Federal Commissioner of Taxation v Westraders Pty Ltd

[1980] HCA 24

HIGH COURT OF AUSTRALIA

Barwick C.J., Mason, Murphy, Aickin and Wilson JJ.

FEDERAL COMMISSIONER OF TAXATION v. WESTRADERS PTY. LTD.

(1980) 144 CLR 55

5 August 1980

Income Tax (Cth)

Income Tax (Cth)—Deduction—Losses—Trading stock—Shares purchased by company—Payment of substantial dividends—Disposal of shares to partnership of &hich company a member—Market value of shares acquired by partnership substantially less than cost to company—Election by partnership to nominate original cost as notional cost to partnership—Sale of shares by partnership at market value—Whether book loss allowable deduction—Income Tax Assessment Act 1936 (Cth), ss. 36 (1)*, 36A (1)**. * (1980) 144 CLR 55 at p 61 ** (1980) 144 CLR 55 at pp 61-62

Decisions

1980, August 5.
The following written judgments were delivered: -
BARWICK C.J. The facts of this case disclose an ingenious use of the provisions of ss. 36 and 36A of the Income Tax Assessment Act, 1936 (Cth), as amended (the Act) to produce what is claimed to be an allowable deduction from a taxpayer's assessable income. The facts were found by the Supreme Court of New South Wales (Rath J.) (1977) 17 ALR 232; 8 ATR 43; 77 ATC 4444; (1979) 38 FLR 306; 24 ALR 139. . They were found on available evidence and have not been challenged at any time in the course of the proceedings in the case. Further, they were confirmed as correct by the majority of the Federal Court (Deane and Toohey JJ.) (1979) 9 ATR 558; 79 ATC 4089 and, as I think, also by Brennan J. although he found himself able to reach a different ultimate conclusion of fact, which his Honour thought not inconsistent with the primary judge's findings. (at p59)

2. Because of the employment of the provisions of the Act to produce a very large diminution of tax, the case affords an occasion to point out the respective functions of the Parliament and of the courts in relation to the imposition of taxation. It is for the Parliament to specify, and to do so, in my opinion, as far as language will permit, with unambiguous clarity, the circumstances which will attract an obligation on the part of the citizen to pay tax. The function of the court is to interpret and apply the language in which the Parliament has specified those circumstances. The court is to do so by determining the meaning of the words employed by the Parliament according to the intention of the Parliament which is discoverable from the language used by the Parliament. It is not for the court to mould or to attempt to mould the language of the statute so as to produce some result which it might be thought the Parliament may have intended to achieve, though not expressed in the actual language employed. In this connection, I would indorse what was said by Deane J. in his reasons for judgment in this case, and which, in my opinion, are worthy of repetition. Speaking of the result of this case in upholding the taxpayer's claim to deduction, his Honour said (1979) 38 FLR, at pp 319-320; 24 ALR, at p 151; 9 ATR, at p 568; 79 ATC, at p 4098. :
"That result may seem both contrary to the general policy of the Act (if it be possible to discern any general policy other than that people pay income tax) and unfair to the ordinary taxpayer who willingly or reluctantly contributes, without resort to tax avoidance, the share of his net income which the Parliament has determined is required by the nation for the common good. If there be, in truth, such contrariety or unfairness, the fault lies with the form of the legislation at the relevant time and not with the courts whose duty it is to apply the words which the Parliament has enacted. For a court to arrogate to itself, without legislative warrant, the function of overriding the plain words of the Act in any case where it considers that overall considerations of fairness or some general policy of the Act would be best served by a decision against the taxpayer would be to substitute arbitrary taxation for taxation under the rule of law and, indeed, to subvert the rule of law itself (see Ransom v. Higgs (1974) 1 WLR 1594, at p 1617 ; Inland Revenue Commissioners v. Duke of Westminster (1936) AC 1, at p 19 )." (at p60)

3. The principle to which his Honour calls attention is basic to the maintenance of a free society. (at p60)

4. Parliament having prescribed the circumstances which will attract tax, or provide occasion for its reduction or elimination, the citizen has every right to mould the transaction into which he is about to enter into a form which satisfies the requirements of the statute. It is nothing to the point that he might have attained the same or a similar result as that achieved by the transaction into which he in fact entered by some other transaction, which, if he had entered into it, would or might have involved him in a liability to tax, or to more tax than that attracted by the transaction into which he in fact entered. Nor can it matter that his choice of transaction was influenced wholly or in part by its effect upon his obligation to pay tax. Of course, the transaction must not be a pretence obscuring or attempting to supplant some other transaction into which in fact the taxpayer had earlier entered. Again, the freedom to choose the form of transaction into which he shall enter is basic to the maintenance of a free society. (at p61)

5. Section 36 (1) of the Act provides:

"Subject to this section, where - a taxpayer disposes by sale, gift, or otherwise of property being trading stock, standing or growing crops, crop-stools, or trees which have been planted and tended for the purpose of sale; (b) that property constitutes or constituted the whole or part of the assets of a business which is or was carried on by the taxpayer; and (c) the disposal was not in the ordinary course of carrying on that business,

the value of that property shall be included in the assessable income of the taxpayer, and the person acquiring that property shall be deemed to have purchased it at a price equal to that value." (at p61)

6. In 1951 this Court decided that s. 36 (1) was only applicable to the disposal of the entirety of the ownership in an article of trading stock and inapplicable to the disposal of an undivided fractional interest in such an article (Rose v. Federal Commissioner of Taxation (1951) 84 CLR 118 ). (at p61)

7. The facts of that case were that a father, the owner of a pastoral business, with livestock as part of its stock in trade, entered into partnership with his two sons. It was agreed between the three that the lands and stock owned by the father should constitute the capital of the partnership, the father making a gift to each of the sons of a one-third interest therein. The Court held that s. 36 (1) did not apply to these facts. (at p61)

8. In 1952 the Parliament inserted s. 36A into the Act, evidently to reverse the consequence of s. 36 (1) perceived by this Court in Rose's Case. Section 36A (1) provides:

