Glenfield Estates Pty Ltd v Commissioner of Taxation

Re: GLENFIELD ESTATES PTY. LIMITED
And: THE COMMISSIONER OF TAXATION
No. G251 of 1987
Income Tax

COURT

IN THE FEDERAL COURT OF AUSTRALIA

NEW SOUTH WALES DISTRICT REGISTRY
GENERAL DIVISION
Lockhart(1), Wilcox(2) and French(3) JJ.

CATCHWORDS

Income Tax - Whether land acquired for the purpose of development and resale was trading stock of a business of dealing in land - whether payment to extinguish option over land is deductible from assessable income pursuant to sub-s. 51(1) of the Income Tax Assessment Act - whether grant of option and subsequent assignments had connection with business of land development - relationship between two limbs of sub-s. 51(1) - transactions explicable only as measures intended to reduce liability to tax - relevance of purpose in determining character of payment - payment of private nature excluded from scope of allowable deductions under sub-s. 51(1) - whether any component of the transaction was a "sham" - whether grant of option effected a disposition of the land within the meaning of ss. 36 and 36A of the Income Tax Assessment Act - circumstances in which s. 36A can apply.

Income Tax Assessment Act 1936 (Cth): ss. 36, 36A, 51, 226, 260.

HEARING

SYDNEY

#DATE 26:7:1988

Counsel for the Appellant: Mr R.J. Bainton Q.C. with Mr C.L. Lonergan

Solicitors for the Appellant: Messrs. J.W. Walker & D.K.L. Raphael

Counsel for the Respondent: Mr R.A. Conti Q.C. with Mr R.B. Wilson

Solicitor for the Respondent: Australian Government Solicitor

ORDER

The appeal be allowed with respect to the application of s. 226 of the Income Tax Assessment Act 1936 to the return furnished by the appellant in respect of the year ended 30 June 1978.

The respondent be directed to amend his assessment to income tax of the appellant for the year ended 30 June 1978 by excising the component of additional tax in the sum of $597,501.36.

Otherwise the appeal be dismissed.

The appellant pay two-thirds of the costs of the respondent of the appeal.

The order for costs made by the Supreme Court be varied by ordering the appellant to pay three-quarters of the costs of the respondent of the proceedings before the Supreme Court.

NOTE: Settlement and entry of orders is dealt with in Order

36 of the Federal Court Rules.

JUDGE1

This appeal is concerned with the application of ss. 36 and 36A of the Income Tax Assessment Act ("the Act") relating to trading stock and with whether sub-s. 51(1) allows a deduction to the appellant. Questions as to the application of s. 260 and as to whether certain elements in the impugned transactions are "shams" also arise.

