Email Ltd v Commissioner of Tax

[2000] HCATrans 254

IN THE HIGH COURT OF AUSTRALIA

Office of the Registry
  Sydney  No S181 of 1999 and

Nos S240-S245 of 1999

B e t w e e n -

EMAIL LTD

Applicant

and

COMMISSIONER OF TAXATION

Respondent

Applications for special leave to appeal

GLEESON CJ
GAUDRON J

TRANSCRIPT OF PROCEEDINGS

AT SYDNEY ON FRIDAY, 16 JUNE 2000, AT 10.26 AM

Copyright in the High Court of Australia

MR I.V. GZELL, QC:  If the Court pleases, I appear with my learned friend, MR M.L. BRABAZON, for the applicant.  (instructed by KPMG Legal)

MR J.W. DURACK, SC:  If the Court pleases, I appear with my learned friend, MR R.L. HAMILTON, for the respondent.  (instructed by the Australian Government Solicitor)

GLEESON CJ:   You need an extension of time for some of these ‑ ‑ ‑

MR GZELL:   Yes, your Honour.

GLEESON CJ:   Is that opposed, Mr Durack?

MR DURACK:   No, your Honour.

GLEESON CJ:   Are you happy with that?

MR GZELL:   Your Honour, I ask for an order in terms of Order 69A rule 3(2) that complies with Order 69A rule 3(1) be dispensed with in each of those six matters.

GLEESON CJ:   All right, we will make that order.  Yes, Mr Gzell.

MR GZELL:   Your Honours will see from the papers that the case involves a holding company which had repeatedly given indemnities to purchasers either of businesses or shares in subsidiaries or joint venture vehicles.  In the case in question, the indemnity was given to the purchaser of a joint venture vehicle, 50 per cent of which was owned by a sub-subsidiary of the applicant.  The indemnity was against claims against that joint venture vehicle by its customers which had been warranted not to exist by the vendors.  The holding company did not charge its subsidiaries for a number of services that it provided and, in particular, it did not charge its subsidiaries for giving indemnities.

There was no suggestion that the holding company was seeking to increase the value of its investment in subsidiaries with a view to their sale.  The primary judge accepted the evidence that the holding company had a policy of causing dividends to be paid up the chain to it.  The primary judge found that the outgoings under the indemnity were incurred in gaining the holding companies dividend income and were also necessarily incurred in carrying on its business for the purpose of gaining those dividends.

GLEESON CJ:   Mr Gzell, can you just remind us?  The indemnities were given for exactly what?

MR GZELL:   The indemnity was given by the holding company with respect to a sale by a sub-subsidiary of its 50 per cent interest in a joint venture vehicle.  The indemnity was with respect to warranties that had been given by the vendors of the joint venture vehicle that no claims other than those revealed in the accounts existed as against the joint venture vehicle.  So that it was against any outstanding warranty claims against a joint venture vehicle, 50 per cent of which was held by a sub-subsidiary of the applicant.

GLEESON CJ:   Although these were indemnities, they were something like guarantees?

MR GZELL:   Like a guarantee and indemnity and, indeed, the terms which are set out at page 5 of the record were contained in the deed of sale itself.

GLEESON CJ:   Presumably, the commercial objective of the exercise was to lend the financial strength of the holding company to the commitments given by the subsidiary.

MR GZELL:   Yes, quite, your Honour.  The primary judge, as I have indicated, found that both limbs of section 51(1) of the old Income Tax Assessment Act applied.  It was conceded by the Commissioner in the Full Court that the second limb applied.  In other words, that these outgoings were necessarily incurred in carrying on the holding company business for the purpose of gaining dividend income.

GAUDRON J:   It was conceded.

MR GZELL:   It was conceded.

GAUDRON J:   Where do we find that?

MR GZELL:   It was conceded in opening by my learned friend and it is referred to in the judgment of ‑ ‑ ‑

GLEESON CJ:   But it was the concluding words of section 51 that were relied on, that the outgoings were said to be on capital account.

MR GZELL:   Yes, quite.

GAUDRON J:   Yes.

