Re Commissioner of Taxation of the Commonwealth of Australia v Consolidated Fertilizers Limited [1991] FCA 349; 91 Atc 4677/101 ALR 385/22 Atr 281 (6 August 1991)

FEDERAL COURT OF AUSTRALIA

Re: COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA
And: CONSOLIDATED FERTILIZERS LIMITED
Nos. G150 and 151 of 1990
FED No. 497
Income Tax
[1991] FCA 349; 91 ATC 4677/101 ALR 385/22 ATR 281

COURT

IN THE FEDERAL COURT OF AUSTRALIA
QUEENSLAND DISTRICT REGISTRY
GENERAL DIVISION
Davies(1), Spender(2) and Lee(2) JJ.

CATCHWORDS

Income Tax - deductibility - legal proceedings to prevent disclosure of trade secrets and confidential information and to defend rights under licence agreement - whether expenditure on revenue or on capital account.

Income Tax Assessment Act 1936 sub-s.51(1)

Broken Hill Theatres Pty. Ltd. v Federal Commissioner of Taxation [1952] HCA 75; (1951-1952) 85 CLR 423

B.P. Australia Limited v Federal Commissioner of Taxation (1965) 112 CLR 386

Consolidated Fertilizers Ltd. v Federal Commissioner of Taxation (199 0) [1990] FCA 436; 98 ALR 550

Federal Commissioner of Taxation v Snowden and Willson Pty. Ltd. (195 8) [1958] HCA 23; 99 CLR 431

Hallstroms Pty. Ltd. v Federal Commissioner of Taxation [1946] HCA 34; (1946) 72 CLR 634

John Fairfax and Sons Proprietary Limited v Federal Commissioner of Taxation [1959] HCA 4; (1959) 101 CLR 30

Sun Newspapers Ltd. and Associated Newspapers Ltd. v Federal Commissioner of Taxation [1938] HCA 73; (1938) 61 CLR 337

Southern v Borax Consolidated Limited (1941) 1 KB 111

HEARING

BRISBANE
6:8:1991

Counsel for the Appellant: Mr R.W. Gotterson QC with Mr W.V. Vitali

Solicitor for the Appellant: Australian Government Solicitor

Counsel for the Respondent: Mr P.A. Keane QC with Mr D.J. McGill

Solicitors for the Respondent: Carswell and Company

ORDER

The appeal be dismissed.

The appellant pay the respondent's costs of the appeal.
Note: Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules.

DECISION

This is an appeal from a judgment of a single judge of the Court in which his Honour upheld the objections lodged by the appellant, Consolidated Fertilizers Limited ("CFL"), with respect to the tax years ended 30 September 1983 and 30 September 1985. In question had been the deductibility under s.51(1) of the Income Tax Assessment Act 1936 (Cth) of approximately $100,000 in the former year and a little over $500,000 in the latter year. The items of expenditure covered legal expenses and the issue was whether the expenditure was on revenue account, as CFL alleged, or on capital account, as the Commissioner alleged.

2. Analogous issues have been considered by the High Court of Australia in several cases including Sun Newspapers Limited v Federal Commissioner of Taxation [1938] HCA 73; (1938) 61 CLR 337, Hallstroms Pty Limited v Federal Commissioner of Taxation [1946] HCA 34; (1946) 72 CLR 634, Broken Hill Theatres Pty Limited v Federal Commissioner of Taxation [1952] HCA 75; (1951-1952) 85 CLR 423 and Federal Commissioner of Taxation v Snowden and Willson Pty Limited [1958] HCA 23; (1958) 99 CLR 431.

