FEDERAL COURT OF AUSTRALIA

Commissioner of Taxation v BHP Billiton Finance Limited [2010] FCAFC 25

THE COURT ORDERS THAT:

1.                  The appeals be dismissed.

2.                  The appellant pay the respondent’s costs.

Note:    Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules.
The text of entered orders can be located using Federal Law Search on the Court’s website.

THE COURT ORDERS THAT:

1.                   The appeals be dismissed.

2.                  The appellant pay the respondent’s costs.

Note:    Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules.
The text of entered orders can be located using Federal Law Search on the Court’s website.

REASONS FOR JUDGMENT

SUNDBERG J:

1                     I agree with the orders proposed by Edmonds J and with his reasons therefor.

Associate:

Dated:         17 March 2010

REASONS FOR JUDGMENT

STONE J:

2                     I have had the considerable advantage of reading, in draft, the judgment of Edmonds J.  I agree with his Honour’s proposed orders and with the reasons for those orders.

Associate:

Dated:         17 March 2010

REASONS FOR JUDGMENT

EDMONDS J:

3                     These are appeals from orders of the Court to the effect that:

(1)        BHP Billiton Finance Ltd (‘Finance’) was entitled to:

(a)        a deduction under:

(i)         section 25-35(1)(b) of the  Income Tax Assessment Act 1997 (Cth) (‘the ITAA 1997’); alternatively

(ii)        section 8-1(1) of the ITAA 1997;

in the year of income ended 30 June 2000 for writing off as bad an amount of $310,881,702.40 (‘the TM debt’) in respect of a loan (‘the TM loan’) made by Finance to Titanium Minerals Pty Limited (‘TM’);

(b)        a deduction under:

(iii)       section 25-35(1)(b) of the ITAA 1997; alternatively

(iv)       section 8-1(1) of the ITAA 1997

in the year of income ended 30 June 2000 for writing off as bad an amount of $1,845,833,281.34 (‘the DRI debt’) in respect of a loan (‘the DRI loan’) made by Finance to BHP Billiton Direct Reduced Iron Pty Ltd (‘DRI’);

(2)        the provisions of Part IVA of the Income Tax Assessment Act 1936 (Cth) (‘the ITAA 1936’) did not apply to cancel any deduction to which Finance was otherwise entitled in respect of the write off of the TM debt; and

(3)        Division 243 of the ITAA 1997 did not apply to deductions claimed by BHP Billiton Limited (‘BHPB’) in respect of expenditure on assets belonging to DRI.

Issues – Live and Abandoned

4                     The issues raised by these appeals can be reduced to the following:

The ss 25-35(1)(b) / 8-1(1) Deductions

(1)               Whether, as the primary judge found, Finance carried on a business of lending money – Issue [2(1)]; and, if so,

(2)               Whether, as the primary judge found, the TM loan and the DRI loan were made by Finance in the ordinary course of that business – Issue [2(2)].

(3)               The appellant (‘the Commissioner’) also grounded his appeal in relation to the TM loan on the basis that, contrary to the primary judge’s finding, the TM loan was not bad when Finance wrote it off.  The Commissioner now accepts it was bad and abandoned this ground.

(4)               Likewise, Finance abandoned its contention below that s 25-35(1)(a) was engaged, a contention which the primary judge rejected on the ground that no interest was written off as bad.

Part IVA

(5)               Whether, as the primary judge concluded, the Commissioner was entitled to rely on s 169A(3) of the ITAA 1936 in making a determination under s 177F(1)(b) of the ITAA 1936 at the time of considering Finance’s objection to an anterior assessment – Issue [2(5)].

(6)               Whether the steps in the scheme identified by the Commissioner, comprising Finance’s acquiescence in the revocation of BHPB’s letter of comfort, the entry into the deed of support, calling for payment of the debt owed by TM and the write off of the TM debt gave rise to a tax benefit or whether, as the primary judge found, the steps in the scheme did not alter the fact that the TM debt was bad and was a debt that Finance was entitled to write off as bad whether the steps in the scheme identified by the Commissioner were taken or were not taken – Issue [2(6)].

(7)               If, contrary to the primary judge’s finding on the issue in (6), Finance did obtain a tax benefit in connection with that scheme, whether, having regard to the eight matters in s 177D(b), Finance or another party which entered into it or carried out the scheme, did so for the sole or dominant purpose of enabling Finance to obtain a tax benefit in connection with the scheme – Issue [2(7)].

Division 243

(8)               Whether any or all of the loans from Finance to DRI were ‘limited recourse debt’ within ss 243-20(1) or (2) of the ITAA 1997 – Issue [2(8)].

5                     Save in the context of the application of Part IVA, the Commissioner abandoned his grounds of appeal in relation to penalties by way of additional tax on the basis that it was reasonably arguable that Finance correctly claimed the disputed deductions.

The Facts

The BHPB Group and the Role of Finance in the Group

6                     The primary judge made comprehensive findings of fact in relation to the BHPB Group (the ‘Group’) and its management, as well as in relation to the role of Finance in the Group.  At [6] and [97] of her reasons, her Honour made the point, which was not disputed on appeal, that the evidence upon which these findings were made was not the subject of challenge or dispute.

7                     For the sake of the reader’s convenience and immediate reference, her Honour’s findings at [7] – [24] of her reasons are set out below:

‘(a)      The BHPB Group

[7]        BHPB was incorporated in 1885 and is the ultimate parent company of a diversified group of multinational natural resource companies.  In the 1990’s, the period with which these proceedings are primarily concerned, the BHPB Group’s principal areas of business were: the minerals group which undertook minerals exploration, production and processing principally of coal, copper, iron ore and manganese ore; the petroleum group which undertook hydrocarbon exploration, production and refining; and the steel group which undertook steel production and group corporate services.

[8]        The BHPB Group’s corporate services group provided transactional services to other members of the BHPB Group including in the areas of finance, treasury and accounting, human resources and supply and procurement.  Finance, the applicant in VID 788 of 2006, formed part of the treasury section of the corporate services group.

(b)        Finance

[9]        Finance was incorporated on 29 August 1975 as a wholly owned subsidiary of BHPB “for the purpose of borrowing funds to re-lend to Group companies”.  Its Memorandum of Association records one of its objects is “to carry on the business of financier in all its branches both within and outside Australia”.

[10]      From September 1985, Finance was registered as a financial institution and a short term money market dealer / operator for the purposes of the Financial Institutions Duty Act 1982 (Vic) and s 98I of the Stamp Duties Act 1920 (NSW) [repealed by the State Revenue Legislation Amendment Act 2008 (NSW)].  By the early 1980’s, Finance had commenced raising finance from external lenders.  From the early 1990’s, virtually all external borrowings of the BHPB Group to fund activities and projects of the BHPB Group were undertaken by Finance. 

[11]      Centralisation of the financing activities of the BHPB Group within Finance provided, what were described as, numerous “administrative and corporate efficiencies” including ensuring that lenders and financiers dealt with one entity whose business could be readily understood by the finance community, centralisation of the foreign exchange operations of the BHPB Group for better monitoring and control of the group’s total foreign exchange exposure and hedging activities (with foreign exchange gains and losses being treated on revenue account) and enhanced transparency of the BHPB Group’s financial results by separating financing activities from operations. 

[12]      As the principal financier, Finance raised money from financial institutions outside the BHPB Group by way of loan facilities, the issue of commercial paper and medium term notes.  Each year, the BHPB board set the borrowing limits and the borrowing program to be carried out by Finance for the next 12 months.  That program stipulated the proportions of short and long term debt, the mix of fixed and floating interest rate debt and the mix of currencies in which funds were to be borrowed.  For example, for the financial year ended 31 May 1996, the BHPB board granted approval for loan and other financing facilities in the name of Finance (or any other wholly owned subsidiary) for an amount not exceeding $2,275 million.  A committee of the board, consisting of two or more of the Managing Director, the Executive General Manager Finance and the Corporate Treasurer was appointed for the purposes of, inter alia, “[a]pproving, executing, delivering and performing all terms and conditions and documentation of loan and other financing facilities to be arranged by [Finance] or any other wholly owned subsidiary up to a total of $2,275 million and all terms and conditions and documentation of guarantees to be issued by [BHPB] in respect of these facilities”.

[13]      Consistent with the annual resolutions of the board of BHPB, over the relevant period Finance raised large sums of money from a variety of sources:

1.         From banks and financiers outside of the BHPB Group by way of medium to long term facilities and by way of short to medium term facilities.  In the period from 17 December 1986 to 8 May 1996, Finance was the borrower under medium to long term facilities totalling billions of dollars in various currencies from numerous international financial institutions including:

2.         By the issue of promissory notes and commercial paper to raise short to medium term finance such as:

[14]      In addition, Finance entered into interest rate and currency exchange swaps with third party financial institutions to limit exposure to risks of fluctuations over the short and long term.  Samples of some of the agreements entered into by, and information memoranda issued by, Finance were tendered in evidence.  In respect of each loan agreement in evidence, Finance was the borrower with its obligations guaranteed by BHPB.  It was also the issuer of the information memoranda (guaranteed by BHPB) and it was the contracting party to the Master Swap agreements (with the obligations guaranteed by BHPB).

[15]      During the 1990’s, Finance’s board comprised senior executives from the BHPB Group.  By way of example, from 1996 to 1999, Mr GW McGregor, the Executive General Manager Finance for the BHPB Group, was also a director of both BHPB and Finance. 

[16]      Finance did not have its own staff.  It utilised the services of BHPB for which it paid management fees.  The fees reflected the proportion of time BHPB personnel spent in providing services to Finance.  In the case of Finance, most of the services provided by BHPB were accounting and treasury personnel.

[17]      The BHPB treasury personnel had responsibility for determining the cash flow requirements of the BHPB Group using data provided by the operating divisions and relevant corporate staff, arranging the funding of those requirements and determining the form in which the funds would be raised.  Performance of those tasks was subject to “Treasury Guidelines” prepared annually by the Treasurer & Vice President Corporate Finance which were then reviewed by the Chief Financial Officer and ultimately approved by the BHPB board.  The guidelines provided a series of rules and protocols for a wide range of matters including credit limits (the total amount that could be borrowed from third parties), foreign exchange risk management, guarantees, interest rate and currency swaps, loan facilities and money market activities.

[18]      The cash flow requirements of the BHPB Group were assessed on an annual basis through the preparation of annual rolling budgets.  Each business unit prepared a budget.  Those budgets were then aggregated to form the BHPB Group budget which was ultimately approved by the BHPB board.  Preparation of the BHPB Group budget commenced in the March preceding the commencement of the next financial year.  The budget forecasts (cash inflows and cash outflows) were prepared for five years on a rolling basis.  The forecasts took into account “operating revenues, new (and yet to be approved) capital investments, capital expenditure sustaining existing projects, exploration expenditure and operating costs”.  Once the budget was approved by the BHPB board, the budget necessarily identified the cash flow shortfall.

[19]      The manner in which the shortfall was funded was determined by the Corporate General Manager Taxation, the Corporate Treasurer and, ultimately, the Corporate General Manager Accounting.  During the relevant period, the policy was recorded in Section 21.19 of the BHPB Accounting Policy Manual as at May 1996 entitled “Funding of Group Companies” in the following terms:

Details of proposed equity and / or debt funding of new group companies, or of revised funding structures for existing group companies, should initially be provided to the Corporate General Manager Accounting.

Proposals will be passed on to the Corporate General Manager Taxation and to the Corporate Treasurer for review.

The Corporate General Manager Accounting will provide Business Groups with a written “sign off” once the Corporate General Manager Taxation and the Corporate Treasurer have indicated that the proposed funding structure is acceptable.  The proposed funding structure should only be put in place upon receipt of this “sign off”.

Continuous Review

Capital funding structures of controlled entities should be reviewed regularly to ensure that the structure remains appropriate to the entities’ operational and financial standing.

For example, the 100% debt funding of an existing company’s activities, other than on a temporary basis, is generally considered to be inappropriate.  Similarly a company with high debt and little equity may need to have its structure reviewed if the consequential interest burden is leading the company into negative shareholder funds.

Reviews of company funding structures must be done in collaboration with the responsible taxation officer.

[20]      Before turning to consider the projects the subject of dispute in these proceedings, other aspects of the funding of group companies should be noted.  First, most BHPB Group companies with bank accounts in Australian currency were part of an ANZ (AFT) sweep facility arranged through Finance.  At the end of each day, each account balance was automatically transferred to a single bank account held by Finance.  A similar arrangement was set up between Finance and Chase Manhattan Bank for BHPB Group companies with bank accounts maintained in US dollars.  A positive bank account of a BHPB Group subsidiary swept to Finance resulted in a credit to the subsidiary’s loan account with Finance and each negative balance swept to Finance resulted in a debit to the subsidiary’s deposit account with Finance.  Any surplus cash would then be placed by Finance on the overnight money market with third party financial institutions.

[21]      Secondly, as a result of the process of capital expenditure approval, selection of appropriate funding structures and the banking arrangements referred to in these reasons for decision, the value of loans made by Finance to BHPB Group companies totalled billions of dollars.  For example, in the 1995 and 1996 years of income, Finance made loans to the entities listed in Schedule A totalling in excess of $17 billion.  Finance had standard lending terms for the inter-company loans which, for the relevant period, were adopted by resolution of the board of Finance on 30 November 1994.  Those terms provided:

… intercompany loans granted by [Finance] to [BHPB] or its subsidiaries (together the “[BHPB] Group”) from 1 December 1994 will, unless special terms are negotiated for a particular loan, be subject to the following conditions:

a)         The interest rate will be 10.45% per annum or such other rate as may be nominated in advance from time to time by [Finance] as the relevant [BHPB] Group intercompany loan rate.  Such interest shall be due and payable within 21 (twenty-one) days of the day on which the relevant outstanding loan is repaid.

b)         Loans are to be made up of such amounts and are to be advanced on such dates as are agreed orally from time to time by the borrower and [Finance].  Each initial loan and each additional loan is to be for a period not exceeding five months at which time all loans shall become immediately repayable.

c)         The currency of each loan will be Australian Dollars.

d)         The application of the loan funds will be to fund normal operating activities including research and development where applicable, of the borrower.

e)         Commitment fees will not apply.

f)          Unless otherwise designated, any repayments shall be applied to reduce the earliest outstanding advance and then be applied first against individual loans in excess of $50,000.

g)         For administrative convenience, each loan made by [Finance] under this arrangement will be entered into the one loan account.  However it is acknowledged that each amount advanced is a separate loan.

h)         [Finance] will consider renewing loans at the close of each five month period should the borrower advise (orally) that it wishes to do so. 

[22]      One relevant change to these terms and conditions was an adjustment to the inter-company interest rate on 3 March 1995 as a result of a review undertaken by officers from the departments of Corporate General Manager Taxation and Manager Corporate Accounting.  After that review, the Corporate Treasurer recommended the following rates apply:

Australian Dollars

11.40%             on funds advanced by [Finance]

7.40%               on funds borrowed by [Finance]

Where interest payments/receipts are made/received sixty (60) days in advance, the following rates apply:

11.20%             on funds advanced by [Finance]

7.20%               on funds borrowed by [Finance]

…

Would you please ensure that all subsidiaries are advised of these rates.

[23]      As a result of the standard loan terms and in particular cll (b) and (h) of those loan terms (see [21] above), each loan from Finance to a BHPB Group member (including BHPDRI and BHPTM the subject of dispute in these proceedings) was for a five (5) month term. 

