FEDERAL COURT OF AUSTRALIA Commissioner of Taxation v R & D Holdings Pty Limited [2007] FCAFC 107 INCOME TAX – claims by RD for transferred losses of its wholly owned subsidiary CR for 1997, 1998 and 1999 tax years – CR owner of tenanted office building subject to mortgage – default by CR – mortgagee enters into possession – very large accumulation of interest liability – for 1998 and 1999 years change in beneficial ownership of RD – CR required to satisfy "same business" test for RD to deduct losses for those years Held: 1. CR entitled to allowable deduction for excess of interest over rental income in each year; 2. CR not carrying on same business for 1997 and 1998 years and thus CR losses not allowable deductions for RD; 3. No error in primary judge's upholding of penalties. Income Tax Assessment Act 1936 (Cth) ss 51(1), 80G, 226H, 226K, 222C(1) Income Tax Assessment Act 1997 (Cth) ss 8-1, 165-13, 165-210 Real Property Act 1900 (NSW) ss 57, 63(1) Avondale Motors (Parts) Pty Ltd v Commissioner of Taxation of the Commonwealth of Australia(1971) 124 CLR 97 cited BRK (Brisbane) Pty Ltd v Commissioner of Taxation (2001) 46 ATR 347approved Commissioner of Taxation (Cth) v Citylink Melbourne Ltd (2006) 288 ALR 301 cited Commissioner of Taxation (Cth) v Riverside Road Lodge Pty Ltd (In liq) (1990) 23 FCR 305discussed Commissioner of Taxation v Munro (1926) 38 CLR 153 cited Deputy Commissioner of Taxation (Vic) v General Credits Ltd [1988] VR 571 applied Federal Commissioner of Taxation v Brown (1999) 43 ATR 1 followed Federal Commissioner of Taxation v James Flood Pty Ltd (1953) 88 CLR 492 cited Federal Commissioner of Taxation v Jones (2002) 117 FCR 95 followed Federal Commissioner of Taxation v Murray (1998) 193 CLR 605 cited Federal Commissioner of Taxation v Total Holdings (Aust) Pty Ltd 79 ATC 4279 cited Fletcher v Commissioner of Taxation of the Commonwealth of Australia (1991) 173 CLR 1cited Forsyth v Blundell (1973) 129 CLR 477cited Guest v Commissioner of Taxation 2007 ATC 4265 referred to Gurfinkel v Bentley Proprietary Limited (1966) 116 CLR 98cited Hart v Commissioner of Taxation (2002) 121 FCR 206 cited Kennedy v De Trafford [1897] AC 180 cited Kennedy v General Credits Limited (1982) 2 BPR 9456discussed Latec Investments Limited v Hotel Terrigal Pty Limited (in liq) (1965) 113 CLR 265 cited Placer Pacific Management Pty Ltd v Federal Commissioner of Taxation 95 ATC 4459 followed Pollard v Director of Public Prosecutions (1992) 28 NSWLR 659 cited Pridecraft Pty Ltd v Federal Commissioner of Taxation (2005) 213 ALR 450 followed Quennell v Maltby [1979] 1 WLR 318 cited R v McKinnon [1959] 1 QB 150 cited Rowe v Wood (1822) 2 Jac & W 553 considered Salt v Marquess of Northampton [1892] AC 1 applied Steele v Federal Commissioner of Taxation (1999) 197 CLR 459 cited Stern v McArthur (1988) 81 ALR 463cited Walstern v Commissioner of Taxation (2003) 138 FCR 1 followed Wragg v Denham (1836) 2 Y&C Ex 117 considered COMMISSIONER OF TAXATION v R & D HOLDINGS PTY LTD NSD 1790 OF 2006 R & D HOLDINGS PTY LIMITED v DEPUTY COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA NSD 1798 AND 1799 OF 2006 HEEREY, STONE & EDMONDS JJ 13 JULY 2007 SYDNEY IN THE FEDERAL COURT OF AUSTRALIA NEW SOUTH WALES DISTRICT REGISTRY NSD 1790 OF 2006 ON APPEAL FROM A SINGLE JUDGE OF THE FEDERAL COURT OF AUSTRALIA BETWEEN: COMMISSIONER OF TAXATION Appellant AND: R & D HOLDINGS PTY LIMITED Respondent NSD 1799 OF 2006 NSD 1798 OF 2006 BETWEEN: R & D HOLDINGS PTY LIMITED Appellant AND: DEPUTY COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Respondent JUDGES: HEEREY, STONE & EDMONDS JJ DATE OF ORDER: 13 jULY 2007 WHERE MADE: SYDNEY THE COURT ORDERS THAT: All appeals are dismissed. Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules. IN THE FEDERAL COURT OF AUSTRALIA DISTRICT REGISTRY NSD 1790 OF 2006 ON APPEAL FROM A SINGLE JUDGE OF THE FEDERAL COURT OF AUSTRALIA BETWEEN: COMMISsIONER OF TAXATION Appellant AND: R & D HOLDINGS PTY LIMITED Respondent NSD 1799 OF 2006 NSD 1798 OF 2006 BETWEEN: R & D HOLDINGS PTY LIMITED ACN 003 077 665 Appellant AND: DEPUTY COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Respondent JUDGES: HEEREY, STONE & EDMONDS JJ DATE: 13 July 2007 PLACE: SYDNEY REASONS FOR JUDGMENT HEEREY AND EDMONDS JJ: 1 In 1989 a company called 410 Chapel Road Pty Ltd completed the construction of an office block on land which it had acquired in Bankstown, New South Wales. Acquisition and construction were financed by a loan secured by a mortgage over the property. The company soon defaulted in the payment of interest due under the mortgage. In 1991 the mortgagee entered into possession of the property and receipt of the rents. The mortgagee finally sold the building in 2000, by which time the mortgage debt had vastly increased due to the accumulation of unpaid capitalised interest. 2 At all times Chapel Road was a wholly-owned subsidiary of R & D Holdings Pty Ltd. In July 1997 50 per cent of the shares in R & D changed hands. 3 The present appeals from the decision of Finn J (R & D Holdings Pty Ltd v Deputy Federal Commissioner of Taxation (2006) ATC 4472) concern R & D's claims for deductions for losses said to have been incurred by Chapel Road in the 1997, 1998 and 1999 tax years. The losses were constituted by the excess of mortgage interest over rental income. R & D says these losses were transferred to it in accordance with (for the 1997 year) s 80G of the Income Tax Assessment Act 1936 (Cth) (the 1936 Act) and (for the 1998 and 1999 years) Div 170-A of the Income Tax Assessment Act 1997 (Cth) (the 1997 Act). 4 His Honour found that Chapel Road incurred the losses in all three years. He upheld R & D's claims for the 1997 year. However, as a consequence of the change in ownership of R & D, Chapel Road was required to satisfy the "same business" test in the 1998 and 1999 years as it did immediately before the change in ownership of R & D, but failed to do so. Thus R & D's claims failed for those years. 5 The present appeals are brought by the Commissioner in respect of the 1997 year and by R & D in respect of the 1998 and 1999 years. The Commissioner, by notice of contention, seeks to uphold his Honour's conclusion for the 1998 and 1999 years on the same ground as raised in his 1997 year appeal, namely that Chapel Road incurred no loss or outgoing. 6 The issues argued on the appeals may be summarised as follows: 1. In the years in question did Chapel Road suffer any loss or outgoing? 2. If yes to 1, was such loss or outgoing incurred by Chapel Road in gaining or producing assessable income? 3. In the 1998 and 1999 years did Chapel Road carry on the same business as it had immediately before the change of ownership in R & D in July 1997? 4. Were R & D's claims for the 1998 and 1999 years "reckless" and "not reasonably arguable" so as to warrant the imposition of penalties? 7 Questions 1 and 2 arise in all three appeals, that is to say the Commissioner's appeal NSD 1790 of 2006, and R & D's appeals NSD 1798 and 1799 of 2006. Questions 3 and 4 arise in R & D's appeals. The property and the mortgage 8 Chapel Road acquired the property in June 1987 for $3.37 million. It constructed a seven floor commercial office block. To fund acquisition and construction it borrowed $12.3 million, later extended to $14 million, from Burns Philp Trustee Company Limited as trustee for Estate Mortgage Trusts. The loan was secured by a mortgage over the property. 9 In late 1989 Chapel Road appointed Raine & Horne as agent for the letting and managing of the building. 10 On 19 March 1990 the Estate Mortgage loan was refinanced by a loan of $14 million from Mercantile Mutual Life Insurance Company Ltd secured by a registered first mortgage loan over the property. The loan was for a term of two years with an interest rate of 21.5 per cent, reducible to 17.5 per cent on payment within seven days of the due date. 11 At the time of the Mercantile Mutual loan Chapel Road had obtained a valuation of $17.5 million for the property. About 60 per cent of the building was leased although some tenants had the benefit of rent-free periods. Default 12 The rent received did not cover the interest and other outgoings. Chapel Road failed to pay the interest due on 31 March and 30 April 1990. 13 On 17 May 1990 Mercantile Mutual gave notice to tenants that it was exercising its rights under s 63 of the Real Property Act 1900 (NSW) (the RP Act) to enter into receipt of the rents. The notice directed tenants to pay rent directly to Mercantile Mutual's agent Dyson Austen & Co. 14 On 23 May 1990 Mercantile Mutual gave notice under s 57(2)(b) of the RP Act in respect of the defaults. Non-compliance with the notice provided a trigger to the mortgagee's power of sale under s 58 of that Act. Management of the property 15 On 5 June 1990 Mr Andrew Richardson of R & D wrote to tenants noting the new rental arrangements but indicating that the property would "continue to be managed" by his company and Raine & Horne. 