QT86/3533, QT86/3534 and Commissioner of Taxation [1988] AATA 78; (1988) 19 ATR 3371; 88 ATC 408 (8 March 1988)

Last Updated: 24 June 2009

ADMINISTRATIVE APPEALS TRIBUNAL

Income tax - Allowable deduction - Acquisition of land for tourist development - Vendor unable to complete - Specific performance - Payment into court - Money borrowed - Whether interest deductible - IT 166 - Income Tax Assessment Act 1936-1984, sec. 51.

Travelodge New Guinea v Chief Collector of Taxes 85 ATC 4432
M.474-475/1984 Board of Review No. 2 (unreported decision dated 30 May 1986)
Somers Bay Investment Pty Ltd v FC of T 80 ATC 4411
FC of T v Western Suburbs Cinemas Ltd [1952] HCA 28; (1952) 86 CLR 102
Southern Estates Pty Ltd v FC of T (1967) 177 CLR 481
Case T99 86 ATC 1165
Case U90 87 ATC 519
Sun Newspapers Ltd and Associated Newspapers Ltd v FC of T [1938] HCA 72; (1938) 61 CLR 337

16 TBRD Case R74

DECISION AND REASONS

Re:

APPLICANT And: Commissioner of Taxation

RESPONDENT

Nos: QT86/3533, QT86/3534

AAT Decision No 4215

Date: 8 March 1988 Place: Brisbane

Dr P. Gerber, Senior Member

ADMINISTRATIVE APPEALS TRIBUNAL )

) QT86/3533, QT86/3534
TAXATION APPEALS DIVISION )

Re:

APPLICANT

And:

RESPONDENT

DECISION

Before: Dr P. Gerber, Senior Member

Date: 8 March 1988

Place: Brisbane

Pursuant to subsection 43(1)(a) of the Administrative Appeals Tribunal Act 1975, the Tribunal affirms the objection decision in relation to the assessments for the year ended 30 June 1985.

(Sgd. P. Gerber)

SENIOR MEMBER

ADMINISTRATIVE APPEALS TRIBUNAL )
)
TAXATION APPEALS DIVISION )

Re:

APPLICANT
And:

RESPONDENT

REASONS FOR DECISION

Before: Dr P. Gerber, Senior Member

Date: 8 March 1988

Place: Brisbane

1. This case involved a number of judicial proceedings which make Kafka's Der Prozess (The Trial) look like restoration comedy. The applications before this Tribunal were made no easier by the failure of the two taxpayers (husband and wife) to be present to explain some of the niceties of the background, having been apparently assured that the case could be conducted "on the papers". I propose to set out the facts in two forms: (i) as a simple melody stripped of its many chords and counterpoint, and (ii) as a theme and variations, which finally becomes so complex as to disguise, and finally obliterate, the original melody.

(i) The simple melody

2. Some time in 1982, this couple (semble) decide to become involved in the tourist industry. They are aware of the availability of some land at Shark Bay, sale price $70,000, and engage a local consulting engineer with instructions to prepare a preliminary feasibility report for a proposed tourist accommodation development on the said land. The engineer duly sends such a report to the husband on 16 August 1982, setting out several alternatives, ranging from 10 holiday units with kitchen and dining room, to 15 holiday units without motel, kitchen or dining room facilities. These are all costed and estimate of annual net returns for each is included. The existing zoning would (semble) permit the construction of each of the alternative proposals. On 12 September 1982, some fairly basic plans, labelled "Basement and Site Plans" are sent to the taxpayers. Some time in March 1983, the two taxpayers entered into a contract of sale for the land with Shylock & Co (hereinafter referred to as "Vendor"), and pay 10% deposit ($7000), settlement being due on 29 April 1983. In order to complete the purchase, the taxpayers were compelled to borrow some $60,000. In the 1985 tax year, each party claims by way of deduction an amount of $2683, being his/her share of the interest on the $60,000 they borrowed. There has been no building activity on the land to this day.

