FEDERAL COURT OF AUSTRALIA

TAXATION AND REVENUE - income tax - allowable deductions - franchise fees designed to capture taxpayer’s excess profits - whether franchise fees are allowable deductions - whether franchise fees are a distribution of profits - whether franchise fees are of a capital nature

Income Tax Assessment Act 1936: s 51(1)

Electricity Industry Act 1993 (Vic): s 163A

Air Caledonie International v The Commonwealth (1988) 165 CLR 462

Australian Tape Manufacturers Association Limited v The Commonwealth (1993) 176 CLR 480

BP Australia Ltd v Federal Commissioner of Taxation (1965) 112 CLR 386

Broken Hill Theatres Pty Ltd v Federal Commissioner of Taxation (1953) 85 CLR 423

Cliffs International Inc v Federal Commissioner of Taxation (1979) 142 CLR 141

Commissioner of Taxes v Nehanga Consolidated Copper Mines Ltd [1946] AC 948

CTC Resources NL v Federal Commissioner of Taxation  94 ATC 407

First Provincial Building Society v Federal Commissioner of Taxation 95 ATC 4145

GP International Pipe Coaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 120

Hallstroms Pty Ltd v Federal Commissioner of Taxation (1992) 176 CLR 141

Matthews v Chicory Marketing Board (Vict) (1938) 60 CLR 263

Mount Isa Mines Ltd v Federal Commissioner of Taxation (1992) 176 CLR 141

National Australia Bank Ltd v Federal Commissioner of Taxation, Federal Court of Australia, 12 June 1997, unreported

Payne v Federal Commissioner of Taxation 94 ATC 4191

Smithkline Beecham Laboratories (Australia) Ltd v Federal Commissioner of Taxation (1993) 44 FCR 129

Sun Newspapers Ltd v Commissioner of Taxation (Cth) (1938) 61 CLR 337

UNITED ENERGY LIMITED v THE COMMISSIONER OF TAXATION OF THE COMMONWEALTH OF AUSTRALIA

VG 673 of 1996

LOCKHART, SUNDBERG and MERKEL JJ

27 AUGUST 1997

MELBOURNE

THE COURT ORDERS THAT:

1.    The appeal be dismissed;

2.    The Commissioner’s disallowance of the applicant’s objection, dated 20 August 1996 in a private ruling, be confirmed;

3.    The applicant pay the costs of the Commissioner of this proceeding

Note:               Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules.

REASONS FOR JUDGMENT

LOCKHART J

The issue in this appeal is whether the applicant, United Energy Limited, is entitled to an allowable deduction under s 51(1) of the Income Tax Assessment Act 1936 (‘the Act’), for franchise fees paid, and payable, by it to the Treasurer for the State of Victoria pursuant to orders made by the Governor in Council of the State of Victoria under s 163A of the Electricity Industry Act 1993 (Vic) (‘the EIA’).

The appeal is against the disallowance by the Commissioner of Taxation of an objection by the applicant to a private ruling dated 20 August 1996 by which the Commissioner ruled that the franchise fees are not deductible under s 51(1) because (a) they were not incurred in gaining or producing the applicant’s assessable income, or (b) they were not necessarily incurred by it in carrying on its business for that purpose, or (c) they were of a capital nature.

The right of the applicant to appeal to this Court from an adverse ruling request is conferred by s 14ZZ of the Taxation Administration Act 1953 (‘the Administration Act’) (see also s 14ZAZA).

The Court is sitting in its original jurisdiction which is being exercised by a Full Court pursuant to a direction by the Chief Justice under s 20(1A) of the Federal Court of Australia Act 1976.

The private rulings system embodied in Part IVAA of the Administration Act was discussed by a Full Court of this Court in CTC Resources NL v Federal Commissioner of Taxation 94 ATC 4072 per Gummow J at 4075-4077 (with whose reasons for judgment Jenkinson J agreed at 4075); and by Hill J at 4093-4095.  See also First Provincial Building Society v Federal Commissioner of Taxation 95 ATC 4145 per Hill J at 4146, with whose reasons for judgment Black CJ agreed.

In a proceeding of this kind the Court is confined to the facts stated in the Commissioner’s ruling: CTC Resources NL per Hill J at 4100 and Payne v Federal Commissioner of Taxation 94 ATC 4191 per Hill J at 4198.  The parties proceeded before us on this basis.

The facts are not in dispute.  Critical to the determination of the question in issue is an understanding of the EIA, in particular s 163A, viewed in the context of the major restructure of the electricity industry of Victoria which took place in the early and mid 1990s.

Background to the Legislation

            In October 1992 the Victorian government announced that it would review the structure and operation of the electricity supply industry (‘ESI’) in Victoria.  Historically that industry had operated as a monopoly and was protected by regulatory and institutional barriers.  Lack of competition meant that there was little pressure on the industry to improve its performance and practices.  This resulted in higher than necessary prices for electricity compared with other States.  The Victorian government perceived that a competitive electricity supply industry was fundamental to an efficient economy and that reform of the industry was essential to revitalize Victoria in the provision of that source of power.

The Victorian government’s announcement identified the need for reform largely due to: -

(a)        too much capacity resulting from excessive capital spending and over design of facilities;

(b)        unfair tariff structure which considerably overcharged some groups of customers and subsidized others;

(c)        no independent regulation of pricing or quality of supply; and

(d)        lack of competitive pressure needed to stimulate innovation, commercial investment decisions, productivity and maximization of value for customers.

The Victorian government engaged experts, both locally and from overseas, to prepare a major review of the ESI; and in October 1993 the government announced that it had established a reform process that would move the ESI through a series of changes to a competitive market.  The first stage was to divide the State Electricity Commission of Victoria (‘SECV’) into three independent businesses which would prepare for corporatization and further divisions after 30 June 1994.  Each division would represent a stage in the supply chain: generation, transmission and distribution.

On 14 December 1993, in furtherance of the government’s stated objective, the EIA was assented to.  This Act had the purpose of restructuring the electricity supply industry.

In February 1994, following extensive work by a variety of industry experts in consultation with SECV management, the Victorian government announced stage 2, which was the initial structure for a corporatized and competitive electricity supply industry, to comprise the following new companies, each with its own independent board:

(1)        an independent company to monitor and control the wholesale electricity market and ensure the security of the supply system (Victorian Power Exchange);

(2)        a transmission grid company to own, maintain and manage the high voltage grid; this company was to be a natural monopoly and remain State owned (Power Net Victoria);

(3)        Generation Victoria, an interim organization comprising generating units to trade in the market as independent producers.  The purpose of this organization was to develop a more competitive structure based on independent generating companies;

(4)        five regionally based distribution companies (DBs), comprising former SECV assets and activities, and 11 Municipal Electrical Undertakings (‘MEUs’).  Three of the DBs were to service metropolitan Melbourne (of which the applicant is one) and two were to service rural Victoria;

(5)        an independent regulator to protect the consumer, monitor and maintain the integrity of supply and ensure that the market operates fairly (Office of the Regulator-General).

The government was concerned to provide a ‘level playing field’ for all entrants into the market.  In relation to the proposed DBs the government undertook a ‘sanity review’ for the purpose of ensuring the creation of a competitive and sustainable DB industry structure to enable each DB to be financially independent on a ‘stand-alone’ basis.

An important report commissioned by the Victorian government was the February 1994 Report of KPMG and CS First Boston (‘the Report’).

The Report noted that the two rural DBs would have lower rates of return (measured by earnings before interest and tax (‘EBIT’) to funds employed (‘ROA’)) than the three urban DBs.  This was partly because of the higher fixed cost structure for rural distribution assets - urban DBs were predicted to earn ROAs of up to 23%.

The Report stated that the ability of the urban DBs to earn an ‘excessive’ return could create overheated competition which would be inconsistent with the Government objectives for the reform of the industry.

The Report expressed the conclusion that the Government could preserve its policy objectives of maintaining uniform retail tariffs across regions by charging additional grid fees, higher wholesale prices or a levy to the three urban DBs so that their ROAs were limited to about 15%.

The Victorian government decided to amend the EIA to introduce an impost in the form of s 163A.  In a Cabinet Paper relating to franchise fees it was said:

‘Further final decisions relating to ESI (Electricity Supply Industry) reform will be required prior to the corporatisation of companies within the Victorian ESI before 1 July 1994.  These will include:

...

(iii)    implementation of an excess profits adjustment for the urban distribution businesses for a transitional period. ...’

In an Explanatory Memorandum titled ‘Victorian Electricity Industry Franchise Fees’ prepared by advisers to the Victorian Government (undated) it was stated:

‘           A key philosophical principle in their establishment was the DBs should be established on a “level playing field” basis.’

...

5.         The reason the DB structure highlights the rural/urban cross subsidy is the existence of the Maximum Uniform Tariffs.

...

            That is, each DB receives the same revenue (on a cents per kilowatt hour basis) for a particular customer type, irrespective of the DB’s cost to supply that customer.’

‘Issue

            Particular beneficiaries of MUTs therefore are those DBs who, purely as a result of where arbitrary lines have been drawn on a map, have a high proportion of customers who historically have been penalised by cross subsidies (ie) urban and smaller business customers.

            This unequal position as between DBs, if not addressed, is fundamentally inconsistent with the level playing field objective, in that DBs enjoying high regulated profit margins could use these margins to cross subsidise pricing to contestable customers to win market share from DBs not enjoying such regulated margins.’

‘           Solution

            To provide for a level playing field, it was decided to impose franchise fees on all DBs such that all DBs would be earning no greater retail margin than would be expected if all customers had been contestable from the outset (approximately 2% on sales).  This is more appropriately viewed therefore as a fee payable by the DBs for the benefit (which unevenly falls on the DBs without any meritorious reason from the DBs’ perspective) of their franchise customer bases.  It should, therefore, mean that all DBs are able to compete on an equal footing without any a priori reason for a difference in their cost of doing business with respect to franchise customers.’

In a document issued by the Victorian government in December 1994 titled ‘Reforming Victoria’s Electricity Industry’ the following appears in paragraph ‘10.3 State Charges’:

‘A franchise fee is to be levied by Government on all parties licensed under the Electricity Industry Act 1993 to sell electricity to franchise customers.

The franchise fee is designed to capture “excess” profits that would otherwise accrue to DBs as a result of Government setting MUTs across Victoria which are in excess of the cost of supplying electricity to franchise customers, including a fair return on assets.

The rationale for a franchise fee is to maintain equity between franchise customers across the State.  Government has set a MUT for each franchise customer class regardless of their location in Victoria until the relevant deregulation date.  Although structures to decline in real terms during the franchise period, the MUTs have historically been set at a price higher than the total expected cost of electricity supply (including a return on assets) in many areas of the State.  The franchise fee applies only to franchise customer sales.  It reduces as franchise customer classes become contestable and does not apply after the franchise period.

In economic terms, the DBs have a monopoly over their franchise customers at a supply price set by Government.  The franchise fee captures for Government the “monopoly rent” that would otherwise be available to the DBs.  Beyond the franchise period, the DBs will no longer have monopoly power over their customers and the monopoly rent is expected to be competed away.  The franchise fee will be fixed or capped such that DB owners are able to enjoy the benefits of productivity savings.

Provision has also been made for Government to charge a further fee.  Government has stated that the objective of this fee is to partially or completely recover expected losses by the SECV Shell arising from the Loy Yang B trader and from sales to the Portland smelter.’

In order to implement Stage 2 of the Government’s reform to the ESI the Government amended the EIA by the Electricity Industry (Amendment) Act assented to on 15 June 1994.  Section 25 of that Act inserted a new Part 12 titled “Regulation of Electricity Industry” which, inter alia, introduced prohibitions against a person engaging in the generation, distribution, supply or sale of electricity unless the person is the holder of a licence.

Further amendments were contained in the Electricity Industry (Further Amendment) Act 1994 assented to on 20 December 1994, which, inter alia, introduced a new s 158A (the provision for the Governor in Council by Order to regulate tariffs and other charges and prices) and s 163A which required a franchise fee to be paid by a distribution company that supplies electricity to franchise customers under licence.

Section 163A was further amended by the Electricity Industry (Amendment) Act 1995 (‘the 1995 Act’).  In the Second Reading Speech to the Electricity Industry (Amendment) Bill, 11 May 1995, Mr S J Plowman (Minister for Energy and Minerals) said:

‘Another important feature of part 2 is the provision setting out the basis on which the government will set franchise fees to be paid by those distribution companies which are licensed to sell electricity to franchise customers.  The franchise fee is designed to capture for the government the “monopoly rent” that would otherwise be available to the distribution companies.  Beyond the franchise period, the distribution companies will no longer have monopoly power over their customers and the monopoly rent will be eradicated by competition and regulated open access rules.’

Relevant Provisions of the EIA

Part 12 of the EIA bears the heading ‘REGULATION OF ELECTRICITY INDUSTRY’.  Section 158A empowers the Governor in Council, by order published in the Victorian Government Gazette, to regulate in such manner as the Governor in Council thinks fit, tariffs for the sale of electricity to franchise customers, charges for connection to and the use of any distribution system and the transmission system and certain prices in respect of goods and services.

A person is prohibited from engaging in the generation of electricity for supply or sale or the transmission, distribution, supply or sale of electricity unless the person holds a licence authorizing the relevant activity or is exempted from the requirement to obtain a licence (s 159).

Section 161 deals with applications to the Regulator General for licences to generate, distribute, supply or transmit electricity. 

Section 162 is directed to applications for the issue of licences.  Section 163 contains provisions relating to licences including paragraph 3(a) which states that one of the conditions to which a licence is subject may be a provision requiring the licensee to pay specified fees and charges in respect of the licence to the Regulator-General.

Section 163AA empowers the Governor in Council on the recommendation of the Treasurer, by Order published in the Victorian Government Gazette, to declare that specified charges or charges calculated in a specified manner are payable as an impost by the holder of a licence at such times and in such manner as are so specified (s 163AA(1)). 

The central section is s 163A headed ‘Franchise Fee’ the terms of which are as follows:

“163A(1)       A distribution company that holds, or has held, an exclusive licence under this Part authorising it to sell electricity to franchise customers must pay to the Treasurer, in respect of each financial year during which it holds, or held, such a licence the impost determined in respect of that year by Order of the Governor in Council, on the recommendation of the Treasurer, applying to that company and published in the Government Gazette:

(a)        if the licence is issued before 30 June 1996:

(i)         before 30 June 1995, in the case of the impost in respect of the financial year ending on that date; and

(ii)        before 30 June 1996, in the case of the impost in respect of each year ending on 30 June in the period beginning on 30 June 1996 and ending on 30 June 2001; and

(b)        if the licence is issued on or after 30 June 1996, before the end of the first year of the term of the licence.

     (2)                        The Treasurer, in recommending the amount of an impost for each financial year payable by a distribution company, must be satisfied that the amount reasonably represents the amount by which the income of the company derived from the sale of electricity to franchise customers in that year is likely to exceed the sum of:

(a)        the costs of deriving the income; and

(b)        taxes payable in deriving that income; and

(c)        an amount determined by the Treasurer to be a reasonable return on the capital of the company used in deriving that income,

having regard to:

(d)        any relevant Order in force under section 158A; and

(e)        the value of property and rights vested in the company under Parts 10 and 11; and

(f)         the amount of liabilities that became liabilities of the company under Parts 10 and 11; and

(g)        the likely number of franchise customers of the company in that financial year; and

(h)        such other matters as the Treasurer determines after consultation with the company.

(3)     The impost in respect of a financial year is payable at such times and in such manner as are determined in the Order.

(4)     For the purposes of the section, a distribution company has an exclusive licence authorising the sale of electricity to franchise customers if that licence is the only licence in force under this Part authorising the sale of electricity to those customers.’

The applicant

The five regionally based DBs were formed on 3 October 1994 with all shares being held by, or on behalf of, the State of Victoria.  The distribution activities and assets of SECV and the MEUs were transmitted to them by allocation under Parts 10 and 11 of the EIA (as amended).  Three of the DBs (the applicant, CitiPower Pty Ltd (formerly CitiPower Ltd) and Solaris Power Ltd) are predominantly based in Melbourne, while Eastern Energy Ltd and Powercor Australia Ltd operate distribution networks covering the rest of Victoria.

To create competition each of the DBs split its business functions into two.  The first is the distribution function or ‘wires business’, and the second is the retail business.  Hence, on 3 October 1994, the applicant was granted a Retail Licence and a Distribution Licence by the Office of the Regulator-General under section 162 of the EIA.

Upon the grant of the licences, the applicant carried on the distribution and sale of electricity in accordance with the terms of its licences.

The distribution licence and the retail licence granted on 3 October 1994 authorized the applicant to distribute and sell electricity in its geographical distribution area, being the eastern fringe of Port Philip Bay in Victoria (Schedule 2 to each of the licences).

Clause 3.5 of the licences provides that the Office of the Regulator-General may, on the giving of 20 business days’ notice, revoke the relevant licence for non-compliance with an enforcement order or an undertaking.

On 7 August 1995 an agreement was entered into between SECV, the State of Victoria and Power Partnership Pty Ltd whereunder Power Partnership Pty Ltd agreed to acquire all of the shares in the applicant from SECV.

Purchasers of electricity from DBs are called customers by the EIA and are one of two classes of customer: ‘franchise’ customer or ‘non-franchise’ customer.  The definition section (s 154) defines a ‘franchise customer’ as meaning a customer other than a non-franchise customer; ‘non-franchise customer’ means a customer who purchases a load or amount of electricity that exceeds prescribed limits determined in accordance with the regulations.

It is agreed between the parties that over time, customers will move from the status of franchise customers to the status of non-franchise customers as the megawatt hour (Mwh) threshold reduces.  Franchise customers do not have a choice of their retail supplier of electricity; their only supplier is the DB responsible for their geographical area.  From December 2000 all customers will be able to choose their retail electricity supplier without geographical constraint; hence the applicant’s retail business will be subject to full competition so that all customers in its distribution area will be able to choose the particular DB which becomes their supplier.

The Franchise Fees

The franchise fees are payable at such times and in such manner as are determined in the relevant order made by the Governor in Council (s 163A(3)).  The franchise fee in respect of the year ending 30 June 1995 was determined by the Governor in Council as being payable by two instalments: the first on 26 June 1995 and the second on 17 July 1995.  The franchise fees for the year ended 30 June 1996 were payable by four equal instalments on 15 October 1995, 15 January 1996, 15 April 1996 and 15 July 1996.  The payments in respect of the subsequent years except the last year (2001) are payable on the same days and months.  The two payments payable in respect of the year ended 30 June 2001 are payable by two equal instalments on 15 October 2000 and 15 January.

The franchise fees are payable in advance with the Treasurer being required to be satisfied that the amount of the impost reasonably represents the amount by which the income of the company derived from the sale of electricity to franchise customers in the relevant year is likely to exceed the sum of the items mentioned in paragraphs (a), (b) and (c) of s 163A(2), namely:

.           the costs of deriving the applicant’s income from the sale of electricity to franchise customers (s 163A(2)(a));

.           the taxes payable in deriving that income (s 163A(2)(b)) (this presumably has in mind taxes, whether State or Federal, which are payable in deriving the income); and

.           an amount determined by the Treasurer to be a reasonable return on the capital of the company used in deriving that income (s 163A(2)(c)).  The Treasurer must have regard to the matters specified in paragraphs (d) to (h) of s 163A(2), the terms of which were set out earlier.

They are assessed with reference to a predetermination of the likely income of the applicant, but the assessment is prospective.  The franchise fees are payable irrespective of the amount of profit actually earned in the relevant years of income by the applicant.

There is no provision in the EIA for the franchise fees to be varied by increase or reduction.

On 20 June 1995, pursuant to s 163A of the EIA, an order was made by the Governor in Council on the recommendation of the Treasurer concerningthe applicant in respect of the year ended 30 June 1995.  The amount payable thereunder in respect of franchise fees was $85,900,000.00 (the 1995 order).

On 15 August 1995 a second order was made under s 163A of the EIA by the Governor in Council in respect of the year of income ended 30 June 1996 and each of the years of income thereafter ending 30 June until 2001.

Franchise fees paid by the applicant to the date of the Commissioner’s determination of the object are as follows:

            Financial Year                          Date Payable                Amount A$

_________________________________________________________

            1995                                        Before 20/6/9543,683,000.00

                                                            26/06/1995                  10,317,000.00

                                                            17/07/1995                  31,900,000.00

            1996                                        15/10/1995                  15,486,736.00

                                                            15/01/1996                  15,486,736.00

                                                            15/04/1996                  15,486,736.00

                                                            15/07/1996                  15,486,736.00

            1997                                        15/10/1996                  16,994,986.00

Submissions of the Parties

Counsel’s submissions were directed to the questions which arise under s 51(1), namely, whether the franchise fees answer the description of losses or outgoings to the extent to which they are incurred in gaining or producing the assessable income of the applicant (the first limb) or are necessarily incurred in the course of carrying on a business for the purpose of gaining or producing such income (the second limb).

The applicant’s contentions may be summarized as follows:-

.           The franchise fees have a direct relation to the applicant’s assessable income and must be met from time to time as part of the process of gaining that income.  They are an outlay incurred in the carrying on of the business.  Reliance was placed upon Amalgamated Zinc (De Bavay’s) Limited v Federal Commissioner of Taxation (1935) 54 CLR 295 per Latham J at 303-304 and John Fairfax & Sons Pty Limited v Federal Commissioner of Taxation (1959) 101 CLR 30 per Menzies J at 49.

.           The franchise fee is expenditure laid out as part of the applicant’s process of earning profit.  It is a statutory obligation imposed in relation to the holding of the licence to sell electricity to franchise customers; reference was made to Tata Hydro-Electric Agencies Limited v Income Tax Commissioner (Bombay) [1937] 2 All ER 291 at 297.

.           Franchise fees are not payable from actual profits earned by the applicant.  They are payable whether or not any profit is earned and irrespective of the size of any profit.  They are paid pursuant to the legal obligation which arises in the case of the applicant not because it earns a profit but because it holds a licence of a particular kind.  It could not earn any part of its assessable income unless it held that licence.

The Commissioner’s contentions in summary form are as follows:

.           The payments described as franchise fees are in truth payments to the Victorian government of excess profits. They represent a distribution to the State of a share of the applicant’s profits.

.           The franchise fees are not a cost in the derivation of the income of the applicant or in the business in which the income was derived.  The payment was and was intended to be an impost to extract profits once made rather than a cost incurred in the process of derivation of income.

.           The impost has the characteristics of a State tax on profits.  It is a compulsory exaction for public purposes enforceable by law and not a payment for services rendered.  Reliance was placed upon Australian Tape Manufacturers Association v The Commonwealth (1993) 176 CLR 480 at 500.

.           The payment of a tax on profits is not an expenditure which is necessary in order to earn profit; it is an expenditure which is chargeable upon and out of profit either ascertained or, as here, estimated.  It is a tax.  Reference was made to Ashton Gas Co v The Attorney-General [1906] AC 10 at 12; Smith’s Potato Estates Limited v Bolland (1948) 30 TC 267 at 294-5; R v Vaccari [1958] 1 WLR 297 at 299; Davies Coop & Co Pty Limited v The Commonwealth (1955) 54 CLR 155 and R v D & W Murray (1909) 11 WALR 92.

Reasons

The franchise fee was aptly described in the words of the Minister for Energy and Minerals of the State of Victoria when the Electricity Industry Amendment Bill (later the EIA) during his Second Reading Speech on 11 May 1995 (previously mentioned) as a franchise fee ‘designed to capture for the government the “monopoly” that would otherwise be available to the distribution companies’ during the term of the franchise.  The franchise fees are payable quarterly in arrears and are payable each year until the year ending 30 June 2001.  As a Victorian government information memorandum relating to the applicant dated March 1995 states at p 152:

‘Franchise fee

The franchise fee is payable each year until the year ending 30 June 2001.

The real level of this fee has been estimated based on advice from Government and indexed for inflation using the CPI assumption.  This fee takes into account estimated distribution fees, retail margins and operating costs.  The fees are to be legally confirmed during April 1995 by an Order in Council as a fixed amount per year, to be indexed for CPI.  United Energy’s nominal franchise fees assuming CPI of 3.5% per annum for the years ending 30 June outside of the forecast period are $80.3 million in 1998, $71.5 million in 1999, $76.1 million in 2000 and $23.8 million in 2001 (in respect of the first six months only).  Franchise fees are not payable in respect of the period after December 2000.  Franchise fees are payable quarterly in arrears.

Franchise fees are forecast to fall and then increase again as a result of the forecast reduction in vesting  contract prices in 1997.’

The amount of the franchise fees is ascertained by direct reference to the calculation by the Treasurer of likely income to be derived by the applicant.  Doubtless the calculation by the Treasurer of that income is fairly close to what it is in fact because of the nature of the monopoly right (the activity being the generation and sale of electricity) and the inelastic list of customers, being the consumers of electricity in the area of Melbourne which is the province of the applicant.

The Victorian government decided to radically alter the electricity industry in Victoria, and ultimately to privatize it.  The applicant became one of  the five DBs with a monopoly in its own sphere of influence to distribute electricity.  The government surrendered its monopoly of the control of this industry but in return demanded through legislation (s 163A) that the residual profit to be derived from the carrying on of the industry became its profit.

Properly analyzed the franchise fees are in reality akin to the State of Victoria taking a share of the profits from the DBs (in this case the applicant), leaving the applicant an amount determined by the Treasurer to be a reasonable return on the capital of the company used in deriving the income (s 163A(2)(c)).  The residue is taken by the State as its share of profits; it has similar characteristics to a payment by way of dividend.

Notwithstanding a degree of recurrence, the franchise fees are not in my opinion expenses or costs incurred in the derivation by the applicant of its income or in the course of carrying on its business from which it derived such income.  It is unreal to regard the payment of the franchise fees as falling within either of the two limbs of s 51(1) of the Act.  The fees are compulsory exactions imposed by the Victorian government to extract a share of the applicant’s profits made rather than a cost incurred in the process of derivation of income.  They are a State tax on profits which answer the description attributed by Latham CJ in Matthews v Chicory Marketing Board (Vict) (1938) 60 CLR 263 at 276, namely:

‘a compulsory exaction of money by a public authority for public purposes, enforceable by law, and is not a payment for services rendered.’

This statement was described by the High Court (Mason CJ, Brennan, Deane and Gaudron JJ) in Australian Tape Manufacturers Association Limited v The Commonwealth (1993) 176 CLR 480 at 500 as an ‘influential statement’; although their Honours also said at 500 that:

‘Although the elements in this statement have been recognized as the positive and negative attributes of a tax, this Court has held that the statement is not an exhaustive definition of what is a tax and has attached important qualifications to the statement.’

(A reference to Air Caledonie International v The Commonwealth (1988) 165 CLR 462 at 467.)

In Air Caledonie a Full Bench of the High Court stated certain of these qualifications as including the following at 467:

‘The third is that the negative attribute - “not a payment for services rendered” - should be seen as intended to be but an example of various special types of exaction which may not be taxes even though the positive attributes mentioned by Latham CJ are all present.  Thus, a charge for the acquisition or use of property, a fee for a privilege and a fine or penalty imposed for criminal conduct or breach of statutory obligation are other examples of special types of exactions of money which are unlikely to be properly characterized as a tax notwithstanding that they exhibit those positive attributes.  On the other hand, a compulsory and enforceable exaction of money by a public authority for public purposes will not necessarily be precluded from being properly seen as a tax merely because it is described as a “fee for services”.  If the person required to pay the exaction is given no choice about whether or not he acquires the services and the amount of the exaction has no discernible relationship with the value of what is acquired, the circumstances may be such that the exaction is, at least to the extent that it exceeds that value, properly to be seen as a tax.’

Also in Australian Tape Manufacturers Association, the High Court at 500-505 discussed this qualification fully.

The arrangement between the applicant and the State of Victoria is one of profit sharing or akin to the payment of dividends to the Victorian government as shareholder.  The franchise fee is not paid as a cost in the business of deriving income but is a dividend or profit paid to the State or a tax which in my view does not fit within either of the two limbs of s 51(1).

In one sense, of course, the moneys in question were expended by the applicant in the course of carrying on its business because it was essential to the whole legislative scheme that the applicant did carry on its business activities as the Victorian government through the SECV had done previously.  It is true that the franchise fees were calculated with respect to each individual financial year; but in the case of the six years ending 30 June 2001 they were calculated on a prospective basis by the very requirements of  the section itself.

To characterize the franchise fees as falling within either limb of s 51(1) seems to me to overlook their essential quality.

There are cases which support the proposition that hidden taxes payable in the course of carrying on a business may be deductible expenses within s 51(1); but all cases depend on their facts.

The franchise fee is in substance residual distribution of profits or dividends to the ultimate shareholder, namely, the government of the State of Victoria.  It does not answer the description of either limb of s 51(1) of the Act.

Even if the franchise fees were within either of the limbs of s 51(1) they would, in my opinion, be payments of a capital nature and thus not deductible.  I agree in substance with the submissions made by counsel for the Commissioner.

The question must be asked: what is the money really paid for and is what it is really paid for in truth and in substance, a capital asset?: Colonial Mutual Life Assurance Society Limited v Federal Commissioner of Taxation (1953) 89 CLR 428 per Fullagar J at 454. 

The answer to the question is determined by a practical examination of the facts concerning ‘what the expenditure is calculated to effect from a practical and business point of view’: BP Australia Limited v Federal Commissioner of Taxation (1965) 112 CLR 386 at 397.  Nor is the answer to be ascertained by ‘any rigid test or description’ (also at 397) per Lord Pearce in delivering the judgment of the Privy Council.

The answer to the question is not determined merely by the labels given to the transaction: Europa Oil (NZ) v Commissioner for Inland Revenue [1976] 1 WLR 464 at 472; Cliffs International Inc v Federal Commissioner of Taxation (1978) 142 CLR 140 at 148.

The fact that payments may be spread over a number of years does not prevent them from being properly characterized as capital in nature: Colonial Mutual Life Assurance Society Limited v Federal Commissioner of Taxation (1953) 89 CLR 428 and Federal Commissioner of Taxation v Ballarat & Western Victoria TV Limited (1978) 78 ATC 4630.

Although the payments made by way of franchise fee are in my view akin to a form of profit sharing arrangement between the State of Victoria and the applicant (or akin to dividend payments by a company to its shareholder), another way to view them would be as payments by the applicant in substance as a purchase price for a business which it acquired for nothing and which gave it monopoly power in a defined area of Melbourne.  In return for obtaining the exclusive right to conduct its business in Melbourne, the applicant makes payment of franchise fee until the monopoly runs out in the year 2001; it receives the monopoly right to distribute and sell electricity in its defined area and in return makes payment of the associated monopoly rent.

Conclusion

I would conclude by noting that it was not contended that the franchise fees, though imposts or taxes, were in essence duties of excise.

            I would:-

1.         Dismiss the appeal.

2.         Confirm the Commissioner’s disallowance of the applicant’s objection dated 21 October 1996 against the decision made by the Commissioner dated 20 August 1996 in a notice of private ruling.

3.         Order the applicant to pay the costs of the Commissioner of this proceeding.

Associate:

Dated:              27 August 1997

REASONS FOR JUDGMENT

SUNDBERG and MERKEL JJ

INTRODUCTION

In a Private Ruling dated 20 August 1996 made on the application of United Energy Limited (“the taxpayer”), the Commissioner of Taxation ruled that

“The imposts payable by the taxpayer to the State of Victoria pursuant to Section 163A of the Electricity Industry Act 1993 (the ‘franchise fees’) are not deductible for the purposes of Subsection 51(1) of the Income Tax Assessment Act as they are not considered to be losses or outgoings incurred in gaining or producing the assessable income, or necessarily incurred in carrying on a business for the purpose of gaining or producing such income.  The ‘franchise fees’ are also considered to represent an outgoing of capital or of a capital nature.”

