FEDERAL COURT OF AUSTRALIA Sun Alliance Investments Pty Ltd (in liq) v Commissioner of Taxation [2003] FCA 75 INCOME TAX – capital gains tax – objection to amended income tax assessment reducing capital losses claimed - consequent increase in taxable income – reduced cost base of asset by operation of rebatable dividend adjustment – meaning of 'profit' – meaning of 'derived' - whether Part IIIA of the Income Tax Assessment Act 1936 (Cth) includes unrealised profits Income Tax Assessment Act 1936 (Cth), Pt IIIA, ss 60ZK(1B), 160AX, 160AY(3), 160XK(5)(b), 160Z(1)(b), 160ZC(2), 160ZD, 160ZH(3), 160ZK(1), 160ZK(1B), 160ZK(5), 160ZK(6), 160ZK(7), 160ZP, 160ZZRN(1)(c) and 160ZZS Taxation Laws Amendment Act (No 2) 1994 (Cth) Income Tax Assessment Act 1922 (Cth) Re The Spanish Prospecting Co Ltd [1911] 1 Ch 92 cited Federal Commissioner of Taxation v Slater Holdings Limited (1984) 156 CLR 447 cited Bond v Barrow Haematite Steel Company [1902] 1 Ch 353 cited In re Income Tax Acts [No 2] [1930] VLR 233 cited QBE Insurance Group Limited v Australian Securities Commission (1992) 38 FCR 270 cited Webb (Commissioner of Taxes (Vic)) v Australian Deposit and Mortgage Bank Ltd (1910) 11 CLR 223 cited Evans v Federal Commissioner of Taxation (1936) 55 CLR 80 cited Federal Commissioner of Taxation v Clarke (1927) 40 CLR 246 cited Tindal v Federal Commissioner of Taxation (1946) 72 CLR 608 cited Brent v Federal Commissioner of Taxation (1971) 125 CLR 418 cited Commissioner of Taxes (SA) v Executor Trustee & Agency Co of South Australia Ltd (1938) 63 CLR 108 cited Industrial Equity Ltd v Blackburn (1977) 137 CLR 567 cited Hancock Family Memorial Foundation Ltd v Porteous (2000) 156 FLR 249 cited Australasian Oil Exploration Ltd v Lachberg (1958) 101 CLR 119 cited Dimbula Valley (Ceylon) Tea Co Ltd v Laurie [1961] Ch 353 cited Dickson v Federal Commissioner of Taxation (1940) 62 CLR 687 cited Read v Commonwealth (1988) 167 CLR 57 cited SUN ALLIANCE INVESTMENTS PTY LTD (IN LIQUIDATION) v COMMISSIONER FOR TAXATION N 341 OF 2000 STONE J 13 FEBRUARY 2003 SYDNEY IN THE FEDERAL COURT OF AUSTRALIA NEW SOUTH WALES DISTRICT REGISTRY N 341 OF 2000 BETWEEN: SUN ALLIANCE INVESTMENTS PTY LTD (IN LIQUIDATION) (ACN 002 561 417) APPLICANT AND: COMMISSIONER OF TAXATION RESPONDENT JUDGE: STONE J DATE OF ORDER: 13 FEBRUARY 2003 WHERE MADE: SYDNEY THE COURT ORDERS THAT: 1. The application be dismissed with costs. Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules. IN THE FEDERAL COURT OF AUSTRALIA NEW SOUTH WALES DISTRICT REGISTRY N 341 OF 2000 BETWEEN: SUN ALLIANCE INVESTMENTS PTY LTD (IN LIQUIDATION) (ACN 002 561 417) APPLICANT AND: COMMISSIONER OF TAXATION RESPONDENT JUDGE: STONE J DATE: 13 FEBRUARY 2003 PLACE: SYDNEY REASONS FOR JUDGMENT introduction 1 Pursuant to s 14ZZ of the Taxation Administration Act 1953 (Cth) the applicant appeals from a decision of the respondent ('Commissioner') disallowing the applicant's objection to an amended income tax assessment issued to the applicant on 24 December 1998. The amendment reduced by $17,080,524 certain capital losses claimed by the applicant and consequently increased the applicant's taxable income by the same amount. 2 The losses in question had been incurred by Royal & Sun Alliance Insurance Australia Holding Limited ('RSA') and transferred to the applicant, RSA's wholly owned subsidiary, in the financial years ended 31 December 1996 and 1997. RSA's years of income ended 31 December in lieu of the succeeding 30 June. They were occasioned by RSA's disposal of shares in two of its subsidiaries, Sun Alliance Insurance Limited ('SAIL') and Phoenix Security Pty Ltd ('Phoenix'). The circumstances of the acquisition and disposal of these shares are described in [8] to [11] below. Relying on s 160ZK(1B) and s 160ZK(5) of the Income Tax Assessment Act 1936 (Cth) ('Act'), the Commissioner reduced the cost base of the shares by the amount of certain rebatable dividends paid by SAIL and Phoenix after October 1992. Consequently the net capital losses of RSA for both of these years were reduced. The Commissioner's reasons for reducing the cost base of the shares are referred to in [13] below. legislative provisions 3 The interpretation of s 160ZK(1B) and s 160ZK(5) of the Act is central to this proceeding, as is their purported application to the cost base of the SAIL and Phoenix shares. Section 160ZK is found in Pt IIIA, Div 3 of the Act. The object of Pt IIIA of the Act is 'to provide for net capital gains to be included in assessable income'; s 160AX. For present purposes it is not necessary to expound the principles of capital gains tax in any detail. It is sufficient to note that the disposal of an asset may result in a capital gain or capital loss. A capital loss will occur where the reduced cost base of an asset exceeds the consideration received in respect of the disposal of that asset; see s 160AY(3) and s 160Z(1)(b). To the extent that a taxpayer's total capital losses exceed the taxpayer's total capital gains in a year of income, the taxpayer is said to have incurred a net capital loss; s 160ZC(2). In certain circumstances, a net capital loss can be transferred within a company group; see generally s 160ZP. 4 As indicated, a capital loss is calculated by subtracting the consideration received in respect of the disposal of an asset from the reduced cost base of that asset. The consideration on disposal of the asset is generally the amount received on disposal of the asset; s 160ZD. The reduced cost base is the cost base adjusted to take account of certain capital deductions and balancing charges. Section 160ZH(3) applies in determining the reduced cost base. It provides: 'Subject to the following provisions of this section, for the purposes of this Part, the reduced cost base to a taxpayer of an asset is the sum of: (a) the reduced amount of any consideration in respect of the acquisition of the asset; (b) the reduced amount of the incidental costs to the taxpayer of the acquisition of the asset; (c) the reduced amount of any expenditure of a capital nature incurred by the taxpayer to the extent to which it was incurred for the purpose of enhancing the value of the asset and is reflected in the state or nature of the asset at the time of disposal of the asset; (d) the reduced amount of any expenditure of a capital nature incurred by the taxpayer to the extent to which it was incurred in establishing, preserving or defending the taxpayer's title to, or a right over, the asset; and (e) the reduced amount of the incidental costs to the taxpayer of the disposal of the asset.' A note to s 160ZH(3) provides, relevantly, 'Section 160ZK affects the meaning of the reduced amount of any consideration, the reduced amount of incidental costs, or the reduced amount of any expenditure.' 