Papua New Guinea Law Reports - 1985
[1985] PNGLR 129
N513
PAPUA NEW GUINEA
[NATIONAL COURT OF JUSTICE]
TRAVELODGE PAPUA NEW GUINEA LTD
V
CHIEF COLLECTOR OF TAXES
Waigani
Bredmeyer J
4 June 1985
14 June 1985
INCOME TAX - Allowable deductions - Losses or outgoings incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income - Tests for determining what is - Australian cases applicable - Income Tax Act (Ch No 110), s 68(1).
INCOME TAX - Allowable deductions - Outgoings incurred in gaining or producing assessable income - Capital items - Principles for determining - Interest rent and rates - Paid during construction phase of hotel - Allowable deduction - Not capital or of capital nature - Income Tax Act (Ch No 110), s 68(1).
INCOME TAX - Interpretation of Act - Derivative of Australian legislation - No relevantly applicable English common law - Australian case law appropriate - Income Tax Act (Ch No 110), s 68(1).
STATUTES - Interpretation - Relevant principles - Derivative of Australian legislation - No relevantly applicable English common law - Australian case law appropriate - Income Tax Act (Ch No 110), s 68(1).
The Income Tax Act (Ch No 110), s 68(1), provides that subject to certain sections of the Act not relevant in this case:
“all losses and outgoings, to the extent to which they are incurred in gaining or producing the assessable income or are necessarily incurred in carrying on a business for the purposes of gaining or producing that income, are allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital private or domestic nature, or are incurred in relation to the gaining or production of exempt income.”
On appeal from refusal by the Chief Collector of Taxes to allow interest, rates and rent paid during the planning and construction phase of a hotel and capitalised in the company’s balance sheets during the four years of construction, as an allowable deduction:
Held
(1)      The Income Tax Act (Ch No 110) having been copied from Australian legislation and there being no relevant or applicable English common law cases, the principles to be derived from Australian authorities on the equivalent to s 68(1) should be adopted and applied.
(2)      In determining whether the Income Tax Act (Ch No 110), s 68(1), is applicable in particular circumstances, the following principles are relevant:
(a)      the two categories of losses and outgoings as “incurred in gaining or producing the assessable income” or “necessarily incurred in carrying on a business for the purpose of producing that assessable income” are not mutually exclusive: the first is directed to expenditure incurred in the actual course of producing assessable income; the second may be concerned with cases where some abnormal event or situation leads to expenditure which is undesired but unavoidable;
(b)      the words “the assessable income” and “that income” refer to assessable income generally of the taxpayer and not to the assessable income of a particular accounting period;
(c)      the phrase “incurred in gaining or producing the assessable income” has been construed to mean “incurred in the course of gaining or producing the assessable income”;
(d)      for expenditure to be an allowable deduction as an outgoing incurred in gaining or producing the assessable income, it must be incidental and relevant to that end, by reference to nature or character rather than frequency or likelihood of use;
(e)      losses and outgoings “necessarily incurred in carrying on a business for the purpose of producing” assessable income require there to be a relation or nexus between the expenditure and the carrying on of the relevant business: the word “necessarily” meaning “clearly appropriate” or “adopted for”;
(f)      the relevant business need not be being actively carried on in the year for which the deduction is sought;
(g)      the question whether interest is actually incurred in gaining or producing assessable income is mainly a question of fact.
Commissioner of Taxation v Total Holdings (Australia) Pty Ltd (1979) 24 ALR 401 at 405-7; (1979) 79 ATC 4279 at 4282-4283, adopted and applied;
(h)      the purpose of incurring the expenditure is relevant to its characterisation.
Commissioner of Taxation v Ilbery (1981) 38 ALR 172 at 180-1; 81 ATC 4661 at 4667-4668, adopted and applied;
(i)       whether losses or outgoings may be expected as “capital” or as being of “a capital nature” requires consideration of: (a) the character of the advantage sought; (b) the manner in which it is to be used, relied upon or enjoyed, and (c) the means adopted to obtain it.
Sun Newspapers Ltd v Commissioner of Taxation (1938) 61 CLR 337 at 359-364 applied;
(j)      how an item of expenditure is treated in the accounts of a taxpayer is not determinative of its true character but it may assist in determining its true nature.
RAC v Insurance Pty Ltd v Commissioner of Taxation (1974) 3 ALR 600; 74 ATC 4169 and Commercial Union Assurance Co of Australia Ltd v Commissioner of Taxation (1977) 14 ALR 651; 77 ATC 4186; Commissioner of Taxation v AGC Ltd (1984) 84 ATC 4642, adopted and applied.
(3)      In the circumstances, the outgoings of interest, rates and rent incurred in the four year prior to the hotel opening for business were incurred “in the course of gaining or producing assessable income” within s 68(1).
(4)      In the circumstances, and despite the accounting practice of the taxpayer, the true nature of the outgoings for interest, rates and rent was of “capital” not of “a capital nature”.
Cases Cited
BP Australia Ltd v Commissioner of Taxation (1965) 112 CLR 386 (Privy Council).
