Victoria Power Networks Pty Ltd v Commissioner of Taxation
[2019] FCA 77
•7 February 2019
FEDERAL COURT OF AUSTRALIA
Victoria Power Networks Pty Ltd v Commissioner of Taxation [2019] FCA 77
File numbers: VID 1126 of 2017
VID 1127 of 2017
VID 1128 of 2017
VID 1129 of 2017Judge: MOSHINSKY J Date of judgment: 7 February 2019 Catchwords: TAXATION – assessable income – income according to ordinary concepts – non-cash business benefits – where electricity distributors were required to connect customers to the electricity network upon request – where the connection works were carried out either by the distributor or by the customer – where, in relation to the first situation, if the connection was ‘uneconomic’, the customer paid a cash contribution to the distributor – whether the cash contribution was income according to ordinary concepts – where, in relation to the second situation, the customer was required to transfer the relevant assets to the distributor and received a rebate from the distributor – where, in relation to that situation, if the connection was ‘uneconomic’, the rebate was the estimated cost of construction less a customer contribution – whether the customer contribution was income according to ordinary concepts – whether the transferred assets constituted a non-cash business benefit – consideration of the amount to be included in the distributor’s assessable income pursuant to s 21A of the Income Tax Assessment Act 1936 (Cth) – consideration of the arm’s length value of the transferred assets Legislation: Income Tax Assessment Act 1936 (Cth), ss 21, 21A, 136AA
Income Tax Assessment Act 1997 (Cth), ss 6-5, 20-30
Taxation Administration Act 1953 (Cth), s 14ZZ
Federal Court Rules 2011, r 33.03
Electricity Industry Act 2000 (Vic)
Cases cited: APA Fixed Investment Trust Co Ltd v Federal Commissioner of Taxation (1948) 8 ATD 369; 4 AITR 105
Arthur Murray (NSW) Pty Ltd v Federal Commissioner of Taxation (1965) 114 CLR 314
Batchelor v Federal Commissioner of Taxation (2014) 219 FCR 453
Boyce (HM Inspector of Taxes) v Whitwick Colliery Co Ltd (1934) 18 TC 655; [1934] All ER 706
Chevron Australia Holdings Pty Ltd v Federal Commissioner of Taxation (2017) 251 FCR 40
Denmark Community Windfarm Ltd v Federal Commissioner of Taxation (2018) 107 ATR 384
Federal Commissioner of Taxation v Becker (1952) 87 CLR 456
Federal Commissioner of Taxation v Cooling (1990) 22 FCR 42
Federal Commissioner of Taxation v Hyteco Hiring Pty Ltd (1992) 39 FCR 502
Federal Commissioner of Taxation v Myer Emporium Ltd (1987) 163 CLR 199
Federal Commissioner of Taxation v Resource Capital Fund III LP (2014) 225 FCR 290
Federal Commissioner of Taxation v Rowe (1995) 60 FCR 99
Federal Commissioner of Taxation v Rowe (1997) 187 CLR 266
Federal Commissioner of Taxation v SNF (Australia) Pty Ltd (2011) 193 FCR 149
Federal Commissioner of Taxation v Spedley Securities Ltd (1988) 88 ATC 4126
First Provincial Building Society v Federal Commissioner of Taxation (1995) 95 ATC 4145
GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124
Hudson’s Bay Co Ltd v Stevens (1909) 5 TC 424
JC Williamson’s Tivoli Vaudeville Pty Ltd v Federal Commissioner of Taxation (1929) 42 CLR 452
Leichhardt Council v Roads and Traffic Authority (NSW) (2006) 149 LGERA 439
Rotherwood Pty Ltd v Federal Commissioner of Taxation (1996) 64 FCR 313
Scott v Federal Commissioner of Taxation (1966) 117 CLR 514
Squatting Investment Co Ltd v Federal Commissioner of Taxation (1953) 86 CLR 570
Walker Corporation Pty Ltd v Sydney Harbour Foreshore Authority (2008) 233 CLR 259
Westfield Ltd v Federal Commissioner of Taxation (1991) 28 FCR 333
Date of hearing: 3, 4 and 5 December 2018 Registry: Victoria Division: General Division National Practice Area: Taxation Category: Catchwords Number of paragraphs: 216 Counsel for the Applicant: Mr JO Hmelnitsky SC with Ms LA Hespe Solicitor for the Applicant: King & Wood Mallesons Counsel for the Respondent: Mr GJ Davies QC with Dr JE Jaques Solicitor for the Respondent: MinterEllison ORDERS
VID 1126 of 2017 BETWEEN: VICTORIA POWER NETWORKS PTY LTD
Applicant
AND: COMMISSIONER OF TAXATION
Respondent
JUDGE:
MOSHINSKY J
DATE OF ORDER:
7 FEBRUARY 2019
THE COURT ORDERS THAT:
1.Within 14 days the parties provide minutes of proposed orders to give effect to these reasons.
Note: Entry of orders is dealt with in Rule 39.32 of the Federal Court Rules 2011.
ORDERS
VID 1127 of 2017 BETWEEN: VICTORIA POWER NETWORKS PTY LTD
Applicant
AND: COMMISSIONER OF TAXATION
Respondent
JUDGE:
MOSHINSKY J
DATE OF ORDER:
7 FEBRUARY 2019
THE COURT ORDERS THAT:
1.Within 14 days the parties provide minutes of proposed orders to give effect to these reasons.
Note: Entry of orders is dealt with in Rule 39.32 of the Federal Court Rules 2011.
ORDERS
VID 1128 of 2017 BETWEEN: VICTORIA POWER NETWORKS PTY LTD
Applicant
AND: COMMISSIONER OF TAXATION
Respondent
JUDGE:
MOSHINSKY J
DATE OF ORDER:
7 FEBRUARY 2019
THE COURT ORDERS THAT:
1.Within 14 days the parties provide minutes of proposed orders to give effect to these reasons.
Note: Entry of orders is dealt with in Rule 39.32 of the Federal Court Rules 2011.
ORDERS
VID 1129 of 2017 BETWEEN: VICTORIA POWER NETWORKS PTY LTD
Applicant
AND: COMMISSIONER OF TAXATION
Respondent
JUDGE:
MOSHINSKY J
DATE OF ORDER:
7 FEBRUARY 2019
THE COURT ORDERS THAT:
1.Within 14 days the parties provide minutes of proposed orders to give effect to these reasons.
Note: Entry of orders is dealt with in Rule 39.32 of the Federal Court Rules 2011.
REASONS FOR JUDGMENT
MOSHINSKY J:
Introduction
The applicant, Victoria Power Networks Pty Ltd (VPN), previously known as CHEDHA Holdings Pty Limited, was during the relevant years of income the head company of a consolidated tax group. Powercor Australia Ltd (Powercor) and CitiPower Pty Ltd (as trustee for the CitiPower Trust) (CitiPower) were subsidiary members of that group. Each of Powercor and CitiPower (the Distributors) held a distribution licence under the Electricity Industry Act 2000 (Vic) and carried on the business of distributing electricity to customers in Victoria.
These proceedings, which are appeals against appealable objection decisions under s 14ZZ of the Taxation Administration Act 1953 (Cth), concern the substituted accounting periods ended 31 December 2007, 31 December 2008, 31 December 2009 and 31 December 2010 (in lieu of the years ended 30 June 2008, 30 June 2009, 30 June 2010 and 30 June 2011).
Under the terms of their electricity distribution licences, Powercor and CitiPower were required to connect customers to the electricity network when requested to do so. The work involved the construction and installation of assets necessary for the delivery of electricity from the transmission grid to the customer.
