Kmart Australia Ltd v Commissioner of Taxation of the Commonwealth of Australia

Production and distribution processes 6 The CDs the subject of these proceedings were more likely than not manufactured by Digital Audio Technologies Australia ("DATA"), a company engaged in production and replication of CDs, owned equally by EMI and Warner Music Australia Pty Ltd. 7 The processes routinely performed by DATA to manufacture a CD are: (1) Pre-mastering (or compilation) - This involves copying the AI in a digital form into the hard drive of a computer and inserting the NAI. The "compiled" AI and NAI is then sent electronically by coaxial cable for glass-mastering. The evidence of Mr Sheard is that for a CD album the pre-mastering or compilation process ordinarily takes about 90 minutes of direct labour, of which about 20 minutes (being 2/9 or 22 per cent) is taken up in inserting the NAI. (2) Glass-mastering - This involves etching the AI and NAI by means of a laser beam onto a glass disc which is then coated in nickel to create a "father" disc. (3) Matrix (or electroforming) - This involves using the "father" disc to create a "mother" disc which in turn serves as a mould to create one or more metal discs called a "stamper". (4) Moulding - This involves injecting liquid polycarbonate into a two part mould, one side of which holds the "stamper". The polycarbonate solidifies in the mould to form a transparent plastic disc. The AI and the NAI are in this way embedded in the plastic disc as part of the moulding process. The AI and NAI take the form of a series of "pits" (shallow depressions) and "lands" (the spaces between them) moulded into a spiral shaped track on one side of the plastic disc. The "playable side" of the CD containing the AI and the NAI is then coated with reflective aluminium and lacquered. The metallised and lacquered CDs are then checked for flaws, and rejects are removed. (5) Screen printing - This involves decorating the "non-playable side" of the CD by applying ink through a fine mesh. (6) Assembly and packing - The completed and functioning CD is then packed in a plastic "jewel case" containing a plastic tray which holds it in place, an insert is added into the sleeve of the jewel case and the finished product is coated in plastic. 8 With the exception of pre-mastering, DATA performs all of these processes with respect to all of the CDs which it manufactures. In relation to pre-mastering, DATA itself performs pre-mastering only on about 21 per cent of the titles it manufactures. The remaining 79 per cent of titles manufactured by DATA are "pre-compiled" by others using the same standard pre-mastering techniques as DATA. When DATA performs pre-mastering it makes a charge of $210 per title. There was an issue between the parties as to the appropriateness of measuring the pre-mastering cost by reference to the $210 fee charged. That issue gave rise to relatively extensive cross-examination and submissions in relation to the average production run, the number of times a production run could be undertaken from the "library" of masters and stampers, and the profit said to be contained in the $210 figure. After I reserved my decision I was notified that it is agreed between the parties that the pre-mastering cost attributable to each CD is 2 cents, hence I need do no more in relation to this issue than record that fact. 9 CDs are manufactured in accordance with an international standard set out in a document known as the Red Book. The standard was jointly developed by Philips and Sony. A royalty is payable by a CD manufacturer for use of the compact disc technology in addition to a lump sum payment of $US 25,000. Royalties are also payable by the distributor to the recording artist, and to the owner of the copyright in the music. The Red Book and the technology comprised in it enable both AI and NAI to be compiled during pre-mastering. 10 At my request, the parties agreed upon the formulation of the issues which fall for decision.

Issue 1: What is to be valued? 11 The question is whether it is the value attributable to the NAI on the CD, or the value of the NAI in isolation which is to be valued. The applicant submits that it is the value attributable to the NAI embedded on the CDs which is the subject of the valuation: the respondent submits that it is the NAI in isolation. 12 This is said to be a question of the construction of Declaration 3 made by O'Connor J, the Act and the pleadings. The terms of the declaration made by O'Connor J accord with my construction of the Act, hence it is unnecessary to consider the effect of admissions as to the operation of s 45 of the Act which were said to arise on the pleadings. In any event that is not a fruitful exercise if this decision is to have an effect beyond the boundaries of the particular case.

Construction of s 45 13 Section 45 of the Act provides: "(1) This section applies if a tax-advantaged computer program is embodied in (or in part of) the goods that are the subject of the taxable dealing. (2) The exempt part is so much of the taxable value as is attributable to the computer program." 14 A computer program is taken to be embodied in the goods only if the goods have been so treated that the computer program can be reproduced from the goods (either with or without the aid of some other device): Act s 13. "Computer program" has the same meaning as in the Copyright Act (1968) (Cth). At the relevant time "computer program" was relevantly defined in the Copyright Act so as to mean: "An expression in any ... code ... of a set of instructions ... intended ... directly ... to cause a device having digital information processing capabilities to perform a particular function." 15 It is common ground that s 45 of the Act requires a valuation exercise to be conducted. That exercise is an artificial one, inasmuch as NAI is an inseparable and integral part of the goods in the sense earlier explained. It is not a separate article, or a separate part of the goods capable of being valued as such. But the section requires an apportionment of the wholesale sales price between the computer program constituted by the NAI and the other elements of the CD which contribute to its taxable value. Those other elements are the AI and the carrying medium in which NAI and AI are embedded. The elements form an integrated whole; no one element has commercial utility except in association with the others. Hence apportionment must be undertaken as a matter of practical common sense: Roadshow Distributors Pty Ltd v Commissioner of State Revenue [1998] 1 VR 523, 529. 16 The NAI component which is ultimately included in each CD is fully programmed at the pre-mastering stage. The NAI, considered as a set of statements or instructions, has been compiled by the conclusion of that stage, and there is no change made to the algorithms as a result of anything which occurs thereafter. But it is not until the completion of the moulding stage that the NAI is embodied in the CDs by means of the pits and lands to which I earlier referred. 17 Expert accounting evidence was given by Professor Walker and by Professor Wells for the applicant, and by Professor Foster for the respondent, as to the appropriate methodology for valuation of the NAI component of the CDs. There are varying ways to estimate the "value" contributed by a component or element of a packaged product as sold in wholesale markets, to which it will be necessary to return later in these reasons. One of those ways is referred to as a "cost-based" method of allocation. All of the experts used cost-based evidence in examining the value to be attributed to the NAI on the CDs, although there were differences of opinion between the experts as to the application of the cost-based methodology. 18 Professor Walker's preferred approach was to consider the relative costs of various "inputs" to the production of a finished product which is then sold in a wholesale market, and then calculate the value of the NAI embedded on the CD ("embedded NAI") in accordance with the formula: embedded NAI = total direct costs of embedded NAI x wholesale price of a CD total direct costs of the CD 19 The most material disagreement between Professor Foster on the one hand, and Professors Walker and Wells on the other, arises from Professor Foster's contention that no part of the costs incurred beyond the pre-mastering stage should be included in the numerator, as the NAI software is in its finished state as a component at the end of the pre-mastering stage. There is no further development of the NAI component at any stage of the production process beyond the pre-mastering stage. On the other hand, Professors Walker and Wells assign a value to the NAI when it is embodied on the CDs by allocating part of the costs of glass-mastering, matrix and moulding to the NAI. They do so on the basis that the subject matter of the valuation is, using the words of Order 3 of O'Connor J: "The non-audio information on the audio compact discs". (emphasis added) 20 Professor Walker makes the point that the NAI software is necessarily transformed during a manufacturing process so that it is embedded on the physical surface of a CD. Professor Wells agrees: while costs have been incurred prior to the production stage, the NAI has no value at that point of the production process. It is not a saleable product. Subsequent costs are necessary for the production of a saleable product and those costs are attributable to the NAI just as they are attributable to the AI. Changes in the value of the NAI are driven by changes in the costs incurred beyond the pre-mastering stage. 21 This difference of opinion between the experts was treated by the parties as giving rise to a question of construction of the Act as to the proper definition of the subject matter which is to be valued under s 45. 22 In the Commissioner's submission, s 45 of the Act requires an apportionment of the wholesale value of a CD between the set of instructions constituting the computer program devoid of any part of the carrying medium and all other parts of the end product. The Act seeks to remove from the taxable value of a CD so much as is attributable to the "intelligence" constituted by the set of instructions. That means that the set of instructions is considered separately from any carrying medium in which it is embodied. The tax advantaged computer program referred to in s 45 of the Act is a set of statements or instructions divorced from any carrying medium in which it is embodied. 23 The Commissioner seeks to gain support for his construction from the context of the legislation (CIC Insurance Ltd v Bankstown Football Club Ltd (1997) 187 CLR 384, 408) including the legislative history and parliamentary intention (Chaudhri v Federal Commissioner of Taxation [2001] ATC 4212; [2001] FCA 554). The relevant history and extrinsic materials is set forth hereunder. 24 In 1989 s 18C was inserted into the Sales Tax Assessment Act (No 1) 1930 (Cth). Section 18C was the precursor of s 45 of the Act. The effect of s 18C was to reduce, for tax purposes, the sales value of goods embodying a computer program by the amount of the sales value attributable to the computer program. 25 The Explanatory Memorandum stated: "Computer programs as such, because they are not goods, are not subject to sales tax under the existing sales tax law. However, the sale value of the carrying media for the programs and other goods in which programs are embodied includes the value of the programs for the purposes of calculating the amount of sales tax payable on the goods concerned. This Bill will reduce the sale value of goods containing computer programs by the amount of that value attributable to any programs in them, other than programs that are on a microchip. Except in cases where the only computer program in the goods is embodied on a microchip, the sale value will be further reduced by the amount of that value attributable to any instruction manual that forms part of the goods. The remainder of the goods - which may only be the carrying medium - and the packaging of the goods will, however, continue to be taxable." 26 The Explanatory Memorandum continued: "The deduction to be made from the 'gross' sale value of the goods is, in the first instance, under paragraph (c), so much of the amount that would, but for section 18C, be the sale value of the goods as is attributable to every program embodied in the goods that is not a program embodied in a microchip (whether the microchip is goods itself or is a component of goods). The amount to be deducted would include the wholesale value of the program (which would include the costs and profits of the manufacturer in relation to the program, but not in relation to the carrying medium, if the goods were sold by her or by him by wholesale). The wholesale value of any services to be provided in relation to the program (for example, installing the program or training licensees and their staff in the use of the program) where the 'gross' sale value includes the value of those services would also be excluded from the wholesale value. Services to be provided in relation to the carrying medium (for example, installing a computer) would not, however, give rise to a reduction in sale value." 27 When the Act was introduced to the Parliament, the Explanatory Memorandum made the same point, that it was only the tax advantaged computer program, and not the carrying medium, which was exempt from tax. 28 In par 10.5 at 155 the Explanatory Memorandum issued in relation to the Act states with respect to tax-advantage computer programs, that it is the set of instructions which is exempt from tax: "These computer programs will have a tax advantage because their taxable value is reduced by the value of the intelligence contained on that disc or cartridge, which is to be treated as an exempt part. Computer programs are discussed in more detail in Chapter 22. This measure will be the same as under the existing law (Clause 45)." 29 Paragraph 22.11 at 329 of the Explanatory Memorandum again highlights the distinction between a set of instructions on the one hand and any carrying medium on the other: "Where a computer program is tax advantaged the taxable value of the computer program will be reduced by the value of the program embodied on the carrying or other medium onto which the program is duplicated. This reduction is described as an exempt part of the taxable value and has the effect that where a tax advantaged computer program is the subject of an assessable dealing, tax will be payable only on the wholesale value of the carrying medium. (Clause 45)." 30 The Explanatory Memorandum at par 22.15 at 330 summarises the main changes to the old Sales Tax legislation brought about by the Act. The following appears: Change Reason 3 The value of the computer program embodied on a disc etc. is to be treated as an exempt part of the taxable value of a computer program. The result is that tax is payable only on the taxable value of the carrying medium. The sale value provisions in the existing law are cumbersome and complex. The different approach to determining the taxable value of a computer program does not result in a different value to that in the existing law but it is a much simpler concept to follow.

31 Whilst the extrinsic materials to which I have referred are not irrelevant, ultimately it is the legislation, rather than those materials, which is to be construed: Federal Commissioner of Taxation v Prestige Motors Pty Ltd (1998) 153 ALR 19, 38. 32 The materials make it plain, as do the terms of the section itself, that the parliamentary intention was to reduce the taxable value of goods by the value of the computer program embodied on the goods. It was not the intention to exempt the carrying medium from sales tax. However, the materials do not focus upon the issue which falls for decision in the present case. 33 It is a precondition to the operation of s 45(2) that a computer program is embodied in the goods which are the subject of the taxable dealing. When that precondition is satisfied, s 45(2) exempts from the taxable value of the goods so much of that value as is attributable ("referrable", "belonging to") the computer program. Having regard to the precondition, the reference is necessarily to the computer program which is embodied in the goods. 34 The computer program is the coded set of instructions (see par 12 above) and the question is whether, and, if so to what extent, the taxable value of the goods has been enhanced because the goods when sold by wholesale had that information embedded in them. 35 If the answer to that question is to be derived from a consideration of the relative costs of the various inputs to the finished product, then it should be remembered that the "finished product" is a CD which has the NAI embedded in it. It is only at that point that the CD is ready for use as such. 36 Thus there cannot be any legal reason for confining the costs of which account is to be taken to costs incurred in relation to the NAI up to the pre-mastering stage, and excluding costs incurred thereafter. Professor Walker criticises Professor Foster's approach because it does not accumulate costs up to the point when the NAI has been embedded in the CD and is ready for use. I agree with that criticism. 37 The fact that the relevant costs are costs of incorporating the information into the carrying medium, and the fact that the carrying medium itself is not intended to be tax exempt, is beside the point. The cost of incorporating the NAI into the CDs is as much an element of the contribution made by NAI to the taxable value of the CDs as the cost of compilation of the NAI up to the pre-mastering stage. 38 However, it would be inconsistent with the statutory scheme to assess the contribution made by NAI to the taxable value of the CDs on the basis that a proportion of the cost of the carrying medium itself should be attributed or allocated to NAI. To do so would be contrary to the clear teaching of the extrinsic materials that the carrying medium, as opposed to the information embedded in it, is not tax exempt. 39 In Professor Walker's third report of 19 October 2001, he argues that the cost of NAI on a CD includes the costs of the carrying medium, and other costs beyond the pre-mastering stage. In his first report, Professor Walker argued that the disc itself never has a separate or independent existence from the AI and NAI incorporated on it, as the disc is not reusable. He said: "Accordingly, in my judgment, part of the cost of producing the disc itself should be included in the cost and taken into account in calculating the wholesale value of the NAI embodied in a CD." For the reasons indicated, I accept the argument that the cost of NAI includes costs beyond the pre-mastering phase of embedding NAI into the CDs. I reject the argument that a proportion of the costs of the carrying medium should be allocated to NAI, because it fails to take account, or sufficient account, of the fact that there are at least three elements which combine to make up a CD, namely NAI, AI and the carrying medium, and it is only the first of those three which is tax exempt. Professor Walker's earlier reports were constructed on the basis that there are only two elements - NAI and AI - between which costs should be allocated. I do not agree with that approach. 40 In determining the value of NAI on a CD on the basis that the value should not include a proportion of the cost of the carrying medium, the exercise should apportion costs (and hence wholesale value) between three elements: - NAI - AI - the carrying medium 41 In his third report Professor Walker states: "7. The costs of compilation, nickel stampers and glass-mastering should not be allocated to the carrying medium because they are incurred in the process of preparing the audio information and NAI and transferring it on to the carrying medium and are not incurred in relation to producing the carrying medium per se. Furthermore, that part of the injection moulding process that embeds the audio information and NAI in to the carrying medium and metallises and applies the protective coating to the aluminium surface of a disk, also form part of the process of placing the audio information and the NAI on to the carrying medium in a readable and durable form: the costs of these processes should be allocated on a 57/43 basis to the audio information and the NAI. 8. On the other hand, that part of the cost of the moulding process that relates to the polycarbonate granules, preparing this material for the injection moulding process and that part of the injection moulding process which relates to forming the transparent CD relate solely to producing the carrying medium. If the cost of the carrying medium is to be excluded, no part of these costs should be allocated to the audio information and the NAI." In cross-examination (T 66-67) Professor Walker made it clear that if he were asked to value the NAI without taking into account the costs of the carrying medium, he would exclude costs associated with the polycarbonate, costs associated with the moulding process so far as it related to the disc itself and costs associated with the jewel case, insert and other packaging material. 42 No expert contradicted the evidence given by Professor Walker to which I have referred, assuming the costs of embodying the NAI in the carrying medium are to be taken into account. I accept that evidence as a correct statement of the types of cost incurred after the pre-mastering stage which should be allocated to the NAI, even though they are costs of embedding the computer program in the carrying medium. 43 The apportionment of these costs is discussed in Issue 6.

Issue 2: Cost-based or market-based determination of value? 44 There is no market for NAI as such, nor is there a market for CDs containing only the NAI computer software. The NAI software is only valued by purchasers of CDs because the NAI, along with other component inputs, enables purchasers of CDs to have music on demand. 45 Market-based transaction evidence is available for key component inputs of CDs. Professor Foster's preferred approach is to take the market value of the key inputs for the AI and NAI on a CD. The AI is available on payment of artists' royalties and copyright royalties. The NAI is created using the Red Book technology which may be acquired under licence upon a lump sum payment of $US 25,000 together with the Philips/Sony royalty of $US 0.030 per full length music CD and $US 0.027 per single music CD. 46 What is acquired under licence is not the NAI, but the technology which will lead to the compilation of the NAI at the pre-mastering stage and its embodiment in the CD at the moulding stage. The royalty charges are for technology covering AI as well as NAI. 47 The content of the two components undergoes some transformation at the pre-mastering stage, which Professor Foster characterises as "minimal". That is important because market prices of inputs may be of little relevance in the determination of the relative market values of AI and NAI if inputs are the subject of considerable manufacturing processes. Professor Foster gave the following example: "Suppose seat belts were the only part of a motor vehicle that were exempt from a wholesale sales tax. If the seat belt is manufactured by an independent company and that company provides the same seat belts to multiple vehicle assemblers the market price of the seat belt is one reliable piece of evidence of the fair market value of the seat belts. If however, a manufacturer purchases fabric and metal clips and then internally assembles the seat belts prior to their attachment to the vehicle, the purchased price of the fabric and metal clips are a less reliable indicator of the fair market value of the seat belt." 48 As the Philips/Sony royalties enable both NAI and AI to be installed during pre-mastering, Professor Foster allocates 2/9ths of the market value of this technology to the NAI (or 1/3rd in the case of a CD single). 49 The percentage derived from the formula: 2/9ths technology royalty technology royalty + artists royalty + copyright royalty is applied to the wholesale price of a packaged and distributed CD to arrive at the amount attributable to the computer program. 50 Both Professor Walker and Professor Wells criticise the market-based approach upon the basis that it does not relate to the value of NAI on a CD. The technology royalties are incurred early in the process, but the product develops and is changed throughout the production process. This criticism is, in my view, well founded. If, as I have found, the relevant enquiry is to determine the contribution to the taxable value of the CDs made by the NAI embodied in the CDs, then the market-based approach is irrelevant, as it does not address that question. Indeed, as I understood the submissions of Mr Gzell QC, he accepted that the market based approach was only relevant if the task was to attribute a value to the computer program alone, and not as embedded in the carrying medium. In the view I take, that is not the relevant task, hence I accept the view of Professor Walker and Professor Wells that the market-based approach is irrelevant. 51 Even if I had come to a different view on the question of construction I would not have been prepared to use the market-based approach as the sole method of valuing the NAI. That is because, although described as a market-based approach, it is not really that at all, since: - technology costs on the one hand, and artists and authors royalties on the other, are established in different markets and at different levels of trade; - whilst NAI is derived from the use of the technology, whether the price of the one indicates the value of the other depends upon whether and to what extent value is added to the other in the pre-mastering process; - the method simply compares the costs of certain inputs into the production of NAI and AI. A cost-based method takes account of all inputs. 52 If the "market value" approach is rejected, as it is, it is common ground that a cost-based approach should be adopted. The rationale underlying a cost-based approach is that the proportion of the costs of the embedded NAI, expressed as a percentage of the total costs of a CD, could be regarded as representing the proportion of the wholesale value of the CD attributable to the NAI on the CD.

Issue 3: Does the object of the cost-based approach include the insert? 53 The cost-based approach is based on the calculation of a ratio of costs attributable to NAI compared with the costs of the whole product, and then applying that ratio to a wholesale price to deduce a value attributable to NAI. Professors Foster and Walker consider costs attributable to NAI as a proportion of the total cost of producing a labelled and packaged CD including, in the case of Professor Foster, distribution costs. Professor Wells excludes the insert. In his view, because the insert has its own classification within the sales tax regime, the insert should be treated as a separate product and the costs of the insert should be eliminated from the calculations of the cost of the AI and NAI. Professor Foster's point is that it is incorrect to have something other than the saleable product as the denominator when the task at hand is estimating the values attributable to one component of the final product. 54 The applicant submits that Professor Wells is correct, and that the insert should be excluded. The respondent submits that the insert should be included. The resolution of that difference depends upon the proper construction of the Act. 55 The wholesale sale of the CD and insert is an assessable dealing: s 16(1)(a). An assessable dealing is not taxable if the goods are covered by an exemption item: s 24. An exemption item means an item in Schedule 1 to the Sales Tax (Exemptions and Classifications) Act 1992: s 5. The insert is an exemption item as it is within Item 100 in Schedule 1 to the Exemptions and Classifications Act. Hence the taxable dealing does not include the insert: s 16(2)(a). Section 16(3)(a) requires the determination of the taxable value of the taxable dealing. The only relevant taxable dealing is the sale of the CD (the insert being exempt), the taxable value of which is determined by the industry agreement under s 43 of the Act. The enquiry postulated by s 45(2) of the Act is how much of that value is attributable to NAI. The insert forms no part of that enquiry, hence Professor Wells was correct to exclude it from his calculations.

Issue 4: Should costs other than pre-mastering costs and technology royalties be included in the numerator of the ratio? 56 It is common ground that an element of the pre-mastering costs and technology royalties should be included in the numerator of the ratio. The issue is whether an element of costs of subsequent steps in the manufacturing process (glass-mastering, matrix and moulding) should also be included. 57 I have already found that the cost of incorporating the NAI into the CDs is as much an element of the contribution made by NAI to the taxable value of the CDs as the cost of compilation of the NAI at the pre-mastering stage (par 37 above). It follows from that earlier discussion that the costs of embodying the NAI into the CD should be included in the numerator of the ratio.

Issue 5: What proportion of technology royalties are attributable to NAI? 58 DATA pays royalties of $US 0.03 per CD and $US 0.027 per CD single and an upfront fee of $US 25,000 in order to obtain use of the methodology in the "Red Book". The overwhelming majority of the "Red Book" concerns NAI and how it is placed on the CD, but the Red Book methodology is necessary to allow insertion of both the AI and the NAI on the CD. 59 The applicant says that 50 per cent of these royalties should be attributed to NAI. The respondent says that 2/9ths should be attributed in the case of full length CDs, (the 2/9ths deriving from the evidence that 2/9ths of the time in the pre-mastering stage involved NAI). 60 Notwithstanding that the figures of 2/9ths is adopted by Professor Foster, the respondent submits that the evidence "falls short of a reliable establishment of those times". Direct evidence as to those times was given by Mr Sheard. That evidence was not contradicted. Although there was some cross-examination around the point, the proposition that Mr Sheard's evidence of approximate times was erroneous was not squarely put to him. In cross-examination Mr Sheard did not resile from the time estimations contained in his affidavit. In those circumstances, I accept the affidavit evidence given by Mr Sheard in this respect. 61 Professor Walker originally allocated 100 per cent of the royalties to NAI. Professor Foster expressed the view that a time-based allocation was appropriate. In Professor Walker's second report he accepted that a 100 per cent allocation is inappropriate, but said that a better basis of apportionment would be the extent to which software and other materials subject to the licences related to NAI and AI respectively. In the absence of that information he assumed an allocation of 50 per cent-50 per cent, "which I suspect is conservative". Although Professor Wells agreed with Professor Walker's allocation of 50 per cent, in cross-examination he said that a space-based allocation of 57/43 was probably more appropriate because it is what you end up with, rather than how long it took to put it there, which provides the more appropriate basis for an allocation. Notwithstanding that view, he acquiesced in the 50/50 apportionment as the selection of the appropriate ratio involved an arbitrary judgment. 62 Arguments can be marshalled in support of a time-based allocation, a space-based allocation and an equal allocation. The question is one as to which accounting experts may reasonably differ, as they do. It was not suggested that there is any generally accepted accounting principle which yields one answer which can be characterised as the correct answer. 63 In those circumstances, I think that I am both entitled and required to make my own judgment. That judgment is that the technology costs should be apportioned on a 50/50 basis, because both the AI and NAI are required to be embodied on the CD; the technology relates to the embodiment of both and, on a space basis, in nearly equal parts; at least 50 per cent of the technology relates to the embodiment of NAI.

Issue 6: The component of glass-mastering, matrix and moulding costs in the numerator 64 The question is: what is the proportion of glass-mastering, matrix and moulding costs referrable to the embodiment of NAI and AI in the disc which should be included in the numerator? 65 The applicant says that 43 per cent (space-based) of those costs should be included. The basis for that percentage appears at 88 FCR 336 at 339C-F. In each "frame" on the CD, there are 588 bits of which 336 contain audio information and 252 contain non-audio information. 66 Professor Foster would apportion the costs by reference to the formula which he derived in Attachment 11 to his report, ie his market-based formula (T 102). Professor Wells (T 133) agrees that part of the costs of glass-mastering, matrix and moulding should be allocated to NAI, but he would not use Professor Foster's market-based formula as the means of allocation because, in his view, it has no relevance to the matter under consideration. 67 I agree with Professor Wells' views in this respect. A space-based allocation is sensible because the object of the processes in question is the incorporation of NAI and AI into the CDs. It may be that the costs in the relevant departments are not affected by what proportion of the space on a CD is occupied by "NAI bits" as opposed to "AI bits", but this does not provide a cogent reason for rejecting the space-based allocation. 68 The reservations which I expressed in relation to the "market-based" approach in Issue 2 are at least of equal relevance here. Further, if the "market-based" formula is intended to reflect some marketplace assessment of the relative importance which end users attribute to NAI and AI, then I am not satisfied that use of the formula achieves that end, or even that it is a useful or meaningful enquiry, given that NAI as well as AI is essential to the production of a CD capable of functioning as such, and the likely lack of detailed knowledge amongst end users of the technology involved in the production of a CD. 69 On this topic, I prefer the allocation basis propounded by Professors Walker and Wells to that put forward by Professor Foster.

