Section 8-1(1) - Loss or outgoing incurred in gaining or producing assessable income or carrying on a business for that purpose
44 SPI must establish that the whole, or some part, of the s 163AA imposts was incurred in gaining or producing its assessable income or in carrying on a business for that purpose. The Commissioner contended that the s 163AA imposts were a compulsory exaction of profits and, accordingly, were not outgoings incurred by SPI in gaining or producing its assessable income nor incurred by it in the course of carrying on its business.
45 The relevant principles were not in dispute. For a payment to satisfy s 8-1(1), there must be a sufficient nexus between the expenditure and the taxpayer's income producing operations and activities: Ronpibon Tin NL & Tongkah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47 at 57. In assessing that nexus, it was common ground that a matrix of circumstances formed the background to the Asset Sale Agreement and the imposition of the s 163AA imposts: Federal Commissioner of Taxation v Star City Pty Ltd (2009) 175 FCR 39 at [60]-[61] and the authorities there cited.
46 Before turning to the application of these principles, it is necessary to say something about the materials adduced as part of that matrix. The materials fell into two groups. The first group comprised contemporaneous materials in the possession of, or otherwise available to, SPI including the Asset Sale Agreement and the Information Memorandum. Those materials form part of the matrix of circumstances.
47 The second group is more problematic. It comprised three publications released by the Department of Treasury and Finance (DTF) and the Office of State Owned Enterprises (OSOE) and numerous memoranda internal to those entities and their advisers dated 20 November 1996 to 15 October 1997. There was no evidence that any of these documents were available to SPI or were considered by SPI (in contrast, the Information Memorandum specifically directed prospective purchasers to a fourth publication released by the DTF and OSOE). In the circumstances, none of these documents form part of the matrix of circumstances. To the extent that those documents record, or contain, information or facts not recorded elsewhere, the facts and information set out in those documents do not form part of the matrix.
48 The fact that the documents listed in [47] above may be put to one side is not surprising. The character of an outlay is determined by reference to the payer's purposes, not the recipient's: Visy Industries USA Pty Ltd v Commissioner of Taxation (2011) 85 ATR 232 at [125]. Put another way, deductibility is determined by reference to the business purpose for which the outgoing was incurred from SPI's (not the recipient's) point of view: Federal Commissioner of Taxation v The Midland Railway Co of Western Australia Ltd (1952) 85 CLR 306 at 313 and Federal Commissioner of Taxation v Ashwick (Qld) No 127 Pty Ltd (2011) 192 FCR 325 at [103]-[104].
49 As Dixon J (as he then was) said in Midland Railway (at 313):
[W]hat governs the issue is the business purposes for which the outgoing was incurred from the point of view of the taxpayer company. The controlling factors are those which arise from the character of the business or undertaking and the relation which the expenditure or the liability to make it bore to the carrying on of the business or the gaining of assessable income.
50 The question of whether expenditure is incurred for the purpose of carrying on a business is to be determined objectively by reference to the relationship between what the expenditure is for and the taxpayer's undertaking or business: Magna Alloys & Research Pty Ltd v Federal Commissioner of Taxation (1980) 11 ATR 276 at 287 and Ashwick (Qld) No 127 at [103]-[105].
51 What then were the business purposes for which the s 163AA imposts were incurred from SPI's perspective? As we have seen, the controlling factors are the character of the business and the relation which the s 163AA imposts bore to that business.
52 SPI was the holder of a licence to transmit electricity energy under Pt 12 of the EIA: see [35] above. SPI derived its assessable income from carrying on its transmission business which included providing "Prescribed Services" to VPX as the operator of the electricity network and from connecting generators, distributors and large customers to the electricity network: see [17] above. To carry on that business, it was required to hold the transmission licence: s 159 of the EIA. The s 163AA imposts were imposed on it because it was the holder of the transmission licence. The payment of the s 163AA imposts was incidental to and arose as a consequence of the conduct of SPI's business; the s 163AA imposts were inseparably connected with the transmission licence which SPI used for business purposes.
53 So far so good. However, the Commissioner submitted that the s 163AA imposts were not deductible because the payments were a compulsory exaction of profits and were therefore not outgoings incurred by SPI in gaining or producing its assessable income nor incurred by SPI in the course of carrying on its business. In support of that contention, the Commissioner relied upon the reasoning of Lockhart J in United Energy. SPI disagreed. SPI contended that the s 163AA imposts were not precluded from deductibility because they were a compulsory exaction.