"Where, for any reason, including - (a) the formation or dissolution of a partnership; or (b) a variation in the constitution of a partnership, or in the interests of the partners,

a change has occurred in the ownership of, or in the interests of persons in, property constituting the whole or part of the assets of a business and being trading stock, standing or growing crops, crop-stools, or trees which have been planted and tended for the purpose of sale, and the person, or one or more of the persons, who owned the property before the change has or have an interest in the property after the change, section thirty-six of this Act applies as if the person or persons who owned the property before the change had, on the day on which the change occurred, disposed of the whole of the property to the person, or all the persons, by whom the property is owned after the change." (at p62)

9. The appellant first submitted that a transaction would not fall within the operation of s. 36A (1) unless it did not occur in the ordinary course of business within the meaning of s. 36 (1) (c): in other words, that it was not enough that the transaction satisfied the requirements of s. 36A (1): it must also satisfy all the requirements, including that of par. (c), of s. 36 (1). In my opinion, this submission should be rejected. In the first place, s. 36A (1) provides its own conditions on which s. 36 (1) is to apply to the transaction. In the next place, s. 36A (1) erects a notional or fictional transaction in order that s. 36 (1) may apply. It is scarce to be thought that a notional or fictional transaction, one which has not taken place, should be required to have taken place in the ordinary course of business. (at p62)

10. The appellant then relies on the reasons for judgment of Brennan J. to submit that the shares disposed of by Jensen Mining and Investment Ltd. (Jensen) to Jenspart Trading Company (Jenspart) were not at the time of their disposal stock in trade of Jensen. (at p62)

11. To enable this submission to be understood, it is necessary to summarise the relevant facts as found by the primary judge. Jensen was at all material times a share trader. It had acquired some shares in order to gain access to the assets of the companies in which they were held and in order by declaration and payment of a dividend to reduce their value on disposal. Undoubtedly, whatever the motivation to acquire these shares, when acquired they formed part of Jensen's stock in trade as a share trader. They were bought to be sold, though not till value had been taken from them by the payment of a dividend. (at p62)

12. Some months before these shares were disposed of and after their value had been diminished, Jensen decided to promote partnerships, in which it would be a participant. The plan devised by Jensen was to dispose of shares whose value had been so diminished to these partnerships so that each partnership could exercise the election given by sub-s. (2) of s. 36A, i.e. by nominating the cost of the shares to Jensen as the notional cost to the partnership. The disposal of such shares at market value would thus disclose a loss deductible under s. 51. (at p62)

13. One such parcel of shares was disposed of to Jenspart of which Jensen was a member to the extent of a 25 per cent interest. The value placed on the shares for the purpose of fixing the extent of Jensen's interest was their market value, the whole of which was treated as Jensen's contribution to the capital of the partnership. But the shares vested in the partnership as a whole. The partnership, including Jensen (who obtained a fee for joining in the election), having given a notice of election under s. 36A (3), disposed of the shares on the day they were transferred to it at a price slightly in excess of the market value placed on them when received from Jensen. However, if ss. 36 (1) and 36A (1) were applicable to the partnership in its dealing with the shares, the result of the election of the partnership under s. 36 (1) was a loss of some $6,463,484 being the difference between the cost of the shares to Jensen, i.e. before their value had been diminished, and the sum realised on their sale by the partnership. (at p63)

14. One of the members of the partnership, Jenspart, was the respondent. It claimed against its assessable income a deduction of its proportion of this partnership loss. The appellant disallowed the deduction. This disallowance gave rise to the respondent's appeal to the Supreme Court, to the appellant's appeal to the Federal Court and to his appeal to this Court. (at p63)

15. The appellant says that, although the shares disposed of to Jenspart were stock in trade of Jensen when acquired, they ceased to be so when Jensen formed the intention of disposing of them to a partnership which Jensen would form and of which it would be a member. It is said that such a method of disposal was not part of the business of a share trader but a departure from it and a distinct and disparate business, as it were, sui generis. (at p63)

16. This submission is, in my opinion, in flat opposition to the express finding of fact of the primary judge. As appears from his judgment, Rath J. was well aware of the so-called new development of Jensen's business, i.e. the plan to form the partnerships, but, none the less, he expressly found the shares in question to have been trading stock of Jensen at the time of their disposal to the partnership Jenspart. (at p63)

17. However, in any case, it is to my mind fallacious to conclude that the disposal to a partnership of which the disponer was to be a member was not a manner of disposal of the shares in a business of share trading. Such a method of disposal was to an extent novel. But it was, however unusual, a method of disposing of the shares bought and held for disposal. To decide upon such a method of disposal did not involve, in my opinion, an abandonment of the business of share trading or the doing of something outside the scope of that business. (at p63)

18. The matter might be pointed up by attempting to apply the reasoning of Brennan J. to the facts of Rose's Case (1951) 84 CLR 118 . Consistently with that reasoning, s. 36A (1) would not apply to those facts. If the reasoning is correct, it should be held that the father, in deciding to form the partnership with his sons and to dispose of his stock to the partnership, removed them from his stock in trade so that when disposed of to the partnership they were no longer part of his stock in trade. Thus would s. 36A (1), which was designed to enable the effect of Rose's Case to be reversed, fail entirely of its purpose. (at p64)

19. In my opinion, the primary judge's finding should stand: and, if it matters, it was in my opinion a correct finding. (at p64)

20. The appellant, as a variant of the primary submission that to satisfy s. 36A (1) the disposal of the stock in trade must not be in the ordinary course of business, submits that ss. 36 and 36A are designed to deal only with tranactions which do not arise in the ordinary course of business. Therefore, if the shares disposed of to Jenspart were part of Jensen's stock in trade at the time of that disposal, the transaction between Jensen and Jenspart in relation to the shares was in the ordinary course of Jensen's business and fell for that reason outside the scope of ss. 36 and 36A. (at p64)

21. But s. 36A (1) sets out particular conditions upon the fulfilment of which s. 36 (1) is attracted. It is unconcerned with the question whether or not the transaction which satisfies the conditions it specifies is a transaction in the ordinary course of business. I can see no warrant for holding that ss. 36 (1) and 36A (1) are only concerned with transactions which are not in the ordinary course of business. It seems to me that this submission must be rejected. (at p64)