Birmingham and District Cattle By-Products Co Ltd v Inland Revenue Commissioners (1919) 12 TC 92.
Broken Hill Theatres Pty Ltd v Commissioner of Taxation (1952) 85 CLR 423.
Cannop Coal Co Ltd v Inland Revenue Commissioners (1918) 12 TC 31.
Commercial Union Assurance Co of Australia Ltd v Commissioner of Taxation (1977) 14 ALR 651; 77 ATC 4186.
Commissioner of Taxation v Australian Guarantee Corp Ltd (1984) 84 ATC 4642.
Commissioner of Taxation v Hatchett (1971) 125 CLR 494.
Commissioner of Taxation v Ilbery (1981) 38 ALR 172; 81 ATC 4661.
Commissioner of Taxation v Munro (1926) 38 CLR 153.
Commissioner of Taxation v Total Holdings (Australia) Pty Ltd (1979) 24 ALR 401; 79 ATC 4279.
Commissioner of Taxation v Walker (1984) 84 ATC 4553.
Commonwealth Taxation Board of Review decision Case 4 Ref No M127/1965 (1966) 13 CTBR(NS) 23.
Inglis v Commissioner of Taxation (1979) 29 ALR 425; 80 ATC 4001.
Lodge v Commissioner of Taxation (1972) 128 CLR 171.
RACV Insurance Pty Ltd v Commissioner of Taxation (1974) 3 ALR 600; 74 ATC 4169.
Softwood Pulp and Paper Ltd v Commissioner of Taxation (1976) 76 ATC 4439.
Somers Bay Investment Pty Ltd v Commissioner of Taxation (1980) 31 ALR 155; 11 ATR 71.
Sun Newspapers Ltd v Commissioner of Taxation (1938) 61 CLR 337.
Appeal
This was an appeal from refusal by the Chief Collector of Taxes to allow objections to tax assessments issued by him in respect of losses and outgoings for interest, rates and rent over a number of years.
Counsel
D G Hill QC and T Griffiths, for the appellant.
A H Goldberg QC and F G A Beaumont, for the respondent.
Cur adv vult
14 June 1985
BREDMEYER J: These two appeals involve the same points of law and have been heard together by consent. Travelodge Papua New Guinea Ltd hereinafter called “Travelodge” or “the taxpayer” has appealed against the Chief Collector’s assessments for the years ending 31 December 1981 and 31 December 1982 in respect of certain losses or outgoings incurred in the previous seven years.
There is no real dispute on the facts. Travelodge called Henry George Ewing, a leading official of the company, and tendered to me numerous documents relating to the company’s affairs including its financial accounts. These documents, and Mr Ewing’s evidence reveal the following facts. In 1971 the directors of Travelodge Australia Ltd approved a proposal to build a hotel in Port Moresby. It was proposed that Travelodge Australia Ltd would contribute cash and expertise in site selection, design, training and management and would earn development fees on the project and management fees on managing it after the establishment period. In January 1971 the company, Travelodge Papua New Guinea Ltd, was incorporated. In January 1972 the government called for tenders for lease of two blocks of land in Port Moresby for the construction of a hotel to the minimum value of $2 million. In May 1972 Travelodge tendered for the lease of the two blocks and offered a premium of $255,000. In support of its application the company said that Travelodge Australia Ltd was the largest accommodation company in the South Pacific having a number of hotels totalling 5,169 rooms. It said that it would set up a training programme to train local people for the skilled and semi-skilled jobs in the hotel. It proposed to build a hotel at a cost of $4.7 million. The lease was granted and ran from 1 June 1973 although the lease document was not issued and signed until May 1974 and not registered as a Crown lease until 12 July 1974.
On 21 December 1973 Travelodge Papua New Guinea Ltd entered into a management agreement with Travelodge Management Pty Ltd whereby the latter company agreed to construct and develop the hotel and to manage it on behalf of Travelodge Papua New Guinea Ltd.
On 21 March 1974 the company let a contract for stage one of the construction, which was excavations and site works and later in October 1974 a further contract which was for foundations and allied work.
Between February 1975 and January 1976 the company was having difficulty financing the construction of the hotel and negotiations took place with the shareholders with a view to them contributing further equity. Sources of loan finance were also explored. Tenders were let and closed in November 1975. Thereafter, negotiations were entered into with one of the tenderers, Morobe Constructions Pty Ltd, and the contract let to that company on 28 July 1976 for K5.095 million. Loans from four sources totalling K5.7 million were arranged to pay for this.
On 20 February 1978 the company was registered under the National Investment and Development Act 1974 (Ch No 120).
On May 1978 a Mr Bill Gregson was appointed as assistant hotel manager. His initial duties were to supervise the arrival, collection and storage of all hotel furniture and fittings.
The construction reached practical completion on 23 October 1978. The first guest was accepted on 25 October 1978. At that time four floors of bedrooms were available, fitted out and furnished, together with public areas and the mechanical services. An official opening ceremony was held on 24 November 1978.
I note that the company’s intention from 1971 onwards was to build and operate the hotel as part of the Travelodge network of hotels in the South Pacific. There is no suggestion in the evidence that the company planned to build the hotel and then sell it.
