FEDERAL COURT OF AUSTRALIA Reef Networks Pty Ltd v Deputy Commissioner of Taxation [2003] FCA 1552 INCOME TAX – private ruling – allowable deductions – depreciation – whether under the 'arrangement' the 'plant' would be used for the purpose of gaining or producing assessable income Taxation Administration Act 1953 (Cth) s 8-1(1), 14ZAA(2), 14ZAAA, 14ZAF, 14ZZ, 14ZZO(b)(iii), 40-25, 40-25(2), 40-25(7), 42-15, 42-170(1), 995-1, Part IVAA Income Tax Assessment Act 1997 (Cth) Division 42 Income Tax Assessment Act 1936 (Cth) s 51(1) New Business Tax System (Capital Allowances) Act 2001 (Cth) Bellinz v Commissioner of Taxation (1998) 84 FCR 154 cited Commissioner of Taxation v McMahon (1997) 79 FCR 127 cited Federal Commissioner of Taxation v Payne (2000) 202 CLR 93 referred to Goldsworthy Mining Ltd v Federal Commissioner of Taxation (1973) 128 CLR 199 cited Goldsworthy Mining Ltd v Federal Commissioner of Taxation (1975) 132 CLR 463 referred to John Fairfax & Sons Pty Ltd v Federal Commissioner of Taxation (1959) 101 CLR 30 referred to Pettigrew v Federal Commissioner of Taxation (1990) 92 ALR 261 referred to Quarries Ltd v Federal Commissioner of Taxation (1961) 106 CLR 310 referred to Ronpibon Tin NL and Tong Kah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47 referred to Ryde Municipal Council v Macquarie University (1978) 139 CLR 633 referred to REEF NETWORKS PTY LTD v DEPUTY COMMISSIONER OF TAXATION N 706 OF 2003 HELY J 22 DECEMBER 2003 SYDNEY IN THE FEDERAL COURT OF AUSTRALIA NEW SOUTH WALES DISTRICT REGISTRY N 706 OF 2003 BETWEEN: REEF NETWORKS PTY LTD APPLICANT AND: DEPUTY COMMISSIONER OF TAXATION RESPONDENT JUDGE: HELY J DATE OF ORDER: 22 DECEMBER 2003 WHERE MADE: SYDNEY THE COURT ORDERS THAT: 1. The appeal be upheld. 2. The objection decision is set aside insofar as it determines that the amount of the depreciation deduction otherwise available with respect to the cable should be reduced by 4/12. 3. The respondent pay the costs of these proceedings. Note: 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 N 706 OF 2003 BETWEEN: REEF NETWORKS PTY LTD APPLICANT AND: DEPUTY COMMISSIONER OF TAXATION RESPONDENT JUDGE: HELY J DATE: 22 DECEMBER 2003 PLACE: SYDNEY REASONS FOR JUDGMENT 1 This is an appeal under s 14ZZ of the Taxation Administration Act 1953 (Cth) ('the TAA') against the decision of the respondent ('the Commissioner') to disallow the applicant's objection against a private ruling made by the Commissioner on 27 July 2001 under Part IVAA of the TAA in respect of the years of income ended 30 June 2001 to 30 June 2003. The private ruling related to a project which will establish a fibre optic cable network between Brisbane and Cairns. 2 The subject matter of the appeal is the 'arrangement' (TAA ss 14ZAF, 14ZAA(2) and 14ZAAA) identified by the Commissioner in his private ruling. The Court does not have the power to redefine the 'arrangement' the subject of the Commissioner's ruling. The question for the Court is whether the Commissioner's opinion as to the application of the law in relation to that arrangement is correct: Commissioner of Taxation v McMahon (1997) 79 FCR 127, 132-133, 140-141, 149-150; Bellinz v Commissioner of Taxation (1998) 84 FCR 154, 160. The applicant has the burden of proving that the ruling should have been made differently: TAA s 14ZZO(b)(iii). The Arrangement 3 The Notice of Private Ruling issued on 27 July 2001 identifies the subject matter of the ruling as being: 'The arrangement as set out in the request for private ruling dated 19 June 2000 including associated documentation, listed in Appendix B of the request, and subsequent correspondence dated 28 August, 20 October and 14 December 2000, 7 March, 5 April, 26 April, 31 May and 20 June 2001.' 4 The arrangement thus described is to be found in some hundreds of pages of documents, including a series of letters which contain a mixture of asserted facts, and submissions as to the taxation consequences of the facts so asserted. In some cases, this method of describing the arrangement may make it difficult to ascertain with precision the hypothetical facts on which the Commissioner's ruling is based. 