22. The final submission of the appellant was that the shares received by Jenspart from Jensen did not form part of the trading stock of Jenspart. This submission is immediately answered, in my opinion, by the terms of the sections with which we are concerned. There is no requirement that the shares should become trading stock in the hands of the disponee. It suffices that they were part of the trading stock of the disponer at the time of their disposition. (at p64)

23. In my opinion, the majority of the Federal Court reached a correct decision in holding that the respondent was entitled to the claimed deduction. Accordingly, the appeal should be dismissed. (at p64)

MASON J. This is an appeal by the Commissioner from the judgment of the Federal Court of Australia (1979) 38 FLR 306; 24 ALR 139; 9 ATR 558; 79 ATC 4089 which by majority dismissed an appeal from the decision of the Supreme Court of New South Wales, Administrative Law Division (Rath J.) (1977) 17 ALR 232; 8 ATR 43; 77 ATC 4444 which had allowed the respondent taxpayer's objection to the assessment of income tax made by the Commissioner upon income derived by the taxpayer during the year ended 30th June 1975 ("the 1975 year"). (at p65)

2. For the 1975 year the respondent taxpayer claimed a deduction of $248,844.00 as "Tax Loss in Share Trading Partnership Jenspart Trading Co." The members of this partnership ("Jenspart") were the taxpayer, Jensen Mining &Investments Ltd. ("Jensen") and seventeen others. Section 92 of the Income Tax Assessment Act 1936, as amended ("the Act") provides that a partner's individual interest in a partnership loss incurred in the year of income shall be an allowable deduction. The deduction claimed was disallowed by the Commissioner. (at p65)

3. Jenspart showed a loss of $6,463,484.00 in its return for the 1975 year. In this return 3.85 per cent of the loss, amounting to $248,844.00, was assigned to the taxpayer. By its return the partnership claimed that it was a share trading partnership and that it had sustained, for taxation purposes, a very substantial loss on the sale of shares which it had acquired from Jensen in circumstances shortly to be described. After taking into account the actual cost of the shares which it sold, together with the actual cost of closing stock at 30th June 1975 and the price of the shares sold as well as stamp duty, brokerage and other expenses, Jenspart made a small "book profit". However, Jenspart and the taxpayer claimed that the profit was converted into a loss for tax purposes of $6,463,484.00 by reason of Jensen and the other members of the partnership having made an election under s. 36A (2) of the Act. The effect of this election, if validly made, was that the cost of the shares transferred by Jensen to Jenspart was deemed to be the price paid by Jensen for those shares. It was common ground that the price paid by Jensen for the shares which it transferred to Jenspart was $6,584,513.00. (at p65)

4. In this Court, as in the Federal Court and the Supreme Court, the broad issue for determination is whether, in the circumstances disclosed in evidence, the election on which the taxpayer relies was validly made under s. 36A (2). The resolution of this issue depends on the interpretation of ss. 36 and 36A of the Act and upon the outcome of certain issues of fact to be discussed, in particular - (a) whether Jensen was carrying on business as a share trader; and (b) whether the shares transferred by Jensen to Jenspart formed part of the trading stock of Jensen in its business as a share trader. For the taxpayer to succeed in bringing into play the provisions of ss. 36 and 36A it is necessary that these two issues of fact be determined in its favour. (at p66)

5. Section 36 (1) provides that where a taxpayer disposes of trading stock otherwise than in the ordinary course of business, the value of the trading stock shall be included in the assessable income of the taxpayer, and the person acquiring the trading stock shall be deemed to have purchased it at a price equal to that value. For this purpose "value" is the market value at the date of the disposal; or, if in the opinion of the Commissioner, there is insufficient evidence of market value on that day - the value which in his opinion is fair and reasonable (sub-s. (8)). (at p66)

6. Section 36A (1) provides that where, for any reason including the formation of a partnership, a change has occurred in the ownership of trading stock, and the person who owned the trading stock before the change has an interest in the trading stock after the change, s. 36 applies as if the person who owned the trading stock before the change had, on the day on which the change occurred, disposed of the whole of the trading stock to the persons by whom the trading stock is owned after the change. Section 36A (2) provides that in certain circumstances the parties referred to in s. 36A (1) may elect that the value shall be cost, not market value, and the taxpayer contends that those circumstances exist in this case. (at p66)

7. Jensen was at all material times a public company. It had commenced business in 1958 as a merchant banker, but in the financial years ending 30th June 1971 and 1972 ("the 1971 and 1972 years") it changed its business. The new business was described as that of a mining and investment company. In these two years it actively subscribed for, bought and sold shares in public and private companies. These activities were so regular, so continuous and of such magnitude that Rath J. held that Jensen carried on the business of a share trader. He also found that Jensen continued its share trading and dealing activities in the years ended 30th June 1973 to 1975 inclusive, notwithstanding that in the latter years Jensen's activity in buying and selling shares was apparently confined to the carrying out of schemes known in taxation circles as "Division 7 schemes". In essence these schemes involved the acquisition by Jensen of a substantial proportion of the share capital of private companies having large amounts of undistributed profits, the declaration and payment of substantial dividends out of those profits by the companies and the subsequent sale of the share capital in the companies at a lower price than that paid on acquisition. (at p67)

8. In May 1975 Jensen made plans for the promotion of partnerships which were designed to take advantage of the deemed price provisions contained in ss. 36 and 36A. Jenspart was such a partnership. It was formed in May 1975. The Partnership Deed dated 28th May 1975 provided that the initial capital of the partnership was to consist of (a) $345,000.00 in cash to be contributed by the partners other than Jensen; and (b) $115,000.00 being the agreed market value of certain shares beneficially owned by Jensen which Jensen, from the commencement of the partnership, held on trust for the partnership until the shares were transferred to the partnership and registered in the names of the partners. (at p67)

9. On 27th June 1975 Jensen executed transfers to Jenspart of the shares it had held in trust for the partnership, being parcels of shares in nineteen companies. On the same day Jenspart transferred all the shares contributed by Jensen, except a parcel of shares in a company known as Beneficial Finance Corp. Ltd., to four other companies. (at p67)

10. As I have said, the original cost to Jensen of the shares transferred to Jenspart was $6,584,513.00. This price reflected the fact that the companies in which the shares were held had large amounts of undistributed profits available for distribution by way of dividend. After causing the profits to be distributed in the form of dividends, Jensen sold the shares to Jenspart for the greatly reduced figure of $111,284.20. In most instances Jensen had carried out what is known as a "dividend stripping" operation. (at p67)

