Regis Aged Care Pty Ltd v Commissioner of State Revenue

[2015] VSC 279

IN THE SUPREME COURT OF VICTORIA Not Restricted

AT MELBOURNE

COMMERCIAL COURT

TAXATION LIST

S CI 2012 3618
S CI 2013 3042

REGIS AGED CARE PTY LTD (ACN 125 223 645)	Appellant
v
COMMISSIONER OF STATE REVENUE	Respondent

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JUDGE:	ALMOND J
WHERE HELD:	Melbourne
DATES OF HEARING:	10- 13, 17-19 and 24 November 2014
DATE OF JUDGMENT:	16 June 2015
CASE MAY BE CITED AS:	Regis Aged Care Pty Ltd v Commissioner of State Revenue
MEDIUM NEUTRAL CITATION:	[2015] VSC 279

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TAXATION – Duty – Appeal against assessments of duty by Commissioner of State Revenue – Duties Act 2000 (Vic), ss 70, 71, 72, 74, 76, 78, 79, 88 – Whether taxpayer ‘land rich’ – Whether taxpayer’s land holdings comprise 60 per cent or more of unencumbered value of all its property – Value of land holdings considered on a standalone and portfolio basis – Allocation of derived unencumbered value of all property between land holdings and non-land holdings not required by s 71(2)(b) – Significant goodwill found to exist – Commissioner of Taxation of the Commonwealth of Australia v Murry (1998) 193 CLR 605 – Taxpayer not a ‘land rich’ landholder as at the relevant date – Appeals allowed – Assessments set aside.

VALUATION – Discounted cash flow methodology – Methodology for determining unencumbered value – Allowance for small company risk – Treatment of value of expected synergies – Treatment of value of contract to purchase land on foot at the relevant date but terminated after the relevant date – Whether accommodation bonds are loans repayable on demand and property that is not counted for the purposes of s 71(3).

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APPEARANCES:	Counsel	Solicitors
For the Appellant	D J Batt QC with P Neskovcin	King & Wood Mallesons
For the Respondent	H M Symon QC with N A Kotros	Solicitor for the Commissioner of State Revenue

HIS HONOUR:

Introduction

1. On 2 July 2007, Regis Aged Care Pty Ltd (‘Regis’) acquired all of the shares in Paragon Group Investments Pty Ltd (‘PGI’).  PGI was at the head of a corporate group owning residential aged care facilities in Victoria and Queensland.

1. By notice of assessment issued to Regis on 23 September 2011, the Commissioner of State Revenue (‘Commissioner’) made an assessment of duty under the land rich provisions in Part 2 of Chapter 3 of the Duties Act 2000 (Vic) (‘Act’) as it then stood and for penalty tax and interest under Part 5 of the Taxation Administration Act 1997 (Vic) (‘TAA’) in respect of Regis’s acquisition of the shares. The assessment was as follows:

Duty	Penalty Tax	Interest	Total
$12,325,500.00	$616,275.00	$1,328,634.90	$14,270,409.90

1. Regis lodged an objection to the assessment both as to the imposition of duty (on the ground amongst others that PGI was not land rich) and to penalty tax and interest.

1. In determining the objection, the Commissioner formed the view that the amount of duty chargeable under the Act was $13,282,500.00 rather than the amount initially assessed. On 31 October 2012, the objection to the assessment was disallowed and a notice of reassessment was issued to Regis whereby the Commissioner reassessed duty, penalty tax and interest in respect of the acquisition of the shares as follows:

Duty	Penalty Tax	Interest	Total
$13,282,500.00	$664,125.00	$1,432,862.38	$15,379,487.38

1. On 21 December 2012, Regis lodged an objection to the reassessment, which was subsequently disallowed.[1]

   [1]The assessment and the reassessment are referred to collectively as the ‘assessments’.

Background

1. The transaction to which the assessments relate occurred as part of the merger on 2 July 2007 of two aged care organisations, known respectively as ‘The Regis Group’ and ‘Retirement Care Australia’.

1. Immediately prior to the merger:

(a)PGI was the holding company of the Regis Group, which operated residential aged care facilities in Victoria and Queensland.

(b)Retirement Care Australia Holdings Pty Ltd (‘RCAH’) was the holding company of Retirement Care Australia, which operated residential aged care facilities in New South Wales, Victoria, Western Australia and South Australia.

1. To effect the merger of PGI and RCAH two new entities were created: Fairway Investment Holdings Pty Ltd (‘FIH’) and Regis.  Regis has at all times been 100% owned by FIH. 

1. Completion of the merger took place on 2 July 2007.  On that date, Regis acquired all of the issued share capital in PGI from the former shareholders of PGI and all of the issued share capital in RCAH from the former shareholders of RCAH.

1. As a result of the merger, the former shareholders of PGI held 54% of the shares in FIH, which is the ultimate holding company of the merged group.  The former shareholders of RCAH held 46% of the shares in FIH.

1. The subject of the assessments is the acquisition by Regis of the shares in PGI.[2]  The acquisition by Regis of the shares in RCAH had not at the date of trial been assessed by the Commissioner.

   [2]Statement of Agreed Facts dated 21 October 2014 (‘SOAF’) [25], Court Book (‘CB’) 1.

Statutory Regime[3]

[3]In these reasons, the provisions referred to are the provisions applicable as at 2 July 2007.

12 At the time of the relevant transaction (2 July 2007), the Act relevantly provided:

10       What is a dutiable property?

(1)       Dutiable property is any of the following –

(a)       each of the following estates or interests in land in Victoria –

(i)        an estate in fee-simple;

…

22       What is the unencumbered value of dutiable property?

(1)The unencumbered value of dutiable property is the amount for which the property might reasonably have been sold in the open market –

…

free from any encumbrance to which the property was subject at that time.

70       Imposition of Duty

This Chapter charges duty at the same rate as for a transfer of dutiable property under Chapter 2 on certain transactions which are not dutiable transactions under Chapter 2.

71       Meaning of landholder

…

(2)       For the purposes of this Part, a landholder is land rich if  -

(a)it has land holdings in Victoria with an unencumbered value of $1 000 000 or more; and

(b)its land holdings in all places, whether within or outside Australia, comprise 60% or more of the unencumbered value of all its property.

(3)In calculating the unencumbered value of the property of a landholder for the purposes of subsection (2), property of any of the following kinds is not counted –

…

(c)loans that, according to their terms, are to be repaid on demand by the lender or within 12 months after the date of the loan;

72       What are land holdings?

(1)For the purposes of this Part, a land holding is an interest in land other than the estate or interest of a mortgagee, chargee or other secured creditor or a profit à prendre.

…

74Constructive ownership of land holdings and other property: linked entities

(1)For the purposes of this Part, a landholder holds land or other property if the landholder is entitled to it through a linked entity.

…

(7)In this section –

linked entity means any person or body, corporate or unincorporated, that may hold property in its own right or for the benefit of any person, and includes a trust but does not include –

(a)       a natural person; or

(b)a public unit trust scheme or a company whose shares are listed on the Australian Stock Exchange or an exchange of the World Federation of Exchanges.

…

76       What are interests and significant interests in landholders?

(1)A person has an interest in a landholder if the person has a beneficial entitlement (otherwise than as a creditor or other person to whom the landholder is liable), whether directly or through another person, to a distribution of property from the landholder on a winding up of the landholder.

(2)A person who, by virtue of subsection (1), has an interest in a landholder has a significant interest in the landholder if the person, in the event of a distribution of all the property of the landholder immediately after the interest was acquired, would be entitled to –

(a)in the case of a private unit trust scheme – 20% or more of the property distributed; or

(b)in the case of a landholder other than a private unit trust scheme – 50% or more of the property distributed.

…

77       How may an interest be acquired?

(1)A person acquires an interest in a land rich landholder if the person obtains an interest beneficially, including if the person’s interest increases, in the landholder regardless of how it is obtained or increased.

(2)Without limiting subsection (1), a person may acquire an interest in a land rich landholder in the following ways –

(a)       the purchase, gift, allotment or issue of a unit or share;

(b)       the cancellation, redemption or surrender of a unit or share;

(c)the abrogation or alteration of a right pertaining to a unit or share;

(d)      the payment of an amount owing for a unit or share.

…

78       When does a liability for duty arise?

A liability for duty charged by this Part arises when a relevant acquisition is made.

79       What is a relevant acquisition?

(1)For the purposes of this Part, a person makes a relevant acquisition if –

(a)       the person acquires an interest in a land rich landholder –

(i)that is of itself a significant interest in the landholder; or

…

…

…

82       Who is liable to pay the duty?

(1)The following are jointly and severally liable to pay duty chargeable under this Part –

(a)       the person who makes the relevant acquisition; and

…

…

83       How duty is charged on relevant acquisitions

(1)Duty is chargeable, at the rate specified under this Act for a transfer of dutiable property, on the amount calculated by multiplying the unencumbered value of all land holdings of the landholder in Victoria (calculated at the date of acquisition of the interest acquired) by the proportion of that value represented by the interest acquired in the relevant acquisition.

…

1. It is not in issue that the ‘land rich’ provisions contained in Chapter 3 of the Act impose duty at the same rate as for a transfer of dutiable property under Chapter 2 of the Act on certain transactions which are not dutiable transactions under Chapter 2.[4] 

   [4]The Act s 70.

1. A liability for duty charged by Part 2 (Chapter 3) arises when a relevant acquisition is made.[5]  A person makes a relevant acquisition if the person acquires an interest in a land rich landholder that is of itself a significant interest in the landholder.[6] Under s 74(1) of the Act a landholder holds land or other property if the landholder is entitled to it through a linked entity. It is not in issue that PGI is deemed to hold various land holdings and other property through its subsidiaries as ‘linked entities’. It is common ground that if PGI was a ‘land rich’ landholder at the date of Regis’s acquisition of all of the shares in PGI then Regis will have made a ‘relevant acquisition’. In these appeals, the appellant accepts that s 71(2)(a) of the Act is satisfied, namely that at the relevant time PGI had land holdings in Victoria with an unencumbered value of $1,000,000 or more. [7]

   [5]Ibid s 78.

   [6]Ibid s 79(1)(a)(i).

   [7]Appellant’s closing submissions dated 21 November 2014 (‘Appellant’s closing written submissions’), [24] fn 2.

1. The core issue in each appeal is whether PGI was a ‘land rich’ landholder; in particular, whether as at 2 July 2007, PGI’s ‘land holdings in all places, whether within or outside Australia, comprise[d] 60% or more of the unencumbered value of all its property’ within the meaning of s 71(2)(b) of the Act.

1. Both the appellant and the Commissioner accept that s 71(2)(b) requires a ratio to be determined and that:

(a)the unencumbered value of PGI’s land holdings as at 2 July 2007 is the numerator of the ratio; and

(b)the unencumbered value of all PGI’s property as at 2 July 2007 is the denominator of the ratio.

Agreed issues

1. The parties agree that the following question arises for determination in these proceedings, namely:

1.As at 2 July 2007, did PGI’s ‘land holdings in all places, whether within or outside Australia, comprise 60 per cent or more of the unencumbered value of all its property’ within the meaning of section 71(2)(b) of the Act?

and that in answering that question the following issues arise or may arise:

1.1(a)What is the appropriate application of the discounted cash flow methodology to determine the unencumbered value of all the property of PGI? (denominator)?

1.1(b)What is the appropriate methodology to determine the unencumbered value of the land holdings of PGI (numerator) for the purposes of section 71(2)(b) of the Act?

1.2How, if at all, are PGI’s expected synergies from the merger to be treated?

1.3      As at 2 July 2007, did the goodwill of PGI have no material value?

1.4How is the contract to purchase the proposed development site at Buderim, terminated after 2 July 2007, to be treated?

1.5Were the accommodation bonds issued by PGI as at 2 July 2007 property of the kind listed in section 71(3) of the Act that is ‘not counted’?

1.6Should PGI’s land holdings be valued on a portfolio basis or individual basis for the purpose of section 71(2)(b) of the Act?

