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CASE 62/94

Members:
TE Barnett SM
SD Hotop SM
RD Fayle SM

Tribunal:
Administrative Appeals Tribunal

Decision date: 2 December 1994

TE Barnett (Senior Member), Associate Professor SD Hotop (Senior Member), Associate Professor RD Fayle (Senior Member)

This application is for a review of decisions by the Respondent to disallow claims in relation to the years of income ended 31 December 1986 and 1987 (being substituted years of income ended 30 June 1987 and 1988) respectively. The Respondent, after having carried out an audit of the Applicant's assessed income tax returns for those years of income, increased the taxable incomes as returned, by making certain amendments. Some of those amendments are the subject of this review, pursuant to s. 14ZZC of the Taxation Administration Act 1953, being applications in relation to reviewable objection decisions made after 1 March 1992. The Respondent had allowed in part some of the claims made in the notices of objection and the Applicant gave notice that some of the grounds had been abandoned. In the result the following disallowed amounts were under review:

Year ended 31 December 1986
--Feasibility study costs               $91,294
--Carry forward losses in
connection with feasibility
studies                                $351,415

Year ended 31 December 1987
--Feasibility study costs                $6,415

2. In addition, the Applicant requested a review of the Respondent's objection decision not to remit the penalty, for false or misleading statements made in the 31 December 1986 return, imposed pursuant to s. 223 of the Income Tax Assessment Act 1936 [``the Act'']. This amounted to $636,822.00.

3. The above claim for carry forward losses pursuant to s. 80 of the Act relates to feasibility study expenses incurred in the previous two years for which no taxable income resulted. These amounted to: 

Year ended 31 December 1984             $111,173
Year ended 31 December 1985             $240,242
                                        --------
Carry forward loss component in
connection with feasibility studies     $351,415
                                        --------

4. All of the feasibility study costs claimed have a common genesis and were claimed pursuant to s. 51(1) of the Act.

5. At the hearing counsel for the Applicant sought to amend the grounds of objection in relation to a portion of the feasibility study costs, being contributions by the Applicant to a superannuation fund on behalf of its employees claimed pursuant to s. 82AAC of the Act. This amendment is necessary because no deduction is otherwise allowable in this respect due to the limitations imposed by s. 82AAR. The Respondent did not oppose the amendment and the Tribunal accepted the amended grounds in accordance with the decision in
Lighthouse Philatelics Pty Ltd v FC of T 91 ATC 4942. The amounts of the claims for superannuation contributions were agreed as $1,835 and $8,874 incurred in the years ended 31 December 1984 and 1985 respectively and which form part of the claim for carry forward losses above. There was no dispute as to these claims and, whilst not overtly conceded by the Respondent, would be allowable prima facie.

6. At the hearing a Statement of Agreed Facts (as amended), and an affidavit by each of Mr MMM and Mr NNN, were taken into evidence. Neither deponent was called for cross- examination. The Tribunal also had before it two volumes of documents (``T documents'') filed pursuant to s. 37 of the Administrative Appeals Tribunal Act 1975 (``the AAT Act'').

7. The Applicant was represented by Mr R Edmonds and the Respondent by Mr M Buss QC.

Agreed facts

8. Apart from the paragraph numbered 19 which, it was submitted by both counsel was

ATC 522

irrelevant to these proceedings, the agreed facts are:
  • (1) AAA Limited (formerly known as BBB Limited, and prior to that as CCC Limited and DDD Limited) (the ``Applicant'') was incorporated in Western Australia.
  • (2) During all relevant years of income the Applicant carried on a mining and mineral processing business producing mineral sands from deposits located at EEE, Western Australia.
  • (3) During the relevant years of income the Applicant operated its Western Australian mining activities under an agreement with the State Government of Western Australia which was ratified as an Act of Parliament: The DDD Agreement Act (WA) (the ``State Government Agreement'').
  • (4) Recital (f) of the State Government Agreement requires the Applicant ``to pursue actively and progressively a policy leading ultimately to the processing in Western Australia of heavy minerals to the maximum degree possible''.
  • (5) Pursuant to Clause 21(1) of the State Government Agreement, the Applicant is required to investigate the technical and economic feasibility of establishing a plant for secondary processing of its mineral products to the maximum degree then practicable either alone or jointly with any other company or companies.
  • (6) Clause 21 of the State Government Agreement further provides:
    • ``(a) If secondary processing is found to be feasible and competitive on world markets in the opinion of the Applicant and the relevant State Government Minister, the Applicant is required to submit a proposal for a secondary processing plant to the State Government and to proceed with the establishment of that plant.
    • (b) If secondary processing is found not to be feasible or competitive then the Applicant is required to undertake further investigation in future years until such time as secondary processing is found to be feasible and competitive.''
  • (7) In February 1984 the Applicant and FFF Company Limited (``FFF Limited'') a major Japanese chemical company, agreed to conduct a joint study on the feasibility of secondary processing of monazite, produced by the Applicant in its mining and mineral processing business, to recover high purity rare earth oxides using new technology developed by FFF Limited.
  • (8) A Phase 1 preliminary feasibility study was completed by the Applicant and FFF Limited in June 1984. The study found good prospects for establishing a viable business venture.
  • (9) A Phase 2 study was commissioned in September 1984 to more accurately determine the viability of the project and to serve as a basis for deciding whether or not to proceed with the development of the rare earth business.
  • (10) The Phase 2 study was completed in February 1985 and a written report was prepared. This report was reviewed and updated in November/December 1985, at which time a further written report was prepared for submission to the Applicant's executive. A supplementary report was prepared in May 1986.
  • (11) In May 1985 inquiries were issued and tenders invited from selected project managers and engineering firms for the design and construction of a rare earth processing plant.
  • (12) After adjudication of tender bids, on 28 June 1985 two wholly-owned subsidiaries of the Applicant (GGG Pty Limited and HHH Pty Limited) entered into an agreement with an engineering firm, III, to build on a turnkey basis a 12,000 tonnes per year rare earth processing plant complete with all ancillary facilities, equipment and services. The agreement was entered into ``on the basis that no work would commence without written authority from the joint venture partners''.
  • (13) In December 1985 the Applicant became a wholly-owned subsidiary of JJJ Company Limited (``JJJ Limited'') by virtue of that company's acquisition of all the issued shares of the Applicant.
  • (14) The Applicant has in all relevant years of income carried on the same business as it carried on immediately before the change in the beneficial ownership of its shares referred to in the preceding paragraph and the Applicant did not during any of the relevant years of income derive income from

