et a JUDGMENT No, . 598/87... '. CATCHWORODS INCOME TAX - Allowable deductions - residence purchased by family trust of which taxpayer is trustee - purchase financed by mortgage - residence leased by trust to beneficiary at commercial rent - rent included in trustee's assessable income - deduction claimed for mortgage interest by trustee - "negative gearing" - whether interest payments of "private or domestic nature" - whether payments to be apportioned as partly deductible - s.260 has no application where deduction "truly allowable under 5.51". COMMISSTONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Appellant - and - JANMOR NOMINEES PTY. LTD. (AS TRUSTEE OF THE J. REDMAN FAMILY TRUST) Respondent No. VG 386 of 1986 No. VG 387 of 1986 CORAM: Fisher, Lockhart and Jenkinson JJ. 17 September 1987 Melbourne Trey ee fed VICTORIA DISTRICT REGISTRY GENERAL DIVISION IN_THE FEDERAL COURT OF AUSTRALIA ) ) ) No.VG 386 of 1986 ) NO.VG 387 OF 1986 ) ON APPEAL FROM THE. SUPREME COURT OF VICTORTA BETWEEN: COMMISSTONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Appellant - and - JANMOR NOMINEES PTY. LTD. (AS TRUSTER OF THE J. REDMAN FAMILY TRUST) Respondent MINUTE OF ORDER JUDGES MAKING ORDER WHERE MADE DATE OF ORDER THE COURT ORDERS THAT: FISHER, LOCKHART & JENKINSON JJ. MELBOURNE 17 SEPTEMBER 1987 1. Leave be granted to the Commissioner of Taxation of the Commonwealth of Australia to appeal from the judgment of the Supreme Court October 1986. 2. The appeal be dismissed. of- Victoria -herein handed down -17 ae weer. ceo 3 ono oe 2. 3. The Commissioner do pay to the respondent its costs of the appeal including the costs reserved to this Court by Jenkinson J. of the Notice of Motion of 18 February 1987. - Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules. Soo ai anepene ne Pay an se esceror w » IN THE FEDERAL COURT OF AUSTRALIA No. VG 386 of 1986 VICTORIA DISTRICT REGISTRY No. VG 387 of 1986 GENERAL DIVISTON ON APPEAL FROM THE SUPREME COURT OF VICTORIA BETWEEN: COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Appellant - and - JANMOR NOMINEES PTY. LTD. (AS TRUSTER OF THE J. REDMAN FAMILY TRUST) Respondent CORAM: Fisher, Lockhart and Jenkinson JJ. 17 September 1987 REASONS FOR JUDGMENT FISHER J.: In this matter I agree with the orders proposed by Lockhart J. and generally with his reasons. In my opinion there is, in the particular circumstances of this matter, an air of unreality attaching to the arguments of the Commissioner in relation to~the claimed s.51l-deduction and -- the assessability of the rent paid by Dr. Redman. Considered objectively, the rent has all the hallmarks of assessable income in the hands of the taxpayer trustee and the latter's payments of interest arose out of a commercial arms length transaction. It '7 2. can hardly be argued that the payments of interest have not the necessary relevance to or in connection with the derivation of assessable income by the trustee taxpayer. The mere fact that the arrangements in relation to the dwellinghouse were motivated by familial considerations does not deny the interest or the rent their essential characteristics. If it were otherwise, rent or interest paid, for example, by a son-in-law for a home provided for himself, his wife and family would be excluded from the assessable income of the provider. Such a restriction would establish a new and neat form of tax avoidance. Equally it would be most surprising if the fact that a borrower was motivated by familial considerations had any impact upon arms length arrangements with third parties. In the present matter the arrangements in relation to the purchase and letting of the dwellinghouse may well have been motivated by familial considerations, but motive or subjective purpose is usually nothing to the point in 5.51 situations (Magna Alloys v Commissioner of Taxation) (1980) 80 A.T.C. 4542 per Brennan J. at 4551-2). Nor has motive any relevance when determining whether a receipt is assessable income. In each instance the essential character is primarily a matter for objective determination. I endorse the reasoning of Jenkinson J. in Federal Commissioner of Taxation v Groser (1982) 65 F.L.R. 121 in this regard. The Commissioner at all times, at least until it became necessary to support his arguments in Court, correctly accepted the rent as assessable income in the hands of the trustee. His initial disallowance of the interest in part reflected his rejection of Je ete a ad vr TN ee ee ee ee st 3. 'negative gearing' rather than the propriety of the deduction of the whole amount under 5.51. I refer in this regard to the adjustment sheet which accompanied the amended assessment. I certify that this and the 2 preceding pages are a true copy of the Reasons for Judgment of Mr Justice Fisher. Associate tt te Dated: (7 Sey Wr. V mon ea ee eee ct IN THE FEDERAL COUR OF AUSTRALIA No. VG 386 of 1986 No. VG 387 of 1986 VICTORIA DISTRICT REGISTRY GENERAL DIVISION ON APPEAL FROM THE SUPREME COURT OF VICTORIA BETWEEN : COMMISSTONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Appellant AND: JANMOR NOMINEES PTY. LTD. (AS TRUSTEE OF THE J. REDMAN FAMILY TRUST) Respondent COURT: FISHER, LOCKHART and JENKINSON JJ. DATE: 17 September 1987 REASONS FOR JUDGMENT LOCKHART J. This is an appeal from the Supreme Court of Victoria (Murphy J.) dismissing an appeal from a majority decision of the No. 3 Board of Review which allowed the respondent taxpayer's appeal. The Board's decision was to allow the taxpayer to deduct, pursuant to sub-s. 51(1) of the Income Tax Assessment Act 1936 ("the Act"), outgoings in the nature of interest on moneys borrowed to enable the taxpayer to purchase a residence for the purpose of letting it to a surgeon, a Mr. Redman. The Commissioner was in doubt as to whether he could appeal to this Court as of right or by leave. Accordingly, the Commissioner eran — pores wep tear ce —— - " 2. filed a notice of appeal to this Court against the decision of the Supreme Court (VG 387 of 1987) and on the same day filed a notice of application for leave to appeal to this Court against that decision (VG 386 of 1987). A Judge of this Court fixed each proceeding for hearing at the March 1987 sittings of the Full Court +in Melbourne. The taxpayer then moved the Court, by notice of motion filed on 18 February 1987, for