GROUNDS OF APPEAL
18 The principal ground of appeal, which encompasses the other grounds, is that the primary judge should have held that the capital expenditure to the extent of £42.912 million was reflected in the state or nature of the shares at the time of their disposal because:
(a) the expenditure had increased the value of the shares, and that increase in value to the extent of £42.912 million remained in existence at the time of the disposal of the shares; and/or
(b) the amount of the expenditure to the extent of £42.912 million was available to be distributed to the holder of the shares pursuant to the rights which comprised the shares.
19 We deal first with the ground in [18(a)]. In the quotation at [16] the primary judge appears to have derived assistance from the following passage from the Explanatory Memorandum to the Income Tax Assessment Amendment (Capital Gains) Bill 1986 (Cth):
An example of the type of expenditure which may be included in the cost base to a taxpayer of an asset under paragraph (c) would be expenditure incurred on the extension of a building …
Note that expenditure incurred in enhancing the value of the asset must be reflected in the state or nature of the asset at the time of disposal. For example, if a carport is erected adjacent to an income‑producing property but at a later stage is dismantled and a garage erected, the expenditure incurred in erecting the carport would be disregarded in calculating the cost base of the property as it is no longer reflected in the state or nature of the asset.
Similarly, paragraph (c) is designed to exclude from the cost base any expenditure incurred for the purpose of enhancing the value of the asset by way of improvements which have wasted away prior to disposal.
20 These two examples concerning a dismantled and a wasted away improvement are clear cases where expenditure incurred for the purpose of enhancing the value of an asset is not reflected in the state or nature of the asset at the time of its disposal. But, with respect to the primary judge, we do not see in them any indication that, as his Honour put it, "'value' would not be included within the concepts of 'state' or 'nature'". All that can be derived from the examples was earlier expressed by his Honour at [43] when he said that they indicate "that any physical change brought about by the expenditure must continue and must not have dissipated prior to disposal of the asset …". Nevertheless, the fact that the examples do not support his Honour's conclusion that "value" is not included within the concepts of "state or nature" does not mean it is wrong.
21 The primary judge's first reason at [52] for his rejection of the appellant's construction is that par (c) "distinguishes the concept of 'value', with 'state or nature'". The same point is more clearly put at [35] where, comparing the two limbs of par (c), his Honour said the legislature has identified two main concepts, "value" on the one hand and "state or nature" on the other. As we understand it, the point he was concerned to make is that the use of "value" in the first limb shows that "state" and "nature" in the second are concerned with something other than value.
22 Such authority as there is provides some support for his Honour's view. Aberdeen Construction Group Ltd v Commissioner of Inland Revenue (1978) 52 TC 281 (Aberdeen), in the Court of Session, concerned par 4(1)(b) of Schedule 6 to the Finance Act 1965 (c 25) (UK), which provided that the sums allowable as a deduction from the consideration in the computation of the gain accruing to a person on the disposal of an asset were restricted to:
the amount of any expenditure wholly and exclusively incurred on the asset by him or on his behalf for the purpose of enhancing the value of the asset, being expenditure reflected in the state or nature of the asset at the time of the disposal …
The only material difference between par 4(1)(b) and s 160ZH(3)(c) is that the former required the expenditure to be incurred "on the asset" for the purpose of enhancing its value, whereas the latter only required it to be incurred "for the purpose of enhancing the value of the asset". For present purposes nothing turns on that difference.
23 In Aberdeen 52 TC 281 the appellant acquired the issued share capital of Rock Fall Ltd for £114,024 and subsequently made loans to it of £500,000. Rock Fall's trading position deteriorated and eventually the appellant agreed to sell its Rock Fall shares for £250,000. The purchase was conditional on the appellant waiving its loans, which it did. The appellant had therefore incurred a loss of £364,024. The Revenue claimed tax on a capital gain of £135,976 being the difference between the price paid for the Rock Fall shares and the proceeds of sale. In the Court of Session the appellant contended, among other things, that the making of the loans and their subsequent waiver constituted deductible expenditure within par 4(1)(b) of the Schedule for the purpose of computing the gain or loss on the sale of the shares. The Court rejected the claim. The Lord President said at 290:
According to the Appellants the money laid out by way of loans was "expenditure" wholly and exclusively incurred "on" the share capital for the purpose of enhancing their value. The words "state or nature" must be applicable to incorporeal property and are wide enough to include every circumstance which can affect the value of such property. It follows that on the extinction of the loans this "expenditure" was reflected "in the state or nature" of the shares sold for they were then shares in a debt-free company and, having been worthless, acquired the value for which they were sold. Once again I am not persuaded that this argument ought to receive effect. It is permissible to suppose that the extinction of the debt owed by Rock Fall enhanced the value of its shares. To describe the making of the loans, or their waiver, as expenditure within the meaning of para 4(1)(b) of Sch 6 is however quite unacceptable. The making of the loan created rights and obligations and the waiver constituted an abandonment of the rights but in neither case was there the kind of expenditure with which para 4(1)(b) is concerned. In any event, by no reasonable stretch of the imagination is it possible to classify the making of the loans or their waiver as expenditure wholly and exclusively incurred "on" the shares and I find it impossible to say that either were reflected in the state or nature of the shares which were sold. The waiver of the loans may well have enhanced their value but what para 4(1)(b) is looking for is, as the result of relevant expenditure, an identifiable change for the better in the state or nature of the asset, and this must be a change distinct from the enhancement of value.
