RCI Pty Ltd v Commissioner of Taxation

RCI Pty Ltd v Commissioner of Taxation - [2010] FCA 939 - FCA 2010 case summary — Zoe

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REASONS FOR JUDGMENT 1 The applicant, RCI Pty Limited, appeals from the respondent's objection decision disallowing an objection against an amended assessment for the 1998/1999 tax year, which for the applicant ended on 31 March 1999 (in lieu of 30 June 1999). The amended assessment was issued by the respondent to give effect to his determination made on 16 March 2006 to include in the applicant's assessable income for the relevant year the sum of A$478,237,746 pursuant to Part IVA of the Income Tax Assessment Act 1936 (Cth) (the ITAA 1936). 2 At issue is the applicant's capital gain derived from the disposal of its shares in James Hardie Holdings (Inc) in October 1998. The Commissioner contends that a dividend payment of US$318,000,000 made, pursuant to a scheme within the meaning of Part IVA, to the applicant on 31 March 1998 reduced the value of the shares and, commensurately, the applicant's capital gain on the subsequent disposal of the shares. The key provision of Part IVA is s 177D which provides: This Part applies to any scheme… where: (a) a taxpayer (in this section referred to as the relevant taxpayer) has obtained, or would but for section 177F obtain, a tax benefit in connection with the scheme; and (b) having regard to: (i) the manner in which the scheme was entered into or carried out; (ii) the form and substance of the scheme; (iii) the time at which the scheme was entered into and the length of the period during which the scheme was carried out; (iv) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme; (v) any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme; (vi) any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme; (vii) any other consequence for the relevant taxpayer, or for any person referred to in subparagraph (vi), of the scheme having been entered into or carried out; and (viii) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in subparagraph (vi); it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for the purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme or of enabling the relevant taxpayer and another taxpayer or other taxpayers each to obtain a tax benefit in connection with the scheme (whether or not that person who entered into or carried out the scheme or any part of the scheme is the relevant taxpayer or is the other taxpayer or one of the other taxpayers). 3 In these reasons it is necessary to discuss transactions involving companies in the James Hardie group of companies. For convenience I will adopt the following abbreviations: James Hardie group of companies JHIL Group The JHIL Group had subsidiaries and operations in Australia and in the United States. James Hardie Industries Limited (now ABN 60 Pty Ltd) JHIL Australian resident company and, until October 2001, the ultimate parent company of the JHIL Group. James Hardie (Holdings) Inc JHH(0) A US company, subsidiary of the JHIL Group. Through its subsidiary JHH(1), the holding company of the James Hardie United States Group. RCI owned all the shares in this company. RCI Pty Limited RCI The applicant, an Australian resident company and a wholly owned subsidiary of JHIL; the holding company of the James Hardie Group's United States subsidiaries. RCI Malta Holdings Limited RCI Malta A subsidiary of RCI. James Hardie USA Inc JHH(1) A JHIL subsidiary in which (indirectly) RCI had a minority interest. James Hardie NV JHNV A Netherlands company which became the head company for the profitable operating companies. James Hardies Industries NV JHINV Parent company of the JHIL Group from October 2001.

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The tax benefit 6 As a non-portfolio dividend within the definition in s 317 of the ITAA 1936, the dividend referred to in step 1 above was exempt from Australian income tax in accordance with s 23AJ of the Act. It is the Commissioner's contention that the declaration of the dividend reduced the market value of RCI's shares in JHH(1) with the result that RCI's capital gain on the transfer of its shares in JHH(0) to RCI Malta was correspondingly reduced. The extent of the reduction was equal to the amount of the dividend, being US$318 million or A$478,237,746. The Commissioner's amended assessment included that amount in RCI's taxable income for the 1999 income year. 7 The written reasons given in respect of the Commissioner's objection decision note that the identification of a tax benefit for the purposes of Part IVA requires a comparison between the circumstances that in fact obtained and a counterfactual. The counterfactual identified by the Commissioner and the corresponding tax benefit was explained in the reasons for the objection decision as follows: The Part IVA determination issued by the Commissioner on 18 March 2006 under paragraph 177F(1)(a) of the ITAA 1936, identified as the tax benefit the non-inclusion of an amount of A$478,237,476 in the assessable income of RCI for the 1999 year of income. This amount was calculated on the basis that, had the scheme not been entered into or carried out, it was reasonable to expect that: (a) a cash dividend of only US$20 million, from revenue profits, would have been declared (those being the available cash reserves of [JHH(0)] as at 30 March 1998); (b) RCI would not have subscribed for the additional 570 shares in [JHH(0)] for US$50,229,768; (c) RCI's shares in [JHH(0)] would have been transferred to RCI Malta for the sum of US$342,061,200 (A$539,613,819) being the market value of [JHH(0)'s] shares of US$94,290,968 (as determined by the directors) plus US$298,000,000, being that part of the US$318 million dividend out of the unbooked valuation reserve minus the US$50,229,768 share subscription; and (d) RCI's cost base in the shareholding of [JHH(0)] would have been A$15,404,309. 8 In order to consider the issues raised in this proceeding and, in particular, to assess the appropriateness of the Commissioner's counterfactual it is necessary to consider the circumstances in more detail. Evidence of those circumstances was given by a number of James Hardie senior executives and advisors, both past and present, namely: Donald Alexander Salter, a financial consultant to the JHIL Group who reported to Mr Harman. Douglas McLellan Edwards, a United States tax professional and partner at Edwards & Chambers Law Firm in Nevada. Mr Edwards was an expert on US corporate tax law. Phillip Graham Morley, financial consultant to JHIL, formerly Chief Financial Officer of JHIL and the JHIL Group from March 1997 to May 2004. Prior to that Mr Morley was Executive General Manager of the Building Services Division of the JHIL Group. Stephen Edward Harman, Group Financial Controller from September 1997 to January 2002. Prior to that Mr Harman was the Manager, Financial Planning for JHIL located in Sydney. Anthony Edward Clemens, chartered accountant and partner of the firm PricewaterhouseCoopers Australia. Michael Robert Brown, a non-executive director of JHINV from 2001 to 20 February 2007. Prior to that Mr Brown was a non-executive director of JHIL from September 1992 to 2001. From 1996 Mr Brown was also Chairman of the Audit Committee of the Board of Directors of JHIL and continued in that role while he was a director of JHINV. Mr Brown should not be confused with Mr Allan Brown, the JHIL Group's treasurer who was not a witness but who was the author of strategy papers exhibited to the affidavit of Mr Morley; see [13] below. 9 The evidence of these witnesses concerned not only the details of the transactions that together comprise the schemes identified by the Commissioner but also the context in which those transactions occurred, particularly in regard to a restructure of the JHIL Group that came to be known as Project Chelsea. The accounts given by these witnesses of the issues they identified as facing the JHIL Group in the period with which this proceeding is concerned are largely consistent with each other. Except where otherwise indicated I have accepted the evidence of the witnesses.

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JHIL Group's financial position 10 From about 1995, although the United States operations of the JHIL Group were profitable its Australian operations were not. This had not always been the case and, in previous years tax losses on the US operations had been offset by interest on deposits made by the JHIL Group in Australia. Gradually the situation changed. In his affidavit affirmed on 13 August 2009 Mr Michael Brown recalled that around the mid-1990s "the Australian operations of the JHIL group were coming under economic pressure. Competition was increasing in the Australian markets for the JHIL group's products and there was no scope for significant growth in Australia." According to the evidence of Mr Harman, by 1996 losses from the Australian operations were in the order of A$194,000,000. From a tax perspective the position was complicated by the fact that borrowings by the JHIL Group used to fund the previously unprofitable US operations gave rise to interest expense in Australia creating tax losses in circumstances where there was no offsetting income. 11 In its written submissions RCI elaborated on the economic inefficiencies that resulted from this imbalance in profitability and the taxation liabilities it generated: The "imbalance" in profitability between Australia and the US created two problems. The first was for JHIL's shareholders, in that the profits arising in the US were being subjected to three levels of taxation. That is, the profits were subject to state and federal corporate tax in the US, then subject to dividend withholding tax when paid as dividends to Australia, and then subject to further tax in the hands of Australian shareholders if profits were distributed to them by further dividends. Tax paid in the US did not generate franking credits in Australia, so the Australian shareholders could not get the benefit of the tax paid on the underlying profits. This created a difficulty because the policy of JHIL - like most public companies - was to pay franked dividends, as franked dividends were preferred by Australia shareholders. In accordance with common sense, the problem was recognised as having an adverse effect on the value of the JHIL shares. Directors' responsibilities included ensuring that the shareholders' interests were properly taken into account by maximising the return to shareholders on the amounts of money they had invested in the company. The second problem was that, under the applicable accounting standards, the Australian tax losses could not be recognised in the consolidated accounts of JHIL as a future income tax benefit asset ("FITB") unless the recoupment of those losses was "virtually certain". The FITB in the year ended 31 March 1996 was around $70 million. 12 In his affidavit of 11 June 2008, Mr Salter stated that the tax issues confronting the JHIL Group and the recognition of accumulated Australia tax losses as a future income tax benefit (FITB) were matters of concern from as early as August 1995 when they were discussed at a meeting attended by, among others, Mr Salter. A major item of discussion at the meeting was the desire of the Group "to borrow funds in the US and repatriate cash to Australia" to generate assessable income in Australia and thus absorb the Australian tax losses. At regular meetings over the next few years "the recognition of Australian tax losses as an FITB continued to be an important issue" as was the balance of franking credits available for distribution to JHIL's shareholders. Various measures were considered as a means of addressing the problems. One such proposal mentioned at a meeting on 21 January 1998 was Project Chelsea.

