Re Areffco and Commissioner of Taxation
[2011] AATA 628
•6 September 2011
Administrative Appeals Tribunal
DECISION AND REASONS FOR DECISION [2011] AATA 628
ADMINISTRATIVE APPEALS TRIBUNAL )
) No 2010/2360-2371
TAXATION APPEALS DIVISION ) Re AREFFCO Applicant
And
Commissioner of Taxation
Respondent
DECISION
Tribunal P W Taylor SC, Senior Member Date6 September 2011
PlaceSydney
Decision The Tribunal sets aside the decisions under review, in so far as they included in the Applicant’s assessable income in any of the income years to which they relate, any part of the fund transfers by MDB in June, July and December 1997. The Tribunal also sets aside the decisions under review in so far as they disallowed deductions for interest liabilities the Applicant incurred to MDB in relation to the loan funds MDB provided in those fund transfers. ..................[sgd]............................
P W Taylor SC
Senior Member
CATCHWORDS
TAXATION AND REVENUE – income tax – whether amounts received by the Applicant should be characterised as a loan or income – whether claimed interest expenses are allowable as deductions – consideration of the sufficiency of documentary evidence and history of the timing and amounts of interest payments – unavailability of witnesses – onus of proof – obligation of the decision maker – decision under review set aside
Administrative Appeals Tribunal Act 1975 ss 33, 45
Taxation Administration Act 1953 s 14ZZK
Bailey v Federal Commissioner of Taxation (1977) 136 CLR 214
Federal Commissioner of Taxation v Dalco (1990) 168 CLR 614
Gauci v Federal Commissioner of Taxation (1975) 135 CLR 81
Gurnett v Macquarie Stevedoring Company Pty Ltd (1955) 55 SR (NSW) 243
Jackson v Lithgow City Council [2008] NSWCA 312
Jones v Dunkel (1959) 101 CLR 298
McCormack v Federal Commissioner of Taxation (1978) 143 CLR 284
Morley v Australian Securities and Investments Commission (2010) ALR 205
Re Sharkey and Commissioner of Taxation (2007) 95 ALD 509
Trautwein v Federal Commissioner of Taxation (No 1) (1936) 56 CLR 63
REASONS FOR DECISION
6 September 2011 Mr P W Taylor SC, Senior Member Contents
The critical issue
The Commissioner’s assessment decision
Direction for separate determination
The basic reasons for the Commissioner’s assessment decisions
Areffco’s origin and partial failure to lodge timely tax returns
Areffco’s impugned borrowings and payments
Areffco’s asserted liability to MDB
Loan documentation produced by Areffco
Deficiencies in loan documentation and conduct
Areffco’s returned income and expenses
The domestic application of the MDB funds
The evidence about loan documentation expectations
Conclusion on the expert opinions on the loan documentation and terms
The loan documentation issues
The interest payment issues
The relevant MDB personnel
IZ’s evidence
The limited assistance MDB provided to Areffco
The “overseas assets” hypothesis and evidence
Emb’s evidence about overseas assets
Mrs Erb’s evidence about overseas assets
Ayb’s evidence about overseas assets
The Commissioner’s criticism of Ayb’s credibility
Areffco’s assertedly inadequate pursuit of loan documents
The flaw in the “security” hypothesis
Burden of proof issues
The deductibility of the interest payments
Decision
Schedule
The critical issue
1. Areffco’s financial statements for the financial years from June 1997 to June 2008 record a loan liability to an Israeli bank (“MDB”), and substantial related interest expenses. The liability amount characteristically approximates the total value of Areffco’s assets. The interest expenses approximate Areffco’s own total income. The reality of the recorded liability, and the character of the asserted interest expenses, are the principal matters for decision in these proceedings.
The Commissioner’s assessment decision
2. The Commissioner decided the asserted loan liability related to funds Areffco received as assessable income in the financial years ended June 1997 and June 1998, and that none of Areffco’s asserted interest payments was a deductible expense. The Commissioner issued assessments, or amended assessments, reflecting those decisions. The Commissioner decided that Areffco was liable to pay not only the assessed primary tax but also penalties. The details of the assessment amounts and their particular components are set out in the Schedule to these Reasons for Decision.
3. Areffco objected to the Commissioner’s assessment decisions in September 2009. Those objections were disallowed in the 27 May 2010 objection decisions under review in these proceedings.
Direction for separate determination
4. The parties agreed to postpone a review hearing on the penalties aspects of the assessments until after the determination of the primary tax issues. I made a formal direction for those aspects of the proceedings to be determined separately, and after, the review of the primary tax assessments.
The basic reasons for the Commissioner’s assessment decisions
5. The Commissioner’s decision implicitly accepts the fact, although not the character, of Areffco’s 1997 receipt of the contentious funds from MDB ($3m in June 1997, $1m in July 1997, $0.75m in December 1997). The Commissioner cannot realistically dispute the fact of either the 1997 fund transfers, or the $6.8m Areffco subsequently paid to MDB between September 1998 and December 2009. All of these payments are corroborated either by Austrac fund transmission records or by apparently probative bank statements.
6. The Commissioner’s contention that Areffco had not actually borrowed any funds from MDB implies that the three 1997 fund transfers involved money Areffco was not obliged to repay. The Commissioner’s hypothesis, prompted by perceived irregularities in the dealings between MDB and Areffco, is that even though MDB was the immediate source of the 1997 transfers, it was able to resort to other offshore funds that belonged either to Areffco or (and more likely) to some other related entity associated with Erb. (I explain the significance of Erb in paragraphs 10 to 23 below). A logical, and necessary, consequence of the Commissioner’s characterisation of the contentious loan receipts as income is that none of Areffco’s asserted interest payments to MDB could be deductible expenses.
7. The Commissioner’s 27 May 2010 objection decision characterised Areffco’s asserted loan liabilities as part of a sham transaction. Areffco sought particulars of that finding. It also sought particulars of the Commissioner’s further findings (i) that Areffco’s tax shortfall (in the light of the revised assessments) had resulted from intentional disregard of a taxation law, and (ii) that there had been fraud or evasion in respect of the 1997-1998 income year.
8. The Commissioner’s ultimate response to these requests was contained in an email letter dated 17 September 2010. It contained propositions that the Commissioner:
(a)did not contend Areffco had been involved in a sham transaction;
(b)did contend that Areffco had intentionally disregarded a tax law by “assertion of the existence of a loan which the Applicant knew not to exist”; and
(c)did contend that Areffco had engaged in fraud or evasion in the June 1998 taxation year because “there was no loan and there were no payments of interest giving rise to the deduction claimed”.
9. There is some dissonance between the Commissioner’s explicit disavowal of any sham contention and the positive assertion that Areffco had not actually borrowed any funds from MDB. The dissonance is made more apparent by the evidence of actual fund movements between Areffco and MDB and the existence of apparently corroborative MDB records. There is the further consideration of the objective unlikelihood (having regard to the matters described in paragraphs 12, 13, 34 and 35 below) that the 1997 receipts could in fact be money Areffco received as a result of its own business or trading activity. (This is a matter to which I return in paragraphs 140, 202 and 203 below.)
Areffco’s origin and partial failure to lodge timely tax returns
10. Areffco is only one of many companies associated with Erb. Erb and his slightly younger brother Emb, were postwar European migrants who settled in Australia in the early 1950s. Over the next 40 years they established together a successful manufacturing business and engaged in numerous residential and commercial property developments. In the course of so doing they established various corporations and trusts, as vehicles for their enterprises. The two brothers worked closely together, and their investment structures and activities were established, and operated, in close parallel.
11. The evidence Areffco tendered in the present proceedings included a detailed narration, with much supporting documentary evidence, of the approximately four decades of the two brothers’ substantially successful dealings. A broad but credible assessment of that evidence is that Erb and his related entities had the following asset values (after taking into account the liability for the contentious MDB loans):
(a)as at 30 June 1997: total assets of about $41m and net assets of about $26m;
(b)as at December 2002: total assets of about $37m and net assets of about $12m. (The difference from 1997 appears to relate principally to (i) the sale of an interest in the shopping centre referred to in paragraph 158 below) and (ii) a substantial increase in borrowings from an Israeli bank.)
(c)as at 30 December 2004: total assets of about $53m and net assets of about $21m. (The difference from 2002 appears to relate principally to (i) the development and consequential revaluation of the Botany property and (ii) the sale of a substantial interest in the fruit juice business. These assets are referred to in paragraphs 19 and 160 below.)
12. The most presently relevant of the corporate entities associated with Erb are Erbnom Pty Ltd (incorporated in 1971) and Ell158 Pty Ltd. Erb incorporated Ell158 in February 1988. Then and subsequently, Erb and his wife held the majority of Ell158’s issued shares. Their children (including the then 22 year old Ayb, whose involvement I describe in paragraphs 19 to 23 below) were its only minority shareholders. Almost 10 years later, on 21 April 1997 Erb caused Areffco to be incorporated. (On the same day Emb incorporated a similarly named company, Adfinco. I refer to that matter in paragraph 145 below.) Ell158 held, and has always held, Areffco’s only issued capital – two $1 shares. Until March 1998 Erb and his wife were its only directors.
13. Areffco lodged its first tax return in May 1998. It subsequently lodged timely annual tax returns for each of the financial years from June 1998 to June 2000. They indicated that Areffco’s only material income was interest receipts, preponderantly from entities associated with Erb. Similarly its only, or its overwhelmingly preponderant, expenses were interest payments to MDB.
14. Areffco’s June 1997 to June 2000 tax returns were all prepared by a tax agent accountant, Mr ESZ. ESZ had a long association with Erb and his various entities. According to Ayb, he effectively retired sometime around 2001. His retirement was associated, at least temporally and probably causally, with the fact that neither Areffco, nor any of the other entities associated with Erb, lodged tax returns for many years after April 2001.
15. In the latter part of 2001 Erb’s family noted some deterioration in his short term memory. This was confirmed by neurological assessment at that time, but was then characterised as being of no great consequence.
16. In 2002 and 2003 Erb was hospitalised on several occasions with heart problems. In November 2003 he underwent heart bypass surgery. In January 2004 Erb was reportedly still then able to drive a car safely. On further neurological assessment at that time his mini mental state examination score was 25 out of a possible 30 – unchanged from the assessment 12 months earlier.
17. Some time around 19 March 2004 the ATO sent final notices to Erb related entities requiring the submission of tax returns for the 2001, 2002, and 2003 financial years. Ayb was certainly aware of these notices by Monday 5 April 2004. That day, after returning with Erb from Israel following the meeting with MDB to which I refer in paragraph 120 below, Ayb wrote to the Deputy Commissioner of Taxation. He reported his father’s ill health and that Erb had requested him to undertake the work of bringing matters up to date. I infer that Mrs Erb was also aware of this development (that is, the apparent neglect that necessitated Ayb’s intervention), because she said she took the “unusual step” of arranging to see Erb’s neurologist without him. The neurologist’s report of 20 April 2004 attributes to her concern about Erb’s continuing memory problems, uncharacteristic fatigue and lack of activity. The neurologist noted that, since at least July 2003, Erb had suffered from severe obstructive sleep apnoea. He opined that this might be contributing to his reported lethargy, and contemplated further investigations “to make sure no more generalised illness has been missed”. But he also said that Erb had dementia, for which there was no further treatment that could be recommended. In August 2004 a psyco geriatric specialist diagnosed Erb as suffering from Alzheimer’s disease.
18. Erb’s contemporaneously recorded deteriorating short term memory and lethargy did not prevent him travelling to Israel, with Ayb, in March 2004 and participating in the meeting with MDB to which I refer in paragraph 120 below. But it does correspond with the objective fact that by April 2004 none of the tardy tax returns, for any of the companies with which he was associated, had been lodged.
