CATCHWORDS Income Tax — Allowable deductions -Whether payments in nature of royalties paid to purchase capital asset —- Whether outgoings of capital - Income Tax Assessment Act, 1936 s.51(1). The Commissioner of Taxation of the Commonwealth of Australia v. Cliffs International Inc. W.A. No. G3 of 1977 Coram: Bowen C.d., Franki and Brennan JJ. Date: 14th December, 1977 Sydney. hh IN THE FEDERAL COURT OF AUSTRALIA WESTERN AUSTRALIA DISTRICT REGISTRY W.A. No. G3 of 1977 GENERAL DIVISION On appeal from the Supreme Court of Western Australia BETWEEN: THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Appellant AND: CLIFFS INTERNATIONAL INC. Respondent ORDER JUDGES MAKING ORDER: Bowen C.J., Franki and Brennan Jd. DATE OF ORDER: 14th December, 1977 WHERE MADE: Sydney. THE COURT ORDERS THAT: 1. Appeal allowed. 2. Orders of the Supreme Court set aside. In lieu thereof order that the assessments be remitted to the Commissioner to be amended. 3. Respondent to pay to the Appellant his costs of the appeal and of the proceedings before the Supreme Court, other than the costs of the issue relating to the legal expenses in both Courts. IN THE FEDERAL COURT OF AUSTRALTA WESTERN AUSTRALIA DISTRICT REGISTRY W.A. No. G3 of 1977 " eee GENERAL DIVISION On appeal from the Supreme Court of Western Australia BETWEEN: THE COMMISSTONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Appellant i CLIFFS INTERNATIONAL INC. Respondent. CORAM: Bowen C.J., Franki and Brennan JJ. 14th December, 1977. SUDGMENT BOWEN C.J.: This is an appeal from a Judge of the Supreme Court of Western Australia delivered on 24th May 1977 dealing with certain income tax deductions claimed by Cliffs International Inc. in respect of the income years ended 31st December 1973, and 31st December 1974. Cliffs International Inc. ("Cliffs") is a company incorporated in Cleveland, United States of America, which is registered as a foreign company in Western Australia. It isa 1° wholly owned subsidiary of The Cleveland-Cliffs Iron Company. The Cleveland-Cliffs Iron Company ("Cleveland-Cliffs") is a company incorporated in Ohio, United States of America. Cliffs W.A. Mining Company Pty. Limited ("Cliffs Western" ), is a company incorporated in Western Australia and is a subsidiary of Cleveland~-Cliffs. oor uit ) is a company in the State nanged its ") is a company "nid") is a year ended 172,084. The - tax payable 5,272,924, 'n adjustment -! 'e items shown rere in issue 137 . in issue xcept unrecouped 4,120 only. Cliffs objected to the assessment in respect of the above items and others which were no longer material when the matter came before the Supreme Court. The objection was disallowed whereupon Cliffs requested that it be treated as an appeal and forwarded to the Supreme Court. It came before that Court as Appeal No. 176 of 1976. A notice of amended assessment was issued by the Commissioner, increasing taxable income for the year ended 31st December 1973 to $2,372,016. The addition, which was in issue, comprised interest received from Mt. Enid, amounting to $98,519. Cliffs objected to the amended assessment. Its objection was disallowed and it thereupon requested that its objection be treated as an appeal and forwarded to the Supreme Court. It came before the Supreme Court as Appeal No. 196 of 1976. Cliffs made a return for the income year ended 31st December 1974 showing a taxable income of $1,746,596. The Commissioner issued a notice of assessment showing tax payable amounting to $1,335,474-52, upon a taxable income of $3,142,293. The difference in taxable income was explained in an adjustment sheet. Amongst the items shown in the sheet were the following which were in issue before the Supreme Court: Royalties $4,176,640 Interest from Mt. Enid $191 ,032 Legal expenses in re payments to Howmet $16,638 Cliffs objected to this assessment. Its objection was disallowed and it requested that its objection be treated as an appeal and forwarded to the Supreme Court. This came before the Supreme Court as Appeal No. 178 of 1976. Before the Supreme Court the appeals were consolidated and heard together. The learned Judge held that for the year ended 31st December 1973 the taxable income of Cliffs should be varied by deleting therefrom the sum of $1,052.867 made up of exchange losses, $39,610, royalties $837,137, and unrecouped losses, $176,120, and that Cliffs was entitled to a credit against income tax assessed of an amount of $11,286-20 equalling the withholding tax already paid on the interest received from Mt. Enid. He furtuer held that for the year ended 3%st December 1974, the taxable income should be varied by deleting therefrom the sum of $1,193,278 made up of royalties $1,176,640 and legal expenses $16,638, and that Cliffs was entitled to a credit of an amount of $19,103-20 equalling the withholding tax already paid on the interest received from Mt. Enid. The Commissioner has appealed against the decision to allow the deduction of royalties, exchange losses and unrecouped losses. It is agreed that the decision on royalties will govern the decision on exchange losses and unrecouped losses. The Commissioner has also appealed against the allowance of legal expenses but not against the decision in respect of the interest received from Mt.Enid. The issues in contention before us are, therefore, whether the royalties and the legal expenses are allowable deductions under s.51 of the Income Tax Assessment Act, 1936. I turn now to the facts. By letter dated 5th March 1962, the Under-Secretary for Mines of Western Australia wrote to Basic stating that Temporary Reserves Nos. 2400H-2417H inclusive had been approved for a period of two years from 1st April 1962 to 31st March 1964. It was further stated that the Reserves were subject to conditions which were attached and covered Crown Lands within a total area of 246 square miles as shown on an attached plan. The annual fees payable were set forth. Under the attached conditions it was provided the occupant should not use the land for any other purpose than that of prospecting for iron ore (condition (2)); the occupant was obliged to commence prospecting operations forthwith and to continue them to the satisfaction of the Minister (condition (3)); no transfer of the authority to occupy would be permitted without the approval of the Minister (condition (8)); the Minister might impose further conditions or cancel if conditions were not fulfilled (conditions (9) and (10)); the occupant was obliged to furnish to the Minister quarterly reports and at the end of each calendar year a full report (conditions (11) and (12)); when it was shown that iron ore had been discovered in payable quantities the Minister, after negotiation of various conditions, would (subject to any contract the Minister might require the occupant to make with the State Government), offer to grant to the occupant mining tenements under the Mining Act and regulations and on acceptance would make such grants accordingly (condition (14)). In 1962 the shares in Basic were held as to 50.1% by Howmet (then called Howe Sound) and as to 49.9%, by Agnew Co. In July 1962, an approach was made by Howmet to Cleveland—Cliffs, seeking to interest it in the Reserves. Cleveland-Cliffs was principally a merchant producer of iron ore. It had acquired a world-wide reputation, particularly for its expertise in the development of technology as it relates to the beneficiation, upgrading, concentrating and pelletising and other forms of improving iron ore. Cleveland-Cliffs had before it a report dated August 1962 submitted to 1t by Howmet. This report was rather brief and not in the depth that would enable an evaluation to be made. It indicated there were two iron ore deposits known as the Middle Robe and Upper Robe deposits. The deposits were of two basically different types - one referred to as . the "Mesa" deposits and the other as the "Gorge" deposits. The nature of the iron ore was that it was of a limonitic order which, in lay terms, would mean that it had a very high chemical water content and which, at that time, was not considered a commercial ore. In evidence it was contrasted with the Hematite ore mined by Hamersley and Mt. Newman which had a higher iron content and less of the so called crystal and chemical moisture. It was apparent that considerable effort would have to be expended before an assessment could be made as to the worth of the deposits. As a result of negotiations, an agreement in writing was entered into on 27th November 1962 between Cleveland-Cliffs, Howmet, Agnew Co., Mr. R.D.G. Agnew and Mrs. Fay M. Agnew (the "Option Agreement"). The material parts of the operative provisions of this agreement are as follows: "4, Howe, Agnew Company and Mr and Mrs Agnew severally but not jointly represent to Cliffs that: (a) (b) (c) (d) (e) Basic is a corporation duly organised and existing under the laws of Australia; Howe and Agnew Company own the entire equity interest 1n Basic ..... Basic holds the exclusive right to occupy and use for the purpose of prospecting for iron ore the Temporary Reserves numbered 2400H~2417H (inclusive) in the Hamersley Range in Western Australia, covering a total area of approxinately 246 square miles (hereinafter called the "Reserves") «eee and all of the terms, provisions and conditions of the said grant and conditions ..... have been fully complied with and performed and are not in default; Basic has no debts, liabilities or obligations of any nature except its obligatiuns as set rorth in the attached Exhibit A, Exhibit A-1 and Exhibit B, the latter being a pro forma balance sheet of Basic as of the date hereof. If Basic incurs any other debts, liabilities or obligations between now and the Closing, Howe, Agnew Company and Mr and Mrs Agnew will take such steps as are necessary to discharge such debts, liabilities or obligations prior to the Closing, or if it is impractical to do so, will deliver to Basic at the Closing a guarantee holding Basic harmless ..... Howe, Agnew and Company and Mr and Mrs Agnew have no rights, interests or claims in the lands in the Reserve .....3; and Basic now has no operating assets relating to any business or operation other than iron ore, and will have at the Closing Date no commitments or obligations of any sort with respect to any such other business or operation. 2. Cliffs will, at its expense, perform the following work and make the following investigations during the term of the option at no expense to Howe or Agnew: (a) Drill, sample and test metallurgically an area of sufficient size to prove tonnages and quality of ore in the Reserve and prepare a report as to the results of such drilling, sampling and testing. (b) Perform metallurgical tests with ore shipments of at least 1,000 to 2,000 tons which shipments are to be shipped to prospective Japanese purchasers for their testing in Japan; (c) Make a preliminary written survey of the railroad route and port site areas for ore to be mined from the Reserve; (d) Make a written market survey and take steps to negotiate the sale of ore, including an analysis of the costs of shipping to markets; (e) Assemble all data pertinent to operation of a mine on the Reserve and to incorporate such data and the shipment of ore therefrom into a feasibility report and furnish Howe and Agnew Company with a copy of such report; and (£) To make and use such feaszbility report to the extent necessary to secure adequate mining rights from the Australian Government. The other parties hereto agree to co-operate with Cliffs in the foregoing. 3. Howe, Agnew Company and Mr and Mrs Agnew agree, so long as they are stockholders of Basic, to cause Basic to do and perform all things required of it to be done and performed with respect to the said prospecting rights ..... 4. Cliffs is hereby granted the option to purchase from Howe and Agnew Company their entire right, title and interest in all of Basic's capital stock and shares, for the Purchase Price set forth below, payable to them in proportion to their participations above set forth, such option to be exercised by written notice by Cliffs to them on or before December the thirty first One thousand nine hundred and sixty three. Such purchase by Cliffs shall be consumated at the offices of Messrs Parker & Parker, 21 Howard Street, Perth Western Australia, at a date specified in Cliffs! notice of exercise of the option, not less than twenty nor more than thirty days from the date of such notice (herein called the "Closing") by making of the Initial Payment by Cliffs to Howe and Agnew Company against delivery to Cliffs of appropriate certificates and assignments. The obligation of Cliffs to consumate the purchase shall be subject to the existence on the date of Closing of the following conditions: (a) That the representations set forth in Article 1 hereof are true and correct. (b) That there shall have been no change from the time of the notice of the exercise of the option until the date of the Closing, 1n the terms and conditions of Basic's rights to mine and remove iron ore from the lands described 1n Exhibit A, in the amount of royalties or other charges imposed by the Australian Government or any political subdivision thereof, and in the right of Basic to consume and to ship and to sell such iron ore; and (c) That Basic has full right, power and authority, subject to the provisions of Australian law, to transfer all of the Reserves or other mining rights under Australian law free and clear of all liens, encumbrances, charges or equities. The other parties hereto agree to furnish to Cliffs, upon its request, such certificates, opinions of counsel and other documents and data as Cliffs may reasonably request to evidence compliance with the foregoing conditions. 