The impact of this case on ATO policy is discussed in Decision Impact Statement: Noza Holdings Pty Ltd and Ors v Federal Commissioner of Taxation; Federal Commissioner of Taxation v Noza Holdings Pty Ltd (VID 758-763, VID 764 & VID 908 of 2009 (First Instance); VID 195-198 & VID 200-201 of 2011 (Appeal)).

NOZA HOLDINGS PTY LTD & ORS v FC of T

Judges:
Gordon J

Court:
Federal Court, Melbourne

MEDIA NEUTRAL CITATION: [2011] FCA 46

Judgment date: 4 February 2011

Gordon J

A. Introduction

1. ITW Inc was and remains a US company listed on the New York Stock Exchange with its head office in Glenview, Illinois. In 2001, ITW Inc and its wholly owned subsidiaries (collectively the ITW Group), operated some 600 decentralised businesses in over 40 countries, principally concerned with the manufacture and sale of a wide range of consumer and industrial products. At that time, the ITW Group's annual revenues exceeded US$9 billion, approximately two thirds of which was derived from the ITW Group's US operations.

2. In 2001, the ITW Group held more than 17,000 patents and pending patent applications worldwide and adopted a practice of working closely with its customers to understand and meet their needs (defined as customer-based intangibles ). It was said that these two aspects of the ITW Group's work were the basis for its success.

3. Customer-based intangibles are a form of intellectual property owned by the ITW Group comprised of confidential customer information and trade secrets relating to ITW Group's customers. Such information is not able to be protected by patents or other statutory measures. To legally protect this information, the ITW Group considered that it was important to properly catalogue the information and ascribe a value to it so that the ITW Group would be able to seek damages from any employee that misused such information, thereby protecting the information in terrorem.

4. In 1999, and again in 2001, the ITW Group entered into a series of transactions designed to centralise ownership of its customer-based intangibles and crystallise their value, thereby facilitating any future legal action for their protection as well as giving rise to state tax savings in the US. The first series of transactions in 1999 was known as Project Siam. The second series in 2001 (which involved companies in Australia) became known as " Project Gemini ". These proceedings concern the Australian taxation consequences of transactions entered into as part of Project Gemini. A flowchart of the series of transactions which comprised Project Gemini is attached as Annexure A [omitted] to these reasons for decision. As the chart reflects, the transactions occurred in three phases - 15 June, 15 October and 15 November 2001.

5. The issues in these proceedings are complex. They involve the application, inter alia, of the consolidation regime principally contained in Pt 3-90 of the 1997 Act, the debt / equity provisions in Div 974 of the 1997 Act and Pt IVA of the 1936 Act, as well as the law of Delaware (and, in particular, the DGCL), to transactions entered into both here and overseas as part of Project Gemini. To put these issues into some context, it is necessary to restate some principles which underpin the consolidation regime.

6. Effective 1 July 2002, Australia introduced a consolidation regime to allow a wholly owned group of resident entities to consolidate their tax position rather than be treated as separate entities. The starting point in considering the consolidation regime is Pt 3-90 of the 1997 Act. Section 700-1 provides:

"This Part allows certain groups of entities to be treated as single entities for income tax purposes.

Following a choice to consolidate, subsidiary members are treated as part of the head company of the group rather than as separate income tax identities. The head company inherits their income tax history when they become subsidiary members of the group. On ceasing to be subsidiary members, they take with them an income tax history that recognises that they are different from when they became subsidiary members.

This is supported by rules that:

(a) set the cost for income tax purposes of assets that subsidiary members bring into the group; and

(b) determine the income tax history that is taken into account when entities become, or cease to be, subsidiary members of the group; and

(c) deal with the transfer of tax attributes such as losses and franking credits to the head company when entities become subsidiary members of the group."

(Emphasis added.)

7. Section 700-5 of the 1997 Act provides an overview of the regime and provides, so far as is relevant:

"(1) The single entity rule determines how the income tax liability of a consolidated group will be ascertained. The basic principle is contained in the Core Rules in Division 701.
(2) Essentially, a consolidated group consists of an Australian resident head company and all of its Australian resident wholly-owned subsidiaries (which may be companies, trusts or partnerships). …
(3) An eligible wholly-owned group becomes a consolidated group after notice of a choice to consolidate is given to the Commissioner.
(4) This Part also contains rules which set the cost for income tax purposes of assets of entities when they become subsidiary members of a consolidated group and of membership interests in those entities when they cease to be subsidiary members of the group.
(5) Certain tax attributes (such as losses and franking credits) of entities that become subsidiary members of a consolidated group are transferred under this Part to the head company of the group. These tax attributes remain with the group after an entity ceases to be a subsidiary member."

(Emphasis added.)

8. The decision to consolidate is optional: s 700-5(3). However, if a group decides to consolidate, all of its wholly owned Australian resident companies must consolidate: s 700-5(2). A "consolidated group" consists of a "head company" and all its "subsidiary members": see also s 703-5(3), 703-15 and 703-20 of the 1997 Act. A "head company" is a resident company: s 703-10 and 703-15. Consolidation is permissible between resident subsidiaries of a foreign parent even though there is no single head company resident in Australia through what is described as a Multiple Entry Consolidated ( MEC ) Group. A MEC Group is treated in the same way as a consolidated group with all members of the group treated as parts of the head company for Australian tax purposes.

9. The Core Rules are in Div 701 of Pt 3-90 of the 1997 Act: s 701-1 to 701-30. The most important is the "single entity rule": s 701-1. In general terms, subsidiary members of the group are treated as parts of the head company, rather than separate entities. They are treated as one single taxpayer. This has important implications. Any transactions between members of the group will be ignored for tax purposes. For example, the assets and available tax losses of the subsidiary members of the group automatically become those of the head company - they are attributed to the head company.

10. In proceedings numbered VID 758-764 of 2009, the taxpayers (AFC and Noza) were Australian resident companies who were members of the ITW Group. AFC was incorporated in Australia and was a wholly owned subsidiary of CSA (also an Australian company). Noza was also incorporated in Australia. Its ultimate holding company was ITW Inc. At the commencement of the 2003 year (1 December 2002), Noza became the head company of a MEC Group pursuant to Div 719 of Pt 3-90 of the 1997 Act. The MEC Group included AFC and CSA. Accordingly, in these proceedings, the relevant taxpayer in the 2002 year was AFC and from 2003 to 2005 the relevant taxpayer was Noza in its capacity as head company of the MEC Group. In proceedings numbered VID 908 of 2009, the relevant taxpayer is CSF, a Delaware limited liability company resident in the US which is a member of the ITW Group and the holding company for CSA.

11. The various Pt IVC proceedings are therefore concerned with the following taxpayers and issues:

Proceeding	Taxpayer	Issue	Income Year
764/2009	AFC	Deductions under s 25-90 and Pt IVA	2002
758/2009	Noza	Deductions under s 25-90 and Pt IVA	2003
759/2009	Noza	Deductions under s 25-90 and Pt IVA	2004
760/2009	Noza	Carried forward losses	2004
761/2009	Noza	Deductions under s 25-90 and Pt IVA	2005
762/2009	Noza	Carried forward losses	2005
763/2009	Noza	Penalties	2003 to 2005
908/2009	CSF	Pt IVA	2003

12. The issues that are to be determined in these proceedings concern transactions which it will be necessary to describe in much greater detail. They concern the consequences of transactions between Australian subsidiaries of the ITW Group (CSA and AFC) and US subsidiaries of the ITW Group (CSF and SGTS). They arise out of, or are associated with, a transfer of royalty rights in 2001 from CSF to AFC. They concern the payment (by the issuing of a promissory note) of dividends on preferred stock issued by another company in the ITW Group (SGTS) to AFC, the payment of dividends on preference shares issued by AFC to CSA by the endorsement of the promissory note to CSA and the payment of dividends on preference shares issued by CSA to CSF by the endorsement of the same promissory note to CSF.

13. Against that background, the questions for determination in these proceedings are:

1. Whether Noza, as head company of the Noza MEC Group, is entitled to a deduction for all or part of the dividends of $222,655,981 declared and further or alternatively, declared and paid by CSA to CSF (by way of endorsement of a promissory note) in the 2003 income year pursuant to s 25-90 of the 1997 Act.
2. Alternatively to (1):
- 2.1 whether AFC is entitled to a deduction on an incurred basis pursuant to s 25-90 for the amounts that accrued as liabilities owing to CSA (having regard to the terms of the AFC Preference Shares) in the 2002 year being $108,837,942 for dividends and $207,504 for default dividends; and
- 2.2 whether Noza, as head company of a consolidated group for the purpose of Pt 3-90 of the 1997 Act, is entitled to a deduction on an incurred basis pursuant to s 25-90 for the amounts that accrued as liabilities owing by CSA and AFC (having regard to the terms of the AFC and CSA Preference Shares) in each of the 2003, 2004 and 2005 years, being:
  - 2.2.1 $108,837,942 for dividends and $4,772,593 for default dividends, totalling $113,610,535 in the 2003 year;
  - 2.2.2 $108,837,942 for dividends and $207,504 for default dividends, totalling $109,045,446 in the 2004 year; and
  - 2.2.3 $108,837,942 for dividends and $4,772,593 for default dividends, totalling $113,818,039 in the 2005 year.
3. Whether Pt IVA of the 1936 Act applies so as to enable the Commissioner to disallow the deductions otherwise allowable to AFC and / or Noza, howsoever allowed.
4. Whether Noza, AFC and CSF are entitled to a reduction in administrative penalty applied by the Commissioner.
5. Whether Pt IVA of the 1936 Act applies so as to enable the Commissioner to determine that a dividend paid by CSA to CSF (of $222,655,981) in the 2003 year is subject to withholding tax under s 128B of the 1936 Act.

14. For the detailed reasons below, the answers are:

1. Yes, in part. Noza, as head company of the Noza MEC Group, is entitled to a deduction of $170,983,354, being part of the dividends of $222,655,981 declared and paid by CSA to CSF in the 2003 income year pursuant to s 25-90 of the 1997 Act. The entitlement to deduction for only part of the "dividend" reflects the conclusion that the difference between the expected market yield for the CSA Preference Shares (of 4.5757%) and the dividend rate of 6% was not "interest, the amount in the nature of interest, or any other amount that is calculated by reference to the time value of money" under s 820-40(1)(a) of the 1997 Act but was a return of capital. The Commissioner already allowed a deduction of A$4,980,097 in the 2003 for interest on the unpaid dividends due in the 2002 year;
2. Alternatively to 1, yes. AFC in the 2002 year and Noza in each of the 2003 - 2005 years is entitled to a deduction pursuant to s 25-90 of the 1997 Act for the amounts that accrued as liabilities owing under the terms of Preference Shares limited to that part of the "dividend" which did not comprise a return of capital;
3. No. Part IVA does not apply;
4. No. Noza and AFC are not entitled to a reduction in administrative penalty applied by the Commissioner in relation to that part of the dividend disallowed. The remainder of the issues concerning penalties do not arise; and
5. No. Part IVA does not apply in relation to CSF and the withholding tax issue.

B. Facts

15. A number of events occurred in Chicago in the US, in Melbourne, Australia and sometimes in both places. For consistency, I have used the time in Melbourne and, where relevant, listed the time in Chicago in brackets.

(1) Project Siam

16. Just prior to the end of the 1999, Sutherland from the ITW Inc's Leasing and Investments department, in conjunction with ITW Inc's US advisers and Patent Legal department, initiated Project Siam. Project Siam involved a number of key steps:

1. the perpetual licence of all of ITW Inc's customer-based intangibles as at that time to a special purpose subsidiary called CBIL Inc (in late 2000 and early 2001, this aspect of Project Siam was revised so that the licence granted by ITW Inc would cover future, as well as existing, customer-based intangibles); and
2. the sub-license of those intangibles back to ITW Inc for a two year period.

17. As noted earlier (see [4] above), by undertaking these two steps, ITW Inc asserted it had centralised ownership of its customer-based intangibles and crystallised their value, thereby facilitating any future legal action for their protection. In addition, Project Siam gave rise to state tax savings in the US as ITW Inc was able to claim deductions for the royalty payments it made on the sub-license granted by CBIL Inc, as well as interest deductions that arose in connection with the transactions.

(2) Early 2001

18. Early in 2001, the ITW Group commenced investigating other ways in which it could improve protection of the customer-based intangibles of ITW Inc and Miller (a wholly owned subsidiary of ITW Inc) and reduce its US state tax obligations. A common method for reducing US state taxes was to make intra-group payments from high taxing US states to low taxing US states where the payment would be deductible in the high-taxing state and assessable in the low-taxing state.

19. As a part of this project, the ITW Group decided to migrate its customer-based intangibles from high-taxing states (including Illinois) to a low-taxing state (namely, Delaware). The plan involved the licensing of customer-based intangibles by ITW Inc and Miller to two Delaware ITW Group resident subsidiaries which would then sub-license the intangibles back to ITW Inc and Miller in exchange for the payment of royalties. During the latter part of 2001, the plan was amended, inter alia, to address technical issues as they arose. (By 2 November 2001, the annual state tax savings expected to arise from the transactions was US$16.2 million in gross terms and US$10.5 million net of US federal taxes, totalling US$243 million in gross terms and US$157.5 million net of US federal taxes.)

20. Also in early 2001, the ITW Group received preliminary advice from its Australian advisers (the tax division of Arthur Andersen ( Andersen Tax )) about the introduction of the Australian consolidation regime. An important element of the new consolidation regime for the ITW Group was the proposed allocation of cost base, whereby the cost base of a company acquired by the ITW Group would be allocated to (or "pushed down" to) the assets owned by that company. Therefore, if or when the consolidated group sold assets to a third party, the consolidated group would be subject to capital gains tax calculated by reference to the gain above the assets' allocated cost base rather than the historical cost base recorded in the assets of the vendor company.

21. Meetings were held between 28 February and 2 March 2001 attended by Sutherland, other ITW Group employees, representatives of Andersen Tax (including Wills, Janetzki and Diskin) and representatives of KPMG Consulting in relation to the introduction of the consolidation regime and the migration of the ITW Group's customer-based intangibles.

22. At those meetings dealing with the proposed consolidation regime, Andersen Tax raised with Sutherland a concern that the proposed consolidations legislation may include an anti-avoidance provision which would restrict the ability to reset the cost base in respect of assets of subsidiaries where there had been a previous "sister to sister" rollover. As Sutherland explained it:

"… Arthur Andersen's concern was that the Australian [consolidation] regime was expected to include a measure to prevent the market value of assets transferred from a parent to a subsidiary being pushed down to the subsidiary's assets where the parent had claimed rollover relief under the capital gains tax rules. In fact, the draft legislation for the consolidation regime contemplated that the subsidiary would be obliged to use, as the cost base of such rolled over assets, the historical cost base of the assets (less depreciation) recorded in the accounts of the parent."

The relevant provision was contained in the Exposure Draft, New Business Tax System (Consolidation) Bill 2000, released on 8 December 2000.

23. Andersen Tax's concern was that such a provision in the consolidation regime would cause the cost base that would otherwise be allocated to intellectual property assets held by two Australian subsidiaries of ITW Inc, Martec and AFC, to be reduced to the historical cost base of the assets recorded in the accounts of two Australian publicly listed companies that had been acquired by the ITW Group in 1996 and 2000, Azon or Siddons respectively. This represented a value substantially below the market value of those assets which the ITW Group had paid to acquire them. The "sister to sister" rollover transactions at the time of these acquisitions were said to be worth approximately $200 million. As will become apparent later in these reasons for decision, the Commissioner placed considerable emphasis on this issue at trial in the context of Pt IVA: see [123], [124] and [326] to [340] below. The Commissioner submitted that although this was one of the reasons offered by the ITW Group to the IDR in the private letter ruling request for the offshore transactions in Australia (which formed part of Project Gemini), when faced with a foreign exchange accounting issue which arose at the end of October 2001, it was not one of the risks taken into account despite its significance earlier in the same year. It will be necessary to return to consider this aspect later in these reasons for decision.

24. In May 2001, the ITW Group decided to restructure its Australian subsidiaries in anticipation of the introduction of the Australian consolidation regime and, at the same time, to combine that restructure with ITW Inc's US customer-based intangible planning. This is what became known as Project Gemini.

25. As noted earlier (see [4] above and Annexure A [omitted]), Project Gemini had three phases. The first phase was the transfer of the shares held in ITW Inc's Australian operating companies to a single Australian holding company - a restructure of the Australian group in anticipation of the consolidation regime. The second phase was to transfer all intellectual property owned by companies in the Australian group to a single Australian company in the group - AFC. The third phase involved the transfer of the royalty rights that were to be created under the revised Project Siam to AFC.

26. The implementation of the third phase was intended to result in two outcomes:

1. a proportion of the US$4 billion cost base of the royalty rights would be included for consolidation purposes in AFC's allocable cost base and was expected to be available to be allocated to other assets held by AFC. (This was expected to result in AFC's intellectual property assets being allocated a cost base that was relatively close to their market value, even if a "sister to sister" anti-avoidance rollover rule was introduced retrospectively); and
2. by integrating the Australian consolidations restructure with the revised Project Siam planning, ITW Inc could approach the IDR for a private letter ruling which included a significant non-Illinois state tax element to the transactions, namely the Australian steps and the taxation consequences flowing from them. (What in fact occurred, as a matter of substance, was that Project Gemini included steps which injected capital into the Australian group to partly fund the purchase of the royalty rights and for that capital then to be allocated to the tax cost setting amount of all of the intellectual property assets owned by AFC and Martec if the anti-avoidance provision foreshadowed by Andersen Tax was introduced on a retrospective basis).

27. A team was established by ITW Inc to execute Project Gemini. The team included:

1. Murtaugh, Cyndi Lafuente and Lauri Ink, ITW Inc employees based in ITW Inc's head office. They were supervised by Sutherland;
2. Lieberman, a Deloitte partner in Chicago specialising in US state income tax;
3. Levy, a Chicago partner at Mayer Brown, a US law firm engaged by ITW Inc to provide US federal tax advice and Frishman, an employee solicitor at Mayer Brown, who was responsible for the legal drafting of the US documentation;
4. Wills, an Andersen Tax partner in Melbourne and Janetzki of Andersen Tax in Melbourne, retained to provide Australian taxation advice; and
5. Chin, a partner at Andersen Legal in Melbourne, who was responsible for the legal drafting of the Australian documentation.

28. Sutherland's evidence was that, from inception and subject to the cost base concerns arising from the introduction of the consolidation regime, Project Gemini was intended to allow the income produced from the royalty rights to pass through the Australian ITW Group companies without giving rise to any saving of income tax in Australia and without the US income becoming subject to Australian income or withholding tax. That is, the transfer of royalty rights to Australia was to be tax neutral (save for the possible consolidation cost base effect).

(3) June 2001

29. In early June, Sutherland revised aspects of Project Gemini. On 6 June 2001, Sutherland sent an email to Murtaugh and some of the ITW Group's advisers including Levy and Wills setting out in summary form a revised proposal for the steps for the transfer of the royalty rights to Australia. The steps were:

1. ITW PMI would contribute a demand note of A$1 billion to the capital of CSA;
2. CSA would contribute that note to the capital of AFC;
3. AFC would acquire the Miller royalty rights from BILCME in exchange for the A$1 billion note and acquire the ITW royalty rights from ICBIL in exchange for AFC's own promissory note;
4. AFC would contribute the royalty rights and its note to a new company in Australia; and
5. the new company would in turn contribute the rights and the note to SGTS, a newly established Delaware resident subsidiary of AFC, in exchange for shares.

(The step involving the "intermediate" company between AFC and SGTS was ultimately removed).

30. On 13 June 2001, Janetzki, Sutherland and Wills held a conference call. The topic of discussion was the proposed transaction in [29(3)] above. An email from Janetzki to Sutherland (copied to Wills) summarising the meeting records that an alternative plan, which involved the royalty rights being held by a United Kingdom company before being transferred to SGTS, was being considered. Sutherland's evidence was that the alternative plan was not pursued for United Kingdom tax reasons.

31. On 15 June 2001, the first phase of transactions of Project Gemini, labelled "15 June" on the flowchart at Annexure A [omitted], were completed whereby:

1. ITW Inc granted the license for the use of ITW Inc's customer-based intangibles to ICBIL for a term of 20 years in consideration for 100% membership interests in ICBIL. In turn, ICBIL sub-licensed the intangibles back to ITW Inc to use the customer-based intangibles for a term of 15 years in consideration for the right to payment of royalties equal to 10% of ITW Inc's "net sale price" for the entire term of 15 years. (The "net sale price" was defined as "the price in ITW Inc's invoices to distributors and customers, less sales tax required by law to be paid by ITW Inc, credit extended by ITW Inc for Intangible Property to Customer Relationship Services accepted and written off or otherwise credited as returns or sales commissions paid by ITW Inc to independent distributors and import duties".);
2. Miller granted the license for the use of Miller's customer-based intangibles to BILCME for a term of 20 years in consideration for 100% of BILCME shares. In turn, BILCME sub-licensed the intangibles back to Miller to use the customer-based intangibles for a term of 15 years in consideration for the payment of royalties equal to 11% of its "net sale price" for the entire term of 15 years;
3. The right to receive the royalty income (the royalty streams ) was then transferred to Investments Inc by ICBIL and BILCME, each under a license receivable purchase agreement, whereby Investments Inc acquired the right to receive the royalty streams under the relevant sub-licenses (in (1) and (2) above) for their current market value, satisfied by US$4 billion worth of preferred stock in Investments Inc; and
4. The royalty streams were then contributed by Investments Inc to the capital surplus of Holdings Inc and, then, in turn, by Holdings Inc to ITW PMI.

32. From 26 to 29 June 2001, Sutherland (and another ITW Group employee) met Wills, Diskin and Janetzki at Arthur Andersen's offices in Sydney to discuss, inter alia, Phases 2 and 3 of Project Gemini. Options "A" and "B" for the subsequent transfer of the royalty rights involving Australian companies in the ITW Group were discussed. Option B (which was not pursued) involved the United Kingdom companies. At that time, Option A involved a transfer of the royalty rights through Australia and involved the following steps as recorded in a "Summary of Meetings" document:

1. [ITW PMI] transfers a US denominated Demand Note (of say US$750 million) to [CSA] in exchange for an issue of shares. This Demand Note is then transferred from CSA to [AFC] in exchange for the issue of shares.
2. AFC would then use the [ITW PMI] Demand Note and its own "purchase money note" debt obligation (of say US$2,250 million) to acquire the royalty rights from [ITW PMI] for their market value of US$3 billion.
3. Concurrently with this process, AFC would establish / incorporate a new wholly owned US subsidiary, … SGTS … with nominal consideration.
4. Subsequently, the royalty rights and the purchase money note debt obligation would be transferred from AFC to SGTS. In return, SGTS would issue an equity interest (with a market value in this example of US$750 million) to AFC. This equity interest would be in the form of preference shares …
5. Other companies in the US ITW group would contribute non-Australian assets to SGTS in exchange for shares. This would dilute AFC's ownership interest in SGTS.
6. SGTS would receive the royalty income from ITW Inc in respect of the royalty rights. This income would be used to service the purchase money note debt obligation to [ITW PMI]. The excess would be repatriated to AFC as a dividend in respect of the preference shares. These dividends would subsequently be flowed through AFC and CSA to [ITW PMI - the US group].
7. At some time later, the SGTS preference shares [Preferred Stock] would be redeemed for their face value.
(Emphasis added.)

Option A was developed further over time and ultimately became the transactions implemented on 15 November 2001, being the transactions from CSF through to SGTS shown on Annexure A [omitted].

33. Some of the taxation issues associated with Option A (as well as Option B) were explained by Wills, Diskin and Janetzki. The "Summary of Meetings" recorded the tax explanation in relation to aspects of Option A in the following terms:

…

• We discussed the repatriation of profits from SGTS to AFC. In this regard, "dividends" received by AFC from SGTS will be exempt from Australian tax, provided that AFC has a voting interest in SGTS of at least 10%. However, in order for this exemption to be available, any relevant dividend payments cannot be debited against the share capital account of SGTS.

• As the cash generated by SGTS is likely to exceed the available accounting profits (by virtue of the fact that SGTS will be entitled to an amortisation deduction in respect of the royalty rights in the US), it would be necessary to ensure that AFC receives the preferential dividend payments. For this reason, it was determined that SGTS would issue preference shares to AFC in exchange for the contribution of the royalty rights. In this regard, [Sutherland] advised that the preference should be cumulative and redeemable, but contingent upon sufficient profits being derived by SGTS. As I noted, in order to claim the foreign dividend exemption, it would be necessary for AFC to have a voting interest in SGTS of at least 10% at all times.

• In addition, [Wills] and [Janetzki] noted that it would be necessary to review the new debt / equity rules that were introduced into Parliament on 28 June 2001. As these rules prescribed certain tax consequences for quasi debt and equity instruments, it will be necessary to ensure that the foreign dividend exemption in respect of dividends paid by SGTS on the preference shares continues to be available under this regime.
…

(Emphasis added.)

The advice was reiterated in a draft Discussion Paper prepared by Janetzki on 12 July 2001.

34. As is apparent, at that stage, the plan was that as SGTS derived sufficient profits it would pay dividends to AFC that would be exempt from Australian tax under s 23AJ of the 1936 Act. Section 23AJ was not mentioned in the "Summary of Meetings" document but it was common ground that that was what was intended. In cross-examination, Sutherland's evidence was that he understood that if Option A was adopted, it would involve dividends flowing from SGTS to AFC qualifying for exemption under s 23AJ of the 1936 Act (even though s 23AJ itself was not explicitly mentioned). Wills' evidence was to a similar effect. Wills' further evidence was that the dividends needed to be exempt under s 23AJ of the 1936 Act to ensure the tax neutrality of the Project Gemini dividend flow into and out of Australia. The substance of the advice from Andersen Tax was that any dividends paid by SGTS to AFC would need to come out of accounting profits in order for the dividend exemption to apply. This advice (accepted by Sutherland) did not change right up to the execution of the Certificate of Designation for the SGTS Preferred Stock. The Commissioner submitted that it was to be inferred that the requirement that dividends be paid only out of "accounting profits" or "accumulated earnings" was inserted to give effect to Andersen Tax's advice as no contrary evidence was led seeking to explain the development or purpose of the provision in SGTS' Certificate of Designation for the SGTS Preferred Stock.

35. Sutherland's evidence was that it was more appropriate for SGTS to issue preferred stock to AFC rather than ordinary shares because:

1. the preferred stock would be treated as debt for US federal and state income tax purposes and that would allow SGTS to claim a larger tax deduction for "interest" (in the form of dividends) paid on that preferred stock; and
2. AFC's rights under the preferred stock would ensure AFC earned a share of the SGTS' profits in priority to any other potential shareholders of SGTS.

As Sutherland explained in a memorandum he sent to Murtaugh and other ITW Inc employees on 29 June 2001, "[i]f all goes well, then the preferred stock will be viewed as equity for Australian tax purposes and debt for US tax purposes …".

36. At the meetings on 26 to 29 June 2001 and in the subsequent draft Discussion Paper, Andersen Tax also advised ITW Inc on the withholding tax implications of the proposed structure, including the on-payment of dividends by CSA to its US parent. The substance of the advice was that it should be possible to manage the on-payment of dividends by CSA to its US parent without generating a significant Australian withholding tax cost, by utilising the "foreign dividend account" provisions. The foreign dividend account provisions were enacted in 1994 by the Taxation Laws Amendment Act (No 3) 1994 (Cth) as Subdiv B in Div 11A of Pt III of the 1936 Act. The measures were repealed in 2005 by the Tax Laws Amendment (Loss Recoupment Rules and Other Measures) Bill 2005. The foreign dividend account rules allowed Australian companies that received foreign dividends (in the present case, those exempt under s 23AJ of the 1936 Act) to pay dividends to foreign shareholders without incurring a liability to pay withholding tax. The absence of a withholding tax cost on the payment of the dividends was important because ITW Inc's principal concern (at that time) was that the arrangement be "tax neutral".

(4) July - September 2001

37. It is against that background that on 18 July 2001, ITW Inc representatives (including Sutherland and Murtaugh) and Lieberman of Deloitte met with the IDR in relation to a private letter ruling to be requested by the ITW Group. The ITW Group were seeking the private letter ruling because, at that time, it was proposed that ITW PMI would transfer the royalty rights for their fair market value of US$4 billion. That transfer would give rise to a US$4 billion gain which ITW Inc and its officers were concerned would be taxable in the state of Illinois. The purpose for transferring the royalty rights in consideration for their market value was stated to be to permit the transferee (ITW PMI) to claim amortisation deductions of that amount in its state income tax returns. However, that element was only financially viable if no state in the US sought to tax the transferor on the US$4 billion gain on the transfer.

39. At the meeting on 18 July 2001 with the IDR, ITW Inc's concerns were realised. The IDR advised that the proposed transfer of the royalty rights for US$4 billion would give rise to a taxable gain in Illinois because of the actions of the resident Illinois officers and directors (as opposed to the actions of the Delaware employee). The tax on the gain, based on the 7% cumulative Illinois state tax rate, was estimated to be US$300 million.

39. During the course of the meeting with the IDR, Sutherland identified two Australian taxation planning advantages of the proposed series of transactions:

1. in relation to the proposed consolidation legislation (see [6] to [9] and [20] to [22] above), a potential advantage in relation to offsetting the cost base of assets of subsidiaries where there had previously been a "sister to sister" rollover transaction in the event that the consolidation legislation contained a provision restricting resetting in those circumstances; and
2. a potential capital loss on the sale of SGTS by AFC.

40. As a result of the discussion at the meeting on 18 July with the IDR, Sutherland and other ITW Inc officers and advisers held further meetings and discussions. Ultimately, Lieberman developed what was described by Sutherland as "a novel and previously untested structure … to avoid the technical hurdle presented by the [IDR]". The "new" structure - involving the use of a "member managed LLC" - was adopted.

41. On 20 August 2001, a private letter ruling request was lodged with the IDR. Sutherland described the request as setting out the following transactions:

"a) [ITW PMI] was to contribute the royalty streams to [CSC] and other assets in its capacity as the CSC's sole member;

b) CSC was to transfer the royalty streams to CSF in exchange for a promissory note in the sum of US$4 billion;

c) CSF was to contribute US$1 billion to the capital of CSA, its Australian subsidiary. This contribution was to be made by way of promissory note issued by CSF for the sum of US$1 billion;

d) CSA was to, in turn, contribute US$1 billion to the capital of AFC, its Australian subsidiary. This contribution was to be made by endorsement of the US$1 billion promissory note in favour of AFC;

e) AFC was to purchase the royalty streams from CSF, in consideration for endorsing the US$1 billion promissory note in favour of CSF and issuing a further promissory note in favour of CSF in the sum of US$3 billion; and

f) AFC was to transfer the royalty streams and assign its obligations under the US$3 billion promissory note to its subsidiary, SGTS, in consideration for the issue of preferred stock by SGTS and common stock. This preferred stock would include terms that would mean it would be treated as debt for US federal income tax purposes."
(Emphasis added.)

42. Sutherland's evidence was that as both CSA and AFC were to be treated as branches of CSF for the purposes of US tax laws, the US tax effect of SGTS issuing preferred stock to AFC was that the US tax law treated the stock as having been issued to CSF and treated the preferred stock as debt for both US federal and US state income tax purposes.

43. A revised request for a private letter ruling was lodged with the IDR on 10 September 2001. Before the revised request was lodged, Andersen Tax advised ITW Inc that the potential capital loss advantage (see [39] above) was no longer available. It is not clear whether ITW Inc told the IDR of this change before submitting the revised request on 10 September. In cross-examination, Sutherland could not recall whether he communicated this change to the IDR.

44. On 15 September 2001, the IDR issued the Private Letter Ruling. The Private Letter Ruling:

"1. confirmed that CSC would not be taxable in Illinois on the gain or interest income to be derived by it as a result of the transactions and CSF would not be taxable in Illinois on the dividends (to be treated as interest) paid to AFC by SGTS (for Illinois tax purposes AFC was treated as a branch of CSF);
2. identified that liability for tax in the state of Illinois was a two step process. The first step involved determining whether an amount was to be included in a taxpayer's base income and the second step involved the application of what was known as a "sales factor" to determine what amount would be taxable in the state of Illinois;
3. confirmed that the gain of US$4 billion would be included in CSC's base income but then concluded that the US$4 billion gain was to be excluded from both the numerator and the denominator of CSC's sales factor. As a result, the calculation of the sales factor, which determined the taxability of the whole of CSC's base income, depended on the treatment of the interest income received by CSC on what was described as "Demand Note 1" (being the issue of a demand note from CSF to CSC); and
4. concluded that the interest would be excluded from the numerator of CSC's sales factor and the interest derived by CSF on the preferred stock and on the US$3 billion note would be excluded from CSF's sales factor."