In the company’s balance sheets for the years 1974 to 1978 it capitalised the interest, rates and rent prior to the earnings of the income. In note 2 to the accounts for the half year to 31 December 1977 these amounts are shown as follows:
“Leasehold land
...
Expenses capitalised for accounting purposes
Capitalised interest	K209,875	
Rates	48,982	
Rent	49,002”	
The appellant’s main argument is that the capitalised interest, rates and rent incurred prior to the hotel earning income were losses and outgoings under the Income Tax Act (Ch No 110), s 68(1), and, as such, should have been allowable deductions under s 101 of the Act. There is no dispute between the parties that if these expenses were losses and outgoings within the meaning of s 68(1), then they are properly deductible under s 101. So the dispute centres on s 68(1).
The Income Tax Act (Ch No 110), s 68(1), reads as follows:
“s68    Losses and Outgoings
(1)      Subject to ss 68a, 163n, 163u, 163v, 164k, and 164s, all losses and outgoings, to the extent to which they are incurred in gaining or producing the assessable income or are necessarily incurred in carrying on a business for the purposes of gaining or producing that income, are allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital private or domestic nature, or are incurred in relation to the gaining or production of exempt income.”
The section contains two limbs at the beginning of it and an exclusion at the end of it. The section is copied from Australian legislation and there is a great deal of Australian case law interpreting the section. Both counsel in this case relied heavily on the Australian authorities. I know that the common law adopted at Independence in Papua New Guinea is the English common law, nevertheless, only two English cases have been cited to me and I have not found them very helpful or apposite — I discuss them in more detail later — and my own reading of relevant parts of Halsbury’s Laws of England (4th ed, 1978), Vol 23, on income tax has not helped me elucidate this section. Because there is a wealth of Australian authority on the section by eminent judges such as Sir Owen Dixon and others and because the Australian and Papua New Guinean sections are identical, I propose to adopt the principles from those Australian authorities and apply them to the facts in this case. Neither counsel has proposed that I adopt any other course.
A great number of Australian cases have elucidated the meaning of the Australian equivalent to our section and that law has been conveniently summarised by Lockhart J in a 1979 case, Commissioner of Taxation v Total Holdings (Australia) Pty Ltd (1979) 79 ATC 4279, and I propose to borrow his summary from 4282-4283 of that report. In doing so I have omitted the numerous cases he cites for each principle.
1.       The two categories of the section are clearly not mutually exclusive, and it has indeed been said that in actual working the addition of the second category can add but little to the operation of the leading words “losses or outgoings to the extent to which they are incurred in gaining or producing the assessable income”. But there may be cases which fall outside the first category and within the second. The first is directed to expenditure incurred in the actual course of producing assessable income. It is, primarily, concerned with expenditure voluntarily incurred for the sake of producing income. Its scope is not, of course, confined to cases where the income is derived from carrying on a business. The second may be thought to be concerned rather with cases where in the carrying on of a business, some abnormal event or situation leads to an expenditure which is not desired to make, but which is made for the purposes of the business generally and was reasonably regarded as unavoidable.
2.       The words “the assessable income” and “that income” refer to assessable income generally of the taxpayer and not to the assessable income of a particular accounting period.
3.       The phrase in the first limb of the section “incurred in gaining or producing the assessable income” has been construed to mean “incurred in the course of gaining or producing the assessable income”.
4.       For expenditure to be an allowable deduction as an outgoing incurred in gaining or producing the assessable income, it must be incidental and relevant to that end. The phrase “incidental and relevant” when used in relation to the allowability of losses as deductions does not refer to the frequency, expectedness or likelihood or their occurrence or the antecedent risk of their being incurred, but to their nature or character. What matters is their connection with the operations which more directly gain or produce the assessable income.
5.       As to the second limb, it is clear that there must be a relation or nexus between the expenditure and the carrying on of the relevant business.
6.       The word “necessarily” in the second limb means “clearly appropriate” or “adapted for”.
7.       In order to be deductible, a loss which flows from carrying on a business, need not necessarily be incurred in a year when the taxpayer is actively carrying on that business. The loss can occur before or after a year in which assessable income is produced.
8.       The question whether interest is actually incurred in gaining or producing assessable income is one mainly of fact. That question is reduced to a question of fact when once the legal standard or criterion is ascertained and understood. Some kinds of recurrent expenditure made to secure capital or working capital are clearly deductible. Under the Australian system interest on money borrowed for the purpose forms a deduction. So does the rent of premises and the hire of plant. If a taxpayer with a continuing business incurs a liability for interest being incidental to or connected with the operations or activities regularly carried on for the production of income, the interest is an allowable deduction.
I turn now from Commissioner of Taxation v Total Holdings (Australia) Pty Ltd and mention a further principle which I take from the judgment of Toohey J in Commissioner of Taxation v Ilbery (1981) 81 ARC 4661 at 4667-4668 who in return relies on several statements of Brennan J made in the High Court of Australia.