    ATC 523

    a business of a kind that it did not carry on before that change in their ownership.
  • (15) A recommendation made by the project committee and contained in the Phase 2 report dated December 1985 was:
    • ``It is recommended that [the Applicant] and FFF Limited each seek Board approval in principle for the project, on the basis of the 12,000 to a plant scale, with design and construction to commence no later than August 1986 to enable production by July 1988.''
  • (16) The project did not receive Board approval and therefore was not commenced.
  • (17) Feasibility study expenses incurred by the Applicant were claimed as allowable deductions in the Applicant's income tax returns for the years of income ended 31 December 1984, 1985, 1986 and 1987. The carried forward loss arising from the claiming of feasibility study expenses as allowable deductions for the years of income ended 31 December 1984 and 1985 was claimed as an allowable deduction in the Applicant's income tax return for the year of income ended 31 December 1986.
  • (18) The Deputy Commissioner of Taxation (``the Respondent'') has allowed or agreed to allow as allowable deductions all the Phase 1 feasibility study expenses claimed by the Applicant for the year of income ended 31 December 1984.
  • (19) [Not relevant]
  • (20) The Phase 2 feasibility study expenses disallowed include the following salary and other employee expenses: 
      (a) Year of income ended 31
      -----------------------
      December 1984
      -------------
      (being 4/11th of the
      relevant salary and
      employee expenses for
      the period)

      Salaries                          $19,007.14
      Payroll tax                         1,179.88
      Superannuation                      1,835.62
      Workers compensation                   74.62
      Employee training                       4.36

  (b) Year of income ended 31
      -----------------------
      December 1985
      -------------
      Salaries                         $111,942.47
      Payroll tax                         5,297.96
      Superannuation                      8,874.27
      Workers compensation                  384.60
      Employee training                   4,060.00

  (c) Year of income ended 31
      ------------------------
      December 1986
      -------------
      Salaries                          $24,228.45
      Payroll tax                         1,150.86
      Workers compensation                  384.89
      Employee training                     760.73
                                       -----------
                                       $179,185.85
                                       -----------
  • (21) The salary and other employee expenses referred to in the preceding paragraph were incurred in relation to employees by the Applicant generally, not specifically in relation to the conduct of the Phase 2 feasibility study.

In his affidavit Mr MMM deposed as follows:

  • • He was employed by the Applicant (then known as DDD Pty Limited) from 1974 to 1986, firstly as Mine Manager at the sand mining operations at EEE in Western Australia, until 1979. He was then transferred to Perth office, initially as assistant marketing manager, then General Manager - Services and in 1984, General Manager, Research and Development.
  • • In February 1984, the Applicant and FFF Limited, a major Japanese chemical company, agreed to conduct a joint study of the feasibility of secondary processing of monazite, produced by the Applicant, to recover high purity rare earth oxides using new technology developed by FFF Limited. In consequence of this agreement, the witness became General Manager, Research and Development for the Applicant, assuming principal responsibility for carrying out the feasibility study. He reported directly to the Managing Director.
  • • In December 1985, during the course of this project, the Applicant, (then known as BBB Limited), was taken over by JJJ Limited and in consequence, the witness became Manager, Rare Earth Project, a position which he held until he left the employ of the Applicant in September 1986. During this period he reported to the General Manager of the Mineral Sands Division.
  • • This joint study was not the first time the Applicant had investigated monazite

    ATC 524

    secondary processing. In the late 1970s to early 1980s the Applicant, in conjunction with KKK Corporation (the Applicant's principal customer) carried out an investigation into opportunities for further monazite processing.
  • • Both investigations were undertaken by the Applicant in the context of and in compliance with obligations imposed on the Applicant pursuant to its agreement with the State of Western Australia for the mining and concentration of heavy mineral sands at EEE which was (eventually) ratified: The DDD Agreement Act (WA).
  • • The investigation with FFF Limited was undertaken in two discrete phases known as ``Phase I'' and ``Phase II'' respectively.
  • • Phase I was completed in June 1984, he being the person principally responsible for the written report. The purpose of the study was to take a broad look at the proposal, particularly at the issues of scale and location, with a view to establishing whether the proposed project had reasonable expectations of economic viability and to set firmer parameters for a more detailed study which would inevitably have to follow.
  • • Phase II was commissioned in September 1984 more accurately to determine the viability of the project and to serve as a basis for deciding whether to proceed with the development of the rare earth business. This study was completed in February 1985 and a written report prepared. He had principal responsibility for the preparation of the report.
  • • One of the major issues arising out of the Phase II report was the matter of environmental approvals. FFF Limited were not prepared to commit to the project until there was greater confidence that approvals would be granted. Following completion of the Phase II study further work continued on environmental aspects.
  • • In November/December 1985 the report was reviewed and updated, he being principally responsible for this.
  • • A supplementary report, for which he was principally responsible, was prepared in May 1986.
  • • He was engaged virtually full time on the project from the outset. He headed a core team comprised of a marketing person, a process engineer, a project engineer and secretary. From time to time other employees were seconded and sometimes people were hired for specific tasks. For some months FFF Limited employees were also working on the project.
  • • At the time of the study, the Applicant was selling monazite to KKK Corporation which was by far its biggest customer. Had the project proceeded, then the Applicant would have gone into competition with KKK Corporation in the market for selling rare earth oxides.
  • • In May 1985 tenders were invited from selected project managers and engineering organisations for the design and construction of the relevant plant.
  • • Prospective tenders were advised that the project was subject to formal approval by the Boards of both FFF Limited and the Applicant.
  • • Tender bids were received and III was selected as the preferred project manager. They were advised of this and that no work was to commence without prior written authority from the joint venture partners.

