Commissioner of Taxation v Roberts

Re: COMMISSIONER OF TAXATION
And: JOAN DOROTHY ROBERTS and VALENTINE ROY SMITH
Nos. T G3 and T G4 of 1992
FED No. 543
Income Tax
(1992) 23 ATR 494/ (1992) 92 ATC 4380
(1992) 108 ALR 385
(1992) 37 FCR 246

COURT

IN THE FEDERAL COURT OF AUSTRALIA

TASMANIA DISTRICT REGISTRY
GENERAL DIVISION
Jenkinson(1), Hill(2) and O'Loughlin(3) JJ.

CATCHWORDS

Income Tax - Deductions and rebates - Particular deductions - Interest and other expenses of borrowing money - Money borrowed by partnership to enable payments to members of partnership - Whether interest on borrowed money is an allowable deduction in calculation of "net income" of partnership - Whether the share of that interest contributed by a member of the partnership admitted after the borrowing upon condition that she accept liability for the interest payments falling due after her admission is an allowable deduction from her assessable income.

Income Tax Assessment Act 1936 - Part III Division 5, s.51(1)

HEARING

MELBOURNE

#DATE 31:7:1992

Counsel for the Appellant: Mr J.M. Batt QC and Mr G.T. Payne

Instructed by: Australian Government Solicitor

Counsel for the Respondents: Mr A. Slater and Mr A.J. Abbott

Instructed by: Dobson Mitchell and Allport

ORDER

No. T G3 of 1992

THE COURT ORDERS THAT:

1. The appeal be dismissed.

2. The appellant pay the respondent's costs of the appeal.
No. T G4 of 1992
THE COURT ORDERS THAT:
1. The appeal be allowed.

2. The orders made on 18 December 1991 by the Honourable Mr Justice Northrop be set aside.

3. The decision of the Administrative Appeals Tribunal given on 19 June 1991 in the proceeding numbered TT90/10 in that Tribunal be set aside.

4. The matter of the referral the subject of the said proceeding be remitted to the Administrative Appeals Tribunal to be heard and decided again in accordance with law.

5. In the said proceeding each party be at liberty to adduce further evidence.

6. There be no order as to costs of the proceeding numbered TG8 of 1991 or of the appeal.

7. This order be not entered before 28 August 1992.
Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules.

JUDGE1

I have had the advantage of reading the reasons for judgment prepared by Hill J. in respect of these appeals. Except on one point, I agree in those reasons and in the orders which Hill J. proposes. Concerning his Honour's adoption of the observations by French J. in Nizich v. Federal Commissioner of Taxation (1991) 91 ATC 4747 at 4752 about the conceptual distinction upon which the administration of the common law has been based for centuries, and concerning his suggestion of amendment of s.44(1) of the Administrative Appeals Tribunal Act 1975, I say nothing.

JUDGE2

The Commissioner of Taxation, the appellant in each of the two appeals before the court, appeals against the judgment of a judge of this court, which set aside the decisions of the Administrative Appeals Tribunal constituted by a Deputy President. The Tribunal had affirmed the disallowance, in determining the net income of the partnership of which each of the respondents in different tax years was a member, of certain amounts of interest paid to the National Australia Bank Ltd ("the bank").