16 In January 1991, according to Mr Richardson, Mercantile Mutual asked him if a single agent, Jones Lang Wooten, should replace the two existing agents in order to save expense. Mr Richardson's evidence was that he agreed, provided JLW kept him fully informed and provided management reports on the property. 17 JLW were duly appointed by Mercantile Mutual as its agent. His Honour found (at [90]) that thereafter Mercantile Mutual was a mortgagee in possession. 18 In the following years Mercantile Mutual through its agent JLW collected the rents and paid the outgoings of the building from those rents. It supplied Chapel Road with annual reports on collections and outgoings. 19 At the beginning of the 1992 tax year the loan debt exceeded $20 million. By the end of the 1997 tax year it had grown to over $65 million and daily interest liability then exceeded $38,000. Sale of the property 20 Mercantile Mutual made an unsuccessful attempt to sell the property in 1997. Finally it effected a sale in November 2000 for $11.75 million. By this time the debt to Mercantile Mutual exceeded $100 million. 1. LOSSES AND OUTGOINGS OF CHAPEL ROAD Legislation 21 Section 51(1) of the 1936 Act, applicable to the 1997 tax year, relevantly provides: "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,… ." 22 Section 8-1 of the 1997 Act, applicable to the 1998 and 1999 tax years, is not materially different. It includes the alternative criteria of losses and outgoings being "incurred in gaining or producing the [in the 1997 Act 'your', ie the taxpayer's] assessable income" or "being necessarily incurred in carrying on a business for the purpose of gaining or producing such [1997 Act 'your'] assessable income". Both provisions exclude losses of capital, and losses of a capital nature or of a private or domestic nature. Trial judgment 23 His Honour summarised the contentions of R & D (at [103]-[104]) and the Commissioner (at [105]-[111]). The latter's case before his Honour, and repeated before us on appeal, was fairly encapsulated as follows (at [112]): "The Deputy Commissioner's general characterisation of Chapel Road was that there was no income producing activity of the company and a fortiori no business of the company. For more than a decade – effectively the entire time that it was the mortgagor of the land – Chapel Road was irretrievably insolvent, had no prospect of ever paying the accumulating excess interest, made no attempt to do so and carried out no activities. The augmentation of the excess interest debt in no way contributed to the derivation (or even the possibility of derivation) of any assessable income." 24 In rejecting the Commissioner's case his Honour noted that in its 1992 to 1997 returns Chapel Road claimed, in addition to liabilities for interest, other deductions under the 1936 Act in respect of its ownership of the property: repairs and maintenance (s 53 and 51(1)), depreciation (s 54), capital allowances (Div 10D), rates and taxes (s 72) and other miscellaneous expenses (s 51(1)). In the proceeding before his Honour the Commissioner had initially taken the position that such expenses were not properly deductible. However, in the end the Commissioner accepted that such expenses were deductible, as was such part of Chapel Road's interest obligation as was discharged in each year by Mercantile Mutual's application of net rental income. 25 His Honour (at [115]) considered it was "artificial" to fragment the interest liability of a given year into that part which was discharged by the mortgagee's monthly application of net rental income and that part which was not. We agree. Chapel Road's interest liability was one and indivisible. It originated from, and was defined by, the terms of the mortgage and was not calculated by reference to expenses that Chapel Road or a mortgagee in possession might incur for expenses such as maintenance or, for that matter, receipts such as rental income. On the Commissioner's argument, if interest liability exceeded rental income plus expenses by only one dollar, that dollar would not be deductible. 26 His Honour noted (at [117]) that there was no suggestion that Chapel Road entered into the original Estates Mortgage loan or the Mercantile Mutual refinancing in order to generate transferable losses for R & D. Nor has it been suggested at any stage of these proceedings that the loans were a sham or otherwise subject to anti-avoidance provisions. 27 His Honour's reasoning may be summarised as follows: · Generally speaking, where borrowed money is laid out for the purposes of gaining assessable income that furnishes the required connection between the interest paid upon it by the taxpayer and the income derived from its use: Federal Commissioner of Taxation v Munro (1926) 38 CLR 153 at 170-171; · What is incidental and relevant is determined not by reference to the certainty or likelihood of the outgoing resulting in the generation of income but to its nature and character, and generally to its connection with the operations which more directly gain or produce assessable income: Commissioner of Taxation v Smith (1981) 147 CLR 578 at 586; · "Outgoing" does not require an actual disbursement: Federal Commissioner of Taxation v James Flood Pty Ltd (1953) 88 CLR 492 at 506. Interest which has not been discharged by payment but rather capitalised can still be a loss or outgoing: Hart v Commissioner of Taxation (2002) 121 FCR 206 at [23] et seq; · The terms of the mortgage meant that each periodic liability, whether paid or capitalised, represented the cost of the money borrowed for the preceding month and was "payable for its period": Commissioner of Taxation (Cth) v Citylink Melbourne Ltd (2006) 288 ALR 301 at [146]. Thus losses or outgoings would occur monthly across the life of the loan and were thus allocated or apportioned to the relevant years of income; · Throughout the whole period of Chapel Road's ownership of the property assessable income was produced as originally intended, albeit from 1991 through the interposition of Mercantile Mutual as mortgagee in possession; · Although Chapel Road could not repay the "continually swelling" principal sum, the nature and character of its interest liability did not change, nor did the purpose for which it had laid out the borrowed moneys; · The relatively insignificant amount of income compared with the great increase of the principal sum only illustrated the "dramatically losing character" of the loan for Chapel Road in the circumstances; · There is no assumption, express or implied, in s 51(1) or s 8-1 that the deductibility of an outgoing in the year in which it is accrued depends on it being met in due course. The appeal 28 On the appeal the Commissioner argued that there was no "loss or outgoing". The relevant provisions did not apply to a liability which has not been and will not be discharged. A "loss" is something which depreciates the taxpayer's financial position; the accrual of interest did not do so in the present case because Chapel Road's financial condition was "irretrievably lost, and was beyond the point at which it could sustain further loss". Therefore Chapel Road was not, "as a practical matter", definitely committed or completely subjected to any discharge of its "jurisprudential liability" for interest accruing on the mortgage in the loss years. 29 The Commissioner's argument involves reading into the text of the relevant provisions a substantial qualification which, as far as we are aware, has never before been suggested. Certainly there is no direct authority for such an argument, although one would think there must have been many irrecoverable losses for which deductions were allowed for transferee companies since s 80G was introduced into the 1936 Act in 1984. No doubt there are other contexts in which genuine but "irretrievable" losses have been allowed. 30 As Finn J pointed out (at [140]), the Commissioner's argument that an obligation will only be allowed when payment in the future is a certainty "… seeks to transform what may be a well-founded factual assumption in a given case as to what will happen in the future, into a legal prerequisite of deductibility." 