Macquarie Finance Limited v Commissioner of Taxation

THE COURT ORDERS THAT:

1. The application be dismissed.
2. The applicant pay the respondent's costs. Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules.

REASONS FOR JUDGMENT HILL J 1 On 14 October 1999 Macquarie Finance Limited (MFL) together with Macquarie Bank Limited (MBL) lodged with the Australian Securities and Investment Corporation (ASIC) a prospectus bearing that date and relating to an offer to the public of what the prospectus called Macquarie Income Securities ("the income securities"). The income securities were a kind of security which was then and still is popularly known as "stapled securities". The offer related to preference shares in the capital of MBL and a beneficial interests in notes issued to Trust Company of Australia Limited (the Trustee) by MFL. The income securities were to be and ultimately were listed on the Australian Stock Exchange. They were stapled, meaning thereby that a holder could not deal with the one without dealing with the other. 2 The prospectus referred to the income securities bearing interest at a floating rate payable quarterly in arrears. The rate was essentially to be calculated by adding 1.7% per annum to a base interest rate based on the 90 day bank bill rate. (I say essentially because, as will be seen, the provisions dealing with "interest" were rather more complicated than that). Until 15 January 2003 the interest rate was to be a minimum of 7.25%. 3 In the year of income ending 30 September 2000 (a substituted accounting period in lieu of the year of income ended 30 June 2000), MFL claimed a deduction of $27,833,226 for what it claimed to be the "interest" payable on the notes. That "interest" was disallowed by the respondent Commissioner. MFL objected, the objection was disallowed and MFL then appealed to this Court in its original jurisdiction against the objection decision. The issue in the proceedings is whether the amount disallowed was, in whole or in part, an allowable deduction to MFL in the year of income.

The background to the income securities issue 4 MBL was at all relevant times an investment bank. It had six principal operating groups: asset and infrastructure, treasury and commodities, corporate finance, equities, banking and properties, and investment services. MFL was incorporated on 14 March 1974 originally under the name Hill Samuel Property Services Limited. It changed its name on 8 February 1985. In the period preceding 1 January 1999 MFL was largely inactive. MFL is a subsidiary of MBL and is one of a number of subsidiaries which, with MBL, forms the MBL group of companies. 5 MBL, although perhaps more accurately described as an investment bank, or financial intermediary is a licensed trading bank under the Australian Banking Act 1959 (Cth). As such it is subject to supervision by the Australian Prudential Regulation Authority (APRA), which authority as the successor to the Reserve Bank of Australia in this regard is responsible for the prudential regulation of banks. It applies the criteria originally formulated as a result of the Basle Agreement or Accord by the Basle Committee on Banking Supervision of the Bank of International Settlements and adopted by the various international regulatory bodies as a means of maintaining minimum standards of capital adequacy for banks. In essence bank regulators adopt a formula based upon the Basle Agreement which divides a bank's capital into three tiers (Tier 1, Tier 2 (upper) and Tier 2 (lower)) which reflect the ability of a bank to absorb losses and provide liquidity to meet liabilities. 6 Professor Officer, Professor Emeritus of the University of Melbourne and an expert in finance and economics, in uncontested evidence summarised the various types of capital belonging in each of the tiers. The summary is based upon the APRA Prudential Statement C1 and is, Professor Officer warns, incomplete. It nevertheless suffices for present purposes. He said: " · Tier 1 Capital is the highest form of capital… · Tier 2 Capital which is divided into two types Upper Tier 2 and Lower Tier 2 Capital. · Upper Tier 2 Capital is represented by general provisions for doubtful debts, asset revaluation reserves, cumulative irredeemable preference shares, mandatory convertible notes and similar instruments and perpetual subordinated debt. · Lower Tier 2 Capital is represented by fixed term subordinated debt and limited life redeemable preference shares and similar instruments which are judged appropriately subordinated and having an original maturity of at least five years. Tier 2 Capital cannot exceed Tier 1 Capital and together they must make up at least 8% of the total risk weighted assets of the bank or institution." The reference to "risk weighted assets" refers to the assigning of a risk weight (0, 20, 50 or 100%) to each asset of the bank reflecting the credit worthiness of the asset. So, in Professor Officer's words, "assets such as notes, gold and deposits are assigned a zero risk weight and thus do not become part of the total risk weighted assets of the bank whereas advances to companies are given 100% weight." 7 The greater the equity capital of a bank as a proportion of its risk weighted assets the greater the security of the bank's depositors and other creditors. Further, an increase in Tier 1 and Tier 2 capital not merely increases the capital adequacy of the Bank, it also permits the Bank to expand its operations. This can be illustrated by a simple example. Assume a bank has Tier 1 capital of $13 million with debt liabilities of $87 million, ie total assets of $100 million. If the bank increases its Tier 1 capital two fold, that is to say to $26 million it can borrow $174 million giving it total assets of $200 million (that is to say it could 'expand its book' to $200 million by the addition of $13 million in Tier 1 capital) without compromising its financial strength and maintaining its credit rating. 8 Mr Gregory Ward was at relevant times head of the Corporate Affairs Group of MBL and a director of MFL and a number of other MBL subsidiaries. One of his responsibilities as head of Financial Operations of the group was to manage the capital requirements of the group. He did so in conjunction with a Mr Paul Robertson, the Group Treasurer of MBL who was responsible for the debt side of MBL's capital. Relevant to decisions about capital raising was the appropriate level and mix of capital required for the short and medium term operations of the Group. This involved, said Mr Ward balancing the cost of capital against the returns that may need to be paid upon capital having regard to the mix of capital and debt raisings. In addition to prevailing market conditions the cost of capital is dependent upon the form of capital raised (debt in the form of interest, being the cheapest end of the spectrum and ordinary equity at the most expensive end). Also relevant were ratings of various independent rating agencies. 9 Both Mr Ward and Mr Robertson gave evidence. So too did a Mr Donnelly, who was an executive director of the Equity Capital Markets Division of MBL. Their credit was not the subject of attack, although it must be said that there was some difficulty with their evidence so far as it concerned the steps in the development of a structure for the issue of the income securities with which the present case is concerned. Unless otherwise stated, I accept their evidence. 10 In early June 1999 MBL had before it a proposal for the acquisition of the Australian investment banking business and assets of Banker's Trust (BTIB) from Deutsche Bank AG (Deutsche). The expected acquisition price was in the order of $100 million based upon a discounted present value of the net assets of BTIB. At the time, the BTIB balance sheet fluctuated in the range of $5 billion to $7 billion in assets with a similar range of fluctuation in liabilities and a net asset position of around $200 million. While the acquisition could have been funded from the existing resources of the MBL group, current and future commitments and operational requirements of the group meant that there was a need to substantially increase the MBL Group treasury pool (whether by increasing capital or engaging in debt funding) by up to $4 billion to meet anticipated on-going business needs. Mr Robertson indeed was working on a program of debt raising in the vicinity of $7 billion. 11 It seems that around October 1998 it was expected that the Basle Committee on Banking Supervision of the Bank of International Settlements would change their standards governing the types of debt or equity which would be included in calculating the required minimum capital adequacy ratios of banks. 12 By around June 1999 there was interest among retail investors in Australia in perpetual income securities which could be traded on the stock exchange, these being hybrid securities which were redeemable at the instance of the issuer and which paid investors "interest" on their investment at a margin slightly above the interest then being paid on fixed or at call deposits. The Basle Standards were understood to treat such securities as qualifying as Tier 1 capital. One issue of perpetual income securities raised in Australia was that of National Australia Bank in May 1999 which apparently closed oversubscribed and involved the issue of $2 billion worth of securities. 13 The possibility of MBL raising money by the issue of similar securities was a matter which both Mr Ward and Mr Robertson had already found interesting. Mr Donnelly was of the view by this time that a debt instrument which also qualified as Tier 1 capital would be attractive for MBL because there was a larger pool of funds available for investment by way of debt than by way of equity and holders of debt did not have the capital and dividend rights of shareholders. From the point of view of the borrower the perpetual security did not have to be repaid or refinanced in the short to medium term and offered greater flexibility than would be available with a share offer. Shareholders of MBL had traditionally received a return on equity of between 20 to 25%. Long term subordinated debt instruments, by contrast, were expected at this time to be able to be issued at a marking of 100 to 200 basic points over the prevailing bill rate. Thus debt was seen as a considerably cheaper form of finance than equity. It was for this reason that from about May 1999 Mr Donnelly had, in conjunction with colleagues, worked on the development of a form of perpetual debt trust security which they referred to as "Capital Escrow Security" (CES), it is hereafter also referred to as MIS. I will return to consider this structure later in these reasons. It suffices here to say that by early June 1999 Mr Donnelly believed that the CES structure would be recognised as Tier 1 capital by APRA. Mr Donnelly had discussed the CES structure with Mr Robertson perhaps before the BTIB acquisition was public knowledge. 14 On 14 June 1999 Mr Moss, the Managing Director and Chief Executive Officer of MBL wrote a memorandum for consideration by the Board of MBL by way of an update on negotiations for the potential BTIB acquisition. One heading in that memorandum concerned "Capital/Funding". The memorandum suggested that additional Tier 1 capital was required in the amount of $252 million with "Project Albatross", or $175 million without that project. It is unclear from the evidence what Project Albatross was but it may be accepted that it was unrelated to the present question and required $77 million of capital. Be that as it may it is clear, despite a protestation of Mr Ward to the contrary, that at least from 14 June 1999 MBL seriously considered the need to raise long term capital. The question was what form that capital raising should take. 15 On 15 June 1999 the acquisition of BTIB was discussed at a meeting of the directors of MBL. The meeting presumably considered Mr Moss' memorandum. It was noted that the Group could, after acquisition, operate with a reduced Tier 1 capital ratio of approximately 9.5 per cent post acquisition, that is to say without any Tier 1 capital raising; or, MBL could proceed with the issue of Tier 1 capital, whether in the form of ordinary shares or a perpetual note instrument which could be underwritten by Deutsche Bank. 16 It is certainly clear that Mr Robertson by the middle of June began consideration of an income security issue in some form. He was attracted by the issue of perpetual debentures by National Australia Bank because such securities offered cheap finance in comparison with ordinary equity finance. Mr Robertson had in mind an issue of income securities in the order of $100 million initially to be followed shortly after by a second issue of the same amount if there were oversubscriptions. 