[6.1] In this chapter and in the chapters that follow, the discussion is arranged under headings that distinguish (i) expenses which are relevant and working from (ii) expenses which are relevant but capital, and from (iii) expenses which are irrelevant. Only expenses which are properly described by the first heading may be deductible under s. 51(1). Expenses described by the second may be deductible under other sections of the Act, more especially the depreciation provisions in s. 54ff. Some expenses described by the third heading were deductible under specific provisions which have now been replaced by provisions allowing “concessional rebates” of tax: Subdiv. A of Div. 17 of Pt III. Specific provisions more recently introduced allow deductions which relate to contributions to superannuation funds (Subdiv. AB of Div. 3 of Pt III) and to costs of home insulation (Subdiv. E of Div. 3 of Pt III). They are exceptions to a general denial of deductibility of expenses covered by the third heading.

The Purpose of an Expense: Objective and Subjective Approaches

[6.2] A good deal of the discussion in the cases on the issues of relevance and working quality has been concerned with identifying the “purpose” of the expense. There is a question of what might be meant by purpose in this regard. It should at the same time be noted that identifying purpose cannot always be a useful exercise. Where a loss is suffered in some transaction and the loss is the item of possible deduction, it is hardly sensible to be concerned with the purpose of the loss. It may be appropriate to consider the purpose of the transaction out of which the loss arose. This purpose may be relevant, on principles examined in Chapter 2 above to a conclusion that the transaction is one which might have given rise to a profit that was income, and for this reason a loss which in fact results is deductible. Where the loss is suffered as a result of the action of some person who has deprived the taxpayer of his property, there is even less sense in seeking to identify purpose.

[6.3] In most circumstances, however, identifying the purpose of an expense is thought to be helpful in characterising an expense as relevant and working, though the word “purpose” does not appear in s. 51(1) as bearing on deductibility. There is a reference to purpose in the second limb but only in the context of “purpose of producing assessable income” in the carrying on of a business. Where purpose is sought to be identified, there is a question of what may be meant by purpose. A variety of judicial opinions appears in the cases. The view of Dixon J. and Latham C.J. in two earlier cases will illustrate. In Amalgamated Zinc (De Bavay’s) Ltd (1935) 54 C.L.R. 295 at 309 Dixon J. said that s. 51 looked “rather to the scope of operations or activities and the relevance thereto of the expenditure than to the purpose in itself”. The objective test thus suggested, if applied without qualifications, would require that an inference be drawn as to purpose from all the circumstances but would exclude any direct evidence, by admission or otherwise, of the purpose in fact of the taxpayer. It would be a matter of what the reasonable man would impute to the taxpayer as his purpose if the reasonable man were to look only at the circumstances and were denied any direct evidence of the taxpayer’s purpose. This method of determining purpose is closely parallel with the method of determining purpose in the interpretation of s. 260 and may well be the method of determining purpose that will be followed under the new Pt IVA that has taken the place of s. 260. However, in the passage quoted from De Bavay’s Dixon J. sought to leave some scope for the subjective purpose. In Finn (1961) 106 C.L.R. 60, Dixon C.J. showed himself again unwilling to exclude entirely any relevance of subjective purpose. In discussing the circumstances which were relevant in judging the purpose of the expenditure he referred to the motivation of the taxpayer, though he prefaced his words by the phrase “so far as motive or purpose is material”. On the other hand in Robert G. Nall Ltd (1937) 57 C.L.R. 695 which, it should be noted, precedes Finn, Dixon J. seemed to exclude subjective purpose entirely. Referring to purpose as “an elusive and indefinite criterion”, he asserted that purpose is “an attribute of the transaction rather than a state of mind” and concluded that “the circumstances of the transaction must give it the [required] complexion” (at 711–12).

[6.4] In W. Nevill & Co. Ltd (1937) 56 C.L.R. 290 and Nall, Latham C.J., in choosing words to explain the application of s. 51, was more ready to give significance to subjective motivation. Thus in Nevill at 301 he referred to determining the purpose of the taxpayer “in relation to the object which the person making the expenditure has in view”. In Nall he preferred some combination of the subjective and the objective. Thus he said at (705–6) that the purpose the taxpayer had in mind was not always the test: s. 51 was concerned with the “relation between the expenditure … and the income produced in the course of the income-earning enterprise” and this relation he thought “contemplates a test which may be applied objectively”. However he thought the application “may be affected … by consideration of … states of mind”.

[6.5] The reference in the judgment of Dixon C.J. in Finn to both “purpose” and “motive” gives warning of the complexities into which too great a concern with subjective purpose may lead. The discussion in [3.19]ff. above of the distinction between purpose and motive drawn in relation to s. 26(a) (now s. 25A(1)) illustrates those complexities.

[6.6] A review of more recent judicial statements on the issue of subjective or objective purpose is made in the judgments in the Federal Court in Magna Alloys & Research Pty Ltd (1980) 80 A.T.C. 4542. Since De Bavay’s, Nevill, Nall and Finn the interpretation of s. 51(1) has experienced a development which has its beginning in Cecil Bros Pty Ltd (1964) 111 C.L.R. 430 and its culmination in the decision of the Privy Council in the New Zealand appeal in Europa Oil (N.Z.) Ltd v. C.I.R. (N.Z.) (No. 2) (1976) 76 A.T.C. 6001. That development may be seen as adopting a subjective approach, and then limiting the evidence that is relevant to a conclusion as to the taxpayer’s purpose. The insistence that it is not for the Commissioner or court to tell the taxpayer how to run his business adopts a subjective approach. A taxpayer whose subjective purpose makes his expense wholly relevant to the derivation of income cannot be told that an objective inference from the circumstances—in particular the excessive amount of the expense—is that the outgoing was at least in part not relevant and, to this extent, must be denied deduction. The culmination of the development is in Europa Oil (No. 2), which may be seen as adopting a rule of evidence that where an outgoing is made in pursuance of a contractual obligation, no evidence of the purpose of that outgoing may be considered except the terms of the contract. Cecil and Europa Oil (No. 2) have already been the subject of some comment in Chapter 4 at [4.240]–[4.242] above and they are again considered below in [9.17]–[9.26]. The Cecil-Europa Oil (No. 2) development has suffered some, though a very little, check in South Australian Battery Makers Pty Ltd (1978) 140 C.L.R. 645. The judges in Magna Alloys had none the less to accommodate the development, and did this by putting payments under contractual obligations to one side, treating the payments made by the company of legal expenses incurred by employees in the defence of criminal proceedings, as voluntary payments.

[6.7] Within the field of voluntary payments, the judgments in Magna Alloys catalogue judicial statements on the subjective or objective question and indeed attempt to reconcile them. Brennan J. attempted a reconciliation thus:

Deane and Fisher JJ. rejected the view of Sheppard J. at first instance that the purpose to be identified was the dominant subjective purpose of the taxpayer:

They then offered a reconciliation in these terms:

[6.8] The reconciliation by Brennan J. might appear to come down on the side of objective purpose, though the preambles make his choice rather hollow—indeed the first of the preambles seems to contradict his choice. The reconciliation by Deane and Fisher JJ. in the “composite question” might be thought to require that purpose must be identified both objectively and subjectively, and the expense must be shown to be relevant in terms of both identifications.

[6.9] In what follows in this chapter the assumption is made that s. 51(1), so far as it looks to purpose at all, looks to the objective purpose served by an expense. Some assumption must be made if discussion is to proceed. The assumption challenges the Cecil-Europa Oil (No. 2) development. Cecil may be explained as a decision of the Full High Court on s. 260 only. It was decided in the Full Court on the assumption that the decision of Owen J. at first instance on s. 51(1) was correct, but there was no endorsement of the decision of Owen J. The Commissioner had not appealed against the decision on s. 51(1). Europa Oil (No. 2) is not a decision in the Australian hierarchy of courts. It may have received some approval in South Australian Battery Makers, but the approval goes to the rule that would exclude evidence of facts other than the contract. South Australian Battery Makers does not approve the choice of subjective purpose which Europa Oil (No. 2) might be thought to have made. There is a reference to the judgment of Gibbs A.C.J. (at 653) to a statement given in affidavit evidence that the annual rent was “a reasonable commercial amount”. Gibbs A.C.J. added this observation: “and [if it matters] that statement was not contradicted in evidence.” Given the limitation of the evidence from which an inference may be drawn—the limitation which follows from the approval of Europa Oil (No. 2)—an objective inference of a purpose other than the purpose of obtaining the use of premises as a lessee could not have been drawn.

[6.10] Where purpose bears on the relevance of an expense, the administration of the law will be assisted by an objective approach. On some matters of the income tax an inquiry which goes to the taxpayer’s mind is unavoidable. Thus, as Brennan J. observed in Magna Alloys, the question whether the taxpayer’s activities amount to a business requires some inquiry of this kind. But to require the taxpayer to establish his subjective purpose, if he is to discharge the onus of proof he carries under s. 190(b), when asserting a deduction under s. 51(1), will make the law unmanageable. Magna Alloys demonstrates the subleties which would be attracted—subtleties which involve distinctions between motive and intention, and involve questions as to which of these is the purpose that must be identified, and subtleties which involve a distinction between dominant and subordinate purposes where more than one is identified, and the significance of the fact that the purposes are supportive or contradictory. These subtleties are attracted in the application of s. 25A(1) (formerly s. 26(a)) which has been held to be concerned with subjective purpose. Experience with them in that context may suggest that they should not be given further room.

[6.11] It is true that an objective approach does not necessarily exclude these subtleties. The inference from evidence other than direct evidence of a taxpayer’s state of mind, could conceivably yield motive and intention and dominant and subordinate purposes, but in fact an inference of one purpose as the purpose that the observer would conclude the taxpayer had is as much as is likely to be drawn. An objective approach will minimise the concern with the state of mind of the taxpayer. Indeed the objective approach is sometimes expressed to be concerned with the purpose of the “transaction itself” (cf. Lord Denning in Newton (1958) 98 C.L.R. 1). The notion of purpose as a state of mind is then so deemphasised that it might be thought to have disappeared, and the inquiry is seen as directed to the “function” of the transaction.

[6.12] One consequence of an objective approach is to qualify in some degree the validity of an observation in Ronpibon Tin N.L. (1949) 78 C.L.R. 47 at 60 which has come to command ritual mention in cases involving s. 51(1): “It is not for the court or the Commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent: see per Ferguson J. in Tooheys Ltd v. C. of T. (N.S.W.) (1922) 22 S.R. (N.S.W.) 432 at 440; per Williams J. in Tweddle v. F.C.T. (1942) 7 A.T.D. 186 at 190.” Yet, where a taxpayer has spent an amount in obtaining the supply of goods or services from another with whom he does not deal at arm’s length, and that amount is greater than he would have spent in obtaining the same supply in an arm’s length transaction, an objective inference may fairly be drawn as to his purpose which will require a conclusion that the expense is in some part not relevant to derivation of income. That objective inference will prevail against any direct evidence of the taxpayer’s state of mind which may support his claim that his purpose was solely to obtain the supply of goods or services.

[6.13] Ritual mention of the observation in Ronpibon was made by Owen J. at first instance in Cecil (1964) 111 C.L.R. 430 at 434. At the same time any objective inference from the facts that the taxpayer’s purpose was in part to shift profit, and not to obtain stock in trade, was rejected. The rejection of the objective inference might be thought to have left the subjective purpose—also in part a purpose to shift profit—to prevail. But it did not. Subjective and objective purposes were both displaced by a principle that the purpose by reference to which an expense is to be characterised where the expense satisfies a contractual obligation, must be found from and only from the terms of the contract. Other evidence of the purpose of the taxpayer must be rejected.

[6.14] It was acknowledged by Owen J. that one of the taxpayer’s purposes was not to obtain stock but to shift profit. It is a strange quirk of legal history that an entirely sensible observation by the High Court, made in the context of arm’s length transactions where there could be no suggestion of a purpose determined subjectively or objectively other than a purpose to obtain services, should have come to be claimed as the basis at once for the suppressing of an objective approach to the determination of purpose, and for a limiting rule of evidence that will nullify both subjective and objective approaches.

[6.15] The significance given to the legal form of a transaction by Cecil and Europa Oil (No. 2) has been the subject of comment in [4.233]–[4.242] above. And it is the subject of further comment in [9.17]–[9.26] below. The significance thus given to form is at odds with decisions of the High Court, for example in Dickenson (1958) 98 C.L.R. 460 in relation to the quality of an item as income, and it is at odds with decisions of the High Court in other cases concerned with s. 51(1). Neither the High Court nor the Privy Council in B.P. Australia Ltd (1965) 112 C.L.R. 386 sought to identify purpose solely by reference to the agreements under which the payments were made. It is true that B.P. Australia Ltd was not concerned with the identification of purpose for its bearing on relevance. The issue was whether the expenses were working as distinct from capital expenses. This was the issue also in Hallstroms (1946) 72 C.L.R. 634 where Dixon J. expressed a view which is opposed to the significance given to form by Cecil and Europa Oil (No. 2). But there would not appear to be any reason why form should prevail where the issue is relevance, but not where the issue is working character.

[6.16] A consequence of Cecil and Europa Oil (No. 2) might appear to be the defeat of the taxpayer where the purpose identified by reference only to the contract does not establish relevance. In Cecil and Europa Oil (No. 2) the contract was for the acquisition of trading stock, and a purpose identified only by the terms of the contract established relevance. At least it was assumed that this was so, though as explained in [4.240] above and [9.17] below, the court simply assumed a rule as to relevance which may not always be a sound expression of the principles in s. 51(1)—a rule that an expense for the purpose of acquiring trading stock is a relevant expense. If Magna Alloys & Research Pty Ltd (1980) 80 A.T.C. 4542 had been seen as a case in which the legal form must prevail, the taxpayer might have been unable to obtain a deduction because the form of a contract to pay legal fees had closed off an inquiry which might have established a purpose that would have given the character of relevance to the expense.

The Significance of the Fact that an Expense is Unusual

[6.17] Statements by Dixon J. in W. Nevill & Co. Ltd (1937) 56 C.L.R. 290 and by the court in Charles Moore & Co. (W.A.) Pty Ltd (1956) 95 C.L.R. 344 indicate that an expense may be deductible notwithstanding that it is unusual. In Nevill, Dixon J. said (at 306): “In the present case the payment of a lump sum to secure the retirement of a high executive officer may have been unusual. But it was made for the purpose of organising the staff and as part of the necessary expenses of conducting the business. It was not made for the purpose of acquiring any new plant or for any permanent improvement in the material or immaterial assets of the concern. The purpose was transient, and, although not in itself recurrent, it was connected with the ever recurring question of personnel.” And in Moore (at 351) there is a similar observation which follows a quotation from the judgment of Rich J. in Ash (1938) 61 C.L.R. 263 at 277: “There is no difficulty in understanding the view that involuntary outgoings and unforseen or unavoidable losses should be allowed as deductions, when they represent that kind of casualty, mischance or misfortune which is a natural or recognised incident of a particular trade or business the profits of which are in question. These are characteristic incidents of the systematic exercise of a trade or the pursuit of a vocation.” The observation in Moore is: “Even if armed robbery of employees carrying money through the streets had become an anachronism which we no longer knew these words would apply. For it would remain a risk to which of its very nature the procedure gives rise. But unfortunately it is still a familiar and recognised hazard and there could be little doubt that if it had been insured against the premium would have formed an allowable deduction. Phrases like the foregoing or the phrase “incidental and relevant” when used in relation to the allowability of losses as deductions do not refer to the frequency, expectedness or likelihood of their occurrence or the antecedent risk of their being incurred, but to their nature or character. What matters is their connection with the operations which more directly gain or produce the assessable income.”

[6.18] The statements need to be considered in context. In each case the statement was made in relation to the relevance of the expense, not its quality as a working expense to be distinguished from a capital expense. It is clear from the words quoted from Nevill that the fact that an expense is unusual may suggest that it goes to the structure of the activity by which income is derived. The court was not prepared to treat the securing of the retirement of a high executive officer as effecting a change in structure, but the possibility is left open that a contract with an employee may be of such importance—albeit as a burden on efficiency—that an expense to secure a release from the contract is a capital expense. In Foley Brothers Pty Ltd (1965) 13 A.T.D. 562 a payment to secure a release from a contract which stood in the way of a restructuring of the company’s activities so as to reduce the scope of its operations was held not to be a working expense. In Charles Moore the robbery was of cash held for purposes of the business operations. It will be submitted later in this chapter that cash so held will always be a revenue asset so that the possibility of a loss arising from the robbery being a capital loss was not fairly raised. If unusual circumstances in which cash is held can make its holding a matter of structure, any general proposition that it is irrelevant that an expense is unusual requires qualification.

[6.19] In Nevill there was no question of closing down the business operations managed by the high executive. If the company had been closing down that part of its operations the payment might well have been held not working, being an expense in effecting a change in structure.

[6.20] Where the issue is simply one of relevance, it is in general enough that the purpose of an outgoing which is not itself recurrent, connects it “with the ever recurring question of personnel” in circumstances such as in Nevill or, in the circumstances of Charles Moore, it is enough that the loss represents “that kind of casualty mischance or misfortune which is a natural or recognised incident of a particular trade or business the profits of which are in question” (Ash (1938) 61 C.L.R. 263 at 277 per Rich J., quoted in Charles Moore (1956) 95 C.L.R. 344 at 350-1). None the less an assertion of the irrelevance of the unusual nature of an expense may be unwarranted. There must be circumstances where an expense apparently connected with “the ever-recurring question of personnel” is denied relevance because of its purpose. If the securing of the retirement of a high executive officer is sought because there has been a successful take-over of the employer company and the new controllers seek to replace the existing executives, it is arguable that the purpose of the payment to secure retirement is not such as to make it relevant to the derivation of income. The purpose is to enable the exercise of power by the controllers. Whether the argument will succeed will, to a degree, depend on the approach—subjective or objective—taken to the determination of purpose, a matter considered under the last heading. If an objective approach is taken—the submission has been made that it should be taken—the purpose established may be no different from the purpose found in Nevill. An objective approach in Magna Alloys & Research Pty Ltd (1980) 80 A.T.C. 4542 to the question of the purpose of the payment of the costs of defence of directors of the taxpayer company in criminal proceedings, supported an identification of purpose to serve the taxpayer’s business interests, though a subjective approach might have required a conclusion that the purpose was to serve the personal interests of the directors.

[6.21] Nevill and Charles Moore support a proposition that an expense is relevant to the derivation of income if it is one of a class of expenses that are a “natural or recognised incident” of the activity, or holding of property, whence income is derived. Where the purpose of the expense bears on its relevance, the fact that the subjective purpose makes the expense an unusual one will not deny it entry to the class, provided an objective inference of purpose would allow it to enter. Where the purpose of an expense has no bearing, as in Charles Moore, a broad view is to be taken of what is a natural or recognised incident, and the wider the description of the class of expenses so regarded the more is the prospect that an unusual expense will enter that class.

The Relevance of the Character of a Receipt by the Payee

[6.22] In Nevill the Commissioner contended that the payment to the managing director was a capital, not a working expense of the company. Dixon J. observed: “Some of the reasons given in support of the argument treated the question whether the payment of the retiring allowance by the company should be considered as part of its capital expenditure as interdependent with the question whether its receipt by the managing director should be considered part of his assessable income or as an addition to his capital. In my opinion there is no necessary connection between the two questions and, indeed, an attempt to obtain guidance in the solution of one by considering the other is not without danger” (at 306).

[6.23] These observations were made in relation to the question whether the company’s expense was a working expense or a capital expense. They are at least equally valid when the question is whether the company’s expense is relevant or irrelevant to the derivation of income. An outgoing must take its character from the circumstances in which it is incurred by the taxpayer claiming the deduction. The income character of the receipt of that outgoing in the hands of the receiver is not in itself relevant to deductibility by the payer. Of course, the Commissioner has an interest in having the diminution of tax which a deduction allowed will involve, matched by an increase in tax which a derivation of income by another will involve. But there is no principle that a deduction by one taxpayer must be matched by a derivation of income by another in the transaction which gave rise to the deduction.

[6.24] This is not to say that the circumstances which give deductibility to an outgoing have no bearing on the derivation of income by the person who receives the amount of the outgoing. And the circumstances of derivation of income in the receipt of the amount of an outgoing by another may have some bearing on deductibility of the outgoing. The circumstances of the payment or receipt by one person, are some part of the circumstances of the receipt or payment by the other. In Chapter 2, [2.206]–[2.207] above, attention was directed to Egerton-Warburton, Colonial Mutual Life and Cliffs International. In Egerton-Warburton (1934) 51 C.L.R. 568 it was said that payments which were income as an annuity in the hands of the taxpayer were deductible by the taxpayer’s sons, who had acquired property from their father under the transaction which required payment of the annuity. It might be suggested that the quality of income in the hands of the father could be explained on the ground that there was a sharing by the father in the income from the property acquired by the sons, and that this directed that the payments by the sons were deductible. Such a suggestion is not, however, supported by Colonial Mutual Life Assurance Society Ltd (1953) 89 C.L.R. 428 where outgoings were held not deductible, though they might have been seen as having been made in the sharing of income with the person receiving them. In Just (1949) 23 A.L.J. 47 the person who had received in the facts of Colonial Mutual Life had been held to have derived income as periodical receipts. The conclusion, it seems, is that the circumstances of sharing may give an income quality to periodical receipts by the person receiving, but will not give the character of deductibility to payments made in the course of sharing. The matter is further considered in [6.301]–[6.307] below. But it would be an unacceptable proposition that the facts by which deductibility by a payer is judged are irrelevant in determining income character in the hands of the receiver, or that the facts by which income character in the hands of the receiver is judged are irrelevant in determining deductibility by the payer. Thus a purpose of a payer to reward another for services when making a voluntary payment to that other must have a bearing on the character of the receipt in the hands of the payee. At the same time it must have a bearing on deductibility by the payer. The matter is considered again in [6.175] below.

[6.25] In Cliffs International Inc. (1979) 142 C.L.R. 140 outgoings were held deductible. There is some support in the judgment of Barwick C.J. for a view that an income quality in the hands of those receiving the amounts of the outgoings, Howmet Corporation and Mt Enid Pty Ltd, was relevant to deductibility by Cliffs International. He expressed an opinion that the receipts would have an income quality. The relevance could be explained in terms of a sharing of the income which Cliffs International derived from the exploitation of the property it had acquired, ultimately from Howmet and Mt Enid. There is, however, another explanation of Cliffs International which would relate deductibility of payments and income quality of receipts in a different way. The judgments of the majority adopt a view that the payments to Howmet and Mt Enid were akin to payments of royalties. They were payments for the use of property, and this, one would think, is reason for saying that those payments were receipts for the use of property in the hands of the receivers. They were, it is true, payments for use and receipts for use only in a broad sense of each notion. The mining rights exploited by Cliffs were now owned by Cliffs. Cliffs had acquired from Howmet and Mt Enid all the shares in a company which owned those rights, and had then acquired the rights by liquidation of that company. None the less, if legal concepts in relation to ownership of the rights are ignored, and the matter is seen in its commercial context, the payments required to be made over the whole life of the rights, were made for the use of property and were received for the use of property.

[6.26] Cliffs International is the subject of further comment later in this chapter. For present purposes it is enough to drawn attention to the case as an illustration of how the characterisation of an outgoing or receipt may be relevant to the characterisation of a corresponding receipt or outgoing. The relevance in this kind of case does not however require any conclusion on income or deductibility. In Chapter 2, several cases, including Hayes (1956) 96 C.L.R. 47 and Scott (1966) 117 C.L.R. 514, concerned with the characterisation of a receipt, paid voluntarily, as a reward for services, were considered. One factor that might justify such a characterisation is that the payer’s purpose (“motive” in the view of Fullagar J. in Hayes) was to reward the taxpayer for services rendered. The payer’s purpose does not however require such a characterisation. And a conclusion that the receiver derives income as a reward for services does not require a conclusion that the payer is entitled to a deduction for a payment that is a reward for services.

The Characterisation of Fines, Penalties and Expenses of Defence

[6.27] An amendment to s. 51 of the Assessment Act in 1984, adding s. 51(4), has dealt expressly with the deductibility of fines and penalties, and may bear on the deductibility of the expenses of defence. Section 51(4) provides: “A deduction is not allowable under sub-section (1) in respect of—

• (a) an amount, however described, payable, or expressed to be payable, by way of penalty under a law of the Commonwealth, a State, a Territory or a foreign country; or
• (b) an amount ordered by a court, upon the conviction of a person for an offence against a law of the Commonwealth, a State, a Territory or a foreign country, to be paid by the person.”

[6.28] The provision clearly extends beyond fines in what may be technically criminal proceedings. But there are questions to be resolved as to how far it extends. Thus, s. 82 of the Trade Practices Act provides for an action for damages at the instance of a person who suffers loss or damage by reason of the contravention of the resale price maintenance provisions of the Act. It may be asked whether damages awarded under such a provision would be denied deduction under s. 51(4). It would be argued that the damages do not amount to a penalty where there is no provision for an award that would be greater than the damage suffered. It would follow that damages awarded under the general law for breach of a statutory duty do not involve a penalty though the possibility of an award of exemplary damages may cast some doubt on that conclusion. An actual award of exemplary damages in an action under the general law not involving a breach of statutory duty is presumably not a penalty within s. 51(4)(a). It would be argued that it is not an award under “a law”.

[6.29] Section 51(4), presumably, will extend to a payment made by a person other than the person on whom the penalty or fine is imposed. The payment might be made directly to the public authority by the employer of the person who has committed the breach, or by the principal of a third party contractor as in Magna Alloys (1980) 80 A.T.C. 4542. Deduction would be denied, as a payment “in respect of” the amount of the penalty. It is doubtful, however, whether a payment made by way of a reimbursement to an employee or a contractor of a penalty or fine imposed on and paid by the employee or contractor is covered by s. 51(4). The words “in respect of” are words of wide meaning but they may not carry the denial of deductibility so far.

[6.30] Section 51(4) is concerned, it seems, only with payments of the amount of the fine or penalty. It would not deny the deduction of expenses of defending proceedings brought against the taxpayer, or his employee or third party contractor. The words “in respect of an amount” would not extend the operation of the provision to cover expenses that are directed to ensuring that no amount ever becomes payable. Magna Alloys had held expenses of defence to be deductible, and a change by s. 51(4) in the law thus established should require some express provision. Section 51(4), it would be argued, is no more than declaratory of the law established by the Federal Court in Madad Pty Ltd (1984) 84 A.T.C. 4739.

[6.31] Section 51(4) is a culmination of the development of the law in the interpretation of s. 51(1). That law is reviewed in what follows not only for the assistance that it may give in the interpretation of s. 51(4), but also to show the state of the law in those areas, more particularly the payment of expenses of defence of proceedings, to which s. 51(4) does not extend.

[6.32] A number of situations must be distinguished in regard to fines, penalties and expenses of defence. The treatment of the payment of a fine or penalty may be different from the treatment of the payment of expenses of defence. And it may be necessary to treat differently a payment by the person on whom a fine or penalty is or might be imposed from a payment by another person. In Magna Alloys & Research Pty Ltd (1980) 80 A.T.C. 4542, referred to above on the question of the nature of the purpose that is relevant to deductibility, there are references to dicta in Australian cases relying on some United Kingdom cases, which suggest that there is an overriding rule which will exclude from deductibility a fine or penalty paid by the person on whom the fine or penalty has been imposed. The Australian cases are Herald & Weekly Times Ltd (1932) 48 C.L.R. 113 and Snowden & Willson Pty Ltd (1958) 99 C.L.R. 431. The United Kingdom cases are I.R.C. v. Warnes & Co. Ltd [1919] 2 K.B. 444, and I.R.C. v. von Glehn & Co. Ltd [1920] 2 K.B. 553. The rule would exclude the payment of the fine or penalty from deductibility, whatever the relevance of the outgoing and however much it fits the notion of a working expense. In the joint judgment of Gavan Duffy C.J. and Dixon J. in Herald & Weekly Times (1932) 48 C.L.R. 113 at 120 it is said: “The penalty is imposed as a punishment of the offender considered as a responsible person owing obedience to the law. Its nature severs it from the expenses of trading. It is inflicted on the offender as a person deterrent …” In Magna Alloys Deane and Fisher JJ. questioned the reason that “its nature severs it from the expenses of trading” observing that:

Deane and Fisher JJ. considered that if deductibility is denied it should be on the basis of an overriding consideration of public policy.

[6.33] In Madad Pty Ltd (1984) 84 A.T.C. 4739, the Federal Court referred to Magna Alloys and the dicta in Herald & Weekly Times and Snowden & Willson, and to the United Kingdom authorities, and concluded that the approach in the dicta of the High Court should be followed, whether those dicta are to be explained in terms of the principle of relevance or public policy. In the result, the court denied deduction of a penalty imposed on the taxpayer for breach of the resale price maintenance provisions of the Trade Practices Act. The penalty, it was admitted, was not imposed in a criminal proceeding, but the court considered that the rule to be found in the dicta applied to such a penalty. The court said (at 4744): “It has been accepted that the taxpayer was not aware that it was infringing the Trade Practices Act, or any other legislation. However, what it did was contrary to one of the provisions of an Act designed to regulate commerce in the public interest. Although the contravention is not to be treated as a criminal offence, there are nevertheless heavy pecuniary sanctions for its observance.” The reference to “heavy pecuniary sanctions” may suggest that the court was adopting a rule that would not apply to minor penalties, such as parking infringement penalties. But any such inference is dispelled by the way the court dealt with the decision of Ormiston J. in Mayne Nickless Ltd (1984) 84 A.T.C. 4458. Ormiston J. had held that fines and penalties paid by the taxpayer and imposed on the taxpayer, or on one of his employees or third party contractors, were not deductible. The majority of the offences in respect of which the fines and penalties were paid were for parking infringements, and the overloading of vehicles. The rest were for speeding, defective tyres, and a number of other offences. The judgment of Ormiston J. is referred to without indication of any disapproval. The Federal Court would, it seems, support a rule that does not distinguish offences either in terms of any moral judgment of them, or in terms of the level of penalty that may be imposed. The reference to Mayne Nickless may also be taken to reflect a view of the Federal Court that the rule denying deduction should extend to payments by the taxpayer of penalties imposed on himself or on others. Section 51(4) may thus be seen as statutory confirmation of the judgment of the Federal Court.

[6.34] Whatever the scope of the rule recognised in Madad in regard to fines or penalties imposed on the taxpayer himself or his employee or third party contractor, it would not necessarly extend to exclude deductibility of the expenses incurred by the taxpayer in defending himself or one of those other persons. Brennan J. in Magna Alloys discounted the denial of the deduction of such costs in the United Kingdom cases by referring to the different words of the United Kingdom legislation governing deductibility. If expenses of defence are to be given the same treatement as a fine that might be imposed, they should be given this treatment only where they are expenses of an unsuccessful defence. If the principle excluding deductibility is put on the ground of public policy, the principle could hardly extend to the expenses of a successful defence, at least if the outcome is a simple acquittal. There is nothing in the judgment of the Federal Court in Madad that might reflect on the decision in Magna Alloys that expenses of defence of criminal proceedings, even though unsuccessful, may be deductible. Section 51(4) does not reverse that decision.

[6.35] The operation of s. 51(1), where deductibility is not denied by s. 51(4), depends on the outgoing being both relevant and working. It will be apparent from the passage quoted above in [6.32] from the judgment of Deane and Fisher JJ. in Magna Alloys that outgoings in meeting the expenses of defence may well have a sufficient connection with income derivation to make them relevant. The illustrations in the quotation are obviously “natural or recognised incident[s]”. The expenses of defence in circumstances otherwise within Magna Alloys, if the proprietor of the business is himself the offender, may not be so obviously natural or recognised incidents. There is a tendency to judge what is natural, not by what commonly happens, but rather by what ought to happen. Relevance, it is none the less submitted, is a matter of connection between the derivation of income and committing the offence: it is not a matter of how income derivation should be carried on.

[6.36] If the moral enormity of the offence is not enough to deny the relevance of the expenses, it may, however, deny their character as working expenses. A conviction may so affect the goodwill of business that the expenses of defence are not working but capital expenses. They are expenses of defending the income producing structure in a situation of peril and on this ground capital. The effect on goodwill aside, conviction for an offence may have the consequence that the taxpayer will thereafter be forbidden to carry on the activity whence income is derived, or be in jail and unable to carry it on: a solicitor’s conviction for fraud may be an illustration. In these circumstances, the expenses of defence may be non-working and capital.

[6.37] Whether or not the taxpayer is convicted, any bearing of moral enormity on the issue of relevance should be excluded. On the issue of relevance the question is simply whether the carrying on of the business brought with it allegations of offences of this kind (adapting the words of Dixon C.J. in Snowden & Willson (1958) 99 C.L.R. 431 at 436). On the issue of working or capital, moral enormity, for reasons already explained, may make the expenses a matter of defending structure in a situation of peril and thus capital.

[6.38] Where payment of the expenses of defence are made, not by the person who has committed the offence, but by a third party, the analysis may be different. The typical case will involve a company employer meeting the expenses of an employee, as in Magna Alloys. There would not appear to be any basis in public policy for denying a deduction to the company, unless the company has induced the criminal activity by its employee. Deane and Fisher JJ. in Magna Alloys said:

[6.39] Relevance, where the expenses are met by the employer, will be established by showing that the committing of the offence by the employee, or the allegation of it, is a natural or recognised incident of the income derivation. The objective inference is that the employer’s purpose is to ensure that the employee does not have to meet expenses which may fairly be said to have arisen in the carrying out of his duty as an employee. Good relations with employees will be served. The employer’s reputation for dealing fairly with his employees is enhanced. Indeed, relevance may be established where the offence is not a natural or recognised incident, if an objective inference is to be drawn that the employer was concerned to preserve good relations with employees. The task of establishing relevance, ought not to be significantly more difficult if the employer has paid the expenses of defence of a third party contractor.

[6.40] A relevant outgoing in meeting the expenses of the defence of an employee or a third party contractor may be capital and thus not working. A conviction of an employee, if not of a contractor, may have implications for the employer’s business which make the expenses a matter of defence of structure in a situation of peril. A suggestion that the expenses were capital in Magna Alloys was rejected by the Federal Court. Where, however, a conviction may lead to imprisonment of a company’s employee who is its sole shareholder, a director, and senior executive, it will be difficult to avoid a conclusion that the expenses are capital. If the employee has no proprietary interest in the company, a conclusion that the expenses are capital is the less likely. But, in theory at least, the employee may be a “key-man” and the continued availability of his services an aspect of the structure of the company’s business.

[6.41] If charges are made against the employer as well as the employee or contractor, the expenses of defence are paid for two purposes and deductibility of the payment as it relates to each purpose will be determined by the application of the analyses explored above. It is unlikely that a different conclusion on deductibility may result in regard to each purpose. If it does, problems of apportionment explored in Chapter 9 below will be raised.

