ACCC Termination Fee Report 111208 Report—PWC ACCC... · 2. Executive Summary In relation to the...

ACCCTermination Fee ReportSeptember 2008 (updated December 2008)

ACCCPricewaterhouseCoopers

2

The report which follows is intended only for use by the Australian Competition and Consumer

Commission as it may contain confidential and/or privileged material. Any unauthorised

review, retransmission, dissemination or other use of, or taking any action in reliance on, this

position paper by persons or entities other than the Australian Competition and Consumer

Commission is prohibited.


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Contents

Definitions 5

1. Scope 7

2. Executive Summary 9

3. Background Facts 15

3.1 Water Charges 15

3.2 Alternative tax status of the Operators 18

4. Technical Analysis 20

4.1 Are there any factors that are now present that would

significantly alter the advice from PwC in 2006 on the

likelihood for the tax timing disadvantage?

20

4.1.1 Application of the Principle of Mutuality 20

4.1.2 Treatment of expenses incurred by Operators 24

4.2 Specific examples of how a significant tax timing

disadvantage could arise upon receipt of a Termination

Fee by irrigation and water service infrastructure

businesses

25

4.2.1 Tax continually paid over the life of the assets - Timing 27

4.2.2 Operator with carry forward losses - Timing 28

4.2.3 No tax paid over the life of the assets - Permanent 30

4.2.4 Operator with carry forward tax losses – Permanent 31

4.2.5 Termination Fee not treated as mutual receipt - Permanent 33

4.3 How a rule might be drafted to give effect to any

necessary tax adjustments in Termination Fee receipts

35

4.3.1 Blanket gross up of Termination Fees to offset tax

disadvantages

35


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Contents (continued)

4.3.2 Specific gross up of Termination Fees to offset tax

disadvantages

36

4.3.3 Other options to offset tax disadvantages resulting from

the receipt of Termination Fees

37

4.3.4 Gross Up Calculation 39

Appendix A - Submissions on Taxation in response to Issues Paper 40

Appendix B - Submissions on Taxation in response to Position Paper 46

Appendix C – Submissions in response to Draft Termination Fee Rules 49

Appendix D – Case Study comparison of an operator that benefits from

the principle of mutuality (eg CICL and CIMCL) and a fully

taxable Operator

51


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Definitions

The following abbreviations are used throughout this document:

ACCC Australian Competition and Consumer Commission.

Access Fee A fee charged to the holder of a delivery entitlement for the

right to ongoing access to water delivery services.

ATO Australian Taxation Office.

CICL Coleambally Irrigation Co-operative Limited.

CIMCL Coleambally Irrigation Mutual Co-operative Limited.

Ex Ante Before the fact – ex ante is contrasted with ex post.

Ex Post

Federal Taxpayer

After the fact – ex post is contrasted with ex ante.

An entity subject to income tax by virtue of the operation of the

Income Tax Assessment Act 1936/1997.

G-MW Goulburn-Murray Water.

Issues Paper ACCC Issues Paper – Water charge rules for charges payable

to irrigation infrastructure Operators (May 2008).

ITAA Income Tax Assessment Act 1997.

MDB Murray Darling Basin.

MIL Murray Irrigation Limited.

Murrumbidgee Murrumbidgee Irrigation Ltd.


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Definitions (continued)

MRFF Macquarie River Food and Fibre.

NANE Non-Assessable Non-Exempt .

NTER

Operator

National Tax Equivalent Regime.

Irrigation and Water Service Infrastructure Operator.

Position Paper ACCC Position Paper – Water charge rules for Termination

Fees (August 2008).

PwC PricewaterhouseCoopers.

Termination Fee A fee levied by an infrastructure Operator when a delivery

entitlement is surrendered to the infrastructure Operator to

terminate any rights or obligations associated with that delivery

entitlement (including any requirement to pay an Access Fee).

The Act The Water Act 2007.

WMI Western Murray Irrigation Limited.

Unless otherwise noted, all section and division references contained herein are

references to the Income Tax Assessment Act 1997.

* * *


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1. Scope

The scope of this engagement is to provide advice on the merits of allowing irrigation and

water service infrastructure businesses to load Termination Fees with tax liabilities in any

circumstances with particular reference to:

Whether there are any factors now present that would significantly alter the advice

from PwC in 2006 on the likelihood for the tax timing disadvantage.

Specific examples of how a significant tax timing disadvantage could arise upon

receipt of a Termination Fee by irrigation and water service infrastructure businesses

(“Operators”). We have been asked to consider the potential net tax disadvantages

taking account not only of the impact of the potential upfront assessability of the

Termination Fees, but the offsetting impact of reduced Access Fees (if any) and

potential altered tax treatment of loss or outgoings incurred over the life of the

infrastructure assets.

How a rule might be drafted to give effect to any necessary tax adjustments in

Termination Fee receipts.

Two further matters have been considered in addition to those covered in the September

2008 draft of this report:

Further consideration of the application of the mutuality principle to the Termination

Fees that may come to be derived by CICL and CIMCL - taking account of the dual

cooperative structure.

Preparation of a case study appendix illustrating the materiality of taxation liabilities

that accrue against the termination of delivery rights and examining the taxation

implications on CICL and CIMCL resulting from a 6, 15 and 30 per cent termination of

delivery rights. In addition the impact of termination on a hypothetical entity identical

to CICL and CIMCL except for its dual cooperative structure has been considered.

Additional commentary on these two aspects has been included in Section 4.1.1,

(Mutuality) and Section 4.2.5 and Appendix D (Case Study).

In undertaking the review, we have had regard to the following information:

The ACCC’s May 2008 Issues Paper on the Water Charge Rules (including

Termination Fees) (“Issues Paper”);

The ACCC’s August 2008 Preliminary Position Paper on Water Charge Rules for

Termination Fees (“Position Paper”);

The ACCC’s Draft advice, draft water charge (termination fees) rules.

The ACCC’s Draft water charge (termination fees) rules for termination fees.

The ACCC’s Explanatory statement, draft rules water charge (termination fees) rules.


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Submissions/input received from Operators in response to the Issues Paper, Position

Paper, or through general consultation. Due to number of submissions we performed

a limited review as set out below:

1) The submissions/inputs received which specifically relate to Question 7 and

25 (taxation related questions) of the Issues Paper (summary analysis

included as Appendix A);

2) Submissions/inputs received by the ACCC in relation to the Position Paper

from CICL/WMI (in a joint submission) and G-MW (summary analysis

included at Appendix B);

3) CICL and CIMCL’s Public Submission to Water Charge Termination Fee

Rules draft advice dated 17 November 2008.

4) MIL’s Public submission to the ACCC draft water market and water charge

rules (termination fees) dated 28 November 2008.

5) The Water Act 2007 (particularly the water charging objectives and

principles).

Various meetings and discussions with members of the ACCC’s Water Charge Rules

team.

Financial statements, calculations and projections made available by the

management of CICL and CIMCL as well as telephone discussions and email

correspondence thereon.

We note that the comments in this paper are limited to income tax and do not extend to

other tax imposts that may apply to the payments (e.g. GST).


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2. Executive Summary

In relation to the specific questions within the scope of this Report, our conclusions are

summarised below:

Whether there are any factors now present that would significantly alter the advice

from PwC in 2006 on the likelihood for the tax timing disadvantage.

There are no additional factors now present that would significantly alter our 2006

advice on the likelihood for a tax timing disadvantage being suffered by the Operators

as a consequence of the receipt of Termination Fees (in place of Access Fees that

would otherwise be received by the Operators).

Specific examples of how a significant tax timing disadvantage could arise upon

receipt of a Termination Fee by irrigation and water service infrastructure

businesses.

Our review of the 28 submissions to the Issues Paper and the 2 submissions to the

Position Paper has identified limited circumstances where a significant tax timing

disadvantage may arise, and/or where a permanent tax disadvantage would occur

(i.e. a cash outflow that would never be recouped). This is supported by the following

facts:

1) Any tax exempt Operators will not suffer any tax timing or other

disadvantages.

2) A number of the Operators operate at a loss, and carry forward significant

pools of tax losses, and are expected to incur future tax losses, such that the

receipt of Termination Fees results in no actual additional tax cost.

3) There are circumstances where an Operator is, and will remain, taxable, such

that the upfront receipt of the Termination Fees may bring forward tax cash

outflows, but this will be offset by a reduction in future year net tax cash

outflows.

4) While there is a risk of potential disadvantage, Operators who currently

benefit from Access Fees being treated as NANE income (e.g. CICL and

CIMCL), may be able to obtain a level of comfort that the replacement

Termination Fees also qualify as NANE income thereby avoiding any tax

timing or permanent disadvantage.

5) In the case of NTER taxpayers obligated to pay their operating profit amount

as either NTER tax payment or dividend to the State Government, any

increase in income tax equivalent that is required to be paid to the State

Government due to the receipt of assessable Termination Fees will decrease

the dividend required to be paid to the State Government. Therefore resulting

in no overall timing disadvantage. NTER taxpayers may only suffer a tax

timing disadvantage where the dividend payout policy entitles the NTER


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entity to retain a percentage of operating profit (e.g. we are aware of

situations where the NTER entity is obligated to pay 65% of operating profit

as either NTER entity or dividend).

