ESSO AUSTRALIA RESOURCES LTD v FC of T

Judges:
Sundberg J

Court:
Federal Court of Australia

Judgment date: 12 May 1997

Sundberg J

Background

Before me are six appeals by the applicant (``the taxpayer'') relating to its years of income ended 31 December 1979 to 31 December 1984 inclusive. In its income tax returns for those years the taxpayer claimed certain deductions which the respondent (``the Commissioner'') disallowed. In one year the Commissioner included an amount in the taxpayer's assessable income which the taxpayer claims is not assessable.

The appeals involve five issues, most of which are common to a number of years. The first relates to exploration and prospecting costs. The question here is whether costs incurred in exploring and prospecting for coal and oil shale are deductible under Division 10AA of the Income Tax Assessment Act 1936 - ``Prospecting and Mining for Petroleum''. That depends on whether exploring and prospecting for these commodities is exploring and prospecting for ``petroleum'' as that word is defined in the Act. The second issue concerns the deductibility of review, evaluation and bidding costs. The questions here are whether the taxpayer is entitled to a deduction under s 51(1) for costs incurred in relation to potential coal, oil shale and mineral prospects, and whether it is entitled to a deduction under s 77 for amounts incurred in reviewing and evaluating potential gold tenements. The taxpayer did not in fact acquire any tenements. The third issue concerns an amount received by the taxpayer from a joint venture partner in respect of deep water mining technology which the taxpayer put at the disposal of the joint venture. The question here is whether the amount is assessable income under either s 25 or s 26(a). The fourth issue relates to the two instalments of an ``operatorship assumption payment'' which the taxpayer says secured to it the right to become operator of a joint venture. The question is whether it is entitled to a deduction for those instalments under s 51(1). The final issue concerns the deductibility of tenement acquisition costs where the tenements the taxpayer had hoped to mine for coal, oil shale, other minerals and gold were abandoned. So far as mineral tenements are concerned, the issue arises under s 122K in Division 10 - ``General Mining''. So far as coal and shale tenements are concerned, the issue arises under Division 10 if they are minerals and under Division 10AA if they are petroleum. In other words the Division which is applicable depends

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on the ``petroleum'' question raised by the first issue. So far as gold tenements are concerned, the issue arises under s 77.

The parties have agreed upon the amounts involved if any of the claimed deductions is allowed, and if the technology payment is assessable.

The taxpayer

At all relevant times the taxpayer (then named Esso Exploration and Production Australia Incorporated) was a wholly owned subsidiary of Esso Eastern Inc (``Esso Eastern''), and was resident in the United States. Esso Eastern was an affiliate of Exxon Company USA (``Exxon''). The members of the taxpayer's board were employees of Esso Eastern, and lived in Houston, Texas, where the board's decisions were made.

The taxpayer had significant operations in Australia, one of them being the oil and gas fields in Bass Strait. All ``upstream assets'' relating to exploration for and production of oil, gas, coal, gold, semi precious and base metals were owned by the taxpayer, but management and labour services were supplied to the taxpayer under a service agreement with Esso Australia Limited (``EAL''), an Australian resident company the principal activity of which was operating a refining and marketing business. The taxpayer's budget and corporate planning data were prepared by EAL and submitted to the taxpayer's board in the form of recommendations.

Under its reporting obligations to Esso Eastern, the taxpayer had to obtain approval from that company for certain proposed activities. Further, where the amount of money involved in a project was sufficiently large, and the project had other ``special features'', approval from Exxon was required. For example, Exxon's approval was required for the use, in a joint venture, of deep water drilling technology developed by another Exxon affiliate, Exxon Production Research Company, and used by the taxpayer under licence.

Exploration and prospecting for coal and oil shale

In each of the years 1980 to 1984 the taxpayer claimed deductions for expenditure incurred on exploration and prospecting for coal and oil shale. The total expenditure was $13,554,137: $3,055,142 for 1980, $4,462,837 for 1981, $3,514,665 for 1982, $1,887,007 for 1983 and $634,486 for 1984.

The claims were made under s 124AH(1) which is in Division 10AA. At the relevant times s 124AH(1) provided:

``Subject to this section, expenditure incurred by the taxpayer during the year of income on exploration or prospecting in Australia for the purpose of discovering petroleum is an allowable deduction.''

The word ``petroleum'' was defined in s 6(1), as it is now, as:

"(a) any naturally occurring hydrocarbon, whether in a gaseous, liquid or solid state;

(b) any naturally occurring mixture of hydrocarbons, whether in a gaseous, liquid or solid state; or

(c) any naturally occurring mixture of one or more hydrocarbons, whether in a gaseous, liquid or solid state, and one or more of the following, that is to say, hydrogen sulphide, nitrogen, helium and carbon dioxide,

and includes any petroleum as defined by paragraph (a), (b) or (c) that has been returned to a natural reservoir."

The question is whether in conducting exploration and prospecting activities for coal and oil shale, the taxpayer was exploring or prospecting for a naturally occurring hydrocarbon, a naturally occurring mixture of hydrocarbons, or a naturally occurring mixture of one or more hydrocarbons and one or more of hydrogen sulphide, nitrogen, helium and carbon dioxide.

Naturally occurring hydrocarbons

Coal and oil shale are not themselves hydrocarbons, though hydrocarbons can be obtained from them by pyrolysis and by hydrogenation. Pyrolysis involves subjecting the coal or oil shale to heat, usually without the aid of additional reagents. This causes the chemical bonds in the coal or oil shale to break, and chemical compounds not previously present in the coal or shale are created (Ex U par 34 n 27, par 40; Ex S pars 4.4.4, 4.5.4; Ex T pars 11, 26.1). Hydrogenation (the addition of hydrogen) is a process involving a chemical reaction between the coal or shale and molecular hydrogen at high temperature and under relatively high pressure, ordinarily in the

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presence of a catalyst. The chemical reaction involves the breaking of the chemical bonds of the original material (Ex T, Table 2). A ``naturally occurring'' substance is one that occurs in nature. It is to be contrasted with a substance which is the product of a conversion process involving human intervention. All but one of the taxpayer's expert witnesses accepted that pyrolysis involves a manufacturing process, and that the hydrocarbons produced as a result are synthetically made and therefore not ``naturally occurring''. All accepted, either expressly or by necessary implication, that the hydrocarbons produced as a result of hydrogenation are synthetically made and therefore not ``naturally occurring''.

Thus Dr Stuntz, an inorganic chemist, agreed that while the hydrocarbons which are produced by catagenesis under the earth's surface are ``naturally occurring'', since they come about without the intervention of man, the application of man-made processes to sources of organic material results in a synthetic product. He accepted that it is not apt to describe synthetic fuels (synfuels) produced by the application of pyrolysis to coal and shale as ``naturally occurring''. Nor is it apt to describe the hydrocarbons which constitute those synthetically created fuels as naturally occurring hydrocarbons (244). (Numbers in parentheses refer to pages in the transcript of evidence.) Although in this part of his evidence he did not mention hydrogenation, it necessarily follows from the fact that hydrogenation is a man-made process (the addition of hydrogen) that hydrocarbons so produced are not naturally occurring.

Stephen Larter, a professor of geology, was of the opinion that the expression ``naturally occurring'', in relation to hydrocarbons, refers to substances which occur in nature as opposed to those which are the product of a conversion process involving human mediated use and the application of heat or chemical action which changes the chemical composition of a substance that has been removed from the earth (Ex 28 par 14). In cross-examination he agreed that pyrolysis and hydrogenation are manufacturing processes, because they involve man's treatment of organic matter, and ``in that sense the product or the outcome of pyrolysis and hydrogenation cannot be said to be a naturally occurring hydrocarbon''. ``Naturally occurring is to be understood as meaning... as distinct from manufacture'' (315).

Professor Murchison, a former professor of organic petrology and now a geological consultant, agreed with the view Professor Larter had expressed in par 14 of Exhibit 28 as to the meaning of ``naturally occurring'' in relation to hydrocarbons. He said that if there has to be an interference by man with the process, it can no longer be regarded as being naturally occurring. Pyrolysis and hydrogenation are manufacturing processes (280).

Dr Neavel, a consultant in coal quality and quality assurance, took ``naturally occurring'' to mean substances that exist in nature without the intervention of humans. When the expression is linked with the term ``mineral'', it refers to substances arising from processes that operate in the natural development of the earth's crust (Ex 34 par 9). In cross- examination Dr Neavel agreed that pyrolysis conducted by man is not a natural process but a man-made manufacturing process. He regarded synfuels created from coal by pyrolysis and hydrogenation as synthetically created. The hydrocarbon compounds within those synfuels are created synthetically by man-made intervention. As opposed to this, an accumulation of natural gas or a reservoir of crude oil constitutes an accumulation of naturally occurring hydrocarbons and hetero- atomic compounds (372-373).