9. Among the evidence gleaned from the T documents is that the Applicant incorporated two separate companies specifically to call tenders for the construction of the plant. Should the Applicant and its then joint venturer have decided to proceed then those companies would construct and operate the plant acquiring raw material from both the Applicant and other sources, and market the product. Under these circumstances the Applicant would, subject to its existing sales contracts, supply its product as raw material to the new venture companies at market price.

10. Other evidence is that the respective Board approvals never eventuated and the project did not proceed.

11. It is relevant at this juncture to refer to relevant aspects of the schedule to The DDD Agreement Act (WA) which sets out the terms of the agreement entered into between the State of Western Australia and the Applicant (``the Agreement'').

12. The Schedule recites that the Applicant had established the existence of a heavy mineral sands ore body near EEE and that it had constructed, at a cost in excess of $1,000,000, a pilot plant at EEE to establish the methods to be

ATC 525

adopted in the mining, concentration and separation of the heavy minerals and the design engineering and economic feasibility of a mining and treatment project. Since then the Applicant has commenced the construction of a plant with a designed capacity to produce not less than 450,000 tonnes per year of heavy minerals, at a capital cost in excess of $16,000,000. Further, the Applicant then desired to mine and concentrate ore at EEE, to transport heavy mineral concentrates by rail to LLL for separation into heavy minerals and to transport heavy minerals to the port of Geraldton for shipment and that the Applicant had entered into long term contracts for the sale overseas of heavy minerals.

13. The recital goes on to say at paragraph (f):

``(f) the State requires the Company [that is, the Applicant], subject to the provisions of this Agreement, to pursue actively and progressively a policy leading ultimately to the processing in Western Australia of heavy minerals to the maximum degree possible.''

14. Relevant clauses of the Agreement, as indicated by Mr Edmonds for the Applicant, are:

``15(1)...

(2) Subject to the performance by the Company of its obligations under this Agreement and the Mining Act and notwithstanding any provisions of the Mining Act to the contrary, the term of the mineral lease shall be for a period of 21 years commencing from the date of receipt of application with the right during the currency of this Agreement to take successive renewals of the said term each for a period of 21 years upon the same terms and conditions, subject to the sooner determination of the said term upon the cessation or determination of this Agreement, such right to be exercisable by the Company making written application for any such renewal not later than 1 month before the expiration of the current term of the mineral lease.

...

20(1) The Company shall pay to the State in respect of all minerals mined or produced by the Company from the mineral lease and sold by it royalties at the rates from time to time prescribed under or pursuant to the provisions of the Mining Act.

...

21(1) At a time convenient to the Company but in any event not later than four years after the commencement date the Company shall investigate the technical and economic feasibility of establishing a plant for secondary processing to the maximum degree then practicable (but excluding therefrom heavy minerals the subject of existing contractual commitments) either by the Company alone or jointly with any other company or companies. The Company shall report in detail the progress and results of such investigations to the Minister not later than 90 days after the expiry of the period referred to in this subclause.

(2) The State may also undertake the studies mentioned in subclause (1) of this Clause and for that purpose the Company shall provide the State on a confidential basis with such information as it may reasonably be required but the Company shall not be obliged to supply technical information of a confidential nature with respect to processes that have been developed by the Company alone or with others or acquired from other sources and that is not generally available to the mineral sands industry.

(3) The Minister may consider the studies undertaken under subclauses (1) and (2) of this Clause and if the Minister is of the opinion that in all the circumstances then applying to the Company the establishment of a plant for secondary processing is technically and economically feasible and competitive on world markets, then the Minister may notify the Company of such decision. If so requested by the Company the Minister shall give to the Company all information obtained during such studies (other than information confidential to third parties).

(4) If the Company disagrees with the result of such studies and/or the Minister's decision thereon the Company shall have the right at any time within six months after the receipt of the Minister's notice to refer the matter to arbitration hereunder. If the Company shall agree that the establishment of a plant for secondary processing is technically and economically feasible and

ATC 526

competitive on world markets (in which case it shall so advise the Minister promptly) or if it shall be so determined by arbitration as aforesaid then the Company shall submit a proposal therefor in accordance with the provisions of Clause 7 of this Agreement, either alone or jointly with another company or other companies. Any such plant shall be in operation not later than three years after the date upon which the Company shall advise the Minister as to its agreement aforesaid or the date of the arbitration award.

(5) If-

  • (a) the Company on completion of its investigations within the period and in the manner outlined in subclause (1) of this Clause is of the opinion that the establishment of a plant for secondary processing is not technically and economically feasible and competitive on world markets and the Minister concurs; or
  • (b) the Minister shall disagree with such opinion but on a reference to arbitration in terms of subclause (4) of this Clause the award shall be in favour of the Company,

then the provisions of subclauses (1), (2), (3) and (4) of this Clause shall continue to apply mutatis mutandis but in relation to the next ensuing four years and so on during the term of this Agreement until such time as the Company shall become obligated in terms of subclause (4) to proceed with the establishment of a plant for secondary processing.

(6)(a) If the Company having become obligated in terms of subclause (4) of this Clause fails to submit proposals or to complete and commission a plant for secondary processing within the time and in the manner prescribed by that subclause, neither failure shall give rise to any action for breach of contract nor shall the provisions of Clause 32 apply but in either such event the State may give notice to the Company that it proposes to negotiate with any other person (in this Clause called `the third party') to establish a plant capable of subjecting the whole or any part of `the Company's surplus production' (as hereinafter defined in this Clause) to secondary processing on terms and conditions not more favourable on the whole to the third party than any terms available to the Company and notifying the Company that the whole or part of the Company's surplus production may be required for secondary processing after the date specified in such notice and may require the Company, during the period specified in such notice, not exceeding 12 months from the date thereof, to refrain from entering into any contract for the sale of the whole or any part of the Company's surplus production for delivery after the date specified in such notice.

