Case S46

Judges:
KP Brady Ch

JE Stewart M
DJ Trowse M

Court:
No. 2 Board of Review

Judgment date: 20 June 1985.

K.P. Brady (Chairman), J.E. Stewart and D.J. Trowse (Members)

The issue in this reference, which relates to the year of income ended 30 June 1978, is whether or not two payments totalling $475,000 made by the taxpayer, a public company engaged in mining, to secure release from obligations under two loan agreements are deductible under sec. 51(1) of the Income Tax Assessment Act 1936. A further claim made for deduction of legal fees in connection with a proposed employee share option scheme was withdrawn at the hearing.

2. The amounts received under the two above-mentioned loan agreements were $2,500,000 and $2,950,000. Despite their magnitude, they formed only a small part of loan funds obtained from some 28 overseas and local lenders to assist in financing the opening up of a nickel mining operation at M, some 170 kilometres from the seaboard. Total capital requirements of the project were estimated at $230 million, which total covered the establishment of a mine, the construction of a railway and the erection of a treatment plant at the seaboard.

3. The project was owned as to 50% by the taxpayer company, which we shall call A Ltd., with the remaining 50% being owned by a non-resident company, B Ltd. That ownership, however, was not direct, but was effected by each company exercising its interest through a wholly owned subsidiary; we shall call those companies A2 and B2. A's managing director, who was called by it to give evidence, stated that all contracts in relation to the project, whether they be engineering contracts, loan agreements or sales agreements, were all done in parallel so that half were with A2 and half with B2. Additionally, loans that were advanced to A2 were guaranteed by B2, and vice versa. The day-to-day running of the mining operation was conducted by a further subsidiary company, which we shall call C. Thus, the development and operation of the project was conducted as a joint venture by the taxpayer in association with B Ltd.

4. The venture was financed by a mixture of equity capital provided by A Ltd. and B Ltd., and by outside borrowings. The latter were structured so that the liability to repay rested wholly with the project companies, A2 and B2; in other words, no guarantees were put up by the taxpayer company and its fellow joint venturer. The lenders outlaid the loan funds on the basis of the cash flows expected to emerge from the project's own intrinsic value. We were informed that that was a popular means of financing new mining ventures, and was called ``project-financing''.

5. An exception to that procedure, however, lay in the previously-mentioned loans of $2,500,000 and $2,950,000 which were obtained by A2 from two resident merchant banks, X and Y. (As an essential part of the joint venture arrangement, loans of similar amount were made in tandem to B2.) It seems that those two lenders were anxious to be protected in the latter part of the period of their loans from unforeseen increases in interest rates, and required the taxpayer company (and its joint venture partner), contemporaneously with the loan agreements, to enter into further agreements called Put Agreements whereby X and Y could require the taxpayer and B to lend to them such amounts as were then outstanding by their subsidiary companies, A2 and B2. The significant point was that the interest rate payable by X and Y would be lower by ⅛% than the rate they were receiving from A2 and B2. In effect, the parent companies (if so called upon by the lenders X and Y) were required to fund the latter's loans to the respective subsidiaries and carry the risk of the market rate of interest exceeding the pegged rate of 7⅞% attaching to those loans. Thus, to the extent of their obligations under the two Put


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Agreements, both the taxpayer and B became involved in committing funds to the nickel project.

6. In due course the amounts of $2,500,000 and $2,950,000 were advanced to A2 (likewise to B2), by a series of draw-downs commencing some time in 1972, and the necessary expenditures were made to get the project under way.

7. Some few years later, with the development of the mine completed and sales of its products actively being made, discussions took place between the parties to the Put Agreements to ascertain whether the lenders would exercise their rights under those agreements and call upon the taxpayer and B to pay over the funds loaned to their respective subsidiaries. Of particular relevance to the discussions was the fact that the interest rates which the merchant banks were being paid were considerably less than the rates ruling on the open market. Also, interest payments in past years had been necessarily deferred because the cash flow from the mining operation had been considerably lower than anticipated due to a substantial fall in nickel prices. Such a call made on the taxpayer would have required it to borrow the necessary funds, and at a time when interest rates were tending to rise steeply. Accordingly, the taxpayer's directors resolved that there was no viable alternative other than for the taxpayer to buy its way out of its agreements with X and Y and to that end agreed an upward combined total payment to them of $500,000. In the result a somewhat lower figure was negotiated, and in December 1977 a sum of $200,000 was paid over to X, and some few weeks later a sum of $275,000 was paid over to Y.

8. In preparing its taxation return for the year of income in issue, the taxpayer company advised the Commissioner as follows:

``The foregoing amounts are claimed as deductions as being necessarily incurred in carrying on the Company's activities to derive assessable income, and to avoid future deductible losses and outgoings that would have resulted from calls being made by the two companies. The payments are not outgoings of a capital nature.''