[24]      It is not in dispute that the interest rate charged on loans from Finance to BHPB Group companies was higher than the interest rate at which it borrowed those funds from external third parties and from other members of the BHPB Group.  Interest derived by Finance on the loans made to BHPB Group members accrued on a daily basis and was returned as assessable income on an accruals basis in Finance’s income tax returns.  As a result of the activities of Finance, it earned substantial interest income generating substantial accounting profits after tax and taxable income.  The gross interest income, the accounting profits (after tax) and the taxable income of Finance from 1986 to 2002 (before rebates and deductions for tax losses carried forward by or transferred to Finance) was as follows:

DRI

8                     The primary judge also undertook separate consideration of the projects constructed and operated by DRI and TM.  Her Honour’s findings in relation to DRI are taken from [26] – [58] of her Honour’s reasons.  Again they are not in dispute:

‘(c)      BHPDRI

[26]      This project involved the construction of a HBI plant at Port Hedland in Western Australia to produce briquettes from iron ore fines which, in 1995, were not only considered to have little if any economic value but were an impediment to the extraction and sale of ore because of the area required to store the fines.  The intention was that “the production and sale of HBI would convert fines with little value to a valuable product and would provide further economic value for the BHPB group” by: (1) enabling more lump ore to be extracted and sold; and (2) satisfying obligations imposed upon BHPM by the Western Australian Government to undertake secondary processing of iron ore in that State.

[27]      Advice and assistance was sought by BHPIO (TB Janes) about the capital structure of BHPDRI in June 1995.  At that time, BHPDRI had paid up capital of $20 million and a submission to the BHPB board seeking approval for expenditure to build a HBI plant near BHPB’s Port Hedland operations had not yet been considered by the BHPB board.  If the total expenditure for the project was ultimately approved, $300 million was forecast to be spent in the 1996 year.  On the assumption that approval from the BHPB board was obtained, on 15 June 1995 BHPIO requested advice and assistance on the preferred capital structure and debt/equity mix and to put the necessary arrangements in place for the issue of additional equity, the establishment of an appropriate inter-company loan and to ensure that the internal funding procedures were correct.

[28]      On 16 June 1995, the Chief Executive Officer of BHPM (Mr JK Ellis) sought approval from the BHPB board for the expenditure of A$1,550 million to build the HBI plant near BHPIO’s Port Hedland operation.  The HBI capital expenditure submission recorded that based on 100% BHPB ownership of the project’s assets (other than the tunnel), inter alia:

1.         the nominal IRR of the proposal was 22.1% (17.7% real) with a payback period of 5 years from project completion in June 1998;

2.         the incremental NPV was:

                                                                                    A$M

at 15% discount rate on real cashflows                           160

at 12.5% discount rate on nominal cashflows                   870

at 8.25% discount rate on real cashflows                                    940

3.         the forecasted results reflected the strategic and incremental benefits to the BHPB Group as a whole and, in particular, BHPB’s iron ore business, from the construction of the proposed HBI plant.

[29]      The BHPM Capital Procedures Manual in place in June 1995 dictated the structure and content of capital expenditure submissions including the HBI capital expenditure submission.  For example, it was the Manual which required, inter alia, that:

1.         submissions were authorised by the BHPB board on the basis of their BHPB Group impact and therefore had to be presented from that perspective.  All inter-business group and inter-divisional group implications had to be considered including the strategic importance to BHPM, the relationship or impacts on the performance of other parts of BHPB and the rationale supporting the expenditure:  Sections 2.2, 3.2, Appendix 1 – Submission Checklist.

2.         all projects had to be in the first instance evaluated on an ungeared or unleveraged basis to highlight the basic return on total assets employed by the project:  Appendix 4 – Common Pitfalls of Investment Analysis.

[30]      The board submission (see [28] above) was supported by a two volume feasibility report comprising (1) a detailed HBI Facility Financial Model and (2) BHPIO Consolidated and Entity Financial Summaries which had been prepared on two distinct bases.  Summaries for ten entities were included, one of which was BHPDRI.  Each entity summary considered the project on a stand alone basis for that respective entity on stated assumptions.  For BHPDRI, on the assumptions stated, the summary assessed the HBI plant as having a nominal DCF rate of return of 3.5% over 20 years or with an NPV at 10% of negative $606 million. On 20 June 1995, consistent with Section 21.19 of the BHPB Accounting Policy Manual as at May 1996 entitled “Funding of Group Companies” (see [19] above), the Corporate Treasurer reviewed the HBI capital expenditure submission and expressed a number of concerns about the proposal to the Executive General Manager Finance. 

[31]      On 28 June 1995, BHPM (Taxation) provided the advice sought by BHPIO in its memorandum of 15 June 1995 (see [27] above).  The advice was in the following terms:

In response to your note of 15 June 1995, I feel it will be appropriate for BHPDRI to continue as the project entity.

Consideration should be given to funding with debt up to a level which is consistent with commercial debt funding levels for major industrial undertakings.  You will recall that in the case of the Pilbara Energy project, a debt:equity ratio of approximately 3:1 was arrived at.

I envisage that [Finance] would lend to BHPDRI at the inter-company rate of interest.

…

There would be a very substantial pool of tax losses generated in this entity in initial years of development and operation from interest, R&D and capital depreciation.  This will provide [BHPB] the desirable flexibility to utilise such tax losses under group tax relief arrangements to offset income and tax payments in other parts of the [BHPB] group.  If [BHPB] invites future external participation in the project, arrangements should be structured to allow BHPDRI to remain a 100% [BHPB] entity so that project tax losses could continue to be transferred for the benefit of the Group. …

[32]      The next day, 29 June 1995, the board of BHPB approved capital expenditure of A$1,550m on the HBI project.  The presentation to the BHPB board was made by the Chief Executive Officer of BHPM, Mr JK Ellis.  Subsequent to the presentation and in response to questions raised during the presentation, on 5 July 1995 further details were provided by Mr Ellis to the Managing Director of BHPB about the profit impact of additional ore sales and the composition of the consequential capital of $1,200m included in the HBI cash flow analysis.

[33]      What then occurred was not explained other than in the most general terms.  However, the loan facility for BHPDRI was established with Finance.  It was not in dispute that the terms of that loan were in accordance with Finance’s standard lending terms for inter-company loans which were adopted by resolution of the board of Finance on 30 November 1994 set out at [21] above.

[34]      As a result of the standard loan terms and in particular cll (b) and (h) of those terms (see [21] - [23] above), each loan was for a five (5) month term.  To accommodate the fact that at the end of each five month period a fresh advance was made, there were two loan accounts for the loan to BHPDRI from Finance – account numbers 325320 and 326320 – which were used for alternate 5 month periods.  Initially loan account 326320 was used.  The opening entry in that account on 31 July 1995 was a debit entry of $8,200,137.58 with the notation “I/CO TRANSFER REF G KERNI”.  On 1 October 1995, that loan account with a debit balance of $20,422,717.50 was closed and a new advance in the sum of $20,422,717.50 was made by Finance to BHPDRI in account number 325320. 

[35]      In October 1995 and May 1996, the directors of BHPDRI resolved to allot 35 million and then, subsequently, 75 million $1.00 shares to BHPM Holdings. 

[36]      During September and October 1996, an exhaustive review of the HBI project was undertaken.  As a result of that review, two events occurred in November 1996.  First, on 12 November 1996, BHPIO (T Janes) revisited the question of the capital structure of BHPDRI which had been adopted in June 1995 (see [31] above) and secondly, BHPM sought approval from BHPB for additional capital expenditure of A$140 million over and above that approved in June 1995.  That capital expenditure submission was prepared in accordance with the Applicable Capital Procedures Manual then in place dated October 1996.

[37]      Prior to the further capital expenditure submission being considered by the BHPB board, both the question of the appropriate debt/equity mix and funding structure for the capital expenditure, consistent with the BHPB Accounting Policy Manual (see [19] above), was considered by Corporate Taxation.  Approval was received for:

1.         an equity investment of $370m to be made by BHPM Holdings in BHPDRI after 31 December 1996; and

2.         to continue the equity funding of BHPDRI on the basis of a 50 / 50 debt to equity ratio (as had existed).

[38]      In reaching those conclusions, the required debt to equity level was considered.  The advice provided by BHPM Taxation on that issue was that:

… it has been seen that the selection of a debt to equity ratio is a matter of choice.  The selection should therefore take into account the intended purpose of the company.  This company will primarily be involved in the export sale of beneficiated product where it maybe [sic] competing directly with local suppliers in foreign countries.  From past experience with claims that our companies are resorting to unfair competition by dumping produce on foreign markets based on the observation that the particular companies never make any profits we need to ensure that this company is not saddled with a level of debt that leads to it being branded in the same way.  For this reason we consider that the current debt to equity ratio (50%/50%) should be maintained.

[39]      On 29 November 1996, the BHPB board approved revised capital expenditure on the HBI project from A$1,550,000,000 to $1,673,600,000.  The approved increase was $123.6m.  Consistent with the advice received from Corporate Taxation, on 30 January 1997 the directors of BHPDRI resolved to allot 370 million $1 shares to BHPM Holdings. 

[40]      As the general ledger for the loans from Finance to BHPDRI records, Finance advanced funds to BHPDRI which, together with the subscriptions of capital, were used progressively to pay expenses incurred by BHPDRI in the development and construction of the HBI plant.  In addition, the general ledger trial balance recording the loan from Finance to BHPDRI reflects that the loan was conducted in accordance with Finance’s standard lending terms for inter-company loans adopted by resolution of the board of Finance on 30 November 1994 (see [21] - [23] above). 

[41]      In August 1997, BHPB’s Managing Director (Mr Prescott) asked Mr McGregor to conduct a review of the HBI project.  At that time, one of the central issues raised by Mr Prescott was that, from the start of the project, not all of the risks associated with the project were understood.  At the time of the review, Mr McGregor was Executive General Manager Finance for the BHPB Group as well as a director of both BHPB and Finance.  The review was completed by 11 September 1997 (“the HBI Audit Report”).  The HBI Audit Report attached to the memorandum from Mr McGregor is important.  That report stated, inter alia, that:

1.         the projected NOPAT [net operating profit after tax] and ROC [return on capital] from the HBI plant per se were very modest, which was recognised at the time of the initial capital submission;

2.         escalation in Capex and cash operation costs (thought to be $140 per tonne) meant that the HBI project on a stand alone basis would not generate a return in excess of 1.5% to 2.5%.  (This is to be compared with the fact that the Detailed Capital Submission Report in 1995 showed that the HBI Plant on a stand alone basis had a DCF rate of return of 3.5%);

3.         HBI was a low margin business that needed cheap gas, cheap electricity, low capital costs and low operating cost to succeed and the HBI project was challenged in relation to each of these matters.

[42]      At that time, the choice was to abandon the project altogether or persist with completion as economically and expeditiously as possible.  In the best interests of Finance and the BHPB Group, Mr McGregor concluded that “a forward view of the project reveal[ed] that there [was] no case to be made for either abandoning the project or slowing it down [and that] the only sensible course of action [was] to complete the project as expeditiously and cheaply as possible”.  As a result, Mr McGregor sought approval for total capital expenditure on the HBI plant of $2,275 million plus $128 million for commissioning costs.  Consistent with the McGregor recommendation, on 18 November 1997, the Chief Executive Officer of BHP Ferrous Minerals forwarded to the Managing Director of BHPB (Mr Prescott) a memorandum entitled “[HBI] Project Supplementary Authorisation” seeking additional capital expenditure of $730 million, an increase of 44% above the existing authorisation.  Based on an incremental cost to complete the project of $550 million, the memorandum reported that (1) the incremental NPV (nominal at 12.5%) was expected to be $888 million with a nominal IRR of 32.3% and (2) if the project did not proceed, the associated NPV loss was expected to be $429 million.  The projected cash flows from the HBI project were set out in Attachment 1 to the “[HBI] Project Supplementary Authorisation” to be:

The uncontroverted evidence was that these projected “cash flows” were calculated prior to commissioning of the project by reference to the outgoings incurred, and then, after commissioning, were calculated by deducting expected costs and the cost of replacement of capital from projected revenues.  By year six, the projected cash flows were positive.  A payback period of six to seven years was expected.

[43]      Mr McGregor’s recommendation together with the supplementary capital expenditure submission was considered and accepted by the BHPB board on 27 November 1997.  After the board meeting, the Managing Director of BHPB (Mr Prescott) forwarded a memorandum to the Chief Executive Officer BHP Ferrous Minerals, copied to the Executive Director Finance, on 1 December 1997 in the following terms:

I confirm that the Board at its meeting on 27 November gave approval for completing and commissioning the Pilbara HBI project as recommended in your memo of 18 November 1997.  In so doing the Board gave approval for the expenditure of an additional $730 million on the project comprising $668 million in additional capital spending and $62 million in additional capitalised pre-commissioning operating expenditure.

In implementing this approval the following imperatives apply:

1.         Every effort must be made to improve the commercial outcomes of the entire project.

2.         There is to be clear and thorough reporting of all significant developments in a timely fashion including all management action to address issues that may arise or opportunities for project outcomes to be improved.

3.         This reporting is to be monthly through Iron Ore’s Business Reports and through appropriate comments in the Managing Director’s Report, also monthly through Project Management’s Business Report and quarterly (or more frequently if required) in the Business Reports presented to the Board.

4.         We are to pursue the proposal to sell down 15% of the project to our Japanese partners in our other iron ore businesses.

5.         We are to further investigate the advantages and disadvantages of iron ore feed price alternatives to the plant.

A copy of this memorandum was sent to Mr Lance Coburn who at this time was the Group General Manager, BHPM Finance.  In his capacity as Group General Manager, BHPM Finance, Mr Coburn had responsibility for the financial aspects of BHPM, which included preparation of statutory accounts for most of the entities within BHPM, and responsibility to ensure compliance with BHPB Group policies and procedures in preparation of capital expenditure submissions and compliance with capital expenditure approvals.

[44]      On 5 December 1997, the Group General Manager BHPB Budgets and Accounting sent a note to Mr McGregor (at that time the Executive General Manager, Finance and a director of Finance) entitled “Asset Carrying Values”.  The note listed those assets which did not or would not provide a return of 10% or greater by May 1998 based on current book values.  One of the assets listed was the HBI plant as a stand alone asset.  The NPV of that operation based on book value determined on a 10% DCF basis was negative $657 million.  This value did not include any benefits from the plant to be derived by the iron ore mines.

[45]      Construction of the HBI Plant continued throughout 1998.  Two critical events occurred during the course of that year.  At the end of the 1998 financial year (31 May 1998) the board of BHPB changed its accounting policy for determining the recoverable value of non-current assets from undiscounted future net cash flows to discounted cash flows using the weighted average pre-tax interest rate of the BHPB Group’s long term borrowings.  This change was adopted to reconcile the accounts prepared under the Australian generally accepted accounting principles (“GAAP”) with those applicable under United States GAAP.  As a result of this change, adjustments were made to the recoverable value of non-current assets which resulted in changes to BHPB’s profit and shareholders’ equity.  In the case of BHPDRI, as at 31 May 1998, the carrying value of BHPDRI’s non current assets was written down by $590 million.  The financial effect of the write down was to reduce the carrying value of certain assets of BHPDRI by that amount and to reduce BHPDRI’s profit by $377,600,000 (after tax).

[46]      The second event was an update on the HBI project presented to the BHPB board on 27 November 1998.  By that time, construction of the plant was “largely complete” with the first briquette expected at the end of January 1999.  However, there were still problems.  The US scrap price had plunged to new depths and the estimated sales of briquettes would not require full plant capacity once the plant was completed and commissioned.  At that time, the options were to “[c]ommission all trains on current schedule (1/99, 4/99, 5/99, 6/99) [and] Operate 1 train and others necessary to meet market” or “Defer Completion & Commissioning Module 2 [and] Commission & Operate When Market Justifies (2002?)”.  On 30 November 1998, the BHPB board agreed that BHP Ferrous Minerals “should complete construction of the entire plant, commission all trains on [the] current schedule and then operate only those trains necessary to meet (R&D) testing and product sales requirements”.