Dietrich Welte, a professor of geology, geochemistry and oil and coal deposits, was of the opinion that because pyrolysis simulates the natural process of catagenesis, the outcome is a natural product so long as no materials have been artificially added in the course of the pyrolysis (141-142). On the other hand, hydrogenation always involves the addition of hydrogen to the natural product to achieve the desired production of hydrocarbon, and so the product is not naturally occurring (141, 159). Professor Welte maintained this distinction throughout his cross-examination, though he readily conceded that pyrolysis is a man-made process which enables kerogen to be turned into hydrocarbons in a fraction of the time involved in nature. While catagenesis and digenesis take millions of years to turn kerogen into hydrocarbons, a man-made process of hydrogenation or pyrolysis can produce hydrocarbons within the space of a day. This is

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because the temperature applied in pyrolysis is many orders of magnitude greater than the temperature in nature (142). Later he said that catagenesis and pyrolysis are really the same except for the enormous time span necessary in nature, ``but indeed, man has to apply heat... It's a man made process.'' (181).

I am unable to accept Professor Welte's thesis that because pyrolysis emulates what occurs in nature, its product is a naturally occurring substance. In my view the vital fact is that, as the Professor conceded, pyrolysis is a man-made process involving the application of intense heat (more than 300 degrees centigrade) over a short period (138), whereas nature supplies heat many orders of magnitude lower and over millions of years (142). As I have indicated, Professor Welte's view was not shared by the taxpayer's other experts. Nor was it accepted by the experts called by the Commissioner. Dr Speight was of the opinion that the term ``naturally occurring hydrocarbons'' does not apply to those hydrocarbons that are produced by applied processes such as the thermal decomposition of coal to produce liquids and gases or the retorting (thermal decomposition) of oil shale kerogen to produce shale oil (Ex S pages 12, 18, 19). Dr Atwood was of the same opinion (Ex T par 63, Sch C par 21). See also Dr Sasse (Ex U pars 44-50), Dr Powell (Ex W pars 10-20), Dr Taylor (Ex X par 21), Dr St John (Ex Y pars 9.6, 9.8.2, 9.9(d)), Dr Snowdon (Ex Z pars 14, 17), Dr Davis (Ex AA pars 8, 32-33, 71-73) and Dr Burnham (Ex BB pars 33-40, 73).

Aided by the expert evidence I have summarized, I have concluded that while coal and oil shale are sources of hydrocarbons, neither they nor the hydrocarbons that can be obtained from them by pyrolysis or hydrogenation are naturally occurring hydrocarbons. Accordingly, in exploring or prospecting for coal and oil shale, the taxpayer was not exploring or prospecting for ``petroleum'' as defined.

Legislative history

The legislative history of the mining and petroleum provisions of the Act supports the conclusion that coal and oil shale have not been and are not now viewed as ``petroleum''.

The Income Tax Assessment Act 1915 (``the 1915 Act'') contained, in s 17, the first provision enabling a person carrying on a mining operation to deduct from the income derived from that operation the capital expended on necessary plant and development. Coal mining was expressly excluded from the concept of mining operations. The Income Tax Assessment Act 1936 (``the 1936 Act'') created Division 10 - Mining. Section 122, which was in that Division, was to the same effect as s 17 of the 1915 Act. The Income Tax Assessment Act 1939 (``the 1939 Act'') inserted s 123A, which permitted a deduction for unrecouped capital expenditure incurred in deriving income in carrying on mining operations for the purpose of obtaining petroleum. Section 122 was expressed not to apply to any expenditure covered by the new section. ``Petroleum'' was defined as:

``naturally occurring solid, liquid, or gaseous hydrocarbons in a free state but does not include any substance which may be extracted from rocks or minerals by any process of destructive distillation.''

``Destructive distillation'' refers to pyrolitic processes in which heat is applied until the chemical components in the original material have been fragmented as far as possible at the temperatures used. The products of such processes will not normally have been present before the application of heat, and are generally of smaller molecular masses than the starting material (Ex U par 35 n 30). Destructive distillation is to be contrasted with fractional distillation, which involves the separation of two or more volatile liquids having different boiling points, so that they pass over at different temperatures and can be collected separately. Unlike destructive distillation, fractional distillation involves no significant chemical changes in the subject material.

As a result of the 1939 Act, putting coal to one side, there was instituted one regime for petroleum mining and another for mining other than petroleum mining.

The Income Tax and Social Services Contribution Assessment Act 1951 (``the 1951 Act'') amended s 122 by including coal mining in the range of mining operations for which deductions could be claimed under Division 10. The Supplementary Explanatory Memorandum on the Bill which became the 1951 Act recorded that:

``Since the inception of Commonwealth income tax in 1915 up to the present time, the coal-mining industry has been excluded

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from the operation of the special provisions for the taxation of the mining industries... It is proposed to adopt a recommendation of the [Commonwealth Committee on Taxation] that the coal-mining industry should be brought within the scope of Division 10. In conformity with the Committee's recommendation, it is proposed that the deduction should not have retrospective effect, but should apply only in respect of capital expenditure incurred during and after the current year of income.''

The Petroleum Search Subsidy Act 1957 was enacted to encourage the search for petroleum in Australia by subsidizing stratigraphic drilling. It defined ``petroleum'' as:

``naturally occurring hydrocarbons in a free state, whether gaseous, liquid or solid, but does not include coal or shale or any substance that may be extracted from coal, shale or other rock by the application of heat or by a chemical process.''

This Act was replaced by the Petroleum Search Subsidy Act 1959. The definition of ``petroleum'' was unchanged.

The Income Tax and Social Services Contribution Assessment Act (No 2) 1963 (``the 1963 Act'') inserted Division 10AA which dealt with the taxation of enterprises prospecting or mining for petroleum. The 1963 Act adopted the definition of petroleum contained in the Petroleum Search Subsidy Act, save that the order of the words ``gaseous, liquid or solid'' in the latter was reversed. In the Second Reading Speech on the Bill which became the 1963 Act the Treasurer pointed out that subsidies paid since 1957 for oil search operations were probably taxable in the hands of the recipients, that this had not been intended, and one of the purposes of the Bill was to ensure that subsidies, both past and present, were not taxable. As a corollary, the Bill also provided that deductions were not to be available for capital expenditure incurred in prospecting for petroleum where such expenditure was reimbursed by the payment of subsidies.

The Petroleum (Submerged Lands) Act 1967 was enacted to give effect to an agreement between the Commonwealth and the States as to the regulation of exploration for and exploitation of ``the petroleum resources of submerged lands... beneath waters that are beyond the outer limits of the territorial sea...''. The Act defined ``petroleum'' as:

"(a) any naturally occurring hydrocarbon, whether in a gaseous, liquid or solid state;

(b) any naturally occurring mixture of hydrocarbons, whether in a gaseous, liquid or solid state; or

and includes any petroleum as defined by paragraph (a), (b) or (c) that has been returned to a natural reservoir in an adjacent area."

This Act is to be read as one with the Petroleum (Submerged Lands) Royalty Act 1967. Both Acts conceive of petroleum as being limited to substances found in ``petroleum pools'' and capable of being produced through a ``well- head'' controlled by a ``valve station''. See for example ss 36, 42(1) and 97(4) of the Petroleum (Submerged Lands) Act and ss 5(2), 6(1) and 8 of the Petroleum (Submerged Lands) Royalty Act.

One of the purposes of the Income Tax Assessment Act (No 4) 1968 (``the 1968 Act'') was to make it clear that income derived from exploration for and exploitation of petroleum and natural gas deposits on the continental shelf by non-residents was taxable in Australia. The definition of ``petroleum'' in the 1963 Act was replaced by the present definition. The new definition was in the same form as that in the Petroleum (Submerged Lands) Act save for the omission of the concluding words ``in an adjacent area''. In the Second Reading Speech on the Bill which became the 1968 Act the Minister said:

``These measures are complementary to the Petroleum (Submerged Lands) Act which was enacted last year. A major objective of these amendments is to make it clear that Australia may tax income derived from, or in connection with, the exploration for, or the exploitation of, petroleum or natural gas deposits on its continental shelf when the income is derived by persons who are not residents of Australia for income tax purposes. These persons are subject to

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Australian tax on income derived from a source in Australia and the Bill proposes, in effect, that for the purposes of determining the source of the relevant income the continental shelf is to be treated as if it were part of Australia.