Certain works were required to be carried out by the Distributor (referred to as non-contestable works), while other works could be carried out by the Distributor or the customer, at the customer’s option (referred to as contestable works). Depending on the type of connection works involved and the choice made by the customer, either:
(a)the Distributor undertook construction of the connection works; or
(b)the customer undertook construction of the connection works. Upon completion of the connection works, the works were transferred to the Distributor (the Transferred Assets) and the Distributor paid a rebate to the customer (the Rebate).
Where the works were contestable, and thus the customer had a choice, the situation where the works would be undertaken by the Distributor was described as “Option 1” and the situation where the customer would undertake the works was described as “Option 2”. I will adopt those expressions in these reasons.
Under the applicable regulatory regime, in every case a calculation was made by the Distributor of the incremental cost in relation to a new connection (the incremental cost or IC) less the incremental revenue in relation to the new connection (the incremental revenue or IR) (the IC less IR calculation). The incremental cost and the incremental revenue were both present day values. There were two distinct situations referred to by the parties:
(a)where the incremental revenue was greater than the incremental cost, referred to in some of the submissions and evidence as an ‘economic connection’; and
(b)where the incremental revenue was less than the incremental cost, referred to in some of the submissions and evidence as an ‘uneconomic connection’.
As explained later in these reasons, the labels ‘economic’ and ‘uneconomic’ are in some respects inaccurate; nevertheless, it is convenient to adopt these labels on some occasions in these reasons. However, it needs to be emphasised that they are merely labels for the two situations described in [5] above.
The issues in dispute in this proceeding concern only situations where the connection was ‘uneconomic’. There is no dispute between the parties in relation to situations where the connection was ‘economic’. Nevertheless, it is necessary to refer to certain facts and matters pertaining to ‘economic’ connections in order to provide context for the issues relating to ‘uneconomic’ connections.
In relation to the situation where the Distributor undertook the construction works, if the connection was ‘uneconomic’, the Distributor was entitled to charge the customer an amount equal to the incremental cost less the incremental revenue (the Customer Cash Contribution).
In relation to the situation where the customer undertook the construction works, if the connection was ‘economic’, the Distributor paid the customer a Rebate equal to the estimated cost of construction. However, if the connection was ‘uneconomic’, the customer was in effect required to make a contribution equal to the incremental cost less the incremental revenue (the Customer Contribution). In such a case, the Distributor paid the customer a Rebate equal to the estimated cost of construction less the Customer Contribution.
The different scenarios can be illustrated by the following four examples, which were set out in a document prepared by VPN for the purposes of the hearing. The examples are necessarily simplified, but assist in understanding the transactions. Examples 1 and 2 concern an ‘economic’ connection. Examples 3 and 4 concern an ‘uneconomic’ connection. In each of the examples, the incremental cost is the total of the “Estimated Cost of Construction” amount plus the “Future Upstream & Opex” amount, and the incremental revenue is the amount specified as “Future Revenues”.
Although Example 3 refers to “Option 1”, I was told by senior counsel for VPN in opening submissions that the example works identically where the works are contestable and where they are non-contestable.
As noted above, the issues between the parties are confined to connections that were ‘uneconomic’ (represented by Examples 3 and 4, above). The positions of the parties can be summarised as follows:
(a)In relation to the situation where the Distributor undertook the works and the connection was ‘uneconomic’ (ie, Example 3), the respondent (the Commissioner) contends that the Customer Cash Contribution (ie, the $40 in Example 3) was income according to ordinary concepts and thus included in VPN’s assessable income under s 6-5(1) of the Income Tax Assessment Act 1997 (Cth) (the 1997 Act). VPN disputes this. VPN contends that the Customer Cash Contribution was an “assessable recoupment” within the meaning of s 20-20 of the 1997 Act. The Commissioner accepts that, if the Customer Cash Contribution was not income according to ordinary concepts, it was an “assessable recoupment” within s 20-20 of the 1997 Act.
(b)In relation to the situation where the customer undertook the works and the connection was ‘uneconomic’ (ie, Example 4), the Commissioner contends that the Customer Contribution (ie, the $40 in Example 4) was income according to ordinary concepts and thus included in VPN’s assessable income under s 6-5(1) of the 1997 Act. VPN disputes this. In the alternative, the Commissioner contends that: the Transferred Assets were a “non-cash business benefit” for the purposes of s 21A of the Income Tax Assessment Act 1936 (Cth) (the 1936 Act); the arm’s length value of the Transferred Assets was equal to the estimated cost of construction (ie, $100 in the example); the recipient’s contribution was equal to the Rebate (ie, $60 in the example); and accordingly, the amount included in VPN’s assessable income under s 6-5 of the 1997 Act pursuant to s 21A of the 1936 Act (being the arm’s length value less the recipient’s contribution) was, in the example, $40. In response, VPN: accepts that the Transferred Assets were a non-cash business benefit for the purposes of s 21A of the 1936 Act; says that the arm’s length value of the Transferred Assets was equal to the amount of the Rebate (ie, $60 in the example); says that the recipient’s contribution was equal to the Rebate; and accordingly, says that the amount included in VPN’s assessable income under s 6-5 of the 1997 Act pursuant to s 21A of the 1936 Act (being the arm’s length value less the recipient’s contribution) was, in the example, $0.
The issues that arise for determination may be summarised as follows:
(a)In relation to the situation where the Distributor undertook the works and the connection was ‘uneconomic’ (ie, Example 3):
(i)was the Customer Cash Contribution (ie, the $40 in the example) income according to ordinary concepts within s 6-5(1) of the 1997 Act?
(ii)was the Customer Cash Contribution an “assessable recoupment” within the meaning of s 20-20 of the 1997 Act?
(b)In relation to the situation where the customer undertook the works and the connection was ‘uneconomic’ (ie, Example 4):
(i)was the Customer Contribution (ie, the $40 in the example) income according to ordinary concepts within s 6-5(1) of the 1997 Act?
(ii)what amount (if any) is included in the assessable income of VPN under s 6-5 of the 1997 Act pursuant to s 21A of the 1936 Act?
For the reasons set out below, I have concluded, in summary, as follows:
(a)In relation to the situation where the Distributor undertook the works and the connection was ‘uneconomic’ (ie, Example 3):
(i)the Customer Cash Contribution was income according to ordinary concepts within s 6-5(1) of the 1997 Act; and
(ii)the Customer Cash Contribution was not an “assessable recoupment” within the meaning of s 20-20 of the 1997 Act.
(b)In relation to the situation where the customer undertook the works and the connection was ‘uneconomic’ (ie, Example 4):
(i)the Customer Contribution was not income according to ordinary concepts within s 6-5(1) of the 1997 Act; and
(ii)for the purposes of s 21A of the 1936 Act: the Transferred Assets were a non-cash business benefit; the arm’s length value of the Transferred Assets was equal to the estimated cost of construction; the recipient’s contribution was equal to the Rebate; and accordingly, the amount included in VPN’s assessable income under s 6-5 of the 1997 Act pursuant to s 21A of the 1936 Act (being the arm’s length value less the recipient’s contribution) was, in the example, $40.
These reasons will be structured under the following main headings:
(a)The evidence.
(b)Factual findings.
(c)Admissibility of expert economic evidence.
(d)Issues relating to the situation where the Distributor undertook the works.
(e)Issues relating to the situation where the customer undertook the works.
(f)Conclusion.
The evidence
At the hearing of the proceeding, VPN called evidence from the following lay witnesses:
(a)Shane Breheny, a former Chief Executive Officer of the group of companies of which VPN is the ultimate parent company (the VPN Group);
(b)Colin Hoole, a retired former employee of the VPN Group; and
(c)Mark de Villiers, an employee of the VPN Group.