5 Section 160ZK(1) provides that a reference in s 160ZH(3) to these reduced amounts is a reference to the sum of: (a) the amounts of consideration, costs or expenditure, as the case may be, reduced by any part of the consideration, costs or expenditure that is allowed or allowable as a deduction; and (b) any amount that is included in the assessable income of the taxpayer as a result of the disposal of the asset and which is attributable to the part of the consideration, costs or expenditure, that was allowed or allowable as a deduction. Subsection 160ZK(1) is subject to s 160ZK(1B), which states: 'If the asset is a share, the amount worked out under subsection (1) is to be reduced by any rebatable dividend adjustment that arises in relation to the share (see subsection (5)).' 6 Subsection 160ZK(5) provides: 'A rebatable dividend adjustment arises in relation to a share (the 'RDA share')if: (a) under an arrangement, a company makes a distribution to the holder of the RDA share; and (b) an amount (the 'attributable amount'), being the whole or part of the distribution, could reasonably be taken to be attributable to profits that were derived by the company before the holder acquired the RDA share; and (c) the holder of the RDA share is entitled to a rebate of tax (the 'dividend rebate') in the holder's assessment for the year of income under section 46 or 46A in respect of an amount (the 'dividend amount') being so much of the distribution as is a dividend; and (d) the holder of the RDA share is, at any time during the period in which the arrangement is made or carried out, a controller of the company or an associate of the controller of the company.' (original emphasis) For the purposes of s 160ZK(5)(d) 'controller' includes a taxpayer who controls the company; s 160ZK(7) and s 160ZZRN(1)(c). 7 The amount of rebatable dividend adjustment in relation to a share that falls within subs (5) reduces the cost base of that share. The amount is calculated by the following formula which is set out in s 160ZK(6): Attributable amount x Amount of the dividend rebate Dividend amount x General company tax rate The factual background 8 RSA is the Australian holding company of the Royal and Sun Alliance Group. The Royal and Sun Alliance Group was formed in October 1992 by the merger of two corporate groups, the Royal Group and the Sun Alliance Group. The merger of various companies within these groups was evidenced by a merger agreement dated 8 October 2002 ('Merger Agreement'). It is not disputed that as a result of the merger, RSA was deemed, for the purposes of capital gains tax, to have acquired its shareholdings in SAIL and Phoenix for consideration equal to their market value on 8 October 1992 ('Merger Date'); see s 160ZZS. This date is also the relevant date for the purposes of s 160ZK(5)(b) of the Act. Dividends declared after the Merger Date 9 In the period after the Merger Date but before RSA disposed of its shares, SAIL paid two rebatable dividends to RSA. The dividends were $50,000,000 paid on 30 October 1992 and $36,337,176 paid on 6 September 1996. Phoenix also paid rebatable dividends after the Merger Date and prior to its liquidation as follows: (a) $12,000,000 on 30 October 1992; (b) $650,000 on 25 May 1994; (c) $3,100,000 on 28 December 1995; and (d) $20,891,449 on 6 September 1996. Disposal of SAIL shares 10 On 11 December 1996, RSA disposed of its shares in SAIL by way of a share buyback by SAIL for a total consideration of $11,108,952. Pursuant to s 60ZK(1B) and s 160ZK(5) of the Act, in calculating its net capital loss, RSA deducted from the reduced cost base of the SAIL shares the amount of the dividends it attributed to profits derived by SAIL prior to the Merger Date which was the date of RSA's deemed acquisition of the shares. This was the entire amount of the $50,000,000 dividend paid on 30 October 1992 and $9,562,000 of the dividend paid on 6 September 1992. As a result of this calculation, RSA claimed a capital loss of $28,058,022 on the disposal of the SAIL shares. The Commissioner, however, treated a further amount of $8,128,000 of the dividend paid on 6 September 1996 as attributable to profits derived by SAIL prior to its acquisition by RSA and, pursuant to s 160ZK(1B) and s 160ZK(5), further reduced the cost base of the SAIL shares. In conjunction with some other adjustments that are not relevant here, the effect was that the Commissioner recognised a capital loss of only $8,098,765. Disposal of Phoenix Shares 11 As a result of the liquidation of Phoenix on 30 December 1997 RSA received $5,835,661 in respect of its shares. In estimating the capital loss on this disposal of its shares RSA had to calculate the reduced cost base of the Phoenix shares. In doing so RSA attributed the whole of the $12,000,000 dividend paid on 30 October 1992 to profits derived by Phoenix before the Merger Date, that is prior to its deemed acquisition by RSA. It attributed the balance of the dividends paid by Phoenix to post-merger profits. The Commissioner did not accept this and attributed an additional amount of $14,522,391 of the dividends paid by Phoenix to profits derived by Phoenix prior to the Merger Date. Accordingly, pursuant to s 160ZK(1B) and s 160ZK(5), the reduced cost base of the Phoenix shares was further reduced by this amount. The result was that the capital loss claimed was entirely eliminated. The Commissioner's adjustments 12 The net result of the Commissioner's adjustments was that the amount of the loss that RSA was able to transfer to the applicant for the 1997 year of income was only $8,098,765 rather than the amount of $25,179,289 that RSA had purported to transfer. As previously mentioned the reduction in the capital loss resulted in a corresponding increase in the taxable income of the applicant. The amended assessment also contained other adjustments that are not relevant to this proceeding. 