3. Since neither the husband nor the wife gave evidence, much of the above rests on speculation. I was not informed about the taxpayers' earlier activities and/or whether they were previously involved in the tourist industry; for all I know, they may both be brain surgeons suffering from cerebral palsy - there is certainly no hard evidence of intention to undertake a tourist development. Despite this gap, I am satisfied that when the acquisition of the Shark Bay land is looked at, both against the background of the engineer's report and the site plans, it is more probable than not that the taxpayers acquired the subject land with the intention of building a tourist development, and no suggestion was made that this land could have been acquired for a private or domestic purpose. Whether the undertaking would ultimately contain 10 units with "facilities" or 15 units with or without kitchen accommodation, is ultimately irrelevant for tax purposes. In short, I am prepared to act on the presumption raised by the evidence - such as it is - that the taxpayers, when entering into the aforementioned contract of sale, intended to embark upon a commercial undertaking. Is that presumption sufficient to enable the interest payment to be deductible under sec 51(1) of the Tax Act?

4. Not surprisingly, the applicants' representative placed heavy reliance on IT 166, which states in its preamble:

"Consideration has been given to the deductibility of interest on money borrowed to construct an income producing asset, such as a block of flats, where the interest is paid during the construction period during which no revenue is being received from the asset."

The Ruling proceeds to spell out that:

"Generally speaking, interest incurred in these circumstances should be allowed as a deduction under sec. 51 so long as the case is one in which there is no room for doubt that the asset under construction is being erected solely and exclusively for the purpose of producing assessable income."

This ukase was first circulated within the Tax Office in 1967 and not publicly released until 1983.

5. Further reliance was placed on the decision in Travelodge Papua New Guinea v Chief Collector of Taxes 85 ATC 4432, decided on a statutory provision similar to our sec. 51(1). In that case, the taxpayer was a company engaged in the hotel business and was the successful tenderer for the construction of a hotel. The company arranged loans totalling K5.7 million during the period of construction and capitalised the interest prior to the earning of any income. Bredmeyer J held that the outgoing should be characterised as recurring expenditures incidental and relevant to the production of the assessable income from the hotel which was not so integrally connected with the creation of the capital asset as to amount to a payment of a capital nature. That case has since been followed in an unreported decision of Taxation Board of Review No. 2 involving a married couple who had jointly purchased a residential property with a view to letting it out. Prior to such letting, the taxpayers decided to do some painting but, as events transpired, it was not until some two and a half years later that the property was first let. The Board concluded that the outgoings of interest, rates, borrowing expenses, insurance and standing charges for electricity and gas incurred during the period the property was vacant were deductible under sec 51(1). The decision is quoted extensively in IT 2374. The Chairman is quoted as having stated that "we do not see how the length of the period between acquisition of the property and installation of a tenant can, of itself, play a deciding role in our determination ...". With the utmost respect, that misconceives the issue. It is perfectly true that an outgoing need not necessarily be incurred in gaining or producing the assessable income in the year in which it is incurred, and such decisions as Somers Bay Investment Pty Ltd v FC of T 80 ATC 4411 are clearly no longer consonant with modern law. But it does not follow from this that the mere acquisition of bare land, coupled with a commercial purpose, is sufficient to make the running expenses associated with the holding of the inert asset deductible under sec. 51(1). In IT 2374, the Commissioner stated that he accepted the correctness of the Board decision, adding that it was consistent with IT 166. He furthermore advised assessors that the decision should be applied in similar fact situations where a property is not used for gaining assessable income for a significant period but it is clear that, throughout the relevant period, the taxpayer's intention was that it would in the future be used exclusively in the production of assessable income.

6. I have not been persuaded that, with the greatest respect for the eminent Members who then constituted Board of Review No 2 that the decision, referred to above, is correct. I am furthermore satisfied that the concession, in the wide terms in which it was made in IT 2374, is insupportable in law. I therefore do not propose to follow it. If, in the unreported Board case, one were asked to identify the taxpayers' business in which these losses were said to have been necessarily incurred, one would have to conclude that that "business" was as notional as the "repairs" in the Western Suburbs Cinemas case [1952] HCA 28; (1952) 86 CLR 102. In my view, there can be no notional business. At its highest, the taxpayers in the aforementioned Board case were preparing the property for letting. That is not enough. As was once said: "To prepare land for primary production ... is not of itself ... to engage in primary production." (per Barwick CJ. Southern Estates Pty Ltd v. FC of T (1967) 177 CLR 481, 488

7. I had occasion to deal with the homespun Jurisprudence enshrined in IT 166 in Case T99 86 ATC 1165. In that case, the taxpayer, a Member of Parliament, acquired some land with the intention - as in the instant case - to develop the land for tourist accommodation. Before the land could be thus developed, it required re-zoning and this had not been achieved at any relevant time. I concluded that section 51 proceeded on the basis that, at the time when an expenditure is incurred, a taxpayer must be actually engaged in carrying on business, or, at the very least, be irrevocably committed to a business. I do not resile from that proposition.

