THE PRIMARY JUDGE'S REASONS
14 Early in his Honour's reasons, the primary Judge described the nature of the December transactions, and their consequences under Australian tax law, as follows:
As will be seen, the relevant facts relating to the [transaction] did not give rise to any allowable deductions to CPL in Australia which were not available to it in Hong Kong, but the income base in Hong Kong in the year in which the [transaction was] consummated included the gross amount of the consideration received by the bond purchasing [partnership], of which CPL was a member, for the sale of the interest coupons … whereas the income base in Australia, while starting from the same point, was, by virtue of the application of the provisions of Div 16E of Pt III of the 1936 Act, spread over the life of the [bond] to equate with [its] treatment for financial accounting purposes. This meant that the income base in Hong Kong for [the transaction] in [the 2003 year] … included AUD60,495,296 …, whereas no amount was included in the income base in Australia for [the transaction] pursuant to Div 16E in the [2003] … (it having been consummated on the last day of the year of income) …. It is true that over the next five years … the balance was brought to account pursuant to Div 16E and included in the Australian income base of CPL in those years, but my purpose in noting the consequence in the [year] the [transaction was] consummated is to illustrate that there is, indeed, a measure of common ground between the examples in the extrinsic material and the facts of the present case.
The "extrinsic materials" to which his Honour referred were an announcement by the Commonwealth Treasurer on 13 August 1998 with respect to the then intended introduction of paras (bb) and (f) into s 177C(1), and of para (d) into s 177F(1), of the 1936 Act, and the Explanatory Memorandum for the Bill then introduced.
15 We should also mention, at this stage, some introductory remarks made by the primary Judge, in a section of his Honour's reasons which he headed "The Opening Salvos". His Honour said:
17. In opening, CPL contended that a reasonable person could not conclude that the dominant purpose of a person making an actual payment of foreign tax was the acquisition of foreign tax credits in the same amount. That is evident, so CPL contended, because no rational taxpayer would pay a dollar of foreign tax simply to avoid an obligation to pay an equal amount of tax in Australia: why, one might ask, would the rational taxpayer be anything other than indifferent as to where it paid that tax?
18. So much may be conceded where the foreign tax on the relevant income is equal to or less than the Australian tax on that income; it may also be conceded where the foreign tax on the relevant income is greater than the Australian tax on that income by reason only of a greater foreign tax rate. But where, as here, the foreign tax rate (17.5%) is less than the Australian tax rate (30%) but the foreign income base, in the years in which the relevant transactions are entered into, is considerably greater than the Australian income base by reason of the different computation of those bases, resulting in greater foreign tax payable than the Australian tax that would otherwise be payable, giving rise to excess foreign tax credits, the door of inquiry under s 177D(b) as to the dominant purpose of a person entering into a scheme giving rise to a tax benefit in the form of those foreign tax credits, is not foreclosed by recourse to arguments based on the rationality of a taxpayer. It has to be determined by reference to the relevant matters or considerations set out in s 177D(b) and one of those matters or considerations will be whether the person has other foreign source income which has not borne foreign tax, or has borne foreign tax in an amount less than the applicable Australian tax, against which the excess foreign tax credits can be applied, in whole or in part, to reduce or otherwise relieve the Australian tax liability on the other foreign source income.
16 Turning to the deliberative section of the reasons of the primary Judge, his Honour first noted that the facts of the case were, for the most part, not in dispute, but that there were two issues of fact that required resolution. The first related to the margin, if any, which CPL earned by receipt of the periodical interest payments which arose under the swap arrangement with the Sydney branch of Citibank NA over the cost of funds in respect of the initial investment of $169,504,704, which was not to be repaid until 31 December 2008. On this point, his Honour referred to evidence, led by CPL, to the effect that it was not possible to calculate the specific expense associated with funding the acquisition of the bond, but that the annual financial reports of CPL did set out the interest rates which, on average, represented the cost of funding "CPL's general pool of funds". Applying those interest rates to the amount of the investment yielded, after five years, an aggregate funding cost of $45,037,388. Since the total of the interest payments received from Citibank NA over the same period was $52,870,576, CPL submitted that it had achieved a margin of some $7,833,178. The Commissioner did not accept that analysis, contending that the evidence was insufficient to demonstrate that CPL had derived any margin on the transactions in addition to the fee and the premium, net of the cost of the transactions itself. His Honour found that it was more likely than not that CPL did achieve a margin over the cost of funds used in the transactions, but added: "It is impossible, on the state of the evidence, to quantify that margin". He continued:
The Court is therefore left with no alternative but to find that the pre-tax profit for CPL on HKBT 2003 was at least AUD6,493,512 and probably more, but how much more cannot be quantified. On the other hand, for reasons which I will come to, it is CPL's post-tax profit on HKBT 2003, both before and post foreign tax credit relief, which shed the more utile light on the matters to which regard is to be had in undertaking the process of drawing a conclusion of the kind mandated by s 177D.
It is to be noted that the sum referred to by his Honour - $6,493,512 - is the sum of the fee and the premium, less the transaction expenses, mentioned earlier in these reasons. It was, in effect, the net balance of the account on the sale of the interest coupons by BPP to CPP (although doubtless some part of the transaction expenses was proper to be apportioned to so much of the December transactions as related to the bond stub).