5. The Purchase Price referred to in Article 4 shall consist of an Initial Payment of TWO HUNDRED THOUSAND DOLLARS $200,000 (US), payable in good New York or Cleveland, Ohio funds by certified or official bank check at the Closing of the purchase hereinabove referred to, plus Deferred Payments equal to 15¢ (US) per ton of Iron Ore payable as in this Article 5 set forth. Such 15¢ per ton payments (hereinafter sometimes called "Deferred Payments") shall be computed and paid as follows: (a) "Iron Ore" shall mean iron bearing material mined and transported from the Reserves by or with the consent of Basic or its successor in interest, whether or not such iron ore shall have been dried, roasted, burned, sintered, crushed, ground, concentrated, pelletized, agglomerated or otherwise beneficiated or processed or prepared prior to sale or consumption, but iron bearing material of low grade may be sold for construction purposes without any liability to pay any Deferred Payments with respect thereto. (b) A "ton" shall be a gross ton of 2,240 pounds avoidrupois weight in the form and at the time transported from the Reserve. Reports as to the weight of any such Iron Ore made by any common carrier trucker, railroad or vessel operator shall be conclusive for all purposes hereof. (In the absence of such reports, reports thereof by Basic or its successor in interest shall, unless fraud is involved, be conclusive on each party hereto unless challenged in writing within thirty days after receipt of such report by such party; (c) Within ninety days after June thirtieth and December thirty first of each year Cliffs shall make or cause to be made to Howe and Agnew Company a report of the tons of Iron Ore mined and transported from the Reserves during the semi-annual period then ended, together with payment by check drawn on good United States funds of their respective participations in the Deferred Payments with respect thereto. Subject to the provisions of paragraph (b) of this Article, in the event Howe or Agnew Company does not object in writing to the computation of such amount within ninety days after receipt of such report, such report shall be binding and conclusive upon the parties, unless fraud is involved. (a) For purposes of this Article 5, iron bearing material mined from the Reserve shall be considered as still located at the Reserve so long as it is located at any plant in Australia for the purpvose of drying, roasting, burning, sintering, crushing, grinding, concentrating, pelletizing, agglomerating or otherwise beneficiating or processing or preparing prior to its sale or consumption. The initial Payment will be in the form of a check payabie jointly to Agnew Company and Howe, and the Deferred Payments will be paid in cash or by check in the proportion of 50.1% to Howe and 49.9% to Agnew Company. 6. Cliffs may, by notice in writing delivered to Howe and Agnew Company prior to the time for completing its purchase as provided in Article 4, designate another corporation (or similar organisation), organised under the laws of Australia or of one of the states of the United States to make the purchase provided for in Article 4. eevee 7. (Provided that Howe, Agnew Company and Mr and Mrs Agnew should be free from any cost or expense in carrying out certain of their obligations). 8. (Provided for service of notices or reports). 9. This Agreement shall be governed by and construed in accordance with the laws of the State of New York, United States of America. This agreement constitutes the entire agreement among the parties and shall not be modified, amended or terminated orally but only by an agreement in writing signed by the parties hereto. 10. Subject to the provisions of Article 6 hereof, this agreement and the rights and obligations herein set forth shall inure to the benefit of and be binding upon the parties hereto and their respective successors, personal representatives and assigns." The occupancy rights referred to in the Option Agreement do not confer any right to mine. However, they do confer valuable rights which the courts will protect (Delhi International Oil Corporation v. Olive (1973) W.A.R. 52). Evidence was given that in the course of negotiations a proposal for a minimum payment or a minimum royalty was discussed and rejected. An undertaking was, at one stage, sought from Cliffs that if they should exercise the option they would Mine the deposits. That was refused. The question was also raised whether Cliffs would transfer back the shares or the rights of occupancy if they exercised the option or did not proceed with the project on the ground. This suggestion was rejected. The sum of $200,000 to be paid under the Option Agreement, if the option was exercised, appears to have been arrived at after Howe raised the question of expenditure on the work that had already been done on the deposit for which they wished to be reimbursed and there was reference to some finder's fee which was payable. Presumably Howe would receive only a proportion of the $200,000 if the option was exercised. As to the figure of 15¢ per ton described in the Option Agreement as "Deferred Payments", it appears it was a negotiated figure, arrived at after consideration of various matters including comparative royalties in the United States. The description "Deferred Payments" was a term that was not brought into the discussions until a very advanced stage. It was then brought in only at the suggestion of Howe for purposes of their own.. Before that, it had been referred to as a royalty and indeed was thought of throughout by Cliffs as a royalty. Evidence of these negotiations leading up to the Option Agreement was admitted on the basis laid down in Ralli Estates Limited v. Commissioner of Income Tax (1961) 1 W.L.R. 329; and see Inland Revenue Commissioners v. Church Commissioners for England (1976) 3 W.L.R. 214. Also on 27th November 1962, an agreement was entered into between Cleveland-Cliffs and Agnew Co. The material part of Clause 1 of this agreement is as follows: "4, If Cliffs exercises its said Option to purchase the entire capital stock or shares of Basic it shall thereafter with all convenient speed form a Company or Companies (hereinafter referred to as "the Operating Company or Companies") to mine exploit and develop the Reserves and to sell (before or after treatment) the ore obtained therefrom and Agnew Company or any Company or Companies nominated by 1t (and if the whole of the shares in such Company or Companies is not owned by Agnew Company Garrick Agnew of Perth and or his wife and children then approved by Cliffs) shall have the right to purchase and Cliffs shall cause the Operating Company or Companies to offer to Agnew Company or such other Company or Companies as aforesaid (all of which Companies are hereinafter included in the expression "Agnew Company") for purchase up to 7% per centum of the capital .....(certain terms and a provision were then stated and a further proviso was as follows) ..provided however that Agnew Company's aggregate investment 1n the Operating Companies shall be limited to the sum of $2,500,000 (US)." In due course, the option under the Option Agreement was exercised. Completion took place on 17th January 1964. Prior to completion, at the end of 1963, Cleveland-Cliffs designated Cliffs to make the purchase on its behalf and assume the obligations and Agnew Co. had sold its shares in Basic to Mt. Enid, which thereupon acquired Agnew Co.'s rights under the Option Agreement. The shares in Basic were transferred to Cliffs except for one which was transferred to Mr. Dohnal, on behalf of Cleveland-Cliffs. On 18th March 1964 the shareholders of Basic met and resolved, inter alia, as follows:- "NATURE OF At the present time all the shares in the PRESENT Company are held by or on behalf of Cliffs ACTIVITIES: International Inc which at present is engaged in investigating the possibilities of mining the Rights of Occupancy held by the Company of the iron ore deposits in the Robe River area. These investigations involve the expenditure of large sums of money. Resolved that the Company acknowledge that these Rights of Occupancy are held on trust for Cliffs International Inc." On 18th November 1964 an agreement was made between the State of Western Australia and Basic. This was approved by the Iron Ore (Cleveland-Cliffs) Agreement Act 1964 in which it is set forth as a schedule. It provides for certain work to be done by Basic during a period described as Phase 1 and for continuation of the rights of occupancy during this period. This is to lead up to the commencement date whereupon Phase 2 commences. The State undertakes to grant a mineral lease for iron ore in a form which is set forth as a schedule to the agreement for a term of twenty one years from the commencement date, with rights to successive renewals of twenty one years. Basic undertakes that it will, within four years after the commencement date, (or extended period approved py the Minister) at a total cost of $35,000,000, instal various facilities to enable it to mine, to transport by rail to the plant site, pelletise and transport to Basic'ts wharf and to commence shipments therefrom in commercial quantities at an annual rate of not less than 1 million tons of iron ore pellets and also within a further period of five years, to increase the capacity of the plant to a minimum of 3 million tons of iron ore pellets per annum. Basic undertakes to pay to the State of Western Australia rental and royalties. The royalties provided by this agreement are on all iron ore (or on iron ore pellets produced from iron ore) from the mineral lease shipped and sold. Basic is given the right at any time to assign or dispose of to an associated company as of right and to pay any other company or person with the consent in writing of the Minister, the whole or any part of the rights of Basic under the agreement and its obligations thereunder. On the 21st October 1965, at an extraordinary general meeting of the shareholders of Basic, it was resolved to insert art. 128 in its articles of association to provide for modes of distribution in a winding up, including division of assets in specie. It was also resolved that the company be wound up voluntarily and a liquidator was appointed. It was further resolved that the liquidator be authorised to divide the assets in specie amongst the members. It will be noted that at the time of winding up, Basic held not only the rights of occupancy which it had resolved to hold in trust for Cliffs, put also the rights under the agreement of 18th November 1964 with the State of Western Australia. On 19th November 1965 an agreement was entered into between the State of Western Australia, Cliffs and Basic (In Liquidation). By this agreement, it was recited that Basic was desirous of assigning to Cliffs the whole of its rights under the agreement of 18th November 1964 and that the Minister had consented to this assignment. In its operative portion, Cliffs covenanted and agreed to perform observe and comply with all the covenants agreements and provisions in the agreement and the State of Wester.. Australia released Basic from its obligations under the agreement. On 7th December 1965, Basic assigned to Cliffs all its interest in the agreement of 18th November 1964 including its rights of occupancy. Consent of the Minister was endorsed upon this assignment. Investigations carried out by Cliffs following the agreement of 18th November 1964 showed that the extent of the deposits on the Temporary Reserves was not as great as initially supposed. Cliffs then looked for additional deposits which could be mined with the satisfactory deposits on the Reserves. It found deposits known as Deep Dale deposits controlled by Dampier which would meet its requirements. On 30th September 1969, an agreement was entered into between Dampier Mining Co. Limited ("Dampier") and Cliffs. It seems that this provided, in effect, for a sub-lease by Cliffs of the mineral lease Dampier had or was to obtain of the Deep Dale deposits for the purpose of mining up to 150 million tons of ore, subject to payment to Dampier of royalty. Consequential amendments were made to the agreement of 18th November 1964 and these were embodied in the Iron Ore (Cleveland-Cliffs) Agreement Act Amendment Act 1970. On 25th May 1970 an agreement was entered into between Cliffs Western (30%), Mitsui Iron Ore Development Pty. Limited (30%), Robe River Limited (35%) and Mt. Enid (5%) (the "Participants" ) whereby they associated themselves in a joint venture for the purpose of the progressive exercise