NT98/444-451, NT99/202 and Commissioner of Taxation

[2000] AATA 754

Administrative

Appeals

Tribunal

 

DECISION AND REASONS FOR DECISION [2000] AATA 754

ADMINISTRATIVE APPEALS TRIBUNAL      )

)No NT98/444-451, NT99/202

TAXATION APPEALS  DIVISION		)
Re		CONFIDENTIAL

Applicant

And COMMISSIONER OF TAXATION

Respondent

DECISION

Tribunal Mr B.J. McMahon (Deputy President)

Date29 August 2000 

PlaceSydney

Decision  The objection decisions are affirmed.

..............................................

BJ McMahon
  Deputy President

CATCHWORDS

TAXATION – income tax – assessable income – whether income should be treated as assessable income or capital profit – whether applicant intended to sell or retain development – purpose of the taxpayer – income to be treated as assessable income – losses disallowed.

Tax Assessment Act 1936 – s 25

Hayes v Federal Commissioner of Taxation  (1956) 96 CLR 47

Magna Alloys and Research Pty Ltd v Federal Commissioner of Taxation (1980) 80 ATC 4542

McCurry v Federal Commissioner of Taxation (1998) 39 ATR 121

The Commissioner of Taxation v Whitfords Beach Pty Ltd (1982) 150 CLR 355

Warriewood Valley Pty Ltd as trustee of the Jill Trust v Commissioner of Taxation (1993) 93 ATC 4653

Westfield Limited v Commissioner of Taxation (1991) 28 FCR 333

REASONS FOR DECISION

29 August 2000 Mr B.J. McMahon (Deputy President)     

1.      These applications concern the income tax liabilities of the applicant company for the years ended 30 June 1989 to 30 June 1994. During that time, the respondent has included in the assessable income of the applicant, a total amount of $26,351,614. The applicant had claimed losses amounting to approximately $48,592,183. No part of the first sum would have been included in the applicant’s assessable income had losses not been disallowed. They were disallowed because, in the respondent’s view, they were absorbed by an amount which the respondent treated as representing assessable income and which the applicant had treated as a capital profit, namely $45,751,334.

2.      The applicant acquired property on the Gold Coast, intending to develop it ultimately as a hotel and shopping centre. In order to facilitate the obtaining of finance, a trust was established in which all units were held by the applicant. The intention at the time was that units would be subscribed for by various financiers. This intention was not realised. The applicant remained the sole unit holder of the trust and its effective controller. On the day the trust was established, the applicant caused ownership of the property to be transferred to the trust, realising a profit of $2,727,357. This profit is the subject of the disputed assessment for the year ended 30 June 1985.

3.      After a period during which efforts were made to find long-term finance, trading losses were incurred by the contracted hotel manager and litigation was concluded against that manager unsuccessfully so far as the applicant was concerned. The hotel was eventually sold at a profit of $45,751,334. In the assessments issued by the respondent, this amount has been treated as a revenue profit. It was therefore absorbed by the trading losses which had been incurred in the management of the hotel. The respondent has also disallowed claims for the investment allowance made by the trust in the years 1986 and 1987 in respect of plant and equipment acquired in the construction of the hotel on the basis that its disposal was intended at the time of acquisition.

4.      The assessments also included sums of $4,703,000 and $4,350,000 received by the trustee which were said to be professional fees. Although objections were made to the treatment of these sums as assessable income, and although the objections were disallowed, and although these applications were brought to review that part of the objection decisions, those claims are no longer pursued by the applicant.

5.      The only issue in these proceedings, therefore, concerns the manner of treatment of the first profit of $2,410,035 and of the second profit of $45,751,334. If they are shown to be capital profits, then none of the relevant assessments to the applicant will stand, except as to the undisputed amounts referred to in the last paragraph. If the two sums are found to be income, then there will be no available losses, relevantly, to offset against income and the assessments will stand.

6. The respondent contends that both of the sums constitute income in the ordinary sense referred to in section 25 of the Income Tax Assessment Act 1936. Alternatively, it is claimed that both sums are included in the applicant’s assessable income under subsection 25A(1) as they constitute profits arising from the carrying on or carrying out of a profit making undertaking or scheme. The applicant contends that the profits arose from forced sales of an asset which the applicant had acquired with the intention of retaining the finished development as an ongoing investment and that the sums merely represent the realisation of a capital asset.