The facts as presented at the Administrative Appeals Tribunal were largely not in dispute. Indeed, the parties had reached agreement on a number of facts and these agreed facts and documentary evidence were supplemented by oral evidence and cross-examination.
Before July 1984, Mr Smith was a member of the firm of Dobson Mitchell and Allport, solicitors practising in Hobart. The firm had a long established practice.
In June 1984 the then partners agreed to admit as a new partner a Mr McKay. The previous practice had been f or new partners to be financed into the partnership by loans from the existing partners which were repaid out of future profits from time to time. However, the partners decided that commencing with Mr McKay all future partners would have to provide their own funds in order to buy into the partnership. In the case of Mr McKay, this would have meant his providing from his own funds the sum of $54,000 to fund the amount required by the existing partners. He was unable to do this.
The existing partners resolved upon a solution which would reduce the cost price to Mr McKay and future partners of a share in the partnership, essentially by reducing the value of the partnership. The solution involved each partner drawing a cheque upon the partnership bank account in the sum of $25,000 and banking that cheque to the credit of his personal bank account. The funds so received by the then partners were used for their personal purposes. It is not suggested that any of these funds found their way back into the partnership. As the partners saw it, they were withdrawing their "capital" from the firm.
The partnership bank account did not have sufficient credit funds to enable this procedure to occur without bank assistance. Accordingly, the partners made an arrangement with the bank for a loan of $125,000. The bank's internal records disclose the circumstances of the borrowing as being to allow Mr McKay to buy into the partnership at a much reduced level, rather than his having to borrow substantial funds. The bank, having approved the facility, accordingly credited the partnership bank account with the loan funds. This, in turn, enabled the cheques drawn in favour of the partners to be met. These transactions took place in the last week of the 1984 financial year and before the end of the year of income.
Mr McKay was admitted to the partnership on 1 August 1984. The amount which he was required to pay for his partnership interest was $34,434, rather than the $54,000 which would otherwise have been necessary. It was, at the time of Mr McKay's admission, and remained the case thereafter, that it was a condition and consequence of admission to the partnership that the incoming partner became and remained personally liable to an unlimited extent for the debts, liabilities and obligations of the partnership, including repayment of the principal and interest on the loan to the bank. When Mr McKay was admitted to the partnership, his admission and liability on the borrowing was noted by the bank. The parties were in agreement that there was a novation of the liability to the bank at the time of Mr McKay's admission and on changes thereafter in the composition of the partnership.
By the end of April 1987, two of the original partners had retired and a further new partner had been admitted. On 1 May 1987, Mrs Roberts became the seventh partner in the firm. The amount needed to fund her purchase of an interest in the firm was $35,072. She accepted her share of the liability to the bank. At all relevant times interest on the borrowing was paid from the partnership bank account. However, the principal had not been repaid.
The decision of the Administrative Appeals Tribunal
The learned Deputy President held that the interest paid to the bank in the relevant years of income from partnership funds was not an outgoing incurred in gaining or producing the assessable income of the partnership, nor was it necessarily incurred in carrying on the partnership business. In so finding, the Tribunal looked to the use to which the funds were put, seeing this as being subservient to the purpose of the borrowing. Reference was made to the leading cases of Ure v Federal Commissioner of Taxation (1981) 50 FLR 219, 81 ATC 4100 and Federal Commissioner of Taxation v Ilbery (1981) 58 FLR 191, 81 ATC 4661 as supporting this conclusion. The Tribunal also concluded, without any discussion, that the interest was of a private or domestic nature and also of a capital nature.
The Tribunal also rejected an alternative submission that whether or not the interest was allowable as a deduction to the partnership as constituted at the time of the transactions in June 1984, the interest was an allowable deduction of each reconstituted partnership thereafter. Thus, it was argued that, to take the case of Mrs Roberts, she simply bought her share of the partnership with the loan already in place and as such the interest paid by the partnership of which she was a member was capable of a different characterisation from that which it had when paid by the partnership as constituted at the time of the commencement of the bank's loan. In the opinion of the Tribunal, while it was correct that a new partnership came into existence each time the partnership was reconstituted, the loan kept its identity so as to maintain the characterisation of the interest payments as non-deductible to the partnership as subsequently constituted.
The decision in the court at first instance
The learned judge below placed particular emphasis upon the admonition contained in the judgment of the High Court in Fletcher v Commissioner of Taxation (1991) 103 ALR 97 at 105; 91 ATC 4950 at 4956 that where the question of deductibility of a partnership outgoing is in dispute the issue must fall to be answered in the context of the calculation of the net income or loss of the partnership for the purposes of s.90 of the Income Tax Assessment Act 1936 (Cth) ("the Act"), rather than the direct deductibility of the outgoing to the partners. His Honour criticised some of the reasoning of the Tribunal as having concentrated too much on the position of the partner taxpayers and not enough on the partnership as a deemed taxpayer for the purpose of s.90 of the Act.
Approaching the matter in this way, his Honour found that the interest was properly to be characterised as having been incurred by the partnership in earning assessable income. His Honour's process of reasoning is to be found in the following passage:

"In the present case, and implicit from all the evidence, is the fact that $125,000 was required by the partnership to enable it to carry on its business. Initially that money had been provided by the `original' five partners. In June 1984, a change occurred. To use a word commonly in use these days, the partnership business was restructured. Each of the five partners withdrew $25,000 capital. In order to enable it to carry on its business, the partnership borrowed $125,000 from the Bank. That loan remains outstanding and the partnership is paying interest on the amount of the loan. There can be no real doubt that if a partnership comes into existence and the partners borrow money to enable them to carry on that business, interest paid on the money so borrowed is deductible under s 51(1) of the Act. This would be so even if the partners, individually, had sufficient capital to provide the same amount as that borrowed.

In the present case, the money borrowed from the bank constitutes part of the capital of the partnership necessary for it to carry on its profession. The partnership pays commercial rates of interest on the loan. The loan is continuing. The partnership pays the interest on the loan. In my opinion the fact that as a result of the `restructuring' each of the five `original partners' receives a refund of capital does not prevent the characterisation of the interest payments as having been incurred by the partnership in earning assessable income."

The relevant statutory provisions

The provisions of the Act directly relating to the taxation of partners are to be found in Division 5 of Part III. A partnership is not liable as such to pay tax, but is obliged to furnish tax returns: s.91. There is, however, to be included in the assessable income of a partner who is a resident during the whole of the year of income his individual interest in the "net income" of the partnership: s.92(1). There is a like allocation of an allowable deduction where there is a "partnership loss": s.92(2). "Net income" and "partnership loss" are expressions defined in s.90. For present purposes it is unnecessary to consider the definition of "partnership loss". "Net income" was, at the relevant time, defined in s.90 as follows:

`net income', in relation to a partnership, means the assessable income of the partnership, calculated as if the partnership were a taxpayer who was a resident, less all allowable deductions except the concessional deductions and deductions allowable under sections 80, 80AA or 82AAT."

Section 51(1) of the Act provides as follows:

"All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income".

The challenge to jurisdiction

Apparently, before his Honour, the Commissioner challenged the jurisdiction of the court to pass upon the appeal from the Administrative Appeals Tribunal. His Honour's judgment does not note this. Perhaps his Honour regarded the matter as self-evident. There is a reference in the judgment to the appeal arising under the Administrative Decisions (Judicial Review) Act 1976 but that is clearly a mistake. The appeal arose under s.44(1) of the Administrative Appeals Tribunal Act 1975 which section, while permitting a party to a proceeding before the Tribunal to appeal to this court, restricts the right of appeal to one that is on a question of law. The appellant Commissioner says that the appeal from the Administrative Appeals Tribunal was incompetent because no question of law arose.
At the heart of the submission was the assertion that there had been no dispute in the Tribunal as to the legal criteria applicable and that accordingly the decision was one of fact and degree. The question before the Tribunal was, so it was submitted, as to the use of the moneys borrowed and that was a question of fact. The question whether the interest was private or domestic similarly involved no question of law, but merely one of fact. While it was conceded that the question whether the outgoings were of capital or of a capital nature involved a question of law, the Commissioner no longer sought to maintain the decision of the Administrative Appeals Tribunal on that point, and in any event success on that question would not have permitted the taxpayers to obtain a favourable result, given the adverse findings on the other issues.
Support for these submissions was sourced principally in the decision of this court in Federal Commissioner of Taxation v Brixius (1987) 16 FCR 359.
Brixius concerned a question of the deductibility of rent paid for a home study. The taxpayer had been successful in obtaining a partial deduction in the Tribunal and the principal argument which the Commissioner sought to put in this court was that the Tribunal had come as a matter of law to the wrong conclusion. The full court of this court (Forster, Fisher and Spender JJ.) were unanimously of the view that no question of law arose. Their Honours said (at 365):

"The difficulty which confronts the Commissioner is that, once having identified the correct principles of law (a matter which was not challenged) the question for determination by the Tribunal is, in a matter of this nature, essentially a question of fact, or of fact and degree.

As a matter of law the question for determination on the first limb of s51(1) is whether the outgoing has the necessary relation to the gaining of assessable income, that is, has it the essential character of an outgoing incurred in gaining such income? The Tribunal correctly identified this principle and the Commissioner did not contend to the contrary. Its task was then to apply the law to the facts as found. The application of s51(1) in this manner is in the varied circumstances of each case very much a matter of fact and degree." (emphasis added)

The words emphasised show that in what their Honour's said they were not seeking to lay down a principle of universal application. The question of the application of settled principle to a question involving apportionment may be a matter of fact and degree in which no question of law arises. But it does not follow in every case that the application of s.51(1) to facts not in dispute will involve no question of law. That would be inconsistent with a long line of authority most recently discussed in the full court of this court in the judgment in Federal Commissioner of Taxation v Cooper (1991) 99 ALR 703 at 719-21, (91 ATC 4396 at 4408-4411) in which all members of the court concurred on this point.
It is well established that a question of law will be involved in any case where, the facts not being in dispute, the only question is whether the case necessarily falls within or outside the statute. To the long list of authorities cited in Cooper at 719-20 (91 ATC at 4409) may be added Federal Commissioner of Taxation v Markey (1989) 87 ALR 454 at 460, Federal Commissioner of Taxation v Inkster (1989) 24 FCR 53 at 75-7, Nizich v Federal Commissioner of Taxation (1991) 91 ATC 4747 at 4752 and TNT Skypak International (Aust) Pty Ltd v Federal Commissioner of Taxation (1988) 82 ALR 175 at 182. Further, as Gummow J observed in TNT Skypak this will be so notwithstanding that:

"... the criterion fixed by the statute for its operation is so supple (if not subtle) that its application to given facts may be described as `one of degree' or `of fact and degree'."

The distinction to be drawn between a case such as Cooper on the one hand and Brixius on the other, is to be found in the discussion in Cooper at 99 ALR 720; 91 ATC 4409, in the following passage:

"The rationale for this view (ie that the question whether a case necessarily falls within or without a statute involves a question of law) is particularly apparent in a case where, only one conclusion being open on the facts, the Board (now the Administrative Appeals Tribunal) arrives at a different conclusion. Since the facts were not in dispute, it follows that the Board must have applied some wrong principle of law, albeit that it has not stated the principle upon which it has relied. It is a different question, of course, and one of fact only, if the issue is whether, a number of results being open, a particular result arrived at was correct, for in such a case the matter is one of degree only."