...''

15. In the event that the State, pursuant to paragraph (a) of subclause 21(6), negotiates with a third party to establish a secondary processing plant, the State may, under paragraph (b) of that sub-clause, direct the Applicant to sell a significant proportion of its production, after allowing for existing contract requirements, to the third party. By paragraph (c) of sub-clause 21(6), the Applicant may be restrained from entering into fresh sale contracts with the possible consequence that its entire production may be directed to the other party's secondary processing plant.

16. In his affidavit Mr NNN deposes that he is currently company secretary of both the Applicant and JJJ Limited. Annexed to the affidavit are extracts from minutes of meetings of the Board of Directors' meetings of the applicant held on 10 March 1981, 9 July 1981 and 24 March 1986, extracts from the minutes of meetings of the Board of Directors of JJJ Limited for the period from January to September 1986, and a letter dated 28 February 1984 from the Applicant to the then Minister for Minerals and Energy.

17. The extracts from the Applicant's Board minutes do not assist the Tribunal except to say that they confirm that the Board was mindful of its obligations under the State agreement and was taking steps to comply.

18. The letter dated 28 February 1984 conveys facts about the Applicant's progress in investigating the feasibility of the rare earth study. The letter states that ``... [t]he plant would convert monazite into approximately 8000 TPA of rare earth chlorides. This material would be further processed to separate and

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purify the individual heavy rare earth oxides and a group of light rare earths''.

19. Under the sub-heading ``Process'' it states:

``The process involves the following stages:

  • • Cracking of monazite with caustic soda to form rare earth and thorium hydroxides, and removal of the phosphates.
  • • Dissolution of the rare earth hydroxides in acid, followed by filtration of the insoluble thorium hydroxide from the rare earths.
  • • Solvent extraction to produce a heavy rare earth fraction and a mixture of light rare earth chlorides.
  • • Ion exchange separation to recover individual heavy rare earth oxides.''

20. The extracts from the JJJ Limited Board minutes of 23 January 1986 make reference to the fact that on the basis of assumptions made in the study by the Applicant, the project was viable but it expressed reservations about the marketing of the plant's production since it was a ``very specialised market'' dominated by KKK Corporation (its customer). The rest of the extracts point to negotiations with KKK Corporation about the possible future construction of such a plant and about revision of the price for which the Applicant sells its monazite to KKK Corporation. The minutes indicate that in the end the price for monazite was increased subject to KKK Corporation agreeing to construct a rare earth plant in Western Australia, an outcome which could not have been foreseen by the Applicant when it embarked on the feasibility studies in question, a point accepted by Mr Edmonds for the Applicant.

21. It is apparent from this letter and other evidence that by then, January 1986, FFF Limited had withdrawn from negotiations to be a joint venture partner in the proposed development.

The submissions

22. In essence, the Applicant's submission is that it was required, as one of the many conditions of the Agreement, and pursuant to the carrying on of its business, to undertake the feasibility studies, with a continuing obligation to do so and report every four years until such time as secondary processing was judged to be viable. Once that occurred then any costs in bringing about an expansion of the business by construction of the secondary processing plant would be of a capital nature. But the Applicant, in meeting the ongoing obligation under the Agreement to investigate and report on the feasibility of secondary processing, was incurring working expenses of a revenue nature, inextricably linked to its business undertaking.

23. On the other hand the Respondent submitted, in essence, that the feasibility study expenditure was of a capital nature, incurred in investigating a possible expansion of the profit- yielding structure of the business, by way of investment in a totally new structure, and not in the course of carrying on its established business of mining, processing and marketing operations. It was submitted that the product under investigation was entirely different and would be produced quite independently and sold into entirely different markets from that of the Applicant's existing business.

24. Mr Edmonds directed the Tribunal to several cases which he maintained supported the claimed deductions for feasibility expenses under s. 51(1). Had the Respondent treated these expenses, incurred in the December 1984, 1985 years, as allowable then they would have culminated in a deduction for a carry forward loss pursuant to s. 80 in relation to the year ended 31 December 1987 together with a deduction under s. 51(1) for the feasibility expenses incurred that year. Therefore the Tribunal is asked to consider the deductibility of the expenses in terms of s. 51(1), since a finding that they meet the criteria of that subsection would automatically give rise to the deduction claimed under s. 80.

25. Subsection 51(1) of the Act states:

``51(1) [Deductions for losses and outgoings] All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.''

26. Mr Edmonds relied to some extent on the decision of the Federal Court (Full Court)
FC of T v Ampol Exploration Ltd 86 ATC 4859;

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(1986) 13 FCR 545 and sought to distinguish the Applicant's case from the decision of the Supreme Court in Victoria in
Softwood Pulp and Paper Ltd v FC of T 76 ATC 4439 and of the Federal Court in
The Griffin Coal Mining Company Ltd v FC of T (Lee J) 89 ATC 4745; on appeal (Wilcox and French JJ; Davies J dissenting) 90 ATC 4870. Other cases cited in the course of his submissions are considered in context.

27. In Ampol Exploration the taxpayer was engaged in exploration for hydrocarbons and claimed, as deductible under s. 51(1) of the Act, expenses incurred in respect of exploration off the China coast, pursuant to an agreement with an agency of the Chinese Government. The only prospect in this exploration was to be the chance of participation in further exploration, for reward. The taxpayer had assigned its rights under the agreement in exchange for rights to a fee. The assignee was 90 per cent owned by the taxpayer and 10 per cent owned by a major shareholder of the taxpayer. The Supreme Court of New South Wales allowed the deduction as to expenses after the date of assignment only. The Full Court (Lockhart and Burchett JJ, Beaumont J dissenting) dismissed the appellant Commissioner's appeal and allowed the taxpayer's cross-appeal finding that the total expense was deductible under both limbs of s. 51(1) and none of the expense was of a capital nature.

28. In the course of his judgment in Ampol Exploration Lockhart J observed, in relation to deductions under s. 51(1) that they must be ``incidental and relevant'' in the context of the business operations and:

``[t]he outgoings must be connected with the operations which gain or produce the assessable income.