3. The facts found by the learned trial Judge included the following:-

"In 1979, the applicant (CFL) contacted an American
academic, Professor N. Cardarelli, who had been
working on a new technology for the controlled
release of chemicals using a polymer system. The
applicant had no previous experience of that
technique. Professor Cardarelli was, when contacted
by the applicant, a director of a United States
company, Environmental Chemicals Inc (ECI).
Negotiations between the applicant and ECI took
place and produced the execution of an agreement of
24 October 1980.
That agreement recited that ECI had developed and
would be developing `technical information, know-how
and confidential formulas' relating to controlled
release and that it had `at least two pending
Australian patent applications' relating thereto.
ECI undertook to furnish the applicant with certain
`technical information, know-how and confidential
formulas' to assist the applicant in preparing and
selling various products in `territory A or B'.
Territory A was defined so as to refer to Australia,
New Zealand, Papua New Guinea and other places in
the vicinity; territory B consisted of Indonesia,
Thailand, Singapore, Malaysia, the Philippines and
Burma. The agreement provided for payment of
various considerations to ECI and contained promises
by the applicant not to disclose the information it
obtained from ECI. ECI promised not to disclose
information to persons other than the appellant in
the two territories (A and B) to enable those others
to manufacture of sell the controlled release
substances the subject of the agreement.
...
Between 1980 and 1984, the applicant spent over $1
million developing the technology, some of the money
being spent on a pilot plant to test manufacturing
techniques. As one would expect, the applicant
field-tested products it developed and also
approached the appropriate governmental authorities
to obtain permission to use and sell its products.
On 15 April 1982, the original licensing agreement
mentioned above (dated 24 October 1980) was varied
by agreement between ECI and the applicant. The
consequence was that the references in the agreement
to territories A and B were replaced by a reference
to `the territory' which included, in addition to
the places mentioned in the original agreement, some
other countries such as China, Korea, Japan and
India. The agreement was amended again on 15
September 1982, so as to make `the territory' mean
`all countries in the world excluding the North and
South American continents'. The result was that the
contractual right of the applicant, as against ECI,
to exploit the technology covered the whole world
except for those two continents.
On 8 January 1983, Cardarelli wrote to the applicant
to say that he had sued ECI `for the voiding of the
assignments of my patents to them'. He explained
that ECI was in financial difficulty and that he was
`taking action to regain my patents'. The letter
said, in effect, that Cardarelli was prepared to
license the applicant on the same terms as ECI had,
except that he would not be `bound to honour terms
outside of Asia'. Had that been accepted by the
applicant, it would have greatly restricted its
opportunities to exploit the technology.
Cardarelli did, in fact, sue ECI, the action being
brought in the United States District Court. The
complaint by which that suit was instituted sought
an order rescinding invention assignment agreements
between the plaintiff and defendant.
...
The applicant sought advice from American lawyers
`as to how CFL should best proceed in order to
protect its trade secrets and the benefits which it
expected to receive as a result of the operation of
a licensed agreement'. `CFL' is the applicant. On
13 May 1983, the applicant wrote to its American
attorneys, instructing them to represent it in
Cardarelli's action to support the defendant's
case - i.e. ECI's case - and to establish
Cardarelli's approval of the grant of the licence by
ECI to the applicant. The letter went on to explain
that, in a cross-action, ECI had sued Cardarelli and
another company (`Albany Incorporated') and that the
applicant wished to be represented there also, being
`particularly concerned that Cardarelli may have
disclosed technological data and know-how to other
third parties'.
On 19 July 1983, the applicant and ECI sued
Cardarelli and a company called Unique Technologies
Inc. in the United States District Court. The
complaint alleged that the applicant had paid
substantial sums (about $.75 million) by way of
royalties and in other payments to ECI, that ECI had
authority to enter into the licence agreement with
the applicant, that Cardarelli threatened to
disclose to third parties and to make available to
his co-defendant (Unique Technologies Inc.)
information and know-how licensed to the applicant
and that the plaintiffs wished to obtain a
preliminary injunction against the disclosure of
trade secrets and confidential information by the
defendants. There were also claims for declaratory
relief and damages.
The foreshadowed claim for a preliminary injunction
was pursued and was successful; on 14 October 1983,
a United States District Judge enjoined the
defendants in the suit just mentioned (brought by
the applicant and ECI) from disclosing confidential
information of certain kinds; the order elaborately
described its scope but it seems unnecessary for the
purpose of these reasons, to set the description out.
In 1984, ECI being thought to have `little hope of
developing as a viable commercial operating
company', it was agreed between the applicant and
ECI that the applicant would take over the conduct
of the proceedings in which the applicant and ECI
were plaintiffs and would meet ECI's liability for
certain legal costs.
The suit by Cardarelli against ECI and that by the
applicant and ECI against Cardarelli were both
settled and the terms of settlement were announced
in open Court on 25 April 1985. The principal terms
of the settlement, so far as relevant for present
purposes, were as follows. Firstly, the applicant
and ECI agreed to indemnify Cardarelli in respect of
a suit which the University of Akron had brought
against ECI. Secondly, it was agreed that the
preliminary injunction I have mentioned would be
incorporated into a sealed agreement. Thirdly,
US$55,000 was to be paid to Cardarelli; the evidence
was that that was to cover his attorney's fees.
On 6 July 1985, a formal order was entered in the
United States District Court which referred to the
settlement I have mentioned."

4. The trial Judge found that the purpose of the litigation so far as CFL was concerned was principally "to protect the applicant's interest in information of commercial value". The trial Judge placed considerable weight upon the evidence of Mr D.R. McGuffog of CFL that "I became concerned that valuable non-patented trade secrets in relation to the technology both obtained from ECI and developed by CFL would become known to competitors of CFL". The trial Judge found "that the substantial funds which the applicant has spent in obtaining and protecting the information to which I have alluded have produced and are likely to produce large amounts of income." His Honour regarded the matter principally as one in which the moneys were expended in defending the information by the use of which the income of CFL was produced. The trial Judge also found that CFL "continually takes steps to preserve information of the kind here in question". His Honour went on to say:-

"More broadly, the picture presented on behalf of
the applicant was that improving its position in the
marketplace by developing new and improved products
is a continual process. It is not in contest that
the applicant expends substantial amounts of money,
and much of its employees' time is taken up, in this
way. The evidence shows that it operates in an area
in which a great deal of technical improvement goes
on. It has to compete internationally. It commonly
binds employees and also contractors and other third
parties to secrecy agreements. It frequently
derives income from the exploitation by it or others
of technical information. It markets in a
`constantly changing regulatory environment'."

