In brief 15 min read
Recent decisions handed down by both the High Court and Federal Court in relation to the 'income/capital distinction' and 'blackhole expenditure' have produced a mix of predictable and unexpected, but generally unfavourable, outcomes for taxpayers. Most buyers have been denied deductions for the purchase price of assets, and thereby forced to delay recognising that cost under the capital gains tax (CGT) regime until a future disposal, whereas some sellers have had their gains taxed as ordinary income, thereby denying them concessions available under the CGT regime on disposal.
- Buyers of semi-privatised state assets should consider the decision of the Federal Court in Origin Energy, where Origin was denied a deduction for 'capacity charges' paid in return for effective control of two power stations for their technical lives.
- In contrast, the decision in Healius provides a rare favourable outcome for buyers, with the Federal Court finding that payments made by a medical centre operator to doctors effectively to secure their custom were deductible. The Commissioner has appealed this decision.
- Following the decision of the Federal Court in Origin Energy and the High Court in Sharpcan, it is possible that only in exceptional cases will buyers be entitled to a deduction under section 40-880 for so-called 'blackhole expenditure'.
- Instead, in many transactions, buyers must account for their purchase price payments as cost base for a CGT asset under the CGT regime. Uncertainty remains regarding the apportionment of that purchase price and the timing of the realisation of any capital gain or loss.
- Sellers of assets should consider the decision of the Full Federal Court in Greig, in which the reasoning appears to suggest that certain investors might be more likely to have their realised gains taxed as income, rather than under the concessional CGT regime.
In-house tax counsel, tax managers and in-house tax teams generally should familiarise themselves with these recent decisions and the implications they may have for ongoing or future engagement with the Australian Taxation Office (ATO), either through audits or the justified trust program.
For asset sales and purchases that have already occurred (including privatisations and similar transactions), tax teams should review the treatment adopted, as well as any advice received, for consistency with the reasoning in these recent cases.
If the COVID-19 pandemic results in distressed business sales or sell-downs of government assets, concessions or enterprises to shore up state and territory budget positions, tax teams should engage with transaction teams to ensure that the appropriate income tax treatment informs modelling and negotiations.
Sophisticated investors such as high-net-worth individuals (and their representatives) should be aware that gains that were until now considered to be the product of investment activities taxed under the CGT regime may instead be properly taxed less concessionally as income, but the corollary is that losses may be deductible.
Expenditure to acquire rights to trade and control of power stations not deductible
In the most recent decision, Origin Energy Ltd v Commissioner of Taxation (No 2), a subsidiary member of Origin's consolidated group entered into agreements with a statutory corporation owned by New South Wales in relation to a coal-fired power station and pumped hydroelectric storage and power station. Under the agreements, the subsidiary member was required to pay the statutory corporation pre-determined annual 'capacity charges', which were required to be made by way of a single upfront lump sum payment of the net present value of those charges. While the statutory corporation retained ownership of the power stations, Justice Thawley found that the subsidiary member acquired a bundle of rights that effectively gave it control over, and risk in relation to, the power stations for their technical lives.
Origin argued that the capacity charges were deductible because they were paid in return for the supply of electricity for on-sale into the National Electricity Market. Against that, the Commissioner argued they were not deductible as they were outgoings of capital because they were not incurred in the operation of Origin's profit-making structure, but rather its extension. Justice Thawley agreed with the Commissioner and held that the capacity charges were not deductible under section 8-1(2)(a) of the Income Tax Assessment Act 1997 (Cth) because they were an outgoing of capital or of a capital nature. His Honour stated that the overarching reason for this was 'that the advantage sought by the expenditure was an acquisition of a new or extended profit making structure.'1
More specifically, Justice Thawley held that:2
"The practical business and legal consequence of the transactions was that OEEL acquired the right to trade the whole of the electricity generated by the power stations for 22 and 28 years. The contractual arrangements giving rise to that right were such that OEEL, through its trading activities, could control when and how much electricity was generated. … The totality of the arrangements gave rise to a new or extended business structure for Origin, which substantially extended its previous operations."