Special deductions are authorised by the income tax law for capital expenditure incurred in prospecting or mining for petroleum, including natural gas.... These deductions expressly apply to prospecting and mining activities in Australia or the Territory of Papua and New Guinea. The amendments proposed by the Bill are designed to ensure that taxpayers, both resident and non-resident, are entitled to the same income tax deductions in relation to petroleum activities on the continental shelves of Australia and the Territory as they would be if the activities had been carried out on the respective mainlands.''

The Explanatory Memorandum on the Bill described the new definition of ``petroleum'' as a ``drafting amendment'', and said that it ``conforms with the definition used in the Petroleum (Submerged Lands) Act''.

The Minerals (Submerged Lands) Act 1981 gave effect to an agreement between the Commonwealth and the States as to the regulation of the exploration for and exploitation of the ``mineral resources of submerged lands... beneath waters that are beyond the outer limits of the territorial sea''. The Act defined ``petroleum'' in the same manner as did the Petroleum (Submerged Lands) Act. It defined ``mineral'' as:

``a naturally occurring substance or mixture of substances that may be recovered from the sea-bed or subsoil in an adjacent area and, without limiting the generality of the foregoing, includes sand, gravel, clay, limestone, rock, evaporates, shale, oil-shale and coal, but does not include petroleum.''

The Minerals (Submerged Lands) Act was repealed and replaced by the Offshore Minerals Act 1994. In presently relevant respects the new Act is in substantially the same form as the earlier one. See the definition of ``mineral'' in s 22(1), the exclusion of petroleum exploration and recovery by s 35, and the definitions of ``petroleum'' and ``hydrocarbon'' in s 4.

What the foregoing history discloses is that:

(a) The 1939 Act established separate regimes for coal mining, mining operations for the purpose of obtaining petroleum, and other mining operations. Coal mining did not benefit from the deductions allowed by Division 10. Petroleum mining was governed by s 123A and other mining by ss 122 and 123.
(b) The hydrocarbons which can be derived from oil shale and coal did not fall within the definition of ``petroleum'' in s 123A because they can be so derived only by a process of destructive distillation.
(c) When the 1951 Act included coal mining in s 122, it is clear that it was intending to subject coal mining to the regime contained in the amended s 122 (mining other than petroleum mining) and not to that contained in s 123A (petroleum mining).
(d) The definition of ``petroleum'' in the 1963 Act (which inserted Division 10AA) excluded coal and shale, and any substance that may be extracted from coal or shale by the application of heat or by a chemical process.
(e) Although the definition of ``petroleum'' in the Petroleum (Submerged Lands) Act does not contain an express exclusion of hydrocarbons that can be extracted from coal or shale, the provisions of the Act make quite clear that ``petroleum'' is limited to substances found in petroleum pools and capable of being produced through a well head controlled by a valve station, and thus does not include coal or shale on the one hand, or the hydrocarbons that can be extracted from those substances by heating or by chemical means on the other.
(f) The 1968 Act adopted the definition of ``petroleum'' contained in the Petroleum (Submerged Lands) Act. The petroleum exploration provisions of the 1968 Act were described in the Explanatory Memorandum as ``complementary'' to the Petroleum (Submerged Lands) Act. It was said that the new definition ``conforms with the definition used'' in the Petroleum (Submerged Lands) Act. It was thus surely intended to have the same meaning in the two Acts.
(g) If there were any doubt about the meaning of ``petroleum'' in the Petroleum

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(Submerged Lands) Act or the 1968 Act, it was removed by the Minerals (Submerged Lands) Act 1981 which included coal and oil shale in, and excluded petroleum from, the definition of ``mineral''. As to the propriety of using later legislation to resolve an ambiguity in earlier legislation, see
Ormond Investments Co v Betts [1928] AC 143 at 164;
DFC of T (SA) v Elders Trustee and Executor Co Ltd (1936) 4 ATD 135 at 143-144; (1936) 57 CLR 610 at 625-626;
Grain Elevators Board (Vict) v Dunmunkle Corporation (1946) 73 CLR 70 at 85-86 and
R v Harrop [1979] VR 549 at 553-554.

Counsel for the taxpayer submitted that no assistance could be derived from the history relating to the adoption in the 1968 Act of the definition first appearing in the Petroleum (Submerged Lands) Act 1967. It was accepted that there was an undoubted temporal connection between the earlier Act and the incorporation of the new definition in the 1968 Act. But it was contended that legislation dealing with petroleum in an off-shore environment would be expected to concern only hydrocarbons in a liquid or gaseous form. It was said that coal and oil shale would not be of economic utility in an off-shore environment. But that was not the view taken by the legislature, as the Minerals (Submerged Lands) Act discloses. Although located off-shore, coal and oil shale are expressly included in the definition of minerals in an Act designed to regulate the exploration for and mining of the minerals covered by the definition.

It was also submitted for the taxpayer that the omission from the definition of ``petroleum'' in the 1968 Act of the express exclusion of coal and shale and any substance derived therefrom by the application of heat or by a chemical process, was a very powerful indication that coal and shale would otherwise be regarded as naturally occurring hydrocarbons. In the Explanatory Memorandum the new definition was described as a ``drafting amendment''. If the effect of replacing the old definition with the new were to include coal and shale and substances extracted from them by heat or chemical means within the definition of ``petroleum'', the change would not have been described in that way. Rather, in my view, it was realised that coal and shale were not themselves hydrocarbons, and that while hydrocarbons could be extracted from coal and shale by the application of heat or by a chemical process, those hydrocarbons were not naturally occurring. The adoption of the new definition was thus aptly described as a drafting amendment because the words ``hydrocarbon'' and ``hydrocarbons'' themselves excluded coal or shale (so the old definition was tautologous), and the words ``naturally occurring'' themselves excluded the substances extracted from coal and shale by the application of heat or chemical process (so the old definition was again tautologous).

Having traced the history of the relevant provisions, it is convenient to note the definition of ``expenditure'' in s 122K in the form it took at times relevant to these appeals. Section 122K is in Division 10 - General Mining. The definition excludes expenditure in connection with coal mining operations incurred before 1 July 1951. Cf par (c) above. This makes clear that the Act does not treat coal as petroleum.

The taxpayer's claims for deductions under s 124AH fail.

Review, evaluation and bidding costs

In each year of income the taxpayer claimed as a deduction the expenditure it had incurred in investigating the acquisition of interests in potential joint ventures for the exploration and mining of coal, oil shale and minerals. In the 1982 year the expenditure related to gold prospects as well. The total claims amount to $2,144,414. Generally the prospect or development opportunity was offered by someone seeking the taxpayer's participation in an exploration or development programme. In many cases a State government would seek tenders in relation to the exploration of an area or the further identification and development of known reserves. In other cases the taxpayer would incur costs in investigating an area it considered had the potential to warrant further exploration. Bidding costs are costs incurred in the preparation of tender documents.

The nature of the evaluation varied from case to case. Sometimes there was a simple in-house review of published geological information. In other cases there was a full-scale study requiring on-site work, geological review, mine planning, marketing studies and a full economic appraisal. Outside consultants were often involved in geological studies and mine planning, or where particular problems with respect to infrastructure or the environment

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were perceived. In most cases the evaluation showed that the prospect was not commercially viable, and for that reason it was not pursued.

As to the prospects other than gold, the taxpayer relied on the second limb of s 51(1), claiming that the costs were outgoings necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. The Commissioner contended that the taxpayer had not in the relevant years established any exploration business, and that the expenditure was incurred in ascertaining the feasibility of potential ventures for the mining of coal, oil shale and minerals. The taxpayer had never committed itself to the extent of actually producing any of those commodities. It did not make the transition from exploring and seeking business opportunities to actually conducting a mining business.

Critical to the resolution of the issue is the characterisation of the business activity in which the taxpayer engaged in the years in question. The evidence is that by 1973 Exxon's subsidiaries, including the taxpayer, were directed to extend the scope of their business operations beyond oil and gas production into other resources including coal, oil shale and minerals. Dr Kruizenga, who from December 1980 to his retirement in 1992 was Exxon's Vice-President-Corporate Planning, said that during 1973 and 1974 the taxpayer undertook coal exploration activities. From 1974 to 1976 it confined its activities to monitoring the Australian coal industry. From 1976 its corporate objectives included participation in the industry. By the end of 1977 it had acquired an interest in a coal prospect and had moved to set up a separate internal coal organization. From 1977 it sought to obtain interests in coal prospects. From 1980 it implemented an exploration strategy.