7.      The two sections relied upon by the Commissioner to a large extent overlap, as was pointed out in Whitfords Beach Pty Limited 150 CLR 355. Whichever is to have application, however, requires an inquiry into the “purpose” of the applicant. This concept was discussed by Brennan J in Magna Alloys and Research Pty Limited 80 ATC 4542 at 4544. The terms of subsection 25A(1) relevantly applicable to this transaction make reference in the first limb to the purpose of profit making. That purpose may be achieved by sale or may be achieved from the carrying on or the carrying out of a profit making undertaking or scheme. Whichever limb applies, it is relevant to identify the purpose of the taxpayer. As Brennan J pointed out, such a purpose is objective. It is an attribute of a transaction. It is to be distinguished from both motive and subjective purpose. The evidence in these proceedings often made reference to the applicant’s “intention”. It is the objective purpose, however, which will determine the applicability of the section. In establishing that purpose, one should look at all of the surrounding circumstances. As was said in McCurry 39 ATR 121 at 127:

“In a case such as this where the Court must examine the purpose of a transaction, the Court is entitled to have regard not only to the evidence which the taxpayers give of what they had in mind, but also to the surrounding facts and to the events which actually occurred. Those events, by hindsight, can throw light upon the considerations which the taxpayer had at the time when the dealing was initiated. That which a person does is a guide to that which he had in mind to do.”

8.      In other words, less weight should be given to statements of purpose or intention by the taxpayer than to objective facts which illustrate that purpose. In Warriewood Valley Pty Limited 93 ATC 4653 at 4662 Lockhart J said:

“Statements by taxpayers, and, in the case of corporate taxpayers, those who control and manage their affairs, must be scrutinised with care, weighed against the objective facts and the inferences to be drawn from the taxpayer’s activities generally. Statements of this kind must ‘be considered most closely and received with the greatest caution’.”

9.      Similar observations have been made in many cases, some of which were cited by Lockhart J following the above passage. Statements by taxpayers, whilst relevant, are of limited assistance only in applying objective tests (Hayes 96 CLR 47 at 55).

10.     The principal proprietor of the applicant was Mr H, who died some three months prior to the hearing. He had made statements to officers of the respondent, to his legal advisers in connection with the preparation for the hearing and to intending financiers. There are inconsistencies in a good many of these. During the relevant period, his partner was Mr G, who now has a business in Vanuatu. Although evidence was given that he regularly comes to Australia, he chose not to give oral evidence in person. After hearing submissions from both counsel I decided that taking his evidence by telephone was inappropriate, having regard to the fact that a number of documents were to be put to him and having regard to the intended length of the cross examination involved. This meant that Mr G’s evidence was not available except where it could be established through prior correspondence or through statements which he had made to others. No good reason was advanced why he could not attend the hearing. As it transpired however, the evidence indicates that Mr G played quite a subsidiary role in guiding the activities of the applicant. Essentially, the actions of the late Mr H were the actions of the applicant.

11. The applicant’s purpose, therefore, was discerned by examining the large number of documents before the Tribunal furnished pursuant to section 37 of the Administrative Appeals Tribunal Act 1975. These consisted of 2002 pages in seven volumes. References preceded by the letter T will be references to those pages. These documents included written statements which Mr H had made to officers of the respondent, statements he had made in correspondence with others and accounts given by third parties of statements he had made either to them or to other parties in their presence. In addition to information culled from these documents, I had before me oral evidence from both of the sons of the late Mr H and oral evidence from a consultant who played some part in these events.

12.     The late Mr H was an airline pilot who retired in 1978. With his wife he moved to the Gold Coast in 1980, where he then met Mr G. In his statement given to the respondent, he asserted that he had developed an interest in five star hotels through staying in them during his long flying career and that above all, he wished to build and operate such a hotel. An appropriate site came to his attention in 1983. Through another company, which he and Mr G controlled, a development application for a hotel on the site was lodged with the Gold Coast City Council on 4 November 1983. At this stage, the applicant company merely held options over the real estate.

