EASTERN NITROGEN LTD v FC of T

Judges:
Lee J

Carr J
Sundberg J

Court:
Full Federal Court

MEDIA NEUTRAL CITATION: [2001] FCA 366

Judgment date: 3 April 2001

Lee J

These two appeals, from a judgment of a Judge of this Court (Drummond J) [reported at 99 ATC 5163], concern the deductibility of outgoings under s 51 of the Income Tax Assessment Act 1936 (Cth) (``the Act'') and the application of Part IVA of the Act to the circumstances relied upon to support the claim of deductibility in respect of those outgoings.

2. I have had the advantage of reading the reasons of Carr J, which set out the relevant facts and it is unnecessary to repeat them.

3. With respect to the first appeal (Q285/99), I agree with Carr J, for the reasons he has provided, that pursuant to the Instalment Purchase Agreement (``IPA'') the ``financiers'' became beneficial owners of the property purchased by the financiers from the appellant under the IPA. That interest in the property was sufficient to enable the financiers, as lessors, to grant to the appellant, as lessee, a right to possess and use the property under a lease-back arrangement made between the financiers and the appellant in an Agreement for Lease of even date under which the financiers agreed to lease the property to the appellant for a term of five years.

4. I also agree with Carr J, for the reasons expressed by him, that on their face the outgoings of rent under the Agreement for Lease were on revenue account and that the relevant facts did not establish that any part of the outgoings was of a capital nature.

5. For the following reasons, I also agree with Carr J that the learned primary judge erred in the construction he applied to s 177D of Part IVA of the Act and in failing to apply the proper construction of the Act to the relevant facts.

6. Pursuant to Part IVA (s 177A to 177G) of the Act the Commissioner may disallow the whole or part of a deduction that is a ``tax benefit'' obtained in connection with a ``scheme'' to which the Part applies. Section 177D provides that Part IVA applies to a scheme where the taxpayer obtains a tax benefit in connection with the scheme and after giving regard to the criteria specified in s 177D(b) it would be concluded that a person entering the scheme did so for the purpose, or the dominant purpose, of enabling the taxpayer to obtain the tax benefit.

7. For s 177D to apply, and a determination made under s 177F that Part IVA applies, it must be shown that the ``maximised... after-tax return'' has been obtained in a manner that speaks of the presence of a purpose above all others to obtain a tax benefit (
FC of T v Spotless Services Limited & Anor 96 ATC 5201; (1996) 186 CLR 404 per Brennan CJ, Dawson, Toohey, Gaudron, Gummow and Kirby JJ at ATC 5206; CLR 416). (emphasis added)

8. Rather than set out a separate conclusion in respect of each item of s 177D(b) the learned primary judge gave composite consideration to the criteria in deciding whether s 177D applied to the relevant facts and in par 121 of his reasons his Honour set out the matters which, if objectively considered, would lead to the conclusion, in his Honour's opinion, that s 177D applied to the circumstances of this case.

9. His Honour attached some importance to the fact that the change in the method by which the appellant obtained finance for use in its business, arose out of a proposal initiated and put to the appellant by Macquarie Bank Ltd (``MBL'') and was not a step taken by the appellant after it had decided for itself that there was a need to change those arrangements.

10. In my opinion, that was a circumstance of neutral consequence. MBL carried on business, inter alia, of arranging financial facilities for operating businesses. MBL did not carry on business as the promoter of schemes in which a taxpayer may participate in order to reduce a


ATC 4167

liability to pay income tax. Indeed, so much was accepted by his Honour as is set out in par 77 of his reasons. Having regard to the foregoing it was not significant, in the terms of s 177D, that the appellant responded to, rather than initiated, the finance proposal outlined by MBL. The need to have, or to obtain, access to working capital on the best available terms was a constant requirement of the business of the appellant. The proposal put forward by MBL was directed to meeting the needs of the business conducted by the appellant and was accepted as such by the appellant.

11. His Honour then stated that the transaction was, in substance, an arrangement under which financiers advanced business funding to the appellant. Again that circumstance, on its face, did not suggest that the appellant, submitted to be the only relevant party for the purpose of s 177D, entered the arrangement with the dominant purpose of obtaining the tax benefit described. Indeed, his Honour's description of the transaction tends to undermine that conclusion.

12. His Honour further stated that the transaction of sale and lease-back had ``a number of elements of artificiality about it'' and in that regard referred to matters such as a sale price that was not related to ``market value''; retention of ``control'' by the appellant of assets sold; and the ``high degree of certainty'' that the appellant would reacquire the assets at the end of the term of the lease. It may be assumed that these points were relevant to the issue raised by s 177D(b)(ii) of the Act, namely, the ``form and substance of the scheme''.

