• Legal database
Legal database

Federal Commissioner of Taxation v. Cliffs International Inc.

Judges:
Bowen CJ
Franki J
Brennan J

Court:
Federal Court (Full Court)

Judgment date: Judgment handed down 14 December 1977.

Bowen C.J.: This is an appeal from a Judge of the Supreme Court of Western Australia delivered on 24th May 1977 dealing with certain income tax deductions claimed by Cliffs International Inc. in respect of the income years ended 31st December 1973, and 31st December 1974.

Cliffs International Inc. (``Cliffs'') is a company incorporated in Cleveland, United States of America, which is registered as a foreign company in Western Australia. It is a wholly owned subsidiary of The Cleveland-Cliffs Iron Company.

The Cleveland-Cliffs Iron Company (``Cleveland-Cliffs'') is a company incorporated in Ohio, United States of America.

Cliffs W.A. Mining Company Pty. Limited (``Cliffs Western'') is a company incorporated in Western Australia and is a subsidiary of Cleveland-Cliffs.

Basic Materials Pty. Limited (``Basic'') is a company incorporated in Western Australia.

Howe Sound is a company incorporated in the State of Delaware, United States of America, which has changed its name to Howmet Corporation (``Howmet'').

Garrick Agnew Pty. Limited (``Agnew Co.'') is a company incorporated in Western Australia.

Mt. Enid Iron Co. Pty. Limited (``Mt. Enid'') is a company incorporated in Western Australia.

Cliffs made a return of income for the year ended 31st December 1973 showing a taxable income of $1,072,084. The Commissioner issued a notice of assessment showing tax payable amounting to $1,022,815 upon a taxable income of $2,272,924. The difference in taxable income was explained in an adjustment sheet which accompanied the assessment. Amongst the items shown in the adjustment sheet were the following, which were in issue or partly in issue before the Supreme Court: - 

      Exchange losses          $39,610

      Royalties               $837,137

      Unrecouped losses       $321,472

Of these items, the full amount was in issue before the Supreme Court in respect of all items except unrecouped losses. These were in issue to the extent of $176,120 only. Cliffs objected to the assessment in respect of the above items and others which were no longer material when the matter came before the Supreme Court. The objection was disallowed whereupon Cliffs requested that it be treated as an appeal and forwarded to the Supreme Court. It came before that Court as Appeal No. 176 of 1976.

A notice of amended assessment was issued by the Commissioner, increasing taxable income for the year ended 31st December 1973 to $2,372,016. The addition, which was in issue, comprised interest received from Mt. Enid, amounting to $98,519. Cliffs objected to the amended assessment. Its objection was disallowed and it thereupon requested that its objection be treated as an appeal and forwarded to the Supreme Court. It came before the Supreme Court as Appeal No. 196 of 1976.

Cliffs made a return for the income year ended 31st December 1974 showing a taxable income of $1,746,596. The Commissioner issued a notice of assessment showing tax payable amounting to $1,335,474.52, upon a taxable income of $3,142.293. The difference adjustment in taxable income was explained in an adjustment sheet. Amongst the items shown in the sheet were the following which were in issue before the Supreme Court: 

      Royalties                           $1,176,640

      Interest from Mt. Enid                $191,032

      Legal expenses in re payments

      to Howmet                              $16,638

Cliffs objected to this assessment. Its objection was disallowed and it requested that its objection be treated as an appeal and forwarded to the Supreme Court. This came before the Supreme Court as Appeal No. 178 of 1976.

Before the Supreme Court the appeals were consolidated and heard together. The learned Judge held that for the year ended 31st December 1973 the taxable income of Cliffs should be varied by deleting therefrom the sum of $1,052,867 made up of exchange losses, $39,610, royalties $837,137, and unrecouped losses, $176,120, and that Cliffs was entitled to a credit against income tax assessed of an amount of $11,286-20 equalling the

ATC 4567

withholding tax already paid on the interest received from Mt. Enid. He further held that for the year ended 31st December 1974, the taxable income should be varied by deleting therefrom the sum of $1,193,278 made up of royalties $1,176,640 and legal expenses $16,638, and that Cliffs was entitled to a credit of an amount of $19,103-20 equalling the withholding tax already paid on the interest received from Mt. Enid.

The Commissioner has appealed against the decision to allow the deduction of royalties, exchange losses and unrecouped losses. It is agreed that the decision on royalties will govern the decision on exchange losses and unrecouped losses. The Commissioner has also appealed against the allowance of legal expenses but not against the decision in respect of the interest received from Mt. Enid.

The issues in contention before us are, therefore, whether the royalties and the legal expenses are allowable deductions under sec. 51 of the Income Tax Assessment Act, 1936.