54 Are there relevant principles and, if so, what are they? First, the mere fact that an exaction is compulsory does not of itself deny deductibility. As SPI submitted, there were, and are, many taxes which are deductible - land tax, the former sales tax, council rates and payroll tax: see, by way of example, Moffatt v Webb (1913) 16 CLR 120; Commissioner of Taxation v Morgan (1961) 106 CLR 517; Layala Enterprises Pty Ltd (in liq) v Commissioner of Taxation (1998) 86 FCR 348; and City Link Melbourne Ltd v Commissioner of Taxation (2004) 141 FCR 69 at [53].
55 Moffatt is instructive. The deduction claimed was for land tax imposed by the Land Tax Assessment Act 1910 (Cth) on land on which the taxpayer carried on his business as a grazier. The Court held that the land tax was an outgoing incurred by the grazier in production of income and was therefore deductible. Justice Isaacs (as he then was) put the issue simply - could the federal land tax be considered as incurred in the production of income because the grazier was bound to pay the tax as owner, regardless of what he did with the land: at 134. In seeking to answer that question, the purpose for which the tax was enacted was "utterly immaterial": at 135. The taxpayer must if he carried on that business or trade pay the tax. It was the legislature which made the taxpayer pay it and it was not a thing open to his own will or option. As Isaacs J stated, the land was as necessary to the business as the personal property - the grass, water and shelter, which were indispensable to the production of the grazier's income. The grazier's actual gross return could not be received without the use of the land. The use of the land was the use of an instrument to which was attached by law a compulsory payment. Justice Isaacs concluded (at 136) that it:
follow[ed] naturally that the payment made under compulsion of law in respect of that necessary element of the business income [was] an outgoing made in the production of the income and in the circumstances ... it was made wholly and exclusively for the taxpayer's business.
56 In order to put the issue beyond doubt, Isaacs J identified (at 136) the "fallacy of the contrary doctrine":
… it confuses, not so much the meaning, as the application of the word "purpose". The land tax is enacted by the legislature for its own purpose, that is, to tax the owner; and when he pays it to the Crown, he pays it as the owner, it is true, but so far, not for any purpose of his. He simply pays it because he is obliged to by law. But when he uses the property to produce an income, that is, for his business purposes, he pays the tax inseparably connected with the land also for his business purposes, namely as an outlay necessary in the existing state of the law to obtain that income by means of that land.
57 Applying those principles to the s 163AA imposts, the result would appear to be the same. The Victorian Government enacted the s 163AA imposts for its own purpose - to impose a "Licence Fee" on the holder of the Transmission Licence. SPI paid it because it was obliged to pay it. It held the Transmission Licence to produce an income for its business purposes and the payment of the s 163AA imposts was inseparably connected with the Transmission Licence - an outlay necessary on the existing state of the law to obtain income by using the Transmission Licence. Put another way, the thing which produced the assessable income was the thing which exposed the taxpayer to the liability discharged by the expenditure: see The Herald & Weekly Times Limited v Federal Commissioner of Taxation (1932) 48 CLR 113 at 118.
58 The question which then arises is whether United Energy leads to a different result. The Commissioner submitted that it does. United Energy distributed and sold electricity in Victoria. United Energy was one of the five regionally based distribution companies referred to in [11] above. It was licensed under the EIA to sell electricity exclusively in a designated geographical area of Victoria. During the transition phase to a "fully contestable" retail market, the distribution businesses had a statutory monopoly over the franchise customers at a supply price set by the Government. Because the MUT was set for each franchise customer class regardless of location, in many cases the MUT exceeded the total expected cost of electricity supply. Franchise fees to capture the excess profits that would otherwise accrue to a retailer as a result of MUT's exceeding the forecast cost of supplying electricity to franchise customers were therefore applied to franchise customer sales during this transition phase. These fees were levied pursuant to s 163A of the EIA:
(1) A distribution company that holds, or has held, an exclusive licence under this Part authorising it to sell electricity to franchise customers must pay to the Treasurer, in respect of each financial year during which it holds, or held, such a licence the impost determined in respect of that year by Order of the Governor in Council, on the recommendation of the Treasurer, applying to that company and published in the Government Gazelle -
(a) if the licence is issued before 30 June 1996 -
(i) before 30 June 1995, in the case of the impost in respect of the financial year ending on that date; and
(ii) before 30 June 1996, in the case of the impost in respect of each year ending on 30 June in the period beginning on 30 June 1996 and ending on 30 June 2001; and
(b) if the licence is issued on or after 30 June 1996, before the end of the first year of the term of the licence.