11. If, by virtue of s. 36A (1), s. 36 (1) applied to the transaction between Jensen and Jenspart, then the value of the shares transferred in the hands of Jenspart was the reduced value. If, however, s. 36A (2) applied to the transaction, then the value of the shares in the hands of Jenspart for the purposes of s. 36 was the cost of the shares to Jensen, viz. $6,584,513.00. (at p67)

12. It is convenient in the first instance to consider the Commissioner's contentions that Jensen was not carrying on business as a share trader in the 1975 year and that even if it was, the shares which it transferred to Jenspart on 27th May 1975 did not form part of the trading stock of Jensen. After a detailed examination of the activities of Jensen, Rath J. concluded that Jensen was a share trader and that the relevant shares were part of Jensen's trading stock. I see no reason to disagree with these findings. However, in order to deal with the arguments advanced for the Commissioner it is necessary to canvass the facts in some detail. (at p68)

13. The Commissioner does not contest Rath J.'s finding that Jensen carried on business as a share trader in the 1971 and 1972 years, conceding that it bought and sold shares in listed companies through brokers on an extensive scale in those years. However, he draws attention to Rath J.'s comments that the operations were not profitable, that the operations in the 1972 year were on a smaller scale and that the management might well have turned its mind "to the wisdom of continuing share trading operations in their then present form". In fact there was no direct evidence that the management gave consideration to this question. (at p68)

14. The Commissioner then says that stock on hand at the end of the 1972 year, valued at $3,860.00 only, was disposed of in the 1973 year, with the exception of a parcel of shares in Arcadia Minerals N.L. which were of negligible value. To this observation he adds the comment that there were no new acquisitions after 30th June 1972 before the 1975 year. This comment ignores the acquisition of shares in seven companies in the 1973 year at a total cost of $3,293,026.00 which were purchased, according to the evidence, in the course of Jensen's share dealing operations. The comment also ignores the acquisition of shares in nine other companies in the 1974 year at a total cost of over $1,000,000.00 again, according to the evidence, in the course of the same business. (at p68)

15. It is true that in its first return of income for the 1973 year Jensen did not claim that it was a share trader. But Rath J. expressly accepted the evidence given by Mr. Fox, the chairman of Jensen, that the return was lodged without his knowledge due to his absence overseas and that steps were subsequently taken to submit an amended return stating that the company was a share trader. (at p68)

16. It is also true that Jensen's annual returns for the years up to 30th June 1974 ("the 1974 year") contain no express reference to share trading and that the 1974 report deccribes the principal activities of the company as "the financing and operation of mining and exploration ventures, the operation of wine bars and country bistro restaurants and a wide range of general investments similar to those undertaken in previous years". However, the accounts of Jensen lodged with its 1974 taxation return give these particulars of its profits and losses from share trading -

"PROFIT (LOSS) FROM SHARE TRADING AS PER ACCOUNTS Metropolitan Tenpin Bowling Limited 94,659

J. &J. Finance Pty. Limited ( 995,000)

Norpe Investments Pty. Limited ( 995,000) Meik Pty. Limited ( 995,000) ___________ (2,890,341) Add amount provided in accounts in previous years 2,985,000 __________ TOTAL PROFIT 94,659 ---------- PROFIT (LOSS) FROM SHARE TRADING FOR TAXATION Metropolitan Tenpin Bowling Limited 94,659

J. &J. Finance Pty. Limited ( 995,000)

Norpe Investments Pty. Limited ( 995,000) Meik Pty. Limited ( 995,000) ___________ (2,890,341)" ------------

The four companies referred to were companies in which shares were acquired in the 1973 year. (at p69)

17. In its 1974 return Jensen gave these further particulars of its share dealing operations -

"SHARE DEALING OPERATIONS As part of its business in share dealing, the company held at the end of the year of income the following shares:- Company Cost Austral Pacific Mining Corp. Limited 10,235 Renmore Pty. Limited 99,250 Toomar Investments Pty. Limited 153,552

N. &K. Properties Limited 454,080

Saxonvale Vineyards Limited 36,432 George Hudson Holdings Limited 761 Arcadia Minerals 1,612 Geear Pty. Limited 100 Colmar No. 1 Pty. Limited 105,500 Scarf Bros. Corp. Pty. Limited 600,930 Hero Scarf Bros. Pty. Limited 283,140 Demos Pty. Limited 74,250 Clabcaux Pty. Limited 27,720 _________ 1,847,562 --------- By virtue of S. 31 of the Income Tax Assessment Act, the taxpayer elects the value of the above trading stock to be its cost price."

Three of the companies mentioned were companies in which shares were acquired in the 1973 year. (at p69)

18. The Commissioner attaches importance to the circumstance that most of the shares acquired by Jensen after the 1972 year and that all the shares in eighteen of the nineteen companies acquired by Jenspart were private company shares, the exception being the shares in Beneficial Finance Corp. Ltd. It is said that shares in private companies are not normally the subject of trading transactions, unlike, for instance, manufactured articles or commodities. No doubt it is true to say that shares in public companies are much more frequently dealt with by traders than shares in private companies, but I can see no reason why private company shares should lie outside the realm of share dealing. In recent years it seems that there has been a strong demand for various classes of private company shares, e.g. shares in loss companies and excess distribution companies. The fact that there are restrictions on the transfer of private company shares does not prevent a person from dealing in them. (at p70)

19. The Commissioner then advances a number of reasons with a view to supporting the conclusion that Jensen, in acquiring shares after the 1972 year, was not motivated by a desire to make a profit on the resale of shares and that it was "on the take-over trail", bent on acquiring cheaply the assets of other companies. Thus it is said that shares in Toomar Investments Pty. Ltd. and Renmore Pty. Ltd. were acquired so that Jensen might purchase inexpensively land which was an asset of these companies. In some instances, such as J. &J. Finance Pty. Ltd., the dividends received exceeded the price paid for acquisition of the shares and in other cases Jensen derived special advantages from the acquisition of shares, e.g. the acquisition of shares in Metropolitan Ten Pin Bowling Ltd. resulted in the ownership by Jensen of its operating subsidiary. (at p70)

