Commissioner of Taxation v Hart & Anor S279/2002 [2003] HCATrans 679 (11 April 2003)

IN THE HIGH COURT OF AUSTRALIA

Office of the Registry

Sydney No S279 of 2002

B e t w e e n -

COMMISSIONER OF TAXATION

Applicant

and

TRUDY AMANDA HART and RICHARD MERALLES HART

Respondents

Application for special leave to appeal

GUMMOW J

CALLINAN J

TRANSCRIPT OF PROCEEDINGS

AT SYDNEY ON FRIDAY, 11 APRIL 2003, AT 10.27 AM

Copyright in the High Court of Australia

MR B.J. SHAW, QC: If the Court pleases, I appear with my learned friend, MS J. DAVIES, for the applicant Commissioner. (instructed by Australian Government Solicitor)

MR R.F. EDMONDS, SC: May it please the Court, I appear with my learned friend, MR M. RICHMOND, for the respondents. (instructed by Gadens Lawyers)

GUMMOW J: Yes, Mr Shaw.

MR SHAW: If the Court pleases, if this appeal for special leave were to be granted, it raises two sets of questions, one relating to the application of section 51 and its successor, the other relating to Part IVA. If I can deal first with Part IVA. The Part IVA questions are, it is submitted, of very considerable significance because they raise a question about the extent of its application in circumstances where it is clear that a part, at least, of the relevant transaction, whether that in itself constitutes a scheme or not, was entered into, it is clear, it is submitted, for purposes, the dominant purpose of which was to obtain a tax benefit.

If I might just remind your Honours of the facts. The Harts owned a house at Jerrabomberra. It was worth about $110,000 and they had a mortgage on it with about $95,000 outstanding and they lived in the house. They bought another house at Fadden for $155,000. They wanted to live in the Fadden house and to keep the other house for renting out. They looked for finance. They found a company called Austral Mortgage which was promoting a loan which was called a "Wealth Optimiser" loan.

It was called "Wealth Optimiser" because it used tax deductions to produce the optimisation of wealth. It did that by dealing with circumstances such as were present here, namely there was a desire to finance the acquisition of two properties, one for private purposes and the other for investment purposes, and what it provided was that a loan would be made of, as it turned out in this case, $298,000, and the borrowers were given the option if they wished, to elect to have the loan divided into two - - -

CALLINAN J: I think we probably understand the arrangement.

MR SHAW: If your Honours please.

GUMMOW J: But what Mr Edmonds fixes on is this phrase "would still make commercial sense" without the Part IVA element, as it were.

MR SHAW: There are two questions. The first question is whether or not the trial judge was right to say that the Commissioner was entitled to rely on the narrow scheme rather than the wider scheme. The trial judge said the Commissioner could rely on either and in either case the dominant purpose was to obtain a tax benefit. The Full Court said that the trial judge was wrong to permit reliance on what is called the narrower scheme.

In our submission, they were wrong in doing that. If they were wrong in doing that, it is perfectly clear that the dominant purpose of persons entering into the narrower scheme was to obtain a tax benefit. There does not seem to be any dispute about that.

CALLINAN J: Well, you probably would not know whether it made commercial sense for about 10 or 20 years.

MR SHAW: One has to look at it, I imagine, your Honour, at the time it is done.

CALLINAN J: Yes, but I mean history will judge it because it depends upon inflation and capital gains, whether the risk of allowing the interest to compound, for example, was going to be justified.

MR SHAW: The compounding of the interest did not make any difference to the total interest which was ultimately paid. It just made a difference to what it was said to be in respect of.

CALLINAN J: But it is relevant to the commerciality of the arrangement, I think.

MR SHAW: It is relevant to that, your Honour, but there is, it is submitted, if it is the narrower scheme, no doubt that the dominant purpose of the persons who entered into that scheme, if it is a scheme, was to obtain a tax benefit for the taxpayers.

GUMMOW J: Now, is there an issue as to how one goes about fixing upon this characterisation of narrower or wider in this realm of discourse?

MR SHAW: Yes, there is a question about that because the Full Court said that if you took the narrower scheme - - -

GUMMOW J: Yes, I understand that, but how does one know which is the correct path to go?

MR SHAW: The Full Court says you cannot have the narrower scheme because if you did it was robbed of all practical meaning. That is one version of it. That is what Justice Hill said. Justice Hely said something quite different. He said you could not take the narrower scheme because that robbed it of its practical context, and practical context and practical content are not the same. Indeed, they are very different things.