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The Allan Brown plan 13 Specific strategies were addressed in two board papers, written in August and September 1996 respectively, by the JHIL Group's treasurer, Allan Brown. These papers, which were exhibited to the affidavit of Mr Morley, suggested four strategies (known as the Allan Brown plan), which Mr Morley described as "redeeming capital invested in the US subsidiaries; paying a dividend from the US to Australia; the US companies paying a lump sum royalty to the Australian companies and the US companies purchasing Australian assets and leasing them back to Australia". The idea behind these strategies was to move funds to Australia so that the earning capacity of those funds could offset the Australian losses. A possible difficulty arising from restrictions on the Group's debt level was identified by Mr Brown in his September 1996 paper. The applicant claims that the Allan Brown plan (as these strategies were known) was a continuing strategy which had nothing to do with the later Project Chelsea. 14 According to Mr Morley the Group proceeded with three of the four strategies in the Allan Brown plan. In December 1996 a new royalty agreement was entered into under which the US companies prepaid royalties for 5 years to an Australian company, Fibre Cement Technology (Australia) Pty Ltd in the amount of A$152,422,565. Some time after February 1997 there was a redemption of share capital by JHH(1) in the amount of US$70 million through the use of funds borrowed in the United States. On 31 March 1997, JHH(0) declared a dividend of US$50 million ('1997 dividend') from a revaluation reserve. In a paper dated 29 January 1997, Mr Brown summarised the effect of prepayment of royalties and the redemption of capital on the net debt position of the US group. The paper showed that the 1997 dividend was paid to RCI in cash on 25 March 1997 with funds borrowed in the United States and that the indebtedness of the US Group was expected to increase by US$175 million. 15 As early as April 1997 Mr Morley was considering how the payment of another large dividend from the United States to Australia could be managed however he was not the only senior executive thinking along these lines. In a memorandum dated 8 February 1997 to Bryon Borgardt, the treasurer of JHH(0), Mr Harman referred to the proposal by Coopers & Lybrand, accountants and financial advisors (C&L) that a dividend of US$100 million be paid before the end of the financial year (ie 31 March 1997) to take advantage of low earnings and profit and thus reduce US withholding tax. In that memorandum, Mr Harman referred to the strain that such a dividend would put on the US balance sheet and the gross borrowing constraints on the Group. A complicating factor at that time was identified by Mr Salter in his memo of 26 March 1998. This was that for the year ended 31 March 1998, JHIL would have insufficient franking credits to frank its dividends to shareholders. This was a direct result of the company profits being earned and taxed in the US rather than in Australia. 16 At about this time, in a number of quarters, attention was being drawn to the complex ownership structure of the JHIL Group and the difficulties it posed for dealing with the profit imbalance in the Group and the consequent tax problems. Mr Harman produced a draft discussion paper dated 17 February 1997 concerning the US corporate structure. He observed that this complex structure resulted in: an inability to remit USA profits back to Australia, due to the presence of the RCI Corporation minority shareholding which would share in any dividend payment increased accounting, taxation and auditing compliance costs difficulty in explaining James Hardie to analysts 17 At the time of Mr Harman's paper, RCI Corporation (not the present applicant) through its subsidiaries, RCI (USA) Finance Corp and RCI (Holdings Corp), held a minority interest in JHH(1). In his paper Mr Harman referred to plans to redeem that investment and stated that: [I]f the redemption takes place before March 1997, this would permit a dividend to be paid to Australia by [JHH(1)] in YEM97 at reduced withholding tax rates over that which would apply if the same profits were remitted in YEM98 or subsequently. In his affidavit sworn on 11 June 2009 Mr Harman also referred to the advantages that were expected to flow from the removal of RCI Corporation from the JHIL Group, in particular, the simplification of the US group structure which would "reduce accounting, taxation and auditing compliance costs". This was accomplished "in or around early March 1997" when RCI Corporation was removed from the US group structure.