20. However, neither the circumstance that Jensen was "on the take-over trail", whatever that colourful expression may mean, nor the fact that it derived special advantages from its acquisitions, not being the making of a profit on resale, nor the fact that the acquisitions took place in the course of carrying out "Division 7 schemes", is enough to justify the conclusion that Jensen was not, or had ceased to be, a share trader in the 1975 year. (at p70)

21. The point is that Jensen engaged in diverse share trading activities and that the character of those activities changed over the years. The cases of Investment and Merchant Finance Corporation Ltd. v. Federal Commissioner of Taxation (1971) 125 CLR 249 and Federal Commissioner of Taxation v. Patcorp Investments Ltd. (1976) 140 CLR 247 , clearly establish that the purchase of shares in companies having large amounts of undistributed profits, the payment by way of dividends from those profits and then the sale of the shares at a reduced price are transactions of a trading nature and may therefore form part of the activities of a share trader. The two cases also establish that shares so acquired may be considered trading stock. As Walsh J. put it in Investment and Merchant Finance Corporation Ltd. v. Federal Commissioner of Taxation (1971) 125 CLR, at pp 270-271 :

"But when shares are bought by a dealer in shares and it is intended that they are to be resold and that this will probably occur in the not distant future, I do not think they are to be denied the description of trading stock, either because the trader expects or intends that they will be sold at less than their cost price or because he seeks to obtain a commercial advantage from the transaction otherwise than from a profit on the resale, that is, an advantage from an expected dividend and from an expected taxation benefit."

See also Patcorp (1977) 140 CLR, at pp 290-291 , per Gibbs J. I agree with these observations. They accord with the notion expressed in the statutory definition of "trading stock" in s. 6 - "anything . . . purchased for purposes of . . . sale". See also Federal Commissioner of Taxation v. St. Hubert's Island Pty. Ltd. (In liq.) (1978) 138 CLR 210 . (at p71)

22. I acknowledge that in the present case Jensen was not in 1975 buying and selling shares through brokers as an orthodox share trader would. Indeed, Jensen's transactions in the later years were limited to Div. 7 schemes and the promotion of s. 36A partnerships. None the less I regard its activities in buying and selling shares, connected though they were with the carrying out of Div. 7 schemes, as constituting the business of share trading. Jensen's earlier activities as an orthodox share trader assist in arriving at this conclusion. But I do not regard them as essential to the conclusion. (at p71)

23. The Commissioner's third submission is that even if Jensen was considered a share trader in the relevant period and the shares were considered part of Jensen's trading stock prior to 27th May 1975, the shares ceased to be trading stock at the time of their transfer to Jenspart. This was the view taken by Brennan J., who dissented in the Federal Court. In support of his submission the Commissioner cited the cases of Danmark Pty. Ltd. v. Federal Commissioner of Taxation (1944) 7 ATD 333 and Watson Bros. v. Hornby (H.M. Inspector of Taxes) (1942) 24 TC 506 as examples of situations in which assets cease to be trading stock and are converted into capital assets. The two cases demonstrate that assets initially acquired as trading stock in a business may in some circumstances be changed into investments or capital assets. (at p72)

24. Although it is clear that a company may change the nature of its activities, there must be sufficient evidence to support such an alteration. Here, as Rath J. found, all the evidence supported the view that Jensen was a share trader and that the shares which it purchased were trading stock. Rath J. saw the promotion of "s. 36A partnerships" as "another business activity" of Jensen's. The relevant shares which were transferred to Jenspart were "trading stock in a business carried on by Jensen". (at p72)

25. Watson Bros v. Hornby (H.M. Inspector of Taxes) which was approved by Sharkey v. Wernher (1956) AC 58 establishes that a trading asset may in some circumstances subsequently be treated as a capital asset. But it has no relevance to a situation, as here, where a trading company is engaged in diverse trading activities, using in a new trading venture or trading phase assets which were clearly trading stock of its business activities prior to the new venture. (at p72)

26. The next argument of the Commissioner was that Jenspart was not a share trader and the shares which were transferred on 27th May 1975 were not trading stock of Jenspart. This is said to be an essential condition of the application of s. 36A. The argument is that because s. 36 states that the value of the property (shares) shall be included in the assessable income of the transferor and because it also states that the purchaser of the property shall be deemed to have purchased it at a price equal to that value, it is to be inferred that both transferor and transferee are traders and that the property is trading stock in the business of each of them. The Commissioner also argues that as s. 36A (1) provides for the notional application of s. 36 in the circumstances postulated in s. 36A (1), it is necessary that the relevant property constitute trading stock in the hands of transferor and transferee if the latter is to have the option under s. 36A (2). (at p72)

27. In my opinion there are two distinct reasons for rejecting this submission. First, as Toohey J. stated in the Federal Court (1979) 38 FLR, at p 325; 24 ALR, at p 157; 9 ATR, at p 563; 79 ATC, at p 4101. -

"In contrast with the opening words of s. 36A (1) the requirement" (in s. 36A (2)) "is that the property becomes an asset of a business carried on by a person or persons by whom the property is owned after the change; the additional requirement of being trading stock does not exist. There is nothing in the language of the section that requires the property to be received as trading stock. What is necessary is that it becomes upon the change in ownership an asset of a business carried on."

Secondly, Rath J. (1977), A.L.R., at p. 252; 8 A.T.R., at p. 61; 77 A.T.C., at p. 4459. accepted that:

"Jenspart was in business as a share trader from the day after its formation. The shares transferred to it from Jensen were sold as part of its share-trading activities, and were an asset of the business carried on by it within the meaning of s. 36A (2) (a)."

