By Professor Miranda Stewart
State governments are keen to raise funds by privatising electricity networks, as has just been legislated in New South Wales, but a privatisation agenda can also cause an election loss, as shown in this year’s Queensland election. Electricity privatisation is controversial and the costs and benefits are hard to understand.
One of the less visible aspects of electricity privatisation is the tax treatment of the asset purchase for the private buyer. This year, one of the few High Court cases on income tax is about the privatisation of Victoria’s electricity transmission networks in the late 1990s. This is the case of AusNet Transmission Group Pty Ltd v Federal Commissioner of Taxation  HCA 25.
AusNet is a listed electricity transmission company that, in its own words, is Victoria’s ‘largest energy delivery service’. According to its website, AusNet owns and operates $11 billion of electricity and gas distribution assets that connect to more than 1.3 million Victorian users in a network of ‘49 terminal stations, 13,000 towers and 6,500 kilometres of high-voltage powerlines’. It’s not surprising that when AusNet has a tax issue, it is similarly large.
AusNet loses case on tax deductibility
AusNet (at that time called SPI Powernet) paid more than $2.5 billion for electricity transmission assets that it purchased in 1997 from a Victorian State-owned company. The asset purchase was just one element in the massive exercise of electricity privatisation (for more, see the first instance decision). The purchase price included the physical assets and the electricity transmission licence which would permit AusNet to operate the network. The contract also required AusNet to pay charges under the Electricity Supply Act 1993 (Vic) of $177.5 million in the 1999, 2000 and 2001 tax years, as the new owner of the transmission licence.
AusNet sought to deduct these charges as current expenses under the general income tax deduction rule (s 8-1 of Income Tax Assessment Act 1997 (Cth)). The Commissioner denied the deduction, arguing that the charges were instead capital in nature. It took more than a decade for this argument, arising out of a complex tax audit, to make its way to the High Court, where AusNet lost.
Applying Australia’s 30 per cent company tax rate, the deduction of $177.5 million was worth about $53 million to AusNet. With interest expense on unpaid tax, AusNet owed a total of $91 million to the Tax Office, of which it had previously paid $30 million. AusNet lost the case in the High Court and announced its ‘disappointment’ to the market in an ASX release.
AusNet also took a related case to the Full Court of the Federal Court, in which it sought to deduct another proportion of the $2.5 billion asset price, as the depreciation cost of alleged copyright assets. The Federal Court was rather unsympathetic and AusNet recently announced an out of court settlement with the Tax Office in which about $16.5 million already paid would remain with the office and AusNet agreed not to claim deductions of $40 million in future years.
What is capital expenditure anyway?
In income tax, as a general rule, taxpayers can immediately deduct the current, or ‘revenue’ expenses of a business. However, ‘capital’ costs are not deductible unless a specific rule — such as the depreciation rule for plant and equipment — applies. Since the early decades of the twentieth century, administrators, taxpayers and courts have all struggled with the question of how to identify capital expenditure. So difficult is this exercise that Lord Green Master of the Rolls said in 1938, in Inland Revenue Commissioners v British Salmson Aero Engines Ltd  2 KB 482, at 498, that ‘in many cases it is almost true to say that a spin of the coin would decide the matter.’
Chief Justice French with Justices Kiefel and Bell, and Justice Gageler writing separately, found in favour of the Commissioner of Taxation. Most of the judges in the Federal Court (including Gordon J at first instance, now elevated to the High Court, and the FCAFC majority on appeal) also found for the Commissioner.
Capital expenditure in ‘penumbral’ cases
The majority judges pointed out that the distinction between capital and revenue expenditure is ‘readily discerned in cases close to the core of each of those concepts. A once and for all payment for the acquisition of business premises would be treated as an outlay of capital. A rental payment under a lease of the same premises would be treated as an outgoing on revenue account.’ The majority said that it is in ‘penumbral’ cases that characterisation becomes a problem.
Their Honours sought to apply a practical and business approach to the problem. French CJ, Kiefel and Bell JJ explained that the courts were given minimal guidance of ‘a very general conception of accountancy, perhaps of economics’ from earlier case law (quoting leading jurist Dixon J in Hallstroms Pty Ltd v Federal Commissioner of Taxation  HCA 34 (1946) 72 CLR 634 at 646).