[47]      Consistent with the recommendation and subsequent approval by the BHPB board, train 1 of the HBI Plant was commissioned in early January 1999.  However, it was shut down after 10 days because of production difficulties associated with the reduction process to produce DRI.  The production difficulties were caused by the iron ore and partly reduced material not flowing continuously through the reactor train.  There were frequent, sudden flow stoppages which upset the process and any attempt to balance the heat and mass flows in the reactor.  In addition, the stoppages greatly increased the rate of accretion growth which required the reactors to be cleaned every 25 rather than every 160 days.  At the end of the 1999 financial year, the carrying value of the HBI plant was written down by a further $531 million after tax. 

[48]      On 21 July 1999, a letter was sent on BHPB letterhead from Joe Czyzewski, a director of Finance, to the directors of BHPDRI in the following terms:

[Finance] is aware that [BHPDRI] has commenced selling product and is working towards generating a viable cash flow in order to service its loans.

In the circumstances, [Finance] confirms that it does not intend for the period of twelve month’s (sic) from the date of this letter, or for such shorter period as we may specify at our election, intend to seek repayment of any loan it may have with [BHPDRI] but shall keep the company’s commercial performance under ongoing review. 

Prior notice shall be given to you should it become necessary for [Finance] to take action in respect of any loan.

[49]      In March 2000, a further review of the HBI project was undertaken in response to the BHPB board’s concerns about current performance of the operations and the inability of the plant to meet commissioning targets.  At the BHPB board meeting on 23 March 2000, a presentation was made about the future of the HBI plant.  The board resolved: (1) that trials to assess the technical adequacy and commercial viability of the HBI facility should proceed until September 2000 when the board would again review the investment; and (2) to approve additional capital expenditure of $46 million.  At the same time, a review of the carrying value of the asset was to be completed by the end of April 2000.

[50]      The board of Finance met on 30 March 2000.  After noting the decisions of the BHPB board on 23 March 2000 and that BHPDRI was indebted to Finance in the amount of $2,113,944,530, the Finance board resolved to write to the BHPDRI directors to advise them that Finance would conduct a review of the loan by engaging Ernst & Young as independent experts to report on the valuation of the loan.  Pending receipt of the Ernst & Young report, the directors of Finance agreed that a provision be made against the loan in Finance’s books by adopting the “worst case” scenario which indicated a negative carrying value of the loan.  Further consideration of the question of interest on the loan was deferred pending receipt of the Ernst & Young report.  Moreover, the directors of Finance agreed to review the provision of further loans to BHPDRI after discussions with BHPB management and to keep the BHPDRI loan under close review.  On 3 April 2000, Finance informed BHPDRI of these matters.  

[51]      As a result of Finance making provision on 31 March 2000 of a $2,174 million doubtful debt for its loan to BHPDRI, Finance was left with negative net assets in excess of $940 million.  The BHBP Group Treasurer (Mr Czyzewski) was concerned that if the situation was not corrected, Finance may have been in breach of its various loan and financing arrangements.  Accordingly, on 7 April 2000, he sought immediate approval for BHPB to seek an allotment of 950 million ordinary fully paid up shares in Finance (the consideration for such an allotment was to be $950 million). 

[52]      On the same day that approval was sought for BHPB to seek allotment of 950 million shares in Finance (7 April 2000), the Chief Financial Officer of BHPB wrote to BHPDRI in the following terms:

At its meeting on 23 and 24 March 2000 the Board of [BHPB] approved additional funding of [BHPDRI] until September 2000.  [Finance] has discussed the provision of further loan funds to [BHPDRI] through the existing intercompany loan facility and advised that it is unable to fund the further approved expenditure.

The shareholder of [BHPDRI], [BHPM Holdings] has agreed to inject equity into [BHPDRI] with a total issue price of $150 million.  This equity injection will be completed immediately.  [BHPB] has agreed to subscribe for equity in [BHPM Holdings] as may be necessary to enable [BHPM Holdings] to meet the equity injection into [BHPDRI].

[53]      Approval for BHPB to seek an allotment of 950 million shares in Finance was provided and, on 11 April 2000, the directors of Finance resolved to allot 950 million ordinary fully paid $1.00 shares to BHPB. 

[54]      At the same time, BHPB Accounting and Reporting made changes to the loan account between Finance and BHPDRI on 10 April in the following ways:

The current loan account between [Finance] and [BHPDRI] (account number 23700011) will be ‘frozen’ at the 31 March 2000 closing balance, including capitalised interest yet to be booked to that date (Note:  there have been no transactions since 1 April 2000).

To facilitate the day to day cash transactions of [BHPDRI], an intercompany loan account between [BHPB] and [BHPDRI] has been established and should be used from today.  The account number is 23700012 and is a standard [BHPB] short term, interest free loan.

Following the $150 million equity injection, this intercompany loan account must be maintained as an asset loan (debit balance) in [BHPDRI’s] accounts as the funding of HBI operations is via equity not the loan facility.  A request for further equity funding will be necessary if required. …

(emphasis in original). 

[55]      After providing their preliminary views in April 2000, Ernst & Young tendered their report on the valuation of the BHPDRI loan receivable to the directors of Finance on 3 May 2000.  Ernst & Young concluded that the value of the HBI plant did not exceed $346 million and had a nil value if the plant was closed.  The report was considered by the directors of Finance at a meeting of the board held on the day the report was issued, 3 May 2000.  The directors resolved that:

1)         the Directors having made due inquiries and on the basis of the advice and conclusions given to Directors by the independent expert, have formed the view that the amount of $1,845,833,281 lent to [BHPDRI] is irrecoverable and bad and be written-off as bad;

2) (a)    the entries be made in the accounts of [Finance] to record the write-off of the irrecoverable amount pursuant to Resolution 1 forthwith; and

    (b)    the provision continue to be carried against the balance of the loan not written-off being $346,000,000.00.

3)         subject to the above accounting entries being completed, [BHPDRI] be subsequently notified that due to the poor financial condition of [BHPDRI] it would not be economically prudent to expend additional monies in taking proceedings to recover any or all of the said monies once they have been written off …

The Directors went on to note that interest on the loan would continue to be capitalised on the balance not written off and provided as doubtful. 

[56]      On 10 May 2000, Finance wrote to both the directors of BHPDRI and to BHPDRI advising of the loan write off of $1,845,833,281 against the outstanding principal and interest of $2,191,833,281 and that following the write off, the directors of Finance had resolved not to take any further action to recover the debt written off as it appeared practically irrecoverable but that Finance reserved the right to recover the balance.  The letter went on to state that Finance did not intend to seek repayment of the balance for the period up to 15 June 2001.

[57]      On 18 May 2000, the directors of BHPDRI resolved to allot 150 million $1 shares to BHPM Holdings.  On 31 May 2000, BHPDRI wrote off the balance of its HBI investment in the sum of $794 million after tax.  Towards the middle of 2000, things appeared to improve after significant further capital expenditure expended to alter the process conditions within the reactor essentially resolved the initial problems. 

[58]      At 30 June 2000, BHPB applied Div 245 of Schedule 2C of the 1936 Act to cancel the losses and Finance claimed the bad debt deductions under s 25-35(1)(b) of the 1997 Act.’

TM

9                     Her Honour’s findings in relation to TM are taken from [61] – [87] of her Honour’s reasons.  Again they are not in dispute:

‘[61]     BHPTM (known as Mineral Deposits Pty Ltd until 14 July 1995) had a long history of mining titanium minerals.  It had titanium minerals mining operations and a processing plant in New South Wales.  BHPTM also held a mining lease over a large resource of titanium minerals (predominantly ilmenite) at Beenup in Western Australia.

[62]      In November 1994, the proposal was to develop ilmenite mining and processing facilities at Beenup in Western Australia and to purchase an interest in an existing ilmenite smelting facility at Tyssedal in Norway.  The proposal was to mine the ore body (containing ilmenite and other heavy minerals) at Beenup and to truck the heavy mineral products to the Port of Bunbury for export to the Tyssedal Facility and other users.  The mine and associated processing facilities were to be conducted by BHPTM. 

[63]      On 15 November 1994, the Chief Executive Officer of BHPM (Mr JK Ellis) sought approval, by way of submission, from the BHPB board for the expenditure of A$222.6 million for the purpose of developing the mining and processing facilities at Beenup in Western Australia and the purchase of an interest in the existing Tinfos ilmenite smelting facility at Tyssedal in Norway.  The capital expenditure submission recorded, inter alia, the nominal IRR of the proposal was 19.1% (15.2% real) with a payback period of 6.7 years.

[64]      On 21 November 1994, the Corporate Treasurer (Mr Zimmerman) sent a memorandum to the Executive General Manager Finance analysing the BHPM capital expenditure proposal.  At that time, the “major technical risks” were that there was “no mineral sands experience of dredging to 45 metres depth and that the deposit [had] a high slimes content”.  The BHPB board approved capital expenditure of $222,600,000 for the BHPTM project at Beenup on 24 November 1994. 

[65]      The general ledger trial balance recording the loan from Finance to BHPTM reflects that the loan was conducted in accordance with Finance’s standard lending terms for inter-company loans adopted by resolution of the board of Finance on 30 November 1994 (see [21] - [23] above).  As a result of those loan terms and in particular cll (b) and (h) of the standard loan terms, each loan was for a five (5) month term. 

[66]      On 5 July 1995, a two year letter of comfort was provided by BHPB to the directors of BHPTM.  So far as is relevant, the letter stated:

1.         Existing Debts

[BHPB] undertakes to your company to ensure that your company is provided with sufficient funds to pay those debts which your company has elected to incur before the date of this undertaking, if your company is called upon to pay those debts and if, but for this letter, your company would now be insolvent.

2.         Future Debts

[BHPB] undertakes to your company to ensure that your company is provided with sufficient funds to pay debts which your company elects to incur after the date of this undertaking, if your company is called upon to pay those debts, and if, but for this letter, your company would be insolvent at the time when it incurs the debt or as a consequence of incurring the debt.

3.         Meaning of “Debts”

Notwithstanding anything in Clause 1, 2 or 5, this letter applies only to debts which your company incurs or has incurred:

(a)        in the normal course of its operations;

(b)        in accordance with all relevant approved operating and capital budgets, business plans, policies and procedures of [BHPB] or otherwise with the express or implied approval of [BHPB].

4.         Discharge by Payment or Subscription

Without limiting any other right of [BHPB], [BHPB] may completely discharge its obligations under this letter in respect of any debt by subscribing for shares issued by your company with a nominal value equal to the amount of the debt or by paying the amount of the debt to your company at any time.

5.         Termination

5.1        Upon the earlier of:

(a)        the expiry of two (2) years from the date of this letter; or

(b)        your company receiving from [BHPB] a notice which states that this letter is revoked,

this letter shall forthwith cease to be of effect, except in respect of debts which exist before that time.

…

6.         Benefit of letter:  Reliance

This letter is for your benefit of your company and its directors only, and is not to be relied upon by any other person. 

[67]      The loan funds provided by Finance were used to fund the continuing development of the Beenup mine from 1995.  Production at the mine commenced on 13 January 1997.  At that time, BHPTM already had entered into a long term contract to supply ilmenite to a BHPB joint venture in Norway (“the Norwegian Contract”). 

[68]      On 17 July 1997, a second letter of comfort was provided by BHPB to the directors of BHPTM.  Again, so far as is relevant, the letter was largely in the same terms as the first letter of comfort (see [66] above) but for cl 5.1(a) which stated “the expiry of one year from the date of this letter”.  The board minutes of BHPTM resolved that “on the basis of” the 17 July 1997 letter of comfort, there were reasonable grounds to believe that BHPTM would be able to pay its debts as and when they fell due and the board authorised the directors to sign the relevant statement to be provided under s 301 of the Corporations Law.

[69]      By late 1997, BHPTM’s Beenup mine had experienced significant operational difficulties.  The material being mined at Beenup was much harder than expected.  Further complications had arisen in disposing of and storing the tailings from the mining operations. 

[70]      By the end of the 1998 financial year (31 May 1998), the project was continuing to encounter serious difficulties and, as a result, was not meeting its contractual commitments to supply titanium minerals to customers.  Two steps were taken by BHPTM.  First, BHPTM declared force majeure under the terms of the Norwegian Contract and secondly, following a review of the carrying value of assets undertaken as part of the preparation of BHPTM’s financial statements for the 1998 year (ending 31 May 1998), on 18 June 1998 Mr McGregor (as Executive General Manager Finance) recommended to the BHPB board that it approve writing down the carrying value of the Beenup assets by $99 million (after tax) on the assumption that an economically feasible solution would be developed to overcome the operational difficulties at the mine.  As noted earlier (see [45] above), on 31 May 1998, the BHPB Group changed its accounting policy for determining the carrying value of assets. 

[71]      On 9 July 1998, a third letter of comfort was provided by BHPB to the directors of BHPTM.  But for the date, the letter was in the same terms as the second letter of comfort (see [68] above).  The board minutes of BHPTM again resolved “on the basis of” the 9 July 1998 letter of comfort that there were reasonable grounds to believe that BHPTM would be able to pay its debts as and when they fell due and the board authorised the directors to sign the relevant statement to be provided under s 301 of the Corporations Law.

[72]      Between May and November 1998, further work continued on the Beenup mine particularly in relation to the issue of disposal of the tailings.  Throughout this period, the board of BHPB continued to approve and support the operations.  In December 1998, a parallel process examining “exit possibilities” commenced.

[73]      The carrying value of the Beenup assets was again reconsidered during the preparation of the half yearly accounts for the period ended 30 November 1998.  Following consideration of a memorandum prepared by Mr Jim Hall (the Group General Manager BHPB Budgets & Accounting) to the Executive Director Finance dated 3 December 1998, the audit committee of BHPB resolved at a meeting on 17 December 1998 that the carrying value of the Beenup assets be retained at $114 million.  The memorandum recorded:

1.                   at 31 May 1998, the carrying value of the Beenup assets was written down by $150 million (pre tax) to $134 million because of technical and other operational problems;

2.                   between 31 May and 30 November 1998, significant progress had been made on a tailings disposal solution but the work was approximately 4 months behind plan;

3.                   the carrying value for the half year November 1998 was fundamentally unchanged from May 1998 and again assumed an economically feasible technical solution to the technical and other operational problems;

4.                   at the BHPB board meeting on 27 November 1998, a quarterly review of the Beenup project was presented to the board at which time the board agreed to continue with operations and in parallel to examine exit options, including by sale, merger or closure;

5.                   the exit options and valuations were to be formalised by 31 May 1999 and if the closure option was adopted, then in addition to considering the carrying value, the BHPB accounts would need to include allowance for rehabilitation and site closure costs, breach of contract claims from customers and other costs.

[74]      Technical difficulties, however, continued to affect the mine and, in February 1999, a decision was made to close the plant and write off the balance of the carrying value of the investment.  On 26 February 1999, BHPB issued a press release announcing the closure of the mine in the following terms:

The decision follows an extensive study into technical problems caused by the high clay content of the Beenup orebody which had impacted on the management of tailings and the mine’s ability to reach satisfactory levels of production.

President [BHPTM], Mr CE (Colin) Smith said the Company had directed considerable engineering and technical resources at resolving the problems at Beenup over a 12 month period.  “After significant effort, it just wasn’t possible to find a feasible solution that would allow the operations to continue.  … there comes a time when a company has to made hard decisions on a project such as this.  That time has come.  We have taken the engineering and technical research as far as we can.

Mr Smith said [BHPB] had looked for a buyer with access to different technology and alternative business objectives for Beenup, but it had become apparent in recent days that this would not be possible.  The search included major titanium mineral producers and processors around the world.

[BHPB] is committed to continuing to manage and effectively address all environmental issues at the site.  A detailed decommissioning and minesite rehabilitation plan is being prepared …

Costs of the write-off of the current book value of the Beenup assets, site rehabilitation and mine closure are expected to be approximately $150 million after tax.

(Original emphasis.)

[75]      Operations at the plant ceased on 16 April 1999.  After the mine closed, the directors of BHPTM conducted a review of options available to the company and considered the means by which BHPTM might have been able to service its loan with Finance.  That review continued at least from May until August 1999.

[76]      On 31 May 1999, Finance provided approximately $62 million to BHPTM to enable it to repay an overdraft it had with the ANZ bank. 

[77]      On 8 July 1999, a fourth letter of comfort was provided by BHPB to the directors of BHPTM.  Again, so far as is relevant, the letter was largely in the same terms as the second letter of comfort (see [68] above) but for the addition of the words “[i]t does not and is not intended to impose any contractual or legal obligations on [BHPB] in respect of any other person nor bind it to any particular requirement or course of action” to the end of the letter.  Before that letter of comfort was considered by the directors of BHPTM, the Group Treasurer (Mr J Czyzewski) informed the directors of BHPTM by letter dated 9 July 1999 that:

I note that the Directors are expecting to have the benefit of a Letter of Comfort from its parent, [BHPB], in the same form as the attached draft.

[Finance] confirms that it will not demand payment of its loan to the company pending a complete review of the company’s future operations, including current proposals to transfer a commercial Group operation into the company.

[Finance] shall review its position in six months time or earlier as warranted in the circumstances.

[Finance] shall advise the directors prior to taking any action in respect of its loan following the review.

[78]      At a meeting held on 19 July 1999, the directors of BHPTM tabled the annual accounts for the 1999 year and after referring to the 8 July 1999 letter of comfort undertaking “(on a conditional basis) to provide sufficient funds to the Company to enable it to pay debts which the Company elects to incur”, the board was of the opinion “there were reasonable grounds to believe that [BHPTM] would be able to pay its debts as and when they fell due” and authorised the directors to sign the relevant statements to be provided under the Corporations Law. 

[79]      BHPTM completed its review of options by early August 1999.  At a meeting of directors of BHPTM on 18 August 1999 (chaired by Mr Coburn) the directors considered the options for meeting the existing and ongoing obligations of BHPTM.  The minutes record what transpired at that meeting in the following terms:

The outcome of recent discussions with the owners of certain profitable mining operations regarding proposals for the transfer of assets into [BHPTM] to strengthen its balance sheet, and as a result, to assist with the servicing of the [Finance] debt, was discussed.  It was noted that the discussions under consideration had produced no agreement and will not be pursued.

It was agreed that no other options for improving the liquidity of [BHPTM] were apparent and it was therefore necessary to consider the means of meeting the company’s existing and future obligations, in particular, the loan payable to [Finance].

[Finance] had provided an undertaking not to call its loan until a review of the reorganisation opportunities had occurred.  [Finance] has now requested the company to provide details of this review on Friday 20 August 1999.  It was agreed that Mr Coburn make the presentation to the board of [Finance].

Finally, the directors examined the balance sheet of the company to ascertain the likely shortfall on realisation of the company’s assets to meet existing obligations in the event that a demand for payment may issue from [Finance].  The directors are currently relying upon the terms of the comfort letter that was provided by the parent, [BHPB], on 8 July 1999. …

[80]      On 20 August 1999, two events occurred.  First, BHPTM (Mr Coburn) sent a letter to Finance concerning the future operations of BHPTM.  The letter stated:

BHPTM has been closely reviewing certain options for the transfer of a profitable mining operation into the company to bolster its balance sheet, and as a corollary, to introduce some means of servicing its loan from [Finance] over an extended period, thus avoiding an event of default.

The discussions with other Group entities concerning these proposals have ended without agreement as the options under consideration were not feasible.  In view of this, the prospects of expanding the company’s activities to assist with the servicing and repayment of its debt to [Finance] are now, in all likelihood, non-existent.

The directors are presently reviewing the company’s balance sheet to assess its ability to meet existing and ongoing obligations.  Should [Finance] call [on] its loan in the immediate future, the directors believe that [Finance] would realise little more than the amount of $11.5 million that BHPTM currently has on deposit with [Finance].

[81]      That letter, together with a presentation on the financial position of BHPTM from Mr Coburn, was considered at a meeting of directors of Finance held on 20 August 1999.  By that date, Mr McGregor had taken leave of absence pending his imminent retirement and the directors attending the meeting were Mr Czyzewski (the Corporate Treasurer) and Messrs HE Rose and BJ Skahill.  BHPTM’s financial position was summarised as follows:

1.                   YEM ’99 financials poor

·         Nopat [Net Operating Profit After Tax]     Loss        $13 million         [before abnormals]

·         Ebit [Earnings Before Interest and Tax]     Loss        $25 million         [before abnormals]

2.                   Beenup operations closed in February 1999

3.                   Write-offs [after tax] as follows:

·         YEM ’98    $99 million

·         YEM ‘99    $154 million

4.                   Review undertaken – As per letter from [BHPB] dated 9^th July’99.

5.                   Transfer to another mining operations not feasible.

6.                   Claim against company for non-performance of supply contract – Approx $49m.

7.                   With the exception of some land which may realise a $2-$3 million above book value, all assets in the attached balance sheet are believed to be at realisable value.

8.                   Any future proceeds will be used to satisfy priority claims.

9.                   The prospects of servicing or repaying the loan from [Finance] are non-existent.

[82]      That same day, 20 August 1999, the Vice President Group Accounting & Reporting, Mr J Hall, forwarded a memorandum to Mr Chip Goodyear concerning the loan from Finance to BHPTM.  A copy of the memorandum was provided to Mr Czyzewski, the Corporate Treasurer and a director of Finance.  After setting out the problems faced by BHPTM and the fact that the directors of BHPTM had advised Finance of the outcome of the recent review, the memorandum continued:

Therefore, the Directors of [Finance] are proposing to write-down the majority of the loan to [BHPTM] of $336 million to its realisable value, having regard to the borrowing company’s financial position and outlook.  It is likely the Company will eventually be liquidated following satisfaction of its commercial obligations.  The write-down will be disclosed in the accounts of [Finance] as a bad debt.

In order to reflect this in the accounts of the affected companies, a number of actions are recommended.  [BHPB] will revoke the Letter of Comfort provided to [BHPTM] on 8 July 1999 and to create a new, but limited, Deed of Support to the extent of future external debts only including any obligations pertaining to the Beenup Project imposed on the Company under the Mining Agreement with the State Government of Western Australia.

The new Deed of Support should provide the Directors of [BHPTM] with greater security, as it will be legally enforceable.  Notwithstanding this, the deed will permit the undertaking to be revoked at the discretion of [BHPB], but without limiting the comfort for any trading obligation incurred up to the date of the termination.  [BHPB] does not propose, however, to support internal funding obligations under these revised arrangements.

…

It is confirmed that as the Deed of Support does not extend [BHPB’s] existing exposure to the Beenup Project, or other activities of [BHPTM], no approval is required from the Board or the Managing Director.  Furthermore, the proposed level of support, up to US$100 million is within your existing authority.

In order to commence these formal arrangements it is necessary to revoke the Letter of Comfort and enter into the Deed of Support.

Your approval is sought for the following:

·         [BHPB] to advise [BHPTM] that the Letter of Comfort dated 8 July 1999 is to be revoked forthwith;

·         A new limited undertaking will be provided by means of a binding Deed of Support with the Directors of [BHPTM] and [BHPTM].  In this regard refer to the memorandum to you from Legal Counsel (Peter Ablett).  If acceptable, please sign the Deed on page 4 and have your signature witnessed.

·         Letter dated 23 August 1999 to the Directors of [BHPTM] stating that the Letter of Comfort is to be revoked with effect from Monday, 23 August 1999 and a proposal to enter into a Deed of Support.  This letter can be signed on behalf of [BHPB] by the Group Treasurer.

[83]      During the morning of 23 August 1999, BHPB informed the Directors of BHPTM in writing that it intended to revoke the letter of comfort of 8 July 1999 and that it proposed a new arrangement by way of a Deed of Support be entered into by the two companies which would be legally enforceable and provide the Directors of BHPTM with greater security.  A draft of the Deed was attached.  The letter went on to state that revocation of the letter of comfort would take effect upon execution of the Deed of Support.

[84]      At 11.15 am on 23 August 1999, the Directors of BHPTM (Messrs Coburn, March, CE Smith and WB Smith) met.  The meeting lasted half an hour.  The minutes of the meeting record that after Mr Coburn explained the outcome of his presentation to the board of Finance, Mr Coburn:

1.                   tabled the letter from BHPB of 23 August 1999 notifying of its intention to revoke the letter of comfort of 8 July 1999 and that, in substitution, BHPB proposed to enter into a new “comfort undertaking” with BHPTM in the form of a Deed of Support which subsumed the letter of comfort;

2.                   explained that there existed some doubt as to the enforceability of the undertaking provided in the letter of comfort of 8 July 1999 whereas the Deed offered greater security as it would be legally enforceable; and

3.                   recommended that the offer from BHPB be accepted.

[85]      The minutes record that the legal ramifications of entering into the Deed and the impact on directors’ responsibilities were then discussed.  After agreeing to review the trading position of BHPTM later in that day, the directors resolved that each of them would sign the Deed of Support and affix the company seal to the Deed.  The Deed of Support was executed and bears the date “23 August 1999”. 

[86]      That was not all that happened on 23 August.  At 12 noon, 15 minutes after the meeting of directors of BHPTM concluded, and one assumes after the Deed of Support had been executed, the directors of Finance met and resolved to call for payment of the BHPTM loan of $339,216,146.22 set off against the deposit of $11,593,237.88 and in the event that there was a failure to repay the balance, to write off the balance outstanding of $310,881,702.40.  Consistent with that resolution, a letter was sent by Mr Czyzewski for and on behalf of Finance to Mr Coburn as a director of BHPTM in the following terms:

We refer to our letter of 9 July 1999 wherein [Finance] gave an undertaking that it would not call its loan whilst the company reviewed its future options which included the proposed transfer of a profitable mining operation into the company to bolster its balance sheet and to introduce a source of ongoing funds which would assist with the servicing of the loan.  You advised [Finance] at a meeting on 20 August 1999 that the review has now been completed and that it was decided that it was not appropriate to pursue the options under consideration. 

We have also been advised that the letter of comfort dated 8 July 1999 provided by [BHPB] to BHPTM has now been cancelled.  This in combination with the results of our assessment of the financial position of BHPTM indicates to us that a material adverse change has occurred in the general financial condition of BHPTM which could materially effect (sic) its ability to perform its loan obligations.

We advise that the loan facility is hereby cancelled and we now declare the loan and all interest accrued thereon amounting to $339,216,416.22 forthwith due and payable.  Please remit these funds immediately.

[87]      Of course, repayment of the whole of the outstanding balance of the loan was not going to occur.  But for the amount on deposit, there were no funds to remit.  Later that same day, BHPTM informed Finance of that fact in writing.  Two remaining steps were then taken on 23 August 1999 to complete the arrangements.  Finance told BHPTM of the write off and the set off against the amount on deposit and the directors of BHPTM resolved to record both the set off and the write off in the accounts of BHPTM.  That is what occurred.’

Bad Debt Write Off Claims: ss 25-35(1)(b) / 8-1(1)

Legislation

10                  Section 25-35 of the 1997 Act provides:

‘(1)      You can deduct a debt (or part of a debt) that you write off as bad in the income year if:

(a)        it was included in your assessable income for the income year or for an earlier income year; or

(b)        it is in respect of money that you lent in the ordinary course of your *business of lending money.  

[Emphasis added.]

…

Special rules affecting deductions under this section

(5)        The rules described in the table may affect your entitlement to deductions under this section, or may result in a deduction being reversed.

Provisions of the [ITAA 1997]are identified in normal text.  The other provisions, in bold, are provisions of the [ITAA 1936].

The Primary Judge – Issue [2(1)]

11                  At [91] of her reasons, the primary judge noted that the Commissioner conceded that the evidence established that since at least the early 1980’s:

1.                  Finance did enter into borrowing transactions with third parties (see [13] of her Honour’s reasons);

2.                  Finance borrowed substantial sums of money from those third parties at commercial rates of interest; and

3.                  Finance on lent those monies to related entities to fund both operational activity and new projects at a higher rate of interest (see [24] of her Honour’s reasons) thereby earning substantial profits on which it paid income tax (see [24]).

12                  At [93] of her reasons, her Honour cited the well known passage from the judgment of Mason, Aickin and Wilson JJ in AVCO Financial Services Ltd v Federal Commissioner of Taxation (1982) 150 CLR 510 at 527 as to the ingredients or indicia of ‘[t]he essence of the business of a finance company’.

13                  At [94] of her reasons, her Honour said:

‘Finance contends that the concessions made by the Commissioner about the activities of Finance (see [91] above) are, themselves, sufficient to conclude that Finance is in the business of “lending money”.  I agree.  However, the Commissioner contends that notwithstanding that on its face Finance was in the business of lending money, one should nevertheless conclude that Finance was not carrying on such a business because “Finance did not make its own decisions with respect to borrowing” and “the evidence [did] not establish that Finance exercised its corporate mind to make decisions about borrowing, particular lending activities, or any of the other activities which might be expected to have been involved in the carrying on of a systematic and organised activity sensibly able to be characterised as a business of lending money”.’

14                  At [98] of her reasons, her Honour said:

‘What then is relied upon to displace a finding that Finance was a separate legal entity which carried on the business of lending money?  As noted, the Commissioner’s objection is not so much that Finance does not carry on a business but that it is the parent company (BHPB) that carries on the business of lending money and Finance does not.  Put another way, that Finance was at the relevant time a “mere conduit” of its parent company, BHPB.  I reject those contentions.  Putting to one side whether the language of s 25-35 imposes a requirement of independent corporate mind and decision making when there exists a separate legal entity that is engaged in the business of lending money (an assumption I make in favour of the Commissioner for the purposes of considering his argument), the Commissioner’s argument fails for at least two reasons.  First, because that conclusion (ie that Finance was a “conduit” for its parent) “begs, not answers, the question whether the activities of [Finance] are correctly characterised as its principal business consisting of the lending of money” (Bivona 21 FCR 562, 567), and, in any event, because the submissions relied upon by the Commissioner are contrary to the facts and no less importantly, contrary to long established authority.’

15                  At [101] – [102] of her reasons, her Honour said:

‘[101]   …  In the present case, even if Finance was acting in the BHPB Group’s interest, as in Commissioner of Taxation v E A Marr and Sons (Sales) Ltd (1984) 2 FCR 326, 330-31, that is sufficient for it to be carrying on a business.  In that case, the Full Court held that informal leasing between parent and subsidiaries constituted carrying on of a business even where no income was derived from the transactions in question and the parent retained complete ability to control the subsidiaries’ lending activities and profits. 