As to the second limb, there must be a nexus between the expenditure and the carrying on of the relevant business. The word `necessarily' means in this context `clearly appropriate' or `adapted for'.''

(at ATC 4869; FCR 558)

His Honour found that:

``... the role of the taxpayer in the Chinese venture was perceived by those who control its affairs as a commercially sound method of carrying on its exploration business and as part of its ordinary business activities. They were seeking a profit opportunity.... The expenditure could not lead to the establishment of an income-producing asset. Nor could it lead to ownership of oil or gas resources.''

(at ATC 4870; FCR 559)

These findings were critical to his Honour's finding that in consequence:

``... the whole of the taxpayer's [ exploration] expenditure... was necessarily incurred in the carrying on of the taxpayer's business of petroleum exploration and is deductible under the second limb of subsec. 51(1). This finding is based on the particular facts and circumstances of this case including the unusual nature of the enterprise established by the Chinese Government and the international petroleum exploration companies to conduct the exploration activities off the Chinese coast.... Exploration or prospecting activities... are the kinds of activities in which a prospecting company engages...''

(at ATC 4870; FCR 560)

In his concurring judgment Burchett J observed:

``An oil exploration company does not expend its moneys upon, for example, seismic surveys, with any expectation of obtaining thereby an enduring asset, but upon the basis that if it engages in efforts of that kind often enough, whilst exercising what judgment the nature of the pursuit permits, one of its outlays may eventually yield a rich return.... From a practical and business point of view, the outlay was calculated to carry that business purpose into effect. (at ATC 4882; FCR 575)

...

In my view, the relevant business of the respondent was the discovery and exploitation of oil, to which the seismic survey expenses were incidental. Their purpose was not to enlarge the framework within which that activity was carried on; they formed part of the activity. They were within the wide class of things forming the constant demand upon the enterprise of which Dixon J. spoke in the Sun Newspapers case.''

(at ATC 4884; FCR 577)

29. We understand the submission of the Applicant to be that these passages are of assistance. It was submitted as an agreed fact that the Applicant was obliged by a requirement of the Agreement, specifically clause 21, to undertake feasibility studies and report the

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results to the government of the day. It was not obliged to do anything more. Once its investigations revealed that a commercially viable secondary processing plant could be established then that was the end of the matter. It was another thing entirely whether the Applicant would decide to construct that plant either alone or jointly with another or others. If it should decide to proceed then it would be as a result of that decision that the Applicant would commence a new business and incur capital expenditure. Hypothetically, so long as each four-yearly report concluded that secondary processing was not then viable, the Applicant was obliged to continue to investigate the feasibility of the secondary processing plant and report again in four years and so on for the duration of the Agreement, or at least that was the position at the relevant time. Mr Edmonds pointed out that subsequent to the relevant years of income, The DDD Agreement Act (WA) was amended and although in his view it is not relevant, clause 21 of the Schedule was amended to delete the reference to ``four years'' and insert instead a requirement that the Applicant should report by 31 December 1992 on its investigations of the technical and economic feasibility of establishing a new plant for secondary processing to the maximum degree then practicable.

30. Further submissions directed the Tribunal's attention to the heralded tests of Dixon J in
Sun Newspapers Ltd v FC of T (1938) 5 ATD 87 at 96; (1938) 61 CLR 337 at 363, as to the distinction between a capital and revenue outgoing for the purposes of s. 51(1) of the Act, the Applicant submitting that the expenditures in question do not meet those tests - firstly, the advantage sought by the expenditure was to meet an ongoing requirement of the Agreement not, it was submitted, as expenditure preparatory to the establishment of new plant; secondly, the advantage, being merely to continue to mine and process the ore or maintain the status quo, gave rise to no enduring benefit. This proposition holds even if the studies reveal (as indeed they did) the prospect of a commercially viable secondary processing operation; and thirdly, the actual (and prospective) feasibility studies required periodic outlays and were not achieved by a once and for all payment; until a certain finding resulted the Applicant was obliged to incur the expenses regularly and the character of the individual components of expenditure was periodic, for example salaries and wages of employees.

31. As regards this submission, the Tribunal merely observes at this stage that if it were accepted then it seems that there would be a basis for apportionment of the expenditure, namely to treat as separate that portion of the expenses incurred up to the point of deciding that there was a prospect of a commercially viable secondary processing enterprise, on the one hand, and, on the other, that portion incurred subsequently, for example in preparing tender documents, in calling and reviewing tenders and in notifying tenderers of the outcome of their tenders. On the basis of the submissions the former would be a revenue expense and the latter would be expenditure of a capital nature - not being expenditure strictly required to meet the obligations under clause 21 of the Agreement, but going beyond that requirement and having all the trappings of expenditure preparatory to embarking on asset expansion to facilitate a new arm of business.

32. However, the Tribunal finds that the Applicant is not assisted by the decision in Ampol Exploration since, unlike the taxpayer in that case, the Applicant was not pursuing the investigation of an activity in which it was already established - a fact which was fundamental to the majority judgments of the Full Court as indicated above.

33. The Tribunal has considered the submissions of Mr Buss for the Respondent and for the following reasons adopts them in principle but with certain reservations concerning the outlays for salaries as detailed at paragraph 20 of the agreed facts.

34. The Respondent's primary submission was that the business of the Applicant was, at all material times, that of mining mineral deposits at EEE and processing these to produce mineral sands, and monazite in particular, for sale. It was these operations alone which gave rise to the Applicant's assessable income (with the possible exception of investment income which is unrelated to the present matter). It was submitted that the feasibility study expenditure is properly characterised as of a capital nature, neither incidental nor relevant to the operations by which the Applicant derived its assessable income. Indeed, should the Applicant not have incurred the expenditure in question its

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assessable income would have been unaffected. The expenditure neither contributed in a temporal sense to the Applicant's assessable income for any of the years of income in which it was incurred nor could it prospectively enhance the assessable income to be derived by the company in the future from its then established business enterprise. At best, should the Applicant decide to use the knowledge gained from the studies and carry out the necessary capital works then it would begin to derive income from a new source and from a new enterprise. It was submitted that the feasibility studies were not an investigation into a possible extension of the existing business but rather an investigation into an entirely new business which would be in full competition with its then major customer. It would have resulted in the Applicant entering into an entirely new market - the supply of processed monazite rare earths. The fact that the expenditure was incurred pursuant to a condition of the Agreement and did not culminate in any further investment does not alter the character of the expenditure which is inherently of a capital nature.