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The Pedley proposal and the development of Project Chelsea 18 At about the same time as Mr Harman circulated his draft paper, a paper by Peter Pedley, a JHIL director, was also under consideration at JHIL. The Pedley paper, entitled, "Considerations for the Reconstruction of James Hardie" was faxed to Tony Clemens of C&L by Ian Wilson of SBC Warburg Dillon Read (Warburgs), for comment. It is not clear when the Pedley proposal was first articulated, however, the evidence, including that of Mr Michael Brown, was that it was circulated early in 1997. This proposal was the genesis of Project Scully, which eventually became Project Chelsea. In brief the proposal was to restructure the James Hardie Group so that the centre of operations was located in the United States rather than in Australia. At this stage the proposal involved the transfer of the Group's Australian, New Zealand and US operating subsidiaries to a new offshore holding company (JH Newco) 15% of which was to be floated on the New York Stock Exchange. It also involved the revaluation of JHH(1), the payment of a dividend to RCI and the transfer of RCI's shares in JHH(0) to JH Newco. 19 The Pedley proposal was reviewed by Mr Morley (with Dr Keith Barton, JHIL Chief Executive Officer) with the assistance of Warburgs, C&L and Allen, Allen and Hemsley, lawyers (Allens). In a letter dated 18 March 1997, enclosing a summary paper on the topic, Mr Clemens said: The most important conclusions coming from the enclosed are: (a) most shareholders in James Hardie, electing to participate in the proposal will wish to receive proceeds from the sale of shares not a buy-back of shares. This will require the involvement of the Investment Bank; (b) the sale of assets in Australia and New Zealand to the US Group could be undertaken in a tax free way in relation to New Zealand but not in relation to Australia, although for reasons noted could be substantially tax free; (c) in relation to Australia, assets will be sold with maximum allocation of purchase price for depreciable assets; (d) the income stream from the investment in the US Group is unlikely to be sufficient to recoup all Australian losses. Therefore, substantial dependence will need to be placed on recapture of depreciation on sale of Australian assets and ongoing royalty streams from licensing technology to the US, Australia and New Zealand. This requires the technology to be continued to be owned by James Hardie Research within the pre-existing group. This may not be what is desirable from a commercial viewpoint. (e) to the extent that income is derived from the US directly, it will suffer a withholding tax of 10% on interest and 15% on dividends. This may be reduced by the establishment of further international holding structures. 20 Exhibited to Mr Morley's affidavit was the James Hardie Business Plan Financials YEM 98-00 which he prepared and presented to the Board on 8 April 1997. Mr Morley states: The Plan records that in order to enable James Hardie to pay franked dividends (a desired financial outcome for JHIL's Australian shareholders) it was necessary to pay tax in Australia. Because the Australian operations had not been profitable, they had generated tax losses (estimated at $150 million) which needed to be recovered before tax would be paid in Australia. I therefore considered it imperative to maximise the level of taxable earnings in Australia. Because the overseas subsidiaries were more profitable, I recommended that the James Hardie Group's practice of maximising dividend payments from these subsidiaries be continued so that the funds remitted could be placed on interest bearing deposit to generate Australian taxable income … I told the Board that I would try to secure the payment of another large dividend from the United States to Australia in the 1998 financial year (as had been paid in March 1997) if this could be done. 21 In its written and oral submissions the applicant placed considerable emphasis on the fact that Mr Morley was not cross-examined on that evidence and submitted that the evidence should be accepted. The submission relied on observations made by Hunt J in Allied Pastoral Holdings Pty Ltd v Commissioner of Taxation [1983] 1 NSWLR 1 at 26. His Honour had referred to the comments of Hope and Glass JJA in Poricanin v Australian Consolidated Industries Ltd [1979] 2 NSWLR 419 at 426 as to the significance that should be attributed to "the failure of a party to cross-examine his adversary upon evidence which the adversary has given to satisfy the onus which lies upon him". Hunt J observed that Poricanin demonstrated that, "in order to achieve fairness to witnesses and a fair trial between the parties, it is … necessary in cross-examination to give the witness an opportunity to deal with the matters from which an inference can be drawn which contradicts his evidence …". 22 While respectfully accepting the comments of both the Court of Appeal and of Hunt J it is necessary to note that Mr Morley's evidence relates to his own intentions and recommendations. It does not go to the objective intention underlying the matters to which s 177D directs the Court to have regard. There would be no inconsistency in accepting Mr Morley's account as entirely truthful and at the same time attributing a different objective purpose to the alleged scheme. 23 A board paper, prepared by Mr Allan Brown and dated 29 January 1997 indicated that the indebtedness of the US group was expected to increase from US$100 million to US$275 million. According to Mr Morley, the increasing indebtedness, in part attributable to the funds borrowed to meet the 1997 dividend payment, meant that the group "was reaching the limits of its borrowing capacity". Mr Harman also described the various problems inherent in the proposal to pay further dividends to Australia including the necessity to ensure that any borrowing to pay the dividend should not breach the group's debt covenant. Mr Morley deposed that "at some time after 30 January 1998" he became aware that the external limits on the group's borrowing capacity did not apply to intra-group borrowings and thus JHH(0) could borrow from other companies in the JHIL Group without regard to those constraints. 24 Mr Morley's recognition of the advantages of intra-group borrowing coincided with his forming the view, consistent with that expressed in the Business Plan presented on 8 April 1997, that "the James Hardie Group's desire to re-gear the US Group and to increase funds on deposit in Australia [coupled with] the ability to pay a dividend at the time when JHH(0) would have minimal exposure to US withholding tax made a compelling case for the payment of a substantial dividend in the year ended 31 March 1998". Mr Harman's evidence was that the drift of the proposal in February 1998 was "that the money would be borrowed from external bankers and then paid to Australia by way of a cash dividend". 25 Early planning of Project Chelsea (then known as Project Scully) is reflected in a memorandum to Dr Barton and Mr Morley dated 3 December 1997 from Ian Wilson, an executive director of Warburgs. The memorandum states: The purpose of this memorandum is to outline a proposal for preliminary due diligence by JHIL prior to undertaking Project Scully. The key objectives are to: flush out any potential show stoppers, of which we are not aware (unlikely); identify key disclosure or due diligence items/issues (whilst not show stoppers) which need to be addressed or managed; and assist in early/advance preparation and planning for the formal due diligence process. 26 The memorandum proposed a series of tasks which Mr Morley described as "a precursor to planning" for Project Chelsea. In December 1997 a group known as the Chelsea Sub-Committee was set up. According to Mr Morley the members included himself, the Chairman of the company, the Chief Executive Officer and three of the five non-executive directors. Mr Brown deposed that he was one of the non-executive directors on the sub-committee and that it was formed "to undertake a more detailed analysis of the proposed restructure." At that time C&L, on the instructions of the JHIL Group, put together a C&L Scully Deal Team of partners and staff which was divided into subgroups designated as: US GAAP Team, Tax & Structuring Team and Valuation Team, with Mr Clemens being the Overall Co-ordinator and Mr P Brunner as SEC Registration US GAAP Co-ordinator. Attached to the list of members of the C&L Scully Deal Team was a timetable listing major tasks to be completed by 13 May 1998 when it was proposed that Project Scully would be announced. 27 A paper entitled, "Project Scully - US Tax Considerations", was prepared by C&L US (Peter Belanger and Keith Sheppard) in May 1997. It considers the payment by JHH(0) of a stock dividend to RCI. The paper notes that the gain to RCI from the subsequent disposal of JHH(0) to the new holding company would be taxable in Australia but also notes that the stock dividend would have increased RCI's cost base. Despite Mr Morley identifying handwriting on the paper as his, he said he did not consider a stock dividend until January 1998. He said it was not a paper that he "would have provided to, or discussed with, the Board". Irrespective of Mr Morley's recollection of the paper, it must follow from his handwriting on the paper that he was at least aware of the stock dividend proposal at that time. 28 A memorandum dated 16 July 1997 from Mr Clemens to the JHIL Board addresses tax issues in relation to Project Scully. The paper distinguishes between tax consequences of "off-market buyback" and "on-market buy back" in the context of repatriation of funds to shareholders. It also refers to a "step up in basis" of the US Group and lists steps by which this could be accomplished. While this aspect of the analysis may be related to FIRPTA rules that ultimately were not relevant, the memo clearly evidences a concern about capital gains tax issues. Following a comment that a stock dividend would not be exempt from tax in Australia, it also refers to an increase in cost base. The last step is that "RCI contributes JHH(0) to New US Co. The basis for US tax purpose is increased. Although the contribution is taxable in Australia, it should not have adverse consequences because the basis was increased in step (d)". 29 The third page of the document prepared by Mr Clemens on about 4 December 1997, is headed, "Tax Structuring". It lists specific tasks to be accomplished between January and March (presumably 1998). The tasks for February and the second half of March were as follows: February Develop unwind projects: Hungary Jersey Kockums New Zealand cross holdings [NB keep Malta] Implement unwind projects Based on data from specific projects above (January), develop detailed structuring plan for Scully and create tax model. Identify pre-31 March 1998 steps required Second half March Refine structure with JHIL executives 30 Mr Clemens was cross-examined extensively on this document. It was put to him that it was necessary to develop an unwind project for Hungary because that country's tax law was about to change and, while until 31 March 1998, it was possible to get dividends out of JHH(1) subject to a withholding tax of 5%, after 31 March this would no longer be possible. Mr Clemens agreed that the document was prepared, at least in part, in anticipation of a change in the law of Hungary and that, as a result, the withholding tax would increase. He was, however, vague about the specifics. He accepted that the plan for Scully developed over January to March and agreed that one of the "pre-31 March 1998 steps" referred to in the plan was the payment of the dividend that is the subject of the present proceeding. Furthermore, Mr Clemens agreed that C&L began assisting management with the preparation of financial statements and the registration statement required for the project before March 1998. 31 The payment of further dividends into Australia was the subject of discussions in early 1998 including at a meeting on 21 January of that year in the offices of C&L, Los Angeles. Present at the meeting were representatives of C&L (from both Australia and the US), Mr Morley, Mr Harman and Bryon Borgardt, then President of the US operations of the JHIL Group. At that time neither Mr Harman nor Mr Borgardt was aware of the proposed group restructure. Mr Harman said that the proposal to pay a dividend by 31 March 1998 was the main issue discussed at the meeting. The agenda and notes of the meeting confirm that payment of a dividend into Australia, funded by borrowings, was under active consideration. They also show that there was concern that borrowing covenants should not be exceeded. Subsequently, that concern was assuaged by the knowledge that the borrowing covenants did not apply to inter-group borrowing. 32 Under the heading "PRE 31.3.98" a note made by Mr Morley reads, "JHH(0) borrows $142 million to pay 'dividend'". On cross-examination, Mr Hilton SC who appeared for the Commissioner, put to Mr Morley that the quotation marks around the word, 'dividend', indicated that he did not regard it as a dividend but rather as a return of capital. Mr Morley rejected this suggestion but had no explanation of why the quotation marks were there. The fact that in the next line, there was a reference to operating companies borrowing "to pay dividend to JHH1" there were no quotation marks around the same word, was said by Mr Morley to be "just happenstance". In submissions, Mr Bloom, senior counsel for the applicant, explained as follows: In the United States, the only part of a dividend, as we would call it, that is treated for tax purposes as a dividend is an amount equal to the earnings and profits. The rest of the actual dividend is treated as reducing capital for tax purposes, and by that is reducing the cost base of the shares in the company. So when one says "dividend" the full amount of the dividend is obviously a dividend. It is only for tax purposes that a smaller amount is treated as a dividend in the US by reference to the [earnings and profits] for the calculation of withholding tax. 33 It is clear from the evidence that at the same time as the dividend was being discussed, planning for Project Chelsea was going ahead. An internal memorandum from Dr Barton to the Chelsea Board Sub-Committee dated 29 January 1998 states that on the recommendation of Michael Brown and Meredith Hellicar (both directors of JHIL) he had started the process of finding a new President, a Chief Operations Officer and Chief Executive Officer designate. A search brief annexed to Dr Barton's memorandum refers to the corporate restructuring which would, "over time have the effect of moving the ownership of the operations and business from Australian shareholders to USA shareholders". Following a description of the company's development since 1993, the memo states: When the restructuring is complete Newco will have approximately $A1.3 billion in annual revenue, $160 million in EBIT and employ approximately 4,500 people principally in Australia, New Zealand, USA and the Philippines. The EBIT split will be about 62% USA, 25% Australia and 10% New Zealand. 34 A fax from Mr Sheppard to Mr Morley dated 30 January 1998 refers to the meetings "last week" and attaches a draft of "the reorganisation steps and the proposed Chelsea structure". It is clear from the steps set out in that document that the payment of a dividend was discussed in the context of Project Chelsea at that time. The steps also included: the revaluation of JHH(0)'s shares in JHH(1) "under Australian GAAP to fair market value, the purpose being stated as, to "enable a step-up in basis of the US Group for Australian tax purposes, achieved through the stock dividend …"; that "RCI contributes Class A shares in JHH(1) to JHH(0)"; and for RCI to contribute its shares in JHH(0) to Malta 1 (which became RCI Malta) "in exchange for shares issued for par and premium". In cross-examination Mr Clemens agreed that this last step had occurred. 35 The fact that the plans for Project Chelsea were gaining strength is clear from the notes of a meeting of the sub-committee dated 3 February 1998 which refer to a review of the rationale for the project. The notes refer to issues with the financial structure of the group both in Australia and in the United States and continue: Addressing these issues under project Chelsea has, if anything, become clearer. We have also become more confident of the benefits that the financial and tax restructuring will deliver: ─ The new international structure will reduce taxes materially. ─ The transfer of the Australian assets to that group will absorb a substantial amount of Australian tax losses and provide tax benefits to the new group The US market conditions and outlook remain reasonably favourable. ─ The US building sector outlook remains fundamentally sound (unaffected by Asia). ─ Asia crisis is projected to keep pressure on US interest rates for 6 months. All good news for US building sector and US equity markets. The conclusions are therefore: ─ Commercial rationale remains compelling: that to fully realise the value of JHIL and for its growth prospects to be realised, JHIL must become a US based company; ─ The financial restructuring is required by the imbalance of the current structure and in fact will add value by reducing future US taxes; and ─ It has become clearer that the two key strategic issues for JHIL relate to asbestos and dealing with the rump. In summary, the primary commercial rationale (existing structure unsustainable, percentage of assets in the US, source of growth opportunities etc, continues to be valid. The financial rationale similarly continues to be valid (the maturity profile of existing debt facilities requires attention and the proposed structure provides significant tax benefits which have been the subject of further work). 