I see no reason to disagree with this finding, despite the Commissioner's challenge to it. (at p73)

28. The fifth and final submission of the Commissioner is that s. 36 and s. 36A should be read together so that the requirement in s. 36 (1) (c) that "the disposal was not in the ordinary course of carrying on that business" is imported into s. 36A so that a "change" referred to in s. 36A (1) is one that occurs otherwise than in the ordinary course of business. It is further submitted that this transfer of shares from Jensen to Jenspart was in the ordinary course of Jensen's partnership promotion business and therefore that s. 36A had no application to the transaction in question. (at p73)

29. In his reasons for judgment Rath J. rejected this submission, as did Toohey J. in the Federal Court, with whom Deane J. agreed. I am in agreement with their Honours' conclusion. (at p73)

30. The terms of s. 36A are quite clear. The section provides its own criteria for a change in the ownership of property coming within its scope. To come within s. 36A (1), there must be (a) a change in the ownership of, or in the interests of persons in, property, (b) the property must constitute the whole or part of the assets of a business and must be trading stock or standing or growing crops, crop-stools or trees planted and tended for the purpose of sale, and (c) the person, or one or more of the persons who owned the property before the change must have an interest in the property after the change. Once these three conditions are satisfied the legal consequences of s. 36 attach to the change in ownership, i.e.: "The value of that property shall be included in the assessable income of the taxpayer, and the person acquiring that property shall be deemed to have purchased it at a price equal to that value." The "value" mentioned is then ascertained by reference to s. 36 (8), unless an election is made under s. 36A (2). (at p73)

31. The Commissioner relies strongly on Rose v. Federal Commissioner of Taxation (1951) 84 CLR 118 , in consequence of which s. 36A was introduced, as demonstrating that s. 36A was designed merely to overcome the shortcomings in s. 36 which the decision disclosed. There the Court held that property in the assets of a business moving under a partnership deed from the sole ownership of one person to the co-ownership of that person and two other persons as partners in equal shares was not "disposed of" within the meaning of s. 36 (1). The inference to be drawn, the Commissioner suggests, is that s. 36 was given an operation in relation to the disposition of undivided fractional interests in property in the circumstances set out in pars. (a), (b) and (c) of s. 36 (1) and not otherwise. (at p74)

32. Mr. Priestley for the Commissioner seeks to give additional force to this argument by pointing to the different provisions made by the Act with respect to (a) sales of trading stock made by a taxpayer in the ordinary course of carrying on a business (ss. 25 and 51) and the taking into account of trading stock of a taxpayer carrying on a business in ascertaining his taxable income (ss. 28 and 31); and (b) the taxation of disposals of trading stock made by a taxpayer otherwise than in the ordinary course of carrying on his business - see s. 36 (1). This argument would have great force if the provisions referred to in (a) above were capable of applying to undivided fractional interests in property and to transactions relating to such interests. Then there would be a compelling reason for regarding s. 36A as a provision aimed directly and exclusively at the gap in s. 36 revealed by the decision in Rose. (at p74)

33. Of necessity the answer to this argument is not without some complication. First, I am unable to conclude that ss. 28 and 31, unlike s. 36, apply to undivided fractional interests in property forming part of trading stock. The definition of "trading stock" in s. 6 which "includes anything produced, manufactured, acquired or purchased for purposes of manufacture, sale or exchange, and also includes livestock" and the reference in s. 31 to "each article of trading stock" suggest that ss. 28 and 31, like s. 36, are not speaking with reference to undivided fractional interests in assets, but to the entirety of the ownership in assets. Even if the judgment of Latham C.J. and the decision in Farnsworth v. Federal Commissioner of Taxation (1949) 78 CLR 504, at pp 512-513 did not deal with this precise topic, they at least raised a very serious question as to the application of ss. 28 and 31 to undivided fractional interests in assets said to constitute trading stock. The application of s. 25 to the proceeds of sale of an undivided fractional interest in property hitherto forming part of the vendor's trading stock would raise another problem. (at p75)

34. The construction and effect of s. 36A (1) should accordingly be approached on the footing that there was a problem in 1952 relating to disposals of undivided fractional interests in property said to constitute trading stock, whether made in the ordinary course of carrying on a business or not, and that the problem was not one which was confined to s. 36. Moreover, I note that when in 1952 s. 36A was introduced into the Act, s. 36 (1) was amended so as to include the present par. (c). Despite the earlier absence of the provision which is now contained in this paragraph, the Court had concluded that s. 36 (1) "had no application to the regular disposal of trading stock in the ordinary course of carrying on a business" (Federal Commissioner of Taxation v. Wade (1951) 84 CLR 105, at p 111 ; Farnsworth's Case (1949) 78 CLR, at p 514 ). The purpose of this amendment, so it seems to me, was to ensure that s. 36 itself would of its own force continue to have the operation which the Court had conceded to it, notwithstanding that the new section 36A gave it an independent and additional operation. (at p75)

35. It is against this background of judicial interpretation and legislative amendment that s. 36A has to be considered. The first point to be made is that the very general words of s. 36A (1) travel beyond the situation which the Commissioner's argument postulates. Secondly, it is of great significance that, whereas the relevant elements of pars. (a) and (b) of s. 36 (1) are expressly reiterated in s. 36A (1), par. (c) of s. 36 (1) is not reflected in any way in the later subsection, notwithstanding its contemporaneous introduction into the earlier subsection. The legislative intention, as I read it, was that s. 36 was to have the operation which had been conceded to it by judicial interpretation, par. (c) being inserted to ensure this result, and s. 36A was to have a comprehensive application to disposals of undivided fractional interests in trading stock whether made in the ordinary course of carrying on a business or not, this application being ensured by the absence of any counterpart to par. (c) of s. 36 (1). By giving s. 36A this comprehensive operation the Parliament not merely cured the defect in s. 36 revealed by Rose (1951) 84 CLR 118 , it also took action to resolve the doubts which were engendered in relation to ss. 28 and 31 by Farnsworth (1949) 78 CLR 504 . (at p75)

36. For these reasons I would dismiss the appeal. (at p75)

MURPHY J. This case arises out of what the taxpayer, Westraders Pty. Ltd., acknowledges is a sophisticated tax avoidance scheme. (at p76)