This rationale does not disappear merely because, in its explicit statement of reasons, the Tribunal has stated principles of law which are not in dispute as between the parties.
There will be occasions when there will be great difficulty in determining whether a question of law is raised in an appeal, so as to make the appeal competent. A jurisdictional debate in matters of this kind is often a sterile exercise. There is unfortunate truth to be found in the criticism of French J in Nizich (at 4752) that the categories of fact and law could well be included in the class of "categories of meaningless reference" described by Professor Stone in Legal System and Lawyer's Reasonings (1968) at 340. Consideration should be given to amending the law either to eliminate the distinction and thereby to create a full right of appeal to this court on both matters of fact and law or at least to minimise the importance of the distinction by permitting the court with leave to entertain an appeal, notwithstanding that no question of law appears to arise, so that in difficult, but nevertheless important, cases the parties might be given permission to litigate the issues, without the necessity of a jurisdictional challenge. In the meantime, valuable court time and the resources of parties continue to be poured into debating the distinction in a jurisdictional challenge.
In the present case there is, in my view, no doubt that there is a question of law to enliven the court's jurisdiction. Not only may that question of law be identified as falling on the Cooper side of the line, but also there was here the issue whether the correct test to be applied to determine the issue of deductibility was one dependent on "purpose" or whether the test of the use to which the funds were put was determinative.
Submissions of the appellant

For the Commissioner it was submitted:

* That his Honour had erred in assuming jurisdiction to make findings of fact.

* That the characterisation of the interest was to be determined exclusively by the use to which the moneys were put and that use was for the private purposes of the partners.

* That the assumption of liability for

interest by Mr Smith and Mrs Roberts did not change the use of the borrowed moneys.

For the respondents to the appeal it was submitted:
* Having regard to the nature of interest as the price for the

continued use of borrowed money and or relief from having to repay principal, the interest in the present case of a partnership with a continuing business was deductible.

* The direct application of the money initially borrowed is not

decisive of the essential character of interest. Here, the interest satisfied the statutory test of having been incurred in the course of the partnership's income producing business or activity. It was a cost of that activity.

* That each partnership formed after the borrowing had a purpose of

retaining the continued use of the money borrowed, which purpose made the interest deductible. Neither was infected by the original circumstances of the borrowing.

* In the case of Mrs Roberts she was

entitled directly to a deduction for the interest she in fact incurred under her

joint and several liability under s.51(1) outside the provisions of Division 5.

Whether his Honour erred in finding facts

For the Commissioner it was submitted that his Honour had erred in the passage cited at length above in that, the appeal being limited to one on a question of law, his Honour was not entitled to make his own findings of fact. The findings said to have been made by his Honour were:
1. That the sum of $125,000 was required by the partnership to enable

it to carry on its business;

2. That initially money had been provided by the original partners;

and

3. That the money borrowed from the bank constituted part of the

capital of the partnership necessary for it to carry on its profession.

It is an inexorable result of the confinement of appeals to this court from the Administrative Appeals Tribunal to appeals on a question of law that the role of this court is limited to resolving the question of law upon which the appeal is brought: Federal Commissioner of Taxation v Swift (1989) 89 ATC 5101 at 5112-3. The ambit of the appeal is confined to the question of law which invests jurisdiction: Brown v Repatriation Commission (1985) 60 ALR 289 at 291. The legislative scheme is thus to leave the Tribunal as the final arbiter of fact, but to commit to this court jurisdiction to correct errors of law made by the Tribunal.
However, there are cases where the court has arguably made findings; cf Statham v Federal Commissioner of Taxation (1989) 89 ATC 4070, although a careful perusal of the cases would rather suggest that all the court did was take the findings of primary fact and draw from those findings ultimate conclusions of fact. These cases, however, have only been where it would be oppressive to send the matter back to the Tribunal and where the facts were "largely undisputed"; Statham at 4075, or where the facts were "beyond dispute"; Jolley v Federal Commissioner of Taxation" (1989) 89 ATC 4197 at 4207, or where the conclusion of fact was "inescapable"; Federal Commissioner of Taxation v Inkster (1989) 89 ATC 5142.
In the present case it is doubtful if his Honour intended, in the passage quoted, to make findings of fact. Perhaps he was merely stating what he saw to be the obvious, and what would not seem really to have been in dispute between the parties, namely that once the payments had been made to the original partners in 1984 there was a need to borrow a like amount, otherwise the partnership bank account would be in overdraft. That seems implicit in the finding that the loan had not been repaid. The finding, if it be one, that some money had, at least, been provided by the original partners, probably is inescapable as a matter of logic. The third so called "finding" seems to be a conclusion which his Honour has drawn from the primary facts not in dispute. Probably it amounts no more than to say that without the $125,000 borrowing the partnership would not have been able to carry on business, since there would be a deficiency of funds in the partnership bank account.
I am content, however, for the purpose of the present argument, to accept that his Honour did make findings and that he was in error in so doing. Accordingly, I will proceed to consider the proper resolution of the present case unaided by them.
The deductibility of interest to Mr Smith
In Federal Commissioner of Taxation v Riverside Road Pty Ltd (in liq) (1990) 90 ATC 4567 at 4573-4575 the full court of this court summarised the applicable principles governing deductibility under s.51(1) of the Act. It is unnecessary to repeat them here. Suffice it to say that what is involved is a process of identifying the essential character of the expenditure to determine whether it is in truth an outgoing incurred in gaining or producing the assessable income or necessarily incurred in carrying on a business having the purpose of gaining or producing assessable income: Lunney v Federal Commissioner of Taxation (1958) 100 CLR 478 at 499; Fletcher v Federal Commissioner of Taxation (1991) 91 ATC 4950 at 4957. The expenditure must have the necessary connection with the operations or activities which more directly gain or produce assessable income so as to meet the statutory criterion that the outgoing be incurred in gaining or producing assessable income or in carrying on a business: Charles Moore and Co (WA) Pty Limited v Federal Commissioner of Taxation (1956) 95 CLR 344 at 351; Federal Commissioner of Taxation v Smith (1981) 147 CLR 578 at 586. That is to say it must be "incidental and relevant" to that end: Ronpibon Tin NL v Federal Commissioner of Taxation (1949) 78 CLR 47 at 56, although as Williams, Kitto and Taylor JJ. observed in Lunney at 497, expressions of the kind "incidental and relevant" are:

"... not used in an attempt to formulate an exclusive or exhaustive test for ascertaining the extent of the operation of the section; the words were merely used in stating an attribute without which an item of expenditure cannot be regarded as deductible under the section."

Interest on moneys borrowed and used in a business will ordinarily be an allowable deduction. Thus, as Dixon J said in The Texas Co (A'sia) Ltd v Federal Commissioner of Taxation (1940) 63 CLR 382 at 468:

"Some kinds of recurrent expenditure made to secure capital or working capital are clearly deductible. Under the Australian system interest on money borrowed for the purpose forms a deduction. So does the rent of premises and the hire of plant."

The circumstances when interest may be deductible were considered in the context of the Income Tax Assessment Act 1922 in Federal Commissioner of Taxation v Munro (1926) 38 CLR 153. That case concerned a borrowing on the security of rent producing property to fund a gift by the borrower and a loan by him without interest to a company in which he and his children were shareholders. The argument for the taxpayer was for relevant purposes that because the money was borrowed by a charge upon rent producing property so that unless the interest were paid the income in the form of rent would not be received, the interest was deductible. It was contended that this was so irrespective of the purpose to which or the manner in which the money borrowed was applied. The argument was, not surprisingly, rejected. In so doing Knox C.J. (at 171) (on this point Higgins J (at 204), Isaacs J (at 197-8) and Starke J (at 218) agreed) looked to the purpose of the borrowing as providing the criterion of deductibility. Rich J, while agreeing in the result gave no reasons (at 210). In the course of his judgment Isaacs J said (at 197-8):

"Had the money borrowed been expended on the property so as to increase the rentals or so as to prevent depreciation which would have reduced the rentals, then it could have been properly said that the interest had been a means of gaining or producing the assessable income. But in employing the borrowed money for purposes independent of the property, leaving its condition entirely unaffected, that result cannot be postulated... In short, the interest paid to the bank was not paid to create any of the assessable income in question: it was incurred because, among other things, that income was in a manner of speaking already in existence."

The court did not draw a distinction between subjective purpose or motivation, on the one hand, and objective purpose determined by the use to which the funds were put on the other, although the decision is consistent with determining purpose in an objective way by reference to the use to which the funds were put.
The mere act of borrowing money, burdened with the obligation to pay interest, does not of itself gain or produce assessable income. The amount borrowed is not assessable income. What operates to gain or produce assessable income is the manner in which those moneys are used, so that the necessary connection between the outgoing for interest and the activities which more directly gain or produce assessable income will be found, in the ordinary case, in the use to which the borrowed funds are put. That is not to say that there may not be cases where motivation or subjective purpose will play a part in the question of characterisation. One such case was Ure v Federal Commissioner of Taxation (1981) 81 ATC 4100.
In Ure, the appellant had borrowed at commercial rates of interest and on lent the borrowed moneys at 1% per annum either to his wife or to a family company. The taxpayer argued, unsuccessfully, by reference to the use to which the moneys were put, being an income producing use, that the whole of the interest on the borrowed funds was deductible. The court apportioned the interest allowing a deduction equivalent to the income to be derived by the on lending.
Brennan J in that case (at 4104), expressed the test of deductibility of interest in terms of the purposes for which the borrowed money was laid out; turning upon the objective circumstances rather than the subjective state of mind of the taxpayer. It depended:

"... upon what the taxpayer in the circumstances of the case is ascertained to have done in using and arranging for the use of the borrowed moneys."

Deane and Sheppard JJ., on the other hand, recognised that in complex cases where there was no obvious commercial explanation it would be necessary, in the process of characterisation, to have regard to:

"... the whole set of circumstances including direct and indirect objects and advantages which the taxpayer sought in making the outgoing...it is `a common sense appreciation of all the guiding features which must provide the ultimate answer'."