[102]    Here, over an extended period, Finance not only borrowed and on lent money on numerous occasions to a variety of entities at rates of interest (which the Commissioner did not suggest were less than commercial) but did so on loan terms stipulated by Finance and where “the rates of interest payable on the money lent were significantly higher than the rates payable on the money borrowed” (see [93] above), thereby generating a substantial profit:  Commissioner of Taxation v Bivona (1990) 21 FCR 562, 567-9.  The fact that the loans made by Finance were made to related entities is not determinative:  Bivona (1990) 21 FCR 562, 569.’

Commissioner’s Submissions on Appeal – Issue [2(1)]

16                  The Commissioner submitted that before the regular or systematic activity of lending money could be characterised as a business of lending money, the activity must have the purpose or object of the generation of profit to the lender.  So much may be accepted (although see Federal Commissioner of Taxation v Stone (2000) 222 CLR 289 at [55] in the joint judgment where it is suggested that a profit motive will not always be necessary); however, it is the next step in the argument where the submission rests on shakier ground.

17                  It is said that the generation of profit to the lender must be understood as ‘necessarily taking into account not only the returns to the lender from the lending activity but the risks to the lender from undertaking the lending activity’; and here there was no analysis by Finance or anyone acting on its behalf of the returns and risks to Finance as lender in making the loans it made, including the TM loan and the DRI loan; there was nothing more than a ‘mechanistic implementation’ of an investment decision of BHPB by Finance making an unsecured loan to the particular group member chosen as the investment vehicle.  So understood, it was submitted that Finance was in a business which was an appendage to the business of the Group as a whole; not a business of lending money.

Analysis – Issue [2(1)]

18                  There is nothing that comes out of the relevant authorities that suggests that a conclusion as to whether an entity is carrying on business of lending money depends on the entity undertaking, each and every time it makes a loan, an analysis, sound or flawed, as to the risks involved in making the loan.  Obviously, an entity which lent money without regard to the ability of its borrowers to service and repay the loans it made to them, would not survive for too long; but that says more about the way an entity carries on its business, rather than the nature of the business it carries on.  As Williams J said in Tweddle v Federal Commissioner of Taxation (1942) 180 CLR 1 at 7:

‘It is not suggested that it is the function of income tax Acts or of those who administer them to dictate to taxpayers in what business they shall engage or how to run their business profitably or economically. The Act must operate upon the result of a taxpayer's activities as it finds them. If a taxpayer is in fact engaged in two businesses, one profitable and the other showing a loss, the Commissioner is not entitled to say he must close down the unprofitable business and cut his losses even if it might be better in his own interests and although it certainly would be better in the interests of the Commissioner if he did so: [Toohey’s Ltd v Commissioner of Taxation (NSW) (1922) 22 SR (NSW) 432 at pp 440 – 441].’

See too Ronpibon Tin NL & Anor v Federal Commissioner of Taxation (1949) 78 CLR 47 at 60 and Magna Alloys & Research Pty Ltd v Federal Commissioner of Taxation (1980) 33 ALR 213 at 233 per Deane and Fisher JJ.

19                  The fact that Finance was the vehicle which financed the Group entities selected by BHPB as the vehicles through which the Group’s investment decisions were executed, does not make Finance’s business an appendage to the business of the Group as a whole; any more than it makes Finance a mere conduit of BHPB’s business.  As the primary judge observed at [98] of her reasons, what was said by the Full Court in Commissioner of Taxation v Bivona Pty Ltd (1980) 21 FCR 562 at 569 fully responds to that submission:

‘The respondent’s activities consisted principally of the borrowing and lending of money.  By far the greatest proportion of its income consisted of interest on moneys lent and its largest outgoing was interest on moneys borrowed from overseas.  There was no suggestion that any of the relevant transactions were shams.  Even if it were right to describe the role of the respondent in its activities of lending money, as counsel for the Commissioner did, as a “conduit” for its parent company or other members of the group, that begs, not answers, the question whether the activities of the respondent are correctly characterised as its principal business consisting of the lending of money.’

20                  More recently, the Full Court in Commissioner of Taxation v Tasman Group Services Pty Ltd (2009) 180 FCR 128 at [56] confirmed that response:

‘While it may be accepted that the business was being financed by SBC, this does not inevitably lead to the conclusion that SBC was carrying on the business.  It is a trite proposition that, where a subsidiary, even if wholly owned by a parent company, carries on a business, the business is that of the subsidiary not the parent.  Irrespective of how closely it may monitor the business activities of the subsidiary, the parent does not itself carry on those activities but is engaged in the separate business of a parent or holding company which is, normally, the receipt of income in the form of dividends from the subsidiary.’ 

21                  This is not a case where Finance’s activities of borrowing and lending money were ancillary, subservient or subordinate to some other business carried on by Finance, such as that of a holding company: cf., Federal Commissioner of Taxation v Total Holdings (Australia) Pty Ltd (1979) 43 FLR 217.  Its activities of borrowing and lending were its only activities; and it had no equity, direct or indirect, in the companies in the Group to which it lent.

22                  There is more than a hint in the Commissioner’s submissions, indeed one might well conclude an assertion of a positive requirement, that each loan transaction should be moved by a profit motive before it can be regarded as part of a continuing business of lending money.  But such an argument was rejected, correctly in my view, by Barwick CJ in Investment and Merchant Finance Corporation Ltd v Federal Commissioner of Taxation  (1971) 125 CLR 249 at 255:

‘[Q]uite clearly neither the attainment of profit nor the expectation of it is essential for a particular commercial transaction to form part of the business of dealing in the commodity purchased.’

The requirement of profit motive is a reference to overall profit – the profit shown in a profit and loss account: Income Taxation in Australia – Income, Deductibility, Tax Accounting, RW Parsons, 1985, Law Book Co Ltd, at [2.449].

23                  The evidence establishes, as the primary judge found, that Finance’s activities involved the borrowing of money and the lending of that money to companies in the Group; that these activities were carried on over a substantial number of years on a regular and systematic basis; that the amounts borrowed and the amounts lent involved very substantial sums of money; that the amounts lent were invariably lent at a rate of interest higher than the rate at which it borrowed those funds; that in consequence, over a period from 1986 to 2002 it derived interest income in excess of $34 billion, accounting profits after tax in excess of $2.8 billion and aggregate taxable incomes in excess of $4.4 billion; more telling, in only two of those 17 years did it suffer a taxable loss – in 1994 ($23,127,060) and in 2000 ($1,659,815,608).

24                  The submission that, in the face of this undisputed evidence, Finance was not, during the whole of this period, carrying on a business of lending money is, in my view, perverse.  There is no error in the primary judge’s finding that, in the relevant years of income, Finance was carrying on a business of lending money and had been for many years prior to those years.

The Primary Judge – Issue [2(2)]

25                  The primary judge rejected the Commissioner’s contention that if Finance’s business was one of lending money, there was insufficient evidence to assess whether each of the loans to DRI and TM was made in the ordinary course of that business.

26                  At [107] of her reasons, the primary judge said:

‘Consistent with the principles in Fairway Estates Pty Ltd v Federal Commissioner of Taxation (1970) 123 CLR 153 and Franklin’s Selfserve Pty Ltd v Federal Commissioner of Taxation (1970) 125 CLR 52, each loan was not an instance of lending for an extraneous purpose.  Finance made the loans to both BHPDRI and BHPTM to advance its own purpose of profit-making by lending.  It was not Finance’s business to make decisions about debt and equity.  Finance’s business was to borrow and lend money following the making of such decisions by others.  But for the lending by Finance, Finance would not have derived the substantial interest income and profits from 1986 to 2002 (see [24] above).  The “hiccough” in the 2000 year is the subject of these proceedings.  The fact that out of 17 years of continued and successful borrowing and lending money, two projects “failed” in one year (the 2000 year the subject of these proceedings) does not and cannot convert these loans to loans for an extraneous purpose or being other than in the ordinary course of that business.’

27                  In relation to the DRI loan, the primary judge found (at [110]) that, contrary to the Commissioner’s contentions, the facts surrounding the HBI project establish that each loan to DRI was not an isolated transaction of a very special character undertaken by Finance at the behest of BHPB; and (at [115]) that the advances by Finance to DRI did not arise external to the ‘taxpayer carrying on a business as a moneylender’.

28                  The primary judge made similar findings in relation to the TM loan (at [116]).

Commissioner’s Submissions on Appeal – Issue [2(2)]

29                  In his written submissions, the Commissioner submitted that whether or not Finance was in  a business of lending money, the advances it made to DRI and TM were not made in the ordinary course of such a business.

30                  The specific submissions largely mirrored those made to, and rejected by, the primary judge below.  In relation to the DRI loan they included:

(i)                  The evidence led by Finance did not equip the Court to determine the ordinary processes or course of any business which Finance might have conducted.  Finance has simply failed to discharge its onus of establishing the ordinary course by reference to which these particular loans must be assessed;

(ii)                the advances by Finance to DRI were made at the behest of BHPB for the benefit of the Group as a whole; they were no more than the means selected by BHPB of providing funds for capital investment in the BHI project;

(iii)               fundamentally, there was simply no suggestion in the decision-making process of any expectation on the part of Finance that DRI would be able to repay the loan or even to pay interest.  The decision-making documents are wholly devoid of any analysis directed to that question.

31                  In relation to the TM loan, the Commissioner’s specific submission on the [2(2)] issue included:

(i)                  Finance was no more than the means selected by BHPB of providing funds for capital investment in the Beenup mine. Advances exceeded the approved expenditure and Finance continued to advance funds when there was no reasonable expectation of Finance receiving its funds, let alone interest on them;

(ii)                that even if Finance initially lent money to earn assessable income, it became apparent in each case, well before writing off the bad debts, that the borrowers were incapable of repaying the loans plus interest.  After that point in time, funds that Finance advanced to TM were not money lent in the ordinary course of its business.

(iii)               Notwithstanding:

(a)                TM had negative net assets and negative shareholders’ equity at 31 May in each of 1996, 1998 and 1999 (the 1997 accounts are not in evidence);

(b)               by December 1997 the Beenup project was overspent, and included substantial spending on items outside the original project scope;

(c)                in May 1998 the carrying value of the Beenup project was written down from $150m to $134m (before tax);

(d)               in February 1999 BHP announced that it would close the Beenup mine; and

(e)                in May 1999 the carrying value of the Beenup project was written down to nil,

Finance continued to permit TM to draw down on its loan account.  Indeed, the draw-downs continued (for project rehabilitation and other costs as well as for repayment by TM of $62 million borrowed form the ANZ bank) even after BHP announced the closure of the Beenup mine.

32                  On the hearing of the appeal, the Commissioner’s counsel made no submissions in chief in relation to Issue [2(2)] causing Finance’s counsel to observe, in the context of the primary judge’s finding that the two loans in question to DRI and TM were made in the ordinary course of Finance’s business of lending money, ‘that … no longer seems to be in issue’.  However, in reply, the Commissioner’s counsel made it clear that the issue of whether the loan to DRI (although not to TM) was made in the ordinary course of Finance’s business of lending money had not been conceded.

Analysis – Issue [2(2)]

33                  What is or is not in the ordinary course of Finance’s business has to be considered and determined by reference to the context in which Finance’s business is carried on; not by reference to the way in which a major banking organisation carries on its banking business.  As indicated above, Finance’s business of lending money consists of borrowing money from external sources and from entities within the Group and lending the funds so borrowed to other entities in the Group at a margin over its cost of funds.  This has been the context in which Finance has carried on its business for many years and invariably such activities have been very profitable to Finance.

34                  In Fairway Estates Pty Ltd v Federal Commissioner of Taxation (1970) 123 CLR 153, Barwick CJ at 162, speaking of the predecessor of s 25-35(1), namely, s 63 of the ITAA 1936, said:

‘In requiring the lending to be in the ordinary course of the business, however, the section, in my opinion, does not require that the advance must conform to the usual or ordinary transaction currently carried out by the taxpayer in carrying on the business of lending money. It is the ordinary course of such a business of which the section speaks. The advance may be of a new type or kind so far as the taxpayer’s business is concerned and yet be in the ordinary course of that business.

I have come to the conclusion that the decisions involving the expression “in the ordinary course of business” found in bankruptcy legislation have no direct bearing on the construction or application of s. 63. Accordingly, I find no need to discuss them. However, the remarks of Rich J. in Downs Distributing Co. Pty. Ltd. v. Associated Blue Star Stores Pty. Ltd. [(1948) 76 C.L.R. 463 at 477] are of use in that they emphasize the notion of a common course in the conduct of a business. The requirement that the transaction be in the ordinary course of the business excludes transactions which are made for purposes other than the carrying on of the business or to achieve ends disparate from those of the business activity.’

35                  Contrary to the Commissioner’s submission, Finance did establish what was the ordinary course of its business of lending money, namely, that described in [33] above.  So understood, the loans to DRI and TM had the following features consistent with the ordinary course of that business:

(1)               The loans were made to entities which were wholly-owned companies in the Group in order to fund projects and operations approved by the board of BHPB;

(2)               each loan was made in accordance with Finance’s standard lending terms for inter-company loans; and

(3)               the loans were recorded in the books and records of Finance in the same way as its other loans and moneys were advanced and interest capitalised and recorded using the same systems and by reference to the same activities ordinarily employed by Finance; and

(4)               the loans were made using a practice and procedure that was entirely consistent with and similar to that adopted by Finance in respect of virtually all of its other loans and which had generated very large profits for Finance (and which the Commissioner taxed in its hands).

36                  The primary judge’s findings that each of the DRI and TM loans were made by Finance in the ordinary course of its business of lending money are not, in my view, put in doubt by any of the Commissioner’s submissions on appeal.

37                  In relation to the DRI loan:

(1)               The Commissioner’s assertion that Finance acted ‘at the behest of BHP’, even if supported by the evidence, which is not apparent, is totally irrelevant.  The evidence was that Finance made the loan to DRI in the expectation that the loan would be repaid in full together with interest.  In accordance with its normal practice in making loans, Finance relied again upon the approval of the capital expenditure by BHPB.  It was not part of Finance’s business to separately evaluate a project or to separately evaluate the risk of default once a project was approved.  The decision to lend was premised on the fact of approval.  Each of the Beenup and HBI project submissions were prepared in accordance with the BHPB Capital Procedures Manual.  It was that manual which advised consideration of the benefits of a ‘project’ to the Group.  Having regard to the long history of Finance’s successfully borrowing and lending money as a result of carrying on its business in reliance upon such Group processes and procedures, it was entirely rational for Finance to continue to so rely on BHPB’s approval of a project for the purpose of conducting its business;

(2)               nor is the Commissioner correct when he asserts that the loan to DRI was ‘no more than the means selected by BHPB of providing funds for capital investment in the HBI project’.  The conflation of the activities of separate entities into some fictional ‘group’ or single entity is impermissible outside the confines of Pt 3-90 of the ITAA 1997; just as it is to determine the tax consequences of a receipt or an outgoing by a member of a group of companies by reference to the tax consequences of the receipt or outgoing by another member of that group: Federal Coke & Co Pty Ltd v Federal Commissioner of Taxation (1977) 15 ALR 449 at 459 per Bowen CJ; Hobart Bridge Co Ltd v Federal Commissioner of Taxation (1951) 82 CLR 372 at 384 – 385 per Kitto J;

(3)               the Commissioner’s further contention that DRI ‘was always forecast to suffer substantial losses’ and that there was no ‘expectation on the part of Finance that DRI would be able to repay the loan’, must also be rejected.  First, the Commissioner’s contention that DRI would not be able to repay its loan relies upon discounted rather than actual cash flows.  As the primary judge pointed out, correctly in my view, loans are repaid out of actual not discounted cash flows.  Second, DRI was expected to be profitable in its own right and to make profits from the sale of briquettes.  Third, the project was approved on the basis of an internal rate of return of 17.7% real which exceeded the BHPB Minerals hurdle rate of 15%, a rate significantly higher than the interest rate charged by Finance.  Fourth, by 1997 the projected cash flows from the HBI project were forecast to average $577.1 m per year after year five and it was considered that the cash flow would be sufficient to enable DRI to repay its debt with accrued interest.  Finally, the HBI project was expected to contribute to the Group’s profits.

38                  In relation to the TM loan, the Commissioner’s contention that the advances made to TM were not made in the ordinary course of its business should also be rejected for the following reasons:

(1)               as described above, the advances made to TM were made using the same processes and procedures as Finance’s other loans;

(2)               the Commissioner’s recourse to ‘economic substance’ in order to treat the loan made to TM by Finance as if it were capital invested by BHPB, is neither supported by the evidence or by authority;

(3)               moreover, his suggestion that the ‘advances exceeded the approved expenditure’ and that loans should have been ‘converted to equity’ ignores the taxable facts.  The fact is that the all of the expenditure on the Beenup project was approved; there is no evidence that any part of the expenditure was incurred without appropriate approval.  Further, whether loans might or might not have been converted to equity is beside the point; the taxable fact is that they were not.  Nor was it part of Finance’s business to approve or consider the capital structure of projects or entities.  Funding of an approved investment was determined in accordance with BHPB’s Accounting Policy.  Under BHPB processes and procedures, the selection of a debt to equity ratio was a matter of choice.  There was no requirement for companies to operate only with positive shareholder funds.  Indeed, that there was a practice of issuing comfort letters to companies with negative shareholders’ funds suggests that there must have been companies with negative shareholder funds;

(4)               finally the uncontroverted evidence was that the Beenup project was expected to be a success and contribute significantly to overall group profits, as well as the profitability of Finance.

39                  The Commissioner’s further alternative contention that the later advances made to DRI and to TM were not made in the ordinary course of its business of lending should also be rejected:

(1)               In the case of DRI, loans were made whilst the project remained approved by the BHPB board: at no stage was a sum advanced at a time when such approval had been withdrawn.  Moreover, in 1997, following the McGregor review, it was decided that it was in the best interests of BHPB and of Finance, to continue to support the project; there was ‘no case to be made for abandoning the project’.

(2)               For the reasons discussed above, the Commissioner’s reliance on an ‘NPV’ calculated for a different purpose is misplaced.  The ability to repay is governed by actual cash flows, not discounted cash flows.

(3)               In the case of TM, the capital expenditure approval process for BHPB provided for supplementary authorisation for over-expenditure or change of scope. In the case of the Beenup project, such supplementary authorisation was sought and was obtained.  The Beenup project continued to receive the approval and support of BHPB notwithstanding that the project was not meeting forecasts or the carrying value was written down. Again, at no stage did Finance lend money to TM at a time when TM was carrying on activities concerned with the project that were not approved by the BHPB board. Following the closure of the plant, the Group considered other ways to make the operations of TM profitable with a view to enabling it to repay its debt to Finance, including transferring other businesses into TM, and in that period, Finance continued to advance funds to TM. Only after those options were exhausted did Finance call in its loan.

40                  In my view, there was no error in the primary judge’s findings that the DRI loan and the TM loan were made by Finance in the ordinary course of its business of lending money.

Alternative head of claim – section 8-1(1)

41                  In the face of my conclusions at [24] and [40] above, the write off of the BDI debt and the TM debt as bad are losses incurred by Finance in the year of income in which they were written off in carrying on business for the purpose of gaining or producing assessable income.  As they are not losses of capital or of a capital nature they are, in the alternative, allowable deductions in that year under s 8-1(1) of the ITAA 1997.

The Application of Part IVA to Cancel the Deduction for the Write Off of the TM Debt as Bad

42                  Before the primary judge and on the hearing of the appeal, Finance disputed the Commissioner’s reliance on the provisions of Pt IVA of the ITAA 1936 to cancel the deduction for the write off of the TM debt as bad on two bases.  First, that the Commissioner had no power to rely upon his s 177F determination because he did not issue an assessment or, more accurately, an amended assessment, to give effect to that determination and secondly, even if he was entitled to rely upon Pt IVA, it did not apply.

The Primary Judge – Issue [2(5)]

43                  The relevant background facts to the first issue – the s 169A(3) issue – were summarised by the primary judge at [163] and [164] of her reasons.

44                  An assessment to disallow Finance’s bad debt deductions (deduction of $2,156,714,984 in relation to the DRI loan and TM loan) was issued to Finance by the Commissioner on 23 June 2005.  That assessment did not give effect to a Pt IVA determination.  Finance objected to the assessment.  Its grounds of objection were limited to contentions that it was entitled to a deduction under s 25-35 or s 8-1 of the ITAA 1997.  Unsurprisingly, Finance’s grounds of objection did not address Part IVA.

45                  On 8 June 2006, in the course of considering Finance’s objection, the Commissioner proceeded to make a determination under s 177F(1)(b) of the ITAA 1936.  The Commissioner did not give effect to that determination by the issue of an amended assessment.  Instead, he relied upon s 169A(3) of that Act.

46                  The primary judge concluded, contrary to the submissions of Finance, that the Commissioner was entitled to rely upon s 169A(3) of the ITAA 1936.  The submissions of Finance, rejected by the primary judge, were repeated on the hearing of the appeal.

Analysis – Issue [2(5)]

47                  Section 169A relevantly provided:

‘(1)      Where a return of income of a taxpayer of a year of income is furnished to the Commissioner (whether or not by the taxpayer), the Commissioner may, for the purposes of making an assessment in relation to the taxpayer under this Act, accept, either in whole or in part, a statement in the return of the assessable income derived by the taxpayer and of any allowable deductions or rebates to which it is claimed that the taxpayer is entitled and any other statement in the return or otherwise made by or on behalf of the taxpayer.

(2)        Despite subsection (1), if, in a document given with a return of income of a taxpayer of a year of income and signed by or on behalf of the taxpayer, a question is raised:

(a)        that is relevant to the liability of the taxpayer in respect of the year of income; and

(b)        on which the taxpayer is not entitled to apply for a private ruling under Part IVAA of the Taxation Administration Act 1953;

the Commissioner must give attention to that question.

(3)        In determining whether an assessment is correct, any determination, opinion or judgment of the Commissioner made, held or formed in connection with the consideration of an objection against the assessment shall be deemed to have been made, held or formed when the assessment was made.’

48                  On its textual face, the import of s 169A(3) is to deem the s 177F determination made by the Commissioner at the time he considered Finance’s objection to have been made when the assessment was made, approximately, one year earlier.  Of course, the Commissioner could only rely on the anterior assessment as giving effect to the subsequent determination under s 169A(3) where the amount specified in the s 177F determination was the same as the amount in the assessment, an objection to which was under consideration, but they are the facts of this case; otherwise, it would be necessary, subject to the limitations of s 177G, to issue an amended assessment, to give effect to the determination.

49                  I agree with the primary judge’s reasoning at [168] – [182] of her Honour’s reasons for rejecting Finance’s contentions that the textual import of s 169A(3) should be read down and limited so as not to apply to determinations made by the Commissioner under s 177F at the time of considering objections to anterior assessments which have not invoked reliance on the provisions of Part IVA.  Neither by reference to considerations of legislative context and policy (see CIC Insurance Ltd v Bankstown Football Club Ltd (1997) 187 CLR 384 at 408 in the joint judgment; HP Mercantile Pty Ltd v Commissioner of Taxation (2005) 143 FCR 553 at [44] – [65] per Hill J), nor by recourse to any extrinsic material which the Court is authorised to take into account (see s 15AA of the Acts Interpretation Act 1901 (Cth)), is such a reading down and limitation to be imported into the proper construction of s 169A(3) of the ITAA 1936.

50                  It follows, in my view, that the primary judge did not err when she concluded (at [184] of her reasons) that the Commissioner was entitled to rely upon the s 177F determination.

The Primary Judge – Issues [2(6)] and [2(7)]

51                  Before the primary judge, the Commissioner contended that if Finance was otherwise entitled to an allowable deduction in the year of income ended 30 June 2000 for the write off of the TM debt as bad, the deduction was liable to be cancelled in reliance on the provisions of Pt IVA specifically, by a determination made pursuant to the provisions of s 177F(1)(b) of the ITAA 1936.

52                  The primary judge, at [194] of her reasons, rejected this contention on the basis that:

‘The fundamental flaw in the Commissioner’s case is that the steps in the scheme did not alter the fact that the BHPTM debt was bad and was a debt that Finance was entitled to write off as bad whether the steps in the scheme identified by the Commissioner were taken or not taken.’

In other words, the primary judge found that the appellant did not obtain a tax benefit in connection with the scheme as identified by the Commissioner.  If the primary judge is correct in that finding, then that is the end of the Pt IVA matter; Issue [2(7)] does not arise.

53                  In the course of her reasons, the primary judge said (at [186]):

‘The Commissioner concedes that his Pt IVA case has a narrow compass.  It only arises if by reason of the 1999 comfort letter it could reasonably be expected that the BHPTM loan was recoverable by Finance.  For the reasons set out above …, even if the terms of the comfort letters are equivalent to a guarantee between BHPB and BHPTM, none of the letters (including the 1999 comfort letter) created third party rights in favour of Finance.  Moreover, even if the 1999 comfort letter had not been revoked, it could not reasonably be expected that BHPB would honour the undertaking made in the 1999 comfort letter to BHPTM and its directors.  As the Commissioner conceded in his written submissions, the most obvious and simple commercial solution was what transpired – the writing off of the debt by Finance.  That result was not surprising.  The alternatives for dealing with the failure of the BHPTM project each had their own difficulties, including legal difficulties.’

54                  At [187] of her reasons, the primary judge recorded three alternatives suggested by the Commissioner:

(1)               That BHPB would provide funds by way of equity or loan to TM for repayment of TM’s loan from Finance;

(2)               Finance could have released the debt before writing it off with the result that Finance would not have been entitled to a bad debt deduction; and

(3)               release of the debt before and not after revocation of the 1999 comfort letter.

55                  The primary judge rejected each of these alternatives on separate grounds.  The primary judge found the first possibility suggested by the Commissioner to be contrary to the way in which BHPB acted and, secondly, in the circumstances in which TM found itself, likely to be contrary to the provisions of the Corporations Law (as it then existed) and the directors’ common law duties.  Adapting the words of Mason J (as he then was) in Walker v Wimborne (1976) 137 CLR 1 at 6 – 7, the primary judge concluded that the provision of funds of BHPB or another Group member (whether by equity or loan) was in the ‘whole of the existing circumstances’ a transaction for the benefit of the entity providing the funding or its shareholders.  TM was non-viable.  In those circumstances, the primary judge found that the provision of further funds by way of equity ‘was not an alternative’ (at [191]).

56                 In relation to the second possibility – that Finance could have released the debt before writing it off with the result that Finance would not have been entitled to a bad debt deduction – the primary judge observed that if a debt is released, there is nothing to write off: Point v Federal Commissioner of Taxation (1970) 119 CLR 453.  In her Honour’s view, the fact that Finance chose what the Commissioner conceded was the single ‘most obvious and simple commercial solution’ – writing off the debt after it was bad and not the uncommercial step of simply forgiving the debt – does not of itself attract the application of Pt IVA.

57                 Her Honour rejected the third possibility as an alternative on the basis that it proceeds on the assumption that the 1999 comfort letter created rights in a third party, a contention which she had already rejected.  In her Honour’s words (at [192]):

‘As a result, even if the Commissioner’s contentions that the events that took place on 23 August 1999 … were artificial and contrived were accepted (a matter I do not need to decide), Pt IVA of the Act would not apply because it could not be said that the debt was not bad in the absence of those steps.’

Commissioner’s Submissions on Appeal – Issues [2(6)] and [2(7)]

58                  On the hearing of the appeal, the Commissioner submitted that the primary judge’s conclusion at [194] of her Honour’s reasons, extracted at [52] above, should be rejected by reference to an argument that had as its starting point her Honour’s acceptance that the letters of comfort were contractually enforceable by TM against BHPB.  The argument was articulated as follows: although the letters of comfort conferred no rights on Finance, Finance (acting reasonably) could have pressed TM to enforce TM’s contractual rights against BHPB (if necessary) by having TM wound up and funding a liquidator to bring proceedings against BHPB.  A liquidator of TM would have been duty bound to have sort to enforce the 1999 letter of comfort for the benefit of TM’s creditors.

59                  The Commissioner also submitted that the primary judge’s suggestion (see [55] above) that the provision of further funds to TM was contrary to the way BHPB acted and contrary to the duties of BHPB directors should be rejected.  The Commissioner observed that while Mr McGregor gave evidence that he could not recall BHPB or any other Group company subscribing capital to a non-viable company, there was conflicting evidence that DRI’s  holding company, BHPM Holdings, subscribed $150 million for additional shares in DRI on 18 May 2000 when, at about the same date (31 May 2000), DRI wrote off the balance of its investment in the HBI plant to nil.  The subscription of further capital to a ‘non-viable’ company was, therefore, a measure that BHPB and other Group companies were prepared to adopt.  Had it done so, TM would have applied the funds provided by BHPB to repay the TM debt, which would have improved Finance’s net asset position, dollar for dollar, by the additional funds.  Because Finance is a wholly owned subsidiary of BHPB, any loss that BHPB suffered from subscribing equity to, or lending to, TM, would have been offset by an equal increase in the value of Finance.

60                  Finally, the Commissioner observed that the primary judge made no finding about whether one or more of the parties who entered into or carried out the scheme did so for the sole or dominant purpose of obtaining the tax benefit, but submitted that if the Court finds that Finance did obtain a tax benefit, it should find that the requisite purpose was present.  The argument was articulated as follows: the steps carried out on or before 23 August 1999 were, as her Honour said, ‘calculated’.  They were carried out in the space of one day for the purpose of enabling Finance to write off most of the loan to TM as bad and then claim the write off as a tax deduction.  In contrast, had BHPB provided equity or lent money to TM to enable it to repay the loan, Finance would not have been entitled to the tax deduction.  In the circumstances, the Court should conclude that the sole or dominant effect of the scheme was the obtaining of the tax benefit.

Finance’s Submissions on Appeal – Issues [2(6)] and [2(7)]

61                  Finance pointed to what the primary judge said at [186] of her reasons (see [53] above) namely that the Commissioner conceded that his Part IVA case had a narrow compass – it only arises if by reason of the 1999 comfort letter it could reasonably be expected that the TM loan was recoverable by Finance.

62                  Finance pointed out that the scheme identified by the Commissioner – comprising Finance’s acquiescence in the revocation of the letter of comfort, the entry into the Deed of Support, calling for the payment of the debt owed by TM and the write off of part of the TM debt – took no account of the failure of the Beenup project, the fact that no viable alternative operations for TM were available to it, that the board of TM had been advised that ‘there exists some doubt as to the enforceability of the undertaking provided in the letter of comfort’ or that the letter of comfort was revoked and replaced with a ‘new Deed of Support [which provided] the Directors of [BHPTM] with greater security as it [would] be legally enforceable’.

