(a) paragraph 6, fourth line, delete $2,641,622 and insert $2,651,622

(b) paragraph 32, fourth line, delete $2,641,622 and insert $2,651,622

(c) paragraph 67, eleventh line and twelfth line, delete $2,641,622 and insert $2,651,622

(d) paragraph 68, fifth line and ninth line, delete $2,641,622 and insert $2,651,622

(e) paragraph 81, fifth line, delete $2,641,622 and insert $2,651,622

(f) paragraph 82, seventh and tenth line, delete $2,641,622 and insert $2,651,622

DECISION AND REASONS FOR DECISION [2010] AATA 758

TAXATION - capital losses - market value substitution rule - arm's length dealings

Income Tax Assessment Act 1997 ss108-5, 110-55(4), 112-20

FCT v Orica Limited [1998] HCA 33; (1998) 194 CLR 500

Granby Pty Ltd v FCT (1995) 129 ALR 503

Spencer v Commonwealth [1907] HCA 82; (1907) 5 CLR 418

Trustee for the Estate of Furse (No5) Will Trust v FCT (1990) 91 ATC 2007

Walstern v FCT [2003] FCA 1428

1. This application concerns disputed entitlements to capital losses that QFL[1] claimed after releasing its related company ABC[2] from two debts. Those debts being the intercompany balance debt[3] and the transfer debt[4] said to be owed to QFL.
2. During the years relevant to the matters in dispute QFL and ABC (until its deregistration) had the same directors and were both wholly owned subsidiaries of QCPL.[5] QFL's business was selling photographic prints that ABC had developed from traditional analogue photographic films.
3. The Quality Group[6] businesses grew from very humble beginnings. Started in 1987 by Di Van Luong, a refugee from Vietnam who came to Australia in 1982, Van Than Luong, who also arrived in Australia in 1982, and Tung Ma, who arrived in Australia in 1983, those businesses grew to become very profitable with revenues exceeding $29 million in 2000.
4. Until 1998 QFL and ABC's businesses were interdependent. Together those businesses entailed: first, securing orders for developing photographic prints from traditional exposed photographic films; second, developing the films and producing photographic prints; and third, supplying the developed prints to retail customers of various organisations such as supermarket, chemist and newsagency chains. QFL conducted the first and third of these steps and ABC the second. The evidence is not clear as to whether the retail sales were by QFL to the customer of the retail chain store (with the retail chain store the agent of QFL) or whether the sale was between QFL and the retail chain store. It can be inferred that QFL proceeded on the basis that the purchaser from it was the customer of the retail chain store.
5. Each of the QFL and ABC businesses was reliant on the other. Not unexpectedly, each company adopted a degree of informality in relation to financial dealings with the other. QFL paid ABC's expenses and recorded the amounts it paid in an intercompany account. ABC charged QFL fees for the development services that it provided and those charges were recorded in the same intercompany account. ABC had materials supply agreements and equipment leasing agreements with Agfa[7] and Copal[8] (an Agfa subsidiary). QFL supported those obligations by executing a guarantee and charge over its assets in favour of Agfa.
6. QFL contends that in 1998 ABC transferred its assets and liabilities to QFL merging the three elements of the photographic business outlined in paragraph [4] above into the one entity (QFL). Following this transfer QFL contends that ABC owed it two amounts totalling $2,641,622. The first amount said to be owed was the pre-existing intercompany balance debt of $614,140 (said to be a loan balance owed by ABC to QFL for expenses and outgoings paid by QFL on ABC's behalf). The second amount said to be owed was the transfer debt of $2,037,482 being the amount by which the ABC liabilities assumed by QFL exceeded the book value of assets transferred (again, said to be a loan made by QFL to ABC as a consequence of the two businesses being merged). Alternatively, QFL contends that it had rights of indemnity and subrogation against ABC in respect of the amount of $2,037,482 for which it became liable on the transfer of ABC's assets and liabilities to QFL.
7. In March 2000 QFL released ABC from debts it owed QFL and in November 2005 ABC was voluntarily deregistered without the loan balances said to be owed to QFL being paid.
8. QFL contends that capital losses[9] arose. The Commissioner has not allowed those capital losses and has imposed penalties.

1. QFL's primary case is: first, that it had two assets, the intercompany balance and transfer debts; second, that these assets were CGT assets[10]; and, third, that CGT event C2 happened to these assets upon the loans being written off. While writing off a loan is not strictly speaking a CGT event, QFL's explanation for this contention relies on the execution the release[11] as the act constituting the CGT event.
2. QFL's secondary case is: first, that it had rights of indemnity and subrogation in respect of the amount of $2,037,482 pursuant to guarantee and indemnity commitments it had executed to support ABC's obligations to Agfa; second, that those rights were CGT assets; and third, that CGT event C2 happened to these assets upon transfer of ABC's assets and liabilities to QFL or upon execution of the release. This case is put on the basis that these rights are both an alternate CGT asset to the debt/loan CGT assets noted at paragraph [9] above and an additional CGT asset such that two capital losses of $2,037,482 emerge.
3. QFL contends that:
   • (a) on its primary case the full amount of each of the loan balances, or debts, namely $2,037,482 and $614,140, is the proper amount to be recognized as the first element of cost base of the two debts, and for the alternate case the amount of $2,037,482 is the appropriate first element of cost base;
   • (b) there is sufficient value in the non deductible liabilities that were transferred to, or assumed by, QFL to allow the first element of cost base of the full amount of $2,037,482; and
   • (c) the market value substitution rule[12] does not apply to reduce the available first element of cost base to a lower amount.
4. QFL also contends that the capital proceeds for the CGT events were nil.
5. The Commissioner agrees with QFL's contention that if there were CGT assets and CGT event C2 happened to them the capital proceeds were nil. He does not agree with QFL's other contentions.
6. The Commissioner supports his assessments contending that:
   • (a) there was not a transfer of assets and liabilities by ABC to QFL. In making this contention the Commissioner does not contend the arrangements QFL asserts were entered were a sham. Rather, the Commissioner puts his case on the footing that the Tribunal cannot be satisfied that there was an effective transfer of assets and liabilities;
   • (b) there were not any loans made by QFL to ABC or any debts owed;
   • (c) there were not any rights of indemnity and subrogation held by QFL;
   • (d) if there were CGT assets then there was not a CGT event;
   • (e) if there were CGT assets and CGT events happened to them, then the first element of the cost base for the assets ought not include amounts that are deductible for QFL; and
   • (f) if there were assets and CGT events did happen to them then the market value substitution rule applies such that there was not a capital loss.