13.     Peat Marwick had always been Mr H’s personal accountants. He instructed them to prepare a feasibility report dealing with the market and financial feasibility of the proposed hotel. Their report dated November 1983 indicates the instructions that must have been given to them concerning the ultimate disposal of the hotel by the sale of units. It states (T434):

“Although it is planned that the units in the hotel be strata titled and sold as investment property, the hotel will appear as any other major tourist hotel. The pattern of individual unit ownership will in no way affect the operation of the property as an international standard hotel. It is expected that the property will be managed by an internationally known operator with an international domestic referral system and close ties to both domestic and international airlines.”

14.     The market and financial feasibility study also contained financial projections for eight years. Counsel for the applicant pointed to this fact as an indicator of the long-term nature of the preparations made by his client.

15.     The company then sought to settle financial arrangements. On its behalf, its associated company (Services) wrote to its proposed engineers, Gibb Australia, on 6 January 1984, telling them of the company’s plans. These included details of the financial structure then proposed by Mr H in his dual capacity as the alter ego of both the applicant and Services:

“Financial Structure:

Several financing structures are under consideration. In summary these are:-

(a)       Long term mortgage finance – 25 years.

(b)       100% bridging finance for purchase and construction.

(c)       Take out finance via leading Merchant Bank of impeccable repute.

(d)An end buyer; this would be a major Australian Institution who will buy the total project. This purchase will occur either at the end of the construction period or within the opening years of the project, and, as such, will be the final source of repayment of (b) and (c) above.

These options will be finalised during January, 1984.

Naturally we favour (d), which requires the setting up of (b) and (c) and as this appears to be possible through Gibb Australia we will be very interested in your reaction.

…

Take Out Finance

Standard Chartered Australia Limited has been asked for a commitment of $60,000,000 to take out the 100% construction finance and other expenditure at the official completion of the project, and for a bridging term thereafter for the purpose of arranging the on sale to the end buyer.”

16.     The indication that Mr H favoured sale to a major Australian institution after the setting up of bridging finance and “take out finance” is consistent with the course of events over the next few years. It illustrates that the search for long-term finance was quite compatible with a purpose of ultimate sale. It illustrates the purpose of the applicant in January 1984.

17.     This was of course prior to the acquisition of the land. The applicant had no funds to finance the purchase of the real estate, let alone the erection of any improvements upon it. There followed negotiations with a Japanese-owned construction company (Kumagai). Kumagai wrote on 23 January 1984 offering a $60 million construction facility. In brief, this involved payment to Kumagai of a head contractor’s fee of 5%, an arrangement of take out finance within five years to relieve Kumagai of any supporting role they would come to occupy, firm arrangements with an internationally known hotel management operating group and a further investigation of the then current plan to ensure that quality and design met the highest specifications for a five star hotel. That offer was accepted on 26 January 1984. Shortly afterwards, Services entered into a 20 year contract for maintenance of the building and for management of the shopping centre and office space which was to be constructed. Once again, the long term of the management contract was relied upon by counsel for the applicant to illustrate a long-term intention to hold the property as an investment. To my mind, it does not illustrate any such purpose. Rather, it indicates that whatever was to happen to the hotel and associated shopping centre in the future, companies associated with Mr H were to retain collateral benefits.

18.     From then on, the applicant was continually seeking long-term finance in accordance with its arrangements to pay out Kumagai. It was an important part of the applicant’s case that these efforts to obtain long-term finance indicated an intention on the part of the applicant to hold the property as an investment indefinitely. In my view, seeking long-term finance was not inconsistent with a general purpose of selling the development. Indeed, the securing of long-term finance was part of the undertaking as outlined in the letter to Gibb Australia. It was envisaged that the project as a whole, completed and fully financed, could be sold to a major Australian institution. Secondly, and more importantly, in the pursuit of the long-term finance, a number of statements were made, some by Mr H and others summarising discussions with Mr H, which contradict the assertions which the applicant now makes.

