Consolidated Fertilisers Limited v. Federal Commissioner of Taxation
Judges:Pincus J
Court:
Federal Court
Pincus J.
The applicant requested the respondent, under the Income Tax Assessment Act 1936, to refer to this Court the respondent's decisions on objections with respect to the tax years ending 30 September 1983 and 30 September 1985. The sums, deductibility of which is in question, are about $100,000 in the former year and a little over $500,000 in the latter. There is no dispute that the sums in question were spent in the course of the applicant's business, but the respondent says that the expenditure was on capital account.
That is, the only point in the case is whether the admitted expenditures were a capital or a revenue matter.
In form, the moneys in question were included in ``management fees'' paid to Incitec Ltd., the applicant's parent company. However, it is not suggested that the deductibility of the sums in question is to be determined by reference to the characteristics of management fees paid to Incitec Ltd.; that company paid the expensed and was, in effect, reimbursed by the applicant. In 1983, the amounts paid were wholly for legal fees charged by a United States firm of attorneys. In the 1985 year, a sum of $101,538.46 was paid to settle litigation in United States courts; the balance consisted of legal fees.
Broadly speaking, payment of the sums in question was made to protect the applicant's interest in information of commercial value, in circumstances which must be explained in some detail.
Despite its name, the applicant's activities are not confined to agricultural fertilisers; it has for many years been involved in the manufacture of other agricultural chemicals also. It used to sell an insecticide to control certain grubs which were regarded as pests in the sugar cane growing industry. The product which was sold for that purpose, called ``BHC'', persisted in the soil for three or four years. It was thought to create environmental problems and the applicant became interested in developing a substitute. In 1979, the applicant contacted an American academic, Professor N. Cardarelli, who had been working on a new technology for the controlled release of chemicals using a polymer system. The applicant had no previous experience of that technique. Professor Cardarelli was, when contacted by the applicant, a director of a United States company, Environmental Chemicals Inc. (ECI). Negotiations between
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the applicant and ECI took place and produced the execution of an agreement of 24 October 1980.That agreement recited that ECI had developed and would be developing ``technical information, know-how and confidential formulas'' relating to controlled release and that it had ``at least two pending Australian patent applications'' relating thereto. ECI undertook to furnish the applicant with certain ``technical information, know-how and confidential formulas'' to assist the applicant in preparing and selling various products in ``territory A or B''. Territory A was defined so as to refer to Australia, New Zealand, Papua New Guinea and other places in the vicinity; territory B consisted of Indonesia, Thailand, Singapore, Malaysia, Philippines and Burma. The agreement provided for payment of various considerations to ECI and contained promises by the applicant not to disclose the information it obtained from ECI. ECI promised not to disclose information to persons other than the appellant in the two territories (A and B) to enable those others to manufacture or sell the controlled release substances the subject of the agreement.
The applicant used information supplied under the agreement, but also did a great deal of work itself in developing the technology. For example, ECI disclosed to the applicant information concerning only three or four active ingredients which had been tried using its technique; the applicant experimented with many other active ingredients, being pesticides and fertilisers. It kept in touch with Cardarelli and there was an exchange of information in both directions.
Between 1980 and 1984, the applicant spent over $1 million developing the technology, some of the money being spent on a pilot plant to test manufacturing techniques. As one would expect, the applicant field-tested products it developed and also approached the appropriate governmental authorities to obtain permission to use and sell its products.
On 15 April 1982, the original licensing agreement mentioned above (dated 24 October 1980) was varied by agreement between ECI and the applicant. The consequence was that the references in the agreement to territories A and B were replaced by a reference to ``the territory'' which included, in addition to the places mentioned in the original agreement, some other countries such as China, Korea, Japan and India. The agreement was amended again on 15 September 1982, so as to make ``the territory'' mean ``all countries in the world excluding the North and South American continents''. The result was that the contractual right of the applicant, as against ECI, to exploit the technology covered the whole world except for those two continents.
On 8 January 1983, Cardarelli wrote to the applicant to say that he had sued ECI ``for the voiding of the assignments of my patents to them''. He explained that ECI was in financial difficulty and that he was ``taking action to regain my patents''. The letter said, in effect, that Cardarelli was prepared to license the applicant on the same terms as ECI had, except that he would not be ``bound to honour terms outside of Asia''. Had that been accepted by the applicant, it would have greatly restricted its opportunities to exploit the technology.
