Section 8-1(2)
168 The primary judge held that '[T]he 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'. His Honour does not expressly identify what, in a practical business sense, the so-called interest is paid for, but it is implicit in his reasons for decision that his Honour regarded it as being the consideration for the subscription to the MIS, ie the consideration payable to investors by reason of their subscription for both the notes and the preference shares.
169 There is no suggestion in the present case that the payments were made voluntarily, that the transaction documents are a sham, or that the transaction documents record part only of a broader arrangement. Accordingly, the substance of the transaction can and should be discovered by a consideration of the transaction documents. In City Link Melbourne Ltd v Federal Commissioner of Taxation (2004) 211 ALR 207 the Full Court emphasised (at [42]) that it does not follow from the necessity to attend to the 'practical reality' of a transaction, that questions of deductibility are to be answered by seeking to characterise an outgoing by reference to whether it is like some other transaction which it is not. Economic equivalence is not the test of deductibility. The Full Court said:
'44. While it will often be relevant to ask what the money the subject of a deduction is paid for, in order to conclude whether the outgoing has the character of capital, generally, however, that question will be answered where the amount in question is consideration for obligations which the payee undertakes in favour of the payee, by having regard to the legal agreements entered into. Generally in such a case it would be unnecessary to go outside the legal agreement to determine deductibility.
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46. There will be, it may be accepted, some cases where regard may be had to the matrix of facts which form the background to the entering into of a legal agreement to determine the character of an amount payable under that agreement: Reuter v FCT (1993) 93 ATC 5030 at 5036; Commissioner of Taxation v Cooling (1990) 22 FCR 42 at 53; 94 ALR 121 at 132-3 per Hill J. The surrounding circumstances may in such cases, cast light on the nature of the relationship between parties to the agreement or deny as relevant to the character of an outgoing a label which the parties have used to describe it.
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47. …the present does not seem to us to be a case where reference to the surrounding circumstances in which the City Link agreements were entered into assists at all in determining the character of the concession fees. What the concession fees were paid for appears clearly enough from the terms of the concession agreement.'
170 Similarly, in BHP Co Ltd Hill J (with whom Heerey and Merkel JJ agreed upon this point), said at 600-601:
'27. In determining whether an outgoing falls for deductibility under s 51(1), it will be critical to determine what the outgoing is paid for. The significance of that question, which is directed to ascertaining the advantage sought to be obtained, is essential to the determination of the true characterisation of an outgoing.
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29. The test suggested in this case might be thought to have undergone some transformation, or at least qualification, in the well-known judgment of Dixon J in Hallstroms …
30. Later, in FCT v South Australian Battery Makers (1978) 140 CLR 645; 21 ALR 59 at CLR 659, Gibbs CJ pointed out that two different questions were involved: the first, as in Colonial Mutual, was what the expenditure was for; the second, as in Hallstroms, once the first question had been answered, was whether the advantage sought by the expenditure was of a revenue nature. In the resolution of this second question, regard is often had to the oft-cited tests of Dixon J in Sun Newspapers …
31. There are cases, and the present in my opinion is such a case, where the question what the payment was for falls to be determined by reference to the legal obligations or rights for which it is paid, that is to say, the question can be answered by reference to the agreement which operates to create the obligation to pay.
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33. …The question of what the payment is for and the question of the advantage sought, are both matters that do not give rise to a need to go outside the legally binding agreement reached at arms length between BHP and GE. And, having looked at the precontractual negotiation material which her Honour, in my view, rightly rejected, there is nothing in it which gives me reason to go beyond the contractual terms of the agreement between the parties.'
171 Whether outgoings are of a capital nature (in the present case, they are not in themselves capital) is often a difficult question. In BP Australia Ltd v Federal Commissioner of Taxation [1966] AC 224 at 264 Lord Pearce, delivering the judgment of the Privy Council, said:
'The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a commonsense appreciation of all the guiding features which must provide the ultimate answer. Although the categories of capital and income expenditure are distinct and easily ascertainable in obvious cases that lie far from the boundary, the line of distinction is often hard to draw in border line cases; and conflicting considerations may produce a situation where the answer turns on questions of emphasis and degree.'