13 The Commissioner's written reasons for disallowing the applicant's objection to the amended assessment state that s 160K(5)(b) applies to rebatable dividends that are attributable to realised or unrealised profits. It was held that, within the meaning of the section, profits can be 'derived by the company' even though, at the relevant time, the profits were not realised. SAIL and Phoenix accounts 14 It is easier to understand the submissions of the parties and the issues in this proceeding if one has some familiarity with the businesses carried on by SAIL and Phoenix and the way in which the relevant amounts were treated in their accounts. SAIL accounts 15 SAIL carried on the business of general insurance. At the Merger Date the market value of the SAIL shares held by RSA was $98,728,974. Its accounts were prepared in accordance with the standards laid down by the Accounting Standards Review Board. In the financial years immediately prior to the year ending 31 December 1992, the increases and decreases in the value of its non-current investments were recognised, in accordance with AASB 1010, as increments and decrements to the Asset Revaluation Reserve. This method of treatment was changed by the introduction of AASB 1023: Financial Reporting of General Insurance Activities. This standard, which applied to general insurers for financial years ending on or after 30 June 1992, required that investments integral to the insurance business be valued on a 'mark to market value basis' and, consequently, valuations of SAIL's investments had to be brought to account in the profit and loss statement. 16 Mr Harold Bentley, Chief Financial Officer of RSA gave affidavit evidence concerning the accounting practices of the Royal Group of companies. He stated that: 'At all times prior to the merger and the introduction of Accounting Standard AASB 1023 (which took effect for the year ended 30 June 1992, or a later substituted period which, for the Royal Group, was 31 December 1992), unrealised increments or decrements to the value of investments held by the Royal Group were taken to an asset revaluation reserve in the balance sheet and were not brought to account in determining the profit and loss. … In accordance with this practice and policy, dividends were declared only out of retained profits and realised gains and not unrealised gains on investments.' 17 Mr Bentley described how, after the introduction of AASB 1023 the Royal Group altered its accounting systems and practice. He stated: 'Adopting AASB 1023, the Royal Group recognised changes in the value of investments as revenue or expenses in the profit and loss account. However … the Royal Group continued its practice of transferring unrealised gains on investments from the profit and loss statement to an asset revaluation reserve known as the "Unrealised Profits Reserve". ' He stated that since the merger this has also been the practice of the Royal and Sun Alliance Group. 18 Included in SAIL's assets at the time of the merger were land and buildings in Bridge Street, Sydney valued then at $57,050,000. As a consequence of the Bridge Street Buildings Agreement ('BSB Agreement') and clause 14 of the Merger Agreement, SAIL was guaranteed that on sale of the Bridge Street Buildings it would receive the whole of that amount but no more. As the cost of the Buildings was in the order of $29,550,000 SAIL was guaranteed a profit of $27,500,000. Certain unrealised losses were deducted from this amount and the balance of $21,345,000 was reflected in the accounts as unrealised profit as at the Merger Date. The amount was subsequently realised and was the main component of the dividend of $36,300,000 declared in September 1996. 19 Mr Bentley described the treatment of the Bridge Street Buildings asset as follows: 'The overall effect of the BSB Agreement was that the carrying value of the BSB properties for SAIL would be $57.050m. This amount was to be net of any selling costs and tax arising on disposal. At each year end and until the BSB properties were sold: (1) the BSB properties were revalued; (2) the BSB properties were recorded in the accounts of SAIL at market value; (3) the likely tax costs and selling costs arising from a sale of the BSB properties that the balance date valuation was calculated;'. 20 Mr Bentley's evidence showed that the net market value of the Bridge Street Buildings had fallen in 1993 to $31,750,000. By 1995 it had regained some of this loss, being then valued at $38,623,500. The Buildings were sold for this amount on 31 August 1995 and SAIL thus incurred a loss of $18,426,500. Mr Bentley noted however that SAIL was entitled to recover this amount under the terms of the Merger Agreement and that this resulted in a realised profit on the sale of the Buildings of $27,576,087. 21 In his affidavit of 18 December 2000 Mr Robert Hardy, then Taxation Manager of RSA confirmed Mr Bentley's description of how the accounts of the Sun Alliance group treated unrealised profits and increases in asset value. He gave this account of his understanding of the reasons for the Group's policy that unrealised gains and losses should be shown as movements in an asset revaluation reserve and realised gains and losses be carried to an asset realisation reserve: 'The Sun Alliance Group considered that any unrealised gain was not available for distribution because the gain was not realised. It is only at the point of disposal of the investment that the investment is realisable at that value. For example, if the investments of a company comprised only a single asset (eg a property) no dividend could be declared even if the market value of the property increased, unless the property was sold. The company needs the proceeds of the sale of the asset to fund the payment of a dividend'. 