From 1973 the taxpayer's activities included testing Victorian brown coal as feedstock for synthetic fuels, and consideration of the acquisition of long term coal conversion resources. In 1979 it decided that synfuels from oil shale were commercially viable, and obtained its parent's permission to tender to participate in the Rundle project. In the same year it planned exploration activities. In 1980 it became the successful bidder in relation to Rundle, and developed corporate policy in relation to synfuels. From 1980 it undertook exploration and bidding activities in relation to other synfuel prospects. From 1982 its involvement in synfuels abated.

From 1973 the taxpayer conducted a wide- ranging and extensive programme of exploration for minerals. It regularly considered submissions from other explorers in relation to potential joint ventures. From time to time it sought joint venture opportunities with respect to minerals. From 1979 it had interests in mineral joint ventures in relation to a number of ongoing projects, several of which were at the development stage.

In the course of his cross-examination Dr Kruizenga was pressed to accept that all the taxpayer had done was engage in feasibility studies. The following exchange occurred in relation to a deposit at Hail Creek:

``You were determining the feasibility of commencing operations in it for the production of income? - In any project you bring it along to the point where you have enough confidence in the projected returns to make a go decision.

So the first thing which was done was to study the feasibility of commencing production? - The reason I answered the way I have, feasibility studies is a word and a phrase that is often used and is referring to what I will call paper work and planning. And on the basis of that one goes on to do the necessary real work, to further define the project, to cost it, to engineer it, to probe the market and so forth on which a commercial decision to invest and produce can finally be made. And by implication, I didn't want it to be an agreement with you that there was just a bunch of paper work going on here, that is far from the truth. There was real money being spent, and real activities being incurred, to further the interests, the business interests of trying to, in the case of Hail Creek, get a significant deposit to the point where a commercial or an investment could be made with some confidence and commercial production could be made''

(52-53).

And later:

``But EEPA was still deciding whether or not it would go into its first mining venture? - No, it had been in many mining ventures. It still had not committed to commercial

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production of any one particular venture but it was in many ventures.

When you talk about ventures you are talking about exploration ventures are you? - And pre development - pre decision to go into commercial development.

Feasibility assessment of the project? - No, the process of this business is a time consuming one but exploration is stage one. It may then take years to develop the knowledge one gains from the initial exploration as to the size of the deposit, the characteristics of the deposit, ways of getting the ore out, ways of treating the ore whatever, then getting it into the market. These things do not happen overnight. It's a long term business and I mean that is just the nature of the business. So you're oversimplifying to say it's feasibility at the exploration stage and bingo that's it and then to decide not to go. Well you need much more information to make these decisions and it's time consuming and expensive to get it. But that's the process.''

(60)

The evidence establishes that the taxpayer was in the business of producing and selling oil and gas. As from 1973 it investigated other resources, including coal, oil shale and minerals. But while in the relevant years (or some of them in the case of oil shale and minerals) the taxpayer was actively involved in exploration activities, it did not commit itself to commercial production. The taxpayer did not make the transition from exploring and seeking business opportunities to actually conducting a mining business. It was thus not in the business of mining for coal, oil shale and minerals, and consequently the expenditure in question was not, in the words of Menzies J in
John Fairfax & Sons Pty Ltd v FC of T (1959) 11 ATD 510 at 519; (1958-1959) 101 CLR 30 at 49, ``part of the cost of trading operations''. See also
Goodman Fielder Wattie Ltd v FC of T 91 ATC 4438 at 4447; (1991) 101 ALR 329 at 340.

I accept Dr Kruizenga's evidence that there was not ``just a bunch of paper work going on here'', and that large sums of money were being spent on genuine exploration activities. But his ``feasibility'' disclaimer discloses that the costs were of a preliminary nature, aimed at ascertaining whether it was commercially worthwhile to enter into mining joint ventures.

The taxpayer in
Softwood Pulp & Paper Ltd v FC of T 76 ATC 4439 was incorporated with a view to establishing a pulp and paper mill. The case concerned the deductibility of preliminary expenses incurred in evaluating whether the mill should be established. The Commissioner's disallowance of the claims was upheld. Although the case did not involve a company with an established business contemplating diversifying into another area, what was said by Menhennitt J is apposite to the present case. Speaking of the first limb of s 51(1) his Honour said, at 4450:

``Everything that was done in this case, up till the time when the project ceased, was in my view entirely preliminary and directed to deciding whether or not an undertaking would be established to produce assessable income.

The project had not reached anything like the stage of doing anything in the course of gaining or producing assessable income. All that had happened was that certain tests had been made to ascertain whether or not the project would be feasible.... I reiterate that no one was committed, at all, to go on with the project... In other words, the project did not approach in any way a situation which could be described as being the course of gaining or producing income. It was all completely anterior thereto and in those circumstances, it appears to me that any losses or outgoings which were in fact incurred by the taxpayer were in the course of investigations to see whether the project would be feasible...''

Dealing with the second limb, his Honour said, at 4451:

``The critical point is that the company had not reached a stage remotely near the carrying on of a business. Even assuming that at some stage prior to the mill turning, the company could be said to be carrying on a business, in this case the company had not even approached the stage of making a decision about carrying on a business. All that had happened had been that certain investigations had been made to decide whether or not the business was feasible, and whether or not it was economically viable on a competitive basis, but nothing had been done which could be said to be carrying on a business or anything associated with or incidental to the actual

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carrying on of a business. Everything which was done was concerned with making a decision whether or not steps should be taken to set up a business, but no decision on even that matter had been reached.''

While the taxpayer may have had the intention ultimately to engage in production, that is not sufficient in itself to constitute a business activity. In
Inglis v FC of T 80 ATC 4001 at 4004; (1979) 40 FLR 191 at 195 Brennan J said:

``Whether any of the outgoings qualified for deduction under the second limb of sec. 51(1) depends upon whether a pastoral business was being carried on during the relevant years: `the outlay must have been incurred in the carrying on of a business, that is, it must be part of the cost of trading operations' (per Menzies J in
John Fairfax & Sons Pty Ltd v FC of T (1959) 101 C.L.R. 30 at p. 49). The carrying on of a business is not a matter merely of intention. It is a matter of activity.''

What was missing in the present cases was the element of commitment to the income producing activity in respect of which the expenditure is claimed to have been incurred. Cf Softwood at 4450, Goodman Fielder at 91 ATC 4447; ALR 340 and Inglis at ATC 4004; FLR 195.

The costs in question were of course incurred in the course of the taxpayer's exploration activities. But in the relevant years the taxpayer was not in the business of exploration. It did not engage in exploration for reward. It did not sell any of its exploration information, or otherwise earn fees for its exploration activities. Cf
FC of T v Ampol Exploration Limited 86 ATC 4859 at 4878-4879; (1986) 13 FCR 545 at 570 per Beaumont J, dissenting.

The review, evaluation or bidding costs in relation to coal, oil shale and minerals were not necessarily incurred in carrying on a business for the purpose of gaining or producing the taxpayer's assessable income. It is accordingly unnecessary to deal with the Commissioner's alternative submission that the expenditure was of a capital nature. See, however, Goodman Fielder at ATC 4448; ALR 341.

I turn now to the review, evaluation and bidding costs relating to gold. Section 77 enabled a deduction to be claimed for a loss incurred in carrying on a business the income, if any, from which would be exempt income. Income derived from the working of a mining property principally for the purpose of obtaining gold was exempt income under s 23(o). In
Parker v FC of T (1953) 10 ATD 287 at 290-291; (1953) 90 CLR 489 at 493-494 Dixon CJ, speaking of s 23(o), said:

``The word `working' has, I think, a definite meaning in its application to `mining property'. It describes the working of the thing itself - not the revolution of the machinery upon it nor the chemical treatment of residues brought upon it. We are not dealing with a case where from the raising of the ore to the extraction by every available means of the maximum gold content a series of processes is pursued in the working of the mining property in order to win gold from the soil.... the expression `mining operations' is not the same as `the working of a mining property'. The former is plainly wider and the latter is directed to a different point. Mining operations means operations pertaining to mining and operations is a very large expression. The phrase `the working of a mining property' looks to the exploitation of a mining lease or other form of interest in the soil.''