1. The parties also agree that if the answer to question 1 is ‘yes’, the following further question arises:

2What was ‘the unencumbered value of all land holdings of [PGI] in Victoria’ as at 2 July 2007 for the purpose of section 83(1) of the Act?

and that in answering that question, the following issue arises or may arise:

2.1What is the appropriate methodology to determine the unencumbered value of the land holdings of PGI in Victoria for the purpose of section 83(1) of the Act?[8]

1.1(a)   What is the appropriate application of the discounted cash flow methodology to determine the unencumbered value of all the property of PGI?

[8]Statement of Agreed Issues dated 21 October 2014 (‘SOAI’) [1]-[2.1], CB 13-14.  The parties also agreed on other issues relating to penalty tax and interest: SOAI [3]-[5], CB 14.

1. Three experts expressed opinions on this issue: the appellant’s experts, Mr David Ferrier, a chartered accountant, and Mr George Kompos, a forensic accountant and the Commissioner’s expert, Dr Hung Chu, a financial analyst.[9]

   [9]Mr Marcus Willison, a land valuer retained by the appellant, did not express an opinion on this issue.

1. Before addressing aspects of their opinions, it is convenient to set out in tabular form a summary of the opinions of these experts on the market value of all of PGI’s property after deduction of excluded property.

Assessed market value of all of PGI’s non-excluded property (the Denominator)[10]
Dr Chu       Mr Ferrier       Mr Kompos   $m               $m  $m
Assessed market value of the PGI Business excluding the value of PGI’s share of Merger synergies	543.9	455.3	n/a
Assessed market value of PGI’s Net Assets excluding PGI’s land holdings and excluding the value of PGI’s share of Merger synergies	n/a	n/a	354.3
Plus instructed value of PGI’s land holdings	n/a	n/a	148.1
Plus value of PGI’s share of Merger synergies	85.2	n/a	n/a
Assessed market value of the PGI Business	629.1	455.3	502.4
Plus net surplus assets (liabilities)	19	43.7	15.4
Plus business related liabilities included in discounted cash flow value	n/a	81.1	n/a
Assessed market value of all of PGI’s property	648.1	580.1	517.8
Less assessed market value of excluded property as per section 71(3)(c) of the Act	(22.9)	(22.9)	(22.9)
Less assessed land value contribution from the Buderim project which subsequently did not proceed	(35.5)	n/a	n/a
Assessed market value of all of PGI’s non-excluded property (the denominator)	589.7	557.2	494.9

[10]Joint Report of Dr Chu, Mr Ferrier, Mr Kompos and Mr Willison dated 15 October 2014 (‘Joint Report’), [101]. CB 1722.

1. Mr Ferrier, Mr Kompos and Dr Chu each agree that in this case the appropriate basis of valuation of PGI’s property is on a ‘going concern’ basis rather than on a ‘liquidation’ basis,[11] and that the market value of the PGI business can be assessed by estimating the cash flows that the business was expected to generate in the future and discounting those cash flows to a single sum using an appropriate risk-adjusted discount rate. This was referred to as the discounted cash flow (‘DCF’) methodology.[12]

   [11]Joint Report [9(a)], CB 1668.

   [12]Ibid [9(b)], CB 1668.

1. They agree that the assessed market value of all of PGI’s property (the denominator) is equal to the sum of the assessed market value of PGI’s tangible assets (including its land holdings), the assessed market value of PGI’s identifiable intangible assets and the assessed market value of PGI’s goodwill.[13] 

   [13]Ibid [9(d)], CB 1668.

1. In performing the DCF analysis, the experts had the benefit of cash flow forecasts in models developed by the management of PGI at the time of the merger, which were reviewed by Ernst & Young and subjected to due diligence on behalf of RCAH.  These were referred to by the experts as Due Diligence DCF Models.[14]  The experts also had the benefit of an audited final merger model, which was referred to as the Merger Model.[15]

   [14]Ibid [8(b)], CB 1666.

   [15]Ibid [8(c)], CB 1666.

1. There are differences in the discount rate used by the respective experts as a result of differences of opinion on the values to be attributed to the individual components used to derive the discount rate (i.e. the weighted average cost of capital).  In particular, the values adopted for the levered equity beta, the pre-tax cost of debt and the adopted percentage for debt in the capital structure produce minor differences in the assessed discount rate, which translate into differences in the assessment of the market value of all of PGI’s non-excluded property.  Minor differences also arise from differences in the assessed market value of surplus assets.

1. There are other differences in approach.  Mr Ferrier and Dr Chu use the PGI cash flow forecasts in the Due Diligence DCF models for a period of thirteen years, being the full period presented in those models.  Mr Kompos uses these PGI cash flows for nine of the thirteen years.

1. At trial, the parties sensibly concentrated on the items in dispute that made a significant difference to the calculation of the ratio.  They identified, but did not unduly focus upon, items in dispute that did not make a significant difference.  Thus, in relation to the derived discount rate (weighted average cost of capital), the parties focused on the small company risk premium, which was the item that made a significant difference to the discount rate and therefore to the assessed market value.  For the same reason, I will substantially confine my attention on this question to discussion of the small company risk premium.

1. Dr Chu notes that the differences of opinion between himself and Mr Ferrier as to various value inputs into the weighted average cost of capital (‘WACC’) – namely the risk-free rate, the equity beta, the cost of debt and the gearing ratio – had partly offsetting impacts on the assessed after-tax WACC adopted by Mr Ferrier and Dr Chu.  The positive impacts on the assessed after-tax WACC of Dr Chu’s adoption of a higher risk-free rate, a higher equity beta and higher cost of debt were quantitatively offset by the negative impact of his adoption of a higher gearing ratio than that adopted by Mr Ferrier.  Dr Chu notes that a key conceptual difference between Mr Ferrier and himself, with significant flow on quantitative implications for the assessed discount rate, is Mr Ferrier’s allowance for a specific risk premium of 5 per cent, which is discussed below.[16]

   [16]Independent expert report in reply of Dr Hung Chu dated 25 July 2014 (’Chu Reply report’), [116], CB 1596.

Allowance for specific risks; small company risk premium and non-negotiability

1. Mr Ferrier initially adopted a risk premium allowance of five per cent for specific risks attached to Regis, reflecting a small company risk premium and a premium for non-negotiability.  This was later reduced to two per cent in the Joint Report. [17]

   [17]Joint Report, [218(b)], CB 1746.

1. Mr Ferrier states that Ibbotson and PricewaterhouseCoopers have conducted studies that have stratified the equity risk premium by entity size, finding a direct relationship between size and return.  In general, these studies have shown that smaller companies are more risky and investors therefore require a greater return, on average, over longer periods of time for bearing the additional risk. Typically a smaller company would require a further premium added to the discount rate to represent the additional risk.  In this context, Mr Ferrier states he has considered the earnings of Regis in relation to twelve comparable companies that operate within the same or similar sectors.[18]

   [18]The companies that Mr Ferrier used for comparison are identified in the Independent expert report of Mr David Ferrier dated 14 October 2013 (‘Ferrier report’), [166], table 166, CB 183-4.

1. Mr Ferrier states that, while Regis was smaller than many of the comparable companies, it was not significantly smaller.  In his opinion, given the comparable size of Regis, there is an additional risk associated with its size and a small private company risk premium should be included, and typically, this premium is in the range of three to six per cent. Mr Ferrier states he considered this range in the context of the size of Regis in making his assessment of an appropriate allowance.[19]  In addition, Mr Ferrier makes an allowance for the difference between ‘the value of a minority or portfolio shareholding’ in an unlisted company and in a listed company, on the basis that it is more difficult to dispose of or trade shares in an unlisted entity due to a lack of a ready market for such shares.  Mr Ferrier states that the value of a portfolio interest in an unlisted company is typically 10 to 40 per cent less than a portfolio interest in a listed company.  Mr Ferrier states that Regis was then an unlisted private company with a small number of shareholders.  He concludes on the basis of these factors that it is appropriate to make an allowance for the specific risks attaching to Regis at 5 per cent.[20]

   [19]Ferrier report, [169]-[171], CB 184.

   [20]Ferrier report, [172]-[175], CB 184-5.

1. In relation to the small company risk premium, Mr Kompos relies on: research from Morningstar to the effect that small companies require significantly higher average annual rates of return;[21] economic modelling by the Capital Asset Pricing Model  does not fully explain the returns of small companies stocks; and the beta for small companies tend to be greater than those for large companies.  However, these beta do not account for all the risks faced by those who invest in small companies.  Mr Kompos says a premium can be added to the Capital Asset Pricing Model to account for this issue using Morningstar’s size premium, which is based upon analysis of public companies in the United States.  Mr Kompos notes that the median size of these entities is significantly larger than most private companies, and accordingly further adjustment should be considered.  Mr Kompos had regard to the size of the comparable companies from which beta had been determined, the scale of the business being valued and the relative size on which Morningstar determined a general small company risk premium range and adopts a small company risk premium of 3.5 per cent.[22]

   [21]Stocks, Bonds, Bills and Inflation Yearbook for the year ending 31 December 2006.

   [22]Independent expert report of Mr George Kompos dated 20 December 2013 (‘Kompos report’), [163], [165], [166], [184]-[187], CB 329, 330 and 333.

1. Dr Chu makes no allowance for a small company risk premium or for non-negotiability.  In response to Mr Ferrier, Dr Chu states that Mr Ferrier failed to distinguish the difference between the asset to which the empirical evidence is related (the Ibbotson and PwC studies) and the asset being valued.  Dr Chu states that:

(a)        the Ibbotson and PwC studies involve a minority equity investment in a relatively small company listed on US stock exchanges, whereas what is being valued in this matter is PGI’s total assets, comprising a significant portfolio of physical land assets and bed licences in a fragmented industry which was experiencing a consolidation phase and enjoying long-term favourable demographic conditions;

(b)        the strategic appeal and the significant size of the underlying asset’s portfolio being valued in such market conditions does not justify the use of a small company risk premium; and

(c)        Mr Ferrier is not comparing like with like and is incorrect. 

1. Further, in Dr Chu’s view it is inappropriate to apply a significant risk premium (in this case on the basis of non-negotiability) because what was being valued was not a minority interest subject to non-negotiability or a severe lack of liquidity. In his view, Mr Ferrier fails to recognise the difference in the asset to which the empirical evidence he cites is related (i.e. minority equity interests in unlisted entities) and the assets being valued here.  Finally, Dr Chu states that Mr Ferrier fails to recognise the fact that the equity betas of small companies are generally larger than those of large companies (other things being equal), thereby already accounting for the larger riskiness of the former relative to the latter, and thus Mr Ferrier was conceptually double counting the differential riskiness.[23]

   [23]Chu Reply report, [117]-[121], CB 1596-7.

1. In response to Mr Kompos, Dr Chu states his view that Mr Kompos’s adoption of a specific risk premium of 3.5 per cent (albeit lower than Mr Ferrier’s) in assessing the market value of PGI’s total assets is incorrect for the reasons previously set out.[24]

   [24]Chu Reply report, [240], CB 1632. Dr Chu refers to his earlier reasons as set out in paragraph [81], which appears to be an erroneous reference.  The issue was dealt with at paragraph [118], CB 1596-1597.

1. In the Joint Report, Dr Chu reiterates his criticisms that:

(a)        Mr Ferrier and Mr Kompos are not comparing like-for-like using data from companies listed on U.S. stock exchanges;

(b)        companies that may be small by U.S. market capitalisation standards are not small by Australian market capitalisation standards; and

(c)        applying U.S.-based studies to Australian companies creates an inherent upward bias of the assessed cost of capital and hence a lower value for the Australian company.[25]

[25]Joint Report, [241]-[244], CB 1752-3.

1. Mr Ferrier was not cross-examined at trial and Mr Kompos was not cross-examined on this issue at trial.

1. Dr Chu was cross-examined on this issue.  He agreed that the business valuation by DCF methodology is very sensitive to the adopted discount rate, which would affect the denominator and flow directly to the numerator such that his adopted figure for the value for land holdings was dependent upon, amongst other things, the discount rate he had adopted.  He did not accept that it was a matter for debate as to whether there should be a small company premium.  Dr Chu stated that a judgement needs to be made and the justification for that judgement was that small companies lack economy of scale, lack management and lack liquidity.  In his opinion, these factors were not applicable for the PGI portfolio of assets because the portfolio was relatively safe, as it had predictable revenue from the government, regularity of care revenue and was sufficiently large to justify the liquidity of the assets.

1. In the result, two of the three experts made a judgement that it was appropriate to apply a small company risk premium. Mr Ferrier and Mr Kompos use available data as a guide to the formation of their opinions.  In addition to reference to the US-sourced data, they have regard to what they consider to be comparable Australian companies.  They do not purport to say that the risks reflected in the US-sourced data are precisely the same as the risks applicable to Australian companies.  It may be inferred that Mr Ferrier made an allowance for Dr Chu’s criticism (without conceding the point altogether) when he reduced his allowance for risk from 5 per cent in his first report to 2 per cent in the Joint Report.  Mr Kompos, in the face of criticism, maintains that the appropriate allowance for the small company risk is 3.5 per cent.  He notes that the beta for small companies tends to be greater than those for large companies, however in his view these beta do not account for all the risks faced by those who invest in small companies.  Thus, Mr Kompos considers it to be appropriate to add a small company risk premium.

1. I am satisfied that an allowance should be made to reflect small company risk.  I accept that an appropriate rate is the revised rate of two per cent nominated by Mr Ferrier. 

1. Dr Chu agreed that if the discount rate that he had adopted was two percentage points higher then, on his calculations, it would reduce the denominator by $180 million and, in turn, the numerator by $182 million.[26]  Although no precise calculations were performed on this basis, the sensitivity of Dr Chu’s figures is a reflection of the sensitivity of the final valuations to changing the inputs (i.e. the discount rates).  Had Dr Chu allowed for a small company risk premium of two per cent, his discount rate would have significantly increased (because one of the components making up the WACC would have significantly increased), and the amount of PGI’s property (the denominator) and PGI’s land holdings (the numerator) would each have been significantly reduced.

   [26]Transcript 646.1-11.  The figure of $182 million recorded on transcript may be erroneous.  The witness may have meant that the numerator will be reduced by $180 million as well, though nothing turns on this.

1. Applied to the figures in this case, I am satisfied that Dr Chu’s assessed market value of PGI’s land holdings would have been reduced significantly – at least a reduction in the order of multiples of tens of millions of dollars less than his valuation of $517.6 million[27] – had Dr Chu allowed for a small company risk premium of, or in the order of, two per cent.  This is also apparent from evidence given by Mr Kompos of the effect on his valuation of adopting a higher discount rate.[28]

   [27]Joint Report, [104]; CB 1723.

   [28]Joint Report, [238]; CB 1752.

1. Other issues in dispute that made a significant difference to the assessed market value of PGI’s non-excluded property were the treatment of the value of expected synergies arising from the merger, the materiality of PGI’s goodwill and the treatment of accommodation bonds.  A discrete issue arose in relation to the assessed value of a vacant site at Buderim, Queensland, and other undeveloped land.  These issues are dealt with separately below.[29]

   [29]In sections 1.2, 1.3, 1.5 and 1.4, respectively.

1. In my view, the adjustment for small company risk is but one factor that demonstrates that Dr Chu’s assessed market value of PGI’s land holdings of $517.7 million is  excessive and cannot be relied upon.  It is sufficient for present purposes to conclude that an appropriate application of the DCF methodology to determine the unencumbered value of all the property of PGI would have allowed for a small company risk premium.

1.1(b) What is the appropriate methodology to determine the unencumbered value of the land holdings of PGI (numerator) for the purposes of section 71(2)(b) of the Act?

1. The Commissioner’s submissions on this question can be distilled into the following three main points:

(a) Land rich case authorities demonstrate that it is ‘customary to allocate’ the value of all of the taxpayer’s property amongst its separate classes of property to derive the statutory ratio established in s 71(2)(b) of the Act. In this regard, I note that the Commissioner’s submissions were substantially modified over the course of the trial. Originally, the Commissioner submitted that ‘there is no question that the task required is allocation of the value of a bundle of assets among the classes or property in the bundle’, and that the Act requires this approach for determining the ratio.[30]

(b)        The basis for valuation of both the unencumbered value of PGI’s land holdings (the numerator) and unencumbered value of all PGI’s property (the denominator) must be the same, as no meaningful ratio can be derived when the denominator and numerator are derived on different bases. In other words, the value of the land holdings must be a subset of the value of all of the property of PGI; [31] and

(c)        Mr Willison’s approach to the valuation of the numerator was to value each land holding on an individual, standalone basis, which is contrary to the requirements of the legislation. The appellant’s use of this value as the numerator, whilst deriving its denominator from the valuations provided by Mr Ferrier and Mr Kompos (who did not allocate value amongst separate classes of assets), precludes the validity of Mr Willison’s land valuation evidence.

[30]Commissioner’s opening written submissions, [17] and Commissioner’s oral opening Transcript 300.29-31 – 301.1-8; Commissioner’s closing written submissions, [13], cf [58].

[31]To the extent that it is not excluded property under s 71(3) of the Act; Commissioner’s oral opening submissions, Transcript 300.29-301.29; Commissioner’s opening written submissions, [20].

1. Ultimately, these submissions were made in support of the contention that Mr Willison’s valuation does not comply with the legislative requirements and, as such, must be disregarded.

Cases relied on by Commissioner

1. In support of its submission that it is either customary, or required by law, to use an allocative method to value PGI’s land holdings as a subset of its total assets, the Commissioner referred to and relied on a digest of authorities. 

1. The Commissioner submitted that these authorities show an allocation of value between land and non-land assets, and that the cases did not turn on whether there should be an allocation but generally on the amounts to be allocated to particular classes of property and the identification of the classes of property or the correct value of the whole of the property.[32]  In the result, the Commissioner relies on the fact that the cases do not engage the question whether there should be an allocation because, it was submitted, it is so obvious that allocation is required as to go without saying.

   [32]Commissioner’s closing written submissions, [13].

1. As noted above, in oral closing submissions, the Commissioner significantly modified his stance that allocation is required, to a submission that the land rich cases upon which he relied show that it is ‘customary to allocate the value of all of the taxpayer’s property amongst its separate classes of property’ to derive the statutory ratio. 

1. The appellant submitted that none of the authorities cited by the Commissioner establish, as a matter of law, a requirement to allocate the denominator value between classes and that there is nothing in the statute which points to that proposition beyond the mere fact that it requires a ratio to be determined.

1. I deal with each authority in turn below.

1. In Commissioner of Taxation v Resource Capital Fund III LP (‘Resource Capital’)[33], the question for determination was whether a taxpayer was assessable on the capital gain made from the sale of shares that it held in an Australian mining company.  At first instance, the primary judge held the taxpayer was not assessable on the capital gain.  The case turned on the ‘principal asset test’ in s 855-30 of the Income Tax Assessment Act 1997 (Cth).  Section 855-30(2) relevantly provided:

   [33][2014] FCAFC 37.

855‑30  Principal asset test

(2)A *membership interest held by an entity (the holding entity) in another entity (the test entity) passes the principal asset test if the sum of the *market values of the test entity’s assets that are *taxable Australian real property exceeds the sum of the *market values of its assets that are not taxable Australian real property.

Note:   The market value of any of the latter kind of assets that are duplicated within the test entity’s corporate group could be disregarded (see section 855‑32).[34]

[34]Emphasis in original.

1. In Resource Capital, the Full Federal Court stated that the section requires the identification of two figures:

(1)the sum of the market values of the test entity’s taxable Australian real property assets; and

(2)the sum of the market values of the test entity’s assets that are not taxable Australian real property.[35]

[35]Resource Capital [2014] FCAFC 37, [49].

1. Among other things, the question raised by the appeal was whether the market value of each asset was to be determined under s 855-30(2) as if each asset was the only asset offered for sale (as the primary judge held) or on the basis of an assumed simultaneous sale of the assets to the same hypothetical purchaser (as the Commissioner contended).[36]

   [36]Ibid [50].

1. The Full Court held that it was implicit that, to determine where the underlying value resided in the bundle of assets, the market values of the individual assets making up that bundle were to be ascertained as if they were offered for sale as a bundle, not as if they were offered for sale on a stand-alone basis.  It followed that the assets were to be valued on the basis of an assumed simultaneous sale of the assets to the same hypothetical purchaser, not as stand-alone separate sales.[37]

   [37]Ibid [51]-[53].

1. The Commissioner submits that even though the assets the subject of debate in Resource Capital were of a distinct kind, the statutory context is relevantly indistinguishable in that, in both cases, the statutory criterion depends on whether the entity’s underlying value comprises principally land or non-land.[38]

   [38]Commissioner’s closing written submissions, [12].

1. The appellant submits that Resource Capital concerns a different statutory context, a different statutory inquiry and a different valuation subject in a very different industry (mining as opposed to residential aged care), and that it is of no assistance for present purposes.

1. In my view, Resource Capital does not assist the Commissioner.  The appeal in Resource Capital only required the determination of the correctness of the primary judge’s valuation hypothesis – i.e. whether, as the primary judge had found, the market value of each asset was to be determined as if each asset was the only asset for sale.[39]  The case says nothing about allocation.  Indeed, senior counsel for the Commissioner ultimately conceded that the question of the allocation or the need for an allocation was not in issue in that case.[40]

   [39]Resource Capital [2014] FCAFC 37 [53].

   [40]Commissioner’s oral closing submissions, Transcript 811.12-13, cf Commissioner’s closing written submissions, [11].

1. The Commissioner cited other cases which it was submitted, without question, make an allocation of value as between land and non-land.

1. E.I.E. Ocean B.V. v Commissioner of Stamp Duties (’E.I.E. Ocean’)[41] involved ascertaining whether a sale was of shares in a land rich company.  In E.I.E. Ocean, the Commissioner’s approach to the valuation of land was to deduct from the total consideration on the sale of shares the sum total of all non-land items, leading the Commissioner to adopt a value for land represented by the balance.  The taxpayer’s approach was to value the land and to allocate the difference between the land value and the total of the sale price to various assets.  Macrossan CJ noted there was ‘nothing inherently wrong with the Commissioner’s ‘subtractive’ approach if it is possible to be satisfied that the component values he has adopted are substantially correct’.[42]  Of the taxpayer’s approach, his Honour said it was not necessary to say more than that the reliability of the taxpayer’s method had no greater claim to acceptance than the Commissioner’s method.  In that case, the duty, if any, payable could not be ascertained until certain factual matters were determined.  As a consequence, the case was remitted for determination of those factual matters, specifically the value of personal goodwill, which plainly could not be included in land value.

   [41][1998] 1 Qd R 36.

   [42]Ibid 38.

1. E.I.E. Ocean illustrates that there may be different approaches taken to ascertain a land rich ratio.  No single approach was mandated by the relevant statutory provision in that case.

1. In MIM Holdings Ltd v Commissioner of Stamp Duties,[43] the taxpayer acquired shares in a company whose articles of association provided that, until the shares were paid up to a certain amount, they carried no entitlement to participate in the distribution on a winding up.  Subsequently, the taxpayer paid a call on the shares and thereby acquired such an entitlement.  The Commissioner of Stamp Duties in Queensland – under the provisions of the Stamp Act 1894 and, in particular, s 56FA.1 – assessed the transaction for stamp duty on provisions providing that stamp duty was payable when a person acquired a majority interest in a land rich corporation.

   [43][2001] 1 Qd R 294.

1. Section 56FA.1 provided that:

‘acquire’, in relation to an interest in a corporation … includes, without limiting the generality of the expression, to acquire an interest by virtue of –

…

(c)the variation, abrogation or alteration of a right pertaining to any share.

1. The trial judge decided that the right to make a call on the shares ‘inhered in the shares from their issue and was realised by the payment up of the required amount’ and did not arise ‘by virtue of any variation of any right pertaining to the shares themselves’.[44]  On appeal, Chesterman J, with whom McMurdo P agreed,[45] concluded that the right to call up the unpaid premium on shares was contingent property, which was acquired when the taxpayer acquired the shareholding.  It followed that there was no acquisition by the taxpayer of an interest in the corporation by virtue of a ‘variation, abrogation or alteration of a right pertaining to a share’, and the acquisition was not dutiable.

   [44]MIM Holdings [2001] 1 Qld R 294, 308 [42].

   [45]See ibid 300 [1]; see also ibid 302-3 [14]-[15], in which Derrington J agreed with Chesterman J's conclusion by slightly different reasoning.

1. Whilst there was some discussion on appeal of the parties’ respective contentions on how a simplified balance sheet would show the respective value of its real and other property, there was no discussion about whether the relevant section required an allocation to be made between the two.

1. HSH Hotels (Australia) Ltd v Commissioner of State Taxation[46] involved the ‘land rich’ provisions of the Stamp Duties Act 1923 (SA). The Commissioner extrapolated a value for a trust that was being acquired by relying on consideration paid for assignment of mortgages, adding certain liabilities and subtracting current assets, hotel furniture, fittings and equipment, china and glassware and motor vehicles to arrive at an implied value of the trust property. The Commissioner failed to include an allowance for any goodwill, and arrived at a ratio of 86.86 per cent. As the 80 per cent threshold applicable in that case had been exceeded, stamp duty was assessed on the transaction. Anderson J decided that whilst an allowance for goodwill had not been made, the goodwill passing in the transaction – which was not site-related – was not sufficient to reduce the value of the real estate below 80 per cent of the unencumbered value of all other property. As a consequence, his Honour found the failure to include any allowance for goodwill in the assessment did not mean that the assessment should be overturned. In HSH Hotels, there was no discussion that the relevant statute required that there be an allocation.  Indeed, there is no discussion about ‘allocation’ per se. 

   [46](2005) 58 ATR 276.

1. Alcan (NT) Alumina Pty Ltd v Commissioner of Taxes[47] concerned the land rich provisions of the Taxation (Administration) Act 1978 (NT) as they applied to transactions by which the taxpayer acquired a majority interest in Gove Aluminium Limited.

   [47][2007] NTSC 9.

1. In determining whether the value of the interest in land in the Territory to which Gove Aluminium Limited was entitled was 60 per cent or more of the value of all of the non-excluded property to which it was then entitled, Mildren J ascertained the total value of Gove Aluminium Limited’s assets as at the relevant date,[48] and then deducted excluded assets and non-land assets.[49]  There were disputes between the parties about the appropriate allowances (if any) to make for assets such as intellectual property, goodwill and other intangibles.  On the facts of that case, the primary judge was not persuaded that there were any intangible assets that, together or separately, had existence as property and that needed to be accounted for and separately valued.[50]  In the result, the taxpayer’s appeal was allowed and the matter stood over for further evidence.

   [48]Ibid [95]-[96].

   [49]Ibid, [98]-[99].

   [50]Ibid, [121].

1. There was no issue raised in this case that the approach to be taken in determining the ratio was mandated by the statute.

1. In Alcan (NT) Alumina Pty Ltd v Commissioner of Taxes (No 3) (a sequel to the first proceeding),[51] Mildren J determined the value of a relevant interest in leases excluding the value of the options to renew the leases after considering expert evidence, which reflected different approaches to the task.[52]  One approach, described as the ‘top down’ method, was to deduct from the total value of non-excluded property the sum of the value of chattels, working capital, intellectual property and the value of the right to renew leases to arrive at what was left, namely, the value of the land.  Another approach was to assess the cash flows that could be expected to be generated from exploiting the leases, taking into account all the rights and privileges available to them as an owner of the assets.  This assumed that a joint tenant would exercise an option in carrying on the business.  The third approach was that, at the end of the existing term of the leases, there would not be any further mining activity and a hypothetical vendor and purchaser would assume that, at the relevant time, the purchaser would terminate operations on the leases, leave the fixtures to the landlord and not seek to recover any part of their value.

   [51][2007] NTSC 70.

   [52]Ibid [8].

1. Mildren J accepted that the ‘top down’ approach was the fairest and best method to use in the circumstances of the case.[53]  However, whilst Mildren J referred to the word ‘allocate’ when he said that:

[t]he main dispute between the experts – and the parties -

is, to adopt Mr Lonergan’s description, …the manner in which we allocate the total enterprise value to ‘land’ and non-land assets…[54]

there is no suggestion that any approach, much less an allocation, was prescribed by statute.[55]

[53]Ibid [8], [18].

[54]Ibid [7].

[55]The decision of Mildren J was overturned on appeal by the Court of Appeal of the Northern Territory, which found that “land” did include “an option to renew a lease”.  The Court of Appeal decision was overturned by the High Court, which restored the decision of the primary judge.

1. Commissioner of State Revenue (Vic) v Snowy Hydro Limited (‘Snowy Hyrdo’)[56] concerned a transaction whereby Snowy Hydro Limited, the taxpayer, acquired all of the issued share capital in Latrobe Valley BV (‘LVBV’).  LVBV was not itself a land owner, but its wholly owned subsidiary Valley Power (‘VP’) owned land on which a power plant had been established.  The question for determination in the proceeding was whether LVBV was land rich for duty purposes, which would only have been so if VP was land rich at the relevant date.  Thus, the Court had to determine whether the value of the land owned by VP represented 60 per cent or more of the unencumbered value of all VP’s property.  The issues in the case involved disputes over individual components of the numerator (land owned by VP) and the denominator (the value of all of VP’s property).  None of these issues concerned whether the statute prescribed that there should be an allocation from the denominator into the numerator or any other type of allocation. 

   [56][2012] VSCA 145.

1. In Snowy Hydro, the parties had prepared an agreed series of alternative computations based on possible outcomes on various appeal issues, and the Court of Appeal chose the computations that reflected the conclusions reached on appeal.  Accordingly, in determining the appeal, it was not necessary for the Court itself to consider whether it was necessary to allocate from the denominator to the numerator to determine the land value.

Conclusions on allocation methodology

1. In my view, there is no reason why one methodology could not be used to determine the numerator and another, different methodology used to determine the denominator, provided that the values attributed to the respective integers are determined on a sound footing.

1. The land rich cases relied upon by the Commissioner to illustrate the ‘proper approach’ demonstrate that no approach is prescribed by the statute. Nor do they demonstrate that it is ‘customary to allocate’ to determine the ratio.  The cases turn on their own facts and demonstrate that approaches will vary to accommodate those facts.

1. It follows that the approach taken by the appellant’s expert land valuer (Mr Marcus Willison) is not precluded for non-compliance with any statutory requirements. That is to say, the fact that the appellant, through its experts Mr Willison in conjunction with Mr Ferrier and Mr Kompos, did not allocate or apportion the value of all of PGI’s property as between the value of land and non-land assets does not suggest that this approach is intrinsically flawed because that approach is not mandated by the statute, nor (if it matters) has it been established that it is customary to do so.

1. I will return to a discussion of Mr Willison’s report below in relation to the Commissioner’s criticism that Mr Willison valued the land on an individual, standalone basis. However, at present, it is sufficient to say that, in my view, Mr Willison’s evidence is to be considered on its merits.

1.2      How, if at all, are PGI’s expected synergies from the merger to be treated?

1. Among other things, the Merger Model modelled the synergies the merging parties expected to realise and the implementation costs of their realisation.

1. Dr Chu expresses the view that:

(a)the market value of PGI’s total assets should be assessed as at the relevant date (2 July 2007) ‘immediately following the finalisation of the Merger Implementation Deed on that date’;[57]

(b)as a result, what is being valued is not PGI’s collection of assets on a standalone basis but PGI’s collection of assets as part of the known larger collection of assets created from the combination of PGI and RCAH’s assets;

(c)the valuation exercise  ‘needs to take into account the evolutionary nature of asset value and the fact that becoming part of the larger known collection of assets represents an upward move in the life cycle of PGI’s collection of assets’;[58]

(d)the share of the expected synergies attributable to PGI was negotiated and agreed upon between two arm’s length knowledgeable parties; and

(e)a hypothetical, knowledgeable Spencer buyer (a willing but not anxious buyer) and hypothetical, knowledgeable Spencer seller (a willing but not anxious seller) of PGI’s collection of assets as at 2 July 2007 should take into account these factors and reflect the benefits associated with PGI’s share of the expected synergies in their assessment of the (hypothetical) price for PGI’s total assets (being the Spencer market value of the assets). 

[57]Joint Report, [142], CB 1733; Chu Reply report, [59], CB 1578.

[58]Joint Report, [142], CB 1733.

1. Dr Chu notes that the expected synergies from the merger were generally cost synergies, not revenue synergies and that the realisation of cost synergies is generally subject to a relatively low level of uncertainty.  He states that it is thus conservative to apply the same discount rate as he had applied to the expected cash flows from the PGI business on a ‘standalone’ basis in assessing the value of PGI’s share of the cost synergies.

1. Dr Chu assesses the present value of the synergies (net of implementation costs) the merging parties expected to be generated from the merger at approximately $131.3 million.[59]  Dr Chu states that his review of the expected synergies from the merger indicated that synergies were expected to be derived from two main sources.  First, from a reduction of costs incurred (pre-merger) by the facilities owned by RCAH to the cost benchmarks established with reference to costs incurred (pre-merger) by PGI; Secondly, in a reduction of the total head office costs of the combined entity by terminating external management contracts on the RCAH side of the merged group.

   [59]Independent expert report of Dr Hung Chu dated 24 January 2014 (‘Chu report’), [104]-[107], CB 1321; Chu report, Appendix G, CB 1408.

1. Dr Chu assesses the value of PGI’s share of the expected synergies (net of implementation costs) at 64.9 per cent of $131.3 million or approximately $85.2 million.[60]  He adds this amount to the ‘standalone’ enterprise value of PGI.[61]

   [60]Chu report, [108]-[109], CB 1322-3.  The percentage of 64.9 per cent was based on PGI’s implied pre-cash payout merger ratio of 64.9 per cent reflected in the terms of the merger.  It is not necessary for present purposes to elaborate in further detail on the accuracy or the basis of the merger ratio percentage used by Dr Chu. 

   [61]Chu report, [110]-[114], [152], CB 1323-4, 1332.

1. Neither Mr Ferrier nor Mr Kompos consider it appropriate to add the proportional value of the expected synergies to the ‘standalone’ enterprise value of PGI at the relevant date.

1. Mr Ferrier describes synergies as the factors that produced additional value from combining two like businesses that create opportunities that would not have been available had they been operating independently.[62]

   [62]Independent expert report in reply of Mr Ferrier dated 25 July 2014 (‘Ferrier reply report’), [49], CB 1520.

1. In Mr Ferrier’s opinion,[63] by including the synergies in the standalone enterprise value of PGI, Dr Chu implies that:

(a)the only transaction available to PGI was one that would result in a merger of two businesses where the owners of those businesses continue to maintain proportional ownership after the transaction; or

(b)for any other transaction type (e.g. an acquisition of PGI for cash or a combination of cash and shares) by another organisation, the acquirer would pay the proportional value of the total synergies to PGI as part of the acquisition price.

[63]Ferrier reply report, [50]-[55], CB 1520.

1. According to Mr Ferrier, application of the synergies on this basis also implies that a transaction with any other hypothetical merger partner for PGI would create synergies with the same proportional value to PGI as those created by the merger transactions.

1. In Mr Ferrier’s opinion, in circumstances where these assumptions are reasonable, it would be appropriate for the synergy value to be included in the standalone value of an entity that is party to a merger.

1. But, according to Mr Ferrier, Dr Chu provides no evidence that the only transaction that would have been available to PGI is a merger on the basis of the merger that actually occurred.  Mr Ferrier states that this is not a reasonable assumption for the following reasons:[64]

   [64]Ibid, [54], CB 1520.

(a)one consideration for PGI proceeding with the merger that resulted in both parties maintaining an ownership interest was the desire by the owners of PGI to continue their involvement in the aged care sector;

(b)in circumstances where the owners of PGI did not have a desire for continued involvement in the aged care sector, an alternative transaction could have included:

(i)a sale of 100 per cent of the shares in PGI for cash;

(ii)a sale of the PGI business (rather than a sale of the shares) for cash; or

(iii)PGI listing its shares on either the Australian Stock Exchange or another relevant stock exchange; and

(c)it is possible that the owners of PGI would have acquired an interest in another aged care business or businesses such that they would be entitled to a higher proportion of any synergy value generated.

1. Mr Ferrier states that in the circumstances set out in (b) and (c), it would be unlikely that the owners of PGI would have received the same level of value from synergies likely to be generated.

1. More generally, Mr Ferrier considered the payment of synergy values in acquisitions in the context that companies may acquire other companies or other businesses to generate synergistic benefits from combined operations.  Relying on the commentary from ‘The Valuation of Businesses, Shares and Other Equity’ by Wayne Lonergan,[65] Mr Ferrier states that purchasers of such businesses may be prepared to pay more than the standalone enterprise value of the businesses being acquired, although the additional amount that can be extracted by sellers is dependent on the number of potential acquirers in the market.

   [65]Ferrier reply report, [56]-[58], CB 1521, quoting Wayne Lonergan, The Valuation of Businesses, Shares and Other Equity (Allen & Unwin, 4^th ed, 2003) 51.

1. Further Mr Ferrier adopted the following passage in Lonergan:

… [O]bserved market prices only include a proportion of those benefits as purchasers are only prepared to share a proportion of these benefits with vendors.  This is due to factors such as the time value of money during the period before the benefits can be obtained, uncertainties as to their timing and quantum.[66]

[66]Ferrier reply report, [58], CB 1521; quoting Wayne Lonergan, The Valuation of Businesses, Shares and Other Equity (Allen & Unwin, 4^th ed, 2003) 51.

1. Mr Ferrier states that Dr Chu allocated 100 per cent of the synergies that proportionately relate to the PGI business by applying a discount rate of 9.25 per cent to the net synergies expected to be earned.  Further, by applying the same discount to the expected synergies as he had to the projected ongoing cash flows from the PGI business, Dr Chu has assumed that the risks associated with the achievement of the synergies are the same as the risks associated with the achievement of the ongoing cash flows from the PGI business.  In Mr Ferrier’s opinion, that is an inappropriate assumption.[67] 

   [67]Ferrier reply report, [59], CB 1521.

1. Mr Ferrier was requested to assess the value attributable to expected synergies to PGI by applying the same assumptions as Dr Chu – that is, on the assumption that the same discount rate that Mr Ferrier had used in his valuation of PGI was appropriate for assessing the value attributable to the synergy benefits.  This produced a value for expected synergies of $55.756 million (cf $85.2 million calculated by Dr Chu).[68]

   [68]Ferrier reply report, [62] Table 61, CB 1522.

1. Mr Ferrier states that, in the event that the Court determines that inclusion of a value attributable to the expected synergies is appropriate, the value of the expected synergies would be an element of goodwill rather than a value that should be added to the value of PGI’s aged care land assets.[69]

   [69]Joint Report, [91]-[92], CB 1720.

1. On the question of expected synergies, Mr Kompos notes that he was instructed to calculate the unencumbered value of all of PGI’s property and that he conducted that task having regard only to the landholder whose property was being assessed under the Act. In Mr Kompos’s opinion, potential merger synergies fell outside the scope of the property that was to be assessed under the Act (the unencumbered value of all of PGI’s property), as they only come into existence after the merger is effected.

1. Alternatively, in the event that potential merger synergies were required to be taken into account under the Act, in Mr Kompos’s opinion any value accretion that would arise from valuing the potential merger synergies would be an element of goodwill rather than a value that should be added to the value of land and buildings. According to Mr Kompos, given that synergies only arise when a group of assets are operated or managed together as a business, it is illogical to argue that those synergies could ever be reflected in the value of any individual asset.[70]

   [70]In the Joint Report, the experts substantially reiterate the opinions previously expressed.  See Joint Report, [144]-[145] (Ferrier), [146]-[150] (Kompos) and [142]-[143] (Chu); Independent expert report in reply of Mr George Kompos dated 25 July 2014 (‘Kompos reply report’), [109]-[114], CB 1481.

1. For the purposes of these appeals, it is not necessary (or possible, on the evidence) to determine precisely what figure is the appropriate figure to adopt for expected synergies.

1. It is sufficient to indicate that I am not satisfied that the discount rate used by Dr Chu to ascertain the present value of expected synergies should be identical to the discount rate Dr Chu used with respect to the projected ongoing cash flows from the PGI business.  It seems to me that the risks are different.  Predicting the ongoing cash flows from PGI’s business is likely to be less complex than predicting the ongoing performance of two merged entities and the achievement of anticipated synergistic benefits, the realisation of which will be dependent upon the proficiency of the management of the newly-merged entity in bringing the costs of the RCA side of the merged entity into alignment with the benchmarks on the PGI side, and the unravelling of contractual arrangements between third parties; for example, the external management contracts.  In my view, the risks are likely to be greater and the value of expected synergies would need to be discounted at a higher rate to reflect the increased risk.  

1. I note that Mr Ferrier’s calculation of the present value attributable to expected synergies was $55.7 million, using the same discount rate as he had used in his valuation of PGI. This figure indicates that the value of expected synergies is highly sensitive to the adopted discount rate.[71]  Both of these reasons  strongly suggest that  Dr Chu’s estimate of the present value of expected synergies of $85.2 million  is excessive.  Based on Dr Chu’s allocation methodology, this carries through to the calculation of the numerator, which translates into an excessive calculation of the value of the land holdings of PGI.  

   [71]Mr Ferrier was requested to use the same discount rate as he had used in his valuation of PGI’s property.

1. Further, I am not satisfied that the whole amount of the present value of expected synergies (whatever that amount may be) would be reflected in the market value of the assets of the entities at the moment when the merger transaction occurred or, as Dr Chu characterised it, ‘immediately following the finalisation of the Merger Implementation Deed’.[72]

   [72]Joint Report, [142], CB 1733.

1. The appellant submits that the consequence of Dr Chu’s analysis is the unlikely prospect that PGI was worth an additional $85.2 million the day after the merger. I am not persuaded that this conclusion follows from the evidence given by Dr Chu. In this regard, Dr Chu gave evidence that the full amount of the expected synergies crystallised on 2 July 2007, (which was the date he was ‘instructed to apply on value’) but that the value of the assets changed as soon as merger negotiations took place.  In my view, nothing turns on fine timing issues in this case (i.e. whether the value of expected synergies should be taken into account immediately before, at the time of, or immediately after the completion of the merger).

1. I do not accept the proposition that the whole amount of the present value of expected synergies will be incorporated in the agreed market value of the merging entities. A practical example may help illustrate the point.

1. During negotiations over the terms of an intended merger, hypothetical ‘buyers’ and ‘sellers’ of the businesses that might be merged must be taken to be conversant with and to take account of the present value of their respective businesses considered separately.  They must be taken to be conversant with and to take into account the value of the expected synergies if a merger were to be effected.  If the expected synergies are of monetary value, that fact may affect the market value arrived at by the negotiating parties.  The market value is ascertained at the time the negotiating parties agree upon a ‘price’, which will be based on the common assumption that the businesses will be merged.  That process is, at least partly, prospective.  Any market value attributed by the hypothetical negotiating parties to expected synergies will crystallise once the parties have agreed on the financial terms of the merger (i.e. the notional price).  The market value of the expected synergies will necessarily be agreed upon before completion of the merger.  It seems to me highly unlikely that a willing but not anxious buyer of the businesses, including the land holdings, would be prepared to pay a willing but not anxious seller the full present value of expected synergies as at the date of the merger.[73]  The value of some or all of the expected synergies may never be realised.  Relevantly, in this case, the synergies were apparently predominantly to be derived from cost containment.  The true value of the synergies would depend on whether costs were in fact contained as modelled, which would in turn depend on  how effectively future management of the merged businesses act to put in place cost containment measures, and whether the assumptions underlying the savings prove to be correct.  In my view, it is highly likely that these elements of uncertainty would result in a discount to the present value of expected synergies from the standpoint of a willing but not anxious buyer.  Similarly, in my view, it is highly likely a hypothetical seller would know that the synergies had yet to be realised and would not expect the price to reflect full value.

   [73]This assumes the absence of a skewing factor such as multiple potential buyers competing on price.

1. Considering the question from a slightly broader perspective, the willing but not anxious seller would (presumably) use the value of expected synergies, being the present value of a future opportunity, as leverage to make a willing but not anxious buyer more interested in the proposed transaction. The hypothetical buyer may be willing to pay a higher purchase price than would be the case without that opportunity. The willing but not anxious buyer, on the other hand, would emphasise that the expected synergies were anticipatory and would likely use that uncertainty as leverage to get the willing but not anxious seller to be more realistic about the selling price.  If these hypothetical actors reach a bargain, taking into account expected synergies, then the agreed price (for that component) will likely fall somewhere between the two extremes. In the result the ‘market value’ ultimately attributed to the expected synergies may bear little resemblance to the calculated value produced by application of economic theory and discount rates to cash flows in a business model.  

1. There is no evidence in this case to suggest that there were other ‘potential acquirers’ in the market, which might have affected the willingness of one or other of the merging entities to pay for any expected synergies. It is possible that neither party would be prepared to pay any amount for expected synergies.

1. For the above reasons, considered separately and in combination, I consider on the balance of probabilities that the amount allowed by Dr Chu for expected synergies is excessive and unreliable.  It follows that the amount that flows through to the value of PGI’s land holdings as at the relevant date (using Dr Chu’s allocation methodology) is excessive and unreliable. I note that Dr Chu provided no independent evidence supporting his contention that, in the circumstances of this case, the full present value of expected synergies would accrue to PGI on the relevant date.

1. In any event, I am not satisfied that the then present value of expected synergies (whatever the amount may be) translated directly into the value of PGI’s land holdings or, to adopt Dr Chu’s terminology, ‘had become impounded into the value of the portfolio of PGI’s assets after the finalisation of the Merger Implementation Deed’,[74] nor am I satisfied that the total additional value is attributable to and inheres in the value of PGI’s land portfolio and is not goodwill.[75]  The notion of the value of cash flows inhering in the value of PGI’s land portfolio is considered in the following section dealing with materiality of PGI’s goodwill.

   [74]Joint Report, [90], CB 1719.

   [75]Ibid.

1. For present purposes, it is enough to note that the notion is novel, and that it is propounded by a person whose expertise lies outside the field of land valuation even though it is intrinsically a question of land valuation.  Synergies can only be realised by the efficient combination of the existing businesses of the merging parties.  That will include the efficient engagement of management in the merged entity, the efficient use of bed licences, and the efficient use of freehold and leasehold land assets.  In the circumstances of this case, in my view, there is no satisfactory basis to assert a ‘bright line’ delineation, such that the value of expected synergies could be attributed entirely to the value of PGI’s land holding assets to the exclusion of its intangible assets.

1. For the above reasons, I am not satisfied that $85.2 million of expected synergies attributed by Dr Chu to the value of PGI’s property is correct, or that that amount inhered in the value of PGI’s land holdings as at 2 July 2007.  In my view, for this reason alone, the value attributed by the Commissioner to PGI’s land holdings is excessive and cannot be relied upon. 

1.3 As at 2 July 2007, did the goodwill of PGI have no material value?

1. The proper characterisation of goodwill was considered by the High Court in Commissioner of Taxation v Murry.[76]

   [76]Commissioner of Taxation of the Commonwealth of Australia v Murry (1998) 193 CLR 605 (‘Murry’).

1. In Murry, a taxpayer who conducted a taxi business in partnership with her husband sold a licence to operate a taxi and some shares in a taxi cooperative company. Included in the transaction was a taxi vehicle owned by a third party. The contract of sale form specified values for the vehicle ($6,000), the shares ($25,000) and ‘goodwill (licence value)’ ($189,000) for a total sale price of $220,000. A notation in the form identified the third party as the owner of the vehicle. The taxpayer realised the capital gain as a result of the transaction and the question for determination was whether the taxpayer was entitled to an exemption of part of that gain in accordance with section 160ZZR of the Income Tax Assessment Act 1936 (Cth), which provided that an exemption was available where the taxpayer disposed of an interest in a business which included goodwill of the business.

1. On appeal to the High Court, the Court considered whether the amount received on the disposal of the taxi licence, or some part of that amount, constituted a payment for goodwill. The taxi licence was found to be simply an item of property whose value was not dependent on the present existence of the business and did not contain any element of goodwill.[77]  It was held by majority (Gaudron, McHugh, Gummow and Hayne JJ, Kirby J dissenting) that, by selling the licence, the taxpayer and her husband did not dispose of a business within the meaning of the exempting provision, nor did they dispose of an interest in a business that included the goodwill of the business.[78]

   [77]Ibid 630.

   [78]Ibid 609.

Attributes of Goodwill

1. In Murry, the Court distilled the following attributes of goodwill:

(i)it is inseparable from the conduct of a business;[79]

(ii)it is an indivisible item of property and an asset that is legally distinct from the sources that have created it;[80]

(iii)it is the attractive force that brings in custom;[81]

(iv)it has multiple sources, including site, personality, service, price or habit that obtains custom;[82]

(v)it does not inhere in the identifiable assets of a business – thus, the sale of an asset that is a source of goodwill, separate from the business itself, does not involve any disposition of the goodwill of the business;[83] and

(vi)it is the legal right or privilege to conduct a business in substantially the same manner and by substantially the same means, which in the past have attracted custom to the business,[84] and is acquired when a person acquires that right or privilege.[85]

[79]Ibid.

[80]Ibid.

[81]Ibid 630, 613-4, citing Mullah & Co’s Margarine Ltd [1901] AC 217, 223-4 (Lord Macnaghten).

[82]Murry (1998) 193 CLR 605, 630.

[83]Ibid 609.

[84]Ibid 623.

[85]Ibid.

1. The Court provided guidance to measuring the value of goodwill, relevantly in the context of a profitable business, as follows:

When a business is profitable and expected to continue to be profitable, its value may be measured by adopting the conventional accounting approach of finding the difference between the present value of the predicted earnings of the business and the fair value of its identifiable net assets. Admittedly this approach can cause problems in valuing goodwill for legal purposes because the identifiable assets need to be valued with precision. Particular assets, as shown in the books of the business, may be under or over valued and may require valuations of a number of assets and liabilities which may be difficult to value. However in a profitable business, the value of goodwill for legal and accounting purposes will often, perhaps usually, be identical.[86]

[86]Ibid 624.

1. There is a fundamental disagreement between the experts on whether PGI had material goodwill value as at 2 July 2007.  In Dr Chu’s opinion, PGI did not have material goodwill as at that date.  However, Mr Ferrier and Mr Kompos are both of the opinion that PGI did have material goodwill value as at that date.

Dr Chu’s conceptual framework

1. Dr Chu relied on a conceptual framework to underpin his conclusion that PGI did not have material goodwill as at 2 July 2007. The elements forming his conceptual framework are as follows.

Net attraction of custom

1. According to Dr Chu, the true nature and quantum of goodwill of a business should be judged by its attractive force, which brings in custom, not including the custom brought in by the attractive forces associated with other identifiable assets employed by the business. He states that conceptualising goodwill as ‘net attraction of custom’ is consistent with the recognition in Murray that goodwill is an asset which is distinct from identifiable assets of the business.  If the goodwill of a profitable business is conceptualised as representing the entire attraction of custom of the business (compared with the net attraction of custom) the attraction of custom of identifiable assets and their values would, according to Dr Chu, be subsumed into goodwill and its value. This would eliminate the distinct boundary between the value of goodwill and the value of the identifiable assets of the entity. Under the ‘net attraction of custom’ approach to goodwill, the subject enterprise can have significant gross attraction of custom but no material goodwill if the attraction of custom is predominantly derived from other ‘tangible and identifiable intangible’ assets employed by that enterprise.  In this regard, Dr Chu notes that in Murry, the majority recognised that:

where the goodwill of a business largely derives from using an identifiable asset or assets, the goodwill of the business, as such, when correctly identified may be of small value..[87]

[87]Ibid 625; Chu report, [190], CB 1338. The Court went on to say: That is because the earning power of the business will be largely commensurate with the earning power of the asset or assets. If the goodwill of a business largely depends on a trade mark, for example, and the trade mark is fully valued, the real value of goodwill can only reflect a value that is similar to the difference between the business as a going concern and the true value of the net assets of the business including the trade mark. A purchaser of the business will not pay twice for the same source of earning power. The purchaser will not pay a sum that represents the earning power of the trade mark and also a sum that represents the earning power of the business. Nevertheless, the earning power of the trade mark is unlikely to equal the earning power of the business.

1. In elaborating on the notion of net attraction of custom, Dr Chu states that the distinction between gross attraction of custom and net attraction of custom is inextricably linked to the distinction between cases where customers are drawn or ‘pulled’ to a business, and cases where customers are ‘pushed’ to a business. In cases where customers are pushed to a business – due to the basic necessity of products or services offered by the business, scarcity of supply, or the monopolistic or oligopolistic nature of the physical assets of the business in the relevant geographic locations – the business should not have material goodwill. This is because there is no material incremental ‘active’ attractive force that brings in custom over and above the ‘passive’ attractive force, which brings in custom vested or entrenched in the physical assets (and licences) of the business. 

1. Dr Chu states that the ability of a going concern business to actively attract custom underpins the value of goodwill as an asset independent of the identifiable assets employed by the business.  He also states that the ‘custom pull’ as opposed ‘custom push’ approach to goodwill is consistent with the ‘net attraction of custom’ approach to goodwill, in that both approaches allow for the attraction of custom created by other assets employed by the business. This recognises the distinct boundary between the value of goodwill and the value of identifiable assets of the business.[88]

   [88]Chu report, [191], [193], CB 1338-9.

Management decisions

1. In Dr Chu’s opinion, it is important to distinguish between the value arising out of the expected outcome of management decisions and those arising out of the realisation of those decisions. While the former may (and only may) be attributed to goodwill, the latter is often not because, once a conscious management decision has been made and the outcome turns out to be value-accretive, the corresponding value uplift may become impounded into the value of other asset classes and no longer be represented by any goodwill value.

1. According to Dr Chu, in the case of land-intensive businesses like residential aged care facilities, some of the accumulated increments in the value of land assets can be a direct result of conscious past management decisions: it is inappropriate, after decisions are made and either implemented or substantially committed to, to attribute those value uplifts to goodwill such that goodwill represents the outcome of historical value-accretive decisions made by management.  Dr Chu states that this is because both the recognition of an asset and the valuation of that asset depend on the future economic benefits expected to be generated from that asset. To the extent that, at some time in the past, goodwill represented the ability of management to make value-accretive decisions, the assessed value in goodwill at a given point of time should only represent the ability of management to make future value-accretive decisions.[89]

   [89]Chu report, [194]-[195], CB 1339.

1. In Dr Chu’s view, it is important not to confuse the existence of the assembled management and skilled workforce with the existence of material goodwill value.  This is because:

(a)        if the incumbent management/workforce is only expected to maintain the attractive force which brings in custom already entrenched in other assets, and an alternative management/workforce can be employed at comparable market rates to perform the same task and achieve the same, if not better, operating outcome, no material part of the ascertainable market value of the going concern business or the market value of the total assets of the entity would be allocated (by a willing but not anxious buyer and a willing but not anxious seller of the land assets) to goodwill in establishing what to pay for the land assets given the ascertainable market value of the total assets; and

1. In this context, it is convenient to consider Mr Willison’s evidence.  Mr Willison is a Certified Practising Valuer, a partner of the firm Ernst & Young in its Real Estate Advisory Services division.  He is a registered valuer in Victoria, New South Wales, South Australia, Western Australia and Queensland, a fellow of the Australian Property Institute and an affiliate member of the Institute of Chartered Accountants.  He has been actively engaged in the health care real estate advisory area since 1985, which includes the valuation of property, particularly health-care related property.  His experience extends to valuation, feasibility studies, implementation and management of healthcare related properties such as private hospitals, retirement villages and aged care facilities.[170]  It includes valuation of numerous aged care and retirement village portfolios.[171]  Mr Willison has been engaged by substantial aged care operators to facilitate the sale of retirement and residential care facilities.[172]  He has completed an independent report on the aged and health care sectors for a major national bank[173] and has been a guest lecturer on health and aged care real estate at Melbourne and RMIT universities.[174]

   [170]Independent expert report of Mr Willison dated October 2013 (‘Willison report’), professional profile, CB 1008 .

   [171]Ibid, CB 1009-11.

   [172]Ibid, CB 1011.

   [173]Ibid.

   [174]Ibid. 

1. Mr Willison was instructed to value PGI’s land holdings on an individual facility basis. For valuing the freehold properties he uses the methodology of capitalisation of market rental.  For leasehold properties, he reviewed the passing rental (actual rental) against his assessed market rental to determine if there was a profit rent (i.e. whether the rent being paid under the terms of the lease is greater than the appropriate current market rent).  For valuation of development property, he uses a direct comparison approach, having regard to the potential use for further development.[175]

   [175]Ibid, CB 969.

1. Mr Willison inspected each of the facilities during 2013.  He considered location, title details, whether there were easements or encumbrances, site dimensions, road access and services (which he assumed were available and connected to each facility as at 2 July 2007), zoning, demographic profile (from the perspective of potential demand for aged care facilities), improvements as at the date of valuation, the nature of accommodation, accreditation and certification status, the market positioning of the facility relative to competing facilities, lease particulars (where appropriate), including an opinion on whether it was reasonable to adopt the passing rent (as at 2 July 2007) as the market rent.  Where the rental level appeared to be above or below market rates, appropriate adjustments were made.[176]  Where the lease relating to a particular aged care facility did not reflect additional facilities under construction, Mr Willison adjusted for increased rental based on the cost of the construction.[177]  Using a base capitalisation rate of 9% adjusted for location, age and condition of the premises and size, Mr Willison arrived at an adopted capitalisation rate, which he applied to the net market rental to arrive at an opinion of the market value of the relevant aged care facility.

   [176]See, eg, Willison report Part B, CB 1076 (assessed market rent for Regis McLeod above the passing rent) and Willison report Part B, CB 1095 (assessed market rent for Sherwood Park below the passing rent).

   [177]See, eg, Willison report Part B, CB 1195 (Regis Anchorage House Salisbury); Willison report Part B, CB 1205 (Regis Treetops Manor, The Gap).

1. As a cross-check, he compared the assessed market value to the rate per bed to see whether it was supported by the values demonstrated in the sales evidence to which he had referred.

1. In Mr Willison’s opinion, the unencumbered value of PGI’s land holdings assessed on an individual facility basis as at 2 July 2007 was $148 million.[178]  Mr Willison gave evidence that – if the facilities were sold together as a portfolio – the value may alter, and that he would anticipate a variance in the overall value of the portfolio of PGI’s land holdings of plus or minus 10%.[179]

   [178]Willison report, CB 967.

   [179]Willison report, CB 968-9.

1. He agreed that the land holdings were a portfolio of assets and that, in the absence of instructions to value the facilities on an individual basis, he would, in the normal course, nevertheless have valued them on an individual basis and then made reference to the highest and best use and considered whether they would have demanded a premium or a discount if they were sold as a portfolio.  Mr Willison accepted that there usually is a premium for a portfolio sale.

1. He agreed that there was some evidence of freehold aged care portfolio transactions as at the relevant date, which he had not set out in his first report, but that he had provided additional evidence as to portfolio sales and the portfolio premium in the Joint Report.  It was not suggested to Mr Willison that his estimated variance of plus or minus 10% if the facilities were sold on a portfolio basis reflected incorrect valuation practice or was otherwise unsound.  Indeed, it was not put to Mr Willison that his opinion (as a matter of valuation practice) on the unencumbered value of PGI’s land holdings was wrong, unreliable or unsound.

1. In my view, there are good reasons to accept the accuracy of the suggested variance of plus or minus 10%.  First and foremost, this is the only evidence of variance before the Court by a qualified valuer.  Secondly, Mr Willison’s personal profile demonstrates extensive valuation experience with respect to portfolios of aged care facilities and retirement villages.[180]

   [180]Willison report Part 2, CB 1009-11.

1. Thirdly, in the Joint Report and at trial, Mr Willison gave evidence that, as at the relevant date, there were few portfolio sales of land and buildings owing to lack of demand from conventional large scale real estate investors, such as property trusts, due to the high risks specific to aged care facilities.  He referred to a portfolio transaction which occurred after the relevant date in 2010 in the hospital sector (12 freehold buildings and land for $160 million at a capitalisation rate of 10.10%).  The sale price reflected a small discount to the individual valuations.  He also referred to a sale of 28 private hospital freeholds with offers made at capitalisation rates between 6.5% and 9.5%.  The valuation methodology adopted was the capitalisation of net income approach with little (if any) premium offered for the portfolio.  This transaction (Healthscope) occurred after the relevant date (2014) and in a stronger market.[181]

   [181]Joint Report, [419(c)], [419(f)] and [425], CB 1793-5.

1. Mr Willison gave evidence of a low level of demand for aged care facilities as at the relevant date.  He said he was aware that a number of healthcare and general property trusts were not actively looking at acquiring aged care facilities due to factors including bond liabilities and regulatory risks. Based on his active involvement in the health care and aged care industries during the previous 20 years, Mr Willison also said that most established portfolio purchasers of specialised freehold assets would not consider residential aged care facilities due to the risk of sanctions and control of bonds and, as a consequence, there was a reduction in the number of potential purchasers interested in asset portfolios in this class.[182]

   [182]Joint Report, [434]-[435], CB 1798.

1. Mr Willison referred to a ‘cluster of facilities’ purchased by the Japara Property Trust, which he acknowledged was not of the same size and scale but nevertheless gave an indication of what a hypothetical buyer in the market would do if buying more than one facility.[183]

   [183]Transcript 439.18-31 - 440.1-6.

1. He  also referred to a portfolio sale of facilities with 416 beds in 2007 (Third Age) and other sales of portfolios that occurred after 2007, including a portfolio sale of 2300 beds (Primelife) and a portfolio sale of 1116 beds (Croft).  According to Mr Willison, there were a lot of portfolio sales after the relevant date but, as at the relevant, date there were few freehold land and building sales. 

1. In substance, Mr Willison said he had regard to the sales that he was aware of as at the valuation date in expressing his opinion regarding what might be achieved if the properties were sold on a portfolio basis.  Whilst it is clear on the evidence that at the time there was limited evidence of directly comparable portfolio sales, in my view, Mr Willison was cognisant of, and did what he could with, the available data, and arrived at an informed opinion, aided by his considerable experience, on the potential variance between valuation on a portfolio basis and on an individual basis.

1. Fourthly, there was no evidence from a qualified land valuer to contradict or undermine Mr Willison’s opinion either as to the ultimate value of PGI’s land holdings or the difference (if any) of valuation on a portfolio basis rather than on an individual basis.

Criticism of Mr Willison

1. Some of the freehold sales relied upon by Mr Willison were sales in which the freehold value had been apportioned from a ‘going concern’ sale.  The instances where this occurred were noted by Mr Willison in his table of primary evidence relied upon, entitled ‘Freehold Aged Care Sales – Primary Evidence’.[184]  Out of 20 properties, nine had been apportioned in this way.  Mr Willison agreed that he had obtained the freehold values from a database kept by the Valuer-General of Victoria from notices of disposition.  It was suggested that he had no way of knowing whether the apportionment of freehold value made in those notices was reliable or accurate.  Mr Willison gave evidence that he had checked the source data in addition to the notices of disposition to ensure that the levels of value were correct. I accept this evidence. It is true that Mr Willison did not elaborate on how he went about checking the source data, but it was not suggested to him that he had not done so, although it was put to him that he had not indicated in his report that that was the case.  Furthermore, there is no evidence to suggest that the values derived from the relevant notices of disposition were incorrect. 

   [184]Willison report, CB 972.

1. Significantly, it is the only evidence before the Court on the issue and it was adduced from a suitably qualified person.  The Commissioner’s valuer could easily have checked the values nominated in the notices of disposition.  Had there been any question about their appropriateness, the Commissioner could have adduced evidence to address any concern. 

1. Further, it was suggested that the primary evidence relied upon for freehold aged care sales involved a range of facilities of different ages and different conditions, different sizes, different numbers of beds and different locations.  In the case of the freehold rental property evidence relied upon, there were a range of rental properties that had different rental levels, different locations of different sizes, different ages, different lease terms and potentially different operations and performance.

1. In my view, this criticism is unwarranted.  It would be rare to have an identical freehold or leasehold sale for comparison purposes.  Significant differences would be expected.  It was suggested that Mr Willison had not referred to comparable sales evidence for a particular facility, or explained either in what respect a particular facility was comparable or the adjustments he made to account for differences – either for the freehold primary evidence or the freehold rental evidence.  Mr Willison disagreed that he had not made sufficient comments to explain why he made adjustments. 

1. In giving his evidence, Mr Willison said, in substance, that he had taken into account the attributes of all of the comparable rental and sales evidence by considering (individual) market rentals, location, age and the other attributes of the buildings.  He explained the process of assessing the relevant facility, noting that the market rental is capitalised at a rate that is adjusted for location, age, configuration, etc  (the adjustments that would normally be made by a freehold purchaser of the asset).  He explained that he then arrived at an overall capitalisation rate and summarised the factors that influenced his adoption of the capitalisation rate. 

1. In substance, it was suggested that Mr Willison had not adequately explained in what respects the comparable sales evidence was comparable, or the adjustments he made to account for differences.  There is some merit in this criticism.  Mr Willison used some shorthand, which did not fully flesh out all of his reasons.  In my view, the inadequacies were not of an order of magnitude that would undermine the reliability of his valuation evidence.  It is not suggested that any of the factors he took into account were not appropriate factors to take into account, that he had made any errors or that the individual capitalisation rates or market rental valuations were wrong.

1. Significantly, there was no evidence given by a qualified land valuer to contradict Mr Willison’s opinion.  Prior to the hearing, the parties were required to identify the experts they intended to engage for the purposes of the proceeding.[185]  The Commissioner’s advised that its experts were Mr Wayne Lonergan and Dr Hung Chu (of Lonergan Edwards & Associates), and Mr Greg Meredith (of Ferrier Hodgson) and that the Commissioner did not, at that time, propose to retain an expert with similar expertise to Mr Willison, but reserved the right to do so to provide evidence in reply following receipt of his expert report.[186]

   [185]Orders 1(b) and 2(b) of Davies J dated 2 November 2012.

   [186]CB 4205.

1. In July 2013, the Commissioner informed the appellant that he had engaged a land valuer, Mr Brian Dudakov, to assist Mr Meredith with the preparation of an expert witness report, and stated that Mr Dudakov requested additional information to assist in its preparation.[187]

   [187]CB 4256.

1. In January 2014, the Commissioner informed the appellant that he was experiencing delays with the report by Mr Greg Meredith and Mr Brian Dudakov,[188] and sought an extension of one or two weeks for the report.[189]  In late-January 2014, the Commissioner sought an extension of time for the filing and service of expert reports in the proceeding, on the basis that one of the two reports commissioned by the Commissioner had not yet been finalised because of the complexity of the valuation issues arising in the matter.[190]

   [188]CB 4257.

   [189]CB 4257.

   [190]CB 4260.

1. In March 2014, the solicitors for the Commissioner provided an expert report from Dr Chu advising that it was the only expert witness report that the Commissioner proposed to rely upon at the hearing.[191]  There was no explanation given for the Commissioner’s decision not to rely upon the evidence of Mr Meredith and Mr Dudakov.  There has been no explanation given to the Court that would rebut an inference that the expert opinion of the land valuer Mr Dudakov would not have assisted the Commissioner’s case.  In the circumstances, I draw the inference that the evidence of the Commissioner’s land valuer would not have assisted the Commissioner’s case.

   [191]CB 4280.

1. It was also suggested to Mr Willison, in substance, that he had not sufficiently explained the importance of location of properties relevant to properties in his market evidence, and he had not sufficiently explained how his rate per bed was consistent with the market evidence.  There is some substance in these criticisms, though it seems to me that the Commissioner is somewhat overcritical because any reasonably informed reader would have noted that the implied rate per bed could be readily compared against the rate per bed in other facilities that Mr Willison listed as comparable from a valuation perspective.  The deficiencies were not significant enough, in my view, to affect the overall reliability of the appellant’s valuation evidence.  Mr Willison impressed me as a careful, considered and very experienced land valuer.  He was the only witness with the qualifications to value land.

1. In my view, the properties should have been valued on a portfolio basis rather than on an individual basis, but the fact that Mr Willison valued the properties on an individual basis and not on a portfolio basis does not mean that his opinion as to the valuation of PGI’s land holdings is of no utility.

1. Mr Willison gave evidence that, even if the land holdings were valued on a portfolio basis, the appropriate methodology is to first value them on an individual basis and then to consider allowing a percentage variance to account for their value as a portfolio.  It is only the latter step that Mr Willison did not perform.  However, he did provide the parameters necessary to carry out that task (variance of plus or minus 10%).  If the highest percentage premium suggested were applied to the values in this case, it would make no difference to answering the ultimate question.  Furthermore, even if Mr Willison’s estimate of the upper end of the variance of 10% is too conservative and, for the sake of argument, had been doubled to 20%, a premium of that order would have no consequence in this case.  This is because, ultimately, the value of PGI’s land holdings portfolio at the relevant date (assuming a 20% premium) would be approximately  $177.6 million, still falling well short of 60% of the value of all of PGI’s property.

‘Going concern’

1. It is clear that Mr Willison valued the land holdings on the basis that sites were being used for aged care facilities.  This is evident from his assumptions, including assumptions that all building and operational approvals were in place, that all town planning approvals and permits were issued, that all facilities were accredited and certified and that there were no sanctions applicable to any of the facilities.[192]

   [192]Willison report, CB 982.

1. It was stated in oral opening that the facilities were to be valued hypothetically at their highest and best use, and that it was not in dispute that this was a use as aged care facilities (or, in the case of greenfield sites, potential aged care facilities).  This correctly reflects the test formulated in Spencer, which contemplates a prudent hypothetical purchaser, conversant with the land not just in its existing state but also aware of any profitable uses to which it might be put.[193]

   [193]Boland v Yates Property Corporation Pty Ltd (1999) 167 ALR 575, 648, [266]-[267].

1. As senior counsel for the appellant submitted, Mr Willison considered the value of the land for the hypothetical owner, but he did not assume that the hypothetical owner was an aged care business operator (an aged care business operator does not need to be the owner of the land to operate the business but needs to have the licences to do so.  It was not disputed that the licences do not run with the land).  It was submitted on behalf of the Commissioner that Mr Willison’s valuation did not have regard to the effect of the business that was being conducted on the land on the income generating capacity of it, and that his valuation reflected only the value of the land and buildings.  In my view, Mr Willison did have regard to the income generating capacity of the land used as an aged care business, by assessing the market rental return for the use to which the land was then being put, but what he strove to do (correctly in my view) was not to include business value as a result of carrying out that task.[194]

   [194]Commissioner’s closing written submissions, [30]-[33].

1. It was suggested that the income generating capacity of PGI’s portfolio of aged care facilities operated as a going concern was reflected in the merger parties’ cash flow model, and that Mr Willison inappropriately failed to use these cash flows in his analysis.[195]  In my view, this criticism is unwarranted.  The cash flow model reflects anticipated business cash flows, namely what is expected to be generated from a combination of things, including land use, bed licences, skilled management, synergies of the merged entities, efficiencies and goodwill.  It is suitable for valuing all of PGI’s property (the denominator) and the experts valuing PGI’s properties all used the cash flows for that purpose.  It was suggested by Dr Chu that Mr Willison should have used the cash flows to value PGI’s land holdings.  I disagree.  The merger cash flows inextricably blend business value with land value, and it would have been a very difficult exercise and beyond the expertise of Mr Willison to have attempted to disentangle the land value from the overall business value.  Mr Willison wisely stayed within his area of expertise and used conventional valuation methodology by capitalising market rental.  He thereby avoided the risk of overlapping business value with the value of land holdings, but his values still reflect the fact that each aged care facility (that was operating) was operating as a going concern at the relevant date.

   [195]Ibid [41].

1. This overlapping of business value with the value of the land holdings is best exemplified with regard to yet-to-be-developed ‘surplus and development’ land.  The Commissioner criticised Mr Willison’s valuation of surplus and development land.  Mr Willison employed a direct comparison approach by comparing the particular site with sales evidence of other development sites, in some cases incorporating residential sales evidence as direct comparison.[196]  For example, a development site at Cansdale Street, Yeronga, Queensland[197] was acquired in 2007 for $2.5 million, valued by Mr Willison as at 2 July 2007 at $2.75 million and valued by Dr Chu as at 2 July 2007 at $28.3 million; likewise with development sites in Malvern and Buderim.[198]

   [196]Willison report Executive Summary, CB 9666.

   [197]Willison report, [73], [78]-[79], CB 1209, CB 1214-5.

   [198]See [234], above.

1. It was submitted by counsel for the Commissioner that these land holdings were treated wrongly because Mr Willison failed to account for the value of this land as part of PGI’s portfolio of land holdings, operated as a going concern.  In particular, it was submitted that he failed to account for the value of the proposed development of the land as part of the operation of the portfolio of PGI’s facilities reflected in the merger parties’ cash flow model.  It was submitted by the Commissioner that that value would be reflected in the price the purchaser would pay for such land as part of the portfolio facilities operated as a going concern.[199]

   [199]Commissioner’s closing written submissions, [36].

1. There is merit in some of this criticism.  To the extent that Mr Willison valued the surplus and development land on an individual basis, self-evidently they were not valued as part of PGI’s portfolio of land holdings.  Nevertheless, as I have previously found, Mr Willison has estimated a variance of plus or minus 10 per cent for the surplus or development land as part of a portfolio.  He takes careful account of the zoning of the land.  He discloses that he had discussions with the relevant municipality, which indicated that aged care development was permitted within the zone and that there was an adjoining retirement community.  He also considers the demographic profile of the area from the perspective of potential demand for aged care facilities and notes that, although the subject site was proposed for an aged care facility, no development approval had been granted.[200]  In this sense, he takes into account the anticipated values for the site.

   [200]Willison report, [76], [77] and [78], CB 1212-4.

1. The criticism that he failed to take into account the value of the land ‘reflected in the merger parties’ cash flow model’ is unpersuasive as, in my view, the merger parties’ cash flow model reflects more than land value.  The merger cash flows reflect the value of cash flows that could be expected once an aged care facility is developed and operated on the site.  In that sense, the cash flows reflect the value of a prospective business opportunity to develop such land.  Doubtless, the opportunity had significant value to the PGI business, but Mr Willison was not retained to give an opinion as to that value. 

1. In any event, I accept Mr Willison’s opinion that the implicit values derived by Dr Chu from the cash flows do not equate with land value.  Taking Yeronga as an example, in my view, a prudent purchaser conversant with the subject would not value the land – either on an individual basis operated as a going concern or as part of PGI’s portfolio operated as a going concern – at approximately 10 times what PGI had recently purchased it for in the absence of development approval and where the development site is reasonably substitutable. I accept the submission of the appellant that, just because PGI has purchased the site and that it now forms part of PGI’s portfolio, does not increase the market value of the land by a factor of ten or more times.  This asserted and remarkable uplift in market value was not supported by any evidence given by a person qualified to value land.

1. Expressed another way, I am not persuaded that a hypothetical, prudent Spencer vendor of land, conversant with the use to which the land could be put as an aged care facility as part of a portfolio, would contemplate selling the land for $2.7 million (in the case of Yeronga) knowing that, upon effecting the sale transaction to an aged care provider with other facilities (like PGI), the land would be worth more than ten times the selling price.  In my view this is a wholly unrealistic notion.

1. Mr Willison was criticised for failing to set out how he arrived at his base capitalisation rate of 9%.  Under cross-examination, Mr Willison indicated the base rate was reflective of the sales evidence and – when reviewing the primary freehold evidence, the secondary freehold and the alternate sales evidence in each case – Mr Willison referred to percentage yields.  The capitalisation rates (or income yields) vary broadly between about 8% and 11% (with one instance at over 12% and one instance at 6.62%).  Given the range of yields demonstrated by the sales evidence, the base income yield of 9% for commercial property of this type  does not appear to be unreasonable.  It was never suggested to Mr Willison that the base capitalisation rate he had adopted was wrong.  Had the Commissioner been in a position to say it was wrong or unreasonable, the Commissioner could have adduced evidence from a qualified land valuer to that effect.  Having not done so, in my view, there is no reason not to defer to the experience and judgment of Mr Willison on such matters.

1. In final submissions, the Commissioner submitted, in a rolled up fashion, that he relied on the further criticism of Mr Willison’s valuation made by Dr Chu, referring to the various reports of Dr Chu but without further elaboration.[201]  In particular, there was an asserted failure on Mr Willison’s behalf to cross-check implied goodwill for reasonableness.  In my view, this criticism is misdirected.  Mr Willison was a land valuer, not a business valuer.  He did not purport to engage in commentary on the business value generally or the integers making up the business value.  In any event, the Commissioner has not contested Mr Willison’s evidence with evidence by a land valuer to demonstrate that Mr Willison had undervalued the land holdings and, therefore, implicitly suggested an unrealistic goodwill value.

   [201]Two such criticisms were footnoted in the Commissioner’s closing written submissions, fn 49.

1. Furthermore, the appellant relied on financial information contained in the Japara Healthcare Ltd prospectus issued in April 2014 in connection with an Initial Public Offering of ordinary shares in the company.  According to the prospectus, Japara Health Care had 35 residential aged care facilities (32 freehold and 3 leased from third parties) with approximately 3,000 places in Victoria, New South Wales, South Australia and Tasmania.  It had total assets of $800 million.  Of its property, plant and equipment of $335 million, the freehold land and buildings component was independently valued at $268.2 million.  Of $382.5 million of intangible assets, $233.4 million was attributed to goodwill and $149.1 million was attributed to bed places.[202]  Dr Chu was extremely resistant to the notion that the substantial goodwill figure referred to in the Japara Healthcare prospectus was a useful indicator, stating that it was a book value and not necessarily a market value, though he did ultimately concede that – in the context of a prospectus – it was not appropriate to rely on book (carrying) values but on fair values.

   [202]Japara Healthcare Prospectus, SCB 234, 237 and 291-2.

1. In my view, the Japara Healthcare Prospectus is a useful indicator that substantial goodwill is likely to exist in a business of this type, and I infer that fair values were likely to have been used in the Japara Healthcare prospectus.  The prospectus appears to have been prepared under the auspices of legal and accounting advisors.[203] The historical and financial information in the prospectus was subjected to assurance procedures by an investigating accountant.[204]  I also note that the prospectus indicates that the intangible assets were tested for impairment annually and when circumstances indicated that the carrying value may be impaired.[205]  This tends to suggest that carrying values were aligned with fair value.  In my view, the prospectus unequivocally suggests that there was, at least in 2014, market recognition of significant goodwill value in a residential aged care operator with a large portfolio of aged care facilities and bed licences.  A cross-check, taking account of the Japara Healthcare transaction, would not have suggested that the implied goodwill figure based on Mr Willison’s valuation of the land holdings was unrealistic.

   [203]Ibid, SCB 393.

   [204]Described as a limited assurance engagement, SCB 342.

   [205]Japara Healthcare Prospectus, SCB 292.

1. For completeness I note that Mr Willison’s valuation methodology was criticised for purportedly creating a mismatch between rent to be capitalised and the capitalisation rate, for not explaining how he calculated his yield figures and for being technically flawed.[206]  In cross-examination, Mr Willison was challenged generally about the sufficiency of his explanation about yields, but it was not suggested to him in cross examination that there was a mismatch or technical flaw.  There was no evidence from a land valuer to the effect that the yields suggested by Mr Willison were inappropriate.  I note that Mr Willison’s adopted capitalisation rates of between 8.5% and 10% are generally in line with the Japara Aged Care and Retirement Property Trust yields disclosed in an Information Memorandum, dated January 2006, for facilities within its existing portfolio and for the properties that were intended to be purchased by the Trust at that time.[207]  The yields ranged between 9% and 10% as at January 2006.

   [206]Chu Reply report [276]-[277], CB 1644.

   [207]Japara Aged Care and Retirement Trust Information memorandum dated January 2006, SCB 408-9.

1. The Commissioner did not adduce any evidence of capitalisation rates in the aged care sector or sales evidence that would justify the notional land values imputed by Dr Chu to the land holdings of PGI.  I am satisfied that Mr Willison’s opinion as to the appropriate capitalisation rates is sound. 

1. In my opinion, PGI’s land holdings should be valued on a portfolio basis in the circumstances of this case for the purpose of s 71(2)(b) of the Act. I accept Mr Willison’s valuation of PGI’s land holdings on an individual basis at $148.1 million and, based on his evidence that there usually is a premium for a portfolio sale of up to 10%, I accept that the valuation of PGI’s land holdings would likely increase up to approximately $163 million on a portfolio basis.

Conclusion

1. In determining these appeals, I have decided that the assessments are incorrect and must be set aside. I have also decided that the appellant has discharged its onus in making out its case that it was not land rich pursuant to s 71(2)(b) of the Act.

1. In particular, I am satisfied that appropriate application of the DCF methodology to determine the unencumbered value of all of PGI’s land holdings would have allowed for a small company risk premium.  Dr Chu’s failure to allow for a small company risk premium is one indicator that demonstrates that Dr Chu’s assessed market value of PGI’s land holdings is excessive and cannot be relied upon.

1. Secondly, I am not satisfied that, in determining the land rich ratio, any particular approach to that task is prescribed by the statute, nor do I find that it is customary to allocate the value of all of the taxpayer’s property amongst its separate classes of property to determine the ratio.  In my view, approaches will necessarily vary to accommodate the facts of each particular case.

1. Thirdly, I do not accept Dr Chu’s evidence that the market value of the expected synergies at the relevant date was $85.2 million and that the whole amount of expected synergies would be incorporated in the market value of PGI at the relevant date; nor do I accept that the then present value of expected synergies inheres in the value of PGI’s land holding assets to the exclusion of its intangible assets.

1. Fourthly, I do not accept Dr Chu’s proposition that PGI had no goodwill (or goodwill of no material value) as at 2 July 2007.  In my opinion, the expert evidence adduced by the Commissioner on this point was unreliable. It strongly reflected a pre-determined view based on Dr Chu’s conceptual framework for the assessment of goodwill.  In light of Dr Chu’s limited experience in the aged care sector, his investment in and rigid commitment to his conceptual framework for the assessment of goodwill, and the absence of objective verification or corroboration of his theories, Dr Chu’s opinion that PGI had no material goodwill as at the relevant date cannot be relied on.  I accept the contrary opinions of Mr Ferrier and Mr Kompos to the effect that PGI had significant goodwill as at the relevant date.

1. Fifthly, in my view, the value of the opportunity reflected in the contract to purchase the proposed development site at Buderim, which was terminated after 2 July 2007, is to be included in determining the unencumbered value of PGI’s property as at 2 July 2007.

1. Sixthly, I am satisfied that the accommodation bonds issued by PGI as at 2 July 2007 are property that is ‘not counted’ pursuant to s 71(3)(c) of the Act.

1. Finally, in my view, PGI’s land holdings should be valued on a portfolio basis, at least for the purposes of determining whether that reflected the highest and best use of the land.  I accept Mr Willison’s valuation of PGI’s land holdings on an individual basis at $148.1 million and his evidence that there usually is a premium for a portfolio sale of up to 10%. I accept that his valuation would likely increase up to approximately $163 million on a portfolio basis. 

1. It is apparent that, even with a premium, the value of PGI’s land holdings comprised less than 60 per cent of the unencumbered value of all its property within the meaning of s 71(2)(b) of the Act as at 2 July 2007. It follows that the answer to question 1 in each appeal is ‘no’. PGI was not a ‘land rich’ landholder as at 2 July 2007. Accordingly question 2 does not arise.

1. Each appeal must be allowed.