19.     On 20 February 1984, a letter from the engineers to Kumagai reported two conversations which the author had with Mr H. According to that author Mr H, on behalf of the applicant, had said that the only gain it would make was at the end of the project when it was finally sold off (T470).

20.     On 1 March 1984, an officer of the Commonwealth Bank recorded the substance of his discussions with the applicant’s representative (not Mr H) as follows:

“Intention of [the applicant] is to sell the venture over the next few years, certainly well before the expiry of the five year term. However, if sale did not eventuate, then the CTB or other lender, because of take out obligation, would need to provide funds to repay $45 million… Intention of owners is to sell and thus avoid having to utilise loan facilities.”

The statement was made by Mr B who, at that time, was involved with both Mr H and Mr G and who must be taken to have been speaking for the company when he made this proposal to the Commonwealth Bank.

21.     The bank decided not to pursue this financing proposal. The assistant general manager recorded his understanding of the project on 5 March 1984 as follows:

“The prospects for marketing the project successfully in 3/5 years’ time would certainly need a lot more investigating.

…

I can certainly understand that Kumagai would not be prepared to provide the whole project costs and rely on an early sale to clear/reduce the debt – in fact I am a little surprised that they are apparently prepared to risk having to carry a residual $15M on second mortgage and be dependent upon sale for clearance.

…

In essence we are asked to commit $45M for funding in five years’ time if the project is not sold in the interim, with a commitment to carry the financing for a further two years in case of need. As our “take-out” hinges basically on sale of the project and it is located in a notoriously volatile property market with the new casino as a potential threat, I do not consider it a banking proposition. In fact the proposal seems more suited to a large property trust, superannuation fund or the like interested in acquiring a “turn key” project – in effect the project needs to be pre-sold in which event we could conceivably fill the role which Kumagai is adopting. In essence the promoters appears to be speculating on an escalation in the value of the project without (as far as I can see) incurring any personal financial risk.”

22.     During this time, there was a cost overrun and Kumagai was obliged to offer more funds. In order to achieve this object, Mr H gave an undertaking on 10 March 1984 to Kumagai in the following terms:

“[The applicant] hereby undertakes to enter a Technical Services Agreement with Kumagai (N.S.W.) Pty Ltd to provide services for which the fee will equal 20% (twenty per cent) of our profit derived from the onwards sale of the project arrived at by subtracting the agreed Total Project Cost up to the date of sale from the nett Sale Price remaining after deducting the costs of sale” (T483)

23.     On 2 April 1984, the offer of finance from Kumagai was made in more formal terms. It included provision for a technical services agreement to be compensated for at a rate of 20% of the difference between the cost of the project less the net proceeds of sale.

24.     The pursuit of long-term finance continued, even before construction commenced. On 19 April 1984, Standard Chartered Bank gave a tentative in principle agreement to provide the $45 million take out finance. For various reasons this did not eventuate. Kumagai suggested to the applicant that it speak to the Bank of America concerning long-term offshore finance. This also came to nothing. During this time, there must have been continuing talk of an ultimate sale of the development. On 15 June 1984 it was recorded that Mr H attended on an officer of the loans department of the Commonwealth Bank seeking accommodation for so much of the Kumagai advance as represented the cost of the land for the project. That officer recorded his understanding of the discussion with Mr H in a diary note as follows:

“I doubt that our CBD would want to investigate the proposal further at this stage, because it still hasn’t as I understand it been pre-sold.”

25.     On 16 May 1984, the applicant entered into a 20 year management contract with an international hotel management company. It contained a clause which was to have disastrous effects. Article 5 required the applicant to provide the equivalent of US$300,000 operating cash on the first operating day and on the first day of each month thereafter, to provide a sum equal to the hotel’s operating costs during the preceding month. Thus, with the losses which were subsequently experienced, the applicant was under an obligation to top-up the working cash requirements on a monthly basis.

26.     Negotiations continued with the Commonwealth Bank in relation to a temporary overdraft and bills discount facility. A note made by the acting chief manager in his diary on 11 July 1984 was as follows:

“Initially, [the applicant] proposed to increase paid-up capital to $5M by a local public raising but have shelved this for the time being.

The cost of the project is expected to be around $100m after allowing for capitalisation of interest over a construction term of two years and a holding term of three years.

