Federal Court Allows Full Interest Deductions for Annuity Purchases

OUTCOME: Allowed

CATCHWORDS INCOME TAX - Allowable deductions - [NAME] formed to acquire units in trust - Trust established to purchase annuities - Interest incurred on money borrowed to effect purchase - [NAME] entitled to deduction for interest - Whether interest incurred in gaining or production of exempt income - Annuity payments - Whether exempt income of trust - Deductible amount in relation to purchased annuity - Whether exempt income - Whether capital - [NAME] derived exempt income - [NAME] had individual interest in exempt income of [COMPANY] exempt income taken into account in calculating net income of [COMPANY]. Income Tax Assessment Act 1936, ss27H, 51(1), 95(1), 97(1)(b)(i) [NAME] and [COMPANY] v Federal Commissioner of Taxation (1959) 100 CLR 537 [NAME] v [NAME] (1934) 51 CLR 568 Foley v Fletcher (1858) 3 H & N 769; 157 ER 678 [COMPANY] v Federal Commissioner of Taxation (1993) 42 FCR 535 [NAME] v Federal Commissioner of Taxation (1991) 173 CLR 264 Federal Commissioner of Taxation v [NAME] (1943) 68 CLR 199 Federal Commissioner of Taxation v [NAME] (1978) 21 ALR 625 [NAME] v Federal Commissioner of Taxation (1938) 59 CLR 787 [NAME] v Federal Commissioner of Taxation (1954) 90 CLR 598 [NAME] v Federal Commissioner of Taxation (1933) 48 CLR 1

[COMPANY] [COMPANY] v THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA VG 157 of 1996 and VG 158 of 1996 COURT: Lockhart, Carr and Sundberg JJ PLACE: [NAME]: 2 June 1997

IN THE FEDERAL COURT OF AUSTRALIA ) VICTORIA DISTRICT REGISTRY ) No VG 157 of 1996 [APPELLANT] ) BETWEEN: [COMPANY] Appellant AND: THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Respondent COURT: Lockhart, Carr and Sundberg JJ DATE: 2 June 1997 PLACE: [APPELLANT] [ADDRESS] orders that:

1. The appeal be allowed.

2. The [APPELLANT] of [NAME] made 18 March 1996 be set aside.

3. The matter be remitted to the respondent for re-assessment in accordance with the Court's reasons for judgment.

4. The respondent pay the appellant's taxed costs of the appeal.

5. The parties bear their own costs of the proceedings before [NAME] on 11 September 1995. Note: Settlement and entry of orders is dealt with in [APPELLANT] 36 of the Federal Court Rules.

IN THE FEDERAL COURT OF AUSTRALIA ) VICTORIA DISTRICT REGISTRY ) No VG 158 of 1996 [APPELLANT] ) BETWEEN: [COMPANY] Appellant AND: THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Respondent COURT: Lockhart, Carr and Sundberg JJ DATE: 2 June 1997 PLACE: [APPELLANT] [ADDRESS] orders that:

1. The appeal be allowed.

IN THE FEDERAL COURT OF AUSTRALIA ) ) VICTORIA DISTRICT REGISTRY ) No VG 157 of 1996 ) No VG 158 of 1996 [APPELLANT] ) ON APPEAL FROM A JUDGE OF THE FEDERAL COURT OF AUSTRALIA BETWEEN: [NAME] [APPELLANT] Appellant AND: THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Respondent COURT: Lockhart, Carr and Sundberg JJ DATE: 2 JUNE 1997 PLACE: [NAME] FOR

JUDGMENT LOCKHART J. I have had the benefit of reading the reasons for judgment of [NAME] J with which I agree. I also agree with the orders proposed by his Honour. I certify that this [APPELLANT] is a true copy of the reasons for judgment herein of the Honourable Justice Lockhart. Associate Dated: 2 June 1997