MR GZELL:   So that, our learned friends, when it came to the Court of Appeal, accepted that one of the positive limbs of section 51(1) applied and confined their case to the capital exclusion.  The primary judge concluded that the outgoings were on revenue account because the advantage sought was to increase the likely flow of dividends.  The Full Court held that the outgoings were on capital account on the basis that the immediate advantage of the giving of the indemnity was a sale at maximum price by the sub-subsidiary.  That advantage increased the value of the holding company’s investment in its subsidiary which the court said was an advantage of a capital nature.

That advantage, in the court’s view, went to the dividend yielding structure of the holding company rather than the process by which dividends were to be earned within it.  In arriving at that conclusion, the Full Court clearly enough relied upon the well known distinction between profit yielding structure, on the one hand, and the process of operating it on the other.

GLEESON CJ:   And the property that was sold by the sub-subsidiary was capital.

MR GZELL:   The property which was sold by the sub-subsidiary was capital to it, yes, clearly.

GLEESON CJ:   So, although it may have been rather more complicated than this, it is as though a holding company has a subsidiary and there is a sub-subsidiary, and the sub-subsidiary sells a factory that it owns to somebody who wants to buy a factory and, as a term of the contract of sale, it enters into certain warranties as to the condition of the premises and the holding company indemnifies the purchaser against any loss that it might suffer as a result of the inability of the vendor to honour those warranties.

MR GZELL:   To other the warranty.  Quite, your Honour, and we do not cavil, and it has never been suggested from this side of the Bar table, that the transaction, so far as the sub-subsidiary was concerned, was anything other than a transaction on capital account.  The difference, as we will develop it, is that there is a distinction between looking at the activity of the sub-subsidiary and looking at the activities of the applicant in this case being the holding companies.

GLEESON CJ:   But where do dividends come into it?

MR GZELL:    Because the purpose of giving the indemnity in this case was to ensure that profits were generated in the sub-subsidiaries which could be dividended up the chain to the holding company.

GLEESON CJ:   Capital profits that would be returned by ‑ ‑ ‑

MR GZELL:   In this case capital profit, but in other cases, no doubt, a revenue profit.  If I can go back to the proposition that clearly enough the court relied upon that well known distinction between profit-yielding structure on the one hand, and the process by which it operates on the other - that contrast between the tree on the one hand and its fruit.  In our submission, that contrast is apt in the case of an operating company which has a structure.  An operating company which has a structure such as the factory that your Honour the Chief Justice mentioned, carries on activities in the factory through its employees with the purpose of generating profits in it as a result of those activities.  But that contrast, in our submission, does not lie easily when you come to consider a holding company.

The profit yielding structure of a holding company which has no other assets other than its investment in subsidiaries, and no other source of income other than dividends generated from profits in those subsidiaries, has as its profit yielding structure the investment in subsidiaries.  The holding company’s process of operating within that structure is not aimed at direct profit generation in the holding company.  It is aimed at profit generation in the subsidiaries, thereby releasing dividend flows.  If those processes are successful, they will lead to an increase in the value of the holding company’s investment in the subsidiaries.

Therefore, an increase in the value of the investment in subsidiaries, which is what the Full Court relied upon in founding its conclusion, can be just as much the result of the process of operating the holding company’s profit yielding structure as it can be the result of an increase in that structure.  So that the mere fact that the value of the investment in subsidiaries rises, should not be determinative of the question whether outgoings of a holding company are on revenue or capital account.  An increase in value in the investment will be the consequence of any successful business activity of the holding company aimed at increasing the profits of its subsidiaries as it will be the consequence of further investment in those subsidiaries.

In our submission, the Full Court, in reasoning that the giving of the indemnity had the consequence of increasing the value of the holding company’s investment in its subsidiary and, therefore, went to profit yielding structure, failed to give sufficient attention to the fact that this is a necessary consequence of activities of a holding company directed to profit generation in its subsidiaries.  That distinction between an operating company and a holding company in relation to the capital exclusion has not been explored by this Court and, so far as we are aware, has not been explored by any superior court elsewhere in the world.  It raises an issue of public importance.

GLEESON CJ:   Well then, maybe the reason it has not been explored is that it involves the application to particular facts and circumstances of a principle which admittedly causes a great deal of difficulty in its practical application but is, theoretically, established.

