5S kay CATCHWORDS INCOME TAX - Allowable deduction - prospecting or exploration expenses of petroleum exploration company - whether expenditure incurred incidental and relevant to gaining or producing assessable income - whether nexus between the expenditure and the carrying on of the relevant business - whether prospecting or exploration expenses are of a capital or revenue nature - question of fact - whether s. 260 applies. Income Tax Assessment Act 1936 (Cth): ss. 51 and 260. THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA v. AMPOL EXPLORATION LIMITED G49 of 1986 Lockhart, Beaumont and Burchett JJ. 27 November 1986 Sydney N_THEENERAL ER COURT OF AUSTRALIA S REGISTRY VISION No. G 49 of 1986 weer ON APPEAL FROM THE SUPREME COURT OF NEW SOUTH WALES BETWEEN : THE COMMISSIONER OF TAXATION OF OMMONWEALTH OF AUSTRALIA Appellant AND: AMPOL EXPLORATION LIMITED Respondent JUDGES MAKING ORDER: LOCKHART, BEAUMONT and BURCHETT JJ. DATE OF ORDER: 27 NOVEMBER 1986 WHERE ORDER MADE: SYDNEY MINUTE OF ORDERS THE COURT ORDERS THAT: The appeal be dismissed. The cross appeal be allowed. The assessment be remitted to the Commissioner of Taxation to be amended by allowing the deduction to Ampol Exploration Limited of $3,475,339.71 as claimed by it in its return of income for the year ended 30 September 1980 and reducing its assessable income accordingly. The Commissioner of Taxation pay the costs of Ampol Exploration Limited of the appeal and cross appeal to this Court and of the appeal to the Supreme Court of New South Wales. Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules. IN THE FEDERAL COURT OF AUSTRALIA NEW SOUTH WALES DISTRICT REGISTRY No. G 49 of 1986 ed GENERAL DIVISION ON APPEAL FROM THE SUPREME COURT OF NEW SOUTH WALES BETWEEN: THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Appellant : AMPOL EXPLORATION LIMITED Respondent CORAM: Lockhart, Beaumont and Burchett JJ. 27 November 1986 REASONS FOR JUDGMENT LOCKHART J. The question in this appeal from the Supreme Court of New South Wales (Rogers J.) is whether certain expenditure incurred by Ampol Exploration Limited ("the taxpayer") is deductible under s. 51 of the Income Tax Assessment Act 1936 ("the Act"). The expenditure of $3,475,340 was incurred during the taxpayer's year of income ended 30 September 1980 in relation to the exploration for oil in certain areas off the coast of China. The Commissioner of Taxation disallowed the claim for deduction. An appeal was brought to the Supreme Court which allowed it in part, namely, as to $1,491,024 being the amount of expenditure incurred after 3 April 1980, a date the significance of 2. which will appear later. The Supreme Court disallowed the taxpayer's appeal as to the balance of the deduction claimed. The Commissioner appealed to this Court from the Supreme Court's judgment allowing the deduction as to $1,491,024 and the taxpayer cross-appealed against the judgment disallowing the deduction as to $1,984,316. The three issues before this Court (as they were in the Supreme Court) are, first, whether the expenditure claimed as a deduction falls within either of the two limbs of sub-s. 51(1) of the Act; second, assuming it does, whether the expenditure is nevertheless of a capital nature; and, third, whether s. 260 of the Act operates to deny the deduction to the taxpayer. As this case turns, like others in this particular area of law, upon its own facts and circumstances it is necessary to refer to the facts in some detail. The taxpayer was a subsidiary of Ampol Limited, (previously known as Ampol Petroleum Limited and to which I shall refer as "Ampol") until some time during the year ended 30 September 1980. On 9 October 1980 Ampol held 49.17 per cent of the issued stock units of the taxpayer and has continued to hold about the same percentage since then. Ampol carries on the business of refining, marketing and distributing petroleum products throughout Australia. The taxpayer has been engaged for many years in the business of exploration for petroleum in Australia both on land and in offshore 3. waters. It is the exploration arm of the Ampol group. On 30 September 1980 the taxpayer held eleven petroleum exploration permit interests in Western Australia (seven on-shore and four off-shore), four in the Northern Territory, one in Queensland where it also had one farm-in arrangement, and another farm-in arrangement in New South Wales. In each case these interests were held in conjunction with other parties and the actual work of exploration or production was done by operators appointed by the parties. For example, for many years up to and including the 1980 year of income the taxpayer held a one-seventh undivided interest in the production of oil and gas from the Barrow Island and Dongara fields in Western Australia, the operator being West Australian Petroleum Pty. Limited. The taxpayer has sometimes conducted exploration activities itself and not through an operator. For example, the taxpayer held an authority to prospect for petroleum in the Galilee Basin of Queensland and it was appointed operator to conduct the exploration on behalf of itself and the other parties involved in the project under an agreement effective from 1 February 1984. The taxpayer is entitled to a fee for its work as operator under that agreement. It is the policy of the Board of Directors of the taxpayer that it should become an operator in other permit areas when suitable opportunities arise. Until 1979 the exploration activities of the taxpayer were principally confined to Australia. When opportunities arose for exploration in areas outside Australia a separate company was formed for that purpose. A.E. Harris is and has been since 1970 the managing director of the taxpayer and since 1977 its chief executive officer. He is and has been since 1959 a director of Ampol and since 1970 its managing director. He gave evidence by affidavit and viva voce before the Supreme Court which was accepted. Over some years before 1979 Mr. Harris had been interested in fostering relations between the People's Republic of China and the Ampol Group with a view to establishing trade relationships between them. In 1973, for example, on behalf of Ampol he initiated discussions with petroleum officials of China concerning the possibility of acquiring Chinese crude oil. Early in 1979 he was aware that the Chinese were entering into agreements with Operators to permit exploration for petroleum in China's sovereign waters, but he had not expected that Ampol would necessarily be invited to join in that activity. There had been no. prior communication between Ampol and the Chinese on this matter. In July 1979 Ampol was invited to participate in the exploration in these areas by the National Oil & Gas Exploration & Development Corporation, an agency of the People's Republic of China. As the petroleum exploration activities of the Ampol group were undertaken by the taxpayer, which at the time the invitation was received was a subsidiary of Ampol, Mr. Harris formed the view that it would be appropriate for the taxpayer to enter into the relevant agreements rather than Ampol. The taxpayer therefore entered into two agreements for a geophysical survey in July 1979; four in August 1979 and one in September 1979. 5. During the 1979 year of income, pursuant to those agreements, the taxpayer became involved in a programme of seismic investigation of petroleum prospects in areas of the South China and Yellow Seas. The taxpayer is a participant with other international petroleum exploration companies in each area. For each area one of the participants is the operator. The taxpayer is not an operator in any of these areas. The operator and other participants share the exploration costs in the proportions agreed between themselves. Ultimately the taxpayer became a participant in relation to seven separate areas. The Participation Agreements, of which there are seven, provide for the participants to contribute to the cost of the work as called upon by the operator. The work consists of seismic surveys. Interpretation of the seismic information is carried out separately by each company. Although basically in the same terms, the agreements differ a little from each other in addition to the fact that the parties thereto differ and the fact that the agreements deal with different areas of the South China Sea. It was common ground that nothing turns on the differences between the agreements for present purposes. The Participation Agreement which was treated before us as a fair sample of them all is dated 25 July 1979. It is between Phillips Petroleum International Corporation Asia as "Operator", a number of international oil companies described as "Original Participants" and other parties approved by "the Chinese side". The latter were divided into "Early Participants", that is, companies which became parties to another agreement called the Survey Agreement within a defined period 6. and "Late Participants" being companies that became parties still later. The recital states that the Survey Agreement was to provide the terme and conditions under which companies other than the Original Participants could participate in the geophysical survey to be carried out. The Participation Agreement allocated the costs and expenses incurred pursuant to the Survey Agreement between all the parties. The Survey Agreement is between the Chinese side, the Operator and the Original Participants. It is attached to and made part of the Participation Agreement. The Survey Agreement provides the terms and conditions under which other companies may participate in the geophysical survey. The Survey Agreement provides for the Operator to conduct a geophysical survey over a portion of the designated area for the purpose of evaluating the hydro-carbon potential of the area "so that it may be offered by the Chinese side for the next phase of exploration and development on a competitive bid basis which will not involve transfer of ownership of oil and gas resources". The Operator is required to conduct the geophysical survey and to organise, carry out and supervise the work and to pay all costs incurred in conducting the work (clause 2). The Operator shall use the most advanced equipment and technology to carry out the survey and to complete the acquisition, processing and interpretation of the data so as to evaluate the prospectiveness of the survey area (clause 3). The survey is to include 13,000 kilometres of seismic lines (clause 4). The Operator shall use its best endeavours to accomplish the survey including the interpretation of the data within 12 months after commencement of acquisition of the data, force majeure 7. excepted (clause 5). In order to be qualified for joining the competitive bidding at the exploration and development phase, Early and Late Participants are required to acquire the data obtained by the Operator on a "shared cost" principle. Late Participants are not only to share in the original costs but to pay a premium. These costs and premiums are non-refundable whether the bidding is or is not successful (clause 7). The Operator is required to turn over to the Chinese side not only the raw field data but also the processed data and interpretations. The Operator shall not divulge the interpretations and the analyses of the prospectiveness of the hydro-carbon potential of the survey area without the consent of the Chinese side. The raw field data and the processed data obtained by the Operator shall not be transferred or sold to other foreign companies, except to participants, until after the completion of the first round of bidding, an expression to which I shall return later. All participants are required to hand over their respective interpretations to the Chinese side within eight months after receiving the last lot of processed data from the Operator and to keep all the data and interpretations confidential and are not allowed to transfer or to sell such data without the consent of the Chinese side. The Chinese side agrees not to divulge the interpretations provided by the Operator or any participant without the consent of such Operator or participant (clause 8). The Operator shall be responsible for the management of all the data obtained in the survey within the period starting from the date of execution of the agreement until the date of the first round of bidding. After the first round of bidding has been completed the Chinese side will have the sole ownership of and 8. management of all the data, it being understood that the Chinese side will not divulge the interpretations of the Operator or other participants. The Operator shall not be entitled to sell the data or copies of it and shall keep all the relevant data and interpretations confidential (clause 9). Pursuant to clause 10, the survey area is to be divided into blocks and offered for bidding. The first round is to open within twelve months of receipt of all the data by the Chinese. The offer is to be made "under terms which will provide, in the event of commercial discovery" for recovery of investments and costs, a reasonable return on capital and a reward commensurate with the risk undertaken and success achieved. Such recovery is not to include the costs of the geophysical survey (clause 10). During the course of the survey the Chinese side is entitled to participate in all phases of work including the acquisition, processing and interpretation of data (clause 12). The operator will pay to the Chinese side 3.5% of the total costs of the survey as a service charge (clause 14). The learned trial Judge said at p. 6: "It will be perceived that the entitlements flowing to Participants under the agreements to actually get to the point of exploiting any deposit of hydrocarbons suggested to exist by the survey data are limited in the extreme. At its highest, an agreement entitles a Participant to the survey data and to participate in the eventual competitive bidding. On the other hand, without the data, no-one would wish to bid even if otherwise able