The trial Judge concluded his reasoning as follows:-

"In general, expenditure made to defend the
confidentiality of commercially valuable information
is likely to be of a revenue kind, especially where,
as is so here, the task of preserving and
maintaining confidentiality is a continuing one.
Snowden and Willson, and even more strongly the
Magna Alloys case (Magna Alloys and Research Pty Ltd
v F.C.T. [1980] FCA 150; (1980) 33 ALR 213), support the
deductibility of expenditures, even if of an unique
kind, to protect commercial reputation. If that be
a general principle, it is hard to see any good
ground for denying a deduction here."

5. Counsel for the Commissioner challenged this finding first on a point of fact. Counsel submitted that what was at risk was not merely confidential information which CFL and ECI had developed, but also the rights which CFL had under patents and patent application both overseas and in Australia and which it had obtained under its agreement with ECI. As the trial Judge commented, Professor Cardarelli was taking action "to regain my patents". Indeed, in the judgment orders, the one in the proceedings brought by Professor Cardarelli against ECI and the other in the proceedings brought by CFL and ECI against Professor Cardarelli and another, the Court expressly found that the assignments executed by Professor Cardarelli in favour of ECI of certain United States letters patent and of the foreign counterparts thereof were good and valid, that such letters patent were the property of ECI and that secret and confidential information and know-how developed by and for ECI were the property of ECI and licensed by it to CFL.

6. I may myself have placed less weight than did the trial Judge on Mr McGuffog's perception of the matters which concerned him and rather more weight upon the subject matter of the litigation as exemplified by the pleadings and the orders of the Court. In the determination of issues arising under s.51(1), particularly as to the distinction between revenue and capital, the objective facts, what is done in fact, tends to be of more significance than subjective motive or perception.

7. But even so, there is no clear dichotomy between patent rights and other registered rights on the one hand and confidential information, secret processes and know-how on the other. These latter matters, like goodwill, may not be property in the strict sense; but they may nevertheless form part of the profit-yielding enterprise. Expenditure of a capital nature may be incurred in gaining or protecting them. As Dixon J. said in Sun Newspapers at 359-60:-

"The business structure or entity or organization
may assume any of an almost infinite variety of
shapes and it may be difficult to comprehend under
one description all the forms in which it may be
manifested. In a trade or pursuit where little or
no plant is required, it may be represented by no
more than the intangible elements constituting what
is commonly called goodwill, that is, widespread or
general reputation, habitual patronage by clients or
customers and an organized method of serving their needs."

8. The crux of the issue thus lies in the distinction between capital and revenue as set out in the classic statement by Dixon J. in Sun Newspapers where his Honour said at p 359:-

"The distinction between expenditure and outgoings
on revenue account and on capital account
corresponds with the distinction 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 difference between the outlay and returns
representing profit or loss."

See also Hallstroms case at 646-7.

9. The contrast is between the acquisition and extension of a profit-yielding enterprise, including the assets employed therein and the regular use of that enterprise, the carrying on of the business, for the purpose of producing a profit. Thus it was that in Sun Newspapers and Broken Hill Theatres, the Court held expenditure to be of a capital nature as it was directed to protecting the taxpayer's business from competition, to protecting its substantial monopoly. On the other hand, in Snowden and Willson, the expenditure was directed to maintaining the reputation and goodwill of the taxpayer and was not concerned with the profit-yielding structure as such. As Dixon C.J. said at 437:-

"An examination of the facts does not support the
views that the proceedings in Parliament and before
the Royal Commission imperilled the existence of the
business or the capital assets of the company. The
proceedings were not necessarily directed at a
winding-up of the company or a stoppage of the
business. Precise definition or distinctions are
difficult in such an affair. But what the company
had most to fear was the embarrassments in the
present and future conduct of its business and, no
doubt, a decline in its custom.
There is no satisfactory ground for saying that the
expenditure was an affair of capital."

10. Legal costs undertaken in relation to the protection of patent rights or of confidential information are not necessarily of a capital nature simply because, in the course of the litigation, a challenge is made of the validity of the patent rights or to the confidentiality of the information. It is as much a part of the regular operation of a business to protect items of an intangible nature as it is to maintain and repair buildings and plant. The cost of fire protection is not of a capital nature simply because a fire, if left unchecked, might destroy a building. Just as the distinction between the capital expenditure involved in the renovation of a building and revenue expenditure spent in its maintenance and repair may be a fine one, so, when in litigation a taxpayer seeks to protect and enforce intangible rights while the other party seeks to challenge those rights, the distinction between profit and revenue may not be easy to draw. Yet in the end, the crucial distinction is, as Dixon J. said, "between the character and organization of the profit-earning business" and "the operations by which it is carried on". See Hallstroms case at 648.

11. In Southern v Borax Consolidated Limited (1941) 1 KB 111, an action had been brought against the taxpayer claiming the taxpayer's title to certain land and buildings was invalid. The proceedings were brought by the City of Los Angeles with a view to requiring the taxpayer to pay annual tolls for the use of the land. Lawrence J. held that expenditure in defending those proceedings was of a revenue nature. In Hallstroms case at pp 649-651, Dixon J. analysed the case and expressed the view that his Lordship's decision was wrong. Dixon J. said at 650:-

"The costs were incurred in order to retain a
capital asset of the company employed in the
business as fixed capital and to avoid the payment,
in consequence of its loss, of a charge upon revenue
of indefinite duration. Next to the outlay of
purchase money and conveyancing expenses in
acquiring the title to the land, it would be hard to
find a form of expenditure in relation to property
more characteristically of a capital nature."