Taylor J, at ATD 293; CLR 498, said the expression ``working of a mining property'' denoted the ``exploitation of the soil for the purpose of the recovery of gold''. See also
Kidston Gold Mines v FC of T 91 ATC 4538 at 4543; (1991) 30 FCR 77 at 81-82 per Hill J. The evidence does not disclose that in the relevant year of income the taxpayer was engaged in the working of a mining property in the sense described in Parker.

Accordingly, the review, evaluation and bidding costs in relation to coal, oil shale and minerals are not deductible under s 51(1), and those relating to gold are not deductible under s 77.

Deep water technology

On 1 December 1977 the taxpayer and Hematite Petroleum Pty Ltd (``Hematite'') entered into a joint venture agreement to explore for petroleum in an area of the Exmouth Plateau and to exploit any commercially viable reserves discovered. The taxpayer and Hematite each had an undivided 50 per cent interest in the exploration permit area, and agreed to bear all the risks and expenses of the venture jointly, and jointly to own the venture assets and the

ATC 4383

petroleum obtained. The taxpayer was designated as operator of the venture. This made it responsible for preparing an exploration programme and submitting it to the Designated Authority, conducting the exploration, delineating a trap, getting the petroleum out of the trap, and generally developing a facility for exploiting petroleum discovered in the area. The agreement required the parties to bear all expenditures and costs incurred in carrying out the joint undertaking in proportion to their respective participating interests in the area: clause 6.01. This obligation was subject to clause 7.01 which was in part as follows:

``EEPA through its Affiliates has access to and is entitled to use in ventures in which it is involved, technology capable of being used in drilling in and producing Petroleum from deepwater environments such as are found in the Area. In recognition that EEPA has agreed to contribute such technology to the Joint Undertaking:

(a) Hematite will bear a proportion of the cost of drilling exploration wells for the Joint Undertaking equal to its 50% Participating Interest plus 10% of such proportion (and EEPA's proportion of such costs will be correspondingly reduced) until the total amount paid by Hematite in excess of its 50% Participating Interest share of such costs equals the sum of US$1.5MM plus the annual increases thereon calculated as provided in Subclause 7.01 (c).

(b) EEPA will receive a share of production additional to its 50% Participating Interest share of production (and Hematite's share of production shall be correspondingly reduced) until the aggregate value of the additional production so received by EEPA equals the sum of US$13.5MM plus the annual increases thereon calculated as provided in Subclause 7.01 (c). At the time, the Parties first agree on a plan of development, they will in good faith negotiate the amount of additional production to be received by EEPA with the objective of EEPA recovering the sum plus increases as aforesaid within seven (7) years after commencement of production, unless to do so would cause Hematite economic hardship in respect of the Joint Venture hereby constituted;

(c) On each anniversary of the date on which the Permit is granted commencing on the first such anniversary the sums referred to in Subclause 7.01 (a) and (b) shall be increased by the product of the average unpaid monthly balances of such sums over each such Year and the average over the same Year of the maximum bank interest rate for overdrafts with limits of less than $100,000 as published in the Reserve Bank of Australia Statistical Bulletin;

...

(f) In lieu of continuing to pay the increased proportion of drilling costs as provided in Subclause 7.01 (a) and in lieu of foregoing a proportion of production as provided in Subclause 7.01 (b), Hematite may at any time elect to pay the whole of or any part of the balance of the amounts referred to and calculated as provided in Subclause 7.01 (a) and (b). Any such payments shall reduce the annual increases under Subclause 7.01 (c) pro rata from the time of payment and annual increases in respect of the outstanding balance (if any) shall abate accordingly;

...''

In about January 1979 Hematite elected to make the payment contemplated by par (f). The sum payable was US$1,657,500, which converted to Australian currency was A$1,464,934. In its income tax return for the year ended 31 December 1979 the taxpayer disclosed the receipt as part of its profit and loss statement and described it as ``Receipt in Respect of Sale of Technology''. In its calculation of assessable income the amount was brought to account as a capital receipt. By an amended assessment the Commissioner adjusted the taxpayer's taxable income to include the amount received.

The Commissioner contends that the technology payment is assessable under s 25(1) and in the alternative under s 26(a). The effect of
FC of T v The Myer Emporium Ltd 87 ATC 4363; (1987) 163 CLR 199, as applied and explained in
FC of T v Cooling 90 ATC 4472; (1990) 22 FCR 42 and
Westfield Ltd v FC of T 91 ATC 4234, was recently summarised by Drummond J in
Selleck v FC of T 96 ATC 4903 at 4910-4913. His Honour said that a gain made by a taxpayer will be assessable as income

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within the ordinary concept of income in any one of the following circumstances:

``(a) If it is a gain made by a taxpayer from a transaction forming part of the ordinary course of the taxpayer's business: the identification of the transaction as having that character `will stamp the transaction as one having a profit-making purpose'...

(b) If it is a gain made from a transaction that is not itself part of the ordinary course of the taxpayer's business but which is an ordinary incident of the business activity of the taxpayer: `the profit-making purpose can be inferred from the association of the transaction... with that business activity.'...

(c) If the activity which generates the gain is not within (a) or (b), the gain will be assessable as income only if it was realised in a business operation or commercial transaction in circumstances in which the taxpayer, at the time it engaged in the transaction, had the intention or purpose of making a gain from that transaction by the means giving rise to the gain... Such a gain will be assessable as income even though the taxpayer did not enter into the transaction that generated it for the sole purpose of making a profit: it will be enough if a not insignificant purpose of the taxpayer, at the time it entered into the transaction, was to obtain a profit...''

The taxpayer was in the business of petroleum exploration and production. The major focus of its activities in and around the years in question was as operator of the Bass Strait fields under a joint venture agreement. Bass Strait was the major source of its revenue (Ex 16 par B 7). The deep water technology used by the taxpayer to drill Australia's deepest water depth well in Bass Strait in 1975 (Ex 20 par 46) was presumably much the same as that the subject of the agreement with Hematite in 1977. Entering into the joint venture agreement with Hematite was part of the ordinary course of the taxpayer's business. The technology payment was a gain derived under that agreement, and was accordingly made from a transaction forming part of the ordinary course of its business, and thus falls within the first category identified by Drummond J. If the payment does not fall within the first category, it falls within the second. As part of its business activities the taxpayer had acquired the right to use the deep sea technology developed by others in the group of companies to which it belonged. It was incidental to the taxpayer's business as an explorer and producer that it obtained authority to use that technology in the joint venture with Hematite, as was its use of the technology. A profit-making purpose can be inferred from the association of the transaction with the taxpayer's ordinary business as an explorer.

If the amount is not income on that basis, it falls in my view within the third category. At the time the taxpayer entered into the agreement with Hematite it had the purpose of turning the know-how available to it to account by stipulating for and obtaining agreement that Hematite would defray more than 50 per cent of the cost of the works and would receive less than 50 per cent of production. It was also agreed that Hematite could elect to pay a sum of money in order to obtain parity with the taxpayer as to the costs and share of production. Doubtless the taxpayer's primary purpose in entering into the agreement was to discover petroleum and exploit it for profit. But that was not its sole purpose. It also wanted to turn to profitable account the deep water technology available to it. This it did by requiring Hematite to pay more than half the outgoings and to receive less than half the profits or, at Hematite's option, to pay a sum of money for parity in those respects. Whichever course Hematite took, there was a gain to the taxpayer, in one case non-monetary and in the other monetary. The fact that the monetary gain would not come in unless Hematite exercised its option does not, to my mind, mean that it was not a purpose of the taxpayer to obtain the gain at the time it entered into the agreement. That purpose was clearly not an insignificant one.

The taxpayer contended that the technology payment was made for a variation of the mode of contribution to costs and sharing of expenditure under the agreement. The interest of the taxpayer under that agreement was a capital asset. The payment of the money altered the entitlement to income and the obligation to contribute to outgoings under the venture. It was an alteration of a permanent kind to the taxpayer's capital asset. What was lost as a result of receipt of the payment was a capital advantage of an enduring kind to contribute less than half the costs and receive more than half

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the profits. But this characterization of the transaction ignores the fact that at the time the agreement containing clause 7.01 was entered into, the taxpayer contracted not only for the right to have Hematite pay more than half the costs and receive less than half the production, but to receive, in a certain event, a payment of cash. Cf
GP International Pipecoaters Pty Ltd v FC of T 90 ATC 4413 at 4419; (1990) 170 CLR 124 at 137. It was a one-off payment. But whilst periodicity, regularity and recurrence have been considered hallmarks of the income character of a receipt, the significance of these considerations is diminished when the receipt in question is generated in the course of carrying on a business, a ``fact of telling significance'':
Allied Mills Industries Pty Ltd v FC of T 88 ATC 4852 at 4861-4862; (1989) 20 FCR 288 at 300.