The taxpayer objected to the Private Ruling.  On 24 October 1996 the Commissioner disallowed the objection.  The notice of disallowance is, in part, as follows:

The payment of franchise fees by United Energy is not considered deductible under subsection 51(1) of the Act for the following reasons:

1.         The expenditure is not  considered to have been incurred in the gaining or producing assessable income of the company, or necessarily incurred in carrying on a business for the purpose of gaining or producing such income.  In particular it is considered:

(i)         payment of the fee is independent of the process by which the company derives its assessable income and as such the expenditure is not considered to have been incurred in the course of the production of that income (refer Amalgamated Zinc (de Bavay’s) Ltd v FC of T (1935) 54 CLR 295);

(ii)        the payments are not incurred in the course of carrying on a business in the sense that they are not in the nature of operating costs (refer John Fairfax & Sons Pty Ltd v FC of T (1959) 101 CLR 30);

(iii)       the payments are made from actual profits earned by United Energy rather than being outgoings incurred in the course of deriving those profits (refer The Commissioner of Taxation (W.A.) v Boulder Perseverance (1937) 58 CLR 223).

2.         The expenditure is also considered to be capital in nature for the following reasons:

(i)         the payment of franchise fees is made in order that United Energy may, or as a consequence of being in a position to, charge a specific price (‘the MUT’) to franchise customers.  This relates to the profit earning structure of the business and is thus capital in nature (refer Sun Newspapers v FC of T (1938) 61 CLR 337;

(ii)        the obligation to pay the franchise fees is a consequence of, and is integral to, the sale of the business and as such is capital in nature (refer Tata Hydro-Electric Agencies Ltd (Bombay) v Income Tax Commissioner, Bombay Presidency and Aden (1937) 2 All E.R. 291 and also Labrilda Pty Ltd v FC of T 96 ATC 4303).”

Pursuant to s 14ZZ of the Taxation Administration Act 1953 the taxpayer appealed to the Court against the decision disallowing its objection substantially on the ground that

The Franchise Fees payable by the applicant to the State of Victoria pursuant to the Franchise Fee order made by the Governor‑in‑Council under section 163A of the Electricity Industry Act 1993 (Vic) during or in respect of the year ended 30 June 1996 (and in following years in which the facts and law remain the same in all material respects) are and will be, wholly or in part-

(a)        losses or outgoings incurred by the applicant in gaining or producing the assessable income of the applicant;

(b)        alternatively to (a), losses or outgoings incurred in carrying on a business for the purpose of gaining or producing such income;

(c)        not outgoings of capital, or of a capital, private or domestic nature, or incurred in relation to the gaining or production of exempt income -

and accordingly are, and will be, wholly or in part deductible pursuant to the provisions of sections 51(1) of the Income Assessment Act.

The appeal was heard by a Full Court in accordance with a direction by the Chief Justice pursuant to s 20(1A) of the Federal Court of Australia Act 1976.

The issue arising on the appeal is whether the franchise fees paid or payable by the taxpayer under s 163A of the Electricity Industry Act 1993 (Vic) (“the Act”) are deductible pursuant to s 51(1) of the Income Tax Assessment Act 1936 (Cth).  They will not be deductible if they are outgoings of capital or of a capital nature.  A conclusion adverse to the taxpayer on that issue will dispose of the appeal.

The Commissioner made the Private Ruling on the basis of the information contained in a number of documents which were listed in the Ruling.  It was common ground between the parties that the appeal is to be determined by reference to the facts stated in the Ruling and the information contained in the documents listed in the Ruling.  The parties put their respective submissions to the Court on that basis.  The facts and information referred to in these reasons are all derived from the Ruling or the documents listed in it.

THE FRANCHISE FEES

In 1994, as part of the restructuring of the electricity supply industry in Victoria, five regionally based distribution companies were established, three (of which the taxpayer is one) to service metropolitan Melbourne and two to service rural Victoria.  The assets of the companies comprised the distribution assets of the State Electricity Commission of Victoria (“SECV”) and of the eleven municipal undertakings which had previously supplied the electricity consumed in Victoria.

An objective of the restructuring was the phasing in of full competition for retail custom between the five distribution companies.  As a result of regulated tariffs, the restructuring would initially favour the urban distribution companies which would enjoy significantly higher rates of return on funds employed than the rural distribution companies.  This would place the urban distribution companies in a position of significant competitive advantage when full competition was introduced.  To offset the higher rates of return for the urban distribution companies, the government decided to implement a system of franchise fees which enabled the excess profits of the urban distribution companies, derived from sales to franchise customers, to be payable to the government during the transition period.  Franchise customers are retail customers within the licence area of a distribution company who are unable to be supplied by other distribution companies and are therefore not able to benefit from competition between distribution companies.  Substantial users of electricity who are contestable (ie able to be supplied on a competitive basis by any distribution company) are non-franchise customers.

In “Victorian Electricity Industry Franchise Fees - Explanatory Memorandum” the rationale for the imposition of franchise fees was explained as follows:

“Introduction

1.         As part of the Victorian electricity industry reform, the Government of Victoria (“Government”) has established a timetable for introduction of competition to the different customer classes.  The timetable is as follows:

(1)           Estimated at October 1994

A key philosophical principle for Government in establishing the reforms was that all customers in Victoria should be able to choose their electricity supplier by 31 December 2000.

The transition in the market can be depicted as follows (illustrative proportions only).  Franchise customers are those who have not yet become contestable.

2.         ...

3.         The distribution sector of the Victorian electricity industry was structured as five separate companies (“DBs”) each with an initial licence to serve franchise customers falling within their region (each transitioning to contestability at the same rate as shown above).  There are two main operations of a DB:

(a)        Distribution (ie) operation of the monopoly poles and wires business;

(b)        Retail (ie) reselling electricity to customers after paying the distributor a usage fee for the network (a la Optus/Telecom).

...

4.         After much analysis, the geographic basis on which the DBs were established was one of concentrations of geographical areas (essentially three urban DBs and two rural DBs), rather than an alternative possible structure which would have given each DB a share of the urban and rural areas.  The structure shown was felt to be the most economically efficient (ie) there would be only two DBs servicing rural areas, not five.  A key philosophical principle in their establishment was the DBs  should be established on a ‘level playing field’ basis.

...

This structure, however, has a significant impact on the economic position of the DBs as it highlights the financial effect of the rural/urban cross subsidy.  This is considered further below,

5.         The reason the DB structure highlights the rural/urban cross subsidy is the existence of the Maximum Uniform Tariffs (MUTs).

In the period prior to each customer group becoming contestable, the Government has regulated a MUT that applies to the customer.  The MUTs are expressed as the current retail tariffs, adjusted annually by a ‘CPI-X’ formula.  The ‘X’ factors vary for different tariffs and over different time periods for the same tariffs.

That is, each DB receives the same revenue (on a cents per kilowatt hour basis) for a particular customer type, irrespective of the DB’s cost to supply that customer.

After contestability, the only elements of a customer’s electricity tariffs that remain regulated are the natural monopoly functions (ie) distribution and transmission. ...

Issue

Because of the different costs to service customers in different parts of the State, the existence of an MUT for each customer class effectively represents a cross‑subsidy from urban customers to rural customers.  Therefore, while these MUTs exist, the profit profile for DBs enjoying the benefit of a franchise customer base in an urban area would be significantly different from that of a rural DB or even that same DB when its customers have become fully contestable.

...

[The] unequal position as between DBs, if not addressed, is fundamentally inconsistent with the level playing field objective, in that DBs enjoying high regulated profit margins could use these margins to cross subsidise pricing to contestable customers to win market share from DBs not enjoying such regulated margins.

Solution

To provide for a level ... playing field, it was decided to impose franchise fees on all DBs such that all DBs would be earning no greater retail margin than would be expected if all customers had been contestable from the outset (approximately 2% on sales).  This is most appropriately viewed therefore as a fee payable by the DBs for the benefit (which falls unevenly on the DBs without any meritorious reason from the DBs’ perspective) of their franchise customer bases.  It should, therefore, mean that all DBs are able to complete on an equal footing without any a priori reason for a difference in their cost of doing business with respect to franchise customers.”

In the Second Reading Speech to the Electricity Industry (Amendment) Bill (11 May 1995), which amended s 163A of the Act to its present form, the Minister for Energy and Minerals said:

“Another important feature of part 2 is the provision setting out the basis on which the government will set franchise fees to be paid by those distribution companies which are licensed to sell electricity to franchise customers.  The franchise fee is designed to capture for the government the ‘monopoly rent’ that would otherwise be available to the distribution companies.  Beyond the franchise period, the distribution companies will no longer have monopoly power over their customers and the monopoly rent will be eradicated by competition and regulated open access rules.”