31 The structure of the income tax system has as one of its foundation stones the obligation of taxpayers to lodge returns within a specified, limited period after the end of each tax year: 1936 Act s 161(1), 1997 Act s 3-10(1). As the experience of this case illustrates, in Australia property investment and loan decisions made in good faith by arm's length investors and lenders may have outcomes very different from those envisaged. Property values and interest rates fluctuate, at times wildly. It would be unfair and unworkable to make claims for losses in taxpayers' returns conditional on the accuracy of their prediction as to future events. Such an intention should not be imputed to Parliament in the absence of clear expression. 32 The interest liability of Chapel Road was not an illusory one, nor a sham. Amongst other things, it could have been relied upon to found a creditor's petition for winding up. 2. INCURRED IN GAINING OR PRODUCING INCOME Commissioner's argument 33 The Commissioner argued that any loss or outgoing was not incurred by Chapel Road in gaining or producing assessable income. The second limb of the statutory tests (incurred in carrying on a business) was not applicable because Chapel Road was not carrying on a business. As will be seen, we agree with the last-mentioned proposition, which will be discussed in the context of the loss transfer issues. The question is whether Chapel Road's losses satisfied the first limb. It would seem that this point was not raised as a separate issue before his Honour. 34 The Commissioner accepted that interest is ordinarily deductible because it is "a recurrent or periodic payment which secures, not an enduring advantage, but, rather, the use of borrowed money during the term of the loan": Steele v Federal Commissioner of Taxation (1999) 197 CLR 459 at [29]. 35 It was also not in dispute that, in the case of expenditure by way of interest on a borrowed amount, it is the purpose of the borrowing which will provide the nexus which characterises the expenditure as being "in gaining" assessable income. However, in the present case the Commissioner argued that although the borrowing originally had the requisite nexus with assessable income, by the time the claimed transferable losses accrued that nexus was "long lost". By the beginning of the 1992 tax year the company had lost possession of the property, the principal debt substantially exceeded the value of the company's total assets and by 1997 it was almost six times that value. R & D's argument 36 R & D point out that the Commissioner does not identify the point in time at which the nexus was lost. It says that no such assertion was made before Finn J and thus no finding of fact was invited or made. 37 In this context R & D say that the point was abandoned at the trial and point to his Honour's judgment at [105]. However, that paragraph is dealing with a quite different point, namely the deductibility of other expenses such as maintenance and rates and so much of the interest as was discharged from rentals. Breaking the nexus 38 A recent line of cases supports the proposition that a loss or outgoing may be deductible even if it is incurred some years after the associated business, or the taxpayer's involvement in it, has ceased: Placer Pacific Management Pty Ltd v Federal Commissioner of Taxation 95 ATC 4459, Federal Commissioner of Taxation v Brown (1999) 43 ATR 1, Federal Commissioner of Taxation v Jones (2002) 117 FCR 95 and Guest v Commissioner of Taxation 2007 ATC 4265. In Placer the claimed deduction was for a payment in settlement of litigation in respect of defective goods supplied. In the other cases it was for interest on a business-related loan. 39 That the gap in time may be considerable is demonstrated by the following table: Case Cessation Deduction Placer 1981 1989 Brown 1990 1994 Jones 1993 1998 Guest 1991 1998 40 The concept of a break in the nexus was applied in Commissioner of Taxation v Riverside Road Lodge Pty Ltd (in liq) (1990) 23 FCR 305. In 1970 the taxpayer company borrowed money to acquire land and construct a motel. There were repayments and further borrowings. In 1979 the taxpayer transferred the property to the trustee of a unit trust, the beneficiaries of which were the shareholders in the taxpayer. The consideration for the transfer was the current value, payable on demand, interest free. The trustee then leased the property back to the taxpayer, which continued to conduct the motel business. The disputed deduction was for interest on pre-1979 loans incurred after the transfer. 41 The Full Court (Northrop, Wilcox and Hill JJ) observed (at 314) that the case was not one where the activities of the taxpayer in operating the motel ceased during any relevant year of income. However, in 1979, as a result of the sale and lease-back, the character of the activities of the taxpayer changed. Before, it was an owner/operator of a motel; afterwards it was an operator of a motel owned by others and of which it was only a tenant. The Full Court disagreed with the view of the trial judge that the 1979 change was not sufficient to change the relationship between the interest payments and the business activity. The interest outgoings ceased to be "relevant and incidental" to the business activities engaged in by the taxpayer after 1979. They had "no real connection at all with the business of running a rented motel" (at 315). 42 In Brown the taxpayers borrowed money to fund the purchase of a delicatessen. They sold the business in 1990 but the proceeds were not sufficient to discharge the loan. They continued to pay interest until the loan was discharged in 1995. The Full Court (Lee, RD Nicholson and Merkel JJ) upheld the decision of the trial judge that there was a sufficient connection between the occasion for the payment of interest and the carrying on of the business. On the appeal, the Commissioner had argued that once the business had ceased the payment of the interest was not to be found in the carrying on of the business but in the voluntary decision of the partnership not to repay the loan and to continue to pay interest installments (at [15]). 43 Their Honours reviewed the case law, and in particular the decision of the High Court in Steele. They applied (at [20]) the statement of the High Court, adopting what was said by Lockhart J in Federal Commissioner of Taxation v Total Holdings (Aust) Pty Ltd 79 ATC 4279 at 4283, that a taxpayer may be entitled to a deduction after a business has ceased, provided the occasion of a business outgoing is to be found in the business operations directed towards the gaining or production of assessable income generally. However, cessation of business may be of factual importance. Their Honours (at [24]) concluded that the trial judge was correct in determining that the occasion for the loss or outgoing in question was the payment of interest which the taxpayers were obliged (their Honours' emphasis) to pay under the loan contract. 44 As to the Commissioner's nexus argument, based on the taxpayers' "entitlement" to pay out the loan, their Honours said (at [27]-[28]) that the fact that the bank might, as a matter of practicability rather than legal obligation allowed early repayment did not alter the analysis. Their Honours continued: "... In our view his Honour was correct in characterising the occasion for the liability in such circumstances as depending upon the terms of the contract rather than upon whether or not the partners might or might not have availed themselves of an opportunity to repay the loan on a particular day because of an indulgence shown by the lender on that occasion. In that regard, it is significant that the partners did apply the net proceeds of sale in repayment of the loan and his Honour did not appear to be prepared to find that the taxpayer and his wife had any other partnership assets which were available, had the Bank agreed, to discharge the loan when, or even after, the partnership business ceased. 28. Had the loan agreement in question been a 'roll over' business loan facility which entitled the taxpayer conducting the business, on the date of each monthly payment, to elect to repay the principal and thereby avoid incurring liability for interest or to 'rollover' the loan and continue to be liable for interest, that may have been a different situation. In that circumstance there may be considerable force in a contention that the occasion of the liability was the election to 'roll over' the loan on each monthly payment date, rather than any liability arising under the terms of the original loan agreement establishing the terms of the 'roll over' facility. In such a case the cessation of the business or sale of the income-producing asset acquired with the borrowed funds might properly be regarded as breaking the nexus in much the same was as certain post cessation interest payments were not allowed as deductions in Riverside Lodge. However, as explained earlier, that is not the situation in the present case." 45 In Jones a husband and wife conducted a trucking business in partnership. They took out a loan with the ANZ Bank in 1990. In 1992 the husband died. In 1993 the business ceased. The wife recommenced full-time employment as a nurse, using more than half her after tax income to repay the loan. In 1996 the wife refinanced the loan with another lender to obtain a lower interest rate. The Full Court (Beaumont, Finn and Sundberg JJ) upheld the wife's claim for deductions of interest for the years 1993-1998. 