Each of these witnesses was cross-examined. Each of the witnesses gave evidence clearly and confidently and displayed a deep knowledge of the subject-matter. I generally accept their evidence. To the extent that there were differences between their affidavit evidence and oral evidence, I prefer the oral evidence.
The Commissioner did not call any lay witnesses, but tendered a number of documents.
Each party relied on expert valuation evidence. The valuation experts called by the parties were:
(a)Antony Samuel, a valuer and forensic accountant at Sapere Research Group Limited (called by VPN); and
(b)Jannaya James, a business valuation specialist at Grant Thornton Australia (called by the Commissioner).
Expert reports were prepared by each of Mr Samuel and Ms James. Mr Samuel also prepared a reply report. The experts together prepared a joint report. They gave evidence concurrently at the hearing. I discuss their evidence further below.
In addition, the parties prepared expert evidence from two economists regarding the economic consequences of the transactions. The experts prepared separate reports and a joint report. There is an issue regarding the admissibility of this material. The experts were:
(a)Jeffrey Balchin, an economic consultant who is the Managing Director of Incenta Economic Consulting (called by VPN); and
(b)Robert McMillan, an economic consultant who is a director of Farrier Swier (called by the Commissioner).
Mr Balchin prepared three reports. Mr McMillan prepared one report. The two experts together prepared a joint report. This evidence was admitted provisionally, subject to relevance. The Commissioner contends that the evidence is not relevant. He submits that all of this material should not be admitted; he relies on the evidence of Mr McMillan only if the evidence of Mr Balchin is admitted. I will consider the admissibility of this material later in these reasons. In any event, neither Mr Balchin nor Mr McMillan was required to attend for cross-examination.
Another issue of admissibility concerned the documents filed by the Commissioner pursuant to r 33.03 of the Federal Court Rules 2011 (appearing under tabs 5, 6, 7 and 8 of the Court Book prepared by the parties). These documents were admitted subject to a relevance objection by VPN. In my view, these documents are relevant insofar as they provide background and context to the issues in dispute in the proceeding. Beyond this, I do not consider it necessary to have regard to these documents.
Factual findings
I now set out my factual findings based on the lay affidavit evidence, the documentary evidence and the oral evidence given during the hearing. There was little dispute about the facts.
The National Electricity Market
There is a national wholesale electricity spot market, known as the National Electricity Market (NEM), through which all electricity is traded through a centralised pool. Generators supply electricity to the NEM at a price, and wholesale purchasers (who are mainly electricity retailers) buy their electricity requirements from the pool of electricity supplied. At the relevant times, the NEM was managed by the National Electricity Market Management Company Limited (NEMMCO), which later became the Australian Energy Market Operator.
Distribution system operators provide a service to retailers by distributing that electricity to their customers, for which those distributors are paid a fee under a Use of System Agreement. Distributors pay fees to the transmission system operators for the transmission of electricity to their distribution networks.
The businesses of CitiPower and Powercor
CitiPower and Powercor carry on businesses as electricity distributors. They own, operate, augment and maintain that part of the electricity network that connects the transmission network owned by transmission network operators (in Victoria, that operator is AusNet) to the premises of the customers who are the consumers of electricity. At the relevant times, each operated in an almost exclusive geographical area of which there were five in Victoria. In the case of Powercor, the area was approximately 165,000 square kilometres in the west of the State. In the case of CitiPower, it was around 5,400 square kilometres within Melbourne, including the central business district and some parts of the inner suburbs.
To conduct a business as an electricity distributor, each of CitiPower and Powercor had distribution licences granted to them by the Essential Services Commission (ESC).
Powercor’s and CitiPower’s revenues came primarily from fees paid by electricity retailers. Electricity retailers are companies that buy electricity from generators on the NEM and sell it to consumers. Electricity retailers do not own network infrastructure assets and have no obligations to maintain the network, but instead pay fees to the distribution network operators for the use of their networks in order to supply electricity to the retailer’s customers.
End users of electricity within a distributor’s geographical area were referred to colloquially as “customers”, even though they did not directly pay tariffs to the distributor. Such end users were referred to both as “customers” and “consumers” in the evidence. The distributors had a relationship with the customers because the distributors had obligations to connect them to the distribution network and to maintain supplies of electricity to them.
CitiPower and Powercor could not control the number of customers (since all customers within its geographic areas were connected to its distribution network) nor the demand of those customers for electricity.
Price regulation
Electricity is a highly regulated industry. Prior to 2007, the ESC regulated the electricity industry in Victoria. In the period 2007-2010, the Australian Energy Regulator (AER) assumed responsibility broadly for pricing and the ESC regulated licensing of energy distributors (and others) and monitored compliance with licensing requirements. The Energy Industry Ombudsman primarily dealt with complaints by customers. As noted above, NEMMCO managed the NEM.
Regulations were in place that set the maximum amount that distributors, like CitiPower and Powercor, could charge retailers for the use of the distribution system. The regulations set out a methodology by which the regulator determined an Annual Revenue Requirement (ARR), which was re-calculated every five years as part of the distributor’s price determination. The ARR was set in a way which (if the forecasts on which it was based were met) provided the distributor with the recovery of its operating costs, a return of the amount the distributor was taken to have invested in the network (known as the distributor’s Regulatory Asset Base) (RAB) and a regulated return on the distributor’s RAB. The ARR was converted into a weighted average price cap by dividing the ARR by the expected level of electricity demand.
The distribution determination (or price determination) relevant to the period in question in this proceeding was issued by the ESC on 19 October 2005 and was effective from 1 January 2006 to 31 December 2010 (2006 Determination). It replaced an earlier five-year determination and was later replaced by another five-year determination.
The 2006 Determination was made following submissions from VPN. When Mr de Villiers began with VPN in 2005, VPN had just submitted its initial regulatory proposal. Once it had been provided to the regulator, a draft decision was released and VPN was given an opportunity to respond to the draft decision and submit a revised proposal.
By the time the 2006 Determination was made, the National Electricity Rules (NER) had come into effect. These were standardised rules made to apply to all States that had privatised their energy industries. The 2006 Determination was not made by reference to the NER. All later distribution determinations were made under the NER, which adopted similar principles to those that had been used in Victoria. However, some of the terminology changed.
The Annual Revenue Requirement
A price determination dealt with a number of things. One of the most important was the calculation of what is now called the annual revenue requirement (referred to in these reasons as the “ARR”). In the 2006 Determination it was referred to as the building block revenue requirement.
An ARR was calculated for each distributor by the regulator and recalculated every five years with each new price determination. The ARR simulated the revenue that a distributor would receive in a competitive market, incurring efficient costs and allowing an adequate return to investors, while also providing an incentive to reduce costs and improve services.
The ARR for a distributor was determined using a “building block” approach, which estimated the components of allowable revenue, having regard to efficient capital and operating costs requirements of providing distribution services. In simple terms, it worked by adding up a number of components of revenue, dividing them by the estimated demand for electricity and arriving at a price.
A number of the components of the ARR related to the RAB of a distributor. The RAB represents the depreciated value of network investments made by the distributor. At the time of privatisation in 1994, an RAB for each distributor had been set. For each regulatory period since, these values were adjusted for inflation, capital expenditure, depreciation, customer contributions, and any disposals for which the distributor received payment.
The key components of the ARR were:
(a)a return on capital, being an amount calculated by multiplying the RAB by the weighted average cost of capital (WACC) determined by the regulator;
(b)depreciation of the RAB (ie, a return of capital);
(c)efficient operating and maintenance expenditure;
(d)incentive scheme financial rewards/penalties. In the relevant period, there was an incentive known as the “efficiency carryover scheme”. This was a mechanism for allowing a distributor that made operating and capital expenditure savings or improvements to keep the benefit of those savings or improvements over six years. It was symmetrical and so also served as a penalty if operating and capital expenditure was in excess of the forecast; and
(e)an amount for the distributor’s forecast tax liability, which was reduced by the assumed value of imputation credits. The calculation of tax assumed that the customer contributions in relation to new connections were assessable to the distributor.
The forecast profit produced by the model was a function of the return on capital and the incentive scheme rewards/penalties. The other components of the ARR were intended to cover the distributor’s forecast expenses and recover the distributor’s costs. Because the return on capital was calculated as a return on the RAB, an amount that was not included in a distributor’s RAB could not generate a return on capital.
The RAB was calculated every five years at the time of a distribution determination by taking the RAB value originally set in 1995 and adjusting it annually for depreciation, inflation and actual capital expenditure made to the year prior to the start of the forecast regulatory period. This RAB value was adjusted through to the end of the forecast regulatory period for forecast depreciation, inflation and capital expenditure. In this way, the RAB represented the cumulative depreciated value of the cost of the distribution network or, put another way, the approximate cost incurred by the distributor in building the network today in its existing configuration and condition.
The ARR was a calculation that fed into the weighted average price cap (WAPC) that the distributor was permitted to charge. It was not an actual amount of revenue that a distributor earned. A distributor could in fact earn more or less revenue than the ARR.
The Weighted Average Price Cap
The WAPC was calculated annually using the following formula:
WAPC = (1 + CPI) x (1 - X) x S x L
CPI is the consumer price index. The first element of the formula ensured that distributors could charge prices that reflected any CPI increase or decrease since the previous distribution determination.
X (or the X factor) was a critical variable. The main purpose of the submissions made to the regulator every five years was to calculate and justify an appropriate value for the X factor for each of the five years in the regulatory period. The X factor represented the real price change (ie, stripping out inflation) from one year to the next. It was determined by the regulator after considering a number of factors including the WACC, the RAB, incentives and the forecast volume of electricity distributed. The X factor could be positive or negative.
S (or the S factor) represented the distributor’s performance against a number of reliability and customer service benchmarks. It was calculated annually, based on performance in the year that was two years prior. Save for one matter, it was a mechanical calculation once the method was set out in the regulator’s determination. For example, one element of the customer service target was answering customer service calls within 30 seconds, and one reliability target related to the frequency of interruptions to supply. The level of performance on this target was fed into a formula that calculated the S factor. The one area of potential uncertainty with the S factor was that certain events were excluded from calculations. For example, if service delivery was affected by a transmission outage (which was not the fault of the distributor), then this would be excluded so as not to penalise a distributor for something beyond its control.
L (or the L factor) is a provision for the pass through of licence fees or levies used to fund the regulator.
Under a WAPC, the distributor was exposed to the risk or opportunity of any differences between forecast and actual volume of electricity distributed. A distributor could increase its profits by underspending on the forecast operating expenditure or capital expenditure. A proportion of that underspend was retained by the distributor. Further, if the distributor’s debt financing costs were lower than the regulatory assumption, the whole of that reduction in debt financing costs was retained by the distributor. There was also a benefit where the distributor was able to leverage its financing to a greater degree than assumed for regulatory purposes while maintaining relatively low debt rates.
Tariff schedules
Once the WAPC had been calculated, it was for the distributor to determine how to meet it. In the case of Powercor and CitiPower, there were around 30 different tariffs, which varied depending on whether the end user of that electricity was domestic or business, their size, their usage, etc. Within each tariff, there were different components, for example a fixed portion and a variable portion. Network tariffs comprised the sum of distribution tariffs (set by reference to the WAPC) and transmission tariffs (set by reference to a revenue cap being the amount that Powercor was charged for transmission costs). Retailers were charged separately for metering services provided by distributors.
Each year, Powercor and CitiPower decided how much to increase and decrease the various tariffs and their components, known as rebalancing the tariffs. This was essentially an economic calculation, done to maximise revenue. No matter how the tariffs were set, the distributor had to ensure that the weighted average tariff was no more than the WAPC. To calculate this, volumes from two years earlier were used. The tariff schedule had to be approved by the regulator before it could be used.
The prices charged by CitiPower and Powercor
Although the regulations only set an upper limit on the prices that a distributor could charge and did not prescribe the minimum prices, in practice CitiPower and Powercor always charged the maximum permitted prices.
New connections
Overview of the process
Under their distribution licences, distributors were required to connect a new customer to the distribution network on request. This was required to be carried out in accordance with Electrical Industry Guideline No 14 – Provision of Services by Electricity Distributors (Guideline 14), a Victorian regulation. The Distributors were required to comply with Guideline 14 as a condition of their licence.
Before setting out the relevant terms of Guideline 14, it will be convenient to describe the processes that CitiPower and Powercor undertook when a new customer asked to be connected to the distribution network. Those processes can be summarised as follows. (The following summary is based on Mr Hoole’s affidavit evidence, as supplemented by his evidence during cross-examination.)
(a)If augmentation of the distribution network was required in order to provide an offer for connection services, then for those works that were contestable services, CitiPower and Powercor were required to call tenders in accordance with the regulatory guideline.
(b)Works that were deemed to be eligible for tenders were referred to as “contestable services”. Contestable services were limited to certain types of work, generally on greenfield sites where there was no existing CitiPower or Powercor infrastructure. Works on existing CitiPower or Powercor assets were not eligible for tenders because, for safety reasons, those works could only be performed by CitiPower or Powercor. Those works were referred to as “non-contestable” services.
(c)The next step after a customer request for connection depended on whether the distributor was CitiPower or Powercor:
(i)For Powercor customers, Powercor sent an option selection form to the customer, asking the customer to choose whether it wanted Powercor to construct the entirety of the works (referred to by Mr Hoole and in these reasons as “Option 1”), or to carry out the contestable works itself (referred to by Mr Hoole and in these reasons as “Option 2”). For Option 2, the customer was also asked to choose whether it wanted to conduct the tender itself, or whether it wanted Powercor to do so.
(ii)For CitiPower customers, there was no separate option selection form. Customers were asked to confirm their option as part of the offer.
(d)In every case where the distributor was requested to connect a new customer, the distributor made an estimate of the cost of construction in relation to the new connection. That estimate was made before, or as part of, the IC less IR calculation. The estimated cost of construction became one of the inputs in the customer contribution model (ie, the model for calculating the customer contribution set out in Guideline 14).
(e)CitiPower or Powercor made an assessment of the incremental cost and incremental revenue associated with the customer request, and determined which was the greater (ie, the IC less IR calculation). The assessment was made in order to determine the amount of the customer contribution, if any, under Guideline 14. Such an assessment was made in every case where the distributor was requested by a new customer to connect the customer to the network.
(f)An offer for connection services was then sent to the customer:
(i)In the case of CitiPower, the offer was made on the basis of Option 1, and asked the customer to confirm that they did not require an Option 2 process. Under the heading “Customer Statement” in the Network Connection Proposal, the customer was asked to tick one of three boxes. The first box (waiving the right to tender) was Option 1. The other two boxes related to Option 2.
(ii)In the case of Powercor, the offer was sent on the basis of the option chosen by the customer under the option selection form.
(g)If the customer chose Option 1, the distributor constructed the connection. If the assessment of the incremental cost was greater than the assessment of the incremental revenue, the customer was required to pay the distributor up-front the difference between the two as a customer contribution (referred to in these reasons as the “Customer Cash Contribution”). The Customer Cash Contribution was payable when the contract was entered into.
(h)If the customer chose Option 2, a third party engaged by the customer undertook the contestable services. CitiPower’s or Powercor’s offer for connection services set out the customer contribution based on the incremental cost less the incremental revenue. It also included the amount of any Rebate to be paid to the customer by the distributor for the contestable services being undertaken by the third party engaged by the customer. The Rebate paid was dependent on the outcome of the IC less IR calculation, hence it could be the amount of the assessed cost of the Transferred Assets or a lesser amount.
