Explanatory Memorandum(Circulated by the Treasurer, the Hon. Leslie Bury)
The general principle of the income tax law (as expressed in section 51 of the Principal Act) is that interest on borrowed money that is incurred by a company in producing its assessable income, or is necessarily incurred by a company in carrying on business for the purpose of producing such income, is an allowable deduction in arriving at the company's taxable income on which its tax is based.
By contrast, dividends paid by a company on its share capital are not an allowable deduction in calculating taxable income.
The effect of these basic rules is that profits of a company that are used to pay dividends effectively bear tax in its hands; if used to pay interest they do not.
On the view that interest paid on convertible notes - on the terms on which the notes were then being issued - had generally more in common with non-deductible dividends on deferred shares than deductible interest on borrowed money, the Principal Act was amended in 1960 by the insertion of section 51AB. Subject to some transitional measures, that section provided that interest incurred by a company on convertible notes was not to be deductible from the assessable income of the company where the notes were issued after 15 November 1960.
As already explained, it is proposed by this Bill to restore deductibility of interest on convertible notes issued after the amendments proposed by the Bill become operative, where the issue is made on terms specified in the Bill. Interest on convertible notes issued between 15 November 1960 and the commencement of this Bill, and convertible notes issued after the commencement of this Bill which do not satisfy the proposed conditions for deductibility, will continue to be non-deductible for income tax purposes.
The following comments outline in a general way how the proposed tests to determine the deductibility of interest on convertible notes will operate.
Firstly, it will be necessary that the convertible notes be issued by a company in respect of moneys subscribed to it by way of loan after the new provisions come into operation, or in respect of a loan raised after that time to replace a non-convertible fixed-term fixed-interest loan subscribed in money. It will also be necessary that conversion of the borrowed moneys into share capital may only take place as a result of the noteholder himself exercising an option to have shares allotted or transferred to him (referred to in the Bill and these notes as an "option to convert"). The issuing company will not be able to take the right to decide whether or not a note is to be converted into equity capital. The noteholder's option may, however, be to acquire shares in the company issuing the notes or in another company, either by the allotment of new shares or the transfer of shares already issued. The subject shares must, in any event, be fully paid-up shares.
The holder's option to convert must be first exercisable by him no later than 24 months after the date on which the note was offered for subscription and last exercisable within the period of twelve months that ends on the maturity date of the borrowing, provided that the period during which the option may be exercised ends no later than 10 years after the date the note was offered for subscription. The option to convert must remain open for exercise by the noteholder throughout the period between the date on which the option may first be exercised and the last date fixed for the exercise of the option. This test will, however, be met if it is open to the noteholder to exercise the option at any time during the option period or, alternatively, if it is open to him to exercise the option during that period at not more than twelve-monthly intervals. A company issuing convertible notes may, of course, provide in the terms of issue that the option to convert is exercisable at all times between the date on which the note is issued and the date of maturity of the loan, subject to the 10 year limitation referred to earlier.
The period of the loan to which the convertible note relates must, except in the case of a foreign loan, be not less than 7 years measured from the date when the notes are offered for subscription. This will not, however, mean that an appropriate part of the loan cannot be retired at an earlier time on a noteholder exercising his option to have shares allotted or transferred to him. Nor will the test preclude provision for repayment of a loan before 7 years in the terms relating to the issue as a safeguard to noteholders (as creditors of the company) in the event of the company defaulting in some way in its obligations in respect of the borrowing.
In fixing the amount to be paid for shares by a noteholder on the exercise of his option to convert, it will be necessary, if interest under the notes is to qualify as an income tax deduction, for the company to set a "conversion price" that is not less than an amount specified in the legislation. In broad terms, this is to be the nominal (or par) value of fully paid-up shares of the kind that is to be allotted or transferred on conversion or 90 per cent of the market value of that kind of share (which must be fully paid-up) at a "valuation date" occurring two weeks before the date of offer of the notes for subscription, whichever of these two amounts is the greater. This necessarily means that the share which a noteholder may acquire, if he exercises his option to convert, must be a fully paid-up share of the same class as shares which have been allotted, and are fully paid-up, at the time that the notes are offered for subscription.
There are to be two bases for determining the market value of a relevant share at the valuation date. Although the bases are different they are designed to achieve, so far as practicable, the same broad result.
If relevant fully paid-up shares were traded on an Australian stock exchange or exchanges in the 3 months period ending on the valuation date, the value of a share for the purposes of the "conversion price" will be the weighted average selling price of such shares in the latest month in that period in which sales were recorded. If it is not practicable to determine the market value of a relevant share in this way, e.g., in the case of unlisted shares or of listed shares that were not traded during the three months referred to above, the value for purposes of fixing a "conversion price" is, subject to certain safeguards, to be taken as the amount which a registered company auditor certifies could be expected, on his view of the company's affairs, to be the price for which a relevant fully paid-up share in the capital of the company would have been sold in a transaction between persons dealing at arm's length from each other, if there had been such a sale on the valuation date.
Finally, it will be necessary that the rate of interest on the notes remain the same so long as the loan continues, and that the terms of the note issue (for example, those dealing with the conversion price and the amounts payable on redemption of the notes) do not vary according to the length of time for which a noteholder holds the notes. These tests are modified slightly for foreign loans so that the terms on which notes relating to those loans are issued may provide for the rate of interest to be adjusted periodically in line with movements in interest rates in a particular international market, and for other terms and conditions to become less favourable the longer the notes are held.
In broad outline, these are the principal tests proposed for determining whether a convertible note issue, made after the amendments proposed by this Bill come into operation, is eligible for tax deductions for interest incurred on it. Other provisions supplement the essential tests and are, in the main, designed as safeguards against circumvention of those tests. These other provisions are explained later in this memorandum.
As a matter of drafting, it has been found expedient to repeal section 51AB of the Principal Act and to insert in it a new Division (sections 82L to 82T) dealing with convertible notes. Parts of this Division will re-enact the terms of section 51AB. The re-enacted provisions are, however, expressed not to apply in relation to a convertible note that satisfies the tests proposed in other parts of the new Division, principally in proposed section 82S.
Notes on each provision of the Bill are set out below.