Clough Limited v Commissioner of Taxation

INTRODUCTION 3 The appellant (Clough) provides engineering, project management and construction services. In 2013, it serviced the 'energy and chemical' and 'mining and mineral' markets in Australia and Papua New Guinea. It had about 1,000 permanent employees in a workforce of 6,000. Central to the success of the business was the retention and incentivising of key employees. These outcomes were sought to be achieved in part by providing attractive entitlements to employees under an employee option plan (Option Plan) and an employee incentive scheme (Incentive Scheme). In the reasons for judgment the subject of this appeal, Clough Limited v Commissioner of Taxation [2021] FCA 108 at [45] (hereafter "J"), the primary judge stated: [A]n important part of the business activities that were required by Clough in order to generate revenue was the securing of experienced permanent employees who could manage and supervise the activities of Clough through appropriate remuneration. Those employees were rewarded in part through their participation in the Option Plan and Incentive Scheme. 4 It is not necessary to set out in detail the terms and effect of the Option Plan and the Incentive Scheme. It is sufficient to understand the following: Under the Option Plan, Clough could offer (and had given) options to employees which entitled the employee, on exercise of the option, to subscribe for and be allotted one share (credited as fully paid) at the specified exercise price. The board could declare that options would vest immediately if in its opinion a "Change of Control Event" occurred, despite the fact that a condition of vesting (such as achieving a particular performance criterion) had not been met. A more detailed explanation may be found at J[49] to [51]. Under the Incentive Scheme, Clough could issue (and had issued) "Performance Rights", which entitled the employee, three years after the date of grant of the right, either to acquire one share or receive in cash the market price of one share (at the election of Clough: cl 12.1). A performance right vested automatically after three years and also vested before three years if a "Change of Control Event" occurred. A more detailed explanation may be found at J[52] to [54]. 5 A "Change of Control Event" within the meaning of the Option Plan and Incentive Scheme included Clough entering into a scheme of arrangement, as in fact occurred. 6 In 2011, approximately 60% of the shares in Clough were owned by Murray & Roberts Limited, a subsidiary of Murray & Roberts Holdings Ltd, the head company of the Murray & Roberts Group. Murray & Roberts was a South African engineering, contracting and construction services company operating in the underground mining market and selected emerging markets in the natural resources and infrastructure sectors in Southern Africa, the Middle East, Southeast Asia, Australasia and North and South America. 7 In 2012 and 2013, there were negotiations concerning potential terms on which Murray & Roberts might acquire the minority shareholding in Clough. The treatment of options and rights granted to employees under the Option Plan and the Incentive Scheme was a key concern to both Clough and to Murray & Roberts. Both accepted that there was an obligation on the part of Clough to make payments to the employees holding options and rights if the change in control were to occur. 8 On 28 August 2013, two entities in the Murray & Roberts Group and Clough entered into a Scheme Implementation Agreement (SIA), under which a Murray & Roberts entity would acquire the remaining shares in Clough pursuant to a scheme of arrangement. Schedule 7 of the SIA set out certain "Incentive Acquisition Principles". Clause 6 required the parties to ensure that options and rights were dealt with in accordance with those principles: J[76]. Schedule 7 required Clough to make an offer to cancel the options and performance rights and to use its best endeavours to ensure that each person receiving an offer accepted the offer: J[77]. Schedule 7 also dealt with what was to occur if the offers were not accepted. 9 In September and October 2013, Clough made offers to all employees holding options or rights in accordance with the SIA. The offers were conditional on the SIA becoming effective. The employees either accepted the offer to cancel or exercised vested options and, in the latter case, thereby became shareholders who could participate in the scheme of arrangement if implemented: J[97]. 10 The scheme of arrangement was implemented on 11 December 2013. On the same day, a subsidiary of Clough made payments totalling $15,050,487 to employees in consideration of the cancellation of their respective options and rights. Clough was delisted from the Australian Securities Exchange (ASX) on 12 December 2013. 11 At issue is the correct tax treatment of these payments of a little over $15 million. 12 The deemed assessment made in respect of the 2014 year of income was issued on the basis that the payments were not deductible. Clough objected against the deemed assessment under Part IVC of Taxation Administration Act 1953 (Cth) (TAA 1953) claiming that its 2014 income tax return understated deductible expenditure by the amount of $15,050,487. Clough's objection was disallowed. Clough commenced proceedings in the original jurisdiction of this Court, those proceedings being an "appeal" against the objection decision under s 14ZZ(1) of the TAA 1953. 13 Clough contended before the primary judge that the payments totalling $15,050,487 were deductible in the income year ended 30 June 2014 under both positive limbs of s 8-1(1) of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) and were not prevented by s 8-1(2)(a) from being deductible as payments of a capital nature. Sections 8-1(1) and (2)(a) of the ITAA 1997 provide: (1) You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a *business for the purpose of gaining or producing your assessable income. … (2) However, you cannot deduct a loss or outgoing under this section to the extent that: (a) it is a loss or outgoing of capital, or of a capital nature; … 14 The Commissioner maintained the position expressed in his objection decision that the amount of $15,050,487 was not deductible under s 8-1, but accepted shortly before trial that the amount claimed was allowable as a deduction over five years under s 40-880 of the ITAA 1997. 15 The primary judge concluded that the payments did not fall within either of the positive limbs of s 8-1 and therefore did not reach a view about whether the payments would have been excluded as being outgoings of capital by reason of s 8-1(2)(a). The primary judge dismissed Clough's appeal. 16 In circumstances where the Commissioner had conceded shortly before trial that the payments were deductible over five years under s 40-880, the deemed assessment was necessarily excessive because it treated the payments totalling $15,050,487 as not deductible. 17 It follows that the primary judge should have allowed Clough's appeal irrespective of whether the payments totalling $15,050,487 were deductible under s 8-1. 18 Questions of characterisation are ones about which minds often differ. The difficulty this case presents is that the payments were made both to facilitate a change in control of Clough and also to honour legal or commercial obligations to employees arising out of the fact that Clough had granted options and rights to its employees in the course of running its business and for the purpose of rewarding and incentivising those employees. For the reasons which follow, in a practical business sense, the payments are better characterised as payments made pursuant to an agreement to secure a change in control rather than as meeting employee entitlements on a change of control. The payments were made to effect a reorganisation of the capital structure of Clough, through a takeover by Murray & Roberts and the delisting of Clough from the ASX. The bringing to an end of the various rights of the employees under the employee schemes was necessary to secure the reorganisation of the company's capital structure for the enduring advantage of the business. There is no doubt that the payments would not have been made unless the employees had entitlements under the employee schemes and that those schemes had been designed to incentivise and reward those employees. The rights were granted to the employees in gaining or producing assessable income. However, the occasion of the outgoings lay in the takeover and the object behind making the payments was the bringing to an end of the employees' rights, at the one time, to facilitate the takeover by Murray & Roberts and the delisting of Clough. 19 Accordingly, the payments were not deductible. The payments did not fall within the positive limbs of s 8-1 and were payments on capital account. It follows that the primary judge did not err on the issue which remained in dispute between the parties at trial. 20 Nevertheless, the appeal must be allowed on the basis that the parties necessarily agreed that the assessment was excessive because the amounts were deductible over five years under s 40-880 of the ITAA 1997.