5 In the present case, the ruling contains some explication of what those facts are, although the generality of the description of the arrangement referred to above is not confined by that explication. However, it was accepted in argument that the key features of the arrangement identified in the private ruling which are, or may be, relevant for the purposes of this appeal are: (a) the project in question involves the construction of a fibre optic cable telecommunications network ('the network') which will be owned by the applicant. The network essentially comprises: · the fibre optic cable (containing 12 fibre optic strands) ('the cable'); · the associated data transmission equipment; and · facilities that support the data transmission equipment; (b) the cable will be 1,800 kilometres in length and will be installed beside the railway line which runs between Brisbane and Cairns pursuant to a corridor licence between Queensland Rail ('QR') and the applicant; (c) eight of the fibre optic strands have supporting electronic equipment, and are described as 'lit' fibres. Four of the fibre optic strands have no supporting electronic equipment, and are described as 'dark' fibres; (d) construction of the network commenced in early 2000 and was completed in April 2001. The estimated life of the cable is 30 years; (e) the applicant entered into a corridor licence with QR on 10 June 1999. Pursuant to this agreement the applicant obtained the right to access the rail corridor to construct, maintain and operate the network for a term of 30 years from 2 March 2000. The consideration for the licence is: - ten equal instalments of $45,000 over the first ten months of construction by way of reimbursement of QR costs; - the grant to QR of the exclusive right to use four dark fibres ('the QR fibres') within the network for the life of the agreement for no consideration; and - $1.00 per annum if demanded; (f) under an agreement between the applicant and Optus Networks Pty Ltd ('Optus') made on 13 December 1999; - Optus has an exclusive licence over eight of the twelve fibre optic strands ('the Optus fibres') for a period of 10 years and 3 months subject to provisions for extension and early termination; - The applicant provides operational and maintenance services to Optus in respect of the Optus fibres; - Optus pays the applicant a licence fee for both the exclusive licence of the Optus fibres and the provision of the operational and management services. The Ruling 6 The part of the ruling which is the subject of the present proceedings is that comprised in the following paragraphs of Ruling 2 made on 27 July 2001; other parts of the ruling were not the subject of challenge on appeal: 'Depreciation deductions (pursuant to the former Division 42) for the cable containing the lit fibres and the QR fibres are allowable to the owner of the cable. For the year commencing 1 July 2001 and later years, a decline in value deduction will be allowable to the holder of the cable under Division 40. Our view is that the cable, comprising all twelve optic fibres, the cable sheath and the internal protective material forms a separate unit of depreciable plant, rather than a particular fibre or cluster of fibres within the cable. … As the lit fibres are leased to a third party, you partly use the cable for the purpose of producing assessable income. A depreciation deduction is thus available to you under the former section 42-15 as the owner of the cable. For the year commencing 1 July 2001 and later years, a decline in value deduction is available to the holder of the cable under section 40-25. … The amount of the depreciation deduction available for the cable must be reduced by an amount that reasonably refects the extent to which the cable is not used (or installed ready for use) for the purpose of producing assessable income. You do not use four of the twelve fibres in the cable for the purpose of producing assessable income. A reasonable reflection of the extent to which the cable is not used for assessable income producing purposes is to reduce the depreciation deduction by that same proportion.' 7 The objection against the ruling that the cable is a single unit of plant was not pursued on appeal. The Legislation 8 For the year of income ended 30 June 2001, the relevant legislation was Division 42 of the Income Tax Assessment Act 1997 (Cth) (now repealed). That Division included the following sections: '42-15 You deduct an amount for depreciation of a unit of *plant for an income year, if in that year: (a) you are its owner or *quasi-owner; and (b) you use it, or have it *installed ready for use, for the purpose of producing assessable income. 42-170(1) Reduce your deduction by an amount that reasonably reflects the extent (if any) that you neither used the *plant, nor had it *installed ready for use, for the *purpose of producing assessable income during the period in the income year you were its owner or *quasi-owner.' 