Justice Gageler went further, saying that the Court must have regard to the ‘whole picture’ of the commercial context. He concluded that taking a ‘practical and business’ perspective, AusNet was required to pay the charges in order to acquire the licence and other assets. On this basis, all of the judges who found for the Commissioner concluded that the charges, although separate from the asset price in the contract, were undertaken as part of the overall obligation to acquire the transmission licence without which ‘the whole business structure would collapse’. Hence, the charges were capital expenditures and not deductible.
The cost of business intangibles, such as license charges, or royalty-type payments, are often the most difficult to characterise. Some expenditures on ‘intangible’ assets are favoured in the tax law — for example, advertising expenses are usually treated as immediately deductible even though they contribute to the long term value of a brand name or business. However, AusNet makes clear that expenditure on a valuable monopoly established by a long term licence is capital in nature, forming part of the structure of the business. Today, when corporate value is increasingly digitised and legal structuring may be used to structure payments for intangibles so as to attract tax benefits, this finding is important.
Is AusNet right as a matter of tax policy?
While the High Court found against AusNet, both Justice Davies (in the Federal Court) and Justice Nettle (in the High Court) disagreed. While great minds may differ on this fundamental question now, as they have done for more than a century, I suggest that the High Court reached the right legal decision in AusNet. But is it the right result as a matter of policy?
The distinction between capital and revenue expenditure is a fundamental element of an income tax as a matter of legal design and tax policy. In principle, outlays on items that are immediately ‘consumed’ or used up within the tax year — for example, wages for employees working in that year — are immediately deductible in calculating taxable profit in that year. But an outlay, or the cost of an asset which has value for longer than one year is not immediately deductible. In principle, the taxpayer should be able to deduct it over the effective life of the asset.
For example, a machine that has a useful life of 5 years should have its capital cost deducted over the 5 year period. The depreciation rules in the income tax law allow such deductions for plant and equipment and for some intangibles such as copyright or patents.
The High Court did not have the option to ‘spread’ the expenditure on the charges over the life of AusNet’s electricity transmission licence, as the license does not qualify as a depreciating asset under Australia’s income tax law. The license cost and the charges are not deductible at all until AusNet ceases its business or sells the assets, when these costs would be taken into account in working out any capital gain or loss for AusNet.
But it must be remembered that AusNet’s transmission licence has a long life; it may even be renewed and be, in effect, perpetual until AusNet ceases the business. As a matter of policy, then, it may be correct to treat costs associated with the licence as not deductible until that time.
Would a cash-flow tax allowing expensing of capital costs be better?
Some leading company tax scholars advocate a move towards expensing of capital costs for businesses, through a tax design called a business cashflow tax (eg Auerbach and Devereux, 2014). This option was discussed in the Henry Tax Review of 2009.
As its name suggests, a cashflow tax would include all income or receipts for tax, but would allow all new investment to be immediately deducted. This ‘expensing’ would apply to the capital cost of the transmission licence and the associated statutory charges in the AusNet case.
It sounds simpler and certainly it would do away with the hard task of characterising capital as compared to revenue expenditures. The Australian Industry Group has suggested this approach for very small businesses (with less than $2 million turnover). But a business cashflow tax would be much less effective at raising company tax revenue — it would require a much higher tax rate — to capture the same return. And there are a number of other design complexities in practice, so that to date, almost no country has enacted a business cashflow tax.
Lesson for future privatisations — and the High Court’s role on tax
The denial of these deductions has cost AusNet in total about $120 million. Had these expenditures been deductible to AusNet, then in essence taxpayers across Australia would have under-written some of the cost of privatising one State’s electricity assets. For future privatisations in other States, AusNet suggests that buyers of electricity assets aiming to deduct some of the purchase cost are out of luck.
The AusNet case is a reminder that legal contests continue to arise about tax questions that are fundamentally economic or accounting in nature. It’s worth remembering that all tax policy must be delivered through law, and in Australia’s system, the High Court remains the ultimate arbiter of what is in the company tax base. Although he dissented, Justice Nettle made clear in a recent speech to the Victorian Tax Bar Association that the High Court is certainly ready to hear tax cases.
AGLC3 Citation: Miranda Stewart, ‘Tax and Power in the High Court: The Capital Cost of an Electricity Monopoly: Ausnet Transmission Group Pty Ltd v Federal Commissioner of Taxation’ on Opinions on High (26 November 2015) <http://blogs.unimelb.edu.au/opinionsonhigh/2015/11/26/stewart-ausnet>.
Miranda Stewart is Professor of Law at Melbourne Law School