Importantly, albeit in limited circumstances, as set out in the following illustrative

example a permanent tax disadvantage may be suffered by the Operator over the life

of the subject assets. In the year of receipt of a Termination Fee, the Operator will

bring a comparatively larger amount into its tax assessable income (assuming the

amount is not treated as NANE income by virtue of the principle of mutuality, or is

otherwise not exempt from tax) but in that year will only be able to claim the same tax

deductions in respect of the underlying infrastructure. However, the Operator will

continue to claim tax depreciation and other costs associated with the maintenance of

the water infrastructure over the life of the Access Fee arrangements. To the extent

that the Termination Fee is calculated by reference to foregone Access Fees over the

life of the subject assets, in most instances the after tax position for the Operator over

the life of the subject infrastructure assets should be approximately the same. The

circumstances where this may not be the case include:

1) Where the Operator is in a current taxpaying position and the receipt of the

Termination Fee results in a higher current year tax liability, and in future

years the reduced Operator income is more than offset by depreciation

deductions giving rise to future year tax losses which are not able to be

recouped against assessable income (under the current tax law, future year

losses cannot be clawed back and offset against prior year taxable income);

and

2) Where the Operator is in a current tax loss position and the dollar value of the

assessable Termination Fee received in a particular year offsets more than

the carry forward tax losses resulting in a tax liability in that year, and the

reduced Operator income in future years gives rise to higher future tax losses

which cannot be clawed back (refer above).


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Base Case – No tax paid over the life of the asset

2008

$M

2009

$M

2010

$M

2011

$M

2012

$M

Total

Other Income 100 100 100 100 100 500

Access Fees 100 100 100 100 100 500

Total Income 200 200 200 200 200 1000

Depreciationdeductions

(220) (220) (220) (220) (220) (1100)

Taxable Income(Loss)

(20) (20) (20) (20) (20) (100)

Cash Outlay(30% Tax Rate)

Nil Nil Nil Nil Nil Nil

Termination Fee received in Year 1 [at nominal value]

2008

$M

2009

$M

2010

$M

2011

$M

2012

$M

Total

Other Income 100 100 100 100 100 500

Termination Fee 500 500

Total Income 600 100 100 100 100 1000


(220) (220) (220) (220) (220) (1100)


380 (120) (120) (120) (120) (480)


114 Nil Nil Nil Nil 114

Furthermore, for completeness we note some Operators operating as co-operatives

have asserted in their submissions that the receipt of Termination Fees (in place of

Access Fees which benefit from the principle of mutuality and are treated as NANE

income) will be a taxable receipt as the Irrigator paying the Termination Fee will

cease to be a member of the co-operative. While the position is uncertain, we

consider that it may be arguable that the principle of mutuality could apply to the

Termination Fee in spite of the departure of the Irrigator (i.e. to the extent that the

water entitlement or delivery income of the Operator currently benefits from the

principle of mutuality, to exclude Access Fee income as NANE income, the


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replacement Termination Fees may also qualify as NANE income). A Private Ruling

could be sought from the Australian Taxation Office (“ATO”) in order the settle this

position1.

Even in the situation where the Termination Fee is assessable, the case study

included at Appendix D supports the conclusion that while a comparative permanent

disadvantage may be suffered by an Operator who otherwise benefits from the

principle of mutuality (eg CICL and CIMCL) as a consequence of the receipt of

Termination Fee amounts in lieu of Access Fee amounts, it is not until the level of

terminations reaches approximately 40% that the position of the mutual Operator

(eg CICL and CIMCL) is comparable to the after tax position of the fully taxable

Operator. This is principally attributable to the fact that the mutual Operator is at a

commercial advantage against a fully taxable Operator, as a consequence of the

mutual Operator excluding from its assessable income a certain level of its Access

Fee income.

How a rule might be drafted to give effect to any necessary tax adjustments in

Termination Fee receipts.

Based on the foregoing, there are limited scenarios where a permanent tax

disadvantage will result from the receipt of Termination Fees by the Operators.

If a rule was introduced which allowed for a gross up of Termination Fees in all

circumstances, Operators who are tax exempt or suffer no disadvantage on receipt of

Termination Fees will, prima facie, enjoy a competitive advantage as compared with

those limited number of Operators subject and liable to income tax who do suffer

some disadvantage from the upfront receipt of Termination Fees. In addition, the

blanket grossing up the Termination Fees transfers a problem, which affects a very

limited number of Operators (based on submissions), to all Irrigators. Therefore a

blanket gross up of all Termination Fees for tax, at the company tax rate of 30%, is

regarded as inappropriate as it is not in line with the overall aim of the Water Charge

Rules (which we understand is to ensure competitive neutrality in the MDB).

As mentioned above, a gross up of Termination Fees for tax may only be warranted

in the limited circumstances where an Operator suffers a permanent tax

disadvantage the size of which cannot be reasonably absorbed by the Operator

(e.g. where an Operator is paying tax at the time a Termination Fee is received, but

anticipates generating net tax losses in future). This being the case, a

commercial/policy issue exists regarding the competitive neutrality of requiring an

Irrigator to pay a higher Termination Fee dependent on the tax profile of the Operator

they have contracted with. This issue is complicated by the fact that a distortion in

trade already exists as a consequence of certain Operators being subject to tax, and

other Operators being exempt from tax. Providing for a ruling that allows adjustments

based on individual business structures may create further incentives to migrate

1 CICL / CIMCL have represented to us that they are in the process of preparing a Private Ruling Requestdealing with this issue.


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towards those type of structures which is not the understood role of the water charge

rules. Arguably any exception to the general rule that Termination Fees should not

be grossed up for tax should focus on nullifying the risk that inappropriate investment

and infrastructure maintenance decisions will be made by Operators.

If an ex ante gross up rule was to be considered, the ACCC could consider the

following rule aimed at compensating Operators for any permanent additional cash

tax outflow:

“The general rule is that there shall be no gross up of the Termination Fee for tax,

except for the circumstances where the Operator can demonstrate to the customer

that it has suffered a permanent additional tax cashflow disadvantage because:

the Termination Fee is assessable for income tax (i.e. principle of mutuality does

not apply to exclude the income as NANE income, or is not otherwise exempt

from tax ); and

the upfront assessability of the Termination Fee is expected to result in a higher

current year tax outgoing, which is not offset by reductions in future tax

outgoings;

and even in these circumstances the gross up will be limited to the additional

permanent cash tax outflow estimated, on a reasonable basis, to be suffered by the

Operator, and only where the additional permanent cash tax outflow is of sufficient

materiality not to be able to be absorbed by the Operator (i.e. will compromise the

viability of the Operator, or the service standards of the Operator or future investment

by the Operator)2.

In reaching an estimate of the additional permanent cash tax outflow disadvantage

suffered, Operators must have regard to the following:

The Operator should forecast the differential in the forecast taxable profit

or loss over the period reflected in the multiple used to calculate the

Termination Fee; and

The differential in estimated taxable income and associated permanent

additional tax outflow disadvantage is calculated by reference to:

The forecasted net taxable income result, including tax liability paid,

on the basis that the Operator continued to receive Access Fees

instead of an assessable Termination Fee; compared with,

The forecasted net taxable income results, including tax liability

paid, on the basis that the Operator receives an assessable

Termination Fee instead of Access Fees.”

We acknowledge that the above approach involves a degree of compliance

administration for those Operators seeking to gross up the Termination Fee to reflect

the expected tax impact. However, it is considered that this approach will at least

2As a general statement, the gross up of the Termination Fee for tax, even if permitted in qualifying limitedcircumstances, should not always equate to 30% of the Termination Fee.


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maintain the current equity and competitive neutrality between the Operators (given

their respective tax status (taxable or exempt) and profile (taxable or tax loss)).

WMI and CICL have also raised a question as to whether it would be possible to

effect an amendment to tax laws to make the “Termination Fee specifically non-

taxable”3. Presumably given the commentary that precedes these remarks WMI and

CICL are referring to a concession which would apply only to the receipt of

Termination Fees by Operators which benefit from the principle of mutuality. In this

regard we note that the Commonwealth Government has recently adopted a tax

reform agenda and the majority of the available Government resources are likely to

be focussed on this broad tax reform agenda. This raises an open question over the

likelihood of successfully lobbying the Government for legislative change to expressly

exclude Termination Fees from assessable income (even in the absence of a

significant tax reform agenda, we would question the appetite of the Federal

Government to exclude Termination Fees from assessable income where the annual

Access Fees are subject to tax).

3WMI and Coleambally have identified this issue in their submission to the August Position Paper.


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3. Background Facts

3.1 Water Charges

In 2007 the Minister for Climate Change and Water asked the ACCC for advice on water

charge rules, resulting in the ACCC publishing Issues Papers and a Position Paper on

the matter. Water charges aim to ensure Operators have full cost recovery for water

services provided to allow an economically efficient and sustainable use of water

resources and water infrastructure assets in the future.