9. Some further points concerning the loan agreements with the two merchant banks, which were in similar terms, should be noted. First, repayment was to be made by way of 20 quarterly instalments which would commence with the first quarterly interest payment due after the expiration of 18 months after the completion date (as defined) of all mining, freight and processing facilities, or on 30 September 1976, whichever was to first occur. Secondly, interest was chargeable quarterly on stipulated interest payment dates at the average of rates offered generally as at those dates by selected finance companies. Thirdly, guarantees of the principal amounts covering a period of 20 years from the commencement of commercial operations, also of interest thereon to the extent of 8% per annum, were given by the State Government where the project was located. It may also be noted that, due to the financial problems above-mentioned, the guarantees were subsequently increased in amount and the loan repayments, as well as interest payments so far as A2 and B2 were concerned, were caused to be deferred.

10. We have seen that the taxpayer company has made its claim under sec. 51(1) of the Assessment Act. To the extent that it is relevant, its terms are as follows:

``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, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital... nature...''

It was stated by Dixon C.J. in
John Fairfax & Sons Pty. Ltd. v. F.C. of T. (1958-1959) 101 C.L.R. 30 at p. 34, that an outgoing may be incurred in gaining or producing the assessable income or in carrying on a business for that purpose, but, notwithstanding, may be a loss or outgoing of capital.

11. It seems to us that in the instant case the outlays were clearly incurred by the taxpayer company in carrying on its business for the purpose of gaining its income. For, in its role as holding company of A2, it was required to assume the risk of interest rates for the loans from X and Y rising above 7⅞% and, when its directors saw that that course of action could jeopardise the company's own finances, they had it pay moneys in order that it should be released from its contractual obligations. But


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the crucial question remains, were the outlays of capital or of a capital nature?

12. The Assessment Act does not contain any statutory criterion of ``capital''. Accordingly, the courts have enunciated a number of tests which, though helpful, cannot be regarded as completely authoritative because the circumstances in which the issue arises are almost infinitely variable (see
Bradbury v. United Glass Bottle Manufacturers (1959) 38 T.C. 369 at p. 373). In
B.P. Australia Ltd. v. F.C. of T. (1965) 112 C.L.R. 386, Lord Pearce, in delivering the judgment of the Privy Council, stated at p. 397:

``The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a commonsense appreciation of all the guiding features which must provide the ultimate answer.''

13. If, as has been stated above, we see the outlays as incurred by the taxpayer company in carrying on its business to gain its income, what considerations, whilst not necessarily conclusive, point to them being disbursements of capital or of a capital nature:

  • • first, it might be said that the outlays were not recurrent and could be considered to be once-and-for-all type payments made to get rid of a threatened disadvantage (see
    British Insulated and Helsby Cables v. Atherton (1926) A.C. 205;
    Vallambrosa Rubber Co. Ltd. v. Farmer (1910) 5 T.C. 529; and John Fairfax & Sons Pty. Ltd. v. F.C. of T. (1958-1959) 101 C.L.R. 30).
  • • secondly, the elimination of the threatened disadvantage could be said to produce a benefit of a lasting character to the taxpayer's profit earning organisation (see
    Sun Newspapers Ltd. v. F.C. of T. (1938) 61 C.L.R. 337;
    Vacuum Oil Co. Pty. Ltd. v. F.C. of T. (1964) 13 A.T.D. 278).
  • • thirdly, the payments could be said to be to preserve the permanent financial structure of the enterprise (see
    Commissioner of Taxes v. Nchanga Consolidated Copper Mines Ltd. (1964) A.C. 948). In other words, the payments could be said to appertain to the character and organisation of the company's profit-earning structure, as opposed to being mere incidents in the operations by which the business was being carried on (
    Hallstroms Pty. Ltd. v. F.C. of T. (1946) 72 C.L.R. 634 at p. 648).

14. The last consideration was regarded by the Commissioner's counsel as being most apposite to the fact situation before us. He contended that the investment of moneys by the taxpayer with the merchant banks under the Put Agreements would have involved a substantial alteration to its capital structure. For if those agreements had ultimately been carried through, they would have introduced into its balance sheet an asset of $5,450,000 as constituted by the deposits, and a corresponding liability had the funds been borrowed. As the company's current assets amounted to $2,537,000 at balance date as at the end of the year in issue, with current liabilities amounting to $961,000, the change on the company's financial structure stemming from the merchant banks' action would have been most significant. It was to avoid that major capital change (so the argument ran) that the payments of $200,000 and $275,000 were made. Thus, the Commissioner's counsel contended that the payments were made to preserve the financial structure of the company, and so were outlays of capital.

15. Needless to say, counsel for the taxpayer saw the position very differently. He pointed to the dictum of Dixon J. (as he then was) in Hallstroms Pty. Ltd. v. F.C. of T. (supra) where, speaking as one of the minority at p. 648, he stated:

``What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.''

