Macquarie Finance Limited v Commissioner of Taxation [2005] FCAFC 205 (16 September 2005)

Last Updated: 16 September 2005

FEDERAL COURT OF AUSTRALIA

Macquarie Finance Limited v Commissioner of Taxation [2005] FCAFC 205

INCOME TAX – deductions – interest payments – whether incurred in gaining or producing assessable income – whether necessarily incurred in business for gaining or producing assessable income – whether of a capital nature - role of purpose of expenditure in characterisation – objective purpose – subjective purpose – corporate purpose –– interest on debenture notes issued as part of capital raising for corporate group – issued by one member of corporate group together with preference shares in parent company – stapled securities – dividends not payable on preference shares while interest paid on notes to noteholders – power of parent company to redirect interest to itself and pay dividends to security holders in lieu – interest payments not deductible – whether tax avoidance provisions of Pt IVA apply


Australian Banking Act 1959 (Cth)
Income Tax Assessment Act 1997 (Cth) s 8-1
Income Tax Act 1936 (Cth) s 82L, 177A, 177C, 177D, 177F


Macquarie Finance Ltd v Commissioner of Taxation [2004] FCA 1170; (2004) 210 ALR 508 affirmed


Amalgamated Zinc (De Bavay’s) Ltd v Federal Commissioner of Taxation [1935] HCA 81; (1935) 54 CLR 295 cited
Australian & New Zealand Savings Bank Ltd v Federal Commissioner of Taxation [1993] FCA 282; (1993) 42 FCR 535 cited
Australian National Hotels Ltd v Federal Commissioner of Taxation (1998) 19 FCR 234 cited
BP Australia Ltd v Commissioner of Taxation of the Commonwealth of Australia [1965] HCA 35; [1966] AC 224 applied
British Insulated and Helsby Cables Ltd v Atherton [1926] AC 205 cited
City Link Melbourne Ltd v Federal Commissioner of Taxation [2004] FCAFC 272; (2004) 211 ALR 207 considered
Coles Myer Finance Ltd v Federal Commissioner of Taxation [1993] HCA 29; (1993) 176 CLR 640 cited
Commissioners of Inland Revenue v Blott [1921] 2 AC 171 cited
Eastern Nitrogen Ltd v Federal Commissioner of Taxation [2001] FCA 366; (2001) 108 FCR 27 applied
Federal Commissioner of Taxation v Broken Hill Pty Co Ltd [2000] FCA 1431; (2000) 179 ALR 593 cited
Federal Commissioner of Taxation v Citibank Ltd (1993) 44 FCR 434 cited
Federal Commissioner of Taxation v Consolidated Press Holdings Ltd [2001] HCA 32; (2001) 207 CLR 235 cited
Federal Commissioner of Taxation v Firth [2002] FCA 413; (2002) 120 FCR 450 cited
Federal Commissioner of Taxation v Hart [2004] HCA 26; (2004) 217 CLR 216 applied
Federal Commissioner of Taxation v Ilbery [1981] FCA 188; (1981) 38 ALR 172 cited
Federal Commissioner of Taxation v Phillips [1978] FCA 27; (1978) 20 ALR 607 cited
Federal Commissioner of Taxation v Radilo Enterprises Pty Ltd (1997) 97 ATC 4151 cited
Federal Commissioner of Taxation v Riverside Road Lodge Pty Ltd (In Liq) [1990] FCA 205; (1990) 23 FCR 305 cited
Federal Commissioner of Taxation v Roberts & Smith [1992] FCA 363; (1992) 37 FCR 246 cited
Federal Commissioner of Taxation v Snowden & Wilson Pty Ltd [1958] HCA 23; (1958) 99 CLR 431 cited
Federal Commissioner of Taxation v South Australian Battery Makers Pty Ltd [1978] HCA 32; (1978) 140 CLR 645 considered
Federal Commissioner of Taxation v Spotless Services Ltd [1996] HCA 34; (1996) 186 CLR 404 applied
Federal Commissioner of Taxation v Midland Railway Co of Western Australia Ltd [1952] HCA 5; (1952) 85 CLR 306 applied
Fletcher v Federal Commissioner of Taxation [1991] HCA 42; (1991) 173 CLR 1 cited
GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation [1990] HCA 25; (1990) 170 CLR 124 cited
Hallstroms Pty Ltd v Federal Commissioner of Taxation [1946] HCA 34; (1946) 72 CLR 634 cited
Herald and Weekly Times Ltd v Federal Commissioner of Taxation [1932] HCA 56; (1932) 48 CLR 113 cited
John v Federal Commissioner of Taxation [1989] HCA 5; (1989) 166 CLR 417 cited
Jupiters Ltd v Federal Commissioner of Taxation [2002] FCAFC 206; (2002) 118 FCR 163 cited
Lunney & Hayley v Federal Commissioner of Taxation [1958] HCA 5; (1958) 100 CLR 478 cited
Magna Alloys and Research Pty Ltd v Federal Commissioner of Taxation [1980] FCA 150; (1980) 33 ALR 213 cited
Mullens Investment Pty Ltd v Federal Commissioner of Taxation [1976] HCA 47; (1976) 135 CLR 290 cited
Robert G Nall Ltd v Federal Commissioner of Taxation [1936] HCA 79; (1937) 57 CLR 695 cited
Ronpibon Tin NL v Federal Commissioner of Taxation [1949] HCA 15; (1949) 78 CLR 47 cited
Steele v Deputy Commissioner of Taxation [1999] HCA 7; (1999) 197 CLR 459 cited
Sun Newspapers Ltd & Associated Newspapers v Federal Commissioner of Taxation [1938] HCA 72; (1938) 61 CLR 337 cited
Texas Co (Australasia) Ltd v Federal Commissioner of Taxation [1940] HCA 9; (1940) 63 CLR 382 cited
Ure v Federal Commissioner of Taxation (1981) 34 ALR 237 cited
Vincent v Federal Commissioner of Taxation [2002] FCAFC 291; (2002) 124 FCR 350 cited
W Neville & Co Ltd v Federal Commissioner of Taxation [1937] HCA 9; (1937) 56 CLR 290 cited

Maurice Cashmere, ‘Part IVA after Hart’, (2004) 33 AT Rev 131
RW Parsons, Income Taxation in Australia, Law Book Company (1985)












MACQUARIE FINANCE LIMITED v COMMISSIONER OF TAXATION
NSD 1439 OF 2004



FRENCH, HELY & GYLES JJ
16 SEPTEMBER 2005
SYDNEY

IN THE FEDERAL COURT OF AUSTRALIA
NEW SOUTH WALES DISTRICT REGISTRY	NSD 1439 OF 2004

ON APPEAL FROM A SINGLE JUDGE OF THE FEDERAL COURT OF AUSTRALIA

BETWEEN:	MACQUARIE FINANCE LTD (ACN 001 214 964) APPELLANT
AND:	COMMISSIONER OF TAXATION RESPONDENT
JUDGES:	FRENCH, HELY & GYLES JJ
DATE OF ORDER:	16 SEPTEMBER 2005
WHERE MADE:	SYDNEY

THE COURT ORDERS THAT:

1. The appeal be dismissed.

2. 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.

IN THE FEDERAL COURT OF AUSTRALIA
NEW SOUTH WALES DISTRICT REGISTRY	NSD 1439 OF 2004

ON APPEAL FROM A SINGLE JUDGE OF THE FEDERAL COURT OF AUSTRALIA

BETWEEN:	MACQUARIE FINANCE LTD (ACN 001 214 964) APPELLANT
AND:	COMMISSIONER OF TAXATION RESPONDENT

JUDGES:	FRENCH, HELY & GYLES JJ
DATE:	16 SEPTEMBER 2005
PLACE:	SYDNEY

REASONS FOR JUDGMENT

FRENCH J:
Introduction

1 In 1999 Macquarie Bank Ltd (MBL) and its subsidiary, Macquarie Finance Ltd (MFL) made a public offer of composite securities known as Macquarie Income Securities. Each security comprised a Debenture Note issued by MFL and a Preference Share issued by MBL. The object of the issue of the securities was to raise additional capital for MBL. It was a further object that the capital so raised would fall within the category known as Tier 1 capital for the purposes of the minimum capital requirements prescribed by the Australia Prudential Regulation Authority (APRA). The greater the proportion of Tier 1 capital in a company, the greater the amount which it could, consistently with those requirements, raise by way of borrowing.

2 The rights and obligations relating to the creation and issue of the securities were derived from three key documents being a Trust Deed, a Subscription Agreement and a Procurement Agreement. Their effect was that the securities were ‘stapled’ in the sense that an MFL note could not be transferred by a holder without the transfer of the corresponding Preference Share in MBL. Interest was payable on the notes for the benefit of noteholders. While interest was payable on the notes, dividends were not payable on the Preference Shares. However, by a mechanism which is explained in the reasons, MBL could require that interest cease to be paid by MFL to the noteholders and that it be redirected to MBL. In that event, MBL would pay corresponding dividends on the Preference Shares.

3 The picture that emerged was of a trinity of agreements interacting in a rather complex way. One of their purposes was to secure Tier 1 capital at a low cost relative to other forms of capital raising. A diagram to aid understanding of the arrangements is Annexure A to these reasons.

4 The issue proceeded on 30 September 1999 raising a first tranche of $200 million and in November 1999 a second tranche also in that amount. In each case a sum of $200 million was paid by the underwriter Deutsche Bank AG in respect of both the Notes issue and the Preference Shares issue. However under the terms of the Procurement Agreement MBL remitted a sum of $200 million to the underwriter in each case so that the net capital raised was $200 million on the Notes issue in September 1999 and the same amount on the Notes issue in November 1999. The money raised on the Notes was on-lent by MFL to Macquarie Leasing Pty Ltd, a subsidiary of MBL, for use in its plant and equipment leasing business. MFL earned $28,433, by way of interest from Macquarie Leasing, in the year of income ended 30 September 2000. It paid $27,933,226 by way of interest for the benefit of the noteholders in that year. MFL claimed the interest so paid as a deduction on the basis that it was incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for that purpose. The Commissioner disallowed the deduction. An appeal to Hill J at first instance was dismissed: Macquarie Finance Ltd v Commissioner of Taxation [2004] FCA 1170; (2004) 210 ALR 508. His Honour held that the interest payments were, in the circumstances of this case, of a capital nature. His Honour also held that, even if the payments were deductible, Pt IVA of the Income Tax Assessment Act 1936 (Cth) (the 1936 Act) would operate to disallow the tax benefit otherwise obtained.

5 MFL appealed against his Honour’s decision. For the reasons set out below I am of the opinion that the appeal should be dismissed. In my opinion the interest payments made by MFL were not incurred in gaining or producing assessable income and were of a capital nature. Having so concluded it was unnecessary to consider the application of Pt IVA. However had the payment been deductible under s 8-1 of the Income Tax Assessment Act 1997 (Cth) (the 1997 Act) then, it is my opinion, for the reasons set out in the judgment of Hely J, that Pt IVA would not have applied to disallow the deduction.

6 In summary, I am of the opinion that the payments made are not deductible and that Pt IVA would not have applied to disallow the deduction if they were deductible. Hely J is of the opinion that the payments made were deductible and that Pt IVA did not apply to disallow the deduction. He would have allowed the appeal. Gyles J is of the opinion that the payments were not deductible and that Pt IVA would have applied to disallow any deduction had they been deductible. In the result, Gyles J and I are agreed that the payments were not deductible and that the appeal should be dismissed with costs.

Factual Background – Macquarie Income Securities – A Capital Raising Mechanism for Macquarie Bank Ltd

7 MBL described itself in its 1999 annual review as a provider of financial services. It is an investment bank which acts as a financial intermediary, accepts deposits, issues securities and makes advances and investments. Those services are provided by a number of subsidiaries. Their activities are carried on through operating groups described variously as asset and infrastructure, treasury and commodities, corporate finance, equities, banking and property and investment services. One of the subsidiaries is MFL. MBL is a licensed trading bank under the Australian Banking Act 1959 (Cth). It is subject to the supervisory authority of the Australian Prudential Regulation Authority (APRA).

8 In June 1999 officers of the MBL group gave consideration to ways and means of raising additional long term funding through increasing capital and/or borrowings in order to meet its anticipated business needs. Their consideration was stimulated by a proposal, developed within the group, for its acquisition of the Australian banking business and assets of Bankers Trust (BTIB) from Deutsche Bank AG. Although that acquisition, which was expected to cost about $100 million, could have been funded from MBL’s existing resources, its projected requirements, including those arising by reason of the acquisition, indicated a need to increase the funds available to them by up to $4 billion.

9 The fund raising had to be conducted within the regulatory framework, including minimum capital requirements prescribed by APRA. Its requirements reflect those adopted by a number of national regulators around the world and established by the Basle Committee of Banking Supervision of the Bank of International Settlements. The Reserve Bank of Australia is a shareholder of that Bank. Under the agreement, bank regulators have established three categories of capital for banks designated Tier 1, Tier 2 (Upper) and Tier 2 (Lower). It is a requirement that Tier 2 capital could not exceed Tier 1 capital and together they must make up at least 8% of the total risk weighted assets of the bank or institution.

10 Where Tier 1 or Tier 2 capital is increased the amount of money that the bank can borrow and invest or advance to creditors is increased by a multiple according to the category of the capital increase. So where a bank, with $13 million of Tier 1 capital and debt liabilities of $87 million, doubles its Tier 1 capital to $26 million it can borrow a total of $174 million providing total assets of $200 million. It can, by raising $13 million in equity, create a further $100 million of assets in investments and advances by borrowing a further $87 million.

11 In 1999 APRA’s guidelines were set out in successive documents entitled ‘Capital Adequacy of Bank’s Prudential Statement C1’ dated March 1996 and September 1999 respectively. The 1996 statement included within the description of Tier 1 capital paid up ordinary shares and non-cumulative irredeemable preference shares. Subject to their compliance with certain conditions Tier 1 capital could also include innovative capital instruments. These were defined as capital instruments other than ordinary shares and non-cumulative irredeemable preference shares. To be included in Tier 1 capital such shares and instruments were required to satisfy conditions set out in Attachment 1A of the Prudential Statement. An instrument would not be eligible for inclusion in Tier 1 capital where it would result in the aggregate amount of innovative capital instruments and non-cumulative irredeemable preference shares exceeding 25% of net Tier 1 capital. The term ‘net Tier 1 capital’ referred to Tier 1 capital net of non-ordinary shares and other capital instruments.

12 The criteria for Tier 1 capital instruments other than ordinary shares which were set out in Attachment 1A of the Prudential Statement required that such instruments normally take the form of shares unless otherwise agreed with APRA. They should be treated as equity under Australian Accounting Standards and reported as such in the bank’s published financial statements, absent an alternative treatment agreed with APRA. The instruments were required to be unsecured and fully paid up. The proceeds of an issue were to be immediately available to the bank. Only proceeds actually received from the issue of the instrument were eligible to be included.

13 Officers of MBL considered more than one mechanism for raising the necessary capital between June and September 1999. The mechanism finally adopted involved the issue of preference shares by MBL and debenture notes by MFL as stapled securities called Macquarie Income Securities (MIS). They were ‘stapled’ in the sense that the holder of a security could not transfer the preference share without the debenture note and vice versa. The transactions had the effect that interest was payable by MFL on the moneys raised by the issue of their notes whereas no dividends were payable under the preference shares. However upon certain events, under the control of MBL, occurring the holders of the securities would cease to receive interest on the notes and would instead receive dividends on their preference shares.

14 On 30 September 1999 the MBL and MFL boards approved a proposal for raising $400 million by two issues of MIS at $200 million each. The relevant documents were approved for execution and were executed by the Board on that day. APRA confirmed on 6 October 1999 that the issue would be treated as Tier 1 capital subject to a revision of the documentation. The capital raising mechanism adopted by MBL and MFL involved three principal agreements described in the following paragraphs.

15 MBL, MFL and Trustee Company of Australia Ltd (the Trustee) entered into a Trust Deed called the ‘Macquarie Income Securities Trust Deed’ on 30 September 1999. Under that Deed MFL issued notes to the Trustee to hold on trust for investors defined in the Deed as ‘Holders’. The notes were direct unsecured debt obligations of MFL. The Holders would obtain a Holder’s Interest which was defined as the entire beneficial interest in the notes. Each Holder’s Interest was to be ‘stapled’ to one preference share in the capital of MBL in the sense that the Holder’s Interest and the preference shares could only be transferred together. The Holder’s Interests were to be issued, in the first instance, to the ‘Initial Holder’ which was the underwriter Deutsche Securities Australia Ltd (Deutsche). The conditions of the notes issued by MFL were set out in Schedule 1 to the Trust Deed. The terms of the preference shares to be issued by MBL under the arrangement were set out in Annexure A to the Trust Deed.

16 By cl 5.1 of the ‘Conditions of Notes’ in Schedule 1 to the Trust Deed, MFL was to pay interest on each Interest Payment Date (defined in the Schedule). The amount of interest payable on the notes, together with the aggregate amount of dividends paid on or before the relevant date during the current financial year of MBL on any preference or other shares of MBL, was not to exceed its Distributable Profits. By cl 2.2 the holder of a note was not a creditor of MFL and had no right to sue for or otherwise claim payment from MFL of moneys owing in respect of the notes. The relevant creditor/debtor relationship existed between MFL and the Trustee (cl 2.2(a)).

17 MBL, MFL, the Trustee and Deutsche also entered into a Subscription Agreement dated 30 September 1999. By that agreement Deutsche undertook to subscribe for two million MIS each comprising a Holder’s Interest in an MFL note and a preference share in the capital of MBL. It would subscribe in its capacity as underwriter of the issue. It would pay $200 million to MBL for the shares and $200 million to MFL for the Holder’s Interests. Upon completion of the public offering in accordance with the prospectus relating to the issue, Deutsche would transfer its securities to investors whose applications had been accepted by it and by MBL and MFL.

18 MBL and Deutsche entered into a Procurement Agreement on 30 September 1999. The essence of the agreement, set out in clause G of its recitals, was that:

‘In consideration for Deutsche giving a notice to the Trustee directing it to make the Payment Direction in certain circumstances, [MBL] agrees to pay to Deutsche the Payment Direction Amounts on the terms and conditions of this agreement.’

It was by virtue of this agreement that the payment of interest to noteholders could be replaced, at MBL’s option, with the payment of dividends on the preference shares ‘stapled’ to those notes. How it worked is set out below. It is necessary, in order to understand its operation, to refer first to certain provisions of the Trust Deed.

19 Under the Trust Deed a ‘Payment Direction’ was defined as an ‘irrevocable payment direction by the Trustee to the Issuer [MFL] to pay to the Company [MBL] amounts due to it in respect of the Notes in accordance with clause 4.15’. Clause 4.15 of the Trust Deed provided:

‘4.15 The Initial Holder [Deutsche] may, by notice in writing in the form of Schedule 4 signed by a duly authorised officer to the Trustee and the Issuer [MFL] irrevocably authorise and direct the Trustee to direct that:

(a) the Issuer [MFL] pays all Moneys Owing in relation to Notes issued as a Series specified in the notice which become due after a Payment Direction Event occurs (including, without limitation, any Redemption Amount provable in the winding up of the Issuer [MFL] and the proceeds of any dividend payable in the winding up with respect to Moneys Owing in relation to Notes issued as a Series specified in the notice which become due after the Payment Direction Event occurs); and

(b) the Company [MBL] pays any moneys payable under the Performance Guarantee in relation to Notes issued as a Series specified in the notice which become due after the Payment Direction Event occurs,

to or as directed by the Company [MBL]. The notice is irrevocable.’

20 By clause 4.16 of the Trust Deed, when Deutsche gave a Payment Direction Notice under cl 4.15, it was binding upon each subsequent Holder of Holder’s Interests (4.16(a)). The Trustee would be taken, in the event of such a Notice, to have irrevocably directed MFL to pay MBL, or as directed by it, moneys owing on the issued notes if and after a Payment Direction Event occurred (4.16(b)(i)). The Trustee would also be taken to have irrevocably directed MBL to pay any moneys payable under the Performance Guarantee in relation to the Notes which became due after the Payment Direction Event. The latter obligation seems to have required MBL to pay guarantee moneys to or as directed by itself (4.16(b)(ii)). MFL also agreed to make all such payments in accordance with the Trustee’s direction (4.16(c)). This meant, in effect, that MFL could be obliged, inter alia, to redirect interest payments on the notes from the noteholders to MBL. The Trustee was irrevocably authorised and directed to act solely in accordance with the directions of MBL in relation to the exercise or non-exercise of any remedies or powers of the Trustee under or in connection with the Notes or any moneys owing which become due after that date or the Performance Guarantee (4.17(a)).

21 The term ‘Payment Direction Event’ was defined in cl 1.1 of the Trust Deed as follows:

‘(a) a Liquidation Event occurs in relation to the Company [MBL] or the Issuer [MFL]; or

(b) the Company [MBL] or the Issuer [MFL] acknowledges in writing that it is unable to pay its debts within the meaning of the Corporations Law; or

(c) at any time, the Company [MBL] gives notice in writing to the Trustee stating that it requires all Moneys Owing in respect of the Notes be paid to it as they become due.’

22 Paragraph (c) of the definition of Payment Direction Event was the paragraph of practical significance for the operation of the arrangements between MBL, MFL, Deutsche and the Trustee. A Payment Direction Notice could be given by Deutsche under clause 4.15 of the Trust Deed. A Payment Direction was to be by notice in writing to the Trustee.

23 The Procurement Agreement provided that, in consideration of Deutsche agreeing to give, on the Subscription Date, a notice to the Trustee and MFL in accordance with clause 4.15 of the Trust Deed directing the Trustee to make the Payment Direction in respect of the two million notes issued to it on the Subscription Date, MBL would pay to Deutsche on the same day the Payment Direction Amount in respect of the two million notes issued on that date (cl 2.1). The Payment Direction Amount was defined in the Procurement Agreement as ‘$100 per note’. A similar provision related to notes issued to the Trustee on the Completion Date (cl 2.2). The net outlay by Deutsche under these arrangements would be $200 million. Another $200 million tranche was to be subscribed for and paid on the Completion Date, ie the completion of the subscription process.