That view of Dixon J. was approved by Dixon C.J., McTiernan, Fullagar and Kitto JJ. in Broken Hill Theatres at 434.

12. It is clear from the reasoning of the trial Judge that his Honour agreed with the view expressed in the carefully drawn statement of facts and contentions lodged on behalf of CFL which stated, inter alia:-

"25. The Applicant engaged in this litigation in
the United States of America for two purposes:
(a) To preserve the trade secrets,
confidential technical
information and know-how
relating to the Controlled
Release Technology including the
Applicant's Trade Secrets and
ECI's Trade Secrets so as to
prevent third party competitors
of competing (sic) against the
Applicant in the non-patented
protected market areas;
(b) To maintain for the Applicant
its exclusive licence rights
under the patents and trade
secrets and confidential
technology which rights would
have been diminished or
eliminated if the claims
advanced by Nathan Cardarelli
had succeeded.
Of these purposes the principal concern was (a),
as it was not thought that there was any great risk
that Nathan Cardarelli would succeed in obtaining
the recission (sic) remedy he sought as clearly
innocent third parties were involved and a formal
assignment document registered with the United
States Patent Office.
...
47. It is contended that the legal expenses in the
present case were incurred with a view to enforcing
the Applicant's existing contractural (sic) rights
to maintain confidentiality and to enforce its
position in respect of the Licence Agreement and to
obtaining a judicial affirmation of them."

13. For my own part, this course of reasoning draws too great a distinction between trade secrets, confidential technical information and know-how on the one hand and exclusive licence rights on the other. I am more impressed by the fact that the challenge came, not from an ordinary trade competitor or from the regular operation of CFL's business, but from Professor Cardarelli, who had initiated the technical breakthrough and who had applied for and obtained the first patents.

14. Between 1975 and 1982, Professor Cardarelli was on the Board of Directors of ECI, the Director of Research and Development of ECI and a major shareholder and consultant to ECI. He played a major part in the development of the controlled release technology and assigned to ECI eight patents in respect of that invention. By March 1982, however, Professor Cardarelli had fallen out with the other founders of ECI and he resigned from the Board of Directors. In February 1983, Professor Cardarelli commenced proceedings in the United States District Court seeking, inter alia:-

"(a) An order rescinding the invention assignment
agreement(s) between Plaintiff and Defendant
which cancels all formal assignments:
(1) filed in the United States Patent Office; and
(2) filed in any foreign country;
(b) An accounting of all license fees and
royalties collected by virtue of
Plaintiff's assignments of invention".

15. Correspondence then ensued between Mr McGuffog on behalf of CFL and Professor Cardarelli. On 28 April 1983, Professor Cardarelli wrote to Mr McGuffog stating, inter alia:-

"I am sorry to hear that you have negotiated an
extension of the geographical license. ... From my
legal viewpoint Environmental Chemicals is engaged
in licensing my intellectual property to a third
party and without my consent. To open negotiations
is one thing, to provide a license is another. I
may not agree to the terms of the license, since I
do not know what they are.
The patents are presently under a legal cloud and a
Federal court will determine ownership. Thus any
business dealings you pursue with Environmental
Chemicals as regards the patents you do so at your
own risk. Any license fees or royalties you send to
Environmental Chemicals, you may later find that you
owe to the trust being establighed (sic) to handle
such income.
... I can not sanction the extension of a license
which I firmly believe to be illegal on the part of
the defendant. From our standpoint any sales by
Consolidated Fertilizer to Europe, Africa or
elsewhere is infringement upon my patents and
subject to legal action."

By this letter, Professor Cardarelli made a direct attack on the capital of CFL's business.

16. It was not only the patent rights which were at risk, but the whole knowledge of the controlled release technology, much of which had been developed by CFL in association with ECI. Professor Cardarelli had extensive knowledge of the trade secrets and of the confidential information surrounding the new technology for he had been intimately involved in the invention of the technology and in its development, both by ECI and by CFL in association with ECI, and he was in a position, by the disclosure of his knowledge, to make a dramatic inroad into CFL's monopoly rights in respect of that technology.

17. CFL and ECI therefore instituted proceedings against Professor Cardarelli and another and sought extensive relief, including declarations that the relevant agreements were valid and subsisting, that ECI was the proper and authorised licensor under its agreement with Professor Cardarelli and that CFL was entitled to and had an exclusive licence throughout the world except for North and South America. The proceedings sought injunctions both temporary and permanent enjoining Professor Cardarelli and the other defendant from the unlawful use and disclosure of trade secrets, secret and confidential information and know-how.

18. Both proceedings were ultimately resolved by agreement. The consent order made in the suit brought by CFL and ECI recited the entry into of an agreement of settlement. The judgment order then recorded:-

"4. Based upon the terms of the aforesaid agreement
of settlement and upon representations of the
parties and their respective counsel, the Court
finds:
(a) The Technological License Agreement
dated October 24, 1980, and the amendatory
agreements dated April 15, 1982, and
September 15, 1982, Exhibits A, B and C
respectively to the Complaint in this
cause, all between Environmental
Chemicals, Inc., and Consolidated
Fertilizers, Limited, are valid and
subsisting in law and in full force and effect.
(b) The assignments heretofore executed
by Nathan F. Cardarelli of the following
identified applications for United States
Letters Patent and of the foreign
counterparts thereof are good and valid in
law and such applications and the foreign
counterparts thereof, together with all
patents issued therefrom, including United
States Letters Patent Nos. 4,237,114;
4,228,614; 4,166,111; 4,299,613;
4,440,374; 4,286,020; 4,405,360;
4,353,962, are the property of
Environmental Chemicals, Inc.: Serial No.
005,174 dated January 22, 1979, Serial No.
051,102 dated June 22, 1979, Serial No.
171,835 dated July 24, 1980, Serial No.
149,982 dated May 15, 1980, Serial No.
171,834 dated July 24, 1980, and Serial
No. 264,822 dated May 18, 1981.
(c) Secret and confidential information
and know-how, including such trade secrets
as are comprised by and contained therein,
developed by and for Environmental
Chemicals, Inc., are the property of
Environmental Chemicals, Inc., and were
licensed by it to Consolidated Fertilizers
Limited by the said Technological License
Agreement dated October 24, 1980, and the
said amendatory agreements dated April 15,
1982, and September 15, 1982."

The consent order made in the proceedings brought by Professor Cardarelli was similar but omitted para (a).

19. I have spent some time on the form of the legal proceedings and the orders made therein for it seems to me that they show that the litigation was devoted to a matter of capital, namely ECI's and CFL 's monopolistic rights to the technology based upon the invention made by Professor Cardarelli and developed by him in his work for ECI.

20. It was submitted by counsel for CFL that CFL's monopolistic rights were not seriously in question, particularly as the sum ultimately paid to Professor Cardarelli, $US55,000, was relatively small and was intended to cover only his attorney's fees. Counsel for CFL categorised the litigation as litigation to enforce the rights which CFL had earlier gained rather than as litigation to obtain or extend its rights or litigation undertaken because the existence of those rights was seriously imperilled.

21. Nevertheless, CFL took the matter seriously, as is demonstrated by its payment of over $600,000 in legal costs as well as other expenditure which it made for the purposes of the litigation and its settlement. CFL intervened in Professor Cardarelli's suit for, whether it expected the suit to succeed or not, CFL had "a vital interest in the outcome", to use an expression appearing in a draft telex in evidence. CFL did have a serious concern that, if it did not intervene in those proceedings and institute proceedings itself seeking an order restraining Professor Cardarelli, the secret information which it exploited for commercial purposes might lose its confidentiality.

22. This is not a case where CFL acquired rights or extended its rights. However, flowing from the differences which had arisen amongst the founders of ECI, the security of its monopoly was placed in jeopardy. Professor Cardarelli, the inventor and source of the process, broke from ECI and disputed CFL's right to exploit the controlled release technology, at least in some countries. CFL entered the litigation to confirm its entitlement in that respect.

23. I look upon the case as one where CFL's capital rights were imperilled and where the legal costs were incurred to consolidate and confirm rights of a capital nature, rather than as one where the outgoings were incurred in the process by which CFL used its capital to obtain regular terms, that is, in the course of the operations by which it carried on its business. The distinction in this, as in other cases, is a fine one but the expenditure seems to me to have the flavour of capital rather than of revenue.

24. I would allow the appeals and would set aside his Honour's orders. I would substitute therefor orders that the appeals from the objection decisions be dismissed and that the assessments be affirmed. I would order that the respondent pay the costs of the appeals and of the proceedings below.

This is an appeal from the judgment of a judge of this Court setting aside the appellant's ("the Commissioner") decisions which disallowed the respondent's ("CFL") objections to amended assessments of taxation issued to it in respect of its taxation years for the years ended 30 September 1983 and 30 September 1985. His Honour's judgment is reported as Consolidated Fertilizers Ltd. v Federal Commissioner of Taxation [1990] FCA 436; (1990) 98 ALR 550.

2. It is unnecessary to repeat in detail the facts as found by his Honour but a summary of the facts and findings salient to this appeal is as follows.

3. CFL is a manufacturer of fertilizers and pesticides. In 1979 it determined that it would be necessary for the purposes of its business to develop products which offered a controlled release of agricultural chemicals. To acquire knowledge of the appropriate techniques it approached an American scientist known for his expertise in that field, Professor Cardarelli ("Cardarelli").

4. At the time CFL approached him, Cardarelli was Director of Environmental Chemicals Inc. ("ECI"), a company incorporated in the United States of America, and to which Cardarelli in June 1978 had assigned his rights as an inventor of a process for the controlled release of chemicals. ECI obtained patent rights in respect of the assigned inventions.