36 In February 1998 there was a live proposal to make an application to the Dutch revenue authorities for a capital duty exemption. In cross-examination Mr Clemens admitted that this proposal was part of the planning for Project Chelsea. A tax structure briefing paper in connection with Project Chelsea was prepared by Warburgs in conjunction with C&L for the purposes of a meeting or the Chelsea Sub-Committee to be held on 3 March 1998. 37 The briefing paper describes key features of the structure at that time including the establishment of an International Finance Services Centre (IFSC) in Ireland which would lend US$1 billion to the US, Australian and New Zealand holding companies. Another key feature was a step up in Australian assets involving the establishment of a new Australian company under the US Group to acquire the Australian assets. The net effect would be "to transfer existing tax losses in Australia to JH Newco as depreciable assets for both Australian and US tax purposes that are recovered over 7-9 years". The paper stated: The structure will allow a deduction for the interest expense on the borrowings used to acquire the Australian assets in both the US and Australia. This involves securing a tax deduction on the interest expense on borrowings from the IFSC in both Australia and the US by using an Australian holding company that is a resident for Australian purposes and a "look through" for entity US purposes. The benefit in Australia is secured by transferring the holding company loss to the Australian operating company. The pre-condition for securing the benefit in the US is achieved by interposing a finance company that pays tax in Australia and, because it is a look through entity for US purposes, has a prima facie tax liability in the US, but has US foreign tax credits for Australian taxes paid. In effect, tax that would have been paid by the Australian operating company is transferred to the financing company to meet the pre-condition of US assessable income, while also generating foreign tax credits. The double dip interest in Australia will provide a tax benefit of $2.3m (A$3.4m) on an annual basis. 38 The notes for the meeting of 3 March 1998 indicate that Sir Llewellyn Edwards and Mr Peter Wilcox were present. Mr Morley confirmed that this was the first time these directors had attended a Project Chelsea Sub-Committee meeting. The notes also show that the tax summary briefing paper referred to above was distributed prior to the meeting and state: C&L are preparing a detailed memo of advice that will sign off on the structure. C&L are meeting with Larry Magid [a tax lawyer with Allens] later in the week to further progress his review. At the meeting it was also resolved that the project team be expanded by the inclusion of, among others, Mr Harman and Mr Borgardt. 39 A contemporaneous memorandum prepared by Warburgs indicates the importance attributed to Project Chelsea's impact on the debt financing strategy for the JHIL group. The memorandum refers to JHIL's debt position ($850m with cash deposits of $420m) and expresses the view, which Mr Morley shared, that "Project Chelsea provides the opportunity to improve financial efficiency by reducing both total outstanding debt and cash deposits whilst increasing the net gearing position". 40 The minutes of a Chelsea Sub-Committee Meeting on 18 March 1998 refer to "Larry Magid (Allens) tax review". They record that there had been a tax review meeting on 6 March 1998 and state, "Conclusion from the tax review meeting was no 'show stoppers' identified but Magid also waiting on detailed memo of advice from C&L to further his review". These minutes list the JHIL personnel who will be aware of Project Chelsea as at 23 March and also record quite intensive planning for the Project. There is reference to a presentation on Chelsea to the GMT (Group Management Team) and to it having been well received. Under the heading, "Next Steps" there is reference to a "US management briefing and organisational meeting" to be held on 23-24 March, to the incorporation of operating forecasts into detailed financial models being expected to take about 2 weeks, and to matters not being progressed sufficiently to make a public announcement of Project Chelsea on 13 May 1998. They state: Consequently, defer the announcement until 2 July, one week prior to the AGM, and release and file the registration statement with the SEC at the same time. The timing of the IPO will not change as a result of the delay of public announcement. 41 It is relevant that the minutes exhibit no doubt that the Project would go ahead. Their concern is with timing in the light of what still needed to be accomplished. Ultimately, the announcement was made on 30 June 1998. While it may be accepted that at this point the JHIL Group was not irretrievably committed to Project Chelsea in that the final sign-off by the Board had not occurred, it would be naïve to assume that there was no commitment to the Project prior to that occurring. The tenor of the sub-committee minutes is of commitment to the Project with concern being directed to finalising the steps and resolving the multitude of issues inherent in such a complex project. 42 On 23 March 1998 Ryan Dudley of C&L sent a facsimile to Mr Sheppard which carried the heading, "Subject: Chelsea". It refers to a previous discussion "on matters to be carried out prior to 31 March 1998 in the US group". The letter comments, inter alia: In relation to the US tax issues on the Chelsea reorganisation, we need to provide finalised advice to Gibson Dunn for them to review. … In particular, I would make the following comments: (a) … (b) In relation to the dividend to be paid prior to 31 March 1998 … we will need to obtain a firm view on the earnings and profits for the current year in order to calculate the dividend withholding tax. Accordingly, could you please arrange for such a number to be calculated. (c) We have discussed the need for a valuation of the shares in JHH(1) held by JHH(0) to be carried out by Mike Wierwille. Based on this valuation we will determine the amount of dividend to be paid and also the amount of the bonus issue of shares prior to 31 March 1998. (d) With regard to your opinion on the interest withholding tax and the IFSC, my comments are as follows: … (e) With regard to the transfer of the Australian assets to an Australian subsidiary of Chelsea, could you please arrange to research the following issues: (i) as part of the stamp duty planning on the transfer of the Australian assets, we are considering a separate transfer of just the plant and equipment from JH Coy to another Australia company prior to a sale to the Australian subsidiary of Chelsea. If the plant and equipment is transferred separately from the business, it appears we should obtain exemption from stamp duty. … The question therefore arises as to the cost base of the plant and equipment in the new Australian company after the transfer to the Australian subsidiary of Chelsea. 43 When asked if the transfer of the plant and equipment was part of preparing for Chelsea, Mr Clemens said "I wouldn't go that far", however he agreed that the transfer did take place separately on 31 March 1998. Mr Clemens also agreed that the letter carried his unqualified approval in every respect and that he had written a comment on the document to the effect that it was an excellent letter. 44 On 30 March 1998 JHH(0) declared a dividend of US$318 million which was said to arise from the revaluation reserve generated by the revaluation of its interest in JHH(1) (apparently to fair market value under the US Generally Accepted Accounting Principles - 'US GAAP'). A memorandum dated 30 March 1998 from Mr Borgardt to the directors of JHH(0) states: The Corporation's investment in [JHH(1)] has been the subject of an independent valuation as of March 30, 1998. Under Australian accounting rules, the carrying value of investments are re-valued from time to time to market value. The results of the current valuation arrived at an upward valuation range of between $330 million and $400 million. … On the basis of this current valuation it is recommended the Board approve a $318 million dividend. Should any of you desire to review the detailed valuation, please advise me. 45 The amount of the dividend was suggested by Mr Harman in a memorandum dated 30 March 1998. The memorandum says that "it has been agreed there is no merit in declaring a stock dividend at this time". It suggests a payment of US$20 million in cash and refers to the "proposed promissory note". The minutes of a special meeting of the Board on 30 March record that the Board resolved to accept Mr Borgardt's recommendation and declare the dividend. A copy of the resolutions passed by the JHH(0) Board shows that the Board also resolved to issue to JHIL a promissory note in favour of JHH(0) with a redemption value of US$307,415,972 and a redemption date of 28 September 1998. The issue price for the promissory note (PN1) was US$298 million which was directed to be paid to RCI. 46 As RCI held 100% of the shares in JHH(0) it was entitled to receive the whole of the dividend. The dividend was paid to RCI on 31 March. JHH(0) contributed US$20 million in cash and the balance of $US298 million was to be paid by JHIL under PN1 in accordance with the directions of the Board of JHH(0). In fact RCI did not receive the whole of the US$20 million as James Hardie Finance Limited deducted US$2.38 million to be remitted to the US Internal Revenue Service for withholding tax. The withholding tax suffered was to be taken up as an expense by RCI. 47 The applicant tendered an expert report prepared by Mr Douglas Edwards concerning the treatment of this dividend under US tax law. Mr Edwards also prepared a supplementary report which expanded upon an aspect of his main report. This was also tendered. According to Mr Edwards the relevant Nevada legislation permits a board of directors to take into account 'unrealized profits' in determining whether a distribution may be made. The definition of "distribution" includes a dividend. Mr Edwards attached to his report a copy of relevant sections of the Nevada Revised Statutes, s 3 of which is as follows: The board of directors may base a determination that a distribution is not prohibited pursuant to subsection 2 on: (a) Financial statements prepared on the basis of accounting practices that are reasonable in the circumstances; (b) A fair valuation, including, but not limited to, unrealized appreciation and depreciation; or (c) any other method that is reasonable in the circumstances 48 In his second affidavit sworn on 20 August 2009, Mr Edwards gave numerous instances of situations in which clients of his, being Nevada corporations, paid dividends out of unrealized profits. On cross-examination Mr Edwards agreed that of the eight examples provided by him, seven of the transactions involved funds being obtained for the distribution from banks or third parties and that in each of those seven cases security was provided for those loans. Mr Edwards admitted that although in each of the eight transactions described by him a substantial quantum of negative equity resulted from the payment of the dividends he was not aware of any other transaction which had resulted in a negative equity of US$234 million. He agreed that in his experience (29 years of practice in Nevada and advising on average 300 clients a year he had never encountered a transaction where "over 90 per cent of the distribution was paid, not by way of cash but by way of a credit to an inter-company loan account supported by a promissory note" and which resulted in negative equity of such magnitude. 49 In terms of the transfer of funds between the Australian and the US companies, the effect of these transactions was that at the request of a US company (JHH(0)), an Australian company (JHIL) paid US$298 million to another Australian company (RCI). As far as RCI was concerned the inter-company payment was made without expense to it because the structure of a dividend payment from JHH(0) had been adopted. This much can be seen from the updated forecast of Australian taxable income dated 31 March 1998, prepared by Mr Harman. The forecast had been updated to reflect "the latest Business Plan Financials being considered by the Board on 1 April, and also to reflect the repatriation of funds from the USA being effected 31 March". The effect over 3 years is stated to include "Increased interest income in Australia following receipt of US$318 million dividend from USA". An internal JHIL memorandum from Mr Harman dated 1 April 1998 setting out the accounting entries that he directed be made reflects the "interest-free" nature of the payment to RCI which, as to the amount of US$298 million was to be on inter-company account. 50 The accounting entries and the accompanying memorandum refer to the JHH(0) dividend but not to the revaluation. In fact the only document in evidence that gives any detail of the valuation and the analysis on which it was based is a memorandum dated 6 April 1998 directed to JHH(0) - Audit file from Mike Wierwille and Lisah Burhan of C&L which states: This memo, summarizes the results of certain procedures performed to confirm management's estimates of the values of James Hardie Building Products ("JHBP") and James Hardie Gypsum Group ("JHGG") as of March 31, 1998 ("the valuation date"). This analysis is intended to determine that the aggregate distributions made by [JHH(0)] to RCI, its Australian parent company, have support for tax reporting purposes. 51 The date of this memorandum and Mr Harman's evidence on cross-examination suggest that the formal valuation did not occur until after 31 March 1998. In particular there was no mention of the revaluation in the reporting package containing the consolidated accounts of JHIL Group. Mr Harman mentioned several times that he would not expect to see the revaluation mentioned because "the reporting package didn't carry that level of detail in it". In cross-examination Mr Harman was also taken to a letter dated 8 June 1998 from C&L to Mr Borgardt of JHH(0). That letter states that the JHH(0) directors authorised the revaluation of assets "and, thus, created a reserve with a credit balance of US$318 million" and refers to the minutes of the JHH(0) Board meeting on 31 March 1998. Mr Harman agreed that the minutes did not refer to any revaluation. 52 On the same day as the dividend was paid, 31 March 1998, there was a meeting of the Chelsea Sub-Committee. The notes of that meeting contain a progress report which includes comments about: the difficulties encountered in the CEO search; the progress of the search for non-executive directors and personnel for the proposed new company; and the preparation of a communication plan including a plan for addressing leaks about the Project. Under the heading of "Timing and Key Actions" the notes refer, inter alia, to the financial plan and model for Project Chelsea, the detailed financing plan being prepared, the intention to hold a Board meeting on 3 June. The notes indicate that the public announcement of Project Chelsea was still planned for 2 July 1998 and state that "It is intended to bring the Australian analysts from [Warburgs] and the co-managers across the Chinese wall approximately a week or so prior to the announcement of Project Chelsea" the purpose being to "enable them to fully understand the transaction and be able to provide investors with an informed opinion". 53 Mr Morley also continued to work on aspects of Project Chelsea. Warburgs circulated a detailed checklist of issues dated 22 April 1998. The checklist shows that a public announcement on 2 July was still contemplated and that the roadshow presentations in support of the IPO for the new company (now referred to as "Newcastle") were scheduled for 9 to 23 September. Mr Morley noted that among the issues remaining to be determined was whether the stock issued on the New York Stock Exchange would give investors a 15% or 20% interest in the James Hardie Group. 54 It is clear from the documentary evidence that during the period from 31 March to 2 July 1998 when Project Chelsea was publicly announced there was intense activity directed to refining all the details of every aspect of this complex Project. The Warburgs checklist mentioned above runs to 31 pages listing tasks and identifying the persons responsible for them. By 31 March 1998 it appeared that all of the senior executives involved in the arrangements for the payment of the dividend except Mr Salter were aware of Project Chelsea. 55 Mr Salter was advised of the payment of the dividend and the financial arrangements that had been made for its payment by a memorandum from Mr Harman dated 1 April 1998. On 24 April 1998 he prepared a document outlining some of the significant tax issues for the year ending 31 March 1998 and another forecast of the tax loss position of the Australian group on 6 May 1998. At both times he was unaware of Project Chelsea which he did not learn about until "in or around the middle of May 1998". 56 In August 1998 RCI subscribed for 500 additional shares in JHH(0) valued at US$50,229,768 in order to meet the US thin capitalisation rules. This was necessary because of the decrease in capital resulting from the March 1998 dividend. As a result RCI held a total of 1070 shares in JHH(0). This subscription, by virtue of RCI being a debtor to JHH(0) for that amount, effected a corresponding increase in the equity in JHH(0). On 23 September 1998, JHIL gave a promissory note (PN2) to RCI in the amount of $50,229,768 in part payment of the amount owing under PN1. Consequently the balance payable by JHIL to RCI was reduced to US$247,770,232. On the same day RCI assigned PN2 to JHH(0) in payment of the amount owing for the additional shares it had acquired. 57 Five days later, on 28 September 1998, JHH(0) assigned PN2 to JHIL in part payment of the amount owing to JHIL pursuant to PN1. Consequently the amount owed to JHIL by JHH(0) was reduced to US$256,770,232 which, on the same day, JHH(0) then borrowed from James Hardie Finance Limited to pay out the balance on PN1. In October 1998 RCI transferred all 1070 shares in JHH(0) to RCI Malta.

