In 1997 the taxpayer merged by way of a scheme of arrangement with Advance Bank Australia Ltd. As a consequence of that merger the taxpayer needed to augment its capital base, in order to comply with the Reserve Bank of Australia's requirement that all banks in Australia maintain certain minimum ratios of capital to risk-weighted assets. In June 1997 LLC raised, in the capital markets of the United States, the sum of US$350 million. Upon raising the funds LLC then on-lent them to the taxpayer in return for a debenture. The debenture required the payment of interest. In the years of income 1999 to 2003 the taxpayer paid LLC interest.
The taxpayer claimed those interest payments as deductions. The Commissioner disallowed the deductions. The taxpayer appealed to the Federal Court (Allsop J), which dismissed the appeal. The taxpayer appealed to the Full Court.
The court unanimously dismissed the appeal, holding that the interest payments were all outgoings of a capital nature within s 8-1(2)(a). Perram J (Emmett and Stone JJ agreeing) held that the payments of interest were an essential element in an overall transaction whose purpose was to achieve a structural advantage accruing to the company by meeting the requirements as to its capital structure. At paras 98 and 102-3 his Honour said:
"It is difficult to be definitive about these matters but when commercial circumstance, or regulatory obligation, impose upon a company particular requirements as to its capital structure, the cost of meeting those requirements may, in some cases, be capital in character. They will be capital in character if the structural advantage accruing to the company by meeting the requirements as to its share capital is an advantage of the kind referred to by Dixon J in Sun Newspapers. Where the conclusion is reached that the structural advantage sought is sufficient to render the outgoings associated therewith as capital in nature, it is important to be clear that that capital nature has nothing to do with the fact that the structure in question is in the shareholders' capital. In that sense, the word "capital" carries with it a considerable risk of conceptual confusion in the context of s 8-2(a). Indeed, it is the structure, rather than the medium in which the structure is expressed, which gives the advantage its capital nature.
The existence of shareholders' equity in a bank increases its ability to absorb losses. The absorption of losses is, no doubt, a benefit to any business, but in the case of banks that utility has the additional beneficial effect of maintaining the confidence of its depositors. The sudden evaporation of that confidence may lead to a significant proportion of depositors withdrawing their funds which, in turn, may expose a bank to a risk of insolvency. It is precisely the need to avoid such losses of confidence and their concomitant damage to the economic system which has led to the introduction of capital adequacy requirements. In this case, compliance by St George with the RBA's requirements had the immediate effect of improving the ability of St George to withstand losses. That ability went to the heart of St George's business as a bank, namely, its continued ability to maintain the confidence of its depositors. It also had, as Hill J pointed out in Macquarie Finance Ltd v Commissioner of Taxation  FCA 1170; (2004) 210 ALR 508 at 512 ..., the superadded effect of allowing the bank to expand its operations where, but for the capital raising, the bank would be prohibited by PSC1 from incurring further debts to make loans.
103 The increased ability to maintain the confidence of depositors and the associated ability to increase the size of its loan book were advantages 'of a lasting character' which enured for the benefit of the 'profit earning subject' which was St George: cf. Sun Newspapers at 361 per Dixon J."
St George Bank Ltd v FCT  FCAFC 62 (Federal Court, Full Court, Emmett, Stone and Perram JJ, 25 May 2009)
For a copy of the decision, go here.