It is clear enough that in CPH, for example, this Court accepted that you could look at part of a series of transactions and regard that part as a scheme and refer to the other part as explaining the purpose of the persons entering into the scheme. The trial judge referred to that at page 32 of the application book at line 36 in a citation from Consolidated Press:

The fact that the overall transaction was aimed at a profit making does not make it artificial and inappropriate to observe that part of the structure of the transaction is to be explained by reference to a s 177D purpose. Nor is there any inconsistency involved, as was submitted, in looking to the wider transaction in order to understand and explain the scheme, and the eight matters listed in s 177D."

So that, in our submission, his Honour Justice Hely's test - and I might add that Justice Conti agreed with both the other judges on this point - that his Honour was not right in saying that you had to take the whole of the relevant context. As to what his Honour Justice Hill said, he seemed to take the approach referring to what was said in Spotless and taken from Brebner that you had to see whether looking at the narrower scheme it robbed it of all practical meaning.

In our submission, that cannot really be said here because the narrower scheme were terms in the loan which the taxpayers could activate at their option or not. If they did, then the loan was divided into the two accounts and they could give a direction as to where the payments were to go. So it is submitted that there is a real question and a very important question about how you identify the scheme, narrower or wider, and there is a difference between the trial judge and the Full Court on that matter.

GUMMOW J: Yes, thank you.

MR SHAW: The next question, your Honours, assume that the Full Court is right about you have to look at the wider scheme, there is a question about how you determine what the dominant purpose of the persons who entered into that scheme was. The Full Court seems to have taken the view that once you included the loan in the scheme then the persons who entered into the scheme must have entered into it for a purpose which was dominantly the commercial purpose of obtaining the loan and applying the moneys to financing the acquisition of the house.

It is submitted that that is inconsistent with Spotless where it was held that the loan that was made was made dominantly in order to obtain a tax benefit and not to obtain the return on the loan, although, of course, a return was obtained. Not only is that so, but if one looks at what Justice Hely says at page 74 of the application book at line 44 in paragraph 86:

Thus, if in the present case the "scheme" were defined as the "plan, proposal, action or course of conduct" whereby monies were borrowed on the terms of the "Wealth Optimiser" structure, rather than on the terms of the "Standard" loan package -

that is the "credit foncier" package -

or some other form of financing, then it might be easy to conclude that the dominant purpose of entering into the scheme so defined was to obtain a tax benefit -

It is obvious, it is submitted, if the question is, "Why did the Harts enter into the "Wealth Optimiser" loan rather than an ordinary standard credit foncier loan?", it is obvious that the answer is, "To obtain the benefit of the tax advantage". But his Honour goes on to say:

That is, I think, the approach which was taken by the primary Judge. But that approach effectively leaves out of account the fact that the "scheme" necessarily included the borrowing of moneys for use in financing and refinancing the two properties. I say "necessarily" because . . . rob it of its practical context.

Now, what his Honour omits to notice in there, that if you ask the question, "Were the moneys borrowed on the terms of the "Wealth Optimiser" structure rather than on the terms of the standard loan package?", each of those schemes does include the borrowing of the moneys and you get a different answer to the question. But it is submitted that there is a very significant question here, even on the view that the wider definition of the scheme is the only permissible one, and it is a question about how do you determine the dominant purpose. Do you do it simply by looking at the transaction in the abstract or do you look at the transaction in terms of what would have occurred if the scheme had not been entered into, or the loan had not been entered into on the terms that it was?

This is made very clear, it is submitted, when one looks at the analysis of Justice Hill when he looks at the various matters which are referred to in section 177D(b). His Honour sets those out commencing on page 66 and he looks at the various matters, going over on pages 66, 67 and 68, and then he deals with the conclusion and says at page 69 at about line 24:

I do not think that a reasonable person would conclude that any person entered into or carried out the scheme or any part of it with the dominant purpose of ensuring that Mr and Mrs Hart merely obtained a higher deduction for interest. On any view of the matter the dominant purpose of the scheme which included the borrowing by the Harts of funds used to finance and refinance the two properties was the obtaining of funds to permit them to do so.

If you go back to the various factors that his Honour refers to and look at what he says about each of them, one finds that all of them either point to the obtaining of a tax advantage being the dominant purpose or are neutral except for one which is the one which is set out at the bottom of page 67 and going across to the top of page 68 and he says about that factor at paragraph 70:

None of the facts set out above under this heading would suggest the additional deduction as the dominant purpose of any relevant person. Rather they point the other way.

