BHP Petroleum (Bass Strait) Pty Ltd v Commissioner of Taxation

introduction 1 The Court has before it 39 tax appeals brought by BHP Petroleum (Bass Strait) Pty Ltd ("BHPPBS") and Esso Australia Resources Ltd ("EARL") against decisions of the Commissioner of Taxation ("Commissioner"). BHPPBS is the applicant in 16 of the appeals and EARL in 23. The appeals raise the same or very similar issues and arise out of the same or very similar circumstances. They were for this reason heard together. 2 The primary issue before the Court concerns the status, for tax purposes, of sums of money to which the applicants claimed an entitlement under certain third party contracts of supply. In particular, the Court must decide whether the Commissioner's assessments of their tax liability for the tax years ended 1991-96 (for BHPPBS) and 1991-97 (for EARL) were excessive, as the applicants contend.

factual background 3 In the mid-1960s, EARL and BHP Petroleum (North West Shelf) Pty Ltd ("BHPPNW") became jointly engaged in the exploration and production of petroleum products in the Bass Strait. Shortly thereafter they began to supply two products, natural gas and ethane, to 6 companies ("buyers") under individual contracts of supply ("Supply Contracts"). The Gas and Fuel Corporation of Victoria ("GFC") and the State Electricity Commission of Victoria ("SECV") were each supplied gas by EARL and BHPPNW (contracting jointly). Hydrocarbon Products Pty Ltd ("HPPL") and Kemcor Olefins Limited ("Kemcor") were each supplied ethane by EARL (contracting independently). Huntsman Chemical Company Australia Pty Ltd ("Huntsman") and Mobil Oil Australia Limited ("Mobil") were each supplied ethane by BHPPNW (contracting independently). The rights and obligations of BHPPNW under its Supply Contracts with the GFC, the SECV, Huntsman and Mobil were assigned to BHPPBS from 1 June 1988. HPPL's rights and obligations under its Supply Contract with EARL were assigned to Huntsman from 25 July 1978. Save for these assignments and for various amendments to terms not presently relevant (as well as the actual petroleum product supplied) the 6 Supply Contracts are identical in all respects material to the current proceedings and remained in force throughout the years in issue. Except where the contrary is indicated, reference throughout these reasons to individual Supply Contracts is thus restricted to those involving EARL and BHPPBS ("sellers") on the one hand, and the GFC or SECV on the other ("GFC and SECV Contracts").

1. The Supply Contracts 4 Under the terms of the GFC and SECV Contracts, the sellers jointly agreed to sell and deliver requested quantities of gas for and to the buyers on a daily basis. The gas became the property of the buyers at the Point of Delivery (as defined): see GFC Contract cl 11.1 and SECV Contract cl 13.1. In exchange for the gas the buyers undertook to pay an annually-determined amount ("Contract Price") to the sellers calculated in accordance with the GFC and SECV Contracts: see GFC Contract cl 12 and SECV Contract cl 19. The Contract Price was paid monthly upon statements prepared and issued by the sellers under the GFC and SECV Contracts ("Standard Monthly Invoices"): see GFC Contract cl 14 and the SECV Contract cl 22. Each monthly amount was calculated by the sellers on the basis of an agreed average price for gas supplied in the preceding month with additional provision, in the twelfth month of each contractual year, for any necessary adjustment to ensure that the total amount paid by each buyer over that year reflected the Contract Price. Payment of the Contract Price was required by the buyers within about a fortnight of receipt or delivery of a Standard Monthly Invoice. Any default in payment entitled the sellers to charge a fixed rate of interest on the amount due unless, amongst other things, the default was the result of a bona fide dispute between the parties: see GFC Contract cl 14.7 and SECV Contract cl 22.5. Provision was also made in each Supply Contract for a redetermination of the Contract Price in certain circumstances upon request by one of the parties. 5 Two additional provisions of the Supply Contracts are of particular importance to the current proceedings. The first of those provisions required an adjustment of the Contract Price to reflect any change in the sellers' tax liability arising from the introduction of new imposts attributable to the production or supply of gas (or ethane) for and to the relevant buyer. Clause 12.8 of the GFC Contract stated as follows. 12.8 The payment for gas determined in accordance herewith shall be: (a) increased to take into account the full amount of any new royalties, taxes (other than income tax), rates, duties or levies imposed on Sellers after 1st January, 1975 and attributable directly to the production of natural gas for Buyer or the supply of gas to Buyer; (b) increased to take into account the increase in amount resulting from any increase in the rate or any change in the basis of calculation of royalties, taxes (other than income tax), rates, duties or levies above the levels existing at 1st January, 1975 and directly attributable to the production of natural gas for Buyer or to the supply of gas to Buyer; (c) decreased to take into account the decrease in the amount resulting from any decrease in the rate or any change in the basis of calculation of royalties, taxes (other than income tax), rates, duties or levies below the levels existing at 1st January, 1975 and directly attributable to the production of natural gas for Buyer or to the supply of gas to Buyer; Any such increases or decreases shall be effective upon the imposition thereof. In the event of any such increase or decrease Sellers shall provide Buyer with details of the increase or decrease and the method and distribution of such royalties, taxes, rates, duties or levies; BUT any increase in the amount of any royalties, taxes (other than income tax), rates, duties or levies above the levels existing at 31st May, 1974 attributable to any change in the basis of calculating the well-head value resulting from the review then current and undetermined at the date of this Contract shall not be taken into account. For the purpose of this Clause, the expression 'Income Tax' shall mean any tax of general application imposed on income, but shall not include any tax specifically imposed on income derived from the production and sale of natural gas or more generally, on income derived from the production and sale of petroleum and other minerals to the extent to which such tax is attributable to income derived by Sellers or either of them from the production of gas for Buyer or the supply of gas to Buyer. I note that the equivalent clauses of the other Supply Contracts (e.g., SECV Contract cl 19.5) referred to imposts "attributable to" the production or supply of gas or ethane, rather than to imposts "attributable directly to" such production and supply as in the GFC Contract. Nothing turns on this distinction in these proceedings. 6 The second provision of particular importance to the current proceedings required that any dispute arising under the Supply Contracts be referred by the contracting parties to arbitration for resolution. Clause 23 of the GFC Contract relevantly provided as follows. 23. Any controversy or claim arising out of or relating to this Contract or the alleged breach thereof shall be settled by arbitration in accordance with the Arbitration Act of the State of Victoria, and in accordance with the following: … (c) the award shall be made in writing and signed by the arbitrators or the umpire as the case may require and shall be final and binding on the parties; the parties shall abide by the award and comply with the terms and conditions thereof; …

I observe that the reference in this and the equivalent clauses of the other Supply Contracts (e.g., SECV Contract cl 25) to the Arbitration Act of Victoria is to be read as a reference to the Commercial Arbitration Act 1984 (Vic) ("CAA") in accordance with the terms of that Act (s 3(2)(b)).