8. Applied to this case, I have not been persuaded that entering into a contract of sale for the acquisition of land without more constitutes either carrying on a business or an irrevocable commitment to the carrying on of a business. Whether IT 166 is correct when applied to the specific example quoted therein, viz. that interest borrowed to construct a block of flats, being built for letting purposes, is deductible and/or whether such a view is reconcilable with the Southern Estates case (supra) is unnecessary for me to decide.
9. For these reasons, based on the simple melody, the claim must fail.

10. I derive considerable comfort in my conclusion from the fact that Mr Roach (Senior Member), in Case U90 87 ATC 519, arrived at the same result, albeit by a slightly different route. In that case, the taxpayer purchased two adjoining blocks of residential land for investment purposes. The intention was at all material times to develop the land so as to become income producing, but no firm plans as to how this was to be achieved were ever formulated. The claim for interest on monies borrowed to finance the land failed. Indeed, on the facts as found, it is difficult to see how the argument for a deduction could have been put. In his decision, Mr Roach gave a useful summary of the relevant law.

"... It is not a question as to whether the expenditure incurred was capital ("once for all" or "non-recurrent in nature"). What is not deductible - special statutory provisions apart - is the cost of acquiring the asset committed to the profit-earning activity. It does not matter whether the operator of a hotel business bought his hotel as a going concern or bought a newly constructed hotel in a condition ready to commence business; or bought an old hotel and remodelled it; or developed a hotel complex on a vacant site or on a previously developed site cleared for the purpose. In none of those cases is the expense of acquiring a "profit-yielding subject" deductible and in my view that extends to the interest costs and all other charges, whether recurrent in nature or not, which are costs of establishing the profit-yielding subject as distinct from the costs of operating it."

The reference to the "profit-yielding subject" is taken from judgement of Dixon CJ the Sun Newspapers case [1938] HCA 72; (1938) 61 CLR 337, 359. Mr Roach identified the "profit-yielding subject" in the case before him as the bare blocks of land, and concluded that expenditures incurred on rates and interest were establishment rather than operating costs, and thus an affair of capital. The two differing approaches are semantic rather than substantive; the result is the same. Both views raise serious doubts as to the correctness of the development of a jurisprudence - at least in this country - which began with IT 166, found an echo in the Travelodge Papua New Guinea case, was adopted in the (unreported) Board case, and finally legitimated per rescriptum principis in IT 2374. It is of historical interest that IT 166 was "born" as a result of a Board decision - 16 TBRD Case R74 - in which a taxpayer purchased property A in 1958, intending to effect repairs and to fit it out as a bed-and-breakfast establishment. The property proved to be unsuitable for that purpose, and in June 1961, the taxpayer purchased property B which was more suited for his intended purpose. In August 1962, property A was sold. Property B was in a state of disrepair, and it was not until September 1965 that the premises were opened as a bed-and-breakfast establishment. Deductions for insurance relating to properties A and B, as well as interest on monies borrowed to acquire those properties were disallowed for the 1962 tax year on the basis that they were of a capital nature. The decision was reached by a very eminent Board, consisting of AM Donovan (Chairman), JD Davies (as he then was) and GR Thompson (Members). This notwithstanding, some anonymous scribe noted in IT 166 that the views expressed in Case R74 "are not accepted, but the decision in that case may be used to support disallowance of claims in cases where the necessary income producing purpose is not present". I am unable to accept the "ruling" expressed in IT 166 and consider, with respect, that Case R74 correctly sets out the law. If my own view be heresy, no doubt I will be corrected on appeal.