Having said that, he says what I read out from page 69 and that can only be because he takes the view that the dominant purpose of obtaining the loan moneys and applying them to the use to which they were put overwhelms everything else on the basis of the scheme which he accepts is the relevant scheme and that must be because he rejects the proposition which is earlier accepted that you can enter into a scheme for the dominant purposes of obtaining a tax benefit consistently with entering into the scheme for rational commercial purposes.

In our submission, the approach which is taken by his Honour has the vice which is referred to by the trial judge at pages 28 and 29 where his Honour cites from what was said by Justice Beaumont in the Full Court in Spotless, and your Honours will remember what his Honour said was approved by this Court on appeal, and at line 24 having said:

Then it is said on behalf of the respondents that `[w]hat the taxpayers did was simply to invest surplus funds in a form of investment in respect of which the . . . Act provided certain consequences -

that was getting the benefit of section 23(q) by having - - -

GUMMOW J: Yes.

MR SHAW: And he goes on to say:

There is an echo here of the `choice' principle developed in the earlier jurisprudence of s 260 - - -

GUMMOW J: Yes, that is right.

MR SHAW: He goes on to say that - - -

GUMMOW J: Old habits die hard.

MR SHAW: Yes, and the habit is revived, it is submitted, here.

GUMMOW J: Yes.

MR SHAW: And it is submitted it is very, very significant if the general anti-avoidance provisions resurrect or permit the adoption of steps which are clearly directed to obtaining a tax advantage and Part IVA is simply helpless in the face of that.

So it is submitted that there is a very significant question here as to how you define the scheme, wide or narrow, and there is, secondly, a very significant question, if you take the wide scheme, how is a dominant purpose to be determined because it is perfectly clear that if you asked, "Why was the "Wealth Optimiser" entered into instead of the standard credit foncier?", the answer is, "To obtain a tax benefit".

So it is submitted that the questions relating to Part IVA are extremely important questions for the proper functioning of the Part and that special leave should be granted in respect of that. As to section 51, may I simply say this, that in the circumstances it is clear enough that the compound interest was incurred because of the exercise of the option - - -

GUMMOW J: If you are right on the compound interest point, you would not reach these other interesting questions about Part IVA, would you?

MR SHAW: Well, you would a bit. There would be some left over. But what I mean is the compound interest does not consume all of the interest. There is that little bit of additional interest which accrues because the principal is not paid off, but subject to that, what your Honour said is right.

GUMMOW J: Now, if you were successful in obtaining a grant, what would you say about terms as to costs? This would be in the nature of a test case, I suppose.

MR SHAW: It would, your Honour, and we accept that if special leave is granted we should pay the costs in any event.

GUMMOW J: Thank you.

MR SHAW: If the Court pleases.

GUMMOW J: Thank you. Yes, Mr Edmonds.

MR EDMONDS: Your Honours, there are at least five heads of reasons why we say there should not be a grant of special leave in this case. The first head is that the Full Court's decision - and if I could deal quickly with 51(1) to start with - that the court's conclusion on the 51(1) issue involved the application of established principles to the facts and we would say that the same can be said of the court's conclusion on the Part IVA issue.

Indeed, when one reads the analysis undertaken by Justice Hill in coming to the section 177D conclusion - and that appears, as my learned friend has already taken your Honours, commencing at about page 66 of the application book - it is apparent that that conclusion is based entirely on findings of fact. No new question of principle is raised, in our submission, by the Full Court's decision in respect of either the 51(1) issue or the Part IVA issue.

Now, if I could come to a couple of the points that my learned friend made. He said that the real issue for the Court here and why it should be taken up is that there is an issue of characterisation of the scheme. We put it slightly differently. The question is, what is the scheme? It is the identity of the scheme and what does it comprise. Below the scheme was put on two alternative bases. The narrow formulation of the scheme consisted only of the terms of the loan. The wider formulation of the scheme, which was the original formulation that was made by the Commissioner in his statement of facts, issues and contentions, was that it included the loan.

Now, the Full Court came to the conclusion that the narrower formulation of the scheme could not stand on its own feet and the reason why it could not stand on its own feet was because, absent the loan, there would be no terms.

GUMMOW J: Yes.

MR EDMONDS: So the court proceeded on the basis that the only scheme that could be properly identified which was capable of standing alone was one which encompassed the loan itself. That deals with the so-called issue of characterisation.

The other point my friend makes is this, that when you identify the scheme by reference to what the taxpayers may have done but for the scheme, then one can readily see that it was entered into for the purpose of obtaining the tax benefits. Now, in our respectful submission, that is an impermissible way to identify the scheme. It is permissible to have regard to what might have been done but for what was done when one is seeking to determine whether a tax benefit was obtained in connection with the scheme, but in terms of identifying the scheme itself, it has to be identified on a stand alone basis by reference to what the taxpayers did, not what they may have done.