an order that the hearing of the appeal, if there was to be an appeal, be deferred until a later sitting of the Fuil Court in Melbourne. Another Judge of this Court heard that motion and found in effect that, on the assumption that leave to appeal was necessary, the Court had no power to make the order sought; but that if the appeal lay as of right then the notice of motion for leave was otiose. His Honour reserved to the Full Court which would hear the motion for leave to appeal each party's costs of the notice of motion of 18 February 1987. On 11 March 1987 the Commissioner filed another notice of motion which sought an order that the motion for leave to appeal be heard concurrently with or immediately before the hearing of the appeal. When the Full Court commenced hearing this matter we were informed by counsel for both parties that it was agreed that the appeal could only be brought to this Court by its leave. Counsel for the Commissioner asked us to hear the appeal and the motion for leave to appeal concurrently. Counsel for the taxpayer raised no objection to this course. ~ We proceeded accordingly. This was obviously the sensible course for the parties and the Court to take, both to save time and costs, and as the argument on the appeal itself was not expected to take more than one day and it would be necessary for counsel to outline the argument in sufficient detail to enable the fo pore A , "ee ens erae poms sae, 3. Court to consider the questions of law involved for the purpose of deciding whether leave to appeal should be granted. With this rather lengthy, but necessary, introduction to the appeal I shall turn to the facts and to the questions of law involved. The facts are in a short compass and are not in dispute. Mr. Redman was a surgeon who returned to Australia in June 1978 from England where he held an appointment at the University of London. He was married with two children. His wife and he wanted to live in the Frankston - Mt. Eliza area of Victoria. He searched for a house. It was always intended that it be a house in which he and his family would live. In November 1978 Mr. Redman commenced practice at Frankston and leased a house in that area in which he and his family lived. The taxpayer was incorporated on 16 October 1978 and a family trust, known as the Redman Family Trust, was established on 19 October 1978. The taxpayer was the trustee of the trust which was a discretionary family trust for the members of the Redman family: Mr. Redman, his wife and two children. Mr. Redman and his wife are the sole shareholders and directors of the taxpayer. On 22 January 1979 the taxpayer and Mr. Redman entered into an agreement under which the taxpayer collected Mr. Redman's bills and performed other services for him. In February 1979 the taxpayer purchased office equipment and furniture and leased it to Mr. Redman. Later it purchased surgical equipment and motor vehicles which it similarly leased to him. Thus the taxpayer performed the services of a service company of the kind recognised in Federal Commissioner of Taxation v. Phillips (1978) 78 A.T.C. 4361. ve a By agreement in writing made on 21 October 1979 the taxpayer purchased a house known as "Delamere" at No. 20 Jacksons Road, Mt. Eliza for $206,500. It became registered as proprietor of the property on 13 December 1979. The principal source: of funds was $175,000 provided by Sandhurst Mutual Permanent Building Society at a rate of interest of 12.25% per annum with repayments spread over 22 years. The balance of the purchase price came from the purchase of a commercial bill which raised some $50,000. [In addition to providing the balance of the purchase price this money was used to pay stamp duty and legal costs relating to the purchase of the property and the purchase of some surgical equipment. Mr. Redman's father in law was an experienced real estate agent and he drew up two leases of the property. One lease was for the whole of the property from the taxpayer to Mr. Redman and the other lease was of one room in the house to him for use as an office. Pursuant to these leases Mr. Redman agreed to pay the taxpayer $200 per week and $130 a month respectively. The rent was submitted to be a realistic commercial rent and was held by the trial Judge to be such and probably even a little more than could have been expected on the open market. Mr. Redman paid the agreed rents to the taxpayer at the end of each month. The trial Judge found~that the property was purchased-by the taxpayer as trustee for the Redman Family Trust after Mr. Redman's accountant had explained to him the "basic elements of negative gearing". His Honour said that this involved the taxpayer borrowing a substantial portion of the purchase price of a property which was to 5. be used for renting. The interest and revenue expenses of the property would at first exceed the income from rent received, but any reasonable loss sustained would be offset against any other assessable income of the owner. As values rose and the interest bill on the property declined it could be anticipated that the rental value of the property would, if it was wisely purchased, increase. As the venture became profitable another property could be purchased. In accordance with such advice the taxpayer entered into the contract to purchase the property. It borrowed money from the building society and purchased the commercial bill to pay for, inter alia, the property. The relevant tax year with which this appeal is concerned is the year ending 30 June 1980. The outgoings of the taxpayer in that year by way of payment of interest on the moneys borrowed to pay for the purchase of the property and its upkeep exceeded the rental income earned. The income and expenditure statement to 30 June 1980 which accompanied the tax return lodged by the taxpayer provided: "Gross rentals received $6,915 Less expenses: Borrowing expenses (amortised) 513 Depreciation (as below) 2,054 Interest on Loans (First Mortgage) 14,251 Insurances 255 Rates 873 Repairs and maintenance including gardening 1,136 19,082 NET LOSS ($12,167)" The Commissioner issued his assessment which disallowed as a deduction the claimed loss of $12,167 and which stated "Loss on rental property not allowed". The taxpayer lodged a notice of objection. The Commissioner