19. For many years before 2004 Erb had maintained a personal business office in factory premises at Botany. Ayb operated a fruit juice company from these premises. He and Erb were both directors of the company. Erb’s role was limited to that of a, somewhat stern, fatherly mentor and a facilitator of finance for the business. But they saw each other daily at the premises and Ayb had many occasions to go to Erb’s office and form an impression of the extent of the records that Erb kept there. According to Ayb’s observation, by about 1994 or 1995, Erb’s factory office had become the place where he kept most of his business records.
20. In late May 2004 the factory premises, including Erb’s office, were badly fire damaged. Not long after the fire, Ayb discovered stacks of unopened correspondence at Erb’s home office. This unopened correspondence included letters from the ATO. Some of this correspondence went back as far as June 2002.
21. Until the events of April to August 2004 Erb was the controlling mind, and the only active officer of Erbnom, Ell158 and Areffco. His wife had been a director of those companies since their incorporation, but she did not take any active part in their affairs. Erb’s son Ayb had been appointed a director of Ell158 in May 1988 (at the age of 22) and as a director of Areffco in March 1998 (at the age of 32), but neither at the time of these appointments, nor for many years afterwards, was he an active officer of either company.
22. The events of April to August 2004 resulted in Ayb assuming the principal responsibility for carrying out the work necessary to bring up to date the accounting affairs of the many entities with which Erb was involved. The work involved reconstructing accounting records, and lodging overdue tax returns for the years after 30 June 2000. Ayb carried out this task with the assistance of accounting personnel he engaged for the purpose. The task was complicated by Ayb’s lack of previous close involvement with Areffco’s affairs, and the absence of relevant records. That absence was at least potentially, though to an uncertain actual extent, attributable to the destruction of Erb’s records in the May 2004 fire.
23. Ayb says he did this reconstruction work in consultation with Erb, and subject to his ultimate direction. There is some apparent incongruity, if not overstatement, in that claim, given Erb’s reportedly deteriorating cognitive abilities, and compromised functioning (evidenced at least by the unopened correspondence and comprehensive failure to lodge tax returns). Nevertheless, Ayb said that despite his ill health, Erb’s long term memory was good (at least throughout 2004 to 2006) and that he was able to give meaningful information relating to the affairs of Areffco and other companies. Ayb says he thought that right up until the time of his death in August 2009 (at the age of 85), Erb retained the propensity to direct him, and the ability to inform him when required. I think the more likely reality is that Erb’s involvement was limited, and became progressively more limited from 2007 onwards. Ayb probably retained a respectful deference towards his father. I would regard such an attitude as understandable in the difficult circumstances of Erb’s apparently forceful personality and his cognitive deterioration, with the obvious problems that appears to have caused with the apparent neglect of significant aspects of his business affairs. (I refer to this matter again in paragraph 179.)
24. Areffco lodged its June 2001, 2002, 2003, 2004 and 2005 tax returns in March and April 2007. It lodged its 2006 tax return in May 2007, and its 2007 and 2008 returns in early 2009. In the course of these proceedings it provided reconstructed balance sheets for those financial years.
Areffco’s impugned borrowings and payments
25. The following Table sets out the dates, amounts and asserted character, of all the material receipts and payments between Areffco and MDB. (The “calculation” column in the Table is referred to in paragraph 110 below.)
Areffco’s impugned borrowings and payments Date to Areffco by Areffco Calculation Loan Advance Term Rate Repayment Interest Rate [[cf balance]] [expiry date] [base %] 5-Jun-97 3,000,000 5-Jun-02 8.298% 4-Jul-97 1,000,000 4-Jul-02 8.298% 4-Dec-97 750,000 4-Dec-02 8.298% 4-Dec-97 [[4,750,000]] 11-Feb-98 187,785 not calculated 1-Jun-98 195,003 8.211% 18-Sep-98 3,200,000 18-Sep-98 [[1,550,000]] 21-Sep-98 65,564 not calculated 29-Dec-98 62,235 not calculated 25-Jun-99 64,310 8.298% 30-Dec-99 64,310 8.298% 28-Jun-00 64,310 8.298% 19-Feb-01 64,310 8.298% no further interest paid until January 2005 23-Dec-02 23-Dec-04 8.298% 31-Dec-04 [[1,550,000]] 8.298% no further interest paid until January 2005 5-Jan-05 [[1,550,000]] 31-Dec-06 63,429 8.184% 4-Apr-05 133,516 8.614% 10-Jan-06 553,121 10.196% no further interest paid until July 2009 20-Jul-09 266,194 8.587% 20-Jul-09 800,000 6-Oct-09 268,563 not calculated 8-Oct-09 375,000 11-Dec-09 375,000 5115 Sub totals 4,750,000 4,750,000 2,057,765 Totals 4,750,000 6,807,765 Areffco’s asserted liability to MDB
26. The significant aspects of the information summarised in the preceding Table, understood against the background of Areffco’s claims and the evidence it adduced to support them, are as follows:
(a)Areffco contends it borrowed AUD$4.75m from the MDB, in three drawdowns or transactions:
(i)5 June 1997: AUD$3,000,000, 5 year term, interest rate 8.298%;
(ii)4 July 1997: AUD$1,000,000, 5 year term, interest rate 8.298%;
(iii)4 December 1997: AUD$750,000, 5 year term, interest rate 8.298%.
(b)Areffco contends it repaid the June 1997 loan in full on 18 September 1998.
(c)Areffco contends the loan period was thereafter extended in December 2002, the suspension of interest payments agreed before March 2004, and that the loan period was extended again in January 2005.
(d)Areffco contends it fully repaid the July 1997 and December 1997 loans in the following manner
(i)18 September 1998: $200,000 of the July 1997 loan;
(ii)20 July 2009: the balance of the July 1997 loan;
(iii)8 October 2009 and 11 December 2009: the December 1997 loan.
(e)Areffco says it has ultimately paid the full amount of the interest on the outstanding balance of the loans. This is despite substantial periods of apparent default, and the consequential higher interest “penalty” obligation the default triggered, (The two substantial periods during which Areffco did not make timely interest payments were (i) February 2001 to January 2005, and (ii) January 2006 to July 2009 - as indicated in the preceding Table.) The Commissioner accepts the fact of the various payments but (i) disputes that they reflect full payment of the asserted interest obligations, and (ii) emphasises the irregularity of the payments as probative of the absence of any real loan and interest payment obligations. (I return to these matters in paragraph 30 below.)
Loan documentation produced by Areffco
27. Areffco has comparatively few documents recording the terms and circumstances of the asserted loans. It relies on the substantial May 2004 fire as a possible explanation for that deficiency. That possibility is real, but the actual extent and location of Areffco’s material records at the time of the fire was not the subject of specific evidence - other than what I have described in paragraphs 19 to 23 above.
28. Those associated with Areffco have made many attempts to obtain material loan records from MDB for the purpose of these proceedings, and other similar proceedings involving entities relating to Erb and Emb. (I describe Ayb’s evidence about these enquiries from about paragraph 164 below.) Relevant to the present proceedings, officers of the bank provided Areffco with the documents listed below:
(a)Areffco’s 4 July 1997 letter to Mr ES, a Senior Manager of MDB in Tel Aviv. The letter, signed by Erb, nominates a loan account number, requests a further draw down of AUD$1m “under the loan” and acknowledges the consequential loan balance of AUD$4m. It also refers to the 5 year loan term, the 8.298% interest rate for the required biannual interest payments, and the additional 1% interest if those payments are tardy by more than 45 days.
(b)Areffco’s 4 December 1997 letter to Mr ES. The letter, written by Erb, requests a further AUD$0.75m advance “under the existing loan arrangements”. The letter is in very similar wording to the 4 July 1997 letter.
(c)Areffco’s 9 December 1997 letter, again written by Erb to Mr ES. The letter acknowledges the three requested “drawdown” amounts and their separate account numbers. It requests “favourable consideration” of the 4 December 1997 drawdown request.
(d)Areffco’s 18 September 1998 letter, again written by Erb to Mr ES. The letter refers to a discussion “yesterday” and records an intention to immediately transfer AUD$3.2m (in partial repayment of the loan account) and AUD$65,564.44 (interest from 1 July 1998 to 18 September 1998).
(e)MDB’s “Deposit / Withdrawal in Foreign Currency” standard forms, with handwritten notes in Hebrew attributed to the bank’s Tel Aviv head office branch. The completed forms are dated 3 July 1997, 11 December 1997 and 23 September 1998. Each form appears to have been noted with brief, but appropriate, details and codes relating to the bank’s internal recording procedures. The 23 September 1998 notes allocate the AUD$3.2m repayment to the discharge of the June 1997 drawdown and the reduction of the outstanding July 1997 drawdown by $200,000.
(f)Two completed MDB forms entitled “Loan Application in Foreign Currency for a Foreign Resident”. The forms have been partly completed by the inclusion of typewritten particulars. They include Areffco’s details, the date “23.12.02”, the loan amounts (AUD$750,000 and AUD$800,000), the interest rate (8.298%), loan term (to 31.12.04). The typewritten insertions include the overstriking of the word “APPLICATION” in the form heading, the substitution of the word “EXTENSION”, and a request at the top of the form to “Please sign where marked X (5)”. There are five handwritten “X” marks in the margin of the form, corresponding to the position of typewritten insertions. Four of those have been initialled by Erb. The fifth mark appears in the margin alongside where Erb has signed the document and written his name.
(g)Two MDB Amortisation Schedules, apparently dated 30 December 2003, referring to loan principal amounts of $750,000 and $800,000. These have been generated by a computer reporting system at the bank’s main branch in Tel Aviv. They appear to show the accumulation of unpaid interest and to record a “complation [sic] date” of 31/12/04.
(h)Six MDB payment forms, apparently generated by a computer reporting system at the bank’s main branch in Tel Aviv on 11 December 2009, recording the calculation of interest due, and its debiting to, the loan accounts for loan balances of $750,000 and $800,000. The stated interest periods are those ended December 2003, June 2004 and December 2004. A note on each form states that arrears interest is not included in the amount until the actual date of payment.
(i)An MDB Amortisation Schedule, dated 3 January 2005 and apparently generated by a computer reporting system at the bank’s main branch in Tel Aviv. The schedule refers to a loan principal of $750,000 and identifies the interest payments due in June and December in 2005 and 2006. The schedule appears to show the accumulation of interest for a two year period, and to record a “termination date” of 31/12/006.
(j)About 44 MDB statement form letters dated 24 January 2008 (although apparently printed on 27 January 2008) and relating to principal and interest amounts for:
(i)Loan account No …0013 (AUD$3,000,000) – 3 statements covering the period from 4 June 1997 to 23 September 1998;
(ii)Loan account No …0021 (AUD$1,000,000) – 4 statements covering the period from 3 July 1997 to 23 September 1998;
(iii)Loan account No …0021 (AUD$800,000) – 16 statements covering the period from 24 September 1998 to 30 December 2006;
(iv)Loan account No …0048 (AUD$750,000) – 19 statements covering the period from 10 December 1997 to 31 December 2006;
(v)Loan account No …0086 (AUD$1,550,000) – 2 statements covering the period from 31 December 2006 to 31 December 2007.