IN THE FEDERAL COURT OF AUSTRALIA ) VICTORIA DISTRICT REGISTRY ) No. VG 157 of 1996 [APPELLANT] ) No. VG 158 of 1996 On appeal from a Judge of the Federal Court of Australia BETWEEN : [NAME] [APPELLANT] Appellant AND : THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Respondent CORAM: [RESPONDENT], CARR & SUNDBERG JJ. DATE: 2 JUNE 1997 PLACE: [NAME] FOR

JUDGMENT CARR J: I agree with the reasons for judgment of Sundberg J and the orders proposed by him. I certify that this [APPELLANT] is a true copy of the Reasons for Judgment of Justice Carr. Associate: Date: 2 June 1997

IN THE FEDERAL COURT OF AUSTRALIA ) VICTORIA DISTRICT REGISTRY ) No VG 157 of 1996 [APPELLANT] ) No VG 158 of 1996 BETWEEN: [COMPANY] Appellant AND: THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Respondent COURT: Lockhart, Carr and Sundberg JJ DATE: 2 June 1997 PLACE: [NAME]

REASONS FOR

JUDGMENT SUNDBERG J: Background The appellant ("the [NAME]") and Australia and [APPELLANT] were the two members of a [NAME] known as [COMPANY] [NAME] No 17. The [NAME] was formed to acquire units in a trust known as the [COMPANY] established by deed dated 29 April 1986 for the purpose of purchasing annuities to be issued by the [COMPANY]. The [NAME] subscribed for 50,000,001 B class units at one dollar each. The partners borrowed the bulk of the subscription money and incurred a liability for interest thereon.

Pursuant to agreements with the [COMPANY] the trustee acquired three annuities and received payments thereunder. In each of the years of income ended 30 September 1986 and 30 September 1987 the [NAME] claimed a deduction for a share of a [NAME] loss calculated on the basis that the [NAME] was entitled under s51(1) of the Income Tax Assessment Act 1936 to a deduction for the interest upon the borrowed money, and under [NAME] to exclude from the net income of the trust the "deductible amount" on the ground that each of the agreements was an annuity. The Commissioner disallowed the claims. On the [NAME]'s objections, the Commissioner took the view that the annuities were "qualifying securities" within s159GP of the Act, which allowed him to include an amount in the net income of the [COMPANY] on an accruals basis. This amount was then included in the income of the [NAME]. The Commissioner allowed the interest deductions he had previously disallowed. The [NAME]'s appeals to this Court ([NAME]) were dismissed: (1992) 92 ATC 4630. His Honour held that none of the agreements was a contract for the purchase of an annuity, but that together they were a contract of loan. On the [NAME]'s appeals to the [ADDRESS] ([NAME] and [NAME] JJ), it was held that the agreements were annuities, and that [NAME] applied to the payments made under them: (1993) 42 FCR 535. [ADDRESS] was of the view that [NAME] was a code for the taxation of annuities, intended to take annuities out of the general provisions of s25 and to include in assessable income only the income portion of an annuity instalment, treating as exempt income a part of the annuity representing the return of the purchase price of the annuity included in the definition of "deductible amount". [ADDRESS] held by majority that it lacked jurisdiction to entertain the Commissioner's contention that if [NAME] applied to the ascertainment of the assessable income of the [NAME], the amounts allowed as deductions under s51(1) should not have been allowed in full, but should have been apportioned on the ground that the interest incurred by the [NAME] was in part incurred in gaining or producing exempt income. The High Court held that this Court had jurisdiction to entertain the Commissioner's contention, and declared that the [NAME]'s assessable income was to be calculated by reference to [NAME], and that the net income of the [NAME] was to be calculated after determination of the [NAME]'s allowable deductions. It remitted to this Court for consideration the deductions allowable to the [NAME] under s51(1). That issue came before [NAME] who held that some part of the interest paid by the [NAME] in each year was incurred in relation to the gaining or production of exempt income of the [NAME], and that there should be an apportionment of the interest into its deductible and non-deductible parts. The parties agreed upon a formula to effect the apportionment. The [NAME]'s claim on the present appeals is that no part of the interest was incurred in relation to the gaining or production of exempt income, and that the whole of the interest is deductible under s51(1). The legislation So far as relevant to the present case s51(1) provides that 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 purpose of gaining or producing such income are allowable deductions "except to the extent to which they ... are incurred in relation to the gaining or production of exempt income". Section 27H(1)(a) provides that a [NAME]'s assessable income includes the amount of any annuity derived by the [NAME] during the year of income excluding, in the case of an annuity that has been purchased, any amount that, in accordance with the succeeding provisions of this section, is the deductible amount in relation to the annuity in relation to the year of income .... The "succeeding provisions" direct that the "deductible amount" is to be calculated in a way which is designed to identify so much of the capital component of an annuity payment as has not been, and will not be, an allowable deduction or the subject of a rebate. The expression "assessable income" is defined as "all the amounts which under the provisions of this Act are included in the assessable income". The expression "exempt income" is defined as "income which is exempt from income tax and includes income which is not assessable income". Did the trust derive exempt income? The [NAME] submitted that [NAME] taxes the whole of an annuity payment. It does not apportion a payment into an assessable income component and an exempt income component.