2. The secondary tax regime 7 From the outset of their joint venture, the sellers have been liable to pay tax and other imposts in respect of petroleum recovered from the Bass Strait. Immediately prior to 1991 that liability arose from three principal sources. The first was the Petroleum (Submerged Lands) Act 1967 (Cth) ("PSLA") and the Petroleum (Submerged Lands) (Royalty) Act 1967 (Cth) ("PSLRA"), pursuant to which royalties were payable on petroleum recovered from all off-shore areas beyond the outer limits of Australia's territorial sea, including the Bass Strait, calculated by reference to the value of petroleum at the wellhead. The second was the Excise Act 1901 (Cth) and the Excise Tariff Act 1921 (Cth) (as amended), which imposed, from 19 August 1975, duties of excise on all stabilised crude petroleum oil and liquid petroleum gas (but not natural gas) calculated by reference to the classification of the particular product. The third was the Income Tax Assessment Act 1936 (Cth) ("ITAA"), which imposed a tax on assessable income, including assessable income derived from gas recovered in the Bass Strait. A fourth source of petroleum-related tax also existed, but did not apply in respect of products supplied under the Supply Contracts. This was the Petroleum Resource Rent Tax Act 1987 (Cth) ("PRRT Act") and the Petroleum Resource Rent Tax Assessment Act 1987 (Cth) ("PRRTA Act"), pursuant to which a petroleum product producer incurred a liability to pay an amount by way of a petroleum resource rent tax ("PRRT") on taxable profit in relation to certain petroleum-related projects, not including projects in the Bass Strait. 8 The Petroleum Resource Rent Legislation Amendment Act 1991 (Cth) ("Amendment Act"), which received Royal Assent on 26 June 1991, altered the secondary tax regime applicable in the Bass Strait. For the purpose of these proceedings, that Act can be considered as having had two principal effects. First, it subjected the sellers retrospectively to the general obligations of the PRRT Act regarding petroleum recovered from the Bass Strait since 1 July 1990 including, in particular, the obligation to pay tax in respect of assessable petroleum receipts derived in relation to a petroleum project under ss 4 and 22 of that Act: see Amendment Act, ss 31, 38. Secondly, it limited the application of the PSLRA to the North-West Shelf petroleum fields from 1 July 1991, thereby removing the sellers' previous liability to pay royalties on the Bass Strait petroleum products. The Amendment Act also effectively removed any excise duties that had been payable on petroleum products recovered from the Bass Strait. It did not affect the sellers' liability to pay income tax under the ITAA. 9 In its original announcement regarding the Amendment Act (published in the 1990-1991 Budget Statement of 21 August 1990), the Federal Government described the effect of that Act as being to increase the efficiency of the secondary tax regime by replacing the then existing excise and royalty arrangements with a tax "based on profits rather than production" that would be "sensitive to changes in prices and costs" (para 4.6). This flexibility would, the Government stated, "remove the pressure for continual changes in excise rates as production declines or market conditions vary" (para 4.6). The Government also recognised, however, that the Amendment Act's retrospective extension of the PRRT Act to cover the Bass Strait petroleum-related projects would require certain transitional arrangements, which it foresaw as operating in the following way (para 4.7). [T]he Bass Strait producers will continue to be liable for excise and royalty until the amending legislation is enacted . It is expected that a reconciliation between the tax liabilities of the two regimes will occur when the 1990-1991 [PRRT] final assessment is made. These interim payments are expected to equate broadly with the [PRRT] liabilities on 1990-91 production. The transitional arrangements referred to here are reflected in ss 39 to 42 of the Amendment Act. 3. The issues for determination in the current proceedings 10 By virtue of s 17 of the ITAA as it stood at the relevant time, income tax was levied "upon the taxable income derived during the year of income by any person". By virtue of s 6, "taxable income" meant "the amount remaining after deducting from the assessable income all allowable deductions". Section 25(1)(a) relevantly provided that, where the taxpayer is a resident, the assessable income of a taxpayer includes "the gross income derived directly or indirectly from all sources whether in or out of Australia". 11 Section 4 of the PRRT Act imposed a tax in respect of "the taxable profit of a person of a year of tax in relation to a petroleum project". Section 5 set the rate of tax at forty per cent. The PRRT Assessment Act provided, in s 21, that: Subject to this Act, tax imposed in respect of the taxable profit of a person of a year of tax in relation to a petroleum project is payable by the person. The term "taxable profit" was calculated as the amount by which assessable receipts exceeded deductible expenditure and the amounts (if any) transferred under ss 45A and 45B: see PRRT Assessment Act, s 22. The term "assessable receipts derived by a person in a financial year in relation to a petroleum project", as defined in s 23(1)(a) of the PRRT Assessment Act, included "assessable petroleum receipts" in relation to a petroleum project. By virtue of s 24, the sellers' assessable petroleum receipts were, for relevant purposes, "the consideration receivable, less any expenses payable, by the person in relation to the sale". The parties proceeded on the basis that the term "consideration receivable" meant "payable": cf West v Miller (1868) 6 LR Eq 59 at 64; also Clyne v Deputy Commissioner of Taxation (1981) 150 CLR 1 at 10. The PRRT Assessment Act, like the ITAA, provided for the annual taxation of profits where the relevant tax year was the year ending 30 June in each year. 12 The issue at the centre of the current proceedings is whether the Commissioner erred in including in his assessments of assessable income and assessable receipts certain amounts to which the sellers were entitled under cl 12.8 of the GFC Contract (or cl 19.5 of the SECV Contract and the equivalent provisions of other Supply Contracts) because of the changes in tax liability introduced by the Amendment Act. In respect of this it was accepted by the parties that, in the particular circumstances of the present case and for the purpose of these proceedings, the operation of the concepts of "income derived" and "consideration receivable" under the ITAA and PRRT Act respectively were not materially different. The parties accepted that the Court's findings in respect of the former should apply in respect of the latter. Accordingly, save where the contrary is indicated, I refer below only to the ITAA. Thus, the Commissioner's case was based on the proposition that the amounts claimed in the pass-on letters and invoices (terms explained below) were (1) income derived by the sellers when they supplied the gas (or ethane) and (2) the consideration receivable for the gas (or ethane) since these amounts constituted part of the price charged for the products. For the reasons set out below, the sellers contested these propositions. 13 Before considering the central issue, it is necessary to give some further explanation of the events following the Federal Government's announcement of the changes that were to be made to the secondary tax regime. The sellers' case was largely that these events - including the disputes that arose between the sellers and the buyers about the impact of the Amendment Act on the Contract Price payable by the buyers - rendered any entitlement on the sellers' part to an increase in the Contract Price non-assessable for tax purposes, at least until the disputes had been finally resolved. This resolution, so the sellers said, came with the settlements in 1996 (for the GFC and SECV Contracts) and in 1994 (for the remaining Supply Contracts). The result (so it was said) was that only the amounts received by the sellers under the terms of such settlements were assessable for income tax and PRRT purposes.