Although the technology payment was described by the taxpayer in its return as a receipt for the sale of technology, that is not an accurate description of the transaction. The taxpayer did not relinquish any part of its business structure. Although it obtained benefits as a result of making the technology available to its joint venturer, it was free to use it for itself in any other project. Indeed the relevant technology had been invented for use in any deep water project, subject only to adaptation for particular sites. There was thus no parting with a capital asset in exchange for the payment. Rather, the taxpayer chose to turn technology available to it to profitable account by sharing it with another in exchange for the payment of money. Cf
Inland Revenue Commissioners v Rolls-Royce Ltd [1962] 1 WLR 425 at 427, 429, 433, 438;
Allied Mills Industries Pty Ltd v FC of T 88 ATC 4852 at 4862; (1989) 20 FCR at 301; Case W10,
89 ATC 182 at 186.

The payment is assessable under s 25(1).

Operatorship assumption payment

South Pacific Petroleum NL (SPP) and Central Pacific Minerals NL (CPM) (known as the Rundle Twins) held an authority to prospect in relation to a deposit of oil shale in the Rundle area. In February 1980 the taxpayer submitted a proposal to acquire an interest in the Rundle Oil Shale Project and was selected as the successful bidder. The taxpayer's bid provided for it to acquire a 25 per cent equity in the resource which could be increased to as much as 50 per cent depending upon the extent of the phase 1 costs to be incurred by the taxpayer. Increased expenditure by the taxpayer would result in an increase in its equity determined in accordance with what was called the ``P'' formula. The taxpayer undertook to commence the work programme as soon as it was selected and without waiting for the execution of formal documentation.

Negotiations continued over a number of months. The taxpayer proposed that it become operator upon the execution of heads of agreement. However the Twins proposed that the taxpayer become operator only when the joint venture agreement was signed. In June 1980 this impasse was broken by the taxpayer agreeing to make ten annual payments of $25 million each, and an additional payment of $27.5 million called an ``operatorship assumption payment''. The P formula was to be abandoned and the taxpayer would become operator on signing the heads of agreement. Heads of agreement were executed in July, and pursuant thereto the taxpayer forthwith became operator of the venture. Shortly after, the taxpayer paid the first instalment of the operatorship assumption payment of US$10m (A$9,388,246). The taxpayer thereupon began what was called a Class V estimate of the project - a detailed estimate of probable cost to determine its economic feasibility. In February 1981 the results of the work program and Class V estimate showed that the original cost estimates were too low. The parties agreed to amend the heads of agreement. In substance it was determined that the taxpayer's obligation with respect to the balance of the operatorship assumption payment would be satisfied by payment of a further US$5m (A$4,655,493) three days after the effective date of the joint venture agreement, which was 25 February 1982.

The taxpayer claimed a deduction for the two instalments in its 1980 and 1982 years of income in reliance on s 51. The Commissioner disallowed the deductions.

To be deductible an outlay must be part of the cost of trading operations to produce income. It must have the character of a working expense:
John Fairfax & Sons Pty Ltd v FC of T (1959) 11 ATD 510 at 519; (1958-1959) 101 CLR 30 at 48. Thus a payment made in order to acquire or add to the profit-yielding structure of a taxpayer is not a deductible expense:
Sun Newspapers Ltd and Associated Newspapers

ATC 4386
Ltd v FC of T (1938) 5 ATD 87 at 93-96; (1938) 61 CLR 337 at 359-363;
Ronpibon Tin NL v FC of T (1949) 8 ATD 431 at 437; (1949) 78 CLR 47 at 59. The label the parties to a transaction ascribe to a payment is not determinative of its character:
SP Investments Pty Ltd v FC of T 93 ATC 4170 at 4181; (1993) 41 FCR 282 at 295. What is an outgoing of capital and what is an outgoing on revenue account depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of legal rights:
Hallstroms Pty Ltd v FC of T (1946) 8 ATD 190 at 196; (1946) 72 CLR 634 at 648.

For the Commissioner it was contended that the payment was part of the price paid for the purchase of a participating interest in the joint venture and associated rights accorded it by the heads of agreement. The Commissioner relied particularly on the evidence of Malcolm Lye, who was in charge of the taxpayer's Rundle Negotiating Team. Mr Lye said that the strategy adopted by the taxpayer was to use a cash payment ``to settle the negotiation''. He agreed that his American superiors supported the idea of a cash payment which would settle the outstanding issues, chief of which was operatorship (223). He also agreed with the statement in a contemporaneous document that ``whilst payment is stated to be for early operatorship in fact it was much more, it really clinched the deal''. He added, however, that ``operatorship was the major final issue'', and ``by settling that it also clinched the deal'' (227). He agreed that it was probably the case that the taxpayer would not have had a joint venture or heads of agreement without the payment, that the payment benefited the project for its entire duration and not just its early stages, and that it was really part of the cost of acquisition of what the taxpayer got under the agreement with the Twins (229-230).

The taxpayer, on the other hand, relied on clause 10.03 of the heads of agreement. This was as follows:

``In consideration of SPP/CPM consenting to the assumption of the operatorship of the Project by EEPA prior to the Effective Date and thus in consideration of SPP/CPM agreeing to EEPA being the Operator of the Project during the period between the execution of the Heads of Agreement and the Effective Date, EEPA shall pay an amount (hereafter referred to as the `Operatorship Assumption Payment')...''

It was said that in the period preceding the execution of the heads of agreement the taxpayer was in a predicament. It could not get operatorship until the joint venture agreement was signed, and that would not be for quite some time. Yet it had to be operator in order to carry out the Class V estimate. Accordingly it agreed to pay $27.5 million in order to acquire operatorship so it could carry out the Class V estimate. Clause 10.03 expresses the consideration in that way - the price of the Twins' agreement that the taxpayer become the operator forthwith and not have to wait until the effective date. The clause was not attacked as a sham, and there was no reason why the parties, who were at arm's length, would falsely state the consideration for the payment.

Under cross-examination Mr Lye was initially adamant that the payment was made to secure early operatorship and not in order to persuade the Rundle Twins to sign the heads of agreement (217-219). Later he conceded that the payment was made in order to ``clinch the deal'', though the item of value to the taxpayer in the transaction was the early operatorship (220). Then he agreed that the taxpayer's strategy was to use the offer of a cash payment to ``settle the negotiation at that point'', and that his American superiors supported the idea of a cash payment which would settle the outstanding issues, the biggest of which from the taxpayer's point of view was operatorship, and from the Twins' point of view was the P and X formula (223). Then he was shown a document dated 27 June 1980 setting out a ``settlement proposal'' prepared by the Twins (Ex ML56 to the affidavit of Mr Lye, which is Ex 24). As originally typed it is in part as follows:

``SPP/CPM proposes a quick resolution of the remaining substantial issues with EEPA in order to:-

1. Sign a heads of agreement without further delay.

2. Concentrate upon advancing the Project engineering and construction as quickly as possible.

SPP/CPM have carefully examined the limits to which they might be willing to go

ATC 4387
to achieve such a quick agreement and would like to make the following proposal

1. SPP/CPM will agree to the elimination of the P formula (or the later X formula) from EEPA's Proposal C.

2. SPP/CPM agree to turn over the operatorship of the project to EEPA immediately.

3. SPP/CPM will sign a Heads of Agreement which commits us to the project with EEPA without right of withdrawal.

In return for the following compensation:-

1. $15 million cash payment upon signing the Heads of Agreement.

2. $10 million cash payment upon signing the Joint Venture Agreement.

3. $10 million cash payment upon the receipt of FIRB approval.

...

SPP/CPM consider these payments to constitute:

1. Modest compensation for giving up its chance to obtain better than 50% initial project interest.

2. Additional incentives for SPP/CPM to conclude Heads of Agreement and Joint Venture Agreements as quickly as possible.

3. An additional incentive to support EEPA in gaining prompt approval of FIRB.

...''

It appears that Mr Kirk, who was Mr Lye's superior, met with the Twins' Mr McFarlane, and they agreed that the three cash payments be altered to $10 million, $5 million and $12.5 million respectively. Mr Kirk then crossed out the typed amounts and inserted the new amounts. These were the figures that appeared in the heads of agreement which were executed three days later. Mr Lye accepted that on 27 June it had been agreed, at least in principle, that the taxpayer would pay the three amounts in return for the Twins' three promises (225).