17 The next day Mr Merven, director of the Risk Management Division of MBL wrote to APRA attaching a document described as "outlining the terms and conditions of a TI capital instrument that Macquarie Bank is considering issuing" and seeking advice as to whether the "capital instrument" would be considered as Tier 1 capital. Mr Merven was not called to give evidence and there was no suggestion that he was not available to be called, although he was no longer with the MBL group. The attached document showed the issue of unpaid Preference Shares linked to a fully paid debt security. Both the shares and the notes were to be issued by the Bank. The notes were to be issued to a trustee which was to issue income units carrying rights to receive interest distributions. The document clearly relates to the CES developed by Mr Donnelly. The preference shares were not to be redeemable by the Bank before the fifth anniversary of issue. The interest distributions were to be payable semi-annually in arrears at the same time and at the same rate as dividends payable on the preference shares. Mr Ward in his evidence said that he had little knowledge of the CES structure. Mr Donnelly in cross-examination suggested that MBL gave no consideration to the issue of CES securities as a means of raising capital for the BTIB transaction. However, it became clear that Mr Donnelly, in saying this, intended to say that MBL was able without any capital injection to acquire the BTIB assets but if it did would thereafter need capital to fund its ordinary business operations. Subject to the question whether it was necessary for MBL to raise funds for the acquisition, rather than after the acquisition and as a result of it, because MBL groups funds would be depleted by the acquisition I think it is clear on the evidence that MBL considered the raising of capital by the use of the CES proposal in the context of the acquisition by MBL of the BTIB business. I would infer that the evidence of Mr Merven would not assist MBL's case in this regard. The suggestion that the CES proposal was at this time unconnected with the BTIB acquisition should not be accepted as appears clearly enough from a letter from Mr Moss, Managing Director of MBL to APRA of 13 July 1999 in which Mr Moss made it clear that the proposal to issue converting preference shares and income securities was "part of its (ie MBL's) acquisition of BT Investment bank (BTIB)" 18 APRA in fact by letter dated 18 June 1999 confirmed that it took the view that the capital escrow securities would qualify for inclusion in the Tier 1 capital of the bank subject to three qualifications not here relevant. APRA's advice was given in respect of the then guidelines applicable to capital adequacy requirements. On 23 June 1999 APRA released new guidelines changing the capital adequacy requirements. At no relevant time did APRA revoke the approval it gave in respect of the CES structure. 19 On 16 June 1999 Mr Ward also received a memorandum from other members of the corporate affairs group of MBL (as did Mr Robertson and Mr Merven) discussing two alternative structures said to be in the course of examination. One of these proposals was similar to NAB's perpetual loan note. The other was a structure where the Bank would issue a "perpetual loan note out of Australia and an unpaid preference share". The second (referred to in the memorandum as the "MIS" structure) appears to be the CES structure. The memorandum notes that the first proposal had been approved and that there had been "verbal advice" confirming the second structure as being Tier 1 capital subject to formal sign-off and approval of the detailed terms of issue which were to be provided on 18 June 1999. The memorandum is said to relate to the raising of "a tranche of $150 million of subordinated debt … as part of an overall debt financing package in relation to a possible acquisition. The two structures discussed were "an alternative… (designed to ensure that) the subordinated debt … qualify as tier one capital of the bank." Mr Ward in his affidavit filed in the proceedings said he had no idea what the $150 million debt raising was to be for. He sought to suggest that it did not relate to the BTIB transaction. This seems to be unlikely and I do not accept Mr Ward's evidence on this matter. 20 Mr Ward in his affidavit said that he had no intention of issuing any additional equity to accommodate the combined BTIB and MBL Group operations. MBL had, he said, more than sufficient equity available. However, according to his evidence there were concerns expressed in mid-June 1999 by some of the major credit rating agencies, which made it necessary for MBL to have an equity raising "to satisfy these concerns". Mr Ward said that it was as a result of these concerns of the credit rating agencies that he with other members of the Bank's Equity Capital Markets Division "devised" a debt and equity combination for presentation to the ratings agencies. This combination comprised in the short term a $2 billion Deutsche standby line of credit, a placement of up to $150 million ordinary MBL shares and an income securities issue of up to $250 million. 21 The ratings agencies were not satisfied with the proposal. Mr Ward said that he was concerned that there was already too much equity on issue. More equity would affect the MBL employee share plan. He concluded that MBL should place up to $250 million additional equity but that the ordinary share component would be reduced to $100 million (roughly the purchase price for BTIB) and the balance of $150 million would be made up of converting preference shares. The proposal was acceptable to the ratings agencies. It was considered by the Board of MBL at its meeting of 18 June. At that meeting it was resolved that the BTIB acquisition be approved, that there be a placement of $100 million ordinary shares and that there be approved the issue of $200 million of Macquarie Income Securities and $150 million of converting preference shares. A $2 billion standby funding arrangement with Deutsche was also approved. 22 There were some changes made to these Board resolutions at a meeting on 20 June, following which on 25 June 1999 an announcement was made relating to the acquisition of BTIB and the proposed funding arrangements. There followed shortly thereafter a placement of the ordinary shares and the converting preference shares as envisaged in the announcement. Preparations were then commenced for the issue of the income securities. A steering committee was established which comprised, among others, Mr Robertson and Mr Donnelly. The minutes of meeting of the initial planning committee held by telephone on 30 June 1999 noted that APRA had given "preliminary approval" for the income securities subject to a review by APRA of the detailed terms of the issue. Mr Ward was to be a member of the Due Diligence Committee established at that meeting. It seems clear that the reference to income securities here was a reference still to the CES structure. 23 On 13 July 1999 there was circulated by Mr Donnelly to Mr Ward and Mr Robertson among others a memorandum which described the structure for the income securities. As then contemplated there was to be issued to investors (stapled) a preference share in MBL and an income unit in the Macquarie Income Securities Trust the assets of which would be a Loan Note issued by Macquarie. Holders of the units would be entitled to a distribution based upon the interest payable on the notes which was to be a floating rate calculated by reference to the 90 day bank bill rate. This proposal still involved only the one company, MBL, not two and involved the issue of units in a unit trust structure. The preference shares, which were part of the structure were to be "nil paid". 24 Mr Moss met on 15 July with representatives of APRA. The financing proposal described in the memorandum of 13 July was approved by APRA. There was some doubt about whether approval would be given as new rules were in the course of adoption by APRA under which it was unlikely that approval would be given. A letter from APRA to Mr Moss dated 19 July noted that the new guidelines would ensure that the bulk (75%) of a bank's Tier 1 capital would be ordinary shareholder's funds. The 25% restriction was not to apply, the view being taken that the approval on 18 June (ie the CES approval) pre-dated the new guidelines. 25 Because it is a matter relied upon by MBL it may be noted here that Mr Ward, at the request of the due diligence committee, reported that there was no likelihood that MBL would exercise its redemption rights in the event that "interest" on the notes was not an allowable deduction because while the decision to repurchase or redeem would be made at the time having regard to all relevant matters, debt was a much cheaper form of finance than capital so that the financing would be "effective" as a form of funding without the tax deduction. 26 Between July and late August the proposed financing structure changed. As at 2 September 1999 there was a structure denominated MIS II which also appears to have a loan issue not involving MFL. The precise details of the second financing structure are not clear to me. However it seems the structure still involved only the one company MBL and not two companies participating in the income securities raising. The difference between the MIS II structure and the CES structure lay, it would seem, in the terms of issue of the preference shares. 27 A third structure was ultimately devised between 2 September 1999 and 16 September 1999. It involved, for the first time, the insertion into the structure MFL as the issuer of the notes rather than MBL. Under the third structure MBL remained as the issuer of preference shares. In that third structure, which was ultimately adopted, preference shares were to be issued fully paid rather than unpaid. The notes being the other part of the issue were to be secured by a debenture trust deed rather than being issued to a trustee which would then issue units to investors in a unit trust. Finally the notes were to be issued initially to an underwriter (Deutsche) which would then sell to MBL the right in certain limited circumstances to require the debenture trustee to pay interest and principal due on the notes not to the holder of the notes but to MBL. The direction to the debenture trustee to pay principal and interest to MBL is referred to as "the payment direction". The investors would purchase the holder's rights in the debentures subject to the payment direction and as well purchase the preference shares from the underwriter (Deutsche). 28 In his affidavit Mr Ward suggested that the change of arrangement (presumably to the third structure) had resulted from objections from Deutsche about the CES structure. Mr Robertson and Mr Donnelly both referred to a problem said to have been raised by Deutsche about stamp duty being payable on transfers of units and a concern as to what recommendations might be made by the Ralph Committee, then enquiring into income tax, inter alia payable on trusts. Mr Robertson said that Deutsche believed that these matters and the unfamiliarity of the CES structure might adversely affect investor interest in the issue of income securities. Mr Donnelly suggested also that Deutsche had a preference to underwrite an issue having some similarity with the National Australia Bank ("the NAB") structure for the NAB issue had been oversubscribed. 29 Both Mr Ward in his affidavit and Mr Robertson in cross examination gave evidence that it was APRA which required that the stapled preference shares be fully paid, rather than issued as unpaid. Mr Robertson's evidence was that it was Mr Merven who told him this. As already noted Mr Merven was clearly involved in the negotiations with APRA but was not called to give evidence in the proceedings. There is nothing in the correspondence from APRA which suggests this to be true and at no time did APRA revoke its approval of the CES structure which involved the issue of preference shares which were unpaid. I would infer that this did not happen and I am more confidently able to draw this inference from the absence of Mr Merven to give evidence: Jones v Dunkel (1959) 101 CLR 298. 