2. A company, Jensen Mining &Investment Ltd. ("Jensen"), engaged in massive share trading and by 1975 had acquired millions of dollars of shares. Many of these were in companies whose main assets were undistributed profits. It "dividend-stripped" these companies and disposed of the stripped shares at their reduced value to partnerships (including itself). The other members of the partnerships had entered them only to avoid taxation by incurring fictional losses in order to claim allowable deductions and reduce their taxable income from other sources. In 1975, Jensen established five such partnerships. The particular partnership which Westraders joined was called Jenspart Trading Company, ("Jenspart"). On 27th June 1975, Jenspart bought shares from Jensen at $111,284, and sold them on the market the same day at $125,200 (which may be treated as the market value). An actual profit of several thousand dollars was made, and there was also a small profit from other share trading. In all, a profit of $9,072 was made, of which Jenspart's share was $349. Jenspart claims to have incurred a fictional loss of $6,463,484 by claiming that the shares Jensen disposed of were acquired not at $111,284 but at $6,584,513, which was the cost of the shares when Jensen originally acquired them. Westraders claimed a deduction of $248,844, being its proportionate share of the claimed "Tax Loss in Share Trading Partnership". (at p76)

3. The Act provides for valuation of trading stock in various circumstances. Section 31 of the Income Tax Assessment Act 1936 (Cth), as amended, provides that the value of each article of trading stock to be taken into account at the end of the year of income shall be, at the taxpayer's option, the cost price or market selling value or the value at which it can be replaced. Where a business or part of a business is transferred, the valuation of trading stock is market value or, if that would be inappropriate, the Commissioner's assessment (see s. 36 (8)). Where the disposal is to a partnership of which the taxpayer is a member, if a taxpayer retains an interest (of at least one quarter of its value) in the stock disposed of, as here, the taxpayer and the purchaser (that is, the partnership) may elect to use a value for the stock on the purchaser's acquisition at either the market value or the value "that would have been taken into account at the end of the year of income if no disposal had taken place" (see s. 36A (2)). The issue is whether the election on which Westraders relies was validly made under s. 36A (2). I share Wilson J.'s view that these provisions do not apply to a disposition in the ordinary course of a taxpayer's business. In the peculiar circumstances of this case, the setting up of such partnerships and dispositions to them of stock (being shares) for tax avoidance purposes had become (as the trial judge found) part of Jensen's ordinary business at the time of the disposal in question. The trial judge also found (1977), 17 A.L.R., at p. 250; 8 A.T.R., at p. 59; 77 A.T.C., at p. 4457. :

"Early in May 1975 Jensen made plans for another business activity, namely the promotion of partnerships. This new business was intended to take advantage of the deemed price provisions of ss. 36 and 36A. In order that the desired result might be achieved, it was necessary for Jensen to be a member of the partnership, and to bring into the partnership shares which by some process had suffered a considerable diminution in value since their acquisition by Jensen. These shares had to be trading stock in a business carried on by Jensen. The shares transferred to Jenspart answered this description, having been acquired for the purpose of sale in Jensen's business as a share trader."

For this reason, the election was not validly made and the appeal should be allowed. (at p77)

4. There is an aspect of this case which troubles me. I state my views on it tentatively because no argument was addressed to it. The "stock" Jensen disposed of to Jenspart was materially different to that which Jensen originally acquired, even if its description had not changed. Jensen's business was dividend-stripping. It acquired shares in companies, then caused the companies' assets to be sold and the proceeds disposed of by way of dividends. The companies were left as shells, the shares being worthless or nearly so. The stock was changed so materially that the value of shares in the stripped companies was less than 2 per cent of the original cost. This can be compared with a jeweller in the business of buying and selling old rings who purchases a considerable number of rings with valuable stones which he removes, leaving none or only the almost worthless chips which once surrounded the main stones, and disposes of the valuable stones in some way. The rings divested of their valuable stones are still trading stock but now worth only a small fraction of the original rings. If the jeweller then disposes of the rings as part of the sale of whole or part of the business or some more elaborate scheme, as in this case, to a partnership of which he is a member, it would be absurd to apply the election provision in s. 36A to allow the value of the stoneless rings to be deemed to be the cost of the original rings. This is basically what has been asserted in this case. Shares subjected to a dividend-stripping operation may be trading stock (see Investment and Merchant Finance Corporation Ltd. v. Federal Commissioner of Taxation (1971) 125 CLR 249 ; Federal Commissioner of Taxation v. Patcorp Investments Ltd. (1976) 140 CLR 247 ), just as rings stripped of their stones may be. It is not commonsense to treat the worthless or nearly worthless shares left after a dividend-stripping operation as if they were the same stock as the shares held before the operation, so that the cost of the original shares is treated as the value "that would have been taken into account at the end of the year of income if no disposal had taken place". (at p78)

5. In this case, the trader, Jensen, was responsible for the stripping and the alteration in a commercial and realistic sense of the stock so that it should not be regarded as the same stock even though the description remains the same. It is another question when shares are drastically reduced in value by events beyond the control of those involved in a disposition of the shares. (at p78)

6. Determining whether stock disposed of is the same as the original stock for the purpose of the election provision may raise questions of degree, which is no novelty. But in this case, the change was a qualitative one. The effect of the dividend-stripping was to divest the shares of their valuable quality and hence their value. The essence of this tax avaoidance scheme was to get something of value which could be dealt with as trading stock, to do something to it to remove its valuable quality (and use it in some other way which does not concern us) and then dispose of the thing in its reduced state, using the election provision of s. 36A to claim the original cost as its value for tax purposes. Jenspart sold the stock at its reduced value and now claims as an allowable deduction the fictional loss between the cost of acquiring it (using the original cost to Jensen of the shares in the unstripped company) and the sale price of the shares in the stripped company. This is a feat of modern magic, successful only because observers allow themselves to be deceived. In commercial reality, the asset-stripped shares Jensen disposed of (at $111,284) were not the same trading stock as the shares originally acquired by it (at $6,584,513). (at p78)

7. In general, the provisions of the Income Tax Assessment Act are intended to apply to commercial realities. Some sections, for example, s. 260, are directed specifically at tax avoidance. Other provisions contemplate application in a commercial and realistic way, not in artificial and contrived circumstances. Section 36A and ancillary sections were intended to deal in an orderly way with the tax consequences of the transfer of businesses in which there was trading stock. They were never intended to be used as a vehicle for artificial and contrived transactions for tax avoidance purposes. It is a mistake to hold that any circumstances (however artificial and contrived) which literally fit the words in s. 36A therefore comply with them. (at p79)

8. Elsewhere such transparent schemes have generally received no encouragement. The United States Supreme Court, for example, has stressed that a transaction will be disregarded if it is sham or unrealistic. In Gregory v. Helvering, Commissioner of Internal Revenue (1935) 293 US 465, at p 470 (79 Law Ed 596, at p 599) the Court said of a claimed corporate reorganization:

"The whole undertaking . . . was in fact an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else. . . . To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose."