4.1 Introduction 14 On 27 August 1990, only 7 days after the Federal Government's announcement of the proposed extension of PRRT to the Bass Strait, the sellers notified the buyers that they intended to pass on the impact of the PRRT to the buyers under cl 12.8 of the GFC Contract (and 19.5 of the SECV Contract and the equivalent provisions of the other Supply Contracts). Thereafter, the sellers adopted a practice of endorsing their Standard Monthly Invoices with a note in the following (or equivalent terms): The Federal Government has replaced the Royalty and Excise Regime with a Resource Rent Tax effective from 1 July 1990. The effect of this change on the gas price is currently being calculated and the Sellers reserve the rights to make appropriate adjustments to the gas price once the process of calculating the impact of the Resource Rent Tax has been completed. 15 On 21 December 1990, the sellers received a written response to their notice and endorsements from the GFC, reserving the GFC's rights to reject any claim for further payments under clause 12.8 following introduction of the PRRT. This notification was followed, in July 1991, with a further exchange of correspondence between the sellers and the GFC contesting the implications of the Amendment Act for the Contract Price payable under the Supply Contracts. Whilst agreeing that some adjustment of the Contract Price was required, the parties disputed just what that adjustment was. At the heart of their disputes was their disagreement over whether or not the newly extended PRRT was "attributable (directly)" to the production or supply of gas (or ethane), with effect that the sellers became entitled to pass on the value of their PRRT liability to the buyers. The GFC argued that it was not, and that the only adjustment of the Contract Price required by clause 12.8 and equivalent provisions was its reduction to take account of the Amendment Act's effective abolition of PSLA royalties. The sellers maintained their entitlement to increase the Contract Price to cover the net burden of the new PRRT, and rejected the GFC's claimed entitlement to off-set that increase to take account of the abolition of royalties. 16 Before long the dispute involving the GFC Contract spread to the remaining Supply Contracts, with the buyers under those Contracts adopting essentially the same position as the GFC. 17 Despite the sellers having consistently maintained an entitlement to increase the Contract Price under each of the Supply Contracts following announcement of the Amendment Act in 1990, it took them over a year to calculate the extent of such entitlement. Claims based on these calculations were first made on or soon after 13 November 1991, when the sellers sent letters to each of the buyers requesting the payment of additional monies owed to them in respect of gas and ethane supplied from 1 July 1990. The sums claimed in these letters took into account both the introduction of PRRT and the abolition of PSLA royalties. 18 The (net) amount of the increase ultimately claimed by the sellers was referred to throughout these proceedings as "pass-on amounts", and the individual letters or invoices by which they were periodically claimed as "pass-on letters" or "pass-on invoices". For the purpose of these reasons, I retain this usage of "pass-on letters" or "pass-on invoices". I use the expression "pass-on amounts" to mean the amounts to which the sellers were entitled under cl 12.8 of the GFC Contract (or cl 19.5 of the SECV Contract and equivalent provisions) as a result of the Amendment Act, rather than to mean the amounts to which they claimed to have an entitlement. 19 The buyers paid none of the pass-on amounts. In addition, from September 1991 in the case of the GFC and February 1992 in the case of the SECV, the GFC and the SECV withheld the payment of all PSLA royalties claimed by the sellers in their Standard Monthly Invoices ("withheld royalties"). This practice resulted in additional claims by the sellers against those companies for interest on the withheld royalties in reliance on the GFC and SECV Contracts: see GFC Contract cl 14.7 and SECV Contract cl 22.5. From 1992, the other buyers took up this practice of withholding PSLA royalties using the calculation of the royalties contained in the sellers' pass-on letters. 20 The contractual disputes between the sellers and each of the buyers were further complicated by the repeated requests of the latter for provision of full details regarding the method by which the pass-on amounts were calculated, and by claims that, when eventually provided, the details did not satisfy the requirements of cl 12.8 of the GFC Contract (or cl 19.5 of the SECV Contract and equivalent provisions). There were, furthermore, requests by Mobil, Huntsman and Kemcor for a redetermination of the Contract Price under each of the Supply Contracts to which they were party. 21 The disputes between the various contracting parties concerning the impact of the Amendment Act on the Contract Price payable by the buyers followed a similar path, and were ultimately referred by the sellers for resolution by arbitration in accordance with the terms of each Supply Contract in late 1991 (for the GFC and SECV Contracts) and early 1992 (for the other Supply Contracts). Of the proceedings thus instituted only those involving the SECV Contract ("SECV arbitration") resulted in an Award. The other proceedings were abandoned following settlement of the disputes in 1996 (for the GFC Contract) and in 1994 (for the remaining Supply Contracts).