The construction of three (including [the applicant’s]) national hotels has been announced for Surfers Paradise but [the applicant] principals remain very confident about their project’s future and prospects of sale. However, the principals acknowledge that the project is not without risk particularly in the event of high interest rates prevailing during construction/borrowing term of up to five years.” [T600]

27.     The construction of the hotel finally commenced on 9 October 1984. On that day, Kumagai agreed to grant an increase in the applicant’s credit facility under the 2 April 1984 loan agreement to an amount of $70 million. On the same day, by a letter signed by Mr H and Mr G on its behalf, the applicant agreed to pay Kumagai a head contract fee of $2.66 million. The letter contained these words:

“In addition [the applicant] will, upon sale of the project, pay to Kumagai a fee for technical services of 25% (twenty-five per cent) of the difference between the total cost of the project and the nett proceeds of the sale. In this event, Kumagai will allow a deduction of $500,000.00 from the resulting amount.”

28.     On 7 November 1984, Allco Leasing Limited submitted to the applicant a financing proposal in the form of a full-funded private trust arrangement. The letter submitting the proposal compared the respective profits on sale and concluded that “there is a higher potential profit on sale under the Allco proposal which reflects the cash savings” (T736). The purpose of the trust was to enable units to be sold. On 15 April 1985, Security Pacific Australia was approached to provide funding for this trust structure. Although it was subsequently involved in funding part of the project, it declined to participate in the unit arrangement. All units continued to be held, therefore, by the applicant. As part of the trust arrangement, an associated company (Trustee) was established.

29.     The property was then sold to Trustee in a way evidently designed to avoid payment of Queensland stamp duty. A written offer was made and was accepted orally in the Australian Capital Territory. The amount chosen as the consideration resulted in a profit of $2,720,357. There is no indication in the hundreds of papers that have been examined why such an amount was fastened upon. It was suggested from the bar table by counsel for the applicant that this could have represented the full value of the property at that stage and that if subsequently it was found that Queensland stamp duty was payable, then it would have been calculated by reference to the full value at ad valorem rates rather than at the higher rates if the consideration had been below value. There is nothing to support such a suggestion. It is equally conceivable that the profit was taken in order to establish a higher plateau within the trust before units were allotted to financiers. In commercial terms, there was no net gain to the applicant. Prior to the sale, the applicant owned the property which was then at a very early stage of construction. After the sale, title continued to remain in the applicant company, although ownership of the property was vested in the Trustee for the benefit of unit holders. As the applicant was the only unit holder, it had not at that stage achieved any financial benefits. Nevertheless, a profit had been taken and the structure was in place to ensure that these benefits could be realised if units were disposed of to third parties.

30.     The financial arrangements between the applicant and Kumagai continued to be discussed during the course of construction. On 5 December 1984, Mr H wrote to Kumagai concerning an offshore funding arrangement involving the issue of 20 promissory notes. In the course of the letter, he referred to Kumagai’s protection which Mr H said could be secured in two ways which he then described. He said:

“The second method is that of procuring the sale of the entire project (as has always been intended) after the point where the income return has stabilised, which should be during 1988/1989.”

31.     A week later, Mr H was again writing to Kumagai, enclosing income and profit projections. In his letter he stated:

“I attach to this letter information of the expectation of profit to the project in the early years of trading leading up to a sale.

…

Considering next the sale price and profit resulting therefrom, we see two valuations, the first based on a 12½% profit on total project cost updated for inflation up to point of sale.”

32.     The schedule attached to the letter was a series of calculations of the amount which Kumagai would receive for the technical services agreement based upon ultimate sale projections. It was a submission by counsel for the applicant that many of these statements by Mr H that the applicant intended to sell the project were made in the context of financial negotiations. It was suggested that Mr H made statements of this kind only in order to encourage long term financiers and that these statements did not express his real intention. I do not accept this hypothesis. Firstly, it seems clear that no other funds would have been available for repayment of the long-term finance except from the proceeds of sale. Secondly, it is beyond belief that experienced financiers could be deceived in such a material particular. In any event, the suggestion of duplicity is made only in relation to representations to long-term financiers. It is difficult to believe that such untrue statements would be made to Kumagai, with whom the applicant was so closely involved during the planning, construction and early financing stage. They were practically joint venturers. It is most improbable that Kumagai would have advanced both building and short-term finance and entered into an agreement in which its compensation depended upon sale, unless meaningful representations had been made to it concerning the applicant’s purpose of sale reasonably soon after completion.