and development of what were called Robe River Rights for the mining, overland transportation, processing, pelletising and loading for shipment of iron ore on the terms and conditions of the agreement. The Robe River Rights included the rights under the agreement of 18th November 1964 with the State of Western Australia and 'the mineral lease, as well as the rights under the Dampier agreement of 30th September 1969. The Participants agreed to enter into an agreement with Cliffs providing for the assignment of the Robe River Rights (other than the mineral lease) and for the granting of a sub-lease of the mineral lease. The Participants agreed with each other to pay to the State of Western Australia and to Cliffs all royalties and charges payable by the Participants in respect of iron ore. Also on 25th May 1970 an agreement was entered into between Cliffs and the four Participants (the "Cliffs Agreement") whereby Cliffs agreed to assign the Robe River Rights except the mineral lease and to grant a sub-—lease of the mineral lease. As rent and royalty to Cliffs under the mineral sub-lease, each Participant assumed an obligation to pay its individual share of rentals and royalties due in respect of the rights and lease and also to pay a royalty on iron ore produced by or for each Participant and sold or shipped for sale or commercial use from the mineral lease area at the rate therein specified. In fact the Participants have mined the deposits over the past few years and, in accordance with the Cliffs Agreement of 25th May 1970, paid rent and royalties to tke State and royalties to Cliffs. Cliffs, in turn, has paid to Howmet and to Mt. Enid, which took the place of Agnew Co., the deferred payments under the Option Agreement in respect of iron ore mined and transported from the Reserves at the rate of 15¢ (US) per ton. In its return of income for the years ended 31st December 1973 and 31st December 1974, Cliffs included as income the royalties which it received from the joint venturers and claimed as a deduction the deferred payments which it paid to Howmet and Mt. Enid. It is the disallowance of the deduction for these latter payments which 1s the principal matter at issue in these proceedings. During the years ended 31st December 1973 and 31st December 1974, the income earning operations of Cliffs do not appear to have been substantial. The accounts submitted with its income tax returns for those years show that, in addition to the rent and royalties which it received from the joint venturers, it received certain interest, part of which was interest on short term Government securities. Its expenditure does not suggest it was engaged in other significant income earning operations, although it does appear that in the income year ended 30th December 1973, it spent $21,894 on exploration and prospecting, while in the income year ended 31st December 1974 it spent $28,715 on exploration and prospecting. During the income year ended 31st December 1974, Cliffs incurred legal expenses and there is a dispute as to whether the amount paid for these expenses is an allowable deduction. The Commissioner claims they are expenditure of a capital nature. They appear to have been incurred in obtaining legal advice on the situation which arose when the Commissioner requested, or required, Cliffs to deduct tax from payments made to Howmet under the Option Agreement. Howmet claimed that it was entitled to be paid the amounts due to it without deduction of tax. Howmet threatened to sue Cliffs in the United States where a defence, based on the Income Tax Assessment Act 1936, would not be available to Cliffs. Cliffs obtained advice as to the way in which it should proceed. It was argued that it was in the course of its profit earning business to do so. The questions arising on this appeal in relation to the deferred payments and the legal expenses concern the operation of s.51(1) of the Income Tax Assessment Act. It will be convenient to deal first with the deferred payments. Here, the facts relevant to the question whether the expenditure is of an income or capital nature, are largely the same as the facts relevant to the question whether the expenditure falls within either of the first two limbs of s.51(1). The question whether the expenditure is of a capital nature, was treated by Counsel for the parties as the main question arising on the appeal. I will deal with this question first. Considerable judicial guidance is available on the construction of this section (see generally Ronbipon Tin No Liability v. Federal Commissioner of Taxation (1949) 78 C.L.R. 47; and John Fairfax & Son Pty. Limited v. Federal Commissioner of Taxation (1959) 101 C.L.R. 30). The exception in the last part of s.51(1) is expressed to be "to the extent to which" losses or outgoings answer the descriptions they are given. Being expressed as an exception, the provision seems to assume that otherwise these items would fall within s.51{1). In some cases, however, it seems it will not operate as a true exception but simply by way of excluding a contrasted category of expenditure. Thus, in deciding that expenditure is of a private or domestic nature the Court may, at the same time, be deciding it is expenditure which would fall outside the first two lambs of s.51(1) (See Lumney v. Federal Commissioner of Taxation (1958) 11 A.T.D. 404; Federal Commissioner of Taxation v. Hatchett 71 A.T.C. 4184; and Federal Commissioner of Taxation v. Fazchney 72 A.T.C. 4245). So too with losses or outgoings of capital or of a capital nature; although it appears that some capital expenditure may answer the description in one or other of the first two limbs of s.51(1) (see John Fairfax & Sons Pty. Limited v. Federal Commissioner of Taxation supra, at pp.34-35). In determining whether an outgoing is of a capital nature, it is necessary to determine what it is incurred for. Sometimes one consideration may point clearly in one direction, while the other, and vaguer indications, point in a contrary direction. It has been said "it is a common-sense appreciation of all guiding features which must provide the ultimate answer" (B.P. Australia Limited v. Federal Commissioner of Taxation (71966) A.C. 224 at p. 264). A test frequently quoted is that of Lord Cave in British Insulated_and Helsby Cables Limited v. Atherton (1926) A.C. 205. His Lordship (at pp. 213-214) said:- "But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or advantage for the enduring benefit of a trade, I think there is very good reason (in the absence of special circumstances leading to an approp- riate conclusion) for treating such an expenditure as properly attributable not to revenue but to capital". This statement places emphasis on what is acquired as well as upon the character of the expenditure. It is a positive statement. It does not follow that the negative furnishes a test of what is not capital (see John Fairfax & Son Limited v. Federal Commissioner of Taxation (1959) 101 C.L.R. 30 at p.36). Expenditure to acquire coal contracts of very short duration has been held to be of a capital nature (John Smith & Sons v. Moore (1921) 2 A.C. 13 at p.20), and where an asset is acquired, recurrent payments, even of indeterminate total amount may have been held to be of a capital nature (Colonial Mutual Life Assurance Society Limited v. Federal Commissioner of Taxation (1953) 89 C.L.R. 428; Tata Hydro-electric Agencies Limited v. Commissioner of Income Tax (1937) A.C. 685). In Sun Newspapers Limited v. Federal Commissioner of Taxation (1938) 61 C.L.R. 337, Dixon J. stressed that the distinction between income and capital expenditure corresponds with - "the distinction between the business entity structure or organisation set up or established for the earning of profits and the process by which such organisation operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss". When on the 27th December 1962 Cleveland-Cliffs entered into the Option Agreement to purchase the shares in Basic, it was interested only in one asset which Basic had. That asset consisted of the exclusive right to occupy and use for the purpose of prospecting for iron ore, the Temporary Reserves Nos. 2400H-2417H (inclusive) in the Hamersley Range in Western Australia. As was insisted upon by Cleveland-Cliffs, Basic then had no other assets and apart from its obligations under the conditions of the grant of the right of occupancy, no obligations or liabilities. When, therefore, Cleveland-Cliffs entered into the Option Agreement to purchase the shares, although from a legal point of view it gained no direct proprietary interest in the right of occupancy, it did obtain the option to acquire a bundle of rights which would enable it to obtain the benefit of the right of occupancy and, at an appropriate time, to obtain this right for itself upon a liquidation of Basic. An alternative course would have been to take an option to acquire the right of occupancy. But this right was not transferable without the approval of the Minister for Mines. The nature of the advantage which Cleveland-Cliffs was placed in a position to gain access to, was a right to use the land in question for the purpose of prospecting for iron ore during the balance of a period of two years expiring on 31st March 1964. The option was exercisable by written notice on or before 31st December 1963. If the option was exercised, the purchase was to be "consumated" at a date specified in the notice, not less than twenty nor more than thirty days from the date of the notice. Regarded from this point of view, the advantage might be of very short duration. However, the right of occupancy might be renewed. Furthermore, under the conditions of the grant, when it was shown to the satisfaction of the Minister that iron ore had been discovered on the reserve in payable quantities, the Minister, after negotiations with the occupant, regarding the mining, treatment, processing and marketing of the ore, would (subject to the provisions of any contract which the Minister might require the occupant to make with the State Government) offer to grant to the occupant for the mining of iron ore, mining tenements under the Mining Act 1904 and the regulations thereunder, on such conditions as the Minister determined, and on acceptance would (subject to the Act and regulations), make such grants accordingly. Although the knowledge which the parties had was fairly limited at the time of purchase, and even more limited at the time of the grant of the option, the advantage was regarded as being of significant value. There was a speculative potential of long term advantage, dependent upon any necessary extension or renewal of the right of occupancy, the discovery of iron ore in payable quantities and the preparedness of the Minister to require a reasonable contract and to make the offer of a grant of mining tenements on reasonable conditions. With hindsight this potential value may be more clearly seen. It was demonstrated by the events which occurred. The option was duly exercised and the purchase was "consumated" on 17th January 1964. Iron ore was discovered which was in payable quantities or, which, when mined in conjunction with ore from the adjacent Dampier Area, would be a commercial proposition. . At the end of 1963, Cleveland-Cliffs designated Cliffs to make the purchase and assume the obligations under the "Option Agreement", At the time of purchase on 17th January 1964, it was Cliffs therefore, who became the purchaser and who paid $200,000 and who promised to make the deferred payments equal to 15¢ (US) per ton of iron ore computed and payable as set forth in clause 5 of the Option Agreement. At this stage, Cliffs simply acquired the shares in Basic. In its hands, these shares constituted a capital asset. Looking at the realities, it acquired the means of access to the right of occupancy which was the only asset Basic had. This right which would continue until 31st March 1964, had inherent in it the possibility of obtaining an extension or renewal and the further possibilities which have been outlined above. However, the asset which Cliffs acquired, whatever way one views it, was in no sense income—producing in its hands, nor did it fit into any income- producing activity carried on by Cliffs in Australia at that time, On 18th March 1964, Basic resolved to hold the rights of occupancy in trust for Cliffs. On 18th November 1964 the agreement between the State of Western Australia and Basic was entered into. This changed the position substantially. The State, by this agreement, undertook in Phase 2 mentioned in the agreement, to grant a mineral lease for twenty~one years with successive renewals for twenty-one years. Basic undertook that it would, at a total cost of $35,000,000 intal various facilities. Basic further undertook to pay to the State rent and royalties. On 21st October 1965, Basic went into liquidation, having amended its articles to permit distribution of its assets in specie. On 19th November 1965, a novation agreement was entered into between the State of Western Australia, Cliffs and Basic. Cliffs succeeded to the rights and obligations of Basic and Basic was released. At