9.       It is important to look at the purpose for the expenditure in deciding whether that expenditure was incidental and relevant to producing the assessable income. The purpose of incurring that expenditure may constitute an element of its essential character stamping it as an expenditure of a business or income-earning kind, or, the purpose may stamp the outgoing as one having no relevant connection with the gaining or producing of assessable income. An outgoing of interest may be incidental and relevant to the gaining of assessable income where borrowed money is laid out for the purpose of gaining that income. The laying out of the borrowed money for the purpose of gaining assessable income furnished the required connection between the interest paid upon it by the taxpayer and the income derived by him from its use.
The facts and decision in the Commissioner of Taxation v Munro (1926) 38 CLR 153 specially at 170-171, illustrate the importance of ascertaining the purpose for which the money was borrowed. In that case a deduction was claimed for interest on £30,000 borrowed on the security income-producing property. £20,000 of the money borrowed was spent on buying shares in another company and £10,000 was lent to that other company free of interest. The purpose of the loan was not to gain further assessable income. The property was producing rent before the borrowing and independently of the borrowing. The borrowing did not produce more rents. The debt was incurred for a purpose wholly unconnected with the production of the taxpayer’s assessable income.
There seemed common agreement between counsel as to what were the leading Australian authorities and the principles which emerged from those cases. There was no argument addressed to me that any of those leading cases was decided wrongly. My task is to apply those principles to the facts of the particular case before me and it was here that counsel differed on how I should do that. Mr Hill QC, senior counsel for the taxpayer, argued that all the interest paid between 1974 and the opening of the hotel to its first guests on 25 October 1978 was an outgoing incidental and relevant to the gaining of assessable income which generated after October 1978. He said that from the incorporation of the company in 1971 onwards the company was committed to building and running an income-producing hotel in Port Moresby and that it never wavered from that course. He says the situation is analogous to a taxpayer who borrows money to build a unit to rent; he normally borrows the money some months in advance of renting the unit. Nevertheless the interest is a deductible outgoing from the moment it begins to run. In the Travelodge’s case the task of building a large hotel of 189 rooms costing over six million dollars must necessarily take much longer. Thus the interval in this case between borrowing and receiving the first guests (and hence income) was four years; but he says there is no difference in principle. The interest was borrowed for the purpose of gaining assessable income. Of course in one sense the interest was paid to produce a capital asset, namely the hotel building. But he says its essential purpose or character was that it was for the hire of the money to construct the asset. In other words the payment of interest was not an outgoing to buy a capital asset, but rather payment by time for the use of the money to construct an income-producing asset. On the other hand, Mr Goldberg QC, counsel for the Chief Collector of Taxes, argued that the interest was incurred for the purpose of establishing a business structure or entity for the earning of profit, that it was a cost of acquiring the capital asset, and that the outgoing was not incurred in the course of gaining or producing assessable income. He argued that the outgoing was related to the structure or organisation set up for the earning of profit and not the process by which such organisation operates to obtain assessable income. He said the outgoing was related to the instrument for earning profits and not the continuous process of its use or employment for that purpose.
Mr Hill was unable to cite any Australian case on identical or very similar facts to the one before me and he said the reason for that was that in Australia the question has been resolved by a ruling of the Federal Commissioner of Taxation, IT 166 “Interest on money borrowed to acquire an income-producing asset”. It appears that this ruling was first issued on 14 December 1967 and reissued on 26 August 1983. I allowed that ruling be handed up to me in argument but of course it is not binding on me. The ruling was in favour of the taxpayer so since then, no one has bothered to take the point to the court for a ruling.
Mr Hill quoted Softwood Pulp and Paper Ltd v Commissioner of Taxation (1976) 76 ATC 4439, a decision of Menhennitt J of the Victorian Supreme Court. Part of the headnote at 4440 reads:
“(1)    The evidence revealed that project planning had never proceeded past a preliminary investigation stage and that neither MacMillan nor the taxpayer had committed itself to the project. This view was supported by the fact that the company’s capital was only £100,000 whereas the contemplated capital cost of the project was between 14 and 15 million pounds.
(2)      The activities undertaken being entirely preliminary and directed at deciding whether or not an undertaking would be established to produce assessable income, it could not be said that the expenses were incurred in the actual production of assessable income.”
At 4447 the judge said:
“Counsel for the taxpayer relied in support of the submission that there was a decision by the taxpayer to go ahead with the company on the terms of the agreement ratified by the South Australian Act of Parliament, but an examination of that agreement makes it clear that the taxpayer was not committed under the agreement to go ahead and on the contrary, whilst it was said that it would do certain things, it was given a very clear let out, which it in fact availed itself of.
...
I reiterate my finding that the taxpayer never committed itself to go on with the project, never made a final definitive decision to do so.”
Mr Hill quoted a number of cases where the facts are not similar to the facts before me but which he said were analogous and he asked me to extract principles from them and apply them to give the deduction under s 68(1) for which he contended. I do not think it necessary to discuss those cases, some of which went one way and some of which went the other but I mention them here: Inglis v Commissioner of Taxation (1980) 80 ATC 4001; Commissioner of Taxation v Ilbery (1981) 81 ATC 4661, and Commissioner of Taxation v Walker (1984) 84 ATC 4553.