MR GZELL:   Yes, but in applying that established principle in the operating company situation is clearly appropriate, because one can draw a distinction between the structure and the operation of the structure aimed at generating profits in that entity.  When it comes to a division of function between a holding company and its subsidiaries, the difficulty of application of that principle becomes apparent.

GLEESON CJ:   Where do you say we find the error in the reasoning of the Full Court?

MR GZELL:   The error lies in assuming that the increase in value of the investment in subsidiaries necessarily meant that there was an increase in the profit yielding structure rather than the mode of operation.  If I can take your Honours to that, it appears, first of all, at page 43, line 45, your Honours will see that a differentiation had been made between the “ultimate” advantage, which is referred to earlier on that page, and the “immediate” advantage, the immediate advantage being sale at maximum price of the shares in the sub-subsidiary.  That advantage increased the value of the holding company’s investment in the subsidiary, and that appears at page 44, line 25:

Having regard to the undoubted fact that the giving of a guarantee operated to permit the shares of Email in MDI –

that is the shares of the holding company and its immediate subsidiary –

…..to attain a value they could not have without the giving of the indemnity……there was an undoubted advantage to Email –

and that advantage is not on revenue account.  Then, at page 44, line 50, their Honours went on to say that the advantage went to the dividend yielding structure of the holding company rather than the process by which dividends were to be earned.  So, the linchpin of the reasoning of the Full Court is because there is an increase in the value of the investment of the holding company and its subsidiary as a result of the sale at maximum price by the sub-subsidiary, that is ant affair of capital, that goes to the profit yielding structure.

GAUDRON J:   If you leave out the profit yielding structure step which, on one view, is just a buttressing of what has already been said, there is nothing wrong with the reasoning that points out that the immediate consequence was to improve the capital holding.  Not simply of the sub-subsidiary, but of the subsidiary.

MR GZELL:   We will cavil with that for a different reason, your Honour.  I will come to that in a moment, and that is the remoteness question.  But subject to that, if one analyses it from the point of view of the obtaining of the high price, there is nothing wrong with the reasoning until you get to the stage of saying, because there was a high price achieved in the sale by the sub-subsidiary, therefore, there was an increase in the value of the investment in subsidiary.  Where we cavil is the consequence which is drawn from that because, in our submission ‑ ‑ ‑

GAUDRON J:   But on the other hand, you have to say, do you not, that it is the ultimate, rather than the immediate, consequence that gives this payment its character?

MR GZELL:   I am not so sure that we have to say that.  We certainly do say that, your Honour, and I will come to that argument in a moment, but the reason that I am not so sure we have to say that is that at the moment I am demonstrating what we respectfully say is a fallacy in the argument of the Full Court, and we say the fallacy is in assuming that because there is an increase in the value of the holding company’s investment in subsidiary, that that is an affair of capital because, as we demonstrated, we think, an increase in the value of an investment in the subsidiary can be just as much the activity of a holding company’s revenue activities, those activities going to the process by which it operates its profit yielding structure, as an increase in that structure.

So, in our submission, where the court went wrong was to apply that principle without realising that there is a significant difference in the application of that principle when you have a holding company and its subsidiaries.

GAUDRON J:   Now, what is it that you say gives it its character as revenue?

MR GZELL:   We say precisely what the primary judge said, that there having been a finding that these were business activities directed to the generation of dividend income, and the purpose of the outgoings was the generation of dividend income, and there was released by the sale by the sub‑subsidiary a profit which was immediately available as a source of declaration of dividend, that that purpose, the purpose of dividend generation in the subsidiaries, is the gravamen of the characterisation of the outgoing in this case and the primary judge was quite right in the way he approached it.

GLEESON CJ:   Was a dividend declared?

MR GZELL:   A dividend was not declared in respect of that particular profit.

GLEESON CJ:   So, what actually happened was that the value of the shares in the subsidiary increased because of the retained profits.

MR GZELL:   Quite.  What happened in the particular case, and this was explored both by the primary judge and the Court of Appeal, the primary judge said that the statement by the deponent that the policy was to take dividends up the chain to the holding company was made out in respect of MDI, which is the subsidiary of the holding company, it was not made out with respect to the sub-subsidiary with respect to this year, notwithstanding which the judge was prepared to accept that the evidence revealed a policy of taking dividends up.  At the time this went to trial a dividend had not been declared with respect to this particular profit.  It had been lent up to the holding company.

But that did not deter his Honour from concluding that it was the policy of the company to cause the profits to be dividended up the chain.  I see the orange light fiercely winking at me.  Might I move on quickly if I might?  So that the gravamen of our argument is that the application of the test to a holding company situation without realising that increase in value of investment in subsidiary does not necessarily connote a profit yielding structure issue, is the central error in the Full Court’s reasoning and raises an issue of public importance.

We say that the Full Court went wrong in a number of other respects.  Briefly, your Honours, I had referred to page 43 where they drew a distinction between the immediate advantage and the ultimate advantage.  The court took the view that the ultimate advantage, that is, of creating the dividend flow, was too remote.  The court did not point to any evidence in the case justifying its conclusion of remoteness.  It only gave an example of an outlay on an office which might in the future generate profits as the only explanation for drawing a distinction between ultimate and immediate advantage.

In this particular case, the profit was immediately available as a source of dividend and, in our respectful submission, once the finding was made and the concession was given that these outgoings were necessarily incurred in carrying on the holding company’s business for the purpose of gaining dividend income, the issue of remoteness could not and should not have arisen.  Your Honours, we have referred to Total Holdings and
E.A. Marr in our written submissions.  We say that the purpose of dividend flows in this case was no less remote than it was in those two cases in which

the courts concluded that the matter was on revenue account, the purpose being the generation of those dividend flows.

The securing of a price – in the course of its judgment the Full Court took the view that there was an advantage of an enduring character to the holding company by reason of the increase in the value of its investment in subsidiaries.  That increase in value was secured, in this case, at a price, the price being the giving of the guarantee in indemnity and the payment under it and one would have thought that where there was little net benefit of an enduring nature, that is not the sort of case in which an affair of capital is grounded upon the notion of the creation of something of enduring benefit.

GLEESON CJ:   Thank you, Mr Gzell.  Yes, Mr Durack.

MR DURACK:   Your Honour, before I turn to what I apprehend is my learned friend’s main point, which is that there is something remarkable about the nature of a holding company with investments in subsidiaries, which means that its profit yielding structure, that is the investment in subsidiaries, should be regarded as in some special category in relation to which some further elucidation of the law is required from this Court, I would just like to point out a couple of things in relation to the facts because the facts were so remarkable in this case that it is hardly surprising that the Full Court, in our submission, should have focused on the immediate object of this expenditure.

My friend referred to the evidence being that the applicant had repeatedly given indemnities.  But there was never any suggestion that the sale by the sub-subsidiary of its investment in the company, Dowell, in respect of which the indemnity was given, was in any way in the ordinary course.  As your Honour said, it was just like the sale of a factory with guarantees given in respect of the condition of the factory.  There was never any suggestion that it was only in relation to such extraordinary sales, if I may say, that indemnities were given.

In other words, it may have been the usual practice to give indemnities of this kind, but it was only the usual practice in connection with the unusual circumstances of the sale by a subsidiary of a capital asset.  Now, the applicant’s summary of argument acknowledges ‑ ‑ ‑

GLEESON CJ:   Was this one of those company structures in which the holding company, in effect, acts as the banker for the group?

MR DURACK:   There was no evidence that that was so and, indeed, your Honour, my learned friend said that the holding company did not charge the subsidiaries for giving indemnities.  That may be true but there was no evidence of it.  But the respondent would not suggest that the parent company charged the sub-subsidiary in respect of this indemnity.  If it had, then there would have been an offsetting revenue item when it met the claims under the indemnity. 

But the second thing, your Honours, was that the trial judge found that Email had given the indemnity so that its wholly owned subsidiary, OCAL, could achieve a sale of, and enhance the sale price of, the shares in Dowell.  So that, as the Full Court said, the giving of the indemnity ensured that a higher price would be received than would have been the case if no indemnity had been given.  The court also found that the only conclusion open on the evidence was that the giving of the indemnity was in furtherance of the sale and maximising the price.  Now, maximising the price meant that the assets of the sub-subsidiary which made the sale were increased.  Now, it is hardly surprising that the court regarded that factor as of primary significance in the characterisation of the payments under the indemnity as capital payments and that they should have regarded the giving of the indemnities as therefore contributing to the capacity of the subsidiaries of the applicant to pay dividends.