Cardarelli did, in fact, sue ECI, the action being brought in the United States District Court. The complaint by which that suit was instituted sought an order rescinding invention assignment agreements between the plaintiff and defendant.
On 25 March 1983, the applicant replied to Cardarelli's letter by one McGuffog, its marketing services manager. He wrote that ECI had extended the area covered by its agreement with the applicant to include all parts of the world except North and South America. McGuffog wrote that he understood that Cardarelli had been at the board meeting when ``approval was given for these negotiations''. The letter asserted that anyone seeking to use patents assigned to ECI and licensed to the applicant would be infringing the applicant's rights. Cardarelli replied on 28 April 1983, expressing regret that the applicant had negotiated ``an extension of the geographical licence''. He denied that he was ``a party to those negotiations''. The letter included the statement:
``The patents are presently under a legal could and the Federal Court will determine ownership.''
McGuffog's affidavit in this Court contained the following passage:
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``As a result of the information in letters from Professor Cardarelli and my knowledge of his history of industrial disloyalty to ECI, I became concerned that valuable not-patented trade secrets in relation to the technology both obtained from ECI and developed by CFL [the applicant] would become known to competitors of CFL... The work undertaken by CFL had transformed the basic theory which had been developed by ECI into a practical process...''
It is my opinion, having heard McGuffog cross-examined, that this passage accurately sets out matters about which he was concerned. The evidence showed that it was McGuffog who, on behalf of the applicant, was in charge of the work done in developing the technology in question.
The applicant sought advice from American lawyers ``as to how CFL should best proceed in order to protect its trade secrets and the benefits which it expected to receive as a result of the operation of a licensed agreement''. ``CFL'' is the applicant. On 13 May 1983, the applicant wrote to its American attorneys, instructing them to represent it in Cardarelli's action to support the defendant's case - i.e. ECI's case - and to establish Cardarelli's approval of the grant of the licence by ECI to the applicant. The letter went on to explain that, in a cross-action, ECI had sued Cardarelli and another company (``Albany Incorporated'') and that the applicant wished to be represented there also, being ``particularly concerned that Cardarelli may have disclosed technological data and know-how to other third parties''.
On 19 July 1983, the applicant and ECI sued Cardarelli and a company called Unique Technologies Inc. in the United States District Court. The complaint alleged that the applicant had paid substantial sums (about $750,000) by way of royalties and in other payments to ECI, that ECI had authority to enter into the licence agreement with the applicant, that Cardarelli threatened to disclose to third parties and to make available to his co-defendant (Unique Technologies Inc.) information and know-how licensed to the applicant and that the plaintiffs wished to obtain a preliminary injunction against the disclosure of trade secrets and confidential information by the defendants. There were also claims for declaratory relief and damages.
The foreshadowed claim for a preliminary injunction was pursued and was successful; on 14 October 1983, a United States District Judge enjoined the defendants in the suit just mentioned (brought by the applicant and ECI) from disclosing confidential information of certain kinds; the order elaborately described its scope but it seems unnecessary for the purpose of these reasons to set the description out.
In 1984, ECI being thought to have ``little hope of developing as a viable commercial operating company'', it was agreed between the applicant and ECI that the applicant would take over the conduct of the proceedings in which the applicant and ECI were plaintiffs and would meet ECI's liability for certain legal costs.
The suit by Cardarelli against ECI and that by the applicant and ECI against Cardarelli were both settled and the terms of settlement were announced in open court on 25 April 1985. The principal terms of the settlement, so far as relevant for present purposes, were as follows. First, the applicant and ECI agreed to indemnify Cardarelli in respect of a suit which the University of Akron had brought against ECI. Secondly, it was agreed that the preliminary injunction I have mentioned would be incorporated into a sealed agreement. Thirdly, $US55,000 was to be paid to Cardarelli; the evidence was that that was to cover his attorney's fees.
On 6 July 1985, a formal order was entered in the United States District Court which referred to the settlement I have mentioned. One effect of the order was that the agreement providing for the settlement was to be sealed and to be ``maintained in confidence''. It was argued on behalf of the applicant, and I accept, that it is a reasonable inference that this sealed agreement came into existence (although it was not tendered in this Court) and incorporated a term obliging Cardarelli to maintain confidentiality in respect of the information which was in issue in the United States proceedings. On reason for that inference is that forcing Cardarelli not to reveal the relevant secrets was an important purpose of the applicant's involvement in the litigation.