issued an amended assessment with an accompanying adjustment sheet which allowed as deductions: borrowing expenses, depreciation, insurance, rates and part of the costs of repairs on the property. It also allowed interest expenses but only to the extent of income received on letting the property. The Commissioner's reasons for disallowing the taxpayer's claim were stated as follows: "That of the amount of $1,136 claimed as a deduction for repairs and maintenance against gross rental of $6,915 in the return of income for the year ended 30 June 1980, no more than $600 is allowable as a deduction pursuant to the provisions of s. 51 or s. 53 of the Act. That of the amount of $14,251 claimed as a deduction in the return of income for the year ending 30 June 1980, as interest on loans, no more than $6,915 is allowable as a deduction pursuant to the provisions of s. 51(1) of the Act." $6,915 is the amount of the gross rentals received by the taxpayer on the property according to its return. The matter went before the No. 3 Board of Review which by a majority upheld the taxpayer's objection and decided to amend the Commissioner's assessment to allow the balance of the interest Payments as a deduction. The balance of the claim for repairs was not allowed by the Board and was not the subject of appeal to the Supreme Court and therefore not to this Court. ayrt te cee eee an 4 5) we? on ee me ergoes = - ve et eet aor . 3 ' -% . —y 7. The Commissioner appealed to the Supreme Court which dismissed the appeal. It is from that decision that the Commissioner brings the appeal to this Court. The Supreme Court made the following findings: - At the time of purchasing the property the taxpayer intended to lease it to Mr. Redman at whatever the appropriate commercial rent was and that by "negative gearing" it intended to set off any annual loss against other income that it might earn. Then as the property was paid off and generated a profit the taxpayer could invest in other property should that have been advisable. Thus it would acquire income earning assets for its beneficiaries. The leases were effectual notwithstanding certain apparent inconsistencies and inappropriate terms. The taxpayer received the best return from the property which it could have expected to receive on the market at the time. The taxpayer realised that in the short term its outgoings in respect of the property, including the servicing of the loan would be likely at first to exceed the rent returned to it from leasing the property. Nonetheless, its income from the services provided under' the "Phillips" type service arrangements was more than sufficient to enable it to service the loan and defray other expenses. Such moneys as the taxpayer was called upon to pay over and above the return TAG mae 8. from the property itself would help to secure a capital asset of an income earning nature and would be in reduction of its assessable income and thus lower its taxable income. In any event this is what the taxpayer believed. In the long term the taxpayer would own a valuable property, of an income earning nature, which would be worth much more than had been originally paid for it, even though annual payments of interest would have to be made up for some years from its independent income which could well have been considered to be assured. The matter should be approached on the basis that the taxpayer was earning a substantial income and saw that, by borrowing in order to purchase the property, it had the opportunity to acquire an income producing and an improving capital asset. The borrowings could be serviced from its other income which would at the same time have the effect of reducing its taxable income. Although Mr. Redman, for personal and family reasons was interested in living in the home, the purchase and letting of the home was dictated by "sound business considerations" and the taxpayer did not engage in the exercise for the same familial purposes as inspired Mr. Redman as a husband and father. The purpose of the letting by the taxpayer to Mr. Redman was to obtain the best income return possible at the time on the property such that it would be easier to pay off its borrowings and the interest thereon. The fact that its wn apes eo om FOTIA eee 9. income tax burden would be reduced, because the outgoings on the property would for some time exceed the rental return from it, would be little consolation to the taxpayer unless over the years it acquired unfettered ownership of the property with its income earning potential. As to s. 260 of the Act, all the taxpayer had done was to adopt a particular course of business conduct which it believed offered, inter alia, certain tax benefits and this did not attract the operation of s. 260. The letting at a commercial rent of the property could not be said to be inexplicable by reference to ordinary business dealings. Even if the arrangement was considered at an earlier stage, namely, when the taxpayer purchased the property, having to borrow the money to do so and intending to let it at a fair rent to Mr. Redman, it could not be suggested that anything in the arrangement, even in so far as it involved "negative gearing", fell outside the scope of ordinary business dealings. Once it can be seen that a particular outgoing incurred has the character of an outgoing incurred in gaining or producing the assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing that income, it is a tax deduction for which the Act itself provides and to which s. 260 cannot apply. The fact that the taxpayer was earning income because of the "Phillips" type arrangement in which it had entered with Mr. Redman enabled FIR pe an een entre wy ee mars 10. it to contemplate the further acquisition of income earning assets for the benefit of the trust. The outgoing of interest on the money borrowed to effect the purchase was an outgoing incurred in gaining or producing the assessable income within the meaning of the first limb of sub-s. 51(1) of the Act. The assessable income was the rent to be earned over the years for which the house was to be let. The fact that Mr. Redman was paying the rent did not cause what was in fact a "commercial rent" to become a "familial contribution". It was at all material times intended by the taxpayer that it should