29. Areffco has a small number of additional documents relating to the asserted loans. These are mainly its own copies of instruction letters it wrote to its Australian bankers requesting the transfer of interest payments to the Israeli bank. There are letters dated 11 February 1998, 1 June 1998, 14 February 2001, 4 January 2005, 31 March 2005 and 4 January 2006 that are either addressed to, or refer to, Mr ES (the MDB manager referred to in paragraph 118 below). There are also letters dated 17 July 2009 and 8 October 2009 that refer to the assistant to Mr IZ, (the MDB Foreign Exchange Department manager referred to in paragraph 126 below). The documents Areffco has been able to produce also include:
(a)copies of the 4 December 1997 and 18 September 1998 letters referred to in paragraphs 28(b) and (d) above;
(b)copies of Austrac reports corroborating each of the original fund transfers by MDB, as listed in the Table in paragraph 25 above;
(c)copies of Austrac records, or bank statement records, evidencing all of the payments Areffco claims to have made to MDB;
(d)various handwritten ledgers and journals apparently recording the use of funds by Areffco between 1997 and 1999, in connection with various payments made to, or on behalf of, entities associated with Erb.
Deficiencies in loan documentation and conduct
30. The Commissioner points to a number of unusual circumstances, and apparent irregularities, to highlight the asserted justification for the assessment decision, and oppose Areffco’s review application. These matters include:
(a)the apparent commercial unreality of the asserted loans and, in particular:
(i)the absence of reasonably expected loan documentation, security and personal guarantees, and
(ii)(assertedly) unusual loan interest rates.
(b)MDB’s apparent failure:
(i)to calculate interest, and to require payment, strictly in accordance with the asserted loan terms, and
(ii)to take any action to enforce the asserted loan terms, despite the substantial periods of Areffco’s default between 2001 and 2005, and 2006 and 2009.
(c)the absence of significant evidence of the subsidiary loan transactions to which Areffco says it applied the impugned MDB loans, and from which it says it derived its income.
31. Areffco and the Commissioner have both provided expert witness evidence dealing with the degree of apparent completeness, sufficiency and regularity of the available documentation and records, especially those that MDB provided to Areffco (and which I described in paragraph 28 above).
32. There is a conflict in the evidence about those matters. But there is some evidence to indicate that ordinary Israeli banking practice would be consistent with the existence of the following documents in relation to the loan transactions for which Areffco contends:
(a)documentation demonstrating the verification of Areffco’s identification details and its capacity and authority to operate a bank account;
(b)a description of Areffco’s business, including financial accounts and business history and MDB’s independent background check on Areffco, perhaps including records of previous credit requests, loan approvals, interest terms and repayment dates;
(c)a formal Loan Agreement;
(d)a list or file containing material such as details of any guarantee and collateral security for a principal loan, perhaps including evidence of charged assets and assessments of their realisable value.
33. There is no evidence of any formal Loan Agreement between Areffco and MDB – other than the two signed December 2002 “Extension” documents referred to in paragraph 28(f) above. There is no evidence of any charge Areffco provided as security. There is no evidence that Erb, or any entity associated with him, provided any guarantee of Areffco’s asserted borrowings from MDB.
Areffco’s returned income and expenses
34. Areffco’s assets, income and expenses are of the same basic nature in all of its financial statements throughout the period from June 1997 to June 2008. They are summarised in the Schedule to these Reasons for Decision.
35. The significant conclusions indicated by the details set out in the Schedule are as follows:
(a)Areffco’s principal assets were loans to Erb related entities;
(b)Interest payments (typically unpaid accrued interest) by these entities were its only material income;
(c)by June 2000 Areffco’s principal asset was a $1.406m loan to Ell158. Its only other material assets were two loans (totalling about $107,000) to other Erb related companies;
(d)Areffco’s principal, indeed its only significant, liabilities (and expenses) were for principal, interest and withholding tax relating to the asserted loans by MDB; and
(e)Areffco never had any significant net assets.
The domestic application of the MDB funds
36. As at 30 June 1998 the three principal debtors, according to Areffco’s contemporaneous tax return were Erbnom (($1.96m), Ell158 ($1.55m) and Ell268 ($0.7m). For the year ended the 30 June 2000, Areffco’s only really significant debtor was Ell158 ($1.4m). It remained the only significant debtor, with a varying loan balance that arguably reflected substantial periods of interest non-payment, in each of the following years, including the year ended 30 June 2008.
37. The Commissioner’s submissions contend that this evidence from Areffco’s financial statements should be dismissed as weightless. The Commissioner correctly contends that the financial statements for all of the years after 30 June 2000 were prepared retrospectively, after the May 2004 fire (which I referred to in paragraph 20 above) and at a time when Areffco, and particularly Ayb, was aware of the Commissioner’s concern about the apparently irregularity of the contentious loan transactions.
38. The Commissioner’s criticism of the retrospective preparation of Areffco’s tax returns and financial statements does not apply to any of the four years from 1997 to 30 June 2000. Each of those tax returns, and the balance sheet accompanying them, appears to have been prepared by ESZ. The tax returns, and balance sheet for the subsequent years, despite having been prepared retrospectively, are merely consistent with the assets, liabilities and income disclosed in the tax returns prepared by ESZ.
39. The existence of the liabilities and assets recorded in Areffco’s 1997 to 2000 tax returns and balance sheet is consistent with the ledgers and journals referred to in paragraph 29(d) above. Those assets and liabilities are also consistent with information Ayb says Erb gave him in response to his enquiries once he set about bringing Areffco’s accounting records up to date after April 2004. Erb told him that a substantial part of the original MDB loans in 1997 were on lent to Ell158, and funded its purchase of an interest in the investment trust that owns the Auburn property.
40. The Commissioner was critical of Areffco’s failure to call Mr ESZ as a witness in the proceedings. I do not regard this criticism as a substantial matter. It is not reasonable to expect that Mr ESZ could have given any significant evidence about the events after 30 June 2000 – that being the date of the last Areffco tax returns and balance sheets with which he was concerned. Conversely, there is no sound basis to expect that he would have been able to contribute, some 10 to 14 years after the relevant events, a reliable account of the details of the contentious loan transactions, other than those that are apparent from the tax returns, balance sheets and handwritten accounting documents that Areffco did produce.
41. I accept that ESZ might have been able to elaborate on at least some of the cryptic narratives that appear in his handwritten ledgers and journals. Explanations of that kind might have contributed to a more complete understanding of the on lending arrangements between Areffco and the other Erb related entities. But Ayb included in his affidavit evidence a transcription of many of these entries, and some additional explanations he said had been provided by Erb. Ayb compiled an apparently comprehensive table setting out the way the 1997 funds had been applied, as recorded in the handwritten ledgers and journals. It is unlikely that ESZ could have contributed any materially greater understanding to the circumstances of the 1997 MDB fund transfers that would in any way have detracted from the inferences and conclusions I would otherwise draw from the evidence. I am definitely of the view that there is no proper evidentiary foundation for concluding that Areffco’s failure to provide evidence from Mr ESZ is relevantly attributable to apprehension that his evidence would not assist in the resolution of these proceedings. Conversely, I am satisfied that the direct evidence from Mr ESZ would not have detracted from Areffco’s position and would not have been likely to assist materially in the resolution of the real issues in the present proceedings.
The evidence about loan documentation expectations
42. Dr Ehud Shapira has impressive tertiary qualifications from institutions in New York and Israel. He had over 40 years banking experience, both in Israel and in the USA. He held senior executive positions in an Israeli bank for about 17 years up until 2006. He became a member of that bank’s board in 2010.
43. Dr Shapira was provided with the substance of the loan related documents described in paragraph 28 above. He was apprised of Areffco’s contentions about the loan terms (that is, those summarised in paragraphs 25 and 26 above. He was also apprised of the substance of the Commissioner’s contentions about the nature of the apparent deficiencies in the available documentation.
44. Dr Shapira thought it likely that the lender bank would have had a range of documents relating to the negotiation of the loan, financial information provided by the borrower, loan documents and details of the loan security. Documentation within those categories was legally required to be kept for seven years after the final repayment of the loan. Because of that requirement, Dr Shapira was very surprised at the paucity of the documents that Areffco had obtained from MDB.
45. Dr Shapira reported that it was standard Israeli banking practice to have a formal signed loan agreement before any loan funds were advanced. That kind of agreement could be either specific to a particular loan transaction, or it could take the form of an acknowledgment of a bank’s standard terms for a class of transaction, such as foreign currency borrowings. The use of standard term documents was common and a document such as the “Application” or “Extension” document referred to in paragraph 28(f) above would be consistent with such a practice. Dr Shapira thought it likely there would be some additional document specifically linking the particular loan to any security the borrower provided. But this likelihood must depend on the content of the particular standard form document. And if Dr Shapira was suggesting that the “Application” or “Extension” wording would necessarily have to have been supplemented by some additional agreement, that suggestion does not appear to be warranted. The “Application” / “Extension” form standard wording included a fulsome licence permitting the lending bank to resort to any other asset that it held, or over which it had been granted a security interest.
46. Dr Shapira said that Israeli banks seldom granted foreign fixed interest loans for a period of 5 years. It was much more common for foreign loans to be subject to floating rates, adjusted bi-annually. In either case the rate would typically be determined by reference to the London Interbank Offered Rate (“LIBOR”) plus a margin influenced by the lending bank’s assessment of the credit risk. The margin range could vary between 0.5 and 3 percentage points above the LIBOR rate, depending the nature of any collateral security the bank held for the loan advance.
47. Dr Shapira noted that the Israeli banking practice preference for the use of a floating interest rate on foreign loans was actually reflected in the standard wording of the Application / Extension document referred to in paragraph 28(f). However, and apparently inconsistent with that standard wording, the nominated interest rate of 8.298% had applied throughout the duration of the loans asserted by Areffco.
48. Dr Shapira considered that the 8.298% rate asserted by Areffco was about 1 percentage point lower than what he would have expected in June 1997. (This expectation was based on a LIBOR rate range between 6.2 and 7.1% and his assessment that the Areffco loan was essentially unsecured.) Conversely, the rate was substantially higher than what Dr Shapira regarded as the prevailing commercial rates in 2002 and 2004 (when the loan periods were assertedly extended or simply carried over). But he conceded the possibility that if a bank had encountered, or anticipated, periods of non-payment of interest, that could explain the use of a higher rate in connection with any renewal or carry over of the loan term.
49. Dr Shapira thought the Areffco loans were unusual in other respects. He thought it was very rare to have a 5 year loan without any requirement for principal repayment during the term. In addition there was a contemplation (expressed in the 4 July and 4 December 1997 letters referred to in paragraphs 28(a) and 28(b) above) that Areffco could repay the loans early, without incurring any early repayment costs, even though they were apparently contemplated by MDB’s standard terms. The fact that the three advances in June, July and December 1997 all bore the same rate was, he thought, unusual if they were actually separate loans. Conversely, if they were merely related drawdowns against a single loan facility limit, it would be usual for a bank to impose a facility of commitment fee. There was no record that Areffco had paid such a fee.
50. Areffco’s asserted loans were extremely exceptional and, in Dr Shapira’s view, not consistent with prudent banking practice. Perhaps the most unusual features of the asserted loans, in his opinion, were the absence of either any apparent security or any recovery action by MDB during the periods of interest non-payment. The absence of any evident security for a loan to a private company such as Areffco was remarkable – because it was an entity that “on lent” the borrowed funds to related entities. Moreover there was no explicit restriction, in the identified loan documents, on the use to which Areffco could apply the loan funds. Even if there had been a record of the loans being supported by a personal guarantee, they would still have been very unusual loans, unless the guarantee was itself supported by security. Ordinary Israeli banking practice required all loans to foreign entities to be supported by tangible collateral security. Although Dr Shapira accepted the potential relevance of what he called a “solidarity” guarantee (that is, an unsecured personal guarantee by the individual officers or shareholders of a corporate borrower) he dismissed its permissible characterisation as “security” and as sufficient to comply with ordinary prudent Israeli banking practice.