The particular regulatory framework for the electricity market provided important context for the contractual arrangement. Key factors in reaching this conclusion appear to have been that the capacity charges were payable in full regardless of the amount of electricity (if any) that Origin's subsidiary required the statutory corporation to generate and supply, and that the rights conferred upon Origin's subsidiary made it, from a practical perspective, the owner of the power stations for their technical life, reducing the statutory corporation, again from a practical perspective, to the role of asset manager.3
From a tax technical perspective, the reasoning is consistent with an increasing trend in income/capital distinction of conducting a two-stage analysis:
- identifying the advantage sought by the expenditure from a practical and business point of view; and
- characterising whether that advantage is one utilised in the operation of the profit-making structure of the business (income) or an expansion of that profit-making structure (capital).4
Indeed, to this end, Justice Thawley spent a significant amount of time in the judgment identifying with some precision the rights acquired by Origin's subsidiary (ie the advantage sought) and the profit-making structure of its business.
From a practical perspective, while each case will no doubt turn on its own facts, the reasoning in Origin Energy would appear to have implications for other buyers of semi-privatised assets, and stands in contrast to some prior cases involving payments for exclusive rights/concessions to operate regulated assets.5
Expenditure to secure doctors' custom deductible
Healius Ltd v Commissioner of Taxation concerned payments made by a subsidiary member of Healius' consolidated group pursuant to agreements entered into with doctors in relation to their practices. These substantial payments (in the order of $350,000 to each doctor) were expressed to be made in return for the purchase of each doctor's practice (including equipment) and associated goodwill. However, Healius' subsidiary employed no doctors and provided no medical services to patients; rather, it operated medical centres and provided rooms, equipment and administrative services to doctors who continued to conduct their own practices as independent contractors, in return for a share of their receipts (ie bulk-billed Medicare rebates).
After a detailed analysis of the agreements and Healius' subsidiary's profit-making structure, Justice Perram held that from both a commercial and legal perspective, no such sale and purchase of practices occurred; rather, the payments were made to induce the doctors to practice at Healius' subsidiary's medical centres in return for contractual undertakings by each doctor to work (extremely high) minimum hours at the centre for a specified period (generally five years) and a related restraint of trade clause prohibiting the doctor from practising (generally for up to eight years) near the location of their former or current (Healius) medical centre.6 Very obviously, Justice Perram was unimpressed with the unequal bargain struck in the agreements, variously describing them as 'unsentimental', 'onerous', 'churlish' and 'Herculean'.7
"The identification of [the relevant taxpayer's] business, structure or organisation is important because the distinction between expenditure and outgoings on revenue account and capital account corresponds with the distinction between 'the business entity, structure or organisation set or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay'".
Having settled the factual context, Justice Perram held that the payments were deductible because they were not expenditure of a capital nature. This was on the basis that the payments were made to secure the custom of the doctors, which in turn generated fees for Healius' subsidiary. The profit-making structure of the business was not expanded by the payments; that structure was constituted by the medical centres operated by Healius' subsidiary, not the medical practices operated by each customer doctor. Rather, the payment was made in the operation of the medical centres to ensure they secured the custom of doctors. To this end, the restraint of trade should be seen as ancillary to the undertaking to practise at the medical centre.8
The Commissioner has appealed this result to the Full Federal Court, which is unsurprising given Justice Perram effectively reasoned that the agreements did something other than what they purported and that this something was the winning of customers, as opposed to expansion of the profit-making structure of the business. In so doing, Justice Perram relied heavily on the advice of the Privy Council in BP Australia Ltd v Commissioner of Taxation,9 aspects of which were observed as being 'problematic' by the High Court in Federal Commissioner of Taxation v Sharpcan Pty Ltd, with the decision restricted to its facts.10 Aware of this, Justice Perram expressly sought to address why the two were indistinguishable,11 and relied on reasoning in other Federal Court cases which apparently (and somewhat inexplicably) were not considered by the High Court in Sharpcan.12 That said, the unusual contractual features of Healius remain somewhat of an elephant in the court room.