22 Mr Hardy referred to the $5,000,000 dividend paid on 30 October 1992 and stated that this dividend 'was sourced only from retained profits and realised gains on investments prior to 30 October 1992.' He similarly stated that the dividend declared on 9 September 1996 was declared from 'retained profits and realised gains on investments'. He pointed out that there were no dividends declared in 1993 and 1994 and stated that: 'Upon the declaration of each dividend, SAIL had sufficient retained profits and realised gains on investments from which the dividends were able and were declared. At no time were dividends declared from unrealised gains.' 23 Mr Bentley summarised the sources of the accumulated profits of SAIL in September 1996 as follows: No Description Profits Losses Total Transfer from reserves $'000 Transfer to reserves $'000 1 Opening retained profits - 1993 9,562 2 Amounts transferred from unrealised profits reserve -1993 10,162 3 Operating Loss -1993 (7,732) 4 Amounts transferred to unrealised profits reserve -1994 (2,969) 5 Operating Profit - 1994 11,896 6 Amounts transferred from profits reserve -1995 14,152 7 Operating profit - 1995 1,266 Totals 47,038 (10,701) 36,337 24 The information in the table indicates that SAIL's operating profit over the period was only $13,162,000. The balance of the profit relates to amounts transferred from the unrealised profits reserve. The applicant accepted that the opening retained profits of $9,562,000 (shown in row No 1 in the above table) are attributable to profits derived by SAIL prior to the Merger Date. There is however no such agreement in relation to the profits in respect of the Bridge Street Buildings. It is useful in the present context to have some understanding of how those assets and the profit related to them were treated in the accounts. 25 The picture of SAIL's accounts that the applicant presented was supplemented by the following summary provided by the respondent (not disputed by the applicant) of SAIL's paid up capital and reserves (in $'000s) at dates set out in the top row of the table: Date 31.12.91 9.10.92 31.12.92 31.12.93 31.12.94 31.12.95 31.12.96 Paid up capital 2,800 2,800 2,800 2,800 2,800 2,800 2,800 Share premium 8,309 8,309 8,309 8,309 8,309 8,309 8,309 11,109 11,109 11,109 11,109 11,109 11,109 11,109 Inv realisation 20,102 Asset revaluation 53,994 11,183 14,152 Unrealised profits 21,345 21,345 Retained profits 32,341 59,562 9,562 11,992 20,919 36,337 nil Distributable funds 106,437 80,907 30,907 23,175 35,071 36,337 nil Increase/decrease (25,530) (50,000) 97,732) 11,896 1,265 (36,337) Profits/(Loss) (14,852) (7,732) 11,896 1,265 nil Tax adjustment (10,678) Dividend (50,000) (36,337) Net movement (25,430) (50,000) (7,732) 11,896 1,265 (36,337) 26 The amounts set out in the above table reflect the bringing of SAIL's assets to account at net market values as a result of AASB 1023 and show the dividends of $50,000,000 and $36,337,000 paid respectively on 30 October 1992 and 9 September 1996. The result was that as at 31 December 1996 there were no retained profits in the accounts of SAIL. Phoenix accounts 27 Phoenix conducted a business of equity investments until 1997 when it was liquidated. At the Merger Date the market value of the Phoenix shares owned by RSA was $28,500,000. Phoenix was dissolved and liquidated on 30 December 1997 and RSA received $5,835,661 in respect of its shares. Consistent with the practice of insurance groups to hold equities in a separate vehicle in order to attract the benefit of rebates provided by s 46 of the Act, Phoenix was used to hold equities. 28 Phoenix reflected increases and decreases in the value of its assets in accordance with AASB 1010. Not being an insurance company Phoenix was not affected by the introduction of AASB 1023. One consequence of this difference between the accounting standards applying to the two companies is that in the Phoenix accounts the unrealised value of its assets did not go into the profit and loss account but was directly recorded in the unrealised profits account in accordance with the longstanding practice of the Group. It will be remembered that under AASB 1023 unrealised profits of SAIL had to be recorded in the profit and loss statement (see [15] above). 29 Phoenix held shares in a number of companies listed on the Australian Stock Exchange and their value was subject to daily market forces. Mr Bentley stated that 'in accordance with the accounting standards and the practice of the Royal & Sun Alliance Group' the shares were valued on a monthly basis. He referred to the Phoenix Monthly Portfolio Valuation Reports for the months of January 1994 to August 1996 which were before the Court. These reports showed significant monthly variations in the value of the portfolio both as to the whole and in respect of individual shareholdings. Some examples of particular share holdings were set out in Mr Hardy's affidavit. 30 At the time of the merger Phoenix had investments valued at cost at $8,900,000. On merger these were revalued to a market value of $20,700,000. This revaluation yielded an unrealised gain of $11,800,000 and this gain was reflected in the revaluation reserve. These investments were realised over subsequent financial years ending on 31 December in the years 1992 to 1996. 31 The dividend of $12,000,000 declared on 30 October 1992 was reflected in the Phoenix accounts for the year ended 31 December 1992. It would appear that this dividend was a necessary step designed to bring the Sun Alliance Group contribution to the merged equity to the required 60 per cent. In his affidavit Mr Hardy stated that the dividend was sourced only from retained profits and realised gains on investments prior to 30 October 1992. After payment of dividends in 1992 the retained profits of Phoenix were only $432,842 and the balance in the Investment Realisation account was $2,621,991. 