Warren v Federal Commissioner of Taxation [1959] HCA 36; (1959) 101 CLR 162 (19 August 1959)

HIGH COURT OF AUSTRALIA

WARREN v. FEDERAL COMMISSIONER OF TAXATION [1959] HCA 36; (1959) 101 CLR 162

Income Tax (Cth.)

High Court of Australia
Taylor J.(1)

CATCHWORDS

Income Tax (Cth.) - Assessable income - Dividends - Exclusion of those paid wholly and exclusively out of profits arising from revaluation of assets not acquired for resale at profit if satisfied by issue of shares of company declaring dividend - Sale of revalued assets before payment of dividend by share issue - Exclusion of amount of dividend from assessable income not thereby lost - Income Tax and Social Services Contribution Assessment Act 1936-1957, s. 44 (2) (b) (iii).*

HEARING

Perth, 1959, July 8, 9;
Sydney, 1959, August 19. 19:8:1959
APPEAL under the Income Tax and Social Services Contribution Assessment Act 1936-1957.

DECISION

August 19.
The following written judgment was delivered:-
TAYLOR J. During the income year ended 30th June 1957 the appellant was a carrying on business in Western Australia, and in that year 5,500 ordinary shares of one pound each in the capital of the company were issued to her pursuant to a special resolution in the following terms: - "That of the profits standing to the credit of 'General Reserve Account' in the books of the company and being profits arising from the revaluation of assets not acquired for the purpose of resale at a profit the sum of 21,501 pounds be capitalised and applied in paying up in full 21,501 unissued shares of One Pound (1 pound) in the capital of the company and that such shares be then issued as fully paid ordinary shares and allotted and distributed among the holders of ordinary shares in the company as at the date of this resolution in the proportions to which they would have been entitled to share in such profits if the same had been distributed by way of dividend on ordinary shares". In assessing the appellant to tax in respect of the relevant year of income the respondent treated these shares as income and increased her taxable income by the addition of an amount of 5,500 pounds. To this assessment the appellant objected and her objection having been disallowed she now brings an appeal to this Court pursuant to s. 187 of the Income Tax and Social Services Contribution Assessment Act 1936-1957. (at p164)

2. The evidence shows that between 1950 and 1953 the company decided to revalue certain of its properties. Details of these properties and of the steps taken from time to time are as follows. (at p164)

3. King Street Property: The freehold of this property was purchased by the company in 1928 for use as its headquarters in Perth and it is still used by the company for that purpose. The cost of the property to the company was approximately 9,965 pounds and this was the figure at which it stood in the company's book of account until it was revalued in 1950. In that year the directors, after having made enquiries in the course of a survey of the company's assets, formed the opinion that a conservative value of the property was 25,000 pounds and they decided to revalue the property at that amount. Thereupon, in pursuance of their directions, the King Street property account was debited with an amount of 15,035 pounds and a "General Reserve Account" was created and credited with a like sum. The effect of this in the company's books was to increase the book value of this property to 25,000 pounds. (at p164)

4. Mosman Park Land: In the year 1943 the company purchased a block of land in the Mosman Park area near Perth for the sum of 225 pounds. The land was purchased for future use in connection with the company's activities and in 1950, when the King Street property was revalued, it was decided also to revalue this land. It was revalued at 1,725 pounds and the necessary book entries were made including a transfer to the General Reserve Account of an amount of 1,500 pounds. Later, in 1953, when the locality in which the land was situated became rapidly transformed into a residential area the land was again revalued. It was found that it had greatly increased in value and it was revalued at the sum of 6,725 pounds. Upon revaluation further appropriate book entries were made and an amount of 5,000 pounds carried to the General Reserve Account. The transformation of the locality into a residential area meant that the land was no longer suitable for the purposes for which the company had purchased it and it was then decided to sell it. Late in 1953 it was sold at auction for the sum of 6,816 pounds. (at p164)

5. Fremantle Store Leasehold: On the formation of the company in 1925 it took over from the partnership of Burridge and Warren a store on leasehold land at Fremantle. The cost to the company was 700 pounds and the building on the land stood in the company's books at this figure for many years. In August 1951 it was revalued by a valuer at the request of the company and he assessed the value at 4,735 pounds. The value of the property in the company's books was brought into line with this valuation, 4,010 pounds being debited to the Fremantle Store Property Account whilst a capital profit of 4,010 pounds was credited to the General Reserve Account. In 1952, however, the lessor terminated the lease of the land and purchased the building upon the land for the sum of 4,000 pounds. At that time the value of the property in the company's books was 4,718 pounds, and the book loss on the sale was met by appropriating the sum of 718 pounds from the General Reserve Account. (at p165)

6. Fremantle Freehold Land: When it appeared that it was possible that the company's leasehold interest at Fremantle might be terminated it was decided to purchase freehold land in Freemantle on which a store could, if necessary, be erected. Accordingly a parcel of land was purchased in August 1951 for 2,529 pounds. Two years later it appeared that the values of land in the vicinity had increased and the land was revalued at the sum of 4,500 pounds. Effect to this revaluation was given by writing up the book value of the land by approximately 1,970 pounds and by crediting that amount to the General Reserve Account. (at p165)

7. As at 30th June 1954 the "General Reserve Account" consisted entirely of the amounts transferred to it in the manner already mentioned and the total amount standing to its credit, after making provision for the appropriation of 718 pounds to offset the book loss made on the sale of the Fremantle store, was 26,797 pounds. The situation remained otherwise unchanged until 31st January 1957 when the special resolution previously referred to was passed by the company and the shares in question were, pursuant to that resolution, allotted to the appellant. The issue of these shares constituted a dividend to the appellant within the meaning of the Act and the question for determination therefore is, in effect, whether the consideration for the shares issued to the appellant was wholly and exclusively satisfied out of profits arising from the revaluation of assets of the company not acquired for the purpose of resale at a profit (s. 44 (2) (b) (iii)). (at p165)