Mr Lye was then shown a document (Ex 27 to the affidavit of Mr Kelly, which is Ex 22) prepared by an Esso accountant which contained this passage:

``In considering the accounting treatment of this payment, one must look at the real nature of the payment and what it achieved. In the negotiations SPP/CPM were refusing to finalise the deal. Eventually EEPA made an offer of more money but insisted upon early Operatorship. Once SPP/CPM agreed to the additional payment, the remaining outstanding issues were agreed quickly.

Thus, whilst the payment is stated to be for early Operatorship, in fact it was much more, it really `clinched' the deal.''

Mr Lye agreed that this was a fair summation of what had occurred, but he later qualified this by saying that since operatorship was the ``major final issue'' or the ``outstanding issue'', its settlement had also clinched the deal (227-228). Later he agreed that without the payment the taxpayer would probably not have had a joint venture or heads of agreement, and that to that extent the payment benefited the entire project. It was really part of the cost of acquisition of what the taxpayer got under the agreement (229-230).

On the whole of the evidence, documentary and oral, I have concluded that the payment was made to secure the Twins' agreement to execute heads of agreement, one of the provisions of which was that the taxpayer would become operator upon the execution of the document, and not solely to achieve early operatorship. Although clause 10.03 points to the payment having that limited role, the parties' description of the consideration in exchange for which the payment was made is not conclusive of its character, being only part of the matrix of facts from which the character of the payment is to be determined:
Rotherwood Pty Ltd v FC of T 96 ATC 4203 at 4213. Other contemporaneous documents, and the substance of Mr Lye's evidence, tend against the taxpayer's characterisation. The nature of the advantage sought by the making of an expenditure is the chief, if not the critical, factor in determining the character of what is paid:
GP International Pipecoaters Pty Ltd v FC of T 90 ATC 4413 at 4419; (1990) 170 CLR 124 at 137.

In my view the operatorship assumption payment was the consideration for the acquisition of an asset of a lasting character which would enure for the benefit of the taxpayer's organization or system or profit- earning subject. Cf per Dixon J in
Sun Newspapers Ltd v FC of T (1938) 5 ATD 87 at 94-95; (1938) 61 CLR 337 at 361. The claim to a deduction under s 51(1) therefore fails.

ATC 4388

Tenement acquisition costs

In each year except 1979 the taxpayer claimed deductions for expenditure described as tenement acquisition costs. Tenements were acquired by the taxpayer for the purpose of conducting exploration and prospecting activities. Each tenement in relation to which such expenses were incurred was abandoned or relinquished during the relevant year, without any consideration being received or where the tenement was valueless. The expenses were for technical/professional services, options, rentals, legal fees, taxes, stamp duty and licence fees. They formed part of the charges made by EAL under the service agreement. The deductions were claimed under s 122K so far as the costs relate to coal, oil shale and minerals, in the alternative under s 124AM so far as they relate to coal and oil shale, and under s 77 so far as they relate to gold. They total $254,331: $78,619 for 1980, $33,238 for 1981, $124,799 for 1982, $8,760 for 1983 and $8,915 for 1984.

Section 122K(1) provided:

``This section applies where deductions have been allowed or are allowable, under this Division or under provisions of a previous law of the Commonwealth relating to the taxation of income derived from mining operations, in respect of expenditure of a capital nature by the taxpayer in respect of property of the taxpayer which, in the year of income, has been disposed of, lost or destroyed, or the use of which by the taxpayer for prescribed purposes has, in the year of income, been otherwise terminated.''

Sub-sections (2) and (3) provided, as they still do, as follows:

``(2) Where the aggregate of:

(a) the sum of the deductions so allowed or allowable; and

(b) the consideration receivable in respect of the disposal, loss or destruction or, in the case of other termination of the use of property, the value of the property at the date of termination of use;

exceeds the total expenditure of a capital nature of the taxpayer in respect of that property, so much of the amount of the excess as does not exceed the sum of those deductions shall be included in the assessable income.

(3) Where the total expenditure exceeds that aggregate, the excess shall be an allowable deduction.''

It was not in dispute that the requirements of s 122K(1) are satisfied. The only question is whether the tenement acquisition costs are ``expenditure of a capital nature'' for the purpose of s 122K(3). If they are, it is agreed that the amounts claimed are deductible. The Commissioner's contention is that these words should not be given their natural meaning, but should be restricted to expenditure of a capital nature otherwise allowable as a deduction under other provisions of the Act, such as s 122A. It was common ground that none of the deductions allowed by Division 10 was applicable to the tenement acquisition costs.

Two arguments were advanced as to why the words ``expenditure of a capital nature... in respect of that property'' should not be accorded the plain meaning they appear to bear. The first was based on the legislative history of s 122K. In 1950 the Commonwealth Committee on Taxation reported to the Treasurer on the taxation of mining industries. One of its recommendations related to the recovery of amounts allowable under Division 10 of Part III. The Committee pointed out that Division 10 contained no provision for the writing back of any amounts received by the taxpayer for items of plant and development works that had been sold, or for which some recoupment of the amount expended had been obtained. The contrast with s 59 was pointed out, and the Committee considered that provisions comparable with those of s 59(1) and (2) should be included in Division 10 so that when the plant or developmental works were sold, lost or destroyed, or the mine operations ceased, or the mining lease was terminated, the sale price or the residual value of the plant or works should be brought to account in the ascertainment of the taxable income of the person carrying on the mining operations. The Committee recommended that the sale or residual value of the property, the cost of which had been allowed or was allowable under Division 10, should be brought to account so that:

• when the consideration received for, or the residual value assigned to, the property, when added to the deductions allowed or allowable in respect of the cost of the property was less than the original cost of

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the property, the difference should be allowed as a deduction;
• when the consideration or residual value, when added to those deductions exceeded the original cost, the excess, limited to the sum of the amounts allowed or allowable as a deduction, should be included in the assessable income.

The Committee drafted a provision (s 124A) to give effect to its recommendation. Sub- section (1) was in part as follows:

``Where any property of a taxpayer in respect of which a deduction has been allowed or is allowable under this Division is disposed of, lost or destroyed-

...

(b) an amount equal to the total expenditure on the property specified in section one hundred and twenty-two of this Act, less the sum of all amounts which have been allowed or are allowable as deductions under any other section of this Division, and of any consideration receivable, in respect of the property shall be an allowable deduction;

(c) the sum of the amounts which have been so allowed or are so allowable and of that consideration exceeds the total expenditure on the property, specified in section one hundred and twenty-two of this Act, the excess, to the extent of the sum of all amounts so allowed and allowable, shall be included in the assessable income of the year of income.''

The ``consideration receivable'' was defined by reference to s 59(3): sub-s (2). The proposed s 124A(3) made sub-s (1) applicable to the case where the property ceased to be used in connection with mining operations because the mine was no longer worked, or the mining lease had been terminated, or for any other reason. The proposed s 122(1) referred to ``expenditure of a capital nature on plant and development of the mining property and housing and staff welfare''. The word ``plant'', and the expressions ``development of the mining property'' and ``housing and staff welfare'', were defined in the proposed s 121D(1).

The Commissioner relied upon the words I have rendered in italics in the draft s 124A(1)(b) and (c). The tenement acquisition costs would not have qualified as expenditure of a capital nature on plant and development of the mining property within the proposed s 122(1). See now the definition of ``allowable capital expenditure'' in s 122A.

Parliament adopted the essential thrust of the Committee's recommendation, but its draft s 124A was adopted only in part. Section 122K, in the form it took during the relevant years of income, was inserted into the Act as s 124 by the 1951 Act. But instead of the recommended verbiage - ``total expenditure on the property specified in section one hundred and twenty- two'', the words ``total expenditure of a capital nature by the taxpayer on that property'' were employed.

Rather than supporting the Commissioner's contention that the words ``total expenditure of a capital nature'' mean ``total expenditure of a capital nature allowable as a deduction under this Division'', the legislative history seems to me to confirm the natural meaning of the words. The Committee recommended a provision which limited the capital expenditure to that incurred on plant, development of the property and housing and staff welfare, and the Parliament enacted a provision referring to capital expenditure at large.