1. The issues that need to be resolved are:
   • (a) whether the transfer debt of $2,037,482, or rights of indemnity or subrogation to recover that amount, existed;
   • (b) whether the intercompany balance debt of $614,140 existed;
   • (c) if the debts or rights of indemnity or subrogation existed, whether they were CGT assets;
   • (d) if the debts or rights of indemnity or subrogation existed and were CGT assets, what was the first element of their cost base?[13];
   • (e) related to issue 4, whether the market value substitution rule applies to set the first element of the cost base of these assets and/or whether the otherwise deductible rule[14] applies to restrict the first element of cost base claimed;
   • (f) whether there was a CGT event; and
   • (g) whether the administrative penalty imposed at 25% was correctly imposed.

QFL and ABC: business activities and arrangements

1. The competing contentions require consideration of QFL and ABC's business activities and arrangements, and to an extent QCPL's as well, over a number of years up to and including the 2000 year.
2. The general features of the business carried on by QFL and ABC are outlined at paragraph [4] above.
3. The path by which QFL and ABC reached the 1998 arrangements began with a partnership of Di Van Luong, Van Than Luong and Tung Ma, who began a photo development business in 1987 that traded as L & D One Hour Photos. That business grew.
4. In 1991 a corporate group comprising, relevantly, QCPL, QFL and ABC and another company, Oz Photos, was formed. QCPL was to be the parent company, QFL and Oz Photos were to be the retail trading companies selling to customers of different retail chains and ABC was to be the manufacturer. QFL was the principal retail trading company taking approximately 90% of the finished product ABC produced.
5. The corporate group was structured as such because of perceived difficulties in determining the appropriate taxable value for sales tax purposes if QFL both manufactured and sold by retail, as different levels of discount were offered to retail customers of different retail chains.
6. Also in 1991 what became a lasting and mutually fruitful relationship began between Agfa and the Quality Group. Over time the Quality Group's photographic businesses grew and the relationships with Agfa deepened.
7. In February 1992, ABC (and a range of related parties) entered supplier agreements with Agfa. In 1993 and 1997 ABC acquired photo processing and development equipment made by Agfa (or one of its subsidiaries). In May 1998, QCPL, QFL, ABC and a number of parties as guarantors entered a replacement supplier agreement with Agfa. Pursuant to this agreement QCPL, QFL and ABC were jointly and severally liable to meet outstanding obligations to Agfa.[15] Also in May 1998 a debenture charge was given by QCPL, QFL and ABC together with guarantees from a number of parties.
8. In 1997 ABC began leasing new, state of the art, photograph development equipment (Dimax equipment) manufactured by Agfa or one of its related companies. It procured the Dimax equipment through arrangements entered with Agfa and Copal. Acquiring the Dimax equipment was to have significant impact for the Quality Group, QFL and ABC in particular. The Dimax equipment was far superior to that previously used, allowing production of greater volumes of higher quality prints at greater speed. The Dimax equipment had twelve times the capacity of other equipment with the capability of producing 40,000 prints per minute. It can be inferred that it was necessary for ABC to acquire this type of technology to remain competitive.
9. The Dimax equipment allowed QFL and ABC to expand their market share significantly. ABC had the only such machine in Australia which allowed QFL to take over large, previously Kodak tied, retail chains such as the Amcal Chemist chain and Bi-Lo supermarkets. The increased costs and losses that the Dimax equipment caused for ABC were mirrored by material increases in QFL's income. With the Dimax equipment the Quality Group grew from an organisation that started as a backyard business processing 100 rolls of film per week, to an organisation in 2004/2005 employing 500 people across Australia, processing more than 100,000 rolls of film per week, with turnover in excess of $35 million per year and having 90 to 95% of the Australian market for developing and processing analogue films. By 2002, Kodak's share of that market had dropped to between 5 and 10%.
10. Commencing in late 1997 (and continuing into 1998) the Quality Group began working on a proposal to start the same kind of business in Vietnam and took steps to advance the proposal. QFL contends that it was the intention that ABC would carry on business there. It will be necessary to consider the steps that were taken in this endeavor in more detail when considering the applicability of the market value substitution rule.