(2) The Treasurer, in recommending the amount of an impost for each financial year payable by a distribution company, must be satisfied that the amount reasonably represents the amount by which the income of the company derived from the sale of electricity to franchise customers in that year is likely to exceed the sum of -
(a) the costs of deriving the income; and
(b) taxes payable in deriving that income; and
(c) an amount determined by the Treasurer to be a reasonable return on the capital of the company used in deriving that income -
having regard to -
(d) any relevant Order in force under section 158A; and
(e) the value of property and rights vested in the company under Parts 10 and 11; and
(f) the amount of liabilities that became liabilities of the company under Parts 10 and 11; and
(g) the likely number of franchise customers of the company in that financial year; and
(h) such other matters as the Treasurer determines after consultation with the company.
(3) The impost in respect of a financial year is payable at such times and in such manner as are determined in the Order.
(4) For the purposes of this section, a distribution company has an exclusive licence authorising the sale of electricity to franchise customers if that licence is the only licence in force under this Part authorising the sale of electricity to those customers.
(Emphasis added.)
59 The Court described the s 163A imposts as "franchise fees". The issue before the Court was whether the franchise fees, levied against United Energy and paid, were deductible? Justice Lockhart decided that the franchise fees were akin to the State taking a share of United Energy's profits leaving United Energy with what the Treasurer determined to be a reasonable return on the capital of United Energy used in deriving its income: at 180. Justice Lockhart described the franchise fees as being in the nature of the payment of a dividend or the residual distribution of profits or dividends to the State: at 181. Put another way, Lockhart J stated that because they were compulsory exactions directed at United Energy's profits they were in the nature of a State tax on profits not a payment for services rendered or a cost incurred in the process of deriving income: at 180. Justice Lockhart said that the franchise fees were not deductible under s 51(1) of the Income Tax Assessment Act 1936 (Cth) (the 1936 Act) (the predecessor to s 8-1 of the 1997 Act). The majority (Sundberg and Merkel JJ) agreed with Lockhart J that the franchise fees were a compulsory exaction imposed by the Victorian Government to extract a share of the profits of United Energy: at 193. The majority accepted that characterisation but resolved the question of deductibility against United Energy on the basis that the amount was in the nature of capital, being profits extracted as a monopoly rent: at 193. It will be necessary to return to this part of the analysis in the next section of the reasons for judgment addressing s 8-1(2) of the 1997 Act.
60 As is readily apparent, the approach adopted by Isaacs J in Moffatt was substantially different to the approach adopted by Lockhart J. Justice Isaacs eschewed any reference to, or reliance on, the fact that the exaction was compulsory or the purpose of the State in imposing the liability to pay the tax. Justice Lockhart, on the other hand, regarded both those matters as not only significant but determinative of the question of the deductibility of the payment.
61 Can these authorities be reconciled? The answer is yes. First, as Lockhart J acknowledged, there are cases which support the proposition that "hidden taxes" payable in the course of carrying on a business may be deductible but, unsurprisingly, all cases depend on their facts: at 181. What then makes some "hidden taxes" deductible and others not?
62 The Commissioner submitted that "it is well established that a payment of profits is not a payment to earn profits and is therefore not deductible". In support of that proposition, the Commissioner cited the Privy Council's statement in Pondicherry Railway Co Ltd v Commissioner of Income Tax, Madras (1931) LR 58 Ind App 239. The Commissioner's submission puts the principle too high. In Pondicherry Railway, it was held (at 251-252) that:
A payment out of profits and conditional on profits being earned cannot accurately be described as a payment made to earn profits. It assumes that profits have first come into existence. But profits on their coming into existence attract tax at that point, and the revenue is not concerned with the subsequent application of the profits.
63 This statement was considered by the High Court in The Midland Railway Co of Western Australia Ltd v Federal Commissioner of Taxation (1950) 81 CLR 384 (before Kitto J) and subsequently by the Full Court in Federal Commissioner of Taxation v The Midland Railway Co of Western Australia Ltd (1952) 85 CLR 306.
64 At first instance, Kitto J said (at 393):
To say that it is payable out of profits or even out of net profits, is not to say that it is payable out of taxable income. Confusion may easily arise from cases dealing with the question whether particular payments are to be regarded as made in the course of ascertaining profits or out of profits when ascertained, because of the different senses in which the "profits" may be used. In this case, for instance, counsel for the Commissioner referred to the statement of the Privy Council in Pondicherry Railway Co Ltd v Commissioner of Income Tax, Madras, that "a payment out of profits and conditional on profits being earned cannot accurately be described as a payment made to earn profits. It assumes that profits have first come into existence. But profits on their coming into existence attract tax at that point, and the revenue is not concerned with the subsequent application of the profits." But, as Lord Greene M.R. pointed out in British Sugar Manufacturers Ltd v Harris, the word "profits" was there used in the sense of "real net profits"; and the statement is inapplicable to a case where the relevant question is whether the payments were incurred in producing, not real net profits (which may approximate to taxable income), but assessable income which by definition includes gross income …
(Emphasis added. Citations omitted.)