35. Mr Buss referred the Tribunal to several cases in support of these submissions.

36. In particular, the Tribunal is guided by the decision of the Full Federal Court, on appeal, in
Griffin Coal Mining Co Ltd v FC of T 90 ATC 4870 (Wilcox and French JJ; Davies J dissenting), whose facts seem more closely aligned to the present facts than do those of Ampol Exploration (supra). The headnote provides a sufficient summary of the facts:

``The taxpayer company carried on a coalmining business in Western Australia. It essentially supplied coal to the State Energy Commission of Western Australia (`SECWA'). In March 1979 the taxpayer contracted to sell coal to SECWA for 25 years. In November 1979 the taxpayer made an agreement with the State of Western Australia which trebled the coalmining leases under the taxpayer's control subject to keeping substantial holdings to satisfy the present and future needs of SECWA. During 1981, 1982 and 1983 various disputes between the taxpayer and SECWA arose which were resolved after involving litigation.

As at July 1980 the prospect of the taxpayer developing its coalmining operations beyond the level required for SECWA was very limited. In 1983 the taxpayer decided to try to diversify its mining activities to lessen its financial dependence on SECWA. Accordingly, the taxpayer expressed interest in becoming involved in a project to construct an aluminium smelter in Western Australia. The taxpayer indicated that it would be willing to supply the coal to meet the energy needs of the smelter at little or no profit, perhaps even at a loss, provided that it was given an equity interest in the project.

In August 1984 the taxpayer and two other companies formed a consortium to build an aluminium smelter and to conduct a feasibility study to determine the construction and operating costs of the smelter and to assess the environmental consequences of the project. The consortium also commissioned an evaluation of the taxpayer's study into supplying coal for the project. In the meantime, the taxpayer continued with its own feasibility study into the project, including investigating the prospects of obtaining alumina and marketing aluminium metal. The taxpayer also used various consultants to advise on matters such as industrial relations, finance, environmental issues and the negotiation of a joint venture agreement. In January 1985 the Western Australian Development Corporation joined the consortium, but it was dissolved in June 1985 following the withdrawal of the two companies other than the taxpayer.

At all times the taxpayer's accounting records maintained a distinction between the costs incurred in respect of the proposal for a coal supply contract relating to the proposed aluminium smelter and the costs incurred in assessing the feasibility of, and obligations arising under, participation in a joint venture to construct the smelter. Some of the costs were directly incurred by the taxpayer and some were its share of the costs incurred by the consortium.

For the 1985 income year, the Commissioner allowed the taxpayer a deduction of $774,000 for expenditure on the study and investigation of the possibility of coal sales to the proposed smelter, but disallowed a deduction of almost $1.44m for `smelter feasibility study costs'. The

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taxpayer's objection was also disallowed by the Commissioner and it appealed to the Federal Court.

Lee J. at first instance dismissed the taxpayer's appeal holding that the smelter feasibility study costs were part of the cost of a new source of income and not incurred in producing assessable income or necessarily incurred in carrying on the taxpayer's existing coalmining business for the purposes of producing assessable income....''

37. Before considering the majority judgment of the Full Federal Court it is useful to consider the gravamen of the dissenting judgment of Davies J in this regard. His Honour, after discussing selected case law concerning the vexed question of the distinction between revenue and capital expenditure for the purpose of s. 51(1) of the Act, and observing that the case is a marginal one, said:

``... I have come to the view that the expenditure was essentially devoted to the improvement of Griffin's coalmining business, and was directed to attaining both tangible and intangible business objectives. The activity which gave rise to the expenditure improved Griffin's relationship with its major purchaser,...''

(at 4871)

38. Pausing there for a moment, the Tribunal notes that the evidence in the instant case is that should the Applicant have proceeded with the development of a secondary processing plant then it would have resulted in going into direct competition with its major customer, KKK Corporation, quite the opposite effect to that observed by Davies J.

His Honour continued:

``... [the expenditure] was directed primarily, though in the end unsuccessfully, to obtaining market for coal from mines which Griffin wished to develop. The expenditure arose out of and reflected Griffin's perceived need to obtain an enhanced market which would enable it to exploit its existing coal reserves and was a revenue-type activity. The expenditure was not expenditure of capital and was not of a capital nature. What it achieved, in addition to the intangible benefits I have mentioned, was information about a possible venture which, had it come to fruition, would have provided the market which Griffin sought. The expenditure was not itself directed to or appropriated for the acquisition of a capital asset. The activity was too preliminary for that. The time for capital expenditure had not arisen and did not arise.''

(at 4872) [ Emphasis added]

39. In the instant case the evidence shows that the Applicant would not have increased its production or sales of its existing product, monazite, should the secondary processing plant have eventuated, but instead, it would have diverted it away from its existing major customer, KKK Corporation, to the secondary process to produce a different product. There was no evidence that the existing mine output would have expanded; rather, the evidence is that the new plant was designed to take not only the Applicant's existing output at market price but additional supplies from other sources as well. And the evidence further suggests that had the Applicant gone into secondary processing then, when its present sales contracts had expired, its major customer KKK Corporation would have had to find an alternative supplier. Accordingly, in the Tribunal's opinion because the facts of the present case are distinguishable from those in Griffin Coal, Davies J's remarks are of no assistance to the Applicant.