11. The agreements with Agfa were important for ABC and QFL. Agfa supplied materials and equipment required for the ABC's activities and provided discounts and credit terms that assisted ABC and QFL with cash flows required to finance their business activities. The agreements were also important for Agfa. The Quality Group became Agfa's largest customer in Australia and the combined QFL, Oz Photos and ABC businesses, which were all supplied by Agfa, grew to have in excess of 90% of the Australian market for developing analogue photographic prints before digital photographic technologies became prevalent.
12. As the Quality Group's photographic business grew, its cash flows were strained. Agfa assisted with these pressures allowing discounts and time for payment. Not surprisingly Agfa and Quality Group personnel met from time to time to discuss their business arrangements and relationships. Agfa was concerned that its position should be protected as it was extending considerable financial accommodation to the Quality Group; ABC in particular.
13. There is some controversy between the Commissioner and QFL as to the level and content of Agfa's concerns with the Quality Group. The precise terms of the discussions between Agfa and Quality Group personnel and exactly what views were expressed is not clear on the evidence. Nevertheless, it can be accepted that:
    • (a) from time to time Agfa may have expressed its concerns with how affairs within the Quality Group were conducted; and
    • (b) those concerns related at least partly to both the split structure of the QFL and ABC businesses (with QFL generating substantially all of the Quality Group revenues and ABC bearing substantially all of the liabilities - significantly to Agfa); and QFL and ABC's sales tax position as a consequence of the split structure.
14. Agfa's concerns caused it to procure an independent review of the finances and arrangements of the Quality Group that was conducted by Deloitte. Following that review Agfa had a preference for the QFL and ABC businesses to be consolidated in one entity.
15. During the year ended 30 June 1998 QFL received advice from its accountants that included advice as to the steps that would be required to transfer ABC's assets and liabilities to QFL. QFL's accountants advised that it would be necessary to arrange with the lessors of processing equipment for those leases to be assigned to QFL.
16. Following discussions with Agfa personnel, shortly before 30 June 1998 QFL and ABC directors decided to amalgamate the ABC and QFL businesses on 1 July 1998.
17. In what was accepted as a transfer of ABC's business, ABC's assets and liabilities were to be transferred to QFL at their book values. The reported value of ABC's liabilities exceeded the reported value of its assets by $2,641,622, the sum of the intercompany balance debt and the transfer debt. Given the intercompany balance debt had already been recognized a further debt of $2,037,482 was recorded in ABC's financial records as a debt (a loan) from QFL to ABC in a journal entry dated 1 July 1998. In effect, ABC recognized that it had to pay QFL to take responsibility for its obligations to the extent they exceeded the book value of the assets transferred. Whether this obligation is a loan or simply a debt is not material to the present outcome.
18. The transfer was not attended with formal steps that might be expected as between independent parties:
    • (a) the values at which the assets were transferred were the written down values as at 1 July 1998;
    • (b) formal valuations of ABC's assets were not undertaken;
    • (c) a transfer agreement document was not produced;
    • (d) formal steps of obtaining creditor and lessor consent were not taken; and
    • (e) there are no directors' minutes for the transfer from ABC, and the resultant transfer debt to QFL; and
    • (f) interest was not charged by QFL in respect of the transfer debt.
19. From 1 July 1998 QFL conducted the activities formerly conducted by ABC with accounting entries made to QFL and ABC's financial records reflecting the transfer. QFL became the employer of the staff required to conduct those activities.
20. For 1999 and subsequent years, QFL recognized the assets and liabilities not as yet discharged that were formerly recognized in ABC's financial records. It reported the results of the activities that included the manufacturing activities previously conducted by ABC. Similarly, for the 1999 and 2000 years ABC recognized its indebtedness to QFL and no longer recognized its former assets and liabilities.
21. ABC did not trade after 30 June 1998 and on 26 August 1998 QFL advised Agfa that ABC is defunct from 1/07/98 and that it would remain as a non-active company.
22. In March 2000 QFL released the transfer debt and the intercompany balance debt. The operative part of the release was:

...[QFL] releases and forever discharges the Debtor from all obligations, now or in the future, to repay the debt owing by the Debtor to QFL Photographics Pty Ltd the sum of $2,651,673 (the "Loan") and surrenders and renounces absolutely all claims and interests whatsoever and however arising which the Company may have as creditor or otherwise against the Debtor in respect of the Loan, or any part thereof

1. ABC was voluntarily deregistered on 28 November 2005.
2. In the 2003 and 2004 years of income QFL was paid a total of $3.3 million to sign an exclusive supply contract with Kodak. That amount was reported as a capital gain.
3. QFL and ABC's financial performance and financial position over the period from 1993 to 2003 is of some significance in evaluating the issues in dispute. Appendices B and C to these reasons tabulate various indictors of financial performance and position of QFL and ABC as shown in their financial statements.

Issue 1 Whether a debt of $2,037,482, or rights of indemnity or subrogation to recover that amount, contended for by QFL, existed.

1. The Commissioner contends there is insufficient evidence to conclude that a transfer (in a non legal sense) of ABC's assets and liabilities to QFL occurred so that a loan made by QFL to ABC or a debt owed by ABC to QFL should not be recognised. The Commissioner contends:
   • (a) there was no transfer of business agreement;
   • (b) there was no valuation process;
   • (c) the transfer was supposedly effected by book entries in the companies' accounts;
   • (d) the principal asset allegedly transferred was the leased equipment, but the terms of the leases required third party approval to assign and a formal assignment of the lease was not executed;
   • (e) debts cannot be assigned at the will of the debtor;
   • (f) there is no satisfactory evidence as to the identity of ABC's creditors (although it is clear that Agfa was not the only creditor); and
   • (g) there is no evidence that ABC's creditors consented to a release of ABC as debtor.
2. Each of these contentions may be accepted as true as a matter of fact, but they do not support the conclusion contended for.
3. In the present circumstances, the first two of the Commissioner's challenges to the transfer of ABC's assets and liabilities ought not be given significant weight, if any at all. Absence of a formal business transfer agreement and valuation of assets are not determinative of whether there was a transfer of ABC's assets and liabilities.
4. Arrangements between closely related entities can be expected to be transacted without the same level of documentation that independent parties might bring into existence. Just because there is an absence of formality in the manner in which a transaction is effected does not mean the transaction was not effected; and it is not for the Commissioner, or the Tribunal on review, to dictate to the taxpayer the manner in which transactions ought be effected.
5. It is for the Commissioner, and the Tribunal on review, to take the transactions as effected and determine how the Assessment Act applies to them. Moreover, the scheme of the Assessment Act recognises that parties who do not have an arm's length relationship might enter transactions on terms, or in a manner, different to those who do have an arm's length relationship. The market value substitution rule is one illustration. The scheme of that and similar rules is that the transfer of the rights involved in the transaction as entered is to be recognised and the Assessment Act substitutes values to be attributed to those transactions for the purposes of determining tax liability where the threshold conditions enlivening their operation are met.
6. Similarly, the contention that the transfer was effected by making entries in the books of account of ABC and QFL again is not determinative. If entries in financial records are the means of recognising an agreement to effect a transaction that they represent, then that transaction is to be recognised for taxation purposes. Here there is no allegation that the entries are a sham. Moreover, there is evidence, noted below, that demonstrates that the entries reflect a consensus among those who controlled ABC and QFL that the transfer would be effected. The book entries in the present circumstances were both evidence of, and part of the means by which, the transaction agreed to be entered was in fact carried out.
7. The Commissioner's remaining criticisms have an appearance of substance but on a deeper analysis they, too, are not determinative. Of itself, the fact that a debtor cannot assign a debt and the fact that creditor and lessor consents were not obtained does not mean that as between QFL and ABC contractual rights were not created. There is no reason why an agreement for consideration between QFL and ABC to the effect that, as between those companies, QFL would be responsible for ABC's liabilities and debts to third parties ought not be recognised. In essence that was the type of transaction that was considered by the courts in the litigation that concluded with the decision in F.C. of T. v. Orica Limited[16] which has been described[17] as an in substance debt defeasance transaction. In such a transaction the primary obligations of the lessee, debtor or obliged party to the relevant lessor, creditor or obligee remain on foot. That type of transaction can be effected without the involvement of the relevant lessor, creditor or obligee. That is what has occurred as between QFL and ABC.
8. Accordingly, if there is sufficient evidence to demonstrate that as between QFL and ABC there was an agreement that QFL would be responsible for ABC's liabilities then ABC had rights that were enforceable against QFL and QFL had rights to enforce the executory consideration provided by ABC; namely the promise to pay the transfer debt. That proposition is supported by:
   • (a) the consistent evidence of all QFL in-house witnesses that the business was to be transferred as at 1 July 1998;
   • (b) QFL conducting the activities previously conducted by ABC;
   • (c) Agfa being informed of the change;
   • (d) the QFL financial statements reflecting the fact that it bore the cost of and enjoyed the benefits of carrying on the activities previously undertaken by ABC;
   • (e) the ABC financial statements reflecting the fact that it no longer carried on business from July 1998; and
   • (f) the financial statements of both companies reflecting the agreement that ABC would pay QFL the shortfall of the value of assets transferred as against the value of ABC's liabilities assumed by QFL.
9. It follows that the conclusion to be reached is that upon the transfer of ABC's assets and liabilities to QFL, on the terms that that happened, the transfer debt of $2,037,482 owed by ABC to QFL came into existence.
10. This conclusion impacts on the findings that ought be made in relation to the alternative assertion that rights of indemnity or subrogation to recover $2,037,482 existed as contended for by QFL.
11. If there were such an asset then QFL faces significant difficulties in establishing that a capital loss arose. First, there were co-sureties who were also liable to meet ABC's debts and QFL had rights against them. Second, the evidence of the identity of all of the creditors to whom ABC owed money and of QFL actually meeting ABC's obligations so as to crystallize any right is not clear. Third, the evidence does not show that a CGT event happened to any such right in the 1998 year. The terms of the release do not specifically address any rights of subrogation or indemnity and it is possible that any such rights had not crystallized by the time the release was executed. These factors are such that it is not clear that an asset in the form of a right of indemnity or subrogation came into existence or that a CGT event happened to it such that a capital loss arose.
12. The conclusion to be reached is that there was no right. Rights of subrogation are rights in equity recognised and enforced to do justice between a party who pays obligor's obligations and the obligor. Among other things, these rights ensure that an indemnified party, such as an obligee, does not enjoy a double recovery of the one entitlement, namely from the obligor and from a third party.
13. The Tribunal finds that there was a contractual agreement between QFL and ABC that ABC would pay QFL for discharging ABC's obligations. In such circumstances there is no need to resort to equitable principles to ensure ABC as an obligor would be relieved of its obligation to external creditors.

Issue 2 Whether a debt of $614,140 contended for by QFL existed.