45. There are other aspects of the Private Letter Ruling that must be noted. First, the Private Letter Ruling was issued on the basis that it was a single ruling. There was a close relationship between the interest/dividends derived by CSF and the interest derived by CSC - one was to be used to fund the other. Secondly, the Private Letter Ruling was issued subject to an important qualification, namely:

"The facts upon which this ruling is based are subject to review by the [IDR] during the course of any audit, investigation or hearing and this ruling shall bind the [IDR] only if the material facts as recited in this ruling are correct and complete. This ruling will cease to bind the [IDR] if there is a pertinent change in statutory law, case law, rules or in the material facts recited in this ruling."

(Emphasis added.)

The qualification reflected s 1200.110(d) of the Illinois Administrative Code, tit 2, which relevantly provided that "[p]rivate letter rulings will cease to bind the [IDR] if there is a pertinent change in … material facts".

46. Thirdly, the Private Letter Ruling incorporated a Statement of Facts prepared by ITW Inc which, after setting out a summary of the background and the relevant legal entities provided, in part:

"C. The Transactions Completed Through June 18, 2001

The organization structure … would be adopted as part of an overall change to the manner in which ITW conducts business operations in Australia. Among other things, ITW is in the process of restructuring its Australian operations to: (1) improve the group's operating efficiencies; (2) eliminate redundant companies; and, (3) take advantage of specific Australian tax planning opportunities.

The transactions in support of the Australian restructuring that have been completed through June 18, 2001, are both complex and numerous, …

D. The Transactions To Be Completed After June 18, 2001

To complete its Australian restructuring, the ITW affiliated group must execute certain additional intercompany transactions. The contemplated intercompany transactions include the following …

1. [ITW PMI] would contribute the following assets to [CSC] in its capacity as [CSC's] sole member:

(a) Its entire interest in [CSF], which includes [CSF's] respective interests in CSA, AFC, and SGTS …;

(b) …

(c) Its entire interest in two License Receivable Purchase Agreements (the 'Purchase Agreements'). One such agreement concerns the right to receive designated receivables under an intangibles licensing agreement by and between ITW and its wholly-owned entity, ICBIL …, a Delaware limited liability company. The other agreement concerns the right to receive designated receivables under an intangibles licensing agreement by and between Miller … and its wholly-owned entity, BILCME …, a Delaware limited liability company.

2. Subsequent to the foregoing, [CSF] would transfer a demand note ('Demand Note 1') to [CSC] in exchange for the Purchase Agreements. The value of Demand Note 1 would be U.S. $4 billion.
For federal tax purposes, the transfer of the Purchase Agreements from [CSC] to [CSF] in exchange for debt would be treated as a taxable event for U.S. federal income tax purposes. As contemplated, [CSC] would realize gain to the extent of the value of Demand Note 1. Pursuant to the U.S. federal consolidated return regulations, the full amount of the subject gain would not be recognized by [CSC] in the current tax year. To the contrary, recognition of the full gain would be deferred until a subsequent tax year following an event requiring recognition either in whole or in part.

3. Following the foregoing, [CSF] would contribute a demand note ('Demand Note 2') to the capital of CSA in its capacity as CSA's sole member. The value of Demand Note 2 would be U.S. $1 billion.
For U.S. federal tax purposes, the transaction would be ignored as a transaction between a corporation and its branch.

4. CSA would then contribute Demand Note 2 to the capital of AFC.
For U.S. federal tax purposes, the transaction would be ignored as a transaction between a branch of a corporation and another branch of the same corporation.

5. AFC would then use Demand Note 2 and its own purchase money note ('Purchase Money Note 1') to acquire the Purchase Agreements from [CSF]. The value of Purchase Money Note 1 would be U.S. $3 billion.
For U.S. federal tax purposes, the transaction would be ignored as a transaction between a corporation and its branch. Moreover, Demand Note 2 would be extinguished upon its return to its issuer, [CSF].

6. AFC would then contribute the Purchase Agreements and its obligation under Purchase Money Note 1 to SGTS in exchange for an issuance of two classes of stock. The first class of stock would be voting common stock. All of the common shares would be issued to AFC. The second class of stock would be voting preferred stock. All of the voting preferred stock would be issued to AFC.
For U.S. federal tax purposes, the contribution would be subject to the non-recognition provisions of IRC section 351. In addition, due to the terms of the voting preferred stock issued to AFC by SGTS, this instrument would be characterized as debt for federal income tax purposes. Moreover, since AFC's basis in the Purchase Agreements would exceed the value of the liabilities assumed by SGTS (Purchase Money Note 1 and the preferred stock), there should not be a federal tax consequence associated with the subject transfer.

…"

(Emphasis added.)

47. Fourthly, the Private Letter Ruling contained the following additional statements:

"… [CSF] would receive principal and interest payments from SGTS in connection with Purchase Money Note 1 as well as interest payments from the preferred stock. [Under the described facts, interest paid by SGTS in connection with the preferred stock would be paid to AFC. As noted, AFC would be classified as a branch of [CSF] for US tax purposes. Therefore, for US tax purposes, the subject income would be deemed to have been earned by [CSF] through one of its divisions. Solely for purposes of this PLR request, such interest income will generally be discussed as if it were paid directly by SGTS to [CSF]]. Likewise, SGTS would report its interest payments to [CSF] as a deductible expense for Illinois tax purposes without offset in combination.

…

No portion of the interest income paid to [CSF] by SGTS pursuant to Purchase Money Note 1 or the preferred stock should be included in the numerator of [CSF's] Illinois sales factor.

…

Accordingly, [CSF] would not have Illinois income producing activities in connection with its receipt of interest income from Purchase Money Note 1 or the preferred stock.

…

Specifically, we request a ruling that:

… (iii) the interest paid to [CSF] by SGTS pursuant to Purchase Money Note 1 or the preferred stock should not be included in the numerator of [CSF's] Illinois apportionment factor …"

(Emphasis added.)

48. Finally, the Private Letter Ruling itself, as well as incorporating the facts outlined above, stated that:

"… [Y]our letter states that the preferred stock of SGTS will be treated as debt for federal income tax purposes.

…

As set out above, the Department rules as follows:

… 2. Interest income of [CSF] with respect to Purchase Money Note 1 and SGTS preferred stock should not be included in the numerator of its sales factors since [CSF] does not conduct income-producing activity in Illinois."

49. The Private Letter Ruling requirement that SGTS issue preferred stock characterised as debt for US federal income tax purposes enabled SGTS to claim "interest" payable on that stock as income tax deductions. Of course, "interest" was in fact dividends payable on the preferred stock but treated as "interest". In 2001, the present value of those "deductions", after allowing for the fact that state taxes were deductible in calculating ITW Inc's federal tax liabilities, was approximately US$10 million.

50. On or about 27 September 2001, the Australian Treasurer announced he had signed a protocol amending the Convention between the Government of Australia and the Government of the United States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income (the USA DTA ) and that legislation to formally ratify the protocol "[would] be introduced in the Australian Parliament as soon as practicable".

51. The protocol "removed withholding tax on certain dividends, enabling major Australian public companies to bring profits made by their US subsidiaries back to Australia without any further tax being payable". Specifically, the protocol provided:

1. no tax would be chargeable in the source country on dividends where a beneficially entitled company resident in the other country held 80% or more of the voting power of the company paying the dividends (and satisfied public listing requirements in the Limitation on Benefits Article); and
2. a limit of 5% would apply for other company shareholdings of 10% or greater (such limits applying to both franked and unfranked dividends).

These amendments to the withholding tax arrangements became significant during early November (see [114] and [121] below). The issue of withholding tax was addressed by Andersen Tax in its draft supplementary discussion paper on 8 November 2001: see [121] below.

(5) October 2001

52. Having received the Private Letter Ruling from the IDR, the ITW Group moved to complete the remaining transactions in Project Gemini by 15 October or 31 October 2001 (at the latest). There were two reasons for this - ITW Inc had told the IDR that prompt action was required and, secondly, ITW Inc wanted to commence the transactions to obtain the benefit of the US state tax savings in October.

53. In fact, completion of the transactions was divided into two stages - 15 October and 15 November 2001.

54. Before turning to consider the events of 15 October and 15 November 2001, it is necessary to identify some events that occurred between the issue of the Private Letter Ruling and completion. One event occurred on or about 2 October 2001 and was described by Mr Chin in the following terms:

"On or about 2 October 2001 I made a file note of a discussion I had with Mr Janetzki. That file note records that changes were being made to some of the steps in Project Gemini Prime (which was the description I used for the final stage of the project) because of the need to comply with an Illinois state tax ruling. I recall being told by Mr Janetzki that the ruling had been issued by the Illinois revenue authorities in relation to Project Gemini."

The file note was in evidence. Chin's file note records that there "may be some changes to Gemini Prime [because] of the need [to] comply with the Illinois State Tax Ruling". Chin's evidence was not challenged and he was not cross-examined. The applicants rely upon this unchallenged evidence as demonstrating that the need to follow the facts in the Private Letter Ruling was of importance for ITW Inc and its advisers from the time they received the Ruling. Murtaugh gave similar evidence stating she believed the binding Private Letter Ruling confirming the gain would not be taxable "was essential for proceeding with Project Gemini". The applicants submitted this was reinforced by consistent evidence of Sutherland (see [81] below), Wills (see [81] below) and Diskin (see [99] below) that, later when the foreign exchange accounting problem arose, ITW Inc considered it important to adhere strictly to the facts stipulated in the Private Letter Ruling.

55. During the same period, various emails flowed from Diskin and Janetzki to Sutherland, Murtaugh and other ITW Inc representatives in relation to various aspects of the structure of Project Gemini including, inter alia, the s 23AJ foreign dividend exemption. However, Arthur Andersen was unable to sign off on the Australian implications of the transactions as Wills was on leave.

56. On 15 October 2001 (as the flowchart at Annexure A demonstrates) the Steps numbered 1 and 2 in the Statement of Facts in the Private Letter Ruling at [46] above were completed. Specifically, the assignee of the royalty rights (ITW PMI) assigned those rights, by way of a contribution of capital, to CSC. On the same day, CSC assigned the royalty rights to CSF in consideration for the issue of a demand note of US$4 billion. The assignment and the consequences that flowed from it were important - it was the event that gave rise to a potential gain to CSC of US$4 billion and was the subject of the discussions with, and ultimately, the private letter ruling request to, the IDR. As noted at [38] above, the Illinois tax on this gain (if assessable) was approximately US$300 million, based on the 7% cumulative Illinois state tax rate.

57. The remaining transactions (described as Steps 3 to 6 in the Statement of Facts in the Private Letter Ruling at [46] above) that were to be undertaken following the assignment of the royalty rights to CSF were delayed. The transactions that were still to be completed after 15 October 2001 were:

1. the contribution by CSF of a demand note with a value of US$1 billion to the capital of CSA (Step 3 in the Statement of Facts in the Private Letter Ruling at [46] above);
2. the contribution of the same demand note by CSA to the capital of AFC (Step 4 in the Statement of Facts in the Private Letter Ruling at [46] above);
3. the acquisition of the royalty rights from CSF by AFC in consideration for the US$1 billion demand note and a purchase money note with a value of US$3 billion issued by it (Step 5 in the Statement of Facts in the Private Letter Ruling at [46] above); and
4. the contribution of the royalty rights and AFC's obligations under the US$3 billion purchase money note to SGTS in consideration for the issue of SGTS voting common stock of US$10 million and SGTS voting preferred stock of US$990 million (Step 6 in the Statement of Facts in the Private Letter Ruling at [46] above).

58. During October 2001, various draft Certificates of Designation for the SGTS Preferred Stock were prepared by ITW Inc's Delaware lawyers, MNAT, for discussion purposes. (Certificates of Designation set out the terms governing the stock). For the SGTS Preferred Stock to be characterised as debt for US tax purposes, ITW Inc had to be satisfied that, on balance, the instrument possessed more characteristics that were similar to ordinary debt rather than characteristics that were similar to ordinary equity.

59. On about 25 October 2001, ITW Inc received advice from Levy, a Chicago tax lawyer and ITW Inc's senior external taxation adviser that the draft Certificates of Designation for the SGTS Preferred Stock "would not have sufficient hallmarks of debt". The draft Certificates had a number of factors which the US advisers saw as unhelpful:

1. the type of instrument (i.e. the use of stock) and the voting rights attached to the stock, were factors consistent with ordinary equity and therefore unhelpful to ITW Inc's preferred characterisation of the stock as debt for US tax purposes;
2. the ten year term of the instrument and the option to convert the preferred stock into ordinary stock also weighed against the characterisation of the instrument as debt; and
3. the changes proposed by the Australian advisers. I now turn to consider those changes in further detail.

60. There were tensions between the requirements in Australia and the requirements in the US about the terms of the SGTS Preferred Stock. From 10 October to 19 October 2001, Andersen Tax in Australia (who had been provided with and reviewed the drafts of the Certificate of Designation) had proposed that the SGTS Preferred Stock include terms to permit the stock to be characterised as a scheme giving rise to an equity interest under Div 974 of the 1997 Act as a precaution against s 23AJ of the 1936 Act being amended in the future to exclude from exemption any dividends paid on a scheme giving rise to a debt interest. Alternatively, Diskin, suggested that if the SGTS Preferred Stock were to be characterised as a scheme giving rise to a debt interest, there may need to be an unwind strategy in the event s 23AJ was amended.

61. In relation to the first alternative, Andersen Tax in Australia had advised Sutherland that SGTS should have an option on redemption to convert the stock into common stock. The presence of such an option was intended to ensure that the SGTS Preferred Stock would be treated as equity for Div 974 purposes, thus protecting ITW Inc against any future changes to s 23AJ of the 1936 Act. In addition, Andersen Tax recommended the terms include an option for AFC to convert the preferred stock to common stock. Despite these suggested changes, Diskin's view at that time remained that the inclusion of options to convert the preferred stock into ordinary stock "may not get us all the way there, but as a belts and braces approach it is probably 'as good as it gets'". The difficulty was that the changes proposed by Andersen Tax in Australia had the effect of undermining the US tax characterisation of the instruments as debt instruments.

62. A further draft Certificate of Designation was produced on 26 October 2001. Diskin reviewed that instrument and requested further information about the US treatment of the stock in order to form a view on the treatment of the instruments under the Australian debt / equity measures. His opinion was sought in respect of various suggested amendments to the terms of the preferred stock that would see them as debt for US purposes and equity for Australian purposes. By email, Diskin said, inter alia:

"But, my concern is why the IRS will accept that this is a debt interest …. I would prefer not to go head to head with the ATO where we have to say it is not a debt interest for our rules and they can point to the in-substance approach by the US."

(Emphasis in the original.)

63. In response to an email from Murtaugh referring to the "revised option wording" in the terms of the preferred stock, Levy provided advice to ITW Inc on 29 October 2001. He said he had been referred to a specific Internal Revenue Service Revenue Ruling that addressed the characterisation of instruments as debt instruments under US federal tax law which he would look into. His advice was blunt - "Everyone thought we had no chance in the world".

64. On 26 October (Chicago Time), Murtaugh provided Kropp (then ITW Inc's Director of Corporate Accounting) with a copy of a slide pack of the Project Gemini transactions (which described the steps) that were to be proposed to be executed on 31 October 2001 and the then draft Certificate of Designation to be issued by SGTS.

65. On 29 October (28 October Chicago time), Kropp reviewed the documents. He was concerned the documents, if executed, would create a significant foreign exchange accounting issue for ITW Inc and formed the view that the transaction could not proceed if the foreign exchange accounting issue was not resolved.

66. At 3.30 pm on 29 October (10.30 pm on 28 October in Chicago), Kropp sent an email to ITW Inc's auditors at Arthur Andersen in the US (Underwood and Foster), to ITW Inc's then Chief Financial Officer (Rodriguez) and to one of Kropp's employees. The email, entitled "Foreign Currency Issue", outlined the foreign exchange accounting issue he had identified and stated:

"As part of the Gemini tax transaction, a foreign currency question has come up.

The facts (greatly simplified as Gemini is quite a complex transaction):

• An Aussie subsidiary will end up holding an investment of A$1.0 billion in the preferred stock of a US subsidiary.

• The preferred stock is redeemable at some point in the future (5 years at the earliest).

• The preferred stock may be redeemed via the issuance of common shares.

• Due to the large amounts involved and the fact that it is denominated in US dollars, [T]reasury does not want to hedge the Aussie investment in US$ preferred stock. There is no economic exposure because it is in US$.

The accounting questions are as follows:

• Is the preferred stock accounted for as debt or equity? For Aussie tax purposes, it is treated as equity. For US tax purposes, it is treated as debt. Since the investment will eliminate in consolidation, the classification would normally not be important; however, it may impact the answer to the second question. Under US GAAP, I believe that mandatory preferred stock would be classified as debt, not equity.

• Since the Aussie company has a US$ investment, it has the currency exposure. The question is how to account for fluctuations in currency? Under SFAS [Statement of Financial Accounting Standards] 52, currency fluctuations related to consolidated investments in subs are recorded through CTA [Cumulative Translation Adjustments].

• Does this apply to preferred stock investments as well?

• If not, presumably we would have to mark-to-market each quarter.

• If so, what happens upon redemption? SFAS 52 says that current currency gains or losses on investments in subs are recorded if the investment is substantially liquidated. Does it matter if the redemption is made in cash or through conversion to common shares?

…

Since this transaction is happening right away (Wednesday), we need to discuss and resolve this right away. Given the large amount of the investment, a small currency fluctuation could result in a material impact on [Earnings Per Share] (eg a 10% swing equals $100 million).

…"

67. Kropp explained in evidence that the foreign exchange accounting issue arose in the following way:

1. the preferred stock issued by SGTS to AFC would be, and were expected to be, treated as debt under US GAAP as a term was included that made it mandatorily redeemable;
2. as AFC, an Australian company whose functional currency was A$, owned the preferred stock, which was denominated in US$, it had a currency exposure related to that debt instrument;
3. as a debt instrument, any change in value of that instrument caused by fluctuations in the US$/A$ exchange rate would be recorded (or "marked to market") in the consolidated profit and loss accounts of the ITW Group which reported to the public on a quarterly basis; and
4. the reporting of currency fluctuations on a US$1 billion debt instrument could give rise to large fluctuations in profit on what was essentially an internal transaction.

As a US company listed on the New York Stock Exchange, ITW Inc was obliged to and did report its profit and loss accounts to the public each quarter.

68. The foreign exchange accounting issue had not been foreseen and it was unacceptable to the ITW Group. Kropp had the power to veto the transaction.

69. At 5.27 pm on 29 October, Janetzki (unaware of the foreign exchange accounting issue) sent an email to Sutherland and Murtaugh (copied to Wills and Diskin) entitled "Project Gemini - Paper re Australian tax considerations". Attached to the email was a draft discussion paper prepared by Andersen Tax concerning the Australian tax consequences associated with Phase three of Project Gemini (being the transactions dated 15 November 2001 in Annexure A [omitted]). This version of the draft paper (in fact the final draft) contained a more detailed analysis of the requirements regarding the terms of the SGTS Preferred Stock and the issues in the following terms:

9. Repatriation of Cash / Dividends form SGTS
SGTS will receive royalty income from ITW Inc as a result of its ownership of the royalty rights. Consequently, SGTS is likely to generate significant cash reserves, which will ultimately need to be repatriated back to ITW Inc. As SGTS will also be generating an amortisation expense / deduction in respect of its ownership of the royalty rights, these cash reserves are likely to exceed its accounting profits.

(i) Dividends Paid by SGTS to AFC
Subject to our discussion below regarding the recently proposed debt/equity rules, "non-portfolio dividends" paid by SGTS to AFC will be exempt from Australian tax (section 23AJ).

Non-Portfolio Dividend

A non-portfolio dividend for this purpose is defined in section 317 as:

"a dividend (other than an eligible finance share dividend or a widely distributed finance share dividend) paid to a company where that company has a voting interest, within the meaning of section 160AFB, amounting to at least 10% of the voting power, within the meaning of that section, in the company paying the dividend".

…

Voting Power and Voting Interest

…

Dividend Requirement

…

It is also relevant to note that the cash generated by SGTS is likely to substantially exceed its accounting profits, by virtue of the fact that it will be generating an accounting expense in respect of the amortisation of the royalty rights. Consequently, it will be important to manage the payment of dividends on the preference shares to AFC, and the repatriation of excess cash to other non-Australian shareholders using alternative means.

We note that the terms of the preference shares are such that dividends paid in respect of those shares, while cumulative, may only be paid out of profits derived by SGTS.

…

70. On 30 October (29 October in Chicago), Sutherland left Chicago to fly to Australia. When he left Chicago, the draft Certificate of Designation for the SGTS Preferred Stock had not been finalised due to the ongoing difficulties with having an instrument characterised as equity under Australia's debt / equity provisions whilst at the same time being characterised as debt under the US federal tax law. The terms of the SGTS Preferred Stock and completion of the transactions were to be attended to when Sutherland arrived in Australia. He was, however, unaware of the foreign exchange accounting issue identified by Kropp.

71. Early on 31 October (early 30 October in Chicago), Kropp discussed the foreign exchange issue with Underwood and Foster, the auditors from Arthur Andersen in the US, who confirmed that the preferred stock would have to be marked to market.

72. At 4.26 am on 31 October, (11.26 am on 30 October in Chicago), Kropp sent an email to Sutherland, Murtaugh and Rodriguez entitled "Aussie Preferred Stock Investment" which read:

"Per my discussion with Andersen re. the $1 billion preferred stock, the preferred stock investment must be marked-to-market each quarter since it is mandatory (sic) redeemable.

The only way to avoid the mark-to-market would be to make it a loan which would never be repaid (ie a permanent investment).

What is plan B?"

(Emphasis added.)

73. Kropp's evidence was that when he referred to "a loan which would never be repaid (ie a permanent investment)", he was not limiting himself strictly to instruments with the legal form of a loan, but was also contemplating instruments that were treated in substance as a loan (such as some forms of preferred stock) but would be treated as equity under US GAAP. Kropp accepted that the phrase "permanent investment" included an instrument where the holder had no right to repayment of the issue price either because the holder had no right to redeem or, in the case of preferred stock, because there was no fixed redemption date. The issue arose because the preferred stock was mandatorily redeemable (that is, the money had to be repaid at the end of the period of the preferred stock - here five years) - that meant that preferred stock would be treated as debt for US GAAP purposes which needed to be marked to market each quarter. This created a financial reporting problem for ITW Inc, the head entity. The Commissioner placed considerable reliance on this email because he asserted that Kropp's only solution - "to make it a loan which would never be repaid (ie a permanent investment") - was the same as, or at least similar to, the Commissioner's counterfactuals (see [297] to [310] below).

74. Murtaugh received the email from Kropp and immediately went to see him. Kropp said to Murtaugh words to the effect that "[t]he transaction cannot be executed in the way that it is presented". Understandably, Murtaugh was distressed. It was the first time she had become aware of the foreign exchange accounting issue and Sutherland (her immediate superior) was on his way to Australia and she had no way of contacting him. Murtaugh immediately began to work on a solution to the problem identified by Kropp which would comply with the facts outlined in the Private Letter Ruling issued by the IDR. At this time, it must be recalled that the US$4 billion gain on the transfer of the licence receivable agreements by CSC had already been triggered (see [56] above).

75. At approximately 7.30 am on 31 October (2.30 pm on 30 October in Chicago), Sutherland landed in New Zealand and telephoned the US to check his messages. He spoke by telephone with Murtaugh and Frishman who told him that Kropp had formed the view that the SGTS Preferred Stock would be treated as a debt instrument for US GAAP purposes and therefore any foreign exchange rate fluctuations between the US dollar and the Australian dollar would be recorded in ITW Inc's quarterly profit and loss accounts reported to the public shareholders. Murtaugh and Frishman also explained that because CSF's investment in Australia was through ordinary stock, the offsetting currency fluctuations would only affect ITW Inc's consolidated equity position and not offset the currency fluctuations on the SGTS Preferred Stock recorded through the profit and loss accounts. Sutherland instructed Murtaugh to work with Levy and Kropp to identify alternatives for the Australian team to consider.

76. Early on the morning of 31 October (the afternoon of 30 October in Chicago), Murtaugh was busy. She telephoned Janetzki and told him for the first time that there was a significant foreign exchange accounting problem with this phase of the restructure transactions and that the transactions would not be able to be executed in the manner then proposed. She also met with Kropp and ITW Inc's US auditors to seek a solution to the foreign exchange accounting issue.

77. At approximately 11.20 am on 31 October (6.20 pm on 30 October in Chicago), Sutherland arrived in Melbourne. Shortly after arriving, he read the email from Kropp: see [72] above.

78. At 11.48 am on 31 October (6.48 pm on 30 October in Chicago), Murtaugh sent an email to Kropp entitled "Gemini slides as they stand today" enclosing draft transaction slides showing a proposed change to step 31 - CSA issuing preferred stock to CSF. The solution proposed by Murtaugh (following her discussions with Kropp) was for the shares to be issued by CSA to CSF to be changed to preferred stock, thereby creating a natural hedge, with the preferred stock to be issued by SGTS. Step 31 was now depicted as follows:

Step 31: [CSF] creates and transfers Demand Note C (US$1 billion) to the capital of [CSA] in exchange for the issuance of common and preferred shares of [CSA].

79. At 11.54 am on 31 October (6.54 pm on 30 October in Chicago), Murtaugh sent an email to Wills, Janetzki and Levy entitled "Here are the revised slides" which read:

"I changed the slide #33 (step 31) to reflect our current thinking. I sent this on to Ron [Kropp] under separate cover. I hope my execution was proper. If there are problems please let me know.

Thanks

Kathy

P.S. David and Peter - Could you make copies for discussion purposes with [Sutherland] and Adrian (probably only need slides 33 through 36)?"

(Emphasis added.)

It was common ground that the phrase "our current thinking" referred to those in the US (including Kropp and Murtaugh) because Sutherland had not arrived at Arthur Andersen's offices and had not discussed the issues with Murtaugh, Levy or Wills.

80. Step 31 was in the form set out in [78] above. The change was to match the instrument issued by SGTS to AFC with the instrument issued by CSA to CSF - a natural hedge. CSF would have CSA issue to it voting common stock in Australian dollars equivalent to US$10 million and voting preferred stock in Australian dollars equivalent to US$990 million. In previous versions of step 31, CSA was to issue only common stock at an amount equivalent of US$1 billion in exchange for a US$1 billion demand note from CSF. Kropp's advice was that this change solved the foreign exchange accounting issue. At 1.06 pm on 31 October (8.06 pm on 30 October in Chicago), Kropp forwarded Murtaugh's email with the amended transaction slides to Underwood and Foster, ITW Inc's US auditors.

81. At approximately 1.00 pm on 31 October (8.00 pm on 30 October in Chicago), Sutherland arrived at Arthur Andersen's offices in Melbourne. Wills and Janetzki were present. Sutherland told them of the foreign exchange accounting problem and said that "any solution to the accounting problem had to be consistent with the Private Letter Ruling issued by the IDR". Sutherland was understandably upset. Wills' unchallenged evidence of that meeting was that:

"[He] understood from [the] discussions that any solution to the accounting problem would have to be consistent with the private letter ruling that had been issued by the [IDR]."

82. Two separate conference calls were held at Arthur Andersen's offices on 31 October (30 October in Chicago). The evidence is not consistent about the timing of these calls. The precise timing of the calls is not significant.

83. One call was between Kropp, Murtaugh, Sutherland and ITW Inc's US advisers. The participants discussed options for resolving the US foreign exchange accounting issue. Wills also attended the conference call. His evidence was that he did not contribute to the discussion about the proposed natural hedge between two instruments because he had previously had little, if any, exposure to such a problem. Kropp gave evidence that he and ITW Inc's US auditors:

"[D]iscussed what we thought the solution to the accounting problem should look like, which was to have matching preferred stock instruments of the same denomination issued by both SGTS and CSA, both of which were to be treated as debt for US accounting purposes."

84. Murtaugh took notes during the conference call. Her evidence was that:

"I do remember that the outcome was that ITW's auditors agreed that changing Step 31 in the manner described above would be sufficient to overcome the accounting issue Mr Kropp had identified."

85. The other conference call was attended by Sutherland, Wills, Janetzki, Levy, Murtaugh and Lauri Ink (an ITW Inc employee). The meeting discussed options to deal with the foreign exchange accounting issue and the US taxation treatment of the preferred stock. Murtaugh again took detailed notes during the conference call. She did not recall the conference call.

86. Sutherland's recollection of the conference call was as follows:

"I recall we had a conference call with Ms Murtaugh and Mr Levy to discuss the accounting issue and the treatment of the terms of the preferred stock for US taxation purposes. We discussed various options to resolve the accounting issue although we did not come to a conclusion on how the issue might be resolved. I recall coming to the conclusion that the likely solution from an accounting standpoint was to internally hedge the foreign currency exposure. This hedge was to be accomplished by matching the stock coming into Australia with the stock going out (to SGTS). However, I was not sure of what the accounting and taxation implications of this change would be. Further, I did not then know whether Australian companies would be able to issue preferred stock in a similar form to that which it was proposed that SGTS issue."

87. Janetzki's evidence was that despite Murtaugh requesting that a copy of the slides be provided to Sutherland (see [79] above), he did not do so. Sutherland's evidence was that he was provided with a copy of the slides. In the end, the conflict in the applicants' evidence is not significant. It is common ground that the possible solution of a natural hedge was discussed after around 2.00 pm on 31 October (9.00 pm on 30 October in Chicago) between Sutherland, Murtaugh, Kropp and ITW Inc's US advisers (see [83] above).

88. At 2.08 pm on 31 October (9.08 pm on 30 October in Chicago), Kropp sent an email entitled "Journal entries - Gemini Oct 31 transactions" to ITW Inc's US auditors, Murtaugh and Sutherland. Attached to the email were draft journal entries incorporating the revised transaction as set out in the transaction slides prepared by Murtaugh.

89. Work on finding a solution continued throughout the afternoon and into the evening. On 31 October (30 October in Chicago), the meetings at Arthur Andersen concluded with no agreed resolution. The natural hedge suggested by Kropp and Murtaugh and approved by ITW Inc's US auditors was not acceptable to Sutherland because he was told during the course of that day "that you couldn't issue US style preferred stock out of an Australian company". That evidence was unchallenged. There were no legal advisers at the meetings in Melbourne on 31 October.

(6) November 2001

90. At 12.25 am on 1 November (7.25 am on 31 October in Chicago), Sutherland sent an email to Murtaugh and Levy entitled "SGTS Preferred". The email stated, in part, that:

"It looks like the only hope that we have of making this work is to stress the US analysis and make the investment "permanent" for US GAAP purposes. This will, of course, work for Australian purposes and should solve our US accounting issues.

Please coordinate with the [Arthur Andersen] accountants as to the changes that need to be made to the instrument to get it into permanent equity character - removal of the mandatory convert/redemption feature, etc.

With any luck, we can still salvage this strategy …"

(Emphasis added.)

91. The Commissioner referred to this as the "Permanent for GAAP Solution" email. Sutherland gave evidence that this further "option" (rather than the "only hope") was considered very late in the evening of 31 October and involved amending the terms of the SGTS Preferred Stock so that they would be treated as equity for US GAAP purposes. His evidence was that at this time he thought that there was a possibility of still maintaining the US tax characterisation of the instrument as debt even though he knew that this was "pushing the boundaries of what might be acceptable" and knew that drafting terms that achieved this balance would be difficult to achieve.

92. During cross-examination, Sutherland acknowledged that the loss of US state tax deductibility on the dividends, payable by SGTS, would have been a problem or an issue with this proposal and that was what he meant when he said "stress the US analysis": see [90] above. The question from his perspective was:

"… what would permanent equity look like - 'permanent equity' - once we look at it then we'll understand what's going to happen. Clearly, if it was debt for accounting purposes it would be easier to have it as debt for tax purposes. Or even if it was 'equity' for accounting purposes it would have been better to have debt for tax purposes. All we were talking about is making a change that was going to put more stress on the US analysis. It was an option that we were considering."

93. Murtaugh's understanding was consistent. As she stated in her evidence:

"[I]n theory a share could be treated as equity for US accounting purposes and as debt for US tax purposes but, in practice, finding that balance was extremely difficult and potentially open to challenge."

Murtaugh understood Sutherland's reference to "stress the US analysis" (see [90] above) to mean that ITW Inc needed to retain the debt characteristics under the US tax analysis while trying to find a way to make it permanent for US GAAP purposes. In her experience, that would not have been an easy task.