this point, Cliffs had substantially added to the obligations which it had undertaken on 17th January 1964. Its real assets had been reduced into possession and added to. Mineral leases had grown out of the rights of occupancy. Although it never used the asset which it purchased on 17th January 1964 in income-producing activities, Cliffs might now proceed to make arrangements which would result in income flowing to it from the use of the rights into which the rights of occupancy had grown. Under the joint venture agreement of 25th May 1970, it transferred its rights, with certain exceptions, to the Participants who, in turn, undertook to pay the rent and royalties to the State of Western Australia and who also undertook to pay to Cliffs royalties on iron ore produced and sold or shipped for sale for commercial use from areas which included the areas covered by the agreement of 18th November 1964. Although the deferred payments bore the appearance of royalties, being computed on iron ore mined and transported from the Reserves, they are not in any sense an outlay made to secure the use, enjoyment or benefit of an asset for a period commensurate with the royalty period. In this latter respect, they may be contrasted with the payment of rent or the payment of certain types of royalties. It is not easy to describe the relationship between the royalties which Cliffs receives from the Participants with the deferred payments which Cliffs makes in discharge of its obligations under the Option Agreement. Presumably if Cliffs defaulted in making these payments, its right to receive the royalties from the Participants might be endangered by some form of execution. In this sense, it may be said that the making of the deferred payments is a prerequisite to Cliffs receiving its income. However, if one has to answer the question "what were the deferred payments paid for", it would appear that the answer must be that both the $200,000 and the deferred payments were paid for the acquisition of the shares and the rights to which they gave access. The "purchase price" of the shares is defined in the option agreement as being the Initial Paymerc of $200,000 (US) plus the deferred payments. True, it is, that the Court is not bound by the label which the parties have attached to the expenditure (Minister of National Revenue v. Spooner (1933) A.C. 684 at p. 688; Europa Oil (N.Z.) Limited v. Inland Revenue Commissioners (1976) 1 W.L.R. 464 at p. 472). The Court's task is to determine the true character of the payments. In undertaking this task, it will regard the description given by the parties as being not without significance., Indeed, the way in which the parties cast their agreement will be of importance in determining the true character of the payments. In the present case, it appears to me that the way in which the parties have treated the deferred payments amounts to more than merely describing them in a particular way; it amounts to ensuring that they are made part of the purchase price. Upon a purchase of shares, the value of which was so speculative, it is not surprising that the parties adopted such a method, nor is it surprising that no ultimate fixed amount was stated which was to be satisfied by the 15¢ (US) per ton. It was open-ended. But the difficulty of stating an ultimate figure was very great and it was probably for this reason that the method was in fact chosen. It is clear that an income may be purchased by expenditure of a capital nature; it is less clear that for the purposes of s.51 a capital asset may be acquired by expenditure of a revenue nature (Egerton-Warburton v. Federal Commissioner of Taxation (1934) 51 C.L.R. 568; Colonial Mutual Assurance Society Limited v. Federal Commissioner of Taxation (1953) 89 C.L.R. 428). It was submitted that where a leasehold interest is granted in consideration of a premzumand a promise to pay rent, the premium is capital expenditure and the rent is revenue expenditure. It was argued that this furnishes an example which may properly be compared with the payments in the present case. However, in the case of the grant of a lease, the rent is closely related to the exclusive use of the land during the period of the payment and will generally cease to run if the lease, for any reason, is terminated. It does not appear to me that it is a true analogy. In the present case the deferred payments are not related to the shares or the use of the rights of occupancy during the period of payment. The most that can be said is that they are related to the mining lease and the production of iron ore therefrom which, in a sense, grew from the rights of occupancy. They will cease to be payable if the iron ore runs out. But I do not think this is enough to give this portion of the so-called "purchase price" the character of revenue expenditure. In the circumstances of the present case, it appears to me that the deferred payments are "for" a capital asset and are expenditure of a capital nature. It is unnecessary to determine whether they were losses or outgoings which fall within the words of either of the first two limbs of s.51(1). My conclusion they are expenditure of a capital nature means that I must hold they are excluded by the latter words of s.51(1). It remains to consider whether the legal expenses amounting to $16,638 incurred in the year ended 31st December 1974 were deductible under s.51(1). I have already stated the circumstances in which they were incurred. It appears to me they were losses or outgoings necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. They were not losses or outgoings of capital. Nor does it appear to me they were losses or outgoings of a capital nature. They did bear a relationship to the deferred payments made to Howmet, which I have concluded were payments of a capital nature. The advice related to the deduction of withholding tax from these payments. But this relationship is, in my opinion, insufficient ao to make the legal expenses an affair of capital. They were / not paid for an asset and they were not incurred in relation to the business entity, structure or organisation set up for the earning of profits (see John Fairfax & Sons Pty. Limited v. Federal Commissioner of Taxation (1959) 101 C.L.R. 30). They were incurred by Cliffs in the course of managing its affairs directed generally to the production of revenue and the avoidance of loss. In my opinion the legal expenses are an allowable deduction under s.51(1). -. The orders I propose are as follows. Appeal allowed. Orders of the Supreme Court set aside. In lieu thereof order that the assessments be remitted to the Commissioner to be amended. Order that the Respondent Cliffs pay to the Appellant Commissioner his costs of the appeal and of the proceedings ' before the Supreme Court, other than the costs of the issue relating to legal expenses in both Courts. I certify that this and the 297 preceding pages are a true copy of the Reasons for Juc; svut herein of his Honour , the Chief Judge, Sir Nigel Bowen Rh inte Associate Dated: Ieper [7 pence ee en nt ee ee te te ke arene a IN THE FEDERAL COURT OF AUSTRALIA WESTERN AUSTRALIA DISTRICT W.A.G. No. 3 of 1977 REGISTRY GENERAL DIVISION ON APPEAL FROM THE SUPREME COURT OF WESTERN AUSTRALIA Between THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA (Appellant) And CLIFFS INTERNATIONAL INC. (Respondent) REASONS FOR JUDGMENT FRANKI J: This is an appeal by the Commissioner of Taxation from a judgment of a single Judge of the Supreme Court of Western Australia. 'the major question involved in the appeal 1s whether certain payments by the respondent, Cliffs International Inc., (Cliffs) referred to as royalties in the notice of assessment issued by the Commissioner and calculated in relation to the weight of iron ore mined and transported were allowable deductions under the provisions of s.51 of the Income Tax Assessment Act 1936 (the Act) for the years ending 31 December 1973 and 31 December 1974. 'The amount involved in this question is $837,137 in the year ended \ 31 December 1973 and $1,176,640 in the year ended 31 December 1974. On 5 March 1962 the Under Secretary for Mines for the State of Western Australia wrote to a company, Basic Materials Co. Pty. Ltd., (Basic) advising that subject to certain conditions, certain temporary mining reserves under the Mining Act 1904 of Western Australia had been approved for a period of two years from a pate nn ee conditions, it was issued with a mining tenement or tenements -2- 1 April 1962 to 31 March 1964. It was common ground before the learned trial Judge that occupancy rights to the temporary reserves were granted to Basic by that letter. The learned trial Judge held that the rights of occupancy gave Basic thé exclusive right to prospect for iron ore and the further right, when it was shown to the satisfaction of the Minister, that iron ore had been discovered on the reserves in payable quantities, to negotiate with him on behalf of the State of Western Australia for a mining tenement to be granted under the Mining Act to mine the iron ore. He also pointed out that the right of occupancy did not give Basic any right to any iron ore discovered upon the reserves. The only way Basic could become the owner of the iron ore, or obtain the right to mine it, was if, after successful negotiations with the Minister pursuant to the applicable = under the Mining Act. These findings were not disputed before us. At the relevant time Basic's shareholding was owned as to 50.1% by Howe Sound Company,whose name was subsequently changed to Howmet Corporation (Howmet),and as to 49.9% by Garrick Agnew Pty. Ltd., (Agnew Co.). In July 1962 The Cleveland-Cliffs' Iron Co., a corporation incorporated in Ohio, United States of America (Cleveland-Cliffs) was approached by Howmet in an endeavour to interest it in the temporary reserves. Cliffs is a corporation incorporated in Cleveland, United States of America and registered as a foreign company in Western Australia and it is a wholly owned subsidiary of Cleveland-Cliffs. The only witness called before the learned trial Judge was Mr. Dohnal, the then managing director of Cliffs. In the latter part of 1962 Mr. Dohnal occupied the position of controller with Cleveland-Cliffs and he gave some oral evidence concerning the a na bene a re el ee -3- matters hereinafter referred to. The learned trial Judge said that Mr. Dohnal had given his evidence very fairly. On 27 November 1962, Cliffs entered into an agreement with Howmet, Agnew Co.and Mr. & Mrs. Agnew, who between them, held*all the shares in Agnew Co. This agreement is of the utmost importance in the determination of this appeal. The central feature of this agreement was the grant to Cliffs in clause four of an option to purchase from Howmet and the Agnew Co., "their entire right, title and interest in all of Basic's capital stocks and shares, for the purchase price set forth below..." The agreement, in clause five, provided that the purchase price referred to in clause four should consist of an "Initial Payment" of two hundred thousand dollars ($200,000) plus "Deferred Payments" equal to 15c(U.S.) per ton of iron ore. Iron ore for the purpose of calculating the payment of 15c per ton was defined as meaning ".,.iron bearing material mined and transported from the Reserves by or with the consent of Basic or its successor in interest..." The agreement further provided that the option could be exercised by written notice from Cliffs to Howmet and Agnew Co. on or before 30 December 1963 and that the purchase should be "consummated" at a specified address and at a date specified in the notice exercising the option (called the closing date) being not less than 20 days but not more than 30 days from the notice exercising the option and the method of "consummation" was to be the making of the Initial Payment by Cliffs to Howmet and Agnew Co.,against delivery to Cliffs of appropriate certificates and assignments, Clause one of the agreement provided that certain representations by Howmet, Agnew Co,and Mr. & Mrs. Agnew to Cliffs, including, that Howmet and Agnew Co, owned the entire equity interest in Basic and that Basic "holds the exclusive rights to occupy and use for the purpose of prospecting for iron hee en Se ee a a -4- ore the temporary reserves numbered 2400H-2417H..." No representation in this clause extended beyond the closing date. By clause two, Cliffs undertook, whether the option was exercised or not, at no expense to Howmet or Agnew Co. to perform certain tasks, but only during the term of the option. These tasks could broadly be described as those of investigating the extent and quality of the reserves and the feasibility of mining and selling ore from the reserves. By clause three Howmet, Agnew Co.,and Mr. & Mrs. Agnew, agreed, so long as they were stockholders of Basic, to cause Basic to do and perform its obligations in respect of the prospecting rights and all parties agreed "to assist Cliffs to secure for Basic, iron ore development and mining rights in the said reserves on such terms and conditions as shall be appropriate for the full development thereof and satisfactory to