[21]

Consideration 61 Section 177F(1)(a) of the Act provides that the Commissioner may make a determination to include in the assessable income of a taxpayer an amount which has not been included if a tax benefit has been obtained (or would but for s 177F have been obtained) in connection with a scheme to which Part IVA applies. For the Commissioner's discretion under s 177F to arise it is therefore necessary that there be: (a) a scheme as defined in s 177A; (b) a tax benefit in connection with a scheme as defined in s 177C(1); and (c) a person or persons who entered into or carried out the scheme or any part of the scheme having the dominant purpose of enabling RCI to obtain a tax benefit in connection with the scheme. 62 The principles applicable to the construction of Part IVA were articulated by the High Court in Commissioner of Taxation v Spotless Services Limited (1996) 186 CLR 404 and in Commissioner of Taxation v Hart (2004) 217 CLR 216. In Spotless Services at 414 a joint judgment of six members of the High Court said that "Part IVA is to be construed and applied according to its terms, not under the influence of 'muffled echoes of old arguments' concerning other legislation". In Hart, at 239, Gummow and Hayne JJ quoted this comment and said: That applies to all aspects of Pt IVA. Whether considering what is a "scheme", or considering other provisions of Pt IVA , it is necessary to eschew arguments that proceed from unstated premises about choice or the drawing of false dichotomies between "rational commercial decisions" and obtaining a tax benefit. It is important to identify why that is so. There is no doubt that "tax laws affect the shape of nearly every business transaction". But, as was said in the joint reasons in Spotless: A particular course of action may be, to use a phrase found in the Full Court judgments, both 'tax driven' and bear the character of a rational commercial decision. The presence of the latter characteristic does not determine the answer to the question whether, within the meaning of Pt IVA , a person entered into or carried out a 'scheme' for the 'dominant purpose' of enabling the taxpayer to obtain a 'tax benefit'." (Emphasis added.) Always the question must be whether the terms of the Act apply to the facts and circumstances of the particular case. 63 The comments quoted above are particularly apposite to the questions raised in this proceeding. The question is not whether there was a rational commercial purpose behind either Project Chelsea or the payment of the dividend, or even whether they were tax driven. The question is whether on its terms the Act applies to either or both of the schemes identified by the Commissioner.