4.2 The SECV arbitration 22 In 1993, the sellers applied unsuccessfully for an interim Award requiring the SECV to pay the withheld royalties with interest. More successful was their substantive claim, heard and decided the following year, to recover from the SECV as monies owed under cl 19.5 of the SECV Contract the pass-on amounts claimed in their pass-on letters and invoices (as amended) from 1991. In determining that claim the arbitrators were required to resolve four main issues, which were described in an Award of 30 November 1994 ("Award") as follows. 1. Whether the tax imposed by the [PRRT Act] and the [PRRTA Act] falls within the description contained in clause 19.5(a)(i) of the [SECV Contract] … and can thus be passed onto the Buyer by way of an increase in the amount Buyer pays for the product supplied ["pass-on issue"]. 2. Assuming that there is a pass on, is the amount of the [PRRT] pass on itself an 'assessable receipt' under Section 23 of the [PRRTA Act], so that such amount can be 'grossed up', i.e. 'so as to recover the tax upon the tax recovered?' ["gross-up issue"] 3. Assuming there can be a pass on, what is the fairest and most reasonable method to determine the difference between the assessable receipts received by Sellers for the supply of natural gas, and the deductible expenditure in respect of such receipts, so as to calculate the amount of taxable profit upon which the 40% [PRRT] is imposed? To ascertain that profit required the allocation of the costs of production of natural gas, which costs include joint costs of the production of both oil and gas. This required the identification and application of the fairest and most reasonable method of allocating such joint costs. Sellers contend such a method is the revenue allocation method. Buyer contended that this method was manifestly unreasonable and unfair, and should be rejected … ["method issue"]. 4. Assuming a pass on, there is the further question of the allocation of [PRRT] amongst customers. Relevantly Buyer takes approximately 13% of natural gas produced, and [the GFC] 82% and there are some other minor purchases ["customer issue"]. (There may have been some misstatement of issues, but if so, nothing turns on this in these proceedings.) 23 Each of these issues was decided in substance against the SECV. In respect of the pass-on issue, the arbitrators held that the sellers' ability to calculate the taxable profit arising from the production of gas - albeit by a method strongly opposed by the SECV - meant that the PRRT payable on that profit could be said to be "attributable" to the production of gas within the meaning of cl 19.5. The arbitrators also relied on this reasoning to support a similar conclusion in respect of the "attributability" of the PSLA royalties. The result was that both the imposition of PRRT and the abolition of PSLA royalties were held to require an adjustment of the Contract Price under cl 19.5. 24 In respect of the gross-up issue, the arbitrators again found against the SECV on the basis that all of the monies received by the sellers as part of the Contract Price under cl 19 were assessable for PRRT purposes. This meant that if, so the arbitrators reasoned, the intention of cl 19.5 was to enable the sellers to pass on in full the net cost to them of any new imposts falling within cl 19.5, then the clause was to be read as requiring adjustment of the Contract Price on a gross-up basis. (I note in this context that only EARL's claim to gross up the amount of PRRT for which it was liable under cl 19.5 was accepted by the arbitrators, since BHPPBS had not at the time of the Award been assessed for PRRT on the pass-on amounts claimed from the SECV.) 25 The method issue was also decided in favour of the sellers. According to the arbitrators, the SECV had failed to show either that the revenue allocation method adopted by the sellers was not a fair and reasonable method of cost allocation, or that such method was manifestly inferior to any alternative method proposed by the SECV. 26 A similar finding resolved the fourth issue. Specifically, the arbitrators rejected the SECV's claim that the production of gas supplied to it by the sellers resulted in little or no profit because of the unprofitable sources from which the gas was taken, and that the sellers' proportionality-based method of allocating PRRT in respect of such gas was for this reason unfair and unreasonable. 27 Finally, the arbitrators held that there was a bona fide (in the sense of a real and genuine) dispute between the sellers raising a serious issue to be tried. This meant that interest was not payable on the withheld royalties or on any other monies that the SECV had refused to pay in default of cl 19. 28 The arbitrators' Award reflected these findings. The SECV subsequently sought to challenge the validity of the Award by two proceedings instituted in the Supreme Court of Victoria. The sellers also sought to appeal against the arbitrators' rejection of their claim to interest and, in the event that the SECV succeeded on their appeal, against the arbitrators' finding in respect of the "attributability" under cl 19.5 of the (abolished) PSLA royalties. The Court heard applications for leave to appeal but the parties settled their dispute in 1996 before the Court delivered judgment.