Mr Goldberg quoted numerous authorities but four in particular, two English ones and two Australian ones, he said were most persuasive and strongly supported the Chief Collector’s assessment. I propose to deal with these cases in some detail. The two English cases were: Birmingham and District Cattle By-Products Co Ltd v Inland Revenue Commissioners (1919) 12 TC 92, a decision of Rowlatt J and Cannop Coal Co Ltd v Inland Revenue Commissioners (1918) 12 TC 31, a decision of Sankey J. These two cases concerned excess profits duty assessed under a special wartime Act, the Finance (No 2) Act 1915 (5 & 6 Geo, 5 Ch 89) (Imp), designed to produce more revenue for the State during World War I. Mr Goldberg urged me to ignore the legislation involved in these two cases, because it is different from our own, but to adopt the principle involved and indeed the principle involved in the Birmingham Cattle case was cited with approval by Menhennitt J in Softwood Pulp and Paper Ltd v Commissioner of Taxation (1976) 76 ATC 4439 at 4451. I do not think it is possible to do that because in order to understand the principle involved one has to look at the legislation to ascertain the issue which the judge had to decide. The Act provided that if wartime profits were higher than pre-war profits then an excess profits duty of fifty per cent was payable. The Act provided a number of ways of ascertaining pre-war profits. In each case it was necessary to ascertain if the taxpayer was “carrying on a trade or business whether continuously or not” pre-war (s 38 and s 39) and, if so, over what periods. In the Birmingham Cattle case, the company was incorporated on 20 June 1913 to process by-products, bone, fat, offal etc, from a number of butchers’ shops. In June it entered into a contract for the erection of works. In July 1913 it erected works. Plant machinery was purchased and installed. Contracts were entered into with butchers for the supply of products and for the sale of the company’s products. In August 1913 a foreman was employed and on 6 October 1913 the company produced its first products. Rowlatt J upheld the Tax Commissioners’ finding that the carrying on of the trade or business commenced in October 1913 and not in June. All that went on before October was preparatory.
In the Cannop Coal case the Tax Commissioners found that the company was carrying on business three years before the war, that is, between 30 June 1912 and 30 June 1914, and the company argued on appeal that it was only carrying on business for two years before the war. The company was incorporated in 1906. It acquired land and commenced digging pits in 1906. The work proceeded slowly. In 1908 the pit sinking was retarded by water. In 1909 and 1910 faults were encountered, in 1910 the pumps failed to act, in 1911 there was a strike, further faults were met with in 1912 and a national strike also occurred in that year. In 1908 the company dug a drift (that is, a sloping shaft) 400 yards distant from the pit shaft. The drift was dug to gain coal to work the pit-sinking machinery. The drift however yielded far more coal than was anticipated and needed for the pit-sinking machinery so the surplus coal obtained from the drift was sold. That coal was sold in 1909 and every year thereafter. The pit shaft itself was completed in late 1911 and coal was first produced from it on 1 April 1912. Substantial sums of money were made from the sale of coal from the drift in the calendar years 1909, 1910, 1911 and thereafter from the sale of coal from both the pit and the drift.
The company argued that it was not carrying on its trade or business three years pre-war because the company was formed to mine coal by means of pits and not by means of a drift and that the pit only produced coal in 1 April 1912. The argument was not accepted. Sankey J held that the trade or business of the company was to obtain coal, and not to obtain coal by means of pits, so that it was carrying on its trade or business in those pre-war years.
Both cases are explicable and, I suggest, correctly decided on the English Act. The first company did not commence its trade until the first sausage was produced; the second commenced its trade when it first obtained and sold coal. By analogy from these cases Travelodge commenced its business as a hotel when the first guest was accepted on 25 October 1978. But the question before me is not, When did the taxpayer commence carrying on its business; because, an outgoing can be deductible under the first limb of s 68(1) even though no business is carried on, and, under principle 7 (supra) an outgoing can be deductible although it was paid before or after any income was earned?
The first of the two Australian cases Mr Goldberg strongly relies on is Case 4 ref M127/1965 (1966) 13 CTBR(NS) 23. That was a decision of the Commonwealth Taxation Board of Review, one of whose members, Mr J D Davies, is now Davies J of the Federal Court of Australia. I quote the headnote:
“Taxpayer, a salaried employee, acquired property A, which was in a state of disrepair, in 1958 for the purpose of setting himself up in the business of apartment house or bed-and-breakfast establishment. Necessary repairs and renovations proceeded slowly, and while these were being carried out industrial development in the area made the situation of the property unsuitable for the purpose.
In June 1961 taxpayer acquired property B, which was also in a state of disrepair but was more suited to his purpose than property A, which he sold at a profit in August 1962. Taxpayer proceeded to bring property B into repair, but again work proceeded only slowly. Although in August 1964 £15 was received from letting, it was not until September 1965 that the premises were formally opened as a bed-and-breakfast establishment. Taxpayer claimed as deductions from his assessable income of the year ended 30 June 1962 insurance of £6 on each of the two properties and interest on moneys borrowed to acquire them, £88 in respect of property A and £297 in respect of property B, but the claims were not allowed by the Commissioner.
