The Taxpayer and Commissioner of Taxation [2010] AATA 819 (25 October 2010)

Last Updated: 27 October 2010

Administrative Appeals Tribunal

DECISION AND REASONS FOR DECISION [2010] AATA 819

ADMINISTRATIVE APPEALS TRIBUNAL )

) No 2009/2965

TAXATION APPEALS DIVISION		)
	Re		THE TAXPAYER

Applicant

And

COMMISSIONER OF TAXATION

Respondent

DECISION

Tribunal

Deputy President P E Hack SC; Senior Member Bernard J McCabe

Date 25 October 2010

Place Brisbane

Decision

The decision under review is affirmed.

...............Signed............
Deputy President

CATCHWORDS

TAXATION – income tax assessment – objections and appeals – business and asset sale agreement – taxpayer agreed to accept novation of material contracts on condition that rival company paid “subsidy payment amount” – Tribunal satisfied that style and course of negotiations suggested taxpayer regarded components of purchase price as variables that could be adjusted to achieve final price for opportunity acceptable to both parties – satisfied from evidence about taxpayer’s careful analysis of rival company’s business, material contracts and negotiations that taxpayer entered into transaction with rival company and novated contracts with view to making profit – Tribunal not satisfied that transaction was unusual having regard to taxpayer’s existing business – Tribunal satisfied that transaction was intimately and incidentally connected with taxpayer’s ordinary business – decision under review affirmed

Income tax Assessment Act 1936, ss 21, 21A

Income tax Assessment Act 1997, s 6-5

Commissioner of Taxation v Sydney Refractive Surgery Centre Pty Ltd [2008] FCAFC 190; (2008) 172 FCR 557

Commissioner of Taxation v The Myer Emporium Ltd [1987] HCA 18; (1987) 163 CLR 199

Federal Coke Co Pty Ltd v Federal Commissioner of Taxation [1977] FCA 3; (1977) 34 FLR 375

Warner Music Australia Pty Ltd v Commissioner of Taxation (1996) 70 FCR 197

REASONS FOR DECISION

25 October 2010

Deputy President P E Hack SC; Senior Member Bernard J McCabe

1. The taxpayer is a proprietary company that provides waste management services. In June 2006, the taxpayer agreed to take on an unprofitable business conducted by a rival (Rivalco). Under the terms of the agreement, the taxpayer acquired plant and equipment worth $X[1]. Rivalco also agreed to facilitate the taxpayer entering into contracts with some local government authorities that had until that point been dealing with Rivalco. In return, Rivalco agreed to pay the taxpayer a total of $Y under the terms of the arrangement. The Commissioner says that payment, together with an amount equal to the value of the plant and equipment, should be treated as assessable income in the hands of the taxpayer in the 2007 income year.
2. In order to decide this case, we must consider whether $XY (being the amount of the cash payment in the amount of $Y, together with a non-cash business benefit to the value of $X million pursuant to ss 21 and 21A of the Income tax Assessment Act 1936 (Cth) (ITAA36)), is ordinary income or statutory income under the Income tax Assessment Act 1997 (Cth) (ITAA97).

AGREED FACTS

3. Most of what follows has been gleaned from a statement of agreed facts that was tendered at the commencement of the hearing. We have adopted that statement for the purposes of these proceedings, although it is also necessary for us to make some additional findings that were not the subject of agreement.
4. The taxpayer provides waste management services to local government authorities and private clients along the east coast of Australia and in New Zealand. Those operations consist of:
   • Domestic, commercial and industrial waste collection (including recycling and disposal);
   • Operation and management of materials’ recovery facilities, transfer stations and landfills.
5. The taxpayer is also the parent of a number of subsidiary companies and participates in joint ventures/partnerships with other companies that possess special expertise in aspects of the waste management business.
6. The taxpayer has a small board of directors. There are three directors, including the chief executive officer (CEO), who are all members of the same family, and two other executives who are described as “associate directors”. One of the associate directors is the chief financial officer (CFO). The other is in charge of tendering. We were told the board met in formal session at least quarterly. An agenda was prepared and minutes were taken at each of those formal meetings. But this was essentially a (large) family business, and its decision-making processes appear to have been more flexible than those in some other businesses. The board members met regularly on an informal basis. Those discussions were not recorded or minuted.
7. Rivalco was also in the waste management business. It was structured differently to the taxpayer at the relevant time. Whereas the taxpayer was essentially a family business, Rivalco was a division of a large multinational company. The Rivalco business traded in a number of Australian cities. Rivalco had secured a number of significant contracts with local government authorities within a particular region (the Material Contracts) in 2004. Some of those contracts were unprofitable, and Rivalco began to look for a way out before the contracts were due to expire in 2009 and 2011.
8. An officer of Rivalco’s parent contacted the CEO of the taxpayer in late 2005 to discuss whether the parties could agree to do something about the Material Contracts. The agreed statement of facts said the officer:

“... proposed that the Material Contracts be novated to the [taxpayer], that certain plant and equipment owned by [the parent of Rivalco] be transferred to the [taxpayer] and that a sum of money be paid by [Rivalco’s parent] to the [taxpayer].”

9. The CEO discussed the proposal with the two associate directors at an informal board meeting. In his statement, the CEO explained the board’s initial response in these terms:

“... the Board met informally to discuss the potential acquisition of the [Rivalco] businesses by the Applicant and whether this was something we, as a Board, wanted to pursue. After discussing the matter, the Board considered that, notwithstanding the magnitude of the losses generated by the [Rivalco] businesses from performing the Material Contracts, the acquisition of those businesses might be a viable commercial prospect. The [Rivalco] businesses included significant waste management contracts (the Material Contracts) and considerable plant and equipment. The Board was adamant that any proposal would need to be considered conservatively to ensure future losses would not have an adverse impact on the Applicant. Provided the financial analysis of the proposal was conducted on this basis, the Board decided it would be a good addition to existing business. In addition, successful performance of the Material Contracts might be regarded favourably by the councils when considering future tenders submitted by the Applicant. Accordingly, for these reasons, the Board decided to give further detailed consideration to the possibility of acquiring the [Rivalco] businesses ...”

10. The CEO commenced negotiations over a possible deal. In the meantime, Rivalco’s financial advisers prepared an information memorandum describing the relevant portion of Rivalco’s business. The taxpayer’s associate director for tendering (assisted by the CFO) was instructed to carry out a due diligence inquiry and report back to the board. He was well placed to do so: he already had a good working knowledge of the Material Contracts as he was in charge of the taxpayer’s unsuccessful tenders for those same contracts. He was able to undertake a careful analysis of the cash inflows and outflows under the contracts and estimate future profits. He considered interest costs, tax considerations, leasing documentation, asset registers, depreciation schedules, registration documents, payroll records and other financial data. He also spoke with staff from the various local councils in question to determine their attitude to the way in which the Material Contracts were being performed.
11. The due diligence process continued from the end of 2005 until May 2006. When it was completed, the taxpayer’s officers produced an analysis of the financial implications of the transaction. A copy of that document was provided to the respondent under cover of a letter dated 4 July 2008. That document included a reference to a “total subsidy”.
12. The letter to the Commissioner of 4 July 2008 purported to explain the commercial rationale of the purchase. The letter suggested the transaction was justifiable because:
    • the plant and equipment under the arrangement could be utilised after the Material Contracts expired;
    • the taxpayer hoped to achieve economies of scale by combining its operations with those of Rivalco that would generate cost savings and allow it to profit where Rivalco had lost money; and
    • completing the Material Contracts might cause the local councils to view the taxpayer more favourably and assist in future tender processes.
13. We note the CEO gave evidence to similar effect in his statement[2].
14. The taxpayer and Rivalco had discussed the amount to be paid in January 2006. The taxpayer made an initial offer on 16 January to acquire the relevant portions of the business on the basis it would be paid in the order of $RZ. The initial offer was rejected by Rivalco but negotiations continued. The negotiations mainly occurred in the course of telephone conversations between officers of Rivalco and the taxpayer, although the CEO of the taxpayer also attended several meetings with Rivalco executives. The two associate directors of the taxpayer also attended at Rivalco’s premises as they conducted due diligence inquiries. None of the meetings or conversations was minuted or otherwise recorded by the taxpayer. The board of the taxpayer also met informally on a number of occasions during this period.
15. The taxpayer’s officers used the information gathered during the due diligence process to value the plant and equipment to be acquired under the deal at $X. The negotiations appeared to focus on the further amount that would be paid if the taxpayer agreed to acquire the business. That further payment came to be described as the “subsidy payment amount”.