1. The Commissioner's contention in relation to this debt relies on lack of arm's length dealings and the unreliability of QFL and ABC's financial records for a number of reasons including inconsistencies in what they report.
2. The debt shown in the financial statements of the companies accumulated on account of amounts paid by QFL on ABC's behalf, reduced by ABC's charges to QFL for developing films and producing photographic prints. The Commissioner contends, and QFL accepts, that the amounts ABC charged for its services did not cover its costs following the lease-financed introduction of the Dimax equipment. The lease charges for that equipment which were paid to the lessor by QFL, and charged to ABC, were a substantial increase in ABC's operating costs. The Commissioner also contends, and QFL accepts, that ABC could have increased its charges to cover its costs. The first of these facts is borne out by the pattern shown in the movement of the intercompany balances owed before and after the Dimax equipment was installed. Before the installation the amounts ABC charged QFL for the services it provided exceeded the amounts that QFL paid on its behalf with the effect that the intercompany account generally showed an amount owed by QFL to ABC. That reversed after the Dimax equipment was introduced.
3. The observations at paragraphs [43] and [44] above apply equally here. Once again, this is not an occasion for telling a taxpayer how it should conduct its business affairs and the fact that two related parties may have chosen to conduct their dealings is a matter for them. If ABC charged fees for services that did not cover its costs and which produced a net amount owed by it to QFL after setting those charges off against amounts that QFL paid on its behalf that is a matter for it. It is that dealing between QFL and ABC that needs to be analysed to determine the tax liability that arises. The Assessment Act includes rules that allow adjustment to values and amounts transacted in non arm's length dealings. If those rules apply then taxation liability is determined by reference to values and amounts other than those actually transacted. The market value substitution rule is one illustration of such a rule.
4. The evidence is unequivocal that QFL paid amounts on ABC's behalf and that ABC charged amounts for its services and that as a result of these charges an amount was recorded as owing. That was the manner in which the two companies dealt with each other and from those intercompany dealings a debt arose as evidenced by the financial records. Again there is no suggestion of sham and the entries made in QFL and ABC's financial records are evidence and recognition of the amount ABC owed QFL.
5. The Tribunal finds that ABC owed QFL the intercompany balance amount of $614,140 as at 30 June 1998.

Issue 3 If the debts or rights of indemnity or subrogation contended for by QFL existed, whether they were CGT assets

1. A CGT asset includes any kind or property and a legal or equitable right that is not property.
2. A debt is at least a legal or equitable right and therefore the Tribunal finds that the intercompany balance and transfer debts meet the CGT asset definition.

Issue 4 If the debts' rights of indemnity or subrogation contended for by QFL existed and were CGT assets, what was the first element of their cost base?

Issue 5 Related to Issue 4, whether the market value substitution rule applies to set the cost base of these assets and/or whether the otherwise deductible rule applies to restrict the first element of cost base claimed.

1. There can be no controversy that QFL and ABC did not share an arm's length relationship. In these circumstances parties who do not share an arm's length relationship can nevertheless deal at arm's length when acquiring a CGT asset.[18] Accordingly the present circumstances invite enquiry as to whether their dealings were at arm's length in relation to both debts and issues 4 and 5 are best dealt with together.
2. QFL has three bases on which it might be said that the market value substitution rule does not apply:
   • (a) that there were prospects of the debts being paid from the proceeds of a new business venture in Vietnam (the Vietnam prospects basis);
   • (b) although not raised in either QFL's submissions or Statement of Facts and Contentions but raised squarely in the evidence of one of its directors, that the value of the assets ABC transferred to QFL together with QFL's goodwill could be sold raising sufficient proceeds to pay out all debt (the goodwill basis); and
   • (c) that QFL was acting in its own interests securing a vital source of supply and nurturing a critical relationship with Agfa and in that sense was acting on an arm's length basis (the own interests basis).

1. QFL relies on the prospects of the Vietnam business generating sufficient profits to allow all of ABC's debts to be repaid. For this to be s foundation for the market value substitution rule not to apply it is necessary to consider the extent to which this initiative had developed as at 1 July 1998 and determine if an arm's length party would have lent money to ABC relying solely on funds from this source to make full repayment of the debt.
2. The following steps were taken for the proposed Vietnam business:
   • (a) a representative of the Quality Group traveled to Vietnam in October 1997, March 1998 and September 1998 to explore business possibilities in Vietnam including conducting market research and speaking with industry contacts;
   • (b) the Quality Group obtained some Vietnam market data from Agfa on 14 August 1997;
   • (c) representatives of the Quality Group had secured indicative support from Agfa for the proposed business;
   • (d) representatives of the Quality Group obtained AGFA Hong Kong's photo price list for 1997;
   • (e) in July 1998 the Quality Group prepared a profit forecast for 1999, 2000 and 2001;
   • (f) on 27 July 1998 a representative of the Group applied to the Vietnamese Government to obtain approval to establish a business in Vietnam; and
   • (g) on 20 November 1998 the Vietnamese Government advised that the Group would need to provide a detailed business plan and reconsider its competitive pricing policy before the Government would consider approving the business proposal.
3. While there can be little doubt that serious enquiries were made to commence business in Vietnam, it must be recognised that as at 1 July 1998 it was not known if or when the business would commence, or what controls there would be in repatriating funds to Australia given Vietnam's different economic and political setting.
4. For both the transfer and intercompany balance debts there is not any expert valuation or banking industry evidence. The Tribunal has to form a view as to whether a market value can be determined on the material available, or whether QFL has discharged its burden of establishing the first element of the cost base for the intercompany balance and transfer debts.
5. Where there are dealings between parties who do not share an arm's length relationship, the scheme of Parts 3-1 and 3-3 of the Assessment Act call for an examination of the terms of the dealing. And the requirement to substitute the market value of a CGT asset for the actual amount paid informs the principal aspect of the dealing that needs to be examined - the price paid or consideration given and whether that is a market value. That value is the value at which an independent willing but not anxious purchaser of the asset and a similarly disposed vendor would meet to conclude a sale of the asset.[19] In this case the rule might be expressed as would a willing but not anxious lender lend $2,641,622 to ABC in ABC's circumstances or would a willing but not anxious person pay $2,641,622 for an assignment of a debt obligation of that amount owed by ABC in ABC's circumstances.
6. Even if it can be accepted that Agfa was keen to support ABC in its Vietnam initiative which is supported by the evidence, and not the Quality Group more generally or those behind the Quality Group, it remains difficult to accept that an arm's length party would pay any amount at all to acquire a right to be paid $2,641,622 by a company in ABC's circumstances. It can be accepted that ABC had a vision to start a business in Vietnam; it had an understanding of the business and political setting in Vietnam and a track record of successful development and conduct of the same kind of business in Australia. Nevertheless, at the time ABC had liabilities of $2,641,622 and did not have any assets or any current income producing activities. The steps taken in furtherance of the Vietnam vision were ultimately abandoned.
7. The Tribunal is not satisfied that QFL has established an arm's length party would lend money in ABC's circumstances.