94. The Commissioner placed considerable significance upon the contents of the "Permanent for GAAP Solution" email of 1 November (see [90] above). The Commissioner submitted that it demonstrated that, at the time it was sent, Sutherland considered the proposal that the preferred stock be made "permanent" for US GAAP purposes (changing the terms of the preferred stock so that they would be treated as equity for US GAAP purposes) to be a feasible alternative. The Commissioner submitted that this proposal was the same as, or at least similar to, the first of the Commissioner's counterfactuals (see [297] to [310] below) which Sutherland said in evidence he would have rejected "almost immediately". I will return to consider this counterfactual in further detail below.

95. Following Sutherland's email, Murtaugh instructed MNAT to revise the draft Certificate of Designation for the SGTS Preferred Stock to remove the mandatory redemption provision to seek to make them "permanent" for US GAAP purposes. During the course of 1 November (mid morning on 31 October in Chicago), revised drafts of the Certificate of Designation were prepared. At 3.42 am on 1 November (10.42 am on 31 October in Chicago), MNAT sent an email to Murtaugh entitled "ITW - Revised SGTS Certificate of Designation" which enclosed a revised preferred stock Certificate of Designation "modified in accordance with [their] discussions [that] morning". The draft Certificate had no reference to the stock being mandatorily redeemable - it was optional. Thirteen minutes later, at 3.55 am on 1 November (10.55 am on 31 October in Chicago), MNAT sent a further revised SGTS Certificate of Designation to Murtaugh and Frishman. Levy reviewed the revised SGTS Certificate of Designation. His unchallenged evidence was that:

"I considered, and still consider, that the changes to the SGTS preferred stock reflected in the drafts distributed by Ms. Fuller on October 31 2001, were negative factors in the characterization of the preferred stock as debt for US income tax purposes."

96. At 4.31 am on 1 November (11.31 am on 31 October in Chicago), Murtaugh sent an email entitled "FW: ITW Revised SGTS Certificate of Designation" to Sutherland, Kropp and ITW Inc's US auditors - Foster and Underwood. The draft certificate was in its amended form - the mandatory redemption feature had been removed and was now optional.

97. Throughout the day on 1 November, meetings were held at Arthur Andersen's offices in Melbourne. The meetings are attended at various times by Wills, Sutherland, Janetzki, Diskin and Chin. It will be necessary to consider aspects of these meetings in further detail below.

98. At 1.38 pm on 1 November (8.38 pm on 31 October in Chicago), Murtaugh sent an email entitled "FW: ITW-Revised SGTS Certificate of Designation" to Sutherland, Kropp, Underwood and Foster enclosing a further revised Certificate. Kropp gave evidence that he does not recall reviewing this document or the earlier document (see [96] above) or discussing them with anyone at the time. Ten minutes later, at 1.48 pm on 1 November (8.48 pm on 31 October in Chicago), Murtaugh sent an email to Sutherland entitled "Gemini meeting" regarding a scheduled meeting with the auditors, other ITW Inc officers and Levy "to keep the ball moving".

99. What transpired during the course of the afternoon on 1 November is far from clear. Sutherland gave evidence that he recalled a telephone call attended by Murtaugh, Levy and himself and possibly Wills and Janetzki. He described the telephone call in the following terms:

"I recall discussing the taxation treatment of the preferred stock as then drafted, and how my suggested treatment of that instrument as equity for US accounting purposes would create further problems because it would conflict directly with the US taxation treatment of the stock. In addition, I recall discussing how we might reconcile the debt treatment of the stock under US taxation law with the potential changes to the Australian law that would prevent an instrument treated as debt under the Australian debt/equity rules from giving rise to exempt dividends under s 23AJ of the [1936 Act].

To this end, I proposed a solution to the tension created by the US need to issue a debt instrument with the Australian objective of ensuring that this instrument be treated as equity. I proposed replacing the term in the SGTS preferred stock which gave SGTS the option to convert preferred to ordinary stock (which had been proposed by Mr Janetzki in October) with a new solution whereby SGTS would issue two series of preferred stock - one that would be drafted as debt for US taxation purposes (these were referred to as 'Series B') and a second that would be drafted as equity under the Australian debt/equity rules ('Series A') and probably equity under the US tax laws. Mr Levy agreed with me that the Series B preferred stock would be viewed as debt for US taxation purposes. Further, if the Australian dividend exemption rules changed, the Series B could be converted into Series A preferred stock which would continue to qualify for the exemption created by s 23AJ. This solution eliminated the problematic option language."

Evidence was given by others of what transpired during that afternoon. Diskin gave evidence that Sutherland had "stressed on a number of occasions" that the solution to the accounting problem needed to be consistent with the Private Letter Ruling from the IDR.

100. Late in the afternoon of 1 November 2001 (31 October in Chicago), the approach fundamentally shifted. Sutherland gave evidence of what occurred in the following terms:

"Late in the afternoon one of the participants in our discussions, I do not recall who, suggested that AFC and/or CSA could issue redeemable preference shares that would be treated as debt under Australian accounting rules. We had not previously contemplated the possibility of AFC and/or CSA issuing redeemable preference shares. We had discussed these companies issuing 'US style preferred stock' and had abandoned that plan as unworkable the day before. At no point in the discussions had the concept of redeemable preference shares come up. As we further discussed the nature of these instruments, I formed the view that it appeared likely that these instruments would also be treated as debt for US accounting purposes. Consequently, I formed the view that the issue of an instrument of this kind by AFC and/or CSA to CSF would give rise to exchange rate fluctuations that would be recorded in ITW's profit and loss accounts in an equal but opposite amount to the amounts that would be recorded in relation to the SGTS preferred stock.

…

Importantly, even though the redeemable preference shares would be treated as debt, they would in legal form be share capital of CSA and AFC. Consequently, the issue of such shares would be consistent with the relevant portion of the [IDR] private letter ruling."

(Emphasis added.)

The last paragraph, commencing "Importantly …", was objected to by the Commissioner. It was admitted into evidence on the basis that it went to Mr Sutherland's understanding and knowledge at the time, not to proof of the fact that the proposed course of action would be consistent with the Private Letter Ruling.

101. The person who made the suggestion that AFC and / or CSA issue redeemable preference shares was never identified. It was possibly Chin. Sutherland, Chin and others discussed the requirements for issuing redeemable preference shares in Australia and Chin's notes of the meeting record that Andersen Legal was to circulate standard terms of redeemable preference shares.

102. Sutherland had decided that the best way for the foreign exchange accounting issue to be resolved was for CSA to issue redeemable preference shares in Australian currency which would match the preferred stock to be issued by SGTS, also in Australian currency.

103. The evidence of Wills, Diskin and Janetzki, all unchallenged, was consistent. Wills said:

"During the afternoon of 1 November 2001, Mr Sutherland decided that the appropriate solution to the accounting problem was to have SGTS issue preferred stock in Australian currency that had terms that would be treated as debt under US tax and accounting rules, and to have AFC or CSA issue to CSF redeemable preference shares that had similar terms. Mr Sutherland explained that as the terms of the two lots of preference shares were similar and in the same currency, the preferred stock of SGTS and the redeemable preference shares of AFC or CSA would form a natural hedge and would avoid the accounting problem which had been identified. Until the accounting problem had been solved by the concept of matching the preferred stock to be issued by SGTS to the redeemable preference shares to be issued by AFC or CSA, there had been no discussion of the Australian income tax consequences of this change. I can specifically recall this as just after the accounting problem had been solved by the proposal to match the terms of the shares to be issued by AFC or CSA to those to be issued by SGTS and to issue both securities in Australian currency I left the room for a short time. When I returned Mr Diskin told me that, as a result of these changes, it was likely that the dividends on the preference shares to be issued by AFC or CSA would be tax deductible. To my knowledge this was the first time the tax consequences of the redeemable preference shares to be issued by AFC or CSA had been discussed with Mr Sutherland."

(Emphasis added.)

104. Diskin's evidence in this respect was as follows:

"Another option, which eventually was accepted by Mr Sutherland, was to have SGTS and CSA both issue preferred stock / [redeemable preference share] instruments in the same currency. I do not now recall who made this suggestion. I do however recall that the intention was that CSA would issue [redeemable preference shares] with a term of years which would be redeemable in cash at the end of the term in a form that [Arthur Andersen] would have commonly used. I recall Mr Sutherland told me that this proposal would avoid the accounting problem because the two instruments would provide a hedge or words to that effect. I recall that Mr Sutherland said words to the effect that this was the least worst option at the time, as it was considered that there might be a withholding tax impost on the dividends paid by CSA to [CSF] if the preference shares were classified as a debt interest for Australian purposes. I recall that an important aspect of the solution to the accounting problem was that both instruments had to be issued in the same currency. The possibility that CSA could issue the preference shares denominated in United States dollars was considered but Mr Chin advised that this was either not possible or not practicable."

(Emphasis added.)

105. Janetzki gave evidence to a similar effect:

"Around 5 pm on 1 November 2001, … Sutherland and … Diskin were discussing possible solutions and one of them, I cannot recall who, drew a revised structure on a whiteboard. The revised structure had 'matching' preferred stock instruments being issued by SGTS and CSA. … Sutherland then explained that for accounting purposes the two instruments would match each other and would avoid the necessity to report currency fluctuations on the preferred stock to be issued by SGTS. I recall … Sutherland saying words to the following effect:

'The matching of the terms of the preference shares to be issued by the Australian company to those to be issued by SGTS would produce a natural hedge and overcome the accounting problem.'"

106. After the issue of the redeemable preference shares had been identified as the solution to the foreign exchange accounting problem, Sutherland sought and obtained advice from Diskin on the Australian taxation implications - that the dividends payable on those shares may be deductible, that the thin capitalisation rules may not apply and that withholding tax would not be payable after July 2003. Sutherland gave evidence that he recalled that shortly after Wills, Diskin, Janetzki and Chin had concluded that the issue of redeemable preference shares by AFC and/or CSA would solve the foreign exchange accounting problem by providing a natural hedge and be consistent with the facts outlined in the IDR's Private Letter Ruling, Diskin informed him that the contemplated redeemable preference shares would be treated as debt under the new Australian debt / equity tax rules with the result that the dividends paid pursuant to the terms of the redeemable preference shares should give rise to an allowable tax deduction.

107. The evidence of the other participants in relation to this aspect of the matter was unchallenged and was consistent with Sutherland's evidence. Diskin's further unchallenged evidence was as follows:

"I recall that after the general structure of the proposed solution had been agreed I thought about the structure and then explained to Mr Sutherland the possible Australian income tax implications of the new structure. I said words to the effect of 'Do you realise what you have just done?' I recall that I then drew a simple representative box diagram on a whiteboard and explained that there was the potential for no thin capitalisation restrictions on any debt deductions arising from the dividends to be paid by CSA. I also explained to Mr Sutherland that it was arguable that no withholding tax would apply to the dividends payable by CSA due to the changes to the United States Convention that had been signed in September 2001 which provided that there would be no Australian income tax on certain dividend payments.

What I wrote on the white board represented my indicative comments on tax consequence. These needed further consideration before they could be considered the final views of [Arthur Andersen]."

108. Janetzki's unchallenged evidence was in similar terms as follows:

"During the course of that discussion, Mr Diskin advised that AFC would receive exempt dividend income but that AFC may be able to claim a debt deduction for the dividends it paid on the preference shares issued to CSF. I recall that the ability of AFC to claim a deduction on dividends it paid to CSF came as a complete surprise to … me. I had not previously contemplated that AFC could claim a deduction for the dividends it paid to CSF. This was because I, … had not contemplated the issue of preference shares by AFC until it was raised as a means of overcoming the accounting problem which Ms Murtaugh had told me about and which took up the bulk of our time on 31 October and 1 November. After Mr Diskin advised that the dividends paid by AFC may be deductible there was a discussion about whether withholding tax would be payable on the dividends paid by AFC."

109. I have set out the evidence concerning the events on 1 November in Melbourne in some detail because this is the point at which the solution to the foreign exchange accounting problem fundamentally changed and which gives rise to many of the issues in these proceedings.

110. At 12.01 am on 2 November, (7.01 am on 1 November in Chicago) Sutherland sent the following email entitled "Unbelievable Improvements to the Australian Structure" to Murtaugh, Levy, Wills, Janetzki, Chin, Frishman and Leigh Zeising:

"Hey,

Guess what …

Under the new plan we are going to introduce the following changes:

1. AFC is going to issue $1.0 billion worth of A$ redeemable preferred shares to [CSF] in exchange for the $1.0 billion Demand Note - these shares should be treated as debt for everyone's purposes.

2. AFC will transfer the Demand Note and issue the Purchase Money Note to CS Financing in exchange for the Royalty Strips (as planned).

3. AFC will transfer the Strips and the Purchase Money Note to SGTS in exchange for two issues of SGTS preferred stock - the first issue will be 8 shares of the drafted 'Series A' preferred that we all know and love (equity for Australian Tax, equity or debt for US tax and probably debt for Australian and US accounting) and the second issue will be $990.0 million worth of new Series B Preferred Shares which will be treated as debt under everyone's rules. Both preferred shares should be denominated in Australian Dollars.

Not only is the above simpler than what has been contemplated to date, it is also significantly better from a tax efficiency standpoint. Here's the story …

The path should really begin at the end with the last step. Under the Australian rules, the foreign dividend exemption overrides the classification of the income from the SGTS Series B preferred stock. As such, while this instrument is treated for all other purposes of the Australian tax rules as debt, for purposes of the foreign dividend exemption, it is a (sic) equity instrument paying dividends - no different than the Series A preferred!!

Consequently, this income will be tax free until they eliminate the foreign dividend exemption (expected to occur sometime in the future - 2 to 5 years from now). At that time, the Series B preferred will be contributed/cancelled/converted into more Series A preferred stock - hence, tax free income still in Australia.

The new magic involves the redeemable preference shares at AFC. Now pay attention … under the Australian rules, this instrument will be treated as a debt instrument. However, under the treaty, the payment will follow the form of the arrangement (i.e., dividends). As a result of this little slight of hand, if no dividends are paid on the preferred until after July 2003, no withholding will be due on the "interest". In addition, because the payments aren't interest payments, no accrual of withholding tax is due!!! This means that the debt securities of SGTS are now naturally hedged into [CSF] assets effectively eliminating the accounting issues. Of course, their (sic) is a tax benefit hidden in this mess… remember, the preferred at AFC are really debt securities under the Australian Debt-Equity rules. Consequently, they generate interest deductions which can be used by the Australian group. These deduction[s] would be limited by the thin capitalization provisions except for the fact that we have several secret and cool arguments against any limitation.

In summary, assuming that everyone loves the terms of these new arrangements, the following will occur:

• No accounting currency exposure will be created anywhere.

• No treasury currency exposure will be created anywhere.

• The state tax arguments get strengthened.

• The Australian tax benefits are exaggerated - interest expense without taxable income (no matching rule).

• No withholding costs created.

All in all, this sounds pretty good!!! Let's hope it works. Adrian and Jackie are to send around copies of standard redeemable preference shares that they have dealt with before. Zorach is confirming the withholding and interest deductibility issues of the redeemable preference shares.

I will call around 2:00 to make sure that this makes sense.

Al"

(Emphasis added.)

111. The email set out a revised structure for the CSF / SGTS transactions. Sutherland proposed that the preferred stock to be issued by SGTS would be by two series. Series B (which would comprise US$990 million of the US$1 billion preferred stock to be issued by SGTS) would be debt for US GAAP purposes. However, unlike the proposed structure from July to October, SGTS would issue preferred stock denominated in A$ rather than US$ and AFC would issue redeemable preference shares rather than ordinary shares. In practical terms, by changing the proposed preferred stock to A$, SGTS would have a foreign exchange exposure which it would need to mark to market each quarter. That foreign exchange exposure would be offset by a foreign exchange exposure of CSF arising from the preference shares issued by CSA, which would also be marked to market each quarter.

112. The Commissioner accepted that the structure adopted by ITW Inc resolved the US accounting foreign exchange issue. However, he pointed to a number of aspects of the solution which he submitted meant that the structure did not achieve the Australian taxation consequences identified in [110] above. First, Sutherland had departed from the "permanent" for US GAAP purposes solution set out in his email only 24 hours earlier (see [90] above) which he had then described as the "only hope". In other words, a solution, without the benefit of the "tax benefits", had been found only the previous day. Secondly, it was an important feature of the solution adopted that SGTS would be exposed to foreign exchange gains and losses which would be marked to market each quarter. This second aspect will be considered in further detail below when addressing the "accumulated earnings" issue.

113. The Commissioner's suggestion that Sutherland "departed" from the "permanent for US GAAP" solution implies that such a solution had been adopted. It had not. It was seen at the time as the most likely area in which the solution would be found. That is radically different from the premise implicit in the Commissioner's proposition that there was a "departure".

114. Thirdly, the new structure was perceived to give rise to substantial deductions under s 25-90 of the 1997 Act. Fourthly, Sutherland's email refers to no withholding tax on the dividends payable by AFC. It is common ground that the reference to "AFC" was in fact an error and should have read "CSA". Notwithstanding that error, the Commissioner submitted that contrary to the terms of the email, it was most unlikely that Sutherland received unequivocal advice on 1 November that no withholding tax would be payable (a point confirmed by Diskin in cross-examination), that the subsequent tax advice of Andersen Tax of 8 November (dealt with in [121] below) was not unequivocal and, indeed, withholding tax would have been payable before 1 July 2003 when the first dividend date occurred. It will be necessary to consider this submission further when addressing the Commissioner's submissions about the application of Pt IVA. However, two matters must be noted at this stage. The Commissioner accepted the order of events just outlined and the Commissioner accepted that events developed in the way described.

115. The applicants described Sutherland's 2 November email in [110] above as "high spirited" and submitted that when read in the context of the stress of the preceding two days, it reflected the great relief at finding a solution to the foreign exchange accounting problem and "surprise" at the "tax benefit hidden in this mess". The applicants placed considerable significance on the email and the events immediately preceding it as evidencing that:

1. the possible deductibility of dividends to be paid on the redeemable preference shares to be issued by AFC/CSA and which matched the preferred stock to be issued by SGTS did not drive or cause the decision to have CSA issue redeemable preference shares, as evidenced by the fact that the unchallenged sequence of events was that Sutherland was not made aware of the possibility that deductions may be available until after deciding on the solution to the foreign exchange accounting issue in a manner consistent with the facts contained in the Private Letter Ruling. (The significance of the deduction under s 25-90 of the 1997 Act is addressed in further detail below); and
2. the Australian tax outcomes were not predominant as evidenced by the order of the outcomes in Sutherland's email: see the italicised list in [110] above.

116. On 2 November, the slide pack for transactions comprising Project Gemini was updated to include the amendments to steps 31 and 33. The amended slides made no mention of any possible Australian tax benefits. By way of contrast, the amended slide pack referred to the US tax benefits.

117. At 11.32 am on 2 November (6.32 pm on 1 November in Chicago), Chin sent an email to Sutherland attaching an example of redeemable preference shares. At 2.12 am on 6 November (9.12 am on 5 November in Chicago), Sutherland sent an email to Levy responding to earlier emails regarding the inclusion of voting rights in the Series B preferred stock SGTS was to issue and the US taxation treatment of that preferred stock as debt.

118. At 1.31 am on 7 November (8.31 am on 6 November in Chicago), Kropp sent an email to Murtaugh regarding accounting issues on Project Gemini. He was unaware of the solution that had been adopted by Sutherland and the team.

119. At 7.19 pm on 8 November (2.19 am on 8 November in Chicago), Janetzki sent Sutherland (copied to Wills) an email entitled "Project Gemini" attaching "Illinois Tool Works: Project Gemini Phase 3 - Taxation Consequences - Supplement to Discussion Paper for Revised Option 2 Scenario". The purpose of the paper was described as follows:

"… [T]o supplement on a very preliminary basis the discussion paper ('the original discussion paper') previously prepared in relation to the Australian taxation consequences associated with the transaction steps proposed in the course of Phase 3 of the Project Gemini transaction. In particular, it seeks to highlight issues that require consideration in order to achieve a solution to the US accounting issues raised in the conference call on 31 October 2001.

…

It is intended that these amendments to the transaction structure would overcome the US accounting problem identified above, without creating any adverse taxation consequences."

120. The draft contained important qualifications. It stated in s 1.2 that the dividend payments in respect of the preference shares may be deductible for Australian tax purposes but foreshadowed in s 1.3 that an alternative view was that the redeemable preferences shares might be "reconstituted by the Australian Taxation Office … as an 'equity interest' rather than a 'debt interest' for the purpose of the debt and equity rules".

121. In addition, the draft discussion paper addressed the withholding tax issue. Andersen Tax's advice was that the dividends paid on redeemable preference shares to be issued by CSA would prima facie be subject to interest withholding tax and that there appeared to be a technical argument that the dividends may follow their legal form for the purposes of the USA DTA and therefore be subject to dividend withholding tax of zero percent if the relevant conditions were satisfied. The Protocol was due to come into effect (and did come into effect) on 1 July 2003. It was subject to a later announcement in September 2003 which I address in further detail below: see [134] and [402] to [409] below.

122. By 14 November, Kropp obviously had been made aware of the changes to the structure and at 7.12 am on 14 November (2.12 pm on 13 November in Chicago), Kropp sent an email to Underwood, Foster and Murtaugh stating that the final structure would be a natural hedge.

123. The transactions initially proposed on 1 November were completed on 15 November. Before turning to consider the details of those transactions, it is relevant to note that from 2 to 15 November there is no evidence to suggest that ITW Inc sought or obtained advice on whether the potential resetting of cost base advantage of the proposed CSF / SGTS transactions would be available under the revised structure. The issue was not referred to in Sutherland's email (see [110] above) or Andersen Tax's draft supplementary discussion paper (see [119] above) despite its potential monetary significance and it being one of the reasons given to the IDR for the series of transactions: see [23] above. In cross-examination, Sutherland said that:

"We did not seek specific advice on that point … It was expected that it wasn't going to change. If there was a view that it had changed in some way, then that would have potentially kept us from doing the deal."

124. Wills' evidence was consistent. He said he did:

"… recall a sense of relief that we were changing to Australian dollars from a foreign exchange perspective, but [he didn't] recall specifically turning [his] mind to the consolidation retrospectivity issue."

125. Again, these issues will be considered further when addressing the Commissioner's submissions about the application of Pt IVA.

First transaction on 15 November - CSF subscribed for CSA Preference Shares

126. On 15 November, CSF subscribed for 941 fully paid redeemable preference shares that were issued by CSA (that is, the CSA Preference Shares). The CSA Preference Shares had a total issue price of A$1,927,699,994 (the A$ equivalent of US$1 billion). CSF issued a US$1 billion demand note to CSA to pay for the CSA Preference Shares. After a period of five years, the CSA Preference Shares were to be redeemed for A$1,813,965,700 plus an amount equal to any unpaid dividends and any unpaid default dividends. Dividends payable on the CSA Preference Shares were on a cumulative preferential basis at the rate of 6% per annum on the capital paid-up on each preference share: cl 3.1. The unpaid dividends were to accumulate annually: cl 3.2. The redemption value (A$1,813,965,700) was less than the issue price. That difference was offset by a higher dividend rate of 6% so that the effective yield on the CSA Preference Shares achieved the existing market yield for equivalent preference shares of 4.5757%. The manner in which the applicants accounted for the dividends will be addressed later in these reasons for decision.

Second transaction on 15 November - CSA transferred US$1 billion demand note to AFC in exchange for AFC Preference Shares

127. CSA endorsed the US$1 billion demand note to AFC in exchange for 941 redeemable preference shares issued by AFC (that is, the AFC Preference Shares). The AFC Preference Shares were issued on the same terms and for the same price as the CSA Preference Shares: see [126] above.

Third transaction on 15 November - CSF transferred the royalty streams to AFC in exchange for US$1 billion demand note

128. CSF then transferred the royalty streams to AFC. In exchange, AFC endorsed the US$1 billion demand note (originally issued by CSF) back to CSF. The US$1 billion demand note was then cancelled by CSF. AFC also issued a US$3 billion purchase note to CSF. The purchase note bore interest at a rate of 5.5% per annum from the date of issue until 15 November 2011. Interest on the note was payable on 31 December each year commencing on 31 December 2001.

Fourth transaction on 15 November - AFC transferred the royalty streams to SGTS

129. AFC then transferred the royalty streams to SGTS in exchange for:

1. SGTS assuming AFC's obligations under the US$3 billion purchase note issued by AFC to CSF. (After SGTS assumed AFC's obligations under the US$3 billion purchase note, the note was cancelled and an identical note issued by SGTS to CSF); and
2. SGTS issuing nine Series A and 932 Series B preferred stock to AFC (the SGTS Preferred Stock ) for a total issue price of A$1,927,699,994 (the A$ equivalent of US$1 billion).

130. As noted, the SGTS Preferred Stock consisted of Series A (9 shares) and Series B (932 shares) with a par value of A$1.00 per share. Each share was issued at the same price of A$2,048,656.35 per share (totalling A$1,927,699,994). The terms and conditions under which the SGTS Preferred Stock were issued were set out in the Certificate of Designation and included:

1. the shares had a five year period with maturity scheduled for 15 November 2006. The redemption value was A$1,813,965,700;
2. preferred dividends were payable annually on 15 November in each of the subsequent five years. The annual dividend rate was 6% of what was described as "Series B Stated Value" (defined in cl B1 as A$1,927,700.00 per share) requiring dividends of $108,837,942. The dividends were payable (Art 3(a)):

when, as and if declared by the Board of Directors, out of funds legally available … representing accumulated earnings of [SGTS].
3. if dividends were not paid on their due date of 15 November, the dividend payment obligation accumulated and an interest charge (at the rate of 4.5757% per annum) was payable in respect of the period the dividend remained unpaid. Any unpaid dividends had to be paid on redemption of the preference shares;
4. at redemption, AFC could require the preference shares to be converted into ordinary shares in SGTS instead of SGTS redeeming them;
5. the only difference between the Series A and B shares was that the Series A shares gave SGTS the option to have the shares converted into ordinary shares in SGTS at redemption time. The Series B shares were only convertible at the option of AFC;
6. the Certificate of Designation was issued pursuant to s 151 of the DGCL.

(7) 2002 year

131. In the 2002 year:

1. in relation to the SGTS Preferred Stock, SGTS did not declare or pay the dividend to AFC. The unpaid dividend obligation was carried forward with the applicable additional "default dividend";
2. in relation to the AFC Preference Shares, AFC did not declare or pay the dividend to CSA;
3. in relation to the CSA Preference Shares, CSA did not declare or pay the dividend to CSF.

132. AFC's income tax return for the 2002 year (filed on 5 September 2003) did not contain any claim for deductions with respect to the AFC Preference Shares. A deemed assessment of AFC's taxable income for the 2002 year arose on the filing of the return. By a notice of objection filed in June 2007, AFC objected to the deemed assessment and contended that it was entitled to a deduction for the dividends to CSA.

(8) 2003 year

133. As noted earlier (see [10] above), on 1 December 2002, Noza became the head company of a MEC consolidated tax group that included AFC and CSA. As a consequence of consolidation, intra-group transactions between AFC and CSA were to be ignored for tax purposes and income received by AFC in respect of the SGTS Preferred Stock and any loss or outgoing incurred by CSA with respect to the CSA Preference Shares were deemed to be income received by Noza and a loss or outgoing incurred by Noza, respectively.

134. On 11 September 2003, the Federal Government announced that it would introduce legislation to amend the International Tax Agreements Act. The effect of the amendments was to apply the debt / equity rules to dividends: s 3(2A) of the International Tax Agreements Act. As a result of the amendments, dividends on the CSA Preference Shares paid by CSA would not be treated as "dividends" for the purposes of the USA DTA and interest withholding tax would be payable. The amending legislation was due to take effect on Royal Assent. Royal Assent was 5 December 2003. Wills told Sutherland about the amendments to the USA DTA in or around September 2003. These amendments will be discussed further in [402] to [409] below.

135. On 14 November 2003, the following transactions were effected:

Sutherland was a director of each of CSF, CSA, AFC and SGTS.

136. On 14 November 2003, SGTS and AFC entered into a Dividend Distribution Agreement. The Dividend Distribution Agreement was entered into and effective as of 14 November 2003. The governing law was the law of the state of Delaware. The recitals recorded that:

1. AFC owned nine shares of Series A SGTS Preferred Stock and 932 shares of Series B SGTS Preferred Stock' representing 100% of the issued and outstanding SGTS Preferred Stock;
2. pursuant to the terms of that stock, cash dividends were payable each year on or about 15 November and when a dividend is not paid in a particular year, interest calculated at 4.5757% per annum shall become payable until such dividend is paid;
3. SGTS failed to pay dividends on or about 15 November 2002; and
4. in lieu of a cash dividend, SGTS desired to distribute to AFC a dividend in the form of a short term promissory note payable on 24 November 2003 with an initial principal of A$222,655,981 and AFC desired to accept the distribution.

137. The Dividend Distribution Agreement went on to provide that:

1. SGTS issued, distributed and delivered dividends in the form of a promissory note in the amount of $222,655,981 (the SGTS Promissory Note ) and AFC acknowledged receipt of the dividends in the form of the SGTS Promissory Note;
2. SGTS and AFC acknowledged and agreed that the dividends shall be issued in the form of the SGTS Promissory Note in lieu of cash dividends and that the SGTS Promissory Note represented payment in full of all dividends plus accrued and unpaid interest due and payable on 15 November 2002 under the SGTS Preferred Stock; and
3. Each of SGTS and AFC represented to the other that it had the requisite power to enter into the agreement and to carry out its obligations under the agreement.

The agreement was executed by Sutherland for and on behalf of SGTS and AFC.

138. The SGTS Promissory Note was also signed by Sutherland as President of SGTS. The SGTS Promissory Note (which was governed by the law of Delaware) provided that SGTS promised to pay to AFC, its successors or assigns, the principal of A$222,655,981 together with interest on the unpaid principal amount at the rate of 1.25% per annum from and including 14 November 2003 up to but excluding 24 November 2003 (the Maturity Date ) with all principal and accrued but unpaid interest payable in a lump sum on the Maturity Date. The SGTS Promissory Note was able to be repaid in whole or in part by SGTS at any time and from time to time without premium or penalty with payments to be made by internal bank or wire transfer of funds to AFC's bank in Australia.

139. In order for SGTS to declare and pay a valid dividend under Delaware law, certain requirements had to be satisfied about the source of the dividend. No meeting of the board of directors of SGTS or resolution of the board of directors was tendered in evidence. However, Sutherland gave evidence that prior to entering into the Dividend Distribution Agreement, and for the purpose of determining whether SGTS had sufficient accumulated earnings for the purposes of Art 3(a) of each Series of SGTS Preferred Stock (see [130(2)] above), he made two adjustments to the accounts of SGTS which had been prepared on the basis that the Series B preferred stock were to be treated as debt for US GAAP. The applicants submitted that with the making of these adjustments, SGTS had sufficient accumulated earnings out of which it could pay a dividend. The additional "qualitative" assessment Sutherland made of the balance sheet did not result in any change to the amount of accumulated earnings.

140. What then were the adjustments Sutherland said he made? His evidence was that:

"On or about Friday November 14, 2003 I determined that the accumulated earnings of SGTS from which it could pay dividends to AFC on its preferred stock exceeded the amount then outstanding in respect of unpaid dividends. In determining the accumulated earnings for SGTS for this purpose:

(a) I used as a starting figure the amount of retained earnings calculated pursuant to US Generally Accepted Accounting Principles (GAAP);

(b) I then adjusted that figure to exclude the accrued preferred dividend expense and the net unrealised foreign exchange loss relating to the preferred stock instrument itself which had been included in the profit and loss accounts; and

(c) Finally, I made a qualitative assessment of the balance sheet of SGTS. The most significant assets on the balance sheet, the royalty rights, were being amortized on a straight line method for accounting purposes. Economically, these assets were not declining in value this rapidly. As such, since the full amortisation expense had been included in the calculation of retained earnings, I knew that an additional upward adjustment would be necessary to arrive at the actual accumulated earnings amount. No other assets or liability had such an economic-accounting value difference.

Whilst I do not now recall the precise amount which I determined to be the accumulated earnings of SGTS at the time, I do recall the amount of accumulated earnings after the adjustments referred to in paragraph … (b) were well in excess of A$222,655,981, being the dividend which had accrued at November 2003. …"

141. Sutherland was cross-examined at length about this issue. Sutherland's evidence was to the effect that "we would have" or "I would have". Sutherland could not recall when he made the adjustments but stated that it was before the dividend was paid. His evidence was that he did the calculation using "pieces of paper" and a calculator. Sutherland did not produce any contemporaneous document to evidence the making of the adjustments. He did not produce the sheet with the calculations that he made. He did not produce the financial statements upon which the calculations were based. His affidavit evidence sought to explain the adjustments he made by reference to SGTS' financial statements as at 31 December 2003, statements which were not in existence on 14 November 2003. In his oral evidence, Sutherland said he based the adjustments on the quarterly accounts as at August or September 2003, but again those accounts were not produced.