to do so. Thus, although the prospect of eventual reward in the sense of participation in drilling for oil was contingent, there was no chance of doing so without first participating in the survey. To emphasise the obvious, the survey data and the interpretations by the various Participants would create a pool of information which would allow both 9. the Chinese and the Participants to determine whether the Area was a possible prospect at all and, if so, what portion should first be explored. As a matter of commercial reality, no Participant could contemplate making a bid without possession of all the data even if the agreement did not preclude it from doing so. It would have been nothing short of gambling to bid without the data. It was for this reason that, in my _ view, participation in the survey was an integral and essential part of the exploration activity." Notwithstanding that it was the taxpayer which was chosen by Ampol to participate in the Chinese enterprise, Mr. Harris was of the opinion that Ampol should be compensated by the taxpayer for "referring the invitation to participate in the seismic activities" to the taxpayer so that the Ampol shareholders, who were not the same as the taxpayer's shareholders, would also benefit. He had discussions with other members of the Boards of Ampol and the taxpayer to whom he conveyed his views. The precise nature of the compensating interests which Ampol should receive had not been determined by 30 September 1979 and was unresolved by the end of November that year. The question was discussed at meetings of directors of Ampol and of the taxpayer on more than one occasion. At the meeting of the Board of the taxpayer held on 24 October 1979, at which Mr. Harris was present, it was resolved: "RESOLVED in recognition of Ampol Petroleum Limited having secured for the Company the exploration opportunity in the People's Republic of China, to offer that Company a 10% interest at no cost (equal to about $250,000 of expenditure) in the seismic surveys being conducted in the area off the coast of China and it was FURTHER RESOLVED to offer Ampol 10. after the completion of such seismic surveys: (a) The right to participate to the extent of a 10% undivided interest in any consequent entitlement to bid for blocks to be offered within these areas and, (b) the right to participate to the extent of a 10% undivided interest in any future exploration, development and production of such areas." A letter of 18 October 1979 written by Mr. Harris to the Board of the taxpaver was tabled. In the letter Mr. Harris said that he believed that the Chinese officials would regard the taxpayer and Ampol as being pretty much as "one". He noted in the letter that:- "a number of multi-national oil companies who are participating in the seismic work are using wholly-owned exploration subsidiaries". He also said in the letter:- "The point should be made that the real advantage of being a seismic survey participant is the understanding that the Chinese Government will limit to such participants the right to bid for exploration permits." At a meeting of the Board of Directors of Ampol held the same day it was resolved to accept the offer of the taxpayer and to instruct the General Secretary to prepare an appropriate agreement for consideration by both companies. The matter came before the Board of the taxpayer again on 28 November 1979. Mr. Harris was present and the minutes record that a draft letter of offer to Ampol consistent with the Board's resolution of 24 October 1979 was tabled by the Secretary. The letter was sent ll. by the taxpayer to Ampol on 28 November 1979 and Ampol replied by letter of the same date. By that letter the taxpayer formally offere4 to Ampol: (a) the right to participate in bids made by the taxpayer for the right to explore and develop areas that may be offered for this purpose by the Chinese side; (b) the right to participate in exploration and development of areas in respect of which successful bids for such purposes are made by the taxpayer; and (c) an entitlement to 10% of any petroleum produced from such areas in respect of which the taxpayer receives an entitlement from the Chinese side and/or an entitlement to 10% of the proceeds of sale of any such petroleum. The letter stated that in consideration of the participation rights and production entitlement offered to Ampol it would be required to underwrite 10% cf the amount of all money bid by the taxpayer for the right to explore and develop areas offered by the Chinese side and to underwrite and contribute to 10% of all the costs and liabilities incurred by the taxpayer in the submission of bids, the undertaking of exploration and development programmes and the production of petroleum from oil fields discovered within the areas. In its reply Ampol accepted the taxpayer's offer. At that time the precise way in which Ampol would be given an interest in the relevant exploration had still not been decided. 12. There were several reasons for the delay in coming to a final decision as to the form which the agreement between the taxpayer and Ampol would take including: (a) (b) (e) (da) (e) the absence of any legislation in China governing the rights and obligations of companies participating in the seismic studies and any future drilling activities; the fact that this was the first occasion that the taxpayer had been involved in a project outside Australia of such magnitude; the difficulties of contracting with a number of foreign companies residing in many different countries and with the relevant Chinese authorities were of a kind not previously encountered by the taxpayer; the few available senior executives involved in the project were also required to spend substantial portions of their time on other Ampol projects and projects of the taxpayer; and the concerns of Mr. Harris regarding the viability and geological worth of the venture which he conveyed to other members of the Board of the taxpayer. There are various ways in which petroleum exploration companies may conduct and enjoy the benefits of exploration activities, the most usual alternatives being those described by Mr. Harris as: (a) (bd) (ec) a working or operating interest; a royalty interest; an overriding royalty; 13. (4d) a net profits interest; (e) a production payment; (£) a carried interest; or (g) sale of the petroleum interest if a commercial field is discovered. These alternatives are described fully by Mr. Harris in his evidence and there is no necessity for me to elaborate. According to Mr. Harris the situation facing the participating companies, including the taxpayer, in the China venture was unique in that none of the more usual methods of conducting exploration activities could be readily adopted. He gave as the reason for this that "in contradistinction to what one would expect to be the case in relation to Australia, the companies carrying out the seismic activities had no petroleum lease or other petroleum interests and, therefore, no interest out of which an interest" of the kind to which I referred earlier (eg. a royalty interest or a carried interest) could be created. Mr. Harris said that the other unique circumstance was that the "entitlement" of the parties to the Participation Agreements was:- "",.. no more than the possibility of being given the right to bid for an area in which further seismic and exploration drilling could be undertaken. If the parties were not invited to bid they were to be reimbursed for the costs incurred. This meant that there had to be, in effect, a new method worked out to cater for the exigencies thus presented. This was another reason for the delay 14. in determining the manner in which the Ampol group should participate in the activities." Mr. Harris's reference to the reimbursement "for the costs incurred" appears to be to the obligation of the Chinese side under at least some of the Survey Agreements involving the taxpayer. The Survey Agreement dated 11 July 1979 for example provides that:- "If the Chinese Side does not offer for competitive bidding at least one-third (1/3) of the Survey Area within three years after the date of this Agreement, then the Chinese Side shall reimburse to the participants all of the costs of conducting the survey including data acquisition, processing and interpretation plus five per cent (5%) annual interest. Mr. Harris gave evidence that he formed the view that the most appropriate course would be for Ampol to be rewarded by having: "a 10% interest in any commercial field which might eventuate from the work and that this might best be achieved by Ampol enjoying its interest through a jointly owned company with Ampolex [the taxpayer], in which it would have a 10% interest. I considered that Ampolex [the taxpayer] should bear the burden of costs in the event that the exploration should turn out to be unsuccessful and that Ampol's interest during the seismic and subsequent exploration and drilling phases should be akin to a carried interest ..." He said that, after detailed consideration of the commercial, legal and accountancy aspects involved in a major project of this kind he formed the view that an incorporated joint venture was appropriate for a variety of reasons including the following: (b) (c) (a) (i) 15. Firstly, it satisfied the need to compensate Ampol in a manner that was commercially realistic given the legal uncertainties of offshore exploration and development, especially in China. Secondly, it accorded with the policy previously employed by the Ampolex group when exploring outside Australia of using a subsidiary for that purpose. That is to gay, in the early 1970's a subsidiary of Ampolex namely Ampol Exploration (Tonga) Pty. Limited was incorporated for the purpose of participating in a petroleum exrloration venture within the Kingdom of Tonga. Furthermore, during the late 1960's and early 1970's, Ampol Exploration (Q'land) Pty. Limited ... a subsidiary of Ampolex had arranged to participate in permits which it expected would be granted in areas off the coast of Queensland and in the Gulf of Papua. Thirdly, that if at any future time it was thought desirable to seek separate funding through say a stock exchange listing in relation to the further exploration and if discovered, the development of any commercially producible reservoir of hydrocarbons in waters offshore China, then the fact that the participating interests were already held by a subsidiary rather than Ampolex itself would facilitate implementation of any such proposal. Fourthly, if a commercially producible reservoir was discovered and developed then it is most likely there would be a substantial debt burden carried by the participants until the project reached the production stage. By isolating Ampolex's involvement into a subsidiary there would be a better opportunity of limiting the liability of Ampolex, in that the security given to lenders over the development period would be restricted to the assets of the subsidiary itself. In the event this limitation plan eventuated, the seeking of other finance to fund exploration and development activities inside Australia would not be impeded by arrangements covering the China project. (44) (e)(i) (ii) 16. The need for this approach has been vindicated as, since 1979, Ampolex has participated in many exploration programmes in its Australian permits, two of which contain the 'Jackson' and 'Jabiru' fields and there could well be a requirement for external funding by Ampolex in the future for these or other yet to be discovered fields. That is, Ampolex is now in a position of freely deciding whether funds borrowed for those projects should be secured on its existing assets. If the debt burden on the subsidiary became too large then administrative difficulties would be reduced in the event of need for a public listing of the company by having transferred the participation interests to that subsidiary at an early stage. Fifthly, the use of a subsidiary as the appropriate vehicle was also recognised as potentially providing better scope for more efficient administrative procedures in relation to offshore projects ... «.. it was thought possible that additional highly technically qualified staff would be required at the development stage and that a reasonable manner of making it plain to them, the requirements and results of their work and the importance of it to the Ampolex group as a whole, was for separate accounting statements. Furthermore, it was considered relevant that because any China project would likely be substantial, requiring a very high level of cost management that this could be achieved through the use of a separate company. This is because the existence of separate companies presents a greater need for precision in allocating common costs than would be the case if the allocation was between divisions of the one company. It is also relevant that to assist in properly managing any external funding of the project on a continuing basis that the availability of a separate set of audited accounts covering the costs could assist relationships with the lenders..." 