[6.42] Some indications were given above of the significance of facts that the employee is a proprietor, a director and senior executive of a company employer, where the question is whether the outgoing is working or capital. The fact that the employee is a proprietor, director and senior executive may bear on the threshhold question of relevance. An objective inference may in some circumstances be drawn that the purpose of the company in meeting the expenses was not to ensure that the employee was indemnified against expenses which might fairly be said to have been incurred in the carrying out of his duties as an employee, but to make company funds available to the employee. The objective inference may be drawn from the circumstances of the employee’s proprietorship, and power to make the decision regarding the payment of the expenses, in necessary combination, one would think, with an element of tenuousness in the relationship between the offence and the carrying out of duties as an employee. In Magna Alloys there were aspects of the circumstances that might have yielded an objective inference that the purpose was simply to make the company’s funds available to its directors. The conclusion of the Federal Court was that such an objective inference should not be drawn. Much of the discussion in the case concerned the bearing of the subjective corporate purpose in the decision of the directors. That discussion is more than persuasive that subjective purpose should have no bearing.

[6.43] The analysis offered in the last paragraph, as appropriate in a case where the employer and the employee are not at arm’s length, has wide implications. It would make ss 108 and 109 of the Act (considered below in [10.348]–[10.358]) largely unnecessary on the question of deductibility by a company of a payment to a shareholder or director, or to a relative of a shareholder or director. The relationship between the company and payee, coupled with other circumstances, in particular the commercial unreality of the payment, may yield an objective inference that a part of the payment was not for a purpose that gave it relevance. The analysis would make some other provisions largely unnecessary on the question of deductibility, such as s. 65 and s. 31C (considered below in [10.310]–[10.328] and [10.290]–[10.293]).

[6.44] Where a business is carried on by a partnership, and the offence is committed by or alleged against a partner, deductibility in computing “net income” of the partnership under s. 90 will follow the analysis above in regard to deductibility by an employer.

[6.45] Where an offence is committed by an employee or alleged against an employee, and the employee himself pays the penalty and expenses of defence there will be a question whether the employee is entitled to a deduction. Payment of the penalty is denied deduction by Madad Pty Ltd (1984) 84 A.T.C. 4739 and s. 51(4). Deductibility by the employee of the expenses of his defence, may be resolved differently from deductibility by the employer had he incurred expenses in the employee’s defence. In the case of the employer, deductibility depends on relevance to business income. In the case of the employee it depends on relevance to employment income. The point has already been made that relevance to business income may be satisfied by a connection which would not satisfy relevance to employment income. It is not a matter of the unavailability to the employee of the second limb of s. 51(1). Relevence to business income may be established under the first limb in circumstances that would not establish relevance to employment income. The cases on self-education expenses incurred by an employee considered later in Chapter 8 ([8.38]–[8.56]) require that the action of the employee which gives rise to the expense whose deduction is claimed must have been something he was employed to do, if the expense is to be held relevant to employment income. Alternatively the action must have “a direct effect on income”—a test of relevance which need not be examined here. Both tests reflect a disposition by the courts to be less than generous in finding employee expenses to be relevant. There may be a sound policy objective. The consequence for the Commissioner of a relaxed test of relevance could be catastrophic in the tax relief afforded. Analytically the question is the same whether the deduction is claimed by an employee or by a self-employed person—is the expense a natural or recognised incident of the income-earning activity? But something may not be a natural or recognised incident of activity as an employee and yet be a natural or recognised incident of activity as a self-employed person. Costs of defence of a charge of overloading a truck may be deductible where incurred by a self-employed driver. Costs in the same circumstances incurred by an employee driver may not be deductible, more especially if the employer has expressly forbidden overloading.

[6.46] The question whether an employee who pays expenses himself is entitled to a deduction, is distinct from the question whether the reimbursement of the expenses by the employer is a derivation of income by the employee, and it is distinct from the question whether a direct payment of the expenses by the employer involves a benefit which is income of the employee under s. 26(e). Where the reimbursement is given under an arrangement by which the employee will be reimbursed, the expenses will not be deductible—there is no outgoing, though there may be an outlay, where an amount is paid in respect of which there is an entitlement to reimbursement. There may however be a loss if the entitlement to reimbursement fails to realise its cost: the employer may fail to meet his obligation to reimburse. If the reimbursement is a voluntary act by the employer—not dictated by any obligation to reimburse—the expenses incurred by the employee, if otherwise deductible, will have been deductible by the employee. The reimbursement will be income of the employee as compensation for a deductible outgoing under the compensation principle (Proposition 15, [2.506]ff. above) or under s. 26(j) ([4.204]ff. above). A direct payment by the employer of the employee’s expenses poses problems of analysis of a kind considered in [4.75]ff. above and [8.53]ff. below in regard to direct payment of education expenses of an employee. There is no necessary correlation between the consequences of a direct payment by the employer that will attract for the employee the contribution to capital principle and the deductibility of a payment by the employee himself.

[6.47] An employee who has paid the amount of a penalty imposed on him may receive reimbursement by his employer. The payment of the penalty will be denied deduction under Madad and s. 51(4). The reimbursement will not be income of the employee under s. 26(j)—the receipt is not compensation for a deductible outgoing. It could however be income of the employee under the ordinary usage compensation receipts principle: the reimbursement is, possibly, compensation for an outgoing on revenue account, s. 51(4) being irrelevant to a conclusion on that issue. The employee may be able to escape an income characterisation of the reimbursement by relying on the contribution to capital principle. Certainly it would be considered fair that he should be so entitled. The employer is probably not entitled to a deduction of the payment in reimbursement. Madad Pty Ltd (1984) 84 A.T.C. 4739 does not expressly cover the situation, though it would be an appropriate extension of the rule there adopted. Section 51(4) may cover the situation: the reimbursement may be seen as a payment “in respect of” the penalty.

The Characterisation of Damages and Expenses of Defence

[6.48] The characterisation of a payment of damages awarded in civil proceedings and the expenses of defence will follow in all respects, save one, the operation of s. 51(1) in relation to penalties. The only respect in which there may be a difference concerns the public policy rule confirmed in Madad, which may deny deduction where payment is made of a criminal penalty. Presumably there is no public policy principle which will operate to deny deduction of the payment of damages for a civil wrong. None was suggested in Herald & Weekly Times Ltd (1932) 48 C.L.R. 113 where the deductibility of criminal penalties is considered in the judgment of Gavan Duffy C.J. and Dixon J. (at 120). And, it was submitted in [6.28] above, s. 51(4) does not deny the deduction of a payment of damages in an action under the general law.

[6.49] If moral enormity is not a ground for denying the relevance of an expense, as was submitted in [6.34] above, where a criminal offence is involved, it is not a ground for denying relevance where a civil wrong is involved. In I.R.C. v. Great Boulder Proprietary Gold Mines Ltd [1952] 1 All E.R. 360 there is an observation by Donovan J. in answer to a submission that damages had been paid by a company for fraud and deceit on its part, that “it is no part of … trading to be fraudulent and deceitful”. Donovan J. said (at 362): “If it is fraudulent and deceitful then the penalty it pays by way of damages cannot be deducted as a trading expense any more than could the penalty in I.R.C. v. Alexander von Glehn & Co. Ltd [1920] 2 K.B. 553.” The observation does not, it is submitted, state Australian law. What is a natural and recognised incident is judged by what happens, not by what ought to happen.

[6.50] Where the liability in damages is incurred by the taxpayer himself or damages are claimed from him, deductibility of damages and costs depends on the degree of connection between the business carried on and the cause of the liability for damages (Herald & Weekly Times Ltd (1932) 48 C.L.R. 113 at 120).

[6.51] In I.T.C. v. Singh [1942] 1 All E.R. 362 the Privy Council held the expenses of successfully defending an action brought against the taxpayer, who was in business as a money lender, were not deductible. The action related to things done by the taxpayer in regard to a loan made in the carrying on of his business. Privy Council and United Kingdom cases need to be received with caution. Thus, in Fairrie v. Hall [1947] 2 All E.R. 141, in holding that damages for libel were not deductible, MacNaghten J. relied on the judgment of Rowlatt J. in I.R.C. v. E. C. Warnes & Co. Ltd [1919] 2 K.B. 444 where the reasoning is coloured by the view that relevance should be judged by what ought to happen. Which is not to say that the facts of I.T.C. v. Singh would not give rise to the same decision in Australia. In Fairrie v. Hall, MacNaghten J. held that the damages for libel “fell on [that taxpayer] in the character of the calumniator of a rival sugar broker. It was only remotely connected with his trade as a sugar broker”. The reference to the loss falling on the taxpayer in the character of a calumniator adopts the kind of analysis made in Strong & Co. Ltd v. Woodifield [1906] A.C. 448. In that case it was held that damages awarded against the owner and operator of an inn were not deductible. The damages had been recovered by a customer injured by the fall of a chimney which was unsafe due to negligence of the taxpayer’s employees in failing to see that the building was in a proper condition. Lord Loreburn said (at 452):

The analysis in terms of character as householders is not helpful, save as a way of expressing a conclusion that the connection with income derivation was insufficient to give relevance to the expense. It is consistent with Strong & Co. that damages for professional negligence paid to a client by a solicitor or doctor are deductible.

The Characterisation of Losses Arising from the Deprivation of Assets where the Assets are the Taxpayer’s own Property

The meaning of “losses”

[6.52] Some attention has already been given to the distinction between the word “outgoings” and the word “losses” used in s. 51(1) ([5.14]-[5.22] above). The class of expenses considered under the last heading were outgoings. The class of expenses now to be considered are losses. The expense arises from the deprivation of an asset, a deprivation which may arise from the “loss” of an asset by its being mislaid and remaining not found, by its destruction or by the wrongful appropriation of the asset by another—all “losses” in the sense that the items are lost to the taxpayer. But the expense is not the loss in this latter sense, but rather the loss in the sense of the failure of the asset to realise its cost, the failure arising from the mislaying, the destruction or the wrongful appropriation.

[6.53] The deprivation of the taxpayer’s own property is a different situation from the deprivation of property the taxpayer holds in trust for another. It will be seen that in the latter situation the expense that may be deductible is an outgoing—the cost of replacing the property in pursuance of an obligation resting on him as trustee. The cost of replacing the property will be an expense of a different amount from the loss expense that may be deductible by a taxpayer who is deprived of his own assets. The loss expense will be the amount of the cost of the asset, its historical cost—not the amount of the cost of its replacement, its present value.

Assets mislaid and assets destroyed

[6.54] The cases, apart from Guinea Airways Ltd (1950) 83 C.L.R. 584, have been concerned with deprivation by robbery and misappropriation. Those cases, considered under later headings, must have a bearing on the resolution of the questions of relevance and working character where a taxpayer is deprived of assets by having mislaid them, or by their being destroyed.

[6.55] The mislaying of an asset, its accidental destruction, or its wilful destruction by someone other than the taxpayer, may be a natural or recognised incident of an activity of producing income. If the event is thus relevant, there will be a loss that is a working expense, should the asset be a revenue asset. It will be apparent from earlier discussion that a finding of a connection which is sufficient to make an expense a natural or recognised incident is not an exercise in logic: it is a matter of evaluation in the wide area between obviously inadequate connection and obviously adequate connection. W. Nevill & Co. Ltd (1937) 56 C.L.R. 290 and Charles Moore & Co. (W.A.) Pty Ltd (1956) 95 C.L.R. 344 indicate a willingness to lean towards an adequacy of connection, the willingness being expressed in a principle which justifies discounting the significance of the unusualness of the event.

[6.56] Guinea Airways is concerned not with relevance, but with the character of the loss as a working loss and, in this regard, with the character of the asset as a revenue asset or a capital asset. The maintaining of a large stock of spare parts which is “beyond any requirements for prospectively immediate use” (at 590), in the view of Latham C.J., following Dixon J. at first instance, gave the spare parts the quality of capital assets, and the loss was thus a capital loss. Kitto J. held the spare parts were capital assets as items “acquired before they were actually needed” (at 592), an explanation which would make spare parts capital in much wider circumstances than those contemplated by Latham C.J. And the extension by Kitto J. of the same idea to cover cash kept in a safe to meet future needs is at odds with the view taken later in this Volume that cash, if held for use in the derivation of income, is always a revenue asset.

[6.57] The assumption in Guinea Airways that the loss was a relevant loss—that destruction of spare parts by enemy action was a natural or recognised incident of conducting an airline—is in line with the conclusions on relevance in Nevill, and more especially, in Charles Moore. The unusualness of a particular event will not preclude relevance where the event can be seen as one of a broad class of events which may be regarded as natural or recognised incidents. Assets held for business purposes are exposed to risks of deprivation by being mislaid, or by destruction in many ways. The particular manner will not take it out of the class.

Assets appropriated by strangers

[6.58] Charles Moore supports a view that the class of events involving appropriation of assets by strangers which will be regarded as having a sufficient connection to be relevant is very wide: “Even if armed robbery of employees carrying money through the streets had become an anachronism which we no longer knew … it would remain a risk to which of its very nature the procedure gives rise” ((1956) 95 C.L.R. 344 at 351).

[6.59] None the less the case leaves unresolved a number of questions as to the bearing of the source of the assets, of which the taxpayer was deprived, on the issue of relevance and on the issue of working character. The issues are run together: “We can see no reason why it should not be considered a loss incurred in gaining or producing the assessable income … and we do not think that it should be regarded as a loss or outgoing of capital or of a capital nature” (at 349). The judgment proceeds to make a number of observations which emphasise the source of the money in daily “takings”: “In the case of a large departmental store such as the taxpayer carries on, the ordinary course of business requires that, day by day and as soon as may be, the takings shall be deposited in the bank.” “Banking the takings is a necessary part of the operations that are directed to the gaining or producing day by day of what will form at the end of the accounting period the assessable income” (at 349–350).

[6.60] The source of the assets held may have some bearing on the issue of relevance, though only an indirect bearing. The fact that the money of which the taxpayer has been deprived is “takings”, in the sense of the proceeds of sale of trading stock, is some evidence that the money was held in the process of deriving income and not privately so that the loss arising from the deprivation was a relevant experience, as distinct from a private or domestic experience. It is not of course definitive. If the taxpayer has taken money from his cash register in order that he might use it for private or domestic purposes and is then deprived of that money, his loss will not be relevant, whether or not he proposed to show the amount drawn in his financial or tax accounts. The money has lost its character as “takings”.

[6.61] And there is no reason why being deprived of money which is the proceeds of sale of capital assets, or which is money borrowed on capital account, should not be treated as a relevant experience. It may be unusual to have money at risk to being stolen where that money is such proceeds, or is so borrowed, but the holding of that money may none the less be in the process of deriving income. A retailer, such as the taxpayer in Charles Moore, may receive moneys deposited by customers in response to an offer of debentures. Being deprived of takings of this kind in circumstances otherwise the same as in Charles Moore, is, it is suggested, a relevant experience.

[6.62] Whether or not the deprivation gives rise to a loss of a capital nature is a distinct issue. And on this issue it may be doubted that the source of the moneys has any bearing, direct or indirect. Whether money is held as a revenue asset or as a capital asset must depend, not on its source, but on the circumstances of the holding. At some point the holding of money as cash, like the holding of the spare parts in Guinea Airways (1950) 83 C.L.R. 584, becomes a holding which is part of the structure of the business. A taxpayer who stores money in his safe or hides it, whether to thwart the Commissioner or because he does not trust banks, may hold the money as a capital, not a revenue asset, but the source of the money has no bearing. “Money”, for purposes of this analysis, should extend to cash, and to money held in a current account so that it can serve as a medium of exchange. It is consistent with Charles Moore that the deprivation would have given rise to a deductible loss if the money, having survived the journey to the bank and been deposited in the taxpayer’s current account, had been appropriated by someone who forged a cheque drawn on that account. A loss arising from the forging of a cheque on one’s bank account is as much a natural or recognised incident of the process of deriving income, as a loss arising from armed robbery. And provided money is not held in the bank account in such an amount that it may be regarded as stored, like the spare parts in Guinea Airways, it should be regarded as a revenue asset and not a capital asset.

[6.63] To allow source of the money to determine its character as revenue or capital, is to generate a confusion as exasperating as that escaped in Charles Moore, by the rejection of the argument made by the Commissioner that the deprivation could not be a loss in gaining income because it was a deprivation of income already gained.

[6.64] The analysis followed in the preceding paragraphs has implications in regard to assets other than money. Trading stock may come to be held in such a way that a loss in relation to them is not a relevant loss. If the proprietor of a second hand car business takes a car from his stock and entrusts it to his daughter for her weekend use, or uses it himself for private purposes, the theft of the car while so used is not a relevant experience. The trading stock provisions are ill-designed to deal with a situation of this kind. Section 28 would wrongly allow a deduction, though not by design. Section 36 is not in its terms appropriate to correct the operation of s. 28. The United Kingdom decision in Sharkey v. Wernher [1956] A.C. 58 would provide a correction, but that decision may not be available to the Commissioner. It is, possibly, excluded by the provisions of s. 36. The matter is discussed in [14.59]ff. below.

[6.65] Trading stock may come to be held in quantity analogous to the holding of spare parts in Guinea Airways. They may thus cease to be revenue assets, and thereafter be held as capital assets. A relevant loss by deprivation of them may thus be a capital loss. Again the trading stock provisions are ill-adapted to deal with a situation of this kind.

[6.66] Deprivation is the occasion of a loss by the failure of the asset to realise its cost. The loss will be the amount of the cost. There may be an insurance recovery which, commercially, mitigates the loss. The insurance recovery is however, at least in the view of Kitto J. in Guinea Airways, a distinct event which may give rise to a derivation of income in the amount of the insurance recovery: the recovery may be income under the compensation principle (Proposition 15) and s. 26(j) (2.506]ff. and [4.204]ff. above). The taxpayer’s loss may be mitigated, commercially, by recovery from the person who was responsible for the taxpayer’s deprivation. There is a question whether this recovery should be treated as negating deprivation, so that the loss that is deductible should be calculated by bringing the recovery to account. The treatment of the recovery in this way poses problems arising from the Commissioner’s limited powers to amend assessments (under s. 170) where deprivation and recovery occur in different years of income. The alternative treatment, which would be the more sensible, would treat the recovery as a distinct event, as in the case of an insurance recovery, and as income under the compensation principle. This treatment does, however, appear to be precluded by the decision in H. R. Sinclair Pty Ltd (1966) 114 C.L.R. 537, considered in [2.547]ff. above. In Sinclair the moneys returned were received as income in the form of business receipts (Proposition 14). But the availability of the Sinclair principle in the circumstances presently considered may be doubted. There is a reference in the judgment of Owen J. to the United Kingdom authority in English Dairies v. I.R.C. (1927) 11 T.C. 597 which may suggest that it is not a business receipt for the taxpayer to receive back money which has been illegally taken from him.

Acts of deprivation by employees or agents

[6.67] Ash (1938) 61 C.L.R. 263 and Levy (1960) 106 C.L.R. 448 remain the Australian authorities where deprivation results from the act of an employee or agent. The issues of relevance and working character again tend to be run together in the cases. And there appears an additional reason why a loss may fail to have a working character. The employee or agent may be a managing director of a company taxpayer, or a partner of the taxpayer, and the loss treated as not working but capital.

[6.68] On the issue of relevance, Levy is simply at odds with Charles Moore & Co. (W.A.) Pty Ltd (1956) 95 C.L.R. 344, though Kitto J. referred to Charles Moore. The loss arose from the forging of cheques on the bank account of the firm in which the taxpayer was a partner. The forging was by an employee, not of the taxpayer’s firm, but of a firm of accountants who were engaged to write up the books of the taxpayer’s firm. Kitto J. expressed the view that no deduction of the loss arising from the forgeries was allowable under s. 51. He said: “… the defalcations would have had to be a kind of misfortune which was a material or recognised incident of the partnership: cf. Charles Moore …; and the facts disclosed as to the nature of the business, the position of [the employee of the accountants] and the method by which [he] effected his defalcations, were quite sufficient to make it clear that the deduction could not possibly be supported on this basis” ((1960) 106 C.L.R. 448 at 458). One would have thought that forgery by an insider is, a fortiori, a natural or recognised incident if armed robbery by an outsider is such. The method by which the forgeries were concealed was commonplace. In any event Charles Moore would discount the unusualness of the method of deprivation, if the particular method of deprivation is of a class that is a natural or recognised incident.

[6.69] The reference, in the passage quoted from the judgment of Kitto J., to the position of the forger—an employee of the accountant engaged to write-up the books—is presumably intended to bear on the issue of relevance only. As such, it is the more difficult to reconcile with Charles Moore. One could understand a view that forgery by a person who is not an employee of the taxpayer is insufficiently connected with income derivation, though the technicalities of a distinction between an employee and an agent seem rather remote from the more significant matter of the opportunities for acts of deprivation offered by the task the employee or agent is asked to perform. But that view can hardly be supported when robbery by a stranger is held to be sufficiently connected.

[6.70] Levy, in relation to s. 51(1), does not examine the revenue or capital nature of the money that was taken by the forger. The case is not inconsistent with the view that money in a current account will generally be of a revenue nature. Nor does the case direct attention to the source of the money in the account as relevant to the nature of that money. The language of s. 71 (discussed by Kitto J. but not in this respect) might have suggested that source is of cardinal importance. Section 71, as then and as now drafted, allows a deduction of a loss “in respect of money that is or has been included in the assessable income of the taxpayer”. The drafting would support an inference that might be drawn from Charles Moore, namely that the revenue or capital nature of the money of which the taxpayer has been deprived depends not on the way in which the money is held, but on whether the derivation constituted by the receipt of the money was on revenue or capital account. Charles Moore, in this regard, and s. 71, confuse distinct notions. Income is a quality of derivation. It is not a quality which attaches to what may be received in the event which constitutes derivation. It may be convenient and acceptable to say that an item received is income: it avoids abstraction. But it is simply confusing if this language is allowed to determine the character, as a revenue asset rather than a capital asset, of what is received. Revenue or capital in this context is a matter of how the asset is held. An architect receives a motor car in payment for services rendered to a client and uses the motor car in his business. The receipt of the motor car is a derivation of income, and it is convenient to say that the motor car is income. But the motor car is a capital asset of the architect’s business.

[6.71] Ash (1938) 61 C.L.R. 263 is a source of the statement of principle governing relevance which requires that the outgoing or loss must be a “natural or recognised consequence or incident” of the process of deriving income, and the judgments approach the decision in the case in terms of relevance, rather than in terms of the working character of the expense. The taxpayer, now in practice alone as a solicitor, had been in partnership with another who had misappropriated moneys belonging to clients or had defrauded clients, and taken the proceeds of his fraud for himself. The expenses for which deductions were claimed were payments, to the clients of the partnership, of the amounts misappropriated, or obtained by the former partner from his frauds. The case thus involved a claim to deduct not a loss but an outgoing. None the less all the judgments assume that the initial question to be answered was whether the act of the former partner was relevant to income derivation by the partnership, and this in turn led to the drawing of a distinction between misappropriation of partnership assets by a partner and misappropriation by employees.

[6.72] Dixon J. said (at 281): “If a proprietor of a business converts its funds to his own use or uses the opportunities the business affords to defraud its clients or customers, his resulting liability cannot be considered an outgoing of the business, still less an outgoing on revenue account.” The statement includes a number of propositions, some acceptable and some not. The act of a proprietor in converting business funds to his own use—presumably by spending them on private consumption—does not involve a relevant loss or outgoing. There is no loss, and so far as there is an outgoing, it has no connection with the process of deriving income—it is a private or domestic outgoing. If a proprietor converts to his own use money obtained by a fraud on clients, the same observations are appropriate. If he converts to his own use money he holds in trust for clients there is no business loss or outgoing. There may be a relevant outgoing arising from the liability to replace the trust funds but this would not be a working expense—it concerns the defence of the business in a situation of peril and may be described as capital. The liability to recompense clients from whom money has been obtained by fraud may give rise to a relevant outgoing. Whether such an outgoing has a working character will depend on the operation of principles examined above in [6.48]-[6.51]. A liability of this kind, in contrast with the liability in Herald & Weekly Times Ltd (1932) 48 C.L.R. 113, may not have a working character: it may be thought to go to the defence of the business in a situation of peril.

[6.73] The first proposition dissected out of the statement of Dixon J., and accepted as correct, is the important one for present purposes. There is no loss and, so far as there is an outgoing, the outgoing is private or domestic. It is not a matter, as other judgments in Ash might make it appear, of whether dipping into the till for private or domestic expenditure by a proprietor is any more or less a natural or recognised incident of the conduct of a business, than is dipping into the till by an employee. Any suggestion that the former is not, while the latter is, reflects some kind of snobbery and not an assessment of fact. Some such suggestion emerges from the judgment of Latham C.J. who referred to the United Kingdom decision in Curtis v. Oldfield (1925) 9 T.C. 319. The managing director of a company had treated company funds as his own and had taken from those funds for his own use. The company, after his death, sought to write-off as a bad debt the amount of his liability to the company to restore money so taken. After conceding that the failure of receipts “to find their way into the till” due to dishonesty of “subordinates” is an expense of the trade, Rowlatt J. said (at 331): “This gentleman was the managing director of the company, and he was in charge of the whole thing, and all we know is that in the books of the company which do exist it is found that the moneys went through the books into his pocket. I do not see that there is any evidence at all that there was a loss in the trade in that respect.” So expressed, the judgment of Rowlatt J. leaves the impression that the tax consequences of misappropriation by an employee will differ, depending on whether the employee is a superior or subordinate. What was important in Curtis v. Oldfield is that the managing director had been a substantial shareholder in the company, so that the misappropriation might be seen as appropriation by a proprietor, which, if treated as an outgoing because of the separateness of the corporate entity, would none the less be a capital outgoing, in the sense in which dividends paid by a company may be regarded as capital outgoings.

[6.74] The suggestion which emerges from the reference to Curtis v. Oldfield is corrected by the statement at the end of the judgment of Latham C.J. that “… fraud of a partner is a business risk. But the loss is a capital loss and expenditure made for the purpose of meeting or retrieving the loss is a capital expenditure” Ash ((1938) 61 C.L.R. 263 at 275).

[6.75] A suggestion that misappropriation by a superior is less likely to be relevant than misappropriation by a subordinate may be drawn from the statement in the judgment of Rich J. in Ash (1938) 61 C.L.R. 263 at 278 that “you cannot treat … the depredations of a partner as if they were the peculations of an office boy”. The suggestion is however corrected by the later statement that “the partner was a proprietor”.

The time when the loss is incurred

[6.76] Whether the deprivation of assets results from action of an outsider or an insider, the moment of incurring of the loss will be the moment when the deprivation occurs. If any amount is subsequently recovered from the person whose actions brought about the deprivation, there will be a need to determine the character of the amount recovered. H. R. Sinclair Pty Ltd (1966) 114 C.L.R. 537 and the discussion in [2.547]ff. above are relevant.

[6.77] Deprivation may not be discovered immediately: there was a considerable delay in Levy. Where the taxpayer has already been assessed in respect of the year in which the deprivation occurred, he will have to rely on the Commissioner’s exercise of his power to amend the assessment so as to allow the deduction of the expense. The Commissioner’s power to amend is limited by s. 170(4) and the taxpayer may be denied an amendment to allow the deduction. In these circumstances, the taxpayer may be able to call on the specific provision in s. 71 which allows a deduction in the year in which the loss is “ascertained”. Section 71 is considered further in [10.84]-[10.87] below.

The Characterisation of Outgoings arising from the Deprivation of Assets held in trust by the Taxpayer

[6.78] The discussion of Ash and Curtis v. Oldfield (in [6.71]-[6.75] above) has endeavoured to show the significance of the circumstance that the assets of which the taxpayer has been deprived were held in trust by him. The deprivation of the asset is not a loss incurred by the taxpayer. There will however, in some circumstances, be an obligation on the taxpayer to compensate the trust fund, and the arising of this obligation, or the transfer of property from his own resources in discharging the obligation, will be an outgoing incurred by the taxpayer. So too a voluntary transfer of property to compensate the fund will be an outgoing incurred. The issue of deductibility thus relates to the outgoing in transferring property to compensate the fund, or in the direct compensation of the beneficiary.

[6.79] The outgoing may be a relevant outgoing notwithstanding that the deprivation was the act of an outsider, an insider, or, indeed, a proprietor of a business which held the assets in trust. In Ash the payments in compensation to those whose property had been misappropriated by the taxpayer’s partner were relevant but not working: they were capital outgoings. They were capital because their function was to meet an obligation arising from an appropriation of the assets of clients by the proprietor of the business. At least this would be the characterisation if the partner who had appropriated had remained a partner. In fact he had ceased to be a partner, and the payments were by the new sole proprietor of the practice. The denial of the deduction could be explained, if other grounds are thought unavailable, by the contemporaneity principle. The outgoings, if identified as the actual payments to clients, were made at a time when the business of practice in partnership had ceased. The outgoings could only escape the contemporaneity doctrine if they could be indentified as outgoings that might be allowed in computing the net income of the partnership for purposes of s. 90.

[6.80] Where the deprivation arises from the act of some person other than a proprietor, the outgoing in restoring the fund or in direct compensation of the beneficiary may be both relevant and have a working character. The relevance issue raises again the scope of Levy and Ash. In C. of T. (N.Z.) v. Webber [1953] N.Z.L.R. 107 an outgoing in direct compensation of the client for whom the asset had been held was treated as deductible. A solicitor taxpayer had been induced by the fraud of his clerk to lend his client’s money. The loan could not be recovered and the taxpayer compensated the client. The issue of working, as distinct from capital character, of the outgoing raises questions already considered in relation to the deductibility of damages and expenses of defence. There will be circumstances in which a payment such as that made in Webber will be held to be capital as a payment in defence of the business structure. A distinction can be drawn between the nature of the payment in Herald & Weekly Times and a payment by a solicitor in settling a claim that involves an allegation of serious impropriety in the care of a client’s funds. None the less, a payment in settlement of a claim that involves an allegation of professional negligence is not necessarily denied deduction. Snowden & Willson Pty Ltd (1958) 99 C.L.R. 431 has some bearing. The size of the payment should not determine the character of the payment, though size of the payment may be the reason why the question of deductibility has been raised. The size of the payment was substantial in Webber—£NZ2,000 in the 1940s.

The Characterisation of Interest, Rent, Rates or Repairs that Relate to Assets of a Business, or to Property Whence Income is Derived

[6.81] Precise analysis requires the drawing of a distinction between the relevance of an expense and the working character of that expense. Relevance, it will be seen, depends on the use made of the money to which the interest relates, or the use made of the property to which the rent, rates and repairs relate. The use must be in some process of income derivation. Working character, it will be seen, depends on the maintenance character of the expense—on its function in servicing the money borrowed or the property to which the rent, rates and repairs relate. The fact that the money borrowed is invested in a capital asset or the property is a capital asset will not deny the interest, rent rates or repairs their maintenance character. A service expense of these kinds is a working expense just as an expense for insurance against damage to a capital asset by fire may be a working expense. In a related field there is a distinction to be drawn between a premium paid for insurance of one’s title to property, and a payment in defence of proceedings which challenge one’s title to property. The former may be deductible as maintenance expenses, while the latter, if the assets are capital assets, may be denied deduction because they are not maintenance but capital expenses.

[6.82] Whether the issue be relevance or maintenance character, any determination of purpose, it is assumed, will be made objectively. The observations in [6.2]-[6.17] above are relevant.

[6.83] Deductibility of interest, rent, rates and repairs is an area of the operation of s. 51 where one might have expected the extended form approach, taken by the courts in other areas, to be applied. It will be recalled that a primary form approach insists that where terms of legal art have been used in the words of a tax statute, and the taxpayer’s actions place him fairly within or without those words, he will be advantaged or disadvantaged as the statute directs whatever might be considered to be the policy of the statute. A taxpayer who was the equity participant in a leveraged lease prior to the amendments announced in December 1981, was entitled to the investment allowance as an owner notwithstanding that, the lessee being a State Government, it could not have been the policy of the investment allowance provisions to give the allowance. The extended form approach gives a greater significance to form. It insists that where terms of legal art have been used by courts in framing rules to give effect to words of a statute which have not used terms of legal art, a taxpayer whose actions place him fairly within or without the words used by the courts will be advantaged or disadvantaged as the statute directs, whatever might be thought to be the policy of the statute. Illustrations of an extended form approach, where the statute merely uses the word income, were noted in Chapter 2, [2.420]ff. above. The extended form approach in its application to the words of s. 51(1) has already been the subject of some comment in [6.6]-[6.9] above. It is in the s. 51(1) context that another approach, associated with a form approach has been most evident. By this associated approach the courts have put limits—blinkers—on what may be looked at in determining whether form is complied with. Thus a rule of extended form is asserted that an expense for the purpose of acquiring trading stock is deductible. The further assertion is then made that the purpose of an expense which arises under a contract may be found only in the terms of the contract, so that, for example, the purpose of a payment under a contract which provides only for the supply of trading stock must be the obtaining of that supply. The principal manifestations of blinkers are in Cecil Bros Pty Ltd (1964) 111 C.L.R. 430 and Europa Oil (N.Z.) Ltd v. C.I.R. (N.Z.) (No. 2) (1976) 76 A.T.C. 6001. They relate to acquisition of trading stock. South Australian Battery Makers Pty Ltd (1978) 140 C.L.R. 645 is a qualified application of blinkers in relation to payments by way of rent. It is qualified in ways explained in [9.19] below.

[6.84] There are special difficulties about the application of blinkers in the contexts of interest, rent, rates and repairs. It will be seen that the rules formulated in judicial decision make deductibility depend not only on the outgoing having been incurred for the purpose of maintaining property, but also on the property maintained being outlaid or employed for the purpose of deriving income. The rules thus require a composite of two purposes. Both the outgoing in maintaining and the outlay or employment of the property may have been the subject of contracts. Where this is the case, there is the prospect of the application of blinkers at two points. In South Australian Battery Makers there was simply no dispute about the employment of the property. In any event its employment did not involve another contract. In Ure (1980) 80 A.T.C. 4264, however, at first instance, Lee J. considered that he was bound by the blinkers approach not only in regard to the maintenance purpose of the payments by way of interest, but also in regard to the purpose in laying out the moneys borrowed by lending them to associated persons: the on-lending was under further contracts. He reached his conclusions on the purpose of the laying out within a view of the facts made somewhat wider by the qualification on the blinkers approach established by the judgment of Gibbs J. in South Australian Battery Makers. In the Federal Court in Ure the possible application of blinkers in regard to the purpose of the on-lending is simply ignored. The reason may be that blinkers had been ignored in the same way in Total Holdings (Australia) Pty Ltd (1979) 79 A.T.C. 4279. If it had been applied in Total Holdings in determining the purpose of the on-lending to the subsidiary at no interest, the consequence would, presumably, have been the defeat of the taxpayer: a loan at no interest does not show any laying out for the purpose of deriving income. A conclusion that the laying out was for the purpose of deriving income required speculation about dividends that might be paid by the borrowing company to the taxpayer, and about the taxpayer’s intentions to continue to hold its shares in the borrowing company, rather than sell them at a gain which would not be income.