That the phrase ``total expenditure of a capital nature'' in s 122K(2) and (3) has what I have called its natural meaning is confirmed by the contrast provided by the phrase employed in sub-s (1) - ``deductions have been allowed or are allowable, under this Division... in respect of expenditure of a capital nature by the taxpayer in respect of property...''. The ordinary meaning is further confirmed by the Explanatory Notes to the Bill which became the 1951 Act:

``Sub-section (3)... provides that, if the expenditure which has not been allowed as deductions exceed the sale price of or the insurance recovery on the amount, the excess shall be an allowable deduction. This provision will ensure that the mine-owner is allowed deductions totalling the full amount of the difference between the cost price of the asset and the amount received on its sale, loss or destruction.''

The emphasis is mine.

The second argument advanced by the Commissioner in support of the proposed reading down of s 122K(3) relied on the results that would flow from acceptance of the

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taxpayer's contention. It was said that it would be absurd if under s 122K(3) a deduction could be claimed in respect of expenditure that fell outside the definition of ``allowable capital expenditure'' in s 122A(1) and (2). It was pointed out that having in sub-s (1) listed a number of expenditures, by sub-s (2) Parliament excluded some that might otherwise have been covered by sub-s (1). It was said that it would be nonsensical if expenditure on these excluded items could nevertheless be deductible under s 122K(3). I do not agree. The intention to be discerned from Division 10 as a whole is that the amount which is to be amortised during the period the property is used does not include all capital expenditure on the property (s 122A(1) and (2)), but when the property ceases to be used, all capital expenditure is to be taken into account (s 122K(3)).

The taxpayer relied on s 122K as to its coal and oil shale operations as well as its mineral operations. In the alternative it relied on s 124AM in relation to its coal and oil shale operations. The ``prescribed purposes'' mentioned in the concluding part of s 122K(1) are ``the purposes for which allowable capital expenditure may be incurred or the purposes referred to in section 122J''. The former are the expenditures listed in s 122A(1). They are linked, directly or indirectly, to the definition of ``prescribed mining operations'' - mining operations for the extraction of minerals ``other than petroleum''. Section 122J(1) allows a deduction for expenditure incurred on exploration or prospecting for minerals obtained by prescribed mining operations. Sub- section (2) denies a deduction unless, in the year of income, the taxpayer carried on a mining business ``other than a business of mining for petroleum''. Since I have held that coal and oil shale and the hydrocarbons obtained from them are not ``petroleum'', mining operations for their extraction will be prescribed purposes within s 122K(1). It follows that the taxpayer is entitled under s 122K to the deductions claimed for tenement acquisition costs in connection with its exploration for coal and oil shale as well as those incurred in relation to exploration for other minerals.

If, contrary to my view, coal and oil shale or the hydrocarbons obtained from them are petroleum, s 122K will not apply. The relevant provision will be s 124AM, the structure of which is essentially the same as that of s 122K save that it applies to property used for the purpose of carrying on prescribed petroleum operations or of exploring or prospecting for petroleum. If s 124AM be the relevant section, what I have said about ``total expenditure of a capital nature'' in s 122K(2) and ``total expenditure'' in sub-s (3) applies to the phrase ``total expenditure of a capital nature'' in s 124AM(2) and ``total expenditure referred to in sub-section (2)'' in sub-s (3), and the taxpayer will be entitled under s 124AM to the deductions claimed for tenement acquisition costs in connection with its exploration for coal and oil shale.

In the 1982 year tenement acquisition costs were incurred in relation to prospecting and exploration for gold. Section 77(1) allowed the deduction of a loss incurred in carrying on an ``exempt business'' - a business the income, if any, from which would be exempt income: sub- s (1A). At the relevant times income from gold mining was exempt from income tax under s 23(o), which provided in part that income was exempt if it was:

``derived from the working of a mining property in Australia, where the working of the mining property by the taxpayer for the period from the commencement by him of mining operations on that property to the end of the year of income has been principally for the purpose of obtaining gold...''

Counsel for the taxpayer said the question here was whether a deduction permitted by s 122K(3) can be taken into account in determining a loss for the purposes of s 77(1). In the relevant years the taxpayer was not engaged in the working of a mining property in Australia. See the discussion under the Review, Evaluation and Bidding Costs heading. Indeed, counsel conceded that this was the case. It follows that the taxpayer was not carrying on an exempt business. The issue identified by counsel (viz whether a deduction under s 122K can be taken into account in determining a loss under s 77(1)) does not arise unless the taxpayer was carrying on an exempt business. But as I understood the argument, it was said that s 77(2) cured the problem. That sub-section provided that:

``In calculating the amount of that loss, no deduction may be made which would not have been an allowable deduction if the

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income (if any) had been assessable income.''

In my view that provision does not assist the taxpayer. In order to claim a loss under s 77(1), the taxpayer must have carried on an exempt business. It may be that sub-s (2) requires one to assume for certain purposes that exempt income is assessable income: see Case Y5,
91 ATC 120 at 131. But it does not require one to assume that a taxpayer who is not in fact carrying on an exempt business is doing so. The claim to deduct the costs in relation to gold mining tenements therefore fails.

Summary of conclusions

(a) Exploration and prospecting for coal and oil shale

The taxpayer is not entitled to deductions under s 124AH for expenditure incurred in its 1980 to 1984 years of income on exploration and prospecting for coal and oil shale.

(b) Review, evaluation and bidding costs

The taxpayer is not entitled to deductions under s 51(1) for review, evaluation and bidding costs incurred in its 1979 to 1984 years of income in relation to minerals, coal and oil shale, or to deductions under s 77 for those costs incurred in its 1982 year of income in relation to gold.

(c) Deep water technology

The sum of $1,464,934 received by the taxpayer pursuant to clause 7.01 of the joint venture agreement with Hematite forms part of the assessable income in its 1979 year of income under s 25(1).

(d) Operatorship assumption payment

The taxpayer is not entitled to deductions under s 51(1) for the $9,388,246 instalment paid in its 1980 year of income or for the $4,655,493 paid in its 1982 year of income.

(e) Tenement acquisition costs

The taxpayer is entitled to the deductions claimed under s 122K in its 1980 to 1984 years of income in so far as those costs relate to coal, oil shale and other minerals. It is not entitled to the deduction claimed under s 77 in its 1982 year of income in so far as those costs relate to gold.

The appeal in relation to the 1979 year is dismissed. Those in relation to the 1980 to 1984 years are allowed, and in each case the assessment is remitted to the Commissioner for reassessment in accordance with these reasons.

Costs

After I had distributed copies of these reasons to the parties, I heard them on the question of costs. The Commissioner submitted that the costs of the appeal which had been dismissed should follow the event. As to the other appeals, he submitted that the taxpayer should pay his costs with respect to the issues on which he had been successful, and that he should pay the taxpayer's costs with respect to the issue on which it had been successful. Such an approach would purport to provide for an allocation of costs between the different issues. However, I do not think it would be possible for the taxing officer to apportion the costs between the various issues involved with any pretence at precision. First, some of the work to which the costs relate was of relevance to all issues. For example, much material was directed to the nature of the taxpayer's business, its corporate structure, the history of its various activities, and the way in which it carried out its activities. Second, there is some overlap between the various issues themselves. Thus the question whether coal and oil shale and the hydrocarbons obtained from them are petroleum, which was central to the issue of exploration and prospecting costs for coal and oil shale, on which the taxpayer was unsuccessful, was also of relevance when considering whether, in relation to tenement acquisition costs with respect to coal, oil shale and other minerals, a deduction was available under s 122K. On that question the taxpayer was successful. Similarly, the issue of deductibility under s 122K also featured in the examination of tenement acquisition costs as they related to gold, with respect to which the taxpayer was unsuccessful. Hence certain affidavits relating to the above matters were of relevance to more than one issue, and court time spent on a point in the context of one issue was important in consideration of another.

In those circumstances I propose to make a broad brush global order as to costs. The taxpayer's measure of success overall was slight. It should pay five-sixths of the respondent's costs, and the respondent should pay one-sixth of the taxpayer's costs.

The Court orders that:

1. The appeal in VG 342 of 1988 be dismissed.

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2. The appeals in VG 343, VG 344, VG 345, VG 346 and VG 347 of 1988 be allowed.

3. The assessments the subject of the appeals referred to in order 2 be remitted to the respondent for re-assessment in accordance with the Court's reasons for judgment.

4. The applicant pay five-sixths of the respondent's costs of the appeals, including costs reserved.

5. The respondent pay one-sixth of the applicant's costs of the appeals, including costs reserved.

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(a) Exploration and prospecting for coal and oil shale

(b) Review, evaluation and bidding costs

(c) Deep water technology

(d) Operatorship assumption payment

(e) Tenement acquisition costs

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