I turn now to the facts. By letter dated 5th March 1962, the Under-Secretary for Mines of Western Australia wrote to Basic stating that Temporary Reserves Nos. 2400H-2417H inclusive had been approved for a period of two years from 1st April 1962 to 31st March 1964. It was further stated that the Reserves were subject to conditions which were attached and covered Crown Lands within a total area of 246 square miles as shown on an attached plan. The annual fees payable were set forth. Under the attached conditions it was provided the occupant should not use the land for any other purpose than that of prospecting for iron ore (condition (2)); the occupant was obliged to commence prospecting operations forthwith and to continue them to the satisfaction of the Minister (condition (3)); no transfer of the authority to occupy would be permitted without the approval of the Minister (condition (8)); the Minister might impose further conditions or cancel if conditions were not fulfilled (conditions (9) and (10)); the occupant was obliged to furnish to the Minister quarterly reports and at the end of each calendar year a full report (conditions (11) and (12)); when it was shown that iron ore had been discovered in payable quantities the Minister, after negotiation of various conditions, would (subject to any contract the Minister might require the occupant to make with the State Government), offer to grant to the occupant mining tenements under the Mining Act and regulations and on acceptance would make such grants accordingly (condition (14)).

In 1962 the shares in Basic were held as to 50.1% by Howmet (then called Howe Sound) and as to 49.9%, by Agnew Co. In July 1962, an approach was made by Howmet to Cleveland-Cliffs, seeking to interest it in the Reserves. Cleveland-Cliffs was principally a merchant producer of iron ore. It had acquired a world-wide reputation, particularly for its expertise in the development of technology as it relates to the beneficiation, upgrading, concentrating and pelletising and other forms of improving iron ore. Cleveland-Cliffs had before it a report dated August 1962 submitted to it by Howmet. This report was rather brief and not in the depth that would enable an evaluation to be made. It indicated there were two iron ore deposits known as the Middle Robe and Upper Robe deposits. The deposits were of two basically different types - one referred to as the ``Mesa'' deposits and the other as the ``Gorge'' deposits. The nature of the iron ore was that it was of a limonitic order which, in lay terms, would mean that it had a very high chemical water content and which, at that time, was not considered a commercial ore. In evidence it was contrasted with the Hematite ore mined by Hamersley and Mt. Newman which had a higher iron content and less of the so called crystal and chemical moisture. It was apparent that considerable effort would have to be expended before an assessment could be made as to the worth of the deposits.

As a result of negotiations, an agreement in writing was entered into on 27th November 1962 between Cleveland-Cliffs, Howmet, Agnew Co., Mr. R.D.G. Agnew and Mrs. Fay M. Agnew (the ``Option Agreement''). The material parts of the operative provisions of this agreement are as follows:

``1. Howe, Agnew Company and Mr. and Mrs. Agnew severally but not jointly represent to Cliffs that:

  • (a) Basic is a corporation duly organised and existing under the laws of Australia;
  • (b) Howe and Agnew Company own the entire equity interest in Basic...
  • (c) Basic holds the exclusive right to occupy and use for the purpose of

    ATC 4568

    prospecting for iron ore the Temporary Reserves numbered 2400H-2417H (inclusive) in the Hamersley Range in Western Australia, covering a total area of approximately 246 square miles (hereinafter called the `Reserves')... and all of the terms, provisions and conditions of the said grant and conditions... have been fully complied with and performed and are not in default;
  • (d) Basic has no debts, liabilities or obligations of any nature except its obligations as set forth in the attached Exhibit A, Exhibit A-1 and Exhibit B, the latter being a pro forma balance sheet of Basic as of the date hereof. If Basic incurs any other debts, liabilities or obligations between now and the Closing, Howe, Agnew Company and Mr. and Mrs. Agnew will take such steps as are necessary to discharge such debts, liabilities or obligations prior to the closing, or if it is impractical to do so, will deliver to Basic at the Closing a guarantee holding Basic harmless...
  • (e) Howe, Agnew and Company and Mr. and Mrs. Agnew have no rights, interests or claims in the lands in the Reserve...; and
  • (f) Basic now has no operating assets relating to any business or operation other than iron ore, and will have at the Closing Date no commitments or obligations or any sort with respect to any such other business or operation.

2. Cliffs will, at its expense, perform the following work and make the following investigations during the term of the option at no expense to Howe or Agnew:

  • (a) Drill, sample and test metallurgically an area of sufficient size to prove tonnages and quality of ore in the Reserve and prepare a report as to the results of such drilling, sampling and testing.
  • (b) Perform metallurgical test with ore shipments of at least 1,000 to 2,000 tons which shipments are to be shipped to prospective Japanese purchasers for their testing in Japan;
  • (c) Make a preliminary written survey of the railroad route and port site areas for ore to be mined from the Reserve;
  • (d) Make a written market survey and take steps to negotiate the sale of ore, including an analysis of the costs of shipping to markets;
  • (e) Assemble all data pertinent to operation of a mine on the Reserve and to incorporate such data and the shipment of ore therefrom into a feasibility report and furnish Howe and Agnew Company with a copy of such report; and
  • (f) To make and use such feasibility report to the extent necessary to secure adequate mining rights from the Australian Government.