Lee J, at first instance, in Griffin Coal (89 ATC 4745) said:

``The outlays and the various preliminary matters relating to the assessment of that proposition were all calculated to carry that business purpose [ie. to diversify its operations by seeking to become a joint venturer in the operation of an aluminium smelter] into effect. Notwithstanding that in the end the venture did not proceed, the expenditures were designed to secure an acquisition of a means of production and to establish a new element of Griffin Coal's business or, indeed, a new business to be conducted by another member of the Griffin group of companies. The fact that the venture did not proceed did not prevent the expenditure being of a capital nature. (See
Softwood Pulp and Paper Ltd. v F.C. of T. 76 ATC 4439.)

...

The object of the expenditure was to establish a new arm of the business of Griffin Coal and a new source of income

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and the outgoings were stamped with that character accordingly.''

(at 4760)

On appeal, Wilcox and French JJ expressly adopted (90 ATC at 4888) the following conclusion of Lee J at first instance (89 ATC at 4759):

``It must be concluded that the subject expenditure incurred by Griffin Coal was part of the cost of formation of a new source of income and that the expenditure was not an aggregation of outgoings necessarily incurred in carrying on the existing business for the purpose of producing assessable income from the conduct of that business.''

Their Honours, in relation to the second limb of s. 51(1), (commonly called ``the business limb''), also agreed with Lee J's characterisation of the expenditure as follows:

``the relevant expenditure was not necessarily incurred in carrying on the business of extraction and sale of coal; but, rather, in seeking to acquire an asset to be used in an expanded business of the company or in a business to be conducted by another member of the group... the outgoings were not expenses necessarily incurred in carrying on the existing business of Griffin Coal.''

(at 4888)

40. Similarly the Tribunal concludes in this case that the Applicant's feasibility study expenditure in question was not necessarily incurred in carrying on its business, in the sense that it was neither incidental or relevant to, nor dictated by, the business end to which the Applicant was directed, that being the sale of its processed mineral sands product, monazite. The expenditure is more appropriately characterised as costs incurred in investigating a diversification of the business and the prospective entry into an entirely new market. The fact that the expenditure was dictated by a need to comply with a condition of the Agreement, whilst seen as an exigent and unavoidable outlay of the business, was not directed to the working of the mine or the processing of the ore into the product the Applicant was then selling. Nor was the expenditure incidental or relevant to the conduct of that business in the sense that had it not been incurred then the existing business would have been jeopardised. Such a breach of the Agreement would not be sufficient, of itself, to void the contract under clause 32 of the Schedule to the Agreement.

41. Counsel for the Applicant submitted that the Applicant's expenditure on employee salaries and on-costs, as detailed at paragraph 20 of the Statement of Agreed Facts should be classified in the same way as all the other expenditures associated with the feasibility study. The Tribunal now turns to consider whether, in this respect, an exception to the above finding is appropriate.

42. The evidence is that Mr MMM was devoted almost full time to the project at all material times, (affidavit paragraph 10). The statement of agreed facts, at paragraph 21, states in relation to the salary and other employee expenses set out in paragraph 20 of the agreed facts, which totalled $179,185.85, that these ``were incurred in relation to employees... generally, not specifically in relation to the conduct of the Phase 2 feasibility study'', a fact ostensibly supported by T documents p254 which is a copy of a working paper used to allocate expenses to the project.

43. The $179,185.85 is an allocation of salary, wages and oncost expenses actually incurred by the Applicant generally, presumably made to maintain costing records because of the joint cost sharing nature of the project, FFF Limited, at that time being the co- joint venturer, (affidavit paragraph 2).

44. Ongoing salary and wages costs of employees engaged in administration and management activities of a business are inherently of a revenue nature, being repetitive, regular and periodic. How such costs are accounted for to enable the preparation of meaningful accounting reports to assist management or comply with statutory requirements is of no consequence for income tax purposes, c.f.
FC of T v Citibank Limited & Ors 93 ATC 4691. With the possible exception of the salary of a person specifically recruited to perform a discrete task with no ongoing tenure (like the expense of a contract to provide a particular service), employee costs generally are working expenses and of a revenue nature. The characterisation of the exception is determined by reference to the nature of the task performed - should it be, for instance, to investigate better marketing techniques then the remuneration or contract expense would be of a revenue nature. On the other hand, should the task be to explore new products and markets then the expenditure would be capital in nature. RW Parsons, in Income Taxation in Australia,

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Law Book (1985), (at p 450) when discussing recurrence of expenses in the context of their classification states:

``The significance of `recurrence' in the more restricted meaning the word carries where the question is whether an expense is a working expense supports the view... that the exception of losses or outgoings of a capital nature in s 51(1), like the other exceptions in the subsection [i.e. private and domestic expenses] is not a true exception. Deductibility depends on an expense being relevant to the derivation of assessable income and on its being a working expense. In whatever way losses or outgoings of a capital nature are identified in other respects, only one basis of identification is significant: a capital expense is a non- working expense.''

45. The Tribunal is of the view that, subject to the possible exception mentioned, the expense of permanent employee remuneration in a business is, by its very nature, a working expense and this holds regardless of how the employer directs that employee to devote his/ her time. The evidence does not suggest that in this instance, despite the fact that Mr MMM did devote most of his time to the feasibility study, that he was employed only for that purpose. On the contrary his affidavit clearly states that he was taken from other duties to head the study team. His salary is properly classified as an ongoing working expense of the Applicant and therefore a revenue expense. It follows that the rest of the salary, wage and oncost expenses, as detailed at paragraph 20 of the statement of agreed facts are similarly working expenses of a revenue nature and deductible under s. 51(1) of the Act, albeit that in any event the superannuation contributions are deductible under a different head. This conclusion is consistent with the Full Federal Court's decision in
Associated Minerals Consolidated Limited v FC of T 94 ATC 4499 which found that the salaries paid to the taxpayer's staff engaged specifically for the purpose of dismantling and removing an item of disused plant were part of the regular cost of conduct of the business and that such expenditure was incurred on revenue account. This followed the decision of Lee J, at first instance, who allowed expenditure for wages of staff involved in the dismantling exercise despite finding that the rest of the expenditure was not allowable because it had the character of capital. His Honour cited in support the decision in
Goodman Fielder Wattie Limited v FC of T 91 ATC 4438 at 4453-4454; (1991) 29 FCR 376 at 394-395, a decision which the Full Court also cited with approval.

