CATCHWORDS INCOME TAX - appeals from Commissioner of Taxation's decisions to disallow applicant's objections - whether determinations of Commissioner should be varied to exclude certain sums from applicant's assessable income - whether certain loan transactions a sham - discussion of principles - whether transactions void against Commissioner by s 260 Income Tax Assessment Act 1936 (Cth) - whether loans stood independently of and were not included in the scheme avoided by s 260 - whether s 260 is a provision which annihilates but does not permit the Commissioner to reconstruct a new and fictitious set of facts creating a liability in the taxpayer. INCOME TAX - claim for deduction in respect of a bad debt - whether amount claimed as a bad debt was a bad debt within s 63(1)(b) Income Tax Assessment Act 1936 - whether debt was in respect of money lent in the ordinary course of the business of lending money - whether applicant carrying on a business of lending money - whether loan made in ordinary course of such a business - whether deduction can be claimed under s 51(1). INCOME - whether sham loan moneys received beneficially by applicant were income. Taxation Administration Act 1953 (Cth) s 14ZZ Income Tax Assessment Act 1936 (Cth) ss 51(1), 63(1)(b), 97, 260 Agreement between Australia and the Kingdom of the Netherlands for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income Article 7 Traknew Holdings Pty Ltd v Federal Commissioner of Taxation (1991) 91 ATC 4272 Sharrment Pty Ltd v Official Trustee (1988) 18 FCR 449 Snook v London and West Riding Investments Ltd [1967] 2 QB 786 Allsene Pty Ltd v Federal Commissioner of Taxation (1989) 89 ATC 5333 Esanda Ltd V Burgess [1984] 2 NSWLR 139 Cranstoun v Federal Commissioner of Taxation (1984) 75 FLR 220 Ferguson v O'Neill [1943] VLR 30 The Squatting Investment Co Ltd v Federal Commissioner of Taxation (1953) 86 CLR 570 Commissioner of Taxation v The Myer Emporium Limited (1987) 163 CLR 199 Commissioner of Taxation v Co-Operative Motors Pty Ltd (FCA/Northrop J - unreported - 23 June 1995) Newton v Federal Commissioner of Taxation (1958) 98 CLR 1 Federal Commissioner of Taxation v Casuarina Pty Ltd (1971) 127 CLR 62 Federal Commissioner of Taxation v Gulland (1985) 160 CLR 55 Davis v Federal Commissioner of Taxation (1989) 86 ALR 195 Peate v Federal Commissioner of Taxation (1964) 111 CLR 443; (1966) 116 CLR 38; [1967] 1 AC 308 Bunting v Federal Commissioner of Taxation (1989) 89 ATC 5245 Newton v Pyke (1908) 25 TLR 127 Commissioner of Taxation v Bivona Pty Ltd (1990) 21 FCR 562 RICHARD WALTER PTY LTD v COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Nos NG 973, 974, 975, 976, 977 and 978 of 1992 Tamberlin J Sydney 11 July 1995 IN THE FEDERAL COURT OF AUSTRALIA) NEW SOUTH WALES DISTRICT REGISTRY) Nos NG 973, 974, 975 GENERAL DIVISION ) 976, 977 and 978 of 1992 BETWEEN: RICHARD WALTER PTY LTD Applicant AND: COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Respondent CORAM: TAMBERLIN J PLACE: SYDNEY DATED: 11 JULY 1995 REASONS FOR JUDGMENT Before me are five applications by Richard Walter Pty Limited ("Richard Walter") which are appeals pursuant to s 14ZZ of the Taxation Administration Act 1953 (Cth) as amended from determinations made by the respondent Commissioner of Taxation ("Commissioner"), under the Income Tax Assessment Act 1936 (Cth) ("the Act"), disallowing the applicant's objections, lodged against the amended assessments of income tax for the income years ended 30 June 1981 to 30 June 1984 inclusive, and income year ended 30 June 1989, in the case of the fifth application. The appeal, NG 974 of 1992, relating to the 1989 year of income, was not pursued at the hearing. The first four appeals seek to vary the determinations of the Commissioner by excluding from the assessable income for year ended 30 June 1981, the sum of $2,143,148 and for the three succeeding years the amounts of $1,869,195, $1,645,165 and $3,737,581 respectively. The fifth appeal, which relates to the year ended 30 June 1989, seeks variation of the objection decision by allowing a deduction of the sum of $190,900.00 shown in the adjustment sheet as "Bad debt disallowed - G.Edelsten" and a further sum of $19,326.00 shown in the adjustment sheet as "Debt collection expenses disallowed" which relates to the Edelsten debt. These figures were corrected during the course of the hearing to $188,708.85 and $18,458.44 respectively. In the first four appeals in respect of income years 1981 to 1984 inclusive, the Commissioner has included the amounts referred to as income in the Richard Walter assessable income in reliance on three grounds. The first is that a number of transactions (the Article 7 arrangements) which were entered into on or shortly prior to 25 May 1981 were a "sham" and of no force or effect. The second alternative ground is that the transactions are void against the Commissioner by reason of the provisions of s 260 of the Act. The third ground in the alternative to the second ground is that the Commissioner is entitled to apply Part IVA of the Act to the transactions. The appeal in respect of the first four matters concerns the restructuring of what may be described as the Wenkart group of companies ("the group") in order to achieve, for years ended 1981-1984 inclusive, the exemption of the amounts referred to by reason of the provisions and effect of Article 7 of the Australia/Netherlands Double Taxation Agreement ("the Agreement"). The 1981 arrangements were designed to channel most of the income of the Morlea Partnership , a member of the group, to a Dutch company and thereby secure the benefit of an exemption in the Agreement. The claimed result of this restructuring is reflected in the following note to the income tax return of Aurelius Commodus Investments BV ("Aurelius Commodus"), a Dutch company which was non-resident in Australia, and to which it was sought to divert the entitlement to the income in question, for the year ended 30 June 1981: "The company was incorporated in the Netherlands, and acquired units in the Aurelius Unit Trust on 29 May, 1981. In addition it has undertaken share trading activities using a Sydney Stock Broker. The company is totally managed and controlled in the Netherlands and does not carry on any business in Australia through a permanent establishment in Australia. Accordingly, the provisions of Article 7 of the Australian/Netherlands Tax Treaty apply to fully exempt from Australian income tax the profits derived by the company in Australia. Details of profits derived by the company in Australia are: $A Distribution from the Aurelius Unit Trust 1,936,587 Less: Share trading loss (see schedule attached) 1,905 Net Income $1,934,682" Article 7 of the Agreement as in force between 1981 and 1984, was in these terms: "ARTICLE 7 Business Profits (1) The profits of an enterprise of one of the States shall be taxable only in that State unless the enterprise carries on business in the other State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State, but only so much of them as is attributable to that permanent establishment ...." The tax benefit sought to be achieved was that the income of the Morlea Partnership which ultimately flowed through to Aurelius Commodus, the Dutch company, as the holder of 99% of the units in the Aurelius Unit Trust which had a 95% interest in the Morlea Partnership, was not subject to Australian income tax, by virtue of the above provision of the Agreement. The four appeals relating to the Article 7 exemption arrangements will be referred to as the Aurelius Commodus Article 7 appeals. The other subject matter of the appeals argued before me, relates to the claim for a deduction in respect of a bad debt advanced by the applicant to Dr Geoffrey Edelsten, ("Edelsten"), during the period 1983-1989 in the total sum of $190,900 together with collection expenses of $19,326. This deduction is claimed for the financial year ended 30 June 1989. The claim is made on the basis that during the relevant period the applicant was a licensed money-lender and lent the moneys in question to Edelsten, who could not pay and accordingly in the year ended 30 June 1989, the loan was written off as a bad debt and the attempted collection expenses were also deducted. The deductions were claimed in respect of those amounts alternatively on the basis of either s 63 (1)(b) of the Act or s 51(1) of the Act. These claims were disallowed by the Commissioner. I will refer to this matter as the bad debt claim. Participants Dr Thomas Richard Wenkart ("Wenkart") is a medical practitioner who was in general practice for many years before establishing the Macquarie Pathology Group. He has many diversified business interests apart from the pathology business. However, the pathology business is the principal provider of the cash flow that funds the other activities of the group. During the year 1970, Wenkart formed a company, Preventicare Pty Ltd, with Edelsten. The company's concept was to act as a central laboratory for pathology services for general practitioners. In 1971 the venture, however, failed and the company was put in the hands of a liquidator. In 1972, pursuant to a scheme of arrangement, Wenkart formed Morlea Pathology Services Pty Ltd to run the pathology laboratory previously conducted by Preventicare Pty Ltd. The existing business grew