9 Asterisked terms (*) are defined in the dictionary starting at section 995-1. Section 995-1 included the following definitions: 'business includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee. purpose of producing assessable income: something is done for the purpose of producing assessable income if it is done: (a) for the purpose of gaining or producing assessable income; or (b) in carrying on a *business for the purpose of gaining or producing assessable income.' 10 For the year ended 30 June 2002 and subsequent years the relevant legislation was Division 40 of the Income Tax Assessment Act 1997 (Cth) which was substituted by the New Business Tax System (Capital Allowances) Act 2001 (Cth) for the former Division 42. That Division includes the following sections: '40-25 You deduct the decline in value 40-25(1) You can deduct an amount equal to the decline in value for an income year (as worked out under this Division) of a *depreciating asset that you *held for any time during the year. 40-25(2) You must reduce your deduction by the part of the asset's decline in value that is attributable to your use of the asset, or your having it *installed ready for use, for a purpose other than a *taxable purpose. 40-25(7) A taxable purpose is: (a) the purpose of producing assessable income; or …' 11 The definition of the expression 'purpose of producing assessable income' in s 995-1 remains as it was in respect of the year of income ended 30 June 2001. 12 It is not in contest that under the 'arrangement' the cable is: - a unit of plant and a depreciating asset, and - used or, installed ready for use, at all material times. 13 The issue is whether under the 'arrangement', so much of the cable as comprised the QR fibres would be used for a purpose of gaining or producing assessable income, or in carrying on a business for that purpose, in terms of the definitions contained in s 995-1 of the 1997 Act. The only aspect of the private ruling which the applicant says should have been made differently is that which concerns the application to the 'arrangement' of: - s 42-170(1) in respect of the year of income ended 30 June 2001; and - s 40-25(2) in respect of the years of income ended 30 June 2002 to 30 June 2003. Consideration 14 Section 51(1) of the 1936 Act and s 8-1(1) of the 1997 Act permit the deduction from assessable income of any loss or outgoing to the extent that: - it is incurred in gaining or producing the assessable income; or - it is necessarily incurred in carrying on a business for the purpose of gaining assessable income. 15 The second limb 'can add but little to the operation of the first': Ronpibon Tin NL and Tong Kah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47 at 56. The fact that an item of expenditure is a necessary prerequisite to the earning of a taxpayer's income does not mean that it is incurred in gaining or producing that income. Outgoings, which although incurred for the purpose of deriving assessable income but which are not incurred in the course of doing so are not deductible under the first limb: Federal Commissioner of Taxation v Payne (2000) 202 CLR 93 at [9], [13] and [16]. The same notion applies to the second limb. A distinction is drawn between expenditure 'in carrying on business' (which is deductible), as opposed to expenditure for the purpose of enabling' a person to carry on business (which is not): John Fairfax & Sons Pty Ltd v Federal Commissioner of Taxation (1959) 101 CLR 30, 47-48, 49. In the case of either limb, the payment must have the character of a working expense. 16 The respondent submits that these principles are applicable to the circumstances of the present case, and that there is no reason in principle why deductions for depreciation should be treated differently in this respect from deductions for outgoings. This submission should be rejected. As Hill J pointed out in Pettigrew v Federal Commissioner of Taxation (1990) 92 ALR 261, 279 the two regimes are quite different. The depreciation provisions are concerned with the amortisation of capital rather than with working outlays, and allow amortisation deductions if the outlays were 'for the purpose of' gaining assessable income, or of carrying on a business to produce assessable income. In neither s 51(1) of the 1936 Act, nor s 8-1 of the 1997 Act is 'purpose' a criterion of deductibility. 