In other words, the distinction to which the Full Court was immediately alive was that this was not a case where the expenditure on the indemnity was directly producing dividends and, indeed, as my learned friend conceded, that there was not even a dividend paid out of this amount for reasons which were never made clear.  But the giving of the indemnity did not directly produce dividends, it increased the capacity of the subsidiaries to pay the dividends and, thereby, increased the value of the profit yielding subject constituted by those shares – the shares in the subsidiaries.

Your Honours, I might remind you that when his Honour Mr Justice Dixon made the comments in Sun Newspapers, which have so frequently been repeated when considering the distinction between income and capital, that is where he made the comments about the three matters that one looked at, he prefaced those statements by talking about the variety of circumstances in which the distinction between the expenditure on the profit yielding subject and expenditure on the process of profit earning, arises.  His Honour said that the profit yielding subject may take an infinite variety of shapes and that it may appear in entirely different forms.

Now, a holding company’s investments in its subsidiaries, of the kind which this particular case exemplifies, is merely, in our respectful submission, one of those infinite varieties of forms in which the profit yielding subject may be discovered.  The question of whether a particular outgoing is income or capital, or whether it was in these circumstances, may be difficult enough in some circumstances, but it does not, in our submission, involve any question of any new principle or a requirement for this Court to elucidate any new principle.  It is simply a case where the resolution of the question can be arrived at by the adoption of principles with which this Court and other courts are familiar.

There is one other matter that I might mention, your Honours, and that is that the loss which the parent company, the applicant in these cases, booked in its accounts in respect of the provision which it took into its accounts when the indemnity was given, a provision for $5 million against which indemnity payments were subsequently made, was treated as an extraordinary loss in its accounts.  It was called an extraordinary loss.  There was nothing about the giving of this indemnity which was regarded by the company as being in the ordinary course of its operations.

In the respondent’s submission, therefore, and contrary to the applicant’s written summary of argument, the giving of the indemnity did alter the capital structure of the applicant.  It enhanced the value of the shares in the subsidiary companies from which it expected a dividend stream.  In that sense, it provided the parent company with an enduring advantage, advantage of which was taken immediately by the borrowing from that subsidiary, by the parent, of all of the funds which were the result of the sale at the enhanced price.  The applicant was, therefore, wrong, in our submission, to say that the Full Court erred in holding that the advantage to the applicant in giving the indemnity was an increase in the value of its investment in MDI.

My learned friend said that that benefit was only obtained by an equal offsetting liability in the applicant.  Now, that does not assist.  When a payment is made for the acquisition of an asset, or the acquisition of something, what is acquired is always acquired at the expense of something.  There is always an offsetting outgoing of funds or the taking on of a liability.  So when, in my learned friend’s written submissions, he refers to there being no net increase in the assets of the applicant, that will always be the case when there is an outgoing, even if it is an outgoing of capital.

My learned friend, although he did not refer to them in his oral submissions, suggested that the decision of the Full Court was somehow inconsistent with the decisions in E.A. Marr & Sons and in Total Holdings, but in those cases the outgoings by the parent company were in the form of rent and interest.  So they already had the revenue character of regularly incurred outgoings and it was that feature which led the Full Court to distinguish them.  There is nothing, in our respectful submission, which suggests that anything in the Full Court’s judgment is inconsistent with those decisions.

Your Honours, a holding company, the business of which is the holding and administration of investments in subsidiary companies is, in our submission, in no different position from the ordinary operating company which conducts a number of businesses.  The expenditure of such an operating company, for example, regularly incurred outgoings such as advertising, will often tend to increase the value of those businesses.  It will increase the goodwill of those businesses and that has been recognised regularly by the courts.  Again, by Justice Dixon, for example, in Sun Newspapers.

The suggestion from my learned friend was that the Full Court was somehow misled into thinking, merely because the asset and the subsidiaries increased in value, that it must have been a capital outgoing.  If the Full Court was misled in that way, then the court must have ignored authorities which make it clear that you can have revenue outgoing which, nevertheless, increase the value of capital assets:  goodwill of businesses, and so on.  In our respectful submission, it would be wrong to think that the Full Court had ignored that circumstance.