out of this action. In December 1977, the assets of Morlea Pathology Services Pty Ltd were transferred to Morlea Professional Services Pty Ltd ("MPS Pty Ltd"). Receipts were paid to the service company on a daily basis under a service agreement dated 23 December 1977 between Wenkart, trading as Macquarie Pathology Services, and MPS Pty Ltd. The fees transferred were approximately 96% of Wenkart's total receipts. The amount of fees paid by Wenkart to MPS Pty Ltd were not based on a fee for service or at a set rate, but represented the remainder of income received by him, after the deduction of minor incidental expenses. In other words, the fee income was merely passed over or transferred to MPS Pty Ltd after passing through Wenkart's hands. The pathology business has been restructured a number of times, each time for the purpose of avoiding tax. Prior to the setting up of the Aurelius Commodus Article 7 structure, pathology fees were paid to Wenkart as the registered provider, and then subsequently 95% (approx) of the fees were paid as service fees to the Morlea Professional Services Unit Trust. The unit holders in the Morlea Professional Services Unit trust were the Morlea Discretionary Trust and the Morlea Trust. The income of these trusts was sought to be annihilated by way of trust strips and other avoidance schemes. MPS Pty Ltd is the ultimate trustee of the Aurelius Unit Trust, manager of the Aborda Trust, and manager of the Morlea Partnership and is the company with which Wenkart has a service agreement to supply to him pathology processing services. Morlea Professional Services Unit Trust ("Morlea Unit Trust") was the provider of pathology services to Wenkart prior to the Aurelius Unit Trust arrangement. The trustee of the trust was MPS Pty Ltd and the unit holders, prior to the appointment of the Morlea Partnership as unit holder, were the Morlea Trust and the Morlea Discretionary Trust. The income of these trusts was stripped in the years prior to this arrangement being implemented. The 1981 trust strip was challenged under s 260 of the Act and was held to contravene the section. See Traknew Holdings Pty Ltd v Federal Commissioner of Taxation (1991) 91 ATC 4272, a decision of Hill J. Aurelius Unit Trust was established on 18 May 1981 by Ligustrum Co Ltd ("Ligustrum"), a non-resident UK company, which was trustee and sole unit holder. Ultera Pty Ltd ("Ultera"), a resident Wenkart company, was the appointer under the trust. On 19 May 1981 Ultera removed Ligustrum as trustee and appointed Sixterra BV, a Netherlands resident Wenkart company. On 25 May 1981 Ultera removed Sixterra BV and appointed Iroos Pty Ltd ("Iroos"), a resident company, as trustee, and then at a later time on the same date ultimately appointed MPS Pty Ltd as trustee. The unit holders of the Aurelius Unit Trust became Ventura Securities Incorporated, a Californian limited partnership, as to 10 units, and Aurelius Commodus, a Netherlands resident company, as to 990 units. Aurelius Commodus is a company incorporated in the Netherlands. It is 100% owned by Kimberton Investments NV, a resident of the Netherlands Antilles, which is in turn 100% owned by Zeeno Investments Ltd, resident in Jersey, which in turn is solely owned by the Mayfair Trust, a Hong Kong blind trust, which Wenkart controls as "protector". Aurelius Commodus holds 990 of 1000 Units in the Aurelius Unit Trust, and is the principal entity on which the arrangement hinges. Morlea Partnership was established by deed of partnership agreement dated 25 May 1981. The partners were Iroos as trustee of the Aurelius Unit Trust having a 95% interest, and Aborda Pty Ltd ("Aborda") as trustee of the Aborda Trust having a 5% interest. Aborda is an Australian resident company and is trustee of the Aborda Trust. Aborda Trust is a partner of the Morlea Partnership, having a 5% interest. The beneficiaries of the trust are all residents related to Wenkart. During the years 1981-1984 Richard Walter was the nominated beneficiary and in fact received all of the distributions of income made by the Aborda Trust. Kimberton Investments BV ("Kimberton") is a company resident in the Netherlands Antilles, and is the 100% beneficial owner of Aurelius Commodus. It is 100% owned by Zeeno Investments Ltd, and is administered by Equity Trust NV. Zeeno Investments Ltd ("Zeeno") is a Jersey resident company administered by Hill Samuel (Channel Islands) Trustee Company. It is the owner of Kimberton, and therefore of Aurelius Commodus. It is the sole general partner of Ventura Securities Inc. Richard Walter is an Australian resident company. It served as the internal financier or group banker for the Macquarie group of companies. It had extensive property interests. Dennis Lear ("Lear") is a director of taxation consultants Greenwoods & Freehills Pty Ltd, and was after 25 May 1981 a tax advisor to the Macquarie Group and Wenkart. Steven A Lang ("Lang") was formerly a partner at Stephen Jaques Stone James, and in concert with Lear and Sharp was believed to have played a significant role in the formation of the Aurelius Unit Trust arrangement. Jeffrey R Sharp ("Sharp") is a director of Greenwoods & Freehills Pty Ltd and with Lear and Lang was believed to be an architect of the Aurelius Unit Trust arrangement. I will first turn to the Article 7 issues and then the claim in respect of the Edelsten bad debt. Article 7 Claim - The Assessments For each of the years of income ended 30 June 1981 to 1984 inclusive, the Commissioner raised assessments against MPS Pty Ltd in reliance on the grounds of sham, s 260 and/or Part IVA of the Act including in MPS Pty Ltd's assessable income: "The net income purportedly derived by Morlea Professional Services Pty Limited as agent for Morlea Partnership ..." The amounts included were, according to the applicant's written submissions: "$2,246,103 (1981), $1,957,047 (1982), $1,730,198 (1983), $3,937,787 (1984) [Ex. A Docs. 14, 17, 20 and 23]. Objections to these assessments have not yet been determined. For each of the years of income ended 30 June 1981 to 1984 inclusive, the Respondent also raised assessments against the Applicant again in reliance on the grounds of sham, Section 260 and/or Part IVA including in the Applicant's assessable income: "The net income purportedly derived by Morlea Professional Services Pty. Limited as agent for the Morlea Partnership...". The amounts included were: $2,143,184 (1981), $1,869,195 (1982), $1,645,165 (1983), $3,737,581 (1984) [Ex. A Docs. 2, 5, 8 and 11]. These amounts differed from those included in Morlea's assessable income by reason that the Respondent gave the Applicant a credit for the amount of assessable income it had derived under the Aborda Trust, the trustee of which was a 5% partner in the Morlea Partnership." The Pre-1981 Structure Prior to 25 May 1981 and during the whole of that year, Wenkart, who is the governing mind and principal of the group of companies relevant to the present matter, structured his pathology practices in substance along the lines indicated on the diagram reproduced below: The Pre-1981 Structure As can be seen from the diagram, Wenkart received fees from patients and from Medicare. Those fees were in turn passed across to the company, MPS Pty Ltd. That company, as trustee for Morlea Unit Trust, provided services to the practice from which the professional fees were generated, in return for service fees. Units in the Morlea Unit Trust were owned as to 100% by the company Ultera. Ultera in turn acted as the trustee of a discretionary trust known as the Morlea Trust of which the discretionary beneficiaries were members of Wenkart's family and companies and entities associated with Wenkart, including the Richard Walter company, which was under the control at all material times of Wenkart and Mr Geoffrey Holden ("Holden"), the financial controller of the group. The recipient of the bulk of the cash from this arrangement was MPS Pty Ltd and the evidence was that on a regular basis, every two or three days, the pools of cash, which accumulated from fees were "lent" to the Richard Walter company. There was no loan agreement. The moneys were "lent" interest free. Apart from journal entries there was no evidence of these payments. In effect, Richard Walter acted as the group financier or banker, drawing off surplus funds from companies which had surplus funds and lending funds to companies which were in need of funds. There were also loans made to outside entities from time to time. Funds were borrowed from outside entities. This was the position up until 24 May 1981. In the May 1981 restructure in the period 18 May 1981 to 25 May 1981, preliminary steps were taken to restructure the group. I should add here that the date of these restructuring steps, and the whole rearrangement, are contested by the Commissioner. The Commissioner's position is that the restructure in fact took place after 27 May 1981 and as a result is subject to Part IVA of the Act. On 25 May 1981, a series of steps were taken by the relevant members of the Richard Walter group of companies and the result of this restructuring is shown in the diagram set out below: The 1981 Restructure 25/05/81 - 30/06/84 The diagram shows that whereas previously the service fees had been directed to MPS Pty Ltd as trustee for the Morlea Unit Trust, after the restructure, the