65 On appeal, Dixon J (as he then was) said (at 312-313):
… from beginning to end the issue is whether the payment or any part of it was an outgoing incurred in gaining or producing the assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing such income … it is not decisive of the issue under s 51(1) that it was paid or payable out of profits, that is so long as it was not payable out of the precise fund called by the Act taxable income.
66 These statements echoed the High Court's earlier consideration of Pondicherry Railway in Commissioner of Taxation (WA) v Boulder Perseverance Ltd (1937) 58 CLR 223 at 234:
No doubt Lord Macmillan made too absolute a statement in Pondicherry Railway Co Ltd v Commissioner of Income Tax, Madras when he said that "a payment out of profits and conditional on profits being earned cannot accurately be described as a payment made to earn profits." In Indian Radio and Cable Communications Co Ltd v Income Tax Commissioner Lord Maugham said that it might be admitted that it is not universally true to say that a payment the making of which is conditional on profits being made cannot properly be described as an expenditure incurred for the purpose of earning such profits.
(Citations omitted.)
67 As these cases demonstrate, broad sweeping statements by reference to the word "profits" do not assist in determining whether a payment is deductible. On the contrary, they ask the wrong question which leads, inevitably, to the wrong answer. The question to be asked is specific - whether the payment or any part of it is an outgoing incurred in gaining or producing the assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing such income. Subject to one matter, whether the s 163AA imposts were payments out of "profits" is not determinative. The one qualification is that if a payment is "payable out of the precise fund called by the Act taxable income", it is not deductible. That is not surprising - it would be contrary to established principle for a payment out of "taxable income" to be deductible. In general terms, your "taxable income" in a defined period is the result (or amount) after deducting allowable deductions from your assessable income (being all the income you have earned). The question therefore remains whether the s 163AA imposts, or any part of them, were an outgoing incurred in gaining or producing SPI's assessable income or necessarily incurred in carrying on its business for the purpose of gaining or producing such assessable income?
68 In answering that question, it is necessary to consider the process Lockhart J engaged in United Energy in determining the character of the franchise fees paid or payable under s 163A of the EIA. Justice Lockhart gave considerable weight to "the purpose of the State in imposing the liability to pay the tax". In doing so, Lockhart J had regard (at 180) to the legislation - the terms of the provision imposing the franchise fee (s 163A): see [58] above. Having regard to the manner in which the amount of the franchise fee was to be determined under s 163A, Lockhart J found (at 180) that:
Properly analysed the franchise fees are in reality akin to the State of Victoria taking a share of the profits from the [distribution companies] (in this case the applicant), leaving the applicant an amount determined by the Treasurer to be a reasonable return on the capital of the company used in deriving the income (s 163A(2)(c)). The residue is taken by the State as its share of profits; it has similar characteristics to a payment by way of dividend.
69 Section 163A(2) expressly provided that the Treasurer's calculation of the franchise fee was to be undertaken after, or at least in part by, determining the distribution company's taxable income, not its assessable income: see [58] above. One step in the calculation was to determine the amount of income the company derived from the sale of electricity to franchise customers (the assessable income) less the costs of deriving that income (giving rise, in general terms, to the company's taxable income). A further step was then to deduct the taxes payable in deriving that income. Two further amounts were then calculated - a reasonable return on the capital used in deriving the assessable income and any "surplus". The "surplus" was expressed by s 163A to be the amount that reasonably represented the amount by which the assessable income was likely to exceed the total of the taxable income and the return on capital. The excess was "taxed" as the franchise fee. As is apparent, the franchise fee was a payment out of profits but a payment out of profits after the calculation of the entity's taxable income. It was not an outgoing incurred in gaining or producing the assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing such assessable income.
70 Section 163AA is in different terms. It does not prescribe how the impost is to be calculated. Having regard to the express terms of s 163AA alone, the Court could not be satisfied that the impost payments were payments of "profits", being a payment out of profits after the calculation of the entity's taxable income. Put another way, there is nothing on the face of s 163AA to suggest that SPI made the payments for any reason other than discharging an obligation to pay imposed upon it as the holder of the transmission licence.
71 The next question which arises is whether other material alters or affects that conclusion? The answer to that question is yes.