Cliffs." Although the provisions of clause three were to be effective throughout the option period, and thereafter if Cliffs exercised the option, upon the "consummation" of the purchase neither Howmet, Agnew Co., nor Mr. & Mrs. Agnew would have any power to control any activity of Basic. Clause six permitted Cliffs to designate another corporation registered in Australia, or in the United States of America, to make the purchase provided for in clause four and that if this was done the new corporation should be substituted for Cliffs in the agreement. Clause seven provided that Howmet, Agnew Co.and Mr. & Mrs. Agnew should be free from any costs or expenses in carrying out their obligations under the agreement other than the obligations contained in clause one and the obligation "to deliver at the Closing all the issued and outstanding stock of Basic to Cliffs." nen ene a a ee hs At Nepean Entree emmanuel -5- It is to be noted that Basic was not a party to this agreement and that after the "consummation" the vendors held no interest in any property, or rights of,any description, which related to or concerned any reservations or rights in relation to mining on the relevant temporary reserves. The only rights they retained were the rights to be paid the "deferred payments" and the only obligation that existed after the closing date was that in clause three. Clause nine provided that the agreement constituted the entire agreement among the parties and that it would be governed by and construed in accordance with the laws of the State of New York, United States of America. The learned trial Judge noted that upon payment of the initial payment Cleveland-Cliffs was in a position to transfer the shares owned by Howmet and Agnew Co.itto itself or to a designated transferee, and thus acquire complete control of Basic, and through Basic, the rights of occupancy. He also pointed out that the agreement did not place any obligation on Cliffs to mine iron ore, or cause it to be mined, should it exercise the option and hence, the agreement by itself, did not assure to Howmet or Agnew Co.any deferred payment. The evidence Mr. Dohnal gave was accepted by the learned trial Judge as indicating that the figure of $200,000 appeared to have been arrived at as a recompense for expenditure incurred by Howmet and Agnew Co.in connection with the work they had done in evaluating the deposit for which they wished to be reimbursed, and it also included what was called a finder's fee. The figure of 15c per ton appeared to have been arrived at after a series of discussions and it was a negotiated amount. The major issue as I have said, concerns the question of whether or not Cliffs could deduct the amount of the deferred payments under the provisions of s.51 of the Act. It had been agreed by the parties before the learned trial Judge that the issues upon this question were: Was this expenditure (a) incurred in gaining or producing Cliffs assessable income; (b) necessarily incurred in carrying on a business for the purpose of gaining or producing Cliffs assessable income (c) an outgoing of capital or of a capital nature? On the same date as the option agreement Cleveland-Cliffs entered into an agreement with Agnew Co.which provided that in the event of Cleveland-Cliffs exercising its option, it would i ew ee thereafter, with all convenient speed, form a company or companies (the operating company) to mine, exploit and develop the reserves and to sell the ore obtained therefrom, and that Agnew Co, any company nominated by it should have the right to purchase, and Cleveland-Cliffs undertook that the operating company would offer upon certain terms and conditions, to Agnew Co.7$% of the capital then or at any time or times there- after to'be subscribed in the operating company. It is to be noted that this agreement did not require Cleveland-Cliffs to conduct any mining. The option was exercised in December 1963. Prior to completion Cleveland-Cliffs designated Cliffs to make the purchase on its behalf and a company Mt. Enid Iron Ore Pty. Ltd., (Mt. Enid) resolved to accept an offer to purchase from Agnew Co., its shares in Basic and this purchase proceeded to completion. On 17 January 1964, the option was completed and all shares in Basic were transferred to Cliffs and Mr. Dohnal on behalf of Cleveland-Cliffs. On 18 March 1964, the shareholders of Basic met and resolved that the company acknowledged that the rights of occupancy were held in trust for Cliffs. On 18 November 1964, the State of Western Australia a en pe a le TN Rl LA AAR ee BA ce oe ee NE A ten enn chee ee _- { _ passed an Act of Parliament called the Iron Ore (Cleveland-Cliffs) Agreement Act No. 91 of 1964 and the effect of this Act was, inter alia, to provide for the continuing exploration by Basic of the temporary reserves with a view to mining the reserves and during the continuance of the exploration, its rights of occupancy were confirmed up to 31 December 1965 and thereafter until application for a mineral lease or the termination of the agreement or the abandonment thereof. On 21 October 1965 it was resolved at an extraordinary general meeting of the shareholders of Basic that it be wound up voluntarily and that the liquidator be authorised to divide all or such parts of the assets of the company as he saw fit amongst the members of the company in specie. At that time the only assets of the company were the rights of occupancy which it had already declared it held in trust for Cliffs and its interest in the Agreement with the State of Western Austraiia. On 19 November 1965 by agreement between the State of Western Australia, Cliffs and Basic, Cliffs undertook as from that date to be bound by the terms of the agreement with the State, of 18 November 1964, and Basic was released by the State from any further performance of its obligations under that agreement. On 7 December 1965 Basic assigned to Cliffs all of its interests in that agreement and its right of occupancy and from that time onward Basic ceased to play any part. I do not consider it necessary to trace the subsequent events in detail but the Iron Ore (Cleveland-Cliffs) Agreement Act 1964 was amended by Acts No. 35 of 1970 and 68 of 1973. Ultimately mining proceeded on the reserves and it was carried on by a joint venture which paid a royalty to Cliffs. I pass now to consider the main question in issue of whether the so called "deferred payments" are allowable an a ee epee -~-8- deductions under s.51(1). It is convenient to commence by considering the questions posed by Fullagar J., in Colonial Mutual Life Assurance Society Ltd. v. Federal Commissioner of Taxation (1953) 89 C.L.R. 428 at p.454. The two questions were: 1) What is the money really paid for? and, 2) Is what it is really paid for, in truth and in substance, a capital asset? eavans en marae The correct approach to a consideration of these questions has i been formulated by the Privy Council first in Inland Revenue Commissioner v Europa Oil (N.Z.) Ltd,, 1971 A.C. 760 (Europa No.1) and in Europa Oil (N.Z.) Ltd., v. Inland Revenue Commissioner 1976 1 W.L.R. 464 (Europa No. 2). The majority judgment in Europa No. 1 at p.771 referred to Inland Revenue Commissioners v. Duke of Westminster 1936 A.C. 1 and reiterated that in a matter of taxation it is necessary to consider and respect the legal form of a transaction. At p.772 it was noted that the Crown was not bound by the taxpayer's statement of account, or by the heading under which the expenditure is placed, but is entitled to ascertain for what the expenditure was in reality incurred. In Europa No. 2, the majority explained the use of the expression "for what the expenditure was inreality incurred" used in Europa No. 1 and at p.472 said:- { "Taken in isolation this might be thought to suggest | that the court was entitled to look behind the legal character of a payment made pursuant to the ' provisions of a contract and to take into account economic benefits which would in fact accri> to the taxpayer otherwise than as a matter of contractual right. Any such suggestion h inowever, already been emphatically repudiated ine 'eceding ea - ee ee a ew ee ee eee 8 - — -9- paragraph in which Inland Revenue Commissioners v. Duke of Westminster (1936) A.C. 1 had been referred to as authority; ,and the repudiation was repeated in the same paragraph as that in which the passage which their Lordships have just cited appears. Its concluding sentence is: 'Taxation by end result, or by economic equivalence is not what the section achieves.! Read in this context it becomes clear that the reference to 'reality' was directed only to the legal character of the payment and not to its economic consequences. All that was meant was that the court was not bound by the description, such as 'price of goods',attached to it in the taxpayer's own accounts or in a particular contract, if upon an analysis of the contractual arrangements taken as a whole under which the payment was made it appeared that its true legal character did not accord with that description." Earlier in the judgment the following appeared:- "| ..that it is not the economic results sought to be obtained by making the expenditure that is determinative of whether the expenditure is deductible or not; it is the legal rights enforceable by the taxpayer that he acquires in return for making it." In considering whether or not the payments referred to in the option agreement as "deferred payments" are deductible under s.51, I consider the critical question is whether or not they are outgoings of a capital nature, because if they are, it matters not whether they are incurred in gaining or producing assessable income or are necessarily incurred in the carrying Seve nee en a en i i nt ce eet en -10- on of a business for the purpose of gaining or producing such an income. That in the agreement they are called "deferred payments" is not conclusive if in reality, they are something else (see Europa No. 2 at p.472, Minister of National Revenue v. Spooner 1933 A.C. 684 at p.688 and Ralli Estates Ltd. v. Commissioner of Income Tax 1961 1 W.L.R. 329 at p.334). In whatever way these payments are examined I consider that whether they be called "deferred payments" or royalties or given any other name they are still payments made as part of the purchase price of the shares. In many cases the courts have had to look at the question of whether payments spread over a period of time were allowable deductions under s.51 or similar sections, and usually the most important matter to be considered has been whether the payments were made for the acquisition of a capital asset. This test has been expressed in several ways.In Poole and Dight v. The Federal Commissioner of Taxation (1970) 122 C.L.R. 427, Walsh J., at p.436 said: "But in my opinion the basic question for decision is whether or not the true character of the payments is that they are made as the consideration for the acquisition of a capital asset." In Sun Newspapers Ltd., and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1958) 61 C.L.R. 337 Latham C.J. said at p.354: "The most authoritative decision upon the question is British Insulated and Helsby Cables Ltd. v. Atherton (1926 A.C. at pp.213, 214), where Viscount Cave said: 'But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special, circumstances leading to an opposite conclusion) te ee ee me ee ee -ll- for treating such an expenditure as properly attributable not to revenue but to capital." The words in this passage, "an asset or an advantage for the enduring benefit of a trade" were also mentioned by Dixon J., at p.361 and referred to as "... a phrase which by constant use had almost become a formula." This passage has been cited as a test in many cases, for example, Hallstroms Pty. Ltd. v. Federal Commissioner of Taxation (1946) 72 C.L.R. 634 at pp.641, 643, and 653-654; Associated Portland Cement Manufacturers Ltd. v. Inland Revenue Commissioners 1946 1 All E.R. 68 at pp.71 and 74; W. Nevill & Co. Ltd. v. Federal Commissioner of Taxation (1937) 56 C.L.R. 290 at p.299; Regent Oil Co. Ltd. v. Strick 1966 A.C. 295 at pp.319, 320, 328, and 343, 344. In John Fairfax & Sons Pty. Ltd. v. Federal Commissioner of Taxation (1959) 101 C.L.R. 30 at p.36, after citing the abovementioned passage Dixon C.J., said:- "That is an affirmative proposition. But it is hardly necessary to say that it is a logical fallacy to turn it around ané say that an expenditure cannot be attributable to capital unless it is made once for all and is made with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade. Nor did Viscount Cave L.C. mean to say that no expenditure falling outside this proposition could be of a capital nature." I am satisfied that if one applies the test whether or not the relative payments were made "...with a view to bringing into existence an asset or advantage for the enduring benefit of a trade" it is clear that they were and I consider that they were of a capital nature. They were part of a transaction which was a sale and purchase of shares and they ee ee = ee eee - eee ca a ee ne oe re ane - 12 - ; are part of the purchase price. .I consider that it is