32 Mr Bentley described in the following table the source of the dividends declared after the declaration of the $12,000,000 dividend. The details of those dividends are set out in [9] above. The company document that was the source of the information was identified in the table in Mr Bentley's affidavit but that information is not reproduced here. No Description Profits Transfers from reserves Losses Transfers to reserves Total $'000 $'000 1 Opening retained profits - 1993 438,842 2 Operating Profit - 1993 1,103,542 3 Amounts transferred to investment realization reserve - 1994 (3,235,228) 4 Operating Profit - 1994 4,313,187 5 Amounts transferred to investment realisation reserve - 1995 (1,604,683) 6 Operating Profit - 1995 2,774,904 7 Amounts transferred from investment realization reserve - 1996 7,461,902 8 Operating Profit - 1996 18,897,352 Totals 34,989,729 (4,839,911) 30,149,818 33 The respondent provided the following table that shows (in $'000) the paid up capital and reserves of Phoenix at specified dates. Date 31.12.91 9.10.92 31.12.92 31.12.93 31.12.94 31.12.95 31.12.96 Paid up capital 165 100 100 100 100 100 100 Share premium 6,435 Capital redemption 133 198 198 198 198 198 198 6,733 298 298 298 298 298 298 Retained profits 4,797 5,047 439 1,542 1,970 41 5,508 Inv realisation 9,662 9,675 2,622 2,622 5,857 7,462 Asset revaluation 18,116 12,811 14,723 19,023 14,948 15,814 nil Distributable funds 32,575 27,533 17,784 23,187 22,775 23,317 5,508 Net movement (5,042) (9749) 5,403 (413) 542 (17,809) The Commissioner's adjustments 34 The net result of the Commissioner's adjustments was that the amount of loss that RSA had to transfer to the applicant for the 1997 year of income was only $8,098,765 rather than the amount of $25,179,289 which RSA purportedly transferred to the applicant. As previously mentioned, the reduction in the capital loss resulted in a corresponding increase in the applicant's taxable income of the applicant, namely $17,080,524. The Issues 35 The facts in this case are not controversial. There is no dispute between the parties as to the original cost of the SAIL and Phoenix shares, the consideration received on their disposal, the capacity of RSA to transfer such losses as were incurred to the applicant or the treatment of the funds shown in the Retained Profits and Investment Realisation Reserve in the accounts of the companies at the Merger Date. It is not in dispute that at all relevant times pars (a), (c) and (d) of s 160ZK(5) were satisfied. 36 What is at issue between the parties is whether the dividends paid by SAIL and Phoenix after the Merger Date could, within the meaning of s 160ZK(5)(b) of the Act, 'reasonably be taken to be attributable to profits that were derived before [the Merger Date]'. If the answer to that question is 'Yes' then, there being no significant difference between the parties as to the relevant facts of the case, it follows that the Commissioner was correct in disallowing the applicant's objection to the Amended Assessment. reasoning 37 The applicant submits that the reference in s 160ZK(5)(b) to 'profits that were derived by the company' before (in this case) the Merger Date does not apply to unrealised increases in the value of the assets of SAIL and Phoenix. In particular, in the case of SAIL, the applicant submits that it is not correct to describe the unrealised increase in the market value of the Bridge Street Buildings as profits that were derived before the merger. Similarly the applicant denies that the unrealised increase in the market value of the investments of Phoenix can be so described. It is submitted that the Commissioner erred in taking such unrealised increases into account in determining the reduced cost bases of the shares. The applicant further submits that even if these increases were profits that were derived before the merger, the dividends paid by the companies could not be attributed to those profits. 38 The Commissioner contends that it is possible for a distribution to be both, (a) paid out of profits that were realised after the merger; and (b) reasonably able to be taken to be attributable to profits that were derived by the company before the merger. It is submitted that if the unrealised gain on the Bridge Street Buildings and the Phoenix portfolio was for s 160ZK purposes a 'profit derived' by the company concerned at the time of the merger, it does not cease to be so merely by reason of being realised later. 39 Much of the applicant's evidence has been directed to establishing that, subject to certain amounts that are not in dispute, the profits available for distribution as a dividend (and in fact distributed as dividends) were not realised until after the merger. This approach assumes that distributions cannot be reasonably attributed to unrealised profits. The assumption is by no means obvious. The question raised by s 160XK(5)(b) is whether the whole or part of the distributions under consideration can 'reasonably' be attributed to 'profits' that were 'derived' by the company before the merger. 40 The reference to 'profits' in the section is unqualified. As a matter of plain English the term 'profits' would seem to include both realised and unrealised profits. I do not mean to suggest that enquiry should stop there. There may be valid and justifiable reasons to imply a qualification where none is expressed but those reasons need to be articulated. In such circumstances the legislative purpose of the amendment that inserted s 160ZK into the Act is highly relevant. Background to s 160ZK(5) 41 Section 160ZK(5) was included in the Act by the Taxation Laws Amendment Act (No 2) 1994 (Cth). The explanatory memorandum to the Taxation Laws Amendment Bill (No 2) 1994 states, as an overview, that it would provide: 'that a capital loss that would otherwise be derived by a controller of a company … on the disposal of any share in the company will be reduced by any distribution made by the company to the controller … that is a rebatable dividend paid out of pre-acquisition profits.' 