72 As the Tariff Order provided (and the Information Memorandum recorded), the purpose of the Tariff Order was to regulate pricing of services - it imposed a cap on the revenue which could be derived from the provision of "Prescribed Services": see [17]-[18] above. It must be recalled that the MAR (the Maximum Allowed Revenue) was in fact "MAC x SMD", where "MAC" was the "maximum average charge" and "SMD" was the "summer maximum demand". The subsequent amendments to the Tariff Order were similarly directed to deliver more predictable transmission pricing outcomes: see [21] above. These controls of (and amendments to) pricing affected the assessable income of PNV.
73 But the revenue cap in the Tariff Order was not limited to derivation of PNV's assessable income. The revenue cap in the Tariff Order was calculated to reflect three matters - efficient levels of operating and maintenance costs, a return on capital and straight line depreciation at rates reflecting estimated useful lives on Current Cost Accounting asset base: see [19] above. The charges were set to enable PNV to recover the cost of its assets over time (reflecting depreciation), to provide it with a return on capital (using the Optimised Depreciated Replacement Cost value of assets multiplied by a weighted average cost of capital) and to recover its estimated operating and maintenance costs: see [19] above. Those elements necessarily included calculation of PNV's taxable income - revenue less estimated operating and maintenance costs and depreciation.
74 An adjustment to the revenue cap was made each year to provide for the expected real rate of improvement in efficiency. As we have seen, the method by which that adjustment was made was "CPI - X", where X was the proxy for the expected real rate of improvement in efficiency: see [19] above.
75 As we know, between the time when the X factor was initially calculated (and the Tariff Order determined in 1995) and the time that PNV was privatised in 1997, the State Government decided to extend the Tariff Order applicable to PNV for a further two years in order to promote price certainty for prospective purchasers of PNV. As a result of changes in the rate of inflation, operational costs and the cost of capital, the level of MAR which the Tariff Order permitted PNV to earn was higher than that required to provide a reasonable return on capital. Consequently, the X factor in the Tariff Order needed to be reset to reflect this change in circumstance.
76 As noted earlier (see [22] above), resetting the X factor would have resulted in lower transmission charges which would have had some unintended - and undesirable - consequences. Those unintended - and undesirable - consequences were a windfall benefit to the owners of the privatised distributors who were charging a fixed retail price for electricity but incurring lower costs (see [22] above) and, in the absence of a change to the Tariff Order, PNV would have derived more revenue (MAR) than it required in order to earn an appropriate return on capital having regard to its expected operating costs: see [23] above. The solution adopted was for the difference between (a) the revenue that would accrue to PNV under the Tariff Order and (b) the MAR that the modelling concluded should have been derived in the period before the Tariff Order lapsed in December 2000, to be recovered from PNV by way of a "special licence fee" that would be separately invoiced and levied by s 163AA of the EIA. These matters were explained to potential bidders in the Information Memorandum: see [23] and [26] above.
77 The question will often arise whether a payment that is calculated by reference to a percentage of profits represents a payment of profits (in the sense of it being a charge on the ultimate fund representing profits), or, instead, remuneration for services rendered, a reward for the use of money, or some other payment laid out for the purpose of earning profits: see, for example, Boulder Perseverance at 229-230. However, such difficulties do not arise in the present case. Here the payments were not ascertained as a percentage of actual profits. Instead they represented amounts to be derived by the licence holder from the provision of the "Prescribed Services" that were over and above all capital and operating costs (including borrowing costs) and after allowing for an appropriate return to shareholders.
78 As is apparent, although the integers in the calculation of the MAR and the licence fee were not disclosed in the express terms of s 163AA, the structure of the imposition of the franchise fee in s 163A and the licence fees under s 163AA was the same - in substance and effect, a share of the profits leaving the holder of the licence with an amount determined to be a reasonable return on the capital of the company deriving that income. The residue, or surplus, was taken by the State as its share of profits.
79 That analysis does not involve characterisation by reference to some other, different transaction. There is no element of "economic equivalence": see City Link Melbourne 141 FCR at 83. As the Full Court said in City Link Melbourne (at 86), Lockhart J's analysis in United Energy was "orthodox analysis":
It is not difficult to see on the facts of the case why Lockhart J saw the fee as "akin" to the State taking a share of profits but the conclusion reached by his Honour was not dependent upon there being some joint venture between the State and the distributor. Rather it depended upon the more orthodox analysis that the fee was not a cost of the distributor of deriving its income.
The position here is no different. The s 163AA imposts were not a cost of SPI of deriving its income. The s 163AA imposts were payments out of SPI's profits after the calculation of SPI's taxable income. They were not an outgoing incurred in gaining or producing SPI's assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing such assessable income.
80 The imposts do not satisfy either limb of s 8-1(1).