46 Their Honours (at [10]) rejected the Commissioner's argument that the taxpayer only became obliged to pay interest in the years in question because she chose not to repay the principal sum and that the "occasion" for the interest repayment was each periodic decision to keep the loan on foot. They did so for two reasons. First, the loan was for a fixed term and was not dependent on periodic decisions on the taxpayer's part to keep it alive. Secondly, she did not have the financial capacity to do so. Their Honours noted (at [11]) that "the borrowed funds and the interest on them were always referable to the former business". 47 Ultimately the question is a factual one: Fletcher v Federal Commissioner of Taxation (1993) 173 CLR 1 at 18. Cessation of business may be of factual importance: Steele at [46]. 48 Riverside Road is perhaps a hard case. Both before and after the sale and lease back the taxpayer carried on, at the same site and under the same name, the same income-earning activity of providing accommodation and meals. If a bystander had asked "What is Riverside Road's business?" the natural response would be "Running a motel" rather than "Running a motel on leasehold property". 49 It might be argued that the present case is stronger for the Commissioner than Riverside Road because not only did Chapel Road cease to carry on the business, but somebody else took it over. And the present case is to be contrasted with cases such as Brown and Jones where a business simply ceased but the business owner's mortgage liability continued. 50 Mercantile Mutual was not a trustee and was acting in its own interests. However, as Stone J demonstrates, it did not have an absolute right to deal with the income from Chapel Road's property as it saw fit. It was obliged to apply any income from the property in a particular way, namely by discharging liabilities, including Chapel Road's liability for interest. If any of the income was left over, it belonged to Chapel Road. The fact that – by a large margin – nothing was left over, does not change the ownership of that income. Chapel Road gained its income by reason of its ownership of the land which the tenants occupied and it incurred interest liabilities (and other expenses) in order to gain that income. 51 As is discussed below in the context of the "same business" issue, Chapel Road was not carrying on a business. It would not have satisfied the second limb of the relevant sections, but it satisfied the first. 3. CARRYING ON THE SAME BUSINESS Legislation 52 His Honour set out at [147]-[149] the relevant loss transfer provisions of the 1997 Act, ss 165-13 and 165-210. Notwithstanding the Plain English drafting, they are rather complicated. It will be sufficient to note the essential statutory test identified by his Honour, namely whether Chapel Road carried on for the whole of the 1998 income year "the same business that it carried on immediately before" 17 July 1997 (the date of the share transfer in R & D). There was no operative difference for the 1998 year. Trial judgment 53 His Honour cited the statement of the High Court in Federal Commissioner of Taxation v Murray (1998) 193 CLR 605 at [54]: "A business is not a thing or things. It is a course of conduct carried on for the purpose of profit and involves notions of continuity and repetition of actions." 54 His Honour noted his earlier findings to the effect that Mercantile Mutual entered into possession as mortgagee from early 1991 and continued in possession until the property was sold in November 2000. The property was managed for Mercantile Mutual by JLW as its agent. JLW engaged in activities to be expected of a manager of an office rental property such as upkeep, provision of services to tenants, receipt of rentals and payment of outgoings. JLW accounted for the net rental to Mercantile Mutual. The latter and JLW provided annual financial statements to Chapel Road. Chapel Road's financial accounts and tax returns identified the income it received and outgoings incurred including its interest obligations. 55 The mortgage empowered the mortgagee, on default by the mortgagor, to enter upon and take possession of and manage the mortgaged land, to lease it, to provide services to occupants of the land, to carry on any business on the land and to employ agents to effect any of the mortgagee's rights. 56 His Honour held (at [159], [172]) that the powers conferred by the mortgage and the RP Act were for the benefit and protection of Mercantile Mutual. In entering into possession, appointing JLW as its agent and carrying on a rental business Mercantile Mutual was not supplying services to Chapel Road, nor acting as Chapel Road's agent. Rather it was exercising powers primarily for its own benefit, albeit with due regard to the interests of Chapel Road, and subject to its duty to account to that company. 57 His Honour found (at [173]) that at the relevant times Chapel Road did not carry on a business at all at the property; Mercantile Mutual did. Chapel Road had no access to the business assets. Although Chapel Road's assets were being put to gainful use, it was not Chapel Road that was doing this but Mercantile Mutual. R & D's arguments 58 R & D's case was largely based on provisions of the RP Act. 59 Section 57(1) provides that a mortgage has effect as a security but does not operate as a transfer of the land mortgaged. 60 Section 63(1), said to be unique in Australian Torrens System legislation, relevantly provides: "Whenever a mortgagee … gives notice of demanding to enter into receipt of the rents and profits of the mortgaged … land to the tenant … all the powers and remedies of the mortgagor … in regard to receipt and recovery of, and giving discharges for, such rents and profits shall be suspended and transferred to the said mortgagee … until such notice is withdrawn, or the mortgagee … is satisfied, and a discharge thereof is duly registered." 61 Proceeding from these provisions, R & D argued that s 63 does not affect any assignment to a mortgagee who enters into possession, and entering possession does not otherwise cause the cessation of a business. Alternatively, any assignment of rights in relation to the business effected by entry of possession is only an assignment by way of security. In any case the rent remains assessable income of Chapel Road because it was applied with or dealt with on its behalf or as it directs. Chapel Road was not carrying on a business 62 The provisions of the RP Act, and general law rules about the obligations of a mortgagee in possession, do not bear on the factual question whether Chapel Road was in July 1997 carrying on a business and, if so, whether it continued to carry on the same business at all time up until July 1999. 63 Carrying on a business, as his Honour pointed out, was not a matter of owning an asset, but of engaging in a course of conduct. In July 1997, and indeed from 1990, Chapel Road was the legal owner of the mortgaged land, but was not in possession of it and carried on no business. It could make no decisions about such matters as engaging tenants or carrying out repairs and maintenance. 