[23]

The wider scheme 65 In relation to the wider scheme the applicant submits that the first three steps, which relate to the payment of the dividend to RCI "do not bear a sufficient relationship to the last step (the transfer of shares) for it to be properly concluded that they are, for the purposes of Pt IVA, part of the one scheme". 66 RCI explains the payment of the dividend in March 1998 as part of the ongoing implementation of a strategy developed in 1995 and 1996 to increase interest bearing debt in the US and assessable income in Australia. It submits that the strategy had nothing to do with the corporate restructure of which the disposal of the JHH(0) shares was a part. In RCI's submission the evidence shows that: The transfer of the JHH(0) shares occurred as part of a reorganisation to, inter alia, separate the operating companies into a new holding structure and to achieve an alignment between the location of profits and management, and also to attract US shareholders to JHIL. The payment of the dividend was a matter of historical fact so far as the restructure was concerned. 67 Three aspects of the evidence are especially relied upon in this regard. First, senior executives such as Mr Harman and Mr Borgardt who were intimately involved in the recommendation to pay the dividend did not, at that time, know about the restructure proposal. Secondly, the JHIL Board resolution to pay the dividend does not mention the restructure; and finally, at the time the dividend was declared there had been no decision to proceed with Project Chelsea. 68 I am not persuaded that any of these factors should lead to the conclusion advocated by the applicant. I do not accept that anything flows from the fact that the Board's resolution does not mention the restructure. For that matter, the Board's resolution does not mention any purpose, including that of rectifying the profit imbalance between Australia and the United States. 69 In my view the dividend payment and the share transfer are connected. For that reason it is not necessary for me to consider the Commissioner's submission, referring to Federal Commissioner of Taxation v Star City Pty Ltd (2009) 175 FCR 39 at [202]-[209], that not all steps in a course of action need to be connected. 70 At one level it is possible to view the dividend payment and the share transfer as unrelated transactions. The former occurred on 31 March 1998 and the latter, months later, on 15 October 1998. Taken in isolation from much of the other evidence, the facts as presented by RCI tend to support that view, as does the fact that some senior executives did not know of the Project until some time after the dividend was declared. I accept that the evidence shows that the proposal for a dividend probably predated the earliest discussions of the corporate reorganisation and, in particular, the Pedley proposal. However, close examination of the documentary evidence which, as the Commissioner submits, is likely to be more reliable than the recollections of persons involved in transactions that took place more than 10 years ago, supports the view that the dividend payments were part of the complex restructure known as Project Chelsea. 71 The development of the proposal can be seen from the account in [19] et seq above. In summary this shows that the financial imbalance between Australia and the USA was identified in Mr Pedley's paper which was faxed to Mr Clemens on 17 February 1997. There followed a review by Warburgs, C&L and Allens during March 1997 and a presentation to the JHIL Board in early May 1997. By that time the proposal envisaged the transfer of Australian and New Zealand assets and the US Group to a new holding company. From that time on the proposal for a dividend (initially a stock dividend) was a constant feature of the proposed restructure although it eventually became a cash dividend that was declared on 31 March 1998. 72 RCI's description of the dividend as a "historical fact" that fortuitously had the effect of bringing about a major tax saving cannot be supported on the evidence. The evidence shows that the payment of a dividend was an integral part of the planning of Project Chelsea from early in its inception. While I do not doubt that the dividend was directed to redressing problems arising from the imbalance of profitability between Australia and the USA, it did so as part of the larger Project Chelsea which was eventually adopted as the ultimate solution to the problem. 73 The fact that Mr Harman, Mr Borgardt and Mr Salter did not know about Project Chelsea until comparatively late in its development (March 1998 for Mr Harman and Mr Borgardt and mid-May 1998 for Mr Salter) is not inconsistent with the Commissioner's position. Both Mr Harman and Mr Borgardt were aware of Project Chelsea by the time the dividend was declared on 31 March 1998. Moreover, when the dividend was declared, the Chairman (Mr McGregor) and Chief Executive Officer (Dr Barton) and the Chief Financial Officer (Mr Morley) of JHIL as well as three non-executive directors Ms Hellicar, Mr Brown and Mr Pedley, were all aware of the Project. As the comments of Gummow and Hayne JJ in Hart quoted above at [62] make clear, the fact that those involved in the dividend planning understood it to have an independent commercial rationale is not inconsistent with it being part of Project Chelsea and thereby being connected to the share transfer from RCI to RCI Malta.

[24]

Narrow Scheme 74 The applicant rejects the narrow scheme by pointing out that it is only the transfer of the shares that could give rise to the tax benefit alleged to have been obtained in connection with the scheme. As the narrow scheme does not incorporate that step it submits that no question of a benefit from the narrow scheme can arise. 75 Attractive as that submission may seem initially, it makes an unwarranted assumption. Section 177D(a) provides that a scheme to which Part IVA applies is, relevantly, one where "a taxpayer … has obtained, or would but for section 177F obtain, a tax benefit in connection with the scheme"; [emphasis added]. There is nothing in the provision which says that the tax benefit has to be generated by a step in the scheme. 76 A similar issue arose in Commissioner of Taxation v Consolidated Press Holdings Limited [2001] 207 CLR 235. As the High Court explained at 254: In contending that a tax benefit was obtained in connection with a scheme, the Commissioner identified, as the relevant scheme, part only of the total plan or course of conduct involved in the corporate arrangements that were made within the Group for the purposes of the BAT takeover bid. Much of the discussion in Consolidated Press concerned the correct interpretation of s 79D of the Act, however at 264 the High Court commented: Objection was also taken to what was said to be the artificiality of the selection of part of the overall transaction as the scheme. … The artificiality was said to result from the fact that the overall transaction was for the clearly commercial purpose of financing the Group's participation in the takeover bid for BAT. However, as was held in Spotless, a person may enter into or carry out a scheme, within the meaning of Pt IVA, for the dominant purpose of enabling the relevant taxpayer to obtain a tax benefit where that dominant purpose is consistent with the pursuit of commercial gain in the course of carrying on a business. The fact that the overall transaction was aimed at a profit making does not make it artificial and inappropriate to observe that part of the structure of the transaction is to be explained by reference to a s 177D purpose. Nor is there any inconsistency involved, as was submitted, in looking to the wider transaction in order to understand and explain the scheme, and the eight matters listed in s 177D. 77 The relationship between the wider and the narrower schemes identified by the Commissioner is similar to the relationship between the narrow and wide schemes identified by the Commissioner in Hart. It will be remembered that Hart concerned a split loan facility which permitted the borrower to direct the lender to split the loan account enabling the borrower to direct payment to any part of the split account. The taxpayers, a husband and wife, split the loan into two parts, one relating to an investment property and the other to a home loan. They then directed the whole of each monthly repayment to the home loan part with the result that the interest on the investment part of the loan account was capitalised and compounded, and was claimed by the taxpayers as an allowable deduction. 78 The wider scheme identified by the Commissioner comprised all the steps in the entry into and implementation of the loan agreement whereas the narrower scheme was restricted to the terms in the loan agreement that allowed the loan to be split and the repayment to be directed to one or other parts of the split account and the taxpayers' direction of repayments to the home loan element. Speaking of the two schemes, Gummow and Hayne JJ said at 240: What the Commissioner identified as the wider scheme falls within the definition of "scheme". That is, all of the steps leading to, and the entering into, and the implementation of the loan arrangements can be understood as together constituting a "scheme". Those steps were a scheme, plan or a course of action. One of the purposes of that scheme was, of course, to provide money for the financing and refinancing of the two properties. But so, too, the steps said by the Commissioner to have constituted the narrower scheme (the provision of the loan permitting both the division of the loan and the direction of repayments to one portion, coupled with the respondents' direction of their repayments to the home loan portion of the loan) can also be identified as a course of action, scheme, plan or action. Not only is that so, the steps identified as constituting the narrower scheme can be seen to have formed a part of the wider scheme. 79 In this case also the narrow scheme (the revaluation of the shares in JHH(1), the declaration of the dividend and the arrangements for its payment) can be seen to have formed part of the wider scheme. In my opinion the authorities support the Commissioner's contention that both the schemes he has identified in this case are schemes within the definition in s 177A.

[25]