The Water Act 2007 (“the Act”) came into effect on 3 March 2008. It builds on previous

reform initiatives and brings with it a range of new functions for the ACCC. The Act

creates new institutional and governance arrangements to address the sustainability and

management of water resources in the MDB, one of Australia’s most important

agricultural regions.

The ACCC has issued papers relating to the following matters:

An Issues Paper on water market rules, released in April 2008, which dealt with the

transformation and/or subsequent trade of a transformed water access entitlement;

An Issues Paper regarding water charge rules for charges payable to irrigation

infrastructure Operators, released in May 2008; and

A Preliminary Position paper on water charge rules for Termination Fees, released in

August 2008.

Draft Advice on water charge rules for Termination Fees, released in October 2008.

The ACCC’s process in developing its advice is to consult with stakeholders by seeking

submissions from interested parties to each of the above papers.

Stakeholders in the MDB have different governance frameworks which presents a

different set of issues for the development of water charge rules that contribute to the

objectives and principles of the Act. The Operators in the MDB have varying corporate

governance arrangements within each jurisdiction:

Victorian Operators are statutory authorities owned by the Victorian government

which must submit their corporate plans to ensure compatibility with government

policy.

New South Wales Operators are all privately owned with the majority of the larger

Operators being non-listed, not-for-profit companies in that member/Irrigators are in

effect the shareholders in the entity that owns the infrastructure.

South Australian Operators are all typically private trusts, where the Irrigators are the

members; and


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Queensland has one main Operator which has recently changed its structure from a

statutory government-owned corporation to a company government-owned

corporation.

Each of the above Operators have substantive government and/or independent

regulatory oversight in respect of operations that are privately owned and constituted as

corporations, irrigation districts or trusts.

In giving advice to the Minister regarding the proposed water charge rules in relation to

regulated water charges payable to Operators, the ACCC must have regard to:

the governance arrangements of those Operators;

the current charging arrangements of those Operators; and

the history of the charging arrangements of those Operators

This report will be an input in the development of draft rules relating to Termination Fees

received by Operators. The draft rules, which follow the earlier release of the Issues

Papers and the Position Paper, will lead into the final drafting of the Water Charge Rules

for Termination Fees and the accompanying advice to the Minister.

The ACCC’s final advice on water charge rules for Termination Fees will be provided to

the Minister in December 2008. Prior to the release of this final advice, the ACCC also

released:

a draft decision incorporating draft rules and a supporting statement of reasons; and

held public forums with interested stakeholders to discuss the ACCC’s draft advice.

ACCC’s proposed method to determine Termination Fees

The Act aims to promote the efficient use of, and investment in, irrigation infrastructure,

on-farm infrastructure and facilitate the efficient functioning of water markets in the MDB.

The ACCC has outlined in its papers to date that Termination Fees are necessary to

meet these objectives. In the August Position Paper, the ACCC defines a number of

possible options to determine the level of a Termination Fee and the adoption of a

Termination Fee cap designed to promote efficiency. It concludes that if Termination

Fees are set too low they can deter Operator and Irrigator investment while if they are set

too high they can act as a barrier to rationalisation of infrastructure and on-farm

operations.

Ultimately, if Irrigators terminate access without paying Termination Fees, then Operators

may not be able to recover their committed fixed costs. Over time this may compromise

the viability of Operators, service standards and level of future investment. The prospect

of Irrigators leaving without paying Termination Fees creates revenue uncertainty for

Operators which may undermine investment.


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In addition, if the Operator is in a tax paying position, then its future infrastructure funding

will need prima facie to take account of any associated income tax imposed on its

revenues.

The approach proposed in the position paper was to adopt a multiple of 12 times the

fixed Access Fee in 2006, falling to 8 times in 2015. There is no clear level to set the

multiple at, however the ACCC considers this method is the most appropriate to provide

a reasonable balance between facilitating the efficient functioning of the water market,

whilst also providing efficient investment incentives for both the Operators and Irrigators

involved.

Consistent with the ACCC’s preliminary position, the analysis presented in Appendix D

assumes a termination fee multiple of 8 times fixed Access Fees.

Draft advice position: level of Termination Fees

The maximum Termination Fee that an Operator may impose upon the termination of

access (in whole or in part) is to be the sum of the annual amounts of all fixed Access

Fees associated with the access services provided for the year in which the access is

terminated, multiplied by 10 for the period in which the access is terminated.

This method has been proposed because it delivers an extended period of revenue

stability for Operators, and fee stability for Irrigators. This should be sufficient to give

Operators time to assess the impact of water trading on demand, and to adjust their

operations if necessary.


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3.2 Alternative tax status of the Operators

The Operator could be either a:

Federal income taxpayer under the Income Tax Assessment Act (“ITAA”)

A Federal Income Taxpayer may be able to rely on the mutuality principle to treat

certain receipts as NANE income, and/or rely on other tax exemptions allowed for in

the ITAA to exclude certain amounts of income from assessable income.

National Tax Equivalent taxpayer under the National Tax Equivalent Regime

(“NTER”)

The NTER is a notional federal income tax that applies to certain government

business enterprises (“GBE’s”) which are exempt from Federal income tax (e.g. as

either a public authority pursuant to section 23(d) of the ITAA or as a State and

Territory Body under Division 1AB of the ITAA).

The NTER is administered by the ATO but all NTER payments are made to the State.

There is usually a relationship between the amount of NTER tax paid to the State and

the amount of dividend paid to the State. For example, a defined percentage of pre-

tax operating income may be required to be paid by the GBE to the State as NTER

payments or dividend such that any NTER payments will reduce the dollar value of

the dividend payments that need to be made by the GBE to the State.

Tax Exempt Entity

Certain entities such as community service entities, municipal corporations and

societies established for the purpose of promoting the development of Australia’s

resources, whilst prima facie subject to tax as Federal income taxpayers, are

exempted from tax and not subject to the NTER.

Specifically the information reviewed as part of the preparation of this report identifies the

following Operators as having the following tax status:

MIL submits it is “subject to Federal Income Tax, and has paid tax consistently

since privatisation.”4

G-MW submits it is “still incurring large tax losses” and any effect of Termination

Fees has been immaterial as the carry forward losses have been able to offset any

Termination Fee received.

SunWater submits in its submission that taxation “has nil effect on the Termination

Fees” as SunWater are not assessed on them.

CICL is a federal taxpayer “not-for-profit co-operative, [whose] long term aim is to

not make profit and therefore pay no tax.” CICL asserts that receipt of a

Termination Fee brings larger revenues into assessable income in a particular year

4We note that at the time of our previous advice, MIL, whilst listed as a Federal taxpayer, did not representitself to be in a tax paying position.


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which leads cash flow issues, in circumstances that it will not recoup the additional

depreciation charge because its aim is to not make profit.

CIMCL states that it is a mutual set up to collect levies from members for the

renewal or assets as they reach the end of their usable life and that by virtue of the

principle of mutuality, the levies collected are not taxable as they are for the benefit

of the contributing members.

Murrumbidgee submits they are “subject to the federal income tax regime” however

they “have not experienced any real tax timing disadvantage due to receipt of

Termination Fees.” Murrumbidgee also explains that it has “not experienced any

real tax timing disadvantage due to receipt of termination fees – although

[Murrumbidgee] acknowledges that such circumstances can occur.”

MRFF’s “understanding is that the Operators would have no tax implications [on

receipt of Termination Fees] as they are a not for profit organisations”.


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4. Technical Analysis

As outlined above, the ACCC has engaged PwC to advise on the merits of allowing

Operators to load Termination Fees with tax liabilities in any circumstances. In the

section below we have addressed in detail the specific questions raised.

4.1 Are there any factors that are now present that wouldsignificantly alter the advice from PwC in 2006 on the likelihood forthe tax timing disadvantage?

In October 2006 PwC was engaged by the ACCC to advise on any income tax

implications that may arise on the payment of water access, exit and Termination Fee

charges paid to Operators.

The previous advice focused on the income tax status of Operators listed in the paper -

being either exempt, NTER or Federal income taxpayers. On review of our previous

advice, there have not been any changes that will significantly alter the previous advice.

We note that during the period from October 2006 to date there have been several

changes to the NTER manual, however prima facie the amendments to the NTER

manual are not applicable to Operators subject to the NTER in the scenarios presented.

4.1.1 Application of the Principle of Mutuality

The other significant issue raised in our previous advice, which was reiterated in our

follow up memorandum dated 16 October 2006, was the principle of mutuality. In its

submission in response to the Position Paper, CIMCL have stated that receipt of a

Termination Fee in circumstances where the Irrigator leaves the co-operative will render

the Termination Fee taxable on the basis that the Termination Fee (as compared with the

Access Fees) is not a contribution that the leaving Irrigator will be entitled to participate in

the associated benefits of5.

The concept of mutuality is based on the simple idea that taxpayers cannot make a profit

from dealing with themselves. This concept extends to a group of people whose dealings

together are in pursuit of a common purpose, and not for profit.