24 Lord Johnston was prepared to assume that the waiver of the debt increased the value of the shares. However, in his view this expenditure was neither "on" the shares nor reflected in their state or nature at the time of disposal: see 293. Lord Avonside said the £500,000 was a loan and not expenditure. It was not wholly and exclusively incurred on the shares. It may have enhanced their value in so far as it might have given Rock Fall working capital helpful to its trading, but when the loan was waived "the shares remained in their state and nature unchanged": at 294.
25 The appellant's appeal to the House of Lords was successful: Aberdeen Construction Group Ltd v Inland Revenue Commissioner [1978] AC 885. However the appellant did not on the appeal rely on the par 4(1)(b) contention, and the speeches in the House of Lords throw no light on it.
26 By the time of the decision of the Special Commissioners in Trustees of the FD Fenston Will Trusts v Commissioner for Revenue and Customs [2007] STC (SCD) 316 (Fenston), par 4(1)(b) of the Schedule had become s 38(1)(b) of the Taxation of Chargeable Gains Act 1992 (Cth). In Fenston, trustees owned all the shares in a company, which they subsequently disposed of for US$1. The question for the Commissioners was whether on that disposal the trustees sustained an allowable loss. The answer depended on whether, in computing the chargeable gains or allowable losses accruing on the disposal, the trustees were able to deduct capital contributions of £1,530,546 they had made to the company.
27 The trustees' argument was that the fact that the shares were more valuable after the capital contribution, because of the consequential increase in the company's surplus, meant that the expenditure on the contributions was reflected in the state and nature of the shares at that time and at the time of disposal. They acknowledged that no additional shares were issued as a result of the contributions and that the rights and restrictions attaching to the shares remained unchanged. Nevertheless they contended that the fact that the surplus available for distribution to shareholders had been increased was sufficient to satisfy the requirement that the expenditure was reflected in the state or nature of the shares at the time of disposal.
28 The Commissioners did not accept the trustees' argument. They said at [23]:
It is clear from [s 38(1)(b)] that Parliament did not intend that all expenditure incurred for the purpose of enhancing the value of an asset should be deductible in computing capital gains. Only such expenditure as would be reflected in the "state and nature of the asset at the time of the disposal" was to be allowed. Further, "state and nature" for these purposes must be something other than merely the value of the asset ‑‑ otherwise this phrase would add nothing to the immediately preceding words. In this case the Capital Contributions did not result in any increase in the number of shares in issue, or result in any change in the rights or restrictions attaching to the shares. The only effect of the Capital Contributions was to increase the surplus of the company ‑‑ which would increase the amount available for distribution to shareholders, and therefore presumably the value of the shares. We do not consider this sufficient for the expenditure on the Capital Contributions to be reflected in the state and nature of the shares, either at the time the expenditure was incurred or at any time subsequently.
29 The trustees had argued that if they were not entitled to a deduction, it was difficult to envisage circumstances to which s 38(1)(b) might apply to intangible assets. The Commissioners were unmoved (at [25]):
We also consider as irrelevant that section 38(1)(b) might have no application to intangible assets if it has no application to the facts of this case. It is clear that the provisions have application in relation to land and buildings (for example expenditure on the construction of a new house on an empty plot), and the provisions are therefore not without meaning.
30 The Commissioners did not refer to the Court of Session's decision in Aberdeen 52 TC 281.
31 In addition to s 160ZH(3)(c), the words "reflected in the state or nature of the asset" also occur in both s 160ZH(1)(c) and (2)(c) of the Act. Section 160ZH(1) deals with the "cost base" of an asset. It is the sum of various amounts including:
(c) the amount of any expenditure of a capital nature incurred by the taxpayer to the extent to which it was incurred for the purpose of enhancing the value of the asset and is reflected in the state or nature of the asset at the time of disposal.