42 The Explanatory Memorandum gives the following example: 'Company X acquired all the shares of company Y for their market value of $10,000. At the time of acquisition of the shares, the balance sheet of company Y was as follows: Share Capital $ 2,000 Retained profits $ 8,000 $10,000 Assets $10,000 Company Y continued business operations over the next four years. During this period, it distributed all of its current earnings as well as the retained profits. Company X then disposed of the shares in company Y for $2,000. The dividends paid by Company Y to company X qualified for the dividend rebate under section 46 of the Act. Consequently, no company tax was paid on those dividends. Moreover, company X has recovered the full amount of its investment of $10,000 in company Y in the form of dividends ($8,000) and disposal consideration ($2,000). Nevertheless under the current law, company X may claim a capital loss of $8,000. This is the difference between the cost of the shares ($10,000) and the disposal consideration ($2,000).' The explanatory memorandum stated that where there was a 'scheme' amounting to dividend stripping the anti-avoidance provisions of Part IVA could apply. It continued: 'However, it should be the general rule that a capital loss should not be able to be claimed where the result of the course of action is that there is no economic loss to the taxpayer. The amendments to the law will have the effect that a capital loss cannot be claimed by company X in the circumstances shown in the example.' 43 Section s 160ZK applies in the circumstances of the example where the dividend is rebatable to the taxpayer. Its effect is to reduce the capital loss by the amount of the tax-free dividend to the extent that the dividend is attributable to profits derived by the company before the taxpayer acquired the share. This purpose does not seem to require that any distinction be drawn between realised and unrealised profits. 44 In considering the meaning of 'profits' the comments of Fletcher Moulton LJ in Re The Spanish Prospecting Co Ltd [1911] 1 Ch 92 at 98 are often used as a starting point: 'The word "profits" has in my opinion a well-defined legal meaning, and this meaning coincides with the fundamental conception of profits in general parlance, although in mercantile phraseology the word may at times bear meanings indicated by the special context which deviate in some respects from this fundamental signification. "Profits" implies a comparison between the state of a business at two specific dates usually separated by an interval of a year. The fundamental meaning is the amount of gain made by the business during the year. This can only be ascertained by a comparison of the assets of the business at the two dates.' 45 This definition has been said to be more useful as a guide than as a rule of general application; Federal Commissioner of Taxation v Slater Holdings Limited (1984) 156 CLR 447 at 460 per Gibbs CJ. The Chief Justice referred with approval to comments of Farwell J in Bond v Barrow Haematite Steel Company [1902] 1 Ch 353 at 365-366 and to In re Income Tax Acts [No 2] [1930] VLR 233 at 245, 250. He stated that Fletcher Moulton LJ's dictum was 'not of universal application and that each case must depend on its own circumstances.' The comments of Fletcher Moulton LJ were considered by Lockhart J in QBE Insurance Group Limited v Australian Securities Commission (1992) 38 FCR 270 ('QBE Insurance'). Interestingly, the case concerned a challenge to the validity of AASB 1023 (see [15] above). It was claimed that it was inconsistent with provisions of the Corporations Law that prohibited payment of dividends other than out of profits. His Honour admitted that 'profits' is an 'elusive concept' and stated, at 286: 'Profit refers to a comparison between the state of a business at the beginning and end of the relevant financial period. It is the amount of gain made by the business during the year or the net balance of all gains earned and losses incurred during a relevant accounting year. … The statement of principle that profit should be calculated by reference to changes in the value of assets of a business during the relevant financial period in Spanish Prospecting is as valid today as it was in 1911 when it was expounded.' 46 The importance of context was emphasised by the High Court as early as 1911 in Webb (Commissioner of Taxes (Vic)) v Australian Deposit and Mortgage Bank Ltd (1910) 11 CLR 223. Higgins J said, at 241, 'It does not follow, however, that because the difference between assets and liabilities is in some cases to be treated as profits, it is to be so treated in all cases. … The truth is, that the meaning of "profits" is not rigid and absolute; it is flexible and relative – relative to each company and in ascertaining the meaning of the word in any context, we must consider the whole context.' 