name given by Austral to a financial product which it was promoting and which was said to be suitable for persons who wished to borrow money to be used both to purchase a residence and an investment property. What was involved was the making of one loan which was split into two parts, the one part relating to the residence and the other to the investment property. A brochure they were given dwelt upon the tax advantages which it was said might accrue to borrowers. Mr and Mrs Hart made enquiries of Austral Mortgage about the product. It was explained to them. In addition they were told of the tax advantages which it was said flowed from it. They were given some documents which explained these tax advantages and sample mathematical calculations showing the consequences of the product when compared with the traditional two loans each of which would be repayable monthly by repayments of principal and interest.
9 They made some enquiries of other lenders, including their own bank (the ANZ Bank), to see if they were offering a similar product. Their Bank Manager advised them the bank had mortgage interest saver accounts that could be linked to a home loan so that the interest on any cash in this account could be used to offset any interest payable on a mortgage loan, but that there would need to be two separate loans. There was perceived by Mr and Mrs Hart to be administrative convenience in having a split loan rather than two separate loans. They made no enquiries of the ANZ Bank as to the monthly repayments required should the ANZ bank make two separate loans to them. They believed, they said, that it would be higher than that required under the Wealth Optimiser product.
10 According to both Mr and Mrs Hart the Wealth Optimiser proposal had the advantage that the amount owing in respect of the home loan would decrease faster than under a standard mortgage loan. However, since the residential property was security for the total monies lent, whether used to refinance the property thereafter to be used for rental or to finance the purchase of a new home, the residential property would remain encumbered until all monies secured had been repaid, unless the lender agreed to reduce the security available.
11 They decided to proceed with the Austral proposal. They received a letter dated 30 August 1996 advising that a "principal and interest" loan of $298,000 to be repaid in full 25 years from the date of settlement and at a variable rate had been approved in principle for the purpose of "purchase & refinance". The document said, inter alia:
"If you ask us to, we will split this amount into a maximum of 2 separate loan accounts. We will calculate interest on each loan account separately and give you a separate statement for each loan account."
12 The current variable interest rate was to be 9.15% per annum, with interest to be calculated daily on the unpaid balance of the loan ("or if applicable on the unpaid balance of each loan account") and was to be debited monthly in arrears. Repayments were to be $2533.00 monthly, but subject to change with variations of the interest rate. The security for the loan was to consist of three properties, the Fadden property, the Jerrabomberra property and another property belonging to Mrs Hart's mother, who was to guarantee the loan.
13 The letter advised that acceptance was to be confirmed by signature of the original of the letter which was to be returned together with fees as notified in the letter.
14 Mr and Mrs Hart signed the acceptance and forwarded it, together with a letter requesting Austral to split the loan account into the two accounts, one for $202,888 and the other for $95,112 with payments made to be allocated all to the first account.
15 In due time Mr and Mrs Hart received a confirmatory letter, referring to the approval letter and setting out the terms of the "Wealth Optimiser" loan. This letter, under the headings "Loan Accounts" and "Effects of Loan accounts" stated:
"Loan AccountsIf you ask us to, we will:
(a) split the Loan Balance into a maximum of four separate Loan Accounts; and
(b) allocate the Loan Balance between those Loan Accounts in accordance with your request.
Effect of Loan Accounts
While the Loan Amount is split into Loan Accounts:
(a) this Agreement applies to each Loan Account as if the balance of each Loan Account was a separate loan made on the same terms and conditions as the loan under this Agreement. For example, interest will be calculated on the balance of each Loan Account and debited to each Loan Account in accordance with clause 8.1; and
(b) provided that we are not entitled to require you to pay the Amount Owing in full immediately ... we will credit all payments received by us under or in connection with this Agreement among the Loan Accounts as requested by you. If you do not make a request, we may credit any such payments as we see fit."
16 Under the heading "Capitalisation of Interest" the letter said:
"On each Payment Date, we will capitalise all interest accrued on the Loan Balance during the immediately preceding Interest Period by debiting your Loan Accounts. Capitalising interest means that interest is added to the amount on which the interest is accruing, and interest then accrues on the total amount."
17 On 8 October 1996 PCL advanced the sum of $298,000 to Mr and Mrs Hart in accordance with the correspondence and on the security contemplated. There was no further request to split the loan accounts. Rather the parties acted upon the original request. Hence $202,888 was the amount to be treated as the principal of Loan Account 1. That amount was applied that day to the acquisition of the Fadden property, plus repayment of moneys that were owed by Mrs Hart's mother to the St George Bank and which had been secured on the Jerrabomberra property. $95,112 was to be the sum to be treated as the principal of Loan Account 2. That amount was applied in repaying monies owed to the Bank by the applicants on the Jerrabomberra property. It might be said here that while some emphasis was placed by the Commissioner on the fact that there was only one advance. In my view nothing turns upon whether there was, in law, one loan or two loans. However, if it matters, I am of the view that as a matter of construction two loans were in fact made totalling in all $298,000. If there was only one loan, the fact that the principal of that one loan was split into two separate loan accounts made on different terms had the same consequence as would have followed had the lender made two loans.
18 Because Mr and Mrs Hart had nominated that their monthly repayments were to be credited to Loan Account 1 no amount of interest was paid by them in the years of income in question on the principal sum owing on Loan Account 2. Thus Loan Account 2 was on each "payment date" debited with the interest payable on the principal of that account. No offsetting credit was made to that account. Interest was debited on Loan Account 1 and was offset by the monthly repayment which was credited to that account. Since the monthly repayment was greater than the interest debited, the capital outstanding on Loan Account 1 diminished monthly. Assuming that this procedure continued as contemplated, the principal of Loan Account 1 would be repaid in approximately 7.39 years. At that time the balance outstanding on Loan Account 2 would have substantially increased as a result of interest on that account being capitalised. The monthly repayments would then be applied against the amount owing on Loan Account 2 until at the end of the 25 year period the whole of Loan Account 2 (the original principal and capitalised interest) would be repaid.
19 In the 1997 year of income the sum of $5,488 accrued due as interest on Loan Account 2 and in the 1998 year of income the sum of $7,385 accrued as interest on the principal and capitalised interest in that account. Of these amounts $67 and $315 for each of Mr and Mrs Hart represented interest on the interest unpaid (referred to in the judgment appealed from as "additional interest" and occasionally as "compound interest") for the 1997 and 1998 years, respectively. For clarity I propose to refer to it as "compound interest" in these reasons. The Commissioner submitted that the compound interest was not allowable as a deduction in each year under s 51(1) of the 1936 Act or s 8-1 of the 1997 Act.