Accordingly, it was said, no part of the payment is exempt income, with the result that the whole of the interest charges is deductible because the whole was incurred in gaining the [NAME]'s assessable income. Reliance was placed on passages from the judgment of [NAME], with whom [NAME] agreed, in [NAME] and [COMPANY] v Federal Commissioner of Taxation (1959) 100 CLR 537. The [NAME], an Australian resident, held as part of its life assurance [NAME] investments in certain United Kingdom securities, the income from which was paid and payable there. In that country income tax had been imposed on "[s]uch portion ... of the income ... as bears the same proportion to the total income from those investments as the amount of premiums received in that year from policy holders resident in the United Kingdom ... bears to the total amount of the premiums received by" the [NAME]: Income Tax Act 1918, Schedule D, Case III, r 3. Section 23(q) of the (Australian) Act exempted from income tax "income derived by a resident from sources out of Australia, where that income is not exempt from income tax in the country where it is derived". [NAME] J, at 550, said: If you impose tax on a proportion of x, you are taxing x, and if x includes y, you are taxing y. In other words, as my brother [NAME] put it during argument, if you impose a tax on 10 per cent of an amount which includes several items, then you are imposing a tax on every item which is included in that amount. At 555 his Honour said: It is true, of course, that r 3 ... does not in terms charge with tax the whole of that interest, but only a specified proportion (2.888 per cent) of that whole. But it does not follow that only that percentage of that whole is to be regarded as "not exempt from income tax" for the purposes of s23(q). It is not possible to say that any identifiable part of the total sum is taxed, and that an identifiable remainder is "exempt". It is not possible to attribute or appropriate the United Kingdom tax paid by the company to any specific part or portion of the total interest from the four classes of security in question. The tax was calculated by reference to a percentage of the total sum, but it was not paid on any specific part of that total sum. ...

The burden cannot be distributed in any way which will leave it resting not on the whole, but exclusively on some severable part, of the interest received. The whole, therefore, is "not exempt". The effect of [NAME](1)(a) is that the deductible amount in relation to a purchased annuity is not included in the assessable income. It is "income which is not assessable income" for the purposes of the definition of "exempt income".