32 Section 160ZH(2) deals with the "indexed cost base" of an asset. Again it is the sum of various amounts including:
(c) the indexed amount of any expenditure of a capital nature incurred by the taxpayer to the extent to which it was incurred for the purpose of enhancing the value of the asset and is reflected in the state or nature of the asset at the time of disposal of the asset.
33 These provisions were considered by the Administrative Appeals Tribunal in Re Taxpayer and Federal Commissioner of Taxation (2004) 58 ATR 1172. The facts are complicated, but the following account, which involves some generalisation and smoothing, sufficiently discloses the point at issue. The taxpayer was a director and shareholder in a private company (the proprietary company) that conducted a franchise business. He intended to form a new company to acquire the shares in the proprietary company and list the new company on the stock exchange. As part of the plan he made incentive payments to several parties in order to secure the surrender of rights they held to market the franchise business of the proprietary company. The new company was then formed, capital gain tax roll‑over relief was obtained for the transfer of the shares in the proprietary company, and the new company was floated on the exchange. Shortly thereafter the taxpayer sold his shareholding in the new company. In calculating his capital gain on the sale, the taxpayer included the incentive payments in the cost base of the rolled over shares in the new company on the basis that they were "reflected in the state or nature" of the shares at the time they were sold within s 160ZH(1)(c). The Commissioner however reduced the cost base by this amount.
34 On the taxpayer's application to the Administrative Appeals Tribunal to review the Commissioner's disallowance of his objection, it was common ground that the incentive payments were an expenditure of a capital nature incurred by the taxpayer when he was a shareholder in the proprietary company and before he exchanged his shares in that company for shares in the new company. The taxpayer argued that the incentive payments were directed to ensuring that the surrenders were executed because they were indispensable to the successful listing of the new company. He contended that because the surrenders were executed and the proprietary company reacquired valuable assets, and because the shares in the new company were listed, the incentive payments were incurred for the purpose of enhancing the value of his shares in the new company and were reflected in the state or nature of the shares in the new company when he disposed of them.
35 The Tribunal affirmed the Commissioner's decision that the taxpayer was not entitled to include the incentive payments in the cost base of the shares in calculating the gain on the sale of those shares, on the ground that they were not reflected in the state or nature of the shares at the time of disposal. The Tribunal found at [43]:
that none of the rights that constituted the applicant's shares in the proprietary company and, subsequently, in the new company, was reflective of the incentive payments. There was no evidence before the Tribunal on which it could find that the applicant's shares in the proprietary company or in the new company, constituted a class of shares reflecting the amount of the incentive payments because they included a special or additional right attributable to such payments. The fact that the issued shares in the new company were listed on the boards of the London and Australian stock markets did not make the state or nature of the applicant's shares reflective of the amount of the incentive payments. The state or nature of the applicant's shares in the new company was indistinguishable from that of other issued shares in the new company. The Tribunal rejects the proposition that any causal link between the incentive payments and the listing of the issued shares in the new company makes the state or nature of the applicant's shares in that company reflective of the amount of the incentive payments for the purposes of ss 160 ZH(1)(c) and (2)(c) of the ITAA 1936. So the Tribunal finds that the state or nature of the applicant's shares in the proprietary company did not reflect the amount of the incentive payment when they were exchanged for shares in the new company, and the state or nature of the shares in the new company did not reflect that amount when the applicant disposed of them.
36 Having reached that conclusion, the Tribunal did not need to determine whether "the incentive payment" was incurred for the purpose of enhancing the value of the taxpayer's shares in the proprietary company and in the new company. The reference to "the incentive payment" in the preceding sentence and the last sentence of the passage quoted at [35], as opposed to "incentive payments" in the balance of the passage, is explained by the fact that at that stage the Tribunal was dealing with only one of the payments. It dealt with the others at [45] of its reasons conformably with its disposition of "the incentive payment".
37 The Tribunal did not refer to Aberdeen.
38 The first limb of s 160ZH(3)(c) is clear. It poses a factual enquiry as to whether expenditure of a capital nature was incurred for the purposes of enhancing the value of the asset. The second limb asks whether that expenditure is reflected in the state or nature of the asset at the time of disposal. The word "reflected" in this context requires that the expenditure can still be seen in the asset, is apparent in it, inheres in it, or is mirrored in it. The words "state" and "nature" are words of broad meaning. The former refers to an asset's condition; its characteristics and attributes. See Macquarie Dictionary - "the condition of a person or thing, as with respect to circumstances or attributes" (meaning 1). The Shorter Oxford Dictionary is to the same effect (meaning 1). The latter refers to an asset's "combination of qualities": Macquarie (meaning 1), Oxford (meaning 1). An asset's "qualities" include its characteristics and attributes: Macquarie (meaning 1), Oxford (meaning 1). We do not agree that because the first limb uses the word "value", it follows that "state" and "nature" in the second do not include "value". The first limb has a part to play in determining the meaning of the second. What must be reflected in the state or nature of the asset on disposal is the expenditure incurred for the purpose of enhancing its value. While the provision does not require the expenditure to have been successful in enhancing the asset's value, in many cases that will be its effect. It would be curious in that situation for the expenditure not to be taken into account on the ground that it is not reflected in the state or nature of the asset on disposal.