20 The Commissioner, as has already been noted, had made a determination under Part IVA of the Act, which was relied upon assuming that the compound interest amounts were allowable deductions, contrary to the Commissioner's submission. The determination took the view that there was a tax benefit which Mr and Mrs Hart had obtained by virtue of the scheme. That was the difference between the interest which was in fact paid on Loan Account 2 (which included the compound interest) and the interest which would have been payable had there been a separate loan of $95,112 used to repay the money outstanding to the Bank on the Jerrabomberra property repayable over the 25 years with instalments of principal and interest paid monthly. In other words the interest on Loan Account 2, which the Commissioner regarded as being properly an allowable deduction, was the amount of interest which would have been paid had the amount which Mr and Mrs Hart were required to pay monthly under the loan agreement been applied rateably to the Loan Account 1 and Loan Account 2 balances. These interest amounts, treated as being incurred by Mr and Mrs Hart jointly, were respectively $29 and $50. The amount disallowed for each of Mr and Mrs Hart on the assumption Part IVA applied was thus $96 and $365 respectively. These two amounts are referred to in the judgment appealed from as the "further interest".
The Judgment appealed from
21 The learned primary Judge was of the view that, but for Part IVA of the 1936 Act, the whole of the interest which accrued on Loan Account 2, including the compound interest was an allowable deduction to Mr and Mrs Hart under s 51(1) of the 1936 Act or s 8-1 of the 1997 Act in the relevant tax year. The compound interest bore, his Honour said, the same character for taxation purposes as the simple interest which accrued due on that account in the relevant year of income and was capitalised. Each was incurred in gaining or producing Mr and Mrs Harts' assessable income and was deductible.
22 However, his Honour found that Part IVA of the 1936 Act applied. There had been a scheme entered into or carried out. The Commissioner had propounded two alternative schemes - a wider and a narrower scheme. I shall outline each in due course. His Honour in some parts of the reasons appears to have preferred the narrower definition of the scheme, although he expressed the view that the result would be the same whichever way one delineated the scheme. In connection with either scheme Mr and Mrs Hart had, so his Honour held, obtained a tax benefit, being a deduction for interest incurred, part of which would not have been allowable or might reasonably be expected not to be allowed to them if the scheme had not been entered into or carried out. That benefit was the amount attributable to the appropriation of all payments to Loan Account 1 compared with that which would have been attributable if the monthly payments had been apportioned rateably between the two accounts in proportion to the capital balances of each account. Further, his Honour was of the view that having regard to the eight matters in s 177D it would be concluded that one or more of the persons who entered into or carried out either scheme or any part of it (Austral and Mr and Mrs Hart) did so for at least the dominant purpose of Mr and Mrs Hart obtaining the tax benefit. Accordingly the scheme was one to which Part IVA applied. His Honour noted that he was satisfied that there was no commercial rationale for the "arrangements in issue" unless the borrower was able to deduct all the interest incurred (presumably by that his Honour meant the interest incurred on the Part 2 Loan Account as it was never suggested that any of the interest incurred on the Part 1 Loan account was deductible). The particular "shape, form or structure" of the scheme was such that it was fashioned by taxation. Without the taxation benefits the scheme would make no sense, his Honour said. The determination made by the Commissioner under s 177F was, accordingly, properly made and the assessments which issued in the result, were properly issued.
The deductibility of the compound or additional interest
23 It is common ground that interest (hereafter referred to as "ordinary interest") which is incurred on a loan used to purchase income producing assets, will be an allowable deduction. So too will be interest which is incurred on a loan used to refinance a previous loan which had been taken out to acquire a property at a time when the property was for use as a residence and where at a later time, when the property is to be let out the original loan is to be repaid. Hereafter I propose, when discussing the relevant legal principles, to refer to the refinancing transaction as if it were the acquisition of a new rental property, since there is no difference in principle between the two transactions.
24 Ordinary interest may be contrasted with "compound interest" which is the amount of interest computed on any unpaid ordinary interest. It was the Commissioner's submission that the compound interest was not deductible on the facts of the present case. However, the submission went beyond the facts of the present case and it may be said that it was a consequence of at least one way the submission was formulated, that compound interest would never be deductible.
25 Two tests have been proposed to determine the deductibility of interest on monies borrowed to acquire income producing assets. The first looks to the purpose of the borrowing; the second, looks to the use to which the borrowed funds are put. Generally, where interest is borrowed to finance the acquisition of an income producing asset it will make no difference which formulation is used. The result will be the same. The interest will be deductible. This is because the purpose of the borrowing will usually be readily seen from examining the use to which the borrowed funds are put. It is unnecessary, therefore, in the normal case to distinguish between the two tests.
26 The question whether a loss or outgoing is deductible under s 51(1) involves a process of characterisation of the loss or outgoing. It will be necessary to determine the essential character of the loss or outgoing, both in examining whether there exists the necessary connection between the incurring of the outgoing and the gaining of assessable income and also in deciding whether the loss or outgoing has, inter alia, the character of private or domestic expenditure: cf Lunney v Federal Commissioner of Taxation [1958] HCA 5; (1958) 100 CLR 478 see McTiernan J at 478 and Williams, Kitto and Toylor JJ at 497; Handley v Federal Commissioner of Taxation [1981] HCA 16; (1981) 148 CLR 182 see Stephen J at 187, Mason J at 194, Murphy J at 196 Aikin J at 200 and Wilson J at 202; and Federal Commissioner of Taxation v Cooper [1991] FCA 164; (1991) 29 FCR 177 see Lockhart J at 181-182 and Hill J at 201. It has been pointed out in a number of cases, including, for example in Fletcher v Federal Commissioner of Taxation [1991] HCA 42; (1991) 173 CLR 1, the relationship between an outgoing and assessable income, that is to say, the question whether the necessary connection exists between them will ordinarily not be affected by the subjective motivation of a taxpayer. At least where a taxpayer derives assessable income from the use of property the connection is apparent on its face. This will be the case, at least, where the loss or outgoing is not grossly excessive and the transaction is one where the parties are dealing with each other at arm's length: cf Ure v Federal Commissioner of Taxation (1981) 34 ALR 237; Federal Commissioner of Taxation v Phillips [1978] FCA 27; (1978) 20 ALR 607 and Fletcher v Federal Commissioner of Taxation [1991] HCA 42; (1991) 173 CLR 1.
27 Because interest is the cost of borrowing money the connection between the interest and assessable income that is derived or the essential character of the interest outgoing is, as noted above, to be ascertained by looking beyond the loan itself to the use to which the borrowed funds are put: Federal Commissioner of Taxation v Roberts & Smith [1992] FCA 363; (1992) 37 FCR 246. This was the starting point of the Commissioner's submissions and it may be accepted. However, it is submitted here that compound interest differs from ordinary interest in that it is not the price of money used to purchase anything. Compound interest is interest which is charged upon interest which accrues due but is unpaid on a loan. The amount upon which compound interest is charged, that is to say, the borrowed fund or capital upon which it is calculated, is not, so the submission runs, really used at all. It is simply money which has not been paid. The capital upon which the compound interest is calculated is not the fund which was borrowed and used to refinance the rental property. That, so the submission would suggest, is a different fund. The rental property has been purchased with funds the interest accruing on which is an allowable deduction. This different capital under consideration here, (ie the unpaid ordinary interest) can only be explained, it is said, because all interest and capital which is paid per month has been credited against Loan Account 1 (the loan account which was used to acquire the Fadden property). This gives, so it is said, to the compound interest, a private character. Alternatively, it is submitted, the compound interest is incurred in order that the home loan can be repaid faster and so the interest has a private character or is not relevantly connected to the rental income produced by letting the property. These latter submissions may be said to be specific to the facts of the present case. However, to the extent that the submission refers to the fund on which compound interest is charged as not having been outlaid to purchase any income producing asset it must have more general application. The submission amounts to saying that the relationship which exists between the ordinary interest calculated on a fund used to purchase an income producing asset and the rental income that property produces had been lost when one comes to consider compound interest. Hence, when compound interest is incurred there is, so the submission would have it, no relationship to be found between that compound interest and the assessable income by way of rent derived from property acquired by the use of the borrowed funds.