(ii) Theme and variations

11. The subject land - Whiteacre - formed part of a larger parcel of land - Blackacre - albeit on separate title. Blackacre is owned by Green. Somewhere in the Dreamtime, Green sells Blackacre to Soames Pty Ltd ("Vendor") which is the trustee of a Unit Trust made up of a gaggle of 26 lawyers (if that is the collective noun), who own the whole of the share capital of Soames and all the units in the trust.

12. From here on, the plot thickens. The duplicate Certificate of Title of Whiteacre shows a registered Bill of Encumbrance in favour of Green, made on 18 September 1981, pursuant to which Soames encumbered Blackacre (which includes Whiteacre) to secure due payment of monies due and owing by Soames to Karl Marx (No. 91) Pty Ltd. The Certificate of Title also discloses a Bill of Mortgage in favour of Australian European Finance Corporation Ltd, the mortgage, so I was informed, being for a very substantial amount. The mortgage was registered on 22 December 1981.

13. By an indenture dated 18 September 1981, Green agreed, inter alia, to release Whiteacre from his security to enable it to be sold. It was a condition of such release that Green would receive 50% of the sale price, or 50% of the "true market value", whichever was the higher. Since the subject land was "sold" to the taxpayers for $70,000 and "true market value" had (semble) been determined at $120,000, the encumbrancee thus became entitled to be paid $60,000 out of the proceeds of the "sale", and (semble) had refused to agree to the sale to the taxpayers at $70,000.

14. In June 1982, Soames Pty Ltd changes Its name to Forsyte Pty Ltd, a fact not recorded on the Certificate of Title until December 1984. As noted in paragraph 2 above, Soames purported to sell the subject land to the taxpayers in March 1983. The contract, in standard form, fails to record either the mortgage or the encumbrance. The only encumbrance noted in the contract is an easement. On May 4, 1983, a caveat is lodged on behalf of the taxpayers, and in July 1983, the taxpayers institute proceedings for specific performance. In November 1983, an order is made that the defendant be at liberty to issue a third party notice against the encumbrancee and the action was certified for speedy trial. The action thereupon proceeded with great speed and efficiency. No third party notice was ever filed, and, on 6 August 1984, the defendant's solicitor was granted leave to withdraw from the action. When the matter came on for hearing in October 1984, nearly twelve months after the order for a speedy trial, there was no appearance for the defendant. In the result, Ryan J. granted specific performance of the contract between taxpayer and Forsyte, nee Soames and ordered a payment into court of the balance of the purchase price. He gave no indication -indeed, why should he - how this decree was to be performed.

15. The taxpayers were compelled to borrow $60,000 so as to be able to comply with terms of the order, and proceeded to pay the balance of the purchase price ($63,000) into court, where, so I am told, the money is gathering dust to this day.
16. The above, like Piltdown Man, has been assembled from a few bones picked up here and there. Not one single relevant document was made an exhibit. If the authenticity of this reconstruction is suspect, the blame must lie with the archeologists who argued this case. However, when this skeleton has been re-assembled, it would seem that the $60,000 was borrowed, not to buy Whiteacre, but in order to comply with a judicial decree which had no hope of being enforceable. Indeed the defendant had pleaded in its defence "that the contract referred to in the statement of claim is impossible of performance", a matter duly recorded in the judgement. In short, impossibility of performance had been alleged and it was shown that there was a substantial probability that it would not be within the power or capacity of the defendant to comply with the proposed order of the court. The doctrine of privity of contract would prevent the taxpayers from enforcing the encumbrancee's undertaking to release the subject land on the terms set out in the indenture. In other words, the proceedings were an exercise in utter futility and one can only express surprise that the plaintiffs proceeded with the action and that the trial judge was persuaded to make such an order on the pleadings. At its highest, the taxpayers had - and may still have - an action for damages.
17. On this somewhat Kafkaesque scenario, involving a melody completely lost in chords, it would seem that the money was borrowed, not for the purpose of producing assessable income, but to comply with a judicial decree irrelevant to the production of assessable income.
18. In the result, at no relevant time were these taxpayers in business, or irrevocably committed to a business, or borrowed money which was connected with a business. In these circumstances, the taxpyers' claim to deduct the interest payment on the money borrowed - whether on the "simple melody" approach, or on the "theme and variations" - must fail.