FC of T v VISY INDUSTRIES USA PTY LTD

Judges:
Edmonds J
Greenwood J
Robertson J

Court:
Federal Court of Australia, Melbourne

MEDIA NEUTRAL CITATION: [2012] FCAFC 106

Judgment date: 10 August 2012

Edmonds, Greenwood & Robertson JJ

THE COURT

INTRODUCTION

1. The ultimate issue raised by these appeals is whether the learned primary judge correctly decided that a fee in the sum of AUD27,053,685 paid by the respondent ("Visy USA", formerly Pratt Trading Pty Ltd) to a related company during the year of income ended 30 June 1999 ("1999 year") was an allowable deduction to Visy USA in the 1999 year pursuant to s 8-1 of the Income Tax Assessment Act 1997 (Cth) ("1997 Act").

2. Under a forward exchange contract made in April 1997, Visy USA was obliged to deliver to Pratt Finance Pty Ltd ("Pratt Finance") on dates between 2015 and 2017 specified United States Dollars ("USD") in exchange for Australian Dollars ("AUD") at a specified exchange rate of USD0.775 ("Forward Exchange Contract").

3. On 28 April 1999, Visy USA and Pratt Investments Inc ("Pratt Investments") entered into a forward agreement ("Forward Agreement") pursuant to which Pratt Investments gave an undertaking to indemnify Visy USA against its potential loss under the Forward Exchange Contract. In consideration of this, Visy USA was required to pay a one-off, non-refundable amount of USD17,801,325 upon execution of the Forward Agreement ("Indemnity Fee"). On 18 June 1999, Visy USA paid the Indemnity Fee which at the then prevailing exchange rate equated to AUD27,053,685. As the AUD had increased in value against the USD since 28 April 1998, Visy USA recorded a realised foreign exchange gain of AUD396,315 as a result of the payment.

BEFORE THE PRIMARY JUDGE

Factual Context

4. The factual context leading up to both the Forward Exchange Contract and the subsequent Forward Agreement was the subject of findings by the primary judge in her Honour's Reasons ("R") at [6] to [70]. Save for one finding at R [39] (see ground 7(a)), her Honour's findings of primary fact were not challenged on appeal. Nevertheless, a number of those findings are important to an understanding of what her Honour drew from those findings, either by way of conclusion or findings of secondary fact, as well as to an understanding of our reasons for concluding that there is no error in her Honour's judgment. If only for these reasons, her Honour's more important findings of primary fact are set out below.

5. The Pratt group of companies carried on a diverse range of businesses, including waste collection, paper and cardboard box manufacture, primary packaging and property and share investments ("Pratt Group"). The Pratt Group has been controlled by the Pratt family since 1948.

6. In the late 1980s, the Pratt Group significantly expanded both in Australia and internationally. A complex group and business structure developed. Between 1989 and 1993, the Pratt Group restructured itself into business groups. Three business divisions were created - the Australian Manufacturing Group ("AMG"), the Overseas Manufacturing Group ("OMG") and the Family Finance and Investment Group. Each division had its own management team. Each division was separately accountable for its operating and financial performance.

7. The AMG included the entities conducting paper packaging and recycling businesses in Australia. The parent company of the AMG was Visy Industries Australia Pty Ltd ("Visy Industries Australia"). All of the AMG's borrowings were raised through Pratt Finance, which acted as the internal finance company for the AMG. The OMG included the entities conducting paper, packaging and recycling businesses and investment activities in the United States ("US"). The Australian holding company of the OMG was Visy USA.

8. In early 1997, Pratt Finance was looking to refinance its debt then constituted by a Bilateral Finance Facility ("BIFF") with a panel of local and overseas banks. The BIFF was due to mature in 2022. The quantum of the debt in early 1997 was approximately AUD563 million.

9. After seeking and receiving advice from Credit Suisse First Boston, the Pratt Group Finance Committee ("Finance Committee") decided that it would recommend to the board of Pratt Finance that it seek to repay the existing local BIFF by borrowing USD400 million through the issue of senior unsecured notes (also referred to as bonds).

10. On 19 March 1997, the board of Pratt Finance resolved that Pratt Finance would participate in the placement of senior unsecured notes ("Bonds") to institutional investors resident in the US, repayable in 15 to 18 years ("Proposed Bond Issue").

11. Given the size of the Proposed Bond Issue denominated in USD, the Finance Committee engaged Coopers & Lybrand to consider the potential choices open to Pratt Finance to hedge its USD liability. Mr O'Halloran, the Group Finance Director of Pratt Holding Pty Ltd and a member of the Finance Committee, described the transaction as "the likes of which [they had] never entered into before".

12. Not all hedging methods identified by Coopers & Lybrand were available to the Pratt Group. For example, one method described utilising the US operations to hedge the debt for the entire life of the debt. Mr O'Halloran's evidence was that method was not available to the Pratt Group because there were no unencumbered US assets.

13. Taking into account the Coopers & Lybrand report, the Finance Committee adopted Mr O'Halloran's recommendations and recommended to the directors of Pratt Finance and Visy USA that they adopt a combination of external and internal hedging methods.