28 There was yet another way in which the argument was put in oral submission. It was said that the compound interest here, was really just a device to obtain an additional tax deduction over and above the interest payable on the fund used to refinance the property which was let out. So, it was submitted, the compound interest lacked the essential character of a deductible outgoing. That was, of course, a submission that was fact specific.
29 In my opinion these submissions, in whichever way they are formulated, are misconceived.
30 There is no reason in principle why there should be any difference between ordinary interest and compound interest. Both are simply the cost of the funds which are borrowed. It is artificial to treat compound interest as the cost of some new fund divorced from the original borrowing. The compounding of interest is no more than a formula for computing the interest to be paid on the funds originally borrowed. Accordingly, as the learned primary Judge held, the compound interest, like the ordinary interest, will take its character from the use to which the original funds borrowed are put.
31 The alternative submission that the compound interest was merely a device to obtain an additional tax deduction would seem to depend upon applying a test which makes deductibility turn upon subjective purpose or motivation of the taxpayer, whether or not that purpose is to be found from the surrounding objective facts. Generally, the question whether or not a taxpayer is motivated, at least in part, to obtain a tax deduction will play no part in determining whether a loss or outgoing incurred is an allowable deduction: see, for example, per Brennan J in Magna Alloys and Research Pty Ltd v Commissioner of Taxation [1980] FCA 150; (1980) 49 FLR 183 at 191. That case raised the question whether a finding that the directors of the taxpayer company had the dominant purpose in making a payment to themselves of protecting their own position precluded the company from deducting the payment made to them. It was held, on appeal, that it did not.
32 However, it can be accepted, at least in the case of a voluntary outgoing that purpose or motivation may play a part in deductibility. The question is not, however, whether a taxpayer had a dominant purpose of obtaining a tax benefit. Rather the test to be applied is one which combines both the objective and the subjective. Deane and Fisher JJ in Magna Alloys at 210 proposed the following test:
"Whether a voluntary outgoing was so incurred [ie necessarily incurred in carrying on a business for the purposes of s 51(1)] depends upon the answer to the composite question ... namely, whether the outgoing was reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of that business and, if so, whether those responsible for carrying on the business so saw it."
33 This formulation, although given in the context of the second limb of the subsection would seem equally apt in the context of the first limb. Hence, it may, in an appropriate case, be necessary to ask whether the outgoing was reasonably capable of being seen as desirable or appropriate from the point of view of gaining or producing the taxpayer's assessable income and if so, whether those responsible for carrying on the income producing activity "so saw it". The fact that the taxpayer had even a dominant purpose of obtaining a tax benefit would not, in my mind, preclude a deduction, so long as the combined test was satisfied. On the other hand, a finding that there was no other purpose of incurring a loss or outgoing than obtaining a tax deduction would.
34 In my view there is nothing in Fletcher v Commissioner of Taxation (Cth) [1991] HCA 42; (1991) 173 CLR 1 at 17-18 which casts doubt on this. Indeed, the decision in that case is consistent with the test in Magna Alloys, although the High Court made no reference directly to Magna Alloys. Fletcher too was a case where a deduction for interest was sought. Under the arrangement it was claimed that the money on which the interest accrued was used to purchase an annuity payable in the future. The arrangement was, on the documentation, but subject to termination earlier, to continue for fifteen years. It was only in the last five years that income would be earned as the annuity fell due for payment. There was provision for redemption of the annuity after the first two years. Interest was payable annually in advance on the money borrowed in the first twelve years. The interest was itself funded by a further loan. Clearly, if the annuity was redeemed and the whole arrangement brought to an end, there would never be any income derived. The effect of the arrangement was that the partnership that was established for the purpose of the arrangement made a substantial loss in each of the first five years, although if the scheme in fact ran its course there would be substantial net income in the final five years. As the full High Court remarked, it was clearly in the interest of the taxpayers to terminate the scheme before the substantial income was derived. The Court discussed the question of the taxpayers' purpose in this context. The judgment points out that ordinarily it is possible to characterise an outgoing as being wholly of the kind referred to in s 51(1) without the need to refer to subjective matters. This is particularly the case where the outgoing gives rise to a larger amount of assessable income. However, the situation could be different where there is no relevant assessable income which can be identified, or where there is a disproportion between the outgoing and the assessable income. In such a case it could be necessary to weigh in a practical and common sense way, the various aspects of the whole circumstances including direct and indirect objects and advantages which the taxpayer sought in making the outgoing.
35 It is significant, however, to note that the High Court remitted the matter to the Administrative Appeals Tribunal to determine whether the contractual arrangements were intended and expected to be terminated, not to determine whether the partnership had a purpose or dominant purpose of obtaining a tax deduction. No doubt, if the parties to the arrangement intended to terminate it before assessable income was derived, then the interest was not incurred in gaining or producing assessable income. If they did not, then the interest would be deductible, even if, subjectively, there had been a dominant purpose in the participants, to obtain a tax deduction.
36 In the present case there is no direct finding by the learned primary Judge as to the subjective state of mind of Mr and Mrs Hart. However, it is clear that the funds in question were borrowed in part for a private and domestic purpose and in part to assist the refinancing of the rental property. The monies were borrowed on terms that included the payment of both ordinary and compound interest. There is no suggestion that the amounts paid were not interest. The combination of the ordinary and the compound interest on Loan Account 2 were together the cost of borrowing money used to refinance the rental property. There is no need, in characterising the interest outgoings to have regard to the taxpayers' subjective state of mind. The objective facts suffice to characterise the compound interest payments, as they characterise the ordinary interest payments as being incurred in gaining or producing assessable income and not as being of a private or domestic kind. In my view the compound interest is, subject to Part IVA of the Act, deductible.
37 Three elements are necessary before there is a scheme to which Part IVA applies. First there must be a scheme as defined. Secondly, the taxpayer must obtain a tax benefit in connection with the scheme. Finally, the scheme must be such that it would be concluded by reference to the eight factors listed in s 177D of the 1936 Act, that the taxpayer or one of the persons who entered into or carried out the scheme or any part of it, did so for at least the dominant purpose of enabling the taxpayer to obtain a tax benefit in connection with the scheme. Once there is a scheme to which Part IVA applies the Commissioner may make a determination and in effect take such steps in the assessment process as would cancel the tax benefit.