So when my friend takes your Honours to those passages of Justice Hely's judgment where his Honour quite rightly said, "If one compares what the taxpayers did by reference to what they would have done", then quite clearly you might come to the view that one form of the loan was entered into in preference to the other because of the tax benefits it carried, but it is an impermissible way, with respect, to identify the scheme. The scheme has to be identified by reference to the particular steps or transactions and without reference to what the taxpayer might have done.

Now, in our submission, the Full Court's decision on both issues, that is the 51(1) issue and the Part IVA issue, is not attended with any real doubt.

GUMMOW J: What do you say about the 51(1) issue?

MR EDMONDS: The four judges below were all of the view that the compound interest was deductible and it perhaps is best put in the judgment of Justice Hely, certainly most succinctly, where at page 71 of the application book his Honour says in paragraph 75:

Compound interest, like ordinary interest, is simply a cost of the funds which are borrowed. Accordingly, compound interest, like ordinary interest, will take its character from the use to which the original funds borrowed are put.

CALLINAN J: But why is not that, as the Commissioner submitted, simply money which has not been paid, that is, the interest which attracts the compound interest is simply money that has not been paid?

MR EDMONDS: It is, and it constitutes interest on the interest. It might not be paid for any number of reasons, your Honour.

CALLINAN J: We know why it was not paid here.

MR EDMONDS: We know why it was not paid here, because the loan repayments were directed to the repayment of the home loan rather than the loan on the investment property.

CALLINAN J: The rental property has been purchased with a loan and that loan attracts interest and that interest is payable, that interest is not in fact paid. Instead, it is allowed to compound. Why is it not, at least, arguable that the compound interest is not a different fund and it was not in any way the price of borrowing the money? That is what interest is, is it not?

MR EDMONDS: It is the cost of borrowing money.

CALLINAN J: Yes, the cost of borrowing money. Well, the compound interest.

MR EDMONDS: Yes, but, with respect, your Honour, what that does is it introduces a motive or subjective purpose test for deductibility under 51(1) when we all know, and it is quite clear, that that is not the relevant test for the purpose of determining the deductibility of - - -

CALLINAN J: You can reach that conclusion objectively. You do not have to take a subjective view of it to reach that conclusion.

MR EDMONDS: With respect, your Honour, the conclusion one would come to if you apply the objective test that it takes its character like ordinary interest from the use to which the original funds were put - - -

CALLINAN J: Or the purpose. What about the purpose?

MR EDMONDS: In many cases, the purpose of the borrowing will be exemplified by the use to which the funds are put. It will be rarely that you will get to a case - I am not saying it cannot occur - where funds are borrowed for a particular purpose and then they are utilised on some other basis, but normally - ordinarily I will put it - the purpose of the borrowing will be reflected in the use to which the funds are put and we say that if the interest, the ordinary interest, is an outgoing on revenue account, the compound interest that is incurred because of non-payment, for whatever reason that may be, will itself be on revenue account and, as I have already said - I will not repeat myself - - -

GUMMOW J: It is all bound in this phrase "the cost", is it not?

MR EDMONDS: Yes, your Honour. It is a cost of the borrowing.

GUMMOW J: Cost in what sense of the borrowing? It is only because something else has happened.

MR EDMONDS: It is the price you are paying for allowing the loan to remain outstanding unrepaid.

GUMMOW J: Yes, it is a further cost.

MR EDMONDS: It is a further cost, and we say that really there is, with respect, little doubt that that is the correct view, both the judge at first instance and all members of the Full Court coming to that view. So far as Part IVA is concerned, your Honours, the Full Court was unanimous in upholding the appeal on this issue. This case, we say, stands in stark contrast to the decision of this Court in Spotless. In Spotless this Court said at page 423 of the report:

viewed objectively, it was the obtaining of the tax benefit which directed the taxpayers in taking steps they otherwise would not have taken by entering into the scheme.

Now, in this case, it was not the obtaining of the tax benefit which directed the taxpayer in taking steps they otherwise would not have taken. It was the desire of the taxpayers to purchase a new home and retain the existing home as an investment property and we make the point in our outline of argument, your Honours, that it is an important fact in this that the decision to buy the new home and retain the existing home as an investment property was one which was taken in advance of the decision to enter into these borrowing arrangements.