(a) The disputes involving the sellers and the GFC and SECV 29 On 20 November 1996, the sellers and the State of Victoria ("State") entered into two deeds of settlement with, respectively, GASCOR ("GASCOR deed") and Generation Victoria ("GenVic deed"). For all purposes material to the current proceedings GASCOR entered into that deed as successor in law of the GFC, and Generation Victoria ("GenVic") as successor in law of the SECV. 30 Under the terms of the GASCOR and GenVic deeds, the State agreed to pay a lump sum to each of the applicants in full and final settlement of the sellers' past and future claims under the Supply Contracts to pass-on amounts, including withheld royalties (GASCOR deed cls 4, 5; GenVic deed cls 5, 6). That agreement was made in the context of wider negotiations between the settling parties arising out of the State's desire to introduce structural reforms and increased competition into the Victorian gas industry (GASCOR deed recital E; GenVic deed recital D). The lump sum to be paid by the State was comprised of two (grossed-up) payments representing, respectively, all: (a) amounts outstanding to [the sellers] on partially paid invoices for gas sold and delivered … and unpaid invoices and letters of demand for the pass-on of PRRT in respect of gas sold and delivered to [the buyers] between 1 July 1990 and 31 October 1996 ('payment 1'); and (b) future entitlements to pass on PRRT from 1 November 1996 pursuant to the [Supply Contracts] ('payment 2'). (GASCOR deed cl 6.3; GenVic deed cl 8.2). 31 Each of these payments, including the amount of PRRT and income tax referable to them and the agreed after-tax amount of each to the sellers, was valued and expressly agreed upon by the parties for the purpose of the deeds (GASCOR deed cl 6.4; GenVic deed cl 8.4). In consideration for such agreement the sellers provided, among other things, a conditional covenant not to challenge the assessability of the payments for tax purposes. The covenant, which is contained in cl 6.3 of the GASCOR deed and 8.3 of the GenVic deed, stated as follows. The parties acknowledge and agree that each of Esso and BHP have entered into letters of understanding [dated 23 and 24 October 1996 respectively] with the Australian Taxation Office in relation to the liability of Esso and BHP to pay PRRT and Income tax on payment 1 and payment 2. Esso and BHP covenant to the State (for the benefit of the State and the Commonwealth of Australia) that: (a) Esso and BHP will not by way of objection or otherwise challenge the assessability of payment 1 to PRRT and Income tax provided that the State acknowledges each of Esso and BHP have reserved the right to contest the timing of derivation of that amount for the purposes of determining the relevant amount of PRRT and Income Tax payable in respect of payment 1; and (b) Esso and BHP will not by way of objection or otherwise challenge the assessability and derivation in the year receivable of payment 2 to PRRT and Income Tax [emphasis added]. 32 The "letters of understanding" between each of the applicants and the Australian Taxation office ("ATO") referred to in this clause concern the sellers' PRRT and income tax liability. Their terms are materially the same. Broadly speaking, they acknowledge the terms of settlement contained in the GASCOR and GenVic deeds, and record the proposed basis of the ATO's assessment of the sellers' PRRT and income tax for the several years of tax from the year ended 1991, as well as the undertaking in respect of such assessment given by the sellers to the State in the GASCOR and GenVic deeds (see above). This undertaking, which records expressly the disagreement at the centre of the current proceedings, is relevantly described in the letter of understanding between BHPPBS and the ATO as follows. 1.1 For PRRT years ended 30th June, 1991 through to and including 30th June, 1996, the ATO proposes that assessments, where appropriate amended assessments, will issue on the assessable receipts derivation basis being the highest of: - Date of letter of demand - Date of gas delivery - Arbitration award 1.2 … 1.3 Assessable income for years of income ended 31st May, 1991 to 1997 will similarly be based on the highest of three bases outlined above for PRRT, albeit with allowance for different year end. Income tax assessments, amended assessments where appropriate, will issue to accord with this approach. 1.4 BHPPBS acknowledges for the purposes of the settlement of the Pass-on dispute that it will not by way of objection or otherwise challenge the assessability of pass-on amounts paid to BHPPBS by way of Payment 1. However, BHPPBS reserve the right to contest the timing of derivation and therefore, year of assessment of such pass-on amounts for income tax and PRRT purposes. Further, BHPPBS will seek to establish by way of objection and, if necessary, litigation that pass-on amounts are not derived until settlement of the dispute. BHPPBS contends that it is not until this time that entitlement and quantum are sufficiently certain so as to constitute derivation. … 3.1 BHPPBS agrees that upon settlement date pursuant to the Deeds of Settlement or such other date as is mutually agreed by BHPPBS and the ATO, to immediately pay to the ATO by way of early payment both the PRRT and income tax referable to the payment(s) made in consideration of the relinquishment of the PRRT Pass-on; ie payment 2 [emphasis added]. (b) The disputes involving the sellers and Mobil, Kemcor and Huntsman 33 The disputes involving the two Supply Contracts to which Huntsman (one by operation of assignment from 25 July 1978) was a party were resolved by deeds of settlement dated 30 December 1994 and 13 February 1995. Those deeds provided respectively for lump sum payments by Huntsman of $3.3 million to BHPPBS and of $3.5 million to EARL in full and final resolution of both the pass on disputes and Huntsman's request for redetermination of its Contract Prices. The same applies for the settlements of the disputes involving Mobil and Kemcor, which were reached on 29 September 1994 and 7 February 1995 respectively, by lump sum payments by Mobil to BHPPBS of $3.596 million, and by Kemcor to EARL of $5.681 million.