38 It is necessary to consider in the present case each of these three elements.
THE SCHEME
39 The Commissioner in his statements of facts, issues and contentions initially formulated his case by reference to what may be referred to as the "wider scheme". He repeated this identification of the scheme in the written submissions made at first instance reproduced in the learned primary Judge's judgment at [29]. The wider scheme so formulated was as follows:
"...the scheme is all the steps leading to and the entering into and the implementation of the loan arrangements between Austral and the applicants, including:(a) the marketing of the `Wealth Optimiser' loan to the applicants;
(b) the splitting of the loan into the home loan portion and the investment loan portion;
(c) the acceptance by Austral of capitalization of interest on the investment loan portion, on the basis that it receives another predetermined amount in reduction of the home loan portion;
(d) the election by the applicants to allocate the whole of the repayments to the home loan portion until that portion of the loan has been paid; and
(e) the consequential incurring of an amount of additional interest and further interest on the investment loan portion."
40 At the hearing below, the Commissioner relied on an alternative definition of the scheme, which may be referred to as the "narrower scheme". As so formulated the narrower scheme was as follows:
"Alternatively, the scheme is said to be the provision in the loan for the division into two portions and the direction of the repayments to one or other portion and the direction by the applicants of the repayments to the home loan portion."
41 The definition of the scheme is very important. Any tax benefit which is identified must have a relationship to the defined scheme and not some other scheme. The conclusion of dominant purpose must be made by reference to the defined scheme, not some other scheme. Any determination made by the Commissioner must, likewise, be made by reference to the defined scheme and not some other scheme.
42 As can be seen from the definition of scheme set out earlier the word "scheme" is widely defined. It may be as wide as a course of conduct or as narrow as a single act. It is, as the High Court made clear in Federal Commissioner of Taxation v Peabody [1994] HCA 43; (1994) 181 CLR 359, for the Commissioner, at least initially, to determine between any narrow or broad definition of scheme and, subject to matters of unfairness, the Commissioner may change his mind. There are, perhaps, however, two qualifications to this. The first is that whatever the Commissioner may put forward as the scheme it must be such that a tax benefit has been obtained in connection with it by the taxpayer. The second, is that the Commissioner could not take a set of circumstances which constituted only part of a scheme if "the circumstances are incapable of standing on their own without being `robbed of all practical meaning'". The words italicised derive from Inland Revenue Commissioners v Brebner [1967] 2 AC 18 at 27 and are quoted by the High Court in Peabody at 383-4. It is not completely clear whether the High Court intended by the quotation merely to adopt the language of the House of Lords in Brebner, or whether they did so by reference as well, to the facts of that case. The legislation under consideration in Brebner was rather different from Part IVA. Be that as it may the case involved an interrelated transaction being both the acquisition of shares with borrowed funds and a corporate reduction in capital, which provided the funds whereby the loan could be repaid. It was held that the Commissioner could not single out the reduction of capital as the relevant transaction divorced from the share acquisition, notwithstanding that the reduction of capital produced an advantageous tax consequence. It was necessary to take the overall transaction for each part of it was interrelated.
43 Perhaps because the alternative or narrow definitions propounded by the Commissioner were somewhat abbreviated, there is some ambiguity in them. On one view the alternative definition appears to ignore the making of the loan and the incurring of interest under it, thus excluding them from being part of the scheme. Indeed, in oral argument, Senior Counsel for the Commissioner appeared prepared to defend a definition of the scheme as excluding the loan and submitted that, however the scheme was defined, Part IVA applied to it on the facts of the present case. It is possible that the learned primary Judge took a similar view.
44 In my view, however, whether a wider or narrower definition of the scheme revealed by the present fact is adopted, it is clear that the definition of a scheme which did not include the loan itself and the incurring of interest under it could not stand on its own feet. It is the loan and the application of funds under it which gives rise to the deduction for interest, even if it is the way the loan is structured that is fastened upon by the Commissioner as indicating the tax avoidance conclusion.
45 While it is clear that it is possible to define the scheme here involved in a way that is narrower than the broader scheme propounded I would find that the relevant scheme was the broader scheme which commenced with the marketing of the "Wealth Optimiser" loan to Mr and Mrs Hart and concluded with the incurring in the years of income in question of interest on Loan Account 1 and the repayment of capital and interest on Loan Account 2.
THE TAX BENEFIT OBTAINED IN CONNECTION WITH THE SCHEME
46 It is clear from the definition of "tax benefit" set out above that in the circumstances of the present case it is necessary to determine what might reasonably have been expected to have happened if the scheme had not been entered into or carried out. As the High Court said in Peabody at 385:
"A reasonable expectation requires more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable for it to be regarded as reasonable."
47 It is submitted by Senior Counsel for Mr and Mrs Hart and indeed, it was accepted by the Commissioner and the learned primary Judge that Mr and Mrs Hart would have proceeded with the borrowing of money to purchase the Fadden property and refinance the Jerrabomberra property. The Commissioner submitted, and the learned primary Judge found, that they would have borrowed on the basis that (whether there was one borrowing or two) the borrowing would be on terms that Mr and Mrs Hart would have made monthly repayments of principal and interest, so that interest would have been spread rateably over the total of the borrowed monies in the proportion that these monies were used to purchase the Fadden property and refinance the Jerrabomberra property. The learned primary Judge referred to such a borrowing as a "credit foncier arrangement". On behalf of Mr and Mrs Hart it was submitted that it could reasonably have been expected that Mr and Mrs Hart would have refinanced the Jerrabomberra property with an interest only loan if they had not proceeded with the Wealth Optimiser finance package.
48 His Honour said that it was more probable than not that any alternative financing would not have included the payment of interest upon capitalised interest upon a loan in relation to the Jerrabomberra property. Subject to substituting the word "incurring" for "payment" this is accepted by counsel for Mr and Mrs Hart. However, it was submitted that the learned primary Judge erred in holding that there was no support in the evidence for holding that Mr and Mrs Hart would have refinanced the Jerrabomberra property with an interest only loan. It is pointed out that his Honour found that one of the alternatives available through the ANZ Bank, that is to say, the bankers for Mr and Mrs Hart, was an interest only loan. However, it is clear that Mr and Mrs Hart did not pursue alternatives open to them, whether through the Bank or other financiers because they were attracted by the Austral package.
49 In my view the evidence does not really allow one to predict on any reasonable basis whether Mr and Mrs Hart would have financed the two transactions which they wished to undertake both by a loan repayable with principal and interest or whether they would have financed the Fadden acquisition with a loan repayable with both principal and interest and the Jerabbomberra refinancing with an interest only loan. There would be advantages and disadvantages of both forms of financing. Given that the onus of showing that the assessment was excessive lies upon the taxpayer it seems to me that the finding made by his Honour should not be disturbed. It was a finding open to him. The difference between the two views is that the view propounded by Senior Counsel for Mr and Mrs Hart would leave the tax benefit in question as confined only to the compound interest - a relatively trivial amount. By contrast, the view of tax benefit propounded by Senior Counsel for the Commissioner would leave the tax benefit as not merely the tax on the compound interest but also the amount of interest representing the difference between the interest payable on the principal sum applied to refinancing Jerrabomberra calculated as if there had been rateable principal and interest payable on that sum and the interest in fact claimed as a deduction.