In its return for the year of income ended 30 June 1978 the appellant, Glenfield Estates Pty. Limited ("Glenfield"), included $745,136.78 as gross profit on the sale of certain land in New South Wales. The Commissioner assessed Glenfield on the basis that the true figure for gross profit was $3,342,969.
The facts are involved. In late 1969 Brian Gerald Kennedy and Allan Malcolm McCullough became interested in acquiring land owned by a Mrs. H.L. Phelan ("the Phelan land") in the Wagga Wagga district which was zoned rural but appeared to them to be ripe for residential development. Mr. Kennedy was an accountant employed by Messrs. Walsh and Blair, solicitors, of Wagga Wagga. Mr. McCullough and his wife June Patricia McCullough, carried on the business of master builders and subdividers. Mr. Kennedy and Mr. McCullough caused Glenfield to be incorporated in New South Wales on 23 January 1970 for the purpose of acquiring the Phelan land. Its first directors were Mr. Kennedy, his wife Carmel Mary Kennedy, Mr. and Mrs. McCullough. In mid January 1970 Glenfield entered into a contract to purchase the Phelan land with the intention of seeking to have it rezoned and in due course sub-divided into residential lots for resale. As this was thought to be a long term project, the Phelan land was leased for the agistment of cattle. On 19 April 1972 Glenfield purchased, by two contracts, land adjoining the Phelan land from a Mr. Jack Lloyd ("the Lloyd land"). The Lloyd land was bought with the same intention as the Phelan land had been bought and was also made available for agistment. The total cost of the Phelan land and the Lloyd land, which I shall describe together as "the land", to Glenfield was $196,581. It had an aggregate area of about 600 acres.
On 16 February 1973 Robert Grant Charles Hartwig and Basil Leonard McMullen became directors of Glenfield. Mrs. Kennedy and Mrs. McCullough resigned as directors on that date.
The new board set about obtaining advice with respect to the minimisation of Glenfield's tax liability which would arise if the land were rezoned and subdivided into about 1,200 building blocks, producing a profit then estimated at about $2m. On 26 February 1973 all directors of Glenfield attended a meeting at which three other gentlemen were present, namely, Mr. A.W. Reid, a partner in the firm of Messrs. John L. Bush & Campbell, Chartered Accountants of Wagga Wagga, who had been the accountants for Glenfield since 30 June 1972; Mr. A. Haagensen, a partner in the firm of Messrs. Priestley & Morris, Chartered Accountants of Sydney; and Mr. D.K.L. Raphael, a member of the firm of Messrs. J.W. Walker & D.K.L. Raphael, Solicitors of Parramatta. Mr. Raphael specialises in the field of income tax law. At the meeting Mr. Raphael gave certain advice to the directors including expressing his opinion that off-shore companies should be used to reduce the impact of taxation upon Glenfield. Mr. Raphael was then retained and instructed to furnish Glenfield "with a detailed plan of proposed actions through to the ultimate disposition of the cash profits flowing from the venture".
On 27 April 1973 Mr. Raphael wrote a detailed letter to Messrs. J.L. Bush & Campbell in which he advised, amongst other things, that companies should be incorporated in the New Hebrides, Singapore and Hong Kong, discretionary trusts should be established, Glenfield should grant to one of two companies incorporated in Singapore an option to purchase the land, the first Singapurean company should assign the option rights to a New Hebridean company, the New Hebridean company should then sell its option rights to the second Singapurean company and the land should subsequently be sold. Mr. Raphael also advised in the letter that certain of the documents be executed "in mid-air aboard an aeroplane owned by U.T.A. and will be signed midway between Port Vila and Noumea".
In July 1973 instructions were given by Glenfield to Mr. Raphael to proceed with the implementation of the proposed scheme. Instructions were given by Mr. Haagensen to Messrs. Sly & Russell, solicitors in the New Hebrides, for the incorporation of two companies in that country as part of the proposals. Shortly thereafter Mr. Raphael prepared drafts of four deeds of discretionary trusts which he proposed to take with him overseas in connection with the companies to be incorporated in the New Hebrides. Mr. Raphael also telephoned Mr. Chan, a solicitor in Singapore, whose firm acts for Mr. Raphael's firm, and provided him with details of the Singapurean companies required for the proposals. Mr. Raphael prepared a draft power of attorney to be granted by Glenfield to him in connection with the grant of an option by Glenfield in relation to the land.
On 2 August 1973 the second of the two Singapurean companies granted a general power of attorney to Mr. Raphael. On 3 August 1973 Glenfield granted a power of attorney to Mr. Raphael to execute a grant of option over the land to any company in any part of the world.
On 10 August 1973 Mr. Raphael and Mr. Haagensen travelled to Singapore. A form of option was drafted in Singapore and executed on 14 August 1973 by Mr. Raphael on behalf of Glenfield as attorney. The written option provided that in consideration of $500 paid by a Singaporean company, Broadbent Realty (Pte.) Limited ("Broadbent") to Glenfield, Glenfield granted to Broadbent "its assigns or its nominee" an option to purchase the land for $500,000, the option to be exercised on or before 30 June 1979. Broadbent was also registered as a foreign company in New South Wales pursuant to advice previously given by Mr. Raphael. Broadbent is controlled by Mr. Chan. Also on 14 August 1973 the directors of Broadbent resolved to sell the right to nominate under the option to Qualquest (Pte.) Limited ("Qualquest") for $500. Qualquest is a company incorporated in Singapore and owned and controlled by Mr. Chan. The directors of Qualquest on the same day resolved to purchase the right to nominate. The directors of Qualquest then resolved to sell the right to nominate to Wellington Limited ("Wellington") for $A1,000. Wellington is a company incorporated in the New Hebrides.
Mr. Raphael and Mr. Haagensen then travelled to Port Vila, attended at the offices of Burns Philp International Trust Company ("Burns Philp") and met officers of that company who were also the directors of Wellington. Mr. Raphael produced the trust deeds which he had previously prepared and gave instructions as to how he wished the shares in Wellington to be issued. He also produced a draft special power of appointment which he had prepared for the grant by Wellington to him of a power to execute an assignment of the right to nominate the exercise of rights under the option granted to Broadbent.
A meeting of the directors of Wellington was held at Vila on 16 August 1973 and the offer to acquire the option rights over the land from Qualquest was accepted. At the same meeting it was also resolved that Wellington grant to Burns Philp an option over the whole of its unissued capital. Mr. Chan and his partner were appointed directors of Wellington. The power of attorney from Wellington to Mr. Raphael was also executed on 16 August 1973. Mr. Raphael and Mr. Haagensen returned to Sydney.
In early September 1973 Mr. Raphael flew to Nadi, Fiji with Mr. P. Boden, the resident partner in Port Vila of Messrs. Moore & Priestley. He took with him drafts of documents which he had prepared. On that flight two deeds dated 4 September 1973 were executed which gave effect to the resolutions relating to the exercise of the option. One deed, dated 4 September 1973, is between Broadbent and Qualquest which recited that Broadbent is the grantee of an option from Glenfield for the purchase of the land and that in consideration of the payment of $500 Broadbent had executed the deed. The operative parts provided, so far as material, that, in consideration of the payment of $500 by Qualquest to Broadbent, Broadbent covenanted to nominate, as a person who may exercise the option, Qualquest or such other person as Qualquest may specify for that purpose (clause a); that on the execution of the deed Broadbent would execute and deliver to Qualquest an appropriate form of such nomination with the name of the nominee in blank; that Qualquest or any other person authorised by it be authorised to complete the same by inserting the name of the nominee in blank and that Qualquest or any other person authorised by it be authorised to complete the same by inserting the name of the nominee in blank (clause b); that Broadbent would not itself exercise the option without first obtaining the approval of Qualquest or the holder of the form of nomination provided any such party had informed Broadbent that it is in possession of the same (clause d).
The other deed of 4 September 1973 was between Qualquest and Wellington and it recited that Qualquest was the beneficial owner free from encumbrances of a nomination in blank executed by Broadbent and that Broadbent was the grantee of certain option rights from Glenfield in respect of the land. The deed provided that, in consideration of the promise of payment of $1,000 on demand or completion of the sale of the land to a purchaser whichever should be the later, Qualquest covenanted to hand to Wellington the nomination in blank (clause a). Each deed contained covenants for further assurance.
The learned trial Judge noted that at this stage of the transaction it was proposed that in due course Wellington would dispose of its rights to nominate under the option to a Singapurean company which would exercise the option and dispose of the residential lots to independent third parties.
In early June 1974 the directors of Glenfield went to Perth to confer with Messrs. T.S. Martin & Associates, Town Planners, to obtain a planning concept for the development of the land. In about January 1976 a development application was lodged with the Council of the City of Wagga Wagga for the first stage of the proposed sub-division. On 26 February 1976 the Council of the City of Wagga Wagga stated that approval of a sub-division referred to as "Stages 1 & 2" of the land had been given. On 7 July 1976 the Council stated that the relevant land had been rezoned as residential.
In about June 1976 Mr. Raphael became aware of the judgment of Mahoney J. in St. Hubert's Island v. Federal Commissioner of Taxation (1976) 76 ATC 4080. In that case the taxpayer contended before Mahoney J. that the relevant land was not trading stock. Mahoney J. noted that it had not been finally determined in Australia whether land is capable of being trading stock as that term is generally understood. His Honour said, however, that having regard to the views which he had formed, it was not necessary for him to express any concluded view upon that question. The decision concerned Mr. Raphael because he thought it might lend support to the view that the land with which this case is concerned was trading stock of Glenfield. Hence, he concluded that the land should be vested in the trustee of a discretionary unit trust, the units of which were to be held upon trust for a number of beneficiaries so that the income could be spread. Mr. Raphael gave advice to the directors of Glenfield to that effect and it was accepted by them. The trial Judge found that by June 1976 the original plan had been abandoned and a revised plan, to which reference shall now be made, adopted.
Mr. Raphael advised that a valuation of the land be obtained immediately and that, when Glenfield made the relevant transfer of the land to the trustee, it would be necessary for it to hold the amount of the difference between the market value of the land and the option exercise price "in suspense" since the trustee of the unit trust would obviously have notice of the existence of the option and would take subject to it. On 20 July 1976 a valuation was obtained of the land subject to the option and the value was $3,915,500. At that date 78 blocks had been developed but not sold.
Mr. Raphael arranged for the incorporation of a company named Ehkuk Pty. Limited ("Ehkuk") on 6 December 1976. At the same time he prepared draft deeds of unit trust and discretionary trust. Mr. Raphael proposed that to save stamp duty the transfer of the land to Ehkuk as trustee be achieved by way of mortgage and transfer of the equity of redemption. On 20 December 1976 the Glenfield Estates Unit Trust with Ehkuk as trustee was established by deed bearing that date.
On 16 February 1977 a deed of mortgage was executed whereby Glenfield mortgaged the land to Ehkuk for a period of one year to secure an advance of $5,000. Mr. Raphael prepared draft minutes dealing with the assignment of the equity of redemption and sent those to Messrs. Bush & Campbell together with a letter setting out the necessary steps to be taken and cheques to be drawn for the purposes of the assignment.
The advance of $5,000 was made on or shortly before 7 April 1977. Glenfield executed a memorandum of transfer under the Real Property Act 1900 (NSW) dated 16 February 1977 of the land to Ehkuk.
In early October 1977 Mr. Raphael said to Mr. Reid of Messrs. John L. Bush & Campbell, after he (Mr. Raphael) had been informed that a valuation of the land had been obtained and a calculation for the price of the exercise of the option had been made:

"What we need to do is to have Glenfield sell its equity of redemption in the land to Ehkuk for its current value subject to all the outstanding mortgages and subject to the option. The company will have to place the difference between the value of the option exercise price into a suspense account and it will have to undertake to pay money out to the holder of the right to nominate or, in the event that the option is in fact exercised, to repay it to Ehkuk."

Mr. Reid said that he would explain that requirement to his clients.

On 13 October 1977 meetings of the directors of Glenfield and Ehkuk were held to give effect to those arrangements. The directors of Glenfield and Ehkuk were identical. On 13 October 1977 the directors of Glenfield resolved that Glenfield offer to sell to Ehkuk, as trustee of the Glenfield Estates Unit Trust, Glenfield's equity of redemption in the land for $3,234,500. The directors of Ehkuk resolved on the same day that Ehkuk, in its capacity as trustee, offer to buy the equity of redemption of Glenfield in the land for the same figure. The price of $3,234,500 was calculated by reference to the value of the unencumbered land of $3,915,500 less mortgages in the sum of $681,000 for which Ehkuk was liable.
The trial Judge said:

"Although the minutes contain no reference to the fact, I am satisfied that the directors of each company resolved to the effect that the sale was subject to all outstanding mortgages and to the option, in that Glenfield undertook to pay the difference between the value of the land ($3,915,500) and the exercise price of the option into a suspense account. In the event that the option was not exercised, Glenfield undertook to pay this sum to the holder of the right to nominate, and in the event that the option was exercised Glenfield undertook to repay it to Ehkuk.

I am satisfied that this aspect of the meeting was omitted from the minutes because they were drafted by Mr. Raphael prior to the meeting having been held and he inadvertently omitted that aspect of the resolutions."

On 24 October 1977 Glenfield resolved to lend $3,915,500 to Ehkuk and on the same day a cheque for $3,234,500 was drawn on the bank account of Ehkuk in favour of Glenfield and banked to the credit of its account. The general journal of Glenfield records the carrying of the required amount to the appropriate suspense account. There is evidence from Mr. D. McGrane, Chartered Accountant and a member of the firm of Messrs. Priestley & Morris, that this was proper accounting treatment.
From about June 1977 onwards Ehkuk entered into contracts for the sale to third persons of various lots in the sub-division of the land.
On 1 March 1979 a meeting of the directors of Glenfield was held in which they acknowledged that they were aware that Glenfield had transferred the land to Ehkuk for valuable consideration and that Ehkuk had taken title to the land subject to the option.
Mr. Raphael advised that an explanatory deed be executed between Glenfield and Ehkuk recording the position between them as to the option.
A deed dated 2 April 1979 was executed by both Glenfield and Ehkuk. The directors of both parties authorised the execution of the deed. Although the deed is set out fully in the reasons for judgment of the trial Judge it is necessary for present purposes to set out certain portions of it. It provides so far as is relevant:

"THIS DEED is made the second day of April One thousand nine hundred and seventy nine BETWEEN GLENFIELD ESTATES PTY. LIMITED a company duly incorporated and having its registered office at 57 Gurwood Street, Wagga Wagga (hereinafter called 'Glenfield') of the One Part AND EHKUK LIMITED a Company duly incorporated and having its registered office at 57 Gurwood Street, Wagga Wagga (hereinafter called 'Ehkuk') of the Other Part WHEREAS Glenfield was the registered proprietor of the land referred to in the Schedule hereto (hereinafter called 'the land') AND WHEREAS the land has been transferred to Ehkuk for the price of Three Million Nine Hundred and Fifteen Thousand Five Hundred Dollars

($3,915,500.00) which represented the value of the same at the time of acquisition thereof by Ehkuk AND WHEREAS Glenfield had informed Ehkuk that an option had been granted to Broadbent Realty Pte Ltd. to acquire the land upon certain terms and conditions and that the same was exercisable at any time up to the 30th June, 1979 NOW THIS DEED WITNESSETH AS FOLLOWS:-

1. GLENFIELD was the registered proprietor of the land and had on the 14th August, 1973 granted an option (hereinafter called 'the Option') to Broadbent Realty Pte Ltd. at an exercise price of Five Hundred Thousand Dollars ($500,000.00) plus interest at 15% from the date of granting thereof to the date of exercise together with other interest at 10% on the cost of all development expenditure to the land after the date of grant to the date of exercise and the actual cost expended on such development.

2. GLENFIELD had been informed by David Keith Louis Raphael that the present holder of the right to exercise the option (Hereinafter called 'the Nominee') would certainly be exercising the same itself or would be assigning the same to a party who would exercise the said option.

3. THE value of the land at the time of completion of the sale was $3,915,500 and the land was subject to mortgages from Glenfield to various parties not exceeding $681,000.00.

4. THE cost of exercising the option would be One Million Three Hundred and Seventeen Thousand Six Hundred and Sixty Seven Dollars and Forty Two cents

($1,317,667.42) as at 13 October, 1977.

...

6. THE parties have been informed by David Keith Louis Raphael that the nominee is almost certainly prepared to assign such right to Ehkuk for an amount equal to the difference between the amount payable to Glenfield and the price paid by Ehkuk."

Between 9 and 12 June 1979 Mr. Raphael and Mr. Haagensen travelled to Singapore and on 12 June, 1979 they went to the offices of a firm of Singapurean solicitors.
On 14 June 1979 Glenfield lodged its income tax return for the year ended 30 June 1978.
On 20 June 1979 a deed was executed between Wellington and Chiswick Limited ("Chiswick"), a company incorporated in the New Hebrides, reciting that Wellington is the beneficial owner free from encumbrances of the nomination in blank executed by Broadbent and that Broadbent is the grantee of certain option rights from Glenfield in respect of the land. The deed provided that, in consideration of the promise of payment of $A2,555,000 to be made on demand or completion of sale of the land to a purchaser whichever shall be the later, Wellington covenanted, upon execution of the deed, to hand to Chiswick the nomination in blank referred to in the recital. On the same day a transfer was executed of that right of nomination under the option to Red Hill Realty (Pte.) Limited ("Red Hill"), a Singapurean company, for the sum of $2,565,000. By deed dated 21 June 1979 Red Hill covenanted with Minniconju Pty. Limited ("Minniconju") a company incorporated in Australia to sell to it the right of nomination under the option for $2,575,000. The trial Judge noted that in each of the last three transactions there was a profit to the vendor company of $10,000.
On Mr. Raphael's advice a board meeting of Ehkuk was held on 28 June 1979, the minutes of which record that it was resolved that Ehkuk, in its capacity as trustee of the Glenfield Estates Unit Trust, repay to Glenfield $2,597,832.58 being the monies due by it to Glenfield. It was also resolved that Ehkuk call upon Glenfield to cause a transfer to be made to Ehkuk of the right to nominate a purchaser owned by Minniconju and call upon Glenfield to pay to Minniconju $2,597,832.58. The resolution noted that the rights of Ehkuk to demand these monies arose from the "explanatory" deed of 2 April 1979, in particular clause 11 thereof. Certain other resolutions were passed including a resolution that Ehkuk borrow $2,597,832.58 from Minniconju interest free repayable on demand.
A meeting of the board of Minniconju was held and the directors passed the necessary resolutions consistent with Mr. Raphael's advice. On 28 June 1979 $2,597,832.58 was paid by Glenfield to Minniconju.
On 30 June 1979 the option expired by effluxion of time, not having been exercised. The trial Judge noted that the events subsequent to the agreement between Ehkuk and Glenfield of 13 October 1977 had been ascertained by the time Glenfield's income tax return for the year ended 30 June 1978 had been lodged, having been signed by its public officer on 14 June 1979.
The profit and loss account of Glenfield annexed to its return disclosed gross profit on the sale of the land as $745,136.78, being the difference between the price paid for the exercise of the option of $1,317,667.42 and the cost of acquistion and development of the land of $572,530.64. The balance sheet of Glenfield, also annexed to the return, contained an item "Current Liabilities - Option rights suspense - note 1 $2,597,832.58". note 1 states:

"the amount of $2,597,832.58 is payable to the holder of the right to exercise an option over land and improvements sold during the year".

Under the heading "current assets" in the balance sheet the following item appears:

"Ehkuk Limited - note 2 $3,254,197.70". Note 2 states:

"The amount of $3,254,197.70 represents the balance of consideration receivable in respect of land and improvements sold during the year."

The return contained a schedule in these terms:

"Sale of Property

Consideration specified in

contract of sale $3,915,500.00

Deduct amount payable to the holder of the right to exercise an option over the said property $2,597,832.00

$1,317,668.00"

The Commissioner adjusted the return by increasing the gross profit on the sale of the land by $2,597.832. He thus assessed the total consideration specified in the contract of sale, namely, $3,915,500 as assessable income for the relevant year and allowed no deduction for the payment of $2,597,832 made by Glenfield to Minniconju.