service fees were directed to an entity known as the Morlea Partnership, conducted by MPS Pty Ltd on behalf of the partners. The two partners in the Morlea Partnership were the Aborda Trust and Aurelius Unit Trust. The Aborda Trust had Aborda as trustee for the same discretionary beneficiaries as in the Morlea Trust. The Aborda Trust had a 5% interest in the Morlea Partnership. The second, and more important partner, was the new trust, known as the Aurelius Unit Trust, of which MPS Pty Ltd was the trustee. Units in that trust were taken up by Ventura Securities Inc as to 1% of the units. This was a Californian corporation. The other and more important participant in the unit trust as to 99% of the units, was the entity described as Aurelius Commodus, the Dutch corporation. As was the case before the rearrangement, the cash received by the Morlea Partnership continued to flow on a regular periodic basis in the order of every two to three days across to Richard Walter, which moneys were used to finance the activities of other members in the group and to lend and borrow moneys from external financiers for the purpose of carrying on its activities. The significance of the rearrangement is that 95% of the service fees were diverted to the Netherlands corporation, Aurelius Commodus, as ultimate beneficiary. The income of that Dutch company was claimed to be exempt from Australian income tax, by reason of Article 7 of the Agreement, because as its tax return claims it was totally controlled and managed in the Netherlands and did not carry on any business in Australia through a permanent establishment in Australia. Accordingly, it was said its income was fully exempt from Australian income tax as being profits derived by the company in Australia. In 1985 legislative amendments to the Act effectively closed off the tax effectiveness of this arrangement. It is conceded by the applicant that the purpose or effect of the new corporate structure was to shelter effectively from Australian income tax the very large bulk of income which had previously come to the Morlea Unit Trust, and that sheltering was achieved because the income was ultimately derived by Aurelius Commodus. Steps in the May 1981 Restructure The reorganisation of the group to take advantage of Article 7 involved the following steps, all of which were carried out on advice and in accordance with documents prepared by Greenwoods & Freehills Pty Ltd and the solicitors to the group, Stephen Jaques Stone James. The documentation was purported to achieve the following results: 1. On 18 May 1981 a company known as Ligustrum established the Aurelius Unit Trust off shore, with Ligustrum as both trustee and holder of all the initial units. Ligustrum was a non-resident UK company resident in Hong Kong. The appointer of the trust was represented to be Ultera, a resident company controlled by Wenkart. Ligustrum held all the units in the trust. 2. Subsequently, 99 units in the Aurelius Unit Trust were acquired by Aurelius Commodus and 1 unit was acquired by Ventura Securities Inc ("Ventura"). Ventura was a Californian incorporated limited partnership of which the sole partner was Zeeno of Jersey, and was also controlled by Wenkart. 3. On 19 May 1981 Ultera purported to remove Ligustrum as trustee of the Aurelius Unit Trust and to appoint Sixterra BV as trustee. Sixterra BV was a Netherlands company. 4. On 25 May 1981 at 5.50 pm Ultera removed Sixterra BV as trustee and appointed Iroos, (an Australian resident company), as trustee of the Aurelius Unit Trust. 5. On 25 May 1991 at 5.58 pm Aborda was appointed as trustee of the Aborda Trust which was in turn settled by Holden, the financial controller of the Wenkart companies. 6. On 25 May 1981 at 6.02 pm Iroos and Aborda entered into a partnership agreement for the establishment of the Morlea Partnership in which Iroos held 95% of the capital and Aborda the remaining 5%. 7. On 25 May 1981 Iroos declared that it held its interest in the partnership known as the Morlea Partnership, on trust for the Aurelius Unit Trust. 8. On 25 May 1981 at 6.30 pm Ultera as trustee of the Morlea Trust declared that Aborda and Iroos were the eligible beneficiaries of that trust. Capital was also appointed to Aborda and Iroos. 9. On 25 May 1981 at 6.30 pm Wenkart appointed the Morlea Partnership as an eligible beneficiary of the Morlea Unit Trust. 10. On 25 May 1981 at 6.50 pm MPS Pty Ltd, as trustee of the Morlea Unit Trust, declared an interim distribution to the Morlea Partnership. 11. Morlea Unit Trust was thereafter represented to be determined and all its capital and income after the interim distribution, to have been distributed by book entry to the partners of the Morlea Partnership. 12. On 25 May 1981 at 6.55 pm, Aborda appointed MPS Pty Ltd as its agent with respect to all matters relating to the Morlea Partnership. 13. On 25 May 1981 at 6.58 pm Ultera removed Iroos as the trustee of the Aurelius Unit Trust and appointed MPS Pty Ltd as trustee. 14. On 25 May 1981 at 7.00 pm MPS Pty Ltd accepted appointment to act as agent for Aborda. 15. The partnership agreement between Iroos and Aborda provided that Iroos held 95% of the capital and Aborda 5% of the capital. Thus it appeared that the pathology service business previously conducted by MPS Pty Ltd as trustee of the Morlea Unit Trust was vested in the Morlea Partnership and thereafter conducted by MPS Pty Ltd purportedly in the capacity of agent for the Morlea Partnership. 16. All of these steps were pre-arranged and documentation was drafted by the group's tax advisers and implemented at one meeting by means of minutes, drafted in advance and about which the only explanation given was that they "worked" for tax purposes. The date of the meeting was said to be two days before Part IVA of the Act came into operation. Structure: 25 May 1981 to 30 June 1984 After the establishment of the Morlea Unit Trust, Wenkart, trading as Macquarie Pathology Services, remained the registered provider and received all professional fees. From 25 May 1981 to 30 June 1984, Wenkart continued to receive all fees and banked them with Macquarie Pathology Services. Almost each working day amounts were transferred from Macquarie Pathology Services to the account of MPS Pty Ltd. Disbursements and expenses were paid from that account and the remaining cash was transferred across to Richard Walter on a regular and recurrent basis every two or three days during this period. The income tax returns for the Morlea Partnership purported to show as a current asset loans to Richard Walter. The loan account balance in the books of the Morlea Partnership was $1,707,500 as at 30 June 1981, $3,376,302 on 30 June 1982, $5,428,989 as at 30 June 1983 and $7,355,581 as at 30 June 1984. The income tax returns for the Morlea Partnership during that period represented that the net income of the Morlea Partnership had been distributed as to 95% to MPS Pty Ltd as trustee of the Aurelius Unit Trust and as to 5% to Aborda in its capacity as trustee of the Aborda Trust as follows: Year of Income Purported Share of Net Income of Aborda Pty Ltd Purported Share of Net Income of MPS Pty Ltd as Trustee of the Aurelius Unit Trust 1981 $102,955.00 $1,956,148.00 1982 $ 87,852.00 $1,669,195.00 1983 $ 77,135.00 $1,465,563.00 1984 $196,889.00 $3,740,898.00 In the income tax returns of the Aurelius Unit Trust for the relevant years of income it was asserted that the net income of the trust estate included MPS Pty Ltd's purported share of the net income of the Morlea Partnership and that the net income of the Aurelius Unit Trust was distributed between the two presently entitled unit holders, Aurelius Commodus and Ventura in the proportions of 99% and 1% respectively, as follows: Year of Income Present entitlement of Ventura Securities Inc. Present entitlement of Aurelius Commodus Investment BV 1981 $19,561.00 $1,936,587.00 1982 $16,691.00 $1,652,455.00 1983 $15,119.00 $1,496,778.00 1984 $37,409.00 $3,703,489.00 Although Aurelius Commodus and Ventura purported to have a present entitlement to a share in the income of the Aurelius Unit Trust, no significant payment was in fact ever made to Aurelius Commodus, or Ventura. In 1982 the debts said to have been owed by Richard Walter, in relation to the transfer of moneys on a two to three day basis, were purported to be unilaterally altered by Holden from a current liability to a non-current liability. In doing this Holden did not take into account the interest of the beneficiary and if the reality was that the assets of MPS Pty Ltd were held in trust for Aurelius Commodus then there would have been a breach of trust. The alleged indebtedness arising by way of loans to Richard Walter was interest free. Holden gave evidence that the change from current to non-current liability was not opposed to the interests of Aurelius Commodus. In considering the effect of the arrangements in place between 25 May 1981 to 30 June 1984, it is important to consider the context in which the arrangements were placed. For the year of income ended 30 June 1980, the net income derived from the pathology service business conducted by MPS Pty Ltd and trustees of the Morlea Unit Trust was stripped in order to avoid tax. The stripping operation involved a breach of trust and this breach of trust was the step which actually stripped the