14. The Finance Committee recommended that Pratt Finance enter into an internal hedge with Visy USA which at the time, directly and indirectly, owned all the issued share capital of the US resident Pratt holding company, Pratt Holdings USA Inc ("Pratt Holdings USA"). Pratt Holdings USA was not the borrowing entity within the US group. The exchange rate for the internal hedge was to be the same as that negotiated with the external financial institutions; that is, USD0.775. Under the arrangement, Visy USA would agree to deliver USD to Pratt Finance at maturity dates between 2015 and 2017 in exchange for AUD at the rate of USD0.775. It became known as the Forward Exchange Contract. Mr O'Halloran's evidence was that advice was not sought about the pricing and terms of the Forward Exchange Contract because:

"We knew that the particular transaction was unique in its own fashion, and we used our own judgment in terms of what the rate ought to be on that contract. We were keen to ensure that the contract did offer Pratt Trading the opportunity to actually do something with the contract, or through to maturity, simply see it out."

15. Messrs O'Halloran and Byrd (Mr Byrd was the Chief Executive Officer of Pratt Industries (USA) Inc) were members of the Finance Committee. Both gave evidence that they considered the risks and opportunities the proposed hedge held for Visy USA. Mr O'Halloran's unchallenged evidence was that:

"In so far as the opportunities were concerned, I expected that the volatility in the AUD/USD exchange rate would continue and that over the term of the contract, the AUD would experience both increases and decreases in value. I also regarded it as highly probable that at some point over the 20 year swap period, the value of the AUD as against the USD would climb above USD 0.775. [Visy USA] stood to make a gain if the value of the AUD increased against the USD. I expected that because Pratt Finance held a credit rating, financial commitments made by it would have significant commercial value and potential for gain. Because Pratt Finance held a credit rating of BBB+ (and was therefore investment grade), I considered that it would be commercially possible for [Visy USA] to realise any gain by either selling the swap at the time when the AUD had increased above USD 0.775 or by entering into some form of derivative transaction. Because of Pratt Finance's credit rating, I considered the forward exchange contract to be like a marketable security in respect of which [Visy USA] would be able to realise any increase in its value even prior to its maturity. This was an issue which was discussed at finance committee meetings held at the time to consider the Coopers & Lybrand report.

I also considered the risks to [Visy USA] should the AUD depreciate against the USD. [Visy USA] directly and indirectly owned all the shares in [Pratt Holdings USA]. This meant that [Visy USA] had a 100% indirect interest in the US operating assets. Because the AMG (of which Pratt Finance was part) and OMG (of which [Visy USA] was part) operated as standalone entities, I considered that it was important that the OMG executives and directors of [Visy USA] be aware of the obligations being placed on [Visy USA]. However, I expected that any depreciation in the value of the AUD against the USD (which could give rise to liability for [Visy USA] under the forward exchange contract) would be matched by an increase in the AUD value of the earnings and cashflows from the US operations and that accordingly, the risks to [Visy USA] were relatively low provided the base value market value of the US business remained stable. As a result, I did not expect [Visy USA] to incur any additional costs merely as a result of having exposure under the contract. Instead, I considered that because of the duration of the forward exchange contract, [Visy USA] was more likely to be able to profit from it at some point over its term with minimal cost and risk."

16. Mr O'Halloran stated in cross-examination that because the AUD "had traded up well and truly above 77 cents at various times in the previous 20 year period", he had "good cause" to think that entry into the Forward Exchange Contract was "a reasonable position" for Visy USA to be in and that "the likely movement in the exchange rate up would give [Visy USA] the profit opportunity to capitalise on the position it was in."

17. Mr Byrd's evidence was to similar effect. In cross-examination he stated that:

"[T]he long dated maturity was particularly advantageous because it gave us many years of opportunities when the Aussie dollar would be in the money as opposed to out of the money. So I - I looked at that as being prudent because of the long dated maturity; not imprudent because of the long dated maturity. Could get as many opportunities in which to either re-hedge or take advantage of when the Aussie dollar is strong."

Mr Byrd could not recall discussing the possibility of profit with anybody else. His explanation was that it was a "no-brainer in terms of there's a profit opportunity as well as a loss opportunity in any financial … unit hedge transaction that you enter into, whether it's … two banks or a private company".

18. Mr Geminder's evidence (Mr Geminder was a member of the Pratt family) was also to similar effect. In cross-examination he stated that:

"It was hoped in fact that [Visy USA] would ultimately make a profit on the instrument that it put in place … I never anticipated that we would lose money on that contract. My anticipation was that we would make money on that contract."

19. The precise form a derivative transaction might have taken in the future was not considered at the time. Mr Geminder explained in cross-examination that:

"We didn't actually sit down and think about when the - when we were in a profitable position, how are we going to crystallise that profit. But - why would we do that? You know, crystallising a profit in a synthetic hedge, or a hedge like that is not that complicated … There's lots of ways that you can crystallise a profit; there are lots of mechanics and lots of tools … lots of ways to make a mark-up to realise a profit ." (Emphasis added.)

20. Mr Geminder's evidence was that it would have been, for example, open to seek to re-hedge either internally or externally, thus achieving both a profit and a hedge. He described the market as "very vibrant and active".

21. Similarly, when asked in cross-examination whether there were other methods that Visy USA could have used to lock in a profit, Mr O'Halloran responded that:

"I've mentioned the concepts of derivatives; I've mentioned the assignment of all of the obligations. Whether there are other opportunities that could avail themself over a period of time with a range of products that appear in a marketplace, I was aware of that. I had been involved in finance for quite some period of time and seen considerable change in different products that avail themselves; we could have levered off the value of the benefit. Pratt Finance had the underlying obligation - was actually BBB rated credit at the time, which is … great credit for a private company … And whilst it had that credit profile, that instrument that was created and the obligations created under it, in our view, had the ability of being levered and a benefit taken from it."