[6.85] The ignoring of the blinkers approach in Ure and Total Holdings in relation to the on-lending may dictate a re-examination of the approach generally, so as to question Cecil, Europa Oil (No. 2) and South Australian Battery Makers. Meanwhile it seems that, however valid the blinkers approach may be where the issue is whether payment of interest is for the purpose of servicing a borrowing, the approach is not valid where the issue is whether the outlay or employment of the money borrowed was for the purpose of deriving income.

Interest

[6.86] The case law assumes that there is a rule, though it is variously formulated, which will determine whether payment to service a loan of money is relevant and working. Relevance and working character, here as in other contexts, tend to be run together. Thus in the proceedings at first instance in Ilbery (1981) 81 A.T.C. 4234, Smith J. accepted a proposition put to him by the taxpayer that “interest on moneys which are borrowed for the purpose of acquiring an income producing asset is deductible” (see (1981) 81 A.T.C. 4661 at 4665 per Toohey J.). By such a formulation of the rule, the purpose of the laying out may connect the payment of “interest” with the derivation of income and make it relevant. If the legal form of “interest” is met, the payment, if relevant, will be a working or maintenance payment, and will be deductible. In the latter respect an extended form approach has been taken. At least it was taken by Smith J. in Ilbery. In the Federal Court it was taken, with some reservation, by Toohey J. The reservation is in the statement: “It is, I think, necessary to distinguish between the prepayment of interest in the present case and the character that payment would have if spread over a number of years as interest on money borrowed for the purpose of purchasing a property as a source of income. The character of the one does not necessarily determine that of the other” ((1981) 81 A.T.C. 4661 at 4668). It will be seen that the denial of deduction of the interest payment by Toohey J. resulted from the application of the contemporaneity principle considered in [5.37]-[5.48] above. It was not therefore necessary for him to pursue his reservation, and consider the submission put to him by counsel for the Commissioner that a prepayment of interest, lacking a recurrent character, must be on account of capital rather than revenue. Such consideration as he gave to the matter suggests that, contrary to his reservation, he would regard any payment which is in form interest as a working expense if it relates to money outlaid for the purpose of acquiring an income-producing asset. If an extended form approach centring on the word “interest” in judge-made rules is not taken, it will be possible to conclude that a pre-payment of interest is not a working but a capital expense. It is an expense of obtaining a lasting advantage—the use of money for an extended period without the need to service it by paying interest, or subject only to service at a reduced rate of interest. Deductibility will then depend on the existence of provisions, in sections other than s. 51(1), which, like the depreciation provisions, would allow deductions by way of amortisation of the pre-payment over the life of the advantage gained—the period of the borrowing. In fact there are no such provisions in the Assessment Act. The outgoing to obtain the tie with a garage proprietor for a period of years, held capital in Strick v. Regent Oil Ltd [1966] A.C. 295, would not attract any amortisation provisions under the Assessment Act.

[6.87] If extended form is attracted by the use of the word “interest” in formulations of a rule by which the deductibility of payments to service a loan will be determined, form will govern only to the extent that the payments are within the word as a term of legal art. A description, in the contract, of the payments in Cliffs International Inc. (1979) 142 C.L.R. 140 as “purchase price” did not preclude a different characterisation. There is no suggestion in Ilbery that an advance payment of the kind with which the case was concerned is not within the word as a term of legal art, though there might be room for a submission that it was not. The fact that payments are called interest is not enough to make them interest, even when they are called interest in a contract which attracts the blinkers approach, though that approach might of course confine the characterisation of the items called interest to inferences from the terms of the contract.

[6.88] The room for an extended form approach is in other respects limited by a want of agreement in judicial statements on the rule expressing s. 51(1) in the context of interest payments. If extended form were applied to the rule accepted by the judge at first instance in Ilbery, the rule would allow the deduction of interest on moneys borrowed for the purpose of acquiring an income producing asset whether or not the moneys borrowed have been laid out for that purpose. Such a rule would exclude the operation of the contemporaneity principle held in other cases to be expressed in s. 51(1). The Federal Court by asserting the contemporaneity principle in denying a deduction to the taxpayer, has rejected the rule accepted at first instance.

[6.89] If one were to try to frame a rule embracing all the requirements for which there is some judicial support, it would assert that interest is deductible if:

• (i) There is a borrowing for the purpose of making an outlay which is for the purpose of deriving assessable income, so that one can trace through purposes; and
• (ii) the money borrowed can be traced through movement of funds into an outlay that involves assessable income derivation; and
• (iii) the money is currently so outlaid; and
• (iv) the payment of interest relates to the use of the money, during the year of income, in the current outlay for the purposes of income derivation; and
• (v) the payment of interest is contemporaneous with the income derivation; and
• (vi) the payment of interest is made for the purpose of servicing the borrowing.

No rule can express the judicial interpretation of s. 51(1) unless it requires that the money borrowed should have been in fact laid out for the purpose of producing income. But its detailed formulation in a number of other respects needs to be settled, if there is to be a rule which in all its terms can attract extended form. Thus there will be need to know whether there must be a purpose at the time of the borrowing to outlay the money in order to produce income. If such a purpose is necessary, some arbitrary limitations on the deductibility of interest payments will result. A taxpayer who borrows to acquire property which will be income producing will be entitled to a deduction. A taxpayer who borrows to acquire property which will not be income producing, but which is later used to produce income, will not be entitled, at any time, to a deduction. Some of these matters are considered below in dealing more closely with Munro (1926) 38 C.L.R. 153, Total Holdings (1979) 79 A.T.C. 4279, Ure (1981) 81 A.T.C. 4100 and Ilbery (1981) 81 A.T.C. 4661.

[6.90] If the question as to when the purpose of laying-out to produce income must subsist is answered, other questions remain. Granted that it must have been possible to trace the money borrowed into the outlay, there is a question whether deductibility is defeated if property into which the outlay is traced ceases to be used to produce income. It would be generally assumed that in these circumstances any entitlement to deduction will cease. And it would be generally assumed that if the asset used to produce income is disposed of, there will not be any entitlement to a deduction unless there is an outlay of any proceeds of the disposition that may be said to represent the money borrowed, and that outlay may be said to relate to income derivation.

[6.91] Where the moneys borrowed have been borrowed for the purpose of investment in business assets, or in property whence income will be derived, and the moneys can be traced through movement of funds into some asset, perhaps traced through several movements to and from other assets, the problems are easier. Tracing through purposes, and tracing through movement of funds into assets producing income can both be satisfied. But moneys borrowed may be used in the making of outgoings—meeting the running expenses of a business—which thereafter precludes any identification of the moneys borrowed in any assets. In these circumstances an acceptable rule determining when interest is deductible may not be easily stated. A sole trader borrows and uses the money borrowed to meet running expenses of his business. Thereafter he draws on the business bank account in order that he might have funds for private purposes. Does the “washing” of the money borrowed through the business ensure continuing deductibility of interest payments? A company borrows in order that it might have funds to pay a dividend. It may be doubted whether the interest on the borrowing is at any stage deductible: at no stage is the money borrowed laid out to produce income. Should it make any difference that the money was borrowed to meet outgoings, so that other funds might be used to pay the dividend? Other questions may be posed which may lead one to despair about ever stating an acceptable rule, indeed to despair about ever achieving coherent and consistent application of s. 51(1) in relation to payments of interest, however free one might be to apply the words of the statute without the incubus of judge-made rule.

[6.92] There is much to be said for a view that would not seek to trace the money on which interest is paid into the money outlaid to produce income, whether it be a tracing through purposes, a tracing through movement of funds, or a tracing which requires both a matching of purposes and a movement of funds. This view would leave the deductibility of interest to rest on the purpose of the borrowing—a purpose, it will be recalled, to be determined objectively and perhaps the better identified as function. The issue would be whether the function of the borrowing is to support the process of income derivation—the conduct of a business or the holding of property whence income is derived—and whether it continues to have that function. In the characterising of a borrowing for purposes of the application of the law as to exchange gains and losses, an approach that does not seek to trace is, it seems, appropriate, though the character of the borrowing that must be shown differs from the character that would justify interest deductions. It does seem absurd that interest on a borrowing on the security of a rented house, to finance the acquisition of a house that will be used as a home, should be denied deduction, though interest on a borrowing on the security of a private home to finance the acquisition of a house that is rented should be allowed deduction. The test of support for the process of income derivation is, of course, vague and indeterminate. Any attempt to make it determinate is likely to end with a rule which would allow deduction of any interest payments in the proportion of the value of a taxpayer’s assets producing income to his total assets. Such a test would, however, encourage borrowing through an interposed entity (partnership, trust or company) which might be thought to distort its operation.

[6.93] A study of attempts to apply s. 51(1) in relation to the deductibility of interest brings a conviction that the only way to achieve consistent, if not coherent, application of the law is to allow deduction of any interest, whatever the destination of the moneys borrowed. This would be the United States solution. The alternative is to deny deduction of any interest, equating it with a distribution of income, an alternative favoured by some economists.

[6.94] Munro (1926) 38 C.L.R. 153 is regarded as establishing a tracing requirement if interest is to be deductible—that the money borrowed must be shown to have been outlaid in new investment in business assets, or in the acquisition of property whence income is derived. Certainly the case requires a tracing through purposes, but it does not necessarily establish that there must also be a tracing through the actual movement of funds. If a taxpayer borrows in order that he might have funds to finance a new investment in business assets or to finance the acquisition of property whence income will be derived, it may be appropriate to treat the money borrowed as so outlaid, whether or not the actual funds outlaid are the funds obtained by the borrowing. The insistence on tracing through purposes appears to preclude a view that would regard a tracing through movement of funds as sufficient. It thus precludes a view that would allow the deduction of interest on money borrowed for a private purpose, if it can be shown by tracing through movement of funds that the money was in fact used for new business investment or in acquiring property whence income is derived. And it precludes a view that would allow the deduction of interest on money borrowed for investment in property used for a private purpose if the property so used is later used for business purposes, or as property whence income is derived. There is a suggestion in the judgment of Mason J. in Handley (1981) 148 C.L.R. 182 at 195, that deduction of interest in these circumstances is denied. In these respects, the consequences of Munro may be thought unsatisfactory. And the consequences may be thought the more unsatisfactory, if there is drawn out from the case an inference that once the money borrowed has been invested in business assets or in assets producing income, interest on the borrowing will continue to be deductible even though the investment has been withdrawn, or the asset ceases to be used in a process of income derivation.

[6.95] Munro (1926) 38 C.L.R. 153 was concerned with a borrowing secured by a mortgage on rent-producing property. The money was borrowed by the taxpayer for the purpose of investment in shares in a newly promoted company, and for the purpose of a loan interest-free to that company. 18,000 of the shares were allotted to the taxpayer’s sons, and 2,000 to the taxpayer. The taxpayer was denied any deduction for interest on the money he had borrowed. The case was decided on the pre-1936 Act. In contrast with the present Act, the pre-1936 Act provided expressly for the deduction of “interest actually incurred in gaining or producing the assessable income” (s. 23(1)(a)). It thus opened the way to a primary form approach. The pre-1936 Act differed from the present Act in another way: it contained an express prohibition against any deduction in respect of “money not wholly and exclusively laid out or expended for the production of assessable income” (s. 25(e)).

[6.96] Knox C.J. said (at 171): “The debt [for the money borrowed] having been incurred for a purpose wholly unconnected with the production of assessable income [of the taxpayer], I think it impossible to say that the interest paid on the amount of the debt was money wholly and exclusively laid out or expended for the production of his assessable income.” The conclusion that the money had been borrowed for a purpose wholly unconnected with the production of assessable income of the taxpayer went further than was necessary. To the extent that the money borrowed was invested in shares issued to the taxpayer there was a connection with the dividends that the taxpayer might receive on those shares. And the loan to the company might be seen as in part connected with those dividends. The conclusion is indeed in some conflict with the conclusion reached in Total Holdings (Australia) Pty Ltd (1979) 79 A.T.C. 4279 considered below. The judgment of Knox C.J. none the less proceeds on a rule that connection with the derivation of income that will make interest payments relevant is established where the borrowing is for the purpose of an investment that will produce income, and that investment is in fact made.

[6.97] The judgment of Isaacs J. contains suggestions of a general principle that an outgoing, to be deductible, must in some sense have generated income. Such a general principle has been rejected by later cases referred to in [5.34] above. His judgment in other respects assumes a rule of tracing through purposes (at 198): “The interest paid in respect of the loan follows accessorially the purpose of the principal sum.”

[6.98] The judgment of Starke J. assumes a rule of tracing (at 218): “It was not an outgoing by means of which the taxpayer procured the use of money whereby he made any income.”

[6.99] The issue in Total Holdings was the extent of the loss available for carry forward by the taxpayer company. The extent of the loss depended on the deductibility of interest payments at a rate of 3 per cent made by the taxpayer to its French holding company in respect of borrowings from the holding company held to be for a number of purposes:

• (i) for the purpose of financing the operations of the taxpayer;
• (ii) for the purpose of investing in the shares of a company (TAL) which at the time of the investment was its wholly-owned subsidiary, but which for a time thereafter became the wholly-owned subsidiary of another company in which the taxpayer owned half the shares;
• (iii) for the purpose of lending to TAL, while it was a wholly-owned subsidiary, on demand at no interest; and
• (iv) for the purpose of lending to TAL on demand with interest at 7 per cent, at a time when it was wholly-owned by the company in which the taxpayer owned half the shares.

Spending in its own operations, investments in shares in TAL and lending to TAL were in fact made by the taxpayer, and there was no dispute that the borrowings from the French holding company were for these purposes. Tracing through purposes was thus established, and there was no question raised about tracing through movement of funds. The reference in the judgment of Lockhart J. to moneys borrowed “which were in turn, or their monetary equivalent was used by the taxpayer” suggests a view that tracing through movement of funds is not essential. The Commissioner’s apportionment of the interest paid on the loan from the French holding company between the several purposes was not disputed. The case was concerned only with the deductibility of interest on the borrowings from the French holding company so far as those borrowings were to be traced into loans made to TAL without interest, and which continued to be loans without interest. The Commissioner did not dispute deductibility of interest so far as the borrowings were to be traced into financing of the operations of the taxpayer, or into investments in shares in TAL, or into loans to TAL which were at 7 per cent interest, or, by renegotiation of terms, had become loans at 7 per cent interest.

[6.100] The Commissioner’s action in not disputing deductibility of the interest paid to the French holding company, in the respects just mentioned, calls for some comment. The assumption in allowing a deduction of interest on borrowings used in the operations of the taxpayer’s business is that it is not necessary, in order to establish deductibility, that it should be possible to trace the borrowings into assets of the business. The assumption, it was explained in [6.91] above, opens the prospect of washing borrowings by their consumption in business expenses, so that interest on them is deductible, and the use of other moneys to make a distribution to the proprietor or shareholder. The view was taken in [6.91] above that interest on a borrowing raised to enable a company to pay a dividend is not deductible.

[6.101] The assumption in allowing a deduction of interest on a borrowing for the purpose of investment in shares is, apparently, that such a purpose is always to be regarded as a purpose of income derivation. Munro (1926) 38 C.L.R. 153 is not consistent with such an assumption. It will be recalled that the money borrowed in that case was outlaid by the taxpayer partly in the acquisition of shares by the taxpayer in a newly formed company, partly in the acquisition of shares by the taxpayer’s sons in that company, and partly in a lending interest free to that company. It might have been thought that the outlay in the acquisition of the shares by the taxpayer, and the outlay in the interest free loan (in proportion to the taxpayer’s shareholding in the company), were outlays for the purpose of income derivation by the taxpayer in the form of the dividends he might receive from the company. However, Knox C.J. said (at 171):

[6.102] One would have thought that in Total Holdings (Australia) Pty Ltd (1979) 79 A.T.C. 4279 the deductibility of interest on borrowings used to acquire shares in TAL would stand or fall with deductibility of interest on borrowings used to make interest free loans to TAL. For this reason, if for no other, the assumption by the Commissioner in regard to the deduction of interest on borrowings to finance share acquisitions, is difficult to follow.

[6.103] The assumption that interest was deductible on a borrowing used to lend to TAL at 7 per cent interest may have been appropriate on the facts—7 per cent was presumably a commercial rate of interest at the time. Ure (1981) 81 A.T.C. 4100, it will be seen, is authority that it is not enough to make interest deductible on the moneys borrowed that they are on-lent at more than a zero rate of interest. The Commissioner’s assumption, as it is stated by Lockhart J. in Total Holdings (at 4284), is obviously too wide:

[6.104] The Commissioner’s assumption that interest became deductible on a borrowing used to make a loan at no interest, when the loan was renegotiated so as to become a loan at 7 per cent interest, is no doubt good sense, but as explained in [6.94] above, it is not clearly supported by the authorities. In describing the Commissioner’s admissions, Lockhart J. (at 4283-4) made no reference to the situation of the renegotiated loans to TAL: “Nor does the Commissioner deny the taxpayer the deductibility of interest paid to [the French holding company] on moneys lent by it to the taxpayer which were, or the monetary equivalent was, then lent to TAL with interest at 7 per cent per annum.” An inference from the emphasis in the words “then lent”, and the absence of any comment on the wider admission in fact made by the Commissioner, may be that Lockhart J. would have rejected the wider admission if he had been given the opportunity.

[6.105] Total Holdings was concerned with the deductibility of interest on borrowings from the French holding company, so far as those borrowings were to be traced into loans made to TAL without interest, and which continued to be loans without interest. A purpose to borrow and lend at no interest does not show on its face a connection between the payment of the interest on the borrowing and a process of income derivation. The finding of a purpose which will connect the payment of interest with a process of income derivation, requires that one go beyond the making of the loan. Lockhart J. (with whose judgment the other members of the Federal Court agreed), in going beyond the loan, relied on evidence given by a witness who was a director of TAL and of the French holding company. The witness gave evidence as to his own state of mind, and of conversations with a director of the taxpayer going to the latter’s state of mind. This reliance might suggest that the purpose of an outgoing by way of interest, which “follows accessorially the purpose of the principal sum” (Isaacs J. in Munro (1926) 38 C.L.R. 153 at 198), is a matter of subjective purpose, and that the general principle in regard to deductibility—that it is the objective purpose that governs ([6.2]–[6.16] above)—is subject to an exception in this context. The investigation of subjective purpose in Total Holdings influenced Sheppard J. in Magna Alloys & Research Pty Ltd (1980) 80 A.T.C. 4542 to take a subjective approach to the determination of purpose in a context other than the deductibility of interest. It has been seen that the subjective approach in the context of the facts in Magna Alloys was rejected, albeit in a somewhat equivocal way, in the Federal Court. Magna Alloys is referred to in the Federal Court in Ure (1981) 81 A.T.C. 4100 as requiring an objective approach where the question is the purpose of outgoings by way of interest (per Brennan J. at 4104). But Lockhart J. in Total Holdings is not expressly rejected.

[6.106] In Total Holdings (Australia) Pty Ltd (1979) 79 A.T.C. 4279 at 4286, Lockhart J. held that the activities of the taxpayer “were designed to render TAL profitable as soon as commercially feasible and to promote the generation of income by TAL and its subsequent derivation by the taxpayer and thence [the French holding company]”. He rejected any inference that “it was the dominant or, for that matter, any purpose of the taxpayer in making interest free loans to TAL that once TAL became profitable, a substantial portion of the shares held by the taxpayer in TAL would be disposed of to some outsider for capital profit”. He went on to assert that “even if the evidence did warrant the drawing of [the] inference [of purpose to make a capital gain], I am far from satisfied that it would operate to deny a business or income producing character to the interest-free loans over such a long period of time”. No reasons for this want of satisfaction are given, except in the reference to “a long period of time”. There must be circumstances where lending interest free to a company in which one holds shares, or, equally, subscribing for shares, reflects a purpose, not to derive income, but to generate a capital gain. It is not easy to appreciate why the Commissioner in Total Holdings made the admission he did in regard to the subscription for shares, while making the argument that there was no income producing purpose in the lending interest free. To the extent that a purpose to obtain a capital gain is to be inferred, the payments of interest should be denied deduction.

[6.107] There will be other circumstances in which the inference must be that moneys were outlaid in acquiring shares, or in lending interest free to a company in which shares were held, for a purpose of obtaining a profit on the sale of the shares, whether in a business of dealing in shares or in a casual profit situation covered by s. 25A(1) (formerly s. 26(a)) or s. 26AAA. In these circumstances, too, there may be at least a partial denial of a current deduction of interest on money borrowed to acquire the shares, or to lend interest free. Where the taxpayer is a share trader the interest may be seen at least in part as a cost of trading stock, formally deductible but subject to deferral until the shares are sold by the operation of s. 28. Where the situation is covered by s. 25A(1) or s. 26AAA or an ordinary usage isolated business venture principle, the interest may be, at least in part, a cost in computing the profit on realisation that will be income, or if there is a loss, that is deductible as a loss. Issues of tax accounting are raised that are more closely considered in Chapters 12 and 14 below.

[6.108] Deductibility of interest depends on the payments having been made for the purpose of servicing the borrowing on which the interest is paid, and on the moneys borrowed having been laid out by the taxpayer for the purpose of the derivation of income. The blinkers approach may apply in limiting the facts that may be considered in determining whether the purpose of the payments is to service the borrowing, so that one may not look beyond the terms of the contract of borrowing. Total Holdings would appear to have rejected the blinkers approach so far as it might have limited the facts that may be considered in determining whether the moneys borrowed are laid out for the purpose of deriving income. It seems that one may look beyond the terms of a contract by which the moneys are on-lent. The blinkers approach, if applied in Total Holdings in relation to the on-lending, would have required a conclusion that interest paid on the moneys on-lent without interest was not deductible. A contract of loan at no interest does not show any purpose of laying out to derive income.

[6.109] Two aspects of the decision in Ure (1981) 81 A.T.C. 4100 have already been adverted to. The case may be seen as some authority that in determining the purpose of the on-lending of money borrowed—which will “accessorially” determine deductibility of interest on the money borrowed if it was borrowed for that purpose—an objective approach is to be taken.Brennan J. said (at 4104): “The purposes for which money is laid out is an issue of fact, turning upon the objective circumstances which human experience would judge to be relevant to the issue (cf. Magna Alloys and Research Pty Ltd (1980) 80 A.T.C. 4542 at 4549).” There is, however, no such adoption of an objective approach in the judgment of Deane and Sheppard JJ.

[6.110] And the case is authority that in reaching a conclusion as to the purpose of the on-lending the blinkers approach has no application. Lee J., at first instance, thought the principle, as expressed in Cecil Bros Pty Ltd (1964) 111 C.L.R. 430, Europa Oil (N.Z.) Ltd v. C.I.R. (N.Z.) (No. 2) (1976) 76 A.T.C. 6001 and South Australian Battery Makers Pty Ltd (1978) 140 C.L.R. 645 did apply, but was able to call on the qualification adopted by Gibbs A.C.J. in South Australian Battery Makers, which allows an examination of the facts beyond the contract to the extent that they show a benefit to the taxpayer other than that stipulated in the contract. Brennan J. in the Federal Court simply failed to make any reference to Cecil, Europa Oil (No. 2) and South Australian Battery Makers, and assumed that in determining the purpose of the on-lending a broad inquiry was appropriate. Deane and Sheppard JJ. did advert to Cecil and South Australian Battery Makers, but the references made to those cases did not direct attention to the blinkers approach. Words are quoted (at 4109) from the judgment of Gibbs A.C.J. in South Australian Battery Makers that the characterisation of an outgoing will ordinarily be determined by reference to “the advantage which the expenditure was intended to gain, directly or indirectly, for the taxpayer”. The application of the Gibbs A.C.J. view of advantages relevant to the determination of the purpose of the outlay of the borrowed moneys in Ure, would have excluded as irrelevant any advantages conferred on others. Yet Deane and Sheppard JJ. found that among the objects of the outlay of the borrowed moneys were included “the financial benefit of the taxpayer’s wife and a family trust” (at 4110), and that these objects justified denying some part of the deduction of interest on the money borrowed. The judgment of Gibbs A.C.J. in South Australian Battery Makers, if held applicable in determining the purpose of the outlay, and thus, accessorially, the purpose of the payment of interest, is inconsistent with the judgments in Ure.

[6.111] The possible application of the blinkers approach in finding that aspect of the purpose of payment of interest that bears on deductibility, but is not concerned with the outlay of the moneys borrowed, was not an issue in Ure or in Total. This aspect is concerned with purpose to service—to maintain—the borrowing. A payment of interest at a rate beyond any commercial rate, more especially when made to an associated person, raises the question whether an inference should be drawn that some part of the purpose of the payment of interest is other than the service of the loan and, in this part, not relevant but private or domestic, or not a working or maintenance expense but a capital expense. On this question it may be difficult to distinguish and escape the authority of Cecil, Europa Oil (No. 2) and South Australian Battery Makers. There is reference in the judgment of Deane and Sheppard JJ. in Ure (1981) 81 A.T.C. 4100 at 4110 to Cecil and Phillips (1977) 77 A.T.C. 4169 as support for the proposition that:

An explanation of Cecil in this way avoids treating the case as an application of the blinkers approach. But it is not the explanation of the case adopted in Europa Oil (No. 2) and South Australian Battery Makers. And the authority of the later cases can hardly be extinguished, at least by the Federal Court, by ignoring them, however much they might deserve to be extinguished.

[6.112] Ure contains a statement of a rule to determine the deductibility of interest, in the judgment of Brennan J., thus (at 4104):

It will be noted that the rule employs the word “interest”, and not some description such as “a payment to service a loan of money”. It thus offers the greater prospect of an extended form approach, which might lead to a payment being deductible if it is within the meaning of the word “interest” as a term of legal art, notwithstanding that the payment can be shown to have other purposes than the servicing of the borrowing, and notwithstanding that the payment is one, as in Ilbery (1981) 81 A.T.C. 4661, that secures a lasting benefit and is thus not a maintenance, but a capital expense. It will also be noted that the words used are “is laid out” for the purpose of gaining that income, though in the next paragraph of his judgment, Brennan J. reverts to language that is closer to the language of Munro when he says that the rule requires an “examination of the purposes for which the money was laid out”. It has been suggested above that any rule should be formulated in terms of the purpose for which the moneys borrowed are laid out at the time that interest is claimed to be deductible. There may not, however, be judicial support for such a formulation: Mason J. in Handley (1981) 148 C.L.R. 182 at 195, was not ready to give it support.

[6.113] There is very little attempt in the judgment of Deane and Sheppard JJ. in Ure to formulate any rule beyond insisting on the significance of the purposes “which the application and use of the borrowed money were intended to gain” (at 4109–4110). They were, however, aware of the problems raised by any attempt to formulate a rule: “Where there is a difference between intended and actual use of the borrowed money or a change in use, difficulties may arise in determining what are the relevant objects or advantages which the payment of interest was calculated to procure. These problems do not arise in the present case however for the reason that there is neither suggestion that there was any difference between the proposed and the actual use of the borrowed money or between the objects or advantages which the borrowed money was intended to achieve and those which it in fact achieved nor suggestion that there was ever any relevant change in the use of the borrowed money” (at 4110). There is some discussion of the problems thus left unresolved, in [6.89]–[6.91] above.

[6.114] In all the judgments in Ure (1981) 81 A.T.C. 4100 there is discussion of the relevance of the use made of the money by the persons to whom it had been on-lent. Brennan J. said (at 4104): “where a question arises as to the purpose for which money is laid out by a taxpayer, it is erroneous to exclude as irrelevant evidence of the use of that money, albeit by others, in conformity with arrangements made by the taxpayer.” Where the moneys are on-lent at a commercial rate of interest a purpose to produce income is sufficiently established, without looking to the way in which the borrower under the on-lending has used the money. Where, however, the on-lending is at less than a commercial rate, the purpose to produce income may be inferred, for example, from the expectation of the taxpayer that the moneys will be used by the borrower from him to generate profits which will be distributed to the taxpayer and received by him as income. This was the way in which an income derivation purpose was found for the on-lending in Total Holdings (Australia) Pty Ltd (1979) 79 A.T.C. 4279. Where the use for the money which the taxpayer might have anticipated cannot involve any derivation of assessable income by the taxpayer, the circumstances are those in Ure. The taxpayer’s purpose in on-lending included the derivation of interest at 1 per cent but that did not wholly explain his actions. It is not a matter of attributing to the taxpayer the purposes of the borrower from him. Those purposes are relevant only so far as they might suggest that the taxpayer has on-lent for the purpose of putting others in funds and not simply as a step which satisfies a condition precedent to his right to interest on the money on-lent. It is appropriate to say that he has used the money he borrowed for two distinct purposes—to obtain interest and to put the borrower in funds. So far as he has acted to put the borrower from him in funds, deduction of the interest paid by the taxpayer depends on whether the use of the funds by the borrower from him may be expected to result in the derivation of assessable income by the taxpayer.

[6.115] The analysis in the last paragraph has a bearing on the operation of s. 67, a section applied by the Federal Court to give the taxpayer a full deduction of guarantee fees and legal expenses and valuation fees associated with his borrowing, albeit a deduction spread over the period of the loan. That a full deduction was allowed when only a small part of the interest expense was held deductible under s. 51 should provoke some questioning of the court’s interpretations of s. 67. All members of the court thought the words of s. 67 which refer to “money used by [the taxpayer] for the purpose of producing assessable income” were satisfied by the circumstances that the taxpayer had on-lent to associated persons at 1 per cent interest. And, indeed, all members of the court thought that the only use of the money made by the taxpayer was a use to produce the 1 per cent interest: other use of the money was use by the borrower from him. Once it was agreed that the taxpayer had outlaid money for purposes other than the derivation of the 1 per cent interest it should have followed that he had used money for purposes other than the derivation of the 1 per cent interest. If it is said that one does not use by giving something to another to use, then there is no use in any lending to another. The lending cannot become use simply because there is a reward for the lending. The reward does no more than satisfy a requirement that the use must be to produce income: it does not convert non-use into use. In 1984, subs. (4) was added to s. 67, so that the section now includes an express provision applicable to circumstances where the money borrowed is used by the taxpayer only partly for the purpose of producing assessable income. The taxpayer is deemed to have incurred only so much of the expenditure as, in the opinion of the Commissioner, is reasonable in the circumstances. If the reasoning of the Federal Court in Ure is to be accepted as correct, there will be no operation of s. 67(4) in the circumstances of Ure, to give the Commissioner power to deny deduction of some of the expenses of borrowing. It is a condition precedent to the Commissioner’s power that the money borrowed has been used by the taxpayer only partly for the purpose of producing assessable income.

[6.116] Section 67 is considered more closely later in this chapter. It is enough to say that the question it raises is raised by a number of other specific provisions of the Assessment Act allowing deductions where property is used for the purpose of producing income. Thus, s. 72 which relates to a deduction for rates and land tax, expressly requires an apportionment so that only a part of the outgoing is deductible if the property is only partly used by the taxpayer to produce assessable income. But on the reasoning in Ure, if some rent is reserved, property let to a relative at less than a commercial rate will be held to have been wholly used by the taxpayer to produce assessable income.

[6.117] The conclusion in Ilbery (1981) 81 A.T.C. 4661, at least so far as it denied a deduction for interest, referable to the use of the money borrowed beyond the year of income, was clearly right. But the principles which most clearly direct that conclusion are not stated in the case. A payment which would obtain for the taxpayer the use of money without interest for a period, and thereafter its use on payment of a reduced rate of interest, is a payment to secure a lasting advantage. The parallel with Strick v. Regent Oil [1966] A.C. 295 is compelling. The payment in Ilbery is indeed the more removed from any claim to working or maintenance character, by the fact that the advantage obtained might come to be enjoyed in circumstances having no relation to any process of deriving income: the money borrowed might cease to be outlaid in any such process. In Strick v. Regent Oil [1966] A.C. 295 (discussed in [7.34]ff. below) the advantage obtained by the payment of the premium—the tying of a garage proprietor so that he would sell only the taxpayer’s product—could only be enjoyed in a process of income derivation. It is true that a payment for an advantage of the kind obtained in Strick v. Regent Oil may be a working expense where the advantage enures for some lesser period than the period in that case: B.P. Australia Ltd (1965) 112 C.L.R. 386 indicates the limits on Strick v. Regent Oil. But in Ilbery the advantage that was obtained from the payment was to subsist for 30 years. And there was the added factor that the advantage was one that could be used in circumstances having no relation to any process of income derivation.

[6.118] Strick v. Regent Oil did not achieve any mention in Ilbery. Nor was there any attempt in Ilbery to show a parallel between the advance payment of interest and the payment of a premium on an ordinary lease of property that might presently be used in a process of income derivation, but which might at any time cease to be so used. There is a reference to B.P. Australia (at (1981) 81 A.T.C. 4661 at 4669) but only as endorsing the statement by Dixon J. in Sun Newspapers Ltd (1938) 61 C.L.R. 337 at 363 explaining when an outgoing is of a capital nature. Toohey J. appeared to accept counsel’s submission that the prepayment of interest could not be denied working character because the prepayment involved no acquisition of assets. Counsel had argued: “If you make a list of [the taxpayer’s] assets on that day before and after the transaction there would be no change.” Accepting counsel’s submission makes the statement by Dixon J. a rule to be applied in its terms rather than its substance and indeed reformulates it in terms of “assets” when the word used was “advantage”. In any event cases subsequent to Sun Newspapers, in particular John Fairfax & Sons Pty Ltd (1959) 101 C.L.R. 30, have accepted that a conclusion that an outgoing is not working is not precluded by the circumstances that no “asset” or, indeed “advantage” results from the outgoing. The matter is considered below in Chapter 7.

[6.119] There is another basis on which deduction should have been denied in Ilbery, a basis which will exclude deduction of interest which relates to any period beyond the year of income. To the extent that the interest paid related to the use of money beyond the year of income, it was not shown to be relevant because it was not established, nor could it be established, that the money would continue to be outlaid in a process of derivation of assessable income. The taxpayer might at any time sell the house and use the proceeds for private purposes. Ilbery was an individual, but the same inability to show relevance will affect a payment of interest in advance by a company taxpayer. A company might sell the house and use the proceeds to pay a dividend or to return capital to its shareholders, or to make a new investment in operations that will produce foreign source exempt income.