5. The dispute between the sellers and the Commissioner 34 Since the announcement of the Amendment Act in 1990, and notwithstanding the disputes precipitated by that announcement regarding the impact of cl 19.5 and equivalent provisions on calculation of the Contract Price under each of the Supply Contracts, the sellers have at all times material to the current proceedings continued to file tax returns with the ATO. Of particular significance in this context is the sellers' treatment, for the purpose of such returns and their financial accounts generally, of two categories of payment. The first comprises the sums to which the sellers claimed to have an entitlement under the Supply Contracts following introduction of the Amendment Act; namely, the pass-on amounts. The second comprises the lump sums that were received by the sellers in settlement of the claims to those amounts ("settlement amounts"). 5.1 The sellers' treatment of the contested and settlement amounts (a) EARL 35 EARL's financial accounts are prepared on the basis of a financial year ended 31 December. 36 In the year ended 31 December 1990 (and consistent with its previous accounting practice), EARL treated all sums claimed in its Standard Monthly Invoices as "income" that was "assessable", for income tax purposes, from the date on which payment by the buyers was claimed as due. Since EARL made no claims for pass-on amounts during 1990, no pass-on amounts were recorded in its accounts to 31 December of that year. 37 EARL's accounting practice for 1990 continued unchanged to 31 December 1992, and was extended during that period to cover pass-on amounts. EARL treated such amounts in 1991 and 1992 as both "income" and "receipts" that were "assessable", for income tax and PRRT purposes respectively, from the date it claimed that payment by the buyers was required. 38 A change in EARL's accounting practice was introduced the following year when, from 1 January 1993, it began to record both pass-on amounts and withheld royalties as "deferred revenue" items that were assessable for neither income tax nor PRRT purposes. EARL (relevantly) explained the reason for this change in its letter to the ATO of 30 July 1993 as follows. In the present circumstances, it clearly cannot be said that the right to receive the pass-on amounts has been earned or established. The validity of the amounts claimed is subject to legal proceedings in which both the principle (i.e. whether EARL and BHP are legally entitled to pass on these amounts under the terms of the contracts) and the quantum (i.e. assuming that legal right to be established, the amount of PRRT and royalty that is properly attributable to gas) are in dispute. To this extent, EARL's right to receive these amounts is at present both contingent and defeasible. Accordingly, we do not believe that any part of these disputed amounts should be included for PRRT or income tax purposes until such time as EARL's legal entitlement to receive them has been determined and the amounts receivable can be reasonably ascertained. Until the arbitrator holds that EARL does have a fixed and enforceable right in this respect, the pass-on amounts merely represent disputed sums that have not only not been received but indeed may never be received. 39 As has been seen, the arbitrators' findings in respect of EARL's entitlement to the contested amounts was challenged in the Supreme Court of Victoria, and thus did not deliver the legal resolution anticipated in EARL's letter. The matter was not resolved until the parties reached a commercial settlement in 1996. It is for this reason that EARL did not record any of the contested amounts as assessable for tax purposes after 1992, and that the only amounts that it did record were the settlement monies received in lieu of the contested amounts, less the value of contested amounts that EARL had previously recorded as assessable in the years ended 31 December 1991-92. (EARL also made additional adjustments, which are not currently relevant, in its accounts from 1995 to take account of further, post-settlement supplies of gas to each of Huntsman, Mobil and Kemcor.) Earl's accounting treatment is generally consistent with the applicants' argument, in the current proceedings, that the revenue to which the sellers were entitled under clauses 19.5 and 12.8 of the SECV and GFC Contracts respectively was only assessable for income tax and PRRT purposes at the point at which it was actually received by them, being the date of settlement, and that the quantum of the revenue so assessable was the quantum of the settlement amounts. (b) BHPPBS 40 Unlike EARL, BHPPBS adopts a financial accounting period ending 30 June. 41 Prior to 30 June 1990, BHPPBS's practice was to record all sums claimed in its Standard Monthly Invoices as assessable for PRRT and income tax purposes as at the date of delivery of gas (or ethane). From the year ended 30 June 1991, BHPPBS continued this practice for all invoiced amounts, including withheld royalties. It did not, however, extend the practice at any time to cover the pass-on amounts, which it treated from the outset as non-assessable. Such treatment, also adopted by EARL from 1 January 1993, was justified by BHPPBS in its letter to the ATO of 8 January 1992 in essentially the same terms as in EARL's letter of 30 July 1993. Accordingly, none of BHPPBS's financial accounts recorded the contested amounts as assessable for income tax or PRRT purposes. The only amounts that were recorded were the settlement monies received in lieu of those contested amounts in 1994 and 1996. 5.2 The Commissioner's response to the sellers' treatment of the contested and settlement amounts 42 The principles underlying the accounting practice adopted by BHPPBS from the outset and by EARL from 1 January 1993 in respect of the contested and settlement amounts were approved by the Commissioner in his initial rulings in respect of the matter, dated 20 January 1992 and 24 October 1994 respectively. Those rulings, both of which responded to a request by BHP Petroleum Pty Ltd (made on behalf of BHPPBS) for an opinion as to PRRT assessability, supported the views: (a) that the disputes between the contracting parties regarding the existence and extent of the sellers' right to the contested amounts made such amounts non-assessable for PRRT purposes; and (b) that, consistent with (a), the contested amounts would remain non-assessable for PRRT purposes unless and until the buyers had assumed the relevant liability by actual payment of the amounts, by agreement, or by legal resolution of the contractual disputes. Hence the