51. Dr Shapira thought the absence of any evidence of recovery action by the bank, during the periods when Areffco paid no interest (2001 to 2005 and 2006 to 2009) was also remarkable. He explained that where loans went into a significant period of default, they had to be reclassified within the lending bank’s accounts, and might require to be written down, as a prudent provision against the ultimate risk of non-payment by the borrower. Because of those requirements, and ordinary commercial self interest, Dr Shapira thought it highly likely not only that MDB would have been concerned to take some action in relation to non-payment, but also that there would be some record and evidence to that effect. He conceded the possibility that the periods of non-payment might have been the result of agreement between the bank and the borrower – for example for the capitalisation of interest. In that event, the non-payment would not, strictly speaking, be characterised as a default and may not require either reclassification of the loan or any provision for the risk of non-payment. But the possibility of such an agreement simply added to Dr Shapira’s disappointed expectation of the likely existence of some related documentary record.
52. Mr Ben Zeev was another very experienced former senior Israeli bank executive, upon whose evidence the Commissioner relied. Mr Ben Zeev opined that it was ordinary banking practice to have a written loan agreement. He appeared to dismiss the possibility that a signed version of the “Application” / “Extension” standard form document (referred to in paragraph 28(f)) would suffice to comply with ordinary practice. But this view is not consistent with Dr Shapira’s evidence. Nor is it consistent with my own reading of those documents. They are patently standard form documents and explicitly refer, in some places, to the signed document being an “agreement” with the bank.
53. Mr Ben Zeev noted that the asserted loans were denominated in Australian Dollars (“AUD”). He conceded that an Israeli bank might have granted such a loan from its own AUD holdings. But he thought it far more likely an Israeli bank granting such a loan would have done so by entering into a currency exchange or “swap” transaction. Such a transaction permits the bank to purchase an exchange rate position and hedge its foreign currency risk. In turn, the cost of the “swap” and the bank’s assessment of its risk would be likely to be reflected in its assessment of the applicable loan interest rate.
54. Mr Ben Zeev thought that both an unsecured fixed interest loan for a 5 year term, and the permissibility of early repayment without charge, were very unusual. But he did note there was an international money market index that did provide indicative swap rates for commercial loans with 5 year terms. Using that index Mr Ben Zeev (like Dr Shapira) thought the 8.298% interest rate asserted by Areffco was a commercially low assessment of the likely loan interest rate in June, July and December 1997. He thought the commercially anticipated rate for the June 1997 loan would have been up to 3 percentage points higher than the 8.298% rate asserted by Areffco. The commercially anticipated rate for the December 1997 loan would have been at least 1 percentage point higher.
55. A potential complication in evaluating these opinions about the commerciality of the interest rate asserted by Areffco is that Dr Shapira and Mr Ben Zeev both declined to say that there was any standard Israeli banking practice in relation to any withholding tax obligations in the borrower’s country. Dr Shapira said that a lender would either require a borrower to pay withholding tax or to provide a tax receipt. I would infer from his expression of these alternatives that there was no standard practice that would uniformly have required a foreign borrower to pay withholding tax in addition to the specified loan interest rate.
56. Nevertheless Mr Ben Zeev’s view that the asserted loan interest rate was too low contributed to his further opinion that the lender would have been required to provide security for the loans - either by way of offsetting deposit, a letter of credit facility or a charge over realisable assets. A mere personal guarantee would be unlikely to be acceptable as “security” unless its practical enforceability was evidenced in the same way.
57. Furthermore, Mr Ben Zeev held the same view as Dr Shapira, that it would not accord with an Israeli bank’s regular course of business to make unsecured loans to an Australian entity, even if the loan was supported by a personal guarantee. It would have been far more usual for the loan to be supported by realisable assets. If the proffered security included Australian assets, it would be usual for the bank to require local appraisals, and local legal assistance in ensuring the potential enforceability of any security transaction.
58. Mr Ben Zeev acknowledged that an Israeli bank might depart from standard practice, at least to the extent of relaxing its ordinary loan security requirements, and the acceptable term of a fixed interest loan. But he considered that unless Areffco had at least US$1m on deposit, it was not likely a bank would depart from its standard lending practices and procedures.
59. Mr Ben Zeev certainly did not regard it as usual for an Israeli bank to acquiesce in substantial interruptions to the timely payment of interest in accordance with the loan terms. Mr Ben Zeev specifically addressed the apparent significance of the periods (apparent from the Table in paragraph 25 above) where Areffco made no interest payments to MDB. Unsurprisingly, he regarded the bank’s apparent inactivity during these periods as inconsistent with expected banking practice. Standard practice would have led the bank to demand payment, including any additional interest for tardy payment, and pursue non-payment by taking action to enforce any available security and collateral obligations.
60. Mr Amos Hacmun supported Dr Shapira and Mr Ben Zeev’s views about the potential availability, at least from MDB, of substantiating loan documents, and particularly credit assessment and security documents of the kind referred to in paragraph 32 above. Mr Hacmun is an Israeli lawyer who practices in the area of banking, corporate and commercial law. Between 2002 and 2004 he was a member of the board of the Israel Continental Bank. Mr Hacmun explained that, under Israeli law, MDB ought to have created various formal agreements for any loan, any guarantee or security for the loan and the current account which would operate in conjunction with the loan. In addition, the bank was required to have obtained from the borrower thorough financial information, including details of its governance and the business sector in which it operated. Where the loan was supported by collateral security, the information would include appropriate valuation details. In addition the bank ought to have obtained from the borrower appropriate confirmation of the authorisation for the loan and the sufficiency of the execution of any loan documents. He also pointed out that the bank ought to have obtained current financial statements from Areffco during the period of the loan, and certainly before any extension or renewal of the loan. There was a small number of exceptions to this latter requirement and, apparently most relevantly, where the bank held a security deposit over which it had a right of priority set off against the outstanding loan obligations.
61. Mr Hacmun further explained that the bank was required to keep any formal agreements and authorisations during the currency of the loan and, in practice, would be likely to retain them for at least seven years after the loan was repaid. The same retention obligation existed in relation to at least some of the financial information the bank was likely to have obtained before granting the loan approval.
62. Mr Hacmun said that a borrower had an enforceable right under Israeli banking regulations to demand the production of at least the agreements under which the bank had operated. In addition, he thought that as a matter of his practical experience an Israeli bank would be expected to fully cooperate to the best of their ability in disclosing relevant documents and in providing information concerning the operation of a borrower’s account.
63. As a consequence of those legal obligations, Mr Hacmun opined that the bank ought to have had, and produced to Areffco, substantially more documents than those summarised in the descriptions in paragraph 28 above. Mr Hacmun also thought the fact Areffco had only been incorporated for a few months at the time of the first loan advance in June 1997 made it highly unlikely that MDB would have simply relied upon Areffco’s contractual repayment obligation and would have required additional guarantees and security. In that regard he pointed out that under the relevant Israeli banking regulations, where a bank obtained collateral security for a loan advance, including obtaining a personal guarantee, it was required to maintain a computerised database recording the relevant details of the security.
64. Mr Hacmun did not say that there was a legal requirement that obliged an Israeli bank to obtain loan security in addition to a personal guarantee. He did, however, emphasise that considerable legal and commercial aspects of prudent and reasonable practice would be likely to require more than just a personal guarantee.
65. Two of Areffco’s witnesses provide a different perspective on the likelihood of foreign loans being made by an Israeli bank without specific evidence of tangible security being obtained. They also had different views about the potential extent of relevant loan documentation.
66. Mr Orly Brown was a former senior banking officer with BH, a major Israeli bank. For a period of three years he had been a chief representative of the bank in Australia. For the previous seven years he had been the chief representative of the bank in Canada. His most recent role at the bank had been as a senior credit officer particularly involved in loans to foreign borrowers investing in Israeli real estate.
67. Mr Brown considered that the loan term and interest rates asserted by Areffco for both the initial advances in 1997, and the extension and renewals in 2002 and 2005, were within the range of applicable interest rates at the relevant times. Indeed, and quite contrary to the views expressed by both Dr Shapira and Mr Ben Zeev, Mr Brown thought it was common practice for banks in Israel to grant loans with terms and conditions similar to those asserted by Areffco. In particular, he referred to the existence of an international market index for five-year loan terms as strong corroboration of his view that granting a fixed interest loan for such a term was “entirely consistent with the market”.
68. In similar contradiction, he also thought it was common practice to accept a personal guarantee as a form of security for loans of that kind. However, he at least implicitly agreed with the substance of the views expressed by Mr Hacmun - that in assessing any such loan application the bank would be likely to require financial information, in the form of financial reports, tax returns or authenticated list of assets. The bank’s decision to approve any such loan application would be based upon an assessment of that kind of financial information and the bank’s assessment of the borrower’s ability and reliability. In making any assessment along those lines the bank would be likely to be significantly influenced by the acceptability of any previous relationship with the borrower.
69. Mr Brown did not initially comment in detail on the extent of the loan related documentation likely to have been created and retained by MDB. He at least implied that the formal loan agreement may not be significantly more extensive than the form of “Application / Extension” document referred to above. To this extent his evidence was broadly consistent with that of Dr Shapira. Their views, as to the potential sufficiency of the “Application / Extension” type of documents to contain all the essential loan terms, is preferable to any contrary inference or expectation that might otherwise be drawn from Mr Ben Zeev’s evidence.
70. Mr Brown made the point that in his experience the practice of Israeli banks exhibited a greater degree of variability, and a greater degree of flexibility than had been the case within the Australian banking system, at least as he had observed it during his time in Australia between 2006 and 2009. He expressed considerable reservations about extrapolating, with reliable confidence, from experience of other countries’ banking practices, to retrospective assumptions or inferences about the decisions made by MDB in the particular circumstances of its dealings with Areffco.
71. In that context Mr Brown also cautioned against too ready an assumption that MDB must ultimately have funded the 1997 advances from foreign currency holdings other than AUD and that it must have been exposed to an exchange rate risk in relation to the loan. He pointed to the fact that MDB was a substantial Israeli financial institution. It is a wholly-owned subsidiary of a publicly listed company that was the third largest bank in Israel. MDB is itself the seventh largest Israeli bank, in terms of assets, and the six largest bank in terms of the number of branches. In Mr Brown’s view it would not be possible to make any really informed assessment of the asserted loan terms without an actual understanding of MDB’s foreign currency position at the time of each of the loan advances or extensions. He made the same point in relation to the asserted loan interest rate and was highly critical of the rather narrow and precise margins which both Mr Ben Zeev and Dr Shapira opined would be applied to LIBOR in order for MDB to arrive at a commercially acceptable interest rate for the asserted loans.
72. In this context Mr Brown agreed with Mr Ben Zeev’s view that an Israeli bank might relax its normal practices in transactions dealing with a valued customer. But he took issue, and strongly disagreed, with the confidence with which Mr Ben Zeev had asserted that “valued customer” status would only be extended to a customer with US$1m on deposit. In Mr Orly Brown’s view the characterisation of any particular customer as “valuable” was a variable and subjective assessment.
73. He thought that the low-interest spread on the initial loan terms in 1997 was actually consistent with the existence of a personal guarantee to support the loan. He noted that the loan spread was considerably greater at the time of the loan extensions in December 2002 (the spread was about 3.5%). According to the views of Dr Shapira and Mr Ben Zeev, this was a very high spread for any loan.