17. Mr. Harris said that in the period prior to 31 December 1979 he had come to the conclusion that the objectives of Ampol being rewarded by a ten per cent interest in any subsequent commercial field which might eventuate from the work might best be achieved by the taxpayer assigning its rights, though not its obligations, under the various Participation Agreements to a jointly owned company to be owned ninety per cent by the taxpayer and ten per cent by Ampol such that the assignee would be entitled to all the benefits of the exploration should it be successful and that the taxpayer should in that event receive a fee of an agreed amount: or, in the event of failure to agree upon an amount, a fee equal to costs plus a profit margin of fifteen per cent. Although Mr. Harris was cross-examined to suggest that the idea of a fee payable to the taxpayer did not arise until long after he formed the view that Ampol should receive a ten per cent interest, he did not agree with the suggestion. Mr. Harris's evidence was that during this period (i.e. before 31 December 1979) he discussed these matters with the members of the Boards of both Ampol and the taxpayer. He conveyed to them the views which he had formed and they agreed with them. On 27 February 1980 the Board of the taxpayer resolved to adopt Mr. Harris's recommendations and to approve the execution of a deed of assignment between the taxpayer, as assignor and a company to be formed and to be known as Ampol Exploration (China) Pty. Limited as assignee. That company was not formed. Instead a company, Ampol Exploration (Q' land) Pty. Limited ("Ampolex Queensland") was selected as assignee. It had been formed some years before to engage in exploration activities off 18. the coast of Queensland and in the Gulf of Papua but had ceased to carry on business. Further allotments of shares were made by it resulting in Ampol holding ten per cent of its iesued share capital. Formal effect was not given to the decision of the Board of the taxpayer approving the execution until 3 April 1980 when the deed of assignment of that date was executed. Mr. Harris said the delay was due to the fact that the Board of the taxpayer:- --- does not customarily, and did not on this occasion, meet in January, and also because of other pressing matters and particularly, because it was decided to assign to an existing subsidiary of Ampolex, ie. - Ampolex Queensland, and to allot shares therein to Ampol rather than to form a new joint company as had been originally proposed and resolved upon by the Board of Ampolex at its meeting held on 27 February 1980." The taxpayer and Ampolex Queensland thus entered into a deed of assignment which provided that, subject to the taxpayer obtaining all necessary consents and approvals that may be required under the various Participation Agreements and to the extent permissible thereunder, the taxpayer assigned to Ampolex Queensland the whole of its rights, including the right to tender and bid for the right to further explore, develop and exploit any one or more of the areas in question: clause 1. The taxpayer covenanted to use its best endeavours as and when required by Ampolex Queensland to procure all necessary consents and approvals required to give effect to the assignment provided that if they could not be procured or if the rights could not, for whatever reason, be assigned then the taxpayer would hold the rights in trust for Ampolex Queensland for its benefit absolutely: clause 2. The taxpayer covenanted to continue to meet all 19. of its obligations and liabilities under the agreements: clause 3. In consideration of the assignment Ampolex Queensland covenanted to pay to the taxpayer fees calculated in accordance with the formula provided in the deed. The fee was to be an amount to be agreed in writing or failing agreement the amount expended by the taxpayer in respect of the area in question plus fifteen per cent: clause 4. The fee was payable within twelve months of notification that the area had been defined and tested to circumscribe a sub-surface hydrocarbon accumulation such that continuous production in commercial quantities was reasonably assured. clause 5. Mr. Harris said that since entering into the deed of assignment the taxpayer carried out all the obligations required of it thereunder. He said that during the course of the seismic investigation of the relevant areas the Operators provided the taxpayer with seismic data regularly and that as the data was received it was referred to a consultant in Australia which had been engaged by the taxpayer to interpret it. Following the interpretation of the data by the consultants, the Board of Directors of the taxpayer resolved on 27 July 1982 to establish a committee of the Board to consider alternative proposals for bidding. Subsequently, applications to bid for blocks were lodged by the taxpayer as a member of a consortium of companies which had agreed to become associated with each other. On 17 August 1982 "bid proposals" were lodged with China National Offshore Oil Corporation, a corporation established under the laws of the People's Republic of China. After protracted negotiations, agreements were finally executed in 1983 by the taxpayer 20. and other companies forming the respective consortia to explore anf develop the areas allotted to them. The Board of Ampolex Queensland was informed of these developments. Counsel for the Commissioner contended that the expenditure the subject of the claim for deduction ie not deductible under either limb of sub-s. 51(1) and is expenditure of a private or capital nature. First, it was said to be expenditure made merely to obtain seismic data and a right to bid competitively with others for an unspecified right to explore and develop undefined mining land. The rights obtained under the Participation Agreements were, at their highest, rights entitling a participant to the survey data and to participate in the eventual competitive bidding. The Commissioner accepted before the trial Judge and before us that there was a sound commercial reason for an assignment, though he disputed that the deed of assignment was explicable on sound commercial grounds. Counsel relied on what he asserted was the extraordinary nature of the deed of assignment and the nature of the fee payable thereunder. Second, it was said that the expenditure was antecedent to the commencement of the business of oil production and it preceded the commencement of a business to be operated by another company or entity. It was submitted that the execution of the deed of assignment did not change the previously fixed character of the outgoings which the taxpayer had already assumed and that there was in fact no change to the existing obligations of the taxpayer. All that the assignment did was to transfer to Ampol Queensland such possibility of future benefits as might exist in return for partial recoupment of the prior and future 21. expenditure by the taxpayer which it was committed to make plus a fifteen per cent profit on such expenditure as may be recouped, if any. I should say at this point that in my view the participants under the Participation Agreements including the taxpayer were under no legal liability to make payments to the Operators unless and until the Operators incurred the relevant expenses and sought reimbursement. It was submitted before the trial Judge by the Commissioner that the deed of assignment was ineffective to achieve an assignment or the creation of a trust of the taxpayer's rights under the Participation Agreements but this submission was not pursued before us. As to s. 260, counsel for the Commissioner submitted that it did not matter if there were sound commercial reasons for the assignment. He submitted that the provision in the deed of assignment for the payment of the recoupment together with the additional fifteen per cent bears on its face the intention of avoiding tax. Reliance was placed upon the decision of the High Court in Federal Commissioner of Taxation v. Gulland (1986) 60 A.L.J.R. 150 especially per Gibbs C.J. at p. 154 and Dawson J. at p. 171 with whose reasons for judgment on this question Wilson and Brennan JJ. agreed. Counsel for the Commissioner argued that s. 260 annihilated the deed of assignment and that the antecedent situation which existed was one in which the taxpayer had an ongoing contractual obligation to make payments from time to time which were not deductible without the aid of the assignment. The only purpose of the recoupment provision for payment of the additional fifteen per cent was to create a tax deduction. 22. Counsel for the taxpayer argued that the taxpayer's principal activity was exploration for petroleum, that the taxpayer engaged in this activity for reward, that it undertook the exploration activities of the Ampol group and accordingly it was considered the appropriate member of the group to enter into the Participation Agreements. Participation involved no more than the possibility of a right to bid to undertake further seismic and exploration work. It did not involve a transfer of oil or gas resources, the property in which remained with the Chinese Government. The taxpayer did not obtain an income producing asset to exploit. Under the deed of assignment the taxpayer sold the benefits under the Participation Agreements to Ampolex Queensland in consideration of a covenant by the latter to pay a fee in the event of a commercial find in an area, by which time the taxpayer's obligation of exploration would have ceased. It was submitted that the outgoings were both incidental and relevant to the taxpayer's exploration activity generally and that as such they were incurred in gaining or producing its assessable income or the assessable income it expected to produce and that accordingly the whole of the outgoings totalling $3,475,340 were deductible. Counsel for the taxpayer also submitted that the taxpayer's exploration activity was not confined to Australia, but that if the Chinese exploration activities were to be separated and said not yet to have produced assessable income, then the outgoings were necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income and fell within the second limb 23. of sub-s. 51(1). They were recurrent and in the nature of operating expenses of the exploration business. The taxpayer obtained no property or income rights by entering into the Participation Agreements. At most, its participation did no more than enable it to bid; it was a mere expectation or possibility. After December 1979, or at the latest 3 April 1980, the outgoings were incurred to produce a fee and generate income from Ampolex Queensland. As to s. 260, counsel for the taxpayer submitted that the case was governed by the principles laid down by the Privy Council in Newton v. Commissioner of Taxation [1958] A.C. 450 which, as counsel for the taxpayer expressed it, was rehabilitated by the High Court in Gulland's Case (supra). It was submitted that the trial Judge correctly found that there was proper commercial reason for the deed of assignment and that it was not impressed with the stamp of tax avoidance. There was ample evidence to explain the deed of assignment as an ordinary business or commercial transaction. There was nothing to suggest a contrived scheme which could only be explained on the basis of tax avoidance. There is an initial question to be considered in relation to the taxpayer's argument that the relevant expenditure is deductible under the first limb of sub-s. 51(1) on the basis that it represents outgoings incurred in gaining or producing its assessable income derived from its activities generally of which the Chinese enterprise and the assignment of its rights to Ampolex Queensland form only a part. This question arises from the language of the taxpayer's notice of objection. 24. The trial Judge noted in the opening paragraph of his reasons for judgment that the expenditure was described in the taxpayer's income tax return for the relevant year as: "... expenditure amounting to $3,475,340 in exploring in permit areas offshore China for the purpose of producing assessable income in the nature of a fee from --.-" Ampol Queensland (the emphasis was that of the trial Judge). In its notice of objection to the Commissioner's assessment the taxpayer claimed that the expenditure of $3,475,340 should be allowed upon certain grounds, the first of which reads, so far as relevant: "1. The taxpayer is entitled under Section 51(1) of the Income Tax Assessment Act 1936 (hereinafter "the Act") to a deduction for the sum of $3,475,340 being losses or outgoings incurred by the taxpayer in gaining or producing the assessable income in the nature of fees from Ampol Exploration (Q'land) Pty. Limited under the terms of an Agreement ... whereby the taxpayer assigned to Ampol Exploration (Q'land) Pty. Limited all of its rights, entitlements, interests and benefits under various petroleum participation agreements relating to exploration in the Northern and Southern Areas of the Yellow Sea; w Upon the appeal to the Supreme Court the taxpayer was limited to the grounds stated in its notice of objection: s. 190 of the Act. The provisions of ss. 190 cannot be waived by the Commissioner: H.R. Lancey Shipping Co. Pty. Limited v. Federal Commissioner of Taxation (1951) A.T.D. 267; Molloy v. Federal Commissioner of Land Tax (1937) 59 C.L.R. 608 at p. 610. 25. However, grounds of objection should not be interpreted narrowly or technically. Any doubt as to whether a particular matter falla within the grounds stated in the objection should be resolved in favour of the taxpayer: New Zealand Flax Investments Limited v. Federal Commissioner of Taxation (1938) 61 C.L.R. 179 per Dixon J. at p. 204; D. v. Commissioner of Taxes (Queensland) (1940) 6 A.T.D. 25 per Mansfield J. at p. 41. The specification by the taxpayer of the assessable income to which the expenditure is said to be related as being "in the nature of fees" from Ampolex Queensland under the deed of assignment at first glance appears to lend support to the view that the taxpayer is confined to income answering that description for the purposes of the first limb of sub-s. 51(1) and cannot put a case based on the wider notion of its "assessable income" from its activities as a whole. It would have been sufficient for the taxpayer to have described the sum of $3,475,340 as outgoings received in gaining or producing the assessable income. By adding "in the nature of fees from Ampol Exploration (Queensland) Pty. Limited under the terms of an Agreement ..." the taxpayer, in my opinion, merely gave them greater particularity. The object of the statutory confinement of the taxpayer to the grounds stated in its objection (sub-s. 190(a)) is to ensure that the Commissioner knows the respects in which the taxpayer challenges the assessment. In this case he would know this without the further particularisation. In my opinion the additional words do not inhibit the taxpayer from putting its argument in relation to the first limb of sub-s. 51(1) on this wider plane. 