5. CFL commenced negotiations with ECI and by a licensing agreement made in October 1980 ECI agreed to deliver to CFL technical information, know-how, and confidential formulas in respect of controlled release processes, and authorized CFL to prepare and sell products incorporating such processes in nominated countries mainly in the South Pacific and South-East Asia.

6. With the benefit of that know-how and information CFL developed and improved the technology and expanded its field of operation. CFL passed on to ECI, and through it to Cardarelli, the further know-how, technical information and confidential formulas it obtained from its own research.

7. In September 1982 the original licensing agreement was amended to expand the area in which CFL could trade in products using the disclosed technology by including all countries in the world excluding the North and South American continents.

8. At about that time Cardarelli fell out with ECI and in early 1983 commenced an action in a United States District Court seeking an order rescinding the agreement he had made with ECI in 1978 for the assignment to ECI of his inventor's rights. Cardarelli informed CFL that he had commenced such an action and if successful would offer CFL a more limited licence in respect of the use of that technology.

9. CFL determined that it should support ECI's defence of that proceeding but it also formed the view that Cardarelli's conduct suggested that valuable trade secrets unprotected by patents were at risk of disclosure to competitors of CFL including secrets relating to technologies developed by CFL and disclosed by it to ECI and Cardarelli.

10. CFL commenced an action against Cardarelli, and a company controlled by him, in the same United States District Court. ECI was joined as a co-plaintiff. CFL sought a declaration as to the respective rights of CFL and Cardarelli, pleading Cardarelli's assertion that CFL had wrongfully paid royalties to ECI instead of Cardarelli and Cardarelli's contention that the amendment of the licensing agreement made in September 1982 was illegal. CFL also sought an injunction against Cardarelli to prevent him carrying out threatened disclosures of secret and confidential technical information and know-how, the subject of the licensing agreement and the subject of disclosures to ECI by CFL subsequent to that agreement. CFL also sought damages and injunctive relief in respect of unfair competition on the part of Cardarelli and in respect of Cardarelli's alleged wilful interference with the contractual relations between ECI and CFL.

11. In October 1983 CFL obtained a preliminary injunction against Cardarelli restraining him from disclosing confidential information.

12. In 1985 CFL began to earn income from the sale of its products which incorporated the know-how it had acquired by licence and had developed on its own account. In April 1985 the actions commenced by Cardarelli and CFL were compromised. The terms of settlement were pronounced in Court and incorporated in a judgment. Although details of the settlement were recorded in a deed kept in confidence, it was accepted by his Honour that the deed incorporated a term obliging Cardarelli to maintain confidentiality in respect of the information the proceedings commenced by CFL had sought to protect.

13. The conduct of the litigation caused CFL to expend approximately $100,000 in legal fees in the 1983 taxation year. In the 1985 taxation year a sum of approximately $500,000 was spent, of which approximately $400,000 was applied to meet legal fees. The balance was an amount required to be paid pursuant to the terms of settlement of the litigation as a contribution to the legal fees incurred by Cardarelli.

14. CFL claimed that these outgoings were allowable deductions from assessable income pursuant to sub-s.51(1) of the Income Tax Assessment Act 1936 in that they were outgoings incurred in gaining or producing assessable income or were necessarily incurred in carrying on a business for the purpose of gaining or producing such income not being outgoings of capital or of a capital nature. In amended assessments the Commissioner disallowed the deductions and later disallowed CFL's objections to the assessments.

15. Before his Honour the only issue was whether the outgoings were on capital account.

16. The Commissioner's first ground of appeal was that his Honour had misdirected himself in law in applying to the facts of the case a principle that "in general expenditure made to defend the confidentiality of commercially valuable information is likely to be of a revenue kind".

17. The ground of appeal relates to a passage in his Honour's judgment (at p 558) which should be set out in full:

"The second characteristic of the expenditure which
the High Court cases suggest is particularly
material in this context, is that it was made to
defend and maintain what the taxpayer had, not to
acquire any capital asset. Although the High Court
cases, and in particular Hallstroms and Duro's case
and Snowden and Willson, do not enable one
confidently to enunciate a principle that purely
defensive expenditures are less likely to be of a
capital kind than acquisitive expenditures, the
actual outcomes of the cases suggest that they must
have depended, at least in part, on that point.
In general, expenditure made to defend the
confidentiality of commercially valuable
information is likely to be of a revenue kind,
especially where, as is so here, the task of
preserving and maintaining confidentiality is a
continuing one."

18. That passage is to be read in conjunction with the following statement made by his Honour earlier in his reasons at p 555:

"It is my view that the answer to the question posed
in this case may best be found by a process of
induction from authorities dealing with similar
situations, and particularly authorities concerned
with the deductibility of expenses incurred in
protecting intangibles, rather than by resort to
broad statements of principle."

19. A proper reading of his Honour's judgment displays no misunderstanding of the relevant principles and no misdirection in law.

20. The second ground of appeal was that his Honour failed to have any sufficient regard to part of the evidence adduced in the hearing.

21. On the hearing of the appeal no attempt was made to demonstrate that his Honour had overlooked or ignored material evidence. The ground was not argued as a separate ground but included as part of the Commissioner's main ground of appeal that his Honour had erred in law in failing to properly apply the law to the facts as found. In so far as the subsidiary ground of appeal was a submission that his Honour had failed to properly evaluate and consider the evidence, his Honour's reasons for judgment plainly show that all elements of the evidence were considered and weighed and that the ground of appeal has no substance.