74. Mr Brown was also critical of Dr Shapira’s view that it was unusual to have a loan that did not include repayment of principal at any time during the five-year term. He referred to the standard form example document that Dr Shapira had included in his report. He pointed out that it specifically contemplated three different options for principal repayment, and one of these was for a single repayment on a nominated date. There is nothing in the standard form document to indicate that its appropriate use is confined to loans of any particular period. And at least in this respect, Mr Brown’s criticism of Dr Shapira’s views appear to have a sound basis.
75. There is a further basis to support Mr Brown’s views. That is provided by the evidence of Mr Baruch Etzion. Mr Etzion is a practising Israeli lawyer. For 14 years he was the deputy general manager of the central Tel Aviv branch of BH.
76. Mr Etzion’s general description of the kinds of bank documentation and security requirements that were characteristic of BH’s practices in the period from 1997 until December 2001 broadly accords with the descriptions given by Mr Hacmun about the nature and scope of the documentation ordinarily required under Israeli law and banking practice. However, he had the same views as Mr Brown about not only the sufficiency of the terms set out in the “Application / Extension” document, but also the similarity of the substance of those documents to the example form that Dr Shapira described in his evidence.
77. Mr Etzion disagreed that it was either rare or uncommon for an Israeli bank to grant a foreign client a loan on the terms asserted by Areffco. In addition, he strongly disagreed with the view that personal guarantees would not have been regarded as security for the loans granted to Areffco. In this his opinion was very similar to that of Mr Brown. He regarded personal guarantees as “essential forms of security”. His principal reason for that view was that it indicated the personal commitment of the people who controlled the borrower corporation to ensuring the loan obligations were duly discharged. Like Mr Brown, he positively asserted that it was not unusual in Israeli banking practice at the time to accept personal guarantees as the only form of security for loans, provided the lending bank was satisfied that the clients were of good standing and had the ability to honour the loan commitments.
78. Mr Etzion said that Israeli bank statements were not issued in English. Some bank statements relating to the deposits were partly in English but, it was not common to find Israeli banks that provided bank statements in English regarding loans to foreign customers. This aspect of Israeli banking practice had resulted in Mr Etzion adopting a practice of telephoning foreign currency borrower clients and informing them of the impending payment requirement. He explained that he would ordinarily have obtained a list of borrowers with the dates and amounts of the impending payments, perhaps for a 30 day period, and he would work through the listed names. He would not usually be given copies of the interest statements themselves, just a listing of relevant borrowers.
79. Mr Etzion described the Areffco loans as unusual – because of the absence of a requirement for capital repayment during the loan period. He suspected that there was also agreement for the postponement of interest. This suggested to him that the loans were tailor made, and the result of banker satisfaction with the relationship with the customer.
80. Nothing in anything Mr Etzion or Mr Brown said offer any explanation, consistent with their experience of Israeli banking practices, for the absence of evidence that MDB pursued Areffco to any extent during the prolonged period when it made no interest payments.
81. Mr Etzion had a further relevance to Areffco’s case. In 1992 he had personally been in charge of the procedure for the approval of a CHF$12,000,000 (Swiss Franc) loan by BH to Bcfinco in May 1993. Bcfinco was incorporated on 1 May 1992. Erb and his brother Erm were, and remained, its only shareholders. They were its only directors until January 1994 when Erb’s wife and son Ayb, and Emb’s son Grb, were added to the board.
82. In support of the November 1992 BH loan to Bcfinco, Erb and Emb each provided a personal guarantee. Other entities associated with Erb (Ell158 and Erbnom) also provided a formal guarantee, and corresponding entities associated with Emb (Ell159 and Embom) were guarantor parties to the same formal document. Each of the corporate and personal guarantee documents (which were materially identical and had been executed on the same date) represented and warranted the accuracy of a statement of assets contained in a letter written by Mr ESZ (the accountant referred to in paragraph 14 above). Mr ESZ’s 6 November 1992 letter certified that he was the auditor of the six guarantor entities and that their combined net assets exceeded US$25,000,000 (approximately AUD$35,000,000 – using approximate USD/AUD 1992 rates of exchange). The major assets listed in Mr ESZ’s letter were 17 real estate properties, which ranged from a shopping centre complex with an annual net income exceeding AUD$3.4m, to Erb and Emb’s family homes.
83. The total BH loan to Bcfinco took the form of separate loan components of CHF$500,000. Mr Etzion explained that this structure was devised to permit Bcfinco to make partial early repayment of principal, without penalty. This request was accommodated by the structure of using multiple loan components each of which was repayable without penalty on any six monthly interest payment date. Erb and Erm each signed 12 of the loan instalment request documents, acknowledging the loan terms, required by the Bank. Each separate loan was for a five-year term at a fixed interest rate of 6.2%. Interest was payable six monthly in arrears. There was no requirement for principal repayment at any time during the loan period.
84. Mr Etzion characterised the November 1992 guarantees, and the May 1993 loan request documents, I have described above, as standard bank documents BH used at the time.
85. Bcfinco equally divided the funds it borrowed from BH and on lent CHF$6m to the corporate trustees of each of Erb and Emb’s family trusts. In a letter he wrote to the Deputy Commissioner of Taxation on 29 March 1994, Erb explained that the purpose of both the borrowing by his family trust from Bcfinco, and in turn the purpose of that company’s borrowings from BH, was to refinance what he described as “onerous” current borrowings which carried an interest rate of 8.07%.
86. In November 1997 the 24 Bcfinco Swiss Franc loans were converted to Australian currency. Each of Erb and Emb signed letters addressed to the bank acknowledging the outstanding AUD value of the loan. In relation to the 12 individual loan instalment requests he had originally signed Erb acknowledged outstanding principal amount of AUD$6.177m and Emb acknowledged an outstanding principal amount of AUD$6.188m.
87. The Commissioner also provided written evidence from an expert with experience in Australian and UK banking practice, a Mr Sturrock. Mr Sturrock, who was not cross examined by the Applicant, did not assert any expertise in relation to Israeli banking practice. Although in his final written submissions the Commissioner suggested that significant weight should be attached to Mr Sturrock’s opinions, in reality they added nothing of substance to, and were in fact less persuasive than, the evidence of Messrs Shapira, Ben Zeev and Hacmun. I note, in that regard that Mr Sturrock’s February 2011 written opinion predates those provided by each of the Israeli banking experts relied on by the Commissioner.
88. Given Mr Sturrock’s lack of knowledge of the details of Israeli banking practice, (at least comparative to the other expert witnesses who gave evidence) much of what Mr Sturrock had to say was based on his assumptions, perhaps partly informed by his actual international banking experience, about the degree of similarity between Israeli banking practices and what he would regard as normal. Many of his opinions included assertions about what was “implausible”, “normal”, “usual”, “axiomatic” or something that he would expect. I accept that there is some validity in the generality of Mr Sturrock’s opinions. There are likely to be many respects in which banking procedures, and prudent banking practice, are common to different jurisdictions and economies. That likelihood was confirmed by the actual evidence the other expert witnesses gave. But Mr Sturrock’s opinions concerning (i) the uncommerciality of the asserted interest rate, the (ii) inevitability that there would be a “properly documented” loan document, (iii) a standard practice that borrowers would always be required to meet withholding tax obligations, and (iv) the inevitability of a requirement for security and guarantees, must defer to the conclusions I have drawn from the evidence of the other banking expert witnesses. They must do so for two main reasons. First, he was in reality comparatively uninformed of the realities of Israeli banking practice – at least to the extent that he did not acknowledge the diversity of views apparent from the evidence given by the other experts. Second, his evidence was expressed at a level of generality, which made it difficult to determine the extent to which his opinions were really based on expertise, as distinct from being pragmatic assessments based on a subjective view about what he thought was usual, logical or axiomatic.
Conclusion on the expert opinions on the loan documentation and terms
89. The evidence of the five expert witnesses who dealt specifically with Israeli banking practice reveals a good deal of common ground, when it is ultimately reviewed. There was a requirement for an appropriate loan document. It could be a formal document, of the kind Mr Ben Zeev favoured, and which was illustrated by the documents with which Mr Etzion had been involved in relation to the 1993 BH loans to Bcfinco. Alternatively, in the view of Dr Shapira and Mr Brown, a standard form document, such as that indicated by the “Application / Extension” document referred to in paragraph 28(f), did contain the essential loan provisions.
90. A fixed interest 5 year loan, with no requirement for periodic repayments of principal during the loan term, and permitting early repayment without penalty, was unusual. It could also be said that usual Israeli banking practice would require security for the loan.
91. These matters suffice to characterise the asserted Areffco loans as unusual. But it is readily apparent from the nuances of difference between the views of all of the Israeli banking experts that there is a degree of flexibility about the real ultimate meaning, and the significance of that characterisation. This can readily be seen in the differing views about the appropriateness of the asserted 8.298% interest rate, and the degree of significance that could or should be attached to it.
92. The obvious inference from the criticisms made by Dr Shapira and Mr Ben Zeev was that the asserted loans were unlikely to be genuine, because they were (at least originally) at too low a rate and, in that sense, unduly favourable to the borrower. But the real justification for that inference is very questionable. First of all there is the evidence that there was no settled practice of imposing the burden of withholding tax on the borrower. Secondly there is the evidence of Mr Brown, who emphasised, to my mind with some justification, that there are a range of factors involved in the selection of an appropriate interest rate, and that it was overreaching to express the view that a transaction was relevantly irregular because the asserted interest rate was towards the end of a permissible range. His view, which diminished the permissible significance of the asserted interest rate, was supported inferentially by some of the comments Mr Ben Zeev made in the course of his cross examination. Mr Ben Zeev thought that the interest rate was too low, unless the lender either regarded the loan as secured or viewed the borrower (and I would include also the guarantor) as having a particularly strong balance sheet.
93. I conclude that the 5 year original loan term, the nominated interest rate, and the repayment provisions for the loans asserted by Areffco were comparatively unusual, but not to an extent that meaningfully contradicts the likely reality of the MDB’s loans.
94. The same is true of the disagreement between the experts about the likely requirement for security for the loans and, in particular, the potential sufficiency of a personal guarantee in an Israeli bank’s approval of a AUD$4.75m loan. On the one hand, there is no real doubt about the likely desirability of both security and a guarantee for such a loan. But the more material question is whether the absence of security, including absence of security for any guarantee, meaningfully contradicts the reality of the asserted loans.
95. None of the experts suggested there was a legal (as distinct from a prudential) requirement for either security or a guarantee for a foreign currency loan. Mr Brown stated clearly that, in his experience, there was actually a preference to obtain personal guarantees from the individuals associated with a foreign borrower. His view in that regard was contradicted by Dr Shapira. He dismissed personal guarantees as having a merely a “solidarity” value. But I am inclined to prefer Mr Brown’s view and to regard Dr Shapira’s contrary opinion as overstated. Dr Shapira’s own recognition of the potential “solidarity” value implies the conceptual value of a personal obligation in providing some measure of comfort to a lending bank. This implication is part of the point that was made by both Mr Brown and Mr Etzion. I can well understand that this point may have limited, indeed merely conceptual, force where the borrowing entity is in truth the apparently substantial entity and the personal guarantor has not been demonstrated to have the potential means of satisfying the guarantee obligations. But if a banker is satisfied that a guarantor does have substantial means, then a personal guarantee would, in my view, have rather more practical value than as mere evidence of “solidarity”.