26. If the words in question do operate to prohibit the wider case being put by the taxpayer then the words "in the nature of" etc. are sufficiently wide to encompass not merely fees under the deed of assignment itself but a right to income broadly of the kind described in the deed. The second ground of objection states, so far as relevant:- "2. Alternatively, and without prejudice to ground 1 above, the taxpayer is entitled to a deduction for the said sum of $3,475,340 under the second limb of Section 51({1) of the Act. That is, the said sum of $3,475,340 being losses or outgoings was necessarily incurred by the taxpayer in carrying on a business for the purpose of gaining or producing the assessable income. The said sum of $3,475,340 was not capital, nor was it of a capital, private or domestic nature and it was not incurred in relation to the gaining or production of exempt income; ..." The language of this second ground of objection, notwithstanding the phrases "the said sum" and perhaps "the assessable income" are not limited by the language of the first ground of objection. The wider case for the taxpayer is open to it with respect to the second limb of sub-s. 51(1) even if the language of the first ground was to be interpreted narrowly. Similarly with respect to the other grounds of objection. Although certain later statements in the notice of objection, a lengthy document, may at first glance tend to support the narrower construction of the grounds of objection, they are really an elaboration of them, are essentially argumentative, are not part of the grounds themselves and do not confine them. 27. Section 51 has attracted much judicial comment. In Federal Commissioner of Taxation v. Total Holdings (Australia) Pty. Limited (1979) 24 A.L.R. 401 I discussed at some length the principles governing the construction and application of the section and, except for a few matters, need not repeat what I said there. It is sufficient for present purposes to say that the two limbs of sub-s. 51(1) are not mutually exclusive so that some cases may be within both limbs. However, some cases may fall only within one limb. The words "the assessable income" and "such income" refer to assessable income generally of the taxpayer and not to the assessable income of a particular period. Expenditure falls within the first limb if it is incurred in the course of gaining or producing the assessable income in the sense that it is incidental and relevant to that end. The phrases "incidental and relevant" in this context refer, not to the frequency, expectedness or likelihood of their occurrence but to their nature or character. The outgoings must be connected with the operations which gain or produce the assessable income. As to the second limb, there must be a nexus between the expenditure and the carrying on of the relevant business. The word "necessarily" means in this context "clearly appropriate" or "adapted for". In order to be deductible, a loss which flows from carrying on a business need not necessarily be incurred in a year when the taxpayer is actually carrying on that business. 28. I turn first to the taxpayer's case based on the second limb of sub-s. 51(1). The principal business of the taxpayer is and has been for many years exploration for petroleum principally on mainland Australia and in its offshore waters. The facts stated earlier establish this. Sometimes the taxpayer has itself conducted the exploration activities, and at other times, perhaps generally, appointed an operator to conduct them on its behalf or on behalf of itself and others where it is a member of a petroleum exploration syndicate. The taxpayer has over the years been involved in negotiating exploration agreements and other agreements relating to interests in petroleum exploration areas. The alternative methods available to exploration companies for conducting exploration activities and enjoying the fruits of them are numerous and varied. The mechanism for conducting the exploration activities with which this case is concerned is certainly unusual (Mr. Harris described the situation confronting the international exploration companies as unique) in that the companies engaged in the activities have no petroleum lease or other petroleum interest and therefore no interest from which an income producing asset could arise. Participation involved no more than the possibility of being granted by the Chinese Government the right to bid to undertake further seismic and exploration work. However, the role of the taxpayer in the Chinese venture was perceived by those who control its affairs as a commercially sound method of carrying on its exploration business and as part of its ordinary business activities. They were seeking a profit opportunity. 29. The Managing Director of both Ampol and the taxpayer decided that, although the offer to participate was extended by the Chinese Government to Ampol, the taxpayer was the appropriate member of the group to enter into the Participation Agreements since it is the exploration arm of the group. The expenditure could not lead to the establishment of an income producing asset. Nor could it lead to ownership of oil or gas resources. The circumstances which brought the deed of assignment into existence and the provisions of the deed itself are relevant matters for the purpose of characterising the true nature of the expenditure for the purposes of the second limb of sub-s. 51(1). Mr. Harris explained those circumstances. Ampol and the taxpayer agreed that Ampol should be compensated by the taxpayer for the latter's obtaining from the former the right to participate in the seismic activities since the shareholders of Ampol were not the same as those of the taxpayer. More than one formula was considered to achieve this object, resulting eventually in the deed of 3 April 1980. It was not until 22 February 1980 however that consideration was given to the concept of a company to be incorporated and owned as to 90% by the taxpayer and 10% by Ampol and a fee payable by it to the taxpayer. The trial Judge rightly concluded that the formula for which the deed provides "did not crystallize in any concluded and legally binding form until the date of execution of the Deed". But it was clear at all material times that Ampol would have a share of some kind in any benefits resulting from the Chinese Government's offer to participate and that otherwise any benefits would accrue to the taxpayer. The 30. method for accomplishing these objectives remained to be determined. Under the deed, the benefits to the taxpayer, if it eventually participates in some commercial enterprise for the working of petroleum deposits, are to be recoupment of its expenditure in respect of the relevant areas plus fifteen per cent and whatever benefits accrue from holding ninety per cent of the shares in the Assignee, Ampolex Queensland. This was the formula finally arrived at to give effect to the broad understanding between both Ampol and the taxpayer. I have the firm impression, however, that the deed was conceived for the additional purpose of adding strength to the taxpayer's argument that the relevant expenditure was not capital in nature. In my opinion the whole of the expenditure totalling $3,475,340 was necessarily incurred in the carrying on of the taxpayer's business of petroleum exploration and is deductible under the second limb of sub-s. 51(1). This finding is based on the particular facts and circumstances of this case including the unusual nature of the enterprise established by the Chinese Government and the international petroleum exploration companies to conduct' the exploration activities off the Chinese coast. It provides no warrant for a more general proposition that outgoings of companies engaged in petroleum exploration are necessarily deductible under the second limb of sub-s. 51({1) if the expenditure is related to that activity. This is a question of fact in each case. Exploration or prospecting activities (eg. geological, geophysical or geochemical surveys and 31. appraigaal digging) are the kind of activities in which a prospecting company engages if petroleum is to be found. It is, as the title of the activity suggests, of an exploratory nature. Petroleum may or may not be found; but unless expenses of this kind are incurred it will not be found. Once a proven field has been established other expenses, for example, development drilling or activities in the course of working or establishing a petroleum field will be incurred and they savour more of a capital nature since the work is done to bring into being a proven capital asset which will be the source of income producing activity. Division lOAA of the Act authorises special deductions in respect of certain expenditure incurred in carrying on "prescribed petroleum operations" or on exploration or prospecting in Australia for the purpose of obtaining or discovering petroleum. It is not necessary that such expenditure be capital expenditure to qualify for the deduction. It may be that some expenditure on exploration or prospecting may also be deductible under sub-s. 51(1). Where both provisions could apply sub-s. 82(1) would apply so that the deduction would be allowable under the section which is in the Commissioner's opinion more appropriate. Division 10AA does not, of course, apply to this case as the expenditure was incurred whilst engaging in exploration activity outside Australia; but I mention it because the presence of the Division does not support the view that outgoings incurred by an petroleum exploration company are necessarily and inherently of a capital nature and not deductible unless allowed by a special provision of the Act such as Division lOAA. The presence of 32. Division 10AA also perhaps explains why counsel were unable to discover any case touching directly on the question of the deductibility under sub-s. 51(1) of exploration expenses of petroleum exploration companies. There is no warrant for dividing the expenditure in this case into amounts which preceded the deed of assignment and those which followed it. The taxpayer's business activities must be viewed as a whole including the particular circumstances of the taxpayer's involvement in the exploration undertaking off the Chinese coast. It is artificial to treat the deed of assignment as the line of demarcation between deductible and non-deductible expenditure. The characterisation of the expenditure, and therefore of the outgoing which it represents, is to be discerned from the business activities of the taxpayer generally and its role as the prospecting arm of the Ampol group in the Chinese project in particular. The understanding between the Boards of Ampol and the taxpayer, informal though it was until April 1980 (though plain enough in February of that year), that a benefit, in the form at least of some payment to the taxpayer in the Mature of reward or profit, would accrue to it, requires that the question of deductibility should be approached in a practical fashion. The whole of the relevant expenditure was incurred in the course of the carrying on of the taxpayer's business of petroleum exploration. I am also satisfied that the total expenditure of $3,475,340 attracts the operation of the first limb of sub-s. 51(1). The trial Judge took the view that the taxpayer's case was "structured" on the 33. basis that the only deductible outgoings could be those incurred in exploring for petroleum for the purpose of producing assessable income, namely, the fee payable under the deed of assignment. His Honour reitected the argument that it is permissible for the outgoings incurred before the execution of the deed to be deductible under the sub-section on the ground, advanced by the taxpayer, that it was at all relevant times the intention of the taxpayer and Ampol that a fee or something akin to a fee would be the taxpayer's reward for its role in the prospecting activities. In my opinion the expenditure incurred before the deed was both incidental and relevant to gaining or producing the taxpayer's assessable income in the form of a fee, using that word in the broad sense of a payment or remuneration for the taxpayer's role in the exploration enterprise off the Chinese coast. The deduction is not denied because the particular form of payment was not finally determined in a legally binding form until 3 April 1980. It was at all relevant times the intent of Ampol and the taxpayer that a just reward of a business character would be paid to the taxpayer. Only the particular method to be selected to achieve this objective remained to be determined. I referred earlier to Mr. Harris's evidence on this aspect of the case and need not repeat it. Viewed from a practical and business point of view the deed of assignment was the method finally selected to express the object of both Ampol and the taxpayer; first, to enable Ampol to derive a fair share of any benefits which might be produced in the future from the 34. 