142. During cross-examination, Sutherland also talked about "rolling" forward the amounts in the quarterly accounts as at 30 September 2003 to November 2003 before making the adjustments. Sutherland accepted that the "rolling forward" was a second level of adjustments. That second level of "rolling forward" was not expressly referred to in his affidavit. I reject the evidence of Sutherland that this second level was "embedded" in paragraph (a) extracted in [140] above. Indeed, Sutherland's evidence was less than satisfactory about when he "rolled forward" to. In response to a direct question about when he rolled forward to, Sutherland's response was "… it would have been to the end. Presumably, it would have been to the beginning of November. To the beginning of November". Moreover, the other directors of SGTS were not involved in this process although the board ratified the decision to pay the dividend to AFC at a SGTS board meeting in May 2004.

143. In addition to the lack of satisfactory evidence about the making of these adjustments, the Commissioner pointed to the fact that in subsequent correspondence from the applicants' advisers to the Commissioner, different and inaccurate statements were made about these adjustments. Ultimately, the Commissioner submitted that on the basis of the oral evidence, the complete absence of relevant documents and figures and the contents of the later correspondence sent by the applicants and their advisers to the Commissioner, the Court should not accept that the applicants established that the adjustments were made or what they were.

144. In my view, the applicants' evidence in relation to this issue was unsatisfactory. Given the size and significance of the issue, the lack of contemporaneous records, the lack of detail in the evidence and the inconsistencies in the evidence were surprising. Moreover, Sutherland's attitude when being cross-examined about this issue was unhelpful. The tone of his evidence suggested that he resented being questioned about whether he in fact had made the adjustments and what he had done to satisfy himself that there were sufficient accumulated earnings in SGTS to pay the dividend. Having regard to all of the evidence (both documentary and oral), I do not accept that Sutherland made the adjustments in 2003 or that the applicants have established on the balance of probabilities that SGTS had sufficient accumulated earnings to pay the dividend to AFC on 14 November 2003.

145. On 14 November 2003, the directors of AFC held a meeting. The minutes record that AFC had received notice from SGTS that it had declared dividends of $222,655,981 in respect of the SGTS Preferred Stock and that AFC would receive payment of the dividends in the form of a SGTS promissory note. The minutes go on to state that AFC resolved to accept the SGTS Promissory Note as payment of the SGTS dividends.

146. On 14 November 2003, it was further resolved by the directors of AFC that the dividend of $222,655,981 payable to CSA pursuant to the AFC Preference Shares be declared payable out of the profits of AFC and be paid to CSA by endorsing the SGTS Promissory Note in favour of CSA.

147. On 14 November 2003, the directors of CSA also held a meeting. The minutes of that meeting recorded that CSA resolved to accept the SGTS Promissory Note from AFC as payment of the dividends owing by AFC to CSA pursuant to the AFC Preference Shares, namely the dividends payable on 15 November 2002, 15 November 2003 and the default dividend in respect of the 15 November 2002 dividend. The minutes go on to state that CSA resolved to pay dividends of $222,655,981 in favour of CSF by declaring that the dividends be payable out of profits of CSA and that the dividends be paid to CSF on 14 November 2003 by endorsing the SGTS Promissory Note in favour of CSF.

148. On 14 November 2003, the SGTS Promissory Note was subsequently endorsed by AFC to CSA and then by CSA to CSF. The dividend payments from SGTS to AFC, from AFC to CSA and in turn from CSA to CSF comprised the following components:

Component of Payment AMOUNT

Dividend - 15 November 2002 (in arrears). $108,837,942

Dividend - 14 November 2003. $108,837,942

"Default dividend" (in respect of 15 November 2002 dividend and paid on 14 November 2003). $4,980,097

TOTAL $222,655,981

It is the amount of $222,655,981 paid by CSA to CSF by way of endorsement of the SGTS Promissory Note which Noza claims as a deduction in the 2003 Year.

149. On 24 November 2003, the SGTS Promissory Note was settled in full (along with A$77,311 of accrued interest) via an intercompany wire transfer of cash from SGTS to CSF.

(9) 2004 and 2005 years

150. In each of 2004 and 2005 years:

1. in relation to the SGTS Preferred Stock, SGTS did not declare or pay the dividends to AFC scheduled for 15 November. These unpaid dividend obligations were carried forward with the applicable additional "default dividends";
2. neither AFC nor CSA declared or paid any dividend payments pursuant to the AFC Preference Shares or the CSA Preference Shares. In accordance with the terms of issue of the AFC and CSA Preference Shares, these unpaid dividend obligations were carried forward with the applicable additional "default dividends".

(10) SGTS financial performance

151. In the 2001-2004 years, SGTS' financial reports recorded SGTS' net income:

y/e 30 December	Net income (loss)
2001	US$124,877,434
2002	(US$98,748,065)
2003	(US$328,597,392)
2004	(US$36,372,348)

C. Legal issues and analysis

(1) Deductibility in 2003 for dividend paid: s 25-90

(a) Introduction

152. Section 25-90 of the 1997 Act provides for deductibility for losses or outgoings that would, absent s 25-90, not be deductible under the general deduction provision (s 8-1 of the 1997 Act) because they were losses or outgoings incurred in deriving non-assessable income, including foreign exempt income under s 23AJ of the 1936 Act.

153. Section 25-90 was introduced by the New Business Tax System (Thin Capitalisation) Act 2001 (Cth). It was enacted on 1 October 2001, with retrospective effect from 1 July 2001: s 2.

154. Paragraph [3.7] of the Explanatory Memorandum to the New Business Tax System (Thin Capitalisation) Bill 2001 which accompanied its introduction described the new thin capitalisation regime in the following terms:

"The new thin capitalisation regime will impose a limit on the extent to which the Australian operations of Australian outward investors can be funded by debt. Accordingly, the current limitations imposed by section 79D and section 8-1 (in relation to exempt income) on interest deductions will be removed in so far as they apply to debt deductions and do not relate to an entity's overseas permanent establishment. Therefore, expenses relating to those deductions will be able to be deducted when incurred in earning exempt foreign income and will no longer be quarantined, subject to the limits imposed by the new thin capitalisation provisions."

155. Paragraph [3.11] of the Explanatory Memorandum provided that the new rules also:

"… incorporate comprehensive concepts of debt and debt deductions that arise from debt arrangements rather than being restricted to the narrow concept of interest as in the existing rules, reflecting a move to economic form over substance."

156. In general terms, s 25-90 allowed a deduction for debt deductions incurred in the derivation of exempt income. As the applicants submitted, this was a novel concept because deductions would not generally be available for expenses incurred in deriving exempt income. Section 25-90 was an exception to this general rule.

157. In the 2003 year (which ended 30 November in this case), s 25-90 provided:

"An *Australian entity can deduct an amount of loss or outgoing from its assessable income for an income year if:

(a) the amount is incurred by the entity in deriving income from a foreign source; and

(b) the income is exempt income under section 23AI, 23AJ or 23AK of the [1936 Act]; and

(c) the amount is a cost in relation to a *debt interest issued by the entity that is covered by paragraph (a) of the definition of debt deduction."

The Taxation Laws Amendment Act (No 4) 2003 (Cth) replaced references in s 25-90 and 23AJ from "exempt income" to "non-assessable non-exempt income". These amendments took effect as from the 2003-2004 year (that is, from 1 December 2003 for the applicants).

158. For an amount to be deductible under s 25-90, the taxpayer had to show that:

1. the amount was a loss or outgoing incurred in the relevant year;
2. the amount was incurred by the taxpayer in deriving income from a foreign source;
3. the income was, in this case, a s 23AJ exempt dividend. (As at October 2001, dividends which satisfied s 23AJ were exempt income); and
4. the loss or outgoing was, in this case, a cost in relation to a debt interest.

159. In these proceedings, a principal issue is whether the amount of $222,655,981 paid by CSA to CSF in the 2003 year by way of endorsement of a promissory note is deductible to CSA (and therefore Noza) pursuant to s 25-90 of the 1997 Act. The Commissioner allowed a deduction of $4,980,097 (representing the default dividend component). The dispute is therefore limited to $217,675,884 of the total amount of $222,655,981. Although the Commissioner accepted that (1) to the extent any income was derived by CSA it was from a foreign source and (2) the CSA Preference Shares were debt interests, he submitted that $217,675,884 of the total amount of $222,655,981 was not deductible in the 2003 year pursuant to s 25-90 because:

1. there was no loss or outgoing incurred by CSA (and therefore Noza) in the 2003 year because the alleged payment of the $222,655,981 by CSA to CSF by way of the endorsement of the promissory note was not a loss or outgoing by CSA in the 2003 year as the promissory note was unenforceable in the hands of CSF. According to the Commissioner, the alleged unenforceability arose because contrary to the terms of the SGTS Preferred Stock (see [130(2)] above), SGTS did not have "accumulated earnings" available from which to legally pay the dividends to AFC;
2. no income was derived by Noza;
3. if income was derived, it was not exempt income pursuant to s 23AJ of the 1936 Act;
4. an amount of $42,208,216 forming part of the total amount of $222,655,981 was not a cost in relation to a debt interest within the meaning of s 820-40(1)(a) of the 1997 Act; and
5. as noted, an amount of $4,980,097 forming part of the total amount of $222,655,981 had already been allowed as a deduction under s 8-1 of the 1997 Act.

160. The applicants rejected those submissions and submitted that a valid dividend was paid. First, the applicants contended that even if SGTS had insufficient accumulated earnings to pay dividends to AFC in November 2003, AFC and CSA had nonetheless incurred a liability when each "declared" their respective dividends by reason of s 254V(2) of the Corporations Act 2001. As the declaration had not been set aside by Court order, each liability continued to exist and that loss or outgoing was incurred by CSA in 2003 (treated as incurred by Noza) and was incurred in deriving dividends that were exempt under s 23AJ. The Commissioner contended that the applicants were not entitled to rely on this contention because it was raised too late in the proceedings.

161. Alternatively, the applicants submitted that a valid dividend was paid out of the accumulated earnings of SGTS in November 2003 because SGTS had sufficient accumulated earnings as a result of adjustments made by Sutherland to the financial accounts which they contend were required to convert or treat the SGTS Preferred Stock from borrowings to equity in accordance with their legal form.

162. Further, the applicants submitted that the dividend was a "dividend" for the purposes of s 23AJ of the 1936 Act, the dividend was derived by AFC when the Dividend Distribution Agreement was entered into, AFC had sufficient profits to declare and pay dividends to CSA and CSA had sufficient profits to declare and pay its dividend to CSF.

(b) Summary of findings

163. For the detailed reasons that follow, I have concluded that Noza incurred a loss or outgoing of $222,655,981 when CSA declared a dividend of $222,655,981 on 14 November 2003 because the declaration created a debt pursuant to s 254V(2) of the Corporations Act 2001: see [169] to [185] below. However, even if the declaration did not create a debt, Noza incurred a loss or outgoing of $222,655,981 when CSA declared the dividend on 14 November 2003 because AFC had declared a dividend in favour of CSA and endorsed SGTS' promissory note to enable CSA to declare and pay the dividend to CSF. In its simplest terms, a promissory note is a written promise to repay a loan or debt under specific terms - usually at a stated time, through a specified series of payments, or upon demand. Here, the promissory note was payable by no later than 24 November 2003 and was in fact paid by intercompany wire transfer on that day.

164. Having regard to the findings in [163], it is unnecessary to consider the further issue of whether SGTS had "accumulated earnings" and / or whether it was permissible to take into account the adjustments purportedly made by Sutherland to the accounts of SGTS. However, in relation to that issue, I accept it was a requirement of the Certificate of Designation of the SGTS Preferred Stock that SGTS have sufficient "accumulated earnings" as at 14 November 2003 before being entitled to declare a dividend in favour of AFC and that the proper construction of Art 3(a) of the Certificate of Designation would permit adjustments to be made: see [191] to [206] below. I do not accept that the applicants discharged the onus of establishing that Sutherland did in fact make the necessary adjustments or if he did, the value of those adjustments: see [139] to [144] above. Accordingly, on the basis of SGTS' accounts, I am not satisfied that SGTS' accumulated earnings were sufficient to pay the dividend on 14 November 2003. The fact that SGTS was not shown to have sufficient accumulated earnings did not mean however that the declaration of the dividend by AFC in favour of CSA was void or can now in some way be set aside or treated as not having happened. Even if the SGTS dividend was in breach of the DGCL (because SGTS did not have sufficient "accumulated earnings" as at 14 November 2003) absent proceedings under s 174 of the DGCL, the dividend was not invalid.

165. Further, I do not accept that the difference between the expected market yield for the CSA Preference Shares (of 4.5757%) and the dividend rate of 6% was a "debt deduction" under s 820-40(1)(a) of the 1997 Act. It was in substance and in form a return of capital or principal. Accordingly, only that component of the dividend comprising 4.5757% of the redemption price ($170,983,354) was deductible under s 25-90 of the 1997 Act.

166. I turn to consider each element of s 25-90 of the 1997 Act.

(c) Was a Loss or Outgoing Incurred?

167. The first issue is whether CSA (and therefore Noza) incurred a loss or outgoing on 14 November 2003 (1) when CSA declared dividends of $222,655,981 payable out of profits of CSA to CSF or (2) when it declared dividends of $222,655,981 payable out of profits of CSA to CSF and then declared that those dividends be paid by endorsing the SGTS Promissory Note in favour of CSF. ITW says yes. The Commissioner says no.

168. It was common ground that any loss or outgoing of CSA is treated as being incurred by Noza as head entity of the MEC Group with effect from 1 December 2002.

(i) Alternative 1 - CSA incurred a liability when CSA "declared" the dividend in 2003

169. The applicants contended that regardless of the characterisation of the payment made by SGTS to AFC and then to CSA, CSA incurred the dividend when it declared a dividend payable to CSF. The contention is based on what were described by the applicants as "two key material facts".

170. The first key material fact was that CSA had a Constitution. Clause 28 of the Constitution was entitled "Dividends" and cl 28.1 provided that:

"The power to declare dividends (including interim dividends) [was] vested in the Directors who may fix the amount and timing of any dividend in accordance with this Constitution."

171. A number of other sub-clauses in cl 28 should be noted. Dividends could only be paid out of the profits of CSA: cl 28.5. Interest was not payable by CSA on any dividend: cl 28.6. A dividend may (not shall) be paid by cheque or warrant through the post: cl 28.8. Directors may (not shall) when declaring a dividend resolve that the dividend be paid wholly or partly by the distribution of specific assets: cl 28.9(a)(i). Finally, all matters concerning dividends were to be determined by the directors as they thought fit: cl 28.9(b).

172. The second key material fact relied upon by the applicants was that CSA in fact "declared" a dividend on 14 November 2003: see [147] above. The resolution of the Board of CSA provided:

"… the Dividends be declared payable out of the profits of [CSA] and that the Dividends be paid to [CSF] on 14 November 2003."

"Dividends" had been defined earlier in the minutes of that meeting to be an amount of $222,655,981 comprised of an amount of $108,837,942 for the 2003 year dividend, an amount of $108,837,942 for the 2002 year dividend and a default dividend of $4,980,097. The minutes also recorded that the CSA directors had "reviewed the current management accounts of [CSA] and believe[d] that profits [were] available from which the Dividends [could] be paid and that the Dividends [could] be paid out of unappropriated profits". The meeting was attended by Sutherland and Rodriguez. Sutherland chaired the meeting and signed the minutes. Sutherland was not cross-examined about any aspect of the contents of the minutes.

173. The applicants contended that the declaration of that dividend by CSA on 14 November 2003 created an "undeniable juridical fact" - the creation of a debt in the sum of $222,655,981 in favour of CSF and it is that debt which constituted the incurrence of a liability for the purposes of s 25-90 of the 1997 Act:
Commissioner of Taxation v Citylink Melbourne Limited 2006 ATC 4404; (2006) 228 CLR 1.

174. In support of that contention (that the declaration of the dividend created an "undeniable juridical fact"), the applicants referred to CSA's accounts for the 2003 year. Like the accounts of SGTS, CSA's accounts proceed from a fiction because they treat the issue by CSA to CSF of the CSA Preference Shares not as an issue of shares but as a loan. However, CSA's accounts contained a note by its directors in relation to the decision to pay dividends to CSF that:

"Legal dividends of $222,655,981 were paid by [CSA] in the year ended 30 November 2003 with respect to the redeemable preference shares. Those payments are not treated as dividends for accounting purposes due to the redeemable preference shares being classified as debt instruments for accounting purposes."

175. What then was the legal position upon CSA declaring the dividend on 14 November 2003? The applicants contended that upon CSA declaring the dividends on 14 November 2003, there immediately sprang "into existence, fully armed so to speak, a debt owing by the company to each shareholder":
Industrial Equity Ltd v Blackburn (1977) 137 CLR 567 at 578. A debt which the applicants contended was a loss or outgoing under s 25-90 regardless of any issue of its payment or the performance of its obligation: Citylink at [137] and
Federal Commissioner of Taxation v Malouf 2009 ATC ¶20-099; (2009) 174 FCR 581 at [8]-[17] and [50].

176. I accept that submission. In the 2003 year, s 254V of the Corporations Act 2001 provided:

"(1) A company does not incur a debt merely by fixing the amount or time for payment of a dividend. The debt arises only when the time fixed for payment arrives and the decision to pay the dividend may be revoked at any time before then.

(2) However, if the company has a constitution and it provides for the declaration of dividends, the company incurs a debt when the dividend is declared."

177. Section 254V was considered in
Bluebottle UK Ltd v Deputy Commissioner of Taxation 2007 ATC 5302; (2007) 232 CLR 598. A number of propositions should be made. Before the Company Law Review Act, a distinction was drawn between a power given in the constituent documents of a company to declare a final dividend and a power to pay an interim dividend. A final dividend had the following characteristics - (1) it reflected the results of a completed year of trading, (2) it could only be paid out of profits, (3) the power to declare it was often vested in the company in general meeting, (4) the declaration gave rise to a debt payable by the company to the shareholder immediately or from the date stipulated for payment (Industrial Equity at 572) and (5) unless the constituent documents of the company expressly said so, a shareholder could not sue to recover a dividend unless and until it had been declared. The position with interim dividends was different. An interim dividend anticipated the profit position at the end of the year. The power with respect to interim dividends was usually vested in the board of directors and described as a power to "pay". A decision to pay an interim dividend was revocable until the dividend was paid:
Brookton Co-operative Society Ltd v Commissioner of Taxation 81 ATC 4346; (1981) 147 CLR 441 at 455;
Marra Developments Ltd v BW Rofe Pty Ltd [1977] 2 NSWLR 616 at 622 and Bluebottle at [18]-[20].

178. The Company Law Review Act radically changed company law. Two aspects of the reforms are relevant - the constituent documents of a company and the law relating to dividends. In relation to the constituent documents of a company, the High Court explained the matter in Bluebottle at [22]-[25] as follows:

"[22] Before the Company Law Review Act, the constituent documents of a company were the memorandum of association and the articles of association. The rules that governed alteration of the memorandum of association differed from those governing alteration of the articles.

[23] The Company Law Review Act [s 134 of the Corporations Law] provided for the government of a company's internal management either by provisions of the Corporations Law that applied to the company as 'replaceable rules', or by a constitution, or by a combination of both. Those sections of the Law designated as 'replaceable rules' could be "displaced or modified by the company's constitution" [s 135(2) of the Corporations Law].
…

[25] The company's constitution, like the former constituent documents of memorandum and articles of association, is one of the two critically important sources of the rights of members. The other source of those rights is the relevant legislation, particularly the Corporations Act. The two sources intersect in what is now s 140(1) of the Corporations Act, which provides:

A company's constitution (if any) and any replaceable rules that apply to the company have effect as a contract:

(a) between the company and each member; and

(b) between the company and each director and company secretary; and

(c) between a member and each other member;
under which each person agrees to observe and perform the constitution and rules so far as they apply to that person."

179. In relation to dividends, the High Court explained the changes in Bluebottle at [26] as follows:

"The provisions made by the Company Law Review Act in relation to dividends were set out in a new Pt 2H.5 of Ch 2H of the Corporations Law and those same provisions are now set out as Pt 2H.5 of Ch 2H of the Corporations Act. The central requirement of these provisions, contained in s 254T, is not a replaceable rule and is that dividends be paid only out of profits of the company. Section 254U provides a replaceable rule. So far as now relevant it provides that:

(1) The directors may determine that a dividend is payable and fix:

(a) the amount; and

(b) the time for payment; and

(c) the method of payment.
The methods of payment may include the payment of cash, the issue of shares, the grant of options and the transfer of assets.

Section 254V then deals with when the company incurs a debt in respect of dividends. It provides:

(1) A company does not incur a debt merely by fixing the amount or time for payment of a dividend. The debt arises only when the time fixed for payment arrives and the decision to pay the dividend may be revoked at any time before then.

(2) However, if the company has a constitution and it provides for the declaration of dividends, the company incurs a debt when the dividend is declared."

180. The following propositions about the applicable law in 2003 may be stated:

1. s 140(1)(a) of the Corporations Act provides that a company's constitution and any applicable rules had effect as a contract between the company and each member under which each person agreed to observe and perform the constitution and rules;
2. s 254T of the Corporations Act is not a replaceable rule. Dividends can be paid only out of profits of the company;
3. s 254U(1) of the Corporations Act is a replaceable rule. It provides that a company's directors might determine that a dividend was payable and fix the amount, time and method of payment; and
4. s 254V of the Corporations Act deals with when a company incurs a debt in respect of dividends. Section 254V(1) provides that a company did not incur a debt merely by the fixing of an amount of time for payment of the dividend. The debt arises only when the time fixed for payment arrived and the decision to pay the dividend could be revoked at any time before then. However, s 254V(2) provides that if a company's constitution provided for the declaration of dividends, the company incurred a debt when the dividend was declared.

(It is relevant to note that from 28 June 2010 the relevant Corporations Act provisions were further amended: Corporations Amendment (Corporate Reporting Reform) Bill 2010 (Cth). The amendments are not relevant to these reasons for decision.)

181. Applying the principles applicable in the 2003 year to the facts of the present case, CSA had a constitution (see [170] and [171] above) that permitted the directors to determine that a dividend was payable and fix the amount, time and method of payment: s 254U(1) of the Corporations Act 2001 and cl 28.1 of the Constitution. That Constitution also provided for the declaration of dividends: s 254V(2) of the Corporations Act 2001 and cl 28.1 of the Constitution. CSA declared a dividend: see [147] above. Accordingly, CSA incurred a debt when the dividend was declared: s 254V(2) of the Corporations Act 2001.

182. The Commissioner submitted that those contentions should not be accepted on a number of bases. First, the Commissioner submitted that the Court should not entertain the argument because it was first raised in the applicants' written submissions filed after the completion of evidence. For reasons which will become obvious, it is necessary to first consider the merits of the applicants' argument before deciding whether they should be entitled to put it.

183. The second basis the Commissioner relied upon was that there was no valid declaration of dividends and further, contrary to s 254T of the Corporations Act 2001, the dividends were not paid only out of profits of CSA. That contention depends upon acceptance of the Commissioner's contention that the SGTS dividend was invalid. In the end, it is unnecessary to resolve that issue because even if CSA had insufficient profits to pay the dividend to CSF, a debt arose upon declaration of the dividend in November 2003 by the operation of s 254V(2) of the Corporations Act 2001. The debt CSA then owed to CSF was a liability that was capable of enforcement by CSF. The Commissioner accepted that, as a matter of corporate law, a valid declaration by the directors that a dividend is payable would give rise to a debt owed by CSA to CSF, but contended that, in the case of CSA, there was not sufficient profits at the time of declaration and hence no dividend could be declared payable. I reject that contention.

184. If it was discovered that the dividend was improper because, for example, it had been declared when there were no or insufficient profits of CSA, the debt remains unless and until:

1. the company issues proceedings to have the declaration of the dividend declared void: Marra Developments at 623;
North Sydney Brick and Tile Co Ltd v Darvall (1989) 17 NSWLR 327. I reject the Commissioner's contention that Marra Developments is no longer good law because it was decided before the Company Law Review Act. Bluebottle resolved that issue: see [167] to [170] above;
2. CSF disputes the validity of a declaration of dividend (because it contravenes the company's constitution and / or contravenes s 254T) and successfully obtains an injunction to restrain payment: Marra Developments at 623; or
3. a creditor of the company disputes the validity of a declaration of dividend because it contravenes s 254T and successfully obtains an injunction to restrain payment: Marra Developments at 623.

185. In the present case, no declaratory proceedings were filed by CSA, no injunctive relief was sought by CSF or a creditor and the dividend was in fact paid (see [147] above). In my view, the Commissioner cannot rely upon the possibility of hypothetical declaratory or injunction proceedings to avoid the incurrence of a debt prescribed by statute: cf
Cridland v Commissioner of Taxation 77 ATC 4538; (1977) 140 CLR 330 at 341.

(ii) Are the applicants entitled to rely upon s 254V of the Corporations Act?

186. Against that background, I return to consider whether the applicants are entitled to rely upon the s 254V of the Corporations Act argument. I accept that the applicants' appeal statement did not refer to the argument and their opening did not clearly and expressly articulate the argument that a debt was incurred by CSA on the declaration of the dividend in favour of CSF by the operation of s 254V(2) of the Corporations Act 2001. However, I do not accept the Commissioner's submission that the applicants are not entitled to rely upon the argument. I say that for a number of reasons. First, the application of s 254V(2) of the Corporations Act 2001 to the facts of these proceedings involves a legal argument based on the application of a statute (s 254V of the Corporations Act 2001) to facts which are not in dispute (that CSA declared a dividend to CSF). CSA's Constitution was tendered during the applicants' opening and, in response to a question about relevance from the Court, Senior Counsel for the applicants stated that "it goes to the question of what legal rights are created when the dividend is declared". That exchange must be read in light of the fact that the Commissioner's written submissions filed before the hearing addressed the same issue (at para [167]) in the following terms:

"Further, and in any event, it is not until a final dividend is declared by the company that an enforceable right to be paid the dividend arises. Therefore, regardless of the existence of profits from which a dividend could be paid, unless and until a dividend is declared there is no enforceable right on the part of a shareholder to be paid, no obligation on the company to pay and thus it is submitted no loss or outgoing is incurred by the company with respect to the dividends. See
Brookton Co-op Society v FCT 81 ATC 4346; (1981) 147 CLR 441 at 455-456 per Mason J (with whom the other members of the Court agreed);
Bluebottle UK Ltd v DCT 2007 ATC 5302; (2007) 232 CLR 598 at 609-611 [18]-[26], 613-614 [31] per the Court and s 254V, Corporations Act 2001.

…"

187. Moreover, the minutes of the meeting of the board of directors of CSA on 14 November 2003 were served on the Commissioner in March 2010 (as an exhibit to an affidavit of Sutherland) in which CSA not only resolved to pay the dividend to CSF by endorsing the promissory note but resolved that the dividends be declared: see [172] above. The argument involves legal characterisation of what occurred, and, what occurred is not in dispute.

188. Thirdly, the consequences of the legal characterisation (namely that CSA incurred a debt) remain because no proceedings of the kinds listed in [184] above were commenced and the Commissioner cannot in my view rely upon the possibility of hypothetical declaratory or injunctive proceedings to avoid the incurrence of a debt prescribed by statute. As noted earlier, I do not accept that if the SGTS dividend was invalid, the CSA dividend was invalid: see [164] above.

189. Fourthly, in support of the contention that the applicants should not be entitled to raise the argument, the Commissioner submitted that he may well have led evidence (including expert evidence) about whether or not there were profits in CSA because if there were not, the payment of the dividend would have been "illegal" under the Corporations Act. That argument proceeds from a premise which is wrong in law. The dividend is not "illegal". It is voidable. Moreover, I do not accept that if the argument had been raised, he may have conducted his case at trial differently:
Coulton v Holcombe (1986) 162 CLR 1. The law has not changed and the declaration of the dividend is not disputed. No evidence was identified which was arguably relevant to a disputed legal or factual issue.

190. Finally, the Commissioner described his complaint as one where he thought he was meeting an "incurred" argument in the 2003 year for $108,837,942 (the 2003 dividend) and not $217,675,884 (which included the 2002 dividend, the default dividend amount and the 2003 dividend). For the reasons stated, I consider that the applicants are entitled to rely upon a contention that $217,675,884 was incurred in the 2003 year. The impact on the applicants raising that contention directly so late in proceedings may well be relevant to the ultimate question of costs.

(iii) Alternative 2 - CSA incurred a liability when CSA declared and paid the dividend to CSF in 2003

191. The applicants' alternative basis for the deduction claim in the 2003 year is that CSA declared and paid the dividend to CSF. In light of the views I have formed about the first alternative, it is strictly unnecessary to address this issue. However, for completeness, it is appropriate that I make certain findings.

192. The Commissioner contended that there was no loss or outgoing by CSA in the 2003 year because the promissory note CSA endorsed in favour of CSF was void and unenforceable by reason of the following facts and matters:

1. the loss or outgoing relied upon is the endorsement of the promissory note by CSA to CSF;
2. the promissory note was issued (and immediately endorsed from AFC to CSA) and then from CSA to CSF in the US and expressed to be governed by Delaware law;
3. under Delaware law, if an unenforceable promissory note is endorsed to a third party who takes "with knowledge" of the defect or invalidity, that third party may not enforce the promissory note;
4. in the present case, the promissory note was issued and endorsed by Sutherland on behalf of SGTS, AFC, CSA and CSF when he was aware of all of the matters that resulted in the promissory note being unenforceable, namely SGTS' non-compliance with Delaware law when issuing the note combined with AFC's knowledge of that non-compliance. (The Commissioner's contention was that a consequence of an alleged non-compliance with Delaware law about the issue of dividends is that any dividend issued would violate the DGCL and be void and incapable of ratification).

193. What then is the alleged non-compliance by SGTS? Under Art 3(a) of each Series of the SGTS Preferred Stock, dividends were payable "when, as and if declared by the Board of Directors, out of funds legally available representing accumulated earnings of [SGTS]": see [130(2)] above. The Commissioner contended that SGTS did not have sufficient "accumulated earnings" as at 14 November 2003. The applicants rejected that contention.

194. In ascertaining whether SGTS had sufficient "accumulated earnings", the Commissioner submitted that it was necessary to ascertain the share capital and distributable profits of SGTS "from the viewpoint of Australian law, as at 14 November 2003". To that end, the Commissioner submitted that as at 14 November 2003:

1. "from the perspective of Australian law", SGTS' share capital consisted of US$1 billion of preference share subscriptions and US$7 million of ordinary share subscriptions:
Archibald Howie Pty Ltd v Commissioner of Stamp Duties (NSW) (1948) 77 CLR 143 at 153 and 157;
Federal Commissioner of Taxation v Midland Railway Company of Western Australia (1952) 85 CLR 306 at 316;
Re Swan Brewery Co Ltd (1976) 3 ACLR 164 at 166;
Comptroller of Stamps (Vic) v Ashwick (Vic) No 4 Pty Ltd 87 ATC 5064; (1987) 163 CLR 640 at [19]-[20] and
St George Bank Ltd v Federal Commissioner of Taxation (2009) 176 FCR 424 at [90];

2. on the face of SGTS' financial documents, SGTS did not have sufficient accumulated earnings to pay the dividend. The accounts of SGTS prepared in accordance with US GAAP showed a decrease in SGTS' net assets between 31 December 2001 and 31 December 2003 and declining retained earnings which had reached a loss of (US$302,468,023) by 31 December 2003 as follows:

	2001	2002	2003
Assets	4,164,129,521	4,190,248,295	4,080,611,296
Liabilities	(4,032,252,087)	(4,157,118,926)	(4,376,079,319)
Net Assets	131,877,434	33,129,369	(295,468,023)
Movement in Net Assets		(98,748,065)	(328,597,392)
Income and Expenses	2001	2002	2003
Intercompany Royalties - ITW	167,640,119	411,797,021	452,227,281
Intercompany Royalties - Miller	22,823,985	45,995,719	48,359,333
	2001	2002	2003
Intercompany Dividend Income - Leasing LLC			3,000,000
Interest expense - CSF	(33,333,333)	(266,666,667)	(266,666,667)
Preferred dividend expense	(5,753,227)	(46,839,229)	(165,055,857)
Administrative expense	(1,250)	(7,299)	(7,143)
Currency Translation Income (Loss)	(5,873,860)	(78,037,610)	(342,677,249)
Income (loss) / Current Earnings	124,877,434	(98,748,065)	(328,597,392)
Retained Earnings	124,877,434	26,129,369	(302,468,023)

3. the adjustments to SGTS' financial statements made by Sutherland (namely the reversal of the "preferred dividend expense" and the "Currency translation income (loss)" in the table above) were neither possible nor permissible.

Accordingly, the Commissioner submitted that the SGTS dividend was in breach of the SGTS Preferred Stock and therefore invalid under Delaware law.