not to the point to say that this makes the purchase price uncertain or to attempt to advance any distinction between consideration and price. I pass next to consider whether any different conclusion flows from the fact that no payments would be made if no mining eventuated, or that the payments are on an annual basis and for an uncertain period, dependent, firstly on the amount of iron ore mined and transported, secondly on the life of the mine, and thirdly on the period of the relevant mining leases. . In Minister of National Revenue v. Spooner 1933 A.C. 684 the Privy Council was considering a case where the respondent sold all her right, title and interest in land which she owned in freehold to a company in consideration of a sum in cash, shares in the company, and an agreement to deliver to her 10% (described as a royalty) of oil produced from the land, on which the company covenanted to carry out drilling and, if oil was found, pumping operations. It was held that receipt by the respondent of the amount described as a royalty, which was in fact discharged, by agreement, by the receipt by her of 10% of the gross proceeds of the oil produced, was of a capital nature. At p.688 their Lordships said:- "The transaction was one of sale and purchase. It may have taken the form which it did because of the uncertainty whether oil would be found by the purchaser or not; as the value of the land depended on this contingency the price, not unnaturally, was made to depend in part on the event." I have referred to this case because, notwithstanding the manner in which the consideration was payable, the transaction was held to be one of sale and purchase, In Colonial Mutual Life Assurance Society Limited Vv. Federal Commissioner of Taxation (1953) 89 C.L.R. 428, a vendor agreed to transfer to the appellant a piece of land adjoining land owned by the appellant in consideration of a promise by the appellant to pay to the vendor, for a period of 50 years an amount equal to 90 per cent of all rents, as and when received, from lessees or tenants of three shops and a basement in a new building to be erected on both blocks of land. It was held that the annual payments were an outgoing of a capital nature and not deductible under s.51(1) of the Act and this was so, notwithstanding that the court in another case (1949 A.L.R. 438) held that the same annual payment was taxable in the hands of the recipient. Williams A.C.J. at p.445 said that it was impossible to distinguish the facts from those in Delage v. Nugget Polish Co. Ltd. (1905) 92 L.T. 682 and Tata Hydro-Electric Agencies Ltd., Bombay v. Commissioner of Income Tax, Bombay Presidency and Aden 1937 A.C. 685. Without dealing with the facts of this latter case, it involved annual payments and, at p.695, Lord MacMillan who delivered the judgment of their Lordships, said, 1n considering a section of the Indian Income Tax Act which allowed a deduction of certain expenditure 'not being in the nature of capital expenditure': "In short, the obligation to make these payments was undertaken by the appellants in consideration of their acquisition of the right and opportunity to earn profits, that is, of the right to conduct the business, and not for the purpose of producing profits in the conduct of the business." Returning to the judgment of Williams A.C.J. in Colonial Mutual Life Society v. Federal Commissioner of Taxation, et mm re Re Et ~14- his Honour concluded (at p.448) by saying:-~ "The present case seems to be one in which it is proper to apply the test laid down by Lord Clyde in Robert Addie & Sons' Collieries Ltd. v. Commissioners of Inland Revenue (1924 S.C. 231): Are the sums in question part of the trader's working expenses, are they expenditure laid out as part of the process of profit-earning; or, on the other hand, are they capital outlays, are they expenditure necessary for the acquisition of property or of rights of a permanent character the possession of which is a condition of carrying on the trade at all? The acquisition of land is an acquisition of property of the most permanent character and the acquisition of the Just Brothers! land was a condition of erecting the new building and carrying on there the business of letting shops and offices and other space." Fullagar J., at p.454 said that it was incontestable that the monies were paid in order to secure a capital asset. At p.459 his Honour said:- "Here we have a transaction of a purely business nature, in which it may be safely assumed that two parties, bargaining on equal terms, had full regard to the value of the land and the probable value of the consideration. According to the documents the periodical payments are the price for which the land is being bought, and no reason can be suggested for not giving to the ee ee ee ee He ee ee -15- documents their full literal effect.. The transaction might perhaps have taken a form under' which parts of the total payments to be made were, or could be, treated as interest on deferred payments of a price. But it did not take any such form. As matters stand, the total of the payments is simply the total price of the land." I am satisfied that the "deferred payments" in issue, are payments made for the purchase of a capital asset namely, the shares in Basic and are not allowable deductions under s.51(1). The shares were undoubtedly an asset for the enduring benefit of the appellant, indeed it was only through that acquisition that the appellant acquired the opportunity to mine. In my opinion even if the word royalties had been used instead of the expression "deferred payments" I would still have considered that such payments were not allowable deductions under s.51. A further question arose in respect of the financial year ended 31 December 1973 with regard to what were called Exchange Losses of $39,610 and unrecouped losses of $176,120. However it was agreed before the learned trial Judge that both these amounts were deductible if the "deferred payments" were deductible. Before us the appeals also proceeded on that basis. The oniy other question for our consideration is whether an amount of $16,658 in respect of legal expenses incurred in obtaining advice concerning the taxation position in relation to the deferred payment to Howmet was an allowable deduction for . the year ended 31 December 1974. -~16- These expenses arose because, after Cliffs advised the Commissioner that it was making the deferred payments to Howmet, the Commissioner wrote requiring Cliffs to retain an amount in respect of income tax pursuant to the provisions of ss.255 and 256 of the Act. Howmet objected to.this and demanded payment of the full amount of deferred payments. I consider that the payments were necessarily incurred in carrying on business for the purpose of gaining or producing assessable income. Although they were related to the liability to deduct tax from payments made by Cliffs which are outgoings of capital or of a capital nature so far as Cliffs were concerned, I do not consider that it can be said that the legal expenses themselves were outgoings of capital or of a capital nature. I would allow the appeal and set aside the orders of the Supreme Court. In lieu thereof I would order that the assessments appealed from should be remitted to the Commissioner to be amended and that the respondent pay to the Appellant Commissioner his costs.of the appeal and of the proceedings before the Supreme Court, other than the costs of the issue relating . to legal expenses in both Courts. 1S I certify thet this and the preceding pages are a true copy of the Reasons for Judgment herein of his Honour x Associate " Ree ee ee IN THE FEDERAL COURT OF AUSTRALIA ) -) WESTERN AUSTRALIA DISTRICT REGISTRY) W.A. No. G 3 of 1977 ) GENERAL DIVISION ) ON APPEAL FROM THE SUPREME COURT OF WESTERN AUSTRALIA BETWEEN: THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Appellant AND: CLIFFS INTERNATIONAL INC. Respondent CORAM: BOWEN C.dJ., FRANKI and BRENNAN JJ. JUDGMENT BRENNAN J.: Cleveland-Clifis Iron Company and its wholly owned subsidiary Cliffs International Inc., the taxpayer respondent, were incorporated in the U.S.A. I shail call them respectively Cleveland-Cliffs and Cliffs. They are so described in certain statutes of Western Australia next to be mentioned. The Iron Ore (Cleveland-Cliffs) Agreement Act, 1964 as amended by the Iron Ore (Cleveland-Cliffs) Agreement Act Amendment Acts of 1970 and 1973 authorized the grant to Cliffs of a mineral lease over a substantial area of land in which there are significant iron ore deposits. Cliffs does not mine the deposits; it granted a sub-lease and assigned its contractual interests (subject to an immaterial reservation) to a consortium which mines the deposits and pays Cliffs a royalty calculated at specified rates upon iron ore produced by or for the participant members of the consortium and sold or shinped for sale or commercial use from defined areas which include the area of the mineral lease. A subsidiary of Cleveland-Cliffs is one of the participants but the other participants are unrelated ./2. ee ee ee ee ee ee ene ae ee ee corporations. The participants' payments of royalty constituted the principal part of Cliffs' assessable income for the years ended 31st December, 1973 and 31st December, 1974. Cliffs claimed to deduct from its assessable income for those respective years payments described by it as "royalties" but more accurately described as "deferred payments", certain payments associated with the deferred payments, and payments made during the 1974 year in respect of legal advice concerning retention of tax [rom payments remitted overseas by Cliffs to a foreign corporation. The Commissioner assessed Cliffs to tax without allowing the claimed deductions. Cliffs objected unsuccessfully and requested the Commissioner to treat its objections as appeals and to forward them to the Supreme Court of Western Australia. The Supreme Court allowed the appeals and varied the assessments by reducing the taxable income by $1,052,867 in respect of the 1973 income year, and by $1,193,278 in respect of the 1974 income year. The appellant Commissioner appeals by leave of this Court against the order of the Supreme Court. The deductibility of two classes of payments falls for decision: the deferred payments paid by the respondent in each of the income years, and a sum of $16,638 paid for legal advice and services in the 1974 year. There are some losses (described as "exchange losses" and "unrecouped losses") included in the deduction of $1,052,867 allowed by the Supreme Court in respect of the 1973 income year but, by agreement of the parties, the deductibility of these losses depends upon the deductibility of the deferred payments. The deferred payments were made during the income 1.2/3. years 1973 and 1974 to Mt Enid Iron Co. Pty. Ltd. of Perth, Western Australia, and to Howmet Corporation of Connecticut, U.S.A. The amounts paid to them were calculated at a rate provided for in an agreement of 27th November. 1962. That agreement, called the Option Agreement, is described in more detail hereafter. The rate at which the deferred payments were made is 15 cents (U.S.) per ton of iron ore mined and transported from an area, previously a Temporary Reserve under the mining laws of Western Australia, which is now part of the area mined by the consortium. The payments are made half yearly upon the tonnage of iron ore mined and transported from the reserve area during the preceding six months. The payments are thus proportionate to the quantity of iron ore mined and transported from the reserve area and are payable at specified intervals of time within a given year of income. The payments so made by Cliffs were treated as expenditure in Cliffs income and expenditure account - an account which accompanied and formed part of its return of income for the years in question. The source of the obligation to make the payments is the Option Agreement. The history of the Option Agreement and of the obligation to make the deferred payments commences with the grant of a right of occupancy by the Minister for Mines of Western Australia to Basic Materials Pty. Ltd. (hereinafter called Basic) over certain Temporary Reserves, 246 square miles in area, for the purpose of prospecting for iron ore. A right of occupancy is a statutory right which may be granted by the Minister for Mines pursuant to ss.276 and 277 of the Mining Act, 1904 of Western Australia. The learned Judge of the Supreme Court described the effect of the relevant provisions of the Mining Act: .