30 Nevertheless the need for any preference shares to be issued to be paid up (rather than that they be issued unpaid or partly paid) may have been thought necessary, as Mr Ward in his evidence said, because the proceeds of the income securities issue were to be lent at interest to another MBL group subsidiary, namely Macquarie Leasing Pty Ltd, to meet ongoing operational and business funding needs of that company. It was said that the APRA rules placed a 30 per cent limit upon intra-group loans by banks calculated as a percentage of a bank's issued capital. This meant in the case of MBL that inter company loans were capped at $215 million based upon MBL's issued capital as at the last balancing date. At that time MBL had already lent funds totalling $325 million to Macquarie Leasing in excess of that limit having obtained a one-off special approval from APRA to do so. It could not lend further funds to Macquarie Leasing without being in breach of APRA's requirements. While there is nothing in correspondence from APRA in evidence suggesting that APRA required any preference shares issued to be paid up, it may be accepted that the APRA guidelines did have the effect of limiting intra-group loans as Mr Ward said. 31 The change to a fully paid preference share component presented a problem for those concerned with structuring the proposal. In its simplest form it would mean that Deutsche as underwriter would need to subscribe both for notes and shares. As Mr Donnelly put it, there needed to be a mechanism to ensure that Deutsche could be fully reimbursed for the sums paid by it to obtain the stapled security. Mr Donnelly said that he developed what became the final structure which involved the introduction of MFL as the issuer of the debt notes and provided for the preference shares to be fully paid. The mechanism used was the "Procurement Agreement" entered into between MBL and Deutsche under which MBL agreed to pay Deutsche the face value of the note in exchange for Deutsche giving a notice (the payment direction) requiring in certain events that the trustee for note holders pay principal and interest under the notes to MBL. 32 As already indicated the final structure required as a party in addition to MBL another company as issuer of the notes. It was Mr Ward who recommended that this be MFL. Mr Ward said that he selected MFL as the proposed vehicle because "it had been operating as a deposit-taking, intra-group financier since incorporation in about 1984". At best this comment taken alone is misleading as a reading of Mr Ward's own evidence makes clear. Although MFL had acted as a deposit-taking, intra-group financier since incorporation it was virtually inactive when the decision that MFL participate was taken. It had not entered into any transactions since 1992. Indeed, it is perhaps because it was inactive and had a clean balance sheet that MFL was inserted. Whether that be the case it is clear, as Mr Ward says in his affidavit, that by 1999 MFL was "only holding deposits for a small number of corporate research and development syndicates which it had on-loaned to its parent company Macquarie Acceptances Limited". 33 It would seem that it was some time between 17 September 1999 and 23 September 1999 that the decision was made to proceed with the final structure. On 17 September Mr Donnelly wrote to Mr Robertson and Mr Ward advising that the issue of Macquarie Income Securities would be cheaper than the issue of the nearest equivalent security - converting preference shares and should therefore "be pursued". On 23 September Mr Robertson wrote to the Board setting out details of the structure that was ultimately adopted and the background to it. By this date Deutsche had agreed to underwrite the issue and there had been meetings with APRA to seek approval that the amount of $250 million be included in MBL Tier 1 capital with any additional amount being treated as Tier 2 capital. Mr Robertson's memorandum notes that by this date MFL had been nominated to issue the notes involved in the structure. By 27 September the executive committee noted that APRA had given its approval. The executive committee approved the proposal to issue $250 million worth of income securities plus oversubscriptions as appropriate. The recommendation to adopt the new structure went before the Boards of MFL and MBL on 30 September 1999. At that meeting resolutions approving the execution of draft documentation were passed. Prior to the meeting and, in fact, on 23 September 1999 Mr Ward was appointed as a director of MFL. 34 On 29 September there were discussions between Mr Robertson and Mr Ward as to the amount to be raised by the MIS issue. Mr Robertson contemplated two issues each of $250 million; Mr Ward two issues each of $200 million. They agreed that day on the lower capital raising and it was the proposal for raising the lower amount which went to the Board. The documents approved for execution at the 30 September meeting were executed that day. APRA confirmed its in principle conclusion that the issue would be treated as Tier 1 capital subject to a review of the final documentation on 6 October 1999. There were later minor changes to the documentation which are presently irrelevant. 35 After the issue had been offered to the public (the offer closed on 15 November 1999 over-subscribed by $200 million), the proceeds totalling $400 million were lent to Macquarie Leasing at interest and used by that company in its business of leasing items such as vehicles, plant, equipment and office machines to the professional and small business markets. The loan to Macquarie Leasing was not documented but it was agreed that interest would be at a margin of 1.8 to 2% above the base interest rate charged on at call deposits. The margin charged by MFL was greater than the margin MFL was required to pay note holders. Thus in the year of income MFL earned $28,433,226 in interest from Macquarie Leasing. In the same year, MFL paid $27,833, 226 to the Trustee to be paid to note holders. 36 One question remained to be resolved. That was the correct method of accounting for the income securities proposed to be issued. The advice received and adopted was that the preference shares to be issued by MBL were to be treated as equity of MBL in the group accounts and the accounts of MBL itself. The notes were treated as debt between parent and subsidiary (ie MFL and MBL). As a result of the payment by MBL to secure the rights under the payment direction there were, inter-company balances ie MBL was entitled (albeit that the entitlement was conditional) to payment from MFL and MFL was required to make payment to MBL. On consolidation these inter-company balances disappeared. In the result the consolidated accounts showed the preference shares as equity (the receivable and debentures having been eliminated) and an asset (cash, securities, loans) depending upon what purpose the subsidiary MFL used the money for within the MBL Group. It might be thought that this analysis presents some problems in that the obligation of MFL to pay MBL only arose in limited circumstances, one such circumstance being liquidation of MFL. But it may be accepted that any other presentation in the consolidated accounts would be, as Mr Ward in his evidence said, misleading. I accept that the method of accounting followed the accounting standard AASB1033, "Presentation and Disclosure of Financial Instruments".

THE MACQUARIE INCOME SECURITIES 37 The structure adopted for the issue of Macquarie Income Securities has largely been revealed in the above discussion. However, for convenience the structure can be summarised here. The proposal was that the income securities would be issued initially as to $200 million and, subject to over-subscriptions another $200 million would be available for issue. To avoid repetition it is proposed to describe the terms of the issue only by reference to the original $200 million. In fact ultimately two issues each of $200 million were made. 38 First there was to be an issue to Deutsche (the underwriter) of 200 million fully paid preference shares in the capital of MBL. Holders of the preference shares were not entitled to dividends unless a "payment direction event" occurred. A payment direction event would occur in the event of liquidation of MBL or MFL, or if either company acknowledged it could not pay its debts, or if MBL gave notice that it required all moneys owing in respect of the notes to be paid to it or APRA determining in writing that MBL's Tier 2 Capital Ratio was less than 5% or that it had a Total Capital Adequacy Ratio of less than 8%. The dividend rate was to be 1.7% per annum above a base dividend rate with dividends being payable semi annually. Dividends were not cumulative but Macquarie was not to declare a dividend on any ordinary share or share ranking junior to the preference shares until two consecutive dividends were paid on the preference shares or with the written approval of APRA if Macquarie elected to make payment of the amount unpaid of the last two such dividends. The shares carried only limited voting rights. In a winding up holders of preference shares ranked equally with holders of converting preference shares but in regards to return of capital ahead of holders of ordinary shares. 39 At the same time as the preference shares were issued MFL issued to a trustee for debenture holders notes under a debenture trust deed. The notes had a face value of $200 million. The notes were unsecured "perpetual debt obligations". Under the deed MFL was to pay all moneys due under the Notes directly to investors unless a payment direction event occurred. The definition of payment direction event was the same as that applicable to the preference shares. Interest was to be calculated by adding 1.7% per annum to the base interest rate with a minimum interest in the period ending on 15 January 2003 of 7.25%. Interest was to be paid quarterly but was not payable, and deemed not to accrue (and any interest payable was not to exceed) the distributable profits of MBL, if MBL could not meet claims of creditors or being unable to pay its debts or otherwise where a payment direction event had occurred. MBL guaranteed MFL's obligations to pay interest. Critical to the structure was what was referred to as the "procurement agreement". Under it MBL was to pay Deutsche an amount equal to the face value of the notes and in this event Deutsche would give a payment direction which required that all monies payable under the notes (including money payable by MBL under its guarantee, would be paid to MBL or as it directed from the date of the payment direction). The payment direction coupled with the payment by MBL had the consequence that MBL reimbursed to Deutsche (in effect) the money Deutsche subscribed for either the preference shares or the notes. Subsequent holders of the notes took their interests in the notes subject to the payment direction. The consequence of a "payment direction event" occurring was that the preference shares would become dividend paying, the investors would still hold the holder's interest as part of the securities however moneys owing on the notes which became due after the payment direction would be paid to MBL. 40 The holder's interests in the notes and the preference shares were stapled, that is to say that a holder could not transfer the one without the other. Any attempt to do so would, so the documents said, be void. 41 There was no obligation on MBL or MFL to redeem the notes or otherwise repay investors. However, MBL could after five years from the issue date at its option repurchase each Macquarie income security. Similarly, MBL could repurchase the securities earlier than the five year period in certain limited circumstances, for example if APRA changed the classification of the income securities so that they no longer were counted as Tier 1 capital. 42 According to the letter from the Chairman of MBL which accompanied the prospectus filed in relation to the public offering: "The proceeds of the offer of Macquarie Income Securities will be used to assist with the long term funding of Macquarie's operations and to enhance Macquarie's financial strength and trading ability." A similar note appeared in the prospectus itself under the heading "Use of Funds".

The issues arising in the proceedings. 43 There are three issues which require determination. They arise in the alternative and may be stated as follows. They are: * Whether the amount of "interest" incurred by MFL is an allowable deduction under s 8-1 of the Income Tax Assessment Act 1997 ("the 1997 Act"). * Whether if otherwise the "interest" would be an allowable deduction under s 8-1 of the Act, it is not deductible because of the application of s 82R(3) of the Income Tax Assessment Act 1936 ("the 1936 Act"). * If the first two questions are decided favourably to MFL, whether the provisions of Part IVA of the 1936 Act operate to disallow to MFL the deduction for "interest". 44 I propose to consider each of these issues in turn.