195. The applicants did not dispute that on the face of SGTS' financial accounts, SGTS did not have sufficient accumulated earnings to pay the dividends. Instead, the applicants contended that the adjustments made by Sutherland were permissible within the meaning of "accumulated earnings" in the Certificate of Designation. Put another way, the applicants contended that the Commissioner's reliance on the unadjusted accounts of SGTS and the Commissioner's reliance upon the "viewpoint of Australian law" was misconceived. For the reasons set out above (see [139] to [144]), I do not accept that the applicants have established on the balance of probabilities that SGTS had sufficient accumulated earnings to pay the dividend to AFC on 14 November 2003. However, even if the adjustments made by Sutherland did result in SGTS having sufficient accumulated earnings out of which to pay the dividend to AFC on 14 November 2003 (a view I reject), that is not the end (or start) of the enquiry.

196. SGTS was a Delaware incorporated entity, resident in Delaware and subject to the DGCL. The SGTS Certificate of Designation was governed by Delaware law: see [130] above. Article 3(a) of the Certificate provided that dividends were payable:

"… when, as and if declared by the Board of Directors, out of funds legally available … representing accumulated earnings of [SGTS]."

197. The Commissioner contended that on the true construction of the phrase "accumulated earnings" in SGTS Certificate of Designation, Sutherland's adjustments were not permissible under the DGCL. The applicants submitted that the DGCL not only permitted but required SGTS to treat its preferred stock as equity and not as debt. Each called an expert to give evidence about what adjustments were permissible under Delaware law. The applicants called Mr Balotti, a director in the corporate department of a Delaware law firm with extensive experience in advising corporations and their directors. The Commissioner called Mr Tumas, a partner in a Delaware law firm also with extensive experience in advising corporations and their directors.

198. What then was permissible under Delaware law? Both experts agreed on the following matters:

1. under the DGCL, the board of directors of a Delaware corporation may declare and pay dividends upon the shares of the corporation's capital stock only (1) out of the corporation's surplus as defined in and computed in accordance with s 154 and 244 of the DGCL or (2) where there was no surplus, out of its net profits for the fiscal year in which the dividend is declared and / or the immediately preceding fiscal year;
2. in computing the surplus as defined and computed in accordance with s 154 and 244 of the DGCL, the "net assets" are determined based on the current values of the assets and liabilities rather than historic values. In other words, some adjustments were inevitable;
3. the use of the term "accumulated earnings" in the SGTS Certificate of Designation imposed a restriction, in addition to the requirements of the DGCL, on SGTS' ability to pay dividends;
4. the phrase "accumulated earnings" is not defined in the DGCL;
5. a certificate of designation is part of the certificate of incorporation of a company;
6. under Delaware law, certificates of incorporation are viewed as contracts. Delaware courts employ generally applicable principles of contract interpretation when construing certificates of incorporation. Delaware adheres to the objective theory of contract construction. A court will first review the language of the contract to decide whether the court can ascertain the parties' intent from their express words or whether the contractual terms are ambiguous. If a contract is not ambiguous, extrinsic evidence may not be used to interpret the intent of the parties, to vary the terms of the contract or to create an ambiguity. If the provisions of a contract are ambiguous, then the interpreting court must look to extrinsic evidence beyond the language of the contract to ascertain the parties' intention. A term is ambiguous only if it is reasonably or fairly susceptible to different interpretations or may have two or more different meanings.

199. The experts did not agree on two matters. First, whether the phrase "accumulated earnings" as used in SGTS' Certificate of Designation was ambiguous. Mr Balotti considered it was unambiguous. He expressed the view that the meaning of the term was able to be ascertained through a reasonable reading of the plain language of the relevant provisions of SGTS' certificate of incorporation. In his view, "accumulated earnings" meant "earnings that have passed through [SGTS'] profit and loss statement and have accumulated on its balance sheet" (i.e. retained earnings or earned surplus). On the other hand, Mr Tumas said the phrase was ambiguous because it could be construed to mean "retained earnings" in the strict accounting sense or adjusted variants of that concept within the meaning of US or Australian tax or accounting principles.

200. The second issue that they disagreed upon was whether the ability to make adjustments to the balance sheet figure for retained earnings in determining the amount of accumulated earnings depended upon the intended meaning of the phrase in the Certificate of Designation. Mr Balotti was of the view that determining the meaning of the phrase "accumulated earnings" was a separate task from determining whether the company was permitted to make adjustments when ascertaining if it had sufficient funds to pay dividends. Mr Tumas, on the other hand, did not view these as separate issues.

201. In my view, these issues are not resolved by simply looking at the phrase "accumulated earnings" in isolation. The phrase that appears in Art 3(a) of both series of the SGTS Preferred Stock provides that dividends were payable:

"… when, as and if declared by the Board of Directors, out of funds legally available representing accumulated earnings of [SGTS]."

(Emphasis added.)

The experts agree that this phrase in Art 3(a) is an additional restriction to the DGCL. The question which is to be answered is what funds were "legally available representing accumulated earnings of SGTS"?

202. For the purpose of determining the rights of the stockholder, I accept that Delaware company law requires SGTS to treat its preferred stock as equity and not as debt: see the decision of the Court of Chancery in Delaware in
Harbinger Capital Partners Master Fund I, Ltd v Granite Board Corp 906 A 2d 218 (Del Ch, 2006), where the Court held that for the purposes of Delaware law the rights of the holders of preferred stock which were treated as debt for accounting purposes were to be treated as equity and not debt for the purpose of considering the rights of the shareholder. I should note in passing that Mr Balotti referred to this decision. Mr Tumas did not refer to or consider this decision.

203. Next, it was common ground and consistent with the statement in [193] above that, but for the treatment of the Series B preferred stock as debt for US GAAP purposes, neither the preferred dividend expense nor the currency translation income (loss) adjustments would have been taken into account as expenses in determining the accumulated earnings of SGTS in 2003.

204. Further, as noted earlier (see [198(1)] above), under the DGCL, the board of directors of a Delaware corporation may declare and pay dividends upon the shares of the corporation's capital stock only (1) out of the corporation's surplus as defined in and computed in accordance with s 154 and 244 of the DGCL or (2) where there was no surplus, out of its net profits for the fiscal year in which the dividend is declared and / or the immediately preceding fiscal year and in computing the surplus as defined and computed in accordance with s 154 and 244 of the DGCL, the "net assets" are determined based on the current values of the assets and liabilities rather than historic values. In other words, some adjustments were inevitable.

205. Other aspects, however, should be noted. First, I do not accept the contention that a failure to make the adjustments identified in [139] and [140] would lead to the absurd result that there would need to be earnings of at least twice the amount of the accrued "interest" before the "interest" which in fact accrued could be paid. I accept that interest of A$108,837,942 would have been taken into account in determining profit for US GAAP purposes, but I do not accept that there would then need to be additional earnings of at least the same amount before SGTS could discharge its obligation on the preferred stock. In the 2003 year, the amount accrued was the same amount as the amount paid. Further, I do not accept that this construction is inconsistent with the decision of the Supreme Court of Delaware in
Weinberg v Baltimore Brick Company 114 A 2d 812 (Del, 1955). That decision is authority (at 817) for the proposition that "[d]ividend restrictions … are ordinarily carefully spelled out …". In the case of the SGTS Preferred Stock they were. The applicants failed to satisfy the Court that they had been complied with.

206. For those reasons, I accept that the type of adjustments identified in [139], [140] and [195] needed to be made in determining the accumulated earnings of SGTS in 2003. However, I am not satisfied that the evidence discloses whether the adjustments were in fact made or whether the adjustments (if they were made) were sufficient for the dividend to be declared and paid in 2003: see [139] to [144] above.

207. Before leaving this issue, I should note that even if the Commissioner is correct in his contention that the phrase "accumulated earnings" is ambiguous, I do not accept that the objective extrinsic evidence to which he referred leads to a different construction. For example, the Commissioner submitted that the extrinsic evidence would include the draft advice from Andersen Tax which stated that because SGTS will amortize the cost of the royalty streams, its cash will exceed its accounting profits and that dividends will need to be paid out of accounting profits. In other words, the Commissioner submitted that the phrase "accumulated earnings" should be construed to read "accounting profits" of SGTS. I reject that submission. As the applicants submitted, if SGTS and AFC had wanted to restrict the dividends to be paid out of the profits calculated according to US GAAP only, they would have said so. They did not.

208. Although I do not accept that the applicants have established that SGTS had sufficient accumulated earnings to pay the dividends to AFC in 2003 (contrary to the terms of the Certificate of Designation), it does not follow that the dividends (and the promissory note) were invalid. Whether acceptance of the Commissioner's argument that the payment of the dividend was in some relevant sense "invalid" would necessitate the further conclusion that the promissory note issued in satisfaction of the dividend was also "invalid" was not directly addressed in argument. Having regard to the conclusions I had reached, no separate examination need be made of that issue.

209. Not unlike the position in Australia (see [180] above), the expert evidence renders much of the preceding analysis not relevant to the issue of "incurrence" currently before the Court. Mr Tumas expressed the view that a dividend paid in contravention of a dividend restriction was void. He was cross examined about that evidence. He was unable to refer to any direct Delaware authority to support his proposition. In cross-examination, the only authority he referred to was the decision in
Ivanhoe Partners v Newmont Mining Corp 533 A 2d 585, 602 (Del Ch 1987) (affirmed in
Ivanhoe Partners v Newmont Mining Corp 535 A 2d 1334 (Del, 1987)) which was concerned with a different issue. On the other hand, Mr Balotti gave unchallenged evidence that a dividend paid in contravention of a restriction would not be void. He said:

"… I believe that the Corporation Law does not declare that dividends not made in accordance with the chapter are void. The remedy that it provides is twofold. The corporation law provides a remedy against directors who authorise negligently invalid dividends, and then ….. over against shareholders who knowingly receive a dividend. It doesn't declare those dividends void, is my recollection. In fact, I think section 174 still refers to a dividend paid not in accordance with the terms of the chapter as a dividend."

210. Section 174 of the DGCL was before the Court. At the relevant time, it provided:

"(a) In case of any wilful or negligent violation of s 160 or 173 of this title, the directors under whose administration the same may happen shall be jointly and severally liable, at any time within 6 years after paying such unlawful dividend or after such unlawful stock purchase or redemption, to the corporation, and to its creditors in the event of its dissolution or insolvency, to the full amount of the dividend unlawfully paid, or to the full amount unlawfully paid for the purchase or redemption of the corporation's stock, with interest from the time such liability accrued. Any director who may have been absent when the same was done, or who may have dissented from the act or resolution by which the same was done, may be exonerated from such liability by causing his or her dissent to be entered on the books containing the minutes of the proceedings of the directors at the time the same was done, or immediately after such director has notice of the same.

(b) Any director against whom a claim is successfully asserted under this section shall be entitled to contribution from the other directors who voted for or concurred in the unlawful dividend, stock purchase or stock redemption.

(c) Any director against whom a claim is successfully asserted under this section shall be entitled, to the extent of the amount paid by such director as a result of such claim, to be subrogated to the rights of the corporation against stockholders who received the dividend on, or assets for the sale or redemption of, their stock with knowledge of facts indicating that such dividend, stock purchase or redemption was unlawful under this chapter, in proportion to the amounts received by such stockholders respectively. (8 Del. C. 1953, § 174; 56 Del. Laws, c. 50; 59 Del. Laws, c. 106, § 6; 71 Del. Laws, c. 339, §§ 26, 27.)"

211. The remedies were clear - action against the directors and, if the claim was successfully asserted, the right for the director to be subrogated to the rights of the corporation against the stockholders who received the dividend "with knowledge" that the dividend was unlawful. The premise underpinning the remedies was that a "dividend" continued to exist even though it had been paid in contravention of the DGCL. Here, no action against the directors was taken. The dividend was declared and paid.

212. Finally, reference should be made to the Dividend Distribution Agreement: see [136] above. The Commissioner did not challenge the validity of that agreement. As noted above, the agreement provided for the payment of dividends by way of the promissory note in lieu of a cash dividend. At cl 3, the parties warranted to each other that each has the requisite power to enter into the Agreement and that the agreement is "valid and binding" except "as such enforceability may be limited by applicable bankruptcy, insolvency, moratorium, reorganization or similar laws in effect which affect the enforcement of creditors' rights …". No one suggested that the exception was engaged here. Moreover, I do not consider that it would have been open to the Commissioner to allege it: Cridland. Under DGCL, a certificate of designation is viewed as a contract whereby the courts "employ general principles of contract interpretation when construing them": see [198(6)] above. Here, the parties to the contract (SGTS and AFC) have agreed to accept the promissory note as payment of the dividend. Absent rights as a creditor, it is not open to the Commissioner to interfere with what they agreed. In any event, the Dividend Distribution Agreement must be read subject to the operation of the DGCL and, in particular, the consequences of s 174 of the DGCL: see [211] above.

213. In the end, I accept that it is the promissory note issued under and in accordance with the terms of the Dividend Distribution Agreement which armed AFC with "funds" to pay the dividends to CSA. The rights the Dividend Distribution Agreement gives AFC for payment are not able to be impugned by the Commissioner. They might have been able to be impugned by action under s 174 of the DGCL, but they were not. There was no proceeding to suggest, let alone establish, that the dividend was paid in contravention of the DGCL:
Federal Coke Company Pty Ltd v Federal Commissioner of Taxation 77 ATC 4255; (1977) 15 ALR 449 at 458-459, Cridland at 341 and
BHP Billiton Finance Ltd v Commissioner of Taxation 2009 ATC ¶20-097; (2009) 72 ATR 746 at [124], [126] and [129]. The fact remains that the promissory note was not cancelled and indeed was honoured by a wire transfer of cash on 24 November 2003.

(iv) Conclusion

214. For those reasons, CSA incurred a loss or outgoing of $222,655,981 when it "declared" the dividend and, if not when it was declared, when it declared and then paid the dividend in the 2003 year.

(d) Was the Loss or Outgoing Incurred in Deriving Income from a foreign source?

215. The applicants submitted that the dividend of $222,655,981 was incurred by CSA (and therefore Noza) in financing the acquisition of the royalty rights from CSF and, in turn, transferring those rights to SGTS in consideration of the SGTS Preferred Stock from which AFC received foreign source income.

216. The amounts relied upon by the applicants as constituting "income" were the dividends paid by SGTS to AFC in the form of the promissory note. The question is whether those dividends are income from property (that is, the SGTS Preferred Stock) according to ordinary concepts or income pursuant to statute (Subdiv D of Div 2 of Pt III of the 1936 Act). Again, AFC and CSA are disregarded as legal entities and treated as part of the consolidated group under the single entity rule.

217. The Commissioner submitted that the $222,655,981 was not income but a return of capital by a company to a shareholder and, even if it was income, it was not derived.

218. "Income" is not defined in either the 1936 Act or the 1997 Act:
Commissioner of Taxation v Stone 2005 ATC 4234; (2005) 222 CLR 289 at [8];
Commissioner of Taxation v Montgomery 99 ATC 4749; (1999) 198 CLR 639 at [65] and
Commissioner of Taxation v Cooke and Sherden 80 ATC 4140; (1980) 29 ALR 202 at 210. Whether a receipt is to be treated as income is determined according to the "ordinary concepts and usages of mankind" except where the 1936 Act or the 1997 Act includes particular receipts or amounts which would not ordinarily be taken to constitute income: Cooke at 210. The requirements for amounts to be classified as income according to ordinary concepts were set out by the US Supreme Court in the often quoted passage in
Eisner v Macomber (1920) 252 US 189 at 206-207:

"Here we have the essential matter: not a gain accruing to capital, not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value, proceeding from the property, severed from the capital, however invested or employed, and coming in, being 'derived' - that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal; that is income derived from property. Nothing else answers the description."

See also Montgomery at [65] where the above passage was said to identify the "core meaning of income" and
Commissioner of Taxation v McNeil 2007 ATC 4223; (2007) 229 CLR 656 at [21].

219. It is well established that a receipt which is in the nature of a return of capital by a company to a shareholder is not income according to general concepts: see
Commissioner of Taxation v Uther (1965) 112 CLR 630 at 635-636. In Uther, Kitto J considered the meaning of the expression "return of paid-up capital" and concluded that a distribution effecting a reduction in the level of paid-up capital was such a return: see also
Commissioner of Taxation v Slater Holdings Limited 84 ATC 4883; (1984) 156 CLR 447. The question of whether a receipt is income according to ordinary concepts or a return of capital, is considered from the viewpoint of the shareholder: McNeil (High Court) at [20].

220. The language of s 25-90 is important. It adopts language similar to s 8-1. Section 8-1 talks about "incurred in gaining assessable income". Section 25-90(a) uses the phrase "the amount is incurred … in deriving income from a foreign source". That language does not require a matching of outgoings and income:Citylink and
Ronpibon Tin NL v Federal Commissioner of Taxation (1949) 78 CLR 47 at 56-57; see also Taxation Determination, TD 2009/21, pg 1.

221. In the context of s 25-90, Parliament did not intend s 25-90 to include a deduction for losses or outgoings incurred in deriving an amount that was of a capital nature, such as a return of shareholder's capital. As paragraphs 1.99 to 1.101 of the Explanatory Memorandum for the New Business Tax System (Thin Capitalisation) Bill 2001 provided:

"1.99 Debt deductions will, in certain instances, no longer be denied to taxpayers because they were incurred in earning exempt foreign income. These debt deductions, provided they are otherwise allowable under the general deduction provisions, will come within the scope of the thin capitalisation regime when determining the amount to be allowed.

1.100 The relevant debt deductions are those incurred in earning foreign income that is exempt income under sections 23AI, 23AJ and 23AK of the ITAA 1936."
(Emphasis added.)

222. The statutory provisions relating to the assessability of distributions from companies are contained in Subdiv D of Div 2 of Pt III of the 1936 Act. Division 2, which begins with s 25, is headed "Income": McNeil (High Court) at [32]. The provisions in Div 2 drew a distinction between distributions of company profits (which are assessable) and returns of capital (not assessable). In
Commissioner of Taxation v McNeil 2005 ATC 4658; (2005) 144 FCR 514 at [96], Emmett J summarised their operation as follows:

"Underlying that regime relating to the assessability of distributions by a company to its shareholders, was the distinction between the concept of a payment out of profits derived by the company and the concept of payment out of amounts standing to the credit of the share capital account of the company. There was a critical distinction drawn between the share capital of a company and distributable profits, being amounts in excess of the share capital. While capital profits, as well as trading profits, were distributable, share capital was not distributable according to company law principles, without the approval of the Court."

223. The applicants rely upon the payment of the dividends from SGTS to AFC as the derivation of income from a foreign source. The Commissioner submitted that regardless of whether the question is considered from the point of view of the shareholder (ordinary income) or the point of view of AFC (statutory income), a return of capital invested is not income. He contended that when SGTS purported to pay dividends of $222,655,981 on 14 November 2003 that payment was necessarily a return of capital by it to AFC because it was not, in Emmett J's words, a payment from distributable profits, being "amounts in excess of the share capital".

224. It is common ground that SGTS did not have a capital account other than shareholders capital (entitled "Common Stock" in the accounts of SGTS). For example, in the accounts there is no reference to capitalised profits. The issue of whether the payment by SGTS was income therefore requires identification of the share capital of SGTS and the distributable profits of SGTS as at 14 November 2003.

225. On 15 November 2001, AFC transferred the royalty streams, an asset valued at US$4 billion, to SGTS: see [129] above. SGTS provided consideration for this transfer by doing two things: (1) by assuming AFC's obligations under the US$3 billion purchase note AFC had issued to CSF, so instead of AFC owing CSF US$3 billion, SGTS now owed CSF US$3 billion; and (2) by issuing US$1 billion of preference shares to AFC redeemable in five years time. The Commissioner submitted that when AFC subscribed for the SGTS Preferred Stock, the US$1 billion in value it provided to SGTS in exchange for the issue of shares was, "from an Australian law point of view", a contribution to the capital of SGTS because the money or money's worth derived by a company from the issue of shares forms part of the share capital of that company with the result that the share capital of SGTS as at 14 November 2003, from the perspective of Australian law, consisted of:

1. $US1 billion worth of preference share subscriptions; and
2. $US7 million worth of ordinary share subscriptions.

226. The difficulty with the Commissioner's contentions is that SGTS is a Delaware company, not an Australian entity. Its share capital is ascertained in accordance with Australian law only where expert evidence is not led that the law of Delaware is different:
Allstate Life Insurance Co v Australia and New Zealand Banking Group Ltd (No 6) (1996) 64 FCR 79 at 83 and
Neilson v Overseas Projects Corporation of Victoria Ltd (2005) 221 ALR 213; (2005) 223 CLR 331 at [125]. Here, both the applicants' expert and the Commissioner's expert agreed that applying the law of Delaware, the SGTS preferred stock issued capital was $489.32 (each share having a par value of US$0.52) and not US$1 billion, the price paid for the preferred stock. Sutherland's evidence was to the same effect. Accordingly, I reject the Commissioner's contention that SGTS' share capital included the US$1 billion. That conclusion however does not dispose of the issue.

227. As noted earlier, it is not necessary for a taxpayer to actually derive a dividend to which s 23AJ of the 1936 Act applies in the same income year as that in which the cost is incurred. In the present case, the Commissioner concedes (as he had to if he wished to maintain the related withholding tax proceeding) that a valid s 23AJ dividend would have been paid by SGTS on or after 30 November 2003 but before the redemption of shares in 2005. That concession is not surprising. It could not seriously be doubted that AFC did not expect to receive dividend income in the five years from 2001 to 2006. AFC owned all of the common stock and the preferred stock in SGTS. SGTS had acquired rights to the royalty streams (valued at US$4 billion) as well as other assets. SGTS' principal liabilities constituted only a loan of US$3 billion. The purpose of the structure was to ensure the tax neutrality of the Project Gemini dividend flow into and out of Australia: see [28] above. The fact that a dividend would be paid in that period constitutes a more than sufficient nexus with the gaining of income from a foreign source: cf
Spassked Pty Ltd v Federal Commissioner of Taxation (2003) 136 FCR 441 at 464 and
Federal Commissioner of Taxation v Total Holdings (Australia) Pty Ltd 79 ATC 4279; (1979) 43 FLR 217. Finally, the expectation about the derivation of income is considered at the time the redeemable preference shares are subscribed for, not the time CSA declared the dividend: Spassked at 464 and Total Holdings.

228. In light of those findings, it is unnecessary to resolve the question about the nature of the payment from SGTS to AFC in November 2003 and, in particular, whether the payment was in the nature of income or a return of capital. The loss or outgoing was incurred at the very least when there was an expectation that a valid s 23AJ dividend would be paid by SGTS on or after 30 November 2003 but before the redemption of shares in 2005. However, again for completeness, I make the following additional findings:

"1. under s 25-90(b), it is necessary that the loss or outgoing be incurred by the taxpayer in deriving income, not a return of capital;

2. assessing or measuring distributable profits of an Australian company requires a comparison to be undertaken usually of the net asset position of a company over a period of time (usually one year):
In Re Spanish Prospecting Company Ltd [1911] 1 Ch 92 at 98; and
QBE Insurance Group Ltd v Australian Securities Commission (1992) 10 ACLC 1490; (1992) 38 FCR 270 at 285 and
Commissioner of Taxation v Sun Alliance Investments Pty Ltd (in liq) 2005 ATC 4955; (2005) 225 CLR 488 at [43];

3. in order to establish that the SGTS dividend was in the nature of income, SGTS (a Delaware company) was required to show that there was profit reflected by an increase in the net assets of SGTS sufficient to allow the distribution of the dividend on 14 November 2003;

4. the accounts of SGTS, which were prepared in accordance with the requirements of the US GAAP, recorded a decrease in SGTS' net assets between 31 December 2001 and 31 December 2003 and the retained earnings, which are a profit account, were also declining and had reached a loss of US$302,468,023 by 31 December 2003: see [194] above;

5. therefore, from the viewpoint of Australian law, SGTS was not in a position to pay a dividend from profits and any dividend issued must have been in the nature of a return of capital and not income:
Commissioner of Taxation v Condell 2006 ATC 4571; (2006) 63 ATR 514 at [19] and
Condell v Commissioner of Taxation 2007 ATC 4404; (2007) 66 ATR 100 at [5]-[8]; and

6. however, SGTS was not an Australian company, it was a Delaware company which was entitled to make adjustments to its accounts: see [206] above."

229. Further, in light of the earlier findings, it is unnecessary to revisit the Commissioner's contention that the receipt of a promissory note did not amount to the derivation of income because the note was invalid under Delaware law and unenforceable in the hands of AFC/Noza. However, again for completeness, I make the following findings:

"1. for income to be derived by a taxpayer, it must be derived in the form of money or money's worth: Cooke at 211;

2. ordinarily, the receipt of a promissory note would be considered the derivation of income by reason of receiving something that is in the form of money's worth as it can be turned to pecuniary account;

3. in the present case, the validity of the promissory note is governed by the law of the place in which it was made, in this case, the law of Delaware: s 77, 89(1) and 95(1) of the Bills of Exchange Act 1909 (Cth);

4. the DGCL (s 170(a) and 173) provide that dividends can only be declared and paid by a corporation out of the surplus, as defined and computed in accordance with s 154 and 244 of the DGCL or in the case where there is no surplus, its net profits for the fiscal year in which the dividend is declared and/or the immediately preceding fiscal year: see [198(1)] above;

5. section 170(a) of the DGCL also provides that the constitution documents of a Delaware Company may impose additional restrictions on the ability of a company to pay a dividend which includes the terms on which the SGTS Preferred Stock were issued. The SGTS Preferred Stock terms provided that dividends were only to be paid "out of funds legally available therefore representing accumulated earnings of [SGTS] only…";

6. the DGCL provides that when the dividend is paid by the issue of a note, the question as to compliance with the requirements is to be determined at the time of delivery of the note and not any later date when it is called upon: s 170(a) of the DGCL;

7. the applicants have not demonstrated that as at 14 November 2003 (the date the promissory note was issued under the Dividend Distribution Agreement) that SGTS had sufficient surplus constituted by accumulated earnings to pay the dividend or SGTS had sufficient net profits constituted by accumulated earnings in that fiscal year and/or the year before to pay the dividend: see [139] to [144] above;

8. the published accounts of SGTS prepared in accordance with GAAP reported that there were insufficient accumulated earnings as at 31 December 2003 to pay the dividend: see [194] above;

9. however, I do not accept that it therefore follows that the promissory note was invalid and unenforceable even if AFC had knowledge of SGTS' non-compliance with Delaware law when issuing the note. The consequence of a failure to comply with the requirements of Delaware law concerning the issue of dividends is that any dividend issued would violate the DGCL but would not be void and incapable of cure by ratification; and

10. the remedy was action against the directors (see [211] above) and no such action was taken. The SGTS Promissory Note was able to be paid in whole or in part by SGTS at any time and from time to time without premium or penalty with payments to be by internal bank or wire transfer of funds to AFC's bank in Australia and, indeed, was repaid to AFC by wire transfer on 24 November 2003."

230. The applicants submitted that the dividends were income from a foreign source because the dividends were principally derived from SGTS' ownership of the royalty rights granted by ITW Inc and Miller, both of whom were residents of the US. The Commissioner accepted that to the extent any income was derived, it was from a foreign source.

(e) Was the Income (ie the Dividends paid by SGTS) "exempt income" under s 23AJ?

231. In the 2003 year, s 23AJ provided:

"(1) Where:

(a) a non-portfolio dividend is paid to a taxpayer by a company that is a resident of a listed or unlisted country; and

(b) the taxpayer is a company that a resident within the meaning of section 6;
then the dividend is exempt from income tax to the extent that it is an exempting receipt of the taxpayer."

232. During closing submissions, the Commissioner conceded that to the extent any income was derived, the dividend paid by SGTS to AFC was a dividend to which s 23AJ of the 1936 Act applied.

(f) Was the loss or Outgoing a Cost in relation to a "Debt Interest"?

233. There was no dispute that the CSA Preference Shares were "debt interests". The question was whether the whole of the loss or outgoing in the sum of $222,655,981 or a lesser amount was a "cost" in relation to a "debt interest" for the purposes of s 820-40(1)(a) of the 1997 Act.

234. Section 995-1 provides that "debt deduction" is defined in s 820-40. Section 820-40(1)(a) of that definition provides that the cost in relation to a debt interest is:

"(i) interest, an amount in the nature of interest, or any other amount that is calculated by reference to the time value of money; or

(ii) the difference between the *financial benefits received, or to be received, by the entity under the scheme giving rise to the debt interest and the financial benefits provided, or to be provided, under that scheme; or

(iii) any amount directly incurred in obtaining or maintaining the financial benefits received, or to be received, by the entity under the scheme giving rise to the debt interest; or
…"

(Emphasis added.)

235. The Explanatory Memorandum accompanying the New Business Tax System (Thin Capitalisation) Bill 2001 (Cth) addressed the issue in the following terms:

"1.15 The following summarises key features of Division 820.
…

What are debt deductions? Debt deductions include any costs that are incurred directly in connection with such debt. Examples include interest payments, discounts, fees and the loss in respect of a repurchase agreement. Some costs are explicitly excluded.

…

What is a debt deduction?

1.57 The thin capitalisation regime disallows all or part of the debt deductions of certain thinly capitalised entities. A debt deduction encompasses the cost incurred in connection with a debt interest that, in the absence of the thin capitalisation provisions, would be deductible. Two broad types of costs are incurred in connection with debt interests:

- costs for the use of the financial benefit received by the entity under its debt interest arrangement; and

- costs directly incurred in obtaining or maintaining that benefit.

1.58 The cost of debt capital may not be explicit in an arrangement. For example, it may be embedded in a payment that does not differentiate between payment for acquisition of a physical asset and payment for not having to pay for that asset when it is delivered. Nevertheless, these costs are debt deductions to the extent that they are otherwise deductible.

1.59 An entity can incur costs directly in connection with debt capital other than interest or other amounts that compensate the provider of debt finance for the time the acquirer of the finance has the use of the funds. For example, there are costs of raising debt finance, such as establishment fees, fees for restructuring a transaction, stamp duty and legal costs of preparing documentation. These sorts of costs are costs of receiving the funds.

1.60 Once the funds have been raised, there may be other costs that the entity has to pay the finance provider that are directly incurred in maintaining the financial benefit received, for example, costs that are to maintain the right to draw down funds. To the extent that these costs can be deducted by the entity they are debt deductions.

161 The definition contains a list of costs which are debt deductions under paragraph (1)(a) of the definition. For example, amounts in substitution for interest, discounts in respect of a security and losses in respect of certain securities arrangements are costs incurred in relation to a debt interest and therefore debt deductions [Schedule 1, item 1, subsection 820-40(2)]

1.62 In order to avoid doubt, the definition also contains a list of amounts which are not debt deductions. Examples of these amounts include:

- foreign currency losses associated with hedging a currency risk in respect of a debt interest;

- foreign currency losses associated with extinguishing a debt interest where the losses are attributable to the outstanding principal; and

- salary or wages paid to employees of an entity."

(Emphasis added.)

236. The express words of s 820-40(1)(a) provide that a debt deduction is available for those amounts which reflect or directly form part of the "cost of debt capital" which includes not only interest but other amounts that compensate the provider of debt finance for the time the acquirer of the finance has the use of the funds or compensates an entity for the costs of receiving the funds.

237. There is not a "debt deduction" for the funds themselves or for other amounts which are indirect (for example, foreign currency losses associated with hedging a currency risk in respect of a debt interest). That construction of the legislation is reflected in the extracts from the Explanatory Memorandum at [235] above.

238. Before turning to consider the instrument in issue in these proceedings, a number of other principles should be restated:

1. the label that an entity uses to characterise a payment (such as "interest") is not determinative:
Commissioner of Taxation v Broken Hill Pty Co Ltd 2000 ATC 4659; (2000) 179 ALR 593. As noted by Hill J in Broken Hill (at [36]):

"Again, there is no dispute as to principle between the parties. The true position is that the label that a party uses to characterise a payment, in the present case the word 'interest', will not be determinative, although it may have some relevance: cf
NM Superannuation Pty Ltd v Young (1993) 41 FCR 182 at 198-9; 113 ALR 39, referred to by the learned trial judge in this context. What that relevance may be will depend on the particular circumstances of the case. A licence does not become a lease because the parties chose to call it one, if it is in truth a licence:
Radaich v Smith (1959) 101 CLR 209. A person does not cease to be an employee and become an independent contractor because the parties use the latter description:
Hannan & Allen v Australian Mutual Provident Society (SC(Vic), Harper J, 15 November 1996, unreported). So, it may be said that an amount payable does not become interest, if the parties chose to adopt that word, if in law it is not."
2. "Interest" refers to a periodic payment of a percentage of capital for the use of that capital amount for a fixed period of time:
Steele v Deputy Commissioner of Taxation 99 ATC 4242; (1999) 197 CLR 459 at [36]; and
3. Characterising a payment requires "both a wide survey and an exact scrutiny of the taxpayer's activities":
Western Gold Mines (NL) v Commissioner of Taxation (WA) (1938) 59 CLR 729 at 740;
Spriggs v Commissioner of Taxation 2009 ATC ¶20-109; (2009) 239 CLR 1 at [60].