Held, disallowing taxpayer’s claims: the amounts were capital costs of establishing a business.”
Dealing with the taxpayer’s argument that his claimed outgoings were deductible under either limb of the subsection (equivalent to our s 68(1)), the Board said the expenditure claimed in each case was properly characterised, not as a revenue expenditure which is deductible from assessable income, but as part of the non-deductible cost of setting up the business from which the income was derived. The Board said that the distinction between a revenue outgoing and a capital cost of establishing a business, depends upon matters of degree. It said that the characterisation of a particular payment depends upon the application of broad principles to the particular payment rather than upon the application of precise or definitive tests. Applying these principles the Board said that there was a great time lag between the acquisition of the properties and the setting up of the business and it was a time lag not occasioned by some extraordinary event but was foreseen and anticipated when the properties were acquired. The Board mentioned that the moneys claimed on property A were taken into account when the taxpayer sold it at a profit. It is also of some significance that the taxpayer was a salaried employee: being a boarding house keeper was not his sole business.
I think that case is clearly distinguishable from the present one. Although the Board did not say so, it would have been open for it to find that the taxpayer was not obviously and unambiguously engaged in business. He may have bought and repaired either or both properties with a view to establishing a boarding house or to selling them at a profit. In the present case I consider Travelodge clearly intended throughout the relevant period 1974-1977 to build and operate a hotel and the time lapse was not inordinately long for the planning, construction, fitting-out and staffing of large luxury hotel in a third world country where the hotel was the first of its kind.
The second Australian case strongly relied on by Mr Goldberg for the Chief Collector of Texas was Somers Bay Investments Pty Ltd v Commissioner of Taxation (1980) 11 ATR 71, a decision of Jones J of the Western Australian Supreme Court. The taxpayer was a joint venturer in the building of a large office building in Perth. The joint ventures took out a contractor’s “All Risk” policy which was really two policies: one against the risk of material damage during construction and the other a public risk liability policy. The cover extended during the construction of the building and twelve months after the date of practical completion. It was a single premium policy although payable in two parts. The taxpayer’s share of the total premium was two payments totalling $21,391. He claimed them as a deduction in the 1974 tax year. During that year the building was under construction and not returning any rents but the company owned other properties which were returning rents, that is, assessable income. Jones J held that the premium payment was an outgoing incurred in carrying on a business for the purpose of gaining or producing assessable income (the second limb of the section), but held that it was caught by the exclusion in the latter part of the section in that it was “an outgoing of a capital nature.” His Honour held at 74-75 that the company, by paying the premium, gained the protection of its interest during the construction of the new building in which it had a share. The building when completed would constitute a fixed capital asset. The payment was a once and for all payment and the term of the policy for a limited period. Thereafter any insurance policy taken out would require the recurring payment of premiums and would obviously be deductible outgoings. His Honour said:
“The payment of the premium was, in fact integrally connected with the establishment of the capital asset, the new building. It was clearly, in my opinion, payment directly connected with an expenditure of capital and was therefore an outgoing of a capital nature.”
I will refer to this case again when I consider the exception in s 68(1) that the outgoing of interest etc was “of capital, or of a capital nature”.
I consider that the outgoings of interest, rates and rent incurred in the period 1974 to 1978 prior to the hotel opening were incurred in the course of gaining or producing assessable income. I consider that those outgoings, correctly understood, should be characterised as incidental and relevant to the production of that income. I consider that the payments of interest were payments for the use of money to build the hotel and that the payments of rent and rates were paid for the use of the land. The interest was paid for the “hire” of the money and the rent and rates paid for the “hire” of the land. I consider that all these outgoings properly fall under the first limb of s 68(1).
As I have found for the taxpayer under the first limb of the subsection it is not necessary for me to decide if the expenditure on rent, rates and interest in 1974-1977 comes under the second limb. If the taxpayer’s business was running a hotel then clearly it was not carrying on a business until October 1978 when the first guest arrived, or perhaps a month or two before when the rooms were fitted out and staff being trained, so the outgoings mentioned were not incurred in the course of carrying on a business to produce assessable income. If, on the other hand, the taxpayer’s business, correctly understood, was the construction and running of a hotel then it was carrying on a business much earlier. I consider it unnecessary to decide the point.
OUTGOINGS OF CAPITAL, OR OF A CAPITAL NATURE
I consider now the exception in the latter part of s 68(1). The leading statement on the law on this topic, on the distinction between expenditure and outgoings on revenue account and on capital account is found in the judgment of Sir Owen Dixon in Sun Newspapers Ltd v Commissioner of Taxation (1938) 61 CLR 337 at 359-364. The passage is far too long to quote in full. Mr Goldberg relies heavily on this passage and urges me to follow its distinctions. Referring to 360 and applying it to the facts of this case, Mr Goldberg says that the construction of the hotel is the establishment of a “profit-yielding subject”. It is an “instrument for earning profits” and expenditure on the establishment of that subject is entirely different from the continual flow of working expenses on the use or running of the enterprise. I quote a short much-cited passage from the judgment at 363.