Accordingly, the deductible amount is exempt income, and the [NAME]'s contention that no part of the annuity payments is exempt income must be rejected. Unlike r 3 considered in [NAME], [NAME] does not impose tax on a proportion of an amount, so as to tax the whole amount. It taxes a specific part of the whole and leaves the balance free of tax. The [NAME] then argued that the "deductible amount" is treated by the Act as capital rather than income, and so could not be "exempt income" for the purposes of s51(1). Counsel submitted that the history of [NAME] and its forbears supports the view that [NAME] treats the deductible amount as capital. When Commonwealth income tax was introduced in 1915, the legislation defined "income" without mentioning annuities. The 1922 Act contained a general definition of "income" which included various items and excluded others. One of the excluded items was "that part of [a purchased] annuity which represents the purchase price". In the 1938 Act the definition of "income" was omitted. Section 26(c) included in the assessable income "the amount of any annuity, excluding, in the case of an annuity which has been purchased, that part of the annuity which represents the purchase price to the extent to which that price has not been allowed or is not allowable as a deduction in assessments for income tax ...". In 1954 s26(c) was replaced by s 26AA, sub-s(1) of which included in the assessable income "the amount of any annuity, excluding, in the case of an annuity which has been purchased, that part of the amount of the annuity which represents the undeducted purchase price". Section 27H replaced s26AA in 1984. On the basis of this history, counsel submitted that when annuities became the subject of specific provision, the only part of a purchased annuity which was regarded as income for the purposes of the Act was the amount of the annuity after excluding that part which represented the undeducted purchase price. The successive provisions, it was said, did not speak of the non-included portion as income, exempt or otherwise, but recognised it as representing a return of capital. Reference was made to the second reading speech of the Treasurer on the introduction of s26AA, in which it was said that "The principle is recognised that purchased pensions and annuities comprise two elements - interest on the sum invested, and a return of the purchase price". Reliance was also placed on the observation of the High Court in [NAME] v [NAME] (1934) 51 CLR 568 at 574 that "every annual payment on account of an annuity may be considered to be composed of a proportion of the principal invested in the annuity and an amount of interest borne by the principal". Counsel accepted that at common law all the instalments of an annuity have the character of income: Foley v Fletcher (1858) 3 H & N 769; 157 ER 678; [NAME] v [NAME] (1934) 51 CLR at 572-573; [COMPANY] v Federal Commissioner of Taxation (1993) 42 FCR at 555-557, 563. The question is whether [NAME] disturbs this position. The section and its predecessors seem to me to be quite neutral on the characterisation of the excluded part. The whole of an annuity payment is not part of the assessable income; only part of it is. The part that is not included is not described as capital. It is simply not part of the assessable income. The observations of [NAME] and [NAME] JJ in [NAME] (1934) 51 CLR at 573 on the definition of "income" in the 1922 Act (part of the history counsel relied on) support the view that the exclusion from the definition of part of a purchased annuity does not alter the common law character of that part. Their Honours said: The Commonwealth Income Tax Assessment Act 1922-1933 contains no explicit provision which includes annuities in the assessable income. But par.(d) of the definition of "income" in sec.4 necessarily implies what indeed would follow from the character of an annuity, that the annual payments are income; for it expressly excludes so much of the annual payments as represent the purchase price of an annuity that is purchased. The passage from the joint judgment relied on by the [NAME] to the effect that every annual payment may be considered to be composed of a proportion of the principal and an amount of interest, does not, when read in its context, assert that every annuity consists partly of capital and partly of income. The passage I have quoted shows that the sentence relied on assumes that the annual payment is income, but says that having regard to the nature of an annuity contract, part of the payment can be seen to represent a return of capital. [ADDRESS] in the earlier consideration of the present case appears to have had no doubt on the matter. [NAME] J, with whom the other members of the Court agreed, said at 563: At common law the whole of the instalments of the annuity have the character of income and thus fall within s25(1). Section 27H is intended to take annuities out of the general provisions of s25 and include in assessable income only the income portion of the annuity instalment, treating as exempt income a part of the annuity