239. In the present case, the issue for determination is the nature of the dividends paid in November 2003 and, in particular, whether each component was "interest, an amount in the nature of interest, or any other amount that is calculated by reference to the time value of money". There is no dispute that the default dividend (A$4,980,097) was in the nature of interest. The Commissioner has allowed a deduction for that amount. The only issue is whether two sums of A$21,104,108 (totalling A$42,208,216) forming part of the $222,655,981 was "interest, an amount in the nature of interest, or any other amount that is calculated by reference to the time value of money".

240. The Commissioner contended that $42,208,216 (the two amounts of $21,104,108) forming part of the $222,655,981 paid by CSA to CSF in the 2003 year was not deductible to Noza pursuant to s 25-90 as it was not a cost in relation to a debt interest as defined in paragraph (1)(a) of the definition of "debt deduction" in s 820-40 but rather was a part return of share capital or principal invested by CSF in CSA.

241. The Commissioner contended that the reason the amount of $42,208,216 was not deductible was because:

1. if the CSA Preference Shares are considered according to their legal form, this amount was a repayment of part of the capital contributed by CSF to CSA; or
2. if the CSA Preference Shares are considered according to their economic substance under the debt / equity rules, this amount was a repayment of part of the principal lent by CSF. (Being the way the dividends were accounted for in the books of SGTS and the Australian entities).

242. The Commissioner submitted that as the redemption value ($1,813,965,700) was less than the issue price ($1,927,700,000), the dividend payments necessarily involved a component of return of principal. The difference between the redemption value and the issue price was offset by the higher dividend rate (of 6%).

243. As a result, the Commissioner submitted that out of the total dividend of $222,655,981, an amount of $217,675,884 (removing the sum of $4,980,097 which has been allowed as a deduction) could be dissected as follows:

COMPONENT OF PAYMENT AMOUNT

Dividend 15 November 2002

Repayment of Principal/Capital $21,104,108

Financing Charge $87,733,834

TOTAL $108,837,942

Dividend 14 November 2003

Repayment of Principal/Capital $21,104,108

Financing Charge $87,733,834

TOTAL $108,837,942

GRAND TOTAL $217,675,884

244. The Commissioner contended that the amount is not a cost in relation to the debt interest; rather it is a repayment of part of the debt interest itself, being the way that part of the dividends was accounted for in the books of SGTS and the Australian entities. The Commissioner submitted that the situation was not dissimilar to that which prevails with the typical residential housing loan where, over the course of the loan, principal as well as interest is repaid each month and the monthly repayments can be divided arithmetically into a principal component and an interest component.

245. As a result, the Commissioner submitted that when the facts are applied to the definition of cost in relation to a debt deduction in paragraph (1)(a) of the definition in s 820-40, only the amount of the actual financing charge, $87,733,834 per year, was deductible. The Commissioner submitted that that amount is the actual rate of return on the preference shares with the remainder of the amount being a repayment of principal/return of capital which does not fit within any of those limbs in the definition and is not a cost in relation to a debt interest.

246. The applicants rejected that contention. They submitted that the entire amount of $222,655,861 was "interest, an amount in the nature of interest, or … [an] amount calculated by reference to the time value of money" within sub-paragraph (1)(a)(i) of the definition of 'debt deduction' in s 820-40 and that the amount also satisfied sub-paras (ii) and (iii) of para (a) of the definition. In other words, the applicants submitted that the entire amount of the dividends payable at a rate of 6% on $1,813,965,700 is deductible under s 25-90 of the 1997 Act.

247. In my view, the applicants are not entitled to a deduction of the entire amount of the dividends payable at a rate of 6% on $1,813,965,700, although I do not accept the figures proposed by the Commissioner. That requires further explanation. It is necessary to start with the terms of the CSA Preference Shares. Each preference share was issued by CSA for $2,048,565.36 on terms and conditions: cl 1(f). Dividends were payable on a cumulative preferential basis at the rate of 6% per annum on the capital paid-up on each preference share. The paid up capital was $1,927,700.00 per share: cl 1(g) and 5(c). Unpaid dividends were to accumulate annually. The premium on each preference share was $120,865.36. The redemption value for each preference share was $1,927,700.00 (representing the capital) plus any unpaid dividends and Default Dividends. CSA was to repay to CSF a sum of $1,813,965,700 (which equals the redemption value of the shares in aggregate - the capital component) in five years and 45 days from the date of issue of the Preference Shares. No payment was made for the use of the amount of the premium. That amount was never required to be repaid and was never repaid.

248. As a result, the dividend payment of $222,655,981 was comprised of the following components:

Components of Dividend A$

6% of [$1,813,965,700] (15 November 2002) $108,837,942

4.5757% of unpaid dividend for 12 months $4,980,097

6% of [$1,813,965,700] (15 November 2003) $108,837,942

The applicants contended that each component was in the nature of interest - a periodic payment of a percentage of the capital outstanding, for the use of that capital for a fixed period of time: Steele at [29] citing
Australian National Hotels Ltd v Commissioner of Taxation 88 ATC 4627; (1988) 19 FCR 234 at 239-241.

249. There is no dispute that the market yield for the CSA preference shares was expected to be 4.5757%. It is also common ground that the higher dividend rate of 6% was fixed so as to offset the difference in the redemption price and the issue price (see [126] above). That being the case, the difference between those dividend rates (of some 1.4%) can be seen as a return of capital or principal. By way of example, had a "premium" not been paid for the shares, the dividend rate would have been 4.5757% and the dividends paid would have been as follows:

Components of Dividend A$

4.5757% of $1,813,965,700 (15 November 2002) $83,001,628.53

4.5757% of unpaid dividend for 12 months $4,980,097

4.5757% of $1,813,965,700 (15 November 2003) $83,001,628.53

$170,983,354

250. Moreover, it is important to recall that interest of 4.5757% was charged on unpaid dividends: see [248] above.

251. It is necessary to address two further matters raised by the Commissioner. The first concerns the manner in which the applicants accounted for the dividends. The Commissioner referred to correspondence the applicants sent the Commissioner (dated 6 October 2004 and 3 May 2005 from ITW Inc Australia to the Commissioner, dated 18 February 2005 from Ernst & Young to the Commissioner and dated 21 March 2007 from PwC to the Commissioner). The 18 February 2005 letter described the treatment of the dividend in the following terms:

"From a financing, accounting and income tax perspective, the dividend payments actually made on 15 November 2003 have been split into an interest / financing component that is calculated by reference to the internal rate of return on the CSA [Preference Shares] (total A$175,467,662) and a principal repayment component (A$42,208,216). The default dividends have also been treated as 'financing' (interest) payments for financing, accounting and income tax purposes."

(Emphasis added.)

252. Indeed, the applicants provided the Commissioner with an extract of CSA's accounting entries which reflected that treatment as follows:

Description Debit Credit

DR Intercompany Interest Payable - CSF A$175,467,668

DR Intercompany Note Payable - A$ redeemable pref - CSF A$42,208,216

DR Intercompany Interest Expense - CSF A$4,980,097

CR Intercompany Note Receivable A$222,655,981

(The distribution is made up of interest A$175,467,668, penalty interest of $4,980,097 and principal reduction of A$42,208,216).

253. As Hely J said in
Macquarie Finance Limited v Commissioner of Taxation 2005 ATC 4829; (2005) 146 FCR 77 at [139], the way in which accounts are required to be prepared cannot be determinative of the issue of deductibility but cannot necessarily be dismissed as irrelevant: see
Commissioner of Taxation v Citibank Ltd 93 ATC 4691; (1993) 44 FCR 434 at 443-446 where Hill J discussed the relevance of accounting treatment to issues arising under taxation legislation.

254. Finally, the Commissioner submitted that the applicants' contentions should be rejected because they would lead to the absurd result that a deduction could be obtained for all principal repayments on a debt interest simply by setting the redemption price to zero. I reject that contention. Every case is decided on its own facts and, in the case of preference shares, the terms on which the shares are issued. The amount on which the interest or the time value of money was calculated was not zero but in excess of $1,813,965,700. The rate at which the "interest, the amount in the nature of interest or the amount calculated by reference to the time value of money" was calculated was specified - 6% for the dividends and 4.5757% for the unpaid dividends for 12 months of the capital amount which was repaid at redemption. If the redemption had been zero, it is highly likely in the absence of some other fact or matter that the taxpayer would have failed. That is not this case.

(g) Conclusion

255. For those reasons, I am not satisfied that the full amount of the dividend at 6% of the redemption value is "interest, an amount in the nature of interest, or any other amount that is calculated by reference to the time value of money" for the purposes of s 820-40(1)(a)(i). I do not accept that the difference between the expected market yield for the CSA Preference Shares (of 4.5757%) and the dividend rate of 6% was "interest, an amount in the nature of interest, or any other amount that is calculated by reference to the time value of money". It was in substance and in form a return of capital or principal. In substance and in form, the 6% interest rate had been reverse engineered to ensure a return of the "premium" over the term of the CSA Preference Shares see [247] and [249] above. Accordingly, only that component of the dividend comprising 4.5757% of the redemption price ($170,983,354) is deductible under s 25-90 of the 1997 Act.

256. Further, I do not accept that the difference between the expected market yield for the CSA Preference Shares (of 4.5757%) and the dividend rate of 6% satisfied sub-paragraph (ii) or (iii) of s 820-40(1)(a) of the 1997 Act. The amount does not satisfy the express terms of those sub-sections and, further, is contrary to the purpose of the section - to provide a debt deduction. The component in issue was not a debt deduction - it was a return of an amount of capital.

(2) Deductibility for dividend on an incurred basis

257. With respect to the 2003 year, it is strictly unnecessary to address this alternative argument given the views I have formed that Noza is entitled to a deduction of $170,983,354, being part of the $222,655,981 declared and paid by CSA to CSF in the 2003 year: see Section C(1) above.

258. There are a number of points to be made about this alternative argument. The issue for determination is whether Noza and AFC are entitled to a deduction on an incurred basis pursuant to s 25-90 for the following amounts that accrued as liabilities owing to CSA (and AFC in the 2003 year):

Year Taxpayer Dividend "Default Dividend"

2002 AFC $108,837,942 $207,504

2003 Noza $108,837,942 $4,772,599

2004 Noza $108,837,942 $207,504

2005 Noza $108,837,942 $5,187,607

For the reasons at [249] to [256] above, I do not accept that the full amount of $108,837,942 in each year satisfied the definition of "debt deduction" in s 820-40(1)(a) of the 1997 Act.

259. The applicants submitted that AFC in 2002 and Noza in 2003 incurred a loss or outgoing of $108,837,942 in the relevant income years on an accrued basis, and that the accrued loss or outgoing was incurred in deriving income from a foreign source that was exempt under s 23AJ. The applicants submitted that given the relationship between s 25-90 and the debt / equity provisions in Div 974, the word "incurred" should be given a more flexible meaning than that which it has under s 8-1.

260. The Commissioner's contentions raised many of the same arguments that I have dealt with earlier: see Section C(1) above. In addition, the Commissioner relied upon two arguments which were said to be relevant only to this aspect of the applicants' argument as to why the amounts were not deductible. Both arguments depended upon the requirement in s 25-90 that:

"An Australian entity can deduct an amount of loss or outgoing from its assessable income for an income year if:

(a) the amount is incurred by the entity in deriving income from a foreign source; and
…"

(Emphasis added.)

The Commissioner contended that there was no loss or outgoing incurred by AFC in the 2002 Year or by Noza in the 2003, 2004 and 2005 Years. The Commissioner's argument was principally directed at cl 3.1 and 3.2 of the terms of both the AFC and CSA Preference Shares.

261. Those clauses provided:

3.1 Each Redeemable Preference Shareholder will be entitled to receive out of the profits of the Company a Dividend, in respect of each Redeemable Preference Share held by that Redeemable Preference Shareholder, annually on 15 November of each year, in priority to the dividend entitlements of any other class of shares (other than Senior Shares).
3.2 Where a Redeemable Preference Shareholder is entitled to a Dividend in respect of a Redeemable Preference Share, if the profits of the Company in any year are insufficient to cover the amount of the Dividend for that year, or where the directors resolve not to pay that Dividend or otherwise fail to declare the Dividend, when the entitlement arises under clause 3.1 of these Terms, then:
- (a) the unpaid amount of the Dividend (to which the Redeemable Preference Shareholder would have been entitled under clause 3.1 of these Terms) will be carried forward to the following year and such Unpaid Dividend will be paid when the Company next declares a Dividend out of the profits of the Company, in priority to the Dividend in respect of the subsequent year or years; and
- (b) a Default Dividend will be payable in respect of any Unpaid Dividend calculated at the rate of 4.5757% per annum of the amount of the Unpaid Dividend from time to time. Such Default Dividend shall be calculated on the basis of a 360 day year. The Default Dividend is payable at the time the Unpaid Dividend is paid or at the time of redemption of the Redeemable Preference Shares, whichever is earlier.
  (Emphasis added.)

262. The Commissioner submitted that on the proper construction of cl 3.1 and 3.2, the entitlement of a holder of either AFC or CSA Preference Shares to be paid a dividend was conditional on the existence of sufficient profits in AFC or CSA to pay a dividend and a decision by the directors of AFC or CSA to declare a dividend and that in the absence of either having occurred, there was no loss or outgoing incurred by the taxpayer in the relevant year.

263. The applicants rejected that contention. They accepted that:

1. as a matter of company law, it was undoubtedly the position that a liability to pay a dividend will only arise following a declaration that it be paid; and
2. in each of the 2002, 2004 and 2005 years, no dividend was declared to be payable by CSA.

264. However, the applicants submitted that although the CSA and AFC Preference Shares were equity (shares), their terms of issue each contained clauses that provided that within 45 days of the fifth anniversary of issue, each company "must redeem each of the redeemable preference shares for an amount in cash equal to the Redemption Value" for each share. "Redemption Value" was defined to mean for each Preference Share "the amount of A$1,927,700.00 per share plus an amount equal to any Unpaid Dividends and Default Dividends in respect of the Redeemable Preference Shares". A consequence of those terms was that each of CSA and AFC was required to pay unpaid dividends and default dividends, as well as $1,927,700.00 on each share, when the shares matured.

265. The applicants submitted that those circumstances were materially the same as those considered in
Federal Commissioner of Taxation v Australian Guarantee Corporation Ltd 84 ATC 4642; (1984) 2 FCR 483 (AGC). In that case, the taxpayer was a finance company which raised funds from the public by issuing what were called "deferred interest debentures". Under the terms of the debentures, no interest was "paid or credited" before maturity or earlier redemption at which time a debenture would "earn and be credited with interest". The issue for determination was whether the "interest" which accrued on the debentures was "incurred" because the taxpayer had subjected himself to a liability to pay interest even though payment would not be made until maturity or earlier redemption. The Court held that interest which accrued was "incurred" by the taxpayer in that year within the meaning of s 51(1) of the 1936 Act. There are a number of facts in AGC which should be noted. The terms of the debentures were important: at 484 and 485 (per Toohey J). Although no interest was paid or credited prior to maturity or earlier redemption, the stock was credited with interest "at redemption" which was then calculated from the date of investment: at 486. The interest was debited annually in its accounts: at 483.

266. In AGC, in deciding that interest which accrued was "incurred" by the taxpayer even though it was not paid, Toohey J (with whom McGregor and Beaumont JJ agreed) referred to a number of authorities and restated some well known principles:

1. an outgoing may be incurred though the sum in question has not been paid or the liability discharged:
New Zealand Flax Investments Ltd v Federal Commissioner of Taxation 93 ATC 4238; (1938) 61 CLR 179 at 207;
Federal Commissioner of Taxation v James Flood Pty Ltd (1953) 88 CLR 492 at 507 and
W Nevill & Co Ltd v Federal Commissioner of Taxation (1937) 56 CLR 290;
2. an outgoing may be incurred in the sense that a taxpayer may completely subject himself to a liability even though the liability is defeasible:
Commonwealth Aluminum Corporation Ltd v Federal Commissioner of Taxation 77 ATC 4151; (1977) 7 ATR 376 at 4160-4161.

267. Reference was made in AGC to
Emu Bay Railway Co Limited v Commissioner of Taxation (1944) 71 CLR 596. That decision concerned the deductibility of interest on debenture stock where the interest was only payable out of the "net income of the Company from time to time available" after certain other costs and expenses were accounted for. The taxpayer contended that the interest was deductible even if not paid because the obligation to pay had been incurred. The majority held that it was not deductible because there was in fact no "net income" and therefore no obligation to pay arose: at 606, 611, 613-4. In other words, in the absence of an obligation to pay, there could not be a loss or outgoing incurred: see also
Nilsen Development Laboratories Pty Ltd v Commissioner of Taxation 81 ATC 4031; (1981) 144 CLR 616 at 623-4 and Citylink at [134].

268. That is not this case. A liability to pay the preferred dividends annually, which were cumulative and with no restriction on the sources of funds from which they may be paid at redemption , represented a definitive commitment that accumulated in each year of income. Subject to my earlier findings at [255], [256] and [258] above, it was a commitment which constituted a "debt deduction" - an amount of interest or in the nature of interest: s 820-40(1)(a)(i). I accept the applicants' submissions that that conclusion (that the dividends which are treated as "interest" under Div 974 are deductible as they accrue) is consistent with the decision in AGC and the policy of Div 974 which sought to align the form and substance of instruments: see Explanatory Memorandum, New Tax System (Debt and Equity) Bill 2001, pg 9.

269. As noted earlier (see [239] above), there is no dispute that the default dividend (A$4,980,097) was in the nature of interest in the 2003 year. The Commissioner submitted that if the default dividends payable by AFC or Noza were deductible on an incurred basis, the assessments were not excessive because AFC and Noza would have to return as income a matching amount of interest income derived from SGTS. It is to that issue I now turn.

270. The SGTS Preferred Stock created an unconditional obligation to pay "interest" should a dividend not be paid in any year of income in the following terms:

Interest shall be payable in respect of any dividend payment or payments on the [Series A and Series B] Preferred Stock that may be in arrears at the annual rate of 4.5757%.

271. That obligation to pay interest was not conditional on the availability of profits to distribute or any decision by the Board of SGTS that a dividend be paid. The payment was described as interest. The payment was compensation for money not paid - namely the dividends. The amount of the payment was calculated by reference to the time value of money not paid.

272. Consistent with the earlier analysis in relation to the interest on unpaid dividends, each of the "interest" amounts on the unpaid dividends will be derived by either AFC (2002 Year) or Noza (2003 to 2005 Years) as ordinary income pursuant to s 6-5 of the 1997 Act. That interest is not exempt income under s 23AJ because they are not dividends - they are interest on unpaid dividends. In that context, it is important to recall again that the Commissioner has allowed a deduction of $4,980,097 in the 2003 year as returned by Noza and that amount will need to be allowed for when considering any adjustments to Noza's taxable income in the 2003 year.

(3) Part IVA

(a) Introduction and Summary of Findings

273. The Commissioner submitted, in the alternative, that to the extent any amount was deductible to the applicants, Pt IVA of the 1936 Act applied to cancel the tax benefit represented by that deduction. In particular, the Commissioner submitted:

1. there was a "scheme" or "schemes" within the meaning of s 177A(1) of the 1936 Act to which Pt IVA applied;
2. Noza or AFC received a tax benefit or benefits within the meaning of s 177C(1) of the 1936 Act with respect to the deductible amounts in the year or years in which those amounts were deductible in connection with the relevant scheme; and
3. having regard to the eight factors in s 177D(b), it would be concluded that Noza or AFC, or one of the persons who entered into or carried out the relevant scheme, or any part of the scheme, did so for the dominant purpose of enabling Noza or AFC to obtain the tax benefit(s) in connection with the scheme.

274. The applicants did not dispute that each of the schemes propounded by the Commissioner was a scheme within the meaning of s 177A. However, the applicants submitted there was no tax benefit in the 2003 year (or, if the alternative basis was accepted, in the 2003 to 2005 years) because the exclusion in s 177C(2)(b)(i) in the 1936 Act was engaged. Further, the applicants submitted that the dominant purpose of the ITW Group (or any other relevant participant) was to resolve the foreign exchange accounting issue in a matter consistent with the facts expressed in the Private Letter Ruling issued by the IDR and in such a way that it would not deprive the ITW Group of the benefit of US state tax deductions.

275. For the detailed reasons that follow, I accept there was a "scheme" within the meaning of s 177A to which Pt IVA applies. I also accept that Noza or AFC received a tax benefit within the meaning of s 177C(1). I reject the applicants' submission that the exclusion in s 177C(2)(b)(i) was engaged. However, I do not consider that the dominant purpose of the scheme(s) identified by the Commissioner (see [278] below) was to obtain the tax benefit identified by the Commissioner. I also reject the Commissioner's counterfactuals as neither were an alternative means of achieving the commercial objectives of Project Gemini. I consider each aspect in turn.

(b) Scheme

276. A "scheme" for Pt IVA is defined in s 177A(1) to mean:

"(a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and

(b) any scheme, plan, proposal, action, course of action or course of conduct."

277. The definition of "scheme" is very broad:
Commissioner of Taxation v Star City Pty Ltd 2009 ATC ¶20-093; (2009) 175 FCR 39 at [202]-[217];
Commissioner of Taxation v Hart 2004 ATC 4599; (2004) 217 CLR 216 at [9], [43], [85] and 260-1 [87];
Commissioner of Taxation v Spotless Services Ltd 96 ATC 5201; (1996) 186 CLR 404 at 425 and
Commissioner of Taxation v Peabody 94 ATC 4663; (1994) 181 CLR 359 at 378.

278. In the present case, the Commissioner submitted that the scheme for the purposes of s 177A(1) was constituted by either of the following "steps, matters, things or actions":

"1. the transfer of the royalty income streams from CSF to AFC, the subsequent transfer of those income streams to SGTS, the issue of the SGTS Preferred Stock by SGTS, the issue of the AFC Preference Shares by AFC and the issue of the CSA Preference Shares by CSA; or

2. the issue of SGTS Preferred Stock by SGTS, the issue of the AFC Preference Shares by AFC and the issue of the CSA Preference Shares by CSA."

279. The applicants accepted that each was a scheme within the meaning of in s 177A(1) of the 1936 Act but submitted that the determination of purpose may be assisted by "looking at the wider transaction":
Commissioner of Taxation v Consolidated Press Holdings Ltd 2001 ATC 4343; (2001) 207 CLR 235 at [96].

(c) Tax benefit

280. Section 177F of the 1936 Act provides for, inter alia, the disallowance of a deduction that by reason of a scheme to which Pt IVA applies would otherwise be allowable to the taxpayer in relation to a year of income. Section 177C(1) relevantly defines a "tax benefit" in the following terms:

"Subject to this section, a reference in this Part to the obtaining by the taxpayer of a tax benefit in connection with a scheme shall be read as a reference to:

…

(b) a deduction being allowable to the taxpayer in relation to a year of income where the whole or a part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer in relation to that year of income if the scheme had not been entered into or carried out;
…

and, for the purposes of this Part, the amount of the tax benefit shall be taken to be:

…

(d) in a case to which paragraph (b) applies - the amount of the whole of the deduction or of the part of the deduction, as the case may be, referred to in that paragraph."

281. The Commissioner submitted that the common element of each scheme was the decision by the applicants to alter the planned and partially implemented structure of Project Gemini so that instead of CSA issuing ordinary shares to CSF it instead issued preference shares that qualified as a debt interest under Australian law. It was this particular change that gave rise to the tax benefit, namely, deductibility of the dividends (at least in part) paid on the CSA Preference Shares under s 25-90. In the absence of the step by which the CSA ordinary shares were converted to CSA Preference Shares, no deduction would have been available.

282. As a result, the Commissioner submitted that Noza and AFC would, but for the provisions of s 177F of the 1936 Act, obtain a tax benefit or benefits in connection with each of the schemes, namely an allowable deduction or deductions in respect of the following amounts:

1. if the applicants' first alternative is correct, then in the 2003 year (to Noza) a deduction under s 25-90 for amounts of $217,675,884 and $4,980,097, or some part of those sums, being a loss or outgoing incurred with respect to a payment to CSF of those sums as a dividend and "default dividend" pursuant to the CSA Preference Shares;
2. alternatively, if the applicants' second alternative is correct, then:
- 2.1 in the 2002 Year, to AFC, a deduction under s 25-90 for amounts of $108,837,942 and $207,504, or some part of those sums, being a liability allegedly incurred to CSF to pay these sums as a dividend and "default dividend" pursuant to the CSA Preference Shares;
- 2.2 in the 2003 Year, to Noza, a deduction under s 25-90 for amounts of $108,837,942 and $4,772,599, or some part of those sums, being a liability allegedly incurred to CSF to pay these sums as a "dividend and default dividend" pursuant to the CSA Preference Shares;
- 2.3 in the 2004 Year, to Noza, a deduction under s 25-90 for amounts of $108,837,942 and $207,504, or some part of those sums, being a liability allegedly incurred to CSF to pay these sums as a "dividend and default dividend" pursuant to the CSA Preference Shares; and
- 2.4 in the 2005 Year, to Noza, a deduction under s 25-90 for amounts of $108,837,942 and $5,187,607, or some part of those sums, being a liability allegedly incurred to CSF to pay these sums as a "dividend and default dividend" pursuant to the CSA Preference Shares.

283. It is necessary to deal with the applicants' alternative deduction cases separately. In relation to AFC in the 2002 year, the applicants accepted that AFC would, but for the provisions of s 177F of the 1936 Act, obtain a tax benefit or benefits in connection with each of the schemes in the 2002 year on an accrued basis.

284. The applicants also accepted that, but for the issue of CSA Preference Shares, there would be no debt interest which could give rise to a deduction to Noza. However, the applicants submitted that Noza's right to a deduction for an expense on a debt interest incurred by CSA was due to the election to form a MEC group pursuant to s 719-50 of the 1997 Act and the allowance of the deduction was relevantly attributable to the making of that election in the sense required by s 177C(2)(b)(i) and 177C(3) of the 1936 Act.

285. Section 177C(2)(b) and 177C(3) relevantly provide:

"(2) A reference in this Part to the obtaining by a taxpayer of a tax benefit in connection with a scheme shall be read as not including a reference to:

…

(b) a deduction being allowable to the taxpayer in relation to a year of income the whole or a part of which would not have been, or might reasonably be expected not to have been, allowable to the taxpayer in relation to that year of income if the scheme had not been entered into or carried out where:

(i) the allowance of the deduction to the taxpayer is attributable to the making of a[n] … election … or choice …, being a[n] … election …, [or] choice … expressly provided for by this Act or the [1997 Act], …; and

(ii) the scheme was not entered into or carried out by any person for the purpose of creating any circumstance or state of affairs the existence of which is necessary to enable … the election … [or] choice, … to be made, given or exercised, as the case may be.

…

(3) For the purposes of subparagraph … (2)(b)(i):

…

(b) the allowance of a deduction to a taxpayer; or
…

is taken to be attributable to the making of a[n] … election, …, if the … election … had not been made, given or exercised, as the case may be:

…

(e) the deduction would not have been allowable; or
…
"

286. I reject the applicants' submissions that Noza's right to a deduction for an expense on a debt interest incurred by CSA was due to an election to form a MEC group and that accordingly the allowance of the deduction was relevantly attributable to the making of that election.

287. In relation to the claim for deductibility by Noza in the 2003 year and the alternative claims for deductibility by Noza on an accrued basis in the 2004 and 2005 years, the various steps identified in the schemes were taken, inter alia, by Australian companies, AFC and CSA. Following the consolidation of those entities into an Australian tax group headed by Noza on 1 December 2002, each of the steps taken by AFC and CSA is deemed by the operation of the Entry History Rule (s 701-5 of the 1997 Act) to have instead been steps taken by Noza. Also because of the operation of the Single Entity Rule (s 701-1 of the 1997 Act) for the 2003 and onwards years, the separate identity of AFC and CSA is ignored and the tax benefit is deemed to have been derived by Noza. The Commissioner did not contend that the schemes were relevantly entered into or carried out "to enable the … choice … to be made" to consolidate: s 177C(2)(b)(ii).

288. That analysis of the consolidation provisions is important. The relevant provisions are deeming provisions - the steps taken by AFC and CSA are deemed by the operation of the Entry History Rule (s 701-5 of the 1997 Act) to have instead been steps taken by Noza and the separate identity of AFC and CSA is ignored by reasons of the Single Entity Rule (s 701-1 of the 1997 Act) for the 2003 and onwards years so that the tax benefit is deemed to have been derived by Noza.

289. Noza's right to a deduction for an expense on a debt interest was not due to the election to form a MEC group. The right to the deduction was available to AFC if there was no consolidation. All the election to consolidate did was move the availability of the deduction up the chain to the head company of the consolidated group. Put another way, but for the choice made by Noza to form a consolidated MEC group pursuant to s 719-50 of the 1997 Act, Noza as provisional head entity of an MEC group, would not have been entitled to claim a deduction under s 25-90. And but for the election, AFC would be entitled to the deduction under s 25-90.

290. In this respect the allowance of each deduction is not "attributable" to the making of that election, in the sense required by s 177C(2)(b)(i) and s 177C(3). It has not been, and could not be, suggested that any of the alleged schemes were entered into for the purpose of creating a circumstance or state of affairs the existence of which was necessary to permit the applicants to make the election created by s 703-50. The exception in s 177C(2)(b)(i) is not engaged.

291. It should also be noted that but for the election to consolidate, the dividend which would have given rise to the deduction under s 25-90, was the dividend in fact paid, or payable, by AFC. The position in respect of CSA (but for consolidation) is that it would have derived an amount of assessable income, treated as being like interest under the debt / equity rules, which would be set-off against a deductible outgoing incurred by CSA. Its tax position in Australia would be neutral. As a consequence of the election to consolidate, the dividend paid or payable by AFC is not deductible but the dividend paid by CSA is deductible to Noza under s 25-90.

292. As noted earlier, the applicants accepted that a tax benefit could exist for any deductions that arise prior to the formation of the MEC group on 1 December 2002 which are the deductions of AFC in the 2002 year on an accrued basis.

(d) Application of s 177D(b) of the 1936 Act - Dominant Purpose

293. Section 177D is the key provision in Pt IVA. It provides that a scheme must be entered into or carried out by a person for a purpose of the kind identified in s 177D(b): see Hart at [16], [34], [43], [50], [56] and [92].

294. The test posited by s 177D is objective: Spotless at 421-422, 424; Consolidated Press at [95] and
Federal Commissioner of Taxation v Sleight 2004 ATC 4477; (2004) 136 FCR 211 at [67(1)] and [205]. The test does not require, or even permit, any inquiry into the subjective motives or state of mind of any person: Hart at [65].

295. Each of the factors set out in s 177D(b) must be considered. However, as Hill J pointed out in
Peabody v Federal Commissioner of Taxation 93 ATC 4104; (1993) 40 FCR 531 at 543:

"This does not mean that each of those matters must point to the necessary purpose referred to in s 177D(b). Some of the matters may point in one direction and others may point in another direction. 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.

See also Sleight at [67]."

296. In evaluating the s 177D(b) factors, the pursuit of a commercial objective is not inconsistent with the existence of a dominant purpose of enabling the taxpayer to obtain a tax benefit: Spotless at 415 and 416; Consolidated Press at [96] and Hart at [16]-[18], [52], [68], [71] and [93]-[96]. Therefore, in ascertaining objective purpose, it is important to consider the question of purpose by reference to the particular way the transaction was structured and the particular features of the transaction that gave rise to the tax benefit (Hart at [6], [12], [16]-[18], [65]-[68] and at [96]) and to compare how the scheme was structured with alternative ways of achieving the same commercial objectives: Hart at [66] and [94].

Counterfactuals

297. Here, the Commissioner submitted that there were at least two potential ways in which the applicants could have addressed the foreign exchange accounting issue aside from the change in structure, namely:

"1. US$ denominated preferred stock could have been issued by SGTS to AFC where repayment was conditional and not certain to occur with AFC and CSA issuing A$ denominated ordinary shares to CSA and CSF respectively; or
2. US$ denominated ordinary shares could have been issued by SGTS to AFC with AFC and CSA issuing A$ denominated ordinary shares to CSA and CSF respectively."

298. The Commissioner submitted that these counterfactuals or alternative postulates would have resolved the foreign exchange accounting issue and would have been financially or commercially advantageous (apart from the tax savings) compared with the transactions entered into. In particular, the Commissioner submitted that for both postulates, the shares issued by SGTS would have been classified as equity instruments for the purposes of US GAAP and the foreign exchange issue would have been resolved.

