Metals Exploration Ltd. v. Federal Commissioner of Taxation.Judges:
Supreme Court of Victoria
This was an appeal from the Taxation Board of Review (No. 2) [reported as Case S46,
85 ATC 346] to the Supreme Court of Victoria pursuant to sec. 196 of the Income Tax Assessment Act 1936. The facts are as follows:
The appellant taxpayer was a public company carrying on a mining business which in 1971 as part of its business activities joined in a 50/50 venture of a mining nature with an American company Freeport to develop a nickel and cobalt project at Greenvale, some 170 kilometres west of Townsville in Queensland. Neither of the parties were directly involved in developing the project, but each formed wholly owned subsidiaries Metals Exploration Queensland and Freeport Queensland which jointly managed the mining project.
The project involved the expenditure of some $230,000,000 to set up the open cut mine, to construct a treatment plant, to erect buildings and to build a railway from Greenvale to Townsville, which the Queensland Government itself wished to operate.
The taxpayer and Freeport each invested $26,000,000 of equity capital in the venture through their wholly owned subsidiaries and the balance of the moneys required was borrowed equally by the subsidiaries from a large number of financial institutions both in Australia and overseas. This is termed ``Project Financing'', and the whole of the responsibility for repayment of the loans rested initially on the project and with the subsidiaries. The parent companies provided no guarantees in the ordinary sense to lenders. However, the State of Queensland did provide guarantees to Australian finance houses which lent money to the subsidiaries and it passed legislation, which along with Orders in Council guaranteed the repayment of capital sums and interest payments thereon up to a rate of 8%. The subsidiaries agreed with the finance houses to pay interest at a rate varying according to average current market rates on named securities plus 2.8 per centum.
Two loans advanced to Metals Exploration Queensland, the wholly owned subsidiary of the taxpayer, by two merchant bankers, Chase N.B.A. Group Ltd. in the sum of $2,500,000 and Patrick Intermarine (Australia) Ltd. in the sum of $2,950,000 are relevant to this appeal. They were (in this atmosphere) small loans when compared to the $175,000,000 loaned by other finance houses. They were some of the
ATC 4507last loans to be negotiated and, by way of exception to the general rule they were loans in which the taxpayer became directly involved.
Before making these advances, these two finance institutions required not only that the capital sums loaned with interest up to 8% be guaranteed by the State of Queensland and that legislation be passed to this effect, but also (having regard to the duration of the loan), that the taxpayer enter into agreements with them, which have been termed ``Put'' agreements.
These ``Put'' agreements, which the taxpayer executed in or about October 1971, committed the taxpayer at the request of the lenders and in the event that capital sums were still owing by its subsidiary some six years into the future, to lend sums to the finance institutions, equal to the sums still owing by the subsidiary, at an interest rate ⅛th of 1% less than the finance company was at any relevant time entitled to receive from the subsidiary.
At the time of entering upon these ``Put'' agreements, the taxpayer did not contemplate that it would even be required to honour them. It expected that in six years time the project would be flourishing, that dividends would be forthcoming, that the loan from the finance house to the subsidiary would be substantially decreased and that interest rates would not have inordinately increased.
Looked at in detail, the taxpayer if called upon to honour the ``Put'' agreement, would have earned interest which would have been assessable income, but would have had to pay interest on its borrowings, which would have been an allowable deduction.
It needs to be emphasised that the practical business effect of the ``Put'' agreements was that the taxpayer was not exposed to any risk as to capital, but was only at risk as to the amount of any interest differential between, on the one hand, the interest that it would become obliged to pay on money borrowed by it to lend to the finance house and, on the other hand, the interest that it received from the finance house on money lent to it.
The Queensland Government guaranteed capital repayments of money lent by the finance house to the taxpayer's subsidiary and interest up to 8%. It was a term of the ``Put'' agreements that the finance house would, on the taxpayer advancing to it a sum equal to the amount of the loan still outstanding, grant in the taxpayer's favour a valid and effective first charge over all the finance house's rights under the general loan deed and the supplemental loan deed made between the finance house and the taxpayer's subsidiary.
Further the finance house would appoint the taxpayer its attorney with power to exercise all the finance house's ``powers rights and discretions'' arising under those deeds and ``in respect of any guarantee of the loan and any interest thereon''.