In the same year, the applicant made substantial commercial sales of a slow-release substance it had developed called ``suSCon Blue''. This product was developed in consequence of the dealings the applicant had
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had with Cardarelli and ECI and its own research work based thereon. In 1985, the applicant sold nearly $1 million worth of the substance and thereafter returns increased each year; in 1989, gross revenue exceeded $6 million. McGuffog expects the return to increase to $12 million by 1992-1993, in addition to which the applicant has made agreements with a number of large pesticide manufacturing companies under which those companies will develop products using the technology discussed above.I am satisfied, and it is indeed undisputed, that the substantial sums which the applicant has spent in obtaining and protecting the information to which I have alluded have produced and are likely to produce large amounts of income. However, it does not follow that the moneys expended in defending the information by use of which the income was produced is deductible. The respondent says, as I have mentioned, that the expenditure was of a capital kind.
Mr Keane Q.C., who led Mr McGill for the applicant, said that the applicant's position was improved by the circumstance that much of the expenditure in question was made on a periodical basis. That submission was supported by evidence that the applicant's American lawyers rendered accounts monthly and were paid monthly. While it is correct that periodicity tends to assist a taxpayer in a case of this sort, it is my opinion that the purpose of the payments is the important point. I could not accept that, assuming the American lawyers' fees were not otherwise deductible, they would become so because paid on monthly accounts, rather than in a lump sum at the conclusion of the litigation.
The evidence was to the effect that the applicant has never, so far as known, engaged in similar litigation; but there was also evidence that it continually takes steps to preserve information of the kind here in question. It was suggested that the only unusual feature of the efforts the cost of which is in issue is that they were very expensive.
More broadly, the picture presented on behalf of the applicant was that improving its position in the marketplace by developing new and improved products is a continual process. It is not in contest that the applicant expends substantial amounts of money, and much of its employees' time is taken up, in this way. The evidence shows that it operates in an area in which a great deal of technical improvement goes on. It has to compete internationally. It commonly binds employees and also contractors and other third parties to secrecy agreements. It frequently derives income from the exploitation by it or others of technical information. It markets in a ``constantly changing regulatory environment''.
It has to be said that the dissection of expenditure on preserving the applicant's confidential information into those sums which may be thought directed to long-term or permanent situations and those of a more ephemeral kind would be very difficult. As to the former, common knowledge suggests that in these days of intense research and development activity, it may be difficult to postulate of any new technology that it will retain its value for a substantial time; it may be quickly superseded. The information in issue has not met that fate.
It is my view that the answer to the question posed in this case may best be found by a process of induction from authorities dealing with similar situations, and particularly authorities concerned with the deductibility of expenses incurred in protecting intangibles, rather than by resort to broad statements of principle. It appears convenient to discuss first a group of High Court cases.
In
Hallstroms Pty. Ltd. v. F.C. of T. (1946) 72 C.L.R. 634, the cost of opposition to an application by a refrigerator manufacturer's trade competitor to extend letters patent was held to be deductible. Had the application succeeded, the taxpayer's business ``would not have been seriously diminished during the period of extension'' (at p. 642). The Court's opinion was reached despite the fact that, as was pointed out by Dixon J. (who dissented), the use of the invention was a matter of lasting importance to the taxpayer (at p. 648).
Williams J., one of the majority, was influenced by the circumstance that (at p. 655):
``The defeat of the application did not clothe the appellant with any fresh right. The expenditure was incurred to safeguard an existing right and for the purpose of earning profits from the sale of the new refrigerator and to produce revenue in the conduct of its
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business. The appellant did not acquire any asset or other advantage from the Electrolux Company.''
(The Electrolux Company was the applicant for extension of a patent.)
With some modification, remarks of this sort may fairly be applied to the present case. They make relevant, as a factor tending to support deductibility, that the expenditure was of a defensive kind, rather than made to acquire an asset. This distinction is comparable with that between insuring against loss of capital, at however great a cost, and acquiring capital:
Australian National Hotels Ltd. v. F.C. of T. 88 ATC 4627 at p. 4633; (1988) 81 A.L.R. 667 at p. 674.