1. The second basis on which QFL relies to support its contention that the market value substitution rule does not apply, is the proposition that had the Dimax equipment been sold together with QFL's goodwill to a competitor, the sale proceeds would have been sufficient to discharge all of ABC's liabilities and as such at the time the intercompany balance debt arose, ABC ought be regarded as capable of paying the debt.
2. This foundation for the entitlement to the first element of cost base contended for suggests that goodwill had value and that it was owned by QFL and available to show the worth of ABC. If the goodwill was owned by QFL then QFL's contention is misconceived. If, however, goodwill was owned by ABC then that could affect the analysis in a material way.
3. Accordingly, it is necessary to consider whether ABC had goodwill and that calls for examination of the impact of the Dimax equipment and the circumstances of the intercompany charges.

1. As explained above the intercompany balance debt arose as the product of various expenses being paid by QFL on behalf of ABC and ABC charging QFL for the products and services it provided to QFL. The amounts credited and debited to the QFL and ABC intercompany accounts were a form of working capital provided by one to the other.
2. There was no formal loan agreement documentation for these intercompany arrangements and interest was not charged to ABC by QFL on amounts reported as owed.
3. From 1993 to 1997 the balance on the intercompany account was in favor of ABC and in 1998 that balance reversed. In 1998 the intercompany charge for the products and services supplied by ABC to QFL were insufficient to cover its costs of operation as the businesses grew.
4. Various witnesses called by QFL gave unchallenged evidence to the effect that:
   • (a) the intercompany charges were insufficient to cover liabilities, principally to Agfa;
   • (b) ABC's accumulated losses as at 30 June 1988 were generated by ABC being unable to meet additional liabilities sustained because of the increases in business volumes processed and the new equipment acquired to do so from the proceeds of sale of prints to QFL;
   • (c) ABC's losses occurred at a time of expanding market share and those losses enabled QFL to increase its profitability;
   • (d) there was little advantage in increasing the product cost to QFL as the tax to be paid on profits would just be shifted from QFL to ABC. This conclusion warrants more critical examination because it overlooks (whether conveniently or otherwise) one distinct advantage the intercompany charges secured for the Quality Group - reduced sales tax liabilities. By the combination of the division of activities between QFL and ABC, the sales of finished product by ABC to QFL and the depressed charges levied for that product, sales tax liability was lower than it otherwise might have been. It can be assumed that for every additional dollar that ABC could have charged for the products it provided, 22.5 cents additional sales tax liability would have arisen. The consistent, and repeated, evidence of the insignificance of any changes to the intercompany charges ABC levied makes no mention of this fact and stands in contrast with the QFL's admission that charges could easily have been increased to absorb losses that were being generated;[20]
   • (e) if ABC's charges to QFL were less than could have been sustained that would have the effect of depressing the value of ABC's goodwill; and
   • (f) if the value of ABC's goodwill was depressed that would mean that the sale transaction which recorded assets in excess of $4 million and liabilities in excess of $6 million does not truly reflect the value that was transacted between the two companies.
5. The evidence of the approach to intercompany charges was succinctly summarised by Counsel for QFL who observed:

... ABC did not pass to QFL all of its manufacturing costs and it incurred losses as a result of that. Now, it would have been quite easy for ABC to simply increase its charges and absorb all its losses and necessarily those charges would have been deductible on revenue account insofar as QFL was concerned. But that didn't happen and that was one of the reasons why a loss eventually occurred in ABC and that loss was on capital account

1. At this point it is necessary to observe that the charges ABC levied for the services it provided were insufficient to meet its own cost of goods sold from 1996 to 1998. The excess of ABC's cost of goods sold over its sales revenue for those years was $1,262,302.00. ABC's profitability declined after the Dimax equipment was acquired at the same time that QFL's sales revenue and profitability increased as shown in Appendices B and C. The Dimax equipment played a pivotal role in generating increased revenues which were enjoyed by QFL.

1. Two telling pieces of evidence concerning the existence of goodwill are the following statements of one of the QFL and ABC directors:

The Dimax machine enabled ABC to send the MSC-3 machines it had used before to other states because the Dimax machine had twelve times the capacity. This in turn enabled QFL to market to national chains of agents such as My Chemist, Amcal and to supermarkets like Coles and Safeway. The Dimax system was considerably in advance of anything Kodak had and saved ABC considerable production costs in comparison to the costs of running the MSC-3 machines on a rational (sic) basis. ... The downside, however, was the fact that ABC's liability for the cost of consumables and for machinery costs to Agfa increased dramatically from a loss of $719,000.00 in 1997 to $2,274,000.00 in 1998. QFL's income, however, increased by 30% and by a further 65% in 1999. These increases were only made possible by the purchase of the Dimax machine. ...