let the premises at the going market rent and this is what it did. There is no warrant for characterising the moneys paid to the taxpayer other than as rent and accordingly as assessable income in its hands. There is nothing to suggest that the loan negotiated with the Sandhurst Mutual Building Society was other than a loan negotiated at arms length at commercial rates; the interest on which the taxpayer was obliged to pay and did pay. It is clear that the moneys borrowed were used to pay for the purchase of the property. In summary, there is nothing to suggest that the taxpayer acted in any way other than in a businesslike manner in entering into the -purchase~-and lease of the property in question. The outgoing of interest was wholly directed to the acquisition of the property as an income earning asset. The rent paid by Mr. Redman was for the enjoyment of a home for himself and his family. Although Mr. Redman's outgoing — er bee rr ee me twee eg paneer li. was no doubt of a private or domestic nature, it did not follow that the taxpayer's outgoing of interest was to be characterised as "private or domestic" and therefore falling outside the qualification for deductibility under sub-s. 51(1) of the Act. The submissions before this Court by counsel for the Commissioner were twofold. It was argued that the rent received by the taxpayer was not assessable income; but, even if the rent was assessable income, the interest payments were not made un gaining or producing the assessable income or, if they were, they were payments of a private or domestic nature. It was argued also that s. 260 of the Act applied to render the arrangements, namely the leases, void. I turn first to the question of the deductibility of the interest payments under sub-s. 51(1) of the Act. In Ronpibon Tin N.L. v. Federal Commissioner of Taxation (1949) 78 C.L.R. 47 the High Court provided some guidance on the meaning of the words "incurred in gaining or producing the assessable income" in the context of sub-s. 51({1) of the Act. Their Honours said at pp. 56-7: " For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the - . assessable... income. it must be incidental and eee ee relevant to that end. The words 'incurred in gaining or producing the assessable income' mean in the course of gaining or producing such income. Their operation has been explained in cases decided under the provisions of the previous enactments: see particularly Amalgamated Zinc (de Bavay's) Limited v. Federal Commissioner of Taxation (1935) 54 C.L.R. 295 at pp. 303-4, 307, 309, 310 and W. Nevill & Co. Ltd. v. Federal Commissioner "of Zoster a cate, aT ———; ro 12. Taxation (1937) 56 C.L.R. 290 at pp. 300, 301, 305-306, 308. Notwithstanding the differences in other respects in the present provision, the expression 'incurred in gaining or producing the assessable income' has been left unchanged and bears the same meaning. In brief substance, to come within the initial part of the sub-section it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income." The interest payments are in discharge of an obligation under the mortgage of the property by the taxpayer to a third party at arms length and the rent is received from a letting at commercial rates. It would be odd if the latter is to be treated as assessable income under sub-s. 25(1) but the former not characterised as expenditure incurred in gaining or producing that assessable income and therefore not deductible under s. 51(1). Counsel for the Commissioner recognised this apparent incongruity and submitted that the rent should not be regarded as assessable income notwithstanding that the Commissioner had treated it as assessable income in both the original assessment and the amended assessment; the latter being the subject of the objection which led to these proceedings. It is, of course, open to the Commissioner to argue his case on this footing although he recognised that he could not disturb the amended assessment except to the extent necessary for the Court to adjudicate on the objection. In other words, the treatment in the amended assessment of the receipt of rent by the taxpayer as assessable income cannot be dislodged by this appeal; but the Commissioner may argue his case with respect to the deductibility of the interest payments on assumptions which are inconsistent with the amended assessment. An approach of this kind does not set the stage very favourably for the a oe oe pacer oe rors en ot tey a awe 13. Commissioner either in his application for leave to appeal or on the merits of the appeal itself. To this observation I should add, however, that it does not follow in revenue law or logic that, if the rent is assessable income in the hands of the taxpayer, the interest payments are necessarily incurred in earning it and are therefore deductible. The Commissioner therefore argued that the rent payments are properly characterised as receipts of a familial nature. There is I think considerable difficulty in accepting the correctness of this argument. Although the Commissioner argued before the Supreme Court that the leases were a sham he abandoned that argument before this Court. The arrangements entered into by Mr. Redman, as director of the taxpayer, for the purchase of the house by the taxpayer and its leasing to him were found by the trial Judge to have been made for mixed purposes. The purchase of the house in the name of the trustee was perceived by Mr. Redman as giving him and his family security from suit if any malpractice proceedings were brought against him. The taxpayer was selected also because of Mr. Redman's desire to minimise death duties in the event of their being reintroduced in Victoria. The trial Judge also concluded that tax advantages for Dr. Redman was a factor in the choice of the taxpayer as the purchaser of the house. Mr. Redman was a medical practitioner recently returned from the United Kingdom. with. a wife.and. young family. He liked the Frankston - Mt. Eliza area and established his practice there and wanted to live there. The house is substantial and was purchased with high negative gearing. He and his wife control the taxpayer and therefore the destiny of its assets and the destiny of the Redman ¢ Son) Se rin ere tn rte are sy qeemacperme emt ae ee eg en rr ne tr ae oe 14. Family