[6.120] The reasoning in Ilbery both at first instance and in the Federal Court offers ritual repetition of general statements about s. 51(1), and then moves to the level of propositions which tend to lose contact with the subsection, and substitute rules which may reduce the analysis to exercises in extended form. The basis of the decision in the Federal Court, so far as it can be identified from the judgment of Toohey J., is the contemporaneity rule: “At the time of the prepayment of interest the taxpayer had not acquired any property from which he hoped to derive income. There was no relevant income-earning undertaking or business in existence” ((1981) 81 A.T.C. 4661 at 4668). It is true that any sovereignty of form expressed in the defeat of the taxpayer, is qualified by an immediately following observation to the effect that the absence of an existing process of income derivation “is not necessarily fatal”. Yet the impression remains that the taxpayer’s claim to a deduction might have been much stronger had he arranged for his clerk to take the cheque for the money borrowed to the nearest office of the building society, and there deposit it for the taxpayer, before the taxpayer drew the cheque for the payment of interest in advance. In any case, the emphasis on want of contemporaneity might have been turned aside by a submission that called on a principle that a cheque is only conditional payment, and that completed payment by the clearing of the cheque in fact occurred after the deposit of the moneys borrowed had been made with the building society. Which indicates how a reliance on extended form may abandon whatever good sense s. 51(1) may express.

[6.121] The trial judge in Ilbery had accepted three propositions put to him on behalf of the taxpayer. They were:

Toohey J. did not expressly question the first proposition, but some observations in his judgment do reflect on the proposition as a correct explanation of s. 51(1). Thus he would not agree that interest will continue to be deductible notwithstanding that the money borrowed has ceased to be invested in an income-producing asset:

And his selection of observations from the judgment of Brennan J. in Ure (1981) 81 A.T.C. 4100 may indicate a view that the purpose in borrowing is irrelevant if, through a movement of funds, it is possible to trace the moneys borrowed into some asset in which the moneys borrowed may be said to be laid out for the purpose of gaining of income (at 4667). Thereafter, however, he switches the focus of the analysis so as to concentrate on the purpose of paying the interest, as distinct from the purpose of laying out the money borrowed. He would indeed appear to have rejected the view of Isaacs J. in Munro ([6.97] above) that “the interest paid in respect of the loan follows accessorially the purpose of the principal sum” ((1926) 38 C.L.R. 153 at 198). His conclusion on purpose of the payment of interest was that “no purpose can be discussed” [quaere discerned] “here other than that of gaining a tax advantage”. In reaching this conclusion he adverted to the fact that “the taxpayer never tried to conceal that his object in paying five years’ interest in one year was to obtain the tax advantages thought to flow from that course” (at 4668). Which may indicate that he rejected the view that seemed to have emerged from Ure, that purpose bearing on deductibility is to be determined objectively.

[6.122] The second proposition, which is, presumably, drawn from W. Nevill & Co. Ltd (1937) 56 C.L.R. 290, is rejected by Toohey J. as not being a rule of universal validity. A payment in a relevant year for the purpose of reducing payments which would otherwise have to be made in later years when those payments would be deductible, may itself be deductible, but it is not necessarily deductible. There is no indication given of what may determine when such a payment will be deductible, and when it will not. One factor of importance will be the extent of the immunity from future payments which follows from the payment. At some point the payment should be taken to have secured a “lasting advantage” (Dixon J. in Sun Newspapers Ltd (1938) 61 C.L.R. 337 at 363) such that it will have a capital, not a working character.

[6.123] Strangely, Toohey J. did not offer an obvious comment on the relevance of the second proposition. It is confined in its terms to a case where the future payments “themselves would be deductible”. No such assumption could be made about the future payments of interest in Ilbery. Toohey J. had already asserted that they would not be deductible if the taxpayer came to occupy the property himself.

[6.124] The translation of Nevill into a rule which beset the court at first instance and the Federal Court, is an illustration of the process by which rules explaining s. 51(1) have come to be created. The application of the rule by the trial judge illustrates the extension of a form approach to those rules. Nevill should be seen as no more than an application of the basic principles of s. 51(1). The application of those principles in somewhat different circumstances where, for example, the payment is to secure the retirement of a life-governing director, may require a different conclusion.

[6.125] In Ilbery (1981) 81 A.T.C. 4661, Toohey J. offered no comment on the third proposition accepted by the trial judge. A rejection of that proposition, and the adoption of a principle as to when an outgoing is incurred, parallel with that adopted in Arthur Murray (N.S.W.) Pty Ltd (1965) 114 C.L.R. 314 as to when an item of income in advance is derived, would have been a significant contribution to the development of principle. There is support for such a principle in Alliance Holdings Ltd (1981) 81 A.T.C. 4637 and Australian Guarantee Corp. (1984) 84 A.T.C. 4024; 4642, though the principle is not as boldly acknowledged as it might have been. Each case involved a borrowing on terms that interest would be paid when the money borrowed was repaid at the end of a fixed period. The question that was raised was whether the undertaking, on the occasion of a borrowing, of a liability to pay interest at a future time can involve the arising of an outgoing by an accruals basis taxpayer. James Flood Pty Ltd (1953) 88 C.L.R. 492, even after Nilsen Development Laboratories Pty Ltd (1981) 144 C.L.R. 616, might establish that it can, though regard will need to be had to the terms of the borrowing to determine whether in fact an outgoing has arisen. The words “arising” and “arisen” are intended to denote the incurring of an outgoing in all respects save the respect that will determine the time of the outgoing. The same words might be used in relation to the derivation in Arthur Murray at a time when amounts for dancing lessons had been actually received or become unconditionally receivable, though the lessons had not yet been given. Woodward J. in Alliance Holdings and, more forthrightly, Lee J. in Australian Guarantee Corp., answered this question in the affirmative, and then decided, as a threshold issue in each case, that an outgoing for interest had arisen at the time of the borrowing. A further issue, more especially recognised in the judgment of Lee J., was then considered and decided. This issue concerns the time of deductibility of the outgoing for interest—the time when the outgoing becomes fully incurred. Each judge held that the outgoing was incurred progressively as the benefit of the use of the money was enjoyed by the taxpayer—proportionally then to the period of the loan that had run during the year of income. In this there was a recognition of the principle that an outgoing, otherwise incurred, will be incurred as the benefit obtained by the outgoing is consumed in a process of derivation of income by the taxpayer. The principle is explained by Lee J. as adopting an aspect of accruals accounting as understood in accounting practice. He saw Arthur Murray as adopting a like aspect of accruals accounting as understood in accounting practice. The decision of Lee J. was upheld by the Federal Court: (1984) 84 A.T.C. 4642. The reasons of the Federal Court follow those of Lee J.

[6.126] There may be reason to question the conclusions in Alliance Holdings and Australian Guarantee Corp. that, the timing aspect aside, an outgoing for interest had been incurred at the time of the borrowing, though references in James Flood to the possibility that an outgoing that is defeasible may yet be incurred may be thought to lend some support. The liability to pay interest in Australian Guarantee Corp. was defeasible to the extent that the lender might in some events ask for repayment of his loan and would then not be entitled to interest from the date he received repayment. If interest were held deductible in the circumstances of Australian Guarantee at the time of the borrowing there would be need of a principle by which the borrower would derive assessable income when the lender received early repayment. Such a principle would need to bring in as assessable income the amount of interest that would never become payable by the borrower. Which may indicate the wisdom of a principle that would spread the deduction of interest over the period of the borrowing. Deduction may then be denied from the time interest ceases to “accrue”. The matter is further considered in [11.73]ff. below. But the principle in regard to timing is a distinct principle, and one that is supported in this Volume as a general principle.

[6.127] Northrop and Sheppard JJ. in Ilbery (1981) 81 A.T.C. 4661 agreed with Toohey J. and added a reason that if the outgoing had been otherwise allowable under s. 51(1) it would have been denied deduction by force of the principle in Ramsay v. I.R.C. [1982] A.C. 300. Ramsay and later United Kingdom cases have worked a significant limitation on the doctrine of form as it applies in the United Kingdom. At its broadest, the limitation directs that one ignore the tax consequences of the legal forms adopted by the taxpayer in a series of transactions, even though those consequences are directed by the statute when the statute is applied severally to each individual transaction. They may be ignored where the individual transactions are aspects of “a closely integrated situation”, and the tax consequences determined by reference to the end result of all the transactions. Ramsay was concerned with a series of transactions involving gains and losses. One of these gains was claimed to be exempt. An individual transaction approach would have left the taxpayer with a tax loss. An overall approach would involve neither gain nor loss. Whatever may have been the appropriateness of the Ramsay approach to the operation of provisions imposing the United Kingdom capital gains tax, it is an approach that should be applied, not as reflecting a distinct principle imported from the United Kingdom authorities, but as the correct approach, in the application of broad principles in the Assessment Act—those principles that make up the notion of income by ordinary usage, and the principles to be drawn from s. 51(1). Stripped of the flourishes which express it in terms of “fiscal nullity”, the Ramsay approach is the approach of Dixon J. in Hallstroms Pty Ltd (1946) 72 C.L.R. 634 at 648: “What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.” The principle in Australian Guarantee Corp. (1984) 84 A.T.C. 4642, it might be noted, reflects a practical and business point of view. To this extent, the rejection of the authority of Ramsay and subsequent cases, in Oakey Abattoir Pty Ltd (1984) 84 A.T.C. 4718 is not significant. The dictum of Dixon J. would justify the analysis adopted by Derrington J. in Alloyweld Pty Ltd (1984) 84 A.T.C. 4328 in holding, in an Ilbery type situation, that the prepayment of interest was, from what he might have described as a “practical and business point of view”, a repayment of part of the money borrowed. Curiously, Alloyweld does not refer to the Federal Court decision in Ilbery.

[6.128] The applicability of an Australian Guarantee Corp. principle to the facts of Ilbery (1981) 81 A.T.C. 4661 is perhaps a remote possibility. It would be assumed that the character of the payment as a relevant and working expense is to be determined at the time an outgoing “arises” in the sense of the word used in [6.125] above. The income character of an item otherwise derived in the circumstances of Arthur Murray (N.S.W.) Pty Ltd (1965) 114 C.L.R. 314 will be judged at the time it arises, though derivation is deferred by the Arthur Murray principle. The deductibility of an outgoing otherwise incurred in the Australian Guarantee circumstances will be judged at the time it arises, though incurring is deferred. The latter proposition may need some qualification to accomodate the possibility that events in the year of incurring may assist a conclusion that the outgoing is relevant, so that an outgoing which could not be shown to be relevant at the time of arising may be shown to be relevant at the time of incurring. The need for such assistance is illustrated by the discussion of the Ilbery circumstances in [6.119] above. Judged at the time of arising, the outgoing in Ilbery was an outgoing to secure an “enduring advantage” and it could not qualify as a working expense. Immunity, complete or partial, from the payment of interest resulting from the payment in advance would extend over 30 years. Whatever assistance the circumstances at the moment of incurring may give on the issue of relevance, they do not assist on the issue of working character. To allow them a bearing on that issue would be to defeat the most fundamental distinction drawn in relation to deductibility, and to set at nought a number of provisions of the Assessment Act, more especially the depreciation provisions in ss 54ff. directed to allowing deductions in respect of certain capital expenses spread over the period of consumption of the benefits arising from those expenses. It is true that no provisions of the Assessment Act will enable the spreading and the allowance of deductions of a capital expense for interest in advance over the period of the borrowing, while the money borrowed continues to be used in a process of income derivation. But this is a deficiency of the Assessment Act common to a number of kinds of capital expenses.

[6.129] B.P. Australia Ltd (1965) 112 C.L.R. 386 is authority that where an asset is acquired that will waste over a relatively short term of use in a process of income derivation, it is proper to treat the expense as an outgoing incurred and allow a deduction forthwith. It may be thought unfortunate that a principle that an expense is not incurred until it is consumed was not established in B.P. Australia. The allowing of an immediate deduction was not questioned in the case. The case is however only authority that an immediate deduction may be allowed when the advantage will endure over a relatively short term. It ought not to be seen as inconsistent with the Australian Guarantee principle.

[6.130] Strick v. Regent Oil Ltd [1966] A.C. 295 is authority that where the asset will waste over a relatively long term, the expense must be seen as securing a “lasting advantage”, in the sense of those words in the formulation of principle by Dixon J. in Sun Newspapers Ltd (1938) 61 C.L.R. 337 at 363, and be denied deduction as capital. Any deduction in respect of the expense must depend on the availability of specific amortisation or depreciation provisions in the Act. There were none such applicable in the circumstances of Strick v. Regent Oil. There are none such applicable in the circumstances of an expense to secure an immunity from an obligation to pay interest.

[6.131] It is implicit in the analysis in the preceding paragraphs that any rule framed in terms of the deductibility of “interest” must always be an unsatisfactory expression of the principles expressed in s. 51(1). The true issues of principle posed by Ilbery (1981) 81 A.T.C. 4661 are simply obscured by any debate as to whether the payment by the taxpayer was correctly described as a payment of interest. Such a debate would only be relevant if, in the circumstances, some specific provisions, for example those relating to withholding tax, attach consequences in terms to a payment of “interest”.

[6.132] If the issue is income quality in the hands of the finance company receiving the payment in the circumstances of Ilbery, the question whether the receipt is interest is equally irrelevant, though it may be relevant if the company is a private company and the issue is the amount of the retention allowable available to that company: the specific provisions of s. 105B, and the definitions of “income from property”, and “income from personal exertion”, are attracted, and the latter definition refers to “interest” in the excluding parts of the definition.

[6.133] Consideration was given in [2.285]-[2.289] above to the questions of whether an amount is income of the lender, if it is the amount of a discount allowed by a borrower who has acknowledged indebtedness of an amount greater than the amount he has received, and whether an amount is income of the lender if he receives a premium on the repayment by the borrower of a loan. The solution to these questions does not depend on whether the discount or premium is “interest”, though again a characterisation as interest may be relevant to the operation of specific provisions such as those imposing withholding tax. The discount or premium could be income as a gain from the carrying on of a business by a person engaged in the business of money lending (Proposition 14), or be income derived from property (Proposition 12), whether or not the person deriving the discount or premium is in business. It is not easy to see how it could be income of the latter kind where it is not received by the person who initially entered into the transaction which gave rise to the loan which is repaid—the initial lender may have sold the debt to the person who receives payment. These matters are further considered in [11.252]-[11.267] below.

[6.134] There are problems of deductibility by the borrower of the amount of discount allowed—in effect the further amount beyond what he received that is payable on repayment—or the amount of the premium paid on repayment. These problems, like those relating to income character, do not depend for their answer on whether the discount or premium is “interest”. The general principle in the case of a borrower who borrows for business purposes, is that the greater amount necessary to discharge a liability on revenue account than the amount received, is a loss incurred in carrying on his business. There may be problems in resolving the issue whether the borrowing is on revenue account, problems explored in [6.322]-[6.330] and [12.192]ff. below in relation to exchange gains and losses. Where the borrowing is not on revenue account or the borrower is an investor who does not have a business, deductibility depends on whether the amount of the discount reflected in the greater amount paid on repayment, or the premium, is a working expense as an expense of servicing or maintaining the borrowing. There is in each case a payment which is an outgoing, and, assuming a use of the money borrowed in a process of income derivation so that the necessary connection with income derivation is established, the payment may be characterised as working, unless it relates to a period of borrowing that amounts to an enduring advantage.

[6.135] If the view is taken that the principle in Australian Guarantee Corp. (1984) 84 A.T.C. 4642 is applicable to a discount allowed, the amount of the discount could be deductible over the period of the borrowing. There would, however, be difficulty where the taxpayer is on a cash basis of returns in relation to the item, if it is insisted that deductibility in the case of a taxpayer on a cash basis requires that there should have been an actual cash outlay. The principle in Australian Guarantee may defer the incurring of an outgoing, it cannot advance the incurring.

[6.136] If the principle in Australian Guarantee is held applicable to a discount allowed, the spreading of the discount over the period of the borrowing should be available to a taxpayer who would in any event be entitled to a loss deduction on discharge of the liability, the liability being on revenue account. Deduction of both the outgoing deduction and the loss deduction is precluded by s. 82.

[6.137] It is a fair comment that the cases on the operation of s. 51(1) in relation to the deductibility of interest leave the interpretation of the subsection in considerable chaos. One thing may be clear: borrowing for the purpose of outlaying the money borrowed in a business or in acquiring property whence assessable income will be derived will not be enough to make interest on the money borrowed deductible. There must be an actual outlay. But the link between the borrowing and the outlay is left largely unexplored. If an objective inference can be drawn that the borrowing was made for the purpose of having money which would be laid out for the purpose of gaining income in some process of income derivation, and money is so laid out, a link—referred to above as a tracing through purposes—is established which may be sufficient. The possibility remains, however, that in addition to a tracing through purposes, a link established by a tracing through a movement of funds is necessary. The cases offer no assistance on the method of tracing through movement of funds that may be necessary. Tracing where moneys are co-mingled in a bank account will require the settling of a rule that may provide for an apportionment, or may adopt the rule in Clayton’s case (1816) 1 Mer. 572; 35 E.R. 781, or, perhaps, a rule of last-in-first-out.

[6.138] There is no indication in the cases that a tracing through a movement of funds is in itself sufficient. We do not know whether interest on moneys borrowed for some private purpose becomes deductible when the moneys borrowed can in fact be traced by movement of funds into an outlay which for the time being is for the purpose of gaining assessable income. It would be generally assumed that interest on moneys borrowed to acquire a house to be used for private purposes, becomes deductible when the private use ceases and the house is let for the purpose of gaining rental income. But there is no judicial statement supporting that assumption. There is a statement, in the judgment of Toohey J. in Ilbery (1981) 81 A.T.C. 4661, that interest on moneys borrowed to acquire a home to be let for the purpose of gaining rental income, ceases to be deductible when the house ceases to be let so that the money is no longer laid out for the purpose of gaining income. And this would accord with the general assumption. But there is no judicial statement that would support another assumption that would be generally made, that interest on moneys borrowed for the purpose of an outlay in a process of income derivation remains deductible if there is a change in outlay which can be traced through a movement of funds, provided the new outlay is for the purpose of gaining income, and this is the case whether or not the new outlay can be said to be within the purpose of the borrowing.

[6.139] What will qualify as an outlay for the purpose of gaining income remains very largely unexplored. Total Holdings (Australia) Pty Ltd (1979) 79 A.T.C. 4279 is authority that a purpose of an indirect gaining of income may be sufficient. Lending by a taxpayer to a company interest free may be an outlay to gain income in the form of dividends on shares held by the taxpayer in the company. The outlay of equipment held on lease by the taxpayer in Marr & Sons (Sales) Ltd (1984) 84 A.T.C. 4580, by allowing its use by subsidiary companies might have been regarded as an outlay for the purpose of gaining income in the form of dividends, so as to justify the deduction of the rental payments made by the taxpayer. It is the gaining of income by the taxpayer that is relevant. An outlay of borrowed money for the purpose of enabling a company with which the taxpayer is associated to gain income, will not in itself make interest paid on the borrowing deductible. Total Holdings is not inconsistent with a conclusion that a purpose of on-lending money to a company in which the taxpayer is a shareholder, or of acquisition of property by a taxpayer with borrowed money, is to obtain a non-income gain that will be derived on a realisation of the shares or of the property acquired, with the consequence that some part of the interest paid on the borrowed money may be denied deduction under s. 51(1). That conclusion is the more likely if the current income from the shares or property is significantly less than the interest paid on the borrowed money.

[6.140] The notion of income in a rule that seeks to express s. 51(1) in terms of an outlay of borrowed money for the purpose of gaining assessable income calls for examination. A taxpayer may borrow money to invest in a superannuation scheme to which Div. 9B of Pt III applies. A purpose to provide money which will be invested by the scheme so that the scheme derives income, is clearly not a purpose that can give deductibility to interest on the money borrowed. The taxpayer may derive income from the scheme on his retirement which is at least in part his assessable income. But the money borrowed is not outlaid for the purpose of gaining income in any sense that will express s. 51(1). The interest paid on the borrowing is a cost of the pension that is income or of the lump sum that is income. In any case the pension received from the fund in any year will be assessable income only in the amount of the balance after the subtraction of the appropriate part of the “undeducted purchase price” under s. 27H ([2.215]ff. above). Unless the unacceptable inference from the words added to s. 25(1) in 1984 is insisted on ([4.5] above), the amount of the pension absorbed by the subtraction, will not be income, and the outlay of the borrowed moneys by investment in the superannuation scheme could be as well said to be for the purpose of gaining this non-income receipt, as it may be said to be for the purpose of gaining the assessable income receipt.

[6.141] Where a taxpayer borrows money to buy an annuity for a fixed term of years, he does not outlay the borrowed money to gain income in the sense of those words in any rule that seeks correctly to express s. 51(1). And the additional argument made in the last paragraph arising out of the operation of s. 27H is equally applicable here. There is another reason why the interest on the borrowed money should not be held deductible over the period of the annuity. A fixed term annuity is, commercially, a return of the amount paid for the annuity, spread over the term, with an element of interest in respect of any amount still awaiting return. It follows that the amount borrowed that remains laid out in the investment in the annuity declines each year. Unless purpose on the initial investment is the only concern of the rule—and there is authority in the judgment of Toohey J. in Ilbery that it is not—the amount of interest that is deductible must decline each year.

Rent

[6.142] The deductibility of rent that relates to property which is used in business, or to property whence income is derived, involves questions which for the most part parallel those raised in regard to interest. In general, the questions are simpler to resolve. Problems of tracing through movement of funds are not raised. The relationship between the payment of rent and the use of the property to produce income will be manifest in most circumstances. In Marr & Sons (Sales) Ltd (1984) 84 A.T.C. 4580 the payments of rent related to leased plant which the taxpayer allowed its subsidiary companies to use in their business operations. One would have thought that, on the authority of Total Holdings, there was an outlay of the plant to produce income, in the form of dividends on the shares in the subsidiaries held by the taxpayer. The Federal Court did not need to reach a conclusion, as it did in fact, that the taxpayer was engaged in a business of leasing plant from others and making it available to its subsidiaries.

[6.143] But some questions are not less difficult of resolution. Where payment of rent is made to an associated person, or where it is paid in circumstances such as South Australian Battery Makers Pty Ltd (1978) 140 C.L.R. 645, the question is raised whether a doctrine of extended form, and a blinkers approach, are applicable. If the property is on-let to another at less than a commercial rent, the questions raised and discussed above in dealing with Ure (1981) 81 A.T.C. 4100 are raised.

[6.144] There are questions as to how any rule of relationship between the payment of rent and the use of the property in a process of income derivation is to be framed. It will be recalled that there are some formulations of a rule in regard to interest that would require that the money should have been borrowed for the purpose of use in the business or in the investment whence income is derived. It would follow that no deduction will be available for rent if a lease is taken of property that is used for a time for private purposes, and thereafter used in a business, or thereafter let to another. And there are questions as to what may follow if a lease of property has been taken for use for business purposes or for on-letting, and thereafter the property ceases to be so used. It would be generally assumed that the rent paid is deductible if it relates to property presently used in a process of income derivation, and that the original purpose in taking the lease under which the rent is paid is irrelevant. The assumption has a bearing on what should ultimately emerge from the cases beginning with Munro (1926) 38 C.L.R. 153 as to the deductibility of interest.

[6.145] The use of the word “rent” in these observations is convenient but the obvious comment must be made that there is no statutory provision by which “rent” is made, in terms, deductible. The governing provision is again s. 51(1) and, granted that the payment is relevant, the deductibility of a payment called “rent” will depend on whether it has a working or maintenance character.

[6.146] Where a payment is made on the obtaining of a lease of property, it will generally be called a “premium”. The Act has dealt, partially, in s. 26AB, with the question of the income character of a premium as defined in the section, received by a lessor or an assignor of a lease, but that section does not deal with deductibility of such a premium. As explained in [2.306]–[2.308] above, the assumption in s. 26AB is that a premium paid, though it relates to property used in a process of income derivation, is not deductible. A premium was denied deduction in the United Kingdom in Strick v. Regent Oil Ltd [1966] A.C. 295 and there is some prospect that a judge-made rule and an extended form approach, will deny deduction generally.

[6.147] The problems in regard to deductibility under s. 51(1) of a premium and of rent in advance, are parallel with those that arise in regard to an advance payment of interest on a debt, problems which have been canvassed earlier in this Volume. If the premium or rent in advance is treated as incurred at the time of payment, it may be regarded as not a working but capital expense. And there is an argument to be made that the outgoing cannot be shown to be relevant to the derivation of income so far as it relates to the use of the property beyond the year of income.

[6.148] If, however, the principle is accepted that an outgoing is not incurred until it is consumed, it is possible to treat a premium or rent in advance as incurred over the period of the lease to which it relates. The principle may assist in the showing of relevance, but it will not assist in overcoming a characterisation of the payment as a capital outgoing, because it gives rise to an enduring advantage.

Rates and repairs

[6.149] The deductibility of rates and repairs that relate to property which is an asset of a business or to property whence income is derived, like the deductibility of rent, involves questions which for the most part parallel those raised in regard to interest. Attention is directed to the discussion of the deductibility of interest and rent.

[6.150] Deductibility of rates and repairs involve special factors. There are specific provisions of the Act, in ss 72 and 53, governing the deductibility of rates and repairs, and there is a question of the effect of those specific provisions on deductibility under s. 51(1). There is a further special factor in regard to repairs. A taxpayer who effects repairs may be the owner of the property or he may have rented the property from another. If he has rented the property from another, there is a question whether the notion of working or maintenance expense may have a scope different from its scope where repairs are effected by an owner.

[6.151] Section 72 allows a deduction of sums for which the taxpayer is personally liable which are paid in Australia by him in the year of income for (a) rates which are annually assessed, or (b) land tax imposed under any law of a State or of a Territory being part of Australia. The deduction is not allowable unless the amount is paid in respect of land that is, or premises that are, used by the taxpayer during the year of income for the purpose of gaining or producing income or carrying on a business for the purpose of gaining or producing income (s. 72(1B)). It will be noted that the words used parallel words in s. 51(1), with the difference that the word income is used unqualified by the word “assessable”. The section would thus appear to allow a deduction notwithstanding that the income gained or produced is exempt income. The section at one time allowed a deduction though there was no gaining or producing of income, assessable or exempt. The section, in this wide operation, had its origin in provisions of the Assessment Act which included an amount in a taxpayer’s income, as imputed income, where he owned land and used it for private purposes. When the provisions in regard to imputed income were repealed the deduction section remained for a period unchanged. In 1973, s. 72 was amended to allow a deduction for rates and land tax in respect of land privately used, only when the amount was paid in respect of land used by the taxpayer during the year of income as his sole or principal residence. Commencing with the 1976 year of income, this deduction was denied and a concessional rebate, under s. 159V, substituted for it.

[6.152] A more important question than the potential application of s. 72 in relation to exempt income, is the scope of the operation of s. 72(1C) where land is used by the taxpayer during the year of income “partly for the purpose of gaining or producing income and partly for another purpose”. In these circumstances “so much only of the amount paid is allowable as a deduction as, in the opinion of the Commissioner, is reasonable in the circumstances”. Where a distinct part of premises is used by the taxpayer in some process of income derivation, and the remainder is used by him for private purposes, s. 72(1C) will clearly be attracted. And it would appear to be attracted where the same premises are used by the taxpayer as a base of business operations and for private purposes or are used for part of the year for letting and for the remainder privately. There will however be a question as to the operation of s. 72(1C) if premises are let to an associated person at less than a commercial rental. In Ure (1981) 81 A.T.C. 4100 the Federal Court, in the application of s. 51(1), allowed a deduction of only a part of interest paid on money borrowed that was in turn lent to associated persons at less than a commercial rate, on the ground that some of the purposes in the on-lending were not purposes to produce income.

[6.153] At the same time the court concluded that the taxpayer was entitled under s. 67 to a deduction of the whole amount of valuation fees and legal costs he had incurred in association with the borrowing, on the ground that he had made only one use of the borrowed money and this was to re-lend it to the associated persons at 1 per cent interest. The notion of use thus adopted by the Court was the subject of some comment in [6.114]–[6.116] above. If the interpretation of s. 67 adopted by the Federal Court is applied to s. 72 where premises have been let to an associated person at less than a commercial rent, it may follow that the whole amount of rates paid in a year will be deductible under s. 72, notwithstanding that the conclusion in Ure as to the deductibility of interest on money borrowed and outlaid in acquiring the premises would require that only a partial deduction would be allowable under s. 51(1). It will be said, on the authority of Ure, that the conditions for the exercise of the discretion given to the Commissioner by s. 72(1C) are not met, and the Commissioner must allow a full deduction under s. 72(1B)(a). Section 82(1) would not appear to assist the Commisisoner to deny the deduction in part by insisting that s. 51(1) is the more appropriate. That section would appear to deal only with circumstances where the same deduction is allowable under more than one section, whether in the same or different years of income, and gives the Commissioner a discretion as to which section is to be taken to allow the deduction. Section 82(1) would not, it is thought, enable the Commissioner to deny a full deduction of an amount deductible under s. 72 by asserting that s. 51(1) is the more appropriate and s. 51(1) will allow a deduction of only part of the amount.

[6.154] In Ure the assumption of all members of the Federal Court was that no part of the valuation fees and legal costs were deductible under s. 51(1). They were not working or maintenance expenses of the borrowing: they were costs of obtaining the borrowed moneys. Section 67 was left to operate, with the curious interpretation given to it by the court, but without any competition from s. 51(1). The majority of the Federal Court thought that s. 67 applied also to the guarantee fees, and that s. 51(1) did not because they were not maintenance expenses. There was therefore no competition between the sections. Brennan J. (dissenting on this point) thought that s. 67 did not apply to the guarantee fees, but s. 51(1) did apply and an apportionment was proper under s. 51(1) that would follow the apportionment of the interest expense. Again there was no competition between the sections.

[6.155] Section 72 and its correlation with s. 51(1) are the subject of further consideration in [10.38]ff. below.

[6.156] Section 53 deals specifically with “expenditure incurred by the taxpayer in the year of income for repairs, not being expenditure of a capital nature, to any premises, or part of premises, plant, machinery, implements, utensils, rolling stock, or articles held, occupied or used by him for the purpose of producing assessable income”. Since 1984, there is an express provision in the section applicable to circumstances where the property is held, occupied or used only partly to produce assessable income. The section has been the subject of extensive judicial interpretation, more closely considered in [10.8]–[10.26] below. The correlation between s. 53 and s. 51(1) has not however been the subject of any judicial decision. The Commissioner is empowered by s. 53(3), where the premises were held, occupied or used by the taxpayer only partly for the purpose of producing assessable income, to allow a deduction of only so much of the repair expenditure as he considers reasonable. There is a question whether the reasoning in Ure referred to in [6.115]–[6.116] will be applicable to deny the Commissioner such power in circumstances where the property has been let to an associated person at less than a commercial rental. If only s. 51(1) governed, he would, on the authority of Ure, be entitled to deny a deduction of some part of the expenditure because there would appear to be more than one purpose in the letting, and some of those purposes are not to derive income. But s. 53, following the Federal Court interpretation of s. 67, would allow a full deduction because there is no “holding” or “use” other than a holding or use to produce assessable income. If the view of s. 82(1) taken above ([6.153]) is followed, that section would not enable the Commissioner to insist on the s. 51(1) consequences against the s. 53 consequences.

[6.157] In the context of repairs, s. 51(1) may have a wider operation than s. 53. It will be seen ([10.8]ff. below) that the word “repairs” in s. 53(1), and the phrase “not being expenditure of a capital nature”, have been interpreted in the cases without drawing any distinction between repairs by an owner of property who uses it to produce income, perhaps by letting it to another, and repairs by a lessee, who may repair in pursuance of a convenant to repair undertaken in his lease. There is no judicial decision that no such distinction should be drawn, though the assumption would appear to be that it should not. Section 51(1) may well admit of such a distinction being drawn, and of a conclusion that repairs which would not be working expenses if carried out by an owner may yet be working expenses if carried out by a lessee. An “improvement”, as that word has been used in the cases involving s. 53, effected to premises, is not a working or maintenance expense if done by an owner. The improvement may involve an accretion to structure in the greater durability of the premises after the repair. But such an improvement may be a working or maintenance expense if done by a lessee in carrying out his obligations under his lease. The expense, looked at in the circumstances of the lessee, merely services the lease. It is no different from rent paid by the lessee. There may be room to say that an improvement is not a working expense, though carried out by a lessee, where the repair involves an improvement in function. The advantage of the improvement will be enjoyed by the lessee for the period of the lease, and it may be seen as involving an accretion to the lessee’s structure. But this reasoning would not be valid where there is an improvement only because of the element of greater durability.

[6.158] Allowing a deduction by the lessee of the cost of improvements, when the like cost if the work had been done by the lessor would not be deductible by the lessor, raises prospects of tax planning suggested by experience with the operation of Div. 4 of Pt III prior to 1964. That Division allowed the lessee deductions in respect of the cost of certain structural improvements and made provision for the inclusion of amounts in the assessable income of the lessor. Tax planning schemes exploited those provisions, more especially where lessor and lessee were associated taxpayers. The schemes relied, in one aspect of them, on a disparity between the greater amount that was allowable to the lessee, and the lesser amount that was included in the assessable income of the lessor.

[6.159] The planning that will be possible if, as is suggested, the lessee may deduct the cost of some improvements under s. 51(1), will exploit the principle in Tennant v. Smith [1892] A.C. 150 discussed in [1.81]–[1.88] and [2.30]–[2.32] above. The realisable value of the improvements which are, it is submitted, income of the lessor as gains derived from property, may be much less than the cost to the lessee. It will be recalled that Tennant v. Smith has been displaced by s. 26(e) in the circumstances of rewards for services. Cooke and Sherden (1980) 80 A.T.C. 4140 has demonstrated the narrowness of s. 26(e) and the need to displace Tennant v. Smith in the context of business gains other than rewards for services. The tax planning now contemplated may indicate the need to displace the Tennant v. Smith principle in the context of gains derived from property.

[6.160] In the context of repairs, s. 51(1) may have a narrower operation than s. 53. Ilbery (1981) 81 A.T.C. 4661 may be taken as authority that the contemporaneity principle, as an aspect of s. 51(1), extends to servicing expenses of property used for the purpose of producing income. The payment of interest in advance was an outgoing incurred before the money borrowed had been invested in an asset producing income. It would follow that an expense for repairs incurred at a time when the property has ceased to be used for the purpose of producing income would not be deductible. No contemporaneity requirement has been read into s. 53, though the words of s. 53(1) do not exclude it. The matter is more closely considered in [10.27]ff. below.

