The Personality of the Parties to the Hypothetical Contract
164 The Commissioner submitted that no evidence was led about C.M.P.L.'s or G.I.A.G.'s attitudes to risk taking as at February 2007. The taxpayer had therefore failed to show that C.M.P.L. would have wanted to secure the commercial benefits of using price sharing as a methodology, so it followed that such benefits were irrelevant. That conclusion was said to be open because both Div. 13 and Subdiv. 815-A require the hypothetical parties to the hypothesised copper concentrate transaction to be clothed with the very same attributes that C.M.P.L. and G.I.A.G. had in February 2007. In such circumstances, the Court was left with the stark evidence that in February 2007, and based on forecast information, C.M.P.L. was going to be worse off by agreeing to price sharing, and there was no other commercial reason as to why it had submitted to such an adverse pricing methodology.
165 In that respect, the presence of the pre-existing C.M.P.L.-G.I.A.G. agreement on different terms loomed large in the Commissioner's case. His case was built upon a comparison of the benefits conferred on C.M.P.L. by that contract as compared with the reduced cash benefits which were expected to arise by reason of the amendments made in February 2007. Why, it was asked, would a party in the position of C.M.P.L. have agreed to such a debilitating change of terms? It simply was not what an independent party dealing at arm's length with a buyer of copper concentrate would ever have agreed to.
166 With respect, we think the Commissioner has asked the wrong question. As a result, whether the C.M.P.L.-G.I.A.G. agreement fell within that range of hypothetical contracts for the sale of copper concentrate which independent parties dealing at arm's length with each other might reasonably be expected to have entered into, did not feature in the Commissioner's analysis. Because the Commissioner was not asking the correct question, he submitted that there was no range of possible outcomes for this particular mine, but just one outcome, namely retention of the pre-existing terms as they were just before February 2007.
167 The Commissioner's submission suffers from a potential difficulty in applying Div. 13 of the 1936 Act. In Federal Commissioner of Taxation v. SNF (Australia) Pty Ltd (2011) 193 F.C.R. 149, this Court squarely rejected the Commissioner's contention that the hypothetical taxpayer had to stand in the shoes of the actual taxpayer and be clothed with all of the attributes of the actual taxpayer. The Commissioner's submission was recorded at 179-180 [96] of the judgment of the Full Court constituted by Ryan, Jessup and Perram JJ., as follows:
The Commissioner's argument hinges, as he submitted in reply, on the proposition that one of the independent parties referred to in the definition of "arm's length consideration" in s 136AA(3)(d) was the taxpayer. This was the case, so he submitted, because the definition provision had to "be read in the context of s 136AD, the operative provision" and that provision commenced "its inquiry with the 'taxpayer' and it is the 'taxpayer' which is the subject of the hypothetical in s 136AA." The three propositions for which the Commissioner contends are, therefore:
(a) the definition provision must be read in the context of the operative provision; and
(b) the operative provision - s 136AD(3) - begins its inquiry with the taxpayer;
(c) therefore the hypothesis required by the definitive provision - s 136AA(3)(d) - must relate to the taxpayer so that "arm's length" in that provision means "arm's length from the taxpayer".
168 The Court rejected the submission at 180 [98]-[99]:
[T]he description of a transaction as being at arm's length is a statement about the independence of two parties from each other. The connexion thus disclosed is a relative one. Generally speaking a statement that two parties have a relative connexion of a particular kind does not carry with it any information about their absolute status. A requirement, for example, that two businesses be more than 20 km apart says nothing about where either business is situated. If one were to look at the definition provision in s 136AA(3)(d) in isolation it would be unsound to read it as requiring any more than that the two parties in question should be independent of each other; that is, the ordinary meaning is not as the Commissioner contends.
The question then is whether the ordinary meaning is somehow displaced or modified by the fact that the definition provision feeds into an operative provision - s 136AD(3) - which in turn utilises it to assess the position of the taxpayer. There is no doubt that s 136AD(3) is, as the Commissioner submits, about the taxpayer; that it requires a comparison between that which was actually paid by the taxpayer and an arm's length consideration; and, that, in appropriate circumstances, it then substitutes one for the other. However, it does not follow from acceptance of all those features that arm's length consideration - which does not, in general, refer to the actual position of either party - must be treated as overlaid by a further requirement that the consideration not only be at arm's length but that the arm in question be attached to the taxpayer.
(Our emphasis.)
169 Chevron must be taken to have softened the foregoing conclusion, at least to an extent. The judgment of the Chief Justice, with respect to the application of Div. 13, recognised the great variety of arm's length transactions that independent parties may negotiate. Each contract will be different but each will still be the product of an arm's length dealing. As a result, Div. 13 should not be applied pedantically or inflexibly. As Allsop C.J. observed at 50-51 [42]:
There may be a free market into which disembodied independent third parties and the taxpayer alike could enter for substitutable or fungible goods; or there may be a market of sorts in which individually reached pricing will be available depending upon the precise characteristics of the party seeking to avail itself of the market. Given the great variety of commercial circumstances to which the provision may apply, it would be wrong either to approach the interpretation of the provisions pedantically or to dictate a rigid or fixed approach to the task of determining the arm's length commercial consideration.
170 For that purpose his Honour observed that the inquiry does not necessarily require the detachment of the taxpayer as one of the independent parties to the hypothetical transaction. At 51 [43] the Chief Justice thus said:
There is no reason derived from the language of s 136AA(3)(d) why the hypothesis based on independence should, of necessity, do other than assess what the taxpayer or a person in the position of the taxpayer would be expected to give by way of consideration in respect of the acquisition of the property to a party independent from it. The independence hypothesis does not necessarily require the detachment of the taxpayer, as one of the independent parties, from the group which it inhabits or the elimination of all the commercial and financial attributes of the taxpayer being part of the circumstances that gave the commercial shape to the property the subject of the acquisition and that may be relevant to the consideration for the property.
171 After considering SNF, the Chief Justice was of the view that the "utter disembodiment of both parties" was not required by Div. 13. At 51-52 [44] his Honour said:
In SNF, the Commissioner's submissions were directed to the asserted inadmissibility of evidence of certain allegedly comparable transactions because the parties did not have the same features as the taxpayer, being a history of making losses. Some of the language in SNF may be seen to be broader than was necessary to deal with the arguments and controversy in question. I do not take from SNF any requirement for a rigid or fixed approach to the place of the circumstances of the taxpayer or the party posited in the position of the taxpayer, in particular, here, its position in the group of which the other party to the actual transaction was a member also. Naturally, the one fixed and rigid proposition is that the parties to the dealing posited by s 136AA(3)(d) must be independent from each other - mutually independent. It does not follow that the party in the position of the taxpayer in the real transaction (here the borrower) must be disassociated in the hypothesis from its place in the group for whose interests it was borrowing. I do not read SNF as requiring the utter disembodiment of both parties from the circumstances of reality if one is seeking to understand not what a market price for goods was but the consideration that would be given for acquiring a characterised loan from an independent lender. The fundamental purpose of the hypothesis is to understand what the taxpayer, CAHPL, or a person in the position of the taxpayer and in its commercial context would have given by way of consideration in an arm's length transaction.
172 The foregoing passages neither support a test which is the "utter disembodiment" of the actual parties from the hypothetical transaction, nor a test whereby the hypothetical party stands entirely in the shoes of the taxpayer. Critically, Allsop C.J. expressed the applicable test in the following way at 52 [45]:
The degree and extent of the depersonalisation will be dictated by what is appropriate to the task of determining an arm's length consideration - that is one that satisfactorily replaces what the taxpayer gave by what it should be taken to have given had it been independent of its counterparty.
(Our emphasis.)
173 We shall return to this expression of the test. But there is another aspect to the hypothetical which we must emphasise at this point: the hypothetical "must be made to work", and in order to make it work, one is required to draw upon those commercially rational practices adopted by independent parties operating in a particular market for goods and services. As Allsop C.J. said in Chevron at 53 [48]:
That the hypothesis must be made to work, if it can, is also to be taken from the commercially rational nature of the task - the property, the acquisition, the consideration are to be seen in their relationship to each other by reference to what can be reasonably expected, assuming independent commercial parties.
174 The reasons of Pagone J. are to similar effect. As his Honour observed at 73-74 [119]:
The hypothetical agreement contemplated by the definition of arm's length consideration in s 136AA(3)(d) does not compel one of the parties necessarily to be the taxpayer (see Federal Commissioner of Taxation v SNF (Australia) Pty Ltd (2011) 193 FCR 149 at [9], [97]-[102]).
175 Justice Pagone was also of the view that in general, the hypothetical transaction for the purposes of Div. 13 had to remain "close" to the actual transaction and that the actual characteristics of the taxpayer must "serve as a basis" in the comparable agreement. As Pagone J. observed at 76-77 [128]:
The need to posit a hypothetical acquisition under an agreement for the purpose of evaluating it by reference to the standard of reasonable expectation requires a consideration of the evidence to determine a reliably comparable agreement to that which was actually entered into. That, as his Honour said at [499] required the hypothetical to remain close to the actual loan. The function of the hypothesis is to identify a reliable substitute consideration for the actual consideration which was given or agreed to be given, and the reliability of the substitute consideration depends upon the hypothetical agreement being sufficiently like the actual agreement. Thus, as his Honour held, the purchaser in this case need not be a hypothetical standalone company (see [79]) and was to be an oil and gas exploration and production subsidiary (see [80]). The characteristics of the purchaser must be such as meaningfully to inform an inquiry into whether the consideration actually given under the agreement exceeded the arm's length consideration under the hypothetical agreement; or, to use the words of the learned trial judge at [80], in the hypothesis the independent parties are to have the characteristics relevant to the pricing of the loan "to enable the hypothesis to work". The actual characteristics of the taxpayer must, therefore, ordinarily serve as the basis in the comparable agreement. That does not mean that all of the taxpayer's characteristics are necessarily to be taken into account. The decision in SNF is an illustration of a feature of the taxpayer (namely that of having a history of incurring losses) being held not to be relevant to determining the arm's length price of an arm's length acquisition. In some cases the consideration that might reasonably be expected to be given in an agreement in which the parties were independent and dealing at arm's length may be found in comparable dealings in an open market. What may readily be ascertained as the consideration in an open market for the property in question may supply the answer to the question but in each case the inquiry called for is a factual inquiry into the consideration that might reasonably be expected to be given in an agreement which did not lack independence between the parties and in which they dealt with each other at arm's length.
176 The extent of depersonalisation here depends, to use the language of Allsop C.J., upon what is appropriate to the task of determining an arm's length consideration. A number of considerations arise.
177 First, one should commence with the simple and uncontroversial proposition that it is only those attributes or features which can affect the consideration which is receivable which should clothe the hypothetical seller of copper concentrate.
178 Secondly, it is only the objective attributes or features which should be included. In SNF at first instance (SNF (Australia) Pty Ltd v. Federal Commissioner of Taxation [2010] FCA 635; (2010) 79 A.T.R. 193) Middleton J. observed at 201 [44]:
Just as in a valuation, the focus is not on the subjective or special factors of the parties involved in the transaction (for example whether they were financially sound or not), but is on the transaction itself and the consideration paid. In this sense, the task is not dissimilar to that undertaken in a valuation: see, for example, Boland v Yates Property Corporation Pty Ltd (1999) 74 ALJR 209 at 225-226 [82]-[83]; 167 ALR 575 at 596-597 [82]-[83] and Spencer v The Commonwealth (1907) 5 CLR 418.
179 Nothing said by this Court in SNF or in Chevron has led us to doubt the general correctness of this observation which we adopt. It means that one should include all of the objective circumstances of the actual C.S.A. mine, such as the means of production, the levels of production, the costs of production, the size of the mine, its location, and any problems arising from the location (e.g. water supply issues), and so on. It would include the objective circumstances of the copper concentrate market as at February 2007, including what was being reported by Brook Hunt, and what C.M.P.L. had budgeted and forecasted about the market. It would also include being a wholly owned subsidiary of a multinational natural resources group, but that group would not necessarily need to be the Glencore Group.
180 Thirdly, we think that it would be appropriate to exclude any considerations that are the product of C.M.P.L.'s non-arm's length relationship with G.I.A.G. and the broader Glencore Group. In our view, that would include whatever attitude or policy C.M.P.L. had formed about the issue of risk when selling to G.I.A.G. Of necessity, any such attitude or risk would have been distorted by C.M.P.L.'s lack of independence from G.I.A.G. Inferentially, as a separate entity it is unlikely to have considered the issue of risk when selling to G.I.A.G., save for its attempt to comply with Div. 13 in the 2007 to 2009 years. It follows that the taxpayer's failure to lead evidence about C.M.P.L.'s appetite for risk taking is not fatal. Nor is the failure to lead evidence about the Glencore Group's policy about risk taking (if any). Whilst such a policy, if it existed, might have been relevant, it was also, for the reasons given below, open to the taxpayer to discharge its onus on this issue through the opinions of Mr. Wilson.
181 Fourthly, and in any event, because the issue of risk taking is so bound up here with the method or formula for determining the consideration payable for the sale of copper concentrate, the taxpayer was entitled to support the appropriateness of the particular formula chosen in February 2007 by reference to what an independent party in the position of C.M.P.L. might have done to address risk in the objective circumstances of the copper concentrate market at that time in selling either to an independent trader or smelter. For that purpose, it could legitimately adopt a more conservative approach to risk so long as it was commercially rational to do so, and it is what an independent party dealing at arm's length might reasonably be expected to have done. The Commissioner was entitled to do likewise in support of a different pricing formula. Such a conclusion is consistent with Div. 13 imposing an objective test: W.R. Carpenter Holdings Pty Ltd v. Federal Commissioner of Taxation (2007) 161 F.C.R. 1 at 8 [27].
182 Importantly for this case, in our view it was open to the taxpayer to form its own commercial judgment about how risk was to be assessed as at February 2007 in the hypothetical transaction between independent parties. It was also open for Mr. Wilson to form such a commercial judgment arising from the fact that the C.S.A. mine was a high cost venture, so long as that judgment was the expression of what an independent party acting at arm's length might reasonably be expected to have adopted. On behalf of the Commissioner, it was also open for Mr. Ingelbinck to perform a similar exercise. It follows that choices which are open to be made about risk may affect the determination of the arm's length consideration. It also follows that there is likely to be more than one price which is an arm's length price. In that respect, a taxpayer is under no obligation to choose a pricing methodology which pursues profitability in Australia at the expense of prudence. There is no obligation to "maximise" profitability at the expense of all else.
183 Fifthly, the possibility of a range of arm's length outcomes, each of which would be sufficient to answer the statutory test, is supported by authority. As this Court said at 187-188 [125] in SNF:
But that does not mean, more generally, that there is only one arm's length consideration. Often enough, for example, goods will change hands at prices which are different to the market value for perfectly legitimate reasons such as a need to secure long term or large volume arrangements or with traded securities, a premium for control and so on. No doubt, it was for similar reasons that Dr Becker, the Commissioner's own witness, in response to the question '[a]nd you accept that, typically, there's not one arm's length price for a particular product?' answered '[t]hat's correct, yes'.
184 Sixthly, what controls the range of acceptable arm's length outcomes is the concept of what might reasonably be expected. As Pagone J. observed in Chevron, that concept calls for evidence which supports a "sufficiently reliable" prediction which can be seen as reasonable. As his Honour said at 76 [127]:
The standard of reasonable expectation found in the words "might reasonably be expected" in s 136AA(3)(d) calls for a prediction based upon evidence. In Federal Commissioner of Taxation v Peabody (1994) 181 CLR 359 the High Court said at 385:
A reasonable expectation requires more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable for it to be regarded as reasonable.
The prediction contemplated by Division 13, like that contemplated by s 177C of the 1936 Act, involves an evaluative prediction of events and transactions that did not take place but the prediction must be based upon evidence and, where appropriate, upon admissible, probative and reliable expert opinion: see Federal Commissioner of Taxation v Futuris Corporation Ltd (2012) 205 FCR 274 at [79]-[81]; see also Peabody v Commissioner of Taxation (1993) 40 FCR 531 at [39] (Hill J).
185 The Commissioner in his written submissions appeared to contend that the hypothetical mandated by Div. 13 required a taxpayer to prove what independent parties would have agreed to be the arm's length consideration, rather than what independent parties might reasonably be expected to have paid or received. He relied on certain sentences in Chevron which appeared, on one view, to adopt a "would" test, but clarified during the hearing before us that he accepted that Div. 13 mandates a "might" test. We respectfully agree with this clarification. We do not think that those sentences in Chevron were intending to convey a test at odds with the language of s. 136AA(3)(c) and (d) of the 1936 Act. The statutory test relevantly requires the hypothetical price to be ascertained by reference to what might reasonably be expected to have been received or paid if the property had been supplied under an agreement entered into between independent parties dealing at arm's length with each other. In our view, Art. 9 of the Swiss Treaty mandates a relevantly analogous inquiry. It refers to what might be expected and not to what would be expected.
186 Finally, in applying the foregoing a degree of flexibility and pragmatism is required. Whilst the onus remains on the taxpayer to discharge its onus of proof of demonstrating excessiveness in the amended assessments, one should not apply Div. 13, or indeed Subdiv. 815-A, narrowly. Predicting how independent parties dealing at arm's length with each other would price a wholly controlled transaction is a difficult and complex issue. That is especially so when one integer which here directly affects the consideration payable is the formation of a commercial judgment about risk taking. The Court should acknowledge, and take into account, the practical difficulties faced by both the taxpayer and the Commissioner in finding evidence that grounds what is sufficiently reliable, or which demonstrates that something is insufficiently reliable. The answer is not always to be found in overly lengthy and complex expert reports. Common sense is required.
187 The foregoing seven propositions are what we consider to be relevant in deciding the "appropriate" degree of "depersonalisation" here, to use the language of the Chief Justice in Chevron, given the particular facts and circumstances of this case.
188 Something should be said at this point about the focus of Mr. Ingelbinck's opinion, and thus also of the Commissioner's case, upon the proposition that if C.M.P.L. had been dealing independently and at arm's length with G.I.A.G., it would never have agreed to the amendments made to the pricing formula in February 2007. In that respect, we think the Commissioner established that, from the perspective of C.M.P.L.'s earnings, it might have been expected in February 2007 for those earnings to decrease with the adoption of price sharing. But in our respectful opinion, the ultimate issue for determination is not whether an arm's length party would have agreed to the amendments, given the pre-existing terms of trade. We agree with the submissions of the taxpayer that the framing of the issue in this way is at odds with the text and purpose of Div. 13 and Subdiv. 815-A. Rather, the relevant issue is whether the consideration received by C.M.P.L. in the 2007 to 2009 years was less than the arm's length consideration, as that term is defined in s. 136AA(3) of the 1936 Act, for the copper concentrate in fact supplied. The answer to that question does not turn upon whether the amendments made in February 2007 were in C.M.P.L.'s interests. It may be the case that both the pre-existing C.M.P.L.-G.I.A.G. agreement, and the agreement as amended in February 2007, included pricing formulae that arm's length parties might reasonably be expected to have adopted. Both may fall within the range of arm's length outcomes. In making this observation, we do not think that the pre-existing terms were irrelevant to the application of Div. 13 here. They form part of the objective history which may bear upon the issue as we have defined it.
189 We turn to consider the issue of "personality" under Subdiv. 815-A and Art. 9 of the Swiss Treaty. As we understood the judgment of Chief Justice in Chevron, Subdiv. 815-A applies in an analogous way to Div. 13. Both must be applied flexibly. As his Honour observed at 62 [90]:
[T]he causal test in s 815-15(1)(c) based on Art 9 is a flexible comparative analysis that gives weight, but not irredeemable inflexibility, to the form of the transaction actually entered between the associated enterprises. A degree of flexibility is required especially if the structure and detail of the transaction has been formulated by reference to the group relationship and a "tax-effective" outcome (even if, as here, one that is not said to be illegitimate). The form of that transaction may, to a degree, be altered if it is necessary to do so to permit the transaction to be analysed through the lens of mutually independent parties.
190 To similar effect Pagone J. said at 90-91 [156]:
The comparison which Art 9 required to be undertaken is akin to that contemplated by Div 13. The object was to determine whether conditions actually prevailing between the relevant enterprises differed from those which might be expected to operate if they had been independent and had been dealing wholly independently with each other. The hypothetical in that exercise is undertaken for the purpose of determining whether the dealing which actually occurred might have been expected to occur on different terms. That will generally require that the parties in the hypothetical will generally have the characteristics and attributes of the actual enterprises in question. The comparison required by Art 9 is expected to be undertaken in a practical business setting of potential transactions able to be entered into and which are to be used as a basis for a reliable hypothesis upon probative material. Ultimately the question was that of determining whether profits might have been expected to accrue to CAHPL if the transaction it entered into with CFC had been entered into where the conditions which operated between CAHPL and CFC did not operate, that is, where CAHPL and CFC had been dealing with each other wholly independently. The hypothetical thus required hypothesising circumstances in a dealing between an enterprise like CAHPL and an enterprise like CFC where, however, the conditions operating between them were between independent enterprises dealing wholly independently with each other.
191 In our view, one of the "conditions" that operated between C.M.P.L. and G.I.A.G. was the price sharing formula adopted from February 2007. As Allsop C.J. observed in Chevron (at 60 [82]), the word "conditions" is "broad and flexible". In our opinion, it is plainly apt to include those terms in the contract which defined the consideration C.M.P.L. was to receive. The task for the taxpayer was thus to demonstrate that the pricing formula established by those terms did not differ from those formulae which might be expected to have operated between independent enterprises dealing wholly independently with one another in the copper concentrate market at the time. In that respect, it was again entirely open for the Commissioner to contend that the pricing formula did so differ, and that as a result profits that might have been expected to accrue under a different arm's length pricing formula had not so accrued. For analogous reasons to those set out above, because risk and the pricing formula were inextricably bound up with each other, it was open for either party to lead evidence about how independent enterprises dealing wholly independently with one another might be expected to have assessed the issue or issues of risk as at February 2007. The failure by C.M.P.L. to lead evidence about its actual risk appetite or that of G.I.A.G. or the broader Glencore Group did not foreclose C.M.P.L.'s ability to lead expert evidence more generally about, and make submissions concerning, what independent enterprises might have done to address the issue of risk.