8. Upon the argument presented on the appeal the critical features in the case are the termination in 1952 of the company's leasehold interest at Fremantle together with the sale of its interest in the building erected on the subject land and the sale of the Mosman Park land in 1953. Each of these events, it will be observed, took place sometime before the resolution which authorised the issue of bonus shares and the respondent relies upon this circumstance to assert that the appellant cannot bring herself within the provisions of s. 44 (2) (b) (iii). But it is conceded that if these events had not taken place and if the company had continued to hold its interests in these properties there would be no question concerning the applicability of that provision. The substance of the respondent's argument was that once the company had sold its store at Fremantle and its land at Mosman Park it could no longer maintain that it held in reserve profits disclosed by the earlier revaluations of these assets. Thereafter, it was said, it no longer held its interests in those assets but, in lieu thereof, the proceeds of sale and, in those circumstances, it was asserted that the question whether it held capital profits available for distribution could no longer be determined merely by having regard to the estimated and unrealised profits disclosed by the revaluations which had, earlier, taken place. In other words, it then has a realised profit on each property or none at all and, that being so, the appellant was not in a position to maintain that the consideration for her shares had wholly and exclusively been provided out of "profits arising" from the revaluations. (at p166)

9. In my view this line of argument is based upon a misconception of the true character of s. 44 (2) (b) (iii). In terms the relevant portion of that sub-section provides that "the assessable income of a shareholder shall not include dividends . . . paid wholly and exclusively out of . . . profits arising from the re-valuation of assets not acquired for the purpose of resale at a profit . . . if the dividends paid from such profits are satisfied by the issue of shares of the company declaring the dividend". But it is apparent that the revaluation of assets does not create profits or cause them to arise (see Dickson v. Federal Commissioner of Taxation [1939] HCA 42; (1940) 62 CLR 687 ; Commissioner of Taxation (N.S.W.) v. Hardie Investments Pty. Ltd. [1946] HCA 56; (1946) 73 CLR 490 ; and Commissioner of Taxation v. Henry (1941) 41 SR (NSW) 185; 58 WN 193 ). When it appears upon revaluation that an asset is worth more than its pre-existing book value the effect of the revaluation is, merely, to disclose or reveal the existence of a capital profit. It is, of course, a book profit and not a realised profit and this is a material circumstance when we come to consider the significance of the expression "paid . . . out of profits arising from the re-valuation". Clearly enough the sub-section does not contemplate a payment physically made out of a tangible fund and one must bear in mind the distinction so clearly and simply drawn by Lord Greene M.R. in Allchin v. Coulthard (1942) 2 KB 228 : "The words 'payment out of' when used in connection with the word 'fund' in its first meaning connote actual payment, e.g. by taking the money out of the drawer or drawing a cheque on the bank. When used in connection with the word 'fund' in its second meaning they connote that, for the purposes of the account in which the fund finds a place, the payment is debited to that fund, an operation which, of course, has no relation to the actual method of payment or the particular cash resources out of which the payment is made. Thus, if a company makes a payment out of its reserve fund - an example of the second meaning of the word 'fund' - the actual payment is made by cheque drawn on the company's banking account, the money in which may have been derived from a number of sources. The phrase 'reserve fund' only has a meaning as indicating the item in the company's accounts to which it decides to debit the payment. It will be seen, therefore, that to speak of an actual payment being made out of a fund in the second sense is really a misuse of language. A fund in the second sense is merely an accountancy category. It has a real existence in that sense, but not in the sense that a real payment can be made out of it as distinct from being debited to it. Unless these two meanings of the phrase 'payment out of a fund' are kept distinct, much confusion of thought must ensue" (1942) 2 KB, at pp 234, 235 . It is in the secondary sense that s. 44 (2) (b) (iii) refers to a payment out of profits arising on revaluation and the sub-section, therefore, recognises that a fund, in the same sense, may be created by the appropriation or segregation of such profits. So understood the provision gives countenance to well-established accountancy practice and recognises that funds in this sense may be created for the purposes of the company concerned. This means, so far as s. 44 (2) (b) (iii) is concerned, that where capital profits accrue to a company and are disclosed by a revaluation of assets not acquired for resale at a profit, the profit may be carried to the credit of a separate fund at such time or times as the company thinks will best meet its needs or serve its purposes. The result is that the sub-section must be taken to acknowledge that once profits have been revealed by a revaluation at some particular time and they have been set aside by the creation of a so-called fund, the fund will not cease to exist merely by reason of the subsequent sale or depreciation, by damage or otherwise, of the revalued assets. This means perhaps no more and no less than that a company may for accounting purposes take and segregate its capital profits disclosed by revaluation as and when it wishes and that once they are taken and segregated then for accounting purposes they will remain available for the use of the company unless and until they have been expended. Once it is seen that over a particular period profits of this character have been made and that they have been taken and set aside the subsequent loss of the revalued asset does not require or justify the conclusion that profits were not made earlier or that the fund created by the appropriation has ceased to exist. Perhaps one may ask what the proper conclusion would be if the facts in the present case showed that instead of selling its Fremantle store and its Mosman Park land the former had been destroyed by fire and the company had made a gift of the latter to some charitable organization. Clearly enough, I should think the conclusion would be that neither event could operate to deplete the existing fund. Having regard to the relevant provisions of the sub-section and their true character I am of the opinion that the fact that the company sold these assets before issuing the shares in question did not result in the appellant being exposed to liability under the Act. The appeal will, therefore, be allowed and the assessment set aside. (at p168)

ORDER

Appeal allowed. Assessment set aside. Respondent to pay appellant's costs of appeal.