Issue 7: Should the ratio be determined by direct costs or full costs? 70 All parties accept that general overheads have to be addressed in the allocation of costs. The difference, described in submissions as a difference in principle, is that Professors Walker and Wells would perform that allocation based only on direct costs (and apportion indirect costs proportionately), whereas Professor Foster bases his calculations on full costs (directly seeking to allocate indirect costs to pre-mastering based on an analysis of labour costs). 71 The context in which this issue arises is as follows: DATA had manufacturing costs of $18,249,713 of which $12,747,549 was assigned to six departments - pre-mastering, glass-mastering, matrix, moulding, screening printing and packaging. A sum of $5,561,027 (which includes some adjustments) is not assigned to any department. No information is available as to how the pre-mastering department, or for that matter, how any other department, uses such of DATA's resources as are captured in that sum. Professor Foster conducted an allocation exercise based on the proportion that the labour costs for the pre-mastering department bear to the total labour costs (4.29 per cent). He did so on the basis that labour is the largest cost item in the pre-mastering department cost pool, and the installation of the computer program is basically a labour activity. 72 Professor Walker's approach was that overheads should be allocated in the proportion provided by the ratio of direct costs of preparing and embedding NAI to the total direct costs of producing a labelled and packaged CD. Professor Walker accused Professor Foster of having adopted a contestable allocation method which allocated only a small proportion of the overhead costs to the pre-mastering department, and a larger proportion to the other departments. Professor Walker ultimately withdrew this criticism (T 74.8). 73 In cross-examination, in response to the proposition that labour is the most appropriate basis by reference to which the costs should be allocated, Professor Walker's response (T 73) was that "it is a convenient one". Professor Foster was not specifically cross-examined on this issue. 74 Although this issue was described in the parties' submissions as being one of principle, the questions involved are questions of fact to be resolved on the evidence (Dart Industries Inc v Decor Corporation Pty Ltd (1993) 179 CLR 101 at 117-118). One has to find a "reasonably acceptable basis for allocation", ie the basis which is most likely to conform to the facts if the facts were known. The decision of Learned Hand J, in Sheldon v Metro-Goldwyn Picture Corp (1940) 106 F 2d 45 does not amount to an approval of one of the approaches adopted in this case over the other. It was simply a decision on the particular facts of that case. 75 I was informed in the course of submissions, (at least by the applicant's counsel) that little ultimately turns on this issue. That may explain why it was not the subject of more detailed consideration at the hearing. Since products may differ in their use or benefits from overheads, it is preferable to allocate the unallocated overheads to the different departments. Given the concession by Professor Walker that Professor Foster's method provides a "reasonably acceptable basis for allocation", and the absence of any corresponding concession on the part of Professor Walker, I prefer the allocation basis put forward by Professor Foster.

Issue 8: How are the pre-mastering costs to be determined? 76 This is no longer an issue between the parties as it is common ground that 36 per cent of the costs of the pre-mastering department should be allocated to CDs, and it is now agreed that the cost of pre-mastering is 2 cents per CD.

Issue 9: Should distribution costs be included in the denominator? 77 The applicant submits that distribution costs should not be included in the denominator. The respondent says that they should be included. If they are to be included, Professor Foster quantifies them at 20 cents per CD. There is no issue as to quantum. 78 Professor Foster adds the distribution costs of the CD to the denominator whereas Professor Wells and Professor Walker do not do so. Professor Foster's point is that if distribution costs are left out of account, the total cost of bringing the CD product to the wholesale sales point are understated. Professor Walker's response accepts that distribution costs are necessarily incurred to bring the CD to the wholesale sales point, however, he contends that those costs are not a component of the CD, and it is reasonable to regard distribution costs as being partly attributable to NAI embedded on the CDs. Professor Foster's rejoinder is that the distribution cost is not attributable to the NAI; it is attributable to the manufactured CD itself. 79 I prefer Professor Foster's approach. Once the NAI has been embodied in the CDs, then any costs incurred thereafter are not attributable to the NAI, but to the finished product. Section 45 requires that there be extracted from the wholesale price of the CD the contribution which the inclusion of the NAI in the CD makes to that price. If that is to be ascertained on a costs basis, then it seems to me that the accumulation of the costs attributable to the NAI should cease at the point when the NAI has been incorporated into the CDs. To notionally divide the CD into two products, NAI and AI, and attribute distribution costs to each, is not consistent with the statutory scheme.