In the State government’s August 1995 Victorian Electricity Distribution Businesses Information Memorandum (Volume 2) the franchise fees were explained as follows:

“3.3.8  Franchise Fees

The government has established franchise fees which are collectable by the State from all parties licensed to retail electricity to franchise customers.  The fees are designed to capture the excess profits that would otherwise accrue to retailers as a result of MUTs exceeding the forecast cost of supplying electricity to franchise customers.

The fees are being set in advance in real terms for each DB.  The fees will be a fixed real amount, indexed to CPWe and will be payable quarterly in arrears.  The fees for the year ended 30 June 1995 have been set in Franchise Fee Orders in Council for each DB.  Franchise fees for the period from 1 July 1995 to 31 December 2000 will be contained in Franchise Fee Orders in Council pursuant to Section 163A of the Electricity Industry Act to be effective from July 1995 and which must be finalised by 30 June 1996.  Once made, the Franchise Fee Order in Council cannot be varied other than by further legislation.

The fees will phase out as franchise customers become contestable and will cease once the market is fully contestable.”  (at 44)

THE ELECTRICITY INDUSTRY ACT 1993

Part 12 of the Act,  which was inserted by the Electricity Industry (Amendment) Act 1994, provides for the regulation of the restructured electricity industry in Victoria.  Section 159 prohibits a person from engaging in, inter alia, the supply or sale of electricity without a licence.  An application for a licence may be made pursuant to s 161.  Section 162 provides for the determination of licence applications. A licence, inter alia, confers the right to sell electricity in the licence area.  Licence fees, payable under s 163(3)(a) and (4), are based on a proportion of the costs of the Office of the Regulator‑General and are payable to the Office.  The functions of the Office are set out in s157.

Under s 162(2B) the licence is exclusive in respect of franchise customers.  The sub-section provides:

If the Office has issued a licence authorising a distribution company to sell electricity to franchise customers, the Office must not issue a licence to another applicant authorising the sale of electricity to those franchise customers unless the Minister and the licensed distribution company have consented to the issue of the licence.

Franchise and non‑franchise customers are defined in s 154:

“‘franchise customer’ means a customer other than a non‑franchise customer;

........

‘non-franchise customer’ means a customer who purchases a load or amount of electricity that exceeds prescribed limits determined in accordance with the regulations”.

The franchise fee for an “exclusive licence” granted under Part 12 is provided for in s 163A:

“(1)      A distribution company that holds, or has held, an exclusive licence under this Part authorising it to sell electricity to franchise customers must pay to the Treasurer, in respect of each financial year during which it holds, or held, such a licence the impost determined in respect of that year by Order of the Governor in Council, on the recommendation of the Treasurer, applying to that company and published in the Government Gazette-

(a)        if the licence issued before 30 June 1996-

(i)         before 30 June 1995, in the case of the impost in respect of the financial year ending on that date; and

(ii)        before 30 June 1996, in the case of the impost in respect of each year ending on 30 June in the period beginning on 30 June 1996 and ending on 30 June 2001; and

(b)        if the licence is issued on or after 30 June 1996, before the end of the first year of the term of the licence.

(2)        The Treasurer, in recommending the amount of an impost for each financial year payable by a distribution company, must be satisfied that the amount reasonably represents the amount by which the income of the company derived from the sale of electricity to franchise customers in that year is likely to exceed the sum of-

(a)        the costs of deriving the income; and

(b)        taxes payable in deriving that income; and

(c)        an amount determined by the Treasurer to be a reasonable return on the capital of the company used in deriving that income-

having regard to-

(d)        any relevant Order in force under section 158A; and

(e)        the value of property and rights vested in the company under Parts 10 and 11; and

(f)        the amount of liabilities that became liabilities of the company under Parts 10 and 11; and

(g)        the likely number of franchise customers of the company in that financial year; and

(h)        such other matters as the Treasurer determines after consultation with the company.

(3)       The impost in respect of a financial year is payable at such times and in such manner as are determined in the Order.

(4)       For the purposes of this section, a distribution company has an exclusive licence authorising the sale of electricity to franchise customers if that licence is the only licence in force under this Part authorising the sale of electricity to those customers.”

To give effect to the intention to phase in full competition for the retail supply of electricity by 2001, ss 2, 39(d) and 39(e) of the Electricity Industry (Amendment) Act 1995 repeal ss 162(2B) and 163A as from 1 January 2001.  The repeal of ss 162(2B) and 163A will bring to an end the statutory provisions which confer exclusivity in respect of franchise customers.

THE RETAIL LICENCES

The taxpayer and each of the other distribution companies were granted Distribution and Retail licences under Part 12 of the Act  as from 3 October 1994 for their respective distribution areas.  Each of the licences contains substantially the same terms and conditions. The taxpayer’s licences authorise it to distribute and sell electricity in the licensed geographical area, which is the eastern fringe of Port Phillip Bay in Victoria (“the licence area”).  Upon the grant of the licences the taxpayer commenced to distribute and sell electricity in accordance with the terms of the licences.

Clause 2 of the Retail licence empowered the taxpayer to sell electricity to franchise customers in the licence area and to non-franchise customers anywhere in Victoria.  The definitions of franchise and non-franchise customers are the same as in s 154 of the Act.  Accordingly, under the licences each licensee is free to compete for non-franchise customers anywhere in Victoria, but not for franchise customers in the distribution area of another licensee, as the sale of electricity to such customers is not authorised under cl 2, and accordingly, is prohibited by s 159 of the Act.  In that way the exclusivity contemplated by s 162(2B) was achieved.

The Retail licence expressly provides for payment of the licence fee but not the franchise fee.  Under cl 15 the licensee is required to pay, as directed by the Office of the Regulator-General, the licence fee, determined in accordance with s 163(4) of the Act, by four equal instalments on the last day of January, April, June and October in each year.  The licence fee is payable for the rights, conferred under the licence, to sell electricity to franchise and non-franchise customers in Victoria.  On the other hand, the franchise fee is payable under s 163A and not by reason of any express provision of the licence.  The franchise fee is not referred to in the licence.  A failure to pay the fee would, however, constitute a breach of the terms of the licence by reason of cl 17 which requires that the licensee “must comply with all applicable laws ...”.

THE ORDERS MADE PURSUANT TO S 163A

On 20 June 1995, pursuant to s 163A, an Order was made by the Governor in Council on the recommendation of the Treasurer in respect of the year ended 30 June 1995.  The franchise fee payable by the taxpayer under the Order is $85,900,000.

On 7 August 1995, by an agreement entered into between SECV, the State of Victoria and Power Partnership Pty Ltd, Power Partnership Pty Ltd agreed to acquire all of the shares in the taxpayer.  The agreement provided that $85 million, being part of the purchase price for the shares, was to be repaid to Power Partnership Pty Ltd if the franchise fees payable under s 163A were not deductible outgoings under s 51(1) or any other section of the Income Tax Assessment Act 1936.

On 15 August 1995 a second Order under s 163A, as amended, was made in respect of the franchise fee payable by the taxpayer for each financial year ending 30 June 1996 until 30 June 2001.  The operative part of the Order is as follows:

“1.       Amounts payable

The amount payable by the licensee under section 163A of the Act:

(a)        in respect of the year ending 30 June 1996 is $59,900,000 (escalated in accordance with clause 2), payable in four equal instalments on 15 October 1995, 15 January 1996, 15 April 1996 and 15 July 1996;

(b)        in respect of the year ending 30 June 1997 is $63,900,000 (escalated in accordance with clause 2), payable in four equal instalments on 15 October 1996, 15 January 1997, 15 April 1997 and 15 July 1997;

(c)        in respect of the year ending 30 June 1998 is $72,400,000 (escalated in accordance with clause 2), payable in four equal instalments on 15 October 1997, 15 January 1998, 15 April 1998 and 15 July 1998;

(d)        in respect of the year ending 30 June 1999 is $62,300,000 (escalated in accordance with clause 2), payable in four equal instalments on 15 October 1998, 15 January 1999, 15 April 1999 and 15 July 1999;

(e)        in respect of the year ending 30 June 2000 is $64,100,000 (escalated in accordance with clause 2), payable in four equal instalments on 15 October 1999, 15 January 2000, 15 April 2000 and 15 July 2000;

(f)        in respect of the year ending 30 June 2001 is $19,400,000 (escalated in accordance with clause 2), payable in four equal instalments on 15 October 2000, 15 January 2001, 15 April 2001 and 15 July 2001.