trust. Hill J in Traknew upheld the application of s 260 of the Act to the stripping arrangements. He pointed out that the appellant did not really challenge the application of s 260 but rather argued as to the consequences of the application of the section. The Aborda Trust was written out and constituted at the meeting of 25 May 1981. It was expressed to be in the same terms as the Morlea Trust which had been constituted on 27 June 1980. The settlor of the Aborda Trust was Holden. The trustee was Aborda. In summary the trust contained provisions to the following effect. Under Clause 3(a) the trustee, Aborda, stands possessed of the fund and the income in trust for one or more of the eligible beneficiaries in such shares as the trustee shall appoint. Any such appointment may relate to the whole or any part of the trust fund and/or the income thereof. By Clause 4, in default of any determination under Clause 3, the trustee stands possessed of the fund and the income. With respect to the income, the trustee may, in its absolute discretion, pay the whole or part as the trustee thinks fit, of the income for the advancement or benefit of such of the eligible beneficiaries as the trustees consider appropriate. Under Clause 7(m), in addition to all other powers the trustee may determine whether any receipt, profit or gain is treated as income or capital. If the trustee fails to make a determination prior to the end of the year, then the income from the trust fund for the year is to be calculated in the same manner as the net income of the trust estate is calculated under the Act. "Eligible beneficiaries" are defined to mean and include the wife of the parent (Wenkart), any children of the parent and their spouses, Traknew Holdings Pty Ltd, Richard Walter, Hapday Holdings Pty Ltd, any company in which Wenkart or any of the eligible beneficiaries are entitled to exercise more than half of the voting power; the Wenkart Foundation; Health Care Research Institute Ltd; Preventicare Pty Ltd; Morlea Pathology Services Pty Ltd; Mountview Pty Ltd; any brother or sister of the father and mother of the parent and any issue of any brother or sister; any other persons or entities as the parent may by notice to the trustee appoint to be an eligible beneficiary. Further Restructure - 30 June 1984 After it became apparent that the Article 7 tax arrangement would no longer be of use it was decided to restructure the group in 1984. On or about 30 June 1984 the pathology business was sold to Macquarie Professional Services Pty Ltd ("Macquarie"). The purchase consideration was $27,661,054 and was left outstanding allegedly as a debt and the debt was distributed in specie through the Morlea Partnership. The only material which evidenced the consequent dissolution of the partnership and the distribution in specie were minutes produced to the Commissioner. According to the minutes, on 30 June 1984 the directors of Macquarie resolved to make an offer for the business of the Morlea Partnership for a consideration of $27,661,054 to be left outstanding at 15% interest. This offer was accepted by the Morlea Partnership and it resolved to allow the consideration to remain outstanding and that there should be no further documentation apart from the minutes. Macquarie then resolved to write up its books to reflect the acquisition of the business. Then it was resolved to wind up the Morlea Partnership and distribute the debt said to be due by Macquarie in specie to the partners as at 30 June 1984. The 95% entitlement of the Aurelius Unit Trust totalled $26,278,001. Macquarie then noted the in specie distribution and the following day the trustees of the Aborda Trust and the Aurelius Unit Trust noted the distribution in specie to them. This arrangement was later varied in December 1984 and January 1985. On 28 December 1984 the directors of MPS Pty Ltd, as trustee of the Aurelius Unit Trust, resolved to wind up the trust and distribute the assets of that trust in specie to the unit holders according to entitlement. Aurelius Commodus declared a dividend of $24,570,650 to another Dutch company, Kimberton which was controlled from Australia. On 15 January 1985, Kimberton declared a dividend in favour of Zeeno, also a company controlled from Australia by Wenkart and Lear, to be satisfied by the in specie distribution of the interest bearing debt on the dividend from Aurelius Commodus. In summary, as a result of the new 1984 structure, the assets of MPS Pty Ltd were sold to Macquarie and the debts said to be due by Richard Walter were said to have been assigned to Macquarie. The profit was said to have been made on the sale by Aurelius Commodus which was distributed by way of dividend to Kimberton and Zeeno, in both cases by distribution in specie. The effect of these arrangements made in June and December 1984 and into January 1985 was that Macquarie received a large tax deduction because it borrowed money to pay its interest obligation and Macquarie got a deduction equal to the interest obligation and as a result sent the moneys offshore thereby avoiding tax as the result of the deduction created. Subsequent steps were taken to restructure the group leading to what was described as the Linwood Finance arrangement. However, this arrangement was effectively conceded to be a tax avoidance arrangement which was struck down. Sham The first contention of the Commissioner is that the loan arrangement to Richard Walter was a "sham" in the sense that the transactions described as "loans" purportedly made by MPS Pty Ltd to Richard Walter were never intended to create legally enforceable debt obligations. It is submitted that it was intended at all times that Richard Walter would receive the money beneficially without any obligation to repay and that such moneys were income in the hands of Richard Walter and assessable to tax. There is no dispute between the parties as to the applicable law which is conveniently summarised and set out in Sharrment Pty Ltd v Official Trustee (1988) 18 FCR 449 at 454 where Lockhart J said: "A "sham" is therefore, for the purposes of Australian law, something that is intended to be mistaken for something else or that is not really what it purports to be. It is a spurious imitation, a counterfeit, a disguise or a false front. It is not genuine or true, but something made in imitation of something else or made to appear to be something which it is not. It is something which is false or deceptive." His Honour went on (at 454-455) to set out a number of guidelines, the substance of which is as follows: 1. The fact that the transaction involved a "round robin" of cheques does not necessarily establish that the transaction is a sham, even when no party has funds to meet the cheques. 2. The artificiality of the transaction does not give rise to its characterisation as a sham or to the characterisation of the constituent documents as a sham so long as each document "had the effect that it purported to have", and so long as none of the documents purported "to do something different from what the parties had agreed to do". 3. The complexity of the transaction does not in itself establish its character as a sham. 4. A purported disposal of property or purported creation of a debt may be a sham where donor and donee or lender and debtor do not intend to give effect to the transaction, it being agreed between them that there will be no change in the legal and beneficial ownership of the property. 5. The fact that a transaction may have been intended to present a shield against creditors does not, absent the transaction being set aside under the Bankruptcy Act 1966 (Cth), for example, characterise it as a sham. Transactions may in themselves be legally effective although intended to achieve an unacceptable purpose. The essential question seems to be whether what has been done has been genuinely done. 6. Circumstances giving rise to suspicion do not establish a transaction as a sham unless it can be shown that the outward and visible form does not coincide with the inward and substantial truth. Other relevant guidance is to be found in Snook v London and West Riding Investments Ltd [1967] 2 QB 786 at 802; Allsene Pty Ltd v Federal Commissioner of Taxation (1989) 89 ATC 5333; Esanda Ltd v Burgess [1984] 2 NSWLR 139 at 144,146 and 153. In Cranstoun v Federal Commissioner of Taxation (1984) 75 FLR 220 at 228, Carter J said: "If two persons sign a document which on its face purports to be a loan agreement evidencing a loan from one to the other for $180,000 but it is agreed either expressly or impliedly that the document is intended to give the appearance only of a loan transaction then it is, in my view, a sham; it is something devised to delude, it is a trick or a hoax, an imposture, it is something that is intended to be mistaken for something else, it is not really what it purports to be, it is a spurious imitation or a counterfeit .... However one defines it, it is in law nothing, nor, in my view, can it be elevated to be something which the law will recognise and enforce merely because documents which are drawn in legal language appear, a series of book-keeping entries is made and extensive use made of the banking system involving debits and credits of the order of hundreds of thousands of dollars. No amount of professional ingenuity will make the agreement