299. In support of that contention, the Commissioner relied upon the evidence of Ms Esther Mills, a Certified Public Accountant licensed in the State of New York who regularly provides advice on the accounting treatment for complex structured transactions. Mills provided a report in which she considered whether the following hypothetical change to Project Gemini would have resolved the foreign exchange accounting issue identified by Kropp at [66] and [67] above. The hypothetical change posed by the Commissioner was:

"USD preferred stock would have been issued by SGTS where the repayment was conditional and not certain to occur together with AUD ordinary shares being issued by each of AFC and [CSA].

300. Ms Mills was not cross-examined. Her response to the hypothetical was:

"The description of the First Alternative Instrument to be issued by SGTS, an instrument whose repayment is conditional and not certain to occur, is general enough to meet the spirit of the criteria in ASR 268 such that it could be classified as part of stockholders' equity. The exact terms of the First Alternative Instrument would have to specify that 'conditional repayment' means that the Instrument's redemption is not at a fixed or determinable price, on a fixed or determinable date; is not at the option of the holder; and is based on conditions that are not outside the control of the issuer. As long as the specific terms of the Instrument met these requirements, it would be considered an equity instrument."

301. The Commissioner contended that because the applicants chose a method of resolving the foreign exchange accounting issue that led to several financial and commercial disadvantages to the applicants (issues I will address below), but which gave rise to a very large tax benefit, it should be concluded that the applicants' objective purpose in entering into the scheme was to obtain the tax benefit.

302. For the reasons that follow, I reject the Commissioner's contentions.

Analysis of the counterfactuals

303. There are problems with the Commissioner's counterfactuals. The first counterfactual was that the SGTS preferred stock "could have been issued by SGTS to AFC where repayment was conditional and not certain to occur" with the consequence that the SGTS stock would be classified as an equity instrument for US GAAP.

304. This option was rejected by Murtaugh on 1 November 2001 when she was asked to consider it: see [93], [95] and [96] above. The option was put to Sutherland during cross examination and rejected by him: see [94] above. The principal reason for its rejection was that it was too difficult to structure an instrument that was equity for US GAAP but nonetheless debt for US tax purposes in order to comply with the IDR's Private Letter Ruling.

305. During cross examination, Sutherland confirmed that both the value of the US tax deductions and the need for compliance with the Private Letter Ruling were important. In response to a question in cross examination about these two factors, he said:

"[Mr Moshinsky]: You didn't see either of these two factors, loss of US tax deductibility for the dividends or a potential inconsistency with the private letter ruling as a problem at that point in time when you were proposing the permanent for GAAP purposes solution?---

[Mr Sutherland]: No, I'm not sure how you could even say that today. We went through that in great detail yesterday. Of course I did. Of course I considered it a big issue. I'm not sure what in the email doesn't suggest that, nor in any of our conversations since then."

The email being discussed is the "permanent for GAAP" email of 1 November 2001 referred to at [90] above.

306. Sutherland's evidence was that he thought the possibility of finding an instrument that straddled the GAAP and tax regimes (as now suggested by the Commissioner) would have been "rare" but given the $300 million capital gains tax liability which had already been incurred "[w]hy wouldn't you try to see if you could make something work?". Murtaugh's evidence was that it had been a very difficult time trying to find a balance between the tax and the GAAP analysis resulting in many drafts of the terms of the shares to be issued and that developing an instrument that was characterised as debt for US tax purposes and at the same time as equity for US GAAP purposes would not have been an "easy task". It was not an easy task. They tried. But no instrument which straddled the GAAP and tax regimes was produced. Even Ms Mills did not produce a specific instrument or give examples of instruments which had successfully straddled the GAAP and tax regimes so that it was equity for US GAAP but nonetheless debt for US tax purposes.

307. That leads me to the IDR Private Letter Ruling. There was unchallenged evidence of the need and desire to comply with the IDR Private Letter Ruling: see the evidence of Chin and Murtaugh at [54] above, Wills at [81] above, Sutherland at [81] and [100] above and Diskin at [99] above. None of the witnesses was challenged about the reasonableness of wanting to avoid the risk of departure from the Private Letter Ruling.

308. No less importantly, it was not suggested that it was inappropriate for ITW Inc to have acted conservatively. That is not surprising given the terms of the request for the Private Letter Ruling (see [41] above), the terms of the Private Letter Ruling itself (see [44] to [48]) above), the novelty of the request for the Private Letter Ruling (see [40] above) and the size of the tax liability which had already accrued: see [56] above. As the applicants submitted, the fundamental difficulty with this aspect of the first counterfactual was the inability to identify an instrument that could have been treated in the US as debt and equity at the same time. No such instrument was ever identified. In my view, such an instrument rose no higher than being a mere "possibility":
Federal Commissioner of Taxation v BHP Billiton Finance Ltd 2010 ATC ¶20-169; (2010) 182 FCR 526 at [68].

309. The alternative under the first counterfactual - a possible instrument that would have been considered as equity for both US GAAP and state tax purposes - suffered from different problems. Such an instrument would have involved obvious and express potential non-compliance with the facts on which the IDR Private Letter Ruling was based and the potential loss of US state income tax deductions available to SGTS on the dividends (treated as interest) payable to AFC. For my part, I place little weight on the size of the US state income tax deductions. I accept that those deductions were a planned part of Project Gemini and ITW Inc was perfectly entitled to consider and adopt solutions which preserved them, but I do not accept that they were so great (US$10 million) as to result in the rejection of the counterfactual. However, for the reasons stated earlier (see [307] and [308] above), I consider that an instrument that was treated as equity for both US GAAP and tax purposes would have given rise to an impermissible risk that the IDR Private Letter Ruling would have ceased to have been binding.

310. For these reasons, I reject the Commissioner's first counterfactual. I do not consider that the first counterfactual constituted an alternative means of achieving the commercial objectives of Project Gemini.

311. The second of the counterfactuals - that US$ denominated ordinary shares could have been issued by SGTS to AFC with AFC and CSA issuing A$ denominated ordinary shares to CSA and CSF respectively - also suffers problems. The shares that would have been issued by SGTS would have been treated as equity for US GAAP purposes. Neither Sutherland nor Murtaugh were questioned about this second counterfactual. It was not put to either witness that the use of ordinary stock was an appropriate and effective means of achieving all of the commercial objectives of Project Gemini, including the US State tax deduction.

312. The failure to put the second counterfactual to the witnesses is important. By not putting it to the witnesses the Court does not have the advantage of those witnesses' views on whether it was an available course of action, or if available, one which would have achieved the desired commercial ends of those employed in the transactions.

313. The only witness who could recall discussing an option of this kind on 1 November 2001 was Diskin. His evidence concerning the discussion about using ordinary stock was as follows:

"A further option discussed was for SGTS to issue ordinary instead of preferred shares to AFC. … Sutherland was adamant that it was too risky from ITW's viewpoint to request a change to the existing ruling. The Project Gemini proposals had from the outset been premised on the basis that the preferred stock to be issued by SGTS would be regarded as debt for US purposes. The issue of ordinary shares by SGTS instead of the preferred stock was rejected."

Diskin's evidence was not challenged. He was only asked whether he had advised on the potential tax outcomes of the proposal and his answer was "No". In light of this evidence it is not useful to consider the second counterfactual proposed by the Commissioner.

General Considerations

314. Finally, before turning to consider the factors in s 177D(b), it is important to restate some facts and matters. The Commissioner accepted that:

1. the objectives of Project Gemini were legitimate commercial purposes which included the obtaining of US state tax benefits for the US group;
2. the commercial purposes could only be achieved by a series of internal transactions within the ITW Inc group both in the US and in Australia;
3. by 15 October 2001, many of the necessary transactions had already been completed in the US and had given rise to a US$4 billion capital gain;
4. neither at the time of identification of the commercial purpose nor at the time of selection of the structure to effect that purpose, was the foreign exchange accounting issue identified as a problem or even a potential problem;
5. at the end of October 2001, the foreign exchange accounting issue had been identified and required a solution;
6. the first course of action considered for dealing with the foreign exchange accounting issue that had emerged was one that was seen as having risks of disturbing the Delaware taxation consequences of the arrangement because it was thought to be arguable that the proposed solution departed from the basis on which the Private Letter Ruling had been issued by the IDR; and
7. the second course of action considered (and ultimately adopted) was one that the taxpayer believed would have substantial Australian taxation benefits. But it was preferred over the first solution to avoid the risks seen in pursuing the first course of action.

315. The fact that the transactions in issue are all intercompany transactions within a group of companies in which corporate dividends are paid otherwise than in cash, and are transactions believed to have very large Australian taxation consequences, if considered alone would very probably excite the closest attention to the possible application of Pt IVA. But once it is accepted (as it was) that the transactions are part of a legitimate series of intercompany transactions that were undertaken for reasons other than the avoidance of taxation (in Australia or the US), the question becomes whether the particular form of transactions undertaken was entered to achieve the relevant taxation purpose or effect.

316. When then it is observed (1) that the transactions had been partly effected (2) a problem emerged that required solution and (3) the solution chosen (which it was thought had very favourable taxation consequences) was chosen to avoid disturbance of the arrangements that had already been made and upon which the participants had relied in securing a favourable Private Letter Ruling from the IDR, the conclusion that Pt IVA is not engaged must follow.

317. Against that background I turn to consider the factors listed in s 177D(b) of the 1936 Act.

Manner - s 177D(b)(i)

318. The Commissioner submitted that the crucial aspect of the manner in which the scheme(s) were entered into were the changes from the planned structure of Project Gemini whereby SGTS issued A$ instead of US$ denominated preferred stock, AFC issued the AFC Preference shares instead of ordinary shares to CSA and CSA issued the CSA Preference Shares instead of ordinary shares to CSF.

319. The Commissioner submitted that the changes resulted in such disadvantageous financial and commercial outcomes for AFC, CSA and Noza that it would be concluded that the dominant purpose of the decision to proceed in this manner was the gaining of the s 25-90 deduction. The disadvantages identified by the Commissioner were:

1. the imposition of Australian interest withholding tax on dividends paid by CSA to CSF;
2. the loss of virtually all of the anticipated tax consolidation benefit which had been the business reason presented to the IDR to justify the issue of the Private Letter Ruling;
3. CSA and AFC lost the benefit of a permanent $1.9 billion contribution to their capital and instead assumed risks without commercial reward; and
4. the assumption of a risk that the IDR would regard the changes as amounting to a "pertinent change … in material facts" which would render the Private Letter Ruling non-binding on the IDR.

It is necessary to address each in turn.

Withholding Tax

320. As originally planned, the dividends received by AFC from SGTS would be exempt from tax under s 23AJ of the 1936 Act. These could then be passed tax-free to CSA via the intercorporate dividend rebate (former s 46 of the 1936 Act). Further, by maintaining a foreign dividend account pursuant to Subdiv B of Div 11A of the 1936 Act, CSA could pass the foreign dividends back to CSF as dividends paid on its ordinary shares exempt from Australian dividend withholding tax. That contention is not in dispute. Indeed, the Commissioner accepted that any dividend paid in the period from 1 July 2003 to 4 December 2003 would not be subject to interest withholding tax.

321. Notwithstanding that concession, the Commissioner contended that the manner in which the scheme was entered into exposed CSA to an Australian interest withholding tax liability on dividends paid on the CSA Preference Shares because:

1. the CSA Preference Shares were classified as a debt interest under Australian debt / equity rules: see the definition of "non-equity share" in s 6(1) of the 1936 Act;
2. the dividends paid on the CSA Preference Shares did not fall within the definition of "dividend" in the withholding tax provisions and were instead classified as "interest": see definition of "dividend" in s 128A(1) and the definition of "interest" in s 128A(1AB) of the 1936 Act; and
3. accordingly, the foreign dividend account exemption would no longer apply and interest withholding tax would apply at the 10% rate on the preferred dividends paid under the CSA Preference Shares.

322. The question of withholding tax cuts both ways. The protocol to the USA DTA (see [50] above) was signed on 27 September 2001 - before the scheme was entered into. It came into effect on 1 July 2003 - after the transactions the subject of the Pt IVA determination. The Protocol exempted any dividend paid on the CSA Preference Shares from Australian withholding tax for the period from 1 July 2003. That exemption was not removed until 5 December 2003 when amendments to the USA DTA came into effect - after the transactions the subject of the Pt IVA determination had been completed.

323. The expectation at the time the scheme was entered into was that no withholding tax would be payable after 1 July 2003. That expectation was recorded in the draft advice given on 8 November 2001 by Andersen Tax which stated that:

"Where dividends are treated as being paid on the AFC preference shares prior to the commencement of the new double tax treaty (expected to be 1 July 2003), interest withholding tax at the rate of 10% will be applicable.

However, for dividends on AFC preference shares paid after that date, it appears that the 'dividend withholding tax' rules will be applicable.

In this regards (sic), pursuant to the treaty it is proposed that no withholding tax would be applicable on dividends paid by an Australian company to a US company where the US company has a voting interest in the Australian company of at least 80% …"

Janetzki was cross examined about this advice. His evidence was that the advice was only based upon what "we had in front of us at that time".

324. At the time the scheme was entered into in 2001, there was no expectation that withholding tax would have been payable after 1 July 2003. Indeed, the Commissioner does not dispute that when CSA paid its dividend in 2003, no withholding tax was payable. Also, at the time the scheme was entered into in 2001, no amendments to the USA DTA that would have had the effect of excluding dividends payable on the CSA Preference Shares from the benefits of the Protocol had been announced by the Australian government.

325. I do not consider that withholding tax was a commercial disadvantage which resulted from the change in structure.

Loss of Anticipated Consolidation Benefit

326. The original plan in early 2001 was for the SGTS Preferred Stock to be a "reset cost base asset" (rather than a retained cost base asset) for tax consolidation purposes so that the value of the asset could be allocated to the intellectual property: see [26] above.

327. The Commissioner submitted that by changing the denomination of the SGTS Preferred Stock to A$ in November 2001, the character of AFC's Preferred Stock investment was changed to a "retained cost base asset" for tax consolidation purposes (s 705-25(5) of the 1997 Act) with the consequence that the ITW Group lost virtually all of the anticipated consolidation benefit because the value of the SGTS Preferred Stock could no longer be allocated to the intellectual property. As a result, the Commissioner submitted the main rationale for the transaction as put forward to the IDR was lost: see [23] above. In support of this contention, the Commissioner pointed out that there was no contemporaneous evidence that the directors of the Australian entities met to discuss the impact on the anticipated tax consolidation benefit brought about by the changes to the denomination of the SGTS Preferred Stock.

328. The applicants rejected the Commissioner's contentions legally and factually. The applicants submitted that the consolidation objective of preserving cost base was not lost.

329. First, the history. The New Business Tax System (Consolidation) Bill 2000 Exposure Draft (the Exposure Draft ) included Subdivision 168-F - "Consequences for asset treatment if entities become members of a consolidated group: group formation case". Section 168-400 (which was page 40 of the Exposure Draft) provided the following Guide to the subdivision:

"When a consolidated group comes into existence, the *head entity of the group is to be treated as if it purchased the CGT assets of each subsidiary member for a payment that reflects the cost to the group of acquiring those assets. To achieve this, the rules in Subdivision 168-E (which deal with an entity joining an existing consolidated group) are applied subject to modifications."

330. The proposed Subdivision 168-E included proposed rules for the setting of cost bases for a consolidated group when a company joined a consolidated group. Pursuant to s 168-225 of the proposed Subdivision 168-E, the head entity of a consolidated group was deemed to purchase each of the CGT assets of an entity joining the group in consideration for a payment generally determined as follows:

1. the joining entity's cost base of the asset, if the asset was a 'retained cost base asset': s 168-230 of the Exposure Draft; or
2. an amount calculated under a four step method, if the asset was a 'reset cost base asset': s 168-235 of the Exposure Draft.

331. A reset cost base asset was defined as any CGT asset that was not a retained cost base asset: s 168-235(2) of the Exposure Draft. The proposed definition of a "retained cost base asset" as contained in s 168-230(3) of the Exposure Draft was:

"A retained cost base asset is:

(a) Australian currency, other than *trading stock or *collectables of the joining entity; or

(b) a right to receive a specified amount of such Australian currency, other than a right that is a marketable security within the meaning of section 70B of the Income Tax Assessment Act 1936.
Example: A debt or a bank deposit."

The definition of retained cost base asset changed slightly when the provision was ultimately enacted in 2002 (as s 705-25(5) of the 1997 Act): see [337] below.

332. The applicants submitted that having regard to the content of the proposed definition of retained cost base asset, the SGTS Preferred Stock could not reasonably be thought to be a debt or a right to receive Australian currency. They pointed to the evidence of Mr Balotti who said that the amount payable on the redemption of the preferred stock was not regarded by Delaware law as an obligation of SGTS and therefore it was quite understandable that no-one sought to question the availability of the consolidation objective of preserving cost base in early November 2001.

333. Indeed, the applicants submitted that the absence of concern about the loss of the anticipated consolidation benefit was, in retrospect, well founded because the objective was not lost as the SGTS Preferred Stock subscribed by AFC were not "a right to receive a specified amount of such Australian currency" for the purposes of the definition of 'retained cost base asset' in s 705-25(5) of the 1997 Act. In particular, the applicants submitted that being shares, the SGTS Preferred Stock represented "an interest consisting of a congeries of rights in personam" (Archibald Howie at 154 per Dixon J) and were therefore a reset cost base asset.

334. Finally, the applicants submitted that there was no contemporaneous evidence to suggest that any witness thought that the consolidation objective had been lost by entering into the scheme. Sutherland was cross examined about this issue. His evidence was as follows:

"[MR MOSHINSKY]: … It seemed to be a fairly significant issue earlier on. Can you explain why you didn't receive advice on whether the changes to the structure impacted on this issue?

[MR SUTHERLAND]: Yes. It was a critical issue. That's why we did the plan the way we did. And no one expected, nor does anybody believe, that it truly changes the outcome. All we did was move an instrument, an SGTS preferred, from US dollar to A dollar. No one viewed that that was a change to the way the consolidation rules would work.

[MR MOSHINSKY]: Was it something that you specifically were advised on at the time, or is it something that [just] wasn't looked at at the time?

[MR SUTHERLAND]: I'm not sure it was either one, that it wasn't looked at or that I wasn't advised. The expectation is that it was looked at and we agreed that it was a reset - it still was a reset cost base asset at the time."

335. Before turning to consider the definition of a retained cost base asset in s 705-25(5) of the 1997 Act and whether the SGTS Preferred Stock satisfied that definition, two matters should be noted. First, I reject the proposition that the terms of the SGTS Preferred Stock are to be interpreted in accordance with Delaware law. Delaware law is the governing law for determining the rights between SGTS and AFC: cf [225] to [229] above. However, Delaware law is not the law for determining whether it was a retained cost base asset under the 1997 Act for the purposes of determining the tax consequences of Noza, the head entity of the MEC.

336. Secondly, it was common ground that there was an absence of concern about the loss of the anticipated consolidation benefit in November 2001.

337. What then was the status of the SGTS Preferred Stock under the consolidation regime of the 1997 Act? At the relevant time, s 705-25 of the 1997 Act provided:

"(1) This section states what the *tax cost setting amount is for a *retained cost base asset.

Australian currency

(2) If the *retained cost base asset is covered by paragraph (a) or (b) of the definition of that expression and is not covered by another subsection of this section, its *tax cost setting amount is equal to the amount of the Australian currency concerned.

Qualifying securities

(3) If the *retained cost base asset is a qualifying security (within the meaning of Division 16E of Part III of the [1936 Act]), the *tax cost setting amount for the qualifying security is instead equal to the joining entity's *terminating value for the asset.
…

Retained cost base asset

(5) A retained cost base asset is:

(a) Australian currency, other than *trading stock or *collectables of the joining entity; or

(b) a right to receive a specified amount of such Australian currency, other than a right that is a marketable security within the meaning of section 70B of the [1936 Act]; or
Example: A debt or a bank deposit.

(c) a right to have something done under an *arrangement under which:

(i) expenditure has been incurred in return for the doing of the thing; and

(ii) the thing is required or permitted to be done, or to cease being done, after the expenditure is incurred."

(Emphasis added.)

338. It is common ground that the SGTS Preferred Stock is not covered by paragraph (a) of the definition in s 705-25(5). What about paragraph (b) of the definition? Did the SGTS Preferred Stock grant AFC "a right to receive a specified amount of … Australian currency" which was not a "marketable security within the meaning of s 70B of the [1936 Act]"? "Marketable security" was defined in s 70B(7) of the 1936 Act to mean a traditional security covered by paragraph (a) of the definition of security in s 159GP(1) of the 1936 Act. Section 159GP(1)(a) of the 1936 Act defined security as "stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security". Interestingly, subparagraph (d) of the definition of security in s 159GP(1) ("any other contract, whether or not in writing, under which a person is liable to pay an amount or amounts, whether or not the liability is secured") was not included in the definition of "marketable security".

339. I accept the Commissioner's contention that the SGTS Preferred Stock fell within the plain words of s 705-25(5) of the 1997 Act. In its terms it granted AFC "a right to receive a specified amount of … Australian currency". It is true (as the applicants contended) it also provided other benefits, however that was not the test prescribed by statute. That construction is supported by the exclusion in s 705-25(5)(b). All marketable securities fall within the definition, except those that are "(a) stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security". Importantly, subparagraph (d) of the definition of security in s 159GP(1) ("any other contract, whether or not in writing, under which a person is liable to pay an amount or amounts, whether or not the liability is secured") was not excluded. In other words, a marketable security that satisfied subparagraph (d) of the definition of security in s 159GP(1) of the 1936 Act fell within paragraph (b) of the definition of retained cost base asset in s 705-25(5) of the 1997 Act. In my view, the SGTS Preferred Stock was a "contract, … in writing, under which [SGTS was] liable to pay an amount or amounts" to AFC.

340. For those reasons, I accept that despite the extensive consideration of the potential for resetting the cost base benefit of the proposed Gemini Project transactions prior to 2 November 2001, the applicants did not turn their minds to this issue in the period between 2 and 15 November 2001. However, for the reasons above and for the reasons that follow, I do not accept the Commissioner's contention that this fact "suggests that the tax benefit was the main driver" for the changes identified in the scheme.

Detriment to Australian Entities

341. The third factor relied upon by the Commissioner was that there was no evidence in the manner that the scheme was entered into that any consideration was given to the disadvantages and financial risks to the Australian entities resulting from the change to the scheme. In particular, the Commissioner submitted that contrary to the original plan, CSA (and then AFC) was no longer to be provided with a $1,927,700,000 contribution to their permanent share capital but rather what was in substance 100% debt funding via a subscription to preference shares which were redeemable in five years with yearly obligations to fixed preferred dividends.

342. In addition to the loss of permanent share capital and its replacement with temporary debt funding, the Commissioner also submitted that the change had two further adverse consequences for the Australian entities:

1. the Australian entities were dependant on SGTS paying dividends under the SGTS Preferred Stock in order to be able to finance their own dividend obligations from profits as required by s 254T of the Corporations Act. The ability of SGTS to pay a dividend depended on it having sufficient accumulated earnings under Delaware law which was uncertain as it depended on the level of net royalties received by SGTS as compared to its interest expenses and other outgoings, costs and losses; and
2. the Australian entities assumed an obligation to repay $1,927,700,000 within five years. Because of the requirements of s 254K of the Corporations Act the preference shares could only be redeemed from profits or the proceeds of a new issue of shares made for the purpose of the redemption.

343. In the context of the factors just identified, the Commissioner raised two further issues. First, that the funding for a five-year term would require refinancing if it was proposed to retain the 15 year rights to the income streams in SGTS (see [129] and [130] above) which would not have been a relevant factor or consideration if capital funding been provided to CSA. Secondly, the manner in which the scheme was entered into failed to reward the Australian entities for their role in facilitating the transfer of the royalty income streams (that is, assumption of risk without commercial reward). I will deal with each in turn.

344. The applicants rejected these factors, but not on the basis that they were an inappropriate description of what occurred. Instead, the thrust of the applicants' submission was that it was more appropriate to analyse the application of the eight factors in s 177D(b) on the basis of the purposes of the ITW Group, rather than individual group entities. The applicants referred, by example, to the decision of the Full Court of the Federal Court in
Commissioner of Taxation v News Australia Holdings Pty Limited 2010 ATC ¶20-191; [2010] FCAFC 78 at [19]-[20]. I do not accept the applicants' submission. News Australia is not authority for the proposition you should consider the purposes of the group rather than the purposes of the individual group entities. And nor could it be. It is the legislation and, in particular, s 177D(b), which prescribes the factors to be considered.

345. One of the factors, s 177D(b)(vi), requires the Court to consider "any change in the financial position of any person who has, or has had, any connection … with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme". As will become apparent (see [370] and [371] below), the application of s 177D(b) resulted in the identification of a number of changes to many companies within the ITW Group that had resulted or were expected to result from the scheme.

346. At one level, the changes in the financial position of other ITW Group companies could be seen to 'net out' the position of CSA. On the other hand, following execution of the transactions AFC owned all of the common stock of SGTS and US$1 billion of preferred stock with rights to 6% dividends for the five year term of the stock. Although the rights to 6% dividends were offset by its own obligations to pay 6% dividends, a commercial benefit of the transaction to AFC arose from its ownership of the common stock of SGTS. SGTS owned royalty rights valued at $4 billion. The value of those rights was tied to the revenues of a company with revenues of US$9 billion per annum. Income derived by SGTS in excess of its liabilities would increase the value of the common stock owned by AFC. As can be seen, the changes are complex and interwoven. No general statements should be or can be made.

347. Finally, the Commissioner points to absence of any evidence of negotiation between the Australian entities and ITW Inc regarding the potential commercial benefits such as a transaction fee or margins on the returns on the investment, the amount paid for either of the royalty income streams or the method of financing. So much may be accepted, but again I do not consider it significant to the extent suggested by the Commissioner that it "suggests that the tax benefit was the main driver" for the changes identified in the scheme.

Risk to the Private Letter Ruling

348. As was clear from the outset (see [37] and [38] above), the transfer of the rights to the income streams from CSC in Illinois to CSF potentially exposed CSC to a tax liability of approximately $US300 million in Illinois. It was for that reason that ITW Inc made a private letter ruling request to the IDR seeking confirmation, inter alia, that any "capital" gain on the transfer of the royalty income streams from CSC to CSF would be treated as tax free in Illinois: see [37] above.

349. To obtain the Private Letter Ruling, ITW Inc needed to identify a commercial or non-tax basis for the transfer of the royalty income streams out of Illinois. The commercial or non-tax basis put forward to the IDR was an Australian business purpose, namely, the consolidation consequences in Australia: see [39(1)] above.

350. The Private Letter Ruling was issued on 15 September 2001: see [44ff] above. It can only be relied upon to the extent that there is no "pertinent change in … material facts": see [45] above. If there was a pertinent change in material facts, then the IDR could treat the Private Letter Ruling as non-binding and impose a very substantial tax liability on the ITW Group.

351. The Commissioner submitted that following the change in the structure (which the Commissioner submitted led to a substantial decrease in the anticipated Australian tax consolidation benefit), ITW Inc did not advise the IDR that the basis it had put forward for the transaction and the Private Letter Ruling was arguably no longer correct. In support of that contention, the Commissioner referred to the evidence of Mr Marcus (a principal of an Illinois law firm and Chairman of that firm's state and local tax practice group), which was in large part received by the Court as a submission: see
Noza Holdings Pty Ltd v Federal Commissioner of Taxation [2010] FCA 996. Mr Marcus submitted that the change from CSA and AFC issuing ordinary shares to issuing preference shares would amount to a "pertinent change in … material facts" if the change resulted in CSA and AFC failing to be classified as disregarded entities for US federal income tax purposes, with the consequence that CSF could no longer be classified as a 80/20 company for Illinois income tax purposes. The applicants did not lead any evidence on this question. The applicants' evidence was that Sutherland "was not prepared to take the risk of departing from the [Private Letter Ruling]".

352. I reject the Commissioner's submission. Taking the Commissioner's own submissions at their highest, the commercial or non-tax basis for the transfer of the royalty income streams out of Illinois did not disappear and was not lost; it was at best a "substantial decrease". Further, as stated above, when the scheme was undertaken (1) the transactions had been partly effected giving rise to a capital gain of approximately $300 million (2) a problem emerged that required solution and (3) the solution chosen (which it was thought had very favourable taxation consequences) was chosen to avoid disturbance of the arrangements that had already been made and upon which the participants had relied in securing a favourable Private Letter Ruling from the IDR. Put another way, the applicants not only turned their mind to the Private Letter Ruling, but structured the scheme so as to comply with the terms of the Private Letter Ruling.

Conclusion - manner

353. During the course of 2001, ITW Inc undertook extensive planning to prepare and complete the transactions which formed Project Gemini in order to achieve a higher level of legal protection for its customer-based intangibles and substantial US state tax savings. As executed, each of these commercial objectives was still achieved.

354. From the outset, the transactions were carefully planned to be tax neutral in Australia (but for the protection against a future consolidation measure that never eventuated) and would have remained so but for the foreign exchange accounting issue identified by Kropp. There is nothing contrived or artificial about the changes made to Project Gemini to resolve the foreign exchange accounting problem. The ITW Group chose a natural and logical solution: it matched the terms of issue of the SGTS Series B preferred stock with the preference shares issued by AFC and CSA. There is nothing about this matching which supports the conclusion that the ruling, prevailing, or most influential purpose of any of the persons who entered into or carried out such schemes was to obtain the alleged tax benefit. As a step, the matching of preferred stock to the preference shares was not an artificial or distorted means of resolving the foreign exchange accounting issue. The solution was in fact proposed by Murtaugh following advice from Kropp that it would resolve the foreign exchange accounting issue: see [80] above. Neither Kropp nor Murtaugh are experts in Australian tax and they did not, nor could they objectively be expected to understand s 25-90.

355. Nor is there anything artificial or contrived about the terms of the Series A and B Preferred Stock issued by SGTS and the Preference Shares issued by CSA. The evidence is that prior to Sutherland's trip to Australia the terms of issue of the SGTS Preferred Stock remained uncertain. On the one hand, ITW Inc's Australian advisers wanted to introduce terms that would make a future application of s 23AJ, even an amended s 23AJ, more certain. However, these changes resulted in the stock looking more like equity and not debt for US state tax purposes. The compromise solution was to provide an "unwind strategy". This involved the issue of two classes of preferred stock. The Series B would be drafted to be debt for US purposes. In the event of s 23AJ being amended, the Series B would be converted to Series A to be equity under Australia's debt / equity rules. The solution was devised in consultation with ITW Inc's US advisors. That solution was not driven to obtain deductions under s 25-90. It was not until the foreign exchange accounting problem was solved that Diskin advised Sutherland of the peculiar provisions of s 25-90 and the peculiar application of the thin capitalisation rules, the combination of which was required to give rise to an allowable deduction: see [115] above.

356. Although I have concluded that the applicants did not turn their mind to the potential resetting of the cost base between 2 and 15 November 2001 and there did not appear to be negotiation between the Australian entities and ITW Inc regarding the potential commercial benefits, the manner in which the scheme was entered into does not support the contention that the dominant purpose of any part of the Commissioner's scheme was to obtain a tax benefit.

Form and Substance - s 177D(b)(ii)

357. As to form and substance, the Commissioner alleged that the schemes "carefully exploited [the] distinction between legal form and economic substance so as to create a deduction". I reject that contention.

358. The 1997 Act (as it applied in 2001) drew a distinction between debt and equity. Following the introduction of Div 974, the form of a capital instrument could not be used to defeat its substance. So, for example, it required instruments to be characterised by reference to general law for some purposes and by reference to Div 974 of the 1997 Act for other purposes. Moreover, Parliament expressly recognised the way the 1997 Act addressed those distinctions in s 25-90, which drew upon both Div 974 of the 1997 Act and the general law characterisation of dividends in s 23AJ of the 1936 Act.

359. In the present case, the form of the issue of the preference shares involved a share issue. But in substance, by their terms, the shares gave rise to schemes which created debt interests. Division 974 recognised this and s 25-90 provided a deduction for the cost of servicing this debt in the unusual situation where non-assessable income was derived.

360. When the form and substance of the schemes identified by the Commissioner are considered, there is no divergence between the form and substance of those schemes that would give rise to an inference that the transactions undertaken were objectively motivated by taxation reasons. The substance of the change in the structure in each case was to avoid a significant foreign exchange accounting problem arising for ITW Inc and to secure the US state tax savings.