24 A Payment Direction Event would have the following effects. It would:

1. Enliven the operation of cls 4.15, 4.16 and 4.17 of the Macquarie Income Securities Trust Deed.
2. Free MFL of its obligations under the notes to the Trustee and to the holders of the stapled instruments and require the payment of moneys due under the notes to be made to MBL or as directed by it.
3. Activate MBL’s obligations to the holders of the stapled instruments with respect to the preference shares as they would then become ‘Dividend Paying’. This term is defined in cls 1.1 and 4 of Annexure A to the Macquarie Income Securities Trust Deed.
4. Cause MBL’s guarantee to the Trustee to lapse – see cl 3 of schedule 3 to the Macquarie Income Securities Trust Deed.

25 Prior to the preference shares becoming Dividend Paying on the Dividend Paying Date following the activation of cls 4.15 et al, the holders of the securities, would have, in respect of the preference share component:

1. No entitlement to dividends.
2. Limited voting rights.

3. No return on a winding up. In a sense this was academic. If MBL were wound up that would constitute a Payment Direction Event (under par (a) of the definition) and as a consequence the preference shares would become ‘Dividend Paying’. Clauses 4.15, 4.16 and 4.17 of the Macquarie Income Securities Trust Deed would be enlivened.
4. No entitlement to a return upon a redemption or buy back of the preference share or on a reduction of capital.
5. A right to transfer the shares but only together with their Holder’s Interest in the corresponding notes.

26 In the event that the preference shares became dividend paying:

1. They would carry an entitlement to dividends at a premium to the Australian Bill Swap Reference Rate which was non-cumulative and would not exceed the after-tax profits of MBL.
2. They would have limited voting rights.
3. There would be an entitlement to $100 per preference share on a winding up in preference to ordinary shares but no right to participate in surplus assets.
4. There would be an entitlement to $100 per preference share on a redemption, buy back or reduction of capital.
5. There would be a right to transfer the preference share but again, only together with the Holder’s Interest in a note.

27 Under the Macquarie Income Securities Trust Deed, MBL guaranteed to the Trustee, on a subordinated basis, the payment of the interest due by MFL on the notes. However subsequent to a Payment Direction Event all moneys payable under the guarantee were to be paid to MBL.

28 There were other deeds entered into on 13 and 14 October 1999 and supplemental condition statements signed on 30 September 1999 and 19 November 1999. It is not essential to refer to them for present purposes.

29 Following the execution of the transaction documents on 30 September 1999 MBL received subscription moneys of $200 million for the initial issue to Deutsche of two million preference shares of face value $100 each. MBL, at the same time, paid the sum of $200 million to Deutsche in consideration of Deutsche giving a Payment Direction Notice to the Trustee and MFL under the Trust Deed and in accordance with the terms of the Procurement Agreement. MFL raised $200 million from Deutsche in respect of the issue of two million notes each and a further sum of $100.

30 On 19 November 1999 MFL raised another $200 million in respect of the issue of a further two million notes to Deutsche. MBL received subscription moneys of a further $200 million for the further issue of two million preference shares of face value $100 each to Deutsche. It paid $200 million to Deutsche in consideration of Deutsche giving a further Payment Direction Notice to the Trustee and MFL. Thus Deutsche, as initial unit holder, gave two Payment Direction Notices to the Trustee and MFL as contemplated and provided for in the Procurement Agreement. The giving of those notices bound subsequent holders of the stapled instruments. It also bound the Trustee and MFL. The result of Deutsche giving the two Payment Direction Notices was that MBL became entitled, and remained entitled, at its discretion to give a notice to the Trustee so as to trigger a ‘Payment Direction Event’ – see par (c) of the definition of ‘Payment Direction Even’.

31 Prior to a Payment Direction Event occurring, the Trustee and the holders of the income securities would have, as against MFL, in respect of their notes, an entitlement to interest on the notes at a premium on the average mid rate for 90 day bank bills. The entitlement would be non-cumulative and could not exceed the after-tax profits of MBL. The rights of the Trustee and the holders against MFL were unsecured. The rights of the Trustee for payment of interest and principal were subordinated to all other creditors of MFL. The notes were perpetual, not being redeemable at the option of the Trustee or at the option of a noteholder. MFL had an option to redeem the notes after five years but only with the written approval of APRA. It could, however, redeem the notes before five years for specified regulatory reasons subject to APRA not objecting to such redemption. MFL was required to redeem upon the winding up of MFL for $100 per note and accrued interest. If MFL were wound up that would give rise to a Payment Direction Event. Clauses 4.15, 4.16 and 4.17 of the Macquarie Income Securities Trust Deed would be enlivened (see cl 4.15(a)). The amount payable upon the winding up of MFL would be a ‘Redemption Amount’ as that expression is defined in the Macquarie Income Securities Trust Deed. This amount would not be paid to the holders but rather to MBL. A holder was not a creditor of MFL and would have no right to sue for interest or principal. However the Trustee had limited creditor enforcement rights. If a Payment Direction Event occurred all amounts otherwise payable to the Trustee or a Holder would be payable to MBL. At the same time the rights attaching to the preference shares would be activated.

32 As a result of the implementation of the transaction documents MFL received subscription moneys of $200 million for the initial issue of two million notes of face value $100 each to Deutsche. It received that sum on 30 September 1999. On 19 November 1999 it received subscription moneys of $200 million for the subsequent issue of two million notes of face value of $100 each to Deutsche.

33 Deutsche sold to retail investors the preference shares and notes as stapled instruments which it had received under the Subscription Deed on 30 September 1999. It also on-sold the preference shares and notes which were issued to it on 19 November 1999.

The Evolution of the Capital Raising Proposals within the Macquarie Group

34 Key participants in the development of the capital raising proposal involving MIS were the following:

1. Gregory Ward, the head of the Corporate Affairs Group of MBL and a director of MFL and other MBL subsidiaries. As Head of Financial Operations for the group he was responsible for managing the capital requirements.
2. Paul Robertson, Group Treasurer of MBL responsible for the debt side of MBL’s capital.
3. Paul Donnelly, Executive Director of the Equity Capital Markets Division of MBL.

Each of these persons gave evidence. Their credit was not attacked although the learned primary judge did not accept all of their evidence about the development of the structure for the issue of the MIS.

35 In June 1999 retail investors in Australia were showing interest in stock exchange tradeable hybrid perpetual income securities redeemable by the issuer and returning ‘interest’ at rates slightly better than interest on fixed or at call deposits. Such securities qualified as Tier 1 capital under the minimum capital ratios for banks fixed by the Basle Committee on Banking Supervision of the Bank of International Settlements.

36 Messrs Ward, Robertson and Donnelly were interested in the possibility of MBL raising money by the issue of securities of that kind. A debt instrument qualifying as Tier 1 capital would make a larger pool of funds available for investment than by way of equity raising. The holders of such securities would not have the capital and dividend rights of shareholders. This form of debt was cheaper than equity. Advantageously to the borrower the moneys raised on such securities did not have to be repaid in the medium term. Shareholders in MBL generally earned a return on their equity of 20% to 25%. Long term subordinated debt instruments were at that time being issued at 100 to 200 basic points over the prevailing bill rate.

37 The initial structure proposed for capital raising was called a Capital Escrow Security Structure (CES). It was also referred to by the learned primary judge as MIS, an acronym for Macquarie Income Securities. It involved a form of perpetual debt trust security.

38 A memorandum dated 16 June 1999 was prepared by Mr Merven, the director of the Risk Management Division of MBL. He attached it to a letter which he sent to APRA. He sought APRA’s advice on whether a capital raising instrument as described in the memorandum would be classed as Tier 1 capital. The memorandum described a security in the form of an unpaid preference share linked to a fully paid debt security. The shares and the notes would be issued by MBL. The notes would be issued to a trustee and the trustee would in turn issue investors with income units carrying rights to receive interest distributions. The preference shares were not to be redeemable by MBL before the fifth anniversary of their issue. The interest on the notes was to be paid semi-annually in arrears at the same time and at the same rate as dividends payable on the preference shares. The learned primary judge found that the memorandum related to the CES structure. He found that MBL was then considering the capital raising using that structure in the context of the acquisition by MBL of the BTIB business [17]. APRA advised, on 18 June 1999, that the Capital Escrow Securities would qualify for inclusion in the Tier 1 capital of the bank subject to certain qualifications which are not material for present purposes. APRA’s advice was given in the context of guidelines then applicable to capital adequacy requirements. It did release new guidelines changing capital adequacy requirements on 23 June 1999 but never revoked its approval for the CES structure.

39 The CES structure and a Perpetual Loan Note issue were canvassed at about the same time in a memorandum dated 16 June 1999 to Messrs Ward, Robertson and Merven from other members of the Corporate Affairs Group. The CES structure was described in the memorandum as involving an issue by the Bank of a ‘perpetual loan note out of Australia and an unpaid preference share’. The memorandum was directed to a capital raising of $150 million of subordinated debt as part of an overall debt financing package in connection with a possible acquisition. It was varied to satisfy rating agencies. At a meeting held on 18 June 1999 the Board of MBL resolved that the BTIB acquisition be approved, that there be a placement of ordinary shares to $100 million and that $200 million worth of MIS and $150 million of converting preference shares be issued. A $2 billion stand-by funding arrangement with Deutsche was approved. Some changes were made at a Board meeting of 20 June. On 25 June 1999 the Board announced its proposed acquisition of BTIB and the funding arrangements. At that stage the income securities which were to be issued accorded with the CES structure [22].

40 A further memorandum refining the structure of the income securities was circulated by Mr Donnelly to Messrs Ward and Robertson on 13 July 1999. He proposed the issue to investors of preference shares in MBL stapled to income units in the Macquarie Income Securities Trust. The assets of the Trust would be Loan Notes issued by Macquarie. Unit holders would get distributions based on interest payable on the Notes. The distributions would be paid at a floating rate calculated by reference to the 90-day bank bill rate. The proposal was approved by APRA on 15 July at a meeting of APRA representatives with Mr Moss [24].

41 An alternative financing structure was developed between July and late August. What emerged on 2 September 1999 was a structure designated MIS II. The learned primary judge described this as ‘a loan issue not involving MFL’. The details were not clear. It still involved only MBL. The terms of issue of the preference shares under the MIS II structure were different from those under the CES structure.

42 MFL was inserted into the arrangements in a third structure proposed between 2 and 16 September 1999. Under this proposal, MFL would issue the notes. MBL would issue the preference shares. The preference shares were to be issued fully paid, rather than unpaid. The notes were to be secured by a Debenture Trust Deed. They would be issued initially to an underwriter. The proposed underwriter was Deutsche. Deutsche would then sell to MBL the right, in certain circumstances, to require the Debenture Trustee to pay interest and principal due on the notes to MBL instead of the holders of the notes. A direction from MBL to make such a payment was the ‘Payment Direction’ referred to in the documents which have already been outlined. Investors would purchase Deutsche’s rights in the debentures subject to the Payment Direction. They would also purchase the preference shares from Deutsche. That was necessarily so because the securities were ‘stapled’. Upon the payment Deutsche would cease to receive interest on the notes and would instead receive dividends on the shares they held.

43 The provision in this revised structure for fully paid preference shares may have been considered necessary because the proceeds of the income securities issue were to be on-lent from MFL to one of MBL’s subsidiaries, Macquarie Leasing Pty Ltd, to meet its operational and business funding needs. APRA’s rules put a 30% limit on intra-group loans by banks calculated as a percentage of the bank’s issued capital. In the case of MBL its intercompany loans were capped at $250 million. At the time that the capital raising was being considered, Macquarie Leasing had borrowed $325 million from MBL pursuant to specific approval from APRA to do so. Any further lending from MBL to Macquarie Leasing would breach APRA’s requirements. The learned primary judge accepted that the APRA guidelines did have the effect of limiting intra-group loans. At that time MFL, which had acted as a deposit taking intra-group financier since its incorporation, was inactive. It had not made any transactions since 1992.

44 Mr Ward said in his affidavit evidence of 1 April 2003 that he selected MFL because it had been operating as a deposit-taking intra-group financier since incorporation in about 1984 although it had ceased accepting deposits from the public in about 1992. By 1999 it was holding deposits for a small number of corporate research and development syndicates which it on-loaned to its parent company, Macquarie Acceptance Ltd, which was in turn a subsidiary of MBL. He said:

‘MFL had a clean corporate history, which made it easier to review from a due diligence perspective for the purpose of the issue of the MIS prospectus to the public and its structure was to be simplified by transferring all of its issued capital to MBL from MFL’s existing parent.’

45 In cross-examination before his Honour Mr Ward agreed that the shift from capital escrow securities to the final form of the transaction was not something requested or sought by MFL. The directors of MFL did not ask that it become involved.

46 The learned primary judge seems to have accepted that MFL was selected to participate in the structure because it was inactive and had a clean balance sheet.

47 Between 17 and 23 September 1999 a decision was made to proceed with the last described structure. Mr Donnelly advised Messrs Robertson and Ward on 17 September 1999 that the issue of MIS would be cheaper than the nearest equivalent security namely converting preference shares. He recommended that the MIS proposal should be pursued. Mr Robertson wrote to the Board on 23 September 1999 outlining the structure ultimately adopted and the background to it. Deutsche agreed to underwrite the issue and there were meetings with APRA seeking approval for the amount of $250 million to be included in MBL Tier 1 capital and any additional amount in Tier 2 capital. APRA had given its approval by 27 September 1999. The recommendation to adopt a new structure was approved by the Boards of MFL and MBL on 30 September 1999.

48 The public issue, which closed on 15 November 1999, was oversubscribed by $200 million yielding total proceeds of $400 million. MFL on-lent this to Macquarie Leasing for use in its plant and equipment leasing business. MFL earned $28,433,226 in the year of income by way of interest from Macquarie Leasing. It paid $27,833,226 to the Trustee for on-payment for the noteholders in the same year.

The Issues for Decision by the Learned Primary Judge

49 The learned primary judge identified three issues for decision:

1. Whether the amount of ‘interest’ incurred by MFL was an allowable deduction under s 8-1 of the 1997 Act.
2. Whether the ‘interest’ if otherwise an allowable deduction under s 8-1 of the 1997 Act, it is not deductible because of the application of s 82R(3) of the 1936 Act.
3. Whether the provisions of Part IVA of the 1936 Act operated to disallow to MFL the deduction for ‘interest’.

The Reasons for Decision of the Learned Primary Judge

50 After setting out the factual background outlined above his Honour dealt with the issues for decision which he had identified.

51 On the issue of deductibility under s 8-1, the Commissioner submitted to his Honour that the ‘interest’ earned by MFL was not deductible as it did not fall within either of the two positive limbs of s 8-1 of the 1997 Act. That is to say it was not incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing that income. Alternatively, it fell within the exclusion in subs 8-1(2) as a loss or outgoing of a capital nature.

52 His Honour set out a number of general propositions which, omitting reference to authority, can be paraphrased as follows:

1. Interest will ordinarily be an allowable deduction under s 8-1 if incurred in the course of an income producing activity or business.
2. Interest is ordinarily a recurrent or periodic payment securing ‘the use of borrower money during the term of the loan’. There may nevertheless be circumstances in which interest will be seen as unrelated to the raising or maintenance of the borrowing and thus, perhaps, on capital account.
3. The question of deductibility is not determined by reference to the label which the parties attach to the outgoing.
4. There must be a borrowing before what is paid can be regarded as interest. That presupposes that the lender is entitled to a return of the money lent.
5. The necessary conditions for deductibility are to be found within the terms of s 8-1. It is not necessary to the deductibility of a perpetual debenture that the transaction be characterised as a loan or a borrowing and the amount paid to debenture holders as ‘interest’.
6. An outgoing, to be deductible, must be ‘incidental and relevant’ to the gaining or production of assessable income or the business the purpose of which is the gaining or production of assessable income. There must be a sufficient connection between the outgoing on the one hand and the gaining or producing of assessable income or the business as the case may be.

His Honour found that there was no need in the present case, to distinguish between the first limb of s 8-1 relating to ‘gaining or producing assessable income’ and the second limb relating to expenditure ‘in carrying on a business’. MFL was carrying on a business. The question was whether the outgoing for ‘interest’ was incurred in, that is to say ‘in the course of’ either its income producing activity or its business.

53 The Commissioner submitted that the role of MFL did not arise out of any business activity which it carried on. The insertion of MFL into the arrangements followed a change in their structure and the need to find a company other than MBL to be the ‘borrower’. As to that his Honour observed that the issue of the notes to Deutsche was intended as part of an arrangement that MFL would use funds borrowed through Deutsche from the public to make loans to subsidiary companies of the MBL group and particularly Macquarie Leasing. It would do so at an interest rate in excess of the ‘interest’ which MFL incurred. The subjective purpose of the parties did not differ from the objective purpose to be ascertained from the terms of the transaction. It could be said that from MFL’s perspective it entered into the transaction intending to use the ‘borrowed’ funds in its business of lending at interest to companies of the MBL group. The intention was demonstrated by the actual use made of the funds. The fact that the interests of MBL were served was not fatal to characterisation of the ‘interest’ paid by MFL as an allowable deduction. He based these observations, however, upon the stated premise that attention was directed only to that part of the transaction relating to the notes issued to Deutsche. The income securities comprised both notes and preference shares stapled in the sense that they could not be transferred separately. This composite character raised more complicated questions which were better considered when determining whether the ‘interest’ paid by MFL was capital in nature.

54 His Honour set out some uncontroversial principles relevant to the capital/revenue characterisation question. In so doing he appears to have proceeded upon the premise, without any explicit finding, that the interest fell within the first and second limbs of s 8-1 and, unless of a capital character, would have been deductible.

55 The propositions set out by his Honour were:

1. It is necessary in determining whether an outgoing is deductible to consider its essential character.
2. The question whether a loss or outgoing is on capital account must be considered ‘from a practical and business point of view’ and by reference to ‘what the expenditure is calculated to affect’. This approach does not exclude from consideration the legal rights obtained by the incurring of the loss or outgoing.
3. The classic exposition of capital is set out in three tests formulated by Dixon J in Sun Newspapers Ltd & Associated Newspapers v Federal Commissioner of Taxation [1938] HCA 72; (1938) 61 CLR 337 at 363:

‘There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward ...or by making a final provision or payment so as to secure future use or enjoyment.’

His Honour also quoted from the judgment of Dixon J at 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. 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.’

56 His Honour observed that under the Australian income tax system a deduction is not available for dividends paid by a taxpayer company on its share capital. A rationale for that rule is that dividends are a distribution or division of profit after that profit has been ascertained so they cannot be treated as part of the cost of earning or deriving that profit. A declaration of a dividend is subsequent to the relevant business activity. The rule can also be explained by the proposition that a dividend is part of the cost of the fixed capital of the business so it is related to the business entity or the structure rather than the process by which it operates.

57 His Honour saw some significance for the present case in the rationale for the non-deductibility of share dividends. He said (at [56]):

‘What distinguishes the present case from a case where "interest" is payable on a loan or for that matter on perpetual or irredeemable debentures is the connexion between the note issue and the preference share issue and in particular the effect of the procurement agreement and payment direction.’

His Honour referred to those aspects of the arrangements whereby Deutsche subscribed for the preference shares and the notes and MBL immediately paid Deutsche an amount equal to that which Deutsche had paid for the shares. They had the result that under certain specified events (Payment Direction Events) the principal and interest under the notes was payable to MBL and not Deutsche or its successors in title. The consolidated accounting for the Macquarie group left the shares as capital but eliminated the notes although, in his Honour’s opinion, not much turned upon the way consolidation applied to the preparation of group accounts.

58 MFL submitted to his Honour that the stapling of the notes to the preference shares and the fact that the issue of income securities advantaged MBL and the group generally did not justify departure from a juristic analysis of the advantages secured by the issue of the notes by MFL. Until the Payment Direction was made, what was payable by MFL was interest and the holders of the securities received interest and nothing else. The Payment Direction might never be given.

59 In his Honour’s opinion the submissions of MFL ignored the relationship between the notes and preference shares brought about by the Procurement Agreement. They also ignored the fact that no dividend was payable on the MBL shares while ‘interest’ was payable to the notes’ holders. The so called interest which MFL was obliged to pay was not ‘in a practical business sense’ consideration paid by MFL for the noteholder (Deutsche or its successors) being kept out of the funds advanced by Deutsche and used to subscribe for the notes. The noteholders might never obtain repayment of the funds advanced. They might be left to look for their rights as shareholders in MBL.

60 His Honour said (at [61]):

‘Although if the stapled securities are looked at individually the legal rights of MFL to the holders of the notes may be seen to have the character of interest, that seems to me to ignore the composite nature of the security and the direction of Dixon J to look at what the interest is paid for from a practical and business like point of view. It seems to me to give undue weight to form and to disregard the substance of the transaction to characterise what is said to be "interest" as the price of the notes only. From a juristic point of view it is not irrelevant that under the Macquarie Income Securities Trust Deed, the principal is not redeemable at the option of the Trustee Company or at the option of the holder of the note, that the holder of the notes is not a creditor of MFL and has no right to sue for interest or principal arrears. The trustee also has limited creditor enforcement rights. It is not insignificant either that the issue of the income securities was related to the capital adequacy requirements of MBL seen in the context of MBL’s acquisition of the BTIB business. Nor does it assist MFL that interest payments on the notes were dependent upon there being distributable profits of MBL. In saying this it must be accepted that the "interest" was payable not by MBL but by MFL, although obviously a note holder was, as a consequence of the structure adopted, in fact a shareholder of MBL.’

61 His Honour referred to Australian National Hotels Ltd v Federal Commissioner of Taxation (1998) 19 FCR 234 and the joint judgment of Bowen CJ and Burchett J in that case as providing support for treating the MFL ‘interest’ as on capital account. In that case their Honours held premiums on policies of insurance against exchange losses were allowable deductions under s 51(1). They said, inter alia, that (at 240):

‘... there is a special feature of loan capital, which flows from the ephemeral nature of a loan. The cost of securing and retaining the use of the capital sum for the business, that is to say, the interest payable in respect of the loan, will be a revenue item. It creates no enduring advantage, but on the contrary is a periodic outgoing related to the continuance of the use by the business of the borrowed capital during the term of the loan.’