Where a customer believed it could undertake the works more cheaply than the distributor could, it could save money by choosing Option 2. Customers choosing Option 2 took on the risk of the actual costs they incurred being greater than the distributor’s assessment of the costs. Adverse weather and issues of coordinating the other contractors working on the site were common causes of cost overruns. The distributors bore the risk of cost variations under the Option 1 process. In other words, they bore the risk that the actual cost might be more than the estimated cost of construction.
Whether Option 1 or Option 2 was chosen, the distributor would ultimately become the owner of the infrastructure installed. In Option 1, the distributor was the owner throughout the process. In Option 2, the distributor became the owner when it certified that the works were completed in accordance with the distributor’s technical standards, thereby taking ownership of the assets, which were then tied into the network by the distributor (referred to in these reasons as the “Transferred Assets” and referred to internally by the Distributors as “gifted assets”). The infrastructure installed by the customer, upon energisation by the distributor, became part of the distribution network. From then on, the distributor was responsible for all ongoing maintenance and asset replacement.
Where a new customer asked to be connected to the network, the distributor carried out calculations of the connection’s “incremental revenue” and “incremental cost”, as required by Guideline 14. Included in the incremental cost were: the distributor’s estimation of the cost of constructing the connection; the estimated incremental cost of augmentation of the broader network to support that connection; and the estimated incremental operating and maintenance costs to support the connection.
Incremental revenue was a calculation of the distribution tariff revenue to be received from the customer over a specified period, either 15 years (for businesses) or 30 years (for domestic customers). Distribution tariff revenue was calculated by multiplying the forecast distribution tariffs by the forecast amount of electricity to be supplied to that customer. In calculating the forecast tariffs to be charged by the distributor, Guideline 14 required distributors to apply the known X factors to the end of the regulatory control period, and then apply the X factor for the final year of that regulatory control period for the duration of the 15 or 30 years, as applicable. The revenue forecasts were then discounted back to a present value using the regulated WACC.
There were four possible situations where a customer requested a new connection (corresponding to Examples 1 to 4 set out in [10] above):
(a)the distributor carried out the construction works, where the incremental revenue exceeded the incremental cost;
(b)the customer undertook the construction works, where the incremental revenue exceeded the incremental cost;
(c)the distributor carried out the construction works, where the incremental revenue was less than the incremental cost;
(d)the customer undertook the construction works, where the incremental revenue was less than the incremental cost.
(These situations appear in a different order in Mr de Villier’s affidavit, but it is convenient to set them out in the same order as Examples 1 to 4 in [10] above.)
In situation (a), no amounts were paid by the customer to the distributor or the distributor to the customer. In situation (b), the distributor paid the customer a Rebate equal to the distributor’s estimated cost of constructing the connection asset. In situation (c), the customer paid a Customer Cash Contribution to the distributor equal to the excess of the incremental cost over the incremental revenue. In situation (d), the distributor paid the customer a Rebate equal to the estimated cost of construction less the Customer Contribution. (In relation to situation (d), I note that Mr de Villiers made a correction in oral evidence to [47] of his affidavit. Further, he said during cross-examination, and I accept, that the Rebate was simply the difference between the estimated cost of construction and the amount of the customer contribution.)
For completeness, I note that, in relation to situation (d), it appears that on some occasions the Customer Contribution was greater than the estimated cost of construction. It seems that, in such cases, no Rebate was paid and an amount (being the Customer Contribution less the estimated cost of construction) was payable by the customer to the distributor. The evidence of Mr Breheny during cross-examination was that such cases were unusual. The parties did not focus on such situations in the course of their submissions and such situations can be put to one side for present purposes.
As explained in [50] of Mr de Villier’s affidavit, the effect of Guideline 14 was that, where someone connected to the distribution network, the existing customers did not bear the excess cost of constructing a connection through increased tariffs where the incremental cost exceeded the incremental revenue. This was achieved by new customers contributing to the cost of connection when the incremental cost exceeded the incremental revenue (either directly, by the customer paying a Customer Cash Contribution, or indirectly, by the Distributor paying the customer a Rebate that was less than the estimated cost of constructing the asset). During cross-examination, Mr de Villiers accepted a series of propositions relating to the objective and operation of Guideline 14. Mr de Villiers gave the following evidence, which I accept:
The prices which the distributors can charge are heavily regulated?—Correct.
The structure of the regulations are such as to – on the basis that the assumptions are accurate, the pricing schedule is set up to enable the distributor to make profits on their operations without the profits being too much?—Well, the prices serve to first allow the distributor to recover the efficient costs of running the network, and to earn a reasonable return on their investment. That’s how I would put it.
And in meeting those objectives, the pricing regulations recognise that new connections are made as part of the business of the distributors, and they recognise that they put in place a structure to enable the distributors to make a charge for the new connections in some circumstances. And the circumstances in which the charge can be made, and the amount of the charge that can be made, by and large the objective is to ensure that making [and] operation of the new connection won’t add to the price burden on existing customers?—Yes. I agree.
So that where the costings are such that the distributor will need to recover more because of the costings, guideline 14 is put in place in order to achieve the objective that the burden of the additional cost is borne by the new customer as opposed to being built into the system and being imposed upon the existing customers?—Correct.
So the way in which that’s achieved is twofold. The first is guideline 14 sets out the circumstances in which a charge up-front can be made on the customer for the new connection?—Yes.
And the second is to ensure that the pricing going forward is not affected by the capital expenditure in relation to the new connection, so far as it’s covered by the contribution?—Yes.
So with the calculation of the RAB, the general rule is that capital expenditure is added to the RAB, so that the revenue requirements can be determined thereafter, but so far as there is a customer contribution that has been obtained from the new customer, that reduces the RAB?—Correct.
So that the existing customers then don’t bear any price increases for the job if there hadn’t been capital expenditure in relation to the new connection?—Correct.
Mr Breheny and Mr Hoole gave evidence during cross-examination, which I accept, that with the exception of certain requests by the State Government, the Distributors always charged the maximum that they were entitled to charge under Guideline 14. It does not appear that the exception is material for present purposes.
Mr de Villiers gave evidence during cross-examination, and I accept, that there were situations where Option 1 and Option 2 were in effect “meshed together” in a project. In such situations, the net payment could have been either way (ie, from the distributor to the customer or vice versa).
Guideline 14
I now set out the relevant terms of Guideline 14. Clause 3 of Guideline 14 was titled “New Works and Augmentation”. Clauses 3.1 to 3.3 provided as follows:
3 NEW WORKS AND AUGMENTATION
3.1 Background
3.1.1Under clause 5.7.3(h) of the Tariff Order, a distributor may levy an excluded service charge as follows:
... capital contributions for new works and augmentation ...
3.1.2In clause 5 of this guideline the Commission regulates generally for excluded services and excluded service charges. For example, clause 5 applies to the excluded service charge distributors may levy on customers under clause 5.7.3(b) of the Tariff Order, for connection to distributors’ distribution systems. However, clause 5 does not apply to the excluded service charge that distributors may levy for new works and augmentation under clause 5.7.3(h) of the Tariff Order. Instead, the specific regulations in this clause 3 apply to that excluded service charge and the related excluded service [see also clause 5.1.4].
3.1.3New works and augmentation may form part of the connection services a distributor provides to a customer so as to allow the supply of electricity from the distributor’s distribution system to an electrical installation of the customer.
3.1.4Under their distribution licences, distributors are required to offer such connection services. Clause 5.1 of the distribution licences provides:
If a retailer or a customer requests the Licensee to offer:
(a)to provide connection services so as to allow the supply of electricity from the Licensee’s distribution system to an electrical installation of the relevant customer; and
(b)to supply electricity from the Licensee’s distribution system to that electrical installation,
the Licensee must make such an offer ...
3.1.5Clause 10.3 of the distribution licences requires distributors to include in any such offer a price and other terms and conditions which are fair and reasonable and consistent with, among other things, any relevant guideline.
3.1.6 As noted in clause 1.2, this guideline is a relevant guideline.
3.2Customers must contribute to the capital cost of new works and augmentation
In making a connection offer, a distributor must include a price that has been determined on the basis that:
(a)the customer is not to contribute towards the capital cost of new works and augmentation unless the incremental cost in relation to the connection offer is greater than the incremental revenue; and
(b)the amount of any such customer capital contribution is not to be greater than the amount of the excess of the incremental cost in relation to the connection offer over the incremental revenue.
3.3 Calculating the customer’s capital contribution
3.3.1In determining the price to include in its connection offer, a distributor must calculate the maximum amount of a customer’s capital contribution for new works and augmentation, as contemplated by clause 3.2, as follows:
CC = [1C - IR]+SF
where:
CC is the maximum amount of the customer’s capital contribution;
IC is the amount of incremental cost in relation to the connection offer;
IR is the amount of incremental revenue in relation to the connection offer; and
SF is the amount of any security fee under the connection offer as contemplated by clause 3.5.
3.3.2 For the purposes of clauses 3.2 and 3.3.1:
(a) incremental cost, in relation to the connection offer, is the sum of:
(1)in respect of any relevant new works, the present value of the incremental capital, operating, maintenance and other costs the distributor will incur in providing services as a result of also providing the connection services offered, in respect of which services the distributor is remunerated by way of distribution tariff revenue. To avoid doubt, this excludes:
(A) transmission costs incurred by the distributor; and
(B) the cost of providing excluded services; and
(2)in respect of any relevant augmentation, the difference between:
(A)the present value of the incremental capital costs the distributor will incur in undertaking that augmentation at an earlier date as a result of the customer having connected to the distributor’s distribution system; and
(B)the present value of the incremental capital costs the distributor would otherwise incur in undertaking that augmentation at a later date, if the customer had not connected to the distributor’s distribution system.
To avoid doubt, for the purposes of this clause 3.3.2(a) the costs a distributor will incur include those costs the distributor will incur in engaging other persons to provide services or to undertake augmentation, as the case may be, on behalf of the distributor;
(b)incremental revenue, in relation to the connection offer, is the present value of the incremental distribution tariff revenue the distributor will earn in providing services as a result of also providing the connection services offered. To avoid doubt, this excludes any component of distribution tariff revenue referable to transmission costs incurred by the distributor; and
(c)each of:
(1) the amount of the incremental cost; and
(2) the amount of the incremental revenue,
is to be such amount as fairly and reasonably estimated by the distributor.
3.3.3 In making calculations under clause 3.3.1:
(a) it is to be assumed that:
(1)the term over which the connection services offered will be provided is 30 years for domestic customers and, unless the distributor fairly and reasonably determines some other term is more appropriate in any particular case, 15 years for all other customers;
(2)the distribution tariff earned by the distributor over that term is:
(A)for the period over which the prevailing Price Determination applies, the distribution tariff the distributor is entitled to earn under that Price Determination; and
(B)after then, the distribution tariff the distributor would be entitled to earn under that Price Determination if it were to continue to apply, with the applicable X-factor being the same X-factor that applies in the last calendar year in respect of which that Price Determination applies;
(b)the amount of electricity supplied to the customer is to be fairly and reasonably estimated by the distributor having regard to the customer’s load and connection characteristics; and
(c)incremental costs include a margin of up to 10% for overheads. This must be the same % margin as contemplated by clause 2.3.2(b).
Several matters may be noted about the text of Guideline 14:
(a)Guideline 14 did not refer to “economic connections” or “uneconomic connections”; rather, it used the expressions “incremental cost” and “incremental revenue”.
(b)Guideline 14 did not refer to Options 1 and 2 and did not refer to rebates. Its provisions appear to be more apposite to a situation where the distributor undertook the construction work than a situation where the customer did so. Nevertheless, in practice, the provisions of Guideline 14 relating to customer contributions were applied both where the construction works were undertaken by the distributor and where the construction works were undertaken by the customer.
Clause 3.2 of Guideline 14 placed a prohibition on the distributor from requiring the customer to contribute to the capital costs of the new works unless the incremental cost in relation to the connection was greater than the incremental revenue. The second part of cl 3.2 provided that where the incremental cost did exceed the incremental revenue, the amount of the customer capital contribution was not to be greater than the amount of the excess.
Under cl 3.3.2(a), the incremental cost included the present value of the incremental capital, operating, maintenance and other costs that the distributor would incur in providing services as a result of the new connection.
The incremental revenue calculated under cl 3.3.2(b) was the present value of the incremental distribution tariff revenue that the distributor would earn in providing services as a result of the connection.
Mr Hoole gave evidence during cross-examination, and I accept, that: the same IC less IR calculation was carried out whether the works were to be undertaken by the distributor or the customer; that calculation determined the amount of any customer contribution and the value of any Rebate payable to the customer; and the amount of the customer’s capital contribution referred to in cl 3.3 would be the same whether the work was to be undertaken by the distributor or the customer. Mr de Villiers’s evidence during re-examination was consistent with this. He said, and I accept, that: the Rebate was calculated by reference to the customer contribution calculated under Guideline 14; and the customer contribution in relation to Option 2 was effectively calculated in the same way as the customer contribution under Option 1.
Regulatory Asset Base
As noted above, an important regulatory concept for distributors is the RAB. This represents the financial value of regulated investments made by the distributor. The RAB was set in 1995 (at the time of privatisation) by statute, then the 2006 opening value was enshrined in legislation again with the introduction of the NER. There is no record of individual assets matched to the RAB. Broadly, the RAB is used in calculations of the distributor’s regulated returns and depreciation.
The investments, the value of which is included in the RAB, are the amounts of expenditure on assets used by the distributor to provide prescribed distribution use of system services, called standard control services under the NER. This consists of the distributor’s network assets, which broadly include connection assets, replacement assets and augmentation assets, information technology, and other non-network costs including property and vehicle costs. Each year, the distributor reports how much capital expenditure has been spent on the regulated business.
Distributors have three separate RABs in their business: one for prescribed distribution use of system services (now called standard control services); one for prescribed metering services (now called metering alternative control services); and one for public lighting excluded services (now called alternative control public lighting services). Standard control services are the distribution of electricity to customers. The metering RAB includes the value of smart meters in the distributor’s area. Public lighting includes the replacement public lighting assets. The regulations relating to each of those RABs are slightly different. For present purposes, it is sufficient to refer to the prescribed distribution use of system services RAB. The description that follows relates only to this RAB.
Every year, all amounts spent by the distributor that are eligible to be included in the RAB (gross capital expenditure, less any contributions made by the customer) were reported to the regulator in regulatory accounts (now “regulatory information notices”).
At the end of each five-year regulatory period, the RAB was recalculated and a new price determination was made by the regulator and (among other decisions) a forecast was made at that point of the expenditure the distributors were expected to make during the next five-year regulatory period.
During cross-examination, Mr de Villiers was taken to p 322 of the 2006 Determination (which set out the RAB for each distributor for the years 2006 to 2010) and gave the following evidence, which I accept, regarding the way in which the estimated cost of construction and any customer contribution were taken into account in the RAB:
And the gross capital expenditure will include the estimated cost of constructing all the assets by the distributors?—No. It will also include – so the way we report it – the way that gross capital expenditure was calculated for our networks was that [it] also included the expenditure estimated for the connecting customers as well.