following excerpt from the Commissioner's ruling of 20 January 1992. The effect of the … judicial pronouncements on the issue raised by the company [BHP Petroleum Pty Ltd] is that it cannot be said that any consideration is receivable where no money has in fact been paid, the company has not passed on the PRRT in the sale price and the very basis of the liability is disputed by the purchasers. Where the purchasers subject themselves to the liability either by actual payment of an amount or by agreement or by legal resolution of the dispute, at that point there will be a derivation of assessable receipts for the purposes of section 23 in the form of assessable petroleum receipts under paragraph 24(b) of the Act. 43 The sellers' ultimate practice of treating the contested amounts as non-assessable for PRRT purposes was thus consistent with the view formally expressed by the Commissioner in 1992 and 1994. This changed, however, in August 1995 with the Commissioner's publication of a position paper for each of the applicants entitled "Proposed amendment action and ancillary matters". That paper gave notice of the ATO's revised preference for a different, "dual assessment approach" to the treatment of the pass-on amounts for PRRT purposes, which it relevantly described as follows. [The ATO] believes that derivation of the pass-on amount occurs at one of two possible points in time. It occurs either at the time the joint venturers issue invoices or other demands for payment in respect of the pass-on amount, or alternatively, at the time the arbitrators make a final award in relation to a reference to them on the issue under the terms of the natural gas supply agreements. Accordingly, the ATO will raise an amended assessment or assessment, as the case may be, on the following bases: (a) 'a date of invoice/demand for payment basis' under which it will include in assessable receipts an amount equal to the total of the pass-on amounts invoiced/demanded in the year of tax (This amount will be adjusted to include the gross-up of the pass-on amount); (b) 'a date of arbitration award basis' under which it will include in assessable receipts for the year in which a final award is made an amount equal to the total pass-on amount for the period specified in the award. (The amount to be included under this basis of assessment will also reflect the gross-up of the pass-on amount) (Also, the ambit of this 'date of arbitration award basis' of assessment may be altered upon the receipt of further advice from Senior Counsel on this matter). The ATO will, of course, only seek to recover the tax payable in relation to one of these bases of assessment. 44 Consistent with this approach, the Commissioner notified the applicants of the ATO's intention to amend their PRRT assessment for the tax years ended 30 June 1992-94 (and 30 June 1993-94 in the case of EARL) adopting a "date of invoice" approach and, subject to its "review of further detailed advice from Senior Counsel", to assess their PRRT liability for the tax year ended 30 June 1995 by reference to the same approach. By return letters of 9 and 10 August respectively, BHPPBS and EARL objected to this proposal and argued that PPRT "should only be payable in respect of amounts actually received from [the buyers]". The Commissioner affirmed his approach in a second position paper dated 27 October 1995 (for EARL) and 24 July 1996 (for BHPPBS), entitled "Derivation of the PRRT pass-on amount". In that paper the Commissioner confirmed the ATO's 1995 position, whilst making some allowance for deferred payments by the sellers of their outstanding tax debts from the years ended 30 June 1993-95. (The Commissioner also notified EARL of the ATO's refusal to refund any of the tax paid by it on the pass-on amounts in the years ended 30 June 1992-93.) The Commissioner on 1 May 1997 issued similar position papers in respect of the applicants' tax obligations under the Supply Contracts involving Huntsman, Mobil and Kemcor. 5.3 Conclusion: the current status of the disputes between the sellers and the Commissioner 45 The GASCOR and GenVic deeds, and the letters of understanding between the sellers and the Commissioner that preceded them, were concluded soon after the ATO's publication of its second position paper for BHPPBS in 1996. As already noted, those letters of understanding signalled the ATO's intention to assess the applicants' PRRT and income tax liability post-1990 and to assume, for the purpose of assessment, that the pass-on amounts were derived by the applicants on whichever of - (a) the date the amounts were claimed, (b) the date the gas the subject of the claims was delivered, or (c) the date of the Award - produced the highest tax assessment. Following such letters the ATO notified the applicants of its preference for the second of these bases, and proceeded to issue assessments and amended assessments accordingly. 46 The applicants objected to the 39 assessments thus issued. The Commissioner disallowed BHPPBS's objections for each of the 1991 to 1996 years on 31 July 1998. In his written notice he stated in part as follows. The Commissioner is of the view that the Pass-on amounts are derived for the purposes of Section 23 and Section 24 of the PRRT Act [Section 25 of the ITAA] on the date of sale (including the date of the delivery) of the gas. However, the Commissioner recognises that the issue is finely balanced. Accordingly, in the event that the pass-on amount is held not be derived on the date of sale (including the date of delivery) of the product to which it relates, the Commissioner is of the view that the date of derivation is the date of issue of the invoices and Letters of Demand. If this view is also not accepted, then the Commissioner is of the opinion that derivation will take place on the date of the earliest occurrence of one of the undermentioned specified events: (a) where there is an arbitration award handed down in relation to the Pass-on amount arising out of a dispute referred to arbitrators under the terms of a product supply agreement - the date of the arbitration award; or (b) where a Deed of Settlement has been entered into in respect of a dispute concerning claims to PRRT Pass-on under a product supply agreement - the date of execution of the Deed of Settlement. 47 On 5 August 1998, the Commissioner disallowed EARL's objections for each of the 1991 to 1997 years upon the same basis as he had disallowed BHPPBS's objections. As noted at the outset of these reasons, it is from the Commissioner's decisions of 31 July 1998 and 5 August 1998 that the current appeals are brought.