16. The taxpayer and Rivalco finally executed the Business and Asset Sale Agreement (the sale agreement) on 9 June 2006. Under the terms of the sale agreement, the taxpayer agreed to accept the novation of the Material Contracts on the condition that Rivalco pay a subsidy payment amount of $Y[3]. The sale agreement also transferred assets (which included intellectual property, goodwill, consumables and identified plant and equipment ) valued at $X.
17. The valuation of $X in respect of the plant and equipment did not include any allowance for GST. The taxpayer paid an amount in respect of GST to Rivalco. The sale agreement included a number of other conditions which do not concern us here. The completion date of the agreement was initially set for 30 June 2006 although the parties concluded a variation agreement on 29 June that extended the completion date to 4 July 2006. We do not think anything turns on that.
18. We were provided with copies of novation deeds that were executed in respect of each of the Material Contracts. We note that Rivalco and the taxpayer were both parties to the various deeds. Under the terms of those deeds, the taxpayer replaced Rivalco and assumed its rights and obligations under the original agreement that the local councils in question had signed with Rivalco. Each of the novation deeds included a condition precedent to the effect that the novated agreements would not take effect unless and until the sale agreement was completed and certain other things occurred. The novated agreements could only take effect with the consent of the local councils in question.
19. The taxpayer included the amount of $XY in its income tax return in respect of the 2007 financial year but promptly lodged a notice of objection to the assessment. The Commissioner disallowed the objection and the matter has now come before the Tribunal for reconsideration.

ADDITIONAL FINDINGS OF FACT

(A) CALCULATION OF THE SUBSIDY PAYMENT AMOUNT

20. The associate director responsible for tendering explained the taxpayer’s position on the quantum of the subsidy payment amount in the course of his affidavit. He said his analysis suggested the taxpayer would need to receive a large payment ($YQ) if it was to perform the Material Contracts without loss[4]. It seems the taxpayer was ultimately prepared to accept a smaller amount ($Y) which represented the net present value of $YQ. The evidence suggests that the taxpayer and Rivalco engaged in lengthy negotiations over the amount of this payment: the CEO in his statement[5] said the negotiations were “protracted”.
21. We accept the evidence[6] that the need to cover projected losses on the contracts was an important factor in determining the quantum of the subsidy payment amount. We also accept the taxpayer would have been aware that it was appropriate to discount the total amount of the losses if the taxpayer were to receive a lump sum payment when the sale was completed.
22. The fact that the negotiations proceeded on an informal basis without records being taken over such a long period makes it difficult to be sure precisely what was discussed, but it may tell us something important about the approaches of the parties. The fact that so many of the negotiations were conducted during telephone calls between senior officers suggests the discussion over the subsidy payment amount was more general than one would expect if it were purely a detailed discussion of data and assumptions. That conclusion is also consistent with the evidence we have already discussed which suggested the taxpayer saw other advantages in the deal (eg, economies of scale, goodwill) that had to be taken into account when putting a price on the opportunity.
23. We do know the taxpayer made an offer early in the negotiation process to acquire the business in return for a payment of $RZ. That fact is reported in the statement of agreed facts. At that point, the value to be assigned to the plant and equipment had not been determined. That approach to the negotiations is consistent with our observation that the taxpayer, at least, may have been focused on the ultimate price it would accept in return for agreeing to effectively relieve Rivalco from its obligations under the Material Contracts. We are satisfied that the style and course of the negotiations suggests the taxpayer regarded the components of the purchase price, namely the value of the plant and equipment and the subsidy payment amount, as variables that could be adjusted to achieve a final price for the opportunity that was acceptable to both parties. We accept that each of those variables was the subject of separate consideration and analysis[7], but it would be a mistake to see those questions otherwise than in the context of a negotiation over the final price to be paid.