My belief that ABC could, as at 1 July 1998, repay QFL for the liabilities associated with the transferred assets ($2,037,533) was based not only upon my view that ABC did, as at that time, have a profitable future in 1999 and beyond. Even if ABC could not have repaid that debt, QFL would have been able to sell the assets transferred from ABC as at 1 July 1998 and QFL's goodwill to a competitor for a price large enough to cover all the ABC transferred liabilities. As at late 1998, the Dimax System, MSC3 printers, C41 processors and invoicing systems were the only ones of their type in Australia. These machines were the reason why QFL and Agfa had been able to reduce Kodak's market share from 90% plus as at 1990 to less than 50% in 2000. If those assets had been put onto the market together with QFL's goodwill, I believe QFL would have received a price large enough to cover the ABC transferred liabilities from competitors like Statewide Photos, Quality Photographics, Kodak or, even, from Agfa itself which might have vertically integrated from supplier to wholesaler. Between 1998 and 1999, QFL's income increased from $14 million to $23 million and then increased further to $28 million in 2000.

1. It is evident that the Dimax System, MSC3 printers, C41 processors and invoicing systems were a significant contributor to QFL's profitability and can be seen as a material contributor to, or source of, QFL's goodwill. However, before the July 1998 transfer, these machines were owned by ABC, a company whose profitability had been suppressed by a level of charge for the goods and services it provided that did not even cover its cost of goods sold as noted above.

The combined impact of the intercompany charges and the Dimax equipment

1. The intercompany charging regime depressed recognition of the value of goodwill in the ABC business which might otherwise have been seen if charges were put on a commercial footing. This, combined with the effect the Dimax equipment had on the QFL business, leaves an important question hanging:[21] what did QFL really pay for in accepting liabilities of $2,641,622 in excess of the book values of tangible assets that it acquired?
2. The transfer allowed QFL to commence carrying on those activities formerly carried on by ABC which were the entirety of ABC's business and were an integral part of QFL's business. Without these activities, or their end product, QFL would not have had anything to sell. Before the transfer the combined result of QFL and ABC's activities were profitable. After the transfer QFL's enlarged business was profitable. It might be said that in return for accepting net liabilities of $2,641,622 QFL acquired all of ABC's assets which included goodwill suppressed in value by reason of the intercompany charges adopted. One way of looking at the transfer of ABC's assets and liabilities, leaving a company owing $2,641,622 without assets and current means of paying its debts, would be that the shortfall of book values of assets transferred against liabilities assumed was an acquisition of goodwill of that amount.
3. In a very real sense, it can be said that in return for assuming responsibility for ABC's liabilities, QFL received assets of a book value of just over $4 million, complete ownership of a source of its goodwill that it had not previously owned and a debt owed by a company without the immediate wherewithal to pay any of it and no present income earning activities.
4. It is difficult to see a party purchasing ABC's assets in excess of their book values unless there were other benefits associated with the acquisition such as a consolidation of sources of goodwill in the one entity.
5. While goodwill is an asset that is connected with (or not severable from) the carrying on of a business and can only be passed from one entity to another in conjunction with a business transfer, if it exists it is a CGT asset and there was a transfer of a business to QFL.
6. If it is true that all of ABC's liabilities could have been discharged upon a sale of its tangible assets and an element of goodwill then it could be said that the business transfer produced for QFL an acquisition of those assets recognised in ABC's balance sheet, a valuable source of goodwill formerly owned by ABC and debts owed by a company that was stripped of all assets and current income earning activities without any immediate capacity to pay them and a hope that new initiatives, if they came to fruition, would generate the income required to do so.
7. Rather than assist QFL's position the introduction of concepts of goodwill tends to suggest that QFL would have a first element of cost base equal to the amount of ABC's liabilities it assumed but that cost base would be referrable to the assets noted at paragraph [83] above.
8. In these circumstances s 112-30 of the Assessment Act would call for apportionment of the first element of cost base between the debts and the goodwill acquired. The appropriate proportions would be by reference to the value of each asset at the time of acquisition. Accordingly, the discussion at paragraphs [62] to [69] above apply to inform what the market value of the debts would be.

1. The third basis on which QFL relies to support its contention that the market value substitution rule does not apply has a number of links in the reasoning. First, QFL had a strong and critical relationship with Agfa. Second, the Agfa relationship was an arm's length one. Third, QFL was totally reliant on ABC for the product it produced. Finally, meeting ABC's liabilities served to preserve and protect QFL's relationship with Agfa and to support its source of finished product. In that sense QFL was acting as an arm's length party would in meeting ABC's liabilities.
2. The market value substitution rule does not look to see whether there is a commercial justification for entering a transaction in a global sense. It looks to market values of the assets that move from one party to another. If that were not the case, the rule would not realign the consideration given by one independent party to another for a bundle of assets where that consideration is skewed heavily, and without reference to real values, in favour of particular assets, for example to assets acquired before 20 September 1985.
3. The system looks at the value of CGT assets on acquisition and QFL's third foundation for not applying the market value substitution rule is not accepted.

1. Having reached these conclusions it is not strictly necessary to consider the otherwise deductible rule. However, it was addressed by the parties.
2. Table 1 shows the liabilities QFL assumed as disclosed in ABC's 1998 year financial statements:

Borrowings (excluding the intercompany balance debt) of $682,106 being:

1. Table 2 shows the assets QFL acquired as disclosed in ABC's 1998 year financial statements:

1. Of the liabilities assumed (in Table 1), it would be expected that QFL would be entitled to deductions for the amounts set out in Table 3 below.