the issues that arise on the appeals

1. The task of the Court 48 The sellers appeal to the Court, pursuant to s 14ZZ of the Taxation Administration Act 1953 (Cth) ("the Administration Act"), against appealable objection decisions of the Commissioner. By virtue of s 14ZZO(b) of the Administration Act, the sellers have the burden of proving that the assessments and amended assessments under challenge are excessive. Then, as Barwick CJ observed in Henderson v Federal Commissioner of Taxation ("Henderson") (1970) 119 CLR 612 ("Henderson"), at 648: But the question of onus apart, the issue on such an appeal is what in fact is the assessable income of the taxpayer derived in the relevant year of tax. No doubt where the Commissioner's figure is the result of the application of some method of computation to figures not otherwise in dispute, the contest may appear to be one as to the appropriate method of computation of the income derived: and the determination of such a method of computation will resolve the issue, which is what is the amount of the assessable income derived. But unless the method of computation yields what is in fact the correct figure for that income it cannot be said to be appropriate in the circumstances or to be not inconsistent with the provisions of the Act. 49 The parties have invited the Court to resolve the question of principle, which will determine the correct basis for the computation of tax, and to leave to them the task of working out the consequences of the Court's determination for each of the 39 assessments in issue. The parties have proposed that, if appropriate, they would submit a minute of the orders that reflected this working out. I agree that this is the appropriate course in the circumstances.
2. The parties' submissions 50 As already noted, the Commissioner assessed the sellers to income tax in the relevant years on a number of bases, including that they derived assessable income by way of the pass-on amounts at the time they supplied gas to the buyers, or at the time they issued the pass-on invoices to the buyers. At the hearing, the Commissioner pressed the first, and not the second of these alternatives. He contended primarily that the pass-on amounts claimed in the pass-on letters and pass-on invoices were assessable income derived by the sellers when they supplied the gas (or ethane) to which the relevant letter or invoice related. 51 The sellers' case was that they did not derive income for income tax purposes until the sellers and the buyers agreed on the amounts payable by way of the pass-on amounts in settlement of the disputes between them. The sellers' assessable income was, on this basis, limited to the amounts payable under the terms of the various commercial settlements. 52 The parties did not dispute that ordinarily the income that, for income tax purposes, the sellers derive from supplying gas and ethane to the buyers should be calculated on an accrual, and not a receipts basis. That is, income is computed by reference to the (net) revenue earned or accrued, and not by reference to the (net) payments received: see Commissioner of Taxes (S.A.) v Executor Trustee and Agency Co of South Australia Ltd ("Carden's Case") (1938) 63 CLR 108, 157 per Dixon J, with whom Rich and McTiernan JJ agreed. This is because in most cases the adoption of an accrual basis for a commercial entity running a trading account will give "a substantially correct reflex of the taxpayer's true income": cf Carden's Case at, 154-6 and Brent v Federal Commissioner of Taxation (1971) 125 CLR 418 ("Brent") at 428-9. By contrast, although for the same reason, a receipts basis is generally adopted in computing the income of an individual offering professional services in exchange for fees: see Carden's Case at 158. 53 The sellers did not dispute that, generally speaking, they derived income from the sale of gas or ethane under the Supply Contracts when they supplied those products, because the Contract Price was payable by virtue of this supply. They also accepted that it was appropriate to compute this income on an accrual basis. Further, the sellers did not challenge the adoption of an accrual basis in computing the income derived by way of the pass-on amounts. Their case was that, even if this were the correct basis, in the case of the pass-on amounts, no income was derived until the parties agreed on the amounts payable in settlement of the disputes over the sellers' pass-on claims. 54 Where the Commissioner or a taxpayer has departed, or sought to depart, from the usual system of accounting employed in determining the taxpayer's income for income tax purposes, the courts have emphasised the need to have regard to the "truth and reality" of the situation. They have referred, in particular, to the need to ensure that the accounting system adopted for an assessment of income is not misleading: see Ballarat Brewing Co Ltd v Federal Commissioner of Taxation (1951) 82 CLR 364 at 369 per Fullagar J; Barratt v Commissioner of Taxation ("Barratt") (1992) 36 FCR 222 at 231. Drawing on this approach, the sellers contended that the truth and reality of the present situation made the adoption of the approach ordinarily used in assessing their income misleading. The Commissioner erred, so they said, in treating this income as having been derived when the gas or ethane was supplied since the truth and reality of the situation dictated that it be treated as derived when agreement on the amount payable was reached at settlement. The truth and reality to which the sellers referred consisted of the disputes between them and the buyers about the sellers' right to the pass-on amounts, the reference of the disputes to arbitration under the Supply Contracts, and the settlements of the disputes. 55 There were three ways in which the sellers relied on these matters in support of their contention that the truth and reality of the situation required the Commissioner to consider that income by way of the pass-on amounts was not derived until the parties agreed to the amounts payable in settlement of the disputes. First, the disputes created genuine uncertainty about the sellers' right to the pass-on amounts. Prior to settlement, this uncertainty, so it was said, prevented the sellers' right from maturing into a recoverable debt in respect of which income was capable of being derived. Secondly, the disputes illustrated the inherent uncertainty and defeasibility of the sellers' right in so far as the right or its enjoyment depended on the further agreement of the sellers and the buyers and, failing such agreement, a final and binding Award (or, in the event of appeal, curial determination). Thirdly, the disputes and the matters associated with them created a situation in which it would be misleading to conclude that income had been derived prior to settlement. In this context, the sellers referred to the position in the United States of America, Canada and United Kingdom, as appeared from North American Oil Consolidated v Burnet (1932) 286 US 417; London-Butte Gold Mines Co v Commissioner of Internal Revenue (1940) 116 F 2d 478; The Cold Metal Process Company v Commissioner of Inland Revenue (1951) 17 TC 916; M.N.R. v Colford Contracting Co Ltd (1960) 60 DTC 1131; Commonwealth Construction Company Limited v R (1964) 64 DTC 6420; M.N.R. v Benaby Realties Limited (1967) 67 DTC 5275; R v Johnson and Johnson Inc (1994) 94 DTC 6125; and WS Try Ltd v Johnson [1946] 1 All ER 532. The Commissioner referred to United States v Lewis (1951) 340 US 590. As appears below, I had not found it necessary to refer to these cases to resolve the issues with which these proceedings are concerned. 56 The Commissioner rejected the sellers' conception of the truth and reality of the situation, including the sellers' submissions concerning the appropriate basis for assessment. The Commissioner's case was that the truth and reality resided exclusively, or almost exclusively, in the terms of the Supply Contracts. The disputes between the sellers and the buyers were, so the Commissioner said, immaterial to any relevant reality. The Commissioner contended that each Supply Contract conferred a right on the seller or sellers to adjust the Contract Price owed in consideration of the sale of gas or ethane to the buyers during the relevant tax years by an amount representing the value of the pass-on amounts. If this were accepted as correct, then the Commissioner was entitled, so he said, to treat the pass-on amounts as part of the Contract Price and, more particularly, to treat the amounts in the pass-on letters and invoices as income that the sellers derived on the date the gas or ethane was delivered. 57 I interpolate here that there are essentially three approaches the Commissioner might have taken in calculating the value of the pass-on amounts and hence the sum of assessable income or assessable receipts. He might have chosen to accept the value that the sellers claimed in their pass-on letters and invoices. He might have attempted to value the pass-on amounts afresh, by reference to the pass-on clause of each supply agreement. He might have chosen to accept the approach sanctioned by the arbitrators in the SECV arbitration to the extent (if any) it differed from the method used to calculate the claims in the pass-on letters and invoices. The Commissioner favoured the first approach. He treated the monies claimed in the pass-on letters and invoices as the income derived by the sellers under the Supply Contracts on the date of the supply of the gas or ethane in connection with which the letters or invoices were sent. 58 As we have seen, these proceedings called into question the proper approach for assessing the pass-on amounts for income tax (and PRRT) purposes. So far as income tax is concerned, there are two aspects to this: first, assuming the amounts were income in the hands of the sellers, when was that income derived by them? Secondly, by reference to what matters is the value of the pass-on amounts and hence the quantum of income to be ascertained? As already noted, the parties conducted the proceedings on the basis that the answers to these questions would also determine the PRRT issues. 59 On the one hand, so far as the sellers were concerned, these issues were essentially interdependent, since their contention was that they did not derive the pass-on amounts until they and the buyers reached agreement on the amount payable in settlement of the disputes. That is, the amount of the sellers' income referable to the pass-on amounts was said to be the quantum of the sum representing these amounts paid at settlement. On the other hand, so far as the Commissioner was concerned, the issues remained separate. Thus, the Commissioner argued that the sellers derived income on the delivery of the gas or ethane as required by the Supply Contracts and the quantum of the income was whatever the sellers claimed in their pass-on letters or invoices. 60 The sellers criticised the Commissioner's approach, contending that the Commissioner had proceeded on the mistaken basis that a taxpayer's income for income tax purposes includes all monies to which the taxpayer claims entitlement regardless of the validity of the claim. There may be some force in this criticism. If, as the Commissioner contends, the sellers were properly treated as having derived income on the date the gas or ethane was delivered under the Supply Contracts because that event made the Contract Price payable, then the quantum of the (net) income thus derived must be equal to the value of the pass-on amounts to which the sellers were entitled under the Supply Contracts. If so, then a question may arise as to whether the pass-on letters and invoices in fact state the pass-on amounts to which the sellers were entitled under the Contracts. I return to this below. 61 The issues in these proceedings are whether the Commissioner erred in treating the sellers as having derived income from the pass-on amounts on the date on which the gas or ethane was delivered under the Supply Contracts and, if not, whether the income so derived was equivalent to the amounts set out in the pass-on letters and invoices. Two further questions arise. The first concerns the nature of the sellers' right to the pass-on amounts during the relevant years of tax, and the second relates to the significance, so far as the right is concerned, of (a) the disputes between the sellers and the buyers as to whether the right to pass on covered PRRT; (b) the arbitration clause in each supply agreement; and (c) the SECV arbitration and the negotiated settlements.

VG 478-516 of 1998: Counsel for the Applicant (all matters): Mr J W de Wijn QC with Mrs J Batrouney SC

Solicitor for the Applicant (all matters): Middletons Moore & Bevins

Counsel for the Respondent (all matters): Mr J D Merralls QC with Mr T Murphy

Solicitor for the Respondent (all matters): Australian Government Solicitor

Dates of Hearing: 5, 6 and 7 December 2000

Date of Judgment: 5 March 2002