The other parties hereto agree to co-operate with Cliffs in the foregoing.

3. Howe, Agnew Company and Mr. and Mrs. Agnew agree, so long as they are stockholders of Basic, to cause Basic to do and perform all things required of it to be done and performed with respect to the said prospecting rights...

4. Cliffs is hereby granted the option to purchase from Howe and Agnew Company their entire right, title and interest in all of Basic's capital stock and shares, for the Purchase Price set forth below, payable to them in proportion to their participations above set forth, such option to be exercised by written notice by Cliffs to them on or before December the thirty first One thousand nine hundred and sixty three. Such purchase by Cliffs shall be consummated at the offices of Messrs. Parker & Parker, 21 Howard Street, Perth Western Australia, at a date specified in Cliffs' notice of exercise of the option, not less than twenty nor more than thirty days from the date of such notice (herein called the `Closing') by making of the Initial Payment by Cliffs to Howe and Agnew Company against delivery to Cliffs of appropriate certificates and assignments.

The obligation of Cliffs to consummate the purchase shall be subject to the existence on the date of Closing of the following conditions:

  • (a) That the representations set forth in Article 1 hereof are true and correct.
  • (b) That there shall have been no change from the time of the notice of the exercise of the option until the date of

    ATC 4569

    the Closing, in the terms and conditions of Basic's rights to mine and remove iron ore from the lands described in Exhibit A, in the amount of royalties or other charges imposed by the Australian Government or any political subdivision thereof, and in the right of Basic to consume and to ship and to sell such iron ore; and
  • (c) That Basic has full right, power and authority, subject to the provisions of Australian law, to transfer all of the Reserves or other mining rights under Australian law free and clear of all liens, encumbrances, charges or equities.

The other parties hereto agree to furnish to Cliffs, upon its request, such certificates, opinions of counsel and other documents and data as Cliffs may reasonably request to evidence compliance with the foregoing conditions.

5. The Purchase Price referred to in Article 4 shall consist of an Initial Payment of TWO HUNDRED THOUSAND DOLLARS $200,000 (US), payable in good New York or Cleveland, Ohio funds by certified or official bank check at the Closing of the purchase hereinabove referred to, plus Deferred Payments equal to 15 ¢ (US) per ton of Iron Ore payable as in this Article 5 set forth. Such 15 ¢ per ton payments (hereinafter sometimes called `Deferred Payments') shall be computed and paid as follows:

  • (a) `Iron Ore' shall mean iron bearing material mined and transported from the Reserves by or with the consent of Basic or its successor in interest, whether or not such iron ore shall have been dried, roasted, burned, sintered, crushed, ground, concentrated, pelletized, agglomerated or otherwise beneficiated or processed or prepared prior to sale or consumption, but iron bearing material of low grade may be sold for construction purposes without any liability to pay any Deferred Payments with respect thereto.
  • (b) A `ton' shall be a gross ton of 2,240 pounds avoirdupois weight in the form and at the time transported from the Reserve. Reports as to the weight of any such Iron Ore made by any common carrier trucker, railroad or vessel operator shall be conclusive for all purposes hereof. In the absence of such reports, reports thereof by Basic or its successor in interest shall, unless fraud is involved, be conclusive on each party hereto unless challenged in writing within thirty days after receipt of such report by such party;
  • (c) Within ninety days after June thirtieth and December thirty first of each year Cliffs shall make or cause to be made to Howe and Agnew Company a report of the tons of Iron Ore mined and transported from the Reserves during the semi-annual period then ended, together with payment by check drawn on good United States funds of their respective participations in the Deferred Payments with respect thereto. Subject to the provisions of para. (b) of this Article, in the event Howe or Agnew Company does not object in writing to the computation of such amount within ninety days after receipt of such report, such report shall be binding and conclusive upon the parties, unless fraud is involved.
  • (d) For purposes of this Article 5, iron bearing material mined from the Reserve shall be considered as still located at the Reserve so long as it is located at any plant in Australia for the purpose of drying, roasting, burning, sintering, crushing, grinding, concentrating, pelletizing, agglomerating or otherwise beneficiating or processing or preparing prior to its sale or consumption.

The initial Payment will be in the form of a check payable jointly to Agnew Company and Howe, and the Deferred Payments will be paid in cash or by check in the proportion of 50.1% to Howe and 49.9% to Agnew Company.

6. Cliffs may, by notice in writing delivered to Howe and Agnew Company prior to the time for completing its purchase as provided in Article 4, designate another corporation (or similar organisation), organised under the laws of Australia or of one of the states of the United States to make the purchase provided for in Article 4.

...

ATC 4570

7. (Provided that Howe, Agnew Company and Mr. and Mrs. Agnew should be free from any cost or expense in carrying out certain of their obligations).