Other clauses were also designed to ensure that the taxpayer would not be at any risk as to capital or interest up to 8%, and this appeal has been conducted before me on the basis that the ``Put'' agreements had this effect.
As I see it, towards the end of 1977 there were two interest rates which were uncertain and which were material to the risk run by the taxpayer. The first was the rate at which it would have to pay interest on loan money should it be required to borrow money to lend to the finance house. This would be determined by current market rates on a sum totalling up to $5,450,000. The second was the interest rate at which it was required to lend to the finance house, which was to be calculated according to cl. 6 of the supplemental loan deed, and was to equal the average of the interest rates offered generally in Australia (as at each interest payment date) by each of several named finance companies, in respect of debentures having a six month maturity plus 2.8 per centum. This was the rate chargeable by the finance house on its loan to the taxpayer's subsidiary, and it was also the rate less ⅛th of 1 per centum agreed in the ``Put'' agreement to be payable by the finance house to the taxpayer. This second interest rate might well differ from the rate at which the taxpayer could borrow.
More importantly by cl. 3(3) of the ``Put'' agreement, the finance house was only obliged to pay instalments of capital and interest to the taxpayer ``as and when repayments in respect of the loan and interest thereon are received by'' (the finance house) ``pursuant to the General Loan Deed and the Supplemental Deed''.
Thus the taxpayer was at risk first that it might be required to pay as interest on its borrowing a rate higher than the rate at which it was required to lend to the finance house and
ATC 4508second, that it might only receive interest from the finance house at 8% this being the highest rate guaranteed by the Queensland Government.
I am satisfied that it is reasonable to conclude that the taxpayer could have raised (by borrowings) the $5.45 m. required to honour the ``Put'' agreement. I am also satisfied that the taxpayer has good reason to be concerned that the probable loss of the interest differential referred to above would seriously erode its assessable income from its other mining activities.
I am satisfied that the taxpayer entered originally upon these ``Put'' agreements in the course of its business and for the purpose of gaining or producing income and for the purpose of ensuring that dividends from the operations of its wholly owned subsidiary, would flow to it in the normal course. No other conclusion seems to be open.
However, six or seven years later the scene had changed. Delays had occurred in the development of the immense project, nickel prices had dropped, the Australian dollar firmed against the U.S. dollar, and, all in all, the Greenvale project flagged.
At this stage approaching 1977 the taxpayer prudently considered its position, and the consequences likely to flow if the ``Put'' agreements were to be exercised.
Members of its Board of Directors, associated with banking, expressed the view to the Board that interest rates could be expected to rise to 13% or even more. In that event, the taxpayer could foresee that, having regard to the capital sums still owing by its subsidiary to the merchant banks it might well be called upon to lend $5,450,000 to the finance house, and suffer by way of loss as an interest differential a sum in the region of $300,000 in the first year and thereafter further sums, decreasing year by year as capital repayments were made to the merchant banks by the Queensland Government.
Several exercises were performed calculating at varying rates, what annual payments by way of interest differential might be involved. There were no constant figures able to be used other than the 8% guaranteed interest.
The future market interest rate (and the rate fixed under the ``Put'' agreement) was conjectural; as was the future market price of nickel and cobalt, but the omens were poor if the oracle (as represented by the bankers on the taxpayer's Board) was to be believed.
Payment of the recurring sums representing the possible interest differential would have substantially altered the consolidated profit and loss account figures thrown up by other mining ventures in which the taxpayer was involved in Western Australia and elsewhere. Better it thought, to cut its losses if possible, than to remain exposed to this uncertain though anticipated income drain.
Mr Fletcher, who was managing director of the joint venture from 1971-1975 and a director of the taxpayer from 1975-1985, gave evidence. He was in my opinion a reliable witness. He stated as I have said that at the time the ``Put'' agreements were executed by the taxpayer, ``the risk wasn't regarded as very great, because it was contemplated that quite a significant portion of the loan would be repaid before the `Put' agreement could have been executed or made to the companies... It - the `Put' agreement - was a devise that the merchant bank was able to use to demonstrate that the loans were not exceeding their time frame... that exceeded the liquidity balance sheets and the time frame''.