4. PENALTIES Legislation 64 No question of penalties arises in the 1997 year. For the 1998 and 1999 years R & D appeals against his Honour's finding that the tax shortfall was "caused by the recklessness of the taxpayer with regard to the correct application of (the) Act" (s 226H, 1936 Act) and that its position "was not reasonably arguable" (s 226K, 1936 Act). The concept of "not reasonably arguable" is defined in s 222C(1) which states that the correctness of the treatment of the application of a law "is reasonably arguable if, having regard to the relevant authorities and the matter in relation to which the law is applied … it would be concluded that what is argued for is about as likely as not correct." "Authority" is defined to include the relevant income tax Act, intrinsic material of which account can be taken in interpreting that Act, the decisions of a court, Tribunal or board of review and public rulings. Evidence 65 Mr Richardson sought advice from his tax agents and an external advisor as to whether Chapel Road's losses could be transferred to R & D. However, the focus of the advice was on the question whether Chapel Road had allowable deductions. It was assumed that if there were such losses they would be transferable. No consideration was given to whether Chapel Road satisfied the same business test. Trial judgment 66 His Honour (at [190]) was satisfied that Chapel Road and R & D and their advisors did not "positively engage" with the questions (i) whether Chapel Road was "carrying on a business" and (ii) what was the significance of Mercantile Mutual being in possession and managing the property, having regard to the effects of the law of mortgages. At best it was simply assumed that if Chapel Road had tax losses, those could be transferred to R & D. 67 Thus Chapel Road and R & D had no informed view, reasonable or otherwise, on the matter. Section 226K applied. R & D's arguments 68 It was put that to be "reckless" within the meaning of s 226H the taxpayer must make a statement not caring whether it is true or false or without an honest belief in its truth: R v McKinnon [1959] 1 QB 150 at 153, Pollard v Director of Public Prosecutions (1992) 28 NSWLR 659 at 675. R & D accepted and adopted the view of the Commissioner in TR 94/4 that "reckless" had a meaning of "gross carelessness", or taking a risk. However, it submitted that he the court should be careful not to allow hindsight to affect its view of the merits of the taxpayer's arguments. 69 R & D noted that the Commissioner did not raise the mortgagee in possession s 63 point in its amended assessment or in argument at first instance, those matters being first raised by the trial judge. However, it accepted that this fact alone did not take the case outside s 226H. Conclusion 70 In Hart v Commissioner of Taxation (2003) 131 FCR at [44] Hill and Hely JJ said that recklessness in the context of s 226H means something more than failure to exercise reasonable care, but less than an intentional disregard of the Act. Their Honours cited with approval what was said by Cooper J in BRK (Brisbane) Pty Ltd v Commissioner of Taxation (2001) 46 ATR 347 at 364: "Recklessness in this context means to include in a tax statement material upon which the Act or regulations are to operate, knowing that there is a real, as opposed to a fanciful risk, that the material may be incorrect, or be grossly indifferent as to whether or not the material is true and correct, and that a reasonable person in the position of the statement-maker would see there was a real risk that the Act and regulations may not operate correctly to lead to the assessment of the proper tax payable because of the content of the tax statement. So understood, the proscribed conduct is more than mere negligence and must amount to gross carelessness." As Hill and Hely JJ held, the test is an objective one but the mere fact that a claimed deduction is not allowable is not of itself sufficient to expose the taxpayer to a penalty. 71 As to the "not reasonably arguable" criterion, in Pridecraft Pty Ltd v Federal Commissioner of Taxation (2004) 213 ALR 450 at [108] Sackville J, with the concurrence of Ryan and Sundberg JJ, adopted the statement of Hill J in Walstern v Commissioner of Taxation (2003) 138 FCR 1 at [108]. That statement included the following propositions which apply in assessing whether a taxpayer's case was reasonably arguable: · The test is objective, not subjective; · There must be room for it to be argued which of the taxpayer's or decision-maker's position is correct so that on balance the taxpayer's argument can objectively be said to be one that, while wrong, could be argued on rational grounds to be right; · The argument must clearly be one where, in making it, the taxpayer has exercised reasonable care; 72 His Honour correctly applied these principles. We do not see any error, particularly in the importance he placed on the failure of the taxpayer and its advisors to avert to the transfer of loss provisions. 5. ORDERS 73 All appeals should be dismissed. There should be no order as to costs. I certify that the preceding seventy-three (73) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justices Heerey and Edmonds Associate: Dated: 13 July 2007 IN THE FEDERAL COURT OF AUSTRALIA NEW SOUTH WALES DISTRICT REGISTRY NSD 1790 OF 2006 ON APPEAL FROM A SINGLE JUDGE OF THE FEDERAL COURT OF AUSTRALIA BETWEEN: commissioner of taxation Appellant AND: R & D HOLDINGS PTY LIMITED Respondent NSD 1799 OF 2006 NSD 1798 OF 2006 BETWEEN: R & D HOLDINGS PTY LIMITED Appellant AND: DEPUTY COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Respondent JUDGES: HEEREY, STONE AND EDMONDS JJ DATE: 13 July 2007 PLACE: SYDNEY REASONS FOR JUDGMENT STONE J: Introduction 74 The issue in each of these appeals is the entitlement of R & D Holdings Pty Ltd to an income tax deduction arising from losses that were incurred by its subsidiary, 410 Chapel Road Pty Ltd, then transferred to R&D and recouped by R&D in the years of income ending 30 June 1997, 1998 and 1999 respectively. The primary judge held that R&D was entitled to the deductions it claimed in respect of the 1997 tax year but not in respect of the 1998 and 1999 tax years. Except for the issue referred to in [75] below, the Commissioner and R&D have each appealed against that part of his Honour's decision adverse to them. For reasons that are explained below, it is my opinion that the primary judge's decision was correct for the reasons his Honour gave. Accordingly, the appeals of the Commissioner and of R&D Holdings must be dismissed. 75 Before the primary judge there was another issue, namely, whether an amount distributed to R&D in the 1998 tax year by the Hallinn Trust included an amount assessable under s 70-35 of the Income Tax Assessment Act 1997 (Cth) ('1997 Act') in respect of trading stock. There was no appeal from his Honour's decision on this point. 76 There is no dispute about the facts relevant to each appeal nor is there any suggestion that the transactions in question were in any way fraudulent or a sham or designed to avoid tax. The question for the Full Court is solely one of construction of the applicable statutory provisions. For the tax year ending 30 June 1997, the relevant provisions are to be found in the Income Tax Assessment Act 1936 (Cth) ("1936 Act"). For the tax years ending on 30 June 1998 and 1999, the 1997 Act is applicable. Facts 77 The parties agree that the facts are as set out by the primary judge at [83]-[97] of his Honour's reasons; [2006] FCA 981. For present purposes a brief summary of those facts is sufficient. The losses in question were incurred by 410 Chapel Road Pty Ltd between 1992 and 1997. Chapel Road, which was formed in 1987 specifically for the development of an office building on land it had purchased at Bankstown, was owned by R&D and Mr Andrew Richardson. Mr Richardson is, as the primary judge remarked, "the pivotal figure in these proceedings". At all relevant times he was a director of R&D and of AJ Richardson Properties Pty Ltd which was involved in the management of the building constructed on the land at Bankstown. 78 The building was made available for leasing in late 1989. The construction had initially been financed by a loan of $12.3 million from Burns Philp Trustee Company Ltd but in March 1990 the loan was refinanced with Mercantile Mutual Life Insurance Company Ltd. The loan was secured by a registered first mortgage over the land. 79 Chapel Road was unable to meet the payments that were due under the mortgage on 31 March and 30 April 1990. On 17 May 1990, Mercantile Mutual's solicitors notified the tenants in writing that Mercantile Mutual was exercising its rights under s 63 of the Real Property Act 1900 (NSW) to enter into receipt of the rents of the Bankstown property and directed them to make future rent payments to its agent, Dyson Austen & Co Pty Ltd. In June 1990, Mr Richardson wrote to the tenants confirming the new rental payment arrangements but indicating that the building would continue to be managed by Richardson Property Group and Raine & Horne. In 1991, Jones Lang Wooten took over the roles of Raine & Horne and Dyson Austen. Mr Richardson agreed to this provided Jones Lang Wooten kept him fully informed and provided management reports on the property. Thereafter, until the property was sold Jones Lang Wooten attended to the provision of services to the tenants, the collection of rents, the payments of outgoings and all the other duties that would be expected of a manager of a commercial rental property. The primary judge concluded that from the appointment of Jones Lang Wooten, Mercantile Mutual "was a mortgagee in possession". There is, however, no dispute that Chapel Road continued to be liable for the capital and interest accruing on the loan despite the mortgagee having exercised its rights under s 63. 