8. (Provided for service of notices or reports).

9. This Agreement shall be governed by and construed in accordance with the laws of the State of New York, United States of America. This agreement constitutes the entire agreement among the parties and shall not be modified, amended or terminated orally but only by an agreement in writing signed by the parties hereto.

10. Subject to the provisions of Article 6 hereof, this agreement and the rights and obligations herein set forth shall inure to the benefit of and be binding upon the parties hereto and their respective successors, personal representatives and assigns.''

The occupancy rights referred to in the Option Agreement do not confer any right to mine. However, they do confer valuable rights which the courts will protect (
Delhi International Oil Corporation v. Olive (1973) W.A.R. 52 ).

Evidence was given that in the course of negotiations a proposal for a minimum payment or a minimum royalty was discussed and rejected. An undertaking was, at one stage, sought from Cliffs that if they should exercise the option they would mine the deposits. That was refused. The question was also raised whether Cliffs would transfer back the shares or the rights of occupancy if they exercised the option or did not proceed with the project on the ground. This suggestion was rejected. The sum of $200,000 to be paid under the Option Agreement, if the option was exercised, appears to have been arrived at after Howe raised the question of expenditure on the work that had already been done on the deposit for which they wished to be reimbursed and there was reference to some finder's fee which was payable. Presumably Howe would receive only a proportion of the $200,000 if the option was exercised.

As to the figure of 15 ¢ per ton described in the Option Agreement as ``Deferred Payments'', it appears it was a negotiated figure, arrived at after consideration of various matters including comparative royalties in the United States. The description ``Deferred Payments'' was a term that was not brought into the discussions until a very advanced stage. It was then brought in only at the suggestion of Howe for purpose of their own. Before that, it had been referred to as a royalty and indeed was thought of throughout by Cliffs as a royalty.

Evidence of these negotiations leading up to the Option Agreement was admitted on the basis laid down in
Ralli Estates Limited v. Commr. of 1.T. (1961) 1 W.L.R. 329 ; and see
I.R. Commrs. v. Church Commissioners for England (1976) 3 W.L.R. 214 .

Also on 27th November 1962, an agreement was entered into between Cleveland-Cliffs and Agnew Co. The material part of Clause 1 of this agreement is as follows:

``1. If Cliffs exercises its said Option to purchase the entire capital stock or shares of Basic it shall thereafter with all convenient speed form a Company or Companies (hereinafter referred to as `the Operating Company or Companies') to mine exploit and develop the Reserves and to sell (before or after treatment) the ore obtained therefrom and Agnew Company or any Company or Companies nominated by it (and if the whole of the shares in such Company or Companies is not owned by Agnew Company Garrick Agnew of Perth and or his wife and children then approved by Cliffs) shall have the right to purchase and Cliffs shall cause the Operating Company or Companies to offer to Agnew Company or such other Company or Companies as aforesaid (all of which Companies are hereinafter included in the expression `Agnew Company') for purchase up to 7 ½ per centum of the capital... (certain terms and a provision were then stated and a further proviso was as follows)... provided however that Agnew Company's aggregate investment in the Operating Companies shall be limited to the sum of $2,500,000 (US).''

In due course, the option under the Option Agreement was exercised. Completion took place on 17th January 1964. Prior to completion, at the end of 1963, Cleveland-Cliffs designated Cliffs to make the purchase on its behalf and assume the obligations and Agnew Co. had sold its shares in Basic to Mt. Enid, which thereupon acquired Agnew Co.'s rights under the Option Agreement. The shares in Basic were transferred to Cliffs

ATC 4571

except for one which was transferred to Mr. Dohnal, on behalf of Cleveland-Cliffs.

On 18th March 1964 the shareholders of Basic met and resolved, inter alia, as follows: -

``NATURE OF PRESENT ACTIVITES:

At the present time all the shares in the Company are held by or on behalf of Cliffs International Inc which at present is engaged in investigating the possibilities of mining the Rights of Occupancy held by the Company of the iron ore deposits in the Robe River area. These investigations involve the expenditure of large sums of money. Resolved that the Company acknowledge that these Rights of Occupancy are held on trust for Cliffs International Inc.''

On 18th November 1964 an agreement was made between the State of Western Australia and Basic. This was approved by the Iron Ore (Cleveland-Cliffs) Agreement Act 1964 in which it is set forth as a schedule. It provides for certain work to be done by Basic during a period described as Phase 1 and for continuation of the rights of occupancy during this period. This is to lead up to the commencement date whereupon Phase 2 commences. The State undertakes to grant a mineral lease for iron ore in a form which is set forth as a schedule to the agreement for a term of twenty one years from the commencement date, with rights to successive renewals of twenty one years. Basic undertakes that it will, within four years after the commencement date, (or extended period approved by the Minister) at a total cost of $35,000,000, install various facilities to enable it to mine, to transport by rail to the plant site, pelletise and transport to Basic's wharf and to commence shipments therefrom in commercial quantities at an annual rate of not less than 1 million tons of iron ore pellets and also within a further period of five years, to increase the capacity of the plant to a minimum of 3 million tons of iron ore pellets per annum.