46. Mr Buss for the Respondent directed the Tribunal's attention to the New Zealand High Court's decision in
The Christchurch Press Company Ltd v Commissioner of Inland Revenue (1993) 18 TRNZ 43 which discusses the question of the nature of salaries. With respect, in the light of the equivocal conclusions there reached and our previous discussion on this aspect of the case the Tribunal is not persuaded to alter its conclusion on this aspect of the present case.

47. In passing, the Tribunal notes that by reference to paragraph 14 of the statement of agreed facts, the provisions of s. 80A of the Act were satisfied at all material times and the deductions allowable under s. 51(1) and s. 82AAC in the years of loss are allowable under s. 80 in the year of income, that is, the year ended 30 June 1987.

The penalties

48. The Applicant objected to the level of penalties imposed as a result of the Respondent's officers having carried out an audit of the Applicant's relevant income tax returns and making amendments, some of which are now under review. The penalty was calculated at the rate of 15 per cent per annum for the ``culpability component'' plus the standard ``interest component'' of 14.026 per cent. The Applicant does not object to the interest component, merely the culpability component.

49. Questions of whether an outgoing is of a revenue or capital nature range from the obvious (such as expenditure on plant and equipment being capital and on office stationery being revenue) to the not so obvious. The present issue falls into the latter category.

50. Under the income tax law as it prevailed at the time when the Applicant lodged the relevant income tax returns for the years of income preceding the years in question, and those for the years in question, such returns were assessed by an officer of the Respondent and a notice of assessment of taxable income and tax payable would issue which may have differed from the taxable income as disclosed.

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Those adjustments resulted from disclosures made in the returns or from other information in the possession of the Respondent.

51. The Act then required taxpayers to disclose material information which would enable a proper assessment of the taxpayer's taxable income. The Respondent could impose additional tax by way of penalties under the Act where material facts or information were omitted, misleading or incorrect. These penalties, potentially up to 200 per cent of the tax assessed on the deficient aspect of the return, act as a deterrent against concealment or vague or inadequate material disclosures which would stand in the way of a proper assessment of tax.

52. A perusal of the T documents in this case indicates that no separate disclosure was made by the Applicant in any of the relevant years' income tax returns. The Applicant claims that the amounts in question are of a revenue nature and therefore it was not necessary to make any specific reference to the expenses, which presumably are embedded in items of expenditure within the various years' profit and loss accounts. It is observed that, compared to the quantum of expense claimed in the return and the assessable income disclosed, the amounts disallowed for each respective year, whilst large in an absolute sense, are comparatively minor in a relative sense. The only relevant disclosures appear in the 31 December 1985 year end accounts directors' report and note, relating to capital commitments, where reference is made to negotiations by subsidiaries to construct a rare earth processing plant - not the sort of disclosure which would alert the assessor of the Applicant's return to the present dilemma.

53. Whilst recognising that one can always be wise after an event, it seems to the Tribunal that the question of whether the claims in dispute were clearly allowable deductions or not is, at best, equivocal. These proceedings are testimony to the nature of the difficulties encountered in making the right decision in this respect. Therefore, in the circumstances there was an onus on the Applicant to at least draw the attention of the Respondent to the expenditure claimed. Failure to do so left the Respondent completely in the dark over what has turned out to be a less than obvious classification of the expense. The Tribunal notes that the return was prepared by a well known tax agent but there is nothing in the returns to indicate that the agent had any inkling of the nature of the expenditure in question.

54. Whether penalties should be imposed requires a judgment as to whether it was reasonably open to the Applicant to conclude unequivocally that the expenditure was deductible and therefore make no particular reference to it in the returns or, on the other hand, to recognise that it was possible that the revenue authorities may have come to a different conclusion (as indeed they eventually did).

55. The Tribunal attributes a degree of culpability to the Applicant for failing to at least identify the expenses separately in the returns, but at the same time it recognises that it was open to the Applicant to maintain that the expenditure was of a revenue nature.

56. In arriving at the culpability component of the penalty imposed, the Respondent had regard to its income tax ruling IT 2517 guidelines. The Tribunal, by reference to the table at paragraph 41 of that ruling, and having regard to the considerations relevant to this decision, considers that this is a case involving a ``contentious issue'' and ``minor carelessness'' rather than deliberate concealment. The ``contentious issue'' category is described in paragraph 19, so far as relevant, as ``... where, although the principles of law are settled, there is a serious question about the application of those principles to the circumstances of the particular case''.

57. The range of culpability penalty for cases of minor carelessness is from 5 per cent to 15 per cent and for contentious issue cases up to 5 per cent. The Tribunal takes the view that this is a mix of both and therefore, believing that this is not a case which warrants the maximum penalty, adopts 10 per cent as appropriate.

The decision

58. For the above reasons and pursuant to s. 43 of the Administrative Appeals Tribunal Act 1975, and s. 14ZZJ of the Taxation Administration Act 1953, the reviewable objection decisions under review are varied to the following extent:

  • 1. That the claims for superannuation contributions for the years ended 31 December 1984 and 1985, as specified at item 20 of the Applicant's Amended

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    Statement of Facts, be allowed pursuant to s. 82AAC of the Act;
  • 2. That the balance of the amounts in respect of salaries, wages and on costs as specified at item 20 of the Applicant's Amended Statement of Facts be allowed pursuant to s. 51(1) of the Act;
  • 3. That the resulting carry forward loss for the year ended 30 June 1987 be allowed pursuant to s. 80 of the Act; and
  • 4. That pursuant to s. 227(3) of the Act, the culpability component of the penalty imposed pursuant to s. 223 of the Act be reduced from 15 per cent per annum to 10 per cent per annum.
  • 5. In all other respects the objection decisions are affirmed.

(Ref No WT94/2-3)


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