1. The excess of liabilities assumed over the proportion of those liabilities for which QFL could be expected to be allowed a deduction is $2,088,383.00 which is $50,901.00 in excess of the transfer debt.
2. QFL contends that there is sufficient in the liabilities assumed for which deductions would not be available to allow the full $2,037,482 as the first element of cost base for the transfer debt.
3. The Commissioner contends that there ought not to be any first element of cost base as the liabilities assumed ought not be aligned to particular assets acquired and that for all of the liabilities assumed deductions either have been by ABC or will be taken by QFL such that double benefits under the tax system would be allowed.
4. Absent specific rules to bring about the effect for which the Commissioner contends, which (beyond the otherwise deductible rule) the Commissioner has not identified, there is no general proposition that a taxpayer is not allowed any amount as the first element of cost base on the basis that a deduction has been allowed in respect of that amount to another taxpayer.
5. In the present circumstances there is sufficient evidence to conclude that particular liabilities can be associated with particular assets (the lease and hire-purchase liabilities assumed with the property plant and equipment). Those liabilities would form the basis of allowable deductions for QFL either immediately or over time. A deduction would be available as and when employee entitlements are satisfied. And a deduction is allowable for the cost of inventory. Accordingly, to the extent of the lease and hire-purchase liabilities assumed and a proportion of the remaining liabilities assumed, equal to the amount of deductions for inventory acquired and employee entitlements assumed, QFL will not have any first element of cost base. After these parts of the liabilities assumed are recognised, the remaining parts can be referrable to the transfer debt.
6. The conclusion to be reached is that had there been first element of cost base after the market value substitution rule, that element of cost base would not have been reduced by the otherwise deductible rule.

1. This issue can be disposed of summarily. The release extinguished the debt owing by the Debtor to QFL Photographics Pty Ltd the sum of $2,651,673. That constitutes CGT event C2.

1. The Commissioner's objection decision was that QFL had not adopted a reasonably arguable position and a finding concerning whether reasonable care had been taken was not made.[22] . The Commissioner's submissions were that penalty at the rate of 25% is appropriate because QFL failed to take reasonable care.[23] The allegation that QFL failed to take reasonable care is that the advice received was limited scope advice.
2. QFL contends that it took reasonable care and adopted a reasonably arguable position such that no penalty is payable. Implicit in this contention is that QFL also had adopted a reasonably arguable position. QFL contends that advice was taken, QFL acted on that advice and that both QFL and its taxation advisor had taken reasonable care.
3. Given the quantum of the capital loss QFL contended for, it is necessary to satisfy the reasonably arguable position test to avoid penalty. The underlying policy of the reasonably arguable position threshold is that for larger amounts of deductions, or capital losses claimed, a higher standard is required than that called for by the reasonable care test.[24]
4. The topics on which QFL took advice are not clear and appear to be limited in scope. Put another way, QFL has not established the scope of the advice sought or the instructions given. In these circumstances QFL has not demonstrated that it has taken reasonable care.
5. To satisfy the reasonably arguable position test it is necessary to demonstrate that the position adopted, whilst wrong, was about as likely as not to be correct. This requires a taxpayer to have adopted a position that is supported by a reasoned case that could be put with some prospect that it might be accepted.
6. The conclusion to be reached in this matter is that QFL did not have a reasonably arguable position. There can be no doubt that the parties did not share an arm's length relationship. Further, there can be no doubt that the dealings which produced ABC's inability to pay its debts were the product of uncommercial dealings that prevented ABC from recovering its costs of goods sold for a three year period while its business activities allowed QFL to enjoy substantial increases in its revenues.
7. Focusing on QFL's primary case, the Vietnam proposed venture may have given cause for optimism, but optimism as to a source of money to pay debts is not usually a basis on which an independent party would make a new loan in excess of $2.6 million to another party. Such a basis for adopting a position that the first element of cost base is the amount of the debts is not one that could be advanced with an expectation that it could succeed.
8. Accordingly, QFL has not demonstrated that it has adopted a reasonably arguable position.

I certify that the one hundred and ten [110] preceding paragraphs are a true copy of the reasons for the decision herein of Mr Frank O'Loughlin, Senior Member

Solicitor for the Respondent ATO Legal Services Branch

Income Tax Assessment Act 1997 (Cth)

capital loss within the meaning of the s.104-25(3) of the Assessment Act

CGT assets within the meaning of the s.108-5 of the Assessment Act

The Commissioner of Taxation of the Commonwealth of Australia

Copal Systems (Australia) Pty Ltd, a finance company subsidiary of Agfa

first element of cost base the first element of cost base within the meaning of s.110-25(2) of the Assessment Act

The deed executed in March 2000 pursuant to which QFL released ABC of debt obligations $2,651,673

The net debt of $614,140 said to have arisen as at 30 June 1998 by reason of QFL paying expenses on behalf of ABC which exceeded charges levied by ABC for supply of finished product and services to QFL

The debt of $2,037,482 said to have arisen as at 30 June 1998 by reason of the transfer of ABC's assets and liabilities to QFL as at 30 June 1998.

Operating expenses (total revenue less operating profit)

Operating expenses (total revenue less operating profit)

[1] Appendix 1 sets out a list of defined terms which are footnoted when used first in these reasons.

[16] [1998] HCA 33; (1998) 194 CLR 500.

[17] Including by the Commissioner - See TD 2008/22 at [19].

[18] Trustee for the Estate of Furse (No 5) Will Trust v F.C. of T. (1990) 91 ATC 4007, Granby Pty Ltd v FCT (1995) 129 ALR 503.

[19] Spencer v Commonwealth [1907] HCA 82; (1907) 5 CLR 418.

[21] A question not raised by the Commissioner and not addressed by QFL, but canvassed during the hearing.

[22] Objection decision p13-17, T18-22.

[23] Commissioner's SFIC [95], written submissions [142] and transcript (T252/3).

[24] Walstern v F.C. of T. [2003] FCA 1428 at [106].