I accept this evidence and his further evidence that because of the Queensland Government guarantees, the risk ventured by the taxpayer ``would purely be the extent to which there may have been an interest differential'' (pp. 7-8 transcript). His evidence which I accept was that by 1975 the Australian dollar had strengthened to $US1.40. The price of nickel had dropped. Oil prices more than trebled and the project depended on oil for its energy. Although cash operating profits of the project exceeded costs, the project could not fund in full the interest payments due to the lenders.
Deferrals were negotiated.
The taxpayer had invested equity capital of $26,000,000 and when the Queensland Government was called upon to meet its obligations under its guarantee and the obligation of the subsidiary ``rolled'', the taxpayer had to consider its commitment.
The project was ``not meeting the market rate of interest'', and ``it was plain that the two
ATC 4509lenders would be making use of the `Put' agreement as a mechanism to make up the difference between the guaranteed interest and the market rate of interest''.
The taxpayer at this stage decided ``given that there was a lot of concern about future interest rates and how they were likely to go up rather than come down, it would be very desirable if'' (the taxpayer) ``was able to rid itself of the uncertain obligation that was there under those agreements... by negotiating with the two lenders an amount to pay as a single payment to relieve us of the obligation'' (pp. 12-13 transcript). As I have said, calculations were made of the possible obligation according to different assumed interest rates.
Then, following discussion with the merchant bankers, it was apparent that the taxpayer's views as to the future, and the views of the merchant bankers ``were not in parallel''. This was fortunate for the taxpayer.
Consequently the taxpayer was able to negotiate favourably, as it turned out, the cancellation of the ``Put'' agreements by payment of a lump sum to the merchant banks. At the same time it wrote down in its books to next to nothing its equity in its subsidiary.
By negotiating the cancellation of the ``Put'' agreements the taxpayer avoided the uncertainty of its commitment, consequent on anticipated rising interest rates, and the consequent recurrent interest drain on its profits made on other ventures in Western Australia and elsewhere.
These lump sums were paid to the merchant banks in the financial year ending 30 June 1978.
It is in these circumstances that the question arises, whether the taxpayer is entitled under sec. 51(1) to claim that these payments to the merchant banks were an allowable deduction as a loss or outgoing.
I have already said that the original ``Put'' agreements were in my opinion entered upon by the taxpayer in the course of its business, and that it did so for the purpose of gaining or producing income. I also am satisfied that any resultant outgoing or loss was incurred in gaining or producing assessable income or attempting to do so.
It has been submitted that in fact the taxpayer's whole basis structure was at risk and that the $5,450,000 that it would have been necessary for it to borrow in order to fund the ``Put'' agreements would have threatened the solvency of the company itself.
The evidence led runs counter to this submission and I do not accept the submission.
Having heard the evidence of Mr Fletcher and Mr de Guin Gand I find that the taxpayer negotiated the cancellation of the ``Put'' agreements in order to avoid the risks of an annual recurrent drain on its income, likely to be occasioned by having to meet an outgoing approximately equal to the amount by which interest calculated on the sum owing by its subsidiary at relevant market rates exceeded 8%. In other words, it had despaired at that time of its subsidiary being able to pay interest as it fell due on its borrowing at the rates fixed under the supplemental loan agreement, and it feared that market interest rates (should it have to borrow and as represented in the supplemental loan agreement) would rise further in the future.
From a business point of view, the consequences of this situation were if possible to be avoided. Hence the cancellation of the ``Put'' agreements was negotiated for a lump sum.
There is no argument but that the lump sums paid on the cancellation of each ``Put'' agreement was in fact in the best interests of the taxpayer. What is debated is whether they were sums deductible under sec. 51(1) of the Act.
In my opinion it is clear that had the ``Put'' agreements remained in force, the taxpayer would have been likely to sustain an assessable income loss of the ``interest differential''. What this would have been, nobody could predict accurately at the time, but the differential payment of interest would in my opinion, have amounted to an allowable deduction from assessable income. Strictly, the taxpayer would have had to pay interest on its borrowing at market rates. It would then have been required to lend to the merchant bank and to have received interest from it at the rate less ⅛th of 1% agreed to be paid by its subsidiary to the merchant bank concerned, and actually received by the said merchant bank - a rate which was likely to be 8% - the maximum rate guaranteed by the Queensland Government to the merchant bank.
see clause 3(3) Exhibit-D
I find that the taxpayer was able to pay the negotiated sums to cancel the ``Put'' agreements out of its operating profits. It did not borrow nor realise a capital asset for this purpose.