33.     Further efforts were made to obtain long-term finance from a Hong Kong company and from Security Pacific Australia in late 1985 without result. Short term facilities were extended by Security Pacific but these needed to be taken out in the near future.

34.     In connection with these approaches, LJ Hooker Limited was instructed by Services to prepare a valuation report. This document dated April 1985 records the valuer’s instructions as follows:

“We have been requested by [Services] to provide various estimates of the potential market realisation of the [name of the hotel] based on the following assumptions.”

35.     LJ Hooker were asked to assume that the project would be sold on the day it commenced full trading and in the alternative, that the project would be sold at the end of a five year trading period. They then set out their opinion and explained the methodology of arriving at the figures in accordance with their instructions.

36.     In 1986, the State Bank of South Australia supplied $35 million for twelve months. Although necessary  at the time, the advance was merely a short-term solution to the company’s financial problems. On 30 April 1986, Kumagai executed a deed of postponement of security to give the State Bank of South Australia first ranking security.

37.     In April 1986 (shortly prior to completion of the hotel) Services prepared a document entitled “Concept Planning” (T770). This reviewed the valuation carried out by LJ Hooker and included the following paragraphs:

“Considerable effort has already been expended in assessing the likelihood of sale on completion of construction and this includes the establishment of a full assessment study with one of the largest Institutional Investors in Australia.

That will be continued as soon as the construction schedule is confirmed and is handled very capably by Mr Lawrence Burr of Lawrence Burr & Associates.

The aspect of that initial approach is that a purchase on opening would be very likely if the (Manager) Group would accept an Operating Lease instead of a Management Agreement.

The latter would of course result in much greater nett profit to the owner but some members of the Institution’s Assessment Panel would rather have the assured lesser lease rental with the normal review procedure. We are currently examining means of resolving this one remaining point which stands in the way of a substantially profitable sale of the entire Complex on opening day.

This same group have expressed firm interest in purchasing the Shopping Complex as entirely apart from the Hotel if we wish to split the title which again is quite possible.”

38.     Practical completion of the building was achieved on 23 May 1986. The financial long term problem, however, was still unsolved. In the course of preparing submissions intended to assist with the financing of the project, the applicant prepared a document entitled “Placement Memorandum” (T1573). It contained the following:

“[The applicant’s] primary objective is to sell the project. It is possible that a sale will be achieved prior to completion. This means that the “take out” commitment would never become fully drawn.

End buyers of this project will be:

·     Australian Life Officers [sic]

·     Superannuation Funds

·     Property Trusts”

39.     The Placement Memorandum then considers as a fall back position the separation of the hotel from the associated shopping centre. It then proposes that the hotel suites be strata titled and sold without disruption to the actual operation of the hotel by the contracted manager. The Placement Memorandum noted that the shopping centre could be sold for $25 million. It noted that hotel suites would have to be sold for a minimum of $85,784 to enable equity holders to recoup their position.

40.     The arrangements with Kumagai were again changed on 18 June 1986. Mr H and Mr G offered Kumagai a revised equity interest in return for supplementary funding in the early years with the trust negotiating long-term funding to relieve Kumagai of its letter of credit obligations. In the course of that letter Mr G, writing as executive director of the applicant, wrote:

“[The applicant] has been prepared at all times to pay 20% of nett profit over total project cost to Kumagai as a fee for technical services rendered.

Currently is not the time to sell this project as no profit would result.”