THE FINDING AS TO DOMINANT PURPOSE
50 The real debate between the parties lies in the question whether his Honour was correct in finding that it would be concluded, having regard to the eight factors in s 177D(1), that both Austral and the Harts entered into and carried out the scheme or any part of it for the dominant purpose of obtaining for Mr and Mrs Hart the tax benefit.
51 The High Court has, in the decisions it has reached to date, clarified some, at least, of the issues which s 177D raises.
52 It is now clear that by dominant purpose is meant the purpose which is "the ruling, prevailing or most influential purpose": Commissioner of Taxation v Spotless Services Ltd [1996] HCA 34; (1996) 186 CLR 404 at 416.
53 While it is necessary for the Judge hearing the matter to consider each of the listed factors in s 177D, it is unnecessary for him or her in the judgment to deal individually with each and a global assessment of purpose will suffice: Commissioner of Taxation v Consolidated Press Holdings Ltd [2001] HCA 32; (2001) 179 ALR 625 at [94]. It may be noted here that his Honour considered each of the listed factors.
54 There is a false dichotomy between obtaining the maximum after tax return on money invested after payment of tax and obtaining a tax benefit as was suggested by the majority of the full Federal Court in Spotless. As the Justices of the High Court (with the exception of McHugh J who delivered a separate judgment) said in Spotless at 415:
"A person may enter into or carry out a scheme, within the meaning of Pt IVA, for the dominant purpose of enabling the relevant taxpayer to obtain a tax benefit where that dominant purpose is consistent with the pursuit of commercial gain in the course of carrying on a business."
55 Further, the task of the Court is not to consider the subjective purpose of a particular person, whether the taxpayer or a person who entered into or carried out a part of the scheme. The purpose in question is to be determined objectively having regard to the eight factors. This is implicit and probably explicit in the judgment of the High Court in Spotless at 423 and the judgment in Consolidated Press at [95]. It is explicit in the judgment of the full Court of this Court in Eastern Nitrogen Ltd v Federal Commissioner of Taxation [2001] FCA 366; 2001 ATC 4164 at 4177 per Carr J, with whom Lee and French JJ agreed.
56 To these principles may be added the proposition that the conclusion which s 177D requires is a conclusion which it is reasonable to draw. So, a conclusion which is merely fanciful or not based on reason would not be a reasonable conclusion: Attorney-General's Department v Cockcroft (1986) 10 FCR 180 at 190 per Bowen CJ and Beaumont J.
57 In Spotless McHugh J, in a separate judgment, noted that the rejection of the dichotomy between seeking a higher after tax profit and the seeking of a tax benefit could cause a problem in future cases. His Honour's comments to this effect (they were not endorsed by the majority in that case, but nor were they rejected) were as follows:
"However, Pt IVA does not authorise the Commissioner to make a determination ... merely because a taxpayer has arranged its business or investments in a way that derives a tax benefit. More is required before the Commissioner of Taxation can lawfully make a determination under that paragraph. First, the scheme must be examined in the light of the eight matters set out in par (b) of s 177D. Second, that examination must give rise to the objective conclusion that the taxpayer or some other person entered into or carried out the scheme or a part of the scheme for the sole or dominant purpose of enabling the taxpayer or the taxpayer and some other person to obtain a tax benefit in connection with the scheme. That conclusion will seldom, if ever, be drawn if no more appears than that a change of business or investment has produced a tax benefit for the taxpayer.The facts of the present case show much more than a switch of investments resulting in a tax benefit. The elaborate nature of the scheme and its attendant circumstances lead inevitably to the conclusion that the scheme was not merely tax driven but that its dominant purpose was to enable the taxpayer to obtain a tax benefit by participating in the scheme."
58 Critical to the judgment below in the present case is the following passage taken from the judgment at [58] and [59] which follows an examination of the authorities to which reference is, but briefly, made above.
"These High Court authorities decide that it is the particular shape, form or structure of the scheme, rather than a general description of the transaction which is under scrutiny. In the present case, to concentrate upon the commercial object or outcome of the transaction as a whole is to focus on a false issue and make the same error as that of the Full Court in Spotless Services. It is appropriate to concentrate upon the narrower scheme propounded by the respondent, explained by reference to the wider transaction. When I consider the matters prescribed by s 177D(b) and, in particular, (i), (ii) and (iv) in the light of the findings I have made, the proper conclusion is that, as Beaumont J held in Spotless Services, without taxation benefits the particular form, shape or structure of this transaction made no sense. To take the words of Hill J at first instance in Consolidated Press ((1998) 88 FCR 21 at 42 (approved by the Full Court of this Court and the High Court):"... a conclusion would be drawn that the dominant purpose ... was to bring about the result that a deduction would be allowed ... which, but for the scheme, would have been disallowed..."
Interest incurred in relation to payment of capital in repayment of a residential loan is not deductible and, if claimed, would be disallowed."
It is to be concluded that at least Austral and those taking the Wealth Optimised Loan entered into the scheme for the purpose of enabling the taxpayer entering the transaction to obtain the tax benefit I have identified. I should say that my view would be the same if the wider scheme propounded by the respondent were adopted, as it is the particular shape, form or structure of the scheme which is to be considered. I should also say that I do not regard Eastern Nitrogen, relied upon by the applicants, as laying down any principle which is contrary to the foregoing, nor do I regard what I have held as inconsistent with the rather delphic remarks of McHugh J in Spotless Services at 425. The respondent was entitled to make the relevant declarations under s 177F(1)."
59 The reference to "shape" presumably derives from the judgment of the majority of the High Court in Spotless. That case involved the deposit at interest of surplus funds with a Cook Islands bank. The steps required to do so were rather cumbersome. Be that as it may, the return on the investment before tax was considerably lower than the pre-tax return available in Australia where the funds had previously been invested. It was argued that the obtaining of a higher after tax return was commercial and not within Part IVA. The High Court pointed out by reference to a decision of the United States Supreme Court in Frank Lyon Co v United States (1978) 435 US 561 at 580 that tax laws affect the shape of nearly every transaction and that the shape of a transaction may not necessarily take only one form and that the adoption of one particular form influenced by tax was only to be expected. Their Honours certainly did not say that it would be an error to take into account the commercial outcome of a transaction, at least where that commercial outcome had nothing to do with tax, or that shape form or structure of a scheme was even the most significant matter to consider under Part IVA. Clearly all relevant circumstances must be considered.
60 It is instructive to compare Eastern Nitrogen and its companion case Federal Commissioner of Taxation v Metal Manufactures Ltd [2001] FCA 365; 2001 ATC 4152 with Spotless. The transaction in the first two cases (there was no significant factual difference for present purposes) involved the taxpayer selling plant affixed to the taxpayer's premises to a financier and then "leasing" the plant back at what can be assumed to be a commercial "rental" at least if calculated by reference to interest on the outstanding money outlaid by the financier. The "form" of the transaction was clearly driven by the fact that assuming the rental was deductible it gave a considerably higher tax deduction than would interest. That was the tax benefit obtained in connection with the scheme. There were, of course, different legal consequences between a loan and the so-called lease. There was some evidence that taking the transaction off balance sheet (ie a loan would be treated as a liability of the company on the balance sheet, the sale and lease back transaction would be differently reported) would make the taxpayer appear more financially sound. That was found to be an important factor. On the other hand it is hard to imagine that the transaction would have been structured in the way it was (where the right of the lender was really a right in equity to enter the premises and remove the plant at the end of the so-called "lease") but for tax. Yet it was held that the scheme was not one to which Part IVA applied. Special leave to appeal this decision was refused by the High Court.