17 The second issue of fact upon which the primary Judge was required to make a finding related to CPL's expectation, on 31 December 2003, as to whether it would have other significant foreign income in the 2003 year. As mentioned above, it did have such income. As found by his Honour, Citicorp Life Insurance Ltd (formerly Metlife Insurance Ltd) which, from 1 January 2003, formed part of the group headed by CPL, returned foreign income of about $51m in 2002 and of $98,344,349 in 2003. Additionally, CPL itself had foreign interest income in the amount of $32,003,170 in 2003. These seemed to be uncontroversial facts. However, CPL's case below involved the proposition that it had no expectation of such income, with the result that his Honour ought to find that, objectively, it would not be concluded that it was a purpose of the scheme in question to increase the level of foreign tax against which the corresponding presumptive Australian tax could be set off for the purposes of s 160AF(1). The only witness whom CPL called on this question was someone whose understanding of the subject was indirect. His Honour did not accept her evidence, concluding:
Whether that be right or not, I am not prepared, on her evidence, to make a finding that CPL, at the time it entered into the HKBTs, had little or no expectation of having any foreign source income other than what would be derived from the HKBTs themselves.
We would, with respect, regard his Honour's finding on this pure question of fact as unexceptionable. It is apparent that his Honour thereafter proceeded on the basis of an inference, which, in our view (particularly in the light of the onus of proof provisions of s 14ZZO of the Administration Act) was readily available, that CPL knew, in the period leading to 31 December 2003, of the probability that the other foreign income which it would return in the 2003 year would be such that the Australian tax paid in respect thereof (within the meaning of s 160AF(1)(e)) would amply account for the Hong Kong tax paid on the proceeds of the sales of the interest coupons.
18 The primary Judge then turned to the specific matters which required consideration under s 177D(b) of the 1936 Act. With respect to the manner in which the scheme was entered into or carried out, his Honour considered that the structure of the scheme was dictated by the guidelines of HK Internal Revenue. However, his Honour continued:
But the identity of the participants in the structure, at least on the BPP… side, were not dictated by the Guidelines; they were dictated by the need for the participants, in particular the principal partner in the BPP… to be entitled to some form of relief in a jurisdiction outside Hong Kong to offset the post-tax loss in Hong Kong. That relief might take a number of forms, but one form it could take was by giving a credit in the jurisdiction of the principal partner's residence for the tax suffered in Hong Kong which might be applied against the tax liability of the principal partner in its jurisdiction of residence against other foreign source income which had not borne foreign tax at a rate equal to the jurisdiction of residence rate. In the relevant years of income, Div 18 of Pt III of the 1936 Act provided such relief.
His Honour then found that the choice of CPL as the principal partner in BPP was "explicable solely on the basis of the foreign tax credit regime in Australia". On appeal, this finding was not challenged by CPL.
19 Observing that the finding just referred to did not conclude the question arising under s 177D(b), the primary Judge turned next to the form and substance of the scheme. His Honour held that the complex form of the scheme was largely the result of the requirements of the HK Internal Revenue guidelines. The substance, however,
… was more transparent and, in consequence, perceptibly simpler. In short, each scheme involved the subscription for an interest-bearing bond and the immediate sale of the interest coupons attached to the bond for a lump sum payment. That all occurred on day one and thereafter the stripped securities were continued to be held, although not necessarily by the day one parties, for the life of the bond. The financial and tax consequences for CPL over the life of the bond flowed from what occurred on day one ….
On appeal, CPL did not submit that his Honour here mischaracterised the substance of the scheme.
20 The primary Judge did not think that the time at which the scheme was entered into, or the length of the period during which the scheme was carried out, had any critical bearing on the conclusion which he should draw as to dominant purpose. However, his Honour added:
That said, it is not without relevance that the HKBT 2003 was consummated on 31 December 2003, the last day of the first year of income that CPL filed an Australian income tax return on a consolidated basis, thus bringing within the filing fiscal entity sources of income, including foreign source of income, that hitherto would not have been included.
On appeal, it was not submitted on behalf of CPL that his Honour ought to have regarded that combination of circumstances as "without relevance".
21 The primary Judge next noted that it was common ground that the result of the scheme in relation to the operation of the 1936 Act, but for Part IVA thereof, would be a reduction in CPL's Australian tax in the 2003 year by an amount of $9,613,285. The only qualification that it is presently necessary to make in relation to that conclusion is that CPL did submit that the "result" proper to be taken into account under the 1936 Act should not be confined to the 2003 year, but should extend to the subsequent years in which CPL returned assessable income deriving directly or indirectly from its participation in the scheme. This aspect of the controversy was effectively the subject of the last of the matters arising under s 177D(b) which his Honour considered, and it is to that aspect that we next turn.
22 The primary Judge next considered the change, if any, in the financial position of CPL that resulted, would result, or might reasonably be expected to have resulted, from the scheme. His Honour noted that the scheme led to a pre-tax profit for CPL of at least about $6.5m (without the margin referred to in para 16 above) and of no more than about $14.3m (if the whole of the margin for which CPL contended had been achieved). However, his Honour also took the view that to approach the subject "without regard to the taxation costs of [the scheme's] implementation [would be] to ignore economic reality". Consequently, his Honour looked at the change in CPL's financial position as a result of the scheme at two levels: first, after taking into account CPL's liability to pay tax in Hong Kong and Australia, and secondly, after taking into account also the foreign tax credits to which CPL was entitled under Div 18. At each of these levels, his Honour considered the position by reference to two alternative assumptions: that the full margin for which CPL contended had been achieved, and that no margin at all had been achieved, respectively. This framework of examination yielded four tables which were based on tables made available to his Honour by CPL, as supplemented and amended by his Honour to cater for his immediate purpose.
23 As corrected in minor (and presently immaterial) respects, those four tables were as follows: