CASE 38/95

Members:
BJ McMahon DP

Tribunal:
Administrative Appeals Tribunal

Decision date: 28 June 1995

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BJ McMahon (Deputy President)

The applicant is a company incorporated in the United States of America and is resident in Australia for tax purposes. It is a subsidiary of a German company. Another subsidiary of the German parent is a company incorporated in Australia. In October 1986 the applicant acquired one-half of the interest of the Australian company in a joint venture that was carrying on an industrial enterprise.

2. The organisation of the affairs of the joint venture was such that the participants were entitled, for tax purposes, to depreciate their percentage ownership of joint venture plant as if it were plant discretely owned by each participant. The written arrangements under which the applicant acquired its interest provided only for a total purchase price. In the subsequent taxation returns of both the American and the Australian companies, an apportionment of the price was made for depreciation purposes. Sums were attributed to furniture and equipment, computer facilities and motor vehicles at their written down value. The

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remainder of the consideration was attributed to plant. The result of this was that the stated consideration was considerably in excess of the written down value of the plant. The American company sought the exercise of the respondent's discretion so as to allow it to depreciate the plant starting from the higher allocated figure. In each of the years ended 31 December 1986 and 1988, adjustments were made to the incomes as returned so as to exclude the higher depreciation claim. Objections to these assessments were disallowed. This application is brought to review those objection decisions. For reasons that are here irrelevant, no question arises concerning the return for the year of income 31 December 1987.

3. Because of the nature of the industry in which these events occurred, it is not possible to give details of the surrounding facts without disclosing the identity of the parties, contrary to the provisions of the Taxation Administration Act, and without, more importantly, disclosing confidential, commercial information. Accordingly, I indicated at the hearing that I would prohibit publication of my findings as to facts and the detailed evidence upon which those findings are based. I believe it important, however, to state publicly the principles that I applied in determining whether the relevant discretion ought to be exercised in the applicant's favour.

4. The discretion appears in sub-section 60(2) of the Income Tax Assessment Act. As with all discretions, it is to be exercised so as to serve the objectives of the legislation, determined from its terms and from the general scope and objects of the relevant surrounding parts of the legislation.

5. It is useful, therefore, to examine firstly the structure of the depreciation provisions. References to and quotations from sections of the Act are based upon the text as it appeared in 1986. Section 54 allows depreciation on plant used for income producing purposes. Sections 55 and 56 set out the way in which the rate of depreciation is to be calculated. By and large, it is generally a percentage rate fixed by the Commissioner, having regard to the cost of the plant and its effective life. Section 56(2) ensures that no further depreciation is to be allowed once deductions have brought the depreciated value down to nil. It provides: ``The deduction allowable in respect of any unit of property shall not exceed the depreciated value of that unit''. That fundamental concept is repeated in sub-sections 60(1) and 62(1).

6. On a disposal of the plant, the difference between the disposal consideration and the depreciated value is assessable, or deductible, depending on whether it results in a surplus or a deficit. Section 59 provides for a balancing charge or deduction as the case may be. Sub- section 59(3)(d) provides that if the plant is disposed of otherwise than by sale, then the proceeds are taken to be the value of the property. Paragraph 59(3)(c) provides that where the property is sold with other assets and no separate value is allocated to the property, then the consideration receivable is deemed to be an amount determined by the Commissioner. This concept is carried over into s 59AA. That section was inserted to deal with disposal of part of an interest in plant (for example, where there is a change in the constitution of a partnership or in the interests of the partners) and to provide that the same considerations are to be taken into account as in a disposal of the entirety. Section 59AA provides that where there is no agreement between the parties as to the specified consideration, then the relevant amount is to be determined by the Commissioner. As there was no amount specified for plant in the present circumstances, it will be necessary to carry out the exercise contemplated by s 59AA. The present transaction which led to the claim for higher depreciation was the disposal of part of the interest of a company in a joint venture. Accordingly, the terms of s 59AA are to be applied.

7. The terms of that section are as follows-

``59AA(1) Subject to this section, where, for any reason, including-

• (a) the formation or dissolution of a partnership; or
• (b) a variation in the constitution of a partnership, or in the interests of the partners,

a change has occurred in the ownership of, or in the interests of persons in, property in respect of which depreciation has been allowed or is allowable under this Act or the previous Act, and the person, or one or more of the persons, who owned the property before the change has or have an interest in the property after the change, the provisions

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of this Act relating to depreciation apply as if the person or persons who owned the property before the change had, on the day on which the change occurred, disposed of the whole of the property to the person, or all the persons, by whom the property is owned after the change for a consideration equal to the amount specified in the agreement in consequence of which the change occurred as the value of the property for the purposes of that agreement, or, if there is no such agreement or no amount is so specified, an amount determined by the Commissioner.

59AA(2) Where-

• (a) the change in the ownership of, or in the interests of persons in, the property occurred in consequence of an agreement;
• (b) an amount was specified in the agreement as the value of the property for the purposes of the agreement; and
• (c) the amount so specified in the agreement is less than the amount that was the market value of the property immediately before the time when the change occurred and is also less than the depreciated value (calculated without regard to the operation of section 57AF) of the property immediately before that time,

the provisions of this Act relating to depreciation apply as if-

• (d) the person or persons who owned the property before the change had, at the time when the change occurred, disposed of the property for a consideration equal to the market value of the property immediately before the time when the change occurred or the depreciated value (calculated without regard to the operation of section 57AF) of the property immediately before that time, whichever is the less; and
• (e) the person or persons who owned the property after the change had, at the time when the change occurred, acquired the property at a cost equal to the amount specified in the agreement.

59AA(3) A reference in sub-section (2) to the market value of property at a particular time shall, if there is insufficient evidence of the market value of the property at that time, be read as a reference to such amount as, in the opinion of the Commissioner, is fair and reasonable.''

8. Sections 59 and 59AA allow the vendor and purchaser to fix the price by reference to which they will be taxed under sub-sections 59(1) and s 54. The power to fix this price is, of course, subject to s 60 and to the anti avoidance provisions to which reference will later be made.

9. It was submitted on behalf of the applicant that the exercise to be carried out by the Commissioner under paragraph 59(3)(c) and s 59AA should be seen as an exercise in determining market value. Although there is some reference to this concept in sub-section 59AA(2), there is no such indication in the 2 amount determination provisions to which I have referred. The Commissioner's role (and the role of this Tribunal) is to apportion the consideration for the whole among the several assets or interests acquired in such fashion as is, in all the circumstances of the transaction, appropriate. This apportionment may or may not reflect the market value.

10. Section 60 is in the following terms-

``60(1) Where, either before or after the commencement of this Act, a person has acquired any property in respect of which depreciation has been allowed or is allowable under this or the previous Act, he shall not be entitled to any greater deduction for depreciation than that which would have been allowed to the person from whom the property was acquired if that person had retained it:

Provided that, where under section 59 an amount is included in the assessable income of the person selling the property, the person acquiring the property shall be allowed depreciation calculated on the sum of that amount and the depreciated value of the property under this Act immediately prior to the time of the sale.

60(1A) For the purposes of sub-section (1), an amount that would, but for sub-section 59(2A) or (2D), be included in the assessable income of the person selling the property shall be deemed to have been so included.

60(2) This section does not apply where the Commissioner is of the opinion that the

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circumstances are such that depreciation in respect of the property should be calculated without regard to this section.''

11. It will be seen that the section limits the depreciation allowable to the value of the plant, after it has been sold. The scheme of the Act is that only the original cost of the plant is available as a depreciation deduction on a regular proportional basis and this total deduction is available only once (
Gustaff Ferling v FC of T (1965) 14 ATD 66 at 69; (1965-1966) 115 CLR 603 at 607-608). This reflects the concept to which I have referred, which appears in sub-sections 60(1), 56(2) and 62(1). These 3 sections fix the upper and lower starting and finishing points for depreciation, namely cost at the upper end and nil at the lower end.

12. There are anti avoidance provisions in the depreciation sections which are directed particularly at dealings which are not at arm's length. Sub-sections 56(4) and 62(3) apply where s 60 has no application because, for example, the plant had not previously been depreciated.

13. The applicant argued that s 60 was also an avoidance provision and that consequently the discretion conferred by sub-section (2) ought to be exercised in a manner similar to the discretion conferred in other avoidance provisions, such as s 99A. I was referred to a number of decisions in which discretions conferred in those circumstances were exercised. The most important was
Giris v FC of T 69 ATC 4015 at 4024; (1968-1969) 119 CLR 365 at 384. It seems to me however that the decisions cited by counsel on this point are not of great assistance.

14. Section 60 does not appear to me to be an anti avoidance provision. Contrary to the sub- sections to which I have referred, there is nothing in s 60 limiting the exercise of the discretion when the parties are not at arm's length. Counsel for the applicant suggested that the history of the section could usefully be consulted in that respect. A provision corresponding to s 60 was introduced in 1924 but, following the decision in
George Hudson & Co Limited v Federal Commissioner of Taxation ([1927] R and McG 97), the provision was amended in 1927 to limit the discretion to exclude cases of acquisitions by companies associated with the transferor. In the 1936 consolidation, that limitation was removed. The section has been in its present form for almost 60 years. It does not appear to me to be of great assistance in construing the section to have regard to what must now be regarded as matters of mere historical interest.

15. There is nothing in s 60 dealing with transactions between related companies. Sub- section (2) is a clearly expressed discretion, the exercise of which should be governed by the same considerations that apply to all other discretions of a general nature. Whenever depreciated property is sold, s 60 performs a limited function. Sub-section (2) gives a degree of flexibility to deal with circumstances where such flexibility would be appropriate. For example, where plant is purchased by a taxpayer from a vendor who, unknown to the purchaser, had previously depreciated it and had acquired it at a lower price than that for which it was sold, it might be thought unfair that such a purchaser, buying in good faith and on the assumption that the whole of his cost would be depreciable, should be entitled to depreciation on the commercially negotiated price.

16. Indirectly, this hypothetical situation is reflected in Taxation Ruling IT 2354 paragraph 6. The general terms of the Ruling are of little assistance in resolving the matters presently before the Tribunal as they deal with a situation unlike the present circumstances. The text of paragraph 6, however, does give an insight into the Commissioner's view as to the circumstances in which the discretion might properly be exercised in the taxpayer's favour-

``The sub-section reflects the fact that in many ordinary commercial transactions, the market value of depreciable property to be sold exceeds the original cost to the vendor and that normal commercial or business practice requires that the purchaser account for depreciation on the cost of the depreciable property. Although the discretion in the sub-section must be exercised in each particular case it is normally exercised in the ordinary arm's length sale of depreciable property ie where there is a bona fide sale, where the purchase price represents the fair market value of the depreciable property and where the depreciable property is for use in the purchaser's income producing activities and

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is no longer used in the income producing activities of the vendor.''

17. One aspect of the facts of the present case which may have some bearing on whether or not the discretion should be exercised in the applicant's favour, is the fact that an election was made under s 160ZZO. The Australian and the American company took advantage of their group status to make this election and to obtain the consequent benefits for capital gains tax purposes. Yet the applicant would say that for the purposes of another part of the Act, namely s 60, the American and the Australian companies should be regarded if not at arm's length, then at least as having had a dealing at arm's length. I will deal with this more fully in my findings as to facts.

18. The applicant also relies upon the Double Tax Agreement between Australia and the United States. It was submitted that if the Tribunal took the view that the dealing was not at arm's length, then the effect of the Agreement was to require the Tribunal to treat the applicant as an independent entity, dealing at arm's length. Relevantly, Article 7 of the Convention provides as follows-

``(1) The business profits of an enterprise of one of the Contracting States shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the business profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment.

(2) Subject to the provisions of paragraph (3), where an enterprise of one of the Contracting States carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the business profits which it might be expected to make if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment or with other enterprises with which it deals.

(3) In the determination of the business profits of a permanent establishment, there shall be allowed as deductions expenses which are reasonably connected with profits (including executive and general administrative expenses) and which would be deductible if the permanent establishment were an independent entity which paid those expenses, whether incurred in the Contracting State in which the permanent establishment is situated or elsewhere.''

19. The applicant is liable to tax in Australia in respect of so much of its ``business profits'' as are attributable to its permanent establishment. It was submitted that in calculating those profits, one should apply the circumstances of the domestic law in accordance with s 3(2) of the Income Tax (International Agreements) Act 1953. It was then submitted that the applicant became subject to Australian tax on ``taxable income'' attributable to the business carried on by its permanent establishment, calculated in accordance with Australian tax law but on the basis of the applicant being independent from its sister company and dealing with it on an arm's length basis. As ``taxable income'' is ``the amount remaining after deducting from assessable income all allowable deductions'' (s 6), the depreciation of plant and equipment used by the applicant must be taken into account in determining ``business profits'' of the permanent establishment. This meant, it was submitted, that in a necessary application of s 60, the discretion in sub-section (2) ought to be exercised on the basis that the relevant transaction was at arm's length.