In Commissioner of Internal Revenue v. Court Holding Co. (1945) 324 US 331, at p 334 (89 Law Ed 981, at p 985) it said: "To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress." (at p79)

9. The transactions in this case are conceded to be a major tax avoidance scheme. The supporters of the scheme seize upon the bar words of s. 36A and claim that these should be applied literally even if for purposes not contemplated by Parliament. The history of interpretation shows the existence of two schools, the literalists who insist that only the words of an Act should be looked at, and those who insist that the judicial duty is to interpret Acts in the way Parliament must have intended even if this means a departure from the strict literal meaning (see the somewhat acid debate by the House of Lords, 13th February 1980). It is an error to think that the only acceptable method of interpretation is strict literalism. On the contrary, legal history suggests that strict literal interpretation is an extreme, which has generally been rejected as unworkable and a less than ideal performance of the judicial function. (at p79)

10. It is universally accepted that in the general language it is wrong to take a sentence or statement out of context and treat it literally so that it has a meaning not intended by the author. It is just as wrong to take a section of a tax Act out of context, treat it literally and apply it in a way which Parliament could not have intended. The nature of language is such that it is impossible to express without bewildering complexity provisions which preclude the abuse of a strict literalistic approach. (at p80)

11. It has been suggested, in the present case, that insistence on a strictly literal interpretation is basic to the maintenance of a free society. In tax cases, the prevailing trend in Australia is now so absolutely literalistic that it has become a disquieting phenomenon. Because of it, scorn for tax decisions is being expressed constantly, not only by legislators who consider that their Acts are being mocked, but even by those who benefit. In my opinion, strictly literal interpretation of a tax Act is an open invitation to artificial and contrived tax avoidance. Progress towards a free society will not be advanced by attributing to Parliament meanings which no one believes it intended so that income tax becomes optional for the rich while remaining compulsory for most income earners. If strict literalism continues to prevail, the legislature may have no practical alternative but to vest tax officials with more and more discretion. This may well lead to tax laws capable, if unchecked, of great oppression. (at p80)

12. The circumstances envisaged by Parliament for the operation of s. 36A do not include a scheme such as this and I am not satisfied that the taxpayer has discharged the onus of proof that the assessment is excessive (see s. 190 (b); Macmine Pty. Ltd. v. Federal Commissioner of Taxation (Cth) (1979) 53 ALJR 362 ; McCormack v. Federal Commissioner of Taxation (Cth) (1979) 143 CLR 284 ). (at p80)

13. The appeal should be allowed. (at p80)

AICKIN J. I have had the advantage of reading the judgments prepared by the Chief Justice and by Mason J. I agree with their reasons and the conclusion at which each of them arrives. I have nothing to add. (at p80)

WILSON J. I have had the advantage of reading the judgments of Barwick C.J. and Mason J. With one important exception, I agree with what their Honours have said in relation to the different issues canvassed in the case. However, the matter upon which I have come to a different conclusion is fundamental to the resolution of the appeal, with the result that I think it should be determined in favour of the Commissioner. (at p81)

2. In my opinion, s. 36A, on its proper construction has no application to transactions in the ordinary course of business. It seems to me that there are two possible routes by which one might arrive at this conclusion, a narrow way and a broad way. The narrow way is the route considered and rejected by Rath J. and the learned Justices in the Federal Court. That is the way of reading pars. (a), (b) and (c) of s. 36 (1) into s. 36A (1), a task which gives rise to extraordinary complexity if only because the latter provision has already in its own words covered the ground which forms the subject matter of pars. (a) and (b). I do not attempt to travel by that route. (at p81)

3. However, Mr. Priestley, for the Commissioner, pointed us also to the broad way, a route on which it appears that I may travel alone. This route takes for its signpost not simply ss. 36 and 36A in isolation, but it places them in the context of the general charging sections of the Act in their application to trading stock. That context exhibits the features that purchases are allowable deductions under s. 51, sales constitute income under s. 25, and the position of stock on hand at the end of the financial year is regulated by ss. 28 and 31. In my opinion, there is nothing to be gleaned from s. 36A or any other section of the Act to yield a legislative intent that these sections to which I have just referred are abrogated in their application to transactions in the ordinary course of business which possess the added feature that the purchaser is a partnership of which the vendor is a member. Section 36A on its proper construction has no application to such transactions. (at p81)

4. There is a further consideration in support of this construction. Given the conditions of its application, s. 36A (1) applies the legal consequences of s. 36 to the change in ownership but on the basis of a fiction that the disponer had disposed of the whole of the property. The effect of so applying s. 36 is to include the value of that property in the assessable income of the taxpayer, and the disponee shall be deemed to have purchased it at a price equal to that value. In my respectful opinion, the effect of these provisions is to emphasise that these fictions are introduced in order to adapt a disposition that is effected otherwise than in the ordinary course of business to fit into the general scheme. There is neither necessity nor occasion to "deem" anything in the case of transactions in the ordinary course of business. Resort to a fiction is unwarranted in such circumstances, resulting from a misconception of the true operation of s. 36A. (at p81)

5. It remains for me to point out the consequence of this conclusion in the present case. The sale of the shares from Jensen to Jenspart was, as found by the primary Judge, a transaction in the ordinary course of Jensen's business as a share trader. The sale was effected at market value, and I am unable to appreciate why the fact that the purchaser was a partnership which included the vendor as a member should have destroyed its evident character. Indeed, from a tax point of view, the transaction brought to an end the entire interest of Jensen as an individual trader in the trading stock in question. Henceforth, its interest for tax purposes in that stock fell to be determined pursuant to the provisions of Div. 5 of Pt III of the Act. (at p82)

6. In my opinion, the taxpayer was not entitled to the benefit of an election under s. 36A (2), and the Commissioner acted correctly in disallowing the claimed deduction. (at p82)

7. I would therefore allow the appeal. (at p82)

Orders

Appeal dismissed with costs.