80 From 1991 to late 2000 when Mercantile Mutual sold the Bankstown building for $11,750,000, the balance of the rent collected by Jones Lang Wooten, after meeting the building outgoings, was paid to Mercantile Mutual in part payment of accrued interest. Jones Lang Wooten supplied Chapel Road with annual reports on collection and outgoings. The net income in those reports was described as "repayments" in the annual loan statements that Mercantile Mutual supplied to Chapel Road. At the time of the building's sale the mortgagor's debt to Mercantile Mutual exceeded $100 million. 81 The financial statements of Chapel Road during the above period are of interest. The primary judge summarised the pertinent aspects of those financial statements at [93]-[94] of his reasons as follows: "In its Financial Statements for the year ending 30 June 1992 Chapel Road's directors reported that while the principal activity of the company had been property investment and development, it had "ceased trading during the financial year". Mr Richardson's evidence is that the quoted statement was inaccurate and could only have been included by oversight as Chapel Road was continuing to trade, receive rental income and incur expenses. The Financial Statements for the years 1993-1998 record the company's principal activities as "Property Investment and Development". The Statements also contained the directors' declarations that there were "reasonable grounds to believe the Company will be able to pay its debts as and when they fall due". The declarations from 1993 to 1995 added the rider that the above "statement is dependent upon the continued support of the company's creditors and financiers". [Emphasis added] 82 In his evidence before the primary judge Mr Richardson said that the statement that Chapel Road had ceased trading during the financial year ending 30 June 1992 was an error and that Chapel road continued to trade, receive rental income and incur expenses. Whether or not his Honour accepted that this claim was made in error, it is clear that he did not accept that Chapel Road was carrying on business during that period. Allowable deductions 83 The primary judge held that R&D was entitled to the deductions it claimed in respect of the 1997 tax year but not in respect of the 1998 and 1999 tax years. Had it not been for a change in the shareholding in R&D in July 1997, R&D would also have been successful in respect of the latter two years. For that reason, and because R&D is appealing the primary judge's decision in relation to the effect of the change of shareholding, the Commissioner has filed notices of contention in respect of his Honour's decision concerning the 1998 and 1999 tax years. The notices of contention take issue with his Honour's judgment in relation to the 1998 and 1999 tax years and raise the same issues as are raised in the appeal concerning the 1997 tax year. The issues are fundamentally the same in respect of all three tax years although the statutory regime differs somewhat. 84 The question whether R&D has an allowable deduction in respect of the 1997 tax year is governed by s 51(1) of the 1936 Act and, in relation to the 1998 and 1999 tax years, the relevant provision is 8-1 of the 1997 Act. Those provisions are as follows: "51(1) 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." "8-1 General Deductions (1) You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. (2) However, you cannot deduct a loss or outgoing under this section to the extent that: (a) it is a loss or outgoing of capital, or of a capital nature; or (b) it is a loss or outgoing of a private or domestic nature; or (c) it is incurred in relation to gaining or producing your exempt income; or (d) a provision of this Act prevents you from deducting it." The 1997 tax year 85 The deductions relevant to the 1997 year were for an amount of loss transferred to R&D by Chapel Road in that tax year and were claimed under s 80G(6) of the 1936 Act which provides: "(6) Subject to this section, where: (a) a resident company (in this section referred to as the 'loss company') is deemed to have incurred a loss for the purposes of section 79E [in a] year of income (in this section referred to as the loss year') (b) a resident company (in this section referred to as the 'income company') has, or would but for the operation of this section have, a taxable income [in a ] year of income (in this section referred to as the 'income year'); … (c) the loss company and the income company agree that the right to an allowable deduction under subsection 79E(3)… in respect of so much of the whole or part of the loss as has not been allowed as a deduction should be transferred to the income company ; … the amount of the loss or of that part of the loss, as the case may be, shall, for the purposes of the application of the provisions of this Act other than this section in relation to the income company in relation to the income year, be deemed to be a loss incurred by the income company for the purposes of section 79E…." 86 The "allowable deduction" which was agreed to be transferred from Chapel Road to R&D was claimed to be allowable under s 79E which, in so far as is relevant, provides: "(1) For the purposes of this section, a taxpayer incurs a loss in a post-1989 year of income equal to the amount (if any) by which the taxpayer's non-loss deductions for the year of income exceed the sum of the taxpayer's assessable income and net exempt income for that year. … (3) Subject to this section, so much of a taxpayer's losses incurred in any of the post-1989 years of income before a particular year of income as has not been allowed as a deduction from the taxpayer's income of any of those years is allowable as a deduction … … (12) In this section: non-loss deduction means an allowable deduction other than one allowable under this section …" 87 In short, the 'loss' transferred to R&D pursuant to s 80G(6) not only must fall within the definition of allowable deductions under s 51(1) but must also be an allowable deduction under s 79E(3). A deduction is allowable under s 79E(3) in respect of the amount (if any) by which Chapel Road's allowable deductions (excluding deductions under s 79E) exceed its assessable income in respect of the relevant year. 88 The Commissioner submits that Chapel Road did not have any assessable income in the years in question and therefore there could be no amount by which deductions allowable to Chapel Road exceeded any assessable income derived by it. The Commissioner also submitted that because Chapel Road's financial position was "irretrievably lost" it was beyond the point at which it could sustain further loss. Consequently, it was submitted, the appeal must be allowed. 89 The parties have agreed that in the relevant years Mercantile Mutual, as mortgagee, was in possession of the Bankstown property. What exactly that phase means in respect of a Torrens title mortgagee is discussed below. In any event, it is not in dispute that, through its agent, Jones Lang Wooten, Mercantile Mutual was in receipt of the rental income from the property and that, after payment of outgoings, it applied the balance to the mortgage debt. As the amount of rental income was not sufficient to cover the amount of interest incurred under the loan, Chapel Road claimed an allowable deduction in respect of the amount of excess interest. R&D submits that this allowable deduction created a loss within the meaning of s 79E(3) because it was the excess of allowable deductions over assessable income. 90 The Commissioner submitted that Chapel Road did not have an allowable deduction because the interest was not incurred in gaining or producing assessable income nor was it necessarily incurred in carrying on a business to that end. The factual basis for this submission was said to be: (a) the mortgage debt greatly exceeded the market value of the property; (b) Chapel Road had no other assets and no prospects of acquiring other assets; and (c) there was no possibility that Chapel Road would ever discharge the obligation in respect of interest provided for under the terms of the mortgage. 