In Coleambally Irrigation Mutual Co-Operative Ltd v FC of T (2004 ATC 4835),

Beaumont, Merkel and Hely JJ commented further on the mutuality principle, saying:

5WMI and Coleambally submitted that “Termination Fees would be taxable as the member is terminating

and therefore will not benefit from collection of the levy.”


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“…all that is required is a reasonable relationship between what a member

contributes, and the member’s expected participation in the common fund.”

In the case, the Federal Court held that the mutuality principle does not apply where

members of an entity are prevented from obtaining the value of the entity’s assets. The

effect of this decision was to exclude the application of the mutuality principle to not-for-

profit entities (because to qualify as a not-for-profit entity under State and Territory

legislation, an entity’s constituent documents must prohibit the distribution of surplus

funds to members).

The Coleambally decision went against longstanding principles adopted by the ATO in its

application of the principle of mutuality, particularly with respect to not-for-profits.

Consequently, in response to this decision, there has been a subsequent change in the

law to reinstate the previous principles and section 59-35 ITAA 1997 was inserted:

“59-35 An amount of ordinary income of an entity is not assessable income and

not exempt income if :

(a) the amount would be a mutual receipt, but for the entity’s constituent

documents preventing the entity from making any distribution, whether in

money, property or otherwise, to its members; and

(b) apart from this section, the amount would be assessable income only

because of section 6-5.”

The effect of this amendment was to make it clear that if the only thing preventing an

amount of ordinary income from being a mutual receipt is the fact that the constituent

documents of that entity prevented the entity from making a distribution, whether in

money, property or otherwise to its members, then the amount will be treated as non

assessable, non exempt income for income tax purposes.

Hill J in Coleambally made the following comments which support the fact that the

principle reasoning for his decision in denying the principle of mutuality was the issue of

distribution clauses within the constitutent documents of Coleambally, and therefore if

they had not existed, the principle most likely would have been applied:

“…it suffices here to say that I would be inclined to the view that but for Rules 71

and 75 (distribution and cessation clauses) the principles of mutuality would apply

in the present circumstances such that contributions to CIMCL would not be

income in the ordinary concepts.”

Hill J applied the law correctly as it was then stated, however the law clearly provided for

inconsistencies in relation to not-for-profits who were required by law to include such

distribution and cessation clauses in order to obtain income tax exemption. This

subsequent change to the law, and insertion on s.59-35, effectively re-opens the ability of

not-for-profits to utilise the principle of mutuality. On the basis that the change in the law


22

had the effect of removing the restriction to the application of the principle of mutuality to

the Access Fees received by CIMCL, CIMCL became entitled to treat its Access Fees as

NANE income.

The characterisation of income derived from members as mutual in nature is contingent

on the existence of a strong relationship between a member’s contribution and

participation in the benefits of membership. The Explanatory Memorandum to the Tax

laws Amendment (2005 Measures No 6) Bill 2005 offers some further clarification on the

broad principles:

“Mutuality is a legal principle based on the proposition that a taxpayer cannot

derive income from itself. Under the mutuality principle, if members contribute to

a common fund created and controlled by them for a common purpose, and those

contributing members are essentially the same as those who participate in the

fund, then the member contributions and receipts from member dealings are not

taxable income. Under the principle of mutuality, all or essentially all, the

contributors to a common fund must be entitled to participate in any surplus of the

common fund.”

However, it is not the relationship alone which determines the mutuality of income. Lord

MacMilan, in IRC v Ayrshire Employers Mutual Insurance Association Ltd (1946) 1 All ER

637 reinforces the fact that the mutuality of income is found in the character of the

transaction rather than purely the fact that it is a dealing between members:

“It is not membership or non-membership which determines immunity from or

liability to tax; it is the nature of the transactions. If the transactions are of the

nature of (in this case) mutual insurance, the resultant surplus is not taxable

whether the transactions are with members or non-members… There is nothing

to prevent a mutual insurance company entering into a contract of mutual

insurance with a person who is not a member of the company.”

This clearly illustrates that the Courts consider it the nature of the transactions

undertaken, and not whether it is a transaction with a member, that should determine the

mutuality of the income derived from that transaction.

Furthermore, for mutuality to exist there is precedent to support the notion that it matters

not that the class had been diminished by persons going out of the scheme or that others

may come in their place in the future provided that there is identity between the

contributors and the participators, at least as a class. Upjohn J in Faulconbridge

(Inspector of Taxes) v National Employers Mutual General Association Ltd (1951- 1952)

33 TC 103 said:

“…at any given moment of time the persons who are contributing must be

identical with the persons who are entitled to participate; whereas it follows, in my

judgement, that it matters not that the class had been diminished by persons

going out of the scheme or that others may come in their place in the future.”


23

On the basis of the foregoing, what matters is that the contributions will contribute to

promote the economically efficient and sustainable use of water resources and water

infrastructure for remaining members and not that the class had been diminished by

persons going out of the scheme or that others may come in their place in the future.

This being the case, it would seem arguable that if the arrangements are such that the

Access Fees are exempt from tax by virtue of the principle of mutuality that the

replacement Termination Fees received by the Operators from Irrigators could similarly

be excluded from assessable income even in scenarios where an Irrigator leaves the

collective.

The rules of CIMCL state the objective of the co-operative is to replace, refurbish and

provide future funding for the timely replacement and refurbishment of Coleambally

irrigation infrastructure for the benefit of its members. The primary activities of CIMCL

include repairs, refurbishment, maintenance and infrastructure construction and

establishing reserves sufficient to meet anticipated expenses and liabilities of CIMCL in

the future. To cover these costs, expenses and overheads of CIMCL carrying out its

primary activities, Irrigators are required to pay, Access Fees (ie Sink Fund Levy (“SFL”)

contributions) in addition to the water supply levies paid to CICL.

The crux of the issue is how critical to the conclusion as to the assessability of the

Termination Fee income is the fact that the Irrigator who pays the Termination Fee will

not be a member of the cooperative and therefore will not benefit from the contribution,

and does this fact alter the nature of the Termination Fee (as a prepayment of otherwise

payable Access Fees). The argument in support of the consistent treatment of Access

Fees and replacement Termination Fees could run along the following lines:

The Access Fees received by CIMCL are accepted as NANE income.

The objective of CIMCL is to fund long term irrigation infrastructure requirements

of its members. That is, the Access Fees received by CIMCL are used to fund

the long term sustainability of the irrigation network well into the future -

potentially when many of the current contributing members of the cooperative will

no longer be members, and therefore will not “participate” in the benefits of the

fund.

The Termination Fees are a prepayment of otherwise payable Access Fees by a

Terminating Irrigator.

The members of CIMCL will benefit from the receipt of the Termination Fees in

much the same way as the members of CIMCL will benefit from the receipt of the

Access Fees.

The conclusion as to the correct tax treatment of the Termination Fees is uncertain. We

understand that CIMCL is proposing to make an application for private ruling dealing with

this issue. We recommend that there may be some benefit in CIMCL engaging informally


24

with the ATO prior to finalising its ruling application in order to gauge the degree of

sensitivity around the issue and assess the merits of lodging a ruling request.

Subsequent to this, we recommend that the Operator (eg CICL and CIMCL) review their

position and seek to obtain a Private Ruling from the ATO in relation to the tax treatment

applying to the Termination Fees and the effect of the receipt of Termination Fees on

their otherwise mutual status.

For completeness we note that if a not-for-profit Operator receives both mutual receipts

and other income (e.g. service charges from third party non-members, interest on

investments, or government grants) these other income receipts remain, prima facie,

taxable.

4.1.2 Treatment of expenses incurred by Operators

If a not-for-profit Operator has incurred expenses in earning both assessable income and

non-assessable, non-exempt (mutual receipt) amounts, the tax deduction the Operator

will be able to claim will be limited to the extent that the expenditure is incurred in deriving

the Operator’s assessable income. This means there may be a need to apportion

expenses between those incurred to produce assessable income and those incurred to

produce NANE income.

Broadly speaking expenses incurred can be categorised for income tax purposes as

follows:

Allowable deductions – expenses relating specifically to assessable non-mutual

income, expenses relating to wholly assessable income (e.g. investment expenses),

and non-apportionable deductions including contributions to staff superannuation,

and donations to approved funds, where the Act provides for claims to be deductible

in full;

Non-allowable deductions – expenses relating specifically to the derivation of mutual

income (ie NANE income); and

Partly allowable deductions – expenses incurred in the derivation of mutual and

assessable income (e.g. depreciation, maintenance, printing, postage, stationary,

telephone, electricity, bank charges, rent and insurance). These expenses will need

to be apportioned.

Where the identification and separation of mutual and non-mutual expenses is not

possible, it will be necessary to use a practical and suitable method for apportioning the

expenses. The ATO will accept various methods of apportionment provided:

there is a reason for apportioning the expenditure;

the method chosen is suitable for that type of expenditure;

the method chosen is reasonable and is not arbitrary; and

it gives a correct reflection of the expenditure incurred.


25

4.2 Specific examples of how a significant tax timing disadvantagecould arise upon receipt of a Termination Fee by irrigation andwater service infrastructure businesses.

In the absence of any tax exemptions or other non assessable income determinations

(e.g. as a result of the principle of mutuality) the receipt of income from Access and

Termination Fees will prima facie constitute assessable income under either the federal

income tax or NTER. In the normal course of business Operators receive Access Fees,

which are prima facie assessable for income tax purposes, and claim tax deductions in

the form of depreciation, funding and maintenance costs relating to their infrastructure.

Our review of the 28 submissions to the Issues Paper and the 2 submissions to the

Position Paper has identified limited circumstances where a significant tax timing

disadvantage may arise, and/or where a permanent tax disadvantage would occur (i.e. a

cash outflow that would never be recouped).

We note the following:

Any tax exempt Operators will not suffer any tax timing or other disadvantages.

A number of the Operators operate at a loss, and carry forward significant pools of

tax losses, and are expected to incur future tax losses, such that the receipt of

Termination Fees results in no actual additional tax cost.

There are circumstances where an Operator is, and will remain, taxable, such that

the upfront receipt of the Termination Fees may bring forward tax cash outflows, but

this will be offset by a reduction in future year net tax cash outflows (resulting in no

real disadvantage).

While there is a risk of potential disadvantage, Operators who currently benefit from

Access Fees being treated as NANE income (e.g. CICL and CIMCL), may be able to

obtain a level of comfort that the replacement Termination Fees also qualify as NANE

income thereby avoiding any tax timing or permanent disadvantage.

In the case of NTER taxpayers obligated to pay their operating profit amount as either

NTER tax payment or dividend to the State Government, any increase in income tax

equivalent that is required to be paid to the State Government due to the receipt of

assessable Termination Fees will decrease the dividend required to be paid to the

State Government. Therefore resulting in no overall timing disadvantage. NTER

taxpayers may only suffer a tax timing disadvantage where the dividend payout policy

entitled the NTER entity to retain a percentage of operating profit (e.g. we are aware

of situations where the NTER entity is obligated to pay 65% of operating profit as

either NTER entity or dividend).

However, tax timing disadvantages and permanent tax disadvantages could potentially

arise upon receipt of assessable Termination Fees by Operators in circumstances where


26

the Operator is subject to federal income tax or NTER tax equivalent6 (subject to the

additional comments below) and is tax paying. In the year of receipt of a Termination

Fee, the Operator will bring a comparatively larger amount into its tax assessable income

(assuming the amount is not treated as NANE income by virtue of the principle of

mutuality, or some other exemption) but in that year will only be able to claim the same

tax deductions in respect of the underlying infrastructure. However, the Operator will

continue to claim tax depreciation and other costs associated with the maintenance of the

water infrastructure over the life of the Access Fee arrangements. To the extent that the

Termination Fee is calculated by reference to foregone Access Fees over the life of the

subject assets, in most instances the after tax position for the Operator over the life of the

subject infrastructure assets should be approximately the same. The circumstances

where this may not be the case include:

Where the Operator is in a current taxpaying position and the receipt of the

Termination Fee results in a higher tax liability, and in future years the reduced

Operator income is more than offset by depreciation deductions giving rise to future

year tax losses which are not able to be recouped against assessable income (under

the current tax law, future year losses cannot be clawed back and offset against prior

year taxable income); and

Where the Operator is in a current tax loss position and the dollar value of the

assessable Termination Fee received in a particular year offsets more than the carry

forward tax losses resulting in a tax liability in that year, and the reduced Operator

income in future years gives rise to higher future tax losses which cannot be clawed

back (refer above).

Furthermore, for completeness we note some Operators operating as co-operatives have

asserted in their submissions that the receipt of Termination Fees (in place of Access

Fees which benefit from the principle of mutuality to be treated as NANE income) will be

a taxable receipt as the Irrigator paying the Termination Fee will cease to be a member of

the co-operative. Whilst the position is uncertain, we consider that it may be arguable

subject to the comments made at item 4.1.1 that the principle of mutuality could apply to

the Termination Fee in spite of the departure of the Irrigator (i.e. to the extent that the

water entitlement or delivery income of the Operator currently benefits from the principle

of mutuality, to exclude Access Fee income as NANE income, the replacement

Termination Fees may also qualify for as NANE income). A Private Ruling could be

sought from the Australian Taxation Office (“ATO”) in order the settle this position.

The examples below outline a variety of different scenarios which result in either a tax

timing disadvantage or a permanent tax disadvantage.

6Where the NTER entity is not obligated to distribute its operating profit as either NTER payment(s) ordividend.


27

4.2.1 Tax continually paid over the life of the assets - Timing

A tax timing disadvantage can arise where the Operator is a Federal income tax payer, or

is subject to the NTER7, who is consistently in a tax payable position. WMI and

Coleambally have addressed this point in their submission stating that after removing the

two abnormal income producing events that have existed during the last 7 years, CICL’s

average yearly profit since privatisation is $0.782M. “This figure is an accurate

representation of the long-term profit expectations of CICL and is consistent with a

principle of minimising profits without losing money in the long term. Based on CICL’s tax

rate of 30%, this produces an average yearly tax bill of $0.235M.”

The example below is based on facts similar to the scenario CICL has identified above.

Upon receipt of a Termination Fee, the Operator will bring comparatively larger revenues

into its assessable income in that year. However they will only be able to claim the same

tax deductions for the underlying infrastructure as in previous years. We emphasise that

this is only a tax timing disadvantage and the permanent tax disadvantage is nil (i.e. in

the long term, disregarding the time value of money).

Base Case – Tax continually paid over the life of the asset

2008

$M

2009

$M

2010

$M

2011

$M

2012

$M

Total

Other Income 100 100 100 100 100 500

Access Fees 100 100 100 100 100 500

Total Income 200 200 200 200 200 1000


(80) (80) (80) (80) (80) (400)


120 120 120 120 120 600


36 36 36 36 36 180

7Where the NTER entity is not obligated to distribute its operating profit as either NTER payment(s) ordividend.


28


2008

$M

2009

$M

2010

$M

2011

$M

2012

$M

Total

Other Income 100 100 100 100 100 500


Total Income 600 100 100 100 100 1000


(80) (80) (80) (80) (80) (400)


520 20 20 20 20 600


156 6 6 6 6 180

As demonstrated above, the initial tax liability paid of $156M in year one will be recouped

through a reduction in the tax payable in future assessable income years as Access Fee

revenue will decrease resulting in a tax timing disadvantage. Effectively the only

difference is that the tax outlaid is brought forward to year one instead of being spread

over the 5 years and therefore results in no permanent difference (i.e. total tax cash

outlaid is $180M in both scenarios).

4.2.2 Operator with carry forward losses - Timing

A tax timing disadvantage can also arise in the scenario where an Operator has brought

forward losses. The receipt of a Termination fee may bring forward the point at which the

Operator begins to pay tax. Several submissions were received addressing this point.

WMI and Coleambally submitted that “no disadvantage occurs if the Termination Fee

collected is smaller than the tax losses” being carried forward. However “if the fee is

greater [than the carry forward tax losses], a tax timing disadvantage will occur.”8 In their

submission, G-MW state that “the receipt of Termination Fees will erode [carry forward]

tax loss[es] at a faster rate than would otherwise have occurred, bringing forward the

timing of when an operator will enter a tax paying position.9”

In the illustrative examples below, the Operator has accumulated brought forward losses

at the outset of $600M.

8 WMI and Coleambally have identified this issue in their submission to the August Position Paper9 G-MW has identified this issue in their submission to the August Position Paper.


29

Base Case – Carry forward losses utilised by Year 5

2008

$M

2009

$M

2010

$M

2011

$M

2012

$M

Total

Other Income 100 100 100 100 100 500

Access Fees 100 100 100 100 100 500

Total Income 200 200 200 200 200 1000


(50) (50) (50) (50) (50) (250)

Losses utilised (150) (150) (150) (150) - (600)


Nil Nil Nil Nil 150 150

Carried forwardloss

(450) (300) (150) Nil Nil Nil


Nil Nil Nil Nil 45 45


2008

$M

2009

$M

2010

$M

2011

$M

2012

$M

Total

Other Income 100 100 100 100 100 500

Termination fee 500 Nil Nil Nil Nil 500

Total Income 600 100 100 100 100 1000


(50) (50) (50) (50) (50) (250)

Losses utilised (550) (50) Nil Nil Nil (600)


Nil Nil 50 50 50 150

Carried forwardloss

(50) Nil Nil Nil Nil Nil


Nil Nil 15 15 15 45


30

Again in this example the overall tax liability is the same in both scenarios. A tax timing

disadvantage results to bring forward a part of the total tax liability from year 5 to

years 3 and 4.

4.2.3 No tax paid over the life of the assets - Permanent

An alternative scenario which could arise is where an Operator is a Federal income tax

payer or is subject to the NTER10 and is consistently making income tax losses. When a

Termination Fee is received by such an Operator and it results in the Operator being in a

tax payable position at year end, a permanent tax disadvantage may arise if they

continue to make income tax losses in future years. This is illustrated in the numerical

example below:


2008

$M

2009

$M

2010

$M

2011

$M

2012

$M

Total

Other Income 100 100 100 100 100 500

Access Fees 100 100 100 100 100 500

Total Income 200 200 200 200 200 1000


(220) (220) (220) (220) (220) (1100)


(20) (20) (20) (20) (20) (100)



10Where the NTER entity is not obligated to distribute its operating profit as either NTER payment(s) or

dividend.


31


2008

$M

2009

$M

2010

$M

2011

$M

2012

$M

Total

Other Income 100 100 100 100 100 500


Total Income 600 100 100 100 100 1000


(220) (220) (220) (220) (220) (1100)


380 (120) (120) (120) (120) (480)



As demonstrated above, a permanent tax disadvantage occurs when the initial tax liability

paid on the Termination Fee, of $114, will not be recouped in future years due to the

Operator continuing to make income tax losses.

4.2.4 Operator with carry forward tax losses - Permanent

In addition, a permanent tax disadvantage can arise in the situation where an Operator,

which is a Federal income tax payer or is subject to the NTER, is not in a tax payable

position and has carry forward losses. If on receipt of Termination Fee the carry forward

losses are not sufficient to offset the increase in assessable income received, the

Operator may become liable to pay income tax during the period in which it would have

otherwise received Access Fees that would have been offset by carry forward losses.

A numerical example is included below:


32

Base Case – Operator with Carry Forward Tax loss

2008

$M

2009

$M

2010

$M

2011

$M

2012

$M

Total

Other Income 100 100 100 100 100 500

Access Fees 100 100 100 100 100 500

Total Income 200 200 200 200 200 1000


(220) (220) (220) (220) (220) (1100)


(20) (20) (20) (20) (20) (100)

Carry forward taxloss

(20) (40) (60) (80) (100) (100)

Cash Outlay (30%Tax Rate)


Termination Fee received in Yr 3 [at nominal value]

2008

$M

2009

$M

2010

$M

2011

$M

2012

$M

Total

Other Income 100 100 100 100 100 500

Access/TerminationFees

100 100 300 Nil Nil 500

Total Income 200 200 400 100 100 1000


(220) (220) (220) (220) (220) (1100)


(20) (20) 140 (120) (120) (260)

Carry forward taxloss

(20) (40) Nil (120) (240) (240)

Cash Outlay (30%Tax Rate)

Nil Nil 42 Nil Nil 42

The net cash outlay of $42 in the example above is a permanent tax disadvantage if the

Operator continues to make tax losses in future years.


33

However, no permanent tax disadvantage will arise where the Operator has carry forward

losses that are sufficient to absorb the assessable Termination Fee received in the

relevant period (and the Operator continues to generate tax losses in future years).

4.2.5 Termination Fee not treated as mutual receipt - Permanent

The worst case scenario would result where a Federal taxpayer who benefited from the

principle of mutuality in relation to their Access Fees entitlements received a Termination

Fee which was treated as taxable. Not only would there be an upfront tax liability, but any

losses carried forward would also be reduced. WMI and CICL draw attention to this

possibility in their joint submission in response to the Position Paper, stating: “CIMCL

collects levies on behalf of the members for the future replacement of assets. As a

mutual the levies are not taxable because they are collected from the members for the

benefit of the members. Interest and other income are taxable. The advice that has

been received is that termination fees would be taxable as the member is terminating and

therefore will not benefit from collection of the levy.” The example below illustrates the

result in this scenario.


2008

$M

2009

$M

2010

$M

2011

$M

2012

$M

Total

Other Income 100 100 100 100 100 500

Access Fees(non taxablemutual income)

100 100 100 100 100 500

Total taxableincome

100 100 100 100 100 500


(220) (220) (220) (220) (220) (1100)


(120) (120) (120) (120) (120) (600)




34


2008

$M

2009

$M

2010

$M

2011

$M

2012

$M

Total

Other Income 100 100 100 100 100 500

Termination Fee(taxable)

500 500

Total taxableincome

600 100 100 100 100 1000


(220) (220) (220) (220) (220) (1100)


380 (120) (120) (120) (120) (480)



In this scenario, not only does a tax liability of $114M result on receipt of the Termination

Fee, but at the end of the period carried forward losses are $600M in the Base Case but

only $480M in the Termination Fee example.

Although this is the case where you are comparing the relative position of a particular

Operator who benefits from the mutuality principle (ie mutual Operator), when a

comparison is made with the after tax position of a fully taxable Operator, the taxation of

the Access Fees in a mutual structure retains its advantage against a fully taxable

Operator until the level of terminations approximate 40%11.

This is primarily attributable to the fact that compared with a fully taxable Operator a

mutual Operator does not pay tax on its mutual Access Fees (and may incur very little

expenditure in the derivation of the mutual income). The effective swapping of mutual

Access Fees for taxable Termination Fees in a mutual Operator erodes the relative

advantage of the mutual Operator as compared with a fully taxable Operator.

Furthermore a material permanent disadvantage is not likely to be suffered by the mutual

Operator until the 30% level of terminations [refer to the case study attached at

11The case study at Appendix D supports that at a termination of delivery rights of 40% the net present value

of tax liabilities in the CICL and CIMCL group and its counterfactual fully taxable business become

comparable.


35

Appendix D12 which supports the potential disadvantage at 30% terminations to be in the

region of 20% of the after tax position].

This disadvantage could be offset by investment of the Termination Fees not required to

meet the current needs of CICL / CIMCL - such that the extent of the disadvantage could

be reduced well below the 20% of the after tax position - determined in the absence of

investment returns.

When factoring in investment returns, the results at Appendix D reflect a potential

disadvantage in the region of 7.9%.

Finally we understand that even these implications can be further mitigated as at these

levels of termination of delivery rights (ie when terminations exceed 30% or more), some

rationalisation may be possible and cost savings may be generated. Any impact of

terminations above that level may therefore be offset to an extent by such savings.

4.3 How a rule might be drafted to give effect to any necessary taxadjustments in Termination Fee receipts

Based on our review of the submissions, and as explored in the section above, there are

only limited circumstances where a material permanent tax disadvantage may arise from

the receipt of Termination Fees.

In many circumstances the advance receipt of Access Fees in the form of Termination

Fees, would either be non-assessable, offset by the Operators carry forward tax losses or

would merely cause a tax timing disadvantage that would be recouped in future years

(e.g. SunWater, MI and G-MW). In these circumstances it is arguable that no gross up is

appropriate.

4.3.1 Blanket gross up of Termination Fees to offset tax disadvantages

If a rule was introduced which allowed for a gross up of Termination Fees in all

circumstances, Operators who are exempt from income tax or suffer no real tax

disadvantage as a consequence of the receipt of a Termination Fee(s) will, prima facie,

have a competitive advantage against those Operators subject and liable to income tax.

12The case study reflected at Appendix D compares the relative position of a mutual Operator with a fully

taxable Operator taking account of the taxation liabilities that accrue from a 6, 15 and 30 per cent

termination of delivery rights. The case study assumes, consistent with the proposition presented by

CIMCL, that CIMCL’s access fee income is non-assessable by virtue of the mutuality principle, but

termination fees are treated as taxable. The hypothetical or counterfactual business operates as a single

entity whose income (access fees and termination fees) are assessable (this represents the more typical

tax treatment for an operator which is subject to tax). The assumptions used in and the results emanating

from the case study are included at Appendix D.


36

In addition by allowing the gross up the Termination Fees, the result will be to transfer a

problem, which only affects a very limited number of Operators (based on submissions),

to all Irrigators. Therefore a blanket gross up of all Termination Fees for tax, at the

company tax rate of 30%, is regarded as inappropriate as it is not in line with the overall

aim of the Water Charge Rules (which we understand is to ensure competitive neutrality

in the MDB13).

4.3.2 Specific gross up of Termination Fees to offset permanent taxdisadvantages

As mentioned above, a gross up of Termination Fees for tax may only be warranted in

the limited circumstances where an Operator suffers a permanent tax disadvantage the

size of which cannot be reasonably absorbed by the Operator (e.g. where an Operator is

paying tax at the time a Termination Fee is received, but anticipates generating net tax

losses in future). This being the case, a commercial/policy issue exists regarding the

competitive neutrality of requiring an Irrigator to pay a higher Termination Fee dependent

on the tax profile of the Operator they have contracted with. This issue is complicated by

the fact that a distortion in trade already exists as a consequence of certain Operators

being subject to tax, and other Operators being exempt from tax. Arguably any exception

to the general rule that Termination Fees should not be grossed up for tax should focus

on nullifying the risk that inappropriate investment and infrastructure maintenance

decisions will be made by Operators.