“There are, I think, three matters to be considered: (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.”
At 363-364, Dixon J applies the principles he has enunciated to the facts of the case before him and concludes (at 364) that the payment of £86,500 to buy out a newspaper to eliminate competition:
“... must be regarded as strengthening and preserving the business organisation or entity, the profit-yielding subject, and affecting the capital structure.”
As with the first two limbs of s 68(1), there is no dispute between counsel for the respective parties over the relevant principles but rather the application of those principles to the facts of the case before me and I regard the cases cited to me, later in time to Sun Newspapers, as example of how those principles have been applied.
I agree with Mr Goldberg that the Total Holding’s case (supra) does not assist the taxpayer much. In that case the taxpayer company claimed a deduction of interest paid to its French parent company on money borrowed although it on-lent that money to an Australian operating company free of interest. In that case the taxpayer company was already in business compared to Travelodge which arguably was not engaged in business until October 1978. That case is not of much relevance on this topic as it mainly turned on the first two limbs of the section and not the question of whether the outlay was of a capital nature. Lockhart J at 4,283 drew a distinction between interest paid by a taxpayer as a prelude to commencing a business which gains income, which may not be deductible, and interest paid as a recurrent expense to further the current or prospective income-producing activities of the enterprise. That is a useful and obvious distinction — between interest paid as a prelude to starting a business and interest paid on working capital during the course of running the business. The judge there was concerned with interest paid by a taxpayer already actively in business, so what he said about interest paid as a prelude to commencing a business was obiter; and, as I have said (supra), the judge was concerned with the two limbs of the section — whether the payment was incidental and relevant to the gaining of income and formed part of the company’s business activities. Lockhart J cited two cases as examples of “prelude” or preliminary payments which are not deductible. They are Lodge v Commissioner of Taxation (1972 128 CLR 171, which concerned the payment of nursery fees by a working mother, and Commissioner of Taxation v Hatchett (1971) 125 CLR 494, which concerned university fees paid by a school teacher who was engaged in university studies in his spare time. I consider those cases of no use to me because I consider that their facts are too different from the facts of the present case.
BP Australia Ltd v Commissioner of Taxation (1965) 112 CLR 386 (Privy Council) is an interesting case because it shows how different courts applying the same principles to similar facts can reach different conclusions. The facts in that case were that BP paid once and for all sums to service station owners to tie them to sell BP petrol exclusively. The facts were thus similar to those in the Sun Newspapers case where the Sun paid cash to buy out its competitor, and, applying the principles of Sun Newspapers case, I would have expected the same result. Indeed the majority of the High Court of Australia (in 110 CLR 387), presided over by Dixon CJ, followed Sun Newspapers and ruled that the payments were of a capital nature and hence non-deductible. On appeal the Privy Council (112 CLR 386, especially at 394) approved generally of the judgment of Dixon J (as he then was) in Sun Newspapers but went on to apply his principles differently to find that the expenditure was of revenue and was not of a capital nature.
In considering whether the outgoings were of a capital nature Mr Goldberg has based an argument on the accounts. In Travelodge’s accounts from 1974 to 1978 the amounts of interest incurred were capitalised and the interest, rent and rates were shown in the balance sheets as fixed assets. The capitalised interest was depreciated from 25 October 1978. Mr Goldberg argued that this was an admission or acknowledgement by the company that these outgoings were of a capital nature and not revenue.
Mr Goldberg argued that the way an item of expenditure is treated in the accounts is not determinative of its true character or nature where that treatment is contrary to legal principle. But where, as here, the accounting treatment of an item is not contrary to legal principle, the way the company has chosen to treat the item is an admission or acknowledgement of the true facts. Mr Goldberg referred to a number of authorities to support this argument. He cited a paragraph from a joint judgment of Dixon CJ and three others in Broken Hill Theatres Pty Ltd v Commissioner of Taxation (1952) 85 CLR 423 at 434-435 and a paragraph from the Privy Council in the BP case (112 CLR 386 at 403). I consider both those passages inconclusive and not authorities for the propositions argued. Mr Goldberg gained much stronger support from RACV Insurance Pty Ltd v Commissioner of Taxation (1974) 74 ATC 4169, a decision of Menhennitt J. In that case the taxpayer, an insurance company, claimed a deduction inter alia for “unreported claims”, that is, claims which were not made to the company in the tax year but which it estimated, based on past experience, would be made to the company in later years for accidents which occurred in that year. Accounting and insurance evidence was given that to allow for such claims as an “expenditure” was a long established practice with insurance companies. The claimed deduction was allowed on appeal and the case does support the view that it is proper to have regard to established insurance and accountancy practices to determine the character of an outgoing. Further support for that view is that found in Commercial Union Assurance Co of Australia Ltd v Commissioner of Taxation (1977) 77 ATC 4186 and Commissioner of Taxation v Australian Guarantee Corporation Ltd (1984) 84 ATC 4642. I conclude from these cases that how an item of expenditure is treated in the accounts of a taxpayer is not determinative of its true character but it may assist in ascertaining its true nature. In addition, evidence of accountancy practice not only of the particular taxpayer but in the taxpayer’s industry may also assist, indeed it may greatly assist, the court in its task of ascertaining the true character of the items. In this case I have the taxpayer’s accounts for 1974-1982 and they show that the outgoings were capitalised in the pre-opening period and I will take that into account. Although I allowed counsel to hand up a number of accountancy works in argument I do not regard them as evidence of practice within the industry. It is not the kind of evidence given in the RACV case for example and I propose to ignore it.