47 In QBE Insurance Lockhart J considered, the meaning of profits is often in context of its use in the Corporations Law, in particular in the provisions relating to the payment of dividends. Lockhart J observed: 'Thus dividends may be paid out of all assets of a company which are profits in a legal sense. When dividends are declared there must be profits to meet them. When s 201 uses the words "payable …out of profits" it does not require the existence of a separate fund from which the profits are to be extracted for the purpose of the payment of dividends. All it requires is that at the date of declaration of the dividend the company's profit and loss account must disclose profits out of which the dividend can be paid.' 48 In these observations Lockhart can be seen to be drawing a distinction that is relevant here, namely the distinction between the profits from which the dividend is to be derived and the profits from which it must be paid. A similar distinction was drawn in Evans v Federal Commissioner of Taxation (1936) 55 CLR 80. A shareholder in a company had received from that company (X co) a distribution of shares in another company (Y co). He was assessed for taxation on the market value of the shares he had received under a section of the Income Tax Assessment Act 1922 (Cth)that made distributions 'out of profits from any source' assessable. The shares had been obtained by X co in consideration of the assignment of certain leases. It was argued that X co had realised no profit on either the acquisition or the distribution of the shares as they were a distribution of capital. In their joint judgment Rich, Dixon and Evatt JJ, at 101, rejected this argument: 'In the first place, the fact that the shares contain no profit on the sale of the leases does not mean that they represent capital and not profit of the company. Actually they represented surplus assets, that is, assets not required to make good issued share capital. This appears from the last preceding balance sheet. In the second place, sec 16(b)(i)(1) brings into charge all dividends and distributions out of profit, whatever be the nature of the profit. The word "derived" does not connote that the profit must be a realized profit. It is enough at least if it is an ascertained profit, ascertained by a proper account. Under the articles, the 5s. 6d. contained in the share could not lawfully be distributed, except as a dividend satisfied by specific assets, and the dividend must be out of profits. The meaning of profits in sec 16(b)(i)(1) is no narrower, and the state of the company's affairs, as disclosed by its balance-sheet, permitted such a dividend. It follows that the whole amount of the 5s. 6d. per share should be included in the appellant's assessable income.' 49 The above passage is relevant to the present enquiry not only for its observations on the nature of profits but also in relation to the meaning of 'derived'. The applicant submits that the phrase 'profits that were derived' should be construed as referring to 'gains that have come home and are available for distribution.' The respondent submits that the term should is much broader and refers to profits both realised and unrealised. 50 The Act does not contain any definition of 'derived'. It is not a technical word and there is no reason why it should not bear its ordinary English meaning. The ordinary meaning has been expressed as 'obtained' or 'got' or 'acquired' (Federal Commissioner of Taxation v Clarke (1927) 40 CLR 246 at 261 per Isaacs ACJ) or as, 'arising or accruing or coming in by way of income, not necessarily actually received'; Tindal v Federal Commissioner of Taxation (1946) 72 CLR 608 at 624. In Brent v Federal Commissioner of Taxation (1971) 125 CLR 418 at 427 Gibbs J said, 'The word "derived" is not necessarily equivalent in meaning to "earned"'. "Derive" in its ordinary sense, according to the Oxford English Dictionary, means "to draw, fetch, get, gain, obtain (a thing from a source)". ' 51 The importance of context was recognised by Dixon J in Commissioner of Taxes (SA) v Executor Trustee & Agency Co of South Australia Ltd (1938) 63 CLR 108 at 155: 'Speaking generally, in the assessment of income the object is to discover what gains have during the period of account come home to the taxpayer in a realized or immediately realizable form.' 52 In the written submissions of the Commissioner the point is made that the word 'derived' is encountered in the Act in three principal contexts and does not necessarily have the same meaning in those contexts. The present context is that of identifying the derivation of the fund of profits from which a dividend is paid. There is, to my mind, a distinction between the source from which the dividend is paid and the derivation of that source. 53 It is clear that dividends can only be declared out of profits; Industrial Equity Ltd v Blackburn (1977) 137 CLR 567 at 580. In Hancock Family Memorial Foundation Ltd v Porteous (2000) 156 FLR 249 at 277 the Western Australian Court of Appeal said that the term profits should be given a broad meaning and that the term 'includes capital profits, both realised and, in some circumstances, unrealised: Australasian Oil Exploration Ltd v Lachberg (1958) 101 CLR 119 at 133; Dimbula Valley (Ceylon) Tea Co Ltd v Laurie [1961] Ch 353.' In considering this issue it is important to realise that profits (realised or unrealised) are not created by the way in which they are treated in company accounts. Accounts describe the substance of what is happening with the company's capital, income and assets. They may do it more or less well. There can be disputes about how well they do it as for instance in QBE Insurance. Latham CJ recognised this in Dickson v Federal Commissioner of Taxation (1940) 62 CLR 687 at 705 when he observed: 'The relevant sub-section evidently contemplates that profits may arise from a revaluation of assets. It is, I think, clear that profits cannot be produced, caused, or brought about by a mere process of revaluation. But, though revaluation cannot create profits, it may reveal or disclose profits.' 