Findings of the Trial Judge
The trial Judge found that the land was trading stock from the outset, having been acquired by Glenfield for the business of land subdivision and resale as residential lots or earlier sale in globo if circumstances so dictated, relying in particular on the judgment of the High Court in Federal Commissioner of Taxation v. St. Huberts Island (1978) 138 CLR 210. His Honour found that the sale to Ehkuk was caught by the terms of sub-s. 36(1) of the Act which at the relevant times provided as follows:

"(1) Subject to this section, where -

(a) 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 the 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."

His Honour held that the land was not sold in the ordinary course of business. He relied particularly on the fact that the sale encompassed the entirety of the land, was made to an associated company at a time when the subdivision of individual blocks was well under way and was "a carefully structured sale designed to inhibit the receipt by Glenfield of the full value of the land".

His Honour then considered the question whether Glenfield was entitled to a deduction of $2,597.832 in respect of the amount in the suspense account as at 30 June 1978. His Honour first considered the application of s. 260 of the Act in these terms:

"The evidence demonstrates beyond question that the grant of the option was never intended to serve any purpose other than that of tax avoidance, albeit there was a change in strategy from time to time to accommodate exigencies which arose.

As one would expect, the detail of the original scheme and the amendments was not fully comprehended by Glenfield's directors, who acted at all times in obedience to the advice of their professional taxation consultants. Thus the Commissioner submits that the minds of Messrs. Haagensen and Raphael should be attributed to the directors. Mr. Raphael identified in evidence the rationale of the original scheme as locating (by the grant and exercise of the option) the source of a substantial proportion of the projected assessable income or profit from the realisation of the land outside Australia in a jurisdiction which levied 'little or no tax'. No other rationale was ever suggested.

At all times prior to 6th May, 1976 Mr. Raphael and those advising Glenfield assumed that for taxation purposes land could not constitute trading stock. However, on that date Mahoney, J. (as His Honour then was) handed down his judgment in St. Hubert's Island Pty. Limited v. Federal Commissioner of Taxation, (1976 ATC 4080) which raised the possibility that land may constitute trading stock within the meaning of s. 36(1) of the Act. This called for a change in strategy and in this regard Mr. Raphael said in evidence:

'I formed the view that the sensible thing to do was ... ... ... that the real estate should be transferred to a new entity ... ... ... Because I thought it was wise to have the land transferred to a unit trust, subject to all the existing obligations, on the basis that if there were an argument as to value and the provisions of s. 36 might be regarded as applying it was as well to contain the matter at that point.'

Thus, by June 1976 the original plan was abandoned. The revised plan, which involved the transfer of the land to Ehkuk was then put into operation. At this time Mr. Raphael specifically advised Glenfield to leave the option on foot, so that it might provide a deduction for the value of the option under s. 51(1) or to enable the value of the option to be treated as income not yet derived. (Arthur Murray (NSW) Pty. Limited, (1965) 114 CLR 314)."

In concluding that s. 260 applied his Honour appears to have implicitly rejected that Glenfield was entitled to a deduction, pursuant to sub-s. 51(1), in the sum of $2,597,832 carried to the suspense account as at 30 June 1978. He said:

"I do not think it is a case where Glenfield had availed itself of tax benefits flowing from the adoption of a particular course of conduct or the choice of alternative tax consequences, nor could it be said that the means adopted to carry the arrangement into effect are fairly referable to ordinary business or family dealings with tax avoidance merely incidental."

His Honour rejected the argument of the Commissioner that the arrangement as a whole was a sham, but he said that he did characterise clause 2 of the deed of 2 April 1979 and the minutes of the meeting of directors of Glenfield of 11 March 1979 - by which his Honour clearly intended to refer to the meeting of 1 March 1979 - as a sham. It does not appear from his Honour's reasons for judgment that his remarks about "sham" played any role in his conclusions, but, as some reliance was placed upon them in argument before us, I have mentioned them.
His Honour concluded his reasons by dealing with the question whether s. 226 of the Act applied. Section 226 in certain circumstances renders a taxpayer liable to pay additional tax equal to double the difference between the tax properly payable by him and the tax that would be payable if he were assessed upon the basis of the return furnished by him.
His Honour found that Glenfield did not make a full and true disclosure of all relevant information in its return of income in that facts sufficient to allow the amount of $2,597,832 to be properly characterised as assessable income were omitted from the return and, accordingly, there had been an omission from the return of assessable income to that extent.
At the commencement of argument before this Court on the hearing of the appeal counsel for the Commissioner informed the Court that the Commissioner no longer pursued his claim for additional tax under s. 226. It appears that the change of attitude by the Commissioner on the s. 226 question was influenced by the decision of this Court in North Coast Grazing Pty. Limited v. Federal Commissioner of Taxation (1987) 87 ATC 4553 at 4556-9. It was agreed between the parties that this Court should, when making its final orders, allow the appeal on that question and direct the Commissioner to amend his assessment to eliminate the component of additional tax which was agreed as being $597,501.36. It was also agreed that, if Glenfield should succeed in this appeal the Commissioner should amend the assessment so as to reduce the taxable income to the figure as returned, namely, $545,182.

The Land as Trading Stock
It was agreed between the parties that the land was trading stock of Glenfield's business of dealing in land. Plainly this is correct. The land was trading stock from the time of its acquisition by Glenfield as it was acquired for the purpose of development and resale: Federal Commissioner of Taxation v. St. Huberts Island (1978) 138 CLR 210 at 226-229 and 231 per Mason J., with whose reasons for judgment Murphy J. and Stephen J. agreed.
Glenfield disposed of the land to Ehkuk during the year of income ended 30 June 1978. The first question is whether the disposal of the land was in the ordinary course of carrying on the business of trading in land. If it was not, then s. 36 of the Act operates to include the value of the land in the assessable income of Glenfield. The trial Judge found that the question should be answered in the negative. His Honour said:

"The relevant factors here are that the sale encompassed the entirety of the subject land. It was a sale to an associated entity at a time when the subdivision of individual blocks was well under way. It was also a carefully structured sale designed to inhibit the receipt by Glenfield of the full value of the land. Accordingly s. 36(1) requires that the full value of the land must be brought to account as assessable income in the year ended 30th June, 1978."