And why did you include that?—So it was – so the way we treated – so, you know, I’ve mentioned that we had option 1 or option 2 projects, so if we just talk about option 1 projects, if you can imagine – so in that situation where we have an option 1 project, and let’s just say it cost $100, and the customer contribution was $40, so we would have $100 going into the gross capital expenditure, $40 being the customer contribution, so the net amount going into the RAB is 60. Now, if you can imagine – so now that same project has been undertaken as an option 2 project, so we would estimate that the construction costs to the customer would be 100 and we would put that into gross capital expenditure and, then, we would report the customer contribution as being the difference between the $100 that the customer pays less the rebate that we pay them. The rebate would be 60 in this instance. So, once again, we have 40, effectively, going into customer contributions and the net amount being 60. So the way we treated those option 1 and option 2 projects would have the same impact on the RAB.
But just a couple of things arising out of that, Mr de Villiers. The first is that what goes into the RAB in relation to option 1 is the gross capital expenditure, which increases the RAB, and then there’s a separate line item for decreasing the RAB by the customer contribution?—Correct.
In relation to option 2, you mentioned the rebate, but the fact is, Mr de Villiers, isn’t the rebate simply the difference between the estimated cost of construction and the amount of the customer contribution?—Yes. Yes, it is.
Yes. So the RAB is dealt with in the same way. The estimated cost of construction increases the RAB and is reduced by the capital contribution in relation to that particular project?—Yes.
Were an asset to be later sold or otherwise disposed of, any payment received by the distributor was deducted from the RAB. If there was no consideration received for the asset, the RAB was not reduced.
The Distributor and the customer were at arm’s length from each other in relation to the transaction.
In these circumstances, applying the definition of “arm’s length value” in s 21A(5) in relation to the Transferred Assets, the amount that the recipient (here, the Distributor) could reasonably be expected to have been required to pay to obtain the Transferred Assets from the provider (here, the customer) under a transaction where the parties to the transaction were dealing with each other at arm’s length in relation to the transaction, was, in my view, equal to the estimated cost of construction.
I turn now to the expert valuation evidence. VPN relies on the expert valuation evidence of Mr Samuel. The Commissioner relies, in the alternative to his submission that it is unnecessary to refer to the expert valuation evidence, on the evidence of Ms James.
Each expert was instructed in effect to express an opinion on the amount that CitiPower and Powercor could reasonably be expected to have been required to pay to obtain the benefit of network connection assets constructed by customers (referred to as Gifted Assets in the expert reports, but as Transferred Assets in these reasons) under a transaction where the parties to the transaction are dealing with each other at arm’s length in relation to the transaction in the years ending 31 December 2007 to 31 December 2010. In answering this question, Mr Samuel was instructed to have regard to the first report of Mr Balchin. Ms James was also provided with a copy of Mr Balchin’s first report.
Mr Samuel and Ms James agreed on the methodology to be applied in determining the amount that VPN could reasonably be expected to have been required to pay for the Transferred Assets. The experts agreed that this was the lower of:
(a)the replacement cost of the Transferred Assets; and
(b)the net present value (NPV) of the expected future net cash flows to VPN from ownership of the Transferred Assets.
The experts also agreed on the following matters:
(a)that the NPV of expected future net cash flows should include the present value of revenues to the Distributor, and the present value of incremental upstream costs;
(b)in the examples used in the joint report (referred to in the joint report as Scenarios 1 and 2 – these were substantially the same as Examples 3 and 4 as set out in [10] above), the present value of incremental upstream revenues was assumed to be $80, and the present value of the incremental upstream costs was assumed to be $20 (in discussing the expert evidence, I will use the labels “Scenario 1” and “Scenario 2” for consistency with the expert evidence);
(c)the NPV was calculated by discounting the distributor’s cash flows at a WACC. The WACC reflected the risks and returns of the Distributor and its business;
(d)a customer contribution of $40 arose where the customer:
(i)contributed $40 to the Distributor, when the Distributor had built the asset (as in Scenario 1); or
(ii)incurred $100 to build an asset, and received a $60 rebate (and therefore incurred a contribution of $40) (as in Scenario 2); and
(e)broadly speaking, unless specifically identified in Section 3 of the joint report, the experts made the same assumptions for the purpose of their reports and adopted the same definition as to parties dealing at “arm’s length”.
The experts agreed that the replacement cost of the Transferred Assets was equal to the estimated cost of construction ($100 in Scenario 2).
The principal disagreement between the experts was their respective approaches to determining the NPV of the expected future cash flows to the Distributor in relation to Scenario 2. In summary:
(a)Mr Samuel’s approach was to include cash flows only, being the Distributor’s incremental upstream revenues and upstream costs. Mr Samuel concluded that:
... in my opinion the amount that VPN could reasonably be expected to have been required to pay to obtain the benefit of the Gifted Assets under a transaction where the parties to the transaction are dealing with each other at arm’s length is equivalent to the rebate actually payable by VPN upon acquisition of the Gifted Assets.
(b)Ms James’s approach was to include the receipt by the Distributor of the customer contribution, in addition to the revenues to the Distributor and its incremental upstream costs. Ms James concluded that:
In this case, the customer contribution is included in the future cash flows and therefore the cost to replace the assets and the present value of the future cash flows are equivalent. Therefore the Distributor should pay an amount equivalent to the replacement cost for the Gifted Assets.
In addition to Scenarios 1 and 2, Ms James relied on a further scenario, referred to as Scenario 3. That scenario was as follows:
Ms James utilised this scenario to illustrate her view that, in all circumstances, in order for the Distributor to have a neutral outcome, the Distributor would be required to pay the cost of the connection assets to the customer, as the financial benefit to the Distributor was the sum of the customer contribution and the present value of incremental upstream revenues from the customer less the present value of incremental expenses. Scenario 3 was a hypothetical scenario developed by Ms James to illustrate her view as set out above; it was not suggested that the customer was required to pay an additional customer contribution in cash if it had transferred connection assets to the Distributor. Scenario 3 was designed to break down the rebate into its component parts, being the amount the Distributor should pay for the Transferred Assets ($100) less the customer contribution ($40) that the Distributor would otherwise receive if it had built the assets itself.
In the joint report at [3.6], Ms James stated that it was her observation that the rebate was merely a mechanism to enable the settlement of:
(a)the transfer of the Transferred Assets from the customer to the Distributor;
(b)the payment to the customer for the Transferred Assets at the cost of the assets ($100); and
(c)the payment from the customer to the Distributor of the customer contribution required to connect the customer to the network ($40).
During cross-examination, Ms James referred to this as her “interpretation” of the calculations. In response to questions during cross-examination, Ms James stated that: she was not saying that the payments were required or that they were obligations; rather, she was saying that the rebate was “a payment which is the net of the cost of the assets and the customer contribution”.
Ms James expressed the opinion (see the joint report at [3.7]) that: the settlement via rebate avoided the need to separately transfer cash relating to the customer contribution, but the Distributor nonetheless received the financial benefit of the customer contribution via the transfer of the Transferred Assets and the payment of the rebate; and therefore that financial benefit should be included in the assessment of the future benefits flowing to the Distributor.
In response to Mr Samuel’s comments to the effect that to include non-cash items in an NPV calculation would be inconsistent with fundamental valuation principles, Ms James expressed the opinion (see the joint report at [3.8]) that: this comment was contrary to the practical application of discounted cash flow valuations; and there are circumstances where it is appropriate to impute a notional cash amount in an NPV calculation as a substitute for a financial benefit or obligation that may not necessarily be paid in cash. Ms James provided examples of this. Ms James expressed the opinion (see [3.9]-[3.10] of the joint report) that: in this case, the NPV calculation should impute a notional cash amount for the customer contribution received in the form of assets; the customer contribution was a key component of the financial benefits received; and therefore there was no difference between the replacement cost of the Transferred Asset and the NPV of the expected future net cash flows.
