VPN Appeal: When arm's length value needs to look at the market in which participants deal

On 21 October 2020, the Full Federal Court of Australia (Logan, Colvin and Thawley JJ) handed down its appeal decision in the case of Victoria Power Networks Pty Ltd v Commissioner of Taxation [2020] FCAFC 169. This case was originally heard in the Federal Court by Moshinsky J who handed down his judgment in February 2019 in favour of the Commissioner. The taxpayer was partly successful in this appeal.

This case concerned the assessability of customer contributions to distributors in relation to "uneconomic" connections, broadly being connections where it was not profitable to provide distribution services to customers at regulated prices due to the relatively high connection costs. For "uneconomic" connections, the relevant regulations allowed the distributor to "charge" a customer for the connection in a manner calculated to ensure the connection was not uneconomic.

Two options were open to distributors to "charge" for these uneconomic connections:

Option 1: The distributor carries out the construction works and the customer is charged a cash contribution equal to the excess of the incremental costs over the connection's incremental revenue; or

Option 2: The customer carries out the construction work with the constructed asset being transferred to the distributor and the distributor paying the customer a rebate to the extent that the estimated costs of construction exceeds the customer contribution (the rebate).

In summary, the Full Federal Court dismissed the appeal insofar as it related to Option 1, agreeing that the customer cash contributions are assessable as ordinary income. However, the Court allowed the appeal in respect of Option 2, finding that the arm's length value considered in determining the amount to be included in assessable income as a non-cash business benefit was the amount of the rebate, not the estimated costs of construction (as held by the primary judge).

Option 1:

In relation to Option 1, VPN sought to argue that customer cash contributions were a receipt of capital, primarily on the basis that the regulatory regime required customers to subsidise the capital cost of connection works to the extent of those contributions, and therefore they were not paid to a distributor either as a reward for the construction of connection works or as a remuneration for providing a service. Alternatively, VPN argued the contributions were a reimbursement that attracted the assessable recoupment provisions in Subdivision 20-A of the Income Tax Assessment Act 1997 (ITAA 1997) which would allow for assessability over time rather than in the year of receipt.

The Full Federal Court disagreed. Justice Logan made the point that just because the distributor uses the customer contributions for capital expenditure does not mean that a receipt in general revenue from which that expenditure is funded is a receipt on capital account. Rather, Justice Logan held that the customer contributions were received as part of the remuneration earned by the carrying on the distributor's business, which included operating and maintaining the requisite network infrastructure, and therefore was ordinary income under section 6-5 of the ITAA 1997. Justices Colvin and Thawley similarly held the amounts to be ordinary income, reaffirming the primary judgement.

Option 2:

For Option 2, when a customer constructs the particular contestable works infrastructure for a new connection and transfers that connection to the distributor, it was not in dispute that (assuming this option does not result in the derivation of ordinary income), that section 21A of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) may apply. The effect of section 21A applying is that the "non-cash business benefit" is required to be brought into account in the distributor's assessable income at "its arm's length value, reduced by the [distributor's] contributions (if any)." The key issue in contention was the meaning of the definition of "arm's length value" in this context.

In relation to the assessment of "arm's length value":

• Justice Logan undertook a forensic analysis of the text of the section 21A to assess the statutory context and assessed that it should not be determined by reference to the transaction between the parties in respect of the benefit, but rather should be objectively tested, taking into account the market in which they must deal (i.e. as distributor and customer who has selected Option 2).
• In doing so, Justice Logan accepted VPN's arguments that section 21A's concept of arm's length value requires consideration of the position of the actual recipient (i.e. the distributor) and not some notional "independent party," thereby distinguishing consideration of the arm's length value in a transfer pricing context (as considered in the Chevron Case). Justices Colvin and Thawley also agreed with VPN in this regard.
• In assessing the arm's length value of the connection assets, the judgements also reflect the importance of assessing the regulatory regime in this context in order to understand the rational business reality for the distributor. Justice Logan observed that it would not be reasonable for a distributor to pay an amount equal to the construction to obtain the benefit of the infrastructure in circumstances where the incremental cost is greater than the incremental revenue from the connection. Justice Colvin also observed that, within the regulated environment, the distributor could not be forced to undertake the connection unless the customer bore the shortfall, and there was no means for the distributor to increase prices for distribution services to cover the shortfall out of its own earnings.
• Essentially, the focus was on what the distributor could reasonably be expected to pay. It was found that the market is regulated and there was never a suggestion that the distributor dealt with customers other than at arm's length. On that basis, and as summarised by Justice Logan, it was held that "a price reasonably to be expected is the price paid by the distributor" [35]. This price was determined to be the estimated cost of the construction less the customer contribution (i.e. the rebate). Justice Logan essentially found that the primary judge and the Commissioner erred in excluding what, in the market concerned, the distributor would be willing to pay for the asset, and that the terms as between the parties reflect this. Additionally, Justice Logan observed that the greatest benefit the customer would expect from the transfer of the asset to the distributor is the rebate.

Having assessed the "arm's length value" to be equal to the rebate, this in effect meant that the amount assessed under section 21A of the ITAA 1936 for Option 2 was nil, as this section requires the arm's length value amount to be brought to account to be reduced by the distributor's contributions (again being the rebate).

The result means that there is an asymmetry in the tax treatment of customer contributions under Options 1 and 2 from the distributor's perspective, even though both are aimed at neutralising uneconomic connections. Importantly, the decision will have far-reaching implications for other industries (such as infrastructure) when assessing the arm's length value for the purpose of section 21A. In particular, it will be important to assess that value in the context of the market in which the actual transaction took place, and have regard to any particular relevant regulatory regime that may underpin the transaction.

Dan Paolini (White & Case, Counsel, Melbourne) and Nicholas Rouse (White & Case, Counsel, Melbourne) contributed to the development of this publication.

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