representing the return of the purchase price of the annuity (if any) included in the definition of "deductible amount". The emphasis is mine. Did the [NAME] derive exempt income? The [NAME] was [NAME] of the [COMPANY]. Any derivation of an amount of exempt income by the [NAME] as a [NAME] could occur only as a result of s97(1)(b)(i). Section 97(1), in its application to a resident [NAME], provides: Where a [NAME] of a [COMPANY] who is not under any legal disability is presently entitled to a share of the income of the [COMPANY] - (a) the assessable income of [NAME] shall include - (i) ... that share of the net income of the [COMPANY] ... ... (b) the exempt income of [NAME] shall include - (i) ... the individual interest of [NAME] in the exempt income of the [COMPANY] ... .... except to the extent to which the exempt income to which that individual interest relates was taken into account in calculating the net income of the [COMPANY]. In [NAME] v Federal Commissioner of Taxation (1991) 173 CLR 264 at 271 the High Court said: a [NAME] is "presently entitled" to a share of the income of a [COMPANY] if, but only if: (a) [NAME] has an interest in the income which is both vested in interest and vested in possession; and (b) [NAME] has a present legal right to demand and receive payment of the income, whether or not the precise entitlement can be ascertained before the end of the relevant year of income and whether or not the trustee has the funds available for immediate payment. Under s95A(2) a [NAME] who has a vested and indefeasible interest in any of the income of a [COMPANY], but is not presently entitled to that income, is deemed to be presently entitled to it. Did the [NAME] have an "individual interest ... in the exempt income of the [COMPANY] ..."? The words "individual interest" mean the interest to which a [NAME] is solely entitled as contrasted with his joint interest in the whole of the income: Federal Commissioner of Taxation v [NAME] (1943) 68 CLR 199 at 204 per [NAME]; Federal Commissioner of Taxation v [NAME] (1978) 21 ALR 625 at 646 per [NAME]. The [NAME]'s counsel submitted that in [APPELLANT] for the [NAME] to have an individual interest in the exempt income it had to have at least an interest that is vested in interest, if not one that is vested in possession. It was said that the [NAME] had no such interest in the exempt income. In [APPELLANT] to understand the submission it is necessary to refer to certain provisions of the trust deed. The trust is divided into two funds: the A class [NAME] and the B class [NAME]: clause 2.2. Only the B class [NAME] ("the [NAME]") is of present relevance. The capital of the [NAME] is held upon trust for the B class investors: clause 3.1(b). B class investors are those who hold B class investment units. The income of the [NAME] is held upon trust for the holders of B class units: clause 3.1(d). B class units are B class investment units and B class management units. The [NAME] holds all the B class investment units. The beneficial interest in the [NAME] is divided into units: clause 5.1. Every investment unit confers "such an interest in [the [NAME]] as is provided in" the deed, but does not confer any interest in any particular part of the [NAME] or of any investment: clause 5.2(a). The capital in relation to the [NAME] is defined as the [NAME] other than the income of the [NAME]. The income of the [NAME] in relation to a financial year is defined as the income in respect of that year as determined in accordance with s95(1) of the Act. Clause 9.2(a) provides that the income of the [NAME] in respect of each financial year is held on trust for the manager to such extent as the trustee determines, and in default of a determination on trust for the investors. Sub-clause (b) provides that subject to sub-clause (a), the income of each year is held on trust for the investors in proportion to the number of investment units held by them. Clause 9.3 requires the trustee promptly to distribute cash representing the income of the [NAME] in accordance with the unit holders' entitlements as and when the cash is received by the trustee. Clause 10.1 requires the trustee to "retain all moneys being capital of [the [NAME]] pending the investment or redemption of Units". By clause 10.2 the capital of the [NAME] is held on trust for the investors in proportion to the number of investment units held by them. Clause 10.3(a) provides that investment units are to be redeemed "as and when and to the extent that the Trustee receives cash representing capital" of the [NAME] to which an investor is entitled. In [APPELLANT] to effect any such redemption, the trustee must pay the investor the redemption price of the relevant units, and thereupon the units are redeemed: sub-clause (c). The redemption price is one dollar, which is the purchase price of a unit: clause 6.1. Clause 15.5 requires the manager, when any cash is received by the trustee which is or is to be paid or distributed pursuant to clause 9 or clause 10, to determine the extent to which such cash represents income and the extent to which it represents capital.