Basic undertakes to pay to the State of Western Australia rental and royalties. The royalties provided by this agreement are on all iron ore (or on iron ore pellets produced from iron ore) from the mineral lease shipped and sold. Basic is given the right at any time to assign or dispose of to an associated company as of right and to pay any other company or person with the consent in writing of the Minister, the whole or any part of the rights of Basic under the agreement and its obligations thereunder.

On the 21st October 1965, at an extraordinary general meeting of the shareholders of Basic, it was resolved to insert art. 128 in its articles of association to provide for modes of distribution in a winding up, including division of assets in specie. It was also resolved that the company be wound up voluntarily and a liquidator was appointed. It was further resolved that the liquidator be authorised to divide the assets in specie amongst the members. It will be noted that at the time of winding up, Basic held not only the rights of occupancy which it had resolved to hold in trust for Cliffs, but also the rights under the agreement of 18th November 1964 with the State of Western Australia.

On 19th November 1965 an agreement was entered into between the State of Western Australia, Cliffs and Basic (In Liquidation). By this agreement, it was recited that Basic was desirous of assigning to Cliffs the whole of its rights under the agreement of 18th November 1964 and that the Minister had consented to this assignment. In its operative portion, Cliffs covenanted and agreed to perform observe and comply with all the covenants agreements and provisions in the agreement and the State of Western Australia released Basic from its obligations under the agreement.

On 7th December 1965, Basic assigned to Cliffs all its interest in the agreement of 18th November 1964 including its rights of occupancy. Consent of the Minister was endorsed upon this assignment.

Investigations carried out by Cliffs following the agreement of 18th November 1964 showed that the extent of the deposits on the Temporary Reserves was not as great as initially supposed. Cliffs then looked for additional deposits which could be mined with the satisfactory deposits on the Reserves. It found deposits known as Deep Dale deposits controlled by Dampier which would meet its requirements.

On 30th September 1969, an agreement was entered into between Dampier Mining Co. Limited (``Dampier'') and Cliffs. It seems that this provided, in effect, for a sub-lease by Cliffs of the mineral lease Dampier had or was to obtain of the Deep Dale deposits for the purpose of mining up to 150 million tons of

ATC 4572

ore, subject to payment to Dampier of royalty. Consequential admendments were made to the agreement of 18th November 1964 and these were embodied in the Iron Ore (Cleveland-Cliffs) Agreement Act Amendment Act 1970.

On 25th May 1970 an agreement was entered into between Cliffs Western (30%), Mitsui Iron Ore Development Pty. Limited (30%), Robe River Limited (35%) and Mt. Enid (5%) (the ``Participants'') whereby they associated themselves in a joint venture for the purpose of the progressive exercise and development of what were called Robe River Rights for the mining, overland transportation, processing, pelletising and loading for shipment of iron ore on the terms and conditions of the agreement. The Robe River Rights included the rights under the agreement of 18th November 1964 with the State of Western Australia and the mineral lease, as well as the rights under the Dampier agreement of 30th September 1969. The Participants agreed to enter into an agreement with Cliffs providing for the assignment of the Robe River Rights (other than the mineral lease) and for the granting of a sub-lease of the mineral lease. The Participants agreed with each other to pay to the State of Western Australia and to Cliffs all royalties and charges payable by the Participants in respect of iron ore.

Also on 25th May 1970 an agreement was entered into between Cliffs and the four Participants (the ``Cliffs Agreement'') whereby Cliffs agreed to assign the Robe River Rights except the mineral lease and to grant a sub-lease, of the mineral lease. As rent and royalty to Cliffs under the mineral sub-lease, each Participant assumed an obligation to pay its individual share of rentals and royalties due in respect of the rights and lease and also to pay a royalty on iron ore produced by or for each Participant and sold or shipped for sale or commercial use from the mineral lease area at the rate therein specified.

In fact the Participants have mined the deposits over the past few years and, in accordance with the Cliffs Agreement of 25th May 1970, paid rent and royalties to the State and royalties to Cliffs. Cliffs, in turn, has paid to Howmet and to Mt. Enid, which took the place of Agnew Co., the deferred payments under the Option Agreement in respect of iron ore mined and transported from the Reserves at the rate of 15 ¢ (US) per ton.

In its return of income for the years ended 31st December 1973 and 31st December 1974, Cliffs included as income the royalties which it received from the joint ventures and claimed as a deduction the deferred payments which it paid to Howmet and Mt. Enid. It is the disallowance of the deduction for these latter payments which is the principal matter at issue in these proceedings.