His Honour placed significance upon the reference in the joint judgment to ‘the ephemeral nature’ of a loan. In the present case the close relationship between the notes and the preference shares as well as the fact that MBL could ensure the loan was never repayable but that an investor was left only with MFL preference shares, could be seen to produce a different result (at [63]):

‘The present case is not concerned with the cost of acquiring or maintaining a loan of an ephemeral character, but rather with the cost of a capital raising which so far as MBL is concerned is the cost of a permanent injection of capital. The circumstance that the capital is in the present conditions used to make loans to Macquarie Leasing is not determinative.’

62 Because the case before him was argued on an all or nothing basis, his Honour did not consider the question whether any relevant apportionment could be made on the basis that the ‘interest’ amount payable by MFL was in truth consideration for both the loan to MFL and the provision of capital to MBL. In the event he found the ‘interest’ paid by MFL not deductible.

63 His Honour dealt with a number of other submissions made on behalf of MFL and his observations in respect of those submissions may be summarised briefly:

1. The payment of interest by MFL was capped by reference to the profits of MBL if the notes were considered separately. But the correct analysis was to look at the two issues as a composite transaction.
2. The noteholders were not shareholders in MFL and the interest paid was not a distribution of MFL’s profits or those of MBL. The real question was not whether the so-called ‘interest’ was a dividend, but whether it was on capital account.
3. There is no doctrine that the law allows taxation by commercial equivalence – Mullens Investment Pty Ltd v Federal Commissioner of Taxation [1976] HCA 47; (1976) 135 CLR 290 at 301. The question to be determined was whether the so-called interest was on capital account and secured an enduring benefit.
4. While the accounting treatment of the ‘interest’ in the consolidated accounts of the group was not determinative of the issue of deductibility, it was not irrelevant.
5. Mr Ward’s view that the notes might be restructured or redeemed after a review within five to 10 years, if commercially appropriate to do so, was not relevant to whether the moneys paid by MBL were interest.
6. The fact that the ‘interest’ did not reduce the amount owing on the notes was of no relevance.
7. Although moneys obtained from bill transactions can be treated as circulating capital of a finance company, that expression says nothing about the deductibility of the ‘interest’.

64 Having determined that the interest was not deductible under s 8-1 because of its capital character under s 8-1(2), his Honour then turned to the second issue, namely the application of s 82L of the 1936 Act. This depended upon whether the MIS were convertible notes. He took the view that there was little he needed to say on that issue.

65 The Commissioner submitted that on the proper construction of the terms of the Macquarie Income Securities Trust Deed the ‘amount of the loan’ to MFL could be converted into shares in the capital of MBL. If either of these submissions, which relied upon the definition of the expression ‘convertible note’ in s 82L of the 1936 Act, were correct then deductibility would be disallowed because of failure to comply with s 82SA(1)(d) of the 1936 Act.

66 His Honour held that at no time was there a note which was to be or could be converted into shares of MBL. Deutsche was issued with fully paid shares in that company from the outset. The rights attaching to them could vary depending on what happened to the note in MFL but the change in rights involved no conversion into shares. Nor was there any right in the noteholders to have preference shares allotted to them. The shares had already been allotted. His Honour concluded that the provisions of Div IIIA of the 1936 Act had no application and that any interest otherwise deductible would not be denied deductibility under that Division.

67 His Honour then considered Part IVA of the 1936 Act. Because he had found that the interest payable on the notes was not deductible to MFL, the anti-avoidance provisions of the 1936 Act in Part IVA had no application. Nevertheless, in the event that he was wrong on the deductibility issue his Honour considered whether Part IVA would apply to disallow a deduction for the ‘interest’ paid by MFL.

68 The first question which his Honour addressed for the purposes of Part IVA was whether there was a ‘scheme’ as defined in s 177A(1) of the 1936 Act. The definition of ‘scheme’ can include a course of conduct or ‘an action’. The Commissioner formulated the relevant scheme in different ways but his Honour focussed only upon the first. That formulation, as described by his Honour, was ‘the whole of the steps entered into by MBL and MFL in issuing the preference shares and the notes including the giving of the Payment Direction pursuant to the Procurement Agreement’ [75]. His Honour was of the view that unless the Commissioner could succeed by reference to all of the steps taken, it was difficult to see that he could succeed by reference to only some of those steps which were reflected in the second and third formulations of the scheme proposed.

69 His Honour identified the relevant tax benefit, purportedly cancelled, by the application of Part IVA and the Commissioner’s notice of cancellation as ‘the deduction for "interest" which on the assumptions [made] for the purpose of considering Part IVA is allowable to MFL’. He found that if the scheme involving the issue of MIS had not been entered into or carried out, MBL would have needed to raise some sort of capital to satisfy the capital adequacy requirements of APRA. There were a number of mechanisms for raising capital including equity raising and the structures canvassed by Mr Donnelly in the course of the development of the capital raising arrangements. The CES (or MIS) and MIS II structures each involved an interest component although neither involved MFL as a party. Only MIS III had MFL as a party and only MIS III involved a tax deduction for interest being obtained by MFL.

70 His Honour accepted that if capital raising were not to be pursued through some form of preference share issue it was inevitable that if there were to be a borrower some company in the group would have to pay ‘interest’. It would be desirable from the Macquarie Group’s perspective that interest payable should be a tax deduction because it would affect the cost of the finance. There was, however, no obvious reason why MFL was inserted into the scheme as against any other company in the group. If there were any particular reason for its choice, it would seem to be because it was virtually dormant. The corporate name ‘Macquarie Finance Ltd’ was desirable for a public issue. It had undertaken some financing transactions in the past.

71 His Honour considered what might reasonably be expected to have happened had the scheme not been entered into or carried out. MFL would not have obtained any tax deduction albeit some other company might have. MFL was not critical to the scheme at all, although it may well have been critical to any alternative scheme that some company pay interest. In his Honour’s view, posited on the hypothesis of the deductibility of the ‘interest’ on the notes, there was a tax benefit to MFL.

72 His Honour had regard to the eight factors required to be considered under s 177D(b) in determining the dominant purpose of MFL or some person, whether or not MFL, who entered into or carried out the scheme. In that connection he gave close consideration to the judgment of the High Court in Federal Commissioner of Taxation v Hart [2004] HCA 26; (2004) 217 CLR 216.

73 His Honour posed the question for decision thus (at [110]):

‘Ultimately, it seems to me that what is to be considered in the present case is whether, having regard to the eight factors in s 177D(b) it would be concluded that the dominant purpose of some person who entered into or carried out the scheme with the particular features I have mentioned was the obtaining for MFL of tax deductions for the ‘interest’ or whether it would be concluded that the dominant purpose of all persons who entered into or carried out the scheme with those particular features was the obtaining of Tier 1 capital.’

74 His Honour observed that a strict application of a view taken by Gummow and Hayne JJ in Hart might be thought to exclude the raising of Tier 1 capital as a purpose, this being a subjective matter. However, he did not think it could be excluded both because that was not the approach adopted by Gleeson CJ and McHugh J, and perhaps Callinan J, and because, in any event, the need for capital could be seen to be objectively determined.

75 His Honour considered the manner in which the scheme was entered into. He held that it took its form because of the ability of MFL to obtain a taxation deduction. The Procurement Agreement and Payment Direction were explicable only by reference to have both the benefits of a share capital raising and the allowance of an interest deduction. MFL’s participation was influenced by the desire to ensure a tax deduction to a company in the group, a deduction that would be unavailable had there been a share issue. He found that the obtaining of Tier 1 capital was a significant purpose of MBL. The tax deductibility of interest payable by MFL was likewise important. Debt financing was cheaper and a more flexible way of raising finance for the group. This advantage was only partly attributable to the tax deductibility of the interest.

76 The question his Honour then posed in relation to the first of the eight factors was whether the tax purpose or the commercial capital raising purpose was predominant in adopting the arrangement which was in fact entered into and having the particular features he had noted. His Honour found the question very difficult but concluded that what might be called the tax purpose predominated, although only marginally.

77 The second factor was the form and substance of the transaction. Its substance was the raising of share capital. Its form was a combination of debt and equity capital raising. The difference between the two could be accounted for by the availability of the tax deduction to MFL. As a matter of form there was a capital raising of $400 million and a debt raising of the same amount. As a matter of substance, the real cost to the group after the Procurement Agreement and payment from MBL to Deutsche was only $400 million. He acknowledged that there was a commercial advantage in terms of cost of finance and flexibility to be taken into account in weighing up which purpose predominated. Although the conclusion to be reached involved a question of judgment, again he thought it was the tax purpose which predominated.

78 The third factor, the timing of the transaction, had little part to play. Its timing and the period during which the scheme was carried out were consequences of commercial factors unaffected by taxation matters.

79 The fourth factor required consideration of the taxation result. That pointed to taxation as the dominant purpose of MBL and MFL and those directing those companies.

80 On the fifth factor, changes in the financial position of MFL resulting in the scheme, his Honour found that the matters arising under that heading were either neutral or favourable to a conclusion of a non-tax purpose. He found the three remaining factors to be either neutral or not suggesting a conclusion that the dominant purpose of the scheme was the obtaining of a deduction for interest. He concluded:

‘It follows, therefore, that if, contrary to my view, the "interest" payable on the notes was an allowable deduction to MFL in the year of income, then that deduction constituted a tax benefit which MFL obtained from a scheme to which the provisions of Part IVA applied and in respect of which the Commissioner was entitled to make a determination under s 177F disallowing to MFL the deduction. I might add that I reach this conclusion with some reluctance. I doubt if the legislature would have regard to the present "scheme" as involving the application of Part IVA when the Part was enacted in 1981. However, it seems to me that the approach of the High Court in Hart requires me to reach the conclusion I have.’

Grounds of Appeal and the Issues in the Appeal

81 There were some six grounds of appeal and a notice of contention filed by the Commissioner. They raised the following three issues (as defined in the Commissioner’s outline of submissions):

1. Whether the ‘interest’ incurred by MFL in favour of the holders of the stapled instruments in respect of the year of income ended 30 September 2000 was incurred by MFL in gaining or producing its assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing its assessable income within the first or second positive limbs of ss 8-1(1)(a) and (b) of the 1997 Act.
2. Whether the outgoings are denied deductibility under s 8-1 on the basis that they fell within the capital exception in s 8-2(a).
3. Alternatively to 1 and 2 above, whether the provisions of Part IVA of the 1936 Act operate to disallow the deductions of the outgoings incurred by MFL.

The Deductibility Issue – Statutory Framework

82 Section 8-1 of the 1997 Act provides:

‘(1) You can deduct from your assessable income any loss or outgoing to the extent that:

(a) it is incurred in gaining or producing your assessable income; or
(b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

(2) However you cannot deduct a loss or outgoing under this section to the extent:

(a) it is a loss or outgoing of capital, or of a capital nature;
...
(d) a provision of this Act prevents you from deducting it.’

The Deductibility of the ‘Interest’ paid by MFL under s 8-1(1) and 8-1(2) – The Contentions

83 MFL supported his Honour’s finding of deductibility under s 8-1 but challenged his conclusion that the interest was an outgoing of capital or of a capital nature. Its principal submissions may be summarised thus:

1. Deductibility under s 8-1(1) turns on whether the outgoing was incurred by MFL in gaining or producing assessable income or in carrying on a business to that end. This requirement is met. The obligation to effect the outgoing was incurred in raising funds deployed directly by MFL in earning interest income.
2. In determining whether the outgoing was of a capital character, for the purposes of s 8-1(2), a legal or juristic analysis must be applied rather than a commercial view. On such an analysis the outgoings incurred by MFL obtained for it, under the instruments binding on it and the transactions it entered into, no more than the use of the proceeds of issue of the notes. The outgoings served only the period to which they related and yielded a periodical return commensurate with their amount.
3. The learned primary judge erred in having regard not to the rights and obligations of MFL under the transaction but to a perception of a ‘practical and business point of view’ taking into account the advantage obtained by MBL.

84 The Commissioner submitted that his Honour erred in finding deductibility under s 8-1(1) but supported his conclusion that the interest payments made by MFL were outgoings of capital or of a capital nature under s 8-1(2). The Commissioner’s principal propositions were as follows:

1. MFL’s liability for the interest in the relevant year of income arose from the transaction documents. The purpose of that liability can be ascertained from them.
2. Although MFL is a separate taxpayer, its activities are to be examined in the context of the role it played in the affairs of the MBL group of companies.
3. The purpose of a taxpayer in incurring an obligation to make an outgoing can be determinative of the deductibility of the outgoing.
4. MFL’s paramount objective purpose was not to raise money in order to on-lend it to a sister MBL company in order to derive assessable income. Rather its purpose was to procure advantages to MBL.
5. The advantages MFL procured for MBL were not merely ‘incidentally’ derived by MBL. The procuring of those advantages was the purpose of MFL in entering into the transaction and were to be pursued even if the outgoings of MFL were not deductible.
6. In support of the characterisation of MFL’s outgoings as capital the Commissioner submitted that by virtue of the transaction documents, MFL acquired an asset of an enduring nature in the form of the right as against Deutsche and subsequent Holders of the stapled instruments to the retention and continued use (in perpetuity) of the money raised by it from Deutsche.
7. The funds raised by MFL under the Transaction Documents were lent by it to a related MBL company, namely Macquarie Leasing.
8. MFL’s participation in the Transaction Documents was a device adopted by MBL to overcome the APRA imposed limitation on the level of inter-group loans by MBL. MFL became a party to the documents at the behest of, and for the purposes of, MBL.
9. MFL secured as against Deutsche and subsequent Holders of the stapled instruments the retention and use in perpetuity of the funds raised by it from Deutsche whether or not it discharged its covenant to pay interest. The non-payment of the obligation to pay the outgoings cannot be enforced by the Holders of the stapled instruments. The Trustee may enforce payment by MFL but that right is subject to the right of MBL to trigger a Payment Direction Event. The Trustee may only require repayment by MFL under the Transaction Documents subject to MBL’s legal right to require payment to itself of $400 million under the Payment Direction.
10. MFL’s obligation to pay the outgoings to the Holders of the stapled instruments did not secure the continued use or retention of the money. The obligation incurred by MFL could be said to have been the price paid for the acquisition of funds by MFL from Deutsche but that obligation did not secure the retention of those funds as against Deutsche and the subsequent holders of the instruments.

Deductibility of MFL Interest Payments under s 8-1(1) of the 1997 Act

85 On the contentions advanced by the Commissioner the purpose for which MFL paid ‘interest’ to the Trustee for the noteholders is central to the characterisation of that outgoing under s 8-1(1) of the 1997 Act. The role of purpose in ascertaining deductibility under s 8-1 and its statutory ancestor, s 51 of the 1936 Act, is the subject of a considerable body of case law which yields a variety of approaches. In that context it is useful briefly to retrace the legislative history and some of the judicial exegesis.

86 Section 8-1 of the 1997 Act reflects the language of s 51(1) of the 1936 Act. That section had its statutory ancestry in s 23(1)(a) of the Income Tax Assessment Act 1922 (Cth) which provided for the deductibility of:

‘All losses and outgoings (not being in the nature of losses and outgoings of capital) including commission, discount, travelling expenses, interest and expenses actually incurred in gaining or producing the assessable income ...’

It was to be read subject to s 25(e) which excluded from the class of deductible expenses:

‘money not wholly and exclusively laid out or expended for the production of assessable income.’

Those provisions reflected those of ss 18(a) and 20(e) of the Income Tax Assessment Act 1915 (Cth) save for the exclusion of capital losses. The provisions of the 1915 Act were modelled on the British Income Tax Acts and similar sections in the Income Tax laws of the various States of Australia.

87 The drafting of the 1936 Act to include expenses necessarily incurred in carrying on a business and the exclusion of the disallowance principle in s 25(e) of the 1922 Act was foreshadowed in the Third Report of the Royal Commission on Taxation 1934. At par 554 of that Royal Commission Report it was said:

‘The problem, therefore, is to draft sections relating both to the allowance and disallowance of deductions which will make it clear that the taxpayer is entitled to claim any expenditure properly incurred by him in the production of his income, whether derived from a trade or otherwise, without at the same time opening the door so wide as to permit the allowance of deductions for which there is no justification. This might, perhaps, be accomplished by means of a section under which the taxpayer would be allowed as deductions all losses and outgoings incurred in gaining or producing the assessable income, or in carrying on a business for the purpose of gaining or producing such income; with a proviso or limiting section excluding the right to deduct any losses or outgoings of capital, or losses or outgoings incurred in relation to the gaining or production of income exempt from tax.’

88 The exclusion from deductibility created by s 25(e) of the 1922 Act required that the relevant expenditure be ‘wholly and exclusively laid out for the production of assessable income’ (emphasis added). The word ‘for’ imported a purpose test – Herald and Weekly Times Ltd v Federal Commissioner of Taxation [1932] HCA 56; (1932) 48 CLR 113 at 118 (Gavan Duffy CJ and Dixon J), 122 (Starke J) and 123 (Evatt J). Evatt J put it explicitly (at 123):

‘The principal relation is expressed by the word "for", which is indicative of the object or purpose of the taxpayer in incurring the expenses claimed by him as a deduction.’

89 By way of contrast there was no express or necessarily implied purpose test in s 23(1)(a) which pre-figured the formulations in s 51(1) of the 1936 Act and s 8-1 of the 1997 Act in its reference to ‘outgoings ... actually incurred in gaining or producing the assessable income’. The contrast between s 23(1)(a) and s 25(e) in relation to ‘purpose’ was drawn by Dixon J in Amalgamated Zinc (De Bavay’s) Ltd v Federal Commissioner of Taxation [1935] HCA 81; (1935) 54 CLR 295 at 309. He said:

‘The expression "in gaining or producing" has the force of "in the course of gaining or producing" and looks rather to the scope of the operations or activities and the relevance thereto of the expenditure than to purpose in itself. Purpose in itself may be the criterion expressed by the word ‘for’ which occurs in the correlative prohibition contained in s 25(e).’

90 In W Neville & Co Ltd v Federal Commissioner of Taxation [1937] HCA 9; (1937) 56 CLR 290 Latham CJ, addressing the operation of s 23(1)(a), pointed to the role of purpose (at 301):

‘No expenditure, strictly and narrowly considered, in itself actually gains or produces income. It is an outgoing, not an incoming. Its character can be determined only in relation to the object which the person making the expenditure has in view. If the actual object is the conduct of the business on a profitable basis with that due regard to economy which is essential in any well-conducted business, then the expenditure (if not a capital expenditure) is an expenditure incurred in gaining or producing the assessable income.’

91 On the other hand Dixon J, speaking of s 23(1)(a), said (at 305):

‘The condition the provision expresses is satisfied if the expenditure was made in the given year or accounting period and is incidental and relevant to the operations or activities regularly carried on for the production of income.’

The purpose of an outgoing in cases under the 1922 Act was directly relevant to the application of s 25(e) and it is perhaps not surprising that its significance to the application of s 23(1)(a) was not universally emphasised. There were however some comments about ‘purpose’ within the context of s 25(e) which had a wider application and resonate with contemporary questions of the construction of s 8-1 particularly in connection with imputed corporate purposes. In Robert G Nall Ltd v Federal Commissioner of Taxation [1936] HCA 79; (1937) 57 CLR 695, Dixon J said (at 711):

‘... purpose is an elusive and indefinite criterion. The purpose of a payment when a deduction is claimed for it becomes an attribute of the transaction rather than a state of mind in some actual person.’

In relation to imputed corporate purpose he quoted Lord Sumner’s judgment in Commissioners of Inland Revenue v Blott [1921 2 AC 171 (at 218):

‘... the company, in so far as intention is a mental act, was incapable of having any intention at all... The intention, which the final decision assumed, was one of those so-called intentions which the law imputes; it is the legal construction put on something done in fact.’

Latham CJ in Nall also made some remarks about imputed corporate intention and the need to accommodate the construction of the Act to allow it to be applied to such intentions or purposes. He said (at 705):

‘The existence of a purpose in the mind of some person cannot always be taken as the test in the application of this provision. The provision must be applied in the case of corporations, and it is impossible to limit the ascertainment of purpose of the case of a corporation to the ascertainment of the actual mental state of some natural person. The words, therefore, must, I think, be given an interpretation which does not necessarily depend upon the object which some person or persons desire to achieve, though, in a case where natural persons are concerned, the object which they naturally have in their minds may properly be taken into consideration in determining whether a particular expenditure is made for the production of assessable income.’

On that basis the section was held to contemplate a test which could be applied objectively and independently of subjective states of mind even though, in the case of natural persons an objective criterion might allow consideration of states of mind (at 705-706).

92 In Ronpibon Tin NL v Federal Commissioner of Taxation [1949] HCA 15; (1949) 78 CLR 47 the Court applied, to the construction of s 51(1) of the 1936 Act, the construction of s 23(1)(a) so far as it required that deductible expenditure be ‘incurred in gaining or producing the assessable income’. The Court said (at 56):

‘For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end.’

Purpose, however, was not far beneath the surface with the Court saying, in relation to the facts of the particular case, that the contingencies attaching to the consequences of a claimed outgoing ‘... made it impossible to say that it was a purpose of gaining assessable income that would be exempt’ (at 57).

93 The Full Court of the Federal Court in Federal Commissioner of Taxation v Phillips [1978] FCA 27; (1978) 20 ALR 607, held payments by a firm of accountants to a unit trust employing the firm’s secretaries and office equipment were deductible under s 51(1). An object of the arrangement in that case was the reduction of income tax by the diversion of profits through the trust to family members of the partners who held units in it. The payments were nevertheless held to have been necessarily incurred in carrying on the accounting business for the purpose of producing assessable income. The fact that the trust’s profits could have accrued to the firm, absent the arrangement, was not to the point. Bowen CJ and Deane J added (at 609):

‘Nor, in the absence of any questions involving the effect of s 260 of the Act, is it to the point that the overall re-arrangement had, with taxation and estate planning considerations in view, been effected to achieve, inter alia, those very results.’

So too, Fisher J (at 618):

‘...having opted to use the services of the unit trust, the deductibility of the expenditure depends upon the character of the expenditure and not the circumstances which brought about the situation in which the unit trust scheme was enabled to offer and to make available the services. It is my opinion that the latter circumstances are not relevant to the question of the complexion of the expenditure.’