22. Mr O'Halloran rejected the proposition that the alternatives that were in contemplation all necessarily involved a termination or cancellation of the Forward Exchange Contract and noted that the Forward Agreement that was entered into between Visy USA and Pratt Investments (see [38]-[42] below) did not involve a termination of the Forward Exchange Contract. The primary judge accepted that as a result of the different "mechanics" and "tools", it was open to Visy USA to crystallise a profit without affecting the hedge arrangement; cancellation of the Forward Exchange Contract was just one option.

23. Visy USA did not seek a fee or immediate payment from Pratt Finance for entry into the Forward Exchange Contract because the exchange rate of USD0.775 which it used represented what was described as a "reasonable amount". As Mr O'Halloran explained:

"I felt that the exchange rate that was in the forward agreement at the time reflected the risk that [Visy USA] was entering into the contract. [Visy USA] was not a bank. The nearest comparable amount that we had was the amount in the cross-currency swaps. We had no indication of how much of the fees embedded in the cross-currency swap actually related to principal and how much related to the interest flux. So the nearest comparably comparable we had was what was actually in the cross-currency swap. We didn't know what was allocated to principal and what was allocated to interest flux. We considered the position of [Visy USA] we considered its asset base. We considered what it might be able to do with the contract, and we considered that it had some 18-year period in which to make a profit."

24. That there was no express cost to Pratt Finance is not surprising. Mr Carroll, General Manager of Finance for the Pratt Group, explained that in a forward exchange agreement such costs are generally built into the exchange rate.

25. It was expected that any loss arising to Visy USA if the AUD was to devalue against the USD would be offset by the gain in value of Visy USA's USD denominated assets. If, on the other hand, the value of the AUD increased against the USD, Visy USA would be able to profit from the hedge. Overall, because of the duration of the Forward Exchange Contract, it was considered that Visy USA would be likely to profit from the Forward Exchange Contract at some point over its term with minimal cost and risk.

26. On 21 April 1997, the directors of Pratt Finance and Visy USA resolved that their respective companies would enter into the Forward Exchange Contract.

27. The terms of the Forward Exchange Contract were as follows:

28. From mid May 1997, as a result of the Asian economic crisis, the value of the AUD fell sharply against the USD.

29. By the end of October 1997, as the Asian economic crisis deepened, the AUD had fallen below USD0.70.

30. As a result of the devaluation of the AUD, at the same time that Visy USA's equity in its US subsidiaries increased, its liability under the Forward Exchange Contract increased.

31. Throughout 1998, members of the Finance Committee had frequent discussions about what (if anything) should be done about Visy USA's exposure under the Forward Exchange Contract. To regard the Forward Exchange Contract as an effective hedge for accounting purposes, the auditors needed to be satisfied that Visy USA would be able to meet its liability under the Forward Exchange Contract if it was called upon to do so.

32. By the middle of 1998, the AUD had fallen below USD0.59 and Visy USA had an unrealised loss under the Forward Exchange Contract of AUD80 million. Meetings were held between Mr O'Halloran and US representatives of Pratt Group and AMG officers.

33. At a meeting held in early September 1998, concern was expressed about the effect of the liability under the Forward Exchange Contract on the Pratt Group's overall balance sheet and the ability of Visy USA to meet the liability if it was called upon to do so. Those concerns and the decisions that were taken were recorded on 7 September 1998, when Mr O'Halloran sent a memorandum to Messrs Byrd, Nixon-Smith (the Chief Financial Officer of the AMG) and others entitled "Foreign Currency Hedges":

"[I]t was agreed that given the recent volatility in the A$ against the US$ it would be prudent to revisit all of our current hedging strategies. This includes both the external hedge positions held by the AMG with local banks and the natural hedge on the equity in the US balance sheet. There was concern with the large unrealised loss position in the total Australian group balance sheet. The general consensus view was that at 56c. we should not take cover but have a stop loss strategy in place. If the A$ fell below 50c. we should take external cover on the natural hedge position as the out of the money position would be simply too high for the group. If the A$ rises we should find a reset point which would give a degree of comfort to the group.

…

[W]e agreed that it made no sense for a 100% privately owned group with significant assets and liabilities in cross currencies to pay substantial sums for external currency hedging cover. Where possible we agreed that where no natural hedge existed within a balance sheet we should try to match positions in both Australia and the United States for the better good of the group as a whole.

We agreed to meet again in November to discuss these issues in greater depth."

34. At about the same time, the auditors questioned the effectiveness of the Forward Exchange Contract. The auditors told the Pratt Group that the effectiveness of the hedge for accounting purposes was dependent on them being satisfied that Visy USA was able to meet any liability it might incur under the Forward Exchange Contract - the internal hedge. It must be recalled that although Visy USA was the ultimate holding company of the OMG (which included the US group), Visy USA did not have direct access to the cashflows of the US businesses.

35. By November 1998, the AUD had recovered but Mr O'Halloran remained concerned about Visy USA's accrued liability under the Forward Exchange Contract. So, on 25 November 1998, he sent a further memorandum to Messrs Byrd, Nixon-Smith and others entitled "Foreign Currency Strategy" which contained his notes of a meeting from the previous week. Relevantly, under the heading "Impact of A$ movement", the memorandum stated:

"In August we agreed not take [sic] cover in relation to the natural hedge. Fortunately this looks to have been a very good idea as rates have moved up since then. There also appears to be good signs on the US market front considering the recent merger activity and a slight movement up in linerboard prices. At the current 63.5c rate we have clawed back A$43m since September. We are still out of the money by A$56m .