Deductibility under s 8-1 of the 1997 Act. 45 Section 8-1 provides for the deduction of what may be called ordinary business expenses. It is substantially similar to s 51(1) of the 1936 Act so that cases decided upon the latter sub-section have equal application to s 8-1. It provides: "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; (b) … (c) … (d) a provision of this Act prevents you from deducting it. 46 The Commissioner submits that the "interest" is not deductible either because it is not within the two positive limbs of the section, that is to say it is not incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing that income or alternatively because it falls within the exclusion in sub-section (2) as being a loss or outgoing of capital. 47 There are some general propositions which can first be stated. 1) Ordinarily interest will be an allowable deduction under s 8-1 if incurred in the course of an income producing activity or business: Texas Co (Australasia) Ltd v Federal Commissioner of Taxation (1940) 63 CLR 382 at 468, Steele v Deputy Commissioner of Taxation (1999) 197 CLR 459. So, as Dixon J said in the former case: "Some kinds of recurrent expenditure made to secure capital or working capital are clearly deductible. Under the Australian system interest on money borrowed for the purpose forms a deduction…." 2) Interest is ordinarily a recurrent or periodic payment securing not an advantage of an enduring kind such that it would be seen as on capital account, but rather "the use of borrower money during the term of the loan": Steele supra per Gleeson CJ, Gaudron and Gummow JJ at 470. However, as their Honours noted in that case there may be particular circumstances where interest may properly be seen as other than the raising or maintenance of the borrowing and thus, perhaps, on capital account. Reference is made in the judgment in Steele in the context that there could be a case where interest was on capital account to Parsons: Income Taxation in Australia (1985) at par 6.111 where the late Professor Parsons discusses critically the decision of the High Court in Federal Commissioner of Taxation v South Australian Battery Makers (1978) 140 CLR 645 and Europa Oil (NZ) Ltd v Commissioner of Inland Revenue (NZ) (No 2) (1976) 76 ATC 6001. The former case involved a lease of premises in circumstances where an associate of the company of the lessee had an option to purchase the premises. The purchase price declined annually and thus took into account rent payable. Had the lessee also been the party with the option to purchase it may well have been the case that the lease payments in question would not have been deductible. 3) The question of deductibility is not to be determined by reference to the label which the parties attach to the outgoing. Hence if what the parties describe as interest is in fact not interest it may be regarded as being capital if otherwise properly so characterised: Federal Commissioner of Taxation v Broken Hill Pty Ltd (2000) 179 ALR 593 at 603. Likewise it may not be determinative of whether the "interest" is deductible that it does not constitute a dividend either in the ordinary or in the defined sense of the term. 4) Interest has variously been described as a payment made by a borrower for the use of the money borrowed: Federal Commissioner of Taxation v Century Yuasa Batteries Pty Ltd (1998) 82 FCR 288 at 291 or the price of money which is borrowed: Re Farm Security Act 1944 of the Province of Saskatchewan [1947] SCR 394 cited in Federal Commissioner of Taxation v Firth (2002) 120 FCR 450 at 454 or as a recompense to the lender for being kept out of his money: Lomax (Inspector of Taxes) v Peter Dixon & Co Ltd [1943] 2 All ER 255 (editorial note). What these descriptions make clear is that there must be a borrowing before what is paid can be regarded as interest. At least ordinarily the concept of borrowing presupposes that the lender is entitled to a return of the money lent. However, there may be a question whether a "borrowing" which is not repayable at all is really a borrowing or whether "interest" thereon is properly to be regarded as interest. Thus in the United States of America Learned Hand J in Jewel Tea Co Inc v United States (1937) 90 F 2d 451 at 453 said: "in the absence of … a provision [that a holder of a security may unconditionally demand his money at a fixed time] the security cannot be a debt". So too in Emu Bay Railway Co Ltd v Federal Commissioner of Taxation (1944) 71 CLR 596 at 608 Rich J (dissenting although in respect of whether the interest in that case had been incurred in the year of income) said: "A borrowing involves the obligation to repay." Likewise the view that a loan involves an obligation on the borrower to repay (which carries with it the corollary that where there is no obligation to repay there is no loan) was accepted by the Full Court of this Court in Federal Commissioner of Taxation v Radilo Enterprises Pty Ltd (1997) 97 ATC 4151 at 4161 per Sackville and Lehane JJ. 5) The Australian income tax legislation does not require that an amount be interest or that there be a borrowing before what is called "interest" may be deducted. Hence, while it may well be relevant that what purports to be a borrowing is not because the principal is not repayable and thus what is termed "interest" is not in fact interest, that characterisation of the transaction is not determinative of the issue whether the "interest" is an allowable deduction. The necessary conditions for deductibility in Australia are to be found solely within the terms of the now s 8-1. Thus it will not be necessary in determining the deductibility of a perpetual debenture, for example, to characterise the transaction as a loan or a borrowing and the amount paid to debenture holders as "interest" to determine deductibility. I should say that as presently advised I do not think that "interest" would necessarily cease to qualify as an allowable deduction merely because it was payable on notes which were non-redeemable so that the lender might not, except perhaps in the case of liquidation, have the amount of the principal refunded to him or her. This would be my view even if the perpetual debenture was not strictly a loan. 6) There have been many decisions of the High Court which have suggested in particular cases what may be seen as paraphrases of the tests of deductibility of outgoings under s 51(1) and thus, by extension, s 8-1 of the 1997 Act. So, for example, it has been said that an outgoing to be deductible must be "incidental and relevant" to the gaining or production of assessable income or the business the purpose of which is the gaining or production of assessable income: Ronpibon Tin NL & Tong Kah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47, W Nevill & Co v Federal Commissioner of Taxation (1937) 56 CLR 290. Phrases such as this serve to indicate the requirement that there be a sufficient connection between the outgoing on the one hand and the gaining or producing of assessable income or business as the case may be. It can thus be said (see Ronpibon Tin at 57)that: "The occasion of the outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce the assessable income". 48 In Federal Commissioner of Taxation v Smith & Roberts (1992) 23 ATR 494 at 502-3 I said: "The mere act of borrowing money, burdened with the obligation to pay interest, does not of itself gain or produce assessable income. The amount borrowed is not assessable income. What operates to gain or produce assessable income is the manner in which those moneys are used, so that the necessary connection between the outgoing for interest and the activities which more directly gain or produce assessable income will be found, in the ordinary case, in the use to which the borrowed funds are put." The reference to the "ordinary case" was intended to leave out of consideration the situation where the test of deductibility of interest is to be found in the "purpose of the borrowing" which will usually, although perhaps not inevitably, be the same as the use to which the borrowed funds are put. 7) In the present case there is no need to distinguish between the first limb "in gaining or producing your assessable income" and the second limb "in carrying on a business" as there is no reason to find that MFL is not carrying on a business. It clearly was. The question is rather whether the outgoing for "interest" was incurred in, that is to say "in the course of" either its income producing activity or its business. 49 The Commissioner submits that in subjecting itself to the obligation to pay interest MFL did so not for the purpose of gaining or producing its income or for any business purpose it had, but rather at the behest of and for the purposes of and benefit of its parent company MBL. Emphasis is placed upon the need for this purpose to distinguish the separate entity MFL from the legal personality of its parent company MBL. That there may be need to keep separate the activity of a parent and its subsidiary in a particular case may be accepted. Reference may be made to Ure v Federal Commissioner of Taxation (1981) 34 ALR 237 at 241 per Brennan J, and at 247-9 per Deane and Sheppard JJ, and see too Franklin's Selfserve Pty Ltd v Federal Commissioner of Taxation (1970) 125 CLR 52 at 66-7. 50 It is true, as the Commissioner submits, that the role of MFL in the present transaction arose not out of any business activity at the time carried on by MFL (indeed in June 1999 it would seem that MFL was practically a dormant company) but rather it was selected by Mr Ward (not at the time a director of MFL) to participate in the transaction relating to the issue of the income securities when the structure being contemplated changed and it became necessary for there to be a company separate from MBL to act as "borrower". 51 However, it is clear that if attention is directed only to that part of the issue as related to the notes originally issued to Deutsche, it was intended as part of the arrangement that MFL would use the funds borrowed through Deutsche from the public to make loans to subsidiary companies of the MBL Group, particularly, Macquarie Leasing Pty Limited at an interest rate in excess of the "interest" which MFL incurred. Further, the present is not a case where any subjective purpose of the parties differs from the objective purpose to be ascertained from the terms of the transaction entered into (cf Spassked Pty Ltd v Federal Commissioner of Taxation (2003) 2003 ATC 5099 at 5121 (par 75)). So far as MFL is concerned it can be said that it entered into the transaction intending to use the "borrowed" funds in its business of lending at interest to companies of the MBL group. That intention is demonstrated by the use which MFL made of the funds. The fact that as well the interests of MBL were served does not require a conclusion that the "interest" was not an allowable deduction. 52 The above discussion has so far concentrated upon the notes divorced from the MBL preference shares to which they are stapled. However, the income securities are not necessarily to be treated as comprised of two separate and unrelated issues of securities. The composite nature of the transaction involving, as it does, both the note issue and the preference share issue raises, however, more complicated questions which are perhaps better considered when determining whether the "interest" is capital in nature. 53 There may first be stated some principles which are not controversial, but are necessarily relevant to the question whether the "interest" is on capital account. 1) In determining whether an outgoing is deductible it will be necessary to consider the "essential character" of the outgoing. The emphasis on "essential character" is relevant as well in determining whether the loss or outgoing satisfies the positive limbs of s 8-1: Lunney v Federal Commissioner of Taxation (1958) 100 CLR 478, and see at 499. 2) In determining whether a loss or outgoing is on capital account it will be necessary to consider "from a practical and business point of view," "what the expenditure is calculated to affect": Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634 at 443-4. However, as Stephen and Aickin JJ pointed out in Commissioner of Taxation v South Australian Battery Makers Pty Ltd (1978) 140 CLR 654 at 662 when Dixon J in Hallstroms referred to practical and business considerations his Honour did not intend to exclude from consideration the legal rights obtained by the incurring of the loss or outgoing. 3) The classic exposition of what is capital is to be found in the three tests formulated by Dixon J in Sun Newspapers Ltd & Associated Newspapers v Federal Commissioner of Taxation (1938) 61 CLR 337 at 363: There are, I think three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part; (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part; and (c) the means adopted to obtain it; that is, by providing a periodical reward … or by making a final provision or payment so as to secure future use or enjoyment." Earlier in the same judgment and in a passage almost as often cited Dixon J had said at 359: "The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss. The business structure or entity or organisation may assume any of an almost infinite variety of shares and it may be difficult to comprehend under one description all the forms in which it may be manifested." 54 In the ordinary case of a loan at interest, the interest may be seen as a recurrent outlay of money used in the taxpayer's business. The payment of the interest is, in the ordinary case, part of the process which the business operated with to obtain its regular returns. The expenditure is clearly not incurred for the purpose of producing a lasting advantage for the enduring benefit of the business: cf British Insulated & Helsby Cables v Atherton (1925) 10 TC 155 per Viscount Cave at 192-3. 55 It is accepted without question in the Australian income tax system and indeed in most other systems that a deduction is not available for dividends paid by a taxpayer company on its share capital. It may not be possible to give a clear logical answer as to the reasons (cf Upfold "When might Dividends be Deductible" (2001) 30 Australian Tax Review 5). One answer might be that dividends are a distribution or division of profit after that profit has been ascertained, which means that they could not be seen to be part of the cost of earning or deriving that profit: Commissioner of Taxation (WA) v Boulder Perseverance Ltd (1937) 58 CLR 223. Such an explanation would require it to be said that the declaration of a dividend is not part of the actual business activity but subsequent to it. Another possible explanation might be that a dividend is part of the cost of the fixed capital of the business, thereby related to the business entity or structure rather than the process by which the business operates. 56 The significance of the question why dividends are not deductible will be apparent here when consideration is given to the facts of the present case. What distinguishes the present case from a case where "interest" is payable on a loan or for that matter on perpetual or irredeemable debentures is the connexion between the note issue and the preference share issue and in particular the effect of the procurement agreement and payment direction. 57 It will be recalled that Deutsche subscribed both for preference shares in MBL and for notes issued by MFL. However immediately after the subscription, and indeed as part of the arrangement, MBL paid Deutsche an amount equal to the amount which Deutsche paid for the shares or the face value of the note, those two amounts being the same. The payment under the procurement agreement had the consequence that in certain specified events the principal and interest under the notes was payable to MBL and not Deutsche or its successors in title. This had the consequence of reimbursing Deutsche for the money it had paid either for the shares or the notes. It might, in parenthesis, be asked why the payment by MBL was not the giving of financial assistance to Deutsche to enable it to subscribe for the shares. Whether that is correct, the consequence was that Deutsche was left with the shares in MBL and such rights as it had under the notes during such time as the contingencies were unfulfilled, one of which was MBL requiring that the money payable under the notes be paid to it. The two rights were "stapled", that is to say they could not be dealt with separately. It is also not irrelevant in this context to note that consolidated accounting had the consequence of leaving the shares as capital but eliminating the note although not much turns upon the way consolidation applies to the preparation of group accounts. 