Full court of the Federal Court upholds appeal by Commissioner of Taxation in relation to tax payer’s entitlement to deductions for capex on copyright.

Background

The case arose out of the privatisation of the Victorian government electricity transmission business, PowerNet in 1997. The business was acquired by SPI PowerNet (known at the time by a different name), a wholly owned subsidiary of an US corporation. The US corporation was in turn acquired by a wholly owned subsidiary of a Singaporean corporation, which later folded its subsidiaries into a tax consolidated group known at the time as SP Australia Networks (Transmission) Ltd (‘SPANT’).

The purchase price of the business was approximately $2.5 billion. This amount was fixed without reference to the collective value of the assets of the business and there was no allocation of the purchase price against specific assets.

Subsequent to the purchase, SPI PowerNet and SPANT claimed tax deductions for capital expenditure on the assets of the business that were acquired in the transaction. The tax deductions were claimed on different bases for each entity – by SPI Powernet in relation to the period before it became part of the SPANT group, and by SPANT as head company of the tax consolidated group which included SPI PowerNet. The two companies’ claims were thus subject to different legislative provisions, albeit based on the same transaction.  

Under the purchase agreement, the assets of the business were defined to include the intellectual property rights of the business, which included copyright in technical drawings, plans and other works which were critical to the operation and maintenance of the business. These works comprised approximately 105,000 documents. The case proceeded on the footing that the works were original works in which copyright subsisted.

SPI PowerNet claimed the copyright in the works was a ‘unit of industrial property’ in relation to which an amount equal to the residual value of the unit (calculated in accordance with a prescribed formula) was an allowable deduction under Division 10B of Part 3 of the Income Tax Assessment Act 1936 (Cth) (the ‘1936 Act’). SPANT claimed the copyright in the works was a depreciating asset in relation to which it was entitled to claim deductions under Division 40 of Part 2-10 of the Income Tax Assessment Act 1997 (Cth) (the ‘1997 Act’). The deductions claimed by SPANT were based on the value and reset costs of the copyright at the date SPI Powernet became part of the SPANT tax consolidated group, which were contested by the Commissioner.

The companies each instituted proceedings in the Federal Court under Part IVC of the Taxation Administration Act 1953 (Cth) (TAA) after the Commissioner issued notices of assessment which reflected its decision that the companies were not entitled to the relevant deductions. In the proceedings the entities had the burden of proving that the assessments were excessive.

The primary judge (Pagone J) heard both proceedings together and found in favour of the companies, ordering that the matters be remitted to the Commissioner to re-determine each assessment. The Commissioner appealed against the decision of the primary judge in both proceedings.

The Full Court of the Federal Court allowed the appeals in both proceedings and ordered that the judgments of the primary judge be set aside. The SPANT proceeding was remitted to the primary judge for further hearing and determination.

Issues in dispute

At issue in the SPI PowerNet proceeding was the question of how the company’s capital expenditure on the copyright in the works ought to be determined (for the purposes of calculating the allowable tax deduction) in circumstances where the total purchase price of the business was a composite amount in which the price for the acquisition of the copyright had not been separately allocated.

Section 124R(5) of Div 10B of Part 3 of the 1936 Act provides that in such circumstances, the capital expenditure must be taken to be “so much of the purchase price of the unit and the other property as the Commissioner determines”.

Pursuant to this section, the Commissioner determined that no part of the total purchase price of the PowerNet business should be allocated to the copyright in the works; that is, the capital expenditure by the company on the copyright in the works was nil. This was because the copyright had no separate value and no such allocation was possible in any event.

The key issue in the SPANT proceeding was whether the primary judge erred in accepting the market value of copyright in the works proposed by SPANT for the purposes of calculating the tax cost setting amount in accordance with Div 705 of the 1997 Act.

Could SPI PowerNet use the provisions of the TAA to challenge the Commissioner’s determination?

A threshold issue arose in the SPI Powernet proceeding concerning the extent to which the Commissioner’s determination under s 124R(5)  - that the capital expenditure by SPI Powernet on the copyright in the works was nil - was capable of being challenged by the company under Part IVC proceedings.