Interest, rent, rates and repairs where there is a charity letting of property

[6.161] Ure (1981) 81 A.T.C. 4100, it will be recalled, broke the grip of the approach in terms of extended form and blinkers which had inhibited any sensible operation for s. 51(1) since Cecil Bros Pty Ltd (1964) 111 C.L.R. 430. Where money borrowed is on-lent at less than a commercial rate, it is possible to find a purpose of the on-lending and, accessorially, a purpose of the payment of interest on the money borrowed which may be a further purpose distinct from that of deriving interest income from the on-lending. It follows from Ure that where money borrowed has been invested in property which is let to another at less than a commercial rent, it is possible to find a purpose in the letting and, accessorially a purpose of the payment of the interest on the money borrowed, which may be a further purpose distinct from that of deriving rent from the letting of the property. It also follows from Ure that a similar analysis may be applied in relation to the purpose of payment of rent in respect of property which is in turn on-let to another at less than a commercial rental. A similar analysis may be applied in relation to the purpose of payment of rates and the costs of repairs in respect of such property.

[6.162] An inference of a further purpose is not necessarily to be drawn. The property may have been already let at less than a current commercial rate at the time it was acquired by the taxpayer, and the taxpayer acquired subject to the existing tenancy. And an inference of a further purpose may not easily be drawn where the actual rent is not significantly less than a commercial rate, at least where the tenant is not an associate of the taxpayer lessor.

[6.163] Where the letting is at a rental significantly less than a commercial rate, and an inference of further purpose is to be drawn, there is a possible conclusion that the apparent purpose to use the money borrowed or the property to which interest, rent, rates or repairs relate, in a process of income derivation is not such as will give an income quality to receipts arising from the use. In Chapter 2, [2.437]ff. above, attention was given to the notion of business in relation to Proposition 14, and to the profit purpose which is an element of that notion. Where the conclusion is that the taxpayer has engaged only in a hobby, proceeds of his hobby will not be income and he will be denied deduction of any costs he has incurred. Though the matter was not pursued in relation to Proposition 12, it is arguable that there is no gain derived from property unless the taxpayer has sought a commercial return from his property. If the inference is that he has merely sought some contribution towards the expenses he must incur in relation to the property, the receipt of the contribution may not be his income, and the expenses he has incurred may not in any part be deductible: Groser (1982) 82 A.T.C. 4478, cf. Kowal (1984) 84 A.T.C. 4001.

[6.164] So far as interest and rent paid are concerned, the end result of this analysis may not be significantly different from the end result of the Ure analysis. It will be recalled that in Ure the amount of interest deductible was limited to the amount of interest received on the on-lending. Where, however, the question concerns the deductibility of expenses in the forms of guarantee fees, legal expenses associated with a borrowing and valuation fees—the other expenses with which Ure was concerned—and s. 67 is otherwise applicable, or where the question concerns rates on and repairs to property and s. 72 or s. 53 is otherwise applicable, the analysis will produce different consequences from those held to follow in Ure. Far from a full deduction being allowable for the fees, rates and repairs, none will be deductible, since the condition of a purpose of gaining or producing income will not be satisfied.

[6.165] Where money is borrowed and applied in acquiring property let at a commercial rate, or expenses are incurred for rent rates or repairs on a property let at a commercial rate, it may not be easy to reach a conclusion that some part of the interest on the money borrowed or some part of the expenses for rent, rates or repairs, was incurred for a purpose other than the derivation of assessable income. An objective inference may in some circumstances be drawn that the taxpayer’s purpose in laying-out the borrowed money in the acquisition of the property, or in the holding of the property on which rent, rates or repair expenses have been paid, was to obtain a gain by realising the property. The circumstances that the interest rent rates and cost of repairs paid exceed the rent received may justify such an objective inference. The fact that current expenses exceed the current return from property is at least a factor which points to a conclusion, within the words of s. 25A(1) (formerly s. 26(a)), that property has been acquired for the purpose of profit-making by sale.

[6.166] Ure has implications for the effectiveness of an income-splitting plan by which a husband owning property already leased will give a concurrent lease—a lease of the reversion—to his wife at a modest rental. The assumption is that he will retain the deductibility of expenses by way of interest, rates and repairs, as outgoings in gaining the modest rental income derived from the property let in the concurrent lease. His wife will be entitled to a deduction of the rent paid to her husband and will derive income in the amount of the commercial rent under the lease first entered into by her husband.

[6.167] The disparity between the rent under the first lease and the rent under the concurrent lease, and the relationship of husband and wife, are enough to support an objective inference that the purpose of the concurrent lease was, at least in part, not the derivation of income by the husband, but to enable the derivation of income by the wife. The husband’s outgoings on interest, and, if the view of ss 72 and 53 taken in this Volume is correct, his outgoings on rates and repairs will be allowable deductions only in part. The outcome of the income-split will be unfavourable: the total tax payable by husband and wife may, indeed, be increased.

Sections 82KJ and 82KL, and Part IVA

[6.168] The possibility of the application of extended form and blinkers approaches in the determination of the purpose of a payment of interest, rent, rates or for repairs, has been adverted to on occasions during the preceding discussion. Ure (1981) 81 A.T.C. 4100 is authority that form and blinkers have no application where the deductibility of interest depends on the purpose reflected in the application of the moneys borrowed. But the possibility cannot be excluded that extended form and blinkers approaches, qualified as they may be by South Australian Battery Makers Pty Ltd (1978) 140 C.L.R. 645, are applicable where it is asserted that the payment of interest, rent, rates or for repairs was not, or was not only, to service the holding of the money or other property involved in a process of income derivation.

[6.169] In none of Munro (1926) 38 C.L.R. 153, Total Holdings (Australia) Pty Ltd (1979) 79 A.T.C. 4279, and Ure, however wide the circumstances that may properly be taken into consideration, could there be any conclusion drawn that the payment of interest had any purpose beyond the servicing of the money borrowed. The addition of facts of the kind that existed in Europa Oil (N.Z.) Ltd v. C.I.R. (N.Z.) (No. 2) (1976) 76 A.T.C. 6001, South Australian Battery Makers or Phillips (1978) 78 A.T.C. 4361 would however raise the possibility of a conclusion of another purpose, and the continuing authority of extended form and blinkers approaches would be fairly posed. The taxpayer in Ure, might, for example, have borrowed from a family trust at a rate of interest in excess of a commercial rate. With effect from dates in 1978 and 1979, ss 82KJ and 82KL may operate to overcome extended form and blinkers approaches, and, to the extent that they do not, Pt IVA (Schemes to Reduce Income Tax) may apply where the scheme was entered into after 27 May 1981 or it is otherwise within the provisions of s. 177D defining the operation of the Part. Sections 82KJ and 82KL are further considered in [10.330]–[10.343] below and Pt IVA in Chapter 16 below.

[6.170] An advance payment of interest of the kind in Ilbery (1981) 81 A.T.C. 4234, 81 A.T.C. 4661, if it were to occur now, would be deductible only if it could escape not only the authority of Ilbery, but also the operation of s. 82KL and Pt IVA.

The Characterisation of Payments of Royalties

[6.171] The discussion that follows concerns royalties in a broad meaning of the word, embracing payments in respect of rights to take something from land or to use land, payments in respect of monopoly rights attaching to items of commercial or industrial property, and payments in respect of the supply of know-how.

[6.172] “Royalties” is defined in the Assessment Act, and the definition is relevant to what may be income by virtue of the specific provisions in s. 26(f). It is also relevant to the operation of s. 6C, which may give an Australian source to items which are royalties within the definition. There is, however, no provision in the Assessment Act which, in terms, makes royalties deductible, whether royalties as defined or royalties in some other usage of the word. The present discussion is concerned with deductibility under s. 51(1). Some mention is also made of possible amortisation deductions under Div. 10 (General Mining) or Div. 10B (Industrial Property) and s. 124J (Timber on land).

[6.173] In [2.309]ff. and [4.114]ff. above attention was given to the question of how far royalties in a broad meaning of the word are income of a person who receives payment of the royalties. An underlying notion that a receipt is income derived from property where it may be said to be a receipt for the use of that property by another, may explain the character of income given to a receipt. At times, however, the quality as a receipt for the use of property by another seems tenuous in an item held to be income. At other times the underlying notion is simply not present and some other quality giving the item its income character must be found. The quality may be periodicity of the receipt.

[6.174] If the notion of receipt-for-the-use were always present and definitive where a royalty is treated as income of a person receiving payment, there might be thought to be room for a principle that a royalty payment that is income of the payee is deductible by the payer, provided it is an expense that is relevant to the derivation of income by the payer. A notion of payment-for-the-use, when present, might be thought to give the character of working expense to a payment. But this will not always be so. A patented process may be used in the construction of plant by a taxpayer who does so under licence and makes a payment therefor. The payment is a cost of the plant and not a working expense.

[6.175] Indeed, the principle is that deductibility of a payment must be judged in the circumstances of payment by the taxpayer who made the payment and claims the deduction. It is irrelevant, in itself, how the issue of deductibility would have been resolved if payment had been made by some other person. And it is in itself irrelevant how the question of income quality of the receipt in the hands of the payee is determined. In B.P. Australia Ltd (1965) 112 C.L.R. 386 the deductibility of the payments was determined without regard to whether the payments would be income in the hands of the payee. It follows that the observations made by Barwick C.J. in Cliffs International Inc. (1979) 142 C.L.R. 140 that the payments made by Cliffs to Howmet and Mt Enid were income in their hands, did not bear directly on the question of deductibility by Cliffs. The matter is considered in [6.22]–[6.26] above.

[6.176] Which is not to say that the circumstances of receipt by another person have no bearing on the character of the payment by the payer. If the circumstances of a receipt give it the character of a receipt for use, it should be seen as a payment for use by the person who claims a deduction of the payment, and may be deductible by him as a working expense.

[6.177] A taxpayer who has been denied a deduction under s. 51(1) in respect of a payment of a royalty, may be entitled to deductions under specific provisions providing for amortisation deductions over the life of wasting assets. Thus a taxpayer who has made payments under a Stanton ((1955) 92 C.L.R. 630) agreement may be denied deduction under s. 51(1), but be entitled to deductions under s. 124J spread over the period during which he fells the timber to which the payments relate. In some circumstances, though presumably not in the actual circumstances of Cliffs International, deductions may be available under Div. 10 (General Mining) of Pt III in respect of payments related to the acquisition of mining rights. Deductions may be available under Div. 10B of Pt III in respect of payments which are “expenditure of a capital nature on the purchase of” an item of commercial or industrial property. Where payments have been made by way of royalty in respect of the use of a patented process in the construction of plant, deductions may be available under the general depreciation provisions of ss 54ff. In all these cases the deductions are spread over the life of the mine, the item of commercial or industrial property or the plant. The denial of deduction under s. 51(1) is only a denial of the earlier deduction that s. 51(1) may have given. Where amortisation or depreciation deductions are not available in the event of the failure of s. 51(1), a court might be the readier to find that s. 51(1) does give a deduction—to find, for example, that payments for know-how are deductible under the section; those payments cannot give rise to amortisation deductions unless the know-how includes patented processes. But the consequence that there will be no deduction at all if s. 51(1) fails, is not so much a mark of the inadequacy of s. 51(1) as a mark of the inadequacy of the amortisation and depreciation provisions of the Assessment Act. The proposition that there must be a gain if an item is to have the character of income (Chapter 2, Proposition 4 above), is asserted only of the individual item of income. Deduction by way of amortisation or depreciation of costs of wasting capital assets employed in a process of income derivation is necessary in all circumstances, if taxable income is to reflect overall gain by a taxpayer in a year of income.

[6.178] It may be helpful to take the situations dealt with in [2.313]ff. above, in connection with the quality of income in the hands of the payee, and consider deductibility by the payer. It will be assumed in the discussion that there is a sufficient connection between the payment and a process of income derivation so that the element of relevance is satisfied, and the issue is therefore whether the payments are outgoings that are working, and thus deductible under s. 51(1), as distinct from capital payments, or, where the payments are outlays in the acquisition of trading stock, deductible by reason of s. 51(2), as distinct from capital payments. Problems may arise in regard to sufficient connection when the use made of the rights to which the payments relate is in part private, or when the payments exceed any commercially acceptable charge and they are made to an associated person. Problems of these kinds have been explored in relation to interest payments and will be further explored in dealing with the question of apportionment of an outgoing so as to deny part of the outgoing ([9.1]-[9.32] below).

Payments in respect of rights inherent in the ownership of land or other rights in relation to land

Payments for use, and payments for trading stock

[6.179] It would be assumed that the payments in a McCauley ((1944) 69 C.L.R. 235) situation in respect of timber taken from land are deductible as working expenses. They are costs of exercising the rights given to the payer by the licence agreement. And they may, in the application of the trading stock provisions, be seen as costs of trading stock and subject, if the timber remains on hand at year end, to what is in effect a deferral of deduction by the operation of s. 28. Payments under a McCauley agreement in respect of blue metal, sand or gravel would be deductible for the same reasons.

[6.180] Deductibility of the payments in a Stanton ((1955) 92 C.L.R. 630) situation is more doubtful. The payments may be deductible by reason of s. 51(2) as costs of trading stock. A number of United Kingdom decisions and one Privy Council decision are relevant: Golden Horse Shoe (New) Ltd v. Thurgood [1934] 1 K.B. 548, Stow Bardolph Gravel Co. Ltd v. Poole [1954] 1 W.L.R. 1503, Hood Barrs v. I.R.C. [1957] 1 W.L.R. 529, Hopwood v. C. N. Spencer Ltd (1964) 42 T.C. 169 and Kauri Timber Co. Ltd v. C. of T. (N.Z.) [1913] A.C. 771. The issue as it appears in these cases is whether the payments are for a source from which the taxpayer may replenish his stock, or for stock which, conveniently, will be held where it stands until it is taken by the taxpayer. If the latter is the correct description the payments will be treated as costs of trading stock, and subject to deferral under s. 28. Factors which point to the conclusion that the payments are costs of trading-stock are:

• (i) the passing of property to the taxpayer in the things—trees, blue metal, sand or gravel—to be taken from the land, if the property passes at the time of the agreement under which the payments are made;
• (ii) a short period within which the taxpayer is obliged or may be expected to remove the things from the land; and
• (iii) the circumstances that the things are “ripe” for taking.

[6.181] In Stanton there is an observation of the court that “in no proper sense could the agreement vest the property in the timber in the purchaser”. If the first factor is essential, the payments in a Stanton situation would not be deductible. The judgment of Buckley J. in Hopwood v. C. N. Spencer rather indicates that the first factor is essential, which would suggest that the drafting of an agreement otherwise on the Stanton model should provide expressly for the passing of property on a notional severance at the time of the agreement.

[6.182] In Hopwood v. C. N. Spencer the expectation of the buyer of the timber was that clearance would take place within 7–10 years. It might be thought that such a period is too long to indicate an acquisition of stock as distinct from a source of stock, more especially when the agreement relates to trees which may continue to mature. The fact that the things to be taken will continue to mature is emphasised in Kauri Timber Co. Ltd v. C. of T. (N.Z.) and Hood Barrs v. I.R.C. as a factor against a conclusion that there is an acquisition of stock. The fact that it was found in Hopwood v. Spencer that the timber was “ripe” for clearance is thus of some significance.

[6.183] There are observations in Hood Barrs which may suggest that the timber acquired should not be more than is necessary to meet “current requirements”. Lord Cohen said (at 539–40): “Like [Lord Sorn in the Court of Session] I see no reason for doubting that under the ordinary contract for purchases of standing timber which a regular timber merchant makes to supply himself with his current requirements, the merchant is not acquiring a capital asset and is entitled to make the appropriate debit in his annual accounts. … In each case it must be, as counsel for the appellant admitted, a question of degree, and …I have no doubt but that in this case, as in Kauri’s case, what the appellant, under the agreements in question, acquired was not goods or stock-in-trade, but an enduring interest in the land and the natural increment of the trees of the nature of a capital asset.”

[6.184] Where the things to be taken from land are not things that “mature” in any sense—such as sand, gravel or blue metal—the third factor is irrelevent. Stow Bardolph Gravel, at least as it is explained by Buckley J. in Hopwood v. Spencer, would indicate that the factor of passing of property determines deductibility. A payment for tailings lying on the surface of land, property in which passes under the agreement, may be deductible as the cost of trading stock as in the Golden Horse Shoe, but a payment for an interest in land involving a right to win gravel or sand, property in which passes only when the right is exercised, cannot be so regarded. It is a payment for a source of stock. In theory, at least, it should be possible to draft an agreement, in other respects on the model of Stanton (1955) 92 C.L.R. 630 that will pass property, at the time of the agreement, in sand or gravel notionally severed from the land. Yet one might wonder why deductibility should depend on some of the more esoteric aspects of property law. The reference to “current requirements” in the passage quoted from the judgment of Lord Cohen in Hood Barrs offers a more appropriate basis of determining deductibility. At least it will be acceptable if the acquisition in excess of current requirements will generate deductions under other principles, or under specific amortisation provisions. The possibility of deductions at the time the taxpayer draws on the source of supply of trading stock is considered in [6.194]ff. below. There is a specific amortisation provision in s. 124J which will allow deductions at the time of taking from a source of supply of timber. The deductions are of so much of the amount paid by the taxpayer to acquire the right to take—a “right to fell standing timber”—as is attributable to the timber felled during the year of income. Where s. 124J is applicable, the question of the consequences under s. 51(1) of a payment under a Stanton agreement in respect of timber becomes less important. Indeed s. 124J may be a code that will displace the operation of s. 51(1). In any event, there will not be substantial differences in effect between a deduction under s. 124J and any deduction under s. 51(1).

[6.185] Where a series of payments are to be made in circumstances otherwise within Stanton but not involving payments of a fixed sum, there may be a case for deductibility. It will be important to know whether the payments are to be made over the whole period during which the payer might take from the land. If they are, there is the more room to assert that the payments are for the trading stock that may be taken from the land during the period to which the payment relates, rather than payments for a source of stock.

[6.186] The fact that a Stanton type payment has been calculated by reference to the anticipated taking from the land ought not increase the prospect of deductibility of the payment as a payment for trading stock. Calculation by reference to anticipated taking does no more than relate the payment to the amount of potential trading stock, and would not dictate a conclusion that the payment was for trading stock as distinct from a source of trading stock.

[6.187] The discussion so far has assumed that the payments are made by a taxpayer who has a non-exclusive licence to enter the land, though he will, generally, have an exclusive right to take from the land. Where the taxpayer has an exclusive licence to enter—a phrase intended to include the situation of a lessee—and to take, his difficulties in establishing that payments are for trading stock may be increased.

[6.188] In a McCauley situation with the added fact of exclusive possession, the characterisation of the payments triggered by taking as payments for use that are working expenses, and may be costs of trading stock, should not be the less appropriate. Where, however, there is a series of payments not triggered by taking, the case the taxpayer might otherwise have made that the payments are working expenses and for stock, at least when the payments are spread over the period of taking, is that much weaker. The conclusion that the payments are for a source of stock may appear to be the more necessary. Exclusiveness of possession of the land whence the timber was to be taken is one basis of distinguishing Kauri Timber from Hopwood v. C. N. Spencer. Where the item that is to be taken is timber, s. 124J may be applicable. Questions of interpretation of s. 124J arise. It is arguable that a taxpayer has not acquired “a right to fell standing timber” when he has acquired a lease that includes a right to fell timber. And it is arguable that he has not acquired “land carrying standing timber”. The argument would be that “land” in this context refers only to the fee simple. If s. 124J does apply, issues as to the relationship between deductibility under that section and under s. 51(1), considered in [6.184] above, will arise.

[6.189] Where there has been an outright disposition of a congeries of rights relating to land—the fee simple in land or a mining lease from the Crown—for a single amount, the prospect that the payer may be entitled to a deduction of what he pays as a cost of trading stock may appear remote. There will, in the case of the sale of the fee simple, be a passing of property in the thing to be taken from the land when property passes in the land itself. But there will be no time limit on the period within which the person acquiring the land may take, and, where trees are to be taken, there will be the prospect of continuing maturation. In the case of mining rights, there will be no passing of property until the thing is taken. This fact and the fact that taking is limited by the period of the mining title are not, presumably, enough to preclude a conclusion that the acquisition of the mining rights is an acquisition of a source of supply of the thing to be mined.

[6.190] Where payments are made that are triggered by the exercise of some of the congeries of rights acquired, the case for deductibility is at its strongest and the scope of the decision in Cliffs International Inc. (1979) 142 C.L.R. 140 is raised. Where the fee simple in land has been acquired, Cliffs International is not directly in point, since the obligation to make payments will be for a set period, and not for the unlimited life of the rights of a fee simple owner. Jacobs J., at least, emphasised the fact that in Cliffs International the obligation to make payments triggered by taking extended over the whole life of the rights acquired.

[6.191] Where the payments made are triggered by the exercise of mining rights, Cliffs International is authority that the payments are deductible, at least when the obligation to make payments extends over the life of the mining rights acquired. They are deductible as expenses of use that are working expenses, which, in an appropriate case may be treated as costs of trading stock acquired as a result of the exercise. It may be doubted that the payments will be held deductible where they extend over a period which is substantially less than the life of the rights acquired.

[6.192] Egerton-Warburton (1934) 51 C.L.R. 568 must be read subject to Colonial Mutual Life Assurance Society Ltd (1953) 89 C.L.R. 428 and both cases must be read subject to Cliffs International. Egerton-Warburton did not involve payments triggered by the exercise of rights. The observations in the case supporting the deductibility of annuity payments that were the consideration for the acquisition of the farming property by the sons from their father could involve a conclusion that payments made in a series for property used in a process of income derivation are deductible. No judgment in Cliffs International would go so far. Colonial Mutual Life denied deduction of payments triggered by the receipt of rents by the payer, though they were not rents from property acquired from the payee. Some property had been acquired from the payee, but the payments were triggered by rents received by the payer from other property owned by him. The property in fact acquired by the payer was a fee simple. The period over which payments were to be made was a term of years. Colonial Mutual Life is not overruled by Cliffs International, though the latter case may be thought to have opened the case to re-examination. Any re-examination, one would think, is unlikely to reach a different conclusion on deductibility on the actual facts of the case. Cliffs International may be seen in correct perspective if matters of legal title to property are not treated as dominant. The legal effect of the transaction and the subsequent liquidation of Basic, was to transfer mining rights, the interest in which could be traced to Howmet and Mt Enid through their ownership of shares in Basic, to Cliffs. The transaction had the effect of a sub-lease of the mining rights at a rental determined by the use made by Cliffs of those rights. The judgment of Barwick C.J. includes an attempt to reconcile such a view of the transaction with an extended form approach which would assert that the payments were for the mining rights, or rather for the shares in the company that had the mining rights: since the shares and, in turn, the mining rights became a capital asset of Cliffs the payments were not deductible. The reconciliation is in the assertion that the description of the payments in the transaction as consideration for the shares was simply a wrong description. It is of course only if some extended form approach is taken that this reasoning becomes, in the circumstances of Cliffs International, reasoning which must be escaped. There is nothing in the words of s. 51(1) which prescribes that expenses which are in law consideration for the acquisition of a capital asset are not deductible. A rule of this kind may be drawn out of judicial pronouncements, and it may be a useful rule so far as it expresses the principles contained in s. 51(1). A frank admission that the rule in the circumstances of Cliffs International is not useful is to be preferred to attempts at reconciliation of the kind offered by Barwick C.J.

[6.193] Had the payments in Cliffs International been required for a period that was substantially less than the mining rights, the appropriate conclusion would have been that the payments were costs of acquiring those rights and not deductible under s. 51(1).

Deduction when the taxpayer draws on a source of supply of trading stock

[6.194] Where the expenses incurred by a taxpayer are denied deduction under s. 51(1) because they are to be regarded as costs of a source of supply of trading stock, there is a question whether a deduction is allowable when items are taken from the source and then become trading stock. There is a principle of United Kingdom income tax law that when an item is held by a taxpayer other than as a revenue asset of a business he carries on, and he thereafter comes to hold it as a revenue asset of his business, he will be taken to have acquired the asset, for purposes of determining income derived in the conduct of his business, at a cost equal to its value at the time the asset became a revenue asset: Sharkey v. Wernher [1956] A.C. 58 and Taylor v. Good [1974] 1 W.L.R. 556 at 558, and cases cited at 559. The principle was accepted as part of Australian income tax law by the High Court in Curran (1974) 131 C.L.R. 409, though the application of the principle in that case is with respect, unacceptable. The asset in that case was acquired in the conduct of the business—it was at no stage held as an asset that was not a revenue asset.

[6.195] The principle would apply to circumstances where a taxpayer has a supply of sand, gravel or the like on his land, and he enters on a business of selling the sand or gravel. He would be entitled to a deduction, as a cost of the trading stock, of the value of the sand or gravel in situ at the time of the taking.

[6.196] Where the taxpayer may be said to have committed the land to the business of selling the sand or gravel, the principle would require that the deduction as the cost of the sand or gravel taken should be its value in situ at the time the land was committed to the business.

[6.197] The principle would operate in the same manner where the item taken from the property is timber. In that case a conclusion should the more readily be reached that the land has become committed to a business of selling the timber, or, it might be better expressed, to a business of growing and selling the timber, so that the cost on taking will be the value of the timber in situ at the time of the commitment.

[6.198] It is a short step from the principle in these applications to a principle that where a taxpayer acquires land as a source of supply of trading stock, be it sand, gravel, timber or other item, he should be entitled to a deduction, on the taking, of such part of the cost of acquisition of the land as relates to the trading stock taken. It is unfortunate that authority may stand in the way of that short step. The United Kingdom cases are not necessarily an obstruction. At least in Hood Barrs v. I.R.C. [1957] 1 W.L.R. 529, the possible application of the principle in Sharkey v. Wernher is left open. Lord Morton said (at 538): “Counsel for the appellant sought to put forward an alternative argument, in the event of his main contention being rejected. The argument was that the appellant would be entitled to deduct, in his trading accounts, for each year in which he exercised his right to cut down trees and made the resulting timber available for use in his business, a sum equal to the market value of that timber at the date when it was so made available. In support of this argument he cited the cases of Craddock v. Zevo Finance Co., Ltd 27 T.C. 267 at 279; Commissioners of Inland Revenue v. Williamson Brothers 31 T.C. 370; and Sharkey v. Wernher [1956] A.C. 58 at 73, 83-84. I am of opinion that this question did not arise under the case stated. … Consequently, I express no opinion on it.” The possibility of a deduction arising at the time of taking is thus not excluded. White (1968) 120 C.L.R. 191 may however be thought to be an obstruction. Indeed it may be thought to be an obstruction to the application of the principle where land becomes committed to the business of selling timber after its acquisition.

[6.199] In the case of timber, s. 124J may to a degree redress any failure of principles of deductibility under s. 51(1), but s. 124J is limited in its application. It applies only in relation to timber. It did not apply to timber in White because of the manner in which the timber was sold—through Stanton-type agreements. And when the provision does apply it applies in a most inappropriate way. The deduction allowed is the cost of the timber in the acquisition of the right to fell or in the acquisition of the land, which is only appropriate when the timber is committed to a business of selling timber at the time of the acquisition of the right to fell or the acquisition of the land. There are questions as to the relationship of s. 124J and s. 51(1) raised in [6.184] above.

Payments in respect of commercial or industrial property

[6.200] The discussion in [6.179]–[6.199] above relating to payments in respect of rights in land and rights in relation to land, has canvassed issues of a kind that arise also in regard to payments in respect of commercial and industrial property. A payment under a non-exclusive licence triggered by the licensee’s action under the licence will generally be deductible as a payment for use that is a working expense and may be a cost of trading stock. The payment will not be deductible if there is no process of income derivation with which the payment is connected, or where the action of the licensee, for example under a patent licence, relates to the construction of a capital asset. Where it relates to the construction of plant, the payment may be a cost of plant and subject to depreciation deductions under the provisions of ss 54ff.

[6.201] Where there is a series of payments under a non-exclusive licence, though not triggered by use, the payments are likely to be regarded as payments for an asset, being the right to use the item of commercial or industrial property, and not a working expense or expenses of acquiring trading stock by manufacture in the exercise of the licence. A payment for the right to use may be deductible under the specific amortisation provisions of Div. 10B of Pt III. The fact that the payments are income in the hands of the payee as receipts for use—Rustproof Metal Window Co. Ltd v. I.R.C. [1947] 2 All E.R. 454 supports a view that they are—does not determine deductibility by the payer, but has some bearing on the issue.

[6.202] A single payment for a non-exclusive licence, though income in the hands of the payee, is probably not deductible under s. 51. It is a payment for the acquisition of the right to use the item of property and may give rise to amortisation deductions under Div. 10B. The fact that the amount of the payment has been determined by reference to an estimate of the extent of anticipated use does not, it is submitted, affect its character.

[6.203] Where payments are made under an agreement providing for an exclusive licence the payments are the more likely to be held to be for the right to use and not deductible under s. 51(1), though there may be amortisation deductions under Div. 10B of Pt III. A single payment and a series of payments will, it is thought, be so regarded. The fact that a series of payments may be income in the hands of the payee, on the authority of I.R.C. v. British Salmson Aero Engines [1938] 2 K.B. 482, does not determine deductibility by the payer. The fact that the amount of the payment or the series of payments has been determined by reference to an estimate of the extent of anticipated use does not, it is submitted, affect its character. Payments that are triggered by the exercise of rights under an exclusive licence may be different. Treating a payment made on the exercise, and because of the exercise, of rights under an exclusive licence as a working expense, and, where appropriate, a cost of stock, rather than as a cost of acquiring the licence, may be supported by Cliffs International Inc. (1979) 142 C.L.R. 140, at least where the payments are to be made during the whole period of the exclusive licence.

[6.204] Payments in respect of the acquisition of the whole congeries of monopoly rights given by an item of commercial or industrial property are the most likely to be denied deduction under s. 51, though amortisation deductions may be available under Div. 10B of Pt III. The fact that the amount of the payment or series of payments has been calculated by reference to an estimate of the extent of anticipated use does not, it is submitted, affect its character. Again payments triggered by the exercise of the rights acquired may be different. Deductibility will depend on the scope of the authority accorded to the decision in Cliffs International.

[6.205] Deductions under s. 51(1), on the authority of Cliffs International, may be available where the alternative of Div. 10B of Pt III could not be available. Where the item of property is acquired by acquiring shares and liquidating the company, a form approach applied to the words of Div. 10B will defeat the taxpayer. He has not incurred “expenditure on the purchase of the unit of industrial property” (s. 124L(1)(b)). And it may be doubted that Div. 10B is applicable to allow deductions where the person who has acquired a unit of property derives income by licensing another to use the unit of property.

Payments in respect of the acquisition of know-how

[6.206] The deductibility under s. 51(1) of a payment for know-how triggered by the use of that know-how again raises the question of the scope of the authority to be accorded to the decision in Cliffs International. Deduction is doubtful if the payments do not extend substantially over the life of the know-how, though “life” in this context will involve some judgment.

[6.207] If deductions are allowed under s. 51 of payments which, though triggered by use, do not extend over the life of the know-how, the prospect is opened of deductions under the section of expenses which are, in effect, costs of a capital asset.

[6.208] There are no specific provisions of the Act allowing amortisation deductions of the cost of know-how, unless the know-how is the subject of monopoly rights as an item of industrial property, in which case Div. 10B is applicable. The availability of deductions under s. 51(1) is so much the more important to the taxpayer.

[6.209] Know-how, it is assumed, is a capital asset, though there may be circumstances in which the taxpayer deals in information, in which event the cost of know-how may be deductible as a cost of trading stock, or it may be subtractable in determining a profit on sale of the information by the taxpayer who has acquired it, if know-how is not within the trading stock provisions.

The Characterisation of Premiums Paid on Policies of Insurance

[6.210] In Chapter 2, [2.523]ff. above, attention was given to the question of the income character of receipts under policies of insurance. A receipt will be income if its function is to substitute for a revenue asset, for income that would have been derived if the event insured against had not occurred, or for a loss or outgoing on revenue account. The purpose of the insurance bears on the determination of the function of the receipt, and purpose, in this regard, is a conclusion from evidence of subjective purpose and objective inference of purpose.

[6.211] There is some correlation between the income character of a receipt under a policy of insurance and the deductibility of a premium paid on that policy, but there is no necessary correlation. So far as deductibility of a premium depends on purpose, it is the purpose of the payment of the premium that is relevant. The purpose of the policy may give to the purpose of the payment of premium the quality of relevance to the derivation of assessable income. But there may be a purpose in the payment of the premium which will deny the payment a working character. The payment may be a single amount paid for cover for a number of years. Or the payment may be payment in advance of premiums that would otherwise have been paid over a number of years. The payment may thus be directed to the securing of a “lasting advantage”, and be a capital outgoing. The discussion in [6.117]ff. above of Ilbery (1981) 81 A.T.C. 4234, 81 A.T.C. 4661, concerned with the payment of interest in advance, is relevant.

[6.212] A payment of a premium so as to secure a lasting advantage is one illustration of circumstances where a premium is not deductible though it is relevant to some process of derivation of income. There is another. A premium paid on a policy of insurance will not be deductible if the premium was paid, not to maintain the business against the cost of an outgoing, but to ensure that there would be funds to meet that outgoing. The distinction may, at first sight, appear to be verbal only. But it has the support of the Federal Court in Ransburg Australia Pty Ltd (1980) 80 A.T.C. 4114. The principle that is sought to be expressed will distinguish a payment to maintain the business by providing funds to meet an expense which is a misfortune, from a payment to provide funds to meet an expense arising from an event which is a normal experience in conducting the business. The premium paid on the policy in Carapark Holdings Ltd (1967) 115 C.L.R. 653 affords an illustration of a payment to maintain the business: the premium ensured that funds would be available to meet expenses made necessary by the death in an air accident of one of the employees of the taxpayer’s subsidiary. Those expenses are not ordinary expenses of carrying on business but were expenses of an extra-ordinary kind, against which the business might want protection. The premium paid in Ransburg is an illustration of a payment made to ensure that there would be funds to meet an outgoing—an outgoing in a long-service leave payment—which was a normal experience in conducting the business. The premium paid in Ransburg was not a maintenance payment. It was paid for the advantages, not of enjoying protection against the misfortune of an event and thus the maintenance of the business against that event, but of having funds available to meet an ordinary expense in carrying on the business.

[6.213] The principle expressed in the last paragraph suggests a lack of correlation between the character of the payment of a premium and the character of a receipt under the insurance policy, where the premium is paid to ensure that money will be received to meet a normal business expense. There will however be a correlation if the receipt is held not to be income. We have been asked to accept one qualification on the compensation receipt principle: the principle does not apply to a refund of an amount that is an allowable deduction. Another qualification, applicable to an amount received in the event of the incurring of an ordinary business expense, might insist that an amount is not received by way of compensation—it does not substitute for an expense—if the receipt serves the same function as the return to the taxpayer of moneys left with another to be returned on the incurring of the business expense. It is only if some rule in regard to insurance receipts is adopted, and an extended form approach applied in the operation of the rule, that there is any difficulty in the way of recognising the qualification. There is an evident distinction in commercial significance between the receipt under the insurance policy in Carapark, and the receipt under the insurance policy in Ransburg. A commercial distinction is recognised in regard to the payment of the premium, by the decision in Ransburg that the premium was not deductible, when, at least in the view of this Volume the premium in Carapark was deductible.