58 It was submitted by Macquarie that the fact that the notes were stapled to the preference shares and the fact that the issue of the income securities advantaged MBL and the group generally were not matters which justified a departure from a juristic analysis of the advantages secured by the issue of the notes by MFL. The Trust Deed and the conditions attaching to the notes did not provide that the interest payable by MFL was to form part of the consideration for the issue of the preference shares by MBL; nor was the interest in any way a dividend payable on the preference shares. Indeed, it was said that until the payment direction was made, at least, what was payable by MFL was interest and holders of the securities received interest and nothing else. The payment direction might, it was said, never be given. 59 Reference was made to authorities from the United States where in some circumstances shares were treated as debt instruments. Presumably the opposite result could also follow. Jewel Tea Co Inc v United States (1937) 90 F 2d 451 at 453 is an example of a case where there is discussion whether a security might be a debt. Other cases include Bauer v Commissioner of Internal Revenue (1984) 748 F 2d 1365 (9 Circ), Hardman v United States (1987) 827 F 2d 14090 (9 Circ). These cases are in the context of a statutory provision giving a deduction for interest … on indebtedness (26 USCA (Internal Revenue Code, 1954, s 163(a). They look at the "economic substance" and not the form, at least where the debtor and creditor are jointly controlled. However, these cases give little assistance in Australia where the taxation consequences will not be determined by whether a payment is interest, but as I have said, by whether the outgoing qualifies for deduction under s 8-1. It is emphasised by Macquarie however, that MFL issued a note; that note is a debt instrument; it paid interest regardless of its actual profits, it owed the principal sum under the notes at all times and was liable to pay interest on the notes. The notes offered the holder no participation in the management and no party intended other than that the notes were debt and not equity. Accordingly what was paid by MFL should be seen to be interest and thus deductible. 60 The submissions of MFL ignore, however, the relationship between the notes and the preference shares brought about by the procurement agreement refunding the face value of one lot of the securities to Deutsche and the ability thereafter of MBL to give the payment direction. They ignore too the fact that no dividend was payable on the MBL shares during such time as "interest" was payable to the notes holder and that upon the payment direction being given the noteholders are entitled to no return on their notes, but must look to the shares they hold in MBL for any return of funds. The so-called interest which MFL is obliged to pay is not, in a practical business sense the consideration paid by MFL for the note holder (Deutsche or its successors) being kept out of the funds advanced by Deutsche and used to subscribe for the notes. The note holders here might never obtain repayment of the funds advanced by Deutsch. They may, depending upon what happens be left to look to their rights as shareholders in MBL. 61 Although if the stapled securities are looked at individually the legal rights of MFL to the holders of the notes may be seen to have the character of interest, that seems to me to ignore the composite nature of the security and the direction of Dixon J to look at what the interest is paid for from a practical and business like point of view. It seems to me to give undue weight to form and to disregard the substance of the transaction to characterise what is said to be "interest" as the price of the notes only. From a juristic point of view it is not irrelevant that under the Macquarie Income Securities Trust Deed, the principal is not redeemable at the option of the Trustee Company or at the option of the holder of the note, that the holder of notes is not a creditor of MFL and has no right to sue for interest or principal arrears. The trustee also has limited creditor enforcement rights. It is not insignificant either that the issue of the income securities was related to the capital adequacy requirements of MBL seen in the context of MBL's acquisition of the BTIB business. Nor does it assist MFL that interest payments on the notes were dependent upon there being distributable profits of MBL. In saying this it must be accepted that the "interest" was payable not by MBL but by MFL, although obviously a note holder was, as a consequence of the structure adopted, in fact a shareholder of MBL. 62 Some support for regarding the "interest" as being on capital account may be found in the judgment of Bowen CJ and Burchett J in Australian National Hotels Ltd v Federal Commissioner of Taxation (1988) 19 FCR 234 at 240. Their Honours were there considering whether premiums to obtain indemnity for exchange losses were allowable deductions under s 51(1) on policies of insurance. Their Honours held the premiums were deductible. In the course of the judgment, their Honours considered the deductibility of interest by way of analogy and said at 240: "Where capital is committed to a business, it will not in general lose the character of capital, and a loss of the whole or part of it will remain a capital loss. There are exceptions… If the capital is raised by loan, an investment of the borrowed moneys in a business will ordinarily remain an investment of capital, and the same consequences will follow. But there is a special feature of loan capital, which flows from the ephemeral nature of a loan. The cost of securing and retaining the use of the capital sum for the business, that is to say, the interest payable in respect of the loan, will be a revenue item. It creates no enduring advantage, but on the contrary is a periodic outgoing related to the continuance of the use by the business of the borrowed capital during the term of the loan. If capital whether or not raised by borrowing, is invested in a building which burns,… the loss is a capital loss." 63 The emphasis their Honours place is on "the ephemeral nature" of the loan. In the circumstances of the present case the close relationship between the notes and the preference shares, as well as the fact that MBL can ensure the loan is never repayable but that an investor is left commercially only with MBL preference shares, can be seen to produce a different result. The present case is not concerned with the cost of acquiring or maintaining a loan of an ephemeral character, but rather with the cost of a capital raising which so far as MBL is concerned is the cost of a permanent injection of capital. The circumstance that the capital is in the present conditions used to make loans to Macquarie Leasing is not determinative. 64 It may be possible to argue that the "interest" amount payable by MFL is in truth consideration both for a loan to MFL and for the provision of capital to MBL. On this basis some part of the "interest" would be deductible. Presumably an apportionment would be made by reference to the value of the shares and the value of the notes after the payment direction has been given. Perhaps apportionment might be appropriate. However, the case was argued on an all or nothing basis and accordingly I have no need to consider further the question how any relevant apportionment should be made assuming that the correct analysis is that the interest payable by MFL to holders of the stapled securities is both the cost of the funds subscribed for the notes and the cost of maintaining the preference shares. The issue of the notes and the shares are not separate transactions. That is clear from the fact that they are "stapled". To treat them as separate transactions is, in my view, to take a blinkered approach. 65 Before turning to the next issue, I would here note some submissions made on behalf of the MFL and the comments I would make with respect of them. 1) The fact that the interest is capped by reference to the profits of MBL is, if the notes are to be looked at separately, merely the measure of the "interest" that is payable. That is true, but if the correct analysis is to look at the two issues, notes and shares as a composite transaction this factor takes on a different significance. 2) Holders of notes are not shareholders in MFL. That may be accepted, although they are shareholders of MBL by virtue of their holding of preference shares. The interest is also not a distribution of profits of MFL or for that matter a distribution of profits of MBL. That is also true. However, the question is not really whether the so-called "interest" is a dividend, it is whether it is on capital account. 3) The characterisation of the "interest" for the purposes of s 8-1 is not to be determined by reference to what transaction might have been entered into so as to achieve the same commercial result. It was forcibly submitted that the Australian income tax legislation does not authorise taxation by commercial equivalence: Mullens Investments Pty Ltd v Federal Commissioner of Taxation (1976) 135 CLR 290 at 301. I am prepared to accept that there is no doctrine of commercial equivalence, but that is rather irrelevant here. The only question to be determined is whether the so-called interest is on capital account and secures an enduring benefit. 4) The way consolidated accounts of the group are required to be prepared can not be determinative of the issue of the deductibility of "interest". Again, that may be accepted, but it is not correct that the accounting treatment should be regarded as irrelevant, although accounting for purposes of consolidation may be thought less relevant than would be evidence of the correct accounting treatment company by company. 5) The fact that Mr Ward explained that following a review within 5 to 10 years and if then commercially appropriate the notes might be restructured or redeemed was said to be relevant and to support the view that what was paid by MFL was interest. In my opinion, however, the view of Mr Ward has no relevance, if only because the decision to redeem or restructure would not be Mr Ward's but rather each such decision would be a matter for the boards of MBL and MFL. 6) The "interest" did not reduce the amount owing on the notes. That is true but, in my view, of no relevance. 7) That the money "borrowed" was circulating capital of MFL analogous to its stock in trade: cf Avco Financial Services Ltd v Federal Commissioner of Taxation (1981) 150 CLR 510, 530 - 1. With respect, while the High Court in Avco did refer to the monies obtained from bill transactions as being circulating capital of a finance company that expression (rather outdated in modern usage and uncertain of meaning) tells nothing about the deductibility of the "interest".

Is the Macquarie Income Security a Convertible Note. 66 Little need be said of this issue. Indeed, counsel for the Commissioner did not seek to allocate much time to this part of the argument, relying instead on his written submissions. This is not to say that counsel in any way resiled from the submission and perhaps it may be said that he was encouraged in the course he took by comments from the bench. 67 Division 3A of Part III of the 1936 Act provides for the deductibility of interest on certain convertible notes: where the loan is made on or after 1 January 1976 (s 82R). The expression "convertible note" is defined in s 82L. In addition to a note that is a convertible note in the ordinary sense of that expression (and it is hard to see how the fact that a convertible note in the ordinary sense of the expression would not in any event fall within the definition) includes a note issued by a company: "that provides, whether in performance of or by virtue of a trust deed or otherwise - (a) that the amount of the loan to the company that is evidenced, acknowledged or created by the note or to which the note relates - (i) whether with or without interest; (ii) … (iii) whether at the option of the holder or owner of the note or of some other person or not; (iv) whether in whole or in part; or (v) whether exclusive or otherwise, is to be or may be converted into shares in the capital of the company or of another company or is to be or may be redeemed, repaid or satisfied by- (vi) the allotment or transfer of shares in the capital of the company or of some other company, whether to the holder or owner of the note or to some other person; (vii) the acquisition of such shares, whether by the holder or owner or by some other person, otherwise than as mentioned in subparagraph (vi); or (viii) application in or towards paying-up, in whole or in part, the balance unpaid on shares issued or to be issued by the company or by some other company, whether to the holder or owner or to some other person; or (b) that the holder or owner of the note is to have, or may have, any right or option to have allotted or transferred to him or to some other person, or for him or some other person otherwise to acquire, shares in the capital of the company or of some other company;" 68 It is submitted on behalf of the Commissioner that on the proper construction of the terms of the MIS trust deed the "amount of the loan" to MFL "is to be or may be converted into shares in the capital" of MBL. Alternatively it is submitted that paragraph (b) of the above definition applies. If either of these submissions is accepted it is submitted that there being a convertible note deductibility is disallowed because of a failure to comply with s 82SA(1)(d) of the 1936 Act. 69 With respect, at no time is there a note which is to be or may be converted into shares of MBL. From the outset Deutsche was issued with fully paid shares in that company. It is true that the rights attaching to those shares could vary depending on what happened to the note in MFL, but the change of rights involves no conversion into shares. No assistance can be obtained from the Explanatory Memorandum which accompanied the Bill which became Act no 87 of 1970 and which introduced Division 3A. It is true that the Explanatory Memorandum contrasts interest which is deductible and dividends which are not under the Australian taxation system an allowable deduction and makes it clear that since amendments to the 1936 Act made in 1960 interest on convertible notes had not been deductible. But that adds little to our understanding. The 1970 legislation restored deductibility to interest on certain convertible notes, although notes which did not satisfy the prescribed tests of deductibility continued to be non-deductible. 70 It is said that the provisions of Division 3A should not be frustrated but indeed applied in the present case by reason of the fact that here the preference shares were already issued and paid up. With respect no question of a "frustration" occurs. Rather the situation here is that the income securities in the present case simply do not fall within the provisions at all. There is thus no need to consider whether the terms applicable to the note satisfied the provisions of s 82SA(1)(d), a necessary precondition to deductibility. 71 Nor is the present a case where the notes are within s 82L(b). There is no right in the holders of notes to have preference shares allotted to them. The preference shares have already been allotted. 72 In my view the provisions of Division 3A have no application here with the result that any interest otherwise deductible is not denied deductibility under that Division.