The general consensus view was that we should now take advantage of the recent surge in the A$ to mitigate any possible future losses in Australia . This should involve taking a direct position against the US assets in the USA to align US$ denominated debt with our US$ held assets …

…

I refer to my earlier comments on the need for the group to match currency positions on a global basis. This seems an ideal opportunity to do something in this regard. If [Visy USA] were to make a payment for an indemnity to Pratt [Investments] against downward movement in the A$ against the US$ we can achieve the same economic effect as the put option. If this can be achieved it is a better long term proposition for the group in terms of both security and long term earnings potential.

…

The best alternative would be to match the repayment profile with US cash flows. The projections for the US operations are for excess cash flows (ie EBITDA) in excess of US$200m annually providing ample cash flow to service the current shortfall …

…

It will be necessary to keep the [Visy USA] forward exchange agreement with Pratt Finance on foot as this is still the best mechanism to protect its balance sheet. [Visy USA] should then take a position with the appropriate Pratt US company (say [Pratt Investments]) which will ensure delivery of the US$ to [Visy USA] on the prescribed dates…We have tried to assess the indemnity payment price based on the NPV of the payments using A$ forward rate projections and believe that A$27m is about right at the current rates."

(Emphasis added.)

Mr O'Halloran accepted that the "we" identified in the above passages was a reference to Visy USA.

36. In early 1999, Mr Carroll had also become concerned about the volatility in the value of the AUD and about Visy USA's ability to meet its liability under the Foreign Exchange Contract. The value of the US group was not increasing at the same rate as Visy USA's liability and, being a holding company, Visy USA did not have direct access to USD. Accordingly, the only way Visy USA could meet its liability if it were called upon to do so would be either to raise US debt itself or sell some of its USD assets. Neither option was considered appropriate. The Pratt Group did not want to have to raise debt to discharge a liability between two Pratt Group companies at a time when the Pratt Group was considering raising debt for the purposes of further expanding its business operations. Visy USA did not want to sell US assets which were part of its long term business strategy.

37. Mr O'Halloran asked Mr Carroll to obtain a price from the Commonwealth Bank of Australia ("CBA") for entering into an option to purchase USD in exchange for AUD at an exchange rate of USD0.775 on various dates between 2015 to 2017. The estimated price provided to buy these options was USD18 million.

38. Four months later, Mr O'Halloran received a memorandum from Mr Byrd entitled "Forward Indemnity Agreement". The memorandum recorded a decision made the previous week about a forward indemnity agreement contingent upon four issues being resolved in the following terms:

  • "1. Pricing: I have discussed the payment with J.P. Morgan & Co. (who have been advising us on matters pertaining to interest-rate and currency risk) and I will obtain a quote from them.
  • 2. Security: You mentioned that the Australian directors and auditors are concerned with the level of security to support the future obligations under the indemnity. Could you please confirm your requirements?
  • 3. Balance Sheet: I can confirm that the funds will be off-balance sheet to the core U.S. manufacturing operations and that the lenders to Pratt Industries (U.S.A.), Inc. will not be affected by the position.
  • 4. Timing: The directors are due to confirm the transaction at next week's board meeting. Can we please ensure all negotiations are completed by then."

39. The contemporaneous documentation records that the price obtained for providing the indemnity under the Forward Agreement was to be an arm's length price. Quotes were sought from JP Morgan and the CBA. JP Morgan estimated the cost of the indemnity to be USD17.6 million using the most recent spot USD/AUD rate of 0.6485. CBA used the same parameters and priced the indemnity at USD18,013,200.

40. By 26 April 1999, the AUD had reached USD0.645. It was agreed that the Forward Agreement should be entered into. The terms of the Forward Agreement were negotiated. On 28 April 1999, the terms of the Forward Agreement were agreed. JP Morgan quoted a sum of USD17,801,325 which Mr O'Halloran accepted.

41. The Forward Agreement between Pratt Investments and Visy USA was dated 28 April 1999. It was signed by Mr Byrd on behalf of Pratt Investments and by Mr Richard Pratt on behalf of Visy USA. The recitals recorded that:

  • "A. [Visy Industries] entered into a forward exchange contract with [Pratt Finance] whereby [Visy Industries] agreed to sell to [Pratt Finance] US$200 million at the agreed fixed exchange rate of 0.7750 on various dates from 2015 to 2017.
  • B. [Visy Industries] now wishes to protect itself from the possibility that it may incur a foreign exchange loss in respect of the Contract.
  • C. [Pratt Investments] has agreed to enter an agreement with [Visy Industries] whereby it shall indemnify [Visy Industries] against any and all losses arising under the Contract in consideration of the payment by [Visy Industries] to [Pratt Investments] of the Payment Amount."

42. Under the terms of the Forward Agreement, in consideration of Pratt Investments entering into the Forward Agreement and undertaking to indemnify Visy USA against its potential loss under the Forward Exchange Contract, Visy USA was required to pay and did pay the Indemnity Fee; a one-off, non-refundable amount of USD17,801,325, upon execution of the agreement. A copy of the Forward Exchange Contract was attached as an Annexure. There was no dispute that Visy USA paid the Indemnity Fee (AUD27,053,685) to Pratt Investments on 18 June 1999. It was this fee Visy USA claimed as a deduction. As the AUD had increased in value against the USD since 28 April 1999, Visy USA recorded a realised foreign exchange gain of AUD396,315 as a result of the payment.