In this regard, the Court considered the effect of ss 175 and 177 of the 1936 Act which preclude certain challenges to determinations made by the Commissioner.

The Court was split in its conclusions on this point. Edmonds J allowed the appeal on the basis that it was not open to SPI Powernet to challenge the s 124R(5) determination by way of Part IVC proceedings. However, Kenny and Greenwood JJ respectfully disagreed on this point (although ultimately also allowed the appeal).

Is a valuation of copyright required in respect of the “allocation” task under s 124R(5)?

Given the conclusions of Kenny and Greenwood JJ in relation to the threshold question referred to above, the relevant question became whether the statutory task of allocation under s 124R(5) involved a valuation of the copyright in the works.

In the proceedings before the primary judge, three experts had been called to give concurrent evidence concerning the appropriate methodology for valuing copyright in the works. The experts agreed that there are three generally accepted methodologies for undertaking such a valuation: an income approach, a market approach and a cost approach. The experts agreed that a replacement cost methodology was also appropriate, but could not agree about its application in the circumstances of the proceedings.  There were other critical points of difference between the experts.

According to Greenwood J (with whom Kenny J agreed) the valuation work undertaken by the experts was misconceived. The experts failed to answer the question asked by s 124R(5) which his Honour framed as:

What are the objectively identifiable considerations going to determining the proper basis upon which, as to method (and the facts relevant to method), a part of an agreed non-separate price for a collection of assets might be allocated, to the copyright subsisting in the various categories of works in question? [Greenwood J’s emphasis] [at paragraph 182].

Greenwood J then listed a number of circumstances to be taken into account in determining the extent that the value of the copyright in the works might inform the answer to that question. In this regard, his Honour considered that if the company had not acquired the copyright in the works, it would have had an implied licence to use the copyright works. On this basis, the part of the total purchase price to be attributed to the acquisition of the copyright works was nil, or if not nil, the company had failed to prove the burden that the assessment was excessive.

Given that the valuation exercise undertaken by the experts engaged the wrong question, the company was unable to show error on the part of the Commissioner in making the determination, and thus failed to show that the assessment was excessive. On this basis, the appeal was allowed.

Were the value and reset costs of the copyright (as at the date SPI Powernet became part of the SPANT tax consolidated group) correctly determined?

In the SPANT proceeding, the value of the copyright for tax cost setting purposes at the relevant time (being the date SPI Powernet became part of the SPANT tax consolidated group) was submitted as being in the range of $230 million to $332 million. This amount was determined by reference to a consultant’s report which was not received into evidence, but which was referred to in oral evidence.

That amount was then adjusted and used by SPANT to calculate the market value of the copyright (separately from other assets) at the relevant time, pursuant to the tax cost setting rules in Div 705 of the 1997 Act. However, the Commissioner’s determination was that the copyright had no separate value to the other assets of the business at the relevant time.

In Edmonds J’s view (with whom Kenny and Greenwood JJ agreed), the primary judge’s conclusions about the expert evidence upon which the market valuation was based disclosed errors and omissions. For example, the primary judge downplayed the differences in opinion between the experts. Moreover, although the experts gave concurrent evidence about the valuation of the copyright works, in Edmond J’s view their individual expert reports were not (and should have been) admitted into evidence.

In view of the sharp differences in the expert evidence and the unresolved questions for the Court regarding the proper methodology for valuing the copyright at the relevant time, the Commissioner’s appeal was allowed and the question of whether it is possible and appropriate to value the copyright separately from the assets to which it is related, and if so, to determine what that value is, was remitted to the primary judge.

Comments

Given that the substantive questions about the appropriate approach to valuing copyright in the circumstances of the case was remitted to the primary judge for further hearing and determination, this case does not contain definitive guidance about this issue. However, the case illustrates the taxation problems that can arise in circumstances where the price attached to the copyright assets is not made clear in the purchase transaction. It also confirms that determinations under s 124R(5) are capable of being challenged in Part IVC proceedings under the TAA.