94 In Magna Alloys and Research Pty Ltd v Federal Commissioner of Taxation [1980] FCA 150; (1980) 33 ALR 213, Brennan J reviewed the authorities on the relevance of purpose to the characterisation of outgoings under s 51(1). He did not regard what Latham CJ said in W Neville & Co as amounting to anything more than the proposition ‘that the taxpayer’s state of mind is evidentiary of what expenditure is for and of the character and scope of the taxpayer’s business or undertaking’ (at 224). Brennan J himself adopted an objective test for purpose. The question whether expenditure is incurred for the purpose of gaining or producing assessable income did not depend, in his opinion, upon the taxpayer’s state of mind (at 225):

‘The relationship between what the expenditure is for and the taxpayer’s undertaking or business determines objectively the purpose of the expenditure. In cases to which a reference to purpose is required or appropriate, objective purpose will be found to be an element in determining whether expenditure is incurred in gaining or producing assessable income or in carrying on business. If the purpose of incurring expenditure is not the gaining or producing of assessable income or the carrying on of a business, the expenditure cannot be said to be "incidental and relevant" to gaining or producing assessable income or carrying on business;...; nor can the undertaking or business be seen to be "the occasion of" the expenditure.’

Deane and Fisher JJ accepted, at 233, that there were circumstances in which the subjective purpose or motive of the taxpayer would be of little assistance in determining whether an outgoing was necessarily incurred in carrying on a business. Subjective purpose or motive was ‘not irrelevant’ but (at 234):

‘... where the taxpayer is a company, the relevant purpose is the corporate purpose which may or may not correspond with the individual subjective purpose or motive of one or more of those comprising the relevant corporate organ or acting as agent on the taxpayer’s behalf.’

95 Deane and Fisher JJ cited Fullagar J in Federal Commissioner of Taxation v Snowden & Willson Pty Ltd [1958] HCA 23; (1958) 99 CLR 431 for the proposition that within the limits of reasonable human conduct the person who is carrying on the business must be the judge of what is ‘necessary’. Their Honours said (at 235):

‘The controlling factor is that, viewed objectively, the outgoing must, in the circumstances, be reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business being carried on for the purpose of earning assessable income. Provided it comes within that wide ambit, it will, for the purposes of s 51(1), be necessarily incurred in carrying on that business if those responsible for carrying on the business so saw it.’

96 In Ure v Federal Commissioner of Taxation (1981) 34 ALR 237, Brennan J revisited s 51(1) in its application to interest payments and expressly relied upon the purpose of the outgoing (at 241):

‘An outgoing of interest may be incidental and relevant to the gaining of assessable income where the borrowed money is laid out for the purpose of gaining that income.’

This seemed to suggest a relevant purpose as a sufficient condition for the characterisation of interest payments as deductible under s 51(1). Deane and Sheppard JJ in the same case said (at 249):

‘... where the outgoing claimed as a deduction is interest paid on borrowed money, one cannot ordinarily look to the direct object or advantage which the outgoing was intended to achieve for the reason that that will ordinarily be the receipt of the borrowed money which is likely to be neutral in character. One must, of necessity, look more to the objects or advantages which the application and use of the borrowed money were intended to gain; FC of T v Munro [1926] HCA 58; (1926) 38 CLR 153 at 197.’

97 In Federal Commissioner of Taxation v Ilbery [1981] FCA 188; (1981) 38 ALR 172, Toohey J cited the observations of Brennan J in Magna Alloys that the purpose of incurring an expenditure might stamp it as expenditure of a business or income earning kind and added (at 179):

‘Conversely, I would add, a purpose may stamp the outgoing as one having no relevant connection with the gaining or producing of assessable income.’

That observation was cited, with apparent approval, in John v Federal Commissioner of Taxation [1989] HCA 5; (1989) 166 CLR 417 at 426. In the joint judgment of the High Court in the latter case it was said (at 426-427):

‘It is readily understandable that, if no income has been gained or produced and a question arises as to whether the occasion would be expected to produce assessable income, consideration of the purpose for which the expenditure was outlaid might not be wholly irrelevant. It may be too that even where income is produced "the purpose for which the advantage occasioning the loss or outgoing is sought may evidence a sufficient relationship with the income-earning process" Handley v Federal Commissioner of Taxation [(1981) [1981] HCA 16; 148 CLR 182 at pp 189-190)] per Stephen J. But the cost of a step taken in the process of gaining or producing income must be regarded as an outgoing or taken into account in calculating the loss (if any) incurred, whatever purpose or motive may have attended all or any of the steps involved.’

98 It may be noted that in determining whether interest is an outgoing ‘incurred in gaining or producing the assessable income’ it is not always necessary to distinguish between the purpose of the taxpayer and the use to which the borrowed funds are put – Steele v Deputy Commissioner of Taxation [1999] HCA 7; (1999) 197 CLR 459 at 474.

99 A purposive approach to the deductibility of interest payments under s 51(1) was evidenced in the judgment of the High Court in Federal Commissioner of Taxation v Consolidated Press Holdings Ltd [2001] HCA 32; (2001) 207 CLR 235. The Court was concerned, inter alia, with the deductibility of interest paid by Australian Consolidated Press in relation to a borrowing for the purpose of acquiring shares. Observing that an outgoing may qualify for deductibility even though no relevant assessable income is generated in the year in which the outgoing is incurred, their Honours said (at 260):

‘But it is the relevance of the loss or outgoing to some kind of income, actual or potential, that warrants the conclusion that it is incurred in a manner necessary for the application of s 51(1). It was the purpose of the borrowing, that is to say, the acquisition of shares expected to produce dividends as a result of the BAT takeover, that gave rise to the potential application of s 51(1).’

100 The trail of jurisprudence on this topic over the years has been a winding one. It does not yield clear or consistent approaches to the way in which the purpose of an outgoing bears upon its deductibility. The position is complicated when the relevant purpose is said to be that imputed, by way of legal fiction, to a corporate taxpayer. However some propositions relevant to the present case are consistent with the general course of judicial decision making on this topic. They are linked to some propositions about the ways in which the purpose of corporate taxpayers in incurring expenditure may be assessed:

1. An expenditure is incurred in gaining or producing assessable income if it is incidental and relevant to the gaining or producing of the income.
2. An expenditure is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income if it is reasonably capable of being seen as desirable or appropriate in the pursuit of the relevant business purposes.
3. The determination of an expenditure as incurred in gaining or producing assessable income or necessarily incurred in carrying on a business may be assisted by reference to the purpose of the taxpayer in incurring it.
4. Where the objectively assessed purpose of the taxpayer in incurring the expenditure is to gain or produce assessable income, then it may be said to have been incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for that purpose.
5. A logical linkage between objective purpose and characterisation of the expenditure under s 8-1(1) is made when the purpose is able to be assessed by reference to the result that the outgoing is designed to achieve. Such assessment involves a causal analysis of the relationship between the expenditure and possible results including the incurring of assessable income.
6. Where the expenditure is incurred pursuant to a particular agreement or transaction or set of agreements or transactions, its purpose may be assessed by reference to the result or outcome which the agreement or transaction under which it is incurred appears designed to achieve. This involves causal analysis of the relationship between the expenditure, the agreement or transaction and theoretical results, including the gaining of assessable income.
7. The subjective intention of a taxpayer, who is a natural person, may be relevant to the drawing of inferences about the causal relationship between an expenditure or agreements or transactions under which it is made and a posited result.
8. The objective purpose of a corporate taxpayer may be determined by application of a putative result or outcomes-based analysis of the kind referred to above.
9. Assessment of the objective purpose of a corporation in incurring an expenditure may be assisted by reference to the subjective purposes of its directing minds or those of its agents. Such purposes may support inferences about a connection between the expenditure incurred and the gaining or incurring of assessable income.
10. When a corporation is part of a group and effectively under the control of a parent company or other members of the group, their purposes may be attributed to it when it acts at their bidding.

101 MFL was a party to the Trust Deed and the Subscription Agreement. Those deeds had the combined effect, inter alia, that MFL could, under certain circumstances, be required to redirect ‘interest’ payments from the noteholders to MBL. MBL would then pay like amounts by way of dividends on the preference share components on the stapled securities. The power to create the circumstances under which this would occur was put in the hands of MBL by virtue of the Procurement Agreement with Deutsche and the interaction of that agreement with the Trust Deed and the Subscription Agreement.

102 At the time that they were entered into the likely effect of the various transaction documents was to enable MBL to meet a need to raise Tier 1 capital for its ongoing operation. That need was in part generated by its proposed acquisition of BTIB. The likely effect may, in the circumstances of this case, be translated into an objective purpose served by the transactions. It is a purpose properly attributed to MBL. That attribution is supported, not only by a consideration of the likely effects of the transactions, but also by the testimony of the relevant officers of MBL who devised the capital raising arrangements and recommended them to MBL’s board. There is nothing to suggest that MFL’s involvement was the result of any independent consideration by that company, or its officers, of its needs or separate purposes. The way in which MFL came to be involved in the arrangements indicates that it was there to serve the purposes of MBL and that those purposes could properly be attributed to it.

103 Under the arrangements which were reflected in the three principal transaction documents the liability of MFL to pay ‘interest’ on the notes which it issued was not tied to any income generating purposes of its own. The capital raised through the issue of the notes as part of the stapled securities, consistently with the transaction documents, could have been put to a variety of purposes within the Macquarie bank group. By virtue of the Procurement Agreement MBL had a capacity, from the outset, to effectively redirect interest payments by MFL from the noteholders to itself. Moneys reflecting the input of those ‘interest’ payments would then have emerged from MBL as dividend payments on the preference share components of the securities. The application of the interest moneys was effectively under the control of MBL from the commencement of the transactions. That dividends to noteholders could effectively be substituted for interest payments to them militates against the characterisation of the ‘interest payments’ as outgoings incurred in gaining or producing income. The relationship of the interest payments to dividends payable on the preference shares marks them as outgoings relevant to the raising of permanent additional capital for the group as a whole rather than as the recurrent cost of the loan applied to any income.

Whether the MFL Interest Payments were Capital Outgoings under s 8-1(2) of the 1997 Act

104 Given the conclusion that the interest payments on the notes were not incurred by MFL in gaining or producing assessable income nor necessarily incurred in carrying on a business for that purpose it is not strictly necessary to determine whether his Honour erred in finding that the payments were outgoings of a capital nature. There is in this case however an overlap between the questions raised by s 8-1(1) and s 8-1(2). The basis of the conclusion that the interest payments were not made for the purpose of gaining or producing assessable income is their relationship to the raising of additional permanent capital. The overlap is not merely an artifact of the facts of this case. Section 8-1(2) does not so much define an exception to the deductibility under s 8-1(1) as distinguish certain classes of payment which are not deductible under s 8-1(1). In RW Parsons, Income Taxation in Australia, Law Book Company (1985) at 306, the learned author observed:

‘5.12 The view adopted in this Volume is that the exceptions in s 51(1) operate only by way of contradistinction. Accepting this analysis, the effect of s 51(1) is to allow the deduction of expenses relevant to the derivation of assessable income, to the extent that they are working expenses, and are contemporaneous with activity whence income is derived, or with the holding of property for the derivation of income. Such a statement of the effect of s 51(1) may obscure some of the problems of interpretation, but it is helpful in asserting the irrelevance of the meanings of "capital" and "private or domestic", save so far as they may identify the reason that an expense is not a working expense. Where an expense is relevant to the derivation of income, to say that it is capital is to say that it is not working because it relates not to the process by which income is derived but to the structure of the activity that produces income, or to the property itself whence income is derived. Where an expense is not relevant to the derivation of income, to say that it is capital gives no more reason why it is not a working expense than may be given by saying that it is a private expense.’

And further at 5.13:

‘(iii) An expense that is relevant to income derivation will be a working expense if it relates to the process by which income is derived. It will not be a working expense, and may be described as a capital expense, if it relates to the structure of the activity that produces income, or to the property whence income is derived.’

The basis upon which the relevant payments are not deductible under s 8-1(1) also marks them, in this case, as outgoings of a capital nature.

105 The High Court said in GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation [1990] HCA 25; (1990) 170 CLR 124 (at 137):

‘The character of expenditure is ordinarily determined by reference to the nature of the asset acquired or the liability discharged by the making of the expenditure, for the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid.’

In so saying their Honours referred to the criteria enunciated by Dixon J in Sun Newspapers Ltd (at 363):

‘... (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision of payment so as to secure future use or enjoyment.’

106 There have been various formulations of the revenue/capital distinction in the context of expenditure. A long standing formulation states that an expenditure incurred to create ‘an asset or advantage for the enduring benefit of a trade’ is likely to be regarded as a capital and not revenue outgoing – British Insulated and Helsby Cables Ltd v Atherton [1926] AC 205 at 213 (Viscount Cave LC); Hallstroms Pty Ltd v Federal Commissioner of Taxation [1946] HCA 34; (1946) 72 CLR 634 at 641 (Latham CJ) and 643 (Starke J).

107 In the present case it is said that the learned trial judge erred in adopting a ‘practical business’ perspective of the interest which MFL was obliged to pay. It was submitted that his Honour took as binding and exhaustive an observation of Dixon J in dissent in Hallstroms in which Dixon J said (at 648):

‘What is an outgoing of capital and what is an outgoing on account of revenue 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.’

That observation was made in the factual context of that case in which Dixon J discounted the difference between, on the one hand, acquiring a freedom to use an invention as of common right and, on the other hand, acquiring an exclusive right of user which an extended patent would have conferred. So the distinction that Dixon J drew between the ‘practical and business point of view’ and the ‘juristic classification of the legal rights’ was connected with the characterisation of the undisputed purpose of the expenditure in contention.

108 In the present case the juristic character of the interest payments as obligations incurred by MFL under the transaction documents already discussed is not in issue. MFL made payments which it was obliged to make to the noteholders. There are two relevant purposes which can be attributed to its assumption of that obligation which would inform the characterisation of the payments. A narrow view which has regard to the MFL/noteholder relationship and the on-lending of subscribed moneys to Macquarie Leasing in consideration of interest paid to MFL, would support the proposition that the ‘interest’ paid by MFL was on the revenue side. On a wider view, the payments made by MFL to the noteholders were by way of expenditure outlaid to secure a permanent capital increase for MBL and associated companies. Consistently with the approach adopted in relation to the application of s 8-1(1), the latter is the purpose for which MFL assumed the application which it did. On that basis the payments were of a capital nature.

109 As Gibbs ACJ said in Federal Commissioner of Taxation v South Australian Battery Makers Pty Ltd [1978] HCA 32; (1978) 140 CLR 645 (at 655):

‘The real problem in the case is not to determine the character of the advantage sought, once it has been identified, but to decide what was the advantage sought by the taxpayer by making the payments.’

MFL put some emphasis in its submissions on the further observation of Gibbs ACJ that in considering the character of the advantage sought by the taxpayer (at 656):

‘... that must mean the character of the advantage sought by the taxpayer for himself by making the outgoings.’

MFL also referred to the statement by Stephen and Aickin JJ in the same case that (at 662):

‘... an examination of the legal rights obtained is essential to the characterization of expenditure, notwithstanding that in some cases it may not alone be sufficient to complete the process, because absence of enforceable rights is not decisive of the revenue character of a business outgoing.’

MFL relied upon observations in various Full Court cases about the importance of the framework of legal rights and obligations created in the particular case – City Link Melbourne Ltd v Federal Commissioner of Taxation [2004] FCAFC 272; (2004) 211 ALR 207 at [44]- [46]; Vincent v Federal Commissioner of Taxation [2002] FCAFC 291; (2002) 124 FCR 350 at [67]; Jupiters Ltd v Federal Commissioner of Taxation [2002] FCAFC 206; (2002) 118 FCR 163 at [25] and Federal Commissioner of Taxation v Firth [2002] FCA 413; (2002) 120 FCR 450 at [18]- [19].

110 In Australia & New Zealand Savings Bank v Federal Commissioner of Taxation [1993] FCA 282; (1993) 42 FCR 535 at 560, a case involving a loan with repayment of a principal sum with interest, Hill J, with whom Davies and Heerey JJ agreed:

‘In the absence of a submission that the transaction entered into by the parties is a sham, a disguise for some other and different transaction, and in the absence of the application of the anti-avoidance provisions of Pt IVA of the Act, the Court must look to see what the transaction entered into by the parties by its terms effects. That is to say, regard must be had to the legal rights which the transaction actually entered into confers. Invocation of the doctrine of substance is of no assistance in this task.’

111 Each case depends upon its own constellation of circumstances. For the reasons which I have already outlined the outgoing in this case was of a capital character. To treat it as merely interest on a loan is to take an artificially narrow view of the nature, the purpose and the circumstances of the payment.

The Tax Avoidance Issue - Part IVA

112 The expenditure by MFL by way of ‘interest’ payments to noteholders being non-deductible under s 8-1, there was no relevant tax benefit to attract the application of Pt IVA. It is, of course, possible to consider the application of Pt IVA on the hypothesis that, contrary to the conclusion already reached, the outgoings were deductible under s 8-1 of the 1997 Act. That process would necessarily import counterfactual assumptions about the purpose of the ‘scheme’ contrary to the conclusions about purpose which have been reached. Conclusions based on such assumptions do not constitute a judicial determination of a live question. They are at best provisional statements of opinion. In so far as such an opinion is of any utility, I would agree, for the reasons expressed by Hely J, that Pt IVA would not have authorised the cancellation of a counterfactual tax benefit in this case.

Conclusion

113 For the preceding reasons, in my opinion, the appeal should be dismissed and the appellant should pay the respondent’s costs of the appeal.

I certify that the preceding one hundred and thirteen (113) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice French.

Associate:
Dated: 16 September 2005

ANNEXURE A
Overview of Securities Issues and Cashflows

IN THE FEDERAL COURT OF AUSTRALIA
NEW SOUTH WALES DISTRICT REGISTRY	NSD 1439 OF 2004

ON APPEAL FROM A SINGLE JUDGE OF THE FEDERAL COURT OF AUSTRALIA

BETWEEN:	MACQUARIE FINANCE LIMITED (ACN 001 214 964) APPELLANT
AND:	COMMISSIONER OF TAXATION RESPONDENT
JUDGES:	FRENCH, HELY & GYLES
DATE:	16 SEPTEMBER 2005
PLACE:	SYDNEY

REASONS FOR JUDGMENT

HELY J:

114 In the year of income ended 30 September 2000 (a substituted accounting period in lieu of the year of income ended 30 June 2000) the appellant (‘MFL’) claimed a deduction of $27,833,226 for what it claimed to be interest payable on notes which it had issued to Trust Company of Australia Ltd (‘TCAL’) pursuant to a trust deed styled ‘Macquarie Income Securities Trust Deed dated 30 September 1999’ (‘the Trust Deed’). The notes were unsecured perpetual debt obligations of MFL. The claimed deduction for that interest was disallowed by the respondent (‘the Commissioner’). MFL objected. The objection was disallowed, and MFL then appealed to this Court in its original jurisdiction against the objection decision.

115 That appeal was unsuccessful, and the application to set aside the objection decision was dismissed: Macquarie Finance Ltd v Commissioner of Taxation [2004] FCA 1170; (2004) 210 ALR 508. MFL appeals to the Full Court from that decision. The issues in the appeal are:

(a) whether MFL is entitled to a deduction under s 8-1 of the Income Tax Assessment Act 1997 (‘the 1997 Act’) for interest on a note issued by it as part of a stapled instrument known as ‘Macquarie Income Securities’; and
(b) whether the Commissioner was entitled to make a determination under s 177F of the Income Tax Act 1936 (‘the 1936 Act’) disallowing that deduction.

BACKGROUND

116 MFL is a wholly owned subsidiary of Macquarie Bank Ltd (‘MBL’) and is one of a number of subsidiaries which, with MBL, forms the MBL group of companies. MBL was at all relevant times an investment bank or financial intermediary, but it was also a licensed trading bank under the Australian Banking Act 1959 (Cth). As such it is subject to supervision by the Australian Prudential Regulation Authority (‘APRA’) which, as the successor to the Reserve Bank of Australia in this regard, is responsible for the prudential regulation of banks. One of APRA’s concerns is whether an Australian bank meets APRA’s minimum capital standards. APRA publishes guidelines or prudential statements which explain its approach to the assessment of the capital adequacy of banks.

117 It is unnecessary for present purposes to explore the detail of APRA’s assessment processes, except perhaps to note that capital, for supervisory purposes, is classified as Tier 1 capital, or Tier 2 capital, which in turn consists of Upper Tier 2 capital and Lower Tier 2 capital. Tier 1 capital includes share capital and non-cumulative irredeemable preference shares as well as what APRA describes as ‘innovative capital instruments’. APRA publishes criteria which must be satisfied before capital instruments other than ordinary shares will be included in Tier 1 capital.

118 The greater the equity capital of a bank as a proportion of its risk weighted assets the greater the security of the bank’s depositors and other creditors. Further, an increase in Tier 1 and Tier 2 capital not merely increases the capital adequacy of the bank, but also permits the bank to expand its operations. The primary judge illustrated this proposition by the following example. Assume a bank has Tier 1 capital of $13 million with debt liabilities of $87 million, ie total assets of $100 million. If the bank increases its Tier 1 capital twofold, that is to say to $26 million it can borrow $174 million giving it total assets of $200 million (that is to say it could ‘expand its book’ to $200 million by the addition of $13 million in Tier 1 capital) without compromising its financial strength and maintaining its credit rating.

119 In 1999 MBL had under consideration the raising of money from the public by means of a debt instrument which also qualified as Tier 1 capital. Various ways in which this might be done were under consideration from time to time. By 30 September 1999 a proposal had evolved under which potential investors would be invited by MBL and MFL to invest in a new form of security to be listed on the Australian Stock Exchange (‘the ASX’) called ‘Macquarie Income Securities’ (‘MIS’). The MIS were to consist of a stapled security comprising a preference share to be issued by MBL, and the beneficial interest in an unsecured note to be issued by MFL to TCAL pursuant to the Trust Deed. Both the preference shares, and the beneficial interest in the notes were to be issued to the underwriter, Deutsche Securities Australia Ltd (‘Deutsche’), which would onsell the stapled security to retail investors for $100.00 for each MIS.

120 A number of agreements were entered into on 30 September 1999 between MFL, TCAL, MBL and Deutsche (or some of them) (‘the transaction documents’) to enable implementation of the proposal. On 12 October 1999 APRA confirmed that the MIS qualified for inclusion in MBL’s Tier 1 as an innovative capital instrument. On 14 October 1999 APRA confirmed that the amount of MIS issued by MBL in excess of the (then) proposed $250 million initial issue could be included as Upper Tier 2 capital. Professor Officer’s evidence was that the effect of $250 million of the MIS qualifying as Tier 1 capital was to enable MBL to expand its assets by nearly $2 billion without a reduction in its Tier 1 capital ratio.