Trust; a trust which benefits himself, his wife and his children. The more commercial the flavour of the leases and rent payable thereunder then the more successful would be his application for deductions in respect of the lease payments for the room used as an office (the High Court did not decide The Commissioner 'of Taxation ve Forsyth (1981) 148 C.L.R. 203 until after the arrangements were entered into). It was perceived that for a considerable time the interest payments and the other outgoings in respect of the property would exceed the rent. The only other source of income came from its activities as a "Phillips" type service company. The transaction was in a sense familial in nature in that it was motivated by familial considerations, but that fact is not conclusive of the character of receipt of rent by the taxpayer from Mr. Redman; nor does it determine the character of the payments of interest made under the mortgage. Illustrations abound of arrangements between members of families that nevertheless have a revenue quality. All the relevant circumstances must be examined to determine whether a receipt or disbursement by a taxpayer is income under s. 25 or a deduction under sub-s. 51(1). There are some elements of the arrangements in this case relating to the purchase, mortgage and lease of the property which have commercial attributes. The mortgage was an arms length transaction at--a commercial rate of interest as -was~-the commercial- bill for $50,000. The rent payable under the lease was also at market value. It was not argued, however, that the arrangements had a business quality in the sense of the carrying on of a business within the meaning of the second limb of sub~s. 51(1). Although the a ry 15. arrangements were of a familial nature, they were plainly intended to have legal effect. The Commissioner rightly eschewed before us his earlier suggestion of sham (that "popular and pejorative word" to adopt the phrase of Diplock L.J. in Snook v. London and West Riding Investments Ltd [1967] 2 Q.B. 787 at p. 802). However, his argument that the taxpayer's receipt of rent was not a receipt of income according to ordinary concepts, but some kind of familial receipt, is really an argument of sham in a different guise. Once it is recognised that Mr. Redman and his wife intended to provide for themselves and their family, by obtaining the property as an asset for their mutual benefit and in the expectation of alleviating the burdens of taxation by the use of negative gearing, then the machinery which was used to achieve that object (including the purchase of the property by the taxpayer and the leasing of it to Mr. Redman at a rent determined with market values considerations in mind) necessarily requires that it had legal operation and denies a sham. Therefore, as perceived on the facts of this case, the receipt by the taxpayer of rent under the leases must be a receipt of income according to ordinary concepts and therefore assessable income under sub-s. 25(1). The leases themselves are curious in some respects; especially since the principal lease is of the whole property and the other lease is of the office alone. The reason for the two separate leases is plain enough. Mr. Redman hoped to gain a taxation benefit that might flow from Forsyth's Case which he had read. The trial Judge said that he assumed that Mr. Redman "was referring either to the decision in the Board of Review or in the Supreme Court of Victoria or to the decision in the Federal Court". It was not until April 1981 that the High Court, by a majority, disallowed the pease oy ry 16. deductions claimed by Mr. Forsyth. That case involved the licensing by a family company which owned the family home to a barrister of a room which served the dual purpose of a study and dressing room for which a licence fee was paid by the barrister. The taxpayer claimed the licence fee as a deduction under sub-s. 51(1) and he succeeded before the Board of Review and the Supreme Court of Victoria and the Full Court of this Court. The High Court by a majority allowed the Commissioner's appeal. See also Handley v. The Commissioner of Taxation (1981) 148 C.L.R. 182. Notwithstanding certain inconsistencies between the two leases I agree with the trial Judge that they were nevertheless effectual and that the taxpayer, on receiving the rents, became the landlord of Mr. Redman who as tenant paid a genuine rent at regular monthly intervals. The payment of interest by the taxpayer was in my view an outgoing incurred in the course of gaining or producing the assessable income of the taxpayer. The high ratio of borrowed money to the purchase price, reflected in the large payments of interest on the first mortgage which considerably exceeded the rent received by the taxpayer ($6,915 rent and $14,251 interest), does not, in my opinion, deprive the interest payments of their character as outgoings incurred in gaining or producing the assessable income. Nor can I:see any warrant for severing the interest payments into a portion which was paid in gaining or producing assessable income and a portion which was not so paid. It is true that sub-s. 51(1) itself recognises the potential for severance or apportionment re men er 17. of outgoings into components, only some of which are allowable deductions. The words "to the extent to which" the losses or outgoings are incurred in gaining or producing the assessable income (I refer only to the first limb) indicate this. The mere fact that the interest payments exceed the receipts of rent cannot justify the severance sought by the Commissioner and reflected in the amended assessment. It is only the 1980 tax year with which this case is concerned; but the characterisation of the receipts and payments necessarily involves an analysis and interpretation of them from the inception of the arrangements of 1979 including the obligation to pay interest which arose from the terms of the mortgage. So regarded, the interest payments are not divisible for the purposes of the first limb of sub-s. 51(1). There remains the question under s. 51 whether the payments of interest are wholly or in part only outgoings of a private or domestic nature. Whether losses or outgoings incurred in gaining or producing assessable income and losses or outgoings of a