96. A banker’s willingness to accept the sufficiency of a personal guarantee might be regarded as a departure from usual Israeli banking practice. But Mr Brown’s opinion, based on his own direct experience, was that such loans did occur. Mr Ben Zeev’s ultimate view was, at least inferentially, not dissimilar. He contemplated relaxation of any normal requirement for tangible security where a banker was satisfied that a borrower or guarantor had a very strong balance sheet. He had definite views about the balance sheet details that would merit such a characterisation, and at least implied that neither Areffco nor any of its associated entities would have a balance sheet of that kind. But the conviction with which he expressed this view is ultimately a matter inevitably influenced by subjective impressions about the nature, extent and acceptability of the actual credit risk in the particular circumstances of the individual loan under consideration. The differences of opinion between the experts in the present case illustrate that proposition. It is, to my mind, further illustrated by the actual circumstances of the 1993 BH loan to Bcfinco. That loan, with which Mr Etzion was personally involved, involved a fixed interest rate, for a 5 year term, with no requirement for periodic payments of principal and with permissible repayment without additional cost. It also seems to have been a loan where, although there were guarantors, and evidence of their net asset value, there was no evidence that any of them provided any actual security.
97. The Commissioner made no suggestion that the CHF$12m 1993 BH loans to Bcfinco, with which Mr Etzion had been personally involved, were illusory. Indeed, the Commissioner distinguished those loans from Areffco’s asserted loans, because of the scope and the availability of the formal loan documents and also because BH obtained a registered charge over Bcfinco in relation to the loan. But at least the latter (the charge) is a matter of little significance. This is because Bcfinco, like Areffco, had no significant assets, no other liabilities and was merely a conduit for the loan funds to related entities. The practical utility of a charge over the assets of such an entity is, to my mind, questionable. Conversely, I doubt that any real significance attaches to the absence of evidence of such a security.
The loan documentation issues
98. For the reasons I have set out above, the loan parameters asserted by Areffco, do not convey satisfaction the loans were illusory. On the contrary, the better view is that these aspects of the asserted loans are actually consistent with the reality of the loans, as Areffco asserts. But the significance of the potentially acceptable nature of those terms has to be assessed in the light of all the other relevant considerations. They include the paucity of documented evidence of the regularity of the loan circumstances.
99. The only copies of any formal loan documents that have been produced are the December 2002 forms described in paragraph 28(f) above. Nor has Areffco produced, either from its own records, or the information it obtained from MDB, any evidence of financial information it provided to MDB in connection with any loan application. Except for the equivocal material referred to in paragraph 128 below, there is no evidence demonstrating that the loans were supported by any kind of security or guarantee. This is despite Areffco’s own contention that such a guarantee was at least likely to have been given. That contention was itself consistent with Mr Brown’s evidence that an unsecured personal guarantee was a commonplace feature of similar foreign currency loans.
100. The absence of any document evidencing the original loan agreement is strange. On the one hand, the June 1997 advance was repaid in June 1998 and records relating to it might have been destroyed, consistent with ordinary practice, by 2005. On the other hand MDB did retain, and produced to Areffco, copies of the 1997 letters referred to in paragraphs 28(a), 28(b) and 28(c). It also retained the September 1998 repayment advice letter. The retention and production of that correspondence, in contrast to the absence of any original loan document, casts some doubt on the likelihood there ever was an original loan document. The absence of some kind of written agreement for the original loan would have been quite contrary to all of the expert evidence about ordinary Israeli banking practice.
101. Similar curiosity exists in relation to the absence of any record of security for the asserted loan. That absence cannot realistically be explained by any routine document destruction practice - because MDB was required to retain documents of that kind at least during the currency of the loan. As is apparent from the repayment dates in the Table in paragraph 25, Areffco did not make its final loan repayment until December 2009, and that was after MDB had provided the documents referred to in paragraph 28 above.
102. If MDB had granted the asserted loans in reliance on satisfaction about the financial capacity of Erb and his related entities, that would likely have been based on information similar to the net asset summary Mr ESZ provided BH, in his November 1992 letter, in connection with its loan to Bcfinco. MDB might not have been legally obliged either to have retained those kinds of documents, or to have produced them in response to Areffco’s 2008 to 2011 requests for assistance in substantiating the reality of the asserted loan transactions. But the absence of those kinds of documents from the material MDB did produce is nevertheless surprising. The absence of these kinds of potentially important documents contrasts with the production of the, arguably much less significant, letters of July and December 1997.
103. There is some evidence (to which I refer in paragraph 167 below) to suggest that the documents MDB produced represent the totality of its available file. But there are also reasons to doubt the accuracy of that suggestion. There are also reasons to doubt that the current contents of the MDB file (if it is correct to refer to a single file on the assumption that it contains all relevant records) reflect the totality of its actual historical records and communications related to the loan. Those reasons relate to (i) a possible distinction between the bank’s central office and its branch office, (ii) the likelihood that MDB’s manager responsible for the loan would have had to maintain diary notes recording and reporting on his periodic supervision of the loan account, and (iii) the evidence of a March 2004 meeting between Erb, Ayb and the MDB account manager, Mr ES (of which some bank record should exist).
104. Despite the seeming deficiencies in the presently available loan documentation, there are also good reasons to accept the reality of the fact of the loan Areffco asserts. The fund movements appear to be objectively corroborated. The fact is that MDB did allocate separate loan account numbers to the asserted loans. It also allocated an account number to Areffco’s deposit account, into which all of the subsequent payments were made. These various account identifiers are apparent from the earliest of the available documents, the July and December 1997 letters. Their use is apparent in the MDB accounting style documents referred to in paragraph 28 above. In addition, the “Application / Extension” documents referred to in paragraph 28(f) implicitly assume the prior existence of the designated loans and explicitly use the account numbers for the existing loans. Finally there is the evidence of the March 2004 meeting to which I referred in the preceding paragraph, and to which I will return (in paragraph 120 below).
105. I infer from this information that MDB did record the asserted loans within its ordinary management and accounting systems. I would infer that it is unlikely to have done so unless the reality was that it had advanced the loan funds as Areffco asserts. I have previously referred to the fact that MDB was a large Israeli bank, and a wholly owned subsidiary of an even larger Israeli bank that was a publicly listed corporation. I would infer the likelihood that such an institution would have appropriate management and accounting systems and a lawful, responsible, ethical approach to the conduct of its business. The expert witnesses, in their descriptions of MDB, confirmed the reasonableness of drawing such an inference. The significance of this inference is that, to my mind, it makes it unlikely that MDB would, in 1997, have engaged in a procedure of merely contriving the appearance of a genuine loan transaction with Areffco. It also makes it unlikely that any such contrivance would have escaped detection over the whole of the subsequent years. Finally it makes it unlikely that, in response to Areffco’s repeated enquiries, including enquiries that came to the attention of MDB’s legal department and senior managers who were apparently not involved in the events of 1997, MDB would have continued dishonestly to assert the existence of genuine loans.
190.Grb met with IZ again on 8 December 2009. On that occasion IZ gave him a bundle of documents which he said comprised MDB’s Adfinco loan file. The file contents are similar to, but somewhat more extensive than, the Areffco loan documents referred to in paragraph 28. In particular, it is notable that the Adfinco file includes:
(a)a standard form loan application dated 9 July 1997 and a 24 June 1997 request for a drawdown of AUD$4 million,
(b)loan “extension” documents (similar to those described in paragraph 28(f)) dated 20 June 2002 and 23 December 2002.
191. Areffco’s solicitor, Mr Douglass went to Israel in August 2010, with Grb. He also had a meeting with IZ. But on this occasion a lawyer from MDB’s legal department also attended the meeting and participated in the discussion. Mr Douglass explained that the reason for the meeting was to obtain evidence for use in the litigation between the Commissioner and the various entities who Mr Douglass acted, including Areffco. Mr Douglass explained that some of the litigation was in the Australian Federal Court, and the evidence had to be submitted in a different form. He asked IZ whether he would be prepared to travel to Australia to give evidence. Mr IZ refused. Mr Douglass said IZ protested that he had already signed a statutory declaration and really done all that he regarded himself as required to do.
192. Mr Douglass travelled to Tel Aviv in February 2011 and again met with IZ at MDB’s offices. He asked him to re execute his February 2010 statutory declaration for the purpose of these proceedings. Mr IZ complied, and signed the statutory declaration dated 14 February 2011. But he again refused to travel to Australia to give evidence in the proceedings.
193. Mr Douglass went to Tel Aviv yet again in March 2011. On this occasion he had a meeting with the same lawyer from MDB’s legal department. Mr Douglass explained the then imminent hearing in these proceedings. He explained that Areffco needed to substantiate the reality of the loan transactions with MDB and that he wanted IZ to sign an affidavit and agree to provide evidence at the hearing - either in person, by telephone or video conference. Mr IZ was not present at the meeting. The lawyer told Mr Douglass he would ask IZ whether he was willing to give evidence.
194. A few days later Mr Douglass had a telephone conversation with the same lawyer. He asked to be able to meet Mr IZ to seek clarification of some of the documentation that he had previously provided. He also asked the lawyer whether he had located the relevant bank file. The lawyer said he had not. Moreover in response to Mr Douglass’ specific request the lawyer said that the bank would not give Areffco access to the bank’s file. The lawyer also told Mr Douglass the bank would not assist by providing any further evidence.
195. The fact that Areffco did not take proceedings against MDB, or make any more formal demand for MDB to produce its loan records, is a relevant consideration. But it is not a matter of much significance, against the totality of the evidence. That evidence establishes:
(a)the contemporaneous correspondence in 1997 between Erb and Mr ES - to which I have referred in paragraphs 28(a) to 28(c) above;
(b)the other MDB loan and accounting records listed in paragraph 28 above;
(c)the objective evidence corroborating the movement of funds between MDB and Areffco;
(d)Areffco’s tax returns and balance sheets for the years ended 30 June 1997 to 30 June 2000, that were prepared by ESZ in an apparently timely and regular fashion;
(e)Areffco’s handwritten ledgers and journals, maintained by ESZ, which appear to evidence the loan funds and their application, at least in the period prior to June 2000;
(f)The evidence of the March 2004 conversation between Erb, Ayb and Mr ES;
(g)The evidence of Ayb and Areffco’s repeated enquiries of MDB in the period from July 2009 to May 2011;
(h)The statement in Mr IZ’s February 2010 statutory declaration that he had produced a complete copy of MDB’s relevant loan file;
(i)The statement Ayb attributed to Mr IZ, in the course of their conversation in July 2009, that the original 1997 loan documents were likely to have been destroyed, having regard to the substantial repayment in 1998, and subsequent loan consolidation.
196. Against this background I very much doubt that Areffco could reasonably have expected to obtain any more meaningful information by making formal demands of MDB. Although the MDB relevant officers refused to co-operate by giving evidence in the present proceedings, I am satisfied that it would not be correct to conclude from the evidence that they were either deliberately or intentionally withholding material information from Areffco. I am also satisfied that it would be wrong to conclude that Areffco refrained from making any formal demand on MDB because of any apprehension that further production by MDB would undermine its assertions about the reality of the loans, or the interest payments it claims to have made.
197. The expert evidence I described in detail earlier in these reasons provides a basis for expecting that MDB would, at least when the loans were first granted, have had (i) the original loan documents, (ii) some explanation of Areffco’s financial status and circumstances and (iii) some kind of security document, even if only a personal guarantee from Erb, or entities related to him. During the currency of the loan, MDB could reasonably be expected to have obtained financial statements from the borrower. At least some of these documents MDB should have retained after the final repayment of the loans in late 2009.
198. But against the evidence that MDB was required to retain these kinds of documents, there is Ayb’s evidence of his repeated enquiries to MDB, his account of what IZ told him was in MDB’s loan file, and IZ’s claim (in his February 2010 statutory declaration) that he had produced the bank’s then existing file. Against this background it is to my mind problematical whether the original 1997 loan documents still existed, and whether they were any more detailed than the simple forms that were the basis for the modified “extension” documents referred to in paragraph 28(f) above.