Issue 10: What should the ratio be applied to? 80 It is common ground that the figure should represent a wholesale sales price of the product. 81 Professor Foster calculates total NAI costs of $0.0116 for a full length CD (Ex 2; Attachment 7). He calculates the total wholesale costs of a CD at the wholesale sales point (assuming 20 cents per CD distribution costs) of $8.5998. Total NAI costs are thus 0.14 per cent of the total wholesale costs at the point of sale. Presumably, Professor Foster would apply that ratio to the wholesale price. 82 Some alterations would need to be made to Professor Foster's cost-based calculations in order to give effect to this judgment. But I could declare that the portion of the taxable value of each CD the subject of these proceedings which is attributable to the embodiment of the NAI in the CD, is exempt in terms of s 45(2) of the Sales Tax Assessment Act 1992. I could also declare that the exempt portion of each such taxable value is to be determined by applying a specified ratio to the wholesale selling price of each CD as reduced by the applicable percentage specified in the s 43 agreement. The specified ratio could follow the general form in the respondent's submissions (to which the applicant has not responded), but adapted to accommodate my conclusions. 83 Professor Walker [Ex B] uses DATA's figures to calculate: - unit cost of embedded NAI = $0.1725 - total unit cost of a CD = $0.8296 - proportion of cost applicable to NAI (0.1725 x 0.8296) = 20.79 per cent 84 Professor Walker: - then uses industry figures to calculate the cost to a distributor of a labelled and packaged CD of $1.81. 20.79 per cent of that sum is $0.3763, which provides the cost of NAI "at distributor level"; - calculates total unit costs at the distributor level at $9.01 when artist royalty and copyright royalty are added to the basic cost of $1.81 (the figures contain a mathematical error of 3 cents, which I shall not attempt to correct); - concludes that NAI is 4.18 per cent of the total wholesale cost of a CD (0.3763/9.01); - 4.18 per cent of a wholesale price of $18.29 = $0.76. 85 The respondent's submission on this issue is as follows: "(a) The application of the ratio obtained from DATA costs plus distribution to the wholesale selling price is preferable. It is simple and it accords with the underlying assumption that a ratio of the costs of production of the music CDs in question reflects the value which may be attributed to different phases of production. (b) If, contrary to the above, the Court prefers the approach of Professors Walker and Wells, the booklet and jewel case costs should be excluded from the ultimate numerator (as they were in the Professors' development of the intermediate numerator based on DATA costs) as the booklet and jewel case are different goods from the music CD and do not contain a computer program. Professor Wells agreed that his exercise and that of Professor Walker included an element for jewel case and jewel case and booklet respectively." 86 There is an issue between the parties as to whether the effect of Professor Walker's calculation is to include in the numerator an element referrable to the jewel case. It is common ground that no part of the cost of the jewel case should be included in the numerator. The issue is as to whether it is there. Professor Wells (T 151.10) appears to accept that "one interpretation of our calculation" is that it is included. Presumably this was on the basis that the booklet and jewel case cost is included in the basic figure of $1.81, and if NAI is established by taking 20.79 per cent of that figure, then the resultant $0.3763 necessarily reflects a component for the jewel case. The applicant responds: "Despite the superficial attraction of this argument, it is not right". To those who are numerate, and I am not, this ought not to be the subject of controversy. I am not sure whether resolution of this question would quell all disputes as to methodology in Ex B. 87 As presently advised, I would be inclined simply to make declarations along the lines earlier discussed without endorsing any particular set of figures. I would invite the parties to confer and to agree upon an appropriate formulation of those declarations. But there is not much point in leaving the matter there, if implementation of those declarations would itself be a matter of controversy. For example, it is not clear to me whether the use of industry figures results in an exacerbation of the differences between Professors Walker and Foster, as this issue was not squarely put to either of them. 88 Professor Foster and Professor Walker are engaged in the application of the same basic formula. The parties are agreed that Issues 1-9 separate them, and I have given a decision on those issues. Perhaps the best way forward is for Professor Walker and Professor Foster's cost-based calculations each to be undertaken on a basis consistent with these reasons. If that results in a different conclusion as to the "value" attributable to embedded NAI on a CD as a percentage of the wholesale price, then the factors which cause the difference in outcome will need to be identified and resolved. 89 I do not feel able to provide a decision on Issue 10 as the submissions are presently formulated. I am not even sure that the issue as formulated is the issue which really arises for decision. I will reserve further consideration of that issue in the light of these reasons. I certify that the preceding eighty-nine (89) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Hely.

Counsel for the Applicant: Mr S Gageler SC, Mr M Leeming

Solicitor for the Applicant: Robert Richard and Associates

Counsel for the Respondent: Mr I V Gzell QC, Mr K Connor

Solicitor for the Respondent: Australian Government Solicitor