These were findings of fact by his Honour and no ground has been established for disturbing them. Indeed, they were not seriously challenged.
Before leaving this question I note that no submissions were made to the trial Judge or this Court that the value of the land was income according to ordinary concepts and thus assessable income of Glenfield pursuant to sub-s. 25(1) of the Act.

Sub-section 51(1) Deduction
The question on which this case turns is whether the payment of $2,597,832.58 by Glenfield to Minniconju on 28 June 1979 is deductible from the assessable income of Glenfield pursuant to sub-s. 51(1) of the Act.
This involves an analysis of the payment to Minniconju to determine whether it constitutes a loss or outgoing within either of the limbs of sub-s. 51(1) and whether it is excepted as being of a private nature.
The first point to note is that the payment of $2,597,832.58 by Glenfield to Minniconju was not made in the 1978 year of income. It was argued on behalf of Glenfield that the payment was necessarily made by Glenfield to Minniconju as the company then entitled to exercise the right of nomination which originated with the grant of the option to purchase the land by Glenfield to Broadbent on 14 August 1973 and which thereafter, following a quintet of sales of the right to nominate found its way to Minniconju. It was submitted that in those circumstances the deduction arose during the 1978 year of income as it was in that year that the expenditure was definitively committed. I am content for present purposes to assume that the deduction, if available, was incurred during the 1978 year of income. However, if it were necessary to determine this question, Federal Commissioner of Taxation v. James Flood Pty. Limited (1953) 88 CLR 492 at 505-507 may present some difficulties to Glenfield.
The payment made by Glenfield to Minniconju was the culmination of a complex and elaborate series of steps designed to achieve a tax advantage to Glenfield. The first step was the grant of the option by Glenfield to Broadbent on 14 August 1973 followed by the sale of the right of nomination by Broadbent to Qualquest and the assignment of the right of nomination by Qualquest to Wellington by deed of 4 September 1973. In about June 1976 Mr. Raphael, the principal tax adviser of Glenfield and the other parties to the transaction, thought that the judgment of Mahoney J. in St. Huberts Island Case might support a view that the land was Glenfield's trading stock. Hence he concluded that the land should be vested in a company, which later became Ehkuk, as trustee of a discretionary unit trust so that the income could be spread amongst the beneficiaries under that trust. Then followed what was in essence the transfer of the land from Glenfield to Ehkuk by the sale of the equity of redemption subject to outstanding mortgages and to the option and the taking by Glenfield of a mortgage over the land from Ehkuk. The last of the events relevant to the sale to Ehkuk occurred on 13 October 1977. There was a pause until 1979 when the "explanatory" deed of 2 April 1979 was executed and the assignment of 20 June 1979 was made by Wellington to Chiswick of the right to nominate under the option. On the same day the further assignment of that right by Chiswick to Red Hill was effected and on the following day, 21 June 1979, the further assignment of that right was made by Red Hill to Minniconju. On 28 June 1979 the sum of $2,597,833 was paid by Glenfield to Minniconju to perfect the title assigned to Ehkuk and to extinguish the option.
The structure that preceded Mr. Raphael's apprehension about the St. Huberts Island Case was not dismantled. It was kept intact. Indeed, it was the foundation upon which the later transactions were built. Without the grant of option from Glenfield to Broadbent and the sale of the right of nomination by Broadbent to Qualquest and by Qualquest to Wellington, all in 1973, there would have been no basis upon which the subsequent assignments in 1979 from Wellington to Chiswick, then to Red Hill and finally to Minnoconju could have operated.
These complex transactions are explicable only as measures to reduce Glenfield's income tax. The grant of the option and the subsequent string of assignments culminating in the payment by Glenfield to Minniconju on 28 June 1979 had no connection with Glenfield's business of land development which was its only business. They neither augmented nor diminished its trading stock, did not prepare the land for subdivision or development and had nothing to do with the derivation of income from the sale of the land.

If the steps taken by a taxpayer to arrange his affairs to achieve a deduction under sub-s. 51(1) have no nexus with the business activities of the taxpayer or the derivation of his assessable income then no deduction is allowable under sub-s. 51(1).
The relationship between the two limbs of sub-s. 51(1) has been considered in a number of cases. In most situations the first and second limbs of sub-s. 51(1) will cover the same ground, although it may be that the second limb will have particular application where an expenditure is necessary as a result of an abnormal event or situation arising in the conduct of a business: Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47 at 56; John Fairfax & Sons Pty. Ltd. v. Federal Commissioner of Taxation (1959) 101 CLR 30 per Fullagar J. at 40; Federal Commissioner of Taxation v. Total Holdings (Australia) Pty. Ltd. (1979) 24 ALR 401 at 404-405; Federal Commissioner of Taxation v. Ampol Exploration Ltd. (1986) 69 ALR 289 at 303. Where a deduction is claimed under the first limb of sub-s. 51(1), for expenditure to be an allowable deduction as an outgoing incurred in gaining or producing assessable income it must be incidental and relevant to that end. The occasion of the outgoing is to be found in whatever is productive of assessable income. See Amalgamated Zinc (de Bavay's) Limited v. Federal Commissioner of Taxation (1935) 54 CLR 295 at 303, 309-310; W. Neville & Co. Limited v. Federal Commissioner of Taxation (1937) 56 CLR 290 at 300-301, 305-306, 308; Ronpibon Tin N.L. v. Federal Commissioner of Taxation (supra) at 56; Charles Moore & Co. (WA) Pty. Ltd. v. Federal Commissioner of Taxation (1956) 95 CLR 344 at 351. Whether or not a particular loss or outgoing is sufficiently incidental or relevant to be deductible will depend upon a number of factors, including in some circumstances "the purposes for which the advantage occasioning the loss or outgoing is sought" and including the role of the loss or outgoing in the conduct of the taxpayer's income-earning activities: Handley v. Federal Commissioner of Taxation (1981) 148 CLR 182 per Stephen J. at 189-190.
The second limb of sub-s. 51(1) allows the deduction of outgoings incurred in the course of carrying on a business. In John Fairfax & Sons Pty. Ltd. v. Federal Commissioner of Taxation (supra) Menzies J. at 49 observed that deductibility of an outgoing under the second limb of sub-s. 51(1) required the satisfaction of two conditions, namely, that it be found that the outgoing was "necessarily incurred in carrying on a business" and that "the carrying on of the business was for the purpose of gaining assessable income". The word "necessarily" in the second limb of sub-s. 51(1) means "clearly appropriate or adapted for"; it places a qualification upon the degree of connection between the expenditure and the carrying on of the business: see Ronpibon Tin Case (supra) at 56; Total Holdings (supra) at 405. To fall within the second limb, the expenditure must be truly incidental to the business: see Ronpibon Tin Case (supra). In Federal Commissioner of Taxation v. Snowden & Wilson Pty. Ltd. (1958) 99 CLR 431, Dixon C.J. at 436-437 indicated that an outgoing would be deductible under the second limb of sub-s. 51(1) where the expenditure was dictated by the business ends to which it was directed and those ends were truly incidental to the business in question, while Fullagar J. at 444 observed that it would be sufficient if the expenditure was incurred because required by the "exigencies of the business" although arising from unusual or difficult circumstances.
Having regard to the circumstances of the transaction and to the absence of any connection between the grant of the option and the various assignments on the one hand and Glenfield's business of land development on the other, the payment by Glenfield to Minniconju in question does not fall within either limb of sub-s. 51(1) of the Act.
The conclusion that the payment by Glenfield to Minniconju was not deductible under sub-s. 51(1) of the Act is confirmed by the fact that, as I have noted earlier, the transactions are explicable only as measures intended to reduce Glenfield's liability to tax. There is no relationship between the business activities of Glenfield or the derivation of its income and the payment by Glenfield to Minniconju. Section 51 is not directly concerned with purpose, whether objective or subjective. To the extent that purpose is relevant in determining the character of the payment, the only purpose that can be discerned here is that of obtaining a tax advantage whether the test to be applied is objective or subjective. See Amalgamated Zinc (De Bavay's) Limited v. Federal Commissioner of Taxation (supra); Magna Alloys and Research Pty. Limited v. Federal Commissioner of Taxation (1980) 49 FLR 183; Ure v. Federal Commissioner of Taxation (1981) 50 FLR 219; Ilbery v. Federal Commissioner of Taxation (1981) 38 ALR 172; Federal Commissioner of Taxation v. Gwynvill Products Pty. Limited (1986) 69 ALR 487; Federal Commissioner of Taxation v. John (1987) 74 ALR 322.

The payment made by Glenfield to Minniconju is, in any event, of a private nature, and therefore expressly excluded from the scope of allowable deductions under sub-s. 51(1). As I observed in Federal Commissioner of Taxation v. Janmor Nominees Pty. Ltd. (1987) 75 ALR 15 at 24-26, the question of whether losses or outgoings in gaining or producing assessable income and losses or outgoings of a private or domestic nature are mutually exclusive has attracted little judicial scrutiny. The cases provide some support for the view that the exceptions in the latter part of sub-s. 51(1) are not true exceptions but merely confirm items which fall outside the positive limbs of sub-s. 51(1): F.C.T. v. Hatchett (1971) 125 CLR 494 per Menzies J. at 498; Handley v. F.C.T. (supra) per Stephen J. at 191-192, per Aickin J. at 200; F.C.T. v. Forsyth (1981) 148 CLR 203 per Wilson J. at 215-216. While the exclusion of losses or outgoings of a capital or domestic nature may have some scope for operation, it is difficult to identify any circumstances in which the exclusion of a loss or outgoing of a private nature will deny a deduction which the two limbs of sub-s. 51(1) would have allowed. As I noted in Janmor Nominees at 26, the form of sub-s.51(1) contemplates losses or outgoings which although incurred in gaining or producing assessable income fall within the exception as being of a private nature. I therefore leave open the possibility that the exclusion may have some work to do, however rare would be the circumstances giving rise to its operation.
I conclude that the payment made by Glenfield to Minniconju is denied deductibility under sub-s. 51(1) because it was a payment of a private nature, a finding coincident with the finding that the outgoing was not sufficiently relevant to the derivation of assessable income by Glenfield to allow a deduction under either limb of s. 51(1). The Commissioner correctly disallowed the deduction.

"Sham"
It is therefore unnecessary to consider the question whether s. 260 operates on the facts of the present case or whether any component of the transaction answers the description of a "sham", using "sham" in the sense in which it is generally used in the reported cases. This sense is exemplified by Snook v. London and West Riding Investments Limited (1967) 2 QB 786 where Diplock L. J. said at p 802 that the term "sham" comprised:

"acts done or documents executed by the parties to the 'sham' which are intended by them to give to third parties or to the court 'the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create."

Although I do not find it necessary to decide the "sham" question, I observe that there is considerable force in the argument advanced by counsel for the Commissioner. In my view there could be no substance in any contention that the steps antecedent to Mr. Raphael's awareness of the St. Hubert Island Case were shams. They were intended to have legal effect. But after the commencement of what was in substance the sale of Glenfield's land to Minniconju it is difficult to see what purpose was served by the retention of the option structure previously established and by further advancing it with the intervention of Chiswick, Red Hill and Minnoconju other than the purpose of creating an artifice or series of steps never intended to have effect according to their tenor. The tax benefit which Glenfield had earlier hoped to gain by employing the option procedures was superseded by the anticipation of a tax benefit of a different character, namely, spreading the incidence of any tax that might arise amongst the beneficiaries under a unit trust of which Ehkuk was the trustee. Achievement of such a tax benefit required that Ehkuk be the owner of the land, and that requirement was inconsistent with the exercise of the option.
The statement in clause 2 of the explanatory deed between Glenfield and Ehkuk of 2 April 1979, to which reference was made earlier, to the effect that Glenfield was informed that the then holder of the right to exercise the option "would certainly be exercising the same itself or would be assigning the same to a party who would exercise the said option" was window dressing for the stage in the transaction which was then to take place. The last thing any participant wanted was that the option be exercised so as to deprive Ehkuk of the land. The statement in clause 2 of the explanatory deed was described by the trial Judge as a sham. All that clause 2 does is to recite information given by Mr. Raphael. It strictly speaking could not be said to be a "sham" in that it does not of itself create any legal relations between parties or any rights and liabilities; but his Honour obviously took the view that the statement asserted something that was in fact never intended to occur or to exist. In that sense his Honour used the word "sham". However, I have not formed a final view on these matters. I prefer to base my conclusions on the grounds previously mentioned.

Sections 36 and 36A
During argument in reply counsel for Glenfield for the first time in this case advanced an argument based on the combined operation of ss. 36 and 36A of the Act. He argued that, after the grant of the option by Glenfield to Broadbent on 14 August 1973, for the purposes of ss. 36 and 36A of the Act the land had to be treated as the trading stock, not only of Glenfield, but of both Glenfield and Broadbent. The genesis of this argument lay in the language of ss. 36 and 36A. The option was said to have effected a change in the ownership by Glenfield of the land, the land being trading stock in Glenfield's business, so that after the change both Glenfield and Broadbent had interests in the land within the meaning of s. 36A. It was submitted that in the result, both Glenfield and Broadbent are to be treated as being the owners of the land as trading stock and its value on 14 August 1973. It followed, on this argument, that since the option was not exercised but the land was sold by Glenfield to Ehkuk, ss. 36 and 36A require the sale to be treated as a sale by both Glenfield and Broadbent to Ehkuk for a purchase price of $3,915,500. It was submitted that Glenfield, as the grantor of the option, had to be treated as having transferred its interest in the land at the option exercise price and that in the result the only assessable income in the hands of Glenfield is $1,317,677.
In my opinion this argument is fallacious for more than one reason. The Federal Parliament plainly inserted s. 36A into the Act in order to reverse the consequence of sub-s. 36(1) recognised by the High Court in Rose v. Federal Commissioner of Taxation (1951) 84 CLR 118, where it was held that the ownership of assets of a business which passed from a sole trader to the co-ownership of that person and two other persons as partners in equal shares was not "disposed of" within the meaning of sub-s. 36(1). Section 36A was intended to extend the operation of s. 36 to circumstances where a change occurred in the ownership of or in the interests of persons in trading stock.
Section 36A relevantly provides:

"36A(1) 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 36 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."

It should be noted that the operation of s. 36A is only with respect to s. 36, namely, that s. 36 shall apply 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 was owned after the change. As to s. 36A see generally Income Tax in Australia by Professor Ross Parsons, para. 14.1, 14.62 and 14.72.
Section 36A is directed to circumstances where the taxpayer disposes of property or his interest in property in favour of some form of co-ownership where he retains some interest in the relevant property after the transfer. It cannot, fairly construed according to its language and in the light of the mischief which is was designed to cure, apply to a case like the present where all that has happened is that the taxpayer has granted an option to someone to purchase the taxpayer's interest in the property. Whatever may be the correct characterisation of an option to purchase real estate, (see Laybutt v. Amoco Australia Pty. Ltd. (1974) 132 CLR 57 per Gibbs J. at 73; KLDE Pty. Limited (In Liq) v. Commissioner of Stamp Duties (1984) 56 ALR 337) the acceptance of Glenfield's argument would make a nonsense of ss. 36 and 36 A If the language of the sections plainly led to the conclusion contended for then I would accept it; but it does not. I share Professor Parsons's view that perhaps the only circumstances in which s. 36A can apply are those specifically identified in the section, namely, the formation or dissolution of a partnership or variation in the constitution of a partnership or in the interests of the partners (Parsons, Income Tax in Australia, para. 14.72.)
Whatever the scope of the section it does not apply to the circumstances that arise in the present case. It would be a misuse of language to talk of the grant of an option in circumstances such as the present as a disposition of the land or any part of it by Glenfield to Broadbent within the meaning of ss. 36 and 36A.
In my opinion the appeal should be allowed with respect to the applicability of s. 226 of the Act; the Commissioner should be directed to amend his assessment to income tax of the appellant for the year ended 30 June 1978 by excising the component of additional tax in the sum of $597,501.36; and otherwise the appeal should be dismissed. As the Commissioner did not inform the Court or Glenfield that he no longer pursued his claim for additional tax under s. 226 until the morning of the hearing before this Court, some deduction should be made from the costs which Glenfield, as the unsuccessful appellant, should otherwise pay to the Commissioner. In my opinion a fair deduction is one-third. Hence, I would propose that the appellant pay two-thirds of the Commissioner's costs of the appeal. There should also be a deduction from the costs payable by Glenfield to the Commissioner on the trial because Glenfield has succeeded on the question of the application of s. 226. In my opinion the order for costs made by the Supreme Court should be varied by ordering Glenfield to pay three-quarters of the costs of the Commissioner of the proceedings before the Supreme Court.

JUDGE2

I have had the advantage of reading the Reasons for Judgment of Lockhart J. I agree with those reasons and with the orders he proposes.

JUDGE3

I have read the Reasons for Judgement of Lockhart J. I agree with those reasons and the orders that his Honour proposes.

[1988] FCA 432

26 JULY 1988