If an ex ante gross up rule was to be considered, the ACCC could consider the following

rule aimed at compensating Operators for any permanent additional cash tax outflow:

“The general rule is that there shall be no gross up of the Termination Fee for tax,

except for the circumstances where the Operator can demonstrate to the customer

that it has suffered a permanent additional tax cashflow disadvantage because:

the Termination Fee is assessable for income tax (i.e. principle of mutuality does

not apply to exclude the income as NANE income, or is not otherwise exempt

from tax ); and

the upfront assessability of the Termination Fee is expected to result in a higher

current year tax outgoing, which is not offset by reductions in future tax

outgoings;

and even in these circumstances the gross up will be limited to the additional

permanent cash tax outflow estimated, on a reasonable basis, to be suffered by the

Operator, and only where the additional permanent cash tax outflow is of sufficient

materiality not to be able to be absorbed by the Operator (i.e. will compromise the

viability of the Operator, or the service standards of the Operator or future investment

by the Operator)14.

13To the extent that competitive neutrality can be achieved given the distortion in trade which exists by virtueof the different tax status of the Operators (fie federal taxpayer, NTER entity or tax exempt).

14As a general statement, the gross up of the Termination Fee for tax, even if permitted in qualifying limitedcircumstances, should not always equate to 30% of the Termination Fee.


37

In reaching an estimate of the additional permanent cash tax outflow disadvantage

suffered, Operators must have regard to the following:

The Operator should forecast the differential in the forecast taxable profit

or loss over the period reflected in the multiple used to calculate the

Termination Fee; and

The differential in estimated taxable income and associated permanent

additional tax outflow disadvantage is calculated by reference to:

The forecasted net taxable income result, including tax liability paid,

on the basis that the Operator continued to receive Access Fees

instead of an assessable Termination Fee; compared with,

The forecasted net taxable income results, including tax liability

paid, on the basis that the Operator receives an assessable

Termination Fee instead of Access Fees.”

We acknowledge that the above approach involves a degree of compliance

administration for those Operators seeking to gross up the Termination Fee to reflect the

expected tax impact. However, it is considered that this approach will maintain equity and

competitive neutrality between the Operators (irrespective of their tax status (taxable or

exempt) and profile (taxable or tax loss)).

The Operator would need to demonstrate and support to the Irrigator in question that it

will incur a permanent additional cash tax outgoing due to receipt of Termination Fees

which will not be offset by the reduction of tax paid in future years. This would be based

on an estimated/reasonable expectation of the additional permanent tax disadvantage

and the Operator would have to provide sufficient details regarding the additional tax

outgoing suffered and be able to quantify and substantiate the loss that is being

estimated based on a mandatory set of criteria, benchmarks, formats and information as

set by the ACCC (refer above for an example). It will be necessary for the Operators to

forecast results, similar to the scenarios outlined in 4.2.1 to 4.2.5, with regard to the

period reflected in the multiple used to calculate the Termination Fee (e.g. If Access Fees

are multiplied over 11 years then the Operator will need to provide the Irrigator with an 11

year forecast).

Where Operators and Irrigators are unable to reach agreement, the ACCC may be

required to resolve the issue by enforcing the rule and compliance with the overall

process.

4.3.3 Other Options to offset tax disadvantages resulting from receipt ofTermination Fees

Based on the comments above, grossing up Termination Fees may not be the most

equitable or practicable method to offset even the permanent tax disadvantages that may

arise on receipt of Termination Fees for a select few Operators that may be affected.


38

We note that WMI and CICL have raised a question as to whether it would be possible to

effect an amendment to tax laws to make the “Termination Fee specifically non-

taxable”15. Presumably given the commentary that precedes these remarks WMI and

CICL are referring to a concession which would apply only to the receipt of Termination

Fees by Operators which benefit from the principle of mutuality. In this regard we note

that the Commonwealth Government has recently adopted a tax reform agenda and the

majority of the available Government resources are likely to be focussed on this broad

tax reform agenda. This raises a question over the likelihood of successfully lobbying the

Government for legislative change to expressly exclude Termination Fees from

assessable income (even in the absence of a significant tax reform agenda, we would

question the appetite of the Federal Government to exclude Termination Fees from

assessable income where the annual Access Fees are subject to tax).

15 WMI and Coleambally have identified this issue in their submission to the August Position Paper.


39

4.3.4 Gross Up Calculation

For completeness, to the extent to which the Operators are permitted to gross up the

Termination fees for income tax, the gross up should prima facie be calculated by

reference to the level of permanent cash tax disadvantage suffered by the Operator.

CICL and CIMCL submit that the gross up of the Termination Fee should be calculated

as set out in the following example:

$M

Pre tax Termination Fee 100

Gross up 42

Grossed up Termination Fee 142

Prima facie income tax @ 30% 42

Net of tax Termination Fee 100

While this is prima facie correct, this formula fails to take account of the potential for the

actual additional tax liability suffered by the Operator to be less than 30% of the

Termination Fee received (refer to the worked examples at Item 4.2.3 and Item 4.2.5

where the permanent tax disadvantage suffered was limited to $114M which was less

than 30% of the $500M (ie $150M), and example at item 4.2.4 where the permanent tax

disadvantage suffered was limited to $42M which was less than 30% of the $300M (ie

$90M).

Appendix A – Summary of Tax Elements in Issues Paper Submissions


40

Submission Question 7 Question 25

The Allen Consulting

Group

Question not addressed Question not addressed

The Bondi Group Question not addressed Question not addressed

The Bourke Shire

Council


Callandoon Water

Board


Central Irrigation

Trust


Coleambally Irrigation

Co-operative Ltd

Question 7(b):

“As a not-for-profit co-operative, our long

term aim is to make no profit and therefore

pay no tax. Consequently, there should be

little difference to other entities (non taxed)

across the basin.”

Question 25:

“CICL has a fixed tax uplift to account for

the worst case scenario (30%) and applied

it to all. Note that the 30% real tax timing

disadvantage results in an uplift of 42.8%

because the tax is applied on the uplifted

amount. See response to Question 7e for

details and basis”



41


Question 7(e):

“One customer currently holds more than

20,000ML of entitlement within CICL.

They wish to take that out. This equates

to a termination fee of over $6 million

(CICL + CIMCL) pre tax uplift. Our annual

operating budget is in the order of $9-10

million and our aim is no profit. We have

to bring that termination fee into our

income and it will therefore attract 30%

income tax as it is too large to offset

against our typical expenditure. The

entitlement is about 4% of our total

entitlement. Where only small amounts

(less than 250 ML) are traded out the

impact is negligible and the real tax timing

disadvantage can be absorbed. But, with

large amounts like this (and they may be

higher if COAG lifts the 4% limit) the real

tax timing disadvantage is very close to

the 30%. Our options are:

(i) Have varying degrees of tax uplift

depending on the quantity traded out

(administrative nightmare);

(ii) Have a fixed tax uplift to account for

the worst case scenario (30%) and

apply it to all (CICL’s approach).

Note that the 30% real tax timing

disadvantage results in an uplift of

42.8% because the tax is applied on

the uplifted amount.

D Ferguson & P Leslie Question not addressed Question not addressed

Trangie-Nevertire

Irrigation Scheme

(TNIS)


Dept of Natural

Resource and Water

(Qld)

Question not addressed Question 25:

“Taxation has nil effect on the termination

fees”

D W Sehestedt Question not addressed Question not addressed

E O Whittle Question not addressed Question not addressed



42


Goulburn-Murray

Water (G-MW)

Question 7:

“G-MW is subject to the National Tax

Equivalents Regime”

Question 25:

“G-MW has not yet made taxation

adjustments to termination fees. G-MW

believes that adjustments are warranted in

situations where post-tax revenue stream

would not otherwise be sufficient to

provide the intended price stability for

remaining delivery system customers.

“For G-MW, any Government grants for

capital purposes will be treated as an

equity contribution direct to the balance

sheet and not included as revenue for

taxation purposes. Other treatments are

similar to those outlined in the Issues

Paper.”

“G-MW is still incurring large tax losses as

tax depreciation is still calculated using

accelerated depreciation rates, and

therefore tax issues have not materialized

yet. As the tax losses reverse in the future

other tax treatments will gain importance.”

“Termination fee receipts to date have

been immaterial. However the taxation

implications will need to be modelled and

they will need to incorporate a tax impact

or there will be real revenue leakage.”

M Brady Question not addressed Question not addressed

Macquarie River Food

& Fibre

Questions 7:

“MRFF’s understanding is that the

operators would have no tax implications

as they are not for profit organizations and

although they may accumulate funds over

a period these are only for reserve

purposes for time of need. With respect to

irrigators, they should not be taxed on

transforming a Water License into a Water

Access License as this is a government

process not a sale. Any tax liability would

only occur at a trade and not

transformation.”

Question not addressed



43


Minerals Council of

Australia


Murray Irrigation

Limited

Question 7

“Murray Irrigation is subject to Federal

Income Tax, and has paid tax consistently

since privatisation.”

Question 25:

“Termination fees treated as taxable

income and incurs company tax liability.”

“Competitive neutrality does not (occur)

where company tax is paid by some

irrigation operators and as a result of

institutional arrangements and

arrangements with Government and not

others.”

“…a distortion to trade exists where

company tax is paid by some irrigation

operators and not others due to prior

arrangements with Government or their

institutional structure.”