In relation to Scenario 3, Mr Samuel expressed the opinion (see the joint report at [3.12]) that the asset contribution is not a future cash flow that can be derived from the same asset, and it is simply wrong to treat it that way. Mr Samuel expressed the view (see the joint report at [3.13]) that the following items identified in Scenario 3 were incorrect:
(a)the “net cash flow” of $140 was not a net cash flow, as the customer would never have to pay a customer contribution of $40 in cash when it had incurred the $100 cost of the assets and therefore would never have to pay $140 in cash; and
(b)the “hypothetical cash payment for Gifted Assets” by the Distributor to the customer of $100 could never occur in reality.
Mr Samuel expressed the opinion (see the joint report at [3.14]) that: Ms James’s assertion that the Distributor would be required to pay the cost of the connection assets to the customer was simply wrong; Ms James had ignored the NPV of the benefits that would be derived from the Transferred Assets, which was only $60; Ms James’s assertion that “the financial benefit to the distributor is the sum of the customer contribution and the present value of incremental upstream revenues from the customer less the present value of incremental upstream expenses” was incorrect as, in Scenario 2, there was no customer cash contribution; the financial benefit to the Distributor was only the present value of incremental upstream revenues from the customer less the present value of incremental upstream expenses, being a net outcome of $60.
In response to Ms James’s opinion relating to Scenario 2, Mr Samuel expressed the opinion (see the joint report at [3.14]) that Ms James’s approach was wrong because:
(a)it was inconsistent with the agreed cash flows for Scenario 2, which did not include a customer contribution cash flow; and
(b)it did no more than redefine the NPV of future cash flow benefits as the replacement cost. It set aside both the actual circumstances (being an actual payment of the rebate of $60) and the NPV of the future cash flow benefits (which was $60).
Mr Samuel stated (see the joint report at [3.16]) that: in his experience as a valuer over the last 26 years, he had never previously encountered an NPV calculation that included non-cash items; and in his opinion, to include non-cash items in an NPV calculation would be inconsistent with fundamental valuation principles and NPV calculations. After responding to the examples relied on by Ms James, Mr Samuel expressed the opinion (see the joint report at [3.18]) that: the examples did no more than demonstrate that all cash flow benefits or expenses should be included in an NPV calculation; in contrast, the only cash flows that arose from the Distributor’s ownership of the connection assets were the incremental upstream revenues ($80) and upstream expenses ($20), producing a net amount of $60; and Ms James’s notional $40 customer contribution in contributed assets could never give rise to any further cash flow or financial benefit as it could not be sold without the Distributor foregoing the incremental upstream revenues and upstream expenses (net amount of $60) and did not increase, in any way, the only cash flows generated by the Distributor, being the incremental revenues and upstream expenses (net amount of $60).
Mr Samuel expressed the opinion (see the joint report at [3.19]-[3.20]) that: the examples provided by Ms James in support of the inclusion of non-cash items in an NPV calculation bore no resemblance to her notional $40 customer contribution; Ms James’s approach of including a notional $40 customer contribution in assessing the NPV was flawed because the purpose of the NPV is to determine, in effect, the value of the connection assets, and Ms James’s approach included, as an input to the NPV, a notional $40 of the same connection assets that were being valued; Ms James’s approach was therefore circular, as it valued the assets by reference to themselves; in other words, she had not applied an NPV approach, but instead had redefined the NPV calculation as replacement cost.
In my view, if the methodology adopted by both experts (namely that the arm’s length value is the lower of the replacement cost of the Transferred Assets and the NPV of the expected future net cash flows to VPN from ownership of the Transferred Assets) is applicable for the purposes of s 21A of the 1936 Act, I prefer the opinion of Mr Samuel to that of Ms James. There is no difference of opinion between the experts as to the replacement cost of the Transferred Assets (the first element of the agreed methodology). The difference relates to the NPV of the expected future net cash flows to VPN from ownership of the Transferred Assets (the second element of the agreed methodology). Ms James’s approach essentially involved looking at the component parts of the Rebate. While her analysis of how the Rebate was calculated is correct (the Rebate was the estimated cost of construction less the customer contribution calculated under Guideline 14), I do not accept that the customer contribution was a cash flow for the purposes of applying the agreed methodology. The customer contribution was merely an input in the calculation of the Rebate. Accordingly, in my view, the only cash flows that arose from the distributor’s ownership of the connection assets were the incremental upstream revenues (in Scenario 2, $80) and upstream expenses (in Scenario 2, $20), producing a net amount of $60.
However, I do not consider the agreed methodology to be applicable for the purposes of s 21A of the 1936 Act in the circumstances of this case. Section 21A(5) relevantly defines the “arm’s length value” in relation to a non-cash business benefit (here, the Transferred Assets) as being the amount that the recipient (here, the Distributor) could reasonably be expected to have been required to pay to obtain the benefit from the provider (here, the customer) under a transaction where the parties to the transaction are dealing with each other at arm’s length in relation to the transaction. The difficulty with the agreed methodology in the circumstances of this case is that it pays insufficient regard to the regulatory regime described above, an objective of which was to ensure that existing customers did not bear the burden of the cost of the new connection to a certain extent in certain circumstances: see [62] above. As noted above, the way this was achieved was twofold. First, Guideline 14 provided for the customer contribution. Secondly, the RAB was calculated in a way that ensured that the pricing going forward was not affected by the capital expenditure relating to the new connection so far as it was covered by the customer contribution. When regard is had to these matters, it becomes problematic to determine the arm’s length value as defined in s 21A(5) on the basis of the NPV of future cash flows without taking into account the customer contribution and the way in which it was taken into account in the RAB and thus affected the pricing going forward. Accordingly, I do not consider the expert valuation evidence to assist in determining the arm’s length value of the Transferred Assets for the purposes of s 21A.
I therefore conclude that the arm’s length value of the Transferred Assets for the purposes of s 21A is equal to the estimated cost of construction (in Example 4, $100).
As noted above, it is common ground that the “recipient’s contribution” for the purposes of s 21A was equal to the Rebate (in Example 4, $60).
Accordingly, the amount included in VPN’s assessable income under s 6-5 of the 1997 Act pursuant to s 21A of the 1936 Act (being the arm’s length value less the recipient’s contribution) was, in Example 4, $40.
As noted above, VPN submits that the consequence of the Commissioner’s position is anomalous, in that the Distributors make a taxable gain when making an ‘uneconomic’ connection (Example 4) but make no gain when making an ‘economic’ connection (Example 2). I do not accept this submission. It fails to have regard to the gains that are made by the Distributor through the tariff revenues it derives in the case where it makes an ‘economic’ connection. In such a case, the estimated cost of construction increases the RAB and is thus taken into account in the pricing going forward. The assessable gain up-front in the ‘uneconomic’ connection situation relates to an amount (the customer contribution) that reduces the RAB and thus is not taken into account in the pricing going forward.
Conclusion
VPN’s written submissions refer to an issue concerning depreciation, but there does not appear to be any dispute between the parties once the issues discussed above have been resolved. It seems to be common ground that the depreciation treatment follows from the resolution of the above issues.
For the reasons set out above, I have concluded as summarised in [13]. In each proceeding, I will make an order that the parties provide proposed minutes of orders to give effect to these reasons.
I certify that the preceding two hundred and sixteen (216) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Moshinsky. Associate:
Dated: 7 February 2019
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