54 The applicant supported its submissions on this point by reference to Read v Commonwealth (1988) 167 CLR 57 ('Read'). The High Court, relevantly, was considering whether a person in receipt of additional units under a commercial unit trust was in receipt of income within the meaning of s 18 of the Social Security Act 1947 (Cth). The trust deed in question required the trust assets to be periodically revalued and any increase or decrease in value to be distributed by the issue of additional units. Section 18 defined income as meaning, 'any personal earning, moneys, valuable consideration or profits earned, derived or received by that person for his own use of benefit by any means from any source whatsoever, within or outside Australia …' (emphasis added) 55 In their joint judgment Mason CJ, Deane and Gaudron JJ stated, at 66, that whether the additional units constituted a 'profit' 'must be assessed in terms of whether they resulted in any consequential financial gain to the appellant'. Their Honours noted that on the evidence it was not possible to conclude that the additional units resulted in an increase in the proportionate beneficial interest in the trust held by the appellant. They stated that, 'In our opinion a mere increase in the value of an asset does not amount to a capital profit. A profit connotes an actual gain and not mere potential to achieve a gain. Until a gain is realized it is not "earned, derived or received". A capital gain is realized when an item of capital which has increased in value is ventured, either in whole or in part, in a transaction which returns that increase in value.' 56 In its written submissions the applicant stated, 'Put simply, neither: (1) the unrealised increase in the market value of the Bridge Street Properties; nor (2) the unrealised increase in the market value of the shares held by [Phoenix], was a "profit". There was no actual gain. In fact, at best, there was a mere potential to achieve a gain. That is not sufficient.' 57 In my opinion the context of the decision in Read is fundamentally and relevantly different from the context in which the issues in this case must be decided. In a case where the issue was whether there should be a reduction in the appellant's pension if she had acquired additional income it is not surprising that the Court should have focused on actual financial gain to the appellant. The position here is the opposite. The purpose of the statutory provisions under consideration here is discussed above at [41]-[43]. As that discussion indicates the purpose of the provisions is to preclude a taxpayer from claiming a capital loss where there is no economic loss to the taxpayer. The issue is whether at the Merger Date there existed profits to which subsequent dividends 'could reasonably be taken to be attributable' and by recourse to which the purchase price could be recouped. In relation to this issue the decision in Read does not assist. The legislative purpose would, in my view, be defeated by applying the analysis in Read. 58 On the evidence before me I am satisfied that at the Merger Date there were profits (realised and unrealised) available to both SAIL and Phoenix and reflected in the market value cost base attributed to their shares. Those profits were subsequently (to the extent necessary) realised and distributed to the shareholder in the form of dividends (or distributions treated as dividends). These profits were derived by the companies before RSA acquired their shares. 59 The applicant submits that even if the unrealised increases in the value of SAIL and Phoenix's assets were identified as 'profits that were derived', it is not reasonable to attribute the source of each dividend in question to profits which were made before the acquisition of SAIL and Phoenix by RSA. In relation to SAIL, the applicant points out that the Bridge Street Buildings substantially declined in value after the Merger Date and that the source of the profit was the Merger Agreement and the BSB Agreement not the pre-merger profits. In relation to Phoenix the applicant claims that there were significant fluctuations in the value of the company's portfolio until they were fixed by realisation which occurred after the Merger Date. 60 These submissions, with respect, do not address the issue. At the Merger Date the value of the Bridge Street Buildings was significantly greater than their historical cost. There was an unrealised profit. That profit was recognised and adopted at the time of the merger. In fact the purpose of clause 14 of the Merger Agreement and the BSB Agreement was to protect this value. In my view the profit realised on sale of the Bridge Street Buildings was directly attributable to the unrealised profit that existed at the time of the merger. The fact that it was paid by a third party is irrelevant. 61 In relation to the fluctuations in the value of the Phoenix investments, the issue is different in that there is no third party guarantee. The problem here arises from a confusion between the substance of the matter and the description of that substance in the company accounts. As with the Bridge Street Building there was an unrealised profit that was recognised and adopted at the time of the merger. It is that profit to which the dividends are attributable even if the fund out of which the dividends were actually paid is different in that it consisted of profit now realised. 62 The evidence in the case of both SAIL and Phoenix indicates that the profits that were unrealised at the Merger Date were realised after that date. Those profits, together with profits derived after the Merger Date, were distributed to the shareholder, RSA. Consequently the dividends paid by the companies can to the relevant extent be attributed to profits derived by the companies before the Merger Date. Section 160ZK therefore applies and gives rise to a rebatable dividend adjustment which, as explained previously has an effect on the cost base of the shares. This result is consistent with the policy of the legislation. Any other result would allow RSA (and consequently the applicant) to claim a capital loss in circumstances where it had not suffered a financial loss. 63 For these reasons the decision of the Commissioner in disallowing the applicant's objection to the amended income tax assessment must be upheld and the application dismissed with costs. I certify that the preceding sixty-three (63) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Stone. Associate: Dated: 13 February 2003 Counsel for the Applicant: Mr B J Shaw QC with Ms M Gordon Solicitor for the Applicant: Pricewaterhouse Coopers Legal Counsel for the Respondent: Mr A H QC Slater with Mr R Hamilton Solicitor for the Respondent: Australian Government Solicitor Date of Hearing: 6 February 2002 Date of Judgment: 13 February 2003