I accept the evidence of Mr de Guin Gand that the sums paid to Chase and Intermarine by the taxpayer were calculated by concentrating upon anticipated interest rates. Exhibit ``L'' is but one of the tables built up as a series of exercises for this purpose.
The sums paid to the finance houses were arrived at by negotiations, conducted at arm's length. Each side had a different view as to the height to which interest rates could escalate during the likely applicability of the ``Put'' agreements. Accordingly each was able to reach an agreement which it believed to be in its own best interests.
None the less, it has been submitted on behalf of the respondent Commissioner that the sums payable were at best ``losses or outgoings of capital, or of a capital... nature'', and so excepted from what otherwise would be allowable deductions under sec. 51(1) of the Act. It is this issue as to the proper characterisation of the payments which must be decided on this appeal.
I have found that the payments were made out of recirculating funds and were made because it was seen by the taxpayer to be commercially prudent to avoid the risk of incurring anticipated increasingly high interest payments to which it would otherwise be exposed each year, which interest payments would constitute a high drain on the taxpayer's assessable income from other business sources.
The ``Put'' agreements were originally entered upon by the taxpayer in the course of the taxpayer's business and within the meaning of sec. 51(1), the interest liability incurred was necessarily incurred in carrying on its business for the purpose of gaining or producing assessable income. (i)
F. C. of T. v. Munro (1926-1927) 38 C.L.R. 153, (ii)
F. C. of T. v. Total Holdings (Australia) Pty. Ltd. 79 ATC 4279.
Had the taxpayer been called upon to honour the ``Put'' agreement, any loss of interest on money borrowed to fulfil its obligation under the agreement, would in my opinion have been an allowable deduction from its assessable income.
This anticipated contractual obligation of a recurring nature - an obligation to pay interest - which was incurred as part of the expense of conducting the taxpayer's business - and was necessarily incurred for the purpose of gaining or producing assessable income, was what the taxpayer wished to avoid. It was this obligation which was avoided by the payment of the sums in question and the consequent cancellation of the ``Put'' agreements.
Hancock v. Gen. Reversionary & Invest. Co. (1919) 1 K.B. 25.
No asset or advantage for the enduring benefit of the taxpayer's business was created by the transaction (
W. Nevill & Co. Ltd. v. F.C. of T. (1936-1937) 56 C.L.R. 290 at pp. 299-301, 303-304, 306;
Ronpibon Tin N.L. v. F.C. of T. (1948-1949) 78 C.L.R. 47 at pp. 55-58;
Anglo-Persian Oil Co. Ltd. v. Dale (1932) 1 K.B. 124 at pp. 137-139, 147;
British Insulated and Helsby Cables v. Atherton (1926) A.C. 205 at p. 213).
The taxpayer's business remained the same, but an expensive method of carrying it on was brought to an end.
The Privy Council in
B.P. Australia Ltd. v. F.C. of T. (1965) 112 C.L.R. 386 considered the appropriate characterisation to be given to the lump sums paid by petrol owners in consideration of the letter agreeing to sell only approved brands of petrol. In the High Court the majority McTiernan, Windeyer, Owen JJ. had confirmed the judgment of Taylor J. that the payments were of a capital nature. Dixon C.J. and Kitto J. dissented. Dixon C.J. had said [(1963-1964) 110 C.L.R. 387] at p. 410:
``I do not think it was acquiring a capital asset or doing any more than so conducting its business on revenue account as to increase it and make as certain as it could that its business was continuing and also would continue, if possible to expand.''
Kitto J. pointed out that the purpose and practical effect of the agreement was to produce a practical certainty that the whole of the custom of the service station would come to the petrol seller and distributor, for the agreed period, that the petrol seller was not establishing once and for all a situation in which to set about selling petrol, that the
ATC 4511agreements did not increase the value of goodwill, and that from an accounting viewpoint it would be odd not to bring in as an item of marketing cost, the moneys expended.