Part IVA 73 On the view I take no part of the interest payable on the notes is deductible to MFL. It follows therefore that part IVA can have no application. However, in case I am wrong, I now propose to consider whether Part IVA would apply to disallow the "interest" payable by MFL as a deduction. 74 Part IVA is the general anti-avoidance provision applicable to authorise the Commissioner inter alia to disallow as deductions amounts which otherwise are allowable deductions under either the 1936 Act or the 1997 Act. The power conferred upon the Commissioner to do so arises only where there is a scheme to which the provisions of Part IVA apply. In summary Part IVA will apply to a scheme where the following elements exist: · there is a scheme as defined in s 177A(1). · there is a tax benefit as defined in s 177C(1) obtained by a taxpayer in connection with a scheme. · It would be concluded having regard to the eight matters listed in s 177D(b) that a person who entered into or carried out the scheme did so for the purpose or for the dominant purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme. · The Commissioner makes a determination under s 177F to cancel the relevant tax benefit. 75 The definition of "scheme" is very wide. It may include a course of conduct or it may include just "an action". The Commissioner particularised the scheme in three different ways. The first particularisation in essence took what may be described as the whole of the steps entered into by MBL and MFL in issuing the preference shares and the notes including the giving of the Payment direction pursuant to the Procurement Agreement. The second particularised the scheme as being the issue of the preference shares on the terms and conditions upon which they were issued. The third particularised the scheme as being the issue of the notes on the particular terms the notes were issued. I do not think it is necessary to consider the second and third particularisations. Unless the Commissioner can succeed by reference to the whole of the steps taken it is hard to see that he could succeed by reference to some only of those steps. 76 In this connection it may be noted that despite what a reading of the joint judgment of Gummow and Hayne JJ in Federal Commissioner of Taxation v Hart (2004)78 ALJR 875may suggest, Part IVA requires identification of the scheme as an important ingredient in the operation of the Part, if only because, as Gleeson CJ points out, before a scheme can be one to which the provisions of the Part apply it must be possible to identify a tax benefit which has been obtained by the taxpayer in connexion with the scheme. That is, the tax benefit which the Commissioner is authorised to cancel. The conclusion as to dominant purpose must be made by reference to the particular scheme and the tax benefit must be related to the scheme. Indeed, it must follow that the identification of the scheme goes, as their Honours say, way beyond any issue of procedural fairness. 77 The judgment of Callinan J would likewise support the view that the identification of the "scheme" is important to the working of Part IVA. 78 The joint judgment of Gummow and Hayne JJ may be said to give the matter a different emphasis. This is not to say that their Honours would suggest that the identification of the "scheme" was of no importance. Their Honour's comments are in the context of the ability of the Commissioner to rely upon a narrower scheme than would be encompassed if the relevant scheme were taken to be the whole of the course of conduct adopted. However, I would, with respect, agree with Gummow and Hayne JJ that too much emphasis can be given to the significance of the width or narrowness of a scheme. Since the various factors in s 177D(b) cover most, if not all, of the objective facts surrounding the scheme it will probably almost always be the case that even a scheme narrowly particularised will be scrutinised by reference to other facts which surround the scheme being entered into or carried out. Whether that is the case or not I do not think that anything in the present case turns upon whether the scheme is narrowly or widely particularised. 79 In the present case the tax benefit which has been cancelled is claimed by the Commissioner to be the deduction for "interest" which on the assumptions I make for the purpose of considering Part IVA is allowable to MFL. For that "interest" to be a tax benefit it is necessary to determine whether the deduction is such that if the scheme had not been entered into or carried out no deduction would have been available to MFL or alternatively it could reasonably be expected that no such deduction would be available to MFL. In my view this is the case here. If the scheme involving the issue of Macquarie Income securities had not been entered into or carried out it may be the case (indeed I find that it was) that MBL would have needed to raise some sort of capital to satisfy the capital adequacy requirements of APRA. The simplest form of capital raising would, no doubt, have been the raising of equity capital by MBL. Such equity raising might, however, have been, on the evidence, expensive. There were other possible mechanisms as is illustrated by the attention devoted by Mr Donnelly to the structures, namely MIS and MIS II. Each involved an interest component, although neither involved as a party to the scheme MFL. On the evidence here it is clear that MFL was only brought into the scheme at the last minute and once the third version, MIS III had been devised and settled upon. Only MIS III had MFL as a party and only MIS III involved a tax deduction for interest being obtained by MFL. 80 If capital raising was not to be pursued by the issue of some form of preference shares then it was inevitable that if there was to be a borrower then some company in the group would have to pay "interest". It is self evident that it would be desirable that any interest payable should be a tax deduction. Clearly the availability of a deduction affects the cost of finance. On the other hand there was, it must be said, no obvious reason why MFL was inserted into the scheme as against any other company in the group so long as the company inserted could be seen to be using the money raised in its business activity in such a way as to entitle it to a deduction. If there was any particular reason why MFL would have been chosen it would seem to be because it was virtually a dormant company. The corporate name Macquarie Finance Limited suggested that MFL was a finance company and this, no doubt, was desirable for a public issue. Further MFL had undertaken some financing transactions in the past so that it could be said to have had a history of being engaged in financing. 81 In determining whether there was a tax benefit to MFL obtained from the scheme entered into it is necessary to consider what might reasonably be expected to have happened had the present scheme not been entered into or carried out. That requires the making on reasonable grounds of what may be termed "the alternative hypothesis". It seems to be quite clear that if this particular scheme had not been entered into or carried out then while some company may have obtained a tax deduction that company would not have been MFL. Indeed, given that the first two alternative proposals did not involve MFL it is clear that MFL was not critical to the scheme at all, although it may well have been critical to any alternative scheme that some company pay interest. In my view there is, accordingly, a tax benefit to MFL. 82 The question then to be considered is whether, having regard to the factors set out in s 177D(b) the relevant conclusion would be reached as to the dominant purpose of some person, whether or not MFL, who entered into or carried out the scheme. The eight factors to be considered are: · the manner in which the scheme was entered into or carried out; · the form and substance of the scheme; · the time at which the scheme was entered into and the length of the period during which the scheme was carried out; · the result in relation to the operation of the Act that, but for Part IVA would be achieved by the scheme; · any changes in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme; · any other consequence for the relevant taxpayer or for any person referred to in the last dot point of the scheme having been entered into or carried out; and · the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in the 6th dot point. While it is unnecessary for the Court to consider individually each of these matters, some of which may point in the one direction and others in the other direction, and it could consider them globally, it is useful here to consider these factors individually: cf Commissioner of Taxation v Consolidated Press (2001) 207 CLR 235. Further it is clear that the conclusion required by s 177D(b) is a conclusion as to the "ruling, prevailing or most influential purpose" (see Federal Commissioner of Taxation v Spotless Services (1996) 186 CLR 404 at 416 and 423) decided by reference to the objective matters to be found in the eight paragraphs enumerated. 83 The conclusion to be reached requires an understanding of what the High Court decided in its recent decision in Hart. It is thus necessary to consider that decision carefully. 84 Hart involved a "product" sold by a bank to customers or potential customers called the "wealth optimiser". The product involved a borrowing which permitted the borrower to allocate some of the borrowed funds to financing the acquisition of an income producing property and the remainder to a non-income producing property such as a family home. Interest on that part of the borrowing allocated to the income producing property was allowed to accumulate subject to interest compounding upon it whereas interest on that part of the borrowing allocated to the non-income producing property was payable in the normal course. The effect was to permit that part of the borrowing related to the non-income producing property to be repaid faster than otherwise would have been the case had interest been payable rateably on the loans so far as they related to both properties and in consequence to increase the deduction available to the borrower for interest attributed to the income producing property. 85 It is important to note that in Hart the tax benefit was not the whole of the interest payable on the loan for had the scheme not been entered into but a borrowing on normal terms and conditions proceeded that part of the interest as was payable in respect of the loan on the investment property would in any event be an allowable deduction. It followed that the tax benefit from the scheme was the amount of interest representing the difference between the interest payable to the lender on so much of the principal sum as was related to the income producing property and the interest that would have been payable to the lender had interest been charged rateably on the loans in respect of the two properties. Another way of putting this is to say that the tax benefit was the difference between the interest deductions obtained from the scheme and the interest deductions that would have been available from a scheme that represented the alternative hypothesis. 86 In the Full Federal Court it was found that the relevant conclusion to be reached under s 177D was that the taxpayers entered into or carried out the scheme for the dominant purpose of obtaining a loan for the refinancing (the case did not involve a financing for acquisition but a refinancing, but nothing turns on that distinction) of the income producing property and financing the acquisition of a non-income producing property (a house in which the taxpayers proposed to live). That conclusion was unanimously rejected by the High Court. Indeed, their Honours seem hardly to mention the commercial purpose at all. It is necessary to seek to understand why the High Court did so. 87 The starting point of the way Part IVA operates in cases such as Hart is to be found in the earlier decision of the High Court in Federal Commissioner of Taxation v Spotless Services Ltd (1996) 186 CLR 404. That case involved a scheme which, in its simplest form had the taxpayer taking funds off deposit with an Australian Bank and instead depositing the funds at a lower rate of pre tax-interest with a bank overseas in a country that imposed a low rate of tax on the interest derived. Under the Australian income tax legislation at the time income derived from sources outside Australia which was subject to tax in the country of the source of the income was exempt from Australian Income Tax (s 23(q) of the 1936 Act). Accordingly the after tax return which the taxpayer received on implementing the scheme was greater than the after tax return had the funds remained on deposit in Australia. The actual steps to achieve this result were rather complicated and need not be here narrated. 88 It seems to have been argued by the taxpayer in the Full Federal Court and also in the High Court that the conclusion that would be reached as to dominant purpose should be taken to be the derivation of the greater after tax return and not as such the derivation of income exempt from tax. That was, it was argued a commercial advantage. That argument was rejected and with respect, one must say rightly since the commercial advantage being the greater after tax return was available only if the income derived under the scheme was exempt from tax. 89 The leading judgment of the Court was that of Brennan CJ, Dawson, Toohey, Gaudron, Gummow and Kirby JJ. McHugh J delivered a separate judgment although his Honour concurred with the majority of their Honours in the result. 