Capital vs revenue? Greig’s case confirms it's all about the facts

27 July 2020

In brief

The question of when a taxpayer holds shares or any other investment on capital account or revenue account is important in determining whether losses arising from the investment are deductible or whether it gives rise to a capital loss. This is relevant in determining whether the losses can only be applied against current or future year capital gains, and for non-corporate taxpayers, whether any gains may be eligible for the capital gains tax discount.

In a recent Federal Court decision (Greig v Commissioner of Taxation [2020] FCAFC 25) for which PwC's Tax Controversy and Dispute Resolution team acted on behalf of the taxpayer, a loss made on the disposal of shares was found to be on revenue account and accordingly deductible.

This case reinforces the principle that when assessing whether an isolated transaction constitutes a “business operation or commercial transaction” that is on revenue account, the activities must be “the sort of thing a business person, or person in trade, might do”.  The Australian Taxation Office (ATO) has also subsequently issued its response to the decision and comments that despite losing the case, the decision does not disturb the Commissioner’s understanding of the principle. The matter demonstrates that whilst the principle is clear, nailing the facts is critical so that there is less scope for reasonable minds to differ on whether it is revenue or capital.

In detail

In the Greig case, the Full Federal Court (by majority) found that the disposal of shares by the taxpayer was on revenue account, and the loss made on particular shares were deductible under section 8-1 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997). In assessing whether the transaction constitutes a “business operation or commercial transaction” (FCT v Myer Emporium Ltd (1987) 163 CLR 199 (Myer Principle)) that supports the outcome that the loss was on revenue account, the significant volume of evidence demonstrated that the taxpayer had acted as a business person would. 

The facts were important

The taxpayer was a senior executive in the Bechtel Group. Between March 2012 and May 2014, he purchased 134,893,686 shares in Nexus Energy Ltd (Nexus) on 64 separate occasions for a total sum of  $11,851,762. 

The taxpayer had a strategy of making a short-term profit by acquiring stocks that he thought were targets for takeovers and subsequently disposing of the shares once their value had increased. The taxpayer identified Nexus as a suitable takeover target because he determined that its share price was significantly undervalued relative to its asset position. This was because Nexus owned a 17 per cent interest in a $3.75 billion joint venture project, holding the "Crux asset”, and had entered into a preliminary agreement in January 2012 with Shell and Osaka Gas to sell 2 per cent of its interest for $75m. This provided a “look-through” value of Nexus’s share at $637m, significantly more than its market capitalisation at the time. 

In early 2014, the Seven Group sought to take over Nexus by acquiring its debts. 

In August 2014, Nexus’ creditors approved a Deed of Company Arrangement (DOCA) under which all Nexus’ shares were compulsorily transferred to the Seven Group for nil consideration. The taxpayer incurred $507,198 in legal fees in unsuccessfully contesting the DOCA. Upon the transfer of his shares, the taxpayer incurred a loss of $11,851,762 in the 2015 income year. 

The taxpayer sought guidance from the ATO in the form of a private binding ruling that the shares were held on revenue account. The Commissioner issued a ruling that the share losses and legal fees were not deductible under section 8-1 of the ITAA 1997. The taxpayer lodged his 2015 income tax return consistently with the private binding ruling to mitigate penalties and interest and then lodged an objection. The objection was disallowed and the taxpayer appealed the decision to the Federal Court.

Decision at first instance

The taxpayer led a large volume of detailed evidence concerning the activities undertaken to pursue the intended profit, including:

1. regularly reviewing research and analyst reports;

2. attending meetings with the Nexus CEO and Managing Director;

3. strategically increasing his stake to become a “substantial shareholder” under ASIC rules in order to exert influence over takeover negotiations;

4. receiving direct offers from third parties seeking to acquire Nexus; and

5. incurring legal fees in defending the value of the shares.

At first instance, Thawley J held that the loss (and legal fees) were not deductible. He determined that the taxpayer had the requisite profit-making intention but his activities were not of a level that constituted a “business operation or commercial transaction”. His Honour determined that shares were a “private investment” and therefore capital in nature.

Decision on appeal

The Full Federal Court held that the Nexus shares were acquired by the taxpayer in a “business operation or commercial transaction”. The types of activities that were relevant to this finding included:

1. a profit-making intention or purpose existed at the acquisition of each bundle of Nexus shares;

2. the realisation of profit formed part of the taxpayer’s larger profit target strategy;

3. each bundle of Nexus shares was acquired in a “systematic fashion on 64 occasions”. The acquisition of additional share bundles was often prompted by an “event”, such as the release of an analyst report, third party interest, developments in the Crux asset;

4. the taxpayer, personally, or through his adviser, actively participated in a plan to “crystallise indirectly what the taxpayer perceived was the true value of the Crux asset”;

5. the taxpayer used his personal experience as managing director of Bechtel, his knowledge of the industry and his previous encounters with the Nexus CEO and Chairman; and

6. the taxpayer acted as a “business person” would, including by engaging professional help, monitoring analysts reports, making strategic acquisitions to increase his influence on a potential sale, directly fielding offers from third parties, and defending the value of his investment in the Supreme Court. 

In light of the facts, it is unsurprising that the majority in the Full Federal Court found that his share trading was not a “hobby” and “was more than a ‘mere’ realisation of an asset”. Steward J commented at [247]: 

Whether the taxpayer’s purchasing of shares was no more “than an example of an ordinary investment engaged in by innumerable private investors each day”, as the learned primary judge found, I cannot say. It may be doubted whether an ordinary private investor would have the same knowledge and experience as a local managing director of a significant worldwide group of companies.

ATO’s response

Despite being unsuccessful in the dispute, the Commissioner stated in its Decision Impact Statement that he does not consider that this decision disturbs the Commissioner’s “understanding of the factors that will be relevant in determining whether an acquisition of shares is made in carrying out a 'business operation or commercial transaction’” and that such a decision was open to the Full Federal Court on the facts. The Commissioner considers that the decision of the majority in the Full Federal Court is “not inconsistent” with the guidance previously provided in Taxation Rulings TR 92/3 and TR 92/4. 

The takeaway

The decision of the Full Federal Court confirms the following key learnings:

• Framework for revenue/capital - The factors set out by the Full Federal Court provide a useful framework for the application of the principle. This decision confirms that the activities of the taxpayer must amount to that of a “business person” before it can amount to being on revenue account. These issues apply to any investment, including property development, and in light of the current economic conditions, the prospect of losses being made by taxpayers makes the revenue/capital question no less significant.  

• The facts will determine the outcome - The decision is a timely reminder that capital/revenue disputes are fact-intensive and the facts will always determine the outcome. In particular, the Full Federal Court closely examined the detailed activities of the taxpayer and his adviser when determining that he acted as a “business person” would. 

• Penalty protection  - Taxpayers who receive an unfavourable private binding ruling may consider lodging an income tax return on the basis of the unfavourable ruling and then objecting against the assessment raised. This offers penalty and interest protection which is critical given the severity of the penalties that can apply to a tax shortfall (particularly for a Significant Global Entity).