Predicting whether an appeal will succeed is a fraught business. However, it is worth observing that, from a practical and business point of view, Healius' subsidiary made its business profits from Medicare rebates paid by the Federal Government to patients, doctors and, finally, to the subsidiary. In that context, the doctors appear to be a fundamental part of the profit-making structure of that business, even if from a technical legal standpoint they are independent contractors. Against that, it should also be observed that Justice Perram has certainly garnered himself some level of protection from being overturned on appeal by conducting a thorough review of the particular rights acquired by Healius' subsidiary under the agreement, as well as the profit-making structure of its business. Ultimately, the appeal will turn on the correct identification of the profit-making structure of the business.
An interesting technical question should the appeal succeed would be whether Healius would nevertheless be entitled to a deduction under section 40-880 for the payments, given Justice Perram held that they were made in order to protect Healius' subsidiary's goodwill.13 It is a technical and not practical question because, as it does not appear to have been a ground of objection by the taxpayer or a point argued before the court, it will not be one the Commissioner is bound to consider when amending Healius' assessment in light of the Full Federal Court's ruling. In any event, as the decision in Sharpcan demonstrates, expenditure incurred to preserve goodwill is interpreted narrowly by the courts.
Gains and losses on shares taxed as income
Unlike Origin Energy and Healius, which concerned the income/capital distinction in the context of asset acquisitions, Greig v Commissioner of Taxation concerned the income/capital distinction in the context of asset disposals.
Mr Greig was a highly paid mining executive, who engaged a stockbroker and financial advisor in the lead-up to his retirement. He instructed the broker-advisor to identify and acquire shares on his behalf in undervalued companies with a view to disposing of them at a profit within as short a time as possible. In accordance with this arrangement, from 2007 to 2014, Mr Greig purchased shares in more than 44 different companies on 282 separate occasions for an aggregate amount of approximately $26 million. He made gains and losses on the disposal of these shares, which he returned as capital gains and losses. However, he made a particularly significant loss of approximately $11.85 million on shares in Nexus Energy Limited, which he claimed was deductible under section 8-1.
By majority, the Full Federal Court held that those losses were deductible under section 8-1(1)(a) in accordance with the principle established in Federal Commissioner of Taxation v Myer Emporium Ltd that a loss will be deductible if the property generating the loss was acquired in a business operation or commercial transaction for the purpose of profit-making.14 It was not in dispute that the requisite profit-making purpose existed.15 Whether the property was acquired in a business operation or commercial transaction required consideration of whether it was acquired by a transaction of a sort that a business person or person in trade does.16 This requirement was apparently satisfied in this case for various reasons:
- the shares were acquired in a systematic fashion on multiple occasions;
- Mr Greig intended to profit from the sale of the shares, which formed part of his sophisticated plan to generate cash for his retirement;
- Mr Greig (personally or through his agent) had a plan, and sought, to crystallise the unrealised value of the company's assets; and
- Mr Greig used his business knowledge and experience and acted as a businessperson (by engaging professional help, undertaking research, monitoring and defending value).17
This conclusion appeared to also answer the question of whether the losses were of capital or of a capital nature for the purposes of section 8-1(2)(a).
However, the majority also held that there was nothing to distinguish the losses from the disposals of Nexus shares from the losses and gains from the disposals of the other shares, meaning that while the losses would be deductible, the gains would also be taxable as income rather than capital gains as returned.18 In this sense, the Commissioner may have lost the battle but won the war, not only against Mr Greig, but also against sophisticated corporate investors and high-net-worth individuals more broadly.19 Where profits on asset sales have to be returned as ordinary income, this means they could not be offset against current year capital losses or unapplied net capital losses carried forward from previous years and cannot be reduced by the 50% CGT discount. While companies are not entitled to the CGT discount, the inability to offset capital losses, arising historically on consolidation, carried forward since the Global Financial Crisis or presently arising from the COVID-19 pandemic, may still have a significant impact.
It is difficult to identify in the reasoning of the majority any facts that would distinguish Mr Greig from many other high-net-worth individuals, sophisticated corporate investors or, indeed, a retail investor engaging in investment as a 'side-hustle'. Justice Steward sought to emphasise that Mr Greig had particular knowledge and experience, but in the same breath acknowledged that Mr Greig was enormously busy and relied upon his broker-advisor.20 It might also be added that Mr Greig's acclaimed knowledge and experience lead to him making $11.85 million in losses from a $26 million investment. Justice Kenny appeared to emphasise the scale of the share trading and the fact that Mr Greig intended to obtain returns in the short term by way of capital gains rather than over a longer term in the form of dividends.21 However, even retail investors commonly seek to obtain returns by way of a combination of dividends and capital gains, but that does not result in their capital gains being taxed as ordinary income. Further, taking into account the scale of Mr Greig's activities would lead to the anomalous result that wealthy investors are not entitled to the CGT concessions that their less wealthy counterparts clearly are.
Consequently, the decision of the majority would certainly appear to provide the Commissioner with grounds to argue that many high-net-worth individual or sophisticated investors who authorise agents to trade securities on their behalf should return gains as ordinary income rather than capital.
Expenditure to acquire control of power stations not deductible
In Origin Energy, Justice Thawley also held that the capacity charges were not deductible under section 40-880(2) of the Income Tax Assessment Act 1997 (Cth) on the basis that they fell within the express exclusions from deductibility in section 40-880(5)(d) for expenditure in relation to a lease or other legal or equitable right, and section 40-880(5)(f) for expenditure taken into account in working out the amount of a capital gain or capital loss from a CGT event.22 Instead, the capacity charges would form part of the first element cost base of the bundle of contractual rights acquired by Origin's subsidiary under the agreements and be taken into account under the capital gains tax regime when a CGT event happened for Origin's subsidiary in relation to those rights, presumably on termination.
While this outcome is entirely consistent with the text of section 40-880, from a practical perspective it reflected the unique factual matrix in which the subsidiary member acquired 'the right to trade, for the contractual term, the generated output of the power stations'.23 It is difficult to assess how widely this reasoning would apply to other scenarios. On one view, all expenditure pursuant to a contract will secure contractual rights,24 which in turn are CGT assets.25 Would it follow that any contractual expenditure should be excluded from deduction because of sections 40-880(5)(d) or 40-880(5)(f)? Given that any capital expenditure incurred by a taxpayer in relation to their business is likely to be incurred pursuant to a contract (unless made by deed or without any corresponding right in return), extending the boundary of the exclusions in sections 40-880(5)(d) and 40-880(5)(f) would appear to render section 40-880 practically inoperative.
Moreover, this outcome leaves taxpayers in an uncertain position regarding precisely when they will realise a capital gain or loss under the CGT regime. This arises because of the need to apportion cost base expenditure across multiple CGT assets (eg separate legal rights),26 and the need to determine the time at which CGT assets expire, resulting in CGT event C2 happening.27 For example, Justice Thawley did not identify each relevant right acquired, explore how the $867m of capacity charges paid to the statutory corporation was to be apportioned between these rights or whether these rights would expire annually (given that the capacity charges were notionally annual), resulting in a capital loss in each income year, or only at the end of the term of the agreements, resulting in a single capital loss upon the expiry of the 22- and 28-year terms of the agreements.