91 The same submission was made to the primary judge who summarised it at [112] thus: "The Deputy Commissioner's general characterisation of Chapel Road was that there was no income producing activity of the company and a fortiori no business of the company. For more than a decade – effectively the entire time that it was the mortgagor of the land – Chapel Road was irretrievably insolvent, had no prospect of ever paying the accumulating excess interest, made no attempt to do so and carried out no activities. The augmentation of the excess interest debt in no way contributed to the derivation (or even the possibility of derivation) of any assessable income." 92 Before the primary judge, and again in this appeal, the Commissioner stressed the unprecedented nature of the present case as being one "in which the amount for which a deduction is claimed under sec 51 is the amount of a liability which has not been and will not be discharged." It was submitted that the authorities relied on by the trial judge all concerned liabilities which not only had accrued but also would be, or were anticipated or intended to be, discharged. In contrast, however, "the accrual of liability for further interest did not depreciate the financial position of Chapel Road because that company's financial condition was irretrievably lost, and was beyond the point at which it could sustain further loss". The Commissioner submitted that the issue was not whether the liability was one that could found a creditor's petition or was illusory but whether its accrual gave rise to a loss. 93 The Commissioner's submissions invited the Court to base its characterisation of the liability created by the accrued interest not merely on whether there was a legal obligation to pay but also on its assessment of whether, as a practical matter, the taxpayer is or is likely to be able to discharge that liability. This seems to me to inject very substantial uncertainty into an otherwise straightforward assessment. This was also the view of the primary judge who, in rejecting this submission, observed that neither s 51(1) nor s 8-1 made certainty of payment a legal prerequisite to deductibility. His Honour continued at [141]-[142]: "To insist on it would introduce an unacceptable measure of uncertainty into these sections. It would require that the deductibility of losses could often turn on a fallible prophesy as to future events. And this would be so notwithstanding that deductions commonly have been allowable in respect of debts which were never later paid because of the onset of bankruptcy or liquidation. The circumstances of this case, doubtless, provide an extreme example of inability to discharge a liability. But this does not assist the Deputy Commissioner. The articulation of the point at which an otherwise allowable deduction of a loss is to be transformed into a loss which is not allowable for the reasons relied upon by the Deputy Commissioner is obviously beset with no little difficulty. If it is to be the law that there is such a point, it is in my view the function of the legislature to identify it. It is not a matter for a court to add such a further and difficult implication and process of speculation into s 51(1) and s 8(1)." Nexus with assessable income 94 The Commissioner submits that, even if the respondent incurred a loss, it did not fall within either limb of s 51(1) in that it was neither "incurred in gaining or producing the assessable income" nor "necessarily incurred in carrying on a business" for the purpose of gaining or producing such income. The argument is that, by the time the claimed transferable losses accrued, the nexus between the loan from Mercantile Mutual and the assessable income of Chapel Road had long disappeared. Within weeks of refinancing the loan, Chapel Road was in default and Mercantile Mutual had exercised its right under s 63, to enter into receipt of the rents and profits. More importantly, in 1991 Jones Lang Wooten had been appointed by the mortgagee to take over the management of the property. The Commissioner submits that from this time the mortgagee and not Chapel Road was running the business and generating such income as it produced and consequently the required nexus between the borrowing and the assessable income did not exist. 95 I should make clear that I accept that once it was in possession, Mercantile Mutual, and not Chapel Road, was carrying on the rental business in respect of the Bankstown property. In my view, however, Chapel Road did have assessable income in the relevant period and the losses it suffered were incurred in gaining that assessable income. In explaining these views it is necessary to consider the nature of the rights and obligations of a mortgagee in possession. 96 The fundamental character of a mortgage is that it provides security for the monies advanced by the mortgagee. It has been long accepted that whether the mortgage takes the form of ownership, possession or charge, its substance as a security provides the context in which the rights of the parties are determined; Salt v Marquess of Northampton [1892] AC 1; compare Gurfinkel v Bentley Pty Ltd (1966) 116 CLR 98. The mortgagee is entitled to the benefit of the security and, subject to the specific terms of the agreement between the parties, it is entitled to give primacy to this interest in exercising its rights under the mortgage whether in relation to possession or sale. Nevertheless the ambit of these rights is circumscribed by the fact that the mortgagee's rights are limited to the vindication of its security. Consistent with this principle it is well established that the mortgagee is not a trustee for the mortgagor; Kennedy v De Trafford [1897] AC 180, Deputy Commissioner of Taxation (Vic) v General Credits Ltd [1988] VR 571. Nevertheless, it is also well established that the mortgagee is not entitled to ignore the mortgagor's interest where protection of that interest is compatible with its right to protect or realise its security. The principle has been vindicated in a wide variety of cases including those dealing with the mortgagee's right to possession (Quennell v Maltby [1979] 1 WLR 318); the mortgagee's exercise of the power of sale (Latec Investments Ltd v Hotel Terrigal Pty Ltd (in liq) (1965) 113 CLR 265; Forsyth v Blundell (1973) 129 CLR 477); and the mortgagor's right to redeem (Salt v Marquess of Northampton, Stern v McArthur (1988) 165 CLR 489). 97 The mortgage to Mercantile Mutual was created not by way of a transfer of the mortgagor's legal title (as with a mortgage under the general law) but as a charge under s 57(1) of the Real Property Act. On default by Chapel Road, Mercantile Mutual had a right to possession in accordance with ss 60 and 63 which, relevantly, provide: "60 The mortgagee, chargee or covenant chargee upon default in payment of the principal sum or any part thereof … may: (a) enter into possession of the mortgaged or charged land by receiving the rents and profits therefor … … in the same manner in which he might have made such entry or brought such proceedings if the principal sum … were secured to him by a conveyance of the legal estate in the land so mortgaged or charged. 63(1) Whenever a mortgagee, chargee or covenant chargee gives notice of his demanding to enter into receipt of the rents and profits of the mortgaged or charged land to the tenant or occupier or other person liable to pay or account for the rents and profits thereof, all the powers and remedies of the mortgagor, charger or covenant charger in regard to receipt and recovery of, and giving discharges for, such rents and profits, shall be suspended and transferred to the said mortgagee, chargee or covenant chargee until such notice is withdrawn, or the mortgage, charge or covenant charge is satisfied, and a discharge thereof duly registered." 98 Once Mercantile Mutual gave notice pursuant to s 63(2) that it required the tenants of the Bankstown property to pay their rent to it, Chapel Road's powers as landlord to recover those rents were suspended and transferred to Mercantile Mutual. Mercantile Mutual then became entitled to enter into possession by receiving the rents and profits and, if it wished, to bring proceedings in the Supreme Court for possession in the same manner as it could have done had its mortgage been created by a conveyance of the legal estate rather than by statutory charge under s 57. It is important to note that although s 60 equates the rights of the mortgagee under the statutory charge to those of a mortgagee who has taken a conveyance of the legal estate; it does not equate the mortgagee's rights to those of an unencumbered owner of the land. This is a significant distinction when considering the rights of a mortgagor whose mortgagee has gone into possession. 