During the years ended 31st December 1973 and 31st December 1974, the income earning operations of Cliffs do not appear to have been substantial. The accounts submitted with its income tax returns for those years show that, in addition to the rent and royalties which it receives from the joint ventures, it received certain interest, part of which was interest on short term Government securities. Its expenditure does not suggest it was engaged in other significant income earning operations, although it does appear that in the income year ended 30th December 1973, it spent $21,894 on exploration and prospecting, while in the income year ended 31st December 1974 it spend $28,715 on exploration and prospecting.

During the income year ended 31st December 1974, Cliffs incurred legal expenses and there is a dispute as to whether the amount paid for these expenses is an allowable deduction. The Commissioner claims they are expenditure of a capital nature.

They appear to have been incurred in obtaining legal advice on the situation which arose when the Commissioner requested, or required, Cliffs to deduct tax from payments made to Howmet under the Option Agreement. Howmet claimed that it was entitled to be paid the amounts due to it without deduction of tax. Howmet threatened to sue Cliffs in the United States where a defence, based on the Income Tax Assessment Act 1936, would not be available to Cliffs. Cliffs obtained advice as to the way in which it should proceed. It was argued that it was in the course of its profit earning business to do so.

The questions arising on this appeal in relation to the deferred payments and the legal expenses concern the operation of sec. 51(1) of the Income Tax Assessment Act. It will be convenient to deal first with the deferred payments. Here, the facts relevant to the question whether the expenditure is of an income or capital nature, are largely the same as the facts relevant to the question whether

ATC 4573

the expenditure falls within either of the first two limbs of sec. 51(1). The question whether the expenditure is of a capital nature, was treated by Counsel for the parties as the main question arising on the appeal. I will deal with this question first.

Considerable judicial guidance is available on the construction of this section (see generally
Ronpibon Tin N.L. v. F.C. of T. (1949) 78 C.L.R. 47 ; and
John Fairfax & Sons Pty. Limited v. F.C. of T. (1959) 101 C.L.R. 30) .

The exception in the last part of sec. 51(1) is expressed to be ``to the extent to which'' losses or outgoings answer the descriptions they are given. Being expressed as an exception, the provision seems to assume that otherwise these items would fall within sec. 51(1). In some cases, however, it seems it will not operate as a true exception but simply by way of excluding a contrasted category of expenditure. Thus, in deciding that expenditure is of a private or domestic nature the Court may, at the same time, be deciding it is expenditure which would fall outside the first two limbs of sec. 51(1) (see
Lunney v. F.C. of T. (1958) 11 A.T.D. 404 ,
F.C. of T. v. Hatchett 71 ATC 4184 ; and
F.C. of T. v. Faichney 72 ATC 4245 ). So too with losses or outgoings of capital or of a capital nature; although it appears that some capital expenditure may answer the description in one or other of the first two limbs of sec. 51(1) (see John Fairfax & Sons Pty. Limited. v. F.C. of T. supra, at pp. 34-35).

In determining whether an outgoing is of a capital nature, it is necessary to determine what it is incurred for. Sometimes one consideration may point clearly in one direction, while the other, and vaguer indications, point in a contrary direction. It has been said ``it is a common-sense appreciation of all guiding features which must provide the ultimate answer'' (
B.P. Australia Limited v. F.C. of T. (1966) A.C. 224 at p. 264 ).

A test frequently quoted is that of Lord Cave in
British Insulated and Helsby Cables Limited v. Atherton (1926) A.C. 205 . His Lordship (at pp. 213-214) said: -

``But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or advantage for the enduring benefit of a trade, I think there is very good reason (in the absence of special circumstances leading to an appropriate conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.''

This statement places emphasis on what is acquired as well as upon the character of the expenditure. It is a positive statement. It does not follow that the negative furnishes a test of what is not capital (see John Fairfax & Sons Limited v. F.C. of T. (1959) 101 C.L.R. 30 at p. 36). Expenditure to acquire coal contracts of very short duration has been held to be of a capital nature
John Smith & Sons v. Moore (1921) 2 A.C. 13 at p. 20 ). and where an asset is acquired, recurrent payments even of indeterminate total amount may have been held to be of a capital nature (
Colonial Mutual Life Assurance Society Limited v. F.C. of T. (1953) 89 C.L.R. 428 ;
Tata Hydro-electric Agencies Limited v. I.R. Commr. Bombay & Aden (1937) A.C. 685 ).

In
Sun Newspapers Limited v. F.C. of T. (1938) 61 C.L.R. 337 , Dixon J. stressed that the distinction between income and capital expenditure corresponds with -

``the distinction between the business entity structure or organisation set up or established for the earning of profits and the process by which such organisation operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.''