63                  Finance submitted that but for the scheme alleged by the Commissioner, the debt would still have been bad and thus capable of being written off.  In particular, Finance pointed to the following matters:

(1)               The letters of comfort were issued for the purpose of directors being able to sign the accounts for the year or years to which the letter related.  Before the primary judge, Finance primarily submitted that whilst the letters gave the directors of TM undoubted comfort for that purpose, they were not intended to create legally enforceable rights and obligations as between TM and BHPB, and that, in particular, TM provided no consideration to BHPB for the grant of such rights.  The primary judge disagreed; she did so however in reliance upon, amongst other things, the decision at first instance in Newtronics Pty Ltd v Atco Controls Pty Ltd (in liq) (2008) 69 ACSR 317 which concerned an issue of a letter of comfort to a subsidiary company in broadly similar circumstances.  The decision has since been reversed by the Victorian Court of Appeal (Atco Controls Pty Ltd (in liq) v Newtronics Pty Ltd [2009] VSCA 238), and for the reasons expressed by that court, Finance again submitted that the letters of comfort here do not create any enforceable rights in TM.

(2)               Even if the letters did create enforceable legal rights, they were only enforceable according to their terms.  Further, and for the reasons expressed by the primary judge, any such rights could only exist as between TM and BHPB.  By its terms each letter did not confer any rights upon Finance.  The July 1999 letter of comfort was expressly limited.  Contrary to the Commissioner’s suggestion at [59] of his submissions, the letter of comfort was not a ‘guarantee’.  Furthermore, the directors of TM had obtained advice and concluded that there were doubts about the enforceability of the letter of comfort.  In those circumstances, the Commissioner’s contention that a liquidator of TM would have been ‘duty bound’ to have sought to enforce the letter by seeking payment from BHPB is mere speculation.

(3)               Finance submitted that the Commissioner’s contention that but for the scheme, it might reasonably be expected that BHP would have provided funds by way of loan or equity to TM to enable Finance to be repaid the amount of the TM loan, is contrary to the evidence.  Finance referred to the evidence of Mr McGregor that he could not recall, at any point, BHPB subscribing capital to a non-viable company.  Finance made the point that the circumstances of DRI to which the Commissioner referred were not put to Mr McGregor and are clearly distinguishable: in May 2000 the HBI project was still considered by BHPB to be viable and it was for that reason that further capital was contributed to DRI.  In contrast, at the time Finance wrote off the debt from TM, all options for the future viability of TM’s operation had been exhausted and the company was likely to be liquidated.

(4)               Finance submitted that, in any event, providing further funds by way of equity, or otherwise, was not a commercial alternative.  It points to the concession of the Commissioner that writing off the debt was the most obvious and simple commercial solution.  In comparison, implementation of the Commissioner’s alternative would have required BHPB to act artificially against its own commercial interest (subscribing $300,000,000 to a company that was going to be liquidated once its commercial obligations were satisfied and requiring the immediate write down of that equity investment) contrary to the duties of the directors of BHPB to act for the benefit of (Mills v Mills (1938) 60 CLR 150 at 185; Charterbridge Corporation Ltd v Lloyds Bank Ltd [1970] Ch 62 at 74; Walker v Wimborne), or in the best interests of (Equiticorp Finance Ltd (in liq) v Bank of New Zealand (1993) 32 NSWLR 50), the company and its shareholders.

64                  Finance submitted that the Commissioner’s submissions with respect to Issue [2(7)] are misconceived insofar as he contends that the Court should conclude that ‘the sole or main effect of the scheme was the obtaining of the tax benefit’.  Finance pointed out that relevantly, that would be so where any debt was written off in the circumstances provided for in s 25-35, but that is not even the test in s 177D.  Instead, the provision focuses on whether, having regard to the eight matters in s 177D(b), a party to the alleged scheme held the requisite dominant purpose.  Finance made the point that here, the course chosen by the Group was that which the Commissioner conceded to have been the most sensible commercial alternative.  In contrast, the alternative postulated by the Commissioner involving as it does a ‘round robin’ of funds is contrived and uncommercial.  Finance submitted that the provisions of Pt IVA do not compel a taxpayer to undertake artificial steps as postulated by the Commissioner merely to avoid a tax deduction which proceeds naturally from the ordinary vicissitudes of business.  No different conclusion should be reached because the steps adopted were ‘calculated, systematic and taken after obtaining the necessary advice’.  That, after all, Finance submitted, is how all commercial transactions, including the writing off of a debt so as to comply with s 25-35, should be undertaken.

Analysis – Issue [2(6)]

65                  As indicated at [2(3)] above, the Commissioner now accepts that the TM debt was bad at the time it was written off by Finance.  It is common ground that the TM debt was written off after the revocation of the 8 July 1999 comfort letter.  The issue arises as to whether the TM debt was bad immediately before the revocation of the 8 July 1999 comfort letter because if the answer to that question is in the affirmative, as the primary judge found, Finance could not have obtained a tax benefit in connection with the scheme as identified and relied upon by the Commissioner. 

66                  This leads one to the next issue of the circumstances which must exist before a debt can be characterised as ‘bad’.  In GE Crane Sales Pty Ltd v Federal Commissioner of Taxation (1971) 126 CLR 177, at 194 – 195, Gibbs J (as he then was) said of the words ‘debts which are bad debts’ in s 63(1) of the ITAA 1936:

‘A sum of money comes within the ordinary meaning of those words if it is owed to the taxpayer by some other person but is reasonably regarded as irrecoverable.’

The exact phrase is not replicated in s 25-35 of the ITAA 1997, however, having regard to the terms of s 1-3 of the ITAA 1997, there is no basis for substituting a different standard as to when a debt is ‘bad’.

67                  In particular, it is not necessary to establish that a debt is one in respect of which nothing can ever be recovered before it can be regarded as bad.  So much comes out of what was said by Harvey CJ in Equity in Elder Smith & Co Ltd v Commissioner of Taxation (NSW) (1931) 31 SR (NSW) 639.  Section 19(1)(k) of the Income Tax (Management) Act 1928 (NSW) allowed deductions for ‘[b]ad debts proved to be such to the satisfaction of the Commissioner and to have been … actually written off …’.  A proviso to s 19(1)(k) rendered subsequent receipts on account of the debts assessable, and was in all relevant respects the same as s 63(3) of the ITAA 1936.  At 643 his Honour said:

‘In passing, one may remark that this last provision [the proviso] shows that the expression, bad debts, means debts which are conjecturally bad, and that it is not necessary to establish that the debts are debts in respect of which nothing can ever be recovered.’

The equivalent of s 63(3) of the ITAA 1936 is to be found at Item 1.4 of the Table in s 20-30(1) of the ITAA 1997 showing deductions under that Act for which recoupments are assessable.

68                  So understood, there is nothing in the evidence which establishes or points to a finding that had Finance written off the TM debt as bad prior to the revocation of the 8 July 1999 comfort letter, that would not have been a reasonable assessment of the irrecoverability of the TM debt, any less than it is now accepted by the Commissioner that Finance’s write off of the TM debt after the revocation of that comfort letter was a reasonable assessment of its irrecoverability.  The matters to which the Commissioner pointed in his submissions on the hearing of the appeal, namely:

(1)               The possibility that Finance could have pressed TM to enforce TM’s contractual rights against BHPB (assuming such rights exist) by having TM wound up and funding a liquidator to bring proceedings against BHPB; and

(2)               the possibility of having BHPB inject debt or equity into TM to enable Finance to be repaid the amount of the TM loan,

are no more than that: possibilities which may enable a conclusion to be drawn that the TM debt, prior to the revocation of the 8 July 1999 comfort letter, was not one in respect of which nothing could ever be recovered.  But that is not the test to be applied in characterising whether or not the TM debt was bad at that time.  The test is whether it could be seen as a reasonable commercial assessment or judgment that the TM debt was irrecoverable at that time.  There is nothing in the evidence to suggest that it would have been anything else.  Indeed, to the contrary, all the evidence points to the TM debt being ‘conjecturally bad’ before the revocation of the 8 July 1999 comfort letter.

69                  For the foregoing reasons, I am of the view that there is no error in the primary judge’s conclusion that Finance did not obtain a tax benefit in connection with the scheme identified and relied upon by the Commissioner and, in the face of that conclusion, it is unnecessary, just as it was unnecessary for the primary judge, to address Issue [2(7)].

70                  Having said that, I would merely make the observation that, in the face of the Commissioner’s concession before the primary judge (see [186] of her Honour’s reasons), that the most obvious and simple commercial solution is what transpired – the writing off of the TM debt by Finance – it is difficult to envisage that any of the matters to which one is mandated to have regard in s 177D(b) viewed alone, together or in the aggregate, would point to a conclusion that the sole or dominant purpose of Finance or any other party which entered into or carried out the identified scheme was to obtain for Finance the relevant allowable deduction.

The Application of Division 243 to DRI

Introduction

71                  Division 243 of Part 3-10 of the ITAA 1997 is headed ‘Limited recourse debt’.  Section 243-10 details what the Division is about in the following terms:

72                  This issue concerns capital allowances claimed by DRI as follows: 

These capital allowances were claimed as deductions by BHPB as head company of the consolidated group:  Part 3-90 of the ITAA 1997.

Legislation

73                  Division 243 was inserted into the ITAA 1997 by the Taxation Laws Amendment Act (No 1) 2001 (Cth).  Section 243-15(1) sets out the basic conditions that must be satisfied:

‘(1)      This Division applies if:

(a)        *limited recourse debt has been used to wholly or partly finance or refinance expenditure; and

(b)        at the time that the debt*arrangement is terminated, the debt has not been paid in full by the debtor; and

(c)        the debtor can deduct an amount as a *capital allowance for the income year in which the termination occurs, or has deducted or can deduct an amount for an earlier income year, in respect of the expenditure or the *financed property.’

(Emphasis added).

74                  Each of the emphasised phrases is defined in the ITAA 1997.  ‘Limited recourse debt’ is defined in s 243-20.  Sub-sections (1) and (2) define ‘limited recourse debt’ in the following terms:

‘(1)      A limited recourse debt is an obligation imposed by law on an entity (the debtor) to pay an amount to another entity (the creditor) where the rights of the creditor as against the debtor in the event of default in payment of the debt or of interest are limited wholly or predominantly to any or all of the following:

(a)        rights (including the right to money payable) in relation to any or all of the following:

(i)         the *debt property or the use of the debt property;

(ii)        goods produced, supplied, carried, transmitted or delivered, or services provided, by means of the debt property;

(iii)       the loss or disposal of the whole or a part of the debt property or of the debtor’s interest in the debt property;

(b)        rights in respect of a mortgage or other security over the debt property or other property;

(c)        rights that arise out of any *arrangement relating to the financial obligations of an end‑user of the *financed property towards the debtor, and are financial obligations in relation to the financed property.

(2)        An obligation imposed by law on an entity (the debtor) to pay an amount to another entity (the creditor) is also a limited recourse debt if it is reasonable to conclude that the rights of the creditor as against the debtor in the event of default in payment of the debt or of interest are capable of being limited in the way mentioned in subsection (1).  In reaching this conclusion, have regard to:

(a)        the assets of the debtor (other than assets that are indemnities or guarantees provided in relation to the debt);

(b)        any *arrangement to which the debtor is a party;

(c)        whether all of the assets of the debtor would be available for the purpose of the discharge of the debt (other than assets that are security for other debts of the debtor or any other entity);

(d)        whether the debtor and creditor are dealing at *arm’s length in relation to the debt.

…

(5)        However, an obligation that is covered by subsection (1) is not a limited recourse debt if the creditor’s recourse is not in practice limited due to the creditor’s rights in respect of a mortgage or other security over property of the debtor (other than the financed property) the value of which exceeds, or is likely to exceed, the amount of the debt.

(6)        Also, an obligation that is covered by subsection (1), (2) or (3) is not a limited recourse debt if, having regard to all relevant circumstances, it would be unreasonable for the obligation to be treated as limited recourse debt.

(7)        A *limited recourse debt is a non‑arm’s length limited recourse debt if the debtor and creditor do not deal with each other at arm’s length in relation to the debt.’

75                  ‘Financed property’ and ‘debt property’ are defined in s 243-30 as follows:

‘(1)      Property is the financed property if the expenditure referred to in paragraph 243‑15(1)(a) is on the property, is on the acquisition of the property, results in the creation of the property or is otherwise connected with the property.

…

(3)        Property is the debt property if:

(a)        it is the *financed property; or

(b)        the property is provided as security for the debt.’

76                  Section 243-40 provides that ‘[t]he debtor’s assessable income for the income year in which the termination occurs is to include the excess referred to in subsection 243‑35(1)’.  It does not apply in years subsequent to the year in which the debt is terminated.  Those years are dealt with in s 243-55 which is in the following terms:

‘(1)      This section applies where this Division (other than section 243‑65) has applied in relation to a debt and the debtor is entitled to a *capital allowance deduction in respect of the expenditure or the *financed property in relation to a time or period after the termination of the debt.

(2)        The *capital allowance deduction is reduced if the amount that would have been worked out under subsection 243‑35(2) would have exceeded the amount worked out under subsection 243‑35(4) if the following assumptions were applied in both subsections:

(3)        The deduction is to be reduced by the amount of the excess.

77                  Finally, s 243-25(1) sets out the circumstances in which the debt arrangement is terminated.  For present purposes, it is sufficient to note that s 243-25(1)(g) provides that a debt arrangement is terminated if the debt becomes a bad debt.

Issue

78                  The principle issue, indeed the only relevant issue, concerning the application of Division 243 is whether any or all of the loans from Finance to DRI gave rise to ‘limited recourse debt’ within the meaning of ss 243-20(1) or (2).

The Primary Judge – Issue [2(8)]

79                  The primary judge approached the issue by first considering the ordinary meaning of the term ‘limited recourse debt’ outside the statutory context with which her Honour was concerned.  Her Honour referred to a number of authorities all of which pointed to the characterisation of debt as limited recourse debt as requiring or bearing the characteristic of limiting the creditor’s right to recover the debt from a specified security, asset, fund or cash flow; in contrast to what is sometimes called ‘full recourse debt’, when a creditor is at large to recover the debt from whatever resources the debtor has available.

80                  Having done that, the primary judge then turned to consider the statutory definitions in ss 243-20(1) and (2) by reference to Finance’s standard terms on which it lent to DRI, observing that they were silent on, or did not address, the rights of Finance against DRI in the event of default, directly or indirectly.  Her Honour concluded that, for that reason alone, it could not be said that the rights of Finance against DRI in the event of default were ‘limited wholly or predominantly’ to any of the matters listed in subparas (a) – (c) of s 243-20(1).  Nor, according to her Honour, as a matter of contract, was there any basis for the implication of a term in the contract between Finance and DRI limiting the rights of Finance wholly or predominantly to any of the matters listed in the subparagraphs of s 243-20(1).

81                  According to the primary judge, DRI’s obligation to Finance was unlimited except as to the amount of the debt or interest.  Finance had a right to call for repayment of the principal and any interest that had accrued, to sue on the promise of repayment in the standard terms and then to prove with other unsecured creditors in the event of a winding up of DRI.

82                  The primary judge then went on to consider the Commissioner’s contention, notwithstanding his concession that:

(1)               DRI’s obligations in respect of the loan from Finance were not secured either against its own assets or assets of any other entity; and

(2)               DRI’s obligations in respect of the loan from Finance were not covered by guarantees, letters of comfort or assurances from any other entity; and

(3)               in the event of default in payment of the debt or interest, Finance was limited to the ordinary rights of an unsecured creditor,

that s 243-20(1) ‘aptly describes the situation which existed as between DRI and Finance’.  The primary judge observed that the Commissioner maintained that contention on two bases.  First, that the noun ‘rights’ when it first appears in s 243-20(1) must be limited to the rights in subparas (a) – (c) and that the rights listed in those subparagraphs need not contain any further limitation and, secondly, consistent with that construction of s 243-20(1), Finance’s practical rights of recovery or recourse against DRI were wholly or predominantly limited to DRI’s assets at the HBI plant at Boodarie.