capital, private, or domestic nature are mutually exclusive is a question that has attracted little scrutiny by the courts. Menzies J. said in Federal Commissioner of Taxation v. Hatchett (1971) 125 C.L.R. 494 at p. 498: -- - ~-"It. must be a. rare case where an outgoing incurred -- in gaining assessable income is also an outgoing of a private nature. In most cases the categories would seem to be exclusive." In Federal Commissioner of Taxation v. Faichney (1972) 129 C.L.R. 38 Mason J. said at p. 44 that such examples of private or domestic es oC Me me eee sees 8 NIE 7 eaten iehemiamieate tenes Jae 18. expenditure that leapt to the mind were those that "could not conceivably be incurred in gaining assessable income". In Handley's Case (supra) Stephen J. considered this question at pp. 191-192 and appears to have adopted an approach similar to that of Menzies J. in Hatchett. In Handley's Case Aickin J. said at p. 200: "Logic would seem to suggest that expenditure incurred on private or domestic matters could not be incurred in gaining or producing assessable income but, as appears from the observations in Ronpibon, and in John Fairfax & Sons Pty. Ltd. v. Federal Commissioner of Taxation (1959) 101 C.L.R. 30, strict logic has not been the sole guide of the draftsman. The fact that s. 51(1) both permits and requires dissection and apportionment of expenditure by the use in the opening words of the expression 'to the extent to which they [i.e. 'all losses and outgoings'] are incurred in gaining or producing the assessable income' suggests that some expenditure may be of a mixed character such that it must be apportioned so as to ascertain that amount which can be regarded as expended in gaining or producing assessable income or carrying on a business. Thus the exclusion of expenditure made on, or in so far as it is on, private or domestic matters comes from the requirement of the opening words of s. 51(1) which limit deduction to expenditure incurred in gaining assessable income. The express exclusion in the closing words of the sub-section of expenditure of a private or domestic nature has the same character as the exclusion of expenditure in gaining exempt income; it must be regarded as having been inserted by way of precaution or emphasis - cp. the discussion by Menzies J. in Federal Commissioner of Taxation v. Hatchett (1971) 125 C.L.R. 494, at p. 498. The fact that the opening words impliedly exclude that which is not incurred in gaining or producing assessable income may make the final express excluding words no more than partly explanatory and partly definitive of what is excluded. In my opinion the section does not require a two-stage apportionment." Mason J. said in Handley's Case at p. 194 that outgoings incurred in gaining or producing assessable income and outgoings of a capital or domestic nature are not mutually exclusive. His Honour said: —— 19. "Whether the same is true of outgoings of a private nature is a question that may be left to some future occasion. The very form of s. 51(1) recognises that there are some outgoings which, though incurred in gaining assessable income, nevertheless fall within the exception. Then, to the extent to which they have the latter character, they are not allowable deductions." Wilson J. took a similar view at p. 202. In Forsyth's Case (supra) Wilson J. said at 216: "T see no reason why it would not be a proper application of s. 51 of the Act in the present case to say that if the proper conclusion on the facts was that the rent was prima facie an outgoing incurred in gaining or producing the assessable income then the exception with respect to outgoings of a domestic nature would operate to exclude it from deductibilty." The conclusion of the majority in each case was that the exclusion of a loss or outgoing of a capital or domestic nature is not redundant; but whether the same is true of a loss or outgoing of a private nature is left undetermined. I confess to having difficulty in assigning any subject matter to the exclusion of a loss or outgoing of a private nature. I respectfully agree with Menzies J. in Hatchett's Case in the passage cited above. However, the form of sub-s. 51(1) which recognises in terms that there are some losses or outgoings which, though incurred in gaining or producing assessable income, nevertheless fall within the exception of a loss or outgoing of a private nature suggests that it may have some work to do, rare though its performance would be. see g eer mms ne Sines so re pee wy Seon tt waueee ote . 20. The taxpayer is liable to pay interest to the mortgagee, a company at arms length to the taxpayer and Mr. Redman. The taxpayer receives rent at market rates from Mr. Redman. Plainly the payment of rent for the office (and a fortiori for the property as a whole) falis squarely within Forsyth's Case and is therefore not available as a deduction to Mr. Redman. But that is not determinative of the question whether the payments of interest are of a capital, private or domestic nature. The taxpayer derives assessable income from its activities as a service company to Mr. Redman and from payments of rent by him. If the interest payments were distinctly less than the amount of the rent received I doubt if it could be seriously argued that those payments were of a capital, private or domestic nature. Why is there any difference because the interest payments are much higher than the rent received? The section requires with respect to an outgoing which was incurred in gaining or producing the assessable income, dissection or apportionment if it has a mixed character, one element which is of a capital, private or domestic nature. The Commissioner says that either all the interest payments have that character or that a dividing line must be drawn between such of the interest payments as exceed the rent received; the excess representing the capital, private or domestic nature of the interest. I can see no support for any such arbitrary division. In my opinion the obligation of the taxpayer to pay interest, in the circumstances of this case,--is-excluded from -the category of private or domestic outgoings (it was not argued that it was of a capital nature). a ee ee - rtrrsas 21. Reliance was placed by counsel for the Commissioner on Ure v. Federal Commissioner of