61 Summarising his conclusion on the question of dominant purpose in Eastern Nitrogen Lee J with whom Sundberg J agreed said at [20]:
"I agree ... that the facts do not show that the dominant purpose of the appellant in entering that transaction which provided for the sale and lease-back of assets of the appellant was to obtain a tax benefit. In applying s 177D it is important not to elide the question posed by Pt IVA, namely, what was the dominant purpose of a relevant party in entering the transaction (or scheme) with the inquiry, would the transaction (or scheme) have been entered into `but for' the tax benefit? The dominant purpose of the appellant was to obtain funds on the best available terms for use in the conduct of the appellant's business. The fact that the arrangements entered into to provide the funds included outgoings deductible under the Act was incidental to the purpose, but not the dominant purpose, of the transaction."
62 Carr J, with whose judgment Sundberg J also agreed, concluded that when one balanced all matters a reasonable person would form the view that while tax was important, the ruling, prevailing or most influential purpose was to obtain a very large financial facility on the best terms reasonably available.
63 As I said in the Full Court decision in Peabody [1993] FCA 74; (1993) 40 FCR 531 at 543 (with Ryan and Cooper JJ concurring), in a passage approved by Carr J in Eastern Nitrogen at ATC 4179, regard must be had to each and every one of the matters in s 177D(b), although some might point in the one direction and some in the other. I might also add, as appears from the judgment of the High Court in Spotless that some of the factors, especially, manner, form and substance and perhaps timing will usually be more significant than other factors, but depending upon the particular circumstances of the case. This is not to say that any factor should be weighted more than another.
64 Before embarking briefly on that task, however, I should say that I have great difficulty with the suggestion, made by the learned primary Judge that there was no commercial rationale for what was done without the interest deduction or that it would make no sense otherwise, unless the scheme to which his Honour was directing attention did not include the loan itself. The fact that his Honour made the comment lends weight to the suggestion that his Honour did, indeed, find that the scheme was to be defined in a way that omitted the actually borrowing. It is obvious enough, however, that so long as the scheme is found to include the making of the loan or loans that one of the objectives of the scheme and indeed, an important objective of it, was the financing of the acquisition of the Fadden property and the refinancing of the Jerrabomberra property.
The Manner in which the scheme was entered into or carried out
65 While the scheme did permit the borrowing of monies for the two purposes indicated, one private and the other income producing, the manner in which the scheme was formulated and thus entered into or carried out is certainly explicable only by the taxation consequences. By "manner" here I refer to splitting what might commercially be seen as one advance into the two separate advances with interest on the income producing advance being permitted to remain unpaid, to be capitalised and the capitalised amount then attracting the compound interest with the amount which would otherwise have gone towards payment of that interest being directed towards the repayment of the capital outstanding on the private advance.
Form and substance
66 In substance there was one advance, in form it can be said that there were two. In substance there was one monthly instalment payable. It mattered not to the lender that the monthly instalment went wholly to repayment of the private advance and the interest thereon, save that, if the interest was taken to be derived on a cash basis, rather than an accruals basis the lender might defer the derivation of the interest income as the monthly instalments went to repay the private loan, rather than in part, in paying interest on the income producing loan. To some extent this factor might support the conclusion that the obtaining of the additional tax deduction was the dominant purpose of the scheme.
Timing
67 An example of the case where timing would be most relevant under Part IVA would be a scheme involving a flurry of activity around the end of the tax year directed at obtaining a deduction in that year. In my view, this is a neutral factor. Timing does not, in my view, seem a factor pointing in any direction in the present circumstances.
Result in relation to the Act
68 Clearly the scheme brings about the obtaining of a tax deduction for a greater amount of interest than would otherwise be available.
Changes in financial position- the Harts, PCL and Austral and other consequences
69 As a result of the scheme Mr and Mrs Hart obtained the funds to permit the purchase of the Fadden property and the refinancing of the Jerrabomberra property. They discharged a liability to the ANZ Bank over the Jerrabomberra property in the sum of $95,112 and acquired an asset, namely the Fadden property which was security for the funds advanced by PCL. PCL in its turn received interest. The Bank as mortgagee of the Jerrabomberra property was repaid. There was a slight impact on Mrs Hart's mother who was involved in giving a third party mortgage and guarantee to secure the borrowed funds. It may have been the case that PCL received a marginally higher interest rate than it might otherwise charge, but there is no finding to that effect. The evidence on this matter is somewhat scant. There is no suggestion that the interest rate was other than a commercial rate. Mr and Mrs Hart paid off the home loan faster than they otherwise would. Unless there was a renegotiation in the future, however, the home would continue as security for the Jerrabomberra refinancing. The Harts, so his Honour found, believed that the ANZ Bank would require greater regular repayments whether it made two loans to be repayable with regular principal and interest payments or two loans, one of which would be an interest only loan. However, they did not, in fact, make any enquiries whether this was in fact the case and there was no finding of fact that it was.
70 None of the facts set out above under this heading would suggest the additional deduction as the dominant purpose of any relevant person. Rather they point the other way.
The nature of any connection between the taxpayers and other relevant persons
71 All the parties to the transactions were dealing with each other at arms' length. There was no connection other than a business transaction existing. The factor is neutral.
The Conclusion to be reached
72 It can be seen that what is here involved is a weighing up of the transaction's commercial side - the financing and refinancing to permit the purchase of the Fadden property and the retention for income producing purposes of the Jerrabomberra property on the one hand and the income tax advantage brought about by the making of the loan in respect of the Jerrabomberra refinancing on terms that no repayments of principal or interest would be made upon it until the principal and interest on that part of the loan used to acquire the Fadden property had been wholly repaid. Nothing turns in my view, as I have already said, on whether the transaction is to be characterised as one loan or two. Indeed counsel for the Commissioner conceded that the same result would generally follow (subject of course to the facts) where a loan is made with the principal only repayable together with accumulated interest, at the end of the loan. Nor can the conclusion differ depending upon whether the loan is made and subsequently there is an election to apply the monthly repayments solely to the Fadden loan or whether the loan is made on terms that this is what is to happen. Should it matter, although the documentation provided for the election to be made after the loan had been made, in fact it had been made before and in the circumstances, the agreement between borrower and lender can be taken to be that the loan would be made on the basis that the election would be exercised.