I regard Travelodge’s accounts as an admission or acknowledgement that it treated the sums in dispute as outgoings of capital but that does not prevent the company now arguing that it should be treated as revenue outgoings. It does not stop the company from so arguing. The accounts are against the company’s argument. They are part of the whole scene which I must consider to determine a correct characterisation of the payments.
I consider now the three matters which Dixon J in Sun Newspapers at 363 said should be considered and apply them to the facts before me.
1. What is the character of the advantage sought by the payment?
The answer is the interest paid was to service the loan obtained to build the hotel; and the rent and rates (which were smaller sums) were paid to “service” the lease and the land. According to the company accounts a premium of $255,000 had been paid to obtain the lease and the annual rent of $14,000 was obviously paid to keep the land to stop the lease being forfeited. The rates too were to pay for services provided to the land by the City Council.
According to Halsbury’s Laws of England (4th ed, 1978), Vol 23 par 524, “interest” has been variously judicially defined as: a payment by time for the use of money; compensation for delay in payment; recompense to a creditor for being deprived of the use of his money; and the creditor’s share of the profit the debtor is presumed to make from the use of money. Of these I prefer the first definition as the simplest and best. The interest paid was a payment made for the use of money borrowed to build the hotel, or money paid to service the loans used to build the hotel which is, of course, a capital asset. That is not saying the interest paid is money paid out to build the hotel. The interest paid is different in kind from money paid, for example, to the builder to build the hotel — which payment is essential to the erection of the capital asset. Unless the builder is paid he will not build the capital asset. On the other hand, the payment of interest is not, of itself, essential to the creation of the asset because if the company had sufficient funds it could build the hotel without borrowing. I note too that the payment of interest does not enhance the value of the asset. The hotel, when erected, was worth $6,000,000 (or whatever); it was worth no more because it was built with borrowed funds.
2. What is the manner in which the advantage is to be used, relied upon, or enjoyed?
The advantage of the payment of interest was that the loan would not be called up and hence the hotel would be erected. The advantage of payment of the rent and rates was that the lease would not be forfeited nor the land compulsorily sold for non-payment of rates. That advantage is really of quiet enjoyment of the land, enjoyment of the land so that the hotel could be built and, in later years, could operate and produce profits.
Dixon J in the Sun Newspapers case at 363 said, “Under this heading recurrence may play its part”. The significance of recurrence is, as the Privy Council said in the BP case at 399:
“As a very rough criterion, capital expenditure is a thing that is going to be spent once and for all and income expenditure is a thing that is going to recur every year.”
3. What is the means adopted to secure that advantage?
In elaborating the meaning of this matter, Dixon J at 363 in effect asked, was the means adopted a periodic outlay to secure the enjoyment of the advantage for a period commensurate with the payment, or, was it a final provision or payment so as to secure the future use or enjoyment of the advantage?
This third matter may have been of value in the situation before the court in the Sun Newspapers and BP cases but, in the present case, it is of little use as it seems to duplicate matter 2. The answer is that these payments of interest, rent and rates paid to service the loan and to secure the taxpayer’s continual occupation of the land were periodic recurring payments.
The Somers Bay case lies directly in the path of the taxpayer’s submissions in this case. I have already quoted the facts and the decision of Jones J that the CAR policy was of a capital nature. I consider that decision was partly wrong in that part of the premium was to purchase protection against public liability, and that was a recurring need and liability. Presumably when the CAR policy expired the taxpayer jointly with the other co-owners would purchase a public liability policy and pay the premiums year after year. Alternatively the Somers Bay case is distinguishable. The interest etc paid in this case was a recurring expenditure and, in its true character, it was paid to service the money borrowed and was not so integrally connected with the creation of the capital asset that it amounted to payments of a capital nature.
I consider that, despite the accounting practice of the taxpayer, the true nature of the disputed outgoings in this case was not of capital and was not of a capital nature. I conclude that the disputed sums properly fall under the first limb of s 68(1) and are not caught by the exclusion in the latter part of the section.
In view of my decision on s 68(1) it is not necessary for me to consider the taxpayer’s alternative argument for depreciation under s 75(2). My finding on s 68(1) in favour of the taxpayer means that the penalty of K5,982 imposed in the assessment issued for the 1981 tax year cannot stand.
The appeals will be allowed. I grant liberty to apply as to costs and the form of the orders to issue.
Orders accordingly
Lawyer for the appellant: Beresford Love, Francis & Co.
Lawyer for the respondent: B O Emos, State Solicitor.