The Respective Submissions

43. Before the primary judge, Visy USA submitted that the Forward Exchange Contract was a commercial transaction or an adventure in the nature of trade which it entered into in 1997 for the not insignificant purpose of profit-making. Secondly, it submitted that any profit which it might earn from the Forward Exchange Contract would be assessable to it and any loss it incurred would be an allowable deduction. Thirdly, it submitted that the Indemnity Fee was incurred by it in 1999 to mitigate against what, by then, was expected to be the incurrence of a loss arising under the Forward Exchange Contract. Finally, it submitted that the occasion for the outgoing was to be found in the profit-making undertaking comprising the Forward Exchange Contract and the steps taken by Visy USA to mitigate against the potential loss from that contract. These submissions were repeated on appeal.

44. Before the primary judge, the Commissioner submitted that the Forward Exchange Contract was not a commercial transaction or an adventure in the nature of trade and further, or alternatively, it was not made with a view to profit; if that submission was rejected, the Commissioner submitted that the Indemnity Fee was an outgoing of capital or of a capital nature. On appeal, these submissions were repeated; although the submission below that the Forward Exchange Contract was not a commercial transaction was not, correctly in our view, at the forefront of the Commissioner's submissions. Nevertheless, ground 12 of the Commissioner's notice of appeal did assert that the primary judge misconstrued the terms of the Forward Exchange Contract in concluding that the terms were to the commercial advantage of Visy USA and that it could profit by those terms.

The Ultimate Conclusion

45. Importantly to the outcome before the primary judge, her Honour rejected the Commissioner's contention that the Forward Exchange Contract was not a commercial transaction or was not an adventure in the nature of trade. Her Honour also rejected the Commissioner's submission that there was no contemporaneous evidence that the Forward Exchange Contract was made with a view to profit or that Visy USA's profit-making purpose was inconsistent with or antithetical to Pratt Finance's hedging and accounting requirements.

46. Her Honour concluded that the Indemnity Fee was an allowable deduction to Visy USA either as being incurred in gaining or producing its assessable income or as being necessarily incurred in carrying on a business for that purpose; and that it was not an outgoing of capital or of a capital nature.

The Reasons

47. The primary judge drew a number of relevant conclusions from her Honour's findings of primary fact and in the process made a number of findings of secondary fact. They included the following:

THE COMMISSIONER'S APPEALS IN THIS COURT

48. As noted in [4] above, the primary judge's findings of primary fact were largely left unchallenged. On the other hand, a large number of the conclusions her Honour drew from the findings of primary fact as outlined in [47] above, comprising the basis of her Honour's process of reasoning for coming to her ultimate conclusion, were challenged by the Commissioner's appeals. There was one exception to this, namely, in relation to ground 3 of the Commissioner's notice of appeal the Commissioner's senior counsel asserted that "there is no place for the application of s 8-1 in respect of outgoings antecedent to the realisation of the expected profit". The Commissioner's senior counsel conceded that this ground was only "faintly" run below and, insofar as the Court required, sought leave to raise it. We do not think leave is required, but for reasons which we deal with at [80] and following below, the ground is, with respect, misconceived for the reasons there given.

49. There were 12 grounds of appeal, but a number can be grouped and considered together because the grounds within each group challenged the same conclusion drawn by the primary judge albeit by reference to different, allegedly erroneous, findings of secondary fact. For example, grounds 7 to 12 of the Commissioner's notice of appeal challenged the primary judge's conclusion that the Forward Exchange Contract was made by Visy USA with a not insignificant purpose of profit-making. Before looking at the primary judge's specific findings of secondary fact that led her Honour to this conclusion and which are now assailed by the Commissioner in grounds 7 to 12 of his notice of appeal, we wish to make a couple of general observations concerning the arguments both in this Court and below.

50. As already noted in [44] above, the Commissioner's argument below that the Forward Exchange Contract was not, from Visy USA's point of view, a commercial transaction, was not to the fore of his submissions in this Court. We have already observed that we think this was a correct course to take, notwithstanding the existence of ground 12 in the Commissioner's notice of appeal. There was no evidence from the witnesses who were called and cross-examined that could be relied on for such an argument and, apart from the bald statement of ground 12 itself that the primary judge misconstrued the terms of the Forward Exchange Contract in concluding that the terms were to the commercial advantage of Visy USA and that it could profit by those terms, nothing was referred to by way of exemplification of the ground.

51. That aside, there will be many cases where a party to a contract does not know, at the time of entering into the contract, whether the terms of the contract will ultimately be to its commercial advantage. That will not impede a conclusion that the contract, from that party's point of view, was a commercial transaction to enter into or, if it be the case, that the party entered into the contract with a not insignificant purpose of profit-making, provided the terms of the contract accommodate the potentiality for realisation of profit if circumstances contemplated by the contract eventuate; then, while the contract might be described, from that party's point of view, as many other things, it cannot be described as not commercial.

52. Finally, by way of general observation, we have to say that we do not find terms such as "profit-making undertaking", "profit-making scheme" or "adventure in the nature of trade" to be helpful in a case such as this where the taxpayer is carrying on a business and the transaction is entered into in the course of that business albeit not in the ordinary course. As the High Court has warned in a different context, the statute is to be construed and applied according to its terms, not under the influence of "muffled echoes of old arguments" concerning other legislation:
Federal Commissioner of Taxation v Spotless Services Ltd (1996) 186 CLR 404 at 414 in the plurality judgment. Terms such as "profit-making undertaking", "profit-making scheme" and "adventure in the nature of trade" have an historical nexus with provisions no longer to be found in the statute. They certainly find no expression in the pivotal passage from the High Court's judgment in
Commissioner of Taxation v Myer Emporium Ltd (1986-1987) 163 CLR 199 at 209, 210 which lies at the heart of this case:

"Although it is well settled that a profit or gain made in the ordinary course of carrying on a business constitutes income, it does not follow that a profit or gain made in a transaction entered into otherwise than in the ordinary course of carrying on the taxpayer's business is not income. Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the character of income. But a gain made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circumstances of the case. Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer's business . Nor does the fact that a profit or gain is made as the result of an isolated venture or a 'one-off' transaction preclude it from being properly characterized as income:
Federal Commissioner of Taxation v. Whitfords Beach Pty. Ltd. The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit."