39 The apparent purpose of the second limb, as appears from the Explanatory Memorandum, is to exclude the expenditure where it has dissipated, wasted away or been destroyed by the time of disposal. It does not strain the expression "state or nature of the asset" to encompass the notion of value. It can hardly be doubted that an asset's value is one of its attributes. We think the draftsman has eschewed repeating the word "value" in the second limb in favour of the more expansive words "state" and "nature" which would include an asset's value as well as other attributes.
40 The primary judge's first reason for adopting his preferred construction was based on a contrast between "value" in the first limb and "state or nature" in the second. His second reason put aside the contrast and looked at the words "state" and "nature" themselves. As appears from the passage quoted at [17], his Honour was of the view that "value" does not form any part of the state or nature of a share. This was because, in his view, the "nature" of a share refers to the bundle of rights attaching to it, rights which exist "irrespective of their value", and the "state" of a share refers not to its value but to other matters such as whether the share is fully paid up. For essentially the same reasons we have differed from his Honour on the first of his reasons, we differ on the second. Again employing the ordinary meaning of the state or nature of a thing, we think it includes its attributes or qualities - words which comfortably encompass value. At [54] of his reasons the primary judge said that a colloquial use of the phrase "state of one's shares" may refer to their "market value" at any given time, but that this is more a reference to the state of one's portfolio globally, rather than to the condition of a particular share in itself. It is true that one is unlikely to talk or enquire about the state of a particular share. However, if one were to ask about the state of someone's NMUK shares, one's interlocutor would almost certainly respond with a statement of or about their market value. This we think supports what we have already said, that the attributes (and thus the state or nature) of a share include its value.
41 We return to the authorities considered at [22] to [37]. The appellant submitted that Aberdeen 52 TC 281 is distinguishable because par 4(1)(b) of Schedule 6 to the Finance Act required the expenditure to be "on the asset", whereas s 160ZH(3)(c) required it to be incurred for the purpose of enhancing the asset's value. We do not think this enables Aberdeen 52 TC 281 to be put aside. Both provisions require, in addition to expenditure for a particular purpose, that the expenditure be reflected in the state or nature of the asset at the time of disposal. However, for the reasons we have given, we do not agree with the Court of Session's conclusion, based on the distinction between "value" and "state or nature", that there must be a change, distinct from the enhancement of value, as a result of the expenditure.
42 While Fenston [2007] STC (SCD) 316 does not rely on Aberdeen 52 TC 281, the reasoning employed by the Special Commissioners is essentially the same as that of the Court of Session. Accordingly, what we have said at [41] is applicable to Fenston. Further, we are unable to agree with the Commissioners' observation quoted at [28] that if the expression "state or nature" included value, it "would add nothing to the immediately preceding words". Each limb of s 38(1)(b) (and s 160ZH(3)(c)) deals with a different point in time. The first when the expenditure is made and the second when the asset is disposed of. The first limb directs attention to the purpose underlying the expenditure, whereas the second limb is concerned with whether the expenditure remains reflected in the state or nature of the asset at the later point in time. Whether an increase in value is reflected in the state or nature of an asset at the later point will depend upon its particular attributes. Shares have attributes that are measurable by reference to the shareholder's funds to which they relate. To conclude that expenditure by way of a capital contribution to shareholders' funds made to enhance value, which remains available for distribution to shareholders, is thereby reflected in the state or nature of the shares does not render the first limb otiose. We also emphasise that on the view we take, the legislation will apply to intangible assets. It will be recalled that the Commissioners were untroubled by the fact that, on their view, s 38(1)(b) might have no application to intangible assets. In our opinion the Special Commissioners should have dismissed the trustees' appeal on the ground that the capital contributions totalling £1,530,546 made to the company had evidently wasted away by the time of sale. The shares were disposed of for US$1.