73 There is no doubt that the Harts were aware of and wanted the tax deductions that were available for interest that was incurred on the Fadden loan. Others involved were similarly aware, and so far as they had any particular purpose in entering into or carrying out any part of the scheme, they played their part in ensuring that all the advantages of the scheme would be obtained. However, with all respect to his Honour, I do not think that a reasonable person would conclude that any person entered into or carried out the scheme or any part of it with the dominant purpose of ensuring that Mr and Mrs Hart merely obtained a higher deduction for interest. On any view of the matter the dominant purpose of the scheme which included the borrowing by the Harts of funds used to finance and refinance the two properties was the obtaining of funds to permit them to do so. In my view the present case is similar to Eastern Nitrogen and distinguishable from Spotless. The scheme was directed to a commercial end, the borrowing of money for use in financing and refinancing the two properties. That is what a reasonable person would conclude was the ruling, prevailing or most influential purpose of the Harts in entering into or carrying out the scheme. Where the facts in Spotless required the opposite conclusion was that the scheme, identified by the High Court as involving the investment of money with the Cook Island Banks by the taking of the steps identified, was not commercial for the simple reason that the interest obtained on those funds was very considerably less than the interest that could be derived by deposits in Australia. It might be added that the conclusion is even more obvious once it is realised that, on the facts of that case, the money in question was taken off deposit in Australia where in fact a higher commercial and higher tax rate was earned and sent to the Cook Island where a lower interest and lower tax rate was obtained. There could be no conclusion but that reached by Beaumont J in this Court and the full High Court on appeal, namely that a reasonable person would conclude that what was done was done to obtain the tax benefit, namely the exemption from Australian income tax of the interest income as a result of the now repealed s 23(q) of the 1936 Act.
74 In my view the appeal should be allowed with costs.
I certify that the preceding seventy-four (74) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Hill. |
Associate:
Dated: 26 July 2002
IN THE FEDERAL COURT OF AUSTRALIA |
|
NEW SOUTH WALES DISTRICT REGISTRY |
N 1615 OF 2001 |
BETWEEN: |
TRUDY AMANDA HART FIRST APPELLANT RICHARD MERALLES HART SECOND APPELLANT |
AND: |
COMMISSIONER OF TAXATION RESPONDENT |
JUDGES: |
HILL, HELY & CONTI JJ |
DATE: |
26 JULY 2002 |
PLACE: |
SYDNEY |
HELY J
75 I have had the advantage of reading, in draft form, Hill J's reasons for judgment. I agree with his Honour's reasons for concluding that compound interest is deductible under s 51(1) of the 1936 Act. Compound interest, like ordinary interest, is simply a cost of the funds which are borrowed. Accordingly, compound interest, like ordinary interest, will take its character from the use to which the original funds borrowed are put.
76 I also agree with Hill J's conclusions in relation to Part IVA, but I wish to make the following observations in relation to dominant purpose. At the relevant time, Austral marketed both the "Wealth Optimiser" loan facility, as well as a "Standard" loan package. The features of the "Wealth Optimiser" facility are described by Hill J. Under the "Standard" loan package, the home loan and the investment loan were effected by two separate loan contracts, with monthly repayments being applied in reduction of principal and interest owing in relation to each loan. In the jargon of the industry the "Standard" loan package was a "credit foncier" loan.
77 The "Wealth Optimiser" loan facility was marketed by Austral as a tax effective product. The monthly repayments were approximately the same as those payable in the case of a "Standard" loan package. But Austral represented that the borrower could obtain deductible interest and tax savings much greater than those to which the borrower would have been entitled had the borrowing been made on the terms of the "Standard" loan package. A brochure which was given to the appellants drew attention to the tax advantages which it was said might accrue to the appellants in consequence of the adoption of the "Wealth Optimiser" structure.
78 The substance and effect of the "Wealth Optimiser" loan facility was that the appellants incurred less (non-deductible) interest in relation to Loan Account 1, and more (deductible) interest in relation to Loan Account 2, than they otherwise might have incurred had they entered into some other financing arrangement.
79 It is clear that the explanation for the "Wealth Optimiser" structure, as distinct from a credit foncier type structure, was tax considerations. The division of the loan into two parts, with all repayments being applied initially in reduction of Loan Account 1, with interest on Loan Account 2 being capitalised, was undertaken with a view to securing a greater tax benefit to the borrowers than would have been available had the borrowing been effected on the basis of the "Standard" loan package. These features of the "Wealth Optimiser" structure are explicable only by the anticipated taxation consequences. That is so even though those features result in Loan Account 1 being repaid much more quickly than would be the case with a credit foncier loan. Tax considerations aside, the earlier repayment of Loan Account 1 was of no practical benefit to the borrowers, as their home remained as security for the repayment of Loan Account 2 notwithstanding the repayment of Loan Account 1.
80 There is an obvious and legitimate commercial objective which was sought to be achieved by the borrowing of monies on the terms of the "Wealth Optimiser" facility, as well as the anticipated tax benefit. It may be accepted that one purpose of taking up the "Wealth Optimiser" loan offer in preference to the Austral "Standard" loan package, or some other form of financing, was the achievement of the tax benefit expected to be generated by use of the "Wealth Optimiser" structure. But it does not necessarily follow from that fact that the dominant purpose of the borrowing on the terms of the "Wealth Optimiser" facility was the achievement of a tax benefit.
81 A particular course of action may be both tax driven, and bear the character of a rational commercial decision. The presence of the latter characteristic does not determine in favour of the taxpayer whether, within the meaning of Part IVA, a person entered into or carried out a "scheme" for the dominant purpose of enabling a taxpayer to obtain a tax benefit: Federal Commissioner of Taxation v Spotless Services Ltd [1996] HCA 34; (1996) 186 CLR 404 at 416. But nor does the fact that a taxpayer adopted one of two or more alternative courses of action, being the one that produces a tax benefit, determine the answer to that question in favour of the Commissioner: Metal Manufactures Ltd v Federal Commissioner of Taxation 99 ATC 5229 at 5275 per Emmett J (on appeal [2001] FCA 365; (2001) 108 FCR 150); Spotless (supra) at 425 per McHugh J; Inland Revenue Commissioners v Brebner [1967] 2 AC 18 at 30, per Lord Upjohn.
82 In construing Part IVA, it is appropriate to bear in mind, as an interpretative aid, the Treasurer's statement in his second reading speech at the time of the Bill for the introduction of Part IVA into the Act, when the Treasurer stated:
"We are acutely aware that the term `tax avoidance' means different things to different people.Reasonable men and women are bound to differ on this crucial question and on the subsidiary matter of the appropriate tests for determining what behaviour a general anti-avoidance provision ought to prescribe. The proposed provisions - embodied in a new Part IVA of the Income Tax Assessment Act - seek to give effect to a policy that such measures ought to strike down blatant, artificial or contrived arrangements, but not cast unnecessary inhibitions on normal commercial transactions by which taxpayers legitimately take advantage of opportunities available for the arrangement of their affairs ... Some writers on the subject suggest that tax avoidance involves conduct entered into for the sole or dominant purpose of obtaining a particular tax advantage.
That description could be expected to cover the types of tax avoidance that, again using the language of social or political debate, are blatant, artificial or contrived, and which are indeed intended to be covered by this Bill.