(Emphasis added.)

In the present factual context, the risk of using language or terms other than of a kind found in this passage is that they may mislead: see
Investment and Merchant Finance Corporation Ltd v Commissioner of Taxation (1971) 125 CLR 249 at 255 per Barwick CJ.

Grounds 7-12

53. By these grounds, the Commissioner assailed a range of findings of secondary fact made by the primary judge upon which her Honour relied for her conclusion that Visy USA entered into the Forward Exchange Contract with a not insignificant purpose of profit-making; in the alternative, these grounds asserted that her Honour erred in not making findings to the contrary or in terms that were inconsistent with such a conclusion.

54. The findings assailed ranged from the criteria by reference to which the exchange rate for the Forward Exchange Contract was selected; the availability of derivative arrangements to Visy USA to crystallise a profit before the maturity of the Forward Exchange Contract; the investment grade credit rating of Pratt Finance to increase the prospect of Visy USA being able to "lever" value; and the terms of the Forward Exchange Contract and its duration to maturity. The contrary or inconsistent findings alleged, in the alternative and in error, not to have been made, covered much the same ground.

55. Having regard to the largely unchallenged findings of primary fact, we are of the view that there was no error on the part of her Honour in making the assailed findings of secondary fact. Equally, we are of the view that there was no error on the part of her Honour in failing to make the contrary or inconsistent findings alleged, in the alternative, in these grounds.

56. It follows, in our view, that there was no error in her Honour's conclusions that Visy USA entered into the Forward Exchange Contract with the not insignificant purpose of profit-making.

Ground 6

57. Before leaving this issue, it remains to address ground 6 which asserted that her Honour erred in applying principles from authorities, such as
Brajkovich v Commissioner of Taxation (1989) 89 ALR 408 and
Babka v Commissioner of Taxation (1989) 89 ALR 373, concerning whether the profits derived from carrying on a business of gambling, punting or wagering are assessable income, to characterise profit that may be realised from a single forward exchange contract, as assessable income.

58. Having reviewed what her Honour said at R [109]-[111] and having re-read the authorities referred to, we reject this ground; it has no substance whatsoever. The most that could be gleaned from what her Honour said in these paragraphs is that the fact that the outcome of a particular activity may be dependent, in part, on chance does not negate a business activity being carried on. With respect, that proposition does not involve any error.

Grounds 1-5

59. The primary judge concluded that the Indemnity Fee was incurred in gaining or producing assessable income. The occasion of the outgoing was to be found in the profit-making undertaking comprising the Forward Exchange Contract (R [118]). According to the Commissioner, that conclusion rested, erroneously, on authority applicable to losses and outgoings necessarily incurred in carrying on a business whilst the Indemnity Fee was, at best, incurred in respect of an isolated profit-making undertaking. In particular, the Commissioner contended, the learned trial judge incorrectly treated the Indemnity Fee:

60. There is a fundamental difficulty with the premise upon which those grounds were predicated which goes back to the concern we expressed in [52] above. That is, the Indemnity Fee was incurred by Visy USA in carrying on a business albeit not in the ordinary course of that business. But s 8-1 of the 1997 Act, like its predecessor s 51(1) of the Income Tax Assessment Act 1936 (Cth) ("1936 Act"), does not distinguish between outgoings incurred in carrying on a business and outgoings incurred in the ordinary course of carrying on a business; both are allowable deductions provided they are not outgoings of capital or of a capital nature.

Grounds 1 and 2: Substituted Expenditure

61. The Commissioner contended that her Honour wrongly relied on Nevill at 307 per Dixon J.

62. The contention went like this: The reasoning in Nevill is not applicable to expenditure incurred in respect of an isolated profit-making transaction such as the Forward Exchange Contract. Nevill concerned the question of whether a termination payment made to an executive of the taxpayer company was an amount necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. Critical to the conclusion in the case were findings that a business is a whole set of operations directed towards producing income and that the expenses of organising staff are a necessary part of the organisation of business. Even if it were correct to say that the Indemnity Fee was occasioned by the Forward Exchange Contract, it was not an incident of operations directed towards producing income. The Forward Exchange Contract was an isolated transaction undertaken outside the course of Visy USA's business.

63. There are, at least, two difficulties with this contention. First, the Forward Exchange Contract, while it may have been undertaken outside the ordinary course of Visy USA's business, was not, as the Commissioner contended, undertaken outside the course of that business. Second, there is nothing in the reasons of Dixon J in Nevill, in particular at 307, that would confine the "substituted expenditure" principle to expenditure incurred in carrying on a business; but, in any event, the Indemnity Fee was so incurred. These grounds cannot be sustained.