Time scheme entered into and length of period - s 177D(b)(iii)

361. The Commissioner submitted that there were "no relevant matters" in relation to this factor. I reject that submission. Timing is not determinative, but it is significant. As the chronology of events demonstrates (see Section B of these reasons for decision), at the time the alleged schemes were entered into (October and November 2001), the dominant purpose was unrelated to the obtaining of an Australian tax benefit. The timing was the result of other important events:

1. transactions that had been partly effected giving rise to a potential capital gain of approximately $300 million: see [56] above;
2. a foreign exchange accounting problem that had emerged and required solution: see [65] to [67] above; and
3. the choice of a solution (which it was thought had very favourable taxation consequences) to avoid disturbance of the arrangements that had already been made and upon which the participants had relied in securing a favourable Private Letter Ruling from the IDR.

362. Timing favours the applicants.

Result of scheme but for the Act - s 177D(b)(iv)

363. The applicants accepted (as they had to) that the tax effect but for the scheme was the deduction claimed (allowable as a deduction when the dividends were paid or declared and paid by Noza in 2003 or when the dividends accrued by AFC in 2002, and by Noza in 2004 and 2005) arising from the application of s 25-90 to the dividends paid.

364. However, in considering this factor, the applicants submitted (and I accept) that one should recall what the High Court said in Hart at [53]:

"The bare fact that a taxpayer pays less tax, if one form of transaction rather than another is made, does not demonstrate that Part IVA applies. Simply to show that a taxpayer has obtained a tax benefit does not show that Part IVA applies."

Change in the financial position of the taxpayer from the scheme - s 177D(b)(v)

365. Noza and AFC need to be considered separately.

366. As to the financial position of Noza (as head entity of the MEC group), the changes made to Project Gemini did not affect it. It received the royalties as head entity that it expected to receive. It paid dividends it expected to pay. And as the owner of the ordinary stock in SGTS, the value of the stock grew with the growth in value of the royalty streams.

367. As for AFC in the 2002 year, there was a change in its financial position because it had the benefit of the tax deduction under s 25-90.

368. Contrary to the submissions of the Commissioner, I do not accept that the change in the financial position of the taxpayer (Noza or AFC) from the scheme included the imposition of withholding tax (see [320] to [323] above) or the adoption of significant risk by the Australian entities for no reward (see [341] to [347] above). The Commissioner also identified the following changes in the financial position of the Noza and AFC:

1. the loss of the potential resetting of the cost base;
2. the making of an unsecured investment in the Preferred Stock of SGTS;
3. the incurring of obligations to pay dividends and redeem the Preference Shares; and
4. the exposure to default interest rates.

Whilst I accept that these financial changes occurred, I do not accept that they are determinative or provide support for the contention that the dominant purpose of the scheme was obtaining the tax benefit.

369. Project Gemini, whilst principally concerned with US state tax planning, brought an advantage to the Australian ITW Inc group. The royalties received by SGTS of over US$2.1 billion benefitted the Australian group in that SGTS could then pay a dividend to AFC on either the preferred or ordinary shares it held (bearing in mind that AFC was the sole shareholder of SGTS).

Change in the financial position of a person other than the taxpayer from the scheme - s 177D(b)(vi)

370. As to the financial position of connected parties, the changes made to Project Gemini were important. Those changes preserved the commercial objectives sought by those parties - including the increased legal protection given to ITW Inc and Miller's customer-based intangibles. But for those changes, the objectives may not have been achieved.

371. The primary object of Project Gemini was to change the financial position of other parties, namely members of the US ITW group. That position was to be changed by savings in US state taxes, which were expected to be in excess of US$243 million at the time Project Gemini was executed: see [19] above.

Consequences for the taxpayer or any other person from the scheme - s 177D(b)(vii)

372. The Commissioner submitted that there were no other consequences. I reject that submission. From the outset, Project Gemini had commercial objectives which included the increased legal protection given to ITW Inc and Miller's customer-based intangibles. Those objectives were secured.

373. In addition, the changes to Project Gemini were effected to ensure that ITW Inc avoided reporting any (potentially substantial) foreign exchange fluctuations in its quarterly reporting. That was achieved.

Nature of any connection between the taxpayer and person referred to in (vi) - s 177D(b)(viii)

374. It is common ground that all of the parties are wholly owned subsidiaries of ITW Inc.

Conclusion

375. For those reasons, I do not consider that the dominant purpose of either of the schemes identified by the Commissioner (encompassing changes to Project Gemini) was to obtain the tax deduction. Instead, the dominant purpose was to resolve the foreign exchange accounting issue in a manner consistent with the Private Letter Ruling issued by the IDR.

376. Further, for the reasons expressed at [303] to [313] above, I do not accept the Commissioner's counterfactuals. Each was not an alternative means of achieving the commercial objectives of Project Gemini.

(4) Penalties

377. The Commissioner, by notice of assessment of penalty, imposed a penalty on Noza in respect of a purported tax shortfall in the 2003 to 2005 income years at the rate of 25%, determined on the basis that Pt IVA applied to disallow the deduction claimed by Noza in each year and that there was a reasonably arguable position that Pt IVA did not apply.

378. As I have concluded that part of the deduction is allowable and that Pt IVA does not apply to disallow the deduction claimed by Noza, it is necessary to consider the question of penalties only in relation to that part of the deduction not allowed. For the sake of completeness, I also make a number of findings relevant to the question of penalties in the context of the application of Pt IVA.

(a) Part of deduction not allowed

379. In relation to that part of the deduction not allowable as a deduction pursuant to s 25-90 (see [233] to [256] above), the applicants submitted that it was reasonably arguable that the amount was allowable pursuant to s 25-90 and therefore any penalty arising from the application of s 284-145 of Sch 1 to the TAA should be reduced to nil.

380. In my view, that contention must be rejected. In the 2003 year, s 284-145 imposed liability for administrative penalties, inter alia, if you attempted to reduce your tax liabilities through a scheme and it was reasonable to conclude that the entities entered into or carried out the scheme for the dominant purpose of getting a scheme benefit from the scheme. That did not occur here. As the Full Court said in
Federal Commissioner of Taxation v Star City Pty Ltd (No 2) 2009 ATC ¶20-129; (2009) 180 FCR 448 at [25], s 284-145 "does not address the situation in which a taxpayer has sought to obtain a benefit or tax advantage by claiming in a taxation statement … a deduction for a loss or outgoing … being a deduction to which, on the proper application of the legislation, the taxpayer was not entitled".

(b) Penalties and Pt IVA

381. As just noted, as part of the deduction was allowable pursuant to s 25-90 but not disallowed by operation of Pt IVA, I make the following findings for completeness. The issue before the Court was whether Noza had voluntarily told the Commissioner about the shortfall before the Commissioner told Noza that a tax audit would be conducted of its financial affairs for the period to which the shortfall relates.

382. If Noza had told the Commissioner about the shortfall before the tax audit commenced, any base penalty amount imposed on Noza would be reduced by 80% pursuant to s 284-225(2) of Sch 1 to the TAA. If Noza voluntarily told the Commissioner about the shortfall after the tax audit commenced and telling the Commissioner about the shortfall can reasonably be estimated to have saved the Commissioner a significant amount of time and resources, then any base penalty imposed on Noza would be reduced by 20% pursuant to s 284-225(1) of Sch 1 to the TAA. I will deal with each in turn.

383. In the 2003 year, s 284-225 of Sch 1 to the TAA provided:

"(1) The *base penalty amount for your *shortfall amount or *scheme shortfall amount, or for part of it, for an accounting period is reduced by 20% if:

(a) the Commissioner tells you that a *tax audit is to be conducted of your financial affairs for that period or a period that includes that period; and

(b) after that time, you voluntarily tell the Commissioner, in the approved form, about the shortfall amount or the part of it; and

(c) telling the Commissioner can reasonably be estimated to have saved the Commissioner a significant amount of time or significant resources in the audit.

(2) The *base penalty amount for your *shortfall amount or *scheme shortfall amount, or for part of it, for an accounting period is reduced under subsection (3) or (4) if you voluntarily tell the Commissioner, in the *approved form, about the shortfall amount or the part of it before the earlier of:

(a) the day the Commissioner tells you that a *tax audit is to be conducted of your financial affairs for that period or a period that includes that period; or

(b) if the Commissioner makes a public statement requesting entities to make a voluntary disclosure by a particular day about a *scheme or transaction that applies to your financial affairs - that day.
…"

"Tax audit" was a defined term. It meant "an examination by the Commissioner of an entity's financial affairs for the purposes of a taxation law": s 995-1 of the 1997 Act.

384. The applicants identified the following documents as having been provided to the Commissioner before the beginning of the tax audit and disclosing the "shortfall amount":

1. a letter dated 6 October 2004 from ITW Australia Pty Ltd, on behalf of Noza, to the Commissioner in response to a question from the Commissioner in a risk review in relation to the 2002 year of income. Noza provided the Commissioner with a detailed description of the relevant steps in Project Gemini. The description included identification of the quantum of the debt interest of $1,927,700,000 held by CSF in CSA and an explanation that the dividend payments on the redeemable preference shares issued by CSA would be treated as a debt deduction pursuant to s 25-90. The letter also identified the repayments due to be paid on the redeemable preference shares;
2. a letter dated 18 February 2005 from Noza, CSA and CSF to the Commissioner in which they sought a private ruling. The request set out the relevant transactions in Project Gemini and identified A$175,467,662 had been treated as interest for income tax purposes.

No other documents were identified by the applicants.

385. When did the audit start? In a letter dated 21 February 2005, from the Commissioner to ITW Inc it stated:

"in accordance with previous discussions on 7 September 2004, we intend to commence an audit of the issues identified during the course of client risk reviews completed for the years ended 30 November 2001 to 30 November 2003 inclusive."

(Emphasis added.)

386. After closing submissions, the Commissioner communicated to the Court that after a review of the documentation, he no longer contended that the tax audit commenced before the letters of 6 October 2004 and 18 February 2005. Accordingly, the Commissioner accepted that he did not commence an audit of the 2003 year until after 21 February 2005.

387. The issue which remains is whether the applicant disclosed the shortfall amount before commencement of the audit. I accept that a private ruling request can provide the disclosure: see s 284-225 and the Explanatory Memorandum to the A New Tax System (Tax Administration) Bill (No. 2) 2000, para 1.138. In relation to the 6 October 2004 letter, it did not disclose the shortfall amount. So much was conceded by Senior Counsel for the applicants when he described the disclosure as "indirect".

388. That leaves the 18 February 2005 letter. That letter dealt with withholding tax. It did not disclose a shortfall amount for the 2003 year or the deduction that would be claimed in the 2003 year.

389. For these reasons, I do not accept that either read separately or jointly, the 6 October 2004 letter and the 18 February 2005 letter constitute a disclosure of the shortfall amount prior to the commencement of the audit. Accordingly, I do not accept that the 25% penalty should be reduced by 80% of the amount assessed under s 284-225(2) of Sch 1 to the TAA.

390. Finally, there is the question of s 284-225(1) of Sch 1 to the TAA. The applicants did not contend that they had satisfied s 284-225(1) and, no less importantly, led no evidence in relation to s 284-225(1)(c). I am not satisfied that s 284-225(1) is satisfied.

(5) Withholding tax and Pt IVA - CSF

391. A further issue in the proceedings is whether Pt IVA authorised the Commissioner to determine that the dividend paid in 2003 by CSA to CSF in the sum of $222,655,981 was subject to dividend withholding tax under s 128B of the 1936 Act.

(a) Facts

392. The relevant facts have previously been described. For the purposes of this aspect of the appeals, the following events on 15 November 2001 are important:

1. 941 fully paid redeemable preference shares were issued by CSA for A$2,048,565.36 per share to CSF in exchange for a US$1 billion demand note: see [126] above;
2. 941 fully paid redeemable preference shares were issued by AFC for A$2,048,565.36 per share to CSA in exchange for the US$1 billion demand note: see [127] above;
3. AFC endorsed the US$1 billion demand note in favour of CSF and also issued a US$3 billion promissory note in favour of CSF, both in consideration for the purchase of certain royalty streams from CSF: see [128] above;
4. AFC transferred the royalty streams to SGTS in consideration for the issue by SGTS to it of nine shares of Series A preferred stock and 932 Series B preferred stock and the assumption by SGTS of AFC's obligations pursuant to the US$3 billion promissory note in favour of CSF: see [129] above.

393. The terms of the redeemable preference shares issued by AFC and CSA included the following:

1. that each shareholder would be entitled to receive a cumulative preferential dividend out of the profits of the issuer at the rate of 6% of the paid up capital of each share annually on 15 November (the 6% dividend ): see [126], [127] and [247] above;
2. that failing payment, the unpaid amount of the dividend would be carried forward to the following year and a default dividend calculated at the rate of 4.5757% per annum of the unpaid amount would become payable to the shareholder: see [126], [127] and [247] above;
3. within 45 days of the fifth anniversary of the issue date, the redeemable preference shares were required to be redeemed for A$1,927,700 per share: see [126], [127] and [247] above.

394. The terms of the Series B SGTS preferred stock instruments provided that dividends were payable out of funds legally available representing the accumulated earnings of the company: Art 3 (see [130(2)] above). The terms of the CSA Preference Shares provided that dividends were payable out of the profits of the company: Art 3.1 (see [126] above).

395. Following completion of the Project Gemini transactions, SGTS, as assignee of the royalty streams, earned substantial royalty income from ITW Inc and Miller calculated as a percentage of the sales of those companies:

Year ended 31 December Royalty income

2001 US$190,464,104

2002 US$457,792,740

2003 US$500,586,614

396. On 14 November 2003:

1. SGTS paid a dividend in the sum of A$222,655,981, comprised of:

A$108,837,942 Dividend payable but unpaid on 15.11.02.

A$4,980,097 Interest payable in respect of the unpaid 2002 accrued dividend.

A$108,837,942 Dividend payable on 15.11.03.

2. SGTS and AFC entered into the Dividend Distribution Agreement pursuant to which SGTS issued a promissory note to AFC in the sum of A$222,655,981;

3. AFC and CSA each paid a dividend in the sum of A$222,655,981, respectively to CSA and to CSF comprised of:

A$108,837,942	Dividend payable but unpaid on 15.11.02.
A$4,980,097	Default dividend payable in respect of the unpaid 2002 accrued dividend liability.
A$108,837,942	Dividend payable on 15.11.03.

Payment in each case was effected by the endorsement of the SGTS Promissory Note.

397. On 24 November 2003, the SGTS promissory note was settled in full (along with A$77,311 of accrued interest) via an intercompany wire transfer of cash from SGTS to CSF: see [149] above.

398. On 13 May 2004, the board of directors of SGTS met and resolved that the declaration and payment of the dividend by SGTS on 14 November 2003, along with other miscellaneous actions, was ratified and made the acts and deeds of SGTS.

399. CSA was an Australian company and CSF was a US company.

(b) Withholding tax provisions

400. At all relevant times, the liability of a non-resident to pay withholding tax was determined by Div 11A of Pt III of the 1936 Act and specifically s 128B.

401. On 1 July 2001, amendments to the withholding tax provisions were made following the introduction of the debt / equity rules: New Business Tax System (Debt and Equity) Act 2001 (Cth). As a result of these amendments, amounts payable on the CSA Preference Shares would have been classified as interest instead of dividends and would have been subject to interest withholding tax under the 1936 Act instead of dividend withholding tax. Consequently, pursuant to Div 11A, had the amount been paid by CSA to CSF before 1 July 2003 it would have been subjected to interest withholding tax at a 10% rate. At that time, the US DTA did not affect the liability.

402. From 1 July 2003, the Protocol amending the US DTA came into effect, which had the effect, inter alia, of inserting a new Article 10 in the DTA: see [50] and [134] above. The Protocol was signed on 27 September 2001. However, it did not come into effect as a part of Australian law until 1 July 2003, after the passage of the International Tax Agreements Amendment Act (No 1) 2002 (Cth).

403. The effect of the amendment was to ensure that no tax, including withholding tax, would be payable in Australia on dividends paid to a company resident in the US, where that company beneficially owned 80% or more of the voting power in the Australian company which paid the dividend, and the other requirements of Art 16(2) or (5) were satisfied.

404. Pursuant to the US DTA (as amended by the Protocol), a payment from CSA to CSF would be characterised as a "dividend" because it would be "income from shares" within the meaning of Art 10(6) of the US DTA. That characterisation would override the characterisation in the 1936 Act. Article 10(3) provided that the withholding tax was reduced to nil if Art 10(3) applied. Article 10(3) of the US DTA applied if the person who was beneficially entitled to the dividends was a company that was a resident of the other Contracting State (namely, the US) that had owned 80% of or more of the voting power of the company paying the dividends for a 12-month period ending on the date the dividend is declared. This requirement was satisfied in this case. Accordingly, after 1 July 2003 a payment of the amount by CSA to CSF would be exempt from withholding tax. Indeed, the Commissioner accepted that but for the application of Pt IVA, no withholding tax was payable at the time that CSA purported to pay the dividend to CSF on 14 November 2003.

405. As noted at [134] above, on 11 September 2003, the International Tax Agreements Amendment Bill 2003 (Cth) was introduced. Section 3(2A) provided:

"After the commencement of this subsection, a reference in an agreement to income from shares, or to income from other rights participating in profits, does not include a reference to a return on a debt interest (as defined in Subdivision 974-B of the [1997 Act])."

406. That had the effect that, as from 5 December 2003, a dividend paid by CSA to CSF would be subject to the interest article in the US DTA, namely Art 11, rather than the dividend article, Art 10.

407. When s 3(2A) is read together with Art 11(2), which provided that "[s]uch interest may be taxed in the Contracting State in which it has its source, and according to the law of that State, but the tax so charged shall not exceed 10 percent of the gross amount of the interest", CSF would have become liable for withholding tax at a rate of 10% from 5 December 2003. There is no equivalent to Art 10(3) in Art 11.

408. Accordingly, as at 14 November 2003, when the dividend payment was purportedly made by CSA to CSF, s 3(2A) of the International Tax Agreements Act was not yet in force and Art 10(3) the US DTA had the effect of relieving CSF from any liability for withholding tax.

409. It is not in dispute that at the time of the payment of the dividend by CSA to CSF on 14 November 2003:

1. section 3(2A) of the International Tax Agreements Act did not yet apply; and
2. Art 10(3) instead applied, and its requirements being otherwise satisfied, the dividend was not subject to tax, or to withholding tax.

(c) Pt IVA of the 1936 Act

410. As noted earlier, the Commissioner submitted that Pt IVA applied to authorise him to determine that the dividend paid in 2003 by CSA to CSF in the sum of $222,655,981 was subject to dividend withholding tax under s 128B of the 1936 Act.

(i) Scheme

411. The scheme for the purposes of s 177A(1) of the 1936 Act was described by the Commissioner as the respective decisions to pay and the actual payment of the following amounts on 14 November 2003:

1. the purported dividend paid by SGTS to AFC;
2. the purported dividend paid by AFC to CSA; and
3. the purported dividend paid by CSA to CSF.

412. CSF did not dispute that the scheme identified by the Commissioner was capable of being a scheme for the purposes of s 177A(1) of the 1936 Act.

(ii) Tax benefit

413. Section 177F(2A) provides that where a tax benefit in the form of the avoidance of withholding tax has been obtained, or would but for that section be obtained, by a taxpayer in connection with a scheme, the Commissioner may determine that the taxpayer is subject to withholding tax under s 128B.

414. Section 177CA provides:

"(1) This section applies in relation to a particular amount if a taxpayer is not liable to pay withholding tax on an amount where that taxpayer would have, or could reasonably be expected to have, been liable to pay withholding tax on the amount if a scheme had not been entered into or carried out.

(2) For the purposes of this Part, if this section applies in relation to an amount, the taxpayer is taken to have obtained a tax benefit in connection with the scheme of an amount equal to the amount mentioned in subsection (1).
(Emphasis added.)"

415. In the present case, the "amount" is the payment of $222,655,981 by CSA to CSF. The Commissioner contended that CSF received a tax benefit within the meaning of s 177CA in relation to that amount because, in the absence of the scheme which had the effect of bringing the payment forward to 14 November 2003, the amount would have been paid later and withholding tax would have been payable. So, for example, if the amount had been paid by CSA to CSF after 5 December 2003, it would have been subject to withholding tax at 10%.

416. CSF rejected that contention. It submitted that the "amount" referred to in s 177CA is a reference to an actual payment, and not to a hypothetical payment never made. In particular, CSF submitted that s 177CA was premised on the existence of such an amount with the object of attacking arrangements where the form of an actual payment was modified to avoid withholding tax. CSF submitted that its construction of s 177CA was supported by an ordinary and natural construction of the words used in Pt IVA. In relation to its submission that the section was premised on the existence of a pre-existing amount, CSF referred to the following sections:

1. s 177CA which refers to "an amount" in respect of which withholding tax would have been payable if a scheme had not been entered into or carried out;
2. s 177F(2A) which refers to the Commissioner making a determination that the taxpayer is subject to withholding tax "on the whole or a part of that amount";
3. s 177F(2C) refers to a determination being given to the "person who paid the amount"; and
4. the statutory fiction created by s 177F(2F) is limited to a fiction that withholding tax was always payable in contradistinction to s 177F(2), which does not create a further fiction that a payment was made when one was not in fact made.

I accept CSF's contention that the phrase "particular amount" in s 177CA is a reference to the amount of withholding tax avoided by reason of the entry into of the scheme.

417. CSF also referred to the following extracts from the WHT EM, which introduced s 177CA, as further support for its construction of s 177CA. The WHT EM stated at pars 2.35 and 2.36 as follows:

2.35 New subsection 177CA(1) will specify a particular amount (of interest, dividends or royalties paid to the taxpayer) to which section 177CA is to apply. Such an amount will have both of the following characteristics:

• as a result of the entering into or the carrying out of a scheme, the taxpayer is not liable to pay withholding tax on the amount. (The existing definition of 'scheme' contained in section 177A(1) applies to this subsection); and

• there is a reasonable expectation that, if the scheme had not been entered into or carried out, then a liability to the taxpayer for withholding tax on that amount, would have arisen.

2.36 Where there is a 'new subsection 177CA(1) amount' new subsection 177CA(2) will apply to designate that amount to be a tax benefit. New subsection 177CA(2) further specifies that the tax benefit is taken to have been obtained by the taxpayer.

…

(Emphasis added.)

418. CSF submitted that the references to an "amount" in respect of which a liability to pay withholding tax "would have arisen" provided further support for the construction that s 177CA is premised upon the actual payment of an amount to a non-resident.

419. The Commissioner rejected that construction on the grounds that it was contrary to the purpose of the provisions and would lead to the absurd result that s 177CA could have no application to schemes that operate by altering the timing of a payment so as to give rise to a tax benefit. Instead, the Commissioner submitted that provided there is an "amount", in this case $222,655,981, and provided there is a scheme, the entry into of which avoids a liability to pay withholding tax, then s 177CA can apply.

420. In support of that construction of s 177CA, the Commissioner raised four points:

"1. CSF's construction was purely grammatical without having regard to the Parliamentary intent of those provisions: cf
Cooper Brookes (Wollongong) Pty Ltd v Federal Commissioner of Taxation 81 ATC 4292 ; (1981) 147 CLR 297 at 321 and
CIC Insurance Limited v Bankstown Football Club Limited (1997) 187 CLR 384 at 408.

2. it is contrary to Parliament's intention, as expressed in the WHT EM, that s 177CA have a comprehensive operation with respect to schemes to avoid withholding tax. The Commissioner referred to paragraphs 2.2, 2.12 and 2.30 of the WHT EM:

2.2 The purpose of these amendments is to provide a mechanism within the Act to effectively counter withholding tax avoidance arrangements in a general and comprehensive way …

2.12 … to provide a mechanism within the Act to effectively counter withholding tax avoidance schemes in a comprehensive way it has become necessary to expand the effect of Part IVA to include avoidance of withholding tax on an amount of interest, dividends or royalties because of a scheme as defined in Part IVA.

…

2.30 New section 177CA will be inserted into Part IVA. This section will extend the operation of Part IVA to arrangements which avoid an amount of withholding tax which would otherwise be levied under s 128B.

3. if CSF's submission was correct, then arguably s 177D(b)(iii) would not be taken into account which would be inconsistent with Parliament's intention that all of the s 177D(b) factors remain relevant to withholding tax schemes as recorded in paragraph 2.41 of the WHT EM:

The proposed legislation makes no amendments to section 177D. Its provisions therefore apply without alteration to new section 177CA in the same way as to section 177C.
4. CSF's submission was inconsistent with the way in which withholding tax is levied. The Commissioner submitted that s 177CA and 177F(2A) contain no reference to years of income because it is not imposed by assessment but by imposing a withholding tax liability with respect to amounts paid with the withholding tax liability automatically becoming a debt owed to the Commonwealth: see s 128B and 128C of the 1936 Act. Accordingly, it would be inconsistent with the basis on which withholding tax is levied to interpret s 177CA as requiring a particular temporal requirement."

421. In the end it is unnecessary to resolve the dispute. At the time the scheme was entered into (14 November 2003) and at the time the "amount" was paid (24 November 2003), the law did not impose withholding tax on dividends paid by CSA to CSF, nor was there any means to modify the form of the payment of any such dividend to create such a liability. As a result, no counterfactual can be devised or hypothesised whereby it can be concluded that dividend withholding tax would, or might reasonably be expected, to have been payable on a payment made in November 2003. That is because all such dividends, regardless of form, were exempt from tax where the requirements of Art 10(3) were satisfied. Put another way, the obligation to pay dividends annually had existed since November 2001. That obligation was cumulative. The right to further dividends arose on 15 November 2003. There was no suggestion (and nor could there be) that the fact the arrangements were entered into in 2001, or their content, formed part of the scheme.

422. The identification of the scheme is important. The Commissioner contended that the payment was brought forward. The date the obligation fell due (15 November 2003) was established in November 2001 and was not altered. The amount was discharged by the endorsement of a promissory note which was not only due but paid on 24 November 2003. At both 15 and 24 November, the law did not impose withholding tax on dividends paid by CSA to CSF.

423. It is not permissible to assess the existence of a tax benefit by law which was introduced after the payment of the "particular amount". As Hill J decided in
CPH Property Pty Ltd v Federal Commissioner of Taxation 98 ATC 4983; (1998) 88 FCR 21 at 42:

"In my view the application of the Part can only be tested with respect to the obtaining of a tax benefit in accordance with the law as applicable to the time the scheme is entered into or carried out."

That observation was endorsed by the Full Federal Court on appeal:
Commissioner of Taxation v Consolidated Press Holdings Ltd (No 1) 99 ATC 4945; (1999) 91 FCR 524 at 552.

424. For these reasons, I do not accept that there is tax benefit to be cancelled pursuant to s 177CA and 177F of the 1936 Act and Pt IVA does not apply to the scheme identified by the Commissioner.

(iii) Dominant purpose

425. Even if there was a tax benefit (contrary to the view that I have formed), I do not accept that it could be concluded that the dominant purpose of any part of the Commissioner's scheme was to obtain a tax benefit. The following facts are worth restating:

1. the parties entered into arrangements for the funding of an acquisition and sale of certain royalty streams in 2001. For the reasons set out in [293] to [376] above, the dominant purpose of those arrangements was to obtain US state tax benefits and to facilitate protection of ITW Inc's intellectual property;
2. part of those arrangements included the issue by CSA of redeemable preference shares using standard terms for the payment of dividends and for the redemption of the shares after five years. The Commissioner did not submit that the terms used were, to any extent, modified or altered to avoid a liability for withholding tax;
3. the terms of issue of the CSA Preference Shares required the payment of a fixed dividend amount on 15 November each year. That obligation was an expected feature of redeemable preference shares, was cumulative and subject to default dividend interest;
4. in accordance with its terms, a dividend was paid in November 2003: see [135] to [148] above. That dividend included payment of the dividend for the 2002 year (payment had been suspended for one year) and a dividend amount representing interest on the unpaid 2002 dividend. Nothing was done to alter the form or amount of the dividend to avoid withholding tax.

426. Against the background of those facts, I turn to consider the factors in s 177D(b).

Manner

427. The Commissioner submitted that the decision to pay the amount of $222,655,981 was "contrived" to ensure that the payment was made prior to 5 December 2003 after which date withholding tax would have been payable on the payment from CSA to CSF.

428. In support of that contention, the Commissioner referred to the fact that there were not sufficient accumulated earnings for the dividend to be paid by SGTS to AFC: see [139] to [144] above. I accept that there were not sufficient accumulated earnings for the dividend to be paid by SGTS to AFC. However, for the reasons stated at [208] to [213] above, I do not accept that it invalidated the payment of dividends from SGTS to AFC and the subsequent dividends that flowed through to CSF.

429. I accept that the decision to pay the amount of $222,655,981 was made prior to 5 December 2003, after which date withholding tax would have been payable on the payment from CSA to CSF. I do not accept that that decision was "contrived".

Form and substance of the scheme

430. I accept that the economic and commercial substance of the scheme was the three payments on 14 November 2003, namely a payment by SGTS to AFC, a payment by AFC to CSA and a payment by CSA to CSF. I do not accept that the form of the scheme was different from its economic and commercial substance. Why? The premise which underpinned the Commissioner's contention - that no dividend could properly be paid by SGTS to AFC - was contrary to the facts and the law: see [208] to [213] above.

Timing

431. The Commissioner submitted that the timing of the scheme was dictated by two events, without which the scheme would not have proceeded.

432. First, the US DTA came into effect in Australia on 1 July 2003, the Protocol having been signed by the US and Australia on 27 September 2001. Under the US DTA, no withholding tax was payable on dividends where the recipient of the dividends held more than 80% or more of the shares in the paying company.

433. Secondly, the International Tax Agreements Amendment Bill 2003, which was introduced on 11 September 2003, clarified the operation of the dividend provisions of the US DTA, such that amounts treated as a return on a debt interest were not to be characterised as dividends: Explanatory Memorandum, International Tax Agreements Amendment Bill 2003, paragraphs 3.9-3.19 and [402] to [409] above.

434. I accept that the payment by CSA to CSF on 14 November 2003 was, therefore, in the "window" in which no withholding tax was payable. However, I do not accept that the timing is determinative. As the Commissioner submitted, a withholding tax liability is imposed with respect to amounts paid with the withholding tax liability automatically becoming a debt owed to the Commonwealth: see s 128B and 128C of the 1936 Act. When the dividend was paid, no withholding tax was payable.

Result Achieved by the Scheme

435. The Commissioner submitted that the result but for the scheme was that CSF was not liable to pay withholding tax on the amount of $222,655,981. But that was the law as at the date of the scheme.

Change in financial position of the taxpayer from the scheme

436. The steps in the scheme affected the financial position of CSF. It would have received the gross amount and not the net amount of the dividends. But that was what the law was at the date of the scheme.

Change in financial position of any connected person from the scheme

437. The transactions took place within a wholly-owned group of companies.

438. The scheme had the effect that, within the ITW Group, intra-group liabilities with respect to accrued dividend payments were discharged through the payment of the promissory note. The financial position of the group, when viewed as a whole, is such that the payments (including the relevant payment from CSA to CSF), was altered only insofar as there was a reduction in the withholding tax liability of the group on the dividend payments received by CSF. A reduction that was legally permissible - that was what the law provided at the time of the scheme.

Any other consequences of the scheme for the taxpayer or any connected person

439. The Commissioner accepted that there were no other consequences of the scheme for the taxpayer or any other person and that this factor was neutral.

Nature of connection between the taxpayer and persons affected by the scheme

440. All of the relevant entities are members of the one corporate group, namely the ITW Group.

(d) Conclusion

441. The parties entered into arrangements for the funding of an acquisition and sale of certain royalty streams where the dominant purpose of those arrangements was to obtain US state tax benefits and to facilitate protection of ITW Inc's intellectual property. The arrangements included the issue by CSA of redeemable preference shares using standard terms for the payment of dividends and for the redemption of the shares after five years. It was not suggested that the terms used were, to any extent, modified or altered to avoid a liability for withholding tax. Nor was it suggested that the size of the dividend reflected anything other than an ordinary market return on an instrument of that nature.

442. The terms of issue of the CSA Preference Shares required the payment of a fixed dividend amount on 15 November each year. That obligation was and remains an expected feature of redeemable preference shares.

443. In accordance with the ordinary commercial terms of the CSA Preference Shares, a dividend was paid in November 2003. That dividend included payment of the dividend for the 2002 year (payment had been suspended for one year) and a dividend amount representing interest on the unpaid 2002 dividend. Nothing was done to alter the form or amount of the dividend to avoid withholding tax. Indeed, given that no withholding tax was then payable, nothing could be done to make dividend withholding tax payable on the dividend paid given CSA's ownership by CSF.

444. For these reasons, I do not accept that it could be concluded that any party to the scheme had a dominant purpose of obtaining the alleged tax benefit.

D. Conclusion and orders

445. Given the complexity of the issues in these proceedings, I will direct the parties to bring in orders to give effect to these reasons for decision by 4.00 pm on 18 February 2011.

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