Section 95(1) defines "net income" in relation to a [COMPANY] as "the total assessable income of the [COMPANY] calculated under this Act as if the trustee were a [NAME] in respect of that income and were a resident, less all allowable deductions ...". It will be recalled that this definition is picked up by the definition of "income" in the deed. It was common ground that the deductible amount was treated as "cash representing capital" of the [NAME] within clause 10.3(a) and used to redeem investment units. The submission was that the effect of clause 10 is that the excluded portion of an annuity is in effect added to the trust capital, thus increasing the trust [NAME] in favour of those entitled to capital as against those entitled to income, and that that portion, when received, is to be distributed to the [NAME] by way of redemption of units. It was said that the [NAME] become entitled to what is distributed, not as a return on their capital investment but as a return of that capital in pro tanto satisfaction of their interests in the trust [NAME]. An analogy was drawn between the partners' receipt and that of the shareholder in [NAME] v Federal Commissioner of Taxation (1938) 59 CLR 787. In that case the receipt by a shareholder of an amount representing three-fortieths of the value of the net assets of the company upon cancellation of her shares, which were three-fortieths of the issued shares, was held to be in satisfaction of, and by way of replacement for, her shares and not as to any part income by way of dividend, notwithstanding that what she received exceeded a full return of her share of the paid-up capital of the company. Counsel for the [NAME] stressed that they were not suggesting that the provisions of the trust deed could, for tax purposes, convert what was truly income into capital. The question, they said, was not whether the excluded portion was exempt income of the trust (which for the purposes of the present submission they accepted it was), but whether it was included in the exempt income of [NAME] in terms of s97(1)(b)(i). It was not so included because [NAME] never obtained an individual interest in that income. Subject to any determination in favour of the manager, the income of the [NAME] is held on trust for the investors absolutely. Upon its receipt by the trustee (as income) the deductible amount is property in which the partners have a beneficial interest, and its character is the same when received by the partners. The provisions of clauses 15.5 and 10.3 cannot alter the character of the receipt for income tax purposes. In [NAME] v Federal Commissioner of Taxation (1954) 90 CLR 598 at 609 [NAME], Kitto and Taylor JJ said: a unit held under this trust deed is fundamentally different from a share in a company. A share confers upon the holder no legal or equitable interest in the assets of the company; it is a separate piece of property; and if a portion of the company's assets is distributed among the shareholders the question whether it comes to them as income or capital depends upon whether the corpus of their property (their shares) remains intact despite the distribution. ... But a unit under the trust deed before us confers a proprietary interest in all the property which for the time being is subject to the trust of the deed ...; so that the question whether moneys distributed to unit holders under the trust form part of their income or of their capital must be answered by considering the character of those moneys in the hands of the trustees before the distribution is made. Returning to s97(1), subject to the manager's interest in the income, the partners are entitled to the whole of it. If before 30 June 1986 the trustee had determined that the manager was to share in the income for the relevant financial year, the partners would have been entitled to the balance of the income. If by that date no determination had been made in favour of the manager, the partners would have been entitled to the whole of the income. See clause 9.2. The [NAME]'s interest in the income was vested in possession, and it was entitled to demand that the share be paid to it. It was thus presently entitled to the share within the meaning of the opening lines of s97(1). The [NAME]'s share of income included its individual interest in the exempt income of the trust. Counsel attempted to deflect the observations in [COUNSEL] by pointing out that no question of redemption of units arose in that case. But that cannot affect the application of those observations to the present case. What the High Court said was that the character of money coming to the trustee before a distribution is made is the character it has in the unit holders' hands after the distribution. In the present case the deductible amount came to the trustee as income. Pursuant to clause 15.5 of the deed the manager determined that that amount represented capital, and in reliance on clause 10.3 the trustee paid it to [NAME] in redemption of its units. To accept the [NAME]'s submission is to permit the terms of the trust deed to convert into capital in the hands of [NAME] that which was income in the hands of the trustee. Further, it is to be remembered that the fact that the deductible amount represents a return of capital in the [NAME] [NAME] sense (see also the language of clauses 10.3 and 15.5) does not mean that it is capital for tax purposes. Then the [NAME] submitted that insofar as [NAME] had an individual interest in exempt income of the trust, because that exempt income was taken into account in calculating the net income of the [COMPANY], it is not included in [NAME]'s exempt income. This submission, which was not put to the primary judge, depends on the final words of s97(1). The assessable income of a [NAME] who is presently entitled to a share of the income of a [COMPANY] includes his individual interest in the exempt income of the estate except to the extent to which the exempt income to which that individual interest relates was taken into account in calculating the net income of the [COMPANY]. The net income of a [COMPANY] is the total assessable income of the estate calculated as if the trustee were a [NAME], less all allowable deductions: s95(1). The submission was that in [APPELLANT] to calculate net income one must first calculate its two integers - assessable income and allowable deductions. If the exempt income enters into the calculation of either integer, it has been taken into account in calculating the net income. In [APPELLANT] to ascertain the [NAME]'s assessable income one had to deduct the exempt income from the amount of the annuity payment: [NAME]. For example, the annuity payment received on 1 November 1986 was $3,639,902 and the deductible amount (exempt income) was $2,793,750. The second figure was deducted from the first to give $846,152 as the amount included in the assessable income. The exempt income was thus taken into account in determining the assessable income integer of the net income, and thus in determining the net income. As to the other integer, assuming a loss carried forward of $3,639,902 and exempt income of $2,793,750, the permissible loss deduction pursuant to s80(2) is the difference between those figures. The permissible loss is deducted from the assessable income to produce the net income of the estate. The exempt income is thus taken into account in calculating the allowable deductions integer of the net income, and thus in calculating the net income. Counsel for the Commissioner submitted that the fact that the deductible amount enters into the calculation of one of the integers that go to make up the assessable income does not mean it is taken into account in calculating the net income. The submission was not developed, but presumably would limit the words "in calculating" in s97(1) to the process described in s95(1) (ie subtracting the allowable deductions from the assessable income), so that they would not cover the anterior process of calculating the assessable income and the allowable deductions. Section 27H(1)(a) excludes the deductible amount from an annuity payment, and the balance forms part of the assessable income. On this argument, it would follow that while the deductible amount is taken into account in calculating the assessable income, it is not taken into account in performing the calculation with which s95 is concerned. The argument cannot be accepted. By the time the s95(1) calculation is performed, exempt income will already have been taken into account in determining the two integers. The s95(1) calculation will never involve taking exempt income into account except in the anterior sense described above. It was also submitted that the use to which the [NAME] sought to put the concluding clause of s97(1)(b) is outside the purpose to be served by the provision. Reliance was placed on a passage in CCH Australian Federal Tax Reporter vol 4 at 30,151 where it is said that the purpose behind s97(1)(b) "appears to be" to enable losses incurred by a [NAME] to be set off against his individual interest in exempt income derived by the [COMPANY]. Losses incurred by a [COMPANY] are carried forward in the [COMPANY] and are not allowable to the [NAME]: [NAME] v Federal Commissioner of Taxation (1933) 48 CLR 1.