121 On 14 October 1999 MBL and MFL issued a prospectus in relation to the issue of the MIS. The prospectus disclosed that the proceeds of the offer: ‘will assist with the long term funding of Macquarie’s operations and will enhance Macquarie’s financial strength and trading ability’. There were two issues or tranches of MIS under the prospectus, each of $200 million.

122 After the public offering, the proceeds totalling $400 million were lent by MFL to Macquarie Leasing at interest and used by that company in its business of leasing items such as vehicles, plant, equipment and office machines to the professional and small business markets. The primary judge found that the loan to Macquarie Leasing was not documented, but it was agreed that interest would be at a margin of 1.8 to 2 per cent above the base interest rate charged on at call deposits. The margin charged by MFL was greater than the margin MFL was required to pay note holders. Thus in the year of income MFL earned $28,433,226 from Macquarie Leasing. In the same year, MFL paid $27,833,226 to be paid to note holders.

THE MIS

123 The agreements entered into on 30 September 1999 were the Trust Deed, and agreements styled ‘Procurement Agreement’ and ‘Subscription Agreement’. Under those agreements (which were amended and supplemented by other agreements), in relation to each tranche of $200 million:

(a) MBL issued 2,000,000 preference shares to Deutsche at $100.00 per share, raising $200,000,000 for MBL;
(b) MFL issued 2,000,000 notes having a face value of $100.00 per note to TCAL. Deutsche subscribed for the beneficial interest (called ‘the holder’s interest’) in each of those notes for $100.00 per note, raising $200,000,000 for MFL;
(c) under cl 4.15 of the Trust Deed, Deutsche, as initial holder of the holder’s interest in the notes, was entitled to give a direction to MFL and TCAL (‘the Payment Direction’) to pay the amount otherwise payable on the notes to MBL, rather than to the holder of the holder’s interest, on the occurrence of what was described as a ‘Payment Direction Event’, which is explained in detail later in these reasons. Under cl 4.16 of the Trust Deed, a Payment Direction, when given, binds the subsequent holders of the holder’s interests in the notes;
(d) MBL paid $100.000 per note (ie $200,000,000) to Deutsche pursuant to the Procurement Agreement, in consideration for Deutsche agreeing to give, on 30 September 1999, a Payment Direction to MFL and TCAL under cl 4.15 of the Trust Deed. Deutsche gave such a direction on that date in relation to the first tranche of $200 million (a similar payment was made and a similar direction was given in relation to the second tranche of $200 million on 19 November 1999); and
(e) each holder’s interest was stapled to one MBL preference share so that the two were only capable of being transferred together as a stapled security.

124 The subscription price of $100.00 per stapled security paid by institutional and retail investors reflected the fact that the holder’s interest in the note would effectively pass to MBL in the event that a Payment Direction Event occurred and that MBL had paid Deutsche the sum of $100.00 per note in order to secure that advantage. Deutsche recouped its outlay as underwriter from the proceeds of the issue of the MIS and the amount which it received in return for the Payment Directions.

125 It is necessary to examine in more detail the terms on which the notes were issued by MFL, the preference shares issued by MBL, and the interrelationship between these two components of the stapled security.

THE NOTES

126 The notes are issued in accordance with the Trust Deed. The conditions of issue are set out in Schedule 1 of the Trust Deed. At cl 2.1 of the conditions of issue the notes are described as ‘debt obligations’ of MFL. The notes are ‘undated’, which is explained in the Prospectus as meaning that they have no maturity date. However, MFL may, with the prior approval of APRA, redeem the notes at face value plus interest at any time after five years from the issue date, or earlier in a number of limited circumstances. The notes are redeemable upon a winding up of MFL.

127 By cl 4 of the Trust Deed, MFL undertakes to TCAL to pay the monies owing in respect of each note (ie, the outstanding principal amount, interest payable and any other monies payable in respect of it) as and when due in accordance with the conditions of issue. Under cl 4.4 of the conditions of issue, the right of TCAL to be paid the monies owing on a note when due is subordinated to the claims of all other creditors of MFL. A holder of a note is not a creditor of MFL and has no right to sue for interest or principal. TCAL may enforce the provisions of the Trust Deed and the notes on behalf of note holders provided it is indemnified.

128 Interest on a note is payable quarterly, and is calculated by adding 1.7 per cent per annum to the base interest rate with a minimum interest in the period ending on 15 January 2003 of 7.25 per cent. MBL guaranteed MFL’s obligations to pay interest if and when due and payable in accordance with the conditions of issue. TCAL’s right to be paid under MBL’s guarantee is subordinated to the claims of all other creditors of MBL, and ranks equally with claims of preference shareholders. Interest is not payable in the circumstances specified in cl 5.5 of the conditions of issue. Under this clause interest payments are subject to a number of conditions including:

– the amount of interest not exceeding MBL’s after tax profits and MBL complying with APRA’s then current capital adequacy guidelines;
– if the amount of interest were an amount payable by MBL, MBL being able to meet the claims of all creditors and depositors as they fall due after making that payment;
– a Liquidation Event (loosely, proceedings for the appointment of a liquidator, receiver or administrator) not having occurred in respect of MBL or MFL; and
– the directors of MFL not having resolved to stop the payment by the business day prior to the interest payment date.

Interest which is not payable in accordance with the conditions in cl 5.5 is deemed never to have accrued and never to be payable. MBL’s guarantee does not apply to interest which is not paid because a condition to that payment in cl 5.5 is not satisfied.

129 If MFL fails to make an interest payment within 20 business days of the due date, MBL is prohibited from paying dividends on shares ranking junior to the preference shares (including ordinary shares) until four consecutive interest payments have been made in full, or an equivalent optional interest payment is made.

130 Unless and until a Payment Direction is given, and a Payment Direction Event occurs, each payment in respect of a note is to be made to the registered holders of the holder’s interest. However, only TCAL may take proceedings to enforce the Trust Deed or the notes, to the exclusion of the holders, whose rights are limited to requiring TCAL to take enforcement action.

131 As indicated above, a Payment Direction was given on 30 September 1999 in relation to the first tranche of $200 million and on 19 November 1999 in relation to the second tranche, which enlivened MBL’s rights under cl 4.15 of the Trust Deed on the occurrence of a Payment Direction Event. A Payment Direction Event is defined so as to mean:

(a) a Liquidation Event occurs in relation to MBL or MFL; or
(b) MBL or MFL acknowledges in writing that it is unable to pay its debts within the meaning of the Corporations Law; or
(c) at any time, MBL gives notice in writing to TCAL stating that it requires all monies owing in respect of the notes be paid to it as they become due; or
(d) APRA determines in writing that MBL has a Tier 1 Capital Ratio of less than 5 per cent or a Total Capital Adequacy Ratio of less than 8 per cent.

132 When a Payment Direction Event occurs TCAL is required to act solely in accordance with MBL’s directions in relation to the notes and monies which become due after that date, including a direction that those monies be paid to MBL, or as it directs. MBL’s guarantee is of no further application once a Payment Direction Event occurs.

133 Thus, as stated in the prospectus, interest payments under the notes are subject to a number of conditions, the primary condition being the profitability of MBL. The prospectus also states that MBL has the right to direct that any future payments of interest and principal under a note are paid to MBL and not to investors. MBL may exercise this right at any time, following which the preference shares will become dividend paying.

THE PREFERENCE SHARES

134 The preference shares are issued for the sum of $100 payable in full upon issue. Initially, the preference shares carry no dividend entitlement. A dividend entitlement only arises when the preference shares become dividend paying upon the occurrence of a Payment Direction Event. The dividend entitlement (when it arises) is equal in amount to the interest otherwise payable on the notes, with dividends being paid semi-annually. Payment of dividends is subject to a number of conditions, including:

– the directors, at their discretion, declaring a dividend to be payable; and
– the amount of the dividend not exceeding MBL’s after-tax profit, and MBL complying with APRA’s then capital adequacy guidelines.

135 The preference shares are not redeemable at the option of the holder. A preference share may only be redeemed by MBL where the note relating to the holder’s interest stapled to that preference share is also redeemed. Otherwise the preference shares are redeemable by MBL in its absolute discretion at any time with the prior approval of APRA, if APRA’s approval is then required under applicable laws or guidelines.

136 The preference shares only carry a voting entitlement where two consecutive dividends are in arrears, or on a limited number of particular resolutions, such as (for example) a proposal for reduction of capital.

137 On a winding up, a preference share carries the right to a return of $100 in preference to ordinary shares (provided the preference share has become dividend paying) but no right to participate in surplus assets.

ACCOUNTING TREATMENT

138 KPMG advised MBL that under applicable accounting standards (in particular Australian Accounting Standards Board 1033: Presentation and Disclosure of Financial Instruments), the proper accounting treatment for monies raised in consequence of the issue of the MIS would be as follows:

– the preference shares issued by MBL would be treated as equity in MBL’s own accounts and in the consolidated group accounts;
– the notes issued by MFL would be considered as debt in MFL’s accounts and the related interest expense charged through the profit and loss account;
– in consequence of the Payment Direction, MBL acquired (contingent) rights against MFL which would be considered as an asset in MBL’s own accounts, but which would be eliminated on consolidation against MFL’s liability on the notes; and
– the interest expense on the notes would be reclassified as dividends in line with the overall structure of the remaining instrument, being the preference shares.

139 In the result, as the primary judge recorded, the consolidated accounts showed the preference shares as equity (the receivable and the notes having been eliminated) and an asset (cash, securities, loans) depending on what purpose the subsidiary of MFL used the money for within the MBL group. As the primary judge held, the way in which the consolidated accounts of the group are required to be prepared cannot be determinative of the issue of deductibility, but the correct accounting treatment of the receipts and payments involved in the books of MFL cannot necessarily be dismissed as irrelevant: see, generally, Federal Commissioner of Taxation v Citibank Ltd (1993) 44 FCR 434 at 443 where Hill J discusses the relevance of accounting evidence to issues arising under taxation legislation.

DEDUCTIBILITY UNDER S 8-1 OF THE 1997 ACT

140 Section 8-1 is substantially similar to s 5(1) of the 1936 Act, so that cases decided under the latter section have equal application to s 8-1. Section 8-1 provides:

‘8-1(1) You can deduct from your assessable income any loss or outgoing to the extent that:

(a) it is incurred in gaining or producing your assessable income; or
(b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

8-1(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature;
(b) ...
(c) ...
(d) a provision of this Act prevents you from deducting it.’

THE JUDGMENT APPEALED FROM – S 8-1

141 The primary judge held that in the present case there is no reason to distinguish between the first and second limbs of ss 8-1(1) as MFL was clearly carrying on a business. The question is rather whether the outgoing for ‘interest’ was incurred in, that is to say ‘in the course of’, either MFL’s income producing activity or its business. The primary judge answered that question in the affirmative, because the obligation to effect the outgoing was incurred in raising funds deployed directly by MFL in earning interest from Macquarie Leasing. However, his Honour held that the outgoings were denied deductibility under s 8-1, as they fell within the capital exception in s 8-1(2)(a).

142 As the primary judge correctly pointed out, the Australian income tax legislation does not require that an outgoing be interest or that there be a borrowing before what is called ‘interest’ may be deducted. The necessary conditions for deductibility in Australia are to be found solely within the terms of the now s 8-1. Thus his Honour held that it will not be necessary in determining deductibility of payments made in relation to a perpetual debenture, to characterise the transaction as a loan or a borrowing and the amount paid to debenture holders as ‘interest’.

143 The primary judge enunciated a number of general propositions in relation to the deductibility of outgoings which are not controversial:

– ordinarily interest will be an allowable deduction under s 8-1 if incurred in the course of an income producing activity or business: Texas Co (Australasia) Ltd v Federal Commissioner of Taxation [1940] HCA 9; (1940) 63 CLR 382 at 468, Steele v Deputy Commissioner of Taxation [1999] HCA 7; (1999) 197 CLR 459 (‘Steele’) at 470;
– interest is ordinarily a recurrent or periodic payment securing not an advantage of an enduring kind such that it would be seen as on capital account, but rather the use of borrowed money during the term of the loan. Where interest is a recurrent payment to secure the use for a limited term of loan funds, then it is proper to regard the interest as a revenue item, and its character is not altered by reason of the fact that the borrowed funds are used to purchase a capital asset: Steele at 470;
– there may be particular circumstances where it is proper to regard the purpose of interest payments as something other than the raising or maintenance of the borrowing and thus, potentially, of a capital nature: Steele at 470;
– the question of deductibility is not to be determined by reference to the label which the parties attach to the outgoing. Hence if what the parties describe as interest is in fact not interest it may be regarded as capital if otherwise properly so characterised: Federal Commissioner of Taxation v Broken Hill Pty Ltd [2000] FCA 1431; (2000) 179 ALR 593 (‘BHP Co Ltd’) at 603;
– there must be a borrowing before what is paid can be regarded as interest. A loan involves an obligation on the borrower to repay the sum borrowed: Federal Commissioner of Taxation v Radilo Enterprises Pty Ltd (1997) 97 ATC 4151 at 4161; and
– there must be a sufficient connection between the outgoing on the one hand, and the gaining or producing of assessable income or business as the case may be. In Federal Commissioner of Taxation v Roberts & Smith [1992] FCA 363; (1992) 37 FCR 246 (‘Roberts & Smith’) at 255, Hill J said:

‘The mere act of borrowing money, burdened with the obligation to pay interest, does not of itself gain or produce assessable income. The amount borrowed is not assessable income. What operates to gain or produce assessable income is the manner in which those moneys are used, so that the necessary connection between the outgoing for interest and the activities which more directly gain or produce assessable income will be found, in the ordinary case, in the use to which the borrowed funds are put.’

144 His Honour also enunciated a number of general principles which are similarly uncontroversial, but are necessarily relevant to the question whether the ‘interest’ is on capital account:

– in determining whether an outgoing is deductible it will be necessary to consider the ‘essential character’ of the outgoing. The emphasis on ‘essential character’ is relevant as well in determining whether the loss or outgoing satisfies the positive limbs of s 8-1: Lunney & Hayley v Federal Commissioner of Taxation [1958] HCA 5; (1958) 100 CLR 478 at 499;
– in determining whether a loss or outgoing is on capital account it will be necessary to consider ‘from a practical and business point of view’, what the expenditure is calculated to effect: Hallstroms Pty Ltd v Federal Commissioner of Taxation [1946] HCA 34; (1946) 72 CLR 634 (‘Hallstroms’) at 648. However, as Stephen and Aickin JJ pointed out in Federal Commissioner of Taxation v South Australian Battery Makers Pty Ltd (1978) 140 CLR 654 (‘South Australian Battery Makers’) at 662, when Dixon J in Hallstroms referred to practical and business considerations he did not intend to exclude from consideration the legal right obtained by the incurring of the loss or outgoing; and
– the classic exposition of what is capital is to be found in the three tests formulated by Dixon J in Sun Newspapers Ltd & Associated Newspapers v Federal Commissioner of Taxation [1938] HCA 72; (1938) 61 CLR 337 at 363:

‘There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward ... or by making a final provision or payment so as to secure future use or enjoyment.’

Earlier in the same judgment and in a passage almost as often cited Dixon J had said at 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. 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.’

145 The primary judge rejected a submission by the Commissioner that in subjecting itself to the obligation to pay interest, MFL did not do so for the purpose of gaining or producing its income or for any business purpose which it had, but rather at the behest of and for the purposes of and benefit of its parent company MBL. His Honour found that MFL’s involvement in the transaction did not arise out of any business activity at the time carried on by MFL (in June 1999 MFL was practically a dormant company) but rather it was selected by a Mr Ward (the Chief Financial Officer of MBL, but not a director of MFL until 23 September 1999) to participate in the transaction relating to the MIS, once the proposed transaction evolved to a point where it was necessary for there to be a company separate from MBL to act as ‘borrower’, as MBL was inhibited by APRA requirements from making further loans from the monies raised from the issue to Macquarie Leasing. Nonetheless, his Honour found that so far as MFL is concerned, it entered into the transaction intending to use the ‘borrowed’ funds in its business of lending at interest to companies in the MBL group, and in fact used the funds in that way. The fact that the interests of MBL were served as well does not require a conclusion that the interest was not an allowable deduction under s 8-1(1).

146 However, when his Honour came to s 8-1(2) he considered that what distinguishes the present case from a case where ‘interest’ is payable on a loan, or for that matter on perpetual or irredeemable debentures, is the connection between the note issue and the preference share issue and in particular the effect of the Procurement Agreement and the Payment Direction.

147 His Honour found that the so-called interest which MFL is obliged to pay is not, in a practical business sense, when regard is had to the composite nature of the MIS, the consideration paid by MFL for the note holder (Deutsche or its successors) being kept out of the funds advanced by Deutsche and used to subscribe for the notes. The note holders here might never obtain repayment of the funds advanced by Deutsche. They may, depending on what happens, be left to look to their rights as preference shareholders in MBL. In his Honour’s view, to characterise what is said to be ‘interest’ as the price of the notes only, is to give undue weight to form and to disregard the substance of the transaction. To treat the notes and the preference shares as separate transactions would be to take a blinkered approach.

148 Factors which influenced his Honour’s conclusion in that regard included that the principal is not redeemable at the option of TCAL or the note holder; the note holder is not a creditor of MFL and has no right to sue for interest or principal arrears; TCAL has limited enforcement rights; the issue of the MIS was related to the capital adequacy requirements of MBL seen in the light of MBL’s acquisition of another business which gave rise to the need for further capital. Nor did it assist MFL that interest payments on the notes were dependent upon there being distributable profits of MBL.

149 His Honour said that it might be possible to argue that the ‘interest’ amount payable by MFL is in truth consideration both for a loan to MFL and for the provision of capital to MBL. On this basis, some part of the ‘interest’ would be deductible, and apportionment might be appropriate. However, the case had been argued on an all or nothing basis, hence his Honour said that he did not need to pursue that question.

150 The primary judge found some support for regarding the ‘interest’ as being on capital account in the judgment of Bowen CJ and Burchett J in Australian National Hotels Ltd v Federal Commissioner of Taxation (1988) 19 FCR 234 at 240 where their Honours said:

‘Where capital is committed to a business, it will not in general lose the character of capital, and a loss of the whole or part of it will remain a capital loss. There are exceptions... If the capital is raised by loan, an investment of the borrowed moneys in a business will ordinarily remain an investment of capital, and the same consequences will follow. But there is a special feature of loan capital, which flows from the ephemeral nature of a loan. The cost of securing and retaining the use of the capital sum for the business, that is to say, the interest payable in respect of the loan, will be a revenue item. It creates no enduring advantage, but on the contrary is a periodic outgoing related to the continuance of the use by the business of the borrowed capital during the term of the loan. If capital, whether or not raised by borrowing, is invested in a building which burns,... the loss is a capital loss.’

The primary judge said:

‘63. The emphasis their Honours place is on "the ephemeral nature" of the loan. In the circumstances of the present case the close relationship between the notes and the preference shares, as well as the fact that MBL can ensure the loan is never repayable but that an investor is left commercially only with MBL preference shares, can be seen to produce a different result. The present case is not concerned with the cost of acquiring or maintaining a loan of an ephemeral character, but rather with the cost of a capital raising which so far as MBL is concerned is the cost of a permanent injection of capital. The circumstance that the capital is in the present conditions used to make loans to Macquarie Leasing is not determinative.’

THE SUBMISSIONS ON APPEAL

151 The Commissioner contends that the primary judge erred in finding that the outgoing for ‘interest’ was incurred in the course of either MFL’s income producing activity or its business so as to fall within s 8-1(1). The purpose of a taxpayer in the incurring of an obligation to make an outgoing can be determinative of the deductibility of the outgoing. Thus where interest at a rate beyond any commercial rate is paid to an associated company a question may arise as to whether the purpose of the expenditure is other than the service of the loan: Ure v Federal Commissioner of Taxation (1981) 34 ALR 237 at 241 and 247.

152 MFL’s liability to make the outgoings in question was ‘incurred’ under the transaction documents and the purpose of the liability can be ascertained from them. In the Commissioner’s submission, the objective conclusion is that MFL’s paramount purpose was not to raise money in order to on-lend the money to Macquarie Leasing in order to derive assessable income. Rather, MFL’s paramount purpose was to procure advantages to MBL, rather than to itself; namely:

(a) to raise funds under a stapled instrument that APRA was prepared to accept as giving rise to Tier 1 capital to MBL;
(b) to acquire the legal right to require MFL to pay the funds raised by it from Deutsche to MBL upon the happening of a Payment Direction Event;
(c) to circumvent the APRA 30 per cent limitation on the making of a further inter-group loan to Macquarie Leasing; and
(d) to satisfy the concerns of rating agencies.

153 The advantages that MFL procured for MBL were not advantages which were merely ‘incidentally’ derived by MBL. Rather, the procuring of those advantages for MBL was the purpose of MFL in entering into the transactions and was to be pursued even if the outgoings of MFL were not deductible.

154 Alternatively, the Commissioner submits that the primary judge erred in holding (at [51]) that ‘[T]he fact that as well the interests of MBL were served does not require a conclusion that the "interest" was not an allowable deduction’.

155 In MFL’s submission, the clear course of authority is that ‘in determining entitlement to a deduction under s 51(1) [and 8-1], ... the legal or jurisprudential analysis rather than the commercial view ...[is] the correct one: Coles Myer Finance Ltd v Federal Commissioner of Taxation [1993] HCA 29; (1993) 176 CLR 640 at 662; ‘ [A] n examination of the legal rights obtained is essential to the characterization of expenditure’: South Australian Battery Makers at 662.

156 As Gibbs CJ said in South Australian Battery Makers (at 651-657): ‘in deciding whether outgoings made by a taxpayer are of a revenue or of a capital nature, it is necessary to consider "the character of the advantage sought" ... in principle, that must mean the character of the advantage sought by the taxpayer for himself by making the outgoings ... the fact that someone else incidentally derives an advantage of a capital kind in which the taxpayer does not share is not enough to give the outgoings the character of capital’. On such analysis, in MFL’s submission the outgoings incurred by MFL obtained for it, under the instruments binding on it and the transactions it entered into, no more than the use of the proceeds of issue of the notes; the outgoings were periodical, served only the period to which they related, and yielded a periodical return commensurate with the amount of the outgoings.