into what in fact it is not if the parties do not so intend." The central feature of a loan transaction is that the parties must intend that the whole of the moneys lent should be repaid. In the present proceedings, I do not consider there was ever intended to be, nor was there, any such obligation created. See Ferguson v O'Neill [1943] VLR 30 at 32. The submission on behalf of the applicant is that within the above principles the loans were not shams because they were intended by those who entered into them to create the very legal rights and obligations which they purported to effect. Reliance is placed on the subsequent conduct of the parties throughout the whole period from 25 May 1981 to 30 June 1984 in the way they accounted for and returned their income. It is pointed out that the principals of the parties to these transactions received legal and tax advice both as to the acts to be done and the form of the documents with a view to achieving the desired objective, namely to gain the protection of Article 7 of the Agreement in relation to the income derived by MPS Pty Ltd as trustee of the Morlea Unit Trust. The parties acted through their legal and accounting advisers at all relevant times and intended to create precisely those rights and obligations in accordance with the documents which they purported to effect on their face. Moreover, it is pointed out that the "loan" payment procedure had been in operation for some years before the restructure of 25 May 1981. In the present case the relevant factors which must be taken into account to decide whether the overall arrangement or any particular part of it was a sham, in my view, are the following: 1. The moneys were paid without any written evidence of any agreement or obligation to repay apart from book entries made by accounts staff. 2. There was never any written or oral evidence as to the terms and conditions on which the moneys were said to be lent or repaid other than the year end financial statements which were the product of year end journal entries formulated by Holden, the Group Finance Director, to achieve the most desirable tax consequences. 3. It does not appear that any interest was ever charged, payable, or paid by Richard Walter in respect of these loans. There was no group policy that interest should not be charged on intra-group loans according to the evidence of Holden. 4. It is true that, as the applicant points outs, there were book entries to indicate some substantial amounts paid by the applicant to MPS Pty Ltd. However, the net movements from MPS Pty Ltd to the applicant were far greater than the converse. For example, to 30 June 1982, the flow of cash from MPS Pty Ltd to the applicant was $1,538,013 and the movement back according to the entries was $500,954. For year ended 30 June 1983, the movement from MPS Pty Ltd to the applicant was $2,301,649 compared with the converse of $866,421.07. In the year ended 30 June 1984, the cash moving from MPS Pty Ltd was $1,926,591 as compared with the converse of $232,459.47. These movements back do not show, in my opinion, that there was an intention to repay all the moneys channelled to Richard Walter. 5. It was within Holden's unfettered power and discretion to move money around the group as he determined to be appropriate. MPS Pty Ltd was completely controlled by Wenkart and Holden. Holden agreed that the real money, the cash money, stayed with Richard Walter and did not go to Aurelius Commodus. He could give no explanation as to the way in which Aurelius Commodus was going to use the 95% of income of MPS Pty Ltd, except that it was going to exploit it by increasing its capital account. He could give no explanation as to what it would do with the amassed capital from time to time. He agreed that part of the arrangement or agreement was that the money be lent to Richard Walter and this was acceptable to Holden because the cash money stayed with Richard Walter. 6. It was impossible for Richard Walter to repay the amounts distributed by MPS Pty Ltd without liquidating the assets of Richard Walter and the evidence was that there was never any intention or even contemplation of doing this. 7. In 1982 the nature of the liability of Richard Walter to MPS Pty Ltd was unilaterally reclassified by Holden from current liability to non-current liability without any board resolution by Richard Walter or MPS Pty Ltd. This was clearly to the detriment of Aurelius Commodus. It appears that no consideration was given by Holden to the trust obligations in this respect. In cross-examination in relation to this matter, Holden was prepared to say as an experienced accountant that he did not know whether a dollar today is worth the same or more in a year's time. That reflects adversely on the credibility of Holden. In my view this unilateral reclassification was done without any thought for, and contrary to the interests of, the beneficiaries allegedly owning the debt due from Richard Walter. 8. The evidence makes it clear that when MPS Pty Ltd needed funds of any size, it borrowed from external financiers instead of calling for repayment of the loan due by Richard Walter which was interest free. There was no evidence of any attempt or proposal to call for repayment of the loan to Richard Walter. 9. The debt alleged to be due from Richard Walter to MPS Pty Ltd was never repaid, but it appears to have been assigned by a series of "round robin" artificial paper transactions orchestrated by Richard Walter's legal and accounting tax advisers, none of whom were called in evidence by the applicant. No explanation was proffered for not calling them. The only witness called by the applicant was Holden, the Group Finance Director. It must be inferred that any evidence to be given by other witnesses which might have been expected to be called by the applicant would not assist the applicant's case. These witnesses included Wenkart, Lang, Sharp and the solicitors from Messrs Mallesons Stephen Jaques. This in my view is significant in a case such as the present where the issues centre on the genuineness of the transactions set out on paper and there is an allegation of a "sham" transaction. I appreciate that the onus is on the Commissioner to establish that the purported loans were a "sham" and that such an allegation is a serious one. However, I do not accept Holden as a reliable witness in relation to this matter and would accept his evidence only where it is corroborated by credible testimony or evidence or where objective circumstances make his version more likely. His evidence that he did not think the change of classification from current liability to non-current liability had an effect on the value of the alleged Richard Walter loan cannot be accepted. He took an extreme and absurd position on this. I also do not accept him when he said he had no knowledge of the structure of the Aurelius Unit Trust and of the chain of non-resident entities which had been set up in relation to it. Nor do I accept that he had no knowledge of the liquidation of Aurelius Commodus. He also said that he had no knowledge of the assignment of a loan from Linwood Finance. He misrepresented the position in the tax returns when he allowed statements to be made which represented that Aurelius Commodus was in no way controlled from Australia when that was clearly established on the evidence. There was a misrepresentation in my view made to the Commissioner in claiming the benefit of a deduction for foreign exchange losses incurred under an agreement of 1 April 1986 when the agreement on the evidence did not come into existence until February 1987. Some of the above considerations taken individually may not justify the finding that the loans to Richard Walter were a sham. However, when examined against the background of the overall taxation arrangements and the history of the taxation measures taken by the group, I am satisfied the cumulative effect of the matters outlined is such as to warrant the finding that the so-called loans were in truth intended to transfer funds to Richard Walter without any obligation to repay those funds. The allegation of sham is a serious one and I have taken this into account in evaluating the evidence in this matter. My conclusion is that the purported "loans" were simply a false label given in order to mask the real transaction intended by the parties, which was the transfer of the beneficial ownership of the moneys to Richard Walter free of any obligation to repay. The nomination of the payments as a loan was calculated to make the true transaction appear as something it was never in truth intended to be. Accordingly, I find that the loans were shams and that the reality of the situation was that Richard Walter received the beneficial ownership of the moneys without any obligation to repay. Income The next question is whether the sham "loan" moneys received beneficially by Richard Walter were income. In my opinion the moneys channelled to Richard Walter were income in the hands of Richard Walter. The moneys were received on a recurrent periodic basis every two or three days by Richard Walter. Richard Walter was engaged at all material times in carrying on a business for the purpose of gain or profit. In the course of carrying on that business it received moneys which were intended to be and were used for the purpose of