Most recently the High Court has considered the relevance of motive or purpose to deductibility under s.51(1) in Fletcher v Federal Commissioner of Taxation (1991) 91 ATC 4950, in a judgment delivered after the present case was decided by the Tribunal. The case concerned a complicated arrangement whereby a partnership borrowed money for the purpose of funding an annuity. The result of the arrangement was that if the arrangement were not terminated, the partnership would, in the early years, have a large net loss, which would be available to the partners to deduct against their other income. In the later years, however, there would be corresponding large amounts of assessable income to be taken into account in calculating the net income of the partnership and thereby, through s.92, to be included in each of the partner's assessable income.
As the court points out in a unanimous judgment of all seven justices, the process of characterisation involved in resolving an issue under s.51(1) will be commonly possible without reference to the taxpayer's subjective thought processes. In other cases motive may be a relevant fact, at least where the outgoing has been voluntarily incurred. Thus motive could be relevant to a case where no assessable income could be identified at the time the outgoing was incurred, or where the relevant assessable income was less than the amount of the outgoing. The court remitted the case to the Tribunal to make findings of fact as to whether the parties intended that the arrangement would be terminated before assessable income was derived.
In Kidston Goldmines Ltd v Federal Commissioner of Taxation (1991) 91 ATC 4538, I pointed to difficulties which may sometimes arise where either test is adopted to the exclusion of the other. I then said (at 4545-6):

"This is not to say that tests such as the purpose of the borrowing or the use and application of the borrowed funds are irrelevant. Rather they are tools to assist in the resolution of what is essentially a question of fact. To be deductible the outgoing, or in a case of apportionment a part of an indivisible outgoing, must be seen to be incidental and relevant to the activity which is directed to the gaining or production of assessable income. In the normal case, the fact that the funds borrowed have been borrowed for the purpose of that activity and can still, in the year of income in which the deduction is claimed, be seen as having that purpose, will lead readily to the conclusion that the interest will be incidental and relevant to the income producing activity. Again, in the usual case the application of funds to an income producing purpose will demonstrate the relevant connection between the outgoing and the income producing activity. Indeed there is much to be said for the view that the tests of purpose and application of funds are but two sides of the one matter."

While acknowledging the usefulness of both the concepts of use to which the funds are put and of subjective purpose, I warned in that case of the danger in substituting for the words of s.51(1) language which does not appear in it. It is a warning to which I adhere. The issue continues to be whether the interest outgoing was incurred in the income producing activity or, in a case falling to be tested under the second limb, in the business activity which is directed towards the gaining or producing of assessable income. As the cases, including Kidston, all show, the characterisation of interest borrowed will generally be ascertained by reference to the objective circumstances of the use to which the borrowed funds are put. However, a rigid tracing of funds will not always be necessary or appropriate: cf Total Holdings (Australia) Pty Limited v Commissioner of Taxation (1979) 79 ATC 4279 and the discussion of tracing in the context of s.51(1) in Parsons, Income Taxation in Australia, Law Book Co, 1985 at 348ff.
For example, let it be assumed that there are undrawn partnership distributions available at any time to be called upon by the partners. The partnership borrows from a bank at interest to fund the repayment to one of the partners who has called up the amount owing to him. That partner uses the moneys so received to purchase a house. A tracing approach, if carried beyond the payment to the partner, encourages the argument raised by the Commissioner in the present case that the funds were used for the private purpose of the partner who received them. But that fact will not preclude the deductibility of the outgoing. The funds to be withdrawn in such a case were employed in the partnership business; the borrowing replaces those funds and the interest incurred on the borrowing will meet the statutory description of interest incurred in the gaining or production by the partnership of assessable income.
In principle, such a case is no different from the borrowing from one bank to repay working capital originally borrowed from another; the character of the refinancing takes on the same character as the original borrowing and gives to the interest incurred the character of a working expense. Both these cases would equally satisfy the second limb of s.51(1). In no sense could the interest outgoing in either case be characterised as private or domestic. Similarly, where moneys are originally advanced by a partner to provide working capital for the partnership, interest on a borrowing made to repay these advances will be deductible, irrespective of the use which the partner repaid makes of the funds.
The respondents rely upon these examples. They rely, as well, upon the decision of Davies J in Yeung v Federal Commissioner of Taxation (1988) 88 ATC 4193. In that case, the taxpayers had contributed moneys to the purchase of real estate in the names of members of their family and themselves. A partnership existed between them in a statutory sense because they were in receipt of income jointly (see the definition of "partnership" in s.6(1) of the Act). The "partnership" borrowed from a related company and the funds were used to repay the taxpayers' original advance. It was held that the interest was deductible. Davies J said (at 4204):

"I am prepared to accept that from the partnership's point of view, what occurred was that two of the partners decided to withdraw funds from the partnership. It does not materially matter whether those funds were loan funds or capital which the partners had invested in the properties. The notional payment out to Dr and Mrs Yeung and the borrowing of an amount from Ozanu Pty Ltd necessarily effected a change in the capital interests which each of the partners had in the partnership. What the partnership achieved by the borrowing from Ozanu Pty Ltd was the maintenance of the income earning properties. Funds were withdrawn, but were replaced by loan funds and the income-earning properties remained held by the six members of the family."

