In Australia, some of the most challenging questions taxpayers face concern what, to the casual observer, might appear a simple matter; entitlement under the general deduction provision, section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), to deductions for losses or outgoings incurred.
Almost without exception, every major corporate taxpayer will face difficulties associated with this question at some stage in their business operations. For some, the difficulties will arise multiple times.
One question that can be difficult to answer is whether a particular outgoing is on capital account – and so not deductible – or on revenue account (and so deductible). As Sir Wilfred Greene so aptly said in IR Commrs v British Salmson Aero Engines Ltd (1938), in considering the task of determining whether an outgoing is on capital or revenue account: “In many cases it is almost true to say that the spin of a coin would decide the matter almost as satisfactorily as an attempt to find reasons”.
The most recent Federal Court case on deductibility of outgoings, SPI PowerNet Pty Ltd v Commissioner of Taxation (SPI), again highlights the difficulty for taxpayers, the Australian Taxation Office (ATO) and courts in this area.
SPI
The taxpayer in SPI derives assessable income from providing its customers access to the electricity transmission network in Victoria. Under the Electricity Industry Act 1993 (Vic) the taxpayer is required to hold a licence to transmit electricity.
In the years in question in the case, apart from licence fees, the taxpayer was also required to pay certain additional amounts (s 163AA imposts) to the State Treasurer. The s 163AA imposts were calculated as the difference between the taxpayer’s gross revenue and its maximum allowable revenue under a tariff order regulating the revenue that the taxpayer could derive from the transmission services.
In financial years 1999 to 2001, the taxpayer paid s 163AA imposts totalling A$177.5 million ($167.8 million). It claimed deductions for these payments under s 8-1 of the ITAA 1997. The deductions were subsequently disallowed by the ATO and became the subject matter of the Federal Court case.
The first question that the court looked at was whether the taxpayer incurred the s 163AA imposts in gaining or producing its assessable income or otherwise necessarily incurred them in carrying on its business for that purpose (the first or “positive” limb of s 8-1). Somewhat surprisingly, the court decided that the taxpayer failed the positive limb.
The court correctly identified that deductibility of an outlay is determined by reference to the business purpose for which it was incurred from the payer’s (not the recipient’s) point of view.
Despite finding that “the s 163AA imposts were inseparably connected with the transmission licence which [the taxpayer] used for business purposes”, the court concluded that the imposts were not incurred in the course of the taxpayer carrying on its business for the purpose of gaining or producing its assessable income.
It did so, adopting a line of reasoning of Justice Lockhart in United Energy v Federal Commissioner of Taxation (1997). In that case, Lockhart J characterised franchise fees paid by United Energy as akin to the state taking a share of United Energy’s profits, leaving it with what the state considered was a reasonable return on the capital that United Energy used in deriving its income.
The court in SPI appeared content to proceed on the same basis as Lockhart J, saying that the s 163AA impost was, in substance and effect, a share of profits, leaving the licence holder with an amount determined to be a reasonable return on its capital.
Although not strictly necessary, the court also considered the second or “negative” limb of s 8-1; in particular, whether the s 163AA imposts were capital or revenue in nature. Again, the court correctly identified the relevant tests to be applied, the most important being the character of the advantage sought by the payer in making the payment.
Despite the taxpayer’s submissions that the character of the advantage from its perspective related to its use of the transmission licence, the court again appeared more focused on the design of the s 163AA imposts as a means of the state extracting “excess profits” from the electricity transmission services. As such, the court held that the s 163AA imposts were capital in nature.
Lessons for taxpayers
The taxpayer in SPI is likely to appeal the decision to the Full Federal Court which may apply different lines of reasoning, and/or reach different conclusions, to those of the judge at first instance. Even so, there are lessons to be learnt from, or reinforced by, the single court decision.
The most obvious lesson is that, despite the question of deductibility of losses and outgoings being the subject of jurisprudence dating back over a century, we are no closer today to having tests, the application of which produce predictable outcomes to the question asked.
The application of the general deduction provision in any given circumstance is still an area of tax law where reasonable people, thinking and acting reasonably, may come to diametrically opposed conclusions. And as such, it is, and will continue to be, susceptible to differences of opinion and disputes between taxpayers and the ATO.
A second lesson (or perhaps curiosity) from the case relates to the fact that the court was prepared to find that the s 163AA imposts failed both limbs of s 8-1. For each limb, the court appeared to rely upon much the same broad proposition, being that the s 163AA imposts were in the nature of payments out of profit already derived.
This leads on to a third lesson. There are many well worn formulations of words that the courts cite and describe as tests or indicia of deductibility. However, there is often a chasm between what appears to be the test or indicia cited and the application of the test or indicia to the facts at hand.
In SPI, the court clearly laid down the proper tests (as formulated by courts over many years) for deciding whether the s 163AA imposts satisfied each of the first and second limbs of s 8-1 of the ITAA 1997. The court also quite properly pointed out that what is relevant is the business purpose (in the case of the first limb test) and the character of the advantage sought (in the case of the second limb test) from the payer’s perspective, not the perspective of the recipient of the payment.
Where taxpayers looking at SPI may be perplexed is how you reconcile the tests so clearly articulated by the court, with the court’s apparent reliance in reaching its decision on what appeared to motivate the state when imposing the s 163AA imposts and that they constituted an extraction by the state of “excess profits”.