Counsel argued that the practical way of categorising the payments was to see them as freeing the taxpayer company of making recurrent payments of interest which would necessarily be uncertain in amount because of the spiral taking place in interest rates. In other words (so the argument ran), the payments


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were made simply for the purpose of reducing outlays in later years bearing in mind that those outlays would themselves be deductible in the year of payment. Counsel pointed to the fact that the erstwhile commercial manager of the taxpayer company, when giving evidence for his former employer, explained the payments in terms that they represented prepayments of interest. Also it came out in that officer's evidence that it was by a process of discounting a number of anticipated future interest rates that the outlays of $200,000 and $275,000 were computed.

16. Counsel referred us to a number of cases and placed considerable emphasis on
W. Nevill & Co. Ltd. v. F.C. of T. (1936-1937) 56 C.L.R. 290 and
Anglo-Persian Oil Co. v. Dale (1932) 1 K.B. 124. In the former case, a company which previously had been managed by a sole managing director appointed an additional managing director for a term of five years at an annual salary of $3,000. The system of joint management was not successful, and in the belief that its abolition would lead to increased efficiency and with a view to reducing salary costs, an arrangement was made in the following year for the resignation of the additional managing director under which the company agreed to pay him a sum of $5,000 in consideration of cancelling his agreement. The company claimed to deduct that sum from its assessable income in the year of payment. The High Court agreed with the taxpayer's claim, Rich J. stating at p. 303:

``The company's purpose in effecting the transaction was to save the salary and at the same time to put an end to joint control. In such an expenditure I can see no characteristics which would make it referable to capital account. There is nothing analogous to the acquisition of a fixed asset, to the enlargement of the goodwill of a company or, as in
Ward's case ((1923) A.C. 145), to the rescue of the business from annihilation.''

17. In the Anglo-Persian Oil Co. case, the taxpayer company appointed agents to manage its business and subsequently terminated that arrangement and made over a payment of $600,000. The sum was treated in the company's accounts as a charge to revenue over a period of five years. The Court of Appeal held that the payment was of a revenue nature and was properly deductible by the company in ascertaining its profits, as it did not bring any asset into existence and could not properly be said to have brought into existence an advantage for the benefit of the company's trade. At p. 139, Lord Hanworth M.R. stated:

``... there is no evidence of the purchase of the goodwill of some business, nor is there any trace of a payment to start a business. The payment is to put an end to an expensive method of carrying on the business which remains the same whether the distributive side is in the hands of the respondents themselves, or of their agents.''

18. Finally, taxpayer's counsel referred us to
F.C. of T. v. Snowden & Willson Pty. Ltd. (1958) 99 C.L.R. 431, particularly at p. 446, and B.P. Australia Ltd. v. F.C. of T. (supra) where the payments in issue were not recurrent, and might, on one view, be regarded as abnormal. Certainly, they were not continuing and operational type outlays; yet they were held not to be payments of capital, nor payments of a capital nature.

19. Fairly obviously, the fact situation before us contains some of the indicia of capital payments enumerated by the Commissioner's counsel and some of the indicia of revenue payments recounted by counsel for the taxpayer. However, the characteristic of the release payments that dominates all other aspects of the issue, in our view, is the lasting quality of the advantage which those payments secured for the taxpayer company. (It will be recalled, see para. 13, that it was on that test that Dixon J. placed heavy emphasis in the Sun Newspapers case (supra).) Holding that view, we regard the payments of $475,000 as outlays of capital.

20. It is highly significant in this regard to note that the activities of the taxpayer company at the time of making the release payments were adversely affected by a shortage of funds and that its subsidiary was experiencing grave problems in meeting its interest commitments. In fact, the State Government was required to pay some interest liabilities under its guarantee. Some brief allusion to the taxpayer's financial problems was made in the evidence of its managing director (see p. 28 of the transcript), also that of the taxpayer's former commercial manager (see p. 40 of the transcript). The taxpayer's annual report and accounts for the year in issue, which were tendered in evidence


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as part of Exhibit A, showed that the nickel project had involved the subsidiary, A2, in enormous losses, causing it, the parent, to write down, in the previous year, its investment in the latter company to a nominal figure only. Added to that was the fact that nickel prices had become further depressed with no recovery expected in the short to medium term. The taxpayer company was thus anxious to minimise any financial involvement of its own in the joint venture, and that matter was in fact conceded (see p. 35 of the transcript).

21. If the two merchant banks, X and Y, had exercised their rights under the Put Agreements to call up the funds of $5,250,000 from the taxpayer, it would have been forced to borrow them at high rates of interest, and the consequential admission of new funds of that magnitude into its business would have fundamentally changed its whole financial structure; for example, the company's creditors would have owned a very large stake in its business. In our view, the release payments were made to avoid funding a borrowing arrangement which was related to a business venture which had proved financially disastrous. We regard the saving in interest outlays which resulted from that action as only an ancillary consideration. We see the benefits gained from the release of the ``Put'' obligations as of substantial value to the taxpayer company and as being of an enduring nature. Accordingly, we hold the payments of $200,000 and $275,000 to be outgoings of capital, or of a capital nature.

22. We therefore uphold the Commissioner's action in disallowing the taxpayer's objection, and we confirm the assessment.

Claim disallowed


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