011 production enterprise, if one emerged at all, and, second, to ensure recoupment of the taxpayer's costs if the oil fields were found to be commercially feasible together with a payment geared to a percentage of those costs, and the major share in the benefits of any such enterprise. The total expenditure was thus connected with the gaining of the payment from Ampolex Queensland. Even if the taxpayer is restricted to the narrow interpretation of its first ground of objection it would nevertheless succeed on the first limb of sub-s. 51(1). I turn to the more difficult question whether, notwithstanding that the expenditure falls within each of the two limbs of sub-s. 51(1), it is nevertheless of a capital nature. The meaning of "capital" in the context of s. 51 has been the subject of a wealth of decisions including of course the oft cited passages from the well known judgment of Dixon J. in Sun Newspapers Limited v. Federal Commissioner of Taxation (1938) 61 C.L.R. 337 at pp. 359-363 and the passages from his Honour's judgment when Chief Justice of the High Court in John Fairfax & Sons Pty. Limited v. Federal Commissioner of Taxation (1959) 101 C.L.R. 30 at pp. 34-35. See also Cliffs International Ine. v. Federal Commissioner of Taxation (1979) 142 C.L.R. 140. In my opinion the expenditure is essentially of a revenue, not of a capital nature. It was not suggested by the Commissioner that the expenditure was of a private nature. I reach this conclusion 35. whether the test is to examine the "true legal character" of the expenditure or to ascertain what it was "calculated to effect from a practical and business point of view": Cliffs International Inc. v. Federal Commissioner of Taxation (supra) per Gibbs C.J. at p. 152 where his Honour acknowledged the sources of those phrases as the authorities cited in Federal Commissioner of Taxation v. South Australian Battery Makers Pty. Limited (1978) 140 C.L.R. 645 at pp. 658-659. The true legal character of the expenditure was that of the ordinary business activity of the taxpayer as a petroleum exploration company. From a practical and business point of view the taxpayer sought to adopt one of a number of possible methods in which it engaged for the purpose of its exploration business to obtain, if all went well, the possibility of a right to bid to undertake further seismic and exploration work. The expenditure could not lead to the establishment of an income producing asset for it to exploit and it was recurrent and in the nature of operating expenses of the taxpayer's prospecting and exploration business. Recurrence is, however, merely one matter to consider. In the Sun Newspapers Case (supra) Dixon J. said at p. 362 that recurrence "is not a test, it is no more than a consideration the weight of which depends upon the nature of the expenditure" and he said at p. 363: "There are, I think, 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 is 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." 36. The payments in question were in truth part of the outgoings of the taxpayer in the course of carrying on its ordinary business activities. It was not expenditure incurred for the purpose of creating or enlarging a business structure or profit yielding or income producing asset. There is no presumption that prospecting or exploration expenses are of a capital nature. It is a question of fact in each case. Ordinarily the purchase by a taxpayer of a right to mine is expenditure of a capital nature and would not be deductible in the absence of special statutory provision. Preliminary expenses incurred in the establishment of a mine also would ordinarily be in the nature of capital expenditure. In general, expenses incurred with a view to setting up a business or extending a business are not allowable deductions. Where expenses are incurred in establishing, developing, extending or rejuvenating a mine, they will generally be of a capital nature since they are incurred for the purpose of bringing a capital asset into existence or enhancing it. An examination of the authorities establishes that there is no presumption that prospecting or exploration costs are prima facie of a capital nature. I see no purpose in referring to all the cases, to which we were referred, bearing on the subject but will mention some of them. Coltness Iron Company v. Black (1881) 6 A.C. 315 was a case where the taxpayers had carried on business as coal and iron masters for a number of years and had opened up several mineral fields, sinking new pits from time to time as the old ones became 37. exhausted. The taxpayers sought to deduct from their gross annual receipts derived from their business sums expended by them in sinking the new pits. It was held by the House of Lords that the taxpayers were not entitled to the deduction sought. In Alianza Company v. Bell [1904] 2 K.B. 666 the taxpayers owned land in Chile containing deposits of a substance called caliche from which they extracted by a manufacturing process nitrates and iodine. The taxpayers claimed to be entitled for the purpose of computing the balance of their annual profits and gains to deduct a yearly sum to meet the exhaustion of the nitrate grounds. It was held by Channell J. that the taxpayers were not entitled to the deduction. In Bonner v. Basset Mines Limited (1912) 6 T.C. 146 a company which carried on a large tin mine claimed to be entitled to a deduction of the cost of deepening a main shaft, the bodies of ore accessible from the original level having been practically worked out. It was held that the deduction could not be allowed. In Kauri Timber Company Limited v. The Commissioner of Taxes (1913) A.c. 771 the taxpayer carried on a business in New Zealand of cutting, milling and selling timber and for the purpose of its business it had acquired upon its incorporation and from time to time thereafter rights over freehold and leasehold bushlands' bearing natural timber in some cases by purchasing the land and in other cases by purchasing the timber thereon with the right to remove it within a stated period. It was held by the Privy Council that under the Land & Income Assessment Act 1908 (New Zealand) the taxpayer was not entitled 38. to make any deduction for income tax purposes from the gross proceeds of its business of the value of the standing timber which it had cut. The Privy Council held that there could be no question that the cost of acquisition of the taxpayers' possession of an interest in land and of timber rights thereon was just as plainly a capital cost ae if the land with the timber on it had been bought outright and just as Plainly it was not a proper accounting debit item ag against revenue. In Hughes v. The British Burmah Petroleum Co. Limited (1932) 17 T.C. 286 the taxpayer had carried on the business of oil producing and refining for some years and bought oil from an Indian oil company. Finlay J. said at 295 that it had been very well settled since the decision of the House of Lords in the Coltness Case that the prime cost of buying a mine or buying a seam of coal is capital expenditure and cannot in any form be deducted. In Knight v. Calder Grove Estates (1954) 35 T.C. 447 the taxpayers carried on in partnership the business of open cast coalmining and purchased the freehold in ten acres of land for 42,000. The conveyance included covenants under which they undertook after getting the coal to reinstate the land and the vendor undertook to repurchase the land for 48500 after the completion of mining operations. Upjohn J. held that the expenditure and the receipts were capital and rejected the view that the expenditure should be regarded as the expense of getting and winning the coal. His Lordship noted that it was not suggested that the purchase of the land was circulating capital or stock in trade or anything of that sort but was 39. the purchase of land for the adventure. Hence on ordinary principles the transaction must be regarded as a capital expenditure "just as when you buy land and put a factory on it, or buy land and sink a shaft ." In H.J. Rorke Limited v. Inland Revenue Commissioners [1960] 1 W.L.R. 1132 the taxpayers carried on the business of open cast coalmining and entered into an agreement with a land owner whereby certain land was let to the taxpayer for one year on payment of a royalty for every ton of coal won from the land. The taxpayers covenanted to restore the surface of the land on completion of the mining operations and other matters. The taxpayers were held not to be buying circulating capital when making the payments in question (ie. coal) but to be acquiring rights which enabled them to obtain it and the whole of the payments were of a capital nature. Commissioners of Inland Revenue v. Carron Co. (1968) 45 T.c. 18 was a case of a taxpayer incorporated in 1773 carrying on business as an ironfounder. It was decided to revise the company's charter to remove what were regarded as archaic conditions. The company petitioned for a supplementary charter but the proceedings were suspended pending the outcome of an action by a shareholder claiming that the procedure adopted in deciding to petition was invalid. The taxpayer won the shareholder's action before the Lord Ordinary and in the First Division of the Court of Session but was advised that its prospects of success in the House of Lords were dubious. The taxpayer settled the action on terms requiring payment of moneys to dissenting 40. shareholders. A supplementary charter was later granted substantially in the form proposed by the taxpayer. Its affairs were then reorganised and its commercial performance improved. The taxpayer claimed to deduct the cost of obtaining the charter and defending the action and the amounts paid to the two dissenting shareholders in respect of their shares and expenses in the action, One of the contentions for the Crown was that the sums in question were incurred on capital account. It was held that the expenditure was essentially of a revenue character in that it enabled the management and conduct of the taxpayers' business to be carried on more efficiently. In Softwood Pulp & Paper Limited v. Federal Commissioner of Taxation (1976) 76 A.T.C. 4439 the taxpayer was incorporated for the purpose of establishing a new paper production industry in South Australia. The venture did not proceed. The taxpayer claimed the expenses incurred by it as a deduction pursuant to sub-s. 51(1). The expenses related to overseas and local travel expenses, legal and accounting expenses, the testing of raw material, professional fees for the conduct of feasibility studies by expert consultants and acquisition of some raw materials. It was held by Menhennitt J. that the activities undertaken by the taxpayer were entirely preliminary and directed to deciding whether or not an undertaking would be established to produce asessable income and that the expenses were not incurred in the actual production of assessable income. Menhennitt J. held also that as the taxpayer had not decided whether or not the business should be proceeded with at the time the expenditure was incurred it could not be held to have been incurred in carrying ona 41. business. Hence his Honour found that the expenditure fell within neither limb of sub-s. 51(1). He went on to say that even if the expenditure did fall within either of the limbs, it would nevertheless be of a capital nature and he held at p. 4454 that the expenses all fell within the concept of establishing or creating the profit yielding subject. I could go on by multiplying the reference to other cases, but there is no useful purpose in doing so. I have said sufficient to confirm first, the danger of seeking to extract principles of general application in this branch of the law from the authorities where the facts are very different from the case under review and, second, the correctness of the frequently repeated statement in the cases (including those to which I have referred) that whether expenditure in respect of which a deduction is sought is capital or not must be a question of fact in each case. Division 10AA of the' Act does not support any presumption that prospecting and exploration expenses are intrinsically of a capital kind. The section does not proceed on the hypothesis that the expenditure to which it is directed and to which it specifically refers (for example, geological, geophysical and geochemical surveys, exploration drilling and appraisal drilling and which are included in the expression "exploration or prospecting") is intrinsically of a capital nature. What the section does is simply to ensure that expenditure which answers the description of expenditure incurred in exploration or prospecting in Australia for the purpose of discovering 42. petroleum is, whatever otherwise might be its character, an allowable deduction. In my opinion the expenditure is of a revenue nature and is an allowable deduction to the taxpayer. I reiterate that whether the expenditure is of a revenue nature turns upon the particular facts of this case. If it be said that the facility for deduction may be open to abuse or that opportunity would be provided for wasteful expenditure by taxpayers not really directed to the discovery of petroleum the answer surely must be that before a taxpayer can be entitled to the deduction he must in fact carry on a business to which the losses or outgoings are related and in which they are necessarily incurred or, whether carrying on a business or not, the losses or outgoings must be incurred in gaining or producing the relevant assessable income. I shall deal briefly with s. 260. The trial Judge found that "there is proper commercial reason for the Deed and it is not impressed with the stamp of tax avoidance". No ground has been shown to warrant this Court's interference with that finding. It is plain to my mind from the evidence, as it was to his Honour, that the deed is explicable by reference to ordinary business dealing notwithstanding that it bears the dual stamp of a business character and the intention to strengthen the argument that the relevant expenditure was not capital in nature. The rebirth of s. 260 in Gulland's Case (supra) and the redemption of Newton's Case (supra) and 43. Peate v. Commissioner of Taxation (1966) 116 C.L.R. 38 does not avail the Commissioner in this case. The appeal should be dismissed and the cross-appeal allowed. The Commissioner must pay the costs of this appeal and cross-appeal and of the appeal to the Supreme Court. | certify that this and the SoerS- hoe (>) preced ng paccs ave a tua Copy of the Reaccns {2° J.