172 The present case is a particularly difficult case, as the structure of the overall transaction has the following features:
- the notes are unsecured subordinated perpetual debt obligations of MFL, subject to MFL's entitlement to redeem the notes in the circumstances earlier described. An investor in the MIS who wishes to realise on his or her investment must sell the stapled security on the ASX at the prevailing market price, or privately;
- neither the giving of a Payment Direction, nor the occurrence of a Payment Direction Event affects MFL's liability to make the so-called interest payments on the notes or to pay the monies owing in respect of the notes in accordance with the terms of issue. Interest is payable by MFL to the holder initially, and on the occurrence of a Payment Direction Event, to MBL. That is also the case in relation to the outstanding principal amount of the notes;
- MFL's obligation to make the so-called interest payments to the holder is dependent on satisfaction of the conditions specified in cl 5.5 of the conditions of issue including the profitability of MBL, upon MBL's compliance with APRA's capital adequacy requirements and upon the directors of MFL not resolving to stop the payment by the business day prior to the interest payment date;
- the failure by MFL to make an interest payment when due does not thereupon result in the amount of the note becoming payable. If interest is not payable in accordance with cl 5.5 of the conditions of issue it does not accumulate. If an interest payment becomes payable but is not paid, then TCAL might institute proceedings for the winding up of MFL, but the institution of proceedings for the winding up of MFL would be a Payment Direction Event on the occurrence of which MFL's obligations on the notes become owed to MBL; and
- MBL can decide at any time that MFL's obligations on the notes are to be owed to MBL rather than to the investors and, of its own volition, trigger the occurrence of a Payment Direction Event, in which case the preference shares become dividend paying.
173 The identification of the 'practical reality' of the transaction depends at least in part on the perspective from which that question is considered. From the perspective of the holder of the MIS (and from the perspective of MBL) MBL can effectively switch the interest obligation owed by MFL on the notes to the holder into a dividend entitlement under the preference shares. From the holder's point of view MBL can effectively convert MFL's liability on the notes both in relation to the outstanding principal amount of the notes and interest into equity in MBL. From the holder's point of view, the investor's return from his or her investment in the MIS will derive from MFL in the form of interest, or from MBL in the form of a dividend, depending upon whether a Payment Direction has been given and a Payment Direction Event occurs. The only circumstance in which the holder will receive repayment of the monies paid by way of subscription for the notes from MFL will be if MFL voluntarily redeems the notes. In all other circumstances the only entitlement in the holder to a return of capital will be as a preference shareholder in MBL.
174 But from MFL 's perspective, the position is different. MFL is and remains liable to make the interest payments on the notes and to pay the monies owing in respect of the notes in accordance with the conditions of issue, but on the occurrence of a Payment Direction Event, the obligation is owed to MBL, rather than to the holder of the beneficial interest in the notes. For so long as the notes remain unredeemed, MFL has an obligation to pay interest on the notes either to the holder, or to MBL. On redemption of the notes after the occurrence of a Payment Direction Event, the redemption amount is payable to MBL, rather than to the holders. Once a Payment Direction Event occurs, the proceeds of the notes issue become available to MBL to fund its obligations under the preference shares.
175 In South Australian Battery Makers at 656 and 662 the High Court held that it is the advantage which the taxpayer seeks and gains from the outgoing that has to be considered in deciding whether the outgoing is of a revenue or of a capital nature. The second of the considerations referred to in Midland Railway quoted above is to similar effect.
176 The primary judge held:
'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.'
177 MFL submits that at [63] of his Honour's reasons (see [150] above), and in the passages quoted immediately above, what the primary judge has done is to focus on:
- the position of the note holders who derived the interest income, rather than on that of the taxpayer by whom the expenditure was incurred; and
- the advantages subjectively sought by MBL and its officers in entering into the transaction, and in selecting MFL as a participant in the transaction, rather than the objective advantage sought and obtained by MFL from the outgoing in question.
178 There is, with respect to his Honour, some force in this criticism. Whilst it is true that the note holders may not get paid on the notes, and depending upon events, might be left to their rights as preference shareholders in MBL, and whilst it is also true that from MBL's point of view entry into the transaction documents effected an increase in its capital, from MFL's perspective its obligations under the notes both in relation to the repayment of principal and as to interest continue after the occurrence of a Payment Direction Event, with the only change being in the identity of the person to whom the obligations are owed. The third of the considerations referred to by the High Court in Midland Railway is thus of relevance. The relevant enquiry is as to the (objective) purpose of the so-called interest payment from MFL's point of view. The perspective of the recipient of the payment is irrelevant, as is any subsequent change in the identity of the person to whom MFL's obligations are owed.
179 In the year of income, a Payment Direction had been given, but a Payment Direction Event had not occurred. MFL was then subject to an obligation to make periodic payments to the holders of the MIS in consideration for their investment in the MIS. The fact that a Payment Direction Event might later occur (and MBL could cause that to happen) in which case MFL's obligation would be owed to MBL, rather than to the holders, cannot be determinative of whether payments made by MFL to the holders in the meantime in discharge of its existing obligations are on capital or revenue account.