41.     There had been a “soft opening” of the hotel on practical completion in May 1986 when trading commenced. It operated at a loss up to 30 June 1986 and continued operating at a loss thereafter, except for one or two exceptional months. As these losses continued, efforts to find long-term finance became more difficult and protracted. The consultant who gave evidence tried to assist in negotiating five year funding. Kumagai became concerned at the decreasing prospects of its being relieved of its obligations and of receiving its capital outlay and building costs. The Commonwealth Bank again declined proposals for five year funding on 12 November 1986. The applicant’s prospects for long-term finance were looking bleak. Extensions were sought from the State Bank and negotiations were undertaken with Citibank which required an unavailable guarantee from Kumagai in order to involve itself.

42.     Ultimately, on 17 September 1987, Trustee began negotiations to sell the hotel, recognising, as counsel for the applicant put it, the inevitable. On 23 September 1987, notice was served on the contracting manager purporting to terminate its management contract. The Trustee sought to conclude a sale of the hotel to Kumagai by 30 September 1987. Prior to this date, the management contracting company commenced proceedings against the Trustee in the Federal Court, seeking an injunction restraining it from terminating the management agreement. The hearing of the application was before Sheppard J in early October. The Federal Court granted an interlocutory injunction restraining Trustee from interfering in the management of the hotel by the manager. In the course of evidence, Mr H told the Court that the decision to sell was forced on the applicant. He said:

“A.      …the decision to sell the hotel is forced upon us (in 1987). We planned a five to six year period during which a record would be established and we go so far as planning a five-year tax-based funding operation, taking into the account all the shortfalls and all the buildups that would be necessary so that we could run that term… We arranged guarantees for that. Now in the light of what has now happened, as we look at our June (1987) balance sheet and take a hard look at the scene, that is not possible and the hotel must be sold.

Q.       …your company’s capital structure does not permit you to run that five or six year term does it?

A.        In the light of the losses, no. …

Q.       … and it necessitated sale?

A.        A sale has been necessary for some time.”

43.     Following the unsuccessful Court case, Kumagai called on the State Bank of South Australia to take possession as mortgagee to sell the hotel free of the management agreement. Kumagai had sought counsel’s advice as to whether such a course was available. The financial accounts for 1987 by now showed the negative worth of the applicant and the fact that continued ownership of the hotel was untenable. The accounts also showed that it would be difficult, if not impossible, to obtain long-term funding. This proved to be the case. Specialist insolvency accountants were called in by Kumagai. They reported on 16 November 1987:

“Ferrier Hodgson report that Hotel Project

(i)        accumulated trading losses $35.2 million

(ii)       probable achievable budget for year to September 1988 – loss $18.5 million

… the future trading prospects are dismal without the support of secured creditors. Such support would be difficult to recommend as the option of sale of the project would remove the problems and risks of future trading which are not, in our view, accompanied by any attendant entrepreneurial reward…

Under the circumstances, the interest of the mortgagees are best advanced by seeking to sell the Hotel for $125M.

Conclusion

(i)        The Trust has suffered and will continue to suffer very large trading losses;

(ii)       To date the capital appreciation has been sufficient to offset these losses;

(iii)      The Trust has no independent financial resources;

(iv)      It is not prudent to expect a continuing capital appreciation of a magnitude equal to future losses;

(v)       Accordingly, the opinion of Mr H that the project must be sold is correct.

We recommend that the mortgagees should seek to sell the property…”

44.     Following this report, negotiations took place between all parties including the management company when a deed of settlement was finally arrived at. As a result of this, and as a result of the introduction of another Japanese company (unrelated to Kumagai), the hotel (rather than units in the trust or shares in the company) was sold to the Japanese purchaser on 4 March 1988. It was this sale which resulted in the profit of $45,751,334, the characterisation of which is the subject of the present proceedings.

45.     There are two main streams to the applicant’s case that the property was purchased and developed to be held indefinitely as an investment. The first stream consists of statements made by Mr H. The second stream consists of inferences to be drawn from the lengthy negotiations seeking long-term finance.

46.     As to the first stream, there is a statement provided by Mr H to officers of the respondent in general terms asserting (T1518) that “all discussions with the parties concerned during this period revolved around our clearly stated intent to own and operate this hotel”. Mr H also said in the Federal Court proceedings that he had not intended to sell the property until there was an economically forced realisation. This statement and the evidence quoted above, however, are consistent with a purpose held from the outset that a sale would take place after “a five to six year period during which a record would be established”. The statement, in my view, is more relevant to the timing of the sale rather to the applicant’s general purpose.