Grounds 4 and 5: Payments of insurance and the Indemnity Fee as an outgoing of capital

64. The Commissioner contended that the primary judge also erred in likening (at R [130]) the Indemnity Fee to a payment for insurance. The Commissioner conceded that economically, both financial arrangements might be comparable but that the primary judge's reasoning demonstrates the dangers of doing so in the taxation context. The Indemnity Fee was not a recurring cost of a business incurred for securing and retaining its capital, for protecting a business against the loss of the capital invested in it and for ensuring the continued availability of the capital investment by which the business earns its income, cf.,
Australian National Hotels Ltd v Federal Commissioner of Taxation (1988) 19 FCR 234 at 240-241 per Bowen CJ and Burchett J. It was a one-off, lump sum payment.

65. The Commissioner contended that in treating the Indemnity Fee as similar to a payment for insurance, the primary judge erred by equating the profit-making undertaking and Visy USA's business. The Indemnity Fee was not incurred in respect of the Forward Exchange Contract but to protect Visy USA's business from the consequences of the separate profit-making undertaking her Honour found. In that respect, it was a capital outgoing.

66. Similarly, the Commissioner contended, the primary judge failed to have regard to both the not insignificant purpose of profit-making she found (at R [104]) and the purpose of making the Forward Exchange Contract as an internal hedge. The Indemnity Fee was not incidental or relevant to the purpose of profit-making but to the maintenance of the internal hedge.

67. We are not sure that we properly comprehend the Commissioner's contentions in [65] and [66] above, however, their foundation seems to be infected with the same difficulty referred to in [52] and [60] above namely, Visy USA's entry into the Forward Exchange Contract and the subsequent Forward Agreement were outside the scope of its business. They were not. They may have been outside the ordinary course of its business but if the former was entered into for the not insignificant purpose of profit-making, as the primary judge found and with which we can find no error, then they carry the same revenue consequences as a transaction entered into by a taxpayer in the ordinary course of its business: Myer Emporium at 209, 210.

68. We agree with the Commissioner's contention that in the area of characterising the nature of receipts and outgoings or profits and losses for income tax purposes, analogies can be dangerous. They can mislead by leading to taxation by reference to economic equivalence, in other words, by reference to the same commercial result. The courts of this country have said on many occasions in the past that this is neither helpful nor, indeed, permissible: see for example
Federal Commissioner of Taxation v Orica Ltd (1998) 194 CLR 500 at [70] in the plurality judgment.

69. That said, an insurance contract is but a contract of indemnity and this is precisely the form and substance of the Forward Agreement. There was no suggestion that the Forward Agreement was not a true contract of indemnity against risk, cf.,
Ransburg Australia Pty Ltd v Commissioner of Taxation (1980) 47 FLR 177 at 182-185 per Fisher J (with whom Deane J agreed). It is true that the counterparty to the Forward Agreement (the insurer) was a related party, but so were the insurers in Australian National Hotels and in
WD & HO Wills (Aust) Pty Ltd v Federal Commissioner of Taxation (1996) 65 FCR 298. As in those cases, the Indemnity Fee was found to be an arm's length price (see [39] above); in Australian National Hotels the amount of the premiums was found to be "related to the difference between the local interest rates and the interest rates available in Saudi Arabia" (at 242 in the majority judgment), while in WD & HO Wills, Sackville J found that "the premiums, despite [their] magnitude, were not unreasonable for the cover obtained and were determined with the benefit of expert advice to Wills" (at 333); see too at 329-330. It follows, in our view, that in the present case neither the size of the Indemnity Fee nor the fact that the insurer was related to Visy USA furthers a conclusion that it was an outgoing of a capital nature.

70. In Australian National Hotels, the loss insured against was on capital account - an indemnity against exchange losses in relation to a foreign currency loan borrowed by the appellant in connection with the extension of a hotel and the construction of a casino - but the majority nevertheless concluded that the premiums incurred by the appellant were deductible under s 51(1) of the 1936 Act; in particular, they were not outgoings of a capital nature.

71. On the other hand, in WD & HO Wills, the loss insured against was on revenue account - an indemnity against liability to consumers of the taxpayer's tobacco products who suffered damage to their health. The present case falls into this latter category because the Indemnity Fee was paid for an indemnity against a loss under the Forward Exchange Contract which, on the primary judge's finding, was entered into for the not insignificant purpose of profit-making. As such, any profit would be assessable but any loss would be deductible with the consequence that payment under the indemnity would be assessable in Visy USA's hands. While the High Court in
Commissioner of Taxation v Smith (1981) 147 CLR 578 at 582 per Gibbs CJ, Stephen, Mason and Wilson JJ said that such a consequence was not necessarily determinative of the question whether the premium is deductible under s 51, it is a consideration that is relevant to that question.

72. So understood, the case for the deductibility of the Indemnity Fee is arguably stronger in this case than the premiums were in the case of Australian National Hotels.

73. However, the Commissioner points to the following matters or considerations as to why the Indemnity Fee should be characterised as being an outgoing of a capital nature and for that reason denied deductibility under s 8-1 of the 1997 Act:

74. The Indemnity Fee was paid by Visy USA as a one-off lump sum payment and was not recurrent. But that alone will not characterise an outgoing as being of a capital nature unless, on balance, the relevant Sun Newspapers matters point to such a characterisation.

75. We agree with the primary judge's conclusions and findings of secondary fact in [47(8) and (9)] above. It is indisputable that the Forward Agreement with Pratt Investments was entered into and the Indemnity Fee paid in the context that the Forward Exchange Contract with Pratt Finance had been on foot for two years and that Visy USA wished "to protect itself from the possibility that it might incur a foreign exchange loss" in respect of the anterior contract. That is the advantage or benefit sought by Visy USA, "from a practical and business point of view", from entering into the Forward Agreement and paying the Indemnity Fee. Moreover, it did these things, as it did in entering into the Forward Exchange Contract, in the course of its business, albeit not in the ordinary course of that business.