When on the 27th December 1962 Cleveland-Cliffs entered into the Option Agreement to purchase the shares in Basic, it was interested only in one asset which Basic had. That asset consisted of the exclusive right to occupy and use for the purpose of prospecting for iron ore, the Temporary Reserves Nos. 2400H-2417H (inclusive) in the Hamersley Range in Western Australia. As was insisted upon by Cleveland-Cliffs, Basic then had no other assets and apart from its obligations under the conditions of the grant of the right of occupancy, no obligations or liabilities. When, therefore, Cleveland-Cliffs entered into the Option Agreement to purchase the shares, although from a legal point of view it gained no direct proprietary interest in the right of occupancy, it did obtain the option to acquire a bundle of rights which would enable it to obtain the benefit of the right of occupancy and, at an appropriate time, to obtain this right for itself upon a liquidation of Basic.

ATC 4574

An alternative course would have been to take an option to acquire the right of occupancy. But this right was not transferable without the approval of the Minister for Mines. The nature of the advantage which Cleveland-Cliffs was placed in a position to gain access to, was a right to use the land in question for the purpose of prospecting for iron ore during the balance of a period of two years expiring on 31st March 1964. The option was exercisable by written notice on or before 31st December 1963. If the option was exercised, the purchase was to be ``consummated'' at a date specified in the notice, not less than twenty nor more than thirty days from the date of the notice. Regarded from this point of view, the advantage might be of very short duration. However, the right of occupancy might be renewed. Furthermore, under the conditions of the grant, when it was shown to the satisfaction of the Minister that iron ore had been discovered on the reserve in payable quantities, the Minister, after negotiations with the occupant, regarding the mining, treatment, processing and marketing of the ore, would (subject to the provisions of any contract which the Minister might require the occupant to make with the State Government) offer to grant to the occupant for the mining of iron ore, mining tenements under the Mining Act 1904 and the regulations thereunder, on such conditions as the Minister determined, and on acceptance would (subject to the Act and regulations), make such grants accordingly.

Although the knowledge which the parties had was fairly limited at the time of purchase, and even more limited at the time of the grant of the option, the advantage was regarded as being of significant value. There was a speculative potential of long term advantage, dependent upon any necessary extension or renewal of the right of occupancy, the discovery of iron ore in payable quantities and the preparedness of the Minister to require a reasonable contract and to make the offer of a grant of mining tenements on reasonable conditions.

With hindsight this potential value may be more clearly seen. It was demonstrated by the events which occurred.

The option was duly exercised and the purchase was ``consummated'' on 17th January 1964. Iron ore was discovered which was in payable quantities or, which, when mined in conjunction with ore from the adjacent Dampier Area, would be a commercial proposition.

At the end of 1963, Cleveland-Cliffs designated Cliffs to make the purchase and assume the obligations under the ``Option Agreement''. At the time of purchase on 17th January 1964, it was Cliffs therefore, who became the purchaser and who paid $200,000 and who promised to make the deferred payments equal to 15 ¢ (US) per ton of iron ore computed and payable as set forth in cl. 5 of the Option Agreement.

At this stage, Cliffs simply acquired the shares in Basic. In its hands, these shares constituted a capital asset. Looking at the realities, it acquired the means of access to the right of occupancy which was the only asset Basic had. This right which would continue until 31st March 1964, had inherent in it the possibility of obtaining an extension or renewal and the further possibilities which have been outlined above. However, the asset which Cliffs acquired, whatever way one views it, was in no sense income-producing in its hands, nor did it fit into any income-producing activity carried on by Cliffs in Australia at that time.

On 18th March 1964, Basic resolved to hold the rights of occupancy in trust for Cliffs. On 18th November 1964 the agreement between the State of Western Australia and Basic was entered into. This changed the position substantially. The State, by this agreement, undertook in Phase 2 mentioned in the agreement, to grant a mineral lease for twenty-one years with successive renewals for twenty-one years. Basic undertook that it would, at a total cost of $35,000,000 install various facilities. Basic further undertook to pay to the State rent and royalties.

On 21st October 1965, Basic went into liquidation, having amended its articles to permit distribution of its assets in specie. On 19th November 1965, a novation agreement was entered into between the State of Western Australia, Cliffs and Basic. Cliffs succeeded to the rights and obligations of Basic and Basic was released.

At this point, Cliffs had substantially added to the obligations which it had undertaken on 17th January 1964. Its real assets had been reduced into possession and added to. Mineral leases had grown out of the rights of occupancy. Although it never used the asset

ATC 4575

which it purchased on 17th January 1964 in income-producing activities, Cliffs might now proceed to make arrangements which would result in income flowing to it from the use of the rights into which the rights of occupancy had grown. Under the joint venture agreement of 25th May 1970, it transferred its rights, with certain exceptions, to the Participants who, in turn, undertook to pay the rent and royalties to the State of Western Australia and who also undertook to pay to Cliffs royalties on iron ore produced and sold or shipped for sale for commercial use from areas which included the areas covered by the agreement of 18th November 1964.