199. I am inclined to think it is likely MDB did have some more records than Mr IZ in fact produced. I am inclined to that conclusion for a number of reasons. First, IZ’s assistant provided some of the documents referred to in paragraph 28(e), and the document referred to in paragraph 28(i), and they are additional to the documents Mr IZ identified as comprising the MDB file. Second, Mr IZ says in his February 2010 statutory declaration (in at least one version of it) that MDB granted the loan “against sufficient securities”. This statement was either based on an assumption about normal practice, or reflected a provable reality. If it was a provable reality, then some corroborating record should exist. If it was not a provable reality then that would tend to suggest a departure from ordinary practice, which should itself be the subject of a reasoned explanatory record. Third, the evidence of the conversation between Erb, Ayb and Mr ES in March 2004 suggests that there were other telephone conversations between Erb and ES. That suggestion is consistent with the absence of evidence of regular statements being issued to by MDB. It would have been normal, and I would think indispensable, banking practice for MDB to have kept some records of these kinds of contact between Mr ES and Erb, particularly having regard to the substantial periods of interest non-payment - apparent from the Table in paragraph 25 above.
200. But the real question to be decided is not whether there is a reasonable basis to suspect the likely existence of other loan related records in MDB’s possession. Instead the more significant questions are whether (i) such additional documents as might reasonably be supposed to exist, or (ii) Areffco’s failure to pursue their production by a more formal process, provide a basis for concluding that Areffco has failed to discharge its onus of proof in the present proceedings. I answer both of those questions in the negative. I do so for two main reasons.
201. The first reason is that I do not consider there is any real basis for concluding that either Areffco, or any other Erb related entity, ever had any overseas asset. (I have set out my reasoning for that conclusion in paragraphs 140 to 175.) I am satisfied therefore, that it is highly unlikely anything MDB might have produced, in response to even the most formal procedures invoked by Areffco, would have disclosed the existence of such an asset.
202. The second reason is that even if I was of the view that Areffco had failed to discharge its onus of proof in establishing that no Erb related entity had provided an overseas located asset as tangible security for the contentious loans, I am satisfied that Areffco has discharged its onus of establishing that Areffco itself did not provide any such security. It has discharged that onus because the recency of Areffco’s incorporation, as at both June and December 1997, its inconsequential capital, its restricted business activities, and its contemporaneous tax returns and balance sheet for the years ended 30 June 1997 and 1998, combine to warrant the finding that Areffco had no meaningful assets or income at the time MDB granted its loans. In these circumstances any tangible security that MDB might have obtained for any of the contentious loans was not Areffco’s own asset. Consequently the hypothesis of some kind of tangible security for the loans does not, in my opinion, cast any doubt on the reality and substance of the asserted loan transactions between Areffco and MDB.
The flaw in the “security” hypothesis
203. I referred in paragraphs 6 and 140 to the hypothesis that the most likely explanation for the MDB fund transfers was the existence of some kind of realisable asset over which it had security, and to which it could resort without risk. More particularly, the hypothesis is that this realisable security asset was provided by some Erb related entity, other than Areffco.
204. The hypothesis that such a security asset had been provided by some related entity is implicitly driven by an acceptance of the reality that Areffco itself had no significant assets at time of the original advance. For the reasons I indicated in paragraph 202, there is no realistic basis for concluding that Areffco had any asset, let alone any overseas assets, at the time of the MDB fund transfers in June, July and December 1997.
205. But the hypothesis that some other related entity provided security for the asserted 1997 loans, even if it was to be accepted, only serves to confound any rational basis for the Commissioner’s assessment decision, especially for the 1997 and 1998 years. If the hypothesised security asset belonged to some other related entity it is necessary to postulate the mechanism by which it served as security for the funds MDB provided Areffco. It is also necessary to postulate the mechanism by which MDB provided the funds to Areffco and the true character of that transaction.
206. The most likely answer to those enquiries is that the hypothesised asset was a surety security, and supported the existence of a true loan transaction between MDB and Areffco. I would not readily come to the conclusion that the hypothesised security provider was willing simply to “gift” the contentious funds to Areffco, to forego any interest income on those funds, or to forego any rights of subrogation it might otherwise have, in the event that MDB called on the security.
207. I raised this matter on several occasions during the course of the hearing. The response provided on the Commissioner’s behalf was to emphasise the burden of proof that s 14ZZK of the Taxation Administration Act 1953 imposes on Areffco. In particular, the Commissioner said that Areffco could not discharge its burden merely by criticising the reasoning process by which the Commissioner’s decision had been reached. Areffco had to demonstrate that the assessment decision was excessive.
Burden of proof issues
208. I accept the generality of the Commissioner’s basic contention. But it is immaterial in the circumstances of the present case. There is in my view simply no factual basis for the Commissioner’s assessment in relation to the characterisation of the 1997 fund transfers as Areffco’s assessable income. Areffco’s evidence demonstrates convincingly that it conducted no business other than the onlending of funds to other entities related to Erb. It did not conduct any income producing activities before it received the funds from MDB. There is no factual circumstance that would permit Areffco’s receipt of those funds, even in the unlikely event that MDB held some kind of realisable security on which it had relied in making the transfers, to be characterised as income.
209. The Commissioner described s 14ZZK(b)(i) of the Taxation Administration Act 1953 as giving rise to a rebuttable presumption of law. The Commissioner did not have to put forward a positive case to show that the assessments were supported by evidence and were justified. Moreover Areffco’s onus meant that it had to do more than merely show the Commissioner’s assessments were affected by a material error. Areffco had to show that the actual assessment amounts were excessive - in the sense that, on the correct view of the facts and the law, the assessment amount was not justified. The Commissioner said these propositions were supported by the highest authority: McCormack v Federal Commissioner of Taxation (1978) 143 CLR 284 at 314; Trautwein v Federal Commissioner of Taxation (No 1) (1936) 56 CLR 63 at 88; Gauci v Federal Commissioner of Taxation (1975) 135 CLR 81 at 89; Federal Commissioner of Taxation v Dalco (1990) 168 CLR 614 at 624.
210. The Commissioner contended Areffco could only discharge its burden of proof by showing that (i) it obtained the contentious funds as loans from MDB, (ii) there was no security for the loan, (iii) the only security for the loans were personal guarantees by Erb and (iv) MDB did not provide the funds as a result of any kind of “back to back” dealings with other banks or as a result of some kind of security having been provided by some entity related to Areffco. The Commissioner characterised this fourth matter as one that was a crucial matter for Areffco to prove. Moreover, it was something that Areffco could not prove by merely partial disclosure of its dealings with MDB, and by inference from loan dealings involving other Erb related entities.
211. Areffco accepted that it had the burden of establishing that the Commissioner’s assessments were excessive. It contended that doing so involved establishing (i) the impugned funds were borrowed, (ii) that it applied the funds for income producing purposes, and (iii) it remitted interest payments to the lender in discharge of payment obligations under the impugned loan transactions.
212. The Tribunal discussed the application of the onus provisions in s 14ZZK(b)(i) in Re Sharkey and Commissioner of Taxation (2007) 95 ALD 509. The reasons in that case emphasised the interplay between the Tribunal’s specific powers under s 43 of the Administrative Appeals Tribunal Act 1975, and the terms of s 14ZZK. That case involved a decision to which s 14ZZK(b)(iii) applied. That paragraph requires an applicant to show that the contentious decision should not have been made, or should have been made differently. But this wording does not connote any greater review liberality than the s 14ZZK(b)(i) requirement to show that the contentious assessment is excessive.
213. In Sharkey the Tribunal said that an applicant had to show that the result of the original decision was not the appropriate outcome of the exercise of the decision maker’s statutory function and powers. An applicant could discharge that onus in various ways - including (i) reliance on new or additional material, (ii) a re-evaluation of the appropriateness of the result of the original decision, or (iii) by a different evaluation of the elements of the reasoning involved in the original decision. By whatever process the applicant sought to present its review application, the Tribunal’s task was to determine what was the correct or preferable result in the proceedings. If the Tribunal came to a comfortable satisfaction that the result of the impugned decision was “excessive”, an applicant would have discharged their onus of proof.
214. The reasoning that underlies the Tribunal’s analysis in Sharkey is consistent with Bailey v Federal Commissioner of Taxation (1977) 136 CLR 214. In that case both Barwick CJ (at 217) and Mason J at 221, emphasised that the process of assessment required the application of the relevant legislative criteria to the material facts. Barwick CJ said that the Commissioner must “of necessity, as part of that process, adopt a view of the relevant facts. They must be facts which disclose a taxable income”. Mason J said that the relevant facts in the process of a review of the assessment decision “include the view of the facts on which the Commissioner has based his assessment”. What both of their Honours were articulating was the proposition that the fundamental basis for any efficient process of adjudication is to define, and concentrate upon, the issues of fact that are material to the decision to be made. And where the applicant faces the burden of showing that the assessment decision is “excessive” that burden can only realistically be discharged by the application of the relevant facts to the statutory criteria that create the potential liability to assessment.
215. These generalities, which simply recognise the process of fair decision making, have a particular emphasis in Tribunal proceedings. That emphasis is provided by AAT s 33(1AA) which obliges a decision maker to assist the Tribunal in reaching its decision in the proceedings. Since the essence of the Tribunal’s function is to arrive at the correct or preferable decision, and since decision makers also have an obligation to provide reasons for the reviewable decision, it is an inescapable consequence that a decision maker must endeavour to provide the Tribunal with an exposition of the rational basis for the Tribunal’s decision. In proceedings of the present kind the applicant taxpayer must discharge the burden imposed by s 14ZZK, but this burden in no sense relieves the Commissioner of the obligations imposed by AAT s 33(1AA). Nor do those obligations cast on the Commissioner any kind of onus in relation to the original decision. What they do is to highlight that the review process includes being satisfied, having regard to the applicant’s onus of proof, that there is a proper basis for deciding that the facts, as found by the Tribunal, give rise to the amount of the liability in the impugned decision.
216. The parties emphasised in their respective submissions the relationship between fact and inference in the setting of a forensic dispute. An inference must be rational and logical. It must also be based on some positive fact that “provides a reason, special to the particular case under consideration, for thinking it likely that in that actual case a specific event happened or a specific state of affairs existed”: Jones v Dunkel (1959) 101 CLR 298 at 305 per Kitto J - cited and applied in Jackson v Lithgow City Council [2008] NSWCA 312 at [10] -[12]. A forensically permissible inference is “a reasonable conclusion drawn as a matter of strict logical deduction from known or assumed facts. It must be something which follows from given premises as certainly or probably true, and the mere possibility of truth is not sufficient to justify an inference to that effect”: Gurnett v Macquarie Stevedoring Company Pty Ltd (1955) 55 SR (NSW) 243 at 248; Morley v Australian Securities and Investments Commission (2010) ALR 205 at [631].
217. The parties were broadly in agreement, and correct, in their respective contentions about the permissible nature of forensic inferences. But they directed their submissions to rather different propositions. The Commissioner contended that Areffco could not rely on the details of (i) the 1988 borrowings facilitated by JL (see paragraphs 143, 145 and 152 above), (ii) the 1992 borrowings involving Mr Etzion (see paragraphs 81 to 86 above) or (iii) the Adfinco borrowings (referred to in paragraphs 146, 189 and 190 above) to justify any inference about the substance of the dealings between Areffco and MDB. Areffco contended that the Commissioner’s apprehensions about the irregularity of the loan documentation and administration, in view of the objective evidence that it had provided, did not permit any inference to be drawn about the likelihood of any “back to back” or security arrangement underlying the contentious Areffco loans.