83                  At [216] the primary judge answered the Commissioner’s contention, and the bases upon which it was put, in the following way:

‘The express words of Div 243 (and, in particular s 243-20(1)) (see [198] above) do not support the Commissioner’s construction.  Moreover, if the construction contended for by the Commissioner were adopted it would lead to two absurd results.  First, that one would assess whether a debt was a limited recourse debt not at the time that the loan was made or relevantly varied but when a project fails and secondly, that the debt of every unsecured creditor, regardless of the contractual arrangements between the parties, would be treated as “limited recourse debt”.  Those results cannot be and were not the results intended by Parliament.  Read as a whole, it is apparent that the definition of limited recourse debt in s 243-20(2) was intended to expand the concept beyond those recorded in contractual arrangements between a debtor and a creditor.  If the Commissioner’s construction were adopted then much if not all of s 243-20 would be superfluous.  Parliament could have simply referred to any arrangement where a project fails and the debtor does not repay the advance.  That is not what occurred.’

84                  The primary judge then turned to s 243-20(2) upon which the Commissioner also relied.  Her Honour observed that it clearly intended to catch those debts which bear no existing legal limitation of the kind specified in subs (1) but where ‘it is reasonable to conclude that the rights’ in the event of default are ‘capable’ of being limited to those rights specified in subs (1).  Her Honour noted the submission of BHPB that subs (2) is intended to catch those arrangements which have the capacity to bring about the limitation described in subs (1) and observed that whether the capacity of that kind described exists is, of course, a question of fact to be resolved having regard to the matters listed in subparas (a) – (d) of subs (2).

85                  The primary judge then went on to reject the submission of the Commissioner, repeated on appeal, that s 243-20(2) adopted what her Honour called a test of economic equivalence – that the section necessitates an assessment of whether more than 50% of the property owned by the debtor is related to property acquired with the relevant loan proceeds.  Her Honour observed that if that were the correct approach, the result would be that funding arrangements at the start of a business would be limited recourse within Div 243 and would then fall in or out of the division depending on whether the venture was a success or a failure.  Her Honour further observed at [229] of her reasons:

‘[229]   … The terms of the funding arrangements (whether limited in the sense of sub-s (1) or considered more broadly under sub-s (2)) would simply be irrelevant.  That is not consistent with the express words of the section.  If the drafters had intended the issue to be approached in that manner, they would have said so.  They did not.’

86                  At [230] of her reasons, her Honour said:

‘Moreover, the express words of sub-s (2) are themselves inconsistent with a test of economic equivalence.  Under sub-s (2), one of the matters to consider in deciding whether the specified limitation is “capable” of being limited in the manner described is “‘whether all of the assets of the debtor would be available for the purpose of the discharge of the debt”:  s 243-20(2)(c).  In my view, that matter is not a factor or pointer in favour of the section adopting or incorporating a test of economic equivalence.  On the contrary, consistent with sub-s (1) and the evident purpose of the legislature to seek to define “limited recourse debt”, it is to be inferred that where all of the assets of the debtor are available for the purpose of the discharge of the debt (other than assets that are security for other debts of the debtor or any other entity) that would be a factor supporting the conclusion that the rights of the creditor against the debtor in the event of default were not capable of being limited in the manner specified.’ 

(Original emphasis.)

87                  The primary judge found further support for the rejection of the proposition that s 243-20(2) adopted or incorporated a test of economic equivalence in the interaction between Div 243 and Div 245 in Schedule 2C to the ITAA 1936.  Her Honour referred to the policy underlying the insertion of each division into the legislative scheme at [231] and [232] of her reasons in the following terms:

‘[231]   … Div 245 in Schedule 2C of the 1936 Act was inserted in the tax legislation to address a “structural weakness”:  Second Reading Speech to the Taxation Laws Amendment Act (No 2) 1996.  Prior to the introduction of Div 245, on forgiveness of a debt a creditor was entitled to a bad debt deduction or a capital loss and the debtor would continue to be entitled to deduct losses accumulated before the debt was terminated and to claim capital allowance deductions for expenditure funded by the forgiven debt.  In other words, both the debtor and the creditor enjoyed a deduction for the same economic loss in relation to a bad debt.  That “weakness” was addressed by Div 245.  In fact, in the present case, BHPDRI applied Div 245 when it lodged its returns to the bad debt written off by Finance. 

[232]    On the other hand, Div 243 (introduced some three years later) is not concerned with or directed to the economic benefit to a taxpayer if a debt is forgiven.  Div 243 is directed to the specific case where a taxpayer is not personally at risk in relation to borrowed funds used to finance an item of capital.  In general terms, the measures were introduced to address not a case of double deductions for the same debt (by two different taxpayers) but the situation where a taxpayer obtained deductions greater than the total amount outlaid by that taxpayer in relation to capital expenditure under hire purchase or limited recourse debt arrangements primarily in cases where the balance of an outstanding debt that had financed the expenditure was not paid and the financier could only recover a specific asset on termination of the finance arrangement:  paras 2.6-2.9 of the Explanatory Memorandum to Taxation Laws Amendment Bill (No 5) 1999 (Cth).’

88                  For the foregoing reasons, the primary judge concluded that Division 243 had no application to the DRI debt.

The Commissioner’s Submissions on Appeal – Issue [2(8)]

89                  On the hearing of the appeal, the Commissioner submitted that the primary judge’s conclusion that Finance’s rights on a relevant event of default were not limited to rights in relation to the assets of the HBI project, within the meaning of s 243-20(1), was based upon a misconstruction of the language and structure of the Division.  The submissions were particularly critical of her Honour’s approach in first looking at the ordinary meaning of the term ‘limited recourse debt’ outside the context of the statute.  In reliance on what Kirby J said, in dissent, in Royal Botanic Gardens and Domain Trust v South Sydney City Council (2002) 186 ALR 289 at [70], the Commissioner submitted that such an approach was an erroneous approach to statutory construction which should be ‘rooted out’.  The proper place to start was the statute.

90                  Turning to the statute, first to s 243-20(1), the Commissioner conceded that the focus should be confined to subpara (a)(i) – whether the rights of the creditor (Finance) against the debtor (DRI), in the event of default in the payment of the debt or interest, are limited wholly or predominantly to:

‘(a)      rights … in relation to … :

(i)         the *debt property …’

Having regard to the definition of ‘debt property’ in s 243-30(3) (see [75] above), it relevantly refers to the assets of the HBI project.  So understood, the issue is whether the rights of Finance against DRI, in the event of default in the payment of the debt or of interest, are limited wholly or predominately to rights in relation to the assets of the HBI project.

91                  The Commissioner submitted that the reference to ‘rights’ was a reference to legal rights, albeit not confined to contractual rights.  The Commissioner next submitted that the appropriate time to test whether the rights are ‘limited wholly or predominantly to rights in relation to … the debt property’, is at the time of the advance.  Even if these two submissions were not common ground, it is fair to say they were not controversial.

92                  However, it is with the Commissioner’s next submission that controversy is introduced.  The Commissioner submitted that the word ‘limited’ does not raise an enquiry as to whether the rights on a relevant event of default are contractually confined in some way, but how far, in practice, are those legal rights projected to extend.  This approach looks to the financial position of the borrower at the time the advance is made rather than any contractual confinement of the lender’s recourse to determine whether the lender’s rights on a relevant event of default are ‘limited’ in the sense used in the section.  Thus, looking at opposite ends of the spectrum, an advance to a special purpose project company to acquire the debt property at a time when it has no other assets will be ‘limited’ in the sense used in the section and will therefore be ‘limited recourse debt’ notwithstanding that the lender’s recourse against the borrower and its assets on a relevant event of default is contractually unlimited.  On the other hand, an advance to a borrower on identical terms and conditions at a time when the borrower owns other assets having a value in excess of the amount of the advance and to which the lender might have recourse on a relevant event of default, would not be ‘limited’ in the sense used in the section and will therefore not be ‘limited recourse debt’.

93                  Immediately on the back of this submission, the Commissioner was quick to point out that such an approach did not trigger the application of Division 243 unless the requirement of s 243-15(1)(b) was also satisfied, namely, that at the time the debt arrangement terminated, the debt had not been paid in full by the debtor.  As the Commissioner put it, this requirement is unlikely to be met if the project is a success; application of the Division is only likely to be triggered if the project fails.

94                  The Commissioner sought further support for the construction of s 243-20(1) for which he contended by the terms of s 243-20(5) which provides:

‘However, an obligation that is covered by subsection (1) is not a limited recourse debt if the creditor’s recourse is not in practice limited due to the creditor’s rights in respect of a mortgage or other security over property of the debtor (other than the finance property) the value of which exceeds, or is likely to exceed, the amount of the debt.’

It was not made clear how the terms of s 243-20(5) support the construction of s 243-20(1) for which the Commissioner contended.  Speaking for myself, I think it supports the construction which found favour with the primary judge.  I return to this matter below.

95                  In the alternative, the Commissioner relied on s 243-20(2) for his submission that the DRI debt was a limited recourse debt.  Additionally, he submitted that s 243-20(2) is of assistance in the construction of subs (1) and that it works harmoniously when one looks to the language of subs (2).  According to the Commissioner, in subss (1) and (2), you are hypothesising an event of default and, in both cases, you are looking to the projected, practical extent of the creditor’s legal rights.  In subs (1), you are simply looking at things as they stand at the time of the debt being incurred.  In subs (2), you are looking at the possibilities that existed at that time, given the factors referred to in paras (a) through to (d).  That is the way in which these provisions are properly construed.

96                  The Commissioner’s written submissions were more detailed and comprehensive, however the foregoing paragraphs paraphrase their essential focus and substance.

BHPB’s Submissions on Appeal – Issue [2(8)]

97                  Not surprisingly, in its submissions BHPB sought to defend the approach of the primary judge below and, in the process, much of her Honour’s reasoning.  I deal with many of these submissions, as well as the observation of the primary judge, in the analysis which follows.  In those circumstances, it does not seem utile to repeat them by way of preface.

Analysis – Issue [2(8)]

98                  It is undoubtedly correct, as BHPB submitted, that the modern approach to statutory interpretation is that articulated in the joint judgment in CIC Insurance at 408.  The modern approach:

‘(a) insists that the context be considered in the first instance, not merely at some later stage when ambiguity might be thought to arise, and (b) uses “context” in its widest sense to include such things as the existing state of the law and the mischief which, by legitimate means such as those just mentioned, one may discern the statute was intended to remedy.’

99                  Moreover, as Hill J, with whom Stone and Allsop JJ agreed, remarked in HP Mercantile at [44]:

‘[T]he Court will prefer an interpretation of a statute which would give effect to the legislative purpose, as opposed to one that would not.  This requires the Court to identify that purpose, both by reference to the language of the statute itself and also any extrinsic material which the Court is authorised to take into account.’

100               While it is true that the term ‘limited recourse debt’ is defined by the relevant provisions of the statute and ultimately those provisions, properly construed, are determinative of its meaning and scope, the Commissioner’s criticism of the primary judge looking first at the ordinary meaning of the term is, in my view, unduly harsh.  It is not as if her Honour allowed that meaning to infect the task of statutory construction which her Honour then undertook.  On the other hand, if her Honour had come to a different view from the one she did, the fact that there was a divergence between the ordinary meaning and the statutory meaning of the term would warrant explication by reference to identifiable legislative policy.

101               In the search for the identity of the legislative policy underlying Div 243, it was entirely legitimate for the primary judge to look beyond the context of Div 243; to look to the ITAA 1936 and the ITAA 1997 as a whole and determine where Div 243 fitted within that legislative scheme.  In particular, it was entirely appropriate for her Honour to consider, as her Honour did at [231] and [232] of her Honour’s reasons (see [87] above), the interaction between Div 243 and Div 245 in Schedule 2C to the ITAA 1936 and the legislative background to each.

102               On the other hand, I am not persuaded that the fact that when DRI lodged its returns of income, it applied Div 245 to the bad debt written off by Finance, has any bearing on the issue.

103               Nevertheless, the legislative policy underlying Div 243 can be clearly identified from the terms of s 243-10, namely, to reverse capital allowance deductions that have been obtained for expenditure that is funded by debt when the debtor (in this case DRI) is not fully at risk in relation to the expenditure and the debt is not fully repaid.

104               The legislative policy so identified, conditions the proper construction of ss 243-20(1) and (2).  They are to be construed so that their application is confined to situations where, at the time of borrowing, the debtor is not fully at risk in relation to the expenditure because of contractual limitations on the lender’s rights of recourse on a relevant event of default or, where, at the time of borrowing, the debtor or someone else has the capacity to subsequently bring about that state of affairs.

105               There are a number of other considerations which support this policy identified construction, rather than the construction for which the Commissioner contended.  Some of these considerations are contextual, while others might be characterised as consequential:

(1)               A criterion of whether the borrower is fully at risk in relation to expenditure rather than one based on the borrower’s financial resources sits more comfortably with the common language of ss 243-20(1), (2) and (3), ‘the rights of the creditor as against the debtor … are … limited’.

(2)               Contrary to the Commissioner’s submission referred to at [94] above, the terms of s 243-20(5) strongly support the policy identified construction.  It operates where, despite the fact that the borrower is not fully at risk by reason of the contractual limitation on the creditor’s rights of recourse, in practice the creditor’s recourse is not limited due to security over property of the debtor (other than the debt property) the value of which exceeds, or is likely to exceed, the amount of the debt.  If the construction of ss 243-20(1) and (2) contended for the Commissioner was the proper construction, s 243-20(5) would be otiose.

(3)               The policy identified construction is also supported by one of the matters to be considered under s 243-20(2) in deciding whether the rights of the creditor as sub-paragraph (c) requires one to have regard to:

‘[W]hether all of the assets of the debtor would be available for the purpose of the discharge of the debt (other than assets that are security for other debts of the debtor or any other entity).’

106               I totally agree with the primary judge at [230] of her Honour’s reasons, that it is to be inferred that where all of the assets of the debtor are available for the purpose of the discharge of the debt (other than the parenthetically excluded assets) that would be a factor supporting the conclusion that the rights of the creditor against the debtor in the event of default were not capable of being limited in the manner specified.

107               While it is undoubtedly true that the construction for which the Commissioner contends does not lead to the result that the debt of every unsecured creditor, regardless of the contractual arrangements between the parties, would be treated as ‘limited recourse debt’, cf., the primary judge’s reasons at [216], even the Commissioner conceded that would be the case if the borrower were a start-up company with no or little assets at the time of borrowing to fund the expenditure, such as a special purpose project company.  Moreover, whether or not Div 243 applied to reverse capital allowance deductions by including equivalent amounts in assessable income would then depend on the success of the project.  If it ultimately failed and the debt could not be fully repaid, the Division would apply.  The only way to avoid that consequence would be to undertake the project in an established company the unencumbered assets of which were, at the borrowing time, greater than the anticipated borrowing.  That would place business in this country, particularly for those involved in resources and infrastructure projects, in a ‘tortuous straight jacket’, the likes of which could never have been part of the policy or the intention of the Parliament in enacting Div 243.  For that reason alone, the Commissioner’s construction must be rejected.

108               For the foregoing reasons, there is no error in the primary judge’s conclusion that the DRI debt was not ‘limited recourse debt’ for the purposes of Div 243.

109               In that event, it is unnecessary to consider BHPB’s alternative argument that Div 243 could have no operation to it as the head entity of a consolidated group for the purposes of Part 3-90 of the ITAA 1997.

110               The appeals must be dismissed.  The Commissioner, must pay the respondents’ costs.

Associate:

Dated:         17 March 2010