22. The thrust of the Commissioner's appeal was that after duly considering the evidence and the relevant principles of law enunciated in leading authorities, his Honour was bound to conclude that the outgoings were of a capital nature.

23. The Commissioner submitted that the litigation in respect of which the outgoings were made sought to defend the "validity" of a capital asset or to obtain an enduring benefit by way of a judicial declaration. Furthermore, it was said that the claims for injunction pursued in the litigation were intended to secure the particular advantage of freedom from competition.

24. As has been often stated, it is difficult to provide a more lucid exposition of the principles to be applied in assessing whether an outgoing is of a revenue or capital nature than that set out by Dixon J. in Sun Newspapers Ltd. and Associated Newspapers Ltd. v Federal Commissioner of Taxation [1938] HCA 73; (1938) 61 CLR 337 at pp 359-363. Several extracts from that passage are of particular relevance. His Honour said at p 360:

"As general conceptions it may not be difficult to
distinguish between the profit-yielding subject and
the process of operating it. In the same way
expenditure and outlay upon establishing, replacing
and enlarging the profit-yielding subject may in a
general way appear to be of a nature entirely
different from the continual flow of working
expenses which are or ought to be supplied
continually out of the returns or revenue. The
latter can be considered, estimated and determined
only in relation to a period or interval of time,
the former as at a point of time. For the one
concerns the instrument for earning profits and the
other the continuous process of its use or
employment for that purpose. But the practical
application of such general notions is another
matter. The basal difficulty in applying them lies
in the fact that the extent, condition and
efficiency of the profit-yielding subject is often
as much the product of the course of operations as
it is of a clear and definable outlay of work or
money by way of establishment, replacement or
enlargement."

And continued at p 361:

"In the attempt, by no means successful, to find some
test or standard by the application of which
expenditure or outgoings may be referred to capital
account or to revenue account the courts have
relied to some extent upon the difference between
an outlay which is recurrent, repeated or continual
and that which is final or made 'once for all', and
to a still greater extent upon a distinction to be
discovered in the nature of the asset or advantage
obtained by the outlay. If what is commonly
understood as a fixed capital asset is acquired the
question answers itself. But the distinction goes
further. The result or purpose of the expenditure
may be to bring into existence or procure some
asset or advantage of a lasting character which
will enure for the benefit of the organization or
system or 'profit-earning subject'. It will thus
be distinguished from the expenditure which should
be recouped by circulating capital or by working capital."

And at p 362:

"But the idea of recurrence and the idea of endurance
or continuance over a duration of time both depend
on degree and comparison. As to the first it has
been said it is not a question of recurring every
year or every accounting period; but 'the real test
is between expenditure which is made to meet a
continuous demand, as opposed to an expenditure
which is made once for all' (per Rowlatt J.
Ounsworth v Vickers Ltd. (1915) 3 KB, at p 273).
By this I understand that 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
trade or its circulating capital and that actual
recurrence of the specific thing need not take
place or be expected as likely. Thus, in
Anglo-Persian Oil Co. Ltd. v Dale (1932) 1 KB 124) the
establishment and reorganization of agencies formed
part of the class of things making the continuous
or constant demand for expenditure, but the given
transaction was of a magnitude and precise
description unlikely again to be encountered.
Recurrence is not a test, it is no more than a
consideration the weight of which depends upon the
nature of the expenditure."

25. In Hallstroms Pty. Ltd. v Federal Commissioner of Taxation [1946] HCA 34; (1946) 72 CLR 634 at pp 646-647 Dixon J. added the following elaboration to that which he had already stated in Sun Newspapers:

"My own opinions upon the question I have attempted
to explain in Sun Newspapers Ltd. v Federal
Commissioner of Taxation (1938) 61 CLR, at
pp.359-363 and I shall not re-state them. I shall
treat the passage to which I refer as incorporated
in this judgment. Once more, however, I shall
endeavour to apply what I conceive to be the
principles that determine whether an outgoing is on
account of capital or of revenue. As a prefatory
remark it may be useful to recall the general
consideration that the contrast between the two
forms of expenditure 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.
The facts upon which the case before us must be
decided present in a somewhat unusual aspect the
elements or factors governing the distinction. The
claim is to deduct legal expenses, and legal
expenses, we may assume, take the quality of an
outgoing of a capital nature or of an outgoing on
account of revenue from the cause or the purpose of
incurring the expenditure. We are, therefore,
remitted to a consideration of the object in view
when the legal proceedings were undertaken, or of
the situation which impelled the taxpayer to undertake them."

26. In that case Dixon J. in dissent would have held that the legal expenses spent on efforts to prevent the extension of a patent were part and parcel of an attempted reorganization of the taxpayer's business in anticipation of the expiration of the patent, a restructuring so fundamental that the business was otherwise doomed and, therefore, an outgoing of capital. His Honour would have held that the outgoing was incurred in the course of the transition from one form of product to another as the subject of the company's business and that the outgoing took its character from the reorganization of the profit-earning business rather than as an incident in the operations carried on by the business. The majority held otherwise and concluded that the outgoing remained an outgoing of the business not capital in nature.