[6.214] A policy of insurance providing for the payment of an annuity is another illustration of circumstances where there is a want of correlation between the income character of a receipt under a policy of insurance and the deductibility of the premium. The receipts of the annuity are income to the extent explored in [2.175]ff. and [2.215]ff. in Chapter 2 above. The premiums are not deductible, though they may be subtractable under the specific provisions of s. 27H, in determining how much of the annuity receipts are income. The assumption in these statements is that the receipts are income only because of their character as an annuity. If the policy may be seen as a policy to provide compensation for the loss of income flows, as it was in D. P. Smith (1981) 147 C.L.R. 578, different consequences may follow, both in regard to the income quality of receipts and the deductibility of the premium. The matter is more closely considered below in dealing with D. P. Smith ([6.226]–[6.229]).

[6.215] Want of correlation between income character and deductibility will arise if a deduction of the premium is allowed, while a receipt under the policy is not income. It would be generally assumed that premiums for insurance against fire of property used in a business or of property whence income is derived, are deductible, though it is not suggested that, unless by the operation of specific provisions, a lump sum receipt under the policy is income. The premium is deductible as an expense relevant to the derivation of income, that is a working expense because its function is to maintain the property employed in the process of income derivation. It’s function is parallel with the function of a payment of rates on property used in a process of income derivation.

[6.216] It may be helpful to focus the discussion on each of a number of classes of insurance policies.

Premiums for insurance of property against damage by fire or other misfortune

[6.217] A premium for annual cover is deductible if the property is used ]used, questions of apportionment so as to deny a full deduction are raised. The discussion in [6.81]-[6.170] above in regard to interest, rent, rates and repairs, is relevant.

[6.218] If the premium is paid for cover for a term of years, or if premiums for a number of years are paid in advance, the payments may be denied deduction on the ground that they are not working expenses. Where the payments relate to a relatively short period of years, they may be deductible. There is some room for a development in principle whereby the deduction in the year of payment will be confined to an amount that is referable to cover in that year, and the balance of the payment will be deductible as it is consumed in cover afforded in subsequent years. The discussion in [6.125] above in relation to Ilbery, is relevant.

[6.219] Deductibility of the premium is not affected by the fact that receipts under the policy will not be income. A receipt under the policy will be income if its function is compensation for the income lost as a result of the insured event. A receipt will not be income if its function is to compensate for the loss of the value of the property itself, unless the property is trading stock or other revenue asset. But the premium will be deductible if its purpose is to maintain the investment in the business that the property represents, or in the property whence income is derived, against misfortune. It will have that purpose, whether the function of a receipt under the policy is to substitute for the value of property lost by the insured event, or the loss of income flows arising from that event, or both of these. The notion of maintaining the investment includes maintaining the process of derivation of income inherent in that investment. The assumption in these observations is that the policy of insurance is a contract of indemnity. A premium on a policy which provides for an agreed amount that may exceed an indemnity, may fail the requirement of relevance, and, if it does not, may yet fail the requirement that it must be a working expense. The premium may be seen as an investment, like the premium in Ransburg.

Premiums for insurance against loss of income arising from some misfortune, other than physical injury to the taxpayer’s person

[6.220] It follows from the discussion under the last heading that premiums for cover against loss of income arising from some misfortune are deductible. One matter may require further emphasis. Deductibility of the premium does not depend on receipts under the policy being income. It is the factor of maintaining the investment that gives deductibility to the premium. There is a tendency to read the word “producing” in the phrase “in gaining or producing” in s. 51(1), in a way that would make it a test of deductibility that some income can be traced to the outgoing. It is evident in the “direct effect on income” test of deductibility of an employee’s outgoings, for which Hatchett (1971) 125 C.L.R. 494 is regarded as authority. Tracing in that context may be helpful as a demonstration of relevance of the expense. But it is not helpful in the present context, where the question is whether the expense is a working as distinct from a capital expense.

[6.221] If tracing is adopted as a test of working character, it may yield a conclusion that the premium on a policy for an annuity is a working expense, and that would be an unacceptable conclusion. The income to which an outgoing must be relevant, and in regard to which it must have a working character, is the income to which the income earning operations or the investment are directed. Premiums on policies now being considered are relevant and working because they maintain the business operations or the process of deriving income from property, not because receipts under the policies are income under the compensation principle.

[6.222] There are suggestions in D. P. Smith (1981) 147 C.L.R. 578, considered in [6.272]-[6.229] below, that the income character of receipts under the policy bore on deductibility in that case. A conclusion that the receipts would be income depended on a conclusion that their function was to substitute for income flows and, in turn, on a conclusion that the purpose of the policy was to maintain those income flows against the insured event.

[6.223] But this legitimate bearing on deductibility is different from a bearing of the kind that would assert that, because the receipts under the policy are income and were “produced” in some sense by the premiums, the premiums are deductible. That kind of bearing seems to be suggested in the judgment of Murphy J. in the observations (at 587):

The observation, in the passage quoted, on the appropriate treatment of premiums on a policy for the payment of an annuity on the happening of a contingency, may indicate the difficulty with any analysis that looks to what was produced. Premiums on a policy for an annuity will not be deductible where the contingency does not involve the loss of income flows, because they are not relevant to the derivation of income. To say that they are not deductible because they are directed to producing a capital asset is not helpful. The right to the receipts after the happening of the contingency in D. P. Smith is as much a capital asset as the right to an annuity.

Premiums for insurance against physical injury to the taxpayer’s person

[6.224] Where the function of a receipt under the policy is to provide an amount that will serve as a solatium and compensation for the loss of earning capacity resulting from the physical injury, the receipt will not be income. So far as the receipt will be a solatium, there is no basis on which it might be held to be income. So far as the receipt will be compensation for loss of earning capacity, it will be a substitute for an asset that is not an asset of any business or employment, nor is it an asset whence income is derived. It is irrelevant that the taxpayer may be engaged in a business operation or be in employment.

[6.225] A premium paid on a policy which provides for such a receipt is not deductible under s. 51(1). It fails the requirement of relevance. It is true that a premium on a policy of insurance against fire, which provides for the payment of a single sum which will substitute for the value of the property lost, is deductible as a relevant and working expense where the property is an asset of a business, or is property whence income is derived. But bodily integrity of a taxpayer cannot be equated with plant in a factory. A premium for insurance of plant against loss by misfortune is an expense of maintaining the investment in the plant, and is deductible for this reason. A receipt under the policy will enable the restoration of the investment. A premium for insurance of the bodily integrity of a taxpayer does not admit of such descriptions. The premium paid is an irrelevant expense for the same reason that, generally, medical expenses which are directed to maintaining or restoring bodily integrity are not deductible. They are not relevant, and may be described as personal outgoings. It is true that there is a connection with the derivation of income, but it is an even more remote connection than that held insufficient in Lunney (1958) 100 C.L.R. 478—concerned with the deductibility of fares to and from work.

[6.226] Where the function of a receipt under a policy of insurance against bodily injury to the taxpayer is to substitute for income flows that would have been derived, different conclusions are open as to both the income character of a receipt, and to the deductibility of the premium. A finding that the function of a receipt is to substitute for the loss of income flows, and is income under the compensation receipts principle, is the more likely if it is one of a number of receipts for which the policy provides, and if the right to a receipt depends on some showing of loss. If this is the function of receipts under the policy, deductibility of premiums paid may be supported by regarding them as payments to maintain income flows from a process of income derivation. This would appear to be the basis of the conclusion in D. P. Smith (1981) 147 C.L.R. 578 that the premiums were deductible, though the judgment of Murphy J. expressed other reasoning that would make deductibility depend on the “production” of actual receipts which are income ([6.223] above). There is some suggestion of that kind of reasoning in the judgment of the majority (at 586):

The suggestion is, however, neutralised by the earlier statement of general principle (at 586): “

As a matter of administrative feasibility, deductibility of a premium could not be made to depend on the generation of receipts under the policy. But in the present context, it seems that while they are theoretically separate issues, deductibility of the premium and income character of any receipts that may arise under the policy are practically inseparable issues. A policy might provide for commutation of a series of receipts whose function is to substitute for income flows. It might be said that in this instance the function of the payment of premiums may remain the maintaining of income flows, though a receipt under the policy will not be income, the assertion being that a receipt in commutation of receipts that would be substitutes for income flows is not income. But the assertion that the commutation receipt would not be income would be unfounded. Apart from the possible operation of the eligible termination payment provisions of Subdiv. AA of Div. 2 of Pt III, considered in this respect in [2.214] above, which would depend on a finding that the receipts commuted would have been an annuity, there is ground for treating the commutation receipt as income. The commutation receipt has the character that the receipts commuted had. The periodicity of those receipts was only an indication of that character. It was not essential to that character.

[6.227] A finding that the function of a receipt under the policy is to compensate for the loss of income flows is the more likely if the policy requires some showing of loss as a condition of a right to a receipt, and if compensation from other sources affects the amount of any compensation under the policy. A conclusion that the function of the receipt was to compensate for the loss of income flows was reached in D. P. Smith (at 584):

The monthly payments were payable, after a waiting period of 30 days, while the insured was unable to perform “each and every gainful occupation for which he [was] reasonably suited …”. Actual loss of income did not have to be shown. The taxpayer in fact received sick pay from his employer for a period, and there was no provision for reduction of the payments by reference to such amounts. On the other hand, during the first two years of disability, he was entitled to payments only if he did not engage “in any occupation or employment for wage or profit”, and there was provision for reduction of payments by any amounts paid to the taxpayer under worker’s compensation legislation.

[6.228] The finding as to the function of the receipts in D. P. Smith did not depend on any precise correlation between the receipts and pecuniary loss. “It is not necessary”, it was said in the principal judgment (at 583), “to look for an indemnity measured with any precision against the loss”. Where there is no correlation between a series of receipts and pecuniary loss, the conclusion may be that the function of the payment is to provide an annuity. In which event the receipts will be income, but the premiums will not be deductible, though they may be subtractable under s. 27H. Where the policy provides for a single amount payable by reference to the nature of the injuries, and not to some continuing disability, the function of a receipt is the more likely to be found to be solatium and, perhaps, compensation for loss of earning capacity. In some cases, the policy may provide for payment of a single amount, and for periodical amounts related to disability. The prospect is then opened that the single amount will not be income, while the other receipts are income. Deductibility of premiums under such a policy may raise a problem of apportionment considered below in Chapter 9.

[6.229] The taxpayer in D. P. Smith was an employee. It is significant that the Full High Court allowed a deduction of the premiums, notwithstanding that there was no express or implied term in his contract with the hospital that employed him, that he would take out a personal disability insurance policy. The premium expenses were incurred in his discretion. There is an assumption reflected, possibly, in the judgment of Rogers J. in Adler (1981) 81 A.T.C. 4687, that an employee’s expenses will not be held to be relevant to the earning of his employment income unless there is an express or implied term in his contract of service that he will incur the expenses, or the expense will have a direct effect on income from the employment. The decision in D. P. Smith that the payment of premiums were deductible outgoings is a rejection of that assumption. At least in the principal judgment, the view was that the income to which the premiums were relevant was the employment income, not the receipts under the policy. There was nothing, express or implied, in the employee’s contract that required him to make the payments, nor could it be said that the payments of premiums had a direct effect on his employment income. The matter of relevance of an employee’s expenses to the derivation of his employment income is considered below in [8.41]-[8.48].

Premiums for insurance on the life of the taxpayer or of another person, or for insurance against bodily injury suffered by another

[6.230] A premium paid by the taxpayer for insurance on his own life, whether the cover is annual or whole of life, is not deductible. The reasons are extensions of the reasons given under the last heading in relation to a policy providing for payment of a single amount in the event of the suffering of bodily injury. The reasons are the more compelling where the insurance is on the life of the taxpayer, and not simply against impairment of his bodily integrity.

[6.231] Where the policy includes a provision for what will be described as an annuity, on attaining a specified age, an argument might be made that the premiums are deductible. The argument would be that they are paid to maintain the income flows that are likely to be lost by retirement. A similar argument, perhaps with greater force, might be made where the issue is the deductibility of contributions made to a superannuation scheme which provides for a pension on retirement. The notion of maintenance in any such argument is clearly different from the notion identified by the word in earlier discussions in this chapter. The payments of premium or contributions are made in the purchase of the annuity or pension. They are not relevant to present income flows by ensuring that substitutes for them will be continued if they cease as a result of misfortune. They are paid for new income flows, which may commence on the relinquishment of present flows. The factor of indemnity against loss, granted that it need not be precise, is simply not present as it was in D. P. Smith (1981) 147 C.L.R. 578.

[6.232] The deductibility of premiums on a policy on the life of another, or against bodily injury suffered by another, raises different issues. The principles established in Carapark Holdings Ltd (1967) 115 C.L.R. 653 in relation to the income character of amounts received under an annual policy on the life of another are equally applicable to amounts received under a policy providing for amounts to be paid to the insured in the event of bodily injury to another. The deceased was the employee of a company that was a subsidiary of the taxpayer. The function of the receipt under the policy, as the court found, was to substitute for dividend income that would not flow from the subsidiary if the subsidiary’s profit suffered as a result of the loss of an employee. Alternatively, it was to provide the funds to meet revenue expenses that would be incurred in showing generosity to the relatives of the deceased employee. Carapark did not involve deductibility of the premiums. They would be deductible as payments to maintain the flow of income from the subsidiary, or to maintain the taxpayer’s investment in its own business against the need to incur expenses arising from the insured event.

[6.233] In Carapark the receipt under the policy was a single amount, which may have suggested that the receipt substituted for some part of the value of the taxpayer’s investment in its subsidiary—the value dependent on the continued availability of the deceased’s services to the subsidiary—though it would not have weakened the inference that the receipt was to provide funds to meet revenue expenses. A view that the receipt substituted for some part of the taxpayer’s investment would have required a conclusion that the receipt under the policy was not income, though it would not have required a conclusion that the premiums were not deductible: the premiums would remain deductible as payments to maintain the property whence income was derived.

[6.234] Premiums on a whole of life policy on the life of another may be regarded differently from premiums on annual policies. The function of a receipt under such a policy may in some circumstances appear to be the same as in Carapark, and the receipt income, but the fact that the cover may extend beyond the period when the taxpayer has any business interest in the survival of the person whose life is insured may tell against a Carapark finding of function. Where the taxpayer has in fact ceased, at the time of death, to have any business interest in the survival, the receipt will be simply the return of an investment. It may be that it should be so regarded whenever the receipt occurs. Whatever the conclusion on income character of a receipt, the premiums are likely to be denied deduction, if not on the ground that they are irrelevant, then, as in Ransburg (1980) 80 A.T.C. 4114, on the ground that they are not working expenses.

Premiums for insurance that will indemnify the taxpayer against expenses

[6.235] There is a distinction to be drawn between insurance to provide funds to meet expenses that have to be incurred because of misfortune, and insurance to provide funds to meet ordinary business expenses. The former covers the insurance in Carapark Holdings Ltd (1967) 115 C.L.R. 653, the latter the insurance in Ransburg Aust. Pty Ltd (1980) 80 A.T.C. 4114.

[6.236] Carapark decided only the question of income character of the receipts. The formulation, in this case, of a rule for this purpose may be too wide. A general statement that a receipt whose function is to substitute for a loss or outgoing on revenue account, may involve a conclusion in the facts of Ransburg that the receipts under the policy are income. Such a conclusion would equate the treatment of Ransburg insurance with the purchase of an annuity, with the difference that the payments of premium, not deductible in either case, may in the case of the purchase of an annuity attract the tax relief given by s. 27H. It is assumed that receipts under a series of Ransburg insurance policies are not an annuity within the meaning of that word in s. 27H.

[6.237] A conclusion that receipts under a Ransburg insurance policy are income will not be drawn if any rule in Carapark which would lead to that conclusion is reframed, in a manner suggested in [6.213] above.

[6.238] Where premiums are paid for insurance that will provide funds to meet expenses that have to be incurred because of misfortune, the premiums will be deductible. Where the premiums are paid for insurance that will provide funds to meet ordinary business expenses, they will not be deductible. Where the function of receipts under the policy is to save the investment in the business, or other process of income derivation, harmless against expenses arising from misfortune, the premiums may fairly be seen as maintenance expenses. Where the issue is deductibility of the premiums, it does not matter whether the expense arising from misfortune is a working or a capital expense. Where the function of the receipts under the policy is to provide funds to meet ordinary business expenses or other ordinary expenses of income derivation, whether working or capital, the premiums will not be deductible.

[6.239] The distinction between expenses arising from misfortune and ordinary expenses, while manifest in the distinction between the Carapark expenses (the result of the death by accident of an executive) and the Ransburg expenses (expenses of long service leave payments to employees) may not always be easily drawn. Inevitably there will be circumstances in a marginal area. If the insurance in Ransburg had related to long service leave rights which were not yet fully vested in the employee, expenses would not have been so obviously different from the Carapark expenses.

[6.240] In Adler (1981) 81 A.T.C. 4687 the only question raised was relevance. Expressed in terms of the distinction drawn in previous paragraphs, it was assumed that the expenses to which the insurance related were expenses arising from misfortune—“loss” which the taxpayer “shall have been obliged by law to pay” as a result of a claim made against him, as a director of several companies, “for a wrongful act”. It might be asked how premiums paid by a newspaper proprietor on a policy giving indemnity against liability for defamation are to be regarded? The distinction between expenses arising from misfortune and expenses which are ordinary business expenses, even if judicially endorsed, should not become part of a rule which will attract an extended form approach. In some industries “misfortunes” are an ordinary business experience, and the distinction drawn is not helpful. The principle expressed in the decision in Ransburg will require some other formulation of a rule, perhaps in terms of likelihood of the insured event. Such a rule would need to be expressed in terms of degree. Ransburg cannot be explained in terms of certainty that the experience of making long service leave payments would be incurred. The taxpayer might have sold the business to another, in which event liability to make long service leave payments would pass to that other.

[6.241] The decision in Adler on the issue of relevance may reflect an assumption, referred to in [6.229] above, that a more stringent test is required by s. 51(1) to determine the relevance of an expense when the income with which it is connected is employment income. Rogers J. simply adopted the view of the Board of Review that only the second limb of s. 51(1) would support deductibility of the premiums paid, so that the taxpayer’s success depended on his showing that he was carrying on the business of a company director. The assumption would seem to be that the premiums could not be relevant to employment income unless that income could also be described as business income. It will be indeed strange if a premium on a policy such as in Adler is not deductible by an executive director who has only one office as director, unless it is a term of his contract of employment that he should take out the insurance.

The Characterisation of Payments arising from the Giving of a Guarantee

[6.242] Ransburg Aust. Pty Ltd (1980) 80 A.T.C. 4114, considered above in relation to the deductibility of insurance premiums, is authority, if authority is necessary, for a principle that a payment to another of an amount on terms that the other will return that amount is not deductible. The payment is an outlay, not an outgoing. The outlay may give rise to a loss deduction if there is a failure to repay. A moneylender, it will be seen, is entitled to a loss deduction if a loan he has made in the course of his business is not repaid: the loss is relevant and working. A payment to a company by way of a subscription for shares is an outlay that may give rise to a loss deduction if the company goes into liquidation and is unable to return the capital subscribed: deductibility of the loss will depend on whether the shares are revenue assets of the taxpayer who has subscribed for them.

[6.243] The treatment of a payment under a guarantee expresses the same principle. The payment is not an outgoing, since there is a right to repayment arising from subrogation to the rights of the creditor who has received payment from the taxpayer-guarantor. A failure by the debtor to pay the taxpayer may give the taxpayer a loss deduction. There will be a loss deduction if the giving of the guarantee is an act done in carrying on a business, so that the rights resulting from subrogation are revenue assets of that business: the loss is thus relevant and working.

[6.244] Where it is apparent at the time of payment under the guarantee that the rights resulting from subrogation are worthless—the debtor may be a company that has already been liquidated—there is an immediate deduction available to the guarantor, if the giving of the guarantee was an act done in carrying on the business. In these circumstances distinguishing an outgoing from a loss is not significant.

[6.245] Where the giving of the guarantee relates to an investment by another in an entity in which the taxpayer-guarantor is interested, whether the investment is a loan to the entity or the allowing of credit in some transaction with the entity, the character of the guarantee and of a payment under the guarantee will reflect the character that an investment by the taxpayer himself would have had. If a direct investment would have been the acquisition of a revenue asset, a payment under the guarantee will be seen as the acquisition of a revenue asset, with the prospect of a loss deduction if the rights of subrogation fail to realise the amount of the payment. The circumstances in which a direct investment will involve the acquisition of a revenue asset are considered in [2.456]ff. above. Generally, the giving of the guarantee and payment under the guarantee will not be acts in carrying on a business. They are unlikely to be such where the taxpayer’s interest in the entity is, for example, the interest of a shareholder in a private company. The making of the payment under the guarantee and the failure of the subrogation rights to realise the amount of the payment may involve a relevant loss, but it is not a working loss. A loan by the taxpayer made directly to the entity would not be a revenue asset. In English Crown Spelter Co. Ltd v. Baker (1908) 5 T.C. 327 a loan to a subsidiary was held to be a capital asset. The loan to the subsidiary by the taxpayer in Total Holdings (Australia) Pty Ltd (1979) 79 A.T.C. 4279 was, presumably, a capital asset. Had a payment of interest been in fact made by the holding company in Marbren Pty Ltd (1984) 84 A.T.C. 4783 in respect of the loan made to its subsidiary, it would not, it is submitted, have been deductible. The payment should be seen as an investment in the subsidiary that was not a revenue asset.

[6.246] Where the giving of the guarantee relates to an investment by another in an entity in which the taxpayer guarantor has no interest, except an indirect commercial interest, the characterisation of the guarantee and of a payment under it becomes more difficult. A taxpayer may guarantee a loan made to another who is a supplier of goods to the taxpayer or is an outlet for the taxpayer’s production. The character of the guarantee and of a payment under the guarantee will reflect the character that a loan made directly to the supplier or outlet would have had. The possibility that such a loan would be a revenue asset is considered in [6.316] below. There is a difference, one would think, between a loan to one of a number of suppliers or outlets, and a loan to a sole supplier or outlet. A loss on either kind of loan may be relevant, but a loss on a loan of the former kind is the more likely to be held to be a working loss. Charles Marsden & Sons Ltd v. I.R.C. (1919) 12 T.C. 217 is an illustration of what was treated as a loan to a supplier, held to be capital. The loan was made to a new supplier and was made, in the view of Rowlatt J. “in order to establish [a] source of … supply” (at 225).

[6.247] The obligation of the debtor that is the subject of the guarantee may be an obligation to repay money lent to him, or to pay for goods or services supplied to him. The obligation may have attached to it an obligation to pay interest on the debt, an obligation that is also covered by the guarantee. It may be thought that the payment under the guarantee should have the same character as a payment by the debtor would have had. If a payment made by the debtor would have been a payment for goods or services or by way of interest, it would be said that the payment by the guarantor under the guarantee should be treated as if it were such a payment. There is no principle which would support such a transfer of character. The payment under the guarantee, on the analysis adopted in preceding paragraphs, is an investment in the debtor. It does not take its character from what would have been the character of a payment to the creditor by the debtor. In any event, the transfer of character would be insufficient to give the quality of deductibility to a payment under the guarantee. A payment for trading stock is deductible only if made by the person who acquires what is trading stock of his business. A payment of interest is deductible only if it is a payment of interest on money used by the taxpayer in a process of income derivation carried on by him.

[6.248] There are related questions. Does a receipt by the creditor under the guarantee take the character a receipt from the debtor would have had? The operation of the compensation receipts principle (Proposition 15, [2.506]ff. above) and s. 26(j) ([4.204]ff. above), in this context, is that a receipt under the guarantee which substitutes for a receipt that would have been income is income of the receiver. To this extent the character that a receipt from the debtor would have had is transferred to the receipt from the guarantor. There will however remain a further question whether a more particular character of a receipt from the debtor is transferred. A liability to withholding tax may arise under Div. 11A of Pt III if a non-resident receives a payment of “interest” from a resident. One view would be that even if the receipt by the creditor may be said to be “interest” in his hands—the matter raised is the scope of that word as used in Div. 11A—it is not a payment of “interest” by the guarantor. The guarantor does not make the payment to service credit made available to him. The judgment of Megarry J. in Re Hawkins [1972] 3 All E.R. 386 may support the view that there is a receipt of “interest” by the creditor, but it does not bear on the question whether there is a payment of “interest” by the guarantor.

[6.249] The discussion so far has been concerned with payments under guarantee, where the guarantor who pays has rights of subrogation. The analysis adopted equates the payment under the guarantee with a direct investment in the entity whose obligations are guaranteed. The possible deduction is a loss deduction, and it is available if the investment is a revenue asset. This analysis is not open where the taxpayer has given a simple indemnity, and makes a payment which does not give rise to rights of subrogation or rights in quasi-contract, to recover what he has paid. None the less an analysis of this kind may be best adapted to the commercial effect of the transaction. A holding company that discharges an obligation of its subsidiary, whether to repay a loan, or to pay for goods or services supplied to the subsidiary, has, in effect, invested in the subsidiary. It may anticipate the return of its investment, whether in a dividend distribution or alternatively on liquidation. A payment by a holding company in pursuance of an indemnity given to the lender or to the supplier to the subsidiary, should be regarded in the same way. The investment is not a revenue asset, and will not generate a loss deduction. The investment may be treated as a laying out of money in order to derive income, so that, on the authority of Total Holdings (Australia) Pty Ltd (1979) 79 A.T.C. 4279, interest on money borrowed by the company for the purpose of making the investment in the subsidiary, will be deductible. But the investment, in line with the analysis of a payment under a guarantee adopted above, does not attract the character and the deductibility that a payment by the subsidiary would have had. Where the obligation of the subsidiary relates to the supply to it of goods or services, a deduction will be available to the subsidiary, assuming it is on on accruals basis of accounting, and, presumably, the discharge of that obligation by the holding company is not a derivation of income by the subsidiary.

[6.250] A payment to discharge an obligation of another, unattended by any right to recover the amount paid, is unlikely to be made save in the holding company and subsidiary situation, or in an individual and wholly owned company situation. If it is made, in situations other than these, the payment is an outgoing and deductibility will depend on relevance and working character. Where it is made under an indemnity, the purpose in entering into the indemnity agreement will determine the purpose of the payment. Where it is made otherwise than under an indemnity agreement, the purpose of the payment will need to be identified. The relevant purpose of the payment is the taxpayer’s purpose, and not the purpose the entity whose obligation is discharged would have had if it had made the payment. A purpose that will make the payment relevant and working will have its equivalent in the purpose that would make an investment in the entity a revenue asset, or in the purpose a taxpayer might have in making a gift to the entity. A purpose of promoting sales to the entity, or a purpose of securing supplies from the entity, by ensuring the continuance of the entity and its goodwill is the most likely. Such a purpose will give relevance to the payment, though there remains the prospect, explained in relation to payments under guarantees ([6.246] above) that the payment may not be working where the entity’s continuance and goodwill are of special importance to the taxpayer.

[6.251] The discussion has so far assumed that the taxpayer that gives the guarantee is not engaged in a business of giving guarantees for rewards. If it is, any investments that result from payments under guarantees will be revenue assets and may give rise to loss deductions. Moreover the discussion has been confined to payments under guarantees, in the sense of promises to answer for the debt or default of another. Payments under “guarantees” given by a seller as to the quality and durability of goods sold, will generally be deductible as expenses of selling in a business of selling.

The Characterisation of Payments to Trade, Business, Professional and Employee Associations

[6.252] There are specific provisions in s. 73 in regard to the deductibility of payments in respect of membership of an association. A deduction not exceeding $42 is allowable in respect of any periodical subscription in respect of membership of any trade, business or professional association (s. 73(3)). In certain circumstances a more generous deduction may be allowable under the section. There is no limit on the amount of a periodical subscription that is deductible if the carrying on of a business from which assessable income is derived by the taxpayer is conditional upon membership of an association, and the subscription is paid in respect of that membership (s. 73(1)). Where an association carries out, on behalf of its members, any activity of such a nature that, if carried out by the taxpayer on his own behalf, the expense of that activity would be an allowable deduction by the taxpayer, any subscriptions, levies or contributions to the association by the taxpayer are deductible by the taxpayer, subject to a ceiling of $42, or, if it is greater, a ceiling of so much of the subscriptions, levies or contributions as have been or will be applied by the association to meet losses or outgoings in carrying out that activity, other than losses or outgoings of capital or of a capital nature (s. 73(2)).

[6.253] The deduction under s. 73(3) is allowable whether or not it is relevant to a process of income derivation in a sense of relevance that would satisfy one of the requirements for deductibility under s. 51(1), though some connection will very likely follow from the requirement that the association to which the periodical subscription is paid should be a trade, business or professional association. The deduction under s. 73(1) has its own test of relevance. The requirement under s. 73(1) that the subscription must be a periodical subscription goes some way to ensuring that the subscription is a working expense, in a sense that would ensure deductibility under s. 51(1). But the fact that a periodical payment secures a lasting advantage and would be not working but capital and be denied deductibility under s. 51(1), will not preclude deduction of the payment under s. 73(1).

[6.254] A deduction under s. 73(2) is available provided the association carries out, on behalf of its members, in the year of income, any activity of such a nature that, if carried out by the taxpayer on his own behalf, its expense would be an allowable deduction to him. Circumstances can be envisaged where this activity constitutes only part of the association’s total activity. The activity will none the less support a deduction of the whole subscription, subject to the ceiling set by the subsection.

[6.255] The deductions allowable under s. 73 are thus in some respects wider than those that might be allowable under s. 51(1), though they are in some other respects narrower. Where they are narrower, the question is raised whether s. 73 excludes deductibility under s. 51(1). An argument might be made that s. 73 is a code intended to displace the operation of s. 51(1). Making such an argument would entail defining the area of the code and, having regard to the variety of circumstances with which the section deals, this might be difficult. The assumption is made in what follows that a taxpayer may claim a deduction under s. 51(1) notwithstanding that the circumstances would attract some deduction under s. 73.

[6.256] It would appear from Gordon (1930) 43 C.L.R. 456 that where the question is the applicability of s. 51(1) the relevance of a subscription to an association to a process of income derivation by a taxpayer is to be judged in the light of the activities of the association. Those activities do not directly determine deductibility as they do under s. 73(2), but they “[tend] to show the purposes for which the taxpayer laid out his money in paying the subscription” (at 464, per Dixon J.). In Gordon a deduction was claimed for a subscription to the Graziers’ Association of N.S.W. It was claimed under a general deduction section more restrictive than the present s. 51(1). The deduction was allowed. Dixon J., whose decision was upheld on appeal, said (at 462):

The reference to extending “its activity or its influence into politics” may suggest that an association may support financially, or promote or oppose, a political party without impairing the deductibility of subscriptions paid to it by its members. The financial support, and promotion or opposition, would need to be in relation to the business or employment interests of members. If the Association incurs expenses in the furtherance of political objects which are unrelated to the business or employment interests of members, deductibility of subscriptions by its members must be affected. The consequence under the general deduction section with which Gordon was concerned may have been a denial of a deduction for the subscription. Under s. 51(1) an apportionment may be proper, so as to deny deduction of only part of the subscription—the part referable to a purpose insufficiently connected with a process of income derivation to be relevant. That part and the part referable might have been the subject of distinct payments to serve each purpose. In fact the Association in Gordon provided in its rules for the furtherance of political objects, but any money applied in the furtherance of political objects had to be made from a separate fund to which members were not compelled to contribute. The taxpayer in Gordon had in fact made a contribution to this fund, but the deductibility of that contribution was not in question in the case.

[6.257] The distinction between extending “activity or influence into politics but without confusing or impairing the performance of [the] main objects” of an association, and engaging in the furtherance of political objects unrelated to the business or employment interests of its members, may not be easily drawn. Two United Kingdom cases may assist: Morgan v. Tate & Lyle Ltd [1955] A.C. 21 and I.R.C. v. Kramat Pulai Ltd [1953] 1 W.L.R. 1332. In the first case deduction was allowed of the expenses of a campaign to prevent the nationalisation of the company’s business. The directors of the company had formed the view that the nationalisation of the sugar refining industry in which the company was engaged, would become part of the Labor Party’s considered official programme. The authority of the decision on the question whether the expense was working or capital is doubtful in Australia: this aspect is considered in [7.66] below. But the decision may afford an illustration of a relevant expense, at least if it is assumed that the nationalisation feared was a nationalisation by acquisition of businesses as distinct from acquisition of shares in companies conducting those businesses. In I.R.C. v. Kramat Pulai deduction was denied of the expenses of printing, publishing and circulating the remarks of the Chairman at a meeting of a company. The remarks “were an attack throughout the whole of it upon the policy and acts of the Socialist Government which was in office after 1945 and still in office at the time of the annual meeting in question”. The conclusion, expressed in the analysis adopted in this Volume, that the expenses were not relevant, would be likely in similar circumstances in Australia. I.R.C. v. Kramat Pulai was decided, like Gordon, in relation to a general deduction provision by which an expense was deductible only if “wholly and exclusively” incurred in a process of income derivation. Section 51(1) allows of an apportionment if some part of the outgoing is relevant. An outgoing may have two purposes each of which might have been separately served, the one giving relevance and the other not. In facts such as I.R.C. v. Kramat Pulai it is conceivable that the remarks were in some part expressly directed at acts of the Government which would have special implications for the company, like the nationalisation of the sugar industry in Morgan v. Tate & Lyle. There might then, in Australia, be grounds for an apportionment, though the operation of the words “to the extent to which” in s. 51(1) in this context is not evident. The view of this Volume would be that the operation of the words is limited to circumstances which, by objective inference, disclose two distinct purposes each of which could be separately served, the one giving relevance, the other not. The publication of words generally supporting a political party or generally criticising a party, show only one purpose, or two purposes each of which could not be separately served, though the taxpayer may have had reason to believe that success of one party or failure of another would have favoured his business operations or his employment conditions in a special way. The publication must be judged for relevance by degree of connection, and an inadequacy of connection of the expense as a whole is not to be expressed by treating some of the expense as relevant and some not. On this analysis, a simple contribution to the funds of a political party will not give rise to any deduction under s. 51(1). It is an expression of general support, and does not yield an objective inference of purpose which will justify a finding of a connection sufficient to make the expense relevant.