2.         Escalation

Where an amount is expressed in this Order to be escalated in accordance with clause 2 the escalated amount is the amount derived by applying the following formula:

EA = A x B

                                     C

where

EA        is the escalated amount;

A          is the amount expressed in the Order as being escalated in accordance with this clause;

B          is the consumer price index number in respect of the relevant quarter; and

C          is the consumer price index number in respect of the quarter ending on 31 March 1994.

In this clause:

consumer price index number means the all groups consumer price index number for Melbourne published by the Commonwealth Statistician in respect of the quarter ending on 31 March in each year; and

relevant quarter means the quarter ending on 31 March immediately preceding the year in respect of which the amount expressed in the Order as being escalated in accordance with this clause is to be paid.”

It is to be observed that the franchise fees payable for the whole of the period the subject of the Orders are predetermined under the Orders, subject only to consumer price index adjustment to maintain the value, in real terms, of the amounts payable.  Accordingly, it is apt to refer to the franchise fees as amounts payable in accordance with the terms of the Orders in respect of each of the years in which the taxpayer will enjoy the exclusive right to sell electricity to franchise customers in its licence area.  The fact that the fee is separately calculated for each year and is payable by instalments does not necessarily make it an annual or a recurring fee.

CAPITAL AND INCOME

The classic formulation of the matters to be taken into account in determining whether an outgoing is of a capital nature is that of Dixon J in Sun Newspapers Ltd and Associated Newspapers Ltd v Federal Commissioner  of Taxation  (1938) 61 CLR 337 at 363:

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

More recently the High Court in GP International Pipe Coaters Pty Ltd v Federal Commissioner  of Taxation  (1990) 170 CLR 120 at 137 said:

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

In Mount Isa Mines Ltd v Federal Commissioner of Taxation (1992) 176 CLR 141 at 149 the High Court, after citing this passage from GP International Pipe Coaters, emphasised the importance of characterising the expenditure by reference to the advantage sought by the making of the outgoing rather than the purpose served by the outcome achieved as a result of the outgoing having been made.

In Hallstroms Pty Ltd v Federal Commissioner of Taxation (1946) 72 CLR 634 at 648 Dixon J said:

“... What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.”

Lord Pearce, delivering the judgment of the Privy Council in BP Australia Ltd v Federal Commissioner of Taxation (1965) 112 CLR 386 at 394-395, accepted as a “valuable guide to the traveller in these regions” the judgment of Dixon J in Sun Newspapers Ltd, but recognised that the line of demarcation between revenue and capital is

“... sometimes difficult indeed to draw and leads to distinctions of some subtlety between profit that is made ‘out of’ assets and profit that is made ‘upon’ assets or ‘with’ assets.”

His Lordship said that the observation of Viscount Radcliffe in Commissioner of Taxes v Nehanga Consolidated Copper Mines Ltd [1964] AC 948 at 960 that the demarcation between

“the cost of creating, acquiring or enlarging the permanent (which does not mean perpetual) structure of which the income is to be the produce or fruit and the cost of earning that income itself or performing the income‑earning operations”

was “as illuminating a line of distinction as the law by itself is likely to achieve”.  At 397 his Lordship observed:

.... Although the categories of capital and income expenditure are distinct and easily ascertainable in obvious cases that lie far from the boundary, the line of distinction is often hard to draw in border line cases; and conflicting considerations may produce a situation where the answer turns on questions of emphasis and degree.  That answer ‘depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process’ (per Dixon J in Hallstrom’s Case).  As each new case comes to be argued felicitous phrases from earlier judgments are used in argument by one side and the other.  But those phrases are not the deciding factor, nor are they of unlimited application.  They merely crystallize particular factors which may incline the scale in a particular case after a balance of all the considerations has been taken. (Footnotes omitted)

THE NATURE OF THE FRANCHISE FEE

Part 12 of the Act implements the franchise customer system in Victoria in accordance with the proposals to which we have referred.  In particular, the combined operation of ss 159, 162(2B) and 163A is that the fee is payable by a distribution company as a “monopoly rent” for the right to be free of competition from the other distribution companies for the retail custom of franchise customers within the licence area.  Unlike the licence fee, which is payable to the Office of the Regulator-General, the franchise fee is payable to the Treasurer.

In the Explanatory Memorandum set out under the heading The Franchise Fees, the fee is said to be “appropriately viewed ... as a fee payable by the DBs for the benefit ... of their franchise customer bases”.  That is in our view an accurate description of the fee.  The “benefit” referred to is that a franchise customer, being one who has “not yet become contestable” under the reforms, must buy electricity from the distribution company for its area for so long as that customer is not “contestable”.  The franchise fee is not payable for the right to sell electricity to customers in the distributor’s licence area.  That right is conferred by a licence to sell electricity granted under ss162 and 163 for which a different fee is payable.  Rather the franchise fee is payable for the advantage enjoyed by the distribution company of being free from the competition of the other four distribution companies for the custom of franchise customers in the distributor’s licence area.  The fee was aptly described by the Minister as a “monopoly rent” for the exclusive right to sell to franchise customers in the distributor’s licence area during the transitional period.

The licence is consistent with the Act.  The exclusivity granted to a licensee in respect of franchise customers does not arise by reason of any term of a Retail licence.  Rather, it arises because each Retail licence authorises sales of electricity only to franchise customers within the licence area.  That limited authorisation and the prohibition against unauthorised sales under s 159(1) ensure the exclusivity required by s 162(2B).

Accordingly, the franchise fee is payable by the taxpayer for and by reason of the exclusivity provided for under ss 162(2B) and 163A(4) and conferred by a combination of s 159(1) and the terms of the Retail licences granted to the five distribution companies.  This conclusion is significant as it is not strictly correct to contend, as did counsel for the taxpayer, that the franchise fee is payable in “consequence” of the licence or the monopoly the licence entitled the taxpayer to exercise in relation to part of its market.

IS THE FRANCHISE FEE A CAPITAL OUTGOING?

The franchise fee is a non-voluntary statutory impost.  But it was not imposed as an afterthought or to appropriate unexpected windfall profits.  The fee was imposed as an integral aspect of the phasing in of full competition for retail custom between the five distribution companies, as part of the scheme for the restructuring of the electricity supply industry in Victoria.  Part of that restructuring was the sale to private interests, on behalf of the State of Victoria, of the five distribution companies on the basis of the State’s grant of the statutory right of exclusivity for franchise customers until 2001 in return for payment to the State of the franchise fee payable under s 163A.  When the restructuring scheme is examined in its totality, it is an oversimplification to say, as counsel for the taxpayer did, that the fee is not a payment for the right of exclusivity but “simply a payment in consequence of the right annually.”

In determining the advantage sought by payment of the franchise fee, from a practical and business point of view, an examination of its role under and as part of the restructuring scheme is required.  In these circumstances it is unrealistic to regard the involuntary nature of the franchise fee as being determinative of its proper characterization under s 51(1). The essential character of the advantage calculated to be gained and in fact gained by the franchise fee is freedom, until the year 2001, from competition from other distribution companies for franchise customers in the licence area. Its character is the same if determined upon a juristic classification of the rights conferred.  This is not surprising as the proposed advantage for which the fee is payable is crystallised in legislative form in ss 162(2B) and 163A of the Act.

In arriving at our conclusion as to the essential character of the franchise fee we do not disagree with Lockhart J that the fee is a compulsory exaction imposed by the Victorian government to extract a share of the taxpayer’s profits.  Our approach accepts that characterization, but identifies the profits extracted as a monopoly rent, the monopoly being the immunity from competition granted by the government in respect of the taxpayer’s franchise customers.