carrying on its business. The payments were made for the purpose of increasing profits to the Wenkart group. In my view, this gain in the sense of receiving the beneficial ownership of funds, being the moneys distributed to it under the guise of loans, constituted a receipt of income in Richard Walter's hands. Richard Walter was carrying on the business and acting as the central banker and financier for the Wenkart group. The receipt of the moneys on a periodic regular and recurrent basis over the years in question and the lending or investing of those moneys indicated that the moneys were in the nature of income. When this is coupled with the fact that the gain is made in the course of carrying on a profit making scheme or business, the conclusion that it is income is further supported. The receipts are not of an extraordinary character. They are not in the nature of a gift in my view. See The Squatting Investment Co Ltd v Federal Commissioner of Taxation (1953) 86 CLR 570 per Kitto J at 627. Nor can they be described as being of a capital nature. They are to be seen in a context where Richard Walter is an integral part of a profit making group and providing important financial services to the group. The almost daily receipts occurred in the normal course of carrying on its ordinary business. The payment of the money to Richard Walter and its use for financing the group are in my view significant elements of what can be described as a profit making scheme. It is income received for the purpose of enabling it to advance the financial interests of the Wenkart group. Accordingly, my conclusion is that the cash received by Richard Walter allegedly on the basis of being loans, but in fact actually received as payments for its own benefit and which gave it an entitlement to use the funds as it saw fit, constituted assessable income in its hands. Cf Commissioner of Taxation v The Myer Emporium Limited (1987) 163 CLR 199 at 209-215; Commissioner of Taxation v Co-operative Motors Pty Limited (FCA/Northrop J - unreported - 23 June 1995) and the cases referred to in that judgment. Section 260 Section 260 as in force in 1981 was as follows : "Every contract, agreement, or arrangement made or entered into, orally or in writing... shall so far as it has or purports to have the purpose or effect of in any way, directly or indirectly: (a) altering the incidence of any income tax; (b) relieving any person from liability to pay any income tax or make any return; (c) defeating, evading, or avoiding any duty or liability imposed on any person by this Act; or (d) preventing the operation of this Act in any respect, be absolutely void, as against the Commissioner, or in regard to any proceeding under this Act, but without prejudice to such validity as it may have in any other respect or for any other purpose." Identification of the Steps The Commissioner identified the transactions in the scheme rendered void against him by the application of s 260 as follows : "1. The inclusion in the Morlea Partnership of Iroos Pty Ltd; 2. The appointment of Iroos Pty Ltd as an eligible beneficiary of the Morlea Trust; 3. The distribution by Ultera Pty Ltd to Iroos Pty Ltd of 95% of the units in the Morlea Professional Services Unit Trust; 4. The distribution by Morlea Professional Services Pty Ltd to Iroos Pty Ltd of 95% of the interim income of the Morlea Professional Services Unit trust; 5. The distribution by Morlea Professional Services Pty Ltd to Iroos Pty Ltd of the capital of the Morlea Professional Services Unit Trust; 6. The entry in the Morlea Professional Services books of account of journal entries purporting to record as loans payments made to Richard Walter Pty Ltd by Morlea Professional Services Pty Ltd." The applicant concedes that the first five steps are caught by s 260 as part of a contract, agreement or arrangement which has the purpose or effect of altering the incidence of tax and which are therefore void as against the Commissioner. The applicant denies that step 6, set out above, which relates to the alleged "loans", is caught by s 260. The applicant also says that after s 260 has operated on the first 5 steps, there is no assessable income in the hands of Richard Walter as contended for by the Commissioner. The Commissioner then contends first that the loan payments were void as part of the scheme avoided by s 260 and as a result the "loans" are annihilated leaving assessable income in the hands of Richard Walter. Second, the Commissioner says that even if this is not accepted the annihilation of the first 5 steps leaves the result that after the application of s 260 to these measures the true position is that Richard Walter has derived income assessable in its hands. The Loans - Step 6 The applicant argued that the loans stood independently of and were not included in the scheme avoided by s 260. It submits that the loans should be looked at as separate and independent transactions from the first five elements of the scheme as outlined above. The loans were said by the applicant to be simply a continuation of measures which had previously been in operation for some years before the 25 May 1981 restructure and were not part of it. The applicant refers to statements of legal principle to the effect that s 260 does not affect a transaction which, although it has a place in a scheme of avoidance, does nothing to avoid tax when considered alone. See Newton v Federal Commissioner of Taxation (1958) 98 CLR 1; Federal Commissioner of Taxation v Casuarina Pty Ltd (1971) 127 CLR 62 at 97; Federal Commissioner of Taxation v Gulland (1985) 160 CLR 55 at 65-66. However, every case depends on the factual context in which it arises. When looked at in isolation a step which in itself may not give rise to tax avoidance may, when considered against the background of an overall arrangement or agreement, be seen to be a part of a scheme to avoid tax or a means of giving effect to a plan for altering the incidence of tax so that it is sufficiently related to, and part of the scheme that it is also avoided by the application of s 260. See Gulland (supra) per Dawson J at 112. In the present circumstances the "loans" must be objectively considered in the light of the backdrop, from 1980 through to 1989, of a series of elaborately and carefully contrived tax avoidance structures and restructures. This began with the Traknew stripping operation which was considered and held to be invalid by Hill J under s 260 in respect of the year ended 30 June 1980. This picture of tax avoidance measures continued from the Traknew arrangement through the Article 7 arrangement which is the subject of the present proceedings, until the loophole under Article 7 was removed in 1984. Thereafter there were further artificial restructuring measures set up after that loophole had been closed which had the effect of altering the incidence of or avoiding tax. On 30 June 1984, when the Article 7 arrangement could no longer serve its tax avoidance purpose, new arrangements were put in place which were clearly calculated to alter the incidence of taxation. In these circumstances the admission of Holden, the chief financial executive of the group at all material times, that "part of the agreement was the money was lent to Richard Walter" is important. On this admission the restructuring was not independent of the scheme. Indeed, the loans were the means by which moneys were almost daily paid across to Richard Walter to use in financing the group. These regular and recurrent payments were central to the operation of the scheme. This was the way the cash was retained in Australia rather than following the paper chain to the Netherlands. It was submitted by the applicant that because the loans had been made continuously for some years before 25 May 1981, they were in a temporal sense not part of the scheme of 25 May 1981. While it is true that loans were made before the restructure, in my view the making of the loans was an important element of the scheme whereby the avoidance exercise was carried through. Further, it was said that the loans did not have the purpose of, or effect of, avoidance under s 260, or the alteration of the incidence of tax. In my opinion they plainly did have this purpose when viewed against the factual background of the restructure. In my view, the loans were part of the scheme. They had the required purpose of avoiding or altering the incidence of tax. The loans are avoided by the application of s 260 as are the other parts of the scheme set out earlier in steps 1-5 above, as identified by the Commissioner. Once the loans are disregarded the situation is that Richard Walter has received the moneys from MPS Pty Ltd without any obligation. For reasons given earlier I consider that the moneys were assessable income in the hands of Richard Walter. Annihilation - Steps 1 to 5 Having made the concession that the first five steps of the arrangement had the purpose or effect of altering the incidence of taxation the applicant points to the principle that s 260 is a provision which annihilates but does not permit the Commissioner to reconstruct a new and fictitious set of facts creating liability in the taxpayer. See Gulland (supra) per Gibbs CJ at 67; per Dawson J at 118. It is necessary to consider what facts remain exposed in the present circumstances once s 260 has