47.     However, he is also recorded as having told an officer of the respondent (at T1503) words almost to the opposite effect. This interview was sought to be explained by his son who gave evidence before me and who was present at the interview. His son asserted that the words as recorded by the officer must have been taken out of context because he did not recall his father ever saying anything to that effect. The document, however, is a signed, dated and timed note of a record of interview which took place (or concluded) at 1.27pm on Monday, 25 January 1993. Mr H junior gave his evidence some seven years later, having been approached for that purpose for the first time only a week or so beforehand. In my view, the officer’s record should be preferred.

48.     Referring to several files and material found in the files, the officer said to Mr H:

“I indicated following from the above that I had noticed in a letter he had referred to ‘mixed feelings’ on the sale. He said ‘it is a long involved project, and acknowledged mixed feelings. He then said words to the effect of: “We could never have kept the hotel in any event. We always knew we would have to sell it. The costs of finance are too large, and a hotel has such costs that the revenues for the first four or five years are eaten up. It doesn’t make a profit for the first four or five years. We always intended to just develop it.”

49.     This account of the interview also has the advantage of being consistent with what Mr H told various financiers from time to time. It is also consistent with his statements and with the obvious fact that the heavy indebtedness of the project could only be eliminated by a sale. There was hardly any equity provided by Mr H or any of his associates. It was only through an appreciation in value that a profit was achieved. Certainly, there was no relevant capital input to cushion initial trading losses. These could only have been recouped ultimately by sale. Mr H’s other son also gave evidence but again it was largely speculation and in general terms related to his understanding of what his father believed from time to time. Against the objective evidence which I have reviewed, it should be given comparatively little weight.

50.     It was asserted that although the whole undertaking may have had as its object the making of a profit, the two lump sum profits that were derived were not those in the contemplation of the participants. Counsel referred to the judgement of Hill J in Westfield Limited v Commissioner of Taxation 28 FCR 333 at 344 where his Honour said:

“While a profit-making scheme may lack specificity of detail, the mode of achieving that profit must be one contemplated by the taxpayer as at least one of the alternatives by which the profit could be realised. Such was the case in Steinberg but even if that go too far, it is difficult to conceive of a case where a taxpayer would be said to have made a profit from the carrying on, or carrying out, of a profit-making scheme, where, in the case of the scheme involving the acquisition and resale of land, there was, at the time of acquisition, no purpose of resale of land, but only the possibility (present one may observe, in the case of every acquisition of land) that the land may be resold.

51.     In my view, this principle has no application in the present circumstances. The profit realised was the profit contemplated. It was only the timing which was not in accordance with the contemplation. The applicant, in its own right in the early stages, and as the sole unit holder of the trust in the later stages, contemplated “as at least one of the alternatives by which the profit could be realised” the sale of the project. That contemplation is evidenced by the many references to the possibility quoted above. The sale by the applicant to the Trust resulted in the taking of a profit in the early stages. The reason for this has not been made clear. The property could have been sold at cost to the Trust. Instead, the profit-taking has fixed the character of that and the subsequent transaction as the realisation of a contemplated, premeditated, sale. The fact that the Trust eventually sold the property earlier than it would have liked is not to the point. Had the property been compulsorily acquired or had it burned down, the result would have been the same. Profit on sale is one that was contemplated by the applicant as at least one of the alternative objects or purposes for which the scheme was propounded. Whenever that profit was realised, it should be brought to account as income. In my view, it would constitute income both under section 25 and under section 25A(1).

52.     For these reasons, the objection decisions are affirmed.

I certify that the 52 preceding paragraphs are a true copy of the reasons for the decision herein of Mr B.J. McMahon (Deputy President).

Signed:   .....................................................................................
  Dominika Rajewski, Associate

Dates of Hearing  14-17 August 2000
Date of Decision  29 August 2000
Counsel for the Applicant               Mr V Gray
Solicitor for the Applicant               Shaw & Associates
Counsel for the Respondent          Mr Kevin Connor
  & Mr Ian Young

Solicitor for the Respondent         Australian Government Solicitor