90 Their Honours pointed out that there was no real dichotomy between commercial gain on the one hand and tax benefit on the other. Tax affects the shape of nearly every business transaction. A particular course of action might be both "tax driven" and as well display the character of a "rational commercial decision". The other way in which the same proposition could have been made in that case was, as already stated, that the commercial benefit said to be the object in mind, was only available if the tax benefit was obtained by the taxpayer from the scheme so that it was not correct to say that the predominant purpose was the commercial purpose when the commercial purpose was dependant upon the tax purpose. In the case before the Court their Honours were of the view that a reasonable person would conclude that the taxpayers entered into or carried out the scheme for the dominant purpose of obtaining a tax benefit (ie the exemption of the interest from Australian tax so that the taxpayer derived no assessable income). 91 McHugh J in his separate judgment was careful to distinguish the scheme employed in Spotless from a mere rearrangement by a taxpayer of its business so as to pay less tax. Spotless involved much more than the mere switching of investments from one attracting tax to another investment having a tax advantage. So to describe the scheme in Spotless would be simplistic. 92 The taxpayers in Hart sought to argue that the conclusion as to dominant purpose which a reasonable person would reach on the facts of that case was that the taxpayer entered into the scheme for the dominant purpose of borrowing monies to invest in a non-income producing property and an income producing property. That argument was, as already noted, accepted by the Full Federal Court which reversed the decision of the Primary Judge who had taken a different view as to the conclusion which would be reached as to the predominant purpose. The Full Court reached the view it did notwithstanding that the manner in which the scheme was formulated was explicable only by the taxation benefits which the scheme provided. 93 Despite the discussion of how the "scheme" should be identified in the various judgments in Hart, and particularly the comment in the joint judgment of the Chief Justice and McHugh J that it was essential that the scheme be defined so as to include the borrowing which produced the funds to enable the investment property to be refinanced and the residential property to be purchased it seems that all members of the High Court really regarded that which produced the tax benefit to the taxpayers to be what is referred to as the "wealth optimiser benefits" of the scheme. The wealth optimiser aspects of the scheme were, in essence, the ability of the taxpayer to allocate the one loan to two different purposes so as to ensure that interest payable on the non-income producing property was payable until the loan to acquire the residential property had been paid off while the interest on the balance of the loan accumulated at interest. In other words, the form in which the loan arrangements were structured was critical to the scheme and it was from these aspects that the tax benefit in the way defined above was derived. 94 If the right question to ask was what conclusion should be drawn as to the dominant purpose of the taxpayers entering into the two loans the answer may well have been the acquisition of the new residential property and the refinancing of the previous house for use as an investment property. This commercial factor was what caused the Full Federal Court to come to the conclusion it did that Part IVA had no application. However, that was clearly not what the members of the High Court regarded as being the correct question to ask. 95 Part IVA requires the drawing of a conclusion from the eight matters listed in s 1277D(b) as to the dominant purpose of some person, including the taxpayer, for entering into or carrying out the scheme. If the scheme is defined to be all the steps taken, including the loan itself but placing emphasis upon those matters which gave rise to the tax benefit (ie the differential interest) obtained by the taxpayer from the scheme, then the question required to be asked is whether having regard to the scheme as so defined which, while it includes the making of the loan has, as its emphasis the wealth optimiser features which produce the tax benefit, it would be concluded that some person entered into it to obtain the tax benefit. That, I think, is the explanation of the judgment of the Chief Justice and McHugh J. Another way this may be stated is that the conclusion in a case like Hart which has to be drawn by reference to the eight relevant factors is a conclusion which has to be drawn by reference to the way the borrowing is structured and not a conclusion as to the borrowing itself. It is a conclusion not as to why the borrowing itself is entered into but why a borrowing on the particular terms and conditions is entered into, that is to say the terms and conditions which were essential to the wealth optimiser product. On this basis the answer to be drawn is the obtaining of the differential interest saving and not any commercial purpose. That this is the way their Honours approached the issue in Hart appears in the following passages. First, at [10], their Honours said: "While the fact of the borrowing cannot be left out of consideration, it was what the mortgage broker described as the 'wealth optimised structure' of the loan arrangements that secured the tax benefits, that is not the deduction of the interest on loan account 2, but part of that deduction". 96 Later their Honours said at [12]: "It was the wealth optimising aspect of the structure, not divorced from the borrowing, but giving the borrowing its distinctive character, that constituted the scheme". 97 On one view, it may be said that their Honours in the circumstances of the case regardedthe conclusion as to purpose to be a conclusion required to be drawn in regard to the form of the borrowing, tested, of course, by reference to the eight relevant matters set out in s 177D(b) one of which includes form itself. That view presents some difficulty. Alternatively, it may be said their Honours adopted a definition of the scheme as not being all the steps taken but what may be described as be the Wealth Optimiser features of the loan package. On the other hand that is not what their Honour said they were doing. Rather, it seems to me that the proper analysis of the judgment is that while the scheme could be defined as being all the steps taken by the parties the conclusion as to purpose had to be addressed by reference to the particular scheme, that is to say all the steps which included the wealth optimiser features. In their Honour's view the only conclusion that could be drawn as to the purpose of the Hart's entering into the particular scheme having those particular features was the tax conclusion. 98 The judgment of Gummow and Hayne JJ clearly expresses a different view as to the significance of "scheme" to the operation of Part IVA. In particular their Honours emphasised that Federal Commissioner of Taxation v Peabody (1994) 181 CLR 359 should not be taken as deciding more than that procedural fairness required the Commissioner to identify the "scheme". What was said in Peabody was not to be taken as imposing a test which required that a single act, for example, could not itself be a "scheme" in the defined sense unless as a scheme it stood on its own feet. Certainly, until Hart, Peabody had been read in this way. It may be said that both the joint judgment of the Chief Justice and McHugh J and the judgment of Callinan J would suggest that there was a restriction upon the Commissioner extracting from a series of acts some single step which produced a tax benefit and treating that out of context as the scheme to which Part IVA applied. How that restriction should be defined may be a question for a later time. Whatever may ultimately be found to be the ratio of Hart in respect of a definition of scheme, that is not a matter which, in my view, need arise in the present case. 99 In Hart the Commissioner had, in the alternative, identified two schemes. The first was a wider scheme consisting of all the steps which the parties took. The narrower scheme was "the provision in the loan for the division into two portions and the direction of the repayments to one or other portion and the direction by the (taxpayers) of the repayments to the home loan portion" (at [48]). It is clear that Gummow and Hayne JJ and probably all of their Honours, would have reached the same result whichever way the scheme was defined. 100 After discussing the definition of scheme Gummow and Hayne JJ proceeded to discuss the principle first enunciated in Spotless that there was no real dichotomy between what might be described as a "rational commercial decision" and the obtaining of a tax benefit. They noted, as was obvious, that the loan in Hart was structured so as to obtain the most desirable taxation result. Their Honours at this point in the judgment discard as irrelevant the fact that the taxpayers in Hart wished to obtain finance to purchase a new residence and to refinance the mortgage over their existing residence to enable it to be obtained for use as an investment property. Their Honours make the point, as an apparent explanation why these matters were irrelevant, that s 177D(b) did not permit or require consideration to be given to subjective motives. That is clearly correct, with respect, but leaves open the question why the objective circumstances including the manner in which the scheme was entered into would not have led to the same conclusion anyway. If the facts had been that the taxpayers first were introduced to the borrowing transaction before they had considered the acquisition of a new residence and using the existing residence for income producing purposes, the point made by their Honours would have been more easily understood. My understanding of the facts in Hart does not suggest this to be the case. 101 Their Honours then proceeded to consider the eight matters in s 177D(b). As to the manner in which the scheme was entered into their Honours said that, whether the scheme was identified as the wider or narrower scheme, the conclusion was evident, as indeed the Full Federal Court had held, that the taxpayers entered into that scheme with the dominant purpose of obtaining the tax benefit in fact obtained. Their Honours reached a similar conclusion in respect to the other seven matters, to the extent they were relevant. No reference is anywhere to be found in this discussion to the commercial aspect of the transaction, namely the use of the borrowed funds. It must be concluded that their Honours did not do so, either because, as their Honours had earlier indicated, the actual purpose of the borrowing was a subjective matter to be ignored or alternatively, because in their Honours' view, it was only if the tax benefit by way of interest differential was available that the financing or refinancing as the case may be was commercially possible. This latter position, while not specifically stated, would fit well with the analysis in Spotless to which I have earlier pointed. 102 That the latter explanation may have been significant to the way the issue was approached by their Honour is reinforced by the importance their Honours placed upon the need to consider how else the loan in question might have been arranged. Although their Honours do not say so directly it may be implicit in their reasons that there was no way the taxpayers could have borrowed in separate loan transactions to be arranged at least with separate lenders, such that the payment of interest was deferred upon the loan in respect of the investment property. At first instance, Gyles J had said that such loan transaction would not have been available to the Harts. It may be said that there was, so far as I am now aware, no evidence before the Court either way as to whether any lender would be prepared to lend upon terms that the loan was not only repayable at the end of the loan term but that interest would accumulate upon it and likewise be payable at the end of the term. This was not a matter which appears to have been explored in the course of evidence. 103 Callinan J after summarising at some length the legislative provisions then turned to the question of the definition of "scheme". His Honour said that on the facts in Hart both the series of steps and individual steps could qualify as a "scheme" in the defined sense. His Honour explained the comments about "scheme" in Spotless as indicating that it was not for the Commissioner to attempt to seize upon an isolated event which standing alone might appear to have a complexion which in the context of the overall circumstances it did not have. That view is closer to the view taken by Gleeson and McHugh JJ. 104 His Honour found also that there was a tax benefit in the defined sense obtained by the taxpayers in connexion with the scheme, although there may be some difficulty in his Honour's comments if taken literally that the scheme produced a tax benefit being a deduction of the whole of the interest relating to the residential property. However, it can be assumed that this is not what his Honour meant. 105 His Honour then turned to consider the eight factors listed in s 177D(b). Both "manner" and "form and substance" led, his Honour said, to tax deductibility as the relevant dominant purpose. His Honour considered whether the substance of the transaction, tax implications apart, could "more conveniently, or commercially, or frugally" have been achieved by a different transaction or form of transaction and suggested that arguably it could have been. His Honour pointed out that as the scheme was implemented the debt in respect of the residential premises would have been quickly discharged but the mortgage on it would remain as security for the outstanding debt as the investment property would likely not be of sufficient value to be security for the debt that would remain after repayment of the loan in respect of the residential premises had been repaid. This was a matter which, his Honour suggested, was not given sufficient weight by the Full Court. His Honour found that it was easy to conclude, in fact, inevitable that a Court would do so, that the dominant purpose was tax minimisation. His Honour continued at [95] - [96]: "What other purpose or purposes could have made commercial or other sense? There was no material before the Court to show that the purchase of the investment property was in fact a good investment in the sense that even if it did not yield a rental sufficient to cover interest and other outgoings there was a reasonable chance that it would appreciate in value. Repayment of the principal owing in respect of the residence did not make it immune to recourse by the lender in the event of default or shortfall in payment or value of the investment property. It may be that the respondents did wish to make an investment and to change their residence. These were entirely irreproachable and proper objectives. But the means adopted to achieve these results could readily, and should be objectively concluded to be a scheme for the [dominant] purpose of enabling the respondents to obtain a tax benefit, and this is so no matter which of the alternative definitions as to the width of the schemes, within which what occurred here falls, is preferred." 