-/4. fend een "The vrovisions of s.267 so far as material, enable the Minister to reserve temporarily any Crown land From occuvation, that is from occupation pursuant to the cther provisions of the Mining Act, but such reservation must be confirmed by the Governor within 12 months and if not so confirmed, then the land ceases to be reserved. The Minister may, again with the approval of the Governor, authorise any person to temporarily occupy any such reserve on such terms as he may think fit but subject to the provisions of s.277. The provision of that section so far as material, provide that a right of occupancy may be granted for a period in excess of one year but, in that event, the Minister shall cause the terms and conditions relating Lhereto to be laid on the table of each House of Parliament within 14 days of the granting. Further, a right of occupancy granted for any fixed period may be renewed from time to time for any term not exceeding 12 months on each occasion of renewal, but 1f any such renewal is granted then the Minister shall cause the terms and conditions relating thereto to be laid on the table of each house of Parliament within 14 days of the granting of the renewal." The Minister granted the right of occupancy to Basic in April, 1972 over an area described as Temporary Reserves Numbers 2400H to 2417H (inclusive). He imposed a condition that no transfer of the "authority to occupy" (sic) would "be permitted without the approval of the Minister for Mines first obtained". The right of occupancy was 3 valuable asset (Delhi International Oil Corporation v. Olive (1973) W.A.R. 52), although -— having regard to the provisions of the Act with respect to the grant of mining leases - 1t conferred no right upon Basic to the grant of a lease over any of the area in respect of which the right of occupancy was granted in the event of the discovery of a deposit of 1ron ore (Cudgen Rutile (No. 2) Ltd. v. Chalk (1975) A.C. 520). However, it did confer rights according to the tenor of the document and the statute (as to which see J.D. & Wm.G. Nicholas and Others v. State of Western Australia and Others (1972) W.A.R. 168), and it gave to the Fe = ne er er ee ae ee err ee ee inne ae — «ne ee oe holder an expectation of the grant oy a mining lease, and perhaps an expectation that a mining tenement of a special kind would be authorized by a special Act, if a commercial deposit of iron ore should be discovered. By November, 1962 the prospect of developing a commercial deposit was established, but much remained to be done before a mining programme could be resolved upon and before the evaluation of the deposit was complete. By that time Cleveland-Cliffs had become interested in the deposit and it negotiated an agreement with the then shareholders of Basic for an option to purchase the shares in Basic. This is the Option Agreement of 27th November, 1962. The two shareholders of Basic were the Howe Sound Company (which has since changed its name to Howmet Corporation, earlier referred to), and Garrick Agnew Pty. Ltd., a company incorporated in Western Australia. The Howe Sound Company (which I shall call Howmet) held 50.1% of the 1ssued capital of Basic and Garrick Agnew Pty. Ltd. held 49.9%. The Agreement conferred upon Cleveland- Cliffs an option to purchase the vendors' "entire right, title and interest in all of Basic's capital stock and shares for the purchase price set forth ... to be exercised by written notice ... on or before December the Tharty-First, One Thousand Nine Hundred and Sixty-Three". The option was exercised in the manner provided for in the Option Agreement. The agreement required that on the date of the completion of the sale effected by the exercise of the option (called, in the language of the Option Agreement, the "closing") an initial payment of $200 , 000 (U.S.) should be paid to the vendors as part of the purchase price. The balance of the purchase price was dealt with in Article 5 of the Option Agreement in the terms following' ../6. ee eee ee pe te ee ee | woe ee ee nee. wos ee ne ee ree en ree ee ere en: - 6. "5. The Purchase Price referred to in Article 4 shall consist of an Initial'Payment of TWO HUNDRED THOUSAND DOLLARS $200,000 (US), payable in good New York or Cleveland, Ohio funds by certified or official bank check at the Closing of the purchase hereinabove referred to, plus Deferred Payments equal to 15¢ (US) per ton of Iron Ore payable as in this Article 5 set forth. Such 15¢ per ton payments (hereinafter sometimes called "Deferred Payments") shall be computed and paid as follows: (a) "Iron Ore" shall mean iron bearing material mined and transported from the Reserves by or with the consent of Basic or its successor in interests, whether or not such iron ore shall have been dried, roasted, burned, sintered, crushed, ground, concentrated, pelletized, agglomerated or otherwise beneficiated or processed or prepared prior to sale or consumption, but iron bearing material of low grade may be sold for construction purposes without any liability to pay any Deferred Payments with respect thereto. (b) A "ton'' shall be a gross ton of 2,240 pounds avoirdupois weight in the form and at the time transported from the Reserve. Reports as to the weight of any such Iron Ore made by . any common carrier trucker, railroad or vessel operator shall be conclusive for all purposes hereof. In the absence of such reports, reports thereof by Basic or its successor in interest shail, unless fraud is involved, be conclusive on each party hereto unless challenged in writing within thirty days after receipt of such report by such party; (c) Within ninety days after June thirtieth and December thirty farst of each year Cliffs shall make or cause to be made to Howe and Agnew Company a report of the tons of Iron Ore mined and transported from the Reserves during the semi-annual period then ended, together with payment by check drawn on good United States funds of their respective participations in the Deferred Payments with respect thereto. Subject to the provisions of paragraph (b) of this Article, in the event Howe or Agnew Company does not object in writing to the computation of such amount within ninety days after receipt of such report, such report shall be binding and conclusive upon the parties, unless fraud 1s involved. (d) For purposes of this Article 5, iron bearing material mined from the Reserve shall be considered as still located at the Reserve so long as it 1s located at any plant in Australia for the purpose of drying, roasting, l./7. ae at. me te 7. burning, sintering, crushing, ,grinding, concentrating, pelletizing, agglomerating or otherwise beneficiating or processing or preparing prior to its sale or consumption, The initial Payment will be in the form of a check payable jointly to Agnew Company and Howe, and tne Deferred Payments will be paid in cash or by check in the proportion of 50.1% to Howe and 49.9% to Agnew Company." By Article 6 of the Option Agreement, Cleveland- Cliffs was entitled to designate another corporation "to make the purchase" of the Basic shares. It designated Cliffs to make the purchase and, in accordance with the terms of Article 6, Cliffs was substituted for Cleveland-Cliffis "as though it were an original party". Cliffs paid the Initial Payment of $U.8S.200,000 and took the transfer of the vendors' shares in Basic. The closing took place on 17th January, 1964, Before the closing, however, Garrick Agnew Pty. Ltd. sold 1ts shares in Basic to Mt Enid Iron Co. Pty. Ltd. According to the terms of admission made by the respondent, Mt Enid "thereby acquired all the right, title and anterest claim and demand whatsoever of Garrick Agnew Pty. Ltd. in and to the Option Agreement". At the closing therefore, the position stood thus: Howmet and Mt Enid, the owners between them of all the issued capital of Basic, sold and transferred their shares to Cliffs, receiving their respective proportions of the Initial Payment of $200,000 (U.S.) and the benefit of Cliffs' contractual obligation to make deferred payments in accordance with Article 5. The payments made by Cliffs in accotdance wath Article 5 to Howmet and Mt Enid in the 1973 and 1974 years are the deferred payments which the Commissioner disallowed 'as deductions. Some months after the closing, namely on 18th 12/8. a _ mer ee ae ee ee November, 1964, Basic and the Premier of Western Australia acting for and on behalf of that State entered into an agreement which was designed to govern the mining of the iron ore deposits in the area of the Temporary Reserves and the development of various associated works and facilities. The agreement was approved by the Iron Ore (Cleveland-Cliffs) Agreement Act, 1964, The terms of the agreement between Basic and the State were necessarily complex. It sulfices, however, to say that the agreement provided that, if Basic shouid perform the onerous obligations accepted by it, the State bound itself to grant 1o Basic a mineral lease for the Mining of iron ore. The provisions of the agreed mineral lease went beyond those authorized by the Mining Act, 1904 as amended. The area, term and conditions of the agreed mineral lease were more appropriate for a large mining undertaking than the area, term and conditions of the ordinary mining lease provided for in the Mining Act. Cliffs decided that it, rather than its subsidiary Basic, should hold the mineral lease and be substituted for Basic as the party bound by the agreement with the State. On 21st October, 1965, at an extraordinary general meeting of Basic, special resolutions were passed as follows: Ci) That the Articles of Association of the Company be amended by adding the following Article to stand as Article 128 'If the Company shall be wound up whether voluntarily or otherwise the Liquidator may with the sanction of a Special Resolution divide among the contributors in specie or kind any part of the assets of the Company and may with the like sanction vest any part of the assets of the Company in trustees upon such trusts for the benefit of the contributors or any of them as the Liquidator with the like sanction shall think f1t' .../9. wwe ee ee ne ree tr ree ae nnn ee een sees, (ii) That the Company be wound up voluntarily and that Eric Joseph Hurst of 25 William Street Perth Western Australia be appointed Liquidator for the purpose of such winding up. (111) That the Liquidator be and is hereby authorised to divide all or such part of the assets of the Company as he shall think [it amongst the members of the Company in Specie" As the sole owner of the shares in Basic, Cliffs was entitled "to bring into existence, certainly and without any Significant delay, a raght in its own favour" to the nett assets of Basic (see per Kitto J. in Davis Investments Ptv. Ltd. v. Commissioner of Stamp Duties (N.S.W.) (1958) 100 C.L.R. 392 at po. 413, 414). By procuring the passage of the special resolutions by Basic, and the distribution of Basic's assets to it in specie, Cliffs exercised the vower which it had acquired by the purchase of Basic's shares. However, before it could secure to itself and in its own name the benefits of the agreement which Basic had with the State, it was necessary for Cliffs to be substituted for Basic — a substitution provided for in clause 13 of the agreement with the State of 18th November, 1964. Accordingly, on 19th November, 1965, an indenture was executed by the State, Cliffs and Basic whereby, inter alia, the State released Basic from its agreement and accepted Cliffs as the covenantor in the place of Basic. By deed dated 7th December, 1965, Basic assigned to Cliffs the benefit of Basic's agreement with the State. The substitution of Cliffs for Basic was recited in the preamble to the variation agreement scheduled to and approved by the Amendment Act of 1970: "By virtue of various agreements under seal the Company is now entitled to all the right title interest claim and demand whatsoever of Basic in and under the Agreement and by virtue of deed of covenant with the State has assumed the obligations of Basic thereunder" 2.10. te ae te 10. By the 1970 Amendment Act and by the 1973 Amendment Act, certain variations of the agreement of 18th November, 1964 were approved, the significant variation being the authority to grant the mineral lease on the terms slatutorily approved to Cliffs instead of to Basic. Cliffs, having become entitled to the benefit of the mineral lease, entered into an agreement dated 25th May, 1970 whereby it agreed to grant to the participants the mineral sub-lease earlier referred to. It 1s unnecessary to mention the sundry provisions of this agreement which related io Cliffs! interests in its agreement with the State and its interests 1n certain other agreements compendiously described as "Robe River Rights". It is sufficient to refer to clause 6(d) by which each of the particapants undertook to pay to Cliffs "as royalty on Iron Ore produced by and for such Participant and sold or shipped for sale or commercial use" from the area defined an amount calculated at specified rates. The receipt of the agreed royalties appears to be Cliffs' principal business, and the royalties constitute the principal part of its assessable income. There is, at all events, no other business and no other income which might relevantly be regarded for the purpose of determining whether the claimed deductions fall within s.51(1). The deferred payments are made by Clifis to Howmet and Mt Enid in an amount arrived at by applying the rate specified in the Option Agreement to the tonnage of iron ore mined and transported from thé area which was comprised in Temporary Reserves numbered 2400H to 2417H. The royalties paid to Cliffs by the participants are calculated on a different basis, and are payable