76. We also agree that the payment of the Indemnity Fee did not secure for Visy USA any enduring benefit of a capital nature. It may have enabled Visy USA, or even the Pratt Group (on a consolidated basis) to avoid bringing to account or disclosing the unrealised loss under the Forward Exchange Contract in circumstances where the assets of Visy USA might have been insufficient to cover that loss, but such a commercial advantage does not re-characterise an outgoing which is clearly on revenue account into one of a capital nature.

77. The foregoing equally deals with the third matter to which the Commissioner referred as set out in [73] above.

78. Just as one has to determine the assessability of a receipt in the hands of a company by reference to its character in its hands and not by reference to its character in the hands of an affiliate (
Federal Coke Co Pty Ltd v Federal Commissioner of Taxation (1977) 34 FLR 375 at 388 per Bowen CJ; at 404 per Brennan J), one has to determine the nature and character of an outgoing incurred by a company under both the positive and excluding limbs of s 8-1 by reference to its nature and character as incurred by the company itself, and not by reference to its nature and character as if incurred by an affiliate, or by the fictional group to which it belongs. This is not to exclude the relevance of the company's role in the group because that may throw light on the nature or character of its activities:
GRE Insurance Ltd v Federal Commissioner of Taxation (1992) 34 FCR 160 at 166; but beyond that one cannot go.

79. These grounds cannot be sustained.

Ground 3: s 8-1 does not operate on the Indemnity Fee

80. As noted in [48] above, at best this ground was only "faintly" run below. It might be described as the tax accounting ground. It went like this: as the amount taken into assessable income is not the gross amount received, there is no place for the application of s 8-1 in respect of outgoings antecedent to realisation of the expected profit:
Commercial and General Acceptance Limited v Federal Commissioner of Taxation (1977) 137 CLR 373 at 381-387 per Mason J; see also
Federal Commissioner of Taxation v Montgomery (1999) 198 CLR 639 at [111] per Gaudron, Gummow, Kirby and Hayne JJ. Applied to the Forward Exchange Contract, as a profit-making undertaking, any gross amount received on its maturity or close-out could not be assessable income of the taxpayer for the simple reason that it would not belong to any recognised category of income according to ordinary concepts (it is not income from a business, from property, from personal exertion, etc) and would not be statutory income either (capital gains tax aside). Therefore, the Indemnity Fee cannot be deductible in its own right (i.e. in gross) under s 8-1 because it cannot satisfy either positive limb of the section. If it is deductible at all, it must be as an integer of a larger profit or loss.

81. The Commissioner further contended that, even if s 8-1 is not, generally, inapplicable in the context of a profit-making undertaking, receipts and outgoings accounting does not here give a correct reflex of the outcome of the profit-making undertaking the trial judge found: cf., Parsons RW, Income Taxation in Australia: Principles of Income, Deductibility and Tax Accounting (Law Book Company, 1985) at [12.4]-[12.7]. The Forward Exchange Contract does not contemplate regular cash flows in each direction such as might call for regular netting off. Rather, it provides for delivery of only five amounts by the respondent to Pratt Finance over the period May 2015 to May 2017; that is, the cash flows are all in one direction commencing only after 18 years. Any profit outcome is unknown until the maturity dates. In those circumstances the paying party, Visy USA, should not get deductions each year and subsequently return the gross gain (if any) on maturity.

82. There are a number of difficulties with this ground and as we observed in [48] above it is, with respect, misconceived.

83. For a start, the ground relies on what was said by the majority in Montgomery at [111]. While we would concede, with respect, that it is not entirely clear to us the basis of the distinction their Honours were seeking to draw in this particular paragraph, they do say in the last sentence:

"By contrast … if the singular adventure is undertaken in the course of a wider business, the gross receipts, as opposed to the net profit from the adventure, are properly characterised as revenue receipts."

That is this case, and it is sufficient to reject this ground.

84. But the ground is fallacious on fundamental principle. If an item is income, either according to ordinary or statutory concepts, its derivation is not deferred, indeed denied, until a profit can be determined in a subsequent year by reference to some wider transaction of which the item of income forms part: Investment and Merchant Finance at 255 per Barwick CJ. Equally, if an outgoing is an allowable deduction in a year because it was incurred in that year, its deductibility is not denied or deferred until a profit can be determined in a subsequent year by reference to a wider transaction of which the outgoing forms part.

CONCLUSION

85. For these reasons, we are of the view that the appeals should be dismissed with costs.

 

Disclaimer and notice of copyright applicable to materials provided by CCH Australia Limited

CCH Australia Limited ("CCH") believes that all information which it has provided in this site is accurate and reliable, but gives no warranty of accuracy or reliability of such information to the reader or any third party. The information provided by CCH is not legal or professional advice. To the extent permitted by law, no responsibility for damages or loss arising in any way out of or in connection with or incidental to any errors or omissions in any information provided is accepted by CCH or by persons involved in the preparation and provision of the information, whether arising from negligence or otherwise, from the use of or results obtained from information supplied by CCH.

The information provided by CCH includes history notes and other value-added features which are subject to CCH copyright. No CCH material may be copied, reproduced, republished, uploaded, posted, transmitted, or distributed in any way, except that you may download one copy for your personal use only, provided you keep intact all copyright and other proprietary notices. In particular, the reproduction of any part of the information for sale or incorporation in any product intended for sale is prohibited without CCH's prior consent.