218. The Commissioner is correct in his submissions about the limited relevance of the other historical loan transactions. They involve other Israeli banks and other borrowers, some of which were not even Erb related entities. They provide a general background which is relevant to the Commissioner’s characterisation of the contentious loans as uncommercial. (I dealt with that aspect of the 1992 loans in paragraphs 81 to 86 above.) They also provide a background which lends some appearance of regularity to Erb’s borrowings from Israeli banks. But I do not regard them as providing any more than relevant background which suggests the possible regularity of the contentious Areffco loans. It is precisely for that reason that I consider no significance attaches to the fact that Areffco was unable to have either JL, or another officer from IDB, available to give evidence in the present proceedings.
219. But the same emphasis on the distinction between mere conjecture and permissible inference, constrains acceptance of the Commissioner’s contentions about what Areffco must actually prove in order to discharge its onus of proof in the present proceedings. The Commissioner submitted Areffco had to establish the four cumulative propositions I summarised in paragraph 210 above. But this overstates the position.
220. The critical matter for Areffco to establish is the reality of the loan transactions and liabilities. That task is complicated by obscurity of the evidence about the nature of any security for the loans. But it is incorrect to say that Areffco must show, as independent matters additional to the reality of the loan transaction and liabilities, that there was no security for the loans, or no security other than a personal guarantee. It is also incorrect to say that Areffco must establish that there was no “back to back” arrangement.
221. The Commissioner rightly emphasised throughout the 2010 objection decision, the evidence and submissions in these proceedings, the apparently irregularities in aspects of the contentious loan transactions. The paucity of available documentation, the doubts as to whether any more elaborate documentation ever existed, the asserted uncommerciality of the loan interest rates, the apparent irregularity in the timely and total payment of interest, and the absence of evidence of security, these are all matters that deserve careful consideration in arriving at satisfaction as to whether or not Areffco has discharged its onus of proof. I have addressed each of those matters earlier in these reasons.
222. But these matters, with the degree of significance I have decided they merit, are not the only relevant considerations. The fund movements between MDB and Areffco are sufficiently corroborated to permit satisfaction that Areffco has discharged its onus of proof that it received the contentious funds from, and made significant payments to, MDB. The various fund movements and payments are also established by apparently regular records of MDB as involving genuine loan transactions. Both former and current officers of MDB, in admittedly untested attributions, have declared the transactions to be genuine loans. There is also the evidence that MDB is a major and reputable Israeli bank. Both relevant senior management of MDB (I so characterise Mr IZ) and its legal department, are aware of the nature of matters in contention in the present case. They have nevertheless provided the material I have identified, knowing the purpose to which it would be used in the present proceedings.
223. In these circumstances the evidence provides a conflict between (i) the apparent objective evidence of the reality of the contentious loans, and their, partly untested, oral corroboration (in the evidence of Ayb, IZ’s statutory declarations and the statements attributed to ES and IZ) and (ii) the significant appearances of irregularity in the documentation and administration of the loan, particularly the irregularity in the payment of interest. This conflict must necessarily be evaluated against the background of possible explanations, and their consistency with the available evidence.
224. To that extent the Commissioner is right to point to the relevance of enquiry as to whether Areffco provided security. If Areffco had provided tangible security for its loan obligations the nature and location of the asset could inform the nature and character of the contentious loan. It would likely substantiate the reality of the loan. But there is no evidence that Areffco provided any security. And it is highly unlikely that it ever had any assets that could have provided any such security. I find that, on the available evidence, Areffco did not provide any tangible realisable security for the contentious loans.
225. If Erb, or some other entity, had provided a guarantee for the contentious loan liabilities that would also be likely to substantiate the reality of the loan. But there is no evidence sufficient to establish that MDB received any such guarantee.
226. In the absence of any, or at least any persuasive evidence, of security for the contentious loans the Commissioner is quite correct to hypothesise that the explanation for the fund transfers MDB made, and perhaps for those asserted repayments that Areffco made, may lie in “back to back” arrangements and in some kind of right of set off over some other asset. But that hypothesis has to be assessed against the available evidence. The purpose of that assessment is not to cast an affirmative burden on the Commissioner. Neither does it involve subjecting Areffco to the positive burden of disproving the existence of any arrangement consistent with the hypothesis. Areffco’s relevant onus is to satisfy the Tribunal that the loan liabilities were real. The quality of Areffco’s evidence in tending to contradict the hypothesis of “back to back” arrangements is relevant to assess. But that evidence does not have to go so far as to negate the mere possibility that such an arrangement might have existed. Neither is it the case that Areffco cannot discharge its onus of proof in the absence of complete disclosure of all MDB’s records. The ultimate question remains whether on the available evidence, including any inferences that can and should be drawn from the absence of evidence that it was within Areffco’s power to produce (and ignoring any question of the destruction or loss of relevant records) Areffco has satisfied the Tribunal of the reality of the contentious loans.
227. The answer to that question inevitably involves testing the hypothesis, of some other explanation for the contentious loans, against the available evidence. It is here, in my opinion, that the strength of Areffco’s case lies. There is simply no evidence of any other kind of transaction. As the Commissioner’s submissions implicitly accept, perhaps the most readily conceived possible explanation for the contentious loans is the existence of some other asset, located in Israel, to which MDB could have resorted. But not only is there no evidence of any such asset, I accept the evidence of Ayb and Mrs Erb, that they were not aware of any such asset. Their ignorance of any such asset is, to my mind, powerfully persuasive in justifying satisfaction that no such asset existed.
228. Similarly there is no evidence of any “back to back” arrangement. A difficulty in evaluating the possibility of such a transaction is that the Commissioner’s submissions never gave the arrangement any particular form. Again I do not suggest that the Commissioner had any onus in that regard. But the practical reality is that it is unhelpfully facile merely to suggest the possibility of such an arrangement without articulating the rational process by which the possibility might be properly assessed. In the present case the Commissioner’s submissions gave the example of “utilising letters of credit between banks” - implicitly suggesting that this clothed the possibility with a form capable of meaningful assessment. But I do not accept that suggestion. I assume the hypothesis contemplated by this example is that some other bank might have provided MDB with an enforceable undertaking that it would put it in funds to either facilitate the 1997 fund transfers or to reimburse it after they had been made, in the event of default. But the example merely prompts the questions (i) which bank would, or did do this, (ii) is it likely that the unnamed bank would undertake such a liability to MDB, without first securing a right of recourse against Areffco (or perhaps some other entity associated with Erb) and (iv) in what circumstances would any entity associated with Erb contemplate undertaking such a liability to the unnamed bank, when the liability seems to have contemplated interest payments that Areffco would remit to MDB in Israel.
229. The Commissioner’s 14 July 2011 further submissions recognised the generality of the hypothesis, in its reference to “banks”. Those submissions suggested that, because there was evidence that other Erb related entities had dealt with IBD and other Israeli banks, Areffco had an obligation to provide the Tribunal with evidence of its enquiries of those banks and provide a complete account of the totality of dealings with them. I observe that there is a certain incongruity in the combination of the Commissioner’s submissions that dealings with other Israeli banks (i) provide no basis for inferences favourable to Areffco about the reality of the contentious loans, but (ii) must be fully disclosed before any finding could be made favourable to Areffco about that reality. I also note that the Commissioner’s submission, whilst restricted to demanding disclosure of Areffco’s dealings with Israeli banks, gives no reason for the restriction to dealings with only those banks. In some supplementary final submissions the Commissioner broadened his contention and asserted that Areffco’s task was not simply to prove there was no assets in Israel but to prove that the transaction did not occur in connection with some other type of transaction involving security, set off or inter bank back to back dealings, for example using letters of credit.
230. Once it is fleshed out, the hypothesised example suggested by the Commissioner is nothing more than a conceivable possibility. But it is not one that has any evidentiary foundation. There is simply no evidence that Areffco had any dealings with any banking institution anywhere that are in any way actually relevant to the contentious loan transactions. Moreover I am unable to articulate to my own satisfaction, and nothing anywhere in the Commissioner’s submissions attempted to articulate, a scenario where any kind of suppositious dealings with other banks could both contradict the objective evidence tending to show the reality of the contentious loans, and be consistent with acceptance of the evidence (i) that Areffco had no asset that was capable of having been used as any kind of security for the loans, and (ii) that neither Ayb nor Mrs Erb were aware of any relevant asset.
231. Notwithstanding the Commissioner’s various submissions, Areffco’s evidence satisfies me that it had no asset, nor did it ever assume any liability, consistent with any kind of “back to back” arrangement. Consequently, whilst I do not consider that Areffco’s evidence had to go so far as positively disproving even the possibility of such an arrangement, I am satisfied that Areffco’s evidence does discharge its onus of proving that the contentious loans were real and that its asserted liabilities for repayment and interest reflect the intended and enforceable reality of the transactions with MDB.
The deductibility of the interest payments
232. The conclusion I have reached on the proper characterisation of the 1997 fund transfers by MDB is that they were loan funds Areffco received subject to a repayment obligation. That conclusion tends to carry with it the further conclusion that the payments Areffco subsequently made were deductible expenses. They represented Areffco’s cost of funds and were expenses it necessarily incurred in deriving the income it received from the Erb related entities to which it on lent the funds.
233. The Commissioner contended, at least in early submissions, that Areffco had failed to demonstrate the reality of the underlying loan transactions. It had also failed to demonstrate the reality of its own interest obligations. In that regard the Commissioner pointed to the asserted uncommerciality of the interest rates, the lack of evidence of statements and payment demands from MDB, the significant periods when interest was not paid, and the asserted lack of correlation between the actual payment amounts and the asserted loan terms.
234. I addressed the first of these points, the evidence relating to Areffco’s use of the funds, in paragraphs 36 to 41. I accept that there is no real documentary evidence to evidence the terms on which these loans were made. But it is necessary to have regard to Erb’s status at the time as the likely dominant decision maker for the affected companies. It is also necessary to pay proper regard to the accounting treatment in the 1997 to 2000 tax returns and balance sheets. Finally, it is necessary to reflect on the reality that Areffco, having assumed a loan liability to MDB, and having no assets of its own, would only have on lent the funds to other Erb companies on the basis that the borrower would pay interest sufficient to meet its own obligations to MDB.
235. In relation to the existence of those obligations I refer back to the MDB loan documentation to which I referred in paragraph 28. There is, in my opinion, a sound evidentiary basis for concluding that Areffco had real interest obligations to MDB as part of the terms of the contentious loans. It is unrealistic to suppose that MDB, as a significant and reputable Israeli bank, did not require Areffco to pay interest on the contentious loan sums. The payment amounts are not relevantly disputed. Having regard to the underlying loan liability, and the nature of Areffco’s business, the interest expenses Areffco incurred were necessarily incurred for the purpose of deriving assessable income.
Decision
236. I set aside the decisions under review, in so far as they included in Areffco’s assessable income in any of the income years to which they relate, any part of the fund transfers by MDB in June, July and December 1997. I also set aside the decisions under review in so far as they disallowed deductions for interest liabilities Areffco incurred to MDB in relation to the loan funds MDB provided in those fund transfers.
Note:
This version of the decision contains the amendments authorised by the member on 4 October 2011.
I certify that the 236 preceding paragraphs are a true copy of the reasons for the decision herein of P W Taylor SC Senior Member
Signed: ....[sgd]............................................................................
AssociateDates of Hearing 9-13 May, 8-10, 17 June 2011
Date of Decision 6 September 2011
Counsel for the Applicant Ms R Seiden and Ms S Kaur-Bains
Solicitor for the Applicant Argyle Lawyers
Counsel for the Respondent Mr B Sullivan SC and Mr B Kasep
Solicitor for the Respondent Maddocks
Schedule
4
11
2