The advantage gained as a result of the franchise fee is akin to that derived by the taxpayer in Broken Hill Theatres Pty Ltd v Federal Commissioner of Taxation  (1952) 85 CLR 423.  In that case the appellant and other proprietors of motion picture theatres operating in Broken Hill successfully opposed an application for a theatre licence in respect of other premises in Broken Hill and thus for a period of twelve months procured immunity from further competition.  Over a period of ten years a number of similar applications were successfully opposed by the appellant, although one was granted.  The issue was whether the legal expenses incurred by the appellant in opposing the licence applications were an outgoing of capital under s 51(1).  In holding that the outgoings were on capital account Williams J, at first instance, said at 430‑431:

“The expenditure now in dispute was, I think, an expenditure made once and for all and with a view to bringing into existence an advantage for the lasting benefit of the appellant’s motion picture business.  This business is of a kind which can only be carried on by persons who are licensed to exhibit motion pictures in particular theatres or halls.  The less the number of licences the less the competition, and the better the opportunity for those privileged to possess licences to carry on a profitable business.  The defeat of any particular application for a new licence frees the existing exhibitors forever from the threat of new competition resulting from the success of that particular application.  The application might be granted or it might be refused.  Expenditure in opposing the application would be of the same nature whether the opposition succeeded or failed (Southwell v Savill Bros Ltd).  The essential purpose of the opposition is to restrict the number of persons licensed to carry on the business to a minimum.  The success of the opposition to the grant of a new licence would benefit what Dixon J described in the passage cited as ‘the business entity, structure, or organization set up or established for the earning of profit’ or what Lord Greene in the Associated Portland Cement Manufacturer’s Case described as the goodwill of the business.” (Footnotes omitted)

On appeal the decision of Williams J was affirmed.  Dixon CJ, McTiernan, Fullagar and Kitto JJ said at 433:

“In our opinion the decision of Williams J in this case was right.  We do not see how his Honour could have reached any other conclusion consistently with the principles laid down in the cases and particularly in British Insulated and Helsby Cables Ltd v Atherton and Sun Newspapers Ltd v Federal Commissioner of Taxation:  see especially the judgment of Dixon J in the latter case.”  (Footnotes omitted)

In rejecting the argument that the outgoing was not of capital, as no new asset was brought into existence, their Honours said at 434:

“The advantage of being free from Boulus’s competition and of all other competition for twelve months is just the very kind of thing which has been held in many cases to give to moneys expended in obtaining it the character of capital outlay”.

Similarly, in Smithkline Beecham Laboratories (Australia) Ltd v Federal Commissioner of Taxation (1993) 44 FCR 129 Hill J held that legal expenses to prevent or delay competitors from obtaining marketing approval for competing products were outgoings on capital account to preserve the taxpayer’s commercial monopoly for its product.  In National Australia Bank Ltd v Federal Commissioner of Taxation (Federal Court of Australia, 12 June 1997, unreported), now under appeal, Heerey J held that a lump sum payment by the National Australia Bank to the Commonwealth, in exchange for the exclusive right to make subsidised loans to Australian Defence Force personnel, was capital expenditure.

Using the words of Dixon J in Sun Newspapers at 359, the franchise fee benefits “the business entity, structure, or organization set up or established for the earning of profit.”  Or, using the words of the joint judgment on appeal in Broken Hill Theatres at 434, “the advantage of being free from ... competition” in the sale of electricity for the period for which the franchise fee is payable is “just the very kind of thing which has been held in many cases to give to moneys expended in obtaining [that advantage] the character of capital outlay”.

Counsel for the taxpayer contended that the franchise fee is a compulsory exaction to redress the excess profits obtained from the statutory monopoly, and that therefore no enduring benefit enured to the taxpayer.  Counsel also submitted that the present case is the reverse of the competition cases, as the fee is an impost for the very reason that the licence entitles the taxpayer to exercise a monopoly in relation to part of its market, rather than a payment to fend off competition or gain that monopoly.  Accordingly the effect of the fee, so it was said, does not enlarge the taxpayer’s goodwill or business undertaking.

In our view the submission takes too narrow a view of the franchise fee.  Immunity from competition in respect of franchise customers in the licence area is secured by the exclusivity conferred under ss 162(2B) and 163A.  The franchise fee is payable under s 163A for that exclusivity.  The immunity, so obtained, is of enduring benefit to the “business entity, structure or organisation” of the taxpayer.

The taxpayer also relied on the annual nature of the impost, the recurrence of the payments, and their relationship to the income earned in the relevant financial year, to contend that the fee had the hallmarks of payments on revenue account.  As was said by Stephen J in Cliffs International Inc v Federal Commissioner of Taxation (1979) 142 CLR 141 at 165, the relevance of recurrence is the light it casts upon the advantage obtained.  In the present case, since the advantage is immunity from competition, the recurrence of the payments is of little assistance to the taxpayer.  Further, the franchise fee is a predetermined amount for each year to 2001.  The fee is based on the value of the estimated advantage gained each year from the immunity from competition granted for that year.  The amount so calculated is payable by instalments.  There is no provision for adjustment if the actual advantage differs from that estimated.  In these circumstances it is not appropriate to describe the fee as an annually recurring impost payable for the right to earn income in the relevant year.

Superficially, the franchise fees bear some resemblance to the payments made by the taxpayer in BP Australia Ltd (supra).  BP made payments to service station owners in order to obtain exclusive outlets for the sale of its products at those service stations.  Agreements were entered into with the owners whereby BP, in consideration of the owners selling during a certain period only brands of petrol approved by it, promised to pay to the owners lump sums to defray some of their expenses, or as assistance to them.  BP claimed the amount of the lump sums as allowable deductions under s 51(1) but was assessed on the basis that the sums were capital rather than revenue expenses.  The assessment was confirmed in the High Court by Taylor J, and on appeal by McTiernan, Windeyer and Owen JJ, Dixon CJ and Kitto J dissenting.  On appeal the Privy Council held that the lump sums paid were on revenue account and were therefore allowable as deductions under s 51(1).

The Privy Council accepted that a payment to buy out a rival in order to secure its goodwill or to suppress it, and so provide or maintain a clear field for an enterprise over a substantial period, was a “definite prima facie pointer towards a capital payment” (at 395).  However, that “monopoly” situation was distinguished from BP’s payments which were to secure the trade of particular retailers, leaving other retailers free to buy and sell products of their choice.  That circumstance was sufficient to distinguish BP’s payments from “...the cases where competition had been stifled for a substantial period or a monopoly has been acquired .....” (at 396).

Although their Lordships accepted that the case was not easy to decide, a factor that appeared, “on a balance of all the relevant considerations”, to weigh strongly in favour of the payments being on revenue account was that they were made to particular customers to secure their particular custom and were therefore more akin to sums expended as part of the money earning process than to sums expended on the structure by which the profits were to be earned.  As Kitto J, whose dissenting view in the High Court in BP Australia (1964) 110 CLR 387 at 412-413 was upheld on appeal, said:

“the effect of a binding promise not to compete is to create for the promisee a more favourable situation in which to carry on his business for the future; it makes an improvement in the conditions in which he may proceed to carry on his profit-making activities.  In other words, the elimination of the competitor is anterior to, and not part of, the trading in which the benefit of it will be felt; and accordingly, in the ordinary case at least, the cost of it is a cost of adding a protective element to the structure of the promisee’s business.  Forming no part of his trading expenses, but being, in effect, the purchase price of a capital asset, it is a capital charge.  But a promise by a service station operator not to deal with oil companies other than the appellant or its allies was only the negative side of the substantial positive advantage which it was the purpose and practical effect of the agreement to produce, namely the advantage of a practical certainty that the whole of the custom of the service station, for motor spirit, would be given to the appellant or its allies for the agreed period; and what the appellant really paid its money for was that positive advantage...  [A] payment made by a trader to a customer for the purpose of securing orders for a quantity of goods is prima facie part of the cost of selling the goods.”

The payments in that case are analogous to the licence fees paid by the taxpayer in the present case for the advantage of supplying and selling electricity in the licence area. They are part of the process by which the taxpayer earns profit from its licence to sell electricity in Victoria.

Payments of fees to the Treasurer of the State of Victoria, as a monopoly rent for freedom from competition in respect of a substantial body of retail customers in the taxpayer’s licence area, are qualitatively different from payments by a supplier to particular customers to buy only its products, and payments of the licence fees payable under the licence to sell electricity in Victoria from year to year.

In our view the franchise fees are clearly distinguishable from the payments considered in BP Australia.

CONCLUSION

The Commissioner did not err in ruling that the franchise fees are not deductible under s 51(1), as they were outgoings of capital or of a capital nature.  For these reasons weagree with the orders proposed by Lockhart J.

Associate:        

Dated:              27 August 1997