The reference to "maintenance of the income earning properties" appears to be a reference to the considerations accepted by Reed A.J. in the difficult case of Begg v Deputy Commissioner of Taxation (1937) 4 ATD 257 to which Davies J refers shortly before the passage cited. In Begg it was held that interest paid on moneys borrowed by an executor to pay succession and estate duties and other outgoings and for the general administration of the estate were deductible because the effect of the borrowing was to preserve the assets and thereby to retain the income which would otherwise be lost if the assets were sold. The case has stood for a long time and the present is not an appropriate occasion to consider its correctness. There may, however, be thought to be some difficulties in reconciling what was there said with the decision of the High Court in Munro. For present purposes it is sufficient to note that the result reached in Yeung seems clearly correct if the case is viewed simply as one involving a borrowing to fund the repayment of moneys originally advanced by a partner and used as partnership capital, particularly given that the original funds were used to purchase the rental property. I agree with his Honour that the decision of the full court in Federal Commissioner of Taxation v Sheil (1987) 87 ATC 4430 turns upon its own special facts and does not require a contrary conclusion.
The question then arises whether the same result should follow in this case. What is said to have happened is that the partnership has repaid to the partners some of their partnership capital; or, as the judge below put it, each of the original partners received a "refund" of capital. The Commissioner, in his statement of findings on material questions of fact lodged with the Tribunal, referred to the decision of the original partners as being to "reduce their capital input by $25,000 each". A perusal of the partnership accounts tendered at the hearing make it clear that this is not necessarily true. The confusion arises from the use of the word "capital" in the context of a partnership.

Lord Lindley's definition of "partnership capital" as set out in the 16th edition of Lindley and Banks on Partnership, Sweet and Maxwell, 1990 at para 17-01, is in the following terms:

"By the capital of a partnership is meant the aggregate of the sums contributed by its members for the purpose of commencing or carrying on the partnership business, and intended to be risked by them in that business. The capital of a partnership is not therefore the same as its property: the capital is a sum fixed by the agreement of the partners; whilst the actual assets of the firm vary from day to day, and include everything belonging to the firm and having money value... The amount of each partner's capital ought ...always to be accurately stated...".

The partnership capital, in the sense used by Lord Lindley, is fixed and, at least without the agreement of all partners, can not be reduced.
A perusal of the interim accounts of the partnership in evidence shows, and the parties are in agreement, that the account to which the payment out to the partners was debited in the present case, although designated to be partnership capital, was an account which represented the net value of the partnership at the date accounts were taken, that is to say, the difference between gross assets, tangible and intangible, and partnership liabilities. For this purpose the accounting convention of treating partnership capital in the sense used by Lord Lindley as a liability was not adopted.
It appears that the goodwill of the practice, for example, has been revalued from time to time and as at the time of the transactions in 1984 stood at $231,000. As the firm probably generated its own goodwill, it would seem the initial valuation of goodwill and subsequent revaluations found their way into the account designated partners' capital. That account is, however, but in truth a book calculation made annually. It may be inferred that it may include the partnership capital in the Lord Lindley sense, as well, perhaps, as undrawn distributions and profits of the year not yet distributed. It should be explained that none of the interim accounts are made up as at year end, so that the accounts reveal a fund which, if the partnership agreement so provided or the partners agreed, would be available for distribution as at that date. In the absence of agreement, accounts of the partnership would be required to be taken each year as at 30 June and a partner's share of the partnership income would be derived by him as at that date: Federal Commissioner of Taxation v Galland (1986) 162 CLR 408. The partnership agreement also provided for asset revaluations, which were thus reflected in the capital account as well.
The difficulty is that there have been no findings of fact by the Tribunal with respect to these matters, the resolution of which are critical for the present appeal. The point can be illustrated by an example.
Let it be assumed that the original partnership capital in the Lord Lindley sense was $10 and that the balance in the account designated as "the capital account" of the partnership was $125,000, which included goodwill. That would mean that the equity of each partner in the partnership, assuming five partners, was $25,000. But it could not be said that each partner had invested funds totalling $25,000 as capital in the partnership. A cheque for $25,000 drawn on the partnership bank account would not operate to repay the partner any funds invested. The partnership capital would remain as $10, and all that would happen is that there would be a borrowing which was used to pay the partner $25,000. That borrowing would reduce the partner's equity in the partnership, but it could not represent a repayment of capital invested. The partnership assets would remain constant. The goodwill would still be worth $125,000; it would not have been distributed to the partners, nor could it be.
On those facts, there could be no question of there being a refund of a pre-existing capital contribution. Rather, looking at the facts objectively, the only purpose of the borrowing would be the provision of funds to the partners to which they were not entitled during the currency of the partnership (save of course by agreement among themselves). The provision of funds to the partners in circumstances where that provision is not a repayment of funds invested in the business, lacks the essential connection with the income producing activities of the partnership or, in other words, the partnership business. Likewise, the interest incurred on the borrowing will not be incidental and relevant to the partnership business.
It may well be that the parties will be able to agree on the composition of the capital account. If at least $125,000 of the amount in that account represents partnership capital in the Lord Lindley sense, undrawn profit distributions, advances by the partners or other funds which have actually been invested in the partnership and which the partners were entitled to withdraw in June 1984, then in my view the taxpayer is entitled to succeed. If, on the other hand, only a nominal amount in the capital account is so made up, then Mr Smith at least must fail. In between, a question may arise as to apportionment. Failing agreement, the appeal of Mr Smith should be remitted to the Tribunal for the purpose of making findings on these matters, with or without the hearing of further evidence as the Tribunal sees fit.
The case for Mrs Roberts
If the Tribunal were to find that the amount paid to each of the five original partners was in truth a refund of moneys previously invested in the partnership business, either by previous partners or by those who were partners when the money was borrowed, then that finding will bring about the result that the interest will be deductible in each year in calculating the net income of the partnership. The consequence for Mrs Roberts is that her application would also be allowed.
However, I think that there is another reason why Mrs Robert's case should be decided in her favour, even if it should turn out that the appeal in Mr Smith's case is allowed.
It will be recalled that each person admitted to the partnership agreed, as a condition of becoming a partner, to accept liability to the bank for the regular interest payments on the bank borrowing. Although the liability was both joint and several, the incoming partner was indemnified by the other partners for their aliquot share of interest.
The making of the regular interest payments was part of the cost to the new partner of becoming a partner. It in no way differed in substance from interest that would need to be paid had the incoming partner borrowed from an external financier to finance the purchase from the other partners of the partnership share. Nor in substance did it differ from a case where the incoming partner was financed into the partnership by the other partners and was required to pay interest to them. Nor would the case have been different if the arrangement had been to indemnify the other partners in respect of a proportionate share of the principal and to assume the liability for interest attaching to that share. In each of these cases the interest liability incurred has the necessary connection with the assessable income of the new partner to be thereafter derived under s.92 of the Act. It is relevant and incidental to that end.
To adapt what was said, albeit in a different context, by Dixon C.J. in Hallstroms Pty Limited v Federal Commissioner of Taxation (1946) 72 CLR 634, the question of characterisation presently involved 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...".