157 MFL submits that the error in the primary judge’s reasoning was to have regard, not to the rights and obligations of MFL under the transaction, but to a perception of a ‘practical and business point of view’ which took into account the advantage obtained, not by MFL, but by its parent MBL. In preferring this perceived ‘substance’ over the ‘legal form’, his Honour overlooked the well-established authorities which dictate that in identifying the substance ‘the Court must look to see what the transaction entered into by the parties by its terms effects. That is to say, regard must be had to the legal rights which the transaction actually entered into confers’: Australian & New Zealand Savings Bank Ltd v Federal Commissioner of Taxation [1993] FCA 282; (1993) 42 FCR 535 at 560. The primary judge should have concluded that both in form and in substance, MFL’s outgoings were ‘a recurrent or periodic payment which ... [secured] the use of borrowed money during the term of the loan’: Steele at 470, and were on revenue account.

CONSIDERATION

158 In Federal Commissioner of Taxation v Midland Railway Co of Western Australia Ltd [1952] HCA 5; (1952) 85 CLR 306 (‘Midland Railway’), Dixon J said (at 312) that in determining whether an outgoing is deductible there are three considerations ‘which it is important to keep steadily in mind’:

‘The first is that from beginning to end the issue is whether the payment or any part of it was an outgoing incurred in gaining or producing the assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing such income: s. 51(1) of the Income Tax Assessment Act 1936-1944. The issue is not whether the payment when made possessed the character of interest on borrowed money, borrowed for the purpose of the business. It is not whether the obligation in pursuance of which it was paid had taken this or that form. It does not depend upon the identity of the actual payee. The question is not what was his title to payment or what was the character of the money in his hands. Further it is not decisive of the issue under s. 51(1) that it was paid or payable out of profits, that is so long as it was not payable out of the precise fund called by the Act taxable income.

The second consideration is that what governs the issue is the business purposes for which the outgoing was incurred from the point of view of the taxpayer company. The controlling factors are those which arise from the character of the business or undertaking and the relation which the expenditure or the liability to make it bore to the carrying on of the business or the gaining of assessable income.

The third consideration is that if a liability of a revenue nature is incurred, subsequent changes in the legal form of the liability, in the identity of the creditor or in the circumstances or contingencies in which it is to become immediately due or in the specification of the sources of payment do not matter, so long as the liability is not capitalized, that is to say converted in some way into a contribution to the capital structure of the business or undertaking.’

SECTION 8-1(1)

159 It follows that the issue for determination is not whether the outgoings in question were interest payments on a loan, but whether they fall within s 8-1(1) of the 1997 Act, ie, whether the outgoings were incurred in gaining or producing assessable income, or in carrying on a business to that end. In the case of a taxpayer who carries on a business, the two limbs of s 8-1(1) overlap and are not mutually exclusive: Federal Commissioner of Taxation v Riverside Road Lodge Pty Ltd (In Liq) [1990] FCA 205; (1990) 23 FCR 305 at 312.

160 What is involved is a process of identifying the essential character of the outgoings in question in order to determine whether they are in truth outgoings incurred in gaining or producing the assessable income of MFL, or necessarily incurred in carrying on business to that end. Determination of the ‘essential character’ of an outgoing is relevant for the purposes of both s 8-1(1) and s 8-1(2).

161 Where what is involved is a borrowing of money, the purpose of the borrowing ordinarily provides the criterion of deductibility: Roberts & Smith at 255. There are cases where the determination of what the outgoing is ‘for’ falls to be determined by reference to the agreement which creates the obligation to pay the sums in question. There may be other cases where it is necessary to go outside the contractual rights and obligations to find the true character of the outgoings. This is often so where the outgoing is in the nature of ‘interest’ where it may be necessary to go outside the loan agreement to determine the advantage sought: BHP Co Ltd at [31] – [32]. It follows from the second of the considerations referred to in Midland Railway that it is the advantage sought by the taxpayer which is determinative.

162 Thus, in the ordinary case, the purpose of a borrowing will be found in the use to which the borrowed funds are put: Roberts & Smith at 255. Where an outgoing gives rise to the receipt of a larger amount of assessable income, the objective relationship between the two suffices to characterise the outgoing as one which was incurred in gaining or producing assessable income: Fletcher v Federal Commissioner of Taxation [1991] HCA 42; (1991) 173 CLR 1 at 18-19. On the objective facts of the present case, the outgoings in question were incurred by MFL by way of consideration for the raising by MFL of $400 million from investors in the MIS which was deployed by MFL in making an intra-group loan to Macquarie Leasing at an interest rate greater than that payable on the notes. The outgoings in question were thus made in the course of MFL earning its assessable income, and were incidental and relevant to that end.

163 When attention is given to the transaction documents under which MFL’s liability to make the payments in question was incurred, what is required is an analysis of all the rights and liabilities thereby created in order to determine the essential character of the outgoings in question. To treat the preference shares and notes as if they were separate transactions would involve a distortion of the facts. Clearly the two are interconnected because it is the combination of the two securities which produces the MIS which were offered for subscription to the public as composite securities.

164 An effect of the overall transaction is that MBL increased its Tier 1 capital by the issue of the preference shares on which no dividend was payable until the occurrence of a Payment Direction Event, which MBL could generate at its own option. The increase in MBL’s Tier 1 capital enabled MBL to expand its operations. The preference shares issued by MBL were fully paid up in accordance with APRA’s requirements, but an amount equivalent to the amount subscribed for the shares was immediately returned to Deutsche in return for the Payment Direction. The net return which MBL obtained from the issue of the preference shares and the MIS was its entitlement to receive the proceeds of the notes following the occurrence of a Payment Direction Event.

165 But looking at the transaction overall does not deny the fact that the business purpose for which the obligations under the MIS were incurred from the point of view of MFL was the raising of money from investors for deployment in MFL’s business. That MBL also benefited by being able to increase its Tier 1 capital is not to the point: South Australian Battery Makers Pty Ltd at 656-658. That MBL could not itself have raised and on-lent the funds to Macquarie Leasing within APRA guidelines does not alter the purpose for which MFL incurred the outgoings which it was obliged to make.

166 Whilst it may be accepted that MBL was the architect of the MIS issue, and that it procured MFL to enter into the transactions to which MFL was a party, the fact remains that it was MFL which entered into those transactions pursuant to a resolution of MFL’s board of directors, and it did so on its own behalf.

167 Accordingly, the Commissioner’s submission that MFL’s ‘interest’ outgoings do not fall within s 8-1(1) of the 1997 Act should be rejected.

SECTION 8-1(2)

168 The primary judge held that ‘[T]he so-called interest which MFL is obliged to pay is not, in a practical business sense the consideration paid by MFL for the note holder (Deutsche or its successors) being kept out of the funds advanced by Deutsche and used to subscribe for the notes’. His Honour does not expressly identify what, in a practical business sense, the so-called interest is paid for, but it is implicit in his reasons for decision that his Honour regarded it as being the consideration for the subscription to the MIS, ie the consideration payable to investors by reason of their subscription for both the notes and the preference shares.

169 There is no suggestion in the present case that the payments were made voluntarily, that the transaction documents are a sham, or that the transaction documents record part only of a broader arrangement. Accordingly, the substance of the transaction can and should be discovered by a consideration of the transaction documents. In City Link Melbourne Ltd v Federal Commissioner of Taxation [2004] FCAFC 272; (2004) 211 ALR 207 the Full Court emphasised (at [42]) that it does not follow from the necessity to attend to the ‘practical reality’ of a transaction, that questions of deductibility are to be answered by seeking to characterise an outgoing by reference to whether it is like some other transaction which it is not. Economic equivalence is not the test of deductibility. The Full Court said:

‘44. While it will often be relevant to ask what the money the subject of a deduction is paid for, in order to conclude whether the outgoing has the character of capital, generally, however, that question will be answered where the amount in question is consideration for obligations which the payee undertakes in favour of the payee, by having regard to the legal agreements entered into. Generally in such a case it would be unnecessary to go outside the legal agreement to determine deductibility.

...

46. There will be, it may be accepted, some cases where regard may be had to the matrix of facts which form the background to the entering into of a legal agreement to determine the character of an amount payable under that agreement: Reuter v FCT (1993) 93 ATC 5030 at 5036; Commissioner of Taxation v Cooling (1990) 22 FCR 42 at 53; 94 ALR 121 at 132-3 per Hill J. The surrounding circumstances may in such cases, cast light on the nature of the relationship between parties to the agreement or deny as relevant to the character of an outgoing a label which the parties have used to describe it.

...

47. ...the present does not seem to us to be a case where reference to the surrounding circumstances in which the City Link agreements were entered into assists at all in determining the character of the concession fees. What the concession fees were paid for appears clearly enough from the terms of the concession agreement.’

170 Similarly, in BHP Co Ltd Hill J (with whom Heerey and Merkel JJ agreed upon this point), said at 600-601:

‘27. In determining whether an outgoing falls for deductibility under s 51(1), it will be critical to determine what the outgoing is paid for. The significance of that question, which is directed to ascertaining the advantage sought to be obtained, is essential to the determination of the true characterisation of an outgoing.

...

29. The test suggested in this case might be thought to have undergone some transformation, or at least qualification, in the well-known judgment of Dixon J in Hallstroms ...

30. Later, in FCT v South Australian Battery Makers [1978] HCA 32; (1978) 140 CLR 645; 21 ALR 59 at CLR 659, Gibbs CJ pointed out that two different questions were involved: the first, as in Colonial Mutual, was what the expenditure was for; the second, as in Hallstroms, once the first question had been answered, was whether the advantage sought by the expenditure was of a revenue nature. In the resolution of this second question, regard is often had to the oft-cited tests of Dixon J in Sun Newspapers ...

31. There are cases, and the present in my opinion is such a case, where the question what the payment was for falls to be determined by reference to the legal obligations or rights for which it is paid, that is to say, the question can be answered by reference to the agreement which operates to create the obligation to pay.

...

33. ...The question of what the payment is for and the question of the advantage sought, are both matters that do not give rise to a need to go outside the legally binding agreement reached at arms length between BHP and GE. And, having looked at the precontractual negotiation material which her Honour, in my view, rightly rejected, there is nothing in it which gives me reason to go beyond the contractual terms of the agreement between the parties.’

171 Whether outgoings are of a capital nature (in the present case, they are not in themselves capital) is often a difficult question. In BP Australia Ltd v Federal Commissioner of Taxation [1965] HCA 35; [1966] AC 224 at 264 Lord Pearce, delivering the judgment of the Privy Council, said:

‘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.’

172 The present case is a particularly difficult case, as the structure of the overall transaction has the following features:

– the notes are unsecured subordinated perpetual debt obligations of MFL, subject to MFL’s entitlement to redeem the notes in the circumstances earlier described. An investor in the MIS who wishes to realise on his or her investment must sell the stapled security on the ASX at the prevailing market price, or privately;
– neither the giving of a Payment Direction, nor the occurrence of a Payment Direction Event affects MFL’s liability to make the so-called interest payments on the notes or to pay the monies owing in respect of the notes in accordance with the terms of issue. Interest is payable by MFL to the holder initially, and on the occurrence of a Payment Direction Event, to MBL. That is also the case in relation to the outstanding principal amount of the notes;
– MFL’s obligation to make the so-called interest payments to the holder is dependent on satisfaction of the conditions specified in cl 5.5 of the conditions of issue including the profitability of MBL, upon MBL’s compliance with APRA’s capital adequacy requirements and upon the directors of MFL not resolving to stop the payment by the business day prior to the interest payment date;
– the failure by MFL to make an interest payment when due does not thereupon result in the amount of the note becoming payable. If interest is not payable in accordance with cl 5.5 of the conditions of issue it does not accumulate. If an interest payment becomes payable but is not paid, then TCAL might institute proceedings for the winding up of MFL, but the institution of proceedings for the winding up of MFL would be a Payment Direction Event on the occurrence of which MFL’s obligations on the notes become owed to MBL; and
– MBL can decide at any time that MFL’s obligations on the notes are to be owed to MBL rather than to the investors and, of its own volition, trigger the occurrence of a Payment Direction Event, in which case the preference shares become dividend paying.

173 The identification of the ‘practical reality’ of the transaction depends at least in part on the perspective from which that question is considered. From the perspective of the holder of the MIS (and from the perspective of MBL) MBL can effectively switch the interest obligation owed by MFL on the notes to the holder into a dividend entitlement under the preference shares. From the holder’s point of view MBL can effectively convert MFL’s liability on the notes both in relation to the outstanding principal amount of the notes and interest into equity in MBL. From the holder’s point of view, the investor’s return from his or her investment in the MIS will derive from MFL in the form of interest, or from MBL in the form of a dividend, depending upon whether a Payment Direction has been given and a Payment Direction Event occurs. The only circumstance in which the holder will receive repayment of the monies paid by way of subscription for the notes from MFL will be if MFL voluntarily redeems the notes. In all other circumstances the only entitlement in the holder to a return of capital will be as a preference shareholder in MBL.

174 But from MFL ’s perspective, the position is different. MFL is and remains liable to make the interest payments on the notes and to pay the monies owing in respect of the notes in accordance with the conditions of issue, but on the occurrence of a Payment Direction Event, the obligation is owed to MBL, rather than to the holder of the beneficial interest in the notes. For so long as the notes remain unredeemed, MFL has an obligation to pay interest on the notes either to the holder, or to MBL. On redemption of the notes after the occurrence of a Payment Direction Event, the redemption amount is payable to MBL, rather than to the holders. Once a Payment Direction Event occurs, the proceeds of the notes issue become available to MBL to fund its obligations under the preference shares.

175 In South Australian Battery Makers at 656 and 662 the High Court held that it is the advantage which the taxpayer seeks and gains from the outgoing that has to be considered in deciding whether the outgoing is of a revenue or of a capital nature. The second of the considerations referred to in Midland Railway quoted above is to similar effect.

176 The primary judge held:

‘60. The submissions of MFL ignore, however, the relationship between the notes and the preference shares brought about by the procurement agreement refunding the face value of one lot of the securities to Deutsche and the ability thereafter of MBL to give the payment direction. They ignore too the fact that no dividend was payable on the MBL shares during such time as "interest" was payable to the notes holder and that upon the payment direction being given the noteholders are entitled to no return on their notes, but must look to the shares they hold in MBL for any return of funds. The so-called interest which MFL is obliged to pay is not, in a practical business sense the consideration paid by MFL for the note holder (Deutsche or its successors) being kept out of the funds advanced by Deutsche and used to subscribe for the notes. The note holders here might never obtain repayment of the funds advanced by Deutsch. They may, depending upon what happens be left to look to their rights as shareholders in MBL.

61. Although if the stapled securities are looked at individually the legal rights of MFL to the holders of the notes may be seen to have the character of interest, that seems to me to ignore the composite nature of the security and the direction of Dixon J to look at what the interest is paid for from a practical and business like point of view. It seems to me to give undue weight to form and to disregard the substance of the transaction to characterise what is said to be "interest" as the price of the notes only. From a juristic point of view it is not irrelevant that under the Macquarie Income Securities Trust Deed, the principal is not redeemable at the option of the Trustee Company or at the option of the holder of the note, that the holder of notes is not a creditor of MFL and has no right to sue for interest or principal arrears. The trustee also has limited creditor enforcement rights. It is not insignificant either that the issue of the income securities was related to the capital adequacy requirements of MBL seen in the context of MBL’s acquisition of the BTIB business. Nor does it assist MFL that interest payments on the notes were dependent upon there being distributable profits of MBL. In saying this it must be accepted that the "interest" was payable not by MBL but by MFL, although obviously a note holder was, as a consequence of the structure adopted, in fact a shareholder of MBL.’

177 MFL submits that at [63] of his Honour’s reasons (see [150] above), and in the passages quoted immediately above, what the primary judge has done is to focus on:

– the position of the note holders who derived the interest income, rather than on that of the taxpayer by whom the expenditure was incurred; and
– the advantages subjectively sought by MBL and its officers in entering into the transaction, and in selecting MFL as a participant in the transaction, rather than the objective advantage sought and obtained by MFL from the outgoing in question.

178 There is, with respect to his Honour, some force in this criticism. Whilst it is true that the note holders may not get paid on the notes, and depending upon events, might be left to their rights as preference shareholders in MBL, and whilst it is also true that from MBL’s point of view entry into the transaction documents effected an increase in its capital, from MFL’s perspective its obligations under the notes both in relation to the repayment of principal and as to interest continue after the occurrence of a Payment Direction Event, with the only change being in the identity of the person to whom the obligations are owed. The third of the considerations referred to by the High Court in Midland Railway is thus of relevance. The relevant enquiry is as to the (objective) purpose of the so-called interest payment from MFL’s point of view. The perspective of the recipient of the payment is irrelevant, as is any subsequent change in the identity of the person to whom MFL’s obligations are owed.

179 In the year of income, a Payment Direction had been given, but a Payment Direction Event had not occurred. MFL was then subject to an obligation to make periodic payments to the holders of the MIS in consideration for their investment in the MIS. The fact that a Payment Direction Event might later occur (and MBL could cause that to happen) in which case MFL’s obligation would be owed to MBL, rather than to the holders, cannot be determinative of whether payments made by MFL to the holders in the meantime in discharge of its existing obligations are on capital or revenue account.

180 The character of the advantage sought by the interest payments was to secure the continued use by MFL of the funds raised by the issue of the MIS with the consequence that the preference shares in MBL would not become dividend paying, and with the result that it is MFL, rather than MBL, which is entitled to enjoy the fruits of the note issue. The funds were raised on the basis that the investor’s return would take the form, at MBL’s option, of interest paid by MFL, or the preference shares issued by MBL would become dividend paying. The ability of MBL to procure a switch from one to the other does not signify that the payments by MFL before any switch occurs are of a capital nature. I do not agree, with respect, with the primary judge’s conclusion that the composite nature of the MIS, and the procurement agreement, leads to the result that the interest payments are on capital account. In my view, MBL’s ability to switch the nature of the holder’s interest in the manner earlier indicated does not affect the characterisation of MFL’s liability on the notes whilst they remain outstanding.

181 However, this case differs in several respects from the ordinary case where loan capital is raised by way of a borrowing at interest for a term, where payments of interest can readily be seen as securing the use of the monies during the term, rather than an enduring advantage. First, there is no obligation on MFL to repay the monies raised by the issue of the notes except on its winding up. Second, the directors of MFL could decide to stop an interest payment by the business day prior to the date on which interest would otherwise be payable, without being in breach of the Trust Deed. If MFL so decided, a dividend stop would be imposed on MBL’s shares pursuant to cl 5.9 of the conditions of issue, which suggests that only in extreme circumstances would MFL so decide. Third, interest is not payable unless the profits of MBL would be sufficient to allow it to be paid if the payment obligation were on MBL rather than MFL. Fourth, even if an interest payment which falls due is not paid so as to give rise to a breach of the Trust Deed, the notes do not thereby automatically become redeemable. TCAL might sue MFL for the recovery of the unpaid interest, or call on MBL’s guarantee. If MFL were wound up for non-payment of interest, the notes become redeemable, although the institution of proceedings for the winding up of MFL are a Payment Direction Event such that monies becoming due thereafter would be payable to MBL.

182 The primary judge did not regard the mere fact that the notes are not redeemable except in a winding up of MFL as leading to the conclusion that the interests payments are of a capital nature. His Honour said (at [47]):

‘I do not think that "interest" would necessarily cease to qualify as an allowable deduction merely because it was payable on notes which were non-redeemable so that the lender might not, except perhaps in the case of a liquidation, have the amount of the principal refunded to him or her. This would be my view even if the perpetual debenture was not strictly a loan.’

183 The so-called interest payments constitute recurring expenditure to meet a continuous demand as opposed to an expenditure which is made once and for all. The payments are regular outlays made by MFL in order to obtain debt finance which MFL used to make advances on which MFL derived assessable income. The expenditure has to be made if the notes are to remain outstanding and, consistently with the principles enunciated in Sun Newspapers at 361-363, should be regarded as being on revenue account notwithstanding the fact that the notes are undated, and redeemable only at the option of MFL, or on its winding up.

184 The Commissioner’s submission that by virtue of the transaction documents MFL acquired an asset of an enduring nature in the form of a right (as against TCAL and the subsequent holders of the stapled instruments) to the retention and use (in perpetuity) of the money raised by it from Deutsche whether or not MFL discharged its covenant to pay interest cannot be accepted. MFL was under an obligation to make periodic payments of interest ‘to meet a continuous demand’ (Sun Newspapers at 362) whilst ever the notes are unredeemed. If MFL failed to make interest payments when due, MFL would be exposed to the risk of winding up, in which event the redemption amount would become payable albeit to MBL. To focus on the rights of the holders of the MIS, rather than the obligations of MFL whether to the holders of the notes or MBL, is to approach the matter from the wrong perspective.

185 It is true that the principal amount of the notes might remain outstanding for an indefinite period, but there is no principle that it is only interest on short term borrowings which is deductible. In the language of Sun Newspapers (at 363) here MFL provided ‘a periodical reward or outlay to cover [the] use or enjoyment’ of the principal amount of the notes ‘for periods commensurate with the payment’. The fact that the directors of MFL may ‘stop payment’ on a dividend payment, whilst potentially relevant, does not indicate that payments of interest which are in fact made are not on revenue account.

186 Reliance was also placed by the Commissioner upon the fact that interest is capped by reference to the profits of MBL. The primary judge did not regard that matter as significant if the notes are to be looked at separately, but stated that if the correct analysis is to look at the shares and notes as a composite transaction, this factor takes on a different significance.

187 The shares and notes must be looked at as a composite transaction because that accords with the facts, but one does so from the perspective of MFL. I do not agree, with respect, that the capping of the dividend by reference to the profits of MBL takes on a different significance when the transaction is considered in this way. The capping has the result that the payment of interest resembles the payment of a dividend by MBL, but that does not mean that MFL’s obligation to pay interest is of a capital nature, because ex hypothesi MFL is discharging a contractual obligation to which it is subject, rather than an obligation of MBL to its shareholders.