99 The rights and obligations of a mortgagee who is in possession of the mortgaged land have been established over centuries and have been shaped by the recognition of the mortgagee's interest as a security. As mentioned above, the mortgagee is not a trustee for the mortgagor nor is it obliged to care for the property as an owner might; Kennedy v General Credits Ltd (1982) 2 BPR 9456. The mortgagee is not, however, entitled to disregard the mortgagor's interest entirely and will be liable "if there be gross negligence, by which the property is deteriorated"; Wragg v Denham (1836) 2 Y&C Ex 117 at 121-2; 160 ER 335 at 337. 100 The mortgagor's continuing interest in the property is also recognised in the obligation of the mortgagee to account to the mortgagor not only on the basis of actual receipts but also for that it would have received but for its "wilful default". The obligations of a mortgagee who takes possession of land from which a business is operated were considered in Rowe v Wood (1822) 2 Jac & W 553 at 554-5; 37 ER 740. Rowe v Wood was discussed by Hope JA in Kennedy at 9457-9458. It is not necessary here to consider his Honour's observations in any detail, however it is clear that his Honour accepted that the mortgagee's interest was limited to preserving or realising its security. The mortgagee was not obliged to risk its own capital in speculation that would ultimately benefit the mortgagor it was also not entitled to "enter into speculative transactions or arrangements at the expense of the mortgagor". There are, as Hope JA recognised in Kennedy, considerable difficulties in giving content to terms such as "gross negligence" and "wilful default" but that problem need not be addressed here. For present purposes, it is sufficient to note that both terms recognise the need to balance the legitimate interests of mortgagee and mortgagor. 101 In electing to go into possession and carry on the rental business through its agent, Jones Lang Wooten, Mercantile Mutual was acting primarily for its own benefit in preserving the security it had under the mortgage. While, as the primary judge observed, it would be a mischaracterisation to describe the mortgagee as carrying on Chapel Road's business by treating the business as a thing rather than a course of conduct, such a description would capture a fundamental element of what was occurring. The course of conduct involved in running the business may have been Mercantile Mutual's (through its agent) but its right to the income was limited to a right to apply the income to Chapel Road's debt. It could not be said that Chapel Road had no interest in the business or the income of the business. 102 Mercantile Mutual was obliged to account to Chapel Road for the income and would have been liable for wilful default. If the income of the business had exceeded the amount due to the mortgagee, that excess would have been the income of Chapel Road not Mercantile Mutual. The fact that the income was never sufficient to generate an excess does not, in my opinion, alter the legal rights of the parties. Although such income as was obtained was compulsorily applied to the mortgage debt, it was no less the income of Chapel Road than the wages of an employee which are subject to a garnishee order are still the wages of the employee. The construction of the property that was generating the rental income had been financed by the loan secured by the mortgage. The losses incurred by Chapel Road arose because the rental income was not sufficient to cover the interest payable on that loan. Nevertheless the losses were incurred in generating that income. 103 As Heerey and Edmonds JJ have shown there have been a number of cases where it has been held that a loss or outgoing may be deductible even if it was incurred after the taxpayer was no longer involved in the associated business and when there was no question of the taxpayer deriving any current income. In Federal Commissioner of Taxation v Brown (1999) 43 ATR 1 at 9, the Full Federal Court recognised that, in particular circumstances, the period of time between cessation of the business and the payment of outgoings might be fatal to the required nexus between the two. Referring to Fletcher v Commissioner of Taxation of the Commonwealth of Australia (1991) 173 CLR 1 at 18 and 19, their Honours commented, however, that "it is a "commonsense" or "practical" weighing of all the factors which must provide the ultimate answer." The argument here is much stronger for the taxpayer than the situation in Brown because here the taxpayer was still obtaining income from the business even though it was no longer carrying on the business itself. 104 The decision in Commissioner of Taxation (Cth) v Riverside Road Lodge Pty Ltd (In liq) (1990) 23 FCR 305 does not detract from the authority of these decisions. In that case the nexus no longer existed because, as a result of the sale and lease-back of the property on which a motel business was conducted, interest payments on the loan to finance the construction of the motel no longer related to the (now) tenant's business of running the motel. 105 For all of these reasons I am of the opinion that the nexus between Chapel Road's losses and the gaining of income was such that the losses in respect of the interest can be said to be incurred in gaining the assessable income and therefore were allowable deductions. That being the case his Honour's conclusion that the provisions of s 80G of the 1936 Act had been met and that R&D Holdings was entitled to recoup the losses in question must be upheld. It follows that the Commissioner's notices of contention in respect of his Honour's judgment in relation to the 1998 and 1999 tax years must be dismissed. The 1998 and 1999 tax years 106 R&D Holdings' entitlement to a deduction in respect of the losses for these years depends on satisfaction of the requirements of Divisions 165 and 170 of the 1997 Act. Pursuant to those provisions it was necessary for the company to show either that, over the relevant income year, it maintained the same owners within the criteria laid down in s 165-12 or that it satisfied the same business test in accordance with s 165-13 and s 165-210. It is not in contention that Chapel Road did not meet the criteria in s 165-12. Between 1987 and 1997 the shares in R&D Holdings were held by AJ Richardson Properties Pty Ltd and Mudipo Pty Ltd however in July 1997 Mudipo sold its shareholding to Ms Diana Richardson. 107 Simplifying the matter somewhat, the combined effect of ss 165-13 and 165-210 is that, to satisfy the same business test, Chapel Road must have carried on the same business during 1998 and 1999 as it did immediately before the sale to Ms Richardson. As the Commissioner pointed out, citing Avondale Motors (Parts) Pty Ltd v Commissioner of Taxation of the Commonwealth of Australia (1971) 124 CLR 97 at 104, for this test to be satisfied it would be necessary for Chapel Road to have carried on a business "immediately before" that time, that is immediately before July 1997. 108 The primary judge held, and I agree, that from the time Mercantile Mutual went into possession Chapel Road did not carry on any business and for that reason it was incapable of meeting the same business test. The fact that Chapel Road was the legal owner of the land on which the business of leasing the Bankstown property was carried on it does not alter the fact that from the time Mercantile Mutual went into possession, it, rather than Chapel Road, was carrying on the business. His Honour set out his reasons for this conclusion at [151]-[152] of his judgment and I respectfully agree with that analysis. It follows that his Honour's decision on this issue was correct and R&D Holdings' appeals in relation to the 1998 and 1999 years of income must be dismissed. Penalties 109 I have had the benefit of reading in draft the reasons of Heerey and Edmonds JJ on the issue of penalties. I respectfully agree with their Honours' reasons and do not wish to add anything on this issue. 110 In my opinion the appeals should be dismissed and there should be no order as to costs. I certify that the preceding thirty-seven (37) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Stone. Associate: Dated: 13 July 2007 Counsel for the Commissioner of Taxation: A H Slater QC and S J McMillan Solicitor for the Commissioner of Taxation: Australian Government Solicitor Counsel for R & D Holdings Pty Ltd: D K L Raphael and J A Watson Solicitor for R & D Holdings Pty Ltd: Sagacious Legal Pty Ltd Date of Hearing: 5 March 2007 Date of Judgment: 13 July 2007