Expenditure to acquire gaming machine entitlements not deductible
The exclusions from deductibility in sections 40-880(5)(d) and 40-880(5)(f) are themselves subject to a further exclusion in section 40-880(6) that effectively provides a deduction for expenditure incurred on a right - the value of which is solely attributable to the preservation (but not enhancement) of goodwill. This further exclusion was considered by the High Court in Federal Commissioner of Taxation v Sharpcan Pty Ltd. That case involved expenditure incurred by the trustee of a trust, which operated a public hotel, to obtain gaming machine entitlements under state legislation. The trustee argued that the expenditure was deductible under section 40-880(6) because, without the gaming machine entitlements, the hotel would no longer be profitable, thereby reducing its goodwill value to nil.
The High Court gave this argument short shrift:
[T]he purpose of s 40-880(6) was to confine deductibility under s 40-880(2) for expenditure in relation to goodwill to expenditure in relation to goodwill that could not otherwise be brought to account under the 1997 Act. Notably, because the GMEs were a kind of property and thus CGT assets, the purchase price of the GMEs could be brought to account under the Act in the first element of the CGT cost base of the GMEs.
Kiefel CJ, Bell, Gageler, Nettle and Gordon JJ
The court also noted that the subjective and objective purpose of the expenditure was to acquire the gaming machine entitlements, not to preserve goodwill, and that the gaming machine entitlements had value apart from their effect on goodwill in that they represented an income stream.28
Put simply, deductibility under section 40-880(2) (even in conjunction with section 40-880(6)) is limited to circumstances where the CGT regime cannot apply. This would tend to suggest that the expenditure in Healius would not have been deductible under section 40-880 in the alternative.
- Before returning a deduction for the purchase price of assets, buyers should conduct a detailed analysis of their profit-making structure and the precise nature of the assets acquired to determine their eligibility.
- Before returning a capital gain or loss on the disposal of assets, sellers should conduct an analysis of whether the disposal occurred in the ordinary course of business, or the asset was acquired in a business operation or commercial transaction with a profit-making purpose.
Origin Energy Ltd v Commissioner of Taxation (No 2)  FCA 409 (31 March 2020) , .
Ibid -, , , , .
See, eg, Commissioner of Taxation v Sharpcan Pty Ltd (2019) 93 ALJR 1147, 1155; AusNet Transmission Group Pty Ltd v Commissioner of Taxation (2015) 255 CLR 439, 450.
See, eg, Commissioner of Taxation v Citylink Melbourne Ltd (2006) 228 CLR 1.
Healius v Commissioner of Taxation  FCA 2011 (29 November 2019) .
Ibid , , , .
Ibid -, , .
(1965) 112 CLR 386.
(2019) 98 ALJR 1147, 1158, 1160.
Healius v Commissioner of Taxation  FCA 2011 (29 November 2019) .
National Australia Bank Ltd v Commissioner of Taxation (1997) 80 FCR 352; Tyco Australia Pty Ltd v Commissioner of Taxation (2007) 67 ATR 63.
Healius v Commissioner of Taxation  FCA 2011 (29 November 2019) .
(1987) 163 CLR 199, 209-10.
Greig v Commissioner of Taxation  FCAFC 25 (2 March 2020)  (Kenny J),  (Steward J).
Ibid  (Kenny J), - (Steward J).
Ibid , - (Kenny J), - (Steward J).
Ibid  (Kenny J), - (Steward J).
For an example of the application of the reasoning of the majority in Greig to a profit making activity, see the recent Administrative Appeals Tribunal decision in Re XPQZ, KYZC, DHJP and Commissioner of Taxation  AATA 1014 (24 April 2020).
Greig v Commissioner of Taxation  FCAFC 25 (2 March 2020) .
Origin Energy Ltd v Commissioner of Taxation (No 2)  FCA 409 (31 March 2020) , -.
See, eg, Commissioner of Taxation v Raymor (NSW) Pty Ltd (1990) 24 FCR 90, 99.
Income Tax Assessment Act 1997 (Cth) s108-5(1)(b).
Income Tax Assessment Act 1997 (Cth) s112-30(1).
Income Tax Assessment Act 1997 (Cth) s104-25(1)(c).
(2019) 98 ALJR 1147, 1162-3.