¢3~77t here.n cf bis Honour Mr. Justice Loostc * Assovtata Dated: 1 WovSenQcte® \AZC N_THE L COURT OF AUSTRALIA ) ) NEW SQUTH WALES DISTRICT REGISTRY ) No. G49 of 1986 ) GENERAL DIVISION ) ON APPEAL FROM THE SUPREME COURT OF NEW SOUTH WALES ADMINISTRATIVE LAW DIVISION BETWEEN: THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Appellant AND: AMPOL EXPLORATION LIMITED Respondent CORAM: LOCKHART, BEAUMONT AND BURCHETT JJ. DATED: 27 November 1986 REASONS FOR JUDGMENT BEAUMONT J. The Commissioner of Taxation appeals from orders made by the Supreme Court of New South Wales (Rogers J.) allowing in part an appeal to that Court by the respondent taxpayer. The taxpayer claimed to deduct certain expenditure, $3,475,340.00 in all, pursuant to s.51 of the Income Tax Assessment Act 1936 (the Act). The expenditure, incurred in the taxpayer's year of income ended 30 September 1980, was wholly disallowed by the Commissioner as a deduction but Rogers J. allowed the claim in part, viz. as to $1,491,024.00. The taxpayer cross-appeals from so much of the judgment of Rogers J. as disallowed the deduction as to the balance, i.e. $1,984,316.00. tJ The taxpayer is a member of the Ampol group of companies. Until some time during the year ended 30 September 1980, it was a subsidiary of Ampol Petroleum Limited (Ampol), but as from 9 October 1980 Ampol has held only 49.17 per cent of its capital. Ampol carries on the business of refining, marketing and distributing petroleum products throughout Australia. The taxpayer's business is that of prospecting and exploring for, and developing, petroleum fields on mainland Australia and in Australian offshore waters. In 1973, Ampol engaged in discussions with the Chinese government about the possible acquisition by Ampol of Chinese crude oil. The discussions continued over a period of years without any result. Then, early in 1979, Ampol became aware that the Chinese government proposed to enter into agreements with a number of foreign oil companies providing for the exploration for petroleum in Chinese waters. Although Ampol was not involved at this stage and did not expect to be invited to participate, on4 July 1979, it received a telex from China National Oil and Gas Exploration and Development Corporation (the China Corporation) stating that the China Corporation had recently signed geophysical survey agreements with Chevron Overseas Petroleum Inc., Texaco International Petroleum Co., Mobil O11 Corporation, Esso Exploration Inc. and Phillips Petroleum Inc. over the offshore area of Pearl River Mouth Basin. The telex stated that those companies had been appointed "operators" responsible for conducting a geophysical survey and that the agreements had stipulated that the participants must purchase all the data in respect of the area in order to be qualified to join in the "competitive bidding in the future exploration and development phase". Ampol was invited to contact the operators for the purpose of ascertaining details of the agreements; it was foreshadowed that upon application by Ampol, and subject to the approval of the China Corporation, Ampol would be issued with a notice of approval for geophysical survey participation. By letter to Ampol dated 5 July 1979, the China Corporation elaborated the matters raised in 1ts telex. Pursuant to the invitation issued by the China Corporation, the taxpayer entered into two geophysical survey agreements in July 1979, four such agreements in August 1979 and one such agreement in September 1979 (the agreements). The agreements provide for a number of programmes of seismic investigation in Chinese waters to be conducted by nominated operators for the purpose of evaluating the hydro-carbon potential of the areas. The taxpayer was a participant but was not an operator. In order to be qualified for joining the competitive bidding at the exploration and development phase, participants are required to acquire the data obtained by the operator ona "shared cost" principle. Included in the costs is a service charge payable to the Chinese of 3.5% of the total costs of the survey. The raw field data and the processed data obtained by the operator are not to be sold or transferred to other foreign companies, except to participants, until after the first round of bidding. After that bidding is completed, the Chinese will have the sole ownership of and management of all the data, which is to be kept confidential by the parties. The survey area is to be divided into blocks and offered for bidding. The first round is to be opened within 12 months of receipt of all the data by the Chinese. The offer is to be made under terms which will - "provide, in the event of commercial discovery for recovery of investments and costs agreed upon in the future contracts, a reasonable return on capital employed and a reward commensurate with the risk undertaken and the success achieved." However, such recovery is not to include the cost of the geophysical survey conducted under the agreements. In the year of income, the taxpayer incurred expenditure in connection with the agreements ain the total sum of $3,475,340.00 - the deduction now claimed. A part of the expenditure was incurred by the taxpayer towards discharge of its obligations under the agreements to contribute towards the operator's survey costs. Another part was attributable to fees paid by the taxpayer to "interpretation consultants" retained by it to interpret the data obtained under the agreements. A dissection of the expenditure was made as follows: BLOCK: Pearl River Mouth Basin (Unified Area) OPERATOR: Phillips Petroleum 401,096 Chevron Petroleum 379,727 INTERPRETATION CONSULTANTS: BLOCK: OPERATOR: INTERPRETATION CONSULTANTS : BLOCK : OPERATOR: INTERPRETATION CONSULTANTS : BLOCK: OPERATOR: INTERPRETATION CONSULTANTS : PAYMENTS TO: Although it appears that items was of the expenditure attempted in the evidence, a clue Esso 520,396 Mobil 370,083 Flower Boery Buchan Pty. Ltd. Sub-Total South Yellow Sea Societe Nationale Elf Aquitaine Arthur Burbury & Associates Pty. Ltd. Sub-Total Gulf of Beibu Wan Amoco J.d. Blumer & Associates and R.S. James/Vaincre Pty. Ltd. Sub-Total South Yellow Sea British Petroleum Arthur Burbury & Associates Pty. Ltd. Sub-Total 1,671,302 214,407 1,885,709 89,485 33,038 122,523 301,618 39,611 341,229 807,504 33,039 840,543 China National Oil & Gas Exploration and Development Corporation Petroleum Corporation of China Chinese Petroleum Corporation Printing, Air Fares, Postage Sub-Total TOTAL was given by the estimated budgets 87,625 91,399 42,343 63,969 285,336 3,475,340 no further break-up of these as to the character of the operators. As an example, Phillips' estimated budget was as follows (made in U.S. dollars): Data Acquisition 13,000 KM 6,076,000 Navigation 519,000 Data Processing 1,920,000 Other charges: Precontract Costs 75,000 Establish a Hong Kong Office 250,000 Singapore and U.S. Office Technical Cost 170,000 Audit 12,000 Training 120,000 Miscellaneous, Insurance Premiums, Etc. 20,000 Sub total 9,162,000 Chinese Service Charge 3.5% 321,000 Sub total 9,483,000 Operator's Overhead Charge 332,000 TOTAL $9,815,000 After the taxpayer's entry into the agreements, certain transactions occurred within the Ampol group to which it will be necessary to refer in due course. However, it will be conventent to consider whether, if matters had stood as I have now described them, the taxpayer would have been allowed a deduction for this expenditure pursuant to s.51(1) of the Act. That sub-section provides: "Sil. (1) All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income." On behalf of the Commissioner it was submitted that the expenditure fell outside s.51(1) as it was capital in character. It was said to be capital expenditure because it was made to obtain assets or, at least, advantages inthe form of seismic data and the right to bid competitively with others for the right to explore and develop the subject areas; alternatively, it was argued, the expenditure should be regarded as made on capital account because it was made before the commencement of the business of oil production. In my opinion, the advantages sought by the expenditure were of a capital nature. This is so, whether the question is approached by looking either at its "true legal character" or at what the payments were "calculated to achieve from a practical and business point of view" (see Cliffs International Inc. v. Federal Commissioner of Taxation (1979) 142 C.L.R. 140 per Gibbs J. at p.152). Its "true legal character" was that of the price paid to obtain, first, the relevant seismic information and, secondly, the right to bid for the srrivilege of possible involvement in the next phase of exploration. From a business and practical point of view, the expenditure was made for the purpose of obtaining that information and that privilege. What was purchased - whether it was the seismic information or the rights and the possibilities inherent in them, or all of these - "was an asset or advantage of an enduring, although not perpetual kind, an asset or advantage that was to form part of the organization set up by the appellant for the earning of profit...In other words, the...payments should properly be regarded as expenditure necessary for the acquisition of property or of rights of a permanent character, the possession of which was a condition of carrying on the business of mining at all, within the test stated in Robert Addie & Sons' Collieries Ltd. v. Commissioners of Inland Revenue ((1924) S.C. 231 at p.235) in the passage cited in Colonial Mutual Life Assurance Society Ltd. Vv. Federal Commissioner of Taxation ((1953) 89 C.L.R. 428). The rights acquired were of a permanent character within this test, notwithstanding that a mineral lease is a wasting asset, for 'When the words 'permanent' or 'enduring' are used in this connection it is not meant that the advantage which will be obtained will last forever' (Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation ((1938) 61 C.L.R. 337) per Latham C.J.; see also per Dixon J. (at pp.362-3) and Ralli Estates Ltd. v. Commissioner of Income Tax ((1961) 1 W.L.R. 329)." (per Gibbs J. in Cliffs International, supra, at p.153). Gibbs J. dissented in the result in Cliffs International. However, the division in the Court reflected a difference of opinion in the characterisation of the complex transaction there in question rather than any divergence on matters of principle. Certainly, as his Honour's reference to Robert Addie indicates, there is ample authority for the proposition that the cost of construction of a mine is to be treated as made on capital account; the cost of mineral 9. exploration, made at an anterior stage, isa fortiori capital expenditure (see Coltness Iron Company v. Black (18811 6 A.C. 315 per Lord Penzance at p.327; Alianza Company Ltd. v. Bell £1904] 2 K.B. 666 per Channell J. at p.673; €19063 A.C. 18; Morant v. Wheal Grenville Mining Co. £18941 3 T.C. 298 per Wright J. at pp.301-2; Bonner v. Basset Mines Ltd. £1912] 6 T.C. 146; Kauri Timber Co., Ltd. v. The Commissioner of Taxes £19133 A.C. 771 at p.778; Re Adam (19283 14 T.C. 34 per Lord President (Clyde) at p-42; Hughes v. The British Burmah Petroleum Co. Ltd. £1932] 17 T.C. 286 per Finlay J. at pp.295-6; Golden Horse Shoe (New) Ltd. v. Thurgood [1934] 1K.B. 548 per Romer L.J. at pp.563-4; Stow Bardolph Gravel Co. Ltd. v. Poole £1954] 1 W.L.R. 1503; Knight v. Calder Grove Estates £19541 35 T.C. 447 per Upjohn J. at p.453; Smethurst v. Davey €19573 37 T.C. 593 per Lord Evershed M.R. at pp.601-2; H.J. Rorke Ltd. v. Inland Revenue Commissioners £19603 1 W.L.R. 1132 per Cross J. at p.1142; B.P. Australia Ltd. v. Commissioner of Taxation [£1966] A.C. 224 at p.270; Regent O11 Co. Ltd. v. Strick £1966] A.C. 295 per Lord Reid at pp.313-4; per Lord Morris of Borth-Y-Gest at pp.330-1; Commissioner of Inland Revenue v. Carron & Co. £19683 45 T.C.18 per Lord Wilberforce at p.75; Whiteman & Wheatcroft on Income Tax, 2nd ed. at pp.404-S5; Hannan, Principles of Income Taxation (1946) at p.353; Parsons, Income Taxation in Australia (1985) p.434, paras.7.19; N.E. Challoner, "Taxation of Mineral Ventures" in The Law of Mining in Australia, the University of Sydney, Committee for Post Graduate Studies in the Department of Law, 1970, at p.7). 