In
Broken Hill Theatres Pty. Ltd. v. F.C. of T. (1951-1952) 85 C.L.R. 423, where the expenditure in question was essentially defensive, it was nevertheless held not to be deductible by Williams J. There, the taxpayer (a motion picture theatre operator) spent money opposing an application for a licence to operate a competing motion picture theatre. The decision of Williams J. was upheld on appeal and in the principal judgment, the importance of the fact that ``no new asset was brought into existence by the company's expenditure'', was depreciated (at p. 434). In that judgment, it was not stated what it was that distinguished the case in principle from Hallstroms, but reliance was placed upon the fact that ``Williams J., who was a party to that decision, did not regard it as an obstacle...'' (at p. 434).
Taylor J. had to consider a problem in the same general category in
F.C. of T. v. Duro Travel Goods Pty. Ltd. (1953) 87 C.L.R. 524. There, money was expended in protection of another intangible, goodwill. The costs incurred, which were held to be deductible, related to litigation to prevent the use by a competitor of a name similar to that of the taxpayer. In arriving at his conclusion, the Judge took into account factors which seem to me to be present here, namely that what was being defended was not only intangible, but was a characteristic of the taxpayer's business needing continual attention, which fluctuated in its nature from time to time and was of a peculiar character (at p. 528).
In
F.C. of T. v. Snowden & Willson Pty. Ltd. (1958) 99 C.L.R. 431, the costs of defending the taxpayer's reputation before a Royal Commission were held to be deductible although the expenditure was not recurrent and ``must be regarded as abnormal'' (at p. 446). The Commissioner's counsel relied upon the Broken Hill Theatres case (at p. 432) amongst others, but Taylor J. said that case was one in which ``the purpose of the expenditure by the taxpayer was to secure for itself freedom from further competition in the locality where it carried on business'' (at p. 452). The distinction between acquisition and defence of business advantages recurs.
In
F.C. of T. v. Finn (1961) 106 C.L.R. 60, the High Court had to consider a case where the expenditure was, unlike those hitherto considered, not of a defensive kind. An architect spent money improving his professional abilities and that was held to be deductible. The case is of present importance only in so far as it throws some light upon the deductibility of expenditures with respect to knowledge. The then Chief Justice said (at pp. 68-69):
``The pursuit of information concerning the modernization or improvements in an art is part of the constant process of keeping up to date which skilled professions call upon those who practise them to pursue, though sometimes in vain.... You cannot treat an improvement of knowledge in a professional man as the equivalent of the extension of plant in a factory. Unfortunately, skill and knowledge of most arts and sciences are not permanent possessions: they fade and become useless unless the art or the science is constantly pursued or, to change the metaphor, nourished and revived. They do not endure like bricks and mortar.''
Kitto J., who agreed, also emphasised that the taxpayer's need to add to his knowledge and understanding of architecture was of a continuing kind (at pp. 69-70).
One could not, on the evidence, form any view as to the extent to which the rate of change of architectural knowledge exceeds or is in arrears of that in agricultural chemistry. But, in my opinion, the point made in Finn's case, that the acquisition of technical knowledge is not necessarily to be equated to purchasing a physical asset such as a building, is of assistance in determing the proper result.
In addition to the cases just discussed, counsel relied upon authorities concerning the
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question whether confidential information is, strictly speaking, property. As de Jersey J. remarked inPancontinental Mining Ltd. v. Commr of Stamp Duties (Qld) 88 ATC 4190 at p. 4191; (1989) 1 Qd.R. 310 at p. 311, there is plenty of support for the view that the ordinary meaning of the word ``property'' does not encompass information. On the other hand, in
Re Keene (1922) 2 Ch. 475, the English Court of Appeal treated secret formulas as part of the bankrupt's property. They were not written down but were said only to exist in the bankrupt's mind; an order directing the bankrupt to disclose the formulas in writing was upheld. Other authorities may be found in which confidential information has, for one purpose or another, been treated as property, as Gibbs J. pointed out in
Brent v. F.C. of T. 71 ATC 4195 at pp. 4198-4199; (1971) 125 C.L.R. 418 at p. 425. Among those are
Moriarty v. Evans Medical Supplies Ltd. (1958) 1 W.L.R. 66 and
Triplex Safety Glass Co. Ltd. v. Scorah (1938) 55 R.P.C. 21 at pp. 27-29. It does not appear to me to be crucial, however, whether the rights the applicant had in respect of the information against ECI or Cardarelli were, in strictness, property.