(B) THE TAXPAYER’S PURPOSE

24. We are satisfied from the evidence about the taxpayer’s careful analysis of Rivalco’s business, the Material Contracts and the negotiations that the taxpayer entered into the transaction with Rivalco and the novated contracts with a view to making a profit. It was not merely attempting to earn goodwill or secure its competitive position so that it might make a profit on future contracts. The taxpayer expected to make a profit out of this transaction.

(C) WAS THIS TRANSACTION A ‘ONE OFF’?

25. We accept the CEO’s evidence[8] that the taxpayer had not “previously taken over or acquired existing waste management contracts with councils”. We also accept his evidence[9] that he was not aware of anyone else in the industry entering into a similar deal. But the CEO did acknowledge in his statement[10] that the taxpayer had acquired other small businesses in the same industry in the past. He said the transaction on this occasion was different because it involved novated contracts, and because it was much larger.
26. While we accept this was the first occasion on which the taxpayer entered into an agreement involving novated contracts, we cannot go so far as to say the transaction is destined to remain a one-off. The evidence establishes that the taxpayer is a growing force in the waste management business. An important part of that business is the provision of waste management services under contracts with local councils. The taxpayer has acquired rivals in the past. There is no reason to doubt it may grow by acquiring other rivals in the future. As the taxpayer grows in size, it can contemplate larger acquisitions like the one involving Rivalco. It is conceivable that those rivals will have contracts with local councils, and those contracts might be novated in the course of an acquisition.
27. The evidence establishes that the taxpayer occasionally acquires rival businesses in the course of carrying on its own business – the business of providing waste management services under contract. Although the details of the transaction in this case were unprecedented, the transaction in substance still involved (a) the acquisition of a rival and (b) entering into waste management contracts with local councils. Since the taxpayer routinely did both of those things in the ordinary course of its business, it is difficult to see how this transaction could be regarded as unusual.
28. The Commissioner conceded it was unusual that such a large transaction would not be accompanied by more extensive documentation. We have already indicated that we do not find the absence of extensive documentation to be remarkable. This was essentially a family business, and we accept its senior managers were accustomed to doing business in an informal way. Indeed, it may be that the informal approach to this transaction tends to confirm there was nothing unusual about what occurred.

THE ISSUES

29. We turn firstly to the question of whether or not the gain made from this transaction should be regarded as “income according to ordinary concepts”[11] within the meaning of s 6-5 of ITAA97.
30. These expressions certainly refer to “a profit or gain made in the ordinary course of carrying on a business”[12]. One determines whether a particular transaction that generated a gain occurred in the ordinary course of a taxpayer’s business by analysing the transaction and judging it by examining “both the scope and nature of a taxpayer's business”[13]. But a profit or gain made otherwise than in the ordinary course of business might also qualify as ordinary income. If the taxpayer entered into what was, for the taxpayer, an unusual transaction with the intention or purpose of making a profit or gain, that profit might still be regarded as income for the purposes of s 6-5[14].
31. We have already observed that the taxpayer was engaged in the waste management business. In the course of conducting that business, it routinely entered into contracts with local councils and others to provide waste management services. It also - occasionally - agreed to acquire businesses (or parts of businesses) from other companies. We acknowledge that this transaction had some unusual features, including:
    • the vendor paid the taxpayer to effectively take the business off its hands;
    • the vendor agreed to facilitate the taxpayer reaching fresh agreements with the local councils that would replace those being terminated by the vendor; and
    • the acquisition was somewhat larger than any of the taxpayer’s previous acquisitions.
32. While those features of the deal were unusual, we do not accept that the transaction was in and of itself unusual when having regard to the taxpayer’s existing business. The transaction was merely a means of securing more waste management contracts with local councils. Indeed, it seems likely that it was the only means of securing those contracts in the circumstances: the taxpayer had unsuccessfully tendered for the contracts some time before and the contracts were not due to expire for some time afterwards. The taxpayer needed Rivalco to stand aside from the contracts before it could access the opportunity to deal with the local councils in question, and it would not have agreed to replace Rivalco without the subsidy payment. While it might be unusual to make a gain as a purchaser under what was described as a sale agreement, it was still “an incident of that business, even if not an ordinary incident of that business”[15].
33. We are satisfied the transaction was intimately and incidentally connected with the taxpayer’s ordinary business so that it can properly be said to have occurred in the course of that business. The transaction is not outside the ordinary course of the business merely because this was the first time – and perhaps the only time – that the taxpayer would strike a deal with these features.
34. The taxpayer referred us to the decision of the Full Federal Court in Federal Commissioner of Taxation v Sydney Refractive Surgery Centre Pty Ltd[16]. In that case, the Court was required to consider whether compensatory damages for defamation should be treated as ordinary income under s 6-5. The Court decided the payment was not ordinary income because it was paid in compensation for a reduction in the capacity to earn. Ryan, Edmonds and Gordon JJ explained at [1]:

“Whether a payment of compensatory damages is assessable must be determined by looking to the nature of the cause of action in respect of which the payment is made, rather than the way in which damages are calculated.”

35. The taxpayer in this case says the fact that the quantum of the payment was calculated having regard to the need to cover likely losses under the novated contracts is irrelevant. The taxpayer says we should have regard instead to the character of the asset in order to determine the character of the payment that was received[17]. According to the taxpayer, the money was paid as consideration for (capital) assets: the plant and equipment and the loss-making contracts. It follows, it is said, that the vendor’s payment to the taxpayer was properly characterised as a capital receipt in the taxpayer’s hands.
36. We do not accept that $Y was paid for loss-making contracts. The contracts themselves were not up for sale. Rivalco wanted to be relieved of its obligations under the contracts. It entered into the sale arrangement and paid the taxpayer a quantity of money in order to convince the taxpayer to replace Rivalco in its dealings with the local councils. The councils that enjoyed the benefit of the Material Contracts had no incentive to release Rivalco from its obligations simply because it had negotiated unprofitable deals. The taxpayer was unlikely to agree to take over the Material Contracts on terms acceptable to the local councils without some assurance that it would be protected against the losses which would otherwise flow. The payment was labelled a subsidy in the sale agreement because that is what it was in the hands of the taxpayer: an amount that was paid to the taxpayer by Rivalco in addition to the regular payments from the local councils that would be received under the novated contracts that replaced the Material Contracts. The payment of a subsidy in the amount of $Y is surely characterised as income in the hands of the taxpayer.
37. We do not think the analysis is any different in respect of the balance of the (deemed) payment under the contract that was not explicitly described as a subsidy. The amount of that part of the total consideration was calculated with reference to the value of the plant and equipment. While that method of calculation suggests on its face that the deemed payment of $X was made in respect of a capital asset, one must recall that the purchaser was not actually paying anything for the plant and equipment that it acquired. The value assigned to the plant and equipment was only relevant insofar as it reduced the portion of the total purchase price that would be paid to the purchaser in cash as a subsidy. We do not think the two amounts can be dealt with separately as the obligations to pay them were all connected in the contract. The promises to pay the subsidy payment amount, allocate value in respect of the plant and equipment and facilitate the taxpayer and the local councils entering into the novated contracts were not readily severable from each other. It follows that the payment of $X had essentially the same character in the hands of the taxpayer as the amount paid as a subsidy. We are satisfied that amount is also ordinary income.
38. We would regard the amount of $XY as assessable income even if we found that the transaction was, in fact, unusual having regard to the scope and nature of the taxpayer’s business. We take that view because we are satisfied the taxpayer entered into the transaction “with the intention or purpose of making a profit or gain”[18].
39. We accept that the task of ascertaining the purpose of the taxpayer requires us to have regard to the objective features of the arrangement[19]. Those objective features clearly point to a transaction that was designed to generate gains for the taxpayer. The cash-flow analysis prepared by the taxpayer’s associate directors, which informed the board’s negotiations, includes references to a “Required Margin” and “Cost Contingency”. The officers were advising what was required by way of subsidy if the taxpayer were to avoid making a loss under the contract. There is no doubt those figures informed the negotiations over the quantum of the subsidy. The CEO referred in his affidavit to the expectation that the taxpayer would be in a position to reduce its costs (and increase its gain) by making savings that were possible when it achieved economies of scale. Indeed, the financial projections prepared in connection with the acquisition[20] and the evidence of the CEO[21] suggest the taxpayer expected to make significant gains from the transaction in addition to positioning itself to compete more effectively in the medium term.
40. That leaves only the question of whether the amount provided for in the contract in respect of the value of the plant and equipment (ie, $X) should be regarded as if it were income in the hands of the taxpayer pursuant to ss 21 and 21A of ITAA36. Section 21 says that consideration that is given or paid other than in cash should be counted as if it were cash. Section 21A clarifies and amplifies the effect of s 21. Section 21A provides that non-cash business benefits that may or may not be readily convertible into cash may nonetheless be treated as if it were cash. The section goes on to establish the way in which a value is to be assigned to the benefit for the purposes of bringing into account.
41. There does not appear to be any reason to doubt that the plant and equipment in this case is a non-cash business benefit within the meaning of s 21A. The items certainly formed part of the consideration that flowed to the purchaser under the contract. The parties assigned a value (ie, $X) to the property after careful analysis and lengthy negotiations. We have no reason to doubt that the valuation is appropriate, and that it should therefore be brought into the calculations.

CONCLUSION

42. The objection decision under review must be affirmed.
    

I certify that the 42 preceding paragraphs are a true copy of the reasons for the decision herein of Deputy President P E Hack SC; Senior Member Bernard J McCabe

Signed: ............Signed............................................................

Associate

Date of Hearing 26 August 2010

Date of Decision 25 October 2010

Counsel for the Applicant Mr F L Harrison QC with Mr D W Marks

Solicitor for the Applicant Moore Stephens

Counsel for the Respondent Mr M van de Walt

Solicitor for the Respondent ATO Legal Services Branch

---

[1] We have decided it would not be appropriate to disclose the precise quantum of the amounts in question because doing so may reveal more about the taxpayer’s cost base (amongst other things) than would be appropriate in a competitive market. Suffice to say that both $X and $Y are significant sums.
[2] Exhibit 6 at [16]-[17]
[3] The expression “subsidy payment amount” was not defined in the sale agreement.
[4] Exhibit 3 at p 3.
[5] Exhibit 5 at p 7.
[6] Exhibit 3 at p 3-4.
[7] And each was the subject of separate clauses in the contract of sale.
[8] Exhibit 5 at [25].
[9] Exhibit 5 at [26].
[10] Exhibit 5 at [25].
[11] Or “ordinary income”.

[12] Commissioner of Taxation v The Myer Emporium Ltd [1987] HCA 18; (1987) 163 CLR 199 at 209, per Mason ACJ, Wilson, Brennan, Deane and Dawson JJ.

[13] Warner Music Australia Pty Ltd v Commissioner of Taxation (1996) 70 FCR 197 at 210 per Hill J. See also Myer at 215.
[14] Myer at 209-210.
[15] See Warner Music Australia at 211.
[16] [2008] FCAFC 190; (2008) 172 FCR 557.

[17] See Federal Coke Co Pty Ltd v Federal Commissioner of Taxation [1977] FCA 3; (1977) 34 FLR 375 at 401-402 per Brennan J.
[18] Myer at 209, 211.
[19] See Federal Commissioner of Taxation v Orica Ltd [1998] HCA 33; (1998) 194 CLR 500 at [17] per Brennan CJ.
[20] Exhibit 1 at p 666.
[21] Exhibit 5.