10. The expenditure, it is true, was recurrent and made over an indefinite period but "if the expenditure can be fully characterized as the payment of consideration for a capital asset or advantage, it will be of a capital nature notwithstanding that the payments are recurrent and are continued for an indefinite period" (per Gibbs C.J. in Cliffs International, supra, at p.156 and the cases there cited). No tangible asset may have been created as a consequence of the taxpayer's expenditure. It is also possible that the exploration may have proved to have been abortive. But 1t does not follow that the expenditure was not on capital account. To use Dixon C.J.'s words, "CLdt is not...right to say that...because you obtain nothing positive, nothing of an enduring nature, for an expenditure it cannot be on account of capital." John Fairfax & Sons Proprietary Limited v. Federal Commissioner of Taxation (1959) 101 C.L.R. 30 at p.36). As Menzies J. observed in that case, the deductibility of an outlay "cannot be made to depend upon the success or failure of what the outlay was intended to achieve." (at p.49). The same principle has been applied in disallowing deductions for unsuccessful applications for licences to carry ona business activity (see Southwell v. Savill Bros. Ltd. £1901] 2 K.B. 349; Pyrah v. Annis & Co. Ltd. £19573 1 W.L.R. 190). Nearer to the present case 1s E.C.C. Quarries Ltd. v. Watkis [19773 1 W.L.R. 1386, where a quarrying company unsuccessfully sought to deduct the cost of an ll. abortive application for planning permission to extract minerals from lands owned or leased by it (per Brightman J. at pp.1396-7; see also Halsbury's Laws of England, 4th ed. Vol. 23 at p.209; Parsons, op cit. at p.447, para.7.62). It may be arguable that the expenditure was made, not as the price for the acquisition of a potential asset or advantage, but rather for the purpose of ascertaining whether the proposed new venture was viable. But this could not improve the taxpayer's position here. Expenditure for a feasibility study is on account of capital (see Softwood Pulp & Paper Limited v. Federal Commissioner of Taxation (1976) 76 A.T.C. 4439 per Menhennitt J. at p.4454). The taxpayer's business was that of exploration for petroleum fields and the exploitation of any commercial discovery for profit. Its business was not that of trading in petroleum prospects or petroleum exploration licences, permits or concessions. In John Smith & Son v. Moore £1921] 2 A.C. 13, Lord Sumner said (at p.38) - "The business carried on was not that of buying and selling contracts, but of buying and selling coals, and the contracts, which enabled the seller of the coals to acquire the coals, were no more the subject of his trading as a stock in trade for sale than a lease of a brickfield would be the subject of a sale of bricks." (See also Golden Horse Shoe (New) Ltd. v. Thurgood, supra, per Romer L.J. at pp.563-4; Whiteman & Wheatcroft, op. cit. at p.407; Parsons, op cit. at p.434, para.7.19). The taxpayer, it 12. is true, could have exploited any field discovered in a variety of ways. But whatever method of commercial exploitation was utilised for this purpose, the costs incurred by the taxpayer were capital expenditure. This is so, even if it were possible to treat the costs as incurred on account of prospecting or exploration carried out by the taxpayer by itself or by an operator on its behalf. The prospecting or exploration was carried out by the taxpayer with a view to its exploitation of any viable deposit discovered. It was not carried out by the taxpayer for the purpose of its trafficking or dealing in any prospect or in any mining information or in any right to exploit any discovery. In rejecting the Commissioner's contention that the expenditure was on capital account because it was anterior to production, Rogers J. said (at p.13 of his Reasons): "The Commissioner was in error in identifying the Taxpayer's business as being restricted to "exploration of some oil prospect, of o11 production rights to be acquired in the future". Once the business of the Taxpayer is correctly identified, not as simply drilling for oil, but exploring for oil and exploiting oil bearing areas, it seems tome that any difficulty in characterisation of the expenditure is resolved. It may be added that the outgoings were of a recurring nature, and of a kind normally regarded as on revenue account, eg labour costs, rentals, transportation of staff, services etc." With respect to the learned Judge, the fact that monies may have been paid by the operators for "labour costs. rentals, transport of staff, services etc." cannot be determinative of the taxpayer's entitlement to a deduction under s.51(1)}. Such 13. payments, taken by themselves, are equivocal or neutral in character for present purposes. The relevant inquiry is to determine for what object or purpose the taxpayer paid the monies. In discharging its liability to the operators and to the interpretation consultants, the taxpayer was expending monies for the purpose or object of gaining the advantages of obtaining seismic information and winning the right to bid with a view to participation in the next phase of exploration. Those advantages were of a capital, rather than of revenue, nature. It does not assist the taxpayer, in this context, to point to the facts that part of its business is to prospect or explore for petroleum and that it regularly incurs outgoings in that behalf by way of salaries, costs of transportation and the like. Its position may have been stronger, for present purposes, 1f prospecting or exploration were its only business. If the taxpayer's only business were to hold out itself for retainer by others to explore or prospect for petroleum on their behalf in return for a fee or other similar reward, such salaries, costs of transportation and the like may have been deductible under s.51(1). But the taxpayer's business is that of the exploration for petroleum with a view to the development of any commercial discovery. In short, the taxpayer was not merely an explorer - it was also concerned to develop any find for its own commercial profit. The second phase, that of exploitation of the discovery, is critical for present purposes. The expenditure was made to obtain for the taxpayer information and standing to participate in a potential commercial discovery. This was done with the 14. prospect of the development of that discovery by the taxpayer as a petroleum field. It should be regarded as made on account of capital rather than on revenue account. It may be thought that such a result is severe (see Regent Oil Co. Ltd. v. Strick, supra, per Lord Reid at p.314). This was recognized by the Assistant Treasurer, Mr. Spender, in moving the second reading of the Income Tax Assessment Bill, 1939 which introduced the former s.123A (later Division 10AA) - "The Government recognises that searching for o11 is an exceedingly speculative and hazardous enterprise and it also recognises that profits cannot be said to have been paid until the total capital expenditure on searching and mining for oil has been recovered." (Emphasis added). (See also the treatment of capital extenditure in Timbs, "Historical Survey of the Mining Provisions of Commonwealth Income Tax Legislation", a study commissioned by the Asprey Committee (The Taxation Review Committee (1975)) at pp.153, 163 and 165). Although Division 10AA of the Act treats expenditure for exploration and for acquisition of mining information as capital items, a specific deduction is allowed only where the activity took place in Australia. In the United Kingdom the costs of searching for or on discovering and testing deposits or winning access to them are, by specific statutory provision, regarded as capital expenditure (see Halsbury's Laws of England, 4th ed., Vol. 23 p.331 para.482; Simon's Taxes (1984), pp.534-5, para. B2.402; pp.1025-6, para.D4.1013). The Asprey Committee was invited to consider the question whether the Act should provide a deduction in respect of expenditure incurred in regard to exploration for petroleum overseas (see Parliamentary Papers, Vol. 16 at p.309, para.19.77; cf. pp. 293-4 paras. 19.18, 19.19; p. 297, para. 19.29; p-312, paras. 19.90, 19.91; see also appendix A, p.319 para. 19.A3). Whether the Act should be amended to permit a deduction for such capital expenditure is not, of course, an issue to be canvassed here. However, so far as it goes, this material lends support for the view that, for the purposes of s.51(1), the taxpayer's expenditure was of a capital character. There remains for consideration the impact, if any, of the subsequent dealings which took place between members of the Ampol group. By letter dated 23 November 1979, Messrs. Thompson Douglass Etherington, Chartered Accountants, wrote to Ampol on the subject of the taxpayer. The relevant part of the letter admitted into evidence reads: "There are two further matters that we wish to raise. Firstly, while appreciating the force of Mr. Cullinan's remarks we consider that exploration and prospecting expenditure may be an allowable deduction under the income tax legislation. This is particularly so in the unusual circumstances confronting the company in these commercial negotiations. We refer particularly to the fact that the company has no certainty of being able to proceed with any further exploration or prospecting work. As we understand the arrangements each piece of work is a separate agreement in itself for which there may be compensation as other participants enter the agreement. Moreover to participate in any subsequent step requires the invitation of the Chinese authorities which 15 1n no way linked to successful participation in the preceding step. For these reasons we believe 16. that the company should consider making a Bubmission to the Federal Treasurer or the Commissioner of Taxation in order to obtain a ruling in this matter." The letter shows that the Ampol group must have appreciated by November 1979 that it was arguable that the taxpayer's expenditure was not deductible for the purposes of Australian income tax. What eventually followed was an attempt by the Ampol group to convert the nature of that expenditure. The group purported to substitute for expenditure already incurred by the taxpayer for exploration carried out with a view to the taxpayer's own exploitation of the area, the expenditure of a "professional" explorer, said to be retained for reward in the form of a fee for services rendered to another member of the Ampol group. The point is emphasised by the taxpayer's return of income. The nature of its business is described as "oil & gas production and exploration" but the deduction now claimed was there described as follows: "Exploration Expenditure During the year of income the company incurred expenditure amounting to $3,475,340 in exploring in permit areas offshore China for the purpose of producing assessable income in the nature of a_fee from Ampol Exploration (Q'land) Pty. Limited." (Emphasis added). In my opinion, it was not appropriate to characterise the expenditure as costs incurred for the purpose of earning a fee from another member of the Ampol group. For one thing, the taxpayer had committed itself to the expenditure by September 1979 when the last of the agreements was entered into. More 17. important, the arrangements for the payment of the fee were made internally within the Ampol group itself. In my view, the character of the expenditure is to be determined by reference to the commitment assumed by the taxpayer under the agreements. For the reasons already given, those costs were capital in nature; it was not open to the taxpayer, ex post facto, to endeavour, by a transaction within its own group of companies, to convert the character of its expenditure into an outlay on revenue account. An alternative submission was made on behalf of the Commissioner that s.260 applied in the present case. In the circumstances, I need not deal with this argument. I would propose that the appeal be allowed, that the cross-appeal be dismissed and that the orders made by Rogers J. be set aside. In lieu thereof, it should be ordered that the appeal to the Supreme Court be dismissed with costs. I would order the taxpayer to pay the Commissioner's costs of the appeal. I certify that this and the preceding sixteen (16) pages are a true copy of the Reasons for Judgment herein of his iw) Mr. be P Colne Associate Dated: o/ November 1986 IN THE FEDERAL COURT OF AUSTRALIA ) ) NEW SOUTH WALES DISTRICT REGISTRY No. G.49 of 1986 ) GENERAL DIVISION ON APPEAL FROM THE SUPREME COURT OF NEW SOUTH WALES BETWEEN: THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA Appellant ig AMPOL EXPLORATION LIMITED Respondent CORAM: Lockhart, Beaumont & Burchett JJ. DATE: 27 November 1986 REASONS FOR JUDGMENT BURCHETT J. I have had the advantage of reading in draft the judgment of Lockhart J. It is unnecessary for me to duplicate his statement of the facts, but I shall state my own reasons for agreeing with his conclusions. The difficulty of cases concerned with the question of whether an outgoing is of capital or of a capital nature or whether it is a revenue outgoing is not a difficulty of comprehension of the principle involved, but of its application 2. to the infinite variety of business circumstances. As Dixon J. pointed out in Halistroms Proprietary Limited v. The Federal Commissioner of Taxation (1946) 72 C.L.R. 634 at 646: "The truth is that, in excluding as deductions losses and outgoings of capital or of a capital nature, the income tax law took for its purposes a very general conception of accountancy, perhaps of economics, and left the particular application to be worked out, a thing which it thus became the business of the courts of law to do." In Heather v. P-E Consulting Group Ltd. [1973] 1 Ch. 189 at 216 Lord Denning M.R. said of the distinction between revenue and capital expenditure: "In many cases the answer is easy, but in others it is difficult. The difficulty arises because of the nature of the question. It assumes that all expenditure can be put correctly into one category or the other. But this is simply not possible. Some cases lie on the border between the two, and this border is not a line clearly marked out. It is a blurred and undefined area in which anyone can get lost. Different minds may come to different conclusions with equal propriety. It is like the border between day and night, or between red and orange. Everyone can tell the difference except in the marginal cases, and then everyone is in doubt." In the search for the elusive borderline between the business entity, structure or organization, set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the courts have been able to offer only the 3. guidance of fairly broad considerations. In the well known passage in Sun Newspapers Limited & Associated Newspapers Limited v. The Federal Commissioner of Taxation (1938) 61 C.L.R. 337 at 363 Dixon J. said: "There are, I think, three mattera 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 is 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." Each of these three considerations relates to "the advantage sought". In the present case, the nature of that advantage is more clearly seen when it is appreciated just what was the relevant business being conducted by the respondent which sought it. The respondent was, at all events so far as concerns that portion of its business which included its activities in China, carrying on business as an oil exploration company. It was not in that respect establishing or extending the production of oil from a proven field. There was no more than the merest possibility that it would ever be doing so. In Hallstroms Proprietary Limited Vv. Federal Comnissioner of Taxation (supra, at 647) Dixon J. referred to: "the general consideration that the contrast between the two forms of expenditure 4. corresponds to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organization and carrying on the business; between' the implements employed in work and the regular performance of the work in