Mr Gotterson Q.C., who led Mr Vitali for the respondent, referred me to authorities in favour of the view that, in some circumstances, money paid to protect intellectual property is not deductible. One such case is
Commissioner of Taxes v. Ballinger (1903) 23 N.Z.L.R. 188, esp. at p. 194. Mr Gotterson said that the rationale of that decision is that retention of the exclusive right to make an article the subject of a patent is a means by which a company earns additional profits; the motive is to retain the power to earn those profits. But a similar characterisation may be made of the expenditure, in the Hallstroms case, on resistance to an application to extend letters patent and to the expenditure on defence of reputation in Snowden & Willson. Indeed, one would expect any business expenditure to be made for the purpose of earning profits, preferably additional profits. Mr Keane relied upon
Magna Alloys & Research Pty. Ltd. v. F.C. of T. 80 ATC 4542; (1980) 33 A.L.R. 213. There, a company succeeded in obtaining a deduction for the costs of defending its directors against charges of criminal conspiracy. The question was not principally one of distinguishing between capital and revenue expenses, but of determining whether the expenditure was incurred in carrying on the company's business. However, the Full Court dealt briefly, but for present purposes usefully, with the former point. Brennan J. pointed out (at ATC p. 4554; A.L.R. pp. 228-229) that the capital of the business was not increased by the expenditure, although it protected the reputation and goodwill of the business. His Honour added:
``Though goodwill is a capital asset of a business it is frequently earned and maintained by the daily activities of those engaged in the business.''
Deane and Fisher JJ. reached the same conclusion in reliance on Snowden & Willson (above). Their Honours remarked (at ATC p. 4562; A.L.R. p. 239):
``Except in the most indirect way, the criminal proceedings imperilled neither the business nor the capital assets of the taxpayer... The outgoings did not involve the acquisition of any enduring or tangible asset.''
It will be noted that each of the reasons treated the defensive character of the expenditure as material.
To return now to the High Court decisions discussed above, there is ground for thinking that they make especially relevant two characteristics of the expenditure in issue here.
One is that it related to knowledge which, while undoubtedly an asset in a commercial sense, is an intangible. For that, and other reasons, it is to be distinguished from physical property; perhaps it should also be distinguished from categories of property which are more precisely definable than knowledge, such as debts due and shares in other companies. Other reasons for treating knowledge as in a special category when considering the capital-revenue distinction are pointed out in Finn's case above.
The second characteristic of the expenditure which the High Court cases suggest is particularly material in this context, is that it was made to defend and maintain what the taxpayer had, not to acquire any capital asset. Although the High Court cases, and in particular Hallstroms' and Duro's case and Snowden & Willson, do not enable one confidently to enunciate a principle that purely
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defensive expenditures are less likely to be of a capital kind than acquisitive expenditures, the actual outcomes of the cases suggest that they must have depended, at least in part, on that point.In general, expenditure made to defend the confidentiality of commercially valuable information is likely to be of a revenue kind, especially where, as is so here, the task of preserving and maintaining confidentiality is a continuing one.
Snowden & Willson, and even more strongly the Magna Alloys case, support the deductibility of expenditures, even if of a unique kind, to protect commercial reputation. If that be a general principle, it is hard to see any good ground for denying a deduction here. It has to be conceded that the statements of general principle found in the cases do not appear to provide a clear answer to the present problem; but it is my view that, considering the authorities as a whole, they suggest that the proper conclusion is one favourable to the applicant taxpayer. In my opinion, the amounts in question were properly deductible.
The respondent's decisions on the objections in question will be set aside. The respondent is ordered to issue amended assessments accordingly and to pay the applicant's costs of these proceedings to be taxed.
THE COURT ORDERS THAT:
1. The respondent's decisions notified on 24 February 1988 on the objections with respect to the applicant's amended assessments in respect of income described in the said notices as having been derived during the years ended 30 June 1983 and 30 June 1985, but in fact derived during the years ended 30 September 1983 and 30 September 1985, be set aside.
2. The respondent issue further amended assessments in accordance with the Court's judgment.
3. The respondent pay the applicant's costs of and incidental to these proceedings to be taxed.
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