PART IVA

188 Part IVA is the general anti-avoidance provision applicable to authorise the Commissioner, inter alia, to disallow as deductions amounts which otherwise would be allowable deductions under the 1936 Act or under the 1997 Act. The power conferred upon the Commissioner to do so arises only where there is a scheme to which the provisions of Part IVA apply. In summary, Part IVA would apply to a scheme where the following elements exists:

− there is a scheme as defined in s 177A(1) of the 1936 Act;
− there is a tax benefit as defined in s 177C(1) of the 1936 Act obtained by a taxpayer in connection with a scheme;
− it would be concluded that having regard to the eight matters listed in s 177D(b) of the 1936 Act that a person who entered into or carried out the scheme did so for the dominant purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme; and
− the Commissioner makes a determination under s 177F of the 1936 Act to cancel the relevant tax benefit.

189 In the present case, the Commissioner particularised the scheme in three different ways. The first of those ways was to take the whole of the steps entered into by MBL and MFL in issuing the preference shares and the notes including the giving of the payment direction pursuant to the procuration agreement. It is not in contest that the scheme so particularised is a ‘scheme’ within s 177A(1) of the 1936 Act. It was not contended by the Commissioner that if he does not succeed in relation to the scheme so particularised that he could succeed by reference to any of the other formulations of the scheme. It is thus unnecessary to attend to the alternative formulations.

190 Nor is it in contest that MFL’s interest outgoing on the notes is a ‘tax benefit’ within s 177C. What is in issue is whether the ‘whole of the steps’ were entered into by any of the parties with the dominant purpose of securing a deduction for MFL in the amount of the interest. In MFL’s submission, undoubtedly it was a purpose of the parties that the interest should be deductible, since the deduction affected the after tax costs to MFL of the fundraising and indirectly to the MBL Group. That purpose, however, was in fact no more than an incidental purpose; and when regard is had to the factors specified in s 177D(b), it would objectively be concluded that it was not the dominant purpose of any of the parties.

Some further facts

191 In order to deal with the issues which arise under Part IVA of the 1936 Act, it is necessary to return to the facts of the case in a little more detail. The primary judge made the factual findings summarised in the succeeding paragraphs in relation to the financing proposals that culminated in the issue of the MIS.

192 In early June 1999 MBL had before it a proposal for the acquisition of the Australian investment banking business and assets of Banker’s Trust (‘BTIB’). The expected acquisition price was in the order of $100 million. While the acquisition could have been funded from the existing resources of the MBL Group, current and future commitments and operational requirements of the Group meant that there was a need to increase substantially the MBL Group treasury pool (whether by increasing capital or engaging in debt funding) by up to $4 billion to meet anticipated on-going business needs.

193 At a board meeting of MBL held on 18 June 1999 it was resolved that the BTIB acquisition be approved, that there be a placement of $100 million ordinary shares, that there be approved the issue of $200 million MIS and $150 million of converting preference shares. A $2 billion standby funding arrangement with Deutsche was also approved. On 25 June 1999 an announcement was made relating to the acquisition of BTIB and the proposed funding arrangements. There followed shortly thereafter a placement of the ordinary shares and the converting preference shares as envisaged in the announcement.

194 By around June 1999 there was interest among retail investors in Australia in perpetual income securities which could be traded on the ASX, these being hybrid securities which were redeemable at the instance of the issuer and which paid investors ‘interest’ on their investment at a margin slightly above the interest on fixed or at call deposits. One issue of perpetual income securities raised in Australia was that of National Australia Bank in May 1999 which apparently closed oversubscribed and involved the issue of $2 billion worth of securities.

195 The possibility of MBL raising money by the issue of similar securities was a matter which both Mr Ward (head of financial operations of the MBL Group) and Mr Robertson (Group Treasurer of MBL) found interesting. Mr Donnelly (an executive director of the Equity Capital Markets Division of MBL) was of the view by around June 1999 that a debt instrument which also qualified as Tier 1 capital would be attractive for MBL because:

− there was a larger pool of funds available for investment by way of debt than by way of equity;
− debt was seen as a considerably cheaper form of finance than equity as shareholders in MBL traditionally received a return on equity of between 20-25 per cent whereas long term subordinated debt instruments were expected at this time to be issued at a marking of 100 to 200 basic points over the prevailing bill rate; and
− the perpetual security did not have to be repaid or refinanced in the short to medium term, and offered greater flexibility than would be available with a share offer.

196 At least from 14 June 1999 MBL seriously considered the need to raise long term capital. The question was what form that capital raising would take. MBL first considered a form of perpetual debt trust security which they referred to as ‘Capital Escrow Securities’ (‘CES’). The CES proposal involved the issue by MBL of unpaid preference shares linked to a fully paid debt security both of which were to be issued by MBL. The notes were to be issued to a trustee which was to issue income units carrying rights to interest distributions. The preference shares were not to be redeemable by MBL before the fifth anniversary of issue. Interest distributions were to be paid on the notes at the same time and at the same rate as the dividends payable on the preference shares. MBL considered the raising of capital by the CES proposal in the context of the acquisition by MBL of the BTIB business.

197 On 18 June 1999 APRA advised MBL that the CES would qualify for inclusion in the Tier 1 capital of MBL and the Group subject to APRA’s satisfaction on three specified matters.

198 Because it is a matter relied upon by MFL, I should record here (as did the primary judge) that in a memorandum dated 9 August 1999 Mr Ward reported to the MIS Due Diligence Committee that MBL had early redemption rights in relation to the CES if a ‘tax event’ occurred, and that a denial of a tax deduction for interest payable on the notes would constitute a ‘tax event’. Nonetheless, in his view debt is much cheaper than equity irrespective of the tax deduction. Although a decision whether to repurchase would have to be made having regard to all relevant matters, nothing had come to his attention to suggest that the denial of a tax deduction for the interest paid on the loan note would prompt the Bank to repurchase the CES.

199 Between July and late August the proposed financing structure changed. As at 2 September 1999 there was a structure denominated MIS II which also appears to have a loan issue not involving MFL. The precise details of the second financing structure were not clear to the primary judge, however, it seemed to his Honour that the structure still involved only one company, MBL, participating in the income securities raising. The only finding which his Honour made in relation to the difference between the MIS II structure and the CES structure was that it appeared to lie in the terms of issue of the preference shares.

200 The third structure was ultimately devised between 2 September 1999 and 16 September 1999 which involved, for the first time, the insertion into the structure of MFL as the issuer of the notes, rather than MBL. Under the third structure MBL remained as the issuer of the preference shares, which were issued as fully paid, rather than as unpaid. The notes were to be secured by a debenture trust deed, rather than being issued to a trustee which would then issue units to investors in a unit trust. The third structure involved the issue of the MIS upon terms which are discussed in some detail earlier in these reasons.

201 The primary judge (at [29]) did not accept the evidence of Mr Ward and Mr Robertson that it was APRA which required that the stapled preference shares be fully paid, rather than issued as unpaid as ‘[T]here is nothing in the correspondence from APRA which suggests this to be true and at no time did APRA revoke its approval of the CES structure which involved the issue of preference shares which were unpaid’. Whilst this matter is not adverted to in correspondence with APRA, it is clear from APRA’s Prudential Statement C1 (Attachment 1A(iii)) that the MIS were required to be fully paid in order to attract Tier I status.

202 His Honour accepted that the need for any preference shares to be paid up may have been thought necessary because the proceeds of the MIS were to be on-lent at interest to Macquarie Leasing and the APRA guidelines had the effect that MBL could not lend further funds to Macquarie Leasing without being in breach of APRA’s requirements.

203 During the course of his judgment, the primary judge made a number of other factual findings which MFL submits were wrongly made on the evidence. Counsel for MFL, Mr Bathurst QC, said in argument that some or all of those asserted errors ‘might not matter very much at the end of the day’, hence any consideration of them is best left until it becomes apparent whether the alleged errors are material.

The judgment appealed from – Part IVA Tax benefit

204 In determining whether there was a tax benefit obtained by MFL in connection with the scheme, it is necessary to consider what might reasonably be expected to have happened had the present scheme not been entered into or carried out. That requires the making on reasonable grounds of what was referred to by Gummow and Hayne JJ in Federal Commissioner of Taxation v Hart [2004] HCA 26; (2004) 217 CLR 216 (‘Hart’) as ‘an alternative postulate’ and by the primary judge as ‘the alternative hypothesis’.

205 His Honour found (at [79] – [81]) that:

− if the scheme involving the issue of the MIS had not been entered into or carried out, MBL would have needed to raise some sort of capital to satisfy the capital adequacy requirements of APRA;
− the simplest form of capital raising would have been the raising of equity capital by MBL, but this might have been expensive;
− there were other possible structures, such as the CES and MIS II, each of which involved an interest component, although neither involved MFL as a party to the scheme. MFL was only brought into the scheme at the last minute;
− if the capital raising was not to be pursued by the issue of preference shares, and if there was to be a borrower then some company in the MBL Group would have to pay interest. If is self-evident that it would be desirable that any interest payable should be tax deductible; and
− if this particular scheme had not been entered into or carried out, then while some company in the MBL Group may have obtained a tax deduction that company would not have been MFL.

206 His Honour found that it was ‘commercially desirable, perhaps even necessary that the MBL group increase its Tier 1 capital’ in consequence of the BTIB acquisition. His Honour did not otherwise identify the ‘alternative postulate’ or ‘alternative hypothesis’. Nonetheless for the reasons summarised in the preceding paragraph his Honour found that MFL obtained a tax benefit in connection with the scheme.

207 As earlier noted, MFL accepted that there was a scheme as formulated by the Commissioner and that MFL obtained a tax benefit in connection with the scheme. That concession was made even though the alternative hypothesis advanced by counsel for MFL was that had the scheme not been entered into and carried out, it was reasonable to expect that there would have been an issue of perpetual debt securities, rather than a share issue, which presumably would have resulted in a tax deduction for some company within the Group, although perhaps not for MFL. There was some evidence from Mr Robertson, the Treasurer of MBL, that had the CES proposal not proceeded because of pricing problems or lack of market interest in the composite security, then his intention was to issue subordinated debt instead. Whilst it might be thought that in substance there is little difference from an investor’s point of view between an MIS and a convertible preference share, there was evidence from Mr Donnelly, an Executive Director of the Equity Capital Markets division of MBL, that in Australia there has never been a market for the raising of capital by convertible preference shares, as distinct from cumulative preference shares.

208 It should also be noted that MFL derived assessable income from Macquarie Leasing in excess of the deduction claimed which it would not have derived but for its participation in the scheme, but whilst this may be relevant when considering the factors set out in s 177D(b) of the 1936 Act, it does not negate the fact that MFL obtained a tax benefit in connection with the scheme.

The 177D(b) factors

209 The primary judge analysed the judgment of the justices of the High Court in Hart in order to determine what the case decided. It is unnecessary to recount the details of this analysis, as no one submitted that the conclusion which his Honour drew as a result of having undertaken it was deficient or wrong. His Honour said:

‘107. ... If Hart stands, as I have suggested, for the proposition that the scheme to be considered was the loan carrying with it the particular terms and conditions which constituted the wealth optimiser features then the scheme to be considered here would be the capital raising with the particular features it had, and in particular the use of notes (or more accurately beneficial interests in notes) carrying interest but stapled to the issue of preference shares; the procurement agreement between Deutsche and MBL involving return to Deutsche of an amount equivalent to the face value of the note and the possibility that at any time MBL could by notice require capital and interest on the notes to be payable to it and thereby ensure that thereafter dividend and capital rights would become applicable to the share holding. If Hart stands for the proposition that the particular form of the loan agreement was the scheme (which is really another way of putting the last proposition) then the present case requires consideration to be given to the particular form of the agreements relating to the preference shares and the notes.

108. Just as in Hart it was necessary to consider the conclusion as to purpose with regard to the particular form of the finance agreement which included the wealth optimiser aspects, so here, what has to be considered under s 177D(b) is the particular form of capital raising involving the particular features which distinguished the scheme, namely the procurement agreement and the payment direction pursuant to it and the particular terms of the preference share and note issues.

109. It may be said in favour of Macquarie that the present is not a case where the transaction was given a particular form dictated by tax which made the commercial end achievable. While Hart may, like Spotless be a case where the commercial benefits obtained were unavailable without the tax benefit, that may be said not to be the case here, in that other types of securities could have been issued to the public without a tax deduction, although presumably the stapled securities represented the cheapest alternative, not merely because of the potential tax deduction but because of market perceptions.

110. Ultimately, it seems to me that what is to be considered in the present case is whether, having regard to the eight factors in s 177D(b) it would be concluded that the dominant purpose of some person who entered into or carried out the scheme with the particular features I have mentioned was the obtaining for MFL of tax deductions for the "interest" or whether it would be concluded that the dominant purpose of all persons who entered into or carried out the scheme with those particular features was the obtaining of Tier 1 capital. While a strict application of the view of Gummow and Hayne JJ might be thought to exclude the raising of Tier 1 capital as a purpose because this was a subjective matter I do not think it can be excluded both because that was not the approach adopted by Gleeson CJ and McHugh J and perhaps Callinan J and because, in any event, the need for capital may be seen to be objectively determined.’

210 In applying Part IVA, it is necessary to determine whether a reasonable person would conclude, having regard to the eight factors listed in s 177D(b) that the relevant parties in entering into and carrying out the particular scheme, had as their most influential and prevailing or ruling purpose, and thus their dominant purpose, the obtaining of a tax benefit in connection with the scheme: Federal Commissioner of Taxation v Spotless Services Ltd [1996] HCA 34; (1996) 186 CLR 404 at 422 and 423. As Gummow and Hayne JJ noted in Hart (at [66]) to draw a conclusion about purpose from the eight matters identified in s 177D(b) will require consideration of what other possibilities existed.

211 The primary judge gave individual consideration to each of the eight factors, although he was entitled to take all the specified matters into account in forming a ‘global assessment of purpose’: Federal Commissioner of Taxation v Consolidated Press Holdings Ltd [2001] HCA 32; (2001) 207 CLR 235 at [94].

212 Before turning to the primary judge’s consideration of the eight matters, two things should be noted. First, the Part IVA enquiry is driven by objective considerations. Evidence of the subjective motives of persons who entered into or carried out the scheme, such as Mr Ward, is irrelevant, nor is it material to enquire whether or not the participants in the scheme would have proceeded with it had they appreciated that a deduction for the interest payments was not available. The conclusion as to purpose is to be drawn from the eight objective matters listed in s 177D(b). The primary judge concluded (at [109] and [112]) that the obtaining of Tier 1 capital was a significant purpose of MBL and that there were commercial attractions associated with debt financing which are only partly attributable to the tax deductibility of interest. There may be room for a difference of opinion as to whether this finding involves impermissible enquiry about why MBL structured the transaction in the way it was (see, in particular, Gummow and Hayne JJ in Hart at [65]). The primary judge concluded, correctly in my view, that the need for capital, and the comparative advantages and disadvantages of debt and equity were matters capable of objective determination. They are matters to which regard may be had if only in relation to par (vii) of s 177D(b). MFL relies upon these matters in support of its submission that the advantage sought by the issue of the MIS was the addition of Tier 1 qualification to the lower cost of funds afforded by a debt security, rather than the addition of deductibility of outgoings to an issue of share capital.

213 Second, a decision to borrow money at interest, rather than to raise equivalent funds by means of a share issue, would, without more, be unlikely to attract the operation of Part IVA for the same reasons that a decision to lease business premises, rather than to buy them, would be unlikely to attract the operation of the Part notwithstanding that the potential deductibility of the rent may be an important factor in the decision-making process: see Hart at [15].

214 As Lee J said in Eastern Nitrogen Ltd v Commissioner of Taxation [2001] FCA 366; (2001) 108 FCR 27 (‘Eastern Nitrogen’) at [18]:

‘To show that a business which depends upon financiers to provide the recirculating capital needed for the operation of the business, has obtained that finance at a net cost, after taking into account provisions of the Act, that is less than the net cost of obtaining finance by another method, will not, in itself, show that the dominant, ruling or supervening purpose of the operator of the business is to obtain the tax benefit constituted by the extent to which deductible outgoings incurred in respect of that borrowing will be greater than the deductible outgoings that would have been incurred under another method of obtaining finance. That is to say, something more must be shown than that the business has obtained finance at best available net cost after-tax before it can be said that a tax benefit has arisen to which s 177C(1)(b) applies.’

(i) The manner in which the scheme was entered into or carried out

215 The primary judge made the following finding in relation to the first factor:

‘111. The first factor to be considered is the manner in which the scheme was entered into. Clearly the scheme took the form it did (its shape) because of the ability of MFL to obtain a taxation deduction. That deduction would only be available if funds were the subject of a loan at interest to a company which used the funds borrowed in making loans to other group companies at interest. A capital raising by MBL say of preference shares would not produce any deduction to any taxpayer and obviously therefore, none for MFL. Even if it were possible for there to be a raising of Tier 1 capital by MBL in such a way as would give MBL a tax deduction for interest that would not be a deduction available to MFL. The manner in which the scheme was entered into (that is to say, its form or shape) was thus here dictated by the desire to have the substance of a share offer to the public which qualified as Tier 1 capital, without the constraints of a share issue and, obviously, no interest to be available by way of deduction. The procurement agreement and payment direction were explicable only by reference to the desire to have both the benefits of a share capital raising and the allowance of an interest deduction. The participation of MFL was clearly influenced by the desire to ensure a tax deduction to a company in the group, a deduction that would be unavailable had there been a share issue.

112. It is clear from the fact that three alternative proposals were considered by staff of MBL that the raising of additional Tier 1 capital could have been achieved in a number of different ways. Despite a suggestion to the contrary I would find that it was commercially desirable, perhaps even necessary that the MBL group increase its Tier 1 capital. Perhaps it was not essential to do so just for the purpose of the acquisition of BTIB but the acquisition even if completed by capital available rendered it necessary for additional capital to be raised. The obtaining of Tier 1 capital was clearly a purpose of MBL and a significant purpose. Tax deductibility for interest payable by MFL was likewise important to the group. It is important to note here, however, that debt financing was a cheaper as well as more flexible way of raising finance for the group. That this was so was only partly attributable to the tax deductibility of interest. The question then is whether the tax purpose or the commercial capital raising purpose was the predominant purpose in adopting the arrangement in fact entered into and having the particular features I have noted. I find the question very difficult. However, in my view what may be called the tax purpose (that is to say the interest deduction to MFL, being the relevant tax benefit) predominates here, although only marginally.

113. Among the factors which reinforce the conclusion I have reached is that whether MFL would ever be under a need to repay the lenders was a matter within the control of its parent company MBL. MBL likewise had no obligation to pay dividends on the preference shares so long as interest was payable on the notes. Interest payable was limited to there being profits in MBL available.’

216 It was open to MBL or to MFL to raise $200 million per tranche by either a debt instrument or a share issue in that amount. Instead, a hybrid instrument was issued, the purpose and effect of which was found by the primary judge to enable MBL to have the benefits of a share capital raising and to enable MFL to have the benefits of a perpetual debt issue, including tax deductibility of interest, lower cost of funds and greater flexibility in relation to the management of the monies raised.

217 The particular features of the scheme identified by the primary judge involve an element of artifice or contrivance, inasmuch as of the $400 million apparently raised in each tranche, only $200 million remained outstanding in the form of a debt instrument carrying interest. It was necessary that this amount remain outstanding if a deduction for the interest payments was to be obtained. The $200 million raised by the share issue was immediately returned to Deutsche in return for the payment direction, which effectively enabled MBL to switch an investor who subscribed for a MIS from debt to equity at the will of MBL.

218 It would thus be concluded from the manner in which the scheme was structured or carried out that at least a reason for MFL’s entry into the scheme structured in that way was for the purpose of enabling MFL to obtain a tax benefit in connection with the scheme. However, this is not a case, as was found to be the case in Hart, in which the manner in which the scheme was formulated and implemented is explicable only by the tax consequences. The primary judge found that, tax deductions apart, debt financing was a cheaper and more flexible way of raising funds than equity. The commercial benefits to MBL and its subsidiaries from adopting the MIS structure and so from the issue of notes by MFL, were not explicable only by the taxation consequences of debt financing.

219 Had the sum of $200 million per tranche been raised by the Commissioner’s ‘alternative hypothesis’, namely an issue of shares other than fully paid shares, such as further converting preference shares in MBL, then no tax deduction would have been available in relation to dividends declared, but this ‘alternative hypothesis’, on the primary judge’s findings, would not deliver the same commercial benefits to MBL and MFL as were obtained by the MIS issue. There was evidence from Mr Donnelly in terms of a memorandum of 17 September 1999 that the MIS represented a cheaper form of capital to MBL than converting preference shares, and should therefore be pursued.

220 His Honour’s conclusion (at [111]) that: ‘[T]he procurement agreement and payment direction were explicable only by reference to the desire to have both the benefits of a share capital raising and the allowance of an interest deduction’ is an inaccurate summation of his Honour’s findings on primary facts. The procurement agreement and the payment direction were explicable by reference to a desire to have both the benefits of a share capital raising, and a debt issue which could be treated as Tier 1 capital, but with the commercial advantages (including, but not limited to, tax deductibility) of a debt raising.

221 Once it was determined that the capital raising was to be by way of debt, rather than by way of a preference share issue alone, then it became inevitable that some company within the MBL Group would have to incur an ‘interest’ liability, and it was obviously desirable that any interest payable should be tax deductible, as that affects the cost of the acquisition of the funds. Whilst it is true that a factor underlying the participation of MFL in the structure (or, for that matter, any other MBL Group company in substitution for MFL) was the desire to secure a tax deduction that would have been unavailable had there been a share issue, there were additional factors also involved, including the commercial advantages of debt finance, and the ability of MFL (or some other MBL Group company other than MBL) to on-lend the proceeds of the MIS issue to Macquarie Leasing.

222 APRA’s guidelines (set out in Prudential Statement C1) require that if an ‘innovative capital instrument’ is to qualify as Tier 1 capital:

‘...

(vi) The instrument must carry no maturity nor be redeemable at the initiative of the holder ... The instrument may, however, be redeemable at the option of the issuing bank ...

(vii) Dividend (interest) payments may be made provided they satisfy the requirements in paragraph 19.’