been applied to avoid steps 1 to 5. The respondent contends that the following facts are exposed after the s 260 annihilation: "(1)the appointment of Aborda Pty Ltd, being the remaining partner of the Morlea Partnership, as an eligible beneficiary of the Morlea Trust; (2) the distribution by Ultera Pty Ltd to Aborda Pty Ltd, as the remaining partner of the Morlea Partnership, of the units in the Morlea Professional Services Unit Trust; (3) the distribution by Morlea Professional Services Pty Ltd to Aborda Pty Ltd, as the remaining partner of the Morlea Partnership, of all of the interim income of the Morlea Professional Services Unit Trust; (4) the determination of the Morlea Professional Services Unit trust; (5) the consequential holding of the residue of the 1981 income by Morlea Professional Services Pty Ltd as agent for Aborda Pty Ltd as the remaining partner of the Morlea Partnership; (6) the consequential holding of the assets of the Morlea Professional Services Unit Trust by Morlea Professional Services Pty Ltd as agent for Aborda Pty Ltd as the remaining partner of the Morlea Partnership; (7) the carrying on of business by Morlea Professional Services Pty Ltd, after 25 May 1981, as agent for Aborda Pty Ltd as the remaining partner of the Morlea Partnership; (8) the derivation by Morlea Professional Services Pty Ltd of income in the 1982, 1983 and 1984 years of income, as agent for Aborda Pty Ltd as the remaining partner of the Morlea Partnership; (9) the receipt as trust income by Aborda Pty Ltd, as the remaining partner of the Morlea Partnership, of all of the income generated by Morlea Professional Services Pty Ltd as agent and bare trustee; (10)determinations by Aborda Pty Ltd in each of the years of income ended 30 June 1981 to 1984 to distribute to Richard Walter Pty Ltd all of the income derived by Aborda Pty Ltd as trustee of the Aborda Trust...." On this analysis, which I accept, the result is the receipt by Aborda as trustee of the Aborda Trust of all income of the Morlea Partnership in the 1981 to 1984 income years. Further, by application of the "proportionate" method as described by Hill J in Davis v Federal Commissioner of Taxation (1989) 86 ALR 195 at 229-230, the consequence is that Richard Walter is to be taken to be presently entitled, within the meaning of s 97 of the Act, to all the net income of MPS Pty Ltd in the years 1981 to 1984. It is agreed that this requires some reconstruction but I consider that such reconstruction is within permissible limits. The first submission for the applicant is that the annihilation of Iroos as a partner in the Morlea Partnership annihilates the Morlea Partnership because there cannot be a "partnership" of one member. Since the Morlea Partnership agreement is the sole source of the rights of the parties to participate in the income stream,the annihilation of that company income eliminates both the entitlements of Iroos and those of the remaining "member", Aborda as trustee of the Aborda Trust. In my view this does not follow. The situation which remains after the application of s 260 is that Aborda is the remaining member of what was referred to as the Morlea Partnership. Aborda became entitled to the distribution of all the units in the Morlea Unit Trust and to the distributions of income. The Aborda Trust is then solely entitled to all the income from the Morlea Partnership. If the involvement of Iroos is ignored then any distribution to Iroos is ignored and there is no flowdown through Iroos to Aurelius Commodus. The whole income stream flows down to the Aborda Trust and then on to Richard Walter. The Morlea Partnership is not annihilated but it is left constituted by the remaining single member. Reconstruction In Davis v Federal Commissioner of Taxation at 228, Hill J observed that in Peate v Federal Commissioner of Taxation (1964) 111 CLR 443; (1966) 116 CLR 38; [1967] 1 AC 308 and in Gulland it was arguable that there had been some reconstruction by the court after the application of s 260, but he did not pursue the matter further. His Honour went on to confirm that the liability must be found in the hypothetical situation left after s 260 has done its work. In that case there was no necessity to address the question because his Honour found that it was possible to trace the flow of income. On examination it can be seen that the courts in a number of instances have implicitly permitted a certain degree of reconstruction after the application of s 260 to an arrangement or agreement. For example, in Peate v Federal Commissioner of Taxation (1964) 111 CLR 443, the company structure was disregarded and the arrangement was treated as a partnership, which of course it was not. A similar situation occurred in Federal Commissioner of Taxation v Gulland. In Newton's case there was a reconstruction of what was formerly a sale agreement and payment of a purchase price into a dividend distribution. In Traknew a sale of shares and payment of the purchase price was left exposed after s 260 was applied, a receipt of a credit operating in law as a payment from the income of the trust to the taxpayer who was a beneficiary of the trust. The receipt was held to be within s 101 of the Act which deemed the beneficiary to have been presently entitled to the amount which brought into operation s 97 which in turn included the amount in the assessable income of the taxpayer. In his decision in Traknew, Hill J at 4282 referred again to the courts having applied some element at least of reconstruction to the facts left exposed by the application of s 260. His Honour also noted that reference was made by Gummow J in Bunting v Federal Commissioner of Taxation (1989) 89 ATC 5245 at 5256-5257 to the above remarks without disapproval. In my opinion in the present case after application of s 260 it is possible to trace the income flow to the Morlea Partnership and then into the hands of Richard Walter through the distribution of the whole of the income of Aborda to Richard Walter. In the relevant years of income Aborda in fact distributed 100% of the income received by it from the Morlea Partnership to Richard Walter. The tax returns of Aborda as trustee for the Aborda Trust for financial years 30 June 1981 through 1984 disclose that the only beneficiary said to be entitled/presently entitled to or having an indefeasible beneficial interest in a share of income from the Aborda Trust was Richard Walter. The Commissioner's submission is that the net income of the Aborda Trust is 100% of the distribution from the Morlea Partnership and that this income is taxable in the hands of the beneficiary. However, Richard Walter had previously been entitled to 5% only of the distribution from the partnership. This being so the question is whether the excess of net income over trust income is taxable in the hands of the trustee or the beneficiary. The applicant points out that the trust deed contains a provision, namely clause 7(m) which reads as follows: "7. In addition to all the powers vested in trustees by law or statute the Trustees without the consent of any Beneficiary shall have and may exercise from time to time all or any of the following powers each of which shall be an independent power and shall not be limited or restricted by reference to or inference from the terms of any other power:-..." "(m)To determine in their absolute discretion whether any receipt, profit or gain or payment, loss or outgoing or any sum of money or investment is or is not to be treated as being on income or capital account PROVIDED THAT if they shall fail to make a determination or to the extent to which they fail to make a determination prior to the end of such year then the income of the trust fund for such year shall be calculated in the same manner as the net income of the trust estate is to be calculated under the provisions of the Income Tax Assessment Act, 1936 as amended..." In the light of this provision the applicant submits that the proportionate approach only operates where there is a difference between the net income and the trust income. As a result of Clause 7(m) it is submitted that the net income will always be equivalent to the trust income and therefore it is not permissible to apply the proportionate method in relation to the excess. I do not accept this submission because it is necessary to look at the substance and reality of the transaction as opposed to the label used to describe it. Clause 7(m) cannot change the legal effect of what has taken place. In my view, this provision does not prevent the application of the proportionate principle with the result that the net income of Richard Walter under the Aborda Trust was 100% of the distribution and not merely 5%. Since these entitlements were distributed as to 100% to Richard Walter they must be treated as assessable income in its hands. This accords with the reality of what occurred, that is Richard Walter in fact received the cash moneys every two or three days. From the foregoing examination my conclusion is that after the operation of s 260 a set of facts and circumstances remained whereby Richard Walter was entitled to and was assessable in respect of 100% of the income distributed by the Morlea Partnership to Aborda Trust and on to Richard Walter. Part IVA My conclusion is that Part IVA of the Act does not apply. The provisions of