Was there a tax benefit in connection with a scheme? 80 For Part IVA to apply it is necessary for the taxpayer to have obtained "a tax benefit in connection with the scheme". Section 177C(1)(a) defines "tax benefit" as an "amount not being included in the assessable income of the taxpayer of a year of income where that amount would have been included, or might reasonably be expected to have been included, in the assessable income of the taxpayer of that year of income if the scheme had not been entered into or carried out". 81 The tax benefit identified by the Commissioner is the net capital gain arising from RCI's disposal of its shares in JHH(0) to RCI Malta, not included in RCI's assessable income in the year of income ending 31 March 1999 (in lieu of 30 June 1999). The capital gain recognised by the applicant and included in its taxable income in that year was A$45,971,764. The Commissioner having made a Part IVA determination pursuant to s 177F(1)(a) increased the capital gain amount by A$478,237,746. 82 Was the tax benefit identified in [81] obtained in connection with the scheme? This requires that there be a comparison "between the scheme in question and an alternative postulate"; Hart at 243 per Gummow and Hayne JJ. As Sackville J pointed out in Commissioner of Taxation v Mochkin (2003) 127 FCR 185 at [26] "that is, as a matter of 'objective fact'". In Federal Commissioner of Taxation v Lenzo (2007) 167 FCR 255 at [121] Sackville J also observed that the question has to be answered "on the assumption that the scheme had not been entered into or carried out". Added to that, in the present matter it is necessary to determine that had the scheme not been carried out the greater capital gain identified by the Commissioner would have been included in RCI's assessable income. 83 The Commissioner's alternative postulate is set out in paragraph 51 of his appeal statement. In summary it postulates that if the scheme or schemes had not been entered into RCI would nonetheless have disposed of its shares in JHH(0) as part of Project Chelsea notwithstanding the significant additional liability to capital gains tax. The alternative postulate must be a reasonable expectation as to what would have occurred in the absence of the scheme or schemes. As the High Court observed in Peabody v Commissioner of Taxation (1994) 181 CLR 359 at 385: A reasonable expectation requires more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable for it to be regarded as reasonable. 84 The burden of proving that the Commissioner's assessment is excessive falls upon the taxpayer, in this case RCI. As Greenwood J observed in McCutcheon v Federal Commissioner of Taxation (2008) 168 FCR 149 at 166, this, necessarily involves each taxpayer adducing evidence which would discharge the onus of demonstrating that the Commissioner's prediction or hypothesis was not sufficiently reliable for it to be regarded as reasonable. 85 There is a wealth of evidence in this matter that satisfies me that Project Chelsea was the means selected by the Board of JHIL to address the very real concerns held by it and its senior executives and advisers about the profit imbalance between the Australian and US operations of the JHIL Group. It is clear that the problem was ongoing and that there was no expectation that the trend of increasing imbalance would be reversed. Project Chelsea was expected to provide a lasting solution to this problem. The notes of the meeting of the Chelsea Sub-Committee of 3 February 1998 stated that the sub-committee concluded that the commercial rationale for the Project was compelling and that for its value and growth projects to be fully realised "JHIL must become a US based company"; see [35] above. In order to effect the restructure involved in Project Chelsea it was necessary for the JHIL Group's operations to be rearranged so as to be concentrated in the United States. The transfer of RCI's shares in JHH(0) to RCI Malta was part of that rearrangement. 86 Although the applicant strongly submitted that without the benefit of the dividend the transfer of RCI's shares in JHH(0) could not reasonably be expected to have taken place, it did not provide any evidence to support this submission. RCI invites the Court to draw this inference, seemingly as a matter of commercial logic, however, its submissions go beyond what could be so inferred. It submits, for instance, that "JHH(0) could have incorporated a new US resident company, to which it could have contributed its shares in JHH(1) … The relevant Australian assets could have been transferred to the new US company, which could then have been floated on the New York Stock Exchange"; emphasis added. While RCI also submits that these possibilities are consistent with Mr Pedley's original proposal and with aspects of C&L's advice at various stages, such observations do not substitute for evidence. Similarly, RCI submitted that it could not be reasonably expected that JHIL would have put to its shareholders a proposal that would carry with it a tax liability in the amount calculated by the Commissioner. No evidence was adduced to support this submission. 87 The Commissioner submitted that in view of RCI's failure to lead evidence from any one of Messrs Brown, Morley, Clemens and Harman about the alternatives to the disposal of RCI's shares in JHH(0) available to the JHIL Group it must be inferred that such evidence would not have assisted it. I accept this submission which accords with the observations of Handley JA in Commercial Union Assurance Company of Australia Ltd v Ferrcom Pty Ltd (1991) 22 NSWLR 389 at 418: In my opinion the Court should not draw inferences favourable to the insured on these matters when no attempt was made to prove them by direct evidence and in particular when no relevant questions were asked of Mr Ferrarese. Rather it seems appropriate to apply the principles of Jones v Dunkel (1959) 101 CLR 298. There appears to be no Australian authority which extends the principles of Jones v Dunkel to a case where a party fails to ask questions of a witness in chief. However I can see no reason why those principles should not apply when a party by failing to examine a witness in chief on some topic, indicates "as the most natural inference that the party fears to do so". See also Braverus Maritime Inc v Port Kembla Coal Terminal Ltd (2005) 148 FCR 68 at 112. 88 In my view RCI has failed to discharge the burden it has of proving that the Commissioner's alternative postulate is unreasonable. The revaluation and declaration of the dividend were part of a scheme (in fact part of both schemes) and the tax benefit that accrued by virtue of the decrease in value of the shares resulting from the dividend was a benefit obtained in connection with the scheme.

[26]

Purpose 89 The Commissioner contends that the dominant purpose of those who entered into or carried out the schemes or any part of the schemes he has identified (see [5] above) was to obtain a tax benefit in connection with the scheme for RCI. Section 177A(5) provides that a reference in Part IVA, to a scheme or part of a scheme being carried out for a particular purpose shall be read as including a reference to the scheme or the part of the scheme being entered into or carried out by the person for 2 or more purposes of which that particular purpose is the dominant purpose. 90 The dominant purpose is to be determined objectively. As Carr J observed in Eastern Nitrogen Ltd v Commissioner of Taxation (2000) 108 FCR 27 at [81]: The whole tenor of the language in which s 177D(b) is expressed is that of ascertaining an objective purpose by having regard to objective facts. 91 The irrelevance of subjective purpose of those who entered into either or both of the schemes is confirmed in a long range of authorities the conclusions of which were summarised by Hill J in Commissioner of Taxation v Sleight (2004) 136 FCR 211 at [66] : There have by now been a number of cases, both in the High Court and in this Court where the provisions of Part IVA have been considered. The propositions which may now be taken as decided may be summarised as follows: 1 Part IVA does not authorise consideration of evidence of the subjective purpose or motivation of a particular person. The subjective state of mind of a person is not a matter listed in s 177D(b) to which regard may be had. Rather the section requires consideration of the eight matters listed in s 177D(b) and no other matters. The subjective state of mind of a person is not such a matter. Hence the section seeks to establish the conclusion which would be reached by reference to what may be referred to as objective factors, that conclusion being however, a conclusion as to the purpose of a person who entered into or carried out the scheme: Federal Commissioner of Taxation v Zoffanies Pty Ltd 2003 ATC 4942 at paras 53-54 per Hill J, with whom, on this point, Hely and Gyles JJ agreed, Eastern Nitrogen Ltd v Federal Commissioner of Taxation (2001) 108 FCR 27 at 44 per Carr J, with whom Sundberg J agreed. 2 The reference to dominant purpose in a case where more than one purpose is present is a reference to the "ruling, prevailing or most influential" purpose: Federal Commissioner of Taxation v Spotless Services Ltd (1996) 186 CLR 404 at 423. 3 The conclusion as to dominant purpose may be reached not only with respect to the dominant purpose of the taxpayer, it may be reached by reference to the dominant purpose of any other person or persons so long as they are persons who entered into or carried out the scheme or any part of it: Spotless (at 418). Likewise, the purpose of an adviser may be attributed to the taxpayer in an appropriate case: Federal Commissioner of Taxation v Consolidated Press Holdings (2001) 207 CLR 235 at 264. 4 It is possible to arrive at the conclusion as to purpose by making a global assessment of the facts, so long as it is clear that the relevant eight factors are taken into account: Consolidated Press Holdings at 263. 5 Some of the eight factors (there is clearly some overlap among them) may point one way, others may point in the opposite direction, and some may be neutral: it is the evaluation of these matters, alone or in combination, some for, some against, that s 177D requires in order to reach the conclusion to which s 177D refers: per Hill J in Peabody v Federal Commissioner of Taxation (1993) 93 ATC 4104 at 4113-4. Nothing said on the appeal at (1994) 181 CLR 359 would cast doubt on this proposition. 6 There is no inconsistency between a finding that the purpose of a person lay in the pursuit of commercial gain in the course of carrying on a business and a finding that the dominant purpose was to enable the relevant taxpayer to obtain a tax benefit: per Gleeson CJ, Gaudron, Gummow, Hayne and Callinan JJ in Consolidated Press Holdings Ltd at (para 96). [Emphasis added] 92 In some ways it is surprising that such a simple test should have occasioned so much uncertainty and debate however, as can be seen from the propositions articulated by Hill J the dominant purpose as ascertained by the Court may not have been the subjective purpose of "any person who entered into or carried out the scheme or any part of the scheme". It may, however, also be the case that the objective purpose is consistent with the subjective purpose of one or other of such persons. As Stone and Jagot JJ remarked in Commissioner of Taxation v News Australia Holdings Pty Limited [2010] FCAFC 78 at [30] It is … hardly surprising if objective intention in fact accords with the person's subjective intention. If subjective intention is reflected in objective evidence, no error is made by taking that evidence into account … Nevertheless, the relevance of such evidence must depend on its connection with the eight matters listed in s 177D(b) and not with the subjective intention of any person. 93 The evidence in this proceeding is replete with statements of the purpose of the various transactions or aspects of them, made by persons involved with those transactions. Those statements reflect the subjective intention or understanding of the makers. Such statements are of little if any assistance in determining the dominant (objective) purpose of the transactions. The relevant evidence is that which speaks to the factors listed in s 177D(b). 94 The applicant concedes that the objective purpose of an adviser may be relevant if the adviser may be described as someone who entered into or carried out the scheme or any part of the scheme. The purpose of the adviser may be attributed to the taxpayer who relies on the adviser; Federal Commissioner of Taxation v Consolidated Press Holdings Ltd (2001) 207 CLR 235 at 264, [95]. The Commissioner submitted that in the present case the purposes of Messrs Clemens and Sheppard, objectively determined, can be attributed to "each of the entities who entered into and carried out the scheme, namely JHIL, RCI and JHH(0) together with their respective officers". In principle I accept the proposition; its application is a matter for further consideration. 95 The High Court approved at [94] the proposition that it is possible to determine objective purpose by making a global assessment of the facts so long as it is clear that the relevant eight factors have been taken into account. In this case I propose to discuss ss (b)(i), (ii), (iii) and (iv) separately however the overlap in the issues relevant to ss (b)(v), (vi), (vii) and (viii) is such that these subsections may be discussed together. It should be noted that the headings below do not set out the words of each subsection accurately. Section 177D is set out in full in [2] above.