[6.258] The discussion of Morgan v. Tate & Lyle and I.R.C. v. Kramat Pulai concerns deductibility of expenses of promoting or opposing the objectives of a political party, or expenses which are contributions to the funds of a party, where the expenses are directly incurred by the taxpayer. Where the question is the deductibility of a subscription to an association which incurs such expenses, deduction may be sought under s. 73(2) rather than s. 51(1). Section 73(2) links deductibility of the taxpayer’s subscription with deductibility to the taxpayer of the expenses incurred by the association had they been incurred by the taxpayer. Section 51(1), at least in the view of Dixon J. in Gordon (1930) 43 C.L.R. 456, does not proceed in this way. Dixon J. said (at 463):

[6.259] The interpretation of Lochgelly Iron & Coal Co. and Grahamstown Iron Co., apparently adopted by the Commissioner in Gordon, is now reflected in s. 73(2), but it is not appropriate in expressing the operation of s. 51(1). The manner in which the association expends its funds is no more than a basis of inference as to the purposes for which the taxpayer laid out his money in paying the subscription. The circumstances may show two purposes in the actions of the association in promoting or opposing the objectives of a political party. It does not follow that there are two purposes in the payment of the subscription so that an apportionment may be made and a deduction allowed of so much of the subscription as is moved by a purpose that gives relevance.

[6.260] Section 73(2) requires that one look at all the expenses incurred by the association. If any of them is an expense that would have been deductible by the taxpayer if he had incurred a like expense himself, the taxpayer’s contribution to the association will be deductible subject to a limit of $42. Alternatively, so much of his contribution as has been or will be applied by the association in meeting the expenses will be deductible, if it is not a capital expense, and if this amount is greater than $42. There are clearly problems in satisfying the hypothesis that the expense would have been deductible by the taxpayer had he incurred it himself. Presumably, one must look to all the circumstances in which the association incurred the expense, including the time of incurring, and attribute them to the taxpayer. The question then becomes whether an objective inference of a purpose of the taxpayer that would give relevance can then be drawn. There will be occasions when the circumstances attributed to the taxpayer are not enough to yield any objective inference of purpose. Thus the expense of subsidising the provision of some facility available to the taxpayer would be deductible by the taxpayer only if he had incurred the like expense in particular circumstances that gave it relevance to his income earning activity.

[6.261] Deductibility under both s. 73(2) and under s. 51(1) is affected by s. 51AB. Section 51AB, which overrides any other provision of the Act, denies deduction of an outgoing incurred to secure for the taxpayer or any other person membership of an association, or rights to enjoy, otherwise than as a member, facilities provided by an association for the use or benefit of its members (subss (3) and (4) of s. 51AB). The section applies where the association was established, or is carried on, solely or principally for the purpose of providing facilities for the use or benefit of its members, in relation to drinking, dining, recreation, entertainment, amusement or sport: s. 51AB(1) (definition of club) and s. 51AB(4). The operation of the section is subject to exceptions which depend on the definition of “excepted facility” in s. 51AB (1). The requirement that the association must have been established or be carried on solely or principally for the purpose of providing facilities will leave s. 73(2) and s. 51(1) to operate where the provision of facilities is a subordinate part of the association’s activities.

[6.262] The payment of a periodical subscription, if it is relevant, will ordinarily be a working expense, but it is not necessarily so. The payment of a subscription that relates to actions to be undertaken by the association, including the provision by it of services to its members, over a number of years may be seen as securing a lasting benefit such as to make the subscription a capital outgoing. B.P. Australia Ltd (1965) 112 C.L.R. 386 and Strick v. Regent Oil Ltd [1966] A.C. 295 have a bearing. The advantage secured by the payment of the subscription, like the advantage in Ilbery (1981) 81 A.T.C. 4234; 81 A.T.C. 4661, may be one that could be used other than in a process of income derivation, though there is a current use which gives the subscription its relevance. A subscription for life membership of an association may afford advantages which will extend to a time when any process of income derivation to which it is relevant has ceased. The advantage may be dining, accommodation and social facilities. The subscription is not working. A subscription for 3 years’ membership is likely to be regarded in the same way. And the possibility of advantage enuring after the cessation of the process of income derivation may justify a conclusion that the expense is not working when the period of membership secured by the subscription extends to any significant degree beyond the year of income in which it is paid. A parallel conclusion in relation to interest in advance is suggested above ([6.117]–[6.131]) in the discussion of Ilbery. Indeed, in both the subscription and interest situations, the prospect of the advantage enuring after the cessation of the process of income derivation may push the analysis a stage further back, so that the relevance of the subscription or interest is denied.

[6.263] The payment of a periodical subscription in respect of a person’s membership of any trade, business or professional association is deductible under s. 73(3), subject to a limit in respect of a subscription to any one association, in the year of income, of $42. Section 73(3) does not exclude deductibility of any amount under s. 51(1), s. 73(2) or s. 73(1). Section 73(1) allows a deduction of a periodical subscription in respect of membership of an association where the carrying on of a business by a taxpayer from which assessable income is derived is conditional upon membership of that association. Section 73(1) and 73(3) do not exclude from deductibility subscriptions that would be non-working when judged by s. 51(1) provided they are “periodical”. Periodical is not defined. Nor do they attract the principles of contemporaneity and relevance. Thus a periodical subscription to a professional association is deductible under s. 73(3) though the taxpayer does not practise the profession.

[6.264] The assumption in the discussion so far has been that the subscription to the association is of the nature of the subscription in Gordon (1930) 43 C.L.R. 456. A return of any surplus of the subscription, or the making of other payment to a member is not contemplated. The mutuality principle (considered in [2.45]ff. above) will apply to the receipts by the association, so that it does not derive income. Where the rules of the association provide for a return of surplus or other payment to a member, there will be prospects of a denial that the mutuality principle is available to the association, and implications for the deductibility of the subscription. There is a prospect of denial of mutuality because the principles of identity and proportion in relation to the return of surplus are not satisfied, or because the association is an Assessment Act co-operative or an insurance association.

[6.265] A possible denial of deductibility where the payment to the association is for the supply to the taxpayer of goods or services is the subject of some observations in [2.84] above. Where the payment to the association is a payment for insurance, deductibility will depend on the operation of principles examined in [6.210]–[6.241] above. In this context, a distinction was drawn between a premium paid for insurance against misfortune, which will be deductible if it is relevant, and a premium for insurance which will provide the taxpayer with funds to meet an expense which is a normal experience in carrying on a business. On the authority of Ransburg Aust. Pty Ltd (1980) 80 A.T.C. 4114 a premium paid in the latter circumstances is not a working expense. There are two United Kingdom decisions denying deductions for subscriptions to trade associations which are not easily explained. They are Rhymney Iron Co. Ltd v. Fowler [1896] 2 Q.B. 79 and Thomas Merthyr Colliery Co. Ltd v. Davis [1933] 1 K.B. 349. In each case deduction was denied of a payment to a trade association in respect of an indemnity in the event of deficiency or stoppage of output caused by strikes. In the latter case, it was conceded that a premium for fire insurance on business assets was deductible (Usher’s Wiltshire Brewery Ltd v. Bruce [1915] A.C. 433) and that a contribution to an association to cover liability to make workmen’s compensation payments was deductible. However, following the earlier case, deduction was denied of contributions for an indemnity against deficiency or failure of output owing to strikes. The reason given for denying this deduction is that the payments had been made “to supply a deficiency at a time when there is no trade being carried on” ([1933] 1 K.B. 349 at 371 per Lord Hanworth M.R.). The reason is not persuasive. The reason that explains Ransburg would have been more persuasive, though it might have been difficult to fit the precise facts of the case into the mould of investment and the return of money invested. Subscriptions by an employee to a trade union that entitle him to pay from the union in the event of a strike could, it is thought, be properly denied deduction under s. 51(1) on the authority of Ransburg.

[6.266] A final matter concerns the test of relevance where subscriptions are paid by an employee. There might be drawn from the judgment of Menzies J. in Hatchett (1971) 125 C.L.R. 494 a rule that an expense incurred by an employee is only relevant if he is required to incur it by the terms of his employment or if it has a direct effect on income. The rule would involve the conclusion that subscriptions by an employee to a trade union will only be deductible under s. 51(1) if union membership is required by the terms of his employment. Which may indicate that the rule is an unsatisfactory expression of the principles underlying s. 51(1).

The Characterisation of Payments in Commutation of Future Payments or which Relieve from or Reduce Future Payments

[6.267] One of the submissions made by the taxpayer in Ilbery (1981) 81 A.T.C. 4661 asserted a rule that an expense which relieves the taxpayer of a liability to make payments in the future which would be deductible, is itself deductible. W. Nevill & Co. Ltd (1937) 56 C.L.R. 290—involving a payment by a company to secure a release from a contract with a managing director—and the United Kingdom decision in Anglo-Persian Oil Co. Ltd v. Dale [1932] 1 K.B. 124—involving a payment to secure a release from a contract with an agent of the taxpayer—were cited to support such a rule. The point was made above, in discussing Ilbery (1981) 81 A.T.C. 4661, that even if such a rule is accepted it has no application to Ilbery facts. The payment in Ilbery secured a lasting advantage—the use of the money borrowed at no interest or at reduced interest. The payment was not a working expense. And the payment in Ilbery could not be said to relieve against payments in the future that would be deductible. It may be correct to say that payments of salary to a managing director to be made in the future (Nevill), or payments of commission to an agent (Anglo-Persian Oil v. Dale), are payments that would be deductible. But one cannot say that payments of interest to be made in the future are payments that would be deductible, so long as it is accepted that the deductibility of payments of interest depends on the money borrowed being currently laid out in a process of income derivation. The facts of Nevill would need to be substantially different if any parallels with the facts in Ilbery were to be found. If a taxpayer who is a sole trader pays salary in advance to an employee currently employed in the trader’s business or in the trader’s private affairs, some parallels may be seen. The analysis and conclusion in regard to deductibility of the advance payment of salary might then follow the analysis and conclusion in relation to the Ilbery facts put forward in [6.117]–[6.181] above. If the contract is to serve for a substantial period and the advance payment covers the whole of that period, the payment may be denied deduction as a non-working and thus capital expense. This is to assume that the payment is relevant. The payment can, however, be denied deduction as not relevant. It relates to an advantage which is not necessarily a business advantage: it may at the choice of the taxpayer, be used in affairs which do not involve any process of income derivation. The connection between the payment and the continuing derivation of income from the business is tenuous.

[6.268] The asserted rule that an expense, which relieves the taxpayer of a liability to make payments in the future which would be deductible, is itself deductible, requires examination. The rule may explain the deductibility of a payment to commute a pension being paid by a former employer to his retired employee. Its value in this context is considered in [6.272] below. But the rule is simply unacceptable as an expression of s. 51(1) in other contexts, more especially in the context of facts such as were involved in Nevill and Anglo-Persian Oil v. Dale. In B. W. Noble Ltd v. I.R.C. [1927] 1 K.B. 719 where the facts are close to the facts in Nevill, deductibility is explained on the basis that “in the ordinary case a payment to get rid of a servant, when it was not expedient to keep him in the interests of the trade, would be a deductible expense” (at 726, per Rowlatt J.). Such a payment is relevant, and it will be a working expense unless the employee has by his contract such a command of the conduct of a business that his contract is an aspect of structure. Nevill does not support the asserted rule. The Commissioner in that case submitted a negative rule that contradicted the asserted rule. His submission was that a payment which secures relief from future expenses is not deductible because it does not increase assessable income. The court rejected the submission, thereby rejecting a “blast from the whistle” ([5.34] above) relationship between expense and income derivation as necessary for deductibility under s. 51(1). But the rejection of this negative rule cannot be taken as an acceptance of the positive rule. The positive rule which the case adopts might be drawn from the judgment of Dixon J. in Nevill (1937) 56 C.L.R. 290 at 306:

The passage quoted reflects conclusions on the issues of relevance and working character.

[2.269] In the concluding part of his judgment Dixon J. dealt with “a different question” arising under the former s. 25(e) which forbade a deduction unless it consisted “of money wholly and exclusively laid out or expended for the production of assessable income”. It was in this connection that he considered the Commissioner’s submission and observed (at 307):

[2 270] The asserted rule is not supported by the other case, Anglo-Persian Oil Co. Ltd v. Dale [1932] 1 K.B. 124, to which counsel referred in the trial court. That case may support a rule that a payment to get rid of an onerous contract may be deductible where the contract is not part of the “fixed capital” of the taxpayer’s business (at 144, per Laurence L.J.). The contract to employ an agent to manage the company’s business in Persia—was “in no sense … part of the fixed capital of the company”. The reference to “fixed capital” is a reference to “structure” in the language adopted in this Volume.

[6.271] Any positive rule suggested by B. W. Noble, Nevill and Anglo-Persian Oil should not be definitive. Adopting any rule raises the prospect of defeat for s. 51(1), if the rule comes to attract an extended form approach. A payment made to a managing director, in other respects like the payment in Nevill, may be denied deduction if it is made as an aspect of the closing down of the business operations in which he was employed: Godden v. A. Wilson’s Stores (Holdings) Ltd (1962) 40 T.C. 161. And such a payment may be denied deduction where it is a payment made by a company employer to give effect to an agreement between former and present shareholders that the company would buy out the contracts of its executive directors: Overy v. Ashford Dunn & Co. Ltd (1933) 17 T.C. 497, Bassett Enterprise Ltd v. Petty (1938) 21 T.C. 730, James Snook & Co. Ltd v. Blasdale (1952) 33 T.C. 244, Faulconbridge v. Thomas Pinkney & Sons Ltd (1951) 33 T.C. 415, George Peters & Co. Ltd v. Smith (1963) 41 T.C. 264, George J. Smith & Co. v. Furlong [1969] 2 All E.R. 760. The payment which is the result of a bargain made in the transfer of control of the company is not to be described as “connected with the ever recurring question of personnel” (Dixon J. in Nevill (1937) 56 C.L.R. 290 at 306) and may be denied deduction. Indeed there is a prospect that a payment to buy out the contract of an executive director may be denied deduction if a change of control of a company has resulted from a take-over bid and the executive director is bought out in order to make way for a nominee of the new controllers. The question is whether the purpose of the payment was to facilitate the exercise of control by the new controllers or to further the derivation of income by the company.

[6.272] Earlier in this discussion a question was reserved about the value of the asserted rule that an expense which relieves the taxpayer of a liability to make payments in the future which would be deductible is itself deductible. The reservation related to the circumstance of a payment to commute a pension being paid by a former employer to his retired employee. In Hancock v. General Reversionary and Investment Co. Ltd [1919] 1 K.B. 25 a payment to purchase an annuity equal in amount to a pension payable to a former employee was held deductible under the United Kingdom legislation. The case links the deductibility of the payment made, in effect to commute the pension payment, with the deductibility of the pension payments that had been made and those that would have been made. The pension payments may be deductible as payments required by the employment contract and thus as deferred remuneration for services performed in the past, or as payments which, though made voluntarily, will enhance the standing of the taxpayer among continuing employees, and promote their loyalty and efficiency. They may be deductible under s. 78(1) (c). The commutation payment attracts deductibility, however, not because it is by way of commutation of those payments, but because it has the same function as those payments. In that function, it may be connected with the process of income derivation, and is thus relevant. It is “connected with the ever recurring question of personnel”. And it does not relate to structure. The commutation payment has the same character as a lump sum paid in the first instance, instead of the payment of the annuity, would have had.

[6.273] Where the pension payments were not and would not be deductible because of their function, the commutation payment will have the like character. Annuity payments by a company to the widow of the former proprietor of the company’s business, arising from an obligation undertaken under the contract by which the company acquired that business, are not connected with the process of income derivation by the company and are not relevant. Alternatively they are capital, as payments for the business. A payment by way of commutation is equally irrelevant or capital. It will have the same character as a lump sum payment to the widow, stipulated for in the contract by which the business was acquired, would have had.

The Characterisation of Expenses which relate to the Formation, Powers and Administration of an Entity

[6.274] Expenses may be incurred in the organisation or reorganisation of a company, trust or partnership, and in the administration of the entity. The reorganisation may involve amendment to constituent documents. Administration may involve the holding of meetings, and the preparation of accounts and other documents, and the filing of these documents.

[6.275] The expenses of organisation—the formation of a company trust or partnership—would generally be assumed to be not deductible, and the expenses of reorganisation and administration to be deductible. These assumptions require examination. The company, partnership or trust is an entity that is a taxpayer, or an entity deemed to be a taxpayer for the purpose of determining the income of others who derive income through that entity. The expenses of formation of an entity, when incurred by the entity, lack sufficient connection with the derivation of income to be relevant: they are private expenses. Where the expenses are claimed by a person who derives income through the entity—a shareholder, a beneficiary in the trust or a partner—the expenses, if regarded as relevant, will generally be denied deduction as not working: they are capital expenses. Where, however, a taxpayer deals in shares the expenses of formation of a company in which he takes shares may be both relevant and working expenses.

[6.276] The expenses of reorganisation so as to extend or restrict the powers of the entity admit of the same analysis as the expenses of formation. I.R.C. v. Carron Co. (1968) 45 T.C. 18 does not, however, follow that analysis where the question is deductibility by a company taxpayer. The expenses related to the obtaining of a supplementary charter which relieved the company of a limit on its borrowing powers. The case proceeds on an analysis which would treat the limit on the company’s powers in the same way as a limit imposed by some licensing authority—for example a quota restriction on import or production of goods. The expenses of obtaining relief from the restriction in the latter circumstances are clearly relevant, and will be working expenses if the limit is not seen as going to the structure of the company’s business. I.R.C. v. Carron Co., in effect, ignores the corporate veil. It treats the restrictions on borrowing not as an aspect of the capacity of the entity to carry on business, but as a restriction on the carrying on of business by the proprietors of that entity. And the case treats a restriction which would affect any activity—business or investment—of the company as if it were a restriction on the particular business activity in which the entity is currently engaged.

[6.277] The I.R.C. v. Carron Co. analysis might be applied to some expenses of reorganisation of a trust or partnership, though the compromises with principles which insist on the separateness of the entity will be more evident. And the I.R.C. v. Carron Co. analysis might be applied to some expenses of administration of the entity. The expenses would be treated not as expenses which concern the personality of the entity—and thus not relevant—but as expenses which concern the carrying on by the entity of its business, or the holding by the entity of property whence income is derived, so that the expenses are relevant and, presumably, working. The expenses associated with the ordinary acts of administration which company law requires of a corporate entity—the preparation and filing of accounts and the making of returns to public authorities—may be illustrations.

[6.278] There must, however, be limits on the deductibility that can be supported by I.R.C. v. Carron Co. The expenses of a reorganisation which concerns the rights of shareholders, partners or beneficiaries, are not relevant to any process of income derivation. Expenses associated with the payment of a dividend or the making of a distribution by a trust or partnership are not relevant to any process of income derivation. (Cf. Aiken v. Macdonald’s Trustees (1894) 3 T.C. 306.)

[6.279] Expenses of the kind now being considered are likely to be paid for the services of a lawyer or an accountant. The character of the expenses as legal or accounting expenses is not in itself significant. The character of an expense that is significant in determining deductibility under s. 51(1) is the function of the payment, not the occupation of the person who receives the payment. Section 64A of the Assessment Act provides for a limited deduction of “legal expenses” as defined. There is a ceiling of $50. In its application to expenses of services of a “barrister or solicitor”, the section is a curious intruder. It appears as a subsidy to the use of the services of a barrister or solicitor. There is a question, however, whether the section has any application in this aspect or in any other. Section 64A(2), the operative provision, borrows from the language of the second limb of s. 51(1) but does not repeat the exclusion of outgoings of a capital nature. The view taken in this Volume is that the exclusion of outgoings of a capital nature in s. 51(1) is stated only by way of contradistinction: it is not a true exception. On this view, s. 64A can have no wider operation than s. 51.

[6.280] Whatever the application of the section, there is a question whether assumptions in the drafting of the section in relation to the other expenses with which it is concerned may have some bearing on the present discussion, and on the discussion under immediately following headings. These other expenses are (i) costs of registration of a document on a public register and of the stamping of a document, and (ii) expenses in connection with proceedings before a court, board, commission or similar tribunal. It might be said that the first group of these other expenses, if costs of stamping documents are ignored, will comprise principally expenses that relate to the formation, powers and administration of an entity, and that the assumption is that such expenses may be relevant to a process of income derivation. It was only necessary to overcome the prospect of denial of a deduction under s. 51(1) on the ground that the expenses were not working. It may be doubted that there is any such assumption in the subsection, more especially because of the inclusion of costs of stamping in the first group of expenses.

[6.281] The assumption that may be drawn from the second group of expenses, and its implications, are considered under immediately following headings.

The characterisation of expenses of collecting and recording receipts which involve the derivation of income, and of payments of taxes

[6.282] The expenses now considered are distinguishable from the expenses of administration of an entity that is the taxpayer in relation to which a calculation of deductible expenses is made. The expenses of administration of an entity may be incurred even though the entity is not engaged in any process of income derivation. The expenses of collecting and recording income are incurred in the very process of deriving income, or they are an immediate consequence of derivation of income.

[6.283] A “blast from the whistle” test ([5.34] above) of the relevance of expenses to the derivation of income would involve the denial of the deductibility of expenses of collection and recording income. The income cannot be said to have been produced by the expenses, within a meaning of “produced” which is expressed in the blast from the whistle metaphor. Such a notion of “produced” has not however been established in any rule expressing the requirement of relevance for purposes of s. 51(1). One of the arguments for the Commissioner in Charles Moore & Co. (W.A.) Pty Ltd (1956) 95 C.L.R. 344 assumed such a notion. It was argued that a loss of money whose receipt is a derivation of income is not relevant to the gaining or producing of income, since any derivation of income to which it relates has already occurred. The argument was expressly rejected by the High Court in holding that the loss was a deductible expense.

[6.284] Relevance is a matter of sufficient connection. There may be such where the expense is inherent in the process of deriving income, or is an immediate consequence of its derivation. A commission paid by a taxpayer to an agent who collects receipts which involve a derivation of income by the taxpayer is deductible under s. 51(1). Section 64 provides specifically that “expenditure incurred by the taxpayer in the year of income by way of commission for collecting his assessable income shall be an allowable deduction”. The section is drafted in language that is conceptually unsound: it assumes that the quality of income attaches to what is received, not to the act of receipt. Similar language used in s. 71 was the subject of comment in [6.70] above. But the section is no more than declaratory of a deductibility in any event given by s. 51(1). The commission paid to an agent has its parallels in some expenses involved in actions to obtain receipts, taken by the taxpayer himself. Travelling expenses of the taxpayer, the travel being undertaken for the purpose of collecting receipts, are deductible. Expenses incurred in suing for the recovery of amounts receivable are deductible.

[6.285] Expenses of collecting receipts, paid in respect of another’s actions or in respect of the taxpayer’s own actions, will be deductible whether the derivation of income is in the arising of the right to receive, an accruals basis of tax accounting being applicable, or in the actual receipt, a cash basis of tax accounting being applicable. There is no basis for drawing a distinction which may allow a deduction to a taxpayer engaged in business, but deny it to a taxpayer who derives income from property.

[6.286] Expenses of recording receipts and of verifying the recording are deductible. There is no basis for attempting to distinguish collection from recording, so as to deny deduction to the latter. In Green (1950) 81 C.L.R. 313 the taxpayer’s income included director’s fees, rents, dividends and interest on mortgages. He claimed and was allowed deductions for (i) fees for keeping books, and audit fees paid to an accountant; (ii) a salary paid to his daughter for her services in acting as a clerk in attending to his financial affairs; and (iii) expenses of travelling from Brisbane to Townsville and Cairns to inspect and supervise the properties whence he derived income in the form of rents. The High Court held all these expenses were deductible. The court said (at 319):

[6.287] There is another observation in the judgment that may be noted. Attention is drawn to the fact that only part of the travelling expenses were claimed, and it is then observed (at 319):

It would be accepted that expenses of travel to negotiate a new lease are not working expenses. Such an assumption underlies the express provisions in s. 68, providing for deduction of expenses relating to lease documents. But expenses of travel to inspect the state of repair of premises and to give instructions for repairs, should be regarded as maintenance expenses and thus working. There is none the less a question of their relevance. Green was decided some years before Lunney (1958) 100 C.L.R. 478 in which it was held that expenses of travel between home and a place of work of an employee, or a person engaged in a business, is not deductible. The expenses are not deductible because they are a consequence of the taxpayer’s choice of a place in which to live. It would seem to follow that expenses of travel between home and a place where property is held from which income is derived, are not deductible. They are equally a consequence of a choice by the taxpayer of a place in which to live. The conclusion that the travel expenses in Green were deductible might be saved by distinguishing Lunney. Where a taxpayer has a place of business in the city in which he lives and may be said to have travelled to and from that place of business when he travels to inspect the property in which he has invested, he may be entitled to a deduction of travel expenses on the authority of Pook v. Owen [1970] A.C. 244. And Lunney might be distinguished on another basis. Where a taxpayer has investments in a number of places away from his home, it is arguable that the expenses of travel arise not from his choice of a place as his home but from the choice of places of investment. An argument of that kind had the support of Brightman J. in Horton v. Young [1972] Ch. 157 in reference to the circumstances of a chimney sweep who leaves home each morning and goes from house to house sweeping chimneys. A more likely illustration would refer to a building worker. A building worker’s situation is however different from that of the taxpayer in Green, in that he has shifting places of work. The taxpayer in Green had fixed places of investment. Lunney, Pook v. Owen and Horton v. Young are discussed in [8.61]ff. below.

[6.288] In Green, deduction was denied by the trial Judge of a part of the travelling expenses on the ground that some of those expenses related to a capital purpose—the negotiation of a new lease. The view taken in this Volume would be that an apportionment is not available under s. 51(1) in such circumstances. The purpose in the travel that was a non-working purpose could not have been served by a distinct payment. A characterisation as relevant and working should be made in relation to the expense as a whole. In [8.16], [8.51] and [8.85] below it is argued that one cannot express a doubt about relevance by making an apportionment and allowing a deduction of part of an amount. It might equally be argued that one cannot express a doubt about the working character of an expense by making an apportionment and allowing a deduction of part of an expense. An apportionment is only proper where there is more than one purpose served by an expense and each purpose could have been served by a distinct payment. These questions are further considered in Chapter 9 below.

[6.289] The view taken in the preceding paragraphs is that expenses of collecting receipts which are income, and the expenses of recording and verifying those receipts, are working expenses and deductible. There is none the less an argument to be made that the expenses of distribution by an entity of moneys it has received, among shareholders, beneficiaries or partners, are not deductible. The expenses are not connected, save historically, with any process of income derivation by the entity whose actual or notional taxable income has been calculated. If the expenses are incurred by the shareholder, beneficiary or partner, they may be relevant and deductible as expenses of collecting income. In the case of a partnership, where any expenses will have been incurred by the partnership as agent for the partners, there may be room for allowing a deduction to a partner of the expenses, as expenses of collecting income. But, where the expenses have been incurred by a company or a trust, it will not be possible to regard them as incurred by the shareholder or beneficiary.

[6.290] Some support for the view that expenses of making a distribution of income are not deductible may be found in the United Kingdom decision in Aikin v. Macdonald’s Trustees (1894) 3 T.C. 306. A deduction was sought by a trust, against income from a foreign source received in the United Kingdom, of an amount being “the average annual expenses incurred in the United Kingdom in connection with the management of the trust”. The denial of the deduction is in some conflict with the view taken above that the expenses of recording and verifying the receipt of income are deductible. So far however as the denial related to the expenses of distribution of trust income, it may be accepted as consistent with the Australian law. The expenses are simply not relevant, and admit of the description “private or domestic”—a description thought appropriate by Lords Adam and McLaren in Aikin v. Macdonald’s Trustees.

Expenses, being payments of taxes and expenses related thereto

[6.291] Distinctions need to be drawn between taxes on income and other taxes, and, in relation to the former, between the Australian income tax and a foreign income tax. And a distinction may be necessary between an expense which is the payment of the tax, and an expense which is related to that payment. It would be generally assumed that tax under the Assessment Act is not deductible in determining the taxable income on which tax is levied. There is no Australian judicial authority, but decisions in relation to the United Kingdom income tax may be persuasive. The principal United Kingdom authority is Smith’s Potato Crisps (1929) Ltd v. I.R.C. [1948] A.C. 508. The case concerned the deductibility of expenses of an appeal against an income tax assessment, not the deductibility of the tax itself. None the less the conclusion denying deductibility of the expenses of the appeal must, a fortiori, apply to the expense of paying the tax. Lord Porter said (at 520-1):

The observations are significant in their recognition of the deductibility of expenses of recording and verifying income discussed under the last heading. They are also significant in their assertion that the expenses of preparing “revenue accounts” should not be deductible. It would follow, logically, that the expenses of resisting an assessment and, a fortiori, the expense of the payment of an assessment are not deductible. The reason for the denial of a deduction of expenses of preparing an income tax return, of disputing an assessment and the payment of an assessment, may not however be adequately expressed in saying that the expense is “incurred directly for tax purposes and for nothing else”. A more adequate statement of reason may be found in the judgment of Lord Normand (at 529–530):

The distinction between an outgoing in gaining income, and an outgoing which is an application of income gained, is drawn in other contexts and is the subject of further examination in [6.301]–[6.307] below. The distinction is not between an outgoing that “produces” income and an outgoing which does not. Any such distinction was rejected in Charles Moore & Co. (W.A.) Pty Ltd (1956) 95 C.L.R. 344 and in W. Nevill & Co. Ltd (1937) 56 C.L.R. 290. An outgoing which does not in any literal sense produce, may yet be an outgoing “in gaining”. But an expense must have more than an historical connection with the derivation of income. It must be connected with the process of derivation of income.

[6.292] The judgment in Green (1950) 81 C.L.R. 313 at 319 includes the observation that “we are not to be taken as deciding whether or not the cost of preparing taxation returns or of advising in relation to taxation liability is a deductible expenditure”. The express provision in s. 69 of the Assessment Act, in allowing a deduction of certain expenses in preparing an income tax return, proceeds on an assumption that such expenses would not otherwise be deductible. There must of course be problems in making the separation, referred to by Lord Porter in Smith’s Potato Crisps (1929) Ltd, between the expenses of recording income and the expenses of preparing a return, but where that distinction can be drawn expenses of preparing a return which are not within s. 69 will not be deductible. Some inference may be drawn from the provision of s. 64A, allowing a very limited deduction for expenses in connection with “proceedings before a court, board, commission or similar tribunal”, that expenses of disputing an income tax assessment are not deductible under s. 51(1).

[6.293] Where the Australian income tax paid is withholding tax, there is an added reason why the tax is not deductible. Section 128D provides that “income upon which withholding tax is payable … shall not be included in the assessable income of a person”. If the withholding tax is seen as incurred in gaining income, it will yet fail to qualify as deductible under s. 51(1) because its relevance is to income which is not assessable income.

[6.294] The conclusions here reached in regard to Australian income tax are not necessarily valid where the question raised is the deductibility of a foreign income tax. Where foreign income tax has been paid on income derived from a foreign source by an Australian resident, the income will generally be exempt from Australian tax under s. 23(q), and any question of deductibility of the foreign tax is sufficiently answered by pointing to this exemption—the foreign tax is not an expense relevant to the gaining of assessable income. In some circumstances s. 23(q) does not confer an exemption—where the income is dividends, or is interest or royalties and the foreign tax is subject to a limit on its amount provided for in a double tax agreement. Where it does not, the problem of deductibility is generally precluded by express provisions allowing a credit for the foreign tax, provisions which are inconsistent with deductibility of the foreign tax.

[6.295] The question of deductibility of a foreign income tax may, however, arise where Australian source income of a non-resident that is subject to Australian tax is also subject to income tax in the country of the taxpayer’s residence. The United Kingdom decision in I.R.C. v. Dowdall, O’Mahoney & Co. Ltd [1952] A.C. 401 involved circumstances of this kind. The House of Lords applied its own decision in Smith’s Potato Crisps (1929) Ltd, referred to above, in denying a deduction. Lord Oaksey said (at 409):

There is, of course, a logical difficulty in transferring the reasoning in Smith’s Potato Crisps to a foreign income tax. The foreign tax will follow its own law as to how income subject to tax is to be calculated, and the idea of an application of income derived, can only be sustained if the use of the same word is assumed to give an identity to the foreign and the Australian tax. And yet the very notion of an application of income derived assumes an identity between net income as it may be calculated in the taxpayer’s own accounting for profit, and taxable income as it is determined for tax purposes. Ultimately an application may be made only of the assets which may be traced to derivations which go to the determination of the taxpayer’s profit. They cannot be made out of the profits themselves. We may gloss over this difficulty and the further difficulty of regarding a payment as an application of taxable income. And it is then a short step in false logic to say that payment of a foreign tax is an application of Australian taxable income, where the base of the foreign tax has been calculated in the manner of the Australian income tax. In fact, the “application of income” notion is no more than a way of expressing the converse of what in more general principle is a test of relevance which requires that the expense be incurred in the process of deriving income.

[6.296] The observation in the last paragraph provides an opportunity to debate the nature and relevance of an asserted fundamental distinction between the United Kingdom and the Australian income tax. The distinction is regularly asserted in judicial pronouncements, most recently in the judgment of Gibbs C.J. and Mason J. in Whitfords Beach Pty Ltd (1982) 150 C.L.R. 355 as an explanation of differences between United Kingdom and Australian law. It is said that, at least when the income is that of a trader, the United Kingdom income tax imposes tax on “profits”, while the Australian law imposes tax on taxable income, the assumption being that the United Kingdom profits are, in some sense, the “real” profits—profits as commercial men see them. The Australian income tax, on the other hand, imposes tax on taxable income—profits, if the word is appropriate at all, as the law determines. It should be clear from the distinction drawn by Lord Porter in Smith’s Potato Crisps (1929) Ltd (quoted in [6.29] above) between “business accounts” and “revenue accounts” that the distinction drawn in the judicial pronouncements in Australia is without foundation. It is true that Schedule D Case 1 of the United Kingdom Income and Corporation Taxes Act 1970 purports to tax the “profits of a trade”. But the “profits of a trade” are determined by statutory provisions and a wealth of judicial decisions as to what are profits, the judicial decisions expressing a concept of income which provides virtually the whole of the original and continuing inspiration of the Australian notion of income by ordinary usage. From profits the United Kingdom law allows a deduction only of expenses “wholly and exclusively laid out for the purposes of the trade”. It is true that the relevant provision of the United Kingdom law is expressed in a negative, denying a deduction of expenses not wholly and exclusively laid out for the purposes of the trade. But a positive test of deductibility has been inferred from the negative, and the approach of the United Kingdom income tax has come to be indistinguishable from the approach that is directed by the express terms of s. 51(1) of the Australian Assessment Act. Again the United Kingdom judicial decisions interpreting the test of “laid out for the purposes of the trade” are a large part of the original and continuing inspiration of the Australian principles of deductibility.