27. The important facts in the present case are that CFL already held the benefit of know-how and confidential information pursuant to the licensing agreement and the right to exploit the use of that technology in trade. Similarly, it was already entitled to the benefits of the knowledge and information that it had gained from its own research in the course of the conduct of its business. In short, it was already the possessor of a "profit-yielding subject".

28. The threat to that source of income was, firstly, a legal proceeding in which the claimants sought to rescind contractual arrangements upon which CFL's licensing agreement was based and, secondly, the threatened disclosure of the trade secrets which were about to bear the fruit of income for CFL.

29. To maximize its prospective profits from the profit-yielding source CFL was bound to respond to each threat and incur expense in doing so.

30. But in supporting ECI's defence denying that Cardarelli had any right to an order to rescind an agreement of five years' standing and in seeking an injunction to prevent the dissemination of confidential information of which it had proprietorship, CFL was not incurring expenditure stamped with the character of an outgoing used to acquire an asset or for the purpose of enhancing or enlarging a business by adding some profit-yielding subject.

31. The acquisition and development of valuable trade secrets led directly to the requirement that CFL be prepared to protect that knowledge in the ordinary course of the conduct of its business. Any expenditure thereon would be within a class of outgoings generated by the constant demands the business had to be ready to meet. The actual recurrence of expenditure upon such a purpose need not take place nor be expected as likely for such expenditure to be in the nature of revenue. (See Federal Commissioner of Taxation v Snowden and Willson Pty. Ltd. [1958] HCA 23; (1958) 99 CLR 431.) It is enough that there be a potential for such an outgoing to be met by the business.

32. In the present case CFL expended funds on repelling claims designed to provide an inducement for the re-negotiation of commercial arrangements. The fees were incurred to allow CFL to continue its business activities without the hindrance of the commercial pressure being applied by Cardarelli.

33. Although the fact that no new asset may have been acquired by the expenditure would not dictate that the expenditure was of a revenue nature (see Broken Hill Theatres Pty. Ltd. v Federal Commissioner of Taxation [1952] HCA 75; (1951-1952) 85 CLR 423 at p 434; John Fairfax and Sons Proprietary Limited v Federal Commissioner of Taxation [1959] HCA 4; (1959) 101 CLR 30 per Dixon C.J. at p 36), a distinction must be made between expenditure incurred for the purpose of preserving and protecting a business as such, being expenditure for a particular purpose on an isolated occasion, and expenditure which the nature of business may require as part of the prudent management thereof.

34. It was submitted that Cardarelli's actions did pose such an isolated threat to CFL's business. However, it was obvious from the evidence that knowledge of the trade secrets of the business was held by various employees and contracting parties. As his Honour said at p 556:

"What was being defended was not only intangible, but
was a characteristic of the taxpayer's business
needing continual attention, which fluctuated in
its nature from time to time and was of a peculiar character."

35. In a matter such as this where a preliminary injunction enjoining Cardarelli from making any disclosure was readily obtained, where no trial of the issues ensued, where the litigation was concluded by the continuation of the effect of that injunction, where Cardarelli abandoned claims which on their face appeared to owe as much to commercial tactics as they did to a grounding in law, it is difficult to conclude that the outgoing for legal fees and for the compromise of the litigation bore any characteristic of a capital nature.The judicial task in a case of this nature was described by the Privy Council in B.P. Australia Limited v Federal Commissioner of Taxation (1965) 112 CLR 386 at p 397:

"The solution to the problem is not to be found by
any rigid test or description. It has to be
derived from many aspects of the whole set of
circumstances some of which may point in one
direction, some in the other. One consideration
may point so clearly that it dominates other and
vaguer indications in the contrary direction. It
is a commonsense appreciation of all the guiding
features which must provide the ultimate answer.
Although the categories of capital and income
expenditure are distinct and easily ascertainable
in obvious cases that lie far from the boundary,
the line of distinction is often hard to draw in
border line cases; and conflicting considerations
may produce a situation where the answer turns on
questions of emphasis and degree. That answer
'depends on what the expenditure is calculated to
effect from a practical and business point of view,
rather than upon the juristic classification of the
legal rights, if any, secured, employed or
exhausted in the process' (per Dixon J. in
Hallstrom's Case [1946] HCA 34; (1946) 72 CLR 634, at p 648)).
As each new case comes to be argued felicitous
phrases from earlier judgments are used in argument
by one side and the other. But those phrases are
not the deciding factor, nor are they of unlimited
application. They merely crystallize particular
factors which may incline the scale in a particular
case after a balance of all the considerations has
been taken."

36. The proceedings involved the application of well known principles to the particular facts of the case. In that application, the characterization of the expenditure as revenue or capital depends on the weight or emphasis to be placed on particular factors, about which reasonable minds might differ. We are of the opinion that the conclusion by the learned trial judge that the expenditure is properly to be regarded as being on revenue account was not only open to his Honour but is correct.

37. The appeal should be dismissed with costs.