If my learned friend’s submissions are taken at face value, what they really amount to is the suggestion that in a holding company subsidiary situation the ordinary distinction between income and capital outgoings will disappear, and that if a holding company buys, for example, items of plant for its subsidiaries, then merely because the result of those acquisitions will be to increase the dividends that they will ultimately receive from those subsidiaries, then the expenditure on the acquisitions of plant must be capital expenditure.  Now, that cannot be right, with respect, your Honours. 

Yet, that is what this transaction is.  It is a capital transaction.  It has never been suggested that it was any part of the ordinary course of the business of the applicant or of its subsidiaries to regularly turn over capital assets.  This is not, and your Honours will remember the London Australia Case, where capital assets were turned over on such a regular basis that the profits from the turning over of the assets were regarded as an integral part of the business.  This is not a case of that kind.  If it were, then there might be some question about the deductibility of this expenditure.

Finally, your Honours – I am not sure whether anything was being made of it ‑ but it is true that the respondent conceded in this case that one of the first limbs of section 51(1) were satisfied, but although I know that Professor Parsons, in his book, suggests that that is the end of the story, that if you make that concession then the expenditure is deductible because it cannot be of a capital nature, that this Court has regularly, at least in recent times, disavowed any suggestion that the exception in section 51(1) operates otherwise than as a true exception.  So that, nothing in particular can flow from that concession.

Finally, your Honours, even if there was lacking an authoritative statement of principle on the question that was involved in this case, then examination of it in this case would involve delving into facts in relation to the accounting treatment of the outgoings and the accounting treatment made in respect of the provision and the possible explanation which was never provided to the court, despite all the claims about the expenditure being for the purpose of increasing dividends, why it was that, in fact, no dividends did flow through to the holding company from this particular profit.  Those are our submissions, your Honours.

GLEESON CJ:   Thank you, Mr Durack.  Yes, Mr Gzell.

MR GZELL:   Thank you, your Honours.  If the Court pleases, in looking at this matter, one has to focus on the position of the holding company and not the position of the sub-subsidiary.  Clearly enough, the activity of the sub-subsidiary was a matter which affected capital and not revenue, but the question is, “What is the position in relation to the holding company?”, and the holding company’s structure was not increased at all by these transactions.  What was increased was the value of the investment, but not the structure itself.  There was no increase in the investment in subsidiaries.  There was no acquisition, for example, of an additional subsidiary or further capitalisation of existing subsidiaries.

All that happened was that there was an increase in the value of the investment and that was the matter upon which the Full Court fastened its attention in arriving at its conclusion.  In that respect, in our respectful submission, it went wrong because it failed to appreciate that that increase in value was just as much attributable to revenue aspects of the conduct of the process of a profit yielding structure rather than the converse.  In our respectful submission, the fact that in the past it has been said that a test can survive a myriad of different examples and situations does not answer the proposition.  The proposition is that it was not a matter which was drawn to the attention of that court.  It is now a matter which is being drawn to the attention of the Court in the instant circumstances.  It is a matter which has not been adequately analysed and is one, in our respectful submission, of importance.

The suggestion that this is not an appropriate vehicle for this proposition to be aired because it may require an analysis of accounting material is, in our respectful submission, not an impediment because this case is one in which the findings having been made as to the positive limbs of section 51(1), and the concession having been made that the second limb of section 51(1) applies, that is sufficient, and it is upon that basis that any appeal would be argued.  Those are our submissions if the Court pleases.

GLEESON CJ:   Thank you, Mr Gzell.

The decision of the Full Court of the Federal Court in this case, which was well open to it, turned upon the application to the particular facts and circumstances of well-established principles concerning the distinction between capital and revenue.  That distinction is notoriously productive of difficulties in its practical application but the principles on the basis of which it is applied are established.  No special leave point arises in this case.  The application should be refused.

Can you resist an order for costs, Mr Gzell?

MR GZELL:   I cannot resist, your Honour.

GLEESON CJ:   The applicant must pay the respondent’s costs of the application.

We will adjourn to reconstitute.

AT 11.04 AM THE MATTER WAS CONCLUDED