[6.297] The conclusion is that there is no substance in the asserted fundamental distinction, and that the United Kingdom cases on the deductibility of income tax paid, if sound in the United Kingdom context, are sound in the Australian context.

[6.298] A foreign tax will not be deductible, by whatever name it is called, if its function, like the function of the Australian income tax, is to tax accretions to economic power. But other taxes may fairly be regarded as relevant to the process of income derivation, and working expenses, so as to be deductible under s. 51(1). Sales tax paid by a manufacturer or wholesale merchant, where he sells in the course of his business, is an obvious illustration. Sales tax paid by a manufacturer who takes goods for his own use is an obvious illustration of a tax that is not deductible. Land tax paid by an investor, where the tax relates to property let to produce income, will be deductible. In this instance there is a supporting express provision in s. 72, a section considered in [6.149]–[6.160] above. Payroll tax paid by a taxpayer in respect of salary and wages of persons employed in business will be deductible. Where the taxpayer’s activities do not amount to a business, though they involve a process of derivation of income, deductibility of payroll tax will follow deductibility of the salary and wages paid.

[6.299] In some instances the relevance of payment of the tax to the derivation of income may not be beyond argument. In Harrods (Buenos Aires) Ltd v. Taylor-Gooby (1964) 41 T.C. 450 the question was whether a United Kingdom company carrying on business in Argentina could deduct an Argentine tax levied on companies carrying on business in that country. The tax was charged at the rate of one per cent on the company’s capital, and was payable whether or not there were profits liable to Argentine income tax. The case for the Revenue was that the payment of tax was made, not in the company’s capacity as a trader, but in its “capacity as a taxpayer”. The Court of Appeal rejected the test and relied on the tests of relevance in Smith’s Potato Crisps examined above, for a conclusion that the tax was deductible. One would have thought that the notion of capacity as a taxpayer and the notion of application of income are indistinguishable. Both express a judgment of insufficient connection—a lack of relevance—to the process of income derivation. The tax in Harrods had more than an historical connection with the derivation of income. It was an expense that had to be met in order to sustain its right to carry on business.

[6.300] It will have appeared from the preceding discussion that the deductibility of preparing a return for the purposes of a tax, and of disputing any assessment, will follow the deductibility of the tax itself, though there will be difficulty, where the tax is not deductible, in separating the expenses of preparing a return from the expenses of recording the transactions which are reflected in the return.

The Distinction between Expenses of Deriving Income and the Application of Income Derived

[6.301] The distinction between expenses of deriving income and the application of income derived was the subject of some comment under the last heading ([6.291] above). In that comment, and earlier in [6.70] above, the point was made that the notion of application of income derived is logically unsound. Income is a quality of derivation of an item. It is not a quality of what have been derived. It is more than a quibble to say that the money in one’s pay envelope is not income. It may be money that in its derivation was income. If it is ever correct to say that money itself is income—the usage is probably beyond being eradicated—it does not retain that quality for any time. It has that quality only for a moment of time—the moment of derivation.

[6.302] To say that the notion of an application of income is logically unsound, is not to dismiss the distinction between an expense of deriving income and an application of income derived as unhelpful in resolving a question of deductibility. In [6.295] above it was suggested that the distinction is helpful in emphasising that an expense to be deductible must be incurred in a process of income derivation. There must be something more than a mere historical connection of the kind that exists where an outgoing has been made, in some sense, out of money which in its derivation was income. The fact that the obligation to make a payment arose because income had been derived adds a further element of connection but it is not sufficient to make the expense relevant. There is another way of expressing the insufficiency of the connection. A payment to discharge an obligation which arises because of acts done or omitted in the process of deriving income may be sufficiently connected. But a payment to discharge an obligation which arises because a derivation of income has occurred is not sufficiently connected. It is for this reason that a payment of income tax is not deductible in determining income subject to tax.

[6.303] In a number of other contexts outgoings have been held not deductible as applications of income derived. The judgment of Lord Davey in Strong & Co. of Romney Ltd v. Woodifield contains a statement that “it is not enough that the disbursement … is made out of the profits of the trade. It must be made for the purpose of earning the profits” ([1906] A.C. 448 at 453). As an explanation of why the outgoing—damages paid to a person staying in the taxpayer’s inn in respect of injury caused by the fall of a chimney—was not deductible, the statement is not persuasive. It could not be said that the obligation to make the payment was simply a consequence of income having been derived. The explanation of Lord Loreburn L.C. that the obligation to pay damages “fell upon [the taxpayers] in their character not of traders but of householders” at least brings the issue closer to the relevance of the outgoing. Strong v. Woodifield was the subject of comment in [6.51] above. It will be seen from the passage quoted in [6.291] above that Lord Normand in Smith’s Potato Crisps (1929) Ltd drew on the statement by Lord Davey to support his conclusion that income tax is not deductible in determining income subject to tax. It is not easy to see what common factor there may be between a payment of damages to an injured guest in a hotel and the payment of income tax.

[6.304] More persuasive is the use of the application of income test of relevance in the context of payments by a company to shareholders or to debenture holders. Where a payment is made to a shareholder, qua shareholder, a characterisation as a distribution of profits—an application of income derived—is likely to be compelling. Where however a payment is made to a debenture holder, the payment may be characterised as a payment to service a borrowing and deductible as an outgoing incurred in the process of derivation of income, in the same way as interest is deductible. The leading Australian decision is C. of T. (W.A.) v. Boulder Perseverance (1937) 58 C.L.R. 223. The case concerned a Western Australian Dividend Duties Act and is not directly relevant to the operation of the Assessment Act. The debenture holders were entitled to interest, on the moneys they had lent to the company, at 10 per cent. In addition each debenture contained a covenant by the company to divide among and pay to the debenture holders, pro rata in proportion to the moneys each had lent to the company, 50 per cent of the profits of the company each year. The deductibility of the payments under the name of interest was not questioned, but deduction was denied of the payments of shares of profits in determining the profits subject to the Western Australian duty. The court (Latham C.J., Dixon J. and McTiernan J.) said:

The distinction between “a payment contingent upon the making of net profits and proportional to their amount”, which may be deductible, and “a payment of part of the net profits under that description” may be thought verbal only, and the reference to the purpose of the statute, towards the end of the judgment, as not “confined to the taxation of profits that are available to shareholders and no one else” serves no more than to limit the decision in the case to the operation of the particular statute. One would have thought that, consistent with the approach taken in cases which rest on the purpose of the payment, the question of deductibility might have been resolved by asking whether the function of the payment was to service the borrowing or to effect a distribution of profits. A conclusion that it was the latter required a denial of the deduction. A number of United Kingdom cases where the characterisation of the payment as payments made to effect a distribution of profits are referred to in Boulder Perseverance. They reflect a disposition, where the return to a debenture holder is related to the amount of profits earned, to assimilate the positions of the debenture holder and of the shareholder.

[6.305] A senior employee of a company may be employed on terms that he is to be paid a share of the profits of the company. In A. W. Walker & Co. v. I.R.C. [1920] 3 K.B. 648, Rowlatt J. distinguished such a payment to an employee from a payment to a debenture holder. The share of profits taken by an employee admits of characterisation as a reward for services and it is possible to confine the application of income principle to payments to persons who have provided share or loan capital, or persons who are, for other reasons, investors. Where the employee is also a shareholder there will be a question whether the payment is made to the employee as employee or as shareholder. Section 109 of the Assessment Act gives the Commissioner a discretion in some circumstances to treat a payment to an employee as a distribution of profits, so that the company is denied a deduction.

[6.306] Denial of a deduction as an application of income may have the consequence that what appears to be the same gain is taxed to two taxpayers. Where one of these taxpayers is a company and the other is a debenture holder in that company, the consequence may be thought acceptable so long as the Australian income tax applies the separate system in taxing a company on its profits and a shareholder on distributions he receives from the company: the position of a debenture holder is assimilated to that of a shareholder. Where the taxpayer making the application of profits is not a company or the application of profits is made by a company to a person who is not a shareholder or debenture holder, or is made to him otherwise than as a shareholder or debenture holder, there would appear to be a prospect of an unacceptable taxing of the same gain to two taxpayers. Where the taxpayers are partners or may be said to be in receipt of income jointly, the provisions of Div. 5 of Pt III avoid two taxes on the same gain. The taxpayers may however be in the kind of relationship that existed between the taxpayer and the bondholders in N.Z. Flax Investments Ltd (1938) 61 C.L.R. 179. The High Court in that case did not have to decide whether the payments the taxpayer had agreed to make to bondholders from the proceeds of sale of flax would be deductible in determining the taxable income of the taxpayer. In Cliffs International Inc. (1979) 142 C.L.R. 140 the taxpayer was allowed a deduction of the payment it made to the persons from whom it had acquired shares, shares which enabled it, in turn, to acquire mining rights. The payments under the agreement with the former shareholders were made on the exercise, and in relation to the exercise, of the mining rights and were probably income of the former shareholders. The High Court held that the payments were deductible. It might, however, have taken a different view if the payments had not been required during the whole life of the mining rights. In Colonial Mutual Life Assurance Society Ltd (1953) 89 C.L.R. 428 the taxpayer was denied a deduction of payments made to another taxpayer who, in Just (1949) 23 A.L.J. 47, had been held to have derived income in the receipt of those payments.

[6.307] These illustrations may indicate that it will not always be possible within existing principle to ensure that the same gain is not taxed twice. At the same time, any development of principle towards recognising a policy against taxing twice will open evenues of income shifting which will raise another policy issue. The existing equipment of principle ought to reject the verbal distinction drawn in Boulder Perseverance and that case should be seen as an aberration, reflecting a disposition to treat debenture holders as shareholders when the development of the law in this area should move towards treating shareholders as debenture holders. A company in the situation of New Zealand Flax should be seen as making payments to investors which are maintenance costs of their investments. For the rest, the principles of relevance and working character should determine deductibility as they did in Cliffs International and Just.

The Characterisation of Losses in Relation to Receivables and Liabilities

The notion of “loss”

[6.308] The expenses so far considered in detail have been mostly outgoings. One important exception was an expense arising from the deprivation of an asset which is the taxpayer’s own property. In [6.52]ff. above, it was asserted that such an expense is a loss—the failure of an asset to realise its cost—though where the asset is cash in Australian currency the amount of the expense will be the same whether it is seen as an outgoing or as a loss. In the opening treatment of the operation of s. 51 ([5.14]–[5.26] above), the distinction between an outgoing and a loss is discussed, and a number of illustrations given of circumstances in which the relevant expense is a loss. Those illustrations comprise circumstances where a specific profit would have been income if a specific profit had resulted instead of the loss. Most of these circumstances concern the failure of a revenue asset to realise its cost. Some however concern the discharge of a revenue liability—a liability on revenue account—by the payment of an amount greater than the amount at which that liability has been brought to account as a deduction by an accruals basis taxpayer, or the amount acknowledged to be payable in respect of a borrowing on revenue account. The deduction of a loss in these circumstances is the correlative of the inclusion in income of a specific profit on the discharge of a liability on revenue account.

[6.309] The determination of the amount of the specific profit or loss on the realisation of a revenue asset or on the discharge of a liability on revenue account is considered again in Chapter 12 below. Some aspects of the determination of a specific profit or loss in relation to an asset which is a receivable, and in relation to liabilities, require consideration here: there are difficult questions of analysis.

Losses in relation to receivables

[6.310] A receivable that may give rise to a profit or loss that is income or deductible will be:

• (i) an amount that the taxpayer is entitled to receive, whether in respect of the supply by him of property which is trading stock, in respect of the supply of services, or in other circumstances, if the whole of the amount that the taxpayer is entitled to receive is an amount that must be brought to account as assessable income because the taxpayer is on an accruals basis in relation to the item. (Accruals basis as distinct from cash basis is explained in [11.24]ff. below); and
• (ii) an amount that the taxpayer is entitled to receive by way of repayment of a lending, where the lending is on revenue account.

There may be a third category: an amount that the taxpayer is entitled to receive as proceeds of the realisation of property which is not trading stock, or in respect of the surrender of rights, where the proceeds of realisation or surrender must be accounted for on the arising of a right to receive, in determining a profit that is income or a loss that is deductible. The general rule would be that only an actual receipt will be brought to account in fixing the profit or loss. To the extent, however, that a receivable should be brought to account, the receivable is one in relation to which there may be a profit that is income or loss that is deductible. In category (i) there is, strictly, no lending, but there may be said to be a grant of accommodation by the taxpayer and the accommodation will be granted on revenue account. The accommodation given is a revenue asset. Accruals accounting will not be appropriate unless the receivable arises in the carrying on of a business. In the third category contemplated, the accommodation granted could not be regarded as a revenue asset unless there is a continuing business, a concept explained in [2.437]ff. above. Where there is no continuing business, the receivable has, however, a similar character: any profit or, loss in relation to the receivable that is income or deductible, will be a profit or loss from the carrying out of the isolated venture from which the receivable arose—an isolated business venture, a venture within one of the limbs of s. 25A(1) or, presumably, a transaction within s. 26AAA. These observations in relation to the first and the possible third category assume that there are no special terms in relation to the amount receivable which would displace the presumption that any accommodation granted is on revenue account, or is granted in carrying out the isolated venture. There will, however, be circumstances in which the character of the accommodation granted must be determined on principles which will determine the character of a lending in category (ii) as a grant of accommodation on revenue account. Thus there may be a long term allowed in which the amount receivable might be paid to the taxpayer by the debtor, and the function of the grant of accommodation is the provision of finance for the debtor which is an investment in the debtor: the debtor may be a company that is a subsidiary of the taxpayer. Where these circumstances exist, the grant of accommodation may be seen as being a grant on capital account, or a grant unrelated to the carrying out of the isolated venture, and the receivable will not on realisation give rise to a profit that is income or a loss that is deductible.

[6.311] The description of category (i) is confined to a taxpayer who is on an accruals basis in relation to the item. Where the taxpayer is on a cash basis in relation to the item, the arising of the receivable is simply not an event that can have tax consequences. The accommodation granted is simply ignored. There will however be tax consequences on the actual or constructive receipt of the receivable, which will be substantially equivalent to the consequences for a taxpayer on an accruals basis which flow from the two events, being the arising of the receivable and the realisation of the receivable. Where the taxpayer is on a cash basis in relation to an item, there will be a derivation on actual or constructive receipt as explained in [11.122]ff. below. Where the constructive receipt takes the form of an application by the taxpayer of his entitlement to receive in making a loan to his debtor, there is room to regard the loan by the taxpayer as a lending on revenue account, though the fact that the taxpayer is on a cash basis in relation to the receivable may suggest that his lending is not on revenue account—that there is no business activity to which the lending is incidental so as to give it the character of a revenue asset. And the possibility that he is engaged in a business of moneylending seems unlikely.

[6.312] A general principle of tax accounting would require that a taxpayer must be taken to have incurred as the cost of a receivable the amount at which the receivable is brought to account as assessable income, or is brought to account in determining a profit that is income or a loss that is deductible. That principle will supply the cost in determining the amount of the profit or loss that may arise on the realisation of a receivable within category (i) or the possible third category. The cost of a receivable in category (ii) is obviously the amount of the money lent.

[6.313] A profit on the realisation of a receivable may arise because the amount of the receivable is expressed in a foreign currency, and the amount received in Australian currency on realisation is greater than the value in Australian currency at which the receivable was brought to account. There is a gain, identified as an “exchange gain”, which is income, being the profit on the realisation of a revenue asset. A loss may arise on realisation because the amount received in Australian currency is less than the value in Australian currency at which the receivable was brought to account. There is then an exchange loss. Where the receivable is money lent, a profit on the realisation of the receivable may arise because the taxpayer receives a premium on the repayment of the loan, either expressed to be such, or a premium in effect because the taxpayer has lent less than the borrower acknowledged he was liable to pay: the borrower may have negotiated at a discount a promissory note in which he gave his underaking to pay (Willingale v. International Commercial Bank Ltd [1978] A.C. 834). A loss may arise because the taxpayer fails to obtain an amount in repayment equal to the amount he had lent.

[6.314] Profit or loss may be realised not on the receipt of payment from the debtor but on the disposition by the taxpayer of the receivable and the receipt of an amount greater or less than the amount at which the receivable had been brought to account, or greater or less than the amount the taxpayer had lent.

[6.315] These propositions are all expressions of basic principles as to the meaning of income and as to the deductibility of expenses under s. 51 (1). There is however a specific provision in s. 63 relating to bad debts. The section has not been taken to cover the field in any sense so as to exclude the operation of s. 51 (1) in determining the deductibility of a loss in relation to a receivable. Some consideration is given to s. 63 in [10.50]ff. below, and some attempt is made to show the correlation between the operation of that section and of s. 51. Two points might be made here. Section 63 allows a deduction in advance of the moment of incurring of a loss in relation to a receivable that is deductible under s.51. The moment of incurring under s. 63 is the “writing-off” of the receivable. The receivables which may attract a deduction under s. 63 are confined to two classes. The first class would correspond with category (i) in the description of situations in [6.310] above. The receivable must have been brought to account as assessable income: it is not enough that the receivable is brought to account in determining a specific profit or loss. The second class covers only some part of the situations covered by category (ii) in [6.310] above. It exends only to loans on revenue account that are made by a money-lender in the ordinary course of carrying on a business of lending money. It may, it seems, extend to some receipts that are within neither category (i) nor category (ii) in the description of situations in [6.310] above. Interest on money lent in the ordinary course of a business of lending money is “in respect of” money so lent: National Commercial Banking Corp. of Australia (1983) 83 A.T.C. 4715. In this aspect the decision in National Commercial Banking Corp. of Australia produces an unsatisfactory result. There may be a loss deduction in respect of a receivable which would be accounted for as income only on actual or constructive receipt. There may be another illustration of a receivable to which s. 63 applies, that could not give rise to a profit that is income or a loss that is deductible under s. 51(1). A parent company may supply goods to a subsidiary on terms that amount to an investment by the parent in the subsidiary. The receivable might be the subject of a write-off under s. 63. But on the argument adopted in [6.310] above, it could not give rise to a loss deductible under s. 51(1).

[6.316] There may be difficulty in determining when a lending is on revenue account. The situation covered by s. 63 will clearly be such. A bank probably carries on the business of moneylending. In any event, loans by a bank or by a life insurance company are revenue assets on the authority of the banking and life insurance cases considered in [2.456]ff. above. A company carrying on a business of investing, in the manner of the company in London Australia Investment Co. Ltd (1977) 138 C.L.R. 106 which subscribes for debentures, lends on revenue account. A loan made by a taxpayer under a scheme to provide financial assistance to employees, or made to a supplier of goods, or to an outlet for the taxpayer’s production, may be a loan on revenue account.

[6.317] Section 63 refers to “bad debts”. Presumably a debt is bad when the debtor is unable to pay the full amount of the debt. A debt in a foreign currency is probably not a bad debt simply because a change in the exchange rate has brought about the consequence that payment in full of the debt will in Australian currency yield an amount less than the amount of Australian currency at which the receivable was brought to account, or the amount in Australian currency of the lending on revenue account. It would follow that write-off under s. 63 is not available in relation to an impending exchange loss. A loss deduction in these circumstances must await the realisation of the receivable, so that there is a deduction under s. 51(1).

[6.318] There is a question of what is meant by the realisation of a receivable so that there may be an exchange loss or other loss in relation to a receivable under s. 51(1). There is very little assistance in the authorities. In A.G.C. (Advances) Ltd (1975) 132 C.L.R. 175, the loss claimed was in respect of a “write-off”, so described, though s. 63 was admitted to be inapplicable. No argument was addressed to the court on the question whether a loss within s. 51(1) had in fact been incurred and the court did not consider the matter. Since A.G.C. (Advances), s. 63A has been added to the Act. The section is clearly intended to control deductions for bad debts by a company whether under s. 63 or s. 51, but in the conditions of deductibility imposed, s. 63A requires that the debt “be written-off as a bad debt” (s. 63A(2)). The section does not define the words “written-off”, though a meaning for the words in line with the interpretation given to them by judicial decisions on s. 63 would clearly be inappropriate.

[6.319] A principle that the Assessment Act is concerned only with realised gains and losses, unless there is an express exception, would be generally accepted. It is suggested that a receivable is realised when it is disposed of, when payment of it is received, when there is a receipt by the creditor which will discharge the debtor, or when the debt becomes irrecoverable—the debtor being bankrupt, or recovery being commercially impossible.

[6.320] The cases on exchange losses afford only indirect assistance. No Australian case involves an exchange gain or loss on the realisation of a receivable. The cases are all concerned with gains or losses on discharge of liabilities. The cases are: Texas Co. (Australasia) Ltd (1940) 63 C.L.R. 382; Armco (Australia) Pty Ltd (1948) 76 C.L.R. 584; Caltex Ltd (1960) 106 C.L.R. 205; International Nickel Aust. Ltd (1977) 137 C.L.R. 347; Thiess Toyota Pty Ltd (1978) 78 A.T.C. 4463; Commercial & General Acceptance Ltd (1977) 137 C.L.R. 373; Cadbury-Fry Pascall (Aust.) Ltd (1979) 79 A.T.C. 4346; Lombard Australia Ltd (1980) 80 A.T.C. 4151; AVCO Financial Services Ltd (1982) 150 C.L.R. 510; and Hunter Douglas Ltd (1983) 83 A.T.C. 4562. However, the cases, especially Caltex, reflect an unwillingness to find that a liability has been discharged, in a sense that will require an exchange gain or loss to be brought to account. The unwillingness there reflected may give some basis for inference that the courts will not, on other fronts, readily conclude that a receivable has been realised so that a gain has been derived or a loss incurred.

[6.321] The calculation of a loss on the realisation of a receivable must bring to account any proceeds of the realisation. Where the taxpayer has released the debt owed to him, for example under a scheme of arrangement between a company, its shareholders and creditors, there will be difficulty in identifying the proceeds of realisation. The effect of the release given by the taxpayer as a creditor of the company may be to increase the value of shares held by the taxpayer in the company. It would appear from the judgment of Owen J. in Point (1970) 119 C.L.R. 453 that the judge might have been prepared to hold in that case that a loss had been incurred by the taxpayer at the time the release of the debt owed to the taxpayer became effective under the scheme of arrangement. But no ground of objection in terms of s. 51 had been taken. The calculation of such a loss would have required a decision on the relevance of the fact that, as a consequence of the taxpayer’s release of the debt, there must have been an increase in the value of the shares the taxpayer held in the company. In G. E. Crane Sales Pty Ltd (1971) 126 C.L.R. 177 a deduction under s. 51 in relation to the loss on the assignment of the book debts to the receiver and manager would presumably have been defeated by want of contemporaneity—the business of factoring had ceased. If it were not so defeated—some doubts about the contemporaneity doctrine in this context are raised in A.G.C. (Advances)—there would be a question of how the release from its debts which the company obtained in exchange for the assignment is to be regarded. The release might be seen as proceeds of the realisation of the book debts.

Losses in relation to liabilities

[6.332] A liability that may give rise to a profit that is income or a loss that is deductible will be:

• (i) an amount the taxpayer is obliged to pay whether in respect of the supply to him of property which becomes his trading stock or in respect of the supply to him of services used in his business, or in other circumstances, if the amount he is obliged to pay is an allowable deduction because he is on an accruals basis of accounting in relation to the item; and
• (ii) an amount that the taxpayer is obliged to pay by way of repayment of a loan, where the loan is a borrowing on revenue account.

There may be a third category: an amount that the taxpayer is obliged to pay in respect of rights which are surrendered, where the amount he is obliged to pay must be accounted for in determining a profit or loss that is income or deductible, and is struck before there has been an actual or constructive payment by the taxpayer of the amount he is obliged to pay. In category (i) there is, strictly, no borrowing, but there may be said to be a receipt of accommodation and the accommodation will be treated as received on revenue account: the liability to pay is a liability on revenue account. Accruals accounting will not be appropriate to the incurring of the liability unless the liability arises in the carrying on of a business. In the third category contemplated the accommodation received will not be regarded as a liability on revenue account unless there is a continuing business. Where there is no continuing business the liability has, however, a similar character: any profit or loss that is income or deductible on the discharge of the liability will be a profit or loss from the carrying out of the isolated venture from which the liability arose—an isolated business venture, a venture within one of the limbs of s. 25A(1), or, presumably, a transaction within s. 26AAA. These observations in relation to the first and the possible third category, assume that there are no special terms in relation to the amount the taxpayer is obliged to pay which would displace the presumption that any accommodation is received on revenue account, or is received in the carrying out of an isolated venture. There will, however, be circumstances in which the character of the accommodation received must be determined on principles which will govern the determination of the character of a borrowing as a receipt of accommodation on revenue account. Thus there may be a long term allowed within which the amount the taxpayer is obliged to pay may be paid by him. The function of the accommodation received may in these circumstances be seen as providing the taxpayer with finance which he receives on capital account: the taxpayer may be a company that is a subsidiary of the creditor who has provided the finance. In these circumstances the liability will not be one that can give rise to a profit that is income or a loss that is deductible on the discharge of the liability. The notion of a borrowing on revenue account involved in the description of the second category is examined in [6.329] below. The assumption there made is that there can be such a borrowing only where there is a continuing business. The possibility cannot, however, be excluded that a borrowing made in the carrying out of an isolated venture which may give rise to a profit that is income or loss that is deductible, is a borrowing that may generate an income profit or a deductible loss on its discharge. The taxpayer may have borrowed in order to acquire property for the purpose of profit-making by sale.

[6.323] The description of category (i) is confined to a taxpayer who is on an accruals basis in relation to the item. Where the taxpayer is on a cash basis in relation to the item the arising of the liability is simply not an event that can have tax consequences. Tax accounting simply ignores the accommodation received. There are however tax consequences on actual or constructive payment of the liability which will be substantially equivalent to the consequences for a taxpayer on an accruals basis which flow from the arising of a liability and the discharge of that liability. Where the taxpayer is on a cash basis in relation to an item, there will be an incurring of a deductible outgoing on actual or constructive payment, as explained in [11.174]ff. below. Where the constructive payment takes the form of a loan by the creditor of the amount of the liability, the loan moneys being applied in payment of the liability, there is room to regard the liability assumed by the taxpayer to repay the loan moneys as a borrowing on revenue account, though the fact that the taxpayer is on a cash basis in regard to the original liability may suggest that the borrowing is not on revenue account—that there is no business activity to which the borrowing may be incidental.

[6.324] A general principle of tax accounting would require that the taxpayer must be taken to have received the amount at which his obligation to pay in respect of the supply to him of property or services is brought to account as an allowable deduction, or is brought to account as a cost in determining a profit or loss that is income or deductible on the discharge of the liability. The amount is the proceeds of his liability to be set against the costs of discharge. The amount a taxpayer in fact receives in a borrowing on revenue account is the amount of proceeds that will enter the calculation of the profit that is income or the loss that is deductible on the discharge of the liability he has assumed in the borrowing.

[6.325] The language of “cost” and “proceeds”, appropriate when the question is one of profit or loss on the realisation of an asset, remains appropriate when the question is one of profit or loss on the discharge of a liability. “Proceeds” precede “cost”. A taxpayer who assumes a liability which is an allowable deduction on the acquisition of trading stock receives proceeds of his liability equivalent to the amount of that liability. If, as a result of a movement of rates of exchange, he pays more than the amount of these proceeds when he discharges the liability, he has a cost which exceeds the proceeds and he incurs a loss. A taxpayer who allows a discount when he receives a promissory note has received proceeds of his note which are less than the cost he will incur when he pays the note. When he pays the note he incurs a loss in the amount by which his cost exceeds the proceeds.

[6.326] It may help an understanding of the tax accounting involved in a gain or loss on the discharge of a liability, to describe the incurring of the liability as the receipt of accommodation of $X. Where, on the discharge of the liability, there is an outlay of $X + $Y, there is a loss of $Y. Where, on the discharge, there is an outlay of $X - $Y, there is a gain of $Y. A parallel description of the gain or loss on the receipt of a receivable is appropriate. The arising of the receivable involves the granting of accommodation of $X. Where, on the receipt of the receivable, there is a receipt of $X + $Y, there is a profit of $Y. Where there is a receipt of $X - $Y, there is a loss of $Y.

[6.327] There are problems as to what will constitute the discharge of a liability on revenue account, so that there is a profit or loss comparable with the profit or loss that will arise on the realisation of a receivable on revenue account. There are a number of cases concerned with what constitutes the discharge of a liability for this purpose. All of them concern exchange gains and losses. In Armco (Australia) Pty Ltd (1948) 76 C.L.R. 584 the High Court was equally divided on a question whether the giving of a promissory note in respect of a liability for goods supplied was a discharge of the liability. In Caltex Ltd (1960) 106 C.L.R. 205 the payment to the creditor of the amount of a liability to pay in foreign currency for goods supplied, the payment being made out of the proceeds of a loan made to the debtor in the foreign currency by an associate of the creditor, was held not to be a discharge of the liability to pay for the goods so as to generate a deductible loss. The case does not afford any definitive view of the meaning of a discharge that will generate a profit or loss. The decision was by majority, and a variety of views are expressed in the judgments of the majority. They are more closely examined in [12.192]ff. below.

[6.328] Though there may be difficulties about what constitutes a discharge, it is clearly established in the exchange gain cases that a gain may arise on a discharge of a liability on revenue account. The leading case is International Nickel Australia Ltd (1977) 137 C.L.R. 347 where the gain arose on the discharge in the ordinary course of business of a liability on revenue account. In that case there are references to a United Kingdom decision in British Mexican Petroleum Co. Ltd v. Jackson (1932) 16 T.C. 570 where the taxpayer obtained a release from its debts in a compromise with its creditors and the House of Lords declined to find that the release resulted in a profit that was the taxpayer’s income. Mason J. in International Nickel distinguished British Mexican Petroleum on the ground that the discharge of the liability did not occur in the ordinary course of business. Which may suggest a principle that a gain or loss on the realisation of a receivable in circumstances which are outside the ordinary course of carrying on the taxpayer’s business will not be income or deductible. A principle of this kind would explain the need for s. 36 of the Act, which requires that the value of certain property, principally trading stock, which are assets of a business, be brought to account as income where the property has been disposed of otherwise than in the ordinary course of carrying on the business.

[6.329] The meaning of “borrowing on revenue account” is examined more closely in [12.206]ff. below. Until the judgment of the Federal Court in Hunter Douglas Ltd (1983) 83 A.T.C. 4562, the approach taken by the courts had been in terms of the function of the borrowing. Function, for this purpose, refers not to the actual use of the money, found in some kind of tracing of it into outlays, but the need for funds that prompted the borrowing. Borrowing is on revenue account if its function is specifically to discharge a liability on revenue account: Thiess Toyota Pty Ltd (1978) 78 A.T.C. 4463, and Cadbury-Fry Pascall (Aust.) Ltd (1979) 79 A.T.C. 4346. A borrowing whose function is to finance the acquisition of trading stock is a borrowing on revenue account. And a borrowing to finance loans made by a taxpayer whose business is to lend is a borrowing on revenue account: AVCO Financial Services Ltd (1982) 150 C.L.R. 510. However, the judgment of the Federal Court in Hunter Douglas is consistent only with an approach that looks to the nature of the borrowing itself, rather than its function. The nature of the borrowing may be seen as involving a broader characterisation, which may be assisted by an identification of the function of the borrowing but is not determined by it. The characterisation of the borrowing as a liability on revenue account will require a conclusion that the borrowing was made in the carrying on of the business of the taxpayer. The borrowing may be directly in the carrying on of the taxpayer’s business operations, as it will be where it is a borrowing by a bank to lend in the course of its business. It may be a borrowing incidental to the carrying on of the taxpayer’s business, for example a short term borrowing associated with the establishment of a letter of credit to finance the acquisition of trading stock. Or it may be a borrowing that reflects system and organisation to minimise the cost of borrowing.

[6.330] The more limited the room for a conclusion that a borrowing is on revenue account, the more significant will be the distinction between the deduction for a loss on the discharge of a liability and the deduction for interest. It will be recalled that the deductibility of interest on a borrowing does not depend on a characterisation of the borrowing as a liability on revenue account. It is a matter of whether the money was borrowed for the purpose of an outlay in a process of income derivation, and, perhaps, whether the money can for the time being be traced into such an outlay. The taxpayer who borrows on capital account, though for the purpose of an outlay in a process of income derivation, will be denied a deduction for a loss on discharge of the liability, arising, for example, from the payment of a premium on discharge, or the allowance of a discount on the issue of his undertaking to pay. The taxpayer who borrows in this way will be allowed a deduction of interest on the borrowing, provided the money borrowed continues to be outlaid in the process of income derivation. The distinction between premium paid and discount allowed, on the one hand, and interest on the other, is not obvious as a matter of substance, and the differential treatment in tax law may not commend itself. It would be possible to treat premium discount and interest in the same way, and to apply the same common treatment to an exchange loss incurred by a borrower. The possibility of treating an exchange loss as interest on a borrowing was suggested by Rogers J. in Hunter Douglas (1982) 82 A.T.C. 4550 at 4559, though he did not pursue the suggestion in making his decision. The possibility may be thought to be excluded by the decision of the High Court in AVCO Financial Services Ltd (1982) 150 C.L.R. 510, where it was assumed that a decision that an exchange loss on repayment of a borrowing is deductible requires a conclusion that the borrowing was on revenue account. And we would be left with a strange mixture of analyses if a loss on the discharge of a liability could be treated as deductible as being in the nature of interest paid to secure the borrowing, though the borrowing was on capital account, and a gain on the discharge of the liability is treated as income only when the borrowing was on revenue account. Perhaps such a strange mixture of analyses is already with us. A premium received on the realisation of a lending may in some circumstances be income, at least in part, as a receipt for allowing the use of money by another, irrespective of whether the lending was on revenue account: Lomax v. Peter Dixon [1943] K.B. 671, discussed in [2.285]ff. above. Yet the premium will in other circumstances be income only if the lending was on revenue account. When the question is whether an amount received that is described as interest may be treated as a premium and not as a receipt for allowing the use of property by another, the description, it seems, precludes a conclusion that the amount is to be treated as a premium. These matters are considered in [2.285]ff. above. They concern the situation of the lender. It may be asked whether the treatment of a payment by a borrower described as interest will be determined by the description. It may be asked whether a payment of so-called “penalty” interest on the early repayment of a borrowing is to be treated as interest, and deductible, provided the money borrowed was used in a process of income derivation, or as a premium that may give rise to a loss realised on discharge of the liability, deductible only where the borrowing was on revenue account. A description of the penalty as interest would appear to be in conflict with substance, if interest as a deductible item is a payment to service the use of property. The payment is in respect of a period when the taxpayer has repaid the borrowing and does not have the use of the money.