Although the deferred payments bore the appearance of royalties, being computed on iron ore mined and transported from the Reserves, they are not in any sense an outlay made to secure the use, enjoyment or benefit of an asset for a period commensurate with the royalty period. In this latter respect, they may be contrasted with the payment of rent or the payment of certain types of royalties.

It is not easy to describe the relationship between the royalties which Cliffs receives from the Participants with the deferred payments which Cliffs makes in discharge of its obligations under the Option Agreement. Presumably if Cliffs defaulted in making these payments, its right to receive the royalties from the Participants might be endangered by some form of execution. In this sense, it may be said that the making of the deferred payments is a prerequisite to Cliffs receiving its income. However, if one has to answer the question ``what were the deferred payments paid for'', it would appear that the answer must be that both the $200,000 and the deferred payments were paid for the acquisition of the shares and the rights to which they gave access. The ``purchase price'' of the shares is defined in the option agreement as being the Initial Payment of $200,000 (US) plus the deferred payments. True, it is, that the Court is not bound by the label which the parties have attached to the expenditure (
Minister of National Revenue v. Spooner (1933) A.C. 684 at p. 688 ;
Europa Oil (N.Z.) Limited (No. 2) v. Commr. of I.R. 76 ATC 6001 ; (1976) 1 W.L.R. 464 at p. 472 ). The Court's task is to determine the true character of the payments. In undertaking this task, it will regard the description given by the parties as being not without significance. Indeed, the way in which the parties cast their agreement will be of importance in determining the true character of the payments. In the present case, it appears to me that the way in which the parties have treated the deferred payments amounts to more than merely describing them in a particular way; it amounts to ensuring that they are made part of the purchase price.

Upon a purchase of shares, the value of which was so speculative, it is not surprising that the parties adopted such a method, nor is it surprising that no ultimate fixed amount was stated which was to be satisfied by the 15 ¢ (US) per ton. It was open-ended. But the difficulty of stating an ultimate figure was very great and it was probably for this reason that the method was in fact chosen.

It is clear that an income may be purchased by expenditure of a capital nature; it is less clear that for the purposes of sec. 51 a capital asset may be acquired by expenditure of a revenue nature (
Egerton-Warburton v. D.F.C. of T. (1934) 51 C.L.R. 568 ; Colonial Mutual Life Assurance Society Limited v. F.C. of T. (1953) 89 C.L.R. 428). It was submitted that where a leasehold interest is granted in consideration of a premium and a promise to pay rent, the premium is capital expenditure and the rent is revenue expenditure. It was argued that this furnishes an example which may properly be compared with the payments in the present case. However, in the case of the grant of a lease, the rent is closely related to the exclusive use of the land during the period of the payment and will generally cease to run if the lease, for any reason, is terminated. It does not appear to me that it is a true analogy. In the present case the deferred payments are not related to the shares or the use of the rights of occupancy during the period of payment. The most that can be said is that they are related to the mining lease and the production of iron ore therefrom which, in a sense, grew from the rights of occupancy. They will cease to be payable if the iron ore runs out. But I do not think this is enough to give this portion of the so-called ``purchase price'' the character of revenue expenditure. In the circumstances of the present case, it appears to me that the deferred payments are ``for'' a capital asset and are expenditure of a capital nature.

It is unnecessary to determine whether they were losses or outgoings which fall within the words of either of the first two limbs of sec. 51(1). My conclusion they are expenditure of a

ATC 4576

capital nature means that I must hold they are excluded by the latter words of sec. 51(1).

It remains to consider whether the legal expenses amounting to $16,638 incurred in the year ended 31st December 1974 were deductible under sec. 51(1). I have already stated the circumstances in which they were incurred. It appears to me they were losses or outgoings necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. They were not losses or outgoings of capital. Nor does it appear to me they were losses or outgoings of a capital nature. They did bear a relationship to the deferred payments made to Howmet, which I have concluded were payments of a capital nature. The advice related to the deduction of withholding tax from these payments. But this relationship is, in my opinion, insufficient to make the legal expenses an affair of capital. They were not paid for an asset and they were not incurred in relation to the business entity, structure or organisation set up for the earning of profits (see John Fairfax & Sons Pty. Limited v. F.C. of T. (1959) 101 C.L.R. 30). They were incurred by Cliffs in the course of managing its affairs directed generally to the production of revenue and the avoidance of loss. In my opinion the legal expenses are an allowable deduction under sec. 51(1).

The orders I propose are as follows. Appeal allowed. Orders of the Supreme Court set aside. In lieu thereof order that the assessments be remitted to the Commissioner to be amended. Order that the Respondent Cliffs pay to the Appellant Commissioner his costs of the appeal and of the proceedings before the Supreme Court, other than the costs of the issue relating to legal expenses in both Courts.


Back to top

This information is provided by CCH Australia Limited Link opens in new window. View the disclaimer and notice of copyright.