20. I do not accept this submission. The purpose of Article 7 is to ascribe to a permanent establishment the hypothetical character of a separate legal entity and a separate taxpayer. It is intended to ensure that, for example, a branch is taxed separately even though not, under Australian law, a separate legal entity. The applicant's submission would require the Convention to be read in such a way as to extend its operation beyond its objectives of avoiding double tax and tax avoidance. The argument would require what would otherwise be a non arm's length transaction, which reduces the tax liability of the permanent establishment, to be treated as an arm's length transaction, notwithstanding that there is a provision applicable to all domestic taxpayers

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which would preclude that result. I agree with the submission of counsel for the respondent that the terms of the Convention and the International Agreements Act should not be construed so as to compel the exercise of a discretion in this way. A foreign permanent establishment is not intended to be given an advantage over a domestic company which is otherwise in the same position. I was referred by counsel for the respondent to a decision of the Federal Court of Appeal in Canada in
Utah Mines Limited v R (1992) 1 CTC 306 which took a similar view to the corresponding provisions of the US - Canada treaty. I am persuaded by the reasoning in that case and am content to follow its result as being in accordance with the general principles of interpretation that ought to be applied in the circumstances.

21. Consequently it will be necessary, because of the terms of the section and of the facts of this case, to determine an amount in accordance with s 59AA based neither upon a presumption that the parties should be treated as having been at arm's length, nor upon any other basis except those suggested by the objective facts. The real question for determination, however, is whether the broad discretion conferred by sub-section 60(2) should be exercised in favour of the applicant. In the circumstances of this case, I have identified 9 factors which ought to be taken into account in addressing this question.

22. Firstly, of course, there is the question of common ownership of both the American and the Australian companies. That fact is not an absolute bar to the exercise of discretion but it is a matter that should be given considerable weight. As a result of the common ownership, the economic advantage of the asset remains ultimately unchanged.

23. The second matter for consideration is to examine the way in which the purchase price for the interest of the Australian vendor was calculated. If it was not calculated with reference to value but to some other consideration, then this is a matter that should be taken into account.

24. The third matter to consider is the extent of the knowledge (if any) of both parties of the fact that the price to be paid greatly exceeded the cost of the plant. To some extent, this will be governed by a finding whether the transaction was at arm's length.

25. The fourth matter for consideration is the way in which the total purchase price came to be apportioned after the event, and whether the apportionment was arrived at explicitly or impliedly to gain an Australian tax advantage.

26. The fifth matter is the roll-over election to which I have referred and whether any significance should be attached to the supposed approbation and reprobation of related party status.

27. Sixthly it will be necessary to examine what, in fact, was the market value of the asset acquired. Most of the evidence in the hearing was directed to this issue. There was a conflict between experts, not only in results but also in methodology. Whilst market value may not be determinative of all the issues, it is a matter to be taken into consideration, together with all other discretionary factors. In addition, determination of the market value (or such an amount as ``in the opinion of the Commissioner, is fair and reasonable'') will assist in arriving at the determination necessary under s 59AA.

28. The seventh matter to be examined is whether in fact the transaction can be regarded as an arm's length transaction notwithstanding any legal arguments to the contrary. This will involve a consideration of the legal and factual control of the decision-making powers of all parties concerned and whether the elements of an arm's length transaction referred to in Income Tax Ruling 2354 can be identified in the present circumstances.

29. The eighth matter to be considered is whether in apportioning the total purchase price after the event, it would have been open to the purchaser to adopt another course. Parts of the consideration were attributed to smaller items where no other possible attribution was available and the balance was attributed to plant. It will be necessary to consider whether this fairly represents the elements involved in the consideration, or whether money was in fact paid for assets other than plant, including what were alleged to be quite substantial elements of goodwill.

30. Finally, general considerations of the economic substance of the transaction should be considered. In deciding whether a wide ranging discretion is available, the Tribunal should not be narrowly constrained by legal formality. It is the task of the Tribunal to consider the individual circumstances of this intra group sale

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and to determine whether they are such as could be contemplated by the legislation as entitling the purchaser to the considerable benefits which it seeks. I will now examine the facts leading up to the acquisition and subsequent apportionment of the purchase price. For reasons to which I have earlier referred, the results of this examination may not be published.