The Privy Council agreed with the minority and said at p. 394:
``A valuable guide to the traveller in these regions is to be found in the well-known judgment of Dixon J. (as he then was) in the case of
Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 61 C.L.R. 337 where he discussed the nature of certain sums spent in buying up the competition of a rival and concluded that they were capital. `There are, I think', he said at p. 363, `three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment'. And he also said at p. 362 `the expenditure is to be considered of a revenue nature if its purpose brings it within the very wide class of things which in the aggregate form the constant demand which must be answered out of the returns of a trade or its circulating capital and that actual recurrence of the specific thing need not take place or be expected as likely''
In my opinion, the dominant feature of the payment of the lump sums in the present case is that its purpose was to eliminate the contractual obligation to incur a recurrent liability to pay interest which could not be recouped, and the payment of which interest itself would have been an allowable deduction on revenue account to the taxpayer. The lump sum payment was from a practical and business point of view calculated to effect a beneficial resolution of this threatened recurrent drain on assessable income. This was the occasion which called for the expenditure.
Hallstrom's case (1946) 72 C.L.R. p. 634
B.P. Australia case (1965) 112 C.L.R. at p. 397
F.C. of T. v. Marbray Nominees Pty. Ltd. 85 ATC 4750 Tadgell J. decided that payment of a lump sum as consideration for the early repayment of a mortgage loan was a charge on revenue account. He said at pp. 4756-4757:
``I consider that the evidence reveals the payment of $5,862 to have been incurred in order to rid the respondent of a recurring obligation to pay interest upon a debt that was part of the expenses of conducting the business as a whole...''
His Honour, having considered authorities which he set out, concluded at p. 4757: ``I cannot see that the outgoing of $5,862 satisfies any of the requirements for an expenditure of a capital nature recognised by the authorities''. This case is for practical purposes very close to the instant case, and in my respectful opinion the decision is correct.
The present case is distinguishable from
F.C. of T. v. Ilbery 81 ATC 4661 where the repayment was not made for any purpose connected with the making of assessable income, but was made solely for the purpose of securing a tax advantage. No such purpose can be discerned in the present case.
The Board of Review appears to have decided in the present case that the payments were payments of a capital nature because of ``the lasting quality of the advantage which those payments secured for the taxpayer company'' (para. 19). It thought that the ``commitment to borrow some $5.45 m. would have fundamentally changed its whole financial structure'' (para. 21).
It stated ``We regard the saving in interest outlay which resulted from the action as only an ancillary consideration''.
I do not agree with these findings. In my opinion insufficient weight has been given to the fact to which I have referred above that capital borrowings were not at risk, and that the only risk was the ``interest differential''. Moreover, it cannot be said, in my opinion, that savings in interest outlays were merely an ancillary consideration. They were, as I have found, the initiating cause for negotiating the cancellation agreements, and for paying the sums in question. There is nothing in the
ATC 4512evidence to support the assertion that the taxpayer was threatened with annihilation.
Just as it was thought appropriate in 1971 for the taxpayer to enter upon the ``Put'' agreements in gaining or producing assessable income, it was in 1977 thought appropriate to incur these outlays to the same end, and it is, in my opinion, clear that the payments were dictated by the desire to avoid losses or outgoings of recurrent interest payments to be made from income earned elsewhere.
In this sense, they were necessarily incurred in carrying on the taxpayer's business for the purpose of gaining or producing the assessable income.
I am of the opinion that they come within both limbs of sec. 51(1).
F.C. of T. v. Snowden & Wilson Pty. Ltd. (1958) 99 C.L.R. 431 at 437 per Dixon C.J.; 443 per Fullagar J.
and that there is nothing sufficient to lead me to find that the payments were losses or outgoings of capital or of a capital nature.
I would allow the appeal, set aside the decision of the Board of Review and direct that the respondent the Commissioner of Taxation alter the adjustment sheet issued herein by eliminating the sum of $475,000 disallowed therein and by making appropriate alterations thereto and to the Notice of Assessment of the appellant taxpayer for the year ending 30 June 1978.