17 There can be no doubt but that the cable was used by the applicant for the purpose of producing assessable income in the years in question. The fact that this 'use' consisted of granting a licence to Optus to use the cable is beside the point: Ryde Municipal Council v Macquarie University (1978) 139 CLR 633, 638; Pettigrew (supra) at 279. However, ss 42-170 and 40-25 of the 1997 Act require consideration of whether the cable was also used in a year of income for a purpose other than gaining or producing assessable income, or in carrying on a business for that purpose. The determination of the 'purpose' for which the cable was used is a matter of objective characterisation. It does not depend upon the subjective intention of the applicant, or of anyone else: Pettigres (supra) at 278-279. 18 The only assessable income which the applicant receives under the 'arrangement' derives from the agreement entered into with Optus. The applicant does not derive any assessable income from the licence of the QR fibres to QR. The respondent's written submissions assert: '23. What that means for relevant purposes is that, while the QF fibres might be used to put Reef in a position where it is able to earn assessable income, they would not be used by Reef in the course of earning assessable income. 24. It would simply not be to the point, even if it were the case, that without the licence of the QR fibres, Reef would not be able to have the fibre optic cable at all – and therefore would not be able to derive assessable income from licensing the Optus fibres to Optus. The use of the QR fibres is quite separate from – and at best prefatory and anterior to – the gaining or producing of assessable income under the agreement with Optus. The licence of the QF fibres might allow Reef to carry on its business by which it derives assessable income. The licence of the QF fibres would not thereby be part of carrying on that business.' These submissions echo the proposition which I rejected earlier that principles applicable to deductions for outgoing should be applied to depreciation allowances. 19 The business of the applicant consists of, or includes, the owning, operating and licensing the use of the cable. The QR fibres were made available to QR pursuant to the corridor licence. Without that licence (or some substitute arrangement) it would have been impossible for the applicant to carry on its business of licensing the use of the cable for reward. Once it is accepted, as it must be, that such use of the cable as involves QR is to put the applicant in a position where it is able to earn assessable income (from Optus), then it follows that the applicant's use of the cable in relation to QR was for the purpose of deriving assessable income, or in carrying on a business for that purpose. Capital expenditure may often be prefatory and anterior to the derivation of assessable income. 20 Accordingly, neither s 42-170(1) nor s 40-25 requires a reduction of the deduction to which the applicant would otherwise be entitled by reason of the applicant's use of the cable in relation to QR. 21 Some support for that conclusion can be derived from the decision of the High Court in Quarries Ltd v Federal Commissioner of Taxation (1961) 106 CLR 310. There, the main source of income of a taxpayer which carried on the business of quarrying and crushing stone was the carrying out of contracts with the South Australian highway authority at various and frequently remote places. The taxpayer's equipment included 'portable sleeping units' which were small enclosed sheds or cubicles taken from site to site upon a trailer attached to a prime mover. The sleeping units were used to provide sleeping accommodation for the taxpayer's employees at the various sites where its operations were carried on, without charge to the employees. It was held, by Taylor J that the sleeping units were used for the purpose of producing assessable income within the meaning of s 54(1) of the 1936 Act. At p 317, his Honour said: 'The ultimate question, therefore, is whether the units were used for this purpose [of producing assessable income]. I have already indicated that it would not be unreasonable to regard the entirety of the taxpayer's equipment comprised in the "train" as a comprehensive unit designed to enable the taxpayer to conduct the major part of its somewhat unusual business. Indeed, I do not see any reason why it should not be regarded as the "heart and core" of the major part of its enterprise (Commissioner of Inland Revenue v Reid (1950) 31 Tax Cas. 402, at p 417) and, therefore, "plant or articles" used for the specified purpose. But the majority of the Board of Review considered the units separately and came to the conclusion that they were outside the section because "they merely provide sleeping accommodation for the company's employees". From one point of view this may be a strictly accurate statement but it fails to do justice to the taxpayer's case. Its business was of a special character, it could be carried on only if the taxpayer transported its crushing plant and its employees to each selected site and, obviously, it could be carried on only if some accommodation for its employees was provided at each site. The sleeping units were, of course, used by the employees for the purpose which their description implies. But this is beside the point. The critical question is concerned with the purpose for which they were used by the taxpayer. Obviously, without the units, or without tents, it would have been impossible for the taxpayer to carry on its business in the manner which its contractual obligations required. For my part I have no doubt that the correct view is that the units constituted "plant or articles" within the meaning of the section and that they were used for the purpose specified in the section.' 22 Quarries (supra) is an illustration of the fact that plant may be used by a taxpayer for the requisite purpose even though the plant does not of itself generate assessable income. The fact that QR does not pay for its use of the cable does not lead to the conclusion that the taxpayer's use of the cable in relation to QR is for a purpose other than the derivation of assessable income. 23 On the other hand, the Commissioner relies upon the decision of the High Court in Goldsworthy Mining Ltd v Federal Commissioner of Taxation (1973) 128 CLR 199 (Mason J); (1975) 132 CLR 463 (Full Court). There, dredging of a harbour by a mining company in order to facilitate the removal of iron ore was held not to constitute an improvement of land used for the purpose of producing assessable income within the meaning of s 88(2) of the 1936 Act. Mason J found that neither the dredging of the seabed, nor the support which it provided for the waters in the navigation channel or harbour constituted a relevant use of the seabed by the appellant. That was also the approach adopted by Stephen J on appeal. 24 Barwick CJ (with whom Gibbs J agreed) said at p 468: 'The taxpayer's case cannot I think be put higher than by saying that unless the improvements had been made in the land leased, iron ore carriers could not use the water above the land leased because it would be too shallow, and without carriers coming to the wharf in the harbour at Port Hedland the taxpayer would have no assessable income. These truths, however, do not of themselves warrant the deduction claimed unless what has just been stated does constitute the use of the leased land by the taxpayer to produce assessable income. I do not think it does. Although it may properly be said that the ships used the deepened channel, that use does not "produce" the taxpayer's assessable income notwithstanding that without it the taxpayer may have no assessable income.' 25 In both Quarries and Goldsworthy (supra) the issue was one of the proper characterisation of the particular fact situation there under consideration, in the particular statutory context. Whilst illustrations are often helpful, neither case lays down any legal rule, and as illustrations it may be thought that the quoted observations point in different directions. In the present case, it seems to me, with respect, that the mere fact that the licence of the cable to QR did not 'produce' assessable income from QR is not determinative of the question of deductibility. A barrister's library, for example, does not of itself produce the barrister's assessable income, but it is used by the barrister for that purpose. 26 The appeal is upheld: - the objection decision is set aside insofar as it decides that the amount of the depreciation deduction otherwise available with respect to the cable should be reduced by 4/12; and - the Commissioner is ordered to pay the applicant's costs of these proceedings. I certify that the preceding twenty-six (26) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Hely. Associate: Dated: 22 December 2003 Counsel for the Applicant: Mr Slater QC, Mr Fraser Solicitor for the Applicant: KPMG Legal Counsel for the Respondent: Mr Gageler SC, Mr Quinn Solicitor for the Respondent: Australian Government Solicitor Date of Hearing: 10 December 2003 Date of Judgment: 22 December 2003