Taxation (1981) 50 F.L.R. 219 where the taxpayer, a solicitor, borrowed money at commercial rates of interest of up to 12.5%, paid interest in the relevant year of income of $8,736 and on-lent the borrowed moneys to his wife and a family company at 1% interest. The principal object of the taxpayer was to reduce his taxable income. An ancillary object was to provide financial benefits to his wife and to a family trust. The taxpayer claimed a deduction for all the interest on his loans but the Commissioner allowed only an amount equal to the 1% interest returned as assessable income. The Commissioner therefore substantially disallowed the claim and allowed only a deduction of $660 for interest being the equivalent of the income received by the taxpayer from the on~lending. The Supreme Court of New South Wales held that, to the extent disallowed by the Commissioner, the payment of interest was an outgoing of a private or domestic nature. The Supreme Court concluded that the only deduction allowable under sub-s. 51(1) was so much of the total interest paid as equalled the amount of interest which the taxpayer was entitled to receive on the on-lending of the money. On appeal to the Full Court of the Federal Court it was held, so far as interest was concerned, that it was necessary to apportion the outgoings in respect of interest between what could properly be regarded as incurred in gaining or producing assessable income (thus not being of a private or domestic nature) and what could not properly be so regarded. The Court declined to interfere with the approach taken by Lee J. in the Supreme Court that the appropriate apportionment was to treat the equivalent of what the taxpayer received from on-lending ($660) as being not of a private or domestic we eg I rcv tee tree ees setpere ee on aan ne mn ee wi a Oe 22. nature and to treat the balance of the interest paid by the taxpayer as being of a private or domestic nature. Ure's Case is plainly distinguishable from the present case. The attribution of a private or domestic nature to the interest paid by the taxpayer in Ure's Case lay essentially in the disparity in interest rates between what was payable to the taxpayer on the money borrowed and what was received by him for the money on-lent. Reliance was also placed by counsel for the Commissioner on Federal Commissioner of Taxation v. Groser (1982) 65 F.L.R. 121. In that case the taxpayer owned a house occupied by his invalid pensioner brother. The taxpayer resided elsewhere. The taxpayer allowed his brother to live in the house for two dollars a week in circumstances where the rack rent at the relevant time was about $75 a week. The taxpayer returned the weekly amounts as income and claimed a deduction for interest and other expenses relating to the property. By agreement between the taxpayer and his brother the pension was paid to the taxpayer who kept an account of expenditure he made on his brother's behalf, including the two dollars a week appropriated by the taxpayer to himself which he called "rent". It was held by the Supreme Court of Victoria that the transactions were of a familial character unconnected with the receipt of income as understood in ordinary usage. The Court held that the two dollars per week did not constitute rent and thus assessable income in the taxpayer's hands, but a contribution towards the funds out of which- expenses were defrayed. It followed that the expenses relating to the house were not incurred in producing assessable income and were not deductible. The Court went on to say that, even if the weekly payments were assessable income, the deductions for expenses could not exceed the —— eanena mani Sera = enn weeny SaaS on eel 23. amount included as assessable income because the outgoings were incurred by the taxpayer mainly for private or domestic considerations, namely, to provide lodgings for his brother. Again, the facts of the present case are plainly distinguishable from those in Groser's Case. Groser's Case was distinguished by the Supreme Court of Queensland in Federal Commissioner of Taxation v. Kowal (1983) 84 A.T.C. 4,001. In that case the taxpayer and his wife purchased his parents' house after the breakup of the parents' marriage when his mother, who was alone in the house, had difficulty meeting mortgage payments and expenses. The property was purchased with money borrowed on mortgage. During the year of income in guestion the property was rented back to the taxpayer's mother for ten dollars per week when a commercial rent would have been about fifty dollars per week. [In his return of income for the relevant tax year the taxpayer included as income half the rent received and claimed as deductions under sub-s. 51(1) half the expenses connected with the property which included the mortgage interest. The Commissioner excluded the rent received from the property from the taxpayer's assessable income and disallowed the deductions claimed. On reference to the No. 3 Board of Review it was held that the rent received by the taxpayer was assessable income, and, by a majority, the taxpayer's claim for deductions under sub-s. 51(1) was allowed. On appeal to the Supreme Court the appeal was allowed in part. The Supreme Court said that the outgvoings were to be apportioned between the amount expended in gaining or producing income and that having a private or domestic nature. An appropriate apportionment was 80% of the outgoings as having the requisite characteristics of outgoings incurred in earned assessable income 24. unless 80% of the outgoings was less than the actual amount of assessable income earning from the borrowed funds in which case the appropriate deduction would be such portion of the outgoings as equalled the income earned. In the result, 20% of the expenditure claimed was disallowed on the ground that that was a fair assessment of the domestic or private portion of the expenditure in the year in question. Accordingly the Commissioner fails in this appeal unless his argument succeeds with respect to s. 260. I should add that the interpretation of the exception to sub-s. 51(1) of losses or outgoings of a capital, private or domestic nature and their application to the facts of this case raise in my view questions of sufficient importance to warrant the grant of leave to