this Part came into effect in relation to schemes entered into after 27 May 1981. The weight of the evidence in this case is that the arrangements were entered into and carried out, or commenced to be carried out, before 27 May 1981. The scheme identified by the Commissioner in relation to Part IVA is the same scheme as identified in respect of s 260. There is no evidence to indicate that there was any backdating in relation to the documentation of the transactions comprising the Article 7 scheme. There was evidence that in relation to one transaction in 1986 there had been a backdating of documents, but this is the only clear evidence of backdating and does not warrant a finding that the 1981 arrangements took effect on or after 27 May. There was evidence that the restructuring entered into in May 1981 was done with the apprehension of the amendments to be made to the Act by introducing Part IVA. It is therefore, in my view, more likely than not that the parties were fully aware of the necessity to implement the restructuring before 27 May 1981 and were anxious to do so. In the absence of any evidence to the contrary in relation to the documents I consider it probable and I accept that the arrangement was commenced to be carried out before 27 May 1981. My conclusion is that the provisions of Part IVA do not apply in the present circumstances. Bad Debt - Debt Collection Expense - 30 June 1989 The question in relation to this matter is whether a bad debt and related collection expenses claimed to have been written off by Richard Walter is an allowable deduction. For the year ended 30 June 1989, Richard Walter lodged a return of income which stated that during the 1989 year it had written off a debt of $190,900 (later corrected to $188,708.85) against a provision in its accounts for bad or doubtful debts. A deduction was claimed in respect of that bad debt which can be described as the Edelsten bad debt. The amounts claimed as a deduction were lent between April 1983 and February 1988 and were partly paid direct to the debtor and partly to third parties on his behalf. Receivers and managers had by then been appointed in respect of Edelsten's affairs and Richard Walter had lodged claims against Edelsten with those receivers and managers in his bankruptcy. The Commissioner's contention is that the amount claimed as a bad debt was not a bad debt within the meaning of s 63(1)(b) of the Act. That provision reads as follows: "SECTION 63 BAD DEBTS 63(1) [Allowable deductions] Debts which are bad debts and are written off as such during the year of income, and: (a) have been brought to account by the taxpayer as assessable income of any year; or (b) are in respect of money lent in the ordinary course of the business of the lending of money by a taxpayer who carries on that business; shall be allowable deductions." (Emphasis added) The issue turns on the question whether the debt was in respect of money lent in the ordinary course of the business of the lending of money by Richard Walter. This is a question of fact. See Newton v Pyke (1908) 25 TLR 127. The question raised is whether Richard Walter was carrying on a business of lending money and whether this loan was made in the ordinary course of that business. The description of the "carrying on" of a business requires a degree of system and continuity or repetition in the conduct of a commercial activity. See Commissioner of Taxation v Bivona Pty Ltd (1990) 21 FCR 562 at 567. The activity should be capable of being described as in effect business operations intended to yield a profit. The evidence was that for nearly 10 years before November 1986, Richard Walter lent money to companies and persons with which it had an "economic" association. It was the financier of the Wenkart group of companies and these activities generated significant amounts of interest relevant to the total income derived by Richard Walter during the years of income. The accounts of Richard Walter for the year ended 30 June 1985 recorded 47 unsecured loans totalling $ 10.5 million, 2 secured loans for $0.3 million and as non-current assets 2 unsecured loans totalling $2.3 million. Interest was derived from subsidiaries in an amount of $60,500. There was interest from other related corporations of $842,322 and interest from other persons of $10,806. These interest receipts represented a return of approximately 7% on total loans. A similar pattern existed for the years ended 30 June 1986 and 1987. The interest returns in 1986 were 4.4% and in 1987 and 1988, 5.25% and 9.10% respectively. Edelsten was a person who had been associated with the Wenkart group in an "economic" sense. However, this association finished in 1976. The loan was made to Edelsten pursuant to an agreement in writing which set out terms and conditions which were commercial and consistent with those one would find in a transaction between parties at arm's length. The loan was not secured. It appears from the above evidence that unsecured loans in substantial amounts had been made by Richard Walter from time to time. Since 1977 Richard Walter has held and renewed a money lender's licence and subsequently a credit provider's licence. This provides some support for the view that Richard Walter was engaged in the business of lending money. I think it is artificial in the circumstances of the present case to draw a distinction between the loans made to members of the group and loans to other persons or bodies. Between November 1986 and February 1987 a total of 12 loans had been made to Edelsten under the written agreement and the total amount under these loans was $170,488.67. The interest rate was the Commonwealth Bank base rate plus 3%. Accrued interest on the loans to 30 June 1987 totalled $18,220.18, making a total of $188,708.85. The regularity and amount of the loans to Edelsten over the period support the view that Richard Walter was engaged in the business of lending money. There is a substantial element of system and continuity in this pattern of lending even if it is taken in isolation. I do not consider that it can be said in the circumstances that the money has not been lent in the ordinary course of Richard Walter's business. Cf Commissioner of Taxation v Bivona Pty Ltd. The question in that case was whether the principal business of the taxpayer consisted of the lending of money. I am satisfied that in the circumstances outlined above, Richard Walter was carrying on the business of money-lending and that the moneys were lent to Edelsten in the ordinary course of the business of Richard Walter as a money lender. Therefore on this view it follows that Richard Walter is entitled to a deduction in respect of the writing off of the bad debt and the accrued interest. Also, I am of the opinion that the deduction can be claimed under s 51(1) of the Act as being a loss or outgoing incurred in earning or producing assessable income and also in carrying on a business for the purpose of obtaining and producing assessable income. I do not think that the loss was one of capital or of a capital nature. Likewise, it follows on the above approach that the costs and expenses of attempting to collect the debts are also deductible under both s 63 and s 51(l) I am satisfied that the collection expenses were actually incurred and were related to recovery of the debt. Accordingly, I consider that the applicant is entitled to claim a deduction in respect of the bad debt in the sum of $188,708.85 and the costs of attempting to collect it in the sum of $18,458.44. Conclusions I have reached the following conclusions: 1. That the loan transactions to Richard Walter from the Morlea Partnership during the income years ended 30 June 1981 through to 30 June 1984 inclusive, were a sham and were not valid loan transactions. 2. That the moneys paid to Richard Walter during those years were gains received for its benefit and use and were in the nature of business gains or profit and accordingly are to be treated as assessable income in the hands of Richard Walter. 3. That s 260 renders void as against the Commissioner the loan agreements with the consequence set out in (2) above. 4. That as a result of the application of s 260 to the enumerated steps in the restructuring of 25 May 1981, the specified transactions are annihilated with the consequence that Richard Walter is liable to income tax on all moneys distributed by the Morlea Partnership. 5. That Part IVA does not apply to the restructuring because the restructuring was commenced to be carried out prior to 27 May 1981. 6. The applicant is entitled to claim a deduction in respect of the bad debt in the sum of $188,708.85 and the costs of attempting to collect it in the sum of $18,458.44. Orders: I direct the respondent to bring in draft short minutes to give effect to these reasons. I will hear the parties on the question of costs when settling the Minutes of Order. I certify that this and the preceding fifty-six (56) pages are a true copy of the Reasons for Judgment herein of his Honour Justice Tamberlin. Associate: Date: 11 July 1995 Counsel for Applicant: Mr R F Edmonds Mr K J Burges Solicitors for Applicant: Mallesons Stephen Jaques Counsel for Respondent: Mr G Nettle QC Ms M Gordon Solicitor for Respondent: Australian Government Solicitor Date of Hearing: 20-24 March 1995 Date Judgment Delivered: 11 July 1995