106 It may be accepted that in Hart there was no evidence as to the quality of the investment decision which the taxpayers took. With respect, it is difficult to see why the quality of the investment in the new residence and use of the old residence as an investment property would matter. In any event this was not a matter adverted to in the other judgments of the High Court and may be here put to one side. What is, however, significant is that like Gleeson CJ and McHugh J his Honour in his consideration of purpose directed attention ultimately to the form of the scheme. 107 I have dealt in considerable detail with the three judgments in Hart, because it is important to determine what the case decided. Particularly, it is important to understand why (perhaps with the exception of Callinan J) none of their Honours seemed to give any weight to the purpose of the taxpayer's borrowing in balancing the obvious taxation advantage against any commercial purpose. If, as it would seem from the judgment of Gummow and Hayne JJ, the investment purpose was required to be excluded from consideration in Hart because the evidence of it was evidence of subjective motivation then it can be said that the desire of MBL for capital might likewise be excluded. On the other hand the objective facts in the present case are such that it is clear that there was a need on the part of MBL for Tier 1 capital. If Hart was decided upon the basis that the investment purposes should be excluded because the investments could not proceed without the taxation benefit available through the wealth optimiser package, that part of the decision would have no reference here as it was quite possible for MBL to raise capital without there being any taxation benefit attached. The lack of taxation benefit not only to MFL but to MBL or any company in the MBL Group, might increase the cost to the group of obtaining finance. And there could be a taxation benefit to MBL or some company other than MFL if finance was obtained through a borrowing which did not involve MFL. If Hart stands, as I have suggested, for the proposition that the scheme to be considered was the loan carrying with it the particular terms and conditions which constituted the wealth optimiser features then the scheme to be considered here would be the capital raising with the particular features it had, and in particular the use of notes (or more accurately beneficial interests in notes) carrying interest but stapled to the issue of preference shares; the procurement agreement between Deutsche and MBL involving return to Deutsche of an amount equivalent to the face value of the note and the possibility that at any time MBL could by notice require capital and interest on the notes to be payable to it and thereby ensure that thereafter dividend and capital rights would become applicable to the share holding. If Hart stands for the proposition that the particular form of the loan agreement was the scheme (which is really another way of putting the last proposition) then the present case requires consideration to be given to the particular form of the agreements relating to the preference shares and the notes. 108 Just as in Hart it was necessary to consider the conclusion as to purpose with regard to the particular form of the finance agreement which included the wealth optimiser aspects, so here, what has to be considered under s 177D(b) is the particular form of capital raising involving the particular features which distinguished the scheme, namely the procurement agreement and the payment direction pursuant to it and the particular terms of the preference share and note issues. 109 It may be said in favour of Macquarie that the present is not a case where the transaction was given a particular form dictated by tax which made the commercial end achievable. While Hart may, like Spotless be a case where the commercial benefits obtained were unavailable without the tax benefit, that may be said not to be the case here, in that other types of securities could have been issued to the public without a tax deduction, although presumably the stapled securities represented the cheapest alternative, not merely because of the potential tax deduction but because of market perceptions. 110 Ultimately, it seems to me that what is to be considered in the present case is whether, having regard to the eight factors in s 177D(b) it would be concluded that the dominant purpose of some person who entered into or carried out the scheme with the particular features I have mentioned was the obtaining for MFL of tax deductions for the "interest' or whether it would be concluded that the dominant purpose of all persons who entered into or carried out the scheme with those particular features was the obtaining of Tier 1 capital. While a strict application of the view of Gummow and Hayne JJ might be thought to exclude the raising of Tier 1 capital as a purpose because this was a subjective matter I do not think it can be excluded both because that was not the approach adopted by Gleeson CJ and McHugh J and perhaps Callinan J and because, in any event, the need for capital may be seen to be objectively determined. 111 The first factor to be considered is the manner in which the scheme was entered into. Clearly the scheme took the form it did (its shape) because of the ability of MFL to obtain a taxation deduction. That deduction would only be available if funds were the subject of a loan at interest to a company which used the funds borrowed in making loans to other group companies at interest. A capital raising by MBL say of preference shares would not produce any deduction to any taxpayer and obviously therefore, none for MFL. Even if it were possible for there to be a raising of Tier 1 capital by MBL in such a way as would give MBL a tax deduction for interest that would not be a deduction available to MFL. The manner in which the scheme was entered into (that is to say, its form or shape) was thus here dictated by the desire to have the substance of a share offer to the public which qualified as Tier 1 capital, without the constraints of a share issue and, obviously, no interest to be available by way of deduction. The procurement agreement and payment direction were explicable only by reference to the desire to have both the benefits of a share capital raising and the allowance of an interest deduction. The participation of MFL was clearly influenced by the desire to ensure a tax deduction to a company in the group, a deduction that would be unavailable had there been a share issue. 112 It is clear from the fact that three alternative proposals were considered by staff of MBL that the raising of additional Tier 1 capital could have been achieved in a number of different ways. Despite a suggestion to the contrary I would find that it was commercially desirable, perhaps even necessary that the MBL group increase its Tier 1 capital. Perhaps it was not essential to do so just for the purpose of the acquisition of BTIB but the acquisition even if completed by capital available rendered it necessary for additional capital to be raised. The obtaining of Tier 1 capital was clearly a purpose of MBL and a significant purpose. Tax deductibility for interest payable by MFL was likewise important to the group. It is important to note here, however, that debt financing was a cheaper as well as more flexible way of raising finance for the group. That this was so was only partly attributable to the tax deductibility of interest. The question then is whether the tax purpose or the commercial capital raising purpose was the predominant purpose in adopting the arrangement in fact entered into and having the particular features I have noted. I find the question very difficult. However, in my view what may be called the tax purpose (that is to say the interest deduction to MFL, being the relevant tax benefit) predominates here, although only marginally. 113 Among the factors which reinforce the conclusion I have reached is that whether MFL would ever be under a need to repay the lenders was a matter within the control of its parent company MBL. MBL likewise had no obligation to pay dividends on the preference shares so long as interest was payable on the notes. Interest payable was limited to there being profits in MBL available. 114 The second factor to be considered is form and substance. Here the substance of the transaction was a raising of share capital. The form was a combination of debt and equity capital raising. The difference between the two can be accounted for, in my opinion, by the availability of the tax deduction to MFL. That the substance was a capital raising by MBL follows the interrelationship of the rights to interest under the notes and the rights applicable to the preference shares stapled with the notes. While as a matter of form there was both a capital raising of $400,000,000 and a debt raising of the same amount as a matter of substance the real cost to the group after the procurement agreement and payment thereunder by MBL to Deutsche was only $400,000,000, that amount representing the amount required to be shown as a liability in the consolidated balance sheet of MBL as paid up capital. Further, it can be seen that in substance (and through its guarantee) MBL really incurred a liability to pay dividends in an amount in effect commensurate with the liability of MFL to pay "interest". There was no obligation to pay interest unless MBL had profits just as would be the case had there been a dividend payable by MBL under an alternative arrangement. 115 However, again it will be important to note that there is a commercial advantage in both cost of finance and flexibility that must be taken into account in weighing up which purpose predominates. While the conclusion to be reached involves a question of judgment I think here that it is the tax purpose which predominates. I should add that unlike Spotless and perhaps, unlike Hart the present is not a case where the commercial purpose can only be achieved if the tax purpose is also achieved. 116 The third factor, timing, has little part to play. The timing of the arrangement and the period during which the scheme was to be carried out were both consequences of commercial factors and unaffected by taxation matters. If anything the third factor may militate against a conclusion of tax purpose. It was submitted for the Commissioner that the decision to adopt the structure in fact implemented was taken soon after the obtaining of taxation advice concerning the alternative structures under consideration. With respect, even if this is so, I do not think that the inference should be drawn that the Macquarie Income Securities took the form they did as a result of taxation advice. 117 The fourth factor requires consideration of the taxation result. Clearly here this points to taxation as amounting to the dominant purpose of MBL and MFL and those directing these companies. 118 The fifth factor requires consideration of changes in the financial position of MFL resulting from the scheme. But for the scheme MFL would not have had funds available to it to onlend to Macquarie Leasing and likewise no interest to pay out on its borrowing or interest to receive from onlending. On the other hand, the financial position of MBL (a matter to be considered as a separate factor) changed because it had issued fully paid preference shares. These matters on balance, however, are in my view either neutral or favourable to a conclusion of a non tax purpose. 119 The remaining matters for consideration are either neutral or do not suggest a conclusion that the dominant purpose of MFL, MBL or any person who entered into or carried out the scheme (for example, Deutsche) was the obtaining by MFL of a deduction for interest. 120 It follows, therefore, that if, contrary to my view, the "interest" payable on the notes was an allowable deduction to MFL in the year of income, then that deduction constituted a tax benefit which MFL obtained from a scheme to which the provisions of Part IVA applied and in respect of which the Commissioner was entitled to make a determination under s 177F disallowing to MFL the deduction. I might add that I reach this conclusion with some reluctance. I doubt if the legislature would have regarded the present "scheme" as involving the application of Part IVA when the Part was enacted in 1981. However, it seems to me that the approach of the High Court in Hart requires me to reach the conclusion I have. 121 Accordingly I would dismiss the application and order MFL to pay the respondent Commissioner's costs of it. I certify that the preceding one hundred and twenty-one (121) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Hill.

Associate: Dated: 14 September 2004 Counsel for the Applicant: B J Shaw QC, D H Bloom QC & S H Steward

Solicitor for the Applicant: Mallesons Stephen Jaques

Counsel for the Respondent: G T Pagone QC, S J McMillan & J H Momsen

Solicitor for the Respondent: Australian Government Solicitor