appeal. It is worth noting that negative gearing arrangements such as those involved in the present case are now limited in their operation by subdivision G of Division 3 of Part III of the Act inserted by s. ll of Act No. 46 of 1986 and applies first in relation to the year of income ended 30 June 1986. Broadly speaking the effect of these provisions is that the aggregate amount of interest incurred in a year of income on borrowings to finance rental property investments made after 17 July 1985 is deductible only to the extent of the aggregate net rental income derived in the year from all such investments. It was submitted on behalf of the Commissioner that s. 260 applied. The difficulties in applying s. 260 to extinguish a 25. deduction otherwise allowable under s. 51 have been referred to in decisions of the High Court and previous decisions of this Court. In Cecil Bros. Pty. Ltd. v. Commissioner of Taxation (1964) 111 C.L.R. 430 Dixon C.J. said at p. 438: "In my opinion, s. 260 of the Act can have no application to such a case as the present. Indeed, in spite of the views expressed by Owen J. and by Menzies J., I have great difficulty in seeing how it could apply to defeat or reduce any deduction otherwise truly allowable under s. 51." Kitto J. agreed with the judgment of Dixon C.J. at p. 438 and Taylor J. said at the same page that he shared the difficulty of the Chief Justice in seeing how s. 260 could extinguish a deduction otherwise properly allowable under s. 51. As Beaumont J. pointed out in Federal Commissioner of Taxation v. Lau (1984) 84 A.T.C. 4,929 at p. 4,946, although the High Court in Cecil Bros did not need to decide the question whether s. 260 could operate to defeat or reduce a deduction otherwise truly allowable under s. 51, the expressions of opinion on the point by Dixon C.J., Kitto and Taylor JJ. should be treated as authoritative for present purposes. Jenkinson J. agreed with the judgment of Beaumont J.. In my opinion this Court should follow the same course, with the result that, as I have concluded that a deduction under sub-s. 51(1) is available, the deduction cannot be denied by s. 260. Leave to appeal from the judgment of the Supreme Court of Victoria should be granted and the appeal dismissed with costs T nity ares me weer ee meres epee 26. including the costs reserved to this Court by Jenkinson J. of the notice of motion of 18 February 1987. I certify that this and the preceding twenty-five (25) pages are a true copy of the reasons for judgment herein of the Honourable Mr. Justice Lockhart. Lv ~ Associate Dated: 17 September 1987 =r IN THE FEDERAL COURT OF AUSTRALIA ) VICTORIA DISTRICT REGISTRY >) No. VG386 of 1986 GENERAL DIVISION ) No. VG387 of 1986 ON APPEAL FROM THE SUPREME COURT OF VICTORIA BETWEEN: COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Appellant AND: JANMOR NOMINEES PTY. LTD. (AS TRUSTEE OF THE J. REDMAN FAMILY TRUST) Respondent CORAM Fisher, Lockhart and Jenkinson Jd. DATE: 17 September, 1987 REASONS FOR JUDGMENT JENKINSON J. I agree in the orders proposed by the other members of the Court, and in their reasons for judgment, which I have had the advantage of reading. In support of his submission that the interest payments under the mortgage were "outgoings of .... a .... private or domestic nature", within s.51(1) of the Income Tax Assessment Act 1936, counsel for the Commissioner relied upon the circumstances that the taxpayer was a mere instrument of Dr. Redman and that the vF transactions of which the grant of the mortgage is part were directed by Dr. Redman, as it was submitted, to the private and domestic purpose of providing for him and his wife and children a family home. Counsel submitted that the Court should look through the separate legal personality of the taxpayer to the reality of that family provision. But reality cannot be denied to the trust to which the house was subject. The house was to be not only a family home, but also part of the trust property, which neither the taxpayer nor Dr. Redman could regard as its or his own. In that property the taxpayer could have no beneficial interest. Nor could Dr. Redman have any beneficial interest in the freehold estate in the house or in the proceeds of any sale of that estate unless and until he had first caused the taxpayer to exercise in his favour a discretionary power conferred by the trust deed on the taxpayer as trustee to benefit one or more of the beneficiaries designated by that deed. Not all of the possible beneficiaries have yet been born. Not all of them are, or will be, members of Dr. Redman's family. The trust comprehends identifiable charitable bodies as well as charitable purposes. The decisions taken by the taxpayer to buy the house and to grant the mortgage and to lease the house to Dr. Redman were all taken in exercise of powers conferred, and in performance of duties imposed, on the taxpayer as trustee. Equity required that in the making of those decisions the taxpayer have regard to the interests of all the possible beneficiaries, including those who might enjoy, in the year 2058 or on such earlier day as the trustee might appoint for the termination of the trust, the corpus of the trust estate, of which the house was to form part. There was no finding by the Supreme Court of Victoria, nor evidence to fp re men ee oa an see ce a erg ie ot require a finding, that the taxpayer or, if the taxpayer be regarded as a mere instrument, Dr. Redman had wholly disregarded the interests of possible beneficiaries other than himself, his wife and his living children. If it be conceded that regard was had in the making of those decisions to the interests of all whose interests the law required to be considered, the submission that the mortgate interest payments were "outgoings of ....a private or domestic nature" cannot in my opinion be accepted. I certify that this and the two preceding pages are a true copy of the Reasons for Judgment herein of The Honourable Mr. Justice Jenkinson. Lvs Dated: 17 September, 1987 Counsel for the Appellant Mr. B.J. Shaw QC and Mrs. A. Moshinsky Solicitor for the Appellant : Australian Government Solicitor Counsel for the Respondent 2 Mr. J.D. Merrails QC and Mr. K.S. Pose Solicitors for the Respondent : Fernon & Ludescher Date of Hearing 12 March, 1987 cory mre ey . ' .