43 While the Administrative Appeals Tribunal's decision considered at [33]‑[37] contains passages that are generally supportive of the Commissioner's case, it is distinguishable. It concerned incentive payments made to third parties, and was not decided on the basis that an increase in the value of shares does not satisfy the requirement that expenditure be reflected in the state or nature of the shares on disposal.
44 The primary judge dealt with the matter on the basis of what is now reflected in the ground of appeal set out at [18(a)], and we have thus far dealt with the appeal on that basis. However before us the taxpayer also put its case independently of an increase in the value of the shares. It contended that the capital contribution was reflected in either the state or nature of the NMUK shares when they were sold because:
(a) the character of the expenditure was a contribution to shareholders' funds;
(b) at the time of disposal the amount of the expenditure remained available to be distributed to the shareholder of NMUK pursuant to the rights which comprised the shares; and
(c) the expenditure was reflected in the shareholder's equity in NMUK.
Item (c) was an agreed fact. See [11].
45 We were told that the taxpayer's alternative argument was put to the primary judge. Hints of it appear at [31] and [48] of his Honour's reasons. However, assuming it was put to his Honour in the form it was deployed before us, it was never distinctly dealt with as a point independent of the taxpayer's increase in value argument. See in particular [48], [52] and [53] of his Honour's reasons. In any event, this point is the subject of the ground of appeal set out at [18(b)].
46 Section 160ZH(3)(c) applied to intangible as well as tangible property: see [12]. The shares in question here are intangibles. In Archibald Howie Pty Ltd v Commissioner of Stamp Duties (NSW) (1948) 77 CLR 143 at 152‑153 Dixon J said:
While a shareholder has not a proprietary right or interest in the assets of an incorporated company, his "share" is after all an aliquot proportion of the company's share capital with reference to which he has certain rights…
The shareholder contributes the amount of the share to the capital of the company. This contribution measures his right to any return of capital which the company may make either as a going concern or in a winding up. Subject to any regulation the articles may make as to the basis upon which assets in excess of share capital may be distributed, the amount of the share determines the proportion in which he shares with other shareholders in a distribution of excess assets.
47 His Honour then referred to the facts of the case, which involved a reduction of capital by way of a distribution in specie, and continued at 153‑154:
The direct allocation of assets for distribution in reduction of the amount of the shares is doubtless within [the relevant section of the Companies Act]. But that means that the shareholder in satisfaction of his proportionate 'interest' in the assets, an interest consisting of a congeries of rights in personam, takes an aliquot part of the assets.
48 In Pilmer v Duke Group Pty Ltd (2001) 207 CLR 165 at [19] the High Court pointed out that the abolition of the concept of par value and of authorised capital effected by the Company Law Review Act 1998 (Cth) requires some modification to Farwell J's well‑known and much approved description of a share in Borland's Trustee v Steel Brothers & Co Ltd [1901] 1 Ch 279 at 288. Justice Dixon's description of a share is unaffected by the legislative change, though that of Williams J in Archibald Howie 77 CLR 143 at 156, describing a share as the interest of a shareholder measured by a sum of money, is no longer apt.
49 It is clear from the passages quoted at [46] that a shareholder's rights derived from the shares extend to a proportionate share of capital contributions in excess of what used to be called the par value of the shares on the distribution of that excess.
50 The taxpayer contends that given the character of a share as a bundle of contractual rights, the question under s 160ZH(3)(c) is whether the capital contribution was at the time of the sale of the shares reflected in the state of the contractual rights represented by the shares. The answer, according to the taxpayer, is that the expenditure was a contribution to shareholders' funds. The rights embodied in the shares reflected the quantum of those funds from time to time. At the time of disposal of the shares the capital contribution was still available for distribution to the shareholder of NMUK pursuant to the rights which comprised the shares. Accordingly the state of the contractual rights was at the time of the expenditure, and remained until the disposal of the shares, enhanced and improved by the expenditure. Thus the expenditure was reflected in the state or nature of the shares at disposal.
51 This alternative argument should also be accepted. Having regard to the legal nature of a share as described in the authorities, the inevitable consequence of the finding that at the time of the sale the expenditure was reflected in the shareholder's equity in NMUK is that it was reflected in the state or nature of the shares in NMUK. We accept the taxpayer's submission that if the expenditure was reflected in the shareholder's equity, it must also be reflected in the state or nature of the very rights which are the source of that equity. The shares themselves and the rights inhering in them (including the shareholder's equity) were not separate rights or interests. The authorities show that the rights derived from a share are embodied within the share. A share is incapable of legal description save by reference to what it represents: the rights and interests its holder derives from it. If, as the primary judge found, the expenditure was reflected in the shareholder's equity, it is reflected in the state or nature of the rights which are the source of the equity.