But it is also apt to describe other arrangements, including some family arrangements, which are beyond the appropriate scope of general anti-avoidance measures and ought, if need be, to be dealt with by specific measures.
In order to confine the scope of the proposed provisions to schemes of the `blatant' or `paper' variety, the measures in this Bill are expressed so as to render ineffective a scheme whereby a tax benefit is obtained and an objective examination, having regard to the scheme itself and to its surrounding circumstances and practicable results, leads to the conclusion that the scheme was entered into for the sole or dominant purpose of obtaining a tax benefit."
83 However, the decision in Spotless makes it clear that Part IVA can apply to real commercial transactions. Where the line is to be drawn is a matter of degree, having regard to the eight factors itemised in s 177D. The primary Judge found [at 58]:
"... without taxation benefits the particular form, shape or structure of this transaction made no sense."
That finding, with which I respectfully agree, simply reflects the fact that the explanation for the "Wealth Optimiser" structure, as distinct from a credit foncier type structure, was tax considerations. It is a relevant, but not necessarily decisive, factor in determining whether there was a scheme to which Part IVA applies.
84 "Scheme" is defined in s 177A in very broad terms, including a plan or proposal, without any pejorative innuendo or connotation of tax avoidance. Whether a scheme is one to which Part IVA applies is to be determined by reference to s 177D.
85 The definition of the relevant "scheme" is important for the reasons which have been explained by Hill J. The more the scheme can be confined to the essential elements by which the tax benefit is obtained, the more likely it will be that the conclusion will be drawn that the dominant purpose for a person entering into a scheme so defined was to obtain the tax benefit.
86 Thus, if in the present case the "scheme" were defined as the "plan, proposal, action or course of conduct" whereby monies were borrowed on the terms of the "Wealth Optimiser" structure, rather than on the terms of the "Standard" loan package, or some other form of financing, then it might be easy to conclude that the dominant purpose of entering into the scheme so defined was to obtain a tax benefit in connection with the scheme.
87 That is, I think, the approach which was taken by the primary Judge. But that approach effectively leaves out of account the fact that the "scheme" necessarily included the borrowing of moneys for use in financing and refinancing the two properties. I say "necessarily" because Federal Commissioner of Taxation v Peabody [1994] HCA 43; (1993-1994) 181 CLR 359 at 383-384 establishes that the relevant scheme cannot be so narrowly defined as to rob it of its practical context.
88 I agree with Hill J that the relevant "scheme" was the borrowing of money for use in financing and refinancing the two properties on the terms of the "Wealth Optimiser" loan facility. I also agree with Hill J that the dominant purpose of the scheme was to secure the acquisition or retention of the properties, rather than the tax benefit.
89 I therefore agree that the appeal should be upheld.
I certify that the preceding fifteen (15) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Hely. |
Associate:
Dated: 26 July 2002
IN THE FEDERAL COURT OF AUSTRALIA |
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NEW SOUTH WALES DISTRICT REGISTRY |
N 1615 OF 2001 |
BETWEEN: |
TRUDY AMANDA HART FIRST APPELLANT RICHARD MERALLES HART SECOND APPELLANT |
AND: |
COMMISSIONER OF TAXATION RESPONDENT |
JUDGES: |
HILL, HELY & CONTI JJ |
DATE: |
26 JULY 2002 |
PLACE: |
SYDNEY |
CONTI J
90 I have had the advantage of reading the reasons for judgment of Hill and Hely JJ. As with Hely J, I am fully in accord with the reasons of Hill J for concluding that the compound interest incurred was deductible under subs 51(1) of the 1936 Act, being reasons which I consider to be essentially in line with those of Gyles J at first instance. The primary judge recorded, incidentally, that it may well be that by some future point in time, compound interest on Loan Account 2 will exceed the rental income for the time being to be derived from the Jerrabomberra property, being a circumstance which did not affect in principle his Honour's conclusion upon the subs 51(1) deductibility issue.
91 Hill J has acknowledged in his reasons for judgment that "... the manner in which the scheme was formulated and thus entered into or carried out is certainly explicable only by the taxation consequences" (referring thereby to the test the subject of sub-paragraph 177D(b)(i) of Part IVA), and further that "[c]learly the scheme brings about the obtaining of a tax deduction for a greater amount of interest than would otherwise be available" (referring thereby to the test the subject of sub-paragraph 177D(b)(iv) of Part IVA). Nevertheless his Honour has found that after taking into account the remaining tests the subject of paragraph 177D(b) of Part IVA, and the extent of evidence bearing upon the same in the proceedings, the dominant purpose of the appellants in taking up the "Wealth Optimiser" finance package was the obtaining of loan funds to permit them to finance and refinance the two properties upon the terms and conditions of that package.
92 Hely J has reached the same conclusion, after accepting the finding of the primary judge that without the taxation benefits, the particular form, shape or structure of this borrowing transaction made "no sense", given however that the explanation for the adoption of that structure was tax considerations not present in the alternative credit foncier loan structure which was also available to the appellants had they so wished. His Honour has thereafter pointed out to the effect that the transaction did "make sense", once regard was paid to the circumstance that the dominant purpose of the appellants to be inferred was the borrowing of money for use in the financing and refinancing of the two properties.
93 In reaching their respective conclusions, both Hill and Hely JJ identified and applied the approach taken by Full Courts in Eastern Nitrogen Ltd v Federal Commissioner of Taxation [2001] FCA 366; (2001) 108 FCR 27; 2001 ATC 4164 and in Federal Commissioner of Taxation v Metal Manufactures Ltd [2001] FCA 365; (2001) 108 FCR 150; 2001 ATC 4152, where the adoption by business enterprises of lease finance transactions instead of money lending transactions in the traditional sense was found to fall outside of the operation of Part IVA, upon the basis that although one of the purposes of the taxpayer in each case was to obtain a tax benefit, the prevailing or most influential purpose of each taxpayer was to obtain a large financial facility on the best terms reasonably available.
94 I agree with the approach and reasoning of Hill and Hely JJ on the Part IVA issue, and would merely add that whilst there was no provision made by the security arrangements for release of the proposed new family home from the lender's security immediately upon repayment in full of Loan Account 1, nevertheless as the primary judge pointed out, the prospect of future release, as a result of negotiation undertaken after such repayment in full, could not be ruled out of consideration in the context of the Part IVA issue, in the light of the generality of sub-paragraph 177D(b)(vii) of the Act reading as follows:
"...any other consequence for the relevant taxpayer, or for any person referred to in sub-paragraph (vi), of the scheme having been entered into or carried out."
95 I therefore agree that the taxpayers' appeal should be upheld.
I certify that the preceding six (6) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Conti. |
Associate:
Dated: 26 July 2002
Counsel for the Appellants: |
R Edmonds SC |
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Solicitor for the Appellants: |
Gadens Lawyers |
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Counsel for the Respondent: |
B Shaw QC with J Davies |
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Solicitor for the Respondent: |
Australian Government Solicitor |
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Date of Hearing: |
8 May 2002 |
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Date of Judgment: |
26 July 2002 |
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URL: http://www.austlii.edu.au/au/cases/cth/FCAFC/2002/222.html