Accordingly, where losses are incurred by a [COMPANY] and those losses are set off or partly set off against exempt income, no part of the exempt income so utilised is included in a [NAME]'s individual interest in the exempt income of the [COMPANY]. Where exempt income derived by the [COMPANY] is not so utilised in the estate, it is included in [NAME]'s individual interest in the exempt income and is then available for losses incurred by [NAME] himself to be set off against it. An example of this type was given by commentators at the time when, in 1936, the predecessor of s97(1)(b) was introduced into the Act. See, for example, [NAME] and [NAME], [NAME] (1938), at 657. The example given by the commentators is inconsistent with the Commissioner's primary submission as to the import of the concluding words of s97, and accords with the [NAME]'s submission, though it is directed only to the allowable deductions integer. I see no reason why the example given should be treated as exhaustive of the function to be performed by the concluding words. In my view the deductible amount was taken into account in calculating the net income of the trust for the purposes of the concluding words of s97(1)(b), and accordingly is not included in the exempt income of [NAME]. It follows that the whole of the interest is allowable under s51(1).

I would allow each appeal and remit the matters to the Commissioner for reassessment on the basis that the interest incurred by the [NAME] is wholly deductible pursuant to s51(1). I certify that this and the preceding seventeen pages are a true copy of the reasons for judgment of the Honourable Justice Sundberg ................................................. Associate 2 June 1997

Counsel for the Appellant: [redacted] Solicitors for the Appellant: [redacted] Counsel for the Respondent: [redacted] Solicitor for the Respondent: [redacted] Date of Hearing: 11 October 1996 Place of Hearing: [NAME] of Judgment: 2 June 1997