“In response to the ACCC’s question on

whether taxation adjustments are made to

termination fees; and on what basis are

they made, Murray Irrigation advises that

termination fees are treated as taxable

income under current tax laws. This

means that the taxed paid on termination

fee income is an unavoidable and

legitimate “cost of business” and should

be added to the termination fee. This

ensures that the irrigation operator is able

to pay the relevant tax ensuring the

remaining customers are no worse off.”



44


“In respect of the ACCC’s question

examples of where a significant,

inexorable, real tax timing disadvantage

has been experienced from the receipt of

termination fees, Murray Irrigation advises

that this matter has not arisen as a tax

issue. However, termination fees are

treated as taxable income and tax will be

payable upon their receipt.”

Murrumbidgee

Irrigation Ltd

Question 7

“MI is subject to the federal income tax

regime.”

Question 25:

“MI currently makes no adjustment for tax

in the calculation of its termination fees.”

“Water delivery prices may vary across the

basin due to varying tax obligations.

However, the effect is likely to be small.

Taxation should be given much lower

priority than other more important issues

in the water charge rules.”

“MI… has not experienced any real tax

timing disadvantage due to receipt of

termination fees – although we

acknowledge that such circumstances can

occur.”

Narromine Irrigation

Board of Management


National Farmers’

Federation


National Water

Commission


NSW Farmers

Association


NSW Irrigators

Council


NSW Murray Wetlands

Working Group




45


South Australia

Murray Irrigators


Southern Riverina

Irrigators & Rice

Growers Association


SunWater Question 7

“SunWater is a Queensland Owned

Corporation which is subject to the

National Tax Equivalents Regime.”

Question 25

“SunWater advise that taxation has nil

effect on the termination fees. The payout

is based on lower bound costs and no tax

liabilities or tax credits arise.”

T Lofler Question not addressed Question not addressed

Victorian Farmer’s

Federation


Western Murray

Irrigation Limited

Question not addressed Questions 15:

“WMI applies GST but makes no taxation

adjustments”

Appendix B – Summary of Tax Elements in Position Paper Submissions


46

Submission Income Tax Related Comments

Goulburn-Murray Water (G-MW) “This position appears to assume that all operators do not face any tax

timing impacts from termination fees, and all are in the same tax loss

position. This general assumption will inappropriately disadvantage

those operators who are in a tax paying position, or are likely to enter a

tax paying position in the near future.

More significantly, the ACCC has dismissed the legitimate costs to

operators from the tax timing effects. Even where businesses are in tax

loss positions, the receipt of termination fees will erode that tax loss at a

faster rate than would otherwise have occurred, bringing forward the

timing of when an operator will enter a tax paying position.

G-MW submits that termination fees include the timing impacts on tax

costs to the business, namely the bringing forward of tax costs including

the bringing forward of the expected date where tax is likely to be

payable for operators currently in tax loss positions.

To do otherwise would undermine the objective of revenue adequacy,

failing to consider what is typically recognised as a legitimate cost to

infrastructure owners.”



47


Joint submission by Western Murray

Irrigation Limited and Coleambally

Irrigation Co-operative Limited

“A significant issue for both co-operatives in Coleambally is the taxation

recommendations sitting on pages 29-30 of the main body of the

position paper. No reference is made to this in the summary section

and could easily be missed. CI strongly objects to the ACCC’s position

“not to allow adjustments to termination fees to account for taxation

liabilities”.

As stated earlier, CIMCL collects levies on behalf of the members for the

future replacement of assets. As a mutual the levies are not taxable

because they are collected from the members for the benefit of the

members. Interest and other income are taxable. The advice that has

been received is that termination fees would be taxable as the member

is terminating and therefore will not benefit from collection of the levy.

With CIMCL being in an accumulation phase and the next major

expenditures due in 2020-2025, tax on the termination fee does result in

a real tax timing disadvantage of the full 30%. That is, the tax goes form

zero to 30% with no costs being able to be offset against it.

For CICL, the effect is nearly the same. In the seven full years that

CICL has been in existence the average yearly profit has been

$1.784M. This figure has been distorted by two abnormal events in the

past two years. In 2006-07, CICL sold 3,500ML of conveyance licence

to Water for Rivers for $4.9M. In 2007-08, $2.113M was received from

Water Smart Australia (NWC program) for the first year’s works of the 4

year Coleambally Water Smart Program ($12.53M in return for 4,400ML

of conveyance licence). Once the Water Smart program is finished it is

expected that CICL would seek no further funding (or give up more

water). Revenue streams such as this are not sustainable in the long

term as CICL would eventually run out of water entitlement to sell –

running the capital down to pay expenses is not sustainable. With these

abnormals removed the average yearly profit since privatisation is

$0.782M. This figure is an accurate representation of the long-term

profit expectations of CICL and is consistent with a principle of

minimising profits without losing money in the long term. Based on

CICL’s tax rate of 30% this produces an average yearly tax bill of

$0.235M.”



48


“In the same period, the average yearly income from members (access

fees) was $5.907M. Therefore CICL tax as a percentage of the access

fee revenue is 3.97%. The effective tax rate on any termination fees will

be 30%, as all deductions will have already been offset against the

normal revenue. Therefore the tax timing disadvantage to CICL is

greater than 26%. Given that irrigation is facing a tougher future and

the profits may be less in the future, uplifting the termination fee by 30%

is not unreasonable.

The example in the position paper on page 30 regarding a tax loss

position has a couple of problems. The first problem is that no

disadvantage only occurs if the termination fee collected is smaller than

the tax loss. If the fee is greater, a tax timing disadvantage will occur.

The second problem is that an organisation, which is in a tax loss

position for an extended period, is either losing money or running down

their infrastructure. Neither position is sustainable. Neither position is

position an option for CICL when the expectation is that the

infrastructure and system will be available in perpetuity.

The alternative option is for the termination fee to be non-taxable.

Although this is not the domain of the ACCC it could still be a

recommendation to the Minister for reference to the ATO. Alternatively,

the government could pass legislation to that effect – are they serious

about water reform or not?”

Appendix C – Summary of Tax Elements in Submissions in response toDraft Termination Fee Rules


49


Coleambally Irrigation

17 November 2008

Tax Impacts

The tax timing disadvantages noted as exceptions in the PwC report

apply to the two CI cooperatives. The first exception applies to CIMCL,

the second to CICL. Therefore the after tax receipts of the termination

fees would be 25-30% lower than the actual fees. This turns the 10x

multiple into a 7 or 8x multiple and less than 10 years of access fees.

It should be noted that these are real impacts. The draft advice suggests

that they can be offset by actions such as avoiding fixed cost in the

future and changing the pricing structure. It also states that there would

be limited impact before the review is conducted in 2012-13.

The costs cannot be avoided. That is why they are called unavoidable

costs. Efficiency gains have been made. The “low hanging fruit” is

already gone. Any remaining gains will be expensive and produce

minimal gains. If gains can be made, they will reduce the access fees

and therefore the termination fees, anyway.

Changing from postage stamp pricing cannot produce significant gains. If

it does it would have to mean that an individual farm’s charges would rise

dramatically as irrigators on the same channel exited. It would also

skyrocket that irrigators termination fee to such an extent that they could

never afford to leave. These surely fall under the “perverse or unintended

pricing outcome.” noted in Schedule 2 of the Water Act. As another point

to note, the costs of running various channels in the CIA (and probably

most systems) do not vary greatly unless irrigators have exited from that

channel. Otherwise, they will not produce the kind of gains needed to

offset the tax impacts.

As to the limited impact before the review in 2012-13, CI has more than

30,000ML (>%6%) sitting on its books waiting to leave the area. If this is

repeated in the years until the review is conducted, the difference

between tax uplift and no tax uplift could be huge.

Appendix C – Summary of Tax Elements in Submissions in response toDraft Termination Fee Rules


50


Murray Irrigation Limited

28 November 2008

Murray Irrigation welcomes the ACCC’s support for the legitimacy of a

termination charge. Murray Irrigation also welcomes the ACCC

proposing a termination charge which is not diminishing. However, the

combined impact of the ACCC’s termination charge on Murray Irrigation

and its members is significant and will be much greater than for any

other infrastructure operator.

There are three compounding issues;

1) Multiple of 10 times rather than the 15 included in

Schedule E of the Murray Darling Basin Agreement;

2) No increase for Company Tax; and

3) The termination charge being based on the actual access charge.

The ACCC’s PricewaterhouseCoopers’ report identifies that where an

operator is in a current tax paying position, receipt of termination fees

may result in a permanent tax disadvantage. This is the case for Murray

Irrigation and the draft advice should explicitly state that where an

infrastructure operator is in a current tax paying position, there may be a

permanent tax disadvantage to the operator. The discussion around

taxation highlights the significant differences between operators’

corporate structures and tax status, which make it very difficult to

establish a competitively neutral market in water delivery. Trying to

impose identical rules for all simply will not work fairly.

Appendix D – Case Study Assumptions and Results


51

Assumptions



52

No Terminations



53

6% Terminations



54

15% Terminations



55

30% Terminations, No Investment Return



56

30% Terminations, 4% Investment Return

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