No suggestion could be made that the payments of interest which Mrs Roberts was required to assume and which were made on her behalf were of a private and domestic nature.
There was no submission made by the Commissioner that the interest payments incurred by Mrs Roberts were of a capital nature. While it is not necessary to explore that issue, the judgment of Barwick C.J. in Cliffs International Inc v The Commissioner of Taxation (1979) 142 CLR 140 would support the view that the payments of interest were, in a case such as the present, on revenue account. A similar conclusion would be drawn from the application of the classic tests for distinguishing income from capital enunciated by Dixon J in Sun Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 at 363; and see generally, McLennan v Federal Commissioner of Taxation (1990) 90 ATC 4047.
It follows that the application by Mrs Roberts must succeed in any event and I would propose in respect of it the making of orders that the Commissioner's appeal be dismissed and that the Commissioner pay the costs of the appeal. I would propose in respect of Mr Smith's case the making of an order that the Commissioner's appeal be allowed in part, that the orders made by Northrop J be set aside, that the decision of the Tribunal made on 19 June 1991 be set aside and that the matter be remitted to the Tribunal to be determined in accordance with law, with or without the taking of further evidence. In the circumstance, as neither party has been successful in the appeal concerning Mr Smith, the appropriate order would seem to be that there be no order as to costs. I would, however, propose the suspension of the orders in the appeal relating to Mr Smith for one month to allow the parties to see if agreement can be reached on the facts and thereby obviate the need for the matter to be remitted to the Tribunal. If agreement can be reached, then it may be that orders could be made by consent disposing of the appeal altogether at that stage.

JUDGE3

In my opinion the Commissioner's appeals in each of these matters should be dismissed. I do not believe that it is necessary for further findings of fact to be made with respect to the financial affairs of the partnership nor with respect to the proper analysis of its capital structure. There was information sufficient to show that at all relevant times the assets of the partnership exceeded its liabilities by sums well in excess of $125,000. I do not feel that it is necessary to attach any weight to the use of the word "capital" by the Commissioner or by the learned Judge below. It is sufficient to recognise that the act of each of the original five partners (of whom Mr Smith was one) in withdrawing $25,000 in 1984 constituted a diminution of the net worth of each partner's interest in the partnership; thus the value of an asset was reduced. The exact treatment of that transaction in the books of account of the partnership might well have been the subject of expert accounting evidence but there is at least room to suggest that it would be appropriate to treat it as a diminution of circulating capital. However, its accounting treatment is not the determining factor in these proceedings.

With the greatest respect to the final view expressed by Hill J., I believe that his exposition of the matter and his review of the authorities, which I otherwise adopt, justify the dismissal of the Commissioner's appeal in the case of Mr Smith. However I do not find it necessary to express a view on the operation of s.44(1) of the Administrative Appeals Tribunal Act 1975.

[1992] FCA 543

31 JULY 1992