Paragraph 19 of APRA’s Prudential Statement C1 provides relevantly that ‘[W]ith regards servicing Tier 1 capital instruments, aggregate dividend (interest) payments in any one year should not exceed the earnings of the bank during that year (ie a bank may not pay dividends from retained earnings).’

223 The factors which his Honour relied upon as reinforcing his conclusion that the tax purpose was predominant do not in fact reinforce that conclusion. They are simply necessary elements of the scheme if it was to receive APRA’s approval as Tier 1 capital, and do not indicate a predominant taxation purpose, as opposed to the more general purpose of securing all of the commercial advantages associated with debt financing, but by means of an instrument which also qualified as Tier 1 capital.

224 All three of the schemes which MBL had under consideration at this time involved a debt/equity combination. Had MBL proceeded with the CES scheme, MBL would have become liable to pay interest on the notes which, (all other things being equal) would have been deductible in its hands. Whether ‘all other things’ would have been equal is unclear. We were told by counsel for the Commissioner, Mr Pagone QC, that it was his client’s expectation that the CES scheme would not have resulted in a deduction of interest payments because the provisions ‘would fall foul of the convertible note provisions’, although this is not a matter which was explored at first instance or developed in argument by Mr Pagone before us. On the other hand, Mr Slater QC contended that the CES scheme did not involve a convertible note as defined in s 82L of the 1936 Act, and that there is nothing to show (or from which one could conclude) that the MIS structure in its final form was adopted to overcome a perceived non-deductibility of interest under the CES structure. Implementation of the CES scheme was not the preferred ‘alternative hypothesis’ or counter factual of either party at first instance or on appeal, perhaps because there were other perceived difficulties (including stamp duty considerations) in its implementation. It is unhelpful to explore the development of the three schemes under consideration at the time because subjective factors impermissibly intrude into that process, and, for all that is known, implementation of any of them might have attracted the operation of Part IVA. Even if it is assumed that the move from the CES proposal to the issue of the MIS was unrelated to tax considerations, the issue remains whether Part IVA applies to that issue.

(ii) The form and substance of the scheme

225 The primary judge expressed his conclusion as follows:

‘114. ... Here the substance of the transaction was a raising of share capital. The form was a combination of debt and equity capital raising. The difference between the two can be accounted for, in my opinion, by the availability of the tax deduction to MFL. That the substance was a capital raising by MBL follows the interrelationship of the rights to interest under the notes and the rights applicable to the preference shares stapled with the notes. While as a matter of form there was both a capital raising of $400,000,000 and a debt raising of the same amount as a matter of substance the real cost to the group after the procurement agreement and payment thereunder by MBL to Deutsche was only $400,000,000, that amount representing the amount required to be shown as a liability in the consolidated balance sheet of MBL as paid up capital. Further, it can be seen that in substance (and through its guarantee) MBL really incurred a liability to pay dividends in an amount in effect commensurate with the liability of MFL to pay "interest". There was no obligation to pay interest unless MBL had profits just as would be the case had there been a dividend payable by MBL under an alternative arrangement.

115. However, again it will be important to note that there is a commercial advantage in both cost of finance and flexibility that must be taken into account in weighing up which purpose predominates. While the conclusion to be reached involves a question of judgment I think here that it is the tax purpose which predominates. I should add that unlike Spotless and perhaps, unlike Hart the present is not a case where the commercial purpose can only be achieved if the tax purpose is also achieved.’

226 In my view, the principal reason, objectively apparent, for the adoption of the form which the MIS took was to achieve the economic substance of a debt instrument (including interest deductibility) but which also satisfied Tier 1 capital criteria. The primary judge acknowledged that there is a commercial advantage in both cost of finance and flexibility by the MIS being structured as a hybrid instrument.

227 The scheme involved the issue of a hybrid instrument such that until the occurrence of a Payment Direction Event MFL was liable to pay interest on a debt instrument, but MBL could, in substance transmogrify the holder’s interest into that of a preference shareholder in MBL. The Commissioner’s submissions placed particular emphasis on the fact that in substance the holders of the MIS received a distribution akin to dividends, and had no entitlement to be repaid principal. But investors were invited to subscribe to a perpetual debt instrument, and consideration of matters of form and substance simply leads to the conclusion already reached that the objectively ascertained purpose of those who participated in the scheme having regard to the s 177D(b) factors was to raise capital by an instrument which had the commercial advantages which flow from debt financing, but with features which would also qualify it as Tier 1 capital.

228 Investors in the MIS did not acquire any right to participate in the profits of MBL (the link to the amount of MBL’s profits was a limitation, not an enlargement, of the interest return on the MIS), nor any right to acquire any ordinary shareholding interest in MBL or in any of its subsidiaries. In this regard they differed in a material respect from the convertible preference shares issued by MBL as part of the same course of fundraising associated with the BTIB acquisition: while the converting preference shares carried a fixed yield (similar to but expected to be higher than the MIS), they did so only for a period of 5 years, following which they were converted into ordinary shares with an effective cost of capital the same as the existing ordinary capital (on which shareholders expected MBL to earn of the order of 26 per cent). There was evidence that the MIS represented a cheaper form of capital to MBL than the converting preference shares.

(iii) The time at which the scheme was entered into and the length of the period during which the scheme was carried out

229 The primary judge found that the third factor, timing, has little part to play, but if anything the third factor may militate against a conclusion of tax purpose. The MIS issue was but part of a broader fundraising involving issues of ordinary and converting preference shares and the obtaining of lines of credit, with the best mix being a matter of commercial judgment.

230 The Commissioner submits that the primary judge erred in concluding that timing had ‘little part to play’ for the reason that the decision to adopt the scheme was taken soon after obtaining advice about possible structures. The primary judge declined to draw the inference that the MIS took the form they did as a result of taxation advice. It has not been shown that his Honour was in error in this respect. ‘Taxation is part of the cost of doing business, and business transactions are normally influenced by cost considerations. Furthermore, even if a particular form of transaction carries a tax benefit, it does not follow that obtaining the tax benefit is the dominant purpose of the taxpayer in entering into the transaction’: Hart at [15].

231 I agree with the primary judge’s assessment of this factor.

(iv) The result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme

232 The result, as the primary judge held, is that a deduction is allowable to MFL which would not be allowable if it had not issued the loan notes and incurred the expense on them. But this conveys little more than that MFL obtained a tax benefit in connection with the scheme. It has little to say about whether it should be concluded that relevant persons who entered into the scheme did so for the dominant purpose of enabling MFL to obtain a tax benefit. If, as his Honour suggests at [81], the present scheme had not been implemented, some company in the MBL Group other than MBL may have obtained a tax deduction, that would point against the obtaining of a tax benefit as the predominant purpose of the scheme.

(v) Any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result from the scheme

(vi) Any change in the financial position of any person who has ... any connection ... with the relevant taxpayer, being a change that has resulted ... from the scheme

233 The primary judge found that but for the scheme, MFL would not have had funds available to it to on-lend to Macquarie Leasing, and likewise no interest to pay out on its borrowing or interest to receive from on-lending. On the other hand, the financial position of MBL changed because it had issued fully paid preference shares. In his Honour’s view these matters, on balance, are either neutral or favourable to a conclusion of a non-tax purpose.

234 MFL submits that Mr Ward’s report of 9 August 1999 referred to above (which was accepted by the due diligence committee) establishes that the availability of a deduction to MFL for the interest outgoing was not one critical to the implementation of the MIS issue. Mr Ward’s subjective opinions are not germane to the enquiry for which Part IVA provides. However, it is clear, as the primary judge found, that MFL derived net taxable income in consequence of the implementation of the scheme which it would otherwise not have derived. That circumstance suggests that obtaining a tax benefit for MFL was not a dominant purpose of any party in entering into the transaction.

235 Any change in MBL’s financial position which results from the scheme is required to be considered under factor (vi). The only change in its financial position is that it issued the preference shares comprised in the MIS and applied the proceeds to payment under the Procurement Agreement so that its issued capital increased, and as a net result of the transaction MBL acquired the right to call for payment to it (in lieu of the holders) of both capital and income under the notes. On the exercise of that right MBL would become liable to pay to the holders of the MIS dividends in an amount equivalent to the interest which they would otherwise have received from MFL. Whereas MFL is entitled to a deduction for interest payments, there is no corresponding right in MBL to a deduction for dividends paid out of profits.

236 No tax advantage to MBL enured from the transaction. Its allowable deductions were not enlarged, and its assessable income was not diminished.

237 The Commissioner submits that the conclusions drawn by the primary judge in relation to these factors are erroneous, but apart from reciting acknowledged features of the transactions, the submissions do not disclose any error.

(vii) Any other consequence for the relevant taxpayer, or for any person referred to in subparagraph (vi), of the scheme being entered into or carried out; and

(viii) The nature of any connection ... between the relevant taxpayer and any person referred to in subparagraph (vi)

238 The primary judge concluded that the remaining matters for consideration were either neutral or did not suggest a conclusion that the dominant purpose of MFL, MBL or any person who entered into or carried out the scheme (for example, Deutsche) was the obtaining by MFL of a deduction for interest. As earlier noted, if the need for capital and the comparative advantages and disadvantages of raising capital by debt or equity in the reality of the Australian financial market place do not fall within any of the earlier paragraphs of s 177D(b), they fall within par (vii).

239 The Commissioner submits that the conclusions drawn by the primary judge in relation to these factors are erroneous, but again, apart from reciting acknowledged features of the transactions, the submissions do not disclose any error.

Balancing the eight s 177D(b) criteria

240 On the primary judge’s findings, obtaining a tax benefit was not the sole purpose of a participant in the scheme, as other commercial advantages flowed from its adoption and implementation. There is no suggestion that the other commercial advantages which flowed from debt financing were inconsequential or immaterial. The question is whether the obtaining of a tax benefit was the dominant purpose of a participant, in the sense in which that term was explained in Spotless. In Eastern Nitrogen Lee J emphasised (at [20]) that it is important not to elide the question posed by Part IVA, namely what was the dominant purpose of a relevant party in entering the transaction (or scheme), with the enquiry, would the transaction (or scheme) have been entered into ‘but for’ the tax benefit? Maurice Cashmere, in an article entitled ‘Part IVA after Hart’ ((2004) 33 AT Rev pp 131-149) describes, at 138, a ‘but for’ test as ‘inevitably self-determining’.

241 The primary judge concluded as follows (at [120]):

‘It follows, therefore, that if, contrary to my view, the "interest" payable on the notes was an allowable deduction to MFL in the year of income, then that deduction constituted a tax benefit which MFL obtained from a scheme to which the provisions of Part IVA applied and in respect of which the Commissioner was entitled to make a determination under s 177F disallowing to MFL the deduction. I might add that I reach this conclusion with some reluctance. I doubt if the legislature would have regarded the present "scheme" as involving the application of Part IVA when the Part was enacted in 1981. However, it seems to me that the approach of the High Court in Hart requires me to reach the conclusion I have.’

242 With respect to his Honour, I am of a different opinion. In my view, addressing the question posed by his Honour in [110] of his reasons, a reasonable person would conclude, having regard to the eight factors listed in s 177D(b), that the dominant purpose of those engaged in the issue of the MIS on the particular terms on which that issue was made was to secure to the MBL Group all of the commercial advantages associated with debt financing (including, but not limited to tax deductibility of interest) whilst at the same time qualifying as Tier 1 capital.

243 There is force in MFL’s submission that ultimately the Commissioner’s case is that MFL borrowed money, thereby incurring deductible interest, and that if another party (MBL) had done something different (issued shares) MFL would not have incurred the deductible outgoing. The fallacy in this case is that – contrary to the direction in s 177D(b) – it confines attention to the tax consequences of the actual and ‘counterfactual’ transactions and leaves out of account the commercial advantages and consequences obtained and flowing from what was done.

244 The Commissioner was not authorised to make a determination under Part IVA to disallow MFL a deduction for the interest outgoing on the notes.

245 Subject to the qualification that the need for the preference shares to be fully paid was a consequence of APRA’s requirements I have not found it necessary to resolve any alleged factual errors on the part of the primary judge.

CONCLUSION

246 In my opinion, the appeal should be allowed, and the appropriate consequential orders made.

I certify that the preceding one hundred and thirty-three (133) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Hely.

Associate:

Dated: 16 September 2005

IN THE FEDERAL COURT OF AUSTRALIA
NEW SOUTH WALES DISTRICT REGISTRY	NSD 1439 OF 2004

ON APPEAL FROM A SINGLE JUDGE OF THE FEDERAL COURT OF AUSTRALIA

BETWEEN:	MACQUARIE FINANCE LIMITED (ACN 001 214 964) APPELLANT
AND:	COMMISSIONER OF TAXATION RESPONDENT

JUDGES:	FRENCH, HELY AND GYLES JJ
DATE:	16 SEPTEMBER 2005
PLACE:	SYDNEY

REASONS FOR JUDGMENT

GYLES J

247 The answer to the question as to whether the payments by the appellant, Macquarie Finance Limited (MFL), to holders of what are described as stapled securities in the subject year of income are deductible pursuant to s 8-1 of the Income Tax Assessment Act 1997 (Cth) (the Act) is not easy, as is illustrated by the difference of judicial opinion upon the point. I agree with the conclusion that the payments are not deductible and would dismiss the appeal.

248 The reasons of each of French J and Hely J, which I have had the advantage of reading, and those of the primary judge explain the factual background and how the issues arise and refer to the relevant authorities. I do not need to traverse that ground again except insofar as it is necessary to explain my own conclusions.

249 I agree with the substance of the reasons of the primary judge with one qualification as to the preferred basis for denying deductibility. The principal criticisms of the primary judgment were, firstly, that the matter was analysed from the point of view of the investor rather than from that of the taxpayer MFL and, secondly, that the decision was not based upon an analysis of the legal effect of the transaction documents but rather upon the notion of commercial or business equivalence.

250 There is some apparent force in these criticisms. It was not argued that any part of the transaction was a sham or not of binding effect. MFL was contractually bound to pay the ‘interest’ by virtue of having issued the notes. MFL remained contractually bound to make such payments unless and until there was a Payment Direction Event. The amount of $200 million was lent by MFL to Macquarie Leasing Limited (MLL) at a rate of interest above the ‘interest’ rate payable by virtue of the notes and assessable income was so earned. That situation did not change during the year in question. The potential for change upon the occurrence of a Payment Direction Event did not affect the contractual position in the relevant year.

251 On the other hand, the primary judge was correct in finding that the ‘stapling’ of the preference shares and notes was also a feature of the transaction that could not be ignored. The investor was both a note holder and the holder of a fully paid preference share at all times and one could not be dealt with without the other. There was no right to demand repayment. The rights conferred by the note might be transmogrified into equivalent rights pursuant to the preference share without any action on the part of the investor. Correspondingly, MFL received the money with no obligation to repay the investor. It received the permanent advantage of that money unless it was obliged to pay it to its parent company by the unilateral decision of Macquarie Bank Limited (MBL). In that event, MBL in turn received the permanent advantage of the money. Payment of the contractual ‘interest’ to the investor from time to time did not secure the continued retention of that amount as against the investor. It was secured whether or not ‘interest’ was paid. From the point of view of both the investor and MBL (and its subsidiaries including MFL), the essential characteristics of the rights and liabilities did not alter whether governed by the note or by the preference shares after a Payment Direction Event. The transaction can be viewed as an affair of capital from start to finish.

252 That conclusion is supported by the circumstance that the transaction resulted in the raising of Tier 1 capital by MBL which was the object of the transaction. Arrangements that qualify as Tier 1 capital for the purposes of Australian Prudential and Regulatory Authority (APRA)’s capital adequacy standards are in the nature of capital for present purposes, regardless of the label attached to them (Radaich v Smith [1959] HCA 45; (1959) 101 CLR 209; Commissioner of Taxation v Krakos Investments Pty Ltd (1995) 61 FCR 489 at 495G–496). APRA’s Prudential Statement C1 – Capital Adequacy of Banks (Statement C1) issued in September 1999 was current at the time of the transactions. The introductory general framework of Statement C1 included the following:

‘Minimum Capital Standards

10. Each Australian bank is expected to maintain a minimum ratio of total capital to risk-weighted assets, on both a consolidated group and stand-alone basis, of 8 per cent (of which at least 4 per cent should be Tier 1 capital). These levels will be kept under review.
11. APRA may require a bank to maintain a higher minimum ratio, eg for a newly established bank, or a bank judged to have an excessive concentration of credit risk exposures or significant other risk exposures.

Definition of Capital

12. Capital is the cornerstone of a bank’s strength. The presence of substantial capital re-assures creditors and engenders confidence in a bank.
13. The essential characteristics of capital are that it should:

• represent a permanent and unrestricted commitment of funds;
• be freely available to absorb losses and thereby enable a bank to keep operating whilst any problems are resolved;
• not impose any unavoidable charge on the earnings of the bank; and
• rank below the claims of depositors and other creditors in the event of the winding-up of a bank.

14. Capital, for supervisory purposes, is considered in two tiers. Tier 1 (or core capital) comprises the highest quality elements. Tier 2 (or supplementary capital) represents other elements which do not satisfy all of the characteristics of Tier 1 capital but which contribute to the overall strength of a bank as a going concern. A summary of the main elements of capital is given in Attachment I.
15. A bank’s capital base (or total capital) is the sum of its Tier 1 and Tier 2 capital less any deductions. At least 50 per cent of a bank’s capital base must be Tier 1 capital.’

253 In my opinion, the reasoning of the primary judge would be unassailable if MBL had issued both the notes and the preference shares. It would be an affront to reality to regard transactions having the same parties and with the same essential characteristics capable of being switched at will by MBL and ‘stapled’ together as separate transactions. The question is whether the interposition of MFL alters that conclusion. In my opinion, it does not. The preference share and the note must be regarded together as, in effect, a tripartite arrangement between MBL, MFL and the investor (through the Trustee). The payment received by MFL was part of a wider transaction which could not be said to result in a debt or a loan except in a very special sense. In my opinion, this conclusion is not to give effect to commercial or business equivalence but rather is the result of properly analysing the effect of the transaction viewed as a whole.

254 On this analysis, the ‘loan’ by MFL to MLL was a marginally profitable loan of capital by one wholly owned subsidiary of MBL to another. As I noted in Spassked Pty Ltd v Commissioner of Taxation [2003] FCAFC 282; (2003) 136 FCR 441 at [128], intra group transactions are not the same for all taxation purposes as arm’s length transactions – see also Franklins Selfserve Pty Ltd v Federal Commissioner of Taxation [1970] HCA 33; (1970) 125 CLR 52 at 58–59, 66–67. Further, the immediate destination of moneys received or outlaid does not necessarily equate to the object of the receipt or payment (Ure v Federal Commissioner of Taxation (1981) 34 ALR 237 per Deane and Sheppard JJ at 247–252). Here it can be said that the object of the receipt and payment of the ‘principal’, as reflected by the stapled note and the paid up preference share, was to provide MBL with Tier 1 capital although the intragroup destination was to be MLL.

255 One conclusion, favoured by French J, is that the outgoings were not incurred by MFL in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income and so not deductible pursuant to s 8-1. Another, favoured by Hill J, is that the outgoings were of a capital nature. In my opinion, the better view is that favoured by French J, but, whether or not that be correct, I also agree with the opinion of the primary judge. In either event, the outgoings are not deductible.

256 The primary judge went on to consider the application of Pt IVA of the Income Tax Assessment Act 1936 (Cth) if a different view were taken as to deductibility pursuant to s 8-1 of the Act. There are always dangers in hypothetical determinations and they are exacerbated in this case because it is necessary to know the precise basis upon which the outgoings have been held to be deductible before the application of Pt IVA can be considered.

257 As it happens, I would have agreed with the conclusion of the primary judge as to the application of Pt IVA if that had become necessary and, indeed, would be of the opinion that the reasoning of the primary judge was too favourable to the appellant in some important respects. I am tempted to take the opportunity to add to the plethora of opinions expressed about the true effect of Commissioner of Taxation v Hart [2004] HCA 26; (2004) 217 CLR 216. It seems to me that undue attention to the rear vision mirror has clouded the relatively straightforward issues of statutory construction that were decisively settled by the High Court in Hart consistently with Federal Commissioner of Taxation v Spotless Services Ltd [1996] HCA 34; (1996) 186 CLR 404 and Commissioner of Taxation v Consolidated Press Holdings Ltd [2001] HCA 32; (2001) 207 CLR 235. I will resist that temptation and shall only state in short form why I would have applied Pt IVA if it had become relevant.

258 The hypothesis to be considered is that the deductibility of the payments would be based upon the separate position of the taxpayer MFL being the recipient of the moneys contributed for the notes and then on lending that money to MLL at interest. I have expressed the view that if the transaction had taken place with MBL alone then it would be clear enough that the payments of ‘interest’ would not be deductible. MFL was inserted into the proposed transaction at a very late stage. On the hypothesis being considered that would be crucial to deductibility.

259 The rationale for, and objective of, the transaction was the raising of Tier 1 capital by MBL. The APRA requirements are set out in Statement C1 and attachments that are in evidence. It is critical to appreciate that no debt instrument could qualify as Tier 1 capital and, indeed, would only qualify as Tier 2 (Upper) capital under stringent conditions. It is apparent from a reading of the relevant parts of Statement C1, including Attachment 1A, that Tier 1 capital is a permanent contribution of funds to the bank and that no payment in respect of it could be deducted on revenue account. The transaction here only qualified as Tier 1 capital because of the issue of fully paid preference shares by MBL not because of the notes.

260 Any counterfactual for the purposes of Pt IVA must involve the raising of Tier 1 capital by MBL. It follows from the above that no counterfactual would involve deductibility for payments made by or on behalf of MBL to investors as no debt or loan instrument upon which interest would be paid on revenue account would qualify. The conclusion that MFL was inserted into the arrangements at a late stage for the purpose of obtaining deductions for payments to investors not otherwise available would be irresistible.

261 The appeal should be dismissed with costs.

I certify that the preceding fifteen (15) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Gyles.

Associate:

Dated: 16 September 2005

Counsel for the Appellant:	T F Bathurst QC, A H Slater QC, A J Payne
Solicitor for the Appellant:	Clayton Utz
Counsel for the Respondent:	G T Pagone QC, S J McMillan, J H Momsen
Solicitor for the Respondent:	Australian Government Solicitor
Date of Hearing:	21, 22 February 2005
Date of Judgment:	16 September 2005