180 The character of the advantage sought by the interest payments was to secure the continued use by MFL of the funds raised by the issue of the MIS with the consequence that the preference shares in MBL would not become dividend paying, and with the result that it is MFL, rather than MBL, which is entitled to enjoy the fruits of the note issue. The funds were raised on the basis that the investor's return would take the form, at MBL's option, of interest paid by MFL, or the preference shares issued by MBL would become dividend paying. The ability of MBL to procure a switch from one to the other does not signify that the payments by MFL before any switch occurs are of a capital nature. I do not agree, with respect, with the primary judge's conclusion that the composite nature of the MIS, and the procurement agreement, leads to the result that the interest payments are on capital account. In my view, MBL's ability to switch the nature of the holder's interest in the manner earlier indicated does not affect the characterisation of MFL's liability on the notes whilst they remain outstanding.
181 However, this case differs in several respects from the ordinary case where loan capital is raised by way of a borrowing at interest for a term, where payments of interest can readily be seen as securing the use of the monies during the term, rather than an enduring advantage. First, there is no obligation on MFL to repay the monies raised by the issue of the notes except on its winding up. Second, the directors of MFL could decide to stop an interest payment by the business day prior to the date on which interest would otherwise be payable, without being in breach of the Trust Deed. If MFL so decided, a dividend stop would be imposed on MBL's shares pursuant to cl 5.9 of the conditions of issue, which suggests that only in extreme circumstances would MFL so decide. Third, interest is not payable unless the profits of MBL would be sufficient to allow it to be paid if the payment obligation were on MBL rather than MFL. Fourth, even if an interest payment which falls due is not paid so as to give rise to a breach of the Trust Deed, the notes do not thereby automatically become redeemable. TCAL might sue MFL for the recovery of the unpaid interest, or call on MBL's guarantee. If MFL were wound up for non-payment of interest, the notes become redeemable, although the institution of proceedings for the winding up of MFL are a Payment Direction Event such that monies becoming due thereafter would be payable to MBL.
182 The primary judge did not regard the mere fact that the notes are not redeemable except in a winding up of MFL as leading to the conclusion that the interests payments are of a capital nature. His Honour said (at [47]):
'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 a 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.'
183 The so-called interest payments constitute recurring expenditure to meet a continuous demand as opposed to an expenditure which is made once and for all. The payments are regular outlays made by MFL in order to obtain debt finance which MFL used to make advances on which MFL derived assessable income. The expenditure has to be made if the notes are to remain outstanding and, consistently with the principles enunciated in Sun Newspapers at 361-363, should be regarded as being on revenue account notwithstanding the fact that the notes are undated, and redeemable only at the option of MFL, or on its winding up.
184 The Commissioner's submission that by virtue of the transaction documents MFL acquired an asset of an enduring nature in the form of a right (as against TCAL and the subsequent holders of the stapled instruments) to the retention and use (in perpetuity) of the money raised by it from Deutsche whether or not MFL discharged its covenant to pay interest cannot be accepted. MFL was under an obligation to make periodic payments of interest 'to meet a continuous demand' (Sun Newspapers at 362) whilst ever the notes are unredeemed. If MFL failed to make interest payments when due, MFL would be exposed to the risk of winding up, in which event the redemption amount would become payable albeit to MBL. To focus on the rights of the holders of the MIS, rather than the obligations of MFL whether to the holders of the notes or MBL, is to approach the matter from the wrong perspective.
185 It is true that the principal amount of the notes might remain outstanding for an indefinite period, but there is no principle that it is only interest on short term borrowings which is deductible. In the language of Sun Newspapers (at 363) here MFL provided 'a periodical reward or outlay to cover [the] use or enjoyment' of the principal amount of the notes 'for periods commensurate with the payment'. The fact that the directors of MFL may 'stop payment' on a dividend payment, whilst potentially relevant, does not indicate that payments of interest which are in fact made are not on revenue account.
186 Reliance was also placed by the Commissioner upon the fact that interest is capped by reference to the profits of MBL. The primary judge did not regard that matter as significant if the notes are to be looked at separately, but stated that if the correct analysis is to look at the shares and notes as a composite transaction, this factor takes on a different significance.
187 The shares and notes must be looked at as a composite transaction because that accords with the facts, but one does so from the perspective of MFL. I do not agree, with respect, that the capping of the dividend by reference to the profits of MBL takes on a different significance when the transaction is considered in this way. The capping has the result that the payment of interest resembles the payment of a dividend by MBL, but that does not mean that MFL's obligation to pay interest is of a capital nature, because ex hypothesi MFL is discharging a contractual obligation to which it is subject, rather than an obligation of MBL to its shareholders.