which they are employed; between an enterprise itself and the sustained effort of those engaged in it." An attempt to apply directly this general statement to the case of an Australian exploration company sharing in the cost of seismic exploration activity in the South China sea immediately emphasises the necessity to define the means of production or the enterprise the subject of the enquiry. For the dichotomy propounded by Dixon J. assigns the expenditure either to the acquisition of the means of production, or to the use of them; either to establishment or extension of a business organization, or to carrying it on; either to its implements, or to their employment; either to an enterprise itself, or to the sustained effort of those engaged in it. These concepts are easily applied to (and naturally fit) expenses in connection with the setting up or operation of a factory, but the comparison they require seems less appropriate for a series of exploration activities which may go on for years without the establishment of any productive field at all. Certainly an expense cannot be assigned to capital or revenue account according as it may be successful: John Fairfax & Sons Proprietary Limited v. Federal Commissioner of Taxation (1959) 101 C.L.R. 30 at 49. But the comparison Dixon J. makes at least assumes it is not such as in itself to be likely to be thrown away; yet most of the activities of an oil exploration company involve expenditure of that kind. It seems to me the test can only be sensibly applied, in such a case as the present, on the basis that, the enterprise being the exploration company itself, the relevant business organization, implement, or means of production, {ses its exploration arm (including all its skilled employees = and sophisticated equipment), and not any one project undertaken by that arm. A project ia a part of the regular performance and sustained effort being carried on by the enterprise, all the activities of which are directed to the finding and commercial exploitation of undiscovered oil. But once the matter is so regarded, there is no longer any question: the expenditure is a quite ordinary incident of the company's operations. An oil exploration company does not expend its moneys upon, for example, seismic surveys, with any expectation of obtaining thereby an enduring asset, but upon the basis that if it engages in efforts of that kind often enough, whilst exercising what judgment the nature of the pursuit permits, one of its outlays may eventually yield a rich return. The whole operation is in marked contrast to such a case as the Hallstrom case where the expenditure, though the result might be seen as doubtful, aimed at a particular business expansion (the manufacture of a product free of restraint by a patent). It is only in a sense akin to that intended by the poet when he wrote that a man's reach should exceed his grasp that the respondent reached for an interest in oil in the South China sea, and only 6. in heaven could the result be predicted. On the other hand, the pursuit of many such projects offered a reasonable prospect of profit from one or some of them, and this was the company's business. From a practical and business point of view, the outlay was calculated to carry that business purpose into effect. Unlike the payment made in the Hallstrom case, the particular expenditure was not so much aimed at changing "the character and organization of the profit-earning business" of the company as it was "an incident in the operations by which (the business) is carried on" (see the Hallstrom case at 648). To see expenditure of this kind as such an incident is not a novelty peculiar to the present appeal. In the report of the Taxation Review Committee (the Asprey Report) presented 31 January 1975 at pp.293-4 it is stated: "The Committee favours the approach that would make all exploration and prospecting expenditure immediately deductible against assessable income derived from any source. The availability of a deduction upon the lines suggested would constitute an acknowledgement that exploration expenditure is a normal operating expense of a mining enterprise and should be treated as such. (Emphasis added.) It hardly needs to be said that a recommendation that a deduction should be specifically allowed is not at all inconsistent with the proposition that in many cases it may already be strictly allowable: Ashfield Municipal Council v. Joyce [1978] A.c. 122 at 137; cf. Corporate Affairs Commission (SA) v. Australian Central Credit Union (1985) 61 A.L.R. 236 at 242. Authority supports the proposition that the fact that the expenditure obtained for the respondent no tangible asset or advantage of an enduring kind ia a consideration against its being on capital account. The true view is that it is not determinative, but it does point in that direction. In John Fairfax & Sons Proprietary Limited v. Federal Commissioner of Taxation (supra, at 54-5) Menzies J. quoted the familiar observation of Viscount Cave L.C. in British Insulated and Helsby Cables Limited v. Atherton [1926] A.C. 205, and added: "There can be no doubt that when the question is whether a payment is of a capital nature er not it is an important circumstance that it has or has not increased the taxpayer's assets but this has not been accepted as an infallible test...". In the South African case Palabora Mining Company Limited v. Secretary for Inland Revenue (1973) 35 S.A.T.C. 159 at 173 Ogilvie Thompson C.J., speaking for the Supreme Court of South Africa, said: "Nor is the circumstance that expenditure has neither created a new asset nor made any addition to an existing asset necessarily conclusive in favour of such expenditure being on revenue account. ... Nevertheless, if no asset has been acquired as a result of the expenditure, that is always a relevant factor." The absence of the establishment of a tangible asset is a factor which is often in the cases taken into account in connection with the fact that expenditure forms part and parcel of an enterprise's ongoing and recurring activities directed to the earning of its income. In B.P. Australia Limited v. Federal Commissioner of Taxation (1964) 110 C.L.R. 387 at 410 Dixon C.J. said: "There appears to me to be no. specific expenditure in increasing its plant, machinery or any other element in _ the profit-earning instrument under its control." He was speaking of payments by an oil company, to the proprietors of certain service stations, to obtain restrictive agreements limiting them to the sale of its petrol. At 415 Kitto J. referred to the expenditure as "a regular feature of (the company's) selling activities", and continued: "How then should the advantage be described for which the appellant made the expenditure we have here to characterize? In the view I take of the case, the advantage was not the acquisition of a new market, not a new framework within which to carry on trade for the future, not an extension of the appellant's selling organization to include a regiment of resellers. It was not such an exclusion of competition as adds to goodwill a negative right and thus increases the value ef goodwill. It consisted simply of the practical assurance of receiving bundles of orders for motor spirit, the circumstances being such that for the foreseeable future it would be only by getting similar bundles of orders that such a trade as the appellant's could be carried on." In the companion case Vacuum Oil Company Proprietary Limited v. Federal Commissioner of Taxation (1964) 110 C.L.R. 419 at 434 Dixon C.J. said: "It appears to me clearly expenditure incurred in the process of marketing the commodity and to be expenditure which ia not made once for all but is likely to be repeated, and not to be sufficiently identified as outside the ordinary conduct of business." Kitto J., at 435, referred to the payments as "part of the process of getting the business - of selling the goods.... ." When the B.P. case went to the Privy Council the views of Dixon C.J. and Kitto J. prevailed: B.P. Australia Limited v. Commissioner of Taxation of the Commonwealth of Australia (1966) A.C. 224. At 266 the advice of the Privy Council, delivered by Lord Pearce, refers to the payments as "part of the constant demand which must be answered out of the returns of the trade." At p.270 he said: "It is of commercial importance that profits should not be inflated for tax purposes by the artificial withdrawal from the profit and loss account of expenditure directly incurred in earning them unless it is of a truly capital nature." The Privy Council applied the well known passage I have quoted from the judgment of Dixon J. in the Sun Newspapers case (supra) together with the further passage (at p.362) where Dixon J. said: "the expenditure is to be considered of a revenue nature if its purpose brings it within the very wide class of things which in the aggregate form the constant demand which must be answered out of the returns of a 10. trade or ite circulating capital and that actual recurrence of the specific thing need not take place or be expected as likely." (With this may be compared the conclusion of Cross J. in Cooper (Inspector of Taxes) v. Rhymney Breweries Ltd. [1965] 1 W.L.R. 1378 at 1385.) Reference was also made to what Viscount Radcliffe said in Commissioner of Taxes v. Nchanga Consolidated Copper Mines Ltd. [1964] A.C. 948 at 960: "Again, courts have stressed the importance of observing a demarcation between the cost of creating, acquiring or enlarging the permanent (which does not mean perpetual) structure of which the income is to be the produce or fruit and the cost of earning that income itself or performing the income-earning operations." Viscount Radcliffe's statement was relied on in the joint judgment of Kitto, Taylor and Menzies JJ. in Foley Brothers Pty. Limited v. Federal Commissioner of Taxation (1965) 13 A.T.D. 562 at 563 where they said: "The true contrast is between altering the framework within which income-producing activities are for the future to be carried on and taking a step as part of those activities within the framework." In my view, the relevant business of the respondent was the discovery and exploitation of oil, to which the seismic survey expenses were incidental. Their purpose was not to enlarge the framework within which that activity was carried on; they formed part of the activity. They were within the wide ll. class of things forming the constant demand upon the enterprise of which Dixon J. spoke in the Sun Newspapers case. The advantage sought by the expenditure was the opportunity to pursue in China exploration of the kind normally pursued by the company in and near Australia, with a view to the rewards the exploration might bring, including such a fee as that in respect of which ultimately a minimum was fixed, though s.51 does not require that an anticipated reward be of so direct a nature: Federal Commissioner of Taxation v. Total Holdings (Australia) Pty. Ltd. (1979) 24 A.L.R. 401 at 410. The manner in which that advantage was to be used was simply as part of the constantly recurring investigations of prospectively oil bearing areas which formed the subject matter of the company's principal activity. The means adopted to obtain that advantage may not, perhaps, in this case be thought particularly significant either way; but it was acquired under participation agreements not in point of principle @ifferent from agreements commonly entered into in order to facilitate the carrying out of exploration work in pursuit of gain by oil exploration enterprises. Having regard both to my understanding of how the general distinction the law requires to be made ought to be applied to the particular circumstances of the activity in question, and also to the three considerations formulated by Dixon J. to assist in the application of that general distinction, I have concluded that the expenditure fell within poth limbs of s.51, and was not of capital or of a capital nature. 12. The appellant submitted that, if his arguments otherwise failed, 8.260 atruck down, as against him, the provision in the deed of assignment by which, in certain events, the respondent was to earn a fee. I agree with Lockhart J. and Rogers J. (in the Supreme Court) that the transaction is explicable by reference to ordinary business dealing. But in any case, on the view which I take, it could not be said that it had the purpose or effect of altering the incidence of any income tax, or of achieving any of the other things mentioned in the section. The circumstances of this case do not require me to consider the distinction drawn by Lord Templeman in Commissioner of Inland Revenue v. Challenge Corporation Limited (1986) 8 N.Z.T.C. 5219 at 5225 between tax mitigation and tax avoidance - in my opinion the assignment had no relevant effect upon the deductibility of the expenses in question in this appeal. It should perhaps be mentioned that, in his argument in the Supreme Court, senior counsel for the Commissioner referred to 8.23(q) and suggested that the outgoings were not incurred in gaining assessable income, or for the purpose of gaining assessable income, since any Chinese sourced income might not have been exempt from income tax in China. But it was pointed out that there was in fact no applicable Chinese income tax, at all events at any relevant time, and no such contention was raised upon the appeal to this Court. 13. I agree with the orders proposed by Lockhart J. I certify that this and the preceding twelve (12) pages are a true copy of the Reasons for Judgment herein of his Honour Mr. Justice Burchett. Shin es Associate Dated: 27 November, 1986. Counsel and Solicitors Mr. D.A. Staff Q.C. with Mr. T.F. for Appellants and Bathurst instructed by Australian Cross-Respondent Government Solicitor. Counsel and Solicitors Mr. C. Sheller Q.C. with Mr. G.C. for Respondent and Lindsay instructed by Freehill Cross-Appellant Hollingdale & Page. Dates of hearing: 2 and 3 June 1986 Date Judgment Delivered: 27 November 1986