13. Where the scheme, as in this case, involves a transaction which, it is conceded, creates legally enforceable rights and obligations, an objective assessment of the purpose of the transaction must have due regard to the effect of those rights and obligations. If there are ``elements of artificiality'' in the context surrounding the transaction, that fact may have relevance to the purpose for which the transaction was entered into but it does not determine the purpose and nor does it remove the requirement to consider the effect of the transaction and the rights, obligations and duties arising thereunder. In the instant case regard had to be given also to the fact that the scheme was a commercial transaction, made between parties acting at arms length, concerned to protect their respective interests in the terms of their agreements. The latter characteristic will not, in itself, prevent the formation of an objective conclusion that the transaction was entered into with the dominant purpose by a party to the transaction to obtain a tax benefit for a taxpayer, but it is a matter to be duly considered. (FC of T v Spotless at ATC 5206; CLR 416 per Brennan CJ, Dawson, Toohey, Gaudron, Gummow and Kirby JJ)

14. With regard to the connection between the sale price and ``market value'', it was a matter of judgment for the financiers to determine whether the price paid for the assets acquired from the appellant was supported by an appropriate valuation, whether based on historical value; ``fire-sale'' value; value as a going concern; or a value calculated by reference to the capacity of the property to generate cash flow. To say that the price paid for the property was ``unrelated to its market value'' involves a restricted consideration of matters that established the relevant value. Objectively considered, the material relevant to sale price and value did not say anything about the form or substance of the agreement that was relevant to the operation of s 177D.

15. With regard to the continuity of possession of the property by the appellant and the expectation of the appellant that it would be able to reacquire the property at the termination of the lease, the respective rights of the parties were as set out in the agreements that formed the transactions. The financiers could have the assets severed from the land and sold in the event that the appellant defaulted under the Agreement for Lease. Furthermore, the appellant obtained no interest in the property leased by making payments of rent and had no recourse to equity to obtain relief in respect of the ``loss'' of any part of the rental payments said to be of a capital nature in the event that the financiers retook possession of the assets and terminated the lease upon default by the appellant. Any anticipation the appellant may have had as to its ability to meet its obligations under the Agreement for Lease, or that it would be able to deal with the financiers at the end of the Agreement for Lease to reacquire the property it had sold to the financier, had no consequence in law and had no bearing on the legal obligations created by the agreements. The foregoing matters referred to by his Honour do not establish that the ``form and substance of


ATC 4168

the scheme'' attracted the application of s 177D.

16. His Honour also had regard to the fact that the finance proposal as put to the appellant by MBL provided finance to the appellant ``at lower after-tax cost than alternative methods of borrowing'' and considered that feature to be the ``chief attraction'' for the appellant.

17. On the facts found by his Honour the ``after-tax cost'' of finance was always of importance to the appellant in the conduct of its business, whatever line of finance was under consideration. Due and proper management of the business required assessment to be made of the net cost of finance after taking into account the extent to which any outgoings associated with that cost were allowable deductions from assessable income. In the circumstances of this case, to say that the appellant was attracted by a proposal that provided finance at a lower after- tax cost than another means of obtaining funds for the business would not, without more, support an objective conclusion that the appellant obtained finance for the dominant purpose of obtaining the tax benefit constituted by the deductibility from assessable income of the outgoings incurred in connection with the obtaining of that finance.

18. To show that a business which depends upon financiers to provide the recirculating capital needed for the operation of the business, has obtained that finance at a net cost, after taking into account provisions of the Act, that is less than the net cost of obtaining finance by another method, will not, in itself, show that the dominant, ruling or supervening purpose of the operator of the business is to obtain the tax benefit constituted by the extent to which deductible outgoings incurred in respect of that borrowing will be greater than the deductible outgoings that would have been incurred under another method of obtaining finance. That is to say, something more must be shown than that the business has obtained finance at best available net cost after-tax before it can be said that a tax benefit has arisen to which s 177C(1)(b) applies.

19. None of the matters referred to by his Honour suggests an objective conclusion that by obtaining finance at the best ``after-tax cost'', the appellant had a dominant purpose in entering the transaction for the provision of finance of obtaining a ``tax benefit''. To so conclude involved misapplication of the law to the relevant facts. For the reasons set out above, the construction of s 177D of the Act adopted by his Honour and the application of that construction to the facts found by his Honour involved an error of law.

20. I agree with Carr J that there is no reason why this Court cannot determine whether s 177D, properly construed, applies to the facts found by his Honour. I agree, for the reasons provided by Carr J, that the facts do not show that the dominant purpose of the appellant in entering that transaction which provided for the sale and lease-back of assets of the appellant was to obtain a tax benefit. In applying s 177D it is important not to elide the question posed by Part IVA, namely, what was the dominant purpose of a relevant party in entering the transaction (or scheme), with the inquiry, would the transaction (or scheme) have been entered into ``but for'' the tax benefit? The dominant purpose of the appellant was to obtain funds on the best available terms for use in the conduct of the appellant's business. The fact that the arrangements entered into to provide those funds included outgoings deductible under the Act was incidental to the purpose, but not the dominant purpose, of the transaction.

21. I also agree with Carr J for the reasons he gives, that in the second appeal (Q286/99) valuation fees and an establishment fee were outgoings incurred in the conduct of the appellant's business, the nature of the outgoings being expenditure incurred in obtaining working capital for the business with no part thereof being of a capital nature. Further, I agree, for the reasons provided by Carr J, that the relevant facts of the arrangement that provided such finance did not attract the operation of Part IVA of the Act.

22. Each appeal must be allowed and orders made as proposed by Carr J.


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