in respect of ore won fiom Lee /It. a te a ee ee Ate ee ii. areas some of which were and some of which were not comprised in Temporary Reserves numbered 2400H Lo 2417H. Although there is no necessary correspondence between the tonnages used in calculating the royalties payable by the participants to Cliffs on the one hand, and in arriving at the amount of the deferred payments to be made by Cliffs on the other, frequently in practice the tonnage upon which a deferred payment by Cliffs is calculated will have attracted the payment of royalty to Cliffs. Of course, the participants mine, treat, transport and sell the ore: Cliffs engages in none of the activities which quantify the royalties payable to it or the deferred payments payable by it. The participants' carrying on of their mining business quantifies the royalties and the deferred paymenis, and effecis an entitlement in Cliffs to the royalties and a Liability in Cliffs te make the deferred payments. When the tonnages of ore are common to the computations of royalties and deferred payments, the entitlement to assessable income is accompanied by a liability to make the deferred payments. Such a concurrence of entitlement and liability warrants enquiry to ascertain whether the occasion of the outgoing is to be found in what is productive of assessable income and whether the outgoing thus falls within one of the limbs of s,51(1) (see Ronpibon Tin N.L. and Tongkah Compound N.L. v. Federal Commissioner of Taxation (1949) 78 C.L.R. 47 at p. 57). Concurrence of entitlement and Liability arising from the carrying on of the participants' business does not without more determine the application of s.51(1). The outgoing must be relevant to Cliffs' income—producing activities (Amalgamated Zine (De Bavay's) Ltd. v. Federal Commissioner of Taxation (1935) 54 C.L.R. 295 at p. 309). .../12. a erm oennen en Ohne mee mene ner ment nen nt emeen: ce te rte cht en heen 12. To ascertain the relevance of an outzoing to the gaining or producing of assessable income, it is necessary to examine the nature of the outgoing. What is it for? The question 1s necessarily to be answered not only to ascertain the applicability of either of the limbs of s.51(1), but to ascertain whether the proviso deprives the outgoing of deductibility. The acquisition of an asset for use in gaining or producing assessable income provides a link of relevance between the outgoing incurred to acquire the asset and the gaining or producing of assessable income, even in some cases where the asset is a capital asset (see Poole v. Federal Commissioner of Taxation (1970) 122 C.L.R. 427 at p. 435), although in cases where the outgoing is capital or of a capital nature the outgoing falls within the proviso and thus is not deductible. When an outgoing is incurred to acquire an asset, and the deductibility of the outgoing under s.51(1) 1s in issue, the use to which the asset is or is intended to be put is one relevant consideration, the nature of the asset is another. Both considerations start with the identification of the asset acquired. Cliffs undertook the obligation to make the deferred payments as part of the purchase price for the shares in Basic. The deferred payments made in discharge of that obligation may therefore be said to have been made to acquire the shares in Basic. So abbreviated and simplistic an analysis of the facts does not reveal "what the expenditure is calculated to effect from a practical and business point of view", to adapt the phrase of Dixon J. in Hallstroms Pty. Ltd. v. Federal Commissioner of Taxation (1946) 72 C.L.R. 634 at p. 648; nor does it take account of the legal rights ./13. roe en ee 13. which ownership of the shares conferred. Such an analysis, if accepted, would deny' deductibility to the deferred payments, because they fall outside either of the limbs of s.51(1). The shares themselves were not used, and were not intended to be used, in gaining or producing assessable income or in carrying on any business for the purpose of gaining or producing such income. Indeed, the shares went out of existence on the dissolution of Basic. The shares - as distinct from the assets to which those shares gave access - are neither incidental nor relevant to any income-producing activity undertaken by Cliffs. The owners of the shares did not have, and could not transfer, any right to the iron ore which lay within the area of the Temporary Reserves, or any right to mine that ore. The vendors of the shares thus had no asset in respect of which royalties could be exacted (see Commissioner of Taxation v. Sherritt Gordon Mines Ltd. (H.C.A.) 20th September, 1977; Barrett v. Commissioner of Taxation (1968) 118 C.L.R. 666). Although the amount of the deferred payments is quantified by reference to the ore which is mined and transported, the right to mine and transvort is not a right which was attached to the shares or incidental to their ownership. Yet it 1s not to be doubted that when Cliffs purchased the shares 1t did so with a view to acquiring the right to mine if it should be commercially feasible to do so. The preferable analysis would ideniify the relevant asset for which the-obligation to make the deferred payments was undertaken as the nett assets of Basic. At the closing Cliffs acquired the power to secure those assets to itself and 1n its own name whenever it should choose to do so, and the acquisition of the shares was, and was intended to be, merely 1/14. i te 14. the conduit through which Basic's assets should flow to Cliffs. There is nothing in the judgments in Steinberg v. Commissioner of Taxation (1975) A.L.dJ.R. 42 which, in my view, would deny validity to this analysis. When Cliffs acquired the mineral lease, and the other rights arising under the 1964 Act, it retained these assets (subject to the variations effected by the Agreements subsequently approved by the 1970 and 1973 Acts) and exploited them by entering into the agreement of 25th May, 1970 with the Participants. The mineral lease and the other rights arising under the several Acts of Western Australia are used in gaining Cliffs' assessable income, and the payments made to acquire these assets therefore fall within the positive provisions of s.5i(1), and are therefore deductible unless the proviso excludes them from the operation of the section. The payments are made recurrently, in amounts which vary with the mining and transportation of the relevant tonnages of ore; the payments do not go in discharge of a fixed liability; the payments will, or may, be payable for as long as the participants carry on their mining business and pay to Cliffs the royalties payable on the ore which 1s mined and sold. These are indicia of an outgoing on revenue account, but they are not the relevant criteria for determining whether or not the deferred payments are of a capital nature. When an outgoing is incurred to acquire an asset, the nature of the outgoing is determined by the nature of the asset acquired. "If the nature of what is acquired makes it a capital asset the payment for it w11l be a capital payment'', said Lord Morris of Borth-y-Gest in Strick (Inspector of Taxes) v. Regent OijJ Co. Ltd. (1966) A.C. 295 at p. 333. Kitto J., in Cooper v. Federal Commissioner ./18. 15. of Taxation (1957) 97 C.L.R. 397 at p. 404 (affirmed on other grounds 100 C.L.R. 131) stated the rule, applicable in the ordinary case of a payment for an asset of a capital nature, to be that "the purchase of a capital asset requires the conclusion that the consideration paid, whether in one sum or in several and whether at one time or over a period, is an outgoing of a capital nature". There may, of course, be difficulty in characterizing the asset acquired by the payment, as the Oil Company cases illustrate (Bolam v. Regent Oil Co. Ltd. (1956) 37 T.C. 56; Strick (Inspector of Taxes) v. Regent Oil Co. Ltd. (1966) A.C. 295; B.P. Australia Ltd. v. Commissioner of Taxation (1966) A.C. 224; (1964) 110 C.L.R. 387; Mobil Oil Australia Ltd. v. Commissioner of Taxation (1966) A.C. 275; (1964) 110 C.L.R. 419). But once it is established that the asset acquired is of a capital nature, the payment made to acauire the asset is shown to have the nature of the asset acquired. In seeking the nature of the payment, regard must be had not so much to the , circumstances attendant upon the payment as to the asset for which the payment is made. If payments be recurrent or veriodic or variable in amount, the asset thereby acquired may more readily be thought not to be of a capital nature. The recurrence, periodicity or variation in the payments do not in themselves determine the nature of the payments, but they may throw light upon the nature of the asset acquired and thus upon the nature of the payments made for the asset in question. The criteria referred to by Dixon J. in Sun Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 61 C.L.R. 337 at p. 363, refer to "the character of the advantage sought" by the making of the payment. There are, his ./16. i te ee ee, 16. Nonour said: "three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it 41s to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment." When a payment is made periodically and particularly when the payment is not made in partial discharge of a fixed purchase price, a question will frequently arise as to whether the payment is made merely to acquire the "use o1 enjoyment" of an asset "for periods commensurate with the payment". But where it is clear that the payment, however made, is made to acquire an asset of a capital nature, the payments are likewise of a capital nature. 'In Colon1zal Mutual Life Assurance Co. Ltd. v. Federal Commissioner of Taxation (1953) 89 C.L.R. 428 at p. 454, Fullagar J. said of the payments made as the price of acquiring an asset: "ITE does not matter how they are calculated or how they are payable, or when they are payable, or whether they may have a period of years to be payable. If they are paid as parts of the purchase price of an asset forming part of the fixed capital of the company, they are outgoings of capital or of a capital nature." In the Colonial Mutual Life case, a contract for the sale of land required the purchaser to pay a price being "an amount equal to 90% of all rents as and when xeceived from lessees or tenants" of premises which were to be built in part on the land sold and in part on other land. The obligation thus incurred by the purchaser stamped the periodic payments to be made by the purchaser with the character of capital. There, as here, the amount to be paid was measured by reference to the yield from the asset which 2. fT. 17. was bought: rent in one case, iion ore in the other. There, as here, it was immaterial that the title to the asset vested in the purchaser before the payment in question was received: the transfer of title to a capital asset in advance of the payment of the price does not alter the capital nature of the price when paid. The obligation by Cliffs to make the deferred payments was undertaken to acquire (according to the analysis which I prefer) the nett assets of Basic. Basic's assets were the rights, including the right to the mineral lease, arising under the 1964 Act. Cliffs acquired additional and varied rights under the 197C and 1973 Amending Acts, and it exploited the mineral lease and the other rights which it acquired in this way by entering into and taking the benefits provided by the Agreement with the participants of 25th May, 1970. The assets which were so acauired and exploited were clearly capital assets in Cliffs' hands. The deferred payments, paid as part of the balance purchase price of capital assets, are likewise payments of a capital nature. The deferred payments are not deductible and it follows, by the parties' agreement, that the exchange losses and unrecouped losses are not deductible. The payments made in the 1974 year for legal advice related to the payment of withholding tax in respect of the deferred payments made to Howmet. The deductibility of these legal costs is not determined by the conclusion that the deferred payments made to Howmet are of a capital nature. The payment of legal costs was necessarily incurred in the carrying on of Clififs' business (Federal Commissioner of Taxation v. Snowden Wilson Ptv. Ltd. (1958) 99 C.L.R. 431). 22. /18. ~ 18. The circumstance that the advice was sought with reference to the retention of tax from a capital payment does not mark the expense as a capital payment. The making of the deferred payments were part of Cliffs ordinary and recurrent business activities. The seeking of advice as to the deduction of tax from those payments in order that Cliffs might fully discharge its due obligations to its creditor, Howmet, was not an affair of capital but, in my view, an ordinary incident of the carrying on of its business. The costs of procuring that advice were deductible. I would allow the appeal except as to the deductibility of the legal expenses and I concur in the orders proposed by the Chief Judge. ~ I certify that this and the preceding 17 pages are a true copy of the reasons for judgment of his Honour Mr. Justice Brennan. Associate. \B.\Z.97