Now, the third set of reasons we say as to why special leave should not be granted is that when the reasons that are given by the applicant in their summary of argument as to why special leave should be granted are subjected to scrutiny, then they do not support that course. Now, the reasons they give in their outline of argument appear at page 98 of the application book and the first reason given is that the case:

raises important issues of principle regarding the tests for deductibility . . . and the application of the provisions of Part IVA.

Now, that might be right. They may be important issues, but they are, as I have already said, established and not new issues. The second reason that is given is that:

the decision of the Full Federal Court has attracted intense public interest because of the opportunity the reasoning of the Full Court is thought to afford for taxpayers to obtain deductions for home loan interest.

Now, this second reason that is given is not supported by any evidence and nor could it be because, as was pointed out by Justice Hill, it was never suggested nor claimed that any part of the interest on the home loan was deductible.

CALLINAN J: That can hardly be any reason to give special leave anyway.

MR EDMONDS: No, your Honour.

CALLINAN J: If people are entitled to do this, they are entitled to do it. They either are or they are not. It does not matter what the newspapers say about it.

MR EDMONDS: Exactly. The fourth head of reasons, we say, is that the Full Court found as a matter of construction that there were two loans, in fact, made here, not one loan which could be split but two loans. That finding was made by his Honour Justice Hill at page 50 of the application book. Arguably, we say that this does not make this an appropriate vehicle in which to grant special leave and, indeed, the respondents - - -

GUMMOW J: Why is that, Mr Edmonds?

MR EDMONDS: We merely make the point that the respondent would have to put that finding in issue and does, indeed, do so in its amended special leave application in paragraph 4. That appears at page 82, if your Honours could go to that, where the respondent indicates that it puts in issue the finding of fact made by his Honour Justice Hill with whom Justices Hely and Conti agreed where they say:

The Full Court should not have found that there were two loans, as there was in law, and in a practical commercial sense, a single loan -

Finally, your Honours, the fifth head of reasons which we say why this case does not raise - - -

CALLINAN J: Just before you leave that last matter, does that finding depend upon the documents?

MR EDMONDS: Construction of the documents, yes, your Honour.

CALLINAN J: It is just a construction point.

MR EDMONDS: It is just a construction point.

GUMMOW J: There is no credit involved.

MR EDMONDS: No. Fifth, your Honours, we say this case does not raise a question of fundamental principle or one of general application which would warrant a departure from this Court's view, which has been expressed on many previous occasions, that ordinarily the Federal Court ought to be regarded as the - - -

CALLINAN J: I do not regard that as being the position at all.

MR EDMONDS: I accept what your Honour says. If your Honours please, they are our submissions.

GUMMOW J: Yes, Mr Shaw.

MR SHAW: If the Court pleases, my learned friend referred to page 30 of the application book and the citation there from what was said by this Court in Spotless. That citation appears between lines 16 going down to line 32. In that paragraph the Court emphasises the importance of looking at the particular scheme which was the basis on which the trial judge proceeded, the particular scheme. His Honour Justice Hill seemed to reject that idea, but not only is that so, my learned friend referred to the last three lines of the citation and you see there that what this Court said was:

viewed objectively, it was the obtaining of the tax benefit which directed the taxpayers in taking steps they otherwise would not have taken by entering into the scheme."

Now, in our submission, it is absolutely clear that that occurred here because what happened was the Harts took advantage of the option that was given to them. They gave a direction for the division of the loan to two accounts and they gave the direction for the application of all the payments which had been worked out on the basis that they were what was necessary to pay off the loan, principal and interest over 25 years, and they directed all the payments to be made first to the home loan until it was paid off and then directed to the investment loan.

So it is submitted that there is no doubt that here steps were taken that otherwise would not have been taken by entering into the scheme and it is submitted that, contrary to what my learned friend says, that passage from Spotless does strongly support the submission which the Commissioner puts.

GUMMOW J: Thank you. We will take a short adjournment.

AT 11.04 AM SHORT ADJOURNMENT

UPON RESUMING AT 11.08 AM:

GUMMOW J: In application No 4 there will be a grant of special leave with respect to the Part IVA issues appearing in paragraphs 3 through to 9 in the draft notice of appeal at pages 87 to 88 of the application book and that grant is conditional upon, as has already been indicated, the Commissioner paying the costs of the respondents of the appeal in any event.

With respect to the compound interest ground which appears in paragraph 2 on page 86, further consideration of that will be referred in to an enlarged Bench for further consideration at the same time as the substantive appeal.

Is there anything else?

MR SHAW: No, your Honour.

GUMMOW J: Thank you, gentlemen.

AT 11.09 AM THE MATTER WAS CONCLUDED