[27]

Section 177D(b)(i) - the manner in which the scheme was carried out 96 I have already decided (see [79] above) that the narrow scheme formed part of the wider scheme and that the wider scheme formed part of Project Chelsea. RCI contends that the payment of the dividend can be independently justified as having its own commercial rationale. Careful consideration of the evidence does not support this contention. 97 RCI submits that the dividend was paid to increase debt in the US and income in Australia thus generating income in Australia to enable fully franked dividends to be paid and to assist in recognising the Australian tax losses as an FITB asset in JHIL's consolidated accounts. It further submitted that the payment of the dividend in March 1998 had the same motivation as the dividend payment made in 1997, namely to reduce the withholding tax payable in the United States. This was possible because in the United States only that part of a dividend that is paid out of earnings and profit is subject to US withholding tax. Thus, in the case of the dividend of $318 million paid on 31 March 1998, only the $20 million paid in cash was subject to withholding tax. The balance, which was paid out of asset revaluation and borrowed from JHIL (secured by PN1), did not, for that reason, attract withholding tax. 98 In its written submissions RCI contends that the manner in which the steps were carried out supports its contentions. The difficulty I have with RCI's submissions in relation to s 177D(b)(i) is that they largely address the purpose of the transactions not the manner in which they were carried out as required by the subsection. To the extent to which the written submissions address manner it is generally by way of assertion. They state, for instance: There is nothing in the context, method or procedure by which either alleged scheme was implemented which would support the view that it was implemented in whole or in part with the dominant purpose of obtaining the alleged tax benefit. To the contrary, the "manner" in which it was carried out indicates that it was carried out for the aforementioned commercial objectives. 99 In contrast, the Commissioner has provided detailed submissions addressing the manner in which the elements of the schemes were carried out. For example, the Commissioner focuses on the fact that the payment of the dividend was said to have been based on the revaluation of JHH(0)'s holding in JHH(1). The evidence suggests, however, that the directors of JHH(0) were given very little information about that revaluation. There is no evidence that they were provided with a copy of any valuation before resolving to approve the proposed dividend. Mr Borgardt's memorandum to the Board (see [45] above) does not give any details of the "independent valuation" to which it refers other than the vague mention of "Australian accounting rules". It does not identify the "independent" valuer(s) or give any indication of the principles or rationale behind the revaluation. 100 As mentioned above at [50], the only document in evidence that gives any detail of the valuation is Mr Wierwille's memo dated 6 April 1998, which, with the evidence referred to in [51] suggests any formal valuation occurred after 31 March 1998. Moreover, as the Commissioner has pointed out, Mr Wierwille's memorandum does not refer to an independent valuation but to merely procedures performed to confirm management estimates of value. 101 These and other aspects of the manner in which the dividend was declared and provision made for its payment suggest that the simple commercial rationale put forward by RCI cannot be accepted as the only or dominant purpose of the persons behind the transaction. The dividend was paid for largely by JHIL in exchange for JHH(0) issuing PN1, yet there is no evidence of any meeting of the directors of JHIL considering the proposal that it should lend US$298 million to JHH(0) which, as a result of the dividend was suffering severe financial stress. Moreover, the quantum of the dividend resulted in JHH(0) being so severely undercapitalised that it was in danger of breaching the US thin capitalisation rules and had to be partially recapitalised by RCI subscribing for additional shares; see [56] above. Ultimately, the amount of the recapitalisation was US$50 million, not US$179 million as originally thought, but, as the Commissioner submits, this was, in 1998 terms, an enormous sum. 102 The evidence of Mr Edwards satisfies me that it was not unlawful for JHH(0) to declare a dividend based on a revaluation of its assets. His evidence was less convincing as to the particular dividend being not unusual; see [48] above. Given the impact of the dividend on JHH(0) it is quite remarkable that there is no evidence of the board of JHIL considering these consequences or giving any real consideration to how the loan was to be repaid when PN1 became due in September 1998. Given that the JHIL group was receiving frequent and detailed advice from the like of C&L and Warburgs, to name but two, the manner in which the schemes were entered into and carried out strongly suggests a purpose beyond that advanced by RCI. 103 The dearth of advice of any substance to the board of JHH(0) about the revaluation and the recommendation that a dividend be declared is in stark contrast to the detailed planning and consideration of the financial position of the JHIL Group which characterised the planning for Project Chelsea and the prospect of a dividend as part of that Project. It also contrasts with the complex arrangements for the payment of the dividend which, being largely by way of inter-company loans, only required a small portion of the payment to be made by cash. The contrast strongly suggests that the board of JHH(0) was merely playing its part in carrying out a step in the larger plan, being Project Chelsea. 104 Project Chelsea required that RCI be divested of its shares in JHH(0). The evidence shows that in the period leading up to the payment of the dividend there was constant concern at the capital gains implications of their low cost base. Initially there was contemplation of a stock dividend (see [28] above) although there is no evidence of why that proposal was replaced by the proposal for a cash dividend. 105 RCI submitted that the dividend of 31 March 1998 was carried out "in a similar manner to the payment of the dividend in the 1997 year" and, as it is not contended that the 1997 dividend was paid other than for commercial purposes, the same should be accepted of the 1998 dividend. The Commissioner rejects this proposition, pointing out that, among other differences, the 1997 dividend was borrowed from external lenders and paid in cash that could be held on deposit in Australia and the interest so generated used to absorb losses carried forward. He also notes that in 1997 a dividend of $100 million was rejected as excessive whereas one year later a dividend of $318 million was declared. These differences, and others identified by the Commissioner, are sufficient to indicate that the 1997 dividend and that of 1998 were motivated by different concerns.

[31]

Section 177D(b)(v), (vi), (vii) and (viii) - the financial and other consequences for RCI and any person connected with RCI resulting from the scheme and the nature of any connection between RCI and such other person 112 In Commissioner of Taxation v Mochkin at [45] Sackville J cited s 177D(b)(i), (v), (vi) and (vii) as imposing criteria "which expressly direct attention to the actual operation of the scheme and its consequences". Section 177D directs one to disregard any application of s 177F. That being so the change in RCI's financial position resulting from the scheme would be a saving in income tax in the order of A$172 million. This would result from the reduction in the value of the JHH(0) shares following the declaration of the 1998 dividend with a consequent reduction in capital gain. 113 The payment of $20 million in cash to RCI, as well as its position as creditor in respect of the amount secured by PN1, changed RCI's financial position. These factors also changed the financial position of JHH(0) in that the payment of the dividend created negative retained earnings and negative shareholder funds. As the Commissioner observed, "Absent support by other entities within the group the company would be insolvent". 114 The financial position of JHIL was also changed in two ways. First, JHIL undertook to make a payment of US$298 million to RCI in exchange for PN1. The obligation of JHH(0) to meet the promissory note on 28 September 1998 was of dubious value given JHH(0)'s financial position. There was no evidence as to how the promissory note was to be met or refinanced when it fell due. Secondly, JHIL was able to recognise the FITB in its balance sheet as a result of the interest income derived from the dividend. However, as the Commissioner points out, this occurred only for one year, after which the amount was written off. 115 It may be accepted that the dividend being declared before the end of March 1998 resulted in a saving in US withholding tax which the Commissioner estimates as "at best" US$24 million. The capital gains saving engendered by the scheme far exceed the saving of withholding tax. As explained in a letter dated 8 June 1998 from C&L to Mr Borgardt, the debt created by payment of the 1998 dividend generated an interest deduction for the 6 month period. The letter anticipates that debt levels are "likely to be reduced" during the 1999 year of income. Despite denials by Mr Morley in cross-examination, this may have been a reference to Project Chelsea. No other explanation for the remark was proffered apart from an increase in general profitability which seems a less likely explanation. 116 RCI submits that a consideration of the factors relevant to ss (b)(v) and (vi) point to either scheme "being one implemented for genuine and real commercial purposes and not for the dominant purpose of obtaining the alleged tax benefit". It points to the increased interest income for RCI on the promissory note that funded the dividend to which Mr Harman referred in his affidavit. Mr Harman based his comment on income forecasts attached to his explanation, dated 31 March 1998, of changes in the Australian taxable income forecast prepared for the audit committee. Mr Harman's document states that the "increased interest income in Australia following receipt of US$318m dividend from USA" is $90 million. In the absence of any evidence concerning the refinancing of the promissory note when it fell due it is difficult to attach much weight to those forecasts.

At a glance

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Judgment (34 paragraphs)

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